Narratives in managers' corporate finance decisions

Narratives in managers’ corporate finance decisions

Les Coleman, Krishnan Maheswaran, Sean Pinder

Department of Finance, The University of Melbourne, Parkville, Vic. 3010, Australia

Abstract

This article uses the extended case method to explore senior executives’ corporatefinance decisions. We quantified firm’s finance practices using a mail survey, andthen – to resolve puzzles in managers’ decision processes – conducted face-to-face interviews with chief finance officers of large listed firms. The interviewsidentified six themes as consistent influences on finance decisions: pressuresimposed by clienteles; constraints on resources; risk management; heuristics; realoptions; and sustainability. We conclude that managers are logical and rationalin their decisions, but employ a wider range of criteria than assumed in conven-tional finance theories.

Key words: Corporate finance; Executive decisions; Extended case method;Risk management; Corporate social responsibility

JEL classification: G31, G32, G34, G35, G36

doi: 10.1111/j.1467-629X.2010.00343.x

1. Introduction

Most analyses of decisions in corporate finance use remote observations, typi-cally large databases of transactions. Thus, the econometrician with access tothousands of decisions can seem to know more than the decision makersthemselves, and invariably concludes that managers’ decisions are sub-optimal

The authors acknowledge financial support from the Accounting & Finance Associationof Australia and New Zealand; and assistance from the Finance and Treasury Associationin collecting data. We are very grateful to the impressive group of managers who gener-ously gave their time and skill in completing the surveys and taking part in interviews. Weappreciate insightful comments from numerous colleagues, especially Rob Brown, Ste-phen Brown, Kevin Davis and participants in research seminars at the University ofAmsterdam and the University of Melbourne. We are also grateful for detailed commentsfrom the Editor and two anonymous referees who significantly strengthened our argu-ment and conclusions. The usual disclaimer applies.

Received 17 July 2009; accepted 27 December 2009 by Robert Faff (Editor).

� 2010 The AuthorsAccounting and Finance � 2010 AFAANZ

Accounting and Finance 50 (2010) 605–633

(that is, irrational or biased). Typical examples include systematic underpricingof initial public offerings (Ritter and Welch, 2002); over-payment for acquisitions(Andrade et al., 2001); and poor hedging judgments (Tufano, 1998). It can seemthat every time managers go near markets they destroy value (Jensen, 2001). Thispuzzle of why finance managers who are experienced, highly educated and paidwell are thought to make poor decisions is a prime motivation for our study.A second motivator of our study is anecdotal evidence that firms increas-

ingly incorporate nonfinancial measures such as ethics and sustainability intofinancing decisions, particularly investment (e.g. Ho and Taylor, 2007). Thesevalue-based measures complement corporate social responsibility (CSR)(Godfrey et al., 2009) and act synergistically with governance, quality andother voluntary corporate codes that avoid or insure against major strategicexposures and so enhance firm decision making and improve financial perfor-mance (Chami et al., 2002). We sought to explore the rationale and practiceof these value-based decisions to better understand whether and where theycan add value.Our research questions involved both the what and the how of decision pro-

cesses of senior finance executives. We designed a research methodology toresolve the questions by, respectively, bulk surveys and face-to-face meetings thatwere designed to understand decision processes. This follows the extended casemethod (Burawoy, 1998), and we are the first to build an integrated picture ofhow senior executives make major finance decisions.The first step was a mail survey of finance executives in major firms about their

practices, and it was designed to extend and validate similar studies which havebeen limited to the northern hemisphere. Our survey was conducted through aprofessional finance association and is similar to that used in the United Statesby Graham and Harvey (2001), which covered capital budgeting, cost of capitaland capital structure decisions. Responses from Australian executives provedsimilar to their U.S. counterparts, with extensive use of discounted analyses forproject evaluation, and more frequent use of sophisticated approaches by large,growth firms with rated debt. Cash-flow volatility was the most important influ-ence on debt levels, but firms also responded opportunistically, particularly tosecure financial flexibility.The survey provided a framework for our second research step which was

to interview senior finance managers – all but one of them chief finance offi-cers (CFOs) and treasurers of major listed companies – to probe the ratio-nales and strategies underpinning their decisions. We deliberately sought thegranularity of face-to-face personal interviews that is common in management(where it yields excellent case studies), anthropology and other social sciencesbut less so in finance research; we commend the methodology to readers.Interviews were semi-structured, following a loose script, and examined impor-tant corporate decisions, especially risk management and sustainability, and anumber of hard-to-quantify considerations such as the influence of constraintsand clienteles.

606 L. Coleman et al./Accounting and Finance 50 (2010) 605–633


The most surprising finding from the interviews was that qualitative criteriadominated executives’ financial strategies. Each understood modern financialtechniques, such as incorporating CAPM and other techniques into analyses, andconsidered real options in investments. But they sought to serve broader businessrequirements, and incorporated many nonfinancial stimuli such as constraintsfrom labour shortages and competitor activity, and the need to send favourablesignals, meet the needs of clienteles, and satisfy rating agencies. Risk management,with its meaning of avoiding loss or poor outcome, proved important in all firms,and was seen as directly linked to the firm’s returns. Most executives expectedsustainability issues to become more intense and pervasive in coming years.The balance of the article starts with a brief discussion of relevant literature, after

whichwe presentmajor findings which are narratives that we identified in the inter-views. Survey responses are presented as a stand-alone Appendix 2.We close withadiscussionof the implicationsof the combinedsurveyand interviewprograms.

2. Literature survey

This section provides a brief introduction to the literature on our research puz-zles of managers as wealth destroyers and the growing importance of risk andsustainability issues; and it outlines the extended case method, especially gather-ing data through interviews.

2.1. Managers as wealth destroyers?

The normative objective of financial decision making is to maximise risk-adjusted returns, and numerous examples such as those noted earlier show exec-utives fail to meet this objective. An explanation proposed by Graham andHarvey (2001, p. 233) is:

Interestingly, financial executives are much less likely to follow the academically pro-scribed factors and theories when determining capital structure. This last finding

raises possibilities that require additional thought and research. Perhaps the rela-tively weak support for many capital structure theories indicates that it is time tocritically re-evaluate the assumptions and implications of these mainline theories.

A re-evaluation of mainline finance decision theories using inferences from sur-veys or observed data suffers from both the joint test and missing variables prob-lems as it relies on theories that cannot explain firm behaviour, and omitsnonquantifiable data. The most direct way would be to ask managers to describetheir rationales, which motivates our interviews.

2.2. Importance of risk and sustainability in finance decisions

Risk in the general sense used by executives as the possibility of loss (Marchand Shapira, 1987) has become important to corporate behaviour because of its

L. Coleman et al./Accounting and Finance 50 (2010) 605–633 607


increase. For instance, firm-specific volatility of US equities increased three-foldafter 1979 (Campbell et al., 2001). Strategic risks have risen, too: the corporatedefault rate trebled in 25 years (Standard & Poor’s, 2004); and in the last decade,mean tenure of chief executives has fallen by a third (Lucier et al., 2005) and thefrequency of corporate crises has increased by a quarter (ICM, 2005). Whenqualitatively different measures show increasing firm risk, it is clear that ‘riskmatters’ (Goyal and Santa-Clara, 2003).Risk is now a topic of broad academic and practitioner interest, and comprises

one of a variety of stakeholder concerns that businesses have become sensitisedto, particularly in relation to their uses of resources and to externalities thataffect their physical and social environments (Ho and Taylor, 2007). This hasbroadened firms’ boundaries and they have rationally adopted performance tar-gets beyond maximising incremental benefits from investment. This led to theconcept of multiple bottom-lines for firms, which are now commonly referred tounder the headings of environmental, social and governance (ESG) (Bassen andKovacs, 2008). Environmental takes into account the firm’s impact on the envi-ronment, through compliance with existing regulations and recognition of futureimpact. Social focuses on equitable treatment of close stakeholders – especiallyemployees, customers and suppliers – and recognises its importance in protectingthe firm’s social license to operate (Gunningham et al., 2004). Governance incor-porates firm ethics and integrity, principles such as transparency and fair dealing,and effective functioning of the Board.ESG is important because investors make decisions about a firm using nonfi-

nancial data: almost ten per cent of funds under management in the UnitedStates are invested on the basis of ESG measures such as ethics, sustainability,and social responsibility (Social Investment Forum, 2006). Lenders, too, areexerting influence such as imposition of the Equator Principles by a number ofglobal banks to enforce minimum environmental and social standards on pro-jects, irrespective of the legislative framework (Hansen, 2006). Extra-financial,values-type criteria are important to firms because they can proxy for manage-rial foresight, which is borne out by the significant positive association betweenfirms’ social performance and their financial performance (Orlitzky et al.,2003).

