How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes

Capital budgeting is a contentious subject in both research and managerial practice. Financial economists such as Brealy & Myers advocate using NPV and related quantitative approaches that comprise what we refer to as the standard capital budgetting model (SCBM); by contrast, strategy scholars such as Bower have argued that socio-political conflicts interfere with such financially-oriented capital budgeting methods and often render them ineffective. We reconcile these competing views by extending the behavioral theory of the firm (BTF) – particularly the notions of Knightian uncertainty and controversy that are central to the BTF – to encompass capital budgeting methodologies. In doing so, we develop a more general organizational capital budgeting model (OCBM) that incorporates traditional capital budgeting theories along with consideration of the firm’s organizational processes and the degree of uncertainty underlying the assumptions that firms must make in their capital budgetting activities. Fourteen structured qualitative case studies of capital budgeting projects in Korean Chaebols provide evidence that the traditional arguments apply at particular levels of uncertainty and controversy: For low Knightian uncertainty and low controversy, the financially-oriented SCBM works well; under high Knightian uncertainty and high controversy, firms instead turn to more qualitative socio-political methodologies. We then complete the uncertainty and controversy matrix with two other combinations: High Knightian uncertainty and low controversy (which we label the plausibility approach), plus low Knightian uncertainty and high controversy (the negotiation approach). The OCBM broadens the traditional capital budgeting model and helps explain firms’ heterogeneous choices of capital budgeting approaches. How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 2 Capital budgeting is a key management capability (Segelod, 1998; Maritan, 2001) with major impact on firms and economies (Baldwin and Clark, 1992; Porter, 1992). Two competing views promote alternative capital budgeting methods. One approach emphasizes financially-oriented analyses such as net present value and internal rates of return (Brealey, Myers, and Allen, 2005; Ross, Westerfield, and Jaffe, 2002), which we refer to as the standard capital budgeting model (SCBM). The major alternative focuses on qualitative socio-political processes (Bower, 1970). In practice, firms use both the SCBM and sociopolitical approaches, as well as hybrid methods. Although numerous studies find heterogeneity in capital budgeting practices, there is little consensus about what factors lead firms to use different approaches. Two social concepts that are central to the behavioral theory of the firm (BTF) – Knightian uncertainty (Knight, 1921; Keynes, 1921) and controversy (Cyert and March, 1963; Burton, DeSanctis, and Obel 2006) – can help reconcile this lack of consensus. The two polar approaches, the SCBM and the socio-political approach, either under-emphasize or over-emphasize how these two social factors can interfere with standard capital budgeting. The financially-oriented tools of the SCBM underestimate the importance of Knightian uncertainty and organizational controversy, while the socio-political approach assumes that these social factors are always present, salient, and paramount. Knightian uncertainty arises when parameters around cash flow estimates are doubtful, while controversy arises when sub-groups have differing goals and/or beliefs about states of the world. We reconcile the competing views by extending the BTF to encompass capital budgeting methodologies. In doing so, we develop a general organizational capital budgeting model (OCBM), in which the SCBM and socio-political approaches are special cases. The paper proceeds as follows. We first develop propositions that address how variation in Knightian uncertainty and controversy influence capital budgeting choices. We then turn to a rich set of structured qualitative studies based on 14 projects at seven Korean Chaebols that explore the propositions. THEORY: ORGANIZATIONAL CAPITAL BUDGETING MODEL Capital budgeting models are methods that firms use to decide which capital projects to assess and how to allocate internal investment resources among projects. Scholars such as Baldwin and Clark (1992, 1994) and Porter (1992) argue that capital budgeting has a major impact on firms and economies. How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 3 Maritan (2001) argues that developing and implementing capital-budgeting methods is an important higher-order firm capability, while Segelod (1998) points out that good investment practices assist strategic and financial planning, as well as help create a common corporate language. In turn, capital budgeting influences the ongoing evolution of firms’ boundaries by determining choices of internally organized transactions versus markets for capital and other resources. The organizational capital