Industry Analysis, Financial Policies and Strategies

Chapter VII

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

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Keeping in mind the framework within which a firm operates there are certain factors that affect the firms profitability, and risk and in turn the financial policies and strategies. 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.

PRINCIPAL AGENT CONFLICTS IN INDUSTRY SETTING

Studies in corporate agency have yielded certain new dimensions. Say for example, a manager reduces his personal welfare, and then based on his firms capital structure, he may go on picking some excessively risky projects thus sacrificing profitable projects and consuming dissipative perks. Apart from a few stray cases, normally results have been derived by viewing a firm in isolation rather than considering the industry as a whole in the equilibrium state. Further it has been seen that if the firms within the industry operate and compete in a product market, then the very nature of the equilibrium may be different. 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. These evidences may include the correlations between the profitability of the firm, its physical capital as well as the book value of the debt. 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. William had earlier postulated that the equilibrium in an industry shows the effect of agency cost of managerial discretion on capital investment. There will always be certain firms that possess the potential to raise external capital so as to carry on the profitable capital investments, whereas there will also be the existence of firms which cannot avoid their dissipative perks and so cannot pursuit such ventures. Thus while, on one hand, the resulting industry will be characterized by the firms that are large in size, highly levered and capital intensive, as well as having high profitability on the other hand, there will be firms that are smaller in size, more labor intensive in nature, relatively unprofitable with almost very less degree of leverage. In the model propounded by Williams, the following consequences can be observed. 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, 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. The capital intensive firm raises capital by means of selling bonds and stocks in a perfectly competitive capital market. 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. It is to be remembered that more and more managers would like their firms to invest, but they are unable to raise the required capital from outside investors due to their lack of creditworthiness. Now these foregone investments having positive net present values, the capital-intensive firms earn positive profits in equilibrium. But on the other hand, the more labor intensive firms can have negative NPVs after taking into account their cost of entry. This foregone investment is the result of the competition existing within the industry and not a case of isolated investment. The capital-intensive firms are characterized by larger size and less of risk involvement as compared to the labor intensive investments. 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. Though it is known that the cost of entry converges to zero, there will be certain capital-intensive firms that will continue earning extraordinary profits and at the same time there will be labor intensive firms, which may fail to earn profits and thus make an exit. Thus it can be said that one can find concentration of firms even with marginally small cost of entry. The main reason that can be attributed to this is the access to capital, which is another form of entry barrier. 120

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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. 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. The analysis of the paper is more closely related to the tradeoff theory from the point of view of an industry. 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. A firm which is undergoing financial distress has the need to sell off its assets, its industry peers also might undergo similar problems. 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. This makes the value of the assets much cheaper in bad times, which ex ante signifies a private cost of leverage. In the following sections, 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, further the discussion concerns the rise in the US corporate leverage in the 1980s. One of the integral components that determine the cost of financial distress is asset liquidity. The theoretical paper as stated earlier focuses on economy and industry wide determinants of asset liquidity. The following conclusions could be drawn from the paper. i. It is not always necessary that the asset liquidation process, be it through an auction or any other form of sale, allocates the asset to the users of highest value. This may result in those assets that have no alternative use fetching prices below the value in best use, 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. Such a situation can involve substantial private as well as social costs. The asset liquidity limits the optimal debt levels. If the cash flow volatility is held constant, the cyclical as well as the growth assets have a lower level of debt finance, following on the same line, the multi decimation firms and the conglomerate firms have a higher optimal debt level at the same level of cash flow volatility. 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. It is to be noted that the industry itself might have an optimal debt capacity even when the individual firms might not. As a result, the asset liquidity and in true the optimal debt levels change over time. As per the statistical evidences, 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 liquid market for division was a result of certain exogenous factors. These factors include antitrust enforcement and the influx of foreign buyers as well as of an important self reinforcement component. The positive prediction made on account of liquidity and debt capacity resulted in the same.

ii.

iii.

iv. v.

Let us now shift our focus towards the several theoretical and empirical studies that consider the firms financial decisions as an integral part of its overall competitive strategy.

