Capital Budgeting by Utilities

Abstract

he theory of capital budgeting has been studied extensively in recent years, and there is a growing body of literature describing the capital budgeting techniques employed by industrial firms. However, in spite of the importance of public utilities, virtually no studies relating to these firms' capital budgeting practices have appeared in the financial journals. This article is aimed at this gap. A number of capital investment selection criteria have been identified in the literalurc of finance. The four most frequently mentioned are payback, average rate of return, ARR. internal rate of return. IRR, and net present value, NPV. The NPV method is generally regarded as being the best in some theoretical senses, while the IRR method is a somewhat distant second. Boih payback and ARR, which may be defined in serveral ways, are generally regarded as being distinctly inferior to the two techniques employing discounted cash flow. Although theory has been extended very elegantly in recent years, the basic techniques were specified reasonably well and widely publicized by the latter 195O's. Once basic theories were accepted academically, various researchers questioned whether or nol business practiced what the academic community preached. Istvan [4, 5], Pfiomn [7], and Soldofsky [8] studied this question in the early 196O's and reported that relatively few firms employed the recommended DCF techniques. The studies by Christy [2], the National Association of Accountants [6], and Terborgh [9], all done in the latter half of the l960s, indicated an increasing use of DCF methods, but they also showed that the payback and ARR were far more widely used. The most recent studies of national firms, the ones by Klammcr [3] and by Abdelsamad [I], showed a continuation of the trend toward DCF; however. 43% of the firms in Klammer's study were still using a non-DCF method in 1970. Two explanations for the non-use, or at least limited use, of DCF were offered. The first hypothesis is that there is simply a learning-and-action lag; the second is that the cost of using a DCF technique may, in some inslances. exceed its benefits. Although neither of these hypotheses has been proved, our own studies suggest that there is some validity to both. Accordingly, we think thai the use of DCF will increase, but it is most unlikely that any future sttidy will ever find that nil investment decisions are made using a DCF cutoff criterion.