budgeting model in this paper extends our understanding of firms’ capital budgeting choices. The most prominent capital budgeting techniques rely on the financial assessments of the standard capital budgeting model. The OCBM incorporates the SCBM, while highlighting variation in capital budgeting methods as a response to deal with varying levels of Knightian uncertainty and/or controversy in the firm. The OCBM presumes that, when a firm selects combinations of valuation strategies and investment opportunities, four considerations arise: Perceived value, net accuracy, Knightian uncertainty, and controversy. The following discussion defines these concepts. The OCBM assumes that firms optimize their goals by choosing valuation methods and investment opportunities that attempt to balance the four considerations (Kang, 2009). We develop a set of orienting propositions that address how different combinations of Knightian uncertainty and controversy will lead to different choices of capital budgeting models, beginning with the SCBM and then moving to the other three approaches within the OCBM. The orienting propositions draw on existing theory to provide direction for our study, while still providing room for exploratory investigation of the concepts within the propositions – by combining deductive and inductive logic, this approach generates both empirical understanding and conceptual development. We regard Knightian uncertainty and controversy (social factors) as stable and exogenous functions of the choice set pair of a capital-budgeting method and an investment opportunity. The states of social factors, in which we investigate a firm’s choice about capital budgeting, are characterized with stable parameters such as how sensitive a goal is to the social factors and how sensitive the social factors are to the chosen pair of a capital-budgeting method and an investment opportunity. Therefore, our investigation is free from reverse causality or endogeneity (we can provide a formal model on request). Simply put, at any time and place, a default state of social factors exists that individuals accept as given. Subsequent longitudinal studies could How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 4 investigate how the social factors change and how capital budgeting responds dynamically, which are beyond the scope of this paper. Table 1 summarizes the central concepts in the propositions. ********** Table 1 about here ********** Standard Capital Budgeting Model: Low Knightian Uncertainty and Low Controversy The SCBM is the application of following formula: Perceived value ≡ E(CashFlow) RCC*Investment. Perceived value is the estimated value calculated when a valuation method is applied for an investment opportunity where, in this case, the valuation method is the SCBM. E(CashFlow) is expected cash flow arising from a project. RCC denotes the opportunity cost of capital. Investment is the size of investment that a project will require. In the SCBM, these variables are quantified with probabilities that capture the risk for a project. As risk increases, decision-makers seek to reduce E(CashFlow) (Black and Scholes, 1973; Dixit and Pindyck, 1996), increase RCC (Brealey, Myers, and Allen, 2005), or decrease Investment (Jorion, 1997), because risky projects are less desirable. Standard textbooks (e.g., Brealey, Myers, and Allen, 2005; Ross, Westerfield and Jaffe, 2002) argue that the SCBM, especially net present value (NPV), is the most accurate method of ordering projects to maximize firm value and stockholder equity. The standard argument suggests that the SCBM achieves the greatest net accuracy, where net accuracy is the weighted distance between gross accuracy and the effort required to accomplish gross accuracy. Gross accuracy can be measured “in terms of the percentage attained of the optimal weighted adding value” (Bettman, Luce, and Payne, 1998), that is, how close to a theoretical optimum a decision-maker would be able to come if they expended full effort. The notion of net accuracy reflects the point that decision-makers must expend resources in order to make estimates, which reduces the benefit of the gross accuracy. The point here is that the SCBM, when it can be applied, is an efficient means of valuation and generates high net accuracy. The SCBM is efficient because it offers flexible options. Decision-makers can determine how to segment expected cash flows, costs of capital, and investment parameters, and can also chose among multiple assumptions in order to define the parameters. Implicitly or explicitly, decision-makers choose among options for SCBM calculations by considering how much time and effort an analysis will require. How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 5 Within the SCBM, NPV is the most influential tool for internal capital allocation. To use our terminologies, NPV is viewed as the best means of maximizing gross accuracy, while the SCBM as a whole offers the best net accuracy (where the difference between gross and net accuracy will depend on how