Capital Budgeting in Utility companies and political risk

capital_budgeting_and_political_risk capital_budgeting_in_utility_sector
Using the attached two files on capital budgeting and the textbook Lasher, W. R. (2011). Practical financial management. Mason, OH. South-Western Cengage Learning, explore the capital budgeting techniques Net Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR), and Payback. Compare and contrast each of the techniques with an emphasis on comparative strengths and weaknesses. Be sure to show you understand how each is applied and used in capital budgeting decisions.

Assemble into a 2-3 page, properly formatted APA paper with accompanying citations and references.

I have compiled the answer for it, should you need please send me a message with your budget.

Capital Budgeting and Political Risk:
Empirical Evidence

Martin Holmén

Department of Economics, Uppsala University, Uppsala, Sweden

Bengt Pramborg

Swedbank, SE-105 34 Stockholm, Sweden

Abstract

This paper surveys and investigates Swedish firms’ use of capital budgeting techniques for
foreign direct investments. We document that the use of the theoretically correct net
present value method decreases with the political risk in the host country, and that the use
of the Payback method increases with the political risk. We conclude that in the presence
of capital market imperfections, unsystematic and country-specific political risks are
important. Because these risks are difficult to estimate (rendering high deliberation costs)
managers are inclined to use simple rules of thumb for their capital budgeting decisions.
Our results can partly explain why surveys find that alternative methods such as the
Payback method are frequently used despite their theoretical drawbacks.

1. Introduction

Several authors have pointed out that the way capital budgeting is taught

and practiced presents a paradox (see, e.g., Weingartner, 1969; Mao, 1970;

Stanley and Block, 1984; Arnold and Hatzopoloulos, 2000). Typically,

students in corporate finance are taught that a project will increase the

shareholder value if its net present value (NPV) is positive. The NPV is

computed by forecasting the project’s cash flow and discounting it at a

discount rate reflecting the price charged by the capital markets for the cash

flow risk. For investors with well-diversified portfolios, only the project’s

systematic risk affects its value: its idiosyncratic risk should not be

considered. Capital market imperfections such as costly external financing

and bankruptcy costs are mostly ignored when it comes to the way capital

budgeting is taught (Stulz, 1999).
1

The authors would like to thank Annika Alexius, Fredrik Berchtold, James Dean, Nils Gottfries,
Niclas Hagelin, Mattias Hamberg, Juha-Pekka Kallunki, Ted Lindblom, Lars Norden, Thomas J.
O’Brien, Jonas Råsbrant, Iwan Meier, and Stefan Sjögren for their valuable comments. Comments
from participants at the 2005 SNEE conference, the 2006 FMA European Conference, the EFMA
2006 Annual Conference, and at seminars at University of Gothenburg, Stockholm University, and
Uppsala University are also acknowledged. Financial support from Jan Wallander and Tom
Hedelius Research Foundation is gratefully acknowledged.

Journal of International Financial Management and Accounting 20:2 2009

r 2009 Blackwell Publishing Ltd.

, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

In practice, the NPV method is used extensively, but it is by no means

the only technique used. Alternative methods, such as the Payback method

and the use of earnings multiples, are also common. The payback is seen as

possibly the most seriously flawed method, because it ignores the time value

of money and cash flows beyond an arbitrary cut-off date. Surprisingly,

Graham and Harvey (2001) report that 57 per cent of the CFOs in their

survey of US firms always or almost always use the Payback method in

capital budgeting decisions, as compared with the 76 per cent (75 per cent)

using the NPV method [internal rate-of-return (IRR)]. The use of the

Payback method seems even more popular in Europe, as reported by

Brounen et al. (2004). They find the Payback method to be the most

frequently used method among firms in the United Kingdom, Germany,

and France, and it is also very common in the Netherlands, where it is the

second most popular method after the NPV.

In this paper, we provide survey evidence on firms’ capital budgeting

methods for foreign direct investments (FDIs) and we investigate the

potential impact of idiosyncratic country-specific political risk on the

capital budgeting process.
2
We provide evidence as to whether such risks

may help explain why firms rely on alternative methods, such as the

Payback method, despite their theoretical flaws. Political risks are most

likely to be associated with high deliberation costs, i.e., substantial

resources spent to make estimates of cash flows and the risk profiles

for FDIs in

countries with high political risk.

3
It is possible that

managers avoid these costs by using rules of thumb, such as the Payback

method, instead of the more information intensive, and therefore costly,

NPV method. If so, this would support the theoretical concept of

bounded rationality, according to which decision makers, when facing

high deliberation costs, use rules of thumb in an effort to approximate

optimality (Baker et al., 2004).

We survey Swedish firms and combine the survey responses

with unique data from the Swedish central bank on each firm’s FDIs

per country and the Economist Intelligence Unit’s (EIU) political risk

indices. This dataset enables us to approximate the political risk of each

firm’s portfolio of FDIs and test (i) whether political risks are related to

the choice of capital budgeting method and (ii) whether firms adjust the

chosen methods for political risks. Previous research has explored how

various firm and manager characteristics correlate with the choice of

capital budgeting method. However, as far as we know, the relation

between firms’ investment risk characteristics and the choice of capital

budgeting method has not previously been explored.

106 Martin Holmén and Bengt Pramborg

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The survey responses suggest that a majority of firms make adjust-

ments for country-specific political risks when evaluating FDIs. In

addition, many firms indicated that they use different decision criteria

for FDIs in countries with higher political risk (developing countries) as

compared with FDIs in countries with lower political risk (developed

countries). Our cross-sectional analysis indicates that when firms evalu-

ate FDIs, the use of the NPV method decreases and the use of the

Payback method increases with political risk. Possibly, managers find it

problematic to assess political risk when using the NPV method and are

therefore more likely to rely on the Payback method as a rule-of-thumb

when these risks are significant. This supports the argument of Baker et

al. (2004) of bounded rationality in the capital budgeting process.

The paper makes two general contributions to the capital budgeting

literature. First, because political risks most likely are unsystematic, our

findings highlight the importance of market imperfections in capital

budgeting. Second, the tendency to use the Payback method instead of

the NPV method when there are substantial unsystematic risks, documen-

ted in the paper, can partly explain why a number of surveys have found

the Payback method to be frequently used, despite its theoretical draw-

backs (see, e.g., Graham and Harvey, 2001; Sandahl and Sjögren, 2003).

The rest of the paper is organized as follows. The next section provides a

discussion on the discrepancy between theoretical recommendations and

corporate practice and our research questions. Section 3 contains a descrip-

tion of the questionnaire and the data. We also define the variables used in

the empirical analysis. In Section 4, we present our results. Finally, Section 5

concludes and puts our results into the perspective of earlier literature on

possible explanations as to why firms frequently use the Payback method.

2. Arguments for using alternative methods

Earlier empirical research has shown the use of alternative methods to

the NPV to be very common (Graham and Harvey, 2001; Sandahl and

Sjögren, 2003; Brounen et al., 2004; Liljeblom and Vaihekoski, 2004).

The common use of the Payback period is seen as especially surprising.
4

Several possible explanations for the use of the Payback method have

been discussed in the literature. Weston and Brigham (1981, p. 405)

suggest that it may be rational for cash constrained firms to use this

method. If an investment project does not create positive cash flows at an

early stage, the firm will cease its operations and will therefore not receive

positive future cash flows, or else will not have the resources to pursue

Capital Budgeting and Political Risk 107

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other investments during the next few years. Other suggested explana-

tions for the use of the Payback method is that it may be used by

managers to approximate the riskiness of a project (Mao, 1970; Ehrhardt

and Brigham, 2003, p. 265), that it can approximate the option value of

waiting to invest (Boyle and Guthrie, 1997; McDonald, 2000)
5
, and that

it can be explained by the lack of sophistication of management (Graham

and Harvey, 2001).
6

In this paper, we focus on capital market imperfections and deliberation

costs as explanations for the use of the Payback method. With perfect

capital markets, unsystematic risks should not be of any importance.

Investors with well-diversified portfolios can diversify unsystematic risk

and their required return reflects systematic risk only. Therefore, rational

value-maximizing managers should evaluate investment projects using the

NPV rule, with a discount rate reflecting systematic risk. Because country-

specific political risk most likely is unsystematic, it should not influence the

required rate of return.
7
However, markets are not perfect, and theoretical

advances within the fields of corporate risk management and capital

structure have shown that total risk may be of importance for financial

management.
8
In fact, Harvey (2000) and Mishra and O’Brien (2005) find

that total risk is the most significant risk factor in explaining ex ante equity

returns in emerging markets.

It might be argued that effects of political risks could be included by

rational managers in an NPV analysis. Several authors have discussed

and modeled how firms should incorporate political risk in their capital

budgeting and a number of ad hoc adjustments to the discount rate have

been developed by investment banks (e.g., Godfrey and Espinosa, 1996).

Many of these models employ equity market return volatility as a risk

factor, based on political risk intuition.
9
Other, more theoretical models

are often relatively difficult to implement (see, e.g., Clark, 1997, 2003;

Mahajan, 1990; Pointon and Hooper, 1995; and Shapiro, 1978). Further-

more, political risks may be non-linear, and a complication is that they

are usually accessible as qualitative judgments only, such as a scaling

from one to five (which is what we use in this paper). Erb et al. (1996a)

show that country risk measures are correlated with future equity returns

and equity valuation. However, translating political risk measures into

estimates of probabilities and expected shortfalls or risk premiums in the

capital budgeting process is complex, especially as the estimated para-

meters may change over time. Therefore, estimating the effects of events

in politically risky countries incurs high deliberation costs. Because

managers have limited available resources, they may be inclined to use

108 Martin Holmén and Bengt Pramborg

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rules of thumb to avoid these costs and proxy for the optimal decision.

Baker et al. (2004) argue that boundedly rational managers cope with

complexity by using rules of thumb in financial management that ensure

an acceptable level of performance and, hopefully, avoid severe bias.
10

As an example, consider the risk that the host country will expropriate

the firm’s FDI. The risk of expropriation is probably negligible until the

project is fully developed (Mahajan, 1990). However, at some point in

time, the risk of expropriation and the associated cost of financial distress

increase significantly.
11

Thus, the present value of expected cash flow

declines significantly after this point in time and the FDI’s NPV is, to a

large extent, determined by the short-term cash flows. Furthermore, the

deliberation costs associated with correctly estimating the risk of

expropriation and the cost of financial distress beyond this point might

be high. Focusing on the short-term cash flows using the Payback

method as a rule of thumb under these conditions may, in fact, (i)

roughly approximate an optimal decision by the NPV method and (ii)

avoid large deliberation costs.

Based on the above discussion, we set out to answer two research

questions: First, we investigate whether firms rely less on the NPV

method and more on rules of thumb when there are large investment-

specific risks for which data is difficult to access or evaluate; in this case

political risk. We specifically ask how firms’ use of the NPV method and

the Payback method is affected by political risk in the host country. If the

deliberation cost were positively correlated with political risk, we would

expect to find an increased use of rules of thumb (Payback method) with

increased political risk.

Second, we investigate if firms adjust the capital budgeting methods

for political risk in the host country. We document the use of several

adjustment methods, and cross-sectionally investigate whether firms

adjust the payback period based on the level of political risk. If the

deliberation cost increases with political risk, firms may be inclined to

shorten the payback period, in effect reducing the forecast period

necessary for making decisions. Segelod (2000), using a survey and

follow-up interviews with executives, finds that managers shorten the

payback period when political risk is higher. Based on this, we expect

that firms will shorten the payback period when making investments in

countries with relatively high political risk.

