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The Capital Structure Puzzle: The Evidence Revisited 8 Michael Barclay and Clifford Smith, University of Rochester

Do Managers Have Capital Structure Targets?

Evidence from Corporate Spinoffs

18 Vikas Mehrotra, University of Alberta, and Wayne Mikkelson

and Megan Partch, University of Oregon

How To Choose a Capital Structure: Navigating the Debt-Equity Decision 26 Anil Shivdasani, University of North Carolina, and

Marc Zenner, Citigroup Global Markets

Morgan Stanley Roundtable on Capital Structure and Payout Policy 36 lifford Smith, University of Rochester; David Ikenberry,

University of Illinois; Arun Nayar, PepsiCo; and Jon Anda

nd Henry McVey, Morgan Stanley. Moderated by Bennett Stewart, Stern Stewart & Co.

Bookbuilding, Auctions, and the Future of the IPO Process 55 William Wilhelm, University of Virginia and University of Oxford

Reforming the Bookbuilding Process for IPOs 67 Ravi Jagannathan, Northwestern University, and

Ann Sherman, University of Notre Dame

Assessing Growth Estimates in IPO Valuations—A Case Study 73 Roger Mills, Henley College (UK)

Incorporating Competition into the APV Technique for

Valuing Leveraged Transactions

79 Michael Ehrhardt, University of Tennessee

A Framework for Corporate Treasury Performance Measurement 88 Andrew Kalotay, Andrew Kalotay Associates

Morgan Stanley Panel Discussion on Seeking Growth in

Emerging Markets: Spotlight on China

94 Michael Richard, McDonald’s Corp., and Stephen Roach and

Jonathan Zhu, Morgan Stanley. Moderated by Frank English,

Morgan Stanley.

Trade, Jobs, and the Economic Outlook for 2005 100 Charles Plosser, University of Rochester

Leverage 106 Merton Miller, University of Chicago

In This Issue: Capital Structure, Payout Policy, and the IPO Process

VOLUME 17 | NUMBER 1 | WINTER 2005

APPLIED CORPORATE FINANCE

Journal of

A M O R G A N S T A N L E Y P U B L I C A T I O N



36 Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005

Morgan Stanley Roundtable on

Capital Structure and Payout PolicyFinancial Decision Makers’ Conference | New York City | December 9, 2004*

Photographs by Yvonne Gunner, New York

* Please see analyst certification and other

important disclosures starting on page 54.



Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005 37

ROUNDTABLE

Bennett Stewart: Good morning, and welcome to this discussion of corporatecapital structure and payout policy. I’mBennett Stewart, Senior Partner of Sterntewart & Company, and I’ll be serving

as moderator.

Although our two main topics are pretty closely related—in fact, it’s hard to talk aboutone without bringing up the other—we’veset up the discussion in two distinct parts.The first will focus on questions of overallcapital structure and financial planning: Ishere such a thing as an optimal capital struc-ure—a ratio of debt-to-total capital that is

most likely to maximize the value of a givencompany? If so, what are the critical factorsin setting a target leverage ratio? Should acompany’s capital structure be designed to

maintain at least an investment-grade rat-ing, or does this end up leaving substantialvalue on the table?

The second part of the discussion willocus on why and how companies are

distributing cash to their shareholders. In1997, the total dollars spent by U.S. com-panies in buying back stock exceeded totaldividend payments for the first time. Andhroughout the 1990s, dividends seemedo be an increasingly unimportant way of

distributing cash and providing returns to

shareholders. But with the passage of theBush dividend tax cut in 2003, and withU.S. companies now sitting on recordamounts of cash, we seem to be experienc-ing a comeback in dividends. Is this trendor real, and can we expect it to continue?

Directly related to corporate payoutpolicy is the matter of corporate invest-ment policy. A number of people haveattributed the build-up of cash on corpo-rate balance sheets to the hurdle rates now being used by managements to evaluate

corporate investment opportunities. The

suggestion is that many companies aresetting their hurdle rates well above theiractual cost of capital, possibly to reporthigher operating returns. If so, companiesmay be passing up promising M&A andother strategic investments. And, as any-

one who is familiar with the concepts of EVA or NPV can tell you, that’s a pre-scription for reducing value.

o explore these issues, our host Mor-gan Stanley has brought together a smallbut distinguished group of academicsand practitioners. At the far end of thetable is Clifford Smith, who is the Louiseand Henry Epstein Professor of Business Administration at the University of Roch-ester’s Simon School of Business. Since joining the Simon School in 1974, Cliff has

done research in corporate finance, finan-cial institutions, and risk management thathas led to 14 books and some 80 articlesin the top finance and economics journals.In the last 25 years, he has done as muchas any academic in finance to demonstratehow and why corporate executives can addvalue through capital structure, risk man-agement, and financial policies generally. And to go along with his research, Cliff has received 29 Superior Teaching Awardsfrom the students at the Simon School.

Next to Cliff is David Ikenberry, whois Chairman of the Finance Departmentat the University of Illinois in Urbana-Champaign. Dave has done a lot of work on stock repurchase—so muchthat I would describe him as the world’sforemost authority on the subject. Fora nice summary of Dave’s thinking inthis area, I would recommend an arti-cle called “What Do We Know Abouttock Repurchase?,” which appeared in

the Spring 2000 issue of the Journal of

Applied Corporate Finance . In the past

year, Dave has shifted his research focusto corporate dividend policy, and hisarticle called “Reappearing Dividends”in the most recent issue of the JACF isalso recommended reading.

Next to Dave is Arun Nayar, who is

Vice President and Assistant Treasurer atPepsiCo, Inc. As Arun will tell us, Pepsi hasbeen quite aggressive in recent years inspinning off its restaurants and bottlers,acquiring new businesses, buying back itsstock, and otherwise pursuing the interestsof its stockholders. Before joining PepsiCoin 2002, Arun served as President of ABBFinancial Services Inc. for ten years. Prior tothat position, he worked with WestinghouseElectric Corporation for more than 12 years,serving in various senior finance positions in

Pittsburgh, Saudi Arabia, and England.Next to Arun is Henry McVey, who is

Managing Director and Chief U.S. Invest-ment Strategist at Morgan Stanley. Beforeassuming his current position, Henry made a name for himself covering broker-age, asset management, and multinationalbank stocks. A few weeks ago he came out with a very interesting report on the cash-heavy balance sheets of the semiconductorcompanies—it was called “Bonfire of theInsanities”—and I’m sure he will be telling

us more about that soon.Last, and to my immediate left, is Jon

Anda, who is Managing Director andGlobal Head of Corporate Finance inMorgan Stanley’s investment bankingdivision. My own relationship with Jongoes back to the days of the old Continen-tal Bank, when we were both pretty muchstarting out. Since then, we’ve been onpanels together and have done work fora number of the same companies. Andbased on those experiences, I’m not a bit

surprised by Jon’s accomplishments.




Part I: Capital StructureThe Theory

Stewart: So, now that I’ve told you alittle about our panelists, let me begin by asking Cliff Smith to give us a very quick overview of the theory of capital struc-

ure. Cliff, what is the current thinkingin the academic finance profession aboutoptimal capital structure? Can a compa-ny’s debt-equity ratio play a major role inmanagement’s efforts to increase share-holder value? Or is financing policy, asModigliani and Miller suggested back in1958, pretty much “irrelevant”?

