Evaluation of Wards and Benders Model of Corporate Financial Strategy - Term Paper Example

Evaluation of Wards and Benders model of corporate financial strategy Name: Professor: Institution: Course: Date: The corporate financial model is a practical guide on how one can use corporate finance to add value to a company. By explaining the elements of financial strategies shows how they can be tailored to meet the needs of the business and consequently compliment its business strategy. The main goal of every business is to create value for it’s for the stake holders and especially the shareholders. Although all stake holders are important, the shareholder is the principal stakeholder of the company and there for all efforts should be made to create a sustainable shareholder value (Rappaport 1998 p 1). For a company to create this value, it must be able to create a competitive advantage so as to exploit all inconsistencies in the market in which it operates. In order to understand the concept of corporate value, it is important to understand issues of perceived risks and the required investment (Bender & Ward 2009 p 4). This essay will focus on determining how financial strategies can be used to identify and exploit value creating opportunities, the relationship between perceived risks and returns, the financial instruments to be used at each stage of the company’s life cycle and why, the limitations of the product life cycle and how the port’s model can be incorporated in the Product life cycle. A financial strategy basically focuses on the financial aspect of strategic decisions and offers a close link between the capital market and the interest of the shareholders. Just like the best corporate and competitive strategies, a sound financial strategy takes into account all external and internal stakeholders of a company (Ogilvie 2009 p3). A financial strategy has two basic components namely rising of funds needed by the business in the most appropriate way and managing the allocation of those funds in the business. When it comes to raising funds in the most appropriate manner, one must take into account the requirements of the key stake holders as well as the strategy of the organization in overall (Bender & Ward 2009 p 5). It’s important to note that the most appropriate way of raising fund may not necessarily be the one with the lowest cost and since the principal objective of a financial strategy is create value, this may not necessarily be achieved by lowering the costs. In employment of funds, we include decisions related to reinvesting or distribution of profits generated by the organization. It is also important to keep in mind that the principle objective of an organization is to come up with a sustainable competitive advantage which will help it to achieve an acceptable, risk-adjusted rate of return for all its key stakeholders, and the most effective way to gauge the success rate of a financial strategy is to check the contribution made to the company’s overall objective ( Bierman 1999 p5). One of the fundamental principal that underlies the financial theory is that all investors will demand a return that is equivalent to the risk they perceive in the investment. Market forces in a perfectly competitive market dictate that investors can only receive their risk adjusted rate of earnings and consequently, no shareholder value is created. It is therefore clear that to create shareholders value, can only be done by exploiting all the imperfections in the market place which arise in products markets where the products are actually sold to the customers. Theoretically, in a perfectly competitive market, the portfolio of projects which make up the firms can only receive the risk adjusted return which is required by the investors. The modem theory of corporate finance indicates that the investor will not even be compensated financially for any unnecessary risk taken by the company or even for the expenditure incurred by the managers. On financial theory, the investors can diversify the risk by developing an appropriate portfolio of different investments which will reduce their dependence on the performance of a single company (Sanwai 2007 p 4). Companies can increase this shareholders value by developing a sustainable competitive advantage through selection and implementation of effective competitive strategies. The diagram below is known as the risk- return line and shows the expected return for any given level of risk. Increased returns more than risk (A) Increased Return Rate of but increased Return risk (B) Reduced risk More than returns(C) Perceived Risk Source: Bender & Ward (2008 p 13). As indicated in the figure above, any strategic move which is above the risk- return line will create shareholders value and consequently, any move below the risk –return line will destroy the already existing value. It is not simply about increasing returns or reducing risks but it is about the level of the increased returns in comparison to the increased perceived risk and vice versa. Adopting strategy A will be beneficial to the shareholder since it value enhancing and will increase the returns by more than the risk profile associated with the investment. Adopting