JOURNAL OFBUSINESS

STRATEGIES

Old Main

Center for Business andEconomic Research

Sam Houston State UniversityVol.1 No.1 Spring 1984

Journal of Business Strategies

Published semiannually by theCenter for Business & Economic Research

Sam Houston State UniversityHuntsville, Texas

Dr. Elliott T. BowersPresident

College Of Business AdministrationB.K. Marks

Dean

Center for Business & Economic ResearchWilliam B. Green

Director

Editorial CommitteeWilliam B. Green, Chairman

Susan Simmons William KilbourneCarol Sangster Nelson Thornton

Sarah Hart

Editorial Review Board

To ensure that articles appearing in the Journal of Business Strategies areconsistent with the goals of the Journal, an Editorial Review Board refereesall manuscripts submitted for publication. The current members of theEditorial Review Board are:

Dalton E* Brannen, University of LouisianaRussell Briner, University of MississippiWilliam B* Green, Sam Houston State UniversityRay Guillett,· University of Texas, Tyler,Sara Hart, Sam Houston State UniversityJeff Harwell, Sam Houston State UniversityCharles Hawkins, Lamar UniversityHerbert Johnson, Sam HoustOtl State UniversityWilliam Kilbourne, Sam Houston State UniversityPaul l..indloff, Sam Houston State UniversityJanis Monroe, Sam Houston State UniversityOris Odorn, University Of Texas? TylerRichaId Pitre, University of Houston, Clear LakeCarol Sangster, Sam Houston State UniversityArthur Sharplin, Northeast Louisiana UniversityMark Simmons, Sam Houston State UniversitySusan Simmons, Sam Houston State UniversitySammie Smith, Stephen F* Austin State UniversityVernon- Sweeney, Sam Houston State UniversityNelson Thornton, Sam Houston State UniversityGary Williams, University of Texas, Texarkana

Journal of Business Strategies

Volume I, Number 1

CONTENTS

Spring, 1984

A Managerial Strategy To Reduce InvestorUncertainty and Increase Share Price 4

John C. Groth and Lyn M. FraserTexas A&M University, College Station

Guide For The Development of AStrategic Plan - 10

James M. TiptonBaylor University, Waco

Chapter 11: A Tool of Strategic Management 24Arthur D. SharplinNortheast Louisiana University, Monroe

Defining Your Business Mission: AStrategic Perspective 33

William A. Staples & Ken U. BlackUniversity of Houston - Clear Lake

A Comparison of Strategies for ExpensingBusiness Property 40

Wallace Davidson & Sharon GarrisonNorth Texas State University, Denton

A MANAGERIAL STRATEGY TO REDUCEINVESTOR UNCERTAINTY

AND INCREASE SHARE PRICE

John C. Groth and Lyn M. Fraser

Departluent of Finance1'exas A&ivl University<='o11ege Station, Texas

INTRODUCTION

Maxilnizing the firm/s share value is a common managerial objective. Weaccept that objective as the appropriate goal for management, because shareprice ellcompasses the nlan,y factors of primary concern to management:earnings per share, riskiness of various investment alternatives l timing ofinvestment returns, dividend policy, and many others. The right decisionswitll respect to such an array of factors yield actions that increase sharevalue. Knowledge and sensitivity to the guidance offered is important to allfunctional areas of management.

The purpose of this paper is to stress the importance of a simple decisionrule regarding investor uncertainty. Actions consistent with the rule willenhance management's efforts to achieve the firm's goal, maximization ofshare price. With that in mind, we outline steps for implementation of thedecision rule. The paper is organized as follows. Part one reviews somegeneral concepts regarding firm valuation, which serve as a background forthe decision rule. Part two sketches the role that uncertainty plays in thedetermination of share price and discusses the causes of investors' perceiveduncertainty. This background leads in part three to the decision rule and thespecific steps tIla! nlanagers can follcJ'AT to increase share price. The papercloses with a sllmmary.

I. BACKGROUND

It is important to recall that s,hare \!aluation takes place in the market place- the world external to the firm. ~rhe n1arket is the true test of the firm'sdecisions and actions regarding earnings .. in\'estments, financing, dividendpolicy, and other factors affecting share price~ It is market participants whodeterlnine the nlarket price of the firm's stock~ .Although management maybelieve the firn1' s stock, is (rver or under valued, share price will change onlyif investors change their expectations~

Managements actions are (lnl)T one of the Inany factors i11flut~ncingmarket

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participants' perceptions of the firm. To increase share price, managers mustinfluence investors' expectations concerning the firm. Since investors arequite astute, creating positive expectations in their minds requires thatmanagement make the right decisions with respect to many dimensions ofinvestor interest. Those decisions can be categorized in four basic areas.First, the investment decisions must have expected outcomes that are favor­able relative to attractive opportunities available to investors elsewhere.Second! management should seek to' finance the firm in the optional way inorder to lower the cost of financial resources. The clue to the right way tofinance comes from the external parties who provide the financial resources.Third, they must formulate and institute the appropriate dividend policy.Finally, they should consider the firm's role in relation to social responsibili­ties, ethics, and other such items. Correct decisions and diligent attention bymanagers to these four basic areas will have a positive impact on share priceand variables such as earnings per share, return on investment, and othermeasures of firm performance.

But there is one more essential ingredient if management's efforts are to berewarded with an increase in share price. Managers must provide informa­tion to the marketplace so their actions can be appropriately evaluated.Certainly management must strive to make and take correct decisions andactions to have favorable impact on firm performance~ But it is equallyimportant that investors have the information necessary to form the rightperceptions. Management thus must not only do the right thing- but alsocommunicate with the marketplace so investors can value the actions.

Needless to say, it is difficult always to recognize and reach the optimalobjectives. Yet the rule offered later in this paper will yield benefits evenwhen outcomes are less than desirable. Regardless of the investment,financing, and dividend decisions that have been and will be made in thefuture, applying the rule will normally lead to an increase in share valueeven given poor decisions and actions. At worst, it will leave the value of theshares unchanged.

Share price is influenced - other things being equal - by the after taxpackage of benefits that investors expect to receive by holding the shares.Another determining factor, which will now be explored, is the perceiveduncertainty associated with those benefits.

II. UNCERTAINTY

In forming expectations and assessing llncertainty, investors want accessto all relevant information and the proper interpretation of that information.To a certain extent, management can control both access and interpretation.

AccessFirst, investors want to obtain the information they need to make sound

investment decisions, and they want it at the same time it is available to

5

other market participants. This is true first because investors like to believethey are making informed decisions and, second, because the market hasproven itself J'efficient" in quickly reflecting available market price informa­tion. Consequently, those that receive information first can benefit from thatinformation, regardless of whether it is "good" or Jibad".

An individual investor certainly does not mind always being the first toreceive information, but he does not like others to receive the informationfirst - .especially if it is bad news that negatively affects the value of thesecurity he owns. In that case getting the information first might have madeit possible to avoid a loss. The situation is different, however, if the investordoes not own the security affected by the information. It is then only a matterof missing the opportunity to purchase on good news or sell short on badnews.

Certain realities suggest that information may not reach each investor atthe same time. For example, some investors can spend all day in a brokeragefirm office accessing the wire service and other news sources. Other inves­tors might have accounts which are large enough that their brokers constant­ly monitor the information that affects the securities in which they areinterested. Most investors, however, must rely on the evening news or thenext day's paper for the same information. The literature is replete withstudies which suggest that by the time information appears in the mediaavailable to the majority of investors, that information has already beencaptured in the price of the securities (e.g., 2, 3, 4). Any real world imperfec­tions that keep investors from getting the same information at the same timeadd to the uncertainty perceived by investors. Similarly, if people perceivethemselves to be at an informational disadvantage, their uncertainty in­creases even if they are not at an actual disadvantage. The increased uncer­tainty results in a lower price for the firm's shares, since other things equal,the more uncertain a benefit, the less the value.

InterpretationA second source of information uncertainty involves the interpretation ofavailable information. For various reasons investors may not properly evalu­ate and utilize information useful in forming/revising expectations. If, forexample, the firm historically has issued erroneous "information", investorsmay hesitate to have confidence in that firm's current and future informationofferings. Lack of credibility increases uncertainty and, correspondingly,decreases share price.

In addition, the form that available information is in can increase thechance of investor misinterpretation. And, any confusion that accompaniesthis misinterpretition can diverge investors' opinions. A lack of marketconsensus in itself can increase uncertainty as perceived by investors. It willalso probably increase variability in the firm's stock price; when divergenceof opinion is great, price might momentarily reflect over or under reaction byinvestors to the information.

6

In summary, although many factors undoubtedly affect investors' per­ceived uncertainty, we focus on how investors perceive information accessi­bility. Remember that perceptions, not necessarily reality, affect investorbehavior. Second, we are interested in uncertainty caused by potentialmisinterpretation of information. Generally, managers can control firm­related information, and they can take measures to reduce uncertainty fromthis information.

III. DECISION RULE

Given the expected package of benefits associated with a firm's stock ­dividends and appreciation in share value - reducing investors' perceiveduncertainty will increase share value, assuming investors prefer less uncer­tainty to more uncertainty, other things being equal. Thus, even if manage­ment has already made decisions and taken actions that affect the package ofexpected benefits, any steps that reduce uncertainty will increase sharevalue. This leads to the decision rule.

RULE: DO THOSE THINGS THAT DECREASE INFORMATIONUNCERTAINTY AS PERCEIVED BY INVESTORS.

Management can take specific steps to promote equal access to informa­tion and to reduce investors' perceived uncertainty about information.These actions should increase share value. So as not to confuse the effects ofother variables, assume management has made the investment and financ­ing decision. The following actions should increase investors' confidence ininformation accessibility and interpretation.

