Solution Manual for Case studies in Finance

Managing for Corporate Value Creation 6th Edition

by Bruner

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Solution Manual for Case studies in Finance Managing for Corporate Value Creation 6th Editio

CASE 11

DEUTSCHE BRAUEREI
Teaching Note

Synopsis and Objectives

A newly-appointed director of a small German beer brewer Suggested complementary cases

must prepare to vote on three issues coming before the board of regarding working-capital
directors the next day: (1) approval of the financial plan for 2001, management and financial
(2) declaration of the quarterly dividend, and (3) adoption of an forecasting: “Kota Fibres,” (Case
10); “ServerVault,” (UVA-F-
incentive compensation plan for the marketing manager. The 1304); and “Body Shop
student’s task is to evaluate the past and prospective financial International 2001,” (Case 8).
performance of the company and to critique its liberal credit and Cases regarding setting financial
inventory policies. The objectives of the case are to: policy: “Gainesboro Machine
Tools Corp.,” (Case 26); “Rosario
Acero S.A.,” (UVA-F-1211).
• Introduce and exercise tools and concepts of financial-
statement analysis (including financial ratios, break-even
analysis, and cash-flow statements).
• Explore possible definitions of the “financial health” of a company.
• Illustrate the linkage between operating policies and financial performance.
• Consider the interdependence among corporate objectives regarding growth, dividends, and
debt financing.
• Explore the linkage between compensation incentives and financial performance. In this
case, the marketing manager is motivated to build sales volume, which he accomplishes with
a dramatic build-up in receivables and inventory.
• Illustrate some of the challenges of doing business in an emerging market.

This teaching note was prepared by Robert F. Bruner. Deutsche Brauerei is a fictional company reflecting issues in
actual organizations. Copyright © 2001 by the University of Virginia Darden School Foundation, Charlottesville, VA.
All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication
may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—
electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School
Foundation.

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110 Case 11 Deutsche Brauerei

Suggested Questions for Advance Assignment to Students

1. What accounts for Deutsche Brauerei’s rapid growth in recent years? Specifically, what
policy choices account for this success?
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?
3. Why does this profitable firm need increasing amounts of bank debt?
4. As a member of the board of directors, how would you vote on:
a. The proposed raise for Oleg Pinchuk?
b. The quarterly dividend declaration of EUR698,000?
c. Adoption of the financial plan for 2001?

Spreadsheet File

A Microsoft Excel spreadsheet file, Case_11.xls, supports student and instructor analysis of
this case. It is recommended that this file be made available to students, where the instructor seeks to
promote the evaluation of scenarios and sensitivities as they relate to possible alternative policies.
However, the case may be taught without the support of this file, perhaps distributing instead a copy
of Exhibit TN6 to the students. In this instance, the case discussion should be oriented toward the
interpretation of the printed data (i.e., in the case and the supplement) and its implications for
decision-makers. Here, the file TN_10.xls is only for instructor use. Please do not give the
instructor’s file to students.

Hypothetical Teaching Plan

1. As Greta Schweitzer, how would you vote on your Uncle Lukas’s proposals regarding(1) the
financing plan for 2001, (2) the dividend declaration, and (3) compensation for Pinchuk?
One can begin by calling on a student to present his position and analysis on these issues,
then taking a formal vote of the class. This question is one of two classic ways to begin a
discussion of this case and has the effect of riveting the attention of the students on the
decisions to be made. This opening will also reveal the unanimity or division of sentiment in
the class and may point out other possible avenues of fruitful case discussion among
opponents. Finally, if the instructor takes another vote at the end of class, this opening can
provide a barometer of thinking: changes in voting patterns can be a basis for useful closing
comments by students or the instructor.
 Case 11 Deutsche Brauerei 111