strategy B is value destroying to the investor and even though the increased returns are increasing, the rise in risk disproportionally moves the shareholders value below the risk-return line. In this case, markets might be fooled for some time by the increase in profits after which the increasing nature of the risk will eventually reduce what had been realized and hence reduce the share prices. And finally in adopting strategy C, although it’s clear that it should add value as it is above the risk- return line, many investors have difficulty understanding why companies on reduce profitability while still adding value. However, this is a common tactic and legitimate especially in instances where companies buy insurance policies which reduce profits but safeguard risk (Bender & Ward 2009 p 5). The fundamental principle is that businesses have to take risks since without risks there will be no rewards or opportunities. However taking too much risk could destroy the business. Risks come as a result of financial strategies and business activities and for this reason, the decision on how much of the financial risk a business will take depends on the business characteristics. The figure below shows that a combination of high financial risks (borrowing too much) and high business risks is foolhardy and is not recommendable. For that reason, quadrant 2 should be avoided just like Quadrant 3 where low-risk businesses usually reduce the cost of capital through taking on more borrowing. Balancing the financial risks with the business risks is the most recommended position. Matrix of financial and business risk High Business Risk Low Low Financial Risk High Low Financial risk High A firm’s business and the financial strategies must operate alongside each other to deliver shareholders value. To succeed doing this, it is useful for its advisors and directors to understand how the shareholders expect to achieve this value and these expectations can be described using profit/earnings (P/E ratio) ratio. P/E Ratio measures the current market price in relation to it earning per share. The ratio points out the growth that the market expects where a lower P/E ratio reflects low growth expectations while a high P/E reflect that a company will have a high growth thus satisfying the shareholders expectations. The figure below shows the relationship between P/E ratio and market perception of growth. Earnings per share High plc Low plc Current eps Time Source: Bender & Ward (2009 p 31) The figure shows two companies that currently have the same earns per share (eps). One company has a high P/E ratio and is expected to have a high plc while the other company has a low P/E ratio and is expected to have a low plc. (Bender & Ward 2009 p 31) P/E ratio not only reflects that company’s expected growth prospects but also indicates the market’s view of its risk profile. This implies that P/E ratio is affected by both the cost of equity and the forecast growth. If growth rises, P/E goes up but the cost of equity rises, the P/E ratio goes down (Eugene et al 2008). If the market perception of a company’s risk increases, the discounted value of its future cash flow will be lower thus its prices will fall and as a result the company will trade on a lower P/E ratio. Also, an increase in esp. which is driven by taking on excessive risk can cause the share price to fall further than raising (Smithson 1998) It could be expected that the P/E ratio might rise if the dividend payout was increase (paying a higher ratio of the profits to the shareholders can have an impact on prices). However, this statement is wrong. The funds that are generated by the company can be used to either reinvest in the future growth of the business or to pay dividends. If the company decides to increases its dividend payout ratio and this means that less money will be left behind to reinvest in the business which implies that future growth will be less what was anticipated (Bender & Ward 2009 p 33). Business risk can be evaluated using a basic product life cycle model through adapting it to the company and its various divisions. This model shows how sales increase as the company is developing. The figure below shows the annual level of cash flow, profits and sales in a business over the lifecycle. (Bender & Ward 2009 p 46) Expanded life-cycle model Launch Growth Maturity Decline £ Sales Profit 0 Cash flow Time Source: Bender & Ward (2009 p 46) In the early stages of the cycle, the company is likely to be making losses but as it goes through the growth stage, it will start to make profits but could still be receiving negative cash as the company invests in the fixed assets and working capital which is need to sustain the rapid growth. It is only when the business enters the maturity stage that cash flow reflects profitability. Once the business has entered the decline stage, profits and sales decline but the cash flow remains positive little ongoing investment is needed (Bender & Ward 2009 p 46). It is possible to integrate the life cycle model and the business risk to develop a financial strategy. In the early stages of the life cycle, the business is risky since there are so many unknowns and this being the