DOI: 10.1111/jacf.

12539

O R I G I N A L A RT I C L E

Vanderbilt University Roundtable on the Capital Structure Puzzle

Stewart Myers1 John McConnell2 Alice Peterson3 Dennis Soter4 Joel Stern4
1
Massachusetts Institute of Technology
2
Purdue University
3
Sears, Roebuck and Co.
4
Stern Stewart & Co.

Correspondence
John McConnell, Purdue University.
Email: [email protected]

VANDERBILT UNIVERSITY ROUNDTABLE Toward the end of the 1970s, there was also discussion of “signal-
ON THE CAPITAL STRUCTURE PUZZLE ing” effects—for example, the tendency for the stock market to
respond negatively to announcements of new stock issues.
April 2, 1998 Nashville, Tennessee A defining moment in the academic capital structure debate
came in 1984, when Professor Stewart Myers devoted his Presi-
JOEL STERN: Good afternoon. I’m Joel Stern, managing partner dential address to the American Finance Association to something
of Stern Stewart & Co., and, on behalf of our hosts here at Vander- he called “The Capital Structure Puzzle.” The puzzle was this:
bilt’s Owen Graduate School of Management, I want to welcome Most academic discussions of capital structure were based on
you all to this discussion of corporate capital structure. Before get- the assumption that companies make financing decisions that are
ting into our subject matter, let me take a moment to thank Hans guided by a target capital structure—a proportion of debt to equity
Stoll for organizing this conference on “Financial Markets and the that management aims to achieve, if not at all times, then at least
Corporation.” I also want to take this opportunity to salute Profes- as a long-run average. But the empirical evidence suggested other-
sor Martin Weingartner—in whose honor this conference is being wise. Rather than adhering to targets, Professor Myers observed,
held—at the conclusion of a long and productive career. Marty’s most large U.S. public companies behaved as if they were follow-
contributions to the field of corporate finance are many and con- ing a financial “pecking order.” They were funding investment
siderable; and, though he may be stepping down from his formal with retained earnings rather than external financing if possible;
position, we expect to continue to hear from him for many more and if external funding was necessary, they issued debt first and
years. equity only as a last resort.
The subject of today’s meeting is corporate capital structure: Since then, the capital structure debate has raged on. Harvard
Does capital structure matter? And, if so, how and why does it professor Michael Jensen entered it in the mid-1980s, pointing to
matter? Although these questions have been seriously debated in the success of LBOs and citing the beneficial effect of debt financ-
the academic finance profession for almost 40 years, we seem to ing on management’s tendency to overinvest in industries with
be no closer to a definitive answer than we were in 1958, when excess capital and capacity. And, as if to oblige Professor Jensen,
Merton Miller and Franco Modigliani published their article the market continued to supply large numbers of LBOs and other
presenting the first of their two famous “irrelevance” propositions. highly leveraged transactions throughout the rest of the decade.
Following the M&M propositions, academic researchers in the Then, in the early 1990s, we saw an almost complete halt to lever-
1960s and 1970s turned their attention to various market “imper- aged deals. But today, of course, leverage is back. A new wave
fections” that might make firm value depend on capital structure of LBOs has shattered most of the old records, and junk-bond
and dividend policy. The main suspects were (1) a tax code issuance is at all-time highs.
that encourages debt by making interest payments, but not div- So, if capital structure is irrelevant, then what’s going on here?
idends, tax deductible, and (2) expected costs of financial distress, And do the successes of the LBO movement have anything to say
including corporate underinvestment, that can become impor- to the managements of our largest public companies? Such effects
tant as you increase the amount of debt in the capital structure. seemed to confirm the existence of large “information costs” that

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2 JOURNAL OF APPLIED CORPORATE FINANCE

might also influence corporate financing choices in predictable three deals involved borrowing substantial amounts of new debt to
ways. buy back shares—and two involved major changes major changes
With us here to discuss these issues, and to help us shed some in dividend policy as well.
light on this capital structure puzzle, is a small, but distinguished
group of academics and practitioners. And let me introduce them
briefly: Capital Structure and “Financial Structure”
STEWART MYERS, whose name I have already mentioned
several times, is the Billard Professor of Corporate Finance at one STERN: So, now that we know who the panelists are, let me turn
of my favorite schools, the MIT Sloan School of Management. the floor over to Professor Stewart Myers. You might not remem-
Stew has done research over the years in issues dealing with capital ber this, Stew, but in 1983 you were kind enough to publish an
structure, valuation, and regulation. He has also been an adviser to article in our Midland Corporate Finance Journal entitled “The
a large number of corporations and financial institutions. And let Search for Optimal Capital Structure.”
me mention that, for us at Stern Stewart, the name Stewart Myers And it was not only a marvelous piece, but it was the lead arti-
has a special significance. As most people here are well aware, cle in the very first issue—Volume 1 Number 1—of that journal.
Stew is the co-author, with Dick Brealey of the London Business Then, about 10 years passed, and you wrote a second article for us
School, of Principles of Corporate Finance, the leading textbook in that was called “Still Searching for Optimal Capital Structure.”
corporate finance. Every person who gets hired at Stern Stewart is And that was also a wonderful piece—one that I use (along with
required to have read that volume by the time he or she walks in the first one) in the courses I teach at Columbia and Carnegie
the door. Mellon.
ALICE PETERSON is Vice President and Treasurer of Sears, My question for you is: What is your current thinking on the
Roebuck and Co. As we all know, Sears has made dramatic capital structure debate? And what are you going to call your next
improvements in operating performance and achieved large article?
increases in shareholder value over the past few years. Alice joined STEWART MYERS: The next one is going to be called “Stop
Sears in 1989 as Director of Corporate Finance, 4 years before Searching for Optimal Capital Structure.” Let me take a minute or
being made Vice President and Treasurer in 1993. Prior to coming two to tell you why. Optimal capital structure is obviously some-
to Sears, she held corporate finance and treasury positions at Kraft thing I’ve been concerned and struggling with ever since I arrived
and at Pepsico. She earned her MBA here at Vanderbilt in 1981, at the doctoral program at Stanford. I’ve been frustrated over the
and she serves on the boards of two New York Stock Exchange years by our inability to come up with any simple answer. But I am
companies. lately coming to a different view. Maybe it will start the discussion
JOHN McCONNELL is the Emanuel T. Weiler Professor of off.
Finance at Purdue University. John has made extensive contribu- When we talk about optimal capital structure, we are thinking
tions to the field of corporate finance, especially in the analysis of the percentages of different securities on the right-hand side of
of innovative securities. I still remember an article on income the balance sheet. We tend to think in terms of the mix of debt and
bonds that John contributed to our old Chase Financial Quar- equity, at least to start, and then go on to consider other securities
terly, the original predecessor of our Journal of Applied Corporate as well. We look at preferred stock, for example, and at hybrid
Finance. And, in an issue of the JACF about 5 or 6 years ago, John securities like convertible debt.
coauthored (with Eduardo Schwartz) a fascinating account of the At what level do we understand how these financing choices
origins of LYONS, the very successful puttable, convertible securi- affect firm value? At a tactical level, I think we understand it very
ties pioneered by Merrill Lynch. Given John’s ability to tell stories, well. For example, if you ask either academics or practitioners to
none of us is surprised that he manages to win teaching awards at analyze a financial innovation like the tax-deductible preferreds
Purdue year after year. that John McConnell just finished telling us about, we do that
Last is DENNIS SOTER, my colleague and fellow partner at pretty well. We understand how those things work, why they’re
Stern Stewart. After graduating from the University of Rochester’s designed the way they are, and what you need to do to get them
Simon School of Business in 1972, Dennis joined me at the sold. So, at this tactical level, we can be fairly satisfied with our
Chase Manhattan Bank. Then, in 1979, we parted ways. Den- understanding of capital structure.
nis became Vice President in charge of corporate development Where we tend to fall down in terms of neat or simple theo-
at Brown Foreman, where he helped transform the firm from ries is in understanding the role of capital structure at what I will
the maker of Jack Daniels (and other mild intoxicants) into call the “strategic” level—that is, when you’re trying to explain
a diversified consumer goods firm. Then he went to Ernst & the debt ratios of companies on average or over long periods of
Whinney, where he was the national practice director of M&A. time. We do have some useful insights about capital structure, and
Next, he joined Citizens Utilities and helped them to become we know what ought to matter. But it’s very difficult to put these
something of an unregulated company as well as a regulated insights together into a simple theory that predicts what managers
company. are going to do—or tells us what they should be doing.
Several years ago, we were very fortunate in persuading each Why aren’t we cracking the problem? I think we are starting in
other that we should be together again. And Dennis now runs the wrong place. We shouldn’t be starting with the percentages of
our corporate finance advisory activity and also oversees imple- different kinds of financing on the right-hand side of the balance
mentations of EVA in middle market-sized companies. In the past sheet. We should not be starting with capital structure, but with
2 years, as I’m sure Dennis will tell us, he served as financial adviser financial structure. By financial structure I mean the allocation
in three highly successful leveraged recapitalizations. Each of these of ownership and control, which includes the division of the risk
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3

