Sie sind auf Seite 1von 12

VOLUME 17 | 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 8 Michael Barclay and Clifford Smith, University of Rochester

Do Managers Have Capital Structure Targets? 18 Vikas Mehrotra, University of Alberta, and Wayne Mikkelson
Evidence from Corporate Spinoffs and Megan Partch, University of Oregon

How To Choose a Capital Structure: Navigating the Debt-Equity Decision 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 55 William Wilhelm, University of Virginia and University of Oxford

Reforming the Bookbuilding Process for IPOs 67 Ravi Jagannathan, Northwestern University, and
Ann Sherman, University of Notre Dame

Assessing Growth Estimates in IPO Valuations—A Case Study 73 Roger Mills, Henley College (UK)

Incorporating Competition into the APV Technique for 79 Michael Ehrhardt, University of Tennessee
Valuing Leveraged Transactions

A Framework for Corporate Treasury Performance Measurement 88 Andrew Kalotay, Andrew Kalotay Associates

Morgan Stanley Panel Discussion on Seeking Growth in 94 Michael Richard, McDonald’s Corp., and Stephen Roach and
Emerging Markets: Spotlight on China Jonathan Zhu, Morgan Stanley. Moderated by Frank English,
Morgan Stanley.

Trade, Jobs, and the Economic Outlook for 2005 100 Charles Plosser, University of Rochester

Leverage 106 Merton Miller, University of Chicago


How To Choose a Capital Structure:
Navigating the Debt-Equity Decision

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

F
ew financial decisions have as significant an work as well as considerable experience in addressing the
impact on a company’s equity value and future practical considerations typically encountered by companies.
livelihood as the management of its capital We conclude by outlining a series of capital structure issues
structure and credit ratings. Companies manage that many companies will want to consider in 2005.
capital structure through debt or equity issuance, debt or
equity repurchases, dividend increases, acquisitions, new What Drives Credit Ratings?
investments, and risk management. Since the Nobel Prize- Companies devote substantial time to communicating and
winning work of Miller and Modigliani in the late 1950s, managing their relationships with credit rating agencies.
finance academics have spent considerable time and energy These discussions typically focus on issues of financial lever-
in identifying what does and does not matter in capital age, performance and outlook, business strategy, controls,
structure decisions. Yet today there is still significant debate financial risks and exposures, corporate governance, distri-
about the costs and benefits of a more or a less levered capi- bution policies, and participation in industry consolidation.
tal structure and the corresponding credit rating. Every day, Although credit ratings are clearly tied to measures of indebt-
highly rated companies wonder whether they should use edness such as leverage and coverage ratios, the evidence
their financial flexibility to lever up and buy back shares, suggests that in most industries, company size is an even
and low-rated firms consider financing strategies to preserve more important driver of ratings than leverage. In many
or strengthen their credit rating. sectors, size measures such as revenues, book value of assets,
The distribution of ratings among S&P 500 companies and equity market capitalization display higher correlations
shown in Figure 1 suggests considerable variation in how with credit ratings than measures of leverage and cover-
companies view the importance of ratings categories. For age. In the energy sector, for example, asset size or proven
the most part, S&P 500 firms are large and successful. Yet reserves alone explain more than 85% of the variation in
their credit ratings range from AAA to B-, and about 15% of Moody’s or S&P ratings. While this relation is surprising at
the companies are not rated by S&P at all. Financial firms, first glance, size tends to capture many company attributes
which have a median rating of A, tend to prefer stronger that ratings analysts value highly in making a rating deter-
ratings than nonfinancial firms, which have a median rating mination—a company’s scale of operations, breadth and
of BBB/BBB+. But apart from this pattern, why do some diversity of product mix, and global brand and presence.
companies want to maintain a AAA rating while others are The dominant effect of size on ratings is apparent from the
happy with BBB? And why do some BBB firms try every- simple comparison of credit ratios for industrial companies
thing to strengthen their rating while some A-rated firms across the ratings spectrum shown in Table 1. The importance
are willing to sacrifice their rating for a stock buyback or the of company size, measured by sales in this example, is clear.
right acquisition? Median sales are $39 billion for AAA companies, $3.2 billion
Underlying the diversity of corporate credit ratings is a for BBB companies, and $271 million for CCC companies.
disparity of views among corporate executives and directors The importance of size in the ratings process means that, for
about the “right” credit rating. As a result, the capital structure smaller companies, an investment-grade rating may simply
decision can be a perplexing one for many companies. In this be out of reach, at least in the short term. For example, a
article, we summarize some of the views that are often advanced BB-rated company with $1.2 billion in sales and a lever-
for a target credit rating and offer our own observations. Our age ratio of 43% could try reducing its leverage to conform
views reflect both our familiarity with a large body of academic to the BBB median of 27%; but increasing revenues to

* We would like to thank our colleague Nishant Mago for his invaluable help in prepar- Strategy Group at Citigroup Global Markets. Although the information in this article was
ing this paper. Nishant’s involvement was critical to the initial thought process, the data obtained from sources that Mr. Zenner and CGMI believe to be reliable, CGMI does not
collection, the analysis, and the writing of this paper. Additionally, we would like to thank guarantee its accuracy, and such information may be incomplete or condensed. All figures
Don Chew (the editor) for his useful comments, and Celia Gong and Janice Willett for their included in this report constitute Mr. Zenner’s judgment as of the original publication date.
assistance throughout this process. Marc Zenner is a Managing Director in the Financial

