MoF Issue 18

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McKinsey onFinance

Perspectives on

Corporate Finance

and Strategy

Number 18, Winter

2006

How to make M&A work in China 1

The conditions are right for Chinas nascent M&A market to flourish.

Companies should try a new approach to deal making.

Capital discipline for Big Oil 6

The oil and gas industry has a history of overinvesting at the topof a cycle. This time it should break the habit.

Making capital structure support strategy 12

A companys ratio of debt to equity should support its business strategy,not help it pursue tax breaks. Heres how to get the balance right.

Better cross-border banking mergers in Europe 18

For those who take a tough stance, such mergers can be lucrative.

Data focus: A long-term look at ROIC 21

Finance theory isnt enough when companies set their expectations forreasonable returns on invested capital. A long-term analysis of marketand industry trends can help.

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McKinsey on Finance is a quarterly publication written by experts

and practitioners in McKinsey & Companys Corporate Finance practice.

This publication offers readers insights into value-creating strategies

and the translation of those strategies into company performance.

This and archived issues ofMcKinsey on Finance are available online at

www.corporatefinance.mckinsey.com.

Editorial Contact: [email protected]

Editorial Board: James Ahn, Richard Dobbs, Marc Goedhart, Bill Javetski,

Timothy Koller, Robert McNish, Herbert Pohl, Dennis Swinford

Editor: Dennis Swinford

External Relations: Joanne Mason

Design Director: Donald Bergh

Design and Layout: Kim Bartko

Managing Editor: Kathy Willhoite

Editorial Production: Sue Catapano, Roger Draper, Pamela Kelly,

Scott Leff, Mary Reddy

Circulation: Susan Cocker, Rachelle Butterworth

Cover illustration by Ben Goss

Copyright 2006 McKinsey & Company. All rights reserved.

This publication is not intended to be used as the basis for trading in theshares of any company or for undertaking any other complex or significant

financial transaction without consulting appropriate professional advisers.

No part of this publication may be copied or redistributed in any form

without the prior written consent of McKinsey & Company.

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How to make M&A work in China

The conditions are right for Chinas nascent M&A market to

flourish. Companies should try a new approach to deal making.

James Ahn,

Thomas Luedi, and

Isiah Zhang

and beer industries, for example, are wide

estimated to have overcapacity of more th

50 percent.

Although transactions more than tripled

over the past seven years (Exhibit 1), the

average inbound deal is still valued at less

than $20 million. That too seems destined

to change. In the first ten months of 2005

for example, investment in Chinas bankin

market alone has exceeded $10 billion

more than five times the maximum amou

that multinational companies invested in

banking sector in previous years.

Multinational companies hoping to tap

Chinas M&A potential will have to maste

some well-documented challenges: they

must ensure that transactions are driven

by strategic considerations and that they

are properly equipped on the local level

to complete deals. Aspiring buyers must

also consider the peculiar dynamics of

the Chinese marketspecifically, the fact

that conventional approaches to M&A ar

inappropriate in China. First, corporate

control is more important than ownership

to the Chinese, and overseas companies

cannot secure or maintain control in the

same way that they might do elsewhere

in the world. Next, traditional valuation

is often impossible, since benchmarks and

reliable financial information are rare.

Often, option value is everything. Finally,

forecasting methods used routinely in mo

mature markets do not apply to China.

Companies must thus be prepared to spenmore time on due diligence.

Structuring a deal for control

Most strategic investors seek control of a

business believing that they can run it mo

effectively than the current owner and

generate greater value. In the developed

world, control is commensurate with equi

ownership; majority ownership gives a

Multinational companies spent more

than $60 billion on new businesses and

joint ventures with Chinese companies in

2004. Cross-border mergers and acquisitions,

by contrast, have yet to induce anything

like the same level of investment fever.

Inbound cross-border M&A deals were

worth less than 12 percent of total foreign

direct investment and individual deals have

been small. By comparison, among the ten

countries, apart from China, that attract

the greatest amount of foreign capital, the

average ratio of inbound M&A to foreign

direct investment was 47 percent in 2004.

Chinas weak M&A market might in

part be a legacy of a time when foreign

investment was restricted largely to joint

ventures. Now, though, the limitations on

investment in many industries are being

removed, and cross-border M&A activity is

poised to increase. State-owned enterprises

are cleaning up their asset portfolios

and improving standards of disclosure,

making them attractive targets for foreigninvestors. A number of private companies

better managed than their state-owned

peersare also emerging as candidates.

In addition, the overcapacity resulting

from Chinas excessive investment in fixed

assets suggests that local and multinational

companies could pick up assets and

businesses inexpensively when the inevitable

restructuring takes place. The automotive

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2 McKinsey on Finance Winter 2006

buyer the right to operate the acquired

business. In China, though, government

regulations still prohibit majority foreign

ownership in more than 25 industries,

including banking, telecommunications,

and auto manufacturing. Furthermore,

Chinese owners often desire control,

or the appearance of control, for

social or personal reasons.

Where buyers cannot acquire majority

ownership, they must exert control by other

means. A deal can be structured to give an

investor adequate board representation,

for example. Few joint-stock companies

listed in China have an accumulative voting

system, so foreign investors cannot assume

that their representation on the board of a

target company will be in proportion to the

stake they purchase. They must thus ensure

that their board standing reflects the true

economics of the transaction and that they

have a say in the election of independent

directors. The use of governance provisions

in this way by some multinational

companies has led to different levels of

control in different industries (Exhibit 2).

Buyers can also insist on the right to

fill crucial posts, such as those of chief

financial officer and chief technology

officer. One global consumer goods

company, for example, needed this kind

of authority before it could meet certain

important goals: to integrate an acquired

companys operations with an existing

management-information-system platform

and to implement proprietary production

techniques designed to eliminate waste and

improve efficiency by up to 40 percent.

