1) What accounts for Deutsche Brauerei’s rapid growth in recent years? Specifically, what policy choices account for this success? There are several factors that lead to rapid growth of Deutsche Brauerei. To begin with, Deutsche Brauerei itself has succeed in Germany by winning quality awards consistently over the years. Secondly, After a fire destroyed the manufacturing plant in 1994, the more efficient equipment was purchased. It was capable of increasing the brewery’s potential output.
Once Deutsche Brauerei expanded into the Ukraine, the additional capacity became necessary to handle the expansion in Ukrainnian market. Therefore, Deutsche Brauerei can effectively utilize the unused capacity. Next, Entering the Urainian market is considered to be one of the significant factor to the rapid growth. The dissolution of the U. S. S. R. brought market reforms so Deutsche Brauerei decided to enter this fragmented beer industry because Ukraine has large population and it located within Central and Eastern Europe.
In 1998. Oleg Pinchuk was hired away from a competitor as the marketing manager. Pinchuk had set up the credit and inventory policy which are extending credit to distributors in Ukraine from 2% 10, net 40 to 2% 10, net 80 and implementing field warehousing in order to support the fragile distributor network. Then, Deutsche’s beer quickly became so popular that the volume sales can offset the negative currency effects due to Russian debt crisis. The next 2 years saw a dramatic increase in sales to 25,847 by the end of 2000.
That is mean sales in Ukraine had greater impact on Deutsche’s total sales that account for 21% and 28% in the year of 1999 and 2000 respectively. Change in credit and inventory policies The new marketing strategy helped to capture the market efficiently Serving market through a network of independent distributors 2) What is Deutsche Brauerei’s credit policy toward its distributors in Ukraine? Why is it different from the policy toward its other distributors? Is the company’s credit policy appropriate? Is it profitable? If not, how would you change it?
If so, what arguments would you offer to the board of directors in its defense? The DB beer in Germany served its markets through a network of independent distributors. The distributors purchased the beer, stored the beer in their refrigerated warehouses and then sold the beer to their customers. Since the Ukrainian market was new, Oleg could not rely upon an established network of distributors. He had to establish a distribution strategy for DB in the Ukraine. Oleg is providing financing to the Ukrainian distributors. But he has had to relax the terms several times now.
It started at 2 percent 10, net 40. It was increased to net 80, and will be increased again to net 90. When DB first entered the Ukranian market, Oleg relaxed the credit policy for Ukranian distributors from 2 percent 10, net 40 to 2 percent 10, net 80 (clients could take a 2% discount if payment was made within 10 days of the invoice, otherwise payment was due in full within 80 days). The credit policy for Ukranian distributors differed because Ukrainian entrepreneurs, while eager and entrepreneurial, were not privy to the same capital or bank loans that German distributors had access to.
The credit policy for the Ukranian distributors was appropriate, given that they were expanding, getting new equipment, and required more time than usual to pay. A flexible credit policy in the Ukraine is appropriate initially while building relationships and as the beer distribution pipeline is developed. However, Oleg would like to extend the credit policy from 80 to 90 days. The current receivables show 6,168 in 2000 and is projected to increase about 50% in 2001 and then another 30% in 2002. Having money tied up in accounts receivables is certainly not as profitable as having cash in hand.
Oleg’s proposal to relax the credit policy even further is a high risk and may result in distributors settling accounts even later. 3) Why does this profitable firm need increasing amounts of bank debt? Although Deutsche Brauerei is so profitable, the company still need to borrow so aggressively. The biggest driver to the short-term borrowing is the large dividend this company pays (75%) and days sales outstanding that will influence account receivable of the company (the more we extend the credit, the more we have account receivable). One of the concerns from the board of directors is their tendency to borrow aggressively.
Based on Pinchuk’s projected income statement and balance sheet, reducing days sales outstanding from 90 days to 80 days can make sales lower than he expected. We assume in conservative way that the sales growth in Ukraine will reduce from 45% to 22. 5% in 2001 and reduce from 30% to 15% in 2002 as well. 4) Imagine you are a member of the board of directors. As a member of the board of directors, how would you vote on these three issues: a. The proposed raise for Oleg Pinchuk? b. The quarterly dividend declaration of EUR698,000? c. Adoption of the financial plan for 2001? a
As everyone knows, entering the Ukrainian market is considered to be a large future success of Deutsche Brauerei. One key in particular to maintain this success in the Ukrainian market is Oleg Pinchuck. His ability to set up distributorships and his previous performances prove us that he is valuable member and his knowledge is very affluent. Unfortunately, Oleg Pinchuk left a competitor to join Deutsche Brauerei, he would leave DB for a competitor if he was not satisfy with the compensation package. Therefore, we think Deutsche Brauerei have to do something to ensure that Oleg does not leave to a competitor.
According to old compensation package, he will receive EUR40,000 base salary and incentive payment which is calculated by 0. 5% of the annual sales increase in Ukraine. Uncle Lukas proposed his base salary up to EUR48,500 and also increase incentive payment up to 0. 6% of the annual sales increase. In our opinion, we agree with increasing in base salary up to EUR48,500 (21. 25% increase), but we prefer to retain the incentive payment at 0. 5% of the annual sales increase because we think that this plan(increasing incentive payment up to 0.
6% of the annual sales increase) may fail to maximize shareholders’ wealth. The reason is that when subject to this formula, Oleg Pinchunck may tempt to accelerate sales as much as he can without concerning about cost such as extending more credit or spending more advertising to boost sales. We would like to recommend giving him more bonus if he can reduce the accounts receivables and inventories or using Economic Value Added to tie his compensation to the firm residual income instead of tie his compensation with sales growth. b. DB could lower their short-term borrowing by lowering their dividend.
