Morgan Stanley Roundtable on Managing Financial Trouble

Against the current backdrop of troubled credit markets and the possibility of growing defaults, a distinguished group of bankruptcy academics and practitioners explore a number of questions raised by the emergence of increasingly active distressed investors: Are these relatively new market forces and mechanisms at least partly responsible for today's historically low default rates? Can they be expected to continue keeping default rates low, even if the economy goes into recession? And perhaps most important, by preventing or delaying defaults, will these new reorganization methods end up increasing recoveries and preserving value? The second half of the discussion focuses on some of the potential problems, or obstacles to the working of these market forces. For example, how will distressed situations play out in cases involving dispersed creditors, such as the holders of CDOs and CLOs? Will there be negative side effects from other financial innovations such as credit derivatives? While acknowledging the challenges of resolving some relatively new kinds of inter‐creditor conflicts, most of the panelists expressed confidence that today's distressed investors, working within the context of a streamlined Chapter 11 process, can be expected to play a major role in preserving values for creditors. At the same time, such investors will help perform the critical economic function of ensuring, in Douglas Baird's words, “that those companies that should survive do survive” and that corporate assets, whether liquidated piecemeal or kept within the firm, end up in their highest‐valued uses with their most efficient users.     

Coming Through in a Crisis: How Chapter 11 and the Debt Restructuring Industry Are Helping to Revive the U.S. Economy

During the recent financial crisis, U.S. bankruptcy courts and debt restructuring practitioners were faced with the largest wave of corporate defaults and bankruptcies in history. In 2008 and 2009, $1.8 trillion worth of public company assets entered Chapter 11 bankruptcy protection—almost 20 times the amount during the prior two years. And the portfolio companies of U.S. private equity firms faced a towering wall of debt that, many observers predicted, was about to wipe out most of the industry. But far from the death of private equity or a severe contraction of corporate America, the past three years have seen an astonishingly rapid working off of U.S. corporate debt overhang, allowing corporate profits and values to rebound with remarkable speed and vigor. And as the author of this article argues, corporate America's recovery from the recent financial crisis provides a clear demonstration of the importance of U.S. bankruptcy laws and restructuring practices in maintaining the competitiveness of U.S. companies and the long‐run growth of the U.S. economy.     

The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in theUnited States and model bankruptcy as a strategic decision.We analyze a firm's choice between liquidation under Chapter7, renegotiation of the debt contract in a workout, and reorganizationunder Chapter 11 of the bankruptcy code. Our premise is thata financially distressed firm chooses its action in order tominimize the loss in value caused by the well-known over- andunder-investment problems. We show that the firm initiates aworkout when it faces under-investment, and commences Chapter11 when it faces over-investment. Some of the results are: (i)in default, total firm value and equity value increase uponthe announcement of a workout and decrease upon the announcementof Chapter 11; (ii) firms with shorter maturity of debt aremore likely to reorganize in a workout; (iii) among the firmsthat renegotiate their debt contract, the proportion of firmsentering Chapter 11 is higher for firms in mature industriesthan for firms in growth industries.     

The Capital Structure of PE‐Funded Companies (and How New Debt Instruments and Investors Are Expanding Their Debt Capacity)

The capital structures and financial policies of companies controlled by private equity firms are notably different from those of public companies. The concentration of ownership and intense monitoring of leveraged buyouts by their largest investors (that is, the partners of the PE firms who sit on their boards), along with the contractual requirement of PE funds to return their capital within seven to ten years, have resulted in capital structures that are far more leveraged than those of their publicly traded counterparts, but also considerably more provisional and “opportunistic.” Whereas the average U.S. public company has long operated with roughly 30% debt and 70% equity, today's typical private‐equity sponsored company is initially capitalized with an “upside‐down” structure of 70% debt and just 30% equity, and then often charged with working down its debt as quickly as possible. Although banks supplied most of the debt for the first wave of LBOs in the 1980s, the remarkable growth of the private equity industry in the past 25 years has been supported by the parallel development of a new leveraged acquisition finance market. This financing innovation has led to a general movement away from a bankcentered funding base to one comprising a relatively new set of institutional investors, including business development corporations and hedge funds. Such investors have shown a strong appetite for new debt instruments and risks that banks have been unwilling or, thanks to increased capital requirements and other regulatory burdens, prohibited from taking on. Notable among these new instruments are second‐lien loans and uni‐tranche debt—instruments that, by shifting the allocation of claims on the debtor's cash flow and assets in ways consistent with the preferences of these new investors, have had the effect of increasing the debt capacity of their portfolio companies. And such increases in debt capacity have in turn enabled private equity funds—now sitting on near‐record amounts of capital from their limited partners—to bid higher prices and compete more effectively in today's intensely competitive M&A market, in which high target acquisition purchase prices are being fueled by a strong stock market and increased competition from corporate acquirers.     

