MoF Issue 7

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McKinsey onFinance

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 levelscomparable 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. Heres how they canbetter serve shareholders and executives.

Viewpoint: Much ado about dividends 18

The proposal to eliminate the double taxation of dividends ismore notable for what it wouldnt do than for what it would.

Perspectives on

Corporate Finance

and Strategy

Number 7, Spring

2003

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McKinsey & Company is an international management consulting firm ser ving corporate and government

institutions from 83 offices in 45 countries.

Editorial Board: Marc Goedhart, Bill Javetski, Timothy Koller, Michelle Soudier, Dennis Swinford

Editorial Contact: [email protected]

Editor: Dennis Swinford

Managing Editor: Michelle Soudier

External Relations: Joan Horrvich

Design and Layout: Kim Bartko

Copyright 2003 McKinsey & Company. All rights reserved.

Cover images, left to right: Chet Phillips/Artville; Chuan Khoo/Artville; Ingo Fast/Artville;

G. Brian Karas/Artville; Mitch Hrdlicka/PhotoDisc

This publication is not intended to be used as the basis for trading in the shares of any company or

undertaking any other complex or s ignificant financial transaction without consulting with appropriate

professional advisers.

No part of this publication may be copied or redistributed in any form without the prior written consent of

McKinsey & Company.

McKinsey on Financeis a quarterly publication written by experts and practitioners in McKinsey & Companys

Corporate Finance & Strategy Practice. It offers readers insights into value-creating strategies and the

translation of those strategies into stock market performance. This and archive issues of McKinsey on

Financeare available on line at http://www.corporatefinance.mckinsey.com

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Just before dawn on July 2, 1997,Bangkoks top bankers were awakened andsummoned 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

bahts peg to the US dollar. When the marketsopened 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.

For all the drama behind the unraveling of

Thailands economy, however, the elements of

the storm had been building quietly for years.

An early sign of a crisis brewing was the mid-1996 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 andother 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 bahts drop occurred

shortly thereafter.

Neither Standard & Poors nor Moodys

predicted the severity of the Thai financial

storm.2 Even the IMF, on the eve of the crisis

in the summer of 1997, praised Thailands

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 th

wind. Seasoned observerswhose task it is toidentify problems before they boil over into

crisisall missed the signs of trouble in

Thailand. They had also missed them

elsewhere, as can be seen, for example, in

Mexicos 19941995 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 becausemost experts doggedly followed conventional

wisdom, which told them to watch the

governments choice of exchange rates and th

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:Argentinas crisis in 20012002 was set in

motion by an unsustainable fiscal situation,

which led to the governments 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

An early warning system for financial crises

An excerpt from Dangerous Marketsprovides indicators to spot coming storms

Dominic Barton, Roberto Newell, and Gregory Wilson

An early warning system for financial crises |

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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 microeconomicconditionswith 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 1. Rating agencies were surprised by the crisis in Mexico

Interest rate spread of Mexican bonds over US Treasuries

BB+ BB

Positive

outlook1Negative

outlook

Stable

outlook

Negative

outlook

Nov1994

Dec1994

Jan1995

Feb1995

Mar1995

Apr1995

May1995

0

400

800

1200

1600

2000

2400

2800

1Ratings 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 & Poors

Crisis

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directed lending, the lack of real competition,

and poor corporate governance are tolerated,

often over a long period of time. It can alsohappen 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 al

the crises we have seen, financial institutions

not only continued their lending to these

increasingly unstable corporate entities but

increasedtheir lending to themsometimes

dramatically. We have also seen them move

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 s tar t heading in

the wrong direction at once, a crisis could be brewing.

Value destruct ion in the private sector. When compa-

nies cannot make enough money to cover the cost of

the money they have borrowed, a crisis may be brew-

ing. The red light start s 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 cr isis we

have studied.

Interest coverage ratio. If the rat io between the cash

flow and the interest payments of a company (the in-

terest coverage rat io) falls below 2, that company may

be facing a liquidity cr isis; if this applies to the aver-age of the top listed companies in a country, a wide-

spread crisis could be pending.