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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 firms capital structure. These research works have thus resulted in two principle hypothesis. The first can be referred to as leverage aggressiveness hypothesis or strategic commitment, and the other is the long purse hypothesis, the former was developed by Brander and Lewis (1986) and Maksimovic (1988). This particular hypothesis postulates that the component of leverage in a firm helps it in boosting the firms growth vis--vis to that of its industry competitors. The main reason being, the firm, via its leverage, goes for aggressive competition in the product markets. This results in the less aggressiveness of the shares yield in their market. Let us come to the other hypothesis, better known as long purse hypothesis, developed by Fester (1966), 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, even to the extent of going bankrupt. Compello, in the year 2002, comes with another hypothesis that is consistent with both the above stated strategies. This hypothesis finds consistency with the leverage hypothesis by stating that the growth of a firm is positively related to its leverage. Further the hypothesis speaks of a relationship that is consistent only in industries where the leverage varies widely across the firms. 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. Here the ten levered rivals refer to those firms that have long purses.

Managerial Agency Cost Cost of Competitions Aggressiveness Striking a Balance

Boltom and Scharfsteen in 1990, in their theoretical model of industry equilibrium, have raised the argument that an individual firm, operating in a competitive industry is required to tailor its financial policies as per its desired competitive position in the product market, keeping in mind the firms capital structure decisions. The papers remind us of Jensens free cash flow argument as stated in 1986. This argument states that the firms board should compel the issue of debt so as to soak up free cash flow and thereby frustrate the managements incentives to overinvest. But it is also to be kept in mind, that within the context of competitive industry, a firm becomes more vulnerable towards those market strategies that are aggressive in nature. This vulnerability may be the result of the increase in leverage. The ultimate result of this leads to the increase of the firms risk towards failure. So, 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 competitors aggressiveness strikes a balance.

Retaining the Option to Increase in Leverage

Another model relating to the equilibrium in a competitive industry was developed in 1997 by Fries, Miller and Perraudin. This model has its implications for a firms optimal capital structure. The model developed by these lets the firm enter into, as well as exit, from the industry. But at the same time it is seen that the firms initial capital investment is irreversible. The model is based on the assumption that the net fax advantage of debt is more than the bankruptcy costs, so that the debt has a net advantage over the equity capital. But due to the existence of the free rider problem, 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. This model gives several interesting insights relating to the capital structure of the firm in the industry, more than that, the 122

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author shows that the optimal initial capital structure for a firm is depended on the demand elasticity for industry output. But at the same time, the firms maintain various options to increase the leverage in an opportunistic way. In a similar discussion, Maksimovic in 1990, stated the importance of the type of loan contract that the firm may receive from a bank, based on the premise that the firm operates in a competitive industry. The commercial loan contracts are basically of two types, one being a simple loan and the other being a commitment contract. The former carries no commitment on the part of the bank to lend any additional loan amount to the firm in future. In the former type of loan, the firm can borrow immediately and even has the option to borrow any further amount in the future at a predetermined interest rate. The commitment contract provides a valuable option to the firm. Here, the firm is required to pay a substantial fee to a bank so as to secure a loan commitment. Now, an obvious question that comes into the forefront is that, 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 author of the paper (Maksimovic) puts forth the argument that, a firm can take help of a loan commitment as a strategic tool, in order to compete more effectively against industry rivals. Let us now see how at all this issue can be explained. Let us consider here the case of a firm A, that is competing with its rivals in an industry, where the future market demand for the industry output is not certain, now, say all the firms within the industry produce their initial composite output capacity as per the current market demand. It may happen later that this market demand fluctuates in either direction. Now, say the market demand rises, those firms that are in a position to increase their output quickly will gain the market share, whereas the other firms stand to lose. On the other hand, if the market demand falls, 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. So, in brief, it can be said that the loan commitment allows a firm to be more flexible in terms of its financials, thus letting it, to compete strategically in a competitive and uncertain product market.

Using the Debt to Prohibit Entry

As propounded by Jensen (1993) and supported by Kaplan et al, the leveraged takeovers and buyouts result in an increased profitability, there are other models that give the same results even though their profoundness has not considered the element of tax incentive for debit. Thus it can be said that an incumbent firm may prevent itself an entry into the industry by the increase in its leverage.

