McKinsey on Finance

Perspectives on Corporate Finance and Strategy
Number 7, Spring 2003

An early warning system for financial crises 1 An excerpt from Dangerous Markets provides indicators to spot coming storms. Are emerging markets as risky as you think? 7 A portfolio perspective on corporate investment reveals risk levels comparable to developed markets. Viewpoint: Time for a high-tech shakeout 13 The capacity glut means the industry needs consolidation. Getting what you pay for with stock options 15 Companies are rethinking stock options. Here’s how they can better serve shareholders and executives. Viewpoint: Much ado about dividends 18 The proposal to eliminate the double taxation of dividends is more notable for what it wouldn’t do than for what it would.

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An early warning system for financial crises
An excerpt from Dangerous Markets provides indicators to spot coming storms.
Dominic Bar ton, Rober to Newell, and Gregor y Wilson


ust before dawn on July 2, 1997,

Bangkok’s top bankers were awakened and summoned to a 6:30 am meeting at a low-rise building facing Bankhumpron Palace, as the ornate Bank of Thailand headquarters is known. As the group gathered nervously, they were informed that after months of resistance, the government was abandoning the Thai baht’s peg to the US dollar. When the markets opened a few hours later, panic ensued. The baht dropped 15 percent against the US dollar, signaling an economic crisis that soon swept across Thailand and the rest of Asia, with repercussions felt around the world.

Neither Standard & Poor’s nor Moody’s predicted the severity of the Thai financial storm.2 Even the IMF, on the eve of the crisis in the summer of 1997, praised Thailand’s “remarkable economic performance” and “consistent record of sound macroeconomic performance.”3 By the fall of 1997, of course, its cheery predictions were left twisting in the wind. Seasoned observers—whose task it is to identify problems before they boil over into crisis—all missed the signs of trouble in Thailand. They had also missed them elsewhere, as can be seen, for example, in Mexico’s 1994–1995 financial crisis (Exhibit 1 on next page).4 How could the experts have been so wrong? How could they not have seen the financial storm approaching? We believe it is because most experts doggedly followed conventional wisdom, which told them to watch the government’s choice of exchange rates and the management of fiscal and monetary aggregates to sense the approach of a crisis. To be sure, macroeconomics matters, as the crisis unfolding in Argentina in 2002 demonstrates beyond any doubt: Argentina’s crisis in 2001–2002 was set in motion by an unsustainable fiscal situation, which led to the government’s default on $141 billion in debt, a significant devaluation of the peso when the link to the dollar was eliminated, and a freeze on deposits, all of

For all the drama behind the unraveling of Thailand’s economy, however, the elements of the storm had been building quietly for years. An early sign of a crisis brewing was the mid1996 collapse of the Bangkok Bank of Commerce. The failure of the bank exposed years of highly questionable banking practices. Then, Somprasong Land, a company that had turned thousands of acres of swampland into suburban housing, became the first real estate company to default on its international bonds.1 Other scandals and failures followed. Before long, foreign bankers began calling in their loans. Hedge funds and other investors, sensing weakness in the economy, began selling the baht short. Thai companies, fearing that the currency was on the brink of devaluation, started dumping the baht for dollars. The baht’s drop occurred shortly thereafter.

An early warning system for financial crises | 1

Exhibit 1. Rating agencies were surprised by the crisis in Mexico
Interest rate spread of Mexican bonds over US Treasuries
2800 BB+ Positive outlook1 2400 Negative outlook Stable outlook BB Negative outlook






Crisis 0 Nov 1994

Dec 1994

Jan 1995

Feb 1995

Mar 1995

Apr 1995

May 1995

Ratings outlook assesses the potential direction of the credit rating over the intermediate to longer term; it takes into consideration any changes in the economic and/or fundamental business conditions of the country. Source: Standard & Poor’s

which triggered the banking crisis. Yet, based on our research, we believe that most of the warning signs of financial storms lie in microeconomic conditions, which we believe presage the arrival of financial crises long before they have built up into cataclysmic events.5 For this reason, we assert that monitoring the microeconomic conditions—with relatively simple metrics— in addition to tracking macroeconomic indicators will not only help track the probable course of a crisis but also indicate where it will strike and even roughly when it may strike.

A pattern of buildup
No one would argue that financial crises are easy to predict. As one former IMF official conceded, “The IMF has predicted 15 of the last six crises.”6 Still, we believe that they are not impossible to predict, particularly since there is a pattern in the unfolding of most financial crises (Exhibit 2). Most begin with weakness in the real sector, specifically in the inability of businesses to sustain efficient and profitable performance. In emerging markets, this is often due to the closed nature of the economy, in which

2 | McKinsey on Finance Spring 2003

Exhibit 2. Ten indicators of an impending crisis

It takes a blend of art and science to see the warning signs of a financial crisis. Listed here are 10 key indicators that managers should monitor; both the level and the trend are important. When several of these indicators start heading in the wrong direction at once, a crisis could be brewing.


Value destruction in the private sector. When companies cannot make enough money to cover the cost of the money they have borrowed, a crisis may be brewing. The red light starts flashing when the return on invested capital (ROIC) for most companies in the country is less than their weighted average cost of capital (WACC). This was the case in every crisis we have studied. Interest coverage ratio. If the ratio between the cash flow and the interest payments of a company (the interest coverage ratio) falls below 2, that company may be facing a liquidity crisis; if this applies to the average of the top listed companies in a country, a widespread crisis could be pending. Profitability of banks. An annual systemwide return on assets (ROAs) of less than 1 percent for retail banks and/or an annual net interest margin of less than 2 percent are often signs of a crisis. Rapid growth in lending portfolios. When banks’ loan portfolios grow faster than 20 percent per year for more than 2 years, we have found that many of those loans turn out to be bad and can fuel a financial crisis. Shrinking deposits or rapidly rising deposit rates. When depositors start pulling their money out of local banks, particularly over 2 consecutive quarters, beware. This action is frequently a sign of imminent crisis.

