StrategicCorporate

Finance

Applications in Valuation andCapital Structure

JUSTIN PETTIT

John Wiley & Sons, Inc.

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Additional Praise forStrategic Corporate Finance

Strategic Corporate Finance provides excellent insight into the keyfinancial issues that corporations are dealing with every day.

Rhod Harries, VP and Treasurer, Alcan

This book is a MUST for all corporate finance professionals. Ihave never read a corporate finance book before that provides sucha complete and integrated overview of which relevant value driversand implications should be considered before making strategiccorporate finance related decisionsM&A projects, equity anddebt financing, Asset and Liability Management, rating, pensions.You financial advisors out there: These are the relevant questionsand necessary answers your industrial clients are expecting fromyou!

Dr. Dietmar Nienstedt, Head of Mergers & Acquisitions,LANXESS AG

In Strategic Corporate Finance: Applications in Valuation andCapital Structure, Pettit brings a fresh and practical approach tocorporate finance, effectively bridging the gap between theory andpractice. He addresses timely and pertinent topics that corporationsface constantly. I have often relied on Pettits prior works as usefulreferences, and it will be nice to have them all in one place. Ihighly recommend his work to anyone looking for a practical andactionable guide to corporate finance.

David A. Bass, Vice President, Treasurer GlobalOperations, Alcon Laboratories, Inc.

StrategicCorporate

Finance

Applications in Valuation andCapital Structure

JUSTIN PETTIT

John Wiley & Sons, Inc.

Copyright c 2007 by Justin Pettit. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the Webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permission.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respect tothe accuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be createdor extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any loss ofprofit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

For general information on our other products and services or for technical support, pleasecontact our Customer Care Department within the United States at (800) 762-2974, outsidethe United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears inprint may not be available in electronic formats. For more information about Wiley products,visit our Web site at www.wiley.com.

The author wishes to acknowledge the generous permission of Blackwell Publishing inallowing him to reuse Corporate Capital Costs: A Practitioners Guide (Journal of AppliedCorporate Finance, Vol. 12, No. 1, Spring 1999) and A Method For Estimating GlobalCorporate Capital Costs: The Case of Bestfoods (Journal of Applied Corporate Finance, Vol.12, No. 3, Fall 1999) in Chapter 1 of this book.

Library of Congress Cataloging-in-Publication Data:

Pettit, Justin, 1965-Strategic corporate finance : applications in valuation and capital structure/Justin Pettit.

p. cm.(Wiley finance series)Includes bibliographical references and index.ISBN-13: 978-0-470-05264-8 (cloth)ISBN-10: 0-470-05264-3 (cloth)1. CorporationsFinance. 2. Capital. 3. Value. I. Title.HG4026.P468 2007658.15dc22

2006021653

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

www.wiley.com

To Krista, Trevor, and Madeleine, for their support,patience, and laughter.

Contents

Preface xi

List of Figures xiii

List of Tables xv

Acknowledgments xvii

About the Author xix

PART ONEManaging the Left-Hand Side of the Balance Sheet

CHAPTER 1The Cost Of Capital 3

Calculation Pitfalls 3Market Risk Premium (MRP) 5Toward a Better Beta 10The Riskless Rate 13The Cost of Debt 14Global Capital Costs 16WACC and Hurdle Rates 23

CHAPTER 2Fix: Finding Your Sources of Value 26

Why Shareowner Value? 27Performance Measurement Pitfalls 28Measuring Economic Profit and Value 30Analyzing the Corporate Portfolio 35Incorporating the Cost of Capacity 39Value-Based Strategies and Tactics 43Managing for Value 45Balancing Performance with Value 52

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viii CONTENTS

CHAPTER 3Sell: Creating Value Through Divestiture 54

Divestiture Creates Value 56Sources of Value: Motives for Divestiture 58Alternative Methods of Disposition 60What Works Best for Whom? 63What Happens Longer Term? 64Practical Impediments to Divestiture 65Financial Policy Considerations 70Tax Considerations and Structural Refinements 70

CHAPTER 4Grow: How To Make M&A Pay 73

M&A Today 73Transactions that Create Value 77M&A Fact and Fallacy 81RX for the Conglomerate Discount 86EVA and M&A 88How Serial Acquirers Create Value 90Financial Policy Considerations 93Financing Growth 94

