Functional strategies - finance

1. Functional strategies - finance Alan Eardley/Geoff Leese November 2006, revised July 2007, August 2008, August 2009

2. Introduction • Reminder of study of functional strategies • Financial strategy issues • Financial strategy objectives • Capital structure (inc gearing) • Capital types • Sources of capital • International differences • Problems of “short-termism”

3. Top level or SBU strategy Functional Strategies Corporate strategy Manufacturing Strategy (week6) Finance Strategy (week 7) Marketing Strategy (week 7) HRM Strategy (week 8) • Examples of functional strategies: • depends on level of SBU • depends on type of business • depends on organisation

4. Finance strategy Issues covered by a typical financial strategy: • Raising capital and sources of funding • Long-term financial planning • Functional or departmental budgeting • Capital structuring ( and ‘gearing’) • Cash management • Reinvesting profits and cash surpluses • Capital investment appraisal All are more complicated for multinational corporations Manufacturing companies face particular problems

5. Finance strategy A good finance strategy helps the company to: • Replace and renew capital assets • Pay interest, share dividends and loans • Make sure funds are available • At the right time • At the lowest cost • Build up and manage reserves • To enable capital renewals (e.g. plant, vehicles) • To cover unforeseen events (e.g. shortages) • Enable long term growth • ‘Fend off’ or enable take-overs

6. Capital Structure How public limited companies obtain capital • Shares (flexibility vs loss of control) • Debentures (secured loans) • Can be repaid from profits or reserves • Loans and overdrafts (can be recalled) • Retained profits • No interest payments, recall or loss of control but • Can reduce share price – encourage take-over • Value of company exceed value of shares Capital structure needs to balance certain factors

7. Capital Structure Factors determining the choice of capital structure: • The risks inherent in the company’s markets • Ability to generate new profit/earning opportunities • Estimates of future costs, profits and investments • Confidence and attitudes of major shareholders • Attitudes of the company’s management • Tax liabilities • Need for flexibility Note the classic example of the decline of GEC from 70s to the ‘Marconi era’ – from ‘cash mountain’ to over-investment and decline in valuation

8. Gearing A very important factor in capital structuring • The ratio of borrowings* to total share capital • Affects the firm’s risk in various financial conditions High geared = risky for shareholders, but high return • More capital from borrowings • Less capital in shares Low geared = safe for shareholders, but lower return • More capital in shares • Less capital from borrowings * Borrowings includes debentures and loans, etc.

9. Capital types Firms use two types of capital: • Fixed capital (spent on fixed assets) • Land and buildings, plant etc. • Working capital (spent on consumables) • Stock, wages, operating expenses etc. These two are inter-related: FC investment creates profits = allows investment in WC WC can be invested in fixed assets There is often a gap between investment and profit that the company has to cover: • Short and long term finance sources • Cash flow

10. Capital types Short term finance • To cover ‘cash flow gap’ (trading cycle) • Overdraft, fixed-term loans, credit, debt factoring Long term finance • To finance long-lived assets • Term should equate to expected life of asset • Debentures and shares

11. Share dilution One way to raise more capital is to issue more shares to finance expansion, take over or profit-making activities BUT… This can have negative consequences, such as: • Profits must be spread among more shareholders • Reduced % dividend payable on each share This is share dilution, and can result in: • A decline in the market price of the shares • Vulnerability to take over • Lack of confidence in the management • Lower credit rating (poorer borrowing prospects) This is over capitalisation - under capitalisation is the opposite

12. Sources of capital 1 Shares (Ordinary and Preference) Public quotation on the UK Stock Exchange (SE) • Restrictions on ‘listing’ • Ready source of finance (when earnings high) • Improved public image (when successful) • Can make take over easier (and being taken over) • Shows worth of company ‘on the market’ • Reduces dependency on banks and lenders Alternative Investment Market (AIM) • Second-level securities market • Less restrictions than SE

13. Sources of capital 2 Venture capital • Sharestaken by a finance company • Takes dividend profit for defined period • Usually sells shares back* at end of period Usually goes with rapid company expansion Drawbacks of venture capital include: • Relatively high cost of capital (may be > 30%) • Need to account to venture capitalist • Restrictions on further borrowing (‘gearing’) • Possibility of loss of control of targets not met * At a price agreed in the original agreement May be said to encourage ‘short termism’ in UK industry

14. Sources of capital 3 Overseas – other EU stock markets (e.g. France) • Traditionally capital is in form of ‘borrowings’ • Some German firms have only 5% share capital • Banks and institutional investors are entrenched Therefore equity investment into UK is attractive • New affluence in ‘unified Europe’ • Lack of opportunities in local equity markets • EU banks have limited capacity for loans • Generally new EU investors are not ‘risk averse’ • Share investment is becoming fashionable • Development of EU stock markets (bourses)

15. Problems with ‘short termism’ TheContinental system favours long term investment • Reinvest profits without worrying about share price • Less worries about hostile ‘take over’ activity The opposite (‘short termism’) has some problems: • Failure to develop new infrastructures • Failure to exploit new technologies • Continuation of outdated production methods Countermeasures may make things worse: • Cutting back on advertising and promotions • Running down R&D projects • Skimping on maintenance and training etc.

16. Summary • Reminder of study of functional strategies • Financial strategy issues • Financial strategy objectives • Capital structure (inc gearing) • Capital types • Sources of capital • International differences • Problems of “short-termism”

17. Further reading • Bennett chapter 10 • Finance - follow the link! • American, but some good articles here! • Advice for small businesses - follow the link! • Lots of useful stuff here. Follow the link to “Finance and Grants” this week.