Corporate Finance Project

Research on Computer Industry

Corporate Finance May 4, 1998
Takeshi Aoki Richard A. Gryziak Koji Hikosaka Hiroyuki Sato Yuji Tokunaga Christine E. Whitney

Corporate Finance Project - Computer Industry

Executive summary We chose the computer industry for our project. We picked five hardware companiesCompaq, Hewlett Packard, Hitachi, IBM, and Unisys – and one software companyOracle- for our analysis. Corporate Governance According to our analysis, we found that all of our chosen companies, except for Hitachi, have good systems of corporate governance. We have concluded that Hitachi’s corporate governance is weak, which is a general characteristic of the Japanese style of management. However, its large debt adds discipline to its management due to monitoring by its lenders. We also found some general characteristics in the computer industry. First, the larger the company, the more attentive it is to its stockholders. Second, in a fast-growing company such as Oracle, it is usual that CEO is one of the founders of the company. This type of company gradually transforms itself into a larger-type firm, such as IBM, and becomes more attentive to its stockholders as it matures. Risk and Return In the risk analysis section, we observed that high-risk companies, such as Unisys, have larger betas and higher costs of equity. As a result of our calculations, we estimated each company’s hurdle rate as follows:
Cost of Equity Cost of Capital Compaq 15.55% 15.55% HP 15.79% 15.16% Hitachi 8.04% 5.14% IBM 13.88% 12.37% Oracle 12.22% 11.94% Unisys 17.58% *12.41%

* Unisys’s cost of capital includes preferred stock. We then compared each company’s ROE with Cost of Equity and ROC with Cost of Capital. Compaq, HP, IBM and Oracle have all achieved excess returns in ROE, but only Compaq and Oracle have excess returns in ROC. This phenomenon led us to the conclusion that Compaq and Oracle generally chose good projects, while HP and IBM are not always as successful. However, HP and IBM return their excess cash the stockholders by paying stable dividends and stock buybacks. Optimal Capital Structure Generally speaking, the debt ratio in the computer industry (12%) is relatively lower than that in other industries. Considering our chosen companies, mature ones such as IBM and Unisys have higher debt ratios, while fast-growing companies, such as Oracle and Compaq, have lower ones. After our analysis, we reached the following optimal debt ratios and paths to the optimal.

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Corporate Finance Project - Computer Industry
Compaq 0.00% 20.00% HP Hitachi 5.68% 42.99% 20.00% 40.00% IBM 15.91% 30.00% Oracle 3.99% 5.00% Unisys 37.49% 20.00%

Current Optimal

Hitachi and Oracle have already realized their optimal financing mix. As for HP and IBM, their debt ratios are lower than the optimal, so they need to increase debt ratios by buying back their stock, which they did recently. Compaq’s debt ratio is lower than the optimal, so Compaq needs to issue short-term debt (based on the duration coming from the regression analysis) in a mix of currencies, because the structure of debt should reflect the mix of the revenues from each country. Compaq’s acquisition of DEC will lead Compaq’s debt ratio to increase, but we believe the company still has some excess debt capacity. Unisys has to decrease its debt ratio immediately by selling assets and renegotiating with lenders. The company is in the process of restructuring its businesses and its finances in an effort to come to terms with this situation. Dividend Policy In summary, the dividend policies of companies in the computer industry are such that they do not generally pay many dividends. In the companies we analyzed, the rule of thumb is that for growth companies, the policy is to not pay dividends. For more mature companies, dividends are one of the ways for returning cash to investors. We found that growing companies such as Compaq and Oracle do not pay dividends at all because of the need of the financing flexibility they require to take advantage good investment opportunities. It is also the case that stockholders in growing companies do not expect dividends and would prefer cash returned to them in the form of buybacks. More mature companies, such as HP, Hitachi and IBM, do pay dividends. Valuation Based on our analysis in each section, we chose the valuation model for each company as follows. Judging from the low average payout ratio, we should not use the dividend discount model because the current dividend payout does not show the real value of the companies. Therefore, we chose Free Cash Flow models. Except for Compaq, we used FCFE models because they do not have plans to change their capital structure significantly. Since Hitachi’s current growth rate is low and it is a mature company, a 1stage FCFE model was chosen. On the other hand, a 2-stage FCFE model is appropriate for HP, IBM, and Unisys because we believe their lengths of faster growth periods would be 5 years. In addition, we selected a 2-stage FCFF model for Compaq because we concluded that the company’s capital structure should move from the current debt ratio of 0% to the optimal of 20%. Finally, we reached the following result of our valuation.
Valuation Current Price Compaq 33.71 28.25 HP 51.57 61.63 Hitachi 916.08 959.00 IBM 106.02 104.63 Oracle 32.05 31.08 Unisys 10.83 13.88

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HP is a family-owned company. the top managers have been compensated extraordinarily well over the past several years. Take the case of Compaq. Overall. The board of directors consists of only insiders. This is known as “keiretsu”. From this analysis.Computer Industry I. In these companies. When we turn our eyes to the CEOs’ compensations for our companies. whose board was recognized for excellence by the Wharton School of the University of Pennsylvania. the board of directors of both Compaq and IBM are ranked as the 3rd and 5th best boards in the U. In the case of Hewlett Packard and Oracle. and the others appear to be independent of the company.. the more attentive it is to its stockholders. Corporate Governance Analysis A. Like other Japanese companies. However. the larger the company. the management has strong power compared to the other companies. The incumbent management is often observed in Japan. Firstly. the largest electrical company in Japan. in a fast-growing company such as Oracle. On the other hand. Secondly. Management and Stockholders Balance of Power Balance of Power IBM Compaq Unisys HP Oracle Hitachi Stockholders Incumbent Managers As shown above. It is doubtful that their corporate governances work as comparatively well here. where management cares only about how there own companies are run. do we see management and ownership that are very clearly separated. because Japanese companies usually hold their stocks only in each other’s companies. such compensations clearly come from the recent growth in earnings of the computer industry. five of our six companies pay attention to their stockholders. It is clear Compaq’s management is responsive to its stockholders. Hitachi’s management appears not to be attentive to its stockholders. respectively. In fact. it is usual to find that the CEO is generally the founder of the 3 .Corporate Finance Project . Business Week and the CEO Report. The Compaq Corporate Governance Committee has also played an important role in keeping the good relationship between the management and the stockholders. according to the Business Week annual survey. only with Hitachi. while the CEO of Oracle is a co-founder of the company.S. management power is stressed by the fact that there are only a few insider directors and the companies have established a record of good corporate governance. it may appear at first glance that management neglected the stockholders to line their own pockets through misappropriating stockholders' money. there are some general characteristics we can draw from examination of the computer industry. Only two of the ten directors on the board are insiders.

743 19.725 N/A N/A 587 415 1.500 4.Corporate Finance Project .250 3. 4 .513 8 3 1 11 1 4 B.189 2. According to Zacks. with the one exception being Hitachi.796 29.200 2. While each company provides substantial amounts of information in the form of financial statements. Lawrence Ellison Lawrence Weinbach 6 years 5 years 21 years 1 year N/A N/A N/A N/A N/A N/A 1.760 3.046 6 15 0. Firm and Financial Markets Source of Information Oracle IBM HP Compaq Hitachi Unisys The Firm External Sources Company Monthly Trading Analy # of Compaq $ 350 million 34 HP $ 72 million 27 Hitachi N/A N/A IBM $ 210 million 21 Oracle $ 184 million 31 Unisys $28 million 10 As reflected above. Both facts lead us to expect less bias in the information that is available about these four firms. these stocks trade frequently in these companies.7 10 2 4 0.4 12 1 0 22.460 14 51 1. and Oracle are well-followed firms.192 1.500 2.03 22.638 184 1. In addition. IBM.000 1.800 6. the power between stockholders and managers are relatively balanced. Stock trades for each company amount to more than $1 million monthly on average. Hewlett Packard. This kind of company gradually moves to the position of the larger firms such as IBM and Compaq. Compaq. there are more than 20 analysts who follow these companies.37 5.Computer Industry company.200 10.3 0.04 20 14 3 4 N/A N/A 32 32 0 0. which become more attentive to the stockholders as they mature. It is concluded that from our examples.02 3.582 38 217 Hitachi IBM Oracle Unisys Tsutomu Kanai Louis Gerstner.000 24. Industry Average CEO Name How long Compensation Salary ($ thou) Bonus ($ thou) Other ($ thou) Total ($ thou) Ranks in industry Ranks among 800 exec Stock owned % total Market Value ($ mil) Board of Directors # of directors # of insider directors # of the directors who are CEOs of other companies Compaq Eckhard Pfeiffer 7 years HP Lewis Platt 5 years 1. Jr.074 10 26 1.700* 2.19 11.331 16. many analysts and investors actively monitor the movement of these stock prices.

