This action might not be possible to undo. Are you sure you want to continue?
Industry Analysis, Financial Policies and Strategies
After reading this chapter, you will be conversant with: • • • • Principal Agent Conflicts Theories of Agency Cost Executive Compensation Design Joint Ventures and Strategic Alliance
but they are unable to raise the required capital from outside investors due to their lack of creditworthiness. highly levered and capital intensive. on one hand. then the very nature of the equilibrium may be different. These evidences may include the correlations between the profitability of the firm. Thus while. one being the labor intensive that involves zero initial investment but carries a higher variable cost of production and the other being the more capital intensive technology. Now these foregone investments having positive net present values. which is another form of entry barrier. and risk and in turn the financial policies and strategies. Thus it can be said that one can find concentration of firms even with marginally small cost of entry. Further it has been seen that if the firms within the industry operate and compete in a product market. This foregone investment is the result of the competition existing within the industry and not a case of isolated investment. Williams had formulated a model relating to industry equilibrium that takes into account the agency costs due to both the shareholder management as well as the shareholder creditor conflict.Strategic Financial Management Keeping in mind the framework within which a firm operates there are certain factors that affect the firm’s profitability. the more labor intensive firms can have negative NPVs after taking into account their cost of entry. and then based on his firm’s capital structure. a manager reduces his personal welfare. normally results have been derived by viewing a firm in isolation rather than considering the industry as a whole in the equilibrium state. PRINCIPAL AGENT CONFLICTS IN INDUSTRY SETTING Studies in corporate agency have yielded certain new dimensions. 120 . more labor intensive in nature. In the model propounded by Williams. The decisions that are taken in the organization reflect the features and dynamics of the industry as a whole rather than the company as such. There will always be certain firms that possess the potential to raise external capital so as to carry on the profitable capital investments. the following consequences can be observed. Say for example. Though it is known that the cost of entry converges to zero. With the existence of these two critical parameters some of the firms get into the equilibrium by way of foregoing the investments with their net present values. which may fail to earn profits and thus make an exit. whereas there will also be the existence of firms which cannot avoid their dissipative perks and so cannot pursuit such ventures. At the same time there will always be some optimal debt for the capital-intensive firms though this level of optimal debt may vary from one firm to the other. the resulting industry will be characterized by the firms that are large in size. as well as having high profitability on the other hand. The capital intensive firm raises capital by means of selling bonds and stocks in a perfectly competitive capital market. Apart from a few stray cases. The model states that each of the firms within the industry can produce a homogeneous product with the help of either of the two available technologies. there will be firms that are smaller in size. there will be certain capital-intensive firms that will continue earning extraordinary profits and at the same time there will be labor intensive firms. relatively unprofitable with almost very less degree of leverage. But on the other hand. The capital-intensive firms are characterized by larger size and less of risk involvement as compared to the labor intensive investments. William had earlier postulated that the equilibrium in an industry shows the effect of agency cost of managerial discretion on capital investment. the capital-intensive firms earn positive profits in equilibrium. its physical capital as well as the book value of the debt. It is to be remembered that more and more managers would like their firms to invest. The main reason that can be attributed to this is the access to capital. he may go on picking some excessively risky projects thus sacrificing profitable projects and consuming dissipative perks. This is a clear suggestion of the fact that these standard predictions lack the well defined empirical content. Thus it can be safely said that there is yet much to be seen on how the theoretical concept can explain the limited evidence on the financial and industrial structure.
