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Deutsche Brauerei, a renowned beer producer established in 1737, is currently under the ownership of the Schweitzer family for 12 generations. The company has gained acclaim for its exceptional beer and has been honored with multiple awards. It is entirely owned by 16 relatives, including uncles, aunts, and cousins. Despite facing financial challenges due to the Russian debt crisis in 1998, Deutsche Brauerei decided to enter the Ukrainian market. Surprisingly, their beer quickly gained popularity in Ukraine and resulted in a significant boost in sales.
In just three years after entering Ukraine, Ukrainian consumers accounted for 28% of Deutsche's total sales. This remarkable growth can largely be attributed to the success of their products within the Ukrainian market.
Lukas has hired Oleg Pinchuk, a marketing professional with experience in the Ukrainian beer market, to aggressively promote their beer. This report evaluates the company's past and potential financial performance, dividend policy, and critiques their credit and inventory policies. Additionally, the report recommends implementing a compensation scheme for Oleg Pinchuk.
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Our belief is that Oleg Pinchuk should receive a raise in his compensation to incentivize him to stay and deliver future results. His strategies for establishing infrastructure in Ukraine have been crucial for the company's sales growth. However, we are concerned that some of his current policies may not be profitable and carry excessive risk amidst signs of an economic downturn. Additionally, we strongly suggest revising the design of the compensation package as it currently gives rise to a significant agency problem. Back in 1998, Oleg Pinchuk joined Deutsche Brauerei as the Sales and Marketing Manager.
Pinchuk had previous experience working for a major beer producer in Ukraine, providing him with valuable knowledge of the industry and the surrounding environment. His main objective was to aggressively market Deutsche Brauerei's beer and take advantage of the vast opportunities in Central and Eastern Europe. According to Pinchuk, the beer sells itself due to its quality; therefore, discount pricing and extensive advertising are unnecessary. The challenge lies in getting people to try the beer and establishing a distribution network.
In 1998, Ukraine faced a significant problem as there were no beer distributors in the country, making it impossible to distribute the product to customers. Ukrainian distributors lacked capital and were unable to secure bank financing due to their lack of collateral, low profits, negative cash flows, and perceived high risk. Moreover, they could not meet the credit terms set for German distributors. This is where Pinchuk's strategies played a crucial role in expanding our presence in Ukraine.
Despite limited resources, Pinchuk successfully organized five distributors and established warehouse arrangements.
To support the establishment and operation of Ukraine distributors' businesses, significant changes were made to the credit policy. The credit terms for Ukraine distributors were relaxed from 2% 10, net 40 to 2% 10, net 80. This adjustment provided financial assistance to the distributors and allowed them more time to pay their debts. Additionally, the company decided to take on a substantial portion of the distributor's inventory. This decision not only relieved distributors from financial burdens and costs but also enabled them to respond quickly to changes in customer demand. As a result of these strategies, the number of customers in Ukraine has increased from zero to 211, with further growth expected in 2001. However, implementing Oleg's strategies required significant investments in working capital for the business.
Particularly in accounts receivable where days in receivables is almost 90 days. The belief is that Pinchuk's analysis of return on investment has been exaggerated since the investments in inventory and capital expenditure required have not been considered. Exhibit 3 illustrates our revised analysis of the return received by the business after considering changes in inventories and capital expenditure. It is assumed that 85% of inventory changes and 90% of capital expenditure are linked to investments in Ukraine. Further explanation of these assumptions can be found in the exhibit.
Despite the risky nature of these investments, our results in the year 2000 still show a high return of 42%, which is significantly greater than the 6.5% cost of financing long-term debt. It is important for the company to consider the risk adjusted cost of capital for the Ukraine, rather than just the cost of financing debt, in order to determine if these investments are worthwhile. Exhibit 4 provides a comprehensive analysis of the impact of these policies on the business' performance and situation. Although sales growth has remained consistently strong, there has been a decline in overall operating profit margin since the implementation of these strategies.
Return on equity and net assets have increased, with rates of 10.3% and 8.4% respectively in the year 2000, demonstrating effective asset management. Nevertheless, it seems that Pinchuk's strategies may have had adverse impacts on the company, leading to a decline in profit margin and higher risk levels. We are of the opinion that the credit policy should not be loosened; instead, it could be tightened even further to less than 80 days. Unfortunately, implementing a stricter policy to reduce risk would result in a decrease in sales.
Despite Pinchuk's potentially damaging strategies, we believe he deserves a salary increase for successfully expanding the company in challenging circumstances. Currently, his compensation includes a base salary of EUR40,000 and an incentive payment of 0.5% tied to sales growth. However, this setup encourages Pinchuk to pursue risky ventures like extending significant credit to distributors who may not be able to repay it. Although this could boost sales and subsequently increase Pinchuk's earnings, it would have adverse effects on both profits and the overall company.
