Strategic Financial Management Robert Alan Hill Download free books at R.A Hill Strategic Financial Management Download free eBooks at bookboon.com Strategic Financial Management 1st edition © 2008 R.A Hill & bookboon.com ISBN 978-87-7681-425-0 Download free eBooks at bookboon.com Strategic Financial Management Contents Contents About the Author Part One: An Introduction 10 Finance – An Overview 11 1.1 Financial Objectives and Shareholder Wealth 11 1.2 Wealth Creation and Value Added 13 1.3 The Investment and Finance Decision 14 1.4 Decision Structures and Corporate Governance 17 1.5 The Developing Finance Function 18 1.6 The Principles of Investment 22 1.7 Perfect Markets and the Separation Theorem 24 1.8 Summary and Conclusions 28 1.9 Selected References 29 Fast-track your career Masters in Management Stand out from the crowd Designed for graduates with less than one year of full-time postgraduate work experience, London Business School’s Masters in Management will expand your thinking and provide you with the foundations for a successful career in business The programme is developed in consultation with recruiters to provide you with the key skills that top employers demand Through 11 months of full-time study, you will gain the business knowledge and capabilities to increase your career choices and stand out from the crowd London Business School Regent’s Park London NW1 4SA United Kingdom Tel +44 (0)20 7000 7573 Email mim@london.edu Applications are now open for entry in September 2011 For more information visit www.london.edu/mim/ email mim@london.edu or call +44 (0)20 7000 7573 www.london.edu/mim/ Download free eBooks at bookboon.com Click on the ad to read more Strategic Financial Management Contents 30 Part Two: The Investment Decision 2 Capital Budgeting Under Conditions Of Certainty 31 2.1 The Role of Capital Budgeting 32 2.2 Liquidity, Profitability and Present Value 33 2.3 The Internal Rate of Return (IRR) 39 2.4 The Inadequacies of IRR and the Case for NPV 40 2.5 Summary and Conclusions 42 3 Capital Budgeting and the Case for NPV 43 3.1 Ranking and Acceptance Under IRR and NPV 44 3.2 The Incremental IRR 46 3.3 Capital Rationing, Project Divisibility and NPV 46 3.4 Relevant Cash Flows and Working Capital 47 3.5 Capital Budgeting and Taxation 49 3.6 NPV and Purchasing Power Risk 50 3.7 Summary and Conclusions 53 Download free eBooks at bookboon.com Click on the ad to read more Strategic Financial Management Contents The Treatment of Uncertainty 54 4.1 Dysfunctional Risk Methodologies 55 4.2 Decision Trees, Sensitivity and Computers 55 4.3 Mean-Variance Methodology 56 4.4 Mean-Variance Analyses 58 4.5 The Mean-Variance Paradox 60 4.5 Certainty Equivalence and Investor Utility 62 4.6 Summary and Conclusions 64 4.7 Reference 64 65 Part Three: The Finance Decision 5 Equity Valuation and the Cost of Capital 66 5.1 The Capitalisation Concept 67 5.2 Single-Period Dividend Valuation 68 5.3 Finite Dividend Valuation 68 5.4 General Dividend Valuation 69 5.5 Constant Dividend Valuation 69 5.6 The Dividend Yield and Corporate Cost of Equity 70 5.7 Dividend Growth and the Cost of Equity 71 your chance to change the world Here at Ericsson we have a deep rooted belief that the innovations we make on a daily basis can have a profound effect on making the world a better place for people, business and society Join us In Germany we are especially looking for graduates as Integration Engineers for • Radio Access and IP Networks • IMS and IPTV We are looking forward to getting your application! To apply and for all current job openings please visit our web page: www.ericsson.com/careers Download free eBooks at bookboon.com Click on the ad to read more Strategic Financial Management Contents 5.8 Capital Growth and the Cost of Equity 72 5.9 Growth Estimates and the Cut-Off Rate 73 5.10 Earnings Valuation and the Cut-Off Rate 75 5.11 Summary and Conclusions 78 5.12 Selected References 78 6 Debt Valuation and the Cost of Capital 79 6.1 Capital Gearing (Leverage): An Introduction 80 6.2 The Value of Debt Capital and Capital Cost 80 6.3 The Tax-Deductibility of Debt 84 6.4 The Impact of Issue Costs 87 6.5 Summary and Conclusions 89 7 Capital