Management should 1) develop a policy regarding the release of informa­tion about the firm, 2) consistently follow this policy and 3) make known toinvestors the information-release policy they have adopted. The policyshould limit the opportunity for certain individuals to trade on releasedinformation, i.e., the information should be made available to all investorssimultaneously. The firm should insure (and assure investors) that "bad"news will be as readily forthcoming as I'good" news. Disclosure practicesshould aim to minimize the chances that investors may misinterpret theinformation. The policy should also contain certain provisions that reduceinvestors uncertainty about availability and accessibility of information.Specifically, the following guidelines are appropriate:

- Management should release all information after the market (on whichtheir firm's stock trades) is closed. Thus, more investors can get theinformation before any trading opportunities.

- As soon as management knows information of potential interest toinvestors, they should release it. If one suspects the information has orwill definitely "leak out", ignore the first guideline and dispatch the

7

information as widely and quickly as possible. State why you did notwait until after the market closed.

- Management should demonstrate a willingness to provide investorswith favorable as well as unfavorable information.

- The information should be clearly presented; management must mini­mize the chance that investors will form misinterpretations.

- Management should welcome the questions of analysts and reportersbut have a specific policy to follow in dealing with such queries. Answertelephone questions only after markets have closed. In case of personalvisits, ensure that analysts will not release any information until afterthe markets close. The firm itself should release a summary of anyinformation provided to analysts.

- The firm should establish a track record of providing as much informa­tion to investors as possible. Such openness by management instillsconfidence that all news will be shared with investors.

- Management should not hedge when presenting information. If man­agement does not fully understand the implications of a certain de­velopment, they should clearly state and assess the possibilities andadmit uncertainty concerning the outcome ..

- Projections should be realistic. When management realizes the projec­tions are not as reliable as originally thought, the projections should berevised. Investors must sense that management will keep themappraised of all developments.

- Management should develop an approach to handle rumors about thefirm. Generally it is best to have a policy of either always or neverresponding to such rumors. The merits and shortcomings of the Ilal_ways or never" approach need to be assessed prior to establishing thepolicy.

IV. SUMMARY

In addition to other factors, uncertainty perceived by investors affectshow investors value a firm's shares. Aside from numerous actions whichmanagement may take (e.g., with respect to investments, financing, growthin earnings per share, and dividends) managers can reduce the uncertaintyperceived by investors regarding two factors: (1) equal access to informationand (2) misinterpretation of information. Reducing uncertainty froln thesesources will increase share value. Managers should implement the specificsteps suggested to minimize uncertainty from these sources.

REFERENCES

1. K. CareYJ "Nonrandom Price Changes in Association with Trading in LargeBlocks: Evidence of Market Efficiency in Behavior of Investor Returns," Journal ofBusiness, October, 1977/ pp. 407-414.

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2. J. Jaffe, "Special Information and Insider Trading," Journal of Business, July, 1974,pp. 410-428.

3. J. Groth, "Security-Relative Information Market Efficiency: Some Empirical Evi­dence," Journal of Finance and Quantitative Analysis, September, 1979

4. J. Groth, W. Lewellan, G. Schlarbaum, and R. Lease, "Security Analysts: SomeAre More Equal," The Journal of Portfolio Management, Spring 1978, pp. 41-48.

5. J. McCain and J. Millar, JJA Note on Public Information and Stock Prices," Journalof Business Research, January, 1975, pp. 61-64.

6. J. Staffels, JJStock Recommendations by Investment Advisory Services: Immedi­ate Effects on Market Pricing, "Finanacial Analysts Journal, March 1966, pp. 44-86.

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GUIDE FOR THE DEVLEOPMENTOF A STRATEGIC PLAN INTRODUCTION

James M. Tipton

Department of Economics, Finance & InsuranceHankamer School of Business

Baylor University, Waco, Texas

INTRODUCTION

Bank and thrift organizations are beginning to devote a considerableamount of time and effort each year to the process of establishing goals andobjectives and developing profit and operational plans for the ensuing year(2). This type of planning is generally characterized as operational or tacticalplanning since it is concerned largely with building on and improving thestatus quo. It is generally the responsibility of the Asset/ Liability Committee(ALCO) to administer and monitor the tactical plans within a financialinstitution. A major component of the ALCO's responsibility is the manage­ment of interest rate risk.

Another dimension of planning is that which is termed as strategic plan­ning. Strategic planning is the process of planning for change in the orga­nization. It typically involves an on-going program of an objective assess­ment of the organization's current position; its strengths and weaknesses;the opportunities and threats presented by external forces such as theactions of competitors, political and regulatory changes, social andtechnological changes, etc.; and finally, the development of plans orstrategies and the commitment of resources to implement these strategies inorder to bring about significant and positive changes in the organization.The objective is to capitalize on strengths and opportunities, to overcomeweaknesses, and to anticipate the effect of changes brought about by exter­nal forces rather than being overwhelmed by these forces. One of the majorbenefits derived from strategic planning is the abilit)7 that it affords mana­gers to make better decisions in their day-to-day operations by virtue ofhaving thought out what it is they are attempting to accomplish in the longerterm.

The purpose of this paper is to present a guide which is being used bybanks and thrifts in the development of their strategic planning. Theapproach of the paper, though broad in nature, allows detailed implementa­tion procedures as well as analysis and forecasting on the microcomputer.!

Financial institutions can be viewed as an aggregation of a diversifiednumber of separate and distinct businesses offering many different products

10

and services to different customer groups. The approach to strategic plan­ning is to first develop functional Strategic Plans for each organizationalproduct or unique area of service. The overall Strategic Plan is then de­veloped through the process of approving or modifying these individualStrategic Plans in order to channel the organization's resources into thoseareas which offer the greatest potential for achievement of the institution'sgoals, i.e., profit, quality, service, growth, etc.

Each functional area of the organization should prepare a Strategic Plancentered around its products and services. The resulting Strategic Plansshould be viewed as long-range plans for the organization's major areas ofbusiness (service) and not merely the plan for an individual division orgroup (3). In most instances, each of the various lines of business (services)involves the interaction and cooperation of a number of different functionalareas or groups. The final plan for a given line of business (service) shouldreflect input from all of the areas involved in providing that service. As afollow-on process, individual divisions and departments may then developtheir own Strategic Plan to support the overall line of business or service. Insome instances, support areas, i.e., data processing, personnel, etc., will notbe able to complete their strategic plans until after the plans for the majorlines of buisness (service) have been completed and approved.

Strategic planning, as opposed to opportunistic decision making, is anon-going process and should be thought of as a cycle, a cycle that occurs inan organization on an annual basis. The results of the first year strategicplanning cycle should produce both a one-year plan and a five-year plan. Onsubsequent years the strategic planning cycle should prod1lce the long rangeplan with a one-year update. The initial cycle will be the most time consum­ing and the most difficult to accomplish because of the learning and manage­ment discipline required.

STRATEGIC PLANNING CYCLE

The Strategic Planning Cycle for a particular line of business or functionalactivity should consist of at least the following eight planning elements:

I. Mission StatementII. Internal Analysis

III. External AnalysisIV. Goals and ObjectivesV. Strategies For Action

VI. Management Review ActionVII. Implementation

VIII. EvaluationThe development of the strategic plan for a particular line of business of

service should be coordinated with, and have the benefit of, the input fromall departments/groups involved in providing the service involved. Careshould be exercised to select the most talented people for key planning

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Figure 1STRATEGIC PLANNING CYCLE

1

PROGRfu'1FEEDBACK

ANDMONITORING

EVALUATIONOF PRODUCTPERFORMANCE

EVALUATIONOF PEOPLEPERFORMANCE

1/ Five/ Year Strategic

Plan\ ACTION and"~1PLE}fENTATIO

I ESTABLISH- STRATEGIES

1. Resource Requirc::ment82. Reward/Return3. Risk

ESTABLISH GOALSJ;\ND OBJECTIVES1. Qualitative2. Quantitative3. Alternatives

<:~_ ANNUAL UPDATE... <';::1r-----

_ ~~_____ _ ANNUAL UPDATE -<,~~:7J-----

-1r--I-N-T-E-l:i\jAL~ I

FINANCl1\L 1 !\ A~ALYSI~.~J Ir-----

- IN"'E- 1". Nf,,\T"\ '. J.. l\., ,!.J \ !

( QUALITATIVE) jv.:.

\-ANALYSIU I-r--&EXTERN!J.I

\ Q.UALITL\TlVE\....~NAL'tSIS_ I

,--_/

rr J

IiII

MISSION/ >,,1SCOPE ~

STATEMENT

Il

~

N

positions, no matter where they are in the organization hierarchy. It isimportant to keep planning as separate as possible from the organizationalstructure.

The proposed goals, objectives and strategies are reviewed in detail by aplanning group or a strategic planning committee. It may modify goals as aresult of capital constraints on the organization, the need to give priority ofresources to other areas of the organization or for numerous other reasons.Once the various functional Strategic Plans have been approved, appropri­ate individuals will assume responsibility and accountability for the attain­ment of the goals and objectives established. Figure 1 is a flow diagram of theStrategic Planning Cycle.

I. MISSION STATEMENT - This is a carefully thought out, concise state­ment of the central purpose of the organization as it currently exists. Themission statement should clarify the nature of the organization's businessdescribing its scope and long-range intent. It should provide the focal pointaround which all the organizational effort revolves and supports. Like thetotal organization's mission statement each division or department of thetotal organization should also have a mission statement briefly describingthat organizational unit's purpose, scope and intent.

II. INTERNAL ANALYSIS - A logical point of departure in any attempt toplan where we go in the future is to review our progress over the past threeto five years and take an objective look at how well we have performed. Weneed to analyze our strengths, weaknesses, products/services, customerbase, staff, anticipated constraints and the costs involved. A committee willbe established and assigned the responsibilities of researching the followingaspects of each product:

1. Past Performance. Depict the trends of your product(s) over the pastfive years in terms of dollars, volumes of activity, profitability, growth orother significant measures. Comment on any significant factors that haveimpacted the year-to-year trends.

2. Strengths/Weaknesses. As objectively as possible, list the strong pointsand the weak points of your organizational unit. What do you think is theimage of your unit internally and in the eyes of its customers?