Our research questions are related to Erb et al. (1996b). Using country

credit risk ratings, they construct expected equity returns and equity volati-

lity estimates for 135 countries, many of which did not have a functioning

Capital Budgeting and Political Risk 109

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equity market at the time. The expected hurdle rates and volatility estimates

are then used to develop payback measures related to the statistical concept

of hitting time. The equity investors can then compare the hitting time with

his or her expectations about political and economic risks. In our capital

budgeting framework, the corporate manager evaluating a FDI when

deliberation costs are high, e.g., no equity market in the host country,

will rely on the Payback method. Furthermore, the higher the political risk,

the shorter the required payback period.

3. Data and Method

In this section, we discuss the survey design, present the questionnaire,

and detail the sampling procedure including the robustness tests we

performed. In addition, we discuss the choice of firm characteristic

variables and the limitations of the data.

3.1 Survey Design and Sample Collection Procedure

Several surveys concerning firms’ capital budgeting practices have been

conducted. Most of these focus on how capital budgeting methods vary

with firm characteristics and over time.
12

Our survey and research design

differ from previous surveys in some dimensions. First, we focus on

capital budgeting for FDIs and survey firms’ use of different capital

budgeting methods for this purpose.

Second, we survey how firms manage political risks when investing

abroad. Several authors have suggested that firms could manage political

risks by pre-investment planning, e.g., buying insurance, structuring the

investment, and/or developing local stakeholders.
13

We survey to what

extent firms actually use these pre-investment strategies to manage

political risks. In addition, we survey whether firms use more stringent

investment criteria and/or different decision criteria when investing in

countries with high political risk.

Third, we relate each firm’s capital budgeting methods to its

actual portfolio of FDIs. Thus, we are able to investigate whether the

capital budgeting methods of a firm with its entire FDIs in low-risk

countries differ from the methods used by firms with some of their FDIs

in high-risk countries. In particular, we focus the analysis on whether

firms are more likely to use the Payback method instead of the

theoretically correct NPV method when the risk of expropriation is

perceived to be high.

110 Martin Holmén and Bengt Pramborg

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The questionnaire was deliberately kept as short as possible in an

attempt to increase the response rate. In this paper, we use three

questions from the survey (see Appendix A for an English translation):

Popularity of different capital budgeting methods: The first question

asked respondents rank how often they use each of a number of capital

budgeting methods.

Methods to manage country-specific political risk: Respondents were

asked to rank how often they use each of a number of methods to manage

country-specific risks. These methods include the adjustments of cash

flows and discount rates as well as e.g., purchasing political risk insurance.

Different decision criteria: Finally, the respondents were asked to

indicate whether they use different decision criteria for investments in

developing countries and developed countries.

In September 2003 with a follow-up in November the same year the

questionnaire was sent to the CFOs of the Swedish firms that had

responded to a survey from the Swedish central bank (Riksbanken) in the

spring of 2003, regarding how much FDI the firm had invested as of

December 2002 (we exclude firms that replied that they had no FDIs). A

total of 497 firms met the criteria and 200 responded, 72 of which only

answered after the follow-up. From the 200 responses, 145 are usable (54

firms responded that the questions were irrelevant for them, for example

because the FDIs had been made some years before. For one firm there is

no accounting data).
14

The ratio of usable responses to the total number

of recipients is 0.291. Compared with other surveys, e.g., Graham and

Harvey (2001) and Brounen et al. (2004), with response rates of 0.12, and

0.05, respectively, this is a high response rate.

We performed two tests to check for response bias. First, we compared

respondents to non-respondents by means of Wilcoxon rank sum tests,

on nine variables.
15

This test indicates no response bias with one

exception: respondents were significantly larger than non-respondents.

Then, we compared the respondents that answered directly to the firms

that only responded after a reminder. This second test, also using

Wilcoxon rank sum tests on nine variables, indicated no response bias.

To check whether it can be expected that the documented size bias will

affect our conclusions, we used a classification, similar to that of Graham

and Harvey (2001), and Brounen et al. (2004), where firms were

considered small if they had total sales of oUSD100 million, mid-sized
if their sales were in the range USD100–1,000 million, and large if their

sales exceeded USD1,000 million. We used the currency exchange rate

SEK/USD as of December 31, 2002, which equals 8.75, to translate SEK

Capital Budgeting and Political Risk 111

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denominated numbers into USD. Using this classification, 63 (50) of the

usable responses are from small (mid-sized) firms and 32 are from large

firms.
16

Thus, the sample mainly contains smaller firms. We expect that

any possible bias will not seriously affect our findings, because the

numbers of firms in the respective category indicate that we should be

able to distinguish size effects cross-sectionally.

3.2 Firm Characteristics

Because we sent the questionnaire to firms that responded to the

Riksbank that they had FDIs, we have ascertained that we have a

sample containing firms with FDIs. Further, the Riksbank survey asked

respondents to specify their FDIs on a country-by-country basis, which

the Riksbank has kindly let us share. Our final sample of 145 firms

reported a total of 1,152 FDIs to the Riksbank and the average firm had

FDIs in eight countries representing on average 25 per cent of its assets.
17

Because the Riksbank data gives us information as to in which countries

firms have FDI, we can calculate a measure of the political risk to which

these FDIs are exposed. From the EIU, we gather information for 61

countries on expropriation risk (and other indices on political risk). Using

this data, we create a firm-specific political risk variable, which is defined

as the weighted average of the EIU index values over the period 1995–

2002.
18
The weights are the proportion of total FDI in each country. The

firms in our sample have FDIs in 4120 countries, so our index is not
complete. However, for most firms, the index covers more than 90 per

cent of total FDI. For the 13 firms with lower index coverage, there are

only six countries missing, namely the three Baltic states, Bermuda,

Luxembourg, and the United Arab Emirates. For these countries, we set

the risk measure on par with countries we estimated to be similar in terms

of political risk.
19

We also use robustness tests to handle these countries,

which are discussed below.

We complement the data from the survey and the risk indices with

publicly available information on firm characteristics. Table 1 reports

descriptive statistics for our sample and formalizes our variable definitions.

Earlier surveys (see, e.g., Graham and Harvey, 2001) have found that larger

firms, highly levered firms, and public firms more commonly use the NPV

method. Therefore, we include these variables as explanatory variables

(Size, Leverage, and Public, as defined in Table 1). It is also possible that

managers in public firms and larger firms are more sophisticated and

therefore less likely to use the Payback method (Graham and Harvey,

112 Martin Holmén and Bengt Pramborg

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Capital Budgeting and Political Risk 113

Table 1. Descriptive statistics

Variable Definition

Source Q1 Median Q3 Mean

Panel A: Firm characteristics

Size Total assets (MSEK) FR 477 2,005 6,218 3,610
Leverage Long term debt � total assets FR 0.09 0.21 0.35 0.25
Liquidity Current assets � short-term debt FR 1.31 1.71 2.46 2.49
Fixed asset ratio Fixed assets � total assets FR 0.88 0.94 0.98 0.91
Investment rate (Yearly change in fixed assets1

depreciation) � fixed assets
FR �0.02 0.08 0.21 0.13

Public Indicator variable for listed firms SSE — — — 0.35
Industry Indicator variable for firms in

capital intense industries
RB — — — 0.66

%FDI Foreign direct investment �
total assets

RB, FR 0.06 0.18 0.35 0.25

Exprop Risk
a

A country-weighted average
of expropriation risk

RB, EIU 1 1 1.07 1.10

GDP growth A country-weighted GDP
per capita growth rate (%)

RB, WB 2.59 2.90 3.29 3.04

Source Q1 Median Q3 Mean

Panel B: Country data

Expropriation risk in countries with FDI
[total no. is 61 (67)]

EIU 1 (1) 1 (1.5) 2 (2) 1.65 (1.67)

GDP growth in countries with FDI
(total no. is 67)

WB 2.16 3.23 4.12 3.30

Top five countries with FDI: RB

No. of firms Total amount
1. Norway (81) 1. USA (28.3%)
2. Denmark (73) 2. Germany (12.9%)
3. Finland (71) 3. Great Britain (11.7%)
4. Germany (63) 4. The Netherlands (7.2%)
5. Great Britain (56) 5. Denmark (5.6%)

The table displays variable definitions and descriptive statistics. Panel A displays firm
characteristics, and Panel B displays statistics on host countries. All variables are defined using
book values unless otherwise stated. The data sources are: FR, Financial Reports ending in the
year 2002; SSE, The Stockholm Stock Exchange; RB, Riksbanken (the Swedish Central Bank);
EIU, the Economist Intelligence Unit; and WB, the World Bank. The risk of expropriation
rating scores countries between 1 and 5, with 5 indicating highest risk and 1 lowest risk. The
descriptive statistics include: Q1, the first quartile; median; Q3, the third quartile; and the mean
value. Panel B displays country statistics on: the average value from 1995 to 2002 of the
expropriation index for countries with FDIs, where the risk of expropriation rating scores
countries between 1 and 5, with 5 indicating highest risk and 1 lowest risk; and the average value
from 1995 to 2002 of GDP growth per capita. Panel B displays statistics on the top five countries
in terms of how many sample firms that had FDIs in the country (the values in parentheses
include six countries for which the authors assigned a political risk index, see footnote 10); and
on the top five counties regarding how much FDI the country received (percentage of total FDI
in parenthesis).
a
The EIU index originally runs from ‘‘1’’ 5 riskiest to ‘‘5’’ 5 safest. As we want to interpret
riskier countries as having higher values, our index is calculated as Exprop Risk 5 �(EIU index
– 6), which creates an index that runs from ‘‘1’’ 5 safest to ‘‘5’’ 5 riskiest.
EIU, Economist Intelligence Unit.

r 2009 Blackwell Publishing Ltd.

2001). Graham and Harvey (2001) also find that firms with high leverage

use most capital budgeting methods more often than those with low

leverage (a notable exception is the Payback method).

As suggested by Weston and Brigham (1981, p. 405), it may be

rational for cash constrained firms to use the Payback method. We

include liquidity (Liquidity) to proxy for this and, in addition, we include

the investment rate (Investment rate) to proxy for how much capital the

firm needs. Firms with low liquidity and a high investment rate may be

inclined to use the Payback method.

Because it is possible that there may be industry effects (Graham and

Harvey, 2001; Sandahl and Sjögren, 2003), we include an industry

dummy for firms in capital intense industries. We define manufacturing,

construction, transport, and real estate as capital intense industries

(Industry), which is similar to the classification used by Graham and

Harvey (2001).
20

In addition, we include the ratio of fixed assets to total

assets (Fixed Asset Ratio) as an alternative proxy for firms’ investments

in fixed assets. Graham and Harvey (2001) used an additional classifica-

tion: a dummy variable for utilities. However, there are only four utilities

in our sample, so this classification is not meaningful for us.

Finally, we include variables to reflect different aspects of firms’

FDIs. The first variable (%FDI) measures the proportion of FDIs of

total assets, which can be interpreted as being a proxy for how important

FDIs are to a firm. The second variable measures the implied expropria-

tion risk of a firm’s FDIs (Exprop Risk), which is the value-weighted

average of each host country’s expropriation risk. This variable is

clarified by an example. If a firm has 25 per cent of its FDIs in Norway

(index values for 2002: Expropriation risk 5 1), and 75 per cent of its

FDIs in Indonesia (expropriation risk 5 4), it will have a value for

Exprop Risk of (0.25n110.75n4) 5 3.25. Our final variable is the value-

weighted GDP-per-capita growth of the host countries where a firm has

FDIs (GDP growth), for which we use the same weighting as for the

Exprop Risk variable. Proxying for the growth rate of investment cash

flows, GDP growth in the host country may affect the value of waiting to

invest and McDonald (2000) and Boyle and Guthrie (1997) suggest that

the Payback method may approximate this option value. Thus, by

including a GDP growth variable, we attempt to control for this

alternative explanation to why firms use the Payback method. Addition-

ally, Segelod (2000) found that firms may adjust their payback periods

when they make capital budgeting decisions based on the growth

prospects of the host country.

