Group # 3
Finance 4360
MWF 2:00
Trent Agnew
Brady Howell
Jared Nazarian
Jimmy Tanner
Jared Taylor
Heather Yee
TABLE OF CONTENTS
Executive Summary……………………………………………………………………………………3
Recommendation 1: EVA Incentive Plan…………………………………………………………….. 4
Recommendation 2: Factoring……………………………………………………………………..…..8
Recommendation 3: Debt Restructuring………………………….……………………..…………...10
Works Cited………………………………….……………………………………………………….13
Appendix 1: Company Overview………………………………….…………………………………15
Appendix 2: Industry Comparison………………………………….…………………………….…..17
Appendix 3: EVA Calculation……………………………….……………………………………….18
Appendix 4: Bonus Bank Plan………………………………………………………………………..20
Appendix 5: Debt Restructure Savings……………………………………………………………….21
Executive Summary
Dana Corporation (DCN) is a leading manufacturer and supplier of axle, driveshaft, engine, frame, chassis, and transmission technologies. Started in 1904 in Toledo, Ohio, Dana Corporation now has forty US subsidiaries and operations in twenty-eight other countries, with nearly 46,000 employees worldwide. Being an essential supplier and manufacturer of automotive, commercial vehicle, and off-highway products, their top two customers are Ford Motor Company and General Motors Motor Company. Due to rising steel prices and low demand of vehicles, the industry as a whole has taken severe losses. Dana’s stock has fallen over 58% since January 2005 and over 87% since April 1998, to a frozen price of $.66. As of March 3, 2006, Dana Corporation was forced to declare Chapter 11 Bankruptcy (which only affects US operations). As a means of restructuring, Dana has brought in several professional restructuring officers (Reuters). Also, Dana has managed to secure 1.45 billion dollars of debtor-in-possession financing from CitiCorp, Bank of America, and JPMorgan Chase (IndustryWeek). This money will be used to support ongoing operations. While still in operation, Dana is furtively finding ways to raise cash for day-to-day operations and the high costs of restructuring the corporation.
In light of the announcement of the restructuring of the corporation, we suggest the implementation of an EVA-based incentive plan. This plan will measure management’s performance, specifically alluding to the improvement of the firm. An EVA incentive plan focuses on making decisions in terms of shareholder wealth, thus essentially eradicating the agency problem. An EVA incentive plan provides incentives for managers to produce short-term gains, as well as positioning management along company shareholders in the long-term.
Another suggestion made is using conventional factoring in the restructure. Conventional factoring will increase net working capital (NWC) without encumbering assets in a shorter time period than would a “normal” loan. We suggest a contract with Ford Motor Company, using conventional factoring. This loan-like security will have an 80/20 split with a 4% discount rate on future sales. This lower discount rate security will help align Ford Motor Company and Dana Corporation’s financial interests.
The third suggestion we made is restructuring Dana’s debt. We would extend long-term notes which would free up immediate cash in order to make interest payments. We also propose the issuance of new stock to retire old debt. Dana will benefit from this in terms of having less debt and thus benefiting from having sufficient pre-tax earnings. Higher pre-tax earnings allow Dana to benefit from tax savings.
With all of the challenges that Dana Corporation faces, we believe that these proposals can assist Dana to once again be a top manufacturer and supplier in the automotive industry.
Recommendation # 1 – EVA Incentive Plan
As Dana goes through the long process of restructuring its operations and focusing on its core competencies, there will be many questions regarding what should be the focal point of management during this time. Being that Dana has a high executive turnover rate and is going through a time of uncertainty, we feel that management needs a common measure to evaluate the improvement of management and the firm, in regards to shareholder value as a whole. Thus, we recommend Dana Corp. implement an incentive plan based on the Economic Value Added (EVA) basis in place of the backward looking incentive plan of paying for performance.
As Bennett Stewart, the inventor of EVA, defines it, “In its simplest form, EVA is net operating profit after taxes less a charge for the capital employed to produce those profits” (Stewart). The chief difference with EVA, per an interview with Stewart, “is the notion that companies can measure the economic profit of their business as opposed to the accounting profit” (SNC). Unlike other measures, EVA “is influenced by all of the decisions that managers have to make within a firm” (NYU). As Dana goes through bankruptcy and the restructuring process, it is important that management decisions take into account both the short-term and long-term goals of the firm. We must remember that EVA is a measurement system and not a solution in itself. There are many other reasons why a more EVA-centered incentive plan should be put into place. As the company goes into the restructuring phase, it is important that all employees be in the same mind frame, thus the “common language” that is EVA would lead to a more focused company (Stewart). EVA is a measure for both management and lower level personnel alike, making implementation even easier. It is the job of all employees, not just top executives, to increase the value of the firm. Using the EVA incentive plan would also allow management stronger guidelines in the decision-making project. During restructuring it is easy to accept any and all projects that seem to have a positive return, but under EVA there are three explicit guidelines on how to increase EVA: “One, increase the return from current assets; two, invest capital and build as long as the return exceeds the cost of capital; three, stop investing in and release capital from activities earning substandard returns” (Stewart). The use of EVA produces incentives for managers to lower the cost of capital, thus increasing the value of the firm.
