Development of Financial Strategy

Chapter 3

Strategy:

A course of action, including the specification of resources required,

to achieve a specific objective.

Financial strategy:

Is the aspect of strategy which falls within the scope of financial

management, which will include decisions on investment, financing
and dividends.

Strategic financial management:

The identification of the possible strategies capable of maximising an

entity’s net present value, the allocation of scarce capital resources
among the competing opportunities and the implementation and
monitoring of the chosen strategy so as to achieve stated objectives.

However, before any investment decisions can be made, the entity's

managers will have to assess whether they have enough cash to
make the new investments, or whether additional finance will have
to be raised.

Therefore, the three key decisions in financial strategy are:

1. Investment – what projects should be undertaken by the

organisation?

2. Financing – how should the necessary funds be raised?

 3. Dividends – how much cash should be allocated each year to
be paid as a return to shareholders, and how much should be
retained to meet the cash needs of the business?

These three areas are very closely interlinked

Financial managers have responsibility for the allocation of financial

resources to achieve the organisation's objectives. An important part
of their job is to understand the short, medium and long-term capital
requirements for investment in fixed assets and working capital that
fits with the overall strategy.

Whilst financial managers are unlikely to be solely responsible for the

final choice of capital investment projects to be undertaken, they will
be actively involved in the evaluation of possible investment
opportunities.

More detail on the investment decision:

When considering whether a project is worthwhile, a company must

consider its implications. Any potential investment is likely to affect:

1. The liquidity of the company–

All projects involve cash flows in and out. The size and timing of
such flows should be considered when appraising projects. If an
aim of investment appraisal is to satisfy shareholders then it is
important to remember that, if a company has no cash, it
cannot pay a dividend.

2. The reported profit and earnings–

All projects will change the revenues, expenses and asset

values shown in the financial accounts. If shareholders are
concerned about such statistics as earnings per share, then the
 effect of investments on reported figures must be part of the
investment appraisal.

The variability of cash flows and earnings– Investors are concerned

about the variability of returns from their investments.

The greater the variability, the greater the risk, and therefore the
greater the return they will require. Thus, when appraising potential
projects, managers should consider not only the likely size and
direction of cash flows and profits but also whether they are likely to
add to or reduce the variability of such flows.

Financing decision:

For both non-current asset and working capital investment, the

financial manager must decide on the most appropriate type and
source of funding.

This will include such considerations as:

1. the extent to which requirements can be funded internally,

from the organisation's operations. This will involve
considerations of dividend policy and tax implications;

2. if new, externally provided, finance is required, whether it

should be in the form of equity or debt finance. This may affect
the level of gearing (the ratio of debt to equity finance) which
can have implications for returns required by the providers of
capital;

3. the extent to which working capital should be financed by long-

term finance or short-term credit.
Financing decisions relate to acquiring the optimum finance to meet
financial objectives and seeing that non-current assets and working
capital is effectively managed.

Optimum level of cash to hold:

The first decision that the financial manager will have to make is how
much cash should be held by the business as a buffer against
unexpected costs.

Key considerations are:

1. Trade off (too much cash v too little cash):

Holding too little cash will potentially leave the entity subject to
liquidity problems and possible liquidation.

2. Flexibility:

Holding cash means that the entity can adjust its business plan
(for example pursue a takeover opportunity or invest in a new
project) rapidly without needing to raise finance first.

3. Expectations of shareholders:

An entity needs to consider whether its shareholders could

make better use of the cash themselves. The shareholders
invest money in the expectation that the entity will invest it to
create wealth.

Theoretically, the entity should only hold cash if the managers expect
to be able to use it to increase the wealth of the
shareholders.
Sources of finance:

The financial manager must possess a good knowledge of the

sources of available funds and their respective costs, and should
ensure that the entity has a sound capital structure, that is, a proper
balance between equity capital and borrowings.

Financing decisions also call for a good knowledge of evaluation of

risk:

Excessive borrowing carries high risk for an entity’s equity because of

the priority rights of the lenders.

A major area for risk-related decisions is in establishing foreign

subsidiaries, where an entity is vulnerable to currency fluctuations.

Foreign debt is often appropriate to create a hedge of the change in

value of the net investment in the subsidiary as a result of currency
movements.

Benefits of matching characteristics of investment and financing:

The matching approach to financing is where the profile of the of the

entity’s financing matches the profile of the assets being funded.

This principle can be applied to the matching of maturities.

For example, using long-term finance to fund both non-current

assets and permanent current assets, and financing fluctuating
current assets by short-term borrowings.

Another area where the matching principle can be applied is in

relation to funding a foreign subsidiary.
A matching foreign currency borrowing can be used to hedge the net
investment in the subsidiary against currency movements.

Hedge:

Transaction to reduce or eliminate an exposure to risk.

Dividend decision:

Dividends provide important returns to shareholders and can be

seen as an indicator of success of the business. Shareholder returns
comprise both increase in share price and cash in the form of
dividends.

