Ch 3 Flashcards
Definition of Strategy
A course of action, including the specification of resources required, to achieve a specific objective.
Definition of Financial Strategy
the aspect of strategy which falls within the scope of financial management, which will include decisions on investment, financing and dividends
Definition of Strategic Financial Management
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
Three Key Decisions in Financial Strategy
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
Implications of Investment Decisions made
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 –
Considerations when deciding on most appropriate type/source of financing
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
Financing Decision - Optimum Level of Cash to hold
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
Financing Decision - Sources of Finance
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.
Financing Decision - Matching Characteristics of Investment and Financing
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
Dividend Decision
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
Interrelation of Three Key Decisions of Financial Strategy
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
Example Inter-relationships in Financial Ratios between Investment, Financing, and Dividend Decisions
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
Major External Influences on Financial Strategy
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
Government Influence on Financial Strategy
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
Example regulatory requirements for consideration when developing financial strategy
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)
Three objectives of regulatory bodies
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
General Points regarding Domestic Tax Implications
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
General Points regarding International Tax Implications
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
Contents of a Business Plan presented when applying for debt finance
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
Steps in lender’s assessment of creditworthiness
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
Use of ratio analysis by lender to analyze credit-worthiness
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
Rationale for analyzing gearing when assessing creditworthiness
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)
Interpretation of SOFP Ratios when determining creditworthiness
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
Interpretation of SOPL Ratios when determining creditworthiness
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
Overview of Independent Credit Rating Agencies
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
Factors when setting a credit rating
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
Updating of credit ratings
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
Meaning and Schedule of Credit Ratings
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
Link between Credit Ratings and Interest Rates
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
