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Investors maximize their wealth by selecting optimum investment and financial opportunities that will give them maximum expected returns at minimum risk. All businesses need to have the following three fundamental essential elements: a clear and realistic strategy, the financial resources, controls and systems to see it through and the right managementteam and processes to make it happen.
Investors maximize their wealth by selecting optimum investment and financial opportunities that will give them maximum expected returns at minimum risk. All businesses need to have the following three fundamental essential elements: a clear and realistic strategy, the financial resources, controls and systems to see it through and the right managementteam and processes to make it happen.
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Investors maximize their wealth by selecting optimum investment and financial opportunities that will give them maximum expected returns at minimum risk. All businesses need to have the following three fundamental essential elements: a clear and realistic strategy, the financial resources, controls and systems to see it through and the right managementteam and processes to make it happen.
Copyright:
Attribution Non-Commercial (BY-NC)
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Descargue como PDF, TXT o lea en línea desde Scribd
Learning Objectives After reading this chapter student shall be able to understand: Strategic Financial Decision Making Frame Work Strategy at different hierarchy levels Financial Planning Interface of Financial Policy and Strategic Management Balancing Financial Goals vis--vis Sustainable Growth Principles of Valuation 1.0 Strategic Financial Decision Making Frame Work Capital investment is the springboard for wealth creation. In a world of economic uncertainty, the investors want to maximize their wealth by selecting optimum investment and financial opportunities that will give them maximum expected returns at minimum risk. Since management is ultimately responsible to the investors, the objective of corporate financial management should implement investment and financing decisions which should satisfy the shareholders by placing them all in an equal, optimum financial position. The satisfaction of the interests of the shareholders should be perceived as a means to an end, namely maximization of shareholders wealth. Since capital is the limiting factor, the problem that the management will face is the strategic allocation of limited funds between alternative uses in such a manner, that the companies have the ability to sustain or increase investor returns through a continual search for investment opportunities that generate funds for their business and are more favourable for the investors. Therefore, all businesses need to have the following three fundamental essential elements: A clear and realistic strategy, The financial resources, controls and systems to see it through and The right managementteam and processes to make it happen. We may summarise this by saying that: Strategy +Finance +Management =the fundamentals of business Strategy may be defined as the long term direction and scope of an organization to achieve competitive advantage through the configuration of resources within a changing environment for the fulfilment of stakeholders aspirations and expectations. In an idealized world, The Institute of Chartered Accountants of India 1.2 Strategic Financial Management
management is ultimately responsible to the investors. Investors maximize their wealth by selecting optimum investment and financing opportunities, using financial models that maximize expected returns in absolute terms at minimum risk. What concerns the investors is not simply maximum profit but also the likelihood of it arising: a risk-return trade-off from a portfolio of investments, with which they feel comfortable and which may be unique for each individual. We call this overall approach strategic financial management and define it as being the application to strategic decisions of financial techniques in order to help achieve the decision- maker's objectives. Although linked with accounting, the focus of strategic financial management is different. Strategic financial management combines the backward-looking, report-focused discipline of (financial) accounting with the more dynamic, forward-looking subject of financial management. It is basically about the identification of the possible strategies capable of maximizing an organization's market value. It involves the allocation of scarce capital resources among competing opportunities. It also encompasses the implementation and monitoring of the chosen strategy so as to achieve agreed objectives. 1.1 Functions of Strategic Financial Management: Strategic Financial Management is the portfolio constituent of the corporate strategic plan that embraces the optimum investment and financing decisions required to attain the overall specified objectives. In this connection, it is necessary to distinguish between strategic, tactical and operational financial planning. While strategy is a long-term course of action, tactics are intermediate plan, while operations are short-term functions. Senior management decides strategy, middle level decides tactics and operational are looked after line management. Irrespective of the time horizon, the investment and financial decisions functions involve the following functions 1 : Continual search for best investment opportunities Selection of the best profitable opportunities Determination of optimal mix of funds for the opportunities Establishment of systems for internal controls Analysis of results for future decision-making. Since capital is the limiting factor, the strategic problem for financial management is how limited funds are allocated between alternative uses. This dilemma of corporate management is resolved by the pioneering work of Jenson and Meckling (1976) 2 , which is popularly known as agency theory. Agency theory refers to a set of propositions in governing a modern corporation which is typically characterized by large number of shareholders or owners who allow separate individuals to control and direct the use of their collective capital for future gains. These individuals, typically, may not always own shares but may possess relevant