Cliff Smith: Thanks for the kind words,Bennett, and I agree with you that Modi-liani and Miller is the logical place to

begin this discussion. Most people inmy profession date the beginning of “modern” corporate finance to the publi-cation of the first M&M paper in 1958.That paper basically said that if youive me three assumptions—no taxes

paid by the corporation or its investors,no bankruptcy or other “contracting”costs, and no effect of financing choiceson managers’ investment and operatingdecisions—then the current market valueof the firm should not be affected by the

structure of the liability side of the firm’sbalance sheet. Given these three assump-ions, M&M showed that the right-hand

side of the balance sheet has no mate-rial effect on the eal source of corporatevalue—namely, the operating cash flowsenerated by the business over time.

M&M’s basic insight was that dif-erences in leverage and the kinds of

securities the firm issues are nothingmore than different ways of dividing uphe operating cash flows and repackaging

hem for investors. And as long as these

financing decisions don’t affect the “real”decisions in any predictable way—forexample, as long as the firm’s managersmake the same investment and operat-ing decisions whether the leverage ratiois 10% or 90%—financing decisions will

not affect the total value of the firm. Andby total value I mean the value of the debtand equity.

Stewart: Let me stop you there for a min-ute, Cliff. In my experience, a lot of CFOsmake decisions about capital structure atleast partly on the basis of the expectedimpact on earnings per share and returnon equity. In other words, by issuing debtinstead of equity, a company can increaseits EPS or its ROE as long as it earns a

return on the new capital that is higherthan its borrowing rate. But I gatherfrom your comments about M&M thatthis kind of leveraging effect should notbe expected to increase value.

Smith: That’s right. The message fromM&M is that these kinds of pro formaEPS and ROE effects are likely to be anillusion; or, as Stew Myers at MIT likesto say, there is no magic in leverage. When companies issue debt, their ROE

will go up if the return on incrementalcapital exceeds the after-tax borrowingrate. But I don’t have to tell anyone inthis room that this is not an acceptablestandard of profitability. The problem with this strategy, as M&M showed, isthat as companies take on more finan-cial leverage, the risk of the equity goesup along with it. And as the risk of theequity increases, stockholders raise their required rate of return and the P/E ratioof the firm goes down. The net effect is a

wash; total firm value remains the same.

M&M made a similar argument aboutcorporate dividend policy. Using essen-ially the same assumptions—no taxes orransactions costs and a fixed investment

policy—they showed that a dollar of divi-dends paid is a dollar of capital gains lost,

and overall value is unchanged.Now, these are explanations for why

capital structure and dividends don’t mat-er. And though they’re arguments that it

probably takes an academic to love, we canderive a good deal of managerial insightabout why financial decisions might mat-er just by taking the M&M statements

and turning them on their heads. Thatis, if changes in capital structure and divi-dends do affect corporate market values,it’s for one of the three reasons that Miller

and Modigliani assumed away. First, therm’s choice of financing and dividend

policy can affect the taxes of the firm orits investors. Second, financing and pay-out policy can affect information costs orcontracting costs, including the costs aris-ing from bankruptcy or financial distress. And third, the firm’s capital structure, and whether it chooses to retain or pay outcorporate cash, can affect management’soperating and investment decisions.

Stewart: If I can put a slightly different wist on what you’re saying, Cliff, thereare three potentially important consider-ations or goals in making the corporateleverage decision: holding down taxes;preserving enough financial flexibility o avoid distress and invest in all posi-ive-NPV opportunities; and paying out

excess capital to encourage managers tooperate efficiently and walk away frombad investments. Of these three goals, which seems to carry the most weight in

corporate decision-making?

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Smith: It depends on what kind of company we’re talking about. In 1977,

tew Myers wrote a classic paper called“Determinants of Corporate Borrow-ing” that started out by viewing thevalues of all companies as having twocomponents: “assets in place,” whichare the more or less tangible assets thatenerate the firm’s current earnings or

cash flows; and “growth options,” whichcan be thought of as opportunities tomake future investments that comeout of the firm’s current operations andcapabilities. He went on to explain why

companies whose value reflects mainly

assets in place—people here at Mor-gan Stanley would probably call them

“value” companies—tend to use muchmore debt than firms whose value comesmostly from growth options. The dan-ger in using debt to finance growthcompanies was identified by Myers asthe “underinvestment problem.” Thebasic argument was that debt-financedcompanies, when faced with a drop inoperating cash flows, are more likely topass up positive-NPV projects than firmsfinanced mainly with equity. To me,that’s a pretty convincing explanation

for why growth companies in general

carry little debt, and why many in facthave negative leverage—more cash than

debt on the balance sheet.But now let’s turn to the case of so-called value companies, or firms inmature industries with few major invest-ment opportunities and whose valuecomes mainly from their current earn-ings. These kinds of companies face what my former Rochester colleagueMike Jensen has called the “free cash flow problem.” By that he means the tendency of managers in mature, cash-generatingindustries to use their excess cash to

undertake low-return investments—to

For growth companies, the emphasis is on

preserving fi nancial fl exibility to carry out

the business plan, which means minimal

debt and low payouts, if any. For compa-

nies with limited investment opportunities

that generate a lot of cash, paying out free

cash fl ow and reducing corporate taxes

are likely to be the major concerns. In the

extreme case of LBOs or other highly

leveraged transactions, the tax shelter

from debt can be a signifi cant source of

value. But even in those deals, I think the

incentive benefi ts from using high leverage

to concentrate the equity ownership and

drive effi ciency outweigh the tax benefi ts.

Cliff Smith

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destroy value by pursuing growth at theexpense of profitability. Both debt anddividends can play an important rolein resolving this problem; both can beused by management to make a cred-ible commitment that the firm’s excess

cash is going to wind up in the investors’pockets instead of being wasted on somecorporate white elephant.

So, Bennett, the short answer to yourquestion has to do with the relationbetween financing decisions and corpo-rate investment incentives. For growthcompanies, the emphasis is on preserving

nancial flexibility to carry out the busi-ness plan, which means minimal debtand low payouts, if any. For companies with limited investment opportunities

hat generate a lot of cash, paying out freecash flow and reducing corporate taxesare likely to be the major concerns. In theextreme case of LBOs or other highly lev-eraged transactions, the tax shelter fromdebt can be a significant source of value.But even in those deals, I think the incen-ive benefits from using high leverage to

concentrate the equity ownership anddrive efficiency outweigh the tax benefits.

What does this mean for most publiccompanies? There’s a nice study by John

Graham at Duke that shows that for theaverage publicly traded corporation—and let’s say it’s a company with a marketleverage ratio of 25%—the tax benefit of debt can be viewed as contributing about5-8% of its current value. This findingsuggests to me that, for most publicly raded companies, reducing taxes is

likely to be a second-order priority. Mostimportant are growth companies’ con-cerns about maintaining flexibility andvalue firms’ commitment to paying out

heir free cash flow.