Firms and Society Social Consciousness and Image Factors All of the 6 firms here Very Low Very High All companies in our analysis are committed to conducting their businesses in a manner that is compatible with the environment and protecting the quality of the communities where they operate. Unisys. we can easily recognize that the management believes that business must work in partnership with suppliers. Secondly. there seems to be a little bias in the information available. while being a relatively low-profile company. biased information is not beneficial for the companies in the long-term. The SLC provides training to elementary school teachers in ways to incorporate Internet and WWW technology into their classes. provides much needed services to a large number of companies and government organizations. In the future. These communities expect their hometown profitable companies to contribute to their societies. For example. and both companies are well known to the public. they also appear to be a kind of investment. Considering how relatively unsophisticated the stock market is in Japan. as computer use grows.Computer Industry In the case of Unisys and Hitachi. a joint project of Unisys and the National Science Foundation. the educational institutions and current students can be potential customers. Hitachi meets its responsibilities as a good corporate citizen through the activities of Hitachi-endowed foundations and programs designed to ensure Hitachi contribute to the betterment of the community. but it has suffered from large operating losses over the past five years. However. Firstly. On other fronts. While such contributions increase the corporate images and benefit the communities. its corporate philosophy is to contribute to society through the development and application of superior technologies.Corporate Finance Project . With Hitachi. Unisys is one of the largest software companies. Considered that the companies wish to keep their corporate images in their respective stock markets. There may be a possibility this company attempted to hide bad news as long as it could. A recent Unisys publication tells of how the company improved the voting system of Costa Rica by digitizing voter information and producing tamperproof voter identification cards. C. government. it has achieved notable 5 . Unisys sponsors the Science Learning Center. the management consists of only the inside directors. it is quite possible that the bias in the information may be even larger than when compared to other US companies. We cite some current examples below. In their annual reports. such bias would not be so serious to the markets. community. It is also interesting that most of companies in the computer industry contribute to educational institutions such as public libraries and elementary schools. according to the annual report of Hitachi. and industry groups in an effort to protect the environment.

social concerns play important roles in each company’s decision making. supported school libraries in Thailand. As can be seen from the above examples. and provided opportunities to enjoy Japanese art and culture for Americans. etc.Corporate Finance Project . 6 .Computer Industry advances in the recycling of products.

So the insider holdings of each firm are nearly the same when compared to the industry average. the hardware industry average is 25.4% and the software industry average is 14. The trading volume implies that insiders of these firms may not have an impact on their respective stock prices. In IBM. institutional holdings account for about 40% to 60% in each company. given their shares are not disproportionately large compared to other funds. but are sufficiently diversified. 7 Ha So ftw ar e In . Here. as well as the average 50. In summary. as there are no large stockholders with more than 5% of the shares in IBM. Considering the scale of these firms. we searched for a stockholder composite as of the end of 1997. In regard to insider holdings.2%.3% institutional holding in the hardware and software industries. As shown in the above graph. Compaq and Unisys have a few large institutional holders. the CEO is a co-founder of the company. while at HP. all four firms (except for Hewlett Packard and Oracle) have far lower insider holdings than other companies in their peer groups 1. respectively. marginal investors are clearly institutional. In the case of Oracle. these four companies are sufficiently diversified. some of its directors are related to the family. so this assumption should work well. On the other hand. Risk and return models assume that the marginal investor is well diversified and that only non-diversifiable risk matters.Computer Industry II. the stockholders are well diversified.Corporate Finance Project . Stockholder Analysis 70% 60% Institutional holdings (%) 30% 25% 20% Insiders holdings (%) 50% 40% 15% 30% 10% 20% 10% 0% HP cle ry i q ch ry M IB st du m ra ta Co Un du Hi O isy pa st s Institutional holdings (%) Insider holdings (%) 5% 0% In re wa rd 1 To analyze the stockholders in each firm. with regard to insider holdings.3% and 47. the marginal investor is the institutional investor.

37 2 The monthly risk-free rate that was used was 0..82% 12% 1. also had the smallest portion of risk that was attributable to market factors compared to the other firms. Compaq HP Hitachi IBM Oracle Unisys Regression Beta Jensen’s Alpha R2 of Regression Standard Error of Beta 1. performed worse than expected. Risk Profile Overall Risk Profile The first step in assessing the relative risk of our companies against the market was to run a regression.89% 35. we looked at each company and the businesses they operated in.37 Business Computer HW Firm Estimated Value (MM) $42. multiplied by the relative divisional weight within each firm.4%.37 1. The regressions yielded each company’s beta and intercept. Below. 100% 100. This is due to the fact that all of our companies are large and have existed for several decades. with the exception of Hitachi.375 Comparable Firms Computer HW Division Wt. * Beta 1. based upon the CAPM. It is also worth noting that none of the firms achieved the same level of performance that the hardware and software industries achieved on average.65 28% 4% 42% 1.Computer Industry III.88 -13.00% Wt. and the remaining balance which indicates the diversifiable risk that was associated with each company’s own specific risk components. which was used to compute Jensen’s Alpha2.33 12. with a Jensen’s Alpha of –13.Corporate Finance Project . Oracle. Through estimating a bottom-up beta. when annualized. The stocks that performed significantly better than expected over this period were HP. Compaq.55 33. it is worthwhile to check the validity of these betas.58% 25% 30% . tells us how each stock performed against expectations.375 $42. that the standard error of the betas for all the regressions was relatively high.6% 33% 30% 1. the S&P 500). The industry averages.4% 15% 49% 1. as reflected by their very high Jensen’s Alphas. may be overstated because they include many new entrants that are start up companies. Next.0 1. Jensen’s Alpha. Only Unisys. we examined the R2 of the regressions. which often times perform better than expected. inflation risk. we present each company’s estimated bottom-up unlevered beta: Compaq Unlevered Beta 1.65% 44% -- Measuring Bottom-up Betas Given that nearly all the companies’ regressions yielded high standard errors in the beta estimates. however. Hitachi’s beta is close to 1. and determined a new beta for the company based on the unlevered betas from industry averages. for the period 1993 to 1997. which had the lowest relative risk among the pack as measured by its regression beta. which explains the risk or variance of each stock attributable to market sources.5% 18% 53% HardWare Industry 1. with a risk that is nearly the same as the market. such as interest rate risk. etc. We should note.5%.59 39. with the highest relative risk among the stocks. This is due to the fact that Hitachi is a huge and diversified conglomerate firm. on the other hand. and Oracle.02 413. of each of our company’s stock against the market (in this case.49 430% 45% -- Software Industry 1. 8 . which is the average monthly risk-free rate of return during this period.

