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Chapter 2 Financial Strategy Formulation

Financial and non-financial characteristics


of companies
Financial

characteristics

Financial ratios

Non-financial

characteristics

Foreign exposure
Quality of management
Ownership structure

Chapter 2 Financial Strategy Formulation


When a financial characteristic of a
company deviates from the norm?
Industry

consideration

Economic cyclicality
Growth prospects
R&D expenses
Competitors
Sources of supply
Degree of regulation
Labour relationships
Accounting policies

Financial Ratios

Profitability ratios
ROCE=PBIT/Capital

employed

PBIT: profit on ordinary activities before interest and


taxation
Capital employed: shareholders funds + long-term
liabilities
Narrate:

How risky is the business?


How capital intensive is it?
Compared with peers
Compared with market borrow rate

Financial Ratios

Profitability ratios
Return

on equity=Earnings attributable to
ordinary shareholders/shareholders equity
Asset turnover: sales per $1 capital employed
= sales / capital employed
Net profit margin = PBIT/Sales
Gross profit margin = Gross profit/Sales

Financial Ratios

Liquidity ratios
Current

ratio = current assets / current


liabilities
Quick ratio (acid test) = current assets less
inventory / current liabilities
Turnover periods: inventory, receivables,
payables
Cash operating cycle
Reasons for changes in liquidity

Financial Ratios

Stock market ratios


Dividend

yield = Dividend per share / Market


price per share

Shareholders will get return in terms of dividends


received plus capital gains

EPS

= (Profit after tax, extraordinary items and


preference dividends) / (Number of equity
shares in issue and ranking for dividend)
Dividend cover =EPS / Dividend per share
Dividend payout ratio = Dividend per share /
EPS

Financial Ratios

Stock market ratios


P/E

ratio = Market value per share / EPS

The ratio reflects the markets appraisal of the


shares future prospects:
Increase faster or
less risky

Factors resulting in a change PE ratio:


Interest rates go up, share price down
Prospects improved, share price up
Investors confidence

Financial Ratios

Debt and gearing ratios


Financial

gearing (based on statement of financial


positions values) = Prior charge capital / Equity capital
(including reserves)

Prior charge capital is long-term loans and preference shares,


excluding loans repayable within one year and bank overdraft

Financial

gearing (based on market values) = Market


value of prior charge capital / (Market value of equity +
Market value of debt)
Operating gearing= Contribution / PBIT

Contribution = sales variable cost of sale

Interest

coverage ratio =PBIT / Interest charges


Debt ratio = total debts / total assets

Financial Ratios

Uses of ratio analysis


Comparison
Users

Investors
Suppliers and lenders
Managers

Financial Ratios

Limitations of ratio analysis


Not

available of comparable information


Historical or out-of-date information
Ratios are not definitive
Need interpretation
Manipulation
Ratios analysis on its own is not sufficient

Financial Ratios

Other information should be considered


The

revaluation of non-current assets


Share capital and reserves
Loans and other liabilities
Contingencies
Events after the statement of financial position
date

Trends
Current and previous years figures
Five year financial summaries

Economic Value Added (not included in 2016


textbook)

EVA is an estimate of the amount by which earnings exceed or fall


short of the required minimum rate of return that shareholders and
debt holders could get by investing in other securities of comparable
risk. It can be used as a performance evaluation tool, and can also
be relevant to valuing acquisitions.
The formula is as follows:

EVA = net operating profit after tax adjusted for non-cash


expenses (WACC x book value of capital employed)
EVA = Book value of capital employed x (return on invested
capital WACC)

Economic Value Added (not included in 2016


textbook)

Adjustment to profit figures


Adjustment

to net (operating) profit

Interest on debt capital (debt is included in capital employed,


and the cost of debt is included in the weighted average cost
of capital)

Goodwill written off

Accounting depreciation (deduct economic deprecation)

Increase in provisions (eg for bad debts)

Net capitalised intangibles (these are viewed as investments


and added to the balance sheet)

