Deleveraging Investing Optimizing Capital Structur

Università Commerciale
Luigi Bocconi
CAREFIN
Centre for Applied Research in Finance
Deleveraging,
Investing
and Optimizing
Capital Structure*
by Stefano Gatti and Carlo Chiarella
CAREFIN, Università Bocconi.
with a foreword by Massimo Della Ragione,
Goldman Sachs International
and should not be taken as representative of their employers or of any other person
**Please note that the views expressed herein are those of the authors only
In collaboration with 2
Preface
The recent global financial crisis created one of the most challenging business environments by Massimo Della Ragione
of the last hundred years, and resulted in a severe shortage of credit for corporates global- Goldman Sachs International
ly. Write downs and tighter regulation on capital ratios have required banks to recapitalize by
hundreds of billions of dollars.
The world of corporate credit had to react to these changes in the lending landscape,
whereby banks have substantially reduced their leverage ratios and credit exposures; CFOs
have faced the complex task of sourcing financing and keeping liquidity at prudent levels,
while trying to maximize access to capital markets to counterbalance the shortage of bank
financing.
Today, while warning of the possible consequences of unjustified and hurried optimism, the
general consensus amongst the economic community is that the worst of the crisis is over
- as signalled by macro indicators such as GDP growth and increased consumption levels.
Credit spreads are at all-time lows (10-year US Treasury recently yielding less than 2.5%,
breaking any historical record) and the general sentiment is positive, as witnessed by the
renewed attention to the “peripheral” European countries by many investors, driving large
inflows of capital (year-to-date, more than Euro 80 billion have been invested in peripheral
equities from outside Europe).
After several years of belt-tightening and savings on costs and investments, corporates find
themselves with high levels of available liquidity (reaching 11% of the total enterprise value
of all listed companies worldwide at the end of 2013), requiring renewed investment deci-
sions and balance sheet optimization strategies.
The breadth and level of possible tailoring of funding instruments available to companies to
optimize their capital structure has never been higher, from straight equity to subordinated
debt, from hybrid instruments to equity-linked solutions and project bonds; navigating the
variety of possible instruments and impacts on a company’s short and long-term strategy
can be at times complex and requires difficult decisions.
In light of shifts in economic conditions and sentiment, this thought-provoking analysis con-
ducted by Stefano Gatti and Carlo Chiarella represents a timely and useful reference frame-
work to interpret and measure the impact of different financing strategies, from return of cap-
ital to shareholders to M&A, to the use of different funding instruments
For the third consecutive year, Goldman Sachs is delighted to co-host with Bocconi
University this important workshop, bringing together corporates and investors and enabling
the sharing of experiences of top managers, rating agencies and portfolio managers in the
field of corporate credit.
Contributing Authors
Stefano Gatti is Program Director of the Bachelor of International Economics and
Finance at Università Bocconi, Milan, where he has also served as Director of the
International Teachers Program. His main area of research is corporate finance and
investment banking. He has written numerous articles in these areas including
publications in reputable academic journals like Financial Management, The
Journal of Money, Credit and Banking, The Journal of Banking and Finance, The
Journal of Applied Corporate Finance and the European Journal of Operational
Research. Professor Gatti has published a variety of texts on banking and finance
and has acted as a consultant to several financial and non-financial institutions, as
well as for the Italian Ministry of the Economy, the Financial Stability Board and the
OECD/Group of the G20. He is financial advisor of the Pension Fund for Health
Care Professions and is member of the Board of Directors and board of auditors
of Italian industrial and financial corporations.
Carlo Chiarella is Assistant Professor of Finance at CUNEF (Colegio Universitario

de Estudios Financieros), Madrid. He holds a Ph.D. in Finance from Università
Bocconi, where he collaborates with CAREFIN Center of Applied Research in
Finance, and has been a Visiting Scholar at NYU Stern School of Business. His
main area of research is corporate finance. His empirical work focuses on the link
between information asymmetries and corporate financing and investment, in par-
ticular in the context of capital markets and mergers and acquisitions.
Contents
• Introduction
• It’s time for corporate cash spending in Europe and the U.S.
• Economic uncertainty, cost of debt and cost of equity:

the drivers of corporate financing and investment policies
• Balance sheet restructuring in Europe: some empirical evidence
• How to re-optimize a firm’s capital structure and its investment policy:

the impacts and interdependencies of different corporate actions
• Looking forward
2014 Deleveraging, Investing and Optimizing Capital Structure
Introduction
As a result of the crisis, in the past few years companies in Europe and around the
world have significantly strengthened their capital structure by deleveraging, exe-
cuting cost and capital expenditure saving programs, increasing their equity base
and maintaining a prudent and conservative strategy. The result has been the
accumulation of large cash piles for precautionary purposes.
Today, a number of macroeconomic factors act as catalysts for a revision of the

financing and investment decisions of European and global firms. The economy is
slowly recovering; credit spreads are still at historical lows; company balance
sheets have been restructured and cash balances are at record highs. In addition,
an abundance of inflows are coming into Europe and, in particular, to the “periph-
ery”, including Italy, driven by macro headwinds losing power and increasing stock
market valuations. Finally, the breadth and tailoring of available financing products
and investors’ specialization has never been higher.
In this environment, scant growth in earnings and pressures from investors, who
are now more demanding in terms of the optimal use of the accumulated cash
piles, are solid motivations for firms to reorganize and optimize their capital struc-
ture as well as their investment policy. Indeed, for the first time in over two and a
half years, survey data by Fitch Ratings show that senior fixed income investors
both in Europe and the U.S. expect companies to put their cash to use for a com-
bination of debt repayment, capital investments and shareholders remuneration
rather than for maintaining cash reserves.1 At the same time, a BofA Merrill Lynch
survey of fund managers worldwide shows near record support for capital spend-
ing and mild support for returning cash to shareholders.2 The proportion of respon-
dents who worry that companies are underinvesting has hit an all-time high (68%),
as well as the spread between the proportion demanding more capital expendi-
tures (58%) and those wanting cash distributions (25%).
Still, companies face a number of challenging dilemmas:
• the need to optimize capital structure and invest for growth against the neces-
sity to maintain an adequate cushion of liquidity to face future downturns and
eventual scarcity of funding;
• the choice between a variety of financing instruments providing for different
needs in terms of size, tenor, credit impact, accounting impact, shareholders’
dilution; liquidity; and
• the use of cash for M&As versus cash disbursement to shareholders via divi-
dend payments or share buybacks.
1
For European data see: Fitch Ratings (2014), European senior fixed-income investor survey, Credit Market Research,
April. For U.S. data see: Fitch Ratings (2014), Calmer macro environment fails to move the needle on investor attachment
to low interest rates, Credit Market Research, April.
2
Bank of America Merrill Lynch (2014), Fund Managers Survey, BofA Merrill Lynch Global Research, April.
4
In this paper we propose a reference framework to interpret corporate financing

and investment policies in light of shifts in the economic environment and changes
in the conditions of debt and equity capital markets.
More precisely, for all the constituent firms of the STOXX Europe 600 ex-financials
Index we investigate the catalysts of the change in their investment and financing
policies and the channels through which these firms have reshaped their policies
in the period between 2004 and 2013.
First, at the aggregate level, we draw a link between the lately observed trends,
namely deleveraging, disintermediation and the accumulation of cash piles, with
shifts in external factors, such as the cost of equity, the cost of debt, their differen-
tial and market confidence.
Next, we assess at the firm level the impact of different corporate actions on cap-
ital structure and on cash saving or spending decisions, overall and across differ-
ent sub-periods linked to the financial crisis. More specifically, we focus on bond
issues, on the financing side, and on acquisitions and share buybacks as poten-
tial uses of cash, given their relatively more exceptional and discretional nature. By
looking at them in isolation, in fact, we then try to answer the following key ques-
tions: What is their impact? What are their interdependences? What drives the
choice of how to spend cash and when?
The remainder of the paper is structured as follows: in the next section we pro-
vide an overview of recent developments in cash accessibility at European and
U.S. firms and pressures to spend it. Then, in the following section we present a
stylized reference framework to define our hypotheses on the effects of shifts in
external factors, such as the cost of equity, the cost of debt, their differential and
economic uncertainty on a firm’s financing and investment policy. Next, we offer
empirical evidence on the links between these drivers and deleveraging, disinter-
mediation and the accumulation of cash piles. Finally, we assess the impact of
alternative initiatives to re-optimize a firm’s balance sheet and we conclude by
looking ahead to forthcoming financing and investment outlooks, given extant
market conditions.
5
It’s time for corporate cash

spending in Europe and the U.S.
In response to the financial crisis, both European and U.S. companies have accu-
mulated substantial cash reserves on their balance sheets. In aggregate terms, at
the end of 2013, European non-financial firms held nearly €500 bn. while the same
figure for US non-financial companies amounted to approximately $1.4 tn. Figure
1 tracks aggregate cash holdings for non-financial constituents of the STOXX
Europe 600 Index and the S&P 500 Index respectively.
FIGURE 1 STOXX 600 (ex-financials) Index S&P500 (ex-financials)

