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    Corporate Financial Strategy - 2

    Transféré par

    olivia
    financiera

    Droits d'auteur :

    © All Rights Reserved
    Téléchargez comme PDF ou lisez en ligne sur Scribd
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    3 Executive summary ~ Linking corporate and financial strategies Introduction 42 The four decisions in financial strategy 42 Balancing businese and fn 43 ‘The life cycle model 43, Debtor equity? Integrating busioess risk and the fife cycle model to develop financing strategy 44 Dividend strategy over the life cycle 44 PIE ratio and share price over the life cycle 45 Putting it all together 45 Key messages 46 Introduction This chapter provides exes sanmary fhe oe model ett in Cs core mod on Chapters and 5 which inks compre and facil settee No eae sacs seca an chapter, as these are covered in the main work, » ore Chapters 4 nd 3 dle The mol try dese vn ‘what to change, all of which is set out in detail in those chapters. Ho d 8. However, we do appreciate that tls makes the length rather daunting, so ths short piece wll give you a quch iden of the concepts, to see whats coming, In this chapter we set out an executive summary of the core model under! of the core model underlying much of the is book. Reading this chapter is suficient to give you a good view of what the ‘The four decisions in finan Financial strategy is about the ch ‘There are four strategic deci -ategy ‘Company makes in raising and deploying its finances. cesacomps sg and deploying its finan 1 How large should thea and in what assets? 2 How much of the finance should be debt, end how much in equity? Executive sunmary: linking corporate and financial strategies 43 we o @) vi xX ies (3) @ x | v vow io ie nnd i Figure 3.1 Matix of business snd fnenial sk. 3. How much profit should be paid out in dividend, and how much retained? 4 Should new equity be issued? ‘An understanding of how shareholder value is created can help answer all of these questions. ‘Balancing business and financial risk ‘The basic principle is really simple. Businesses need to take risk ~ without risk there is no oo much risk can destroy the organization. Risk comes activites as well s financial strategy, and therefore the decision on how much to take will depend fundamentally on the characteristics ofthe business. Figure this igure 3.1 shows that a combination of high business risk and high financial risk (Le. bor- ‘owing too much) would be foolhardy and is not recommended: Quadrant 2isto be avoided. Likewise, in most circumstances, Quadrant 3 isto be svoded: low-risk businesses could and, should reduce their cost of capital by taking on more borrowing. Quadrants I and 4 are both good places tobe, balancing the business and financial risks, ‘The life cycle model In order to evaluate business risk we use a model based on the product life cycle, adapting it {to companies and their divisions. The basic life cycle model used by marketers often shows sport this rapid growth, It the profitability. Cace the 44 Executive summary: linking corporate and financial strategies LAUNCH | GROWTH! MATURITY | DECLINE & Cash flows ll risk, jows uf eash from companies that are already cash-negative. Taus, businesses sag should be fanced wih equity ats prepared asept aig isk such An early-stage com: ithad th profits out Executive summary: linking corporate and financial strategies 45 Similar arguments apply to growth companies, which often pay no dividends. However, in some cases the arguments aga desire to give a litle something back Accordingly, some growth companies ‘Mature companies are in a different wer business opportunities, their money is not should be repaid to sharcholders, and the dividend these points, our basic exposition of a company's financial strategy is shown in Figure 33, GROWTH Business risk high 46 Executive summary: linking corporate and financial strategies Key messages be managed against the business risk, in order to produce the most of which to create value ‘company’s life cycle, as should the financing strategy and the dividend pay-out strategy. ‘+ Tfyouhave read this chapter, you have read the basic model but you have not leamed enough to understand itor manipulate it! Chapters 4 and 5 give you the underlying rationale | Ortopas 4 Linking corporate and financial strategies Learning objectives 47 Introduction 48 Assescing business risk 48 Strategic analysis 49 Porter's five forces 49 PESTLE analysis 51 Resource-based theory 51 Linking corporate and financial strategies to enhance shareholder value 51 Constituents of financial strategy 52 Financial risk 54 Balancing business and financial risk $5 ‘Risk management as part of financial strategy $7 Privately held companies are different $7 Pecking order theory 58 Key messages 59 Suggested further reading 59 ‘Learning objectives ‘After reading this chapter you should be able to: 1 Distinguish between business risk and financial risk, and explain why there should ‘be an inverse relationship between them, 2. Explain the different elements of financial strategy. 