1) What has contributed to Deutsche Brauerei’s rapid expansion in recent times? What specific policy decisions have led to this achievement? There are various factors that have attributed to the rapid growth of Deutsche Brauerei. Firstly, the company has consistently won quality awards in Germany, which has played a significant role. Secondly, following a fire that destroyed the manufacturing plant in 1994, more efficient equipment was purchased, thereby increasing the brewery’s production potential.
Once Deutsche Brauerei expanded into Ukraine, the need for additional capacity arose to accommodate the expansion in the Ukrainian market. Consequently, Deutsche Brauerei can efficiently utilize the unused capacity. Moreover, entering the Ukrainian market is acknowledged as a crucial factor contributing to the company’s rapid growth. The market reforms following the dissolution of the U.S.S.R. prompted Deutsche Brauerei’s decision to venture into this fragmented beer industry. This choice was influenced by Ukraine’s sizable population and its strategic location within Central and Eastern Europe.
Oleg Pinchuk, who was recruited from a competitor in 1998, became the marketing manager. During his tenure, Pinchuk made significant changes to credit and inventory policies. These changes included extending credit terms for distributors in Ukraine from 2% 10, net 40 to 2% 10, net 80. Additionally, he implemented field warehousing to support the fragile distributor network. These adjustments proved successful as Deutsche’s beer quickly gained popularity and volume sales counteracted any negative currency effects caused by the Russian debt crisis. Consequently, sales soared to 25,847 by the end of 2000, representing a substantial increase over the following two years.
The sales impact on Deutsche’s total sales in Ukraine increased from 21% in 1999 to 28% in 2000. This increase was a result of changes in credit and inventory policies, as well as the implementation of an effective new marketing strategy. In addition to direct sales, Deutsche also serves the Ukrainian market through a network of independent distributors.
It is important to evaluate how Deutsche Brauerei’s credit policy towards its distributors in Ukraine differs from the policy applied to other distributors. Assessing whether the current credit policy is appropriate and profitable for the company is crucial. If necessary, adjustments should be made to optimize profitability.
If it is the case, what arguments would you present to defend the board of directors? In Germany, DB beer was distributed through independent distributors who purchased, stored, and sold the beer to customers. However, in Ukraine where the market was new, Oleg had to create a distribution strategy for DB as there was no established distributor network. To aid this process, Oleg has been offering financial support to Ukrainian distributors, although he has had to adjust the terms on multiple occasions.
Initially, the credit terms for Ukranian distributors were set at 2 percent 10, net 40. These terms were then increased to net 80 and will soon be further increased to net 90. Oleg adjusted the credit policy when DB first entered the Ukranian market, allowing Ukranian distributors to take advantage of a 2% discount if they paid within 10 days of receiving the invoice. Otherwise, full payment was due within 80 days. This difference in credit terms for Ukranian distributors was necessary because Ukranian entrepreneurs did not have the same access to capital or bank loans as German distributors did, despite their eagerness and entrepreneurial spirit.
The credit policy for the Ukranian distributors was deemed appropriate due to their expansion, acquisition of new equipment, and extended payment deadlines. It is essential to have a flexible credit policy during the initial stages of relationship-building and the development of the beer distribution pipeline in Ukraine. However, Oleg wishes to extend the credit policy from 80 to 90 days. The current accounts receivables indicate a total of $6,168 in 2000, with projected increases of approximately 50% in 2001 and an additional 30% in 2002. It is important to note that having funds tied up in accounts receivables is less profitable than having immediate cash on hand.
Oleg’s proposal to further relax the credit policy is risky and may lead to distributors delaying payment even more. Additionally, why does this profitable firm require increasing levels of bank debt? Despite its profitability, Deutsche Brauerei still relies heavily on borrowing. The main reason for short-term borrowing is the substantial dividend (75%) the company pays out and the impact of days sales outstanding on accounts receivable. As we extend credit more, we accumulate higher levels of accounts receivable. The board of directors is concerned about the company’s tendency to borrow aggressively.
Pinchuk’s projected income statement and balance sheet show that if we decrease days sales outstanding from 90 days to 80 days, it may result in lower than expected sales. We expect a conservative decline in sales growth in Ukraine, with a decrease from 45% to 22.5% in 2001 and from 30% to 15% in 2002. As a board member, you will need to vote on three matters:
a) approving Oleg Pinchuk’s proposed raise,
b) declaring a quarterly dividend of EUR698,000,
c) adopting the financial plan for the year 2001.
Entering the Ukrainian market is considered a significant achievement for Deutsche Brauerei. One crucial factor for sustaining success in this market is Oleg Pinchuck. His proficiency in establishing distributorships and his past accomplishments make him a highly valuable member of our team. However, it is important to note that Oleg Pinchuk had left a competitor to join Deutsche Brauerei. If he is not satisfied with his compensation package, there is a risk that he might leave DB for another competitor. Therefore, it is imperative for Deutsche Brauerei to take necessary steps to ensure Oleg’s loyalty and prevent him from joining a competitor.
According to the previous compensation package, he would receive a base salary of EUR40,000 and an incentive payment calculated at 0.5% of the annual sales increase in Ukraine. Uncle Lukas has proposed increasing his base salary to EUR48,500 and also increasing the incentive payment to 0.6% of the annual sales increase. In our opinion, we agree with the increase in base salary to EUR48,500 (a 21.25% increase), but we prefer to keep the incentive payment at 0.5% of the annual sales increase. We believe that increasing the incentive payment to 0.6% may not be necessary.
6% of the annual sales increase) may fail to maximize shareholders’ wealth. This is because when following this formula, Oleg Pinchunck might be inclined to increase sales without considering costs. This could involve extending more credit or spending more on advertising to boost sales. Our recommendation is to provide him with a higher bonus if he can decrease accounts receivables and inventories. Alternatively, we suggest tying his compensation to the firm’s residual income using Economic Value Added, rather than tying it to sales growth. b. DB could reduce their short-term borrowing by decreasing their dividend.