Stewart: Cliff, before we move on to ourother panelists, there’s another questionabout debt and taxes that’s been puzzlingme. Many of the high-tech companieshave also issued a lot of stock options;and when those options are exercised by

the employees, the companies receive very large tax deductions based on the gains.It seems to me that this is another reason why a firm like Microsoft appears to haveignored the tax benefit of debt financing.But, as Microsoft and other companiesshift their employee compensation fromstock options to restricted stock, will thatincrease the effective marginal tax rate of the high-tech community and perhaps itsappetite for debt?

Smith: Well, as has become evenclearer to me from listening to someof the sessions here this morning, the job of the CFO is a pretty demandingand all-encompassing one. It’s critically important that a company’s financingdecisions be coordinated with its strat-egy and operations—and this includesits compensation and HR policies.Trevor Harris and Dick Berner of Mor-gan Stanley were talking earlier aboutthe problem of managing long-lived

corporate liabilities like pension andpost-retirement healthcare benefits. And as they pointed out, these legacy costs are fixed obligations of the firm,even if they don’t show up on a tradi-tional GAAP balance sheet. Whenmaking the firm’s financing decisions,the CFO has to think in terms of an eco-nomic balance sheet that takes accountof those obligations. So, the greater thefirm’s unfunded pension and healthcareliabilities—and, I might add, the larger

the allocation of stocks in the pension

und—the lower is the firm’s optimalleverage ratio.

But, to return to your original ques-ion, Bennett, I suspect that Microsoft’s

past decision to avoid both debt and divi-dends had something to do with the tax

shelter provided by the exercise of stock options. I also think its recent decisiono pay a $30 billion special dividend had

a lot to do with the Bush tax cut; in fact,hat tax cut was probably a necessary

condition for the dividend to even beconsidered. But the more fundamentalexplanation for Microsoft’s new payoutpolicy is that the company now clearly has far more capital than can be profit-ably reinvested in the business.

A Corporate Perspective:The Case of PepsiCoStewart: Thanks, Cliff, for that over-view of the theory. Let’s now turn to Arun Nayar and the practice of financeat PepsiCo. Arun, would you tell us how you think about capital structure pol-icy? What are the elements that go intoyour analysis, and do you have a targetcapital structure that reflects the thingsCliff was talking about—things likeaxes, financial flexibility, and the firm’s

investment policy?

Arun Nayar: The most critical issue forus in making our financing decisions atPepsiCo is our business strategy. Our cap-ital structure is designed to support andhelp drive the strategy of the company.

To provide a little context, PepsiCois a consumer products company ina dynamic industry with lots of oppor-unity for global investment and consol-

idation. And very much consistent with

what Cliff was saying, it’s important for

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us to maintain a capital structure thatives us enough financial flexibility to

capitalize on “tuck-in” opportunities ashey emerge in the marketplace.

We design our capital structure withhe aim of preserving broad access to all

he key capital markets around the worldunder almost all conceivable market con-ditions. And this means that we need tomaintain a high investment-grade rating.To that end, we have recently been some- where between a strong A and a low AA.For us to stay around the midpoint of thatrange, our analysis suggests a leverageratio of about 20% debt as a percentageof the book value of our total capital.

In conclusion, our bond rating is aallout of our capital structure strategy

rather than the driver of it.

Stewart: Arun, just for the sake of argu-ment and to provoke some discussion, letme challenge you a bit on this. It seemsto me that PepsiCo, even while pursuinga global investment strategy, could useconsiderably more debt than it does now,

perhaps even twice as much. Your stock price volatility is about 20% per annummeasured over the past five years, whichputs you among the least volatile stocksin the Russell 3000. Over the past fiveyears, your sales have grown about 5%per annum on average, your company generates a very strong cash flow, andyou have an enviable portfolio of con-sumer branded products. As you say, theratio of the company’s debt and leases tototal capital is about 20%. But, as a per-

centage of the market value of its total

capital, the leverage ratio is only about4%. So, my question is this: WouldPepsiCo’s value be higher if the com-pany operated with more debt, eitherbecause of lower taxes or better spendingdiscipline? To put the question another

way, is the company paying a high priceto maintain its financial flexibility, ordo you feel pretty confident that yourinvestors are focused on your growthopportunities and are wil ling to give youthat flexibility?

Nayar: My sense from talking to inves-tors is that PepsiCo tends to be viewedas a growth company, particularly by investors representing the buy side. Thismeans that the market is expecting us to

grow our revenues and earnings while

Our stockholders want growth in revenues

and earnings. But, as we’re keenly aware,

our investors also want high returns on

capital. And this makes getting the right

capital structure a balancing act. It’s a mat-

ter of preserving enough fl exibility to carry

out our business plan while also making

sure that we don’t have too much capital.

That last part of the equation is what our

dividend and buyback policies are designed

to accomplish. Our policy is to return 100%

of our free cash fl ow in one way or another

to our shareholders.

Arun Nayar

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still providing acceptable returns on capi-al. And the way we accomplish this is by nding and investing in growth opportu-

nities. To use Cliff Smith’s terms, we are arm with lots of valuable growth options,

and our financing policy is designed to

enable us to exercise those options when we find them.

And let me also point out, Bennett,hat your calculations of our leverage

ratios are misleading. They fail to takeaccount of an important element of ourbusiness model. For those of you whoare not familiar with that model, Pep-siCo has a beverage business and a snack ood business. A big part of our beverage

business has effectively been outsourced.That is, although we manufacture the

concentrate or syrup, we sell it to ouranchor bottlers; the bottlers convert thesyrup into the final product and thendistribute the product to the consumer.The anchor bottler business, althoughonce wholly owned by PepsiCo, wasspun off in 1999 and has been indepen-dently owned since then. We continueo have a material ownership stake inhese businesses, but the majority of the

stock is publicly owned. So these busi-nesses are independently owned, and

independently operated and managed—and because the businesses generate very stable cash flows and have fairly modestrequirements for outside capital, they operate with considerably higher lever-age ratios than our own.

Now, the important point here is that when the rating agencies look at ourrating, they look at the leverage of thecombined system. Even though we only uarantee some of our bottlers’ debt,he agencies combine all of our bottlers’

debt with our own under the assumption

that the financial health of our bottlers iscritical to our future success and going-concern value. So, when designing ourcapital structure—and we spend a lotof time thinking about it—we have tobalance the rating agencies’ concerns

against those of our equity investors ina way that satisfies both.

o, again, our stockholders wantgrowth in revenues and earnings. But,as we’re keenly aware, our investors also want high returns on capital. And thismakes getting the right capital structurea balancing act. It’s a matter of preservingenough flexibility to carry out our busi-ness plan and tuck-in acquisitions whilealso making sure that we don’t have toomuch capital. That last part of the equa-

tion is what our dividend and buyback policies are designed to accomplish.

Investors’ PerspectiveStewart: Thanks, Arun. And sinceyou’ve mentioned your stockholders anumber of times, let’s turn now to Henry McVey to get an equity investor’s perspec-tive on these issues. Henry, as Morgantanley’s chief U.S. investment strategist,

how do you view PepsiCo? Is it a fairly mature value company that could make

greater use of debt to reduce taxes andraise returns by increasing efficiency? Oris it a growth company that needs aboveall to preserve its flexibility?

Henry McVey: We view Pepsi as agrowth stock. We think managementis doing the right thing with its capital. And as long as they—or any company—continue to use their capital to fundpromising investments and return theexcess in the form of dividends and

buybacks, we’re going to give them the

benefit of the doubt and let them financehe business as they see fit.

