You are the Chief Financial Officer of a large publically traded U.S. based manufacturing corporation with annual sales revenues of over $2 billion. You hold a dominant market share position in your industry and the vast majority of your sales take place in your home country, the United States. Your firm’s strengths are its technical manufacturing expertise and a very efficient supply chain management system. All of your manufacturing locations in various parts of the country are non-union. Over the last decade, the market for your firm’s products has exhibited slow growth and the majority of your revenue increases have come from taking market share away from your competitors. While this has been a successful strategy, it has been a high cost – low margin proposition. This strategy combined with the a recent economic recession has left the company in a weaker than normal financial situation. Cash reserves are low and both short and long term debt is higher than what the firm would usually consider acceptable but current low rates that have been locked in have kept interest expense manageable. Projections are for both long term and short term interest rates to rise. The firm’s debt rating was downgraded last year by the ratings agencies and is now at the bottom of investment grade. The stock price of the firm has recovered from its low during the recession but has not increased at the same pace as the general stock market over the past two years. Shareholders are unhappy with the lack of movement in the stock price and are demanding management take action. The company pays a small dividend which it can cover with existing earnings.
The CEO of your firm has decided that it is time for the firm to explore entering new markets and/or look at acquisitions to get the company back on the growth track. He has tasked the leaders of your organization to bring forward ideas and options which have been narrowed down to two. He is looking for a recommendation from you as CFO on one of the following two options.
Option 1
This option is favored by the VP of Operations. It involves entering a new market that is similar to your firm’s primary market. It involves proven technologies that are certainly within your firm’s manufacturing, engineering and distribution capabilities. It also is a slow growth, lower margin industry and it is composed of many smaller manufacturers most of whom are unionized. The VP feels that within 5 years your firm would be well established, turning a profit and have made significant progress in becoming the dominant player in the industry. The project just meets your firm’s IRR hurdle and since there are few unknowns in this option, the likelihood of success is high and this business would become a steady but not spectacular contributor to the bottom line. There is a high level of confidence in the cash flow projections and the perceived risk level is low. Your biggest decision in this option is whether to begin operations as a new start-up venture or expand through a series of takeovers or acquisitions of the smaller competitors.
Option 2
This option is favored by the VP of Marketing and Sales. It involves entering a market that is very different than the one you are in currently. It is in a fairly new, high growth, potentially very profitable area. The projected returns far exceed your company’s IRR hurdle but cash flow projections (provided by the VP) are potentially too optimistic. Your existing manufacturing skill set will be of little value in this industry. Mostly, the production and sales will take place off-shore in developing markets by contracting with low cost local manufacturers and distributors which are activities in which your company has little previous experience. Initial cash requirements to start this business will be low but could increase significantly in year three and beyond depending on how much early success is achieved. This industry is in its beginning stages so there are not any major competitors currently. This emerging opportunity is well known though and several other major corporations are thought to be seriously considering entry as well. If so, they would be formidable competitors.
Answer the following questions:
1. Recommendations. Which option will you choose to recommend to the CEO? Give 2 – 3 primary reasons for this choice. Give 2 – 3 primary reasons for not choosing the other option. Is there another option that should be considered? If so, detail the option and list your reasons for its selection.
2. Funding. Either option will require a fair amount of capital at some point in the process. Option 1 will require larger sums early in the process (years one and two) and Option 2 will require them in later years (years three and four). Given your firms below average financial situation, what funding method makes the most sense? Should you go to the debt markets and issue out bonds or go the equity markets and issue out more stock? Explain the benefits and risks to the approach you choose? Are there any other funding options?
3. Risk Assessment. In situations like this it is rare for any option to be a clear cut choice. Both options contain risks and costs some of which are given and some of which are only a possibility. Some are long term and some are short term. Detail those for both options and assign a risk level to them (high, medium, low). These could be (and likely are) both internal and external to the company. Each risk you list should be identified as short, long and either high, medium or low.
Any specific numbers answer these questions.