49 Services Test and .0% Wt. * Beta 0.65% 38.450 Comparable Firms Computer HW Computer Software IBM Unlevered Beta 1.501.00% Wt. 100% 100.450 Hewlett Packard Comparable Unlevered Firms Beta Computer 1. * Beta 0.16 $2.98 0.729 Y822.64 Division Wt.37 0.05 $2.00% .54% 100.29 9 .23 .8 0.57 $70. * Beta 0.02 1.164.304 Y2.37 0.322 Comparable Firms Computer HW Electrical Equipment Machinery Hitachi Unlevered Beta 1.770.178.57 0.611.03 2.660 Comparable Firms Computer SW Oracle Unlevered Beta 0.5206 0.045 $3.511.Corporate Finance Project .80 Measurement Products Medical .00 Business Computer & Peripherals Software Services Firm Estimated Value (MM) $49.6375 0.57 1.00% 1.Computer Industry Business Computer Services Test and Measurement Products Medical Electronic Equipment Electronic Components Chemical Analysis Firm Estimated Value (MM) $99.3% 2. 41.46% 58.98 Business Computer Systems Information Services Global Customer Services Firm Estimated Value (MM) $2.17 Components Chemical .98 Division Wt.164.9% .00% Wt.6% 10.493.653.98 1.3038 0.82% 100.49 Division Wt.43 $120.00% Wt.42 $2.39 Business Computer HW Electrical Equipment Machinery Firm Estimated Value (M) Y2.42 Comparable Firms Computer Systems Computer Software Computer Services Unisys Unlevered Beta 1.03 . 38% 31% 31% Wt.491.2% 100.95 Electronic Equipment Electronic 1. * Beta 0.53% 14.660 $31.1172 0.967 Y6.982 100.35 $2.92 Analysis Division Wt.14 Business Computer SW Firm Estimated Value (MM) $31.2484 1.4619 $6. 82. * Beta 1.7 $12.9 $120.98 Division Wt.37 0.2649. 46.08 2.938.

shares outstanding. This addition increases Oracle’s market value of debt substantially to $1.0 Bottom-up Betas IBM Oracle 1. the company has substantial operating leases on its books.0.37 [ 1 + ( 1 . In the case of IBM.88 For purposes of our analysis.37 1.493) (75. and the debt to equity ratios for each of the firms are presented below: Share Price3 Shares O/S (MM) MV of Eq.6 million.14 [ 1 + ( 1 .81%) ] = 2. we must look at the relative debt to equity ratios for each of the firms. The formula for moving from an unlevered to a levered beta is presented below.287 $19.0. market values of debt and equity. In the case of Oracle. yielding a marginal corporate tax rate of 49.000 Y2.01 Beta Estimate Compaq 1.413.3%.420 million of preferred shares for Unisys Corporation.Computer Industry Moving toward Levered Betas Before we can arrive at a new beta estimate.12 Summary of Beta Estimates Used Forward in Analysis Regression Betas HP Hitachi 1.200.92%) ] = 1.Corporate Finance Project . its regression beta was well below the software industry average beta (while its bottom-up beta was more in line with industry average).500 $42.25 1.28 0. IBM and Oracle. Levered Beta for Company = Levered Beta for Compaq = Levered Beta for HP = Levered Beta for Hitachi = Levered Beta for IBM = Levered Beta for Oracle = Levered Beta for Unisys = 5 Unlevered Beta [ 1 + ( 1-t) (D/E) ] 1.36) (4%) ] = 1.505 0% 6% 75.041 $64.625 968.39 [ 1 + ( 1 . Includes market value of $1.395 $1.4 million.98 [ 1 + ( 1 .154 $3.97 $30. we used the new bottom-up beta estimates for only two of our companies.30) (6%) ] = 1. the present value of the company’s operating lease liability is $960.88 250. it had a relatively high standard error in the beta estimate.36) (100. and correspondingly. (MM) Est.59 1.41% 18. 5 Hitachi’s tax rate was estimated through running a regression of 10 years worth of income and tax data.36) (18.36) (0%) ] = 1.63 1.6 Unisys $13.477 $3.375 $0 HP $61. the software division has grown at a faster rate than the hardware division. its revenue resources have changed.01 1.1 $101.41%) ] = 1.264. 3 4 All share data as of close of each company’s respective fiscal year end.55 Unisys 1.92% 4% 100.0.81% While Oracle’s market value of straight debt is $304. 10 . which is 8%. MV of Debt (MM)4 D/E Compaq $28. along with the results of each company’s levered beta.864 Hitachi Y959 3.28 1.337.45 1. and Oracle had substantially increased its financial leverage in recent years.08 977.0.000 Y3. as reflected above.264. When discounted back at Oracle’s present cost of debt.163 Oracle $31.2 million. The share price.38 1.00 [ 1 + (1 – 0.29 [ 1 + ( 1 – 0.47 $3.000 IBM $104.

55% 100% 5.88% Oracle 12. the long-term treasury bond rate for the period of our analysis.04% 57% 1.58% Cost of Equity As we can see. 11 . This runs counter to how the industry has performed.31% 43% 5.58% IBM A+ 6. Its risk is the market risk and is based upon the lower Japanese risk-free rate.55% HP 15.12% 6.8% Oracle BBB 8% Unisys 10% Bond Rating Pre-tax Cost of Debt6 After-tax Cost of Debt 5.22% Unisys 17. below we present the costs of equity (expected returns) for each company: Compaq 15. both its regression beta and its bottom up beta were 1. For the risk premium.88% 84. In the case of Compaq. where we used the long-term treasury bond rate of 1.04% IBM 13.22% 96% 5.69% 5. adding on the appropriate default spread based upon each company’s bond rating.12% 0% 15.68% 15. its standard error of the beta estimate is reasonably low.35% 5. we used a geometric historical risk premium for stocks over the long-term treasury bond of 6.Computer Industry For all other companies. Using the CAPM formula.16% Hitachi 8. and its regression beta is higher than the industry average. we used what we believe are the more reliable regression beta estimates. Hitachi.31% 4.37% Oracle 12. we used the regression beta for our analysis forward because there has been no substantial change in the business mix or financial leverage of the company. estimated from the beta.58%.86% 12.94% Unisys 17.79% 94. The return that investors expect to make by investing into any company becomes the cost of equity for managers running that company. From Betas to Costs of Equity To arrive at a cost of equity from the appropriate beta for each company.69% 1. the return that investors expect to make on an investment in Unisys. given its comparatively high risk.12% 4. we used the Japanese riskfree rate of 1. For HP.12% 4% 11.4% Estimating Costs of Capital For each company. Estimating Costs of Debt The current bond ratings for all our companies are presented below.8% 6. it has a high R-squared. Lastly. along with the after-tax cost of debt.Corporate Finance Project . In the case of Hitachi. The costs of capital for each company are presented below: Compaq 15.79% Hitachi 8.41% Cost of Equity E/(D+E) AT Cost of Debt D/(D+E) Cost of Capital 6 We used the long-term treasury bond rate of 6% for all companies (except Hitachi.16%.32% 4.55% HP 15.4% 29. we assumed a risk-free rate of 6%. is the largest among all companies at 17.09% 4.88% and the same risk premium.91% 12. it has been in a rather extraordinary position because it has operated at a loss over the last several years.04%. which are factored into obtaining a current cost of debt for all companies: Compaq BBB 8% HP AA 6. we computed a cost of capital by taking the cost of equity.35% 15. By comparison. Hitachi’s expected return is the lowest at 8. for Unisys. For our foreign company.7% Hitachi Aa2 2. so we believe the regression beta is a more appropriate measure of risk for the company.14% IBM 13.88%).58% 49.

We calculated the cost of preferred stock as: Cost of Pref.Computer Industry Note that. The cost of capital for each company is the benchmark each company uses to analyze projects on a predebt basis. Div.Corporate Finance Project .5% The cost of capital as calculated above for Unisys includes the weighted average cost of preferred stock of 8. yielding a total weighted average cost of capital of 12.34%. in addition. Stock = Pref.5% multiplied by the preferred stock ratio of 20. Unisys has preferred stock outstanding./MV Pref.4/1420.41%. In the next section. Equity = 120.2 = 8. we will determine how each company has performed based on their respective costs of equity and costs of capital. 12 .

