Journal of Advances in Management Research

Capital budgeting decision-making practices: evidence from Pakistan

Afeera Mubashar, Yasir Bin Tariq,
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Capital
Capital budgeting decision-making budgeting
practices: evidence from Pakistan decision-making
practices
Afeera Mubashar and Yasir Bin Tariq
COMSATS University Islamabad – Abbottabad Campus, Abbottabad, Pakistan

Abstract
Purpose – The purpose of this paper is to examine the current trends of capital budgeting practices (analysis
techniques, discount rate estimations and risk assessment methods) among Pakistani listed firms and analyze
the responses conditional on firms’ demographics and executive characteristics.
Design/methodology/approach – An online questionnaire was sent via e-mail to top 200 non-financial
firms (in terms of market capitalization) listed on Pakistan Stock Exchange.
Findings – With a response rate of 35 percent, it is concluded that the theory–practice gap is low
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as Pakistani listed firms are using discounted cash flow methods of capital budgeting and preferring net
present value over internal rate of return. Similarly, weighted average cost of capital is estimated using target
value weights, and capital asset pricing model (with extra risk factors) is used to determine the cost of equity
capital. For risk assessment, sensitivity analysis and scenario analysis are the dominant approaches; however
despite the theoretical superiority, the use of real options is very low. Overall, investment decision responses
significantly differ across firm’s demographics and executive characteristics.
Practical implications – Pakistani business schools need to address the low usage of advanced methods
such as modified internal rate of return and real options among Pakistani listed firms.
Originality/value – This is the first comprehensive study on the topic in Pakistan and have highlighted the
areas of capital budgeting where Pakistani firms’ practices deviates from finance theory.
Keywords Real options, Risk, Cost of equity, Cost of capital, Capital budgeting
Paper type Research paper

1. Introduction
Profitable long-term investments are vital for the sustainability and growth of a firm.
The survival and vitality of a firm depend upon its ability to regenerate returns from
long-term assets/investments through the proper allotment of capital (Ryan and Ryan, 2002;
Arnold and Hatzopoulos, 2000). To increase the wealth of its shareholders, a firm needs to
continuously identify, analyze and choose long-term investment projects that could help
achieving these goals, i.e., increase in wealth, survival and growth. This process of selecting,
analyzing and investing capital in long-term assets/investments which provide returns for
more than one year is known as capital budgeting (Fabozzi and Peterson, 2002). Investing in
efficient investment projects is crucial because resources are limited and firms must grow
their value (Klammer et al., 1991).
Corporate financial policy also known as financial management is comprised of three
major decisions, i.e., investment decisions, financing decisions and dividend decisions
(Freeman and Hobbes, 1991). Capital budgeting decisions fall under the domain of
investment decisions. These decisions play an important role in increasing the value of the
firm (Slagmulder et al., 1995). Investment decisions are more important than financing
and dividend decisions as these decisions have a complicated nature (Nurullah and
Kengatharan, 2015) and they require significant resources and long-term financial
commitment. Once the investment decisions are taken, it becomes impossible to manipulate
them without incurring significant losses (Hall and Millard, 2010). To comprehend
investment decisions, firms should consider it as a continual process based upon several
interrelated steps.
In corporate finance literature, capital budgeting practices are grouped into investment Journal of Advances in
Management Research
analysis (capital budgeting techniques (CBT)), discount rate setting and risk analysis © Emerald Publishing Limited
0972-7981
(Souza and Lunkes, 2016). Traditionally, CBT are classified into two types, i.e., naive (basic) DOI 10.1108/JAMR-07-2018-0055
 JAMR techniques and sophisticated techniques (Haka et al., 1985). Naive CBT do not consider cash
flows, time value of money and risk factors, whereas sophisticated techniques consider
these factors while analyzing investment opportunities. Net present value (NPV ), internal
rate of return (IRR), modified internal rate of return (MIRR) and profitability index (PI) are
considered as sophisticated CBT, whereas payback period (PBP) and accounting rate of
return (ARR) are classified as naive CBT (Brigham and Ehrhardt, 2002).
Estimating the cost of capital is also a vital component of long-term investment
decisions. It is recommended to calculate the cost of every source of capital based on their
relative weights in the capital structure (Brigham and Ehrhardt, 2002). Three main sources
of financing are: issuing debts, preferred stocks and common stocks. Majority of the firms
take faulty investment decisions by considering only the cost of a single source of funding,
e.g., cost of equity or cost of debt. For calculating the discount rate, weighted average cost
of capital (WACC) is the recommended approach as compared to “cost of equity” and
“cost of debt.” The weights used for calculating WACC (discount rate) should be based upon
“target or market value weights” rather than “book value weights.” Ideally, “target value
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weights” should be used but “market value weights” are considered as an appropriate proxy
for calculating WACC (Gitman and Vandenberg, 2000).
In the context of capital budgeting, the term “risk” refers to the variability of cash flows
that a project will generate in the future (Verbeeten, 2006). For effective investment
decisions, it is not enough to make only discounted cash flow (DCF) estimations using cost
of capital but it also requires accountability for uncertainty (Brigham and Ehrhardt, 2002).
Risk affects the estimation of future cash flow streams and cost of capital which, in turn,
affects NPV/IRR estimates. There are versatile techniques for adjusting risk in investment
decisions (Ho and Pike, 1991). The major methods used to analyze risk in capital budgeting
decisions are sensitivity analysis, scenario analysis, decision tree, Monte Carlo simulation
and real options (Souza and Lunkes, 2016). In the real world, there exists a variance between
theory and practice, which is mainly due to impractical managerial attitude toward
investment decisions, negligence of informational hurdles and inability of other employees
to take part in organizational decision-making (Mukherjee, 1985).
One of the extensive progresses in the field of investment decisions from the past decade
is the use of real options while analyzing potential investment opportunities. Majority of the
capital budgeting decisions have different options that include abandonment options,
expansionary options and growth options (Ross et al., 2005). To calculate real NPV, the use
of real options should be used as a complementary tool to traditional DCF methods (Amram
and Howe, 2002). However, this effective approach is often neglected in calculating NPV
(Phelan, 1997). Copeland and Antikarov (2001) predicted that real options would become the
most famous method of capital budgeting in the coming decade. The available empirical
evidence suggest that we are not there yet.
Capital budgeting practices are the most vital component of financial management
(Bunch, 1996) and one of the most widely investigated topic in corporate finance literature.
Majority of the studies investigated the capital budgeting practices among surveyed firms
are from developed economies followed by emerging economies (e.g. the USA (Graham
and Harvey, 2001), Canada ( Jog and Srivastava, 1995; Bennouna et al., 2010), Japan
(Shinoda, 2010), the UK (Arnold and Hatzopoulos, 2000), India (Singh et al., 2012; Verma
et al., 2009) and Sri Lanka (Nurullah and Kengatharan, 2015)). However, in contrast to the
developed world, this area is less investigated in emerging economies. Pakistan is a
rapidly growing emerging economy, ranked as 24th largest economy in 2016 and expected
to become 16th largest economy by 2050[1]. Till date and as per best of our knowledge,
there is no comprehensive study exploring the key aspects of capital budgeting practices
by listed firms in Pakistan. This presents an opportunity to investigate the topic under
discussion for an emerging economy like Pakistan. Therefore, the aim of this study is to
 fill this gap in the empirical literature by providing first-time comprehensive empirical Capital
evidence from Pakistan. budgeting
Following the methodology of Graham and Harvey (2001), our study is different from decision-making
previous studies conducted in emerging economies in several ways. We not only
investigated the theory–practice gap by documenting the preferred CBT of surveyed firms, practices
but also documented the detailed responses regarding cost of capital, methods for
calculating cost of capital, the use of real options and how risk is addressed while making
capital budgeting decisions. Furthermore, we analyzed CFO’s responses conditional on
firms and executive’s characteristics to find out the relationship of firm size, leverage,
dividend policy, executives’ demographics, etc., with the selection of CBT, discount rate and
risk assessment methods.
The rest of this paper is organized as follows. The following section summarizes the
empirical findings of previous studies in developed and emerging economies. Section 3
explains the research design adopted by this study which is followed by the analysis and
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discussion of results and finally the conclusion of the study.