2.3. Extended case research methodology

A number of articles have reported the results of large scale (N > 70) mail orelectronic surveys that use self-reports by finance executives to investigate howdecisions are actually made. See Brau and Fawcett (2006), Fraser (2004), andGraham and Harvey (2001); Australian examples include Coleman (2007), andMitchell et al. (2001). A number of survey researchers have extended their resultsthrough follow-up interviews of a smaller group (typically N = 10–20) to pro-vide additional explanation of factors that drive finance decisions. Pioneeringcontributions in this area were by Lintner (1956), Duhaime and Grant (1984),



and March and Shapira (1987). More recent studies of finance decisions includethose of Graham et al. (2005), and Hodge et al. (2006).Interviews have proven successful across many disciplines, including finance

management, because they enable researchers to ask qualitative questions, elicitmotivation and rationale for actions, and explore questions in terms that arefamiliar to the executives. This overcomes a number of well-recognised short-comings of remote surveys, especially their inflexibility, tendency to elicitanswers based on theory or belief rather than actual practice, and difficulty inderiving an explanatory model that matches all responses (Podsakoff and Organ,1986).The unique perspectives provided by surveys and interviews have been com-

bined in what Burawoy (1998) termed the ‘extended case method’. This involvessequentially: surveying relevant literature (in our case decisions in corporatefinance) to identify core concepts and theories; compiling empirical data to testthese concepts and theories (through a mail survey); and then filling in gaps andresolving puzzles by detailed investigation. The last, semi-structured interviewstage involves multiple iterations as actual practice is identified, tested for confor-mance to theory, and – as necessary – examined further in subsequent interviewsto ensure its validity. Unlike databases and surveys that strictly separate analystsfrom their subjects, interviews provide productive interaction with subjects andmake research reflexive.

3. Research design and data collection

3.1. Survey design and distribution

The first part of the study is a survey of finance executives, using questionssimilar to those of Graham and Harvey (2001) with two additions. The firstaccounts for the tax system in Australia, which is an imputation system wheretax paid by companies is, with some notable exceptions, effectively a prepaymentof personal tax. Consequently, the tax advantage created by firms adopting par-ticular capital structures is much diminished. Secondly, the study was extendedto include questions on the increasingly important topic of payout decisions.Questions were designed with significant input from finance academics, research-ers with survey-based experience, and the Finance and Treasury Association(FTA), which is the pre-eminent professional body for corporate treasurers inAustralia.This initial mail survey of executives contained 145 questions on 21 topics con-

cerning capital budgeting practices, cost of capital, capital structure decisions,development of payout policy and key characteristics of the firm. Respondentswere asked to provide answers to three styles of questions: general characteristicsof the firm (e.g. size, industry, P/E ratio); the frequency of use of a particularcapital budgeting technique; and the importance of different factors on corporatefinance decisions. The last two questions were scored using a five-point scale



where, respectively, 0 = ‘Never’ or ‘Not Important’; and 4 = ‘Always’ or ‘Veryimportant’.The FTA required total confidentiality for its member respondents and man-

aged the survey mail out and receipt of responses. The survey was sent in March2005 to chief financial officers of 1373 Australian firms included in the FTA pro-prietary database, with a covering letter encouraging participation in the project.A reply-paid envelope was provided, and we received 76 usable responses to givea response rate of 5.5%. This is typical for an unsolicited survey (Smee andBrennan, 2000), and comparable to the 8.5% response rate of Graham andHarvey’s despite our inclusion of 24 additional questions.1

3.2. Interview design and conduct

The second part of the study involved interviews with senior finance execu-tives, which were specifically intended to explore in detail the way they actuallymake decisions. These constitute our prime data.We approached twelve CFOs or Treasurers of Australian companies (nine

after an introduction from the FTA, and three through an unsolicited telephonecall). Each agreed to be interviewed, which emphasises the willingness of seniorfinance executives to engage in a dialogue with academics. Interviewees weremen, aged between 40 and 55, with between four and 20 years of experience withtheir current employer, and all had tertiary qualifications. Each firm was in thetop 100 listed on the Australian Securities Exchange by market capitalisation,headquartered on the Australian east coast (in Brisbane, Melbourne and Syd-ney), and involved in the construction, finance, manufacturing or mining sectors.Semi-structured interviews were conducted face-to-face in each interviewee’s

office by two authors during 2007–2008. We began with an assurance of confi-dentiality, and asked an open-ended question about allocation of expected cash-flow, given the alternatives of investment, adjusting debt and returning equity.The balance of the interview (see Appendix 1) was designed to cover standardfinance theories and our earlier survey findings. Interviewers were alert, however,to the opportunity to probe answers and only loosely followed ‘the script’; thus,a number of the questions received little attention. Interviewees were encouragedto give examples to illustrate their answers, and the process generally followedthe framework advocated by Strauss (1987). Interviews were recorded (and sub-sequently transcribed by a commercial service) and took between 55 and 90 min.The authors verified each transcription and lightly edited them to ensure that thewritten comments flowed.

1 In surveys such as this it is desirable to test for non-response bias. That is, to examinewhether the sample of respondents differs from the total survey population, typically bytesting for differences between early and late responders on the assumption that the latterare more representative of non-responders (see Rogelberg and Stanton, 2007). Unfortu-nately controls on the survey distribution process precluded such a test.



An obvious limitation of this study is the number of executives interviewed.However, as is typically found, a point of diminishing returns is reached rela-tively quickly (e.g. Danneels, 2007). After transcribing and editing the interviews,we found that over a quarter of the material was relevant and directly illuminat-ing of our research questions. However, even after further harsh paring, for rea-sons of space we have only been able to include (in the following sections) abouta third of this relevant material. An important feature of the quotations reportedis that each was matched (obviously with different words) by at least one otherinterviewee, so that the comments are robust to conditions in at least two firms.

4. Empirical findings: survey and interview results

Survey results are reported in a stand-alone Appendix, and the balance of thissection reports interview findings under six headings that reflect the many influ-ences on corporate finance decisions: clienteles; constraints; risk management;heuristics; real options; and sustainability.

4.1. Survey results

Survey results are reported in Appendix 2 using the same format as Grahamand Harvey (2001), and – to show the influence of firms’ structure – are split byseveral criteria. Division of firms into small and large was made at medianannual sales of $500 million (as opposed to $1 billion for Graham and Harvey).Division into growth and nongrowth firms is at a price-to-earnings ratio ofgreater or less than 14 (as per Graham and Harvey). Leverage is high above adebt-to-equity ratio of 0.30 (also as per Graham and Harvey).Figure 1 provides descriptive statistics. Survey results proved similar to US

results with the notable exception of the idiosyncratic impact of the imputationsystem. To enable the tables to stand alone, we provide comments with each thatidentify any differences from results of Graham and Harvey (2001) and notetheir relevance for finance theory. As few Australian firms issue convertible debt,we have omitted this result and several other tables covering cost of equity, termof debt, foreign debt and special dividends. These are available from the authorson request.

