ubs cah

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January 2005

Investment

Banking

Strategic Decapitalisation:

Does Excess Cash Matter?

Cash balances are at record levels and continue to grow. Withbalance sheets largely mended, cash flow improving, and thecost of capital rising, balanced decapitalisations can offercompelling economics: lower capital costs, higher returns,enhanced credit strength, and real intrinsic value.

! Why Now?! How Much Is Too Much?! The Costs & Benefits of Excess Cash! How the Market Views Excess Cash! When Too Much Is a Good Thing! Optimal Capital Allocation

Justin PettitExecutive Director

Head of Strategic [email protected]

M.K. [email protected]

Kyle [email protected]

* The authors gratefully acknowledge the thoughtful input and analytical support of Michelle Degen(Washington University Olin School of Business) and Tin-Kyaw Lin (Grinnell College); however, any errorsor omissions remain purely our own.

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Contents

SITUATION OVERVIEW 1TRENDS & IMPLICATIONS 2HOW MUCH IS TOO MUCH? 5

THE COSTS & BENEFITS OF EXCESS CASH 8HOW THE MARKET VIEWS EXCESS CASH 10OPTIMAL CAPITAL ALLOCATION 12APPENDIX A: ECONOMIC IMPACT OF BALANCED DECAPITALISATION

ILLUSTRATION 16APPENDIX B: NYSE & NASDAQ SHAREHOLDER DISTRIBUTIONS 17BIBLIOGRAPHY 18LIST OF FIGURES 19LIST OF TABLES 19STRATEGIC ADVISORY GROUP PUBLICATIONS 19

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STRATEGIC DECAPITALISATION: DOES EXCESS CASH MATTER?

1

SITUATION OVERVIEW

Global cash and near-cash balances are at record levels and continue to grow,topping $2,700bn for all NYSE and NASDAQ listed companies and growing 24%annually. Cash and cash equivalents constitute a record proportion of corporatebalance sheets, now at 17% of total corporate assets about 20% as large asaggregate corporate revenue. The "problem" is pervasive across most industry

sectors, attracting research analyst scrutiny in the Americas, Europe, and Asia.Figure 1 shows the sum of about 4,000 U.S. exchange listed cash holdings, up770% since 1994. On an industry sector basis (not shown), the largest increasescame from media (1,700%), power (1,360%), and telecommunications (1,300%).

Figure 1 NYSE & NASDAQ Cash & Near-Cash Holdings

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Cash&Equivalents($bn)

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Cash/Sales(%)

Total Cash & Investments Cash / Sales

SOURCE: UBS Investment Bank, Compustat Database

And until recently the debt and equity markets seemed united in their support ofexcess liquidity insurance against risk and dry powder for growth. But now withbalance sheets largely mended, volatility easing, and the outlook for corporate cashflow on the rise, the need for (and benefit of) excess liquidity has been reduced.

Historically, much of this cash was "trapped" overseas for tax reasons but inAmerica, passage of The American Job Creation Act (2004) has created a one-timewindow of opportunity to redeploy capital to more productive uses.

Increasingly, the optimal capital structure question is growing to the left-hand side ofthe balance sheet it is now as much a question of cash balances and pension assetsas it is about financial leverage. Amidst the prospect of rising capital costs bothdebt and equity the opportunity cost of being overcapitalized will be a greaterburden to financial performance (ROE, ROCE, EVA) and an overhang on intrinsicvalue (NPV) and market multiples. Balanced decapitalisations now offer compellingeconomics.

There is already tremendous momentum for decapitalisations, triggered by analystsand investors, distribution actions by other companies, and a general public concernaround corporate governance and the stewardship of capital. Since the highlyanticipated Microsoft announcement in July-04, we have witnessed boardsworldwide and across industry sectors review this issue. Optimal capital structure hasnever been so passionately debated since the issue has been broadened toencompass the left-hand side of the balance sheet.

We propose a decapitalisation strategy that balances the competing needs of allstakeholders maintaining sufficient operating liquidity and dry powder for growth,while enhancing both credit profiles and stock returns (Appendix A).

There is less needfor excess liquidityand its opportunitycost is climbing

Optimal capitalstructure is now asmuch about assetsas it is aboutleverage

A balanceddecapitalisation isthe optimaleconomic solution

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2

TRENDS & IMPLICATIONS

Many factors have contributed to the current condition. High volatility and a difficultoperating environment created the need for excess liquidity. Ratings agencies andanalysts have been very vocal advocates of excess liquidity after being "burned" bymany high-profile corporate liquidity crunches. And historically low interest ratesreduced the opportunity cost of being overcapitalized.1 But the tides have shifted

and new economic forces have created the impetus for change.Balance Sheets MendedLeverage and credit quality are on the mend (Figure 2). A reduction in financialleverage creates less need for balance sheet liquidity. Total adjusted leverage for allNYSE and NASDAQ listed companies declined from 51% Debt / Capital in 2002 to39% in 2004. Global speculative grade defaults fell from 8% to 1%.

And while American issuers are evaluated on a gross debt basis, European and Asianissuers are frequently evaluated on a net debt basis, which would give an even morestriking view. On a net debt basis, NYSE and NASDAQ net leverage was down from33% to 13% Debt / Capital over the same 2002-2004 period.

Figure 2 NYSE & NASDAQ Financial Leverage & Default Rates

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Debt / Capital Investment Grade Defaults Speculative Grade Defaults

SOURCE: UBS Investment Bank, Compustat Database.

The spike in financial leverage at the start of the decade was exacerbated byadditional obligations of unfunded post-retirement health benefits and under-funded pension plans. Many ratings agency analysts more formally adoptedmethodologies that explicitly adjusted financial ratios for these obligations.

Pension under-funding a considerable overhang on credit ratings in recent years has improved tremendously from voluntary contributions, a rebound in the equitymarkets, and reduced pension liabilities (due to higher discount rates). One rating

agency report estimates the aggregate pension position has improved by 50% fromits lowest position in 02, but has still not recovered to the level of the prior decade.2

Post-retirement health benefits have been reduced through curbs in benefits as wellas the effects of higher discount rates in the calculation of accumulated projectedbenefit obligations.

1 Optimal financial policy for this era is detailed by Justin Pettit, et al., Financial Strategy for a Deflationary Era, UBSInvestment Bank, March 2003.2 Blitzer, David, Howard Sliverblatt, Dave Guarino, Pension Status of S&P 500 Member Companies Standard andPoors, August 2004.

We are leaving anera of high needfor, and low cost of,excess liquidity

Lower corporateleverage, includingpensions, reducesthe need for excessliquidity

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3

Volatility DownIn addition to financial leverage, cash flow volatility is also down, reducing the needfor excess liquidity. Figure 3 illustrates the broad reduction in implied stock volatility(down roughly 70% from its '02 peak) that is analogous to the reduction incorporate operating cash flow volatility that is well underway.

Figure 3 U.S. Equities Implied Stock Volatility Index (VIX)

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SOURCE: UBS Investment Bank, Bloomberg.