Another successful approach to structuring

deals involves outlining important areas

of decision making and establishing

mechanisms to exercise control over them.

If direct control of the board is impossible,

a buyer might push decisions down to

a level where it can exercise authority

through day-to-day operational decisions.

The general manager of a chemical joint

venture, for example, was appointed by

the multinational partner. This manager

was given the right to make almost all

important decisionsincluding decisions

relating to budgeting, hiring, and firingexcept for those that by law must be made

unanimously by the board.

Some multinational companies, aiming

to win as much control as possible, use

several of these techniques in parallel.

Often multinationals combine them with

an agreement to increase ownershipand

controlover time. Some arrangements will

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be easier than others for a Chinese seller to

accept, so it is imperative that buyers mix

and match according to the specific context

of a deal. One global consumer goods

company negotiated the right to nominate

three out of nine board members directly,

to select and approve three independent

directors, to appoint the vice chairman,

to establish and nominate executive

committees, and to oversee essential

functional tasks. The company thus wielded

the degree of control necessary at least to

voice its opinions at the board level and to

influence board committees.

Determining intrinsic value

Many buyers confess that valuing companies

in China is guesswork. There are few

benchmark transactions or publicly traded

companies to act as a guide and few

completed transactions in any one industry.

Relying heavily on a multiples-based

valuation1 can lead to highly distorted results,

while the Chinese market is too dynamic f

discounted-cash-flow analysis to be accura

forecasting cash flows beyond three to five

years is mere conjecture. In addition, Chin

counterparties often use a statutory valuat

which is similar to valuing assets at book

value but does not take into account the

level of cash flow the assets could generate

It is no surprise, then, that a statutory

valuation might undervalue or overvalue

an asset. Chinese negotiators just dont

think in future-cash-flow terms, says one

negotiator from a multinational company.

The Chinese, for their part, complain that

foreigners routinely offer purchase prices

below the minimum required by law, so

the deals are just not viable (Exhibit ).

These contrasting views highlight the

importance both of calculating a range of

valuations based on different scenarios in

order to arrive at an acceptable value rang

and of using the right methodology. Most

overseas companies say that they will not

pursue a deal unless it fits within their valu

metrics or their framework for return on

investment. Some attempt to account for

the additional downside risk by including

a large risk premium in the discount factor

Uncertainty has upside as well as downside

potential in China, however, and buyers th

use the wrong methods of valuation might

forgo strategically important deals. In our

experience, a few practical tips are useful.

Use a wider range of valuations and let

strategy be your guidePast growth rates and margins do not

provide an accurate guide on how an

industry will develop in China. Yet the

boards of multinational companies often

insist that their valuation teams come up

with a single, bottom-line number. As a

result, deal teams frequently feel pressure

under- or overprice a purchase rather than

explain why the value realized could be

1For example, price-to-earnings (P/E) ratios oreconomic value (EV) to earnings before interest,

taxes, depreciation, and amortization (EBITDA).


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higher or lower, depending on the industrys

evolution. Using a wider range of valuations

would give a buyer leeway to assess the most

likely outcomes and to base its decisions on

the way China fits into the overall company

and industry strategy.

Be realistic about synergies

Buyers often look to the synergies of deals to

justify investments. But capturing synergies

in China is difficult. Cross-selling products,

for example, is unrealistic if brands and

products are positioned for different market

segments: it is just not feasible to try tocross-sell, say, a premium brand of beer

through a largely rural distribution network.

Synergies in revenues and labor (through

massive layoffs of workers) are also hard to

achieve. In addition, buyers must be aware

of potential postacquisition cost increases

owing to the expense of an expatriate

staff and spending on health and safety

improvements. Savings in production and

operations are easier to capture, although

sometimes a deals value resides not in its

synergies but in its long-term option value:

capturing the potential and growth of the

sizable Chinese market.

Share upside and downside risk

When differences over the valuation of a

company cannot be bridged, buyers should

seek to structure a deal so that it takes

this uncertainty into account. In one joint

venture, the multinational partner agreed

that it would make an additional payment

three years after the transaction date if the

venture achieved an agreed-upon earnings

target and if tax regulations changed. Such

earn-out mechanisms are useful when

opinions vary over other external factors,

such as industry growth and the cost of

key inputs. The trick with earn-outs is to

focus on matters that are generally beyond

the influence of either negotiating party;

otherwise, there is room for gamesmanship,

which should be avoided.

A detective force for due diligence

Due diligence is the core of acquisition

procedures. In our experience, buyers tend

to be either overly cautious (thus missing

potentially attractive opportunities) or

overly optimistic (and likely to find surprises

later on). The information needed for robust

due diligence is elusive in China, where IT

systems are generally weak, databases lack

breadth and capacity, and legal systems and

requirements remain opaque. Furthermore,

agreements are often oral, and the highproportion of cash deals makes it difficult to

validate the true ownership of stated assets.

For these reasons, investors should expect

a high level of liability and risk exposure

and make sure that any team conducting

due diligence on their behalf has enough

time and people to dig for information.

Accounting and legal advisers with local

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experience are essential. Wherever possible,

teams should be based locally and have the

insider knowledge and relationships needed

to understand target companies fully.

The most delicate due-diligence issues for

negotiations in China include the following:

Asset ownership. Many newly formed

Chinese companies do not have adequate

documentation to show what assets

belong to them. Furthermore, problems

often arise in transactions between related

parties, where there is little evidence

on the nature and details of such deals.

Buyers should confirm the ownership of

assets, investigate related companies, and

ascertain whether acquired assets are

subject to a bank pledge.

Business scope licenses. Companies are

normally allowed only a narrow scope for

business in their articles of incorporation

and business licenses. Certain specialized

lines of business require licenses from

government agencies, and Chinese law

does not always permit the transfer of

these licenses in M&A transactions. In

addition, foreign ownership can often

affect applications and license renewals.