4.2. Restrictions and pressures from clienteles

A striking finding from our interviews was how many senior executives sawthe need to cater to the expectations and requirements of shareholders, whichmatches findings from the survey. However, translating this into practice provedcomplex, and firms diverged in how they identified and served various clienteles,and in the balance struck between different expectations of retail and institu-tional investors. Most managers complained good naturedly that investors provefickle.



We’ve become trapped by our dividend because of a history of paying out at a cer-tain level. There is a perception that we have a strong and loyal shareholder base

that relies upon the dividend yield … In the end you are a function of what the busi-ness produces, you are also a function of your history if you have been locked in toa dividend regime like we have. [CFO manufacturing firm]

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We have got a lot more retail investors on our register than we had when we floated.They have obviously been attracted by the dividend yield, which is unfortunate,

because it is a volatile stock … Quite frankly if and when the stock price drops, theyare going to be most unhappy. [Treasurer mining company]

Most firms have a formal process of collating information on shareholderrequirements, but the correct balance is hard to strike between clienteles.

There is a regular program of engagement with brokers and analysts and major

investors. But our investors have different views on what is important … When wego to different institutional holders we get different stories. We walk out of one meet-ing and it’s different to the previous meeting, so you can’t actually please them all.

[CFO manufacturing firm]

Institutional shareholders are much more demanding than retail shareholders. They

in essence want to have time with our CEO and CFO and then want to have a chatabout the strategies and want to have a chat about the actual expectation for every-thing going forward. That’s a key part of them trying to understand whether to

invest more or to reduce their investment in the group. [GM Strategy finance firm]

Most firms felt that shareholders imposed strong requirements, which was mostevident with off-market share buybacks (see Table 7) that have increased substan-tially since changes to the Corporations Law after 1995. This simplified the processand was further reinforced by favourable tax treatment, especially for sharehold-ers on low marginal tax rates such as mutual funds. As a result, the number ofoff-market buybacks in Australia rose from one or fewer per year prior to 1997 tobetween four and eight in each year during 1999-2008 (Brown, 2009).

The recent share buyback was a straight tax decision. [Treasurer mining company]

The presence of a large number of retail investors on the registry is a major consider-

ation and it’s probably one of the reasons why we’ve actually chosen special divi-dends as opposed to buybacks. [GM Strategy finance firm]

One manager with a majority shareholder noted dryly, perhaps reflective of himseeing his major shareholder as a captor rather than client:

That’s a big constraint. The [majority] shareholder is unwilling to inject additional

equity, but he can’t afford to go below 50% equity because he wants to consolidateour numbers… We would love to raise additional capital but we can’t. So we put inplace a hybrid that the banks see as capital but we count as debt because it has a

coupon and repayment date. [Treasurer industry omitted]

Even though the clientele effect can be hard to break, given the downside of a divi-dend clientele and retail investors, especially in what might prove a volatile stock,several companies were actively trying to shape and diversify their ownership.

We’d like to broaden our shareholder base by growing the institutional part of itand increase the regions where shareholders come from. Particularly we’d like to



grow our US shareholding because we see that there’s a lot of money there, and his-torically there has been stronger multiples paid for earnings out of the US, and other

markets, than out of Australia. [CFO mining company]

Most executives report only general or perceived pressures from some clien-teles, and few reported feeling it in relation to specific decisions. When asked‘Have you been forced to take decisions or take risks by outside influences?’they invariably answered ‘No’. Drilling down a bit further, however, revealeda number of exogenous contributors to the pressures they felt when makingdecisions.

By far the biggest issue in investments is working out what the long-term commodityprice is going to be. And if the consensus starts to move up, then really you areforced to move with that consensus. But by the same token, you’ve got to be very

careful not to get carried away. [Treasurer mining company]

They also recognise the need to respond to other firms in their supply chain, andto competitors

When the global names amongst our customers talk about how they are going to becarbon neutral, they put that pressure back on us. [CFO manufacturing firm]

In summary, we found that finance executives are keenly aware of heterogeneousexpectations of different stakeholder groups.

4.3. Financial and other constraints

Theoretically a firm adds value by investing in all projects whose incrementalrisk-adjusted expected return exceeds the marginal cost of capital. However, asmany as 70% of firms stop well short of this limit (Zhang, 1997), frequentlybecause of practical barriers including difficulties in identifying sufficient suitableinvestments and an inability to execute investments because of a shortage of non-financial resources, particularly skilled labour and management time (Richard-son, 1964). All managers reported constraints on their investment strategy, butthese were rarely financial.

Three things have constrained us: inappropriate use of capital and working capital;

the fact that we weren’t bringing talent along as quickly as we should; and we wer-en’t getting the right prices in the market place. [CFO manufacturing firm]

Investment comes down to what is available. The issue with the mining industry iswhere you find the resources... Factors that constrain us are that it’s an extremelycompetitive industry. [Treasurer mining company]

At the time of interviews, the unemployment rate was the lowest for over threedecades, and sectors where interviewees worked were experiencing strong growthin demand. A shortage of skilled staff was a chronic problem that had becomeacute.



The constraint we talk about now is people … The company hasn’t been constrainedby a lack of cash. [Treasurer construction firm]

The constraints felt by senior financial managers are a direct reflection of thestate of the markets at the time, and responses provide a useful contrast to thepost-GFC difficulty that many firms faced in sourcing capital for investment.

4.4. Risk management

Companies established broad-based criteria to achieve target risk levels, eitherallocating capital between countries and business lines, or setting individual hur-dle performance criteria, including earnings and rates of return on assets, equityor revenue. Most companies broadly adhere to Australian Standard 4360 on RiskManagement, which covers strategic, operational and financial risks. Risk man-agement is generally not within a centralised function, but embedded in processesand approvals throughout the firm.

We have a high level approach to risk, making sure that we identify risks around

our operations, particularly on the social, community and environmental side, andsafety. We take safety incredibly seriously. [CFO mining company]

Our risk area has been strengthened over the last couple of years. Now there’s awhole procedures manual on risk. So when you’re making a decision, these are guide-lines we expect you to comply to... We are in the business of taking risk. If we didn’t

take a risk we wouldn’t have a job. Risk management is all about trying to maximisethose profits on jobs where you are taking risk. [Treasurer construction firm]

In addition to a home country bias, operational and reputational risks wereimportant determinants of countries in which investments are made. Part of therisk is political, largely a reflection of the difficulty in dealing with some host gov-ernments. Most country risk, though, appeared to relate to different standards,particularly in relation to operational safety.

In Indonesia and The Philippines, our perception is that the political risk there is abit more than we are prepared to take... I’m never going near Papua New Guinea

again in my life. [Treasurer mining company]

We’re in Dubai because it has similar conditions to here or New Zealand or Hong

Kong... One of the main reasons we don’t go into China is our strict rules on safety.If you kill 60 workers there you count it as six and don’t worry about it. But wecan’t afford to have a single death. It’s all reported. Our corporate governance pro-

cesses say: ‘Sorry, fellas. You can’t do that’. We won’t go into China until such timeas jobs are bid on the same standards as in our world. [Treasurer industry omitted]

We’ve had manufacturing plants in China for years and we’re big on the ethicalissues. Our factories have to be compliant, and we won’t take on a new supplierunless we are sure it’s ethical and compliant... We have several offices throughout



Asia with two hundred people who go to the factories. The majority are locals, speakthe language. And they just appear unannounced and wander in, check books, check

quality, check people and all that sort of thing. Most of their job is quality controlbut also they do audit checks of the factories. [Treasurer manufacturing company]

A recurring driver to secure integrity in processes was the firm’s history, and sev-eral managers reported a strong inheritance from ‘dark periods’ in previoustimes.

Given where we came from [i.e. near bankruptcy], we have an absolute test on share-

holder value. [Treasurer mining company]

In looking ahead at future issues of risk and opportunity, most executivesthought in terms of economic and social changes requiring what one termed ‘overthe horizon thinking’. Not surprisingly, many ‘talked up their own book’. Min-ers, for instance, foresaw a resurgence of industrialisation. All managers wereacutely aware of environmental pressures, although not always in a negative way.