3° Assess how risky a particular business is, with a view to understanding how it 4 should be financed. Understand the seven drivers of value, and how they can be related to business strategy in order to increase val 5 Discuss how the elements of financial strategy might apply differently to public and privately owned companies, i I 48 Linking corporate and financial strategies Introduction ‘Business risk isthe inherent risk associated with the underlying natu of the particular busi ness and the specific competitive strategy that is being implemented. It covers everything ‘except the risk from the financing structure, Financial strategy includes a company’s ehoice of sources of finance and its dividend policy, and should relate to the business risks that a ‘company faces. In this chapter we consider the two types of risk and develop thoughts about how a business should be financed, I is inappropriate for a company with high business risk to adopt financial strategy involving high financial risk, Similarly, for public companies it is unwise fora low-risk business to use mostly equity, which is low-risk finance, Assessing business risk ‘Businesses take risks, they have to: without risk there is litle chance ofa reward. One of the ccharncteristics that distinguishes successful bu those that fil is-the way i Which they understand and manage the risks they face, both business and financial, Accordingly, an understanding of financial strategy involves first a clear appreciation of business risk. Once the business risk is analysed, the financial strategy can be designed to complement it Ifthe financial strategy is appropriately designed and properly implemented itcan enhance shareholder value but, even more dramatically, when an inappropriate finan- cial strategy is applied the entre business can be placed in jeopardy, Accordingly, we start by considering business risk, Business risk deseribes thei (both geographically and industrially) low overall business risk. It must be evel of retun matches the level of associated risk, either is acceptable. ‘do with risk as discussed by financiers, calculated as Pin the Capital Asset Pricing Model (See Appendix 1). Company-specfic risks are irelevant in a Aiversified investment portfolio, and all that matters is comelation with markets. However, here ‘we are concemed with corporate financial suategy, no! investment stretegy, and business risk does matter. ‘The simplest way to consider business rskis that treats to all ofthe risks thatthe company faces, other than those which relate directly to financing decision. i ths deals with the volatility ‘ofthe opersting cash lows. Such volatility might arse from sources extemal to the organization, for example: changes in legislation or in fashions or peblicopsion; the actions of competitors; oF the general economic climate, Businesses th in different currencies also face business risks, as exchange rate chang? Internal risks also need to be considered, for example: thers associtod facturing processor the ways oF its cost structure. Interel ial risks need to be considered. ‘of business risk is shovin in in which an organization communicates wit risks are often easier to control than exteral embarrassingly simple igure 4.1 the constituen ess risk relates 10 vari Linking corporate and financial strategies 49 Fixed Variable NZ Sales less Costs = Profits LN O™N Price Volume Committed? Produets Markets Figure 4.1. Analysis of business rise ies, whieh i cedunting mode: then begin to see what affects each of thes items for our particular company. For sles, it might be appropriate to examine what affects our seling price andthe volumes we sell or an analysis of products and markets may be more useful yrobably both should be used. For cost analysis, «preliminary approach may be to determine the operating leverage the relative level of fixed to variable costs onthe basis hat companies levels of fixed costs may have ted costs may also be imp ris more vulnerable (i. ris ne "For each basiness the specific risk factors wil differ. Working ‘examples of issues to consider in analysing business risk. Also of importance is the company's attitude to risk, reflected in the culture of the organization, as prom evidenced in its behaviour and attitudes. Organizations will display different ievels of toler- ance to different risks, ether because they clearly understand them aid know how to eal with them (which is good) or because they don't understand them at all (which is rather less 0). Strategic analysis ‘As we stated earlier, this is nota book about corporate strategy, but if we are to match financial sirategy with business strategy itis important ta have at least some understanding of some of the key tools ofthe latter. Accordingly, before we dive into finan quick look at some useful strategic tools which can inform our anal oppoctunties. strategy, let us have a 5s of business risks and Porter's five forces y known model, Michael Porter st out five forces that drive * bargaining power of buyers, that of suppliers, the threat al competition: sv entrants, the 50 Linking corporate and financial strategies Working Insight 4.1 Some examples of issues to consider in analy Linking corporate and financial strategies $1 PESTLE analysis In analysing a comp smpetitive postion, it is essential to understand how changes ‘ill affect it Some of rivers of change ae: Political oonomic Social Technological what is this onary prsl coed at, which enables it to compete successfully? It has been argued that any asses that an organi- zation