Due-diligence teams should sort out

these matters.

Land use rights. In China, land is

owned by the state, and companies and

individuals hold allocated or granted

land use rights. When Chinese partnerscontribute capital to a deal in the form

of land, it is essential to understand what

land use rights are attached to it.

Tax and financial liabilities and benefits.

Different legal entities might be entitled

to different tax and financial benefits

and incentives from the local or central

government. These incentives might not

transferable to a foreign owner. In addit

Chinese companies are often exposed

to off-balance-sheet liabilities. Buyers

should draft and sign indemnification

agreements to protect themselves

against damage from hidden liabilities.

If an overseas company remains unsure of

a target companys value after due diligen

has been carried out, it could insist on a

clause requiring the shares it has bought t

be repurchased at a fixed price in certain

circumstances. The acquisition of Bank

of China shares by the Royal Bank of

Scotland, in September 2005, provides an

example. If additional due diligence finds

any surprises, the price per share will

change in Royal Bank of Scotlands favor

and if Bank of China does not pursue an

initial public offering within three years, i

will be required to buy back all of Royal

Bank of Scotlands shares. This type of

structure gives a multinational company

more confidence when acquiring a busine

and puts the Chinese seller under pressure

to implement proposed changes. It also

ensures that both the buyers and the

sellers objectives are aligned for value.

Multinational companies planning M&A

ventures in China will be breaking new

ground. To succeed, they must be prepare

to adapt their deal-making mechanisms to

the characteristics of the local market. Mo

James Ahn ([email protected]) is an

associate principal in McKinseys Hong Kong office

and Thomas Luedi ([email protected]

is a partner in the Shanghai office, where Isiah Zha

([email protected]) is a consultant.

Copyright 2006 McKinsey & Company. All

rights reserved.


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Capital discipline for Big Oil

The oil and gas industry has a history of overinvesting at the top

of a cycle. This time it should break the habit.

Richard Dobbs,

Nigel Manson, and

Scott Nyquist

Cash is gushing into international oil

companies after the recent jump in the price

of oil and gas. According to our estimates,

the five largest corporations generated

more than $120 billion in cash flow before

capital expenditure in 2005equivalent to

about twice their capital expenditure over

each of the past few years and more than

one and a half times the annual cash flow

recorded during the industrys last boom,

from 1979 to 1981.1 Suppliers are also

benefiting: oil field service companies are

expected to report increases of more than

50 percent in full-year 2005 profits over the

figures for 2004.

What should companies do with the

extra cash? Although executives might

be expected to relish such a problem, the

decisions they make will have ramifications

far beyond the oil industry. On the one

hand, companies face pressure to invest

more in exploration, production, and

refining (where margins have also risen):

consumers and governments are angryabout high prices, the industrys large profits,

and the channeling of those profits into

share buybacks and dividends rather than

into investments that might bring down

prices. On the other hand, with the industry

outperforming the S&P 500 by almost

0 percent since 200, the capital markets

seem to be rewarding companies for the

share buybacks and dividendsamounting

in total to almost $120 billionthat have

been announced during this period.2

The conundrum is this: has the industry

entered an era of permanently higher oil

and gas prices and refining margins or is it

merely experiencing another market bubble?

If executives believe the former hypothesis,

they will focus their companies excess cash

on long-term investments, though at the risk

of precipitating the kind of price collapse

that would destroy the value of those

investments. If they believe the latter, they

will return the cash to shareholders and risk

missing opportunities to create value over

the long term if prices remain high.

We believe that such crucial decisions would

be better informed if the industry were to

reflect upon its historyin particular, its

inability to return its cost of capital over

four decades of boom and bust. Coupled

with an understanding of the economics

of new capacity and of alternative fuel

technologies, the evidence suggests that

dangers await companies that place too

large a bet on a fundamental structural

change by investing in projects that will

be profitable only if the market has indeed

altered for good. They would do better to

exercise discipline over capital spending and

to invest in opportunities to build sources

of competitive advantage that they can

sustain regardless of whether prices shift

structurally or revert to levels closer to the

long-term averages.

A familiar road

The history of the oil industry is long on

boom-and-bust cycles in crude prices and

refining margins and short on examples of

capital discipline. In the 25 years to 1998, the

industrys total return to shareholders (TRS)

was below that of the S&P 500 (Exhibit 1)

because the industry failed to return its cost

of capital over the cycle. During booms, oil

1Adjusted for inflation.

2This sum is based on the figures for 2004 and

estimates for 2005.

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companies would behave as if the world had

changed permanently, investing in projects

that could make a profit only if prices

stayed high. The exceptions were the larger,

globally integrated companies, such as BP,

ExxonMobil, and Royal Dutch/Shell, which

delivered TRS in line with the overall market.

These companies did show capital discipline:they made strategic investments in assets

and technologies, including very large oil

fields and deep-water drilling, that demanded

specialist capabilities and large amounts of

capital, as well as investments in refining

portfolios that use better technologies and

are located in economically attractive places.

In this way, they generated returns roughly in

line with the cost of capital over the cycle.

Since 1998, the industry has enjoyed its

longest boom in 40 years and consistently

earned returns above its cost of capital

(Exhibit 2). Recently, prices have been

pushed ever upward thanks to unexpected

increases in demand from the United

States and China, as well as a tightening

of supplies caused by delays in upstream

projects, the war in Iraq, and last autumn

hurricanes in the Gulf of Mexico. Margin

on refining have also risen. These externa

factors, combined with a fall in real

interest rates,4 have enhanced the value

of oil companies (Exhibit ). Since 1998,

the industrys TRS has been 1 percent,

compared with less than 1 percent for

the S&P 500.

Here we go again?