3. Staffing. Present an analysis of your current staff in terms of age of keypersonnel, experience and expertise in their field and the degree of stabilityor turnover experienced in the staff.

4. Product/Services. Describe briefly each of the major products or ser­vices your organizational unit offers. Discuss the year-to-year growth ineach of these products or services and its relative profitability.

5. Customer Base/Potential. Present an analysis of your present customerbase considering such matters as the number of customers served, thedegree of concentration and diversity of the customer base, geographic

13

dispersion of customers, etc. If a significant portion of your unit's profitabil­ity is dependent on a few key customers, give an objective evaluation of yourposition with each of these customers, i.e., relationship with key indi­viduals, factors which could cause you to lose that customer, etc.

6. Constraints. What factors within our organizational unit keep you fromdoing a more effective job? This could be current organization policies andthe quality of performance by other organizational units upon whom youdepend. Also consider the way your unit is organized in terms of workassignments and the adequacy of physical facilities.

7. Cost to Produce the Products/Services. Determine to the degree possi­ble the cost to produce your product or services. How much per unit? Is itprofitable and by how much?

III. EXTERNAL ANALYSIS - In addition to looking in the organizationand assessing past performance, it is also essential to look outside at variousexternal factors that influence productivity. To supplement your commit­tee's efforts it may be necessary to seek assistance from the Strategic Plan­ning Committee which will be able to offer guidance and suggestions on factfinding and analysis. Principle areas of research should include:

1. Competition. List banks, S&Ls, and other firms that you consider to bethe major competition in your market area. Analyze to the degree possibletheir strengths and weaknesses and your best guess of the share of themarket they currently hold.

2. Market. Describe in terms of geographic area and total dollar volumethe current and potential market for your unit's services. Estimate the shareof this potential market you currently serve. Indicate portions of this poten­tial market that appear promising for further cultivation.

3. Environment. Any "attempt to develop plans for the future of anybusiness must take into consideration external forces and the environmentin which you will be required to operate. A close examination of past trendsand current developments can give you considerable insight into what youmay be faced with in the future.

The major external forces which will impact the bank and all financialinstitutions in the future can be grouped under the general headings of:

• Political/RegUlatory• Social• Technological• Economical

The major probable developments in each of these areas need to beresearched and applied each time the organization completes the StrategicPlanning Cycle.

IV. GOALS AND OBJECTIVES - Up to this point we have reviewed pastperformance, assessed current operations with emphasis on strengths,weaknesses and postition in the competitive marketplace, and attempted to

14

anticipate the factors in the environment which may impact our business inthe future.

As a result, you should have a reasonably clear perspective on howeffectively you are presently conducting the principal activities, how pro­ductively the resources are currently employed, what your capacities are,how external factors will influence future performance, and where, in gen­eral terms, the organization is headed. This all comes down to the primarymanagerial challenge of the long-range plal1ning process - what do wewant the organization to be and where should the organization be heading,and then what must you as a manager do, and when, if you are to attain thedesired results.

The first step in this process is the development of goals and objectives forthe organization. Goals are defined as the ideal end or outcome of purpose­ful action. They are the important conditions and outcomes that you wish toattain, and toward which you direct your efforts. These can include suchmatters as improving profitability, increasing share of market, provding thebest in services, challenging the human resource, accepting community andindustry responsibilities, etc.

Objectives represent the translation of goals into measurable terms. Theyare primarily quantitative performance targets designed to strive for theachievement of a goal. Objectives are accompanied by specific assignmentsof responsibility and achievement dates. Objectives should be both realisticand challenging. Objectives are supported by statements describing meas­ures of effectiveness.

Measures are a means of determining whether or not an objective (andeventually, a goal) is being achieved. A measure indicates the progress madeat any point in time toward reaching an objective; i.e., the degree to which atangible impact on a specific situation is being realized. Measures also helpyou determine the rate at which resources are being expended in reachingobjectives and whether or not you are operating within your plannedbudget. There are measures of efficiency and measures of effectiveness.

1. A Measure of Efficiency reflects an ability to perform certain tasks withskillful use of resources or to accomplish desired results with little wastedresources. Measures of efficiency indicate how economically resources arebeing utilized. They are usually expressed as cost per work unit produced,cost per customer, cost per employee hour, units produced per hour, or assome other expressed relationship between production and resources.Measures of efficiency do not usually provide an indication of the quality ofoutput. Example:

• Employee Compensation (salary) as a % of revenue.• Percent reduction of operating costs over the past six months.2. A Measure of Effectiveness reflects the value or quality of the product

or service provided. Not in itself concerned with how efficiently resourcesare being utilized, an effectiveness measure provides an indication of howsuccessfully resources are being applied to the objectives. Effectiveness

15

measures tend to be more subjective than efficiency measures since valuejudgments are involved, but should be quantifiable when possible. Ex­ample:

• % of market gain over the past year.• % increase in ROA during 19__.

v. STRATEGIES FOR ACTION - Strategies are defined as the specificaction plans, programs and projects selected from among alternatives bymeans of which an organization intends to attain its goals and objectives.They are the commitment to specific action aimed at capitalizing onstrengths, correcting weaknesses, solving problems, grasping opportunitiesand improving performance. This is the who, what, where, and how phaseof the planning process in which goals are translated into action plans andindividual responsibilities through formal planning decisions and com­munication sessions.

In reaching the decision point of the strategy, it is important that the rangeof feasible alternative courses of action available to reach a given objectjve beevaluated. The strategy (action plan) selected through this process of evalua­tion will be the one which is expected to produce optimum results in themost efficient manner, consistent with corporate goals and objectives, with­out affecting undesirable trade-offs or levels of risk, such as short-termprofits verus long-term asset quality. Not only does this evaluation ofalternative strategies expose all facets of a decision to analysis, it also leads tothe development of contingency plans which are useful in the event condi­tions change and strategies need to be altered.

Among the factors to be considered in determining what course of actionwill be adopted and how it will be carried out are:

1. Corporate performance goals and priorities.2. Anticipated competitor strategies/responses.3. The specific levels and types of resources required, together with their

cost and availability.4. The means of deploying new resources (or redeploying existing re-

sources).5. The costlbenefit implications.6. Acceptable trade-offs in terms of profit,risk and customer relations.7. The impact upon market or internal relationships.8. The probablility of success.9. The assignment of responsibility for the completion of specific tasks by

required dates.In describing each strategy adopted, these supporting elements should bespelled out clearly. A brief summary should be prepared to state the case foreach proposed strategy (e.g., new program or project, new product, changein pricing, different approach to existing markets, new market thrust). Itshould set out clearly the contribution (performance impact) the strategywill make toward attainment of the related objective(s), the resources re-

16

quired, the estimated incremental costs and incremental benefits of suchprograms, projects, markets and products, and the alternatives which wereconsidered and why they were rejected. Be certain to describe not only whatyou plan to accomplish, but how specifically you plan to do it. The followinggeneral questions are provided as guidelines:

1. Basic Profitability and Performance:• How will you monitor product (service) profitability? By what

criteria?• How specifically do you plan to increase income? Fees? Service

charges?• Are there new opportunities to increase income? Where? How?• How do you monitor the profitability of a customer relationship? At

what point do you drop a relationship?• What programs can be initiated to better control and/or reduce staff

expense and other operating costs?• Which unit expenses are fixed and which are variable? How variable?

How will you manage variable expenses more effectively?• Are there operating efficiencies that can be realized?• What programs should be emphasized to capitalize on the strengths

of your unit previously described? Minimize the impact of weakness­es? How do you plan to correct these weaknesses?

2. Marketing and Competitive Position:• What particular market segments and customer groups offer the

greatest opportunity for profitable growth?• Based upon your recognition of the services and products you pro­

vide, and the feasible limits of your ability to cover the market, whatmix of services should we offer to meet the needs of these marketsmost profitably?

• How can the profitability of existing markets be increased (improvedmargins, reduced expenses, greater penetration/volume, culling,de-emphasis or abandonment of marginal or unprofitable markets orproducts)?

• How do you view the profit potential of new markets and/or newproducts/services?

• Are certain markets likely to be vulnerable to competitive rate/pricecutting in the future?

• How can you enhance the quality, service and pricing of your pro­ducts/services to customers (product management)?

• What types of customers should you concentrate your calling effortsupon? Which are the most profitable? Least profitable? What areyour priorities?

• What needs to be done to improve business development activitiesand calling officer skills? How can you better structure your callingprogram?

• How can you cross-sell other banking services more effectively?

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• What changes are planned to improve the customer appeal of yourservices and products? Your delivery systems?

• How can you improve the effectiveness of your advertising andpromotional programs?

3. Innovation:• What new products, programs or services do you plan to introduce?

When? How? Results anticipated?• How can your unit be more responsive to customer needs for new

products or services?• How can we encourage and implement the development and design

of innovative services, programs and products?• What research, EDP and/or operations support do you require?• What is your plan for implementation? Who? How? When?• What services do you plan to delete or change? When? Impact?

4. Productivity and Efficiency:• What programs do you plan in order to promote productivity in­

creases, superior competitive performance and profitability? Howwill you measure/monitor results?

• How can the organization handle increasing volumes with existingstaff and facilities?

• What programs do you plan to implement in order to improve thequality, quantity, efficiency and timeliness of your operations?

• Do you have under-utilized capacity (e.g., people, equipment, facili­ties) in any area? What do you intend to do about it?

• How efficient and effective is the organization structure and division­al working relationship communicated? Do they support your plan?What needs to be done?

• What new systems do you require in order to implement your plans?• What research is required?

5. Financial Resources:• What price/cost relationships do you require to meet your profit

projections?• What is your estimate of net funds required (provided) over the

planning period?6. Human Resource:

• What are the personnel needs required to fulfill your profit objec­tives? To implement your programs? What categories and when?

• What changes, if any, do you require in recruitment, training orevaluation of performance, and how do you expect to achieve this?

• How can you develop managerial/supervisory personnel more effec­tively?

• What administrative, operational or structural changes are necessaryto meet your profit goals?