One of the most important aspects of an EVA incentive plan is that all decisions are made in terms of shareholder value, eliminating the agency problem. As long as management makes decisions in terms of EVA, they need not worry that the decision conflicts with shareholders. "No more fussing around in the fall for months, messing around with a huge planning documents and worrying about sandbagging and things like that. It is gone," says Chuck Bowman, director of financial planning and analysis." (Kroll, p.109) Even though management might end up growing the firm and/or receiving higher benefits than under the previous compensation structure, the returns on projects will be significantly higher, leading to an increase in the value of the firm, which should alleviate shareholder’s concerns. Being that EVA gives management an ownership in the company, each decision is made knowing that it not only affects the firm’s value, but their own wealth as well. As Joel Stern, a partner of Bennett Stewart, points out, it also “makes top managers responsible for a measure that they have more control over - capital decisions – rather than one that they feel they cannot control as well – the market price per share” (NYU). The first step that Dana needs to take is to get the CEO deeply involved in the EVA bonus system. EVA is a measurement system that must start from the top and work its way down. The incentives must motivate employees both in the short and long run. With Dana struggling in terms of asset efficiency and sales compared to its competitors (see Appendix 2), it is important for management to make the right decisions for how to restructure the company. EVA allows management to relate everything to shareholder value, which will aid the company in coming out of bankruptcy. EVA will allow management and employees to share a “common language” in which to review decisions.
While EVA and other incentive plans are known to encourage short-term gains in value, EVA differs in that it is also set up for long-term success. By using a bonus bank system as an ingredient of EVA, managers are less likely to make decisions that will bring short-term windfalls at the expense of long-term growth and gains. This is especially key for Dana Corp., as it will be important that management not fall into the trap of trying to become profitable again in the short-term at the detriment of the long-term strategic plan. If management is not looking long-term, it is easy to have “the gain from the EVA in the current year to be more than offset by the present value of the loss of EVA from the future periods” (NYU).
EVA CALCULATIONS:
The first step in developing the EVA incentive plan is to calculate EVA for the previous year (See Appendix 3: EVA Calculation for Dana).
The next step is to determine the target EVA number, which we propose doing through a capitalized plan. We will find the average EVA for the past three years for Dana Corporation. We will use a three year average in order to show an accurate forecast minus fluctuations. The target EVA will be calculated from the most recent three years for every term. As long as actual EVA is showing improvement, management is performing well.
The third step in determining EVA is to decide on the leverage factor, which shows how far actual EVA can fall before the bonus becomes zero. The leverage factor determines the rate of change in bonuses as EVA surpasses or falls short of target EVA, determined by the Compensation Committee from an evaluation of the long term volatility of industry returns. The Compensation Committee would look at the industry returns and determine the difference between the target EVA and where the industry EVA is equal to zero.
At this stage, a bonus percentage must also be decided upon. The Board of Directors with management’s input will appoint a Compensation Committee. This Compensation Committee will determine the bonus percentage for every upcoming year with stockholders’ interests as first priority. For the first year, the bonus percentage should be calculated by using multiple performance measures. Since asset management has been one of Dana Corporations major problems, asset efficiency ratios like capital intensity and receivables turnover will be used to determine the percentage. The capital intensity ratio measures the dollar investment needed to generate $1 of sales. The receivables turnover ratio measures how long it takes to receive sales. Tracking stocks will also be issued in order to add incentive to raise stock price. The bonus percentage will be calculated as: 1/3 of the percent change of the capital intensity ratio + 1/3 the percent change in the receivables turnover ratio + 1/3 the percent change in stock price. This allows for no limitations on the amount of bonus that can be received. Having no cap on the bonus amount is not a negative thing because as the bonus amount increases, shareholder value increases by a larger amount, thus the bonus is at no additional cost to shareholders. The combination of the three performance measures will give Dana management proper incentives to increase the value of the firm by focusing on net working capital and cash flows. After completing this portion of the calculation, the company must determine a bonus percentage for each group of employees, such as plant managers.
