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Corporate finance project computer industry

EXECUTIVE SUMMARY

We chose the computer industry for our project. We picked five hardware companies- Compaq, Hewlett Packard, Hitachi, IBM, and Unisys and one software company- Oracle- for our analysis.

CORPORATE GOVERNANCE

According to our analysis, we found that all of our chosen companies, except for Hitachi, have good systems of corporate governance. We have concluded that Hitachis corporate governance is weak, which is a general characteristic of the Japanese style of management. However, its large debt adds discipline to its management due to monitoring by its lenders.

We also found some general characteristics in the computer industry. First, the larger the company, the more attentive it is to its stockholders. Second, in a fast-growing company such as Oracle, it is usual that CEO is one of the founders of the company. This type of company gradually transforms itself into a larger-type firm, such as IBM, and becomes more attentive to its stockholders as it matures.

RISK AND RETURN

In the risk analysis section, we observed that high-risk companies, such as Unisys, have larger betas and higher costs of equity. As a result of our calculations, we estimated each companys hurdle rate as follows:

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Corporate finance project computer industry Compaq Current optimal 0.00% 20.00% HP 5.68% 20.00% Hitachi 42.99% 40.00% IBM 15.91% 30.00% Oracle 3.99% 5.00% Unisys 37.49% 20.00%

Hitachi and Oracle have already realized their optimal financing mix. As for HP and IBM, their debt ratios are lower than the optimal, so they need to increase debt ratios by buying back their stock, which they did recently. Compaqs debt ratio is lower than the optimal, so Compaq needs to issue short-term debt (based on the duration coming from the regression analysis) in a mix of currencies, because the structure of debt should reflect the mix of the revenues from each country. Compaqs acquisition of DEC will lead Compaqs debt ratio to increase, but we believe the company still has some excess debt capacity. Unisys has to decrease its debt ratio immediately by selling assets and renegotiating with lenders. The company is in the process of restructuring its businesses and its finances in an effort to come to terms with this situation.

OPTIMAL CAPITAL STRUCTURE

Generally speaking, the debt ratio in the computer industry (12%) is relatively lower than that in other industries. Considering our chosen companies, mature ones such as IBM and Unisys have higher debt ratios, while fast growing companies, such as Oracle and Compaq, have lower ones. After our analysis, we reached the following optimal debt ratios and paths to the optimal.

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Corporate finance project computer industry Compaq HP Hitachi IBM Oracl e 3.9 9% 5.0 0% Unisys

Current Optimal

0.00% 20.00%

5.68% 20.00 %

42.99% 40.00%

15.91% 30.00%

37.49% 20.00%

Hitachi and Oracle have already realized their optimal financing mix. As for HP and IBM, their debt ratios are lower than the optimal, so they need to increase debt ratios by buying back their stock, which they did recently. Compaqs debt ratio is lower than the optimal, so Compaq needs to issue short-term debt (based on the duration coming from the regression analysis) in a mix of currencies, because the structure of debt should reflect the mix of the revenues from each country. Compaqs acquisition of DEC will lead Compaqs debt ratio to increase, but we believe the company still has some excess debt capacity. Unisys has to decrease its debt ratio immediately by selling assets and renegotiating with lenders. The company is in the process of restructuring its businesses and its finances in an effort to come to terms with this situation.

DIVIDEND POLICY

In summary, the dividend policies of companies in the computer industry are such that they do not generally pay many dividends. In the companies we analyzed, the rule of thumb is that for growth companies, the policy is to not pay dividends. For more mature companies, dividends are one of the ways for returning cash to investors.

We found that growing companies such as Compaq and Oracle do not pay dividends at all because of the need of the financing flexibility they require to take advantage good investment opportunities. It is also the case that stockholders in growing companies do not expect dividends
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Corporate finance project computer industry and would prefer cash returned to them in the form of buybacks. More mature companies, such as HP, Hitachi and IBM, do pay dividends.

VALUATION

Based on our analysis in each section, we chose the valuation model for each company as follows. Judging from the low average payout ratio, we should not use the dividend discount model because the current dividend payout does not show the real value of the companies. Therefore, we chose Free Cash Flow models. Except for Compaq, we used FCFE models because they do not have plans to change their capital structure significantly. Since Hitachis current growth rate is low and it is a mature company, a 1- stage FCFE model was chosen. On the other hand, a 2-stage FCFE model is appropriate for HP, IBM, and Unisys because we believe their lengths of faster growth periods would be 5 years. In addition, we selected a 2-stage FCFF model for Compaq because we concluded that the companys capital structure should move from the current debt ratio of 0% to the optimal of 20%. Finally, we reached the following result of our valuation. Compaq Valuation Current Price 33.71 28.25 HP 51.57 61.63 Hitachi 916.08 959.00 IBM 106.02 104.63 Oracle 32.05 31.08 Unisys 10.83 13.88

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Corporate finance project computer industry CORPORATE GOVERNANCE ANALYSIS

A. Management and Stockholders

balance of power

As shown above, five of our six companies pay attention to their stockholders. Overall, the board of directors of both Compaq and IBM are ranked as the 3rd and 5th best boards in the U.S., respectively, according to the Business Week annual survey. In these companies, management power is stressed by the fact that there are only a few insider directors and the companies have established a record of good corporate governance.