Nonperforming loans. Ill-advised lending eventually ends up bloating nonperforming loan (NPL) portfolios. When true NPLs exceed 5 percent of total bank assets, the warning lights should be red. The trouble is that banks often do not fully disclose NPLs until the crisis has hit. Also, different countries have different definitions of nonperforming loans. Interbank, money market borrowing rates. When a retail bank is chronically short of funds, borrowing in the interbank market, or offering rates higher than the market in order to drag in funds, the market is, in essence, giving a vote of no confidence to the bank. The weakness of one bank can lead to contagion. Term structure of foreign bank loans. Many companies in emerging markets borrow from foreign banks in dollars, euros, or yen to lower interest rates. When more than 25 percent of foreign lending to a particular country has terms of less than a year, a warning light should be flashing since those loans are highly vulnerable to withdrawal in the event of a crisis. Rapid growth or collapse of international money and capital flows. When foreign investors, through equities, bonds, and bank loans, pour money into a country that is neither productive nor well managed, a credit binge results that may lead to a crisis. Such inflows can set the conditions for a crisis. Asset price bubbles. Asset price bubbles—and busts— occur the world over, but are particularly common in emerging markets where asset markets are thinly traded and the moods of investors can be volatile.









directed lending, the lack of real competition, and poor corporate governance are tolerated, often over a long period of time. It can also happen in mature economies (for example, Sweden in 1985) and in individual sectors (for example, the US savings and loan crisis of the mid-1980s). These structural weaknesses are often revealed when the government attempts to integrate the country into the global

economy in one bold stroke. It is often too much, too soon. Next, misguided lending fans the flames. In all the crises we have seen, financial institutions not only continued their lending to these increasingly unstable corporate entities but increased their lending to them—sometimes dramatically. We have also seen them move

An early warning system for financial crises | 3

As markets develop and expand to areas of the world in which they had not traditionally had a major role, it is highly likely that crises will grow in frequency as well as in magnitude and intensity.

Ecuadorian economy, or internal, such as in the rapid loss of depositor confidence in Argentina after years of economic mismanagement. In one crisis after another, we have found a pattern of gradual buildup in the corporate and banking sectors, followed by a triggering event in the macroeconomy. In Mexico’s crisis, for instance, the banking system was fueled by excess liquidity. That in turn encouraged the banks to lend generously to the private sector. But at the same time that the corporate sectors were being fed by the credit boom, they were simultaneously suffering from a flood of imports, leading to performance problems long before the crisis. This, paradoxically, was caused by government policies that began in 1989 when much of the economy was privatized and liberalized, followed a few years later by the North American Free Trade Agreement between Canada and the United States. These changes were all necessary and caused confidence in the Mexican economy to rise dramatically. They also encouraged the foreign lending boom that eventually led to the overvaluation of the Mexican peso. As in Thailand, Mexico’s government did not see the imbalances building in its economy and was blindsided by the crisis that hit at the end of 1994. Sweden offers a similar pattern. From a history of tight bank regulation, the Swedish financial sector was deregulated in 1985. The removal of lending restrictions triggered aggressive lending by foreign and domestic banks, much of it going directly into real estate.7 Before long, property values were soaring. In 1989, Sweden liberalized its capital

away from their areas of expertise into highrisk corporate and consumer lending. Poor banking skills are at the heart of most of these missteps, but they are exacerbated by questionably close relationships between the banks and their debtors, pressure by the government to lend money to facilitate economic development, and the lack of caution that comes when deregulation and a wave of foreign capital wash into the economy. All of these actions lead to a rapid and unsustainable buildup in bad loans. In this stage of the crisis, the regulatory system—which should prevent such problems—either fails completely or is inadequate to correct the problems. The regulators are civil servants who frequently lack the skills to manage a booming economy—let alone the power to face off against the financial institutions, which may be arbitraging the regulations and hiding the true extent of their problems. The final stage comes when macroeconomic policies and exogenous shocks set off the crisis. Macroeconomic policies—mostly those setting exchange rates and fiscal policies— often determine the timing and magnitude of the crisis. Crisis triggers can be external shocks, such as El Niño’s effect on the

4 | McKinsey on Finance Spring 2003

restrictions and citizens were allowed to invest in assets abroad.8 Many bought property outside the country, borrowing in foreign currencies with lower interest rates. Against this mounting problem, the Swedish economy was being eroded by a growing trade deficit, partially fueled by real exchange rate appreciation. In addition, the government’s policy of pegging the exchange rate encouraged creditors to take unhedged loans in foreign funds. Because the pegged currency masked the true exchange rate risk, borrowers obtained what appeared to be “cheap” foreign currency loans with little thought that the krona would ever depreciate. It took just a few swift measures by the Swedish government to make the storm clouds coalesce; in 1992, in an attempt to protect the exchange rate in the face of international turmoil, the government imposed a new tax system and introduced a more restrictive monetary policy. The new tax system favored saving rather than borrowing, thereby reducing interest payment deductibility. These measures led to a sharp decrease in inflation and large after-tax increases in real interest rates. As a result, the real estate market plummeted, which, in turn, resulted in a flood of nonperforming loans. By the early weeks of 1993, the krona had lost 25 percent of its value, and foreign capital was fleeing Sweden for safer havens.9 In these examples and others, we see two important benefits from having a better understanding of crisis dynamics and what causes financial storms. First, by understanding the fundamental causes of financial storms, we hope that their sudden impact, high cost, and prolonged duration can be minimized. Second, by recognizing that the

seeds of a financial storm grow first and foremost in the real and banking sectors, we hope that executives can see the warning signs of a storm early—in time to make informed decisions that help to shelter their companies from the fury of the storm.

