INTRODUCTION

is considered as one of the most

leading multinational companies in the world and is ranked among the top ten U.S. Companies in patents granted. In the array of thousands of products, 3M products are considered to be the most innovative. 3M produces more than 200 innovative products each year. With a ticker symbol of MMM, It is listed on the New York, Pacific, Chicago and Swiss stock Exchange.

3M, established in 1902, now operates in more than 60 countries and is engaged in producing more than 75,000 products including adhesives, sand paper, post-it products, abrasives, pharmaceuticals, fluorochemicals, optics, coatings, ceramics, LCDs, cables and other industrial and office equipments. It is said that a quarter of the world’s population uses one or more 3M products daily and its demand for the products is increasing day by day leading the company to make solid sales growth and make further prosperity in future.

With referring to the organizational growth and success over the past few years, the company continues to invest in growth programs and brand building throughout the portfolio. Its capital budgeting decisions regarding research and development and other capital expenditures are hoped to increase in every coming year which requires the challenges of meeting growing needs for finances, efficient allocation of resources, making good investment decisions and most importantly maintaining a balance between the objective of profit and

shareholder’s wealth maximization. It has to have a competitive edge and maintain itself financially sound and stable in accordance with the growing global demand of its products and increasing innovation in the world.

WHY CAPITAL BUDGETING

DECISIONS ARE IMPORTANT?

Capital Budgeting decisions are the most important and critical decisions that directly influence the company’s performance in terms of profitability and liquidity. These decisions can lead the company to reach the heights of success and can even lead

the company to face disaster. So effective capital budgeting decisions are key to the organizations’ success because they involve risk and understanding of uncertainty about each investment and project, which is usually difficult to analyze.

Case study

OVERVIEW / ANALYSIS

Since 3M makes almost 60% of its revenue from international markets that’s why its primary growth strategy is based on continuing international expansion and producing more innovative products into new or existing markets. Currently 3M manages its business operations in six business segments i.e. Health care, Industrial and Transportation, Display and Graphics, Consumer and Office, Electro and communication, Safety security and protection services.

3M’s FINANCIAL MANAGEMENT STRUCTURE

IN TERMS OF CAPITAL BUDGETING DECISIONS

3M’s capital budgeting decisions are mostly related to its R&D, acquisitions, strategic alliances,

mergers, investments in plant, property, equipment and usually in available for sale securities.3M invests more than $1 billion per year in research and development and related activities, and is awarded nearly 600 U.S. patents each year. 3M’s capital expenditures totaled $943 million in 2005 and are expected to increase up to $1.1 billion

in the year 2006. 1A brief overview about the company’s capital budgeting activities over the past few years is given below:

In 2005, 3M spent about $26 million for capital projects related to protecting the environment which are further expected to increase to $35 million for new programs to build pollution control devices, modern facilities and modify manufacturing processes to minimize waste and reduce emissions.

In 2005, 3M announced to build an LCD optical film manufacturing facility in Poland in order to cater to the LCD-TV market in Europe and to better serve its customers.

In 2005, 3M (industrial business

segment) acquired a CUNO filtration plant for purification of fluid and gases

for $1.36 billion ($1.27 billion paid in cash and $80 million of debt out of which mostly has been paid) along with the intangible assets of $268 million.

In the years 2003, 2004 and 2005, 3M business segments continued to buy 100% of outstanding shares from various companies, manufacturing lines and subsidiaries for the purpose of expansion and other activities.

In 2006, company combined its industrial and transportation business segment to increase efficiency and lower down its operational costs.

In 2005, approximately $3.6 billion of cash was used to repurchase 3M common stock under its repurchase authorization and for the

payment of dividends and contributed $788 million to its pension and

postretirement plans.

1 Only few of the material investments have been mentioned in the analysis to give the readers idea about the company’s capital budgeting activities.

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3M paid its first dividend of 6 cents per share in 1916 and since from then, it believes in delivering sustainable and higher returns to the company’s shareholder. Its dividend expenditures totaled $1.268 billion in 2005 ($1.68 per share), $1.125 billion in 2004 ($1.44 per share) and $1.034 billion in 2004 ($1.32 per share)2.

3M invests large amount of expenditures in Research and product development. Its total expenditures regarding R&D totaled $1.242 billion in 2005, $1.194 billion in 2004 and $1.147 billion in 2003 including the expenditures regarding the development of new and improved products of $798 million in 2005, $759 million in 2004 and $749 million in 2003. Regarding product development, 3M uses six sigma3 to increase the productivity and operational efficiencies by reducing defects to deliver high performance, reliable products to its customers.

