Cost-of-capital estimation and capital-budgeting practice in Australia

Australian Journal of Management, June, 2008 by Giang Truong, Graham Partington, Maurice Peat

Abstract:

We use a sample survey to analyse the capital-budgeting practices of Australian listed companies. We find that NPV, IRR and Payback are the most popular evaluation techniques. Real options techniques have gained a toehold in capital budgeting but are not yet part of the mainstream. Discounting is typically by the weighted average cost of capital, assumed constant for the life of the project, and with the same discount rate across divisions. The WACC is usually based on target weights for debt and equity. The CAPM is widely used, while other asset pricing models are not. The discount rate is reviewed regularly and is updated as conditions change. In most companies, project analysis takes no account of the value of imputation tax credits. Australian corporate practice is generally consistent with the practice of Australian price regulators, except that regulators take into account the value of imputation tax credits when computing the cost of capital.

Keywords:

COST OF CAPITAL; CAPITAL BUDGETING; DISCOUNT RATE; CAPM; SURVEY.

1. Introduction

Capital budgeting is a key issue in corporate finance. Over several decades, major theoretical developments in capital budgeting have been incorporated into corporate practice. It is over four decades since one of the key developments, Sharpe's (1964) publication of the Capital Asset Pricing Model (CAPM). American evidence suggests that the adoption of the CAPM in the practice of capital budgeting has been widespread (Graham & Harvey 2001). However, there is little Australian evidence on this issue. While the CAPM was being increasingly adopted in practice, at least in the US, it has also come under academic attack (Fama & French 1992). At the same time, new approaches to asset pricing and capital budgeting have been developed. Developments in real options, for example, have reached the textbook level (Copeland & Antikarov 2001), but relatively little is known about the impact of these developments on capital budgeting practice.

A number of surveys into the capital budgeting practice of Australian firms have been conducted including McMahon (1981), Lilleyman (1984), Freeman and Hobbes (1991) and Kester, Chang, Echanis, Haikal, Isa, Skully, Kai-Chong and Chi-Jeng (1999). These surveys covered a range of issues; such as which capital-budgeting techniques were used, how firms ranked the importance of these techniques, and how discount rates were determined.

Given the rate of change in business practice over the 1990s, and the developments in the academic literature, it is timely to investigate the extent to which the CAPM and newer theoretical developments have affected Australian practice. We consider a number of issues that have received little or no attention in previous Australian investigations of capital budgeting practice. These include: the extent to which companies use real-options analysis in addition to popular techniques such as discounted cash flow (DCF); the use of time-varying discount rates; the extent of use of the CAPM and alternative asset-pricing models such as the Fama and French three-factor model; the inputs companies use when applying the CAPM; whether companies incorporate the value of imputation tax credits into their capital-budgeting procedures, and if so, how they do it; and whether there are differences between Australian corporate and regulatory practices in relation to the cost of capital.

The paper is organised as follows. In section 2 literature relevant to the study is reviewed. Section 3 describes the survey questionnaire, survey sample, and survey process. Section 4 provides the survey results and statistical analysis. Section 5 concludes the paper.

2. Relevant Literature

The most recent Australian capital budgeting surveys were by McMahon (1981), Lilleyman (1984) and Freeman and Hobbes (1991). These surveys revealed the growing popularity of DCF techniques and reliance on the weighted average cost of capital (WACC) as the discount rate. For example, Freeman and Hobbes found that 75% and 72% of respondents reported using NPV and IRR techniques respectively. However, methods such as the payback period, accounting rate of return, or discounted payback were used by a substantial number of companies. Similar to McMahon, Freeman and Hobbes found that 62% of respondent companies used the WACC to calculate the hurdle rate used in the capital budgeting process. However, 39% of respondents said they relied on the cost of borrowing to determine the hurdle rate.

A more recent international survey that included Australian companies in the sample, among companies from six Asia Pacific countries, was undertaken by Kester et al. (1999). This survey confirmed the popularity of DCF methods in Australia and the popularity of the CAPM, which was used by 73% of the companies surveyed. Information on the use of the CAPM was not included in previous surveys in Australia. The rate of CAPM usage was significantly higher than in the other Asia Pacific countries surveyed, which covered Hong Kong, Indonesia, Malaysia, the Philippines and Singapore.