Ch 3

Question 1

Definition of Strategy

Answer 1

A course of action, including the specification of resources required, to achieve a specific objective.

Question 2

Definition of Financial Strategy

Answer 2

the aspect of strategy which falls within the scope of financial management, which will include decisions on investment, financing and dividends

Question 3

Definition of Strategic Financial Management

Answer 3

The identification of possible strategies capable of maximizing an entity’s NPV

The allocation of scarce capital resources among competing opps

The implementation and monitoring of the chosen strategy to achieve objectives

Question 4

Three Key Decisions in Financial Strategy

Answer 4

INVESTMENT

What projects to undertake

FINANCING

Raising funds for them

DIVIDENDS

How much cash to return to sh/h vs retained for business cash needs

Question 5

Implications of Investment Decisions made

Answer 5

COMPANY LIQUIDITY

projects involve cash in- and outlows; size and timing needs considering

if aim of inv appraisal = satisfy sh/h => remember that no cash = no dividends

REPORTED PROFIT AND EARNINGS

projects affect rev/exp and asset values in F/S

if sh/h worry about EPS or similar, inv appraisal must consider effect of investments on F/S

VARIABILITY OF CASH FLOWS AND EARNINGS

from investor’s perspective: var + means risk + means reward needs to be +

thus, in inv appraisal, mgrs must consider size and direction of CF, but also whether var is going + or –

Question 6

Considerations when deciding on most appropriate type/source of financing

Answer 6

Extent to which reqs can be funded internally from ops – affects dividend policy and tax implications

If external finance, equity or debt – which can affect gearing and affect required return by capital providers

Extent to which funding of working capital is by l/t finance or s/t credit

Question 7

Financing Decision - Optimum Level of Cash to hold

Answer 7

TRADE OFF (too much vs too little)

too little = liquidity issues or liquidation vs too much = opportunity cost of interest on deposits/investment returns OR org vulnerable to takeover

Fin Mgr has to balance the two and determine the optimum level

FLEXIBILITY

Holding cash means org can quickly change plans without needing to raise finance (e.g. pursue a new project or takeover opportunity)

SH/H EXPECTATIONS

Org should consider whether sh/h could make better use of cash themselves

Sh/h invest assuming that entity will invest to create wealth - thus cash should only be held if it can be used to increase sh/h wealth

Question 8

Financing Decision - Sources of Finance

Answer 8

Good knowledge of soruces of available funds and respective costs req’d

Entity must have sound capital structure balancing equity cap and borrowings

Clear understanding of profit <> CF - cash req’d to pay for assets and sustain working cap cycle

Good knowledge of risk evaluation - high borrowing affects equity b/c priority rights of lenders

Risk heightened when establishing foreign subs b/c FX flux. Foreign debt often appropriate to hedge change in value of net inv in foreign sub due to currency mvmts.

Question 9

Financing Decision - Matching Characteristics of Investment and Financing

Answer 9

Profile of entity financing matches profile of assets being funded (based on maturity)

L/T Assets funded with L/T finance = finance in place for life of asset, economic benefits from assets can help repay

Finance will mature (and be repaid) at same time that asset is disposed of - then new finance can be obtained to fund replacement

Nearly all companies have certain level of CA and working cap permanently tied up (e.g. minimum inventory levels or A/R) - as always required, often called “permanent CA” and funded with l/t finance

Question 10

Dividend Decision

Answer 10

AMOUNT TO BE PAID OUT

When deciding on type of investment and level of financing, need to balance potential impacts on risk and level of dividends (b/c unhappy sh/h will not invest further, thus future investments become tricky) with cash needs of the business.

CASH TO RETAIN TO SUPPORT GROWTH (also a financing decision)

Business may wish to retain some cash to provide rapid access to funds in response to opportunities and/or be flexible in poor trading conditions

Remember - level and regular growth of dividends represent a significant factor in determining MV of for-profit entities

Question 11

Interrelation of Three Key Decisions of Financial Strategy

Answer 11

INVESTMENT decisions cannot be made without considering where/how funds are raised.

Type of FINANCE available will in turn depend to some extent on size/duration/risk of project.

