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ues of debt and equity to compute a firm™s financial leverage. What are the limita-
tions of using book values rather than market values for comparing leverage across
industries or firms? For what types of industries/firms are book values likely to be
most misleading?
4. One important driver of a firm™s capital structure and dividend policy decisions is
its business risk. What ratios would you look at to assess business risk? Name two
industries with very high business risk and two industries with very low business
risk.
5. U.S. public companies with “low” leverage have an interest-bearing net debt-to-eq-
uity ratio of 0 percent or less, firms with “medium” leverage have a ratio between
1 and 62 percent, and “high” leverage firms have a ratio of 63 percent or more. Giv-
en these data, how would you classify the following firms in terms of their optimal
debt-to-equity ratio (high, medium, or low)?
• a successful pharmaceutical company
• an electric utility
• a manufacturer of consumer durables
• a commercial bank
• a start-up software company
6. A rapidly growing Internet company, recently listed on NASDAQ, needs to raise ad-
ditional capital to finance new research and development. What financing options
are available, and what are the trade-offs between each?
7. The following table reports (in millions) earnings, dividends, capital expenditures,
and R&D for Intel for the period 1990“95:
Capital
Year Net Income Dividends Expenditures R&D
1990 $650 $0 $680 $517
1991 819 0 948 618
1992 1,067 43 1,228 780
1993 2,295 88 1,933 970
1994 2,288 100 2,441 1,111
1995 3,566 133 3,550 1,296

What are the dividend payout rates for Intel during these years? Is this payout pol-
icy consistent with the factors expected to drive dividend policy, as discussed in the
chapter? What factors do you expect would lead Intel™s management to increase its
dividend payout? How do you expect the stock market to react to such a decision?
8. U.S. public companies with “low” dividend payouts have payout ratios of 0 percent
or less, firms with “medium” payouts have ratios between 1 and 48 percent, and
“high” payout firms have a ratio of 49 percent or more. Given these data, how
would you classify the following firms in terms of their optimal payout policy
(high, medium, or low)?
668 Corporate Financing Policies




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Corporate Financing Policies




• a successful pharmaceutical company
• an electric utility
• a manufacturer of consumer durables
• a commercial bank
• a start-up software company
9. It is frequently argued that Japanese and German companies can afford to have
more financial leverage and to follow lower dividend payout policies than U.S.
companies because they are largely owned by financial institutions that have long-
term horizons. Does this argument make economic sense? If so, explain why, and
if not, why not. What other factors might explain differences in capital structure
and dividend policy across countries.
10. In 1990 U.S. tax law increased capital gains rates from 20 percent to the same level
as ordinary income rates, between 28 and 34 percent. What implications does this
change have for corporate dividend policy and capital structure?


NOTES
1. See Merton Miller, “Debt and Taxes,” Journal of Finance 32 (May 1977): 261“276.
2. Paul Healy and Krishna Palepu in “Earnings and Risk Changes Surrounding Primary Stock
Offers,” Journal of Accounting Research (Spring 1990): 25“49, find that announcements of stock
issues are interpreted by investors as a signal from management that the firm is riskier than inves-
tors expected.
3. These issues are discussed by Stewart Myers and Nicholas Majluf in “Corporate Financing
and Investment Decisions When Firms Have Information That Investors Do Not Have,” Journal
of Financial Economics (June 1984): 187“221.
4. Findings by Paul Healy and Krishna Palepu in “Earnings Information Conveyed by Divi-
dend Initiations and Omissions,” Journal of Financial Economics (1988): 149“175, indicate that
investors interpret announcements of dividends initiations and omissions as managers™ forecasts
of future earnings performance.
CUC International, Inc. (A)




I
n March 1989 Stuart Bell, Executive Vice President and CFO of CUC
International, Inc., was concerned that the company™s stock was seriously undervalued.
He attributed the undervaluation to the investment community™s concern about the qual- 3
Business Analysis and Valuation
ity of CUC™s earnings: Applications



I am afraid our accounting is misunderstood by many investors. Recently, we have
been forced to spend a lot of top management time and energy defending our pol-
icy in analysts™ meetings. As a result we have been unable to focus investors™ at-
tention on our innovative business strategy and the tremendous cash-¬‚ow
generating potential of our business. Concerns about our earnings quality are
scaring new institutional investors from investing in our business. Many money
16
managers tell me that they love our business concept but are afraid to buy our Corporate Financing Policies

stock because they are worried about our accounting. The accounting is also giv- CUC Inter-
ing short sellers an excuse to scare our current investors and drive down the stock national
price.
While Bell was convinced that CUC™s accounting was appropriate, he wondered
whether it was actually hurting, rather than helping, the company. What, if anything,
should CUC do to shore up investors™ con¬dence in the company?


BUSINESS HISTORY AND OPERATIONS
CUC International, located in Stamford, Connecticut, was a membership-based con-
sumer services company. CUC marketed its membership programs to credit cardholders
of major ¬nancial, retailing, and oil companies, including Chase Manhattan, Citibank,
Sears, JC Penney, and Amoco. The company was formed in 1973 as Comp-U-Card of
America, went public in 1983, and was renamed CUC International in 1987. As a result
of its strong performance, the company was included in Inc. magazine™s list of the fastest
growing public companies in 1984 and 1986.
CUC™s most popular product was Shoppers Advantage, introduced in 1981. Consum-
ers paid an annual membership fee for this service, which entitled them to call the com-
pany™s operators on a toll-free line, or to use on-line computer access seven days a week

.........................................................................................................................
This case was prepared by Professor Paul Healy of M.I.T. Sloan School and Professor Krishna Palepu of Harvard
Business School as the basis for class discussion rather than to illustrate either effective or ineffective handling of
an administrative situation. Copyright © 1992 by the President and Fellows of Harvard College. Harvard Business
School case 9-192-099.




