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Financial Policy and Corporate Strategy

Learning Objectives
After reading this chapter student shall be able to understand:
Strategic Financial Decision Making Frame Work
Strategy at different hierarchy levels
Financial Planning
Interface of Financial Policy and Strategic Management
Balancing Financial Goals vis--vis Sustainable Growth
Principles of Valuation
1.0 Strategic Financial Decision Making Frame Work
Capital investment is the springboard for wealth creation. In a world of economic uncertainty,
the investors want to maximize their wealth by selecting optimum investment and financial
opportunities that will give them maximum expected returns at minimum risk. Since
management is ultimately responsible to the investors, the objective of corporate financial
management should implement investment and financing decisions which should satisfy the
shareholders by placing them all in an equal, optimum financial position. The satisfaction of
the interests of the shareholders should be perceived as a means to an end, namely
maximization of shareholders wealth. Since capital is the limiting factor, the problem that the
management will face is the strategic allocation of limited funds between alternative uses in
such a manner, that the companies have the ability to sustain or increase investor returns
through a continual search for investment opportunities that generate funds for their business
and are more favourable for the investors. Therefore, all businesses need to have the
following three fundamental essential elements:
A clear and realistic strategy,
The financial resources, controls and systems to see it through and
The right managementteam and processes to make it happen.
We may summarise this by saying that:
Strategy +Finance +Management =the fundamentals of business
Strategy may be defined as the long term direction and scope of an organization to achieve
competitive advantage through the configuration of resources within a changing environment
for the fulfilment of stakeholders aspirations and expectations. In an idealized world,
The Institute of Chartered Accountants of India
1.2 Strategic Financial Management

management is ultimately responsible to the investors. Investors maximize their wealth by
selecting optimum investment and financing opportunities, using financial models that
maximize expected returns in absolute terms at minimum risk. What concerns the investors is
not simply maximum profit but also the likelihood of it arising: a risk-return trade-off from a
portfolio of investments, with which they feel comfortable and which may be unique for each
individual.
We call this overall approach strategic financial management and define it as being the
application to strategic decisions of financial techniques in order to help achieve the decision-
maker's objectives. Although linked with accounting, the focus of strategic financial
management is different. Strategic financial management combines the backward-looking,
report-focused discipline of (financial) accounting with the more dynamic, forward-looking
subject of financial management. It is basically about the identification of the possible
strategies capable of maximizing an organization's market value. It involves the allocation of
scarce capital resources among competing opportunities. It also encompasses the
implementation and monitoring of the chosen strategy so as to achieve agreed objectives.
1.1 Functions of Strategic Financial Management: Strategic Financial Management is the
portfolio constituent of the corporate strategic plan that embraces the optimum investment and
financing decisions required to attain the overall specified objectives. In this connection, it is
necessary to distinguish between strategic, tactical and operational financial planning. While
strategy is a long-term course of action, tactics are intermediate plan, while operations are
short-term functions. Senior management decides strategy, middle level decides tactics and
operational are looked after line management.
Irrespective of the time horizon, the investment and financial decisions functions involve the
following functions
1
:
Continual search for best investment opportunities
Selection of the best profitable opportunities
Determination of optimal mix of funds for the opportunities
Establishment of systems for internal controls
Analysis of results for future decision-making.
Since capital is the limiting factor, the strategic problem for financial management is how
limited funds are allocated between alternative uses. This dilemma of corporate management
is resolved by the pioneering work of Jenson and Meckling (1976)
2
, which is popularly known
as agency theory. Agency theory refers to a set of propositions in governing a modern
corporation which is typically characterized by large number of shareholders or owners who
allow separate individuals to control and direct the use of their collective capital for future
gains. These individuals, typically, may not always own shares but may possess relevant

1
Strategic Financial Management: Exercises, Robert Alan Hill.
2 Jensen, M.C> & W.C. Meckling (1976), Theory of the Firm: Managerial Behaviour, Agency Costs and
Ownership Structure, Journal of Financial Economics, October, V.3,4, pp. 305-360
Financial Policy and Corporate Strategy 1.3

