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.
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