Corporate finance in Europe: confronting theory with practice

Financial Management (Financial Management Association), Winter, 2004 by Dirk Brounen, Abe de Jong, Kees Koedijk

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.