Module IV: Financial Strategy Business and Financial Strategy

1. Module IV: Financial StrategyBusiness 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. Change in Assets Growth requires new assets Change in Debt = Change in Equity The Balance Sheet Identity

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. Change in Debt Change in Assets = Change in Equity Derivation

9. Derivation Note: S1 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 Optimal Leverage Zone Balances Tax Advantages of Debt Against the Costs of Financial Distress Firm Value All Equity Firm Value Leverage Ratio

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