UNIT-1

FINANCIAL GOLAS AND STRATEGY

Strategic Financial Management

The subject strategic financial management basically involves in applying the knowledge and
techniques of financial management to the planning, operating and monitoring of the finance
function in particular as well as the organization in general. So, strategic financial
management basically involves planning the utilisation of company’s resources in such a
manner that it brings maximum value to the shareholders in the long run.

FINANCIAL PLANNING (Financial Management by I.M.Pandey, Page No: 561-567)

Financial planning involves preparation of projected or proforma profit and loss account,
balance sheet and funds flow statement. Financial planning and profit planning help a firm’s
financial manager to regulate flows of funds which is his primary concern. It focuses on
aggregate capital expenditure programmes and debt-equity mix rather than the individual
projects and sources of finance.

Definition

 Financial planning refers to planning with respect to all finances and investments.
Financial planning is the process of analysing a firm’s investment options and
estimating the funds requirement and deciding the sources of funds.
 Financial planning indicates a firm’s growth, performance, investments and
requirements of funds during a given period of time, usually three to five years.
 Financial planning involves the questions of a firm’s long-term growth and
profitability and investment and financing decisions.

Features of a Financial Planning

 Evaluate the current financial condition of the firm

 Analysing the future growth prospects and options
 Appraising the investment options to achieve the stated growth objectives.
 Projecting the future growth and profitability
 Estimating funds requirement and considering alternative financing options
 Comparing and choosing firmm alterative growth plans and financing options
 Measuring actual performance with the planned performance.

Steps in financial planning (Strategic Financial Management by Ravi M.Kisore, Page No: 14)

 Clearly define mission

 Determination of Financial Objectives
 Formulation of Financial Policies (Financial Policies to achieve Long & Short term
objectives, Example: Debt-Equity ratio, Minimum cash balance etc..)

ALIET 1 STRATEGIC FINANCIAL MANAGEMENT

  Designing Financial procedure: ( Procedures followed for day to day functioning,
Example: Cash flow control system, Capital budgeting procedures, Financial
forecasting techniques etc)
 Search for opportunities:
 Screening alternatives:
 Implementation, monitoring and control

Types of financial planning/ Classification of financial planning

 Long-term financial planning (Strategic Financial Planning): Large companies

generally prepare financial plan for a long period, say, five years. Small companies
may choose a shorter period, say one year. The financial plan of large companies may
be highly detailed document containing financial plans for different strategic business
units and divisions. In practice, long term financial plans consider the proposed
outlays of fixed assets, R&D, product development actions, capital structure and
sources of financing. Termination of products, projects, repayment of debt also
include in long term financial planning. These plans are supported by a series of
annual budgets and profit plans.
 Short term financial planning (Operating Financial Planning): Short term plans
generally covered 1to 2 years. These plans include the sales forecast and various
forms of operating and financing data. The result of short term financial plans is
operating budgets, cash budget and proforma of financial statements. Generally short
term financial planning process begins with the sales forecasts.

STRATEGIC FINANCIAL PLANNING/STRATEGIC FINANCIAL MANAGEMENT

(Strategic Financial Management by Palanisamy Saravana, Jayaprakash Sugavanam Page No: xviii-xxvi)

Meaning

 Chartered Institute of Management Accountants of UK (CIMA) defines strategic

financial management as “the identification of the possible strategies capable of
maximizing an organization’s net present value, the allocation of scarce capital
resources between competing opportunities and the implementation and
monitoring of the chosen strategy so as to achieve stated objectives”.
 Strategic financial planning refers to designing a financial framework of a company
with a view to maximize its profits, keeping in mind the company’s objectives, the
purpose for the company is formed.
 A long-term decision on finances and investment strategy called strategic financial
planning.
 In simple words, any strategy that is developed by the company with respect to
finance is called strategic financial planning.
 Strategic financial management relates to long-term management of funds.
 Strategic financial management refers to specific planning of the usage and
management of a company's financial resources to attain its objectives as a business
concern and return maximum value to shareholders over the long run.

