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Applications in Valuation andCapital Structure
John Wiley & Sons, Inc.
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.
Applications in Valuation andCapital Structure
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
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
To Krista, Trevor, and Madeleine, for their support,patience, and laughter.
List of Figures xiii
List of Tables xv
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
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
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
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
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.Similarl