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1Financial Policy and Corporate Strategy

Learning Objectives

After reading this chapter student shall be able to understand:

Strategic Financial Decision Making Frame Work Strategy at different hierarchy levels Financial Planning Interface of Financial Policy and Strategic Management Balancing Financial Goals vis--vis Sustainable Growth Principles of Valuation1.0 Strategic Financial Decis ion Making Frame Work

Capital investment is the springboard for wealth creation. In a world of economic uncertainty,the investors want to maximize their wealth by selecting optimum investment and financial

opportunities that will give them maximum expected returns at minimum risk. Sincemanagement is ultimately responsible to the investors, the objective of corporate financialmanagement should implement investment and financing decisions which should satisfy theshareholders by placing them all in an equal, optimum financial position. The satisfaction of

the interests of the shareholders should be perceived as a means to an end, namelymaximization of shareholders wealth. Since capital is the limiting factor, the problem that the

management will face is the strategic allocation of limited funds between alternative uses in

such a manner, that the companies have the ability to sustain or increase investor returnsthrough a continual search for investment opportunities that generate funds for their business

and are more favourable for the investors. Therefore, all businesses need to have the

following three fundamental essential elements:

A clear and realisticstrategy, The financial resources, controls and systems to see it through and The right managementteam and processes to make it happen.We may summarise this by saying that:

Strategy + Finance + Management = the fu ndamentals o f bus iness

Strategymay be defined as the long term direction and scope of an organization to achieve

competitive advantage through the configuration of resources within a changing environmentfor the fulfilment of stakeholders aspirations and expectations. In an idealized world,

The Institute of Chartered Accountants of India


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1.2 Strategic Financi al Management

management is ultimately responsible to the investors. Investors maximize their wealth byselecting optimum investment and financing opportunities, using financial models thatmaximize expected returns in absolute terms at minimum risk. What concerns the 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 eachindividual.

We call this overall approach strategic financial management and define it as being the

application to strategic decisions of financial techniques in order to help achieve the decision-

maker's objectives. Although linked with accounting, the focus of strategic financialmanagement is different. Strategic financial management combines the backward-looking,report-focused discipline of (financial) accounting with the more dynamic, forward-looking

subject of financial management. It is basically about the identification of the possiblestrategies capable of maximizing an organization's market value. It involves the allocation of

scarce capital resources among competing opportunities. It also encompasses the

implementation and monitoring of the chosen strategy so as to achieve agreed objectives.

1.1 Functions of Strategic Financial Management: Strategic Financial Management is theportfolio constituent of the corporate strategic plan that embraces the optimum investment and

financing decisions required to attain the overall specified objectives. In this connection, it isnecessary to distinguish between strategic, tactical and operational financial planning. While

strategy is a long-term course of action, tactics are intermediate plan, while operations areshort-term functions. Senior management decides strategy, middle level decides tactics and

operational are looked after line management.

Irrespective of the time horizon, the investment and financial decisions functions involve the

following functions1:

Continual search for best investment opportunities Selection of the best profitable opportunities Determination of optimal mix of funds for the opportunities Establishment of systems for internal controls Analysis of results for future decision-making.Since capital is the limiting factor, the strategic problem for financial management is howlimited funds are allocated between alternative uses. This dilemma of corporate management

is resolved by the pioneering work of Jenson and Meckling (1976)2, which is popularly known

as agency theory. Agency theory refers to a set of propositions in governing a moderncorporation which is typically characterized by large number of shareholders or owners who

allow separate individuals to control and direct the use of their collective capital for futuregains. These individuals, typically, may not always own shares but may possess relevant

1 Strategic Financial Management: Exercises, Robert Alan Hill.2 Jensen, M.C> & W.C. Meckling (1976), Theory of the Firm: Managerial Behaviour, Agency Costs and

Ownership Structure,Journal of Financial Economics, October, V.3,4, pp. 305-360



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Financi al Polic y and Corporate Strategy 1.3

professional skills in managing the corporation. The theory offers many useful ways toexamine the relationship between owners and managers and verify how the final objective ofmaximizing the returns to the owners is achieved, particularly when the managers do not own

the corporations resources. According to this theory, strategic financial management is the

function of four major components based on the mathematical concept of expected NPV (netpresent value) maximization, which are:

1. Investment decision2. Dividend decision3. Financing decision and4. Portfolio decision.The key decisions falling within the scope of financial strategy include the following:

1. Financial decisions:This deals with the mode of financing or mix of equity capital and

debt capital. If it is possible to alter the total value of the company by alteration in the capitalstructure of the company, then an optimal financial mix would exist - where the market value

of the company is maximized.

