The role of formal capital budgeting analysis in corporate investment decision-making: a literature review

Panel: Panel 1. The foundations of future energy policies: Initiating change and breaking walls

Author:
Catherine Cooremans, HEC University of Geneva, Switzerland

Abstract

According to mainstream energy economics, energy-efficiency investment decisions made by businesses are strictly based on capital budgeting analysis. As a result, these investments are not decided upon because they are profitable only in appearance, since several hidden and transaction costs, as well as a high level of risk, lower their profitability below a firm's cost of capital.

It is curious that the energy-economics literature hasn’t explored important questions discussed for several years by some finance research: do financial factors and capital budgeting tools really determine investment decisions? Does the investment type influence the decision-making process and the final decision?

Different streams of literature – organizational finance, strategic decision-making, technology investment analysis – have discussed these questions to improve our understanding of how capital budgeting systems work and have evolved. Several empirical studies have investigated the role of formal appraisal tools on capital investment decision-making. Their findings converge on the following conclusions: conventional financial analysis tools are widely used, and yet their real role is often secondary in investment decisions; sometimes they are simply used as a communication tool; the strategic character of investments has a heavier decisional weight. However, practices diverge with national cultures.

The goal of this paper is to review this literature, in order to escape the fruitless debate on energy-efficiency investments profitability as well as to highlight new ways to consider – and, more importantly, to influence - decisions made in this regard. Ultimately, a better knowledge of corporate investment decision-making will enable the design of more effective public policies to promote corporate energy-efficiency investments, since the partial influence of financial factors and the importance of strategic factors in investment decisions entail several practical conclusions: first, improving investment profitability (through subventions or low-interest loans) is not sufficient to ensure a positive decision; secondly, information on profitability is not of much help either; thirdly, it is necessary to ascertain - and communicate about - the impact of energy-efficiency investments on a company's competitive advantage, or in other words, to highlight the strategic character of these investments.