The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in the United States and model bankruptcy as a strategic decision. We analyze a firm's choice between liquidation under Chapter 7, renegotiation of the debt contract in a workout, and reorganization under Chapter 11 of the bankruptcy code. Our premise is that a financially distressed firm chooses its action in order to minimize the loss in value caused by the well-known over- and under-investment problems. We show that the firm initiates a workout when it faces under-investment, and commences Chapter 11 when it faces over-investment. Some of the results are: (i) in default, total firm value and equity value increase upon the announcement of a workout and decrease upon the announcement of Chapter 11; (ii) firms with shorter maturity of debt are more likely to reorganize in a workout; (iii) among the firms that renegotiate their debt contract, the proportion of firms entering Chapter 11 is higher for firms in mature industries than for firms in growth industries.     

The Future of Private Equity

A distinguished University of Chicago financial economist and longtime observer of private equity markets responds to questions like the following:

• ? With a track record that now stretches in some cases almost 30 years, what have private equity firms accomplished? What effects have they had on the performance of the companies they invest in, and have they been good for the economy?
• ? How will highly leveraged PE portfolio companies fare during the current downturn, especially with over $400 billion of loans coming due in the next three to five years?
• ? With PE firms now sitting on an estimated $500 billion in capital and leveraged loan markets shut down, are the firms now contemplating new kinds of investment that require less debt?
• ? If and when the industry makes a comeback, do you expect any major changes that might allow us to avoid another boom‐and‐bust cycle? Have the PE firms or their investors made any obvious mistakes that contribute to such cycles, and are they now showing any signs of having learned from those mistakes?

Despite the current problems, the operating capabilities of the best PE firms, together with their ability to manage high leverage and the increased receptiveness of public company CEOs and boards to PE investments, have all helped establish private equity as “a permanent asset class.” Although many of the deals done in 2006 and 2007 were probably overpriced, the “cov‐lite” deal structures, deferred repayments of principal, and larger coverage ratios have afforded more room for reworking troubled deals. As a result of that flexibility, and of the kinds of companies that get taken private in leveraged deals in the first place, most troubled PE portfolio companies should end up being restructured efficiently, thereby limiting the damage to the overall economy. Part of the restructuring process involves the use of the PE industry's huge stockpile of capital to purchase distressed debt and inject new equity into troubled deals (in many cases, their own). At the same time the PE firms have been working hard to rescue their own deals, some have been taking significant minority positions in public companies, while gaining some measure of control. Finally, to limit overpriced and overlev‐eraged deals in the future, and so avoid the boom‐and‐bust cycle that appears to have become a predictable part of the industry, the discussion explores the possibility that the limited partners and debt providers that supply most of the capital for PE investments will insist on larger commitments of equity by sponsors to their own funds and individual deals.     

Bankruptcy as an Auction Process: Lessons from Sweden

The traditional U.S. Chapter 11 bankruptcy process in which financial claims are renegotiated under court protection and the firm continues to operate under existing management has long been criticized by economists as an inefficient way of dealing with financially distressed companies. In this paper, the authors make the case for a mandatory auction bankruptcy system of the kind now used in Sweden—one that requires all companies filing for Chapter 11 to be sold in open auctions soon after the filing. After discussing the notable features of and differences between the U.S. and Swedish bankruptcy systems, the authors summarize recent research (much of it their own) on the benefits and possible drawbacks of the Swedish system. Among the most notable findings of this research, there is no evidence that mandatory bankruptcy auctions in Sweden lead to “fire‐sale” discounts in auction premiums. Moreover, the fact that three‐quarters of the Swedish companies that filed for bankruptcy survived as going concerns should allay concerns that an auction system will produce excessive liquidations. At the same time, the post‐bankruptcy operating profitability of the companies that emerge from Swedish auctions as going concerns tends to be on a par with that of their (non‐bankrupt) industry peers. Such post‐operating performance, when combined with a 75% rate of reorganization (versus liquidation), suggests that allowing auction investors—instead of the bankruptcy court—decide which companies survive and how they get capitalized and restructured has been quite effective in accomplishing the two aims of a bankruptcy system: (1) preserving intact all economically viable enterprises while (2) eliminating the excess capacity that results from prolonging the existence of companies that are never expected to earn high enough returns on capital to attract private investment. Consistent with these findings, the U.S. in recent years has seen a sharp increase in the use of auctions in Chapter 11 bankruptcies, though on a voluntary rather than a mandatory basis. Such a change reflects the growing recognition of the role of auction processes in reducing bankruptcy costs and preserving going‐concern values as U.S. capital market participants push harder for private workouts, “prepackaged” Chapter 11 filings, and auction sales in Chapter 11.     