ALIET 2 STRATEGIC FINANCIAL MANAGEMENT

Features of strategic financial management (Strategic Financial Management by Rajni Sofat,
PageNo: 27-28)
 It relates long-term management of funds
 It focuses on profitability and wealth maximization
 It covers financial and economic resources
 It prepare road map for future
 It promotes growth, profitability and sustainability of the organization
 Contemporary financial evaluation technique
 It is structured as well a flexible in nature
 It considers costs on a strategic basis

Scope of Strategic Financial Planning

 Financial planning and analysis: The financial position of the company is known by
the financial statements of the company. The financial statements of the company
depict the position of the company. Planning is an act of thinking ahead and framing
actions for achieving the organizational goals.
 Managing the cash: Cash management plays a vital role in a company. The cash
position in a company is determined by the operating cycle of the company, the time
lag between money received by the company and the money spent by the company.
Operating cycle is a short-term financial decision making process, which governs the
day-to-day financial operations of the company.
 Financial decision making: Decision making in any organization is a process
whereby the best alternative to the problem is taken to arrive at solution. Every
decision-making process chooses the best alternative to move towards the
organizational goal. Financial decision making is of two types, long term and short
term. Long term decision making relates to the strategic decisions like how to finance
the company, through debt, through equity, and so on. Short term decision making in
finance relates to day-to-day operations of the company, which is again related to the
operating cycle of the company. Hence, decisions can be long term or short term, but
analysing each course of action requires a strong financial planning.
 Financial control and implementing the same: Control mechanism means the
measurement of the actual performance as compared to the planned performance. The
variance is identified and corrective action taken to rectify the variance.
 Effective utilization of the cash surplus: Once the company’s performance is
monitored and controlled, the company starts improving in its financial performance
and the results achieved are the best. Making profit implies more cash accumulation
in the company. Once the company is cash-rich, the company has a huge benefit with
respect to financial independence. This can lead to the company achieving its desired
results as cash position of the company is strong. Once cash-rich, the company can
also go in for making decisions relating to restructuring of the company.
 Restructuring of the company: Mergers and acquisitions and corporate restructuring
are the decisions that the company takes for furtherance of its growth.

ALIET 3 STRATEGIC FINANCIAL MANAGEMENT

Decisions in Strategic Financial Management (Financial Management by I.M.Pandey, Page
No: 4-5)
There are three types of decisions that are usually taken by managers. These are:

 Financing / Capital structure decision: Financing decision is the second important

function to be performed by the financial manager. Broadly, he or she must decide
when, wherefrom and how to acquire funds to meet the firm’s investment needs. The
central issue before him or her is to determine the appropriate proportion of equity
and debt. The mix of debt and equity is known as the firm’s capital structure. The
financial manager must strive to obtain the best financing mix or the optimum capital
structure for his or her firm. The firm’s capital structure is considered optimum when
the market value of shares is maximised. Financing Decisions Refers
- When to procure capital – (correct time)
- Where to procure capital-(Identifies & select the sources)
- How to procure-(Debt –Equity mix)

 Investment decision: Investment decisions involve capital expenditures. They are,

therefore, referred as capital budgeting decisions. A capital budgeting decision
involves the decision of allocation of capital or commitment of funds to long-term
assets that would yield benefits (Cash flows) in the future. Two important aspects of
investment decisions are (a) the evaluation of the prospective profitability of new
investments and (b) the measurement of a cut-off rate against that the perspective
return of new investments could be compared. In brief Investment decision refers
- Where to invest
- What amount to be invest
- How long we keep

 Dividend decision: Dividend decision is the third major financial decisions. The
financial manager must decide whether the firm should distribute all profits, or retain
them, or distribute a portion and retain the balance. The proportion of profits
distributed as dividends is called the dividend payout ratio and the retained potion of
profits is known as the retention ratio. In simple dividend decisions refers:
- How much should pay
- How much should retain

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SHARE HOLDER VALUE CREATION

In highly volatile and complicated marketplace, creating shareholder value is the key to
success in today's marketplace. The value of a firm is the market value of its assets which is
reflected in the capital markets through the market values of equity and debt. Thus, share
holder value is:

Share holder value = Market value of the firm – Market value of the debt.

The market value of the shareholders ‘equity is directly observable from the capital markets.

Reasons for share holder value creation

Creating value for shareholders is now a widely accepted corporate objective. The interest in
value creation has been stimulated by several developments.

