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Strategic Financial Management. An Overview. Introduction. Finance is the middle ground between theoretical economics and the accounting world of numbers. Finance is applied economics. From another view, while accounting is the language of business, finance is the literature.
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Strategic Financial Management An Overview
Introduction • Finance is the middle ground between theoretical economics and the accounting world of numbers. Finance is applied economics. • From another view, while accounting is the language of business, finance is the literature. • Financial implications are at the heart of every business transaction and decision.
Introduction • Finance is not an end in and of itself. It is a tool, a most valuable tool used to communicate, judge, and monitor the results of business decisions. It is a tool well-suited for the boardroom as well as the shop floor; from the executive suite to the distribution center; from corporate and divisional staff offices to a distant sales office. • In a world of geo-political, social and economic uncertainty, strategic financial management is in a process of change, which requires a reassessment of the fundamental assumptions that cut across the traditional boundaries of the subject.
Objectives of a Firm • 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) is what we term normative theory. Normative financial theory dictates what financial managers "ought to do" when faced with financial decisions. Positive, or descriptive, financial theory includes both research designed to find relationships among variables and surveys designed to find out what financial managers are actually doing. Positive studies have revealed that financial managers do not always act in the way that normative theories would say is appropriate for the situation.
Investors maximize their wealth by selecting optimum investment and financing opportunities, using financial models that maximize expected returns in absolute terms at minimum risk. • It represents the foundation of modern finance within which:
What concerns investors is not simply maximum profit but also the likelihood of it arising: a risk-return trade-off from a portfolio of investments, 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 separated from its 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 (shareholders) by placing them all in 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 include alternative providers 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. • As employees, management’s own satisficing behavior should also be subordinate to those to whom they are ultimately accountable, namely their shareholders, even though empirical evidence and financial scandals have long cast doubt on managerial motivation.
In our ideal world, firms exist to convert inputs of physical and money capital into outputs of goods and services that satisfy consumer demand to generate money profits. Since most economic resources are limited but society’s demand seems unlimited, the corporate management function can be perceived as the future allocation of scarce resources with a view to maximizing consumer satisfaction. And because money capital (as opposed to labor) is typically the limiting factor, the strategic problem for financial management is how limited funds are allocated between alternative uses. • The pioneering work of Jenson and Meckling resolves this dilemma by defining corporate management as agents of the firm’s owners, who are termed the principals. The former are authorized not only to act on the behalf of the latter, but also in their best interests.
Armed with agency theory, you will discover that the function of strategic financial management can be deconstructed into 4 major components based on the mathematical concept of expected net present value (ENPV) maximization: • Explained simply, the market price equity (shares) acts as a control on management’s actions because if shareholders (principals) are dissatisfied with managerial (agency) performance they can always sell part or all of their holding and move funds elsewhere. The investment, dividend, financing, and portfolio decision
Axiom 1: The risk-return tradeoff • We won’t take additional risk unless we expect to be compensated with additional return. Almost all financial decisions involve some sort of risk-return trade off.
Axiom 2: The time value of money • A dollar received today is worth more than a dollar received in the future
Axiom 3: Cash-Not Profits-is King • In measuring value we will use cash flows rather than accounting profits because it is only cash flows that the firm receives and is able to reinvest.
Axiom 4: Incremental cash flows • It is only what changes that counts. In making business decisions we will only concern ourselves with what happens as a result of that decision.
Axiom 5: The Curse of competitive markets • Why it’s hard to find exceptionally profitable projects. • In competitive markets, extremely large profits cannot exist for very long because of competition moving in to exploit those large profits. As a result, profitable projects can only be found if the market is made less competitive, either through product differentiation or by achieving a cost advantage.
Axiom 6: Efficient capital markets • The markets are quick and the prices are right
Axiom 7: The agency problem • Managers won’t work for the owners unless it’s in their best interest. • The agency problem is a result of the separation between the decision makers and the owners of the firm. As a result, managers may make decisions that are not in line with the goal of maximization of shareholder wealth.
Axiom 9: All risk is not equal • All risk is not equal since some risks can be diversified away and some cannot. The process of diversification can reduce risk, and as a result, measuring a project’s or an asset’s risk is very difficult.
Axiom 10: Ethical dilemmas are everywhere in finance • Ethical behavior is important in financial management, just as it is important in everything we do. Unfortunately, precisely how we define what is and what is not ethical behavior is sometimes difficult. Nevertheless, we should not give up the quest.