2. Investment decision:This involves the profitable utilization of firm's funds especially in

long-term projects (capital projects). Because the future benefits associated with such projectsare not known with certainty, investment decisions necessarily involve risk. The projects aretherefore evaluated in relation to their expected return and risk. These are the factors that

ultimately determine the market value of the company. To maximize the market value of the

company, the financial manager will be interested in those projects with maximum returns andminimum risk. An understanding of cost of capital, capital structure and portfolio theory is a

prerequisite here.

3. Dividend decision: Dividend decision determines the division of earnings between

payments to shareholders and reinvestment in the company. Retained earnings are one of themost significant sources of funds for financing corporate growth, dividends constitute the cash

flows that accrue to shareholders. Although both growth and dividends are desirable, thesegoals are in conflict with each other. A higher dividend rate means less retained earnings andconsequently slower rate of growth in future earnings and share prices. The finance manager

must provide reasonable answer to this conflict.

4. Portfolio decision: Portfolio Analysis is a method of evaluating investments based on their

contribution to the aggregate performance of the entire corporation rather than on the isolatedcharacteristics of the investments themselves. When performing portfolio analysis, information

is gathered about the individual investments available, and then chooses the projects that help

to meet all of our goals in all of the years that are of concern. Portfolio theory, as firstconceived in the 1950s by Dr. Harry Markowitz, provided a classic model for managing riskand reward. Markowitz realized that stocks and bonds interacted in a predictable manner (i.e.,

when one class of stock went down, others tended to go up), and by managing theseinteractions he could diversify risk. Strategic Portfolio Management takes the insights gained

from portfolio analysis and integrates them into the decision making process of a corporation.



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1.2 Strategic Decision Models and Characteristics: For the past few decades, researchershave attempted to model the strategic decision process and identify the major types orcategories of strategic decisions. This is a difficult task since strategic decisions are often

described as "unstructured", "unprogrammed", and "messy". Mintzberg, Raisinghani, and

Theoret (1976)3 provided an early attempt at modeling the process of strategic decisionmaking and identified three major phases with subroutines or subphases within each. These

included the following:

The Identificatio n phase

1. The Decision Recognition Routine: Opportunities, problems, and crisis are recognized and

evoke decisional activity.

2. The Diagnosis Routine: Information relevant to opportunities, problems, and crisis iscollected and problems are more clearly identified.

The Development phase

1. The Search Routine: Organizational decision makers go through a number of activities to

generate alternative solutions to problems.

2. The Design Routine: Ready-made solutions which have been identified are modified to fit

the particular problem or new solutions are designed.

The Selection Phase

The Screen Routine: This routine is activated when the search routine identifies morealternatives than can be intensively evaluated. Alternatives are quickly scanned and the most

obviously infeasible ones are eliminated.

2.0 Strategy at Different Hierarchy Levels

Strategies at different levels are the outcomes of different planning needs. The three Levels of

an enterprise strategy are

1. Corporate level2. Business unit level3. Functional or departmental level2.1 Corporate Level Strategy: Corporate level strategy fundamentally is concerned with

selection of businesses in which a company should compete and with development and

coordination of that portfolio of businesses. Corporate level strategy is concerned with:

Reach defining the issues that are corporate responsibilities. These might includeidentifying the overall vision, mission, and goals of the corporation, the type of business a

corporation should be involved, and the way in which businesses will be integrated and

managed.

3Mintzberg, H., Raisinghani, D., & Theoret, A. (1976). The structure of unstructured decision processes.Administrat ive Science Quarterl y, 21, 246-275.



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Competitive Contact defining where in a corporation competition is to be localized. Managing Activities and Business Interrelationships corporate strategy seeks to develop

synergies by sharing and coordinating staff and other resources across business units,investing financial resources across business units, and using business units to

complement other corporate business activities.

Management Practices corporations decide how business units are to be governed:through direct corporate intervention (centralization) or through autonomous governance

(decentralization).

2.2 Business Unit Level Strategy: Strategic business unit may be any profit centre that can

be planned independently from the other business units of your corporation. At the business

unit level, the strategic issues are about both practical coordination of operating units andabout developing and sustaining a competitive advantage for the products and services that

are produced.

2.3 Functional Level Strategy: The functional level of your organization is the level of theoperating divisions and departments. The strategic issues at the functional level are related tofunctional business processes and value chain. Functional level strategies in R&D, operations,

manufacturing, marketing, finance, and human resources involve the development and

coordination of resources through which business unit level strategies can be executedeffectively and efficiently. Functional units of your organization are involved in higher level

strategies by providing input into the business unit level and corporate level strategy, such asproviding information on customer feedback or on resources and capabilities on which the

higher level strategies can be based. Once the higher level strategy or strategic intent isdeveloped, the functional units translate them into discrete action plans that each department

or division must accomplish for the strategy to succeed.