This will not make the board of directors happy, since it has been mentioned that for some of their family members, this is their source of income. But lowering the dividend can be offset against moving into new markets. The Ukrainian market has a good financial projection. The €2. 5 million in additional profits can be reinvested into the company to fund its growth instead of increasing the owner’s income. This will have a positive long-term effect. And since this company is always positioning itself for the long-term, it is something they should vote on at the next board meeting.
C. Alternatives a. Freezing dividends to EUR2,186 thousands levels for the year of 2001 and 2002 . This will free-up money for the Ukraine capital expansion. b. Reducing days sales outstanding from 90 days to 80 days and assume in conservative way that the sales growth in Ukraine will reduce from 45% to 22. 5% in 2001 and reduce from 30% to 15% in 2002. c. Do not invest in new plant and equipment. Sales growth is only 3% per year in both Ukraine and Germany. Also, decrease days sales outstanding to 41 days. d. combine alternative a and alternative b Results Base Case (from Pinchuk’s projection)
a. From this alternative, we fixed the amount of dividend to EUR 2,186 thousands (same as the year of 2000). As you can see, Deutsche Brauerei has short term debt and D/E ratio lower than base case forcasted by Pinchuk. Also, there is a little effect to ROE. b. Based on Pinchuk’s projected income statement and balance sheet, reducing days sales outstanding from 90 days to 80 days can make sales lower than he expected. We assume in conservative way that the sales growth in Ukraine will reduce from 45% to 15% in 2001 and reduce from 30% to 15% in 2002 as well.
Base on our calculation, although we will receive lower net income, the company’s financial risk also decrease too. DB can lower their short-term borrowing because they rely less on short term debt. As a result, Debt to equity ratio is substantially improve from 77% and 82. 71% to 67. 49% and 66. 26% in 2001 and 2002 respectively. c. Since Deutsche Brauerei will exhaust its unused productive capacity by late 2001, the company has to think about investing in new plant and equipment of EUR 7 million in 2001 and investing in a state-of-the-art warehouse and distribution center of EUR 6.8 million in 2002.
Based on our calculation(stop expanding in Ukraine and reducing days sales outstanding to 41 days), cutting budgets of new investment will lead to lower short term debt, D/E ratio and higher net income d Alternative b is freezing the amount of dividend to EUR2,186 thousands and reduce days sales outstanding to 80 days. The short term debt is significantly lower than base case that Pinchuk forcasted. D/E ratio, ROE, Net income are lower as well.
Evaluation of Alternatives and Recommendations
In our opinion, we think alternative c is not a smart business move because the Ukrainian market has shown us that there are huge opportunities for Deutsche Brauerei’s product outside of Germany (sales in Ukraine grew 47%). If Deutsche Brauerei does not invest in those assets recently , the company will absolutely run out of It’s productive capacity and this will not good for the firm in long term. Moreover, Exhibit1 also show us that if Deutsche Brauerei increase it’s volumn, the profits rise disproportionately faster.
Lowering Deutsche Brauerei’s short term debt by lowering the amount of dividend would not make the board of director happy because this company traditionally has 75% of dividend payout ratio(constant payout ratio) and half of the family stockholders are rely on the dividend as main source of income, but lowering dividend has several benefits that the board of directors have to reconsider. One of the benefits in particular is that paying lower the amount of dividend can be offset by expanding in Ukrainian market. The Ukrainian market has huge potential to earn more profits and has a good financial projection.
Therefore, we would recommend changing the dividend policy from constant payout ratio policy to constant nominal payment policy. Moving onto the differences between this two types of dividend policies, Firstly, the constant payout ratio policy will fix a certain proportion of earning to pay as dividend in each dividend period. This will lead to volatile amount of dividend and if one day the firm is facing with earning drop, the dividend may lower than previous years (see the effect of this in Exhibit). Next, the constant nominal payment policy is the policy that fix amount of dividends is made in each period( the firm can the dividend later).
Based on our calculation, if we freeze dividend at EUR 2,186 thousands, more than the €1. 5 million (additional money) from 2001 and 2002 can be reinvested into the company to fund the company’s growth instead of borrowing. This will have a greater positive long-term effect to Deutsche Brauerei. Furthermore, after the business cycle in Ukraine reach to mature stage, the company can increase more dividend to serve the retirees’ needs later so this is the point that we think Greta should vote on at the next board meeting.
According to alternative b, we think DB should not extent days sales outstanding to 90 days although we assume that the sales will be lower as we have mention before. The reason is that if we focus on the current account receivables(6,168 thousands in 2000) and it is projected to increase around 50% in 2001 and another 30% in 2002. Having more accounts receivable is absolutely not as good as having cash in hand because it causes more Allowance for Doubtful Accounts. If Oleg decided to further extend the credit policy, the company would face with higher risk.
In conclusion, firstly, we would recommend alternative d (combine alternative a and b together). This is the aggressive expansion in the Ukrainian market and not extend more credit policy (see the projected income statement and balance sheets in exhibit). Next, Greta will need to strongly advise to the board of directors to approve paying more compensation for Oleg Pinchuk as we have mentioned. Finally, DB should declare the quarterly dividend lower than 25% of projected dividend just in case the actual dividend is not as the same as its projection of projected dividend just in case the actual dividend is not as the same as its projection.
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