The Theory and the Current Practice of Corporate Finance - Case Study Example

A critique of the survey report ‘the theory and practice of corporate finance: Evidence from the field’ of John R. Graham & Campbell R. Harvey, (Word count – 2260) Introduction: This is a critique of the survey report ‘the theory and practice of corporate finance: Evidence from the field’ of John R. Graham & Campbell R. Harvey, which was published in the Journal of Financial Economics. The aim of the survey was to find out the current practice of corporate finance. This survey project is a joint effort of the Fuqua School of Business of Duke University with the Financial Executives Institute (FEI). The survey report is the result of a comprehensive survey undertaken targeting as large as 4400 firms. They claim that their survey is based on a moderately large sample and a broad cross-section of firms. This survey balances between large sample analysis and clinical studies. The authors claim that their survey differs from the earlier surveys conducted in no. of dimensions. The scope of the survey was broad. There were more than 100 questions to be answered making it exhaustive in all respect. They claim that their sample is representative of the population. They also claim that they analyzed responses conditional on firm characteristics. They examined the relations between executives’ responses with firm size, P/E ratio, leverage, credit rating, dividend policy, type of industry, management and ownership, CEO age, CEO tenure and the education level of the CEOs. By doing this they shed light on the implications of various corporate finance theories related to firm size, risk, investment opportunities, transaction costs, information asymmetry and management incentives. They have also used a wide spectrum of firms chosen from small firms to fortune 500 listed companies. They found that their survey was both reassuring and surprising in nature. For instance, the survey indicates that the size of the firm affects the practice of corporate finance significantly, to evaluate new project most firms use present value technique, company wide discount rates than a project specific discount rates are used for evaluation of their projects by most o the firms. The goal of the survey: The goal of the survey as stated by the authors are- ‘The researchers will use the results to develop new theories to modify or abandon existing views’. They also set their goal as ‘we also hope that practitioners will learn from our analysis by noting how other firms operate and by identifying areas where academic recommendations have not been fully implemented’. The scope of survey: The survey was conducted with a broad scope. They have examined capital budgeting, cost of capital and capital structure. Methodology used: As a first step they had developed a draft survey questionnaire based on review of existing literatures. That draft survey was circulated to a group of prominent academics for feedback. A revised survey was prepared incorporating the suggestions received. Advice was sought from marketing research experts on the survey design and execution. Final changes were made in wording of the questions and incorporating the suggestions received by conducting beta testing at FEI and Duke University. The main aim was to minimize the biases induced by the questionnaire and to maximize the response rate. The survey was for the CFOs, but there were no. of questions about the characteristics of the Chief Executive Officers; it was assumed that CFOs acted as agents of CEOs. The final version contained 15 questions, most of which had subparts and it was three pages long. It was assumed that some respondents might only fill up first and second pages leaving the third page. To overcome this assumed problem, two versions of the questionnaire were prepared by interchanging the questions 1-4 and 11-14. However it was found that the response rate did not differ much. One section of the questionnaire contained the demographic information about the respondent firms. Special care was taken for delivery mechanism of the questionnaires. From Duke University a set of survey papers were sent to the CFOs of the 1998 edition of the fortune 500 companies. Another set of survey papers were sent from FEI to their 4,440 member firms. Follow up actions consisted of phoning all the Fortune 500 companies from Duke university, re-mailing to all the 4,440 firms with a new due date. To make the survey papers anonymous, a third party was used for receiving the completed forms. The response rate was nearly 9%, which was quite satisfactory as per the expectations of the surveyors. Capital budgeting methods: The survey tries to find out how the firms evaluate projects i.e. the capital budgeting methods used by the firms and the process is exhaustive. The questions asked about the evaluation technique used by the firm like adjusted present value, payback period, discounted payback period, profitability index or accounting rate of return. They also ask whether the firms use the evaluation techniques or simply bypass them using earning multiples. They also try to find out if the firms use any other technique that are taught in many MBA programs like simulation analysis and value at risk. They show interest in the importance of real options in project evaluation. They found that 74.9% of CFOs almost use net present value technique and 75.7% almost always use internal rate of return technique. The most interesting result as per their analysis came from examining the responses conditional on firm and executive characteristics. They found that large firms were more likely to use NPV than small firms, CEOs with MBA degree are more likely to use net present value compared to their non-MBA counterparts, dividend paying firms are more likely to use NPV and IRR than non-dividend paying firms. Public companies are more likely to use NPV and IRR than their private counterparts. Another interesting aspect comes out; that the third most preferable technique used is payback period. It is also found that mature CEOs use payback method more than their younger counterparts for both small and large firms, CEOs of long tenure uses payback method, whereas in small firms CEOs without MBA are more prone to use payback method suggesting that lack of sophistication is the driving factor behind the popularity of the payback period method. Cost of Capital: They try to find out the methodology used by firms to calculate the cost of equity capital, whether the firms use the capital asset pricing model (CAPM) or a multibeta CAPM, or average historical return of dividend discount model. It is found that CAPM is the most popular method of estimating the cost of equity capital, the second being average stock return and the third being multibeta CAPM. The results are in contrast with the survey of Gitman and Mercurio (1982) and more recent Bruner, Eades, Harris and Higgins (1998). The cross-sectional analysis shows that large firms are more likely to use the CAPM than the small firms; CEOs with MBA are more likely