Prospects UpNot only has cash flow volatility declined, but the prospects for future corporate cashflows have also improved, again reducing the need for excess liquidity. For example,consensus earnings estimates for '04 are up 550% over '02 levels, and '05 isestimated to be up an additional 15%. The combinedeffect of reduced leverage,reduced volatility, and enhanced future cash flows is a dramatically lower cashbalance required for adequate operating liquidity.

Rising RatesWhile the need for excess liquidity has declined, the cost of excess liquidity has risen.With Treasury rates already rising and widely expected to continue to rise, the cost ofcapital is climbing. For example, 10-year Treasuries, after bottoming out at 3.1% inJune-03, are now at 4.2% and approach 6% just a few years out on the forwardcurve. While interest income on LIBOR-based excess cash will also rise, the negativecarry between WACC and after-tax interest income will worsen. The opportunitycost of excess capital creates a large and growing drag on returns on capital,economic profits, and net present value.

Languishing StocksWith many stocks still languishing (the FTSE was only up about 5% and the Dow1%) and investors getting restless, investors and research analysts have been vocally

calling for large returns of capital this phenomenon is pervasive across industriesand countries. The "invisible hand" at work, capital is a scarce resource that must befreed to seek out its most productive users and most promising uses.

We are witnessing a pervasive trend of new or upsized share repurchase programs,increased dividends and dividend initiations, and even a return of the one-timespecial dividend, to eliminate historically large cash balances that accumulated in thewake of the recent period of difficult economic conditions.

Lower volatilityreduces the needfor excess liquidity

Improved cash flowprospects reducesthe need for excessliquidity

Higher capital costsincrease theopportunity cost ofexcess liquidity

The "invisible hand"at work capitalseeks its mostproductive users &most promisinguses

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4

A Note on Repatriation Policy

In the case of many American large-cap technology, industrial and healthcarecompanies, a large proportion of excess cash is "trapped" overseas as earningsthat have not been economically viable to repatriate due to prohibitive taxes.These funds remain parked overseas, awaiting foreign investment opportunities.

But recent U.S. tax reform will now effectively create a one-year window torepatriate funds at an effective U.S. federal income tax rate of 5%. TheAmerican Jobs Creation Act of 2004 is estimated to provide $137bn in taxreductions, over the next ten years, for businesses and individuals. The Act,signed into law October 22, 2004, is comprised of four elements:

- Tax relief for U.S.-based manufacturing activities ($77 billion)- Reforms of multinational businesses ($43 billion)- Four dozen more targeted items of business income tax relief ($10 billion)- Individual tax cuts and excise tax reforms ($7 billion)

The Act allows a U.S. corporation to elect to deduct 85% of certain cashdividends it receives from its controlled foreign corporations (CFCs), eitherduring the taxpayers last tax year, which begins before the date of enactment,

or during its first tax year which begins during the one-year period beginning onsuch date. The term cash dividends includes cash amounts treated asdividends under sections 302 or 304 of the IRC. The dividend must meet severalcriteria to be considered deductible.3 Some guidance is still being clarified oneimportant area of clarification is that of allowable "uses" of repatriated funds.

The amount equal to the dividend must be invested in the U.S. pursuant to anapproved domestic reinvestment plan before the dividend is paid. The domesticreinvestment plan must provide for the reinvestment of the dividend in the U.S.(excluding executive compensation), including the funding of worker hiring andtraining, infrastructure, research and development, capital investments, orfinancial stabilization for the purposes of job retention or creation.

Financial stabilization is generally expected to include bond repurchases, but

ideally aught to also include stock repurchases. Just as bond repurchasesenhance a credit profile and provide demand for market supply in the debtcapital markets,stock repurchases enhance an equity profile and providedemand for market supply in the equity capital markets. Liquidityand adequatereturns are essentialto orderly capital markets, whether it be the debt orequitycapital markets.

Stock repurchases help to avoid overcapitalization, and thus improve return onequity, return on capital employed, economic profit (EVA) and fundamentalintrinsic value. The market multiple of the firm will rise as returns on equity andtotal capital employed rise. A more highly valued firm will be more competitiveand better positioned for growth in the competitive global business landscape.

Finally, stock repurchases are requiredif optimal capital structure is to bemaintained while repurchasing bonds. Businesses require the ability to performboth debt andequity repurchases to achieve and maintain optimalleverage andkeep the weighted average cost of capital optimizedand at a competitive level.

3 For example, if the dividend is paid directly or indirectly from funds borrowed from a related person (other thananother CFC), such as the U.S. shareholder, the net increase in CFC indebtedness to such lenders reduces thedeductible amount of the dividend. A CFC cash dividend received by the shareholder during the election year iseligible only to the extent it exceeds an average of the annual sums of dividends received during the base period.The base period generally is comprised of the five taxable years ending on or before June 30, 2003, discarding theyears with the highest and lowest annual amounts. Eligible dividends generally cannot exceed $500 million unlessdescribed as permanently reinvested outside the U.S. in the corporations audited financial statement filed with the

Much of the excesscash is "trapped"overseas awaitingforeign investment

Stock repurchasesprovide marketliquidity, improvereturns on capital,and are needed tomaintain optimal

capital structure

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5

HOW MUCH IS TOO MUCH?

Corporate cash and cash equivalents is a large and growing number on mostbalance sheets today. But many analysts are now suggesting that this is a large andunmanagednumber. Only recently have we seen such interest in determining therightlevel of cash. The search for optimal capital structure has been expanded to

include assets cash and marketable securities and corporate pension assets.

Cash balances vary widely. The 4,000 cash balances in our study ranged from $3mmat the 10th percentile to $930mm at the 90th percentile, with a mean of $691mm(Table 1). Even after adjusting for variation in company size, cash ranged from about1% of revenue at the 10th percentile, to 143% at the 90th percentile. On an industrysector basis (not shown), the largest cash to sales positions are in healthcare (724%),technology (73%), and media (48%). We obtain similar insights with other sizecriteria, such as cash as percentage of assets or enterprise value.

Table 1 Cash & Cash Equivalent Balances (2004)

10th 90thPercentile Median Average Percentile

Cash & Equivalents ($mm) 3 50 691 930

Cash / Sales (%) 1 17 109 143Cash / Assets (%) 1 15 26 64

Cash / Enterprise Value (%) 1 9 18 39SOURCE: UBS Investment Bank, Compustat Database. Data independently arrayed.

In order to better manage cash balances as part of the optimal capital structuresolution, companies have started employing a variety of methods to help determineacceptable, if not optimal, cash balances cash positions within industry norms.Typical approaches involve industry benchmarking and "rules of thumb" pluswhatever guidance is made available by ratings agencies and analysts. We refineboth of these approaches, adding multivariate regression and simulation-basedliquidity models to provide guidance and facilitate management of cash balances.

Benchmarking & HeuristicsThe most common approach to managing cash balances is to benchmark againstindustry comparables. This approach implies that cross-sectional average industrylevels are at a rational level. Industry surveys, often highlighted in trade magazines,are a perennial source of this type of information. Conventions, often industry orcompany-specific, also fall into this category 2% of revenue, six months of fixedcost, twelve months of R&D, $1bn, or the cost of two fabrication plants. While theoriginal source of these heuristics is frequently unknown, and the underlying logicoften weak, they remain the traditional compliment to industry benchmarking.

