Presidential Address: Corporate Finance and Reality

John R. Graham is the D. Richard Mead, Jr. Family Professor at Duke University’s Fuqua School of Business. This post is based on his Presidential Address, delivered at the 2022 meeting of the American Finance Association.

In a traditional corporate finance framework, managers maximize shareholder value, form rational expectations, optimize corporate investment intertemporally, and invest in positive net present value projects, among other things. These principles only partially align with real-world decision-making. This gap between academic research and the practice of finance is reflected in the modest statistical fit of traditional corporate finance models and the even more modest ability to predict outcomes out-of-sample or provide quantitative guidance for specific companies. In a capital structure context, for example, Graham and Leary (2011) show that standard academic models explain about 10% of within-firm variation in leverage; analysis in this paper shows explanatory power is even worse out-of-sample.

To address the research-practice gap, it is important to start by understanding in detail what real-world companies do. In a corporate finance setting, we can use surveys to directly gather this information from the expert practitioners who choose actual corporate outcomes. A clear understanding of practice helps researchers understand whether the gap between research and practice might be caused by practitioner mistakes, deficiencies in academic models, or both. And when research and academic models do align, a clear understanding of practice helps us understand the mechanisms behind the corporate outcomes we usually study.

I gathered the data for this paper by surveying thousands of CFOs over many years. The survey data are used in two primary ways. The first is to comprehensively document key stylized facts of real-world corporate decision-making, with the goal of understanding how these elements affect corporate outcomes, knowledge that can in turn be used to discipline academic models. The paper studies a variety of corporate policies, including corporate investment, capital structure, payout, and corporate expectations and planning. Studying corporate planning is fairly new, even though planning is the foundation of many financial decisions and underlies the cash flow forecasts that are a staple of finance teaching and research. The paper updates and builds upon previous surveys of financial executives that coauthors and I conducted over the past 25 years (e.g., Graham and Harvey, 2001). Comparing the new surveys to previous surveys allows me to determine what has (or has not) changed. I detect a fair amount of ‘stickiness’ in corporate decision-making, which implies that the distance between theory and practice has largely held steady over the past two decades.

The goal of this paper is not just to describe the practice of corporate finance. The second key objective is to identify common themes that pervade corporate decision-making. One common theme is that in many instances companies focus on the near-term. CFOs say that the information in their corporate plans is only reliable two years ahead on average and that the reliable horizon has gotten shorter. This makes planning difficult and affects other corporate decisions, such as encouraging a focus on shorter horizon investment projects, frequent focus on the payback method and near-term cash flows in capital budgeting, and benchmarking debt to current cash flows rather than to long-term value.

The full paper discusses in detail another half dozen common practice of finance themes, which I mention here only briefly in the interest of space. Other common elements of real-world corporate finance include that managers misestimating the likelihood of very bad and very good outcomes, and so experiencing frequent surprises; managers using decision-rules that appear to be conservative, fairly simple, and “sticky” in that decision processes today are quite similar to those used decades ago; and managers overwhelmingly believing that their companies are undervalued and trying to time the market in response. Finally, CFOs say that the goal of the firm has shifted to increasingly emphasize stakeholders beyond just shareholders. The full paper explores how research can address and integrate these common elements of practice, in hopes of closing the research-practice gap and increasing the value of research to practitioners, policy-makers, and teachers.

The complete paper is available for download here, and a video presentation at 5:44 of the following link: https://youtu.be/henjrUBi22g.

References

Graham, John R., and Campbell Harvey, 2001, The Theory and Practice of Corporate Finance: Evidence from the Field, Journal of Financial Economics 60, 187–243.

Graham, John R., and Mark T. Leary, 2011, A Review of Empirical Capital Structure Research and Directions for the Future, Annual Review of Financial Economics 3, 309-345.

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