The Capital Budgeting Decisions ofSmall Businesses

Morris G. Danielson and Jonathan A. Scott

This paper uses survey data compiled by the National Federation of Independent Business to analyze thecapital budgeting practices of small firms. While large firms tend to rely on the discounted cashflow analysisfavored by finance texts, many small firms evaluate projects using the payback period or the owner's gutfeel. The limited education background of some business owners and small staff sizes partly explain whysmall firms use these relatively unsophisticated project evaluation tools. However, we also identify specificbusiness reasons—including liquidity concerns and cashflow estimation challenges—to explain why smallflrms do not exclusively use discounted cashflow analysis when evaluating projects. These results suggestthat optimal investment evaluation procedures for large and small flrms might differ. [G31 ]

•This paper analyzes the capital budgeting practices ofsmall firms. The US Small Business Administration esti-mates that small businesses (which they define as firmswith fewer than 500 employees) produce 50% of privateGDP in the U.S., and employ 60% of the private sectorlabor force. Many small businesses are service oriented;but according to the 1997 Economic Census, over 50%are in agriculture, manufacturing, construction, transpor-tation, wholesale, and retail—all industries requiringsubstantial capital investment. Thus, capital investmentsin the small business sector are important to both theindividual firms and the overall economy.

Despite the importance of capital investment to smallfirms, most capital budgeting surveys over the past 40years have focused on the investment decisions of largefirms (examples include Moore and Reichardt (1983),Scott and Petty (1984), and Bierman, (1993)). An ex-ception is Graham and Harvey (2001), who comparethe capital budgeting practices of small and large firms.Even their small firms are quite large, however, witha revenue threshold of $1 billion used to separate firmsby size.

Indeed, less than 10% of their sample report revenuesbelow $25 million. Thus, Graham and Harvey's results

Morris G. Danielson is an Assistant Professor of Finance at St. Joseph'sUniversity in Philadelphia, PA 19131 and Jonathan A. Scott is anAssociate Professor of Finance at Temple University in Philadelphia,PA 19122.

We acknowledge the helpful comments of Jacqueline Garner, WilliamPetty, and participants at the 2005 Financial Management Associationand Eastern Finance Association Conferences.

do not directly address the investment decisions of verysmall firms.'

There are several reasons small and large firms mightuse different criteria to evaluate projects. First, smallbusiness owners may balance wealth maximization (thegoal of a firm in capital budgeting theory) against otherobjectives—such as maintaining the independence of thebusiness (Ang (1991) and Keasey and Watson (1993))—when making investment decisions. Second, small firmslack the personnel resources of larger firms and, there-fore, may not have the time or the expertise to analyzeprojects in the same depth as larger firms (Ang, 1991).Finally, some small firms face capital constraints, mak-ing project liquidity a prime concern (Petersen and Rajan(1994) and Danielson and Scott (2004)). Because ofthese small firm characteristics, survey results on thecapital budgeting decisions of large firms are not likelyto describe the procedures used by small firms.

To document the capital budgeting practices of smallbusinesses, defined here as firms with fewer than 250employees, we use survey data collected for the NationalFederation of Independent Business (NFIB) ResearchFoundation by the Gallup Organization. The resultsinclude information about the types of investments the firmmakes (e.g., replacement versus expansion), the primary

'The Federal Reserve Board of Governor's Survey of Small BusinessFinance serves as the data source in many studies of small businessfinance. The firms in the Board of Governor's Survey tend to be muchsmaller than the firms in the Graham and Harvey (2001) sample; in the1993 Board of Governor's survey, 83% of the firms report revenuesunder $1 million. The firms in the Graham and Harvey sample, there-fore, are much larger than firms typically included in studies of smallbusiness finance.

45

46 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006

tools used to evaluate projects (e.g., discounted cashflow analysis, payback period), the firm's use of otherplanning tools (e.g., cash flow projections, capital budgets,and tax planning activities), and the owner's willingnessto finance projects with debt. The survey also includesdemographic variables that allow us to examine therelations between capital budgeting practice and firmcharacteristics such as size, sales growth, industry, ownerage, owner education level, and business age.

Not surprisingly, we find small and large firms evalu-ate projects differently. While large firms tend to rely onthe discounted cash fiow calculations favored by capitalbudgeting theory (Graham and Harvey, 2001), smallfirms most often cite "gut feel" and the payback periodas their primary project evaluation tool. Less than 15%of the firms claim discounted cash fiow analysis as theirprimary criterion, and over 30% of the firms do not esti-mate cash fiows at all when they make investment deci-sions. The very smallest of the surveyed firms (firmswith three employees or fewer) are significantly lesslikely to make cash fiow projections, perhaps because oftime constraints.

Certainly a lack of sophistication contributes to theseresults, as over 50% of the small-business owners sur-veyed do not have a college degree. Yet, there are alsospecific business reasons why discounted cash fiow anal-ysis may not be the best project evaluation tool for everysmall firm. For example, 45% of the sample would delaya promising investment until it could be financed withinternally generated funds, suggesting the firms face real(or self-imposed) capital constraints.^

We also find that the most important class of invest-ments is "replacement" for almost 50% of the firms.Discounted cash fiow calculations may not be requiredto justify replacement investments if the owner is com-mitted to maintaining the firm as a going concern and ifthe firm has limited options about how and when toreplace equipment.

