V O L U M E 1 7 | N U M B E R 1 | W I N T E R 2005

Journal of

APPLIED CORPORATE FINANCE

A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Capital Structure, Payout Policy, and the IPO Process
The Capital Structure Puzzle: The Evidence Revisited Do Managers Have Capital Structure Targets? Evidence from Corporate Spinoffs How To Choose a Capital Structure: Navigating the Debt-Equity Decision
8 18

Michael Barclay and Clifford Smith, University of Rochester Vikas Mehrotra, University of Alberta, and Wayne Mikkelson and Megan Partch, University of Oregon

26

Anil Shivdasani, University of North Carolina, and Marc Zenner, Citigroup Global Markets

Morgan Stanley Roundtable on Capital Structure and Payout Policy

36

Clifford Smith, University of Rochester; David Ikenberry, University of Illinois; Arun Nayar, PepsiCo; and Jon Anda and Henry McVey, Morgan Stanley. Moderated by Bennett Stewart, Stern Stewart & Co.

Bookbuilding, Auctions, and the Future of the IPO Process Reforming the Bookbuilding Process for IPOs

55 67

William Wilhelm, University of Virginia and University of Oxford Ravi Jagannathan, Northwestern University, and Ann Sherman, University of Notre Dame

Assessing Growth Estimates in IPO ValuationsA Case Study Incorporating Competition into the APV Technique for Valuing Leveraged Transactions A Framework for Corporate Treasury Performance Measurement Morgan Stanley Panel Discussion on Seeking Growth in Emerging Markets: Spotlight on China

73 79

Roger Mills, Henley College (UK) Michael Ehrhardt, University of Tennessee

88 94

Andrew Kalotay, Andrew Kalotay Associates Michael Richard, McDonalds Corp., and Stephen Roach and Jonathan Zhu, Morgan Stanley. Moderated by Frank English, Morgan Stanley.

Trade, Jobs, and the Economic Outlook for 2005 Leverage

100 106

Charles Plosser, University of Rochester Merton Miller, University of Chicago

Morgan Stanley Roundtable on Capital Structure and Payout Policy

Financial Decision Makers Conference | New York City | December 9, 2004*
Photographs by Yvonne Gunner, New York

* Please see analyst certication and other important disclosures starting on page 54.

36

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

ROUN DTAB LE

Bennett Stewart: Good morning, and

welcome to this discussion of corporate capital structure and payout policy. Im Bennett Stewart, Senior Partner of Stern Stewart & Company, and Ill be serving as moderator. Although our two main topics are pretty closely relatedin fact, its hard to talk about one without bringing up the otherweve set up the discussion in two distinct parts. The rst will focus on questions of overall capital structure and nancial planning: Is there such a thing as an optimal capital structurea ratio of debt-to-total capital that is most likely to maximize the value of a given company? If so, what are the critical factors in setting a target leverage ratio? Should a companys capital structure be designed to maintain at least an investment-grade rating, or does this end up leaving substantial value on the table? The second part of the discussion will focus on why and how companies are distributing cash to their shareholders. In 1997, the total dollars spent by U.S. companies in buying back stock exceeded total dividend payments for the rst time. And throughout the 1990s, dividends seemed to be an increasingly unimportant way of distributing cash and providing returns to shareholders. But with the passage of the Bush dividend tax cut in 2003, and with U.S. companies now sitting on record amounts of cash, we seem to be experiencing a comeback in dividends. Is this trend for real, and can we expect it to continue? Directly related to corporate payout policy is the matter of corporate investment policy. A number of people have attributed the build-up of cash on corporate balance sheets to the hurdle rates now being used by managements to evaluate corporate investment opportunities. The

suggestion is that many companies are setting their hurdle rates well above their actual cost of capital, possibly to report higher operating returns. If so, companies may be passing up promising M&A and other strategic investments. And, as anyone who is familiar with the concepts of EVA or NPV can tell you, thats a prescription for reducing value. To explore these issues, our host Morgan Stanley has brought together a small but distinguished group of academics and practitioners. At the far end of the table is Clifford Smith, who is the Louise and Henry Epstein Professor of Business Administration at the University of Rochesters Simon School of Business. Since joining the Simon School in 1974, Cliff has done research in corporate nance, nancial institutions, and risk management that has led to 14 books and some 80 articles in the top nance and economics journals. In the last 25 years, he has done as much as any academic in nance to demonstrate how and why corporate executives can add value through capital structure, risk management, and nancial policies generally. And to go along with his research, Cliff has received 29 Superior Teaching Awards from the students at the Simon School. Next to Cliff is David Ikenberry, who is Chairman of the Finance Department at the University of Illinois in UrbanaChampaign. Dave has done a lot of work on stock repurchaseso much that I would describe him as the worlds foremost authority on the subject. For a nice summary of Daves thinking in this area, I would recommend an article called What Do We Know About Stock Repurchase?, which appeared in the Spring 2000 issue of the Journal of Applied Corporate Finance. In the past

year, Dave has shifted his research focus to corporate dividend policy, and his article called Reappearing Dividends in the most recent issue of the JACF is also recommended reading. Next to Dave is Arun Nayar, who is Vice President and Assistant Treasurer at PepsiCo, Inc. As Arun will tell us, Pepsi has been quite aggressive in recent years in spinning off its restaurants and bottlers, acquiring new businesses, buying back its stock, and otherwise pursuing the interests of its stockholders. Before joining PepsiCo in 2002, Arun served as President of ABB Financial Services Inc. for ten years. Prior to that position, he worked with Westinghouse Electric Corporation for more than 12 years, serving in various senior nance positions in Pittsburgh, Saudi Arabia, and England. Next to Arun is Henry McVey, who is Managing Director and Chief U.S. Investment Strategist at Morgan Stanley. Before assuming his current position, Henry made a name for himself covering brokerage, asset management, and multinational bank stocks. A few weeks ago he came out with a very interesting report on the cashheavy balance sheets of the semiconductor companiesit was called Bonre of the Insanitiesand Im sure he will be telling us more about that soon. Last, and to my immediate left, is Jon Anda, who is Managing Director and Global Head of Corporate Finance in Morgan Stanleys investment banking division. My own relationship with Jon goes back to the days of the old Continental Bank, when we were both pretty much starting out. Since then, weve been on panels together and have done work for a number of the same companies. And based on those experiences, Im not a bit surprised by Jons accomplishments.
37