2. How does this company make money? What is its strategy? How has the company been
doing?
These questions represent another classic opening of discussion. Beginning with them will
prompt a much more analytical, less decision-oriented discussion than the first approach.
Open-ended questions such as these will generate energy in the class, though the instructor
should take care to limit the amount of time spent in this phase of the class, since students
will find it easy to offer observations about the firm’s apparent strategy and financial
performance. By letting the students assess the problems of this company in a nondirective
fashion, the instructor can gauge students’ abilities and build students’ “ownership” of the
analysis. The next three questions are a directive approach to problem assessment and could
supplement this question or be used in place of it.
3. What does the break-even chart tell us?
This question gives students an opportunity to exercise their ability to interpret break-even
analyses. Key teaching points should include explaining the preparation of a break-even
chart, the interpretation of the break-even volume (938,799 hectoliters [HL]), and the
comparison of the break-even volume to the current volume (1,173,000 HL). Another key
point is that the chart in case Exhibit 5 is relevant only for the current cost structure of the
company—if variable costs increase or the plant expansion is approved, the break-even
volume will rise. Finally, students should be aided in understanding that “break-even” refers
to operating profit, not free cash flow. The typical use of the break-even chart ignores taxes,
investments, and the depreciation tax shield.
4. What do the financial forecast and the sources-and-uses-of-funds statement tell us? How
about the financial ratios?
The income statement shows that the firm will earn a profit. The balance sheet reveals
growing debt requirements. However, the sources-and-uses-of-funds statement and the
financial ratios provide a more direct route to insights about strengths and weaknesses than
does the forecast income statement and balance sheet. In this segment of the discussion, the
instructor may wish to review the categories of financial ratios and the basic definition of
what constitutes a source and a use of funds.
5. Why does this profitable firm need to borrow?
This question may be rendered redundant by the discussion of question 4, although it serves
as a useful summary of financial demands on the company and provides an opportunity to
underscore the interdependence of growth, dividend, and debt policies.
6. What do you conclude from case Exhibit 7 about Deutsche’s distributors in Ukraine?
Question 4 exercises students’ abilities in longitudinal analysis of ratios; this question, which
compares some of Deutsche’s distributors to the industry averages, invites cross-sectional
analysis. The comparison will raise concerns about the creditworthiness of some of the
distributors and the reasonableness of Deutsche’s rapid eastern expansion.
112 Case 11 Deutsche Brauerei

7. Are the credit and inventory policies in Ukraine sensible? What risks is the company
assuming? What returns are possible?
This segment of the discussion provides an opportunity to test directly the profitability of
Pinchuk’s expansive policies. At the heart of this analysis is a comparison of marginal costs
and benefits. Depending on how liberally the class defines “marginal,” the expansion policy
looks like a wholesale success or an expensive failure. The resolution of the debate depends
on the benefits of possible hidden options for further expansion into the East. In essence,
Pinchuk looks like a hero or a despoiler depending on how optimistic the class is about
economic prospects in Ukraine and other eastern European countries.
8. Let us return to the issues at hand: financial plan, dividend declaration, compensation. What
should Greta Schweitzer propose instead?
At this point the instructor needs to aim for decisional closure in a way that summarizes the
key insights in this case. One effective approach is to identify students who are at opposite
ends of the decision spectrum (e.g., “yes” on the plan, “yes” on the dividend, and “yes” on
the compensation proposal versus “no” to them all) and ask the students to make brief
statements to the board of directors in favor of their proposals. Then the instructor can hold a
vote on the three questions and note where there have been any major changes in voting
patterns. Asking students why they shifted their votes usually raises insights about (1)
Pinchuk’s self-interest, (2) the enormous “bet” the company is making on continued success
in Ukraine, and (3) worrisome trends in the company’s financial performance. If time
permits, the instructor can ask students how they would communicate their decisions and to
whom.

Case Analysis

The following discussion illuminates some of the analysis underlying possible responses to
discussion questions 3, 4, 5, 6, and 7. Student discussion, however, might not follow this particular
order of presentation.

Break-even analysis

Pinchuk’s break-even analysis is presented in footnote 6 and Exhibit 5 of Discussion

the case. These data provide an opportunity for the instructor to review elements of question 3
break-even analysis. The primary objective in this discussion should be to explore
how break-even analysis complements other tools of financial analysis and how
break-even analysis may be misused.

As Lukas Schweitzer says in the case, “As we increase our volume above the break-even
volume, our profits rise disproportionately faster.” He is referring to the firm’s operating leverage.
Deutsche’s operating leverage can be calculated as the elasticity of profits (earnings before interest
 Case 11 Deutsche Brauerei 113

and taxes [EBIT]) with respect to unit volume: the figure is 5.0. 1 This might explain Lukas
Schweitzer’s appetite for growth: a one-percentage-point increase in unit volume is associated with a
five-percentage-point gain in EBIT. According to Lukas Schweitzer’s interpretation, the company is
doing well and is bound to do better as it expands.

This is a facile interpretation of operating leverage and the break-even chart in two respects.
First, elasticity cuts both ways; a figure of 5.0 also indicates that a drop in unit volume will depress
earnings proportionately more. Second, the chart is merely an expression of the EBIT of the firm, not
of cash flow. Finally, the chart depicts the cost and revenue structure of the firm at this time. A
variety of contemplated and unexpected changes could make this analysis obsolete. For instance, the
addition of the new plant capacity and warehouse will almost certainly raise the fixed costs of the
company. More experience in the east could cause the firm to revise upward its assumptions about
allowances because doubtful receivables could also cause an increase in costs.