1 Strategic Financial Management: Exercises, Robert Alan Hill. 2 Jensen, M.C> & W.C. Meckling (1976), Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure, Journal of Financial Economics, October, V.3,4, pp. 305-360 The Institute of Chartered Accountants of India Financial Policy and Corporate Strategy 1.3
professional skills in managing the corporation. The theory offers many useful ways to examine the relationship between owners and managers and verify how the final objective of maximizing the returns to the owners is achieved, particularly when the managers do not own the corporations resources. According to this theory, strategic financial management is the function of four major components based on the mathematical concept of expected NPV (net present value) maximization, which are: 1. Investment decision 2. Dividend decision 3. Financing decision and 4. Portfolio decision. The key decisions falling within the scope of financial strategy include the following: 1. Financial decisions: This deals with the mode of financing or mix of equity capital and debt capital. If it is possible to alter the total value of the company by alteration in the capital structure of the company, then an optimal financial mix would exist - where the market value of the company is maximized. 2. Investment decision: This involves the profitable utilization of firm's funds especially in long-term projects (capital projects). Because the future benefits associated with such projects are not known with certainty, investment decisions necessarily involve risk. The projects are therefore evaluated in relation to their expected return and risk. These are the factors that ultimately determine the market value of the company. To maximize the market value of the company, the financial manager will be interested in those projects with maximum returns and minimum risk. An understanding of cost of capital, capital structure and portfolio theory is a prerequisite here. 3. Dividend decision: Dividend decision determines the division of earnings between payments to shareholders and reinvestment in the company. Retained earnings are one of the most significant sources of funds for financing corporate growth, dividends constitute the cash flows that accrue to shareholders. Although both growth and dividends are desirable, these goals are in conflict with each other. A higher dividend rate means less retained earnings and consequently slower rate of growth in future earnings and share prices. The finance manager must provide reasonable answer to this conflict. 4. Portfolio decision: Portfolio Analysis is a method of evaluating investments based on their contribution to the aggregate performance of the entire corporation rather than on the isolated characteristics of the investments themselves. When performing portfolio analysis, information is gathered about the individual investments available, and then chooses the projects that help to meet all of our goals in all of the years that are of concern. Portfolio theory, as first conceived in the 1950s by Dr. Harry Markowitz, provided a classic model for managing risk and reward. Markowitz realized that stocks and bonds interacted in a predictable manner (i.e., when one class of stock went down, others tended to go up), and by managing these interactions he could diversify risk. Strategic Portfolio Management takes the insights gained from portfolio analysis and integrates them into the decision making process of a corporation. The Institute of Chartered Accountants of India 1.4 Strategic Financial Management
1.2 Strategic Decision Models and Characteristics: For the past few decades, researchers have attempted to model the strategic decision process and identify the major types or categories of strategic decisions. This is a difficult task since strategic decisions are often described as "unstructured", "unprogrammed", and "messy". Mintzberg, Raisinghani, and Theoret (1976) 3 provided an early attempt at modeling the process of strategic decision making and identified three major phases with subroutines or subphases within each. These included the following: The Identification phase 1. The Decision Recognition Routine: Opportunities, problems, and crisis are recognized and evoke decisional activity. 2. The Diagnosis Routine: Information relevant to opportunities, problems, and crisis is collected and problems are more clearly identified. The Development phase 1. The Search Routine: Organizational decision makers go through a number of activities to generate alternative solutions to problems. 2. The Design Routine: Ready-made solutions which have been identified are modified to fit the particular problem or new solutions are designed. The Selection Phase The Screen Routine: This routine is activated when the search routine identifies more alternatives than can be intensively evaluated. Alternatives are quickly scanned and the most obviously infeasible ones are eliminated. 2.0 Strategy at Different Hierarchy Levels Strategies at different levels are the outcomes of different planning needs. The three Levels of an enterprise strategy are 1. Corporate level 2. Business unit level 3. Functional or departmental level 2.1 Corporate Level Strategy: Corporate level strategy fundamentally is concerned with selection of businesses in which a company should compete and with development and coordination of that portfolio of businesses. Corporate level strategy is concerned with: Reach defining the issues that are corporate responsibilities. These might include identifying the overall vision, mission, and goals of the corporation, the type of business a corporation should be involved, and the way in which businesses will be integrated and managed.