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

ROUN DTAB LE

Part I: Capital Structure

The Theory Stewart: So, now that Ive told you a

little about our panelists, let me begin by asking Cliff Smith to give us a very quick overview of the theory of capital structure. Cliff, what is the current thinking in the academic nance profession about optimal capital structure? Can a companys debt-equity ratio play a major role in managements efforts to increase shareholder value? Or is nancing policy, as Modigliani and Miller suggested back in 1958, pretty much irrelevant?
Cliff Smith: Thanks for the kind words,

nancing decisions dont affect the real decisions in any predictable wayfor example, as long as the rms managers make the same investment and operating decisions whether the leverage ratio is 10% or 90%nancing decisions will not affect the total value of the rm. And by total value I mean the value of the debt and equity.
Stewart: Let me stop you there for a min-

Bennett, and I agree with you that Modigliani and Miller is the logical place to begin this discussion. Most people in my profession date the beginning of modern corporate nance to the publication of the rst M&M paper in 1958. That paper basically said that if you give me three assumptionsno taxes paid by the corporation or its investors, no bankruptcy or other contracting costs, and no effect of nancing choices on managers investment and operating decisionsthen the current market value of the rm should not be affected by the structure of the liability side of the rms balance sheet. Given these three assumptions, M&M showed that the right-hand side of the balance sheet has no material effect on the real source of corporate valuenamely, the operating cash ows generated by the business over time. M&Ms basic insight was that differences in leverage and the kinds of securities the rm issues are nothing more than different ways of dividing up the operating cash ows and repackaging them for investors. And as long as these
38

ute, Cliff. In my experience, a lot of CFOs make decisions about capital structure at least partly on the basis of the expected impact on earnings per share and return on equity. In other words, by issuing debt instead of equity, a company can increase its EPS or its ROE as long as it earns a return on the new capital that is higher than its borrowing rate. But I gather from your comments about M&M that this kind of leveraging effect should not be expected to increase value.
Smith: Thats right. The message from

M&M is that these kinds of pro forma EPS and ROE effects are likely to be an illusion; or, as Stew Myers at MIT likes to say, there is no magic in leverage. When companies issue debt, their ROE will go up if the return on incremental capital exceeds the after-tax borrowing rate. But I dont have to tell anyone in this room that this is not an acceptable standard of protability. The problem with this strategy, as M&M showed, is that as companies take on more nancial leverage, the risk of the equity goes up along with it. And as the risk of the equity increases, stockholders raise their required rate of return and the P/E ratio of the rm goes down. The net effect is a wash; total rm value remains the same.

M&M made a similar argument about corporate dividend policy. Using essentially the same assumptionsno taxes or transactions costs and a xed investment policythey showed that a dollar of dividends paid is a dollar of capital gains lost, and overall value is unchanged. Now, these are explanations for why capital structure and dividends dont matter. And though theyre arguments that it probably takes an academic to love, we can derive a good deal of managerial insight about why nancial decisions might matter just by taking the M&M statements and turning them on their heads. That is, if changes in capital structure and dividends do affect corporate market values, its for one of the three reasons that Miller and Modigliani assumed away. First, the rms choice of nancing and dividend policy can affect the taxes of the rm or its investors. Second, nancing and payout policy can affect information costs or contracting costs, including the costs arising from bankruptcy or nancial distress. And third, the rms capital structure, and whether it chooses to retain or pay out corporate cash, can affect managements operating and investment decisions.
Stewart: If I can put a slightly different

twist on what youre saying, Cliff, there are three potentially important considerations or goals in making the corporate leverage decision: holding down taxes; preserving enough nancial exibility to avoid distress and invest in all positive-NPV opportunities; and paying out excess capital to encourage managers to operate efciently and walk away from bad investments. Of these three goals, which seems to carry the most weight in corporate decision-making?
A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance Volume 17 Number 1

ROUN DTAB LE

For growth companies, the emphasis is on preserving nancial exibility to carry out the business plan, which means minimal debt and low payouts, if any. For companies with limited investment opportunities that generate a lot of cash, paying out free cash 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 signicant source of value. But even in those deals, I think the incentive benets from using high leverage to concentrate the equity ownership and drive efciency outweigh the tax benets. Cliff Smith
Smith: It depends on what kind of

company were talking about. In 1977, Stew Myers wrote a classic paper called Determinants of Corporate Borrowing that started out by viewing the values of all companies as having two components: assets in place, which are the more or less tangible assets that generate the rms current earnings or cash ows; and growth options, which can be thought of as opportunities to make future investments that come out of the rms current operations and capabilities. He went on to explain why companies whose value reects mainly

assets in placepeople here at Morgan Stanley would probably call them value companiestend to use much more debt than rms whose value comes mostly from growth options. The danger in using debt to nance growth companies was identied by Myers as the underinvestment problem. The basic argument was that debt-nanced companies, when faced with a drop in operating cash ows, are more likely to pass up positive-NPV projects than rms nanced mainly with equity. To me, thats a pretty convincing explanation for why growth companies in general

carry little debt, and why many in fact have negative leveragemore cash than debt on the balance sheet. But now lets turn to the case of so-called value companies, or rms in mature industries with few major investment opportunities and whose value comes mainly from their current earnings. These kinds of companies face what my former Rochester colleague Mike Jensen has called the free cash ow problem. By that he means the tendency of managers in mature, cash-generating industries to use their excess cash to undertake low-return investmentsto
39

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

ROUN DTAB LE

destroy value by pursuing growth at the expense of protability. Both debt and dividends can play an important role in resolving this problem; both can be used by management to make a credible commitment that the rms excess cash is going to wind up in the investors pockets instead of being wasted on some corporate white elephant. So, Bennett, the short answer to your question has to do with the relation between nancing decisions and corporate investment incentives. For growth companies, the emphasis is on preserving nancial exibility to carry out the business plan, which means minimal debt and low payouts, if any. For companies with limited investment opportunities that generate a lot of cash, paying out free cash 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 signicant source of value. But even in those deals, I think the incentive benets from using high leverage to concentrate the equity ownership and drive efciency outweigh the tax benets. What does this mean for most public companies? Theres a nice study by John Graham at Duke that shows that for the average publicly traded corporation and lets say its a company with a market leverage ratio of 25% the tax benet of debt can be viewed as contributing about 5-8% of its current value. This nding suggests to me that, for most publicly traded companies, reducing taxes is likely to be a second-order priority. Most important are growth companies concerns about maintaining exibility and value rms commitment to paying out their free cash ow.
40