26 Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005
Figure 1 Senior Bond Rating Distribution – As of the End of December 2004

25%
Actual
S&P 500 Companies (Excl. Financials) Median
20%

17.7%
Percent of Index

15%
14.6%

12.0%
10.5% 10.8%
10%

7.7%
6.5%
5.7%
5%

2.2% 2.6%
2.2% 2.2% 2.2%
1.4% 1.4%
0% 0.2% 0.2%

AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- NR

Actual
S&P 500 Financials Median
25%
24.4%

20%
Percent of Index

18.3%

15%
14.6%
13.4%

10%

6.1%
5%
3.7% 3.7% 3.7% 3.7% 3.7%
2.4% 1.2% 1.2%
0% 0.0% 0.0% 0.0% 0.0%

AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- NR

Source: FactSet and Citigroup.

Table 1 Adjusted Key Industrial Financial Ratios, Long-Term Debt, Three-Year (2001-2003) Medians

AAA AA A BBB BB B CCC

EBITDA Interest + Dividend Coverage (x) 4.0x 3.9x 4.1x 4.5x 3.0x 1.7x 1.0x
Total Debt / Market Capitalization (%) 0.5% 8.1% 17.2% 27.2% 43.2% 55.9% 80.8%
Sales ($mm) $38,859 $17,832 $5,472 $3,202 $1,171 $513 $271
Number of Companies 6 18 124 207 274 250 43

Source: Standard and Poor’s Industrial Creditstats (2004)

$3.2 billion is probably impossible in the near term without Foods has a similar debt-to-EBITDA ratio, yet its rating is
a major acquisition. only BBB. Nestlé’s asset base, however, is 6.6 times greater
To gain more insight into the relative importance of than Tyson’s. Similar size effects can be seen in the energy,
leverage and size, we compared the size of some of the most chemicals, pharmaceutical, and specialty retail sectors (see
highly rated companies in five subsectors with lower-rated Table 2).
companies in the same industry that have comparable Because of the importance of size in the ratings process,
debt-to-EBITDA ratios. For example, Nestlé, which is targeting a certain credit rating is as much a strategic issue as a
AAA-rated, has a debt-to-EBITDA ratio of 2.2x. Tyson financial decision. As already noted, for many middle-market

Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005 27
Table 2 Leverage vs. Size — As of 3rd Quarter 2004

Asset Ratio
Debt / Debt / (Company 1 /
Industry Company 1 Rating EBITDA Company 2 Rating EBITDA Company 2)

Chemicals DuPont AA- 2.4x Olin Corp. BBB- 2.2x 22.2x


Energy Royal Dutch Petroleum AA+ 0.4 Petro-Canada BBB 0.5 7.8
Food Nestle(1) AAA 2.2 Tyson Foods BBB 2.2 6.6
Pharmaceuticals Eli Lilly AA 1.4 Genzyme Corp. BBB 1.4 4.9
Retail Wal-Mart AA 1.6 AutoZone BBB+ 1.6 29.4

1. Nestle’s financials as of 12/31/03.


Source: FactSet and Citigroup.

companies, an investment-grade credit rating may be unachiev- Figure 2 Ratings vs. Spreads: Medium-Term
able with their current size—or, alternatively, the leverage ratio Maturities — As of December 31, 2004
required to obtain such a rating may mean almost no reliance
on debt financing. Large, equity-financed M&A transactions Spread (Bps)

represent perhaps the only way many smaller companies can


75th Percentile
hope to obtain an investment-grade rating. This is not, of 400

course, to recommend such a course of action. Acquisitions, 350


50th Percentile
like all corporate investments, should be evaluated solely on
25th Percentile
their expected contribution to shareholder value. What we are 300

suggesting, however, is that a company’s target credit rating 250


should not be determined without considering its business
200
strategy. And in the absence of a plan to increase company size
in the near future, the possible range of ratings for mid- and 150
smaller-sized companies tends to be limited.
100

