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The Canadian Financial Advisor

The theory and practice of corporate finance

Benjamin Felix

This paper is a discussion of the findings of a survey that received responses from 392 CFOs.  The survey allows the surveyor to gain insights into subjective areas of interest in corporate finance, including the methodology used by these practitioners for Capital Budgeting Methods, estimating Cost of Capital, and Capital Structure.  I will discuss the survey’s finding in each category and how they relate to the theory that I have learned.

In gaining an understanding of how practitioners approach capital budgeting, the survey asked participants about their usage of net present value, internal rate of return, adjusted present value, payback period, discounted payback period, profitability index, and accounting rate of return.  The results showed that 74.9% of CFOs always or almost always use NPV, and 75.7% of CFOs always or almost always use IRR.  Large firms, firms with high debt ratios, dividend paying firms, and public companies were more likely to use NPV and IRR.  After the NPV and IRR, the payback period was most widely used; it was found that CEOs without MBAs, Mature CEOs, and CEOs with long tenure were more likely to use this method.  It is inferred that the use of the payback period method is caused by a lack of sophistication.  This data is consistent with what has been taught in the business courses that I have taken.  NPV and IRR tend to be strong methods for capital budgeting as they take the time value of money into account and they both allow the project to be compared to other available investments.

The next survey section asked participants three question about how they calculate their cost of capital.  The first question asked how firms calculated their cost of equity; CAPM, average historical returns, or dividend discount model.  The second question asked about the risk factors used, and the last question determined how these models are used once they are constructed.  It was found that CAPM is the most common method of estimating the cost of equity capital with 73.5% of respondents stating that they almost always or always use it.  The next most common methods were average stock returns and a multibeta CAPM.  Large firms are much more likely to use the CAPM, and small firms are more likely to determine their cost of equity directly from investors.  Public firms are much more likely to use CAPM which makes sense as it is difficult to accurately determine a beta for a private firm.  Additional risk factors that are used in calculations include interest rate risk, exchange rate risk, business cycle risk, and FX risk.  Large firms are more likely to adjust for FX risk, business cycle risk, commodity price risk, and interest risk.  Small firms are more affected by interest rate risk.  Interestingly, most firms with overseas sales would use a single company wide discount rate to evaluate a project. (58.7% of respondents), and 51% of firms said that they would use a risk adjusted number.  Large firms were found to be more likely to match their discount rate to the appropriate risk of the project than small firms.  The likelihood that a firm with foreign exposure will use a company wide discount rate is surprising as they are more likely to have projects with varying risks.  The use of CAPM as the main method for determining the cost of equity is interesting after learning about the three factor model.  The differences in the way that firms behave could be attributed to them not fully understanding the risks that they are exposed to when they are selecting projects.  It is also important to note that firms are often not aware that it is dangerous to select projects or evaluate divisions using a company wide cost of capital.

The final section of the survey discusses capital structure; there were numerous questions in this section and I will only discuss the ones that I found to be most salient.  The participants were asked about the corporate tax advantage of debt and it was determined that it is only moderately important in capital structure decisions.  The tax advantage was considered most by large, regulated, and dividend paying firms.  It was determined that firms do not see it as important to maintain a target debt/equity ratio; firms will use the most beneficial form of financing at a given time rather than trying to maintain a set ratio.  Firms do tend to issue stock when prices are high and they will delay issuance in the event that their stock is undervalued.  If a firm knows that they have a high credit rating, but are currently labelled with a low rating, they will not issue short term debt to bridge the gap as was hypothesized by Flannery, Kale, and Noe.  To the contrary of this finding, it was found that firms do try to time the market by timing beneficial interest rates.  When considering issuing new equity, earnings dilution was the most important factor affecting the decision by participating firms which is contrary to what is often taught in business school.

The results of this survey were enlightening as they offer insights from practitioners into the academic theories that are posed by the people that study behavior and data.  Often times, academic theory will not agree with what is true in practice; one of the most interesting parts of this study was that it offered reasons as to why the theories did not hold true in practice.  In many cases, outdated models or methods were used by executives of small companies, older executives, and executives that did not have MBAs.  This shows us that when best practices are not followed, it may be due to a lack of knowledge rather than the academic theories being incorrect.

(Link to paper)