How Do CFOs Make Capital Budgeting

and Capital Structure Decisions?

Survey Techniques and Sample
Characteristics
Survey Targets:
CFOs of all Fortune 500 companies in 1998
4,440 firms whose officers are members of Financial Executive
Institute.
9%response rate:392 returns
Wide variety of firm characteristics
Size
Industry
Growth prospects: high growth(P/E ratio>=15)
Debt ratios
CEO characteristics
Age
Job-changing frequency
Education



Techniques for Capital Budgeting Decisions
Techniques that CFOs always or almost always
used
NPV and IRR as the most frequently used
techniques.
Firms more likely to use NPV or IRR
Large firms
Highly leveraged firms
Paying dividends
may reflect the fact that many none paying dividends
firms are high growth firms whose expected cash inflows
from their investments are often not expected to
materialize for years.
With MBA CEOs
Public companies



Techniques for Capital Budgeting Decisions
The shortcomings of the payback criterion :
it ignores the time value of money
the value of cash flows beyond the cutoff date, and the
cutoff is usually arbitrary.
Firms more likely to use the payback period
Small
(Among small firms) with older CEOs with long tenures and
without MBAs
Why do small firms tend to favor ad hoc decision rules?
small firms have more unpredictable projects
crude rules of thumb resemble the solutions produced by
optimal decision rules, particularly in the evaluation of
highly uncertain investments.



Techniques for Capital Budgeting Decisions
Cost of Equity Capital
CAPM is the most popular method: 73.5%.
large companies :much more likely to use the CAPM;
small firms :use a cost of equity determined by what
investors tell us they require.
How to evaluate a new investment project?
nearly 60% : use a single company-wide discount rate.
51%:use a risk-matched discount rate
some companies evaluate projects with both
company-wide and risk-matched.
larger companies were significantly more likely to use
a risk-matched discount rate
Capital Structure Decisions
Two main theories of capital structure choice
The trade-off theory
The pecking-order theory
The trade-off theory
trading off the benefits of debt against its costs
Benefit of debt:
Interest payments are tax deductible
a potentially valuable role in mature companies by curbing a
managerial tendency to overinvest
Costs of debt: Personal tax and financial distress

Capital Structure Decisions(Contd)
The pecking-order theory
actual corporate leverage ratios typically do not
reflect capital structure targets
The financing order for investment need:
Using internal funds if possible
Issuing debt rather than equity
an equity offering is typically regarded as a very
expensive last resort
issuing equity brings negative market reaction due to
information gap between management and investors

The factors that CFOs use to decide
the right amount of debt
No.1 Financial flexibility(60%)
Flexibility tends to be associated with maintaining a
target credit rating.
No.2 Credit rating(60%)
Since size is a major factor in securing (at least) an
investment-grade rating, the factor is especially
important for large, Fortune 500 companies.
No.3 Earnings volatility(48%)
Consistent with the trade-off theory prediction
Companies use less debt when the probability of
bankruptcy is higher.

Supporting the trade-off theory!
Information Cost Explanations of
Capital Structure
Having insufficient internal funds was No.4
important factor on the decision to issue debt
(46.8%)
When feeling their stock is undervalued,
companies are hesitant to issue common equity.
issue convertible debt instead
Companies with a proxy for growth did not place
special emphasis on stock undervaluation as a
factor in their financing decisions.


Supporting the pecking-order theory,
but not for the information gap!
The reasons for the popularity of
convertible bonds
To avoid the larger dilution of value associated
with equity issues
To minimize the expected distress costs
associated with a heavy debt load
less expensive than straight debt
An inexpensive way to issue delayed common
stock
The flexibility for management to call and/or
force conversion of the bonds
Timing Market Interest Rates
When market interest rates were particularly low,
time interest rates by issuing debt.
large companies have more flexibility in timing
issues because of
their larger cash reserves
greater access to markets
Firms issued short-term debt to time market
interest rates.
When short rates were low relative to long rates
When expecting long-term rates to decline
The Corporate Underinvestment
Problem
The problem is likely to be most troublesome for
highly leveraged companies
Because of the profits will be used to pay off existing
debtholders.
smaller growth firms
because they have the projects that will need funding

Conflicts between Managers and
Stockholders
Issuing debt to avoid agency cost
According to Jensens free cash flow theory, high
leverage forces mature companies to pay out their
excess cash.
Issuing equity to avoid possible takeover
Diluting the stock holdings of certain shareholders

Product Market and Industry Factors
The extent of debt usage varies widely across
industries.
durable goods companies are likely to use less debt
customers might avoid purchasing a durable goods
companys products if they think that the firm will go
out of business
companies study their competitors debt ratios
before making their own debt decisions
the central role of credit ratings in corporate debt
decisions
the extent to which industry debt ratios determine
such ratings.

Risk Management
Motivations for using foreign debt
act as a natural hedge and so eliminate the need to
hedge with currency derivatives.
keeping the source close to the use of funds
Matching the maturity of assets and liabilities
Manage interest rate fluctuations

Common Stock and EPS Dilution
Corporate managers focus too much attention
on EPS and too little on economic value.
Issuing undervalued equity is often difficult to
separate accounting from real dilution.
Concern about EPS dilution was particularly
evident among
regulated companies
larger and dividend-paying companies