and returns of the enterprise—and particularly of its intangible decisions, what are the goals and performance measures, and how
assets—between the insiders in the firm and the outsiders. are people rewarded for meeting them.
What’s really going on in the public corporation is a coinvest- STERN: So, your concept of financial structure is essentially
ment by insiders, who bring their human capital to it, and by the same as what some people are calling corporate governance
financial investors. These two groups share the intangible assets or organizational structure—it’s the assignment of decision rights,
of the organization. And, in order to make that shared investment monitoring, performance measures, incentives, and all of that?
work, you’ve got to figure out issues of ownership and control, MYERS: Financial structure is my shorthand—just two
incentives, risk-sharing, and so forth. You’ve got to start by mak- words—for all of that sort of stuff. My point is that these
ing sure you get all of those things right. That’s what I call financial issues of financial structure are the first-order concerns of most
structure. corporations. Management has to get them right.
Financial structure is not the same thing as a financing mix. Now, that’s not the same as saying that managers have to do all
Let me offer a simple example. Take a high-tech venture capital these things consciously. Sometimes they get it right because they
startup and compare it to Microsoft. Even though their debt ratios do what other corporations have done and survived.
are likely to be identical—that is, zero—I think we’d all agree that Once an industrial corporation goes public, it’s ordinarily a
they are not the same thing from a financial point of view. The mid-cap firm with a financial structure well in place. In a sense,
same comparison could be made between a publicly held man- it has solved 80% of its problem—that is, as long as it keeps
agement consulting company and the usual private management operating efficiently. Having solved that problem, I don’t think
consulting firm. Though their balance sheets might look exactly most corporations worry a great deal about their debt-equity ratio.
the same, I would say they’re very different. In particular, I would Obviously, they worry if it gets too high and they worry if it gets
predict that if you take a small consulting company public, it’s too low. But there’s a big middle range where it doesn’t seem to
almost sure to crater. The assets go home every night, and it’s matter very much. I think that’s why we’re having a hard time pin-
going to be very difficult to have the right incentives to keep key ning down exactly what the debt-equity ratio is or should be. It’s a
people in the company while at the same time satisfying outside “second order” thing compared to the choice of financial structure.
investors. STERN: Well, people have pointed out that the tax-
So, if Stern Stewart ever goes public, Joel, I’m going to wait deductibility of interest expense makes debt a way of adding
6 months and then sell you short. considerable value. And because of the value added by those tax
STERN: I actually had a dream that somebody was going to shields, one could argue that aggressive use of debt may turn out
do that to us—but I had no idea, Stew, that it was going to be to be the best defense against an unfriendly takeover. Doesn’t that
you! I must confess that such thoughts have passed through my argument seem to imply that capital structure could at least become
mind. But, if we were to take such a course (which we have no a first-order concern?
plan to do), we would design the new firm so as to protect out- MYERS: By raising the issue of hostile takeovers, I think you
side investors not so much from the possibility that the assets go are mixing up the investment decision with the financing decision.
home at night, but that they might move to the island of Maui, I would like to keep them separate, at least as a starting point.
permanently. Most takeover targets become targets not because they don’t have
Incidentally, this is not an unreasonable issue because Booz- enough debt, but because of bad investment decisions and poor
Allen did that once. You may not be aware of it, but in the operating performance. The primary cause of the wave of LBOs
1970s Booz-Allen went public at a price in the mid-teens. The in the 1980s was not corporate failure to exploit the tax advantage
shares went as high as about $20 and then dropped to about of debt. Most of the LBOs—and I’m oversimplifying a little—
$2—and they stayed between $2 and $6 for quite a while. The were “diet deals.” They involved taking over mature companies
reason I know about it is that I served on the board of direc- with too much cash and too few investment opportunities and
tors of a company with the Vice Chairman of Booz-Allen. And putting them on a diet. So, although there were tax savings, the
every time the possibility of going public was raised for this pri- transactions themselves were not tax-driven.
vately held company, he would say: “It’s the wrong thing to do.”
And he would drag us through this horrible experience once
more. Capital Structure and Management Incentives
But Booz-Allen made a fundamental mistake—one that, if cor-
rected, might have changed the outcome. They didn’t differentiate DENNIS SOTER: Most of the companies that we have worked
between outsider shares and insider shares. If the insiders own with over the years do spend a lot of time thinking about capital
shares that only gradually convert to outsider shares, the insiders structure. Now, it’s true that they typically do not think about
aren’t going anywhere. They could also have issued stock options it the way academics do—that is, in terms of a market debt-to-
to the employees with values tied to the value of the insider shares. equity ratio. Most of them define their objectives in terms of bond
With insider shares and options, it would take a long time for ratings or book leverage. But they do have loosely defined financial
people to take out the wealth that they were building up in the strategies and some idea of what constitutes an appropriate mix of
firm. debt and equity in their capital structure.
How do you feel about that idea, Stew? I’d like to ask Professor Myers a question: You used the term
MYERS: I think you’re just making my point. First of all, I “optimal capital structure.” Would you define that for us?
don’t think that it makes sense to take a small consulting company MYERS: In its simplest terms, optimal capital structure is the
public. But if you did, you’d have to pay attention to financial optimal percentage of debt on the balance sheet.
structure—to issues like who owns what, who gets to make what SOTER: But optimal from what standpoint?
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4 JOURNAL OF APPLIED CORPORATE FINANCE

