Structuring Corporate Financial Policy Diagnosis of Problems and Evaluation of Strategies

I. Goal: To understand how to diagnosis of problems and evaluate strategies

II. Steps 1. Identifying corporate financial policy: Elements of its design A. Concept of Corporate Financial Policy - Financial policy: a set of broad guideline or preferred style to guide the raising of capital and distribution of value

The Elements of Financial Policy Every financial structure reveals underlying financial policies. The following seven elements reveals underlying financial policy 1. Mix of Classes of Capital Example- Debt & Equity / Common Stocks & Retained Earnings Some firms exhibit a pecking order of Financing : Internal Cash Flows, Debt and finally Equity.

The Elements of Financial Policy, Cont. 2. Maturity Structure Firm’s judgment about future financing opportunities and taking risk - Neutral: Maturity of Asset = Maturity of Liability - Managers’ bet about refinancing and interest rate risks 3. Coupon and Dividend Payment - Managers’ bets

The Elements of Financial Policy, Cont. 4. Currency - Level of Exposure to Exchange Rate Risks - Capital Sources 5. Exotica - Financial Innovation 6. External Control - Fear & Expectation

The Elements of Financial Policy, Cont. 7. Distribution These elements become a basis for developing a broad, detailed picture of firm’s financial policies

C. Comparative Illustration Financial Polices for Eli’ s and Genentech

II. Framework for Diagnosing Financial Policy Opportunities and Problems. It is based on the perspective of competitors, investors and senior corporate managers 1) Investor View: Does financial policy create value? - Maximizing shareholder’s wealth - Minimizing risks 2) Competitor View: Does the financial policy create competitive advantage? - Competitors’ F/S is an indicator or benchmark.

II. Framework for Diagnosing Financial Policy Opportunities and Problems. 3) Internal View: Does the financial policy sustain the vision of senior management? - Funds the growth goals and dividend payouts of the firm without severely diluting the firm’s current equity owners Investor View: Value Creation + Competitor View: Competitive Advantage + Internal View: Survival → Financial Structure: Mix, Maturity, Basis, Currency, Exotica, External Control, Distribution

III. Analyzing Financial Policy (FP) From the Investors’ Viewpoint 1) Is the FP Increasing the firm value? Cost of Debt Cost of Equity Debt/Equity Mix: WACC P/E, Market/Book Multiples: Compared to Benchmark Bond Rating: Financial Ratio Ownership: Individual, Institution, Blockholders Short Position on the Stocks

IV. Analyzing Financial Policy From a Competitive Perspective 1) Why it matters? Standard Practice in the Industry and Strategic Position Strategic Competitive Instrument 2) Steps: Define the universe of competitors “Spread” the data and financial ratios on the firm and its competitors in comparative fashion

IV. Analyzing Financial Policy From a Competitive Perspective Identify similarities and difference. Add more information such as foreign competitor, another ratios. Discuss with CFO or Industry experts. 3) Plausible quantitative measures Size: sales, market value, # of employee Asset Productivity: ROA Shareholder wealth: P/E Predictability: Beta, Historical trends Growth: 1 to 10 year compound growth

IV. Analyzing Financial Policy From a Competitive Perspective Financial flexibility: debt, coverage ratios, cost of capitals Industrial Issues: R&D, Unfunded pension liabilities or medical benefit obligation…

V. Diagnosing Financial Policy From an Internal Perspective. 3 Major concerns: Financial Flexibility Sustainability of financial policy Feasibility of strategic goals

1) Financial Flexibility: Simply represented as the excess cash and unused debt capability. All reserves that could be mobilized should be reflected Financial flexibility = excess cash + (debt at minimum rating – current debt outstanding)

1) Financial Flexibility: - How to measure the debt at minimum rating? (1) Select a target minimum debt rating acceptable to the firm. (2) Determine the book value debt/equity mix consistent with the minimum rating (3) Determine the book value of debt consistent with (2). Financial flexibility indicates the financial reserves on which the firm can call to exploit unusual surprising opportunities.

2) Self-sustainable Growth & Feasibility Self sustain growth model: Growth rate =ROE*(1 - dividend payout ratio) An assumption: over the forecast period, the firm sells no new shares of stock. As long as the firm does not change its mix of debt and equity, the model implies that assets can grow only as fast as equity and dividend payout ratio.

2) Self-sustainable Growth & Feasibility Test of feasibility of a plan: Compare the growth rate from the model to the targeted growth rate dictated by the plan. Enriching the model, using DuPont Analysis or Financial Leverage Equation (FLE) Ex) DuPont: ROE=P/S*S/A*A/E FLE: ROE=ROTC+((ROTC-Kd)*(D/E)) ROTC=return on capital, Kd= cost of debt This model provide no guarantee that a strategy will maximize value

VI. What is best? The following framework is a way of identifying the tradeoffs among “good” and “bad” Flexibility- ability to meet unforeseen financing requirement as they arise. Predictable Risk in business Income measures such as DCF value, projected ROE, EPS and cost of capital. Control- percentage of share distributions of the company and debt structure Timing- Is the current capital market environment is the right moment to implment any alternative financial structure.

VII Conclusion Final decision for alternative structures remain for CFO and adviser. Good Luck.