Our suggestion is to modify the compensation structure of Pinchuk in order to shift the focus of his incentive payment from sales growth to collection and profits. We propose increasing his base salary to EUR50,000 and tying his incentive payment to annual profits, specifically 0.6% of the yearly increase in profits. However, our financial plan for 2001 anticipates a decline in profits compared to the previous year, with a net profit of EUR 2,712,000. Consequently, there will be no incentive payment for Pinchuk in 2001. Our intention is for this situation to motivate him to improve profits in the subsequent year by adjusting his marketing and collection strategies.
Historically, DB has distributed 75% of its profits annually as dividends to shareholders. Currently, the company is experiencing financial challenges due to high inventory levels and lenient credit terms for Ukrainian distributors. If the company continues with the 75% dividend payout, it will need to acquire additional debt to fund its planned investment in a new plant. This will further increase its existing short-term debt burden. Furthermore, there is uncertainty regarding the projected profit growth stated in the financial plan due to a possible economic downturn in 2001.
Deutsche Brauerei may find guaranteeing a dividend payout of EUR698,000 too risky. Instead of relying on more bank borrowings, it would be safer for the company to retain higher earnings in order to cover their borrowings and finance future investments and projects. This approach also serves as a buffer against any potential financial crisis. While this reduction in dividend payout might disappoint older shareholders who depend on it, paying out 75% of dividends is detrimental to the company.
By decreasing the dividend payout percentage to 60%, the company can keep 40% of their net profits for reinvestment and financing future projects, which will also address their current lack of cash. The table provided demonstrates how retained earnings change based on different dividend payout percentages - higher dividends result in lower retained earnings.
To ensure consistency, it is recommended that the company pays out the same dividend amount (EUR 546,500) to shareholders in Q1 of 2001 as they received in 2000. However, if the projected forecast for 2001 is accurate and there are no financial crises, shareholders can anticipate a higher dividend payout in the following quarter. Based on our suggested financial plan with a net profit of EUR 2,712,000, a dividend payout of 60% would yield EUR 406,800 for shareholders in Q2.
Deutsche Brauerei has identified a significant issue in its 2001 Financial Budget. The problem is due to the company's dependence on short-term debt financing, which is caused by various factors such as operating strategies, policies, substantial sales growth, dividend payments, and capital expenditure. All of these factors are funded through working capital. Consequently, the company's cash reserves have decreased and it has been compelled to borrow money in the short term for financing investments. As a result, there has been a consistent debt/total capital ratio of around 42% (Exhibit 4).
Deutsche Brauerei's financing strategy heavily depends on short-term debt, resulting in a notable decline in their cash reserves. Short-term debt requires immediate repayment and usually comes with higher interest rates compared to long-term debt. From 1997 to 2000, the company saw a significant rise in short-term bank borrowings, with projected further increases for 2001 and 2002 (see Exhibit 1), indicating a rising trend. Conversely, the company's long-term debt has consistently decreased since 1997, demonstrating their reliance on short-term borrowing.
The credit policy of granting Ukraine distributors 80 days to pay has led to significant increases in sales and accounts receivables. Exhibit 4 indicates a substantial growth in sales and receivables primarily from Ukraine. In 1998, accounts receivable in Ukraine amounted to EUR 424,000 and by 2000, it had dramatically risen to EUR 6,168,000. In comparison to Germany, Ukraine's accounts receivable have experienced an exceptionally high growth rate. This is primarily attributed to the fact that most new sales in Ukraine are made on credit. Though the credit policy states a payment deadline of 80 days, the actual average collection period in 1999 and 2000 was 85 and 87.1 days respectively. The extended collection period is causing Deutsche Brauerei to finance working capital through short-term borrowing. Additionally, the company holds a significant amount of inventory for distribution in Ukraine. This requires additional investment in inventory and results in a longer cash conversion cycle. Exhibit 1C illustrates that Deutsche Brauerei's inventories were stable until 1999 and subsequently approximately doubled.
The high dividend payout ratio has resulted in an increase in the usage of short-term financing. Although the company is earning substantial profits to cover these dividends, the funds are already tied up. This necessitates acquiring additional short-term financing for the payouts. Furthermore, the company's plough back ratio of 25% is insufficient for reinvestment, thus requiring further borrowing for future capital expenditure. The projected capital expenditure for both 2001 and 2002 amounts to EUR 7 million, thereby making the need for additional short-term borrowing even more critical. To avoid significant depletion of cash in upcoming years, it is imperative that Deutsche Brauerei reassesses its debt financing alternatives.
The company is recommended to opt for long-term debt instead of short-term debt to alleviate cash limitations and secure funds for investing in a new plant and equipment in 2001. Long-term debt can also be utilized in 2002 to finance the anticipated construction of a new warehouse, estimated at EUR 6.8 million. It would not be wise to finance such a costly project with short-term debt, making long-term debt the suitable option. Proposed Changes to 2001 Financial Budget:
To improve the accuracy of Pinchuk's predictions for the upcoming year, adjustments need to be made to his forecasts and assumptions. Specifically, while sales growth in Germany is expected to be satisfactory, the projected sales growth for Ukraine appears overly optimistic. Typically, new projects initially experience rapid growth rates that subsequently decline. For instance, in 1999, Ukraine witnessed a real sales growth of 312%, but by 2001 it had dropped significantly to 47%.