The company strongly believes that its ongoing cash flows provide great source of its funding for expected investments and capital expenditures. It has sufficient access to the capital markets to meet its investment funding needs. The company allocates its funding needs from debt as well as from equity. It obtains

finances from operations as well as from long-term debt and short-term borrowings i.e. by issuing and trading commercial papers, medium term notes, floating rate note, convertible notes, and marketable securities. The company has entered into various indentures with the banks (including Citi Bank) with respect to short term and long term senior debt securities.

2 Dividend per share over the years have been shown in graph given at appendix 2 3 Six sigma is explained in detail in appendix 3

The table 1.1 (given in the appendix 1) comprises information about its short-term and long-term debts along with the interest rates and their maturity dates. Its overall long-term debt has increased from $ 727 million to $1,309 million in 2005 but its short-term debt has decreased from $2,094 million to $1,072 million in 2005.

3M has contingently convertible 30-year zero-coupon senior notes which are redeemable into 9.4602 shares of 3M common stock after some conditions have been met. In 2005, the conversion price for the fourth

quarter was $120 per share. In November 2005, 22,506 out of the 639,000 outstanding bonds were redeemed which resulted 3M to payout approximately $20 million.

3M has various pension and post retirement plans for its employees. 3M’s goal of this investment strategy is to meet the obligations and earn the highest rate of return on actuarial basis. The company determines discount rate for measuring plan liabilities for these plans and determines the rate of return by analyzing the returns on fixed income investment having similar duration liabilities (determined by

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recognized rating agencies). Table 1.2 (given in appendix 1) depicts the discount rate, expected rate of return estimated over the past few years.

The company estimates its fair value of assets and investments using discounted cash flow analysis. It also uses discount rate to determine its fair value of obligation and liabilities. Management makes estimation and assumptions while showing the long term effects of assets and investments in the financial statements and adjust those assumptions according to the changing circumstances and requirements.

3M uses net present value method to evaluate its investment decisions. It

3M Diamond Grade Reflective sheeting

uses 4Mapping portfolio tools i.e. bubble diagram and ellipses to plot probability of success against Net Present Value.

3M invests heavily in intangible assets including patents, goodwill, trademarks etc. In 2005, 3M acquired goodwill of $3.5 billion (including $1.002 billion of goodwill acquired from acquisitions primarily related to the CUNO acquisition). The impairment testing of goodwill is done at reporting level to recognize any impairment loss5 over the year.

3M has 18 reporting units to which goodwill is directly assigned. The estimated fair value of a reporting unit is determined by discounted cash-flow analysis or by multiplying each reporting units’ earnings with the price earning ratio for comparable industry group.

The company also raises funds through repurchase of common stock to support the stock based compensation plans and other corporate purposes. The company contributes treasury shares, accounted at fair value to

employee savings plans to cover obligations.

It has many stock option ownership programs including Employee stock Ownership plan (ESOP), General Employee stock Ownership plan (GESPP) and Management Stock Ownership Program (MSOP). 6Black-Scholes option pricing model is used for calculating the weighted average fair value per option at the date of grant for these plans.

3M uses ‘Discount Dividend Model7’ also known as ‘Gordon Model’ to evaluate its dividend decisions. This model calculates the present value of the future dividends that are expected to pay to its shareholders in future. It relates the market value of the firm to its dividend policy by calculating expected return, current dividend yield and projected dividend growth.

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4 Explanation is given in Appendix 3.5 Impairment loss is recognized when carrying value of asset exceeds the fair value of the asset.6 Black-Scholes option pricing model is discussed in detail in appendix 37 Dividend Discount Model is explained in detail in appendix 3

CORPORATE STRATEGY

Innovation is the basic corporate strategy that 3M is using for driving its organization. It invests a large sum in its R&D and believes its innovation and patents to be the great sources of its competitive advantage. 3M's corporate strategy is based on a paradigm shift towards 21st century competitiveness that requires movement towards long term “sustainable growth” without compromise of financial success. It has pursued this goal, in part, through its technical corporate culture with a workforce that is empowered to innovate. In their annual report for the year 2005 it is stated:

“Every day, people at 3M find ways to make life better and easier for people around the world. We increase and efficiency by sharing technologies, manufacturing operations, brands and other resources across our businesses and geographies. Our businesses produce innovative products, hold leading market positions and generate solid returns on investment.”

At 3M innovation is a dynamic process. All employees are encouraged to innovate and according to the 15% rule (their most famous management principle), employees are allowed to spend 15% of their working time on their own innovative ideas. The company is more than hundred years old and has been through various circumstances. Shift towards an innovative organization has been gradual. It had to face many challenges and adapt to them by changing its organizational structure.

