650  Capital Structure, Dividends, and Share Repurchases company credit ratios clustered around industry-specific averages, further in- dicating that each industry has its own effective capital structure.29 From a company’s credit rating, you can also estimate the interest rate payable on its debt funding. The difference between the yields on corpo- rate bonds and risk-free bonds—the credit spread—is greater for compa- nies with lower credit ratings, because their probability of default is higher. Exhibit 33.10 plots cumulative default probabilities against the credit ratings over five and ten years and the average credit spread for each rating. The credit spread reflects the increasing default probability almost proportionally, but for ratings below the investment-grade benchmark of BBB, it increases more sharply. One explanation is that some institutional investors cannot invest in debt that is below investment grade (BBB–), so the debt market is considerably smaller for below-investment-grade debt, and interest rates correspondingly higher. EXHIBIT 33.9  Interest Coverage and Credit Rating for Selected Industry Sectors Rating Semiconductors Communication services Food, beverage, and tobacco Utilities 68 Volatility2 % 32 16 16 13 CCC+ – B– – B – B+ – BB– – BB – BB+ – BBB– – BBB – BBB+ – A– – A – A+ – AA– – AA – AA+ – AAA – Interest coverage1 0 10 20 30 40 50 60 Materials 70 1 EBITDA/interest. EBITDA is earnings before interest, taxes, depreciation, and amortization. 2 Median volatility of EBITDA over the prior 5 years in each sector. Source: S&P Capital IQ; Corporate Performance Analytics by McKinsey. 29 E. Schwarz and R. Aronson, “Some Surrogate Evidence in Support of the Concept of Optimal Finan- cial Structure,” Journal of Finance 22, no. 1 (1967): 10–18. Payouts to Shareholders  651 Payouts to Shareholders Most successful companies, at some point, find it virtually impossible to rein- vest all the cash they generate. In that case, there is little alternative but to re- turn surplus cash to shareholders. Although some executives might consider that a failure to find value-creating investments, it is actually an inevitable consequence for maturing companies with high returns on capital and mod- erate growth. For example, a company with $1 billion of net operating profit after taxes (NOPAT), a return on invested capital of 25 percent, and annual revenue growth of 5 percent needs net investments of only $200 million per year to continue its growth at that rate. That leaves $800 million of surplus cash flow for additional investments or payouts to shareholders (see Exhibit 33.11). Finding $800 million of new investment opportunities at attractive returns in every year is a challenge in many industries. Reinvesting all its surplus cash flow in new opportunities at its current return on capital of 25 percent would imply that the company grows revenues by 20 percent each year. The payout levels for different combinations of return and growth in Exhibit 33.11 indicate that for most successful companies, even those with double-digit growth rates, the implications will eventually be similar: there is no choice but to return substantial amounts of cash to shareholders. Between 2002 and 2014, Procter & Gamble returned $113 billion in dividends and share repurchases to its shareholders, representing more than 90 percent of EXHIBIT 33.10  Default Probability and Credit Spread 0 0 5 10 15 20 25 30 Cumulative default probability, % Rating 100 200 300 400 500 700 600 Spread, basis points Default probability after 5 years Default probability after 10 years Average spread over government bonds AAA – AA+ – AA – AA– – A+ – A – A– – BBB+ – BBB – BBB– – BB+ – BB – BB– – B+ – B – B– – Source: S&P Capital IQ; Corporate Performance Analytics by McKinsey.