2. Literature review
Investment decisions are one of the three main pillars of corporate financial policy.
Its importance is also evident from the wide body of empirical literature available on
different aspects of investment decisions. Here this study briefly and specifically discusses
the literature addressing the extent of usage of capital budgeting methods and how different
factors could influence the selection of specific capital budgeting methods.
The available empirical literature on capital budgeting can be broadly divided into three
set of studies. First set of studies include capital budgeting studies carried out in the
developed economies. These include studies conducted in the USA (Gitman and Forrester,
1977; Schall et al., 1978; Block, 1997; Farragher et al., 1999; Graham and Harvey, 2001; Ryan
and Ryan, 2002), the UK (Pike, 1989; Pike and Sharp, 1989; Pike, 1996; Arnold and
Hatzopoulos, 2000; Alkaraan and Northcott, 2006), Australia (Truong et al., 2008), Canada
( Jog and Srivastava, 1995; Bennouna et al., 2010), Spain (Andrés et al., 2014) and Hong Kong
(Lam et al., 2007; Chen, 2008). The second set contains studies from developing/emerging
economies. For example, studies conducted in Malaysia (Kwong, 1986), India (Babu and
Sharma, 1996; Singh et al., 2012; Batra and Verma, 2017), Argentina (Pereiro, 2006),
South Africa (Correia and Cramer, 2008), Jordan (Khamees et al., 2010), Poland (Wnuk-Pel,
2014), Sri Lanka (Nurullah and Kengatharan, 2015), Brazil (Souza and Lunkes, 2016), Kuwait
(Alkulaib et al., 2016) and Morocco (Baker et al., 2017).
Finally, the third set of studies is of multi-country studies where either groups of
countries are studied or comparison is made between countries from developed and
developing economies. These include studies such as that of Brounen et al. (2004)
(investigated four European countries, i.e., the UK, France, Germany and the Netherlands),
Rossi (2014) (three European countries i.e. Italy, Spain and France), Andor et al. (2015) (ten
Central and Eastern European (CEE) countries), Brunzell et al. (2013) (five Nordic countries)
and Hermes et al. (2007) (comparative study of China and the Netherlands).
A tabular summary of 33 studies from developed and developing economies,
summarizing the respective survey findings of individual studies, is given at the end of
this section.
One of the comprehensive studies was conducted by Graham and Harvey (2001).
They conducted a survey in the USA and asked 392 CFOs about capital budgeting, cost of
capital and debt equity structure. With the response rate of 9 percent, they concluded
that large firms are inclined toward NPV and CAPM contrary to small firms who relied on
PBP technique. There exists a significant difference of CBT across small and large firms.
Bennouna et al. (2010) investigated the capital budgeting practices of 88 large
 JAMR Canadian firms. With response rate of 18.4 percent, it was concluded that Canadian firms
are the frequent users of DCF and are inclined toward sophisticated methods like real
options, Monte Carlo simulation, decision trees and game theory when dealing with
uncertainty. Still 17 percent of large firms do not use DCF techniques. However, the use of
real options in these firms is about 8 percent.
Block (1997) carried out a comprehensive survey of 232 small US firms and reported that
42.7 percent of firms use PBP while evaluating investment project. The industry’s nature
and capital budgeting decision-making practices are significantly related. Nurullah and
Kengatharan (2015) conducted a comprehensive survey of trading and manufacturing listed
firms of Sri Lanka and reported that NPV is the most preferred approach of capital budgeting
followed by PBP and IRR. Size of the budget and education of CFO are significantly related with
the use of sophisticated capital budgeting technique. Similarly, sensitivity analysis is the most
frequently used risk assessment technique and WACC is used to estimate the cost of capital.
Andor et al. (2015) conducted a comprehensive phone survey of 400 CEOs of small,
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medium and large firms in ten countries of CEE. They concluded that capital budgeting
practices of CEE are mostly affected by firm size, culture and existence of code of ethics and
firm objectives, while targeted leverage, management ownership and number of projects to
be analyzed also play a moderate role. Large firms are employing DCF practices (56 percent)
more than SMEs (45 percent). An interesting finding of their study is that even though there
are several advantages of advance capital budgeting practices including DCF, sensitivity
analysis and real options but still management can reject a handsome project that was once
chosen based on DCF methods.
Based on the survey of South African listed firms, Correia and Cramer (2008) reported
that South African firms have aligned their capital budgeting practices with textbook
recommended methods. South African firms prefer DCF methods of capital budgeting, and
for estimating the cost of equity, CAPM is used while majority of firms have either strict or
low targeted debt-equity ratios. Similarly, a survey of 313 CFOs across four European
countries (the UK, the Netherlands, Germany and France) was conducted by Brounen et al.
(2004). They concluded that large firms are preferring sophisticated CBTs and CAPM
whereas small firms rely on simple PBP. Andrés et al. (2014) carried out a survey of CFOs of
140 large non-financial Spanish companies. They reported that Spanish firms use PBP
(75 percent) more than IRR and NPV. The prevalence of PBP method is higher in Spanish
firms as compared to European and North American firms. It can be due to its simplicity
and ease of calculation. However, these firms were not inclined toward real options.
Furthermore, it was found that financial officers of Spanish firms do not rely on a single
method of capital budgeting.
Arnold and Hatzopoulos (2000) conducted a survey of 296 UK firms and revealed that the
theory–practice gap is minimum as UK firms are preferring DCF-based CBTs. Singh et al.
(2012) administered a survey of 166 non-financial Indian firms, listed on Bombay Stock
Exchange (BSE-200 index). They reported that Indian firms are using both discounted and
non-discounted capital budgeting methods and IRR is preferred over NPV. For risk
measurement, sensitivity analysis was the preferred approach. Similar findings were
reported by Batra and Verma (2017). Additionally they revealed that company size, CFO’s
age and CFO’s education are significantly associated with the use of sophisticated CBT.
A survey of 51 Brazilian companies was conducted by Souza and Lunkes (2016) and
they reported that Brazilian firms are using PBP (70.5 percent) more frequently than NPV
(64.5 percent) and IRR (61 percent). WACC is used to assess the cost of capital and
sensitivity and scenario analysis are the commonly used methods for risk assessment.
It was concluded that there exists a theory–practice gap in Brazilian firms. Wnuk-Pel (2014)
conducted a survey of 100 Polish firms. They concluded that the surveyed Polish firms are
following textbook-based methods of capital budgeting and these decisions are influenced
 by company size, nature of company, budget size and origin of equity capital. Hermes et al. Capital
(2007) compared the capital budgeting practices of 250 Dutch and 300 Chinese listed and budgeting
non-listed companies. With 17 percent responses from Dutch firms and 15 percent responses decision-making
from Chinese firms, it was revealed that Dutch CFOs prefer to use sophisticated CBT than
Chinese CFOs and reason being Dutch CFOs are more qualified than Chinese CFOs (Table I). practices
Based on the review of empirical capital budgeting literature, we can conclude that both
developed and emerging economies are moving from naive techniques of capital budgeting
to advanced techniques. Large firms of both developed and emerging economies are most
frequent users of sophisticated techniques of capital budgeting. Also, most of the firms are
not relying on the single technique of capital budgeting, instead firms are using more than
one technique to make capital budgeting decisions.
The use of CBT is affected by several firm-specific and executive-specific factors such as
CFO and CEO’s age, sales, nature of industry, whether debt is rated or not, education and
experience of CFO and CEO. The prevalent use of PBP method in small firms especially in
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emerging economies can be attributed to potential budget constraints faced by those firms
and PBP emphasis on liquidity. As far as risk assessment techniques are concerned, both
developed and emerging economies are frequent users of sensitivity analysis and scenario
analysis. Despite the theoretical advantage, the use of real options is still not very common.