CHALLENGES AND ORGANIZATIONAL CHANGES WITH REFERENCE TO

STRATEGIC DEVELOPMENT

Some of the challenges faced by the organization in the transformation into an innovative organization are mentioned in the table 1.3 in Appendix 1. At 3M, Managers are now engaging the staff for maximum innovation. This transformation required the leaders to take responsibility for articulating the direction, for creating an environment that empowers the members of the organization, to have a deep understanding of the changing needs of the environment and enabled the individuals to be creative and to be driven by their own will by communicating a clear vision of the future.

COMPETITORS

3M is the member of conglomerate industry. No organization competes with 3M on all product platforms; it has encountered strong competition

in specific business lines. In particular, Avery Dennison Corporation AVY), Johnson and Johnson (JNJ) and DuPont (DD) compete with 3M.

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A comparison of 3M performance with its competitors is given in table 1.4 in Appendix 1.

FINANCIAL PERFORMANCE

3M’s corporate strategy has great impact on its financial performance. Due to the increasing demand for its innovative products and effective decision making to reach operational excellence enabled the company to generate the highest sales revenue8 of $21.2 billion in 2005 with an increase of 5.4% over the previous year. It reported a net income of $3.2

billion with an increase of 7.0%.

Operating income grew up to $5 billion with an increase of 9.4%. Earnings per share reported $4.12, 9.9% higher as compared to the year 2004. Dividends per share with an increase of 16.7% reported to $1.68. However because of heavy investments and payment of some long term debts in 2005, the company reported a net decrease in cash & cash equivalents of $1,685 million as compared to the year 2004. But these outflows were because of heavy investments which would benefit the company on the long-term basis.

While talking about the company’s ratios, there had been an improvement in its profitability ratios as compared to the previous years. Pretax ROA increased from 23.78% in 2004 to 24.18% in 2005. ROE increased by 5.4%. Return on Common Equity (ROCE) reported 31.04%. Gross Profit Margin was 50.24% in 2004 and increased up to 50.96% in 2005, Operating Margin (22.88% in 2004, 23.66% in 2005) and the Net Profit Margin was increased from 14.94% in 2004 to 15.11% in 2005.

The company’s liquidity ratios declined because of decrease in cash and cash equivalents in

8 Graph representing the sales revenue, EPS, dividends per share over the years have been given in Appendix 2

2005 but these ratios are still considered good as compared with the industry ratios and are sound according to the rule of thumb. The company currently has a rating of AA credit rating from Standard & Poor’s and Aa1 credit rating from Moody’s Investors Service.

In 2004, the current ratio for 3M was 1.44 and it had decreased to 1.36 in 2005. For 2004, the quick ratio was 1.12 and it decreased to 0.95 in 2005. However decline in debt

ratio from 20.4% in 2004 to 14.0% and debt to equity ratio from 0.27 to 0.24 in 2005 is a positive sign.

Overall increased profitability ratios, high amount of return on investments, increase in sales, and continuous payment of dividends to its stockholders over the years show the company’s financial soundness and increase the shareholder’s confidence to make the company attractive for the investors.

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RISK MANAGEMENT

3M Diamond Grade Reflective sheeting

“To understand uncertainty and risk is to understand the key business problem – and the key business opportunity”— David B. Hertz, 1972.

Risk is the most important factor incorporated in the capital budgeting decisions that directly influences the credibility of an investment. When a company invests in a project, it always has some degree of uncertainty involved in it. Financial managers look for the projects whose expected rate of return is higher with less amount of risk involved in it to ensure shareholder’s wealth maximization and company’s profitability.

RISK FACTORS

3M deals with different types of market and company risks. Briefly, they are as follows:

The effects of, and changes in, worldwide economic conditions e.g. recession, social, political, labor conditions or government policies in which company operates etc. can have an impact on its results. Change in consumer preferences, introduction and timings of competitive products, changing customer order patterns can affect the demand for 3M products and hence can affect the company’s revenue and profit margins. As company makes almost 60% of its revenue from international markets therefore its receivables, and expected returns for the investments, sales and earnings can be affected by exchange rate fluctuations. Developments of new products may subject to many risks and is largely dependent on the timings

of their launch and acceptance of that product in the market. There is no guarantee that all these products will be commercially successful.

Price fluctuations, interruption in supply, shortages of raw material, changing demand, natural disasters and other factors can have a material effect on the company’s results. e.g. In 2005, the company had to face many problems regarding costs and supply of oil-derived raw materials because of hurricanes hit in Katrina and Rita. Its capital budgeting decisions regarding acquisitions, strategic alliances, divestitures and other events resulting from portfolio management actions, possible organizational restructuring and any other change in its business strategy can affect the future results. The company’s future results can be affected if company generates less productivity improvements than estimated. The Company and some of its subsidiaries are facing many claims, lawsuits, legal and regulatory proceedings and litigation including those involving product liability, property and other matters can result in the outcomes other than those of estimated which can affect the future results.