Stewart: Cliff, before we move on to our

other panelists, theres another question about debt and taxes thats been puzzling me. Many of the high-tech companies have 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 rm like Microsoft appears to have ignored the tax benet of debt nancing. But, as Microsoft and other companies shift their employee compensation from stock options to restricted stock, will that increase the effective marginal tax rate of the high-tech community and perhaps its appetite for debt?
Smith: Well, as has become even

fundthe lower is the rms optimal leverage ratio. But, to return to your original question, Bennett, I suspect that Microsofts past decision to avoid both debt and dividends had something to do with the tax shelter provided by the exercise of stock options. I also think its recent decision to pay a $30 billion special dividend had a lot to do with the Bush tax cut; in fact, that tax cut was probably a necessary condition for the dividend to even be considered. But the more fundamental explanation for Microsofts new payout policy is that the company now clearly has far more capital than can be protably reinvested in the business. A Corporate Perspective: The Case of PepsiCo Stewart: Thanks, Cliff, for that overview of the theory. Lets now turn to Arun Nayar and the practice of nance at PepsiCo. Arun, would you tell us how you think about capital structure policy? What are the elements that go into your analysis, and do you have a target capital structure that reects the things Cliff was talking aboutthings like taxes, nancial exibility, and the rms investment policy?
Arun Nayar: The most critical issue for

clearer to me from listening to some of the sessions here this morning, the job of the CFO is a pretty demanding and all-encompassing one. Its critically important that a companys nancing decisions be coordinated with its strategy and operationsand this includes its compensation and HR policies. Trevor Harris and Dick Berner of Morgan Stanley were talking earlier about the problem of managing long-lived corporate liabilities like pension and post-retirement healthcare benets. And as they pointed out, these legacy costs are xed obligations of the rm, even if they dont show up on a traditional GAAP balance sheet. When making the rms nancing decisions, the CFO has to think in terms of an economic balance sheet that takes account of those obligations. So, the greater the rms unfunded pension and healthcare liabilitiesand, I might add, the larger the allocation of stocks in the pension

us in making our nancing decisions at PepsiCo is our business strategy. Our capital structure is designed to support and help drive the strategy of the company. To provide a little context, PepsiCo is a consumer products company in a dynamic industry with lots of opportunity for global investment and consolidation. And very much consistent with what Cliff was saying, its important for
A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance Volume 17 Number 1

ROUN DTAB LE

Our stockholders want growth in revenues and earnings. But, as were keenly aware, our investors also want high returns on capital. And this makes getting the right capital structure a balancing act. Its a matter of preserving enough exibility to carry out our business plan while also making sure that we dont 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 ow in one way or another to our shareholders. Arun Nayar
us to maintain a capital structure that gives us enough nancial exibility to capitalize on tuck-in opportunities as they emerge in the marketplace. We design our capital structure with the aim of preserving broad access to all the key capital markets around the world under almost all conceivable market conditions. And this means that we need to maintain a high investment-grade rating. To that end, we have recently been somewhere between a strong A and a low AA. For us to stay around the midpoint of that range, our analysis suggests a leverage ratio of about 20% debt as a percentage of the book value of our total capital. In conclusion, our bond rating is a fallout 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, let me challenge you a bit on this. It seems to me that PepsiCo, even while pursuing a global investment strategy, could use considerably more debt than it does now, perhaps even twice as much. Your stock price volatility is about 20% per annum measured over the past ve years, which puts you among the least volatile stocks in the Russell 3000. Over the past ve years, your sales have grown about 5% per annum on average, your company generates a very strong cash ow, and you have an enviable portfolio of consumer branded products. As you say, the ratio of the companys debt and leases to total capital is about 20%. But, as a percentage of the market value of its total

capital, the leverage ratio is only about 4%. So, my question is this: Would PepsiCos value be higher if the company operated with more debt, either because of lower taxes or better spending discipline? To put the question another way, is the company paying a high price to maintain its nancial exibility, or do you feel pretty condent that your investors are focused on your growth opportunities and are willing to give you that exibility?
Nayar: My sense from talking to inves-

tors is that PepsiCo tends to be viewed as a growth company, particularly by investors representing the buy side. This means that the market is expecting us to grow our revenues and earnings while
41

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

ROUN DTAB LE

still providing acceptable returns on capital. And the way we accomplish this is by nding and investing in growth opportunities. To use Cliff Smiths terms, we are a rm with lots of valuable growth options, and our nancing policy is designed to enable us to exercise those options when we nd them. And let me also point out, Bennett, that your calculations of our leverage ratios are misleading. They fail to take account of an important element of our business model. For those of you who are not familiar with that model, PepsiCo has a beverage business and a snack food 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 our anchor bottlers; the bottlers convert the syrup into the nal product and then distribute the product to the consumer. The anchor bottler business, although once wholly owned by PepsiCo, was spun off in 1999 and has been independently owned since then. We continue to have a material ownership stake in these businesses, but the majority of the stock is publicly owned. So these businesses are independently owned, and independently operated and managed and because the businesses generate very stable cash ows and have fairly modest requirements for outside capital, they operate with considerably higher leverage ratios than our own. Now, the important point here is that when the rating agencies look at our rating, they look at the leverage of the combined system. Even though we only guarantee some of our bottlers debt, the agencies combine all of our bottlers debt with our own under the assumption
42

that the nancial health of our bottlers is critical to our future success and goingconcern value. So, when designing our capital structureand we spend a lot of time thinking about itwe have to balance the rating agencies concerns against those of our equity investors in a way that satises both. So, again, our stockholders want growth in revenues and earnings. But, as were keenly aware, our investors also want high returns on capital. And this makes getting the right capital structure a balancing act. Its a matter of preserving enough exibility to carry out our business plan and tuck-in acquisitions while also making sure that we dont have too much capital. That last part of the equation is what our dividend and buyback policies are designed to accomplish. Investors Perspective Stewart: Thanks, Arun. And since youve mentioned your stockholders a number of times, lets turn now to Henry McVey to get an equity investors perspective on these issues. Henry, as Morgan Stanleys 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 and raise returns by increasing efciency? Or is it a growth company that needs above all to preserve its exibility?
Henry McVey: We view Pepsi as a

growth stock. We think management is doing the right thing with its capital. And as long as theyor any company continue to use their capital to fund promising investments and return the excess in the form of dividends and buybacks, were going to give them the

benet of the doubt and let them nance the business as they see t. But, Bennett, there are a number of sectors in the U.S. economy today where your question is right on target. Its a question that investors in many of the largest-cap growth stocks in the S&P 500 are asking themselves right now. The reality is that a lot of these companies are no longer growth stocks, but they havent adjusted their balance sheets and payout policies to reect this change. The U.S. semiconductor industry is a good example. In the industry report that you mentioned earlier, I wrote that almost every major player has far too much cash on the balance sheet. In fact, just a few days after that report was released, Intel announced that it was doubling its dividend. So, in looking at todays market, I tend to put all companies into one of two bucketsand though the buckets are somewhat related to Cliffs distinction between mature and growth companies, theyre not the same. My classication system has more to do with whether we think companies have the right package of nancing policies and growth opportunities, or whether the package needs to be changed. On the one hand, if we basically approve of how a company is investing its capital in the business, then thats a company that were probably going to consider recommending. As I said before about PepsiCo, were ne with just letting such companies grow. On the other hand, if a company makes poor acquisitions or its growth slows and management fails to recognize that and pay out the excess capital, thats where we think the business model needs a fundamental restructuring. Thats how
A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance Volume 17 Number 1