 Capital markets are becoming progressively global. Investors can willingly shift
investments to higher yielding, often foreign, opportunities.
 Institutional investors, which usually were inactive investors, have begun exerting
influence on corporate managements to create value for shareholders.
 Business press is highlighting shareholder value creation in performance rating
exercises.
 More focus is to link top management compensation to shareholder returns.

Determinants of Shareholder Value Creation

 Investment
 Dividend policy
 Growth
 Restructuring strategies
 Liquidity
 Risk
 Cost of capital

ALIET 5 STRATEGIC FINANCIAL MANAGEMENT

Approaches for Measuring Shareholder Value

 Market value added (MVA)

 Market-to- Book value (M/BV)
 Economic Value Added (EVA)

MARKET VALUE ADDED (MVA) /ENTERPRISE VALUE ADDED (EVA) (Financial

Management by I.M.Pandy, Page No: 734-735)

Does higher growth and accounting profitability lead to increased value to shareholders?
Modern financial management posits that a firm must seek to maximise the shareholder
value. Market value of the firm’s shares is a measurement of the shareholders wealth. It is the
shareholders’ appraisal of the firm’s efficiency in employing their capital. The capital
contributed by shareholders is reflected by the book value of the firm’s shares. In terms of
market and book values of shareholder investment, shareholder value creation (SVC) may be
defined as the excess of market value over book value. SVC is also referred to as the market
value added.

Meaning:

 Market value is also referred as the enterprise value. It is the total of the firm’s market
value of debt and market value of equity. Invested capital (IC) or Capital employed
(CE) is the amount of equity capital and debt capital supplied by the firm’s
shareholders and debt-holders to finance asset.

 In simple it is the amount of wealth that a company is able to create for its
shareholders since its foundation
 It is the difference between current market value of company stock and the initial
capital

Formula for Market value added

ALIET 6 STRATEGIC FINANCIAL MANAGEMENT

 MVA= Current market value of the firm – Invested capital

Or

Number of common shares outstanding x market price per share + Number of preferred
shares outstanding x market price per share - Book value of invested capital

Interpretation

 MVA is positive = MV is in excess of IC or CE – Maximize Share holder value or

wealth.

 MVA is negative = MV is in deficit of IC or CE- Not Maximize Shareholder value or

wealth.

Steps to be followed to determine MVA

 Multiply the total of all common shares outstanding by their market price
 Multiply the total of all preferred shares outstanding by their market price
 Combine these totals
 Subtract the amount of capital invested in the business

Evaluation of MVA

Merits

 Performance indicator of the company

 Increase the attractiveness of prospective investors
 Higher returns for investors
 Survival of the company

Limitations

 Invested capital may be historical value

 It ignores the cash flows received by the shareholders in the form of dividends.
 It does not consider opportunity costs of invested capital.

MARKET-TO-BOOK VALUE (M/B)/ PRICE TO BOOK VALUE (P/B) (Financial

Management by I.M.Pandy, Page No: 735-736)

An alternative measure of shareholder value creation is the market-to-book value approach. As you
know, the market value of equity is given as follows:

Market value of equity = Market value of the firm – Market value of debt

Meaning:

 It is a financial value metric used to evaluate a company’s current market value

relative to its books value.
 In simple a comparison of market value with the book value of a given firm.

ALIET 7 STRATEGIC FINANCIAL MANAGEMENT

We obtain market value per share (M) when we divide the market value of equity by the
number of shares outstanding. Similarly, the book value per share (B) can be calculated by
dividing invested equity capital by the number of shares outstanding. A firm is said to create
shareholder value when its market value per share is greater than its book value per share;
that is M > B. The market-to-book value (M/B) analysis implies the following

Formula

M/B = Market value per share / Book value per share

Or
Market to book ratio = Market capitalization/ Total book value

Where market capitalization = Market price per share * No of shares outstanding

Where book value = Book value per share * No of shares outstanding

Interpretation

Value creation: If M/B > 1, the firm is creating value of shareholders.

Value maintenance: If M/B = 1, the firm is not creating value of shareholder.

Value destruction: If M/B < 1, the firm is destroying value of shareholder.

