24 Evaluating Finance Strategies

Question 1

How does the evaluation of strategy relate to understanding the objective of finance, and what is the objective of finance

Answer 1

• To evaluate strategy you need to know objective
• For finance it is the maximisation of shareholder wealth
  o This must be in all answers
• It is the balance of risk and return

Question 2

What are the key areas to focus on when discussing capital structure

Answer 2

• Introduce debt to optimal level to reduce cost of capital
  o But depends on school of though
  o When tax is introduce both similar for different reasons
• Nature of the tax shield and its effects
• If want to issue debt, then what sort
  o Irredeemable, redeemable both have advantages and disadvantages
• How will that effect existing shareholders
  o Clientele effect
  o Risk levels change as debt is introduced so now financial and business risk carried by shareholders

Question 3

What are the key areas to focus on when discussing mergers and acquisitions

Answer 3

• This is when a merger takes place to stop a rival getting a company
• Increase in debt to finance can lead to overstepping debt ratio targets
• Also as unexpected could lead to liquidity issues which could accrue financial distress if it gets out to the market
• Clientele effect, officially if a large shareholder
• Also need to think about impact to company after
  o As now created a portfolio
  o Correlation of returns
  o Should companies be diversifying

Question 4

What are the key areas to focus on when discussing dividend decisions

Answer 4

• Assumed objective is to maximise shareholder wealth
• Depends on shareholders if they want this via dividends or capital gains
  o High tax payers will prefer capital gains
  o Elderly will want dividends
  o But assume basic rate
• If this is a good strategy depends on companies IRR
• Also can they make the payments
  o Can make profit without cash
• How do shareholders behave post dividend policy change
  o Efficiency of markets
  o As dividend can become a signalling device
• For instance, if a companies want to reinvest more as have a good project but directors feel markets are inefficiency and therefore likely to react badly to this they will need to be very careful not to send out the wrong signal by clear communication
• Two schools of thought in dividend policy

Question 5

What are the key areas to focus on when discussing investment decisions

Answer 5

• Objective is to maximise the shareholders wealth
• Strategy is to select the best projects
  o But who
  o Ratios, models
• Must be comparative as if capital rationing is limiting funds need to find maximum return per unit of fund
• Strategy must be a combination of all directors opinions in the company
  o Stand alone strategy is not a strategy as it does not pull in all wider implications