3. Research methodology
3.1 Research design
This is an exploratory study using survey methodology (online questionnaire) to collect
primary data to fulfill the research objectives of this study. The aim was to collect responses
from Pakistani listed firms on three main areas of investment decisions, i.e., CBT, discount
rate (cost of capital) and risk techniques used in capital budgeting decisions. A modified
version of the questionnaire of Graham and Harvey (2001) was used. The permission to use
their questionnaire was obtained via e-mail.
The first part of the online questionnaire measures the preference of firms regarding CBT.
We followed the standard 5 – category scale of Graham and Harvey (2001) where “0 – never,
1 – rarely, 2 – sometimes, 3 – almost always, 4 – always.” The second part of the online
questionnaire is covering the questions related to the cost of capital and most favorable
method for calculating the cost of capital. It also covers the timing related to the calculation of
cost of capital and the most frequent methods used to estimate “cost of equity capital.”
The third part of the online questionnaire is concerned with the methods used to analyze risk
in capital budgeting decision-making process. And finally, the fourth part of questionnaire is
asking for demographic information of CEO, CFO and firms’ characteristics.
The online questionnaire[2] was sent to the top 200 non-financial listed firms in terms of
market capitalization. The reason for choosing top 200 firms is as follows. Traditionally
studies addressing Pakistani firms chose KSE-100 indexed firms, which can be described as
top 100 firms in terms of market capitalization and a representative of Pakistani stock
market. If we had sent questionnaire to only KSE-100 indexed firms, our response rate
would have been very low given the fact that out of KSE-100, approximately 20 are financial
firms[3]. Therefore, we sent our questionnaire to top 200 non-financial firms (in terms of
market capitalization) that also includes KSE-100 non-financial firms.
The link to the online questionnaire was sent to top 200 listed non-financial firms via e-mail.
The e-mail addresses and telephone numbers were fetched from the official website of Pakistan
Stock Exchange (PSX) and companies’ respective websites. The e-mails were addressed to the
CFOs/finance directors of the firms. Initially, the questionnaires were sent to 50 firms. Majority
of the firms did not respond to e-mails. Therefore, after sending questionnaires to the firms via
e-mail, we followed up via telephone. It took us five months to gather the responses. Out of
200 firms, 70 firms responded. The response rate of this study is 35 percent.
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Table I.
JAMR

Summary of capital

chronological order)
budgeting studies (in
Authors’ name and year of Famous capital budgeting, cost of capital estimation
S. No. publication Sample of the study and risk assessment techniques Least popular techniques

1 Schall et al. (1978) 198 US firms DCF methods, WACC and shorting PBP Cost of equity
2 Kwong (1986) 70 Malaysian firms listed on PBP, IRR and subjective evaluation PI, Net future value
Kuala Lumpur stock exchange
3 Jog and Srivastava (1995) 582 Canadian firms IRR, PBP and sensitivity analysis CAPM
4 Babu and Sharma (1996) 73 Indian firms IRR, PBP, Risk adjusted discount rate and sensitivity
analysis
5 Block (1997) 232 small US firms PBP and cost of funding Historical returns and
Probabilistic analysis
6 Gitman and Forrester (1977) 268 firms US firms IRR, PBP and WACC PI
7 Farragher et al. (1999) 379 US firms NPV, IRR, CAPM and sensitivity analysis ARR
8 Arnold and Hatzopoulos (2000) 296 UK firms NPV, IRR, sensitivity analysis and scenario analysis MIRR
9 Graham and Harvey (2001) 392 CFOs of US firms NPV, IRR and RADR APV
10 Ryan and Ryan (2002) 205 US firms NPV, IRR, inflation adjusted cash flows, sensitivity MIRR
analysis and scenario analysis
11 Brounen et al. (2004) 313 CFOs of UK, Netherlands, The UK and the Netherlands firms use PBP and NPV France and Germany less
Germany and France frequently use PBP and NPV
12 Alkaraan and Northcott (2006) 320 UK firms NPV, IRR and sensitivity/scenario analysis ARR and CAPM
13 Pereiro (2006) 55 respondents from Argentina NPV, IRR, PBP and CAPM Real options
14 Hermes et al. (2007) 250 Dutch and 300 Chinese firms Dutch CFOs prefer NPV while Chinese CFOs prefer –
IRR. WACC is used to calculate cost of capital
15 Lam et al. (2007) Hong Kong building contractors PBP and shortening PBP IRR
16 Correia and Cramer (2008) 28 firms listed on JSE NPV, IRR and WACC with target value weights PI, Monte Carlo simulation,
APV and real options
17 Truong et al. (2008) 356 Australian firms NPV, IRR, PBP and WACC ARR
18 Bennouna et al. (2010) 88 large Canadian firms NPV, IRR, sensitivity analysis and risk-adjusted Real options
discount rate (RADR)
19 Hall and Millard (2010) 67 firms listed on Johannesburg ROI, NPV and sensitivity analysis Accounting payback
Stock Exchange
20 Khamees et al. (2010) 81 Jordanian industrial firms of PI, PBP and sensitivity analysis Scenario analysis
Jordon
21 Shinoda (2010) 225 firms listed on Tokyo Stock PBP and NPV DPBP
Exchange

(continued )
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Authors’ name and year of Famous capital budgeting, cost of capital estimation
S. No. publication Sample of the study and risk assessment techniques Least popular techniques

22 Maquieira et al. (2012) 290 Latin American firms PBP and PI CAPM
23 Singh et al. (2012) 166 Indian non-financial firms PBP, ARR and sensitivity analysis PI
24 Brunzell et al. (2013) 157 CFOs from 5 Nordic NPV, PBP and WACC Real options
countries
25 Andrés et al. (2014) 140 Spanish firms PBP, IRR and NPV Real options
26 Rossi (2014) CFOs of Italy, Spain and France PBP and IRR ARR
27 Wnuk-Pel (2014) 100 Polish firms NPV, sensitivity analysis and scenario analysis ARR, WACC
28 Andor et al. (2015) 400 CEOs of 10 Central and DCF, sensitivity analysis and CAPM Cost of capital
Eastern European countries
29 Nurullah and Kengatharan (2015) 28 trading and manufacturing NPV, sensitivity analysis and WACC MIRR and ARR
firms of Sri Lanka
30 Rossi (2015) 71 Southern Italian firms NPV, past experience to calculate cost of capital ARR
31 Alkulaib et al. (2016) 908 listed and non-listed firms of NPV, IRR and real options DPBP
Kuwait
32 Souza and Lunkes (2016) 51 Brazilian firms PBP, NPV, IRR, WACC, sensitivity analysis and ARR, MIR and real options
scenario analysis
33 Batra and Verma (2017) 77 Indian firms PBP, NPV, WACC and sensitivity analysis Real options, simulation
analysis and MIRR
decision-making
practices
budgeting
Capital

Table I.
 JAMR 3.2 Methods of analysis
The collected survey data were analyzed and presented using frequency tables and inferential
statistics. This study used non-parametric Mann–Whitney U test to test the significant
difference of investment decision mean responses conditional on firms’ demographics and
executive characteristics.

3.3 Hypothesis
To analyze the CBT, cost of capital and risk assessment responses conditional on firm’s
demographic and executive characteristics, this study has tested 48 individual hypotheses
that can be grouped into three main hypotheses. Each main hypothesis has 16
sub-hypotheses for each individual firm and executive’s characteristics:
H1. There is a significant difference of capital budgeting responses across firm’s
demographic and executive characteristics.
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H2. There is a significant difference of cost of capital responses across firm’s

demographic and executive characteristics.
H3. There is a significant difference of choice of risk assessment responses across firm’s
demographic and executive characteristics.

4. Results and analysis

4.1 Firm’s demographics and executive characteristics
Table II presents the summary (frequencies and percentages) of demographics and
executive characteristics of respondent firms.

4.2 Capital budgeting methods

Respondents were asked about the most frequently employed CBT (methods) for evaluating
potential long-term investments.
Table III presents the percentages (frequencies in parenthesis) of respondents using CBT.
The results in Table III indicate that NPV, IRR and PI are the most frequently used methods
of capital budgeting by Pakistani listed firms. Out of these DCF methods, NPV is the most
popular approach (61.4 percent of respondent firms always use NPV ) of capital budgeting.
On the other hand, IRR is always used by 27 percent firm, but interestingly
100 percent firms use IRR with NPV as a second choice. The finance theory suggests
that NPV is a technically superior method than IRR. Present study’s findings have
confirmed that theory–practice gap is low among Pakistani listed firms as their first
preference is NPV.
The increase in popularity of DCF methods among Pakistani listed firms can be
attributed to firm’s access to computer technology and advanced software that have make
computations of these techniques feasible and less cumbersome. Further, the education of
finance directors/CFOs and management has also improved over the years (Pike, 1996).
DCF methods of capital budgeting are widely popular in both developed and emerging
economies (e.g. Canada (Bennouna et al., 2010), the UK (Arnold and Hatzopoulos, 2000), the
USA (Graham and Harvey, 2001) and India (Batra and Verma, 2017)). The present study’s
findings are similar to Truong et al. (2008), Ryan and Ryan (2002), Bennouna et al. (2010),
Nurullah and Kengatharan (2015), Hermes et al. (2007) and Maquieira et al. (2012) but
different from the study conducted in Spain (Andrés et al., 2014).
As Pakistan is an emerging economy in which the financial markets are volatile,
therefore, it provides a better environment for using NPV over IRR. One can make a
reasonable explanation that as IRR uses a single discount rate and single discount rate
 Frequencies Percentages
Capital
budgeting
Firm’s annual sales revenue (PKR) decision-making
o 50m 1 1.4
100–499m 1 1.4 practices
500–999m 7 10.0
1–5bn 20 28.6
W5bn 41 58.6
Total 70 100.0
Firm’s foreign sales as a percentage of total sales
0 36 51.4
1–24 33 47.1
25–49 1 1.4
W50 0 0
Total 70 100.0
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Firm’s dividend payment