A Theory of Workouts and the Effects of Reorganization Law*

We present a model of a financially distressed firm with outstanding bank debt and public debt. Coordination problems among public debtholders introduce investment inefficiencies in the workout process. In most cases, these inefficiencies are not mitigated by the ability of firms to buy back their public debt with cash and other securities-the only feasible way that firms can restructure their public debt. We show that Chapter 11 reorganization law increases investment, and we characterize the types of corporate financial structures for which this increased investment enhances efficiency.     

Postbankruptcy Performance and Management Turnover

This article examines the performance of 197 public companies that emerged from Chapter 11. Over 40 percent of the sample firms continue to experience operating losses in the three years following bankruptcy; 32 percent reenter bankruptcy or privately restructure their debt. The continued involvement of prebankruptcy management in the restructuring process is strongly associated with poor post-bankruptcy performance. The substantial number of firms emerging from Chapter 11 that are not viable or need further restructuring provides little evidence that the process effectively rehabilitates distressed firms and is consistent with the view that there are economically important biases toward continuation of unprofitable firms.     

A Primer on Distressed Investing: Buying Companies by Acquiring Their Debt

Distress or vulture investing requires a high level of business acumen combined with deep knowledge of accounting, finance, and corporate and restructuring law. In this paper, the authors provide a pedagogical discussion of an important—and socially beneficial—kind of vulture investing through which creditors often gain control of distressed companies. Such investing requires intensive information gathering and active participation by the investor, in contrast to most passive investing in publicly traded securities, as the investor seeks control over the distressed firm's equity. The process is made more risky and difficult by the many conflicting interests of creditors and equity holders who work throughout the process to protect their individual interests. The authors provide a detailed discussion of such conflicts and how restructuring practitioners seek to manage them.     

Post-Chapter 11 Bankruptcy Performance: Avoiding Chapter 22

Despite the long experience in the U.S. with restructuring companies in bankruptcy, there remains a persistent tendency for companies to emerge from Chapter 11 with too much debt and too little profitability. In this article, the author uses a variant of his well-known "Z-Score" bankruptcy prediction model to assess the future viability of companies when emerging from bankruptcy, including the likelihood that they will file again—a surprisingly common phenomenon that is now referred to as "Chapter 22."
The author reports that those companies that filed second bankruptcy petitions were both significantly less profitable and more highly leveraged than those that emerged and continued as going concerns. Indeed, the average financial profile and bond rating equivalent for the "Chapter 22" companies on emerging from their first bankruptcies were not much better than those of companies in default.
The authors findings also suggest that a credible corporate distress prediction model could be used as an independent, unbiased method for assessing the future viability of proposed reorganization plans. Another potential application of the model is by the creditors of the "old" company when assessing the investment value of the new package of securities, including new equity, offered in the plan.     

VALUE MAXIMIZATION AND STAKEHOLDER THEORY: COMPATIBLE OR NOT?

Complicating the current corporate governance controversy is a major disagreement about the fundamental purpose of the corporation. There are two main views on what should constitute the principal goal of the firm. Most economists tend to endorse value maximization—that is, maximization of the value of the firm's debt plus equity—or a version of value maximization known as “value‐based management” (VBM) that aims to maximize shareholder value. The main challenger is “stakeholder theory,” which argues that the corporation exists to benefit not just investors but all its major constituencies—employees, customers, suppliers, the local community, and the federal government, as well as shareholders. Thus, whereas the success of a corporation under VBM could be assessed simply by its long‐run return to shareholders, under stakeholder theory a company's success would be judged by taking account of its contributions to all its stakeholders. Using statistical analysis of various measures of corporate success in satisfying non‐investor stakeholders, the author investigates whether a broader focus on multiple stakeholders is necessarily inconsistent with the pursuit of long‐term shareholder value. His main findings in fact suggest just the opposite—namely, that long‐term value creation appears to be a necessary condition for maintaining corporate investment in stakeholder relationships. More specifically, the author's study shows that companies with higher levels of value creation tend to have stronger reputations for treating stakeholders well while companies that create little value end up shortchanging not just their shareholders but all their constituencies. For profitable companies that have previously failed to devote the optimal level of resources to their non‐investor stakeholders, the message of this article is that investing in stakeholders can add value—and, in fact, it pays for companies to spend an additional dollar on stakeholder relationships as long as the present value of the expected (long‐run) return is at least a dollar.     

