Transcript Hedging Overview

Fair Value Accounting
Allen Questrom vs. Federated Dept. Stores
Bob Jensen
Emeritus Professor of Accounting
Trinity University in San Antonio
190 Sunset Hill Road
Sugar Hill, NH 03586
603-823-8482
[email protected]
http://www.trinity.edu/rjensen/
Bob Jensen’s Summary of Accounting History and Theory
http://www.trinity.edu/rjensen/theory.htm
“Not everything that can be counted, counts. And not everything that counts can
be counted.”
Albert
Einstein
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Compensation Contract

Allen Questrom, Chief Executive Officer (CEO) of
Federated Department Stores 1990-1995

Pulled Federated out of bankruptcy

Five-Year Compensation Contract
$1.2 million annual salary +
0.75% share of the first $0.50 billion increase in equity value
1.50% share of increase in equity value $0.50 -$1.00 billion
2.00% share of increase in equity value > $1.00 billion
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February 3, 1990 Agreed Equity Value

$?? Market Value of new common shares issued when
coming out of bankruptcy

$2.80 Billion Market Value of $11.50 J.P. Morgan
Valuation

Questrom compensation to be based on market value in
5 yrs

Page 224 Timeline
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January 28, 1995 Equity Value Dispute

$3.4 Billion Market Value of $18.625 Share Price

$4.0 Billion Intrinsic Value of $22.00 J.P. Morgan
Valuation

$6.0 Billion Intrinsic Value of $32.86 Seneca Financial
Valuation

$5.0 Billion Intrinsic Value of $27.50 Smith Barney
Valuation
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Questrom Resigned and Sued For $63 Million

According to the Seneca Financial Group, the total increase in value
exceeded $3.2 billion ($6 billion minus original value of $2.8 billion,
based on the February 3, 1990 estimate provided by J. P. Morgan).

The $63 million bonus is calculated as follows:
Increase in Value Bonus
$500 million × (0.0075)
$3.75 million
($1 billion – $500 million) × (0.015)
$7.50 million
($6.4 billion – $1 billion – $2.8 billion) × (0.02) $52.00 million
Total $63.00 million
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$3.4 Billion Market Value of
$18.625 Share Price

Allegedly not appropriate as the marginal price X No. of shares

Affected by short-term market transients that wash out daily

Ignores important blockage factors

Temporarily depressed by R.H. Macy Company acquisition in late
1994
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Financial Statements on pp. 227-228

Questrom closed unprofitable stores and spent hundreds of
millions upgrading existing stores

Not many new stores except for Macys acquisition in late 1994

$1.8 billion loss in 1990 turned into over $100 million profits in the
years 1992-1995

Extraordinary gain of $2.072 billion in 1992 due to early debt
extinguishment
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Operating Cash Flows on the Decline
Net Income (Loss)
1990
1991
1992
1993
1994
1995
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$(1,774)
$ (272)
$ 837
$ 113
$ 191
$ 189
Operating Cash Flows
Change in Cash
1990 ($ 873)
1991 $ 259
1992 $ 548
1993 $ 442
1994 $ 411
1995 $ 161
$ 326
$ 8
$ 549
($ 435)
($ 344)
($ 16)
Forecasted Net Income for RI Model
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Net Income (Loss)
1996 $ 75
1997 $ 266
1998 $ 536
1999 $ 662
Shareholders’ Equity
$3,639 on January 28, 1995 (Actual)
$5,178 on January 30, 1999 (Estimated)
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Forecasted Free Cash Flow for FCF Model
Page 228
Free Cash Flow
Cash from operations
+/- After tax net interest payments
-/+ Net cash used (generated) from investing activities
Note that investing hurts FCF
Estimated Free Cash Flow
1996 $
75
1997 $ 266
1998 $ 536
1999 $ 662
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Valuation using Forecasted Dividends
PV = D/ (r-g)
D = Steady state dividend estimate
r = Cost of capital
g = Dividend growth rate
Federated provides no basis for D est.
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Cost of Common Equity Capital
In Practice
The CAPM has three components
(1) the riskless rate rf, reported to be 0.078 in January 1995
(2) the risk premium for the entire market (rm – rf) = .97 in 1995
(3) the systematic risk of the security, β=.93 for Federated in 1995
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Weighted Average Cost of Capital (r)
In Practice (with no preferred stock)
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Weighted Average Cost of Capital (r)
r is approximately 0.09 using the previous formula
rES cost of equity capital is calculated in the following manner:

The riskless rate (7.8 percent) is proxied by the1995 yield on a tenyear Treasury Security (7.8 percent) (Ibbotson and Associates1995).

Betas can be obtained from financial services such as Bloomberg’s, or
theycan be calculated from a database such as CRSP. Federated’s fiveyear monthly Beta for 1998 (obtained from Bloomberg) was 0.93.

At the end of1995, the risk premium was approximately 7 percent
(Ibbotson and Associates1995). Based on this data, the rES is
approximately 14 percent [0.078 + (0.93× 0.07)] and WACC is 9%
[(0.55 × 0.055) + (0.45 × 0.14)].
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FCF Valuation Using Free Cash Flow
In Theory
In Practice
Estimate FCF for n years and add in a discounted terminal value at
the end of the nth year.
FCF is overly sensitive to terminal value unless n is very large
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Equity Valuation Using Free Cash Flow
In Theory the Market Value of the Debt is Subtracted from FCF
FCF valuation does not work well for firms not is some type of
steady state.
FCF punishes value estimates for increased net cash flow
investments
FCF punishes value for leveraged debt and increased value of that
debt
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Equity Valuation Using Free Cash Flow
R
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January 28, 1995 Equity Value Dispute
 $18.625
Share Price
 $22.00
J.P. Morgan Valuation
 $32.86
Seneca Financial Valuation
 $$27.50
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Smith Barney Valuation
Equity Valuation Using RI Model
In Theory
In Practice
Estimate equity value for n years and add in a discounted terminal
value at the end of the nth year.
RI is less sensitive than FCF model to terminal value unless n is very
small
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Equity Valuation Using RI Model
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Class Discussion of These Outcomes
Why do FCF vs. RI estimates differ so much in this case?
What is a better approach aside from moondust?
What do you think the judge decided in the Questrom vs. Federated
Compensation dispute?
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Ex Post
The judge threw out Questrom’s lawsuit in February 2000
Instead of $63 million, Questrom received $15.3 million and had to
pay his own attorny fees.
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Ex Post
In May 1999, Questrom became the CEO of Barney’s, an insolvent upscale retailer.
Within a year of his hiring, he led Barney’s back to solvency and profitability.
At the end of July 2000, Questrom resigned from Barney’s to become the CEO of
JCPenney. Once again his stated mission was to turn around a troubled retail firm.
While not in bankruptcy, JCPenney had recently experienced a decline in sales, a
sharp drop in profits, and a stock price plunge of 75 percent. Operational problems
and an “identity crisis” seemed to plague the company.
In 2007 Allen Questrom joined the Board of Wal-Mart with an assignment to
improve the clothing sales operation.
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Ex Post
While Questrom seems to be doing very well, his former employer, Federated,
has been experiencing problems after 1999. It acquired the catalog
retailer, Fingerhut, for $1.7 billion. This investment has proven costly, as
Fingerhut’s operation of selling to lower-tiered customers on credit has not fit
well with the upscale image of the Federated-Macy’s department stores. Further,
the Fingerhut acquisition was made to help develop an e-commerce business, which
has not done well. Worse, Fingerhut experienced problems with receivables
that caused bad debts to soar and profits to be less than expected. Analysts slashed
their estimates of Federated’s future profits (Quick 2000b) leading to a 50 percent
decline in Federated’s stock price, from almost $54 in the summer of 1999
to $24 as of July 31, 2000.
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The End
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