The Theory and Practice of Corporate Finance: Evidence from the Field

TLDR: The authors survey 392 CFOs about the cost of capital, capital budgeting, and capital structure and find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes.

Abstract: We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on net present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. Older executives without an MBA are more likely to rely on payback than are younger executives with an MBA. Surprisingly, most companies use a single company-wide discount rate to evaluate a project in a new industry and country. In addition to market risk, firms also frequently adjust cash flows or discount rates for interest rate risk, exchange rate risk, business cycle risk, and inflation risk. Few firms adjust discount rates or cash flows for book-to-market, distress, or momentum risks. A majority of large firms have a tight or somewhat tight target debt ratio, in contrast to only one-third of small firms. Executives rely heavily on informal rules when choosing capital structure. 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 some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes. If CFOs behave according to these deeper hypotheses, they apparently do so unknowingly.