What Drives the Cost of Debt? 50

Our focus on ratings thus far has been driven by the idea 0
that ratings are the primary determinant of a company’s cost B- B B+ BB- BB BB+ BBB- BBB BBB+ A- A A+ AA- AA AA+ AAA
of debt. But does the rating determine the cost of debt when S&P Credit Rating
we control for differences in debt maturity and look just at
longer-term, fixed-rate financing? The specific question we
asked was this: Do all companies with the same rating have How much of the variation in spreads is explained by
the same spread over the ten-year Treasury? ratings alone? Figure 3 shows that ratings by themselves
In Figure 2, we show the median, lowest-quartile, explain 58% of spread variation (when we use a loglinear
and highest-quartile spreads over the benchmark Treasury regression model). It also confirms the lesson from Figure 2
for various ratings categories of bonds trading on Decem- that spreads vary significantly across ratings. This comparison
ber 31, 2004. To control for the spread term structure, is based on a sample of 1,064 bonds with varying maturi-
we look only at bonds with four to six years of remaining ties and structural features. When we control for maturity
maturity. This figure leads to two important observations. and callability, we can explain another 14% of the variation
First, spreads vary widely within rating categories. Even in in spreads. Beyond ratings and structural bond character-
the case of investment-grade firms, the lowest (interest-rate) istics, we can explain over 75% of bond spread variation
quartile within a given rating group tends to be priced at a if we include market leverage ratios and dummy variables
spread that is up to 90 basis points smaller than the highest controlling for the utilities, financial, and transportation
quartile—and the spread differences between the lowest and sectors. The explanatory power of market leverage, which is
highest companies within individual rating categories are driven by leverage and equity values, is undoubtedly tied to
well above 90 basis points. Second, the lowest quartile of the fact that stock prices react more rapidly than ratings to
BBB bonds has a tighter spread than the highest quartile of a firm’s changing conditions. The variables that control for
A-rated bonds. This means that many BBB companies have the issuer’s sector most likely relate to the market’s expecta-
access to cheaper debt financing than some A-rated firms. tions about recovery values for different industries in the
Thus, ratings are not the only driver of the cost of debt. event of default.

28 Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005
Figure 3 Ratings vs. Spreads: All Maturities—As of December 31, 2004 (R-squared = 58.3%)

1,000
Bond Spread (bps) (Log Scale)

100

10

CCC B BB BBB A AA AAA

S&P Credit Rating

In sum, other factors besides ratings and leverage also good example. Both customers and trading counterparties
influence a company’s cost of debt. Over the last few decades, prefer to deal with insurance companies, brokers, and banks
for example, an exposure to floating-rate debt would have with high ratings. In some cases, particularly insurance, a
significantly reduced the cost of debt relative to fixed-rate high rating is required by regulatory authorities in order for
financing. Clearly, with an upward-sloping yield curve, a company to operate in certain lines of business. Similarly,
floating-rate debt is less expensive than fixed-rate debt in the suppliers will be more willing to invest in new production
short term. It is also widely acknowledged to have been less methods to satisfy a buyer if they know the buyer is going to
expensive over five- to ten-year periods. Over the last two be around for a long time. And a warranty for an appliance
decades, a floating-rate debt strategy would have generated or a car has a lot more value when the manufacturer has stay-
savings on the order of 100 to 150 basis points per year. ing power. These issues tend to be particularly important for
These savings are roughly comparable to the spread between business services companies that provide outsourcing services
a AAA and a BBB firm. In other words, BBB firms with using long-dated contracts. In these sectors, companies such
mostly floating-rate exposure could have had lower-cost as IBM and Hewlett-Packard have been able to use their
debt than AAA firms with mainly fixed-rate debt (though it strong ratings as a marketing tool to win new business.
should be noted that most AAA and other highly rated firms As these examples suggest, conservative capital struc-
choose a liability mix with a heavy floating-rate emphasis). tures and high ratings help some firms generate more
business; and, in such cases, capital structure is a key part
Choosing the Right Credit Rating of the business strategy. But this argument becomes signifi-
Determining the right credit rating for a company involves cantly less relevant for companies with short-lived products.
balancing many different factors, some of which are more A strong credit rating is not likely to affect the behavior of
relevant for certain sectors or companies. customers choosing a restaurant or a piece of candy.

Long-Term Contracting Considerations Minimizing the Cost of Debt


Some companies have strong ratings to allow for more Some companies suggest that the capital structure decision
effective long-term contracting with major stakeholders, is mainly about securing the “cheapest” source of debt. Such
including customers and suppliers. Financial firms are a companies tend to justify their high A or AA ratings as a

Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005 29
means of preserving greatest access to low-interest debt. But opportunities with heavy capital requirements?) and the impor-
when carried to its logical conclusion, this argument suggests tance of long-term contracting in its business model. In sectors
that all firms should aim for a AAA rating. such as insurance, for example, where a high rating is critical to
There are a number of problems with this argument. winning customers, the costs of distress are material.
First of all, as just discussed, a rating is certainly not the What are some of the insights of tradeoff theory?2
only driver of the cost of debt. More important, the benefit • Companies with large and stable profits should, all
of cheap debt for a AAA firm is almost by definition quite else equal, make greater use of debt to take advantage of
limited. For most companies, very little debt could be issued interest tax shields.
before their ratings dropped below AAA level, thereby forcing • Companies with non-interest tax shields (NOLs,
the firms to operate with low leverage. And this means that for example) do not benefit as much from debt and should
the corporate capital structure decision involves a tradeoff therefore use less of it.
between the amount and cost of debt issued. • Companies with high costs of distress (illiquid assets,
The appeal of cheap debt rests in part on the observation emphasis on long-term contracting) should use less debt.
that borrowing at higher rates dilutes reported earnings. But • Companies with a tax domicile in a country with a
this view ignores the role of the tax benefit of debt in reduc- lower effective marginal tax rate should have less-levered
ing a company’s weighted average cost of capital; what’s capital structures.
more, it overlooks the possibility that the proceeds of the • Companies in countries where equity financing is
debt can be used to repurchase shares, which could more not double-taxed, or where equity receives some credits for
than offset any EPS dilution. corporate taxes paid or is taxed at a lower personal tax rate
Nevertheless, there is a version of the cheap debt argu- than debt, should have less debt financing.
ment that could provide a sensible reason to target a high We have found that for many industries, the tradeoff
credit rating. Particularly in the case of financial firms theory suggests a rating in the BBB neighborhood, while, as
with short-term assets such as credit card loans and auto suggested by Figure 1 earlier, the rating of the median S&P
loans, it may be sensible to match these assets with short- 500 industrial firm tends to be higher. Given that the rating
term liabilities. For such companies, a substantial portion agencies already take into account the variability of an indus-
of their funding comes from the commercial paper (CP) try’s operating performance, a BBB rating corresponds to a
market. The low cost of CP borrowing keeps rates on loans substantial market leverage ratio (30-60%) for companies
to credit card and auto purchasers low as well. Since short- with fairly stable cash flows and limited investment require-
term CP ratings are directly linked to long-term credit ments—and food companies and regulated utilities come to
ratings, companies that are heavily reliant on CP funding mind here. But for more cyclical industries and those requir-
generally find it optimal to target a strong credit rating. ing greater capital expenditures, such as energy and established
technology companies, a BBB rating is likely to mean consid-
The Tradeoff Theory erably lower market leverage ratios, on the order of 10-20%
The tradeoff theory is the foundation of much academic for technology companies and 30-40% for energy firms.3
thinking on optimal capital structure. The risk-adjusted
cost of debt is said to be lower than the risk-adjusted cost of The Pecking Order Theory—or the
equity because debt payments are tax-deductible and distri- Laissez-Faire Approach
butions to equity are not. The “cheapness” of debt relative The tradeoff theory predicts that profitable companies gener-
to equity would suggest an unlimited amount of debt as the ating a lot of cash should issue debt to reduce their corporate
optimal capital structure. Beyond a certain point, however, income taxes. In practice, however, we observe that many of
the likelihood of financial distress and its associated costs the most profitable firms in a given sector have high credit
outweigh the “cheapness of debt” benefits. ratings and low leverage ratios. The pecking order theory
While it is relatively easy to estimate the after-tax cost of attempts to explain—if not to justify—this behavior. It begins
debt for various leverage and rating scenarios,1 it is typically by observing that most companies prefer to use internal cash
much harder to quantify the costs of financial distress. What flow to make new investments rather than tapping external
we do know is that these costs relate directly to a company’s capital markets. For profitable firms that generate more than
investment strategy (for example, does it have lots of growth enough cash to meet their investment needs, there is no obvi-

1. See J. Graham, “Estimating the Tax Benefits of Debt,” Journal of Applied Corporate W. Mikkelson and M. Partch, “Do Managers Have Capital Structure Targets? Evidence from
Finance, Vol. 14, No. 1 (2000). Corporate Spinoffs, and A. Dittmar, “Capital Structure in Corporate Spin-Offs,” Journal of
2. Academic research is at best modestly supportive of the tradeoff theory. Consistent Business, Vol. 77 (2004).”
with the theory, however, two recent studies examining post-spinoff capital structures sug- 3. See in this issue M. Barclay and C. Smith, “Another Look at the Capital Structure
gest that companies take into account both the level and stability of their operating cash Puzzle.”
flow when designing the capital structure of the newly spun-off entities. See in this issue