114 Martin Holmén and Bengt Pramborg

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Panel B in Table 1 shows descriptive statistics at the host country

level. The expropriation risk index is quite skewed and most countries

(31 countries out of 61) have the lowest possible ranking of ‘‘1’’. Only a

few countries have an index value larger than ‘‘2’’ (the numbers in

parentheses include the six countries with the authors’ assigned risk, see

footnote 19). Further, countries are ranked based on how much FDI they

have received. It can be seen that Norway is the country where most

sample firms had FDIs (81 firms), followed by other countries in

Northern Europe. In contrast, the country that received the largest

amount of FDIs is the United States (28 per cent), followed by North

European economies.

Table 2 displays Spearman rank correlations of the firm chara-

cteristic variables used in this study. The rank correlations indicate

that larger firms are associated with higher leverage, lower liquidity,

more fixed assets, and that they are more likely to be public firms.

Moreover, larger firms are exposed to higher expropriation risk. It is

also evident that firms in capital intense industries have a larger

proportion of their assets as FDIs, and that those with large proportions

of FDIs are exposed to a higher expropriation risk. Finally, we note

that FDIs with a higher expropriation risk also are those with higher

GDP growth.

The data collection procedure described above enables us to use a

unique dataset to analyze important aspects of firms’ capital budgeting

methods. However, a number of drawbacks should be kept in mind.

First, there is a timing issue that we cannot resolve with the present data

set. We have access to how much FDI each firm had invested in 2002, but

we have no information as to when each investment was made. Thus,

responses regarding capital budgeting practices do not necessarily

specifically relate to the FDIs reported in the database. Second, we

have information on a country-by-country basis for each firm, but not on

a project level. Therefore, several investments made over a possibly long

period of time may be included in the same FDI number. Third, the data

provided on FDIs is accounting numbers. FDIs may have different

economic values than accounting values, caused by e.g., inflation and

standardized depreciation schedules.

The usual limitations of survey research apply, where a major caveat is

that responses represent beliefs. We cannot verify that the beliefs coincide

with actions, and we cannot be certain the respondents were interpreting

the questions correctly.
21

Among other reasons, these potential short-

comings suggest that our findings should be further investigated.
22

Capital Budgeting and Political Risk 115

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116 Martin Holmén and Bengt Pramborg

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r 2009 Blackwell Publishing Ltd.

4. Results

This section contains our main results. First, in Section 4.1, we report on

the survey results and perform univariate tests (pairwise rank correla-

tions). The indicated relationships are further investigated in Section 4.2

using cross-sectional regressions.

4.1 Descriptive Statistics and Univariate Tests

The first question of the survey asked respondents to rank how often they

used different capital budgeting methods. Figure 1 displays the results.

The first six bars from the left in the figure show the proportion of firms

that used each method at least seldom. It is evident that a majority of

firms used each method, except real options. Further, the result suggests

that firms that adopted a method used it quite frequently, real options

once more being the exception. However, few firms (12 per cent)

used Real Options, and those that used the method did so relatively

Capital Budgeting and Political Risk 117

33%
24% 22%

31%

25%

10%

15%

26%

13%

11%

19% 12%

15%

9%
6%

0%
25%

50%

75%

100%

NPV IRR Earnings
multiples

Payback Accounting
return

Payback vs
NPV

Always Almost Always Sometimes Seldom

Real options

Figure 1. The Relative Popularity of Different Capital Budgeting Methods.

The first six bars on the left in the figure display the proportion of firms

that used each capital budgeting method for foreign direct investments

decisions and the frequency of usage for each method, respectively. The last

bar displays the proportion of firms that used the Payback method more

often than net present value (NPV) (the number of observations is 143).
r 2009 Blackwell Publishing Ltd.

infrequently. These results are broadly in line with those of Graham and

Harvey (2001) and Brounen et al. (2004). The right-most bar shows the

proportion of firms that used the Payback method more often than the

NPV method. Forty per cent of the sample firms used payback more

often than the NPV, confirming the importance of the Payback method

for FDI investment decisions. In fact, another 32 per cent used the

Payback method equally often as the NPV, and only 28 per cent of the

sample firms used the NPV more often than the Payback method.

Table 3 displays Spearman rank correlations between the explanatory

variables (firm characteristics) and the frequency at which each capital

budgeting method was used. It is evident that the use of the NPV method

is positively related to firm size and public firms. Furthermore, firms with

118 Martin Holmén and Bengt Pramborg

Table 3. Spearman rank correlations, question 1

NPV IRR
Earnings
Multiples Payback

Accounting
Return

Real
options

Size 0.52nnn 0.26nnn 0.15n 0.05 0.19nn 0.24nnn

Leverage �0.04 0.04 �0.07 �0.18nn 0.02 0.01
Liquidity �0.17nn �0.06 0.00 �0.01 �0.06 �0.22nnn
Fixed asset ratio 0.22nnn 0.25nnn �0.12 �0.07 0.04 0.08
Investment rate �0.06 �0.02 �0.06 0.06 0.05 0.09
Public 0.29nnn 0.01 0.30nnn 0.05 0.11 0.24nnn

Industry 0.06 0.08 �0.14 �0.05 �0.05 �0.06
%FDI 0.01 �0.01 0.05 �0.04 �0.01 �0.06
Exprop Risk �0.05 �0.03 0.00 �0.08 0.05 �0.03
GDP growth 0.00 �0.05 �0.07 �0.00 �0.01 �0.16n
NPV 0.45nnn 0.27nnn 0.05 0.16n 0.23nnn

IRR 0.12 0.15n 0.17nn 0.21nn

Earnings multiples 0.06 0.35nnn 0.20nn

Payback 0.24nnn 0.06
Accounting return 0.12

The table reports Spearman Rank correlation coefficients for firm characteristic variables and
responses to question one regarding the use of different capital budgeting methods. The firm
characteristic variables are defined as follows: Size is the book value of total assets; Leverage is
long-term debt divided by total assets; Liquidity is the ratio of current assets to short-term debt;
Fixed Asset Ratio is the ratio of fixed assets to total assets; %FDI is the book value of foreign
assets to total assets; Investment rate is the change in fixed assets from the previous year plus
depreciation; Public is an indicator variable that is assigned the value of one for listed firms;
Industry is an indicator variable that is assigned the value of one for firms in capital intensive
industries; Exprop Risk is defined as the value weighted expropriation risk of the firm’s FDIs.
Expropriation risk estimates are collected from EIU Country Forecasts. The risk of expropria-
tion rating scores countries between 1 and 5, with 5 being high and 1 being non-existent. The
responses to the questions take values from 0 to 4, where a higher value indicates more often (see
the survey in Appendix A). Significance is indicated as follows:
n10% level; nn5% level; nnn1% level.
The number of observations is 142.
FDI, foreign direct investments.

r 2009 Blackwell Publishing Ltd.

low liquidity and a large share of fixed assets used NPV more frequently.

We also note that public firms were more likely to use earnings multiples

than other firms. This might be an important metric for these firms to

consider because they have to communicate their earnings to analysts

and the public (see, Graham et al., 2006, for survey evidence on the

importance of reported earnings). There is a negative correlation between

the use of the Payback method and liquidity, which supports the notion

that firms that are capital constrained use the Payback method (Graham

and Harvey, 2001). Finally, we note that all correlations between the

different capital budgeting methods are positive and most are significant.

This suggests the methods to be complements rather than substitutes.

The next question asked the respondents to rank how often they used

a number of pre-specified methods to manage country-specific risks, and

the final question asked the respondents to indicate whether they used

different decision criteria in countries with high political risks versus

countries with low political risks. Figure 2 displays the results.

Capital Budgeting and Political Risk 119

0%
25%
50%
75%
100%
Always Almost Always Sometimes Seldom

Insurance and management Investment criteria

Figure 2. Methods to Manage Country-Specific Political Risk.

The first eight bars on the left in the figure display the proportion of firms

that used each method to manage political risk and the frequency of usage

for each method, respectively (the numbers of observations are in the range

134–140). The last bar on the right shows the proportion of firms that used

different decision criteria for investments in developing countries as

compared with developed countries (the number of observations is 117).

r 2009 Blackwell Publishing Ltd.

The left-hand side of the figure shows that the involvement of local

partners was used by more than 75 per cent of the sample firms and many

of those firms used this strategy frequently. The second most used method

was to limit dependence to one partner, while limiting technology transfer

and purchasing political risk insurance was used by fewer firms. In terms of

adjusting their investment criteria for country-specific political risks (right-

hand side of the figure), our findings indicate that 450 per cent of the
sample firms required higher returns, adjusted cash flow and/or earnings

estimates, and used shorter payback periods. Interestingly, asked directly,

43 per cent of the respondents indicated that they used different decision

criteria when making FDIs in countries with high political risk as compared

with countries with low political risk. Comments we received include that

the firm ‘‘refrains from investments in countries with high political risk’’,

that the firm ‘‘uses higher hurdle rates for these investments’’, and that the

firm ‘‘uses a shorter payback period’’. This suggests that firms do consider

this (mostly idiosyncratic) risk and that it is an important factor for firms

making foreign investment decisions.

Table 4 displays rank correlations between firm characteristics and

methods to manage country-specific risks. The positive correlations be-

tween the methods suggest them to be complements rather than substitutes.

Moreover, it is noteworthy that for firms with higher expropriation risk in

their FDIs, it was more common to buy political risk insurance, require

higher returns, and use shorter payback periods. However, because larger

firms also are characterized by a higher expropriation risk, size could

contribute to explain the use of political risk insurance and the requirement

of higher returns.

This section has provided descriptive statistics and univariate tests on

firms’ capital budgeting methods for FDIs. To provide further evidence

as to which factors may explain the use of different methods, in particular

whether country-specific political risks may explain differences in capital

budgeting methods, we use cross-sectional regressions.

4.2 Cross-Sectional Regressions

In this section, we use cross-sectional regressions to investigate our

research questions as to whether (1) political risk affects the choice of

capital budgeting method, and (2) managers adjust the payback period

based on political risk. The explanatory variable of main interest to us is

the value-weighted expropriation risk of firms’ portfolios of FDIs

(Exprop Risk), which serves as a proxy for firm-specific political risk

120 Martin Holmén and Bengt Pramborg

r 2009 Blackwell Publishing Ltd.

Capital Budgeting and Political Risk 121

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r 2009 Blackwell Publishing Ltd.

exposure. We also include a number of control variables as discussed in

Section 3.2.

Table 5, panel A, displays the results from logit regressions. Models 1

and 2 include indicator variables representing the use of the NPV method

and the Payback method, respectively. The third model’s dependent

variable is an indicator variable set to one for firms using the Payback

method more frequently than the NPV method. All estimated regression

models are adjusted for heteroskedasticity according to White (1980).

Model 1 indicates the use of the NPV method to decline with the risk of

expropriation. The coefficient for expropriation risk is negatively sig-

nificant at the 10 per cent level, i.e., firms are less likely to use the NPV

method when political risk is high. Model 2 provides evidence that firms

more frequently rely on the Payback method when the perceived

expropriation risk is high. In model 2, the coefficient for expropriation

risk is positively significant at the 5 per cent level. Model 3 presents

stronger results in line with our expectations. The dependent variable

indicates whether the firm uses the Payback method more frequently

than the NPV method when evaluating FDI. The coefficient for expro-

priation risk is positively significant at the 5 per cent level. These results

are consistent with managers using the Payback method as a rule of

thumb to avoid high deliberation costs.