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Corporate finance project computer industry B. FIRM AND FINANCIAL MARKET SOURCE OF INFORMATION

external sources

1: hitachi 2:unisys 3:hp 4:compaq

the firm

none

COMPANY COMPAQ HP HITACHI IBM ORACLE UNISYS

MONTHY TRADING ANALYSIS $350 MILLION $72 MILLION N/A $210 MILLION $184 MILLION $28 MILLION 34 27 NA 21 31 10

As reflected above, Compaq, Hewlett Packard, IBM, and Oracle are well-followed firms. According to Zacks, there are more than 20 analysts who follow these companies. While each company provides substantial amounts of information in the form of financial statements, many
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Corporate finance project computer industry analysts and investors actively monitor the movement of these stock prices.

In addition, these stocks trade frequently in these companies. Stock trades for each company amount to more than $1 million monthly on average. Both facts lead us to expect less bias in the information that is available about these four firms. In the case of Unisys and Hitachi, there seems to be a little bias in the information available. Unisys is one of the largest software companies, but it has suffered from large operating losses over the past five years. There may be a possibility this company attempted to hide bad news as long as it could. With Hitachi, the management consists of only the inside directors. Considering how relatively unsophisticated the stock market is in Japan, it is quite possible that the bias in the information may be even larger than when compared to other US companies. However, biased information is not beneficial for the companies in the long-term, and both companies are well known to the public. Considered that the companies wish to keep their corporate images in their respective stock markets, such bias would not be so serious to the markets.

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Corporate finance project computer industry C. Firms and Society

very high very low

all six firms are here none

Social Consciousness and Image Factors

All companies in the analysis are committed to conducting their businesses in a manner that is compatible with the environment and protecting the quality of the communities where they operate. In their annual reports, we can easily recognize that the management believes that business must work in partnership with suppliers, government, community, and industry groups in an effort to protect the environment. These communities expect their hometown profitable companies to contribute to their societies.

It is also interesting that most of companies in the computer industry contribute to educational institutions such as public libraries and elementary schools. While such contributions increase the corporate images and benefit the communities, they also appear to be a kind of investment. In the future, as computer use grows, the educational institutions and current students can be potential customers. We cite some current examples below.

Firstly, Unisys, while being a relatively low-profile company, provides much needed services to a large number of companies and government organizations. A recent Unisys publication tells of how the company improved the voting system of Costa Rica by digitizing voter information and producing tamper- proof voter identification cards. On other fronts,
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Corporate finance project computer industry Unisys sponsors the Science Learning Center, a joint project of Unisys and the National Science Foundation. The SLC provides training to elementary school teachers in ways to incorporate Internet and WWW technology into their classes.

Secondly, according to the annual report of Hitachi, its corporate philosophy is to contribute to society through the development and application of superior technologies. Hitachi meets its responsibilities as a good corporate citizen through the activities of Hitachi-endowed foundations and programs designed to ensure Hitachi contribute to the betterment of the community. For example, it has achieved notable advances in the recycling of products, supported school libraries in Thailand, and provided opportunities to enjoy Japanese art and culture for Americans, etc. As can be seen from the above examples, social concerns play important roles in each companys decision making. STOCKHOLDER ANALYSIS

Institutional holdings Hard ware industry Software industry compaq hp hitachi ibm oracle unisys 50 60 % 40 50 % 60 70% 50- 60 % 40 50% 50 60% 40 50% 40 50% insider holdings 30 -40% 60% 0 -10% 30 40% 0% 0-10% 50 60% 0 10%

To analyze the stockholders in each firm, we searched for a stockholder composite as of the end of 2008. As shown in the above graph,
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Corporate finance project computer industry institutional holdings account for about 40% to 60% in each company. In IBM, the stockholders are well diversified, as there are no large stockholders with more than 5% of the shares in IBM. Compaq and Unisys have a few large institutional holders, but are sufficiently diversified, given their shares are not disproportionately large compared to other funds. Considering the scale of these firms, as well as the average 50.3% and 47.3% institutional holding in the hardware and software industries, respectively, these four companies are sufficiently diversified.

On the other hand, with regard to insider holdings, all four firms (except for Hewlett Packard and Oracle) have far lower insider holdings than other companies in their peer groups1. In the case of Oracle, the CEO is a co-founder of the company, while at HP, some of its directors are related to the family. So the insider holdings of each firm are nearly the same when compared to the industry average. The trading volume implies that insiders of these firms may not have an impact on their respective stock prices.

In summary, marginal investors are clearly institutional. Risk and return models assume that the marginal investor is well diversified and that only non-diversifiable risk matters. Here, the marginal investor is the institutional investor, so this assumption should work well.

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Corporate finance project computer industry

RISK PROFILE OVERALL RISK PROFILE

The first step in assessing the relative risk of our companies against the market was to run a regression, based upon the CAPM, of each of the companys stock against the market (in this case, the S&P 500), for the period 2004 to 2008. The regressions yielded each companys beta and intercept, which was used to compute Jensens Alpha2. Jensens Alpha, when annualized, tells us how each stock performed against expectations. The stocks that performed significantly better than expected over this period were HP, Compaq, and Oracle. Only Unisys, with the highest relative risk among the stocks, performed worse than expected, with a Jensens Alpha of 13.5%.