professional skills in managing the corporation. The theory offers many useful ways to
examine the relationship between owners and managers and verify how the final objective of
maximizing the returns to the owners is achieved, particularly when the managers do not own
the corporations resources. According to this theory, strategic financial management is the
function of four major components based on the mathematical concept of expected NPV (net
present value) maximization, which are:
1. Investment decision
2. Dividend decision
3. Financing decision and
4. Portfolio decision.
The key decisions falling within the scope of financial strategy include the following:
1. Financial decisions: This deals with the mode of financing or mix of equity capital and
debt capital. If it is possible to alter the total value of the company by alteration in the capital
structure of the company, then an optimal financial mix would exist - where the market value
of the company is maximized.
2. Investment decision: This involves the profitable utilization of firm's funds especially in
long-term projects (capital projects). Because the future benefits associated with such projects
are not known with certainty, investment decisions necessarily involve risk. The projects are
therefore evaluated in relation to their expected return and risk. These are the factors that
ultimately determine the market value of the company. To maximize the market value of the
company, the financial manager will be interested in those projects with maximum returns and
minimum risk. An understanding of cost of capital, capital structure and portfolio theory is a
prerequisite here.
3. Dividend decision: Dividend decision determines the division of earnings between
payments to shareholders and reinvestment in the company. Retained earnings are one of the
most significant sources of funds for financing corporate growth, dividends constitute the cash
flows that accrue to shareholders. Although both growth and dividends are desirable, these
goals are in conflict with each other. A higher dividend rate means less retained earnings and
consequently slower rate of growth in future earnings and share prices. The finance manager
must provide reasonable answer to this conflict.
4. Portfolio decision: Portfolio Analysis is a method of evaluating investments based on their
contribution to the aggregate performance of the entire corporation rather than on the isolated
characteristics of the investments themselves. When performing portfolio analysis, information
is gathered about the individual investments available, and then chooses the projects that help
to meet all of our goals in all of the years that are of concern. Portfolio theory, as first
conceived in the 1950s by Dr. Harry Markowitz, provided a classic model for managing risk
and reward. Markowitz realized that stocks and bonds interacted in a predictable manner (i.e.,
when one class of stock went down, others tended to go up), and by managing these
interactions he could diversify risk. Strategic Portfolio Management takes the insights gained
from portfolio analysis and integrates them into the decision making process of a corporation.

1.2 Strategic Decision Models and Characteristics: For the past few decades, researchers
have attempted to model the strategic decision process and identify the major types or
categories of strategic decisions. This is a difficult task since strategic decisions are often
described as "unstructured", "unprogrammed", and "messy". Mintzberg, Raisinghani, and
Theoret (1976)
3
provided an early attempt at modeling the process of strategic decision
making and identified three major phases with subroutines or subphases within each. These
included the following:
The Identification phase
1. The Decision Recognition Routine: Opportunities, problems, and crisis are recognized and
evoke decisional activity.
2. The Diagnosis Routine: Information relevant to opportunities, problems, and crisis is
collected and problems are more clearly identified.
The Development phase
1. The Search Routine: Organizational decision makers go through a number of activities to
generate alternative solutions to problems.
2. The Design Routine: Ready-made solutions which have been identified are modified to fit
the particular problem or new solutions are designed.
The Selection Phase
The Screen Routine: This routine is activated when the search routine identifies more
alternatives than can be intensively evaluated. Alternatives are quickly scanned and the most
obviously infeasible ones are eliminated.
2.0 Strategy at Different Hierarchy Levels
Strategies at different levels are the outcomes of different planning needs. The three Levels of
an enterprise strategy are
1. Corporate level
2. Business unit level
3. Functional or departmental level
2.1 Corporate Level Strategy: Corporate level strategy fundamentally is concerned with
selection of businesses in which a company should compete and with development and
coordination of that portfolio of businesses. Corporate level strategy is concerned with:
Reach defining the issues that are corporate responsibilities. These might include
identifying the overall vision, mission, and goals of the corporation, the type of business a
corporation should be involved, and the way in which businesses will be integrated and
managed.

3
Mintzberg, H., Raisinghani, D., & Theoret, A. (1976). The structure of unstructured decision processes.
Administrative Science Quarterly, 21, 246-275.

Competitive Contact defining where in a corporation competition is to be localized.
Managing Activities and Business Interrelationships corporate strategy seeks to develop
synergies by sharing and coordinating staff and other resources across business units,
investing financial resources across business units, and using business units to
complement other corporate business activities.
Management Practices corporations decide how business units are to be governed:
through direct corporate intervention (centralization) or through autonomous governance
(decentralization).
2.2 Business Unit Level Strategy: Strategic business unit may be any profit centre that can
be planned independently from the other business units of your corporation. At the business
unit level, the strategic issues are about both practical coordination of operating units and
about developing and sustaining a competitive advantage for the products and services that
are produced.
2.3 Functional Level Strategy: The functional level of your organization is the level of the
operating divisions and departments. The strategic issues at the functional level are related to
functional business processes and value chain. Functional level strategies in R&D, operations,
manufacturing, marketing, finance, and human resources involve the development and
coordination of resources through which business unit level strategies can be executed
effectively and efficiently. Functional units of your organization are involved in higher level
strategies by providing input into the business unit level and corporate level strategy, such as
providing information on customer feedback or on resources and capabilities on which the
higher level strategies can be based. Once the higher level strategy or strategic intent is
developed, the functional units translate them into discrete action plans that each department
or division must accomplish for the strategy to succeed.
Among the different functional activities viz production, marketing, finance, human resources
and research and development, finance assumes highest importance during the top down and
bottom up interaction of planning. Corporate strategy deals with deployment of resources and
financial strategy is mainly concerned with mobilization and effective utilization of money, the
most critical resource that a business firm likes to have under its command. Truly speaking,
other resources can be easily mobilized if the firm has adequate monetary base. To go into
the details of this interface between financial strategy and corporate strategy and financial
planning and corporate planning let us examine the basic issues addressed under financial
planning.
3.0 Financial Planning
Financial planning is the backbone of the business planning and corporate planning. It helps in
defining the feasible area of operation for all types of activities and thereby defines the overall
planning framework. Financial planning is a systematic approach whereby the financial
planner helps the customer to maximize his existing financial resources by utilizing financial
tools to achieve his financial goals.
Financial planning is simple mathematics. There are 3 major components:

Financial Resources (FR)
Financial Tools (FT)
Financial Goals (FG)
Financial Planning: FR +FT =FG
In other words, financial planning is the process of meeting your life goals through proper
management of your finances. Life goals can include buying a home, saving for your children's
education or planning for retirement. It is a process that consists of specific steps that help
you to take a big-picture look at where you financially are. Using these steps you can work out
where you are now, what you may need in the future and what you must do to reach your
goals.
Outcomes of the financial planning are the financial objectives, financial decision-making and
financial measures for the evaluation of the corporate performance. Financial objectives are to
be decided at the very out set so that rest of the decisions can be taken accordingly. The
objectives need to be consistent with the corporate mission and corporate objectives.
There is a general belief that profit maximization is the main financial objective. In reality, it is
not. Profit may be an important consideration but not its maximization.
Profit maximization does not consider risk or uncertainty, whereas wealth maximization does.
Let us Consider two projects, A and B, and their projected earnings over the next 5 years, as
shown below:
Year Product A Product B
1 10,000 11,000
2 10,000 11,000
3 10,000 11,000
4 10,000 11,000
5 10,000 11,000
50,000 55,000
A profit maximization approach would favor project B over project A. However, if project B is
more risky than project A, then the decision is not as straightforward as the figures seem to
indicate. It is important to realize that a trade-off exists between risk and return. Stockholders
expect greater returns from investments of higher risk and vice versa. To choose projectt B,
stockholders would demand a sufficiently large return to compensate for the comparatively
greater level of risk.
According to Drucker, profit is the least imperfect measure of organizational efficiency and
should remain the main consideration of a firm to cover the cost of survival and to support the
future expansion plans. But profit maximization as a financial objective suffers from multiple
limitations. Firstly the level of operation for long run profit maximization may not match with
the optimum levels under short run profit maximization goal. In that case, if one assigns more
importance to short run profit maximization and avoids many activities like skill development,
training programme, machine maintenance and after sales service, long run survival even may
be at a stake and long run profit maximization may become a day dreaming concept. In the

reverse case, short run shortcomings may have telling effects on the organizational
performance and hence long run profit maximization may gradually become an impossible
proposition in comparison to stronger competitors performances.
Profit maximization also ignores an important aspect of strategic planning. Risk consideration
has rarely been incorporated in the profit maximization rule. As a result two projects with same
expected profit are equally good under profit consideration. Under the profit cum risk
consideration the project with lesser variability will be preferred by the investor than the one
with higher variability. Higher variability means higher risk and lower variability means lower
risk. Problem becomes more involved when both expected profits and their variability are
unequal and reversibly ordered. Decision making based on usual expected profit consideration
will be of limited use for such situations.
It is also worth pointing out that profit maximization objective does not take into consideration
effects of time. It treats inflows of equal magnitude to be received at different time points as
equal and thereby ignores the fact that money values changes over time. Conceptually, a
benefit of an amount A
k
received in the k-th year cannot be identical with a series of benefits
received at the rate A for each of the k years. The later scheme may be more beneficial for a
firm than the former one. Unfortunately profit maximization or benefit maximization approach
fails to discriminate between these two alternatives and remains indifferent.
In view of the above limitations of the profit maximization approach choice of financial
objective needs a strategic look. The obvious choice in that case may be expressed in terms
of wealth maximization where wealth is to be measured in terms of its net present value to
take care of both risk and time factors. Wealth ensures financial strength of the firm, long term
solvency and viability. It can be used, as a decision criterion in a precisely defined manner
and can reflect the business efficiency without any scope for ambiguity. There are some
related issues that may draw attention of the planners during the interface of financial planning
and strategic planning. Cash flow, credit position and liquidity are those three critical
considerations.
Cash flow is the most vital consideration for the business firm. It deals with the movement of
cash and as a matter of conventions, refers to surplus of internally generated funds over
expenditures. To prepare a cash flow statement, all the factors that increase cash and those
that decrease cash are to be identified from the income and expenditure statements. This
information is to be then presented in a consolidated form for taking strategic decisions on
new investments and borrowings. A substantially positive cash flow may enable the firm to
fund new projects without borrowing cash from investors or bankers. Borrowing means paying
interest and is some sort of weakness for the firm. Internal generation of cash and internal
funding of projects add to the strength of the firm. Thus objective should be to enjoy an
attractive cash flow situation.
Generation of cash from internal activities depends on the industry life cycle. At the initial
stage, i.e. the stage of introduction and the stage of growth, the firm makes reinvestment of
cash in operations to meet cash needs of the business. By operations we refer to activities
that change the utility of any input. Product research and product design are the key
operations during the stage of introduction. Installation of plant and facilities and addition to

