I.               Picking a company

a.     Pick a company which has been around at least a year (preferably two), since it is nice to have two annual reports to compare. If you want to pick a company that has been listed less than that, make sure that you can get at least one year of financial statements.

b.     It can be listed anywhere in the world

c.     Make sure that the companies in your group are tied together by a common thread – same sector or industry.

 

II.             Getting data on the company

a.     Much of the data comes from Bloomberg and if you have never used a Bloomberg before, it can be daunting.... Let me know if you get stuck (You can also get a manual on using Bloomberg data written by yours truly under updated data on my web site)

http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html

b.     Print off the HDS page (just page 1) for your company and visit the SEC site at

http://www.sec.gov

and print off the latest 14-DEF for your firm. If you are wondering what an HDS page and how to get it, you need to get to a Bloomberg terminal, click the equity button and find your company. Once you have found the company, type in HDS and you will get a listing of the top holders of equity in your company.... print off just the first page.

If you have a foreign company

            Analyzing a non-US company can be interesting but sometimes frustrating. Here are some suggestions on getting information (which is the most frustrating part):

a.     Bloomberg: When you type in your company's name into Bloomberg, the first thing that will strike you is the number of listings that Bloomberg will pull up on your company. (Nokia has more than a 100 listings under equity). To get the listing that will contain all the information for your company, you need the primary listing in the local market. (The ADRs (which are the listings traded in the US) will not provide you with adequate information.) Look for the country code for the local market (In Western Europe, for example, FP: France, IM: Italy, GR: Germany, GA: Greece; LN: UK; SW: Switzerland; Pl: Portugal: FH: Finland etc...You can get a more complete list on Bloomberg). Once you have found the listings on the local market (and there will often be more than one), it is a process of trial and error. Check a listing and type in DES. If you get only 2 or 3 pages, you have the wrong listing... Keep trying and you will hit the jackpot...) Once you have found the listing, print off everything you would for a US company (HDS, Beta, DES (first 10 pages), FA (item 25))

 

2. Financial Filings: You will be able to get annual reports for almost any non US company. I usually try the company's own web site first (companyname.com usually gets you there) and print off the annual report. You can also try the following web site that lets you print off annual reports once you have registered with them (a pain, but it is free).

http://www.carol.co.uk

The UK does have its own version of the SEC and you can get information on UK companies by going to

http://www.companies-house.gov.uk/

 

IV. Stockholder/ Manager Objectives

a.     Assessing a Board

Business Week assesses the quality of a firms' board every year. To get a sense of how they makes their assessments, you can read the article from Business Week.

There are a number of interesting sites that keep track of directors and their workings. I have listed a few below:

http://www.corpgov.net/links/links.html : This is a general site listing corporate governance links

http://www.ecgi.org/ : Covers corporate governance in Europe

http://www.theyrule.net/: Covers only large firms but provides a look at the linkages between directors in different companies. Food for the conspiracy buff in you.

2. Assessing a company's good citizen standing

This is difficult to do. You can get the outliers in both directions by looking at rankings in financial publications like the Wall Street Journal, Fortune and Business Week. For instance, you can get the “most admired companies” by going to

http://www.fortune.com/fortune/mostadmired

For how organized labor views companies,

http://www.aflcio.org/corporateamerica/

If you interested in socially responsible investing, try this web site:

http://www.socialinvest.org/

It has links not only to mutual funds that invest in socially conscious companies but also on resources that can be used to put pressure on companies that are not socially responsible.

 

 

IV. Finding your firm's marginal investor

V. Risk and Return

a.     Risk free Rates

If you are now ready to dip your toes in the water, you can get started building towards a minimum acceptable hurdle rate. If you are analyzing a company in US dollars (it could be a US or non-US company), this will be easy. Go to

http://www.bloomberg.com/markets/C13.html?sidenav=front

Get the 10-year bond rate.

If you are analyzing a company in Europe, I mentioned in class that you would want to use the lowest 10-year Euro bond rate that you can find:

http://www.bloomberg.com/markets/iyc.html

 

b.     Risk Premiums

Historical Risk Premium:  If you are analyzing a US company, you can get the historical premium out of my notes (4.53% for 1928 - 2002). If you have a non-US company, don't even bother estimating a historical premium. Instead, do the following.