MYERS: Maximizing the market value of the company. I’m not capacity that their shareholders would benefit from a leveraged
saying that’s the wrong question, or an irrelevant or an uninter- recapitalization.
esting question. It’s a very interesting question. But I think by
focusing too narrowly on that, you miss these other things which
I put under the rubric of financial structure—things which I tend Too Much Stock Ownership?
to think are more important to corporate managers, and so more
powerful in explaining the corporate behavior we see. JOHN McCONNELL: When I started my career many years ago,
STERN: I think you’re right, at least in the sense that I regularly I taught a course on corporate capital structure, thinking that I
see behavior that doesn’t appear to me to be value-maximizing. For knew something about it. Then, for a period of a few years, I
example, in a roundtable discussion we ran a few years ago, one quit teaching capital structure because I concluded I knew abso-
of the participants was an owner of a publicly traded company lutely nothing. More recently, I’ve started teaching a course that
where he and his family owned about 37% of the equity. And I I call capital structure, but which really amounts to a course in
asked him why his debt ratio was so low. I said to him, “You’re corporate governance. And, so, I think I’ve been undergoing an
volunteering to pay an awful lot in taxes that you could avoid. evolution in thinking that is quite similar to the one Stew has just
Why don’t you raise your debt ratio to the point where most of described.
your pre-tax operating income is tax-sheltered?” And like you, Dennis, as Stew was defining optimal capital
You see, the amount of taxes he was paying was quite sizeable; structure and describing the capital structure puzzle, I too was
it was some $12–$15 million a year that was literally going out thinking about management incentives. Most of us, I suspect,
the door that could have been saved just by changing the capital would agree with the general proposition that there is a tax shield
structure. Why do companies do that, Stew? associated with debt financing. There would certainly be some dis-
MYERS: Tell me what he said first. agreement about how valuable that tax shield is: Does it amount
STERN: He looked at me somewhat quizzically, and he said, to a full 34 cents on the dollar of debt financing, or does that
“Well, don’t you have to pay taxes?” number fall to only 15 or 20 cents when you consider the taxes
MYERS: You’re absolutely right. If you look at taxes alone, and paid by debt holders? But, regardless of which end of this range
you calculate the present value of the taxes that could be saved you choose, most people in this room would probably agree that
by greater use of debt, it seems like a big number. It’s hard to the value of such savings can be substantial. And thus most of
explain why corporations don’t seem to work very hard to take us here would also likely agree that, for whatever reason, many
advantage of the tax shelter afforded by debt. I can’t really explain public corporations are not using enough debt—not using the
why companies aren’t taking advantage of those savings. value-maximizing level of debt.
I also agree with Dennis that corporations will say that they But let me also respond to Dennis by saying that stock own-
have target debt ratios. But the fact is they don’t work very hard to ership may not be a complete answer to the question. I’m on the
get there. If a company is very profitable and doesn’t have a need board of directors of a bank with about $600 million in assets,
for external funds, it’s probably going to work down to a low debt and there is great latitude as to the minimum capital ratio that the
ratio. If it’s short of funds, it’s going to work up to a high debt bank can have. The owners of the bank, however, insist for some
ratio. These companies are not treating their debt ratio targets as reason upon keeping their capital ratio high. In so doing, they
if they were first-order goals. forgo not only possible tax benefits, but also the deposit insurance
SOTER: Let me offer one possible clue to this capital struc- “funding arbitrage.”
ture puzzle by asking a question: Is it in the personal interests Like the company Joel was describing earlier, 47% of the stock
of the chief executive officer and the chief financial officer to of this particular bank is owned by a single family of investors.
employ leverage aggressively? Are they motivated through incen- And if one thinks only in terms of their ownership incentives, it
tives, either through stock ownership or otherwise, to have an would seem that that particular ownership structure would be one
aggressive debt policy? that would have sufficiently strong incentives to induce managers
I submit that very few CFOs of the largest U.S. public compa- to have a high leverage ratio. But instead, they have low leverage
nies have enough equity ownership to even consider undertaking and considerable excess capital.
a leveraged recapitalization. If it’s successful, he or she looks good And this case, by the way, is by no means an anomaly; it is quite
for the moment. But if it’s doesn’t work, he’ll never get another job representative of U.S. public corporations with heavy insider own-
in corporate America as a chief financial officer. So there is a great ership. The studies that have looked at the relationship between
deal of personal risk for corporate management for which there insider stock ownership and leverage ratios show that, beyond a
may be little compensating reward. Without a significant owner- certain point, companies with very large insider ownership tend
ship interest, who wouldn’t prefer to have a single-A bond rating to have lower-than-average leverage ratios. Like other academic
and sleep well at night? studies in which the relationship between ownership concentra-
STERN: Unless they were subjected to an unfriendly tion and stock value is shown to be a bell-shaped curve, these
takeover—in which case they would lose their jobs for sure. studies of leverage and insider ownership suggest that insiders can
SOTER: Joel, you’re citing an extreme example, one where actually own too much stock in their own firm.
there’s so much unused debt capacity that a company invites a hos- STERN: I was thinking along the same lines, John, when we
tile bid. In my experience, there are many other companies that, were doing some work with the Coca-Cola Company. The CEO
although not takeover candidates, still have enough excess debt of Coke had a very large percentage of his own personal net worth
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5