capacity for meeting the increased demand are the key operational requirements during the
stage of growth. The stage of growth is also marked in the aggressive promotional activities.
And all these operations need huge investment. During the stage of shakeout and maturity,
the need for excess investment declines sharply. This enables the firm to generate positive
cash flow. Thus, the cash flow position of a firm changes from weakness to strength as the
industry of the other matures. During the stage of decline reversal of this process take place;
the decrease in demand increases the cost of production. The cost of promotion increases so
rapidly that the outflow of cash soon takes over the inflow of the same resulting in cash
drainage. Thus industry life cycle has a role to play in cash flow planning.
Credit position of the business firm describes its strength in mobilizing borrowed money. In
case the internal generation of cash position is weak, the firm may exploit its strong credit
position to go ahead in the expansion of its activities. There are basically two ways of
strengthening the credit position. The first way is to avoid unnecessary borrowings. If the level
of current debt is low the firm is likely to enjoy reasonable credit in future. The other way of
enjoying credit facilities is to create the awareness about the future business prospect For
example if awareness can be created in the mind of the investors and others about quick and
high growth and steady and long maturity prospects of an industry then it will be easier for the
company to get external funds irrespective of its current cash flow position.
Conversely borrowing will be extremely difficult if the industry enters into a declining stage of
life cycle curve. Since bankers and investors are generally interested in long run results and
benefits and are willing to forego short run benefits, choice of the business field is very
important for attracting investors and creditors. Thus to be in, or not be in is dependent on
cash flow position and credit position of the firm and these are in turn dependent on the position
of the offer in respect of the life cycle curve, market demand and available technology.
Liquidity position of the business describes the extent of idle working capital. It measures the
ability of the firm in handling unforeseen contingencies. Firms into major investments in fixed
assets are likely to enjoy less liquidity than firms with lower level of fixed assets. The liquidity
of the firm is measured in terms of current assets and current liabilities. If the current assets
are more than the current liabilities the firm is said to be liquid. For example a drop in demand
due to sudden arrival of competitive brand in the market may cause a crisis for liquid cash. In
case the firm has excess current assets which are easily encashable, it will be able to
overcome the crisis in the short run and draw new strategic plan and develop new strategic
posture to rewinover the competitors in the long run.
4.0 Interface of Financial Policy and Strategic Management
The interface of strategic management and financial policy will be clearly understood if we
appreciate the fact that the starting point of an organization is money and the end point of that
organization is also money. No organization can run an existing business and promote a new
expansion project without a suitable internally mobilized financial base or both internally and
externally mobilized financial base.
Sources of finance and capital structure are the most important dimensions of a strategic plan.
We have already emphasized on the need for fund mobilization to support the expansion