2016
Dividend-paying firms 56 80
Non-dividend-paying firms 14 20
2015
Dividend-paying firms 57 81.4
Non-dividend-paying firms 13 18.6
2014
Dividend-paying firms 54 77.1
Non-dividend-paying firms 16 22.9
No dividend payments in the last 3 years 10 14.3
Nature of industry
Non-manufacturing firms 6 8.6
Manufacturing firms 64 91.4
Total 70 100.0
Firm’s P/E ratio over the last 3 years
Non-growth 35 50.0
Growth 35 50.0
Total 70 100.0
Firm’s debt rating
Non-rated 14 20.0
Rated 56 80.0
Total 70 100.0
Firm’s number of employees
o100 1 1.4
100–500 14 20.0
501–1,500 30 42.9
1,501–2,500 12 17.1
W2,500 13 18.6
Total 70 100.0
CFO membership
No membership 1 1.4
ACCA 1 1.4
ICMA 3 4.3
ICAP 44 62.9
CIMA 13 18.6 Table II.
Firm’s demographics
and executive
(continued ) characteristics
 JAMR Frequencies Percentages

CFA 8 11.4
Total 70 100.0
Age of CFO
Less than 40 7 10.0
40–49 37 52.9
50–59 22 31.4
60 or more 4 5.7
Total 70 100.0
CFO tenure (time in current job) (years)
o4 26 37.1
4–9 34 48.6
W9 10 14.3
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Total 70 100.0
Total work experience of CFO (years)
o10 13 18.6
10–20 47 67.1
W20 10 14.3
Total 70 100.0
CFO education (Respondents fall in more than one category)
Undergraduate 1 1.4
MBA or business-related master’s 30 42.9
Non-MBA masters 0 0
WMaster’s degree 11 15.7
Professional qualification 68 97.1
Age of CEO (years)
Less than 40 0 0
40–49 4 5.7
50–59 50 71.4
60 or more 16 22.9
Total 70 100.0
CEO tenure (time in current job) (years)
o4 19 27.1
4-9 22 31.4
W9 29 41.4
Total 70 100.0
Total work experience of CEO (years)
o10 0 0
10–20 23 32.9
W20 47 67.1
Total 70 100.0
CEO education (Respondents fall in more than one category)
Undergraduate 5 7.1
MBA or business related masters 57 81.4
Non-MBA master’s 2 2.9
WMaster’s degree 6 8.6
Table II. Professional qualification 20 28.6
 Never Sometimes Almost
Capital
(0) Rarely (1) (2) always (3) Always (4) Mean budgeting
decision-making
Net present value (NPV ) – 10% (7) 28.6% (20) 61.4% (43) 3.51
Internal rate of return (IRR) – – 72.9% (51) 27.1% (19) 3.27 practices
Profitability index (PI) – – 4.3% (3) 68.6% (48) 27.1% (19) 3.22
Hurdle rate – 21.4% (15) 74.3% (52) 4.3% (3) 2.82
Payback period (PBP) – 11.4% (8) 21.4% (15) 51.4% (36) 15.7% (11) 2.71
Discounted payback period (DPBP) 7.1% (5) 28.6% (20) 62.9% (44) 1.4% (1) 2.58
Earnings multiple approach (EMA) 1.4% (1) 15.7% (11) 31.4% (22) 48.6% (34) 2.9% (2) 2.35
Adjusted present value (APV ) 1.4% (1) 18.6% (13) 31.4% (22) 44.3% (31) 4.3% (3) 2.31
Table III.
Modified internal rate of return (MIRR) 1.4% (1) 40% (28) 40% (28) 18.6% (13) – 1.75
Percentages and
Accounting rate of return (ARR) – 45.7% (32) 37.1% (26) 17.1% (12) – 1.71 frequencies (in
Others 1.4% (1) 35.7% (25) 55.7% (39) 5.7% (4) 1.4% (1) 1.70 parentheses) of firms
a
Note: Respondents were asked: how frequently does your firm use the following techniques when deciding using capital
which projects or acquisitions to pursue? budgeting techniquesa
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cannot be used for long-term projects in which there are varying rates of “cost of capital”
and mixed cash flows. Therefore, it is not advisable to use IRR over NPV.
The survey results also show that respondent firms frequently use PBP in addition to DCF
capital budgeting methods. It means that firms are also emphasizing on the liquidity. Studies
have indicated that emerging economies are suffering from financial constraints; therefore,
firms in financially constrained economies use PBP method as a complementary tool to assess
the immediate liquidity of potential investment projects (Danielson and Scott, 2006).
Furthermore, respondents were asked whether they use “cash flows” or “accounting
income” while calculating DCF techniques like NPV and IRR. All the respondents (100 percent)
said that they use “cash flows” rather than the “accounting income” while employing DCF
methods of capital budgeting. The results indicate that Pakistani firms are using DCFs
methods of capital budgeting with their recommended computational procedures. Previously,
studies of Farragher et al. (1999) and Bennouna et al. (2010) reported that 85 and 91.5 percent of
firms are using “cash flows,” respectively.

4.3 Cost of capital

The minimum acceptable rate of return, i.e., the cost of capital or discount rate is essential
for methods using DCF computations which involve time value of money (Table IV ).
The respondents were asked about the methods used to determine the minimum
acceptable rate of return (discount rate or cost of capital). Majority of the respondents
(80 percent) are using WACC to evaluate their potential investment projects, while the
“cost of debt” is the least popular method (4.3 percent). This is in line with the finance

Frequencies Percentages

WACC 56 80.0
Cost of equity 6 8.6
An arbitrarily chosen figure is used 5 7.1
Cost of debt 3 4.3
Table IV.
Total 70 100.0 Frequencies and
Note: aRespondents were asked: which of the following approaches are used in your company to determine percentages of
minimum acceptable rate of return (Discount rate) to evaluate capital investments/projects (please tick one minimum acceptable
circle only)? rate of returna
 JAMR theory which recommends that instead of using cost of a single source of capital to
determine the minimum acceptable rate of return, firms should use the combined, i.e.,
weighted average cost of all financing source in the captial structure. The previous
empirical literature is also inclined toward the use of WACC (Hall and Millard, 2010;
Nurullah and Kengatharan, 2015; Block, 1997; Graham and Harvey, 2001; Ryan and Ryan,
2002; Schall et al., 1978; Arnold and Hatzopoulos, 2000; Truong et al., 2008; Chazi et al.,
2010; Khamees et al., 2010; Bennouna et al., 2010).
Respondents were also asked about the weighting schemes used to calculate WACC.
As per Table V, majority of respondent firms are using “target value weights” while
calculating WACC. The “book value weight” is the least popular method. It means that
Pakistani firms are using WACC with its ideal computational procedures. These results are
in sharp contrast to the findings of previous studies where they indicated that most of firms
are not using the recommended weights for calculating WACC. Generally, firms preferred
“book value” weights for estimating WACC instead of “target value” weights (Bennouna
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et al., 2010; Arnold and Hatzopoulos, 2000).

