Graham and Harvey (2002) and Meier and Tarhan (2007), estimated binary models explaining choices of capital budgeting methods, as in Brounen, De Long, Koedijk (2004) and Hermes, Smid, and Yao (2007). However, there is still a shortage of studies looking into cross-sectional determinants of the choices of capital budgeting methods determinants of the choices of capital budgeting methods in a broader context. Meier and Tarhan (2007) asserted that (1) over time, firms show an increasing tendency to use DCF-based methods, (2) firms mostly uses WACC as the discount rate, and (3) when computing the discount rate, the cost of equity is typically inferred from the CAPM. They found an increasing usage of these methods and models over time. These findings suggest an increasing sophistication in capital budgeting over time. Buyer seller

Below are some of the determinants of the choices of capital budgeting methods;

Real Options

Jagannathan and Meier (2002) show that a hurdle premium (a hurdle rate higher than the cost of capital) may capture the option value, and that, given the uncertainty associated with the cost-of-capital, managers may choose a single, high enough hurdle rate that is near optimal for a range of costs of capital. They predict that a higher hurdle premium would be more likely for projects that require the use of skilled manpower, or special purpose facilities that take time to build and face organizational constraints, and lock in much of the capacity of the firm. For such projects, the option to wait would be more valuable, and hence the hurdle rate used might be higher independent of the project’s systematic risk. i.e. firms with complex projects would have a higher hurdle rate premium.

McDonald (2006) suggests that the simultaneous use of many capital budgeting methods parallel to DCF, such as IRR, payback, and P/E multiples, may mean that managers perform a variety of formal calculations, and then make decisions by weighing the results and also using subjective judgment. A part of such judgment may represent their “adjustments” of DCF methods to take real option values into account.

Agency Problems

Poterba and Summers (1995) suggest that some managers may set hurdle rates above their required returns as a way to correct for overly optimistic cash flow projections in projects they are asked to consider. For project managers (the ones who suggest the projects for top managers) to want to push their projects in such a way, there must be some rewards from getting their projects approved. Also relying on an agency explanation, Berkovitch and Israel (2004) suggest that in large corporations with a relatively high likelihood of realizing good investment opportunities, a centralized capital allocation process with hurdle rates above the cost of capital will be used. Smaller, manager owned companies will only consider the NPV rule, and the owner”s personal preferences.

Martin (2008) suggests that also the use of a single discount rate instead of project specific rates may have its roots in managerial incentives to get projects, which benefit them personally, approved. Such incentives could encourage managers to inflate the expected cash-flows, and, if possible, understate project risks. While systematic inflation of cashflows is relatively easy to detect ex-post, it is harder to determine whether the discount rate used has been appropriate. To curb with the problem, firm may restrict the use of discount rates to a single one. Martin (2008) suggests that larger and more bureaucratic firms with multiple levels of management might be more subject to such incentive problems as compared to smaller firms run by their owners.

Political Risk

Holmen and Pramborg (2006) focus on capital market imperfections, and suggest that since political risk may be non-linear, and involve a high degree of qualitative judgment, firm may tend to use of rules of thumb such as the payback method. They report that in their sample of Swedish firms, the use of NPV decreases with the political risk of the host country, and the use of the payback method increases.

CEO / CFO Characteristics

Manager Qualifications such as the level of their knowledge of capital budgeting methods may also matter. Graham and Harvey (2002) find that CEOs with MBAs are more likely than non-MBA CEOs to use NPV. Also Brounen et al. (2004) and Hermes et al. (2007) find that CFO”s education (as well as age, in Hermes et al. 2007) is significant determinants for whether the firm uses NPV.

Short-Term Pressure

Several studies (e.g. Graham et al. 2006), have reported evidence of value-destroying actions / myopic management decisions. If the managers feel pressure to produce improved results above all in the short-term, even actions that hurt long-term performance may be undertaken. Liljeblom and Vaihekoski (2009) studied effects of such short-term pressure. Using ownership data on the main owners, they grouped firms in potentially more long-term vs. short-term oriented firms and found that reported WACCs (based on survey data) were significantly higher (17.1% vs. 12.8%) among firms grouped as potentially more short-term oriented.