Our view is that we are in a generation of industrialisation that is going to go on forat least another couple of decades. [CFO mining company]

Greenhouse gas will be the next thing. Reporting on your emissions and what you’regoing to do will just take off. Then you’ll get the thing audited, and that becomes areport. [CFO mining company]

To be frank, global warming may be a good thing for us. It will mean that shippingroutes are opening up around the Arctic, so mining there actually becomes a viable

proposition. [Treasurer mining company]

International operations were important growth opportunities, but offered risks.

India is another big market for us, if only everything there could come together. It’s

just all over the place in India, but there’s huge potential and certainly the group isfocusing in on it and on theMiddle East at the moment. [Treasurer construction firm]

Without exception the managers interviewed were not only aware of the sourcesof risk for the firm, but were also proactive in preparing for risks that mayemerge in the future.

4.5. Heuristics

Most executives reported that their investment decision making relied on strate-gic benefits and rules-of-thumb rather than detailed calculations of rates of return.

We have quite a clear and disciplined strategy about what we will invest in and whatwe won’t. It’s not driven so much by IRRs (Internal Rates of Return) or anythinglike that. It’s a commitment to specific commodities and regions where we have a

competitive advantage, both geologically and also understanding how to do businessin those parts of the world. We are focussed on our region, we’re focussed on our



metals... If you’ve got good grade, good metallurgical process, you’re in the rightmetal, you’ve got the right size orebody, the IRR will look after itself. [CFO mining

company]

A few years ago, we had a long hard look at what our strategy should be going for-

ward. Our targets are where we could get a good position in the industry and negoti-ate good prices. This focus has determined what geological provinces around theworld we look in. [Treasurer mining company]

We further probed this qualitative, strategic rationale to understand the role ininvestment of quantitative assessments and traditional finance measures such asrate of return.

Investing is risky business. You can have all the maths you like out there, all the pro-jections, all the analysis. But judgement comes into play. Maths is the easy bit. Thedifficult part is the strategic judgements that you make about what markets you want

to be in, what customers, what places. [CFO manufacturing firm]

In our latest acquisition the price was struck at the start of negotiations. Only later we

went back and looked if it met investment hurdles. [Treasurer manufacturing firm]

Pushed to explain ‘How do you get the strategic decisions right?’, managerstalked about simplicity and focus.

We focus on keeping it simple and understanding what are the really fundamentalthings you’ve got to get right. [CFO mining company]

Even though investment strategy was at least as much qualitative as quantitative,financial performance was a sine qua non and investments are universallyrequired to add to earnings per share and provide a minimum return across amix of assets, equity and sales.

Every time we build a project we’re almost betting the company so it does mean thatwe’re reasonably conservative and very disciplined about our investment decisions.[CFO mining company]

Financial strategies were generally vanilla, with not much time spent on thefunding decision. Facilitating business operations is the priority because manag-ers see that is where value is created, not through financing.

Our general debt funding is built up from the business plan: this is what we’re look-ing at, how best can we service that debt? And we don’t try and get sexy, you keep itpretty simple. I think that’s been the nature of the balance sheet and what you see

across the group. Don’t get too fancy about anything. [Treasurer construction firm]

Once you know you’ve got a project, the funding is not a big worry … I’m not a fan

of getting too smart or overly complicated with big structures. With new projectswe put in place a pretty basic bank debt deal. I just want the money, don’t want tobuggerise around. It’s not the main game, it’s not what creates value – not in the



mining business. What creates the value is what’s in the ground. I don’t want to holdthe project up to get some smart structure in place. Just get the money and get the

thing built. Commissioning takes out a lot of the risk and we can re-look at financingafter that. … We make sure we’ve got good banking relationships in place, banksthat we know and trust and are going to support us. [CFO mining company]

The findings of our survey and that of Graham and Harvey (2001) found thatmanagers almost always utilise discounted cash-flow techniques when makinginvestment decisions. Neither, however, quantified the weight given to their con-clusions. Our interviews suggest that cash-flow calculations are merely a formal-ity, as managers already know from experience and the firm’s strategic objectiveswhether a project is viable or not. Furthermore, the managers were generally scep-tical of the role of complex funding mechanisms in creating value for the firm.

4.6. Real options

The concept of real options, in the sense of placing a value on retaining futureflexibility when making a decision today, was familiar and important to manag-ers. Whilst some were aware of techniques to price real options, most believedthat the market did not place full value on them. Even so, they sought strategieswith inbuilt flexibility and regarded this as a very tangible additional benefit.Real options proved important in strategy development, but are seen as separateto the formal investment process.

We look at the base business, how do we maintain or sustain and grow the basebusiness and then what are strategic options on top of that. Do we go andformally calculate that optionality, the value of that? No, it’s more of a business

awareness, a commercial awareness rather than an explicit calculation. [CFOmanufacturing firm]

Interviews probed the extent to which uncertain future opportunities – which areeffectively expansion options – are priced into project evaluations. Few managerswould justify an investment on ‘strategic grounds’.

Something may offer intangible opportunities down the track, but these are not

valued except in a roundabout fashion as a footnote which acknowledges theunknowns. [CFO mining company]

It would be extraordinary if we did invest for ‘strategic’ reasons because there’s scep-ticism around the review table about the very word. Faced with a ‘strategic invest-ment’, we sort of go: ‘Sorry, what does that mean?’ There’s a cynicism that’s now

developed: so, unless an investment can be demonstrated in terms of its economicworth, it’s not appropriate to spend that money. [CFO manufacturing firm]

Several managers displayed appetite for strategic risk with small projects. Thisreflected a seed capital approach in which small amounts of money may fund astrategic project.



If it was a relatively small investment and … it gave you a strategic interest in some-thing, then yeah it could get up on those grounds alone. But ultimately it would need

to stack up on economic terms. [Treasurer mining company]

The responses by interviewees are consistent with survey responses reported byus and Graham and Harvey (2001) because few managers account for the valueof real options when making investment decisions – even where they are relevantto the decision at hand (Table 1, see Appendix 2). The further insight providedby the interviews is that managers are keenly aware of the existence of realoptions, even though they do not explicitly account for their value.

4.7. Sustainability

Sustainability was a hot topic at the time of the interviews, and all managers hadexperienced stakeholder pressures concerning it and related issues such as CSR.However, sustainability had long been present in other guises because most firmsindicated that sustainable operations have favourable economic consequences.

Key performance measures on our business are in fact all about sustainability. Theyare about energy usage, waste, health and safety measures, lost time injury frequencyrates. In fact you can plot the lost time injury frequency rate over time: if it’s going

down, return on funds will be going up. It’s amazing: safe, clean, efficient operationsare profitable. It’s typically about discipline … I’m a little bit cynical: all this is nowbeing branded as sustainability, but in fact it’s all about economics, about smart

ways of doing business. [CFO manufacturing firm]

Sustainability is not a fad for us: it’s a key part of our core values … In fact, I expect

the financial report will start to become less important and the sustainability onemore important. [CFO mining company]

Interviewees were then asked to reflect on how a commitment to sustainabilityprovides a tangible payoff to the firm.

Sustainability shows up in the fact that we have very little disputation with our staff.

It shows up in the fact that we have never lost a day’s work because of any politicalor community unrest... It shows up in our environmental performance, in our safetyrecord. [CFO mining company]

A personal view is that having a legitimate sustainability strategy that is going toeffectively preserve the environment might well be a precursor to someone investing.

Do they attribute any value to sustainability? Probably not. Their decision to investand what they’re prepared to pay reflects what sort of value they think they cancreate through investing in the business. [GM Strategy finance firm]

Perhaps reflecting the fallout from high profile cases involving ethics breachesand criminal acts, most firms had an explicit ethics policy that went well beyondcompliance.