CHAPTER 5Cash and The Optimal Capital Structure 97

Trends and Implications 98How Much Is Too Much? 100The Costs and Benefits of Excess Cash 105How the Market Views Excess Cash 108Optimal Capital Allocation 109

PART TWOManaging the Right-Hand Side of the Balance Sheet

CHAPTER 6An Executives Guide to Credit Ratings 117

Trends and Implications 117Empirical Evidence 123Limitations of Quantitative Credit Analysis 123What Metrics Matter Most? 126

Contents ix

Case Study: Treatment of Pension and PostretirementLiabilities 131

Multivariate Credit Models 133Industry Considerations 135Case Study: Property and Casualty Insurance 135Application Issues 137How to Manage Your Agencies 137Case Study: Illustration of Secured and Unsecured Notching 139

CHAPTER 7Todays Optimal Capital Structure 141

Value-Based Financial Policy 141Less Debt Is Now Optimal 143Extend Duration When Rates Are Low 146Maintain Financial Liquidity to Insure Your Equity 149A New Perspective on Equity 151Case Study: Does Tech Need Debt? 154

CHAPTER 8Dividends and Buybacks: Calibrating Your Shareholder Distributions 160

The Cash Problem 162Dividends Are Back 163How Dividends and Buybacks Create Value 165Should You Increase Your Dividend? 171How Large Should Your Buyback Program Be? 178How to Execute Your Share Repurchase Program 181

CHAPTER 9The Stock Liquidity Handbook 187

Measuring Stock Liquidity 188The Liquidity Discount 191Implications of Stock Illiquidity 192Solutions to Illiquidity 193Stock Splits 195

PART THREEManaging the Enterprise

CHAPTER 10Strategic Risk Management: Where ERM Meets OptimalCapital Structure 203

The Value of Risk Management 204

x CONTENTS

Mapping and Modeling Risk 209Managing to a Benchmark 213External Considerations and Constraints 216ERM Case Study: Metallgesellschaft AG 219Capital Structure Solutions 220

CHAPTER 11Best Practices In Hedging 224

Which Exposure to Hedge 225Hedge Horizon 230Hedge Ratio 232Options versus Forwards 233Accounting Considerations 235Implementation 236

CHAPTER 12ERM Case Study: Reengineering The Corporate Pension 238

Why Now? 239The Problems with Equity 240The Case for More Bonds 243Optimal Capital Structure Reprise 246Capital Markets Solutions 248The Boots Case 251Why It Still Hasnt Happened 252

APPENDIX AResources 254

Tools and Portals 254New Research and Literature Search 254Economic Research and Data 254News and Market Data 254Corporate Governance and Compensation 255Other Agencies 255

Endnotes 256

References 268

Index 277

Preface

S trategic Corporate Finance provides a real-world application of theprinciples of modern corporate finance, with a practical, investmentbanking advisory perspective. Building on 15 years of corporate financeadvisory experience, this book serves to bridge the chronic gap betweencorporate finance theory and practice. Topics range from weighted averagecost of capital, value-based management and M&A, to optimal capitalstructure, risk management and dividend/buyback policy.

Chief Financial Officers, Treasurers, M&A and Business Developmentexecutives, and their staffs will find this book to be a useful reference guide,with an emphasis more on actionable strategic implications, than tacticalmethodology per se. Board members and senior operating executives mayuse this book to better understand issues as well as to prompt questionsto ask, and frameworks to employ, to get them to the answers they need.Similarly, investors who read this book will benefit from an improvedpractical understanding of the corporate finance issues, the degrees offreedom in their management, and their impact on company performanceand value. Investment bankers and consultants will use this book fortraining, and as a general reference guide. Finally, students who wish tobetter understand how their corporate finance knowledge, skills, and toolsmight be put to use in the real world should read, and re-read, this book.

Each chapter in this book represents a recurring theme or topic interms of actual client questions. The material is based on real-world adviceand includes much of the thought process and some of the analytics thatwere undertaken to develop the recommendations. In getting to these views,significant input is drawn from the literatureboth the theory and theempirical researchas well as our own empirical work. Early work in thepublic domain is cited.