What can be said in favor of break-even analysis? It is a simple analysis and a useful tool for
the management of costs and revenues. For instance, the margin of safety between the break-even
volume of 938,799 HL and the volume in 2000 of 1,173,000 HL is comfortable but not massive.
Break-even analysis could help Lukas Schweitzer understand where to focus his attention most
effectively as he tries to improve the profitability of the firm: raising unit prices and reducing unit
variable costs. For instance, one can exercise the break-even model in Case_11.xls to observe the
effects of one-percentage-point improvements in unit revenues, unit variable costs, and fixed costs
on break-even volume:

New Break-even
Break-even Reduction
(units) (units)

1% increase in unit revenues 911,469 27,330

1% decrease in unit variable costs 920,405 18,394
1% decrease in fixed costs 929,411 9,388

The important insight afforded by this sensitivity analysis of break-evens is that Deutsche’s
current break-even is affected more by prices and unit variable costs than by fixed costs. Greta
Schweitzer should explore Pinchuk’s pricing strategy in more detail.

1
If unit volume rises by 1% (i.e., from 1.173 million HL to 1,184,730 HL), EBIT will rise from EUR6.13 million to
EUR6.44 million, for a change of 5.01%. The elasticity of EBIT with respect to unit volume is, thus, 0.0501/0.01, or 5.0.
The worksheet titled “Exhibit 5” in the student file Case_11.xls contains this calculation, ready for student interpretation.
114 Case 11 Deutsche Brauerei

Analysis of financial forecasts

Novices to financial statement analysis typically find financial statements to Discussion

be impenetrable, taken at face value. Accounting tells us that the most important question 4
information is hidden in the footnotes to the financial statements (none are given in
this case). Finance tells us to look for economic trends and relationships with the
help of various tools. Provided in this case are completed sources-and-uses-of-
funds statements and a wide range of financial ratios.

Sources and uses: Case Exhibit 3 helps the student answer the two basic questions: “Where
got?” and “Where gone?” Funds derive substantially from earnings and very rapid depreciation of
the relatively new plant. Funds are applied substantially to working capital (in support of Ukrainian
expansion), dividend payments, and debt amortization. Looking toward the future, one sees massive
capital expenditures (EUR13.8 million) and significant increases in short-term debt. Lukas
Schweitzer’s statement is laughable: “I’m guessing that [our banker] can’t wait to get more of our
business!” The banker is probably alarmed over the firm’s changing asset mix and heavy reliance on
debt financing.

Financial ratios: Case Exhibit 4 presents 22 financial ratios spread over the four major
categories. The instructor may wish to help novices understand the interpretation of the categories
and of specific ratios, but the definitions at the bottom of case Exhibit 4 should provide enough
explanation. The ratios raise many questions that Greta Schweitzer should explore with her uncle.
They include the following:

• Profitability: Why did profitability decline from 1997 to 2000? What conditions warrant
more optimistic assumptions for 2001 and 2002? What is the impact on borrowing if
profitability holds at the current levels?
• Leverage: As debt ratios rise over the two forecast years, what provision is made for eventual
debt repayment? The rise in the EBIT-coverage ratio is associated with the anticipated
improvement in profitability. Is this assumption warranted?
• Asset utilization: Asset utilization (line 10) improves because sales (line 11) are projected to
grow faster than assets (line 12). This masks dramatic growth in receivables (line 13),
virtually all of which comes from Ukraine (compare lines 14 and 15). However, those
Ukrainian receivables grew because of faster sales growth in Ukraine than in Germany. They
also grew because of the dramatic change in the credit terms made to the Ukrainian
distributors: days’ sales outstanding (DSO) leapt from 41 in 1997 to 54 in 2000. The
inventory-to-sales ratio also increased, probably for the same reason.
• Liquidity: The quick and current ratios improve (the company becomes more liquid) over the
1998 to 2000 period. In the forecast period, liquidity worsens.
 Case 11 Deutsche Brauerei 115

In conclusion, the financial-statement analysis suggests that the company’s Discussion

rapid expansion over the past three years is almost solely based on expansion in question 5
Ukraine as an outgrowth of aggressive credit and inventory policies. The analysis
also presents a discontinuity: projected performance will be different from the past
because of optimistic assumptions about sales growth and margins and aggressive
capital expenditures. Such actions, however, will result in significant leverage
increases. The reason why this profitable company needs to borrow is that profits do not equal cash
flow. Significant drains on the company’s funds are not reflected in the measures of accounting
profits: i.e., dividends and asset investments for working capital and plant and equipment.