Conclusions and outlook for future crises
The process of tying emerging markets to the global economy offers great rewards to all, but it does not come without pain and cost if these emerging markets are not ready or do not have adequate “immune systems” in place. We believe that several significant crises might lie ahead. It is almost preordained that this should be the case. As markets develop and expand to areas of the world in which they had not traditionally had a major role, it is highly likely that crises will grow in frequency as well as in magnitude and intensity. Many observers believe that there might be at least three major financial storms brewing in the world economy. These are likely to be among the largest experienced to date: 1. Japan, which The Economist in early 2002 called the “nonperforming economy,” has delayed needed reforms for a very long time and caused enormous unresolved pressures to build in its banking system and macroeconomy.10 The costs to the Japanese people and to the world of this continued inattention are likely to be bigger than anything previously experienced. 2. A similar, albeit smaller, storm might be taking shape in China, where years of rapid credit portfolio buildup in state-owned enterprises (SOEs) have allowed a portfolio of nonperforming loans to accrue, estimated at

An early warning system for financial crises | 5

more than $600 billion.11 The catalyst of a potential Chinese storm might be allowing Chinese depositors to move their deposits freely within China or make investments outside the country. 3. Another, fortunately smaller, event of similar characteristics might be taking shape in India, where decades-long protection accorded to inefficient state-owned enterprises might eventually lead to an economic reckoning. Here the likely precipitating event could be further trade liberalization that exposes ancient behemoths to more intense competitive pressure. The pressures building in these three economies and in those of many others are daunting. Liberalization is gradually reaching all of Eastern Europe, Southeast Asia, and Africa. Further deregulation is likely in the developed markets of Europe and North America as pension reform, bank deregulation, and financial services convergence continue. Moreover, the linkages between the world’s economies are increasing, as corporations globalize, more institutions and individuals invest outside their own countries, and financial institutions become more interconnected through payment systems, syndicated loans, repurchase agreements, interbank lending, and capital market investments.

Dominic Barton (Dominic_Bar is a director in McKinsey’s Seoul office; Roberto Newell (Rober is a recently retired director in the Miami office; and Greg Wilson (Gregor is a principal in the Washington, DC, office. This ar ticle is adapted from their book, Dangerous Markets: Managing in Financial Crises, New York: John Wiley & Sons, 2003.


Pasuk Phongpaichit and Chris Baker, Thailand’s Boom and Bust, Silkworm Books: 1998, pp. 105 and 112. “Thailand: Bond payment—Bangkok Land asks for a delay,” Southeast Bangkok Post, October 29, 1997. Pasuk Phongpaichit and Chris Baker, Thailand’s Boom and Bust, Silkworm Books: 1998, p. 316; Thailand Annual Repor t, International Monetar y Fund, 1997. Exper ts similarly missed the signs of crisis in Indonesia, Korea, and Malaysia. We examined crises in Argentina (2002), Ecuador (1998), Jamaica (1998), Colombia (1998), Mexico (1994), the United States (1986), Sweden (1992), Turkey (2001), Thailand (1997), Korea (1997), Indonesia (1997), Chile (1983), and Russia (1998). We also examined the situation of other countries whose financial sectors are threatened by many of the same underlying conditions discussed herein, including China (2001), Japan (2002), India (2000), Taiwan (2000), Guatemala (2001), Nicaragua (2001), Venezuela (2001), and Honduras (2001), as well as a few others which, at the time of our reviews, were in a situation intrinsically healthier and more stable, including Brazil (1999), Peru (2000), and El Salvador (2001). “IMF splits over plan for global warming,” Washington Times, May 2, 1998, A-11. Lending restrictions prior to 1985 included restrictions on interest rates, limitations on lending to the private sector, obligations for all banks to invest in government securities and mor tgage bank securities, and a ban on foreign bank par ticipation. The removal of these restrictions was coupled with the addition of state subsidies for housing construction, increasing the demand for real estate lending. “Government lifts restrictions on ownership of foreign shares,” Reuters News, Januar y 19, 1989. Sveriges Riksbank (Central Bank of Sweden). “The nonperforming economy,” The Economist, Februar y 16–22, 2002, p. 24. Ernst & Young, Nonper forming Loan Repor t: Asia 2002, November 2001.







All of these events will keep managers busy tracking the crisis warning signs that are flashing in many dangerous markets. Executives also should start now to take the precautionary measures essential to weather the first 100 days of a financial storm. MoF





6 | McKinsey on Finance Spring 2003

Are emerging markets as risky as you think?
A por tfolio perspective on corporate investment reveals risk levels comparable to developed markets.
Marc H. Goedhar t and Peter Haden


nternational companies have long

recognized the promise of doing business in fast-growing emerging markets. When it comes to actually acting on that potential, however, many companies systematically overestimate the risks. High-profile setbacks in Russia, difficulties in managing operations in China, and the on-again, off-again performance of Latin America have heightened sensitivities to the risks of investing in the developing world.

assumptions about the cost of capital—often pegging it at more than double the level of similar projects in the United States and Europe. As a result, good investment opportunities are often rejected and the performance of existing businesses underestimated. The cost of capital for emerging market investments may be higher than it is in the United States and Europe. But we are convinced that it is actually much closer to the levels of developed markets than routinely accepted.1 A more systematic examination of emerging market risk and cost of capital shows why.