ROUN DTAB LE

In looking at todays market, I tend to put all companies into one of two buckets. My classication system has more to do with whether we think companies have the right package of nancing policies and growth opportunities, or whether the package needs to be changed. On the one hand, if we basically approve of how a company is investing its capital in the business, then thats a company that were probably going to consider recommending. Were ne with just letting such companies grow. On the other hand, if a company makes poor acquisitions or its growth slows and management fails to recognize that and pay out the excess capital, thats where we think the business model needs a fundamental restructuring. Henry McVey
we tend to view the big pharma companies, for example, where investors have reassessed the growth prospects of essentially the entire sector. The High-Leverage Model Stewart: What youre essentially talking about, Henry, are changes in payout policy rather than changes in capital structurethough, as I think we would all agree, an increase in the payout has the effect of increasing a companys leverage ratio. But before we leave the subject of capital structure behind, let me describe the kind of value that might be achieved with a more aggressive use of leverage. A case that comes to mind is that of Ball Corporation, a $5 billion aerospace and packaging company. In the early 1990s, the company adopted an EVA performance measurement and incentive system that really focused management on increasing their returns on capital. They sold their glass packaging business to Saint-Gobain and spun off a group of non-core manufacturing businesses into Alltrista. Since then, they have also made major investments in China and in Asia generally, and
43

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

ROUN DTAB LE

they made a billion dollar acquisition in Europe in 2002, in addition to acquiring the metal beverage container assets of Reynolds Metals in 1998. Their sales growth rate has been 13% a year for the past ve years. Perhaps most remarkable of all, theyve gone through this entire period of growth and investment without an investment-grade bond rating. The company operates with a 67% ratio of debt to total capital, its market leverage ratio is now about 40%, and its bond rating is BB-. In fact, they will tell you that they work hard to avoid becoming an investment-grade credit; and yet if youd 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 this strategic use of leverage. The company went private in the 1980s, and then became a serial re-capitalizer. Every three years or so, they would borrow a large amount that would be used either to make a major acquisition or to buy back outsiders equity, thereby increasing managements equity stake. Then, in 2002, the company went public again. But they still operate with a 75% book debt-to-capital ratioand a 44% debtto-market value ratio. And I think this kind of high-leverage strategy ends up adding a lot of value for companies like ARAMARK. It gives them a very low weighted average cost of capitaland they have solved their free cash ow problem through large share repurchases nanced by debt. But, as head of corporate nance at Morgan Stanley, Jon Anda is much more familiar with such highly leveraged companies and transactions than I am. Jon, would you give us your view of Ball Corp.
44

and what you think it says, if anything, about the optimal capital structure for most publicly traded U.S. companies?
Jon Anda: Bennett, as you know, Im

a big fan of Ball Corp. and its nancing approach. Its a great illustration of a company that has executed a successful growth strategy while making aggressive use of leverage. It shows that, even for companies without investmentgrade ratings, our nancial markets will provide funding when they like what management is doing with the capital. But I also agree with Cliffs distinction between mature and growth companies, and, in thinking about public companies, I like to start with Henrys concept of the two buckets. If youre a company that generates lots of cash while producing returns on invested capital close to your cost of capital, then ne-tuning your capital structure could become very important. In fact, if you dont make use of leverage in such cases, then a nancial sponsor like Blackstone is likely to do it for you. But if youre a company that is producingor is capable of producingvery high returns and you need large amounts of outside capital to do it, then youre going to be a lot more conservative in using debt. And there may be good reason for this conservatism. If you go back in time two or three years, the spreads even on investment-grade bonds widened dramatically; we had lots of fallen angels, and single-A credits were trading at 400 basis points over Treasuries. So, even though spreads are a fraction of that today, its no surprise to me that companies arent lining up to do leveraged transactions. Now, there have been a number of releveraging trades in the

market, like the ARAMARK transactions you mentioned. But these releveragings are being done mainly by nancial sponsors who paid ve times cash ow and are now looking to transfer ownership. So, while I understand the case for high leverage in certain circumstances, leverage doesnt play much of a role in our dialogue with clients these days; its just not what people seem to be thinking about.
Stewart: Since you mentioned Blackstone,

lets consider how the private equity community looks at these issues. The companies owned by private equity investors typically use as much debt as they can raise, both to concentrate ownership and to minimize their cost of capital. Do you think the willingness of private equity investors to pay premiums for public companies has anything to do with the companies failure to use their debt capacity?
Anda: In the eyes of private equity inves-

tors, a signicant part of the value comes from the capitalized value of the tax shields provided by the debtand public companies could realize some of that value by levering up and having the stream of tax shields capitalized as a perpetuity. But I think private equity takes a fundamentally different approach to increasing value than most public companies. Most important, private equity investors have shorter, well-dened investment horizons; when they go in, there is almost always a plan to exit the business. In my recent dealings with nancial sponsors, Ive been seeing a lot of turnover in their portfolios of companies, and this turnover seems to be accelerating. And theres often a good deal of opportunism
A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance Volume 17 Number 1

ROUN DTAB LE

behind these leveraged deals that involves a kind of arbitrage of public markets. For example, in some of the recent multi-billion dollar LBOs involving natural resource and chemical companies, my sense is that the buyout rms saw a lot of upside in the commodity price cycle that was not being reected in the companies stock prices. And using leverage of 80% or more, the nancial rms have taken these companies private with the idea that they can make some operating improvements and then either sell the businesses or take them public again after a few years. Now, I agree with your point that, for companies with very stable cash ows and few investment opportunities, the possibility of an LBO is something they need to keep in mind. But I dont see most large public companies as LBO candidates; their investment requirements are generally too large and too risky for private equity investors. And if you ask me what our corporate clients are thinking about these days, its not about the possible gains from leveraging up and minimizing their WACC. The big topic is corporate liquidity. Companies today are awash in cash. At the moment, corporate cash holdings of the S&P nancials amount to about 45% of total debt, as compared to a historical average of 20-25%. And in the tech sector, cash represents 27% of total assets. Corporate managements are saying, Weve got so much money that we dont know what to do with it. How do we get it back to shareholders? Should it be through dividends or buybacksor how about a special dividend? As Arun was saying earlier, when you make these decisions, you have to start by focusing on the asset side of the balance

sheet. Youve got to gure out what kind of investment opportunities you have and the amounts of capital they will require. And having gotten a good x on your investment requirements, you can then start thinking about your capital structure and how much cash you should be paying out. Part II: Payout Policy
The Theory Stewart: Thanks, Jon. Thats a great