much effort decision-makers must expend to use different tools within the SCBM portfolio). The titles of two chapters of the finance text by Brealey, Meyers, and Allen (2005) illustrate the preference for using net present value: "Chapter 5: Why Net Present Value Leads to Better Investment Decisions than Other Criteria" and "Chapter 6: Making Investment Decisions with the Net Present Value Rule." External capital markets also use variations of NPV for valuation models. Many stock analysts, venture capitalists, and bank officers use NPV-based models such as discounted cash flow, discounted earnings, earnings multiple, and EVA. The assumptions and mathematical formulation of such models are equivalent to NPV. Real option techniques are also part of the SCBM. Abel, Dixit, Eberly and Pindyck (1996) show that real options techniques are a special case of NPV if a decision-maker accounts for future marginal returns to capital at the future optimal levels of the capital stock. Moreover, the decision-making process of real options is as financially mechanical as other SCBM methods (Adner and Levinthal, 2004), in that the value of underlying investment opportunities follows some exogenous process and a decisionmaker exercises the real option (i.e., investment) when the underlying value reaches some critical value. If the firm can accurately estimate the cash flows and investment costs that a given project will generate and if there is broad agreement about organizational goals among decision-makers within the firm, then the standard capital budgeting method that maximizes net present value is often optimal. Here, decision-makers can estimate cash flows in terms of probability distribution parameters (i.e., Knightian uncertainty is low, as we discuss below). Moreover, when decision-makers have substantial agreement about organizational goals (i.e., controversy is low, as we discuss below), then it is straightforward to generate a list of options and compare the values generated by SCBM methods. In such conditions, the SCBM is an effective and efficient method of making capital budgeting decisions. These are strong assumptions, however, concerning low Knightian uncertainty and limited controversy. Without these assumptions, capital budgeting choices become more complicated. We focus on how Knightian uncertainty and controversy affect capital budgeting decisions because they are key How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 6 elements in discussions of organizational decision-making processes that draw on the behavioral theory of the firm (Cyert and March, 1963). Bower (1970: 314) also highlights these factors, noting that, “At least two kinds of problems exist” in attempting to undertake financial approaches to capital budgeting, including both uncertainty and what Bower refers to as controversialism (i.e., controversy, in our terms). First consider Knightian uncertainty. Knightian uncertainty arises when cash flow estimates are difficult to estimate with any degree of predictability (Knight, 1921; Nelson and Winter, 1982), so that estimates become qualitative rather than quantitative. Financially-oriented budgeting methods tend to break down as Knightian uncertainty increases. Indeed, the SCBM is not useable at high levels of uncertainty, because standard capital budgeting methods require predictable cash flow estimates to evaluate a project. Hence, as Knightian uncertainty increases, firms will become more likely to deviate from the SCBM in favor of alternative capital budgeting approaches, as we discuss below. Now, consider issues that arise when there is substantial controversy within a firm about key goals for a firm and, in turn, which projects to assess and undertake. Controversy arises when decisionmakers within a firm have differing goals and/or different beliefs about states of the world (Cyert and March, 1963; Bower, 1970). For instance, some members might want to focus on short-term stockholder equity, while others might want to consider externalities that a firm imposes on society with its environmental emissions. Even if the assumptions underlying these goals can be quantified, controversy about the competing goals will tend to interfere with use of the SCBM. Suppose there are three projects A, B, and C. Some subgroups may perceive project A as most attractive based on an NPV calculation. Some subgroups may perceive project B as better using different assumptions about NPV. Other subgroups may perceive project C as attractive using qualitative indexes such as project scorecards. Initially, at least, the primary point of agreement among the subgroups will be that they disagree (Aumann 1976). Instead of attempting to select a project through methodological debates that may never end, the firm will often be better served by a decision-making and implementation process that builds compromise. The logic here suggests that the SCBM will be most common in conditions of low Knightian uncertainty and low controversy. The first proposition states this