Among the different functional activities viz production, marketing, finance, human resourcesand research and development, finance assumes highest importance during the top down and

bottom up interaction of planning. Corporate strategy deals with deployment of resources and

financial strategy is mainly concerned with mobilization and effective utilization of money, themost critical resource that a business firm likes to have under its command. Truly speaking,other resources can be easily mobilized if the firm has adequate monetary base. To go into

the details of this interface between financial strategy and corporate strategy and financialplanning and corporate planning let us examine the basic issues addressed under financial

planning.

3.0 Financial Planning

Financial planning is the backbone of the business planning and corporate planning. It helps in

defining the feasible area of operation for all types of activities and thereby defines the overallplanning framework. Financial planning is a systematic approach whereby the financial

planner helps the customer to maximize his existing financial resources by utilizing financial

tools to achieve his financial goals.

Financial planning is simple mathematics. There are 3 major components:



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Financial Resources (FR) Financial Tools (FT) Financial Goals (FG)Financial Planning: FR + FT = FG

In other words, financial planning is the process of meeting your life goals through proper

management of your finances. Life goals can include buying a home, saving for your children'seducation or planning for retirement. It is a process that consists of specific steps that helpyou to take a big-picture look at where you financially are. Using these steps you can work out

where you are now, what you may need in the future and what you must do to reach your

goals.

Outcomes of the financial planning are the financial objectives, financial decision-making andfinancial measures for the evaluation of the corporate performance. Financial objectives are to

be decided at the very out set so that rest of the decisions can be taken accordingly. The

objectives need to be consistent with the corporate mission and corporate objectives.

There is a general belief that profit maximization is the main financial objective. In reality, it is

not. Profit may be an important consideration but not its maximization.

Profit maximization does not consider risk or uncertainty, whereas wealth maximization does.Let us Consider two projects, A and B, and their projected earnings over the next 5 years, as

shown below:

Year Product A Product B

1 10,000 11,000

2 10,000 11,000

3 10,000 11,0004 10,000 11,000

5 10,000 11,000

50,000 55,000

A profit maximization approach would favor project B over project A. However, if project B is

more risky than project A, then the decision is not as straightforward as the figures seem toindicate. It is important to realize that a trade-off exists between risk and return. Stockholders

expect greater returns from investments of higher risk and vice versa. To choose projectt B,

stockholders would demand a sufficiently large return to compensate for the comparativelygreater level of risk.

According to Drucker, profit is the least imperfect measure of organizational efficiency and

should remain the main consideration of a firm to cover the cost of survival and to support thefuture expansion plans. But profit maximization as a financial objective suffers from multiple

limitations. Firstly the level of operation for long run profit maximization may not match withthe optimum levels under short run profit maximization goal. In that case, if one assigns more

importance to short run profit maximization and avoids many activities like skill development,training programme, machine maintenance and after sales service, long run survival even may

be at a stake and long run profit maximization may become a day dreaming concept. In the



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reverse case, short run shortcomings may have telling effects on the organizationalperformance and hence long run profit maximization may gradually become an impossible

proposition in comparison to stronger competitors performances.

Profit maximization also ignores an important aspect of strategic planning. Risk considerationhas rarely been incorporated in the profit maximization rule. As a result two projects with same

expected profit are equally good under profit consideration. Under the profit cum riskconsideration the project with lesser variability will be preferred by the investor than the one

with higher variability. Higher variability means higher risk and lower variability means lower

risk. Problem becomes more involved when both expected profits and their variability areunequal and reversibly ordered. Decision making based on usual expected profit consideration

will be of limited use for such situations.

It is also worth pointing out that profit maximization objective does not take into considerationeffects of time. It treats inflows of equal magnitude to be received at different time points as

equal and thereby ignores the fact that money values changes over time. Conceptually, abenefit of an amount Akreceived in the k-th year cannot be identical with a series of benefits

received at the rate A for each of the k years. The later scheme may be more beneficial for afirm than the former one. Unfortunately profit maximization or benefit maximization approach

fails to discriminate between these two alternatives and remains indifferent.

In view of the above limitations of the profit maximization approach choice of financial

objective needs a strategic look. The obvious choice in that case may be expressed in termsof wealth maximization where wealth is to be measured in terms of its net present value to

take care of both risk and time factors. Wealth ensures financial strength of the firm, long termsolvency and viability. It can be used, as a decision criterion in a precisely defined mannerand can reflect the business efficiency without any scope for ambiguity. There are some

related issues that may draw attention of the planners during the interface of financial planning

and strategic planning. Cash flow, credit position and liquidity are those three criticalconsiderations.

