The decision to buy back stock is an integral part of a broader set of considerations regarding a firm’s capital structure, and it’s a fairly disciplined process. Treasury most often leads this process. For those that do, capital structure is one of treasury’s more important strategic contributions to a corporation’s financial value.
Norfolk Southern is one such company, announcing it would boost share buybacks in 2015. The railway operator intends to triple its current amount, after buying back $218 million in the second half of 2014.
Based on interviews with treasury practitioners, AFP collected the following 12 pointers on the process of deciding an organization’s capital structure.
Start by looking at your company’s capital needs. Capital structure is driven by the firm’s need for capital and its business strategy. The ultimate goal of the capital structure is to support the company’s business strategy. When looking at capital allocation consider the following factors:
- Organic growth
- Returning cash to shareholders.
Consider the amount of minimum liquidity required to finance these needs. This will determine the construction of your company’s balance sheet. Many companies calculate a basic amount of liquidity they require, including access to contingent capital such as bank lines, capital markets (term debt, convertibles and CP).
Run this liquidity level through “what if” shock scenarios. For example, what would happen if there were a 20 percent to 30 percent drop in business activity (assuming still positive cash flow)? Use the stress test to arrive at a final liquidity figure.
Decide whether there is an optimal credit rating that would guarantee your company access to the capital markets should the need for additional liquidity arise. Maintain the balance sheet required to keep the desired rating. Work with rating agencies to define financial ratios and discuss capital planning. Remember that the fewer surprises the better. The credit rating is not important in itself; it is the access it provides that matters. Investment grade companies have a lot more flexibility using tier-1 CP markets, for example, even if their “optimal” capital structure in terms of minimizing WACC is BBB.
Consider the following factors as they relate to your organization:
- Business risk, i.e., is your company in a volatile business that has unexpected cash flow needs and faces potential threats from competitors? If so, your company may need a bigger liquidity cushion even if that means a suboptimal WACC.
- Financial risk, i.e., does your company have enough cash and cash equivalent on hand to handle operations, growth and potential acquisitions? If not, can it easily access such funds?
- If access to additional funds is non-existent, what structure does your company need to put in place to create the financial flexibility its business requires?
- What are the needs of the various constituents within the capital structure universe: shareholders, bondholders, employees?
Consider how to maximize firm value through earnings per share or cash flow per share. As the perception of risk in the company drops, valuation rises—increasing value to shareholders.
Devise a clearly defined decision-making framework to share with the board and senior management that could guide specific liquidity scenarios. Having a framework puts discipline around the process and shows management that treasury is thoughtful and methodical rather than arbitrary in its decision-making process. Having a framework also means that capital structure decisions are not made on the fly as market conditions change but within the context of the company’s business and capital allocation needs.
Run this framework by industry peers to see what others are doing. “You don’t want to be an outlier,” as one treasurer put it.
Educate others within treasury as well as finance partners like tax. It’s important to get everyone in the organization to buy into the framework so that the company follows a cohesive path as its goes through business cycles.
Get buy-in from the board.
Issue debt considering market conditions. Tier-1 CP may be the cheapest alternative and has proven a reliable source of funding even in times of crisis, but it has limited capacity and carries refinancing risk. Market conditions are conducive to term debt, particularly for investment-grade companies. Companies worried about interest coverage ratios may choose converts instead. Don’t issue debt unless your company has a use for the funds. Issuing at 2 percent sounds great but sitting on cash earning 20 bps burns a hole in the balance sheet.
Finally, decide how to return excess cash to shareholders: There are arguments on both sides including tax benefits and flexibility. Many of them tilt the scales in favor of buybacks.For more guidance on capital structure, click here.