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 firms production and product market decision with that of its financial decisions. Say for example, many of them have come out with the fact that the firms product quality, pricing and warranties is depended on the firms risk of bankruptcy. If there is a substantial bankruptcy for a firm because of increased leverage, it may opt for cutting costs. This it will do, at the cost of its product quality, as a result its product warranties may be of little value to its purchasing consumers. If viewed from another angle, the firm may intentionally increase its leverage, and in turn its bankruptcy risks, and it may use this as a means of securing concessions from its employees, suppliers or customers. There has been enough evidence of the existence of the effect of financial decision on the production and product market decision of a firm. In a particular study mode by Phillips (1995), the pricing and productions decisions of four industries have been done. These industries have recently increased their financial leverage to a 123

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considerable degree. In three out of these four industries, it was found that the industry output was negatively related with the average debit ratio of the industry. Further it was seen that, with these leverage increasing recaps, the incentives to the managers in order to maximize shareholders wealth had increased substantially. The firms were found to increase their profit margins and decrease outputs, which reflected that the increase in leverage decreased the agency cost and also inefficient investment. At the same time it was seen that, the firms within each of these industries increased their leverage simultaneously. 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. This will ultimately result in greater efficiency to the firms.

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 firms shareholders. In normal cases, the executives compensation contracts include incentive tools that motivate the management to either increase the firms earnings or its share price. If the Reitmans (1993) model is taken into account, it is seen that the optimal compensation plan not only includes the profit incentives and grants of stock, but also stock options. These stock options act as a deterrent to the overly aggressive behavior of the management. If not, the aggressive behavior might merge from the firms competitors by competing in difficult situations. 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. The value of the stock option is nothing once the stocks price falls below its strike price. Thus it can be judged by intuition that, the option of a particular firm will only be in the money if the competitor firm abstains from producing too much. This lets the owners of the firm to allow their managers in playing more aggressively if the competitor firm behaves similarly, but to counteract with maximizing its sales if it is faced by overly aggressive behavior. In other words it can be said that, if the managers in two different firms that are competing with each other are given stock options, there will be at least some chances that both of them will opt for competing less aggressively, instead of violently engaging themselves in mutually destructive research paper. 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. It seems strange in explaining the fact that the manager of high profit earning industry gets considerable amount of bonus, whereas the manager in an industry that makes lower profits gets lower performance bonuses even when such lower profit making industry outperforms its competitors. The answer that the authors of the paper give is that, the relative performance incentives affect the firms competitive strategy in a way that lessens the returns to the shareholders. The very fact that there is absence of relative performance based incentives where the compensation decreases with rival firms performance can be explained from the existence of the strategic interaction within the firms. 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 firms own as well as its rival performance. At the same time, those firms that are in a more competitive industry puts a much greater weight on its competitive firms performance roped to its own performance. The paper thoroughly examined the actual executive compensation contract, and found out evidences that were in line with their arguments. 124

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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, let us speak about two types of co-operative relationships that have been quite often seen among two firms in a given industry. The first being joint venture, and the other being strategic alliance. 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. Further, 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. They can even find solutions to the inter-firm contracting problems; go on for reducing the trade risk at key stages of the industry. They can reap the advantages of developing a new market; start the distribution network for the new product or service. Ultimately, they can represent a partial combination of corporate resources. In a way they can be distinguished from a merger or acquisition, where one finds a complete and permanent combination of the two firms. The joint ventures in fact involve a more systematically drawn arrangement that involves the creation of a jointly owned private firm. On the other hand, in a strategic alliance there is simply the pooling of specific resources between the firms. 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. Further it was also seen that with the announcement of horizontal alliances, there had been greater transfer or pooling of technical knowledge which tends to produce larger wealth effects than marketing alliances. 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.

SUMMARY
Agency theory suggests that firms in an industry shall be grouped into two. One would consist of large, capital intensive, levered and highly profitable firms and the other group shall consist of small, labor intensive, less levered and less profitable firms. As a result of the asset substitution problem associated with debt, 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. An industry may have an optimal debt capacity even though individual firms within the industry do not. This happens as a result of bankruptcies and liquidations within the industry, when it is depressed. Hence the assets are sold at fire sale prices. Hence the future expected cost of financial distress and bankruptcy increases thereby limiting the composite debt capacity in the industry. A firms leverage should be set to balance the managerial agency costs (which decreases as the firms leverage decreases) with the costs associated with competition in terms of product market strategy (which increases with the firms leverage). The executive compensation contracts should reflect the firms industry relative performance as well as absolute performance, depending upon the level of competition in an industry. A firm in a competitive industry should maintain excess debt capacity as a matter of competitive strategy. Leverage can be used to create a barrier to the entry of rival firms in an industry. Co-operative relationship among firms, like joint ventures and strategic alliances are becoming means to compete effectively in an industry. 125