CIMA Paper F3 Financial Strategy Notes
Contents About ExPress Notes 3 1. Formulating Financial Strategy 7 2. Evaluating Financial Strategy 11 3. Evaluating Financing Decisions 15 4. Cost of Capital in Financing Decisions 25 5. Evaluating Investment Decisions 33 6. Valuations 38 7. Mergers & Acquisitions 46 Page 2
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Chapter 1 Formulating Financial Strategy START The Big Picture Financial strategy is designed in the context of a corporation s overall strategic objectives and in keeping with its mission statement and core values. Managers are expected to have a clear understanding of where their company is headed if they are to be able to define and communicate objectives clearly throughout the organisations. Financial vs. non-financial objectives Different organisations have different financial and non-financial objectives: Profit-seeking companies: Maximising shareholder wealth is an over-arching objective; Page 7
Other (non-financial) objectives: supporting environmental good practices; promoting progressive labor policies/practices; pursuing steps to enhance its image/reputation; enforcing high standards of professional integrity/conduct Non-profit organisations: Though making a profit is not an objective of such organisations, cost controls (and maximizing funding sources) are; this is best summarized in the concept of Value for Money, consisting of: Economy: Getting the best deal on inputs; Efficiency: Converting inputs into the maximum number of outputs; Effectiveness: Ensuring that organizational objectives are being met Public-sector entities: Government-related organisations providing services to the public (non-financial objectives) and covering costs, providing a surplus, or at least minimize deficits (financial objectives). Financial objectives The financial objective of a firm is generally considered to be the maximisation of shareholder wealth. To achieve this, financial management consists of making decisions in three key areas: 1. Investing: What spending needs to be done to carried out to obtain the maximum financial impact (e.g. equipment, R&D, acquisitions, training, distribution network, technology, inventory) 2. Financing: Where to source the funding so as to minimize the cost of capital to the firm (equity, debt, suppliers) 3. Dividends: How much cash to allocate to the shareholders to maintain their commitment to the company while retaining appropriate resources for reinvestment Page 8
Matching principle Matching investments and financing Funding strategies are guided by the following considerations: Temporary cash shortages can be funded short-term, while Permanent shortages should be funded long-term The matching principle can be applied to the assets being financed: Fixed assets are generally funded long-term, along with the permanent portion of current assets (e.g. buffer stocks); Current assets of a fluctuating nature can rely on short-term finance (e.g. seasonal upswings in inventories / receivables) Cash surpluses, on the other hand, can be dealt with based on whether they are: Short-term: in this case they may be invested in short-term, low-risk, liquid investments (e.g. Treasury bills or marketable securities); Long-term: Make acquisitions; Reduce debt; Pay extraordinary dividend, etc. Dividends Dividend policies The relationship between dividend policy and shareholder wealth is addressed in different ways: The traditional theory of dividend policy maintains that there is an optimal payout ratio for dividends that suits shareholders and that will maximize the share price. Cash dividends can be seen as a payment to shareholders of residual or excess cash not required in the business for operational reasons. Page 9
External constraints Financial strategy must be formulated in the context of external constraints: Funding: Will the financial markets be willing to provide the funding needed? Regulatory bodies: The Chief Financial Officer must be aware of regulatory constraints on the choices made, both in the domestic market and where foreign operations are concerned. Examples: Price controls; Listing requirements (stock exchanges); Anti-monopoly rules; Industry-level regulations (incl. self-regulation); Corporate strategy: Is the strategy consistent with the company s risk acceptance and ethical policies; Economic factors: Where is the economy headed and how will trends affect financial strategy? Page 10
Chapter 2 Evaluating Financial Strategy START The Big Picture Identifying the risks to a chosen strategy and the techniques necessary to evaluate them are key parts of the skill set of any manager. Financial risks In formulating financial strategy, a company must plan for and make assumptions regarding: Interest rate risks Another area of financial risk is the sensitivity of a company s assets and liabilities to a change (up or down) in interest rates. A company should know what the net impact of such movements will be on its financial condition. Page 11
Inflation Price increases reduce the purchasing power of money. Foreign Exchange Risks Foreign exchange risk occurs when a company is potentially affected by changes in foreign exchange rates. Companies with assets, liabilities, revenues or expenses denominated in currencies different fro its home currency is exposed to foreign exchange risk. Assessing creditworthiness When assessing the creditworthiness of (potential) clients, companies can use the approach typically employed by banks, referred to (originally) as the 3 C s of credit, later expanded to the 5 C s. They are: Character: Focuses on the reputation of the principals/decision makers at a company; credit checking agencies and bank references assist to this end; Capacity: Examines the company s cash flow generation in the context of management s ability to perform competently and reliably in meeting their obligations, based on an examination of their track record (either directly or via the experiences of others). Financial statement analysis is a major part of the exercise here (and in the next point); Capital: Identifies and assesses the financial staying power and resources of the business; how much of a capital cushion do they have to withstand losses and how much do they have committed at risk in a proposed transaction that incentivizes them to succeed (one can refer to this as the pain factor ); Collateral: Assesses what (if any) security the company is willing to provide in support of the intended transaction. Banks refer to this as providing additional exits ( ways out ) from a transaction. Conditions: This is a general review of the economic environment to appreciate to what extent a customer may be affected by a decline in general business conditions (business cycle influences). Page 12
Financial forecasting Financial modelling involves the determination of cash flows and financial statements based on forecasts and assumptions. Variables include: Interest rates; Volume of sales; Profit margins; Foreign exchange rates Forecasts are made over a number of years. Sensitivity analysis This asks the following question: How are budgetary outcomes affected if certain key variables are altered? The technique is one-dimensional in that it isolates and alters each (key) variable in turn in order to measure the impact. Monte Carlo simulation This is a simulation model that uses probability distribution analysis to analyze the possible outcomes affecting a business (or a project). It is built on the simultaneous changes of many variables, the relationships between these variables being defined in advance, e.g. if price is reduced, how much demand may go up. Each variable itself has a probability distribution and the combinations of variables are modeled by running the model repeatedly, resulting in a distribution of simulation results. Modigliani and Miller Modigliani and Miller (MM) developed a theory which suggested that financial gearing does not matter. WACC stays the same as (cheaper) cost of debt is offset by rising cost of equity. Their theory at this stage ignored taxes. Page 13
They further concluded (in MM Proposition 1) that the enterprise value of a company remains the same, regardless of its capital structure. Furthermore (MM Proposition 2) the addition of debt introduces financial risk, which causes the cost of equity to rise. WACC remains unchanged. The drawback of MM theory is that it ignores the tax deductibility of interest payments. When this possibility is introduced (tax relief on debt), MM observed that the WACC will decline in linear fashion. MM concluded that on this basis, a company should (theoretically) borrow as much as possible! Another conclusion of MM is that the value of a leveraged company will exceed the value of the same company unleveraged by the value of its tax shields. Trends in financial reporting Convergence of reporting standards Financial reporting is on a global trend of convergence, e.g. plans to harmonise IFRS with US GAAP. Environmental concerns Issues of environmental concern and sustainability have become established and recognized agenda points for corporations. Many stakeholders are coming to expect explicit acknowledgment of such matters. The triple bottom line approach expands the scope of a company s concerns, beyond the merely economic, to social and ecological as well. Carbon trading programmes are schemes by which a company which outperforms its environmental targets is rewarded by being able to sell its credits to companies that pollute beyond permitted limits. To operate properly, this arrangement requires supervision by a central authority (government) in what is known as a cap and trade regime. Page 14