669
670 Corporate Financing Policies




16-20
Corporate Financing Policies




to inquire about, price, and/or buy brand-name products. Shoppers Advantage offered
more than 250,000 brand-name and specialty items. Many members used the service
principally as a reference for comparison pricing, not necessarily to purchase items di-
rectly. The company™s large membership base allowed it to negotiate attractive discounts
on the products offered in its catalog. As a result, the company guaranteed its subscribers
the lowest prices available on goods it sold. If a member, after purchasing merchandise
through CUC, sent an advertisement from an authorized dealer with a lower price within
30 days of placing an order, the company agreed to refund the difference. Members™ pur-
chase orders were executed through independent vendors who shipped the merchandise
directly to customers, enabling the company to carry no inventory.




CUC International
The ¬rm acquired a large share of its new members through agreements with major
credit card issuers, who provided CUC access to its list of cardholders. These individuals
were solicited by three direct marketing approaches: billing statement inserts, solo mail-
ings, and telemarketing. In billing statement insert programs, membership applications
were enclosed in the monthly billing statements of credit card issuers. Solo mailings
were membership offers mailed directly. Telemarketing involved following up mailings
with telephone calls to explain membership offers further. CUC paid 10 percent to 20
percent of initial and renewal membership fees as a commission to the credit card com-
pany.
CUC incurred a large one-time cost for new member solicitations. Because only a
small fraction of people reached through direct mail solicitations purchased the service,
membership acquisition costs typically exceeded membership fees in the ¬rst year. For
example, in 1989 the annual membership fee for Shoppers Advantage was $39, the av-
erage solicitation cost per new member was $29.37, commissions to the credit card com-
panies were $6.63, and the average operating service cost per member was $5.00. Thus
on average for each new member acquired, CUC incurred a cash out¬‚ow of $2 in the ¬rst
year.
Members subscribed to Shoppers Advantage for a single year at a time. Renewals
were automatically billed each year through the credit card company, and members
could elect to cancel the service. There were thus no direct solicitation costs for renew-
ing members. In 1989 CUC had a net cash in¬‚ow of $27.37 for each renewing member”
membership fees were $39, and the commissions to the credit card companies and op-
erating service costs totaled $11.63.1 Membership renewal rates were therefore a key de-
terminant of the pro¬tability of the Shoppers Advantage program. The average annual
renewal rate for Shoppers Advantage in recent years was 71 percent, making the pro-
gram very pro¬table. This average was based on eight years™ experience with the product
since 1981.
CUC capitalized on its Shoppers Advantage experience by introducing a variety of
other membership-based products. These included: (1) Travellers Advantage”a travel
membership created in 1988 to provide subscribers access to database information and
reservations on discount airline travel, hotels and auto rental, tours, and cruises;
(2) AutoVantage”provided subscribers with new car price and performance summaries,

.........................................................................................................................
1. The ¬gures in this and the previous paragraph are from an analyst report by Brian E. Stack of Advest, Inc. dated
October 30, 1989.
671
Corporate Financing Policies




16-21 Part 3 Business Analysis and Valuation Applications




used car valuations, and parts and service discounts; and (3) Premier Dining”a service
introduced in 1989 that offered subscribers two-for-one dining at mid- to upscale restau-
rants in major U.S. cities. The company made large marketing investments to build
memberships in these new programs.
CUC™s management explained the key elements of its business strategy as follows:

The company™s expansion has been built on a foundation of creating, developing,
and marketing a broad array of valuable services to consumers. . . . Aggressive
marketing is an important strength. We sell our goods and services directly to mil-
lions of customers of major credit card issuers. Because our consumer services
are a natural enhancement to personal ¬nancial services, more than 40 of the top
CUC International




50 money center banks and a growing number of retailers and oil companies ¬nd
it advantageous to work with CUC. . . . As competition heats up in the ¬nancial
services industry, demand for CUC™s services is likely to increase. Credit card is-
suers rely upon our services to draw new customers, increase card use, and raise
average balances. They also use our services to differentiate their cards from oth-
ers, and to tailor what they offer to appeal to different life-style and geographic
preferences. Finally, card issuers bene¬t from the stream of membership commis-
sions they receive from CUC.2
By December 1988, CUC had approximately 12 million members enrolled in its pro-
grams. Revenues had grown from $45 million in the year ending January 31, 1984 (¬scal
year 1984) to $198 million in the year ending January 31,1988 (¬scal 1988), and earn-
ings had grown from $3 million to $17 million during this period. Exhibits 3 and 4
present the ¬nancial statements for the year ended January 31, 1988, and for the nine
months ended October 31, 1988. Management expected the company to continue its
rapid growth in the future, with revenues for the ¬scal year ending January 31, 1989 pro-
jected to be approximately $270 million.


THE FINANCIAL REPORTING CONTROVERSY
CUC™s management decided that because current marketing outlays provided signi¬cant
future bene¬ts, the company should capitalize membership solicitation costs in its ¬nan-
cial statements, and amortize them over three years at rates of 40 percent, 30 percent,
and 30 percent. This choice was endorsed by Ernst & Whinney, the company™s auditors,
and by the Securities and Exchange Commission when the company went public.
While it was unusual to capitalize marketing costs, CUC™s managers believed that this
decision was justi¬ed given the nature of the company™s business and their con¬dence
in future renewal rates. Bell explained the rationale behind CUC™s accounting choice:
Many companies spend money on acquiring plant and equipment, and they capi-
talize these costs. Our business does not require major investments in plant and
equipment. Instead, it requires investments in membership acquisitions. Because

.........................................................................................................................
2. Source: CUC™s 1988 Annual Report.
672 Corporate Financing Policies




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Corporate Financing Policies



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