3 Mintzberg, H., Raisinghani, D., & Theoret, A. (1976). The structure of unstructured decision processes. Administrative Science Quarterly, 21, 246-275. The Institute of Chartered Accountants of India Financial Policy and Corporate Strategy 1.5
Competitive Contact defining where in a corporation competition is to be localized. Managing Activities and Business Interrelationships corporate strategy seeks to develop synergies by sharing and coordinating staff and other resources across business units, investing financial resources across business units, and using business units to complement other corporate business activities. Management Practices corporations decide how business units are to be governed: through direct corporate intervention (centralization) or through autonomous governance (decentralization). 2.2 Business Unit Level Strategy: Strategic business unit may be any profit centre that can be planned independently from the other business units of your corporation. At the business unit level, the strategic issues are about both practical coordination of operating units and about developing and sustaining a competitive advantage for the products and services that are produced. 2.3 Functional Level Strategy: The functional level of your organization is the level of the operating divisions and departments. The strategic issues at the functional level are related to functional business processes and value chain. Functional level strategies in R&D, operations, manufacturing, marketing, finance, and human resources involve the development and coordination of resources through which business unit level strategies can be executed effectively and efficiently. Functional units of your organization are involved in higher level strategies by providing input into the business unit level and corporate level strategy, such as providing information on customer feedback or on resources and capabilities on which the higher level strategies can be based. Once the higher level strategy or strategic intent is developed, the functional units translate them into discrete action plans that each department or division must accomplish for the strategy to succeed. Among the different functional activities viz production, marketing, finance, human resources and research and development, finance assumes highest importance during the top down and bottom up interaction of planning. Corporate strategy deals with deployment of resources and financial strategy is mainly concerned with mobilization and effective utilization of money, the most critical resource that a business firm likes to have under its command. Truly speaking, other resources can be easily mobilized if the firm has adequate monetary base. To go into the details of this interface between financial strategy and corporate strategy and financial planning and corporate planning let us examine the basic issues addressed under financial planning. 3.0 Financial Planning Financial planning is the backbone of the business planning and corporate planning. It helps in defining the feasible area of operation for all types of activities and thereby defines the overall planning framework. Financial planning is a systematic approach whereby the financial planner helps the customer to maximize his existing financial resources by utilizing financial tools to achieve his financial goals. Financial planning is simple mathematics. There are 3 major components: The Institute of Chartered Accountants of India 1.6 Strategic Financial Management
Financial Resources (FR) Financial Tools (FT) Financial Goals (FG) Financial Planning: FR +FT =FG In other words, financial planning is the process of meeting your life goals through proper management of your finances. Life goals can include buying a home, saving for your children's education or planning for retirement. It is a process that consists of specific steps that help you to take a big-picture look at where you financially are. Using these steps you can work out where you are now, what you may need in the future and what you must do to reach your goals. Outcomes of the financial planning are the financial objectives, financial decision-making and financial measures for the evaluation of the corporate performance. Financial objectives are to be decided at the very out set so that rest of the decisions can be taken accordingly. The objectives need to be consistent with the corporate mission and corporate objectives. There is a general belief that profit maximization is the main financial objective. In reality, it is not. Profit may be an important consideration but not its maximization. Profit maximization does not consider risk or uncertainty, whereas wealth maximization does. Let us Consider two projects, A and B, and their projected earnings over the next 5 years, as shown below: Year Product A Product B 1 10,000 11,000 2 10,000 11,000 3 10,000 11,000 4 10,000 11,000 5 10,000 11,000 50,000 55,000 A profit maximization approach would favor project B over project A. However, if project B is more risky than project A, then the decision is not as straightforward as the figures seem to indicate. It is important to realize that a trade-off exists between risk and return. Stockholders expect greater returns from investments of higher risk and vice versa. To choose projectt B, stockholders would demand a sufficiently large return to compensate for the comparatively greater level of risk. According to Drucker, profit is the least imperfect measure of organizational efficiency and should remain the main consideration of a firm to cover the cost of survival and to support the future expansion plans. But profit maximization as a financial objective suffers from multiple limitations. Firstly the level of operation for long run profit maximization may not match with the optimum levels under short run profit maximization goal. In that case, if one assigns more importance to short run profit maximization and avoids many activities like skill development, training programme, machine maintenance and after sales service, long run survival even may be at a stake and long run profit maximization may become a day dreaming concept. In the The Institute of Chartered Accountants of India Financial Policy and Corporate Strategy 1.7
