Strategic Financial

Management
Strategic Financial Decision Making Frame Work

Strategy at different hierarchy levels

Financial Planning

Interface of Financial Policy and Strategic

Management Balancing Financial Goals vis-à-vis

Sustainable Growth

Principles of Valuation
2
 Introduction
Strategy:

The long-term direction and the scope of an

organization to achieve competitive advantage
through the configuration of resources within
the changing environment for the fulfillment
of stakeholder’s aspirations and expectations.
Enables
management of an Systems
organization in a approach, which is Planning process
systematized concerned with must be holistic, Applying financial
fashion by a)WHERE the periodic, futuristic, techniques to
developing a series organization wants intellectual and strategic decisions
of plans and to reach and creative with to help achieve
policies known as b)HOW the emphasis given on the decision-
strategic plans, organization critical resources maker's objective
functional policies, proposes to of the firm
structural plans and reach that
operational plans. position.
A clear and realistic strategy

The financial resources, controls and systems to see it

through

The right management team and processes to make it

happen

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 The
Strategy Finance Management fundamentals of
business

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SFM Defined :

It combines the backward-

looking, report-focused Allocation of
discipline of (financial) scarce capital
accounting with the more resources among
dynamic forward looking competing
subject of financial opportunities
management.

Identification of Implementation
possible and monitoring
strategies capable of the chosen
of maximizing an strategy so as to
organization’s achieve agreed
market value. objectives.
 Strategic Financial Management
•Strategic financial management means not only
managing a company's finances but managing
them with the intention to succeed—that is, to
attain the company's goals and objectives and
maximize shareholder value over time.
 A Company Needs To
•Define its objectives precisely,
• Identify and quantify its available and potential
resources, and
• Devise a specific plan to use its finances and
other capital resources toward achieving its
goals.
 In a nutshell:
• Strategic financial management is about creating
profit for the business and ensuring an
acceptable return on investment (ROI).
• Financial management is accomplished through
business financial plans, setting up financial
controls, and financial decision making.
Financial management addresses several
important questions:
1. What long-term investments should the firm take on? (Capital
budgeting)
2. Where will we get the long-term financing to pay for the
investment? (Capital structure)
3.How will we manage the everyday financial activities of the firm?
(Working capital)
 Objectives and Goals

• Goal: The Financial Goal of the firm should be

shareholder’s wealth maximization, as reflected in
the market value of the firm’s share.
• Firms’ primary objective is maximizing the welfare of
owners, but, in operational terms, they focus on the
satisfaction of its customers through the production
of goods and services needed by them
 Shareholders’ Wealth
Maximization
• Maximizes the net present value of a course of action
to shareholders.
• Accounts for the timing and risk of the expected
benefits.
• Benefits are measured in terms of cash flows.
• Fundamental objective—maximize the market value of
the firm’s shares.
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Investment decision

Dividend decision

Financing decision

Portfolio decision

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 Profitable utilization of firm's funds
especially in long-term projects
(capital projects)
Evaluate projects in relation to their expected return and risk.

To maximize the market value of the company, invest

in projects with maximum returns and minimum risk.

An understanding of cost of capital, capital structure

and portfolio theory is a prerequisite

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 Investment decisions
• The investment decision relates to the selection of assets in which funds
will be invested by a firm. The assets which can be acquired fall into two
broad groups: (a) long-term assets (Capital Budgeting) (b) short-term or
current assets (Working Capital Management).
•(a) Long Term Investment Decisions
• Capital Budgeting Capital budgeting is probably the most crucial financial
decision of a firm. It relates to the selection of an asset or investment proposal
or course of action whose benefits are likely to be available in future over the
lifetime of the project.
•Capital Budgeting decisions
• Use Pay Back period, NPV, IRR, etc. for evaluation
 Division of A higher dividend rate
earnings between means less retained
payments to earnings and consequently
shareholders and slower rate of growth in
reinvestment in the future earnings and share
company prices.

Evaluate projects Finance manager

in relation to must provide
their expected reasonable answer
return and risk. to this conflict

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 Dividend Decisions
• Two alternatives are available in dealing with the profits of a
firm.

(1)They can be distributed to the shareholders in the form of

dividends or

(2) They can be retained in the business itself.

i.e the Dividend Payout Ratio

 Optimal financial mix
Mode of financing or
– Where market
mix of equity
value of the company
capital and debt
is maximized
capital

It is possible to
alter the total value
of the company by
alteration in the
capital structure

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 Financing Decisions
•The concern of the financing decision is with the financing-mix or
capital structure or leverage. There are two aspects of the financing
decision.
a) First the theoretical relationship between the employment of
debt and the return to the shareholders. i.e. the capital structure
theory
b) The second aspect is the determination of an appropriate
capital structure i.e. the capital structure decision.
 To maximize the market
Profitable utilization of
value of the company,
firm's funds
invest in projects with
especially in long-
maximum returns and
term projects (capital
minimum risk.
projects)

An understanding
Evaluate projects
of cost of capital,
in relation to
capital structure
their expected
and portfolio theory
return and risk.
is a prerequisite
The Identification phase

The Development phase

The Selection Phase

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The Decision Recognition Routine: Opportunities,
problems, and crisis are recognized and evoke
decisional activity

The Diagnosis Routine: Information relevant to

opportunities, problems, and crises is
collected and problems are more clearly
identified
The Search Routine: Organizational decision
makers go through a number of activities to
generate alternative solutions to problems

The Design Routine: Ready-made solutions

which have been identified are modified to fit
the particular problem or new solutions are
designed

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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.