Aggregate cash holdings
in Europe (€ bn.) $ 1,410
and U.S. ($ bn.)
in the period 2007-2013
$ 1,210
$ 1,110
$ 1,020
$ 970
$ 740
$ 690
€ 507
€ 475
€ 404 € 407 € 423
€ 350 € 372
Source: Bloomberg
Companies are currently at absolute record high levels of cash holdings, but while
cash
2 hoarding might have been the best course of action amid post-crisis turmoil,
there may be merits now in spending it by investing in growth or by paying it back
to shareholders to be invested more productively elsewhere. Optimization is no
longer about stabilizing capital structure; now it encompasses the most efficient
capital allocation. Accordingly, increasing pressures to re-optimize capital alloca-
tion come from emboldened activist shareholders, whose assets under manage-
ment reached $93 bn. in 2013, 42% higher than the year before ($65 bn.) and
almost triple the 2008 level. Indeed, a survey by Ernst & Young (EY) among
approximately 1,600 senior executives worldwide reveals that for more than 90%
of the respondents, shareholder pressure is setting their top priorities and corpo-
rate spending is one of the most frequently raised issues.3 In fact, Figure 2 shows
that dividend payments, share buybacks and acquisitions are among the most fre-
quent targets of shareholder activism.
3
Ernst and Young (2014), Capital Confidence Barometer: 10th edition, Global Research, April
6
Goal of shareholder activism Activist Hedge Funds AUM ($ bn.)

FIGURE 2
Growing pressures
from shareholder activism
Cost reduction 47%
Dividend payment 26% 2013 - $ 93
Share buybacks 24%
Divestment 22% 2012 - $ 65
Portfolio analysis 20%

2008
Acquisition 12% -
$ 36
Spinoff/IPO 9%
Source: Ernst & Young, FTI Consulting and Hedge Fund Research
In principle, this emboldened shareholder activism together with the incipient

recovery of earnings and the unrelenting caution about investing for growth should
jointly push companies to distribute cash back to their shareholders rather than to
spend on investment. Nonetheless, as credit conditions stabilize and credit avail-
ability is at its highest, companies covered by EY’s survey indicate a growing desire
to take on more leverage and increase investment for both organic and external
growth. Indeed, Figure 3 reports aggregate volumes of investment grade (IG) and
high yield (HY) corporate bond issuance in Europe and the U.S.
EU HY #ORPORATEEXFINANCIALS "OND)SSUANCE U.S. HY Corporate Bond Issuance ($bn.)

(¼bn.) FIGURE 3
Corporate bond issuance
IG Corporate (ex financials) Bond Issuance IG Corporate Bond Issuance ($bn.)
¼BN in Europe (€ bn.)
and the U.S. ($ bn.)
300 40% 1,600 35%
% HY % HY in the period 2007-2013
35% 1,400 30%
250
30% 1,200
25%
200
25% 1,000
20%
150 20% 800
15%
15% 600
100
10% 10%
400
50 5%
5% 200
0 0% 0 0%
2007
2008
2009
2010
2011
2012
2013
2007
2008
2009
2010
2011
2012
2013
Source: Fitch Ratings Credit Market Research, April 2014;, Société Générale Cross Asset
Reserarch; May 2014.
7
Indeed, the most recent period is one of exceptional support for bond issues by
investors forced down the credit curve by historically low government bond yields
and the accommodative monetary policy adopted by central banks. The U.S. debt
capital market, which is more developed than the European one, has fully recov-
ered to its pre-crisis level of investment grade corporate bond issuance. In addi-
tion there has been a significant surge in high yield bond issuance. Even more
striking developments have marked the European market. New European corpo-
rate bond issuance by non-financial firms has been above €300 bn. both in 2012
and 2013, almost twice as high as the levels recorded in the past. In addition, the
market has become accessible to a broader spectrum of companies. There were
over 100 debut issuers in 2013 and the share of high yield bond issues has grown
from less than 2% of total new issuance in 2008 to approximately 35% in 2013.4
As shown in Figure 4, this coincided with a period in which the spread between
investment grade and high yield cost of funding has progressively narrowed.
Investment grade corporate bond yield has reached an all-time record low, while
the average funding cost has progressively dropped from approximately 8% in
2008 to less than 6% in 2013.
FIGURE 4
EU Average IG(AAA-A) IG(BBB) HY(BB) HY(B)
European corporate bond 12.00%
cost of funding
across rating classes: 10.00%
median fixed coupon (%)
8.00%
HY(B)
6.00%
HY(BB)
4.00%
IG(BBB)
2.00% IG(AAA-A)
0.00%
2007 2008 2009 2010 2011 2012 2013
Source: Fitch Ratings
Today’s abundance of cash on firms’ balance sheets and the ample accessibility
to cash on debt capital markets would suggest impending corporate spending and
capital structure re-optimization, as demanded by shareholders. In light of this, in
the next section we propose a reference framework to capture the implications of
alternative courses of corporate spending on firms’ balance sheets.
4
Fitch Ratings (2014), EMEA Corporate Bonds: Ratings and Issuance Trends, Credit Market Research, February.
8
Economic uncertainty,
cost of debt and cost of equity:
the drivers of corporate financing
and investment policies
A company’s balance sheet is the result of its financing and investment behavior.
Our reference framework for the analysis that follows is shown in Figure 5. In this
simplified context, the left-hand side of the balance sheet includes the uses of
funds, cash holdings kept for liquidity needs or precautionary purposes and invest-
ments in net working capital and fixed assets made by the company (tangible and
intangible). The right-hand side of the stylized balance sheet accounts instead for
the different sources of funds for the company, broken down into equity and alter-
native types of financial debt – e.g. bank loans and corporate bonds. Equity can
build up from external investors who acquire a stake in the business, as well as
from a company’s internal funds such as retained earnings accumulated after div-
idends have been paid to shareholders.
{ }
FIGURE 5
A stylized balance sheet
Bank loans of a non-financial firm
Assets kd
ROA Bonds WACC
ke
Cash Equity
A company is operating efficiently if the profit on its uses of funds (i.e. on the asset
side) is at least equal to the cost of its sources of funds (i.e. the liabilities side).
On the asset side, firms need to find the right balance between the necessity to
maintain an adequate cushion of liquidity, to cover ordinary operations and to face
future downturns or scarcity of funding, and the need to invest for growth. Large
cash holdings, in fact, provide protection but generate low returns which depress
overall profitability, as measured in terms of Return on Assets (ROA).
On the liabilities side, instead, firms need to find the right balance between alter-
native sources of funds in order to optimize the capital structure and minimize its
cost of financing, captured by the Weighted Average Cost of Capital (WACC) that
is a function of the cost of debt (kd), the level of the tax rate (t), the cost of equity
(ke) and the relative weights of debt and equity.
9
Our reference framework makes it clear how the investment and financing policies
of a firm are closely linked with contingent external factors, such as uncertainty on
the state of the economy and conditions in debt and equity capital markets.
Indeed, firms repeatedly face a dual problem:
1 First, is the extant investment policy and capital structure optimal, given the
existing economic conditions? For example, large cash piles and low leverage
are optimal in bad times but represent for shareholders excess conservatism
and an inefficient capital structure when economic conditions are good.
2 So, if general market conditions change, then the second problem is how to re-
optimize a firm’s capital structure and its investment policy.
Custom corporate responses to varying economic conditions are summarized in

Figure 6. In conservative periods, firms tend to focus on the reorganization of lia-
bilities by deleveraging and optimizing the sources of financing (e.g. by means of
disintermediation when the conditions in debt capital markets are favorable and
firms disproportionately rely upon bank loans, as they do in Europe). On the asset
side, firms compress investments and cash distributions to build up precautionary
liquidity reserves.
In expansionary periods instead firms try to boost returns on assets and returns on
equity by putting excess cash to use and by targeting a more leveraged capital
structure.
FIGURE 6 Invest Return Invest Return

How to re-optimize Capital Capital
a firm’s capital structure
and its investment policy:
conservative periods (left)
vs. expansionary
periods (right)
Preserve Reorganize Preserve Reorganize

