151graham 8 STERN STEWART JOURNAL OF APPLIED CORPORATE FINANCE HOW DO CFOS MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS? by John Graham and Campbell Harvey, Duke University* e recently...

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151graham 8 STERN STEWART JOURNAL OF APPLIED CORPORATE FINANCE HOW DO CFOS MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS? by John Graham and Campbell Harvey, Duke University* e recently conducted a comprehensive survey that analyzed the current practice of corporate finance, with particular focus on the areas of capital budgeting and capital structure. The survey results enabled us to identify aspects of corporate practice that are *This paper is a compressed version of our paper that was first published as “The Theory and Practice of Corporate Finance: Evidence from the Field” in the Journal of Financial Economics, Vol. 60 (2001), and which won the Jensen prize for the best JFE paper in corporate finance in 2001. This research is partially sponsored by the Financial Executives International (FEI) but the opinions expressed herein do not necessarily represent the views of FEI. We thank the FEI executives who responded to the survey. Graham acknowledges financial support from the Alfred P. Sloan Research Foundation. 1. In the original JFE version of this paper, we show that our sample of respondents is representative of the overall population of 4,400 firms, is fairly representative of Compustat firms, and is not adversely affected by nonresponse bias. The next largest survey that we know of studies 298 large firms and is presented in J. Moore and A. Reichert, “An Analysis of the Financial Management Techniques Currently Employed by Large U.S. Corporations,” Journal of Business Finance and Accounting, Vol. 10 (1983), pp. 623-645. consistent with finance theory, as well as aspects that are hard to reconcile with what we teach in our business schools today. In presenting these results, we hope that some practitioners will find it worthwhile to observe how other companies operate and perhaps modify their own practices. It may also be useful for finance academics to consider differences between theory and practice as a reason to revisit the theory. We solicited responses from approximately 4,440 companies and received 392 completed surveys, representing a wide variety of firms and industries.1 The survey contained nearly 100 questions and explored both capital budgeting and capital structure decisions in depth. The responses to these questions enabled us to explore whether and how these corporate policies are interrelated. For example, we investigated whether companies that made more aggressive use of debt financing also tended to use more sophisticated capital budgeting techniques, perhaps because of their greater need for discipline and precision in the corporate investment process. More generally, the design of our survey allowed for a richer under- standing of corporate decision-making by analyzing the CFOs’ responses in the context of various company characteristics, such as size, P/E ratio, leverage, credit rating, dividend policy, and industry. We also looked for systematic relationships between corporate financial choices and manage- rial factors, such as the extent of top management’s stock ownership, and the age, tenure, and education of the CEO. By testing whether the responses W 9 VOLUME 15 NUMBER 1 SPRING 2002 varied systematically with these characteristics, we were able to shed light on the implications of various corporate finance theories that focus on variables such as a company’s size, risk, invest- ment opportunities, and managerial incentives. The results of our survey were reassuring in some respects and surprising in others. With respect to capital budgeting, most companies follow aca- demic theory and use discounted cash flow (DCF) and net present value (NPV) techniques to evaluate new projects. But when it comes to making capital structure decisions, corporations appear to pay less attention to finance theory and rely instead on practical, informal rules of thumb. According to our survey, the main objective of CFOs in setting debt policy was not to minimize the firm’s weighted average cost of capital, but rather to preserve “finan- cial flexibility”—a goal that tended to be associated with maintaining a targeted credit rating. And con- sistent with the emphasis on flexibility, most CFOs also expressed considerable reluctance to issue common equity unless their stock prices were at “high” levels, mainly because of their concern about dilution of EPS. (As we shall argue later, although such reluctance to issue equity is likely to be consistent with finance theory’s emphasis on the costs associated with “information asymmetry,” the extent of CFOs’ preoccupation with EPS effects seems to contradict the theory.) The survey also provided clear evidence that firm size significantly affects the practice of corporate finance. For example, large companies were much more likely to use net present value techniques, while small firms tended to rely on the payback criterion. And, providing some encouragement to proponents of academics’ trade-off model of capital structure (discussed in more detail later), a majority of large companies said they had “strict” or “some- what strict” target debt ratios, whereas only a third of small firms claimed to have such targets. In the next section, we briefly discuss the design of the survey and our sampling techniques (with more details provided in the Appendix). Then we review our findings, first on capital budgeting policy and next on capital structure decisions. SURVEY TECHNIQUES AND SAMPLE CHARACTERISTICS Perhaps the most important part of survey research is designing a survey instrument that asks clear and pertinent questions. We took several steps to achieve this end. After spending months develop- ing a draft survey, we circulated the draft to a