J. K. Dietrich - FBE 532 – Spring, 2006 Module IV: Financial Management: Strategy -- Business and Financial Planning Week 10 – March 30, 2006

J. K. Dietrich - FBE 532 – Spring, 2006 Objectives u This class discussion will show you how to analyze a firm’s proposed financial strategy is linked to its business strategy using the concept of sustainable growth u We also examine the strategic role of financial flexibility u We use two examples to illustrate these concepts: Telefonos of Chile and Massey-Ferguson Ltd.

J. K. Dietrich - FBE 532 – Spring, 2006 Sustainable Growth Theory u How fast can a firm grow when it does not rely on new equity for funding? u 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 532 – Spring, 2006 Growth requires new assets Change in Assets = Change in Equity Change in Debt The Balance Sheet Identity

J. K. Dietrich - FBE 532 – Spring, 2006 Sustainable Growth: Derivation u Sustainable growth models are based on a number of simplifying assumptions u Assumptions –Constant returns to scale technology –Fixed reinvestment ratio –New equity only from retained earnings

J. K. Dietrich - FBE 532 – Spring, 2006 Notation u Define:

J. K. Dietrich - FBE 532 – Spring, 2006 Notation u More definitions

J. K. Dietrich - FBE 532 – Spring, 2006 Derivation Change in Assets = Change in Debt Change in Equity

J. K. Dietrich - FBE 532 – Spring, 2006 Derivation Note: S 1 on both sides of equation

J. K. Dietrich - FBE 532 – Spring, 2006 Example: PPL Source of ratios: Calculated average from Exhibits 1 and 2, PPL Case

J. K. Dietrich - FBE 532 – Spring, Interpretation u 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 532 – Spring, Sustainable and Optimal Growth u 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 532 – Spring, 2006 Sustainable and Actual Growth u 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 532 – Spring, 2006 Financial Policies u Financial policies (debt and dividends) and sustainable growth are jointly determined. Inputs into g * are:

J. K. Dietrich - FBE 532 – Spring, 2006 Key is Consistency u You cannot choose dividend and debt policy independently of your desired product market strategy expressed in terms of growth in sales or assets u Recognition of the consistency between financial constraints and growth plans is essential in making intelligent strategic decisions

J. K. Dietrich - FBE 532 – Spring, 2006 Useful Simplification of g * u A convenient simplification of the sustainable growth model is: (Rough estimate you can do in your head.) u You can use spreadsheet SUSGROW.XLS to compute using complete formula

J. K. Dietrich - FBE 532 – Spring, 2006 Example: Telefonos de Chile u Following privatization in 1991, Telefonos was growing at 30% annual rate u 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 532 – Spring, 2006 Statement of Income

J. K. Dietrich - FBE 532 – Spring, 2006 Balance Sheets

J. K. Dietrich - FBE 532 – Spring, 2006 Sustainable Growth Calculation

J. K. Dietrich - FBE 532 – Spring, 2006 Financial Flexibility u High leverage enables a company to grow faster and also can raise its ROE (see sustainable growth formula) u Negative side to additional debt comes in the form of expected costs of financial distress and loss of flexibility u Even if default possibility is remote, lack of flexibility can impose severe costs

J. K. Dietrich - FBE 532 – Spring, 2006 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

J. K. Dietrich - FBE 532 – Spring, 2006 Example: Massey-Ferguson u In the 1970s, Massey-Ferguson, John Deere, and International Harvester (Navistar) had virtually all the North American market in heavy farm equipment u Massey increased its leverage to finance acquisitions and undertook an aggressive growth strategy targeting less-developed countries and Europe

J. K. Dietrich - FBE 532 – Spring, 2006 Debt Policy u Massey financed its aggressive growth with debt, as did International Harvester u Deere was more conservatively financed, especially with respect to use of short-term debt u All three had roughly equal shares of the market

J. K. Dietrich - FBE 532 – Spring, 2006 Debt-Capital Ratios

J. K. Dietrich - FBE 532 – Spring, 2006 Events u When the Fed raised interest rates, interest payments for Massey and Harvester increased dramatically u Simultaneously, durable good purchases fell as producers faced higher service costs. u As a result, Massey and Harvester suffered huge losses while Deere used new debt financing to expand aggressively.

J. K. Dietrich - FBE 532 – Spring, 2006 Net Income

J. K. Dietrich - FBE 532 – Spring, 2006 Market Share,

J. K. Dietrich - FBE 532 – Spring, 2006 Outcome u 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. u Massey’s original shareholders were wiped out as a result of the restructuring.

J. K. Dietrich - FBE 532 – Spring, 2006 Review u 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. u A key element of financial strategy is flexibility. This is hard to quantify, but is often critical in practice.

J. K. Dietrich - FBE 532 – Spring, 2006 Next Week – April 4 & 6, 2006 u Review RWJ, Chapter 18, on dividend strategy for make-up class on April 4 u We will also discuss Clarkson Lumber case then u Prepare Avon Products case for discussion, although write-up and discussion will not be due until Thursday, April 6 u Begin analysis of international sources of capital and review of Genset Initial Public Offering case as soon as possible for write-up and discussion on April 13