The executives who must decide which

direction the industry will take see

conflicting signals. Initially, the case for th

idea that a structural change has occurred

seems strong: most large oil fields are

maturing, a significant proportion of the

reserves is located in politically unstable

or unsafe areas, and the need for secure o

supplies is greater than everin develope

and developing economies alike. Indeed, i

demand, rather than constraints on supply

by OPEC,5 that differentiates the recent

spike in oil prices from earlier increases. I

refining, the chronic overcapacity of the

1980s and 1990s has also disappeared.

At the same time, though, the messages

from financial markets are decidedlymixed. The forward curve6 of prices

suggests a structural shift: crude futures

contracts appear to have abandoned the

$20-to-$25 range of the past decade and

are forecasting prices as high as $60 a

barrel until 2010. To justify the stock pric

of oil and gas companies, you would have

to believe that oil prices will be something

closer to $0 to $40 a barrel. Moreover,


The industry has wrestled with this problemfor more than 150 years: in the early 1860s,

for example, overinvestment in Oil Creek,Pennsylvania, pushed down the price of crude

oil from $10 a barrel to 50 cents in less thansix months and to 10 cents within a year. See

Daniel Yergin, The Prize: The Epic Quest forOil, Money & Power, reissue edition, NewYork: Free Press, 199.

4A fall in real interest rates lowers the discountrate, thereby increasing the value of future cash

flows and thus share prices.

5Organization of Petroleum Exporting Countries.

6The forward curve may not be a reliableindicatorit lacks real liquidity and has been

consistently wrong in the past.

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predictions vary wildly from one analyst to

another, with long-run price forecasts for

crude oil ranging from as little as $30 to

more than $90 a barreland even a few

extreme forecasts of more than $200.

Executives must also factor in the

macroeconomic conditions, such as global

GDP growth, that influence margins.

Traditionally, economic growth slows as

oil prices rise, although high prices might

have less effect now than they had in

the past, given the combination of low

worldwide interest rates7 and what by

historical standards is a lower than usual

global dependency on crude oil. Even so,the developing worlds demand for oil is

vulnerable to a setback in Chinas fragile

banking system, for example, or to a

monsoon in India.

More difficult still is the task of forecasting

the behavior of other executives, national oil

companies, and new industry participants

and investors, such as private equity firms.

Their actionsparticularly in relation to

capital investment and the development of

alternative fuels and fuel efficiencycould

swiftly change the industrys outlook.

The old enemy

With so much cash available, companies

may be sorely tempted to loosen their

capital discipline. Many opportunities

to invest in refining and upstream assets

are highly attractive at current prices and

margins. Moreover, companies that in recent

years have invested in projects requiring

prices and margins to remain high have

reaped rewards, at least so far. And evidence

suggests that the level of investment is

rising rapidly: capital expenditure by

integrated players and by the exploration

and production business has nearly doubled

since 1999 (Exhibit 4).

There are three main reasons for the increase

in capital expenditure. One is inflationthe

result of higher prices for commodities

such as steel and of shortages in essential

inputs such as engineering resources and

drilling equipment. Another is incremental

investments (which can have quick

paybacks) in existing fields and refineries.

But the third is strategic bets on high long-

term oil prices and refining margins. In some

cases, such bets are being placed because

industry players have difficulty finding

investment opportunities that are attractive

at lower prices and because of pressure

to replace reserves.8 In hindsight, it will

be thought that these investments eitherreflected deep insights into a structural shift

in the oil industry or represented further

examples of its lack of capital discipline.

The risk is that lax discipline in pursuing

investments could severely erode margins.

McKinsey analysis suggests that if all private

sector and national oil companies increased

their capital spending from the current

7In the previous oil price spikes, countriestightened monetary policy to offset inflation,

but this approach also exacerbated theeconomic shock of higher oil prices.

8Ivo J. H. Bozon, Stephen J. D. Hall, and SveinHarald ygard, Whats next for Big Oil?TheMcKinsey Quarterly, 2005 Number 2, pp. 94

105 (www.mckinseyquarterly.com/links/19866).

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level of about 75 percent of cash flow to

90 percent (in line with the industry average

over the past decade), by 2010 worldwide

production and refining capacity would

rise by 10 to 15 percent of the current level,

in addition to the growth that is already

expected. Depending on how much demand

grows, a significant amount of this capacity

could be unused, leading to the familiar bust.

A further threat to oil and gas prices

comes from the rise of alternative fuelsand substitute technologies. The longer

crude prices and refining margins remain

high, the greater the incentive for outsiders

to invest in renewable generation, in

nonfossil fuels such as biodiesel, and in

hybrid-car technologyand the more

price-competitive these technologies

become as a result of scale effects.

Governments can also tilt the field toward

new technologies by providing incentives

for reducing carbon dioxide emissions.

Clearly, the industry faces more uncertain

than it has at any time in the past decade.

This uncertaintyand the accompanying

volatilitywill probably continue for

some time. Given these conditions, there

are three possible outcomes. In the first,

capital discipline could slip in the core

business while investment in alternative

technologies increased. The result would b

excess capacity and below-cost-of-capital

returns across the value chain. In the seco

scenario, the downturn might be limited t

refining and service areas such as shipping

since it is easier to add capacity there than

in exploration and production. Such an

outcome might lead to a softer landing of

adequate returns on capital in exploration

and production, where overinvestment is

less likely because exploration opportunit

are limited and often found in restricted

geographies, such as Iraq. In this scenario

exploration and production investments

might also benefit from OPECs support o

oil prices. The longer prices remain high,

however, the greater the opportunity for

overinvestmentand the worse the first tw

scenarios become. In the third scenario, th

whole industry could enjoy a soft landing

executives were to use discipline in placin

their bets and if investment in alternative

fuels were limited.

What will set the winners apart?