bas which can confer competitive advantage must have the following characteristics and be Valuable Rare Imperfe Non-substtu strategy that tis believed will be successful, aa that busines strategy is derived from analysis 3 Bene nal of Management, 52. Linking corporate and financial strategies Matt iw sive emery Enema! Managenet ‘SHAREHOLDER STRATEGY —-------¥ water i a nays T cashflows Financial oO overtime strategy Key snd targets Figure 4.2 Developing strategies to enhance shareholder value. | Linking corporate and financial strategies $3 Working Insight 4.2 Creating value with the seven drivers 1 Increase sales grow 2 Increase operating profit margin 3. Reduce cash tex ate 44 Reduce incremental investment in capital expenditure 5 6 2 be treated equally =n different businesses, diferent drivers willbe efficiency, the ultimat ‘burden tha the comps Inially the directors have 1 How large do we want (or need) the asset base to be, and in 3 How much ofthe profit should be paid out indi be retained for future growth)? 54 Linking corporate and financial strategies ‘Table 4.1 Ris from different perspectives —_EaaE Debs Equity ay Features for issuer Interest rust be paid Can choose whether to pay (he company) Repayment must be made dividends ‘The lender may have the right © No repayment obligation repossess asets ‘A LOW-RISK INSTRUMENT A HIGH-RISK INSTRUMENT ‘Features for ivestor —nterestis contractual Dividends ae atthe discretion Repayment is contactal ofthe company ‘The lender may abtnn security _No ight o receive capital beck ALOW-RISK INSTRUMENT A HIGH-RISK INSTRUMENT $$ $$ EEA AGE RISK INSTRUMENT Putting it very simplistically, these are the only four decisions that nerd to he taken in Financial strategy 5 Financial risk relates to th level of debt @ company is carying (its gearing, or leverage). Ia assessing the riskiness of debt and equity itis essential to specify the perspective from which the ‘analysis is being made, Ths i illustrated with respect to debt and equity funding in Table 4.1 financial risk by a whole ude ensuring that it has priority in terms of both repayment of principal and payment of interest, possibly by taking secur specific assets, and by insisting on covenant jn agreements, which can entitle it to demand early and imme- diate repayment ifthe financial postion ofthe borrower appears to deteriorate. Clearly these steps transfer a large part of the financial risk to the company, as any breach of the loan ‘agreement conditions can place the continued existence of the e°mpany in jeopardy. Conversely the financial rights of the same company's shareholders are minimal and ‘hence their financial risk is higher. The company has discretion over whether or not to pay & dividend, even if it has sufficient distributable profits, whereas the payment of interest is effectively committed and mandatory. Ordinary shareholders cannot demand from the ‘company the repayment oftheir investment even ino dividends are paid over a long period, «except by placing the company into liquidation; in which case they ar lest inthe queue and o not receive any distribution until all the company’s creditors have been paid in full. They seek a large part oftheir retarn 7m of a capital gain inthe share price ~ which is by igher level of risk on the part of the shareholders, of course, retums which they can achieve ifthe share price rises. ives @ more certain but much lower maximum return in nt of principal ‘We deal above with ‘plain vanilla" debt and equity. Many yeers ago, when we frst became involved in corporate finance, most financing options could quite easly be categorized as Linking corporate and financial strategies 55 High o @ v | xX Business risk @ @ xX | v Low Tow Tigh Financia risk Figure 4.3 Matrix of business and fneneial sk, cither debt or equity; nowadays there is a continoum between secured term lending at one extreme and ordinary, permanent shares atthe other. Many of the categories in between are discussed in Chapt For the purposes ofthis discussion of business and financial risk, our perspective is thet of the company raising funds and investing them. Although the shareholders’ risk associated with investing inequity is quit high, the financial risk of using predominantly equity financing from the company’s perspective is much lower than ifa high proportion of debt funding were used. Balancing business and financial risk Financial risk should complement the business risk profile, in order to develop logical elter- native financial strategies for different types of business. Combining a high business risk strategy with high financial risk strategy (such as would be achieved by borrowing to fund 8 startup bio-tech company) gives a very very high total risk profile: such a company may succeed spectacularly ‘more likely to fil completely and disappear. Thus, as illustrated in Figure bination of strategies in Quadrant 2 is not a logical, ful business. account, tis type of strategy can be seen to be potentially very attractive to risk-taking entre- preneurs. Ifmost ofthe required funding can be raised in the form of debt, the ent have rery little oftheir own money. Ifthe business tums out to be su will get the these upside gains: being fixed, high-risk business fails, a it probabl the small amount of hich they have be the ultimate combination