DIVIDENDS = payment of return on INVESTMENT back to sh/h – level and risk of dividends will depend on project and how it was FINANCED.

e.g. debt finance can be cheap (esp if interest is tax deductible) – but interest out of project earnings, which can increase sh/h dividend risk

Question 12

Example Inter-relationships in Financial Ratios between Investment, Financing, and Dividend Decisions

Answer 12

Inv decision to undertake profitable project financed by raising new debt or equity => may impact multiple investor and lender ratios e.g. EPS, earnings yield, interest cover

Fin reqs and cash available for dividend payments determined based on overall consideration of future forecasted CFs arising from inv dec’ns, business strategy, and forecast business/econ variables

Change in dividend policy can immediately impact investor ratios e.g. dividend cover and dividend yield – less obvious impacts such as increasing amount of fund available for reinvestment => increased growth in profit and thus + EPS

Question 13

Major External Influences on Financial Strategy

Answer 13

need to keep sh/h happy and provide satisfactory ROI

poor creditworthiness or lack of liquidity in banking sector/capital mkts => limited access to finance

gearing - balancing the +ve tax relief on interest payments vs –ve introduction of financial risk

debt covenants (e.g. minimum level of interest cover)

government influence

regulatiors

major economic influences – interest rates, GDP growt, inflation rates, exchange rates

accounting concepts

Question 14

Government Influence on Financial Strategy

Answer 14

EMPLOYMENT POLICY

funding vocational training and employment programs to stimulate employment

REGIONAL POLICY

funding to support regions with high unemp or social deprivation

TAXATION POLICY

on profits generated by companies and on sh/h dividends

LEGISLATION

laws around how people should behave and how business should be conducted

Question 15

Example regulatory requirements for consideration when developing financial strategy

Answer 15

LEGISLATION

Companies Acts, Health and Safety regs, consumer protection/rights laws, contract and agency laws, employment law, laws re. environment/promoting competition

Stock Exchange regs

Regulatory bodies in certain industires: Oftel (telco), Ofcom (media), Ofwat (water)

Question 16

Three objectives of regulatory bodies

Answer 16

PROMOTION OF COMPETITION

preventing “cross subsidy”, whereby portions of overhead costs are transferred from lower- to higher-margin products

limiting non-price barriers affecting entry of new competitors - e.g. trade restrictions or restricted access to distribution channels

assuring reasonable quality of product in relation to price

PROTECTION OF CUSTOMERS FROM MONOPOLY POWER

controls on prices or quality of svc when a market participant adjudged to have significant market power and there are no other protections for consumers

PROMOTION OF SOCIAL AND MACROECONOMIC OBJECTIVES

e.g. availability and affordability of svcs in particular areas or to particular groups

regulators often use “public interest tests” to judge acceptability of strategy - e.g. something which compromises national security would be blocked

Question 17

General Points regarding Domestic Tax Implications

Answer 17

Profits generated by new investment project = taxable

Tax allowable depreciation normally available on assets purchased = reduced overall tax liability

Debt interest = tax deductible = tax savings (not the case with sh/h dividends)

Investors will pay income tax on dividends // if no dividend paid, share price increases subject to capital gains tax upon sale of shares

in certain conditions, some share purchases are afforded tax relief on investment in shares and/or when they are sold – e.g. to encourage investing in unquoted trading companies, UK’s Enterprise Investment Scheme

Question 18

General Points regarding International Tax Implications

Answer 18

Main consideration = minimizing overall tax liability of international entity

Location of head office in a low tax economy

Transfer pricing = tax authorities require fair “arm’s length” level, will disallow those which appear solely to transfer profits into low-tax countries

Royalties and management charges (between group companies) - not allowed for tax purposes if felt to be increasing profits in low-tax country and decreasing in high-tax country

Question 19

Contents of a Business Plan presented when applying for debt finance

Answer 19

Purpose, amount, duration of borrowing

Detailed CF forecasts, showing likely CF of borrower and aiming to show lender that prospects of borrower are good

Explanation of how borrower is proposing to repay borrowing

Question 20

Steps in lender’s assessment of creditworthiness

Answer 20

ANALYSIS OF BUSINESS PLAN

including ratio analysis of recent a/c and forecasts

BUSINESS PROSPECTS OF POTENTIAL BORROWER

e.g. quality/track record of their mgmt, risk profile of org, prospects of the industry sector (market share trends, competitor growth, etc.)