tied up in the equity of the company. He was the third or fourth We call our overall financial metric Shareholder Value Added.
largest shareholder. And it occurred to me that the concentration It is simply operating profits less the cost of all the capital it takes
of the CEO’s wealth in Coke stock, and thus in an undiversified to create those profits. When we break down capital costs into
portfolio, could be a major factor in keeping the company from the amount of capital times the cost of capital, we focus signif-
having a high debt ratio. That is, given his personal portfolio, it icantly more managerial effort on the amount of capital—and
may have been rational for him to keep the financial risk of the our approach is operationally focused. In other words, we want to
company to a minimum. attack the root need for the capital—and, for us, that’s inventory
What this suggests to me is that, in cases with very large inside and stores and fixturing. I often say that, of our 350,000 asso-
owners, we may need to devise a compensation scheme that helps ciates at Sears, nearly all of us have a daily impact on the amount
overcome the owners’ risk aversion so as to align their risk-reward of capital, but only a handful decide how to fund the capital needs.
tradeoff with that of well-diversified shareholders. So, we spend disproportionately more time talking about how
McCONNELL: What about the use of nonvoting stock? That to get more profit using less assets. For the few of us who do focus
would allow insiders to raise capital for investment opportuni- on the righthand side of the balance sheet, there is considerable
ties without reducing their control over decision-making. For effort aimed at achieving the lowest long-term cost of capital by
example, the CEO of Coca-Cola could have had the company managing the capital structure.
issue nonvoting stock, and then concentrated his own holdings How does a company decide its optimal mix of debt and equity?
in the voting stock. Is something like that what you have in At Sears we start by asking how much financial flexibility we want
mind? to pay for. That leads to a discussion in which we determine our
STERN: No, that wouldn’t be a solution to the problem I’m target debt rating, which in turn translates into a target capital
thinking about. The concern I have is that because the CEO’s structure. With every strategic plan we’re gauging the extent of
holdings represent such a large percentage of his own personal net free cash flow, the appropriate level of capital expenditures, and
worth, he was much more risk averse than institutional investors whether and to what extent we should be buying back stock. I can
with well diversified portfolios. And this risk aversion may well tell you we have dug seriously into the capital structure question
have caused him to use less than the amount of leverage that would several times over the last 5 years as we have IPO’d and spun off
have optimal from the perspective of his institutional owners. various business units and not only for the businesses leaving the
McCONNELL: One possible solution to this problem— portfolio, but for those remaining, too.
not for Coke, but at least in the case of small, closely held So, what are these financial flexibility considerations? They
companies—would be for the CEO to sell a large fraction of his include growth prospects and whether a company is inclined to
equity, thus allowing him to diversify his portfolio and allowing grow organically or by acquisitions. They also include the need
outsiders to have greater control over the firm. This could end up to position the company to weather extreme economic cycles and
significantly increasing the value of the firm, at least in countries exogenous risks. Other considerations are ownership structure and
like the U.S. with its strong legal protections for small investors stock positioning, as well as dividend policy, and our ability to
and well-functioning corporate control market. manage overall enterprise risk.
One consideration that doesn’t show up on most companies’
list, but which is very important for Sears, is its ongoing debt-
A Corporate Perspective: The Case of Sears financing needs. Sears is different from its retail competitors by
virtue of our successful credit business. Our $28 billion consumer
STERN: But, to return to our subject, we really don’t have an receivables portfolio is the largest proprietary retail credit portfo-
explanation why public companies have low debt ratios—or at lio by a wide margin (the next largest is J.C. Penney at $5 billion).
least low enough that they end up paying millions of dollars more The $25+ billion in debt financing required to fund this prof-
in taxes than seems necessary. Since we have with us a senior exec- itable credit business is a key consideration in determining our
utive from one of America’s largest public companies, why don’t target debt rating. We have targeted a ‘Single-A’ long-term debt
we turn to her? Alice, what’s your explanation of all this? And how rating to optimize our overall cost of capital. We think a “Double-
do you think about corporate financial policy at Sears? A” rating is entirely too expensive, but feel that “Triple-B” greatly
ALICE PETERSON: Let me start by reinforcing Stewart limits our flexibility. Importantly, impacts from a downgrade
Myers’s point that capital structure is a relatively small part of a would disproportionately affect Sears versus our retail and service
much larger, value-creating equation. At Sears, as in most compa- competition.
nies, creating shareholder value is the main governing objective. To give you a sense of how we incorporate this shareholder
Behind our mantra to make Sears a compelling place to shop, value discipline into our daily lives, the way we approach target-
work, and invest, we use an EVA-type metric to track performance setting for the enterprise-wide capital structure is by solving for
in the “invest” category. the capital structure that optimizes our market value. We take
In order to create value for investors, companies need a business into consideration historical performance, economic scenarios,
model to guide them in generating excess returns. Business mod- business and industry prospects, risk of bankruptcy, and capital
els vary widely from company to company, even within the same constraints. Coming at it from the other side, we also focus on
industry. Such a business model incorporates overall objectives, our individual businesses’ cost of capital. Our individual busi-
organization, strategies, and financial goals. It occurs to me that nesses include very different formats: full-line stores, Homelife
Stewart Myers’s broad definition of capital structure runs through furniture stores, Sears Hardware stores, our services business, and
our entire business model. our credit card business, to name just a few. These businesses
 17456622, 0, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/jacf.12539 by Thomas Biuso - Thomas Biuso : [email protected] , Wiley Online Library on [03/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
6 JOURNAL OF APPLIED CORPORATE FINANCE

represent different levels of risk, and so warrant different hurdle Rethinking the Value of Financial Flexibility
rates.
We address the individual businesses’ cost of capital in two SOTER: I want to respond to this issue of financial flexibility, and
ways: First, we take a rating agency view of the business. We I want to do so by elaborating on my earlier statement about man-
ask ourselves, “What are the business’s prospects for cashflow, agement’s reluctance to make aggressive use of leverage. There’s
and what are the associated risks?” We also assess the business’s more to my explanation than just risk aversion. And it comes
competitive position and develop an industry outlook. Second, down to this: Corporate managers don’t like to have their strate-
we approach the same business’s cost of capital by looking at its gies subjected to the scrutiny of markets. They like to be able to
competitors and other benchmarks. We ask: “What is their capi- draw down bank lines and write a check. All things equal, they
tal structure, and their cost of capital? And are there tax issues?” would prefer not to have to act like an LBO firm in which every
We want to know whether our financial “DNA” is a help or a deal is funded on a one-off basis.
hindrance to competing effectively. We look at on versus off-book I would take issue with Alice’s argument that most public com-
capital. We do analytics, we compare managements, and we look panies are not underleveraged. I do not think that a “Single-A”
at “the story” behind each business. Needless to say, it’s impor- rating is likely to be a value-maximizing capital structure for
tant that the cost of capital and the capital structure for all our most companies. We have looked at about 25 different industries;
component businesses add up to the enterprise-wide picture. By and, with few exceptions, our analysis suggests that the optimal,
pursuing this simultaneous top-down and bottom-up approach, value-maximizing capital structure is below investment grade.
we find we are getting at all the issues that allow us to get more McCONNELL: How do you know that, though?
debt in our capital structure for the same amount of financial SOTER: Without going into details, our method involves an
flexibility. assessment of the trade-off between realizing the tax benefits of
STERN: Well, to return to my earlier question, are there many debt financing versus the increased probability of financial distress
public companies that are passing up opportunities to add sig- and its associated costs.
nificant value by raising their debt ratios? Or are we missing PETERSON: Well, that’s all well and good. But how would I
something important here? get $25 billion on an ongoing basis with a sub-investment-grade
McCONNELL: Well, Joel, I think we’ve already heard the rating?
best answer we’re going to get. Our incentive structures are not SOTER: You could issue subordinated debt.
very effective in overcoming managers’ risk aversion; there just PETERSON: Dennis, the entire high-yield debt market in
isn’t enough reward for success to justify the personal risks to recent years was only $40 billion. And costs can be considerably
management. above investment-grade debt costs.
STERN: But if the incentive structures are not effective, then SOTER: I agree that the costs of the debt will go up. As we all
why don’t we see more unfriendly takeovers to make sure that they know, the cost of debt is always going to go up as you use more
are aligned properly? of it. But I’m looking at debt as a substitute for higher-cost equity.
PETERSON: Well, let me remind you both of your earlier And the question I’m trying to answer is this: How much debt can
comments. You both told stories in which owners with a long- you issue until your debt and equity become so risky that your
term commitment to an institution were reluctant to jeopardize weighted average cost of capital begins to go up. In other words,
the future of that institution by taking on too much debt, or at what level do you minimize capital costs?
operating with insufficient capital. There are costs—significant What I am suggesting is that most public companies would
potential costs—to operating a business with too much leverage, actually reduce their weighted average cost of capital and increase
or too little equity. their overall value by using debt to the point where their debt rat-
When I think about what gets written up about public ing falls below investment grade—not far below investment grade,
companies—more so by fixed income analysts and rating agen- but below investment grade.
cies than by equity analysts—capital structure is very much talked PETERSON: Yes, but that would significantly reduce the
about. It becomes the issue—and for equity as well as fixed financial flexibility of the company, and potentially destroy more
income analysts—when a heavy debt load significantly reduces a value than it creates. Your financing strategy might work for com-
company’s flexibility. And if for no other reason than this, com- panies without the scope and aspirations of, say, the company I
panies are very aware of it. I know that we focus very much work for. But when you want to grow, either internally or by
on our competitors’ capital structures. We often consider what acquisition, and when you have a $25 billion financing require-
their balance sheets permit them to do in the way of compet- ment, you’re going to want the financial flexibility that comes
itive strikes. To listen to the academics here, we’d believe that with an investment-grade rating. And when your business strategy
corporations don’t proactively engineer their capital structure. depends on maintaining strong relationships with your suppliers
And to listen to Joel and Dennis, we’d believe few compa- and other constituencies, that sub-investment-grade rating could
nies in America have enough debt. I think both notions are jeopardize your entire business model.
unfounded. SOTER: I’m not sure companies need as much financial flexi-
So, I must confess that this idea that public companies are sys- bility as they think they do. Let me give you an example. About a
tematically underleveraged is Greek to me. Within our current year ago, SPX Corporation, a New York Stock Exchange company
business model, our company is not underleveraged today. We (and also our client), announced a leveraged recapitalization. At
were clearly overleveraged 5 years ago. the time, SPX had one issue of subordinated notes outstanding
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7