Next, I examined the R2 of the regressions, which explains the risk or variance of each stock attributable to market sources, such as interest rate risk, inflation risk, etc., and the remaining balance which indicates the diversifiable risk that was associated with each companys own specific risk components. Oracle, which had the lowest relative risk among the pack as measured by its regression beta, also had the smallest portion of risk that was attributable to market factors compared to the other firms.

We should note, however, that the standard error of the betas for all the regressions was relatively high, with the exception of Hitachi. Hitachis beta is close to 1, with a risk that is nearly the same as the market. This is due to the fact that Hitachi is a huge and diversified conglomerate firm. It is also worth noting that none of the firms achieved the same level of performance that the hardware and software industries achieved on average, as reflected by their very high Jensens Alphas. This is due
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Corporate finance project computer industry to the fact that all of our companies are large and have existed for several decades. The industry averages, on the other hand, may be overstated because they include many new entrants that are start up companies, which often times perform better than expected.

Measuring Bottom-up Betas

Given that nearly all the companies regressions yielded high standard errors in the beta estimates, it is worthwhile to check the validity of these betas. Through estimating a bottom-up beta, we looked at each company and the businesses they operated in, and determined a new beta for the company based on the unlevered betas from industry averages, multiplied by the relative divisional weight within each firm.

Below, we present each companys estimated bottom-up unlevered beta: COMPAQ Business EstimatedValue (MM)
$42,375

Comparable Firms
Computer HW

Unlevered Beta
1.37

Division Wt.

Wt. * Beta
1.37

Computer HW

100%

Firm

$42,375

100.00%

1.37

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HEWLETT PACKARD Business Estimated Value (MM) Comparable Firms


Computer Services Test and Measurement Products Medical Electronic Equipment Electronic Components Chemical Analysis

Unlevered Beta
1.49 .80 .95 1.17 .92

Division Wt.
82.6% 10.0% 2.9% 2.3% 2.2% 100%

Wt. * Beta
1.23 . 8 .03 .03 .02 1.39

Computer $99,491.7 Services $12,045 Test and Measurement Products $3,493.05 Medical Electronic Equipment ElectronicComponen $2,770.35 ts Chemical $2,2649.9 Analysis firm $120450

HITACHI Business
Computer HW Electrical Equipment Machinery Firm

Estimated Value (M)


Y2,611,729 Y822,304 Y2,178,967 Y6,501,322

Comparable Firms
Computer HW Electrical Equipment Machinery

Unlevered Beta
1.37 0.8 0.64

Division Wt.
46.53% 14.65% 38.82% 100.00%

Wt. * Beta
0.6375 0.1172 0.2484 1.00

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Corporate finance project computer industry

IBM Business
Computer & Peripherals Software Services Firm

Estimated Value (MM)


$49,938.57 $70,511.43 $120,450

Comparable Firms
Computer HW Computer Software

Unlevered Beta
1.37 0.98

Division Wt.
41.46% 58.54% 100.00%

Wt. * Beta
0.57 0.57 1.14

ORACLE
Business
Computer SW Firm

Estimated Value (MM)


$31,660 $31,660

Comparable Firms
Computer SW

Unlevered Beta
0.98

Division Wt.
100% 100.00%

Wt. * Beta
0.98 0.98

UNISYS
Business Computer Systems InformationServic es GlobaCustomer Services firm Estimated Value (MM) $2,653.16 $2,164.42 $2,164.42 $6892 Comparabl e Firms Computer Systems Computer Software Computer Services Unlevered Beta 1.37 0.98 1.49 Division Wt. 38% 31% 31% 100.00% Wt. * Beta 0.5206 0.3038 0.4619 1.29

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Corporate finance project computer industry

MOVING TOWARD LEVERED BETAS

Before we can arrive at a new beta estimate, we must look at the relative debt to equity ratios for each of the firms. The share price, shares outstanding, market values of debt and equity, and the debt to equity ratios for each of the firms are presented below:

Compaq Share Price3 Shares O/S (MM) MV of Eq. (MM) D/E

HP

Hitachi

IBM

Oracle

Unisys

$28.25 1,500 $42,375

$61.63 1,041 $64,154

Y959 3,337,000 Y3,200,000

$104.625 968.1 $101,287

$31.08 977.97 $30,395

$13.88 250.47 $3,477

0%

6%

75.41%

18.92%

4%

100.81%

While Oracles market value of straight debt is $304.2 million, the company has substantial operating leases on its books. When discounted back at Oracles present cost of debt, which is 8%, the present value of the companys operating lease liability is $960.4 million. This addition increases Oracles market value of debt substantially to $1,264.6 million, as reflected above.

The formula for moving from an unlevered to a levered beta is presented below, along with the results of each companys levered beta.

