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Intel Case Study

Prepared for:

Taylor Nadauld

By:

Geoff Bays
Carl Dixon
Jordan Walton
Calvin Weight

Intel Innovation and Success


Intels success can be attributed to its ability to adapt to perpetual paradigm shifting and its
solid business relations with major buyers of integrated circuits. During the early 1990s
Intel had an established reputation as a company that was consistently at the forefront of
innovation. In the integrated circuit industry, a companys innovation is fundamental to its
success. Moores Lawthe industry-wide benchmark for innovationwas created by
Intel cofounder Gordon Moore. The law claims that the number of components on a chip
doubles every two years. Intels adherence to Moores law is costly. In 1992, Intel projected
$700 million in research and development costs and $1.2 billion in property plant and
equipment costs. Thus far, these investments have been lucrative. Harvard Professor
Kenneth A. Froot estimated, Intel was responsible for 16 of the 22 major breakthroughs in
microelectronics between 1971 and 1981."
Intels strong customer ties with major buyers of integrated circuits have also proved
beneficial. IBM, Intel's largest buyer, has proved to be an important source of Intel's annual
revenues. In 1980, IBM chose Intel to be their "computational centerpiece" for many of their
microcomputers and computers. Intel has achieved large success in the past with their
i80286 and most recently with the i80386DXTM. Sales from the i80386DXTM have had a
major positive impact increasing from 822 million in 1989 to 1084 million in 1990 to 1361
million in 1991. This increase in sales has also been impacted by Microprocessors, which
have increased from 672 million in 1987 to 2501 million in 1991 (see Exhibit 1). The
increase is greatly attributed to the i386 microprocessor which had very few competitors
entering its "ramp up phase" (profitable phase) and high customer demand.
Market Segments
80386
Microprocessors

1987
210
672

1988
538
989

1989
822
1174

1990
1084
1854

1991
1361
2501

Exhibit 1: Analyst Estimates of Market Segments ($ millions)


As noted above, Intel's innovative culture and successful business partnerships with major
buyers (namely IBM) have fueled the companys recent successes. However, to be a
forerunner in innovation, Intel has made large investments in research and development
and property, plant, and equipment, which have thus contributed to their fixed costs. These
fixed costs lead to a higher operating leverage which can make the good times better and
the bad times worse. Because Intel is in a very competitive industry, this may be a cause for
concern. "Clones" and innovative products of other companies have the potential to capture
part of Intel's future sales revenue if they are effective in beating Intel to the market.

Optimal Target Capital Structure


For Intel to continue to be a leader in its industry, it must choose the optimal capital
structure. To achieve an optimal target capital structure, Intel must evaluate the levels of
competitive threats, financial distress costs, indirect costs, conflicts of interests, flexibility,
management incentives, and market signals. These factors meshed with Intel's situation
dictate the need for low debt (we recommend approximately 13%) and high equity.

Recommended Capital Structure


Intel should consider altering its capital structure to increase company ROE and to take
advantage of tax benefits. Intel wants to raise their level of debt to the industry average to
take advantage of the tax shields associated with debt. However, Intel needs to be
conservative in how much debt it allows because Intel needs the flexibility of cash on hand
to fund continued research and development, purchase of property, plant, and equipment,
and to act as a reserve to buffer any losses, lawsuits, and other unforeseen expenses. The
nature of Intel's industry raises the concern of being able to service its debt. However,
currently Intels ability to service debt is not a concern due to its huge excess cash reserves.

Intel's Cash Balances


According to Exhibit 12 in the case, the increase in cash for the years 1991 through 1995
would total an increase of $2.749 billion. In 1990 the ending balance of cash was $1.785
billion so by 1995 the cash balance would be $4.534. The pessimistic forecasts for the same
years predict a total increase of $1.211 billion in cash, which would make a 1995 yearend
cash position of $2.996 billion. The average of these two extremes project an ending cash
position of $3.765 billionor $1,980 billion above the 1990 cash level (see Exhibit 2).

