Bob Jensen Emeritus Professor of Accounting Trinity University in San Antonio 190 Sunset Hill Road S

1
Fair Value AccountingAllen Questrom vs.
Federated Dept. Stores

• Bob JensenEmeritus Professor of
  AccountingTrinity University in San Antonio 190
  Sunset Hill RoadSugar Hill, NH 03586
• 603-823-8482rjensen_at_trinity.edu
• http//www.trinity.edu/rjensen/
• Bob Jensens
  Summary of Accounting History and Theory
• http//www.trinity.edu/rjensen/theory.htm
  
• Not everything that can be counted, counts.
  And not everything that counts can be
  counted. Albert Einstein

2
Compensation Contract

• Allen Questrom, Chief Executive Officer (CEO) of
  Federated Department Stores 1990-1995
• Pulled Federated out of bankruptcy
• Five-Year Compensation Contract1.2 million
  annual salary 0.75 share of the first 0.50
  billion increase in equity value1.50 share of
  increase in equity value 0.50 -1.00 billion
  2.00 share of increase in equity value gt 1.00
  billion

3
February 3, 1990 Agreed Equity Value

• ?? Market Value of new common shares issued when
  coming out of bankruptcy
• 2.80 Billion Market Value of 11.50 J.P. Morgan
  Valuation
• Questrom compensation to be based on market value
  in 5 yrs
• Page 224 Timeline

4
January 28, 1995 Equity Value Dispute

• 3.4 Billion Market Value of 18.625 Share Price
• 4.0 Billion Intrinsic Value of 22.00 J.P.
  Morgan Valuation
• 6.0 Billion Intrinsic Value of 32.86 Seneca
  Financial Valuation
• 5.0 Billion Intrinsic Value of 27.50 Smith
  Barney Valuation

5
Questrom Resigned and Sued For 63 Million

• According to the Seneca Financial Group, the
  total increase in value exceeded 3.2 billion (6
  billion minus original value of 2.8 billion,
  based on the February 3, 1990 estimate provided
  by J. P. Morgan).
• The 63 million bonus is calculated as follows
• Increase in Value Bonus
• 500 million (0.0075) 3.75 million
• (1 billion 500 million) (0.015) 7.50
  million
• (6.4 billion 1 billion 2.8 billion)
  (0.02) 52.00 million
• Total 63.00 million

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3.4 Billion Market Value of 18.625 Share Price

• Allegedly not appropriate as the marginal price X
  No. of shares
• Affected by short-term market transients that
  wash out daily
• Ignores important blockage factors
• Temporarily depressed by R.H. Macy Company
  acquisition in late 1994

7
Financial Statements on pp. 227-228

• Questrom closed unprofitable stores and spent
  hundreds of millions upgrading existing stores
• Not many new stores except for Macys acquisition
  in late 1994
• 1.8 billion loss in 1990 turned into over 100
  million profits in the years 1992-1995
• Extraordinary gain of 2.072 billion in 1992 due
  to early debt extinguishment

8
Operating Cash Flows on the Decline

• Net Income (Loss) Operating Cash Flows Change
  in Cash
• 1990 (1,774) 1990 ( 873) 326
  1991 (272) 1991 259
  8 1992 837 1992 548 549
  1993 113 1993 442 ( 435) 1994
  191 1994 411 ( 344)1995 189
  1995 161 ( 16)

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Forecasted Net Income for RI ModelPage 228

• Net Income (Loss) 1996 75
  1997 266 1998 536 1999
  662
• Shareholders Equity
• 3,639 on January 28, 1995 (Actual)5,178
  on January 30, 1999 (Estimated)

10
Forecasted Free Cash Flow for FCF ModelPage 228

• Free Cash Flow Cash from operations/- After
  tax net interest payments-/ Net cash used
  (generated) from investing activities
• Note that investing hurts FCF
• Estimated Free Cash Flow 1996 75
  1997 266 1998 536 1999
  662

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Valuation using Forecasted Dividends

• PV D/ (r-g)
• D Steady state dividend estimate
• r Cost of capital
• g Dividend growth rate
• Federated provides no basis for D est.