The Effect of Bankruptcy Protection on Investment: Chapter 11 as a Screening Device

Asymmetric information and conflicts of interest between equity and debt holders can force a distressed but efficient firm to liquidate and may enable a distressed inefficient firm to continue. In the extreme, if it is costless for an inefficient firm to mimic an efficient firm in a debt restructuring, efficient and inefficient firms are equally likely to continue or liquidate. This article shows that Chapter 11 procedures impose costs on inefficient firms that would otherwise mimic efficient firms. This separation induces voluntary filing for bankruptcy by inefficient firms and consequently enables efficient firms to continue when they would otherwise be liquidated.     

Is Managerial Myopia a Persistent Governance Problem?

Critics of U.S. corporations have long argued that companies are overly focused on short‐term results and, as a consequence, sacrifice their own long‐run value and competitiveness. These criticisms have expanded in recent years to include those from prominent politicians, investors, consultants, and academics. If such criticisms have merit, they would imply a massive governance failure in which there has been decades of underinvestment with little adjustment on the part of managers, boards, or the market for corporate control. This article evaluates the economic underpinnings of these criticisms and analyzes their implications in the context of empirical evidence produced by several decades of research on corporate investment policies, the outcomes of corporate control events, investor horizons, and the market pricing of companies with little if any earnings. In reviewing the findings of these studies, the author finds little evidence to support the view that U.S. companies sacrifice long‐run value and competitiveness by systematically underinvesting. First, although U.S. companies have indeed cut back on tangible investments such as property, plant, and equipment, these cutbacks have been more than offset by the dramatic growth in investment in intangibles, such as spending on developing knowledge capital, brand‐building, and IT infrastructure. Second, when subjected to events that have the effect of reducing managerial control over investment policies and transferring control to outside investors—such as leveraged buyouts and recapitalizations, forced CEO dismissals, and shareholder activist campaigns—companies tend to reduce, not increase, investment spending. In fact, it is difficult to find any corporate control threats that have had the goal or effect of increasing investment. Third, and at the same time, the rising concentration of large institutional investors, including indexers such as BlackRock and Vanguard, suggests that investors have become, if anything, more long‐term oriented over time. Fourth, there is no evidence that the market shuns companies that have yet to report large (or indeed any) earnings. These findings suggest that curbing overinvestment, and not discouraging myopia and underinvestment, may well still be the larger corporate governance challenge facing investors when monitoring and attempting to influence the performance of U.S. companies.     

UNIVERSITY OF GEORGIA ROUNDTABLE ON: Enterprise‐Wide Risk Management

For many years, MBA students were taught that there was no good reason for companies that hedge large currency or commodity price exposures to have lower costs of capital, or trade at higher P/E multiples, than comparable companies that choose not to hedge such financial price risks. Corporate stockholders, just by holding well‐diversified portfolios, were said to neutralize any effects of currency and commodity price risks on corporate values. And corporate efforts to manage such risks were accordingly viewed as redundant, a waste of corporate resources on a function already performed by investors at far lower cost. But as this discussion makes clear, both the theory and the corporate practice of risk management have moved well beyond this perfect markets framework. The academics and practitioners in this roundtable begin by suggesting that the most important reason to hedge financial risks—and risk management's largest potential contribution to firm value—is to ensure a company's ability to carry out its strategic plan and investment policy. As one widely cited example, Merck's use of FX options to hedge the currency risk associated with its overseas revenues is viewed as limiting management's temptation to cut R&D in response to large currency‐related shortfalls in reported earnings. Nevertheless, one of the clear messages of the roundtable is that effective risk management has little to do with earnings management per se, and that companies that view risk management as primarily a tool for smoothing reported earnings have lost sight of its real economic function: maintaining access to low‐cost capital to fund long‐run investment. And a number of the panelists pointed out that a well‐executed risk management policy can be used to increase corporate debt capacity and, in so doing, reduce the cost of capital. Moreover, in making decisions whether to retain or transfer risks, companies should generally be guided by the principle of comparative advantage. If an outside firm or investor is willing to bear a particular risk at a lower price than the cost to the firm of managing that risk internally, then it makes sense to lay off that risk. Along with the greater efficiency and return on capital promised by such an approach, several panelists also pointed to one less tangible benefit of an enterprise‐wide risk management program—a significant improvement in the internal corporate dialogue, leading to a better understanding of all the company's risks and how they are affected by the interactions among its business units.     

