Corporate Finance: Capital Cost, Budgeting, and Structure

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Table of Contents

Introduction
Cost of capital
Capital budgeting
Capital structure
Methodology
Conclusion
Works Cited

Thesis statement: The practice of corporate finance has evolved such that there are several methods that various players in the industry have identified as appropriate to be used as project evaluation methods and these are the NPV, CAPM and the discount rate method.

Introduction

The authors in this paper carried out a study that aimed at analysing the current practice of corporate finance in the areas of cost of capital, capital budgeting and capital structure. The study was conducted with a great reference to Lintner’s path breaking analysis on dividend policy. The hope of the two authors is that the findings of the study will help other researchers and academicians to improve their knowledge on issues related to corporate finance and how they affect firm performance. The authors therefore chose to concentrate on three main issues in corporate finance and the summary of these issues is presented below (Graham and Harvey, 2).

Cost of capital

An evaluation of the use of cost of capital by firms noted that CAPM is by far the most popular method of estimating the cost of capital. It is also noted that CAPM is mostly preferred by larger firms than smaller firms. The results from the survey showed that firms that have already established themselves are likely to use a company-wide discount rate to evaluate their projects while firms with foreign exposure use it to evaluate overseas projects. The survey also noted that public corporations are most likely to use a risk matched-discount rate than private corporations. They also noted that the use of CAPM by small firms is inversely proportional to managerial ownership (Graham and Harvey, 7).

Capital budgeting

The survey conducted by the authors is different from those of others because it does not concentrate on large firms only, but also small sized firms and that the IRR is the only primary method of evaluation. The new survey not only focuses on the controlled characteristics of the firm but also enquires if the firms uses evaluation techniques (e.g. pay-back period, profitability index, accounting rate of return), use of earnings multiples and use of other types of analysis. Results from the respondents showed that the use of net present value as an evaluation technique is more preferred by large firms than by small firms.

It is also important to note that the results of the survey showed that firms that pay dividends are more likely to use the NPV and the IRR methods of capital budgeting than those firms that do not pay dividends. The authors also indicate that their results did not find any relationship between the use of the payback period method of capital budgeting and the leverage of the company, the credit ratings of the company as well as the dividend policy of the company (Graham and Harvey, 5).

Capital structure

The survey shows that the desire for financial flexibility is not determined by the factors behind pecking-order theory which suggest that firms use external financing only when internal funds are insufficient. Insufficiency of internal funds leads to the decision of issuing debt and this mostly happens to small firms compared to large firms. Equity-issuance decisions are also affected by the stock price performance especially where information asymmetry is involved. The results of the survey also show that credit ratings are important to debt decisions and that industry debt ratios are an important input for bond ratings.

However, it is important to note that the decision to issue equity is not influenced greatly by the equity policies of other firms in a given industry. The results also show that most firms choose their debt maturity by matching it with asset life hence differentiating between short-term and long-term debt. Such matching of the debt maturity and asset life helps in the management of risk associated with the capital structure of a company (Graham and Harvey, 10).

Methodology

The survey focused on three main areas: cost of capital, capital budgeting and capital structure. The survey questionnaires contained 15 questions where some of them had subparts and covered the three areas that were the main focus of the survey. The survey questionnaires were sent out to respondents of the study. A total of 392 questionnaires were returned and subjected to data analysis (Graham and Harvey, 3).

Conclusion

Based on the survey the authors conclude that NPV and CAPM are widely used currently as compared to the previous decades. The authors also conclude that small firms are less likely to use NPV or CAPM whereas in capital structure financial flexibility and credit rating are most important debt policy factors. When determining capital structure, financial executives are less likely to follow the academically proscribed factors and theories hence the need for additional thought and research. NPV and CAPM are widely understood because they make a more precise prediction and have been accepted as a mainstream for longer as compared to capital structures theories.

Works Cited

Graham, John, and Harvey Campbell. “The theory and practice of corporate finance: Evidence from the field” Journal of Financial Economics, 61(2001): 000-000. Print.

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