Economic Value Added (not included in 2016


textbook)
Adjustment to profit figures
Adjustment

to capital employed

Cumulative goodwill

Depreciation previously written off

Net book value of intangibles

Provisions (eg for bad debts)

Debt to net assets

Economic Value Added (not included in 2016


textbook)
Advantages of EVA
Keeps

the focus on shareholder value

The

most meaningful measure of profit for


shareholders

A single
Easy

goal

to understand

Economic Value Added (not included in 2016


textbook)
Disadvantages of EVA
Easy

to manipulate

Short-term
Makes

focus

comparison difficult

Market Value Added

MVA = Market value of Debt


+ Market value of Equity
- Book value of Equity
- Book value of Debt

MVA does not take opportunity cost of


capital into account

Other information from companies accounts

Revaluation of fixed assets

Share capital and share issues

Financial obligations

Debentures, loans and other liabilities

Contingencies

Events after the reporting period

Optimal capital structure

Decisions on how to finance the acquisition


of assets are based on the cost of the
various sources of finance
The

capital structure decision

The prime objective of a profit making company is


to maximise shareholder wealth. Investments will
increase shareholder wealth if they cover the cost
of capital and leave a surplus for the shareholders

Sources

of finance

Optimal capital structure

The choice between debt and equity


Advantages

of debt
Disadvantages of debt

Debt instruments
Types

of corporate debt
Trust deed
Issuing corporate bonds
Cost of debt

Optimal capital structure

Preference shares
Characteristics

of preference shares
Types of preference shares
Advantages and disadvantages of preference
shares
Cost of preferred stock

Optimal capital structure

Retained earnings
Advantages

and disadvantages of using


retained earnings
Cost of retained earnings

Optimal capital structure

Cost of capital
Cost

of the different forms of capital reflect


their risk

In the event of a company being unable to pay its


debts and going into liquidation, ordinary
shareholders rank after preference shareholders,
who in turn rank after the providers of debt finance

This

means that the cheapest type of finance


is debt and the most expensive type finance is
equity (ordinary shares)

Optimal capital structure


Required

return vs cost of capital

Difference

between the required return and


cost of capital
Perspective and corporate tax
E.g. bond has 100 market (and nominal
value) a 10% coupon and corporation tax is
30%.

The

required return and the cost of debt

Note Kd Investors return

The cost of equity using the CAPM

The cost of equity beyond the CAPM

Arbitrage Pricing Theory (APT)


E(ri ) rf (E(rA ) rf ) A (E(rB ) rf ) B ..... (E(rm ) rf ) m ....

The Fama and French three factor model:


E(rj ) rf i, m (E(rm ) rf ) i,SSIZE i,D DIST

The cost of equity bond-yield-plus


premium approach

Based on the empirical observation that


the return of equity is higher than the yield
on bonds.
Since equities are riskier than bonds, the
difference between the two is a reward the
investor requires in order to invest in the
riskier asset.
Bond yields + fixed premium

The cost of equity - the dividend growth


model

Assumptions

Footnotes

Dividends are paid and the company has a share price


Dividend growth can be estimated and is constant
If there is a dividend about to be paid & the share is cum div, then the
share price needs to be adjusted by stripping the dividend out of the
share price
If issue costs are given, these reduce the net proceeds from the issue
of equity and so they need to be subtracted from the market value of
the equity in the calculation

Question: Cost of retained earnings (P.43)

The cost of equity - the dividend growth


model
Estimating the rate of growth in dividends
using

rate of growth in the past g n D0 /Dividend n years ago 1

Example (a): AB plc has just paid a dividend of 40 cents per share, this
has grown from 30 cents four years ago.
Required
What is the estimated cost of equity capital if the share price is $8.20?
using

g=rb

b = the proportion of earnings retained in the company


r = the rate of return that the company can earn on re-investment
Example (b): RS plc has just paid a dividend per share of 30p. This
was 50% of earnings per share. In turn, earnings per share were
20% of net assets per share. The current share price is 150p.
Required
What is the cost of equity capital?