Cash flow is the most vital consideration for the business firm. It deals with the movement of

cash and as a matter of conventions, refers to surplus of internally generated funds over

expenditures. To prepare a cash flow statement, all the factors that increase cash and thosethat decrease cash are to be identified from the income and expenditure statements. This

information is to be then presented in a consolidated form for taking strategic decisions onnew investments and borrowings. A substantially positive cash flow may enable the firm tofund new projects without borrowing cash from investors or bankers. Borrowing means paying

interest and is some sort of weakness for the firm. Internal generation of cash and internal

funding of projects add to the strength of the firm. Thus objective should be to enjoy anattractive cash flow situation.

Generation of cash from internal activities depends on the industry life cycle. At the initial

stage, i.e. the stage of introduction and the stage of growth, the firm makes reinvestment of

cash in operations to meet cash needs of the business. By operations we refer to activitiesthat change the utility of any input. Product research and product design are the key

operations during the stage of introduction. Installation of plant and facilities and addition to



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capacity for meeting the increased demand are the key operational requirements during thestage of growth. The stage of growth is also marked in the aggressive promotional activities.And all these operations need huge investment. During the stage of shakeout and maturity,

the need for excess investment declines sharply. This enables the firm to generate positive

cash flow. Thus, the cash flow position of a firm changes from weakness to strength as theindustry of the other matures. During the stage of decline reversal of this process take place;the decrease in demand increases the cost of production. The cost of promotion increases so

rapidly that the outflow of cash soon takes over the inflow of the same resulting in cash

drainage. Thus industry life cycle has a role to play in cash flow planning.

Credit position of the business firm describes its strength in mobilizing borrowed money. Incase the internal generation of cash position is weak, the firm may exploit its strong credit

position to go ahead in the expansion of its activities. There are basically two ways ofstrengthening the credit position. The first way is to avoid unnecessary borrowings. If the level

of current debt is low the firm is likely to enjoy reasonable credit in future. The other way of

enjoying credit facilities is to create the awareness about the future business prospect Forexample if awareness can be created in the mind of the investors and others about quick andhigh growth and steady and long maturity prospects of an industry then it will be easier for the

company to get external funds irrespective of its current cash flow position.

Conversely borrowing will be extremely difficult if the industry enters into a declining stage of

life cycle curve. Since bankers and investors are generally interested in long run results andbenefits and are willing to forego short run benefits, choice of the business field is very

important for attracting investors and creditors. Thus to be in, or not be in is dependent on

cash flow position and credit position of the firm and these are in turn dependent on the positionof the offer in respect of the life cycle curve, market demand and available technology.

Liquidity position of the business describes the extent of idle working capital. It measures the

ability of the firm in handling unforeseen contingencies. Firms into major investments in fixedassets are likely to enjoy less liquidity than firms with lower level of fixed assets. The liquidity

of the firm is measured in terms of current assets and current liabilities. If the current assetsare more than the current liabilities the firm is said to be liquid. For example a drop in demand

due to sudden arrival of competitive brand in the market may cause a crisis for liquid cash. Incase the firm has excess current assets which are easily encashable, it will be able to

overcome the crisis in the short run and draw new strategic plan and develop new strategic

posture to rewinover the competitors in the long run.

4.0 Interface of Financial Policy and Strategic Management

The interface of strategic management and financial policy will be clearly understood if we

appreciate the fact that the starting point of an organization is money and the end point of that

organization is also money. No organization can run an existing business and promote a newexpansion project without a suitable internally mobilized financial base or both internally and

externally mobilized financial base.

Sources of finance and capital structure are the most important dimensions of a strategic plan.

We have already emphasized on the need for fund mobilization to support the expansion



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activity of firm. The generation of funds may arise out of ownership capital and or borrowedcapital. A company may issue equity shares and / or preference shares for mobilizingownership capital. Preference Share holders as the name stands enjoy preferential rights in

respect of dividend and return of capital. Holders of equity shares do not enjoy any such

special right regarding dividend and return of capital. There are different types of preferenceshares like cumulative convertible preference shares which are convertible into equity sharesbetween the end of the third year and the fifth year. Rate of dividend paid till conversion into

equity shares remains constant. Debentures, on the other hand, are issued to raise borrowedcapital. These are of varying terms and conditions in respect of interest rate, conversion into

shares and return of investment. Public deposits, for a fixed time period, have also become a

major source of short and medium term finance. Organizations may offer higher rates of

interest than banking institutions to attract investors and raise fund. The overdraft, cashcredits, bill discounting, bank loan and trade credit are the other sources of short term finance.

Along with the mobilization of funds, policy makers should decide on the capital structure to

indicate the desired mix of equity capital and debt capital. There are some norms for debtequity ratio. These are aimed at minimizing the risks of excessive loans, for public sectororganizations the norm is 1:1 ratio and for private sector firms the norm is 2:1 ratio. However

this ratio in its ideal form varies from industry to industry. It also depends on the planningmode of the organization under study. For capital intensive industries, the proportion of debt to

equity is much higher. Similar is the case for high cost projects in priority sectors and for

projects in under developed regions.