But, Bennett, there are a numberof sectors in the U.S. economy today where your question is right on target.It’s a question that investors in many

of the largest-cap growth stocks in the&P 500 are asking themselves right

now. The reality is that a lot of thesecompanies are no longer growth stocks,but they haven’t adjusted their balancesheets and payout policies to reflect thischange. The U.S. semiconductor indus-ry is a good example. In the industry

report that you mentioned earlier, I wrote that almost every major player has

ar too much cash on the balance sheet.In fact, just a few days after that report

was released, Intel announced that it wasdoubling its dividend.

o, in looking at today’s market, Iend to put all companies into one of two

buckets—and though the buckets aresomewhat related to Cliff’s distinctionbetween mature and growth companies,hey’re not the same. My classification

system has more to do with whether wehink companies have the right package

of financing policies and growth oppor-unities, or whether the package needs

o be changed. On the one hand, if webasically approve of how a company isinvesting its capital in the business, thenhat’s a company that we’re probably oing to consider recommending. As

I said before about PepsiCo, we’re fine with just letting such companies grow.On the other hand, if a company makespoor acquisitions or its growth slows andmanagement fails to recognize that andpay out the excess capital, that’s where we think the business model needs a

undamental restructuring. That’s how

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we tend to view the big pharma compa-nies, for example, where investors havereassessed the growth prospects of essen-ially the entire sector.

The High-Leverage ModelStewart: What you’re essentially talk-ing about, Henry, are changes in payoutpolicy rather than changes in capital

structure—though, as I think we would

all agree, an increase in the payout hasthe effect of increasing a company’sleverage ratio. But before we leave thesubject of capital structure behind, letme describe the kind of value that mightbe achieved with a more aggressive useof leverage.

A case that comes to mind is thatof Ball Corporation, a $5 billion aero-

space and packaging company. In the

early 1990s, the company adopted anEVA performance measurement andincentive system that really focusedmanagement on increasing their returnson capital. They sold their glass packag-ing business to Saint-Gobain and spunoff a group of non-core manufacturingbusinesses into Alltrista. Since then,they have also made major investments

in China and in Asia generally, and

In looking at today’s market, I tend to put allcompanies into one of two buckets. My classi-

fi cation system has more to do with whether

we think companies have the right package

of fi nancing policies and growth opportuni-

ties, or whether the package needs to be

changed. On the one hand, if we basicallyapprove of how a company is investing its

capital in the business, then that’s a company

that we’re probably going to consider rec-

ommending. We’re fi ne with just letting such

companies grow. On the other hand, if a com-

pany makes poor acquisitions or its growthslows and management fails to recognize that

and pay out the excess capital, that’s where

we think the business model needs a funda-

mental restructuring.

Henry McVey

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hey made a billion dollar acquisition inEurope in 2002, in addition to acquir-ing the metal beverage container assetsof Reynolds Metals in 1998. Their salesrowth rate has been 13% a year for the

past five years. Perhaps most remark-

able of all, they’ve gone through thisentire period of growth and investment without an investment-grade bond rat-ing. The company operates with a 67%ratio of debt to total capital, its marketleverage ratio is now about 40%, and itsbond rating is BB-. In fact, they will tellyou that they work hard to avoi becom-ing an investment-grade credit; and yetif you’d invested $10,000 in their stock in 1994, you would have $65,000 today versus $25,000 in the S&P 500.

ARAMARK is another example of his strategic use of leverage. The com-

pany went private in the 1980s, andhen became a serial re-capitalizer. Every hree years or so, they would borrow a

large amount that would be used eithero make a major acquisition or to buy

back outsiders’ equity, thereby increas-ing management’s equity stake. Then, in2002, the company went public again.But they still operate with a 75% book debt-to-capital ratio—and a 44% debt-

o-market value ratio. And I think thiskind of high-leverage strategy ends upadding a lot of value for companies like ARAMARK. It gives them a very low weighted average cost of capital—and

hey have solved their free cash flow problem through large share repurchases

nanced by debt.But, as head of corporate finance at

Morgan Stanley, Jon Anda is much moreamiliar with such highly leveraged com-

panies and transactions than I am. Jon,

would you give us your view of Ball Corp.

and what you think it says, if anything,about the optimal capital structure formost publicly traded U.S. companies?

Jon Anda: Bennett, as you know, I’ma big fan of Ball Corp. and its financ-

ing approach. It’s a great illustrationof a company that has executed a suc-cessful growth strategy while makingaggressive use of leverage. It shows that,even for companies without investment-grade ratings, our financial markets willprovide funding when they like whatmanagement is doing with the capital.

But I also agree with Cliff’s distinctionbetween mature and growth companies,and, in thinking about public compa-nies, I like to start with Henry’s concept

of the two buckets. If you’re a company that generates lots of cash while produc-ing returns on invested capital close toyour cost of capital, then fine-tuningyour capital structure could become very important. In fact, if you don’t make useof leverage in such cases, then a financialsponsor like Blackstone is likely to doit for you. But if you’re a company thatis producing—or is capable of produc-ing—very high returns and you needlarge amounts of outside capital to do it,

then you’re going to be a lot more conser-vative in using debt. And there may be good reason for this

conservatism. If you go back in time twoor three years, the spreads even on invest-ment-grade bonds widened dramatically; we had lots of fallen angels, and single-A credits were trading at 400 basis pointsover Treasuries. So, even though spreadsare a fraction of that today, it’s no surpriseto me that companies aren’t lining up todo leveraged transactions. Now, there have

been a number of eleveraging trades in the

market, like the ARAMARK transactionsyou mentioned. But these releveragingsare being done mainly by financial spon-sors who paid five times cash flow and arenow looking to transfer ownership.

o, while I understand the case for

high leverage in certain circumstances,leverage doesn’t play much of a role inour dialogue with clients these days; it’s just not what people seem to be think-ing about.

Stewart:Since you mentioned Blackstone,let’s consider how the private equity com-munity looks at these issues. The companiesowned by private equity investors typically use as much debt as they can raise, botho concentrate ownership and to minimize

heir cost of capital. Do you think the will-ingness of private equity investors to pay premiums for public companies has any-hing to do with the companies’ failure to

use their debt capacity?

Anda: In the eyes of private equity inves-ors, a significant part of the value comesrom the capitalized value of the tax

shields provided by the debt—and publiccompanies could realize some of that valueby levering up and having the stream of

ax shields capitalized as a perpetuity.But I think private equity takes a funda-mentally different approach to increasingvalue than most public companies. Mostimportant, private equity investors haveshorter, well-defined investment hori-ons; when they go in, there is almost

always a plan to exit the business.In my recent dealings with financial

sponsors, I’ve been seeing a lot of turnoverin their portfolios of companies, and thisurnover seems to be accelerating. And

here’s often a good deal of opportunism

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behind these leveraged deals that involvesa kind of arbitrage of public markets. Forexample, in some of the recent multi-bil-lion dollar LBOs involving natural resourceand chemical companies, my sense is thathe buyout firms saw a lot of upside in the

commodity price cycle that was not beingreflected in the companies’ stock prices. And using leverage of 80% or more, the

nancial firms have taken these companiesprivate with the idea that they can makesome operating improvements and theneither sell the businesses or take them pub-lic again after a few years.