Multi-Factor ModelsMultivariate regression models are a more "tailored" form of industry benchmarkingthat control for variation among companies of significant factors empirically known

to be determinants of corporate cash holdings. For example, company size is a keydeterminant of cash holdings. Larger companies don't require as much cash,because their cash flows tend to be more diversified, reducing volatility, and theneed for operating liquidity. They are more likely to have more opportunities to finddeferrable costs internally, reducing the need for external financing. Larger

SEC on or before June 30, 2003. If the applicable financial statement does not specify the amount of earningspermanently reinvested outside the U.S. but does specify a tax liability attributable to such earnings, the amounteligible is the amount of the tax liability divided by 35%. Specific rules govern allowable foreign tax credits anddeductions and the computation of the alternative minimum tax. The minimum "floor" for taxable income is fifteenpercent of the dividends.

Many analysts havesuggested cash is anunmanaged asset

Larger companieshave less volatile

cash flows and canraise capital moreeasily and costeffectively

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6

companies can also typically raise capital more easily and more cost effectively,reducing the need for excess liquidity. Larger companies also tend to be strongercredits, again making financing easier when needed.

To account for variation in company size, we tend to benchmark cash as apercentage of revenue, rather than absolute dollar amounts (although thisinformation can also be useful, especially with respect to "dry powder" for

acquisitions). But there are diminishing returns to scale, and empirically, a natural log(Ln) function more appropriately controls for the size effect than any linear factor whether it be a percentage of revenue, assets, or enterprise value.

Multivariate regression models provide a form of benchmarking that controls for thenumerous key determinants of corporate cash holdings (e.g. size, growth prospects,R&D intensity, competitive dynamics, volatility, financial leverage, etc.).4,5 However,because these types of models "predict" an "average" level of cash, they tooassume that what companies are doing (albeit after controlling for various factors) isoptimal. Therefore, we recommend a multi-year data set, rather than any cross-

sectional snapshot a sector may drift into periods of over- and under-capitalizationbut is more likely to "mean revert" toward optimal levels over time.

Agency GuidanceRating agency guidance on cash balances has lagged behind that which is availablefor leverage.6 There is very little information, it is not very specific or actionable, verylittle is quantitative, fact-based, or data-driven, and the conceptual frameworks arenot yet fully developed. Short-term ratings, though primarily focused on obligations,look to cash balances as an important factor to determine ratings.7

Recognizing the need for more guidance, the agencies have targeted this area forcontinued development.8 Speculative grade liquidity ratings are a good first step,with a conceptual framework that defines adequate operating liquidity as the cashbuffer required to ensure no need for external sources over the next four quarters.9

Anecdotal guidance is most prevalent in technology where large cash balances are

encouraged.

10

The apparent logic is that higher business risk warrants a largepermanent cash balance to provide offsetting cushion. But there is neither rationalefor how large, nor can we find empirical evidence to support any discernable impacton risk from cash holdings.11 And finally, this rationale overlooks company-specificfactors, such as back-up lines and facilities, equity cross-holdings and other potentialsources of liquidity, and the nature of discretionary or variable capital and expenses.

4 Regression equation: Cash / Sales = -14.8 + 0.6 x Enterprise Value / Total Capital - 4.2 x Ln(Sales) + 99.3 x TotalCapital / Net Assets 0.2 x Debt / Assets - 1.8 x Operating Cash Flow / Net Assets (R2 = 13%; Standard Error = 185).5 Opler, Tim, Lee Pinkowitz, Rene Stulz, Rohan Williamson, The Determinants and Implications of Corporate CashHoldings, National Bureau of Economic Research, Working Paper 6234, October 1997.6 A discussion of credit analytics and the state of the ratings agencies is provided in a recent report by Pettit, Justin,Craig Fitt, et al., The New World of Credit Ratings, UBS Investment Bank, September 2004.7

An issuers operating cash flow, current and anticipated cash balances, internal resources, alternative sources ofliquidity, and cash flow projections are all central to the analysis of short-term credit. Rowan, Mike, John Lentz,Speculative Grade Liquidity Ratings, Moodys Investor Service, September 2004.8 Hsi, Paul, Mitchell Jakubovic, Richard Lane, Brian Oak, Balancing Growth and Excess Cash in the North AmericanTechnology Sector, or Dude, Wheres My Cash? Moodys Investors Service Credit Research, October 2004.9 Speculative grade liquidity (SGL) ratings reflect the issuers ability to generate cash internally and the reliance andavailability of external resources, additionally SGL ratings are not mapped to long-term ratings; therefore, issuerswith similar senior implied ratings might have different SGL ratings. Rowan, Mike, John Lentz, Speculative GradeLiquidity Ratings, Moodys Investor Service, September 2004.10 For example, we have heard some suggest that cash balances must exceed total liabilities for "A" ratedtechnology credits. In one case, the indicated cash balance is many, many times larger.11 In fact, our analysis found no empirical evidence of a dampening effect on industry specific asset Betas derivingfrom large cash holdings. For example, in the biotechnology sector we find a near zero correlation between cash /sales and asset Beta (R2 = 0.5%, Standard Error = 0.32).

Multi-factor models:benchmarking thatcontrols forvariation in keydeterminants

The foundation formuch anecdotalguidance remainsundeveloped

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7

Stress Testing & Liquidity ModelsStress testing is an attempt to quantify, from the perspective of the company and itscash flows, how much cash is actually required to provide adequate operatingliquidity, and to potentially "pre-fund" any near-term needs (commercial paper andnear-term maturities, puts, near-term capital expenditures, near-term cashacquisition opportunities). Cash flow projections, typically based on the consensusoutlook, are stressed with worst-case scenarios to evaluate the need for additionalcash reserves. Under most cases for evaluating liquidity, the time horizon is fourquarters, and we assume capital markets may be accessed for longer-term needs.

Monte Carlo simulations effectively automate our normal course sensitivity analysis,developing thousands of cash flow scenarios, based on a few reasonableassumptions. Building on the speculative grade liquidity-rating concept, Monte Carlosimulations can estimate the required cash holdings for self-sufficiency at any givenstatistical confidence interval, or to predict the probability and severity of cash drawfor any given level of operating cash balance (Figure 4).12

Figure 4 Simulation Approach to Estimating Operating Liquidity

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There are many important practical limitations to this framework and its application.Competitive dynamics (e.g. competition for acquisition targets; customer, supplier,

or labor bargaining power) and other strategic considerations may well warrantlarger cash positions than what is required for normal operating liquidity. There arealso many companies with limited access to the capital markets that thereforerequire more capital "pre-funding" (e.g. cases of extreme leverage, early stageprofitability, or constraints imposed by insiders).

The very nature of volatility assumptions is such that catastrophic scenarios welloutside the boundaries of historical outcomes will be understated by simulationanalysis. Therefore, manually developed "shock cases" remain the best way to stresstest cash flows and develop contingencies for catastrophic loss.

Finally, in the case of smaller companies (e.g. less than $100mm revenue) or newercompanies (e.g. less than 20 quarters of relevant public financial statements), thenecessary consensus outlook and volatility assumptions will not be sufficiently robustto provide reliable guidance. In these cases, simple cash flow modeling and stresstesting, supplemented with benchmarking time series data for close comparables,will provide the most reliable and intuitive guidance.

