Case 32. 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

B. 7 elements revealing underlying financial policy 1. Mix of Classes of Capital Ex) Debt & Equity / Common Stocks & Retained Earnings Ex) A Pecking order of Financing : Profit -> Debt -> Equity 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

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

7. Distribution These elements become a basis for developing a broad, detailed picture of firm’s financial policies C. Comparative Illustration Eli’ s and Genentech’ s Example:

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.

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

• 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

• • 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: a) Financial Flexibility b) Sustainability of financial policy c) 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)

- 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.

• 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?

A way of identifying the tradeoffs among “good” and “bads” • Flexibility • Predictable Risk • Income • Control • Timing

• Final decision for alternative structures remain for CFO and adviser.

• Good Luck.