© 2000 John Petroff
|
|
© 2000 John Petroff |
These are large tag items that will be used over many years. Most are sold to other industries. Two determinants are studied here: business investment demand and cost of capital. Cost of capital enters the equation as hurdle rate in obtaining financing, and as the discount rate for NPV calculation: the higher it is, the lower discounted cash flows turn out to be, and the smaller is the NPV. Thus, as for growth industries, financial considerations argue against a correlation between new durables purchases and expansion when cost of capital is highest. But the major determinant is the expected sales volume generated by the use of the equipment. This drives the business investment demand.
Another characteristic of these products is that it often takes one or more year to build and set-up the equipment, especially if it consists of an entire new factory. Here also, sales expectations of purchasing firms are paramount. In recession, orders disappear, whereas in expansions, demand becomes exuberant. Manufacturers of durable goods must work feverishly well into the start of the slow-down to deliver all the orders received during an expansion. Then, as some of the equipment received is no longer needed, the excess capacity of purchasers will aggravate the business slowdown and postpone new orders.
Because durable goods manufacturers must have large fixed assets that are usually financed with debt (as suggested in the case of standardized products in Section B-5), these industries are especially vulnerable to periods of recession and even recovery. New orders will not be received from purchasers until they themselves plan equipment replacement or expansion. Graph G-14.12 below presents the annual rate of change in mining and oil field machinery output and the annual rate of change in net domestic production. Graph G-14.12 shows that the amplitude of the variations are much more pronounced than that of the business cycle.
As suggested in Graph G-14.12, it is well known that durable goods are the most cyclical component of GDP. Moreover, because manufacturers of durable goods have large fixed assets and much debt, and consequently their overhead is large, profits experience even greater instability than sales.
An analyst must look for the ability of a company to overcome one or several years of low activity and severe losses well after the trough of the business cycle. This cushion must be financed by equity and be readily available in what has been referred to as free cash. In addition to that, the strongest company in the industry will be the one that is capable to anticipate future demand growth, and build up its inventory of finished equipment ready for shipment wherever the equipment is standardized and not custom made for each client. Another corporate strategy would be to shift resources from the cyclical product line to a defensive or counter-cyclical activity. This justifies again corporate strategies of diversified lines of activity and alliances (suggested in Section C-4 and in Section C-5) .
See review questions Q-14D2.1 through Q-14D2.8
See research assignment .R-14D2.1
| Previous: 1-Growth_industries |
|
Next: 3- Cyclical non-durables |