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Corporate finance project computer industry Levered Beta for Company = Unlevered Beta [ 1 + ( 1-t) (D/E) ]

Levered Beta for Compaq = 1.37 [ 1 + ( 1 - 0.36) (0%) ] = 1.37

Levered Beta for HP = 1.39 [ 1 + ( 1 - 0.30) (6%) ] = 1.45 Levered Beta for Hitachi5 = 1.00 [ 1 + (1 0.493) (75.41%) ] = 1.38

Levered Beta for IBM =

1.14 [ 1 + ( 1 - 0.36) (18.92%) ] = 1.28

Levered Beta for Oracle =

0.98 [ 1 + ( 1 - 0.36) (4%) ] = 1.01

Levered Beta for Unisys =

1.29 [ 1 + ( 1 0.36) (100.81%) ] = 2.12

Summary of Beta Estimates Used Forward in Analysis

Regression Betas Compaq Beta Estimate 1.55 HP 1.59 Hitachi 1.0 Unisys 1.88

Bottom-up Betas IBM 1.28 Oracle 1.01

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Corporate finance project computer industry For purposes of the analysis, we used the new bottom-up beta estimates for only two of our companies, IBM and Oracle. In the case of IBM, the software division has grown at a faster rate than the hardware division, and correspondingly, its revenue resources have changed. In the case of Oracle, it had a relatively high standard error in the beta estimate, its regression beta was well below the software industry average beta (while its bottom-up beta was more in line with industry average), and Oracle had substantially increased its financial leverage in recent years.

3 All share data as of close of each companys respective fiscal year end. 4 Includes market value of $1,420 million of preferred shares for Unisys Corporation. 5 Hitachis tax rate was estimated through running a regression of 10 years worth of income and tax data, yielding a marginal corporate tax rate of 49.3%.

For all other companies, I used what we believe are the more reliable regression beta estimates. In the case of Hitachi, both its regression beta and its bottom up beta were 1. For HP, it has a high R-squared, its standard error of the beta estimate is reasonably low, and its regression beta is higher than the industry average. In the case of Compaq, we used the regression beta for our analysis forward because there has been no substantial change in the business mix or financial leverage of the company. Lastly, for Unisys, it has been in a rather extraordinary position because it has operated at a loss over the last several years. This runs counter to how the industry has performed, so we believe the regression beta is a more appropriate measure of risk for the company.

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Corporate finance project computer industry FROM BETAS TO COSTS OF EQUITY To arrive at a cost of equity from the appropriate beta for each company, we assumed a risk-free rate of 6%, the long-term treasury bond rate for the period of our analysis. For the risk premium, we used a geometric historical risk premium for stocks over the long-term treasury bond of 6.16%. For our foreign company, Hitachi, we used the Japanese riskfree rate of 1.88% and the same risk premium.

Using the CAPM formula, below we present the costs of equity (expected returns) for each company:

Compaq

HP

Hitachi

IBM

Oracle

Unisys

Cost of Equity

15.55%

15.79%

8.04%

13.88%

12.22%

17.58%

As we can see, the return that investors expect to make on an investment in Unisys, given its comparatively high risk, is the largest among all companies at 17.58%. By comparison, Hitachis expected return is the lowest at 8.04%. Its risk is the market risk and is based upon the lower Japanese risk-free rate. The return that investors expect to make by investing into any company becomes the cost of equity for managers running that company.

ESTIMATING COSTS OF DEBT The current bond ratings for all our companies are presented below, which are factored into obtaining a current cost of debt for all companies:
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Corporate finance project computer industry For each company, I computed a cost of capital by taking the cost of equity, estimated from the beta, along with the after-tax cost of debt. The costs of capital for each company are presented below: Compaq
Bond Rating Pre-tax Cost Debt6 of 5.12% 4.69% 1.31% 4.35% 5.12% BBB 8%

HP
AA 6.7%

Hitachi
Aa2 2.58%

IB M
A+ 6.8%

Oracle
BBB 8%

Unisys

10 % 6.4 %

After-tax Cost of Debt

ESTIMATING COSTS OF CAPITAL

Compaq
Cost of Equity E/(D+E) AT Cost of Debt D/(D+E) Cost of Capital 15.55% 100% 5.12% 0 % 15.55%

HP
15.79% 94.32% 4.69% 5.68% 15.16%

Hitachi
8.04% 57 % 1.31% 43 % 5.14%

IB M
13.88% 84.09% 4.35% 15.91% 12.37%

Oracle
12.22% 96% 5.12% 4% 11.94%

Unisys
17.58% 49.8% 6.4% 29.86% 12.41%

6 We used the long-term treasury bond rate of 6% for all companies (except Hitachi, where we used the long-term treasury bond rate of 1.88%), adding on the appropriate default spread based upon each companys bond rating.

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Corporate finance project computer industry Note that, in addition, Unisys has preferred stock outstanding. We calculated the cost of preferred stock as: Cost of Pref. Stock = Pref. Div./MV Pref. Equity = 120.4/1420.2 = 8.5 The cost of capital as calculated above for Unisys includes the weighted average cost of preferred stock of 8.5% multiplied by the preferred stock ratio of 20.34%, yielding a total weighted average cost of capital of 12.41%. The cost of capital for each company is the benchmark each company uses to analyze projects on a predebt basis. In the next section, we will determine how each company has performed based on their respective costs of equity and costs of capital.

