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Corporate Financial Strategy

4th edition
Dr Ruth Bender

Chapter 1

Corporate financial strategy: setting the


context

Corporate Financial Strategy

Setting the context: contents


Learning objectives
Risk and return
The two-stage investment process
What does good look like?
NPV illustration (Working Insight 1.3)
Value is created above the line (Figure 1.4)
Individuals have different risk appetites (Figure 1.5)
The seven drivers of value
Economic profit (Working Insight 1.5)
Total shareholder return (Working Insight 1.6)
The value matrix (Figure 1.6)
Stakeholders are important
Agency and double agency

Corporate Financial Strategy

Learning objectives
1. Understand what financial strategy is, and how it can add value.
2. Explain why shareholder value is created by investments with a
positive net present value.
3. Appreciate how the relationship between perceived risk and required
return governs companies and investors.
4. Differentiate the different models of measuring shareholder value.
5. Explain why share price is not necessarily a good proxy for company
value.
6. Outline how agency theory is relevant to corporate finance.

Corporate Financial Strategy

Risk and return

Required
return

Perceived risk

Corporate Financial Strategy

The two-stage investment process

Shareholders
(and others)
invest in the company

Company invests in a
portfolio of projects

Corporate Financial Strategy

What does good look like?


Is it a good

Product?

Is it a good Product?
Is it a good Business?
Is it a good

Company?
Is it a good

Investment?

Corporate Financial Strategy

Value is created above the line

Required
return

Increase return
more than risk

Reduce risk
more than
return

Perceived risk
Corporate Financial Strategy

Individuals have different risk appetites


Longserving
manager

Required
return

Venture
capital fund

Welldiversified
institutional
investor

Perceived risk
Corporate Financial Strategy

The seven drivers of value

1. Increase sales growth

More profit

2. Increase operating profit margin


3. Reduce cash tax rate

Out of fewer
assets

4. Reduce working capital as % of sales

At lower risk

6. Reduce weighted average cost of


capital

For as long as
possible

7. Increase timescale of competitive


advantage

5. Reduce fixed assets as % of sales

Rappaport, Creating Shareholder Value, 1998


Corporate Financial Strategy

Economic profit
Operating profit after tax
Capital employed
Cost of capital

2,400
20,000
10%

Operating profit after tax

2,400

less cost of capital (20,000 x 10%)


Economic profit

2,000
400

Return on capital employed (2,400/20000)


Spread

2%

Economic profit (2% x 20,000)


Corporate Financial Strategy

10

400

12%

Total Shareholder Return (TSR)

Share price at 1 January


Share price at 31 December

100
110

Capital gain in the year


Dividend paid in the year
Total return

5
15

Total shareholder return (TSR)

Corporate Financial Strategy

10

11

15%

Figure 1.5 The value matrix


> 1.0

Value multiple
Market value

Fair value

= 1.0

< 1.0
Negative

Corporate Financial Strategy

12

Economic profit

Positive

Stakeholders are important


Shareholders
Investment institutions,
family members, prospective
investors
Debt holders
Banks, investment
institutions, individuals

Business and
Financial
strategy

Customers
Direct customers, end consumers,
consumer groups

Managers
Board of directors, senior managers,
other managers

13

Suppliers
Long term suppliers, raw material
suppliers, sub-contractors

Government and regulators


Tax authorities, trade department,
employment department, governance
regulators
Employees
Individuals, unions / staff
associations, pensioners

Corporate Financial Strategy

Community
Local community, environmental
bodies, public at large

Agency and double agency

Net assets

Debt

Fixed assets
Current assets
less current
liabilities
Non-operating
assets

Equity

Management
Employees

Corporate Financial Strategy

14

Fund
managers

Individual
shareholders
and
pensioners

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