Finally, investments in new product lines are the mostimportant class of investments for almost one quarter ofthe sample firms. Because the ultimate success of thistype of investment is often uncertain, it can be difficult toobtain reliable future cash fiow estimates, reducing thevalue of discounted cash fiow analysis. Thus, our resultssuggest that optimal methods of capital budgeting analy-sis can differ between large and small firms.

^Survey participants were asked: "Suppose you had the opportunityto make an investment in your business that would allow eamings torise 25% within the next two years. The project had minimal risk, butyou did NOT have the cash right then to make the investment. Wouldyou most likely . . . ?" The choices included waif until you accumulateenough cash, borrow the money and make the investment, seek an out-side investor, and other Wait until you accumulate enough cash wasselected by 45% of the respondents.

I. Capital Budgeting Theory andSmail Firms

Brealey and Myers (2003) present a simple rule man-agers can use to make capital budgeting decisions: Investin all positive net present value projects and reject thosewith a negative net present value. By following this rule,capital budgeting theory says firms will make the set ofinvestment decisions that will maximize shareholderwealth. And, because net present value is a completemeasure of a project's contribution to shareholder wealth,there is no need for the firm to consider altemative capi-tal budgeting tools, such as payback period or account-ing rate of return.

Yet, small firms often operate in environments that donot satisfy the assumptions underlying the basic capitalbudgeting model. And, small firms may not be able tomake reliable estimates of future cash fiows, as requiredin discounted cash fiow analysis. We discuss these poten-tial problems in detail, and explain why discounted cashfiow analysis is not necessarily the one best capital budg-eting decision tool for every small firm.

A. Capital Budgeting Assumptions andthe Small Firm

Capital budgeting theory typically assumes that theprimary goal of a firm's shareholders is to maximize firmvalue. In addition, the firm is assumed to have access toperfect financial markets, allowing it to finance all value-enhancing projects. When these assumptions are met,firms can separate investment and financing decisionsand should invest in all positive net present value projects(Brealey and Myers, 2003).

There are at least three reasons to question the appli-cability of this theory to small firms. First, shareholderwealth maximization may not be the objective of everysmall firm. As Keasey and Watson (1993) point out, anentrepreneur may establish a firm as an altemative tounemployment as a way to avoid employment boredom(i.e., as a life-style choice) or as a vehicle to develop,manufacture, and market inventions. In each case, theprimary goal of the entrepreneur may be to maintain theviability of the firm, rather than to maximize its value.'

Second, many small firms have limited managementresources, and lack expertise in finance and accounting(Ang, 1991). Because of these deficiencies, they may notevaluate projects using discounted cash fiows. Providing

Mn a survey of Swiss firms, Jorg, Loderer, and Roth (2004) find thatmaintaining the independence of the firm was cited more frequentlythan shareholder value maximization as a goal of managers. They alsofind that firms pursuing goals other than shareholder value maximi-zation were less likely to rely on discounted cash flow analysis forinvestment decisions.

DANIELSON & SCOTT —THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES 47

some support for this conjecture, Graham and Harvey(2001) find that small-firm managers are more likely touse less sophisticated methods of analysis, such as thepayback period."

The final impediment is capital market imperfections,which constrain the financing options for small firms.Some cannot obtain bank loans because of their informa-tion-opaqueness and lack of strong banking relationships(e.g., Petersen and Rajan (1994) (1995) and Cole (1998)).Ang (1991) notes that access to public capital marketscan be expensive for certain small firms and impossiblefor others. These capital constraints can make it essentialfor small firms to maintain sufficient cash balancesin order to respond to potentially profitable investmentsas they become available (Almeida, Campello, andWeisbach, 2004). Thus, capital constraints provide smallprivately held firms with a legitimate economic reason tobe concerned about how quickly a project will generatecash flows (i.e., the payback period).

B. Cash Flow Estimation Issues

In his critique of capital budgeting theory. Booth(1996) describes estimation issues managers must confi-ontwhen implementing discounted cash flow analysis. Heconcludes that discounted cash flow analysis is lessvaluable when the level of future cash flows is moreuncertain. According to this view, discounted cash flowanalysis can be applied most directly to projects with cashflow profiles similar to the firm's current operations (suchas projects extending those operations). Discounted cashfiow analysis will be less valuable to evaluate venturesthat are not directly related to current activities.

Although Booth developed these ideas for large mul-tinational corporations, they can also be applied to smallfirms. If a small firm is considering investment in a newproduct line, future cash flows cannot be estimateddirectly from the past performance of the firm's currentoperations. In addition, because of the firm's scale, mar-ket research studies to quantify fiiture product demand(and cash flows) might not be cost effective. For thesereasons, small firms may not rely exclusively on dis-counted cash flow analysis when evaluating investmentsin new product lines.