Cash Liabilities Cash Liabilities
10
But then under extant favorable conditions, firms will be faced with an additional
dilemma: how can the accumulated cash be best put to work?
Two basic options are available.
The first option is to return cash to shareholders via dividends or share buybacks,
as outlined in Figure 7. This reduces the cash balance on the asset side and equi-
ty on the liability side. Using cash to repurchase shares has a given effect with no
uncertainty: it enhances ROA and, if debt doesn’t change, there is a reallocation
of the weights of debt and equity in the capital structure whose effect on WACC
depends on the differential between the cost of equity and the cost of debt.
FIGURE 7
How to put cash to use.
Option 1: return capital
to shareholders
Bank loans Bank loans
via dividends or share
buybacks.
Assets Bonds Assets Bonds
Cash Equity Cash Equity
The second option is to use cash for increased investments (e.g. either for organ-
ic growth, by means of Capex, or for M&As), as outlined in Figure 8. While this
strategy is also aimed at increasing the return on assets by putting cash to work,
its effect is less certain than with share buybacks. Who knows if the
investment/acquisition will be successful? How long will it take before it becomes
profitable? Nonetheless, the impact of this second option on the liability side of the
balance sheet and on WACC can be substantial. More precisely, if the invest-
ment/acquisition is entirely self-financed, firm capital structure is unaffected. On
the contrary, if incremental debt or equity is issued in addition to the used cash,
there is a reallocation of the weights of debt and equity in the capital structure,
whose effect on WACC depends, again, on the differential between the cost of
equity and the cost of debt.
11
FIGURE 8
How to put cash to use.
Option 2: investments
for organic growth or M&A.
Bank loans
Bank loans Assets Bonds
Assets Bonds
New Funds
New
Investments
Cash Equity Equity
Cash
Our intuition is that two external drivers, taken together, determine whether or not
companies are willing to put cash to use rather than to preserve it for precaution-
ary reasons: the cost of equity and debt and in particular their differential (i.e. the
risk premium of equities relative to bonds) and economic uncertainty. Therefore,
these conditions potentially explain in what circumstances and in which ways com-
panies reshape the structure of their balance sheets. Our explanation is that all
these factors have, in principle, a direct impact on the financing behavior of com-
panies, which should actively target a capital structure that minimizes the cost of
financing. However, these variables also shape the investment policy as they affect
the choice of whether to spend or save cash, and eventually determine the condi-
tions by which using cash for investments is more attractive than returning it to
shareholders, and vice versa.
Accordingly, we expect share buybacks to be most beneficial when the econom-

ic outlook is still uncertain, yields on corporate borrowing are low (i.e. cost of debt
is low) and share prices are low (i.e. cost of equity is high). As confidence grows,
however we expect the pressure to use cash to turn progressively towards organ-
ic growth and M&As, and especially if the spread between the cost of equity and
debt is large. Indeed, looking in particular at M&As, when the cost of equity is high
valuations are more attractive from the perspective of an acquirer but, if the deal is
not entirely self-financed, issuing incremental equity is more costly too. Low cost
of debt then provides cheap financing to fill the funding gap and support the real-
ization of M&A deals. But a necessary condition is that economic uncertainty is
low, since companies would otherwise avoid building up incremental leverage.
12
Balance sheet
restructuring in Europe:
some empirical evidence
Since 2004 many changes in the state of the economy and capital market condi-
tions have successively put different pressures on European firms to reorganize
their operations. These changes have also determined several shifts in the relative
attractiveness and impact of alternative investment and financing policies. These
varying conditions give us the opportunity to analyze how economic uncertainty,
the cost of equity, the cost of debt and their differential have shaped the evolution
of corporate balance sheets in Europe.
Figure 9 (see page 14) shows the dynamics of these variables since 2004.
Economic uncertainty is captured by means of the Euro STOXX 50 Volatility Index
(VSTOXX) which reflects market expectations of future volatility derived from real-
time option prices for European stocks. The cost of equity is proxied by the inverse
of the Price/Earnings ratio of the STOXX Europe 600 ex-financials Index, while the
cost of debt is proxied by the after-tax6 yield to maturity of respectively the iBOOX
Euro Corporate Bond Index, for investment grade issuers, and the iBOOX Euro
High Yield Index, for sub-investment grade issuers.
The period in question allows us to consider varying market conditions, as it alter-

nates phases of economic growth with periods of crisis or recession (i.e. those
when real GDP growth is negative, which are delimited in Figure 9 by gray shaded
areas). In addition, an initial period of widespread market confidence, which goes
on until the end of 2007, is followed by a more turbulent period thereafter, with
multiple intervals of high uncertainty (i.e. those conventionally identified as periods
when the level of the VSTOXX index is higher than the 30% threshold, which are
bordered in Figure 9 by yellow dotted lines). Accordingly, the sample period also
presents several shifts in the conditions of capital markets. Before year 2004 the
differential between the cost of equity and the cost of debt was less than 100 b.p.,
on average. Since then, however, it has widened substantially. Indeed, at the
beginning of 2006, following a sharp rise in the cost of equity alongside a reduc-
tion in the cost of debt, the gap was five times larger than it was two years before.
Then, the cost of debt started to rise, smoothly for investment grade issuers and
at a stronger pace for high yield issuers. The differential with respect to the cost of
equity, which was rising moderately, remained stable until the fall of 2008 for
investment grade issuers while it progressively narrowed for high yield issuers.
5
In our calculations we assumed a 35% tax rate, independent of firm nationality.
13
FIGURE 9
EU GDP Growth Rate VSTOXX
The drivers of a changed 50.0%
financing and investment
40.0%
policy in Europe
(2004-2013): 30.0%
Economic growth (GDP), 20.0%
uncertainty (VSTOXX),
cost of debt (kd), 10.0%
cost of equity (ke) 0.0%
and their differential (Dk).
-10.0% 2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
ke kd (IG) kd (HY)
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Dk (ke-kd (IG)) Dk (ke-kd (HY))
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
-2.0%
-4.0%
-6.0%
-8.0%
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Source: Eurostat, Bloomberg, Markit iBOOX Euro Corporate Bond Index, Markit iBOOX Euro High
Yield Index, STOXX Europe 600 ex-financials Index and Euro STOXX 50 Volatility Index.
14
It was when the stock market collapsed, following Lehman Brothers’ filing for
bankruptcy, that the gap between the cost of equity and the cost debt for invest-
ment grade issuers peaked due to an abrupt upsurge in the former. In the mean-
time, the same differential narrowed and even turned negative for high yield issuers
as lack of confidence made their cost of debt rise steeply. The following year saw
a large, swift drop in the cost of equity, as the stock market bounced back despite
the bad economic outlook. The differential with the cost of debt of investment
grade issuers dropped significantly. Only during 2010 and 2011, as the cost of
equity was on the rise while cost of debt continued to decline, the spread between
the cost of equity and debt progressively rebounded towards pre-crisis levels.
Finally, capital market conditions in the recent past have been particularly favor-
able. Since the resolution of the concerns about the European sovereign debt cri-
sis in the summer of 2012, the cost of debt has reached record low levels thanks
to renewed confidence and expansionary monetary policy. At the same time, since
2012 companies have enjoyed a continued period of growth in stock market val-
uations and a corresponding fall in the cost of equity, which tightened the gap with
respect to the cost of debt.
Given all these changes in the state of the economy and capital market conditions
the first empirical question we want to shed light on in our analysis is: To what
extent have these shifts successively put different pressures on European firms to
re-optimize their balance sheets?
Financing and investing policies of European companies

between 2004 and 2013
To draw a link between the reshaping of companies’ balance sheets and shifts in
the state of the economy and capital market conditions, we form a sample of 437
European publicly-listed non-financial firms. In particular, our sample includes all
the most recent constituents of the STOXX Europe 600 ex-financials Index with
financial data available on Bureau van Dijk - Orbis database. For these companies,
we collect annual balance sheet data for the period 2004-2013. The total sample
size is 4,370 firm-year observations.
The sample is populated by large listed companies and is representative of a broad

set of European countries and sectors, as shown in Figure 10 and Figure 11.
According to the summary statistics reported in Table 1, sample firms are on aver-
age large, solid and profitable. They operate with moderate leverage (measured as
the ratio of financial debt over total assets) and retain a substantial part of their total
assets in the form cash holdings.
15
TABLE 1 mean median st.dev. min. max.

