636  Capital Structure, Dividends, and Share Repurchases A Four-Step Approach With these guidelines in mind, we recommend a sequential approach to estab- lishing capital structure and payout policies. With a clearly defined corporate strategy in place, the approach itself consists of four stages: 1. Project and stress-test the operating cash flows. 2. Develop a capital structure target based on the company’s risk profile and risk appetite. 3. Estimate the surplus or deficit cash flow to shareholders by combining the operating cash flow and the capital structure target. 4. Decide on the payout of cash flow surplus and financing of cash flow deficit, including tactical measures, such as share repurchases, dividend payouts, share issuances, and measures to adjust the company’s debt to the specified target levels. To illustrate the approach, we can apply it to a hypothetical company in international branded consumer products. In the past, the company, which we Figure 33.1  Cash Deployment: Value Creation Hierarchy Investments Invest in business if return on capital exceeds cost of capital Financing Manage capital structure to support business Payout Return to investors if return on capital falls short of cost of capital Organic growth Invest if value to company exceeds capital expenditures (i.e., if ROIC is higher than WACC)1 Acquisition Acquire if value to company exceeds acquisition price (i.e., if ROIC including goodwill is higher than WACC)1 Divestment Divest if sales price exceeds value to company Leverage adjustment Balance higher efficiency vs. lower flexibility of more debt Dividend payout Set at sustainable level to signal management confidence Share repurchase Return residual cash to shareholder Type of deployment Guidance Value creation potential High Low 1 ROIC is return on invested capital; WACC is weighted average cost of capital. A Four-Step Approach  637 call MaxNV, has generated annual operating earnings before interest, taxes, depreciation, and amortization (EBITDA) of around $1 billion, with some fluctuations resulting from movements in raw-materials prices and currency rates. MaxNV has held little debt, but acquisitions have driven up its ratio of net debt to EBITDA from 1.5 in 2015 to 2.8 at the beginning of 2020 (calculated as net debt at beginning of year over expected EBITDA for the year, which for 2020 would equal $2.8 billion divided by $1.0 billion). Step 1: Project and Stress-Test Operating Cash Flows MaxNV’s strategic plan under a base-case scenario foresees annual EBITDA growth of 5 percent, from $1.0 billion in 2020 to $1.2 billion in 2024 (see Exhibit 33.2). Growth derives in part from planned bolt-on acquisitions of around $0.2 billion per year, with some revenue lost to minor divestments. In the base case, MaxNV generates around $3.0 billion in free cash flow from operations over the next five years. We tested some of the most important business risks for MaxNV’s key market and product segments by developing two downside scenarios. In a competitive-disruption scenario, new entrants with direct-to-customer sales will be more successful than anticipated. Beyond 2021, this will start to de- press price and volume levels and require MaxNV to accelerate acquisitions EXHIBIT 33.2  MaxNV: Projections of Operating Cash Flows $ million   Projections  Cumulative, 2020–2024 2020 2021 2022 2023 2024 EBITDA1 Base 1,000 1,050 1,103 1,158 1,216 5,526 Competitive-disruption impact – – (100) (200) (200) (500) Economic-downturn impact – (100) (150) (100) (100) (450) Capital expenditures Base (100) (105) (110) (116) (122) (553) Competitive-disruption impact – (50) (50) (50) (50) (200) Acquisitions Base (200) (200) (200) (200) (200) (1,000) Competitive-disruption impact – – (500) – – (500) Divestments Base – 25 50 – – 75 Competitive-disruption impact – – – 25 25 50 Operating taxes Base (188) (197) (207) (217) (228) (1,036) Competitive-disruption impact – – 25 50 50 125 FCF2 from operations Base 513 573 636 625 666 3,012 Competitive-disruption impact – (50) (625) (175) (175) (1,025) Economic-downturn impact – (100) (150) (100) (100) (450) 1 Earnings before interest, taxes, depreciation, and amortization. 2 Future cash flows.