Deutsche’s distributors compared to the industry

Case Exhibit 7 presents information on Deutsche’s Ukrainian distributors Discussion

and the average for the industry. The purpose for discussing this information is to question 6
highlight that, by extending credit heavily to eastern distributors, Deutsche is
essentially using its own borrowing power to finance the distributors—and through
them—the retailers. Bank financing is not easy to access for smaller companies in
Ukraine; thus, doing business there requires becoming a banker of sorts.

Exhibit TN1 affords the basis for possible comments by the instructor on Deutsche’s role as
a provider of capital. As Pinchuk’s comment in the case suggests, the distributors and retailers
cannot obtain bank credit because they display obvious flaws: no collateral, low profits, negative
cash flow, and apparently high risk. This situation is repeated in many emerging markets— in effect,
the supplier is the banker. In this case, Deutsche borrows from the bank at 6.5% and relends the
funds through receivables (and, in effect, through inventories) to the distributors. They relend the
funds through receivables to the retailers. Pinchuk expresses great optimism that Deutsche’s banking
business is profitable. This optimism hinges importantly on Deutsche being paid in a timely manner.
Case Exhibit 7 invites the student to form his own opinion about the probability of being repaid. One
of the distributors (Kiev) looks strong compared to the industry averages; another (Donetsk) is
decidedly weak. In all, one must guess that this chain of “lending” is not lost on the banker who sees
the increasingly risky mix of assets on Deutsche’s balance sheet. Deutsche’s interest rate of 6.5%
may not compensate the banker adequately for the shift in risk.2

The comparison reveals that the distributors are greatly assisted by trade payables and
relatively low inventory levels. Their receivables as percentages of sales are somewhat higher than
the norm, and DSOs are also somewhat longer, suggesting that, indeed, the distributors are extending
credit to the retailers. Low levels of short- and long-term debt are consistent with the dearth of debt
financing.

2
The case states that the rate of interest on short-term euro government debt is 4.58%. Deutsche borrows at a
premium of 192 basis points over the government rate, not a particularly high premium by American or European
standards and probably not in keeping with Deutsche’s future leverage and business risk. The banker may wish to raise
Deutsche’s interest rate.
116 Case 11 Deutsche Brauerei

Several comparisons emerge from case Exhibit 7. Profit margins for four of the distributors
are materially lower than the norm. Is this situation due to price competition or to poor cost control?
The sales-to-assets ratio is close to the norm, suggesting that the distributors are not building up
assets unnecessarily. Ranking the distributors, Kiev is unquestionably the strongest. Kharkiv or
Donetsk would be the weakest, worse enough in profitability and liquidity to warrant careful controls
on credit and inventory.

The broad point of this comparison must be to trigger questions about Pinchuk’s credit
controls as he increases shipments to existing distributors and expands the number of distributors.
Such controls might include monthly reports on distributor performance, visits and inspections of
distributor facilities and inventories, and careful monitoring of receivables collection. The objective
of these controls should be to signal any adverse changes quickly so that Deutsche might protect
itself or offer counsel to the distributor or both. Is Pinchuk up to this? The case suggests that rigorous
financial controllership is absent at Deutsche Brauerei. Therein lies the core of Deutsche’s moral
hazard exposure. Pinchuk has strong personal financial incentives to expand the business among
distributors in Ukraine, but he may have less regard for risk.

If students are insufficiently attuned to the risks of liberally extending trade credit, the
instructor could invite students who may have some experience in this area to describe what they
have learned. Publications oriented to the managers of small businesses have regular discussions of
trade credit decisions. For instance, Exhibit TN2 presents quotations from one such article, “How
not to handle your receivables,” which the instructor might use to stimulate student attention toward
Oleg Pinchuk’s receivables policy.

Profitability of eastward expansion

From the standpoint of finance theory, the risks that Pinchuk is taking Discussion
invite the question of returns. Pinchuk’s analysis and comments in the case (see question 7
case Exhibit 6) seem to offer evidence that the returns on the marginal
receivables are huge—on the order of 120% to 130% in the next two years.
Novices will accept those numbers at face value. The instructor might walk the
students through the calculations in case Exhibit 6 and then invite them to consider whether Pinchuk
has thought of everything. Given that he is using those calculations to argue for the attractiveness of
the eastern expansion, the analysis ignores several related effects:

• Inventories: The expansion is supported by stocks of Deutsche’s beer in field warehouses.