Sample summary Total Assets (€ bn.) 16,478 4,891 28,884 0.122 199,393
statistics Market Cap. (€ bn.) 11,784 4,609 19,030 0.231 103,112
Cash (€ bn.) 1,053 0.332 0.901 0.001 11,967
Cash (% of Total Assets) 8.73% 6.13% 8.21% 0.00% 47.34%
Capex (€ bn.) 0.947 0.246 0.781 0.131 14,927
Capex (% of Total Assets) 6.76% 5.49% 8.72% 0.00% 45.14%
Leverage 19.97% 17.92% 12.01% 0% 74.97%
Return on Assets 6.21% 5.48% 7.13% -17.29% 46.79%
Return on Equity 16.97% 15.62% 10.38% -82.02% 259.56%
Dividend Payout Ratio 49.48% 44.11% 23.80% 2.32% 97.15%
Interest Cover Ratio 8.49 5.38 5.92 1.15 16.33
Liquidity Ratio 1.01 0.94 0.36 0.18 3.24
1.60%
3.64%
FIGURE 10 2.96% 2.29%
Sample breakdown Great Britain France
3.65%
by country
3.65% 30.83%
Germany Switzerland
4.11%
Sweden Netherlands
5.48% Spain Finland
Italy Denmark
6.40%
Norway Belgium
7.53% 15.07%
Others <1%
12.78%
Source: Orbis - Bureau van Dijk. All constituent firms of the STOXX Europe 600 ex-financials
Index are considered.
Machinery, Equipment, Forniture, Recycling

FIGURE 11 8.05%
18.62% Other Services
Sample breakdown 4.37%
by sector Chemicals, Rubber, Plastics, Non-metallic Products
4.37%
Post, Telecommunications
5.29% Wholesale, Retail
Food, Beverages, Tobacco
5.29%
13.79% Agriculure, Mining, Natural Resources
Gas, Water, Electricity
5.98% Metals and Metal Products
Construction
6.67%
Transport
13.33%
6.90% Others <3%
7.36%
16
We start our analysis by exploring how varying market conditions affect:
• the tradeoff between the necessity to maintain an adequate cushion of liquidi-

ty and the need to invest for growth, on the asset side; and
• the optimal balance between alternative sources of funds, on the liabilities side.
By looking at Figure 12, which tracks mean cash holdings (as a fraction of total
assets) and leverage (i.e. financial debt over total assets) since 2004, it is easy to
see two distinct trends that reveal how the financial crisis has marked a shift in the
financing and investment policies of European companies. Approaching the crisis
amid widespread confidence, year after year, European companies had been pro-
gressively reducing their cash holdings and increasingly relied on debt financing.
On the assets side, as the level of the VSTOXX was reliably low, holding unproduc-
tive cash piles was unattractive. On the liabilities side, as the spread between the
cost of equity and debt was on the rise, firms became keen to increment leverage
as debt was relatively more convenient. At that time, the outbreak of the crisis was
largely unanticipated and its severity as well as its prolonged duration were very
much underestimated. Henceforth, since 2008, under the pressure of transformed
economic conditions, companies have inverted their previous trends by building
up precautionary non-profitable liquidity cushions, on the asset side, and by
deleveraging their capital structure on the liabilities side.
In particular, since the outbreak of the financial crisis, firms have increased the
share of cash on their balance sheet by on average of one-third, and reduced their
leverage by approximately one-tenth as well.
Cash Leverage VSTOXX pre/post crisis (mean)

FIGURE 12
30.00% Main trends in financing
and investment policies:
25.00% post-crisis deleveraging
and cash hoarding
20.00%
15.00%
10.00%
5.00%
0.00%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
17
These observed shifts in the financing and investment policies of firms were not
determined by the lack of investment opportunities but represent instead a
response to the transformed economic environment. Indeed, Figure 13 shows
how the same trends are confirmed if we consider different subsamples of firms
formed on the basis of their average annual growth of total assets in the pre-crisis
period, to proxy for different investment opportunities across firms. Along with the
surge of widespread uncertainty, as the VSTOXX index became more volatile and
its level exceeded the 30% threshold on several occasions, firms started to save
cash and deleverage in order to face the downturn and funding shortages.
Cash Holdings Leverage

FIGURE 13
14.00% 24.00%
Investment opportunities,
post-crisis cash hoarding 12.00% 23.00%
and deleveraging: 10.00% 22.00%
mean cash holdings (as a
8.00% 21.00%
fraction of total assets, left)
and leverage (financial debt 6.00% 20.00%
over total assets, right) 4.00% 19.00%
across subsamples of firms
2.00% 18.00%
classified on the basis
of their average annual 0.00% 17.00%
2008 2009 2010 2011 2012 2013 2008 2009 2010 2011 2012 2013
growth rate of total assets
in the pre-crisis period. Top Pre-crisis Asset Growth Tercile Top Pre-crisis Asset Growth Tercile
Bottom Pre-crisis Asset Growth Tercile Bottom Pre-crisis Asset Growth Tercile
Source: Orbis-Bureau van Dijk
However, by looking in more detail at the liabilities side of the balance sheet not
only do we find evidence of a clear post-crisis shift in firms’ financing policy, but
we also observe a significant reorganization of sources of funds. In this respect,
Figure 14 tracks the evolution of the relative contribution to total liabilities of
respectively bank loans, corporate bonds and retained earnings. Two main trends
are observable. First, post crisis deleveraging is mainly attributable to the repay-
ment of bank debt and to an increased retention of earnings, accumulated after
the distribution of dividends to shareholders. In addition, regarding the reorganiza-
tion of financial liabilities, Figure 14 clearly shows a rising tendency towards the
disintermediation of corporate funding, as companies were progressively replacing
bank loans with corporate bonds.6
6
Disintermediation of corporate funding reflects the contraction in bank lending, which has accompanied banks’ efforts
to recapitalize and to progressively comply with revised Basel III capital and liquidity regulatory requirements, as well
as the unprecedented conditions in corporate debt capital markets. In particular, according to an investigation by Fitch
Ratings on corporate funding in Europe, the drop in bank lending led to bond issues accounting for a near 40% of total
new corporate debt issuance in 2013, up from as low as 20% in 2007. See Fitch Ratings (2014), Corporate Funding
Disintermediation 2Q14, Credit Market Research, EMEA April.
18
Bank Loans Bonds Retained Earnings

FIGURE 14
25.00% Post-crisis restructuring
of liabilities
and disintermediation.
20.00%
15.00%
10.00%
5.00%
0.00%
2007 2008 2009 2010 2011 2012 2013
The reorganization of liabilities is tightly inter-linked to the build-up of cash

reserves, across the balance sheet. Figure 15 attempts to disentangle the absolute
growth in cash holdings across two alternative channels: financial debt (which
includes both bank loans and bonds) and retained earnings. In particular, the fig-
ure compares the growth of cash balances with the growth of alternative potential
sources of cash, measured in absolute terms, from the beginning of year 2008 to
the end of 2010, and from the beginning of year 2011 to the end of 2013.
During the height of the recession, from 2008 to 2010, cash balances grew by
about 1.27 times the corresponding change in bank loans and bonds. This is con-
sistent with the view that precautionary cash piles were built up in this first phase
mainly through delayed investments, aggressive cost cuts and lower payouts.
Indeed, according to Spearman’s test of correlations, which captures the implicit
ranking of observations at firm level, growth in cash holdings from 2008 to 2010 is
positively associated with growth in retained earnings (at the 1% significance level)
and only weakly associated with growth in debt (at the 10% significance level).
Nonetheless, comparative growth trends apparently indicate that more recent cash
accumulation could be attributed instead to the particularly favorable market condi-
tions (offering access to cheap debt) and only marginally to the modestly improving
global economy. In fact, between 2011 and 2013 debt level grew by about 3.5
times the increase in cash balances. In addition, according to Spearman’s test of
correlations, growth in cash is more reliably associated with growth in debt (at the
5% significance level) while it is unrelated to retained earnings.
19
Cash Debt Retained Earnings Cash Debt Retained Earnings

FIGURE 15
The alternative sources
€Bn
€ Bn
70 20
of post-crisis growth
60 15
in cash holdings:
absolute changes 50
10
in financial debt 40
and retained earnings 5
30
in different post-crisis 0
periods. 20
10 -5
0 -10
2008-2010 2011-2013
Moving across the balance sheet, the necessity to build precautionary cash
reserves has inevitably determined a shift also in the investment behavior of
European companies, and more in general in their use of cash. Figure 16 tracks
the aggregate volume of cash spent by companies in our sample, either investing
for growth or returning capital to shareholders. After a prolonged period of rising
cash spending, in 2009, in response to the transformed economic conditions,
companies sharply reduced their capital expenditures for organic growth by delay-
ing investments, shelving their acquisition projects, and downscaling their payout
plans. This course of action helped them build the precautionary liquidity cushions
they needed to face the crisis, but, since then, their spending has not yet fully
recovered to its pre-crisis level despite the improved economic outlook.
Capex M&A Dividends Buybacks VSTOXX