reverse case, short run shortcomings may have telling effects on the organizational performance and hence long run profit maximization may gradually become an impossible proposition in comparison to stronger competitors performances. Profit maximization also ignores an important aspect of strategic planning. Risk consideration has rarely been incorporated in the profit maximization rule. As a result two projects with same expected profit are equally good under profit consideration. Under the profit cum risk consideration the project with lesser variability will be preferred by the investor than the one with higher variability. Higher variability means higher risk and lower variability means lower risk. Problem becomes more involved when both expected profits and their variability are unequal and reversibly ordered. Decision making based on usual expected profit consideration will be of limited use for such situations. It is also worth pointing out that profit maximization objective does not take into consideration effects of time. It treats inflows of equal magnitude to be received at different time points as equal and thereby ignores the fact that money values changes over time. Conceptually, a benefit of an amount A k received in the k-th year cannot be identical with a series of benefits received at the rate A for each of the k years. The later scheme may be more beneficial for a firm than the former one. Unfortunately profit maximization or benefit maximization approach fails to discriminate between these two alternatives and remains indifferent. In view of the above limitations of the profit maximization approach choice of financial objective needs a strategic look. The obvious choice in that case may be expressed in terms of wealth maximization where wealth is to be measured in terms of its net present value to take care of both risk and time factors. Wealth ensures financial strength of the firm, long term solvency and viability. It can be used, as a decision criterion in a precisely defined manner and can reflect the business efficiency without any scope for ambiguity. There are some related issues that may draw attention of the planners during the interface of financial planning and strategic planning. Cash flow, credit position and liquidity are those three critical considerations. Cash flow is the most vital consideration for the business firm. It deals with the movement of cash and as a matter of conventions, refers to surplus of internally generated funds over expenditures. To prepare a cash flow statement, all the factors that increase cash and those that decrease cash are to be identified from the income and expenditure statements. This information is to be then presented in a consolidated form for taking strategic decisions on new investments and borrowings. A substantially positive cash flow may enable the firm to fund new projects without borrowing cash from investors or bankers. Borrowing means paying interest and is some sort of weakness for the firm. Internal generation of cash and internal funding of projects add to the strength of the firm. Thus objective should be to enjoy an attractive cash flow situation. Generation of cash from internal activities depends on the industry life cycle. At the initial stage, i.e. the stage of introduction and the stage of growth, the firm makes reinvestment of cash in operations to meet cash needs of the business. By operations we refer to activities that change the utility of any input. Product research and product design are the key operations during the stage of introduction. Installation of plant and facilities and addition to The Institute of Chartered Accountants of India 1.8 Strategic Financial Management
capacity for meeting the increased demand are the key operational requirements during the stage of growth. The stage of growth is also marked in the aggressive promotional activities. And all these operations need huge investment. During the stage of shakeout and maturity, the need for excess investment declines sharply. This enables the firm to generate positive cash flow. Thus, the cash flow position of a firm changes from weakness to strength as the industry of the other matures. During the stage of decline reversal of this process take place; the decrease in demand increases the cost of production. The cost of promotion increases so rapidly that the outflow of cash soon takes over the inflow of the same resulting in cash drainage. Thus industry life cycle has a role to play in cash flow planning. Credit position of the business firm describes its strength in mobilizing borrowed money. In case the internal generation of cash position is weak, the firm may exploit its strong credit position to go ahead in the expansion of its activities. There are basically two ways of strengthening the credit position. The first way is to avoid unnecessary borrowings. If the level of current debt is low the firm is likely to enjoy reasonable credit in future. The other way of enjoying credit facilities is to create the awareness about the future business prospect For example if awareness can be created in the mind of the investors and others about quick and high growth and steady and long maturity prospects of an industry then it will be easier for the company to get external funds irrespective of its current cash flow position. Conversely borrowing will be extremely difficult if the industry enters into a declining stage of life cycle curve. Since bankers and investors are generally interested in long run results and benefits and are willing to forego short run benefits, choice of the business field is very important for attracting investors and creditors. Thus to be in, or not be in is dependent on cash flow position and credit position of the firm and these are in turn dependent on the position of the offer in respect of the life cycle curve, market demand and available technology. Liquidity position of the business describes the extent of idle working capital. It measures the ability of the firm in handling unforeseen contingencies. Firms into major investments in fixed assets are likely to enjoy less liquidity than firms with lower level of fixed assets. The liquidity of the firm is measured in terms of current assets and current liabilities. If the current assets are more than the current liabilities the firm is said to be liquid. For example a drop in demand due to sudden arrival of competitive brand in the market may cause a crisis for liquid cash. In case the firm has excess current assets which are easily encashable, it will be able to overcome the crisis in the short run and draw new strategic plan and develop new strategic posture to rewinover the competitors in the long run. 4.0 Interface of Financial Policy and Strategic Management The interface of strategic management and financial policy will be clearly understood if we appreciate the fact that the starting point of an organization is money and the end point of that organization is also money. No organization can run an existing business and promote a new expansion project without a suitable internally mobilized financial base or both internally and externally mobilized financial base. Sources of finance and capital structure are the most important dimensions of a strategic plan. We have already emphasized on the need for fund mobilization to support the expansion The Institute of Chartered Accountants of India Financial Policy and Corporate Strategy 1.9
