Introduction
Graham and Harvey surveyed about 4,440 firms chief finance officers, and only 392 reviews came back. Large enterprises rely primarily on present value methods, capital structure and capital asset pricing models whereas small businesses likely use the payback period technique (Graham 12). Companies are more concerned about sustaining financial flexibility, healthy credit rating, stock appreciation, and EPS (earnings per share) dilution, especially when the entities are issuing equity. Little evidence was also found that organizational executives have a great concern about asymmetric information, personal taxes, free cash flows, and asset substitution. There is also some support for trade off capital structure theories and pecking order theory.
Capital Budgeting Methods
Capital budgeting is a fundamental tenet of the premises of modern finance that focus on the intrinsic value of an asset or a whole enterprise as the sum of discounted present values of all its expected future inflows or earnings (Jagannathan 22). Hence, companies looking to invest in capital ventures should use the net present value approach which takes the project whose NPV is positive and reject the one which is negative. The respondents needed to answer a series of questions on a 5-point scale. The primary capital budget methods used are the internal rate return (IRR), net present value (NPV) method, the hurdle rate and payback (Graham 26). There was some disparity between big and small businesses where large corporates are likely to use the NPV method and the IRR than small firms with low levels of debts. Also in the findings is that mature CFO’s with a long serving term use the payback period method often than young CFO’s. However, there was no evidence that severely Capital constrained businesses to use the payback period method more often.
Cost of Capital (Equity)
The capital asset pricing model is by far the dominant traditional approach used to calculate the cost of equity (Jagannathan 34). The dividend discount model was rarely used among the finance practitioners. The historical average returns are used more often than multifactor models. Chief finance officers with higher levels of education are more likely to use the multi- or single-factor capital asset pricing model than those with lower qualifications. The average stock earning is the second while the multi-factor CAPM is the third traditional approaches in the finance industry. Very few firms utilized the dividend discount model for the calculation of the cost of equity. The case of NPV and DCF analysis above shows that big businesses were more likely to use the capital asset pricing model while small firms, in comparison, were more prone to use the cost of equity as determined by what the investors required of them (Graham 45).
Specific Risk Factors
The specific risk factors considered by most practitioners they face include market risk, foreign exchange risk, slow GDP growth risk, unexpected inflation and interest rate risk. Findings were that most firms usually use a single firm-wide discount rate, and that big business are more prospective to use risk matched discount rates contrary to small enterprises. The companies with international exposure are highly likely to utilize a single enterprise-wide rate of discount due to exchange risk associated.
Trade-Off Theory
The most important aspects of any firm that affects its levels of liability are the flexibility of finance and its credit ratings to lenders (Jagannathan 56). Tax allowance of liability is also a critical component on most firms. The tax advantage is also essential for large dividend paying corporates. Trade-off theory states that businesses have optimum debt-to-equity ratios, by which they control by trading off their profits of debt alongside the company’s costs. In the initial method of this model, the key benefit of using liability is the tax allowance of deductible interest (Graham 55). The most recent forms of the trade-off model also attempt to integrate Jensen’s free cash flow proposition, in which liability takes a crucial role in mature corporations by minimizing the tendency of administrators to over-invest. The major costs of debt funding are those connected with financial distress, mainly in the form of suppliers and customers defections and business under-investment.
Pecking Order Theory
The pecking-order theory presents that managers are hesitant to sell underpriced securities in a market even though it’s often disposed to grant overpriced or fairly-priced equity (Jagannathan 38). Therefore, investors logically interpret most of the organization’s decisions using equity as a signal that the perceptions of the managers are the major influence on the overhaul of the business through forecasts the share price movements in the future. Some of the corporations use correctional strategies to offer better value that the real economic costs of the securities using the overhauls at the time of announcing the issues. However, some companies choose to undervalue or fairly value their stocks at the exact time of announcement and attract adverse market reactions and leading to the dilution of the current shareholders (Graham 45).
Risk Management
Companies design various ways that enable them to organize their debt with an objective of controlling the risk. For instance, for businesses with foreign revenues can use foreign-denominations liability that acts as a regular hedge to disregard the need to hedge with foreign exchange derivatives. Natural hedges appeared to be particularly imperative for public corporations with significant exposures to the overseas markets (Graham 67). Another important reason for using international debt was the pivotal role it has in keeping the source near to the utilization of capital which is of particular importance for small production firms. The aim to control interest rate risk explains why corporates wish to match the maturity of their assets with debts. If liabilities and assets the periods are not streamlined, interest rate movement can affect the level of capital available for investing and working capital for running of daily business. Most CFO’s match decides the long term and short term debt through matching asset and liability lives.
Practical Cash Management Considerations
Other findings were that cash management and liquidity management played a critical role in financial decision-making in most corporations. For instance, most enterprises issue longer term liability to evade the need to refinance during periods of low performance. One implication of this is that it is manifestly evident that management perception about interest rate played a key role in the timing of liability issues. Avoidance of dangerous times has been particularly significant for the highly leveraged manufacturing businesses suggesting speculation that is an attempt to time the market which is commonly viewed by the corporation as a form of managing interest rate risk (Graham 51). Management efficiently ensures that their strategic investments and operations will not be affected by the spike in interest rates or severe market conditions.
Works cited
Graham, John R, and Campbell R. Harvey. Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective. Cambridge, MA: National Bureau of Economic Research, 2001. Print.
Jagannathan, Ravi, Iwan Meier, and VefaTarhan. The Cross-Section of Hurdle Rates for Capital Budgeting: An Empirical Analysis of Survey Data. Cambridge, Mass: National Bureau of Economic Research. 2011. Web. 16 Apr. 2016.