Step 1: Get the sovereign rating for your country

http://www.moodys.com/moodys/cust/RatingAction/bl_rList.asp?busLineId=7

Step 2: Get a default spread for a bond issued by your country

http://www.bradynet.com/prices.html

If you cannot find dollar or Euro denominated bonds, you can use the typical spreads for your rating by using the attached spreadsheet that I updated on my web site. (It also happens to have the updated ratings through January 28, 2004)

Step 3: Estimate the volatility of the equity market and the country bond. For this, you have to go to the nearest Bloomberg terminal (yech!). Find the equity index (start with WEI) and click on the index. Once you find it, type in HVT and change the default from daily (D) to weekly (W). Try the same with the bond. If you run into a dead end, try the following approximation:

If you have a BBB or higher rated company, use a relative volatility of two (equity market is twice as volatile as bond market)

If you have a company rated below BBB, use a relative volatility of 1.5

Step 4:  Add the premium you get in step 3 to the historical risk premium for the US.

 

Implied Equity Premium: You can download the implied premium spreadsheet from my web site (under spreadsheets) and play with it. Remember that this is an implied premium for an entire market. It has nothing to do with your company. You need to input a dividend yield and growth rate for the entire market. Should you use this premium or the historical premium? Depends upon your point of view. If you want your valuation to be market neutral, use the current implied equity risk premium.

 

c.     Regression Logistics

Betas are wondrous things, shifting and changing, as you change your index, your return period (two years, three years, five years etc...) and your return interval (daily, weekly, monthly). Just a quick review of the key issues on estimating betas:

1. All regression betas come with standard errors. While you can get a point estimate for a beta, it is more honest to consider the range for betas. (The standard error itself is related to the R-squared of the regression; high R-squared generally goes with low standard errors).

2. Because of the standard error (noise) in beta estimates, you should not be surprised to see different services report different betas for the same company. You can, for instance, compare your Bloomberg beta to the beta reported in Yahoo! Finance. The betas will be different for any number of reasons - different return periods, different return intervals, different indices - but if you consider the range on each beta (because of the standard errors of the estimates), you would be hard pressed to reject the hypothesis that the betas in the different services are the same.

3. If you really want to see how betas change, capture a Bloomberg terminal (this may require hand-to-hand combat), find your stock, type BETA and play with the defaults. You can change the index (SPX to Dow to NYSE to NFT (MS Global Equity index), the return interval (D, W, M, Q) and the return period and see how the beta shifts as you do this. Note that the regression with the lowest standard error on the beta may not necessarily yield the best beta estimate.

 

d.     Evaluating your firm's regression

You can check the numbers from your risk analysis (remember page 107 of your lecture notes). Assuming that you have done this already, I have attached a spreadsheet that will let you check your calculations. One of the inputs that you require for Jensen's alpha is the average T.Bill rate from the last 5 years. If you want to do this precisely, you can visit the Federal Reserve site at St. Louis:

http://research.stlouisfed.org/fred/data/irates/gs6m

You can get approximate answers using the annual averages I have included in the attached spreadsheet.

            If you are wondering why you use current 10-year T.Bond rates for expected returns and T.Bill rates for the Jensen's alpha, it is a matter of perspective. When estimating expected returns, you are looking at a long term return for the future and hence you use the 10-year T.Bond rate today.  When analyzing Jensen's alpha, you are looking at an investor who buys and sells each month for the last 5 years and hence you use the average T.Bill rate over the last 5 years....

 

e.     Estimating a bottom-up beta

Step1: You have to get a breakdown of the businesses that your firm is in. You can get this by downloading your firm's 10K from the SEC web site.

http://www.sec.gov/edgar/searchedgar/webusers.htm

 Once you have it, browse through it (I would say read it but that would be a painful exercise) to find the breakdown of your firm's business. Usually, the company will give you at least revenue and operating income by business. If you have a non-US company, you should be able to find this information in their annual report.