Another important dimension of strategic management and financial policy interface is the

investment and fund allocation decisions. A planner has to frame policies for regulatinginvestments in fixed assets and for restraining of current assets. Investment proposals mootedby different business units may be divided into three groups. One type of proposal will be for

addition of a new product to the fold of offer of the firm. Another type of proposal will be toincrease the level of operation of an existing product through either an increase in capacity in

the existing plant or setting up of another plant for meeting additional capacity requirement.There is yet another type of proposal. It pleads for cost reduction and efficient utilization of

resources through a new approach and or closer monitoring of the different critical activities.Now, given these three types of proposals a planner should evaluate each one of them by

making within group comparison in the light of capital budgeting exercise, In fact projectevaluation and project selection are the two most important jobs under fund allocation.

Planners task is to make the best possible allocation under resource constraints.Dividend policy is yet another area for making financial policy decisions affecting the strategicperformance of the company. A close interface is needed to frame the policy to be beneficial

for all. Dividend policy decision deals with the extent of earnings to be distributed as dividend

and the extent of earnings to be retained for future expansion scheme of the firm. From thepoint of view of long term funding of business growth, dividend can be considered as that part

of total earnings, which cannot be profitably utilized by the company. Stability of the dividendpayment is a desirable consideration that can have a positive impact on share price. Thealternative policy of paying a constant percentage of the net earnings may be preferable from

the point of view of both flexibility of the firm and ability of the firm. It also gives a message of



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lesser risk for the investors. Yet some other companies follow a different alternative. They paya minimum dividend per share and additional dividend when earnings are higher than thenormal earnings. In actual practice, investment opportunities and financial needs of the firm

and the shareholders preference for dividend against capital gains resulting out of share are to

be taken into consideration for arriving at the right dividend policy. Alternatives like cashdividend and stock dividend are also to be examined while working out an ideal dividend policy

that supports and promotes the corporate strategy of the company.

It may be noted from the above discussions that financial policy of a company cannot beworked out in isolation of other functional policies. It has a wider appeal and closer link with

the overall organizational performance and direction of growth. These policies being related toexternal awareness about the firm, specially the awareness of the investors about the firm, in

respect of its internal performance. There is always a process of evaluation active in the mindsof the current and future stake holders of the company. As a result preference and patronage

for the company depends significantly on the financial policy framework. And hence attention

of the corporate planners must be drawn while framing the financial policies not at a laterstage but during the stage of corporate planning itself. The nature of interdependence is thecrucial factor to be studied and modelled by using an in depth analytical approach. This is a

very difficult task compared to usual cause and effect study because corporate strategy is thecause and financial policy is the effect and sometimes financial policy is the cause and

corporate strategy is the effect. This calls for a bipolar move.

5.0 Balancing Financial Goals Vis-a-Vis Sustainable Growth

The concept of sustainable growth can be helpful for planning healthy corporate growth. Thisconcept forces managers to consider the financial consequences of sales increases and to setsales growth goals that are consistent with the operating and financial policies of the firm.

Often, a conflict can arise if growth objectives are not consistent with the value of theorganization's sustainable growth. Question concerning right distribution of resources may

take a difficult shape if we take into consideration the rightness not for the currentstakeholders but for the future stake holders also. To take one illustration, let us refer to fuel

industry where resources are limited in quantity and a judicial use of resources is needed tocater to the need of the future customers along with the need of the present customers. One

may have noticed the save fuel campaign, a demarketing campaign that deviates from theusual approach of sales growth strategy and preaches for conservation of fuel for their use

across generation. This is an example of stable growth strategy adopted by the oil industry asa whole under resource constraints and the long run objective of survival over years.

Incremental growth strategy, profit strategy and pause strategy are other variants of stable

growth strategy.

The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that canbe achieved, given the firm's profitability, asset utilization, and desired dividend payout and

debt (financial leverage) ratios. Variables typically include the net profit margin on new andexisting revenues; the asset turnover ratio, which is the ratio of sales revenues to total assets;

the assets to beginning of period equity ratio; and the retention rate, which is defined as the

fraction of earnings retained in the business.



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Sustainable growth models assume that the business wants to: 1) maintain a target capitalstructure without issuing new equity; 2) maintain a target dividend payment ratio; and 3)increase sales as rapidly as market conditions allow. Since the asset to beginning of period

equity ratio is constant and the firm's only source of new equity is retained earnings, sales and

assets cannot grow any faster than the retained earnings plus the additional debt that theretained earnings can support. The sustainable growth rate is consistent with the observedevidence that most corporations are reluctant to issue new equity. If, however, the firm is

willing to issue additional equity, there is in principle no financial constraint on its growth rate.Indeed, the sustainable growth rate formula is directly predicated on return on equity.