Profi tability of banks.An annual systemwide return on

assets (ROAs) of less than 1 percent for re tail 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 f inancial

crisis.

Shrinking deposits or rapidly rising deposit rates.

When depositor s 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 untilthe 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 indollars, 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 bubblesand 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.

10

9

8

7

6

5

4

3

2

1

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away from their areas of expertise into high-

risk 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 thebanks 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

systemwhich should prevent suchproblemseither fails completely or is

inadequate to correct the problems. The

regulators are civil servants who frequently

lack the skills to manage a booming

economylet 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 macroeconomicpolicies and exogenous shocks set off the

crisis. Macroeconomic policiesmostly 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 Nios effect on the

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 Mexicos 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 toperformance 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,

Mexicos 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 Swedishfinancial 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


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.

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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 governments

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 inflationand 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 betterunderstanding 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 sign

of a storm earlyin 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, bu

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 migh

lie ahead. It is almost preordained that thisshould 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 Economistin 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

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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 threeeconomies 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 worlds

economies are increasing, as corporations

globalize, more institutions and individualsinvest outside their own countries, and

financial institutions become more

interconnected through payment systems,

syndicated loans, repurchase agreements,

interbank lending, and capital market

investments.

All of these events will keep managersbusy 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

Dominic Barton([email protected])

is a director in McKinseys Seoul office;Roberto

Newell([email protected]) is a

recently retired director in the Miami office; and

Greg Wilson([email protected]) is a

principal in the Washington, DC, office. This article is

adapted from their book, Dangerous Markets:

Managing in Financial Crises, New York: John Wiley &

Sons, 2003.

1 Pasuk Phongpaichit and Chris Baker, Thailands Boom and

Bust, Silkworm Books: 1998, pp. 105 and 112.

2 Thailand: Bond paymentBangkok Land asks for a delay,

Southeast Bangkok Post, October 29, 1997.

3 Pasuk Phongpaichit and Chris Baker, Thailands Boom and

Bust, Silkworm Books: 1998, p. 316; Thailand Annual

Report, International Monetary Fund, 1997.4 Experts similarly missed the signs of crisis in Indonesia,

Korea, and Malaysia.

5 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 situationintrinsically healthier and more stable, including Brazil

(1999), Peru (2000), and El Salvador (2001).

6 IMF splits over plan for global warming, Washington

Times, May 2, 1998, A-11.

7 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 mortgage bank securities, and a ban on foreign bank

participation. The removal of these restrictions was coupled

with the addition of state subsidies for housing

construction, increasing the demand for real estate lending.

8 Government lifts restrictions on ownership of foreignshares, Reuters News, January 19, 1989.

9 Sveriges Riksbank (Central Bank of Sweden).

10 The nonperforming economy, The Economist, February

1622, 2002, p. 24.

11 Ernst & Young, Nonperforming Loan Report:Asia 2002,

November 2001.


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100

0

100

200

300

400

500

600

100

0

1985 1989 1993 1997 2001 1985 1989 1993 1997 2001

100

200

300

400

500

600

Select individual emerging market returns2

IndexedROIC

IndexedROIC

Combined portfolio returns

1In stable currency and adjusted for local accounting differences.2Combined portfolio included additional countries not reflected here.Source: Company information

Emerging markets

Country A

Country B

Country CCountry D

Country E

1981

Disguised example

1981

Developed markets

emerging market portfolio can be quite stable

if investments are spread out over several

countries. At one international consumer

goods company, for example, returns oninvested 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, wheredependence 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 country-

specific risk, but also strengthened its positionas 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 oninvestments 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


Exhibit 1. Returns on a diverse emerging market portfolio are surprisingly stable1

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Are emerging markets as risky as you think? |

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 notbeen 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).

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

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 oemerging market investment risk. For exampl

it is possible to illustrate how either approach

might work for an investment in two identica

production plants, one in Europe and the othe

in an emerging economy (Exhibit 3).

Cash flow scenario approach

The cash flow scenario approach examines

alternative possibilities for how future cashflows 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 econom

distress risk, and a second that reflects cash flo

under adverse economic conditions.