lead-in to the second part of our discussion. So lets turn to Dave Ikenberry, our resident academic expert on corporate payout policy. I earlier introduced him as the worlds 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 youre at it, Dave, would you also comment on why, and under what circumstances, dividends might provide a more cost-effective way of distributing capital than buybacks?
David Ikenberry: Lets start with the

question of why companies repurchase their shares. When we talk to CFOs and practitioners, we hear a variety of stories and motivationsbut underlying all this variety, there are clearly some common themes, and Ive come up with a classication scheme that groups them into four major categories. The categories are not mutually exclusive; in fact, some companies could be buying back shares for all four of these reasons. Most of these explanations apply to dividends as well, though to varying degrees. One common explanation for stock buybacks is that they provide companies 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 proper debt-equity balance. And for companies looking to make very rapid and dramatic changes in leverage ratios, both xed-price offers and Dutch auctions nanced by new debt offerings provide ways of doing this. Open market repurchases can have the same effect, but gradually and over time. And the same is true of dividends. The payment of a dividend effectively increases a companys leverage ratioand the announcement of a dividend increase reduces a rms debt capacity. A second motive for repurchases one that applies equally to dividendsis one that weve already discussed: namely, to pay out a companys free cash ow, or the excess cash that cannot be protably reinvested in the business and that may be wasted if left on the balance sheet. Now, you often hear analysts and other commentators criticize stock repurchases as a managerial admission of failure, a sign of managements lack of imagination. But while such criticism may be appropriate in a handful of cases, it generally completely misses the point of a repurchase. In most cases, buybacks are managements way of telling their shareholders that the company has more capital than it can protably employ. Far from being an admission of failure, its 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 protable, companies and channeling that capital into growth companies. In this sense, buybacks and dividends are an important part of the natural growth
45

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

ROUN DTAB LE

and maturation cycle that all companies go through. They help move capital from the old economy into the new economy. Viewed in this light, repurchases and dividends are a way for managers to say to the capital markets, Here is my excess cash, take it; you have better opportunities for 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 announcements of increases in dividends. A third major motive for repurchasesand here is where they part company from dividendsis that they provide a more exible, tax-advantaged substitute for dividend payments. Finance academics have been struggling for years to try to understand why companies pay dividends in the rst place, given their tax treatment. Repurchases provide a more tax-efcient approach to paying excess capital, even with the recent change in the tax law. And besides reducing investor taxes, repurchases also give management a great deal more nancing exibility than dividends. Whereas dividends are expected to be paid every quarter, buybacks can be accelerated or deferred in response to changes in the rms protability or investment requirements. Consistent with this idea of dividend substitution, traditional cash dividends as a percentage of total corporate distributions fell sharply during most of the 1990s, a period when repurchases were surging. As Bennett mentioned earlier, 1997 was the rst year in U.S. history that more cash ow was returned to shareholders in the form of repurchases than dividends. But starting around 2000, this trend began to reverse itself; and with the maturing of growth compa46

nies like Microsoft and some help from the Bush tax cut, weve seen a major resurgence of dividendsand Ill come back to this in a minute. The fourth common motive for both stock buybacks and dividends is to signal managements condence about the rms future earnings powerand, in some cases, managements sense that the rm is undervalued. Theres no clear consensus among academics today about whether dividends or repurchases are the more effective way for managers to signal their condence to investors. On the one hand, a companys existing stockholders benet when management ends up buying back lots of shares at what turn out to be bargain pricesand this, of course, gives managers an incentive to buy back stock when they think the rm is undervalued. On the other hand, one could argue that raising the dividend represents a rmer commitment to pay out excess cash than the announcement of an open market repurchase program (though xed tenders and Dutch auctions are a different story). And the research we have at the moment suggests that, at least for value companies, dividend increases may now be a more effective signal than buybacks. But the kind of information thats being signaled by a dividend increase is not clear. Rather than higher future earnings, as in most of the signaling stories told by academics, the message being sent to investors may just be one of more disciplined nancial management, a rmer commitment to pay out the rms excess cash ow. And that brings us back to the point where Cliff started.
Stewart: Dave, youve mentioned four

a fth motiveto increase earnings per share? Thats one we tend to hear quite often both from corporate managers and sell-side analysts.
Ikenberry: A lot of managers may say

reasons to buy back stock. But isnt there

and even believe they are buying back shares mainly to boost EPSand surveys conrm that this is a dominant motivebut as academics we try to understand the more fundamental forces that are driving this behavior. We are skeptical that increasing EPS is a logical reason to buy back shares because the available empirical evidence suggests that the market sees through the EPS effect, so we try to nd something real underlying the accounting cosmetics that are often used to justify corporate decisions. Now, when you look a little more closely at what happens in these share repurchases, you often nd some real economic benets behind the increase in EPS. If a company repurchases shares and then gets an increase in earnings per share, it tells me that the company had an inefcient allocation of assets before it bought back the shares. For example, a company with lots of idle cash on its balance sheet may get a boost in EPS from buying back its shares. But, as Cliff said earlier about leverage and EPS, the accounting effect is purely cosmetic. There is no information content in the accretion, no value creation; its just simple algebra. And thats why I would argue that the real underlying benet is not the EPS effect per se, but the improvement in the allocation of capital and the resulting increase in return on capital. So, the EPS benets of stock buybacks are really a matter of moving assets on the left-hand
A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance Volume 17 Number 1

ROUN DTAB LE

In most cases, buybacks are managements way of telling their shareholders that the company has more capital than it can protably employ. Far from being an admission of failure, its 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 protable, companies and channeling that capital 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
side of the balance sheet to higher-valued uses. Or, as I suggested earlier, its about returning a companys excess capital to investors and increasing the overall rate of return.
Stewart: Thanks, Dave, for that over-

Isnt that the message of M&M that we were all taught in business school?
Ikenberry: The fundamental question

view of the question. But let me play devils advocate again just by posing a very basic question: How can the payment of dividends by itself add value? After all, isnt a dollar of dividends received just a dollar of capital gains lost?

here is how much capital a company ought to have. And once you answer that question, then the excess should be distributed back into the capital markets in order to reassure investors. Several people today, including Jon Anda and Henry McVey, have suggested that theres been considerable corporate hoarding of cash during the last three or

four years. And to the extent that such hoarding raises concerns about companies ultimately wasting the capital, there are basically two different, but related, ways of addressing the problem. You can lever up the rm, perhaps by borrowing and using the debt to buy back shares. Or you can keep leverage where it is, and instead use some combination of dividends and buybacks to pay out excess cash ow. So, the rst question, as Jon Anda and Arun Nayar have said, is what are the companys investment opportunities and require47