SECURITY AVAILABLE

if so, significant risk reduction

CREDIT RATING

poor rating likely drvies rejection or higher interest rate to offset additional risk to lender

OTHER BORROWINGS AND COVENANTS

higher risk if borrower already highly geared and has covenants in place for existing borrowings b/c less cash available, reduced asset base available for security

existing covenants may also give priority to existing > new lenders

Question 21

Use of ratio analysis by lender to analyze credit-worthiness

Answer 21

ASSESSING LIQUIDITY

key objective, ensuring CF will be sufficient to pay interest and repay capital

INTEREST COVER RATIO gives idea of likeliness even with falling profits

Interest cover wirth regard to EBITDA or CASH may be preferable to PROFITS

Stock Market Ratios (P/E RATIO) give a view of how the market view the firm; high P/E ratio => good growth prospects => lower risk for lending

Question 22

Rationale for analyzing gearing when assessing creditworthiness

Answer 22

Important Measure of risk

Important to assess ability of satisfying 12m+ debts, especially for sh/h and creditors

SOFP shows currently liquidity (s/t liquidity) and capital structure (level of fixed prior capital charge)

SOPL shows profitability, ability to generate cash (some of which may be available to repay debt)

Question 23

Interpretation of SOFP Ratios when determining creditworthiness

Answer 23

Capital Structure of entity shows relative risk accepted by sh/h and creditors

L/T debt increases cf sh/h funds = more risk assumed by l/t creditors = higher rewards required = fewer rscs available for sh/h

High proportion of debt also causes sh/h yo demand higher returns on equity

Difficult to say in practice what level is “safe” - compare gearing ratio to prior years/budgets, to similar entities, and assess whether appears too high

Consider in particular levels of NCA which could be used for security - high level of NCA cf current value of debt finance = should be able to raise more debt finance quite readily

Question 24

Interpretation of SOPL Ratios when determining creditworthiness

Answer 24

Interest Cover < 1 indicates trouble servicing debt finance; the higher the number is beyond 1, the lower the risk (b/c easier to continue paying interest)

Lack of CASH rather than lack of PROFIT usually the reason entities fail to meet interest obligations; thus EBITDA or CF used by analysts to give a more useful measure of cover

Question 25

Overview of Independent Credit Rating Agencies

Answer 25

Exist to help investors determine risk associated with investing in specific companies, instruments, or markets

e.g. A company making a public bond issue will obtain a specific rating from a rating agency before the issue takes place

Rating is according to likelihood that entity will be able to repay debts

Question 26

Factors when setting a credit rating

Answer 26

Plans and forecasts of company

Strength/trends in industry and org’s relative competitive position therein

Country risks - political, regulatory

Quality, experience, track record of mgmt team

Corporate attitude to risk taking

Financial position - capital structure, debt profile

Financial ratios

Guarantees or other parental support

Question 27

Updating of credit ratings

Answer 27

Constant process based on ongoing monitoring of entity performance

Changes can be based on actual results or forecast results from analysts

Downgrades can be made or a warning of possible future downgrade made by issuing a Negative Outlook Statement

In this case, significant impact on ability to raise finance - entity may need to delay planned debt issue, or a current issue may not be fully subscribed

Question 28

Meaning and Schedule of Credit Ratings

Answer 28

See attached diagram

Rating refers to entity’s specific financial obligation or to general creditworthiness

Investment Grade = lower credit risk - securities or entities carry a quality level that many institutions require when considering investments

BBB and down = speculative or junk = indicative of high risk

Question 29

Link between Credit Ratings and Interest Rates

Answer 29

AAA rating (S&P) is very low risk investment

Thus loans to AAA entity carry relatively low interest rates

Lower rated entities have to pay higher rates of interest - or may struggle to raise debt finance at all

Risk and return always linked = investor will demand higher return to compensate increased risks taken