There are also reasons why a small firm may not usediscounted cash flow analysis to evaluate replacement

"The small firms in Graham and Harvey (2001) have up to $1 billionin annual revenues. Thus, it is likely that many of these firms havemore complete management teams than the small firms envisioned byAng (1991). In contrast, we evaluate the capital budgeting policies ofvery small firms—our sample includes only firms with less than 250employees, and over 80% of the firms have less than 10 employees—where the problem of incomplete management teams is likely to bemost severe.

decisions. In many cases, replacing equipment is nota discretionary investment for a small firm; the firmmust replace the equipment to stay in business. Insome replacement decisions, a small firm may havelimited replacement options and differences in the futuremaintenance costs of the various options can be difficultto forecast.'

Because small firms do not satisfy the assumptionsunderlying capital budgeting theory, and because ofthese cash flow estimation challenges, it would be natu-ral for small firms to evaluate projects using differenttechniques than large firms. But, evidence about thesedifferences is largely anecdotal. We use survey data todocument the capital budgeting practices of small firmsand to provide evidence about whether small-firm projectevaluation methods are related to the type of investmentunder consideration.

II. Description of Data

The use of survey data to document capital budgetingpractices has a long history in the finance literature.' Yet,survey results should be interpreted with caution becausesurveys measure manager beliefs, not necessarily theiractions; survey participants may not be representative ofthe defined population of firms; and survey questionsmay be misunderstood by some participants (Grahamand Harvey, 2001, p. 189). Nonetheless, surveys provideinformation that cannot be readily gleaned from finan-cial statements. In particular, surveys can shed light onhow firms make investment and financing decisions andwhy they use these approaches.

The data for this study were collected for the NFIBResearch Foundation by the Gallup Organization. Theinterviews for the survey were conducted in April andMay 2003 from a sample of small firms, defined as abusiness employing at least one individual in addition tothe owner, but no more than 249. The sampling frame forthe survey was drawn at the NFIB's direction from thefiles of the Dun & Bradstreet Corporation. Because the

'Booth (1996) also concludes that discounted cash flow analysis mightnot be used for replacement decisions, but for a different reason. Heargues that the payback period combined with judgment can often leada firm to the correct decision for replacement projects, making dis-counted cash flow analysis unnecessary.

'Scott and Petty (1984) summarize the results of 21 early studies oflarge firm capital budgeting practices. The selection criteria in thesestudies include membership in the Fortune 500/1000, a minimum levelof capital expenditures, size, or stock appreciation in excess of certainbenchmarks. In more recent studies, Moore and Reichardt (1983) sur-veyed 298 Fortune 500 firms, Bierman (1993) looked at 74 Fortune100 firms, and Graham and Harvey (2001) investigated the behaviorof 392 firms chosen from the membership of the Financial ExecutivesInstitute and the Fortune 500.

48 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006

distribution of small businesses is highly skewed whenranked by number of employees, interview quotas wereused to add more larger firms to the sample. Once thedata were compiled, the responses were weighted toreflect population proportions based on US Census data,yielding a sample of 792 observations.

Exhibit 1 summarizes the demographic characteris-tics of the sample—industry, sales growth, business age,employment, owner education, and owner age. For eachattribute, we group responses into three to five categories.

Exhibit 1 shows 72% of the sample firms are in con-struction, manufacturing, retail, or wholesale, all indus-tries requiring substantial capital investments. Serviceindustries, where capital expenditures may have lessimportance, account for 20% ofthe sample.

The sample is distributed evenly across four real salesgrowth categories. The high-growth category is definedas a cumulative (not annualized) increase of 20% ormore over the past two years, and includes 24% of thesample firms. At the other extreme, 24% of the firmsreport two-year sales declines of 10% or more. This dis-tribution implies that approximately 75% ofthe samplefirms have experienced an average annualized growthrate of 10% or less over the last two years. Thus, many ofthe capital budgeting decisions of small firms may befocused more on maintaining current levels of serviceand quality, rather than on expansion.

Similarly, the sample is distributed fairly evenly acrossfour business-age categories, ranging from six years inbusiness or less (23% ofthe sample), to 21 years in busi-ness or more (27% ofthe sample). The number of yearsin business could infiuence both the type of investmentsa firm will make and the firm's planning process. Forexample, firms in business longer may have more equip-ment in need of replacement. A business with a limitedoperating history may not be able to obtain a bank loanunless it can demonstrate that it has appropriate planningprocesses in place.

The median (mean) number of total employees is 4(9). 16% of the firms have only one employee, and only18% have 10 or more. Thus, it is likely that many samplefirms do not have complete management teams, and maynot have adequate staff to fully analyze capital budgetingalternatives.

The data in Exhibit 1 also suggest that the educationalbackground of owners could influence how the firmmakes capital budgeting decisions. Over 50% of thebusiness owners do not have a four-year college degree,and only 13% have an advanced or professional degree.Therefore, many ofthe small-business owners may havean incomplete (or incorrect) understanding of how capi-tal budgeting alternatives should be evaluated.