12 For example in Figure 4 we simulate quarterly cash flows from a consensus outlook with 14% volatility in top-linegrowth and 6% EBITDA margin volatility (both normally distributed and based on an analysis of historical companyand comparable data). In this instance, we found that a target cash balance of roughly $1bn (4% of revenue)provided this company with adequate operating liquidity with a near-zero probability of draw (at 99% confidence).

Stress testingestimates howmuch cash mightpractically berequired under aworst-case scenario

Monte Carlosimulations enhancesensitivity analysisand quantify theliquidity-ratingframework

Strategicconsiderations,market access,catastrophic loss,and data reliabilityare all importantlimitations

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8

THE COSTS & BENEFITS OF EXCESS CASH

The costs and benefits of excess cash are both highly variable. While the costs areopportunity costs, they can be quantified. Many of the benefits are strategic innature and therefore very difficult to quantify.

Operational & Strategic BenefitsThe presence of excess cash and liquidity has more recently become recognized forits advantages by investors, rating agencies, and debt and equity analysts not only inthe technology sector, but also in healthcare, industrials, and others.

Cash provides an important buffer against operating volatility and unexpectedoperating cash flow shortfalls, to lower the probability of financial distress and toensure self-sufficiency and the ability to invest in growth through difficult quarters.Excess cash balances may also be used as a buffer against uninsurable shortfalls.

Cash also provides "dry powder" for acquisitions, and other growth investments,which can be especially important in consolidating industries, or for highly acquisitivecompanies especially where cash deals predominate.

There are other strategic advantages to enhanced financial strength including

competitive advantage against market entrants through a greater ability to engagein aggressive pricing, increased bargaining strength with suppliers from a greaterthreat of vertical integration or switching, and increased bargaining strength withlabor through a greater capacity to sustain prolonged labor action.

Some research suggests that excess cash "signals" the presence of excessopportunity and the ability to exercise these real options in the future.13 Thus, anyaction to reduce excess cash position should be carefully positioned with the capitalmarkets to avoid any negative signal regarding future investment opportunity.

Finally, excess cash can be a substitute for expensive outside financings, therebyreducing transactions costs. Companies tend to use cash to manage the significantfixed costs associated with capital raising activities.

Agency CostsThe risk that excess cash will create a tempting source of funds for ill-consideredacquisitions or ventures is a well documented one the subsequent economic costhas been coined, "Agency Cost."14 And consistent with agency cost arguments,persistent excessive cash holdings have been shown empirically to impair operatingperformance and lead to a greater risk of investment in negative NPV projects.15 Thisis another reason why excess cash tends to draw the attention of hostile bidders.

Our own investigation found the strongest correlation between sustained levels ofexcess cash and under-performance to be in the energy and utilities sector, as well asthe broad category of technology-media-telecom (weighted toward telecom).

Interestingly, we found the opposite to be true in the healthcare sector that is,higherlevels of performance were associated with sustained levels of excess cash.This offers clear support for our preceding rationale of the importance of strategic

13 Schwetzler, Bernhard and Carsten Reimund, Valuation Effects of Corporate Cash Holdings: Evidence fromGermany, HHL Leipzig Graduate School of Management, Working Paper, 2004.14 Jensen, Michael, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, American EconomicReview, May 1986.15 The loss in value attributed to over investment is caused by the cash holding itself being easily turned into badacquisitions or investments thus pointing on the dark side of liquidity; greater asset liquidity increases the potentialconflict between managers and shareholders. Myer, Stweart, Raghurma Rajan, The Paradox of Liquidity, QuarterlyJournal of Economics, August 1998.

Excess cashprovides operatingliquidity, drypowder for growthand other strategicbenefits

Persistent excesscash holdings areassociated withlower performanceand greater risk ofnegative NPVinvestments

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9

liquidity. The higher organic growth prospects, acquisition growth, and R&D intensityassociated with this sector seem to make our results especially intuitive.

Opportunity CostDespite the strategic benefits, textbook theory suggests corporations should seek tominimize excess cash to minimize the opportunity cost of capital employed andmaximize shareholder value. The after-tax returns on cash are clearly insufficient to

meet the required return on capital the weighted average cost of capital andtherefore represent a negative NPV investment. And as interest rates climb, the gapbetween the returns on cash and weighted average cost of capital will widen. Notonly does excess cash not earn the corporate weighted average cost of capital, wefound no evidence to support the use of a lower hurdle rate for this asset class. Thecostof "cash equity" is just as high we found no support for the notion thatprolonged periods of excess cash holdings lead to lower levered betas (Figure 5).16

Figure 5 Unlevered Beta versus Cash Intensity for Biotechnology (Dec-04)

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Nor is the amountof equity appreciably lowered we found no support for the

notion that excess cash holdings increase debt capacity (there should be very littleequity required to "back" this low-risk asset class) when credit analysis is focused ongross leverage ratios. The rating agencies in America tend to focus credit analysis ona gross debt basis, rather than a net debt basis.17 As share repurchases grow inEurope and Asia, we expect this view to grow internationally. Finally, while thematched maturity cost of low-duration, low-risk funds is low, this overlooksreinvestment risk and the overall WACC.

We conclude that there is no reason to believe excess cash should be held to a lowerhurdle than WACC, and that in the absence of strategic and operational benefits,represents a negative-NPV investment. Therefore, it is not surprising that actions toreduce excess liquidity, such as the two recent self-tenders by The Limited, havebeen very well received in the market and should give cause for consideration.

Companies that have taken action to reduce excess cash tend to receive positivemarket reactions especially if the distributions are large, one-time, events.

16 Figure 5 represents all 180 listed biotechnology companies. Based on LTM cash and cash equivalents and revenuefigures, market value of equity, Debt / Enterprise Value and Barra Beta as of 12/4 as well as an assumed marginal taxrate of 35%. Company levered Barra Betas were then adjusted for debt: Unlevered Beta = Levered Beta / (1+ (Debt /Market Value of Equity) x (1 Tax Rate%). Our analysis found no empirical evidence of a dampening effect onindustry specific asset Betas deriving from large cash holdings. For example, in the biotechnology sector we find zerocorrelation between cash / sales and assets Beta (R2 = 0.5%, Standard Error = 0.32).17 Pettit, Justin, Craig Fitt, et al., The New World of Credit Ratings, UBS Investment Bank, September 2004.

As interest ratesclimb, the gapbetween after tax

returns on cash andWACC will climb

In the absence ofstrategic benefits,cash is a negativeNPV investment

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Case Study: High Rating or "High Yield" Strategy?

On July 11, after an exhaustive review of its strategic alternatives, CitizensCommunications (CZN) announced its intention to dramatically alter its financialstrategy, with a special dividend of $2 per common share and the initiation of aregular quarterly dividend of $0.25 per share (73% payout ratio, 21% yield).

Figure 6 Post Announcement TSR

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TotalReturn

IndexedStockPrice(%)

S&P500 CZN "A" Rated Telecom Peers

Special Dividend

Announcement

7/11/04

CZN Return = 21.3%

"A" Rated Telco = 13.3%

S&P 500 = 0.7%

SOURCE: UBS Investment Bank, Compustat Database, Bloomberg.

