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Strategic Financial Management

30th July 2010

Financial Strategy
‡ Functional Strategies are drawn to Support the business plan ‡ The strategy is to maximize the return to the shareholders

Operating & Investment Decisions

Financing & Funding Decisions

Cash Flow

Value to Shareholders

Cost of Capital

Shareholder Value Analysis
Key decisions impacting Shareholder Value ‡ Investment Strategy
± Invest only when the asset is expected to earn more than the minimum acceptable return ( hurdle rate )
‡ Capital Investments , Acquisitions & Working Capital

‡ Financing Strategy
± Capital Structure to optimize the cost of capital
‡ Borrowing Strategy & credit rating

‡ Pay-out Strategy
± Combination of incremental dividend and plough back for capital appreciation

which is added to the cost of the respective source of capital .Investment Strategy Cost of Capital ± What it should be ? The composite cost of capital of both (equity & debt ) needs to be lower / = the Hurdle rate Investors expect returns over the time horizon of their holdings Hurdle Rate is the minimum rate of return which investor would make elsewhere on similar investments Both equity and debt have an element of risk .

having impact on sales and earnings ‡ Operational Risks associated with the power projects ‡ Regulatory regime capping the returns Systematic Risk : Variability in the return due to factors that influence return on all traded security ‡ Macro economic conditions ‡ Swings in Interest Rates & Exchange Rates .The basics of Risk Specific Risks : Variability in the return due to factors unique to a Project/ Company .

The basics of Risk Systematic Risk is measured by Beta Beta establishes relationship between the excess returns of an individual asset to that of the market portfolio . where the beta of the market portfolio is 1 Beta is the covariance of the asset with the market divided by the variance of market portfolio Covariance measures the tendency of any pair of random variables to move together Assets having betas in excess of 1 are riskier than the market portfolio and vice versa .

Determinants of Beta The Beta of a firm is determined by 3 variables ‡ The type of business ( degree of sensitivity to overall economic scenario ) ‡ Degree of Operating Leverage of the firm ( Relationship between fixed costs and total costs ± HOL -> High Beta ) ‡ Degree of Financial Leverage of the firm ( Equity Beta of an un-levered firm is lower than the levered firm ) .

‡ It is defined in terms of relationship between fixed costs and total costs ‡ A firm having HOL ( high fixed cost relative to total cost ‡ The beta of such firms will be High ‡ Higher degree of financial leverage increases the equity beta .Determinants of Beta ‡ Degree of Operating Leverage is a function of the cost structure of the firm . other things remaining equal .

30*20 % ) = 10.Cost of Capital We source capital needs from both equity and debt Cost of equity ( Ke) = Risk free return + Risk premium* beta => R f + beta ( Rm.Rf) Where R f = Risk free rate R m = Expected Return on market portfolio Cost of Debt => Post tax cost of debt = Interest Rate * ( 1. Capital* Ke) WACC ( .3399)] + (0.70 gearing) = [0.tax rate ) Wtd Avg Cost of Capital =( Proportion of debt* Post tax Interest Rate ) + (Proportion of Sh.62 % .70*10%* (1-.

Capital Allocation Rules ‡ Cost of Capital represents the hurdle rate of the firm to which project specific risk premium is added to arrive at project specific hurdle rate ‡ Expected Return on Capital > Cost of Capital ( Project is viable )] ‡ Pay back Period is a measure of how quickly the cash flows generated can cover the initial investment .

the NPV decreases and reaches ³0´  If IRR > Cost of Capital ( Accept the Project) ‡ . select the project with highest NPV Internal Rate of Return is the discount rate that makes the NPV zero  As the discount rate increases.Capital Allocation Rules ‡ Discounted Cash Flow measure ( NPV ) ‡ Cash flow over the life of the project ‡ Discount Rate or Hurdle rate If NPV > 0 accept the project For competing projects .

accept the project Accounting Rate of Return is also known as return on capital Employed ARR = PBIT / Capital Employed .Capital Allocation Rules Profitability Index : It is the ratio of the present value of project benefits to present value of initial costs or outlay PI = NPV / PV of Outlays If PI > 1 .

since the reinvestment assumptions could lead to serious errors . use NPV ‡ Beware of very high IRR . since it captures the Time value of Money ‡ In case of variable discount rates select NPV ‡ In case of Unconventional Cash flows .Which method to follow ‡ DCF is superior for longer time horizon .