of ‘you take all the risk and we'll take al 56 Linking corporate and financial strategies because the lender is commiting what can be reg corporate finance: accepting a debttype return wile taking equi ‘In our opinion, funding should only be regar form as originally expected. Normally this allematve exit route ‘would be provided by realizing the underlying value of certain assets owned by the business or pledge as secarity forthe loan bya gusrantr. an unacceptable risk return relationship, igh bus ‘The greater problems at this very simple level of financial strategy tend te be encountered with the lower busines risk companies In genera, business ris iLestab- tions of today, with much lower business risk profiles, Not only does the but, a the company matures, the cashflow tends to become he Linking corporate and financial strategies 57 reduces overtime asthe company's core business matures or it diversfies into other areas, by ma of the outstanding debt of the company. Consequently, although the most common direction of strategic movement would be from Quadrants i.e, moving from high to low business risk and from low to high financial risk itis possible and logical for companies tomove in the opposite direction Risk management as part of financial strategy td in Chale 6 on oro governnce, However on eget of ik hanage of by changing the business risk profile of the business: dividual goals of these shareholders, so the assumed asthe company’s target. Added to this is the treat of ta Bosiness risk Financial risk Figure 4.4 Matrix of business and financial risk fre private company. for them to follow the preseribed strategy of gearing up alow risk business. Thus fora private ‘ompeny we can redraw the risk matrix as Figure 4.4. Pecking order theory One final thought about the choice of finance is relevant. Although debt is cheaper than equity, and although there are ‘rules? finance might be appropriate, managers tend assume that companies would only wish than low, because they would raise more money or suff is that investors expect equity to has internal resources avail ‘metry and can be accessed pext easiest f ‘ompanies where the asymmetry display the pecking order in ther financial choices, even the suggestions in the rest ofthis book 1 ternal fs Linking corporate and financial strategies 59 information asymmetry (ie. intemal funds, then debt) over expensive equity. Suggested further reading wing open 2010 ned it Mangement 4 Copsrae Governance Mara Soaps ‘er short hep heir ron hv ‘oracrne, buss vey ineesty ad Is ila ion comtbsc a 5 Financial strategies over the life cycle Leaming objectives 60 Understanding the lifecycle 60 The Boston matrix. 62 ‘Business risk and cash flows over the life cycle 63, ‘Changing the financing strategy over the life cycle 67 Debt profile 70 A logical dividend policy 71 ‘The impact onthe price/earnings multiple 73 Impact ofa diversi strategy 78 Applicaton internally tothe divisions of @ group 80 Acavest 81 Key messages 2 Suggested further reading 82 _| Learning objectives ‘After reading this chapter you should be able to | 1. Understand and apply a mode! that relates business risks and financial strategy to the business life eye Evaluate the appropriateness of company's gearing and dividend polices. 3° Appreciate the inevitability ofa declining PYE multiple and understand how this affects shareholder returs as a company matures | Understanding the life cycle Products can follow a well rationally explained by ised life eyce, with trends in sales valves, in reat terms, age of development. The basic practical much easier to use the technique to explain ‘why sales moved as: sales willbe inthe stages, as shown in future tend ins Financial strategies over the life eyele MATURITY LAUNCH | GROWTH ! aon profes cul Pin the launch stage, both prot and cash flow are likely to be negative, reflecting the investment made in developing the product and the market. The progression through the life cycle sees both profit and cash flow becoming positive (there is litle point im stating if this io happen). The stage at which ea in on the organization will 1 characteristics ofthe enterprise; assumed that capitalization ‘mean that profits tur the comer the initial sales levels during the launch phase of any product will below at this stage there is significant business risk that sales will never increase and may disappear ‘or isnot accepted by the market. Should uct becomes accepted by the critial mass of the important opinion-forming segment of potential customers, sales levels in the market as ‘of dramatic sales growth cannot continue for ever, asthe total demand for any product is finite. Inevitably the increase in sales starts to slow down as all che potential customers for the product come into the market snd establish their normal rate of usage forthe product. is very common to find that this period of fast growth in demand attracts a number of late entrants into the market; the apparent risk associated with the product has reduced since ted by the customers, bu the continuing growth indicates an oppostunity to capacity forthe product, but the existing players are also tryin ‘market. This can cause a significant increase in total industry capaci ve sparc new capacity, which can cause rium position ie established. This ove: price competition