2.

FINANCIAL STRATEGY – EVALUATION

1. Financing Decisions
 The primary objective of a profit-making company is normally assumed to be to maximise
shareholder wealth.
 Investments will increase shareholder wealth if they cover the cost of capital and leave a surplus
for the shareholders.
 The lower the overall cost of capital the greater the wealth that is created.
 In order to be able to minimise the overall cost of finance, it is important initially to be able to
estimate the costs of each finance type.
 The cost of the different forms of capital will reflect their risk.
 Debt is lower risk than equity because debt ranks before equity in the event of a company
becoming insolvent, and because interest has to be paid.
 Therefore, debt will be cheaper than equity and the more security attached to the debt the
cheaper it should be.
 These cost of capital (WACC) calculations can be performed as part of
• an evaluation of different proposed financing strategies, or
• as part of an evaluation of the investment decision.

FINANCING DECISION F I N A N C I N G DEC I SI O N

IRR 14.00%
IRR 14.00%
SHAREHOLDERS… 3.20%
SHAREHOLDER… 5.20%
WACC 10.80%
WACC 8.80%

2. Assessing Corporate Performance – Financial Analysis/Ratio Analysis

2.1 Points to be considered on Financial Analysis or evaluation:

a) Perspective from Users of Financial Information
If users are shareholders – EPS, share price increase
If users are management – ROCE

b) Growth
Growth in turnover or profit normally be calculated
Look at the overall level of growth trends in it
Growth = (Figure in Year t/Figure in Year t-1) -1

c) Areas for analysis:

Profitability – how well a company performs, given its asset base
Liquidity – the short term financial position of the company
Gearing – the long-term financial position of the company

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Investor’s ratios – how well investors will appraise the company

d) Bases for comparison

Horizontal Analysis vs. Vertical Analysis
EG: Sales growth from last year vs. Gross Profit ratio
Comparison is likely to be one of the following:
 with previous years for the same company
 with other similar companies
 with industry averages

Within organization it is normal to reward management on some measure of profit such as ROI or RI.
In simple terms we would expect a close relationship between profit and shareholders’ wealth.

2.2 Assessing Corporate Performance – Financial Analysis/Ratio Analysis

Profitability Ratios:

Gearing ratios

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Liquidity ratios

Investor Ratio

PP 1: Splinter Co is considering selling its equity stake in Neptune Co.

Neptune Co. operates in a sector that is underperforming.
Over the past two years, sales revenue has fallen by an average of 8% per year in the sector.
Given below are extracts from the recent financial statements and other financial information for
Neptune Co and the sector.

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3. Risk Management

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Risk Types
 Market Risks  Environmental Risk
 Product Risk  Health & Safety Risk
 Commodity Price Risk  Business Probity Risk – related with
 Product Reputation Risk (Eg: TATA Nano) governance and ethics of the organization
 Credit Risk  Derivate Risk
 Currency Risk  Entrepreneurial Risk – associated with new
 Interest Rate Risk business or venture
 Political Risk  Financial Risk – Gearing Risk or Liquidity Risk
 Legal or Litigation Risk  Strategic Risk – possible consequences of
 Regulatory Risk strategic decisions
 Compliance Risk  Operational Risks – potential losses that
 Technological Risk might arise in business operations.

Business Risk further categorized by:

 Generic: affects all business
 Specific : affects individual business

Correlation between Risks

 Positive Correlation– means move in the same direction. Eg. Environmental risk and reputation risk.
 Negative Correlation – means move in opposite direction. Eg. Huge investment in Environmental
Equipment means increased financial risk and decreased environmental damage risk.