While CZNs annual dividend represents a free cash flow payout ofapproximately 73%, the payout in 2004 rises to an even higher 207% includingthe special dividend.

Upon announcement, S&P lowered CZNs senior issuer rating two notches from"BBB" investment grade to "BB+ speculative grade. The downgrade was basedon reduced financial flexibility due to the increased fixed charge servicing and anexpectation that any further deleveraging would be difficult.

However, post-announcement, CZN total shareholder returns (21%) haveoutperformed both A rated telecom peers (13%) and the S&P 500 (0.7%). 18

HOW THE MARKET VIEWS EXCESS CASH

There is very little empirical evidence on the valuation effects of excess liquidity. Thefew working papers and published studies on corporate cash holdings tend to focuson the determinants and consequences of cash holdings from an operationalperspective, rather than a capital markets perspective. However, one recent studycites a stock market valuationpremium companies with persistent excess cashlevels were associated with higher excess enterprise values.19 Our research findssimilar results but suggests this effect is most pronounced during challengingeconomic periods and in certain industries with significant growth prospects that aremore often challenged by the effects of business cycles and exogenous volatility.

Our MethodologyWe evaluated the impact of excessive cash holdings on market values to understandempirically, if there is any evidence to suggest excess cash holdings create or destroy

shareholder value. We analyzed a subset of 145 companies that maintainedexcessive cash balances (defined as the top 10 percent of industry-specific, sales-normalized, cash holders from 2001 through 2003), and compared their market

18 Returns were indexed to price five days prior to announcement date.19 Schwetzler, Bernhard & Carsten Reimund, Valuation Effects of Corporate Cash Holdings: Evidence fromGermany, HHL Leipzig Graduate School of Management, Working Paper, 2004. Schwetzler & Carsten defineexcess enterprise value as the logarithm of the ratio of actual enterprise value and an imputed enterprise value ofeach firm in a given industry. Imputed enterprise value is determined by a sample of firms in each industry. Thisconclusion is based on the assumption that the industry median is a good proxy for the optimal cash holdings of allfirms in this industry.

CZN "High Yield"strategy hasoutperformed itsA rated peergroup

We studied theimpact of excesscash on both marketvalues andoperatingperformance

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valuations on a wide variety of market multiples to the market multiple of mediancash holders (45-55th percentiles) for each industry. We obtained similar resultsthrough other approaches to defining our sample population due to the significantoverlap in the composition of the sample group.

When Too Much Is a Good ThingWe found valuation effects to be most pronounced within the industrial, telecom,

and media sectors, where the companies that sustained excess cash holdingsenjoyed a substantive premium valuation over the valuation of "median cashholders in the same industry (Figure 7). These sectors are characterized by highervolatility and business cycle exposure, larger capital requirements, and moresignificant growth prospects than the sectors where pervasive excess cash holdingsdid not lead to valuation premiums (power, energy, and consumer).

Figure 7 Valuation Impact of Excess Cash Holdings

(50)

(25)

0

25

50

Industrial Telecom Media Power Consumer Energy

(Discount)

orPremium

onPrice

/Book(%)

Sectors That Benefit Sectors That Suffer

SOURCE: UBS Investment Bank, Compustat Database. Data independently arrayed.

The 15-45% premium enjoyed by excess cash holders supports earlier research thatfound the market will, at times, reward excess liquidity. We did not find this to betrue in every industry, however, with several sectors actually receiving a valuationdiscountfor holding excess cash. Furthermore, the research to date has focused ondata drawn from recessionaryperiods where the market is more likely to rewardexcess liquidity. This effect is likely due to the protection against financial distressand the strategic value attributable to cash during times of economic difficulty.Future areas for study should include periods of strong economic growth.

However, anecdotally, the positive excess returns associated with the recent spate ofdecapitalisation announcements would suggest that the market premium on excesscash has faded, and may have completely disappeared. We expect that as economicconditions recover, the marginal premium awarded to excess cash holders willdiminish as the insurance premium and strategic values become less important.

Companies and sectors that trade at relatively high valuation multiples are most

likely to benefit from a financial policy that, during periods of economic uncertaintyand challenge, directs more capital to excess liquidity to capitalize on the "insurancevalue" of excess cash holdings. But in periods of economic recovery and growth,these same companies and sectors are the ones that will benefit most from actionsto redeploy this capital, ideally in the business where it can create the most value.Alternatively, in the event of no near-term uses, a balanced decapitalisation of debtreduction and share repurchases can also offer compelling economics.

We found the

effects mostpronounced for theindustrial, telecomand media sectors

Those with high

valuation multiplesare most likely tobenefit in adownturn, but in anupturn, are mostlikely to benefitfrom redeployment

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OPTIMAL CAPITAL ALLOCATION

An optimal allocation of capital considers and balances the competing needs andobjectives of all stakeholders within the enduring value maximization objective.Analysts, investors, and other stakeholders will all seek to determine whether thecompany has appropriately considered and balanced their needs to support itsstrategy. The existing capital structure must also be evaluated to determine the

appropriate prioritization and scaling of needs, including operating liquidity, drypowder, pensions and leverage, dividends, and share buybacks.

Figure 8 Capital Allocation Spectrum

Operating Liquidity Dry Powder Pension Funding Leverage Dividends & Buybacks

Cash on hand for operatingliquidity

Maintain strategic reserve inlight of industry dynamics andas a low-cost "option" ongrowth opportunities

Growth (organic, M&A) fulfilsexpectations embedded in astock price

Enhance credit quality

Reduce overhang aroundstock price

Tax deductible up to fullfunding limitation

Enhance credit quality

Potential for lucrativerefinancing opportunities

Buybacks can send a bullishsignal to the market orefficiently redeploy excesscapital

Dividends enjoying renewedappeal


Operating LiquidityAs discussed, a certain level of cash "work in process" buffer is required to fill thesystem and provide adequate operating liquidity normal course funding self-sufficiency to ensure continued operations without undue risk of financial distress.Operating liquidity needs are increased by higher operating volatility, lower expectedoperating cash flows, and higher fixed costs, including dividends and debt servicing.

Dry PowderWith valuations predicated on profitable growth, growth capital represents the useof cash with the greatest potential upside for many companies. Dry powder can alsoprovide back-up liquidity for event" risk. However, pre-funding growthopportunities by holding excess cash creates a drag on ROCE, economic profit, andNPV, that is likely to worsen as rates rise and cash balances grow. Furthermore, while

operating liquidity needs may be estimated with cash flow simulation analysis, thereis no analytic framework to quantify "optimal" holdings for dry powder. Dry powderneeds are increased by larger growth expectations and prospects, or greateranticipated challenges associated with capital raising when opportunities arise.

Pension FundingWhile pension funding has been greatly restored from the many factors discussed,this potential use of proceeds may still be attractive in some jurisdictions. In somecases, pre-funding is tax deductible. In many cases, it will reduce an overhang on thecredit profile, creating a tax efficient route to store dry powder. While clearly anydegree of over-funding is generally undesirable, rating agency dialogue can be mostproblematic when funding is below the 80% level. However, in some jurisdictions,such as Germany, pension liabilities are typically not funded.