Supporting the evidence of Graham and Harvey (2001), we find larger

and public firms to be more likely to use the NPV method, while firms

with a large proportion of fixed assets are more likely to use both the NPV

method and the Payback method. This result is counter to the findings of

Graham and Harvey (2001) who find opposite signs in their (univariate)

analysis. Leverage is negatively related to the Payback method, but we

find no significant relation to the use of the NPV method. Our proxies

for cash constraints and capital needs (Liquidity, Investment Rate, and

the capital intense Industry Dummy) are insignificant in all

models.

Similarly, the GDP growth in the host country is insignificant in all

models.

In panel B of Table 5, we report further evidence on the choice of

capital budgeting method using ordered logit models. In model 1 the

dependent variable is equal to 0 if NPV is never used, 1 if NPV is seldom

used, 2 if NPV is sometimes used, 3 if NPV is almost always used and 4 if

NPV is always used when evaluating FDIs. The second model is similar,

but includes the use of the Payback method as the dependent variable. In

Model 3 the dependent variable is equal to the frequency (0–4) at which

payback is used when evaluating FDIs minus the frequency at which

122 Martin Holmén and Bengt Pramborg

r 2009 Blackwell Publishing Ltd.

Capital Budgeting and Political Risk 123

Table 5. Logit and ordered logit regressions with the frequency at which the
NPV method and the Payback method, respectively, are used when evaluating
Foreign Direct Investments

Panel A: Logit Regressions Panel B: Ordered Logit Regressions

Model 1
NPV

Model 2
payback

Model 3
payback

versus NPV

Model 1
NPV

Model 2
payback
Model 3
payback
versus NPV

Exprop Risk �1.419 2.864 2.001 �1.654 0.863 1.860
(�1.72)n (2.53)nn (2.03)nn (�2.13)nn (1.18) (2.45)nn

%FDI 0.778 �1.117 �0.499 0.432 �0.210 �0.720
(0.62) (�1.09) (�0.54) (0.46) (�0.26) (�0.89)

Public dummy 1.278 0.115 �0.766 0.658 0.187 �0.477
(2.41)nn (0.23) (�1.79)n (1.81)n (0.53) (�1.44)

Size 0.480 0.140 �0.367 0.479 0.054 �0.218
(2.73)nnn (1.15) (�3.41)nnn (4.28)nnn (0.69) (�3.46)nnn

Leverage �1.237 �3.894 �0.703 �0.695 �2.169 �1.223
(�1.22) (�3.11)nnn (�0.81) (�0.73) (�2.47)nn (�1.31)

Fixed asset ratio 4.022 3.799 �0.961 3.647 1.497 �0.537
(1.89)n (1.91)n (�0.52) (2.44)nn (0.98) (�0.52)

Liquidity 0.069 0.112 �0.058 0.039 0.039 �0.010
(0.91) (1.16) (�1.30) (1.10) (1.11) (�0.53)

Investment rate �0.300 �0.209 0.394 �0.186 0.079 0.144
(�0.78) (�0.38) (0.84) (�0.51) (0.26) (0.50)

Industry dummy �0.301 �0.608 �0.260 �0.166 �0.139 �0.250
(�0.52) (�1.09) (�0.62) (�0.41) (�0.43) (�0.77)

GDP growth �0.104 �0.469 �0.401 0.096 �0.217 �0.222
(�0.39) (�1.38) (�1.59) (0.44) (�0.97) (�0.93)

Prob4F 0.019 0.080 0.003 0.000 0.451 0.000
No. of
observations 1/0

97/44 112/30 56/86

Total no. of
observations

142 142 142 142 142 142

The table reports estimated logit (panel A) ordered logit regressions (Panel B) with the frequency at which the
NPV method and the Payback method are used when evaluating Foreign Direct Investments (FDIs). In
panel A Model 1 (Model 2) the dependent variable is equal to 1 if NPV (Payback) is used when evaluating
FDIs, and zero otherwise. In panel A Model 3 the dependent variable is equal to one if Payback is used more
frequently than NPV when evaluating FDIs, and zero otherwise. In panel B Model 1 (Model 2) the
dependent variable is equal to 0 if NPV (Payback) is never used, 1 if NPV (Payback) is seldom used, 2 if NPV
(Payback) is sometimes used, 3 if NPV (Payback) almost always, and 4 if NPV (Payback) is always used
when evaluating FDIs. In panel B Model 3, the dependent variable is equal to the frequency at which
Payback (0 to 4) is used when evaluating FDIs minus the frequency at which NPV (0 to 4) is used when
evaluating FDIs. Thus, the variable varies between �4 and 4. Coefficients are reported with z-values in
parenthesis. Reported z-values are asymptotically robust to heteroskedasticity (White, 1980). Significance is
indicated as follows:
n10% level; nn5% level; nnn1% level.
The number of observations is 142. Exprop Risk is defined as the value weighted expropriation risk of the
firm’s FDIs. Expropriation risk estimates are collected from EIU Country Forecasts. The risk of
expropriation rating scores countries between 1 and 5, with 5 being high and 1 being non-existent.
%FDI is equal to the book value of the firm’s all FDIs divided by the book value of the total assets. Public
Dummy is equal to one if the firm is listed on a stock exchange, and zero otherwise. Size is equal to the
natural logarithm of the book value of total assets at the end of 2002. Leverage is equal to the book value
of long-term debt divided by the book value of total assets at the end of 2002. Fixed Asset Ratio is equal to
fixed assets divided by total assets. Liquidity is the ratio of current assets to short-term debt. Investment
rate is equal to the change in fixed assets from the previous year plus depreciation. Industry dummy is
equal to one if the firm is active in a capital intense industry, and zero otherwise. GDP growth is equal to
the value weighted GDP growth per capita 1995–2002 in the countries where the firm has FDIs.

r 2009 Blackwell Publishing Ltd.

NPV is used when evaluating FDIs. Thus, the variable can assume values

between �4 and 4.
The results are similar to those reported in panel A. The frequency at

which NPV is used declines with the risk of expropriation. The coefficient

for expropriation risk is negatively significant at the 5 per cent level in

model 1, but insignificant in model 2. It is positive and significant at the 5

per cent level in model 3; once more in line with our expectations. The

results for the control variables are also similar to those reported above,

i.e., large and public firms more frequently use the NPV method while the

fixed asset ratio (leverage) is positively (negatively) related to the use of

the NPV method (Payback method). In sum, our results suggest that

country-specific political risks affect the choice of capital budgeting

method for FDIs.

Now, we turn our attention to our second research question: whether

managers are more likely to shorten the payback period if they are exposed

to higher political risk. Table 6 displays the results from our cross-sectional

regressions. In panel A, the dependent variable is an indicator variable

which is set to one if a firm shortens the payback period to manage political

risk and zero otherwise (see, question 2.e in Appendix A). In panel B, the

dependent variable represents how often the firms use a shorter payback

period to manage political risk. It is evident that none of the firm

characteristic variables contribute to explain this method, except Exprop

Risk and GDP Growth. The first models in each panel, for which all

variables are included, can be rejected by an F-test; an indication that they

are mis-specified. Only including Exprop Risk and GDP Growth, the

models cannot be rejected. Thus, it seems as if the major determinants of

the practice of adjusting the payback period are project-specific risk and

return (as proxied by political risk and the GDP growth of the host

country). A potential explanation for our results is that managers make

adjustments to cope with the trade-off of reducing deliberation costs

(shortening the payback period when the political risk is higher, thereby

reducing the need to make longer term projections), and approximating

optimality as far as possible (lengthening the payback period when

expected growth is higher, capturing more of the long-term profitability).

We perform a number of robustness tests for the choice of capital

budgeting method. First, we test for the probability of reverse causality,

i.e., are firms more likely to invest in countries with high expropriation

risk because they use the Payback method? We estimate simultaneous

equations using a two step procedure with the Payback and NPV

indicator variables, respectively, and Exprop risk as dependent variables.

124 Martin Holmén and Bengt Pramborg

r 2009 Blackwell Publishing Ltd.

Capital Budgeting and Political Risk 125

Table 6. Logit and ordered logit regressions on the frequency at which the
shorter payback period method is used to manage country-specific political risk

Panel A: Logit
regressions

Panel B: Ordered
Logit regressions

Model 1 Model 2 Model 1 Model 2

Exprop Risk 2.903 2.746 1.722 1.508
(1.91)n (1.98)nn (2.87)nnn (2.37)nn

%FDI 1.105 1.243
(0.85) (1.04)

Public Dummy �0.157 �0.298
(�0.31) (�0.67)

Size 0.043 0.030
(0.37) (0.26)

Leverage �0.360 �1.224
(�0.32) (�1.23)

Fixed asset ratio 0.297 1.151
(0.15) (0.83)

Liquidity 0.044 0.130
(0.47) (1.89)n

Investment rate �0.112 �0.188
(�0.22) (�0.44)

Industry dummy �0.135 0.091
(�0.29) (0.25)

GDP growth �0.688 �0.626 �0.589 �0.468
(�1.93)n (�1.78)n (�2.17)nn (�1.70)n

Prob4F 0.79 0.07 0.14 0.06
No. of observations 1/0 70/35 70/35
Total no. of observations 105 105 105 105

The table reports estimated logit (panel A) and ordered logit regressions (Panel B) with the
frequency at which firms use a shorter payback period (SPP) for managing political risk. In
panel A, the dependent variable is equal to 1 if SPP is used, and zero otherwise. In panel B, the
dependent variable is equal to 0 if SPP is never used, 1 if SPP is seldom used, 2 if SPP is
sometimes used, 3 if SPP is almost always used, and 4 if SPP is always used. Coefficients are
reported with z-values in parenthesis. Reported z-values are asymptotically robust to hetero-
skedasticity (White, 1980). Significance is indicated as follows:
n10% level; nn5% level; nnn1% level.
Only firms that use the Payback method are included (105 observations). Exprop Risk is defined
as the value weighted expropriation risk of the firm’s FDIs. Expropriation risk estimates are
collected from EIU Country Forecasts. The risk of expropriation rating scores countries
between 1 and 5, with 5 being high and 1 being non-existent. %FDI is equal to the book value
of the firm’s all FDIs divided by the book value of the total assets. Public Dummy is equal to one
if the firm is listed on a stock exchange, and zero otherwise. Size is equal to the natural logarithm
of the book value of total assets in the end of 2002. Leverage is equal to the book value of long-
term debt divided by the book value of total assets at the end of 2002. Fixed Asset Ratio is equal
to fixed assets divided by total assets. Liquidity is the ratio of current assets to short-term debt.
Investment rate is equal to the change in fixed assets from the previous year plus depreciation.
Industry dummy is equal to one if the firm is active in a capital intense industry, and zero
otherwise. GDP growth is equal to the value weighted GDP growth per capita 1995–2002 in the
countries where the firm has FDIs.
FDI, foreign direct investments.

r 2009 Blackwell Publishing Ltd.

We find no indications of reverse causality. Second, we use alternative

specifications of our control variables, which do not change our results.
23

Third, we adjust the Exprop Risk index by adding (subtracting) the value

of 0.5 to (from) the author-assigned index values as discussed on page 10

and in footnote 19 and, in addition, by adding the maximum (minimum)

level of political risk to the proportion not indexed.
24

Adding political

risk to the author-indexed and not-indexed proportions of FDI

strengthen our results, while reducing political risk weaken the signifi-

cance for the coefficient for political risk in Table 5, models 1 and 2.