activity of firm. The generation of funds may arise out of ownership capital and or borrowed capital. A company may issue equity shares and / or preference shares for mobilizing ownership capital. Preference Share holders as the name stands enjoy preferential rights in respect of dividend and return of capital. Holders of equity shares do not enjoy any such special right regarding dividend and return of capital. There are different types of preference shares like cumulative convertible preference shares which are convertible into equity shares between the end of the third year and the fifth year. Rate of dividend paid till conversion into equity shares remains constant. Debentures, on the other hand, are issued to raise borrowed capital. These are of varying terms and conditions in respect of interest rate, conversion into shares and return of investment. Public deposits, for a fixed time period, have also become a major source of short and medium term finance. Organizations may offer higher rates of interest than banking institutions to attract investors and raise fund. The overdraft, cash credits, bill discounting, bank loan and trade credit are the other sources of short term finance. Along with the mobilization of funds, policy makers should decide on the capital structure to indicate the desired mix of equity capital and debt capital. There are some norms for debt equity ratio. These are aimed at minimizing the risks of excessive loans, for public sector organizations the norm is 1:1 ratio and for private sector firms the norm is 2:1 ratio. However this ratio in its ideal form varies from industry to industry. It also depends on the planning mode of the organization under study. For capital intensive industries, the proportion of debt to equity is much higher. Similar is the case for high cost projects in priority sectors and for projects in under developed regions. Another important dimension of strategic management and financial policy interface is the investment and fund allocation decisions. A planner has to frame policies for regulating investments in fixed assets and for restraining of current assets. Investment proposals mooted by different business units may be divided into three groups. One type of proposal will be for addition of a new product to the fold of offer of the firm. Another type of proposal will be to increase the level of operation of an existing product through either an increase in capacity in the existing plant or setting up of another plant for meeting additional capacity requirement. There is yet another type of proposal. It pleads for cost reduction and efficient utilization of resources through a new approach and or closer monitoring of the different critical activities. Now, given these three types of proposals a planner should evaluate each one of them by making within group comparison in the light of capital budgeting exercise, In fact project evaluation and project selection are the two most important jobs under fund allocation. Planners task is to make the best possible allocation under resource constraints. Dividend policy is yet another area for making financial policy decisions affecting the strategic performance of the company. A close interface is needed to frame the policy to be beneficial for all. Dividend policy decision deals with the extent of earnings to be distributed as dividend and the extent of earnings to be retained for future expansion scheme of the firm. From the point of view of long term funding of business growth, dividend can be considered as that part of total earnings, which cannot be profitably utilized by the company. Stability of the dividend payment is a desirable consideration that can have a positive impact on share price. The alternative policy of paying a constant percentage of the net earnings may be preferable from the point of view of both flexibility of the firm and ability of the firm. It also gives a message of The Institute of Chartered Accountants of India 1.10 Strategic Financial Management
lesser risk for the investors. Yet some other companies follow a different alternative. They pay a minimum dividend per share and additional dividend when earnings are higher than the normal earnings. In actual practice, investment opportunities and financial needs of the firm and the shareholders preference for dividend against capital gains resulting out of share are to be taken into consideration for arriving at the right dividend policy. Alternatives like cash dividend and stock dividend are also to be examined while working out an ideal dividend policy that supports and promotes the corporate strategy of the company. It may be noted from the above discussions that financial policy of a company cannot be worked out in isolation of other functional policies. It has a wider appeal and closer link with the overall organizational performance and direction of growth. These policies being related to external awareness about the firm, specially the awareness of the investors about the firm, in respect of its internal performance. There is always a process of evaluation active in the minds of the current and future stake holders of the company. As a result preference and patronage for the company depends significantly on the financial policy framework. And hence attention of the corporate planners must be drawn while framing the financial policies not at a later stage but during the stage of corporate planning itself. The nature of interdependence is the crucial factor to be studied and modelled by using an in depth analytical approach. This is a very difficult task compared to usual cause and effect study because corporate strategy is the cause and financial policy is the effect and sometimes financial policy is the cause and corporate strategy is the effect. This calls for a bipolar move. 5.0 Balancing Financial Goals Vis-a-Vis Sustainable Growth The concept of sustainable growth can be helpful for planning healthy corporate growth. This concept forces managers to consider the financial consequences of sales increases and to set sales growth goals that are consistent with the operating and financial policies of the firm. Often, a conflict can arise if growth objectives are not consistent with the value of the organization's sustainable growth. Question concerning right distribution of resources may