rated “Single-B.” The “corporate” credit rating assigned the another 110 years. And when you think about what you need to
company by Standard & Poor’s was “BB-.” As part of the recap- do to ensure that that happens, you come to appreciate that finan-
italization, the company borrowed about $100 million to buy cial conservatism allows you to live through all kinds of economic
back 18% of its outstanding common stock in a Dutch auction. cycles and competitive changes that could affect your company.
Within about 8 weeks of the announcement of the Dutch auction, Much of our sense of the company comes from the knowledge
the stock price had run from $43.50 right through the tender of its accomplishments, from our sense of being part of a team
range of $48–$56, and settled at around $70. And, now that that has done big things. We started Allstate from scratch in 1931,
about 12 months have passed, it’s currently trading at around $78. and we started the Discover Card from scratch in the late 1980s.
Now, what about this issue of financial flexibility? First of all, The treasurer of a company must understand the capital resources
SPX basically funded the entire transaction by completely elim- (and their costs) needed to carry out the strategic plan and to sup-
inating the modest dividend that the company had been paying port the business model. And that requires a degree of financing
on its common stock. In fact, the cash flow savings from elimi- flexibility that is not available to firms with the highly leveraged
nating the dividend were actually larger than the after-tax cost of balance sheets that Dennis has described.
servicing the additional debt. MYERS: I’m with Alice on this one. I don’t deny that there are
And, to take this issue of financial flexibility one step further, let situations in which the medicine of debt and restructuring is very
me point out that SPX is now attempting to take over a company apt and is very successful. But there are other situations where you
almost four times its size. Clearly, they’re not going to be able to don’t want the company to go on a “diet,” or not at least on a
finance that transaction with bank lines. They’re going to have to “crash diet.” And, in such cases, you certainly don’t want to let
finance it in the marketplace. But, given their recent track record, your thinking be driven by a second-order concern like taxes.
it seems unlikely they will have any trouble financing the deal. The first consideration should always be the investment oppor-
And that brings me back to the point that I was trying to make tunities, the business opportunities. The second consideration is
earlier—namely, that most managements don’t like to be sub- the financial structure of the business. The third concern—and
jected to the scrutiny of the marketplace. What the story of SPX it’s a distant third in my view—is the percentage mix of debt and
makes clear is that, provided you are willing to submit to the mar- equity on the balance sheet.
ket test, you may not need much financial flexibility. As we were When you do get to the issue of the percentages on the balance
all taught in business school, you can raise capital on a project- sheet, taxes are only one of four or five things we know are poten-
by-project basis provided the market thinks the investments are tially important. For this reason, I think it’s sort of back-asswards
promising. And the run-up in SPX’s stock price—from about $75 to start off with taxes and say that’s the primary concern, even
to $78—since the announcement of the transaction suggests that though we can agree that it is one important element.
the market has already accepted the deal. My second observation, Alice, if I were to put your speech in
But I can assure you that before SPX decided to undertake its academic lingo…
leveraged recap 1 year ago, management was very concerned about PETERSON: By all means.
financial risk and flexibility. And one of our biggest challenges in MYERS: …would go something like this: Economic theory is
this case was convincing them of the limited significance, if not making a big mistake in treating all the employees of the corpo-
complete irrelevance, of bond ratings in the process of creating ration as temporary workers. As I suggested earlier, to succeed a
value. corporation requires a coinvestment of financial capital from the
outside and human capital that is built up inside the business.
You need the human capital to make the business work in the
The Case for Financial Flexibility long run. And it’s not necessarily inefficient for people who have
most of their human capital tied up in the business to be conserva-
HANS STOLL: Well, Dennis, I’m not as convinced as you seem tive in protecting it. Where human capital is fungible and people
to be that companies can always go to the capital markets when move all around—say, in the case of swaps traders—companies
they have profitable opportunities. There are real problems arising can afford to be much more aggressive in taking financial risks.
from the so-called information asymmetry between management And the employees won’t care. But, in cases where there’s lots
and investors—a possibility that could make financial flexibility of human capital really locked up in an organization—cases, for
quite valuable in some circumstances. If your company is fully example, where somebody spends his or her whole career at a
levered, and your earnings have turned down for reasons beyond company—it’s understandable that they would want to protect
your control, you may be forced to pass up some profitable invest- that investment.
ments. Convincing the capital markets to provide funds in such
cases could be very costly.
Alice, is that one major reason why companies want financial EVA as a Substitute for Leverage
flexibility?
PETERSON: Well, that’s part of the explanation. But it goes STERN: Well, Stew, I’d like to make a suggestion to you. I think
further than the here and now. Every company is different, that what you’re saying is almost certainly true— especially given
and some of the middle market companies that Dennis deals the existing distribution between fixed and variable pay that exists
with might very appropriately have the perspective that he has in most public companies. If you take a look at people in middle
described. At Sears, we are very conscious of having been in busi- management and below, their variable- pay component is typi-
ness for 110 years, and we’re planning to be around for at least cally a very modest amount. But, when you put them on an EVA
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8 JOURNAL OF APPLIED CORPORATE FINANCE