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7. Capital Expenditures:• What new facilities and/or equipment will you require to attain your

profit objectives and over what time frame?• How will this be accomplished, and what are the costlbenefits?• What are the trade-offs?• What space requirements do you foresee over the next three to five

years? Cost? Benefits?8. Social Responsibility:

• How do you intend to contribute to achievement of the organiza­tion's Equal Employment Opportunity Compliance and AffirmativeAction program? What is your specific program?

• What things can you do to promote the growth and development ofyour market area?

• What programs can be developed to respond more effectively to theconsumer movement? What profit potential can be developed indoing so?

It is important that planning efforts be coordinated and integrated amongall line and/or staff units which will be involved in the implementation of aplan. A review program is intended to assess the advantages and risks ofeach plan, assure coordination between units of the organization in thedevelopment of related elements of their plans, evaluate the trade-offs, andprovide consistency between corporate and unit goals and objectivesthroughout the organization.

Contingency Planning: It is important to consider what impact suchvariables as price, competition, economic conditions, technological change,and the like, could have upon performance. In developing strategies andprograms, these critical variables should be identified, responsibility shouldbe assigned for monitoring them, and an effective means (contingency plan)for dealing with each should be formulated. At minimum, consider theimpact of economic/monetary oscillations, and build sufficient flexibilityinto the plans that will allow for their change or modification.

VI. MANAGEMENT REVIEW ACTION - The management review actionis the process of presenting, reviewing and deciding upon the StrategicPlans. Each staff department or divisional manager will present his StrategicPlan to Executive Management for a review. The written plan is to besubmitted to Executive Management at least one week prior to an oralpresentation. Each Strategic Plan is to be presented in a standard formatwhich includes the following elements:

1. Mission Statement2. Products/Services3. Internal Analysis

• Past Performance• Strengths

Figure 2STRATEGIC PERSPECTIVE

Il·1PLEMENTATION

I

~XEClJ\\DN

O~ .. ONr: I\ND FIVE

'{Ef\~ STRf\TEGlC

PL(\~

SUPPORT

Mort~~age LendingNon-Hortgage Lending,Trus t i Servic.(~s ,Marketing &'Cus~oQer Service~

Operations/Data ~rocessing

Accounting & ;Control, iEmployee' Relatiorts :Investment Servi~es

Funds Hanagement 'I ,

DEPT/DIVORGA~IZATIO~ UNITS(Develops 1 & 5 Yr.

Strategic Plans)• . i i-------r- I

. i SE~\OR; : 0 I

, . {\\~~i\(;Et'\el\)T II 0 ' ; I I i

1 .: t~YOLVEI'l\~\11 0 ! !

; !No

STI.<ATEGIC "~ EXECUTIVE----;>... rLANNING 7 REVIEWCO~·~1ITTEE

~I ~ MISSION ~IP-(ofi t Business/Project Strategic

()

• Weaknesses4. External Analysis

• Competition• Market Potential• Threats

5. Recommended Goals and Objectives• One Year• Three to Five Years

6. Strategies for Action/Resources Required/Follow-Up Plan7. Recommendations for Decision

Figure 2, Strategic Perspective, clarifies the functions and responsibilities ofeach portion of the strategic planning process.

VII. IMPLEMENTATION - The responsibility for implementation of amanagement decision rests with the managers accountable for affectedfunctional areas. If the plan is approved, the resources required to imple­ment the plan should be identified and their expenditure approved. It will bethe responsibility of individual managers and their employees to implementtheir plans on a day-to-day basis in order to achieve their objectives withinthe resources approved. Throughout this day-to-day management/imple­mentation process, records must be kept and observations made to evaluatethe effectiveness of the Strategic Plan.

VIII. EVALUATION - The evaluation process should take place on acontinuous basis throughout the implementation phase of the cycle. Aformal evaluation is to be made each year on how well the organization hasperformed against its plan and established objectives. The evaluation pro­cess is divided into two formal assessment activities:

1. Evaluation of People Performance. This is carried out by each boss/subordinate during their annual performance planning and performancereview discussions. Employee Relations Department assists management inthis area by providing performance evaluation forms and coordinating theactivity.

2. Evaluation of Product Performance. This activity is monitored by eachmanager against his department's goals and objectives. Emphasis is given tosales performance, market share, and profits.

SUMMARY

Strategic planning and strategic thinking have become necessities forincreasing profits in that they provide a means to deal with change. Changesin economic conditions, regulatory requirements, legal structure, growthand diversification, and increased competition must be projected and dealtwith effectively. Without prior planning and preparation there is littlechance one will utilize change to any extent.

21

Upon completion of the Strategic Planning Cycle, management will have abasis for:

• Making better decisions regarding- Budgets- Space- People

• Improved communication to all employees through the context of thejob.

• Motivating employees through responsibility and achievement.• Rewarding employees through performance.• Achieving the organization's goals and objectives.A word of warning is in order. Strategic planning is a highly creative

process. To be successful, planning requires imaginative thought ratherthan mechanistic procedure. Without flexibility in the planning processthere is little chance that the organization will be able to adapt to unantici­pated external and internal conditions. Finally, without regularity there islittle chance that planning will be anything more than a "quick-fix."

NOTES

lComputer programming is available from the American Bankers' Association foruse on the microcomputer which allows low cost strategic information. The primarymanual, Microcomputer Modeling to Improve Community Bank Financial Performance,brings both modeling and analytical powers to users for approximately forty dollars($40.00). In addition, the basic model is easily adaptable for thrifts as well as asset/liability (tactical) modeling.

REFERENCES

1. Ernest, J.W., and Patera, G.E., "PlanIling and Control systems for CommercialBanks," The Changing World of Banking, Prochnow, H.V., and Prochnow, H.V.,Jr., Eds., New York: Harper and Row, 1974, pp. 244-277.

2. Gluck, F., Kaufman, S., and Walleck, A.S.,"The Four Phases of Strategic Man­agement," The Journal of Business Strategy, Vol. 2. No.3, Winter 1982, pp. 9-21.

3. Cup, B.E., and Whitehead, D.O., "Shifting the Game Plan: Strategic Planning inFinancial Institutions," Economic Review, Federal Reserve Bank of Atlanta, Decem­ber 1983, pp. 22-33.

4. Johnson, H.E., "Comprehensive Corporate Planning for Banks," The BankersHandbook, Baughn, W.H., and Walker, C.E., Eds., 1978, pp. 273-287.

5. Jones, CeL, "Know Thy Niche," The Bankers Magazine, July-August 1982, pp.32-35.

6. Kahn, S.J., "Management Strategies for the '80s," The Southern Banker, June 1982.7. Metzger, R.O., and Rau, S.E., "Strategic Planning for Future Bank Growth," The

Bankers Magazine, July-August 1982, pp. 57-65.8. Microcomputer Modeling to Improve Community Bank Financial Performance,

Washington, D.C.: American Bankers Association, 1982.9. Nelson, R.R., "Strategic Marketing," The Bankers Magazine, July-August 1982, pp.

43-46.

22

10. Porter, M.E., Competitive Strategy: Techniques for Analyzing Industries and Competi­tors, New York: The Free Press, 1980.

11. Rockwell, G.B., "Strategy Development," The Bank Director's Handbook, 1981, pp.153-170.

12. Thompson, T.W., Berry, L.L., and Davidson, P.H., Banking Tornorrow, 1978,chapters 2, 3, 4, 11.

13. Yalif, A. , "Strategic Planning Techniques." The Magazine of Bank Administration,April 1982, pp. 22-26.

23

CHAPTER 11: A TOOL OF STRATEGIC MANAGEMENT

Arthur D. Sharplin

Department of ManagementNortheast Louisiana University

Monroe, Louisiana

Since the current bankruptcy law was enacted in 1978, there has been avirtual avalanche of bankruptcy filings. The number of "straight" bankrupt­cies, under Chapter 7 of the U.S. Bankruptcy Code, more than doubled from1979 to 1983; but the number of "reorganizations" under Chapter 11 almostquintupled, to more than 18,000 filings in the year ending July 31, 1983. Justas remarkable as the number of filings is the diversity of strategic purposeswhich have been served by those filings (1).

Because of the uses to which Chapter 11 has been put, many feel that thelaw should be repealed or its provisions modified (2). Repeal appeared tohave been effectively accomplished in 1982 when the Supreme Court ruledChapter 11 to be unconstitutional because of the extraordinary powers itconfers upon bankruptcy judges, who lack the lifetime tenure and the salarymaintenance protection which insulate other federal judges against politicalinfluence. However, the law continues in effect under a "Special Rule,"which was established by the federal judiciary in December 1982. Under theSpecial Rule, bankruptcy judges operate with district court oversight andcontroversial matters are heard by district court judges if a party at interest inthe bankruptcy court so moves.

The Supreme Court has refused to hear challenges to the Special Rule andseveral appeals courts have upheld its constitutionality. In addition, pro­posed bills in Congress would cure Chapter 11's unconstitutionality byessentially incorporating the provisions of the Special Rule (3). In light ofthis, it appears probable that the provisions of Chapter 11 will remain ineffect for a long time and corporate managers will continue to take advan­tage of its provisions to serve themselves or one or more of their multipleconstituencies. Let us consider how Chapter 11 can be turned to the benefitof different constituent groups, especially the managers themselves.

Managers May Extend Their Tenures or Obtain Favorable Severance

Most executives who file Chapter 11 petitions for their companies do so totheir own benefit, if not for their own benefit. By the time a company seeksprotection under the bankruptcy law it is usually doomed to failure withoutsuch protection and company executives are facing imminent loss of their

24

jobs. After a Chapter 11 filing managers typically continue in office andenjoy full pay, benefits and perquisites. They may even be able to enhancetheir compensation packages. Of course, a party at interest in the bankrupt­cy court may object to the executive pay and benefits, but this seldom occurs.

