Wards Model Essay Example Pdf - Free Essay Example

Sample details Pages: 10 Words: 3040 Downloads: 4 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? In their book- Corporate Financial Strategy-(CFS), Bender and ward (1995) had tried to build closer links between finance and strategy. Dealing first with CFS, it should not be considered with corporate finance as the discipline addresses a range of issues which interconnects finance and competitive strategies. In the book, they based their model with the product life cycle (PLC) by matching external sources of finance to strategies for corporate development throughout the life cycle of a company and composed financial elements mainly venture capital, debt, dividend, profit, P/E, and risk into the model. Don’t waste time! Our writers will create an original "Wards Model Essay Example Pdf" essay for you Create order In their model, they tried to describe each stage of the PLC and the effects on these financial elements throughout the stages of the company life cycle and described in details how to raise finance throughout the company life cycle and whether to pay dividend or retain earnings etc. In this article, the main purpose is to analyse each stage of their model and how these stages have effects on these elements and evaluate the model in terms of its strength and weaknesses and recommendations if any to improve the model. Bender and Wards model The use of the PLC concept as a framework to formulate and implement timely financial strategies can be justified in bender and wards model of CFS as they have adopted the same curve as PLC where the main objective is to ensure overall company profitability and maximize shareholders wealth over the life cycle. In their model, they describe optimal financial decisions that a company should take at various stages of the company life cycle (CLC). The PLC concept has an essential impact on companys strategy in different areas such as finance. The basic issue Ward and Bender explained through their book- is that there are loads of finance textbooks, which explain the theory and put it into some sort of context, but there did not seem to be anything that said look this is what you actually do, and this is why you do it. They started the model with defining the risk in two ways- financial risk and business risk. By financial risk, in the model it specifically means the amount of borro wing a company has in its capital structure. So, if a company has a lot of borrowing then it is taking on a lot of financial risk; if it has no borrowing or gearing at all, then it has got no financial risk. And that way it is easy because it means that business risk is everything else, but business risk really is what it says. In their model, the business risk refers to the volatility of profits and cash flows of a company and that is going to depend on whether it is a younger company or a mature company, what sort of industry it is in and how susceptible it is to the economic cycle. Moreover, to connect the strategy and financial, they put emphasize on the importance of P/E ratio which represents the ratio of current share price to its earnings per share (EPS), where high P/E ratio represents the high potential for growth in future. According to their model, at the beginning stage, venture capital is the main source of financing the operations in any company and will remain the main source of funding until the company will start heading towards the maturity stage. According to the model, at the launch stage, the business risk is so high because of the product risk in the new market and low operating income (or some time even suffering losses), so to create the balance it with the financial risk the company should not borrow to keep the financial risk low. Static trade-off theory also supports the opinion that a firm in growth stage should not finance with debt because of the high bankruptcy cost. There is also no benefit in tax with expenditure of interest because of their low revenue. Moreover if a company try to finance it business with debt at the launch stage it might lose the opportunity to increase its revenue or minimizes its losses as it has to pay interest on the fund acquired through debt. And when the company is unknown and the business risk is high at this stage and it is likely that company might suffer initial losses, borrowing does not soun d an attracting option for funding as it will create an imbalance between financial risk and business risk. And also at this stage, according to the model, it is wise no to pay dividend as company has not sufficient earnings to pay out. Ward also mention that at this stage the P/E ration of the company is normally high because of the low earning per share (EPS). Even at the growth stage the company is still facing high business risk as it has to pay promotional expenses for increasing the sales. At this stage company can enter in to small stock market to raise their equity from the broader range of equity investors and keep the level of its financial risk still low. Despite of that many companies still fail to manage the rapid growth sales, so it is wise not to go for borrowing at this stage as well and finance should be taken from capital market in the form of equity and by retaining the profit of the company and company should pay small dividend to keep the investors interest i n the company (Bender Ward, 2003). Capital structure may be influenced by the firms life stages, as needs for funds may change with the changing circumstances of the firms from equity to cheap source of financing that is debt (Bender Ward, 1993). It is not always advisable for mature company to only use equity financing therefore, company should use debt financing in order to balance companys finance and business risk in particular circumstances during the maturity stage. Damodaran (2001) also proposed that expanding and