Read a 16 pages article and anwser 7 questions, each question should have one to two paragraph, each anwser should not be longer than a page
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-