• Fixed assets: In the next two years, Deutsche will invest in added productive capacity and a
field warehouse. Both of those investments are stimulated largely by the eastern expansion.
 Case 11 Deutsche Brauerei 117

Exhibit TN3 recalculates Pinchuk’s returns, adding in the effects of the inventories3 and fixed
assets. The impact is to reduce significantly the returns on investment. But even if fully burdened
with inventories and fixed assets, the returns are 26% and 27%, respectively, for 2001 and 2002.
Novices may point out that this is still higher than the cost of borrowing at 6.5%. Yet there remain
two other concerns:

• Bad debts: Pinchuk’s analysis assumes no losses on credit extended. A sensitivity analysis on
credit losses (Exhibit TN4) shows that at losses of around 32% of the outstanding
receivables, the returns on investment fall below Deutsche’s cost of borrowing. This is a high
loss rate compared to usual credit losses among healthy commercial customers in developed
countries (where the typical rate is between 1% and 4%). Still, the unusual markets in
Ukraine may offer those high losses for some period of time into the future. The best one can
say is that credit losses are an important point of judgment.
• Cost of funds: A comparison of the prospective ROI against Deutsche’s 6.5% cost of
borrowing is inappropriate if the credit to Ukraine is riskier than Deutsche’s debt to the bank.
There is no information in the case from which to estimate a target-required rate of return on
credit to Ukraine, but intuitively it should be a higher figure than 6.5%. Taking the view that
Deutsche is investing in the distributors and retailers in an emerging market, the required rate
of return might be considerably higher, such as the 35% or more required by a venture
capitalist.
• Time value of money: Truly, the proper way to assess the attractiveness of expansion into
Ukraine is to project the cash flows associated with the expansion well into the future and
then to discount them to the present using a risk-adjusted rate of return. This type of analysis
is beyond the reach of novices in a typical course where this case might appear. Yet students
at the intermediate level and higher might be stimulated to complete a rough discounted cash
flow (DCF) analysis. Exhibit TN5 gives an estimate of the free cash flows associated with
the eastern expansion. For simplicity, the terminal value assumes that further growth of sales
stops after 2002 and that the cash flow in 2003 is capitalized at 12% (not a scientifically
generated cost of capital, but rather, a guess at a target return for what might be a maturing
business in the consumer packaged-foods industry). The result is a multiple internal rate of
return (IRR) (because of two sign changes) and a net present value of EUR27.8 million at a
discount rate of 25%. The expansion into Ukraine appears to be a value-creating
investment—if there are no credit losses. Plainly, the “key bet” in this rough analysis is on
the maturity, permanence, and vitality of the business in the east after 2003.
• Country risk: Political and economic instability may warrant a higher hurdle rate. Yet the
international bonds issued by the Ukrainian government were trading at yields of around
16% in January 2001 (a detail not mentioned in the case). The analysis in Exhibit TN3
shows the Ukrainian expansion yielding returns significantly higher.

3
Investment in inventories is reflected here at book value, assuming they are carried at the lower of cost or market
value.
118 Case 11 Deutsche Brauerei

In sum, despite the flaws in Pinchuk’s very rough analysis, the Ukrainian expansion does
appear to be a profitable activity for Deutsche. How profitable depends on luck and on the ability to
manage the foreseeable risks. Stated differently, Deutsche has invested in a growth option. The key
issue is the adoption of sensible financial policies that will carry the firm until the growth option
matures.

What should Deutsche do?

As director of the company, Greta Schweitzer is well advised to encourage Discussion

her Uncle Lukas to explore alternative strategies for the near term. The company’s question 8
banker will almost certainly argue the same point. The instructor could encourage
students to revise the forecast (using the spreadsheet model in Case_11.xls),
adopting some of the following changes:

• Stop the capital expansion oriented toward the east. Cutting capital spending will go far
toward cleaning up the firm’s balance sheet. The more conservative students will favor this
approach, notwithstanding the profitability of the Ukrainian expansion.
• Tighten the credit policy toward the Ukrainian distributors. Relatively small changes in DSO
will produce material reductions in borrowing needs. Obviously, this change may be a way
to slow growth without brutally stepping on the brakes. On the other hand, if credit is so hard
for the distributors to come by, tightening credit may choke off the distributors. What
alternatives do the distributors have? What responsibility does Deutsche have to its
distributors?
• Improve profitability. The ratios suggest some slackening in cost control in recent years.
Sensitivity analysis of the model suggests that improving the operating margin reduces the
borrowing requirements. The case provides no information on which to evaluate this
alternative. Students may be prone to suggest this action without appreciating the difficulty
with which operating firms improve margins. In any event, Greta Schweitzer should inquire
closely into the nature of the margin erosion.
• Cut the dividend or raise more equity capital. A 75% dividend payout dramatically lowers
the self-sustainable growth rate of the firm. Students quickly suggest cutting the dividend.
Although this action will help reduce the firm’s borrowing needs, severely cutting the
dividend will hurt the firm’s equity holders. The case mentions that the company is entirely
owned by members of the extended Schweitzer family and that half of those family members
are “retirees who rely on the dividend to make ends meet.” Greta Schweitzer will need to
answer not only to Lukas Schweitzer, but also to other members of the Schweitzer family if
Deutsche cuts the dividend. A slightly stronger case might be made for raising equity,
although some of this new capital is liable to come from outside the Schweitzer family.
Students with any familiarity with family business politics will suggest that bringing
outsiders into the Deutsche equity group may be difficult.
 Case 11 Deutsche Brauerei 119

