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  • 1


  • 1. Module IV: Financial Strategy Business and Financial Strategy Week 11 – November 4 and 6, 2002
  • 2. 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.
  • 3. 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
  • 4. Growth requires new assets = Change in Equity Change in Debt The Balance Sheet Identity Change in Assets
  • 5. 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
  • 6. Notation
    • Define:
  • 7. Notation
    • More definitions
  • 8. Derivation Change in Assets = Change in Debt Change in Equity
  • 9. Derivation Note: S 1 on both sides of equation
  • 10. Example: PPL Source of ratios: Calculated average 1999-2000 from Exhibits 1 and 2, PPL Case
  • 11. Interpretation
    • Higher sustainable or potential growth is associated with:
      • Higher profitability
      • More efficient use of assets
      • Lower dividend payout rate
      • Higher leverage
  • 12. 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
  • 13. 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
  • 14. Financial Policies
    • Financial policies (debt and dividends) and sustainable growth are jointly determined. Inputs into g * are:
  • 15. 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
  • 16. 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
  • 17. 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?
  • 18. Statement of Income
  • 19. Balance Sheets
  • 20. Sustainable Growth Calculation
  • 21. 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
  • 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. 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
  • 24. 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
  • 25. Debt-Capital Ratios
  • 26. 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.
  • 27. Net Income
  • 28. Market Share, 1976-1980
  • 29. 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.
  • 30. 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.
  • 31. 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