high-growth firms would finance themselves primarily with equity mostly through venture capital and when it enters in the maturity stage, the funding would be replaced by debt. Likewise in the Bender and Ward model also, as the company progress towards the maturity, the business risk tends to reduces and at this stage, company can think of taking the advantage of borrowed money from the market to decrease its cost of equity by the mean of cheap debt. As company moves from equity to debt financing, its financial risk gradually increases as it uses more and more debt financing. Since the potential opportunity for growth is low, the money is not working hard in the business and now company should start to repay the invested amount to its shareholders in form of dividends. Now at the declining stage, company knows that what is going to happen, so here it should use debt financing for the business activities because the business risk is low at this stage. Dividend should increase to its maximum level at this stage as the opportunity for growth is very low. At this stage, the principle source of finance that is debt is associated with high financial risk, which offsets the low business. Critical Evaluation of the Model Looking from the practicality of the model, Bender and Ward model seems very attractive and guides company how, when and by what mean to raise money. Nevertheless, what about the companies (industry) which are already at the maturity stage. However, their model finds difficulty to answer this question, as these mature companies want growth. Their model simply adopts the PLC model and extended it to company life cycle. Another consideration about their model is that the PLC is not following the classical mode of theorising and since their model is based on PLC, the weaknesses of the PLC can also affect their model (Sion 2012). It is not clear that the PLC is a concept, theory, model or framework? Management only looks for the practicality of the model but what is the underlying theory behind that which is missing in bender and wards model. It is also not necessary that all the companies go through all the stages of the life cycle. It is not unusual for product to gain second life or even reincarnation that can help companies to progress from maturity stage not to decline or death but to fresh period of repaid growth. And now a day, many companies borrow money from the financial institutes as they are the cheap sources of financing and government also provides financial support for companies to start the business and encourage them for borrowing and also help the mature companies or industries to bring them back to the growth track. There is also a lot of confusion about the fact that what kind of evidence can prove the model. There are number of mature companies who have no dividend which is against their model. It is also not clear that what kind of hypothesis can prove or disprove the model. Moreover, the model is over emphasized on finance and give relatively low importance to the strategy thus difficulties can be found to interlink finance and strategy. In addition, the concept of value is also not very defined in their model; however, they came very close to define the value in their model. For linking strategy and finance together, value can be considered the main concept that is required to interlink these two disciplines. However, their model gives more weight to finance and thus it misses the link with strategy. The value is behind their model but they did not realize the actual value, which arises from the consumption of the financial resources and utility. The model is developed by using PLC idea but there are many other strategic theories like porters five force, value chain, generic strategy which are well defined in terms of value and can help to interlink finance and strategy together. One of the limitations of the PLC is that it cannot predict the length of the each stage of the life cycle and also cannot forecast the sales accurately. Although the PLC stages concept provides the manager directions about the changes of characteristics of companies and diagnosis tool to direct the company to reach and keep their b est life stage. However the limitation of the model is that it is not clear that when and how a company should raise the money as the model fails to predict the length of each stage and as a result company cannot clearly decide when the best time to use debt funding is. The PLC also assumes that the entire product passes through these four stages of the life cycle. If this is correct then the company must enter to decline stage after the maturity stage and company usually wants to avoid this stage. In reality, as said earlier, a product can rebirth after the maturity stage and can avoid the decline stage by improving the quality of the product and thus it can again enter in the growth stage. Another possibility is that a product may perform so badly at the launch stage because of the poor marketing strategy and thus it straight away move towards the declining stage of the life cycle. And bender and ward has applied the same concept of PLC in their model, so these limitations of PLC are directly affecting their model. In addition to these, another criticism against their model comes from the MM theory developed by Modigliani and Miller (1958). According to their theory, borrowing can help small companies to grow rapidly as borrowing supports the sales increase and consequently the growth of the company. They argued that the change in debt-equity ratio will not affect the value of the company and as a company increases its debt the overall cost of equity tends to decreases and shareholders bear higher risk due to the increased possibility of the bankruptcy. Also the agency problem is missing in Bender and Ward model. In their model it is not clear who controls the company, managers who are the