We have a set of core values that we use which resonate strongly. We talk aboutrespect, action, performance and openness. Respect takes into account community,

social, safety, environmental as well. [CFO mining company]

We have a values gateway at senior executive level where we score each other on

how we behaved. Before you get a bonus of any kind you have to pass the gateway.It demonstrates that values are critical. [CFO manufacturing firm]

Looking ahead, all firms anticipated intensifying pressures towards sustainabilityand CSR. This is based on internal commitment because the strategies improveperformance; and also envisages strong drives from key stakeholders, especiallycustomers.

A lot of our stakeholders and banks we deal with read our CSR Report because

most have environmental policies they’ve got to meet. Some of our shareholders,institutional advisers, advisers to our institutional shareholders would read it. A lotof the NGOs and key stakeholders around those sorts of things would read it,governments would read it. [CFO mining company]

Interviewees were aware of the growing focus on sustainability and corporateand social responsibility, and were almost unanimous that these concepts coin-cided with the effective economic management of the firm. Far from beingviewed as fringe topics to be paid lip-service only, the managers interviewed dis-played awareness of how these issues were viewed by the community at large,and had formed a coherent view on their future development.

5. Discussion and conclusion

This study is the first to apply the extended case method (Burawoy, 1998) todevelop an integrated picture of how senior executives make major finance deci-sions across capital budgets and investments, sources of finance, returns to share-holders, risk management and CSR, especially sustainability. It elucidatedfinance managers’ views about environment, social and governance (ESG) issues;brought some surprises to light; and helped resolve our puzzle of why – accord-ing to much finance research – experienced, highly educated and well-paidfinance managers seem to make poor decisions.We found considerable merit in the iterative process of developing theory, vali-

dating it using a mail survey, and then resolving key issues in face-to-face inter-views. The processes proved reinforcing, with the semi-structured interviewsparticularly strong in assessing qualitative decision stimuli and those that lieoutside normative depictions.In considering the puzzle of poor financial decision making, our most surpris-

ing finding was that decisions are dominated by qualitative and nonfinancial cri-teria. With investments, for instance, executives understood CAPM and othermodern financial techniques, but believed that their application – what severaltermed ‘doing the maths’ – was easy in comparison with identifying



opportunities, evaluating strategic factors such as markets and competition, andsuccessfully executing the investment. This recognised that wide error barsaround cash-flow forecasts did not support complex analysis; thus, several man-agers relied heavily on heuristics developed from previous investment decisions.A second important consideration was constraints on investments, principallyfrom labour shortages and competitor activity.The finance managers that we interviewed had rational explanations for their

decisions, which – despite being financial – did not unconditionally target finan-cial objectives. They saw their role as supporting broader business decisions, sothat – in their terminology – finance is transparent to the rest of the firm. Impor-tantly, none of these considerations can be identified using remote observationsof financial data.As a result of nonfinancial strategic objectives and constraints, executives

sought flexibility to quickly respond to business needs at low cost that emergedas a conscious drive to secure real options in investment. Few managers believedthat investors placed any significant value on future flexibility, but they sought itthemselves. Like markets, though, they were sceptical of value in ‘strategicinvestments’, except possibly for small-scale seed ventures, and demanded tangi-ble justification for all capital expenditures.A second important qualitative impact on financial decisions is pressure from

expectations of different stakeholder groups inside and outside the firm. Theseshaped firms’ decisions so they send favourable signals to meet clientele needsand satisfy rating agencies.Managers follow each of the standard risk management techniques (Mehr and

Hedges, 1963): avoidance, transfer (through insurance, sharing or hedging),retention (through self-insurance and diversification), and reduction (throughenterprise risk management). Many firms avoided countries with unreliable gov-ernments or poor workplace safety practices. They made extensive use of naturalhedging, especially through debt; and actively diversified risks, especially fund-ing. Each had strong, formal, usually embedded risk management programs toreduce operational and financial risks. Effective risk management – particularlya good safety record – was seen as directly linked to improved returns.Although concepts such as ethics and sustainability are relatively recent addi-

tions to the academic literature, managers reported that they tacitly underpinmany longstanding business practices. Most firms had explicit ethics policies –including peer reviews – that go well beyond mere legislative compliance. Thesenonvalues-based objectives had three motivations. The first was personal: a sta-ted commitment to ethics and sustainability that is close to a bias, perhaps irra-tional, or at least not justified in economic terms. The second is that ethics, inparticular, acts as a form of insurance to prevent the company from having itsexecutives adopt damaging practices. This was frequently informed by the com-pany’s experience, and seemed to be rational in that it is specifically aimed atavoiding the possibility of future value loss. The third, purely rational, motiva-tion was that strategies which are ethical and sustainable deliver superior



decisions as measured in financial terms: the most obvious example was evidencethat safe, energy-efficient plants have higher profitability. Looking ahead, eachexecutive anticipated that issues related to sustainability will become moreintense and pervasive, perhaps making their annual Sustainability Reports morewidely read and important than Financial Reports.Our interview data demonstrate the important conclusion that finance manag-

ers are conversant with modern financial techniques, but incorporate many non-financial stimuli in their decisions. In addition, these stimuli are oftenqualitative or otherwise not observable from outside the firm. In other words,finance decisions are not taken in isolation to unconditionally maximise theirincremental return, but are integrated into broad company strategies and aresubject to involuntary pressures from clienteles, labour and competitiveconstraints, and ESG objectives. Thus, it should not be a surprise to find thatvariables based on finance theory have limited ability to explain finance deci-sions. Managers seem to treat finance as a function akin to human relations orlegal whose decisions – despite having their own objectives – must supportbroader firm objectives.Interestingly, this interpretation matches that of Friedman (1970) who, in one

of the most-cited critiques of finance executives, concluded: ‘there is one and onlyone social responsibility of business – to use its resources and engage in activitiesdesigned to increase its profits.’ The onus remains on finance executives to ensuretheir decisions generate shareholder value.In conclusion, the style of field research inherent in the extended case method

has proven illuminating. It enables interaction between analysts and subjects thatis specifically excluded by studies using surveys and databases; it also enables iter-ations so theories from the literature can be validated through managers’ obser-vations and deviations from theory tested against other managers’ behaviour.

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Appendix 1

Interview Protocol

Finance decision Questions

Capital expenditure 1. How are capital budgets set? What limits/constraints apply?

Do they vary from year to year?

2. What procedures are used to develop and validate investment proposals?

3. What economic criteria are applied in investment decisions?

4. How is discount rate determined? How is project risk priced?

5. How are nondiscretionary/nonincome producing projects approved?

6. Does financing play any role in investment decisions?

7. Are investments post audited?

8. Are acquisitions treated differently? What motivates them?

9. How are asset sales evaluated?

Financing 10. What criteria are used in sourcing finance?

11. Does the firm have a target gearing level? Why?

12. When is external finance sought?

13. How is the choice made between debt and equity?

14. What is the preferred method of raising equity?

15. What is the preferred source of debt?

16. How is advice on funding strategies obtained?

17. What if any link is there to investing?

18. Is rating or market concerns an issue?

19. How is leasing evaluated?

Payout policy 20. How are dividends set?

21. Are stable dividends desirable? Is payout ratio fixed?

22. Are special dividends considered?

23. Can shareholders reinvest dividends? Why/why not?

24. What drives the decision on a share buyback?



Appendix 1 (continued)

Finance decision Questions

Corporate structure 25. Does the firm have a target size?

26. What drives the business unit (BU) mix?

27. Are BUs integrated for financial decision making?

28. Do investor preferences drive decisions on structure?

Governance systems 29. How are managerial biases addressed?

30. What influences come from executive compensation?

31. Does the Board operate efficiently?

32. Does the Board add value to corporate finance decisions?

Ethics and values 33. Do ethics or values (corporate social responsibility, SRI)

impact corporate finance decisions?