until a more stable a | 62 Financial strategies over the lifecycle ,,, Amicipstd sles forecast used to justify capacity increases Sales / capacity — Overcapacity position ‘Actual sles level Histrest | Figure 5.2 Shake-out period. is diagrammatically shown in Figure 52, and the maturity stage ofthe lifecycle cannot be ‘Properly started until this position is resolve. Inthe maturity stage, demand and supply are mach more in balance, so thatthe remaining efficient producers can expect to make stable profits on their substantial sales volumes Unfortunately, this happy state of affairs eventually ends when demand forthe product starts to die away. This can be caused by saturation of the market or by the launch of a better replacement product whick rapidly atracts away most of the current mature product's users. An important element highlighted by the product lifecycle isthe concept of changes in ‘market share forthe competitors in any particular industry. Iti quite straightforward to distinguish between the different stages of development in terms of the key strategie thrusts ofthe business and to relate these to the relative associated busines risks at each sage, This can be most easily demonstrated by applying the Boston Consulting Group's portfolio ‘atrix, albeit in a slightly different manner to its traditional use. ‘The Boston matrix Figure 5.3 shows the product lift eycle in a diagrammatic repeseatation developed by the ‘Boston Consulting Group to explain the c f product portfolio management to senior ‘managers of large groups. share ofthe company, Financial strategies over the life cycle 63 Rateot ret oP Bow | Cash Dog cow Lonlegaive Low 180" Relative marketshare (beet cB Coin Com) Figure 5.3 Potoio mati, incorporating produc lifecycle. vy mgt peo ns ee scales Shiro hegre te Sur Tra mbes cone tbe coma! runes [OLimimeneugivpaneemasc apnoea ss Sechmaucee ace Spee tes War nc i nage — wo saeco naga aka nana Stem area oy liven Sets Smee ain Segoe ea ene SOMES Wain ee tein snyuan om misery. ‘expanded upon in the rest of this ‘business risk profile ofthe compan development ‘During the develooment and launch stage we have many assumptions, edge. Any forecasts we prepare to show the business's future are specul 64 Financial strategies over the Table 5.1 Unkaowns decrease over thei LAUNCH GROWTH eyele , DECLINE, Market share | Size of market st | maturity | Length of maturity | Length of matty | petiod | period | Rate of eventual decline tment in research and development, market research, and fixed ales income. Depending on the industry, this stage could last 3 Sales volumes start to grow, the strategic ‘market share development. ‘maximum size. This requires a clear focus on market share development, but a Jeading company in a Growth Very high Maturity = i] igure $4 Busines se Financial srategies over the Wfeeycle 65 high-growth industry should also invest in ensuring that the market matures a as large a size shift in management satly on continually changing the product, unless t in the marketplace, Some management 1d receivables (see Chapter 2 ses may need capacity incre negative and might stay negative during the high growth reasonably balanced, depending onthe rate of growth and cd assets or working capital. Once the rate of growth while the cash produced ftom sales revenues increases (high sales volumes at a good profit pe un) resulting ina strong positive net cash low. le represents a very significant 66 Financial strategies over the lifecycle GROWTH ‘LAUNCH, Cash inflow: Cash inflow: Sales High Sales Low Cash outfow: Cash outflow: Marketing, fixed assets, R&D, lanneh marketing, working capital ete." High fixed assts,ctz. "High Net eash flow ? Neteash Now Negative Cash flow starts negative, becoming neural oF postive ‘MATURITY High Low Net eash low Cash fow starts postive, Figure 5.5 Net cash flows at different stages of development. this mature stage ofthe life from its market e. It is important thatthe business does not switch suddenly 0 °& 10 & cost-cutting, short-term profit maximization ‘mindset, This type of change co ‘rapid decline in market share and a dramatic shortening of the period over which high profits and strong positive cash flows can be gener ated. The key object ‘maintain market share as long asthe total market demand justi- fies the req iarketing support, but a the same time to look for efficiency gains ‘which can improve the overall return on investment This fundamental change from a growth ‘management focus to a profit improvement emphasis is difficult for many management ‘teams to accept and implement, with the result that many businesses try conditions and competitive pressures make this financially very unatiract spossible in their original business, they may tun toa diversificai ag phase for as long as possible, Unfortunately the 19 and growth tend to Financial strategies over the Ife cycle 67 and during the final decline stage of the life eycle, cash the investment in working capital decreases, the business cash flow must be atleast neutral, as otherwise the product “However, as is argued later inthis chapter such a reinvestment is neither inevi ‘many cases, desirable. In fact, for some grou f the product life cycle may be f managers the declining, more exciting, as the d ‘ash flows do remain 1 long it wl phase and, ifno