take a difficult shape if we take into consideration the rightness not for the current stakeholders but for the future stake holders also. To take one illustration, let us refer to fuel industry where resources are limited in quantity and a judicial use of resources is needed to cater to the need of the future customers along with the need of the present customers. One may have noticed the save fuel campaign, a demarketing campaign that deviates from the usual approach of sales growth strategy and preaches for conservation of fuel for their use across generation. This is an example of stable growth strategy adopted by the oil industry as a whole under resource constraints and the long run objective of survival over years. Incremental growth strategy, profit strategy and pause strategy are other variants of stable growth strategy. The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can be achieved, given the firm's profitability, asset utilization, and desired dividend payout and debt (financial leverage) ratios. Variables typically include the net profit margin on new and existing revenues; the asset turnover ratio, which is the ratio of sales revenues to total assets; the assets to beginning of period equity ratio; and the retention rate, which is defined as the fraction of earnings retained in the business. The Institute of Chartered Accountants of India Financial Policy and Corporate Strategy 1.11
Sustainable growth models assume that the business wants to: 1) maintain a target capital structure without issuing new equity; 2) maintain a target dividend payment ratio; and 3) increase sales as rapidly as market conditions allow. Since the asset to beginning of period equity ratio is constant and the firm's only source of new equity is retained earnings, sales and assets cannot grow any faster than the retained earnings plus the additional debt that the retained earnings can support. The sustainable growth rate is consistent with the observed evidence that most corporations are reluctant to issue new equity. If, however, the firm is willing to issue additional equity, there is in principle no financial constraint on its growth rate. Indeed, the sustainable growth rate formula is directly predicated on return on equity. "Assuming asset growth broadly parallels sales growth, the SGR is calculated as the retained [return on equity], i.e. your company's [return on equity] minus the dividend payout percentage," wrote John Costa in Outlook 4 . "Just as the break-even point is the 'floor' for minimum sales required to cover operating expenses, so the SGR is an estimate of the 'ceiling' for maximum sales growth that can be achieved without exhausting operating cash flows. Economists and business researchers contend that achieving sustainable growth is not possible without paying heed to twin cornerstones: growth strategy and growth capability. Companies that pay inadequate attention to one aspect or the other are doomed to failure in their efforts to establish practices of sustainable growth (though short-term gains may be realized). After all, if a company has an excellent growth strategy in place, but has not put the necessary infrastructure in place to execute that strategy, long-term growth is impossible. The reverse is true as well. The very weak idea of sustainability requires that the overall stock of capital assets should remain constant. The weak version of sustainability refers to preservation of critical resources to ensure support for all, over a long time horizon .The strong concept of sustainability is concerned with the preservation of resources under the primacy of ecosystem functioning. These are in line with the definition provided by the economists in the context of sustainable development at macro level In terms of economic dimension sustainable development rejects the idea that the logistic system of a firm should be knowingly designed to satisfy the unlimited wants of the economic person. A firm has to think more about the collective needs and less about the personal needs. This calls for taking initiatives to modify, to some extent, the human behaviour. Sustainability also means development of the capability for replicating ones activity on a sustainable basis. The other economics dimension of sustainability is to decouple the growth in output of firm from the environmental impacts of the same. By decoupling we mean development of technology for more efficient use of resource. Complete decoupling is unrealistic from the thermodynamic angle but the materials balance principle demands for decoupling and hence attempts should be made by the firm to be more and more decoupled.
4 Costa, J ohn. "Challenging Growth: How to Keep Your Company's Rapid Expansion on Track." Outlook. Summer 1997 The Institute of Chartered Accountants of India 1.12 Strategic Financial Management
The sustainable growth model is particularly helpful in situations in which a borrower requests additional financing. The need for additional loans creates a potentially risky situation of too much debt and too little equity. Either additional equity must be raised or the borrower will have to reduce the rate of expansion to a level that can be sustained without an increase in financial leverage. Mature firms often have actual growth rates that are less than the sustainable growth rate. In these cases, management's principal objective is finding productive uses for the cash flows that exist in excess of their needs. Options available to business owners and executives in such cases including returning the money to shareholders through increased dividends or common stock repurchases, reducing the firm's debt load, or increasing possession of lower earning liquid assets. Note that these actions serve to decrease the sustainable growth rate. Alternatively, these firms can attempt to enhance their actual growth rates through the acquisition of rapidly growing companies. Growth can come from two sources: increased volume and inflation. The inflationary increase in assets must be financed as though it were real growth. Inflation increases the amount of external financing required and increases the debt-to-equity ratio when this ratio is measured on a historical cost basis. Thus, if creditors require that a firm's historical cost debt-to-equity ratio stay constant, inflation lowers the firm's sustainable growth rate. 6.0 Principles of Valuation The evaluation of sustainable growth strategy calls for interface of financial planning approach with strategic planning approach. Choice of the degree of sustainability approach for sustainability and modification in the sustainability principle must be based on financial evaluation of the alternative schemes in terms of financial and overall corporate objectives. Basically there are two alternative methods for evaluation. One is known as valuation method and the other one is known as pricing method. Valuation method depends on demand curve approach by either making use of expressed preferences or making use of revealed preference. In finance, valuation is the process of estimating the potential market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation. Valuation of financial assets is done using one or more of these types of models: 1. Discounted Cash Flows determine the value by estimating the expected future earnings from owning the asset discounted to their present value. 