Objective analysis leads us to a different perspective. Research we conducted found that while risk in an individual emerging market may be higher, compared to developed markets, it is seldom higher for each and every business within that individual market, let alone across all emerging markets. Indeed, for the company that approaches emerging market investing as a portfolio of businesses, the risks of individual markets may well diversify away. Unfortunately, the perception of elevated risk often colors what should be a clinical evaluation of a company’s many investment decisions and skews the methodologies used to evaluate a project’s risk and return profile. As a result, analysts and business managers overestimate the risk premium, assigning it to levels that even substantial underlying risks would not justify. Thus they also grossly inflate

The risk of emerging market investments
No question, emerging market investments are exposed to additional risks, including accelerated inflation, exchange rate changes, adverse repatriation and fiscal measures, and macroeconomic and political distress. These elements clearly call for a different approach to investment decisions. However, while individual country risks may be high, it is important to keep in mind that they have low correlations with each other. As a result, the overall performance of an

Are emerging markets as risky as you think? | 7

Exhibit 1. Returns on a diverse emerging market portfolio are surprisingly stable 1
Disguised example

Select individual emerging market returns2 600 Country A Country B Country C Country D Country E

Combined portfolio returns 600




400 Emerging markets

Indexed ROIC


Indexed ROIC





100 Developed markets

0 1981 —100






0 1981 —100






In stable currency and adjusted for local accounting differences. 2 Combined portfolio included additional countries not reflected here. Source: Company information


emerging market portfolio can be quite stable if investments are spread out over several countries. At one international consumer goods company, for example, returns on invested capital for the combined portfolio of emerging market businesses have been as stable as those for developed markets in North America and Europe over the last 20 years2 (Exhibit 1). We found similarly low correlations of GDP growth across emerging market economies and the United States and Europe over the last 15 years. These findings, we believe, also hold for other sectors, possibly even banking and insurance, where dependence on the financial system leaves them more exposed than sectors such as manufacturing or services. Moreover, country-specific risks can affect different businesses differently. In the case of

one parent company, sustaining its emerging market businesses during a crisis not only demonstrated that it could counter countryspecific risk, but also strengthened its position as local funding for competitors dried up. For this company, sales growth, when measured in a stable currency, tended to pick up strongly after a period of crisis, a pattern that played out consistently through all the crises the parent encountered in emerging markets. Finally, academic research3 into stock market returns over the past 20 years has turned up little correlation between returns on investments in emerging economies and those in the rest of the world. Simply put, a boom in developed markets does not indicate a likelihood of a boom in emerging markets.4 Over time, the lack of a correlation has meant that emerging market risk could be diversified

8 | McKinsey on Finance Spring 2003

Exhibit 2. Betas for many emerging markets are comparable to or less than betas in developed markets
Betas vs. global market index
World Europe USA Jordan Colombia Pakistan India Chile Egypt Argentina Taiwan Venezuela Indonesia Malaysia Philippines China South Africa Mexico Turkey Korea Thailand Brazil Hungary Poland Russia Source: Datastream 1.00 0.93 0.84 0.06 0.22 0.37 0.43 0.50 0.52 0.55 0.79 0.79 0.82 0.87 0.94 0.97 0.98 1.00 1.04 1.13 1.20 1.30 1.30 1.47 2.28

away in investment portfolios. Indeed, according to McKinsey analysis of annual returns over the past 15 years, a wide portfolio of emerging market index investments has not been more risky than an investment in a single blue-chip corporation in the United States or Europe.5 In fact, systematic measurements of risk find emerging market indexes to be on the whole less risky than the world portfolio over the past 15 years (Exhibit 2).

portfolio performance evaluations? Either a cash flow scenario approach or a country risk premium approach can produce accurate valuations if they take into account findings on emerging market investment risk. For example, it is possible to illustrate how either approach might work for an investment in two identical production plants, one in Europe and the other in an emerging economy (Exhibit 3).

Cash flow scenario approach
Analyzing and valuing emerging market risk
Actual risks in emerging markets may often be smaller than commonly assumed, at least for those corporations and shareholders who take a portfolio approach to investing there. But how should those risks be reflected in emerging market investment decisions and The cash flow scenario approach examines alternative possibilities for how future cash flows might develop. At a minimum, the approach should evaluate two scenarios, one that assumes that cash flow develops according to the business plan, i.e., without local economic distress risk, and a second that reflects cash flow under adverse economic conditions.

Are emerging markets as risky as you think? | 9

Exhibit 3. Scenario approach vs. country risk approach
Net present value for identical facilities in . . . . . . a European market Probability Cash flows in perpetuity

. . . an emerging market Probability Cash flows in perpetuity 2 Year 1 Year 2 Year 3 Year 4 . . . 80% 20% ‘As usual’ 100 103 26 105 26 108 27

Year 1 Year 2 Year 3 Year 4 . . . 100% 0% Scenario approach ‘As usual’ ‘Distressed’ 100 0 103 0 105 0 108 0

‘Distressed’ 25 Expected cash flows

Expected cash flows 100 Cost of capital Net present value 1333 103 105 108

85 Cost of capital Net present value 1133

87 10.0%




85% of European NPV

Cash flows in perpetuity 1 Year 1 Year 2 Year 3 Year 4 . . . ‘As usual’ Country risk premium approach 100 103 105 108

Cash flows in perpetuity 1 Year 1 Year 2 Year 3 Year 4 . . . ‘As usual’ 100 103 105 108

Cost of capital Net present value 1333


Cost of capital Country risk premium

10.0% 1.3%

Adjusted cost of capital 11.3% Net present value
1 2


85% of European NPV

Assuming perpetuity cash flow growth of 2 percent. Assuming perpetuity cash flow growth of 2 percent and recovery under distress of 25 percent of cash flows “as usual.” Source: McKinsey analysis

Setting up the parameters for scenario analysis is always subjective. Once key assumptions are established, however, comparisons among scenarios are valid. In our analyses, we assume for simplicity’s sake that if adverse economic conditions develop in the emerging market, they will do so in the first year of the plant’s operation. In reality, of course, an investment will face a probability of distress in any and each year of its lifetime, but modeling risk over time would require much more complex calculations—without changing the basic results. We also assume that in most financial crises an emerging market business would not wind up entirely worthless, so we apply a 20 percent chance of financial distress, with the cash flow 75 percent lower than for a business-as-usual scenario. As a consequence, the plant in the emerging economy could expect future cash flows

significantly lower than its European equivalent. But because the country distress risk is diversifiable, the beta and cost of capital are identical for both plants. Risk is taken into account, but not in the cost of capital. Instead, it is reflected in the expected value of future cash flows. As a result of this local economic distress risk, the value of the emerging market plant is indeed significantly lower than the value of its European sister plant.