Gearing and the Cost of Capital 91 7.1 The Weighted Average Cost of Capital (WACC) 92 7.2 WACC Assumptions 93 7.3 The Real-World Problems of WACC Estimation 95 7.4 Summary and Conclusions 100 7.5 Selected Reference 100 I joined MITAS because I wanted real responsibili� I joined MITAS because I wanted real responsibili� Real work International Internationa al opportunities �ree wo work or placements �e Graduate Programme for Engineers and Geoscientists Maersk.com/Mitas www.discovermitas.com Ma Month 16 I was a construction Mo supervisor ina const I was the North Sea super advising and the No he helping foremen advis ssolve problems Real work he helping fo International Internationa al opportunities �ree wo work or placements ssolve pr Download free eBooks at bookboon.com �e G for Engine Click on the ad to read more Strategic Financial Management Contents Part Four: The Wealth Decision 101 8 Shareholder Wealth and Value Added 102 8.1 The Concept of Economic Value Added (EVA) 103 8.2 The Concept of Market Value Added (MVA) 104 8.3 Profit and Cash Flow 104 8.4 EVA and Periodic MVA 105 8.5 NPV Maximisation, Value Added and Wealth 106 8.6 Summary and Conclusions 112 8.7 Selected References 114 DTU Summer University – for dedicated international students Application deadlines and programmes: Spend 3-4 weeks this summer at the highest ranked technical university in Scandinavia DTU’s English-taught Summer University is for dedicated international BSc students of engineering or related natural science programmes 31 15 30 March Arctic Technology March & 15 April Chemical/Biochemical Engineering April Telecommunication June Food Entrepreneurship Visit us at www.dtu.dk Download free eBooks at bookboon.com Click on the ad to read more Strategic Financial Management About the Author About the Author With an eclectic record of University teaching, research, publication, consultancy and curricula development, underpinned by running a successful business, Alan has been a member of national academic validation bodies and held senior external examinerships and lectureships at both undergraduate and postgraduate level in the UK and abroad With increasing demand for global e-learning, his attention is now focussed on the free provision of a financial textbook series, underpinned by a critique of contemporary capital market theory in volatile markets, published by bookboon.com To contact Alan, please visit Robert Alan Hill at www.linkedin.com Download free eBooks at bookboon.com Part One An Introduction Download free eBooks at bookboon.com 10 > @$FFHSW (TXLYDOHQW8WLOLW\ 8L :HLJKWHG8WLOLW\ 8L3L !> @5HMHFW Now look at the utility data, which rejects the project To understand why, assume you ask the investor to enter a game with a 50/50 chance of receiving nothing or £100k to which we attach arbitrary utility values of zero and one respectively Next you ask what the game is worth The investor’s response is £40k This represents their indifference between certain cash and the game Thus, three points on the individual’s utility curve associated with certain cash equivalents can be obtained (shown in bold) based on the following equation of indifference: (8) Certain Utility = Probabilistic Utility + U (£40,000) [0.5 U (£0) = 0.5(0)] + [0.5 U (£100,000) = 0.5 (1.0)] = 0.5 = Probabilistic Utility If the game’s entry price was £50k he would walk away However, other scale points, such as £50k (with a value of 0.65 say) can be established by gaming cash amounts for known utilities If the procedure is repeated exhaustively, the investor’s utility function consistent with his risk attitude will emerge, like the profile plotted in Figure 4.2 overleaf The curve’s geometry (if not its specific values) applies to any rational investor Except for small gambles relative to current wealth, it reveals risk aversion, denoted by the convex shape of the function (looking from above) Near the origin, the concave sector denotes risk preference Note that the utility of one for £100k is only twice that of 0.5 for £40k (which we originally calculated) but more than half the utility of £200k, as risk aversion sets in Returning to our example, the application of Equation (8) using