When deciding on the type of investment and level of finance

needed, the financial manager must have regard for the potential
effects on the risk and level of dividends payable to shareholders.

The business may wish to retain cash resources to finance

investments rather than increase gearing by raising new funding.
Cash resources may also be retained in order to provide rapid access
to funds to respond to investment opportunities that might arise in
the future or to provide flexibility in the face of poor trading
conditions.

The dividend decision thus has two elements:

1. the amount to be paid out, and

2. the amount to be retained to support the growth of the entity

(note that this is also a financing decision).

The level and regular growth of dividends represent a significant

factor in determining a profit-making entity’s market value, that is,
the value placed on its shares by the stock market.
Links between the three key decisions:

It is clear from the discussions above that the three areas are closely
interrelated.

Investment decisions cannot be taken without consideration of

where and how the funds are to be raised to finance them. The type
of finance available will, in turn, depend to some extent on the
nature of the project – its size, duration, risk, capital asset backing,
etc.

Dividends represent the payment of returns on the investment back

to the shareholders, the level and risk of which will depend upon the
project itself, and how it was financed.

Debt finance, for example, can be cheap (particularly where interest

is tax deductible) but requires an interest payment to be made out of
project earnings, which can increase the risk of the shareholders'
dividends

Major influences include:

1. The need to maintain good investor relations and provide a

satisfactory return on investment

2. Limited access to sources of finance, either due to weak

creditworthiness or lack of liquidity in the banking sector and
capital markets

3. Gearing level. The main argument in favour of gearing is that

introducing borrowings into the capital structure attracts tax
relief on interest payments. The argument against borrowing is
that it introduces financial risk into the entity. Financial
managers have to formulate a policy that balances the effects
of these opposing features.
 4. Debt covenants. These are clauses written into debt
agreements which protect the lender's interests by requiring
the borrower to satisfy certain criteria (e.g. a minimum level of
interest cover)

5. Government influence

6. Regulatory bodies

Government influence:

Governments often play a large part in influencing business activity.

Some examples of the way in which governments can have an
influence are as follows:

1. Employment policy.
2. Regional policy.
3. Taxation policy.
4. Legislation.

Regulatory bodies:

The objectives may be classified under three headings:

1. The promotion of competition.

2. The protection of customers from monopoly power.
3. The promotion of social and macroeconomic objectives.
The impact of taxation on financial strategy:

The financial manager will have to consider the taxation implications

of all his decisions when setting the entity's financial strategy.

For companies with operations in several countries, there will be

both domestic and international tax implications.

Domestic tax implications:

Any profits generated by a new investment project will be taxable.

However, tax allowable depreciation will normally be available on
assets purchased, to reduce the overall tax liability.

Debt interest is tax deductible. Therefore, if the entity decides to

finance new investments through debt finance, there will be tax
savings when the interest is paid. This is not the case with dividends
to shareholders (if equity finance is used).

Dividends to shareholders will be taxed under income tax rules.

However, if the entity chooses not to pay out a dividend, any

increases in share price will be taxed under capital gains tax rules
when the shares are sold. Therefore, most investors have a
preference as to whether they'd like the entity to pay out a dividend
or not.

International tax implications:

The main additional tax consideration for an entity with international

operations is how to minimise the overall tax liability of the
international entity.
For example, a decision will need to be made as to where the head
office of the entity should be located. Multinational companies are
often attracted to set up their operations in a low tax economy.

Also, the group's transfer pricing policy will be an important

consideration. Tax authorities only allow transfer prices that are set
at a fair, 'arm's length' level, so there is no opportunity to manipulate
the entity's tax liability. The authorities will disallow any transfer
prices that are considered to be set purely for the purposes of
moving as much profit as possible into the lowest tax country.

The tax authorities also monitor royalties and management charges

alongside transfer prices. Any royalties or management charges paid
from one group company to another will not be allowed if the
authorities feel that they are being used to increase profits in one
group company (based in a low tax country) at the expense of
another (based in a higher tax country)

Assessment of creditworthiness by the lender:

The lender will carry out an assessment of the potential borrower by

considering the following information:

1. Analysis of business plan

2. Business prospects of the potential borrower
3. Security available
4. Credit rating
5. Other borrowings and covenants

Analysis of capital structure:

The gearing ratio is an important measure of risk. It is important to

analyse, particularly for users such as shareholders and creditors, the
ability to satisfy debts falling due after one year.
There are two elements to consider: repayment of capital and
payment of interest.

The assessment of an entity’s gearing risk can be identified from two

areas. The statement of financial position shows the current liquidity
and capital structure of the entity, that is the short-term liquidity and
the level of fixed prior charge capital. The statement of profit or loss
shows the profitability of the entity generally, indicating its ability to
generate cash, some of which may be available to repay debt.

Credit ratings: read from book.