case, it is not wise to finance this risks using debts as this would increase the overall risks and increase the overall cash flow which are cash negative already. For this reason, it is advisable to finance the launch stage using equity which is prepared to face a high risk. The business is still risky during the growth stage and managing rapid growth is quite a difficult task and for this reason many companies are not able to grow through this stage successfully. Using debt to finance this stage is also not advisable and companies should use equity which is obtained from the capital market. During maturity stage, the business stabilizes and the risks reduce and the overall cost of cost is expected to expect to go down as the company resort to taking cheap debt to replace expensive equity capital. During the decline stage, the business risk is low and the financial risk is high and for that reason, the company can borrow (Bender & Ward 2009 p 47). The dividend strategy is also expected to change over the life cycle. During the early stage of the life cycle it is not wise to start paying out dividends to the shareholders since the company is barely making profits and at this stage, the company needs to keep aside as much money as possible to safeguard against the risks it will face. Also, at this stage, cash is negative and paying out dividends to the shareholders would means that this cash have to be replaced through more investment in the equity which is pointless (Gibson & Charles 2008). Growth prospects are high in this stage, another reason why the company should not pay out dividend to the investors since they stand to gain more should their earnings be reinvested. Similar case applies to the growth stage where companies do not payout dividends. However some companies at this stage have nominal dividend payout as a signal to the investors of better things to come. Companies in the maturity stage are at a less risky position but still need less investment. With few opportunities of growth, much less investment and working capital is needed, the company should increase the dividends of the shareholders. At the decline stage, there are no growth or investment opportunities and the company should pay out the maximum payable dividends to the shareholders (Bender & Ward 2009 p 47). The P/E ratio and the share prices also changes over the life cycle stages. P/E ratio of company indicates the market expectation of its growth and it is for this reason the growth potential of a company decreases over the lifecycle and so does the P/E ratio (Martin et al 1994 p 25). At the start of the cycle, the Earnings per Share (EPS) and turns positive as the company’s profits are growing. All this factors put together, will affect the share price depending on how investors perceive future prospects. In the early stages of the life cycle, the company’s share price will be relatively volatile which a reflection is of the change in expectation of the profit potential and risks. However, when the company matures, the expectations will stabilize and the share prices will increase. Combinations of all this aspects that reflect the change of the financial strategies over the life cycle are summarized in the diagram below. Growth Finance risk low Funding equity Business risk high Dividend payout nominal Growth high P/E high eps low Share price growing and volatile Launch Financial risk very low Funding equity Business risk very high Dividend payout nil Growth very high esp nominal P/E very high Share price growing and highly volatile Maturity Business risk medium Financial risk medium Funding debt Dividend payout high Growth medium/low P/E medium Share price stable with limited volatility eps high Decline Business risk low Financial risk high Funding debt Dividend payout total Growth negative P/E low eps declining Share price declining and volatile Source: Bender and Ward (2009 p48) This model has been criticized in the past on several grounds (Levitt 1965). To begin with, it has been questioned how a product life cycle can be simply extended into a company’s life cycle. For many, this extension has made it look simplistic and to others, the extension is not possible all together (Kevin et al 2004). There is also the criticism on the model Ward used; the product life cycle model while there are other important models that could have been used such as the porter’s five forces, generic strategies, resource-based theories and the value chain model (Box, 1983). The product life cycle in itself has been under criticism. While it is known universally, it has not been widely accepted. Many people think it’s absurd to compare the life expectancy of living things with the average life of brands given that most new products merely go beyond 3 years while others go for over 100 years. Well managed brands could live forever and even if brands die, they could still rise again in future unlike living things (Day 1981). The Product Life Cycle confuse marketers since this concepts states that different strategies should be used for every stage of the lifecycle and that all a marketer needs to do is to find out the stage at which the product is and apply the relevant strategies to maximize