be it through an auction or any other form of sale.Industry Analysis. Such a situation can involve substantial private as well as social costs. i. It is to be noted that the industry itself might have an optimal debt capacity even when the individual firms might not. the asset liquidity and in true the optimal debt levels change over time. ii. In the following sections. iii. These factors include antitrust enforcement and the influx of foreign buyers as well as of an important self reinforcement component. which ex ante signifies a private cost of leverage. If the cash flow volatility is held constant. This leads to the fact that the assets are forced to be sold at a price that is much below its price when it was best in use. The paper is built on the premise that the distress and failure are more likely to occur where the entire industry within which the firm operates is in distress. It is not always necessary that the asset liquidation process. Financial Policies and Strategies Dynamics of Asset-Liquidity and Financial Strategy Sheifer and Vishy in their theoretical paper focuses on the problem of liquidating the assets of a firm that are under distress as well as a firm that has gone bankrupt. iv. the example of asset buyers is taken in order to explain the variation in debt capacity across the industries as well as over the business cycle. The paper further concludes that the optimal level of debt or rather leverage of any firm is dependent on the leverage of other firms in the industry within which it operates. the cyclical as well as the growth assets have a lower level of debt finance. when they go out in times of industry wide recession or in times the industry buyers cannot bid for the assets due to industry set guidelines. The liquid market for division was a result of certain exogenous factors. As a result. A firm which is undergoing financial distress has the need to sell off its assets. following on the same line. The theoretical paper as stated earlier focuses on economy and industry wide determinants of asset liquidity. This may result in those assets that have no alternative use fetching prices below the value in best use. Let us now shift our focus towards the several theoretical and empirical studies that consider the firm’s financial decisions as an integral part of its overall competitive strategy. The following conclusions could be drawn from the paper. As per the statistical evidences. the multi decimation firms and the conglomerate firms have a higher optimal debt level at the same level of cash flow volatility. v. further the discussion concerns the rise in the US corporate leverage in the 1980s. This makes the value of the assets much cheaper in bad times. The asset liquidity limits the optimal debt levels. 121 . Let us here probe into what actually determines the liquidation value of the assets with a stronger focus on the potential buyers of the assets. The positive prediction made on account of liquidity and debt capacity resulted in the same. One of the integral components that determine the cost of financial distress is “asset liquidity”. allocates the asset to the users of highest value. there has been a consistent increase in the leverage of companies during the 80s both by firms involved in corporate control transactions and by other firms too. The major reason that can be cited for this is the liquid market for corporate divisions. The analysis of the paper is more closely related to the tradeoff theory from the point of view of an industry. its industry peers also might undergo similar problems.
Here the ten levered rivals refer to those firms that have long purses. from the industry. This argument states that the firm’s board should compel the issue of debt so as to soak up free cash flow and thereby frustrate the management’s incentives to overinvest. This vulnerability may be the result of the increase in leverage. But it is also to be kept in mind. This model gives several interesting insights relating to the capital structure of the firm in the industry. The first can be referred to as “leverage aggressiveness hypothesis” or strategic commitment. developed by Fester (1966). This model has its implications for a firm’s optimal capital structure. This particular hypothesis postulates that the component of leverage in a firm helps it in boosting the firm’s growth vis-à-vis to that of its industry competitors. But at the same time it is seen that the firm’s initial capital investment is irreversible. The model developed by these lets the firm enter into. the 122 . which states that the firm might deliberately go for low leverage so as to be able to pursuit major market share by adopting predatory market strategies and thereby put a major levered rival in the back seat. Compello. better known as long purse hypothesis. keeping in mind the firm’s capital structure decisions. operating in a competitive industry is required to tailor its financial policies as per its desired competitive position in the product market. as well as exit. more than that. the former was developed by Brander and Lewis (1986) and Maksimovic (1988). in their theoretical model of industry equilibrium. a firm becomes more vulnerable towards those market strategies that are aggressive in nature. goes for aggressive competition in the product markets. But due to the existence of the free rider problem. These research works have thus resulted in two principle hypothesis. Managerial Agency Cost – Cost of Competitions Aggressiveness Striking a Balance Boltom and Scharfsteen in 1990. This results in the less aggressiveness of the share’s yield in their market. via its leverage. Let us come to the other hypothesis. The ultimate result of this leads to the increase of the firm’s risk towards failure. have raised the argument that an individual firm. it is not possible for the firms to decrease the amount of debt in their capital structure in periods of time though it is possible for them to increase it. so that the debt has a net advantage over the equity capital. one has to remember that the firm should increase leverage till the time where the marginal benefits accrued due to the reduction in managerial agency cost and the marginal costs of competitor’s aggressiveness strikes a balance. comes with another hypothesis that is consistent with both the above stated strategies. Further the hypothesis speaks of a relationship that is consistent only in industries where the leverage varies widely across the firms. Retaining the Option to Increase in Leverage Another model relating to the equilibrium in a competitive industry was developed in 1997 by Fries. This hypothesis finds consistency with the leverage hypothesis by stating that the growth of a firm is positively related to its leverage. in the year 2002. The papers remind us of Jensen’s free cash flow argument as stated in 1986. So. that within the context of competitive industry. Miller and Perraudin. The main reason being. even to the extent of going bankrupt.Strategic Financial Management Leverage Aggressiveness vs Possessing a Long Purse The theoretical research paper that has come of late focuses on the effect of product market competition on a firm’s capital structure. The model is based on the assumption that the net fax advantage of debt is more than the bankruptcy costs. the firm. and the other is the “long purse hypothesis”. This hypothesis also states that the relationship between the leverage of the firm and the growth tends to get reversed in times of recession that speaks of the fact that in difficult times the levered firm may be prone to predatory market strategies of the less levered rivals.
