We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. We find that a surprising number of firms use their firm risk rather than project risk in evaluating new investments. Firms are concerned about maintaining financial flexibility and a good credit rating when issuing debt, and earnings per share dilution and recent stock price appreciation when issuing equity. We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes. Key words: capital structure, cost of capital, cost of equity, capital budgeting, discount rates, project valuation, survey. 1 We thank Franklin Allen for his detailed comments on the survey instrument and the overall project. We

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This paper examines the ability of the risk-shifting hypothesis and the backdoor equity hypothesis to explain firms ’ decisions to issue convertible debt. Using a security choice model that incorporates pre-offer issue, issuer, and macroeconomic information, we document significant variation in the market reaction to new convertible debt issues depending on whether investors expect the motivation for issuance to be asset substitution or asymmetric information. Our results suggest that both motives explain the use and design of convertible debt. Some firms issue convertible debt instead of straight debt to mitigate the costs of bondholder/stockholder agency conflicts. Other issuers use convertible debt instead of common equity to reduce the costs of adverse selection. Thus, in contrast to standard securities like straight debt or common equity, which solve some financing problems but exacerbate others, hybrid securities such as convertible debt are seen as providing a more flexible funding choice that can solve conflicting financing problems. Financial economists study the security issue decision to understand more fully why firms choose to issue a particular security and how investors in financial markets react to that choice. The research documents several results about investor reaction to the announcement of

Venture capital ¯nancing is characterized by extensive use of convertible securities and stage ¯nancing. In a model where an entrepreneur obtains funding for a project from a venture capitalist, we illustrate an advantage of convertible debt over a mixture of debt and equity in stage ¯nancing situations. Essentially, when the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in window dressing and bias positively the short-term performance of the project, reducing the probability that it will be liquidated. An appropriately designed convertible debt contract prevents such short-termistic behavior since window dressing also increases the probability that the venture capitalist will convert debt into equity.

Many firms issue hybrid securities such as convertible debt instead of standard securities like straight debt or common equity. Theoretical arguments suggest that firms face high debt- and equityrelated external financing costs, and that convertible debt minimizes the sum of these financing costs for some issuers. Moreover, theory suggests that an appropriately designed convertible security provides efficient investment incentives. We show, however, that firms perform poorly following the issuance of convertible debt. Our empirical evidence suggests that the efficient investment decisions predicted by theory are not achieved by the actual design and issuance of convertible debt securities in practice. We suggest an alternative interpretation of convertible debt offers in which investors ration the participation of some issuers in the seasoned equity market. 2

Firms issuing convertible debt experience poor long-run stock price and operating performance. We examine the possibility that this poor performance may be caused by an unexpected increase in the cost of capital. Our finding that the cost of capital decreases following a convertible debt offer is inconsistent with this interpretation. We also provide evidence that idiosyncratic and total risk increases and that these increases are not related to corresponding changes in the issuer’s industry. The results are consistent with an interpretation that idiosyncratic risk affects investment decisions following convertible debt offers, which in turn adversely impacts future operating performance. Our empirical evidence reinforces the notion suggested in earlier studies that the efficient investment decisions predicted by theory are not achieved by the actual design and issuance of convertible debt securities in practice. 2

Over the last several years, a combination of loan losses and regulatory barriers to equity issuance have left Japanese banks starved for capital. In September 1995, the Mitsubishi Bank was permitted to issue a complicated convertible security in a foreign market. We value the security using standard option pricing methods, including a technique to handle the path-dependency of the security’s payoff. We find that the security was valued by investors at more than 20 percent below its theoretical value. We estimate the loss to Mitsubishi Bank’s shareholders from this difference at $420 million. Consistent with this analysis, an event study shows a statistically significant negative abnormal return to Mitsubishi Bank’s stockholders on the day after the first report of the security appeared in the Japanese financial press. We attribute the gap between market price and theoretical value to the security’s design, which offers investors a combination of payoffs they find unattractive. We argue the security’s design was heavily influenced by regulatory constraints. The loss suffered by Mitsubishi Bank’s shareholders represents a measurable private cost of regulation, against which the regulation’s social benefits, if any, should be weighed.

that have substantially improved content as well as presentation. All remaining errors and ambiguities remain the authors’.

this paper, we analyze a comprehensive survey on the practice of corporate finance. Perhaps the best-known field study in this area is John Linther's (1956) path-breaking analysis of dividend policy. The results of that study are still quoted today and have deeply affected the way that dividend policy research is conducted

This paper presents a didactic summary of arguments in many other articles. There are no original insights in this paper. I thank Toni Bernardo, Julian Franks, Heinz Zimmermann (the editor), students in my 230 and 231A classes at UCLA, and especially Claudio Loderer (the referee) for valuable comments. The author is responsible for all remaining errors, and, when it is not to complain about such an error, the author can be reached at ivo.welch@anderson.ucla.edu or the U.S. telephone number (310) 825-2508. NOTE: This article may be reproduced for academic or classroom use without cost. There is no need to clear use through the Copyright Clearance Center. This article is published in Finanzmarkt und Portfolio Management, 1995-2, with free copying permission indicated on the top page