Business Risks
 Risk arising from an adverse event or
(accident/natural disaster)
 Risks arising from financial factors (financial
risk).
 the volatility of earnings due to the
financial policies of a business.
 Long-term financial risks are mainly
caused by the structure of finance;
the mix of equity and debt capital
 Short-term financial risk may include
 Interest rate risk
 Currency risk
 Credit risk
 Liquidity risk

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Non-Business Risks
 Political risk – the risk of government action which damages shareholder wealth (eg exchange
control regulations could be applied that may affect the ability of the subsidiary to remit profits to
the parent company).
 Economic risk – for example the risk of a downturn in the economy.
 Fiscal risk – including changes in tax policies which harm shareholder wealth.
 Operational risk – human error, breakdowns in internal procedures and systems.
 Reputational risk – damage to an organisation's reputation can result in lost revenues or significant
reductions in shareholder value.
 Business risks also includes some operational risks.
 Business risk is a mixture of systematic and unsystematic risk.

Rationale for Risk Management

 The risk is something that we concern about.
 But the return that organization is expecting is possible only when it is ready to assume some
kind of risks.
 Thus, stakeholders group do not want to eliminate risk for an organization at all.
 They could have different attitude to different types of risks therefore stakeholders like
shareholders, customers, employees, governments all have an influence on the company’s
strategy.

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Approach to Risk Management Process
1. Set Responsibilities
2. Set Risk Appetite
3. Identify risks
4. Assess Risks
5. Respond to risks
6. Monitor and review

1. Set Responsibilities
 The Board has overall accountability for risk management as a part of its Corporate Governance
responsibilities.
 The Board can delegate its responsibilities to separate line manager or a separate risk committee.

Risk Committee
 Set up by the Board
 Consist members of the Board
 The responsibility of risk management shall be taken up by the audit committee in the absence of
risk committee.

Risk Manager
Risk managers or analysts
 specialize in identifying potential causes of accidents or loss,
 recommending and implementing preventive measures, and
 devising plans to minimize costs and damage
 should a loss occur, including the purchase of insurance

2. Set Risk Appetite

 Different business will have different attitudes towards taking risks. Risk appetite normally depends
on risk attitude of management and risk capacity of organization.
 Risk-averse businesses may be willing to tolerate risk up to a point provided they receive an
acceptable return.
 Risk-seeking businesses are likely to focus on maximizing returns without worrying about the level
of risks.

Factors influencing risk appetite

 Personal views of individuals who vary in their attitudes
 Response to shareholders´ demand

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  Organizational influences – size, structure and stage of the development of the organization
 National influences

3. Identify risks
Methods of identifying risk or risk factors may be:
 Brainstorming and workshops
 Stakeholder consultation
 Benchmarking
 Scenario analysis
 Results of audits and inspections
 Use of standard checklists
 Risk registers

Risk Factors – that could impact the successful implementation of the strategy or the achievement of
the firm’s objective.
- Internal events
- External events
- Leading event indicators (overdue customers)

4. Assess risks
Risk assessment can be done through various methods:
Risk quantification- calculate possible results or losses and add on distributions and confidence limits,
value at risk, regression analysis, scenario planning, decision trees, etc.
Risk rating – prioritizing in terms of likelihood and impact
Sensitivity Analysis – "what-if" or simulation analysis and is a way to predict the outcome of a decision
given a certain range of variables.

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Expected Values – EV of loss = probability of loss *impact or size of potential loss
EV = ∑PX where, p= probability of outcome occurring, x = value of outcome
Accounting ratios – Debt ratios, gearing ratios, cash flow ratio, liquidity ratios

Subjectivity
One problem with risk quantification is its subjectivity. Example tossing of coin and getting head is
objective assessment but estimating the impact of risk of an accident is heavily influenced by
subjectivity.

5. Respond to risks
TARA (4T)
Organization will consider following approaches for the following combinations:
 Risk Transfer – low likelihood but high impact. Eg: earthquake, fire, etc.
 Risk Avoidance (Terminate) – high likelihood and high impact. Eg: activity that causes loss of
specialist staff.
 Risk Reduction (Treat) – high likelihood and low impact. Eg: activity that causes loss of lower level
staff.
 Risk Acceptance (Tolerate) – low likelihood and low impact. Eg: activity that causes loss of
insignificant suppliers.

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Diversifying Risks
Managing portfolio of assets which may be positively or negatively correlated or through forward or
backward integration or diversification in terms of product or market (Ansof matrix).

