Module IV: Financial Strategy Business and Financial Strategy

J. K. Dietrich - FBE 432 – Spring, 2002

Module IV: Financial StrategyBusiness and Financial Strategy

Week 11 – November 4 and 6, 2002


Objectives

This lecture will show you how to analyze a firm’s 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.


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


Growth requires new assets

Change in Assets =

Change in Equity

Change in Debt

The Balance Sheet Identity


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


Notation

Define:

T ratio of total assets to sales

p = net profit margin on sales

d = dividend payout ratio

L = debt / equity ratio

S sales this year

S = change in sales (S0

1

S0)


Notation

More definitions

NI = Net Income

= S p

RE = Retained Earnings

= Net Income Retention Ratio

= S p (1- d)

1

1


Derivation

Change in Assets

T S

=

Change in Debt

Change in Equity

NI (1 d) L

NI (1 d)


Derivation

L)(1d)(1pT

L)(1d)(1p

S

Sg*

L1d)(1pS

SSTST

0

1

01

Note: S1 on both sides of equation


Example: PPLSustainable Growth Analysis

Inputs

T Total Asset/Sales Ratio 0.44p Profit Margin 9.0%d Dividend Payout Ratio 33%L Debt/Equity Ratio 0.81

Outputg Sustainable Growth Rate 32.99%

Source of ratios: Calculated average 1999-2000 from Exhibits 1 and 2, PPL Case

11J. K. Dietrich - FBE 432 – Spring, 2002

Interpretation

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

12J. K. Dietrich - FBE 432 – Spring, 2002

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


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


Financial Policies

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

Equity

Debt PolicyDebt

Earnings

Earnings Retained1

Earnings

Dividendsd


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


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

ROEd1g*


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?


Statement of Income1989

Total Operating Revenues 103,535 Total Operating Costs 60,346

OPERATING INCOME 43,189

Other Income (203)

INCOME BEFORE TAX 42,986

INCOME TAXCurrent (298) Deferred (3,322)

NET INCOME 46,606 Dividends 29,941

(Millions of Chilean pesos)


Balance SheetsASSETS 1989 1988

Current Assets 76,272 54,182 Property, Plant and Equipment 295,440 216,796 Other Assets 12,634 24,867

TOTAL ASSETS 384,346 295,845

LIABILITIES

Current Liabilities 74,841 37,728 Long-Term Liabilities 85,681 55,824

SHAREHOLDERS EQUITYCommon Stock 200,560 195,694 Retained Earnings 23,264 6,599

Total Equity 223,824 202,293

(Millions of Chilean pesos)


Sustainable Growth Calculation1989-90

S Sales 103,535 NI Net Income 46,606 TA Total Assets 384,346

T Total Assets/Sales 3.71 p Net Income/Sales 0.45 d Dividends/Net Income 0.64 L Debt/Equity 0.38

g* Sustainable Growth Rate 6.4%

g Actual Growth Rate 29.9%


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


Debt Policy and Flexibility

Leverage Ratio

Firm Value

All Equity Firm Value

Optimal Leverage Zone Balances Tax Advantages of Debt Against the Costs of Financial Distress


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


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


Debt-Capital Ratios

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

MASSEY-FERGUSON LIMITED INTERNATIONAL HARVESTER DEERE & COMPANY

1976

1980


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.


Net Income

(500) (400) (300) (200) (100) 0 100 200 300

MASSEY-FERGUSONLIMITED

INTERNATIONALHARVESTER

DEERE & COMPANY

1980

1976


Market Share, 1976-1980

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

MASSEY-FERGUSON LIMITED INTERNATIONAL HARVESTER DEERE & COMPANY

1976

1980


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.

Massey’s original shareholders were wiped out as a result of the restructuring.


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.


Next Week – Nov. 11 & 13, 2002

Review RWJ, Chapter 18, on dividend strategy for Saturday’s 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

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Module IV: Financial Strategy Business and Financial Strategy

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