Capital Structure Modigliani and Miller ( M & M ) propagated the theory of capital structure ±Market Value of the firm is constant . regardless of the leverage ± Proposition I ± The expected return on Equity is an increasing function of firm¶s leverage ± Proposition II .Financial Leverage .

Capital Structure Capital Gearing ( CG) is the ratio of all long term liabilities to the shareholders¶ funds as shown in the Balance Sheet It is often referred as DE Ratio = Long Term Loans / Shareholders¶ funds .

Cost of Capital Particulars PBIT ( in Mlns) Less : Interest PBT Less : Tax @ 30 % PAT Total to Investors Zero gear 1000 0 1000 300 700 700 Geared 1000 300 700 210 490 790 So . the tax advantage on debt returns more to the investors .

100 mln . 25 mln) Interest on 10 % Shareholders' earnings Return on Equity 50 % Gearing ( Rs.5 2.50 mln .0 mln ) Interest Shareholders' earnings Return on Equity 25 % Gearing ( Rs. Rs.5 43% 0 5 5% 0 20 20% 0 35 35% ( p =0.5 17.5 3% 2. 50 mln ) Interest on 10 % Shareholders' earnings Return on Equity 5 0 0% 5 15 30% 5 30 60% 2. Rs. Rs.20) 35 .5 23% 2. 75 mln .70) 20 Excellent ( p= 0.Capital Structure V Return on Equity Bad Net Operating Income ( Before Interest ) Zero Gearing ( Rs.10) 5 Normal ( p =0.5 32.

Stand Alone Ratios Year Ends (Months) OPM (%) [Value in Rupees Crores] 200803(12) 41.25 29.74 Return on net worth 21.5 .69 Financial charges coverage ratio 9.Tata Steel Group .71 Debt/Equity 1.92 1.85 72.08 0.53 Reported EPS 63.43 23.94 200703(12) 39.52 30.77 Dividend per share 16 15.61 NPM (%) 23.45 Current ratio 3.

Dividend Policy ‡ How do the firms decide dividend pay out ? ± Expected return on investment = Dividend yield+ price appreciation ± Dividend Yield = Annual Dividend per Share / Price per share ± Dividend payout ratio =Dividend Paid/ PAT ‡ Company may pay out less ± Retain cash for reinvestment ± To build up a cash cushion to take care of bad periods ± Retain cash to smooth out dividend over time ‡ To enhance the value of the firm ± Retain if good projects are in hand ± Pay out if reinvestment opportunities are less attractive .

Financing Power Projects Financing of Project Equity 30% Debt 70% ECB 40% DB 30% .

Flexibility in availment ‡ ‡ ‡ ‡ Credit rating & Cost benefit Secured Vs Unsecured Pool of Currency & Hedging Strategy Mix of Floating & Fixed rate loans .Borrowing Strategy ‡ Selection of Source will depend upon ± ± ± ± Cost of funds Maturities Moratorium period matching Project Schedule.

40 15.30 8.50 100.584.40 656.197.458.10 8.50 59.245.50 36.50 27.628.90 73.30 440.10 Loan Funds Secured Loans Unsecured Loans 4.60 51.201.80 2.60 35.458.000 0 2004 2005 2006 2007 2008 2009 .50 44.464.80 7.SOURCES OF FUNDS of NTPC LIMITED AS ON 31-Mar-04 Shareholders' Funds Share Capital Reserves and Surplus 31-Mar-05 31-Mar-06 31-Mar-07 31-Mar-08 31-Mar-09 (Rs.30 Other Sources of Funds Total Sources of Funds 51.10 52.124.20 44.596.000 10.20 81.80 41.000 30.567.245.00 81.60 20.732.738.776.000 80.550.536.393.812.10 17.875.738.540.60 8.70 19.087.958.00 65.50 40.661.737.596.000 60.80 337.245.530.30 48.000 90.201.50 24.50 49.90 6.713.000 70.598.80 8.440.452. in Crores) 7.598.60 4.60 57.596.540.647.90 17.000 40.822.351.90 59.10 94.60 25.20 Total Sources of Funds 94.000 20.314.90 27.370.638.60 1.969.245.80 537.536.50 5.70 12.70 14.20 34.868.40 10.190.50 33.10 73.90 8.484.70 8.60 65.245.000 50.