Chemical Analysis & Service Long term Have cash outflows that are primarily in dollars Stable High fixed costs Mixture of medium and long term Mainly in US$ 13 . but with inflows that are frequently in foreign currencies due to large overseas sales Short term Both in US $ and foreign currency Linked to a high-technology index fund. but can be cyclical Be long term Have cash outflows that are primarily in dollars.Computer Industry IV. if possible • Computer Software Business • • Be very competitive and volatile Be short term Have cash outflows that are primarily in dollars. if possible • • • • • • Stable Sensitive to exogenous factors. but with inflows that are frequently in foreign currencies due to large overseas sales • • • Mixture of medium and long term Both in US$ and foreign currency Linked to the specific country ratings.Corporate Finance Project . but with inflows that are frequently in foreign currencies due to large overseas sales Mixture of medium and long term Both in US$ and foreign currency • Electrical Machinery • • Stable. but with inflows that are frequently in foreign currencies due to large overseas sales • • • Short term Both in US $ and foreign currency Linked to a high-technology index fund. Investment Return Analysis Business • • Project Flow Characteristics • • • Type of Financing/Appropriate Debt Computer Hardware Business Be short term for personal computers. medium term for mainframe computers Have cash outflows that are primarily in dollars. if possible • • • Can be considerably profitable due to low fixed costs • • Electrical Equipment Be medium to long term Have cash outflows that are primarily in dollars. such as politics and macro-economic factors • • Test & Measurement Medial Electronic Equipment.

we computed the return of equity of each firm as follows: Compaq ROE ROC 22. IBM’s ROE is significantly higher.Computer Industry Measuring Past Returns We assumed that the current book value of assets and equity of our companies reflected the current capital and equity invested in existing projects.08% 16. Graphically. Since Compaq and Oracle have little to no debt. these returns appear as follows: ROE & ROC 50% 0% -50% -100% -150% -200% Cma o pq HP Ha h tc i i I M B Oa l rc e U iy n s s Return on Equity Return on Capital 14 .13% Hitachi 2.29% Hitachi’s ROE and ROC are extremely low compared with the US companies. Using the net income and book value of equity. Unisys operates at a loss and thus.4% IBM 29. reflecting its relatively high debt ratio and its active stock buybacks.4% 12. its ROE is negative.87% HP 21. their ROCs are not much different from their ROEs.Corporate Finance Project .19% 22.77% Oracle 38.56% Unisys -176.29% 9.75% 36.72% 2.

77% 12. it is meaningful to use both book value basis returns and market value returns to get more precise and comprehensive information of the companies in our analysis.32% $612 16.52% (IBM).53% $562 -176.87% .72% 8.56% 11. we compared market value based excess return (return on stock – required return) in the following dividend chapter.74% -Y 153.64% $555 21.04% -5.55% 6.Corporate Finance Project .55% 7.37% 0. as compared to their equity return spread of 5.79% 5. However.29% 17. The accounting returns certainly give us general information on each company’s performance. thus its EVAs are negative. and do not reflect market value. This suggests that since HP and IBM do not have many good projects.4% 12.14% -2.8% 9. return spreads of cost of capital for HP and IBM are close to zero.58% -193. they just buy back stocks alternatively.12% . Hitachi’s return spread is negative.4% 5.29% $783 2.87% 15. Reflecting its low ROE & ROC.4% 13.08% 15. On the other hand.24% 12.93% $101.88% 15. Since.29% 12.32% -Y 172.94% 24.62% $560 9.31% 12.67 Calculation of EVA Compaq HP Hitachi IBM Oracle Unisys Industry Average ROC Cost of Capital Capital Return Spread EVA (MM) 22.22% 26. meaning both companies are picking up good projects.29% (HP) and 15. accounting returns do not necessarily reflect the company’s real picture.4% $183 36.41% -3.216 38.Computer Industry Evaluation of Past Returns Calculation of Equity EVA Compaq HP Hitachi IBM Oracle Unisys Industry Average ROE Cost of Equity Equity Return Spread Equity EVA (MM) 22.000 12.16% 0.$108 25.45 Compaq and Oracle are well outperforming their respective cost of equity and cost of capital. 15 .000 29.94% $182 2. as is its EVA.6% $50. because they are influenced by certain accounting standards. Hitachi’s ROE and ROC do not match the hurdle rates. Unisys’ projects did not generate necessary return to the company.$939 22.19% 15.52% $3.75% 12.1% 15.

together with its big size. On the other hand. on the other hand. provides the company with buffers to exposure in its highly risky computer hardware business. IBM transitioned into other areas. given its relatively small company size. IBM’s policy to buy back stocks suggests that the company does not have many good projects to invest. medical electronics and chemical analysis. and 2) new related businesses. So. HP’s diversification into relatively low risk businesses. there is room to grow for the company. Oracle. is concentrating on the fast-growing software service business. its diversification may limit its opportunities to capture any high growth opportunities in the computer hardware business. Compaq has been growing rapidly and is likely to continue to do so in the future. While focusing on the computer hardware business. Compaq is entering into the network business. Given the current bad fundamentals for the Japanese economy. Unisys is in the process of turning itself around. Since new CEO Larry Weinbach came on board in September of 1997. both domestically and internationally. This success resulted from the conversion of $616 million in bonds and the 16 . were created and grew at a rapid pace. which is a business of both high profitability and risk. we believe Compaq’s good brand image will make it possible to earn higher operating margins. which are relatively less risky than its current stronghold. Unisys has since contracted out to manufacture desktop computers and low-end servers. such as software services and consulting. If stockholders acted to check the managers.Corporate Finance Project . Its low ROE and ROC are a reflection of Hitachi’s power structure between strong incumbent managers and weak stockholders. However. Hitachi should increase its ROE and ROC in order to match the required hurdle rates. we anticipate that IBM will grow at a moderate rate. More importantly. Through acquiring DEC. Given that the company is still relatively small. So. such as network computer and IT solution consulting business. it would be harder for the firm to generate a negative EVA. and is now concentrating on its mainframes and high-end servers. although its growth may be volatile. such as electrical manufacturing. we anticipate that HP’s growth will be stable in the future. Thus. Unisys is focussing on the future. it may grow only modestly. Unisys is over 80% of the way towards achieving Weinbach’s goal of reducing debt by $1 billion dollars by the year 2000.Computer Industry Assessments for the Future We believe that the computer hardware and software industries have huge opportunities for further growth in the future based on the following reasons: 1) we expect that the customer base will continue to expand. we do not foresee high growth for Hitachi.

Computer Industry retirement of $198 million in additional debt. 17 . we believe that Unisys is poised to make a comeback.Corporate Finance Project . With this financial restructuring and the streamlining of its manufacturing operations.