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Cost of Common Equity Capital

• In Practice
• The CAPM has three components
• (1) the riskless rate rf, reported to be 0.078
  in January 1995
• (2) the risk premium for the entire market (rm
  rf) .97 in 1995
• (3) the systematic risk of the security, ß.93
  for Federated in 1995

13
Weighted Average Cost of Capital (r)

• In Practice (with no preferred stock)

14
Weighted Average Cost of Capital (r)

• r is approximately 0.09 using the previous
  formula
• rES cost of equity capital is calculated in the
  following manner
• The riskless rate (7.8 percent) is proxied by
  the1995 yield on a ten-year Treasury Security
  (7.8 percent) (Ibbotson and Associates1995).
• Betas can be obtained from financial services
  such as Bloombergs, or theycan be calculated
  from a database such as CRSP. Federateds
  five-year monthly Beta for 1998 (obtained from
  Bloomberg) was 0.93.
• At the end of1995, the risk premium was
  approximately 7 percent (Ibbotson and
  Associates1995). Based on this data, the rES is
  approximately 14 percent 0.078 (0.93 0.07)
  and WACC is 9 (0.55 0.055) (0.45 0.14).

15
FCF Valuation Using Free Cash Flow

• In Theory
• In Practice
• Estimate FCF for n years and add in a discounted
  terminal value at the end of the nth year.
• FCF is overly sensitive to terminal value unless
  n is very large

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Equity Valuation Using Free Cash Flow

• In Theory the Market Value of the Debt is
  Subtracted from FCF
• FCF valuation does not work well for firms not is
  some type of steady state.
• FCF punishes value estimates for increased net
  cash flow investments
• FCF punishes value for leveraged debt and
  increased value of that debt

17
Equity Valuation Using Free Cash Flow

• R

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January 28, 1995 Equity Value Dispute

• 18.625 Share Price
• 22.00 J.P. Morgan Valuation
• 32.86 Seneca Financial Valuation
• 27.50 Smith Barney Valuation

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Equity Valuation Using RI Model

• In Theory
• In Practice
• Estimate equity value for n years and add in a
  discounted terminal value at the end of the nth
  year.
• RI is less sensitive than FCF model to terminal
  value unless n is very small

20
Equity Valuation Using RI Model
21
Class Discussion of These Outcomes

• Why do FCF vs. RI estimates differ so much in
  this case?
• What is a better approach aside from moondust?
• What do you think the judge decided in the
  Questrom vs. Federated Compensation dispute?

22
Ex Post

• The judge threw out Questroms lawsuit in
  February 2000
• Instead of 63 million, Questrom received 15.3
  million and had to pay his own attorny fees.

23
In May 1999, Questrom became the CEO of Barneys,
an insolvent upscale retailer. Within a year of
his hiring, he led Barneys back to solvency and
profitability.At the end of July 2000, Questrom
resigned from Barneys to become the CEO of
JCPenney. Once again his stated mission was to
turn around a troubled retail firm. While not in
bankruptcy, JCPenney had recently experienced a
decline in sales, a sharp drop in profits, and a
stock price plunge of 75 percent. Operational
problems and an identity crisis seemed to
plague the company.In 2007 Allen Questrom
joined the Board of Wal-Mart with an assignment
to improve the clothing sales operation.
Ex Post
24
While Questrom seems to be doing very well, his
former employer, Federated,has been experiencing
problems after 1999. It acquired the
catalogretailer, Fingerhut, for 1.7 billion.
This investment has proven costly, asFingerhuts
operation of selling to lower-tiered customers on
credit has not fitwell with the upscale image of
the Federated-Macys department stores.
Further,the Fingerhut acquisition was made to
help develop an e-commerce business, whichhas
not done well. Worse, Fingerhut experienced
problems with receivablesthat caused bad debts
to soar and profits to be less than expected.
Analysts slashedtheir estimates of Federateds
future profits (Quick 2000b) leading to a 50
percentdecline in Federateds stock price, from
almost 54 in the summer of 1999to 24 as of
July 31, 2000.
Ex Post
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The End