FINAL COURSE STUDY MATERIAL

PAPER : 2

Strategic Financial
Management
Volume I

BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

The Institute of Chartered Accountants of India

This study material has been prepared by the faculty of the Board of Studies. The objective of
the study material is to provide teaching material to the students to enable them to obtain
knowledge and skills in the subject. Students should also supplement their study by reference
to the recommended text books. In case students need any clarifications or have any
suggestions to make for further improvement of the material contained herein, they may write
to the Director of Studies.
All care has been taken to provide interpretations and discussions in a manner useful for the
students. However, the study material has not been specifically discussed by the Council of
the Institute or any of its Committees and the views expressed herein may not be taken to
necessarily represent the views of the Council or any of its Committees.
Permission of the Institute is essential for reproduction of any portion of this material.
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A WORD ABOUT STUDY MATERIAL

Strategic Financial Management (SFM) is a blend of Strategic Management and Financial
Management. It has acquired a critical significance now-a-days, due to recent surge in
globalization and massive cross border flow of capital. The study of this subject opens new
opportunities for Chartered Accountancy students. The paper stresses the importance of
applying the knowledge and techniques of financial management to the planning, operating
and monitoring of the finance function in particular as well as the organization in general.
Further, this paper not only focuses on these aspects at the domestic level but also at the
international level as well.
This study material provides the concepts, theories and techniques relating to Strategic
Financial Management and aims to develop the students ability in understanding the different
concepts and their application in the real life situations.
The study material is divided into thirteen chapters. Latest developments in the field of finance
including international finance have been incorporated in almost all the chapters. The study
material also focuses on the decision making in an international context and it provides
comprehensive coverage of important areas like foreign exchange market, derivatives, foreign
exchange exposure, risk analysis and management, raising of capital abroad, mergers and
acquisitions and portfolio management, capital budgeting and working capital management in
a multinational context. Chapters have been organised in such a way so as to provide a logical
sequence to facilitate easy understanding. A helpful feature in this study material is the
addition of a number of illustrations in each chapter to help students to have a better grasp of
the subject. For a quick grasp of the subject during examination days a summary has also
been inserted in the end of each chapter. Numerous graphs and figures have also been added
to make things more appealing. Some of the chapters also contain Glossary of terms used.
This study material should be studied in combination of Practice Manual of SFM to
practice more practical questions for better understanding of the subject.
Students are advised to supplement their knowledge by referring to the recommended books
and the compilation of the subject. They need to practice the practical problems thoroughly.
Students are also advised to update themselves with the latest changes in the financial sector.
For this they may refer to academic updates in the monthly journal The Chartered Accountant
and the Students Newsletter published by the Board of Studies, financial newspapers, SEBI
and Corporate Law Journal etc.
Significant changes/additions incorporated in this study material have been given in
bold and italics in the respective chapters. Further these changes have been
tabulated chapter-wise with the corresponding section and page references and
given as Significant Changes in the Revised Edition.

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Significant Changes in the Revised Edition

Chapter
No.

4
5

Name of the
Chapter

Section/Sub-Sections wherein major

additions/deletions have been done
1.1 Market Feasibility
1.2 Technical Feasibility
Project Planning 2.3 Project Cost Accounting
and
Capital Illustration 1
Budgeting
4.1 Risk Adjusted Discount Rate Method
9.0 Real Option in Capital Budgeting
9.2 Why Option based analysis fits in with
Capital Budgeting framework
4.4 Modigliani and Miller (MM) Hypothesis
Dividend
Decisions

Page
Numbers
2.4
2.5
2.17
2.23
2.26
2.49
2.51

Capital 3. Stock Market and its Operations

13. (c)
Indian Commodity Exchange (ICEX)
21. Forward Rate Agreement
Portfolio Theory 2.1 Security Analysis
2.3 Portfolio Selection
4.4.2 Portfolio Risk
4.4.3 Reduction or dilution of Portfolio Risk
through Diversification
8.2 Sharpe and Treynor Ratios
1.3 Corporate Finance
Financial
Services in India 1.5 Trading
1.6 Research
1.7 Syndicate
1.8 Commercial Banking Vs. Investment
Banking
1.9 Details of some functions of an
Investment Bank
2.2 Credit Rating Process
2.6 Credit Rating Agencies and the US subprime crisis
8.2 Benefits of Debit Cards
9. Online Share Trading