Countr y risk premium approach
The second approach is simply to add a country risk premium to the cost of capital for comparable investments in developed markets. The resulting discount rate should then be applied to the business-as-usual cash flows (without taking country risk into account in the cash flow projections). In our analysis, using the same plant net present value (NPV)

10 | McKinsey on Finance Spring 2003

Exhibit 4. The probability of financial distress must be extremely high to justify double-digit risk premiums

20% 18% 16% 14% 0% recovery 12% Risk premium 10% 8% 6% 4% 2% 0% 20% Source: McKinsey analysis 40% 60% Probability of distress 80% 100% 120% 25% recovery

as the cash flow scenario approach, led to an implied discount rate of 11.3 percent, reflecting a country risk premium of only 1.3 percent. Unfortunately, some practitioners make the mistake of adding the country risk premium to the cost of capital to discount the expected value of future cash flows which already include the probability of distress, rather than the cash flows under the ‘business as usual’ scenario. The error results in a value that is too low because it accounts for the probability of a crisis twice. Others set the country risk premium too high. Even at the fairly high probability of distress and the conservatively low recovery rate6 in our scenario above, the resulting 1.3 percent risk premium is still far lower than the doubledigit premiums often proposed in emerging

market investments. In order to justify some of the higher premiums we’ve seen, the probability of a local economic crisis for an investment would need to be practically certain, at 80 percent or higher (Exhibit 4). Such extremely high distress probabilities and low recovery rates implicit in double digit risk premiums are inconsistent with our findings on the limited impact of country risk on business performance for some international corporations. Aside from typical calculation errors, the country risk premium approach does have a fundamental flaw: there is no systematic methodology to calculate a precise country risk premium. While we were able, in our example, to re-engineer the country risk premium because the true value of the plant was already known from the scenario approach, in most cases the true value of an

Are emerging markets as risky as you think? | 11

investment is obviously not known. As a substitute, the country risk premium is sometimes set at the spread of the local government debt rate7 over the risk-free rate— but that is reasonable only if the quality of local government debt service is perfectly correlated with returns on corporate investments.

performance assessments must explicitly account for local economic and business conditions for emerging markets, such as inflation and GDP development. And just as for any business with volatile results, shortterm performance assessments cannot rely on figures alone.

Implications for evaluating financial performance
Corporations face similar issues in evaluating historical emerging market business performance in terms of economic profit8 or some other comparison of return on capital vs. cost of capital. Again, both the scenario approach and the country risk premium approach can be applied in principle. When assessing returns on capital over longer periods of time, the cost of capital should be used without incorporating a country risk premium. That’s because over longer periods of time a particular emerging market is more likely to have experienced some economic distress and the risk will already be reflected in the data for the local assets under evaluation and in the historical business results. In contrast, it may make sense to incorporate some country risk premium when assessing returns on capital over shorter periods of time. If a crisis has not materialized, the countryspecific risk will not already be incorporated in data for local assets. Of course, this premium should reflect realistic assumptions on distress probability and recovery rates. Because of the uncertainty surrounding this premium, the resulting short-term evaluation will be relatively inaccurate and must be interpreted with caution. Financial

A systematic assessment of the cost of capital for emerging markets may well reveal a lower cost of capital if portfolio diversification and the true exposure to country risk are taken into account. Such assessments also illuminate the advantages of developing distress scenarios and planning for financial upheaval should it occur. MoF
Mark Goedhart (Marc_Goedhar is an associate principal in McKinsey’s Amsterdam office; Peter Haden ( is a consultant in the London office. Copyright © 2003, McKinsey & Company. All rights reser ved.

When expressed in the same stable currency such as US dollars or euros. All returns on capital measured in stable currency and adjusted for local accounting differences. See for example, C.M. Conover, G.R. Jensen, and R.R. Johnson, “Emerging markets: When are they wor th it?” Financial Analysts Journal 1996, Volume 52, Number 5. Even if emerging market economies integrate with global and developed market economies, the relative risk of individual emerging economies would decline and the cost of capital would still not be significantly higher than for developed markets. All market returns measured in US dollars. Recover y rate here indicates the value of cash flows under the local economic distress scenario as percentage of the cash flows under the business plan scenario. This is a promised yield rather than an expected yield on government bonds, fur ther underlining that the countr y risk premium-based cost of capital must be applied to promised i.e. business-as-usual cash flows instead of expected cash flows, which already include the probability of distress. Economic profit is a measure of periodic value creation defined as ROIC invested capital WACC invested capital.