Faced with such uncertainty, how mightexecutives plot their strategies? First, they

need to move the focus of their discussion

with boards and investors beyond volume

based metrics such as market share and

reserves replaced. A preoccupation with

these measures increases the likelihood

of an indiscriminate capital expenditure

to meet a target. Instead, the emphasis

should be on the conditions needed for ne


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reserves to create value. Next, since the

industrys immediate outlook is sound, the

logical move would be to pursue investment

opportunities that benefit from high current

and likely near-term margins but do not

depend on permanent structural price shifts.

In an uncertain climate, executives should

also keep the following principles in mind:

Think for the long term. In current

conditions, oil companies should be ableto build positions that are competitive

under most market conditions. They can

invest, for example, in new technologies

and capabilities, in new territories (as

ExxonMobil has done in Qatar and

Schlumberger in Russia), and in the

booming markets of China and India.

To give themselves options down the

road, they should also invest enough in

less common types of oil, such as heavy

crude and tar sands, and in alternatives

to oil and gas, such as wind power, solar

power, and biofuels.9 These options, which

could be attractive if costs came down

significantly or higher prices and margins

were sustained, must be balanced against

their longer-term strategic positioning.

Sell high. With so much money

available, now is a good time to dispose

of disadvantaged assets at attractive

prices to buyers who might also be

better placed to exploit them. Sellers

can then redeploy their human and

financial capital to other investments.

Focus M&A. Companies should

avoid deals whose value relies on the

sustainability of high margins. Mergers of

equals, asset swaps, and the purchase of

capabilities are all relatively independent

of future market prices. In addition,

if companies understand the margin

assumptions embedded in their own

share price, they can selectively use their

shares for acquisitions when prices are in

line with these assumptions. Companies

might be able to pay high prices by using

the futures market, hedging near-term

production to justify the acquisitions,

and then keeping the assets as a long-

term play. They might also undertake

strategic acquisitions, including assets or

capabilities to support future business

building, to enter new geographies, or to

acquire expertise in alternative fuels.

Maintain capital discipline. Rather than

spend excess cash on projects that require

high prices and margins, executives should

use them to increase dividends or buy back

shareseven if this approach affects the

companys ability to replenish reserves

or to bolster market shareand resist

pressure from governments and consumers

9Ivo J. H. Bozon, Stephen J. D. Hall, and SveinHarald ygard, Whats next for Big Oil?TheMcKinsey Quarterly, 2005 Number 2, pp. 94

105 (www.mckinseyquarterly.com/links/19866).

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to invest more. When deciding between

share buybacks and increased or special

dividends, executives must take into

account the valuation of their companies

instead of considering only the boost

in earnings per share. They should also

develop a deep understanding of the way

cash flows evolve over the economic cycle,

so that they have the flexibility to seize

opportunities both when cash is plentiful

and when it is not (see Making capital

structure support strategy, in the

current issue).

During all oil price booms, it becomes

possible to imagine that the industrys

economics have changed forever. But

history shows that the point when industry

observers start to say that things are really

different this time around usually marks

the top of the cycle. By then, the seeds of

the crash to come have germinated. In the

current boom, companies at all stages of

the value chain need to maintain investme

discipline. Executives should use excess ca

to build sources of competitive advantage

while shifting the focus to measures of tru

value creation. They will then be equipped

to generate value in a highly uncertain

environment and to break the pattern of t

past 40 years. MoF

The authors wish to acknowledge the contribution

to this article of Andre Annema, John Bookout,

Jiri Maly, Matt Rogers, and Jeneiv Shah.


Richard Dobbs ([email protected]

and Nigel Manson (Nigel_Manson@McKinsey

.com) are partners in McKinseys London office, an

Scott Nyquist ([email protected]) is

a partner in the Houston office. Copyright 2006

McKinsey & Company. All rights reserved.

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Making capital structure support

strategy

A companys ratio of debt to equity should support its business

strategy, not help it pursue tax breaks. Heres how to get the

balance right.

Marc H. Goedhart,

Timothy Koller, and

Werner Rehm

CFOs invariably ask themselves two related

questions when managing their balance

sheets: should they return excess cash to

shareholders or invest it and should they

finance new projects by adding debt or

drawing on equity? Indeed, achieving the

right capital structurethe composition

of debt and equity that a company uses

to finance its operations and strategic

investmentshas long vexed academics

and practitioners alike.1 Some focus on the

theoretical tax benefit of debt, since interest

expenses are often tax deductible. More

recently, executives of public companies

have wondered if they, like some private

equity firms, should use debt to increase

their returns. Meanwhile, many companies

are holding substantial amounts of cash and

deliberating on what to do with it.

The issue is more nuanced than some

pundits suggest. In theory, it may be possible

to reduce capital structure to a financial

calculationto get the most tax benefits

by favoring debt, for example, or to boostearnings per share superficially through

share buybacks. The result, however, may

not be consistent with a companys business

strategy, particularly if executives add too

much debt.2 In the 1990s, for example,

many telecommunications companies

financed the acquisition of third-generation

(3G) licenses entirely with debt, instead of

with equity or some combination of debt

and equity, and they found their strategic

options constrained when the market fell.

Indeed, the potential harm to a companys

operations and business strategy from a bad

capital structure is greater than the potential

benefits from tax and financial leverage.

Instead of relying on capital structure to

create value on its own, companies should

try to make it work hand in hand with

their business strategy, by striking a balance

between the discipline and tax savings that

debt can deliver and the greater flexibility of

equity. In the end, most industrial companies

can create more value by making their

operations more efficient than they can with

clever financing.

Capital structures long-term impact

Capital structure affects a companys overall

value through its impact on operating cash

flows and the cost of capital. Since the

interest expense on debt is tax deductible in

most countries, a company can reduce its

after-tax cost of capital by increasing debt

relative to equity, thereby directly increasing

its intrinsic value. While finance textbooks

often show how the tax benefits of debt

have a wide-ranging impact on value, they

often use too low a discount rate for those

benefits. In practice, the impact is much

less significant for large investment-grade

companies (which have a small relevant

range of capital structures). Overall, the

value of tax benefits is quite small over

the relevant levels of interest coverage

(Exhibit 1). For a typical investment-gradecompany, the change in value over the range

of interest coverage is less than 5 percent.