point. How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 7 Proposition 1: The lower the Knightian uncertainty and controversy for a given project, the more likely a firm will adopt the standard capital budgeting model for that project. The logic so far suggests that firms will deviate from the SCBM to assess projects as Knightian uncertainty and controversy increase, without stating what capital budgeting methods they will turn to. The next subsections derive propositions that assess how different combinations of Knightian uncertainty and controversy influence the choice of alternative capital budgeting methods. This discussion outlines three approaches to capital budgeting in addition to the SCBM, which we label the plausibility, negotiation, and socio-political approaches. Together, the four approaches make up the more general OCBM. The alternatives within the OCBM tend to be categorical sets of organizational processes, rather than incremental deviations from the SCBM. The flow of our argument arises from the following logic. The SCBM is a natural benchmark because of its prevalent prescription and use. The SCBM often allows decision-makers to choose projects that maximize perceived value with the greatest net accuracy relative to more qualitative capital budgeting approaches, thereby addressing two of the four considerations of the OCBM (perceived value and net accuracy). Nevertheless, the SCBM does not consider Knightian uncertainty and controversy, which are the other two important considerations of the OCBM. By varying Knightian uncertainty and controversy from the benchmark of the SCBM, we obtain the plausibility, negotiation, and socio-political approaches to capital budgeting. Plausibility Approach: High Knightian Uncertainty and Low Controversy Consider the case when controversy remains low, but Knightian uncertainty increases. In such cases, we propose that, rather than standard quantitative financial methods, valuation becomes increasingly more likely to adopt methodologies of environmental scanning, scenario planning, goal setting, and related techniques, which we label the “plausibility approach”. This term reflects the idea that firms can develop alternative scenarios, often based on qualitative assessments, and then compare the scenarios in terms of their plausibility. Many scholars, especially within the BTF, argue that organizations both attempt to avoid uncertainties and engage in activities that help reduce uncertainties. Cyert and March (1963) propose the How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 8 assumption of uncertainty avoidance. Schmeidler (1989), Boudreaux and Holcombe (1989), and Gilboa and Schmeidler (1989) discuss how firms seek to avoid Knightian uncertainty, even under risk neutrality. To mathematical economists such as Gilboa and Schmeidler, Knightian uncertainty denotes the situation in which a decision-maker does not know which probability distribution is appropriate to describe states of the world. Spender (1989) argues that uncertainty reduction is the essence of the cognitive model of entrepreneurship, such that managers deal with uncertainties with industry recipes, which are the body of shared knowledge about an industry. At a high level, the BTF argues that organizations conduct problemistic search in order to deal with uncertainty. In the context of capital budgeting, this means that a firm may not simply apply standard valuation models to exogenous investment opportunities, but instead will construct investment opportunities through a search process. As a result, the search for potential projects and choice of actual projects tends to converge, meaning that the activities of constructing and evaluating investment opportunities become inseparable. In practice, this means that the firm begins by establishing the limits of desirable projects. Because the resources of the firm are limited, the first task is to propose which resources will be devoted to a project. The availability of resources is then used to identify reasonable projects, screen out those which are not feasible, and create new possible projects. Scenario planning is a common tool in this search process, in which building scenarios helps the firm assess what might happen under different combinations of future states of the world (Schwartz, 1991; van der Heijden, 1996). The logic of scenario planning is to map the possibilities of what might happen without assigning specific probability distributions to possible events. Scenario planning arises in situations such as preparing for oil shocks, investigating national security, setting political agendas, planning for long horizons, assessing potential market transformation, and studying breakthrough technologies. Scenarios incorporate market forecasts and internal firm modifications to outline the major parameters of a project with a bias on the short run. When this analysis is complete, the firm has developed a plausible choice set of projects (Godet, 2001). Choice criteria include assessments about which projects provide the greatest potential