Finally, 63% of the business owners are at least 45years old, and 32% are 55 or older. There is some evi-dence that older managers evaluate capital investments

using less sophisticated methods (see Graham andHarvey, 2001).

III. Survey Results

We use the NFIB survey to address three questionsconcerning the capital budgeting activities of small firms.We first consider whether the investment and financingactivities of small firms conform to the assumptionsunderlying capital budgeting theory. Then, we look atthe overall planning activities of small firms (e.g., use ofbusiness plans, consideration of tax implications) andidentify firm characteristics that tend to be present whenmore sophisticated practices are in place. Finally, weprovide evidence about the specific project evaluationtechniques small firms use (e.g., payback period, dis-counted cash flow methods). We identify significant dif-ferences between the average responses in varioussubsets of firms and the overall sample averages using abinomial Z-score. We use multinomial logit to evaluatehow the choice of investment evaluation tools is relatedto a set of firm characteristics.

A. Investment Activity

Exhibit 2 describes the investment activities of samplefirms. It identifies the firms' most important type ofinvestment over the previous 12 months, and reports thepercentage of firms that will delay a potentially profita-ble investment until the firm has enough internally gen-erated cash to fiand the project.

The most important type of investment is replacementfor 46% ofthe sample firms. Firms in service industrieswere more likely than the average sample firm to selectthis response, and those in construction and manufactur-ing were less likely. Firms with the highest growth ratesand those in business less than six years were less likelythan the average sample firm to report replacement activ-ity as the primary investment type. Finally, the impor-tance of replacement activity increases with the ageof the business owner; it is significantly less than theoverall sample mean when the business owner is youngerthan 44.'

'The significance of the subsample entries depends on the differencebetween the subsample mean and the overall sample mean in a givencolumn, and on the number of observations in the subsample (most ofthese numbers appear in Exhibit 1). Thus, it is possible for two sub-samples to have similar response percentages, one significant and theother not. For example, 54% ofthe service firms identify replacementas the primary investment type, while 55% ofthe firms in the "other"industry category select this investment type. This response percentageis significantly different from the overall sample average for servicefirms, but not for the "other" firms. As shown in Exhibit 1, there aretwice as many service industry firms.

DANIELSON & SCOTT —THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES

Exhibit 1. Sample Description

49

The weighted distributions of the responses to the National Federation of Independent Business' Reinvesting in the BusinessSurvey conducted by the Gallup Organization.

No. of Obs % of Total

IndustryServiceConstruction/manufacturingRetail/wholesaleOther

Real 2-year sales growth

20 percent or higher10-19 percent+/- 10 percent-10 percent or lowerNo answer

Business age< 6 years6-10 years11-20 years

21 + yearsNo answer

Employment1

2-3

4-1010+

Owner education levelLess than college degreeCollege degreeAdvanced/prof, degreeNo answer

Owner age<35 years35-44 years45-54 years55+ yearsNo answer

Total

155194378

65

19417920018732

183173213216

7

127233287145

415260105

12

81194244255

18792

202448

24

23

25

24

4

23222727

1

16293618

5233132

102431322

100

Projects to extend existing product lines are shown asthe primary investment activity for 21% ofthe samplefirms. Construction and manufacturing firms select thisresponse at a higher rate than the overall sample average.The remaining subsample averages are not significantlydifferent from the overall sample averages (at the 5%significance level).

Investments in new product lines are reported as themost frequent investment for 23% of the sample firms.Firms in the service industry were less likely than theaverage sample firm to select this response. Firms withthe highest growth rates were more likely (than the over-all sample average) to be expanding into new productlines, while those with the lowest growth rate were lesslikely. The oldest firms were also less likely than theaverage firm to be considering expansion into new prod-uct lines.

Exhibit 2 also suggests that many small firms facereal (or self-imposed) capital constraints. Approximately45% of the sample firms report they would delay apromising investment until it could be financed withinternally generated funds (wait for cash). Firms mostlikely to wait for cash include the youngest firms,the smallest firms, and those whose owner does nothave a college degree. As these firms are likely to facecapital market constraints, this result supports the pre-diction in Almeida, Campello, and Weisbach (2004)that capital constraints will make a firm more likely tosave cash. Firms with older owners are also slightlymore likely to wait for cash than firms with youngerowners.

These results suggest three reasons small firmsmight not follow the prescriptions of capital budgetingtheory when evaluating projects. First, it is noteworthy

50 JOURNAL OF APPLIED FINANCE — FALUWINTER 2006

Exhibit 2. Investment Activity

Percentage distributions are presented for the question, "Measured in dollars, what was the purpose of the largest share of theinvestments made in your business in the last 12 months?" The last column presents the percentage of all firms that would delayinvestments until they could be financed internally with cash. ++ (- -) indicates that the cell percentage is significantly greaterthan (less than) the column total, at a 5% significance level, and + (-) indicates that the cell percentage is significantly greater than(less than) the column total, at a 10% significance level, using a binomial Z-score.

