Dissecting the theory-practice gap - A study of the capital budgeting processes of large Swedish Industrial Machinery firms
A firm’s success depends on its ability to allocate capital to productive use. This is carried out through a process referred to as capital budgeting. Previous research shows that the theory-preferred sophisticated Capital Budgeting Techniques (CBT) are becoming increasingly popular with time but that European and Swedish Industrial Engineering firms in particular to a great extent still use less sophisticated CBT. Reasons behind this gap have not been identified by the academic world, which constitutes an academic problem. Purpose The purpose of this study is to investigate the underlying reasons to a potential theory-practice gap within the firms included in the study. The study is intended as a complement to previous research of an explanatory nature and as input to further research in the area where identified reasons can be useful. Method The study is of a qualitative nature as this approach is better suited for capturing the various complex reasons affecting the design of a capital budgeting process. The methodology components consist of a literature study, containing both corporate finance theory and previous research and an empirical study of four interviews. The firms are evaluated on four components, cost of capital, CBT, risk and project characteristics. Further, only tangible projects in the production process are considered due to research quality reasons. The interviewed firms are all part of the Industrial Engineering industry’s sub-industry, the Industrial Machinery industry and listed on the Nasdaq OMX 30 index. Results and study findings The study has identified a theory-practice gap within the firms investigated. All firms employ a more or less fixed cost of capital for the firm, not reflecting the true cost of capital. In line with previous research, we find a great reliance on the payback-technique as an actual decision measure even though it is often combined with more sophisticated CBT. Risk is almost exclusively assessed qualitatively and only one firm incorporates risk in the CBT. Strategic value of a project affects the process as numerical criteria are lowered but is not valued using theoretical approaches. Flexibility is handled in a similar manner. We identify the main reason to the gap to be the priority of the capital budgeting process. Only limited evaluation and enhancements of the process are made which impedes firms to find all projects adding to firm value. The fundamental strategy of corporate finance theory that all projects with Net Present Value greater than zero should be undertaken seems to be overlooked. Future areas of research An obvious extension of this research would be to look at the investment process for all project types. Other possible future areas for research are similar studies in other industries in order to identify further reasons to a theory-practice gap. It is also of interest to perform research with a quantitative approach to investigate whether the findings can be generalized within the industry or country. Interesting research would also be to investigate the hypothetical relationship between reward systems based short-term profitability and capital budgeting practices.