MANAGING FOR SHAREHOLDER VALUE AT BANK OF AMERICA

In this brief and informal speech to senior executives representing a group of the bank's largest corporate clients, Bank of America's CEO and Chairman describes the bank's mission and the "necessary conditions" for achieving it. Besides mentioning a number of recent initiatives aimed at improving quality of service—including an extensive employee stock option plan—he also comments on the role of the bank's stock repurchase program in its overall attempt to maximize "economic profit" and shareholder value.     

DESIGNING CAPITAL STRUCTURE TO CREATE SHAREHOLDER VALUE

In the past decade, many U.S. companies have launched aggressive share repurchase programs with the expectation that value can be created by returning excess capital to shareholders and moving the firm closer to its optimal capital structure. But how much capital does a company really need to support its business activities? This article presents an economic framework or “model” that can be used to simulate the effect of various capital structure choices on shareholder value. The fundamental insight underlying the model is that judicious use of debt can add value by reducing corporate taxes and strengthening management incentives to increase efficiency, but that too much debt can result in a loss of business and perhaps a costly reorganization. Indeed, one of the key findings of the authors' recent research is that companies with highly leveraged balance sheets suffer disproportionately large losses in market share and value during industry downturns. As illustrated in a case study of a hypothetical general merchandiser, the model makes it possible to identify an optimal debt-equity ratio (and percentage of fixed- versus floating-rate debt)—one that balances the value of the tax shield from debt against the increased risk of financial distress.     

STERN STEWART ROUNDTABLE ON CAPITAL STRUCTURE AND STOCK REPURCHASE

This roundtable brings together a small group of finance theorists and practitioners to discuss two important—and in most companies closely related—financial policy decisions: (1) the optimal mix of debt and equity and (2) the amount (and form) of cash distributions to shareholders. The result is an interesting set of comments and exchanges that show current theory and corporate practice to be consistent in some respects, but at odds in others. In the first part of this two‐part discussion, the University of Rochester's Clifford Smith presents a broad theoretical framework in which companies set leverage targets by weighing tax and other benefits of debt against potential costs of financial distress, particularly in the form of underinvestment. According to this theory, mature companies with stable cash flows and limited investment opportunities should make extensive use of debt, while growth companies should be funded primarily (if not entirely) with equity. But, as becomes clear in the case study of PepsiCo that follows the opening discussion, putting theory into practice is far from straightforward. Consistent with the theory, Pepsi does have a target leverage ratio, and management has attempted to adhere to that target through a policy of regular stock repurchase. But if the company's decision‐making process appears consistent with the framework mentioned above, it also relies on conventional ratingagency criteria to an extent that surprises some of the panelists. Moreover, Pepsi's policy of maintaining a single‐A credit rating sets off an interesting debate about the value of preserving access to capital markets “under all conditions.” In the second part of the discussion, Rice University's David Ikenberry begins by offering four main corporate motives for stock repurchases: (1) to increase (or at least maintain) the target corporate leverage ratio; (2) to distribute excess capital and so prevent managers from destroying value by reinvesting in low‐return projects; (3) to substitute for dividends, thereby providing a more flexible and tax efficient means of distributing excess capital; and (4) to “signal” and, in some cases, profit from undervaluation of the firm's shares. As in the first part of the discussion, the case of Pepsi largely supports the theory. Assistant Treasurer Rick Thevenet notes that, in 2000, the company generated free cash flow of $3 billion, of which $800 million was paid out in dividends and another $1.4 billion in stock buybacks. And each of the four motives cited above appears to have been at work in the design or execution of Pepsi's buyback policy. There is also some discussion of a fifth motive for buybacks—the desire to boost earnings per share. Although this motive is perhaps the most widely cited by corporate managers, the idea that EPS considerations should be driving corporate buyback programs is shown to rest on flawed reasoning. Moreover, questions are raised about what appears to be an EPS‐driven phenomenon: the corporate practice of attempting to buy back as many shares at the lowest price possible—and the lack of disclosure that often surrounds such a practice. In closing, Dennis Soter offers the novel suggestion that corporate buyback policy should not be designed to transfer wealth from selling to remaining shareholders, but rather to “share the gains from value‐creating transactions.” Through more and better disclosure about their repurchase activities (and Pepsi's policy appears to be a model worth emulating), companies are likely to establish greater credibility with investors, thereby increasing the liquidity and long run value of their shares.     

BANK OF AMERICA ROUNDTABLE ON THE SOFT REVOLUTION: ACHIEVING GROWTH BY MANAGING INTANGIBLES

Economist Paul Romer has developed a new theory of economic growth—one that moves the factors of scientific discovery, technological change, and innovation back to the center of economic analysis. For corporate management, Romer's theory amounts to a new model of value creation. Where the old idea was to accumulate and make the most efficient use of hard assets—machines, factories, and natural resources—the new model points to soft, or intangible, assets as the key to growth and profitability.
More precisely, the focus of Romer's model is something he calls nonrivalrous information, or software for short. Software, in brief, is valuable knowledge or formulas or instructions that can readily transmitted to others and therefore replicated throughout an organization. It is nonrivalrous because it can be used outside the firm—and indeed throughout the nation and the world—without diminishing its value to the firm.
In this roundtable, Romer discusses his concept of software and its potential corporate applications with the CEOs of three successful companies. Besides illustrating the variety of forms software can take, the discussion also considers the challenge of managing the development of corporate software. One of Romer's messages to corporate management is that all workers are potentially creators of software—and this theme is echoed in the testimony of each of the three CEOs. In each case, moreover, a certain amount of decentralization of decision-making is said to be necessary to achieve continuous improvement. And a number of comments by the panelists suggest that decentralization reinforced by stock ownership or well-designed profit-sharing schemes has considerable potential to add value.     

