Dr. P.V. Viswanath

pviswanath@pace.edu

• Porter Model Analysis
• Dupont Analysis of Articles
• Dupont Analysis of Firms
• Differences in Corporate Governance
• Question on the Credit Rationing Problem
• Questions on the Short-sighted investment problem
• Information Effects of Security Issuance
• Risk Management at Apache
• Term Project

Porter Model Analysis

Answer the questions below. Keep in mind that we're thinking of interactions between financial and non-financial strategic decisions. This means that the two decisions cannot be delegated to two different individuals without significant co-ordination. Also keep in mind that when I say strategic decisions, I mean decisions, i.e. some _choice_ is being made. Keep in mind our list of financial decisions as a guideline for what decisions are financial; availability of financial resources is not a decision.

1. What are the corporate decisions that you think of as financial?
2. How can Financial Strategies make it more difficult for new firms to enter the industry and compete with your firm?
3. How can the right financial decision help overwhelm or outgun existing competitors? 
4. How can financial decisions help redress the balance of power between the firm and its suppliers?
5. How can financial decisions help increase the firm’s economic power vis- à-vi s its customers?
6. Can financial decisions help the firm ward off substitutes competing against its products?
7. Think again about capital structure, about financial risk management, about dividend policy and how they might affect all the issues relating to value creation in firm

Dupont Analysis of Articles (Group Assignment)

Read the articles below, answer the following questions and send me your response in a Word file:

1. The second article seems to be contradicting the first article. Is this so? Can you reconcile the two messages? Or are they irreconcilable? And, if they are, which message is wrong? Write no more than 500 words.
2. The first article seems to suggest that the margin vs volume discussion is only relevant when comparing across industries. However, in a given industry, you have to go with either profit margin or sales volume. (And in the internet sales case, the first article seems to suggest that you have to go with profit margin if the goal is to increase profits.) Can one use the Dupont formula as a framework for product/marketing strategy even within a given industry? Write no more than 500 words.

Here is a post on Facebook by KJB Security Products on Monday, November 30, 2009 at 4:43pm titled "Profit Margin vs. Sales Volume."

When it comes to increasing your bottom line, there are two approaches retailers may take: Increase profit margin or increase sales volume. Ideally, a company would do both, but that’s usually not possible, especially during a recession. Taking a couple steps back, Profit Margin (PM) is the percentage of profit you make on a sale, after taking all of your costs into consideration. For example, if you bought a TV direct from the manufacturer for $100, and sold it for $200, your gross profit margin would be 50%.

Sales Volume (SV) refers to the total number of sales that you make. Some retailers are more focused on the total sales volume, and simply look to move as many products as they can, usually by focusing on a low-price strategy, thereby resulting in a lower profit margin. This allows them to make more sales, but at what cost? Say you took that TV you bought for $100, and sold it for $150 instead of $200. Your margin just dropped to 25%, and you made $50 less. The theory here is to realize more sales, in order to “make up” for the decreased margin. This strategy works extremely well for big retailers, such as Wal-Mart, that operates on a razor thin profit margin of barely 3%.

The reason that Wal-Mart is able to sell at such an unheard-of profit margin is because they make up for it in volume. This strategy works great for large retailers, but the same strategy can backfire for someone in the specialty electronics industry.

When you sell based on price instead of margin, you are inherently facing several problems. The first is when you realize what brought customers to you in the first place. They bought from you because you had the lowest price for the product they wanted. They didn’t come to you because of the relationship you had built with them, your customer service, the sales experience, technical support, or brand recognition. They bought from you because your price was simply a few dollars lower than your nearest competitor. So you may have got the sale this time, but next time that customer wants to buy a product…instead of going directly to you, they again start their search for the lowest price. By then, your competitor might have undercut you by a few dollars, and since you were simply selling on price, as soon as a competitor pops up that sells the product for less, you’ve lost your customer.

On the other hand, rather than focusing on the price, smart smaller retailers focus on the added-value they package with every sale: Great customer service; helpful technical support; a friendly a knowledgeable sales staff. These are the things that keep customers coming back to you every time they want to make a purchase. And when you do that, combined with a healthier profit margin, you will see that even if you make a few less sales, you can still make more money with higher profit margins.