Now, I agree with your point that,or companies with very stable cashows and few investment opportunities,he possibility of an LBO is something

hey need to keep in mind. But I don’tsee most large public companies as LBOcandidates; their investment require-ments are generally too large and toorisky for private equity investors.

And if you ask me what our corporateclients are thinking about these days, it’snot about the possible gains from lever-aging up and minimizing their WACC.The big topic is corporate liquidity.Companies today are awash in cash. Athe moment, corporate cash holdings

of the S&P financials amount to about5% of total debt, as compared to a his-orical average of 20-25%. And in theech sector, cash represents 27% of total

assets. Corporate managements are say-ing, “We’ve got so much money that wedon’t know what to do with it. How do we get it back to shareholders? Should itbe through dividends or buybacks—orhow about a special dividend?”

As Arun was saying earlier, when youmake these decisions, you have to start by

ocusing on the asset side of the balance

sheet. You’ve got to figure out what kindof investment opportunities you have andthe amounts of capital they will require. And having gotten a good fix on yourinvestment requirements, you can thenstart thinking about your capital struc-

ture and how much cash you should bepaying out.

Part II: Payout PolicyThe Theory

Stewart: Thanks, Jon. That’s a greatlead-in to the second part of our discus-sion. So let’s turn to Dave Ikenberry, ourresident academic expert on corporatepayout policy. I earlier introduced him asthe world’s foremost authority on the subject of stock buybacks, so let me ask him

to start by telling us why companies buy back their stock. And while you’re at it,Dave, would you also comment on why,and under what circumstances, dividendsmight provide a more cost-effective way of distributing capital than buybacks?

David Ikenberry: Let’s start with thequestion of why companies repurchasetheir shares. When we talk to CFOs andpractitioners, we hear a variety of storiesand motivations—but underlying all

this variety, there are clearly some com-mon themes, and I’ve come up with aclassification scheme that groups theminto four major categories. The catego-ries are not mutually exclusive; in fact,some companies could be buying back shares for all four of these reasons. Mostof these explanations apply to dividendsas well, though to varying degrees.

One common explanation for stock buybacks is that they provide compa-nies with a way of adjusting their capital

structure. If a company feels it has too

little debt and more equity than it needs,buying back stock can restore the properdebt-equity balance. And for companieslooking to make very rapid and dramaticchanges in leverage ratios, both fixed-priceoffers and Dutch auctions financed by

new debt offerings provide ways of doingthis. Open market repurchases can havethe same effect, but gradually and overtime. And the same is true of dividends.The payment of a dividend effectively increases a company’s leverage ratio—andthe announcement of a dividend increasereduces a firm’s debt capacity.

A second motive for repurchases—one that applies equally to dividends—isone that we’ve already discussed: namely,to pay out a company’s free cash flow, or

the excess cash that cannot be profitably reinvested in the business and that may be wasted if left on the balance sheet. Now,you often hear analysts and other com-mentators criticize stock repurchases as amanagerial admission of failure, a sign of management’s lack of imagination. But while such criticism may be appropriatein a handful of cases, it generally com-pletely misses the point of a repurchase.In most cases, buybacks are manage-ment’s way of telling their shareholders

that the company has more capital thanit can profitably employ. Far from beingan admission of failure, it’s a statementof their responsibility to shareholdersto invest only in positive-NPV projects. And when viewed as part of a broadeconomic cycle, both repurchases anddividends provide a means of liberatingcapital from mature, though perhaps stillquite profitable, companies and channel-ing that capital into growth companies.In this sense, buybacks and dividends are

an important part of the natural growth

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and maturation cycle that all companieso through. They help move capital fromhe old economy into the new economy.

Viewed in this light, repurchases anddividends are a way for managers to say o the capital markets, “Here is my excess

cash, take it; you have better opportunitiesor it than we do.” Despite the objections

of some analysts, the markets generally react favorably. And the markets also, of course, tend to respond well to announce-ments of increases in dividends.

A third major motive for repur-chases—and here is where they partcompany from dividends—is that they provide a more flexible, tax-advantagedsubstitute for dividend payments. Financeacademics have been struggling for years

o try to understand why companies pay dividends in the first place, given their taxreatment. Repurchases provide a moreax-efficient approach to paying excess

capital, even with the recent change inhe tax law. And besides reducing investoraxes, repurchases also give management

a great deal more financing flexibility han dividends. Whereas dividends are

expected to be paid every quarter, buy-backs can be accelerated or deferred inresponse to changes in the firm’s profit-

ability or investment requirements.Consistent with this idea of dividendsubstitution, traditional cash dividendsas a percentage of total corporate distri-butions fell sharply during most of the1990s, a period when repurchases weresurging. As Bennett mentioned earlier,1997 was the first year in U.S. history hat more cash flow was returned to

shareholders in the form of repurchaseshan dividends. But starting around

2000, this trend began to reverse itself;

and with the maturing of growth compa-

nies like Microsoft and some help fromthe Bush tax cut, we’ve seen a majorresurgence of dividends—and I’ll comeback to this in a minute.

he fourth common motive for bothstock buybacks and dividends is to “sig-

nal” management’s confidence aboutthe firm’s future earnings power—and,in some cases, management’s sense thatthe firm is undervalued. There’s no clearconsensus among academics today about whether dividends or repurchases are themore effective way for managers to signaltheir confidence to investors. On the onehand, a company’s existing stockholdersbenefit when management ends up buy-ing back lots of shares at what turn outto be bargain prices—and this, of course,

gives managers an incentive to buy back stock when they think the firm is under-valued. On the other hand, one couldargue that raising the dividend representsa firmer commitment to pay out excesscash than the announcement of an openmarket repurchase program (though fixedtenders and Dutch auctions are a differ-ent story). And the research we have at themoment suggests that, at least for valuecompanies, dividend increases may now be a more effective signal than buybacks.

But the kind of information that’sbeing signaled by a dividend increaseis not clear. Rather than higher futureearnings, as in most of the signalingstories told by academics, the messagebeing sent to investors may just be one of more disciplined financial management,a firmer commitment to pay out the firm’sexcess cash flow. And that brings us back to the point where Cliff started.

Stewart: Dave, you’ve mentioned four

reasons to buy back stock. But isn’t there

a fifth motive—to increase earnings pershare? That’s one we tend to hear quiteoften both from corporate managers andsell-side analysts.

Ikenberry: A lot of managers may say

and even believe they are buying back shares mainly to boost EPS—and sur-veys confirm that this is a dominantmotive—but as academics we try tounderstand the more fundamental forceshat are driving this behavior. We are

skeptical that increasing EPS is a logicalreason to buy back shares because theavailable empirical evidence suggests thathe market sees through the EPS effect,

so we try to find something “real” under-lying the accounting cosmetics that are

often used to justify corporate decisions.Now, when you look a little more

closely at what happens in these sharerepurchases, you often find some realeconomic benefits behind the increasein EPS. If a company repurchases sharesand then gets an increase in earnings pershare, it tells me that the company hadan inefficient allocation of assets before it bought back the shares. For example,a company with lots of “idle” cash onits balance sheet may get a boost in EPS

rom buying back its shares. But, as Cliff said earlier about leverage and EPS, theaccounting effect is purely cosmetic.

here is no information content in theaccretion, no value creation; it’s justsimple algebra.