group of academics and practitioners and incorporated their suggestions into a revised version. Then, after getting the advice of marketing research experts on both the survey’s design and execution, we made changes to the format of the questions and to the overall design in order to minimize biases induced by the questionnaire and maximize the response rate. The final survey was three pages long and took approximately 15 minutes to complete. We mailed the survey to the CFOs of all (1998) Fortune 500 companies and also faxed surveys to 4,440 firms with officers who are members of the Financial Executives Institute (313 of the Fortune 500 CFOs are also FEI members).2 The 392 returned surveys represented a response rate of nearly 9%. Given the length and scope of our survey, this response rate compared favorably to the response rate for other recent academic surveys.3 We received responses from CFOs representing a wide variety of companies, ranging from very small (26% of the sample firms had sales of less than $100 million) to very large (42% had sales of at least $1 billion). Forty percent of the firms were manufacturers, and the remaining firms were evenly spread across other industries, including financial (15%), transportation and energy (13%), retail and wholesale sales (11%), and high-tech (9%). Sixty percent of the respondents had price-earnings ratios of 15 or greater (a group we refer to later as “growth firms” when we analyze the effect of investment opportunities on corporate behavior). The distribution of debt levels was fairly uni- form. Approximately one-third of the sample com- panies had debt-to-asset ratios (expressed in book values) below 20%, another third had debt ratios between 20% and 40%, and the remaining firms had debt ratios greater than 40. We refer to companies with debt ratios greater than 30% as “highly levered.” 2. FEI has approximately 14,000 members that hold policy-making positions as CFOs, treasurers, and controllers at 8,000 companies throughout the U.S. and Canada. Every quarter, Duke University and FEI poll these financial officers with a one-page survey on important topical issues. See http://www.duke.edu/ ~jgraham under “FEI Survey.” The usual response rate for the quarterly survey is 8-10%. 3. See, for example, E. Trahan and L. Gitman, “Bridging the Theory-Practice Gap in Corporate Finance: A Survey of Chief Financial Officers,” Quarterly Review of Economics and Finance, Vol. 35 (1995), pp. 73-87; the authors obtained a 12% response rate in a survey mailed to 700 CFOs. The response rate also compared favorably to the response rate for the quarterly FEI-Duke survey, which usually runs around 8-10%. 10 JOURNAL OF APPLIED CORPORATE FINANCE The creditworthiness of the sample also showed broad variation. Twenty percent of the companies had credit ratings of AA or AAA, 32% had an A rating, and 27% were rated BBB. The remaining 21% had speculative debt with ratings of BB or lower. Though our survey respondents were CFOs, we asked a number of questions about the characteristics of the chief executive officers. We assumed that CEOs are the ultimate decision-makers and that CFOs act as agents for the CEOs. Nearly half of the CEOs for the responding firms were between 50 and 59 years old. Another 23% were over age 59, and 28% were between the ages of 40 and 49. The survey revealed that executives change jobs frequently. Nearly 40% of the CEOs had been in their jobs less than four years, and another 26% had been in their jobs between four and nine years. We defined the 34% who had been in their jobs more than nine years as having “long tenure.” Forty-one percent of the CEOs had an undergraduate degree as their highest level of education. Another 38% had MBAs and 8% had non-MBA masters degrees; 13% had gone beyond the masters level. Finally, the top three executives owned at least 5% of the common stock in 44% of the companies. These CEO and firm characteristics allowed us to examine whether managerial incentives or en- trenchment affected the survey responses. We also studied whether having an MBA affected the choices made by corporate executives. All in all, the variation in executive and company characteristics permitted a rich description of the practice of corporate finance, and allowed us to make a number of inferences about the extent to which corporate actions are consistent with academic theories. Our survey differed from previous work in several ways. The most obvious difference is that previous work has almost exclusively focused on the largest firms. Second, because our sample is larger than previous surveys, we were able to control for many different firm characteristics. As with all survey research, however, it’s important to keep in mind that survey results represent CFO beliefs or opinions. We have no way of verifying that such beliefs account for (or are even consistent with) their actions. What’s more, in some cases, corporate executives might be influ- enced by a theory without knowing it. In this sense, as Keynes once wrote, “practical men...are usually the slaves of some defunct economist.” CAPITAL BUDGETING DECISIONS It is a major tenet of modern finance theory that the value of an asset (or an entire company) equals the discounted present value of its expected future cash flows. Hence, companies contemplating invest- ments in capital projects should use the net present value rule : that is, take the project if the NPV is positive (or zero); reject if NPV is negative. But if NPV has been the dominant method taught in business schools, past surveys have sug-
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An influential paper titled “How Do CFOs Make Capital Budgeting and Capital Structure Decisions?” by two finance professors from Duke have surveyed company CFOs on how they make capital budgeting and capital structure decisions. The paper have been studied and then the following answers have been provided.