Soft. Avg.98 Y36.00 $0.19 Ind.39 Y36.00 $0.46 0.00 $0.00 $0. 7.21 $43.034 Compaq Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 $0.09 $528.1 Y37.35 37.21 $0.67 0.00 $0.00 $0.85 0.42 Avg.63 $81.Corporate Finance Project .10 37. Dividend Policy: The Tradeoff The way the six companies return cash to stockholders is different and the reasons they return the cash also vary. Hewlett Packard Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 $228 $280 $358 $450 $532 $6 $25 $325 $726 $305 $234 $305 $683 $1.117 $5.01 Hardware Ind.Computer Industry VIII.176 $837 Hitachi Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 37.35 Y37.98 36.251 $933 $672 $6.86 $113. 7.63 Unisys Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 Oracle Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 $43.30 18 .25 0. Avg.16 $75.&Serv 7.06 0.45 0.09 $528.00 $0.83 Hitachi 41.00 $0.77 HP 17.711 $7.526 $5. The following tables sum up the dividend and stock buyback of the last 5 years.005 $6.39 36. Ind.63 Y37.00 IBM Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 $933 $662 $591 $706 $783 $10 $5. Wt.16 $75.63 $81.00 In the following table we compare the 3 companies of ours that pay dividends to industry averages: Dividend Dividend Payout Yield IBM 12.86 $113.

we must view Hitachi as an exception because it is a Japanese company and operates under different constraints. Not paying dividends gives Compaq more flexibility in accepting projects Implication for IBM IBM was a typical dividend paying company before the recession. To better understand some of the tradeoffs of different dividend policies. we will compare the policies of Compaq and IBM. stockholders choose it for its capital gains potential. which exemplify two common dividend policies. our 3 companies have higher payout ratios and yields than the industry averages. Information Effects and Signaling Incentives Effect on Flexibility Bond Covenants and Ratings Agency Concern Considering that it has no debt. However. this is not a concern Since IBM does not have many good projects. In the future. they tend to return money to stockholders. Therefore.Computer Industry As shown above. they do not require much flexibility. namely the policy of paying dividends and the policy of not paying dividends. when Compaq decides to return money to stockholders it should do so in the form of buybacks. stockholders would prefer buybacks over dividends. Considering its no-dividend policy. IBM should continue its current dividend policy. Factor Stockholder Tax Preference Implication for Compaq Considering its history of no dividends. but 5 years of low dividends have changed stockholders attitudes so now they do not expect high dividends Its announcement that it would reduce dividends sent its stock plummeting. so ratings are a concern and effects their dividend policy.Corporate Finance Project . As suggested above. They have many bond holders. 19 . it is unlikely that Compaq would use dividends to signal information about future cash flows.

00 $556.00 $253.37) ($11.80 $416.00 ($11.00 ($411.14) $145.80 $943.00 $557.50 ($88.6% 1997 $88.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE Oracle Year Net Income (Cap Ex .28 $112.Corporate Finance Project .00 $642.00 $177. It also shows where the companies paid out too much.00 $184.318.68 $63.5% 1995 $113.8% -241.2% 107.52 $109.84 $81.00 $83.00 $188.93 $162.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE Compaq Year Net Income (Cap Ex .40 $1.0% 99% 1993 $98.64) $36.47 $278.182.433.75 $37.60 1993 $77.77 $43.34 $264.00 $1.394.00 1994 $867.75) $36.55 $205.21 Average $449.00 1996 $1.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE Hitachi Year Net Income (Cap Ex .7% -20.090.014.72 $140.3% -269.00 $190.00 $784.7% 49.09 41% -119% 1993 $1.0% 1994 $65.16 ($14.058.2% 20 .5% 190.00 $1.00 $472.10 56.4% Average $2.8% Average $97.00 $683.96) $74.00 $1.00 $168.60 ($11.00) 1997 $1.97 $202.00 $1.63 41.00 $234.39 25.00 17.5% 1994 $1.472.0% 1996 $141.2% 1997 $3.25 $70.00) $390.00 $721.119.00 $859.75) ($15.29 $91.00 $812.5% 38.4% 249.35 48.177.9% 1995 $2.00 $422.676.65 $83.4% 104.00 19.00 17.13 $75.16 1995 $441.599.46 $120.5% -111.12) $37.4% 120.26 ($36.176.9% 111.09 1997 $821.855. Hewlett Packard Year Net Income (Cap Ex .00 $1.00) 1995 $789.00 $318.28 $85.00 17.586.32 $107.86 1996 $603.94 $113.00 $1.00 $837.Computer Industry IX.00 Average $1.00 $305.64 $72.00 17.80 $6.00 $887.98 33.63 1994 $283.00 $1.87 $37.39 1993 $462.40 $752.2% 44.1% 94.958.91 $90.75 $168.36) $37.82) $37.39 ($31.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE 29.87 ($176.93 $422.00 ($641.52) ($32.20 $647.3% 50.98 $22.00 $224.06 $528.00 $397. Dividend Policy: A Framework The following tables sum up our results of what the companies should have returned and what they did.00 $647.33 $132.77 $112.0% 1996 $2.00 14.71 $268.16 ($32.20 $107.

711.02) $6. its yield is just 1.59) ($59. 1) 2) 3) 4) Those that pay dividends: Hitachi Those that buyback stocks: Oracle Those that pay dividends and buyback stocks: Hewlett Packard and IBM Those that that do neither: Compaq and Unisys 1) Hitachi has been paying the same 11 yen per share dividend since 1990.468.9% 1995 $4.672.5% -11.15%. we can get and idea of how much the companies could have returned to stockholders and how much they actually did.40) $5.00 $613.1% 1996 $5.101.24 $672.093.034. Hitachi's dividend ratios are between Toshiba and Matsushita: not so high but not so low.70) ($334.10) $4.50 ($122.70) $358.261. since its net income per share was just 25.70 ($99.59) $343.458.32) $933.943.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE 1993 ($8.812.0% Yield: Y10/Y547=1.27 1994 $100.96 $5.7=53.61 By looking at the shaded areas in the above tables.15) Average ($152.82% Yield: Y13/Y1.266.00 14.65 $7.019.Corporate Finance Project . which is not very low.63) ($170. The companies can be categorized in 4 ways by looking at how they return cash to stockholders.429.27 ($1.89) $356. 21 . even though its profits have been declining due to the Japanese recession. Their 10-year historical dividend payout ratio is 26. the following information is included for comparison.265.160.31 $4.653.469.60) ($119.15 $726.60) ($618.021.40 10% 71% 1993 $565.86 $1.55 yen in 1997.67) ($30.117.39 $2.00) ($2.124.9% 1994 $3.23) $6.65% Compared with other Japanese computer and electronics companies.Computer Industry Unisys Year Net Income (Cap Ex .00 ($604.66 1995 ($624. This is common in large mature Japanese companies.1% 88.00 -11.29) $2. Even though this dividend is regular.00 12.180. However. 11 yen per share means its payout ratio is 43%.9% 65.0% Average $2.40 ($167. As this is the only Japanese company in the group.4=33.5% Dividend pay out = Y13/Y39. Toshiba: Matsushita: Dividend pay out =Y10/Y18.61 ($7.12) ($2.52) ($225.178.89) $6.46) 1997 ($853.00 21.01 $6.00 ($692.093.27) 1996 $49.31%.00 ($2.05 ($206.00 13.75 ($841.0% 88.78) ($204.00 $1.56) ($120.3% 1997 $6.9% 124.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE IBM Year Net Income (Cap Ex .54) $132.985=0.

2) Oracle is unique in our survey because it has been returning cash in the form of stock buybacks. they prefer capital gains and stable growth. From the data. lead by Louis Gerstner. appears to be behaving in the same manner. announced a decrease in dividends which was greeted with further downward pressure on their stock price. is a company that has been loosing money for several years and has posted negative FCFE for 6 of the last 10 years. It is also buying back stock. This came on the heels of mounting loses as a result of mismanagement. 4) The last two companies also appear similar if looking at their dividends and buyback policies. on the other hand.Computer Industry Since most of Hitachi’s shareholders are institutional investors. It is not surprising that the firm does not pay any dividends. IBM’s new management. with a little analysis we can see some differences. they are widely different. 22 . it seems that Oracle is transforming itself from a growth company to a more mature company. In this way it returned cash to shareholders and helped bring the price back up. Both companies have a low positive EVA. which is consistent with large mature companies which do not have attractive projects.Corporate Finance Project . its investors are not expecting any in the future. Jr. 3) Hewlett Packard and IBM seem very similar on the surface in terms of their cash returning policies. which signifies that it is investing in good projects. To counter this effect IBM started to repurchase its stock. IBM. rather than obtaining large dividends. From 1991-1992 IBM’s stock price fell 43%. HP is a typical large mature company with a relatively stable dividend payout ratio..32%. But by looking back a few years. It has an EVA of 7. However. Its policy of not returning money to shareholders and reinvesting it in projects is the definition of a growth company. on the other hand. This is due to the difference in tax treatment. In 1993. As Oracle does not have as many good projects as in the past it is returning cash in the form of stock buybacks. Compaq is a typical growth company. Unisys. but other than that. Since Oracle has never paid dividends. we can discover a different reason for IBM’s actions.

