Environmental volatility and capital budgeting practices

Date
1986
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Abstract

Attempting to predict future organizational conditions is an important part of capital budgeting. A volatile environment could make this prediction task difficult for a company, thereby affecting the capital budgeting system. This study attempted to provide insight to the relationship between environmental volatility and capital budgeting practices in organizations. Questionnaires concerning capital budgeting practices were completed by the Chief Financial Officers of 104 industrial and nonindustrial companies. On a list of capital budgeting elements, the CFO's indicated which of the elements were included in their systems. Weights were assigned to the elements by a panel of experts. The weighted elements were then combined into capital budgeting sophistication scores for the firms. Environmental volatility was assessed with two types of measures. Subjective measures of market, financial, technological, and socio-political environmental components were determined from executives' environmental perceptions, as reported in questionnaires. Also, objective indexes of market, financial, technological, and overall volatility were formulated from financial statement data contained on the COMPUSTAT tapes. Regression analysis was used to study the relationship between environmental volatility, along with firm size, and capital budgeting sophistication. A model with the objective measures of volatility and size as independent variables was significantly related to capital budgeting sophistication for both the industrial and the nonindustrial subgroups. A similar model using the subjective environmental volatility measures, along with size, showed a weaker association with capital budgeting sophistication for both subgroups. Generally, the environmental components demonstrated significant, negative relationships to capital budgeting sophistication for the industrial subgroup, but were insignificant for the nonindustrial subgroup. Size showed a significant, positive relationship to capital budgeting sophistication for the industrial firms. This association was not significant for the nonindustrial companies. Models with environmental volatility, size and capital budgeting sophistication as independent variables were regressed against earnings performance. Both the objective and subjective models were significant for the industrial, as well as the nonindustrial, subgroups in this part of the analysis. A curvilinear relationship was found between capital budgeting sophistication and performance for the industrial companies, but these variables were not strongly related for the nonindustrial companies. Examination of subgroups of the industrial firms found that companies having very sophisticated or unsophisticated capital budgeting systems had higher average performance scores than did companies with middle levels of capital budgeting sophistication. This pattern was particularly apparent for firms in volatile environmental components.

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Keywords
Capital budget, Capital investments
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