Risk management 34. How is insurance evaluated?

35. Is self-insurance seen as an option? Where?

36. What is your definition of risk?

37. What is the firm’s risk propensity?

38. How is risk managed?

General 39. What is the principal objective behind corporate finance

decisions? Profit, risk reduction?

40. Are business or other cycles important?

41. Are corporate finance decisions paced? How?

42. What influence does stock price have on corporate finance decisions?

43. What nonfinancial factors affect decisions? e.g. nature of

income or expenditure; competitors; analysts

44. What influence do clienteles – such as shareholders,

especially institutions – have?



Appendix

2Tab

le1a

Howfrequentlydoes

yourfirm

use

thefollowingtechniques

when

decidingwhichprojectsto

pursue?

Technique

%Always

oralmost

always

Mean

Size

P/E

Leverage

Rated

debt

Pay

dividends

Industry

Small

Large

Growth

Nongrowth

High

Low

Yes

No

Yes

No

Energy,

materials

andIT

Other

Internal

rate

ofreturn

72.06

2.88

2.27

3.37***

2.84

3.00

2.90

3.21

3.29

2.68*

3.10

2.32*

3.26

2.73

Net

presentvalue

70.59

3.04

2.70

3.32**

3.18

2.68

3.29

3.00

3.64

2.78***

3.14

2.78

3.06

3.00

Hurdlerate

60.61

2.55

2.25

2.76

2.60

2.42

2.77

2.57

3.09

2.29**

2.75

2.00

2.57

2.53

Payb

ack

period

56.72

2.54

2.48

2.58

2.44

2.78

2.32

2.69

2.48

2.55

2.67

2.21

2.95

2.37*

Sensitivity

analysis

50.75

2.42

2.03

2.71*

2.31

2.68

2.43

2.36

3.00

2.11***

2.53

2.11

2.89

2.23*

Earnings

multipleap

proach

35.94

1.81

1.59

1.97

1.46

2.72***

2.07

1.83

1.82

1.80

2.02

1.28*

1.89

1.78

Realoptions(w

hen

relevant)

26.56

1.41

1.48

1.35

1.40

1.41

1.57

0.92

1.52

1.26

1.28

1.72

1.67

1.30

Accountingrate

ofreturn

26.15

1.42

1.39

1.43

1.28

1.78

1.57

1.33

1.65

1.25

1.55

1.05

1.67

1.32

Discountedpaybackperiod

25.00

1.25

0.78

1.59**

1.22

1.33

1.07

1.67

1.61

0.94*

1.28

1.17

1.72

1.07

VaR

orother

simulationanalysis

17.91

1.07

1.03

1.11

1.08

1.05

1.20

1.23

1.32

0.92

1.06

1.11

1.47

0.92

EconomicValueAdded

(EVA)

15.38

1.05

0.68

1.32**

0.98

1.22

1.27

0.75

1.48

0.75**

0.93

1.33

0.94

1.09

Adjusted

presentvalue

12.50

0.73

0.52

0.89

0.74

0.72

0.62

0.92

0.87

0.60

0.83

0.50

0.72

0.74

Profitabilityindex

10.94

0.70

0.70

0.70

0.63

0.89

0.97

0.67

0.74

0.60

0.76

0.55

1.00

0.59

aRespondentsareasked

torate

onascaleof0(never)to

4(always).***,**,*denotesasign

ificantdifference

atthe1%

,5%

and10%

levelrespectively.

To

showtheim

pactoffirm

s’structuralfeatures,they

aredivided

into

twogroupsin

each

table,largelyto

beconsistentwithGraham

andHarvey’spresentation.

Smallfirm

shavemedianan

nual

salesbelow

$500million;growth

firm

shaveaprice-to-earnings

ratiogreaterthan

14;

andfirm

swithhighleverage

havea

debt-to-equityratioab

ove

0.30.Resultsin

thistableshowthat

discountedcash-flowtechniques

–NPVan

dIR

R–dominateother

methodsofproject

evalua-

tion.Ran

kingofthefirstsixproject-evaluationtechniques

(asmeasuredbythepercentage

ofrespondentswho‘A

lways’or‘A

lmostalways’usedatechnique)

isidenticalto

thatreported

inTab

le2ofGraham

andHarvey(2001).Largerfirm

sandthose

withrateddebtaremore

likelyto

employdiscountedcash-flow

techniques,although

afirm

’sgrowth

prospectshad

nonoticeableim

pactoninvestmentan

alysis.Alsoofnote

isthelack

ofsupportforsomecontemporary

project

evaluationtechniques

such

asVaR

analysisandreal

optionsan

alysis(even

whereitisseen

asrelevantto

thedecision).Ignoringthevalueofreal

optionsis

ofconcern

particularlywherethereisuncertainty

aboutfuture

cash-flowsfrom

theproject

(becau

seoffactors

such

asregu

latory

chan

ges,

the

response

ofcompetitors

andtechnologicalad

vances),an

dthefirm

has

ahighdegreeofflexibilityin

howitrespondsto

thesechan

ges.



Tab

le2a

How

frequentlywould

yourcompanyuse

thefollowingdiscountrateswhen

evaluatinganew

project

intheAustralian

market?Toevaluate

thisproject

we

would

use…

%Always

oralmost

always

Mean

Size

P/E

Leverage

Rated

debt

Pay

dividends

Industry

Small

Large

Growth

Nongrowth

High

Low

Yes

No

Yes

No

Energy,

materials

andIT

Other

Thediscountrate

forour

entire

company

63.07

2.62

2.21

2.94**

2.47

3.00

2.75

3.00

3.04

2.50

2.81

2.11

3.00

2.47

Thediscountrate

forthe

Australian

market

21.88

1.38

1.33

1.41

1.35

1.44

1.58

0.70**

1.57

1.23

1.29

1.58

1.41

1.36

Arisk-m

atched

discountrate

forthisparticularproject

22.95

1.39

1.67

1.18

1.58

0.88**

1.64

1.00

1.45

1.21

1.26

1.72

1.76

1.29

Adivisional

discountrate

13.11

0.80

0.56

1.00

0.76

0.94

0.93

1.00

1.00

0.61

0.98

0.39*

1.12

1.68

Adifferentdiscountrate

for

each

componentcash-flowthat

has

adifferentrisk

characteristic

(e.g.depreciationversusoperating

cash-flows)

6.45

0.60

0.75

0.47

0.65

0.44

0.68

0.60

0.70

0.42

0.64

0.50

0.82

0.51

aRespondentsare

asked

torate


4(always).**

denotessign

ificantdifference

atthe5%

level.Thisshowsthatover

60%

offirm

suse

asinglecompany-widediscountrate

toevaluatenew

projectsrather

than

onethat

reflects

therisk-profile

oftheproject,whichiscontraryto

themessage

delivered

inalm

osteveryintroductory

corporate

finan

cecourse(e.g.Welch,2009,p.398).Largerfirm

saremore

likelyto

use

acompany-w

idediscountrate.



Tab

le3a

Does

yourfirm

estimatethecostofequitycapital?If‘yes’howdoyo

udetermineyo

urfirm

’scostofequitycapital?