For a more applicable example, let’s take KJB’s Sleuthgear Recluse. If your cost for the Recluse is $249, and you sell it for the MAP price of $449, you’d make an easy $200 per sale. At that price, let’s say you sell 5 per month…your total profit would be $1000. Maybe then you decide if you lower your price, and sell it for $349 instead, you can sell an additional 3 units per month…so now you’ve increased your sales to 8 units, but since you lowered your profit margin, you’re actually only making $800 in profit. So just because you made more sales, you’re actually making less money per sale. At the end of the day, which would you rather have, more total sales, or more money in your pocket?

For one other quick example, let’s take the D1400 Voice Recorder. Let’s say your cost is $19, and you are deciding whether to sell it for $49 or $29. At $29 you’re may sell 20, for a total profit of $200. At $49, you might sell a few less, maybe 15…but at a total profit of $450. By keeping your margin higher, not only will you make more money, but you will be able to more easily absorb incidental costs such as return and technical support costs.

The lesson to take from this margin vs. volume discussion is that lowering your price, while having the advantage of possibly increasing sales, does not necessarily translate to more profits (and in many cases, results in lower profits). By keeping your margins higher on your products, you can put more money in your pocket, which at the end of the day, is the goal of every business.

Now read this article called "Sales Volume vs. Profit Margin" at http://www.yournew.com/internet_marketing_myths.cfm

We find that a concern many companies express is that their Internet ventures may serve to improve the sales volume of their business at the cost of reduced profit margin. This is perhaps the biggest fear, with the very least supporting evidence. That is, indeed, a myth.

First, it is important to understand that it is common to achieve an even higher profit margin from your online sales than offline sales. This is for multiple reasons, but can include cost factors as basic as a lower cost of aquiring the sales lead, and lower cost of inventory, inventory management, and accounting. This is also largely because online shoppers are often far more motivated by company credibility and shopping convenience than by saving a couple dollars.

Second, let's say that you are in a highly competitive industry where you fear that if you advertise your pricing online you will never be able to see the same profits from your non-Internet customers. A good example of this is the automobile industry. The same example works for any industry, but for this purpose, let's use cars. Too many automobile dealers fear that because they have a car advertised online that they must sell each car at their advertised lowest price on the Internet. One really quick answer to this is in the form of a question ... "Does this happen when you advertise with your local newspaper or television?" Of course not. You probably do not even offer the same special pricing on television as you do in newspapers or yellow page advertisements. You offer a specific vehicle and you advertise that unit at that price. If you commoditize yourself and forget that every buyer and every sale is unique, you do so at your peril. Many people will pay more for the same things they have always sought ... service, convenience, company reputation, and presentation. The list goes on, but most importantly, you must understand that the Internet does not take away from the things that set your business apart. You simply have a new set of tools with which to promote those valuable benefits.

If you do not reach out to the people who are shopping online, you are missing an exceedingly important part of your market. If you are in this position, what you will clearly need to address is the fact that if you do not market your business in every possible way, including a well presented Internet presence, you will become even less visible over time. Time is not on your side as your competition is gaining market share and polishing their online presentation, just as they have been in the years while you neglected yours.

Dupont Analysis of Firms

Pick two publicly tradef firms in the same industry -- pick one that is a low margin/high volume type of firm (e.g., Honda) and one that is a high margin/low volume firm (e.g., BMW). Define the variables in PowerPoint file dupoint_analysis_application.pptx for the two firms using the accounting information in the firms’ financial statements in 10-K reports in SEC.gov or finance.yahoo.com.
Once you have the values of these variables, figure out what their generic strategies are. Then compare operating performance and opine which firm is a better company to invest in. See example in file Group assignment #3 DuPont Analysis Example Comparison of 2 companies.xlsx

Using financial data for several years, explain the difference in their marketing strategies in terms of volume versus profit margin. Explain how the firms' tactical actions are reflected in the firm’s actions. That is, explain how decisions that the firms have taken in the past and are taking currently affect the denominators or the numerators of the Dupont Ratios. This write-up should be about three pages; remember though, it’s not the length that’s important, but the content. 