the investor’s utility curve reveals that despite a positive ENPV the project should be rejected The utility of its cost exceeds the cash equivalent of the expected utility of the discounted cash flow distribution U (£50,000) = 0.65 > S{0.167+0.300+0.260+(0.075)+(0.152)} = 0.5 = U (£40,000) Review Activity Summarise the problems that confront practising financial managers who use certainty cash equivalents, rather than mean-variance as a basis for investment appraisal Download free eBooks at bookboon.com 63 Strategic Financial Management The Treatment of Uncertainty Figure 4.2: The Investor Utility Curve 4.6 Summary and Conclusions ENPV maximisation using the certainty cash equivalents of expected utilities is more sophisticated than mean-variance analysis because it not only incorporates probabilistic estimates of a project’s outcomes but also the investor’s risk psychology But remember: Utility functions, like project probability distributions, are subjective, differ from individual to individual, susceptible to change and must be combined (somehow) for group decisions Certainty cash equivalents, like mean-variance analyses, not only depend upon the borrowing and reinvestcdsment assumptions of the basic NPV model but must also utilise gains and losses discounted at a risk-free rate to avoid the duplication of risk 4.7 Reference Arnold, G.C and Hatzopoulos, P.D., “The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom”, Journal of Business Finance and Accounting, Vol 25 (5) and (6), June/July, 2000 Download free eBooks at bookboon.com 64 Part Three The Finance Decision Download free eBooks at bookboon.com 65 Strategic Financial Management Equity Valuation and the Cost of Capital 5 Equity Valuation and the Cost of Capital Introduction Part Two provided a detailed explanation of the investment decision with only oblique reference to the finance decision, which determines a company’s cost of capital (discount rate) designed to maximise shareholder wealth But if wealth is to be maximised, management must determine what return their shareholders require from an investment and then only accept projects that have a positive NPV when discounted at that rate There is also the question as to what cut-off rate should apply to investment proposals if corporate finance were obtained from a variety of sources, other than ordinary shares? Each stakeholder requires a rate of return that may differ from the equity market and may be unique In this newly leveraged situation, the company’s overall cost of capital (rather than its cost of equity) measured by its weighted, average cost of capital (WACC) would seem to be the appropriate investment acceptance criterion Download free eBooks at bookboon.com 66 Click on the ad to read more Strategic Financial Management Equity Valuation and the Cost of Capital Given the normative assumption of financial management, the purpose of Part Three is straightforward How does a firm maximise corporate wealth by securing funds at minimum cost that not only provides shareholders with their desired rate of return, once investment takes place, but also satisfies the expectations of all capital providers? To set the scene, Chapter Five provides an explanation of the most significant explicit, opportunity cost of external funding available to management The cost of ordinary shares measured by their rate of return, often termed the equity capitalisation rate or yield 5.1 The Capitalisation Concept In Chapter Two we defined an investment’s present value (PV) as its relevant periodic cash flows (Ct) discounted at a constant cost of capital (r) over time (n) Expressed algebraically: Q 39Q 6&W U ...R.A Hill Strategic Financial Management Download free eBooks at bookboon.com Strategic Financial Management 1st edition © 2008 R.A Hill & bookboon.com... bookboon.com 10 Strategic Financial Management Finance – An Overview Finance – An Overview Introduction In a world of geo-political, social and economic uncertainty, strategic financial management. .. *DLQV 6KDUHSULFH Figure 1.3: Strategic Financial Management Download free eBooks at bookboon.com 16 Strategic Financial Management 1.4 Finance – An Overview Decision Structures