 

Step 2: Estimate bottom-up unlevered betas for each business. There are four routes you can follow-

a. The Easy Route: You can use the unlevered betas that I have computed by business on my web site. You can get to it by going to updated data and looking for levered and unlevered betas by business. The advantage is that it is easy to do... The disadvantage is that you will not get the wonderful experience of doing it yourself and the breakdown may not be detailed enough for you.

b. The Slightly more involved route: At the top of the updated data page, you will find the complete excel dataset of the 7000+ companies that I used to construct the industry average tables. You can download the dataset (Do it on a high-speed line because it is a very large dataset) and then create your own group of comparable firms. All of the raw data on the company is provided - betas, debt, equity and cash - and you have to construct your own unlevered beta. Try it if you have a chance.

c. Do you Yahoo? Don't you hate it when you get an email with that ending? You can, however, get a quick and dirty estimate of unlevered betas from Yahoo! Finance.

http://finance.yahoo.com/

Enter the symbol for your firm and under "profile", you will find ratio comparisons. One of the numbers that they report is the beta for your company and the beta for the industry (they have their own categorization). The beta they report is a levered beta but on the same page, they report a book debt to equity ratio and a price to book ratio. You can compute an average debt to equity ratio for the industry by dividing the book debt to equity by the price to book...

Market debt to equity = Book debt to equity/ Price to book ratio

Since the tax rate is reported for the industry, you can compute an unlevered beta.

d. The Bloomberg Way: After all, real finance mavens use Bloomberg. You can get the information to estimate unlevered betas by getting on a Bloomberg terminal and typing QSRC. You can then screen across markets and industries to pick firms in particular markets. Once you have your sample ready, you can modify the output page to contain the information you need - betas, debt, equity, cash and tax rates, for example. The advantage is that you can do this for non-US stocks. The disadvantages is that Bloombergs are notoriously user unfriendly and you can get only a paper printout. (We don't pay enough for a download function)

 

Step 3: Compute the values of each of the businesses that your firm is in. I would recommend using revenues as the starting point. If you are not comfortable using pricing ratios, weight the businesses based on revenues. If you would like a more precise estimate, go back to the comparable firms you pulled up in step 2 and compute the value to sales ratio for the industry

Value to Sales = (Market value of Equity + Debt - Cash) / Revenues

Multiply the revenues from each of the businesses by these value to sales ratios to get estimated values, and use them to compute weights.

 

Step 4: Compute a bottom-up unlevered beta for your company. It will be the product of the unlevered betas in step 3 and the weights in step 4… If you have cash, give it an unlevered beta of zero and make sure that your weights add up to one.

 

f.      Estimating Dollar Debt and Cost of Debt

Step 1: Peruse your company's balance sheet to see how much interest bearing debt it has outstanding. If you have the 10K, use it since it contains more information. (If there is conflict between your 10K and Bloomberg, go with the 10K). To find interest bearing debt, start with the current liabilities since short term debt and the short term portion of long term debt will be listed there. Then move on to long term liabilities to look for long term interest bearing debt. I have to warn you that there will be a bunch of other long term liabilities that are not interest bearing debt - ignore them.

 

Step 2: If you are working with the 10K, look for two more pieces of information in there:

- Lease and rental commitments for the next 5 years and beyond (do not count capital leases). If you cannot find this information anywhere in your 10K, don't panic. About a third of all US companies have no operating lease commitments.

- A schedule of when the debt is owed. It will be listed by year. Take a weighted (by how much debt is due in each year) average of when the debt comes due.

Both pieces of information will be in the footnotes. European companies report this information in their annual reports.

 

Step 3: Obtain the interest expenses for the most recent financial year. If you cannot find any interest expenses, check to see if you have any debt. If you don't, there's your reason. If you do find debt but no interest expenses, if may be because your firm is netting interest expenses against the interest income from cash. (This will especially be the case when you have relatively little debt.) If you have a net interest expense instead of a gross expense, try this: multiply your cash balance by a riskless rate (say 3%) to get an estimate of interest income and add this to your net interest expenses.