12 | McKinsey on Finance Spring 2003


Time for a high-tech shakeout
The capacity glut means the industr y needs consolidation.
T. Michael Nevens


he technology industry badly needs a

shake-out: a consolidation of the myriad technology providers that sprang up in the 1990s would benefit both the industry and its customers. Yet because of the interlocking interests of executives and board members, this catharsis probably won’t come from within. Interlopers from the edge of the industry or beyond will probably drive the change. During the 1990s, the boom in hightechnology spending spelled prosperity for new and established companies alike. The popularity of enterprise resource planning and electronic customer relationship management systems, preparations for the “millennium bug,” personal-computer upgrades to take advantage of the Internet and growing corporate networks, demand for cell phones and personal digital assistants, and the telecommunications companies’ rush to build new networks—all created about $1 trillion more in demand than trends would have suggested in 1989. Now that demand is gone and we know there was less benefit from the technology purchases than the new-economy prophets would have had us believe. The overhang of capacity is significant. In software, for example, the number of companies increased by 15 percent

over the 1990s while the market grew by 12 percent. For these companies to meet the projected consensus earnings reported by Zacks Investment Research, average net margins would have to increase by 94 percent, to a record 18 percent. At the same time, software investment rose to 11 percent of worldwide capital spending during the 1990s. While software may gain a slightly larger share over the coming years, the sheer scale of the industry will probably limit growth in demand to a maximum of 8 to 12 percent. Yet the companies formed are still with us. Some are substantial businesses with good long-term prospects. They will invest through this downturn and emerge as leaders; think of Intel riding out the perilous financial times of the mid-1980s as the initial PC bubble burst. Many companies, though, are investing for a future they cannot reach. They need to be restructured—downsized, merged, acquired, or liquidated. But the restructuring hasn’t happened. Managers and boards of high-tech companies share an interest in maintaining their positions. Because high-technology companies favor executives in the industry as board members (for their expertise), these informal coalitions cross company boundaries.

Time for a high-tech shakeout | 13

The investment bankers and private equity firms that might propose a restructuring fear disrupting their relationships with this community and reducing the odds of winning future business from it. In fairness, these executives and directors are also cautious because of the conventional wisdom that hostile deals do not work in high technology and that most mergers have not been successful. This belief is exaggerated and is grounded in a misreading of history. When the last extended downturn hit in the 1980s, the high-tech industry was much smaller and populated by a fraction of the number of current companies. More important, enterprise-installed bases of technology were smaller, and hence predictable revenue streams for support and maintenance were neither as large nor as stable as they are today. Moreover, the potential benefits of consolidation are substantial. Most enterprise software companies, for example, spend 25 to 35 percent of their revenues on selling, general, and administrative expenses. If companies selling to the same customers were consolidated, the new company could slash these outlays. Further, many companies are investing in research and development for product lines that have a dimmer future than management would like to believe. These outlays can run to an additional 15 or so percent of revenues. Cool-headed managers can find savings here as well. Last, a number of companies are trading at or below the value of the cash on their balance sheets. There is economic value to harvest either by finding tax-efficient ways to return that cash to investors or by merging

companies to channel the cash to businesses with a brighter future. In the larger context, restructuring could spur the industry to do a better job for customers. Customer spending will probably pick up when enterprises become convinced that they can get top- and bottom-line benefits from their technology investments. Companies need tailored solutions and help to make their organizations, business practices, and processes more productive. Many small technology companies cannot accomplish this. What will it take to open the gates to restructuring? Most likely the industry will require outside intervention. Much as T. Boone Pickens and Drexel Burnham Lambert shook up the energy and other industries in the 1980s, people and companies outside the circle that formed during the prosperity of the 1990s may lead the way. Many leaders of the restructuring of the 1980s are reviled for the excesses of that period, but their actions ultimately made US industry more competitive, laying the foundation for the burst of productivity and growth that blessed the US economy for much of the 1990s. This is a task worth undertaking. As the industry works through the current slump, conditions are ripe for a return to average annual growth rates of 8 to 10 percent. Top companies will outperform those levels. The sooner restructuring gets under way, the sooner there will be a chance for better times. MoF
Mike Nevens is a retired director in McKinsey’s Silicon Valley office and formerly led the Firm’s global High Tech Practice. This ar ticle was originally published in the Financial Times on Januar y 6, 2003. Copyright © 2003 by McKinsey and Company. All rights reser ved.

14 | McKinsey on Finance Spring 2003

Getting what you pay for with stock options
Companies are rethinking stock options. Here’s how they can better ser ve shareholders and executives.
Neil W. C. Harper and Jean-Christophe De Swaan


xecutives can no longer think of stock

options as a free ride. The exodus of investors from equity markets and the accounting scandals that toppled Enron and WorldCom have made scores of blue-chip companies—Coca Cola, General Electric, and Procter & Gamble among them—announce plans to account explicitly for the cost of options they use to compensate executives and other employees. In November of 2002, the International Accounting Standards Board published a proposal to force all companies to do the same. In any case, rather than burying options payouts as a footnote in financial reports, more and more companies will now report them the same way they report office rents, salaries, and other business expenses. Such accounting changes are unlikely to harm stock prices, and over time such a healthy standard of disclosure should spread throughout the economy, thereby providing investors with clearer and more complete information.

talent. As the income statements of many companies begin to reflect, for the first time, the true cost of options, senior executives and boards should take the opportunity to rethink this popular approach to compensation in light of five principles that help them align more closely the role of options as managerial incentives with the interests of shareholders.

1. Explicitly tie compensation to unique value creation
In case after case, investors have seen executives reap extraordinary rewards tied to share price increases that had little to do with management and everything to do with factors beyond its control, such as movements of interest rates and changes in macroeconomic conditions. Since standard stock options don’t differentiate between value created by external factors and individual performance, investors may be shortchanged and CEOs may be rewarded regardless of merit—as happened during the stock market run-up of the late 1990s—and top-performing CEOs may be penalized if their tenure coincides with a bear market. Indeed, McKinsey research shows that from 1991 to 2000, market and industry factors drove about 70 percent of individual company returns, while companyspecific factors were responsible for only 30 percent.