And that’s why I would argue that thereal underlying benefit is not the EPSeffect per se, but the improvement in theallocation of capital and the resultingincrease in return on capital. So, the EPSbenefits of stock buybacks are really a

matter of moving assets on the left-hand




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side of the balance sheet to higher-valueduses. Or, as I suggested earlier, it’s aboutreturning a company’s excess capital toinvestors and increasing the overall rateof return.

Stewart: Thanks, Dave, for that over-view of the question. But let me play devil’s advocate again just by posing avery basic question: How can the pay-ment of dividends by itself add value? After all, isn’t a dollar of dividends

received just a dollar of capital gains lost?

Isn’t that the message of M&M that we were all taught in business school?

Ikenberry: The fundamental questionhere is how much capital a company ought to have. And once you answerthat question, then the excess should bedistributed back into the capital marketsin order to reassure investors.

everal people today, including Jon Anda and Henry McVey, have suggestedthat there’s been considerable corporate

hoarding of cash during the last three or

four years. And to the extent that suchhoarding raises concerns about companiesultimately wasting the capital, there arebasically two different, but related, waysof addressing the problem. You can leverup the firm, perhaps by borrowing andusing the debt to buy back shares. Or youcan keep leverage where it is, and insteaduse some combination of dividends andbuybacks to pay out excess cash flow. So,the first question, as Jon Anda and ArunNayar have said, is what are the company’s

investment opportunities and require-

In most cases, buybacks are manage-

ment’s way of telling their shareholders

that the company has more capital than

it can profi tably employ. Far from being

an admission of failure, it’s a statement

of their responsibility to shareholders to

invest only in positive-NPV projects. And

when viewed as part of a broad economic

cycle, both repurchases and dividends

provide a means of liberating capital from

mature, though perhaps still quite profi t-

able, companies and channeling that capi-

tal into growth companies. In this sense,

buybacks and dividends are an important

part of the natural growth and maturation

cycle that all companies go through.

David Ikenberry




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ments, and how much capital do they need? And, number two, if they decidehey have excess capital, should they pay

it out using dividends or buybacks?Now, on this second question, there’s

been some major shifting in recent years.

Five or six years ago, I used to tell cor-porate treasurers and CFOs and CEOshat the common dividend was an

endangered species. Gene Fama and KenFrench published a widely cited study called “Disappearing Dividends.” But,as you mentioned, Bennett, I’ve recently published a study with my colleagueBrandon Julio that has the title “Reap-pearing Dividends.” So why are dividendssuddenly coming back into favor?

One factor is the way corporate

executives and employees are now beingcompensated. As Henry mentioned in hispresentation earlier this morning, the riseof stock options alone would encouragecompanies to shift toward repurchases andaway from dividends; and to the extenthat options are a key part of a firm’s busi-

ness and compensation strategy—andMicrosoft certainly comes to mind here—hen dividends are clearly disadvantaged.

But another factor working against divi-dends is their tax treatment: the interest

on corporate debt is deductible, as Cliff said earlier, while dividends are not.Finally, from management’s point of view, dividends are less flexible than stock repurchase programs, which can alwaysbe canceled—and generally without giv-ing notice to shareholders, though thisis about to change. And for companiesembarking on a high-growth phase, main-aining such flexibility can be critical.

But these are al l reasons to prefer buy-backs to dividends and, as I just said, my

conjecture of a few years ago that the com-

mon dividend would become extinct hasturned out to be wrong (and that’s one of the reasons I’m in the academy and not inthe forecasting business). Dividends havecome back with a vengeance. For exam-ple, if you look back to the mid-1980s,

80% of S&P 500-type companies paida dividend. By the height of the Inter-net bubble in 2000, that percentage hadfallen to 40%. But today that number isapproaching 50% and rising.

Stewart: Okay, I think we all agree thatcompanies ought to pay out their excesscapital and cash flow. But I still havetrouble understanding why dividends aresuddenly the preferred method—and let’stry and keep the question of stock options

out of the equation, at least for a moment. We know that a dividend paid is a capitalloss; that is, when a company goes ex-div-idend, the price drops by pretty much theamount of the dividend paid. At the sametime, you’ve forced the taxable sharehold-ers who receive the dividend to incur atax, even if it’s only 15 cents on the dollarnow. Why not instead offer to buy back stock and give your investors the choice of selling and being taxed?

Ikenberry: I agree, Bennett, that althoughdividends aren’t as painful to investors asthey were in the past, they still have a taxbite. I think the real answer to your ques-tion has to do with Cliff’s point earlierabout the strength of management’s com-mitment to pay out free cash flow, the ideathat companies that pile on debt effectively commit themselves upfront to an irrevers-ible, contractual stream of payments.Now, Cliff talked about this commitmentmainly in the context of debt versus equity,

but you can also apply it when comparing

dividends to, say, an open market buyback program. In my view—and I got the senserom some of Henry’s comments that he

shares this view—dividends represent armer commitment to pay out excess cashhan the announcement of a typical open

market repurchase program. Unlike buy-backs, which are often canceled and havelittle surrounding disclosure, dividendsare a bright line number; they’re very easy to see and they’re commitments thatstretch out indefinitely. In this sense, they have some of the same properties as debtservice payments.

But, as Cliff also pointed out, forcompanies whose value comes more fromrowth opportunities than current opera-ions, maintaining financial flexibility is

oing to be more important than commit-ing to pay out cash flow. Both Henry and

Arun see PepsiCo as a growth company,and growth companies need to preserve

nancing flexibility. And this is evenmore true of pharmaceutical companieslike Pfizer. That industry today is goinghrough some tough times. But what ishe value of Pfizer, after all? When you

really boil it down, it’s the expected valueof its R&D pipeline. And the company’s

nancing policies have to be designed to

continue funding its R&D program andhe commercial development of its mostpromising new drugs. In this sense, theirR&D program represents a portfolio of “real options”—they need to maintainhe financing flexibility to exercise those

real options.

Payout Policy:The Case of PepsiCoStewart: Thanks, Dave. Arun, wouldyou please tell us your thinking on pay-

out policy at PepsiCo?




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Nayar: When we look at the questionof payout policy, we start by looking athe level of our free cash flow. We ask

ourselves: How much cash flow is beingenerated by our businesses, and what is

our current best estimate of our capital

outlays over our planning horizon? Ourrst priority is making the right cor-

porate investment decisions. As we alllearned in business school, that meansollowing the net present value rule:ake all investments that promise to

earn more than the cost of capital andreject the rest. And to achieve that goal, we subject all our major investment proj-ects—and even most minor ones—toairly intense scrutiny.

Then, after getting estimates of

our investment requirements and set-ing them against our expected cash

inflows, we estimate our excess cash, or what we’ve been calling our “free cash

ow.” Our policy is to return 100% of our free cash flow in one way or anothero our shareholders. That’s a discipline

we impose upon ourselves. In carryingout that policy, over the last five yearsPepsiCo has returned some $15 billiono the shareholders through dividends

and buybacks. Roughly a third of that

$15 billion has come in the form of div-idends, with the other two-thirds in theorm of share buybacks.