IndustryServiceConstruction/manufacturingRetail/wholesaleOther

Real 2-year sales growth20 percent or higher10-19 percent+/- 10 percent-10 percent or lower

Business age<6 years6-10 years11-20 years21 + years

Employment12-34-1010+

Owner education levelLess than college degreeCollege degreeAdvanced/prof, degree

Owner age<35 years35-44 years45-54 years55+ years

Total

Replace

54**3 0 "4955

3 7 "525047

3 8 "405151

47474248

444553

3 3 "3 8 "495146

Type of Investment Recently Made

Expand ExistingProduct

2131**1812-

24212220

2327*16-20

202025*19

212022

2323212021

New ProductLine

16-28*2422

31**212316-

26272417"

20212623

232323

2928231923

Other

31 -59**

5335

4236

542-5

441

9**41 "44

Wait forCash

42424556

45503547

52443845

58434337

493844

4238494745

that replacement activity is the most important typeof investment for almost half of the sample firms. Ifreplacing old equipment is necessary for the firm toremain in business, the owner's capital budgetingdecision is essentially a choice between replacingthe machine and staying in business, or closing the busi-ness and finding employment elsewhere. In this case,maintaining the viability ofthe firm as a going concem,rather than maximizing its value, might be the owner'sprimary objective.

Second, the results suggest that many small firmsplace internal limits on the amount they will borrow.Thus, many small firms cannot (or choose not to) separate

investment and financing decisions, contrary to capitalbudgeting theory.

Finally, the results suggest that the personal financialplanning considerations of business owners may affectthe investment and financing decisions of small firms. Inparticular, older owners are more conservative in theirstrategies than younger owners (older owners focus moreon replacement activity and are more likely to report thatthey will wait for cash). These results conflict with anassumption of capital budgeting theory: that the transfer-ability of ownership interests (at low cost) allows man-agers to separate the planning horizon of a business iromthe planning horizon of its owners.

DANIELSON & SCOTT —THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES 51

B. Planning Activity

Exhibit 3 analyzes three dimensions of each firm'splanning environment: how frequently firms estimatecash fiows in making capital budgeting decisions;whether they have written business plans; and whetherthey consider tax implications in making capital budget-ing decisions.

Exhibit 3 reports that only 31% of the samplefirms have a written business plan. Over 30% of thesample firms do not estimate future cash fiows whenmaking investment decisions, and 26% of the firmsdo not consider the tax implications of investmentdecisions. Thus, many small firms do not have aformal planning system that guides capital budgetingdecisions.

Firms with the highest growth rates (over 20% growth)are more likely to use each of these planning tools, par-ticularly written business plans and consideration of taxeffects. Similarly, firms that extend existing product linesor invest in new lines of business engage in more plan-ning activities than the average sample firm. As firmsexpand, they use up more of their borrowing capacity,reducing their future financial fiexibility (assuming thatthey face capital constraints). For these firms, it may beessential to plan ahead, so the firm is not forced to passup promising opportunities in the future.

Newer firms (less than six years old) and youngerowners (less than 45 years old) are more likely than otherfirms to use written business plans. This is an expectedresult, given that banks require evidence of planningbefore extension of credit to firms with short operatinghistories.

The smallest firms (three or fewer employees) areless likely to make cash fiow projections, while firmswith ten or more employees are more likely to makethese estimates. This finding supports conjecturesmade by Ang (1991) and Keasey and Watson (1993) thatpersonnel constraints (incomplete management teams)may hamper small firms in planning.

The planning activities of small firms are also stronglyrelated to the educational background of the businessowner. If the business owner does not have a collegedegree, the firm is less likely than the average firm to makecash fiow projections or to use written business plans. Ifthe business owner has an advanced/professional degree,the firm is more likely to engage in such activities.

C. Project Evaluation iVIethods

Exhibit 4 summarizes responses about the primarytool firms use to assess a project's financial viability:payback period, accounting rate of return, discounted

cash fiow analysis, "gut feel," or combination. The mostcommon response is the least sophisticated, gut feel—selected by 26% ofthe sample firms.^

The use of gut feel is strongly related to the businessowner's educational background. Owners without a col-lege degree resort to it most frequently, and owners withadvanced degrees least. The use of gut feel is alsoinversely related to a firm's use of planning tools. Firmswith written business plans and firms that make cashfiow projections are significantly less likely to rely ongut feel.

While the use of gut feel is concentrated in the leastsophisticated of small firms, it is also widely used byfirms that make primarily replacement investments. Afirm may have limited options when it replaces equip-ment, and estimating future cash fiows (i.e., incremen-tal maintenance costs or efficiency gains) for eachoption might be difficult. For example, if a firm mustreplace a delivery truck, it may be difficult for the firmto estimate differences in the future annual operatingcosts of two replacement vehicles under consideration.Moreover, if an investment is necessary for the firm'ssurvival (and the owner is committed to maintainingthe business as a going concem), the maximization offirm value may not be the business owner's primaryobjective. Instead, the owner may simply look for thealtemative promising the required level of performanceat the most reasonable cost. Thus, it is not surprising tofind that small business owners use relatively unsophis-ticated methods of analysis to evaluate replacementoptions.