INVESTMENT RETURN ANALYSIS Business Project Flow Characteristics Type of Financing/Appropriate Debt Short term Both in US $ and foreign currency Linked to a high-technology

Computer Hardware Business

Be short term for personal computers, medium term for mainframe computers Have cash outflows that are primarily in dollars, but with inflows that are frequently in foreign currencies due to large overseas sales Be very competitive and volatile Be short term Have cash outflows that are primarily in dollars, but with inflows that are frequently in

index fund, if possible

Computer Software Business

Short term Both in US $ and foreign currency Linked

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Corporate finance project computer industry foreign currencies due to large overseas sales Can be considerably profitable Electrical Equipment due to low fixed costs Be medium to long term Have cash outflows that are primarily in dollars, but with inflows that are frequently in foreign currencies due to large overseas sales Electrical Machinery Stable, but can be cyclical Be long term Have cash outflows that are primarily in dollars, but with inflows that are frequently in foreign currencies due to large overseas sales Stable Sensitive to exogenous factors, such as politics and macroTest & Measurement Medial Electronic Equipment, Chemical Analysis & Service economic factors Long term Have cash outflows that are primarily in dollars Stable High fixed costs Mixture of medium and long term Mainly in US$ Mixture of medium and long term Both in US$ and foreign currency Linked to the specific country ratings, if possible Mixture of medium and long term Both in US$ and foreign currency to a high-technology

index fund, if possible

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Corporate finance project computer industry

MEASURING PAST RETURNS We assumed that the current book value of assets and equity of our companies reflected the current capital and equity invested in existing projects. Using the net income and book value of equity, we computed the return of

equity of each firm as follows:

Compaq ROE ROC 22.19% 22.87%

HP 21.08% 16.13%

Hitachi 2.72% 2.4%

IBM 29.4% 12.77%

Oracle

Unisys

38.75% 176.29% 36.56% 9.29%

Hitachis ROE and ROC are extremely low compared with the US companies. Unisys operates at a loss and thus, its ROE is negative. Since Compaq and Oracle have little to no debt, their ROCs are not much different from their ROEs. IBMs ROE is significantly higher, reflecting its relatively high debt ratio and its active stock buybacks. Graphically, these returns appear as follows: ROE & ROC
COMPANY Compaq Hp Hitachi IBM oracle unisys RETURN ON EQUITY 0 25% 0-25% 0-10% 0 40% 0 50% (150) (200)% RETURN ON CAPITAL 0 40% 0 25% 0 10% 0 20% 0 50% 0 15%

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Corporate finance project computer industry

EVALUATION OF PAST RETURNS

CALCULATION OF EQUITY EVA Compaq ROE Cost of Equity Equity Return Spread Equity EVA (MM) 22.19% 15.55% 6.64% $555 HP 21.08% 15.79% 5.29% $783 Hitachi 2.72% 8.04% -5.32% -Y 172,000 IBM 29.4% 13.88% 15.52% $3,216 Oracle 38.75% 12.22% 26.53% $562 Unisys 176.29 % 17.58% 193.87 % - $939 Industry Average 22.4% 12.8% 9.6% $50.6 7

CALCULATION OF EVA
Compaq HP Hitachi IBM Oracle Unisys Industry Average ROC 22.87% 16.1% 2.4% 12.77% Cost ofCapital 15.55% Capital Return Spread EVA (MM) 7.32% $612 15.16% 0.94% $182 5.14% -2.74% -Y 153,000 12.37% 0.4% $183 11.94% 24.62% $560 12.41% -3.12% - $108 12.31% 12.93% $101.45 36.56% 9.29% 25.24%

Compaq and Oracle are well outperforming their respective cost of equity and cost of capital, meaning both companies are picking up good projects. On the other hand, return spreads of cost of capital for HP and
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Corporate finance project computer industry IBM are close to zero, as compared to their equity return spread of 5.29% (HP) and 15.52% (IBM). This suggests that since HP and IBM do not have many good projects, they just buy back stocks alternatively. Reflecting its low ROE & ROC, Hitachis return spread is negative, as is its EVA. Hitachis ROE and ROC do not match the hurdle rates, thus its EVAs are negative. Unisys projects did not generate necessary return to the company The accounting returns certainly give us general information on each companys performance. However, accounting returns do not necessarily reflect the companys real picture, because they are influenced by certain accounting standards, and do not reflect market value. Since, it is meaningful to use both book value basis returns and market value returns to get more precise and comprehensive information of the companies in our analysis, we compared market value based excess return (return on stock required return) in the following dividend chapter. DIVIDEND POLICY: THE TRADEOFF

The way the six companies return cash to stockholders is different and the reasons they return the cash also vary.

The following tables sum up the dividend and stock buyback of the last 5 years HP
YEAR DIVIDENDS EQUITY REPURCHASES CASH TO STOCK HOLDERS 2004 $228 $6 2005 $280 $25 2006 $358 $325 2007 $450 $726 2008 $532 $305

$234

$305

$628

$1176

$837

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Corporate finance project computer industry

HITACHI
Year Dividends 2004 37.35 2005 37.10 2006 37.98 2007 36.39 2008 36.63

+ Equity Repurchases = Cash to Stockholders Y37.35 Y37.1 Y37.98 Y36.39 Y36.63

UNISYS
Year 2004 Dividends + Equity Repurchases = Cash to Stockholders $0.00 $0.00 $0.00 $0.00 $0.00 2005 2006 2007 2008

ORACLE
Year Dividends + Equity Repurchases CASH HOLDERS 2004 2005 2006 2007 2008

$43 $43

$81 $81

$75 $75

$113 $113

$528 $528

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Corporate finance project computer industry

COMPAQ
Year Dividends + Equity Repurchases = Cash to Stockholders $0.00 $0.00 $0.00 $0.00 $0.00 2004 2005 2006 2007 2008

IBM
Year 2004 2005 2006 2007 2008

Dividends

$933

$662

$591

$706

$783

+ Equity Repurchases

$10

$5,526

$5,005

$6,251

= Cash to Stockholders

$933

$672

$6,117

$5,711

$7,034

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Corporate finance project computer industry

Dividend Payout IBM HP Hitachi Hardware Ind. Avg. Soft.&Serv Ind. Avg. Ind. Wt. Avg. 12.85 17.06 41.46 7.67 7.25 7.45

Dividend Yield 0.77 0.83 0.01 0.42 0.19 0.30

As shown above, our 3 companies have higher payout ratios and yields than the industry averages. However, we must view Hitachi as an exception because it is a Japanese company and operates under different constraints.

