SFM-Chapter 1

STRATEGY

STRATEGIC FINANCIAL MANAGEMENT

Financial Objective of business• Profit maximization• Wealth maximization

• Welfare of employees

• Serving customers

• Welfare of management

• Relationships with Suppliers

• Responsibilities to Society

Non financial objectives of business

The agency theory• A theory explaining the relationship between principals

such as a shareholders and agents such as a company's executives. I

• In this relationship the principal delegates or hires an agent to perform work.

• The theory attempts to deal with two specific problems: first, that the goals of the principal and agent are not in conflict (agency problem),

• and second, that the principal and agent reconcile different tolerances for risk.

Importance of SFM• 1. To maintain equilibrium between the contradictory interests of various

stakeholders.

• 2.To assure steady growth in the long run.

• 3.To achieve accelerated growth.

• 4. To capture short term and long term exceptional opportunities of business.

• 5.To create an ability and action plan to meet depressionary pressures, competitors unexpected tactics and other global and domestic adversities.

• 6. To create scope to fund new ventures, new technologies, new markets and new benchmarks to increase profitability and productivity.

Long term and short term planning

1. Acquiring sufficient funds2. Proper utilization of funds3. Increasing profitability4. Maximizing firm value5. Estimating financial requirements6. Deciding capital structure7. Selecting source of finance8. Selecting pattern of investment9. Proper cash mgt10. Implementing financial controls and proper use of surplus.

• Value is created when management generates revenues over and above the economic costs to generate these revenues.

• Costs come from four sources: employee wages and benefits; materials & supplies, economic depreciation of physical assets; taxes and the opportunity cost of using the capital.

• Value is only created when revenues exceed all costs including a capital charge. This value accrues mostly to shareholders because they are the residual owners of the firm.

• Shareholders expect management to generate value over and above the costs of resources consumed, including the cost of using capital.

• If suppliers of capital do not receive a fair return to compensate them for the risk they are taking, they will withdraw their capital in search of better returns, since value will be lost.

• A company that is destroying value will always struggle to attract further capital to finance expansion since it will have a share price that stands at a discount to the underlying value of its assets and by higher interest rates on debt or bank loans demanded by creditors.

• The value perspective is based on measuring value directly from accounting-based information with some adjustments, while the wealth perspective relies mainly on stock market information.

Share holders Value Drivers

1. Revenue2. Operating margin3. Cash Tax rate4. Incremental capital expenditure5. Investment in working capital6. Cost of capital7. Competitive advantage period

VBMS• It is a customer focused system built upon

shared principles and core values designed to instill an ownership culture in the organization

1.Profit centre concept2.Formula based profit sharing3.ESOP

• What are the factors affecting the corporate decisions?

• There are linkages between the variables and the effect on their decision.

• The decision support models helps in predicting a firm’s future.

Models for Maximizing Shareholders Value

• Marakon Model

• Alcar Model

• Mc Kinsey model

Marakon Model• A firm’s value is the ratio of its market value to

book value.• An increase in the value results in the increase in

the value of the firm and vice versa• It states that a firm can maximize its value by:• Understanding the financial factors that affect a

firms value• Strategic forces• Strategies leading to higher value of the firm• Create internal structures to counter the

divergence between shareholders and management’s goals.

• According to Marakon model shareholder wealth creation is measured as the difference between the market value and the book value of a firm's equity.

• The book value of a firm's equity, B, measures approximately the capital contributed by the shareholders, whereas the market value of equity, M, reflects how productively the firm has employed the capital contributed by the shareholders, as assessed by the stock market.

• Hence, the management creates value for shareholders if M exceeds B, decimates value if m is less than B, and maintains value is M is equal to B.

• According to the Marakon model, the market-to-book values ratio is function of thee return on equity, the growth rate of dividends, and cost of equity.

• The measure considers the difference between the ROE and required return on equity as the source of value creation. This measure is a variation of the EV measures.

• Instead of using capital as the entire base and the cost of capital for calculating the capital charge, this measure uses equity capital and the cost of equity to calculate the capital (equity) charge.

• Correspondingly, it uses economic value to equity holders (net of interest charges) rather than total firm value.

Marakon Model• The key steps in the Marakon approach are:

• 1.Specify the financial determinants of value

• 2.Understand the strategic drivers of value

• 3.Formulate higher value strategies.

• 4.Develop on superior organizational capabilities.

• 1.Specify the financial determinants of value• According to this model• M/B=r-g/k-g• Hence according to this model M/B>1 only

when r>k

• 2. Understand the strategic drivers of value• The 2 strategic factors of value creation are:• 1.Market economies:• Intensity of indirect competition• Threat of entry• Supplier pressures Limiting forces• Regulatory pressures• Intensity of direct competition• Customer pressures Direct forces

• Competitive position:• When the company is able to command a price

premium relative to competitors.• The company can either increase its price and let

the market share be same or decrease the price and increase the market share

• The sources of economic cost advantage are:• Access to cheaper raw materials• Efficient process technology.• Access to low cost distribution channels• Superior management• Economies of scale in some markets

• ALCAR APPROACH• The Alcar group Inc. a management and software company, has developed an

approach to value-based management which is based on discounted cash flow analysis.

• The emphasis is not on annual performance but on valuing expected performance. The implied value measure is akin to valuing the firm based on its future cash flows and is the method most closely related to the DCF/NPV framework.

• With this approach, one estimates future cash flows of the firm over a reasonable horizon, assigns a continuing (terminal) value at the end of the horizon, estimates the cost of capital, and then estimates the value of the firm by calculating the present value of these estimated cash flows.

• This method of valuing the firm is identical to that followed in calculating NPV in a capital-budgeting. Since the computation arrives at the value of the firm, the implied value of the firm's equity can be determined by subtracting the value of the current debt from the estimated value of the firm. This value is the implied value of the equity of the firm.

• To estimate whether the firm's management has created shareholder value, one subtracts the implied value at the beginning of the year from the value estimated at the end of the year, adjusting for any dividends paid during the year.

• If this difference is positive (i.e., the estimated value of the equity has increased during the year) management can be said to have created shareholder value.

• The value drivers of firm’s value are:• The growth rate of sales• Operating profit margin• Income tax rate• Incremental investment in working capital• Incremental investment in fixed assets• Cost of capital

• The Alcar approach has been well received by financial analysts for two main reasons:

* It is conceptually sound as it employs the discounted cash flow framework* Alcar have made available computer software to popularize their approach

The Alcar approach seems to suffer from two main shortcomings:

• (1) In the Alcar approach, profitability is measured in terms of profit margin on sales. It is generally recognized that this is not a good index for comparative purposes.

• (2) Essentially a verbal model, it is needlessly cumbersome. Hence it requires a fairly involved computer programme.

• McKINSEY APPROACH:• McKinsey & Company a leading international

consultancy firm has developed an approach to value-based management

• The company’s overall aspirations , analytical techniques and management processes are aligned to maximize its value.

• The key steps in maximizing firm’s value are:• Identification of value drivers• Development of strategy• Setting of targets• Deciding on action plans• Setting the performance measurement system• Implementation