Gut feel is also used extensively by firms in the ser-vice industry. Although some service firms make sub-stantial capital expenditures, the investments of manyservice firms might be limited to business vehicles oroffice equipment. Because a firm's primary considera-tions when evaluating this type of purchase decision maybe cost, reliability, and product features, stmcturing adiscounted cash fiow analysis of these investments canbe difficult.

Payback period is the second most common response,selected by 19% of the sample. The payback periodis used slightly more often by firms that will wait forcash, as expected. Firms using the payback period aresignificantly more likely than other firms to estimatefuture cash fiows (because cash fiow estimates arerequired for this calculation). Finally, use ofthe paybackperiod appears to increase with the formal education ofthe business owner.

These results suggest that the payback period con-veys important economic information in at least some

'Vos and Vos (2000) report "intuition" as the most frequently usedproject evaluation technique in a survey of 238 small New Zealandbusinesses.

52 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006

Exhibit 3. Investment Planning Tools

Responses are presented to three questions about planning tools used in the evaluation of capital investments. "Make CFProjections" presents the percentage of respondents who said they typically make cash flow projections prior to making a majorinvestment in their business. "Written Business Plan" presents the percentage of respondents who said they had a written businessplan projecting the major investments planned over the next few years. "Taxes Calculated/Considered" presents the percentageof respondents who reported they typically calculated or considered the tax implications of a major investment in their business.++ (—) indicates that the cell percentage is significantly greater than (less than) the column total, at a 5% significance level, and+ (-) indicates that the cell percentage is significantly greater than (less than) the column total, at a 10% significance level, usinga binomial Z-score.

Planning Tools

Make CF Projections Written Business Plan Taxes Calculated/Considered

Industry

Service 71 34 72Construetion/manufacturing 68 32 71Retail/wholesale 70 30 75Other 67 27 83*

Real 2-year sales growth20 percent or higher 74 38** 79*10-19 percent 66 29 75+/ -10 percent 68 28 74—10 percent or lower 70 29 68

Business age<6 years 80** 46** 79*6-10 years 71 28 7211-20 years 71 28 7221+years 58"- 23"- 74

Employment1 6 1 " 35 752-3 64- 24-- 774-10 72 33 7210+ 81** 36 74

Owner education levelLess than college degree 65- 27- 73College degree 73 35 75Advaneed/prof. degree 81** 38 83**

Owner age<35 years 80 40* 7335-44 years 73 37* 7845-54 years 69 34 7355+years 66 2 1 - 74

Wait for cash 69 32 77Investment type

Replacement 67 2 3 - 72Expand existing product 71 37* 76New product line 74 42** 80*Other 81 49* 83

Total 69 31 74

circumstances. For example, the payback period can be The accounting rate of return is the next most frequenta rational project evaluation tool for small firms facing choice, identified by 14% ofthe firms as their primarycapital constraints (i.e., firms that do not operate in evaluation method. The use of accounting rate of returnthe perfect financial markets envisioned by capital budg- increases with firms' growth rates; it is significantlyeting theory). In this case, projects that return cash higher than the sample mean for firms entering new linesquickly could benefit a firm by easing future cash flow of business. Each of these characteristics can indicateconstraints. high borrowing needs. The accounting rate of return is

OANIELSON & SCOTT—THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES 53

Exhibit 4. Investment Decision Tools

Responses are presented to the question about the investment tools used to assess the financial viability of a major investmentin the business. ++ (—) indicates that the cell percentage is significantly greater than (less than) the column total, at a 5%significance level, and + (-) indicates that the cell percentage is significantly greater than (less than) the column total, at a 10%significance level, using a binomial Z-score.

IndustryServiceConstruction/manufacturingRetail/wholesaleOther

Real 2-year sales growth20 percent or higher10-19 percent+/- 10 percent-10 percent or lower

Business age<6 years6-10 years11-20 years21 + years

Employment12-34-1010+

Owner education levelLess than college degreeCollege degreeAdvanced/prof, degree

Owner age<35 years35-44 years45-54 years55+ years

Wait for cashInvestment type

ReplacementExpand existing productNew product lineOther

Planning toolsCash flow projection madeWritten business planTaxes calculated/considered

Total

Payback

18191923

1526**2118

21191720

22201621

182024

2614--

24**1621

20201921

23**192019

ARR

II14166-

17141211

141019**11

14151216

1218*11

1019**151112

111420**17

1518*1614

Investment Tools

DCF

1311139

14111114

18**12137--

13111312

121017**

1418**7 "

1315

1217*9

14

1416*14*12

Gut Feel

33**222529

26272431

24292328

25252825

292317-

192131*2724

31**20-2314

22-2 0 -2426

Combination

II15*8-

14

99

129

89

1114

1112109

101213

141110118

138

133

13131211

thus especially important if a firm must provide bankswith periodic financial statements or is required to complywith loan covenants based on financial statement ratios.