This book is organized into three parts. Part One addresses the left-hand side of the balance sheet and related performance measurement andvaluation topics. Part Two deals with the right-hand side of the balancesheet and topics in optimal capital structure. Part Three addresses enterprisemanagement in a holistic approach, as corporate finance issues increasinglyrequire. Each chapter begins with an executive summary to make readingthis book a realistic possibility for the reader.

xi

xii PREFACE

Part One outlines the principal topics in managing the left-hand sideof the balance sheet, following the prevalent Fix, Sell, Grow mantrain use today, with an intrinsic value perspective. Chapter 1 provides acomprehensive users guide to the weighted average cost of capital and allthe practical complications that arise in estimating and applying WACC inpractice. In Chapter 2 we put this benchmark for value creation to use. Oursolution is a deep dive on how to find the sources of value creation, byovercoming the allocation and cost accounting issues that often plague theeconomic profit framework, as well as traditional performance measures.Chapter 3 makes the case for divestitures, outlining who, why, how, andwhen. Chapter 4 tackles growth, a difficult step for many that remainsunder-served by much of the existing literature today, and a topic thatdemands thoughtful consideration by value-based management enthusiasts.Chapter 5 rounds out Part One with todays hot topic of excess cash: whenit matters and what to do about it.

Part Two moves to the right-hand side of the balance sheet to addressoptimal capital structure. Chapter 6 provides an executives guide to creditratings, with trends and implications of todays new ratings climate, dis-cussion of the quantitative approaches to ratings and their limitations, anunderstanding of the qualitative analysis, and specific discussion aroundratings challenges like pensions, excess cash, notching, and the investmentgrade versus speculative grade worlds. Chapter 7 outlines a framework foroptimal capital structure, with special consideration to the key factors andwhat is different today, and their implications for financial policy. Chapter 8is a handbook for setting dividend and share repurchase policy, with specialattention given to todays growing problem of too much cash. Chapter 9addresses stock liquidity, an important problem for many smaller and mid-dle market domestic companies, as well as American Depositary Receipts(ADRs) and the vast majority of stocks listed on overseas exchanges.

Part Three elevates the discussion to an enterprise-wide perspectiveof capital management. Chapter 10 introduces the strategic risk manage-ment concept and frameworks, with examples of the interplay betweenprocess control efforts, financial and operational hedging, and capital struc-ture solutions. Chapter 11 outlines best practices in financial hedging.Chapter 12 serves as an enterprise risk management (ERM) case study byshowing how corporate pensions can be re-engineered to create considerableshareholder value.

List of Figures

Figure 2.1 Cost of Capacity Framework 41Figure 2.2 Economic Run Length 48Figure 2.3 Product Value versus Set-Up Time/Cost 49Figure 2.4 Modified Build to Order (BTO) Concept 50Figure 2.5 Performance/Value Matrix 52Figure 3.1 Distribution of Divestiture Returns 57Figure 4.1 2004 GV and COV per $1 of Book Capital 74Figure 4.2 EVA-Based Postacquisition Audit 90Figure 5.1 Stochastic Solution to Requisite Operating Liquidity 105Figure 5.2 WACC Considerations 111Figure 6.1 Short-Term versus Long-Term Ratings 130Figure 6.2 Illustration of Pension Adjustments 132Figure 6.3 Regression-Based Credit Model 134Figure 6.4 Illustration of Notching Up and Notching Down 139Figure 7.1 Framework for Financial Policy 142Figure 7.2 Value Proposition of Debt 144Figure 7.3 Dynamic Strategies Outperform Efficient Frontier 147Figure 7.4 Volatility and Outlook Drive Liquidity 151Figure 7.5 WACC Minimization Doesnt Equal

Value Maximization 155Figure 7.6 Framework for Optimal Financial Strength 156Figure 8.1 Technology Sector Dividends and Buybacks 161Figure 8.2 Technology Sector Cash and Debt 162Figure 8.3 Dividend Capacity Analysis 173Figure 8.4 Dividend Policy 177Figure 10.1 Lower Volatility Associated With Higher

Credit Quality 206Figure 10.2 The Value of Risk Management Varies 208Figure 10.3 Components of Enterprise Risk 210Figure 10.4 Strategic Risk Management Spectrum 220Figure 11.1 Hedging Alternative Exposures 226Figure 11.2 Illustration of Layered Hedges 231

xiii