incentive system— one where there are no caps on their awards favorite subject of his. Both Mike and my partner, Bennett Stew-
and there is a bonus bank system to ensure that their payments are art, are fond of talking about the effectiveness of high debt ratios
based on sustained improvements in performance—their behavior in discouraging managers from doing foolish things with share-
changes … almost overnight. holder resources. The basic idea is that debt exerts a discipline on
In some cases, they become in favor of a more aggressive capi- management that can be valuable in companies with too much
tal structure because that reduces their cost of capital and increases cash and few profitable investment opportunities.
their EVA. In addition to the case of SPX, which Dennis just men- As we have argued in a series of articles, our EVA-based incen-
tioned, other companies such as Equifax and Briggs and Stratton tive compensation is also designed to deal with this corporate
have done leveraged recapitalizations after first going on an EVA “free cash flow” problem. And, because our system can be taken
program. I would also suggest that, after going on EVA, companies well down into the corporate structure—that is, into the indi-
in so-called mature industries often begin acting as if their indus- vidual business units and below—I would argue that EVA might
tries were not as mature as management seemed to think they even be more cost-effective than debt financing in discouraging the
were. That is, companies whose rates of return were well below corporate waste of capital.
their cost of capital for a long time suddenly became superior So, to the extent that we have succeeded in designing and
performers. implementing a measurement and reward system that motivates
MYERS: That’s great, Joel. But, once again, you are making my managers to make the most efficient use of capital—and I recog-
point. What you’re saying is that by going in and changing finan- nize that this is the critical assumption—then why would it be
cial structure—which includes the system of incentives inside the necessary to resort to debt to accomplish the same goal? That is,
business—you can get the people who contribute human capital assuming debt creates a valuable discipline for management in cer-
to the organization to take additional risks because they’re given a tain cases, why wouldn’t the “localized” incentives provided by an
reward. EVA plan be expected to do an even better job? After all, as you
STERN: Yes, that’s right. have pointed out, Stew, too much debt could kill all corporate
MYERS: My point, though, is that there’s an investment in investment, good as well as bad. An EVA system encourages man-
human capital that, from an efficiency point of view, you will agers to fight for just those projects that promise to earn their cost
want to protect much of the time. Now, you don’t want to protect of capital.
it when it’s ceased to be productive—and that happens in many SOTER: Let me take a crack at that one, Joel. At the risk
large bureaucratic organizations. But, by and large, it is econom- of being asked to leave the partnership, let me tell you the fol-
ically efficient that when you ask people to make an investment lowing story. In 1992 we were helping Equifax, the nation’s
of human capital in your firm, you do not then do things—like largest provider of consumer financial information, to adopt EVA
raising the leverage ratio too high—that would needlessly put that incentives. At the same time, we were asked to advise the com-
investment at risk. pany on what turned out to be a rather aggressive leveraged
STERN: Forgive me, Stew, but I still have a problem with this. recapitalization.
Let’s assume we do all of the things in the sequence that you pro- As the chief financial officer told me, “Look, anything can hap-
pose, and that the issues of capital structure and taxes are the last pen. There is no contractual obligation on the part of the board
things on the list. And let’s assume that we get the 20 incentives to continue to have EVA incentives here in this company. But
right, and that we carry them down deep into the company. the contractual obligations associated with debt are real, and the
Now, having done those things, we once again come to this consequences of failing to meet them are far more weighty to the
issue about whether debt is not significantly less expensive than company and to the stockholders than canceling an EVA plan.”
equity. And, as you suggest, Stew, in many cases we may come to As this statement suggests, there is an important difference
the conclusion that the company cannot support much leverage, between the contractual nature of the company having to service
whether because the debt would endanger the strategic plan or debt versus the obligations under EVA incentives. And the com-
put the human capital investment at undue risk. My argument is pany’s willingness to bind itself in this way sends a strong signal
this: Even under these circumstances, I still suspect that there are to investors. It demonstrates to the marketplace that agency prob-
a good many companies where lots of talented, energetic people lems are being addressed inside the company, and it can be very
would be more than willing to put their human capital at risk for effective in eliminating at least the perception, if not the reality, of
the right payoffs. corporate reinvestment risk.
After all, this is essentially what KKR does when they go into a STERN: I have two responses, Dennis. First of all, I accept your
company. They say to operating management, “If you’re willing to resignation. The second is, if you take a look at recent announce-
take some additional risk, and subject yourself to very challenging ments of public companies of just their intent to go on an EVA
performance standards, we can make it very rewarding for you.” plan, the market response has been noticeably positive. In some
As we now know from the research, the same operating managers cases, we have seen share values change by as much as 25% within
have shown themselves capable of doubling their companies’ oper- a week’s time.
ating cash flow in a period of 3 years or less when you change the Last week I took part in a conference at Stanford law school,
incentive system. And this is basically what we’re trying to accom- and on the panel sitting next to me was George Roberts of KKR.
plish with EVA, but without the risk to human capital imposed I went through a rather lengthy discussion of the content, the
by high leverage. design structure, and the outcomes of EVA plans. And when
In a conference we held a number of weeks ago for our EVA George was asked to comment on it, he said: “That sounds like
clients, Michael Jensen and I got into an intellectual fist-fight on a a better idea than the one we’ve got. Why would you want to use
 17456622, 0, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/jacf.12539 by Thomas Biuso - Thomas Biuso : [email protected] , Wiley Online Library on [03/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
9

leverage unless you really have to? The discipline of debt is a very order. Therefore, our test has power. At the same time, we show
blunt instrument to accomplish what you are saying you can do that if the companies were actually following the pecking order, it
unit by unit throughout the organization.” would look like they were seeking out some debt-equity target.
You see, we can even design the incentive system to encour- So if you want to start with one description of how large, estab-
age teamwork among the different business units while preserving lished companies behave, why not start with the one that has a
rewards for individual performance. We could say to an operating very high R2 and for which we can show statistical power?
head, “Seventy percent of the annual reward will be based on the SOTER: Is the pecking order theory consistent with value-
performance of your unit, and 30% will be based on the perfor- maximizing behavior?
mance of all the other units.” This way, if good ideas are developed MYERS: Yes.
in one part of the organization that could help other parts, they SOTER: But as I understand it, one of the premises of the peck-
will quickly move from unit to unit. ing order theory is that dividends are sticky. And, for that reason
So, what I am really suggesting, then, is that EVA can provide a alone, I have trouble seeing how that policy can be consistent with
solution to this human capital problem that Stew has mentioned value-maximizing behavior.
as a reason for avoiding high leverage. We can take managers MYERS: Are we talking about dividend policy now?
and employees with large investments in human capital and make SOTER: I don’t see how you can separate the two. In my experi-
them rationally less risk averse by making them partners in creat- ence, they are interdependent decisions— or at least we encourage
ing sustainable improvements in value. This way, managers and management to view them that way.
the existing shareholders can end up the big winner, and not MYERS: Why do dividends matter aside from taxes?
somebody like KKR that comes in from the outside. SOTER: If they don’t matter aside from taxes, then my first
thought would be: Why don’t we cut back on dividends before we
even seek or consider seeking external financing? This is what we
The Pecking Order and Dividend Policy did in the case of SPX that I just mentioned.
MYERS: I don’t have a complete answer to that, and I think
HANS STOLL: Up to this point, we have discussed capital struc- that’s one of the biggest unsolved problems in academic finance.
ture policy as if it were designed primarily to reduce taxes and We don’t have a good theory of dividend policy. We have no the-
agency costs while also holding down expected costs of financial ory of dividend policy that goes back to any kind of fundamentals.
distress. But we have said very little about information costs. As And so I admit the pecking order takes the stickiness of dividends
Joel mentioned earlier, in 1984 Stew Myers presented a theory as a fact. It doesn’t try to explain it. I don’t think anybody can
of capital structure called the “pecking order” theory, which relies explain it.
heavily on information costs to explain corporate behavior. And SOTER: Let me give you one other example of how a dividend
I was wondering, Stew, if you could share with us your current cut can be used to facilitate an increase in leverage. A year ago, we
thinking on the role of information costs in corporate financing advised IPALCO Enterprises, the parent company of Indianapolis
decisions? Power and Light, in becoming the first utility ever to undertake a
MYERS: The pecking order starts out with the prediction that leveraged recapitalization. IPALCO started off with a “AA” bond
companies will issue debt instead of equity most of the time rating and a 42% debt-to-capital ratio. The company borrowed
because of information problems. If the information problems are more than $400 million and used the proceeds to buy back its
important, then you’re going to see the debt ratio vary across time common stock. In the process, the company’s debt-to-capital ratio
according to companies’ needs for funds. Companies with a bal- went from 42% to 69%. But the increase in debt was financed in
ance of payments deficit with respect to the outside world will be effect with an almost 33% cut in the dividend, from $1.48 per
increasing their debt ratios while those that have a surplus will be share to $1 per share. In fact, the annual savings from the dividend
paying down debt and reducing leverage. cut of about $41 million exceeded the increase in the after-tax
I like to put it just that baldly, not because I think it’s the com- interest expense by about $25 million. That is, IPALCO’s after-tax
plete answer, but because I want to get away from academics’ cash flows actually increased by $25 million even as the leverage
“nesting instinct.” The tendency of academics is to begin by ratio increased from 42% to 69%. And both of the rating agencies
observing that there are four or five things that could affect capital the day after the announcement reaffirmed the company’s “AA-”/
structure. Therefore, they say, let’s find ten proxies for these four “AA” bond ratings, which further suggests that leverage ratios, at
or five factors and run a regression. But, because each proxy has least in traditional book accounting terms, just don’t matter.
some connection to two or three of the underlying variables, you IPALCO’s operating cash flows have also increased since that
end up not being able to interpret the regression. Or you interpret time, and the stock market seems to have liked what’s happened.
it the way you like to interpret it, but not against an alternative In 1997, the company’s stock provided a total shareholder return
theory. of 58.5%, putting it among the top three electric utilities last year.
Lakshmi Shyam-Sunder and I have a paper coming out shortly
in the Journal of Financial Economics where we show that, for a
sample of relatively mature and established public companies, the What’s in the Leverage Signal: Insider Confidence
pecking order works great. We get R2 s up around 0.80 in a time or Behavior Change?
series. We also show that if it were true that companies were really
trying to move to a target capital structure based on a tradeoff of McCONNELL: I want to just stop and take stock for a moment,
taxes and cost of financial distress, you could reject the pecking and to make sure that, if there is a debate here, we all understand
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10 JOURNAL OF APPLIED CORPORATE FINANCE