The effect of debt on cash flow is less

direct but more significant. Carrying some

debt increases a companys intrinsic value

because debt imposes discipline; a company

must make regular interest and principal

payments, so it is less likely to pursue

1Franco Modigliani and Merton Miller, Thecost of capital, corporate finance, and the theory

of investment,American Economic Review,June 1958, Number 48, pp. 26197.

2There is also some potential for too little debt,though the consequences arent as dire.

Richard Dobbs and Werner Rehm, The valueof share buybacks,McKinsey on Finance,Number 16, Summer 2005, pp. 1620

(www.mckinseyquarterly.com/links/19864).

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frivolous investments or acquisitions that

dont create value. Having too much debt,

however, can reduce a companys intrinsic

value by limiting its flexibility to make value-

creating investments of all kinds, including

capital expenditures, acquisitions, and, just

as important, investments in intangibles

such as business building, R&D, and sales

and marketing.

Managing capital structure thus

becomes a balancing act. In our view, the

trade-off a company makes betweenfinancial flexibility and fiscal discipline

is the most important consideration in

determining its capital structure and

far outweighs any tax benefits, which

are negligible for most large companies

unless they have extremely low debt.4

Mature companies with stable and

predictable cash flows as well as limited

investment opportunities should include

more debt in their capital structure, since

discipline that debt often brings outweigh

the need for flexibility. Companies that fa

high uncertainty because of vigorous grow

or the cyclical nature of their industries

should carry less debt, so that they have

enough flexibility to take advantage of

investment opportunities or to deal with

negative events.

Not that a companys underlying capital

structure never creates intrinsic value;sometimes it does. When executives have

good reason to believe that a companys

shares are under- or overvalued, for exam

they might change the companys underly

capital structure to create valueeither b

buying back undervalued shares or by usi

overvalued shares instead of cash to pay f

acquisitions. Other examples can be foun

in cyclical industries, such as commodity

Making capital structure support strategy

4At extremely low levels of debt, companies cancreate greater value by increasing debt to more

typical levels.

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chemicals, where investment spending

typically follows profits. Companies investin new manufacturing capacity when

their profits are high and they have cash.5

Unfortunately, the chemical industrys

historical pattern has been that all players

invest at the same time, which leads to

excess capacity when all of the plants

come on line simultaneously. Over the

cycle, a company could earn substantially

more than its competitors if it developed a

countercyclical strategic capital structure

and maintained less debt than mightotherwise be optimal. During bad times,

it would then have the ability to make

investments when its competitors couldnt.

A practical framework for developing

capital structure

A company cant develop its capital

structure without understanding its future

revenues and investment requirements. Once

5Thomas Augat, Eric Bartels, and Florian Budde,

Multiple choice for the chemical industry,The McKinsey Quarterly, 200 Number ,pp. 1266 (www.mckinseyquarterly.com/

links/19865).

8/14/2019 MoF Issue 18

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those prerequisites are in place, it can begin

to consider changing its capital structure in

ways that support the broader strategy. A

systematic approach can pull together steps

that many companies already take, along

with some more novel ones.

The case of one global consumer product

business is illustrative. Growth at this

companywell call it Consumercohas

been modest. Excluding the effect of

acquisitions and currency movements, itsrevenues have grown by about 5 percent a

year over the past five years. Acquisitions

added a further 7 percent annually, and

the operating profit margin has been

stable at around 14 percent. Traditionally,

Consumerco held little debt: until 2001,

its debt to enterprise value was less than

10 percent. In recent years, however, the

company increased its debt levels to around

25 percent of its total enterprise value in

order to pay for acquisitions. Once they

were complete, management had to decid

whether to use the companys cash flows,

over the next several years, to restore its

previous low levels of debt or to return ca

to its shareholders and hold debt stable at

the higher level. The companys decision-

making process included the following ste

1. Estimate the financing deficit or surplus

First, Consumercos executives forecastthe financing deficit or surplus from its

operations and strategic investments

over the course of the industrys busine

cyclein this case, three to five years.

In the base case forecasts, Consumerco

executives projected organic revenue

growth of 5 percent at profit margins o

around 14 percent. They did not plan f


8/14/2019 MoF Issue 18

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any acquisitions over the next four years,

since no large target companies remain in

Consumercos relevant product segments.

As Exhibit 2 shows, the companys cash

flow after dividends and interest will be

positive in 2006 and then grow steadily

until 2008. You can see on the right-hand

side of Exhibit 2 that EBITA (earnings

before interest, taxes, and amortization)

interest coverage will quickly return to

historically high levelseven exceeding

ten times interest expenses.

2. Set a target credit rating. Next,

Consumerco set a target credit rating

and estimated the corresponding

capital structure ratios. Consumercos

operating performance is normally stable.

Executives targeted the high end of a

BBB credit rating because the company,

as an exporter, is periodically exposed

to significant currency risk (otherwise

they might have gone further, to a low

BBB rating). They then translated the

target credit rating to a target interest

coverage ratio (EBITA to interest

expense) of 4.5. Empirical analysis

shows that credit ratings can be modeled

well with three factors: industry, size,

and interest coverage. By analyzing other

large consumer product companies, it

is possible to estimate the likely credit

rating at different levels of coverage.

3. Develop a target debt level over the

business cycle. Finally, executives set

a target debt level of 5.7 billion for2008. For the base case scenario in the

left-hand column at the bottom half of

Exhibit 2, they projected 1.9 billion

ofEBITA in 2008. The target coverage

ratio of 4.5 results in a debt level of

8. billion. A financing cushion of spare

debt capacity for contingencies and

unforeseen events adds 0.5 billion, for a

target 2008 debt level of 7.8 billion.