Exhibit TN6 gives summary results of a sensitivity analysis of the forecast model. The first two sets
of results are based on growth-reduction assumptions. The third set assumes the dividend will be cut
radically from a 75% payout to 25%. Implications for short-term debt balances, annual net income,
and return on equity for these scenarios include the following:

Short-term debt: In all the scenarios, the company borrows significantly less than the base-
case forecasts (case Exhibit 1). In two of the scenarios, however, the trend is still toward increasing
debt. But in scenario (B), which is associated with no further plant expansion, the firm becomes
highly liquid, paying off its debt and running a large excess cash balance. Plant expansion
contributes more to debt needs over the next two years than does net working capital.
Profits: Profits decline from this base case if Deutsche merely slows its growth in the east
(scenario A). But profits rise if plant expansion is abandoned (scenario B). Profits also rise under the
low dividend-payout scenario (C) due to low interest expense. The main insight here is that in the
next two years slower growth can lead to even higher profits than the aggressive expansion strategy
offers.
Return on equity (ROE): ROE tells much the same story as profits. The strategy emphasizing
tight asset utilization (scenario B) dominates the base-case ROE for 2001.

In short, a sensitivity analysis of the financial model can show that financial prosperity is
attainable if the company takes actions other than the aggressive expansion strategy. This result
suggests that, if Lukas Schweitzer is interested in increasing the profits of Deutsche, the company
has alternatives to expanding eastward. Tough cost management might yield significant gains in
profits without requiring an expenditure on plant and equipment. Bringing to light an alternate
strategy highlights the territorial (i.e., not necessarily economic) foundations of Lukas Schweitzer’s
ambitions. He wants to expand into the east but does not appear to appreciate the tradeoffs involved.
Considering alternate scenarios serves to focus students on the basic question of the attractiveness of
expansion into the east.

The dividend payout

A company forecast analysis makes it apparent that the dividend declaration is linked to the
company’s growth plans and financing strategy. This relationship can be illustrated by the self-
sustainable growth4 formula, which implies that with an ROE of 10.3% for 2000 and a dividend
payout of 75%, the firm could sustain growth in assets of 2.6% without changing its capital structure.
Instead, assets are projected to grow at 10.9% in 2001. The depressed profit margin and high
dividend payout will force the company to lever up.

The profile of Deutsche’s equity owners may prevent serious change in the payout ratio. Half
the owners are retirees who depend on the dividend “to help make ends meet.” Rather than distant,
anonymous investors, they are all relatives of Lukas and Greta Schweitzer. You can run but cannot
hide from investors like those.

4
The self-sustainable growth rate of the firm is estimated using the model G ss = ROE (1 − DPO), where G is the
growth rate, ROE is the return on equity, and DPO is the dividend payout rate.
120 Case 11 Deutsche Brauerei

Oleg Pinchuk’s compensation

The question of Pinchuk’s pay could occupy a substantial part of the discussion period. The
discussion plan suggested in this note proposes that Pinchuk’s pay be treated as a residual issue,
which the board may decide on after it reaches consensus on the financial plan and the dividend
question.

The instructor may want to note that the contemplated compensation plan represents a 44%
raise in pay. The case states that Pinchuk received EUR82,344 in 2000. Applying the new formula to
forecast results for 2001 suggests that he will receive EUR118,288 in 2000.5 Does Pinchuk’s past or
prospective performance warrant this much of a raise? Lukas Schweitzer obviously thinks it does,
but he focuses rather narrowly on Pinchuk’s sales accomplishments: rapid growth of sales and
distributorship.

Doubters in the class will argue that Pinchuk has pushed the eastward expansion more out of
self-interest than out of concern for investors’ interest. Receivables and inventory have ballooned
under his expansion.6 Pessimists could argue that one day the expansion in Ukraine will stop, and
when it does, the huge field inventory will spoil and the receivables will default. Accordingly, this
view suggests that Pinchuk should receive no raise and perhaps even be fired.

Others may argue that Pinchuk has simply responded to economic incentives and in doing so,
has created a potentially profitable growth option for the company. If anything, those students may
say Pinchuk should be allowed to participate in any profitable realization under this growth option.
The instructor can encourage students to suggest modifications to Pinchuk’s compensation plan. In
general, Pinchuk should be motivated to think more like a stockholder than as a salesman—to focus
not only on sales increases but also on collections, profits, and the efficient use of assets.