Optimal capital structure

New share issues by quoted companies


Reasons

for issuing new shares


Practicalities for issuing new shares
Timing of new share issue
A rights issue
Scrip dividends
Bonus issues
Stock splits

Optimal capital structure

Methods for obtaining a listing


Direct

offer by subscription to general public


Offer for sale
Offers for sale by tender
A placing
A stock exchange introduction
Underwriting
Costs of share issue on the stock market
Cost of equity for new share issue on the stock
market

The cost of irredeemable debt


Although it is the investors required rate of return that
determines the rate of interest that the company has to pay, we
assume that any debt interest payable attracts tax relief for the
company and that therefore the actual cost of debt to the
company is lower.

Example: F plc has in issue 8% irredeemable debentures


quoted at 90% ex int.
(a) what is the return to investors ?
(b) what is the cost to the company, if the rate of corporation
tax is 30% ?
If issue costs are given, these reduce the net proceeds from the
sale of a debenture and so they need to be subtracted from the
market value of the debt in the calculation.

The cost of redeemable debt

Internal rate of return (IRR) approach


Time
0
1-n
n

$
(Market value)
Interest x [1 - tax]
Redemption value

Step 1 - calculate the NPV of the project, at say 5


Step 2 - calculate the project, at say 10
Step 3 - calculate the internal rate of return using the formula

The cost of redeemable debt


Example: Mantra plc has $100,000 5%
redeemable debentures in issue. Interest is paid
annually on 31 December. The ex-interest market
value of the stock on 1 January 2007 is $90 and
the stock is redeemable at a 10 premium on 31
December 2011. Corporation tax is 30%.
Required
What is the cost of debt?
If the examiner gives you a debt beta, then the
cost of debt can be estimated using the CAPM.

The cost of convertible debt

Convertible debentures give the holder the right


to convert $100 into a no. of shares. If the
conversion ratio was $100 for 20 shares and the
share price at the redemption date was $4,
conversion would not happen and the
calculations for the cost of debt would be
unchanged. However, if the share price was $6
then the calculations would change to the IRR of:
Time
$
0
(Market value)
1-n
Interest x [1 - tax]
n
Value of the shares (here $120)

The cost of preference shares

The preference shareholder will receive a fixed


income, based upon the nominal value of the
shares held (not the market value). These
dividends are paid out of post-tax profits and
therefore do not receive tax relief. The cost of
preference share capital is calculated as:

The cost of bank debt

The cost of a bank loan will be given by the


examiner - just multiply this by (1 -t) to get
the post-tax cost.

weighted average cost of capital (WACC)


Ve = total market value (ex-div) of issued shares
Ke = cost of equity in a geared company
Vd = total market value (ex-interest) of debt
Kd = cost of debt
A third source of finance may have to be added in to the formula
The WACC can only be used for project evaluation if:
(a) in the long-term the company will maintain its existing capital
structure (ie financial risk is unchanged)
(b) the project has the same risk as the company (ie business risk is
unchanged).

Changing risk

Where the risk of an extra project is different from normal, there is an argument for
a cost of capital to be calculated for that particular project; this is called a marginal
cost of capital.

Dividend policy

Irrelevant theory
The value of a company is not affected by its financial
policy

Ways of paying dividend


Dividend capacity

Dividend policy

Theories of dividend policy


The

residual theory

only pay dividend when all profitable projects had been funded
Target

payout ratio

pay out as dividends a fixed proportion of earnings


Dividend

as signals

to convey good private information to the marketplace


Agency

theory

an instrument to monitor managers, thus raise new capital


simultaneously
Dividend

and taxes

low tax-rate individuals may prefer to get dividend

Risk management

Risk requires

Rationale for risk management


Risk mitigation

Is the process through which a corporation reduces its risk


exposure
Priorities for risk mitigation
Strategies: hedging and diversification

Hedging

Identify
Measurement
Transfer

Financial hedging: using financial instruments


Operational hedging: using non-financial instruments (e.g. real
options)