"Assuming asset growth broadly parallels sales growth, the SGR is calculated as the retained

[return on equity], i.e. your company's [return on equity] minus the dividend payout

percentage," wrote John Costa in Outlook4

. "Just as the break-even point is the 'floor' forminimum sales required to cover operating expenses, so the SGR is an estimate of the

'ceiling' for maximum sales growth that can be achieved without exhausting operating cash

flows.

Economists and business researchers contend that achieving sustainable growth is notpossible without paying heed to twin cornerstones: growth strategy and growth capability.

Companies that pay inadequate attention to one aspect or the other are doomed to failure intheir efforts to establish practices of sustainable growth (though short-term gains may be

realized). After all, if a company has an excellent growth strategy in place, but has not put the

necessary infrastructure in place to execute that strategy, long-term growth is impossible. Thereverse is true as well.

The very weak idea of sustainability requires that the overall stock of capital assets shouldremain constant. The weak version of sustainability refers to preservation of critical resources

to ensure support for all, over a long time horizon .The strong concept of sustainability isconcerned with the preservation of resources under the primacy of ecosystem functioning.These are in line with the definition provided by the economists in the context of sustainable

development at macro level

In terms of economic dimension sustainable development rejects the idea that the logistic

system of a firm should be knowingly designed to satisfy the unlimited wants of the economicperson. A firm has to think more about the collective needs and less about the personal

needs. This calls for taking initiatives to modify, to some extent, the human behaviour.Sustainability also means development of the capability for replicating ones activity on a

sustainable basis. The other economics dimension of sustainability is to decouple the growthin output of firm from the environmental impacts of the same. By decoupling we mean

development of technology for more efficient use of resource. Complete decoupling isunrealistic from the thermodynamic angle but the materials balance principle demands for

decoupling and hence attempts should be made by the firm to be more and more decoupled.

4Costa, John. "Challenging Growth: How to Keep Your Company's Rapid Expansion on Track." Outlook. Summer1997



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The sustainable growth model is particularly helpful in situations in which a borrower requestsadditional financing. The need for additional loans creates a potentially risky situation of toomuch debt and too little equity. Either additional equity must be raised or the borrower will

have to reduce the rate of expansion to a level that can be sustained without an increase in

financial leverage.

Mature firms often have actual growth rates that are less than the sustainable growth rate. Inthese cases, management's principal objective is finding productive uses for the cash flows

that exist in excess of their needs. Options available to business owners and executives insuch cases including returning the money to shareholders through increased dividends or

common stock repurchases, reducing the firm's debt load, or increasing possession of lowerearning liquid assets. Note that these actions serve to decrease the sustainable growth rate.

Alternatively, these firms can attempt to enhance their actual growth rates through theacquisition of rapidly growing companies.

Growth can come from two sources: increased volume and inflation. The inflationary increasein assets must be financed as though it were real growth. Inflation increases the amount of

external financing required and increases the debt-to-equity ratio when this ratio is measuredon a historical cost basis. Thus, if creditors require that a firm's historical cost debt-to-equity

ratio stay constant, inflation lowers the firm's sustainable growth rate.

6.0 Princ iples of Valuation

The evaluation of sustainable growth strategy calls for interface of financial planning approach

with strategic planning approach. Choice of the degree of sustainability approach forsustainability and modification in the sustainability principle must be based on financial

evaluation of the alternative schemes in terms of financial and overall corporate objectives.Basically there are two alternative methods for evaluation. One is known as valuation method

and the other one is known as pricing method. Valuation method depends on demand curveapproach by either making use of expressed preferences or making use of revealed

preference.

In finance, valuation is the process of estimating the potential market value of a financial assetor liability. Valuations can be done on assets (for example, investments in marketable

securities such as stocks, options, business enterprises, or intangible assets such as patents

and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required inmany contexts including investment analysis, capital budgeting, merger and acquisition

transactions, financial reporting, taxable events to determine the proper tax liability, and in

litigation.

Valuation of financial assets is done using one or more of these types of models:

1. Discounted Cash Flows determine the value by estimating the expected future earningsfrom owning the asset discounted to their present value.

2. Relative value models determine the value based on the market prices of similar assets.3. Option pricing models are used for certain types of financial assets (e.g., warrants, put

options, call options, employee stock options, investments with embedded options such



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as a callable bond) and are a complex present value model. The most common optionpricing models are the Black-Scholes-Merton model and lattice models.

Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare

this required rate of return to the asset's estimated rate of return over a specific investmenthorizon to determine whether it would be an appropriate investment. To make this comparison,

you need an independent estimate of the return outlook for the security based on either

fundamental or technical analysis techniques, including P/E, M/B etc.