Analysts' Roundtable on Integrating ESG into Investment Decision‐Making

In this third of the three discussions that took place at the SASB 2016 Symposium, practitioners of a broad range of investment approaches—active as well as passive in both equities and fixed‐income—explain how and why they use ESG information when evaluating companies and making their investment decisions. There was general agreement that successful ESG investing depends on integrating ESG factors with the methods and data of traditional “fundamental” financial statement analysis. And in support of this claim, a number of the panelists noted that some of the world's best “business value investors,” including Warren Buffett, have long incorporated environmental, social, and governance considerations into their investment decision‐making. In the analysis of such active fundamental investors, ESG concerns tend to show up as risk factors that can translate into higher costs of capital and lower values. And companies' effectiveness in managing such factors, as ref lected in high ESG scores and rankings, is viewed by many fundamental investors as an indicator of management “quality,” a reliable demonstration of the corporate commitment to investing in the company's future. Moreover, some fixed‐income investors are equally if not more concerned than equity investors about ESG exposures. ESG factors can have pronounced effects on performance by generating “tail risks” that can materialize in both going‐concern and default scenarios. And the rating agencies have long attempted to reflect some of these risks in their analysis, though with mixed success. What is relatively new, however, is the frequency with which fixed income investors are engaging companies on ESG topics. And even large institutional investors with heavily indexed portfolios have become more aggressive in engaging their portfolio companies on ESG issues. Although the traditional ESG filters used by such investors were designed mainly just to screen out tobacco, firearms, and other “sin” shares from equity portfolios, investors' interest in “tilting” their portfolios toward positive sustainability factors, in the form of lowcarbon and gender‐balanced ETFs and other kinds of “smart beta” portfolios, has gained considerable momentum.     

Baylor University Roundtable on The Corporate Mission, CEO Pay, and Improving the Dialogue with Investors

A small group of academics and practitioners discusses four major controversies in the theory and practice of corporate finance:

• • What is the social purpose of the public corporation? Should corporate managements aim to maximize the profitability and value of their companies, or should they instead try to balance the interests of their shareholders against those of “stakeholder” groups, such as employees, customers, and local communities?
• • Should corporate executives consider ending the common practice of earnings guidance? Are there other ways of shifting the focus of the public dialogue between management and investors away from near-term earnings and toward longer-run corporate strategies, policies, and goals? And can companies influence the kinds of investors who buy their shares?
• • Are U.S. CEOs overpaid? What role have equity ownership and financial incentives played in the past performance of U.S. companies? And are there ways of improving the design of U.S. executive pay?
• • Can the principles of corporate governance and financial management at the core of the private equity model—notably, equity incentives, high leverage, and active participation by large investors—be used to increase the values of U.S. public companies?

     

University of Texas Roundtable on Financing and Managing Energy Investments in a Low‐Price Environment

During the past 18 months, the U.S. oil industry has seen oil prices plunge from well over $100 a barrel to under $30. In a session that was part of a recent Private Equity Conference at the University of Texas in Austin, the CEO of a small independent producer and a representative of a large global oil and gas company discussed the challenges of financing and operating energy companies in today's low‐price environment with the director of energy research at a brokerage firm, the senior partner responsible for the natural resource investments of a well‐known private equity firm, and the head of the oil and gas restructuring practice of a national law firm. The panelists appeared to reach a consensus on at least the following three arguments:

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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.     

Valuing Companies with Cash‐Flow@Risk

The classic DCF approach to capital budgeting—the one that MBA students in the world's top business schools have been taught for the last 30 years—begins with the assumption that the corporate investment decision is “independent of” the financing decision. That is, the value of a given investment opportunity should not be affected by how a company is financed, whether mainly with debt or with equity. A corollary of this capital structure “irrelevance” proposition says that a company's investment decision should also not be influenced by its risk management policy—by whether a company hedges its various price exposures or chooses to leave them unhedged. In this article, the authors—one of whom is the CFO of the French high‐tech firm Gemalto—propose a practical alternative to DCF that is based on a concept they call “cash‐flow@risk.” Implementation of the concept involves dividing expected future cash flow into two components: a low‐risk part, or “certainty equivalent,” and a high‐risk part. The two cash flow streams are discounted at different rates (corresponding to debt and equity) when estimating their value. The concept of cash‐flow@risk derives directly from, and is fully consistent with, the concept of economic capital that was developed by Robert Merton and Andre Perold in the early 1990s and that has become the basis of Value at Risk (or VaR) capital allocation systems now used at most financial institutions. But because the approach in this article focuses on the volatility of operating cash flows instead of asset values, the authors argue that an internal capital allocation system based on cash‐flow@risk is likely to be much more suitable than VaR for industrial companies.