In a small percentage of Chapter 11 cases, professiQnal "turn-aroundartists" are employed. Among the better known of such specialists areSanford Sigoloff, the new leader of Wicke's Corporation; Joe B. Freeman, ofAM International; and Victor Palmieri, the chairman of Baldwin UnitedCorporation. When these specialists take over, they typically replace seniormanagers and often fire managers far down in the organizations. Even then,however, top managers frequently leave on very favorable financial terms.The deposed chief executive of AM International, for example, receivedseverance pay along with a lucrative consulting contract. When the seniorvice-president of Manville Corporation left shortly before the Chapter 11filing, he did so under a new and highly favorable early retirement plan. Thetwo top executives of International Harvester, which threatened a Chapter11 filing for more than a year, left with millions in severance pay and debtforgiveness. Such results are predictable because executive compensationtypically accounts for a small proportion of total corporate expenses andthere are much more pressing matters facing creditors and other parties atinterest. In addition, any top management team which is deposed withoutgracious treatment can contest their removal in the cognizant district court.

Power and Cash Simplify the Management Job

Company management has increased power under Chapter 11 because itis typically able to pick the forum in which the Chapter 11 process will beconducted. There are districts which tend to be "pro-debtor" and otherswhere creditors are favored. In the Western District of Louisiana, for exam­ple, top managers are often replaced with a trustee. In the Southern Districtof New York, where Cincinnati's Baldwin United and Denver's ManvilleCorporation filed, this does not happen. The bankruptcy code allows abankruptcy petition to be filed wherever the company has had a "principalplace of business" for the 180 days preceding the Chapter 11 filing. For mostmajor corporations, this includes almost any bankruptcy district in theUnited States. Even smaller companies can establish a "principal place ofbusiness" in any district where they desire to file as long as they anticipatethe filing, even potentially, as much as six months in advance. This allowsmanagement to "judge shop" and to select that district in which they feelthat they are most likely to have their way.

Managers who stay in power after a Chapter 11 filing may find their jobsmuch easier to perform. The monthly struggle to pay maturing debt ceasesand cash shortages are usually quickly eliminated. Receivables due at thetime of the filing flow in and payables, leases, trade accounts, installmentnotes, etc. no longer have to be paid. This can produce from thousands to

25

hundreds of millions of dollars in added cash. (Post filing cash and near cashexceeded $65 million at Continental Airlines and $200 million at Manville.)Until a reorganization plan is confirmed - and to some extent thereafter­prefiling creditors have little control over what is done with inflowing cash.Management is relieved of the trying responsibility of dealing with dozensor hundreds of separate creditors and can confront them collectivelythrough their duly appointed committees in the bankruptcy court. WhenContinental Airline's secured creditors tried to restrict the use of cash fromprefiling accounts receivable, they were unsuccessful. Of Manville's morethan $230 million in cash and marketable securities as of June 30, 1983, only$77 million was restricted as to use.

Managers of most companies feel obligated to provide creditors withtimely financial information whenever they demand it. Under Chapter 11,however, such timeliness is not required. While bankruptcy law contem­plates monthly financial reports, many courts allow substitution of Secur­ities and Exhange Commission Forms 10-K and 10-Q. The 10-Q forms arefiled within 45 days after the end of each calendar quarter and the 10-Kreports are required three months after year end. So corporate managerstypically have additional power because they have access to and control overfinancial facts and figures which creditors and others do not have - at leastfor a few months.

Top managers of a firm which has filed a Chapter 11 petition typically havethe power to dismiss employees and other managers willy-nilly or to affordexceptional benefits to those whose allegiance they consider most useful."Saving the company" justifies almost any kind of extreme action. Thenecessity to compensate valuable team players to get them to give their bestto a company which may not have a long term future provides a rationale forhigh pay. There is really no need for company management to struggle withthe question of whether a manager is really worth the amount paid or notbecause any savings achieved through compensation efficiencies typicallymust be allocated to provide additional payment to creditors and otherclaimants.

Managers operating under the shield of Chapter 11 may also have aneasier time meeting competition in the marketplace. Not only have theyavoided some of the usual expenses of doing business, like interest andsome of the principal on unsecured debt, there is no real need to sell at abovethe cost of production if pricing below costs will make the sale. Besides, anyprofit made will usually just go to pay creditor claims.

Eliminating Problem Divisions

Chapter 11 also simplifies the management job by providing a rationale fordisposing of difficult to manage and/or unprofitable segments of the com­pany. The typical pattern in major company reorganizations is to sell offwhole divisions, thereby obtaining cash while improving profitability and

26

simplifying management. Manville sold its Belgium operation - by theway, to the managers of that organization - and its U.S. pipe operationalong with a large number of other assets and divisions. Wickes Corporationsold its House of Fabrics chain, a furniture manufacturing division, and anumber of other units. If management sells any part of the company at all,this makes the job of managing easier. But it is possible to concentrate upondisposing of those elements that require most of management's time andenergy while retaining decentralized and profitable parts of the company.The debtor in possession is required to report major asset disposals to thebankruptcy court and sometimes the proceeds from such sales are restrictedas to use, but it is seldom that such sales are effectively opposed.

An Easy Assignment: Minimize Profits

Prior to the confirmation of a plan for reorganization, managers actuallyhave an incentive to minimize profits, a condition which greatly simplifiesthe job of management. Executives need not worry that low profits may costthem their Chapter 11 shield. The provisions of the bankruptcy code whichallow the conversion of a Chapter 11 proceeding to a Chapter 7 liquidationare seldom used. Even if such an effort is made by creditors it can becontested in the district court by management. Any attempt to vacate aChapter 11 petition can be similarly resisted. In one Chapter 11 case inShreveport, Louisiana the bankruptcy judge ruled that he debtor should bestripped of Chapter 11 protection. The Company appealed that ruling to thedistrict court and immediately filed a new Chapter 11 petition, which thebankruptcy court honored. A similar motion has been filed by the AsbestosClaimants Committee in the Manville Case. That motion was not carriedforward for more than a year. Such efforts in other cases are likely to meetwith little success because of the heavy burden the bankruptcy code placeson a party which desires to have a Chapter 11 case converted to a Chapter 7case and because of the presumption that the "debtor in possession" that is,current management, will continue to operate the firm while in Chapter 11.

If prior to filing a reorganization plan, the bankrupt firm were to earnsignificant profits, this would surely result in creditor demands for a largerpercentage payout to themselves and stockholder resistance to any effort todilute their interest or diminish their returns under a reorganization plan.So, in the period between the filing of a Chapter 11 petition and the con­firmation of a reorganization plan there are strong incentives for minimizingprofitability as long as this can be done without risking conversion to aChapter 7 liquidation, imposition of a liquidating plan under Chapter 11, orthe replacement of company management by other managers or a trustee.

Even after a plan is confirmed there is often little reason for companymanagement to put forth the effort required to earn profit. Amounts dueunsecured creditors are often stated as a percentage of profits and moreprofits just means that more must be paid. Second, management can prob-

27

ably defer payment of planned amounts with relative impunity, standingready to appeal any adverse bankruptcy court decisions to the district court.

A successful Chapter 11 might be defined as one in which the debtor inpossession (1) files a reorganization plan providing for payment of all or aportion of the company's debts over an extended period of time, (2) paysthose debts in accordance with the plan, and (3) emerges from reorganiza­tion a profitable company. Of the 200 or more cases which have been filedsince 1978 in the Western District of Louisiana, not a single case meets thisdefinition. This relfects the disincentives which managers have to fulfill thespirit of Chapter 11.

Extending the Grace Period

If managers desire to delay the confirmation of a reorganization planunder Chapter II, it is usually easy to do so. For the first 120 days after aChapter 11 petition is filed, management alone has the right to propose aplan of reorganization. This 120 day period can only be extended or allowedto expire. If it expires, any party at interest, including a stockholder, acreditor, the bankruptcy court, or perhaps others, can propose a plan. If thiswere to occur in a major case, pandemonium might result, with many plansbeing filed and probably with no plan likely to receive the required commit­tee approvals for confirmation. Because of this spectre, bankruptcy judgesare hesitant to terminate the 120 day exclusionary period and the period isoften extended for a year or more. Even if management believes that thecurrent extension at a particular time is "the final one" it is only necessary topropose a reorganization plan, however unlikely that plan is to be con­firmed. As long as the plan is submitted "in good faith," the debtor inpossession is automatically granted another 60 days to win approval of theplan by various committees. This period, too, can be extended for as long asthe judge feels that there is some likelihood of achieving a confirmable plan.

Potential Benefits to Stockholders

It is possible for a Chapter 11 proceeding to result in a great improvementin shareholder interest, either collectively or as separate groups. It is evenpossible that Chapter 11 might benefit particular shareholders at the ex­pense ·of others of the same class.

Stockholders in GeneralTo begin with, Chapter 11 can hardly damage shareholder interest for a

company which is truly insolvent. When companies are liquidated underChapter 7 unsecured creditors seldom get significant payment on theirclaims. Rare indeed would be any return at all to shareholders, preferred orcommon. Just as rare would be a Chapter 11 reorganization plan whicheliminates all shareholder equity. Such a plan would hardly receive therequired two-thirds approval of shareholders.

28

If, as is usual, the Chapter 11 proceedings result in the elimination of somecorporate debt, the payment of such debt over extended terms withoutinterest, or the substitution of equity for debt, the company's equity secur­ities have some potential value. In addition, the favorable tax treatment ofdebt discharges under bankruptcy law accrues to the benefit of shareholders(4). This is reflected in the fact that Manville Corporation common stock,after having sold for less than $8 per share shortly before the Chapter 11filing, increased to the range of $12 to $16 per share during 1983. In Novem­ber 1983 Revere Copper's common stock was selling around $13 per shareand Baldwin United's was priced at over $3 a share.

Shareholders may benefit in a major way if management is able to gainconfirmation of a reorganiazation plan which provides for a reasonablyquick payout of a small percentage of corporate debt· and then if manage­ment tries to maximize company profitability. Of course, the amount andterms of payment for which creditors will settle is largely dependent upontheir perception of the alternatives. If ,managers convince creditors thatcompany profitability will be low, creditors are likely to accept either a lowpercentage of payment or very extended payment terms.

