Through analyzing the softness and hardness of budgeting constraints in research and development (R&D) investment under different institutions, we develop a theory of optimal R&D financing. Our theory not only provides a clear comparison of investment efficiency between centralized economies and market economies but also extends the analysis of soft budget constraints to firms in market economy. Based on this theory, we characterize optimal choices of R&D project financing in centralized and decentralized economies. Our results explain why some projects are financed internally by a large firm but others are cofinanced externally by several firms. We also explain what makes a centralized economy inefficient in R&D.
This paper reports on a field study of capital budgeting and strategy in 23 firms. The objectives of the study were twoâfold: first to develop a classification scheme for overall capital budgeting processes and second to relate the different types of capital budgeting to extant models of strategy. Based on our findings, there are three different types of capital budgeting processes: centralized, decentralized and integrated. In centralized capital budgeting, top management make all important strategic capital budgeting decisions. Operating managers simply âbidâ on implementing projects selected by top management. In decentralized capital budgeting operating managers identify and initiate projects that are approved by top management based upon projected financial performance. Integrated capital budgeting has elements of both decentralized and centralized capital budgeting. We found the three types of capital budgeting to have a contingent relationship with Bartlett's (1986) typology of multinational strategy: global, multinational and transnational . Global firms choose to respond to pressures for integration and coâordination. Typically these firms are highly centralized and have standardized products which can be sold in multiple markets and produced in largeâscale facilities to take full advantage of economies of scale. Multinational firms, in response to pressure to accommodate regional markets through product specialization, operate in a number of highly differentiated markets with significantly dissimilar requirements. In pursuing economies of scope, these firms operate in a decentralized manner with national or regional managers making key strategic decisions. Transnational firms employ a complex structure that addresses the needs for both product differentiation and global integration. In our study, we found that global firms were more likely to have centralized capital budgeting, multinational firms to have decentralised capital budgeting and transnational firms to have integrated capital budgeting. Capital budgeting is one of the most important of management functions. Through capital budgeting decisions management determines the structural cost drivers of the firm and enacts the strategies that define the way in which a firm competes. Although there is an obvious link between strategy and capital budgeting, that link has not been made in either research or practice (Pinches, 1982). The need to understand the link between capital budgeting and strategy is especially evident in manufacturing firms that must continually invest in new technologies. In a review of some 150 articles on capital budgeting for new manufacturing technologies, Dimnik and Kudar (1991) found frequent criticism of current capital budgeting practices for failing to incorporate strategic issues. The most commonly proposed solution to this problem was to modify project evaluation and selection techniques by using multiâattribute decisionâmaking models to quantify strategic issues. This response is typical of much of the literature on capital budgeting, which has traditionally focused on the technical issues of project evaluation and selection (Pinches, 1982). A more complete understanding of the relationship between the capital budgeting process and firm strategy will allow specific suggestions for improvement to be implemented. This paper reports on a field study of capital budgeting and strategy in 23 firms involved in a wide range of manufacturing activities. The objectives of the study were twoâfold: to develop a classification scheme for overall capital budgeting processes, and to relate the different types of capital budgeting to extant models of strategy. We found it necessary to develop a new classification scheme for capital budgeting because the standard model of capital budgeting does not explain practice (Dimnik, 1991). The traditional model of capital budgeting assumes that projects bubbleâup from operating managers for approval by top management and emphasizes the use of discounted cash flow methods of selecting projects. The bubbleâup assumption of capital budgeting can be traced to Bower (1970) and the preâoccupation with discounted cash flow techniques to Dean (1951). Bower held that: [A] company's top management approves or rejects projects but has little direct influence on how they get defined or on which ones are pushed through the firm's lower levels of decisionâmaking to become claimants for topâexecutive approvalâŚTop management cannot keep the character and composition of the projects that rise for their approval from being coloured by structural context. However, top