 

Step 4: Obtain a rating for your company.

a. If your company is rated: You can get the rating by going onto Bloomberg and looking under corp bonds or into the bondsonline.com site that I pulled up in class yesterday:

https://www.bondpage.com/general/menu/index.cfm?Method=top_side_main_frame&Active=corporate

Type your name under issuer and voila....

 

b. If your company is not rated:

You can use the attached ratings.xls spreadsheet to get a synthetic rating for your firm. (I modified it this morning to allow for operating leases). You can use this spreadsheet for non-US companies as well. If your company has a market cap of $ 5 billion and higher use 1 (for type of firm). If less than $5 billion, use 2....

If you have negative operating income and no rating, talk to me...

 

Step 5: Estimate a pre-tax cost of debt for your firm by first estimating the default spread, based upon your rating, and then adding this default spread to the 10-year riskless rate. (Stick with the same currency that you used for your cost of equity).

Use the industrial spreads over 10-yr bonds.

 

Step 6: Convert your operating leases into debt. All you will be doing is computing the present value of your commitments back to today. You can do this yourself or use the operating lease conversion spreadsheet that is on my web site (under spreadsheets)

 

Step 7: Estimate a marginal tax rate for your firm. Start with the effective tax rate which should be reported in your 10K but remember that this rate may be lower than the marginal. To get the marginal tax rate, you will usually have to go to the tax code but let me save you the trouble. In the US, you can safely assume that the marginal tax rate (if you have an operating profit) is 35% +, maybe close to 40%. For the marginal tax rates in other countries, try the following link:

http://www.kpmg.bg/dbfetch/52616e646f6d4956fefc52f7c01fc4dc9af95853c3c2815c/ctrs2002__final_.pdf

 

Step 8: Compute the market value of your interest bearing debt. To do this, set the following parameters:

Coupon payment (PMT)= Annual interest expense from last year (gross)

Maturity (n) = Weighted average maturity of your debt from step 2

Face Value (FV) = Book value of interest bearing debt from step 1

Interest rate (r or i) = Pre-tax cost of debt from step 5

Estimate the present value of the debt. You will have the market value.

 

Step 9: Compute the market value of equity (market price * Number of shares = Market cap), taking into account all classes of shares outstanding (except for preferred stock) and compute the weights of debt and equity:

Market value of debt = Market value of interest bearing debt (from step 8) + PV of operating leases (from step 6)

Market value of equity = Market capitalization

 

g.     Estimating bottom-up levered beta

Compute a levered beta for your company. In making this estimate, you will be using an unlevered beta from the bottom-up estimate. Since the debt that you used for that unlevered beta calculation was only interest bearing debt (no operating leases were considered), use only the interest bearing debt and the market value of equity to compute a debt to equity ratio.(This is inconsistent with how you define debt in step 9 but the only way to preserve consistency is to convert the operating leases of all firms into debt and who has the patience for that?) Using the marginal tax rate, estimate a levered beta:

Levered Beta = Unlevered Beta (1 + (1-t) (Debt/ Equity))

 

h.     Estimating Cost of Capital

To compute a cost of capital for your firm, you need to use the levered beta from the last step to get a cost of equity and the after-tax cost of debt from the earlier step. You will weight each by the market value of equity and debt (including operating leases) to get a cost of capital.

Cost of capital = Cost of equity (E/ (D+E)) + After-tax cost of debt (D/(D+E))

Preferred stock is a pain in the neck. You cannot include it with debt since preferred dividends are not tax deductible. You cannot include it with equity, because it is not equity.

If you have preferred stock that is less than 5% of firm value, ignore it

If you have preferred stock that is greater than 5% of firm value, then create a third component in your cost of capital and weight it based on the market value of preferred stock. Attach the cost of preferred stock

Cost of preferred stock = Preferred dividend yield = Preferred dividend/ Preferred stock price.