RISK MANAGEMENT STRATEGY BEINGFOLLOWED BY 3M TO OFFSET RISKS

3M has a financial risk management committee, comprising senior management, to deal with the company’s financial risk policies and provides

guidelines and procedures for risk management and derivative instrument utilization for control and valuation.

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Regarding the risk factors mentioned above, the company is using various techniques and strategies to minimize these risks. The activities undertaken by the management to offset these risks are: Hedging is the most important activity which 3M uses to counter risk. The company has various contractual derivative arrangements to manage risks associated with foreign exchange rate, interest rate and commodity price risks. The company uses interest rate swaps, forward and option contracts to manage risk. It uses a mix of floating and fixed interest rate debt and uses interest rate swaps to help managing the borrowing costs. In 2005, half of the currency impacts were reduced by hedging. The company is engaged in supply contracts, price protection agreements and forward physical contracts to ensure uninterrupted supply throughout the year and to manage commodity price risks. The company is doing global sourcing for coping with the commodity price inflation which would help in reducing the cost of raw material. The company uses tools like six sigma to improve its operational efficiency and productivity to reduce its operational costs in order to avoid risk regarding new product development.

3M uses variance/co-variance statistical model named “third-party bank dataset9” to assess interest rates, currency fluctuations and the risks associated with the loss in after-tax earnings in financial instruments and derivatives.

3M’s COMPLIANCE WITH LATEST REGULATORY

REQUIREMENTS

3M makes its financial statements in accordance with the Generally Accepted Accounting Principles (GAAP) and takes care of adopting new regulatory

9 Explanation is given in Appendix 3

requirements that are essential for the company to opt in order to come up to the international financial reporting standards. Its financial statements are audited by PricewaterhouseCoopers LLP which, (in the financial statements of 2005 under the “Report of Independent Registered Public Accounting Firm”), reports the 3M management to have an

effective internal control over the financial reporting.

The company makes sure that its financial reports are transparent and reflect the information about estimates, transactions, records, policies, risks, assumptions and other publicly available information, fairly and properly.

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3M is very much compliant to new accounting and management policies and discloses all the material information in their financial statements and press releases. e.g. In 2005, 3M adopted FASB Interpretation No.47: “Accounting for Conditional Asset Retirement Obligations” (FIN 47) which requires to record fair value of liability for a long term tangible asset retirement obligation on discounted basis. The adaptation of FIN47 resulted in an asset retirement obligation liability of $59 million and after-tax charge of $35million which are represented in 2005 income statement as cumulative effect of accounting change.

On January 1,2006, 3M adopted SFAS No. 123 (revised 2004), “Share-Based Payment” to grant stock-based compensation awards to retirement eligible employees. In September 2004, 3M adopted FASB’s Emerging Issues Task Force finalized EIFT issue No. 04-08, “The effect of

contingently convertible on Diluted earnings per share”.

3M makes forward looking statements to give a future view about the company either as a part of financial statements, in press releases or in other reports filed with the SEC. Forward looking statements give prediction about the company’s future performance or plans. The words depicting future like ‘expect’, ‘will’, ‘plan’, ‘intend’ etc and certain part of the financial statement including management discussion on performance of their future expectations can be identified as forward-looking statements. The assumptions and estimations made can differ from the actual results because of the risk factors discussed above.

The company’s provides maximum information about its policies and risk management but doesn’t imply any information about Capital Adequacy under value at Risk (VAR) and

aggregate risk because 3M considers the disclosure of this information to be a source of competitive advantage for its competitors. The only information available in the 3M financial statement is that all the derivative activities governed at 3M are followed by written policies and value-at-risk analysis is performed for these

derivatives. They use Capital Adequacy under value at Risk but don’t want to disclose this information.

CONCLUSION

3M is a multinational giant with well-diversified portfolio of products. Its significant growth along with a steady flow of new and innovative products and the expense on research, development and related expenses are expected to increase in the coming years which require the company to face new challenges regarding its capital budgeting decisions that would directly impact the organization’s structure and company’s financial performance. In this rapidly changing global environment of uncertainty, proper risk management is necessary to acquire required efficiency in order to have a good financial management structure.

DISCUSSION QUESTIONS

What kind of corporate strategy does 3M follow? And do you believe that in the coming years, that will

necessarily make 3M a market leader?

How will the company’s capital budgeting decisions impact their financial performance in the coming years?

What further steps should 3M take to offset the risks that they face? Do you believe that the strategies they are currently following are feasible or not?

Just because the company discloses in their financial reports, the new regulatory requirements, does that mean that the company is clearly transparent? Explain your answer.

How far the company has been able to pursue the goal of having a balance between shareholder’s wealth maximization and profit maximization?