Fair Value Accounting Allen Questrom vs. Federated Dept. Stores

1. Bob JensenEmeritus Professor of AccountingTrinity University in San Antonio 190 Sunset Hill RoadSugar Hill, NH 03586 603-823-8482rjensen@trinity.edu http://www.trinity.edu/rjensen/ Bob Jensen’s Summary of Accounting History and Theory http://www.trinity.edu/rjensen/theory.htm “Not everything that can be counted, counts. And not everything that counts can be counted.” Albert Einstein Fair Value AccountingAllen Questrom vs. Federated Dept. Stores

2. Compensation Contract • Allen Questrom, Chief Executive Officer (CEO) of Federated Department Stores 1990-1995 • Pulled Federated out of bankruptcy • Five-Year Compensation Contract$1.2 million annual salary +0.75% share of the first $0.50 billion increase in equity value1.50% share of increase in equity value $0.50 -$1.00 billion 2.00% share of increase in equity value > $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

6. $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)

9. 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

11. 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.

12. Cost of Common Equity Capital In Practice The CAPM has three components (1) the riskless rate rf, reported to be 0.078 in January 1995 (2) the risk premium for the entire market (rm – rf) = .97 in 1995 (3) the systematic risk of the security, β=.93 for Federated in 1995

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 Bloomberg’s, or theycan be calculated from a database such as CRSP. Federated’s 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

16. 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

18. 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

19. 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 Questrom’s 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 Barney’s, an insolvent upscale retailer. Within a year of his hiring, he led Barney’s back to solvency and profitability.At the end of July 2000, Questrom resigned from Barney’s to become the CEO of JCPenney. Once again his stated mission was to turn around a troubled retail firm. While not in bankruptcy, JCPenney had recently experienced a decline in sales, a sharp drop in profits, and a stock price plunge of 75 percent. Operational problems and an “identity crisis” seemed to plague the company.In 2007 Allen Questrom joined the Board of Wal-Mart with an assignment to improve the clothing sales operation. 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, asFingerhut’s operation of selling to lower-tiered customers on credit has not fitwell with the upscale image of the Federated-Macy’s 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 Federated’s future profits (Quick 2000b) leading to a 50 percentdecline in Federated’s stock price, from almost $54 in the summer of 1999to $24 as of July 31, 2000. Ex Post

25. The End