The most theoretically correct method—discountedcash flow analysis—is the primary investment evalua-tion method of only 12% of the firms. Not surprisingly,owners with advanced/professional degrees are mostlikely to use this method; 17% of these firms identify it

as their primary evaluation tool. Firms with writtenbusiness plans and those that consider the tax implica-tions of investments are also significantly more likelyto use discounted cash flow techniques. Thus, firms usingthis project evaluation method are among the most so-phisticated of the small firms.

Firms extending existing product lines are also signifi-cantly more likely to use discounted cash flow analysis.

54 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006

This result is evidence that discounted cash flow analysisis most useful when evaluating projects with cash flowprofiles similar to current operations (such as projectsextending existing product lines), because it is easier toobtain reliable cash flow estimates in this case.

Another noteworthy finding is that 18% of the firmsin business less than six years use this method, the mostof any age group. Although younger firms are less likelyto have complete management teams in place, it is alsopossible that banks may encourage newer firms to dem-onstrate adequate planning (and project evaluation)procedures before qualifying for credit.

Of the specific evaluation techniques firms couldchoose from, combination of methods was selected leastoften, by 11% of firms. Use of this approach does notappear to be strongly related to any of the firm character-istics listed in Exhibit 4.

The results in Exhibit 4 are very different fi om resultsin Graham and Harvey (2001). Approximately 75% oftheir firms evaluate projects using estimates of project netpresent value or internal rate of return. The vast majorityof their firms also appear to consider multiple measures ofproject value in making investment decisions. However,even the smaller firms in the Graham and Harvey studyare much larger than the firms in our sample and are thusmore likely to have complete management teams. It istherefore not surprising that their firms use more sophis-ticated methods of project analysis.

D. Multivariate Analysis

To provide a multivariate perspective on how smallfirms make investment decisions, we use multinomiallogit to jointly identify factors influencing the choice ofa project evaluation tool. This technique is appropriatewhen an unordered response, such as a set of projectevaluation tools, has more than two outcomes.

Exhibit 5 reports the results of this exercise; gut feelis the omitted category. Thus, the coefficients listed inExhibit 5 should be interpreted as the increase (a positivecoefficient) or the reduction (a negative coefficient) inthe log odds between the evaluation tool specified andgut feel.

The results show that firms using any of the formalinvestment evaluation tools are more likely to make cashflow projections than firms using gut feel. Firms usingthe accounting rate of return, discounted cash fiow, or acombination of methods are more likely to consider taximplications when they evaluate projects. These resultscorroborate the results in Exhibit 4—-firms using gut feelto evaluate projects have much less structured planningenvironments than other firms.

Exhibit 5 also identifies factors that differentiatebetween firms attaching primary importance to the vari-ous investment evaluation tools. The results suggest that

capital constraints and the type of investment (e.g.,replacement, expand product line, new product line) caninfluence how firms evaluate projects.

The wait for cash coefficient is positive and signifi-cant for both payback period and discounted cash flowanalysis. These results suggest that firms committed tofunding projects internally are not necessarily irrationalor unsophisticated. Instead, the decision to wait for cashmight be an acknowledgment that the firm does not oper-ate in a perfect financial market, and faces capital con-straints. Because the firm knows it may not be able tofund all valuable projects, it will evaluate projects usingthe payback period (to help it allocate investment fundsover a multiyear horizon) or discounted cash fiow analy-sis (to help it identify the best projects).

The accounting rate of return is fi-equently the choiceof firms pursuing either growth strategy: expand productline or new product line. The coefficients for both of thesevariables are positive and significant for accounting rateof return. As a firm grows, it may need to raise new capi-tal, either by obtaining a bank loan or by attracting newequity investors. In either case, the firm's historical andprojected financial statements will be used to communi-cate information about the firm to investors. The account-ing rate of return can be valuable to firms pursuing growthstrategies because it provides information about how aproject will affect a firm's financial statements (and itsability to meet accounting-based loan covenants).

The importance of discounted cash fiow analysisdepends on the type of growth the firm is pursuing. Thecoefficient for expanding an existing product line is posi-tive and significant for discounted cash fiows, but thecoefficient for new product line is not. Firms will usediscounted cash fiows to evaluate projects that extendexisting product lines because future cash fiow estimatescan be based on past performance in this case. But, if itis contemplating a new product line, where obtainingfuture cash fiow estimates can be difficult, the firm is lesslikely to use a discounted cash fiow method of analysis.

IV. Summary

Firms with fewer than 250 employees analyze poten-tial investments using much less sophisticated methodsthan those recommended by capital budgeting theory. Inparticular, survey results show these businesses use dis-counted cash fiow analysis less frequently than gut feel,payback period, and accounting rate of return.

