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Costly Information, Informed Investors and the Use of Sophisticated Capital Budgeting Techniques

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  • Mark Freeman
  • Garry Hobbes

Abstract

This paper aims to explain why firms do not use NPV for all capital budgeting decisions. Differential usage is attributed to the cost of information and the incomplete dissemination of knowledge of evaluation techniques. Analysis of Australian survey data indicates that 34% of informed managers switch to naive techniques for smaller dollar projects - a cost of information effect. We find 40% of organisations with large capital expenditures do not use NPV, suggesting a lack of knowledge of the NPV technique. Thus significant proportions of large Australian organisations lack detailed knowledge of DCF techniques while others fail to use those techniques for reasons of excessive cost. We also find, after controlling for cost and mandatory considerations, that many large firms with sophisticated capital budgeting procedures actually accept projects that do not meet threshold criteria. The explanation appears to lie in the recognition that projects have strategic and growth options, but an apparent inability amongst managers to factor these values into their project evaluation criteria such as NPV.

Suggested Citation

  • Mark Freeman & Garry Hobbes, 1991. "Costly Information, Informed Investors and the Use of Sophisticated Capital Budgeting Techniques," Working Paper Series 1, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
    • Handle: RePEc:uts:wpaper:1
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    File URL: http://www.finance.uts.edu.au/research/wpapers/wp1.pdf
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    References listed on IDEAS

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    1. Petry, Glenn H., 1975. "Effective use of capital budgeting tools," Business Horizons, Elsevier, vol. 19(5), pages 57-65, October.
    2. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-157, April.
    3. Schall, Lawrence D & Sundem, Gary L & Geijsbeek, William R, Jr, 1978. "Survey and Analysis of Capital Budgeting Methods," Journal of Finance, American Finance Association, vol. 33(1), pages 281-287, March.
    4. Allen Rappaport, 1979. "A Critique of Capital Budgeting Questionnaires," Interfaces, INFORMS, vol. 9(3), pages 100-102, May.
    5. Petry, Glenn H., 1975. "Effective use of capital budgeting tools," Business Horizons, Elsevier, vol. 18(5), pages 57-65, October.
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