1. Estimate the financing deficit or surplus. First, Consumerco’s executives forecast the financing deficit or surplus from its operations and strategic investments over the course of the industry’s business cycle — in this case, three to five years.
In the base case forecasts, Consumerco’s executives projected organic revenue growth of 5 percent at profit margins of around 14 percent. They did not plan for any acquisitions over the next four years, since no large target companies remain in Consumerco’s relevant product segments. As Exhibit 2 shows, the company’s 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 levels even 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. Consumerco’s 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 for 2008. For the base case scenario in the left-hand column at the bottom half of Exhibit 2, they projected €1.9 billion of EBITA in 2008. The target coverage ratio of 4.5 results in a debt level of €8.3 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 3.
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 those funds 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 30 percent. Increasing the regular dividend sends the stock market a strong signal that Consumerco thinks it can pay the higher dividend comfortably. The remaining €1.3 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 effect 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 should ultimately support a company’s business strategies by balancing the flexibility of lower debt with the discipline (and tax savings) of higher debt.
About the Authors
Marc Goedhart is an associate principal in McKinsey’s Amsterdam office; Tim Koller is a partner and Werner Rehm is a consultant in the New York office.