%Always

oralmost

always

Mean

Size

P/E

Leverage

Rated

debt

Pay

dividends

Industry

Small

Large

Growth

Nongrowth

High

Low

Yes

No

Yes

No

Energy,

materials

andIT

Other

UsingtheCAPM

74.36

2.92

2.50

3.07

3.00

2.77

2.73

3.22

3.44

2.37***

2.91

3.00

3.42

2.70

UsingtheCAPM

but

includingsomeextrarisk

factors

30.77

1.26

1.10

1.31

1.57

0.62**

1.41

1.00

1.27

1.05

2.17

1.09

1.75

1.04

Usingthefirm

’sshare

market

return

onequity

28.21

1.15

0.90

1.24

0.92

1.61

1.13

0.33

0.78

1.47

1.18

1.00

0.75

1.33

Byregulatory

decisions

23.08

1.03

1.80

0.76*

1.08

0.92

1.36

0.44**

1.17

0.68

0.94

1.50

0.33

1.33**

Usingthefirm

’saccounting

return

onequity

17.95

0.95

1.40

0.79

0.73

1.39

1.09

0.56

0.50

1.26*

0.82

1.67

0.67

1.07

Backoutfrom

adividend/

earnings

model

7.69

0.64

0.60

0.66

0.69

0.54

0.64

0.22

0.72

0.42

0.64

0.67

0.75

0.59

Whatever

ourinvestors

tell

usthey

require

5.13

0.51

0.80

0.41

0.65

0.23*

0.50

0.56

0.50

0.32

0.45

0.83

0.42

0.56

aRespondents

are

asked

torate


4(always).***,**,

*denotesasign

ificantdifference

atthe1%

,5%

and10%

levelrespectively.

When

estimatingthecostofequitycapital,over

70%

ofrespondentsutilise

thestan

dardCAPM

whichisalmostexactlythesameresultsas

reported

inTable

3ofGraham

andHarvey.



Tab

le4a

What

factors

affecthowyo

uchoose

theap

propriateam

ountofdebtforyo

urfirm

?

%Im

portan

t

orVery

Importan

tMean

Size

P/E

Leverage

Rated

debt

Pay

dividends

Industry

Small

Large

Growth

Nongrowth

High

Low

Yes

No

Yes

No

Energy,

materials

andIT

Other

Thevo

latility

ofourearnings

and

cash-flows

49.15

2.32

2.11

2.50

2.30

2.38

2.50

2.23

2.43

2.30

2.31

2.36

2.59

2.21

Finan

cial

flexibility(w

erestrict

debt

sowehaveenough

internal

funds

availableto

pursuenew

projects

when

they

comealong)

47.46

2.24

2.15

2.30

2.33

2.00

2.33

1.92

2.35

2.10

2.11

2.64

2.47

2.14

Ourcreditrating(asassign

edby

ratingagencies)

32.20

1.59

0.85

2.22***

1.63

1.50

1.63

1.54

2.83

0.67

1.69

1.29

2.12

1.38

Thetran

sactioncostsan

dfees

forissuingdebt

23.33

1.30

0.96

1.58*

1.30

1.20

1.42

0.85

1.57

1.10

1.33

1.21

1.41

1.26

Thetaxad

vantage

ofinterest

deductibility

21.31

1.30

0.93

1.61**

1.32

1.24

1.52

1.14

1.39

1.22

1.45

0.79

1.71

1.14

Welimitdebtso

ourcustomers/

suppliersarenotworriedab

out

ourfirm

goingoutofbusiness

20.34

1.15

1.22

1.09

1.18

1.07

1.21

0.64

1.09

1.17

0.98

1.71

1.47

1.02

Thepotential

costsofban

kruptcy,

near-ban

kruptcy,

orfinan

cial

distress

18.97

1.16

0.92

1.34

1.12

1.27

1.14

1.31

1.39

0.93

1.30

0.71

1.35

1.07

Thedebtlevelsofother

firm

sin

ourindustry

15.25

1.12

0.67

1.50***

1.09

1.19

1.30

1.15

1.39

1.00

1.31

0.50***

2.00

0.76***

Werestrict

ourborrowingso

that

profitsfrom

new

/future

projectscanbecapturedfully

byshareholdersrather

than

lenders

10.34

0.76

0.81

0.72

0.81

0.60

0.83

0.92

0.61

0.79

0.86

0.43

1.12

0.61



Tab

le4a(continued)

%Im

portan

t

orVery

Importan

tMean

Size

P/E

Leverage

Rated

debt

Pay

dividends

Industry

Small

Large

Growth

Nongrowth

High

Low

Yes

No

Yes

No

Energy,

materials

andIT

Other

Wetryto

haveenough

debtthat

wearenotan

attractive

takeovertarget

6.90

0.48

0.23

0.69**

0.35

0.87

0.45

0.62

0.52

0.48

0.55

0.29

0.88

0.32

Thepersonal

taxcostourinvestors

face

when

they

receiveinterestincome

5.17

0.52

0.54

0.50

0.51

0.53

0.62

0.38

0.57

0.31

0.59

0.29

0.76

0.41

Toensure

that

upper

man

agem

ent

workshardan

deffi

ciently,

weissue

sufficientdebtto

mak

esure

that

alarge

portionofourcash-flowiscommitted

tointerestpayments

3.45

0.57

0.58

0.56

0.56

0.60

0.66

0.62

0.35

0.66

0.64

0.36

0.88

0.44

Ahigher

debtratiohelpsusbargain

for

concessionsfrom

ourem

ployees

00.21

0.31

0.13

0.23

0.13

0.17

0.15

0.04

0.17

0.16

0.36

0.35

0.15

Ifweissuedebtourcompetitors

know

that

wearevery

unlikelyto

reduce

our

output

00.29

0.23

0.34

0.28

0.33

0.31

0.23

0.26

0.28

0.32

0.21

0.53

0.20


torate

onascaleof0(N

otim

portan

t)to

4(V

eryim

portan

t).***,

**,*denotesasign

ificantdifference

atthe1%,5%

and10%

level

respectively.Responsessupport

both

thetrade-offan

dthepeckingorder

theories

ofcapital

structure.Themost

importan

tfactorin

choosingdebtlevelwas

volatility

offirm

earnings

andcash-flowsthat

isconsistentwiththetrade-offtheory’ssuggestionthat

businessrisk,an

ditsim

pactontheprobab

ilityofthe

firm

beingin

finan

cial

distress,actsas

aconstraintonthelevelofdebtthat

afirm

canissue.Sim

ilarly,theim

portan

ceascribed

tothedebtlevelsofcompeti-

tors,thetaxdeductibilityofinterest

paym

ents

andpotential

ban

kruptcycostsfurther

supportsthenotionthatfirm

sareaw

areoftheissues

central

tothe

trad

e-offtheory.Survey

responsesalso

supportthepeckingorder

theory,as

isbestdem

onstratedbytherelatively

highlevelofim

portan

ceattributedto

the

notionthat

debtisonly

issued

when

thereareinsufficientinternal

fundsavailab

leto

fundcapital

expenditures.Im

portan

tly,

wefindthat

firm

sin

growth

industries

(Energy,MaterialsandInform

ationTechnology)rate

thisfactoras

more

importan

tthan

firm

soperatingin

other

sectors.A

reasonable

explana-

tionforthisisthatfirm

soperatingin

growth

industries

are

more

likelyto

beaff

ectedbytheinform

ationasym

metry

problem,whichisthefoundationofthe

peckingorder

theory.Ofnote,thetaxpositionofinvestors

isarelatively

unim

portan

tfactorto

firm

swhen

makingtheirdecisionas

towhether

toissueaddi-

tional

debt.Resultsagainare

similar

tothose

inTab

le6in

Graham

andHarveywiththetopfive

reasonsin

common.



Tab

le5a

What

other

factors

affectyo

urfirm

’sdebtpolicy?