46 Dividend Yield 0 0.29% HP Hitachi Unisys Oracle IBM Compaq Based on the table above.48% 60.66% 23. except for Unisys.Computer Industry How much do we trust management at these computer companies? First.11% 14. such as Hitachi or IBM. in terms of stock price performance. as well as to a representative cross section of its peer group.66% 27.63 31.58 16. Compaq. while a company that has high excess return.64% 21.63% 13.96% -16.13 37. Excess Returns (Return on Stock-Required Return) Recent 5 year Average Standard Div.6 2.15 20.88 The forecasted growth rates were taken from the Zacks service by way of Bloomberg.16 0 0 0 0 0 0 0.17% 12. tend to pay higher dividend.7 0 0 0 0 0 0 12.48 15.63 13.12% 37. except for Hitachi. Microsoft Intel Dell Micron DEC Cisco 3Com Compaq IBM Oracle HP Unisys Hitachi Expected Growth 23. we consider each company to have appropriate corporate governance.75 34.13 55.06 0 41.64 29.Corporate Finance Project .58 12 29. we can say that the companies that have smaller excess return (return on stock – required return). each company’s stock has performed well compared to the market.83 0 0. except for Unisys. in terms of corporate governance.38 10 24.85 0 17. we have examined dividend yields and payouts.51% 6.47 10.08 61.85 24.25 104. we can conclude we can trust these companies management.94 28. Second. tends to pay no dividend.01 Price 64.81 19.77 0 0. 23 . Comparison to Peer Group In comparing our companies to each other. 8. Therefore.25 42 9.07 Dividend Payout 0 2.63 70. after adjusting for risk.59% 11.

58 0 0.37 -1.04) Expect.16 Cisco 29.4 .07 0. However.07 -0.16 -0.30 By looking at the shaded areas of the above left table.08 -0. we can see how well the regression predicts payout ratios.77 0.04 Dell 29.19) Expect Actual Predict.47 0.17 0.48 0 -0.85 14.05 6.49 DEC 12 0 12.Computer Industry We ran the two regressions in order to see how well expected growth predicts payouts and yields.83 0.54 Oracle 24.62 8.59 -13.38 0 0.Actual Predict Differed Yield -ed ence Growth Yield Microsoft 23.81 0 0.21 -0.85 0 0.29 19.335 .0108 (Expected Growth Rate) R-Sq = 8.05 3Com 24. 24 .Corporate Finance Project .22 Hitachi 2.48 0 0.49 -7. this can be attributed to the large portion of the sample group that does not pay dividends which provides little variation across the group.23 0.57 HP 15.15 0 0.12 0.35 Oracle 24.64 0. However.11 Intel 19.0.07 41.61 -3.15 0 -0.07 Compaq 20.07 -0.77 5.22 -0.31 -0.66 Unisys 10.44 Unisys 10.16 DEC 12 0 0.16 0.9% (t=1. as mentioned above.16 -12. It is also true that these companies generally stick to a given policy and their stockholders have chosen to invest accordingly.02 -0.1.11 -0.23 0.01 -0.23 Compaq 20.58 0 7.7 4.01 0. The regression results suggest that HP and Hitachi are high compared to other firms in the industry. This gives the companies greater flexibility for investing and paying out dividends.20 -1.17 Dividend Yield = 0. Conclusions on Dividend Policy In summary.67 Dell 29.58 0 0.02 (Expected Growth Rate) R-Sq = 48% (t=3.57 0.59 Hitachi 2. Except for Unisys. it seems that investors in our six companies know what type of dividend policy to expect.46 22.38 0 3. A similar situation is shown in the above right table.81 0 0. Hitachi is a unique case because it is a Japanese company operating under different constraints.61 IBM 10 12.08 Intel 19.64 2.02 Micron 16.85 0 -6.77 Micron 16.6 0 0.06 8.47 17.07 HP 15. The results are as follows: Dividend Payout Ratio = 24.11 IBM 10 0.58 0 -5.6 0 13.11 -0.01 3Com 24. when we regressed yield against growth.21 Cisco 29. management has earned a certain measure of trust based on excess returns for their investors.Differ-ed Payout ed ence Growth Payout Microsoft 23. The results suggest that IBM and HP’s yields are too high compared to the industry and that Hitachi’s are too low.

39 Y36.10 37.00 $0.67 0.63 Unisys Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 Oracle Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 $43.06 0.00 $0.42 Avg.63 $81.86 $113. The following tables sum up the dividend and stock buyback of the last 5 years.30 25 .1 Y37.526 $5.45 0.Corporate Finance Project .00 $0. 7.00 $0.21 $43.034 Compaq Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 $0.117 $5.09 $528.00 $0.176 $837 Hitachi Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 37.16 $75.16 $75.711 $7.86 $113. Ind. Hewlett Packard Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 $228 $280 $358 $450 $532 $6 $25 $325 $726 $305 $234 $305 $683 $1.35 Y37.09 $528.39 36.98 Y36.251 $933 $672 $6.19 Ind.35 37.01 Hardware Ind.98 36.77 HP 17. Avg.005 $6.00 In the following table we compare the 3 companies of ours that pay dividends to industry averages: Dividend Dividend Payout Yield IBM 12. 7.63 Y37.00 IBM Year Dividends + Equity Repurchases = Cash to Stockholders 1993 1994 1995 1996 1997 $933 $662 $591 $706 $783 $10 $5.25 0. Dividend Policy: The Tradeoff The way the six companies return cash to stockholders is different and the reasons they return the cash also vary. Wt.00 $0.Computer Industry VIII.&Serv 7.00 $0. Avg.85 0.83 Hitachi 41.00 $0.46 0. Soft.63 $81.21 $0.

stockholders choose it for its capital gains potential. They have many bond holders. our 3 companies have higher payout ratios and yields than the industry averages. stockholders would prefer buybacks over dividends.Corporate Finance Project . Considering its no-dividend policy. so ratings are a concern and effects their dividend policy. Not paying dividends gives Compaq more flexibility in accepting projects Implication for IBM IBM was a typical dividend paying company before the recession. Therefore. they do not require much flexibility. In the future. it is unlikely that Compaq would use dividends to signal information about future cash flows. we will compare the policies of Compaq and IBM. Factor Stockholder Tax Preference Implication for Compaq Considering its history of no dividends. which exemplify two common dividend policies. However. IBM should continue its current dividend policy. this is not a concern Since IBM does not have many good projects. when Compaq decides to return money to stockholders it should do so in the form of buybacks. Information Effects and Signaling Incentives Effect on Flexibility Bond Covenants and Ratings Agency Concern Considering that it has no debt. but 5 years of low dividends have changed stockholders attitudes so now they do not expect high dividends Its announcement that it would reduce dividends sent its stock plummeting. namely the policy of paying dividends and the policy of not paying dividends. 26 .Computer Industry As shown above. To better understand some of the tradeoffs of different dividend policies. we must view Hitachi as an exception because it is a Japanese company and operates under different constraints. they tend to return money to stockholders. As suggested above.