In theory, therefore, an asset is correctly priced when its estimated price is the same as therequired rates of return calculated using the CAPM. What does Capital Asset Pricing Model -

CAPMmean?

A model that describes the relationship between risk and expected return and that is used inthe pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time

value of money and risk. The time value of money is represented by the risk-free (rf) rate in

the formula and compensates the investors for placing money in any investment over a periodof time. The other half of the formula represents risk and calculates the amount of

compensation the investor needs for taking on additional risk. This is calculated by taking arisk measure (beta) that compares the returns of the asset to the market over a period of time

and to the market premium (Rm-Rf).

If the estimate price is higher than the CAPM valuation, then the asset is undervalued (and

overvalued when the estimated price is below the CAPM valuation). The CAPM says that theexpected return of a security or a portfolio equals the rate on a risk-free security plus a risk

premium. If this expected return does not meet or beat the required return, then theinvestment should not be undertaken. The security market line plots the results of the CAPM

for all different risks (betas).Using the CAPM model and the following assumptions, we can

compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, thebeta (risk measure) of the stock is 2 and the expected market return over the period is 10%,

the stock is expected to return 17% [3% + 2(10% - 3%)].

Valuation methods are in general more complex in implementation than pricing methods. Butdemand curve methods are more useful for cases where it seems likely that disparity between

price and value is high.

After the evaluation comes the question of policy choice. In case of sustainable growth theconventional cost benefit analysis may not be an appropriate tool for making choice decision.

This is due to the fact that conventional cost benefit analysis is based on the principle of



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allocation of resources for maximizing internal benefit. It has no in built sustainability criterionto guarantee that a constant stock of natural resources will be passed between current andfuture users. This problem comes up because conventional cost-benefit analysis draws no

distinction between natural capital and man made capital and is considered to be equitable.

One proposed sustainability criterion is due to Turner and Pearce who advocated the constant

natural assets rule. Their compensation principle requires the passing on the future users astock of natural assets which is no smaller than the stock in the possession of current users.

According to them Hicks Kaldor potential compensation rule should be extended further sothat there will be actual compensation rule for natural resources. Within the constant natural

assets rule the extended cost-benefit analysis can still retain the flavour of economic efficiencyif one takes into consideration how resources should be best allocated among the competing

users. The constant natural assets rule is directly applicable for renewable assets. But all theresources are not renewable in nature. In case of non-renewable assets, actual compensation

rule should be interpreted not in terms of providence of actual assets but in terms of the

services rendered by the actual assets. For example, oil, the black liquid cannot be preservedin constant quantity across time. But the services that oil provides to current users must beprovided in future so that actual compensation remains the same. These are all high level

strategic decisions but come under the purview of financial strategic planning. Only a close

interface can help in arriving at an acceptable situation and plan

Summary

1.0 Strategic Financial Decision Making Framework

All businesses need to have the following three fundamental essential elements:

A clear and realisticstrategy, The financial resources, controls and systems to see it through and The right managementteam and processes to make it happen.1.1 Functions of Strategic Financial Management: Strategic Financial Management is the

portfolio constituent of the corporate strategic plan that embraces the optimum investment and

financing decisions required to attain the overall specified objectives.

Irrespective of the time horizon, the investment and financial decisions functions involve the

following functions:

Continual search for best investment opportunities Selection of the best profitable opportunities Determination of optimal mix of funds for the opportunities Establishment of systems for internal controls Analysis of results for future decision-making.According to Agency theory, strategic financial management is the function of four major

components based on the mathematical concept of expected NPV (net present value)maximization, which are:



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1. Investment decision- This involves the profitable utilization of firm's funds especially inlong-term projects (capital projects). Because the future benefits associated with such

projects are not known with certainty, investment decisions necessarily involve risk.

2. Dividend decision- Dividend decision determines the division of earnings betweenpayments to shareholders and reinvestment in the company.

3. Financing decision- This deals with the mode of financing or mix of equity capital and debtcapital. If it is possible to alter the total value of the company by alteration in the capital

structure of the company, then an optimal financial mix would exist - where the market

value of the company is maximized.

4. Portfolio decision- Portfolio Analysis is a method of evaluating investments based on theircontribution to the aggregate performance of the entire corporation rather than on theisolated characteristics of the investments themselves.

1.2 Strategic Decision Models and Characteristics: For the past few decades, researchers

have attempted to model the strategic decision process and identify the major types or

categories of strategic decisions. These are as follows:

The Identificatio n phase

1. The Decision Recognition Routine: Opportunities, problems, and crisis are recognized and

evoke decisional activity.

2. The Diagnosis Routine: Information relevant to opportunities, problems, and crises is

collected and problems are more clearly identified.

The Development phase

3. The Search Routine: Organizational decision makers go through a number of activities to

generate alternative solutions to problems.