Many small-business owners have limited formal edu-cation, and their firms may have incomplete manage-ment teams. Therefore, a lack of financial sophisticationis an important reason why the capital budgeting prac-tices of small firms differ so dramatically fi-om the rec-ommendations of theory. Small staff sizes also constrain

DANIELSON & SCOTT—THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES 55

Exhibit 5. Multinomiai Logit Results

Mulitnomial logit estimates are presented of the factors that affect the decision tool most frequently used to assess the financialviability ofa project. All of the dependent variables are 1/0 variables that take a value of 1 if the method of investment evaluationin each column is reported for large investments. The omitted choice is Gut Feel; thus the significance of the coefficients shouldbe interpreted as the effect on the log odds of the evaluation tool choice relative to Gut Feel. In each case where there is a setof 1/0 variables for the independent variable, the omitted variable is identified and significance should be interpreted relativeto this omitted variable. The observations included in these estimates are limited to those respondents reporting one of the fiveinvestment analysis techniques, which limits the sample size to 583 observations.

Industry

Manufacturing/constructionRetail/wholesaleService/other (omitted)

Real 2-year sales growth10 percent or higher (omitted)No change (+/- 10 percent)-10 percent or lower

Business ageUnder 6 years (omitted)6-10 years11-20 years20+ years

EmploymentUnder 4 (omitted)10-AprOver 10

Owner education levelCollege (BA or AA)Graduate schoolNo college (omitted)

Owner ageUnder 3535-4445-5455 up (omitted)

Wait for cashInvestment type

Replacement (omitted)Expand product lineNew product line

Planning toolsCash flow projection madeWritten business planTaxes calculated/considered

Constant

***significantat theO.Ol level.**significant at the 0.05 level.

•significant at the 0.10 level.

Payback

Coeff

0.221-0.063

0.374-0.330

0.1510.4510.604

-0.666-0.503

0.2510.915

1.3670.4480.432

0.426

0.3810.255

1.297-0.041-0.047-3.836

Std Err

0.3320.287

0.2960.305

0.3620.3810.384

0.278**0.331

0.2680.388**

0.486***0.3710.296

0.241*

0.3130.305

0.286***0.2750.2741.512**

Rate

Coeff

0.5120.621

-0.142-0.420

-0.2160.9240.442

-0.570-0.336

0.2990.059

0.2490.8810.164

-0.084

0.6400.637

0.6350.3630.744

-1.849

of Return

Std Err

0.3830.333*

0.3360.338

0.4110.391**0.422

0.310*0.358

0.2870.461

0.5780.374**0.336

0.269

0.339*0.322**

0.296**0.2970.344**1.646

Coeff

0.0400.259

0.3470.226

-0.1790.314

-0.482

-0.346-0.243

-0.2060.683

0.4480.565

-^.845

0.593

0.8800.031

0.7310.4221.020

-0.461

DCF

Std Err

0.3990.334

0.3600.342

0.4000.4030.461

0.3210.397

0.3220.439

0.5510.3780.384**

0.280**

0.343**0.377

0.323**0.3080.394***1.738

Combination

Coeff

0.512-0.505

0.250-0.252

0.3491.4041.671

-0.838-1.067

0.0851.104

1.7120.8030.089

-0.452

-0.0180.334

1.1570.3970.762

-3.402

Std Err

0.3790.362

0.3560.366

0.4890.485***0.499***

0.336**0.418**

0.3270.472**

0.603***0.441*0.370

0.305

0.3950.361

0.357***0.3220.388**1.898*

the atnount of capital budgeting analyses the fimis can

perform. Beyond this, there are also substantive reasons

a stnall firtn tnight choose to use methods other than dis-

counted cash flow analysis to evaluate projects.

The primary reason is that many small businesses do

not operate in the perfect capital markets that capital bud-

geting theory assumes. Most of the firms in our sample

are very small (with fewer than 10 employees); they have

short operating histories (almost half have been in busi-

ness under 10 years), and their owners are not college edu-

cated. These characteristics may limit their bank credit,

posing credit constraints. Ifso, these firms may be required

56 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006

to finance some future investments using internally gener-ated funds, and it would not be surprising for the ownersto consider measures of project liquidity (such as the pay-back period) when making investment decisions.

Second, many of the investments that small firmsmake cannot easily be evaluated using the discountedcash flow techniques recommended by capital budgetingtheory. Many investments by small firms are not dis-cretionary (a firm either makes a specific investmentor it goes out of business), and future cash flows can bedifficult to quantify. For example, if a firm is introducinga new product line, estimates of future cash flows can beimprecise (and market research studies required to obtainbetter cash flow estimates may not be cost effective).

When future cash fiows cannot be easily estimated, dis-counted cash fiow analysis may not provide a reliableestimate of a project's contribution to firm value, and itis not surprising that a firm might resort to gut feel toanalyze the investment.

For these reasons, small firms face capital budgetingchallenges that differ from those faced by larger firms.Thus, it is possible that optimal capital budgeting meth-ods for large and small firms may differ. However, a fullyintegrated capital budgeting theory—identifying theconditions under which discounted cash flow analysis isappropriate—has yet to be developed. The question ofhow to better tailor the prescriptions of capital budgetingtheory for small firms remains unanswered. •

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