activity of firm. The generation of funds may arise out of ownership capital and or borrowed
capital. A company may issue equity shares and / or preference shares for mobilizing
ownership capital. Preference Share holders as the name stands enjoy preferential rights in
respect of dividend and return of capital. Holders of equity shares do not enjoy any such
special right regarding dividend and return of capital. There are different types of preference
shares like cumulative convertible preference shares which are convertible into equity shares
between the end of the third year and the fifth year. Rate of dividend paid till conversion into
equity shares remains constant. Debentures, on the other hand, are issued to raise borrowed
capital. These are of varying terms and conditions in respect of interest rate, conversion into
shares and return of investment. Public deposits, for a fixed time period, have also become a
major source of short and medium term finance. Organizations may offer higher rates of
interest than banking institutions to attract investors and raise fund. The overdraft, cash
credits, bill discounting, bank loan and trade credit are the other sources of short term finance.
Along with the mobilization of funds, policy makers should decide on the capital structure to
indicate the desired mix of equity capital and debt capital. There are some norms for debt
equity ratio. These are aimed at minimizing the risks of excessive loans, for public sector
organizations the norm is 1:1 ratio and for private sector firms the norm is 2:1 ratio. However
this ratio in its ideal form varies from industry to industry. It also depends on the planning
mode of the organization under study. For capital intensive industries, the proportion of debt to
equity is much higher. Similar is the case for high cost projects in priority sectors and for
projects in under developed regions.
Another important dimension of strategic management and financial policy interface is the
investment and fund allocation decisions. A planner has to frame policies for regulating
investments in fixed assets and for restraining of current assets. Investment proposals mooted
by different business units may be divided into three groups. One type of proposal will be for
addition of a new product to the fold of offer of the firm. Another type of proposal will be to
increase the level of operation of an existing product through either an increase in capacity in
the existing plant or setting up of another plant for meeting additional capacity requirement.
There is yet another type of proposal. It pleads for cost reduction and efficient utilization of
resources through a new approach and or closer monitoring of the different critical activities.
Now, given these three types of proposals a planner should evaluate each one of them by
making within group comparison in the light of capital budgeting exercise, In fact project
evaluation and project selection are the two most important jobs under fund allocation.
Planners task is to make the best possible allocation under resource constraints.
Dividend policy is yet another area for making financial policy decisions affecting the strategic
performance of the company. A close interface is needed to frame the policy to be beneficial
for all. Dividend policy decision deals with the extent of earnings to be distributed as dividend
and the extent of earnings to be retained for future expansion scheme of the firm. From the
point of view of long term funding of business growth, dividend can be considered as that part
of total earnings, which cannot be profitably utilized by the company. Stability of the dividend
payment is a desirable consideration that can have a positive impact on share price. The
alternative policy of paying a constant percentage of the net earnings may be preferable from
the point of view of both flexibility of the firm and ability of the firm. It also gives a message of

lesser risk for the investors. Yet some other companies follow a different alternative. They pay
a minimum dividend per share and additional dividend when earnings are higher than the
normal earnings. In actual practice, investment opportunities and financial needs of the firm
and the shareholders preference for dividend against capital gains resulting out of share are to
be taken into consideration for arriving at the right dividend policy. Alternatives like cash
dividend and stock dividend are also to be examined while working out an ideal dividend policy
that supports and promotes the corporate strategy of the company.
It may be noted from the above discussions that financial policy of a company cannot be
worked out in isolation of other functional policies. It has a wider appeal and closer link with
the overall organizational performance and direction of growth. These policies being related to
external awareness about the firm, specially the awareness of the investors about the firm, in
respect of its internal performance. There is always a process of evaluation active in the minds
of the current and future stake holders of the company. As a result preference and patronage
for the company depends significantly on the financial policy framework. And hence attention
of the corporate planners must be drawn while framing the financial policies not at a later
stage but during the stage of corporate planning itself. The nature of interdependence is the
crucial factor to be studied and modelled by using an in depth analytical approach. This is a
very difficult task compared to usual cause and effect study because corporate strategy is the
cause and financial policy is the effect and sometimes financial policy is the cause and
corporate strategy is the effect. This calls for a bipolar move.
5.0 Balancing Financial Goals Vis-a-Vis Sustainable Growth
The concept of sustainable growth can be helpful for planning healthy corporate growth. This
concept forces managers to consider the financial consequences of sales increases and to set
sales growth goals that are consistent with the operating and financial policies of the firm.
Often, a conflict can arise if growth objectives are not consistent with the value of the
organization's sustainable growth. Question concerning right distribution of resources may
take a difficult shape if we take into consideration the rightness not for the current
stakeholders but for the future stake holders also. To take one illustration, let us refer to fuel
industry where resources are limited in quantity and a judicial use of resources is needed to
cater to the need of the future customers along with the need of the present customers. One
may have noticed the save fuel campaign, a demarketing campaign that deviates from the
usual approach of sales growth strategy and preaches for conservation of fuel for their use
across generation. This is an example of stable growth strategy adopted by the oil industry as
a whole under resource constraints and the long run objective of survival over years.
Incremental growth strategy, profit strategy and pause strategy are other variants of stable
growth strategy.
The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can
be achieved, given the firm's profitability, asset utilization, and desired dividend payout and
debt (financial leverage) ratios. Variables typically include the net profit margin on new and
existing revenues; the asset turnover ratio, which is the ratio of sales revenues to total assets;
the assets to beginning of period equity ratio; and the retention rate, which is defined as the
fraction of earnings retained in the business.