Determinants of Market - to- Book value Ratio

 Economic profitability of Spread: The magnitude of the spread between return on

equity and the cost of equity, i.e. ROE-ke determines the market to book value ratio.
The spread, sometimes referred to as the economic profitability, must be positive to
create the shareholder value. The higher the positive spread, the higher the market to
book value ratio.
 Growth: Growth depends on the firm’s retention ratio and the return on equity, given
the firm’s ROE, higher the retention ratio, higher will be the growth rate. However, a
higher growth rate does not necessarily increase the shareholder value. It will
accelerate the M/B ratio only when the return on equity is greater than the firm’s cost
of equity (ROE > ke).
 Investment period: The number of years over which the future investment will grow
also determines the market value.

Limitations of market to book value

 Useful to companies with majorly tangible assets

 Does not consider future profit growth

ECONOMIC VALUE ADDED (Financial Management by I.M.Pandy, Page No: 736-740)

ALIET 8 STRATEGIC FINANCIAL MANAGEMENT

Consulting firm Stern Steward has developed the concept of Economic Value Added. EVA is
a useful tool to measure the wealth generated by a company for its equity shareholders. EVA
can also be referred to as economic profit, as it attempts to capture the true economic profit of
a company. Essentially, it is used to measure the value a company generates from funds
invested into it.

Economic value added (EVA) is a measure of surplus value created on a given investment.
When a person is investing his funds, he does this only because he expects to earn a profit
from the investment. Let us say, gold seems to be a good instrument to invest with a high-
profit margin.

 Total investment (i.e., price at which gold is purchased) = $ 1000

 Brokerage paid to the dealer for the purchase of gold = $ 15

In a year, I would like to sell off the gold on account of a liquidity crunch.

 The selling price of gold = $ 1200

 Brokerage paid to the dealer on sale of gold = $ 10

In the above Economic Value Added example,

Economic Value Added = Selling price – Expenses associated with selling the asset –
Purchase price – Expenses associated with buying the asset

Economic Value Added = $ 1200 – $ 10 – $ 1000 – $ 15 = $ 175

Meaning

 Economic value added (EVA) is an internal management performance measure that

compares net operating profit to total cost of capital.
 Economic value added (EVA) is a measure of a company's financial performance
based on the residual wealth calculated by deducting its cost of capital from its
operating profit, adjusted for taxes on a cash basis.
 In corporate finance, economic value added (EVA) is an estimate of a firm's economic
profit, or the value created in excess of the required return (Cost of capital) of
the company's shareholders.
 EVA is the incremental difference in the rate of return over a company's cost of
capital.

The formula for calculating EVA is = Net Operating Profit after Taxes (NOPAT) - Invested
Capital * Weighted Average Cost of Capital (WACC)

Where invested capital = Total assets – Current liabilities

Or

EVA = NOPAT - (Total Assets - Current Liabilities) * WACC.

ALIET 9 STRATEGIC FINANCIAL MANAGEMENT

 Or

EVA= Net operating profit after tax- Cost charges for capital employed

Formula for calculating WACC

The weighted Average Cost of Capital is the cost the company incurs for sourcing its funds.
The importance of deducting the cost of capital from the Net Operating Profit is to deduct the
opportunity cost of the capital invested. The formula to calculate the same is as follows:

Weighted Average Cost of Capital = (Cost of Debt) * (1 – Tax Rate) * (Proportion of debt) +
(Cost of Equity) * (Proportion of equity)

Note: An important point to note about this formula is that the Cost of Debt is multiplied by
(1 – Tax Rate) as there is tax saving on interest paid on debt. On the other hand, there is no
tax saving on the cost of equity, and hence the tax rate is not taken into account.

Interpretation

 If company’s EVA is positive, it means the company is garnering value from the
funds invested into the business.
 If a company's EVA is negative, it means the company is not generating value from
the funds invested into the business. \

Components of EVA

 Net operating profit after tax (NOPAT)

 Weighted average cost of capital (WACC)

Features of EVA Approach

 It is a performance measure that ties directly, theoretically as well as empirically, to

shareholder wealth creation.
 It converts accounting information into economic reality that is readily grasped by
non-financial managers. It is a simple yet effective way of teaching business literacy
to everyone.
 It serves as a guide to every decision from strategic planning to capital budgeting to
acquisitions to operating decisions.
 It is an effective tool for investor communication.