management can influence that structural context by means of the organization chartâŚand the measurement and reward system it employs (Caves, 1980, p.76). This bubbleâup assumption is implicit in most capital budgeting research and is incorporated in leading accounting and finance textâbooks. For, example, Haka (1987) described the impact of rewards on the path that a âproposal follows from its originator in operations to its approval by top corporate executivesâ. Principles of Corporate Finance , Brealey et.al ., stated that âmost firms let project proposals bubbleâup from plants for review by division management, and from divisions for review by senior managementâ. Accounting: Text and Cases , Anthony and Reece stated that âas proposals for capital expenditures come up through the organization, they are screened at various levels. Only the sufficiently attractive ones flow up to the top and appear in the final capital expenditure budgetâ. Dean (1951) defined capital budgeting in economic terms and stressed that without systematic acceptance and rejection criteria, the capital budgeting decision has no solid foundation. He recognized that procedural and organizational issues were important in capital budgeting but defined the âproblemâ of capital budgeting as finding the answers to three questions: (1) How much money will be needed for the expenditures in the coming period? (2) How much money will be available? (3) How should the available money be doled out to candidate projects (p.555)? Dean emphasized discounted cash flow methods and this emphasis is adopted in leading accounting and finance textâbooks and colours much of the academic research on capital budgeting (Pinches, 1982). It is especially evident in the many surveys of capital budgeting practices (Oblak and Helm, 1980; Bavishi, 1981; Stanley and Block, 1984; Woods et.al. , 1985; Hodder, 1986; Kim, 1986; McLean, 1986; Baker, 1987; Klammer et.al. , 1991). The bubbleâup, discounted cash flow model of capital budgeting is inadequate for explaining what is found in actual practice. For example, in a survey of 32 operating managers, Dimnik (1990) found that in some firms operating managers initiated capital budgeting proposals and were very conscious of financial criteria for project approval and aware of the impact of investment decisions on their measures of performance. In other firms, operating managers had little say in investment decisions and little knowledge of financial criteria applied to investment proposals. In these firms, analytical techniques such as discounted cash flow, when used at all, were used only by top management and their staff to justify their decisions. Based on these and other personal observations, we concluded that before we could offer insights into the relationship between capital budgeting and strategy, we had to first develop an understanding of capital budgeting that went beyond the traditional model. The remainder of the paper is organized as follows. In the next section, we define capital budgeting and briefly discuss various frameworks for analyzing strategy. Then we describe our field research and provide a general description of our findings. This is followed by a discussion of a new classification scheme for capital budgeting and the suggestion that capital budgeting is related to a firm's strategy for global competition. The paper ends with a discussion of the shortcomings of the study, the implications of our findings and some suggestions for future research.
0 Until more than a decade ago, financial economists typically explored problems of capital structure and dividend policy under the assumption that operating cash flows or investment decisions were exogenously determined, either with certainty or with an endowed, known distribution. Micro and macro-economic theorists, on the other hand, discussed what might be called operating income maximization, and treated as irrelevant the origin of the funds they allocated between labor and capital. It is now the consensus, I believe, that although these approaches constitute important simplifications, they may obscure some of the more important activities that take place in the firm. Interactions of production and financial decisions have thus been the focus of many recent studies. This research is extremely important for financial decision makers. If indeed it turns out that there are economically significant interactions between production and financing, then proper financial management may be vastly more difficult than typically portrayed in modern textbooks. Most of what is taught in capital budgeting, for example, is based on separation of investment and financing. If in reality this is not the case, then decentralization of the firm's operations can not be maintained, and all decisions will have to be made at the same time. Indeed, the many papers described here show how investment decisions, product pricing, labor negotiations, and market power may all be significantly related to the choice of capital structure. While this survey represents an attempt to assess the economic significance of each interaction, it must be emphasized that, as a casual glance at the references should reveal, we are dealing with on-going research that is not, as yet, supported by sufficient empirical evidence to yield definitive answers.
