__ March 2014
- What the Paper is about
The paper is about John R. Graham and Campbell R. Harvey‘s analysis of their survey regarding the current practices of corporate finance. It looks into three main aspects: capital budgeting, cost of capital and capital structure :
The objectives of the research study are: (a) to serve as basis for development of new corporate finance theories, or to modify/nullify existing ones; and (b) for practitioners to learn from the findings, especially from cases where academic theories were not applied completely.
It is differentiated from earlier surveys conducted in terms of: (a) depth and breadth of scope; (b) huge sample size covering 4,440 firms; 392 CFOs with 9% response rate- large enough to conclude that it represents the population; and (c) analysis of responses relative to respective firm’s conditions, which gives balance of qualitative and quantitative interpretation of results.
- The Survey Methodology
Design. The survey questionnaires focus on three areas: capital budgeting, cost of capital and capital structure. Academicians and research experts were consulted in developing the survey questionnaires. The final version of the survey questionnaires had 15 questions and subparts- covering a total of 100 questions. The actual survey was done jointly with Financial Executives Institute (FEI) to leverage on its 14,000 members who hold critical positions in 8,000 companies in both USA and Canada.
Delivery and Responses. In cooperation with FEI, a total of 4,400 questionnaires were sent out twice to Chief Financial Officers (CFOs) by mail and fax to ensure high response rate. Of these, 392 came back, which is equivalent to a 9% response rate.
Sample Characteristics. Companies covered include small (<$100m in sales) and large size (>$1B sales). In terms of sector representation: 40% are from manufacturing sector and the rest from various industries i.e., financial, retail, high-tech, etc. Sampled companies were also classified into growth (>15 P/E ratio) and non-growth, by debt levels (>30% is considered highly levered), by credit ratings, and with reference to the characteristics of their Chief Executive Officers (CEOs). Sample firms also represent those considering issuing equity (36%), convertible debt (20%) and debt in foreign markets (31%), as well as companies with publicly traded stocks, dividend-paying, and from regulated sectors. The broad and diverse samples lead the researchers to conclude that their survey represents the population and allows qualitative explanation of corporate practices in the field.
- The Results
- Capital Budgeting. This aspect of the survey examines how firms assess capital projects.
The study showed that about 75% of the respondents use Net Present Values (NPVs) and internal rate of return (IRR). More likely to apply NPV and IRRs are large firms, public ones, those who pay dividends, and with CEOs who have MBA. Meanwhile, highly levered and regulated firms employ sensitivity and simulations analysis more.
On the other hand, small firms, those with CEOs who are mature or of long tenure, have no MBA are more likely to use payback criterion, despite the criticisms on this methodology. They also hardly use advance simulation techniques in their project evaluation.
- Cost of Capital. This portion of the survey aims to determine how firms estimate their cost of capital i.e., whether through: capital asset pricing model (CAPM), multibeta CAPM, average historical returns or dividend discount model.
The findings show that smaller firms use cost of capital based on investors’ expectation. Meanwhile, large firms or those with significant foreign sales are more likely to use CAPM. Firms with low leverage and small management ownership are likewise likely to apply CAPM, as well as those with CEOs who have MBAs, which further considers risk factor analysis.
In terms of risk considerations the research highlights that for large firms, the critical risk factors are: foreign exchange risks, business cycle risks, commodity prices risk, and interest rate risks. On the other hand, small firms are more concerned with interest rate risk, while growth firms are more prone to foreign exchange risk than non-growth firms.
On the question whether firms generally use company-wide or project-specific risk, the study showed that about 59% prefer company-wide risk, more particularly for the growth firms.
- Capital Structure. This section tests the popular finance theories on debt and equity.
In general, the survey revealed moderate evidence for pecking order theories of capital structure. When issuing debt or equity, the foremost concerns are: EPS dilutions, credit rating, maturity matching, stock price fluctuations, hedging for foreign debts, and cash management. These are highlighted in the following examination of corporate practices of popular finance theories:
- Target Debt Ratios. This section of the survey tests the theory whether firms have target debt ratios.
The study showed that large, regulated and dividend-paying companies with potentially high corporate taxes put more weight on the tax advantage of debt when they consider using debt. About 37% of them have flexible debt ratio, 34% have relatively tight range, and only 10% have strict target debt ratio (usually investment grade companies). Large companies are more likely to have target ratios than small firms. It is also more significant for companies with CEOs who have short tenure or when top officers have less than 5% ownership of the firm. It is also noted that firms may issue equity to maintain target debt-equity ratio.
- Pecking-order model of financing hierarchy. This part examines this theory which assumes firms have no target debt ratios, but rather secures external financing when internally generated funds are not enough.
The research revealed that when issuing debt, firms are more concerned about maintaining financial flexibility and credit rating. On the other hand, when issuing equity, firms are more concerned on earnings per share dilution and recent stock price appreciation. While there is significant support for pecking order and trade-off capital structure, there is little proof for concern on asset substitution, asymmetric information, transaction costs, free cash flows or personal taxes.
- Agency costs.
- Underinvestment (Myers, 1977). Related to the issue of conflict between bondholders and equity holders, the survey asks respondents “if their choice between short- and long-term debt , or overall debt policy is related to their desire to pay long-term profits to shareholders, not debtholders. Results show that there is no proof for the above “Underinvestment” argument, which is contradicts past research studies.
- Asset Substitution. This theory rationalizes why stockholders prefer high-risk projects, which run counter against debtholders’ preference. Similarly the survey results do not provide support for this theory’s practice.
- Conflicts between managers and stockholders (Jensen, 1986). This theory suggests that when there is excess cash flow, managers then to make misuse cash or make inefficient investment decisions. To test this, the survey asks if short-term debt is used to discipline managers in the use of cashflow. As above, there was no support to this theory in practice.
- Product market and industry factors. As highlighted in the survey results, target debt ratio may vary from firm to firm and over time as may be influenced by the firm’s stock’s price. Contrary however to what the outcome of other studies suggests, that a firm’s debt-ratio can be the industry-wide ratio, this study revealed that product and market factors have little to do with this fact. Likewise, the surveyed firms’ equity policy is not influenced by industry players.
- Capital structure. Results show that firms issue foreign debts to serve as a hedge against foreign currency fluctuations. Firms may also choose long or short-term debts to match their asset life.
- Cash management considerations. This posits that liquidity and cash management impacts corporate financial decision. The survey showed that highly levered, investment grade or manufacturing firms tend to secure debt as buffer during difficult times. A number of firms borrow an amount that they can afford to repay. The duration may also depend on their needs.
- Other factors:
- Debt. Survey showed debt do not provide significant bargaining tool. Many firms secure debt to minimize their weighted average cost of capital (WACC). Others borrow for growth, while some noted that bond or bank covenants impact their debt policy.
- Common stock. The survey tests whether earnings dilution matter in equity issuance (Brealey and Myers, 1996). Results showed that a significant number of respondents find this a very important consideration. It is stronger among large and dividend-paying companies, but less so for companies with CEO who has an MBA The notion that issuance of stock is the cheapest source of capital and less risky is more popular among start-up companies, than the large ones.
- The Conclusion
The researchers repeatedly mentioned that the study’s results are both “reassuring and puzzling”. This is because while many practices support finance theories on capital budgeting and cost of capital, such as NPV and CAPM, there were inconsistencies in application when probed deeper i.e., in terms of using company-wide risk or project-specific hurdle rates. Respondents were also noted to less likely follow the principles of capital structure, which was suggested as an area for further studies.