Chapter 3 - Development of financial strategy

Question 1

What are three key decisions?

Answer 1

Financing decision
Investment decision
Dividend decision

Question 2

What are the links between the three decisions?

Answer 2

When deciding which investments to undertake, the entity needs to decide how finance will be raised.
If large amounts of finance are available, this will enable the entity to undertake more/better investments.
If investments generate lots of cash, this will enable the entity to pay large dividends.

Question 3

What are the main influences on financial strategy?

Answer 3

Need to maintain good investor relations
Limited access to sources of finance
Gearing level
Debt covenants
Government influence
Regulatory bodies
Major economic influences
Tax consideration
Accounting concepts

Question 4

What are the domestic tax implications on financial strategy?

Answer 4

Profit generated by new investment project will be taxable
Debt interest is tax deductible. Using debt to finance new investments, gives tax savings when the interest is paid.
Higher tax rates will make debt more attractive since it will obtain tax relief at a higher rate.
Dividends to shareholders will be taxed under income tax rules, but share price rises due to good investments will be taxed under capital gains tax rules

Question 5

What are the international tax implications on financial strategy?

Answer 5

Multinational companies are often attracted to set up their operations in low tax economy.
Double taxation treaties will help eliminate issues with paying tax in multiple countries on the same profits.

Question 6

What information is presented by the borrower to the lender?

Answer 6

Business plan

Contents include:
Purpose, amount and duration of borrowing
Detailed cash flow forecasts
Explanation of how the borrower is proposing to repay the borrowing

Question 7

How does the lender assess the creditworthiness of the borrower?

Answer 7

Analysis of business plan
Assessment of business prospects
Security available
Credit ratings
Other borrowings/covenants

Question 8

How are credit ratings graded?

Answer 8

AAA to AA, A, BBB, BB, B, CCC, CC etc

Question 9

What is AAA to A classified as?

Answer 9

Low risk
Investment grade

Question 10

What is BBB classified as?

Answer 10

Medium risk
Investment grade

Question 11

What is BB or below classified as?

Answer 11

High risk
Junk grade