Differences in Corporate Governance

Write a 1,500-word paper on the differences in Corporate Governance in the U.S., and Japan, based on the reading, US – Japan Corporate Governance in Documents on Blackboard. Include your thoughts on how a Japanese-style corporate governance model would affect our conclusions regarding the impact of capital structure on operating and competitive strategy.

Risk Management at Apache

1. What are the risks that Apache faces?
2. How is Apache managing its risks now? What risk-management techniques is it using? Comment on the quality/effectiveness of the risk-management strategy.
3. Should Apache manage risk?  Why?
4. What are the operational problems with risk management at Apache?
5. What risk management techniques would you recommend?  Why?

Evaluation rubrics:

1. Is the write-up coherent?
2. Is the writing grammatical?
3. Are the ideas innovative? Have you brought in issues that are not obvious from the case description?

Question on the Credit Rationing Problem:

We see that if bondholders assume project A will be chosen, equityholders will find it optimal to choose project B. Complete the payoff matrix from the Credit Rationing Problem with a 0% risk-free rate of return for the case where the bondholders assume project B will be chosen.  In particular, answer the question as to which project equity holders will choose under this assumption.

If bondholders assume that Project B will chosen, we must solve the equation , where x is the face value of the bond. Solving, we get x= 300; i.e. they would now charge an interest of 200%. The new payoff matrix for equityholders, if they choose project B would be:

If they choose project A, instead, the payoff matrix will be:

Project A is equally as bad as Project B; hence the equityholders will be indifferent between the two.

Of course, if bondholders believe that equity holders will choose project B, then they will want a face value of 300m, but they know that this is not feasible; hence they will not provide the $100. The maximum they will provide is money for a bond with face value of 150, since that is the maximum payoff. The price that they will then pay is 150(0.2) + 50(0.8) = $70.

The equityholders will then have to chip in the additional $30. At this point, both projects become negative NPV and neither project will be chosen.

Questions on the Short-Sighted Investment Problem

Answer the questions from the slides on Capital Structure and Stockholder Incentives.

• We can see that the firm will not be bankrupt even if it takes the long-term project because the value of the project plus existing assets is $40m + $20m from the long-term project and 50 + (60+10)/2 from existing assets for a total of $145m., while the face value of liabilities are $140m. 
• If so, why are we considering additional debt?  Why not consider additional equity, which the firm could also raise, given that it is not bankrupt?
• Would that then lead the firm to pick the long-term project?
• Why issue junior debt?  Why might there be a covenant preventing the firm from raising new debt with equal seniority to existing debt?
• What if the firm could issue such debt?  Would the firm then end up choosing the long-term project?

Information Effects of Security Issuance

I. Suppose the market has the following information: Tatler's Inc. is worth either $200m (the good state, with probability 0.8) or $100m (the bad state, with probability 0.2). Tatler's also has the right to invest in a new government project, which is likely to bring it an NPV of $30m. (in the good state) or $20m. (in the bad state). Tatler's management, however, knows exactly what state the company is in. The project requires an investment of $50m. but the firm can obtain this funding from a private investor to whom it can reveal its information credibly and without worrying that the information will be leaked to its competitors.

1. What will be the market value of the company?
2. It turns out now that the private investor is not available to invest in the deal and Tatler's must issue new equity to finance the project. Will Tatler's raise the outside equity and invest in the project, if the firm is actually in the good state? What if it is in the bad state? What will be the market value of the company?

II. Suppose the market has the following information: Tatler's Inc. is worth either $200m (the good state, with probability 0.2) or $100m (the bad state, with probability 0.8). Tatler's also has the right to invest in a new government project, which is likely to bring it an NPV of $30m. (in the good state) or $20m. (in the bad state). Tatler's management, however, knows exactly what state the company is in. The project requires an investment of $50m. but the firm can obtain this funding from a private investor to whom it can reveal its information credibly and without worrying that the information will be leaked to its competitors. (This problem is exactly the same as the previous one, except the probabilities are reversed.)

1. What will be the market value of the company?
2. It turns out now that the private investor is not available to invest in the deal and Tatler's must issue new equity to finance the project. Will Tatler's raise the outside equity and invest in the project, if the firm is actually in the good state? What if it is in the bad state? What will be the market value of the company?
3. How is your answer to this question different from that of the previous question?