Until recently, the payment terms under Chapter 11 plans typically ex­tended for less than five years after confirmation. Recent plans have tendedto provide full payment of claims but over a period of up to ten years. In fact,a plan suggested by District Judge Edelstein in the Manville Corporationcase contemplates payment over at least a 20 year period and perhapslonger. Judge Edelstein suggested that the entire profit of the company beallocated to pay claims. If management were forced to follow a plan whichcontemplates such extensive payouts over such a long period of time, it isunlikely that shareholders in the aggregate would benefit. It is possiblethough, that after profits fail to meet expectations and payments are corres­pondingly low I management might be able to negotiate a revised plan lessfavorable to claimants and more favorable to shareholders. After that, man­agement might be encouraged to put forth the effort required to increaseprofitability.

If a company is solvent when its managers lead it into the Chapter 11process, the shareholders stand a very good chance of losing, even thoughdebt may be reduced and certian expenses may be avoided. The perverseincentives to management discussed above may lead managers to sub­optimize shareholder interest.

In some cases (Continental Airlines, Braniff, Wilson Packing Company,among others) Chapter 11 filings allowed the renegotiation or outrightavoidance of labor contracts. In others (Rath Packing Company, Food Fair,Inc., among others) pension costs were reduced by' termination of retire­ment plans, renegotiation of contribution rates, or withdrawal from mul­tiemployer plans (5) Any contract, executory or not, may be avoided orrenegotiated under the threat of cancellation by the debtor corporation. This

29

includes leases, supply contracts, debt indentures, and many more whichmay involve continuing costs for the obligor. Shareholders in solvent com­panies which file under Chapter 11 may benefit when any of these contractmodifications or cancellations decrease costs.

Preferred vs. CommonIf a single committee represents preferred and common shareholders, as

is typically the case, common shareholders should usually gain in relation tothe preferred shareholders because of a Chapter 11 reorganization. In case ofliquidation, preferred shareholders would receive the par value of theirshares before anything went to common shareholders. Since the bankruptcycode requires a two-thirds vote in amount of each class of interests before areorganization plan can be confirmed, the common shareholders will nor­mally block confirmation of any plan which fails to provide them significantbenefits. preferred shareholders, on the other hand, usually benefit vis a viscreditors because these shareholders would normally receive nothing in aChapter 7 liquidation and are able to insist upon some benefits to gain theiracceptance of a plan.

Individual ShareholdersEven though stockholders in general may not gain from a Chapter 11

reorganization, it is possible that certain individual shareholders will. This isespecially true for those holding large blocks of stock or those who havereliable sources of information about how the Chapter 11 is going. As thefortunes of the company ebb and flow with each new filing by a party atinterest and with each new ruling by the cognizant bankruptcy judge ordistrict judge or by other judges in related cases, stockholders who are ableto predict the impact on share prices are able to buy and sell profitably. In theManville Corporation case, both common and preferred stock prices havegyrated widely as various developments have occurred in the case. Forexample, Manville common shares which sold for less than $5 the day afterthe Chapter 11 filing sold for a high of $16 in 1983 with several variations inthe 30 percent range during the intervening months. Revere Copper's com­mon stock ranged from 43/4 to 14 'l's in the year after that company's filing. Ingeneral these variations did not follow changes in the productivity or earn­ing capabilities of the corporations but rather accompanied the variouspleadings and rulings in the cases. The opportunity that these kinds ofvariations provide for persons with special contacts need not be explained.

How Creditors Fare

The bankruptcy code appears to provide adequate safeguards to protectcreditors from losing from a Chapter 11 reorganization as compared to aChapter 7 liquidation. The code requires that the reorganization plan pro­vide a settlement for all claimants at least as favorable as that they would

30

receive under a Chapter 7 liquidation. It would also at first appear thatcreditors can make sure they gain from Chapter 11 by withholding theirapproval of any proposed reorganization plan which provides less thanwhat they would receive under Chapter 7. However, any real losses whichoccur after the Chapter 11 filing may reduce the amounts which creditorseventually receive. Because of the flexibilities allowed under accountingconvention, managers have little trouble hiding moderate real losses. Inaddition, no matter how much has been lost up to any point in the Chapter11 process, creditors are likely to find it difficult to terminate the process aslong as management is able to show a prospect for improvement. So,reorganization often proceeds along until creditors are much worse off thanthey might have been at the start with a liquidation. For example, Samba'sRestaurant, Inc. lost more than $30 million after filing for Chapter II,provoking the assistant trustee in the case to conclude that there would benothing at all left for the unsecured creditors and not enough to even pay theclaims of secured creditors.

Even when the company's assets are not depleted through losses, unse­cured creditors may lose because they are often not paid interest on theirclaims. In fact, it is not even necessary to accrue such interest in the debtor'sbooks. Secured creditors may lose because the value of the assets on whichthey hold liens may be diminished through use and lack of maintenance. Atthe same time, as in the Sambo's case, the company's other assets may bedepleted to the extent that nothing is available to make up the deficiency inthe liened property. Continental Airline's secured creditors tried to protectthemselves against this eventuality by asking the bankruptcy court to re­strict certain cash balances. The judged refused to do so. Of course, securedcreditors have access to their collateral to the extent that it is not required forthe continuation of the business, but managers seldom have any problemshowing that a partiuclar asset is required. Consequently, secured creditors,at a minimum, often must accept delay in payment (6).

Creditors of all kinds may come out ahead, as compared to how theywould fare upon liquidation. This would be the case if current corporatemanagers, notwithstanding the disincentives to do so, have both the abilityand inclination to operate the company more profitably than potentialpurchasers. Of course, this should rarely be true.

Conclusion

Chapter 11 provides a procedure which may produce major and con­tinuing benefits to corporate managers and almost certainly improves thesituation for stockholders, but which is exceedingly unlikely to benefitcreditors. Company managers are the primary referees as well as the mainbeneficiaries.

31

REFERENCES

1. For an interesting overview of some of these purposes, see Anna Cifelli,"Management by Bankruptcy," Fortune (31 October 1983), pp. 69-72.

2. James E. Stacy, "Innovation Through Bankruptcy?" Business Horizons (MarchiApril 1983, pp. 41-45. While Stacy reports the clamor for tightening the bankruptcylaw, he feels that such sentiment is misguided, that the law as it stands benefits thepublic by encouraging innovation.

3. For a readable discussion of the "Special Rule," see David Ranii, "Bankruptcy'sTwilight Zone," The National Law Journal, Vol. 6 (7 November 1983), pp. I, 9-11.

4. Richard A. Noffke, "Discharge of Indebtedness Under the Bankruptcy Tax Actof 1980," Taxes, Vol. 60 (September 1982), pp. 635-649.

5. Richard S. Soble, "Bankruptcy claims of Multiemployer Pension Plans," LaborLaw Journal (January 1982), pp. 57-63. Soble discusses the difficulties of collectingpension liabilities from bankrupt companies which withdraw from mulitemployerplans.

6. See, for example, "Continental's Feisty Chairman Defends Deregulation - andHimself," Business Week (7 November 1983), pp. 111-115.

32

DEFINING YOUR BUSINESS MISSION:A STRATEGIC PERSPECTIVE

William A. Staples and Ken U. Black

School of Business and Public AdministrationUniversity of Houston - Clear Lake

Introduction

One of the major problems for managers of business organizations is toallocate the necessary time for planning the future direction of their com­panies. Most of one's day is spent on administrative or tactical problems tothe exclusion of issues of a more strategic nature. This occurs more frequent­ly in smaller companies in which a manager may have to handle both theday-to-day operations and the long-range planning. However, even in largeorganizations, strategic or top level managers often spend a high percentageof their time devoted to internal rather then external matters.

The purpose of this article is to discuss the nature of strategic planning forthe manager of either small or large organizations. While the time allottedand depth of analysis for strategic planning may vary by size of company,the basic procedure remains the same. In addition to providing an overviewof the process of strategic planning, specific emphasis will be given to theimportance of defining your business in terms of a company's missionstatement. The argument will be made that once an organization has definedits business mission, the remaining steps of the strategic planning processwill become easier for the manger.

Strategic Planning Process

The process of strategic planning involves a number of steps that involveanalyses of conditions both inside and outside the organization. Table 1 liststhe major steps in the strategic planning process. (1) The initial step is thedefinition of the company's mission and management philosophy. Thestatement of mission and operating philosophy will basically define thetypes of business ventures, both product and market, which a company willpursue. A second step in the process would be to assess the company'sinternal strengths and weaknesses. An analysis of most companies wouldreveal one or more dominant functions, such as marketing, production,finance, or research and development. At the same time a company isidentifying its strengths, the weaknesses tend to be revealed as well. Thethird major step shifts to outside the organization in terms of monitoringchanges in the external environment. Key elements of the external environ-

33

ment that are included for analysis are competitors, customers, suppliers,and dealers or distributors. In addition, attention should also be devoted tochanges in cultural or social attitudes, technological advances, the state ofthe economy, the political climate, and legal requirements.

TABLE ISTRATEGIC PLANNING PROCESS

1. Define the company's mission and management philosophy2. Identify internal strengths and weaknesses3. Monitor changes in the external environment4. Identify opportunities and threats5. Formulate specific goals or objectives6. Identify and evaluate alternative strategies7. Select a strategy or strategies8. Prepare functional plans to support each strategy

At the completion of the first three steps, the management of a companyshould be able to identify some actual or potential opportunities or threats.A given change in the external environment will normally have a positive,negative, or no effect on a company. With respect to managerial decision­making, the task is to capitalize on the opportunities and minimize thethreats. One author (2) has suggested that an environmental opportunitymayor may not be a company opportunity. The following assumptions maybe in order to determine if an environmental opportunity is worth pursuingfrom the company's point-of-view. First, every environmental opportunityhas specific success requirements. Second, each company has distinctivecompetencies or things it can do especially well. Third, a company is likely toenjoy a differential advantage in an area uf ~nvironmentalopportunity if itsdistinctive competencies or strengths exceed those of its actual or potentialcompetitors.