The board of directors may not be pleased with this, as it has been noted that some family members rely on it as their main source of income. Nevertheless, reducing the dividend can be balanced by exploring new markets, such as the Ukrainian market, which offers promising financial prospects. The extra €2.5 million in profits can then be reinvested in the company to support its expansion instead of increasing the owners’ earnings. This will yield positive long-term effects. Furthermore, considering this company’s proactive approach to planning ahead, it should be an agenda item for voting during the upcoming board meeting.
There were four proposals made to improve the financial situation. The first proposal suggests maintaining dividends at EUR2,186 thousand for 2001 and 2002 in order to allocate funds towards capital expansion in Ukraine.
The second proposal recommends reducing days sales outstanding from 90 days to 80 days and assumes a more conservative sales growth rate of 22.5% in 2001 and 15% in 2002 for Ukraine.
The third proposal advises against investing in new plant and equipment due to a sales growth rate of only 3% per year in both Ukraine and Germany. Furthermore, it suggests lowering the days sales outstanding to 41 days.
Lastly, the fourth proposal combines the dividend freeze from alternative a with the reduced days sales outstanding from alternative b. These alternatives are referred to as the base case based on Pinchuk’s projection.
a. We have set the dividend amount to EUR 2,186 thousands, the same as in 2000. Deutsche Brauerei’s short term debt and D/E ratio are lower than the base case forecasted by Pinchuk. The effect on ROE is minimal.
b. Based on Pinchuk’s projected income statement and balance sheet, decreasing days sales outstanding from 90 days to 80 days can result in lower sales than expected. We conservatively assume that sales growth in Ukraine will decrease from 45% to 15% in 2001 and from 30% to 15% in 2002.
According to our calculation, the company’s financial risk decreases as we receive lower net income. This is because Deutsche Brauerei (DB) can rely less on short-term debt, leading to a decrease in their short-term borrowing. As a result, the Debt to equity ratio improves substantially from 77% and 82.71% in 2001 and 2002 respectively to 67.49% and 66.26%. Furthermore, since the company will exhaust its unused productive capacity by late 2001, it must consider investing EUR 7 million in new plant and equipment in 2001 and EUR 6 million in a state-of-the-art warehouse and distribution center.
In 2002, there were 8 million of something. By stopping expansion in Ukraine and reducing days sales outstanding to 41 days, cutting investment budgets will decrease short term debt, decrease the D/E ratio, and increase net income based on our calculations. Alternative b suggests freezing the dividend amount at EUR2,186 thousands and reducing days sales outstanding to 80 days. The short term debt in this case is considerably lower than what Pinchuk forecasted. The D/E ratio, ROE, and net income are also lower. Evaluating the alternatives, we recommend the first option.
Based on our perspective, we believe that alternative c is not a wise decision for Deutsche Brauerei. The Ukrainian market has demonstrated significant potential for the company’s product beyond Germany, with sales in Ukraine experiencing a growth of 47%. If Deutsche Brauerei does not invest in these assets promptly, the company will undoubtedly deplete its productive capacity, which will be detrimental in the long run. Additionally, Exhibit1 further illustrates that an increase in volume for Deutsche Brauerei leads to disproportionately faster profit growth.
Lowering Deutsche Brauerei’s short term debt by reducing the dividend amount may not please the board of directors. This is because the company has a traditional dividend payout ratio of 75% (constant payout ratio), and half of the family stockholders rely on the dividend as their main source of income. However, reducing the dividend does have several advantages that the board of directors must reconsider.
One specific benefit is that the reduction in dividend can be compensated by expanding into the Ukrainian market. The Ukrainian market presents significant potential for earning higher profits and shows promising financial projections.
Therefore, we suggest changing the dividend policy from a constant payout ratio policy to a constant nominal payment policy. This shift will result in a fixed amount of dividend being paid in each period instead of a fluctuating amount based on earnings. Under the constant payout ratio policy, dividends can vary and may decrease if the firm’s earnings drop (refer to Exhibit for an illustration). On the other hand, the constant nominal payment policy ensures a stable dividend amount is paid out in each period, allowing the firm to adjust dividends later if needed.
According to our calculation, by keeping the dividend at EUR 2,186 thousands, we can reinvest more than the €1.5 million from 2001 and 2002 into the company for future growth instead of borrowing. This will have a greater positive long-term impact on Deutsche Brauerei. Additionally, once the business cycle in Ukraine reaches a mature stage, we can increase the dividend further to support the needs of retirees in the future. This is the point that we suggest Greta votes on during the next board meeting.
According to alternative b, we believe that DB should not extend days sales outstanding to 90 days, even though we expect sales to be lower, as previously mentioned. The reasoning behind this is that if we focus on the current account receivables (6,168 thousands in 2000), it is projected to increase by around 50% in 2001 and another 30% in 2002. Having a larger amount of accounts receivable is not as beneficial as having cash on hand because it leads to an increase in the Allowance for Doubtful Accounts. If Oleg decides to further extend the credit policy, the company will face a higher risk.
In conclusion, our first recommendation is to combine alternative a and b together to form alternative d. This involves aggressively expanding in the Ukrainian market and implementing a policy to not extend more credit. (Please refer to the projected income statement and balance sheets in the exhibit for more details.) Additionally, we advise Greta to strongly recommend to the board of directors that they approve increased compensation for Oleg Pinchuk, as previously mentioned. Finally, it is advised that DB declares a quarterly dividend lower than 25% of the projected dividend. This precaution is necessary in case the actual dividend does not match the projected amount.
