Fundamentals of corporate finance

We present the results o fan international survey of 313 European CFOs on capital budgeting, cost of capital, capital structure, and corporate governance. We find that although large firms often use present value techniques and the capital asset pricing model to assess the feasibility o[an investment opportunity, CFOs of small firms still rely on the payback criterion. In capital structure policy, financial flexibility appears to be the most important factor in determining the amount a/corporate debt. Corporate finance practice appears to be influenced mostly by firm size, to a lesser extent by shareholder orientation, and least by national influences.

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In this article, we conduct a survey on how professionals deal with different dilemmas within modern financial management. We measure the extent to which theoretical concepts have been adopted by professionals from a wide range of firms from the UK, the Netherlands, Germany, and France.

Recent studies have documented fundamental differences between the financial markets and systems when comparing the United States with Europe. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998) focus on the underlying disparities between the legal systems encompassing both continents, as well as on the relation between legal systems and the development of capital markets. Rajan and Zingales (2003) stress the continental differences by comparing the polar forms of financial systems: the institution-heavy relationship-based, more prevalent in Europe, and the market-intensive arms' length, more prevalent in the United States. Finally, from a corporate governance perspective, Chew (1997) shows how the Anglo-Saxon marked-based corporate governance system differs significantly from the relation-based or insider system, which is most widespread in Europe. In this study, we investigate the effect of the corporate governance system on individual firms and include this important issue in our overall analysis of European corporate finance practices. We conclude that the US and European financial markets and firms differ considerably. We contribute to the debate in the current literature by comparing the corporate finance practice of individual firms in both continental markets. We test whether the apparent differences in institutional settings translate into significantly different financial management practices.

To address theory with the behavior of financial managers in practice, we apply survey research. (1) We analyze many corporate finance issues, ranging from capital budgeting techniques to capital structure and corporate governance. Doing so allows us to link the different issues and to deepen our analysis.

Furthermore, we analyze the responses in our survey conditional on firm-specific characteristics. This approach enables us to test whether these factors drive the results. We sample a cross-section of 6,500 companies from the UK, Netherlands, France, and Germany. We collect 313 responses. The size of our sample represents one of the largest survey samples in the financial literature.

Survey research is relatively rare within the empirical corporate finance literature, in which most studies are based on large samples of financial observations. Although these large samples offer cross-sectional variations and the statistical power to analyze these variations, they are limited in their ability to deal with non-quantifiable issues. Our approach combines a relatively large sample with the ability to ask qualitative questions.

Survey research is also associated with some limitations. We measure beliefs rather than actions. In doing so, we implicitly assume that managers "do what they say they do." To test this assumption, we consider the consistency of the answers and where possible, compare our survey evidence with other research. Moreover, the anonymity of our survey stimulates frank responses. Another limitation of survey research is potential respondent bias. We take this drawback into consideration when we compose our samples and construct our questionnaire. Thus, we are able to limit this bias to the minimum.

By using an international sample we are able to assess whether existing insights on corporate finance practices documented by Graham and Harvey (2001) also hold outside the US. Furthermore, we address the corporate governance policy of firms, which enables us to investigate whether corporate governance differences influence the way in which firms organize their financial management. Finally, we extend the univariate results of Graham and Harvey (2001) by using multivariate regression analysis.

This study complements and adds to Bancel and Mittoo's (2004) survey of European CFOs (published in this same issue). We complement Bancel and Mittoo's work as we include questions on capital budgeting and cost of capital estimation and we study both public and private firms. Bancel and Mittoo focus exclusively on the debt policies of publicly listed corporations. Our data set facilitates cross-country comparisons, while Bancel and Mittoo cluster countries into four legal systems (their study covers 87 observations from 16 countries). We complement Bancel and Mittoo's analysis of legal systems and country-level governance characteristics, because we include firm-level corporate governance characteristics. We limit our discussion of the capital structure results to a comparison of the relative importance of the static trade-off and pecking-order theories.

Our results on capital budgeting show that European firms are still remarkably keen on applying the payback criterion, instead of discounting their cash flows by using the internal rate of return (IRR) or the net present value (NPV). Similar to their US colleagues, European CFOs determine their cost of capital using the capital asset pricing model (CAPM), rather than applying arithmetic-average historic returns or the dividend discount model.

Overall, we find that firm size is positively related to the use of the discounted cash flow method and the application of the CAPM. Smaller firms and firms less oriented towards maximizing shareholder value are more likely to evaluate their investment opportunities by using the payback period criterion and setting their cost of capital at whatever level their investors tell them.

For capital structure, we find smaller disparities between corporate debt policies. In all four national samples, respondents report that financial flexibility is the key factor when determining their debt structure. This result corroborates previous studies from the US.

Our main results show that corporate financial management practices are predominantly determined by firm size, to a lesser extent by shareholder orientation, and least by country of origin. Interestingly, we can relate our findings on the role of shareholder orientation to the international differences in legal systems and capital markets documented by La Porta et al. (1997, 1998), Rajan and Zingales (2003) and Chew (1997). We confirm that shareholder orientation prevails in the UK and in the Netherlands, but in the German and French firms shareholders are less important. We also find that in capital budgeting, the orientation towards shareholders induces managers to apply techniques that are based on maximizing the wealth of these stakeholders. However, in capital structure choice, we find neither a role for shareholder orientation nor strong country differences. Apparently the fundamentals of capital structure choice are independent of legal system and capital market development.

The article is organized as follows. In the next section, we present the sample collection procedures and sample statistics. Section II offers a comprehensive overview of our results on capital budgeting. Section III deals with the common practices regarding the cost of capital. Section IV focuses on our capital structure results. Section V concludes.

I. Data and Method

This section details the procedures we used to obtain our data and the robustness tests we performed. We also present our sample statistics.

A. Sample Collection Procedures

Our survey comprises four groups of questions. First, we use several questions to describe the firm and its CEO. Next, we pose questions on the firm's capital budgeting techniques and the ways in which the firm estimates its cost of capital. We continue by focusing on capital structure policy. We finish our questionnaire by asking firms about their goals and their perception of the importance of different stakeholders.

The starting point for our questionnaire is the survey of Graham and Harvey (2001). To facilitate a fair comparison of both sets of survey results, we ask exactly the same questions. In addition we add questions on the firm's goals and stakeholders.