Exhibit 2. Betas for many emerging markets are comparable to or less than betas in developed markets

Betas vs. global market index

Source: Datastream

Russia

Poland

Hungary

Brazil

ThailandKorea

Turkey

Mexico

South Africa

China

Philippines

Malaysia

Indonesia

Venezuela

Taiwan

Argentina

Egypt

Chile

India

Pakistan

ColombiaJordan

USA

Europe

World

2.28

1.47

1.30

1.30

1.201.13

1.04

1.00

0.98

0.97

0.94

0.87

0.82

0.79

0.79

0.55

0.52

0.50

0.43

0.37

0.220.06

0.84

0.93

1.00

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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 simplicitys sake that if adverse economicconditions develop in the emerging market,

they will do so in the first year of the plants

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

calculationswithout 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 a20 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.

Country risk premium approach

The second approach is simply to add a

country risk premium to the cost of capital forcomparable 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)


Exhibit 3. Scenario approach vs. country risk approach

Net present value for identical facilities in . . .

. . . a European market . . . an emerging market

1Assuming perpetuity cash flow growth of 2 percent.2Assuming perpetuity cash flow growth of 2 percent and recovery under distress of 25 percent of cash flows as usual.

Source: McKinsey analysis

Scenario

approach

Country risk

premium approach

Probability

Year 1

As usual100%

Year 2 Year 3

100

Distressed

Cost of capital

0%

103 105

Year 4

108

100 103

10.0%

Net present value 1333

105 108

0 0 0 0

. . .

Cash flows in perpetuity 1

Expected cash flows

Probability

Year 1

As usual80%

Year 2 Year 3

100

Distressed

Cost of capital

20%

103 105

Year 4

108

85 87

10.0%

Net present value 85% of European NPV

85% of

European NPV

1133

89 92

25 26 26 27

. . .


Expected cash flows

Year 1

As usual

Year 2 Year 3

100

Cost of capital

103 105

Year 4

108

10.0%

Net present value1333

. . .


Year 1

As usual

Year 2 Year 3

100

Cost of capital

103 105

Year 4

108

10.0%

Country risk premium 1.3%

Adjusted cost of capital 11.3%

Net present value 1133

. . .


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Are emerging markets as risky as you think? | 1

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 double-

digit premiums often proposed in emerging

market investments. In order to justify some o

the higher premiums weve 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 systematicmethodology 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

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

Probability of distress

Source: McKinsey analysis

Riskpremium

0%20% 40% 60% 80% 100% 120%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0% recovery 25% recovery

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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.

Implications for evaluating f inancial

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 scenarioapproach 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. Thats 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 reflectedin 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 country-

specific risk will not already be incorporated

in data for local assets. Of course, thispremium 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


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, short-

term performance assessments cannot rely on

figures alone.

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 itoccur.

Mark Goedhart([email protected])

is an associate principal in McKinseys Amsterdam

office;Peter Haden([email protected]) is

a consultant in the London office. Copyright 2003,

McKinsey & Company. All rights reserved.

1 When expressed in the same stable currency such as US

dollars or euros.

2 All returns on capital measured in stable currency and

adjusted for local accounting differences.

3 Seefor example, C.M. Conover, G.R. Jensen, and

R.R. Johnson, Emerging markets: When are they worth it?

Financial Analysts Journal1996, Volume 52, Number 5.

4 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.

5 All market returns measured in US dollars.

6 Recovery 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.7 This is a promisedyield rather than an expectedyield on

government bonds, further underlining that the country risk

premium-based cost of capital must be applied to promised

i.e. business-as-usual cash flows instead ofexpectedcash

flows, which already include the probability of distress.

8 Economic profit is a measure of periodic value creation

defined as ROIC invested capital WACC invested

capital.

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Time for a high-tech shakeout | 1

Time for a high-tech shakeout

The capacity glut means the industry needs consolidation.

T. Michael Nevens

The technology industry badly needs ashake-out: a consolidation of the myriadtechnology 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 wont come from

within. Interlopers from the edge of the

industry or beyond will probably drive the

change.