7% -20.00 $318. Dividend Policy: A Framework The following tables sum up our results of what the companies should have returned and what they did.5% -111.84 $81.87 ($176.586.8% -241.28 $85.21 Average $449.318.87 $37. It also shows where the companies paid out too much.34 $264.5% 190.75) ($15.52) ($32.2% 44.35 48.91 $90.97 $202.3% 50.00 ($641.13 $75.98 33. Hewlett Packard Year Net Income (Cap Ex .2% 27 .0% 1994 $65.00 $1.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE Compaq Year Net Income (Cap Ex .63 1994 $283.0% 1996 $141.2% 1997 $3.00 $812.119.63 41.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE Oracle Year Net Income (Cap Ex .00 $188.50 ($88.77 $43.46 $120.29 $91.00 $1.9% 111.5% 38.80 $943.16 1995 $441.Corporate Finance Project .82) $37.00 $253.00 1994 $867.86 1996 $603.090.65 $83.6% 1997 $88.64 $72.55 $205.855.00) 1997 $1.64) $36.93 $162.676.32 $107.60 ($11.09 1997 $821.2% 107.00 ($11.00 $837.00 $305.75 $168.06 $528.72 $140.0% 1996 $2.472.00 $184.47 $278.00 $1.00 14.80 $6.98 $22.25 $70.00 $887.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE Hitachi Year Net Income (Cap Ex .8% Average $97.28 $112.00 $234.00 ($411.09 41% -119% 1993 $1.00 $1.0% 99% 1993 $98.00) $390.40 $752.00 $83.00 $683.75 $37.00 19.40 $1.00 $177.00 $168.00) 1995 $789.75) $36.80 $416.7% 49.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE 29.00 $784.16 ($32.77 $112.00 $721.00 17.00 17.182.176.94 $113.00 1996 $1.00 $190.16 ($14.4% 249.12) $37.00 Average $1.68 $63.00 $397.00 17.177.958.4% Average $2.96) $74.71 $268.394.599.93 $422.00 $1.3% -269.00 17.00 $422.20 $107.39 25.39 ($31.00 $224.00 $472.433.Computer Industry IX.39 1993 $462.00 $1.33 $132.20 $647.1% 94.60 1993 $77.00 $556.5% 1994 $1.9% 1995 $2.00 $557.37) ($11.4% 104.26 ($36.52 $109.00 $647.5% 1995 $113.00 $859.058.14) $145.00 $642.00 $1.36) $37.10 56.4% 120.014.

672.00 14. even though its profits have been declining due to the Japanese recession.5% -11.00 21.117.89) $6.1% 1996 $5.9% 1995 $4. the following information is included for comparison.59) $343.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE IBM Year Net Income (Cap Ex .00 -11.70) ($334.178.469.60) ($618.66 1995 ($624.093.27) 1996 $49. we can get and idea of how much the companies could have returned to stockholders and how much they actually did.429.00 ($2. which is not very low.50 ($122.943.00 $613.54) $132.63) ($170.01 $6.653.1% 88.15%.4=33.27 1994 $100. Toshiba: Matsushita: Dividend pay out =Y10/Y18.9% 65. since its net income per share was just 25.59) ($59.093. its yield is just 1.10) $4.019.9% 124.00 13.101.Corporate Finance Project .40 10% 71% 1993 $565.40) $5.23) $6. The companies can be categorized in 4 ways by looking at how they return cash to stockholders.5% Dividend pay out = Y13/Y39.60) ($119.00 $1.3% 1997 $6.55 yen in 1997. Even though this dividend is regular.034.12) ($2.00) ($2. However.65 $7.75 ($841.32) $933.15) Average ($152.0% Yield: Y10/Y547=1.0% Average $2.266.00 ($692.985=0.160.29) $2.021.9% 1994 $3.180. This is common in large mature Japanese companies.00 12.05 ($206.468. 11 yen per share means its payout ratio is 43%.52) ($225.458.39 $2. Their 10-year historical dividend payout ratio is 26. As this is the only Japanese company in the group.89) $356.812.70) $358.56) ($120.86 $1.40 ($167.124.70 ($99.00 ($604.31%.Depr) (1-DR) Change in WC * (1-DR) FCFE Cash to Shareholders Payout Ratio Cash Paid as % of FCFE 1993 ($8.265.02) $6.78) ($204.46) 1997 ($853. 28 .31 $4.65% Compared with other Japanese computer and electronics companies. Hitachi's dividend ratios are between Toshiba and Matsushita: not so high but not so low.Computer Industry Unisys Year Net Income (Cap Ex .27 ($1.7=53.96 $5.261.15 $726.67) ($30.0% 88.61 By looking at the shaded areas in the above tables.82% Yield: Y13/Y1.61 ($7.24 $672.711. 5) 6) 7) 8) Those that pay dividends: Hitachi Those that buyback stocks: Oracle Those that pay dividends and buyback stocks: Hewlett Packard and IBM Those that that do neither: Compaq and Unisys 1) Hitachi has been paying the same 11 yen per share dividend since 1990.

Both companies have a low positive EVA. they are widely different. But by looking back a few years. Compaq is a typical growth company. its investors are not expecting any in the future. From the data. on the other hand.Corporate Finance Project . it seems that Oracle is transforming itself from a growth company to a more mature company. 2) Oracle is unique in our survey because it has been returning cash in the form of stock buybacks. they prefer capital gains and stable growth. This is due to the difference in tax treatment. with a little analysis we can see some differences. This came on the heels of mounting loses as a result of mismanagement. Unisys. which is consistent with large mature companies which do not have attractive projects. 29 . Since Oracle has never paid dividends. 4) The last two companies also appear similar if looking at their dividends and buyback policies. lead by Louis Gerstner. It is also buying back stock. 3) Hewlett Packard and IBM seem very similar on the surface in terms of their cash returning policies. HP is a typical large mature company with a relatively stable dividend payout ratio. Jr.Computer Industry Since most of Hitachi’s shareholders are institutional investors. announced a decrease in dividends which was greeted with further downward pressure on their stock price. is a company that has been loosing money for several years and has posted negative FCFE for 6 of the last 10 years. It has an EVA of 7. but other than that. In this way it returned cash to shareholders and helped bring the price back up.32%. appears to be behaving in the same manner. It is not surprising that the firm does not pay any dividends. rather than obtaining large dividends. As Oracle does not have as many good projects as in the past it is returning cash in the form of stock buybacks. However. Its policy of not returning money to shareholders and reinvesting it in projects is the definition of a growth company. In 1993. on the other hand.. From 1991-1992 IBM’s stock price fell 43%. IBM’s new management. we can discover a different reason for IBM’s actions. To counter this effect IBM started to repurchase its stock. IBM. which signifies that it is investing in good projects.

85 0 17. Second.64% 21.63 13.7 0 0 0 0 0 0 12.46 Dividend Yield 0 0.38 10 24.11% 14.63 70.48% 60.08 61.29% HP Hitachi Unisys Oracle IBM Compaq Based on the table above. Therefore.63 31. we have examined dividend yields and payouts.58 16. each company’s stock has performed well compared to the market.15 20.06 0 41.6 2. 8. tends to pay no dividend.25 42 9.83 0 0. except for Hitachi.16 0 0 0 0 0 0 0.07 Dividend Payout 0 2. in terms of stock price performance. Microsoft Intel Dell Micron DEC Cisco 3Com Compaq IBM Oracle HP Unisys Hitachi Expected Growth 23.01 Price 64.85 24.58 12 29. Excess Returns (Return on Stock-Required Return) Recent 5 year Average Standard Div.59% 11. we can say that the companies that have smaller excess return (return on stock – required return).12% 37.Computer Industry How much do we trust management at these computer companies? First. except for Unisys.13 55.47 10.66% 27.94 28.Corporate Finance Project .64 29. Compaq.48 15. while a company that has high excess return. we consider each company to have appropriate corporate governance.63% 13.88 30 . Comparison to Peer Group In comparing our companies to each other.51% 6. in terms of corporate governance. after adjusting for risk.96% -16. such as Hitachi or IBM. we can conclude we can trust these companies management. except for Unisys. tend to pay higher dividend.17% 12.13 37.75 34.77 0 0. as well as to a representative cross section of its peer group.81 19.25 104.66% 23.