FIGURE 16
Investment and distribution 1000 40%
policies (2004-3013): 900 35%
Capex (to purchase 800
30%
or upgrade fixed assets 700
other than those associated 600 25%
with acquisitions) and M&A 500 20%
vs. dividends and share 400 15%
buybacks. (Volumes, € bn.) 300
10%
200
100 5%
0 0%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Thomson Reuters and Orbis - Bureau van Dijk. All constituent firms of the STOXX Europe
600 ex-financials Index are considered.
20
By looking in more detail at the evolution of investment and payout policies in the
pre- and post-crisis period, we find that there is apparently a link between corpo-
rate cash spending and the differential between the cost of equity and debt. In this
respect, Figure 17 tracks trends in corporate cash spending, showing respective-
ly how much of it is related to investment, by means of Capex or M&As, and the
proportion associated to payouts to shareholders, via dividends or share buy-
backs. More precisely, we find that in the pre-crisis period, when the differential
between the cost of equity and debt was high, payouts to shareholders progres-
sively gained importance relative to investments for growth. In the wake of the
financial crisis, however, companies significantly reduced both investments and
payouts to shareholders, especially M&As and share buybacks. Indeed, we find
that their individual contribution to respectively overall investments and payouts
drops significantly post-2008. In addition, as the differential in the cost of equity
and debt temporarily narrowed, spending cuts apparently affected the payouts to
shareholders more than investments in relative terms. Hereafter, uncertainty about
the economic outlook has inhibited growth in investment, especially with respect
to M&As. Payouts to shareholders have instead progressively risen to the detri-
ment of investments, mainly as a result of increased dividend distributions, but also
driven by a slow recovery of share buybacks, as the differential between the cost
of equity and debt resumed its pre-crisis level.
Capex M&A Dividends Buybacks

FIGURE 17
% Invested (dx) 2ETURNEDDX Corporate cash spending
100% 100% 100% 50% (2004-2013): Investment
90% 95% 90% 45% via Capex or M&As
80% 90% 80% 40% vs. payout to shareholders
70% 85% 70% 35% via dividends
60% 80% 60% 30% or share buybacks.
50% 75% 50% 25%
40% 70% 40% 20%
30% 65% 30% 15%
20% 60% 20% 10%
10% 55% 10% 5%
0% 50% 0% 0%
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Source: Thomson Reuters and Orbis - Bureau van Dijk. All constituent firms of the STOXX Europe
600 ex-financials Index are considered.
Among the alternative investment and payout channels, M&As on one side and
share buybacks on the other seem to be the most exposed to shifts in extant eco-
nomic conditions. Figure 18 provides a closer look at the links between volumes
of M&As and share buybacks with our proxy of economic uncertainty and the
spread between the cost of equity and debt.
21
M&A % Mktcap Buyback % Market Cap

FIGURE 18
Dk (IG) Dk (IG)
Uncertainty and cost VSTOXX (dx)
VSTOXX (dx)
of capital as drivers
of M&A vs. share buybacks 8% 40% 8% 40%
7% 35% 7% 35%
6% 30% 6% 30%
5% 25% 5% 25%
4% 20% 4% 20%
3% 15% 3% 15%
2% 10% 2% 10%
1% 5% 1% 5%
0% 0% 0% 0%
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Source: Thomson Reuters. All constituent firms of the STOXX Europe 600 ex-financials Index
are considered.
The willingness (or unwillingness) to put cash to use rather than to preserve it for
precautionary reasons is a shared driver of both M&As and stock buybacks.
Overall, periods of more a uncertain economic outlook are associated with
depressed activity on both sides. While share buybacks are seen as defensive
actions and M&As are considered expansionary actions, and as such alternative
uses of cash, both the former and the latter are functions of the solidity of corpo-
rate balance sheets, the strength of cash flows and the availability of credit.
However, M&A trends are relatively more sensitive to any shift in market confi-
dence, because the effect of an acquisition on a firm’s performance is less pre-
dictable than with share buybacks. The result is that, in relative terms, economic
uncertainty de-incentivizes M&As more than it discourages share buybacks, and
vice versa. More precisely, economic uncertainty is less detrimental to stock buy-
backs as it works against long-term investment, whose effect is uncertain, and in
favor of actions with more predictable impact, to optimally rebalance a firm’s cap-
ital structure and sources of financing, and to boost share prices and returns to
shareholders as well.
Looking at deal volumes (as a percentage of total market capitalization) in the pre-
2008 sub-period, when the barometer of confidence was high (i.e. when the VIX
index was low), Figure 18 reports that M&A activity was substantially more intense
than share buybacks. In addition, in the first part of the sub-period, both share
buybacks and M&As advance amid confidence and growth in the differential
22
between the cost of equity and debt. However, when in 2008 uncertainty becomes
substantial and companies turn more prudent, trends in M&As and share buy-
backs diverge. While M&A activity slows down, share buybacks grow sharply, sup-
ported by a record high spread between the cost of equity and debt. In principle,
in fact, a large spread between the cost of equity relative to bonds pushes man-
agers to appease shareholders’ appetite for returns by repurchasing shares.
Indeed, the equity risk premium relative to bonds is directly linked to the magni-
tude of the beneficial impact of a share buyback program on WACC. So, to the
extent such a program determines a reallocation of the weights of alternative
sources of funds and a drop in the cost of equity, it is more attractive for corpora-
tions to purchase their equity when the spread between the cost of equity and the
cost of debt is larger.
In the post-crisis period the need to preserve cash prevails and pre-crisis differ-
ences narrow substantially as corporate spending is cut and deal volumes of both
share buybacks and M&As are subdued. However, as uncertainty slowly fades
away M&A volume sluggishly rises, while the volume of share buybacks progress-
es in line with the relative cost of equity and debt: advancing when the gap
between the cost of equity and debt widens (such as in 2010 and 2011) and drop-
ping when it narrows (such as in 2012 and 2013).
23
How to re-optimize
a firm’s capital structure and
its investment policy: the impacts
and interdependencies
of different corporate actions
Having explored the most recent developments in the financing and investment
behavior of European companies, our analysis now aims to isolate the specific
impact of alternative courses of action that managers can take to reshape their
balance sheets.
We focus in particular on a firm’s potential responses to the present need to opti-

mize capital structure and invest for growth as the pressures to deleverage and
maintain precautionary liquidity are progressively vanishing. More specifically, with
regard to reorganizing sources of financing, the focus is on bond issues. Despite
the variety of financing instruments currently available, we consider bond issues
the most attractive source of funding given the extant bond market conditions.
With respect to the uses of cash, instead the focus is on share buybacks and
M&As, which are of a more exceptional and discretionary nature as compared to
dividends and capital expenditures.
Given our objective, we collect data on bond issues, share buybacks and M&As
by our sample firms in the period between 2004 and 2013 from Reuters’ Thomson
One Banker database. Out of 437 firms in the sample:
• 236 issued at least one bond for a total amount of 1534 issues (of which only
8.2% were high yield) or €1.19 tn.;
• 86 embarked on a least one M&A transaction for a total volume of 132 deals
(of which 60% were cash deals) and an aggregate value of €335 bn.; and
• 43 undertook at least one share buyback program for a total of 67 plans and
an aggregate value of €67 bn.
Each of these firms, whether involved in either a bond issuance, an acquisition or

a share buyback, is considered as actively reshaping its balance sheet.
Accordingly, every year, to each one of these firms we matched an inactive control
firm with the closest market capitalization among those operating in the same sec-
tor and located in the same country. Table 2 summarizes differences between
active and control firms measured at the end of the year preceding a bond issue,
an acquisition or a share buyback plan respectively. Active firms differ significantly
from their corresponding control firms only in a few dimensions. Bond issuers are
on average larger, more leveraged and less profitable than their control firms.
Acquirers and firms involved in share buybacks are instead on average relatively
more profitable than their control firms, but less inclined to make capital expendi-
tures or dividend distributions.
24
Bond Control M&A Control Share Control TABLE 2