for success, which provide the greatest flexibility in adapting as uncertainties are resolved, and/or which projects offer the greatest potential for the firm to manage the How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 9 factors that generate uncertainties rather than take uncertainty as given (Schwartz, 1991). Hence, the firm has developed an alternative approach to manage or limit its exposure to uncertainty and identify a plausible future that will be acceptable to the decision-makers. The plausibility approach also encompasses qualitative environmental scanning systems that firms use to assess market conditions (e.g., the Five Forces model of industry analysis (Porter, 1980)) and internal capabilities analyses that consider how an organization might adapt to address threats and respond to opportunities. Such scanning processes serve to generate goals and potential projects as the basis of discussion and additional analysis (Cyert and March, 1963). As with scenario planning tools, goals and projects tend to be emergent outcomes of scanning processes, rather than ex ante inputs. If the plausibility approach leads to sufficient quantification of market forecasts, necessary internal changes, and reasonable understanding of what might happen under the various scenarios, then the approach can also include tools that are similar to the SCBM. A fundamental difference, however, is that the financial tools of the SCBM are not the starting point of the processes underlying the plausibility approach. Instead, the financial tools provide an ex post test of a project’s plausibility. The logic here suggests that the plausibility approach helps a firm avoid and manage uncertainty, rather than begin by analyzing uncertain projects in order to make a choice. Proposition 2: The greater the Knightian uncertainty for a given project, while controversy remains low, the more likely a firm will adopt the plausibility approach to capital budgeting for that project. Negotiation Approach: Low Knightian Uncertainty and High Controversy Now consider the case when Knightian uncertainty is low and controversy is high, where valuation again tends to deviate from SCBM. We propose that the core of valuation methodology now becomes an exercise in controversy reduction, which we call the “negotiation approach.” This label highlights the point that capital budgeting choices in this context typically involve intense negotiations within the firm about which projects to assess and select. Controversy conceptualizes goal conflict that arises among subgroups in organizations and society. Discussion of how controversy affects decision-making dates back centuries, at least to Hobbes’s (1651) discussion of difficulties in creating and maintaining social contracts, a point that more recent How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 10 work by Rawls (1971) reinforces, as do historical discussions of dispute and struggle by Aristotle (ethical treaties), Hegel (master-slave dialectic), and those influenced by them. More recent institutional economics highlights the need for organizational processes that align interests between principals and agents (Holmstrom and Tirole, 1989; Jensen and Meckling, 1976), as well as deal with opportunism and information asymmetry (Coase, 1946; Akerlof, 1970; Williamson, 1975). The core point here is that controversy among coalitions results in behaviors such as opportunism, information hoarding, principalagency conflicts, conflict of interest, communication barriers, and political issues that organizations must resolve in order to make decisions. Such resolution typically requires negotiation among coalitions. Controversy is a central element of Cyert and March’s (1963) behavioral theory of the firm. The BTF views the organization as coalitions of individuals with complex interests. Controversy among coalitions generates the need for bargaining and negotiations to make decisions. In turn, the BTF proposes that the coalitions generate organizational goals through the resolution of controversy. Thus, specific organizational goals tend to emerge from the dynamics of underlying controversy. Influenced by the BTF, many scholars have reinforced the difficulties that firms face in dealing with controversy. Nelson and Winter (1982) argue that existing routines need to equilibrate intra-organizational conflict, for instance, while Bower (1970) found that top executives’ choices of projects reflected assessments of what he referred to as controversalism. Controversy in capital budgeting is the natural extension of such a coalition view of organizations. In the context of capital budgeting, when the controversy is high in a firm, then there is conflict about goals for projects. For instance, one group might want to maximize growth and another group to maximize cash flow in the short term – a given project might be acceptable for growth, but not for shortterm cash-flow maximization. One approach for resolving controversy is to develop a “coalition-neutral” goal function and then apply it