However, the significance for model 3 in both panels of Table 5 remains.

Fourth, we use a number of alternative indices for political risk: e.g., the

EIU indices ‘‘Policy environment for foreign investment rating’’, ‘‘Poli-

tical stability rating’’ and ‘‘Degree of property rights protection’’. As

compared with the results for Exprop risk, the results using alternative

indices somewhat weaken the significance of the coefficient for political

risk in models 1 and 2 (in both panels of Table 5), but for model 3, the

coefficients are about as significant as those reported. In sum, we

interpret the results from the robustness tests as supportive of our finding

that political risk affects the investment decision process.

Further, we cross-check whether other risk management methods

influence firms’ capital budgeting decisions (see Appendix A, questions

2a–2d, and the left-hand side of Figure 3). For example, managers may be

more (less) likely to use the NPV method (Payback method) for FDIs in

host countries with high political risk if they use political risk insurance to

manage political risk. We include dummy variables, representing the usage

of these alternative methods, in the regressions of Table 5, but this does not

change our results. Finally, we investigate whether firms with more political

risk are more likely to use any of the methods in question 2 (thus including

these methods as dependent variables in cross-sectional regressions). To

save space, we do not report the results. We note, however, that the use of

political risk insurance is significantly and positively related to political risk,

firm size, and liquidity, and that it is significantly and negatively related to

GDP growth.

5. Conclusion and Discussion

We survey Swedish firms’ capital budgeting techniques for FDIs and

focus on whether and how country-specific political risks are taken into

account. Almost two-thirds of the firms adjusted for country-specific

political risks by increasing the discount (hurdle) rate, decreasing

126 Martin Holmén and Bengt Pramborg

r 2009 Blackwell Publishing Ltd.

forecasted cash flows, shortening the payback period, and/or requiring

higher earnings multiples. Forty-three per cent of the firms used different

decision criteria for FDIs in countries with high political risk (developing

countries) as compared with FDIs in countries with low political risk

(OECD countries).

Our cross-sectional analysis indicates that the use of the NPV method

(the Payback method) decreases (increases) with the risk of expropria-

tion. We also find that firms adjust the payback period based on political

risk and host country growth. We conclude that in the presence of

political risks, managers are reluctant to rely on the traditional NPV

method and we suggest this to be due to the fact that managers find it

difficult to take such risks into account. This is consistent with managers

being boundedly-rational decision makers, using simple rules of thumb

when the deliberation cost is high. Further, our results are consistent

with the notion that the rules of thumb are adjusted to proxy optimal

decision as far as possible.

Our interpretation of the results has implications for some of the

explanations as to why firms frequently use the Payback method that

have been proposed in the literature. First, Weston and Brigham (1981)

suggest that cash constrained firms use the Payback method not to be

forced to use external financing. External financing is more costly due to

capital market imperfections. However, our cross-sectional results fail to

support this argument for the use of the Payback method.

Second, Graham and Harvey (2001) suggest that the management’s

lack of sophistication can explain the use of the Payback method, and

that firm size may be a proxy for this. We find support for a size effect,

but argue that lack of sophistication can be interpreted in terms of high

deliberation costs. Managers of smaller firms may have less specialized

training in financial management and/or less resources to evaluate

investment alternatives (economies of scale). Therefore, the deliberation

costs may be relatively higher for these managers and they might be

inclined to use the Payback method.

Third, McDonald (2000) and Boyle and Guthrie (1997) argue that the

Payback method may be used to approximate the value of the waiting to

invest option. The shorter the estimated payback period, the more costly

it is to delay the investment.
25

Our results suggest that firms shorten the

cut-off payback period when the risk of expropriation increases. Thus,

when the risk of expropriation is substantial, the cost of waiting to invest

must be high before the firm decides to invest. This behavior is consistent

with McDonald (2000) and Boyle and Guthrie (1997).

Capital Budgeting and Political Risk 127

r 2009 Blackwell Publishing Ltd.

Fourth, Mao (1970) and Ehrhardt and Brigham (2003) suggest the

Payback method to be a complement to the NPV analysis, because it can be

used as an approximation of the riskiness of a project. Our findings suggest

that in general the different capital budgeting methods seem to be

complements. However, we find that when political risk is perceived to be

substantial the Payback method is used as a substitute for the NPV method.

Finally, a general implication of our results is that political risk may be

socially costly, not only in the sense of reducing foreign investments in

the country (Globerman and Shapiro, 2003; Moosa and Cardak, 2006),

but also in the sense that the foreign investments taking place will mainly

be short term. Long-term investments are reduced, which potentially

reduces the benefits for the host country.

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Froot, K.A., D.S. Scharfstein and J.C. Stein, ‘‘Risk Management: Coordinating Corpo-
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Notes

1. This absence is remarkable, given that capital market imperfections are an integral
part when teaching corporate capital structure and risk management. In fact, given capital
market imperfections it is not necessarily the case that the NPV rule maximizes share-
holder value (Brealey and Myers, 2000, p. 24).
2. Political risk incorporates factors influencing the host country’s political and

economic environment. The FDIs of a multinational corporation are located in the host
countries’ jurisdiction. The FDIs’ cash flows can therefore be affected by changed policies
by the host country. A host country’s expropriation of the multinational’s FDI is the most
dramatic form of such a policy. Other potential policy changes include rules pertaining to
capital repatriation, equity ownership restrictions, legal requirements, tax codes, laws for
the protection of patents, local personnel and product usage, and bureaucratic procedures
(Mahajan, 1990). Political risks are not limited to overseas investments. However, in some
parts of the world, unanticipated actions by governments and courts toward foreign
companies are much more likely.
3. With perfect capital markets, these risks would not be of any importance as they are

mostly unsystematic. However, with imperfections such as costly external financing and
financial distress costs, firms should take these risks into account.
4. The Payback method does not consider the time-value of money, and cash flows

beyond an arbitrary cut-off date are disregarded. While the NPV method is the theoretically
correct method, the Payback method is the method associated with most excessive short-

130 Martin Holmén and Bengt Pramborg

r 2009 Blackwell Publishing Ltd.

termism. See, e.g., Segelod (2000) for a discussion and empirical evidence on short-termism.
Other methods, such as earnings multiples, are also related to short-termism (because
typically, only next year’s earnings are used as the input).
5. Even though Boyle and Guthrie (1997) only consider traditional cash flow risk, they

point out that in an international environment, their model could be expanded to include
uncertainty about foreign laws and regulations, i.e., political risks.
6. Chaney (1989), Narayana (1985) and Weingartner (1969) have suggested that the use

of payback stems from various aspects of the shareholder-manager agency problem.
7. Some country risks may to some extent be systematic and should therefore be part of

the cost of capital (Bruner et al., 1998; Damodaran, 2003). However, many political risks,
such as the risk of expropriation, are most likely unsystematic.
8. These imperfections include indirect and direct financial distress costs (Jensen and

Meckling, 1976; Smith and Stulz, 1985), agency costs (Myers and Majluf, 1984; Stulz, 1984),
and costly external financing (Myers and Majluf, 1984; Froot, Scharfstein, and Stein, 1993).
9. Note however that many developing countries have no equity markets (Erb et al.,

1996b). Thus, there is a negative correlation between political risks and the existence of an
equity market.
10. Bounded rationality assumes that some type of cognitive or information-gathering

cost prevents agents from making fully optimal decisions. See, Conlisk (1996) for a review
of the bounded rationality literature.
11. Other unsystematic risks that are similar to political risk in this respect include the

risk for technological breakthroughs by competitors and the loss of vital suppliers or
customers. In the short run, technological breakthroughs by a competitor are unlikely but
in the medium and long run, new technologies will most likely emerge. Similarly, in the
short run, suppliers and customers might be contracted, but it is uncertain whether they
will renew the contracts.
12. For the United States, see, e.g., Mao (1970), Schall et al. (1978), Stanley and Block

(1984), Moore and Reichert (1983), Trahan and Gitman (1995), Bruner et al. (1998), and
Graham and Harvey (2001). For the United Kingdom, see, e.g., Sangster (1993), Pike
(1996), and Arnold and Hatzopoloulos (2000). For France, Germany, the Netherlands,
and the United Kingdom, see, Brounen et al. (2004). For Finland, see, Liljeblom and
Vaihekoski (2004). For Sweden, see, e.g., Segelod (2000) and Sandahl and Sjögren (2003).
Some of these studies, notably Graham and Harvey (2001), do not only consider capital
budgeting but also cost of capital and capital structure issues.
13. See, e.g., Bradley (1977), Robock (1971), and Shapiro (1981).
14. We received various comments from the firms that considered the questionnaire

irrelevant. Common reasons include that the firm ‘‘makes almost no investments in
foreign countries’’, the firm ‘‘had made no FDIs during the last five years’’, the firm ‘‘did
not make FDIs anymore’’, the firm ‘‘was sold to another company recently’’, and the firm
‘‘had recently gone bankrupt’’.
15. The variables are: size, industry, liquidity, investment rate, proportion of current

assets, leverage, proportion of FDI, and our measures of risk and growth in firms’ FDI
portfolios: political risk and GDP growth per capita of host countries. All variables are
explained in detail in section 3.2.
16. We find similar numbers of firms classified as small, mid-sized, and large, respectively,

when we classify the firms based on total assets (TA), using a cut-off value for small firms of
TAoUSD250 million, and for large firms of TA4USD2,500 million. We use different cut-
off values because TA are, on average, about 2.5 times larger than sales.
17. Specifically, the 1,152 FDIs are reported on a country level, not on a project level.

Since there can be more than one FDI per country, the number of projects is likely to be
considerably larger. However, in this paper, we use the convention to call the total
invested amount by a firm in one country an FDI.

Capital Budgeting and Political Risk 131

r 2009 Blackwell Publishing Ltd.

18. We use the average value over a number of years, because we do not have any
information as to when each firm made its FDI, only the balance as of December 2002. As
a robustness test, we also used the values as of 2002. The results were similar.
19. We set the expropriation risk (which ranges from ‘‘1’’ to ‘‘5’’, with ‘‘5’’ being the

riskiest) of the Baltic states, Bermuda and the United Arab Emirates to ‘‘2’’, which is on
par with, for example, Bulgaria, Slovakia, and Saudi Arabia while Luxembourg received a
‘‘1’’, the ranking for countries with the lowest risk.
20. They used a dummy for industry that is set to one for firms in manufacturing/

transport/energy, and zero for other firms. We used this specification, which did not
change our results.
21. For example, we cannot be sure that the respondents were thinking specifically

about the political dimensions of overseas projects when answering question two of the
questionnaire. Respondents could be answering how they managed country specific risks
in general. However, in this case the general implications of our results would still be the
same, i.e., in the presence of capital market imperfections, how are capital budgeting
techniques affected by unsystematic risks when these risks are difficult to quantify.
22. In this respect, it may be useful to know that the Riksbank survey on FDIs is not

unique. The World Bank requires the Riksbank to perform this survey on an annual basis,
and this also applies to other central banks. Thus, it should be possible to make out-of-
sample research using similar data.
23. For Size we used the log of sales, for Liquidity we used the acid ratio, and we also

used other industry categorizations (e.g., a dummy for manufacturing only).
24. Thus, for a firm with 90 per cent of its FDI covered by the EIU index, we assigned

the maximum value of the countries rated by the EIU for the remaining 10 per cent. Thus,
in this case, the remaining 10 per cent would be assigned an Exprop risk value of ‘‘4.88’’.
25. Compare with the early exercise of an American call option on a stock paying high

dividends.