LeverageSimilar to holding cash for growth, debt reduction creates a source of dry powderby freeing debt capacity and improving financial strength in the current interestrate environment, this can be less NPV negative than holding idle cash. However,debt reduction faces practical constraints, such as illiquid or non-callable debt,potential book losses, and the additional cost of swap unwinds. Moreover, manycompanies have already taken advantage of a prolonged low rate environment andrefinanced their most uneconomic debt with new debt at attractive terms. Debtreduction can also face diminishing returns due to potential credit ceilings on the

An optimalallocation ofproceeds considersand balancescompeting needs

and objectives

There is no analyticframework toquantify optimal"dry powder"

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rating, due to size, industry, and other qualitative factors. Finally, where net debttreatment is already enjoyed, debt reduction from excess cash offers no creditenhancement and eliminates the real option to use differently.

Optimally capitalized companies should balance share repurchases with debtreduction to maintain their optimal mix of debt and equity. Figure 9 illustratescorporate weighted average cost of capital as a function of financial leverage that

proportion of enterprise value capitalized with debt. Assuming the starting point formost companies today is their optimal capital structure, if debt reduction outpacesshare repurchases, the company moves (to the left) toward a stronger credit profilebut incurs a higher weighted average cost of capital due to the larger component ofhigher cost equity. Similarly, if share repurchases outpace debt reduction, thecompany moves (to the right) toward a weaker credit and also incurs a higherweighted average cost of capital due to the fading expected value of the tax shieldand the costs associated with a higher risk of financial distress.

Figure 9 Weighted Average Cost of Capital Considerations

AAAs

AAs

As BBBsBBs

Bs

Target Leverage

WeightedAverage

CostofCap

ital

Buyback

Equity

Buyback

Debt


Similarly, overleveraged companies should over-emphasize debt reduction in theirmix of bond and stock repurchases, while underleveraged companies should over-emphasize stock repurchases in their mix of bond and stock repurchases to advance

the company toward optimal capital structure through a balanced decapitalisation.DividendsDividends are typically the first point of discussion when a company decides it hastoo much cash, especially in today's more dividend-friendly tax regime. But dividendsare a slow, inefficientmethod to redeploy excess capital and they commit thecompany to a higherfixed cost burden to cover. The fixed cost burden makesregular dividends less appropriate for highly cyclical or volatile sectors or companies.

Notwithstanding media attention and apparent investor interest, our own study ofthe past 5 years of NASDAQ and NYSE dividend increases larger than 5% foundexcess returns of only 1%. Our analysis did find that the announcement of dividendinitiations and major increases produced excess returns under certain conditions.

We found 2-3% excess returns associated with large increases from companies thatwere modestly leveraged, undervalued, and had dividends well below their closestcomparables. Dividends are also a useful means of distribution in cases of smallpublic float and poor stock liquidity.

Special dividends are mostcommon in cases where poor stock liquidity makes sharerepurchases problematic, where tax and regulatory reasons prohibit self-tenders, orwhere a founder wishes to receive cash while maintaining proportionate ownership.

We recommend calibrating dividends to not exceed that portion of quarterly freecash flow that is recurring and stable, while volatile or uncertain excess cash flows

Optimallycapitalizedcompanies should

balance sharerepurchases withdebt reduction topreserve their mixof debt and equity

Dividends are aninefficient methodto redeploy excesscash and commit thecompany to a higherfixed cost basis

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are distributed through share buybacks. Issuers should note, however, that largedividends reduce the value of stock options and convertible bond warrants, andimpair operating liquidity and credit quality.

Share RepurchasesShare repurchases offer an efficient mechanism for redeploying excess capital thatdoesnt earn its cost of capital, and is not otherwise immediately needed. They are

also an efficient way of making changes to the capital structure.20

Sharerepurchases can also signal fiscal discipline to the capital markets and confidence infuture earnings.21 Self-tenders allow timely retirement of a sizable number of shares,but are less flexible than open market repurchases and typically require a substantialpremium to the current market price.

Our investigation of the past five years of NASDAQ and NYSE distributionannouncements is presented in Figure 10. One-time actions (special dividends,modified Dutch Auction self tenders, and fixed price self tenders) lead to largersustained stock price premiums and are associated with stronger signals becausethey tend to be larger, are a commitment to execute (not just an authorization), andtend to accompany structural changes to the balance sheet. They also frequentlyaccompany changes to the business-strategy itself.

Figure 10 Excess Returns of Dividend & Buyback Announcements 22

1.4 2.34.3

9.7

13.9

-

4

8

12

16

DividendIncrease

Open MarketRepurchase

SpecialDividend

DutchTender

Fixed-PriceTender

ExcessReturns

OverS&P500(%)

Ongoing Distributions One-Time Distributions

SOURCE: UBS Investment Bank, Compustat Database, Bloomberg, SDC.

Open Market Programs: Similar to normal course dividend increases, traditionalopen market share repurchase programs are not intended to send a signal so muchas to redeploy excess capital that would otherwise not earn its cost of capital. Openmarket repurchase programs are commonly employed to repurchase 1-2% annuallyof the shares outstanding to offset the dilution of equity linked compensationprograms and to provide some degree of market liquidity in the stock. Theseprograms are typically constrained in size by the stock liquidity, with 10-15% of theaverage daily trading volume a typical buying volume in practice. Together, dividends

20 Shareholder distribution policy should be given thoughtful consideration especially when deciding betweendividends and buybacks including what type of buyback strategy to implement. For an in-depth discussion on

shareholder distributions refer to Frieman, Adam, Tad Flynn, Justin Pettit, et. al., The Shareholder DistributionsHandbook, UBS Investment Bank, May 2003.21 A study conducted by Lie, Erik, John J. McConnell, Earnings Signals in Fixed-Price and Dutch Auction Self-TenderOffers, Journal of Economics, December, 1998, concluded that earnings improvements follow both types oftenders, but no significant difference between the Dutch and fixed price tenders.22 Includes all U.S. exchanged listed companies that increased dividends and/or issued special dividends for the past 5years. Dutch tender, and fixed-price tender share repurchase data for all U.S. exchanged listed companies over thepast 5 years. Excess returns calculated as median excess returns (i.e. differential over beta adjusted S&P returns) from5 trading-days before the announcement to 5-trading days after the announcement. In The Relative SignalingPower of Dutch-Auction and Fixed-Price Tenders Offers and Open Market Repurchases (September 1991) RobertComment and Gregg Jarrell observe a 2.3% impact to stock prices from open market repurchase announcements. Ina similar study Kail Li and William McNally observe 2.2% (Open Market versus Tender Offer Share Repurchases: AConditional Event Case Study, University of British Columbia, Working Paper, Spring 1999).

Share repurchasesare an efficient wayto redeploy excesscash that doesn'tearn its WACC

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plus share repurchases constitute a total shareholder "yield" of cash distributed fromthe company back to shareholders. The most appropriate mix of dividends versusshare repurchases is a function of the quality of the cash flows, volatility orcyclicality, and the need for financial flexibility.

