How CFOs Really Practice Finance

Shareholder value could suffer by following “rules of thumb” instead of textbook theory. The debate about how best to practice corporate finance can be likened to the one about whether life exists in outer space: lots of theories but little agreement. Recently, in an effort to learn more about the daily practices of CFOs, John Graham and Campbell Harvey of Duke University's Fuqua School of Business compiled responses from 392 CFOs in a working paper titled “The Theory and Practice of Corporate Finance: Evidence From the Field”. Their research focused on capital budgeting, cost of capital and capital structure.

Graham and Harvey found that although the financial theories and tools of academia are slowly being adopted into the field, CFOs are reluctant to forsake their favorite “yardsticks” in favor of textbook approaches to solving problems.

Nowhere was this more apparent than in regard to capital structure. For example, financial theory, starting with the Nobel Prize–winning Franco Modigliani and Merton Miller papers in the 1950s, asserts that companies choose their capital structure on the basis of a trade-off between the benefits of debt (the tax deductibility of interest payments) and the drawbacks of debt (higher interest payments). However, the surveyed CFOs cited as the most important factor “maintaining financial flexibility” — that is, keeping debt levels low in order to be ready for unforeseen opportunities. The tax benefits of debt and wariness about financial vicissitudes —the more theoretically based rationales for determining capital structure — were ranked fourth and fifth.

“Capital structure is the area where people use ‘rules of thumb’ the most. But, the responses did not strictly follow what is expected from the theory,” says Graham. “I surmise that the polled CFOs may be making decisions that are consistent with the theory of optimal structure, as their concern about their credit ratings indicates, even though they do not ascribe those actions to the theory's main tenets.”

Graham explains further that the study's results may have implications for shareholder value creation over the long term:

“Being ultraconservative with capital structure and making suboptimal decisions about capital budgeting could hurt shareholders in the long run,” he says. “Some of the country's leading companies have very little debt — Microsoft, Wal-Mart and Intel, for example — and they could probably take on more, increase their tax shield and still have an AA credit rating.”

The researchers also asked CFOs about the decision to issue common stock. The most relevant factor was earnings per share (EPS) dilution.

“We don't have an academic theory that justifies EPS dilution as the leading concern of CFOs,” Graham says. “If you dilute your earnings in the short term to invest in a valuable project that takes a number of years to pay off, you might think that shareholders would reward the company.” Either management doesn't do a good job explaining why EPS decreases in the short term, or “the stock market knows something about why EPS matters that academics haven't yet figured out.”

CFOs do seem to flex their intellectual muscles when choosing financial measures for capital budgeting. The majority use internal rate of return (IRR) and net present value (NPV). However, the use of “payback period,” which Graham and Harvey regard as a relatively unsophisticated measure of corporate value compared to IRR and NPV, ranked third.

However, when it comes to the actual implementation of IRR and NPV, CFOs tend not to spend much time adjusting the measures for risk, despite recent academic interest in the subject. More than half of the CFOs do not adjust either cash flows or their discount rate for the risks presented by interest rates, foreign exchange, the business cycle, commodities or inflation.

Despite these and other results, Graham remains optimistic about the future of financial decision making.

“Many academic theories are relatively pervasive in practice,” concludes Graham. “For example the vast majority of companies do use the capital asset pricing model (CAPM), which they didn't do 20 years ago. On this and other matters, we are starting to see that business-school tools are actually starting to take hold in the field.”