5.4
5.61
5.69
7.4
7.5
7.16
7.19

Indian
Market

Mutual Funds

2.2 Portfolio Classification

3.9 Exchange Traded Funds

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4.15

7.39
8.3
8.4
8.5
8.6
8.7
8.8-8.13
8.15
8.19
8.37
8.37 &
8.41
9.6
9.9

10

11

12

13

5.0 Advantages of Mutual Fund

Illustration 4
8.2 Treynor Ratio
Money Market 1.2 The Distinct Feature of Money Market
Operations
1.5 Distinction between Capital and Money
Market
3.0 Instruments
Advantages of developed bill market
Role of Credit Rating Agencies
Difference between Commercial Bill and
Commercial Paper
FDI, FIIs and 8.3 Project vis--vis Parent Cash Flows
International
9.2 Multinational Cash Management
Financial
Management
8.2 Purchasing Power Parity
Foreign
Exchange
10. Risk Considerations
Exposure and 13.1 Derivatives
Risk
15.1 Currency Exchange Risk
Management
1.0 Introduction
Mergers,
Acquisitions & 5.0 Problems for M&A in India
Restructuring
9.0 Acquisition Process
14.3 Case Study- Rationale for M&A and
Valuation
15.3 Corporate Controls
19.0 Cross-Border M&A

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9.12
9.16
9.21
10.4
10.7
10.15
10.24
10.29
10.36
11.26
11.28
12.10
12.15
12.21
12.34
13.2
13.10
13.1313.18
13.31
13.36
13.47

SYLLABUS
PAPER 2 : STRATEGIC FINANCIAL MANAGEMENT
(One paper Three hours 100 marks)
Level of Knowledge: Advanced knowledge
Objective:
To apply financial management theories and techniques for strategic decision making.
Contents:
1.

Financial Policy and Corporate Strategy

Strategic decision making framework

Interface of Financial Policy and strategic management
Balancing financial goals vis--vis sustainable growth.
2.

Project Planning and Capital Budgeting

Feasibility study
Cash flow Projections Impact of taxation, depreciation, inflation and working capital
Capital Budgeting Decisions - Certainty Equivalent approach, Evaluation of Risky Investment
Proposals, Risk and Return analysis, Simulation and decision tree analysis, Sensitivity
analysis, Capital Rationing, Adjusted Net Present Value, Replacement decisions, Application
of Real Options in capital budgeting, Impact of inflation on capital budgeting decisions
Preparation of Project Report
Social cost benefit analysis.
3.

Leasing decision including cross border leasing

4.

Dividend Decisions

Dividend theories, Determinants of dividend policies.

5.

(a) Indian Capital Market including role of various primary and secondary market
institutions
(b) Capital Market Instruments
Financial derivatives stock futures, stock options, index futures, index options

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Option valuation techniques : Binomial model, Black Scholes Option Pricing Model,
Greeks Delta, Gamma, Theta, Rho and Vega
Pricing of Futures Cost of carry model
Imbedded derivatives
(c) Commodity derivatives
(d) OTC derivatives -Swaps, Swaptions, Forward Rate Agreements (FRAs), Caps,
Floors and Collors.
6.

Security Analysis

Fundamental analysis - Economic analysis, Industry analysis and Company Analysis

Bond valuation, Price Yield relationship, Bond Price forecasting application of duration and
convexity, Yield curve strategies
Technical Analysis market cycle model and basic trend identification, different types of
charting, support and resistance, price patterns, moving averages, Bollinger Bands,
momentum analysis.
7.