Respondents were asked about “how often firms review their cost of capital,” Table VI
shows that more than half of the firms (57.1 percent) review their cost of capital “whenever
there is a significant change in the business environment” whereas 24 percent of the
respondents review the cost of capital whenever a new project is to be evaluated. While
“semiannually” and “quarterly” are the least popular time to review the cost of capital
estimates. Previously, Zubairi (2008) has reported that majority of firms (85 percent) review
the cost of capital at “project evaluation time” while 67 percent of firms review the cost of
capital when there is “significant change in business environment” (Table VII).
Respondents were asked about whether the firms estimate their cost of equity capital.
In total, 91.4 percent of the respondents said that they estimate their cost of equity capital
(Table VIII).
In connection with the previous question, respondents were also asked about the most
frequent method used to calculate the cost of equity capital. In response, 93.8 percent of the
respondents said that they always or almost always use CAPM with some extra risk factors
for computing the cost of equity capital. “Whatever investors tell” is the second most

Frequencies Percentages

Target values 43 61.4

Estimates 13 18.6
Current market values 9 12.9
Table V.
Frequencies and Book value derived from balance sheet 3 4.3
percentages of We do not use WACC 2 2.9
weights used for Total 70 100.0
calculating WACCa Note: aRespondents were asked: “If weighted average cost of capital (WACC) is used, weights are defined by”

Frequencies Percentages

Whenever there is a significant change in business environment 40 57.1

Whenever there is a new project to be evaluated 17 24.
Table VI.
Frequencies and Semiannually 10 14.3
percentages of Quarterly 3 4.3
company’s review of Total 70 100.0
its cost of capitala Note: aRespondents were asked “how often firms review their cost of capital”?
 favored approach with 87.5 percent firms always or almost always choosing this option. Capital
The least popular method is dividend discount model (DDM). These results (CAPM extra budgeting
risk factors and whatever investors tell) are similar with the study of Graham and Harvey decision-making
(2001) and sharply contrast with the findings of Gitman and Mercurio (1982) who found that
majority of respondents use DDM (Table IX). practices
We asked the respondents about whether they adjust cash flows or discount rate for the
different types of risks. To address the risk of unexpected inflation, interest rate and term
structure, majority of the respondent firms prefer to adjust the discount rate. These results
are similar to the findings of Graham and Harvey (2001), Batra and Verma (2017) and
Nurullah and Kengatharan (2015).

Frequencies Percentages
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Table VII.
Yes 64 91.4 Frequencies and
No 6 8.6 percentages of
Total 70 100.0 cost of equity
Note: aRespondents were asked: “Does your firm estimate the cost of equity capital?” capital estimatesa

Sometimes
Never (0) Rarely (1) (2) Almost always (3) Always (4) Mean

CAPM (extra risk) – – 6.3% (4) 64.1% (41) 29.7% (19) 3.23
Investors tell – 4.7% (3) 7.8% (5) 57.8% (37) 29.7% (19) 3.12
CAPM ( β) – 10.9% (7) 21.9% (14) 50% (32) 17.2% (11) 2.73 Table VIII.
Regulatory authority decision – 15.6% (10) 31.3% (20) 42.2% (27) 10.9% (7) 2.48 Percentages and
frequencies (in
Historical return – 17.2% (11) 26.6% (17) 53.1% (34) 3.1% (2) 2.42
parentheses) of
Dividend discount model 4.7% (3) 12.5% (8) 34.4% (22) 43.8% (28) 4.7% (3) 2.31 methods used
Others 3.1% (2) 10.9% (7) 67.2% (43) 18.8% (12) – 2.01 to determine
No equity 32.8% (21) 42.2% (27) 23.4% (15) 1.6% (1) – 0.93 cost of equity
Note: aRespondents were asked: “How do you determine your firm’s cost of equity capital?” capital estimatesa

We adjust discount rate We adjust cash flows Both Neither

Risk of unexpected inflation 55.7% (39) 10% (7) 34.3% (24) –

Interest rate risk 52.9% (37) 11.4% (8) 35.7% (25) –
Term structure risk 51.4% (36) 8.6% (6) 35.7% (25) 4.3% (3)
Business cycle risk 28.6% (20) 32.9% (23) 38.6% (27) –
Commodity price risk 28.6% (20) 32.9% (23) 38.6% (27) –
Foreign exchange risk 35.7% (25) 24.3% (17) 40% (28) –
Distress risk 37.1% (26) 18.6% (13) 42.6% (30) 1.4% (1) Table IX.
Size 37.1% (26) 12.9% (9) 47.1% (33) 2.9% (2) Percentages and
frequencies (in
“Market-to-book” ratio 37.1% (26) 11.4% (8) 50% (35) 1.4% (1)
parentheses) of
Momentum 31.4% (22) 17.1% (12) 50% (35) 1.4% (1) adjustment in
Others 25.7% (18) 10% (7) 44.3% (41) 20% (4) cash flows or
Note: aRespondents were asked: “When valuing a project, do you adjust either the discount rate or cash flows discount rate for
for the following risk factors?” different risk factorsa
 JAMR For risks such as business cycle risk, commodity price risk, foreign exchange risk, distress
risk, size and market-to-book ratio risk, majority of the respondent firms chose to
adjust both discount rate and cash flows. These results are in contrast with the previous
findings of Batra and Verma (2017), Nurullah and Kengatharan (2015) and Graham and
Harvey (2001).

4.4 Risk assessment methods

Respondents were asked about the most frequently employed risk assessment method(s)
for evaluating their capital projects. The results in Table X suggest that the most
frequently used approach to assess a project’s risk is scenario and sensitivity analysis as
97.20 percent respondents always or almost always use these two methods. The next most
popular approach is the simulation analysis and the rest are used sometimes and rarely.
However, despite the theoretical advantage in today’s rapidly changing environment, the
use of “real option” is the least popular method to measure risk in investment decisions.
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Only six respondents (8.6%) replied that they almost always use real option as a risk
assessment method.
Since the study of Graham and Harvey (2001), the recent literature has documented that
real options is still the least popular method to measure risk in capital budgeting in other
parts of the world (e.g. Central and East European countries (Andor et al., 2015), Canada
(Bennouna et al., 2010), India (Batra and Verma, 2017), Australia (Truong et al., 2008), and
Fortune 1000 firms (Block, 2007)). This study suggests that in Pakistan there is a lack of
awareness and management support toward the use of real options. This method is quite
complex and requires sophisticated and advance level input from management to make it
work. Majority of the firms preferred to use traditionally accepted DCF methods and
associated risk assessment methods for their project evaluation (Block, 2007).
Respondents were also asked whether they conduct the post audit of their capital
expenditure. All the surveyed firms conduct the post audit of capital expenditures.

4.5 Grouping of firm’s demographics and executives’ characteristics

The second objective of this study is to analyze the responses conditional on executives and
firms’ demographics and characteristics. Table XI shows the criteria used to make groups
using firm’s demographics and executives’ characteristics. These groups are then used to
test whether the selection of specific capital budgeting methods, cost of capital and risk
methods are significantly different among groups.

4.6 Analysis of the capital budgeting responses conditional on firm’s demographic and
executive characteristics
Respondents were asked to score “How frequently the firms use several capital budgeting
techniques” on a standard scale of 0 to 4. These responses were then analyzed using firm’s

Never (0) Rarely (1) Sometimes (2) Almost Always (3) Always (4) Mean

Scenario analysis – 1.4% (1) 1.4% (1) 28.6% (20) 68.6% (48) 3.64
Sensitivity analysis – 1.4% (1) 1.4% (1) 28.6% (20) 68.6% (48) 3.64
Simulation analysis – 14.3% (10) 24.3% (17) 54.3% (38) 7.1% (5) 2.54
Table X.
Decision tree analysis 10% (7) 47.1% (33) 18.6% (13) 24.3% (17) – 1.57
Percentages and
frequencies (in Others 14.3% (10) 31.4% (22) 45.7% (32) 8.6% (6) – 1.48
parentheses) of risk Real options 11.4% (8) 47.4% (33) 32.9% (23) 8.6% (6) – 1.38
assessment techniques Note: Respondents were asked: “Which techniques does your firm use to assess a project’s risk (please tick
a

in investmenta one circle per line)?”

