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.&

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