Chapter 2.1 Strategic Financial Management 5y3l2g

STRATEGIC FINANCIAL MANAGEMENT Chapter 2

2/5/2018

MIchael Karl M. Barnuevo, MBA

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What is strategic financial management ■ The identification of the possible strategies capable of maximizing an organization'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

2/5/2018

MIchael Karl M. Barnuevo, MBA

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What is finance? ■ Corporate finance is an area of finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions (wikipedia.com) ■ Corporate Financial Management deals with the decisions of a firm related to investment, financing and dividend 2/5/2018

MIchael Karl M. Barnuevo, MBA

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Investment Decision ■ To carry on business, a firm invests in tangible assets like plant and machinery, buildings, and intangible assets like goodwill and patents. This comprises the investment decision

2/5/2018

MIchael Karl M. Barnuevo, MBA

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Financing Decision ■ These assets don’t come free; one has to pay for them, so a company needs to tap various sources of funds including shares, bonds, bank loans. This forms the financing decision

2/5/2018

MIchael Karl M. Barnuevo, MBA

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Dividend Decision ■ The investment in assets generates revenues and cash flows for a specific period of time. The managers of the company can either retain cash with the company for further investment or distribute to the owners of the company—the shareholders. This constitutes the dividend decision

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MIchael Karl M. Barnuevo, MBA

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■ In short, a finance manager will be concerned with such financial decisions as: ■ Which investment/s should the company accept and what are the financial implications of undertaking the same? ■ How should the company finance those investments? What should be the mix of owners’ contribution— equity and borrowed funds, i.e., debt at any given point in time? ■ How much of the income generated from operations should be returned to shareholders in the form of dividends and how much is to be retained for further investment?

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MIchael Karl M. Barnuevo, MBA

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Financial decisions: Time perspective ■ Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders

■ On the other hand, the short term decisions can be grouped under the heading "Working capital management". ■ This subject deals with the short-term balance of current assets and current liabilities;

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MIchael Karl M. Barnuevo, MBA

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Financial decisions: Time perspective ■ The focus here is on managing cash, inventories, and short-term borrowing and lending (such as the on credit extended to customers).

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MIchael Karl M. Barnuevo, MBA

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Objective of financial managers ■ Corporate Finance theoreticians generally agree that the objective of a firm is to maximize wealth ■ Whose wealth? whether it should be the wealth of shareholders or the wealth of the firm, which includes bondholders and preferred stockholders ■ Shareholder wealth maximization rule requires managers to work towards a sustainable increase in the price of the firm’s stock

2/5/2018

MIchael Karl M. Barnuevo, MBA

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Objective of financial managers ■ Alternative to the above rule is to maximize profit, social value, or growth of the firm ■ The underlying assumption is that, an increase in any of these proxies results in an increase in the value of the firm (alternatively, shareholder value) ■ Maximize Profit? Increase sales, suppress expenses, extract the last rupee from the customer, pay the lowest possible price to suppliers, pay less salaries to employees,

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MIchael Karl M. Barnuevo, MBA

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Social Responsibility as an objective ■ Can social responsibility be an objective? ■ Businessmen are supposed to be socially responsible ■ But social welfare activities have conceptual problems? What is right or wrong, how much to spend on social responsibility? Moreover, what was considered moral 30 years ago could be immoral now? 2/5/2018

MIchael Karl M. Barnuevo, MBA

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Growth as an Objective ■ Can growth be an objective of a firm? ■ Business in pakistan, india and south Korea are dominated by family groups, and conglomerates. ■ Businesses groups in south Korea are called chaebol, typically own 30—50 companies in all key business areas; and the big five—Daewoo, Samsung, Hyundai, LG, and SK— for 20 percent of all borrowing and contribute to almost 50 percent of GDP

2/5/2018

MIchael Karl M. Barnuevo, MBA

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Growth as an Objective ■ Debt ratios at the top 30 chaebol are in the range of 550 percent; they suck up a major portion of the available credit and drive out smaller businesses

■ The chaebol understand only one language: borrow to the hilt; focus on size and not profit; focus on growth and not productivity; invest aggressively and acquire companies ■ Productivity in South Korea is about half that of US levels

2/5/2018

MIchael Karl M. Barnuevo, MBA

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Growth as an Objective ■ When earnings fall due to recession, competition, or some such thing, these companies will default on borrowings ■ To summarize, growth, though important, need not necessarily lead to an increase in shareholder value

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MIchael Karl M. Barnuevo, MBA

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Multiple Objectives ■ Do Firms Pursue Multiple Objectives? ■ In a survey of management views on alternative objectives, it has been found in the companies locally that in 67 percent companies—with high profitability—the first preference is given to the objective of maximizing percent ROI and, in 33 percent companies, the first preference is given to the objective of maximizing aggregate earnings

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MIchael Karl M. Barnuevo, MBA

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MIchael Karl M. Barnuevo, MBA

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Impediments to shareholder wealth maximization ■ There could be potential conflict of interest between shareholders and bondholders, managers and shareholders, majority and minority shareholders. So, maximizing wealth of one group could be achieved at the expense of other groups ■ Shareholders vs Bondholders ■ Managers vs Shareholders ■ Shareholder vs Shareholder

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MIchael Karl M. Barnuevo, MBA

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Shareholders vs Bondholders ■ Bondholders get a fixed, contractual payment (interest) during the term of the bond but have a prior claim on the assets of the company; whereas equity investors have a residual claim on the cash flows of the company as they are owners. ■ A company making losses may be tempted to borrow and take on business gambles, the benefits of which largely go to shareholders. It’s a ‘heads-I-win, tails-you-lose’ strategy. If the project succeeds, shareholders enjoy the upside potential but bondholders get fixed interest payment; if the project fails, shareholders have nothing to lose—it’s not their money anyway

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MIchael Karl M. Barnuevo, MBA

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Managers vs Shareholders ■ Investment in projects generates cash flows, which can either be reinvested in the business or returned to shareholders in the form of dividends who in turn can decide where to invest their money. Managers, as agents of shareholders, have discretion over investment of residual cash flow. ■ Increasing dividends reduces the resources under the manager’s control and limits growth. Since managers are appraised on the basis of growth, it is likely that they may pursue unprofitable projects that do not yield adequate returns; leaving the shareholders in a lurch. This leads to conflict of interest between managers and shareholders.

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MIchael Karl M. Barnuevo, MBA

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Shareholder vs Shareholder ■ The majority shareholder often serves as the chairman of the board. ■ A share is a share in the share capital of the company. Each share entitles the holder to exercise one vote at the annual general meeting. If this is true, then the value of the share should be the same for all shareholders irrespective of how many shares one is holding—one million or 100 shares.

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MIchael Karl M. Barnuevo, MBA

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MAXIMIZE EQUITY VALUE OR FIRM VALUE? ■ There is a misconception that maximization of equity value and maximization of firm value are the same. They are not the same.

■ Even though equity is a part of the firm’s capital structure, there is also debt and many financial instruments with both debt and equity features that managers should take into . As described in earlier sections shareholders can increase their wealth at the expense of other investors.

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MIchael Karl M. Barnuevo, MBA

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Conclusion ■ The objective of a firm should not be to make a profit or even maximize profit, increase market share or sales, but to maximize shareholders’ wealth

■ But this should not be achieved at the expense of other investor groups ■ Financial markets are efficient to some extent, they can see whether a firm is adding value or not; this will be reflected in the share price of the firm

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