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Industry Size of firm Foreign sales Dividend paid P/E ratio Debt rating
Manufacturing Non- Large firms Small firms Yes No No Yes Non- Growth Yes No
firms manufacturing growth
firms
Yes No Annual sales Annual sales With foreign Without Not paid Paid P/E ratio P/E With Without
revenue of revenue of less sales as a foreign sales as dividend individend less than ratio rated rated
greater 5 than or equal to 5 percentage of a percentage of the past 3 in the or equal greater debt debt
billion rupees billion rupees total sales total sales years past 3 to 9 than 9
years
Employees CFO membership CFO age CFO tenure in current CFO total work experience
job
Small Large With Without Older CFO Younger CFO Short Long Short Long
membership membership
Less than or Greater than Membership No membership in Greater than Less than or Less than 4 Greater Less than 10 years Greater than or
equal to 1,500 1,500 in professional body 49 years equal to 49 years than or equal to 10 years
employees employees professional years equal to
body 4 years
CFO education CEO age CEO tenure in current job CEO total work experience CEO education
Professional Non- Older CEO Younger CEO Short Long Short Long MBA Without
degree holders professional degree MBA
degree holders holders degree
With Without Greater than Less than or equal Less than 4 Greater than or Less than or equal to Greater than Yes No
professional professional 49 years to 49 years years equal to 4 years 20 years 20 years
degree degree
Notes: To test the capital budgeting responses conditional on firms’ and executive’s characteristics, the above groups were made using firm’s demographic information
and executives’ characteristics. Mean difference test is used to see if the selection of capital budgeting methods, cost of capital and risk methods are significantly different
between groups

executives’
decision-making
practices

demographics and
budgeting
Capital

Table XI.
Grouping of firm’s

characteristics
 JAMR demographic and executive characteristics. Mann–Whitney U test is used to analyze
whether “mean ranks” are significantly different between the groups. Grouping of firm’s
demographic and executive characteristics is given in Table XI.
The results in Table XII show that non-manufacturing firms are significantly more likely
to use APV, PI, EMA and ARR than manufacturing firms. Large firms (in terms of sales
revenue) are significantly more likely to use NPV than small firms. These results are like
Graham and Harvey (2001), Andrés et al. (2014), Brounen et al. (2004) and Wnuk-Pel (2014).
Large firms are also significantly (at 5 percent significance level) more likely to use IRR,
hurdle rate, EMA and APV. Employing sophisticated DCF capital budgeting methods could
be a costly affair. The use of DCF methods by large firms can be attributed to the fact that
large firms are dealing with big projects and have less or no budget/financial constraints.
This makes the use of DCF methods of capital budgeting less costly for them. In contrast
small firms are significantly more likely to use PBP than large firms. These results are
similar with the previous studies of Graham and Harvey (2001), Andrés et al. (2014), and
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Ryan and Ryan (2002). Small firms have budget constraints; therefore, these firms are more
likely to use less costly CBT. Furthermore, small firms are also in constant financial
pressure. Therefore, these firms might feel a need to acquire initial investment quickly.
Firms with foreign sales as a percentage of total sales are more likely to use APV. Foreign
sales affect the financial risk, currency risk and political risk of the firms. Therefore, firms use
APV because in global market uncertainties, revenues and financing patterns are expected to
change significantly and APV accounts for all “financing side effects.” For the rest of CBTs,
there is no significant difference between firms with foreign sales and no-foreign sales.
Companies that pay dividend are significantly more likely to use EMA and hurdle rate in
addition to DCF methods like NPV and APV. It means that companies that pay dividend are
already liquid and there is no capital rationing. Therefore, these firms use sophisticated
CBT. Growth firms are more likely to use NPV, IRR and hurdle rate. These firms have large
potential projects that minimize the cost of using DCF methods of capital budgeting than
non-growing firms.
Firms that have rated debt are significantly more likely to use NPV, hurdle rate, EMA
and APV. Firms with non-rated debt are more likely to use PBP. Rated debt signals the
creditworthiness of firms making a certain financial environment. It encourages firms to
engage their funds for a longer time in projects by preferring sophisticated methods of
capital budgeting. Firms with non-rated debt may face the risk of insolvency/bankruptcy.
Therefore, these firms might need to acquire initial investment quickly, thus it could be the
reason for preferring the PBP method over sophisticated methods of capital budgeting.
Firms with higher number of employees are significantly more likely to use NPV and
hurdle rate. A firm with a large number of employees means that it has employees with
versatile financial skills. Thus, making a suitable environment for using advance methods
of capital budgeting. CFOs with longer tenure in the current job are significantly more likely
to use NPV and hurdle rate, whereas CFOs with shorter tenures are more likely to use PBP.
Experienced CFOs prefer using hurdle rate and DPBP.
Professional degree holder CFOs are more likely to use textbook recommended method
like NPV. In addition, they also use simpler methods like hurdle rate. Older CEOs with
longer tenure in the current job are significantly more likely to use PBP. These results are
like Graham and Harvey (2001). Older CEOs could be inflexible toward advanced
methods of capital budgeting because with the passage of time their learning power
decreases. Furthermore, with increasing age one usually become risk averse that is why
older CEOs prefer PBP which is an indication of liquidity or how early a project could
recover its investment. In contrast, experienced CEOs are more likely to use NPV than less
experienced CEOs. Non-MBA degree holder CEOs prefer DPBP and PI at 1 and 5 percent
levels of significance, respectively.
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Industry Size Foreign Sales Dividend paid P/E ratio Debt Rating Employees
Manufacturing Non-manufacturing Small Large No Yes No Yes Non-growth Growth No Yes Small Large
NPV 34.94 41.50 24.48 43.29*** 34.46 35.59 22 41.29*** 31.77 39.23* 21.36 39.04*** 32.13 41.21**
IRR 36.39 26.0 30.83 38.8** 34.63 35.41 32.67 36.71 32.00 39* 38.50 34.75 34.75 36.77
Hurdle rate 34.94 41.50 31.1 38.61** 33.67 36.45 25.55 39.77*** 30.97 40.03** 27.14 37.59** 32.99 39.75*
EMA 34.16 49.83** 28.97 40.12** 31.92 38.36 27.81 38.8** 34.97 36.03 27.64 37.46* 33.26 39.29
APV 34.78 43.17** 30.16 39.28** 30.75 39.64** 29.29 38.16** 34.83 36.17 27.54 37.49* 32.74 40.17
PBP 35.34 37.25 40.71* 31.82 37.72 32.03 39.93 33.6 37.64 33.36 42.93* 33.64 37.73 31.73
DPBP 34.88 42.17 37.48 34.1 37.17 32.64 35.79 35.38 37.37 33.63 42.04 33.87 34.35 37.44
PI 34.16 49.83** 36.74 34.62 36.38 33.5 35.48 35.51 38.26 32.74 30.46 36.76 33.38 39.10
ARR 34.27 48.67* 33.78 36.72 34.21 35.86 33.93 36.17 36.04 34.96 31.64 36.46 34.45 37.27
MIRR 35.30 37.58 31.14 38.59 33.5 36.64 35.4 35.54 36.99 34.01 32.43 36.27 36.07 34.54
Others 36.02 30.00 32.4 37.7 34.06 36.03 32.29 36.88 35.11 35.89 37.82 34.92 36.57 33.69
CFO membership CFO age CFO tenure CFO experience CFO education CEO age CEO tenure
No Yes Mature Young Short Long Short Long Non-PHD PHD Young Mature Short Long
NPV 4.00 35.96* 36.88 34.68 30.65 38.36* 28.92 37.00 4.00 36.43*** 41.13 35.16 32.66 36.56
IRR 26.00 35.64 35.42 35.55 35.42 35.55 34.08 35.82 26.00 35.78 34.75 35.55 37.05 34.92
Hurdle rate 8.00 35.90* 38.23 33.89 29.90 38.81** 28.62 37.07* 8.00 36.31*** 24.75 36.15 30.92 37.21
EMA 23.50 35.67 37.58 34.27 33.94 36.42 29.58 36.85 23.50 35.85 44.50 34.95 38.24 34.48
APV 8.00 35.90 33.77 36.52 32.96 37.00 32.96 36.08 16.75 36.05 38.75 35.30 37.61 34.72
PBP 41.50 35.41 34.94 35.83 42.92** 31.11 30.69 36.60 41.50 35.32 19.50 36.47* 27.50 38.48**
DPBP 47.50 35.33 39.27 33.27 36.06 35.17 28.35 37.13* 47.50 35.15 23.50 36.23 34.55 35.85
PI 27.50 35.62 39.10 33.38 33.58 36.64 37.81 34.97 27.50 35.74 44.25 34.97 38.08 34.54
ARR 16.50 35.78 36.15 35.11 34.31 36.20 36.50 35.27 40.50 35.35 31.00 35.77 29.71 37.66
MIRR 15.50 35.79 36.67 34.81 36.67 34.81 39.04 34.69 29.50 35.68 34.63 35.55 30.92 37.21
Others 14.00 35.81 38.13 33.94 37.90 34.08 35.35 35.54 30.00 35.66 30.00 35.83 35.34 35.56

