Module iv financial strategy business and financial strategy
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Module IV: Financial Strategy Business 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

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Module iv financial strategy business and financial strategy

Module IV: Financial StrategyBusiness and Financial Strategy

Week 11 – November 4 and 6, 2002


Objectives

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

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

Growth requires new assets

Change in Debt

=

Change in Equity

The Balance Sheet Identity


Sustainable growth derivation

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

Notation

  • Define:


Notation1

Notation

  • More definitions


Derivation

Change in Debt

Change in Assets

=

Change in Equity

Derivation


Derivation1

Derivation

Note: S1 on both sides of equation


Example ppl

Example: PPL

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


Interpretation

Interpretation

  • Higher sustainable or potential growth is associated with:

    • Higher profitability

    • More efficient use of assets

    • Lower dividend payout rate

    • Higher leverage


Sustainable and optimal growth

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 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

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


Key is consistency

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

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


Example telefonos de chile

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 income

Statement of Income


Balance sheets

Balance Sheets


Sustainable growth calculation

Sustainable Growth Calculation


Financial flexibility

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

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


Example massey ferguson

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

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

Debt-Capital Ratios


Events

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

Net Income


Market share 1976 1980

Market Share, 1976-1980


Outcome

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

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

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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