Beyond traditional open market programs, there is a wide range of alternatives,including option-based repurchase programs, accelerated blocks, and structured

private repurchase agreements that may be tailored to specific corporate objectives,such as cost objectives, risk preferences, and price targets. In some cases,opportunistic repurchases may also be undertaken by a counter-party throughblackout periods unlike traditional 10B-18 programs.

Fixed Price Tenders: The fixed price self-tender is a tool most commonly employedas an exit vehicle for founders and financial sponsors because a fixed price self-tender allows a much larger (usually 10-20% of outstanding) proportion of shares tobe repurchased. Shares can be repurchased quickly, but the company must pay apremium (frequently 10-15%) and can easily under or over price the shares, leadingto either under or over subscription in the tender. Fixed price self-tenders havehistorically been associated with the greatest premiums paid, and therefore, thegreatest stock price impact on announcement. However, they are also associated

with the greatest risk of the share price fading back down after the tender, creatinga wealth transfer from the non-tendering to the tendering shareholders. Wealthtransfer is the greatest risk in any self-tender as it rewards exactly the wrongshareholders and weighs on the fiduciary responsibility of the board. A companymust suspend its open market repurchase program during any tender and for 10days thereafter. With the advent of the much safer modified Dutch auction, the fixedprice self-tender has fallen into relative disuse.

Modified Dutch Auction Tenders: Similar to Treasury auctions, or the Google IPO,the modified Dutch Auction self-tender uses market forces of supply, demand, andprice elasticity to price the self-tender more efficiently and safely, and to minimizethe risk of wealth transfer. Volumes are typically slightly smaller (8-15%) than fixedprice tenders, as are the premiums paid (5-12%). However, the long-runperformance is better, with fewer cases of share prices coming back down after thetender clears, and many cases of the share price continuing to rise in the monthsafter the tender. The purchase price is therefore typically less than a fixed-pricetender but still with a large amount of shares repurchased quickly, most within 20days. The Dutch auction is the most efficient means of reaching all shareholders andminimizes the risk of over-pricing that may occur in a fixed-price tender.

Annual repurchaseprograms for 1-2%

of outstanding canmanage share countflat and providemarket liquidity

Fixed price tendersare more commonlyused as an exit forfounders andfinancial sponsors

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APPENDIX A: ECONOMIC IMPACT OF BALANCED DECAPITALISATION ILLUSTRATION

To illustrate the economics of a "balanced decapitalisation" we model the impacton a hypothetical industrial company of $650mm revenue, $5bn of marketcapitalization, $900mm of debt, and $1.5bn of cash. We assume $100mm of cashis required for normal operating liquidity and strategic reserve, leaving $1.4bn ofcash available for redeployment. The opportunity cost of excess capital creates a

large and growing drag on the companys ROCE, EVA and NPV.In Table 2, we compare the base case with three alternatives: debt reduction, sharebuybacks, and the combination of both actions.

Similar to holding cash for growth, debt reduction creates a source of drypowder by increasing debt capacity and financial strength. Debt reduction in thiscase reduces Debt / EBTIDA from 1.7x to 0.95x and interest coverage improves byabout one turn.

The share repurchase increases ROCE and EPS but financial leverage (especially on adebt to capital basis) also climbs. A combined action of debt reduction and sharerepurchases improves both financial leverage and financial performance.

Table 2 Illustration of a Balanced DecapitalisationDecapitalisation Scenario

Status Quo Debt Equity Balanced

EBITDA ($mm) 524 524 524 524

Operating Income 400 400 400 400

Interest Expense 88 68 88 68

Other Income / (Expense) 113 102 86 75

Taxes 149 152 139 143

Net Income ($mm) 276 282 259 265

Shares Outstanding (mm) 200 200 160 160

EPS ($) 1.38 1.41 1.62 1.65

Accretion/Dilution (%) - 2.2 17.1 19.8


NOPAT ($mm) 333 326 316 309

Capital 3,510 3,110 2,510 2,110

ROCE (%) 9.5 10.5 12.6 14.6

WACC (%) 10.0 10.5 10.4 9.9

EVA ($mm) (17) 1 55 99

Net Present Value - 170 693 1,168

NPV per Share - 0.85 4.33 7.30


Debt Retired ($mm) - 400 - 400

Equity Repurchased - - 1,000 1,000

Total Decapitalisation ($mm) - 400 1,000 1,400

Stock Price ($) 25.00 25.00 25.00 25.00

Repurchase Premium (%) - - - -

Offer Price ($) 25.00 25.00 25.00 25.00

Initial Shares Outstanding (mm) 200 200 200 200

Number of Shares Repurchased (mm) - - 40 40

Shares Repurchased/Outstanding (%) - - 20 20

SOURCE: UBS Investment Bank, Public Filings, Compustat Database.

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APPENDIX B: NYSE & NASDAQ SHAREHOLDER DISTRIBUTIONSFigure 11 Share Buybacks Increasingly Important

-

100

200300

400

500

'93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04

TotalDivide

ndsand

Buybacks

($bn)

-

1.0

2.0

3.0TotalDividendYield(%)

Dividend Buybacks Total Yield


Table 3 Breakdown of Distributions by Broad Sectors1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

ConsumerDividends (%) 64 59 49 45 43 43 42 51 46 47 42

Buybacks (%) 36 41 51 55 57 57 58 49 54 53 58

Total ($bn) 25.3 31.4 40.4 48.4 51.7 65.8 61.7 52.2 65.8 70.3 91.5

EnergyDividends (%) 93 92 91 82 75 94 72 73 79 72 63

Buybacks (%) 7 8 9 18 25 6 28 27 21 28 37

Total ($bn) 14.5 16.6 17.5 23.5 28.7 27.2 38.4 58.7 47.8 59.8 69.3

Financial InstitutionsDividends (%) 52 57 53 49 48 53 55 51 51 61 60

Buybacks (%) 48 43 47 51 52 47 45 49 49 39 40

Total ($bn) 13.8 15.9 21.1 29.6 40.9 50.2 58.6 62.9 69.3 74.0 88.0

HealthcareDividends (%) 69 66 63 54 49 43 53 49 42 45 46

Buybacks (%) 31 34 37 46 51 57 47 51 58 55 54

Total ($bn) 16.4 17.1 21.0 26.7 32.5 41.4 40.8 49.0 64.4 69.7 66.0

Industrial

Dividends (%) 69 50 58 46 48 49 48 60 72 70 59Buybacks (%) 31 50 42 54 52 51 52 40 28 30 41

Total ($bn) 31.5 54.7 47.2 63.8 73.2 72.6 76.9 63.9 54.2 59.2 79.3

MediaDividends (%) 47 58 59 42 50 48 40 31 51 64 47

Buybacks (%) 53 42 41 58 50 52 60 69 49 36 53

Total ($bn) 4.5 3.7 4.7 6.8 7.0 7.8 9.9 15.0 8.4 10.2 20.2

PowerDividends (%) 40 86 99 90 55 86 48 27 98 100 98

Buybacks (%) 60 14 1 10 45 14 52 73 2 0 2

Total ($bn) 0.1 0.1 1.6 0.8 1.6 1.1 1.9 4.6 1.6 1.9 1.7

Real EstateDividends (%) 39 58 41 32 58 25 18 28 31 37 30

Buybacks (%) 61 42 59 68 42 75 82 72 69 63 70

Total ($bn) 1.6 1.1 1.8 3.3 8.1 5.2 6.9 5.0 5.3 5.2 7.2

TechnologyDividends (%) 48 30 26 18 16 15 16 17 16 21 17

Buybacks (%) 52 70 74 82 84 85 84 83 84 79 83

Total ($bn) 6.7 14.1 17.9 28.0 34.2 41.3 48.8 38.8 44.9 50.0 76.4

TelecommunicationsDividends (%) 92 86 83 83 65 64 75 75 64 81 72

Buybacks (%) 8 14 17 17 35 36 25 25 36 19 28

Total ($bn) 11.0 13.5 15.7 25.5 28.1 30.9 34.1 30.7 29.2 30.0 39.1

SOURCE: UBS Investment Bank, Compustat Database. Data independently arrayed.

