Components of Financial Strategy - Assignment Example

? Financial Accounting Q1: (i) Components of Financial Strategy Two components of financial strategy are 1. The funds required by organizations and most appropriate methods for raising these funds. This involves evaluation of the funding requirements of the business and then approaching different venues for raising capital that is either through borrowing or issuing equity in the capital markets and collecting funds from shareholders’ investment in the company’s shares (Bender & Ward, 2012). 2. Employment and management of these funds in the business. This involves decisions pertaining to investment or divestment or distribution of funds of the organization. (ii) The main focus of a financial strategy is related to the financial element of the strategic planning and decision making by companies. Decisions that can be prescribed in financial terms are covered in the financial strategy (Bender & Ward, 2012). Thus, it could be stated that the financial decisions are different from business decisions that the company may undertake however, they are related to each other and have implications for them. (iii) There are four reasons that market value might differ from fundamental value which are given below: a. The share price often reflect future prospect of the company’s performance (Bender & Ward, 2012). If the market expects that the financial results of a company will exceed the expected growth rates than the share price will react positively in advance (Bender & Ward, 2012). This is usually reflected by high price to earnings ratio. It is understood that companies’ stock which have higher price to earnings ratio are likely to show increase in the market value of their shares as the market develops an expectation that these companies are likely to outperform their expected targets. For example, a recent launch of iPhone 5 pushed the market value of Apple’s stocks higher. b. The information asymmetry in the capital market can lead to the market view positively about the company and that is why the share price is higher than the fundamental value. The information asymmetry can have short term positive impact on the market value of the company’s share however as the information becomes mature and better view of the company’s performance becomes clearer the market value of shares will begin to coincide with the fundamental value of business per share. c. The company announces a future investment project which is expected to yield higher returns for the company and thus, the market reacts positively to the news. Although, the investment is yet to be placed by the positive sentiments about the projections that the company makes for its investment decision can have positive impact up on the market value of the company’s shares. For example, a company Medinah Minerals announced its exploration project in South America which lead to major interest by shareholders in its stocks and the market value went up above the fundamental value of the company. d. If a company approaches to takeover another company then managers or shareholders of the target company may enter in the market to alter the market value of its shares so that higher bid can be achieved. In this case, the market value of shares will be higher than the fundamental value of the company. This is a strategy to prevent takeover bids by other entities. For example, this defense tactic is very much common in the US as compared to the UK. Q2: (i) Year 0 1 2 3 NPV Project A Cash Flows (240,000.00) - - 325,000.00 Discount Factor 1.00 0.90 0.81 0.73 Discounted CF (240,000.00) - - 237,637.20 (2,362.80) 0 1 2 3 NPV Project B Cash Flows (198,000.00) 110,800.00 82,500.00 45,000.00 Discount Factor 1.00 0.90 0.81 0.73 Discounted CF (198,000.00) 99,819.82 66,958.85 32,903.61 1,682.28 NPV is the sum of future cash flows discounted to the present time and it is understood that only those projects which result in positive NPV must be accepted by companies and all those projects which have negative NPV must be rejected (Bender & Ward, 2012). Since, Project A has a negative NPV as compared to Project B therefore Project B must be accepted instead of Project A. (ii) Year 0 1 2 3 NPV Project A Cash Flows (240,000.00) - - 325,000.00 Discount Factor 1.00 0.93 0.86 0.79 Discounted CF (240,000.00) - - 257,995.48 17,995.48 0 1 2 3 NPV Project B Cash Flows (198,000.00) 110,800.00 82,500.00 45,000.00 Discount Factor 1.00 0.93 0.86 0.79 Discounted CF (198,000.00) 102,592.59 70,730.45 35,722.45 11,045.50 As the required rate of return is reduced from 11% to 8% the results indicate that both projects have a positive NPV. However, project A has a higher NPV as compared to project B therefore it should be accepted. (iii) Year 0 1 2 3 IRR Project A Cash Flows (240,000.00) - - 325,000.00 11% Payback: 3 Years 0 1 2 3 IRR Project B Cash Flows (198,000.00) 110,800.00 82,500.00 45,000.00 12% Payback: 2.1 Years Internal Rate of Return (IRR) is rate at which the NPV of the project becomes zero. This is the minimal rate that must be generated from the projected to cover its initial cost of investments. This must be greater than the required rate of return or cost of capital of a company (Bender & Ward, 2012). As both projects A and B have IRR greater than the required rate of return therefore both projects are considered to add value to the business. Considering both projects to be independent of each other, both should be accepted if the company has available funds for allocation to both projects. However, looking at the payback periods of both projects it can be clearly suggested that project A has a longer payback period as compared to project B and therefore, if the company undertakes project B then it can generate profits much quicker than project A. Q3: (i) Business Risk vs. Financial Risk Business risk refers to all types of risks which are related to the strategic decisions made by the business except those related with the financial strategy of the company. For example, the company