to use CAPM or CAPM with extra risk factors than their non-MBA counterparts. They try to find out the sources of risk other than market risk and how are they treated in project evaluation. They include the risk factors as defined by Fama and French (1992), Jagdeesh and Titman (1993), Chen, Roll and Ross (1986) ad Harvey (1991). They modified the question to include whether, in response to risk factors, the firms modify their discounts rate, cash flow, both or neither to find out the percentage of each category. It is found that the most important additional risk factors are interest rate risk, exchange rate risk, business cycle risk and inflation risk. It is found that for the calculation of discount rates, the most important factors are interest rate, size, inflation and foreign exchange rate risk and for calculating cash flows, the effects of commodity prices, GDP growth, inflation and Foreign exchange rate. It is found that when adjusting the risks small and large firms has different priorities; for large firms the most important risk factors are foreign exchange risk, business cycle risk, commodity price risk and interest rate risk, whereas small firms are more affected by interest rate risks. The authors showed specific interest in finding out how the cost of equity models are used, in particular how a firm evaluates a new project in overseas market, whether companies consider the company-wide risk or the project risk. They find that 58.8% of the firms would always or almost always use the company-wide discount rate, though the hypothetical project would have different risk characteristics. It is also found that 51% of the firms confirmed that they would use risk-matched discount rate to evaluate the project. It is also found that large firms are more likely to use the risk-matched discount rate than their smaller counterparts. It is found that very few firms use a different discount rate to separately value different cash flows within the same project. Capital Structure: To assess the capital structure, the survey structures the questions around debt, equity, debt maturity, convertible debt, foreign debt, target debt ratios, credit ratings and actual debt ratios. They try to find out the Target debt ratios and the costs and benefits of debts. The results show that the CFOs feel that the corporate tax advantage of debt is moderately important in capital structure decisions. For large, regulated and dividend paying companies, that probably have high corporate tax rates tax advantage is the most important factor in deciding the capital structure as they get large tax incentives to use debts. The survey investigates whether firms issue debt when foreign tax treatment is favorable and the results find that the favorable foreign tax treatment is fairly important. No evidence is found that the firms directly consider personal taxes when deciding the debt policy. Firms are found to be very concerned about their credit ratings. Credit ratings are very important determinant of debt policy for utilities and firms that have rated debt, large firms that are in Fortune 500 list CFOs are found to be concerned about earnings volatility when making debt decisions. On the question of whether firms have target debt-equity ratio; 19% responded in negative, 37% have flexible target, 34% shows some tight target or range and 10% have strict target-debt ratio. Another noteworthy finding; 55% of large firms have somewhat strict target ratios in comparison of 36% of small firms. Interestingly the targets found to be important for young CEOs or CEOs of short tenure and when the top three officers own less than 5% equity of the firm. Actual debt ratios found to vary across firms and through time. The survey indicates that the firms do not rebalance in response to market equity movement. Moderate evidence is found that firms consider transaction costs when, making debt issuance decisions. It is found that specifically for small firms transaction costs is a discouraging factor in debt usage. The survey tries to find the asymmetric information of capital structure and seek support to Pecking-order model of financing hierarchy. The pecking-order model assumes that firms do not target any specific debt ratio but use external financing only in situations of insufficiency in internal funding, if firms use external funds, they prefer to use debt, convertible securities and equity only as last resort. It is found that the most important factor affecting corporate debt decisions is management’s desire for financial flexibility, with 59% of the respondents preferring the same. The firms found to be reluctant to issue common stock when they perceive that it is undervalued and instead issue convertible debt. The effect of recent increase in price of common stock in issuing equity also covered and found that it is the third most popular factor. Not much evidence is found to suggest that firms use capital structure to signal their quality or future prospects. It is found that the firms use convertible stock issuance as an inexpensive way to issue delayed common stock. The firms issue short-term debts when they have knowledge that their present pricing is undervalued. Moderately strong evidence is found that firms try to time the market, and firms issue short-term debt in an effort to time market interests rates. On the question of, if their choice between short- and long-term debts or their overall debt policy is related to their desire to pay long-term profits to shareholders and not debt holders, the answer found to be very small. On the subject of conflict between managers and equity holders very little evidence is found that managers are disciplined. Very little evidence is found to suggest that product market factors affect debt decisions. Moderate evidence is found that firms issue equity to dilute the stock holdings of certain shareholders. Conclusion: The authors claim that their findings are reassuring as well as puzzling. They find reassuring to find NPV as an important tool in project evaluation method. They find it surprising that more than half of the respondents would use their firms’ overall discount rate to evaluate a project in overseas market. They also find it interesting that CFOs pay little attention to risk factors based on momentum and book to market value. They identify fundamental differences in approaches between small and large firms. They find that informal criteria like financial flexibility and credit ratings are most important debt policy factors. They suggest found moderate support that firms follow the trade off theory and target their debt ratio. Interesting facts come out that financial managers do not necessarily follow the academically proscribed factors and theories during determining capital structure. This raises the possibilities that require additional thoughts and research. There comes out a strong possibility that it is time to critically evaluate the assumptions and implications of the mainline theories now are in vogue. Further studies can be conducted on these lines. Read More