Advanced Financial Management Term Report

FINANCIAL VALUATION OF A FIRM IN DIFFERENT STAGES OF PRODUCT LIFE CYCLE AND MARKET STRUCTURE

Name: Muhammad Adeel Mustafa ID: 2009-1-26-10132 Submitted to: Sir Nayyar Nizzami

Financial valuation of a company in different stages of product life cycle

The product or industry life cycle of a firm consists of the following four stages. We will examine the financial value of a firm in each of the four stages: Introduction Phase Growth phase Maturity phase Declining phase

Introduction phase
Once a company has progressed beyond the initial development stage, it is in the introductory stage which can be characterized as: (i) (ii) (iii) (iv) (v) Experiencing an increase in sales. Operating at break-even or slightly better. Working capital consists of trade credit and the founders initial investments. Having a home grown management team. Still concentrating on entering the market and securing distribution.

Cash flows of a company in Introduction phase

The introductory phase occurs at the beginning of a companys life, when the company is purchasing fixed assets and beginning to produce and sell products. When a company is in the introductory stage, one would expect that the company will not be generating positive cash from operations. It will be spending considerable amounts to purchase productive assets such as buildings and equipment. To support asset purchases the company will have to issue stock or debt. One would expect cash from operations to be negative, cash from investing to be negative, and cash from financing to be positive.

Dividend policy of a company in Introduction phase

When the firm is in the introduction stage, it needs to retain its profits to finance development and growth. If any dividends to be issued to the investors, they tend to be stock dividends.

Summarized financial characteristics of a company in Introduction phase

Revenues are low Net income may be negative (losses) Negative cash flow from operating activities Negative cash flow from investing activities External financing (positive cash flow from financing)

Growth phase
A rapidly growing company is primarily concerned with developing its market and may experience any one or more of the following conditions: (i) (ii) (iii) (iv) (v) (vi) Dramatic increases in sales High operating margins Working capital and credit lines that are being exhausted by the cash required to fuel the growth The company is expanding beyond the capabilities of existing management The possibility of increased competition. Having difficulty entering certain segments of the market.

The right buyer can provide a company in the accelerated growth stage with the resources needed to sustain growth. The buyer can provide much needed working capital, management expertise, competitive strength, and expansion into new markets.Companies in the accelerated development stage make attractive acquisition candidates. At this point in the companys development, sales and earnings are still on the upward side of their curve, a situation which supports a higher valuation.

Cash flows of a company in Growth phase

During the growth phase, the company is striving to expand its production and sales. When a company is in the growth phase, one would expect to see the company start to generate small amounts of cash from operations. Cash from operations on the cash flow statement will be less than net income on the income statement during this phase. Because sales are projected to be increasing, the size of inventory purchases must increase. However, less inventory will be expensed on an accrual basis than purchased on a cash basis in the growth phase. Cash collections on accounts receivable will lag behind sales, and because sales are growing, accrual sales during a period will exceed cash collections during that period. Cash needed for asset acquisitions will continue to exceed cash provided by operations, requiring that the company make up the deficiency by issuing new stock or debt. The company continues to show negative cash from investing and positive cash from financing in the growth phase.

Dividend policy of a company in Growth phase

When the company is in the growth stage, the need of capital from investors decline as the company is generating profits. Thus the need of investment decline and the management decide to issue small cash dividends to the company stock holders.

Summarized financial characteristics of a company in Growth phase

Increasing revenues Net income becomes positive Increasing cash flows from operations Continuing negative cash flows from investing activities Decreasing positive cash flows from financing activities

Maturity phase
A mature company is primarily concerned with maintaining its share of the market and may experience: (i) (ii) (iii) (iv) (v) (vi) A leveling off of sales. Some erosion of operating margins Excessive leverage. Under-valued or nonperforming assets A sense of systemic managerial complacency. More extensive competition.