to all projects, but such opportunities are uncommon because the presence of controversy interferes with the process and definition of the goal function. Instead, firm members typically develop and advance goals through the analysis and consideration of actual decisions for given alternative projects. Hence, the firm’s project goals tend to be emergent, rather than being given as initial states. In capital budgeting, therefore, the OCBM needs to incorporate controversy in the goal function of How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 11 an organization in order to build a model of how an organization chooses capital-budgeting methods. Firms will tend to resolve controversy about capital budgeting goals in what we call a negotiation approach. Various negotiation mechanisms are possible, such as voting, bargaining to enlarge the opportunity set as one group wins one issue in exchange for winning on a different issue, consensusbuilding meetings, and top-down resolution by the CEO. In the end, the firm needs to come to some decision that permits it to move ahead. Jacobides and Croson (2001), Gulati, Lawrence, and Puranam (2005), Kretschmer and Puranam (2008), and Kaplan (2008) discuss organizational processes related to communication, coordination, and contests that firms use in order to resolve controversial states. As in the plausibility approach, SCBM calculations can be part of this process by helping to identify baselines, but the financial analyses themselves will not resolve goal conflict among the coalitions. It is important to recognize that controversy can create benefits by generating diversity, creativity, and novelty of opinion. For instance, Bartlett and Ghoshal (1993) find that the ASEA Brown Boveri Corporation deliberately created internal controversy to introduce discipline and refinement in decisionmaking. Capron and Mitchell (2009) find that the controversies in organizations can both improve effectiveness in creating capabilities and improve the likelihood of survival. Laux (2008) proposes that influencing activities provide the incentive to acquire and reveal costly information. Hence, controversy can lead to the ability to generate novel projects for assessment, whereas the SCBM largely takes the set of projects to be analyzed as a given. Nonetheless, even though controversy may help generate information, it needs to be resolved in decision-making. Eisenhardt (1989a) argues that the resolution of controversy can enhance performance, but controversy, per se, may not. Maritan (2001) finds that firms benefit from a degree of organizational politics in capital budgeting but, again, must resolve the political disagreements. Lind and Tyler (1988) argue that participation in decision-making processes generates the perception of procedural fairness and enhances performance, especially under controversy. Stakeholder theory also relates controversy with capital budgeting. If we characterize a firm with explicit contracting only, the maximization of shareholder value through NPV is consistent with the maximization of the economic value a firm creates. However, if a firm contains a bundle of implicit How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 12 contracts, it is important to balance the interests of relevant stakeholders because shareholders are no longer the only residual claimants. In this case, instead of relying on NPV that may maximize shareholder values at best, decision-makers need to ensure effective negotiation processes as well as stakeholder access to the negotiation processes in order to maximize economic value. This view is in line with incomplete contracting approaches (Aghion and Bolton, 1992; Baker, Gibbons and Murphy, 2001, 2002; Hart and Moore, 1990) and transaction cost economics (Williamson, 1975, 1979, 1985, 1996). For reviews, see Asher, Mahoney, and Mahoney (2005) and Mahoney (2009). The next proposition addresses the relationship between controversy and capital budgeting. Proposition 3: The greater the controversy for a given project, while uncertainty remains low, the more likely a firm will adopt the negotiation approach to capital budgeting for that project. Socio-political Approach: High Knightian Uncertainty and High Controversy Now consider the issues that emerge as both Knightian uncertainty and controversy increase. In such cases, project valuation becomes increasingly likely to resemble the strategy formulation processes that Bower (1970) found in his case studies of socio-political resource allocation processes in multidivisional firms. Bower described a bottom-up process by which business-level managers initiated and defined investment requests, and middle-level managers integrated the behaviors at business levels, while corporate management designed the structural contexts (rules of the game) to support the projects in line with the strategic direction. He found that capital budgeting behavior frequently reflected sociopolitical processes, as the following quotation highlights. The processes by which resources are