132 Martin Holmén and Bengt Pramborg

r 2009 Blackwell Publishing Ltd.

Capital Budgeting and Political Risk 133

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134 Martin Holmén and Bengt Pramborg

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r 2009 Blackwell Publishing Ltd.

CAPITAL BUDGETING BY UTILITIES

EUGENE F. BRIGHAM and
RICHARD H PETTWAY

Dr. Brigham, Professor of Finance and Director of the Public Utilitv
Research Center. University of Florida, rs author and coauthor of a
number of hooks and many articles in finance. Dr. PeUway.
Associate Professor of Finance. University of Florida, has published
articles in the Journal of Financial and Quanlitaiivc Analysis, the
Financial Analysts Journal, and oiher academic fournals.

he theory of capital budgeting has been studied
extensively in recent years, and there is a growing
body of literature describing the capital budgeting
techniques employed by industrial firms. However, in
spite of the importance of public utilities, virtually
no studies relating to these firms’ capital budgeting
practices have appeared in the financial journals. This
article is aimed at this gap.

A number of capital investment selection criteria
have been identified in the literalurc of finance. The
four most frequently mentioned are payback, average
rate of return, ARR. internal rate of return. IRR,
and net present value, NPV. The NPV method is
generally regarded as being the “best” in some the-
oretical senses, while the IRR method is a somewhat
distant second. Boih payback and ARR, which may
be defined in serveral ways, are generally regarded as
being distinctly inferior to the two techniques em-
ploying discounted cash flow.

Although theory has been extended very elegantly
in recent years, the basic techniques were specified
reasonably well and widely publicized by the latter
195O’s. Once basic theories were accepted academi-
cally, various researchers questioned whether or nol
business practiced what the academic community

preached. Istvan [4, 5], Pfiomn [7], and Soldofsky
[8] studied this question in the early 196O’s and re-
ported that relatively few firms employed the recom-
mended DCF techniques. The studies by Christy [2],
the National Association of Accountants [6], and
Terborgh [9], all done in the latter half of the
l960″s, indicated an increasing use of DCF methods,
but they also showed that the payback and ARR
were far more widely used. The most recent studies
of national firms, the ones by Klammcr [3] and by
Abdelsamad [I], showed a continuation of the trend
toward DCF; however. 43% of the firms in
Klammer’s study were still using a non-DCF method
in 1970.

Two explanations for the non-use, or at least
limited use, of DCF were offered. The first hypoth-
esis is that there is simply a learning-and-action lag;
the second is that the cost of using a DCF technique
may, in some inslances. exceed its benefits. Although
neither of these hypotheses has been “proved,” our
own studies suggest that there is some validity to
both. Accordingly, we think thai the use of DCF
will increase, but it is most unlikely that any future
sttidy will ever find that nil investment decisions are
made using a DCF cutoff criterion.

Autumn 1973 11

Capital Budgeting in the
Utility Sector

in our work with public utilities it became appa-
rent almost immediately that their approach to in-
vesting decisions is unlike Ihat of other companies.
Regulation itself has led to a modification of tradi-
tional approaches to capital budgeting. Consider
Exhibit 1. which presents what might be called the
“traditional view” of the capital budgeting process.
Here, the firm takes on projects so long as their
rate of return exceeds the cost of capital, and the
capital budget for the period in question is I*. The
area under the rate of return schedule, but above
the cost of capital schedule, represents what might
be called a “producer’s surplus.” The area labeled
“producer’s deficit” is rejected.

According to traditional regulatory theory, this
conceptual model is not generally applicable to utility
companies. In the regulatory process, a target, or
allowed rate of return, is specified. This return is,
either implicitly or explicitly, recognized as being a
point (perhaps the midpoint) within a range of rates
of return frequently called the “zone of reasonable-
ness.” If “good” capital investments cause the actual
rate of return to exceed the upper end of this range,
then a rate reduction is ordered to drive rates back
down to target. Thus, according lo uadiiional re-
gulatory theory, the existence of the regulatory pro-
cess will eliminate the “producer’s surplus” shown in
Exhibit 1. If the surplus is eliminated by regulatory

action, this means that Ihe least profitable of the se-
lected projects will have a zero NPV, and its IRR
will equal the cost of capital. Hence, the rule of
choosing projects so as lo maximize NPV does not
appear to be operational—at least under the tradi-
tional view of regulatory theory.

Public Utility Investment Decisions in
Today’s Environment

The preceding theoretical discussion must be modi-
fied to conform to the reality of the present situation
faced by public utilities.

Rate of Return Patterns Under Inflation. Exhibit
2{A) shows the rate of return pattern facing a typical
utility company when (I) inflation is driving costs up
constantly. (2) prices, which are set by regulatory
action, are increased at discrete intervals, and (3) no
regulatory lag is present. As operating costs rise,
profits and. consequently, the realized return on in-
vestment decline. When the lower control limit is
reached, rates are raised, causing the realized rate of
return to rise to ihe target level. However, continued
inflation causes the cycle to be repeated, and rates of
return are again eroded. The net result is that the
rate of return will, on average, fall below the target
level.

Exhibit 2(B) shows the effects of regulatory lags.
At point A the actual rale of return penetrates the
lower control limit, prompting the company to ask

Exhibit 1. Conceptual Model of the Capital Budgeting Process for an Unregulated Firm

IRR, or Marginal Return
on Investment Schedule

Percent

“Producer’s
/ Surplus”

/ / J , /

Marginal Cost of
Capital Schedule

/”Producer s
Deficit”

Investment
During Period ($)

12 Financial Management

for a rate hearing, which occurs al poinl B. At point
C an order is issued permitting the company to raise
rates, and the rate increase takes effect at point D.

As we have shown it, the actual rate of return
does not return to the target level. The cost figures
generally used in the point B rate cases are those of
the most recent past year. If inflation continues, by
the time the new rates take effect, the cost figures
are otitdatcd. that is. they arc too low. Hence, the
calculated utility rates are too low lo return the rate
of return on investment to the target level.

It would, of course, be possible for regulatory au-
thorities to anticipate price increases. In utility par-
lance this is called using a forward test year. Alter-
natively, the regulatory lag could be shortened by
setting the control limits closer to the target rate of
return. Such procedures are beginning to be employed
by regulatory agencies; the automatic fuel adjustment
clause, which permits certain electric utilities to raise
prices automatically when fuel costs rise, is an exam-
ple. However, the past test year is used more fre-
quently than the forward test year, and this has a
negative impact on utility profits under inflationary
conditions.

A Rising Cost of Capital. Controversy exists o\cr
measurement of the cost of capital, but because of
an increase in interest rates, no one seriously argties
that it has not risen in recent years. However, be-
cause of regulatory lags, the target rate of return has
generally been set below the actual cost of capital.

Exhibit y illustrates this. From TQ to T ] . the
cost of capital is both stable and equal to the al-
lowed rate of return. At T| the cost of capital be-
gins to rise, and during the interval from T] to TT
the rate of return shortfall widens. At T-?, a rate
case is held, and the allowed rate of return is ad-
justed upward. However, the continuing increase in
the cost of capital causes the cycle to be repeated,
and over the entire period the actual rate of return
averages less than the cost of capital. Note also that
the debt cost used in the target rate of return is the
“embedded” cost, or the average cost of all out-
standing debt. If the cost of new debt is above a
company’s embedded debt cost-as it has been in re-
cent years for virtually all utilities-then the embedded
eost will rise over time.

Mandatory and Discretionary
Investment Decisions

It is useful to describe now another feature of uti-
lity operations. That is. they are legally required to
make the investments needed to provide service upon
demand. Thus, utility companies’ capital

investments

may be divided into mandatory and discretionary
investments. This is illustrated in Exhibit 4, where
we show the marginal cost of capital and rate of re-
turn schedules for both investment components. As
we have drawn it, the mandatory category is sub-
stantially larger in dollar terms than the discretionary
category; this seems to be In accord with the actual
situation.

Exhibit 2. Typical Rate of Return Pattern Under Inflationary Conditions

(a) No Regulatory Lag (b) With Regulatory Lag

Rate of
Return

, y.£per Control Limit

Target (or Allowed)
Rate of Return

.Actual Rate
of Return

Lower Control Limit

Time

Autumn 1973 13

Exhibit 3. Illustration of Rising Cost of Capital Combined with Lagged Changes in the Allowed
Rate of Return

Actual Cost
of Capital

Percent

Rate of Return x:
Target (or Allowed)
Rate of Return

Time

Exhibit 4. Capital Budgeting with Mandatory and Discretionary Investments

Percent

Rate of Return
on

Discretionary
Investments

Rates of Return
on Mandatory

Cost of Capital

Investment
During Period ($)

Mandatory
Investments

Discretionary
Investments

14 Financial Management

An example will illustrate what is involved. As-
sume that in certain geographic areas a telephone
company may have excess switching capacity, per-
mitting it to earn a relatively high rate of return on
the small investment needed to serve new customers.
Profitable investments of this type give rise to the
area designated as A. On the other hand, in some
other district where existing capacity is fully utilized,
to install a new telephone might require an invest-
ment of $2,000, as opposed to an average plant cost
of $1,000 for each telephone presently in service. The
pricing system used in the regulatory process is, in
general, based on average costs, not marginal costs.
In the absence of an immediate price increase, growth
in the second area necessarily means that the average
rate of return on investment will decline. Thus, in-
vestment here will correspond to area B in Exhibit
4.

Companies do have a certain amount of discretion
in supplying new types of service or in making cost-
reducing replacement decisions. For example, electric
utilities are sometimes able to negotiate special rates
for large industrial customers who seek to purchase
interruptabie power, and it is possible for these uti-
lities to earn a rate in excess of cost of capital. Sim-
ilarly, companies may install new and lower-cost gen-
erating equipment to replace obsolete equipment, and
the returns on such investments might also exceed
cost of capital. Discretionary investments such as these
give rise to the “producer’s surplus” shown as area
C in Exhibit 4.

If area B exceeds the sum of areas A and C, and
if regulatory lags are long, then the existence of
mandatory investment will cause an erosion of rate
of return.

When inflated operating costs, a rising cost of
capital, mandatory investments, and regulatory lags
are combined, the net result is a substantial diver-
gence between the cost of capital and the actual rate
of return on total investment. Exhibit 5 illustrates
this situation, and the questionnaire results described
later suggest strongly that this is indeed the current
situation for utilities. Consequently, incremental in-
vestment with high IRR’s or NPV’s would indeed
benefit the companies, and their high incremental
profits would not be reduced by regulatory actions.
Thus, it would seem that the rationale against utili-
ties’ use of the DCF methods is less valid than
under the static conditions assumed in traditional
theory.

The Public Utilities’ Investment
Acceptance Criterion

When choosing among competing projects, the
utility industry selects projects whose future costs,
when discounted at the cost of capital, are lowest.
Future costs, or revenue requirements as they are
frequently called, include the following items: (1)
labor, fuel, repair parts, and other operating costs;
(2) depreciation; (3) property ta.xes; (4) income taxes;
and (5) a return on the capital invested in the pro-

Exhibit 5, Combined Effect of Rising Costs, a Rising Cost of Capital, and Regulatory Lag

Cost of Cap i t a l

Percen t

Actual Rate of Return

Time

Autumn 1973 15

ject. The sum of these cost items, all discounted at
the current (marginal) cost of new capital, is the
present value of revenue requirements.