To better understand some of the tradeoffs of different dividend policies, we will compare the policies of Compaq and IBM, which exemplify two common dividend policies, namely the policy of paying dividends and the policy of not paying dividends.

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Corporate finance project computer industry

Factor

Implication for Compaq

Implication for IBM

Stockholder Tax Preference

Considering its history of no dividends, stockholders choose it for its capital gains potential. In the future, stockholders would prefer buybacks over dividends.

IBM was a typical dividend paying company before the recession, but 5 years of low dividends have changed stockholders attitudes so now they do not expect high dividends Its announcement that it would reduce dividends sent its stock plummeting.

Information Effects and Signaling Incentives

Considering its no-dividend policy, it is unlikely that Compaq would use dividends to signal information about future cash flows.

Effect on Flexibility

Not paying dividends gives Compaq more flexibility in accepting projects

Since IBM does not have many good projects, they tend to return money to stockholders. Therefore, they do not require much flexibility. They have many bond holders, so ratings are a concern and effects their dividend policy.

Bond Covenants and Ratings Agency Concern

Considering that it has no debt, this is not a concern

As suggested above, when Compaq decides to return money to stockholders it should do so in the form of buybacks. IBM should continue its current dividend policy

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Corporate finance project computer industry DIVIDEND POLICY: A FRAMEWORK

The following tables sum up our results of what the companies should have returned and what they did. It also shows where the companies paid out too much. The companies can be categorized in 4 ways by looking at how they return cash to stockholders.

1) Those that pay dividends: Hitachi 2) Those that buyback stocks: Oracle 3) Those that pay dividends and buyback stocks: Hewlett Packard and IBM 4) Those that that do neither: Compaq and Unisys

1) Hitachi has been paying the same 11 yen per share dividend since 1990, even though its profits have been declining due to the Japanese recession. This is common in large mature Japanese companies. Even though this dividend is regular, its yield is just 1.15%. However, since its net income per share was just 25.55 yen in 2008, 11 yen per share means its payout ratio is 43%, which is not very low. Their 10-year historical dividend payout ratio is 26.31%. As this is the only Japanese company in the group, the following information is included for comparison.

Toshiba: Dividend pay out =Y10/Y18.7=53.5% Y10/Y547=1.82% Matsushita:Dividend pay out = Y13/Y39.4=33.0% Y13/Y1,985=0.65%
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Yield: Yield:

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Compared with other Japanese computer and electronics companies, Hitachi's dividend ratios are between Toshiba and Matsushita: not so high but not so low. Since most of Hitachis shareholders are institutional investors, they prefer capital gains and stable growth, rather than obtaining large dividends. This is due to the difference in tax treatment.

2) Oracle is unique in the survey because it has been returning cash in the form of stock buybacks. From the data, it seems that Oracle is transforming itself from a growth company to a more mature company. Since Oracle has never paid dividends, its investors are not expecting any in the future. As Oracle does not have as many good projects as in the past it is returning cash in the form of stock buybacks.

3) Hewlett Packard and IBM seem very similar on the surface in terms of their cash returning policies. Both companies have a low positive EVA, which is consistent with large mature companies which do not have attractive projects. However, with a little analysis we can see some differences. HP is a typical large mature company with a relatively stable dividend payout ratio. It is also buying back stock.

IBM, on the other hand, appears to be behaving in the same manner. But by looking back a few years, we can discover a different reason for IBMs actions. From 1991-1992 IBMs stock price fell 43%. This came on the heels of mounting loses as a result of mismanagement. In 1993, IBMs new management, lead by Louis Gerstner, Jr., announced a decrease in dividends which was greeted with further downward pressure on their stock price. To counter this effect IBM started to repurchase its stock. In this way it returned cash to shareholders and helped bring the price back up.

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Corporate finance project computer industry 4) The last two companies also appear similar if looking at their dividends and buyback policies, but other than that, they are widely different. Compaq is a typical growth company. It has an EVA of 7.32%, which signifies that it is investing in good projects. Its policy of not returning money to shareholders and reinvesting it in projects is the definition of a growth company. Unisys, on the other hand, is a company that has been loosing money for several years and has posted negative FCFE for 6 of the last 10 years. It is not surprising that the firm does not pay any dividends.

How much do we trust management at these computer companies? First, in terms of corporate governance, except for Hitachi, we consider each company to have appropriate corporate governance. Second, in terms of stock price performance, except for Unisys, each companys stock has performed well compared to the market, after adjusting for risk. Excess Returns (Return on Stock-Required Return) Recent 5 year Average HP Hitachi Unisys Oracle IBM Compaq 8.64% 6.59 -16.48% 14.63% 12.66% 27.12% Standard Div. 21.51% 11.96% 60.11% 13.17% 23.66% 37.29%

Based on the table above, we can say that the companies that have smaller excess return (return on stock required return), such as Hitachi or IBM, tend to pay higher dividend, while a company that has high
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Corporate finance project computer industry excess return, Compaq, tends to pay no dividend. Therefore, we can conclude we can trust these companies management, except for Unisys.

