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Module IV: Financial Strategy Business and Financial Strategy Week 11 – November 4 and 6, 2002 J. K. Dietrich - FBE 432 – Spring, 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 MasseyFerguson Ltd. J. K. Dietrich - FBE 432 – Spring, 2002 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 J. K. Dietrich - FBE 432 – Spring, 2002 Growth requires new assets Change in Assets Change in Debt = Change in Equity The Balance Sheet Identity J. K. Dietrich - FBE 432 – Spring, 2002 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 J. K. Dietrich - FBE 432 – Spring, 2002 Notation Define: T ratio of total assets to sales p = net profit margin on sales d = dividend payout ratio L = debt / equity ratio S0 sales this year S = change in sales (S1 S0 ) J. K. Dietrich - FBE 432 – Spring, 2002 Notation More definitions NI = Net Income = S1 p RE = Retained Earnings = Net Income Retention Ratio = S1 p (1 - d) J. K. Dietrich - FBE 432 – Spring, 2002 Derivation NI (1 d) L Change in Debt Change in Assets = Change in Equity TS J. K. Dietrich - FBE 432 – Spring, 2002 NI (1 d) Derivation TS TS1 S 0 Note: S1 on both sides of equation S1 p (1 d) 1 L S p (1 d) (1 L) g* S 0 T p (1 d) (1 L) J. K. Dietrich - FBE 432 – Spring, 2002 Example: PPL Sustainable Growth Analysis Inputs T p d L Total Asset/Sales Ratio Profit Margin Dividend Payout Ratio Debt/Equity Ratio 0.44 9.0% 33% 0.81 Output g Sustainable Growth Rate 32.99% Source of ratios: Calculated average 1999-2000 from Exhibits 1 and 2, PPL Case J. 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 J. K. Dietrich - FBE 432 – Spring, 2002 11 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 J. K. Dietrich - FBE 432 – Spring, 2002 12 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 J. K. Dietrich - FBE 432 – Spring, 2002 Financial Policies Financial policies (debt and dividends) and sustainable growth are jointly determined. Inputs into g* are: Debt Debt Policy Equity Dividends Retained Earnings d 1 Earnings Earnings J. K. Dietrich - FBE 432 – Spring, 2002 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 J. K. Dietrich - FBE 432 – Spring, 2002 Useful Simplification of g* A convenient simplification of the sustainable growth model is: g* 1 d ROE (Rough estimate you can do in your head.) You can use spreadsheet SUSGROW.XLS to compute using complete formula J. K. Dietrich - FBE 432 – Spring, 2002 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? J. K. Dietrich - FBE 432 – Spring, 2002 Statement of Income (Millions of Chilean pesos) 1989 Total Operating Revenues 103,535 Total Operating Cos ts 60,346 OPERATING INCOME Other Income INCOME BEFORE TAX INCOME TAX Current Deferred NET INCOME Dividends J. K. Dietrich - FBE 432 – Spring, 2002 43,189 (203) 42,986 (298) (3,322) 46,606 29,941 Balance Sheets (Millions of Chilean pesos) ASSETS 1989 Current Assets 76,272 Property, Plant and Equipment 295,440 Other Assets 12,634 TOTAL ASSETS 384,346 LIABILITIES Current Liabilities Long-Term Liabilities SHAREHOLDERS EQUITY Common Stock Retained Earnings Total Equity J. K. Dietrich - FBE 432 – Spring, 2002 1988 54,182 216,796 24,867 295,845 74,841 85,681 37,728 55,824 200,560 23,264 223,824 195,694 6,599 202,293 Sustainable Growth Calculation 1989-90 103,535 46,606 384,346 S NI TA Sales Net Income Total Assets T p d L Total Assets/Sales Net Income/Sales Dividends/Net Income Debt/Equity 3.71 0.45 0.64 0.38 g* Sustainable Growth Rate 6.4% g Actual Growth Rate J. K. Dietrich - FBE 432 – Spring, 2002 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 J. K. Dietrich - FBE 432 – Spring, 2002 Debt Policy and Flexibility Firm Value Optimal Leverage Zone Balances Tax Advantages of Debt Against the Costs of Financial Distress All Equity Firm Value Leverage Ratio J. K. Dietrich - FBE 432 – Spring, 2002 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 J. K. Dietrich - FBE 432 – Spring, 2002 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 J. K. Dietrich - FBE 432 – Spring, 2002 Debt-Capital Ratios 90% 80% 1976 1980 70% 60% 50% 40% 30% 20% 10% 0% MASSEY-FERGUSON LIMITED J. K. Dietrich - FBE 432 – Spring, 2002 INTERNATIONAL HARVESTER DEERE & COMPANY 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. J. K. Dietrich - FBE 432 – Spring, 2002 Net Income 1980 1976 DEERE & COM PANY INTERNATIONAL HARVESTER M ASSEY-FERGUSON LIM ITED (500) (400) (300) J. K. Dietrich - FBE 432 – Spring, 2002 (200) (100) 0 100 200 300 Market Share, 1976-1980 60.0% 50.0% 1976 1980 40.0% 30.0% 20.0% 10.0% 0.0% MASSEY-FERGUSON LIMITED J. K. Dietrich - FBE 432 – Spring, 2002 INTERNATIONAL HARVESTER DEERE & COMPANY 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. J. K. Dietrich - FBE 432 – Spring, 2002 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. J. K. Dietrich - FBE 432 – Spring, 2002 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 J. K. Dietrich - FBE 432 – Spring, 2002