Once opportunities or threats have been identified, some specific pro­grams may be required. Whether a program is designed for an opportunityor a threat, some goals or objectives will be necessary. With respect toopportunities, most objectives traditionally refer to measures such as sales,market share, profits, or return-on-investment among others. The problemis that managers often fail to state specific objectives. While "increasingmarket share" may be a worthy objective, "increasing our market share forbrand A by 5% by the end of 1984" is more meaningful. With the latterobjective, a person in the company would know the extent of the increasedesired in market share as well as the time period in which to accomplish theobjective. For control purposes, the second objective will be much easier for

34

program and personnel evaluation. Managers should also remember to setobjectives when they are trying to minimize a possible threat. For example,"Decreasing customer complaints by 15% during the next calendar year"would also be an appropriate objective.

Once the overall goals or objectives have been formulated, a managermust identify and evaluate alternative strategies which may be used to attainthe objectives. From a company-wide perspective, six major possibilities areavailable for consideration. The six options are presented in Table 2. Thestrategy option with the least risk will be market penetration which wouldinvolve attempting to gain greater sales, market share, or profits by beingmore productive in our existing markets with our existing products. Ifmanagement decided to enter new markets with existing products, marketdevelopment would hopefully occur. On the other hand, if either minor ormajor changes were made in the product offering, product developmentwould be the strategy. The most risky approach would involve a change inboth the product offered and market served which would result in a diversi­fication strat~gy. A company may also desire to explore the possibility ofgaining greater control of the manufacturing or distribution of its productthrough forward or backward integration. For example, a retailer may assessthe feasibility of backward integration with respect to obtaining an interestin a wholesaler or manufacturer. Horizontal integration could also beselected and would involve the purchase of a competitor. A final strategicoption is to cease offering a given product or serving a particular market dueto a variety of factors, including increased competition, declining sales andprofits, or the existence of alternative products and markets which offer agreater potential gain.

TABLE 2STRATEGY ALTERNATIVES

1. Market PenetrationExisting ProductsExisting Markets

2. Market DevleopmentExisting ProductsNew Markets

3. Product DevelopmentNew ProductsExisting Markets

4. DiversificationNew ProductsNew Markets

5. IntegrationVerticalHorizontal

6. Market or Product Contraction

The actual selection of a strategy will depend to a large degree on thecompany's strengths and its current product-market situation. It is not

35

unusual for a company to pursue multiple strategies at anyone time. forexample, while a company may always strive to do a better job with itsexisting products and customers, the company may also be entering newmarkets or introducing new or improved products or services. Due toincreasingly short product life cycles, the strategy of product or marketcontraction will also occur more frequently than desired for most com­panies. Regardless of the strategy or strategies under consideration forselection, a manager may wish to consider three questions. (6) The firstquestion, "Where are we now?", involves an assessment along traditionallines of sales and profitability although other indicators may also be used.The second question, "Where do we want to be?", should point to desiredlevels of some of the same indicators used to answer the first question. Thethird question, "How shall we get there?", forces the manager to considerusing one or more strategic options to attain the desired position.

The final step of the strategic planning process requires the preparation offunctional action plans to support each strategy that will be implemented.This step means the beginning of the transition from strategic to tacticalplanning. While the individual functional plans in research and develop­ment, production, and marketing may be relatively easy to prepare, theintegration of these functional plans into an overall tactical plan may be verydifficult. The tendency exists for each department within the organization tostress their dominant concerns. For example, production usually stresseslong production runs of few models, while marketing desires the opposite.The need for functional integration is particularly critical when a companyembarks on major changes in their products, markets, or both.

While each of the eight steps of the Strategic Planning Process listed inTable 1 could be the focus of an article, the reminder of the discussion willfocus on the initial step of defining a company's mission and managementphilosophy. The next section discusses the qualifications of an effectivemission statement.

Company Mission Statements

The preparation of a company's mission statement is one of the mostcritical and fundamental components of the strategic planning process. Asnoted in Table 1, the definition of the company's mission and managementphilosophy is the initial step in strategic planning. However, this critical stepis often the most difficult activity for management to undertake and com­plete. A number of leading authorities in management have suggested thelevel of overall importance of a mission statement. One authority (4) sug­gests that the mission statement stake out broad areas of business in whichthe firm can, or perhaps cannot, operate. Another expert (7) advances theidea that the mission statement is the foundation on which detailed objec­tives, strategies, and tactical plans can be worked out.

36

Given the importance of a company's mission statement, the major con­cern of managers is how to approach this activity. One author (2) hassuggested that a mission statement is developed by answering questionssuch as "What is our business? Who is the customer? What is value to thecustomer? What will our business be? What should our business be?"Answers to these questions may be an appropriate step in the formulation ofa mission statement. However, one individual (5) has indicated that themission of a company should fit the following qualifications:

1. It should define what the organization is and what the organizationaspires to be.

2. It should be limited enough to exclude some ventures and broadenough to allow for creative growth.

3. It should distinguish a given organization from all others.4. It should serve as a framework for evaluating both current and

prospective activities.5. It should be stated in terms sufficiently clear to be widely understood

throughout the organization.An example of a company's mission statement may help to clarify the

relationship of the mission statement to the strategic planning process. It hasbeen suggested (8) that Southwest Airlines' primary mission or purpose is"to provide mass transit for as many passengers as possible". In accordancewith this mission statement, Southwest Airlines has stressed lower fares toincrease the overall market as well as its own market share. Specific actionstaken include minimum fares, frequent flights, and high labor productivity.Compare the above mission statement for Southwest Airlines to the follow­ing for a publishing firm which states its mission is "to provide high qualitytextbooks" or a drilling equipment manufacturer's mission "to providequality drilling equipment to the oil industry". The major limitation of thelast two mission statements is a reliance on a product, rather than a custom­er, orientation. The difference between a product or customer orientation isa key to establishing a management philosophy to guide the present andfuture activities of the organization.

Management Philosophy

The content of a company's mission statement will vary to a large degreeon whether a company defines its business in product or customer terms.One author (3) has suggested that firms succeed or fail over time based ontheir ability to define themselves in terms of customer needs. The tendencyfor managers to define their businesses too narrowly in product terms hasbeen called "marketing myopia". Table 3 provides some examples of thedifferences between a product and a customer-defined business.

The critical point for managers to consider with respect to formulatingtheir company's mission statement and management philosophy is that

37

basic customer needs continue long after a given product or service hasvanished from the marketplace. While the need for a telephone may someday be non-existent, the need for communication will continue. Similarly,while the need for oil and gas may diminish, the need for energy will exist.The identification of potential opportunities and threats in the strategicplanning process will hinge to a large extent on how managers view changesin the external environment. The adoption of a customer-orientation fordefining the company's mission should help to spot both opportunities andthreats which may have been missed or simply dismissed if a company wasoperating under a product-dominated management philosophy.

While some managers may believe that a product definition is objectivewhile a consumer-orientation is subjective, they should recognize that themajority of successful products and service are geared to specific customerneeds. Rather than developing a product and trying to find a market, theoperating philosophy of organizations should be to identify customersneeds and then provide a product or service to fulfill those needs.

TABLE 3PRODUCT VERSUS CUSTOMER ORIENTATIONS

Product-OrientationTelephonesOil and GasRailroadsMoviesBowling BallsComputersBanking

CompanyAT&TExxonUnion PacificUniversal StudiosBrunswickIBMChase Manhattan

Customer-OrientationCommunicationEnergyTransportationEntertainmentRecreationInformation ProcessingFinancial Services

Conclusions

The purpose of defining your business mission is to specify the purpose ofthe company and to provide direction for those who work in the organiza­tion. The argument has been advanced (5) that the organization which has aclear understanding of why it exists, what it wants to achieve, and forwhom, is more likely to succeed. In addition, the emphasis on strategicmanagement and planning is likely to increase in the future; so the activitiesof the strategic planning process will become critical for long-run survival. Astatement of a company's mission and management philosophy shouldenable a manager to successfully undertake the task of identifying andimplementing effective business strategies.

38

REFERENCES

1. Henry, Harold W., "Strategic Management: Longer View, Broader Options,"Survey of Business (Spring, 1981), pp. 4-9.

2. Kotler, Philip, "Strategic Planning and the Marketing Process," Business (May­June, 1980), pp. 2-9.

3. Levitt, Theodore, "Marketing Myopia," Harvard Business Review (July-August,1960), pp. 24-47.

4. Linnemann, Robert E., Shirt-Sleeve Approach to Long Range Planning for the SmallerGrowing Corporation, (New York: Prentice-Hall, 1980).

5. McGinnis, Vern J., "The Mission Statement: A Key Step in Strategic Planning,"Business (November-December, 1981), pp. 39-43.

6. O'Dell, William F., Andrew C. Ruppel, Robert H. Trent, and William J. Kehoe,Marketing Decision making, (Cincinnati, Ohio: South-Western Publishing Com­pany, 1984).

7. Steiner, George A., Strategic Planning - What Every Manager Must Know, (River­side, New Jersey: The Free Press, 1979).

8. "Upstairs in the Sky: Here Comes a New Kind of Airline," Business Week (June 15,1981), pp. 78-92.

A Comparison of Strategies for ExpensingBusiness Property

Wallace Davidson and Sharon GarrisonDepartment of Finance, Insurance, Real Estate & Law

North Texas State UniversityDenton, Texas

The United States Tax Code provides taxpayers with ma11Y options ortradeoffs of which people in business should be aware. Whenever a tradeoffis granted, the taxpayer needs to be able to determine which of the options isoptimal given his/her current economic status.

The Economic Recovery Tax Act of 1981 (ERTA) includes a provision thatprovided taxpayers with a choice. Under ERIA, a taxpayer may write offproperty, up to certain limits, as an immediate tax deduction or may elect toreceive an investment tax credit and depreciation deduction. Under the firstalternative 100% of the cost may be expensed during the tax year of acquisi­tion. Under the second alternative, the total tax writeoff is greater than100%, but it occurs over a longer period of time. This problem is a classic casein which the taxpayer must choose between a larger amount or, a fasterwriteoff.