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

ROUN DTAB LE

ments, and how much capital do they need? And, number two, if they decide they have excess capital, should they pay it out using dividends or buybacks? Now, on this second question, theres been some major shifting in recent years. Five or six years ago, I used to tell corporate treasurers and CFOs and CEOs that the common dividend was an endangered species. Gene Fama and Ken French published a widely cited study called Disappearing Dividends. But, as you mentioned, Bennett, Ive recently published a study with my colleague Brandon Julio that has the title Reappearing Dividends. So why are dividends suddenly coming back into favor? One factor is the way corporate executives and employees are now being compensated. As Henry mentioned in his presentation earlier this morning, the rise of stock options alone would encourage companies to shift toward repurchases and away from dividends; and to the extent that options are a key part of a rms business and compensation strategyand Microsoft certainly comes to mind here then dividends are clearly disadvantaged. But another factor working against dividends is their tax treatment: the interest on corporate debt is deductible, as Cliff said earlier, while dividends are not. Finally, from managements point of view, dividends are less exible than stock repurchase programs, which can always be canceledand generally without giving notice to shareholders, though this is about to change. And for companies embarking on a high-growth phase, maintaining such exibility can be critical. But these are all reasons to prefer buybacks to dividends and, as I just said, my conjecture of a few years ago that the com48

mon dividend would become extinct has turned out to be wrong (and thats one of the reasons Im in the academy and not in the forecasting business). Dividends have come back with a vengeance. For example, if you look back to the mid-1980s, 80% of S&P 500-type companies paid a dividend. By the height of the Internet bubble in 2000, that percentage had fallen to 40%. But today that number is approaching 50% and rising.
Stewart: Okay, I think we all agree that

companies ought to pay out their excess capital and cash ow. But I still have trouble understanding why dividends are suddenly the preferred methodand lets try and keep the question of stock options out of the equation, at least for a moment. We know that a dividend paid is a capital loss; that is, when a company goes ex-dividend, the price drops by pretty much the amount of the dividend paid. At the same time, youve forced the taxable shareholders who receive the dividend to incur a tax, even if its only 15 cents on the dollar now. Why not instead offer to buy back stock and give your investors the choice of selling and being taxed?
Ikenberry: I agree, Bennett, that although dividends arent as painful to investors as they were in the past, they still have a tax bite. I think the real answer to your question has to do with Cliffs point earlier about the strength of managements commitment to pay out free cash ow, the idea that companies that pile on debt effectively commit themselves upfront to an irreversible, contractual stream of payments. Now, Cliff talked about this commitment mainly 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 viewand I got the sense from some of Henrys comments that he shares this viewdividends represent a rmer commitment to pay out excess cash than the announcement of a typical open market repurchase program. Unlike buybacks, which are often canceled and have little surrounding disclosure, dividends are a bright line number; theyre very easy to see and theyre commitments that stretch out indenitely. In this sense, they have some of the same properties as debt service payments. But, as Cliff also pointed out, for companies whose value comes more from growth opportunities than current operations, maintaining nancial exibility is going to be more important than committing to pay out cash ow. Both Henry and Arun see PepsiCo as a growth company, and growth companies need to preserve nancing exibility. And this is even more true of pharmaceutical companies like Pzer. That industry today is going through some tough times. But what is the value of Pzer, after all? When you really boil it down, its the expected value of its R&D pipeline. And the companys nancing policies have to be designed to continue funding its R&D program and the commercial development of its most promising new drugs. In this sense, their R&D program represents a portfolio of real optionsthey need to maintain the nancing exibility to exercise those real options. Payout Policy: The Case of PepsiCo Stewart: Thanks, Dave. Arun, would you please tell us your thinking on payout policy at PepsiCo?
A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance Volume 17 Number 1

ROUN DTAB LE

Nayar: When we look at the question

of payout policy, we start by looking at the level of our free cash ow. We ask ourselves: How much cash ow is being generated by our businesses, and what is our current best estimate of our capital outlays over our planning horizon? Our rst priority is making the right corporate investment decisions. As we all learned in business school, that means following the net present value rule: take all investments that promise to earn more than the cost of capital and reject the rest. And to achieve that goal, we subject all our major investment projectsand even most minor onesto fairly intense scrutiny. Then, after getting estimates of our investment requirements and setting them against our expected cash inows, we estimate our excess cash, or what weve been calling our free cash ow. Our policy is to return 100% of our free cash ow in one way or another to our shareholders. Thats a discipline we impose upon ourselves. In carrying out that policy, over the last ve years PepsiCo has returned some $15 billion to the shareholders through dividends and buybacks. Roughly a third of that $15 billion has come in the form of dividends, with the other two-thirds in the form of share buybacks.
Stewart: How do you choose between

holders can expect to grow in the future. We at PepsiCo are very conscious that our dividend has been raised each year for 33 consecutive years, and we want to set 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 cash ow in the form of stock repurchases, which is consistent with our strategy of returning 100% of free cash ow to our shareholders. Leveraged Recaps as an Alternative to Dividends Stewart: Okay, thats one way of solving the free cash problem and of keeping yourself from falling into the trap of accumulating excess liquidity. But let me, again for the sake of argument, try out a more drastic proposal. If paying dividends isnt part of your discipline, you could consider saying to your shareholders, Were having a 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 the next ve years. But were going to give it to you not as a dividend but in the form of a stock buyback. This way only the investors who choose to sell get taxed. And to keep your taxes lower, we wont pay dividends in the future; that money will be used instead to pay off the debt. Why dont we see more companies using this method for capturing the disciplinary benets of dividendsthat is, monetizing them through a debtnanced repurchase?
Smith: Bennett, what youve just pro-

dividends and repurchases?

Nayar: We really start by nding the

appropriate dividend policy. Our goal is to have a fairly consistent and predictable dividend payout, one that is not going to be affected by changes in the tax law ve years from now and one that our share-

the solution thats being used in the LBO and private equity business. But we rarely see that solution used by publicly traded companies. And theres a good reason its too extreme, it takes away managements exibility to respond if something goes wrong. What youve given us is an either/or set of alternatives. Youve proposed a light switch that is either on or off, when what I think most CFOs want is a rheostat; they want some control over things. And when Arun tells us that exibility is very important for a company like PepsiCo, Im inclined to agree. Now, thats very different from saying that the CFOs mission is to maximize exibility. I think we can all agree that it would be fundamentally inappropriate for every CFO of every company to say that his or her job is to maximize exibility for the organization. What you want is the right amount of exibilitynot too little, not too much. Financial exibility comes with a price and with a responsibility to justify that exibility to your shareholders. What we want to achieve is a reasoned balance of the exibility you get in terms of capital structure decisions, payout policy, HR policies, and risk management. And for most companies, forecasting the dividends they would expect to pay over the next ve years, selling debt to raise that amount of capital, and using that debt to repurchase shares would involve an unacceptable sacrice of exibility. Most CFOs will choose a more balanced approach, a payout policy that isnt set in stone. The Changing Investor Paradigm Anda: I agree with Cliff that the kind of leveraged recap that Bennetts propos49