committed in turn involve (1) intellectual activities of perception, analysis, and choice which are often subsumed under the rubric ‘decision making’; (2) the social process of implementing formulated policies by means of organizational structure, systems of measurement and allocation, and systems for reward and punishment, and finally (3) the dynamic process of revising policy as changes in organizational resources and environment change the context of the original policy problem. (Bower, 1970: 7-8) In later work, Bower and co-authors (e.g., Eisenmann and Bower, 2000) argue that the qualitative processes of setting goals flow down from senior management as well as up from middle management. In either case – whether cascading up or cascading down – the processes emphasize qualitative approaches to generating goals and objectives. Following Bower, we refer to this set of processes as the “socioHow Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 13 political approach” to capital budgeting. This label reflects the intense political interactions among subcoalitions at multiple levels of an organization that take place in identifying potential projects and allocating resources. When both Knightian uncertainty and controversy are high, the SCBM is unworkable, because it is not possible to quantify cash flow accurately and the concerns of the firm members are too complicated. As with the plausibility approach, one step in beginning capital budgeting activities in such a setting is to establish parameters for the scope of the projects. Faced with high uncertainty, decision-makers need to determine whether potential projects fit within the firm and its resources and capabilities, and whether the firm would be able to implement the projects. Again, scenario planning including marketing forecasts, management cost studies, and cash flow estimates tend to narrow the range of possibilities and help reach a consensus on what is feasible. Because of the high controversy about goals, however, this process will require intense negotiation. Disagreements about goals mean that the roughly quantified studies that arise in the face of high uncertainty will require substantial compromises about assumptions in their development. Decisionmakers will commonly disagree about data themselves, and will require negotiation in both development and interpretation of the data for the analyses. Goals tend to be emergent when uncertainty and controversy are high. Coalitions can develop along various dimensions – for instance, marketing members may stick together, new product advocates see the world and possibilities in a different light, and the finance group may focus on the stock price. The possible coalitions are vast and shifting in the process of considering the set of projects. As in the negotiation and plausibility approaches, the analytical tools of the SCBM can be part of the socio-political approach, but in a different manner than in the SCBM cell of the OCBM. Rather than offering an unbiased analytical technique, the financial tools become embedded in the negotiation process, used to convince others and build a consensus. Simply put, decision-makers bring forth the tools of the SCBM when the analysis supports a coalition position – not to develop that position. In brief, the socio-political approach to capital budgeting includes activities from both the plausibility and negotiation approaches. Yet, this is not simply a two-step sequence of applying How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 14 plausibility tools and then negotiating, or vice versa. Instead, the processes tend to be interwoven and applied simultaneously, such that goals emerge jointly with the development of the feasibility calculations and scenario planning. Thus, the process has open issues that must come together in order to arrive at capital budgeting decisions – this is a political process at its core. The final proposition summarizes the logic of the Bower model. Proposition 4: The greater the combined presence of Knightian uncertainty and controversy for a given project, the more likely a firm will adopt the socio-political approach to capital budgeting for that project. We note that the OCBM includes Bower’s socio-political model as a special case, reflecting a particular combination of uncertainty and controversy. Moreover, while Bower (1970:12) argued that “the theory [underlying traditional capital budgeting] is false on theoretical grounds because it ignores the essential effects of uncertainty”, the OCBM also incorporates the SCBM as a special case, again with a particular combination of uncertainty and controversy. To date, no research has investigated how the Bower model changes as social factors change (i.e., as uncertainty and/or controversy decline) and, in turn, how to reconcile Bower and the SCBM. The OCBM encompasses both the SCBM and Bower model, while defining the negotiation and plausibility approaches as additional means of capital budgeting that reflect different combinations of uncertainty and controversy.