Usually Gross Risks (risks without mitigation) and Residual Risks (risk that remain once management
response to risk is give) are compared to assess how effective such risk response action has been.

6. Monitor and review the process and adapt if necessary

Review the process – wherein organization might ask the
following questions when assessing whether they
managed risks well enough or if there was something they
could have done differently:
Frequency of Review
Normally an annual review can be done as a best practice
of governance.
However, considering the dynamic nature of risks like
terrorist attack or periodic economic uncertainty, review
may occur more frequently.
Frequency of review may varies in relation to size,
structure and development of an organization.

4. Behavioral Finance
Conventional financial management is based on the assumption that markets are efficient, and that
investors behave in ways that are logical and rational.

Behavioural finance
 Behavioural finance is a relatively new field that seeks to combine behavioural and cognitive
psychological theory with conventional economics and finance to provide explanations for why
people make irrational financial decisions.
 Behavioural finance considers the impact of psychological factors on financial strategy.

Management behaviour
Hindsight bias and Overconfidence
 Tendency to overestimate their own abilities (overconfidence).
 Which may be caused because some past event was predictable and completely obvious (Hindsight
bias)

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 This may help to explain why many acquisitions are overvalued.
 This can lead to managers taking actions that may not be in their shareholders' best interests, such
as defending against a takeover bid.

Entrapment
 Managers are also reluctant to admit that they are wrong (they become trapped by their past
decisions, sometimes referred to as cognitive dissonance).
 This helps to explain why managers persist with financial strategies that are unlikely to succeed.
 Managers may feel that a failing strategy would damage their reputation, and possibly their future
prospects. Therefore, they may decide to commit more funds trying to ensure that the strategy is
successful (known as entrapment)

Agency issues
 Agency theory also highlights that managers may have different objectives from shareholders, such
as maximising their own short-term rewards and expanding the company by acquisition or other
means in order to enhance their own reputation.
 Analysis of these types of behavioural factors can help to evaluate possible causes behind a failing
financial strategy.

Search for patterns

 Investors look for patterns which can be used to justify investment decisions.
 This might involve analysing a company's past returns and using this to extrapolate future
performance, or comparing peaks or troughs in the stock market to historical peaks and troughs.
 This can lead to herding (social conformity that group cannot be wrong) and even cognitive
dissonance (not admitting that they are wrong)

Narrow framing
 Many investors fail to see the bigger picture and focus too much on short-term fluctuations in share
price movements;
 If a single share in a large portfolio performs badly in a particular week then, according to theories
such as CAPM, this should not matter greatly to an investor who is investing in a large portfolio of
shares over, say, a 20-year period.

Availability bias (Over-reaction)

 People will often focus more on information that is prominent (recent available).
 This may help to explain why share prices move significantly shortly after financial results are
published.
 Predictably over-react to new information, creating a larger-than-appropriate effect on a security's
price.

Anchoring
 Investors have a tendency to attach or 'anchor' their thoughts to a reference point – even though it
may have no logical relevance to the decision at hand.

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 Decisions may not be based on an assessment of relevant financial information, but on other readily
available information/grounds.

Conservatism
 Investors may be resistant to changing their opinion,
 for example, if a company's profits are better than expected the share price may not react
significantly because investors underreact to this news.

Gambler's fallacy
 Investors have a tendency to believe that the probability of a future outcome changes because of
the occurrence of various past outcomes
 For example. if the value of a share has risen for seven consecutive days, some investors might sell
the shares, believing that the share price is more likely to fall on the next day.
 This is analogous to tossing a coin once. We know that the outcome will either be a head or a tail,
not the expected value of ‘half a head’ or ‘half a tail’. But, expecting that head will occur because for
past 5 times tail has occurred.

Confirmation bias
 Investors having a preconceived opinion seeks information that supports their opinions or ideas,
while ignoring or rationalizing the rest.
 As a result, this bias can often result in faulty decision making because one-sided information tends
to skew an investor's frame of reference, leaving them with an incomplete picture of the situation.

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