further positive or neutral, the product may be demand completely disappears. One ‘change managers during the progress it. Far too often, products ae kept going too long ‘up or that a way will be found to eut costs still Changing the financing strategy over the life cycle Having looked at business risks and cash flows, we can develop the appropriste financial stategy for each stage ofthe life cycle, Tw ‘matters need to be considered: ‘+ The business should make the best use of ts available cash; and ‘© Business risk and financial risk should be inversely correlated (as shown in Figure 4.3) Let us remind ourselves ofthe key characteristics of debt and equity, from the point of view of the company being funded, Debt is high risk, and involves cash outfiows in interest strategy ofthe business. | | | RING AEP AS 68 Financial strategies over the life eyele Growth ase ik igh Launch Busnes ik ery high Financial siselow | Financial risk very low Maturity Decline Busines ik main Busines isk ow Financial risk medivm | Financial risk high re | Figure 5.6 Financial isk ‘Once the product is launched and intial sales growth can be demonstrated together with substantial future growth prospects, available is can be combined with providing an exit forthe venture capital company, a8 illustrated in Figure 5.7 — The best way of achieving this type of exit route for venture capital initial funding is ‘through an Initial Public Offering (IPO), where a much broader range of equity investors ean be attracted to bu company as, by existing success ari haneing soe of fnding over he who maturity stag Financial strategies over the lifecycle 69 Required relved risk ‘Figure §.7 The changing rik profile of equity investment At the very highs launch stage, the required return isX. Equity funding is provided by veature ‘apital, As the business moves into the growth stage it needs futher fanding, but the risks have ‘Ered ch are prep ree Tsien ere pa lente ca tation. The flotation has the added positive at this time and this combination allows 9f funding which have been accessed s0 far (gow invests) Maturity Dectine Finacial iskmediam | Rania igh | astm | snes ow = Figure 5.8 Changiag sources of funding, ost] RINGAR RAL 10 Financial strategies over the lifecycle ‘Therefore the only logical source of additional equity funding during this maturity stags forsome ofthe profits being made by the company tobe reinvested ito the business. Addition financing can be raised through borrowing money. This is now practical because the positive cash flow of the business provides the source of servicing the debt, paying the interest and ‘repaying the principal. If debt financing had been used at the earlier stages ofthe lifecycle, the absence of such positive cash low would mean thatthe repayments could only be made by ver the original loans or by raising equity to repay the debt funding. ‘This isa reminder of key issue regarding the use of debt and equity funding: a lender's isk is lower than an equity investors risk, due to the security taken and legally granted priority on fall repayment. (Remember thatthe risk ranking is reversed when vie of the company, i. the user of the funding ) Risk and return are pos ‘the retum required on debt funding should always be less than that req. forthe same company; i.e. debts cheaper forthe company. Ths is completely logical from the ‘company’s perspective because as det is higher-risk finding for the company, the company should demand a i justly incuring the extra risk, Jong as increasing the financial risk through borrowing does not lead to an ‘unacceptable total combined risk, the cheaper debt funding will increase the residual profits achieved by the company. Thus the profits generated by the mature company, which uses some debt financing, will be enhanced and the return on equity will lok even better, as less ‘equity is required to fund the business. practical to borrow equity-type risk, the residual value of those assets which ate, of necessity, tied up inthe business unt it finally liquidated, These funds can then be distributed to affecting the position ofthe the residual value ofthe assets, and who receives a rsk-rl the principal souree of funding forthe declining business is debt finance with its high financial risk, partially offsetting the low business risk associated with this of development, Debt profile {In considering the balance between debt and equity in a company’s financial tegy, one ‘ther issue should be mentioned: ofthe debt, how much should be borrowed short hhow much long-term? ‘The answer to this question depends, unsurprisingly, o ‘and the structure of is operations. Broadly, the company’s debt portfolio should a ‘math long-term assets with long-term Financial strategies over the life cycle. 