posed is a slightly less drastic version of

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

ROUN DTAB LE

ing is really an extreme solution. Its one that was used with some success in the 1980s, although it had its share of failures, too. But its one that most publicly traded companies are going to shy away from. For most public companies, getting the right payout policy is about getting the 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 their free cash ow in the form of buybacks and a third as dividends, a lot of companies are now thinking about reversing those proportions. As both Cliff and Dave were saying, investors are likely to view dividends as a stronger commitment than buybacks. Two years ago I gave a presentation in this room on what I called the changing investor paradigm. Im not going to repeat it all, but I think there has been a major shift in the perspectives 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, I believe that we have gone from a world in which investors focused mostly on earnings growth and P/E multiples to one in which the main focus has become variables like free cash ow, returns on capital, and DCF. Now, this idea is likely to meet with resistance from people who are committed to the efcient markets view of the world. In this view, highly sophisticated marginal investors are always looking through accounting numbers to the economic reality of cash ow, or what my colleague Trevor Harris calls sustainable earnings. But my own sense is that while
50

the sophisticated bargain hunters on which the theory relies are usually pretty effective in correcting undervalued situations, at least given a little time, in the past there have not been enough of these investors to keep some stocks from becoming way overvalued. And that, with the help of some accounting chicanery, is what we saw during the recent tech bubble. But I think all this has been changing in the past few years, and that our nancial markets are now in the process of becoming more efcient. For those of us who work closely with investors, there have been two major changes. First is the recent increase in investors computing power. In the late 90s, few sell-side analysts had valuation models; and although buy-side analysts had models that allowed them to do more than just project growth in EPS, these models were still fairly limited. But since the bursting of the tech bubble, rst the buy side and now the sell side are building much more powerful models that use sensitivity analysis to calculate, analyze, and project variables like DCF and residual income. So, the models are available, and theyre enabling analysts to look through accounting numbers to the underlying cash generation and earnings power. And as a consequence, the markets scrutiny of accounting numbers appears to have reached a new level. The second major change is the growth of hedge funds. The popular conception of hedge funds is that they use a highly quantitative approach that involves trading in and out of stocks. Whats not well known is that, in addition to these quant and momentum investors, there are a large and growing number of fundamentals-driven hedge funds that, like the spinoffs from Tiger Management, focus

mainly on free cash ow and returns on capital. Such funds now control huge pools of capital and often take very large positionssome long, some short. And they often hold these positions for a considerable period of time. My reason for bringing up hedge funds in this context is that such investors pay very close attention to how companies invest their capital and what they do with their free cash ow. They want high returns on total capital; and if management cant earn acceptable returns, they want the capital back. And the mix shift toward dividends that were now seeing reects in part the markets recognition that the old accretive EPS buyback, as Dave Ikenberry just pointed out, is yet another accounting illusion. That is, the idea that a low P/E company can increase its value by using an EPS-increasing buyback just doesnt y any more. And, in most cases, I dont view buybacks as an effective signaling device either. Investors today are saying, Im looking very carefully at your free cash ow. Theres a lot of it, more than I think you need, and I would like to have some of it. Now, an interest payment, as Bennett was suggesting, may be better than a dividend in some circumstances, and we can debate that point. My own feeling, though, is that investors trust most companies to choose their capital structure; and as long as that capital structure isnt totally inappropriate, investors are then going to monitor the companies free cash ow very carefully. And if the cash ow 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

A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance Volume 17 Number 1

ROUN DTAB LE

I think there has been a major shift in the perspectives 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 growth and P/E multiples to one in which the main focus has become variables like free cash 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 powerful computing models to see through accounting numbers to companies underlying cash generation and earnings power. Second is the large and growing number of fundamentalsdriven hedge funds that pay very close attention to how companies invest their capital and what they do with their free cash ow. Jon Anda

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

51

ROUN DTAB LE

major development. The inows to the U.S. mutual fund industry peaked in 1993; since then, the ten-year compound annual growth rate in mutual fund ows has been 1%. Today, over 50% of total trading volume is related to hedge funds and program trading. So we now have a very different investor base. I recently attended a Morgan Stanley conference for its 50 largest investors, and my impression was that these people were all credit investors. Free cash ow was the number one topic of discussion, and less than half the ideas being discussed in the room were about growth stocks. The bigger focus was on companies that were yielding as much as 5%! And its not just the largest investorspeople who put their money in 401(k)s also now appear to be looking for yield. This focus on yield may end up contributing to another change I see coming in the hedge fund industry over the next three to ve years. As the funds continue to grow and take in new money, my prediction is that theyll end up relying less on performance fees and move back toward the management fee model that prevails in the mutual fund industry. The focus on higher-yield stocks, to the extent it reects reduced investor expectations for growth, is consistent withand could help drive this shift toward management fees. So, to sum up, the U.S. investor base has changed dramatically in the past few years. Hedge funds are a major force today. Theyre going to have much more capital in the future, and their inuence on corporate investment decisions is going to grow along with it. And as Jon was telling us, the hedge funds care a lot about free cash ow and what companies are doing with itand there arent many prospects
52

for growth and multiple expansion in the mega-cap segment of the market. But if this focus on free cash ow and dividends may turn out to be a valuable discipline for many if not most companies, Im also worried that some companies will be discouraged from reinvesting enough in their business. In this sense, investor pressure on free cash owwhich is basically a good thing can be taken too far. In Closing: The Problem of Corporate Underinvestment Stewart: Okay, so up to this point, weve been focusing almost entirely on corporate efforts to address their free cash ow problem, which is essentially a problem of overinvestment. But now were talking about a possible underinvestment problem. Jon, are you seeing anything with your clients that would make you think this is likely to be a big concern?
Anda: My feeling is that a large number

opportunities for companies to create economic valueor what you call EVA, Bennettbut theyre just not doing it.
Stewart: Well, I too have seen lots of com-

of companies today are using hurdle rates that are well above their weighted average cost of capital. Given todays interest rates, a stock with a beta of one has a cost of equity of about 8% and, assuming a capital structure of 30% debt, a WACC of about 7%. But rather than using 7%, a lot of companies seem to be using their existing returns on invested capitalin many cases anywhere from 12% to as high as 15% as their effective hurdle rates. In fact, it seems to me that theres been a de-linkage between WACC and hurdle rates during this entire interest-rate cycle. And the consequence is that companies are likely to be walking away from some value-adding projects. To me, it looks like there are a lot of