Issuer Firms Firms Buyback Firms Sample statistics
Total Assets (€ bn.) 30,362* 19,874 19,371 28,120 18,382 21,019 of bond issuers, acquirers
Market Cap. (€ bn.) 15,562 14,303 22,870 21,826 17,793 16,794 and buyback firms.*,**
Cash (€ bn.) 1,739 1,357 1,377 1,426 1,142 1,011 indicate significance
Cash (% of TA) 9.05% 10.13% 9.68% 10.87% 10.45% 10.36% differences in t-tests
Capex (€ bn.) 1,830 1,106 1,063* 1,637 0.971** 1,968 of equality of means across
Capex(% of TA) 7.22% 6.34% 5.09%** 6.70% 5.44%* 6.50% active and control firms,
Leverage 23.33%** 19.48% 17.37% 18.03% 22.93% 19.23% at 10% and 5% level
Return on Assets 5.16%** 6.40% 7.15%** 6.25% 6.99%** 6.24% respectively.
Return on Equity 15.43%* 17.22% 18.40% 16.66% 19.37%* 17.51%
Dividend Payout Ratio 52.56% 48.55% 44.22%* 59.16% 47.94% 55.37%
Interest Cover Ratio 6.41* 8.83 9.39 9.30 8.17 6.85
Liquidity Ratio 0.89 1.03 1.05 1.01 0.97 1.00
To isolate the specific impact of each alternative action that managers can take to
reshape the balance sheet, we took the variation in a few select financial indica-
tors across companies actively involved in some form of reorganization and com-
pared this change to their inactive control counterparts. A significant “difference in
differences” would then be interpreted as evidence of the link between bond
issues, acquisitions and share buybacks respectively and the observed variations
in the financials of active companies. In addition, this methodology allows us to
quantify the economic impact of each action and how it is affected by changes in
the state of the economy and conditions of capital markets. To this end, we con-
duct our analysis for the whole sample as well as across separate sub-periods
linked to the financial-crisis. In this way, pre-crisis effects, up to the end of year
2007, are compared to those of different post-crisis phases, namely between
2008 and 2010 (when the crisis was most severe) and between 2011 and 2013.
The impact of bond issues to rebalance the sources and uses of funds
The first comparison involves bond issuers, whom we consider representative of
companies more actively restructuring their capital structure and optimizing their
sources of funds, and their corresponding control firms. Figure 19 shows the dif-
ferential impact of a bond issuance on average cash holdings (as a fraction of total
assets), bank loans (as a share of total liabilities) and leverage. Overall, companies
that issue bonds report a larger drop in bank loans and a slower fall in leverage
than corresponding inactive firms, while the proceeds from bond issuance appar-
ently impact the accumulation of cash holdings only marginally. In particular, Figure
19 shows that the contribution of bank loans to total liabilities drops on average by
5% points more for bond issuers than for corresponding inactive firms. This sub-
stantially increases in the latter period, between 2010 and 2013, when credit mar-
ket conditions were exceptionally supportive for disintermediation. Pre-crisis
growth in leverage is approximately 2% stronger for bond issuers while in contrast
post-crisis decline in leverage is lower. In addition, only in the most recent years
growth in cash holdings (as a share of total assets) were approximately 1.5%
points higher for firms issuing bonds rather than for their inactive counterparts.
25
We have two possible explanations for this latter evidence:
• The first is that since the cost of debt has hit record lows, it has become less
costly for issuers to allocate a part of the proceeds for the build-up of precau-
tionary liquidity cushions.
• The second is that it may indicate that some of the recent bond issues are to
be attributed to firms with upcoming debt maturities who have refinanced their
obligations to lock in favorable market conditions.
Cash Bank Loans Leverage

FIGURE 19
Rebalancing sources 7.00%
of cash: the impact
5.00%
of a bond issue
2.28% 2.53% 2.65%
on cash holdings, 3.00%
1.73%
bank loans and leverage. 1.09%
0.40% 0.44%
1.00%
-1.00%
-0.52%
-3.00%
-5.00%
-5.09% -4.39% -4.53% -6.24%
-7.00%
total pre 2008 2008-2010 2011-2013
Source: Thomson Reuters and Orbis - Bureau van Dijk.
We now turn to the analysis of the inter-linkages across the balance sheet between
sources and uses of cash. Companies use bond issues to restructure their liabili-
ties and minimize the costs of financing, But the funds raised on the markets can
also be used to finance investment and in some circumstances to remunerate
shareholders. Figure 20 shows the differential impact of a bond issuance on invest-
ment, in terms of capital expenditures (as a fraction of total assets) and the likeli-
hood of a firm to embark on an acquisition in the year of the issue or the following
year. Indeed, bond issuers report on average relatively larger growth in spending
than their corresponding control firms for investments in organic growth and are
more likely to initiate an M&A.
However, Figure 20 indicates that the impact of a bond issue on capital expendi-
tures and M&A activity can vary significantly across sub-periods, depending on the
extant economic conditions. In fact, in the pre-crisis period a bond issuance proved
to be an expansionary action which was accompanied by a significant boost in cap-
ital investment. But during the toughest phase of the recession, between 2008 and
2010, similar action primarily represented a response to the need to refinance debt
and optimize capital structure, given the transformed operating environment. In
such a period of subdued capital expenditure plans, with companies more focused
on reducing debt and conserving cash, bond issuers cut capital expenditure on
average only by only one percentage point less than their corresponding inactive
26
firms, while in the pre-crisis period they were expanding investment by on average
4 percentage points more. Only in the last period between 2011 and 2013 did bond
issues start to provide new impetus for growth in capital expenses. Analogously, the
figure shows that bond issuers were approximately 4.5% more likely on average
than their inactive counterparts to complete an acquisition in the same year of the
issue or the following year. However, this differential narrows in the post-financial cri-
sis period when uncertainty hiders overall M&A activity and the proceeds of bond
issues are destined for more conservative uses.
Capex M&A
FIGURE 20
7.00% 7.00% Rebalancing sources
5.31%
4.71% of cash: the impact
5.00% 5.00%
3.85% 3.72% of a bond issue
2.70%
3.00% 3.00% on investments;
0.87% 0.71% Capex (% of total assets)
1.00% 1.00% and the likelihood
to embark on an M&A.
-1.00% -1.00%
.%
-3.00% -3.00%
-5.00% -5.00%
-7.00% -7.00%
pre 2008
2008-2010
2011-2013
total
total
pre 2008
2008-2010
2011-2013
Finally, Figure 21 reports the impact of a bond issuance on payouts to sharehold-

ers, in terms of dividends (as a percentage of market capitalization) and the likeli-
hood of a firm embarking on a share repurchase program in the year of the issue
or the following year. Only in the last period between 2011 and 2013 did bond
issues start to provide new impetus and more flexibility for the remuneration of
shareholders via dividend payments. In addition, the figure shows that bond
issuers are approximately 2% more likely than corresponding inactive firms to start
a share buyback program in the same year of the issue or the following year.
However, since the financial crisis, the willingness of companies to repurchase
shares backed by a bond issue is apparently declining. A reasonable explanation
could well be that, other conditions being equal, using debt for share buybacks
entails a more significant reallocation of the relative weights of debt and equity and
results in a more leveraged capital structure than using cash. This outcome is
indeed less attractive when economic conditions recommend prudence, as has
been the case in the post-2008 period.
27
Dividends Buybacks
FIGURE 21
Rebalancing sources 7.00% 7.00%
of cash: the impact 3.98%

5.00% 5.00%
of a bond issue on payouts
2.29% 2.74%
to shareholders; Dividends 3.00% 3.00%
(% of market capitalizaiton)
0.44% 0.18% 0.86% 0.67%
and the likelihood 1.00% 1.00%
to embark on a share
-1.00% -1.00%
buyback plan. -0.10%
-3.00% -3.00%
-5.00% -5.00%
-7.00% -7.00%
total
pre 2008
2008-2010
2011-2013
pre 2008
total
2008-2010
2011-2013
Summing up, in the last few years bond issues have been playing a key role in pro-
viding firms with the flexibility to accommodate refinancing, deleveraging and dis-
intermediation pressures. Now these instruments appear to be a valid way to
finance growth and spur firms’ investments, as was the case in the pre-crisis peri-
od. In fact, unparalleled demand for yield by investors in bond markets and
improved investment opportunities provide access to funding for a broader spec-
trum of companies with a renovated appetite for growth and a stronger disposition
to invest.
Rebalancing uses of cash: are M&A and stock buybacks substitutes?

