Corporate Financial Decision Making in Canada

In recent years, Canadian corporations have been confronted with many changes, including tax reform, the free trade agreement, increased volatility in stock and foreign exchange markets, liberalization of Canadian financial markets, and the globalization of product and financial markets. To remain competitive and profitable in this environment, corporations will have to employ superior financial decision making skills to analyze investment decisions and to raise debt and equity capital, among other things. For public policy and corporate decision makers, it is equally important to understand how these changes can affect capital formation in Canada. This study, for the first time, provides direct empirical evidence about the financial decision processes followed by Canadian corporations. (1) In addition, our study addresses questions related to the qualitative and quantitative techniques being used by Canadian corporations in their capital budgeting decision, the process of arriving at their investment decision, the sources of capital to finance investment and their cost estimates, and the factors affecting capital structure and dividend policies of firms. The rest of the paper is organized as follows: the next section deals with existing (mostly non-Canadian) research in this area. The research methodology and data sources are described next. Individual sections on the five main areas explored in this study are then presented. The paper ends with summary and conclusions. LITERATURE REVIEW The existing literature on corporate financial decision making can be subdivided into five broad areas: the impediments to capital formation, the impact of foreign competition on capital formation, the capital budgeting process/techniques, the interaction of capital formation with the debt levels and cost of capital, and dividend policy. Figure 1 presents a representative list of publications in these areas. (Figure 1 omitted) A majority of the papers concentrated on the capital budgeting process/techniques used in the United States. Only two focused on the impediments to capital formation, including foreign competition, the interaction of capital formation and debt level, and the level of dividend payout. For example, Schall, Sundem, and Geijsbeek, Jr. (1978) concentrated on the usage of sophisticated capital budgeting methods whereas Klammer and Walker (1984) focused on project evaluation techniques. Using a questionnaire approach, Pohlman, Santiago, and Markel (1988) investigated cash flow estimation practices of large firms with a view to filling an important gap in the capital budgeting literature on how firms actually generate cash flow information used in their capital budgeting process. The most relevant research in terms of this study is the work by Blume, Friend, and Westerfield (1980, 1984) (BFW, hereafter) who concentrated on the non-financial and financial impediments to capital formation, the capital budgeting process and related financial decisions, and the prospective capital requirements and sources planned to be used in financing these requirements. Their first survey (1980) was conducted in order to gauge the evolution of the corporate financial decision making and assess the rate of capital formation in the U.S. as it varies across time. Based upon their sample of 50 of the 100 largest non-financial corporations listed on the New York Stock Exchange and 341 of the 1224 other NYSE-listed firms, BFW concluded that the most important impediments to capital formation in the U.S. in 1979 were taxation, inflation, the high cost and unavailability of external financing, government regulation, and the inadequacy of profits and internally generated funds. Their sample firms, at the time of the survey, regarded the costs of short-term bank debt and external equity as excessive. The use of discounted cash flow techniques for capital budgeting, such as the net present value rule or the internal rate of return, was documented to be on the increase with 80 percent of the responding firms using these methods. …