Case 1 - Warren Buffett by yaofenji


									          Morgan Stanley Roundtable on
        Capital Structure and Payout Policy

    Journal of Applied Corporate Finance, 2005, 17, Winter, 36-54.

   Bringing it together

    o Capital Structure
    o Payout Policy

 Insights from leading experts
                         The Commentators

Bennett Stewart
   Consultant, Stern-Stewart
Cliff Smith
   Prof, Rochester
Dave Ikenberry
   Prof, Illinois (Urbana-Champaign)
Arun Nayar
   VP and Assistant Treasurer, Pepsico
Henry McVey
   Chief U.S. Investment Strategist, Morgan Stanley
Jon Anda
   Global Head of Corporate Finance, Investment Banking Division, Morgan
                   Capital Structure Theory

Modigliani and Miller Irrelevance theorems:

 What are the three main assumptions?
        No taxes
        No contracting costs including bankruptcy costs
        Fixed investing policy

        Financing decisions have no effect on the value of the

 What is the basic insight?

   o where not to look – must be due to the three assumptions

   o e.g. don‟t use debt financing to increase ROE or EPS
                     Capital Structure Theory

Relaxing the assumptions:
                                                                    Tangible assets

   Why is it useful to distinguish between „assets in place‟
    and „growth options‟?

   What is the „under-investment‟ problem?

   What is the Free Cash Flow problem?

   How do these influence optimal capital structure?
       Growth firms – financial flexibility, low debt, low payout
       Value firms - high FCF and limited investment opportunities – high payout,
       minimize corporate taxes
                     Capital Structure Theory

   How significant is the tax benefit of debt for the
    average publicly traded company estimated in
    John Graham‟s study?
       5% - 8% of current value ; second order priority

   How does this compare to the benefits of
    controlling investment incentives?
       Flexibility and FCF more important

   Impact of unfunded liabilities?

       Reduce debt
                Capital Structure at PepsiCo
Designed to support the company‟s overall strategy,
and preserve capital market access around the world

   What is PepsiCo‟s leverage ratio?

     20% of book value of total capital ; A / AA rating

   Nayar states that

    “PepsiCo is a consumer products company in a
    dynamic industry with lots of opportunity for global
    investment and consolidation … … we are a firm
    with lots of valuable growth options, and our
    financing policy is designed to enable us to
    exercise those options when we find them.”
                 Capital Structure at PepsiCo

   Does Stewart appear to agree?

     5% of market value of total capital ; High price for financial flexibility

   How about McVey?

      Pepsi – growth stock; in agreement with management on financial policy
       Investors‟ perspective: Morgan Stanley
How does McVey prefer to classify firms?

    o two „buckets‟ – those with and without the right package of
      financing and investment opportunities

         Pepsi?
         semi-conductor, big pharma?
   Jon Anda adds

    o “if you ask me what our corporate clients are thinking about
      these days, it‟s not about the possible gains from leveraging up
      and minimizing their WACC. The big topic is corporate liquidity.
      Companies today are awash in cash”

    o “Management is asking „how do we get it back to
          Assess investment opportunities
                   Payout Policy - Theory

 What is payout policy?

       Dividends and /or   Repurchases

 MM world (no taxes, financial distress or
  investment effects): payout policy doesn‟t matter
   o it doesn‟t affect the value of the firm
   o   a dollar of dividends is a foregone dollar of capital gains
                 Payout Policy - Theory
4 Reasons for repurchasing shares (Ikenberry):

   o Adjusting capital structure (especially debt financed
   o Disburse free cash flow
   o Substitute for dividends (increase flexibility, reduce taxes)
   o Signaling future earnings power

 What about:
   o To increase EPS?
   o To increase option values?
                   Payout Policy - Theory

   Do firms always prefer repurchases to dividends –
    when would a firm prefer dividends?
        Dividends firmer commitment to pay out excess cash

   Overall, firms should maintain a balance of
    flexibility and commitment

   How should the balance be chosen – what is the
    fundamental objective?
                   Payout Policy at PepsiCo
Nayar states that
    “Our first priority is making the right corporate investment
    decisions. As we all learned in business school, that means
    following the net present value rule …

    after getting estimates of our investment requirements and
    setting them against our expected cash inflows …

    our policy is to return 100% of our free cash flow in one way
    or another to our shareholders.”

   How does PepsiCo choose between dividends and
        Consistent dividend policy – increase in dividend payout each year
         Leverage, Payout Policy and Investor
What is a “leveraged recap as an alternative to dividends”?
  (Stewart, Smith)
         Forecast amount of dividends payable over next few year; Borrow PV of
         that amount ; buy back instead of paying dividends

   How does this affect financial flexibility?

What is the “changing investor paradigm”? (Anda, McVey)

   Investors are becoming more sophisticated

   What is behind this?

      Quantitative power; Easy and cheap access to information
      Hedge funds
      Leverage, Payout Policy and Investor

Why might the focus on FCF and payouts lead to a
 corporate under-investment problem?

Leverage and Payout Policy should maintain an
  optimal balance between…

   financial flexibility and disbursement of excess cash flow…

   i.e. to support all positive NPV investments

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