Concluding Comments: What is “Financial Health”?

Ultimately, students will base any action proposal on their perceptions about the financial
health of Deutsche Brauerei. Probing those perceptions and developing from them a working
definition of financial health can give the class a useful way to gain some closure on the case
discussion. An obvious starting point is for the class to note that Deutsche is liquid, solvent, and not
on the brink of bankruptcy. The company is also profitable and paying an ample dividend to its
shareholders. On this foundation, some students will make the case that the company is doing just
fine. Other students will summarize the following disturbing facts (as cited earlier): profit margins

5
The base salary is EUR48,500. The incentive payment is 0.6% of Deutsche’s sales increase in Ukraine,
EUR11.631 million.
6
A comparison of lines 11 and 13 in case Exhibit 4 reveals that receivables have grown materially faster than sales
in three of the past four years and are projected to grow in the next two years. Inventories for 2001 (EUR14,795)
represent an unbelievable 79 days of cost of goods sold (2001 cost of goods sold of EUR68,159 equals the sum of
depreciation of EUR6,766 and production cost of EUR61,393). German beers are noted for their absence of
preservatives. How long can Deutsche’s quality product stay in storage?
 Case 11 Deutsche Brauerei 121

narrowing; heavy investment being made in receivables in a market region that is less creditworthy
than Deutsche’s current market; large capital expenditures being planned at the same time that
significant increases in debt are occurring; no obvious program for repaying debt; and anticipated
declines in liquidity. In short, one sees a company entering a new phase, where its reserves are
declining in the face of unanticipated adversity. A “financially fit” company is declining to a merely
“healthy” company—yet hardly a “sick” company. Our assessment of financial health needs to
embrace the different degrees of fitness in order to obtain sound managerial insights.
122 Case 11 Deutsche Brauerei

Exhibit TN1
DEUTSCHE BRAUEREI
Flow of Credit to Deutsche Brauerei’s Distributors

Deutsche Distributor
2% 10
Net 80

6.5% Interest

Bank Retailer
 Case 11 Deutsche Brauerei 123

Exhibit TN2
DEUTSCHE BRAUEREI
How not to Handle Your Receivables1

• Start with an unknown individual who has a minimum of capital and a great story about his
prospects in a far corner of the state.
• Offer extended terms so he can finance the inventory needed to generate the fantastic
business he has described.
• When he is past due on his payments, rationalize that this is temporary, perhaps because of
seasonality.
• Let the account salesperson verify that the inventory is, in fact, in place.
• As you look at the financial statements, be sympathetic that his is a new operation having
trouble getting a handle on its operating results.
• When you start to realize your customer is in trouble, don’t take your losses early. Stick with
him, and you ought to be able to double the amount you have to write off.

1
This exhibit appeared as a sidebar in Charles J. Bodenstab, “The Receivables Challenge,” Inc. 11 (May 1989): 137.
124 Case 11 Deutsche Brauerei

Exhibit TN3
DEUTSCHE BRAUEREI
Revision of Oleg Pinchuk’s Analysis of the Return on Investment
from Investment in the Ukrainian Expansion
(values in thousands of euros, except where indicated otherwise)

Assumptions
Revenue per HL (EUR) 78.49
Variable costs per HL (EUR) 52.31
Contribution percentage 33%
Tax rate 35%
Credit losses (% of outstanding) 0%
Actual Projected
1997 1998 1999 2000 2001 2002
Sales in Ukraine 0 4,262 17,559 25,847 37,479 48,722
Change in sales 0 4,262 13,297 8,288 11,631 11,244
Variable costs on the marginal sales 0 (2,841) (8,863) (5,524) (7,752) (7,494)
Contribution on the marginal sales 0 1,421 4,435 2,764 3,879 3,750
Less credit losses 0 0 0 0 0 0
Contribution after credit losses 0 1,421 4,435 2,764 3,879 3,750
Taxes on the marginal contribution 0 (497) (1,552) (967) (1,358) (1,312)
Marginal after-tax profits 0 924 2,883 1,797 2,521 2,437

Variable costs/sales (%) 0% 67% 67% 67% 67% 67%

Change in accounts receivable, Ukraine 0 424 3,665 2,078 3,074 2,772
Investment in accts. Receivable 0 283 2,443 1,385 2,049 1,848

Change in inventories 0 267 1,417 5,072 1,906 1,861

Added sales in Ukraine as a percent of total new sales (%) 0% 87% 89% 81% 85% 85%
Change in inventories attributable to Ukraine 0 233 1,267 4,087 1,628 1,574
Investment in inventories 0 233 1,267 4,087 1,628 1,574

