1. MBA 643 Managerial Finance Lecture 13: How Do CFOs Make Capital Budgeting and Capital Structure Decisions? Spring 2006 Jim Hsieh

2. 2 Overview The Role of Financial Managers –Capital budgeting decisions (corporate investment policy) –Capital structure decisions (corporate financing policy) Survey Background –Survey Targets: CFOs of all Fortune 500 companies in 1998 and 4,440 members of Financial Executive Institute –392 returns (response rate: 9%) –Firm characteristics vary by size, industry, growth prospects, and debt ratios.

3. 3 CFOs Age: –23%: >59; 49%: 50~59; 28%: 40~49 Tenure: –40%: in the current jobs less than 4 years –26%: 4~9 years –34%: >9 years Education: –41% with undergraduate degrees –38% with MBAs –8% with non-MBA master degrees –13% with beyond-master degrees

4. 4 Capital Budgeting Decisions Top 7 techniques that CFOs always or almost always used: –IRR (75.6%); NPV (74.9%); Hurdle Rate (56.9%); Payback (56.7%); Sensitivity Analysis (51.5%); P/E Multiples (38.9%); Discounted Payback (29.5%) Firms that are more likely to use NPV: –Large, Highly levered, or With MBA CEOs Firms that are more likely to use Payback: –Small, With non-MBA CEOs, or With mature CEOs

5. 5 Why Do Firms Still Use Payback? Is it because firms are severely capital constrained? –If a project does not generate positive cash flows early on, it will be cancelled. –This implies that capital-constrained firms are more likely to use payback. –The authors do not find the relation. They conclude that lack of sophistication is a driving factor behind the popularity of the payback rule. One encouraging news: The use of NPV is increasing. The likelihood of using NPV is also related to firm size and CEO characteristics.

6. 6 How Do Firms Estimate the Cost of Equity Capital? CAPM is the most popular method: 73.5%. –Other popular choices: Average historical returns (39.4%), CAPM with other extra risk factors (34.3%), DDM (15.7%) What types of firms are more likely to use CAPM? –Large Smaller firms tend to use “whatever investors tell us they require”. –Public Expected because it’s hard to estimate betas for private firms –High foreign sales –MBA CEOs (But only for single-factor CAPM, not multi-factor)

7. 7 If Firms Use Multi-Factor CAPM, What Factors Do They Use? Market risk (beta): 74% –Not all firms use the traditional CAPM!! Interest rate: 49% Foreign exchange: 44% GDP or business cycle: 43.5% Unexpected inflation: 38% Size: 33% Other factors: Market-to-book ratio (12%), Momentum (10%)

8. 8 What Are the Factors That Affect Corporate Decisions to Issue Debt? The trade-off Theory –Benefit of debt: Interest payments are tax deductible –Costs of debt: Personal tax and financial distress The pecking-order Theory –The model assumes that firms do not target a specific debt ratio. –Because of information asymmetry between managers and investors, firms are reluctant to use external capital markets. –It predicts firms’ financing order: internal funds, external debt, external equity.

9. 9 The Trade-off vs. Pecking-order In practice, what are the factors that CFOs use to decide the right amount of debt? –Financial flexibility (59.4%): Restrict debt usage so the company will have enough internal funds for future new projects –Credit ratings (57.1%) –Volatility of earnings and cash flows (48.1%) –Insufficient internal funds (46.8%) –Tax advantage of interest deductibility (44.9%) –Bankruptcy/distress costs (21.4%) –Not important: Personal tax costs our investors face (4.8%)

10. 10 Do Firms Have a Target Debt Ratio or Range? No target ratio or range (19%) Flexible target (37%) Somewhat tight target/range (34%) Very strict target (10%) What types of firms are more likely to have a target debt ratio? –Large Firms (55% with at least somewhat tight target, vs. 36% for small firms) –Firms with investment-grade debt (64%) –Regulated (67%)

11. 11 Why Do Firms Issue (or Not Issue) Common Stock? Earnings-per-share dilution (68.6%) Equity undervaluation/overvaluation (66.9%) Selling price “high” (62.6%) Funding employee stock option plans (53.3%) Maintaining a target debt/equity ratio (51.6%)

12. 12 Conclusion Executives use the mainline techniques (NPV & CAPM) that business schools have taught for years to value projects and to estimate the cost of equity. But, executives are less likely to follow academic theories in capital structure. Possible reasons: –Assumptions and implications from CS theories are not practical? –Theories are valid, but corporations ignore the theoretical advice? –Business schools are better at teaching capital budgeting and cost of capital than at teaching CS?