Utility theory assumes that customers’ cash pay-
ments will actually equal revenue requirements; hence,
the annual revenue requirement is really the expected
annual cash flow. Also, note that if revenues arc
exactly equal to revenuerequirements,asutility theory
assumes they will be, the NPV of any project, or at
least the NPV of the total investment required to
provide a class of service, will be zero.

The PV of annual cost criterion is applied in two
separate but related ways. First, for mandatory in-
vestments sales revenues are simply disregarded on the
grounds that they will be the same regardless of
which mutually exclusive project is chosen. In other
words, an electric company may project a requirement
to generate an additional 10 million kilowatts to
meet service demands, then set about deciding how
to provide this added capacity. The theoretically best
method—given the assumed level of demand—is the
one having the lowest present value of future revenue
requirements.

The other way in which the PV of cost criterion
is used, and this holds especially when a new type
of service not presently offered is being considered,
involves (I) calculating the minimum revenue require-
ments associated with the new service, then (2) con-
ducting some type of demand/regulatory analysis to
see if the project will in fact produce revenues equal
to its estimated revenue requirements. To illustrate,
suppose a telephone company is considering providing
data transmission service to a group of business
firms. Several switching systems might be used, so
they are analyzed to determine the one with the low-
est present value of revenue requirements. The com-
pany would then attempt to determine whether or not
actual revenues, given the proposed price structure,
would be sufficient to meet the projected revenue re-
quirements. If projected revenues are sufficient, then
the project would be undertaken. If they are not,
then the project might be deferred, abandoned, or
the company might discuss with the regulatory com-
mission and the prospective users the possibility of
setting higher rates for the service. This type of anal-
ysis is really quite similar to the orthodox NPV
method. Note, however, that it is used only for dis-
cretionary (cost saving or new product) investments.
However, mandatory investments are far more impor-
tant for most utility companies.

We should note two objections utility executives
have raised against the NPV method. First, they
point out that no explicit revenue projections are re-
quired to use the minimum PV of cost method, but
revenues are required to calculate the NPV. We sug-

gest that revenue projections are no more difficult
for most utilities than they are for most industrial
companies, so this objection to NPV seems of ques-
tionable validity. Second, they pointed out that utility
revenues are generated by a complex system, yet
most investment decisions relate to only one part of
the system. We would agree that the PV of annual
cost method is quite appropriate whendecidingwhich
of two replacement transformers is best and it is
known for certain that replacement must occur. How-
ever, it seems preferable to us to explicitly consider
revenues when analyzing major system additions be-
fore the fact, rather than to assume the necessary
rate increases.

The Questionnaire Results

At the outset of the project, the plan was to rep-
licate the type of survey thai others had done, ex-
cept that regulated utilities would be sampled rather
than unregulated industrial companies. For the reasons
cited above, however, we developed a new question-
naire, designed to provide answers to the following
set of questions with respect to utilities:

1. What selection techniques are used when choos-
ing among alternative investments?

2. How do they account for risk differences among
projects?

3. Do they conduct post-audits?
4. Do they experience periods of capital rationing,

and if so, how is this problem handled?
5. What is their most difficult problem encountered

in the capital budgeting process?
6. What is the average embedded (historical)

cost of capital, and how does it compare to the cur-
rent (marginal) cost of capital?

7. What capital costs, embedded or current, are
used as the hurdle or discount rate?

8. What is the allowed, or target, rate of return,
and how does this rate compare to the actual rea-
lized rate of return for the current year?

9. Is dividend policy influenced by either capital
requirements (investment opportunities) or by condi-
tions in the capital markets?

The Sample Companies

During questionnaire development, it became ap-
parent that dissimilarities made it impossible to survey
electric, gas. telephone and water utilities with the
same questions. We concentrated on the 116 electric
utilities listed on the Compustat public utility tapes,
which account for 99.5% of privately-owned electric

16 Financial Management

company assets. Questionnaires were sent to the chief
financial officer of each company. Forty-six percent
of the sample completed and returned our question-
naire. We compared the responding and nonrespond-
ing firms with respect to size and location, and we
found no significant differences. The questionnaires
were completed in the fall of 1972.

Project Selection Criteria

We asked the following question: “What invest-
ment selection technique or techniquesdoes your com-
pany use when choosing among alternative projects?
If more than one standard is used, please indicate
the approximate percentage of the total dollar volume
of investment that is evaluated by each method.”
The responses are given in E.xhibit 6.

Several comments should be made about the results
shown. First, most individualcompaniesactuallyindi-
cated thai they use only methods I. 2, and 5. Nine-
ty-four percent, or 50 out of 53 of the companies,
use the DCF method (minimum PV of reventie re-
quirements) to analyze at least some of their capital

Exhibit 6. Project Selection Methods Employed
by Eleetric Utilities, 197

Perccnl of loial
dollar volume of

capital expcndittiics
evaluated by mcUiod

in a typical year*

1. “Urgency”: Capital expendi-
tures required lo restore service
after a system breakdown

2. No formal analysis is made; in-
stead, Ihe judgment of the de-
cision maker is relied upon

3. Pick project with lowest lolal
“first costs” (i.e., the lowest
iniiial costs)

4. Pick project with the lowest
present value (PV) of initial
cosi

5. Pick project with the lowest
PV of annual costs

4.1%

17.8

7.4

1.7

69.0

100.0%

•The pcrcel1tage^ given here are unweighted averages of
the individual questionnaire responses.
•”Companies that use the equated or level annual charge
method are included in this group. Generally, revenue
requirements equals ihe expected first cost of the project
multiplied by an annual cosl percentage which consisls of
expected eost of money, property and income taxeb, de-
preciation, and maintenance costs.

projects. This contrasts with Klammcr\ finding that
only 57% of the Fortune 500 industrial companies
used a DCF mehlod.

As indicated earlier, discretionary invcsttiients are
generally accepted only if the utility’s manager thinks
revenue requirements will be realized. If expected reve-
nues equal reventie requirements, then e.\pected NPV
wili equal zero, while if expected revenues e.xceed
revenue requirements, NPV will be positive. Thus, to
the extent that discretionary investments are handled
in this manner, utilities do, in effect, use the NPV
method.

Most respondents indicated that at least some pro-
jects are accepted on the basis of urgency, and our
discussions with utility e.xecutives lead us to conclude
that the urgency criterion is eminently reasonable.
Similarly, almost all the companies indicated that some
projects are accepted without formal analysis, relying
instead upon judgment. A typical example is the
worn out transformer, which the engineer decides to
replace with whatever new transformer he believes to
be the best. As with the urgency criterion, our dis-
cussions with utility e.xeeutives convinced us that the
nonuse of formal capital budgeting procedures for
this set of projects does not necessarily imply ineffi-
cient or unsophisticated management. Rather, it sug-
gests a conscious comparison of the costs of follow-
ing formal procedures versus the benefits gained by
using informal procedures.

Adjustments for Risk

If all projects under consideration are not equally
risky, then this fact should be taken into account.
The two procedures most commonly recommended in
the finance literature are (I) the use of risk-adjusted
discount rates and (2) the use of certainty equiva-
lents. Exhibit 7 shows what electric utility companies
actually do. First, no respondent indicated that his
company used certainty equivalents, and only about
15% of the companies use the risk-adjusted discount
rate technique.

This is not to say, however, that most electric uti-
lity companies indicated no formal recognition of risk
differentials; 58% of the companies did acknowledge
risk in some manner. The two most commonly used
procedures are (1) sensitivity analysis of cost and
revenues under alternative conditionsabout investment
alternatives; and {2)an arbitrary downward adjustment
in the expected life of an abnormally risky project.

It is interesting that utilities do formally analyze
risk to a greater extent than the Fortune 500 indus-
trial companies. Klammer found that only 40% of
the industrial firms surveyed explicitly analyze risk
versus 58% of the utility companies.

Autumn 1973
17

Exhibit 7. Procedures Used to Account for
Differing Degrees of Project Risk

Primary
method

used**

Secondary
method used (if

an\ indicated)*’

1. Raise the cost of
capital used in cal-
culating revenue
requirements for
riskier projects

2. Adjust downward
the e.xpccled life if
the project is more
risky than normal

3. No formal differ-
entiation is recog-
nized

4. Use ”sensitivity
analysis” (i.e..
formally consider
what will happen
lo eosts and reve-
nues under alterna-
tive conditions,
and use this infor-
mation in a judg-
mental manrtcT to
reach a decision as
to the best alierna-
tive)

4.4%

1.0

42.3

10.4%

8.4

42.3
100.0%

*Only 32.5% of the responding ciimpanics indicated thnl
they used two methods to account for riiik differentials.
•*The percentages given here are unweighted averages of
the indi\iduai questionnaire responses.

Post-Audits of Investment Projects

Post-audits supposedly lead to better capital bud-
geting by (I) uncovering serious weaknesses or sys-
tematic biases and (2) stimulating decision makers to
be more careful.

Exhibit 8 shows tlic percentage of the electric
companies that conduct post-audits. The table is di-
vided into two sections, one for residential and com-
mercial investments, the other for industrial invest-
ments. The primary reason for using this breakdown
is that industrial service is frequently discretionary,
and some utility executives feel that p9st-audit$ are
more applicable for investments of this type. The
table also recognizes that post-audits can be made
separately for construction costs, operating costs, and
operating revenues.

Exhibit 8. Post-Audits of Investment Projects

Percentage of respondents
thai conduct post-audit*.

Post-audit
of initial
outlay costs

Post-audit of
operating costs

Posl-audii of
operating revenues

Rcsiitcniial and
conimi-rciai
rnM-‘stmtrnts

Industrial
service

investments

60.9% 63.0%

30.2% 38.6%

25.6% 35.7%

Only a little over 60% of the titilities conduct
post-audits. This compares with Klammcr’s finding
that 88% of the largest industrial firms employed
post-audit^i of construction costs. One explanation
given by a utility company executive for his own
company’s lack of interest in construction cost post-
audits for all projects relates to the very long con-
struction periods sometimes involved. Today it takes
an average of 14 years to plan and build a nuclear
plant. With such a long time frame, the initial cost
estimates are simply not relevant. Early estimates are
avaiiabie and could be looked up and analyzed, but
why bother? This executive also suggested that a
considerable amount of utility investment is done under
fixed cost contracts, and post-audits are obviously not
useful in these instances.

Exhibit ii also shows that post-audits of operating
costs and operating revenues are not conducted gen-
erally. A noticeably larger percentage, however, of
industrial as opposed to commercial residential pro-
jects are subjected to post-audits. The principal reason
for the companies” infrequent use of operating cost-
revenue post-audits is. apparently, that since most of
their investments are mandatory, they simply must be
made regardless of either the operating cost of the
project or its revenues.

Capital Rationing

Exhibit 9 indicates that 40% of the companies
surveyed have been subject to capital rationing. Of
the firms, 89% indicated that in response to funds
shortage they would apply for a rate increase. If a
rate increase were granted, then their higher earning
power would presumably enable them to obtain the
capital necessary for making alt “identified and justi-
fiable” investments.