what the debate is about. If I understand Stew’s observation, it But let me also make the following observation: If signaling is
is that capital structure may matter but it doesn’t seem to mat- the explanation, there are almost certain to be a number of other,
ter very much, at least from a manager’s perspective. Managers real effects behind the signal. For example, both SPX and Briggs
don’t spend a lot of time worrying about it. Is that a reasonable and Stratton had been EVA companies for some time before mak-
characterization? ing announcing their recaps. And, since investors had already
MYERS: That’s right, at least for large, established companies achieved a degree of confidence in these two management teams,
within a wide middle range of debt ratios. this signal of future improvements coming on top of recent past
McCONNELL: What Dennis is arguing, if I understand it, is achievements could be especially convincing.
that capital structure definitely matters, and he has given us several And, to show you what I mean by real improvements, let me
case illustrations. One problem with the use of cases, of course, is now go back to the case of IPALCO. About 7 months after
that you hear only about the ones that work—which is not to say, IPALCO completed its recap, I had lunch with the chief finan-
Dennis, that all of yours didn’t work; I’m sure they did. cial officer, John Brehm. In describing some of the events that had
Ron Masulis has done a classic study of the stock market’s happened internally since the recap, he said, “It’s been extraordi-
response to exchange offers. And that study shows very clearly— nary. Through 8 months of 1997, we have been right on budget
and for a large sample of companies, not just one or two with respect to reported earnings per share, but we are $40 mil-
interesting cases—that when companies announce that they are lion ahead on cash flow since the recap.” He said that the recap
issuing new debt to retire stock, their stock price increases. And had really focused people on generating cash flow. They are run-
the study also shows the converse: when stock is issued to retire ning the business differently, even though it has not yet been
debt, stock prices decline. Now, the question is: Why does that reflected in reported earnings. (And I must confess that even I
happen? How should we interpret the market’s reaction? was a little surprised; I didn’t think anything would have focused
Some people have argued that there is a signaling effect at the attention of utility managers.)
work here. That is, most companies tend to do leverage-increasing So, I think there are several things at work here. Yes, there is
recaps only when they expect earnings—or, more precisely, oper- some signaling. But you have to ask: What’s being signaled—
ating cash flows—to increase in the future. To the extent investors or why is management more confident about future operating
understand this, they raise stock prices in anticipation of higher cash flow? Well, a big part of the answer is that managers
future operating earnings. This may in fact explain the market’s now have stronger incentives to produce operating cash flow,
reaction to the leveraged recaps that Dennis described. and debt helps increase cash flow by sheltering corporate taxes.
And the opposite story is likely to explain the market’s negative And, on top of all this, the substitution of stock buybacks
response to leverage-reducing recaps. If you look closely at Ron’s for cash dividends has the effect of increasing after-tax rates of
data, what you find is that 90% of the companies that do leverage- return to stockholders by distributing cash in a more tax-efficient
reducing recaps are actually in some degree of financial distress. So, way.
what we may be picking up from the announcement of an equity MYERS: There is a signal in the utility business, by the way. If
increasing swap is a signal that we’re in real trouble, guys. I were a utility investor, my worry would be that the utility would
My question, Dennis, is this: Are these leveraged recaps valuable take all this cash flow that’s coming into its pockets and burn it
in and of themselves—say, for their tax savings and for some ben- somewhere. And the leveraged recap acts as a signal, in your case,
eficial incentive effect? Or are they simply functioning as signals that they are not going to do that.
of management’s confidence in future earnings? PETERSON: I agree that, just as there’s nothing like the
SOTER: You are certainly right to warn that I could be deal- prospect of the guillotine to concentrate the mind, leverage can
ing with a biased sample, and I realize that anecdotal evidence have wonderful effects in certain circumstances. But I also believe
does not constitute proof. But let me respond to your question by that we can create incentives inside companies that produce the
telling you a little more about IPALCO. LBO mindset and the behavior that goes with it without piling
McCONNELL: Go ahead. I’ve been at Purdue for 20 years on leverage. In other words, I think we have to think about how
now, and it’s close to my heart. we get the behavior we want, and I think there are a lot of ways to
SOTER: Since it’s a utility, Indianapolis Power and Light prob- do it.
ably goes well beyond what most unregulated companies provide The foolproof way, as Joel has pointed out, is to lever up and
in terms of disclosure. In fact, for all practical purposes, they share require managers to own lots of stock. There is nothing like having
with the investment community a 5-year plan. Utility analysts that debt service staring them in the face every day. So I agree with
are famous for forecasting earnings per share within one penny that point.
each quarter because management is spoon-feeding them all the
information. So, I don’t think there was much room for signaling
associated with their new financial strategy. Dividend Policy and Investor Clienteles
On the other hand, I think you can argue that there was a lot
signaling in the cases of SPX and Briggs and Stratton. In the case STERN: Alice, what is the feeling about dividend policy at Sears?
of Briggs and Stratton, the stock price went from $42.75 to $48 Could Sears cut its dividend by a third, or even to zero, and
during the week of the announcement. And, as I mentioned ear- borrow a lot more and thereby increase its value?
lier, SPX’s stock price started at $43.50, ran right through the price PETERSON: We haven’t increased our dividend for more than
range for the Dutch auction (of $48 to $56) and settled at close 10 years. In fact, we have effectively cut it by virtue of the spinoffs
to $70. that we’ve done. When we spun off Dean Witter Discover, we
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11