COMPARISON TO PEER GROUP

In comparing our companies to each other, as well as to a representative cross section of its peer group, we have examined dividend yields and payouts.

Expected Growth Microsoft Intel Dell Micron DEC Cisco 3Com Compaq IBM Oracle HP Unisys Hitachi 23.81 19.64 29.58 16. 12 29.85 24.15 20.38 10 24.48 15.47 10.6 2.07

Dividend Payout 0 2.7 0 0 0 0 0 0 12.75 0 17.06 0 41.46

Dividend Yield 0 0.16 0 0 0 0 0 0 0.77 0 0.83 0 0.01 42

Price 64.63 70.25 9.13 37.13 55.75 34.94 28.25 104.63 31.08 61.63 13.88

The forecasted growth rates were taken from the Zacks service by way of Bloomberg.

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Corporate finance project computer industry We ran the two regressions in order to see how well expected growth predicts payouts and yields. The results are as follows: Dividend Payout Ratio = 24.4 - 1.02 (Expected Growth Rate) R-Sq = 48% (t=3.19)

Expected Growth Microsoft Intel Dell Micron DEC Cisco 3Com Compaq IBM Oracle HP Unisys Hitachi 23.81 19.64 29.58 16.58 12 29.85 24.15 20.38 10 24.48 15.47 10.6 2.07

Actual Payout 0 2.7 0 0 0 0 0 0 12.85 0 17.06 0 41.46

Predict- ed Payout 0.11 4.37 -5.77 7.49 12.16 -6.05 -0.23 3.61 14.20 -0.57 8.62 13.59 22.29

Difference

-0.11 -1.67 5.77 -7.49 -12.16 6.05 0.23 -3.61 -1.35 0.57 8.44 -13.59 19.17

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Corporate finance project computer industry Dividend Yield = 0.335 - 0.0108 (Expected Growth Rate) R-Sq = 8.9% (t=1.04)

ExpectedGr owth Microsoft Intel Dell Micron DEC Cisco 3Com Compaq IBM Oracle HP Unisys Hitachi 23.81 19.64 29.58 16.58 12 29.85 24.15 20.38 10 24.48 15.47 10.6 2.07

Actual Payout 0 .16 0 0 0 0 0 0 .77 0 .83 0 41.46

Predict- ed Payout .08 .12 .02 .16 .2 .01 .07 .11 .23 .07 .17 .22 .31

Differ ence

-.08 .04 -.02 -.16 -.21 -.01 -.07 -.11 .54 -.07 .66 -.22 .30

By looking at the shaded areas of the above left table, we can see how well the regression predicts payout ratios. The regression results suggest that HP and Hitachi are high compared to other firms in the industry. However, this can be attributed to the large portion of the sample group that does not pay dividends which provides little variation across the group.

A similar situation is shown in the above right table, when we regressed yield against growth. The results suggest that IBM and HPs yields are
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Corporate finance project computer industry too high compared to the industry and that Hitachis are too low. However, as mentioned above, Hitachi is a unique case because it is a Japanese company operating under different constraints.

Conclusions on Dividend Policy

In summary, it seems that investors in our six companies know what type of dividend policy to expect. Except for Unisys, management has earned a certain measure of trust based on excess returns for their investors. This gives the companies greater flexibility for investing and paying out dividends. It is also true that these companies generally stick to a given policy and their stockholders have chosen to invest accordingly.

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Corporate finance project computer industry VALUATION Valuation summary $us per share
Value DDM HP Unisys Compaq IBM Oracle Hitachi 40.38 1.36 17.37 84.38 22.95 1009.04 FCFE 51.57 10.83 20.85 106.02 32.05 916.08 FCFF 33.71 Actual Price 61.63 13.88 28.25 104.63 31.08 959 Difference (actual-value) amount % 10.06 3.05 -5.46 -1.39 -0.97 42.92 19.5% 28.2% -16.2% -1.3% -3.0% 4.7% Overvalued Overvalued Undervalued Undervalued Undervalued Overvalued

Two of the companies are pretty overvalued: Hewlett Packard (19.5%) and Unisys (28.2%). When we change the 5-year growth rate of Hewlett Packard (18.28% to 23.5%), expected values match the current prices. Therefore it can be said that the market expects HP to grow much faster than its fundamental growth capacity (14.99%). Unisys is losing money every year. Without its preferred stock, it would have negative shareholder's equity. It's bond rating is "B." Even when we made a pretty optimistic profit plan for Unisys, its stock is still quite overvalued. Although Compaq is also overvalued by FCFE model by 35.5%, if we change the capital structure of Compaq to the optimal level (debt ratio from the current 0% to 20%) and use FCFF model, the value of share becomes $33.71, which is pretty close to the current price. Therefore, markets may expect that Compaq will change its capital structure and take on debt in future. On the other hand, IBM and Oracle are slightly undervalued. Therefore, we recommend selling short HP and Unisys, and buying IBM and Oracle. 2. Choosing the right model

