Group 4:overview of Strategic Financial Management

_Reporters: Tiples, Del Rosario, Taghoy, Forones, Esmalla, carias, Rosel, Tupaz, Ong
4.1 Financial Objectives and Shareholders wealth
All the traditional finance literature confirms that investors should be rational, risk-averse individuals who
formally analyze one course of action in relation to another for maximum benefit, even under conditions of
uncertainty. What should be (rather than what is) we term normative theory. It represents the foundation of
modern finance within which:
 Investors maximize their wealth by selecting optimum investment and financing opportunities, using
financial models that maximize expected returns in absolute terms at minimum risk.
 What concerns investors is not simply maximum profit but also the likelihood of it arising: a risk-return
trade-off from a portfolio of investment, with which they feel comfortable and which may be unique for
each individual.
 Thus, in a sophisticated mixed market economy where the ownership of a company’s portfolio of
physical and monetary assets is divorced from it’s control, it follows that:
 The normative objective of financial management should be:
 To implement investment and financing decisions using risk-adjusted wealth maximizing criteria,
which satisfy the firm’s owners (the shareholders) by placing them in all equal, optimum financial
position.

Of course, we should not underestimate a firm’s financial, fiscal, legal and social responsibilities to all its
other stakeholders. These includes alternative provides of capital, creditors, employees and customers,
through to government and society at large. However, the satisfaction of their objectives should be
perceived as a means to an end, namely shareholder wealth maximization.

Armed with agency theory, you will discover that the function of strategic financial management can be
deconstructed into four major components based on the mathematical concept of expected net present value
(ENPV) maximization:

The investment, dividend, financing and portfolio decision.

In our ideal world, each is designed to maximize shareholder’s wealth using the market price of an ordinary
share (or common stock to use American parlance) as a performance criterion.
The over-arching, normative objective of strategic financial management should be the maximization of
shareholder’s wealth represented by their ownership stake in the enterprise, for which the firm's current
market price per share is a disciplined, universal metric.

4.2 Wealth Creation and Value Added

 Modern finance theory regards capital investment as the springboard for wealth creation.
 Essentially, financial managers maximize stakeholder wealth by generating cash returns that are more
favorable than those available elsewhere.
 In a mature, mixed market economy, they translate this strategic goal into action through the capital
market.

The Mixed Market Economy

 firms should
make money
profits that at least
equal their overall
cost of funds, as
measured by their
investors’ desired
rates of return.
 These will be distributed to the providers of debt capital in the form of interest, with the balance either
paid to shareholders as a dividend, or retained by the company to finance future investment to create
 capital gains.
 If firms make money profits that exceed their overall cost of funds, they create EVA (economic value
added) for their shareholders.
 EVA provides a financial return to shareholders in excess of their normal return that no expense to
other stakeholders.
 Companies engaged in inefficient or irrelevant activities, which produce periodic losses (negative EVA)
are gradually starved of finance because of reduced dividends, inadequate retentions and the capital
market’s unwillingness to replenish their asset base at lower market prices (negative MVA)

This illustration
distinguishes the
“winners” from the
“losers” in their drive
to add value by
summarizing in
financial terms why
some companies fail.
These may then fall
prey to take-over as
share values
plummet, or even
implode and
disappear altogether.

4.3 INVESTMENT
AND FINANCE DECISION
What is investment?
_Investment involve money, property, bonds and stock use for the investment.
_Investing is putting out money to be sure of getting more money back later at an appropriate rate
THE IMPORTANCE OF INVESTMENT TO OUR LIFE
_To have a better future.
_To gain more profit.
_Fighting Inflation
Investments help you protect your capital against price rise. A good way to beat inflation is to park your
money in investments that offer returns that are higher than the rate of inflation.
INVESTMENT DECISION
_Mindset
_Strategy
_Invest
The decision often follows research to determine cost and returns for each option
Types of investment
1. Tangible_Money, Building , land
2. Intangible_Bonds,Stocks, Intelligence
Finance Decision:
Finance:
“Finance" is a broad term that describes two related activities: the study of how money is managed and the
actual process of acquiring needed funds.
 Know your needs and wants
4.4 Decision Structures and Corporate Governance
Decision Structures
Is a representation technique used to organize and visualize decision rules for an operational business.