1. As we already know, managers rely primarily on IRR and NPV when deciding on a new project. However, in Figure 1, the “hurdle rate” appears to be the third most common decision rule. Can you explain what the hurdle rate is
in one paragraph?
Ans: While deciding whether to take a new project or not, the CFOs use mostly IRR and NPV. The third most common rule which is being applied is hurdle rate. It refers to the minimum rate of return that is required by managers and the investors while investing in a project. This rate helps to understand the compensation that will be received against the risks which are being undertaken. Hurdle rate is decided based on various factors including cost of capital, associated risks and the returns from the similar projects and investments (Leitner, Stephan and Behrens 2015). Generally riskier the project, higher is the hurdle rate and vice versa. The rate of return from the new project or investment in which the company is planning to invest should be higher than the hurdle rate, then only the situation will be sound and the investment will be worth. If the investor notices that the rate of return is much lower than the hurdle rate, then he should not proceed with the investment.
This rate can be considered to be the break-even point and often weighted average cost of capital is used as the hurdle rate. But more appropriate hurdle rate is when the risk premium is added to the weighted average cost of capital (Nangia et al. 2011). Risk premium is assigned to each of the investment to check the amount of risk that is involved with the investment. Higher the risk, higher will be the risk premium, it states that if the risk of losing the money is high then the return from the investment should also be high. When hurdle rate is applied while choosing a project, then there can be no biasness towards any project since it is important to understand the financial merit of the attached intrinsic value. But there is also one disadvantage of using the hurdle rate in determining a project and that is it only considers the rate of return and totally ignores the dollar value that is even if the dollar value is very small, the project is accepted just because the rate of return is high. This can be explained with the example that Project A has a value of $10 and the rate of return is 30% whereas Project B has a value of $100 and the rate of return is 10%, using the hurdle rate only project A will be selected due to higher rate of return, but overall return of project B is higher.
2. Similarly, CFOs rely on “Real Options” in 27% of the decisions. Again, summarize this approach in a paragraph.
Ans: In 27% of the scenarios, it has been found that CFOs rely on real option to decide whether to take up on a project or not. Real options are the economically valuable right which is used to decide whether a project should be accepted or abandoned. The term real has been used since it is mostly applied on tangible assets like land, building, plan, machinery, inventory, etc and not on financial instruments like call and put options contracts, which gives the right to the holder to buy or sell an underlying asset. This way it is very different from option contracts since those are applied on exchangeable as securities and not on physical assets. Real options are actually the choices which are being given by the management of the company to itself in order to change, expand as well as curtail projects based on the changing market conditions including technology, social, economic, political, etc (Baker et al. 2010). Other commonly used valuation techniques used on the projects like IRR, NPV, hurdle rate ignores the potential benefit from the project or investment which is being considered by real option. But factoring in real options affects the valuation of potential investments.
The opportunity cost of continuing or discontinuing with the project can be well understood using this option so that better decision making can be done. Real options are actually the opportunities of which the business may or may not take advantage of or realize. This can be explained with an example, when a company has to invest in a new facility or make an merger and acquisition, it considers the real options available from that new facility or merger and acquisition in terms of consolidating operations, venturing into new market, launching new products and several adjustments in terms of the changing market conditions and after analysing all the available real options, it depends on the company if it wants to make the investment. But there can be issues being faced at the time of estimating the real options (Lambrecht 2017). So, the potential for real option value is being factored by the management in spite of the fact that the value might be uncertain and vague. Even though real option is different from financial options contracts yet the valuation technique is almost similar under both the techniques that is the spot price or the current market price is being used.
3. The survey Figure 2 shows that a lot of CFOs value financial flexibility when issuing debt. What do they mean by financial flexibility? How is financial flexibility important for the company?
Ans: Financial flexibility refers to the ability of the company to react to expenses and...
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