Category: Investing

Corporate Finance and Sustainability

The Case of the Electric Utility Industry

In our last article from the (JACF Winter issue) we discuss how although the electric utility industry is in transition, it still needs to move faster for the country to meet its emissions goals. The industry has historically moved cautiously, but policies and regulatory approaches must avoid unintentionally reinforcing the status quo. Incentive-oriented policies and redesigned regulations must balance environmental sustainability with economic sustainability. The authors draw on well-established corporate finance principles to guide more effective policies. Shareholder-focused utility executives must make investments conditioned by three elements: (1) the return on equity the utility can expect to make on each project; (2) the investors’ required return on equity capital for each project; and (3) the size of the investment.

The well-established economic value added (EVA) model can assist policy analysis: V=(r-k)I; where V is the shareholder value created, r is the return on equity, k is the return investors require if they are to invest in the stock, and I is the scale of the project. Any new incremental V translates into higher stock prices.

All three elements of their model (i.e., risk, return, and scale) require attention by regulators and policymakers to create value for shareholders. The authors show how the right state policies could create powerful incentives for shareholder focused utility executives to support such transitions.

Authored by Steven Kihm, Seventhwave; Peter Cappers, Lawrence Berkeley National Laboratory; Andrew Satchwell, Lawrence Berkeley National Laboratory; and Elisabeth Graffy, Arizona State University

Clawbacks, Holdbacks, and CEO Contracting

Clawbacks” are much discussed in the context of senior executive compensation

“Clawbacks” are much discussed in the context of senior executive compensation, yet the discussion has largely ignored the presence of holdbacks that are already in place in many firms. Holdbacks are deferred compensation that is potentially foregone in the event that the CEO leaves the firm without good reason or they are dismissed for wrong-doing. They are explicit or written features of a CEOs employment contract, as Stuart Gillan writes in the sixth article of the Winter 30.1 issue.

Holdbacks are already in use at 70% of S&P 500 firms and average $18.4 million each. Firms with higher CEO replacement costs, greater information asymmetry, a recent bad experience (fraud, lawsuit, or restatement), or in more certain environments are more likely to have a holdback. In contrast, clawback adoptions are mainly driven by firms’ bad experiences and external pressure from shareholders. Holdbacks and incentive-based compensation are substitutes, as termination incentives can reduce the need for incentive compensation. As managers reasonably demand a premium for accepting risky compensation, a measure of abnormal compensation is positively associated with holdbacks, but there is no significant association between clawbacks and holdbacks.

These findings suggest that the holdbacks many firms already have in place could help an “ex-post settling up” in the event of financial misconduct, or even simply misstated financials. As companies have more control over the amounts held back ex-ante, holdbacks are potentially more efficient.

Authored by Stuart Gillan, University of Georgia, and Nga Nguyen, Marquette University

Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy

Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy

In our third article of the Winter 30.1 issue we look at whether logically, the practice of corporate finance and corporate strategy should be closely coordinated, but in reality there remains a massive gap between the two. This can lead strategically oriented firms to de-emphasize or even discard NPV. Neither financial theory nor competitive strategy has been very open to the economic value of investment opportunity capture. Strategy must recognize that financial flexibility provides powerful advantages and financial theory must evaluate entire strategic programs rather than discrete, stand-alone projects.

Necessarily, the financial discussion of cost of capital and capital structure has to change. The authors offer two specific concepts to bridge the Gap between Finance and Strategy:

1) Reserve Financial Capacity is the annual sum of Free Cash Flow, Financing Flexibility and Cash Reserves over the period envisioned for strategy execution. Individual projects must belong to strategic programs in the sense that they either: 1) keep the base business running; 2) preserve an existing competitive position; or 3) form part of a program to enhance advantage or fashion a strategic breakout.

2) Strategically Sustainable Cost of Capital is the true, blended cost of capital required to complete an entire capital program.

These concepts provide financial rigor to firms with well-defined strategies and allow managements to wield Financial Flexibility as a strategic weapon, creating options on unique buying opportunities, such as at the bottom of industry cycles. The paper includes flowcharts illustrating how the standards of judicial review apply to various categories of business decisions that directors may have to make. It concludes with practical suggestions for directors and General Counsels to establish business judgment rule protection for board decisions or, where applicable, withstand more stringent standards of review.

Authored by Stephen V. Arbogast, Kenan-Flagler Business School, University of North Carolina at Chapel Hill and Dr. Praveen Kumar, C.T. Bauer College of Business, University of Houston.

Are U.S. Companies Underinvesting? Fall 2014 issue

The theme of our Fall 2014 issue of the Journal of Applied Corporate Finance is Are U.S. Companies Underinvesting?

In a letter he sent out to CEOs of the 500 largest companies in the U.S., Laurence D. Fink, head of BlackRock, the world’s largest asset manager, argued that too many of them have been returning capital to shareholders via dividends and share repurchases rather than reinvesting in their companies.

Fink blames activist investors for pushing management to pay out cash rather than investing for long-term value creation: “The effects of the short-termist phenomenon are troubling both to those seeking to save for long-term goals such as retirement and for our broader economy.”

Current corporate financial policies come at the expense of “innovation, skilled work forces or essential capital expenditures necessary to sustain long-term growth,” according to Fink.

During my 30-plus years as editor of the Journal of Applied Corporate Finance, I can’t think of a time when U.S. public companies were not being widely criticized for “underinvesting,” for failing to devote enough of today’s profits to increasing tomorrow’s earnings and value.

And yet, as Floyd Norris recently pointed out in his New York Times column, Misreading the Lessons From Financial Crises the stock returns of U.S. companies during the 36-year period since 1978 have been the best in American history.

In 2013 the average corporate return on invested capital for the largest 1,500 U.S. non-financial public companies reached its highest level in the last 60 years.

In our Fall 2014 issue you will find a roundtable discussion, “Capital Deployment Roundtable,” which reports that in 2013 the average corporate return on invested capital for the largest 1,500 U.S. non-financial public companies reached its highest level in the last 60 years.

For these and other discussions on U.S. corporate underinvesting, click here to purchase and download articles from our Fall 2014 issue. Don Chew, Editor.