may be exposed to business risk when it is planning to enter a foreign market with its existing product profile (Bender & Ward, 2012). On the other hand, financial risk refers to risks associated with the company’s financial strategy decisions. These decisions are directly related to shareholders’ interest in the company and risks arising from such decisions are outcome of both formal and informal financial systems (Bender & Ward, 2012). There is an obvious relationship between business risk and financial risk. Companies can trade off between both types of risks if they undertake decisions in a way that business decisions taken by the company actually reduce the financial risks. For example, the company can shifts its production facility to a country which has low cost factor and thus, it can be assist the company in reducing its cost of operations and therefore reduce its funding requirements. There is an inverse correlation between business risk and financial risk. This implies that as the company grows and its business becomes well placed in the existing or newer markets the business risks decline but the corresponding financial risk increases due to the increase in the business exposure (Bender & Ward, 2012). (ii) Decisions for Financial Strategy There are four decisions in financial strategy that organizations have to make including: a. Investment Decision These decisions are pertaining to the profitable utilization of the organization’s funds. These decisions are particularly of long term nature and there is an element of uncertainty related to the outcomes associated with these decisions. Therefore, it could be inferred that this type of decisions has risks associated. The main focus of these decisions is to invest funds in those projects which add value to the business and shareholders by generating profits and positive cash flows (Bender & Ward, 2012). b. Dividend Decision These decisions are pertaining to the retention and distribution of the organization’s funds. Retained earnings are reinvested in the business for generation of further earnings for shareholders. Distribution covers decisions related to dividends that the company may decide to pay to shareholders instead of retaining earnings within the business. This decision is undertaken by the company to keep its stocks attractive to shareholders (Bender & Ward, 2012). For example, Apple Inc. recently announced its second dividend in its entire corporate history as the company’s stocks are badly hit due to the shortfall in achieving sales targets of iPhone 5 and also tough competition by Samsung in handheld Smartphone market. c. Financing Decision These decisions are related to the procurement of funds from different sources. Typically, companies can acquire equity capital and / or debt capital. These decisions have implications on the capital structure of the company. The company thus has to decide whether to acquire cheap borrowed funds from institutions or go to the capital market to acquire a large pool of funds at higher costs (Bender & Ward, 2012). d. Portfolio Decision These decisions are related to the assessment of existing or potential investments that the company has to decide which affect overall performance of the company. This therefore involves analysis of combination of decisions that the company confront rather than considering investments on individual basis (Bender & Ward, 2012). Q4: (i) Reasons for Floating Shares The company must choose to float its shares on the stock exchange for four reasons despite of the high costs associated with such decision which are discussed in the following: 1. The company has a strong business and financial position and this may attract shareholders easily to invest in its shares in the capital market (Bender & Ward, 2012). 2. The company if borrows then has contractual obligations to pay its interest payments and principal amounts on are regular basis however with its shares floated in the capital markets the company can delay distribution of funds to shareholders through dividends (Bender & Ward, 2012). 3. The company may have existing high levels of leverage which may discourage the management to borrow more as it would further weaken the company’s capital structure and make it less attractive to investors (Bender & Ward, 2012). 4. The company may decide to floating shares if it foresee additional capital requirement which would be easier to acquire from the capital market based on its performance (Bender & Ward, 2012). (ii) Benefits of Going Public There are several benefits arising by going public and out of these two benefits are discussed here: 1. By going public the company can improve its access to debt sources of capital. It has been observed that publicly listed companies have greater accessibility to debt markets as compared to companies which are not listed (Bender & Ward, 2012). 2. The company can improve its debt to equity ratio by going public and thus, it may be able to borrow cheaper funds from institutions such as banks on much more flexible terms than in the case of operating with high debt to equity ratio (Bender & Ward, 2012). (iii) Risks of Going Public There are several risks associated with going public and out of these two potential risks are provided below: 1. The loss of control is one of the major risks to the company as the control of the company goes in the hands of the external forces rather than the management. This can also be understood by considering the risks of hostile takeovers of companies in which the interests of existing shareholders are at risks (Bender & Ward, 2012). 2. The market can exert pressure on the management to generate results which are favorable to the shareholders. This could affect the ability of the company to have a long term approach to its financial decisions and it would rather focus on short term financial objectives as desired by the shareholders (Bender & Ward, 2012). Reference List Bender, R., & Ward, K. (2012). Corporate Financial Strategy. New York: Routledge. Read More