VI.   Measuring Investment Returns

a.     Estimating Return on Capital

To estimate the return on capital for your firm for the most recent year, you need two numbers - an after-tax operating income for the year and the book value of debt and equity at the start of the year. You should be able to get the pre-tax operating income from the most recent income statement and the book values of debt and equity from last year's balance sheet (For 2002 operating income, use 2001 book value of debt and equity). The debt will include all interest bearing debt and the shareholders equity should be the total (which will include paid-in capital and retained earnings)

Return on capital = Operating income from most recent year (1 - Marginal tax rate)/ (Book value of debt + Book value of equity from end of previous year)

b. Mechanical issues in computing return on capital
* In computing return on capital, you should be using the book value of debt and equity from the end of the previous financial year. The book value of equity can be negative but the book value of capital should always be positive.
* If you have a lot of operating leases, you will get a cleaner estimate of return on capital if you adjust both the book value of capital and the operating income for the operating leases. Your adjusted return on capital will be
Adjusted return on capital =( EBIT (1-t) + Pre-tax cost of debt * PV of Operating leases (1-t))/ (Book value of equity + Book value of debt + PV of Operating leases)
Technically, you should be using the present value of operating leases from the end of the previous year (In other words, you will need the previous year's 10K. If you do not want to do this, go ahead and use this year's operating lease commitment PV

* If my book value of equity is negative, how do I compute ROE?
You cannot. Just put in NA or NMF for the ROE. The book value of capital should not be negative... Use it to compute the ROC.
* I am getting a really low ROC for my firm. Is this possible?
Firms screw up and take bad investments. It is all too common.
c. From Return on capital to EVA

* To go from return on capital to EVA, you will need your company's cost of capital. Some of you noted the seeming inconsistency of using book value for return on capital and market value for cost of capital. I think that you can live with it if you recognize that you are trying to measure two different things - the return on capital measures how well you are doing on the projects you have already invested in (hence book value matters) whereas the cost of capital measures what it costs you to raise money (where market value matters)
EVA = (ROC - Cost of capital) (BV of Debt + BV of Equtiy)
* You should stick with the previous year's book value of debt and equity in this calculation as well.
Comparing EVA across companies is problematic since it is a dollar value and will be larger for larger companies. One way you can compare your firm's EVA to the industry average is to compute what your company's EVA would have been if it had earned the same return spread (ROC - Cost of capital) as the rest of the industry
Industry average EVA = (Industry average ROC - Industry average Cost of capital) * (Your firm's book value of capital)

You can get the industry averages by going to this dataset that I have on EVA.
* As a final note, you are getting a snap shot of one year when you compute your firm's EVA and ROC. To get some sense of trends, you may want to compute the EVA and ROC over four or five years.

VII.   Capital Structure

a.     Qualitative Analysis of Optimal Capital Structure

In this section, you will take your firm through the five components that go into the trade off and see where your firm will fall in terms of debt ratios based upon each:
a. Tax Rate: Take note of your company's effective tax rate and also check to see whether your company operates in any high tax rate entities (Germany is a good example). You can compare your company's tax rate with the average paid by other firms paid in the industry by going to my web site and checking the data set that summarizes debt fundamentals by industry.
b. Added Discipline: Generally, the power of debt to act as a disciplinary mechanism will be greater in larger firms with more dispersed stockholdings. You can look at both the size of the firm (in terms of market cap) but it may be more useful to look at insider holdings. Firms with less insider holdings should be more likely to use debt as a disciplinary mechanism than firms with high insider holdings.
a. Bankruptcy costs: You have to look at two things. One is the probability of bankruptcy. This should be a function of the volatility of earnings and cashflows in your business. A technology firm should have a higher probability of bankruptcy for any given level of earnings than a food processing firm. The other is the cost of bankruptcy - especially indirect costs. Firms that produce assets with long lives and a need for service should have higher indirect costs because the perception of default can be devastating for their sales.
b. Agency costs: Firms that have intangible assets should be faced with higher agency costs since lenders will have a tougher time monitoring how the money is used. They should therefore borrow less.
c. Future Financing Flexibility: If you are in an industry which is in transition or a business where future investment needs are uncertain, you will value financing flexibility more and borrow less.
When you do this part of the analysis, you have to recognize two things. One is that it is subjective. The second is that it will give you a sense of direction rather than a numerical answer. In other words, you may able to tell me that your firm should have a lot of debt but you won't be able to tell me whether that is 50% or 70%.

