Dr. P.V. Viswanath

pviswanath@pace.edu

• Discussion Board Assignments
• Porter Model Analysis
• Dupont Analysis of Articles
• Dupont Analysis of Firms
• Questions on the Short-sighted investment problem
• Risk Management at Apache
• Term 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 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. managers are more committed to the goals of the firm)
• Timely access to resources
• Satisfied work force

If you can think of a connection between a financial decision and one of these factors, you have a topic for your project!

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.

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.)

Companies that hedge:

Here are some companies that hedge. Look at their 10K filings and other information and explain why they hedge.

• 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)

Porter Model Analysis

Go through the Porter Analysis slides and answer the questions in those slides. 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. 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.

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 firms. 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. 

Alternatively, you can pick one firm and show how its marketing strategy has evolved over time, using the same guidelines as above.

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?

Questions on the Short-Sighted Investment Problem

Answer the questions on slide 11 of Capital Structure and Stockholder Incentives

1. We can see that the firm will not be bankrupt even if 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?
2. Why issue junior debt?  Why might there be a covenant preventing the firm from raising new debt with equal seniority to existing debt?
3. What if the firm could issue such debt?  Would the firm then end up choosing the long-term project?