Portfolio Theory and Asset Pricing

Efficient Market Theory Random walk theory ; Markowitz model of risk return optimization
Capital Asset Pricing Model (CAPM)
Arbitrage Pricing Theory (APT)
Sharpe Index Model
Portfolio Management - Formulation, Monitoring and Evaluation
Equity Style Management
Principles and Management of Hedge Funds
International Portfolio Management.
8.

Financial Services in India

Investment Banking
Retail Banking
On Line Share Trading
Depository Service.
9.

(a) Mutual Funds: Regulatory framework, formulation, monitoring and evaluation of

various schemes of Mutual funds, Money market mutual funds.
(b) Exchange Traded Funds.

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10. Money Market operations

11. (a)

Foreign Direct Investment, Foreign Institutional Investment.

(b) International Financial Management

Raising of capital abroad - American Depository Receipts, Global Depository
Receipts, External Commercial Borrowings and Foreign Currency Convertible
Bonds
International Capital Budgeting
International Working Capital Management.
12. Foreign Exchange Exposure and Risk Management
Exchange rate determination, Exchange rate forecasting
Foreign currency market
Foreign exchange derivatives Forward, futures, options and swaps
Management of transaction, translation and economic exposures
Hedging currency risk.
13. Mergers, Acquisitions and Restructuring
Meaning of mergers and acquisition, categories, purposes
Process of mergers and acquisition Identification and valuation of the target, acquisition
through negotiation, due diligence, post merger integration
Legal and regulatory requirements
Merger and Acquisition agreement
Reverse merger
Potential adverse competitive effects of mergers
Corporate Takeovers: Motivations, Co-insurance effect, Cross-border takeovers, Forms of
takeovers, Takeover defenses
Going Private and Other Control Transactions: Leveraged Buyouts (LBOs), Management
Buyouts (MBOs), Spin Offs and Asset Divestitures
Corporate Restructuring : Refinancing and rescue financing, reorganizations of debtors and
creditors, Sale of assets, targeted stock offerings, downsizing and layoff programmes,
negotiated wage give-backs, employee buyouts.

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CONTENTS
CHAPTER 1 FINANCIAL POLICY AND CORPORATE STRATEGY
1.0
2.0
3.0
4.0
5.0
6.0

Strategic Financial Decision Making Frame Work ............................................ 1.1

Strategy at different hierarchy levels .............................................................. 1.4
Financial Planning ......................................................................................... 1.5
Interface of Financial Policy and Strategic Management .................................. 1.8
Balancing Financial Goals vis--vis Sustainable Growth ................................ 1.10
Principles of Valuation ................................................................................. 1.12

CHAPTER 2 PROJECT PLANNING AND CAPITAL BUDGETING

1.0

Feasibility Study ............................................................................................ 2.2

2.0

Contents of a Project Report ........................................................................ 2.13

3.0

Social Cost Benefit Analysis......................................................................... 2.18

4.0

Capital Budgeting under Risk and Uncertainty .............................................. 2.21

5.0

Capital Budgeting under Capital Rationing .................................................... 2.39

6.0

Capital Budgeting under Inflation.................................................................. 2.41

7.0

Capital Asset Pricing Model Approach to Capital Budgeting ........................... 2.44

8.0

Replacement Decision ................................................................................. 2.47

9.0

Real Option in Capital Budgeting .................................................................. 2.49

CHAPTER 3 LEASING DECISIONS

1.0

Leasing ....................................................................................................... 3.1

2.0

Types of Leasing .......................................................................................... 3.2

3.0

Advantages of Leasing .................................................................................. 3.3

4.0

Disadvantages of Leasing .............................................................................. 3.4

5.0

Financial Evaluation ..................................................................................... 3.4

6.0

Break Even Lease Rental (BELR) ................................................................. 3.17

7.0

Cross Border Leasing .................................................................................. 3.20

CHAPTER 4 DIVIDEND DECISIONS

1.

Introduction ................................................................................................... 4.1

2.

Dividend Policy.............................................................................................. 4.1

3.

Practical considerations in Dividend Policy ..................................................... 4.2

4.

Theories on Dividend Policies ........................................................................ 4.7

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CHAPTER 5 INDIAN CAPITAL MARKET

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.