Exhibit 2: Net Expected Change in Cash Above 1990 Level


Our team recommends distributing more cash in part because of Intel's low Long-Term
Debt-to-Assets Ratio of 10.43 percent (as compared to the industry average of 13.82

percent.) This low ratio can prove beneficial because of the inherent volatility in the
integrated circuit industry as this low debt ratio can allow for flexibility during tumultuous
economic times. A problem arises from Intel's trend in progressively decreasing debt from
the books year-to-year. In 1987, the LT-Debt-to-Assets Ratio was 12 to 13 percent but by
1990 this level had dropped to 6 percent. Intel would be able to increase profitability if they
increased their financial leverage by increasing their level of debt.
Despite the volatility of the integrated circuit industry, it is clear that Intels cash levels are
much too high. With cash levels of $2.4 billion in 1992, Intel could finance its planned
investment expenditures out of cash for almost two and one-half years without using any
cash flow from operations. Intel has year's cash of 2.9 (year 1990) versus the industry
average of .49 (See Exhibit 3). Cash is useful to meet cash flow needs, but 2.9 years is
excessive. Even if Intel lowered the balance of cash by 50 percent, Intels cash levels would
still be 2 to 3 times the industry average.
As noted previously, Intel also has very low levels of financial leverage. If Intel wants to
decrease cash levels while increasing, financial leverage, the best option is to issue stock
repurchases. By decreasing its cash levels Intel is able to raise its LT Debt-to-Assets ratio.
(Since treasury stock is a contra equity account, repurchasing shares will also increase the
debt-to-equity levels for Intel.)

Cash Disbursement Decision


Traditionally the two ways Intel can disburse cash to its equity holders are (1) through the
issuance of dividends and/or (2) stock repurchases. Although both of these cash
disbursement techniques ultimately give firm funds to investors, there are specific benefits
and costs associated with each form of disbursement.
When a company has excess profits, it can either reinvest this money into the operations of
the firm (through retained earnings) or disburse it out to investors through dividends.
While we might assume that investors would be ecstatic to receive this periodic return on
investment, there are several costs associated with dividends.
First, dividends are a tax-inefficient way to distribute funds. Because dividends are
distributed from profits, they are subjected to the corporate tax rate. However, once these
dividends are disbursed to the investor, for tax purposes these dividends are also
considered taxable income. This is important because the taxable income is taxed at the
investors tax ratenot the capital gains tax rate. For wealthy investors this can be very
expensive.
Secondly, because investors entrust managers to profitably invest their capital, returning
dividends to the investors may indicate an inability to perform this task.
Lastly, from managements perspective, issuing dividends may be the beginning of a cycle
that cannot easily be stopped. Once Intel starts issuing dividends, it will be difficult to stop
without raising serious concerns about the profitability potential of a company. Robert
Higgins eloquently stated our opinion when he wrote, Dividends reduce the size of
managements empire, an act counter to basic human nature.
In our opinion, if Intel were to disburse cash to shareholders they should do so by
repurchasing shares. Historically, subsequent hikes in stock price have followed Intel stock
repurchases. In 1987, Intel repurchased and retired 13.35 million shares for $27 per share,
which drastically increased price per share from around $28 to over $40 per share. Intel
again made a repurchase in 1990 of 3.20 million shares; similar results followed and share
prices rose from around $30 per share to over $50 per share. Moreover, from an investors
perspective, stock repurchases are taxed at a lower rate. In 1991 and 1992, the tax rate on
long-term capital gains tax for the highest tax bracket was 28%. Compared to a 31% tax rate
for income (which dividends are taxed at) it is easy to see why investors would be in favor
of stock repurchases.

Repurchase Decision and Type


If the price of Intel's shares increase a repurchase becomes more and more expensive. The
best recommendation would be a type of repurchase that maximizes the amount of shares
that they can acquire with as little cost as possible. A lengthy debate involved in an openmarket repurchase will cause delays and allow other investors to push up the price before
Intel goes in and repurchases. Alternatively, announcing a flat fixed-price tender offer will
have to be competitive to attract the volume that they desire. The problem with the fixedprice option is that the best price for Intel would be the lowest price that would generate
the volume Intel desires. This will leave the majority of stockholders disappointed at the

value of the equity. Consequently, this decision will not necessarily be in the best interest of
the majority of the shareholders.

Dutch Auction
A Dutch auction would make the most sense to Intel. With a Dutch auction, Intel can choose
how many shares it wishes to buy back and specify a maximum price at which they are
willing to do so. Shareholders then place bids at which they are willing to have their shares
repurchased. Those who want to ensure that their shares are repurchased will bid at a
lower price. The Dutch auction insures that Intel can purchase back their shares at a
competitive price based on the demand for their shares. The Dutch auction is more
advantageous than both the open-market repurchase and the fixed-price tender offer
options of repurchasing shares because it is a very quick process and gives agency to Intel's
shareholders to sell their shares at the price of their choosing.