Executives then tested this forecast

against a downside scenario, in which

EBITA would reach only 1.4 billion

in 2008. Following the same logic,

they arrived at a target debt level of

5.7 billion in order to maintain an

investment-grade rating under the

downside scenario.

In the example of Consumerco, executives

used a simple downside scenario relative to

the base case to adjust for the uncertainty

of future cash flows. A more sophisticated

approach might be useful in some industries

such as commodities, where future cash

flows could be modeled using stochastic-

simulation techniques to estimate the

probability of financial distress at the

various debt levels illustrated in Exhibit .

The final step in this approach is to

determine how the company should move to

the target capital structure. This transition

involves deciding on the appropriate mix of

new borrowing, debt repayment, dividends,

share repurchases, and share issuances over

the ensuing years.

A company with a surplus of funds, such

as Consumerco, would return cash to

shareholders either as dividends or share

repurchases. Even in the downside scenario,

Consumerco will generate 1.7 billion of

cash above its target EBITA-to-interest-

expense ratio.

For one approach to distributing thosefunds to shareholders, consider the dividend

policy of Consumerco. Given its modest

growth and strong cash flow, its dividend

payout ratio is currently low. The company

could easily raise that ratio to 45 percent

of earnings, from 0 percent. Increasing the

regular dividend sends the stock market a

strong signal that Consumerco thinks it can

pay the higher dividend comfortably. The

8/14/2019 MoF Issue 18

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remaining 1. billion would then typically

be returned to shareholders through share

repurchases over the next several years.

Because of liquidity issues in the stock

market, Consumerco might be able to

repurchase only about 1 billion, but it

could consider issuing a one-time dividend

for the remainder.

The signaling effect6 is probably the most

important consideration in deciding between

dividends and share repurchases. Companies

should also consider differences in the

taxation of dividends and share buybacks,

as well as the fact that shareholders

have the option of not participating in a

repurchase, since the cash they receive must

be reinvested.

While these tax and signaling effects are

real, they mainly affect tactical choices

about how to move toward a defined long

term target capital structure, which shoul

ultimately support a companys business

strategies by balancing the flexibility of

lower debt with the discipline (and tax

savings) of higher debt. MoF

Marc Goedhart ([email protected]

an associate principal in McKinseys Amsterdam of

Tim Koller ([email protected]) is a part

and Werner Rehm ([email protected]

a consultant in the New York office. Copyright 2McKinsey & Company. All rights reserved.

6The markets perception that a buyback

shows how confident management is that thecompanys shares are undervalued, for example,or that it doesnt need the cash to cover future

commitments, such as interest payments andcapital expenditures.

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Better cross-border banking mergers in Europe

harmonization of retail products and

services across European countries. But

the extent to which these factors prevent

acquiring banks from extracting cost

efficiencies is likely to be small, given

the domestic nature of retail banking.

Although bank secrecy, data protection,

and outsourcing laws may be more

complex when institutions operate across

borders, there is evidence that these

obstacles are not insurmountable.

If the transaction and efficiency barriers

specific to cross-border deals cannot explain

the value gap, what does? The answer lies in

the actions of national regulatory authorities,

unions, and incumbent managementand,

more specifically, in the way foreign

acquirers react to them. These measures

represent potentially serious impediments

to improved performance in all types of

deals. Typical steps by national stakeholders

include implicit threats (real or perceived)

against foreign acquirers in order to

frustrate any subsequent restructuring or to

limit access to local opportunities.

The responses to such behavior in the ten

completed transactions we examined reveal

a pattern. The acquirers management, in

an effort to maintain good relations with

local stakeholders, often entered into lengthy

and complex negotiations that ultimately

guaranteed the status quo at the target

bank, thus severely curtailing the acquirers

freedom to integrate it and to generate

stand-alone performance improvements.Such voluntary agreements covered issues

such as future head counts, the composition

and size of local management teams, the

continuation of bank sub-brands, and a

rigid commitment to the structure of the

regional headquarters.

Acquirers have not provided similar

guarantees to banks in Central and Eastern

Europe, where cross-border takeovers hav

been much more successful. In general,

such guarantees are uncommon there

because these countries have generally

welcomed foreign capital and recognized

the importance of banking skills to the

development of their markets.

Before this year, evidence had already

indicated that a tougher approach could p

off. When the Portuguese regulator wante

to use the prudence test to block Banco

Santander Central Hispanos fiercely resis

bid for Mundial Confianca, in 1999, the

Spanish bank promptly filed a complaint

with the European Commission. Thanks

to the pressure this move created, BSCH

was subsequently able to acquire Totta, a

subsidiary of Mundial Confianca. The tim

has come for other acquirersheartened

by the tougher attitude of the European

Commission and by recent events in

Germany and Italyto negotiate firmly,

thereby ensuring that banks can extract th

full value of cross-border deals.

ABN Amro, for instance, didnt back

down when the Bank of Italy opposed

the companys original bid for Banca

Antonveneta. Such tactics clearly

caught the attention of the Brussels

authorities, the international media,

and the European financial community

in general. Elsewhere, the terms of

UniCreditos pending offer for Germanys

HypoVereinsbank, put forth in the summ

of 2005, do not seem unduly restrictive.

Given experience and very recent events,

a future acquirer could choose to take a

tougher approach by informing a targets

management that voluntary guarantees of

the kind that marked previous deals are

unacceptable. Moreover, when manageme

is reluctant to provide general information

about market and operational risksor

8/14/2019 MoF Issue 18

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about the loan book, in particularthe

acquirer could mobilize other stakeholders

(such as shareholders and the press) or

sympathetic regulators. A bank could also

appeal to outside opinion, though any tough

stance should be accompanied by a clear

willingness to work with the regulatory body.