Overview of Indian Financial System .............................................................. 5.1

Capital Markets/Securities Market .................................................................. 5.2
Stock Market and its Operations ..................................................................... 5.4
Settlement and Settlement Cycles ................................................................ 5.11
Clearing Houses .......................................................................................... 5.11
Green Shoe Option ...................................................................................... 5.12
100% Book Building Process ........................................................................ 5.13
IPO through Stock Exchange On-line System (E-IPO) ................................... 5.14
Introduction to Capital Market Instruments .................................................... 5.14
Capital Market Instruments .......................................................................... 5.15
Introduction to Commodity Derivatives .......................................................... 5.58
Necessary Conditions to Introduce Commodity Derivatives ............................ 5.58
The Indian Scenario .................................................................................... 5.59
Investing in Commodity Derivatives .............................................................. 5.62
Commodity Market ....................................................................................... 5.63
Commodity Futures ..................................................................................... 5.64
Commodity Swaps ....................................................................................... 5.66
Hedging with Commodity Derivatives ............................................................ 5.67
Introduction to OTC Derivatives ................................................................... 5.68
OTC Interest Rate Derivatives ...................................................................... 5.68
Forward Rate Agreements ........................................................................... 5.69
Interest Rate Swaps .................................................................................... 5.70
Swaptions ................................................................................................... 5.75
Interest Rate Caps ...................................................................................... 5.80
Interest Rate Collars .................................................................................... 5.84
Caps and Floors Versus Swaptions .............................................................. 5.87
The Indian Scenario .................................................................................... 5.87

CHAPTER 6 SECURITY ANALYSIS

1.
2.
3.
4.

Introduction .................................................................................................. 6.2

Fundamental Analysis .................................................................................... 6.2
Technical Analysis ....................................................................................... 6.12
Bond Valuation ............................................................................................ 6.25

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CHAPTER 7 - PORTFOLIO THEORY

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.

Introduction ................................................................................................... 7.2

Phases of Portfolio Management .................................................................... 7.3
Portfolio Theories ........................................................................................ 7.6
Risk Analysis ................................................................................................ 7.7
Markowitz Model of Risk-Return Optimization .............................................. 7.25
Capital Asset Pricing Model (CAPM) ............................................................ 7.27
Arbitrage Pricing Theory Model (APT) .......................................................... 7.35
Sharpe Index Model .................................................................................... 7.35
Formulation of Portfolio Strategy ................................................................. 7.43
Tax Efficient Strategies for Taxable Portfolios .............................................. 7.50
Asset Allocation Strategies ......................................................................... 7.51
Principles and Management of Hedge Funds ............................................... 7.51
International Portfolio Management ............................................................ 7.62
Estimating the Project Discount Rate ........................................................... 7.64
Random Walk Theory .................................................................................. 7.67
Efficient Market Theory.7.67

CHAPTER 8 FINANCIAL SERVICES IN INDIA

1.
2.
3.
4.
5.
6.
7.
8.
9.

Investment Banking ....................................................................................... 8.2

Credit Rating .............................................................................................. 8.13
Consumer Finance ...................................................................................... 8.19
Factoring..................................................................................................... 8.23
Housing Finance ........................................................................................ 8.28
Asset Restructuring/Management Company ................................................ 8.31
Depository Services .................................................................................... 8.32
Debit Cards ................................................................................................ 8.35
Online Share Trading ................................................................................... 8.37

CHAPTER 9 MUTUAL FUNDS

1.0
2.0
3.0
4.0
5.0
6.0

Introduction .................................................................................................. 9.2

Classification of Mutual Funds ........................................................................ 9.4
Types of Schemes ........................................................................................ 9.7
Key players in Mutual Funds ...................................................................... 9.10
Advantages of Mutual Fund ......................................................................... 9.11
Drawbacks of Mutual Fund .......................................................................... 9.12

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7.0
8.0
9.0
10.0
11.0
12.0

Evaluating performance of Mutual Funds ..................................................... 9.13