(continued )
decision-making
practices
budgeting
Capital

results of capital
Table XII.
Mann–Whitney U test

with group alternative

budgeting practices

specifications
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JAMR

Table XII.
CEO work experience CEO education
Short Long Non-MBA MBA
NPV 26.30 40.00*** 39.18 34.81
IRR 32.09 37.17 32.36 36.08
Hurdle rate 29.59 38.39** 37.91 35.05
EMA 34.24 36.12 39.41 34.77
APV 31.67 37.37 40.09 34.64
PBP 35.80 35.35 41.14 34.45
DPBP 32.20 37.12 43.45*** 34.02
PI 34.78 35.85 46.50** 33.45
ARR 32.85 36.80 44.59* 33.81
MIRR 36.04 35.23 35.86 35.43
Others 35.24 35.63 39.45 34.76
Notes: Significant differences of CBT with demographic characteristics of firm. *,**,***Significant difference at 10, 5 and 1 percent levels, respectively
 4.7 Analysis of the cost of equity capital estimation method responses conditional on firm’s Capital
demographic and executive characteristics budgeting
Respondents were asked whether their firms estimate the cost of equity capital and if the decision-making
answer is yes which method is used to determine the cost of equity capital. Their responses
were analyzed conditional on firm’s demographics and executive’s characteristics. practices
Table XIII reports the results of Mann–Whitney U mean rank test.
There is no significant difference in selection of method for estimating cost of equity
across industry, firm size and firms with or without foreign sales except non-manufacturing
firms are more likely to use regulatory authority decision for the cost of capital
(at 10 percent level of significance). Growing firms are more likely to use historical returns
for estimating the cost of equity as these days past data are readily available. Furthermore,
access to modern computer technology makes the “trend analysis” more feasible.
Dividend-paying firms prefer the “decisions of regulatory authority” to estimate the cost of
equity capital.
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CFOs and CEOs with long tenure in their current jobs are also more inclined toward the
“decisions of regulatory authority” for calculating the cost of equity capital. Additionally,
long-tenured CFOs also prefer “whatever investors tell them.” CFOs with professional
degrees are significantly more likely to use CAPM (β). It is a known fact that CAPM ( β) is a
complex technique to estimate the cost of equity. That is why trained CFOs prefer this
method to estimate cost of equity because they have the knowledge and skills to use CAPM
( β) for estimating the cost of equity capital.

4.8 Analysis of the risk assessment responses conditional on firm’s demographic and
executive characteristics
Respondents were asked “Which techniques does your firm use to assess a project’s risk?”
The responses were analyzed across groups that were made based on firm’s demographics
and executives’ characteristics (Table XIV ).
Large firms in terms of annual sales revenue are significantly more likely to use scenario
analysis, sensitivity analysis, simulation analysis and real options. These sophisticated
methods of risk assessment require professional and trained analyst and finance managers
and access to computer technology and software. For larger firms, both resources are easily
available as these firms have less or no budget constraints. Furthermore, larger firms are
dealing with big projects that decrease the cost of using sophisticated risk assessment
techniques. The results bear similarity to those of Graham and Harvey (2001).
Firms with foreign sales are significantly more likely to use real options at 1 percent
level of significance because it provides flexibility to firms doing business in the
international market. These firms also have international competitors that compel them to
use more advance techniques for assessing risk. On the other hand, firms with local sales
prefer sensitivity analysis as the risk assessment method. Dividend-paying firms are
employing all risk assessment methods including real options. Since dividend payments
signal the liquidity and an indication of no budget constraints, therefore, these firms can
use advance methods to analyze risk. Growth firms are more likely to use sensitivity
analysis, simulation analysis and decision tree analysis to assess risk but not real options.
The firms with rated debt are more likely to use scenario analysis, simulation analysis and
real options. To ensure creditworthiness, a stable stream of future cash flows to avoid the
risk of bankruptcy, firms with rated debts are more inclined toward advance techniques to
analyze risk in capital budgeting.
CFOs and CEOs with longer tenure in the current job and firms with larger number of
employees are inclined toward using simulation analysis. Simulation analysis is a lengthy
and complex method for assessing the riskiness of projects. Therefore, experienced top
management can better guide managers to implement this method. Similarly, bigger firms
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JAMR

Table XIII.

specifications
equity capital

responses with
results of cost of

group alternative
estimation method
Mann–Whitney U test
Industry Size Foreign sales Dividend paid P/E ratio Debt rating Employees CFO age
Manufacturing Non- Small Large No Yes No Yes Non- Growth No Yes Small Large Younger Mature
manufacturing growth
Historical return 33.16 26.17 31.30 33.38 33.06 30.90 27.66 34.54 28.38 36.13* 35.32 31.92 32.79 32.04 31.04 34.94
CAPM (β) 32.80 29.58 32.26 32.68 34.94 28.97 31.89 32.76 29.82 34.87 31.14 32.78 34.15 29.92 32.16 33.06
CAPM (extra risk) 31.72 40.00 30.28 34.12 33.73 30.21 28.95 34.00 31.50 33.38 31.14 32.78 30.96 34.90 33.63 30.63
Investors tell 31.62 41.00 32.04 32.84 33.13 30.84 31.58 32.89 29.77 34.91 28.27 33.38 32.00 33.28 31.80 33.67
Regulatory
authority decision 31.13 45.75* 28.87 35.15 33.42 30.53 23.18 36.43*** 30.23 34.50 31.18 32.77 30.40 35.78 31.59 34.02
Dividend discount
model 31.80 39.25 32.48 32.51 29.00 35.10 33.55 32.06 31.50 33.38 34.77 32.03 32.37 32.70 33.40 31.00
Others 31.66 40.58 30.37 34.05 29.98 34.08 29.97 33.57 34.00 31.18 38.50 31.25 30.63 35.42 30.59 35.69
No equity
estimation 32.66 31.00 32.74 32.32 31.83 32.18 30.84 33.20 37.80 27.82 25.73 33.91 36.13 26.84 32.58 32.38
CFO tenure CFO CFO CEO age CEO tenure CEO work CEO
experience education experience education
Short Long Short Long Non- PHD Younger Mature Short Long Short Long Non- MBA
PHD MBA
Historical return 33.29 32.03 27.77 33.48 6.00 32.92 39.13 32.06 35.25 31.42 32.10 32.70 30.60 32.85
CAPM (β) 34.46 31.33 29.05 33.22 4.00 32.95* 31.75 32.55 32.83 32.37 29.29 34.07 31.70 32.65
CAPM (extra risk) 33.75 31.75 35.91 31.79 25.00 32.62 32.50 32.50 29.17 33.80 29.64 33.90 31.75 32.64
Investors tell 27.13 35.73** 32.36 32.53 27.00 32.59 34.00 32.40 26.78 34.74 30.14 33.65 29.10 33.13
Regulatory
authority decision 24.31 37.41*** 26.50 33.75 5.50 32.93 36.50 32.23 27.61 34.41* 30.05 33.70 36.30 31.80
Dividend discount
model 30.02 33.99 33.86 32.22 7.50 32.90 45.13 31.66 37.81 30.42 31.98 32.76 31.55 32.68
Others 28.10 35.14* 29.18 33.19 6.00 32.92* 37.88 32.14 34.22 31.83 32.67 32.42 36.50 31.76
No equity
estimation 40.21 27.88 31.73 32.66 56.00 32.13 45.50 31.63 31.67 32.83 39.67 29.00 34.40 32.15
Notes: Respondents were asked: If they estimate cost of equity capital then how do they determine firm’s cost of equity capital? *,**,***Significant difference at
10, 5 and 1 percent levels, respectively
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Industry Size Foreign sales Dividend paid P/E ratio Debt rating Employees
Non- Manufacturing Small Large No Yes No Yes Non- Growth No Yes Small Large
manufacturing growth
Scenario analysis 40.83 35.00 30.50 39.04*** 37.33 32.45 23.33 40.71*** 32.60 38.40 27.93 37.39* 33.64 38.65
Sensitivity analysis 33.42 35.70 30.90 38.76** 38.26* 31.44 26.57 39.33*** 31.63 39.37** 29.50 37.00 35.44 35.60
Simulation analysis 45.50 34.56 24.55 43.24*** 32.17 38.09 26.00 39.57*** 30.67 40.33*** 24.00 38.38*** 31.58 42.13**
Real options 30.92 35.93 26.55 41.83*** 25.40 45.47*** 27.40 38.97** 34.04 36.96 28.07 37.36* 33.68 38.58
Decision tree analysis 24.50 36.53 34.28 36.37 32.38 37.86 29.14 38.22* 31.51 39.49* 31.14 36.59 36.91 33.12
Others 18.00 37.14 34.84 35.96 32.10 38.17 32.07 36.97 32.73 38.27 34.64 35.71 37.55 32.04
CFO professional body CFO age CFO tenure CFO experience CFO education CEO age
membership
No Yes Younger Mature Short Long Younger Mature Non- PHD Young Mature
PHD
Scenario analysis 2.00 35.99** 33.90 38.21 31.71 37.74 30.00 36.75 7.25 36.33** 29.50 35.86
Sensitivity analysis 12.50 35.83 34.41 37.35 34.33 36.19 32.62 36.16 12.50 36.18** 38.00 35.35
Simulation analysis 5.50 35.93 34.26 37.60 30.15 38.66* 37.62 35.02 5.50 36.38** 29.38 35.87
Real options 25.00 35.65 33.98 38.08 32.33 37.38 38.00 34.93 25.00 35.81 39.00 35.29
Decision tree analysis 24.00 35.67 32.25 41.00* 35.46 35.52 34.77 35.67 24.00 35.84 48.75 34.70
Others 21.50 35.70 34.98 36.38 37.12 34.55 35.65 35.46 35.00 35.51 41.75 35.12
CEO tenure CEO work CEO education
experience
Short Long Short Long Non- MBA
MBA
Scenario analysis 33.42 36.27 26.33 39.99*** 42.45 34.20
Sensitivity analysis 33.42 36.27 31.26 37.57 43.41 34.03
Simulation analysis 28.47 38.12* 30.48 37.96 38.50 34.94
Real options 29.58 37.71 39.65 33.47 31.45 36.25
Decision Tree analysis 36.58 35.10 38.39 34.09 30.73 36.39
Others 34.61 35.83 39.24 33.67 30.41 36.45
Notes: Respondents were asked: “Which techniques does your firm use to assess a project’s risk?” *,**,***Significant difference at 10, 5 and 1 percent levels, respectively
decision-making