If rate increases were not granted. 75% of the
companies indicated that they would eliminate or
postpone those projects that would be least likely to

18 Financial Management

Exhibit 9. Capital Rationing in the Electric Utility industry

I. Percentage of respondents that have
experienced capital raiioning
during the past 5 years*

II. Procedures for dealing with Capital
raiioning

1. Apply for a rate increase

2. Eliminate or postpone thoie projects that
are least likely lo meet revenue requirements

3. Lca!>e fixed assets

4. Make less capital intc^^ive in\cstments
(i.e.. accept Ihe al(erna[i\c with ihc
lower first cost or initial outlay)

Have had
Capital

Raiioning

40%

Percentage of rcspondcnis
thai indicated their firm

would l.-ike the action noted

89%

75%

55%

‘ . \ periixl of capital rationing is defined as a period when the firm could not obtain sufficient funds at or below its allowed
rate of return to make all its identified and justifiable investments.

meet revenue requirements, and over half the com-
panies indicated that they would lease rather than
purchase fixed assets. The willingness to lease was
somewhat surprising, but apparently utilitycompanies
that are strapped for capital are increasingly resorting
to leasing arrangements. The fourth alternative men-
tioned was to make less capital intensive investments.

Perceived Problem Areas in Capital
Budgeting

Far and away their most serious problem in the
eyes of utility executives is obtaining permission from
environmental protection agencies and. or the Atomic
Energy Commission to build new generating plants.
No other factor was considered to be a serious pro-
blem by even half as many respondents.

The remainder of Exhibit 10 was somewhat sur-
prising. We expected the companies to have trouble
estimating annual costs and revenues and cost of
capital, but obviously they do not consider these esti-
mates 10 be serious problems. In retrospect, it is
easy to see why this is so. The cost of capita! for
utility companies is, rightly or wrongly, determined
in rate cases. Also, capital budgeting techniques
used tend to suppress revenue estimates; re\enue
shortfalls are supposed to be made up by rate
increases. Further, the companies frequently assume
that, once a project is in operation, the regulatory
process will provide sufficient revenues to cover oper-
ating costs.

It is also interesting to examine the second col-
umn in the table headed **A Fairly Serious Pro-
blem.” Many items not consideied to be “very
serious” are considered, nevertheless, to be “fairly
serious”. For example, estimating the annual oper-
ating costs of a project, response 9 in E.\hibit 10, is
not generally considered to be a very serious pro-
blem, but it is considered to be a fairlv serious one.

Cost of Capital, Allowed Rates of
Return, and Realized Rates of Return

The average after-tax current cost of capital. 9.3%,
indicated in Exhibit 11, is well above the indicated
embedded cost of capital. 8.0%. This differential is,
presumably, caused by the fact that the embedded
cost of debt for most companies is well below the
current rate of interest on long-term bonds. It is also
interesting to note that the average allowed rate of
return as prescribed by regulatory authorities, 7.6%,
is below the indicated 8.0% a\erage embedded cost
of capital. There are a large number of rate cases in
process across the country today, and allowed rates
of return will presumably be increased somewhat.

The last item shown in Exhibit II. the current
rate of return on in\estment. is substantially lower
than either the allowed rate of return or the cost of
capital. Thus, the situations shown in both Exhibits
2 and 5 seem to exist today.

Autumn 1973 19

Exhibit 10. Percei>ed Problem Areas in Capital Budgeting

Obtaining rcgulalory approval for new plants from environmental
protcelion agencies and/or AEC

Specification of first cost or capital requirements of a new
investment

Estimation of the cosl and availability of llie input
factors (i.e., fuel, labor)

Estimation of ihc project’s economic life giving regard
lo bolh demand factors and obsolescence of ihe
invcsiment due to new technology

Estimation of when the plant will be placed in service

Making in\cstmcnis that should be profitable, given demand
and technology factors, but thai are nol allowed lo earn
their expected return by regulatory authorities

Making sure all reasonable alternatives have been considered

Specification of the effects of inflation on annual costs
in general

Estimation of annual operating cost of the project

Predicting the needs of the franchise area in advance

Esiimaiion of annual revenue attributed to the project

Specification of a “cost of money” or cost of capital

Estimation of project life from a wear/iear standpoint

Perccni of Respondents Stating that
the Indicated F-‘actor is:

A Very A Fairly Not at
Scriouii Serious all

Problem Problem Serious

19
19
2
43

43
43

25
34
34

The Cost of Capital Used as the
“Hurdle Rate”

We asked the companies to indicate which cost of
capital, the embedded cost or the current (or mar-
ginal) cost, was used in llie capital budgeting pro-
cess. The o\orwhclming majority of tlie companies
used cither the current cost of capital or a figure
very close to the current cost; no company used the
embedded cost of capital when analyzing new invest-
ments.

Dividend Policy

At least some of ihe writinjjs in finance suggest
that companies should alter their dividend payout
policies as changes occur in either investment oppor-
tunities or in capital market conditions. Todetermine
whether or nol utility companies do adjust their di-
vidend policies, we asked the following: It has been
suggested that utility companies’dividend policies may

be affected hy capital investment opportunities or
requirements and by capital market conditions (i.e.,
ihe slate of stock and bond markets). For example,
in a period of high investment demand and light
money, companies might not increase dividends if
earnings increased, thus reducing the payout ratio,
or they might even cut dividends in order to con-
serve capital. Recognizing that it might take several
years to effect such u change, do you think that
your own company’s dividend policy would be
affected by:

Percent responding:

Yes No
a. Changes in capital expenditure

opportunities or requirements?

b. Capital market conditions?

34%

40’̂ ,, 60%

According to the respondents, only about one-third
of ihc utility companies’ dividend policies are ad-
justed in response lo changing investment oppor-
tunities or capital market conditions.

20 Financial Management

Exhibit U . Cost of Capital, Allowed Rates
of Return, and Realized Rates of Return,
Electric Companies, 1972*

!, Average After-Tax Current (or Marginal)
Cost of Capital 9..V”,

2. Average After-Tax Embedded Cost of
Capiial 8.0%

3. Allowed, or Target, Rate of Return as
Prescribed by Regulatory Agencies 7.6%

4. Current Actual Rate of Return on Investment 1 .IX

•The cost of equity capital is defined as the rate of return
on book equity thai was authorized if a rate caî e was
recently concluded, or the rate of return most likely to be
allowed if a rate case were lo be decided now. The
problems encountered when attempting to measure the
cost of equity are well known, and il is possible iha[
Commission-determined costs of capital arc seriously over-
or undersuued. We have simply avoided this issue by
accepting ihe Commission’s estimates.

It should be noled that iho figures given are returns on
hook equity, which may be different from investors’ re-
quired rates of return on market values. For a discussion
of this point, sec the discussion of A.A. Robichek in the
1971 AT&T rate ease (FCC Doeket No. 19129) or
E.F. Brigham in the 1972 Conisal rate case (FCC Doeket
No. 16070).

Also, it should be noted thai different companies cm-
ploy different rate base valuation methods (i.e.. original
cost vs. “fair value”), and different rates of relurn on
these different rate bases are appropriate. Such differences
were considered in ihe study upon which Exhibit II is
based.

Source: Eugene F. Brigham and Richard H. Pettway.
“Capital Budgeting in ihe Public Utility Sector.”
University of Florida, Public Uliiily Research
Center. Working Paper No. 3-73. October 1973.

One thing was very clear from comments attached
to the questionnaire—the utility company executives
very definitely think thai the market price of their
stock is influenced by dividend policy. Quite a few
respondents made note of the fact that Potomac
Electric Power Company, in a well-known case, took
exactly the action suggested inourquestionnaire, and,
apparently as a resull of this action, the price of the
stock dropped precipitously. Academicians mighl ar-
gue that the stock price declined because of other
factors, but it would be hard to convince a number
of utility company executives that ihis was ihc case.

Conclusions

Under inflation the established pattern of rate
regulation has nol worked oui as utility Ihcory as-

sumes, and, as a resull, the utility companies have
been placed in a difficult position. On the one hand,
they must make whatever invcsttneni is necessary to
meet service demands, yet rising costs, coupled wiih
prices of their products ihat rise only with a lag,
have caused rates of return to erode. Thus, many
utilities are placed in a position where they must ac-
cept projects whose internal rates of return are less
than their cost of capital.

Frotii a survey we conclude the following abou(
capital budgeting by electric utilities.

1. Utility companies use a DCF selection criterion
(minimum PV of revenue requirements) to a greater
extent than do the Fortune 500 industrials. This dif-
fercniial usage probably results from the fact that the
utilities arc large and capital intensive, make very
long-term investments, and can estimate cash flows
better than firms more subject to competitive pres-
sures.

2. Utilities seem to recognize risk differentials
among projects to at least as great an extent as do
industrial companies, but since these differences can-
not generally be quantified, they influence project se-
lection in a judgmental manner, not through a for-
mal technique such as certainty equivalents or risk-
adjusted discount rales.

3. Utility companies do not employ post-audits
of investment projects to as large an extent as do in-
dustrial firms.

4. Capital rationing is becoming a problem for
utililies. Their first reaction is lo seek rate increases
which will enable them to raise additional funds, but
if rate increases are nol forthcoming, then projects
will be eliminated or postponed, assets will be leased,
or less capital intensive alternatives will be accepted.

5. Utility companies do not generally consider in-
put estimates to be a very serious problem. Inter-
estingly, they overwhelmingly consider obtaining ap-
proval for new generating plants from environmental
protection agencies or the AEC lo be the single most
difficult aspect of capital budgeting.

6. The current cost of capital exceeds ihe embedded
cost, and this cost exceeds both Ihe allowed and rea-
lized rates of return. This situation has given rise to
a large number of pending rate cases.

7. When utiiiiies use the discounted cash flow tech-
niques, they use the marginal cost of capital as a
hurdle rale.

8. The majority of the companies Indicated thai
their dividend policy is nol influenced by capital
needs or by capita! market conditions, al least not in
the short run.

Overall, the electric companies seem to be oper-
ating largely in a manner that, while different be-
cause of their regulatory environment, is generally

Autumn 1973 21

consistent wiih the types of capital budgeting tech-
niques recommended in the aeadeniic literature. How-
ever, we do feel that public utilities should at least
consider employing the NPV method ralhcr than ihc
PV of annual cost method for both discretionary and

mandatory system expansion investments. While dif-
ficulties would certainly be encountered in making
these calculations, the NPV method would provide
valuable data on the explicit impact of expansion on
both profitability and revenue requirements.

REFERENCES

1. Mouslafa Abdclsamad. A Guide to CapitalE.xpemtiture
Analysis, New York, AMACOM. American Management
Association, 1973.

2. George A. Christy, Cupiial Budgeting—Curreni Pruc-
lices and Their Efficiency, Eugene, Oregon, Bureau of
Business & Economic Research, University of Oregon.
1966.

3. Gordon R. Corey. “The Avcrch and Johnson Pro-
position: A Critical Analysis,” Bell Journai (Spring
1971). pp. 358-373.

4. Donald F. Istvan. Capital Expenditure Decisions:
Haw They arc Made in Large Corporations. Bloomington,
Indiana, Bureau of Business Research, Indiana University,
1961.

5. Donald F. Istvan, “The Hconomie Evaluation ofCap-
it;il Expenditures,” ‘ The Journal of Business {\9(}\).

6. Nat ional Assoeiation of Accountants , Financial Anal-
ysis to Guide Capiial Expenditure Decisions. Research
Report 43. New York. Niiiional .Association of Accoun-
tants. 1967.

7. Norman P, Pflonin, “Managing Capital Expendi-
tures,” Studies in Business Policy, 107, New York. The
National Industrial Conference Board, 1963.

8. Robert M. Soldofsky, “Capital Budgeting Praetiees in
Small Manufacturing Companies,” .Siudie.s in the Factor
Markets for Small Business Firms, Ames, Iowa, Iowa
State University, 1963.

9. George Tcrborgh, Business Investment Management.
a MAPI Study and Manual. Washington. D.C.. Ma-
chinery and Allied Products Institute and Council for
Teehnologica! Advancement. 1967.

22 Financial Management

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