Review of “The theory and practice of corporate finance: evidence from the field”

by John R. Graham, Campbell R. Harvey

In this paper, Graham and Harvey conducted a survey of 392 CFO’s in the context of what
capital structures they have or what capital budgeting techniques they use. These findings are
shown with statistical values. There has been many researches similar to this but Graham and
Harvey’s paper differs from them with the broadness of their work. They sampled more than
4000 firms and total of 392 CFOs responded. In this paper the responses examined based on
company characteristics. Survey approach is not very common in corporate financial
research, however this approach provides a balance between the large-sample analyses and
clinical researches.

The results of the survey are quite interesting. According to findings, the most influential
factor of the practice of corporate finance is firm size. Large firms usually are more likely to
use NPV and CAPM techniques whereas smaller firms often prefers the payback criterion.

The introduction section of the paper provides some information about the firms in the
sample. Firms range from very small and very large. So-called very small firms are those that
have less than $100 million in sales and it is %20 of sample firms. Very large firms are those
that have sales of at least $1 billion, they make up %42 of sample firms.

The survey focuses on three areas: capital budgeting, cost of capital, and capital structure.

1. Capital budgeting methods

This section examines how companies evaluate projects. The most used capital budgeting
technique according to the majority of the respondents are IRR and NPV. 74.9% of CFO’s use
NPV and 75.7% of them use IRR. These two techniques are often preferred by large firms.
However, there seems to be no difference in the use of techniques between growth and
nongrowth firms. Other than NPV and IRR, payback period is the most often used method.

2. Cost of capital

In this section Graham and Harvey determined that how firms calculate the cost of capital.
Not surprisingly, CAPM is the most frequently used method of estimating the cost of capital,
used by 73.5% of the CFOs in the sample. Average stock returns and multibeta CAPM come
after that respectively. Another finding is large firms are more likely to use CAPM than small
firms. The reason for that is small firms often determine cost of capital by what their investors
require.

3. Capital structure

This section of the article explores how companies decide how much debt to have and which
financial theories to follow.

One theory, called the "pecking-order hypothesis," says companies prefer their own money or
retained earnings first, then borrow money (debt), and as a last resort use equity if they need
more money. The survey found that 60% of companies follow this approach.

Management’s desire for financial flexibility is the most significant factor influencing
corporate debt decisions. They try to minimize obligations in order not to have to shrink their
business. This is generally consistent with pecking-order model. Also, credit ratings plays an
important role on determining the debt policy.

According to another theory called the "trade-off theory," businesses should have an ideal
debt-to-equity ratio since it allows them to balance the benefits of borrowing against the risk
of defaulting on their debt.

The decision to issue debt is moderately affected by not having enough internal funds.
Another influence to issue debt is the situation when the equity is undervalued by the market.
In addition, very few businesses indicate that signaling-related issues influence their debt
policy.

In conclusion, Graham and Harvey’s valuable work provides a useful resource for other
researchers as well as CFOs who want to optimize their decision-making processes. All things
considered, there are significant differences between the decisions of large and small
companies. Furthermore, there are also distinctions between debt and equity strategies driven
by specific goals.