2. Relative value models determine the value based on the market prices of similar assets. 3. Option pricing models are used for certain types of financial assets (e.g., warrants, put options, call options, employee stock options, investments with embedded options such The Institute of Chartered Accountants of India Financial Policy and Corporate Strategy 1.13
as a callable bond) and are a complex present value model. The most common option pricing models are the Black-Scholes-Merton model and lattice models. Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare this required rate of return to the asset's estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment. To make this comparison, you need an independent estimate of the return outlook for the security based on either fundamental or technical analysis techniques, including P/E, M/B etc. In theory, therefore, an asset is correctly priced when its estimated price is the same as the required rates of return calculated using the CAPM. What does Capital Asset Pricing Model - CAPM mean? A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (R m -R f ). If the estimate price is higher than the CAPM valuation, then the asset is undervalued (and overvalued when the estimated price is below the CAPM valuation). The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% [3% + 2(10% - 3%)]. Valuation methods are in general more complex in implementation than pricing methods. But demand curve methods are more useful for cases where it seems likely that disparity between price and value is high. After the evaluation comes the question of policy choice. In case of sustainable growth the conventional cost benefit analysis may not be an appropriate tool for making choice decision. This is due to the fact that conventional cost benefit analysis is based on the principle of The Institute of Chartered Accountants of India 1.14 Strategic Financial Management
allocation of resources for maximizing internal benefit. It has no in built sustainability criterion to guarantee that a constant stock of natural resources will be passed between current and future users. This problem comes up because conventional cost-benefit analysis draws no distinction between natural capital and man made capital and is considered to be equitable. One proposed sustainability criterion is due to Turner and Pearce who advocated the constant natural assets rule. Their compensation principle requires the passing on the future users a stock of natural assets which is no smaller than the stock in the possession of current users. According to them Hicks Kaldor potential compensation rule should be extended further so that there will be actual compensation rule for natural resources. Within the constant natural assets rule the extended cost-benefit analysis can still retain the flavour of economic efficiency if one takes into consideration how resources should be best allocated among the competing users. The constant natural assets rule is directly applicable for renewable assets. But all the resources are not renewable in nature. In case of non-renewable assets, actual compensation rule should be interpreted not in terms of providence of actual assets but in terms of the services rendered by the actual assets. For example, oil, the black liquid cannot be preserved in constant quantity across time. But the services that oil provides to current users must be provided in future so that actual compensation remains the same. These are all high level strategic decisions but come under the purview of financial strategic planning. Only a close interface can help in arriving at an acceptable situation and plan Summary 1.0 Strategic Financial Decision Making Framework All businesses need to have the following three fundamental essential elements: A clear and realistic strategy, The financial resources, controls and systems to see it through and The right managementteam and processes to make it happen. 1.1 Functions of Strategic Financial Management: Strategic Financial Management is the portfolio constituent of the corporate strategic plan that embraces the optimum investment and financing decisions required to attain the overall specified objectives. Irrespective of the time horizon, the investment and financial decisions functions involve the following functions: Continual search for best investment opportunities Selection of the best profitable opportunities Determination of optimal mix of funds for the opportunities Establishment of systems for internal controls Analysis of results for future decision-making. According to Agency theory, strategic financial management is the function of four major components based on the mathematical concept of expected NPV (net present value) maximization, which are: The Institute of Chartered Accountants of India Financial Policy and Corporate Strategy 1.15
1. Investment decision- This involves the profitable utilization of firm's funds especially in long-term projects (capital projects). Because the future benefits associated with such projects are not known with certainty, investment decisions necessarily involve risk. 2. Dividend decision- Dividend decision determines the division of earnings between payments to shareholders and reinvestment in the company. 3. Financing decision- This deals with the mode of financing or mix of equity capital and debt capital. If it is possible to alter the total value of the company by alteration in the capital structure of the company, then an optimal financial mix would exist - where the market value of the company is maximized. 4. Portfolio decision- Portfolio Analysis is a method of evaluating investments based on their contribution to the aggregate performance of the entire corporation rather than on the isolated characteristics of the investments themselves. 