Negative Interest Rate On Euro

Central banks are in a "race to the bottom", or an effort to lower the domestic currency to improve economic performance. The European Central Bank (ECB) may soon see exactly how low it can go by implementing negative interest rates. When a commercial bank makes a deposit with a central bank, the central bank pays the commercial bank interest on that deposit. The ECB is considering a negative interest rate on those deposits, which means the commercial bank would pay the ECB for all deposits. The result is that commercial banks will deposit fewer euros with the ECB and instead be forced to put those euros in circulation. This would likely lead to a euro devaluation.

Mangerial Idiosyncrasies And Corporate Capital Structure

Coming back for his second appearance, our guest blogger this week is Dr. Harry DeAngelo, the Kenneth King Stonier Chair in Business Administration at the Marshall School of Business at USC. Dr. DeAngelo is a noted expert on payout policy, capital structure, and corporate governance. Here, Dr. DeAngelo discusses how transitory debt can affect the capital structure decision. For a more detailed analysis, you can read the entire paper "Capital Structure Dynamics and Capital Structure" here. 

Corporate capital structures generally show a remarkable degree of variation over time.  One under-appreciated source of variation is the unique personal views about appropriate financial policies held by the people running a firm.  There is scope for managers’ idiosyncratic preferences to have a significant influence on the debt-equity mix when taxes and financial distress costs have only a second-order impact on firm value over a reasonably wide range of leverage ratios. 

Coca-Cola’s dramatic shift in capital structure in the 1980s (detailed below) provides a useful illustration of how the idiosyncratic views of top management can radically reshape financial policy.  The Coca-Cola case also highlights how debt can serve as a transitory vehicle for funding investment opportunities.  For more on the latter view, see my previous post.

  

Coca-Cola’s “levering up” of the 1980s: The appointment of Roberto Goizueta as CEO in 1980 marked a sharp shift in Coca-Cola’s financial policies toward more aggressive use of debt, including a willingness to borrow to make acquisitions (e.g., to acquire Columbia Pictures in 1982).  The CEO’s letter to shareholders in the 1985 annual report spelled out the firm’s new financial principles: “In the financial arena, The Coca-Cola Company is pursuing a more aggressive policy.  We are using greater financial leverage whenever strategic investment opportunities are available.  We are reinvesting a larger portion of our earnings by increasing dividends at a lesser rate than earnings per share growth….And, we are continuing to repurchase our common shares when excess cash or debt capacity exceed near-term investment requirements.”  In a 1984 interview, the firm’s CFO stated “We can go up to $1 billion without hurting our triple-A rating, and we would not hesitate to do so if something unusual comes along….” and “we will not hesitate to be a double-A company.  I want to make that very clear.”  The firm did, in fact, lose its triple-A rating because of its more aggressive use of debt. 

The Coca-Cola case study is from “How Stable Are Corporate Capital Structures?” by Harry DeAngelo and Richard Roll, which is forthcoming in the Journal of Finance.  The case appears in the paper’s Internet Appendix, which also contains case studies of 23 other firms that, like Coca-Cola, were (i) in the Dow Jones Industrial Average at some point, and that were (ii) publicly held from before the Great Depression until at least 2000.

Exxon's Performance

While we don't often discuss an analyst's report, a recent report on Exxon caught our eye. One way to create a positive NPV project is to have economic moats. An economic moat can be a competitive advantage over others in the same industry, or barriers to entry. The article discusses several concepts that we think should interest you after what you have learned in this class so you can see how key concepts are applied in other areas of finance. For example, the article discusses Exxon's low cost of capital (Why would Exxon have a lower cost of capital than its competitors?), as well as economic rents. You can think of economic rents as a positive NPV. The article also discusses Exxon's lower F&D (finding and development) costs in relation to its peers, as well as a lower cost structure, which is the application of ratio analysis.

The Check Is Not In The Mail

According to the 2013 AFP Electronic Payments Survey, about seven percent more companies are using electronic payments for business-to-business (B2B) payments than were using electronic payments four years ago. Overall, about 50 percent of companies use electronic payments of some sort for B2B payments. Surprisingly, more companies with sales under $1 billion use electronic payments than companies with sales over $1 billion. The increase in the number of electronic payment users may not reduce overall float since the electronic payment may be made later than it would be with a check, but "The check is in the mail." may no longer be a viable excuse for late payments.

PS4 Synergies

As we mentioned, synergies are an important concept in capital budgeting. Take the PS4. Based on a tear down price evaluation, Sony makes about $18 per unit, not including logistical costs, marketing, and other expenses. So how does Sony plan to make a profit on the PS4? Through licensing fees to outside game makers and their own software sales. And while the $18 profit may seem small, Sony actually lost about $300 on each PS3 system it sold.

Lease Accounting Change In The Works

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have decided that leases should be reported on a company's balance sheet. The proposed new standard would require a company to report the present value of lease payments on the balance sheet as a long-term liability. Opponents argue that the change would increase debt-equity ratios and companies will scale back operations to reduce debt-equity ratios back to current levels. Another argument against the new rules is that the increased debt-equity ratio would mean that some companies will exceed the debt-equity ratio written into bond and loan covenants. From a financial perspective, the rule changes will have little or no impact as equity analysts have long treated lease payments as a form of debt. Of course, the change will also result in improved performance for these companies, at least to the untrained eye. Because the rule changes increase debt to balance the balance sheet, there will be a resulting drop in the book value of equity, thus increasing ROE.

A Useful Income Statement

We have heard that the job of an equity analyst is to take what an accountant has produced and fix the mistakes. And while we know that you have been taught basic accounting principles, we should make you aware that there are problems using financial statements when analyzing a company. For example, revenue can be a distorted number. The 25 largest U.S.-based non-financial companies prepare an alternate income statement that they use with investors. A major change is separating revenue into recurring and nonrecurring items. Recurring items are those that regularly occur in the company's business operations. For example, if we are looking at Home Depot, sales of home remodeling supplies are a recurring item. Nonrecurring items are those that are unique and unlikely to be repeated, such as the one-time sale of an asset or an insurance settlement. If we use sales that include nonrecurring items, it will likely give us an incorrect estimate of the company's future sales.