b. Cost of Capital Approach to Optimal Capital Structure
1. Open the attached excel spreadsheet (you can also download the spreadsheet from my web site under spreadsheets). If you are working on a financial service firm, you should go to me web site and download the other capital structure spreadsheet (capstruo.xls)
2. Before you input any numbers, go into preferences in excel, open the calculation option and make sure that there is a check in the iteration box.
3. Read the Read me worksheet in the spreadsheet
4. Go to the input page and input the numbers for your firm. Each input box has a comment in it. Read the comment before you input the value. You can start off using the most recent year's numbers but may want to come back and normalize some of the numbers (EBITDA) later.
5. For the moment, leave the answers to the last two questions on the input page at their default levels. (Yes and Yes)
6. Go to the output page. You should see the current and optimal debt ratio for the firm as well as the current cost of capital and the optimal cost of capital. You will also see the entire schedule of ratings and costs of equity for every debt ratio. I also calculate the change in value per share for your firm and do your laundry while I am it.... (Hey... What can I say? I am a full service operation)
Here is the good news for those of you who are lagging on the project. This spreadsheet will get you caught up with your hard working teammates.. One final point about the synthetic ratings worksheet embedded in this spreadsheet. It treats operating leases slightly differently from the stand alone synthetic rating sheet. This sheet makes the more reasonable assumption that only the imputed interest expense on the operating leases counts towards the interest coverage ratio.

 

c. Mechanics on computing optimal debt ratio
I do not want the optimal capital structure spreadsheet to become a black box... So, let me try to explain some of the things that I am doing in the spreadsheet:
a. Refinancing old debt: As I mentioned in class yesterday, I assume that you have to refinance all of your old debt at whatever new interest rate you will have at the new debt ratio. Thus, if you have $ 1 billion in debt at 6% on your books and you increase your debt ratio (thus lowering your rating) and your interest rate to 8%, I assume that you will be forced to refinance the debt at 8%. This is not that unrealistic. A bank will probably have covenants that allow them to renegotiate the interest rate on old debt and many corporate bonds today have put clauses allowing bondholders to reset interest rates in the event of a recapitalization.
b. Firm value calculation: In computing the change in firm value, I calculate the change using both a perpetuity assumption and a growing perpetuity. In the latter case, I estimate the "implied growth rate" in your cashflows from your market value but I then cap this growth rate at the riskfree rate. (I am assuming that the riskfree rate is a good proxy for the long term nominal growth rate of the economy)
c. Per share value change: To compute the change in value per share, I divide the firm value change by the primary shares outstanding before the stock buyback. I am assuming that investors are rational and will demand their share of the spoils when they sell their shares back to the firm.

d. Checking for downside risk
To check for downside risk, there are two paths you can take. One is to reduce your operating income based upon either past standard deviation in operating income or what happened during the last recession. Don't do this if your operating income is already depressed. The other is to constrain your bond rating to be higher than investment grade and computing your optimal debt ratio with this constraint.
Your final recommendation on debt ratio for your firm should reflect this downside assessment and may very well be lower than the unconstrained optimal that you computed in the previous step.

e. Explaining your optimal debt ratio
Once you have your optimal debt ratio, you may want to explain why it is what it is. To do this, compare your firm's optimal debt ratio to those of others in your group and compare them on three dimensions:
1. Tax rate: Other things remaining equal, the higher your marginal tax rate, the higher your optimal debt ratio. (In fact, experiment in your capital structure spreadsheet with a 0% tax rate and and a 70% tax rate for your firm and see what happens to the optimal debt ratio)
2. Cashflow generating capacity (EBITDA/ (Market value of equity + Market value of debt)): The higher this ratio, the higher your optimal debt ratio will be. Again, you can have firms that you categorize as very successful - Microsoft, for example - which have low optimal debt ratios because their market values are so high.
3. Volatility in Earnings/ Business: This will show up in a couple of places. One is in the cost of equity (higher unlevered beta) and the cost of debt (lower ratings). The other is when you do the what-if analysis on your operating income...