± Increased liquidity for strategic investment and debt reduction.Working Capital Strategies Active working capital management is an extremely effective way to increase enterprise value. . Optimising working capital results in ± a rapid release of liquid resources ± improvement in free cash flow ± permanent reduction in inventory and capital costs.

debtors etc. .Current Liabilities.Working Capital Concepts Net Working Capital = Current Assets . Gross Working Capital The firm¶s investment in current assets. Where Current assets are the assets that can be converted into cash within an accounting year & include cash .

Impact on Expected Profitability Optimal Amount (Level) of Current Assets Return on Investment = Asset Level ( Rs) Net Profit Total Assets Current Assets = (Cash + Receivables + inventories.000 Sales (units) 50.000 .) Return on Investment = Net Profit Current + Fixed Assets Policy A Policy B Policy C Current Assets 0 25.

Policy A Asset Level (Rs) Policy B Policy C Current Assets 0 25.000 Output (units) 50. total assets will decline and the ROI will rise.Impact on Expected Profitability Optimal Amount (Level) of Current Assets Profitability Analysis Policy Profitability A Low B Average C High As current asset levels decline.000 .

Important Financial Ratios .

. ‡ Inventory Turnover = Cost of goods sold / Inventory ‡ Fixed Asset Turnover = Sales / Fixed assets. ± Operating Margin = Operating Income/ Net Sales ± Net Margin = Net Profit / Net Sales ± Return on Equity (ROE) = Net Income / Equity ± Asset Management Ratios show how efficient a company is in its operations and use of assets.Analysis of the Financial Ratios Ratio analysis can be broken down into various categories: ± Profitability Ratios indicate show the return on capital employed.

Analysis of the Financial Ratios Liquidity Ratios give a picture of a company's short term financial situation or solvency ‡ Current Ratio ± Current Asset / Current Liability ‡ Working Capital =Current Assets-Current Liabilities Debt Management Ratios show the extent of use of debt in a company ‡ Debt-Equity Ratio = Total Debt / Total Equity ‡ Times Interest Earned = EBIT / Interest ‡ Debt Service Coverage Ratio = EBIT / (Interest + Repayments ) .

‡ PE Ratio . ‡ Price / Book .Analysis of the Financial Ratios Predictor indicate the potential for growth or failure. ‡ EPS Ratios .

DuPont System of Analysis ROE = Profitability x Efficiency x Leverage = Return on Sales x Asset turnover x Assets-toEquity Ratio = Net Profit x Sales Sales Assets x Assets Equity .

Strategies to improve ROE Reduce the amount and cycle of working capital Coal/ Oil Spares Receivables Power generation Realization & Payments Metering & Billing Reduce the Cost of Generation ‡ Efficient use of fuel . power and other resources ‡ Reduction in Project Cost ‡ Reduction in Financing Cost ‡ Reduction in Project implementation time .

Tax rate ) / Invested Capital Where.Drivers Of Value Creation Key drivers of value creation are : Return on Invested Capital ( ROCE) ‡ ROCE = PBIT( 1. Invested Capital = Net fixed Assets + Net Current Assets The Growth Rate = Ge Which depends on the reinvestment rate .

60 mln . NOPAT = PAT + Interest *( 1-tax rate ) Cost of Eq =16 % .7 %*200 = 49 -19.3) ± 9.EVA ± A Measure of Shareholder Value EVA = NOPAT ± WACC*Invested Capital Where . PBIT = 70mln EVA = 70*( 1-.Cost of Debt = 7 % DE = 70 : 30 WACC = 70*7 % + 30 * 16 % =9. Debt = 140 mln.7 % Equity =60 mln.40=29.