Decision criteria in capital budgeting under uncertainties: Implications for future research

Capital budgeting decisions about physical, productive assets such as those of the manufacturing firm are studied via simulation experiments. Four criteria are investigated: net present worth (NPW); utility of NPW of cash-flows (UNC); dynamic utility of NPW (DUN), which explicitly incorporates dependence of preferences on equity position; and DUN without discounting. The latter of these is equivalent to a form of Thompson and Thuesen’s dynamic investment criteria. The decision procedure selects that combination of available productive assets that maximizes the value of the criterion employed in any given experimental run. Two main types of uncertainty are examined: uncertainty about project cash-flows (cash-flow uncertainty) and uncertainty due to incomplete information (basic uncertainty). Incomplete information assumes that at any particular decision time the firm has made no cash-flow estimates of future project opportunities. No significant difference is found in the performance of the firm using different criteria, provided the same discount rate is used. Cash-flow uncertainty is found to have a much larger effect than basic uncertainty. Quality of cash-flow information is found to be significant in the performance of the firm. An unexplained result is found that using no discounting with low quality of information results in statistically better performance relative to using an 8% discount rate. The implications to future research directions in capital budgeting are: (1) it seems inadvisable to focus much research effort on increasing the sophistication of project evaluation; (2) the firm should concentrate its effort on getting high quality cash-flow information of current projects; and (3) capital budgeting may benefit from a re-emphasis of research effort from project evaluation to other phases of the capital budgeting process.