 

f. Other Capital Structure Approaches
If you just want to get a sense of how the APV approach works, you can download the apv.xls spreadsheet on my web site (I have also attached it to this email). I don't think it will add much to your analysis and you can skip it if you do not have the time. You can try to do a relative capital structure analysis of your company by looking at companies in your sector - in fact, use the same companies you used for your bottom-up levered beta calculation - and run a regression of debt ratios against fundamentals. This is similar to what I did for Disney with entertainment companies. You can get the raw data for this regression by going to my web site and downloading the compfirm.xls spreadsheet which is at the top of the updated data page. Finally, I have an updated market regression for debt ratio under updated data online (Cross sectional regression of debt ratio)... You can plug in the numbers for your company to see what its optimal debt ratio would be
http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html

g. Getting to the optimal debt ratio
Once you have the optimal debt ratio, you need to go through the framework for getting to the optimal. Here are the steps:
Step 1: Evaluate whether you have the luxury of time. If you have an underlevered firm, you are looking at the likelihood of being taken over in a hostile acquisition. Make a judgment based upon
a. The market cap of the firm: The larger the market cap, the smaller the likelihood
b. Insider holdings: The greater the insider holdings, the lower the likelihood
c. Jensen's alpha: The more negative the alpha, the greater the likelihood
If you have an overlevered firm, you are looking at the likelihood of bankruptcy. Your best assessment will come from the bond rating of the firm. If it is below investment grade, the chance of bankruptcy is high.
Step 2: Examine whether your company has good investment opportunities. You can get a partial picture by computing the EVA and ROC for the firm. If they are positive and you believe that this will hold for future projects, you should invest in projects with your excess debt capacity (if you are underlevered) or with equity (if you are overlevered)
Step 3: Make your recommendation of the best path to the optimal debt ratio for your firm.

 

h. Designing the perfect debt

1. Keeping in mind the objective of matching debt to assets, think about the typical investments that your firm makes and try to design the right debt for the project. If your firm has multiple businesses, design the right kind of debt for each business. In making these judgments, you should try to think about
- whether you would use short term or long term debt
- what currency your debt should be in
- whether the debt should be fixed or floating rate debt
- whether you should use straight or convertible debt
- what special features you would add to your debt to insulate the company from default
Your objective is to get the tax advantages without exposing yourself to default risk.
2. You should also try to do a quantitative analysis of your debt. I have attached a spreadsheet that has built into it the macro-economic data that you need - interest rates, inflation, GDP growth and the weighted dollar. You can enter the data for your firm and the spreadsheet will compute the regression coefficients against each. You can use annual data (if your firm has been around 5 years or more). If it has been listed a shorter period, you may need to use quarterly data on your firm. The data you will need on your firm are:
- Operating income each period (this is the EBIT)
- Firm value each period (Market value of equity + Debt); you can use book value of debt because it will be difficult to estimate market value for each period.
I have to warn you in advance that these regressions are exceedingly noisy and the spreadsheet also includes bottom-up estimates by industry. The industries are listed by SIC code and you can find your company's SIC code by going to compfirm.xls, the spreadsheet with individual firms on my web site.

 

VI.   Dividend Policy

1. Qualitative Analysis of Dividend Policy
Step 1: Examine how much your company pays in dividends and how much it bought back in stock over each of the last 5 years. The best place to get this information is the statement of cashflows.
Step 2: Examine the following qualitative factors to make a judgment on what you would expect your company to be paying in dividends:
a. Investment opportunities: Look at both your EVA calculation and how much your company invested in capital spending and acquisitions. The better your investment opportunities, the less you should return to stockholders.
b. Stability of Earnings: If your earnings are volatile, you should pay less in dividends (and perhaps shift to stock buybacks). To make an assessment of earnings stability, use both common sense (tech earnings are much more volatile than food processing earnings) and your firm's own earnings history. (try computing a standard deviation in earnings)
c. Signalling needs: If you are smaller firm with no or very few analysts following you, you may choose to use dividends as a signal and end up with more dividends.
d. Capital structure and bondholder constraints: If you are overlevered (from your capital structure) analysis, you should not be paying dividends. If you are underlevered, you may want to pay out more.
e. Stockholder characteristics: There will be an element of self-fulfilling prophecy here. If you have historically paid dividends, you have probably accumulated an investor clientele who likes dividends.
Based upon the qualitative factors, make a judgment on how much your company should be paying in dividends.
Step 3: Compare the actual dividend policy to your expected dividend policy. At this stage, remember that a policy of not paying dividends is also a dividend policy and has to be justified or rejected.

