Week 11 Slides


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  • Week 11 Slides

    1. 1. Module IV: Financial Strategy Business and Financial Strategy Week 11 – November 4 and 6, 2002
    2. 2. Objectives <ul><li>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 </li></ul><ul><li>We also examine the strategic role of financial flexibility </li></ul><ul><li>We use two examples to illustrate these concepts: Telefonos of Chile and Massey-Ferguson Ltd. </li></ul>
    3. 3. Sustainable Growth Theory <ul><li>How fast can a firm grow when it does not rely on new equity for funding? </li></ul><ul><li>Sustainable growth theory is useful because it highlights </li></ul><ul><ul><li>Limits of internal financing </li></ul></ul><ul><ul><li>The need for external financing </li></ul></ul><ul><ul><li>Inconsistencies between business and financial objectives </li></ul></ul>
    4. 4. Growth requires new assets = Change in Equity Change in Debt The Balance Sheet Identity Change in Assets
    5. 5. Sustainable Growth: Derivation <ul><li>Sustainable growth models are based on a number of simplifying assumptions </li></ul><ul><li>Assumptions </li></ul><ul><ul><li>Constant returns to scale technology </li></ul></ul><ul><ul><li>Fixed reinvestment ratio </li></ul></ul><ul><ul><li>New equity only from retained earnings </li></ul></ul>
    6. 6. Notation <ul><li>Define: </li></ul>
    7. 7. Notation <ul><li>More definitions </li></ul>
    8. 8. Derivation Change in Assets = Change in Debt Change in Equity
    9. 9. Derivation Note: S 1 on both sides of equation
    10. 10. Example: PPL Source of ratios: Calculated average 1999-2000 from Exhibits 1 and 2, PPL Case
    11. 11. Interpretation <ul><li>Higher sustainable or potential growth is associated with: </li></ul><ul><ul><li>Higher profitability </li></ul></ul><ul><ul><li>More efficient use of assets </li></ul></ul><ul><ul><li>Lower dividend payout rate </li></ul></ul><ul><ul><li>Higher leverage </li></ul></ul>
    12. 12. Sustainable and Optimal Growth <ul><li>Sustainable growth is not optimal growth rate </li></ul><ul><ul><li>Optimal growth maximizes the value of the firm </li></ul></ul><ul><ul><li>Sustainable growth (g*) is the only growth rate consistent with the firm continuing its operations without any outside equity </li></ul></ul><ul><ul><li>Despite Modigliani-Miller propostions, leverage matters if new (outside) equity matters </li></ul></ul>
    13. 13. Sustainable and Actual Growth <ul><li>Sustainable growth is clearly distinct from actual growth </li></ul><ul><ul><li>When a firm tries to grow faster than g * it must raise new equity capital, increase leverage, or use its assets more productively </li></ul></ul><ul><ul><li>When a firm grows slower than g * it accumulates more retained earnings, reduces its debt, or uses its assets less productively </li></ul></ul>
    14. 14. Financial Policies <ul><li>Financial policies (debt and dividends) and sustainable growth are jointly determined. Inputs into g * are: </li></ul>
    15. 15. Key is Consistency <ul><li>You cannot choose dividend and debt policy independently of your desired product market strategy expressed in terms of growth in sales or assets </li></ul><ul><li>Recognition of the consistency between financial constraints and growth plans is essential in making intelligent strategic decisions </li></ul>
    16. 16. Useful Simplification of g * <ul><li>A convenient simplification of the sustainable growth model is: (Rough estimate you can do in your head.) </li></ul><ul><li>You can use spreadsheet SUSGROW.XLS to compute using complete formula </li></ul>
    17. 17. Example: Telefonos de Chile <ul><li>Following privatization in 1991, Telefonos was growing at 30% annual rate </li></ul><ul><li>It needed $2 to $5 billion to finance demand in Chile </li></ul><ul><ul><li>Use data in following slides </li></ul></ul><ul><ul><li>What is sustainable growth rate and what can you conclude from this analysis? </li></ul></ul>
    18. 18. Statement of Income
    19. 19. Balance Sheets
    20. 20. Sustainable Growth Calculation
    21. 21. Financial Flexibility <ul><li>High leverage enables a company to grow faster and also can raise its ROE (see sustainable growth formula) </li></ul><ul><li>Negative side to additional debt comes in the form of expected costs of financial distress and loss of flexibility </li></ul><ul><li>Even if default possibility is remote, lack of flexibility can impose severe costs </li></ul>
    22. 22. 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
    23. 23. Example: Massey-Ferguson <ul><li>In the 1970s, Massey-Ferguson, John Deere, and International Harvester (Navistar) had virtually all the North American market in heavy farm equipment </li></ul><ul><li>Massey increased its leverage to finance acquisitions and undertook an aggressive growth strategy targeting less-developed countries and Europe </li></ul>
    24. 24. Debt Policy <ul><li>Massey financed its aggressive growth with debt, as did International Harvester </li></ul><ul><li>Deere was more conservatively financed, especially with respect to use of short-term debt </li></ul><ul><li>All three had roughly equal shares of the market </li></ul>
    25. 25. Debt-Capital Ratios
    26. 26. Events <ul><li>When the Fed raised interest rates, interest payments for Massey and Harvester increased dramatically </li></ul><ul><li>Simultaneously, durable good purchases fell as producers faced higher service costs. </li></ul><ul><li>As a result, Massey and Harvester suffered huge losses while Deere used new debt financing to expand aggressively. </li></ul>
    27. 27. Net Income
    28. 28. Market Share, 1976-1980
    29. 29. Outcome <ul><li>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. </li></ul><ul><li>Massey’s original shareholders were wiped out as a result of the restructuring. </li></ul>
    30. 30. Review <ul><li>The business and financial strategies of the firm are not independent. </li></ul><ul><ul><li>The sustainable growth model is useful as a diagnostic tool, but use it wisely. </li></ul></ul><ul><li>A key element of financial strategy is flexibility. This is hard to quantify, but is often critical in practice. </li></ul>
    31. 31. Next Week – Nov. 11 & 13, 2002 <ul><li>Review RWJ, Chapter 18, on dividend strategy for Saturday’s class </li></ul><ul><li>Prepare Avon Products case for discussion, although write-up and discussion will not be due until Monday, November 18 </li></ul><ul><li>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 </li></ul>