Module%20IV:%20Financial%20Strategy%20Business%20and%20Financial%20Strategy

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Module IV Financial StrategyBusiness and
Financial Strategy

• Week 11 November 4 and 6, 2002

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Objectives

• This lecture will show you how to analyze a
  firms proposed financial strategy is linked to
  its business strategy using the concept of
  sustainable growth
• We also examine the strategic role of financial
  flexibility
• We use two examples to illustrate these concepts
  Telefonos of Chile and Massey-Ferguson Ltd.

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Sustainable Growth Theory

• How fast can a firm grow when it does not rely on
  new equity for funding?
• Sustainable growth theory is useful because it
  highlights
• Limits of internal financing
• The need for external financing
• Inconsistencies between business and financial
  objectives

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Growth requires new assets
Change in Debt

Change in Equity
The Balance Sheet Identity
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Sustainable Growth Derivation

• Sustainable growth models are based on a number
  of simplifying assumptions
• Assumptions
• Constant returns to scale technology
• Fixed reinvestment ratio
• New equity only from retained earnings

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Notation

• Define

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Notation

• More definitions

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Derivation
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Derivation
Note S1 on both sides of equation
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Example PPL
Source of ratios Calculated average 1999-2000
from Exhibits 1 and 2, PPL Case
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Interpretation

• Higher sustainable or potential growth is
  associated with
• Higher profitability
• More efficient use of assets
• Lower dividend payout rate
• Higher leverage

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Sustainable and Optimal Growth

• Sustainable growth is not optimal growth rate
• Optimal growth maximizes the value of the firm
• Sustainable growth (g) is the only growth rate
  consistent with the firm continuing its
  operations without any outside equity
• Despite Modigliani-Miller propostions, leverage
  matters if new (outside) equity matters

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Sustainable and Actual Growth

• Sustainable growth is clearly distinct from
  actual growth
• When a firm tries to grow faster than g it must
  raise new equity capital, increase leverage, or
  use its assets more productively
• When a firm grows slower than g it accumulates
  more retained earnings, reduces its debt, or uses
  its assets less productively

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Financial Policies

• Financial policies (debt and dividends) and
  sustainable growth are jointly determined.
  Inputs into g are

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Key is Consistency

• You cannot choose dividend and debt policy
  independently of your desired product market
  strategy expressed in terms of growth in sales or
  assets
• Recognition of the consistency between financial
  constraints and growth plans is essential in
  making intelligent strategic decisions

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Useful Simplification of g

• A convenient simplification of the sustainable
  growth model is(Rough estimate you can do in
  your head.)
• You can use spreadsheet SUSGROW.XLS to compute
  using complete formula

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Example Telefonos de Chile

• Following privatization in 1991, Telefonos was
  growing at 30 annual rate
• It needed 2 to 5 billion to finance demand in
  Chile
• Use data in following slides
• What is sustainable growth rate and what can you
  conclude from this analysis?

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Statement of Income
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Balance Sheets
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Sustainable Growth Calculation
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Financial Flexibility

• High leverage enables a company to grow faster
  and also can raise its ROE (see sustainable
  growth formula)
• Negative side to additional debt comes in the
  form of expected costs of financial distress and
  loss of flexibility
• Even if default possibility is remote, lack of
  flexibility can impose severe costs

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Debt Policy and Flexibility
Optimal Leverage Zone Balances Tax Advantages of
Debt Against the Costs of Financial Distress
Firm Value
All Equity Firm Value
Leverage Ratio
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Example Massey-Ferguson

• In the 1970s, Massey-Ferguson, John Deere, and
  International Harvester (Navistar) had virtually
  all the North American market in heavy farm
  equipment
• Massey increased its leverage to finance
  acquisitions and undertook an aggressive growth
  strategy targeting less-developed countries and
  Europe

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Debt Policy

• Massey financed its aggressive growth with debt,
  as did International Harvester
• Deere was more conservatively financed,
  especially with respect to use of short-term debt
• All three had roughly equal shares of the market

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Debt-Capital Ratios
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Events

• When the Fed raised interest rates, interest
  payments for Massey and Harvester increased
  dramatically
• Simultaneously, durable good purchases fell as
  producers faced higher service costs.
• As a result, Massey and Harvester suffered huge
  losses while Deere used new debt financing to
  expand aggressively.

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Net Income
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Market Share, 1976-1980
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Outcome

• Faced with falling market share, rising costs,
  and customers who were concerned about obtaining
  spare parts and service should Massey fail, the
  firm fell into financial distress.
• Masseys original shareholders were wiped out as
  a result of the restructuring.

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Review

• The business and financial strategies of the firm
  are not independent.
• The sustainable growth model is useful as a
  diagnostic tool, but use it wisely.
• A key element of financial strategy is
  flexibility. This is hard to quantify, but is
  often critical in practice.

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Next Week Nov. 11 13, 2002

• Review RWJ, Chapter 18, on dividend strategy for
  Saturdays class
• Prepare Avon Products case for discussion,
  although write-up and discussion will not be due
  until Monday, November 18
• Begin analysis of international sources of
  capital and review of Huaneng Power case as soon
  as possible for write-up and discussion on
  November 25