Capital expenditures 0 2,247 0 6,980 6,822

Added sales in Ukraine as a percent of total new sales (%) 87% 89% 81% 85% 85%
Capital expenditures to support Ukrainian expansion 0 2,010 0 5,962 5,772

Return on marginal investment in receivables (%) 0% 327% 118% 130% 123% 132%
Return on marginal investment in receivables 0% 179% 78% 33% 69% 71%
and inventories (%)
Return on marginal investment in receivables, 0% 179% 50% 33% 26% 27%
inventories, and fixed assets (%)
 Case 11 Deutsche Brauerei 125

Exhibit TN4
DEUTSCHE BRAUEREI
Sensitivity Analysis of ROI to Variations in Credit Loss Percentage

ROI for 2001 Based on

A/R & A/R, Inventory,
A/R Inventory & Fixed Assets
0% 123% 69% 26.2%
1% 120% 67% 25.5%
5% 108% 60% 23.0%
7% 103% 57% 21.8%
10% 94% 52% 19.9%
% Credit Loss

15% 79% 44% 16.8%

20% 64% 36% 13.7%
32% 31% 17% 6.5%
40% 6% 3% 1.2%
50% -24% -13% -5.0%
60% -53% -29% -11.2%
70% -82% -46% -17.5%
80% -112% -62% -23.7%
90% -141% -78% -29.9%
100% -170% -95% -36.2%
 126
Exhibit TN5

Case 11 Deutsche Brauerei

DEUTSCHE BRAUEREI
Rough Discounted Cash Flow Analysis of
Ukrainian Expansion: 1998 to 2002
(values in thousands of euros, except where indicated otherwise)

Assumptions
Revenue per HL (EUR) 78.49
Variable costs per HL (EUR) 52.31
Contribution percentage 33%
Tax rate 35%
Credit losses (% of outstanding) 0%
Actual Projected
1997 1998 1999 2000 2001 2002 2003+
Sales in Ukraine 0 4,262 17,559 25,847 37,479 48,722 48,722
Variable costs on the Ukrainian sales (2,841) (11,703) (17,227) (24,980) (32,474) (32,474)
Contribution on the Ukrainian sales 1,421 5,856 8,620 12,499 16,249 16,249
Less credit losses 0 0 0 0 0 0
Contribution after credit losses 1,421 5,856 8,620 12,499 16,249 16,249
Taxes on the marginal contribution (497) (2,050) (3,017) (4,375) (5,687) (5,687)
Marginal after-tax profits 0 924 3,806 5,603 8,124 10,562 10,562
Less investment in accounts receivable 0 283 2,443 1,385 2,049 1,848 0
Less investment in inventories 0 233 1,267 4,087 1,628 1,574 0
Less capital expenditures to support Ukrainian expansion 0 0 2,010 0 5,962 5,772 0
Cash flow 408 (1,914) 131 (1,515) 1,368 10,562
Terminal value (assuming no growth, WACC = 12%) 88,015
Free Cash Flow 0 408 (1,914) 131 (1,515) 89,383
Internal Rate of Return
from the Ukrainian Expansion: Multiple
 Case 11 Deutsche Brauerei 127

Exhibit TN5 (continued)

Net Present Value, 1998 to

2002 at these discount
rates:
NPV
Rate (EUR, thousands)
25% 27,836.9
50% 10,931.3
100% 2,440.2
200% 277.2
300% 65.7
400% 32.2
500% 25.7
600% 24.2
700% 23.6
800% 23.1
900% 22.5
1000% 21.8
Solution Manual for Case studies in Finance Managing for Corporate Value Creation 6th Editio

128 Case 11 Deutsche Brauerei

Exhibit TN6
DEUTSCHE BRAUEREI
Sensitivity Analysis of Financial Forecast
(all figures in thousands of euros)

The following table gives the short-term debt balances, annual net income, and return on
equity for the following three scenarios, in which changes have been made solely in the indicated
assumptions:

A. Credit extension is cut back in the east to 41 days and the annual rate of sales in the east
grows only 2% per year (down from 45% and 30%).
B. The plant is not expanded in 2001 and 2002; company sales growth in the east and west is
only 2% per year. Days’ sales outstanding in both east and west are 41 days.
C. Dividend payments as a percentage of net income are reduced to 25%.

Scenario Short-Term Debt Net Income Return on Equity

2001 2002 2001 2002 2001 2002
A. 10,626 10,530 3,606 3,811 12.3% 12.6%
B. 4,276 (1,387) 3,874 4,315 13.2% 14.2%
C. 15,939 17,160 3,805 4,489 12.2% 13.0%
Base case 17,862 21,372 3,724 4,311 12.7% 14.2%

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