1.2 Strategic Decision Models and Characteristics: For the past few decades, researchers have attempted to model the strategic decision process and identify the major types or categories of strategic decisions. These are as follows: The Identification phase 1. The Decision Recognition Routine: Opportunities, problems, and crisis are recognized and evoke decisional activity. 2. The Diagnosis Routine: Information relevant to opportunities, problems, and crises is collected and problems are more clearly identified. The Development phase 3. The Search Routine: Organizational decision makers go through a number of activities to generate alternative solutions to problems. 4. The Design Routine: Ready-made solutions which have been identified are modified to fit the particular problem or new solutions are designed. The Selection Phase 5. The Screen Routine: This routine is activated when the search routine identifies more alternatives than can be intensively evaluated. Alternatives are quickly scanned and the most obviously infeasible ones are eliminated. 2.0 Strategy at different hierarchy levels Strategies at different levels are the outcomes of different planning needs. The three Levels of an enterprise strategy are 2.1 Corporate Level Strategy: Corporate level strategy is concerned with: Reach defining the issues that are corporate responsibilities. Competitive Contact defining where in your corporation competition is to be localized. Managing Activities and Business Interrelationships corporate strategy seeks to develop synergies by sharing and coordinating staff and other resources across business The Institute of Chartered Accountants of India 1.16 Strategic Financial Management
units, investing financial resources across business units, and using business units to complement other corporate business activities. Management Practices corporations decide how business units are to be governed: through direct corporate intervention (centralization) or through autonomous governance (decentralization). 2.2 Business Unit Level Strategy: At the business unit level, the strategic issues are about both practical coordination of operating units and about developing and sustaining a competitive advantage for the products and services that are produced. 2.3 Functional Level Strategy: Functional level strategies in R&D, operations, manufacturing, marketing, finance, and human resources involve the development and coordination of resources through which business unit level strategies can be executed effectively and efficiently. Among the different functional activities viz production, marketing, finance, human resources and research and development, finance assumes highest importance during the top down and bottom up interaction of planning. 3.0 Financial Planning Financial planning is a systematic approach whereby the financial planner helps the customer to maximize his existing financial resources by utilizing financial tools to achieve his financial goals. Financial planning is simple mathematics. There are 3 major components: Financial Resources (FR) Financial Tools (FT) Financial Goals (FG) 4.0 Interface of Financial Policy and Strategic Management The interface will be clearly understood if we appreciate the fact that the starting point and end point of an organization is money. Sources of finance and capital structure are the most important dimensions of a strategic plan. A company may issue equity shares and/ or preference shares for mobilizing ownership capital. Along with the mobilization of funds, policy makers should decide on the capital structure to indicate the desired mix of equity capital and debt capital. There are some norms for debt equity ratio. This ratio in its ideal form varies from industry to industry. Another important dimension of strategic management and financial policy interface is the investment and fund allocation decisions. A planner has to frame policies for regulating investments in fixed assets and for restraining of current assets. Investment proposals mooted by different business units may be divided into three groups. Dividend policy is yet another area for making financial policy decisions affecting the strategic performance of the company. A close interface is needed to frame the policy to be beneficial The Institute of Chartered Accountants of India Financial Policy and Corporate Strategy 1.17
for all. Dividend policy decision deals with the extent of earnings to be distributed as dividend and the extent of earnings to be retained for future expansion scheme of the firm. It may be noted that financial policy of a company cannot be worked out in isolation of other functional policies. It has a wider appeal and closer link with the overall organizational performance and direction of growth. 5.0 Balancing Financial Goals vis--vis Sustainable Growth The concept of sustainable growth can be helpful for planning healthy corporate growth. This concept forces managers to consider the financial consequences of sales increases and to set sales growth goals that are consistent with the operating and financial policies of the firm. Often, a conflict can arise if growth objectives are not consistent with the value of the organization's sustainable growth. Question concerning right distribution of resources may take a difficult shape if we take into consideration the rightness not for the current stakeholders but for the future stake holders also. The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can be achieved, given the firm's profitability, asset utilization, and desired dividend payout and debt (financial leverage) ratios. The sustainable growth model is particularly helpful in situations in which a borrower requests additional financing. The need for additional loans creates a potentially risky situation of too much debt and too little equity. Either additional equity must be raised or the borrower will have to reduce the rate of expansion to a level that can be sustained without an increase in financial leverage. 6.0 Principles of Valuation In finance, valuation is the process of estimating the potential market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation. Valuation of financial assets is done using one or more of these types of models: 1. Discounted Cash Flows determine the value by estimating the expected future earnings from owning the asset discounted to their present value. 2. Relative value models determine the value based on the market prices of similar assets. 3. Option pricing models are used for certain types of financial assets (e.g., warrants, put options, call options, employee stock options, investments with embedded options such as a callable bond) and are a complex present value model. The most common option pricing models are the Black-Scholes-Merton models and lattice models. The Institute of Chartered Accountants of India