Hyoung-Goo Kang
Duke University
hyoung.kang@duke.edu
This paper introduces a new concept: Organizational Capital Budgeting Model (OCBM). Standard Capital Budgeting Model (SCBM), such as NPV and its variations, is the special cases of OCBM. OCBM is a framework to embed the capital budgeting in finance and the decision-making in organization/ strategy literature in order to describe the resource allocation practices in use.
OCBM starts from a simple idea. Firms need theoretical lenses in order to recognize 'raw' investment opportunities. When a theoretical lens meets an investment opportunity, valuation occurs. Let us call the theoretical lenses as valuation strategies. Then, a firm's choice set is {valuation strategies x investment opportunities}, instead of just {investment opportunities}. It also implies that a firm partially constructs the value of investment by choosing valuation strategies.
OCBM presumes that four types of meanings are generated when a firm chooses a pair (valuation strategy, investment opportunity). The meanings are value (V), net accuracy (B), controversy (C) and uncertainty (C). OCBM assumes that firms maximize goal which increases with financial factors {V, B} but decreases with social factors {C, U}. The social factors are intuitively derived from discount cash-flow model (DCF). In general, DCF is Val = Profit/ Risk. I interpret Val as meaning, Profit as the source of controversy, and Risk as uncertainty, because the allocation of profit involves the controversy among coalitions, and uncertainty is immeasurable risk (Knightian uncertainty). The social factors affect the choice, resulting in the social construction of investment opportunities.
To formalize, OCBM is defined as the solution of OCBM-maximization. OCBM-maximization is:
max G(V, S, C, V)
with respect to (s, k)
subject to (s, k) Є S x K.
Thus, OCBM is s(k) = arg.max{s} G(V, S, C, U) with respect s in S given k. This optimization set-up produces following predictions. For simplicity, let NSCBM = OCBM\SCBM, i.e. non-SCBM in OCBM set.
Predictions:
1. The more important the social factors become; the more NSCBM is used.
2. The more sensitive the social factors become with respect to valuation methods; the more NSCBM is used.
3. The importance of controversy and uncertainty increases the use of NSCBM.
In order to test OCBM, I use qualitative studies about the practices of Chaebols (large Korean conglomerate) for several reasons. Firstly, Chaebols are interesting and important topic themselves. Chaebols are important in Korean economy. Some of them are very large and important players even in global market. Secondly, the cases about Chaebols are interesting tales about the conflict of interest, information asymmetry and corporate diversification to be relevant to all the other firms. In particular, Chaebols have developed salient systems to coordinate their subsidiaries in the presence of extreme agency problems. The analysis into such system will offer fresh intuitions about internal capital market of other cases.
Besides testing OCBM, the qualitative study provides ethnographic description about capital budgeting process. The capital budgeting process includes the announcement of budgeting rules, idea generation, organization design and post-investment activities. This study employs multiple qualitative techniques such as interviews, archival analysis and surveys to identify the practices. Such study will be useful for future researchers to study Chaebols.
The results correspond to the predictions of OCBM. OCBM explains the deviations of capital budgeting practices from textbook methods and can predict the direction. When controversy is high, OCBM functions as the tool for communicating and information sharing. When uncertainty is high, capital budgeting is inseparable from researches and learning. I want to emphasize that the findings do not invalidate SCBM. On the contrary, OCBM stresses the importance of social contexts and the endogeneity/ social construction of investment opportunities. The results in fact fit an argument of resource-based view of firm, i.e. 'no rule for riches'. The notion of correct capital budgeting is organization specific. Thus, competitive advantages and heterogeneous firm performances can come from the capabilities of properly constructing the meaning of investment opportunities through valuation strategies.