That said, unsolicited bids have a greater

chance of succeeding when the target is

perceived to be weak and the acquirer

strong. Shareholders in such cases will be

more inclined to sell, the potential for value

creation will be greater, and nationalistic

forces will be less likely to defend a badly

managed institution. MoF

The author would like to thank Guy Morton of

Freshfields Bruckhaus Deringer for his contribution to

this article.

Philipp Hrle ([email protected]) is

a partner in McKinseys Munich office. Copyright

2006 McKinsey & Company. All rights reserved.

8/14/2019 MoF Issue 18

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Data focus:

A long-term look at ROIC

Finance theory isnt enough when companies set their expectations

for reasonable returns on invested capital. A long-term analysis of

market and industry trends can help.

Bin Jiang and

Timothy Koller

Savvy executives know that the

decision to invest in a project often hangs

on reasonable expectations of its return

on invested capital. But what constitutes

reasonable? Companies that rely on the

wrong benchmark can overlook good

investments or pursue bad ones. We find t

empirical analyses ofROICsparticularly

those illustrating industry-specific pattern

over timecan help executives ground th

expectations in the collective long-term

experience of other companies.

We analyzed the ROIC histories of about

7,000 publicly listed nonfinancial US

companies from 196 to 2004. These

companies had revenues of more than

$200 million in 200 dollars, adjusted

for inflation. Our sample included active

companies as well as companies that were

8/14/2019 MoF Issue 18

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acquired or dissolved, and we looked at

patterns that both included and excluded

goodwill. The revenues of the companies

we studied account for 99 percent of those

of all nonfinancial US publicly traded

companies in 2004, or some 82 percent if

financial ones are included. Our work had

several key findings.

First, the average US company has returned

its cost of capital over time. From 196

to 2004, the US markets median ROIC,

excluding goodwill, averaged nearly

10 percent. That level of performance was

relatively constant and in line with the long-

term cost of capital (Exhibit 1). The stable

median ROIC may reflect a balance between

investment and consumption. Companies

that drive innovations in technology or

business systems may earn above-average

returns initially, but competition eventually

compels most businesses to pass the savings

along to consumers.

Second, historical ROICs can vary widely

by industry. In the United States, the

pharmaceutical and consumer packaged-

goods industries, among others, have

sustainable barriers, such as patents and

brands, that reduce competitive pressure

and contribute to consistently high ROICs.

Conversely, capital-intensive sectors (such

as basic materials) and highly competitive

sectors (including retailing) tend to generate

low ROICs.

These differences in the way industries

perform havent changed substantially

over time. In Exhibit 2, the ROIC ranking,

based on the ranking for 196 to 2004 as

a whole, largely mirrors the average for

the period from 1995 to 2004. In general,

the persistence of differences in ROIC

across sectors suggests that individual

companies should be benchmarked

against comparable ones operatingin similar or adjacent industries.

Finally, we found that the median or

mean returns of general, broadly defined

industry groups can be downright

misleading. Executives who look at the

mean or median ROIC of an industry

without understanding the distribution

ofROIC performance within it may not

8/14/2019 MoF Issue 18

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the industrys performance was so uneven

as to render this metric meaningless. Thes

wide variations suggest that the industry

comprises many distinct subgroups that

have very different structures and are sub

to very different competitive forces. To fo

reasonable expectations, it is often necess

to dig down to more refined subindustry

groupings. By contrast, the utility industry

median ROIC is only 7 percent, but

the spread from the best to the worst

companies is a slim 2 percent. Any execut

encountering projected returns outside th

of this relevant benchmark industry range

would do well to look on those forecasts

with a gimlet eye. MoF

Bin Jiang ([email protected]) is a consul

in McKinseys New York office, where Tim Koller

([email protected]) is a partner. Copyrig

2006 McKinsey & Company. All rights reserved

Data focus: A long-term look at ROIC

have sufficient information to assess a

company or to project its ROIC accurately.

Indeed, intra-industry differences are

sometimes far more dramatic than those

among sectors (Exhibit ). Take the software

and services industry. Its median ROIC

from 196 to 2004 was 18 percent, but the

spread between the top and bottom quartile

of companies averaged 1 percent. In fact,

8/14/2019 MoF Issue 18

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Index of articles, 20042005

Previous issues can be downloaded from McKinsey & Companys Web site at

www.corporatefinance.mckinsey.com. Individual articles are available to McKinsey Quarterly

subscribers at www.mckinseyquarterly.com. A limited number of past issues are available in

hard copy; please send a request by e-mail to [email protected].

Number 17, Autumn 2005

Measuring stock market performance

Reducing the risks of early M&A

discussions

Smoothing postmerger integration

Comparing performance when invested

capital is low

What global executives think about

growth and risk

Number 16, Summer 2005

Measuring long-term performance

Viewpoint: How to escape the short-term

trap

The view from the boardroom

The value of share buybacks

Does scale matter to capital markets?

Number 15, Spring 2005

Do fundamentalsor emotionsdrive the

stock market?

The right role for multiples in valuation

Governing joint ventures

Merger valuation: Time to jettison EPS

Number 14, Winter 2005

Outsourcing grows up

Finance 2.0: An interview with

Microsofts CFO

The hidden costs of operational risk

The right passage to India

Number 13, Autumn 2004

The right restructuring for US automotive

suppliers

Agenda of a shareholder activist

When payback can take decades

The scrutable East

Number 12, Summer 2004

Private equitys new challenge

A new era in corporate governance reform

Can banks grow beyond M&A?

Internal rate of return: A cautionary tale

Taming postmerger IT integration

Number 11, Spring 2004

High techs coming consolidation

When efficient capital and operations go

hand in hand

All P/Es are not created equal

Putting value back in value-based

management

Number 10, Winter 2004

Where mergers go wrong Running with risk

The CFOs central role

What is stock index membership worth?

Why the biggest and best struggle to grow

Investing when interest rates are low

8/14/2019 MoF Issue 18

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8/14/2019 MoF Issue 18

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