30 Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005
Figure 4 Financial Flexibility as a Call Option On the other hand, financial flexibility is likely to be
value-reducing if:
• Management is unwilling to sacrifice its rating for any
Payoff purchase (an external asset or even its own stock)
• Acquisitions do not create much value—assets tend
to be fully priced and do not generate returns on capital in
Expected (normal) Use financing flexibility to
excess of the cost of capital
reinvestment needs make unanticipated invest- • New investments arrive at a predictable rate and are small
that can be financed ments (acquisitions) with
without flexibility positive excess returns
enough that they can be purchased using internal cash flow
Cost of maintaining
financing flexibility Upper bound of Actual reinvestment Precautionary Ratings Cushion
call option due needs (% firm value) The credit rating process is often asymmetric. Ratings down-
to limited finan-
cial flexibility grades tend to occur relatively quickly after poor financial
Payoff: (Annual expected reinvestment – Historical net capital expenditure) performance, but upgrades rarely follow improvements in
x Excess Return/WACC performance with the same rapidity. In other words, after
Excess Return/WACC = PV of excess returns in perpetuity ratings downgrades, companies typically need to demon-
strate stronger performance metrics and ratios than their
ous reason to raise capital. And unless acted upon by an outside pre-downgrade measures just to regain their previous ratings.
force, such companies will tend to operate with increasingly For this reason, and particularly for companies in volatile
unlevered capital structures. We could also call this approach business environments, it is often prudent to maintain a
the “laissez-faire approach” to financing. precautionary ratings cushion and target a higher rating to
be able to weather a downturn and preserve a stable financ-
Assessing the Value of Financial Flexibility ing environment. Since it can take several years to recover
The extent to which the pecking order theory describes actual from a downgrade, a ratings cushion improves a company’s
corporate behavior is a matter of debate, both in academic ability to withstand a period of poor performance and carry
and practitioner circles. What is clear, however, is that the out a recovery plan.
pecking order places a premium value on retaining financial
flexibility (and, more specifically, on minimizing the odds Off-Balance-Sheet Liabilities
that the firm will have to raise costly equity capital). In so Some companies’ arguments for low leverage ratios and
doing, the pecking order fails to consider, or at least views strong ratings focus on liabilities that are not reflected on
as relatively unimportant, any possible costs associated with corporate balance sheets. Over the last few years, capital
having too much flexibility. But what management tends to market participants have become very attentive to pension
regard as value-preserving flexibility may in fact be viewed and OPEB liabilities, rental expenses, and other off-balance-
by outsiders as value-reducing financial “slack,” and decid- sheet liabilities. Rating agencies take these liabilities into
ing how much flexibility a firm needs is likely to be a critical account when evaluating a firm’s credit quality, and they
part of the capital structure decision. should be taken into account when estimating a company’s
From an analytical perspective, financial flexibility can be optimal leverage. In other words, off-balance-sheet commit-
seen as giving the company a “real option” on capital markets ments are an integral part of a firm’s liability structure
that would enable it to fund valuable projects with external because, like debt, they increase the likelihood of financial
debt when its cash flow is insufficient and management is distress—and they also often generate tax shields.
reluctant to raise equity.4 Figure 4 illustrates how the value of Some go further and argue that corporate R&D and
financial flexibility can be viewed in a real options framework. capital expenditures, which can be critical to a compa-
As the figure suggests, financial flexibility is valuable if: ny’s survival, should also be viewed as future liabilities.
• The company intends to use its flexibility and is We believe that unless expenditures for R&D and capital
willing to exercise the call option—that is, sacrifice its rating assets are contractually determined and mandatory, they
to take on debt and purchase a valuable asset cannot lead to financial distress and should therefore not
• Acquisitions are valuable—firms can purchase assets and be included in the firm’s liability structure. Nevertheless,
generate a return on capital in excess of the cost of capital as we saw earlier, a company’s capital structure should be
• New investments are unpredictable and significantly designed to ensure its ability to fund all foreseeable positive-
larger than what can be purchased from internal cash flow NPV expenditures.

4. See A. Damodaran, “The Promise of Real Options,” Journal of Applied Corporate


Finance, Vol. 13, No. 2 (Summer 2000).

Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005 31
The Link Between Capital Structure and Table 3 Valuation Effect of Volatility for Investment-
Risk Management Grade vs. Non-Investment-Grade Firms
With increasing volatility in currencies as well as in oil and
other commodity prices, companies in recent years have Increase in Valuation Multiple
Action Investment Grade Non-Investment Grade
become proactive in managing their financial risk expo-
sures. Often, however, risk management strategies are not 10% decrease in EPS Volatility 0.5% 1.2%
sufficiently integrated with the capital structure decision. 10% decrease in Cash Flow Volatility 2.8% 4.1%
The link between risk management and capital structure
Source: Citigroup and Compustat
runs in both directions.
Risk Management to Ratings. Rating agencies explicitly
consider the riskiness of a company’s overall business and also age, the lower volatility resulting from risk management can
how the firm manages its risk. A consumer company with a indirectly strengthen a company’s credit rating.
huge market share selling a very stable product will have much Ratings to Risk Management. Risk management can be
lower business risk than an independent E&P company whose beneficial, but costly. A highly levered company at the cusp
cash flows fluctuate with oil prices. Therefore, the consumer of investment grade can ill afford to take the chance that it
company will be able to have higher leverage, all else equal, might be downgraded. Even though floating-rate debt may
for a given credit rating. But in addition to business risk, be less expensive in the long run, such a firm cannot afford
agencies consider how the consumer company manages its an unexpected surge in rates, which would cause its cash flow
sources of risk. Is the candy company well protected against coverage ratios to plummet. On the other hand, a highly
price changes in key raw materials such as cocoa, sugar, and rated company with limited leverage can take advantage
milk? Is the energy company hedging part of its output? Is the of the lower cost of floating-rate financing because interest
emerging market company exposed to dollar debt payments rate fluctuations are unlikely to have a significant economic
even though most of its revenues are in local currency? All impact on its rating or cost of debt. With little debt on the
else equal, companies with more effective risk management balance sheet, even large interest rate increases are unlikely
systems should have higher ratings, or should be able to to have much effect on the firm’s ability to service its debt.
support greater leverage within a given rating. And what’s true of companies on the boundary of invest-
Though the economic benefits of hedging can be ment grade is likely to be even more true of companies with
substantial for some companies, the data do not suggest a credit ratings one or two notches below investment grade.
large impact on ratings by active risk management. In a study To the extent such companies want access to capital, they
of S&P 1500 companies,5 we found only a weak negative have incentives to manage risk to avoid being downgraded
relationship between credit ratings and earnings volatility, to a lower rating. For companies with weaker credit ratings,
and no relationship between credit ratings and the volatility capital market access can be seriously jeopardized by a drop
of operating cash flows.6 Therefore, the credit rating benefit in earnings. Thus, for companies with (or close to) high-yield
from a risk management strategy might be more limited than status, risk management is likely to be more important than
expected, particularly if companies are hedging variability in for highly rated companies. Consistent with this argument,
cash flows. To understand this apparently limited effect of our research shows (see Table 3) that the positive correla-
risk management on credit ratings, it’s worth recalling that tion of earnings and cash flow stability with higher valuation
firm size is a key driver of ratings in most sectors, and that multiples is stronger for non-investment-grade than invest-
large firms tend to be more diversified than small firms, all ment-grade companies.
else equal, which creates “natural” hedging.
But if credit ratings are largely uncorrelated with cash The Shareholder Return Perspective
flow volatility, other studies have shown that both lower Ultimately, financial policies should be chosen to maximize
earnings and cash flow volatility are associated with higher shareholder value. A high target rating can provide signifi-
valuation multiples.7 Moreover, this relationship between low cant financial flexibility, but may be inefficient in minimizing
volatility and high valuation multiples is comparable to the the overall cost of capital. How does the risk-return tradeoff
correlations between multiples and traditional value “drivers” inherent in the capital structure choice affect shareholders?
like profitability, size, and growth. And this in turn suggests To provide some perspective on this question, we collected
that, by increasing equity value and so reducing market lever- data on S&P 1500 companies at the start of 1994. For each