agents or the shareholders who are the source of financing at the launch and maturity stage? And one of the important criticisms against their model is risk. In their model the business risk is keep on declining as the company progresses to maturity and decline so the q uestion arises here is that what motives company to proceed to decline stage? It is not clear in their model. Although there are lots of limitation for the model, Bender and Ward are the first one who came with the concept to link finance and strategy together, and it is impossible for any model to meet out all the necessary criteria in the relevant field of research. Despite of that, there are also lots of advantages of their model. The interesting thing about the model is that it is very simple to understand and managers can use it easily to grow their business and change the financial sources for the company over the stages of the organization life cycle. The model gives crucial weight to venture capital for any company as it is the best way of financing the new business at the launch and maturity stage which keeps the balance between business and financial risk and when the company is in mature stage it can use debt funding. Adding to this, their model clearly identifies the high risk of borrowing and kept risk grounded to the firm level, which can help to company to avoid the credit crisis. Frielinghaus, Moster and Firer (2005) also conclude that capital structure life stage asserts that more debt should be utilised by firms as they mature, but they also have mentioned that there is a little test has been done to test this model empirically. It also helps people to understand the difference between junior and major stock markets which will help them to guide in their financial decision. Although the model is not tested against the evidence so far, it can be tested against the real situation of the companies in the stock markets. Porters budge Others might still give the importance to the simplicity of the model and will criticise the model, however, complexities can be built into the model. An important step in improving the model is taken by Sion by introducing the porters bulge derived using the porters five forces model. Many companies who are at the growth stage want to remain at this stage for longer period. But the potential high growth attracts entry and rivalry in the industry which can shake out the present companys life cycle and that is where the PLC and Porters five force model can be combined together to improve the model. In porters bulge, Sion introduced three new stages in the life cycle of a company by taking into account the industry in which a company operates, shaping between growth and maturity stage which are new entries, rivalry and shake-out. The five-force model will help to compare bender and ward model and can bring different point of view which can affect the company at the growth stage. A t the growth stage, the industry attracts the potential entrants and that can cause the market share of a company. At this stage, a company might experience slow but positive growth in sale, no growth in sale or a negative growth in sale and then accelerates with rapid pace depending on the rivalry increased because of the new entrants. At this stage a company will face stifle decline earlier in the life cycle but with the help of differentiation or new product introduction or developing alternative use of the old product can help the company to avoid the initial decline stage (porters bulge) in their sales. The introduction of revitalized product will smoothen the porters bulge. This idea of Sion is supported by the from the real world as many growing companies continuously keep on spending on the research and development to introduce new product every year to remain in the growth stage for longer period of time. But the problem with this is that competitors might also follow th e same trend and some time the company which is not able to compete in this kind of environment will straight away face the declining stage before the maturity period of the life cycle because of the shakeout in the industry. Another concern is that the five-force model assumes the neoclassic economics and perfect market which are not robust enough the present financial situations (crisis). It isolates the finance from the capital market, business and accounting. Conclusion The points Bender and Ward are trying to pull out very simply are that one can take a life cycle model of the company and can correlate what business risk and financial risk looks like over the life cycle, adjusting it for the type of business that the company is in. And say in these early stages company need equity it doesnt matter that debt is cheap, it need equity and this is what dividend policy should be and this is the type of investments it should be making and this is how it should be funding them. And then the message, as move through the life cycle and through the book, is company can make it more complex after this, but the only reason for complexity is if it benefits company rather than its investment bank. Its basically a practical guide to corporate finance for people who do understand a little bit of the theory. Their model also explains what the corporate financial strategy is all about and how a company should raise money throughout the life cycle of the company a nd how it should apply the money within the business. The link between Bender and Ward model and Porters five-force model can also help to connect the finance and strategy as these two models are interconnected with each other. To further evaluate the model, it will be required to analyse the number of companies where the focus should mainly be on the launching and growing companies to test the practicality of the model. This will help to fully understand the model from both qualitative and quantitative. Words count: 3039