3.3 Financial strategy

Financial strategy examines the financial implications of corporate and business-level strategic options and identifies the best financial course of action. It can also provide competitive advantage through a lower cost of funds and flexible ability to raise capital to support a business strategy. Financial strategy usually attempts to maximize the financial value of a firm.

The trade-off between achieving the desired-to-equity ratio and relying on internal long-term financing via cash flow is a key issue in financial strategy. Many small- and medium-sizing family-owned companies such as Urschel Laboratories try to avoid all external sources of funds in order to avoid outside entanglements and to keep control of the company within the family. Many financial analysts believe, however, that only by financing through long-term debt can a corporation use financial leverage to boost earnings per share-thus raising stock price and the overall value of the company. Research indicates that higher debt levels not only deter takeover by other firms (by making the company less attractive) but also lead to improved productivity and improved cash flows by forcing management to focus on core businesses.

Research reveals that a firm’s financial strategy is influenced by its corporate diversification. The recent trend away from unrelated to related acquisitions explains why the number of acquisitions being paid for entirely with stock increased from only 2% in 1988 to 50% in 1998.

3.3 Financial strategy

A very popular financial strategy is the leveraged buyout (LBO). In a leveraged buyout, accompany is acquires in a transaction financed largely by debt, usually obtained from a third party, such as an insurance company or an investment banker. Ultimately the debt is paid with money generated from the acquired company’s operations or by sales of its assets. The acquired company, in effect, pays for its own acquisition. Management of the LBO is then under tremendous pressure to keep the highly leveraged company profitable. Unfortunately, the huge amount of debt on the acquired company’s books may actually cause its eventual decline by focusing management’s attention on short-term matters. One study of LBO’s (also called MBOs [Management Buy Outs]) revealed that the financial performance of the typical LBO usually falls below the industry average in the fourth year after the buyout. The firm declines because of inflated expectations, utilization, of all slack, management burnout, and a lack of strategic management. Often the only solution is to go public once again by selling stock to finance growth.

The management of dividends and stock price is an important part of a corporation’s financial strategy. Corporations in fast-growing industries such as computers and computer software often do not declare dividends. They use the money they might have spent on dividends to finance rapid growth. If the company is successful, its growth in sales and profits is reflected in higher stock price, eventually resulting in a hefty capital gain when shareholders sell their common stock. Other corporations, such Maytag Corporation, that do not face rapid growth must support the value of their stock by offering consistent dividends. Like Maytag, they may even go into debt to finance these dividends.

3.3 Financial strategy

A number of firms are supporting the price of their stock by using reverse stock splits. Contrasted with a typical forward 2-for -1 stock split in which an investor receives an additional share for every share owned (with each share being worth only half as much), in a reverse 1-for -2 stock split, an investor’s shares are split in half for the same total amount of money (with each share now being worth twice as much). Thus, 100 shares of stock worth $10 each are exchanged for 50 shares worth $20 each. A reverse stock split may successfully raise a company’s stock price, but does not solve underlying problems. A study by Credit Suisse First Boston revealed that almost all 800 companies that had reverse stock splits in a five-year period underperformed their peers over the long term.

A recent financial strategy being used by large established corporations to highlight a high-growth business unit in a popular sector of the stock market is to establish a tracking stock.

A tracking stock is a type of common stock tied to one portion of a corporation’s business. This strategy allows established companies to highlight a high-growth business unit without selling the business. By keeping the unit as a subsidiary with its common stock separately identified, the corporation is able to keep control of the subsidiary and yet allow the subsidiary the ability to fund its own growth with outside money. It goes public as an IPO and pays dividends based on the unit's performance. Because the tracking stock is actually an equity interest in the parent company (not the subsidiary), another company cannot acquire the subsidiary by buying its shares. Examples of corporations that use tracking stocks as part of their financial strategy are AT&T (AT&T wireless), Sprint (Sprint PCS), JCPenney (CVS Drugs), and Staples (Staples.com).