Stewart: How do you choose betweendividends and repurchases?

Nayar: We really start by finding theappropriate dividend policy. Our goal iso have a fairly consistent and predictable

dividend payout, one that is not going tobe affected by changes in the tax law five

years from now and one that our share-

holders can expect to grow in the future. We at PepsiCo are very conscious thatour dividend has been raised each yearfor 33 consecutive years, and we want toset it at a level where we can sustain not just the current level but the growth rate

of the dividend as well.Having set the level of the dividend,

we then return the rest of our free cashflow in the form of stock repurchases, which is consistent with our strategy of returning 100% of free cash flow to ourshareholders.

Leveraged Recaps as an Alternative to DividendsStewart: Okay, that’s one way of solvingthe free cash problem and of keeping

yourself from falling into the trap of accu-mulating excess liquidity. But let me, againfor the sake of argument, try out a moredrastic proposal. If paying dividends isn’tpart of your discipline, you could considersaying to your shareholders, “We’re havinga Christmas sale on dividends this year. We are going to borrow and pay you today the present value of all the future dividends we would otherwise expect to pay over thenext five years. But we’re going to give itto you not as a dividend but in the form

of a stock buyback. This way only theinvestors who choose to sell get taxed. And to keep your taxes lower, we won’tpay dividends in the future; that money will be used instead to pay off the debt.”

Why don’t we see more companiesusing this method for capturing thedisciplinary benefits of dividends—thatis, monetizing them through a debt-financed repurchase?

Smith: Bennett, what you’ve just pro-

posed is a slightly less drastic version of

the solution that’s being used in the LBOand private equity business. But we rarely see that solution used by publicly tradedcompanies. And there’s a good reason—it’s too extreme, it takes away manage-ment’s flexibility to respond if something

goes wrong. What you’ve given us is aneither/or set of alternatives. You’ve pro-posed a light switch that is either on oroff, when what I think most CFOs wantis a rheostat; they want some control overthings. And when Arun tells us that flex-ibility is very important for a company like PepsiCo, I’m inclined to agree.

Now, that’s very different from sayingthat the CFO’s mission is to maximize flexibility. I think we can all agree thatit would be fundamentally inappropri-

ate for every CFO of every company tosay that his or her job is to maximizeflexibility for the organization. Whatyou want is the ight amount of flex-ibility—not too little, not too much.Financial flexibility comes with a priceand with a responsibility to justify thatflexibility to your shareholders. What we want to achieve is a reasoned balance of the flexibility you get in terms of capi-tal structure decisions, payout policy,HR policies, and risk management. And

for most companies, forecasting thedividends they would expect to pay overthe next five years, selling debt to raisethat amount of capital, and using thatdebt to repurchase shares would involvean unacceptable sacrifice of flexibility.Most CFOs will choose a more balancedapproach, a payout policy that isn’t setin stone.

The Changing Investor Paradigm Anda: I agree with Cliff that the kind

of leveraged recap that Bennett’s propos-




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ing is really an extreme solution. It’s onehat was used with some success in the

1980s, although it had its share of fail-ures, too. But it’s one that most publicly raded companies are going to shy away rom. For most public companies, getting

he right payout policy is about gettinghe right mix of debt structure, buybacks,

and dividends. And the recent move toward dividends

is what I would call a mix shift . That is,instead of paying out two-thirds of theirree cash flow in the form of buybacks

and a third as dividends, a lot of com-panies are now thinking about reversinghose proportions. As both Cliff and

Dave were saying, investors are likely toview dividends as a stronger commitment

han buybacks. wo years ago I gave a presentation in

his room on what I called the “chang-ing investor paradigm.” I’m not going torepeat it all, but I think there has been amajor shift in the perspectives and meth-ods of investors that bears very directly on what companies should be doing withheir excess cash. Since the bursting of he Nasdaq bubble in 2000 and 2001, I

believe that we have gone from a worldin which investors focused mostly on

earnings growth and P/E multiples toone in which the main focus has becomevariables like free cash flow, returns oncapital, and DCF.

Now, this idea is likely to meet withresistance from people who are commit-ed to the efficient markets view of the

world. In this view, highly sophisticatedmarginal investors are always lookinghrough accounting numbers to the eco-

nomic reality of cash flow, or what my colleague Trevor Harris calls “sustainable

earnings.” But my own sense is that while

the sophisticated “bargain hunters” on which the theory relies are usually pretty effective in correcting undervalued situa-tions, at least given a little time, in the pastthere have not been enough of these inves-tors to keep some stocks from becoming

way overvalued. And that, with the helpof some accounting chicanery, is what wesaw during the recent tech bubble.

But I think all this has been chang-ing in the past few years, and that ourfinancial markets are now in the processof becoming more efficient. For those of us who work closely with investors, therehave been two major changes. First is therecent increase in investors’ computingpower. In the late ’90s, few sell-side ana-lysts had valuation models; and although

buy-side analysts had models that allowedthem to do more than just project growthin EPS, these models were still fairly lim-ited. But since the bursting of the techbubble, first the buy side and now the sellside are building much more powerfulmodels that use sensitivity analysis to cal-culate, analyze, and project variables likeDCF and residual income. So, the modelsare available, and they’re enabling analyststo look through accounting numbers tothe underlying cash generation and earn-

ings power. And as a consequence, themarket’s scrutiny of accounting numbersappears to have reached a new level.

The second major change is the growthof hedge funds. The popular conceptionof hedge funds is that they use a highly quantitative approach that involves trad-ing in and out of stocks. What’s not wellknown is that, in addition to these quantand momentum investors, there are alarge and growing number of fundamen-tals-driven hedge funds that, like the

spinoffs from Tiger Management, focus

mainly on free cash flow and returns oncapital. Such funds now control hugepools of capital and often take very largepositions—some long, some short. Andthey often hold these positions for a con-siderable period of time.

My reason for bringing up hedgefunds in this context is that such investorspay very close attention to how compa-nies invest their capital and what they do with their free cash flow. They want highreturns on total capital; and if manage-ment can’t earn acceptable returns, they want the capital back. And the mix shifttoward dividends that we’re now seeingreflects in part the market’s recognitionthat the old accretive EPS buyback, asDave Ikenberry just pointed out, is yet

another accounting illusion. That is, theidea that a low P/E company can increaseits value by using an EPS-increasing buy-back just doesn’t fly any more. And, inmost cases, I don’t view buybacks as aneffective signaling device either. Investorstoday are saying, “I’m looking very care-fully at your free cash flow. There’s a lotof it, more than I think you need, and I would like to have some of it.”

Now, an interest payment, as Ben-nett was suggesting, may be better than a

dividend in some circumstances, and wecan debate that point. My own feeling,though, is that investors trust most compa-nies to choose their capital structure; andas long as that capital structure isn’t totally inappropriate, investors are then goingto monitor the companies’ free cash flow very carefully. And if the cash flow clearly exceeds promising corporate uses for it,investors will ask for the money back.

McVey: Like Jon, I think that the growth

of money being run by hedge funds is a




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I think there has been a major shift in theperspectives and methods of investors that

bears very directly on what companies should

be doing with their excess cash. Since the

bursting of the Nasdaq bubble in 2000 and

2001, we have gone from a world in which

investors focused mostly on earnings growthand P/E multiples to one in which the main

focus has become variables like free cash

fl ow, returns on capital, and DCF.

