GrahamHarvey 2001: TheoryPractice of Corporate Finance

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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• Survey of 392 CFOs.
• Fig 1
• Panel A Range of firm sizes.
• Panel C Range of industries.
• Panel E Range of debt ratios.
• Panel K About 38 of CEOs have an MBA.
• Panel N Sample includes private and public
  companies.

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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• Fig 2 Popularity of different capital budgeting
  techniques (in order)
• IRR
• NPV
• Hurdle rate
• Payback
• Large firms, highly levered firms, and firms with
  MBA-CEOs more likely to use NPV method.

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NPV and IRR
Security Market Line (CAPM)
Accept
Expected Return
Reject
Rf

Beta
4
NPV and IRR
Expected Return
Accept
IRR
Cost of Capital
Reject

Beta
5
NPV and IRR
Security Market Line (CAPM)
A
Expected Return
B
Cost of Capital
C
D
Rf
Beta
A CAPM (Accept), CoC (Accept) B CAPM (Reject),
CoC (Accept) C CAPM (Accept), CoC (Reject) D
CAPM (Reject), CoC (Reject)
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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• Fig 3 Popularity of different methods for
  calculating cost of equity capital (in order)
• CAPM
• Average historical return
• Multibeta CAPM
• Large firms, low levered firms, and firms with
  MBA-CEOs more likely to use CAPM.

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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• Fig 5 Factors that CFOs thought determined the
  appropriate amount of debt (in order)
• Financial flexibility (p. 218 minimizing
  interest obligations such that they do not need
  to shrink their business in case of an economic
  downturn).
• Credit rating.
• Earnings and cash flow volatility.
• Insufficient internal funds.
• Level of interest rates.
• Interest tax savings.
• Transaction cost and fees.
• Equity misvaluation.
• Comparable firm debt levels.
• Bankruptcy/distress costs.

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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• Fig 7 Factors that CFOs thought relevant in
  deciding whether or not to issue stock (in
  order)
• Earnings per share dilution.
• Stock misvaluation.
• Recent rise in stock price.
• Providing shares for employee/bonus stock option
  plans.
• Maintaining target debt-to-equity ratio.
• Diluting holding of certain shareholders.
• Stock is least risky source of funds.

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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• 5.1. Tradeoff theory of capital structure choice
  Firms have optimal debt-equity ratios which they
  determine by trading off the benefits of debt
  (tax advantage of interest deductibility), with
  the costs of debt (financial distress costs, and
  tax expense incurred by bondholders).
• Fig 5 Corporate tax advantage of debt only
  moderately important.
• Fig 5 Financial distress moderately important.
  But credit rating may be a proxy for financial
  distress costs.
• Fig 5 Personal tax considerations appears to be
  not important.

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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• 5.2. Asymmetric information explanations of
  capital structure choice
• 5.2.1 Pecking-order theory Firms do not target a
  specific debt ratio, but instead use external
  financing only when internal funds are
  insufficient External funds are less desirable
  because informational asymmetries between
  management and investors imply that external
  funds are undervalued. Hence, if firms use
  external funds, they prefer to use debt,
  convertible securities, and, as a last resort,
  equity.
• Table 9 Consistent with the pecking-order theory
  Having insufficient internal funds is a
  moderately important influence on the decision to
  issue debt, especially for smaller firms (that
  are likely to suffer from greater
  asymmetric-information-related equity
  undervaluation).

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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• 5.2. Asymmetric information explanations of
  capital structure choice
• 5.2.2 Recent increase in stock price A surge in
  share price increase can correct an
  undervaluation or lead to an overvaluation.
• Table 8 Recent stock price increase third most
  important factor in equity-issuance decision.
• 5.2.4 Convertible debt issuance Conversion
  feature makes convertible debt relatively
  insensitive to asymmetric information (between
  management and investors) about the risk of the
  firm.
• Table 10 Firms use convertible debt to attract
  investors unsure about the riskiness of the firm
  (more relevant for smaller firms).

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Graham-Harvey (2001) Theory-Practice of
Corporate Finance

• 5.3. Underinvestment problem
• Table 6 Consistent with theory underinvestment
  more of a concern for growth firms compared to
  non-growth firms.
• Table 6 Overall, underinvestment does not appear
  to be a major concern.

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• What Do We Know About Capital Structure
• Rajan-Zingales (1995)
• Factors Correlated with Leverage
• 1. Tangibility of Assets
• Tangible assets can serve as collateral,
  diminishing the risk of the lender.
• Assets would retain more value in case of
  liquidation.

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• Factors Correlated with Leverage
• 2. Investment Opportunities
• The Underinvestment Problem With risky debt
  outstanding, shareholders may sometimes not
  undertake positive NPV projects.
• Company Value Value of Tangible Assets in Place
  Value of Future Growth Opportunities
• V TA G
• V/TA 1 G/TA
• Market/Book Correlated with Growth
  Opportunities.
• Hence, high Market/Book companies (because they
  have more future growth opportunities) will issue
  less debt (be less levered).

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• Factors Correlated with Leverage
• 2. Investment Opportunities
• High Market/Book companies (because they have
  more future growth opportunities) will issue less
  debt (be less levered).
• Implying negative correlation between market/book
  and leverage.
• Rajan-Zingales (1995) Page 1456
• The negative correlation of market-to book with
  leverage seems to be driven mainly by large
  equity issuers.
• Above evidence for companies in the US, Japan,
  UK, and Canada.
• From a theoretical standpoint, the evidence is
  puzzling. If the market-to-book ratio proxies for
  the underinvestment costs associated with high
  leverage, then firms with high market-to-book
  ratios should have low debt, independent of
  whether they raise equity internally via retained
  earnings, or externally.
• Firms attempt to time the market by issuing
  equity when their price (and hence, their
  market-to-book ratio) is perceived to be high.

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• Factors Correlated with Leverage
• 3. Size
• Larger firms tend to be more diversified and fail
  less often, so size may be an inverse proxy for
  the probability of bankruptcy. Hence, larger
  firms may issue more debt.
• 4. Profitability
• More profitable companies use less debt.
• Firms cash flow identity

New debt New equity Net income Interest
payment Dividend New investment
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• Firms Histories and Their Capital Structures
• Kayhan-Titman (2004)
• Optimal Capital Structure Tradeoffs between the
  costs and benefits of debt.
• At the optimum Relation between capital
  structure and firm value may be weak, such that
  cost of deviating from the optimum is small.
• When this is the case, capital structures are
  likely to be strongly influenced by transaction
  costs and market considerations that may
  temporarily affect the relative costs of debt
  versus equity financing, making the idea of a
  target debt ratio much less important.

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• Debt-Value Function

V0
Value of Company
V1
V2
D1
D0
D2
Debt/Total Capital
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• Debt-Value Function
• Small deviations from optimal capital structure,
  D0, may not have a big impact on firm value.

V0
Value of Company
D0
Debt/Total Capital
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• Table A2 Predicting Leverage
• Leverage is positively related to
• Property, plant, and equipment
• Size.
• Leverage is negatively related to
• Market-to-book
• Profitability
• Selling expense
• RD.
• Leverage Deficit Actual Leverage Predicted
  Leverage

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• Table 3 Leverage
• Prior stock returns have a very significant
  impact on capital structure.
• Prior stock returns might also lead to a change
  in target capital structure.
• High stock returns might signal more growth
  opportunities suggesting lower debt ratios.
• As firm performs better, managers may get
  entrenched. Managers prefer less debt (than
  optimal) because they personally incur bankruptcy
  costs and have less discretion in more levered
  firms.