This paper presents a concise, clearly stated solution to this problem. Byunderstanding the results in Table I, a taxpayer with business property willbe able to make the correct tax decision.

I. The Economic Recovery Tax ActThe Economic Recovery Tax Act of 1981 (ERTA) includes a provision that

was designed to be of particular benefit to small businesses or individualswith business property. This provision gives the taxpayer the choice oftreating certain investment property as an expense in lieu of capitalizing anddepreciating such property. Section 179 outlines the election to expensecertain depreciable business assets. Section 179 property is defined as prop­erty that would ordinarily be covered under the ACRS depreciation codesand which is acquired by purchase for use in a business or trade. Suchproperty is allowed as a deduction on the taxpayer's return for the year inwhich the property is placed in service. The aggregate amount which may bededucted for any taxable year may not exceed the following amounts:

1982 $ 5,0001983 5,0001984 7,5001985 7,5001986 and thereafter $10,000

40

In the case of a husband and wife filing separate returns, the applicableamount on each return shall be 50% of the above amounts. If a taxpayerelects to expense business property, then those amounts may not be depre­ciated under the ACRS statutes. If such property is not used in the trade ofbusiness at any time before the close of the second taxable year in which theproperty is placed in service, then regulations provide for recapturing thededuction.

Whether to take the first-year writeoff or to take an investment tax credit(ITC) and depreciate the property involves some planning on the part of thetaxpayer. Strategies depend on the value of the first year tax deductionversus the aggregate value of the investment tax credit and depreciation ofthe asset. The value of each of the alternatives will be examined in the nextsection.

II. The Value of the Strategies

Taxpayers have the option to expense an asset with a price of $7500 or lessin 1985, or to take an investment tax credit (IrC) and depreciate the asset.Since there is a choice involved, it will be shown that the optimal solutiondepends upon the taxpayer's tax bracket and opportunity cost of funds. Anytaxpayer will be able to use the valuation models which follow to determinethe optimal strategy. Our analysis will proceed by first examining five yearACRS property, and then three year property will be discussed separately.

When a depreciable asset is purchased, a taxpayer may, pursuant toERTA, expense that asset up to a maximum limit specified earlier. In otherwords, the asset may be used as an immediate tax writeoff. With proper taxplanning the taxpayer may reduce his withholdings immediately. There­fore, the value of this strategy is:

v~ = (cost of the asset) (tax bracket)V~ = xt

(1)

V represents the value of the strategy. The superscript denotes five yearproperty, and the subscript shows that this is the first of the two alternatives.The value of the strategy depends upon the cost of the asset, x, and thetaxpayers tax bracket, t. Notice that a taxpayer in a larger tax bracket getsgreater value from expensing the property. In other words, deductions aremore valuable to taxpayers in higher tax brackets.

The second of the two alternatives would involve taking a 10% investmenttax credit and depreciating the asset over its five year life. Since the passageof the Tax Equity and Fiscal Responsibility Act of 1982, the depreciable baseof the asset must be reduced by one half of the lIe or in the case of five yearproperty by 5%. We can see that, the value of this strategy is:

41

4V~ = .10X + .15 (X - .05X)t + .22(~~.~5X)t + I .21 (X - .05X)t (2)

i=2 (1 +k)i

where: x is the cost of the assett is the taxpayers tax bracket.

The first term on the right is the 10% ITC. The second term is the firstyear's depreciation tax deduction. A five year ACRS asset may be depreci­ated at a rate of 15% its first year, 22% its second year, and 21 % in years 3-5.The depreciable base of the property is (X - .05X). It includes the originalcost of the asset X, less one-half of the lTC, .05X. Since the taxpayer, throughproper tax planning, can reduce the tax liability immediately (by reducingthe withholdings for individuals or reducing the quarterly tax payment forcompanies), this second term does not have to be discounted. The third termis the present value of the second year's depreciation deduction discountedat the taxpayers opportunity cost of funds, k. The fourth term is the sum ofthe present value of the third, fourth, and fifth year's depreciation taxdeductions. Notice that this analysis presumes that the first year's deprecia­tion deduction will benefit the taxpayer immediately. Through proper taxplanning, the taxpayer can reduce the quarterly tax payments made to theIRS. So the first year's deduction benefits the company immediately.

We now have the value of the two strategies, but the important point is todetermine under what conditions Vf dominates V~. To learn this, the indif­ference point, Vf = V~ will be found by subtracting V~ from V~. This is donein (3) below.

v~ - v~ = Xt - .10X - .15 (X - .05X)t - .22(X - .05X)t - i .2l(X - .05X)t (3)1+ k i =2 (1 + k)i

Notice in (3) that the cost of the asset, X, is multiplicative throughout theexpression. In other words, X can be factored out. The optimal choicebetween the strategies is therefore independent of the cost of the asset aslong as the cost is less than the limits specified in the tax code.

II. ·Optimal StrategyA taxpayer would .be indifferent between the stragegies for five year

property when V~ - V~ = O. Setting equation (3) equal to zero and dividingthrough by X yields (3-a):

42

o = t - .10 - .15(.95)t -4.22(.95)t - I

l+k i=2.21(.95}t(1 +k)l

(3-a)

In (3-a), notice that the only two vairable which affect the value of theexpression are the tax rate, t, and the taxpayers opportunity cost of funds, k.By substituting different tax rates into the expression, the indifferencediscount rate can be found. In Table 1 these discount rates are shown forseveral tax brackets. If we look in the 50% tax rate column for five yearproperty, the indifference discount rate is 8.82%. This implies that a tax­payer in a 50% tax bracket would be indifferent between expensing anddepreciating the asset when that taxpayer has an opportunity cost of fundsof 8.82%. The other cells may be interpreted in the same way.

At discount rates above 8.82%, the optimal solution would be to take theimmediate tax writeoff. A larger discount rate would reduce the value of thefuture depreciation deduction below the immediate writeoff. At discountrates below 8.82% the future depreciation deductions are larger than thevalue of the immediate writeoff, so the taxpayer should select the tax credit.

The 10% tax bracket cell deserves some attention. The value of the im­mediate writeoff would be equal to the 10% ITC. But the depreciationdeductions that are taken ina ddition to the ITC would mean that theimmediate writeoff would never be optimal.

For three year property, the analysis is similar. The value of the twostrategies can be estalbished. The taxpayer may write off the propertyimmediately or take a 6% ITC and depreciate 97% of the assets cost overthree years. The depreciation rates to be applied to the property for its threeyear tax life are 25%, 38, and 37%, respectively. It can easily be demonstratedthat the choice in this case depends on the same variables as in the five yearcase, the tax rate and opportunity cost of funds.

The results for the three year property appear in the second line of Table 1.The interpretation is the same. For a taxpayer in a 50% tax bracket, a discountrate above 9.33% would favor the immediate writeoff while a ldower dis­count rate encourages the depreciation strategy.

At low discount rates the depreciation/ITe strategy is optimal. At higherdiscount rates the immediate writeoff is optimal. Notice in Table 1 that as thetax rate drops, the indifference discount rate rises. Since the ITC is a creditwhich reduces the tax liability on a dollar for dollar basis, and is thereforeindependent of t, it takes increasingly larger discount rates to make theimmediate writeoff strategy dominate the depreciation strategy at lower taxrates.

ConclusionThis paper showed that the ERTA gave taxpayers a choice with regards to

depreciation of assets. The financial planner must be aware of this choice

43

and must know how to select the optimal strategy. It was shown:1. that taxpayers may choose to expense assets costing $7,500 or less

rather than depreciating them:2. that the optimal strategy is independent of the asset's original cost as

long as the cost is below the $7,500 prescribed in the Tax code;3. that the optimal strategy depends upon the taxpayer's bracket and

opportunity cost of funds; and4. that at a given tax bracket, a larger opportunity cost of funds favors the

immediate writeoff strategy.

Table 1The Indifference Cost of Capital* For

Various Tax Rates

Tax Rates5 Year Property3 Year Property

50%8.829.33

46%10.0510.56

40%12.5412.98

30%20.0219.85

20% 10%43.42 **37.60 208.06

*At discount rates greater than those shown in the table, the taxpayer shouldimmediately expense the property. When the taxpayer's opportunity cost offunds is less than those shown, the optimal strategy is to take the ITC anddepreciate the property.**At a tax rate as low as 100/0, it would never be optimal to expense the asset,because a 10% ITe taken immediately would be larger than the value of thefuture deduction.

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PUBLICATION GUIDELINES

The editors of the Journal of Business Strategies invite submission ofmanuscripts to be consider for publication. The articles should be concise,direct analyses of current problems and issues of interest~obusiness decisionmakers. The emphasis of these articles is expected to tie on new interpreta­tions, fresh insights, and clearly stated solutions to problems faced by busi­ness decision makers. The articles should be of practical value to businesspeople and business educators. It should not be assumed that readers arecompletely familiar with the concepts and terminology of the specific subjectunder study. Directness and clarity of presentation are desired.

STYLE GUIDELINES:All articles should be typed double-spaced and submitted in duplicate. The

length of the article should not exceed 20 pages, including tables, appendicesand references.

A separate page showing the title, author's name, affiliation, and positionshould be attached as a cover sheet.

The number and complexity of charts and tables should be kept to aminimum, be as simple as possible, and placed on separate pages. Camera­ready copy is preferred.

REFERENCES:An alphabetical, numbered list of references cited in the text should be

included on a separate page at the end of the article. Within the body of themanuscript, reference and page number(s) should be enclosed in parenthe­ses. Example: Several studies (3, 7, 10) support this conclusion. Or, one study(3, pp. 7-18) supports this conclusion.

The Journal of Business Strategies Is published semiannually (Spring & Fall).

ADDRESS FOR SUBMISSION:Dr. William B. Green, EditorJournal of Business StrategiesThe Center for Business and Economic ResearchSam Houston State UniversityHuntsville, TX 77341

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