BANK OF AMERICA ROUNDTABLE ON BUSINESS UNIT EFFICIENCY VERSUS LEVERAGING CORPORATE COMPETENCIES

Corporate strategist C.K. Prahalad begins by observing that the efficiency achieved by U.S. companies in recent years, brought about in part by EVA and EVA-like systems, is a necessary condition for wealth creation in the new competitive environment. For this reason, the EVA movement is now spreading to Europe and Asia. But, as Prahalad goes to argue, efficiency is not a sufficient condition for wealth creation; equally important is the quest for profitable growth opportunities. And this raises a potential objection to EVA and indeed all divisional performance measurement systems: They could end up reducing long-term growth and value by discouraging managers from capturing synergies among business units and leveraging core competencies to the fullest extent possible.
Following Prahalad's discussion of the problem of capturing synergies and leveraging cross-unit capabilities in large, multi-business companies, moderator David Glassman explores potential solutions with top executives from a number of U.S. and Canadian companies. Among the most promising suggestions are significant managerial stock ownership (as exemplified by a plan used at Baxter International), a cross-unit auction system for evaluating large infrastructure investments pioneered by Stern Stewart, and, probably indispensable, strong encouragement of business unit collaboration by an active and accessible CEO.     

CAPITAL STRUCTURE,SHAREHOLDER RIGHTS,AND CORPORATE GOVERNANCE

We show how capital structure is influenced by the strength of shareholder rights. Our empirical evidence shows an inverse relation between leverage and shareholder rights, suggesting that firms adopt higher debt ratios where shareholder rights are more restricted. This is consistent with agency theory, which predicts that leverage helps alleviate agency problems. This negative relation, however, is not found in regulated firms (i.e., utilities). We contend that this is because regulation already helps alleviate agency conflicts and, hence, mitigates the role of leverage in controlling agency costs.     

THE GROWTH OPTIMAL CAPITAL STRUCTURE: MANAGER VERSUS SHAREHOLDER OBJECTIVES

Utilizing a geometric mean wealth maximization approach, this paper shows potential differences between the capital structure preferred by stockholders and the one preferred by managers. In general, managers may prefer more conservative, equity-oriented financing, while stockholders desire greater financial leverage. The problem arises because of differences in the degree of portfolio diversification achieved by managers and stockholders. Stockholders tend to have reasonably well-diversified portfolios, causing them to be concerned with systematic risk. Managers' portfolios are apt to be more concentrated and directly tied to the financial success of an employer, causing managers to be concerned with total risk. Thus, for a given capital structure, each party views the firm as having a different level of risk. Several executive compensation plans are considered that might more closely align the interests of managers and stockholders.     

THE EFFECTS OF BANK CONSOLIDATION ON RISK CAPITAL ALLOCATION AND MARKET LIQUIDITY

We investigate the effects of financial market consolidation on the allocation of risk capital in a financial institution and the implications for market liquidity in dealership markets. An increase in financial market consolidation can increase liquidity in foreign exchange and government securities markets. We assume that financial institutions use risk‐management tools in the allocation of risk capital and that capital is determined at the firm level and allocated among separate business lines or divisions. The ability of market makers to supply liquidity is influenced by their risk‐bearing capacity, which is directly related to the amount of risk capital allocated to this activity.     

AN IMPLICIT CLIENTELE TEST OF THE RELATIONSHIP BETWEEN TAXATION AND CAPITAL STRUCTURE

This paper presents a test for the existence of high and low tax bracket debt clienteles. The test generates some evidence consistent with the implication of debt clientele theory that over time, firms' debt ratios should vary with the relative tax incentives for investors to hold debt. The results, however, do not support the existence of extreme financial leverage clienteles. Rather they are consistent with an incomplete equity market: low tax bracket investors hold the stock of highly levered firms and high tax bracket investors hold the stock of the low leverage firms.     

BANK REGULATIONS,CAPITAL STRUCTURE,AND RISK

The joint influence of the Federal Reserve's (Fed) discount window credit and reserve requirements and FDIC's deposit insurance on a bank's optimal capital structure and asset risk choices is analyzed. The specific seniority of such regulatory claims, and potentially strong negative correlation between bank asset classes, significantly alters our traditional view of such regulatory influences on bank behavior. I find that the discount window's presence does not always prompt bank risk taking and leverage, but it does partially offset such incentives under certain conditions. In addition to its cost, a reserve requirement provides the bank with an indirect subsidy that may encourage deposit funding. Thus, regulatory reforms, such as the FDIC Improvement Act of 1991, which curtail banks' access to the discount window, may not always be appropriate to resolve a bank's incentive for moral hazard behavior. The Fed's presence needs to be more comprehensively examined to design effective regulatory policy.