2. A Framework for analyzing Dividend Policy
Step 1: Collect the information to compute the FCFE every year for your company for the last 5 years. This information should be in the statement of cashflows each year. In making this assessment, consider the following:
a. Start with the net income each year and add back the non-cash charges (depreciation, amortization and other non-cash charges)
b. Subtract out capital expenditures. If there were cash acquisitions done during the period, add the value of these acquisitions to the cap ex. If you are using a statement of cashflows, the cap ex number will already be a negative cashflow. (Don't take a negative of a negative and make cap ex a positive cashflow)
c. Subtract out changes in non-cash working capital. You can get the individual items out of the 10K statement of cashflows or look at the Bloomberg summary of the statement of cashflows (in the description) where you consolidate the non-cash working capital. Here again, the sign on the cashflow should tell you whether non-cash working capital changes are creating positive or negative cashflows.
d. You should end up with the FCFE each year

You can use the spreadsheet on my web site to do this.
Step 2: Compare the cash returned by your firm to its stockholders each year over the same period. The dividends and the stock buybacks should both be reported in the statement of cashflow. If your company has both stock buybacks and stock issues in the same year, it is probably best not to net them out and to focus on the stock buybacks alone.
Step 3: Retrieve the EVA and Jensen's alpha you have already computed for your firm. There are four possibilities:
Scenario 1: Positive EVA, Positive Jensen's alpha: Firms with good projects delivering higher than expected returns
Scenario 2: Positive EVA, Negative Jensen's alpha: Firms with good projects but project returns were not as high as expected
Scenario 3: Negative EVA, Positive Jensen's alpha: Bad projects but returns may be improving and are better than expected
Scenario 4: Negative EVA. Negative Jensen's alpah: Bad projects delivering less than expected returns

 

Calculation details:

1. Where can I get stock returns and information on interest rates for 2000-2002?
I realize now that I forgot to update the dividends spreadsheet to incorporate this data for the last 3 years. The data can be obtained by going to updated data on my web site and clicking on historical returns. You need the stock returns and the T.Bill rates for each of the years for which you have data.
2. If my company has both stock issues and buybacks, should I net out stock issues against buybacks?
No. Stick with just the stock buybacks.
3. My FCFE jump around from year to year. Should I be worried?
This is normal. That is why you estimate the average FCFE over the period and compare it to the average dividends +stock buybacks over the same period.
4. Where can I get returns on my stock each year for the dividends spreadsheet?
The FA print out from Bloomberg has returns on your stock each year for the last 10 years.

3. Making a recommendation on dividend policy
If your firm is not paying out as much as it can afford to but returns scenario 1 (from step 3 of last part): let company accumulate cash and give it freedom to set dividend policy it wants
If your firm is not paying out as much as it can afford to but returns scenario 2 (from step 3 of last part): Give it freedom to set dividend policy but watch trend in returns; if returns continue to drop you may revisit the question
If your firm is not paying out as much as it can afford to but returns scenario 3 or 4 (from step 3 of last part): Company should return cash to stockholders
If your firm is paying more than it can afford to but returns scenario 1 (from step 3 of last part): Company should stop returning cash to stockholders and invest in projects
If your firm is paying out more than it can afford to but returns scenario 2 (from step 3 of last part): If downward trend in returns is long term, continue to pay out cash. It it can be reversed, invest in projects
If your firm is paying out more than it can afford to but returns scenario 3 or 4 (from step 3 of last part): Company should stock returning cash and fix its investment problem. Fixing the investment problem (investing less in bad projects) may make its dividend problem go away.