panies that are earning high returns on capital use those returns as the benchmark for future investments. In fact, there was a recent article in the JACF that argued that the largest oil companies have been sacricing potential value by aiming for returns on capital that are too high. This typically happens because managements think that if theyre earning 15% on capital today, then anything less will disappoint investors. But, as you suggest, Jon, this is not consistent with our EVA measure, its not consistent with the NPV and DCF concepts taught in our business schools, and I dont believe it reects the way the market prices stocks. Take the case of Wal-Mart. At the beginning of the 1990s, it was earning rates of return on capital of over 25%. The company continued to invest heavily throughout the 90s; and even though its average return fell during the period, its new investments were covering the cost of capital in their own right and thus creating EVA, and the companys market value continued to rise. But I agree with you, Jon, that a lot of managements think in terms of maintaining or maximizing returns instead of EVA or DCF. Why do you think this is happening today?
Anda: I think part of it has to do with

managers confusion about what investors really want, but a lot of it also has to do with the current economic and business climate. Our clients are saying, We see a low-growth scenario in the developed world and a high-growth
A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance Volume 17 Number 1

ROUN DTAB LE

I have seen lots of companies that are earning high returns on capital use those returns as the benchmark for future investments. This typically happens because managements think that if theyre 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 dont believe it reects the way the market prices stocks. As anyone familiar with the concepts of EVA or DCF can tell you, passing up promising M&A and other strategic investments is a prescription for reducing value. Bennett Stewart
scenario in the developing world. Were generating a lot of cash and dont need to spend much to remain competitive here. But what about opportunities in China and India? The problem, however, is that its not easyor necessarily a good ideato quickly put capital to work in places in China and India. You need to be deliberate and take your time. So, in the meantime you accumulate cash or you buy back stock. But, in so doing, companies may be passing up good opportunities to add value.
Stewart: Okay, lets leave it at that, and

particular for your willingness to discuss PepsiCos policies. Its all well and good to discuss these topics from a theoretical point of view, but the practitioner perspective is enormously valuable, especially from a well-respected company like PepsiCo.

let me thank you all very much for taking part in this discussion. Arun, thank you in
Journal of Applied Corporate Finance Volume 17 Number 1 A Morgan Stanley Publication Winter 2005 53

ROUN DTAB LE

Analyst Certication

The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specic recommendations or views in this report: Henry McVey.
Important US Regulatory Disclosures on Subject Companies

The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and its afliates (collectively, Morgan Stanley). Within the last 12 months, Morgan Stanley managed or co-managed a public offering of securities of PepsiCo, Inc. Within the last 12 months, Morgan Stanley has received compensation for investment banking services from PepsiCo, Inc. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from PepsiCo, Inc.

Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from PepsiCo, Inc. Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with, the following companies covered in this report: PepsiCo, Inc. Within the last 12 months, Morgan Stanley has either provided or is providing non-investment banking, securities-related services to and/or in the past has entered into an agreement to provide services or has a client relationship with the following companies covered in this report: PepsiCo, Inc. The research analysts, strategists, or research associates principally responsible for the preparation of this research report have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, rm revenues and overall investment banking revenues.

54

Journal of Applied Corporate Finance Volume 17 Number 1

A Morgan Stanley Publication Winter 2005

Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN 1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwell Publishing, with ofces at 350 Main Street, Malden, MA 02148, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: +44 1865 471775. Information for Subscribers For new orders, renewals, sample copy requests, claims, changes of address, and all other subscription correspondence, please contact the Customer Service Department at your nearest Blackwell ofce (see above) or e-mail subscrip@bos.blackwellpublishing.com. Subscription Rates for Volume 17 (four issues) Institutional Premium Rate* The Americas $330, Rest of World 201; Commercial Company Premium Rate, The Americas $440, Rest of World 268; Individual Rate, The Americas $95, Rest of World 53, 80; Students**, The Americas $50, Rest of World 28, 42. *Includes print plus premium online access to the current and all available backles. Print and online-only rates are also available (see below).

Journal of Applied Corporate Finance is available online through Synergy, Blackwells online journal service, which allows you to: Browse tables of contents and abstracts from over 290 professional, science, social science, and medical journals Create your own Personal Homepage from which you can access your personal subscriptions, set up e-mail table of contents alerts, and run saved searches Perform detailed searches across our database of titles and save the search criteria for future use Link to and from bibliographic databases such as ISI. Sign up for free today at http://www.blackwell-synergy.com. Disclaimer The Publisher, Morgan Stanley, its afliates, and the Editor cannot be held responsible for errors or any consequences arising from the use of information contained in this journal. The views and opinions expressed in this journal do not necessarily represent those of the Publisher, Morgan Stanley, its afliates, and Editor, neither does the publication of advertisements constitute any endorsement by the Publisher, Morgan Stanley, its afliates, and Editor of the products advertised. No person should purchase or sell any security or asset in reliance on any information in this journal. Morgan Stanley is a full service nancial services company active in the securities, investment management, and credit services businesses. Morgan Stanley may have and may seek to have business relationships with any person or company named in this journal. Copyright 2005 Morgan Stanley. All rights reserved. No part of this publication may be reproduced, stored, or transmitted in whole or part in any form or by any means without the prior permission in writing from the copyright holder. Authorization to photocopy items for internal or personal use or for the internal or personal use of specic clients is granted by the copyright holder for libraries and other users of the Copyright Clearance Center (CCC), 222 Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided the appropriate fee is paid directly to the CCC. This consent does not extend to other kinds of copying, such as copying for general distribution for advertising or promotional purposes, for creating new collective works, or for resale. Institutions with a paid subscription to this journal may make photocopies for teaching purposes and academic course-packs free of charge provided such copies are not resold. For all other permissions inquiries, including requests to republish material in another work, please contact the Journals Rights and Permissions Coordinator, Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ. E-mail: journalsrights@oxon.blackwellpublishing.com.

Customers in Canada should add 7% GST or provide evidence of entitlement to exemption.

Customers in the UK should add VAT at 5%; customers in the EU should also add VAT at 5%, or provide a VAT registration number or evidence of entitlement to exemption. **Students must present a copy of their student ID card to receive this rate. For more information about Blackwell Publishing journals, including online access information, terms and conditions, and other pricing options, please visit www.blackwellpublishing.com or contact our Customer Service Department, tel: (800) 835-6770 or +44 1865 778315 (UK ofce). Back Issues Back issues are available from the publisher at the current singleissue rate. Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mailing to rest of world by DHL Smart & Global Mail. Canadian mail is sent by Canadian publications mail agreement number 40573520. Postmaster Send all address changes to Journal of Applied Corporate Finance, Blackwell Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA 02148-5020.