The right buyer can provide a mature company with the spark it needs in order to return to growth. The buyer may be able to provide more effective channels of distribution, improved operating margins through combined operations (economy of scale), expansion capital or credit enhancement, opportunities to increase facility utilization, a fresh managerial perspective, and a strengthened competitive position. Companies in the maturity stage also make attractive acquisitions even though they may lack the appeal of a growth company. The company has established itself in the market, has a record of earnings, and provides a foundation on which to build with the assistance of the right buyer.

Cash flows of a company in Maturity phase In the maturity phase, sales and production level off. Cash from operations and net income are approximately the same. Cash generated from operations exceeds investing needs. In the maturity phase, the company can actually start to retire debt or buy back stock.

Dividend policy of a company in Maturity phase

If the firm is successful in its maturity stage, it will tend to begin issuing regular and growing cash dividends to the stock holders.

Summarized financial characteristics of a company in Growth phase

Peak revenues Net income also peaks Positive cash flows from operations Cash flows from investing activities may begin to increase Cash flows from financing activities may become negative (repayment of debt, stock purchase etc)

Declining phase
A declining company is primarily concerned with maintaining its customer base and may experience: (i) (ii) (iii) (iv) (v) (vi) A decline in sales. Marginal or break-even operating profits Difficulty servicing debt A pressing need for capital to fuel a turnaround Difficulty retaining talented personnel Intensive competition.

The right buyer can provide a declining company with the time and resources needed in order to effect a turnaround. The declining company will likely need an infusion of capital and managerial talent. In addition, the right buyer can help provide a sense of direction and stimulate renewed commitment on the part of key personnel to help them face the immediate challenges, identify and address the cause(s) for decline, and defend the companys share of the market.

Cash flows of a company in Declining phase

During the decline phase, sales of the product fall due to a weakening in consumer demand. During this phase, cash from operations decreases. Cash from investing might actually become positive as the firm sells off excess assets. Cash from financing may be negative as the company buys back stock and retires debt.

Dividend policy of a company in Declining phase

When the company is in the declining stage, profits are declining and the company is unable to provide the dividends to the stock holders. All the cash coming from the operations will be invested back to sustain the operation and efforts in driving the company back to the growth stage.

Summarized financial characteristics of a company in Growth phase

Revenues decrease Net income decreases (may become negative) Cash flows from operations decreases Cash flows from investing activities positive (as firm divests) Cash flows from financing activities negative

Financial value of firms in different Market Structures

Pure Competition
Firms operating in perfect competition tend to have very low profits. In terms of stock value creation they tend to have negative EVAs. They need much higher capital requirements to compete with other companies. As they are not generating higher profits, the firm will be paying lower cash dividends to its investors. Products tend to be standard, unable to differentiate. Years of intense competition drive profits down. Typical industries that tend to operate in perfect competition: commodities, agribusiness, natural resources, metals, chemicals among them.

Monopolistic Competition
Firms operating in monopolistic competition have better profits, however their EVAS tend to be close to zero. Their products can differentiate, however the differentiation is mostly based on actions, which the competition can imitate. In the long run, the investment efforts are not always recovered for the reaction of the competition. Typical industries that tend to operate in monopolistic competition: manufacturing, autos, electronics, infrastructure, utilities, telecommunications, transportation, airlines, construction, commercial banking.

Oligopolistic competition
Firms operating in oligopolistic competition tend to have much higher profits, in terms of EVAs they tend to be between 4% to 10%. The company is generating positive cash flows and will give high cash dividends to its investors. Some examples are: cellular telephony, oil, some branded products, etc.

Pure Monopoly
Firms operating as pure monopoly have much higher profits, in terms of EVA it can exceed 10%.the firm is generating positive cash flows from the operations. Due to higher profits, a firm will be paying high cash dividends to its stock holders and has high retained earnings to invest back in the firm operations. Typically firms with market power such as Microsoft, Intel, and others.