Evaluation of EVA

Merits:

 It is a performance measurement tool to determine whether firm is adding value to the

shareholder’s or not
 It helps in better decision making
 It offers better incentive plan for managers and employees

ALIET 10 STRATEGIC FINANCIAL MANAGEMENT

  It offers superior financial information to the firm that helps in improving
performance of firm

Limitations:

 It concentrates on short-term goals and gives less emphasis on long-term goals

 Manipulation is very easy while calculating EVA. Managers can manipulate in
accounting methods and show the desired results.

EVA Adjustments

EVA measures economic profit since it accounts for the cost of capital. However, it s still
based on accounting information. Hence, to become a true measure of economic profit, the
calculation of EVA needs over 150 adjustments. However, here are only few critical
adjustments necessarily for estimating EVA, others have minor effect.

S.No Adjustment Explanation Changes to Net Changes to

operating capital
profit employed
There are certain expenses that
can be classified as long-term
expenses such as research and
development, branding of a new
product, re-branding of old
products. These expenses may Add to Capital
be incurred in a given period of Employed.
Long-term time but generally have an Add to Net Also, check
1 expenses effect over and above a given Operating Profit out Return on
year. Capital
These expenses should be Employed
capitalized while EVA
calculation as they generate
wealth over a period of time
and not just reduce profit in a
given year.
Let us categorize depreciation
as accounting depreciation and
economic depreciation for the The difference
purpose of understanding. in the value of
Accounting depreciation is one accounting
Add accounting
which is calculated as per depreciation and
depreciation
Depreciatio Accounting policies and economic
Reduce
2 n procedures. In contrast, depreciation
economic
economic depreciation is one should be
depreciation
that takes into account the true adjusted from
wear and tear of the assets and the capital
should be calculated as per the employed
usage of assets rather than a
fixed useful life.
Non-cash These are expenses that do not Add to Net Add to capital
expenses affect the cash flow of a given Operating Profit employed by

ALIET 11 STRATEGIC FINANCIAL MANAGEMENT

 period.
EVA Example: Foreign
3 exchange contracts are reported
at fair value as on the reporting
adding it
date. Any loss incurred is
to Retained
charged to the Income
Earnings
Statement. This loss does not
lead to any cash outflow and
should be added back to the Net
Operating Profit.
Similar to non-cash expenses, Subtract from
there are non-cash incomes capital
Subtract from
4 Non-cash which do not affect the cash employed by
Net Operating
incomes flow of a given period. These subtracting it
Profit
should be subtracted from the from Retained
Net Operating Profit. Earnings
To arrive at accounting profits,
numerous provisions are
created, such as deferred
tax provisions, provision for
doubtful debts, provision for
expenses, allowance for
Add to Net Add to capital
5 Provisions obsolete inventory, etc. These
Operating Profit employed
are provisional figures and do
not actually affect the economic
profit. In fact, these provisions
are generally reversed on the
first day of the next reporting
period.
Tax is supposed
to be deducted
Tax should also be calculated after calculating
on actual cash outflow rather Net Operating
6 than the mercantile system Profit. So it is
Taxes
where all accruals are taken into directly
account, and only then tax is deducted, and
deducted. no other
adjustments are
required.

Strategies to Enhance EVA/ Value drivers of EVA

 Revenue enhancement
 Cost reduction
 Asset utilization
 Cost of capital reduction

MANAGERIAL IMPLICATIONS OF SHARE HOLDER VALE (Financial Management

by I.M.Pandy, Page No: 741-742)

The shareholder value approach is based on the assumption that a principal-agent relationship
exists between the shareholder and the management. As shareholders agent management is

ALIET 12 STRATEGIC FINANCIAL MANAGEMENT

charged with the responsibility of creating wealth for shareholders. Therefore, all
management actions and strategies should be guided by SVC. The share holder value depends
on

 Future cash flows and their risk.

