To learn about the daily practices of the CFOs, John Graham and Campbell Harvey of Duke
University conducted a survey from 392 CFOs [1], focusing on Capital budgeting, cost of
capital and capital structure.
Capital Budgeting
As per the literature IRR and NPV are the most commonly used methods of capital budgeting
We have also studied that NPV and IRR provide the most reliable results. Graham and
Harveys survey also suggests that most of the large firms use the IRR and the NPV
techniques of capital budgeting. They regard them as sophisticated techniques. The third most
common technique as per their survey which is generally used by the small firms is the
payback period method which they have regarded as the unsophisticated technique because
the payback period method has certain limitations which makes them less desirable and
reliable to be used as they ignore the time value of money and cash flows beyond the cut off
date [2, Ch. 5].
Cost Of Capital
The results indicate that CAPM is the most popular method of estimating the cost of equity
capital , apart from them average stock return and multi- beta factor models are used. The
results show that a large number of firms use firm risk rather than the project risk in
evaluating the new investment opportunities. This is contrary to what we have studied - when
business risk of an investment project differs from the business risk of the investing company
then the return required on the investment project is different from the average return
required on the company’s existing business operations, so it is not appropriate to use the
existing cost of capital as the discount rate and hence CAPM can be used to calculate the
project specific discount rate which reflects the risk of the investment project [2, p. 214].
Capital Structure
The capital structure is the area where people use the rule of thumb the most, but the
responses did not completely follow the theory. The theory asserts that companies choose
their capital structure on the basis of trade off between the benefits of debts and the
drawbacks of debts i.e Tax shield versus financial distress [2, Ch. 18]. But the surveyed
CFO’s cited their most important factor is “ maintaining financial flexibility” i.e keeping the
debt levels low in order to be ready for the unpredicted future opportunities and credit ratings
for issue of debt, EPS dilution and stock price appreciation influencing equity issuance. It is
found that firms are more concerned about the cash flow volatility which is consistent with
the trade off theory’s assumption that firms reduce the usage of debt when the probability of
bankruptcy is high . There is mixed evidence for the target leverage hence there is less
support to the notion that companies trade off costs and benefits to derive an optimal debt
ratio . The pecking order states that firms do not target a specific debt ratio instead they use
external financing only when the internal financing is insufficient [2, Ch. 18]. Financial
Flexibility is in the favour of pecking order theory as it is against external financing but the
desire for flexibility is not related to the degree of informational asymmetry and it less
important to the no dividend firms . Theory states that firms issue short term debts if they
expect improvement in their credit ratings [3] but the evidence states that firms do not use
short term debt to time rating improvement. Thus there is little evidence in support of trade
-off theory and pecking order theory but there is weak evidence for credit ratings, transaction
costs , asymmetric information.
Bibliography
[1] J. R. Graham and C. R. Harvey, “The theory and practice of corporate finance: evidence
from the field,” J. Financ. Econ., vol. 60, no. 2, pp. 187–243, May 2001, doi:
10.1016/S0304-405X(01)00044-7.
[2] R. A. Brealey, S. C. Myers, and F. Allen, PRINCIPLES OF CORPORATE FINANCE, 10th
edition. New York, NY: McGraw-Hill Education / Asia, 2010.
[3] M. Flannery, “Asymmetric Information and Risky Debt Maturity Choice,” J. Finance, vol.
41, pp. 19–37, Feb. 1986, doi: 10.1111/j.1540-6261.1986.tb04489.x.