5. The S&P Super Composite 1500 Index comprises the S&P 500, S&P MidCap 400, Global Markets, NY (2004).
and S&P SmallCap 600 indices. 7. A 10% reduction in cash flow volatility corresponds to a 3-4% increase in valuation
6. See C. Czapla, E. Lindenberg, A. Shivdasani, and Y. Polyakov, “Reducing Volatility multiples; the effect is more pronounced for speculative-grade companies.
in Earnings and Cash Flow: Does the Market Care about Risk Management?,” Citigroup

32 Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005
Table 4 Breakdown of Total Shareholder Returns per Broad Rating Category

1994 Status Year-End 2003 Status

Upgrade Downgrade Same Delisted Default All


Rating Count Count Return Count Return Count Return Count Return Count Return Return

AAA 18 0 N/A 8 12.4% 6 16.7% 4 20.0% 0 N/A 15.5%


AA 76 1 12.2 49 8.0 9 14.5 17 33.7 0 N/A 14.6
A 223 28 16.8 93 7.4 40 14.5 60 21.3 2 (40.0) 13.2
BBB 192 25 10.8 55 2.8 31 8.5 71 27.9 10 (50.8) 11.3
BB 113 24 12.8 17 (2.1) 8 7.0 50 17.8 14 (47.6) 4.9
B 44 3 17.6 3 (3.4) 1 (11.1) 24 17.5 13 (56.4) (6.4)

666 81 13.8% 225 5.7% 95 11.8% 226 23.1% 39 (51.0%) 10.1%

company, we computed the shareholder return over the Figure 5 Total Annual Shareholder Returns per
subsequent ten-year period and grouped the companies into Ratings Category (1994-2003)
buckets according to their initial rating in 1994.
20%
Two primary insights emerge from the data. As can be seen
Annualized Total Return (%, 1994-2003)

in Figure 5, higher-rated companies have performed better over 15%


the past decade, on average, than lower-rated firms. Moreover,
within individual rating categories, returns were higher for 10%

companies rated in the upper part (say, BBB+) rather than the
5%
lower part (BBB-) of the category. But the greatest impact of
credit ratings on returns shows up at the lower end of the ratings 0%
spectrum. The returns of companies rated BB were about ten
(5%)
percentage points higher than those of B-rated companies, on
average, and BBB companies outperformed BB companies (10%)
by about six percentage points. By contrast, the returns were B BB BBB A AA AAA
more tightly clustered among investment-grade companies; for
S&P Senior Bond Rating (1994)
example, AAA companies outperformed BBB companies by
only four percentage points. To learn more about the causes of the differences in stock
But since the direction of causality is unclear in this performance across ratings, we looked at how returns varied
case—that is, the higher stock returns may have contributed with changes in ratings (including upgrades, downgrades,
to (instead of resulted from) the higher credit ratings—we delistings, and defaults) in each rating category. As can be seen
have to ask ourselves: What role, if any, did the higher ratings in Table 4, companies that maintained or strengthened their
play in bringing about the higher returns? Some answers to rating clearly performed better, while companies that were
this question might be found by looking more carefully at downgraded did not perform as well. But this is not surprising
companies within the BBB category, which is the median for since companies tend to be upgraded after (though often well
rated industrial companies. Although BBB-rated companies after) the stock has performed well, and downgrades occur
produced returns that were lower than the average returns (relatively soon) after poor performance.8
of the other three investment-grade categories, the average But what does this tell us about the relationship between
return was dragged down by that of BBB- firms. But compa- credit ratings and stock returns? At first glance, the findings
nies with a straight BBB rating outperformed all other rating on downgrades might suggest that higher leverage is the cause
subcategories, including AAA-rated companies—a finding of the lower shareholder returns. To get to the bottom of
that casts doubt on the proposition that higher ratings are a the question of what causes downgrades, we tracked ratings
major contributor to higher stock returns. reports and other news reports on 210 downgrade events over

8. In evaluating the total shareholder returns to companies with different ratings, it’s explanation here is that a weak rating may force management teams to consider strategic
important to take into account the effect of delisted and defaulted companies. Companies options for the company, including a possible sale, especially if its competitors tend to be
are typically delisted after being acquired—and as can be seen in the table, acquisitions large companies with stronger credit ratings. Acquisitions are less likely for highly rated
are associated with higher than average returns in all rating categories, and they are much companies because they tend to be large, as discussed earlier. The frequency of defaults,
more prevalent in the non-investment-grade than investment-grade categories. Part of the which lead to negative returns, also increases with lower ratings.

Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005 33
Table 5 Shareholder Returns for Downgraded Firms it is the strength of the company’s credit rating relative to its
Classified by the Reason for Downgrade competitors that may matter most.
But if a strong rating plays a key role in providing strategic
Reason for Downgrade Count Avg. Return flexibility in an M&A context, relatively few acquirers tend
to actually exploit this advantage. Perhaps the concern is that
Added Leverage 53 10.0%
Operational / Competitive Issues 118 4.2
the flexibility might be needed for a future acquisition oppor-
Both 14 1.2 tunity. But academic studies of corporate M&A provide no
Uncertain 25 (14.0) evidence of harm to shareholders of the acquiring firms when
deals are financed primarily with debt; in fact, one study of
210 3.3%
large U.S. deals during the 1990s reported that debt-financed
purchases were viewed much more favorably by the market
the period 1994-2003. As shown in Table 5, we concluded than stock-financed poolings.9 Moreover, in our own recent
that only 53, or about 25%, of these downgrades resulted study, we found that companies that sacrificed their rating to
from earlier corporate decisions to increase leverage. And in make a large M&A deal tended to perform no differently in
those 53 cases, the average annual shareholder return (10%) either the short or the long term following the acquisition than
was well above the average for all 210 downgraded companies companies that preserved their credit rating.10 By contrast, we
(3.3%), and not far below the average return (11.3%) on all found that companies that announced 100% stock transac-
BBB firms. In the large majority of cases, however, the primary tions tended to perform worse than those paying with cash or
cause of the default was not additional debt but rather a reduc- a mix of cash and stock.
tion in EBITDA that led to a higher debt-to-EBITDA ratio Another channel by which ratings can affect the M&A
and hence the downgrade. And for the 118 companies that process is through their effect on financing synergies. In
were clearly downgraded because of operational or competi- many situations, a highly rated acquirer purchasing a lower-
tive problems, total shareholder returns were just 4%. rated target is able to secure the higher credit rating for the
In sum, the value loss associated with downgrades appears combined entity. This implies that most of the outstanding
largely attributable to reductions in operating cash flow. By debt of the target can be refinanced at the stronger rating,
contrast, when companies have exercised their option to thereby lowering the future cost of debt financing. In some
use financial flexibility by increasing leverage (say, to make sectors, such as financial institutions, this effect produces
a major acquisition), such decisions have been associated a financing synergy that often constitutes a significant
with an increase in shareholder value. In fact, proponents of portion of the expected value added by the transaction.
higher leverage might even cite these findings to argue that
such financing can help prevent the operating problems that Ratings Issues for 2005
sometimes lead to ratings downgrades. Many companies are now reassessing how they manage their
balance sheet flexibility and their rating agency relation-
The Relationship between Capital Structure and ships, and we believe that this trend will accelerate in 2005.
M&A Activity Managers should ask the following basic questions:
Capital structure and M&A are inextricably linked. In many • Is the emergence of new rating agencies reducing the
situations, the expected effect on credit rating of a debt- importance of the Moody’s and S&P ratings in determining
or cash-financed acquisition is a key consideration for an the cost of capital? How many and which rating agencies
acquirer and can be a driving factor behind the decision to use should rate us? If unhappy with agency analysts and the
equity to fund a deal. Corporate buyers typically try hard to prices paid for ratings, infrequent issuers should consider
preserve their rating during acquisitions, but some companies reducing the number of raters.
are willing to sacrifice their rating if the target is sufficiently • How is the growth and development of the credit
attractive. As mentioned earlier, financial flexibility can be default swap market affecting my opportunities and cost of
very valuable in an acquisition situation. And the absence debt financing? Are the spreads in this market leading indica-
of such flexibility can be particularly damaging if it forces tors of rating agency actions, and how should the prices in
the firm to pass up a valuable acquisition opportunity. In this market guide my corporate financing decisions?
industries where there is rapid consolidation and acquisition • To what extent should we consider rating agency
is an important means of preserving strategic positioning, the preferences when considering value-enhancing acquisi-
possibility of losing a valuable asset or company to a better- tions or dividend and stock buyback decisions? Many
capitalized competitor can be a major concern. In such cases, companies, including TXU, HCA, The Limited, and

9. See E. Lindenberg and M. Ross, “To Purchase or Pool: Does It Matter?,” Journal of 10. See T. Hazelkorn, A. Shivdasani, and M. Zenner, “Creating Value with Mergers and
Applied Corporate Finance, Vol. 12, No. 2 (1999). Acquisitions,” Journal of Applied Corporate Finance, Vol. 16, No. 2-3 (2004).