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Corporate • Framework for attaining the corporate objectives
under values and resource constraints, and
Strategy internal and external realities

Business • Managerial plan for achieving the goal of the

business unit
• Must be consistent with the corporate strategy

Strategy
• Lowest level plan to carry out principal activities of
a business
Functional • Must be consistent with the business strategy

Strategy
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Financial Resources (FR)

Financial Tools (FT)

Financial Goals (FG)

Financial Planning: FR + FT = FG

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 Profit
maximization
It can be used,
as a Wealth ensures
as a decision
financial financial strength
criterion and
objective suffers of the firm, long
can reflect the
from multiple term solvency
business
limitations e.g. and viability
efficiency
it does not
consider impact
of Time

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 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

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 • Refers to surplus of internally generated funds over
Cash expenditures

Flow

• Firm’s strength in mobilizing borrowed money

Credit
Position

• Extent of idle working capital. Measures the ability of

Liquidity the firm in handling unforeseen contingencies

Position

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 Sustainability means development of the capability for
replicating one’s activity on a sustainable basis

Overall stock of capital assets should remain constant

Preservation of critical resources to ensure support for all,

over a long time horizon

A firm has to think more about the collective needs and

less about the personal needs

Decouple the growth in output of firm from the

environmental impacts of the same

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 Discounted • Estimate value by estimating the expected future
Cash earnings from owning the asset discounted to their
present value
Flows

Relative value • Determine the value based on the market prices of

models similar assets

• For certain types of financial assets (e.g., warrants,

Option pricing put options, call options, employee stock options, etc)
.
models • Use Black-Scholes-Merton model and lattice models
 Risk and Uncertainty
•Risk refers to the variability in the actual returns vis-à-vis
the estimated returns, in terms of cash flows.
•Risk is an integral part of investment decision. The
uncertainty related with the returns from an investment
brings risk into an investment.
•The possibility of variation of actual return from the
expected return is known as risk.

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 Definition of Risk
•Risk is the potential for variability in return.
•Risk involved in capital budgeting can be measured in
absolute as well as relative terms. The absolute measures of
risk include sensitivity analysis, simulation and standard
deviation. The coefficient of variation is a relative measure
of risk.

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 Types of Risk

Risk

Systematic Risk Unsystematic Risk

1. Interest Rate Risk 1. Business Risk

2. Market Risk a) Internal Business Risk
3. Purchasing Power Risk b) External Business Risk

4. Exchange Rate Risk 2. Financial Risk

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1
 Types of Risk

•It is classified into mainly two types.

1. Systematic Risk

2. Unsystematic Risk

•Systematic Risk is the risk which is directly related with overall movement in general market or

economy. This type of risk covers factors which are external to a particular company and are

uncontrollable by the company.

•Unsystematic Risk refers to variability in returns caused by unique factors relating to that firm or

industry like management failure, labor strikes, and shortage of raw material. There are two source of

unsystematic or unique risk –business risk and financial risk.

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 Risk-return Trade-off
• Risk and expected return move in tandem; the greater the risk,
the greater the expected return.
• Financial decisions of the firm are guided by the risk-return
trade-off.
•The return and risk relationship:
•Return = Risk- free rate + Risk premium
• Risk-free rate is a compensation for time and risk premium
for risk.

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 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.
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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

Other half of the formula represents riskand

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 (Rm-Rf).

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Question

Explain briefly, how

financial policy is linked
to strategic management

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Maximising value to the shareholders is
the ultimate objective

The firm should be taking strategic

steps with value-maximization objective

This is the basis of financial policy

being linked to strategic management.

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Manner of raising capital as source of finance and capital structure

Cut-off rate(opportunity cost of capital) to accept investment decisions

Investment and fund allocation

Foreign Exchange exposure and risk management

Liquidity management

Dividend policy decision

I Issue of bonus shares

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Strategic Financial Decision Making Frame Work

Strategy at different hierarchy levels

Financial Planning

Interface of Financial Policy and Strategic

Management Balancing Financial Goals vis-à-vis

Sustainable Growth

Principles of Valuation
46
 Review Question
• Discuss the importance of strategic management ?
• Explain the different levels of strategy?
• Discuss the methods of valuation in brief?
• Explain briefly, how financial policy is linked to strategic
management?
• Explain the interface of Financial Policy and strategic management?
• Write a short note on Balancing Financial Goalsvis-a-vis Substainable
Growth