71 sway? Short-term debt needs tobe refinanced at regular intervals and, ifthe company’s finan- al situation has deteriorated or the ere 1s tightened, this may become a problem. ‘Exceptions do exist to this broad rule about using long-term funding for long-term needs. -term interest rates are considerably lower than long-term ones, and the company that long-tenm rates will fall, it may be worth using short-term finance to start, with the intention of refinancing a a later date, ina more favourable environment, Ths strategy debt, the issue is one of timing Allogical dividend policy ‘Throughout this discussion on increasing levels of financial risk, the issue of how investors receive theirrequired | etur has been critical. Ordinary shareholders can only receive ‘this retum in two w er the company pays a dividend, or the value of thir shares the form of a combination of dividend yield and capital appreciation but, theoretically, the shareholder should be indifferent as to Whether the company pays a dividend or not. This is because, ifthe company does not pay a dividend, the value of the shares should increase to 1s which should be generated by the reinvest- paid out as dividends. Clearly this argument restricted to one product, which progresses dhzo Hence for the curent structured analysis its possible to indicate a logical dividend policy fora company at each stage of development, and this is diagrammatically shown in Figure 5.9. During the cash-negative launch phase itis completely logical for shareholders to expect divi- ‘ad from the company. They ae supplying all the funding =nd therefore ifthe company were to pay a dividend, they would have to increase their investment in order to pay part of it back to themselves! Consequently a nl dividend pay-out ratio is appropriate for these start-up, venture ‘apital-funded businesses; all ofthe high required retam being inthe form of capital grow, ‘There is also a very simple practicel restraint on many such companies paying dividends In order to pay dividends, require both cash and distributable profits, Le, profits after tax generated either i ‘year or retained from past years. During the launch phase the business could well be generating accounting losses and therefore might have no istributable profits from which it could declare a dividend. ‘Even when the company has moved into the high growth stage of the lifecycle, the cashflow is stil, atbest, only neutral and the source of funding is stil equity. Thus a high dividend pay-out 72 Financial strategies over the lif cycle Launch Busines ike hi Financial vy ow Punding eauly ining gay Nominal dividend | Nil dividend pay-out | High dividend pay-out | Tow dividend pay-ont ratio ratio Figure $9 Dividend policy: pay-out ratio, ‘opportunites while they exist and this could be constrained if cash were paid out as dividends. ‘As new investors ate being atracted into the company during this stage in order to replace the ‘existing venture capitalist and to finance the rapid growth, itmay be necessary to pay a nominal dividend out of the increasing profit stream. However, most of the required investor retum ‘would still come from capital growth in the value of the ares in the compa. (Once the maturity stage ofthe life eycle is reaches for a number of reasons. The cash flow fro financing is now a practical and sensible should now be high and relatively stab supported. More fundamentally, itis important thatthe dividend pay- ‘there will be restricted opportunities for reinvesting the whole ofthe eurent profit stream in the existing bus hing retums setting Js of reinvestment. Ifa company cannot reinvest funds atthe rate of its sharcholers, it destroys shareholder value by retaining these funds, Consequently as profitable reinvestment opportunities reduce due to the lack of growth in the now mature business, shareholder value can be maximized by paying out these surplus funds as di Furthermore, a the company matures, the opportunites forthe sharehold- ain must be limited, asthe high-growth period isin the past. another of the potential confiets discussed in agency theory, because senior managers will non paying dividends might decrease both earnings per share and share price, both of which are metries commonly used for management incentives, None of these arguments is based on the concept of maxim nolder wealth; they are more closely focused on a concept of increasing mana Financial strategies over the lifecycle 73 profits will de away asthe product Figure 59 then advocates dend pay-out ratio. In this context the fee cash flow generate iness which, during this declining ely to bein excess ofthe profits reported by the company. ‘During the maturity phase, the company produces high profits and high net cash flows, cout of which it should pay a high proportion as dividend. As illustrated in Working Insight 5: this dividend yield wil represent a substantial proportion of the total return expected by the shareholders, because future prospects for capital growih are now relatively low. However, one the product starts to decline, this fature growth becomes negative with the result thatthe company may not want to reavest to manta the existing scale of business ‘This means thatthe deprecation expense (which sof course, anon-ash operating expense charged in arriving at posttax profits) may not necessarily be reinvested in replacing the tassels which are being used up. This would increase the level f fie cash flow generated by the business which coud be pai out as dividends to shareholders “The dividends could be further jue of essential assets were fanded by borrowing, andthe cash distributed to shareholders, as suggested earlier. This clearly iehlights that part of the high dividends pad by declining companies really represents & repayment of shareholders" capital picture ofthe dividend pay jevitably the strong cash flows ant