The change by itself won’t make it any easier for executives and boards to manage compensation. For a start, treating options as an expense opens up another arcane accounting debate: how to calculate their real cost. Moreover, managers must continue to evaluate the desired mix of cash, restricted stock, shadow stock, options, and other such mechanisms; the strategic implications of these mechanisms; and their effect on an organization’s ability to attract executive

Getting what you pay for with stock options | 15

Executives . . . have ample opportunity to affect share prices by managing in ways that aren’t necessarily in investors’ best interests.

managing in ways that aren’t necessarily in investors’ best interests. Increasing the financial leverage of a company or the degree of business risk it bears are prime examples. Consider the situation of a CEO who holds a substantial number of options that are in effect worthless because the share price has fallen significantly below the “strike” price at which the executive can exercise them. If there is little likelihood that the share price will rise sufficiently, the CEO might well consider undertaking risky acquisitions or new projects that could increase the expected volatility of the stock price and restore his options’ value. All approaches to valuing stock options agree that increasing the volatility of the underlying stock price boosts an option’s value—because as the share price movements increase, so does the probability that the stock price will exceed the option’s strike price at some time during the option’s life. The CEO faces limited downside; the options were worthless to begin with, and no matter how far the stock might plunge, they can’t become any more so. He or she has nothing to lose and everything to gain from greater volatility—which, however, increases the potential magnitude of downward share price movements and may therefore introduce a degree of risk that many investor groups would neither anticipate nor welcome. To guard against such circumstances, the board’s best response might be to reduce the weight of stock options in the CEO’s compensation.

One way to home in on unique value creation would be to strip out the effect of factors beyond the executive’s control and the return on equity expected by shareholders. What remains—reflecting improvements in performance or changes in expectations for which the executives were themselves responsible—should be compared with the achievements of their peers. In general, executives ought to be held accountable for their ability to meet their shareholders’ expectations as defined by the cost of equity. In addition, they should (and presumably would wish to) be rewarded for any individual value creation and penalized for any individual value destruction. Indexed options are one tool for achieving this. Unlike standard options, indexed options make it possible to benchmark an executive against a set of his or her peers. Of course, making the right selection of peers is crucial; in the few cases where indexed options have been employed for this purpose, their impact has been diluted by the use of too lenient or broad a definition of the peer group.

2. Minimize incentives to alter the company’s risk profile
Investors have also discovered that executives of the companies whose shares they own have ample opportunity to affect share prices by
16 | McKinsey on Finance Spring 2003

3. Favor the grant of restricted stock over stock options
As noted, indexed stock options offer one way to distinguish between value created by external forces and value arising from

individual performance. But the solution they offer is only partial. Indexed options can still create incentives for executives to pursue interests that are unlikely to maximize shareholder value. One answer would be to replace stock options with restricted stock, granted under conditions related to executive tenure and performance. By requiring executives to invest some minimum proportion of their wealth or multiple of their salaries in the stock of the companies they run, boards can ensure that they will care about a sustained drop in share price. Many companies, including Citigroup and Bank One, have instituted such rules.

Boards can also move to restrict the sale of a significant proportion of stock awards. This would ensure that senior executives focus on the creation of long-term value.
taking short positions in other companies in the same sector, thus offsetting a portion of their holdings. Given that there are many ways to hedge, it is difficult to make it impossible for executives to hedge themselves completely against a drop in the value of their own companies. To provide the greatest transparency, boards might consider asking senior executives to disclose their same-industry holdings, or indeed the entirety of their investment activity, on a regular basis as a deterrent to egregious hedging practices.

4. Restrict the timing of stock sales
Boards can also move to restrict the sale of a significant proportion of stock awards over a period of, say, two years after the end of an executive’s tenure. This would ensure that senior executives focus on the creation of long-term value and not on short-lived bumps in the stock price. It would also deter CEOs from leaving unpleasant surprises for their successors and would create greater incentives for them to orchestrate or facilitate their replacement by strong successors.

5. Limit potential for hedging strategies
Senior executives have many ways to hedge their holdings in their company’s shares. From a senior executive’s perspective this may seem sensible as a way to ensure portfolio diversification. But it poses a danger for shareholders because it can, without their knowing it, limit the executive’s real exposure to the results of his decisions. They could, for example, carry out a hedging strategy by

Continuing accounting scandals have given companies an opportunity to rethink stock options and their ideal role in aligning management and shareholder interests. The principles described here are not a comprehensive solution to the questions surrounding the use of stock options. But as a clear point of departure from earlier practices, they may help in better balancing the interests of executives with those of the companies and investors they serve. MoF
Neil Harper ( is a principal in McKinsey’s New York office, where J.C. De Swaan (Jean-Christophe_De_Swaan is a consultant. Copyright © 2003, McKinsey & Company. All rights reser ved.

Getting what you pay for with stock options | 17


Much ado about dividends
The proposal to eliminate the double taxation of dividends is more notable for what it wouldn’t do than for what it would.
Timothy M. Koller and Susan L. Nolen Foushee


n January President George W. Bush

proposed eliminating the double taxation of stock dividends. Taxing dividends twice, that is, at both the corporate and the individual level, has long differentiated the US tax system from those in many other countries, including France, Germany, and Australia. As the proposal moves to debate in Congress, discussion is likely to focus on whether and how much the change, if adopted, would stimulate the economy, and which portions of the US population are likely to benefit most from the tax cut.

acquisitions seemed to claim pride of place in the strategic thinking of many executives. We doubt it. Indeed, when viewed from an understanding of the shareholder makeup and share price movements of US companies, we believe that the proposed tax cut will not have a significant or lasting effect on US share prices. Moreover, history and practice suggest that if the proposal becomes law, most US companies will not—and should not— significantly change their dividend policies.