The above analysis of the past trends in alternative uses of cash seems to indicate
that M&As and share buybacks are not mutually exclusive courses of action.
However, they affect a firm’s balance sheet and profitability in very different ways.
For a direct comparison of alternative corporate spending options, we now look at
them in isolation to grasp their specific impacts and to assess how these vary
under different market conditions.
We focus first on M&As. Figure 22 captures the average impact of an acquisition

on a company’s cash holdings (as a share of total assets) and leverage, by com-
paring acquirers and a sample of inactive control firms. In the analysis we gener-
ally consider both stock and cash deals, but to highlight the specificity of cash
deals we provide in parallel specific evidence for a subsample compiled according
to the method of payment. Overall, acquisitions are apparently only slightly more
cash-consuming and not significantly accretive of leverage. Indeed, acquirers
28
report on average a negative adjustment in cash holdings compared to their con-

trol counterparts. This effect, however, is significant only in the period preceding
the crisis, when the differential is larger than 2 percentage points. In general, in
fact, M&As are mostly financed by the issue of incremental debt in cash deals, or
new equity in stock deals. Consistently, looking in more detail at the subsample of
cash deals, we show how acquisitions are indeed accretive of leverage, by approx-
imately 3 percentage points on average. In addition, there is an alternative expla-
nation why the fewer transactions that occur post-crisis apparently have a less
detrimental impact on companies’ cash holdings. In the last few years, since 2011,
in response to increased uncertainty, firms have been more frequently using stock
as the method of payment.
Cash Leverage Cash Leverage

FIGURE 22
7.00% 7.00%
Rebalancing uses of cash
5.00% 5.00%
4.20% 3.94% with M&As: the impact
3.64% of M&As on cash holdings
2.89%
3.00% 3.00% (% of total assets)
0.19% 0.39%
and leverage. Overall (left)
0.69%
1.00% 1.00%
0.22% and for the subsample
-0.04% -0.06% of cash deals (right).
-1.00% -1.00%
-0.74% -0.86%
-1.31% -0.94% -1.45%
-3.00% -3.00%
-2.19%
-5.00% -5.00%
-7.00% -7.00%
pre 2008
2008-2010
2011-2013
total
pre 2008
total
2008-2010
2011-2013
Figure 23 gauges the impact of an acquisition on a company’s profitability, in term

of its return on assets (ROA) and its return on equity (ROE) in the subsequent peri-
od. In line with academic research on gains and losses from M&As,7 in the year in
which the acquisition is completed and the following year, acquirers underperform
with respect to inactive control firms. This is even more apparent if the deal was
realized in the post-crisis period, when the economic outlook was more uncer-
tain. Overall, acquirers revise their performance on average worse than the con-
trol firms they are paired with by approximately 2.5 percentage points with
respect to return on assets, and by approximately 4 percentage points in terms
of return on equity. Analogous evidence is observable in the subsample of cash
deals. In either case, synergies take time to materialize and substantiate the
rationale behind the transaction.
7
See as a reference Betton, S. and Eckbo, B. E. and Thorburn, K. S., Corporate Takeovers. Handbook of Corporate
Finance: Empirical Corporate Finance, Vol. 2, Chapter 15, pp. 291-430, Elsevier.
29
Roa Roe Roa Roe

FIGURE 23
Rebalancing uses of cash 7.00% 7.00%
with M&A: the impact
5.00% 5.00%
of M&As on profitability.
Overall (left) and 3.00% 3.00%
for the subsample
of cash deals (right). 1.00% -2.73% -.% -6.11% 1.00%
-1.46% -0.26% -6.36% -6.39%
-1.00% -1.00%
-1.43% -1.62%
-3.00% -3.00%
-2.91% -2.57% -2.82% -2.97% -3.00%
-5.00% -4.19% -5.00%

-5.13%
-7.00% pre 2008 -7.00%
2008-2010
2011-2013
total
total
pre 2008
2008-2010
2011-2013
Finally, Figure 24 reports the impact of an acquisition on the soundness of a firm’s

balance sheet, in terms of the Interest Cover Ratio (ICR) and the Liquidity Ratio
(LIQR). Overall, and across all sub-periods, acquisitions are shown to be detrimen-
tal for debt sustainability while liquidity is apparently unaffected. The ICR of acquir-
ing firms negatively spreads apart from that of their corresponding control firms by
2 percentage points on average. Consistent with this evidence, according to a Fitch
Ratings credit market survey, a majority of worldwide fixed income investors, indi-
cate that renewed M&A activity currently represents a source of risk for corporate
debt holders, as the possible detrimental impact on ratings from additional debt can
cause spreads to widen even for investment grade acquirers.8
ICR LIQR ICR LIQR

FIGURE 24
7.00% 7.00%
Rebalancing uses of cash
with M&As: the impact 5.00% 5.00%
of M&As on the Interest
Cover Ratio (ICR) and 3.00% 3.00%
the Liquidity Ratio (LIQR). 0.08% 0.07% 0.03%
1.00% 1.00%
Overall (left) and -0.07% -0.22%
for the subsample -0.11% -0.03% -0.06%

-1.00% -1.00%
-0.28%
of cash deals (right).
-3.00% -3.00%
-2.19% -2.04% -2.39% -2.17% -2.93%
-3.55%
-5.00% -5.00% -4.30%
-7.00% -7.00%
total
pre 2008
2008-2010
2011-2013
total
pre 2008
2008-2010
2011-2013
8
Fitch Ratings (2014), Calmer macro environment fails to move the needle on investor attachment to low interest rates,
Credit Market Research, April 2014.
30
For a direct comparison of the alternative uses of cash, we now turn to the analy-
sis of the impact of share buybacks on the same financial dimensions as above.
The impact of a share buyback program on a company’s balance sheet is more

predictable, as it carries given effects with no uncertainty: share repurchases imply
the distribution of cash and the reallocation of the relative weights of debt and
equity in the capital structure of the firm. Figure 25 summarizes the impact of a
share buyback program on a company’s cash holdings (as a share of total assets)
and leverage, by comparing buyback firms and a sample of inactive control firms.
Consistently, firms that are involved in share buybacks comparatively report shrink-
ing cash holdings and growing leverage. Overall, firms that buy back their shares
report on average a negative adjustment in cash holdings compared to their cor-
responding control firms, equal to approximately 2 percentage points, and a com-
mensurate growth in leverage. However, the relative magnitude of these two
effects depends on the extent to which firms issue debt to repurchase their own
shares. Accordingly, Figure 25 shows how from pre- to post-crisis, the impact of
share buybacks on cash holdings has progressively decreased, while the impact
on leverage has grown as firms have resorted more notably to bond issues to
repurchase shares, while keeping cash on balance.
Cash Leverage
FIGURE 25
7.00% Rebalancing uses of cash
with share buybacks:
5.00%
3.38% the impact of a stock
2.25% 1.48% 2.16%
3.00% repurchase on cash
holdings (as a share of total
1.00% assets) and leverage.
-1.00%
-0.65%
-3.00%
-2.51% -2.19%
-3.79%
-5.00%
-7.00%
total pre 2008 2008-2010 2011-2013
In terms of profitability, companies involved in buybacks over-perform with respect to

their inactive control counterparts in the year the buyback is announced and the fol-
lowing year. Figure 26 shows how in the pre-crisis period, for example, firms that
repurchased their shares corrected their performance on average better than their
control counterparts by approximately 2 percentage points with respect to both
return on assets and return on equity. This effect, however, depends decisively on
the differential between the cost of equity and debt and how the share buyback plan
is financed. In line with this caveat, in fact, in the post-crisis period the benefits of
share buybacks respectively dropped in terms of ROA and risen for ROE relative to
the pre-crisis period, as firms financed their plans by using relatively less cash and
more leverage. In addition, in the latest period when the differential in the cost of equi-
ty and debt were narrowing, the benefits of share repurchases were less significant.
31
Roa Roe
FIGURE 26
Rebalancing uses of cash 7.00%
5.00%
the impact of a stock 3.61%
repurchase on profitability. 2.09% 2.06%
3.00%
1.23%
0.17% 0.13% 0.27% 0.80%
1.00%
-1.00%
-3.00%
-5.00%
-7.00%
total pre 2008 2008-2010 2011-2013
Finally, on the basis of Figure 27, share repurchase programs do not seem to
have any significant impact on either the Interest Cover Ratio or the Liquidity
Ratio. For neither one nor the other is any significant difference reported across
companies that are involved in a share buyback program and their corresponding
control firms.
ICR LIQR
FIGURE 27
Rebalancing uses of cash 7.00%
5.00%
the impact of a stock
on the Interest 3.00%
Cover Ratio (ICR) 0.04%
1.00%
or the Liquidity Ratio (LIQ).
-1.00%
-0.01% -0.01% -0.12% -0.10% -0.04% -0.05% -0.09%
-3.00%
-5.00%
-7.00%
total pre 2008 2008-2010 2011-2013
32
What is optimal for shareholders and when?

