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

2. 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.

3. 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

4. J. K. Dietrich - FBE 532 – Spring, 2006 Growth requires new assets Change in Assets = Change in Equity Change in Debt The Balance Sheet Identity

5. 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

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

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

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

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

10. J. K. Dietrich - FBE 532 – Spring, 2006 Example: PPL Source of ratios: Calculated average 1999-2000 from Exhibits 1 and 2, PPL Case

11. J. K. Dietrich - FBE 532 – Spring, 2006 11 Interpretation u Higher sustainable or potential growth is associated with: –Higher profitability –More efficient use of assets –Lower dividend payout rate –Higher leverage

12. J. K. Dietrich - FBE 532 – Spring, 2006 12 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

13. 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

14. 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:

15. 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

16. 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

17. 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?

18. J. K. Dietrich - FBE 532 – Spring, 2006 Statement of Income

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

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

21. 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

22. 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

23. 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

24. 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

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

26. 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.

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

28. J. K. Dietrich - FBE 532 – Spring, 2006 Market Share, 1976-1980

29. 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.

30. 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.

31. 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