During the 1990s, the boom in high-

technology spending spelled prosperity for

new and established companies alike. The

popularity of enterprise resource planning and

electronic customer relationship managementsystems, 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 networksall 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 goodlong-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 restructureddownsized, merged,

acquired, or liquidated.

But the restructuring hasnt 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

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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 weresmaller, 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 wereconsolidated, 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. BoonePickens 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 theUS 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.

Mike Nevensis a retired director in McKinseys

Silicon Valley office and formerly led the Firms global

High Tech Practice. This article was originally

published in theFinancial Times on January 6, 2003.

Copyright 2003 by McKinsey and Company. All

rights reserved.

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Executives can no longer think of stockoptions as a free ride. The exodus ofinvestors from equity markets and the

accounting scandals that toppled Enron and

WorldCom have made scores of blue-chip

companiesCoca Cola, General Electric, and

Procter & Gamble among themannounce

plans to account explicitly for the cost ofoptions 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 harmstock prices, and over time such a healthy

standard of disclosure should spread through-

out the economy, thereby providing investors

with clearer and more complete information.

The change by itself wont 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 realcost. 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

organizations ability to attract executive

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 ligh

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 factor

beyond its control, such as movements of

interest rates and changes in macroeconomicconditions.

Since standard stock options dont

differentiate between value created by

external factors and individual performance,

investors may be shortchanged and CEOs

may be rewarded regardless of meritas

happened during the stock market run-up of

the late 1990sand top-performing CEOs

may be penalized if their tenure coincides wita bear market. Indeed, McKinsey research

shows that from 1991 to 2000, market and

industry factors drove about 70 percent of

individual company returns, while company-

specific factors were responsible for only

30 percent.

Getting what you pay for with stock options

Companies are rethinking stock options. Heres how they can better serve

shareholders and executives.

Neil W. C. Harper and Jean-Christophe De Swaan

Getting what you pay for with stock options | 1

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Getting what you pay for with stock options | 1

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.

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 executives 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 theirsuccessors 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 companys shares. From

a senior executives perspective this mayseem sensible as a way to ensure portfolio

diversification. But it poses a danger for

shareholders because it can, without their

knowing it, limit the executives real exposure

to the results of his decisions. They could, for

example, carry out a hedging strategy by

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 dropin 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.

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 compre-

hensive 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.

Neil Harper([email protected]) is a

principal in McKinseys New York office, whereJ.C.

De Swaan(Jean-Christophe_De_Swaan

@McKinsey.com) is a consultant. Copyright 2003,

McKinsey & Company. All rights reserved.

MoF

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.

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Much ado about dividends | 1

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.

. . . and not do for shareholders . . .

Nonetheless, the proposed tax cut isnt likely to

have any significant, lasting effect on US share

prices. Thats 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 acompany 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).

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

companys top 40 to 100 investorsagain,

usually big institutional investorsaccount fo

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 proposedto 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

Exhibit. Most US shares are held in tax-exempt

individual and institutional accounts

September 2002; percent

1As foreign investors tax status can be complex, we have kept them in a

separate category.2Percentage 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 CompanyInstitute; McKinsey analysis

Foreign

investors1

100% $11 trillion

Non-tax-exempt

US individuals

Tax-exempt

US individualsand institutions2

11

28

61

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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 tax-paying 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.

Tim Koller([email protected]) is a principal

in McKinseys New York office, whereSusan Nolen

Foushee([email protected]) is a

consultant. Copyright 2003 McKinsey and

Company. All rights reserved.

1 Merton Miller and Franco Modigliani, Dividend policy,

growth, and the valuation of shares, Journal of Business,

October 1961, Volume 34, pp. 411433.

2 For companies in the S&P 500 with market capitalization

between $500 million and $200 billion. SeeKevin P.

Coyne and Jonathan Witter, What makes your stock

price go up and down, The McKinsey Quar terly, 2002

Number 2, pp. 2839.

MoF


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, sharerepurchases will remain a more attractive

option, as they have no implicit promise that

the company will repeat the action every

quarter.

Its 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 aretypically 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-to-

capital ratios remarkably constant over the

past 40 years, at an average of 45.5 percent

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