Sustainable growth models assume that the business wants to: 1) maintain a target capital
structure without issuing new equity; 2) maintain a target dividend payment ratio; and 3)
increase sales as rapidly as market conditions allow. Since the asset to beginning of period
equity ratio is constant and the firm's only source of new equity is retained earnings, sales and
assets cannot grow any faster than the retained earnings plus the additional debt that the
retained earnings can support. The sustainable growth rate is consistent with the observed
evidence that most corporations are reluctant to issue new equity. If, however, the firm is
willing to issue additional equity, there is in principle no financial constraint on its growth rate.
Indeed, the sustainable growth rate formula is directly predicated on return on equity.
"Assuming asset growth broadly parallels sales growth, the SGR is calculated as the retained
[return on equity], i.e. your company's [return on equity] minus the dividend payout
percentage," wrote John Costa in Outlook
4
. "Just as the break-even point is the 'floor' for
minimum sales required to cover operating expenses, so the SGR is an estimate of the
'ceiling' for maximum sales growth that can be achieved without exhausting operating cash
flows.
Economists and business researchers contend that achieving sustainable growth is not
possible without paying heed to twin cornerstones: growth strategy and growth capability.
Companies that pay inadequate attention to one aspect or the other are doomed to failure in
their efforts to establish practices of sustainable growth (though short-term gains may be
realized). After all, if a company has an excellent growth strategy in place, but has not put the
necessary infrastructure in place to execute that strategy, long-term growth is impossible. The
reverse is true as well.
The very weak idea of sustainability requires that the overall stock of capital assets should
remain constant. The weak version of sustainability refers to preservation of critical resources
to ensure support for all, over a long time horizon .The strong concept of sustainability is
concerned with the preservation of resources under the primacy of ecosystem functioning.
These are in line with the definition provided by the economists in the context of sustainable
development at macro level
In terms of economic dimension sustainable development rejects the idea that the logistic
system of a firm should be knowingly designed to satisfy the unlimited wants of the economic
person. A firm has to think more about the collective needs and less about the personal
needs. This calls for taking initiatives to modify, to some extent, the human behaviour.
Sustainability also means development of the capability for replicating ones activity on a
sustainable basis. The other economics dimension of sustainability is to decouple the growth
in output of firm from the environmental impacts of the same. By decoupling we mean
development of technology for more efficient use of resource. Complete decoupling is
unrealistic from the thermodynamic angle but the materials balance principle demands for
decoupling and hence attempts should be made by the firm to be more and more decoupled.

4
Costa, J ohn. "Challenging Growth: How to Keep Your Company's Rapid Expansion on Track." Outlook. Summer
1997

The sustainable growth model is particularly helpful in situations in which a borrower requests
additional financing. The need for additional loans creates a potentially risky situation of too
much debt and too little equity. Either additional equity must be raised or the borrower will
have to reduce the rate of expansion to a level that can be sustained without an increase in
financial leverage.
Mature firms often have actual growth rates that are less than the sustainable growth rate. In
these cases, management's principal objective is finding productive uses for the cash flows
that exist in excess of their needs. Options available to business owners and executives in
such cases including returning the money to shareholders through increased dividends or
common stock repurchases, reducing the firm's debt load, or increasing possession of lower
earning liquid assets. Note that these actions serve to decrease the sustainable growth rate.
Alternatively, these firms can attempt to enhance their actual growth rates through the
acquisition of rapidly growing companies.
Growth can come from two sources: increased volume and inflation. The inflationary increase
in assets must be financed as though it were real growth. Inflation increases the amount of
external financing required and increases the debt-to-equity ratio when this ratio is measured
on a historical cost basis. Thus, if creditors require that a firm's historical cost debt-to-equity
ratio stay constant, inflation lowers the firm's sustainable growth rate.
6.0 Principles of Valuation
The evaluation of sustainable growth strategy calls for interface of financial planning approach
with strategic planning approach. Choice of the degree of sustainability approach for
sustainability and modification in the sustainability principle must be based on financial
evaluation of the alternative schemes in terms of financial and overall corporate objectives.
Basically there are two alternative methods for evaluation. One is known as valuation method
and the other one is known as pricing method. Valuation method depends on demand curve
approach by either making use of expressed preferences or making use of revealed
preference.
In finance, valuation is the process of estimating the potential market value of a financial asset
or liability. Valuations can be done on assets (for example, investments in marketable
securities such as stocks, options, business enterprises, or intangible assets such as patents
and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in
many contexts including investment analysis, capital budgeting, merger and acquisition
transactions, financial reporting, taxable events to determine the proper tax liability, and in
litigation.
Valuation of financial assets is done using one or more of these types of models:
1. Discounted Cash Flows determine the value by estimating the expected future earnings
from owning the asset discounted to their present value.
2. Relative value models determine the value based on the market prices of similar assets.
3. Option pricing models are used for certain types of financial assets (e.g., warrants, put
options, call options, employee stock options, investments with embedded options such