It may happen later that this market demand fluctuates in either direction. and in turn its bankruptcy risks. In a similar discussion. Now. many of them have come out with the fact that the firm’s product quality. On the other hand. an obvious question that comes into the forefront is that. a firm can take help of a loan commitment as a strategic tool. Thus it can be said that an incumbent firm may prevent itself an entry into the industry by the increase in its leverage. If there is a substantial bankruptcy for a firm because of increased leverage. The former carries no commitment on the part of the bank to lend any additional loan amount to the firm in future.Industry Analysis. The commitment contract provides a valuable option to the firm. say the market demand rises. as a result its product warranties may be of little value to its purchasing consumers. In the former type of loan. to compete strategically in a competitive and uncertain product market. But at the same time. In a particular study mode by Phillips (1995). in brief. Let us now see how at all this issue can be explained. These industries have recently increased their financial leverage to a 123 . If viewed from another angle. and it may use this as a means of securing concessions from its employees. The author of the paper (Maksimovic) puts forth the argument that. Here. say all the firms within the industry produce their initial composite output capacity as per the current market demand. the firms maintain various options to increase the leverage in an opportunistic way. the leveraged takeovers and buyouts result in an increased profitability. So. Now. if the market demand falls. why at all a firm should pay any fee to secure a commitment contract rather than go for a security with simple loans with the banks over a period of time when the firm would require the funds. the firm can borrow immediately and even has the option to borrow any further amount in the future at a predetermined interest rate. whereas the other firms stand to lose. based on the premise that the firm operates in a competitive industry. Maksimovic in 1990. thus letting it. that is competing with its rivals in an industry. Using the Debt to Prohibit Entry As propounded by Jensen (1993) and supported by Kaplan et al. any firms that have earlier promised to outsize their output capacity may have to suffer substantial losses and may even turn out to be a failure. stated the importance of the type of loan contract that the firm may receive from a bank. those firms that are in a position to increase their output quickly will gain the market share. it can be said that the loan commitment allows a firm to be more flexible in terms of its financials. the firm is required to pay a substantial fee to a bank so as to secure a loan commitment. the firm may intentionally increase its leverage. Financial Policies and Strategies author shows that the optimal initial capital structure for a firm is depended on the demand elasticity for industry output. one being a simple loan and the other being a commitment contract. This it will do. now. where the future market demand for the industry output is not certain. in order to compete more effectively against industry rivals. at the cost of its product quality. There has been enough evidence of the existence of the effect of financial decision on the production and product market decision of a firm. Relationship between Financial Decisions and Production and Product Market Decisions Several research papers have stated that there exists a clear level of interaction between the firm’s production and product market decision with that of its financial decisions. The commercial loan contracts are basically of two types. Say for example. pricing and warranties is depended on the firm’s risk of bankruptcy. there are other models that give the same results even though their profoundness has not considered the element of tax incentive for debit. the pricing and productions decisions of four industries have been done. Let us consider here the case of a firm ‘A’. it may opt for cutting costs. suppliers or customers.