The final bonus can be determined by using the formula: Bonus = Base Salary x Bonus % x (1 + ((Actual EVA – Target EVA) / Leverage Factor)). We have recommended to use the bonus bank concept derived by Bennett, in which annual bonus awards will not be paid out in full, but instead will be held “at risk, with full payout contingent on continued successful performance” (Bennett). Each year’s bonus is carried forward from the prior year and a fraction - such as, one third - of the total is paid out, with the remaining amount rolled into the next year. There is much practicality in using the bonus bank idea. It will provide incentives for management to increase the firm’s value in the long run and to decrease employee turnover. Employee turnover is one of Dana Corporation’s significant problems that can be rectified by the proper use of the bonus bank incentive concept. This method ensures management’s continual strive to lower cost of capital and add value to the firm. The bonus bank plan will be implemented in a quick and efficient manner, in which the change does not affect company morale or value (see Appendix 4).
EVA Example:
Here is a very brief example of how a manager’s bonus would be calculated within Dana Corporation. Assume their base salary is $100,000. As we show in Appendix 3, Dana’s current EVA isnegative $2,131,703,196.Suppose we set their bonus percentage to be 20%, Dana's target EVA to be negative $500 million, and the leverage factor to be $300 million. The actual EVA for the year ends up being negative $400 million. Taking out 1/3 of this as their bonus, then the EVA bonus paid to them will be $8,889 and the remaining $17,778 will be rolled into the bonus bank.
One of the main reasons we felt that an EVA incentive plan would help Dana Corp. is the tremendous success others have had when implementing it. For example, Eli Lilly experienced a 324% increase in stock price during the two years after which it implemented an EVA-based plan (Cornelius). Many other companies have implemented EVA into their incentive plans, including Coca-Cola, Credit Suisse, Briggs & Stratton, Morgan Stanley and the United States Postal Service (SternStewart). According to Stewart, the correlation between stock price and EVA can often be
60-70%, with an average correlation of 44% across thousands of companies in different industries (SNC). The EVA bonus system is valuable because it takes into account both debt and equity financing, unlike other incentive plans. This drives managers toward the goal of lower cost of capital, thus increasing total value of the firm. A firm value is much like the value of a bond. As the cost of capital/interest rate decreases, the value of the firm/bond increases. This shows how much EVA can effect stock price and lead to increased shareholder value. During this time of restructuring and uncertainty, it is important that investors and employees alike see that the company is taking measures to ensure the rebound of Dana to its previous stature. Pointing out the success these other companies have had with EVA-based incentive plans could help in this capacity. The implementation of EVA is not a solution within itself. The combination of EVA and the incentive plan will drive management towards decisions that benefit the shareholders wealth.
Recommendation # 2 - Factoring
In order to increase working capital, Dana Corporation should acquire a secured loan by conventional factoring from Ford Motor Company. Ford Motor Company is Dana’s largest customer and depends heavily on Dana’s operations. We recommend that Dana approach Ford with a factoring plan that would allow for immediate cash in exchange for future products on discount. Factoring is not a process that requires a lengthy amount of time to set up. A factoring plan could be set up within a week’s time without having to deal with the SEC or other administrative bodies.
The factoring plan will be a two year program that will increase Dana’s short term net working capital while not increasing liabilities or encumbering assets like a bank loan would. Having maintained a long term business relationship with Ford, our reputation will weigh heavily on the discount amount that must accompany the factoring. The relationship Dana has with Ford makes up 25% of Dana’s total annual sales. The 25% of annual sales is found by taking the average percentage of sales to Ford for the past three years. This is an assumption that the past three years will reflect the next year.
Ford should be approached with a factoring plan stating a 4% discount rate and a 20% reserve account factoring technique. The discount rate and the reserve account will give the required return for the risk that Ford will be taking. The risk is much lower for Ford because of the symbiotic relationship between the two companies. The factoring contract with Ford will give Dana 80% of the future sales at the beginning of every month, then upon delivery, Ford will give the remaining 16%. Dana Corporation will receive .25(9,056,000/12)*.8= $150,933 at the beginning of every month. This will increase cash flows and net working capital significantly. The amount per month is also based on the assumption that Ford does not have fluctuating purchases. We are assuming that Ford buys the exact same amount every month. Factoring will allow for new projects to be taken and for expenses to be decreased periodically. This is an interest rate lower than what any bank would currently loan Dana Corporation. Ford will be willing to take on this venture because it will reduce their manufacturing costs while helping a firm, in which they rely heavily upon.