Recapitalization

1. Suppose you are hired as a consultant for Tailways, Inc., just after a recapitalization that increased the firm’s debt-to-assets ratio to 80 percent. The firm has the opportunity to take on a risk-free project yielding 10 percent, which you must analyze. You note that the risk-free rate is 8 percent and apply what you learned about taking positive net present value projects; that is, accept those projects that generate expected returns that exceed the appropriate risk-adjusted discount rate of the project. You recommend that Tailways take the project. Unfortunately, your client is not impressed with your recommendation. Because Tailways is highly leveraged and is in risk of default, its borrowing rate is 4 percent greater than the risk-free rate. After reviewing your recommendation, the company CEO has asked you to explain how this “positive net present value project” can make him money when he is forced to borrow at 12 percent to fund a project yielding 10 percent. You wonder how you bungled an assignment as simple as evaluating a risk-free project. What have you done wrong?
2. Consider the case of Ajax Manufacturing which just completed an R&D project on widgets that required a $70 million bond obligation. The R&D effort resulted in an investment opportunity that will cost $75 million and generate cash flows of $85 million in the event of a recession ( prob. 20%) and $150 million if economic conditions are favorable ( prob. 80%). What is the NPV of the project assuming no taxes, no direct bankruptcy costs, risk neutrality, and a risk-free interest rate of zero? Can the firm fund the project if the original debt is a senior obligation that doesn’t allow the firm to issue additional debt?

Assume now that if Ajax Manufacturing (see exercise above) uses a more capital-intensive manufacturing process, it can produce a greater number of widgets at a lower variable cost. Given the greater fixed costs, the cash flows are only $5 million in an unfavorable economy with the capital-intensive process but are $170 million in a favorable economy. Hence, equity holders would receive $100 million in the good state of the economy ($170 million -$70 million) and zero in a recession because $5 million is less than the $70 million debt obligation. Can the firm issue equity to fund the project?

Term Project

Students will form teams of four or five persons. Each team will first come up with a topic for a team project. The topic for this project will be one that looks at the inter-relatedness of finance and non-finance decisions. The key is whether it’s possible for the finance decision and the non-finance decision to be taken independently or if they need to be co-ordinated. If they need some kind of co-ordination, then the two decisions are inter-related. For example, during the course of the term, we will be looking at how capital structure decisions and hedging decisions affect various non-finance decisions, such as marketing strategy, personnel decisions, investment decisions, product quality decisions etc. These are all possible topics for your paper.

Here are some factors that are relevant to corporate success and which might be affected by the firm’s financial decisions:

• Flexibility
• Commitment
• Willingness to take risks
• Impact on the agency problem between managers and shareholders (i.e. alignment of managers' objectives with the goals of the firm)
• Timely access to resources
• Satisfied work force

You should have several parts to the written report, which should be about 20 pages (double-spaced; this is an estimate -- the length is not important, but rather the content):

• one, analysis of the interrelatedness of the financial decision and the non-finance decision. See if there any published research papers/media articles on this topic. If there are such articles, then review them and explain the implications of the articles for your topics.
• two, find examples of actual firms/ actual situations that demonstrate the importance of the interrelationship that you are investigating.

Keep in mind the distinction between cross-sectional regressions and time-series regressions. Present graphs wherever relevant.

• Cross-sectional regressions explain differences between behavior at the firm-level. Each observation in such a regression typically pertains to a firm. Thus, if you have a regression that explains capital-structure choices for firms, you may have 30 observations in your sample, each observation pertaining to one firm and containing information about the firm's debt-assets ratio, R&D expenditures, proportion of intangibles to total assets etc.
• Time-series regressions explain how a single economic unit behaves (often, over time). Thus, you may have 15 annual observations on the change in a firm's debt-to-assets ratio and changes in its R&D expenditures. If you regress the first variable on the second variable, you may find that the firm's change in R&D expenditures is related to the firm's financial leverage. Of course, regressions indicate relationships which may or may not be causal.