results of risk
practices
budgeting
Capital

Table XIV.
Mann–Whitney U test

specification
with group alternative
assessment methods
 JAMR have a larger pool of skilled employees that can use complex computer programs to employ
methods like simulation analysis.
CFOs with professional degrees are more likely to use scenario analysis, sensitivity
analysis and simulation analysis. CFOs having membership in a professional body and
CEOs with overall more work experience are more likely to use scenario analysis. As
scenario analysis is a “behavioral approach,” therefore, CEOs with more work experience
prefer to use their intuition to analyze worst-case and best-case scenarios for assessing risk
in capital budgeting.

5. Conclusion
The aim of this study is to investigate and document the trends in capital budgeting
practices, i.e. CBTs, cost of capital estimation methods and risk assessment methods of
Pakistani listed firms and to analyze these responses conditional on firm’s demographics
and executive’s characteristics. An online questionnaire was sent to top 200 PSX listed firms
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in terms of market capitalization. With a response rate of 35 percent, this study found that in
line with the recommendations of the finance theory, Pakistani listed firms are preferring
DCF methods of capital budgeting. Out of these methods, NPV is the most popular method
as compared to IRR, but IRR is always used along with NPV. However, in contrast Pakistani
firms are not preferring MIRR, which is theoretically a better alternative to IRR.
This study found that all the respondent firms (100 percent) use “cash flows” rather than the
“accounting income” for calculating DCF methods of capital budgeting. This is an interesting
finding since no previous study has reported 100 percent of the respondents were using cash
flows while employing DCF CBT. It can be concluded that Pakistani listed firms are employing
DCF methods of capital budgeting with accurate computational procedures. Despite the
theoretical inferiority of PBP, 67.1 percent of the respondents said that they always or almost
always used PBP to evaluate investment projects. PBP is a very simple and intuitive method for
analyzing capital projects. Its popularity as a complementary tool can be attributed to the fact
that it provides a rough estimate about the liquidity and uncertainty of potential investments.
Therefore, this simple technique is used along with more advanced DCF-based methods.
WACC is the most preferred method for estimating the minimum rate of return, also
known as “discount rate” among Pakistani listed firms. Again, Pakistani firms are following
textbook recommended method for estimating the cost of capital. The weights used for
calculating the WACC are based upon the “target values” whereas the “book value weights”
are seldom used. More than half of the firms review their cost of capital when there is a
significant change in the business environment, while quarterly is the least popular time to
review the cost of capital estimates.
For estimating the “cost of equity,” this study found that the Pakistani firms are inclined
towards CAPM with some extra risk factors. On the other hand, the least popular method is
DDM for calculating the cost of equity. For risk methods, majority of the respondents
said they prefer to adjust discount rate for risk of unexpected inflation, interest rate risk and term
structure risk. For other types of risks, firms prefer to adjust both discount rate and cash flows.
This study also found that the most frequently used technique to assess the project’s risk
is scenario analysis, sensitivity analysis and simulation analysis. The use of real options is
very low in Pakistan. In total, 58.8 percent of the firms said they never or rarely used
real options as a risk assessment method whereas 33 percent said they sometimes use real
options. Here in this respect Pakistani listed firms are not following the recent
advancements of academic finance where it is recommended that real options is the valuable
tool to assess a project’s implicit risk. Without considering real options while evaluating
projects, a firm could reject a potentially viable project and vice versa.
Finally, the likelihood of using specific techniques/methods (for capital budgeting, cost of
capital estimation and risk assessment) are linked to the firm’s demographics and executive
 characteristics. Along with expected findings such as the use of sophisticated CBTs by larger Capital
firms and PBP by smaller firms there are some interesting findings as well. For example, CFOs budgeting
with less time in the current job are significantly more likely to use PBP. Similarly, CFOs decision-making
holding non-business degrees are more likely to use DPBP and PI. These methods do consider
time value of money but the main methods like NPV and IRR are not preferred by non-business practices
degree holder CFOs. Finally, dividend-paying Pakistani firms cited “regulatory authority
decisions” as motivation or preferable method for estimating the cost of equity capital.

5.1 Implications and recommendations of the study

The survey results have sound suggestions for investors, financial managers and
academicians/business schools. Since advance capital budgeting methods aim to enhance
firm’s value, our survey results recommend certain advancement in capital budgeting
decisions for better “investment decisions”:
• Pakistani firms are using IRR more than MIRR in contrast with the finance literature
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that suggests using MIRR over IRR. The executives need to value MIRR as it helps
firms to counter the multiple IRRs problem because of non-traditional cash flows.
• Majority of the respondent firms are not using real options explicitly while calculating
NPV. Real options are more valuable in uncertain environments as they give
management a degree of flexibility to change the course of the project, e.g., deferring,
expansion, abandonment, etc., in the given circumstances. Since Pakistan is an emerging
economy where the financial markets are characterized by volatility and uncertainty,
therefore, firms should use real options for project evaluation to handle risk.
• Furthermore, Pakistan has recently became a part of China–Pakistan Economic
Corridor. This will open a plethora of business opportunities for Pakistani firms. To
exploit these opportunities, Pakistani firms need to adopt methods like “real options”
that can addresses contingent business venues.
• Pakistani business schools should address the departure of practice from finance theory
by Pakistani firms, e.g., less or no use of MIRR and real options, in their curriculum.

6. Limitations of the study

The study has the following limitations
• The focus of this study was on selected aspects of capital budgeting.
• This study is limited to top firms in terms of market capitalization listed on PSX and
overall these firms are most likely to employ DCF capital budgeting procedures.
Consequently, these results cannot necessarily be generalized to all firms especially
small firms listed on PSX.
• This study has relied on a traditional survey method. Interviews and case study
methods could be used to analyze the in-depth responses of CFOs and CEOs
regarding capital budgeting choices.

Notes
1. PwC Report titled: “The long view – how will the global economic order change by 2050”, available at
[Link]/gx/en/world-2050/assets/[Link]
2. Developed using Google Forms.
3. KSE-100 index is reconstituted semiannually, thus the number of financial firms could vary from
one year to another.
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