its profits at that particular stage(Kevin et al 2004). This may sound easy but researchers have identified over 17 patterns including the S –curve, cycle recycle pattern, growth-slump-maturity pattern and others. It is difficult for a marketer to identify which pattern fits his or her product and hence it is difficult to know whether the product is in decline (Gorchels 2010). The product could just probably be experiencing a slight decline before making a dramatic increase during the growth period. It’s also important to note that the recommended actions for each stage are based on observations made from other companies (Kevin J & Clancy 2001). This is not necessarily correct since it may or may not work for your brand and it is not directly linked to profitably. The model also does not provide that your company will necessarily fit in the four stages of the life-cycle (Kevin et al 2004). It is possible to integrate the Product Life cycle with the Porter’s five forces model to come up with the Porter’s bulge (Owen 2010). In launch stage, there are high levels of business mortality, high risk since everything is unknown, small team who are well motivated, informal communication and clear leadership. During the growth stage, the following activities occur; co-ordination is more difficult, management processes e.g. staff reviews, competition for market share, financial control e.g. budget, training and recruitment more formal, more formal communication and strategic options are considered. Also during this stage, entry and rivalry from porter’s model are experienced where new entries are attracted which leads to rivalry and eventual shake out (Owen 2010) Porter’s Bulge Source: Owen (2010) In the launch stage, the firm aims to build product awareness and develop a market for the product through product branding, distribution and promotion. The prices for this product may be low so that they can build market share rapidly or high price to recover the development costs (Gorchels 2010). As a result of these activities, the market share of the company increase since customers is aware of this product and this increases the company’s revenue’s. Due to this grow; other new entries are attracted to join the industry since the product is going well in the market. The new entries will develop products that act as a substitute to the original brand and this lowers the market share due to decreased sale for the original brand (Owen 2010). There will be rivalry among these brands since they target the same market and each brand will develop strategies that will aim at increasing its market share and kick out other brands. Due to this intense competition among brands, some brand may be shaken out of business since they can not cope with the competition while the remaining brands will defend their market share and at the same time maximise profits. Finally, the brands will reach the decline stage and the companies may decide to harvest the brands, add new feature or discontinue them. (Quick MBA 2010) In conclusion, corporate financial model is a practical guide on how one can use corporate finance to add value to a company. The main goal of every business is to create value for it’s for the stake holders and especially the shareholders. Although all stake holders are important, the shareholder is the principal stakeholder of the company and there for all efforts should be made to create a sustainable shareholder value. Company have to consider the risk involved in undertaking activities in the company, the P/E ratio and Dividend payout when making key decision on product life cycle. Ward’s model outlines the financial strategies available in each stage of the product life cycle. It is possible to integrate the Product Life cycle with the Porter’s five forces model to come up with the Porter’s bulge References Bender R & Ward K, 2008, Corporate Financial Strategy, 2nd Edition, Macmillan; Britain Bierman H 1999, Corporate Financial Strategy and decision making to increase shareholders value New Hopes: United States of America Box, J. 1983, Extending product lifetime Prospects and opportunities, European Journal of Marketing, vol 17, 1983, pp 34–49 Day, G. 1981, the product life cycle: Analysis and applications issues, Journal of Marketing, vol. 45, Autumn 1981, pp 60–67 Eugene F, Brigham, Joel F and Houston 2008, Fundamentals of financial management , 12th Edition, Cengage Learning: London Gibson & Charles H 2008 Financial Reporting and Analysis 2nd Edition, Cengage Learning: London Gorchels L 2010, the Product Manager's Handbook: The Complete Product Management Resource Retrieved on 24th March 2011 from http://www.amazon.com/exec/obidos/ASIN/0658001353/quickmba Kevin J Clancy & Peter C 2004, Product Life Cycle: A Dangerous Idea Retrieved on 24th March 2011 from http://www.copernicusmarketing.com/about/product_life_cycle.shtml Kevin J & Clancy 2001, Counterintuitive Marketing Strategies for Branding Financial Services Online Retrieved on 24th March 2011 from http://www.copernicusmarketing.com/about/financial_services.shtml Levitt, T 1965, Exploit the product life cycle, Harvard Business Review, vol 43, November-. 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