Thus, it is expected that the sales growth for the year 2001 will decrease significantly, likely to around 30% instead of the previously mentioned 45%. Additionally, the operating margins appear to be overly optimistic at 7%. Comparatively, Germany and Ukraine had operating margins of 6.10% in 2000, which is considerably lower than the average of 6.88% over the past four years. As a result, it is advisable to maintain the operating profit margin at 6.1% for 2001, considering the potential impact of the projected global recession on increasing profitability.
We have also revised the dividend payout policy to 60% as previously discussed in the dividend declaration section. It may be deemed as a risky approach to extend the credit policy in the Ukraine to 90 days, especially considering the current indications of a global financial crisis. While sales may rise in terms of accounts receivable, the company is already at risk of significant financial losses if distributors begin to default. The distributors in the Ukraine would be severely impacted by a financial crisis and would likely be unable to meet their payment obligations.
The recommendation is to maintain the policy at 80 days in order to avoid potential loss. Additionally, it is suggested to raise the allowance for doubtful debts from 2% to 6% in preparation for a possible economic downturn. As previously mentioned, it is advisable to tighten the policy rather than extending it to 90 days in 2001. Exhibit 2C includes a sensitivity analysis on the allowance and net profit, which aims to determine how assuming a different percentage for the allowance of doubtful debt would impact net profit. According to Pinchuk's projections, a 2% allowance percentage was assumed for the year 2001.
However, it is suggested that the current percentage standing at a relatively low rate should be increased to 6% to consider the potential recession as mentioned earlier. Conducting a sensitivity analysis allowed us to obtain the following outcomes for 2001 - setting the allowance percentage at 2% would result in a net profit of EUR 3,083,000. Conversely, if the allowance is raised to 6%, the net profit would decrease to EUR 2,712,000. We believe that this decline would account for the possible recession that may occur in 2001. Additionally, we recommend the company to engage in some long-term borrowing while simultaneously reducing their investment in working capital.
By obtaining a long-term loan of EUR 14 million, the firm can reduce its dependency on short-term borrowing. According to our assumptions, this loan will decrease short-term borrowings to EUR880,000, a much lower amount compared to the firm's projected cash balance of EUR12 million. As a result, the firm's reliance on short-term borrowing will be eliminated and its liquidity greatly improved. A sensitivity analysis displayed in Exhibit 2D examines the impact of adjusting long-term debt and dividend policy on the required amount of short-term borrowing in 2001.
Keeping the current dividend policy of 75% and assuming a firm borrowing of EUR 14 million, the short-term borrowing would amount to EUR 1,292,000. However, if the payout ratio is reduced to our recommended ratio of 60%, the short-term borrowing would decrease to EUR 881,000. Moreover, reducing the ratio to below 30% would eliminate the need for short-term borrowing in 2001. It is worth mentioning that eliminating short-term debt entirely is unnecessary due to the substantial amount of cash available to the firm. Please refer to Exhibit 1A for our forecast of Deutsche Brauerei's income and balance sheet for 2001.
We anticipate that the net income for 2001 will exceed EUR 2,712,000, which is approximately EUR 1 million below Pinchuk's projection. Our proposed policy changes, such as obtaining a long-term loan to finance planned capital expenditure for 2001 and address the current cash issue, have been taken into account. Our recommendations for Deutsche Brauerei include adjusting Oleg Pinchuk's compensation scheme. Specifically, it is suggested that his base salary range from EUR 40,000 to EUR 50,000. Additionally, instead of tying his incentive payment to sales growth by 0.%, it is proposed that the incentive payment be determined by an annual profit growth of 0.6%. This adjustment would likely require Pinchuk to reassess his marketing and collection strategies. However, it is believed that this revised scheme would provide him with the motivation to consistently increase profits, benefiting both him and the company. Furthermore, based on our analysis of dividend payouts, we recommend that the company decrease the dividend payout ratio from 75% to 60%. This reduction would enable Deutsche Brauerei to retain more earnings for future investments and cover short-term borrowings.
This also improves their current cash shortage situation. Lastly, it is recommended that several changes be made to Pinchuk’s proposed financial budget for 2001. Instead of predicting a growth rate of 45% for sales in the Ukraine, it is recommended to use a more conservative figure of 30%. Also, instead of using an operating margin of 7% for both Germany and Ukraine, an operating margin of 6.10% should be adopted for 2001. In addition, instead of relaxing credit terms from 80 days to 90 days, the company should keep it at 80 days and aim to reduce it in the future.
It is recommended that the company consider a long-term loan of EUR 14 million for the construction of the warehouse and increase the allowance for doubtful debts from 2% to 6%. These suggestions are based on the anticipation of a potential recession in the upcoming year. Despite challenging conditions, Deutsche Brauerei has achieved success in expanding into the Ukrainian market. By making minor adjustments to their current strategies, the company has the opportunity to achieve even greater success.
Deutsche Brauerei: Success in the Ukrainian Market. (2018, Sep 25). Retrieved from https://studymoose.com/what-is-deutsche-brauerei-company-essay
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