%Im

portan

t

orvery

importan

tMean

Size

P/E

Leverage

Rated

debt

Pay

dividends

Industry

Small

Large

Growth

Nongrowth

High

Low

Yes

No

Yes

No

Energy,

materials

andIT

Other

Weissuedebtwhen

ourrecentprofits

(internal

funds)arenotsufficient

tofundourcapital

expenditures

35.09

1.77

1.62

1.90

1.98

1.25*

1.90

1.54

2.36

1.48**

1.70

2.00

2.35

1.53**

Usingdebtgivesinvestors

abetter

impressionofourfirm

’sprospects

than

issuingshares

12.50

0.73

0.44

0.97*

0.71

0.80

1.00

0.54

0.95

0.61

0.86

0.31*

1.24

0.51**

Weuse

debtwhen

ourequityis

undervalued

bythemarket

10.91

1.10

0.42

1.06**

0.73

0.93

0.59

1.00

0.73

0.81

0.83

0.62

1.47

0.47***

Weissuedebtwhen

interestrates

areparticularlylow

9.09

0.93

0.54

1.23**

0.90

1.00

0.89

0.92

1.00

0.81

0.95

0.85

1.31

0.77

Weissuedebtwhen

wehave

accumulatedsubstan

tial

profits

7.14

0.57

0.44

0.68

0.54

0.67

1.71

0.00

0.64

0.50

1.50

1.00

0.88

0.44

Wedelay

issuingdebtbecau

seof

tran

sactioncostsan

dfees

5.36

0.64

0.72

0.58

0.71

0.47

0.71

0.38

0.55

0.57

0.56

0.92

0.82

0.56

Wedelay

retiringdebtbecau

seof

recapitalisationcostsan

dfees

3.57

0.57

0.44

0.68

0.51

0.73

0.36

0.62

0.45

0.57

0.56

0.62

0.71

0.51

Chan

gesin

theprice

ofour

ordinaryshares

3.57

0.52

0.20

0.77***

0.67

0.49

0.46

0.36

0.50

0.61

0.60

0.23

0.88

0.36*

aRespondentsare

asked

torate

onascaleof0(N

otim

portan

t)to

4(V

eryim

portan

t).***,

**,*denotesasign

ificantdifference

atthe1%

,5%

and10%

level

respectively.Thisprovides

further

supportforthepeckingorder

theory

withdebtlargelyconsequentonweakcash

generation.Resultsaresimilar

toTable9

inGraham

andHarvey,

although

USexecutivesare

more

opportunisticin

theirstrategy

withthemostcommonfactorbeinglowinterestrates.



Tab

le6a

What

factors

influence

yourfirm

’sdecisionab

outitsdividendpayoutpolicy?

%Im

portan

t

orvery

importan

tMean

Size

P/E

Leverage

Rated

debt

Pay

dividends

Industry

Small

Large

Growth

Nongrowth

High

Low

Yes

No

Yes

No

Energy,

materials

andIT

Other

Abilityofthefirm

tomaintain

thelevel

ofdividendspaidout

50.00

2.19

1.45

2.69***

1.80

2.89***

2.37

2.38

2.55

2.21

2.40

0.50***

2.29

2.14

Levelofdividendspaidoutbythefirm

previously

44.44

2.04

1.41

2.47**

1.66

2.74***

2.15

2.46

2.15

2.21

2.25

0.33***

2.41

1.86

Surplusoffundsthat

cannotbe

currentlyinvested

inwealth-producing

projects

41.82

1.80

1.70

1.88

1.64

2.11

1.93

2.23

2.19

1.72

1.84

1.50

2.24

1.61

Leveloffran

kingcreditsavailableto

be

paidoutto

shareholders

40.74

1.80

1.64

1.91

1.54

2.26

2.07

1.85

1.85

1.93

1.85

1.33

2.24

1.59

Market’sresponse

tothefirm

’s

announcementofthedividend

33.33

1.44

0.82

1.88***

1.09

2.11**

1.63

1.54

1.55

1.55

1.58

0.33**

1.82

1.27

Costofreplacingfundspaidoutas

dividends

14.81

1.00

0.73

1.19

1.06

0.89

1.15

1.15

1.20

0.93

1.06

0.50

1.24

0.89


torate

onascaleof0(N

otim

portan

t)to

4(V

eryim

portan

t).***an

d**

denote

sign

ificantdifference

atthe1%

and5%

levelrespec-

tively.Consistentwiththepeckingorder

theory

andtheim

portan

ceofthesign

alsentthroughthedividenddecision,themost

importan

tfactors

considered

infirm

s’payouts

are

theabilityto

maintain

thedividendinto

thefuture

(andnotbeforced

todecreasetheamountifmarket

conditionsdeteriorate),whilst

ensuringthedividenddeclaredat

leastmatches

that

historicallypaid.Thismatches

longstan

dingtheory

(Lintner,1956)that

dividendscanbeexplained

in

term

sofreported

earnings

andhistoricalpayoutratios,an

dthat

dividendsareusedbyman

agersto

sign

alconfidence

infuture

cash-flows(A

llen

andMicha-

ely,

2003).In

jurisdictionssuch

asAustraliawheretaxationofcapitalgainsdiffersto

that

ofincomean

ddifferentshareholder

groupshavedifferentmarginal

taxrates,aclienteleeff

ectcanem

erge

andpayoutpolicies

respond–orcater–to

investordem

and(Bak

erandWurgler,2004),whichiswhyfran

kingcredits

areim

portant.



Tab

le7a

Has

yourfirm

ever

considered

conductingasharebuyb

ack?If‘yes’,what

factors

affectedyo

urfirm

’sdecisionsab

outconductingthebuyb

ack?

%Im

portan

t

orVery

Importan

tMean

Size

P/E

Leverage

Rated

debt

Industry

Small

Large

Growth

Nongrowth

High

Low

Yes

No

Energy,

materials

andIT

Other

Surplusoffundsthat

cannotbe

currentlyinvested

in

wealth-producingprojects

77.27

3.05

2.71

3.20

3.10

3.00

3.13

3.33

3.22

2.92

3.38

2.86

Leveloffran

kingcredits

availableto

bepaidoutto

shareholders

54.55

2.50

2.29

2.60

2.50

2.50

2.63

2.83

3.11

2.08*

2.25

2.64

Market’sresponse

tothefirm

’s

announcementofthebuyb

ack

54.55

2.50

1.43

3.00**

2.80

2.25

3.13

2.00

3.44

1.85***

2.63

2.43

Positive

impactonthefirm

’s

earnings

per

share

54.55

2.50

1.57

2.93**

2.60

2.42

2.88

1.83

3.22

2.00**

2.75

2.36

Buyb

ackproceedsfor

shareholdersrelative

tothe

receiptofordinarydividend

income

40.91

1.95

1.00

2.40**

2.30

1.67

2.25

1.83

3.22

1.08***

2.38

1.71

Costofreplacingfundspaidout

viathebuyb

ack

31.82

1.64

1.14

1.87

2.00

1.33

1.63

1.67

2.22

1.23*

2.25

1.29

Abilityto

conduct

thebuyb

ack

withoutcreatingan

expectation

that

itwillnecessarilyoccuragain

9.09

1.45

1.43

1.47

1.40

1.50

1.50

1.33

1.22

1.62

1.38

1.50

aRespondentsare

asked

torate

onascaleof0(N

otim

portan

t)to

4(V

eryim

portan

t).***,

**,*denotesasign

ificantdifference

atthe1%

,5%

and10%

level

respectively.Themostim

portan

trationaleforsharerepurchases

isthepresence

offree

cash-flows.Respondents

also

recogn

ised

theim

portan

ceoftheposi-

tive

sign

alconveyed

bythebuyb

ackan

nouncement,whichcanbeseen

asan

alogo

usto

thenegativesign

alconveyedbythean

nouncementofanequityissue

asper

thepeckingorder

theory.Theexpectedpositive

impactonEPSfrom

therepurchaseiscuriousbecau

se–unless

debtlevelswerereducedbyapropor-

tionateam

ount–an

yincrease

inEPSwould

also

beaccompan

iedbyanincrease

inthefinan

cial

risk

bornebyremainingshareholders,an

dtherefore

increase

theirrequired

return.Theabilityforfirm

sto

structure

repurchases

insuch

away

asto

pass

onlargevolumes

offran

kingcredits,an

drepurchaseforcash

considerationbelow

thetradingprice

ofthefirm

’sshares

isreflectedin

therelatively

highim

portan

ceattributedto

theleveloffran

kingcreditsavailable

to

bepassedonto

shareholders.



Documents

Narratives in managers' corporate finance decisions