5 elements of Decision Structure

1. The problem Rationalization
2. The Boundary Conditions
3. The Right Thing to Do
4. Action
5. Feedback
Corporate Governance
Refers to actions taken by organizations to improve relationships and interactions with others, including
consumers, stakeholders and business partner.
Good characteristics of Good
Governance
1. Clear Strategy
2. Effective Risk Management
3. Discipline
4. Fairness
5. Transparency

4.5 THE DEVELOPING FINANCE FUNCTION

Six main featured:
1. TRADITIONAL
Traditional thinking predates the Second World War. Positive in approach, which means a concern with
what is, the discipline was Balance Sheet dominated. Financial management was presented in the literature
as merely a classification and description of long term sources of funds with instructions on how to acquire
them and at what cost.
2. ECONOMIC
Economic theory, which was normative approach, came to the rescue. Spurred on by post-war recovery and
the advent of computing, throughout the 1950s an increasing number of academics began to refine and to
apply the work of earlier economists and statisticians on discounted revenue theory to the corporate
environment.
3. SYSTEMATIC
Still emphasize the financial decision-maker’s responsibility for the maximization of corporate value.
4. BEHAVIOURAL
Have developed this approach further by suggesting that perhaps we can’t maximize anything.
5. MANAGERIAL
Managerial techniques developed during the 1940s from an American awareness that numerous wide-
ranging military, logistical techniques could successfully be applied to short term financial management;
notably inventory control.
6. POST_MODERN
Research has really taken off since the millennium and the dot.com-techno crisis,
spurred on by global financial meltdown and recession.

4.6 The principle of investment

The previous section illustrates that modern financial management (strategic or otherwise) raise more
question that it can possibly answer.

Theories of finance have developed at an increasing rate over the past fifty years. Unfortunately, unforeseen
event always seen to overtake them

Current financial models

-Also appear more abstract than ever. They attract legitimate criticism concerning their real world
applicability in today’s uncertain, global capital market, characterized by geo- political instability
To maximize the wealth of the stakeholders

- companies are assumed to raise fund from their stakeholders, or borrow more cheaply from third
parties (creditors) to invest in capital projects that generate maximum financial benefit for all.
Capital project
 -Is defined as an asset investment that generate a stream of receipts and payment that defined the total
cash flow of the project

INITIAL CASH OUTFLOW

- is immediate payment by a firm for asset

Future receipts and payment

-Are termed future cash inflow and future cash outflows, respectively.

-Wealth maximization criteria based on expected net present value (ENVP) using a discount rate rather
than an internal rate of return(IRR)can reveal that when fixed and current asset are used efficiently by
management.

If ENPV is positive, a project anticipated future net cash inflows should enable a firm to repay cheap
contractual loans with accumulated interest and provide a higher return to shareholders.
To do contractual obligation of larger interest payments associated with more borrowings ( possibility of
higher interest rates to compensate new investors.

4.7 Perfect Market and the Separation Theorem

Opportunity cost of capital- The difference in return between an investment one makes and another that
one chose not to make. This may occur in securities trading or in other decisions.
Cut-off rate- The point at which an investor decides whether or not a particular security is worth
purchasing.

Perfect competition market is a market in which there are large number of buyers and sellers, buying and
selling the homogenous products at certain price levels.

Perfect markets, are the bedrock of traditional finance theory that exhibit the following characteristics:

a. Large number of buyers

b. Many sellers in the market
c. The product are homogenous
d. Free entry and exit in the market
e. Perfect knowledge
g. No transportation cost
h. Independence in decision making

Do perfect market contribute to our understanding of the capital market?

-The assumption of a perfect capital market (like the assumptions of perfect competition in economics)
provide a sturdy theoretical framework based on logical reasoning for the derivation of more sophisticated
applied investment and financial decision.

-Perfect markets underpin our understanding of the corporate wealth maximisation process, irrespective of a
firms distribution policy, which may include interest on debt, as well as the returns to equity (dividends or
capital gains).

_Seminal twentieth century research by two Nobel Prize winners for Economics, Modigliani and
Miller.

Perfect market equilibrium:

Partial equilibrium implies that the analysis only considers the effects of a given policy action in the
market(s) that are directly affected. That is the analysis does not account for the economic interactions
between the various markets in a given economy.
In a general equilibrium setup all markets are simultaneously modeled and interact with each other.

Separation Theorem
It was based upon the pioneering work of Irving Fisher (1930) is quite emphatic concerning the
irrelevance of dividend policy.

What is the 'Fisher's Separation Theorem'

The Fisher's separation theorem is a theory stating that:

1. A firm's choice of investments are separate from its owner's attitudes towards the investments.

2. It is possible to separate a firm's investment decisions from the firm's financial decisions.

Fisher's separation theorem stipulates that the goal of any firm is to increase its value to the fullest extent,
regardless of the preferences of the firm's owners. The theorem is named after American economist Irving
Fisher, who first proposed this idea.

According to fisher, once a firm has issued shares and received their proceeds, it is neither directly
involved with their subsequent on the capital market, nor the price at which they are traded.

So how can management pursue policies that perpetually satisfy sharholder wealth?
Fisher analysis illustrates that in perfect capital markets where ownership is divorced from control,
dividend distributions should be an irrelevance.

The corporate investment decision is determined by the market rate of interest, which is separate from an
individual shareholders preference for consumption.