4. The Design Routine: Ready-made solutions which have been identified are modified to fit

the particular problem or new solutions are designed.

The Selection Phase

5. The Screen Routine: This routine is activated when the search routine identifies more

alternatives than can be intensively evaluated. Alternatives are quickly scanned and the

most obviously infeasible ones are eliminated.

2.0 Strategy at different hierarchy levelsStrategies at different levels are the outcomes of different planning needs. The three Levels of

an enterprise strategy are

2.1 Corpor ate Level Strategy: Corporate level strategy is concerned with:

Reach defining the issues that are corporate responsibilities. Competitive Contact defining where in your corporation competition is to be localized. Managing Activities and Business Interrelationships corporate strategy seeks to

develop synergies by sharing and coordinating staff and other resources across business



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units, investing financial resources across business units, and using business units tocomplement other corporate business activities.

Management Practices corporations decide how business units are to be governed:through direct corporate intervention (centralization) or through autonomous governance

(decentralization).

2.2 Busin ess Unit Level Strategy:At the business unit level, the strategic issues are aboutboth practical coordination of operating units and about developing and sustaining a

competitive advantage for the products and services that are produced.

2.3 Functional Level Strategy: Functional level strategies in R&D, operations,

manufacturing, marketing, finance, and human resources involve the development and

coordination of resources through which business unit level strategies can be executedeffectively and efficiently.

Among the different functional activities viz production, marketing, finance, human resources

and research and development, finance assumes highest importance during the top down and

bottom up interaction of planning.

3.0 Financial Planning

Financial planning is a systematic approach whereby the financial planner helps the customer

to maximize his existing financial resources by utilizing financial tools to achieve his financial

goals.

Financial planning is simple mathematics. There are 3 major components:

Financial Resources (FR) Financial Tools (FT) Financial Goals (FG)4.0 Interface of Financial Policy and Strategic Management

The interface will be clearly understood if we appreciate the fact that the starting point and endpoint of an organization is money. Sources of finance and capital structure are the most

important dimensions of a strategic plan. A company may issue equity shares and/ or

preference shares for mobilizing ownership capital.

Along with the mobilization of funds, policy makers should decide on the capital structure to

indicate the desired mix of equity capital and debt capital. There are some norms for debtequity ratio. This ratio in its ideal form varies from industry to industry.

Another important dimension of strategic management and financial policy interface is the

investment and fund allocation decisions. A planner has to frame policies for regulatinginvestments in fixed assets and for restraining of current assets. Investment proposals mooted

by different business units may be divided into three groups.

Dividend policy is yet another area for making financial policy decisions affecting the strategic

performance of the company. A close interface is needed to frame the policy to be beneficial



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for all. Dividend policy decision deals with the extent of earnings to be distributed as dividendand the extent of earnings to be retained for future expansion scheme of the firm.

It may be noted that financial policy of a company cannot be worked out in isolation of other

functional policies. It has a wider appeal and closer link with the overall organizational

performance and direction of growth.

5.0 Balancing Financial Goals vis--vis Sustainable Growth

The concept of sustainable growth can be helpful for planning healthy corporate growth. Thisconcept forces managers to consider the financial consequences of sales increases and to set

sales growth goals that are consistent with the operating and financial policies of the firm.

Often, a conflict can arise if growth objectives are not consistent with the value of the

organization's sustainable growth. Question concerning right distribution of resources maytake a difficult shape if we take into consideration the rightness not for the current

stakeholders but for the future stake holders also.

The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can

be achieved, given the firm's profitability, asset utilization, and desired dividend payout and

debt (financial leverage) ratios.

The sustainable growth model is particularly helpful in situations in which a borrower requestsadditional financing. The need for additional loans creates a potentially risky situation of too

much debt and too little equity. Either additional equity must be raised or the borrower willhave to reduce the rate of expansion to a level that can be sustained without an increase in

financial leverage.

6.0 Principles of Valuation

In finance, valuation is the process of estimating the potential market value of a financial asset

or liability. Valuations can be done on assets (for example, investments in marketablesecurities such as stocks, options, business enterprises, or intangible assets such as patents

and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required inmany contexts including investment analysis, capital budgeting, merger and acquisition

transactions, financial reporting, taxable events to determine the proper tax liability, and in

litigation.

Valuation of financial assets is done using one or more of these types of models:

1. Discounted Cash Flows determine the value by estimating the expected future earningsfrom owning the asset discounted to their present value.

2. Relative value models determine the value based on the market prices of similar assets.3. Option pricing models are used for certain types of financial assets (e.g., warrants, put

options, call options, employee stock options, investments with embedded options such

as a callable bond) and are a complex present value model. The most common optionpricing models are the Black-Scholes-Merton models and lattice models.

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