Module IV: Financial Management:
Strategy -- Business and Financial
Planning
Week 10 – March 30, 2006
J. K. Dietrich - FBE 532 – Spring, 2006
Objectives
 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
 We also examine the strategic role of financial
flexibility
 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
 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 532 – Spring, 2006
Growth requires new assets
Change in
Assets
Change in Debt
=
Change in
Equity
The Balance Sheet Identity
J. K. Dietrich - FBE 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
Notation
 More
definitions
NI = Net Income
= S1  p
RE = Retained Earnings
= Net Income  Retention Ratio
= S1  p  (1 - d)
J. K. Dietrich - FBE 532 – Spring, 2006
Derivation
NI  (1  d)  L
Change in Debt
Change in
Assets
=
Change in
Equity
TS
J. K. Dietrich - FBE 532 – Spring, 2006
NI  (1  d)
Derivation
TS  TS1  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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
Debt-Capital Ratios
90%
80%
1976
1980
70%
60%
50%
40%
30%
20%
10%
0%
MASSEY-FERGUSON LIMITED
J. K. Dietrich - FBE 532 – Spring, 2006
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 532 – Spring, 2006
Net Income
1980
1976
DEERE & COM PANY
INTERNATIONAL
HARVESTER
M ASSEY-FERGUSON
LIM ITED
(500)
(400)
(300)
J. K. Dietrich - FBE 532 – Spring, 2006
(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 532 – Spring, 2006
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 532 – Spring, 2006
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 532 – Spring, 2006
Next Week – April 4 & 6, 2006
 Review
RWJ, Chapter 18, on dividend strategy for
make-up class on April 4
 We will also discuss Clarkson Lumber case then
 Prepare Avon Products case for discussion, although
write-up and discussion will not be due until
Thursday, April 6
 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
J. K. Dietrich - FBE 532 – Spring, 2006