Further it was seen that. Thus it can be safely said that the rival firms operating in a particular industry should respond as a coherent unit as far as financial decisions are concerned. instead of violently engaging themselves in mutually destructive research paper. If not. 124 . At the same time it was seen that. In other words it can be said that. those firms that are in a more competitive industry puts a much greater weight on its competitive firm’s performance roped to its own performance. In three out of these four industries. The firms were found to increase their profit margins and decrease outputs. and found out evidences that were in line with their arguments. Thus it can be judged by intuition that. the incentives to the managers in order to maximize shareholder’s wealth had increased substantially. The very fact that there is absence of relative performance based incentives where the compensation decreases with rival firm’s performance can be explained from the existence of the strategic interaction within the firms. The answer that the authors of the paper give is that. The paper thoroughly examined the actual executive compensation contract. If the Reitman’s (1993) model is taken into account. if the managers in two different firms that are competing with each other are given stock options. Agarwal and Samwick have found an appropriate answer to the question as to why it is always found that the compensation contracts tend to blind the managers compensation to the firms absolute performance rather than focusing on other performance that is relative to its industry competitors. The value of the stock option is nothing once the stock’s price falls below its strike price. the relative performance incentives affect the firm’s competitive strategy in a way that lessens the returns to the shareholders. The main reason that can be attributed to the stock options in acting as a barrier towards the aggressive behavior of the management is due to its non-linearity. It seems strange in explaining the fact that the manager of high profit earning industry gets considerable amount of bonus.Strategic Financial Management considerable degree. there will be at least some chances that both of them will opt for competing less aggressively. In normal cases. The very fact that there is a need to soften the product market competition gives rise to an optimal compensation contract that gives rise to a positive effect on both the firm’s own as well as its rival performance. the firms within each of these industries increased their leverage simultaneously. This will ultimately result in greater efficiency to the firms. which reflected that the increase in leverage decreased the agency cost and also inefficient investment. it was found that the industry output was negatively related with the average debit ratio of the industry. with these leverage increasing recaps. This lets the owners of the firm to allow their managers in playing more aggressively if the competitor firm behaves similarly. but also stock options. whereas the manager in an industry that makes lower profits gets lower performance bonuses even when such lower profit making industry outperforms its competitors. but to counteract with maximizing its sales if it is faced by overly aggressive behavior. the aggressive behavior might merge from the firm’s competitors by competing in difficult situations. At the same time. the executives’ compensation contracts include incentive tools that motivate the management to either increase the firm’s earnings or its share price. the option of a particular firm will only be “in the money” if the competitor firm abstains from producing too much. Designing Executive Compensation as a Competitive Strategy It is to be remembered that the component of incentives in an executive compensation contract helps in bringing together the interest of the executive with that of the firm’s shareholders. These stock options act as a deterrent to the overly aggressive behavior of the management. it is seen that the optimal compensation plan not only includes the profit incentives and grants of stock.
Leverage can be used to create a barrier to the entry of rival firms in an industry. The first being joint venture. SUMMARY • Agency theory suggests that firms in an industry shall be grouped into two. Further it was also seen that with the announcement of horizontal alliances. in a strategic alliance there is simply the pooling of specific resources between the firms. go on for reducing the trade risk at key stages of the industry. They can reap the advantages of developing a new market. The joint ventures in fact involve a more systematically drawn arrangement that involves the creation of a jointly owned private firm. These results are suggestive of the fact that alliances add the maximum value by allowing the firms to maintain the focus of their businessmen by the use of complimentary technical skills of the similar partner firms. In a way they can be distinguished from a merger or acquisition. As a result of the asset substitution problem associated with debt. 125 • • • • • • • . when it is depressed. An industry may have an optimal debt capacity even though individual firms within the industry do not. depending upon the level of competition in an industry. they can represent a partial combination of corporate resources. capital intensive. like joint ventures and strategic alliances are becoming means to compete effectively in an industry. A firm’s leverage should be set to balance the managerial agency costs (which decreases as the firm’s leverage decreases) with the costs associated with competition in terms of product market strategy (which increases with the firm’s leverage). On the other hand. Both of these relationships take into account the sharing of some of the resources of both the interacting firms for a certain temporary span of time. Co-operative relationship among firms. and the other being strategic alliance. They can even find solutions to the inter-firm contracting problems. This happens as a result of bankruptcies and liquidations within the industry. Further. less levered and less profitable firms. let us speak about two types of co-operative relationships that have been quite often seen among two firms in a given industry. labor intensive. Ultimately. start the distribution network for the new product or service. One would consist of large. The executive compensation contracts should reflect the firm’s industry relative performance as well as absolute performance. levered and highly profitable firms and the other group shall consist of small. Hence the future expected cost of financial distress and bankruptcy increases thereby limiting the composite debt capacity in the industry. the cohesion is formed so that both the units can take advantage of competing in a more effective way in the common industry within which they operate. There have been several studies done on this which found out that the market generally reacts in a positive way to the announcement of a strategic alliance. there had been greater transfer or pooling of technical knowledge which tends to produce larger wealth effects than marketing alliances. the firms would come under two major segments –– one would consist of highly levered firms who would pursue more profitable projects and the other group shall consist of firms with low leverage and will pursue less risky projects. A firm in a competitive industry should maintain excess debt capacity as a matter of competitive strategy. Hence the assets are sold at ‘fire sale’ prices. where one finds a complete and permanent combination of the two firms. Financial Policies and Strategies JOINT VENTURES AND STRATEGIC ALLIANCES As we were almost close to our discussion on the financial strategies and policies in the contract of an industry.Industry Analysis.