We won’t comment on those broader macroeconomic and political issues. From the corporate perspective, however, we have watched with interest as business commentators have analyzed the proposal from the corporate perspective. Some have turned to finance theory to analyze whether the proposal could raise share prices of companies that pay dividends and change the policies of those that currently do not. Others suggest an even more sweeping implication: that ending the double taxation of dividends might better align corporate strategies with economic fundamentals, putting capital to better use and restoring a greater degree of soundness to strategy formulation after a period in which debt-financed growth and

What the tax cut would do . . .
At the level of the individual investor, the amount of the proposed tax cut would depend on the extent to which income has already been taxed at the corporate level. Investors who receive dividends from companies that have paid US income tax on all their earnings would not pay additional taxes. If those companies have paid tax on only part of their earnings, investors would get a similarly proportioned tax reduction. As long as companies have paid taxes on their earnings, even those that retain their earnings rather than distribute them as dividends would pass along the benefit to investors. The policy would mandate that when investors sell shares

18 | McKinsey on Finance Spring 2003

in companies that have paid taxes on their earnings, those companies must recalculate the stated purchase value of the shares to reflect undistributed earnings. Investors would then pay proportionately lower taxes on the narrower capital gains.

Exhibit. Most US shares are held in tax-exempt individual and institutional accounts
September 2002; percent
100% Foreign investors1 11 $11 trillion

. . . and not do for shareholders . . .
Nonetheless, the proposed tax cut isn’t likely to have any significant, lasting effect on US share prices. That’s primarily because the key investors who drive share prices are already exempt from taxes. Indeed, what little impact the proposal might have had was likely reflected in the 2.2 percent gain in the S&P 500 on the day before the proposal was announced. Those who believe otherwise draw on classic finance theory.1 In a world without taxes, the thinking goes, shareholders would be indifferent to whether or not a corporation pays dividends, since the funds to pay dividends would come at their own expense. In a world with taxes, shareholders may face differing tax rates on dividends versus capital gains. Therefore, shareholders will care whether a company chooses to retain its earnings or distribute them as dividends, as this affects how much cash they ultimately earn from their investments. If all investors paid taxes on dividends, then yes, share prices would probably increase if the tax were eliminated. In the United States, however, tax-paying US individual shareholders are in the minority, in terms of their overall ownership of US shares. In 2002, they owned 28 percent of all US shares, whereas US institutions and individuals who hold shares in tax-exempt accounts accounted for 61 percent of share ownership, with the remainder held in foreign hands (Exhibit).

Non-tax-exempt US individuals

28 61

Tax-exempt US individuals and institutions2

As foreign investors’ tax status can be complex, we have kept them in a separate category. Percentage of tax-exempt individuals has been estimated based on 2001 figures for holdings in IRA accounts of mutual funds. Source: US Federal Reserve Flow of Funds Accounts; Investment Company Institute; McKinsey analysis


For the most part, tax-paying individual shareholders ultimately do not drive share prices; non-tax-paying institutional investors do. Furthermore, the trading activity of a company’s top 40 to 100 investors—again, usually big institutional investors—account for 70 percent of its stock price movements.2 Since they are indifferent to the issue of taxes on dividends, these investors are unlikely to set in motion the kinds of changes in their portfolios that would actually drive share prices up. Indeed, experience in other countries would seem to confirm our expectations. For example, when the incoming Labour government in the United Kingdom proposed to drop dividend tax credits for investors in mid-1997, some observers estimated that the market would fall by as much as 13 percent. Although the leading UK share index, the FTSE 100, dropped 2 percent after the first leaks of the plan, by the time of its official

Much ado about dividends | 19

announcement the index had fully recovered its value.

. . . and strategists
Similarly, if the proposed tax cut is enacted into law, most US companies probably should not significantly change their dividend policies. The questions they consider will remain the same: can they consistently and reliably pay at the proposed level every quarter? Or would this amount to a one-off distribution that would be better accomplished with a share repurchase? How would the markets interpret any changes in dividend policy? For many companies who want to execute a one-off distribution, share repurchases will remain a more attractive option, as they have no implicit promise that the company will repeat the action every quarter. It’s also unlikely that companies would pay increased dividends at the expense of making needed capital investments. In fact, our observations in practice suggest the contrary: companies that can find valuable projects are typically not constrained by sources of financing, whether equity or debt, or by commitments to pay dividends. Rather, managerial constraints, such as finding the time and skills to bring promising projects to fruition, are a much greater hurdle. Others have suggested that companies will now have an incentive to raise equity (with the promise of future dividend payments), correcting a perceived swing toward debt financing in the 1990s. However, with the exception of telecoms and utilities during that period, US companies have held their debt-tocapital ratios remarkably constant over the past 40 years, at an average of 45.5 percent—

and the balance overall during much of the 1990s was actually lower than the 40-year average. Thus, there is no swing to debt financing to correct. Still others have predicted that managers will have to introduce or increase dividends in order to meet investor demand. With a few exceptions, we believe that the preponderance of tax-indifferent institutional investors will mean little demand for significant increases. The few exceptions will include companies that have accumulated large cash reserves, which will likely come under pressure from their shareholders to distribute them, and companies where CFOs must plan to optimize shareholder wealth via dividends for taxpaying individual shareholders that hold significant stakes.

In the end, the proposed tax cut will have no significant impact either on investor wealth or on manager behavior. Both investors and managers would be better off looking at the underlying ways to create value than overly concerning themselves with the mechanics of how it is returned to shareholders. MoF
Tim Koller ( is a principal in McKinsey’s New York office, where Susan Nolen Foushee ( is a consultant. Copyright © 2003 McKinsey and Company. All rights reser ved.


Mer ton Miller and Franco Modigliani, “Dividend policy, growth, and the valuation of shares,” Journal of Business, October 1961, Volume 34, pp. 411–433. For companies in the S&P 500 with market capitalization between $500 million and $200 billion. See Kevin P. Coyne and Jonathan Witter, “What makes your stock price go up and down,” The McKinsey Quar terly, 2002 Number 2, pp. 28–39.


20 | McKinsey on Finance Spring 2003


Copyright © 2003 McKinsey & Company

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