34 Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005
Clorox, have recently decided to exploit some of their • Does it pay to have a very high rating? Does it hurt
financial flexibility (sometimes at the expense of their to have a very weak rating? Would any part of our business
credit rating) to return cash to shareholders. Given operations be hurt with a lower rating? And how costly
the positive market response, should more companies would it be compared to using this flexibility to lever up and
consider such transactions? buy back stock?
• Which financial metrics really affect ratings? Are
they the same as the ones identified by the rating agencies,
or are there other important “underlying” or “invisible” anil shivdasani is the Wachovia Distinguished Professor of Finance
factors at work? and Chairman of the Finance Department at the University of North Caro-
• Do the agencies dislike a sector so much that they lina’s Kenan-Flagler Business School.
disregard capital structure and focus almost entirely on
operating characteristics? And in that case, should we aim marc zenner is head of the North America Division of Citigroup’s
to improve our rating and, if so, what are the strategies that Financial Strategy Group. Prior to moving into investment banking, he
will lead to this improvement? was Chairman of the Finance Department and Professor of Finance at
• How do capital markets react to ratings changes, the University of North Carolina’s Kenan-Flagler Business School from
and do ratings matter if capital markets are open and 1989-2000.
inexpensive?

Journal of Applied Corporate Finance • Volume 17 Number 1 A Morgan Stanley Publication • Winter 2005 35
Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN Journal of Applied Corporate Finance is available online through Synergy,
1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwell’s online journal service, which allows you to:
Blackwell Publishing, with offices at 350 Main Street, Malden, MA 02148, • Browse tables of contents and abstracts from over 290 professional,
USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call science, social science, and medical journals
US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: • Create your own Personal Homepage from which you can access your
+44 1865 471775. personal subscriptions, set up e-mail table of contents alerts, and run
saved searches
Information for Subscribers For new orders, renewals, sample copy re- • Perform detailed searches across our database of titles and save the
quests, claims, changes of address, and all other subscription correspon- search criteria for future use
dence, please contact the Customer Service Department at your nearest • Link to and from bibliographic databases such as ISI.
Blackwell office (see above) or e-mail subscrip@bos.blackwellpublishing.com. Sign up for free today at http://www.blackwell-synergy.com.

Subscription Rates for Volume 17 (four issues) Institutional Premium Disclaimer The Publisher, Morgan Stanley, its affiliates, and the Editor cannot
Rate* The Americas† $330, Rest of World £201; Commercial Company Pre- be held responsible for errors or any consequences arising from the use of
mium Rate, The Americas $440, Rest of World £268; Individual Rate, The information contained in this journal. The views and opinions expressed in this
Americas $95, Rest of World £53, Ð80‡; Students**, The Americas $50, journal do not necessarily represent those of the Publisher, Morgan Stanley,
Rest of World £28, Ð42. its affiliates, and Editor, neither does the publication of advertisements con-
stitute any endorsement by the Publisher, Morgan Stanley, its affiliates, and
*Includes print plus premium online access to the current and all available Editor of the products advertised. No person should purchase or sell any
backfiles. Print and online-only rates are also available (see below). security or asset in reliance on any information in this journal.


Customers in Canada should add 7% GST or provide evidence of entitlement Morgan Stanley is a full service financial services company active in the securi-
to exemption. ties, investment management, and credit services businesses. Morgan Stan-
ley may have and may seek to have business relationships with any person or

Customers in the UK should add VAT at 5%; customers in the EU should also company named in this journal.
add VAT at 5%, or provide a VAT registration number or evidence of entitle-
ment to exemption. Copyright © 2005 Morgan Stanley. All rights reserved. No part of this publi-
cation may be reproduced, stored, or transmitted in whole or part in any form
**Students must present a copy of their student ID card to receive this rate. 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
For more information about Blackwell Publishing journals, including online ac- internal or personal use of specific clients is granted by the copyright holder
cess information, terms and conditions, and other pricing options, please visit for libraries and other users of the Copyright Clearance Center (CCC), 222
www.blackwellpublishing.com or contact our Customer Service Department, Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided
tel: (800) 835-6770 or +44 1865 778315 (UK office). 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 advertis-
Back Issues Back issues are available from the publisher at the current single- ing or promotional purposes, for creating new collective works, or for resale.
issue rate. Institutions with a paid subscription to this journal may make photocopies for
teaching purposes and academic course-packs free of charge provided such
Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mail- copies are not resold. For all other permissions inquiries, including requests
ing to rest of world by DHL Smart & Global Mail. Canadian mail is sent by to republish material in another work, please contact the Journals Rights and
Canadian publications mail agreement number 40573520. Postmaster Permissions Coordinator, Blackwell Publishing, 9600 Garsington Road, Oxford
Send all address changes to Journal of Applied Corporate Finance, Blackwell OX4 2DQ. E-mail: journalsrights@oxon.blackwellpublishing.com.
Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA
02148-5020.

Das könnte Ihnen auch gefallen