Our analysis so far has shown that the alternative actions that managers can take
to put their cash to use are not mutually exclusive. What has also emerged is how
different the impact of these actions can be, especially under varying economic
conditions. Hence, in order to shed light on what the optimal use of cash is from
the perspective of shareholders in different periods, Figure 28 reports the average
abnormal announcement return associated with share buybacks and M&As
respectively, overall and in different sub-periods.
M&A Buyback
FIGURE 28
2.50% How to spend it,
1.93% according to shareholders:
2.00%
share buyback vs. M&A
1.35% abnormal announcement
1.50%
1.14%
returns.
1.00%
0.63%
0.50%
0.05%
0.00%
-0.50%
-0.35% -0.44% -0.47%
-1.00%
total pre 2008 2008-2010 2011-2013
Source: Thomson Reuters and STOXX Europe 600 ex-financials Index.
In line with academic research on the subject, the market looks more favorably on
buybacks rather than acquisitions.9 In fact, the abnormal return at the announce-
ment is positive for buybacks and negative for acquisitions. On average, acquirers
report a negative 0.32% abnormal announcement return, while firms announcing a
buyback program earn a positive 1.38% abnormal return. In general, this reflects
the fact that shareholders are better off if excess cash is returned to them through
share buybacks which boost stock valuations and appease their appetite for
returns. However, the latest period (between 2011 and 2013) saw favorable market
conditions, restored confidence, and the necessity to revive scant growth in earn-
ings. These factors concurred to make capital investment and acquisitions also rel-
atively more attractive in the perspective of shareholders, whose mounting priority
was the need to put inefficient cash to work. In addition, share buybacks have lost
some of their previous appeal lately because better investment opportunities have
emerged and the differential between the cost of equity and debt has shrunk.
9
See as a reference for M&A: Betton, S. and Eckbo, B. E. and Thorburn, K. S., Corporate Takeovers. Handbook
of Corporate Finance: Empirical Corporate Finance, Vol. 2, Chapter 15, pp. 291-430, Elsevier. Aas a reference for share
repurchase, see Chan, K., Ikenberry, D., and Lee,I.. "Economic sources of gain in stock repurchases." Journal of Financial
and Quantitative Analysis 39.03 (2004): 461-479.
33
Looking forward
In light of the considerations above, M&As and investments within Europe have
been picking up the pace in the first semester of 2014.
The renewed drive coincides with a period of exceptionally favorable conditions in

the European corporate bond market. Five years after their disappearance in 2008,
covenant light financing opportunities (i.e. contracts that carry just one mainte-
nance covenant) are again abundant. According to S&P Capital IQ data, approxi-
mately €8 bn. of European covenant light bonds were issued in 2013, and the
same trend has been confirmed in the first quarter of 2014. Moreover, the devel-
opment of the corporate hybrid bond market, which in Europe recently doubled in
size with €27 bn. worth of new issues coming to the market, is also supporting this
renewed activity. The rationale is that these instruments are very attractive for
acquirers who want to preserve the strength of their balance sheet. In fact, while
they carry a higher yield with respect to senior unsecured debt, to which they are
subordinated, corporate hybrid bonds obtain partial equity credit by rating agen-
cies. Thus they can serve as instruments for raising funds for acquisitions or invest-
ment without overly pressuring existing credit ratings. In particular, according to the
estimates of corporate hybrid analysts at Société Générale, approximately 30% of
hybrid issuance in the last 6 months of 2013 is related to M&A activity.10
Looking ahead, according to Fitch Ratings survey data,11 investors worldwide are
confident that fundamental credit conditions in the markets for leveraged loans and
corporate bonds, both high yield and investment grade, will not deteriorate. Only
a few respondents indicate an increase in the interest rate as a risk factor, while
the majority expresses concerns over a possible stock market decline instead.
Corporate leverage is expected to increase modestly and the issuance of specu-
lative and investment grade securities should remain strong. These expectations
are in line with the view supporting a sustained deal flow both for M&As, as long
as yields remain low, and for share buybacks, if the relative cost of debt and equi-
ty widens again with a slowdown in stock valuations.
Still, a potential reason for concern over forthcoming investment flows may be the
materialization of a refinancing cliff in the near future, when all the issues that have
fueled the reshape of corporate balance sheets since the financial crisis will mature
and will need to be refinanced in a comparably less favorable environment. Indeed,
according to study on European refinancing by Standard & Poor’s,12 approximate-
ly €1.3 tn. of debt instruments issued by European non-financial European firms
are expected to mature by year-end 2018, by more than €200 bn. per year and
with a peak of €300 bn. in 2014.
10
Société Générale (2014) M&A into orbit, Cross Asset Research, April.
11
Fitch Ratings (2014), Calmer macro environment fails to move the needle on investor attachment to low interest rates,
Credit Market Research, April.
12
Standard & Poor’s (2013), European refinancing study, Global Fixed Income Research, June.
34
Notes
35
Notes
36
Notes
37
Notes
38
Notes
39
Notes
40
As a result of the crisis, in the past few years companies in Europe and worldwide have
significantly strengthened their capital structure by deleveraging, executing cost and
capital expenditure saving programs, increasing their equity base and maintaining a
prudent and conservative strategy. The result has been the accumulation of large cash
piles for precautionary purposes.
Today, as the economy is slowly recovering and macro headwinds are losing power,
scant growth in earnings and pressures from investors, who are now more demanding
in terms of the optimal use of the accumulated cash piles, are solid motivations for firms
to reorganize and optimize their capital structure as well as their investment policy.
In this third issue of the CAREFIN Bocconi position papers, we propose a reference
framework to interpret corporate financing and investment policies in light of shifts in
the economic environment and changes in the conditions of debt and equity capital
markets. More precisely, by looking at the period between 2004 and 2013 we study for
all the constituent firms of the STOXX Europe 600 ex-financials Index, how economic
uncertainty, the cost of equity, the cost of debt and their differential affect the balance
between:
• the need to invest for growth and the necessity to maintain an adequate cushion
of precautionary liquidity;
• alternative financing instruments;
• the use of cash for M&A and the use of cash for disbursement to shareholders
via dividend payments or share buybacks.

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Università Commerciale

Carlo Chiarella is Assistant Professor of Finance at CUNEF (Colegio Universitario

• Economic uncertainty, cost of debt and cost of equity:

• Balance sheet restructuring in Europe: some empirical evidence

• How to re-optimize a firm’s capital structure and its investment policy:

Today, a number of macroeconomic factors act as catalysts for a revision of the

Still, companies face a number of challenging dilemmas:

In this paper we propose a reference framework to interpret corporate financing

It’s time for corporate cash

FIGURE 1 STOXX 600 (ex-financials) Index S&P500 (ex-financials)

Goal of shareholder activism Activist Hedge Funds AUM ($ bn.)

Dividend payment 26% 2013 - $ 93

Share buybacks 24%

Divestment 22% 2012 - $ 65

Portfolio analysis 20%

In principle, this emboldened shareholder activism together with the incipient

EU HY #ORPORATEEXFINANCIALS "OND)SSUANCE U.S. HY Corporate Bond Issuance ($bn.)

Source: Fitch Ratings

Custom corporate responses to varying economic conditions are summarized in

FIGURE 6 Invest Return Invest Return

Preserve Reorganize Preserve Reorganize

Two basic options are available.

Cash Equity Cash Equity

Bank loans Assets Bonds

Cash Equity Equity

Accordingly, we expect share buybacks to be most beneficial when the econom-

The period in question allows us to consider varying market conditions, as it alter-

Financing and investing policies of European companies

The sample is populated by large listed companies and is representative of a broad

TABLE 1 mean median st.dev. min. max.

5.48% Spain Finland

Machinery, Equipment, Forniture, Recycling

We start our analysis by exploring how varying market conditions affect:

• the tradeoff between the necessity to maintain an adequate cushion of liquidi-

Cash Leverage VSTOXX pre/post crisis (mean)

Cash Holdings Leverage

Source: Orbis-Bureau van Dijk

Bank Loans Bonds Retained Earnings

The reorganization of liabilities is tightly inter-linked to the build-up of cash

Cash Debt Retained Earnings Cash Debt Retained Earnings

Capex M&A Dividends Buybacks VSTOXX

Capex M&A Dividends Buybacks

M&A % Mktcap Buyback % Market Cap

We focus in particular on a firm’s potential responses to the present need to opti-

Each of these firms, whether involved in either a bond issuance, an acquisition or

Bond Control M&A Control Share Control TABLE 2

We have two possible explanations for this latter evidence:

Cash Bank Loans Leverage

Source: Thomson Reuters and Orbis - Bureau van Dijk.

Source: Thomson Reuters and Orbis - Bureau van Dijk.

Finally, Figure 21 reports the impact of a bond issuance on payouts to sharehold-

of cash: the impact 3.98%

Rebalancing uses of cash: are M&A and stock buybacks substitutes?

We focus first on M&As. Figure 22 captures the average impact of an acquisition

report on average a negative adjustment in cash holdings compared to their con-

Cash Leverage Cash Leverage

Source: Thomson Reuters and Orbis - Bureau van Dijk.

Figure 23 gauges the impact of an acquisition on a company’s profitability, in term

Roa Roe Roa Roe

EU HY #ORPORATEEXFINANCIALS "OND)SSUANCE U.S. HY Corporate Bond Issuance ($bn.)