81 0 0. as mentioned above.16 -0. management has earned a certain measure of trust based on excess returns for their investors. Except for Unisys. when we regressed yield against growth. A similar situation is shown in the above right table.6 0 0. this can be attributed to the large portion of the sample group that does not pay dividends which provides little variation across the group.01 0.02 Micron 16.11 IBM 10 0.31 -0.17 0.38 0 3.30 By looking at the shaded areas of the above left table. We ran the two regressions in order to see how well expected growth predicts payouts and yields. Conclusions on Dividend Policy In summary.Corporate Finance Project .15 0 -0.77 Micron 16.15 0 0.22 -0.48 0 0.07 -0.11 -0.1. However. it seems that investors in our six companies know what type of dividend policy to expect.4 .Differ-ed Payout ed ence Growth Payout Microsoft 23.59 Hitachi 2.47 0.19) Expect Actual Predict.07 -0.01 -0. It is also true that these companies generally stick to a given policy and their stockholders have chosen to invest accordingly.12 0. However.67 Dell 29.05 6.Actual Predict Differed Yield -ed ence Growth Yield Microsoft 23.57 HP 15.01 3Com 24.58 0 0.37 -1.85 0 0.58 0 0.64 2.16 -12.77 5. The regression results suggest that HP and Hitachi are high compared to other firms in the industry.47 17.08 Intel 19. we can see how well the regression predicts payout ratios.05 3Com 24.11 -0.58 0 7.61 -3.49 DEC 12 0 12.02 (Expected Growth Rate) R-Sq = 48% (t=3.46 22.21 Cisco 29.6 0 13.62 8.57 0.07 41. Hitachi is a unique case because it is a Japanese company operating under different constraints.04) Expect.0.64 0.20 -1.61 IBM 10 12.85 14. The results suggest that IBM and HP’s yields are too high compared to the industry and that Hitachi’s are too low. 31 .23 Compaq 20.16 Cisco 29.17 Dividend Yield = 0.08 -0.11 Intel 19.49 -7.07 0.29 19.66 Unisys 10.77 0.21 -0.02 -0.16 0.16 DEC 12 0 0.85 0 -6.07 HP 15.81 0 0.9% (t=1. The results are as follows: Dividend Payout Ratio = 24.54 Oracle 24.44 Unisys 10.22 Hitachi 2.59 -13.35 Oracle 24.23 0.Computer Industry The forecasted growth rates were taken from the Zacks service by way of Bloomberg.335 .04 Dell 29.23 0.38 0 0.58 0 -5. This gives the companies greater flexibility for investing and paying out dividends.0108 (Expected Growth Rate) R-Sq = 8.07 Compaq 20.83 0.06 8.48 0 -0.7 4.

2%).46 -1. Therefore it can be said that the market expects HP to grow much faster than its fundamental growth capacity (14.83 20.06 3.39 -0.63 13.28% to 23.88 28. it would have negative shareholder's equity.25 104.5%) and Unisys (28.97 42.05 -5. the 32 .38 1. Without its preferred stock. Unisys is losing money every year.08 FCFF 33. expected values match the current prices.37 84.Corporate Finance Project .57 10.04 Value FCFE 51. Valuation Value and Actual Price HP Unisys Compaq IBM Oracle Hitachi 0 US$ per share DDM HP Unisys Compaq IBM Oracle Hitachi 40.02 32.05 916.3% -3.5% 28. Valuation Summary Two of the companies are pretty overvalued: Hewlett Packard (19.5%). if we change the capital structure of Compaq to the optimal level (debt ratio from the current 0% to 20%) and use FCFF model.95 1009.2% -16.5%.92 19." Even when we made a pretty optimistic profit plan for Unisys.38 22. It's bond rating is "B. its stock is still quite overvalued. Although Compaq is also overvalued by FCFE model by 35.99%).71 - 20 40 60 80 Actual 100 120 Value Actual Price 61.2% -1.Computer Industry X.63 31.36 17.7% Overvalued Overvalued Undervalued Undervalued Undervalued Overvalued 1.0% 4.85 106. When we change the 5-year growth rate of Hewlett Packard (18.08 959 Difference (actual-value) amount % 10.

2 stage model Except for Hitachi and Oracle. the size of most of the companies are large." (1) 5 year rapid growth. we estimate that they will grow at a higher rate for the first five years. Therefore. On the other hand. and therefore chose a 1-stage model. Choosing the right model For the valuation. Oracle's expected growth rate is so high (28. we estimate Hitachi should already be in a stable growth period. except Compaq. Therefore. On the other hand. since each company would not take highly risky projects or change its business structure significantly in the future. and costs of equity as discount rates for three reasons. Second. 33 . markets may expect that Compaq will change its capital structure and take on debt in future. and buying IBM and Oracle. we recommend selling short HP and Unisys.S. free cash flow to equity should be more appropriate than free cash flow to firm. IBM and Oracle are slightly undervalued.Corporate Finance Project . free cash flow model is more preferable than the dividend discount model.71. More details are on the attached "The Values of Equity in Computer Companies. we use free cash flows to equity as cash flows. we expect that their capital structures would not change significantly. we made the assumptions listed below. and then the growth rate will become stable. which is pretty close to the current price. Therefore. First. and Japanese economy has still not recovered. Therefore. so the length of high growth periods should be moderate.Computer Industry value of share becomes $33. On the other hand. except Compaq. (2) Cash flows to equity and cost of equity Basically. we used a 2-stage model for valuation because each company has high expected growth for the first five years due to the computer industry's faster growth rate (fundamental EPS growth: 21% in hardware and 18% in software) than general U. the current cost of equity is appropriate for discount rates.95%) that we used a 3-stage model with 5 years rapid growth and a 5-year transition period. although all of four companies have moderate barriers to entry and high expected growth rates. Third. 2. Since Hitachi is a mature company. Therefore. economy (5%). each company's dividend payments do not always show each company's actual value.

(3) 50% fundamental growth. and 25% EPS growth We assigned the following weights for the rapid growth rate. analysts’ expectation at 25%.Corporate Finance Project . we also used FCFF model and discounted by cost of capital (15. Based on the assumptions below. however. since Oracle's EPS growth (68. capital expenditure is usually larger than depreciation even in mature companies like IBM. we estimate its capital expenditure to be the same amount as depreciation because of its current downsizing process.29%) is unusually high. We did this because the fundamental growth rate is too objective and based on the growth of earnings. (4) 130% Capital expenditure/ Depreciation Since computer industry is capital intensive industry. On the other hand.30.89% (Unisys average 95-97) catch up industry average in 2001 6. due to the restructuring efforts and selling non-performing assets. since Unisys almost finishes its capital restructuring . we weighted it 50% on fundamental and 50% on historical growth. we use current debt ratio for this valuation. Therefore. 3. and 25% for the historical growth rate of earnings per share. The problem of Unisys It is difficult to evaluate the value of Unisys because it has been losing money for the last several years. even given that its current EPS is negative $5.21% (Unisys average 95-97) 111 (1997 level) 34 . 25% analyst's expectations. since we couldn’t get reliable analysts’ expectations. we weighted 50% on fundamental and 50% on analysts' expectations.Computer Industry Since Compaq should change its capital structure gradually from zero to 20%.5%). since Unisys’s fundamental and historical growth rates are negative. which is the current industry average. we only used the analysts’ expectation for the company. However. For Hitachi. we hope the firm will recover in five years and then grow at a stable rate. We weighed fundamental growth at 50%. In Unisys. we estimate that stable capital expenditure should be 130% of depreciation. Key assumptions Sales growth Operation margin Operating margin after 2001 Non-operational costs Preferred Dividend 2.33% (Current Industry average) 4. However.

000 3.Corporate Finance Project . dividend Turn to positive in 2001.000 7.000 2.000 5.000 6.000 4.Computer Industry Net Income after pref. and grow stable Unisys Profit Plan 9.000 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Operation Costs Total Costs Revenue 35 .000 8.000 1.

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