There are two major factors driving this

change. First, both the buy side and the

sell side are now using much more powerfulcomputing models to see through account-

ing numbers to companies’ underlying cash

generation and earnings power. Second is the

large and growing number of fundamentals-

driven hedge funds that pay very close atten-

tion to how companies invest their capital andwhat they do with their free cash fl ow.

Jon Anda




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major development. The inflows to theU.S. mutual fund industry peaked in1993; since then, the ten-year compoundannual growth rate in mutual fund flowshas been –1%. Today, over 50% of totalrading volume is related to hedge funds

and program trading.So we now have a very different investor

base. I recently attended a Morgan Stan-ley conference for its 50 largest investors,and my impression was that these people were all credit investors. Free cash flow was

he number one topic of discussion, andless than half the ideas being discussed inhe room were about growth stocks. The

bigger focus was on companies that wereyielding as much as 5%! And it’s not justhe largest investors—people who put

heir money in 401(k)s also now appearo be looking for yield.

This focus on yield may end up con-ributing to another change I see coming

in the hedge fund industry over the nexthree to five years. As the funds continueo grow and take in new money, my pre-

diction is that they’ll end up relying less onperformance fees and move back towardhe management fee model that prevails

in the mutual fund industry. The focus onhigher-yield stocks, to the extent it reflects

reduced investor expectations for growth,is consistent with—and could help drive—his shift toward management fees.

So, to sum up, the U.S. investor basehas changed dramatically in the past few years. Hedge funds are a major force today.They’re going to have much more capitalin the future, and their influence on cor-porate investment decisions is going torow along with it. And as Jon was telling

us, the hedge funds care a lot about freecash flow and what companies are doing

with it—and there aren’t many prospects

for growth and multiple expansion in themega-cap segment of the market.

But if this focus on free cash flow and dividends may turn out to be avaluable discipline for many if not mostcompanies, I’m also worried that some

companies will be discouraged fromreinvesting enough in their business. Inthis sense, investor pressure on free cashflow—which is basically a good thing—can be taken too far.

In Closing: The Problem ofCorporate UnderinvestmentStewart: Okay, so up to this point, we’vebeen focusing almost entirely on corpo-rate efforts to address their free cash flow problem, which is essentially a problem

of overinvestment. But now we’re talkingabout a possible underinvestment prob-lem. Jon, are you seeing anything withyour clients that would make you think this is likely to be a big concern?

Anda: My feeling is that a large numberof companies today are using hurdle ratesthat are well above their weighted aver-age cost of capital. Given today’s interestrates, a stock with a beta of one has a costof equity of about 8% and, assuming a

capital structure of 30% debt, a WACCof about 7%. But rather than using 7%,a lot of companies seem to be using theirexisting returns on invested capital—inmany cases anywhere from 12% to ashigh as 15%—as their effective hurdlerates. In fact, it seems to me that there’sbeen a de-linkage between WACC andhurdle rates during this entire inter-est-rate cycle. And the consequence isthat companies are likely to be walkingaway from some value-adding projects.

To me, it looks like there are a lot of

opportunities for companies to createeconomic value—or what you call EVA,Bennett—but they’re just not doing it.

Stewart: Well, I too have seen lots of com-panies that are earning high returns on

capital use those returns as the benchmark or future investments. In fact, there was a

recent article in the JAC that argued thathe largest oil companies have been sacri-cing potential value by aiming for returns

on capital that are too high. This typically happens because managements think thatif they’re earning 15% on capital today,hen anything less will disappoint inves-ors. But, as you suggest, Jon, this is not

consistent with our EVA measure, it’s notconsistent with the NPV and DCF con-

cepts taught in our business schools, and Idon’t believe it reflects the way the marketprices stocks. Take the case of Wal-Mart. At the beginning of the 1990s, it was earn-ing rates of return on capital of over 25%.

he company continued to invest heavily hroughout the ’90s; and even though its

average return fell during the period, itsnew investments were covering the cost of capital in their own right and thus creat-ing EVA, and the company’s market valuecontinued to rise.

But I agree with you, Jon, that a lotof managements think in terms of main-aining or maximizing returns instead of

EVA or DCF. Why do you think this ishappening today?

Anda: I think part of it has to do withmanagers’ confusion about what inves-ors really want, but a lot of it also haso do with the current economic and

business climate. Our clients are say-ing, “We see a low-growth scenario in

he developed world and a high-growth




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scenario in the developing world. We’reenerating a lot of cash and don’t need to

spend much to remain competitive here.But what about opportunities in China

and India?” The problem, however, ishat it’s not easy—or necessarily a goodidea—to quickly put capital to work inplaces in China and India. You need tobe deliberate and take your time. So, inhe meantime you accumulate cash or

you buy back stock. But, in so doing,companies may be passing up goodopportunities to add value.

Stewart: Okay, let’s leave it at that, andlet me thank you all very much for taking

part in this discussion. Arun, thank you in

particular for your willingness to discussPepsiCo’s policies. It’s all well and goodto discuss these topics from a theoreticalpoint of view, but the practitioner perspec-

tive is enormously valuable, especially froma well-respected company like PepsiCo.

I have seen lots of companies that are

earning high returns on capital use those

returns as the benchmark for future invest-

ments. This typically happens because

managements think that if they’re earning

15% on capital today, then anything less

will disappoint investors. But this is not

consistent with the NPV concepts taught in

our business schools, and I don’t believe it

reflects the way the market prices stocks.

As anyone familiar with the concepts of

EVA or DCF can tell you, passing up prom-

ising M&A and other strategic investments

is a prescription for reducing value.

Bennett Stewart




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Analyst Certification

The following analysts hereby certify hat their views about the companies and

heir securities discussed in this report areaccurately expressed and that they havenot received and will not receive director indirect compensation in exchange forexpressing specific recommendations orviews in this report: Henry McVey.

Important US Regulatory Disclosures

on Subject Companies

The information and opinions in thisreport were prepared by Morgan Stanley & Co. Incorporated and its affiliates (col-

lectively, “Morgan Stanley”). Within the last 12 months, Morgan

tanley managed or co-managed a publicoffering of securities of PepsiCo, Inc.

Within the last 12 months, Morgantanley has received compensation for

investment banking services from Pep-siCo, Inc.

In the next 3 months, Morgan Stanley expects to receive or intends to seek com-pensation for investment banking servicesrom PepsiCo, Inc.

Within the last 12 months, Morgantanley has received compensation for

products and services other than invest-ment banking services from PepsiCo, Inc.

Within the last 12 months, Mor-gan Stanley has provided or is providinginvestment banking services to, or has aninvestment banking client relationship with, the following companies covered inthis report: PepsiCo, Inc.

Within the last 12 months, Mor-gan Stanley has either provided or isproviding non-investment banking,securities-related services to and/or in

the past has entered into an agreementto provide services or has a client rela-tionship with the following companiescovered in this report: PepsiCo, Inc.

he research analysts, strategists, orresearch associates principally respon-sible for the preparation of this researchreport have received compensation basedupon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenuesand overall investment banking revenues.



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