Posts Tagged ‘debt’

Ralph knew that his managers needed clear targets and performance measures to track their progress. While the stock price performance was the ultimate measure, he needed something more concrete and directly manageable by his managers,particularly his business unit managers. He also knew that traditional accounting measures like net income ignored the opportunity cost of the capital tied up to generate earnings. Return on invested capital (ROIC), on the other hand, ignored value-creating growth. So he turned to a measure that incorporated both growth and return on invested capital, called economic profit (EP). EP is the spread between the return on capital and its opportunity cost times the quantity of invested capital:Ralph chose this measure because he knew that the discounted value of future economic profit (plus the current amount of invested capital) would equal the discounted cash flow (DCF) value (see Chapters 3 and 4 for a more complete  description). In other words, EG could maximize DCF value by maximizing economic profit. Ralph asked that all strategic plans and budgets include economic profit targets for each of the business units.
Knowing that lower level managers also needed targets and performance measures that they could directly influence, he asked his business unit managers to translate economic profit targets into specific operational performance measures for their operating managers. For example, the manufacturing manager might be measured by cost per unit, quality, and meeting delivery schedules. Sales might be measured by sales growth, price discounts of list prices, and selling costs as a percent of revenues.
This integrated system of target setting and performance measurement required a new mindset for Ralph’s accounting group, which was accustomed to dealing with accounting results. The accounting group resisted but Ralph convinced it of the benefits of integrating financial results with operating measures and with moving toward more economically relevant financial measures.

Ralph also urged his CFO to look hard at EG’s financial structure and come up with an aggressive plan to take advantage of the tax advantages of debt financing. EG had had a policy of maintaining an AA rating from Standard & Poor’s and liked to think of itself as a strong investment-grade company. Ralph knew that many companies had taken on much higher debt levels and performed well. The performance of many had been spectacular, as managers thought harder about how to generate additional cash flow and looked more critically at investment requirements and so-called fixed expenses.
EG had sizable and stable free cash flows that could support much higher debt. The Consumerco business, which generated the bulk of the cash, was recession resistant. Ralph also knew that he did not need much reserve financial capacity given the relative maturity of EG’s core business and its limited need for capital. He also believed that EG would be able to get access to funding for a major expansion or acquisition, if it made economic sense. Otherwise, it was probably a poor investment in the first place.
By the CFO’s calculations, EG could indeed carry a lot more debt than it did, depending on the interest coverage Ralph wished to maintain. As the financial performance of the EG businesses improved, EG would be able to carry an even higher debt load comfortably. Ralph figured that at a minimum, EG could raise $500 million in new debt in the next six months and use the proceeds to repurchase shares or pay a special dividend. This debt would provide a more tax-efficient capital structure for EG, which would be worth about $200 million in present value to EG’s shareholders, assuming a combined federal and state marginal tax rate of about 40 percent.