as a callable bond) and are a complex present value model. The most common option
pricing models are the Black-Scholes-Merton model and lattice models.
Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare
this required rate of return to the asset's estimated rate of return over a specific investment
horizon to determine whether it would be an appropriate investment. To make this comparison,
you need an independent estimate of the return outlook for the security based on either
fundamental or technical analysis techniques, including P/E, M/B etc.
In theory, therefore, an asset is correctly priced when its estimated price is the same as the
required rates of return calculated using the CAPM. What does Capital Asset Pricing Model -
CAPM mean?
A model that describes the relationship between risk and expected return and that is used in
the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time
value of money and risk. The time value of money is represented by the risk-free (rf) rate in
the formula and compensates the investors for placing money in any investment over a period
of time. The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This is calculated by taking a
risk measure (beta) that compares the returns of the asset to the market over a period of time
and to the market premium (R
m
-R
f
).
If the estimate price is higher than the CAPM valuation, then the asset is undervalued (and
overvalued when the estimated price is below the CAPM valuation). The CAPM says that the
expected return of a security or a portfolio equals the rate on a risk-free security plus a risk
premium. If this expected return does not meet or beat the required return, then the
investment should not be undertaken. The security market line plots the results of the CAPM
for all different risks (betas).Using the CAPM model and the following assumptions, we can
compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the
beta (risk measure) of the stock is 2 and the expected market return over the period is 10%,
the stock is expected to return 17% [3% + 2(10% - 3%)].
Valuation methods are in general more complex in implementation than pricing methods. But
demand curve methods are more useful for cases where it seems likely that disparity between
price and value is high.
After the evaluation comes the question of policy choice. In case of sustainable growth the
conventional cost benefit analysis may not be an appropriate tool for making choice decision.
This is due to the fact that conventional cost benefit analysis is based on the principle of

allocation of resources for maximizing internal benefit. It has no in built sustainability criterion
to guarantee that a constant stock of natural resources will be passed between current and
future users. This problem comes up because conventional cost-benefit analysis draws no
distinction between natural capital and man made capital and is considered to be equitable.
One proposed sustainability criterion is due to Turner and Pearce who advocated the constant
natural assets rule. Their compensation principle requires the passing on the future users a
stock of natural assets which is no smaller than the stock in the possession of current users.
According to them Hicks Kaldor potential compensation rule should be extended further so
that there will be actual compensation rule for natural resources. Within the constant natural
assets rule the extended cost-benefit analysis can still retain the flavour of economic efficiency
if one takes into consideration how resources should be best allocated among the competing
users. The constant natural assets rule is directly applicable for renewable assets. But all the
resources are not renewable in nature. In case of non-renewable assets, actual compensation
rule should be interpreted not in terms of providence of actual assets but in terms of the
services rendered by the actual assets. For example, oil, the black liquid cannot be preserved
in constant quantity across time. But the services that oil provides to current users must be
provided in future so that actual compensation remains the same. These are all high level
strategic decisions but come under the purview of financial strategic planning. Only a close
interface can help in arriving at an acceptable situation and plan
Summary
1.0 Strategic Financial Decision Making Framework
All businesses need to have the following three fundamental essential elements:
A clear and realistic strategy,
The financial resources, controls and systems to see it through and
The right managementteam and processes to make it happen.
1.1 Functions of Strategic Financial Management: Strategic Financial Management is the
portfolio constituent of the corporate strategic plan that embraces the optimum investment and
financing decisions required to attain the overall specified objectives.
Irrespective of the time horizon, the investment and financial decisions functions involve the
following functions:
Continual search for best investment opportunities
Selection of the best profitable opportunities
Determination of optimal mix of funds for the opportunities
Establishment of systems for internal controls
Analysis of results for future decision-making.
According to Agency theory, strategic financial management is the function of four major
components based on the mathematical concept of expected NPV (net present value)
maximization, which are:

1. Investment decision- This involves the profitable utilization of firm's funds especially in
long-term projects (capital projects). Because the future benefits associated with such
projects are not known with certainty, investment decisions necessarily involve risk.
2. Dividend decision- Dividend decision determines the division of earnings between
payments to shareholders and reinvestment in the company.
3. Financing decision- This deals with the mode of financing or mix of equity capital and debt
capital. If it is possible to alter the total value of the company by alteration in the capital
structure of the company, then an optimal financial mix would exist - where the market
value of the company is maximized.
4. Portfolio decision- Portfolio Analysis is a method of evaluating investments based on their
contribution to the aggregate performance of the entire corporation rather than on the
isolated characteristics of the investments themselves.
1.2 Strategic Decision Models and Characteristics: For the past few decades, researchers
have attempted to model the strategic decision process and identify the major types or
categories of strategic decisions. These are as follows:
The Identification phase
1. The Decision Recognition Routine: Opportunities, problems, and crisis are recognized and
evoke decisional activity.
2. The Diagnosis Routine: Information relevant to opportunities, problems, and crises is
collected and problems are more clearly identified.
The Development phase
3. The Search Routine: Organizational decision makers go through a number of activities to
generate alternative solutions to problems.
4. The Design Routine: Ready-made solutions which have been identified are modified to fit
the particular problem or new solutions are designed.
The Selection Phase
5. The Screen Routine: This routine is activated when the search routine identifies more
alternatives than can be intensively evaluated. Alternatives are quickly scanned and the
most obviously infeasible ones are eliminated.
2.0 Strategy at different hierarchy levels
Strategies at different levels are the outcomes of different planning needs. The three Levels of
an enterprise strategy are
2.1 Corporate Level Strategy: Corporate level strategy is concerned with:
Reach defining the issues that are corporate responsibilities.
Competitive Contact defining where in your corporation competition is to be localized.
Managing Activities and Business Interrelationships corporate strategy seeks to
develop synergies by sharing and coordinating staff and other resources across business