Traditionally, financial management theory has emphasized the separation of the capital investment and financing decisions [2, pp. 81 and 176]. This separation assumes that the firm's financing decision is taken as given when the investment decision is made or that the two decisions are independent of each other. In reality, these decisionis are seldom independent. Mergers and acquisitions are typical examples of capital investments that make the investment/financing separation inappropriate. The tone of research on the interaction between investment and financing decisions was set by Myers [16]. Myers advanced the concept of Adjusted Present Value (APV), which permits an examination and evaluation of the consequences of interactions between the firm's financing and investment decisions. A new project's APV is defined as the sum of the present value of its net operating income assuming all-equity financing plus the value of any additional debt capacity to the firm contributed by the project. The definition of the new project's APV presented above represents a fairly simplified version. However, a closer look at the concept of APV brings up other potential issues relating to stock purchase decisions, dividend policy, and transaction costs associated with new sources of funding, etc. These are important financial management variables that have been considered in other research efforts [1, 3, 7, 17]. The second phase of the investment/financing interaction process was developed by Bower and Jenks (BJ) [1]. They used the simplified concept of APV in their effort to estima e divisional screening rates for decentralized investm nt decisions. After assuming that each investment project had its implicit optimal debt ratio, BJ used this implicit ratio to estimate the project's cut-off rate in the fr m work of the capital asset pricing model. While BJ's study does provide an important application of the APV concept, it does not go far enough: (a) It does not provide any theoretical basis for assessment of the implicit debt ratio of each project. Their analysis instead relies on average debt ratios of different industries observed on an ex post basis. (b) It assumes that the firm's debt capacity is increased by an amount equivalent to the project's debt capacity. Although the additivity of the firm's debt ca-
Abstract As the petroleum industry has embraced the concept of rate of return as an investment criterion, numerous papers on the subject have appeared in the literature. The purpose of this paper is to clarify the significance of these methods and extend their application. Because of space limitations, no attempt has been made to duplicate these previous efforts. Instead, the emphasis has been placed on proper utilization of the results. Discussed are:the problem of multiple rates of return on acceleration projects;effect of time on comparative results;development of realistic mathematical model; andformal consideration of probability in the economic evaluation. Several reasonable solutions to these problems are presented. Introduction The rate-of-return concepts embraced by the petroleum industry in the last few years represent techniques that have been widely employed by other groups in the fields of finance and banking for the past century. In the process of attempting to utilize these "new" methods in the industry, many modifications of the basic compound-interest equations have appeared. Refs. 1 through 11 out-line the more popular approaches used. In their preoccupation with obtaining numbers, many have lost sight of the inherent characteristics of many equations used, as well as the real goals of investment. Put another way-rate of return as found by any equation, no matter how good, is not in itself a satisfactory investment criterion. Any economic decision involves either formal or informal consideration of the following:risk factors, includingprediction of future events. and economic climate andprobability of success or failure;rate of return on investment;effect that failure(s) would have on an organization's economic future;tax ramifications;current investment needs and opportunities;cash generation needs in future years to remain in a sound and dynamic position (might involve deferral of revenue for economic reasons);romance factors; andan organization's financial structure. The detailed discussion here will be limited to Items 1 and 2. Usually, these are the ones formally considered by the practicing engineer, while the remainder are usually management prerogatives. Some understanding, though, of Items 3 through 8 is essential for intelligent engineering appraisal. Space does not permit a complete discussion of those latter factors, but a few comments are essential. In theory there is always an infinite number of investment opportunities available for the investment dollar. In practice this is never really true. There are always limitations imposed by organizational policy, personnel capabilities and governmental interference in economic affairs. A decentralized region, area or division, for example, has certain geographic limitations that restrict investment potential. An oil-company management is not likely to seriously consider a project to manufacture television seas unless they have an insufficient number of attractive oil investments. If they do consider it, they must include in their cost considerations the acquisition of new qualified personnel. Most managements inherently limit the largest portion Of their investments to areas where they have experience and are in a position to make qualified judgment decisions. This is one reason why diversification is necessarily slow. No comment should be necessary about the limitation imposed by governmental regulation. It must also be recognized that not all investments are profit motivated. Some are made for strategic reasons. Strategic here means that said investment is necessary to achieve long-range company goals. This class of investment must necessarily strengthen the organization so that it enhances the probability of success of profit-motivated investments. One example of this is represented by funds expended for laboratory research and field tests (pilot floods, special tests, etc.). These cannot be compared with profit-motivated investments by means of a single yardstick, such as rate of return, because strategic investments yield a return that is impossible to measure in dollars and cents. Can anyone cite the cash flowback resulting from research, public relations, college aid programs and similar efforts? No! Yet, any enlightened executive recognizes their value. The eight factors previously listed are primarily important in profit-motivated investments, which comprise the bulk of all investments made. No finite discussion is possible on such things as the romance factors. JPT P. 708^