reduced our total dividend payments; and when we spun off back their shares in the open market. So, it’s a nice, almost
Allstate, we reduced it again. laboratory-controlled, example of where we cut cash dividends
But that, of course, is not the same thing as cutting it to zero. and substituted a policy of open market repurchases.
And that is an action with very serious consequences. Sears is one PETERSON: Our payout ratio is in the 20%–25% range,
of the most actively traded stocks in the United States. And, when which is a little bit lower than that of our peer group. Another
you have a stock that is as actively traded and as broadly held consideration—although not necessarily the most important
as ours, if you decide to eliminate your dividend you must be factor— is that our shareholders are often our customers. These
prepared to deal with a very dramatic shift in your stockholder so-called “retail” investors tend to want dividends.
base. I’m not saying that it couldn’t be done. But it would take MYERS: I tend to agree with Alice’s position. And I would
a great deal of preparation, and it would have to be communi- think even the most zealous market-efficiency types should not
cated very, very carefully to the investment community. And it’s have trouble with it. The “perfect markets” view of finance would
not something that we plan to do any time in the near future. say that, aside from temporary signaling effects, it doesn’t really
In other words, positioning your company for the stock market matter very much whether you pay dividends or buy back shares.
is an extremely critical part of the whole circle of activities and And so, if somebody says, “Why pay dividends?,” the standard
decisions that turn on how much flexibility you want as a com- answer is, “Why not? There are clienteles out there that want
pany. As in the case of leverage, you need to set your dividend dividends, and consumers are sovereign.”
policy in such a way that it supports your business model, your So, if somebody was going to pay dividends in this world, why
ability to carry out your strategic plan. wouldn’t Sears be likely to satisfy that demand? I don’t see any-
SOTER: I’m not as convinced that dividend policy needs to thing wrong with that argument. The only possible objection I
be established with a concern for the needs of the current stock- can see would be taxes again. But I don’t think anybody has proved
holder base. In 1994, we advised the board of FPL Group, the that high dividend yields lead to a higher cost of capital because
parent company of Florida Power & Light, in its decision to com- of taxes.
mit what in the minds of many was financial hara-kiri. FPL was STERN: Let me ask you a question, then, Stew. If what you’re
the first profitable utility, to my knowledge, to voluntarily cut its saying is true, then why don’t some companies have two classes
dividend. The dividend was cut nearly one-third, from a quar- of shares, one that would pay a high dividend and one would pay
terly payout of 62 cents to 42 cents per share; and in its place a low dividend? This way, the shareholders could buy whichever
the board authorized management to repurchase up to 10 million mix of those shares they wanted so as to write their own dividend
shares of common stock in the open market. If ever there was a policy. If dividends were so terribly important that there was an
test of the so-called “clientele effect,” this was it. I recall a director optimal dividend policy for investors, then you would expect that
at the board meeting that preceded the final decision to make the there would be more than one class of share available to investors
cut asking the question, “What’s the likely impact on our stock so that they could manufacture their own dividend policy.
price?” I responded— conservatively I hoped—that the market MYERS: You didn’t hear what I said. I said that dividend policy
price would drop up to 25%, and would not fully recover for as is not important, aside from the short-run signals that are given.
long as 2 or 3 months. It doesn’t matter whether cash is paid out via dividends or share
Sure enough, the stock dropped 15% on the day of the repurchases. (The total amount of cash paid out does matter, of
announcement. But within 3 weeks the price had fully recovered. course.)
What’s more, the dividend cut itself caused 15 brokerage houses But there are people out there who, for whatever reasons, want
to put a “buy” on the stock. And the stock attracted lots of new some dividends. Somebody has got to give it to them. It doesn’t
institutional investors, even as it lost many others. During the cost Sears very much to give it to them. They are natural provider
12 months following the dividend action, FPL’s stockholders real- of that service. Why not? If somebody else wants to repurchase
ized a total return of 23.8%, more than double the S&P Electric shares, good for them. I just don’t care.
Index. So, there was a significant change in the investor clientele, SOTER: What if I were to suggest that here, too, we can have
in the composition of the stockholder base. our cake and eat it, too. Before joining Stern Stewart, as Joel men-
And this also tends to happens with leveraged recapitalizations. tioned, I worked for Citizens Utilities. The founder of Citizens
When we advised Equifax in 1992 in a very aggressive lever- Utilities was Richard Rosenthal, and some of you may be aware
aged recapitalization, there was also a significant change in the of this case because, back in the ’70s, John Long at the University
investor make-up of the company. These two experiences lead of Rochester wrote a paper about the company’s highly unusual
me to believe that one stockholder clientele is indeed as good as dividend policy.
another. For many years, Citizens had two classes of common stock, one
MYERS: Your case is interesting, Dennis, but I’m not sure it that paid a cash dividend, and one that paid a common stock
has much to say 24 to a company like Sears. Suppose Sears cuts dividend of an equivalent amount. Richard had gotten this grand-
its dividend to zero, but without taking a leveraged recap. All it’s fathered originally in 1956 and, through successive tax acts, that
going to do is to tell shareholders, “Don’t worry, we’ll use the waiver had been extended. But, in 1990 as the Bush tax act was
money we would have used for the dividend to buy back shares coming up, we saw that we were going to lose the exemption. So
over time?” we had two options: We could eliminate the stock dividend and
SOTER: That’s exactly what Florida Power & Light did. They change it to a cash dividend, or we could convert the cash div-
did not do a leveraged recapitalization, but they did announce idend class to a stock dividend, and so eliminate cash dividends
that they would be using part of the cash savings to buy altogether.
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12 JOURNAL OF APPLIED CORPORATE FINANCE

We chose the second course. We obviously weren’t going to start So, we achieved a significant reduction in taxes for the
paying cash dividends on the stock dividend class. To soften the stockholders who elected to continue to receive income.
blow for the stockholders who wanted cash, we created the “stock MYERS: It’s good financial engineering. But, again, I think it’s
dividend sale plan.” We said, in effect, “We’re going to give all a second order effect, just as Miller & Modigliani taught us.
stockholders stock dividends, but those stockholders who want to STERN: Well, I think that’s a good note on which to bring
receive cash income can make an election that effectively enables this to a close, and I want to thank you all very much for your
them to convert those dividends into cash.” You see, the company participation. We expected this to be an exciting program, and I
couldn’t just buy back their shares because the IRS would have think we got our fair rate of return.
viewed that as a sham, and the cash would have been taxed as ordi-
nary income. So, instead we simply made arrangements with an
investment bank and our transfer agent to aggregate those shares
that stockholders elected to cash in to maintain their income How to cite this article: Myers, Stewart, John
stream—and those shares were sold, with no commission costs McConnell, Alice Peterson, Dennis Soter, and Joel Stern.
(except the bid-ask spreads), to provide stockholders with the same 2023. “Vanderbilt University Roundtable on the Capital
cash income. Our shareholders were taxed on that income at a Structure Puzzle.” Journal of Applied Corporate Finance
capital gains tax rate, and only on the difference between the sales 1–12. https://doi.org/10.1111/jacf.12539
price and their basis.