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Corporate finance project computer industry For the valuation, we can made the assumptions listed below. More details are on the attached "The Values of Equity in Computer Companies." (1) 5 year rapid growth, 2 stage model Except for Hitachi and Oracle, we used a 2-stage model for valuation because each company has high expected growth for the first five years due to the computer industry's faster growth rate (fundamental EPS growth: 21% in hardware and 18% in software) than general U.S. economy (5%). On the other hand, although all of four companies have moderate barriers to entry and high expected growth rates, the size of most of the companies are large, so the length of high growth periods should be moderate. Therefore, we estimate that they will grow at a higher rate for the first five years, and then the growth rate will become stable. we estimate Hitachi should already be in a stable growth period, and therefore chose a 1-stage model. On the other hand, Oracle's expected growth rate is so high (28.95%) that we used a 3-stage model with 5 years rapid growth and a 5-year transition period. (2) Cash flows to equity and cost of equity Basically, except Compaq, we use free cash flows to equity as cash flows, and costs of equity as discount rates for three reasons. First, each company's dividend payments do not always show each company's actual value. Therefore, free cash flow model is more preferable than the dividend discount model. Second, we expect that their capital structures would not change significantly, except Compaq. Therefore, free cash flow to equity should be more appropriate than free cash flow to firm. Third, since each company would not take highly risky projects or change its business structure significantly in the future, the current cost of equity is appropriate for discount rate. Since Compaq should change its capital structure gradually from zero to 20%, I also used FCFF model and discounted by cost of capital (15.5%). However, since Unisys almost finishes its capital restructuring , I use current debt ratio for this valuation. (3) 50% fundamental growth, 25% analyst's expectations, and 25% EPS growth
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Corporate finance project computer industry I assigned the following weights for the rapid growth rate. I weighed fundamental growth at 50%, analysts expectation at 25%, and 25% for the historical growth rate of earnings per share. I did this because the fundamental growth rate is too objective and based on the growth of earnings. However, since Unisyss fundamental and historical growth rates are negative, we only used the analysts expectation for the company. For Hitachi, since we couldnt get reliable analysts expectations, we weighted it 50% on fundamental and 50% on historical growth. On the other hand, since Oracle's EPS growth (68.29%) is unusually high, we weighted 50% on fundamental and 50% on analysts' expectations. (4) 130% Capital expenditure/ Depreciation Since computer industry is capital intensive industry, capital expenditure is usually larger than depreciation even in mature companies like IBM. Therefore, we estimate that stable capital expenditure should be 130% of depreciation, which is the current industry average. In Unisys, however, we estimate its capital expenditure to be the same amount as depreciation because of its current downsizing process. 3. The problem of Unisys It is difficult to evaluate the value of Unisys because it has been losing money for the last several years. Based on the assumptions below, even given that its current EPS is negative $5.30, due to the restructuring efforts and selling non-performing assets, we hope the firm will recover in five years and then grow at a stable rate.

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Corporate finance project computer industry CONCLUSION I believe that the computer hardware and software industries have huge opportunities for further growth in the future based on the following reasons: 1) I expect that the customer base will continue to expand, both domestically and internationally; and 2) new related businesses, such as network computer and IT solution consulting business, were created and grew at a rapid pace.

Compaq has been growing rapidly and is likely to continue to do so in the future, given its relatively small company size. Through acquiring DEC, Compaq is entering into the network business, which is a business of both high profitability and risk. However, I believe Compaqs good brand image will make it possible to earn higher operating margins.

HPs diversification into relatively low risk businesses, such as electrical manufacturing, medical electronics and chemical analysis, provides the company with buffers to exposure in its highly risky computer hardware business. On the other hand, its diversification may limit its opportunities to capture any high growth opportunities in the computer hardware business. So, together with its big size, I anticipate that HPs growth will be stable in the future. Hitachi should increase its ROE and ROC in order to match the required hurdle rates. Its low ROE and ROC are a reflection of Hitachis power structure between strong incumbent managers and weak stockholders. If stockholders acted to check the managers, it would be harder for the firm to generate a negative EVA. Thus, we do not foresee high growth for Hitachi. Given the current bad fundamentals for the Japanese economy, it may grow only modestly. While focusing on the computer hardware business, IBM transitioned into other areas, such as software services and consulting, which are relatively less risky than its current stronghold. IBMs policy to buy back stocks suggests that the company does not have many good projects to invest. So, we anticipate that IBM will grow at a moderate rate.
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Corporate finance project computer industry Oracle, on the other hand, is concentrating on the fast-growing software service business. Given that the company is still relatively small, there is room to grow for the company, although its growth may be volatile. Unisys is in the process of turning itself around. Since new CEO Larry Weinbach came on board in September of 1997, Unisys is focussing on the future. Unisys has since contracted out to manufacture desktop computers and low-end servers, and is now concentrating on its mainframes and high-end servers. More importantly, Unisys is over 80% of the way towards achieving Weinbachs goal of reducing debt by $1 billion dollars by the year 2000. This success resulted from the conversion of $616 million in bonds and the retirement of $198 million in additional debt. With this financial restructuring and the streamlining of itsmanufacturing operations, we believe that Unisys is poised to make a comeback.

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Corporate finance project computer industry :BIBLIOGRAPHY

1:hp.com 2:caompaq.com 3:Unisys.com 4:oracle.com 5:ibm.com 6:hitachi.com 7:google

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