STRATEGIC

FINANCIAL
MANAGEMENT
Chapter 2

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What is strategic financial
management

■ The identification of the possible strategies

capable of maximizing an organization's net
present value, the allocation of scarce
capital resources among the competing
opportunities, and the implementation and
monitoring of the chosen strategy so as to
achieve stated objectives

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What is finance?

■ Corporate finance is an area of finance

dealing with financial decisions business
enterprises make and the tools and analysis
used to make these decisions
(wikipedia.com)

■ Corporate Financial Management deals with

the decisions of a firm related to
investment, financing and dividend

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Investment Decision

■ To carry on business, a firm invests in

tangible assets like plant and
machinery, buildings, and intangible
assets like goodwill and patents. This
comprises the investment decision

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Financing Decision

■ These assets don’t come free; one has

to pay for them, so a company needs
to tap various sources of funds
including shares, bonds, bank loans.
This forms the financing decision

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Dividend Decision

■ The investment in assets generates

revenues and cash flows for a specific
period of time. The managers of the
company can either retain cash with the
company for further investment or distribute
to the owners of the company—the
shareholders. This constitutes the dividend
decision

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■ In short, a finance manager will be concerned with such
financial decisions as:
■ Which investment/s should the company accept and what
are the financial implications of undertaking the same?

■ How should the company finance those investments? What

should be the mix of owners’ contribution— equity and
borrowed funds, i.e., debt at any given point in time?

■ How much of the income generated from operations should

be returned to shareholders in the form of dividends and
how much is to be retained for further investment?

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Financial decisions: Time perspective

■ Capital investment decisions are long-term choices about which

projects receive investment, whether to finance that investment
with equity or debt, and when or whether to pay dividends to
shareholders

■ On the other hand, the short term decisions

can be grouped under the heading "Working
capital management".

■ This subject deals with the short-term balance

of current assets and current liabilities;

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Financial decisions: Time
perspective
■ The focus here is on managing cash,
inventories, and short-term borrowing
and lending (such as the terms on
credit extended to customers).

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Objective of financial
managers
■ Corporate Finance theoreticians generally agree that the
objective of a firm is to maximize wealth
■ Whose wealth? whether it should be the wealth of
shareholders or the wealth of the firm, which includes
bondholders and preferred stockholders

■ Shareholder wealth maximization rule requires managers to

work towards a sustainable increase in the price of the firm’s
stock

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Objective of financial
managers
■ Alternative to the above rule is to maximize profit, social
value, or growth of the firm
■ The underlying assumption is that, an increase in any of these
proxies results in an increase in the value of the firm
(alternatively, shareholder value)

■ Maximize Profit? Increase sales, suppress expenses, extract

the last rupee from the customer, pay the lowest possible
price to suppliers, pay less salaries to employees,

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Social Responsibility as an
objective
■ Can social responsibility be an objective?
■ Businessmen are supposed to be socially
responsible
■ But social welfare activities have conceptual
problems? What is right or wrong, how
much to spend on social responsibility?
Moreover, what was considered moral 30
years ago could be immoral now?

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Growth as an Objective

■ Can growth be an objective of a firm?

■ Business in pakistan, india and south Korea are
dominated by family groups, and conglomerates.
■ Businesses groups in south Korea are called
chaebol, typically own 30—50 companies in all key
business areas; and the big five—Daewoo,
Samsung, Hyundai, LG, and SK—account for 20
percent of all borrowing and contribute to almost
50 percent of GDP

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Growth as an Objective

■ Debt ratios at the top 30 chaebol are in the range

of 550 percent; they suck up a major portion of the
available credit and drive out smaller businesses
■ The chaebol understand only one language: borrow
to the hilt; focus on size and not profit; focus on
growth and not productivity; invest aggressively and
acquire companies
■ Productivity in South Korea is about half that of US
levels

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Growth as an Objective

■ When earnings fall due to recession,

competition, or some such thing, these
companies will default on borrowings
■ To summarize, growth, though important,
need not necessarily lead to an increase in
shareholder value

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Multiple Objectives

■ Do Firms Pursue Multiple Objectives?

■ In a survey of management views on alternative
objectives, it has been found in the companies
locally that in 67 percent companies—with high
profitability—the first preference is given to the
objective of maximizing percent ROI and, in 33
percent companies, the first preference is given to
the objective of maximizing aggregate earnings

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Impediments to shareholder wealth
maximization

■ There could be potential conflict of interest

between shareholders and bondholders, managers
and shareholders, majority and minority
shareholders. So, maximizing wealth of one group
could be achieved at the expense of other groups
■ Shareholders vs Bondholders
■ Managers vs Shareholders
■ Shareholder vs Shareholder

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Shareholders vs Bondholders

■ Bondholders get a fixed, contractual payment (interest) during

the term of the bond but have a prior claim on the assets of
the company; whereas equity investors have a residual claim
on the cash flows of the company as they are owners.
■ A company making losses may be tempted to borrow and take
on business gambles, the benefits of which largely go to
shareholders. It’s a ‘heads-I-win, tails-you-lose’ strategy. If the
project succeeds, shareholders enjoy the upside potential but
bondholders get fixed interest payment; if the project fails,
shareholders have nothing to lose—it’s not their money
anyway

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Managers vs Shareholders

■ Investment in projects generates cash flows, which can either

be reinvested in the business or returned to shareholders in
the form of dividends who in turn can decide where to invest
their money. Managers, as agents of shareholders, have
discretion over investment of residual cash flow.
■ Increasing dividends reduces the resources under the
manager’s control and limits growth. Since managers are
appraised on the basis of growth, it is likely that they may
pursue unprofitable projects that do not yield adequate
returns; leaving the shareholders in a lurch. This leads to
conflict of interest between managers and shareholders.

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Shareholder vs Shareholder

■ The majority shareholder often serves as the

chairman of the board.
■ A share is a share in the share capital of the
company. Each share entitles the holder to exercise
one vote at the annual general meeting. If this is
true, then the value of the share should be the
same for all shareholders irrespective of how many
shares one is holding—one million or 100 shares.

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MAXIMIZE EQUITY VALUE OR
FIRM VALUE?
■ There is a misconception that maximization of
equity value and maximization of firm value are the
same. They are not the same.
■ Even though equity is a part of the firm’s capital
structure, there is also debt and many financial
instruments with both debt and equity features that
managers should take into account. As described in
earlier sections shareholders can increase their
wealth at the expense of other investors.

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Conclusion

■ The objective of a firm should not be to make a profit or even

maximize profit, increase market share or sales, but to
maximize shareholders’ wealth
■ But this should not be achieved at the expense of other
investor groups
■ Financial markets are efficient to some extent, they can see
whether a firm is adding value or not; this will be reflected in
the share price of the firm

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