Endoegeneity, Causality and Correlation

In this course, we are investigating the impact of financial decisions on operating and other non-financial business decisions. We are _not_ investigating the impact of operating decisions on financial decisions. This is taught in Advanced Corporate Finance courses. Thus, we are not interested in the fact that firms might finance R&D using equity rather than debt. As a result, there is often a high correlation between capital structure and R&D. We are interested in firms that for exogenous reasons change their leverage and as a result adopt more aggressive or less aggressive R&D strategies. In other words, we are not looking at correlations alone, we are trying to demonstrate the causal relationship running from capital structure (or financial hedging) to operating decisions.

Evaluation Rubrics:

Here are some rubrics that I will be using in evaluating your paper:

• Do you have a literature survey? How well have you described the literature in this area? Have you related it to the concepts and theories described in the course?
• Do you explain your sample selection methods? Have you explained where you get your data from? Did you look at your data to make sure that there were no "wrong" numbers? Are your results excessively dependent on a few data points? Did you look at the scatter plot? Have you used the right technique of analysis? Have you interpreted your results properly?
• Does you paper have a clear layout of the hypotheses that you're testing and the reason why you are looking at those hypotheses? Are you hypotheses poperly grounded in theory?
• Have you included a layout of the paper and a roadmap for the reader? Does your paper flow properly? Have you simply assigned different sections of the project to different team members with nobody to oversee and edit the final version? Do you use the first person singular as a result in parts of the paper? Do I feel like I am reading several papers just stitched together?
• Do you give examples from actual firms and events to illustrate (not to prove, necessarily) your conclusions?
• Do you cite sources throughout the paper? Do you have a proper bibliography?
• Do your paragraphs relate to each other? Do your paragraphs have no more than one (or two) main points or are they a hodge-podge of ideas?
• Have you run your paper through a spelling and grammar check? Did you go to the Writing Center to get the help of an editor?

Some topics for projects:

• Which firms/industries that should overhedge their risks? Which firms should underhedge their risks? (See Hedging Strategy slides.)
• How do firms change their competitive strategies when they take on a lot of debt (or when they reduce their debt a lot)? (Look for firms that have actually changed their leverage significantly. Look at their 10Ks to check this; don't just look at their D/E ratio, since this can change due to a change in the market value or book value of their equity.)
• Here are some companies that hedge. Look at their 10K filings and other information and explain why they hedge. You can search for other firms that hedge; this is only a small sample.
  • Rolls-Royce (The Perils of Prudence, The Economist, June 18 2009)
  • Thyssen-Krupp (The Perils of Prudence, The Economist, June 18 2009)
  • 3-M (The Perils of Prudence, The Economist, June 18 2009)
• Free Cash Flows & Advertising: how does the availability of free cashflows affect the advertising budget, considering that higher financial leverage means lower free cashflows, all other things being the same. How does a firm's capital structure affect its market share? Does a firm's capital structure affect its profit margins? What happens when a firm's capital structure pushes it into financial distress? How are its operating policies affected?
• Impact of Capital Structure on Advertising
  To look at the relationship between a firm’s capital structure and the intensity of its advertising efforts.  The hypothesis is that as a firm increases its debt, it will scale back its advertising and marketing efforts
• Leverage and Employment
  Leverage has a negative impact on a firm’s employee levels. Over-leveraged firms lay-off more workers in order to reduce cash outflows.
• Leverage and R&D
  As a firm’s leverage increases, what happens to R&D? According to some theories, it decreases
• Free Cashflows and Advertising
  As the availability of internal cash improves, firms might invest more in advertising
• Free Cashflows and R&D
  As the availability of internal cash improves, firms might invest more in R&D
• Capital Structure and Market Share
  Hypothesis: Highly leveraged firms lose market share over time
• Does Leverage affect Profit Margins?
  The hypothesis is that firms with high leverage will try to produce more and keep profit margins low in order to compete better because they are under pressure to obtain enough cashflow to pay off creditors.
• Working Capital and Supplier Diversification
  If it is difficult to obtain working capital, firms might choose to diversify over suppliers to obtain more control over payments.
• Working Capital and Marketing/Merchandising Strategy
  The greater working capital availability (particularly from suppliers), the easier it will be for the firm to provide credit to customers.
• Working Capital and Production Strategy
  The greater the availability of working capital, the longer can the production cycle be.
• Working Capital and Inventory Policy
  The easier it is to obtain funds, the longer will firms keep stock in inventory; this will affect merchandising, as well.