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BIBLIOGRAPHYAase, Knut, "Equilibrium Pricing in the Presence of Cumulative Dividends Following a Diffusion,"Mathematical Finance, November 2002

Blitzer, David, Howard Sliverblatt, Dave Guarino, "Pension Status of S&P 500 Member Companies"Standard and Poor's, August 2004

Comment, Robert, Gregg Jarrell,"The Relative Signaling Power of Dutch-Auction and Fixed-Price

Tender Offers and Open Market Repurchases," Journal of Finance, September 1991Frieman, Adam, Tad Flynn, Justin Pettit, et. al., "The Shareholder Distributions Handbook," UBSInvestment Bank, May 2003

Hsi, Paul, Mitchell Jakubovic, Richard Lane, Brian Oak, "Balancing Growth and Excess Cash in theNorth American Technology Sector, or Dude, Where's My Cash?" Moody's Investors Service - GlobalCredit Research Special Comment, October 2004

Jarrell, Gregg, Robert Comment, "The Relative Signaling Power of Dutch-Auction and Fixed-PriceTender Offers and Open Market Repurchases," Journal of Finance, December 1991

Jensen, Michael, "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,"AmericanEconomic Review, May 1986

Li, Kail, William McNally,"Open Market versus Tender Offer Share Repurchases: A Conditional EventCase Study," University of British Columbia - Sauder School of Business and Wilfrid Laurier University,

Working Paper, March 1999Lie, Erick, "Earnings Signals in Fixed-Price and Dutch Auction Self-Tender Offers," Journal ofEconomics, December 1998

Lie, Erick, "Excess Funds and Agency Problems: An Empirical Study of Incremental CashDisbursements," Review of Financial Studies, December 1999

Mikkelson, Wayne, M. Megan Partch, "Do Persistent Large Cash Reserves HinderPerformance?,"Journal of Financial and Quantitative Analysis, June 2003

Myers, Stewart C., Raghuram G. Rajan, "The Paradox of Liquidity," Quarterly Journal of Economics,August 1998

Opler, Tim, Lee Pinkowitz, Rene Stulz, Rohan Williamson, "Corporate Cash Holdings," Journal ofApplied Corporate Finance, Spring 2001

Opler, Tim, Lee Pinkowitz, Rene Stulz, Rohan Williamson, "The Determinants and Implications of

Corporate Cash Holdings," National Bureau of Economic Research, Working Paper 6234, October1997

Pettit, Justin, Craig Fitt, et al., "The New World of Credit Ratings," UBS Investment Bank, September2004.

Pettit, Justin, et al., "Financial Strategy for a Deflationary Era," UBS Investment Bank, March 2003

Rowan, Mike, John Lentz, "Speculative Grade Liquidity Ratings", Moody's Investor Service, September2002

Schwetzler, Bernhard & Carsten Reimund, "Valuation Effects of Corporate Cash Holdings: Evidencefrom Germany," HHL - Leipzig Graduate School of Management, Working Paper, 2004

Wruck, Karen, "Financial Policy, Internal Control and Performance: Sealed Air Corporation's LeveragedSpecial Dividend," Ohio State University - Department of Finance, Working Paper, May 1998

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LIST OF FIGURESFIGURE 1 NYSE & NASDAQ CASH & NEAR-CASH HOLDINGS 1FIGURE 2 NYSE & NASDAQ FINANCIAL LEVERAGE & DEFAULT RATES 2FIGURE 3 U.S. EQUITIES IMPLIED STOCK VOLATILITY INDEX (VIX) 3FIGURE 4 SIMULATION APPROACH TO ESTIMATING OPERATING LIQUIDITY 7FIGURE 5 UNLEVERED BETA VERSUS CASH INTENSITY FOR BIOTECHNOLOGY (DEC-04) 9FIGURE 6 POST ANNOUNCEMENT TSR 10FIGURE 7 VALUATION IMPACT OF EXCESS CASH HOLDINGS 11FIGURE 8 CAPITAL ALLOCATION SPECTRUM 12FIGURE 9 WEIGHTED AVERAGE COST OF CAPITAL CONSIDERATIONS 13FIGURE 10 EXCESS RETURNS OF DIVIDEND & BUYBACK ANNOUNCEMENTS 14FIGURE 11 SHARE BUYBACKS INCREASINGLY IMPORTANT 17LIST OF TABLESTABLE 1 CASH & CASH EQUIVALENT BALANCES (2004) 5TABLE 2 ILLUSTRATION OF A BALANCED DECAPITALISATION 16TABLE 3 BREAKDOWN OF DISTRIBUTIONS BY BROAD SECTORS 17STRATEGIC ADVISORY GROUP PUBLICATIONSPettit, Justin, et. al., Strategic Decapitalisation: Does Excess Cash Matter? UBS Investment Bank,January 2005.

Leaman, Rick, Jimmy Neissa, Justin Pettit, et. al.,"Where M&A Pays: Who Wins & How?," UBSInvestment Bank, December 2004.

Pettit, Justin, Craig Fitt, et. al.,"The New World of Credit Ratings," UBS Investment Bank, September2004.

Pettit, Justin, et.al.,"Positioning for Growth: Carve-Outs & Spin-Offs," UBS Investment Bank, April2004.

Pettit, Justin, et. al.,"How to Find Your Economic Profits," UBS Investment Bank, January 2004.

Beaumont, Peter, Justin Pettit, Andrew Robertson, Adrian Walking, et. al.,"FX Strategy Revisited," UBSInvestment Bank, October 2003.

Pettit, Justin, et. al.,"Healthcare Cost of Capital Handbook," UBS Investment Bank, July 2003.

Blair, Effron, James Douglas, Justin Pettit, et. al.,"Consumer & Retailing Cost of Capital Handbook,"UBS Investment Bank, July 2003.

Leaman, Rick, Jimmy Neissa, Justin Pettit, et. al.,"Renewing Growth: M&A Fact & Fallacy," UBSInvestment Bank, June 2003.

Frieman, Adam, Justin Pettit, Tad Flynn, et. al.,"The Shareholder Distribution Handbook," UBSInvestment Bank, May 2003.

Pettit, Justin, et. al.,"Financial Strategy for a Deflationary Era," UBS Investment Bank, March 2003.

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