Diversification

Product diversification
Geographical diversification

Different types of risk

Systematic and unsystematic risk

Business risk and non-business risk

Whether can be diversified


Whether related to products and services
Operating gearing=Contribution/PBIT

Financial risk

Systematic risk borne by equity shareholders


Relating to the structure of finance
Other shorter-term financial risk include:

Longer-term risks include:

Credit risk
Liquidity risk
Cash management risk
Currency risk
Interest risk
Risks arising from other changes in the macroeconomic environment

Relationship between business and financial risk

Different types of risk

Political risk
the

risk that political action will affect the


position and value of a company. This can
involve changes in regulations (regulatory
risk), or tax policy (fiscal risk)
outbreak of war / civil unrest
confiscation of assets (nationalization) /
restrictions on foreign ownership
import quotas / tariffs
exchange controls

Different types of risk

Economic risk
Arises

from the changes in economic policy in the host


country that affect the macroeconomic environment in
which the multinational company operates
Restrictive monetary policy lead to high interest rates
and recession (reduced demand)
Inflation, leading to devaluation of local currency and
decrease remittance value to the parent company
Currency inconvertibility for limited period
Host country economic shocks, affecting exchange
rate, monetary policy, etc

Different types of risk

Fiscal risk
Is

the risk that tax arrangements in the host


country may change after the investment in the
host country is undertaken
Imposition of indirect taxes
Imposition of excise duties on imported goods
and services
Increase in the corporate tax rate
Abolition of the accelerated tax depreciation
allowances for new investments
Changes in tax law regarding admissibility of
expenses for tax deductibility

Different types of risk

Regulatory risk
Is

the risk that arises from the change in legal


and regulatory environment which determines
the operation of a company
Minimum wage legislation
Pollution controls
Anti-monopoly laws
Disclosure requirements or stricter corporate
governance
Health and safety legislation

Different types of risk

Operational risk
Is

the risk arising from the execution


(operation) of an organisations business
functions
Internal fraud
External fraud
Damage to physical assets
Business disruption and systems failure
Employment practices, workplace safety
Clients, products, business practices
Process management

Different types of risk

Reputational risk
Is

the risk related to the way in which a


business is viewed by others
One of the consequences of operational risk

Strategies to deal with risks

Negotiations with host government


Insurance
Production strategies
Producing

key parts directly, outsourcing remainder


Control of patents

Contacts with markets


Financial management
Obtain

funds locally/borrow worldwide


Obtain guarantee from government for investment

Management structure
Joint

ventures
Ceding control but obtaining profit by management
contract

Capital investment monitoring (self-read)

The need for investment monitoring


Aspects of the monitoring process

Monitoring and risk management planning

Monitoring and risk management execution

Risk assessment against the deliverables at each time point to take


place
Evaluate the compliance with budget & schedule along critical path
Assign risk according its probability and impact
Risk mitigation actions

Project reassessment

Establish organisation and assign role and responsibility


Select milestones and risk tracking method
Determine critical path

Generate report on whether revision or not

Post-completion audit
make a conclusion for performance measurement or reference

Behavioural finance

Psychological factors affecting decision making


Overconfidence
Search

for patterns, herding and cognitive dissonance


Narrow framing
Availability bias
Conservatism

Behavioural finance

Share valuation

Acquisitions

Behavioual finance explain why many acquisitions are overvalued (p.315)

CAPM

Managers over-confident most boards believe their shares are


undervalued managers taking actions not in shareholders best
interests (e.g. delisting, defending against takeover bid)

Behavioual finance conflicts with theories that asset prices and


investor returns are determined in a rational manner e.g.
investors show a greater aversion to risk

Financial strategy
Overconfidence

and cognitive dissonance explain why


managers persist with investment strategies that are
unlikely to succeed.