The criteria for evaluating the performance .................................................. 9.19
Factors influencing the selection of Mutual Funds ........................................ 9.22
Signals highlighting the exit of the investor from the Mutual Fund Scheme .... 9.23
Money Market Mutual Funds (MMMFS) ......................................................... 9.24
Exchange Traded Funds ............................................................................. 9.24

CHAPTER 10 MONEY MARKET OPERATIONS

1.0
2.0
3.0
4.0
5.0
6.0

Introduction ................................................................................................. 10.2

Institutions ................................................................................................. 10.12
Instruments ................................................................................................ 10.14
Determination of Interest Rates ................................................................... 10.36
Future Possibilities ..................................................................................... 10.37
Recent Development in Money Market ......................................................... 10.37

CHAPTER 11 FOREIGN DIRECT INVESTMENT (FDI), FOREIGN INSTITUTIONAL

INVESTMENT (FIIs) AND INTERNATIONAL FINANCIAL MANAGEMENT
PART - A
1.0

Costs Involved............................................................................................. 11.2

2.0

Benefits derived .......................................................................................... 11.2

3.0

Foreign Institutional Investment .................................................................... 11.3

PART B
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0

Introduction ................................................................................................. 11.5

Instruments of International Finance ............................................................. 11.8
Financial Sector Reforms in India ................................................................. 11.8
International Financial Instruments and Indian Companies ............................ 11.9
Euro-Issues ................................................................................................ 11.19
GDRs Vs. Euro-Bonds ................................................................................ 11.22
Cross-Border Leasing ................................................................................. 11.23
International Capital Budgeting ................................................................. 11.23
International Working Capital Management ................................................. 11.26

CHAPTER 12 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

1.
2.
3.

Introduction ................................................................................................ 12.2

Foreign Exchange Market ........................................................................... 12.3
Market participants ...................................................................................... 12.4

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4.
5.
6
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.

Nostro, Vostro and Loro Accounts ................................................................ 12.4

Exchange Rate Determination ..................................................................... 12.5
Exchange Rate Quotation .......................................................................... 12.6
Exchange Rate Forecasting ........................................................................ 12.8
Exchange Rate Theories ............................................................................. 12.9
Risk Management ...................................................................................... 12.13
Risk Considerations .................................................................................... 12.14
Foreign Exchange Exposure ...................................................................... 12.17
Types of Exposures .................................................................................... 12.17
Techniques for Managing Exposure ............................................................ 12.18
Strategies for Exposure Management ......................................................... 12.32
Hedging Currency Risk .............................................................................. 12.33
Conclusion ................................................................................................. 12.36

CHAPTER 13 MERGERS, ACQUISITIONS & RESTRUCTURING

1.0

Introduction ................................................................................................. 13.1

2.0

Reasons and Rationale for Mergers and Acquisitions .................................... 13.4

3.0

Gains from Mergers or Synergy .................................................................... 13.7

4.0

Accounting for Amalgamations ..................................................................... 13.9

5.0

Problems for M & A in India.......................................................................... 13.9

6.0

Mergers in specific sectors .......................................................................... 13.10

7.0

Acquisition and Takeover ............................................................................ 13.10

8.0

Takeover by Reverse Bid ............................................................................ 13.12

9.0

The Acquisition Process ............................................................................. 13.13

10.0

Defending a company in a takeover bid ....................................................... 13.18

11.0

Legal Aspects of M & As ............................................................................ 13.19

12.0

Due Diligence ............................................................................................ 13.19

13.0

Target Valuation for M & A .......................................................................... 13.20

14.0

Case Studies .............................................................................................. 13.29

15.0

Corporate Restructuring .............................................................................. 13.32

16.0

Financial Restructuring ............................................................................... 13.37

17.0

Marger Failures or Potential Adverse Competitive Effects ............................. 13.40

18.0

Acquiring for Shares ................................................................................... 13.41

19.0

Cross-Border M&A ..................................................................................... 13.46

20.0

Decade of Corporate Churning and Change ................................................. 13.47

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