units, investing financial resources across business units, and using business units to
complement other corporate business activities.
Management Practices corporations decide how business units are to be governed:
through direct corporate intervention (centralization) or through autonomous governance
(decentralization).
2.2 Business Unit Level Strategy: At the business unit level, the strategic issues are about
both practical coordination of operating units and about developing and sustaining a
competitive advantage for the products and services that are produced.
2.3 Functional Level Strategy: Functional level strategies in R&D, operations,
manufacturing, marketing, finance, and human resources involve the development and
coordination of resources through which business unit level strategies can be executed
effectively and efficiently.
Among the different functional activities viz production, marketing, finance, human resources
and research and development, finance assumes highest importance during the top down and
bottom up interaction of planning.
3.0 Financial Planning
Financial planning is a systematic approach whereby the financial planner helps the customer
to maximize his existing financial resources by utilizing financial tools to achieve his financial
goals.
Financial planning is simple mathematics. There are 3 major components:
Financial Resources (FR)
Financial Tools (FT)
Financial Goals (FG)
4.0 Interface of Financial Policy and Strategic Management
The interface will be clearly understood if we appreciate the fact that the starting point and end
point of an organization is money. Sources of finance and capital structure are the most
important dimensions of a strategic plan. A company may issue equity shares and/ or
preference shares for mobilizing ownership capital.
Along with the mobilization of funds, policy makers should decide on the capital structure to
indicate the desired mix of equity capital and debt capital. There are some norms for debt
equity ratio. This ratio in its ideal form varies from industry to industry.
Another important dimension of strategic management and financial policy interface is the
investment and fund allocation decisions. A planner has to frame policies for regulating
investments in fixed assets and for restraining of current assets. Investment proposals mooted
by different business units may be divided into three groups.
Dividend policy is yet another area for making financial policy decisions affecting the strategic
performance of the company. A close interface is needed to frame the policy to be beneficial

for all. Dividend policy decision deals with the extent of earnings to be distributed as dividend
and the extent of earnings to be retained for future expansion scheme of the firm.
It may be noted that financial policy of a company cannot be worked out in isolation of other
functional policies. It has a wider appeal and closer link with the overall organizational
performance and direction of growth.
5.0 Balancing Financial Goals vis--vis Sustainable Growth
The concept of sustainable growth can be helpful for planning healthy corporate growth. This
concept forces managers to consider the financial consequences of sales increases and to set
sales growth goals that are consistent with the operating and financial policies of the firm.
Often, a conflict can arise if growth objectives are not consistent with the value of the
organization's sustainable growth. Question concerning right distribution of resources may
take a difficult shape if we take into consideration the rightness not for the current
stakeholders but for the future stake holders also.
The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can
be achieved, given the firm's profitability, asset utilization, and desired dividend payout and
debt (financial leverage) ratios.
The sustainable growth model is particularly helpful in situations in which a borrower requests
additional financing. The need for additional loans creates a potentially risky situation of too
much debt and too little equity. Either additional equity must be raised or the borrower will
have to reduce the rate of expansion to a level that can be sustained without an increase in
financial leverage.
6.0 Principles of Valuation
In finance, valuation is the process of estimating the potential market value of a financial asset
or liability. Valuations can be done on assets (for example, investments in marketable
securities such as stocks, options, business enterprises, or intangible assets such as patents
and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in
many contexts including investment analysis, capital budgeting, merger and acquisition
transactions, financial reporting, taxable events to determine the proper tax liability, and in
litigation.
Valuation of financial assets is done using one or more of these types of models:
1. Discounted Cash Flows determine the value by estimating the expected future earnings
from owning the asset discounted to their present value.
2. Relative value models determine the value based on the market prices of similar assets.
3. Option pricing models are used for certain types of financial assets (e.g., warrants, put
options, call options, employee stock options, investments with embedded options such
as a callable bond) and are a complex present value model. The most common option
pricing models are the Black-Scholes-Merton models and lattice models.

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