John R. Graham
Associate Professor of Finance, Fuqua School of Business, Duke University, Durham, NC 27708 USA Campbell R. Harvey
Professor of Finance, Fuqua School of Business, Duke University, Durham, NC 27708 USA National Bureau of Economic Research, Cambridge, MA 02912 USA March 8, 2002
1A longer and more detailed version of this paper is published as “The Theory and Practice of Corporate Finance: Evidence from the Field” in the Journal of Financial Economics Vol. 60, 2001, pp. 187-243. This research is partially sponsored by the Financial Executives International (FEI) but the opinions expressed herein do not necessarily represent the views of FEI. Graham acknowledges financial support from the Alfred P. Sloan Research Foundation.
How do CFOs make capital budgeting and capital structure decisions? 1 1. Introduction
A large body of academic research describes the optimal decisions that corporations should make, given certain assumptions and conditions. Anecdotal evidence, however, suggests that the way that corporations actually make decisions is not always consistent with the academic decision rules. In this paper, we analyze a comprehensive survey that describes the current practice of corporate finance. This allows us to identify areas where the theory and practice of corporate finance are consistent and areas where they are not. Our survey is distinguished from previous surveys in several ways. First, we examine both capital budgeting and capital structure decisions in detail. This allows us to determine how these corporate policies are interrelated, which provides a rich context within which to understand corporate decision-making. For example, we investigate whether firms that consider financial flexibility a capital structure priority also are likely to value real options in capital budgeting decisions. We explore capital budgeting and capital structure decisions in depth, asking nearly 100 total questions.
Second, we sample a large cross-section of approximately 4,440 firms. In total, 392 Chief Financial Officers responded to the survey, for a response rate of 9%. The next largest survey that we know of is Moore and Reichert (1983) who study 298 large firms. In the Journal of Financial Economics 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.
Third, we analyze the responses conditional on firm characteristics. We examine the relation between the executives' responses and firm size, P/E ratio, leverage, credit rating, dividend policy, industry, management ownership, CEO age, CEO tenure and CEO educational attainment. By testing whether responses differ across these characteristics, we shed light on the How do CFOs make capital budgeting and capital structure decisions? 2 implications of various corporate finance theories related to firm size, risk, investment opportunities, transaction costs, informational asymmetry, and managerial incentives. The results of our survey are both reassuring and surprising. With respect to capital budgeting, most firms follow academic advice and use present value techniques to evaluate new projects. In contrast, when it comes to making capital structure decisions, corporations rely heavily on practical, informal rules and pay less attention to academic advice. The most important factors affecting debt policy are maintaining financial flexibility and having a good credit rating. When issuing equity, respondents are concerned about earnings per share dilution and recent stock price appreciation. We find little evidence that real world capital structure decisions are made according to academic theories related to asset substitution, asymmetric information, transactions...