Choosing between debt reduction and share repurchase as a use for excess cash wouldn’t be a cut-and-dried matter of arithmetic even if companies didn’t have to worry about bankers’ conditions or credit ratings. That’s because it’s far more difficult to accurately estimate the cost of equity than that of debt. The appropriate risk premium to be added to the price of equity has long been subject to debate, whereas the premium for debt is widely accepted to be the spread between its current interest rate and that on comparably termed Treasuries. “The theoretical models will tell you that the optimal credit rating is right below investment grade,” Dana’s Richter concedes. But he notes that in reality, access to capital is more limited at that level, and such access “is worth more than a few basis points” in terms of the cost of capital. As a result, says Richter, “our objective is to get back to investment grade.”
That’s why Dana plans to use much if not most of the $1.1 billion it earned from its July 9 sale of its replacement- parts business to The Cypress Group, a New York-based private-equity group, to pay down debt and fund its pension plan instead of repurchasing shares. The remainder of the proceeds will be devoted to reinvestment in Dana’s core manufacturing business and to “bolt-on” acquisitions.
As for spending cash on acquisitions, there’s plenty of risk that a deal will produce less than what a company has earned in the past. Yet managers seem increasingly confident that they can effectively deploy excess cash in new investments. The value of M&A activities worldwide increased 37 percent during the first six months of this year, with more companies using cash rather than stock to fund the deals.
Varian, for instance, plunked down $18 million in cash last March for OpTx, a supplier of oncology-practice software, and expects the acquisition to add $9 million to its annual revenues. That deal followed by three months a $35 million cash deal for Zmed Inc., a medical-device and-software company. Finney says Varian is looking to do more such acquisitions, describing them as “our number-one priority.” The trouble is, she says, it’s not easy for Varian to find good acquisition opportunities in light of the 50 percentplus market shares it currently possesses in its two main markets, radiation oncology and brachytherapy.
New opportunities also seem to be appearing in the battered telecom industry. In June, SBC Communications Inc., the regional Bell giant, announced plans to spend up to $6 billion during the next five years on a new fiber-optic network. A few months earlier, in one of the biggest deals of the year, Cingular Wireless LLC, a joint venture between SBC and BellSouth Corp., acquired AT&T’s wireless division for $41 billion in cash. An SBC spokes-person says such moves reflect management’s recognition that SBC needs to invest in new technology to remain competitive. But the moves also reflect the fact that SBC’s cash has risen from 1.5 percent of sales in 2001 to 12.7 percent in 2003 (compared with 9.7 percent for its industry average) and from 3 percent of its debt to 28 percent over the same period.