 The cost of capital,

We should note that SVC emphasizes the present value of future cash flows rather than
earnings. SVC takes a long-term perspective and focuses on valuation. A number of
companies in India use the DCF analysis to evaluate projects. They accept those projects
which are expected to generate internal rate of return higher than the cost of capital, or a
positive net present value of future cash flows when discounted at the cost of capital. More
and more corporate mangers now relies the strong need for the extensive adoption of SVC in
evaluating all management actions, projects, business strategies and overall strategic
planning.SVC can be used to evaluate the consequences of strategies pursued by the
company. At the business unit or division level, it is used to evaluate the alternative
competitive strategies, to identify the key business factors that impact SVC and to set
performance targets that are consistent with value creation.

Fig: Steps to calculate shareholder value

ALIET 13 STRATEGIC FINANCIAL MANAGEMENT

 Fig: Share holder value network

Fig: Share holder value network

ALIET 14 STRATEGIC FINANCIAL MANAGEMENT

Problems
Market Value Added

Problem: 1

Company XYZ whose shareholders’ equity amounts to $750,000. The company owns 5,000
preferred shares and 100,000 common shares outstanding. The present market value for the
common shares is $12.50 per share and $100 per share for the preferred shares.
Solution:
Market Value of Common Shares = 100,000 * $12.50 = $1,250,000
Market Value of Preferred Shares = 5,000 * $100 = $500,000
Total Market Value of Shares = $1,250,000 + $500,000 = $1,750,000
Market Value Added = $1,750,000 – 750,000 = $1,000,000

Market to Book value/Price to book ratio

Problem: 1
Assume there is a company X whose publicly traded stock price is $20 and it has 100,000
outstanding equity shares. The book value of the company is $1,500,000.
Solution:
Market-to-book value ratio = 20* 1 00 000 / 1,500,000 = 2,000,000/1,500,000 = 1.33
Here, the market perceives a market value of 1.33 times the book value to company X.

Problem: 2

ALIET 15 STRATEGIC FINANCIAL MANAGEMENT

Solution:

Market to Book value ratio = 6/5 = 1.2

Economic Value Added

ALIET 16 STRATEGIC FINANCIAL MANAGEMENT

ALIET 17 STRATEGIC FINANCIAL MANAGEMENT
ALIET 18 STRATEGIC FINANCIAL MANAGEMENT
Key terms:

 Operating cycle: The operating cycle is the average period of time required for a
business to make an initial outlay of cash to produce goods, sell the goods, and
receive cash from customers in exchange for the goods.
 Funds flow statements: Funds Flow Statement is a statement prepared to analyse the
reasons for changes in the Financial Position of a Company between 2 Balance
Sheets. It shows the inflow and outflow of funds i.e. Sources and Applications
of funds for a particular period.
 Deferred tax: Difference between taxable income and book value income.
 Deferred tax liability: The amounts of corporate taxes payables in the future period.
 Capital expenditure: Money spent by a business or organization on acquiring or
maintaining fixed assets, such as land, buildings, and equipment.
 Capital structure: The term capital structure is used to represents the proportionate
relationship between debt and equity.
 Financial analysis: Financial analysis (also referred to as financial statement
analysis or accounting analysis or Analysis of finance) refers to an assessment of the
viability, stability and profitability of a business, sub-business or project.
 Institutional investors: A financial institution, such as a bank, pension fund, mutual
fund and insurance company, that invests large amounts of money in securities,
commodities and foreign exchange markets, on its own behalf or on the behalf of its
customers.
 Corporate governance: Corporate governance is the system of rules, practices and
processes by which a firm is directed and controlled. Corporate
governance essentially involves balancing the interests of a company's many
stakeholders, such as shareholders, management, customers, suppliers, financiers,
government and the community.
 Distress cost: Distress cost is a special category of cost faced by firms that are in
financial distress such as a higher cost of capital.
 Terminal value: In finance, the terminal value of a security is the present value at a
future point in time of all future cash flows when we expect stable growth rate forever
 Provision: Provisions are meant to cover the expected losses.
 Reserve: After paying tax but before paying dividends
 Retained earnings: What is left after paying dividends to stock holders?
 Accounting profit: It is the book keeping profit and it is higher than economic profit.
Accounting profit = Total monetary revenue – Total monetary cost
 Economic Profit: It is the monetary costs and opportunity costs a firm pays and the
revenue a firm receives. Economic profit = Total revenue – (Explicit cost + Implicit
cost)

ALIET 19 STRATEGIC FINANCIAL MANAGEMENT