io and its offsetting relationship with always be considered in the cantext of a itmatures. Te reducing rsk profile means the sot of relationships which can apply lustrated in Working Insight 5.1 between dividend yields and capital growth are ‘The impact on the price/earnings multiple ‘Working Insight 5.1 shows thatthe capital growth component ofthe total expected shareholder retum reduces as the product passes through its life cycle. This is logical because the future Working Insight 5.1 Mlustrative example of changes in total shareholder return and its component elements Generated by ‘Siage ofmaturity Total annual required Dividend yield + Capital growth return (Le. Ke) Bivmavatad pies euetercree | eres | DINUATE RG Financial strategies over the lifecycle Very high growth Maturity Decline Busines risk medium Busnes rick ow Fonencil risk medium | Fama igh nding dete ‘Funding debt. Dividend pay-out hich | Dividend pout al Figure $.10 Future growth prospects. IE. Accordingly, ‘the PVE ratio might be expected to fll over the company's lifecycle, Figure 5.11 shows tic, Busines isk ery high Foran very ow Very high PIE Decline sins ist ow Figure 5.11 Priselearsings multiple, reflects its expected Financial strategies over the lifecycle 15 Working Insight 5.2 ‘The impact on required eps of a declining P/E multiple O, a. 8. 3 ‘Stage of maturity Appropriate P/E multiple Required eps Market price of share aed : isapld ioe om, o inl in th she pce when ey hgh PE les ap pi Ie ane ofa wih wl nt a de or ae as aeay brn an sosount of in te curet care rie.‘ sare piel ol oe the company can actualy exceed ths expec and pdr ae of gow ot cone fo 16 Financial strategies over the ife cycle 1 Financial strategies over the lifecycle 77 LAUNCH Working Insight 5.3, Uphill struggle im nat Dividend poy ou nominal Sage of Growah igh PIE high MATURITY BBsnes risk medion roncal sk medio ia Puding debt Dividend py-ou high Growth medir/ow PIE medi | Eps high | ‘Share price stable with limited volaiy IAPERA Figure 5.12 Shate price and volatility. ino to be completed by adding in the share price ofthe company over the product life mulling the opening sar ric fo the previ gs by the compound factor regued fort Sse, as shown by he rand | inthe ie. changing dividend pay- ‘which should reduce expectations of future growth as the irement for share value growth has on the rated in Working Insight 5.3, Cote: 2 abot ie ed frp to row ‘growth, As already di ‘fessionals who apres ‘course interlinked) can lead to @ rapid decline in share values, developments can create quite spectacular growth in share pris < a = Ss & 18 Financial strategies over the life cycle bby this stable dividend stream. I is also much easier to value this type of income-generating share by reference to equivalent risk-adjusted interest-eaming altemative investments: thus prices of high dividend-paying shares tend to move very directly asa result of any changes in interest rates which affect the yields on corporate bonds and other such investments This period of relatively ow volatility comes to an end asthe single-product company ‘moves into the final phase of it life eycle because the volatility ofthe now declining share price increases again. In spite ofthe reducing busines risk, the share price is now controlled bby total dividend pay-out policy and the investors view on the length of time for which such ‘payments can be maintained. Consequently, small external influences onthe rate of decline of the product and its consequent cash generation capability ean have very significant impacts on ‘he share value, thus increasing the volatility ‘a diversification strategy cd to single-product companies as they and their products progress entioned earlier, the inevitable result of te ul cessarly of great concer fo shareholders in the company, although these shareholders are likely to change overtime as the relative balance in the form of their financial return betwe i investors ean generate any desired mix of capital gain table portfolio of companies. Similarly they can create a ie investor is forced to accept the reducing risk: and increasing dividend yi should be offered by a maturing company. A readjust- ‘ment to the overall portal ‘made either by reinvesting this increasing income stream inhhigher-risk, hgher-growth companies, or, more rapidly, by actully selling some shares in the now mature business ‘The costs ofthese changes tothe investors’ portfolios are normally very small and, more ‘importantly, such changes should be easily planned well in advance if the company and the capital markets are using the appropriate signalling procedures. Therefore, from a sharehold- 1's perspective there is no obvious need for a company to implement a diversification strat ‘egy when the growth prospects from the original core bu duce due to the product's ‘maturity. However, such corporate strategies of utilizing the strong positive cash flow from the successful, but now mature, core businesses to invest in new higher-growth potential products, le atthe very heart ofthe Boston matrix. quired for reinvestment in the core bus id the launch of other new products, which are a the Financial strategies over the life cycle 79 Prue rang __houat ten coe cutee a Dig Site ee ES ans # rt sant | et

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