A very interesting paper on practise of corporate finance by companies of different sizes, industries, capital structure, and management profile
Excerpts
Capital Budgeting:We find that CEOs with MBAs are more likely than non-MBA CEOs to use net present value - but the difference is only significant at the 10% level.
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Firms that pay dividends are significantly more likely to use NPV and IRR than are firms that do not pay dividends. This result is also robust to our analysis by size. Public companies are significantly more likely to use NPV and IRR than are private corporations.
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Our finding that payback is used by older, longer tenure CEOs without MBAs instead suggests that lack of sophistication is a driving factor behind the popularity of the payback criterion.
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The influence of leverage on the earnings multiple approach is also robust across size (i.e., highly levered firms, whether they are large or small, frequently use earnings multiples).
Cost of CapitalCAPM is by far the most popular method of estimating the cost of equity capital: 73.5% of respondents always or almost always use the CAPM....The second and third most popular methods are average stock returns and a multibeta CAPM, respectively.
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Large firms are much more likely to use the CAPM than are smaller firms ... Smaller firms are more inclined to use a cost of equity capital that is determined by "what investors tell us they require." CEOs with MBAs are more likely to use the single factor CAPM or CAPM with extra risk factors than are non-MBA CEOs; but the difference is only significant for the singlefactor CAPM.
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Overall, the most important additional risk factors are: interest rate risk, exchange rate risk,business cycle risk, and inflation risk. For the calculation of discount rates, the most important factors are interest rate risk, size, inflation risk, and foreign exchange rate risk. For the calculation of cash flows, many firms incorporate the effects of commodity prices, GDP growth, inflation and foreign exchange risk.
Interestingly, few firms adjust either discount rates or cash flows for book-to-market, distress, or momentum risks. Only 13.1% of respondents consider the book-to-market ratio in either the cash flow or discount rate calculations. Momentum is only considered important by 11.1% of the respondents.
Capital StructureThe tax advantage is most important for large, regulated, and dividend-paying firms – companies that probably have high corporate tax rates and therefore large tax incentives to use debt.
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When we ask firms directly about whether potential costs of distress affect their debt decisions, we find they are not very important (rating of 1.24 in Table 6), although they are relatively important among speculative-grade firms. However, firms are very concerned about their credit ratings (rating of 2.46, the second most important debt factor), which might be an indication of concern about distress costs. Among firms that have rated debt and for utilities, credit ratings are a very important determinant of debt policy.
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We ask directly whether firms have an optimal or "target" debt-equity ratio. Nineteen
percent of the firms do not have a target debt ratio or target range (see Figure 1G). Another 37% have a flexible target, and 34% have a somewhat tight target or range. The remaining 10% have a very strict target debt ratio. These overall numbers provide mixed support for the notion that companies trade off costs and benefits to derive an optimal debt ratio....Targets are important if the CEO has short tenure or is young, and when the top three officers own less than 5% of the firm. Finally, the CFOs tell us that their companies issue equity to maintain a target debt-equity ratio (rating of 2.26; row e of Table 8), especially if their firm is highly levered (2.68), firm ownership is widely dispersed (2.64), or the CEO is young (2.41).
Flexibility: The most important item affecting corporate debt decisions is management's desire for "financial flexibility,"
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Internal funds deficit: Having insufficient internal funds is a moderately important influence on the decision to issue debt...More small firms (rating of 2.30) than large firms (1.88) indicate that they use debt in the face of insufficient internal funds, which is consistent with the pecking-order if small firms suffer from larger asymmetric-information-related equity undervaluation.
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Equity undervaluation: Firms are reluctant to issue common stock when they perceive that it is undervalued...Rather than issuing equity when they feel it is undervalued, many firms issue convertible debt instead: Equity undervaluation is the second most popular factor affecting convertible debt policy (rating of 2.34 in Table 10), a response particularly popular among growth firms (2.72).
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Market timing is especially important for large firms (2.40), which implies that
companies are more likely to time interest rates when they have a large or sophisticated debt issuance department. We also find evidence that firms issue short-term debt in an effort to time market interest rates. CFOs issue short-term when they feel that short rates are low relative to long rates (1.89 in Table 11) or when they expect long-term rates to decline (1.78).
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We find moderate evidence that firms issue equity to dilute the stock holdings of certain shareholders (rating of 2.14 in Table 8). This tactic is popular among speculative-grade companies (2.24); however, it is not related to the number of shares held by managers. We also ask if firms use debt to reduce the likelihood that the firm will become a takeover target. We find little support for this hypothesis (rating of 0.73 in Table 6).
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Among the 31% of respondents who seriously considered issuing foreign debt, the most popular reason they did so is to provide a natural hedge against foreign currency devaluation (mean rating of 3.15 in Table 7). Providing a natural hedge is most important for public firms (3.21) with large foreign exposure (3.34). The second most important factor affecting the use of foreign debt is keeping the source close to the use of funds (rating of 2.67), especially for small (3.09), manufacturing firms (2.92).
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The most popular explanation of how firms choose between short- and long-term debt is that they match debt maturity with asset life (rating of 2.60 in Table 11). Maturity-matching is most important for small (2.69), private (2.85) firms.
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Fourteen firms write that they choose debt to minimize their WACC
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Among the 38% of firms that seriously considered issuing common equity during the sample period, earnings dilution is the most important concern affecting their decision...EPS dilution is a big concern among regulated companies (3.60), even though in many cases the regulatory process ensures that utilities earn their required cost of capital, implying that EPS dilution should not affect share price. Concern about EPS dilution is strong among large (3.12), dividend-paying firms (3.06).
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We ask the executives whether the ability to call or force conversion is an important feature affecting convertible debt policy. Among the one-in-five firms that seriously considered issuing convertible debt, there is moderate evidence that executives like convertibles because of the ability to call or force conversion (rating of 2.29 in Table 10).
Source:
Graham, John R. and Harvey, Campbell R., "The Theory and Practice of Corporate Finance: Evidence from the Field" (December 1999). AFA 2001 New Orleans; Duke University Working Paper. http://ssrn.com/abstract=220251
