Strategic Financial Management

FINAL COURSE STUDY MATERIAL

PAPER

2

Strategic Financial Management

BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

This study material has been prepared by the faculty of the Board of Studies. The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge and skills in the subject. Students should also supplement their study by reference to the recommended text book(s). In case students need any clarifications or have any suggestions to make for further improvement of the material contained herein they may write to the Director of Studies. All care has been taken to provide interpretations and discussions in a manner useful for the students. However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees. Permission of the Institute is essential for reproduction of any portion of this material.

The Institute of Chartered Accountants of India

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Published by Dr. T.P. Ghosh, Director of Studies, ICAI, C-1, Sector-1, NOIDA-201301Typeset and designed by Gursharan K Madhwal at Board of Studies, The Institute of Chartered Accountants of India.

PREFACEStrategic Financial Management is a blend of Strategic Management and Financial Management. It has acquired a critical significance now-a-days, due to recent surge in globalization and massive cross border flow of capital. The study of this subject opens new opportunities for Chartered Accountancy students. The paper stresses the importance of applying the knowledge and techniques of financial management to the planning, operating and monitoring of the finance function in particular as well as the organization in general. Further, this paper not only focuses on these aspects at the domestic level but also at the international level as well. This study material provides the concepts, theories and techniques relating to Strategic Financial Management and aims to develop the students ability in understanding the different concepts and their application in the real life situations. The study material is divided into thirteen chapters. Latest developments in the field of finance including international finance have been incorporated in almost all the chapters. The study material also focuses on the decision making in an international context and it provides comprehensive coverage of important areas like foreign exchange market, derivatives, foreign exchange exposure, risk analysis and management, raising of capital abroad, mergers and acquisitions and portfolio management, capital budgeting and working capital management in a multinational context. Chapters have been organised in such a way so as to provide a logical sequence to facilitate easy understanding. A number of self-examination questions are given at the end of each chapter, which will be useful to test the understanding of concepts discussed in the chapter. Another helpful feature in this study material is the addition of a number of illustrations in each chapter to help students to have a better grasp of the subject. Numerous graphs and figures have also been added to make things more appealing. Some of the chapters also contain Glossary of terms used. Students are advised to supplement their knowledge by referring to the recommended books and the compilation of the subject. They need to practise the practical problems thoroughly. Students are also advised to update themselves with the latest changes in the financial sector. For this they may refer to academic updates in the monthly journal The Chartered Accountant and the Students Newsletter published by the Board of Studies, financial newspapers, SEBI and Corporate Law Journal etc. The concerned Faculty of Board of Studies of Strategic Financial Management, Dr. S.Z.H. Zaidi and Ms. Nidhi Singh have put their best efforts in preparing the study material. The Board has also received valuable inputs from Dr. Swapan Kanta Basu Chaudhuri of Kolkata, for which the Board is thankful to him. In case students have any suggestions to make this study material more helpful, they are welcome to write to the Director of Studies, The Institute of Chartered Accountants of India, CI, Sector-I, Noida-201 301.

SYLLABUSPAPER 2 : STRATEGIC FINANCIAL MANAGEMENT(One paper Three hours 100 marks) Level of Knowledge: Advanced knowledge Objective: To apply financial management theories and techniques for strategic decision making. Contents: 1. Financial Policy and Corporate Strategy Strategic decision making framework Interface of Financial Policy and strategic management Balancing financial goals vis--vis sustainable growth. 2. Project Planning and Capital Budgeting Feasibility study Cash flow Projections Impact of taxation, depreciation, inflation and working capital Capital Budgeting Decisions - Certainty Equivalent approach, Evaluation of Risky Investment Proposals, Risk and Return analysis, Simulation and decision tree analysis, Sensitivity analysis, Capital Rationing, Adjusted Net Present Value, Replacement decisions, Application of Real Options in capital budgeting, Impact of inflation on capital budgeting decisions Preparation of Project Report Social cost benefit analysis. 3. 4. 5. Leasing decision including cross border leasing Dividend Decisions (a) Indian Capital Market including role of various primary and secondary market institutions (b) Capital Market Instruments Financial derivatives stock futures, stock options, index futures, index options

Dividend theories, Determinants of dividend policies.

Option valuation techniques : Binomial model, Black Scholes Option Pricing Model, Greeks Delta, Gamma, Theta, Rho and Vega Pricing of Futures Cost of carry model Imbedded derivatives (c) Commodity derivatives (d) OTC derivatives -Swaps, Swaptions, Forward Rate Agreements (FRAs), Caps, Floors and Collors. 6. Security Analysis Fundamental analysis - Economic analysis, Industry analysis and Company Analysis Bond valuation, Price Yield relationship, Bond Price forecasting application of duration and convexity, Yield curve strategies Technical Analysis market cycle model and basic trend identification, different types of charting, support and resistance, price patterns, moving averages, Bollinger Bands, momentum analysis. 7. Portfolio Theory and Asset Pricing Efficient Market Theory Random walk theory ; Markowitz model of risk return optimization Capital Asset Pricing Model (CAPM) Arbitrage Pricing Theory (APT) Sharpe Index Model Portfolio Management - Formulation, Monitoring and Evaluation Equity Style Management Principles and Management of Hedge Funds International Portfolio Management. 8. Financial Services in India Investment Banking Retail Banking On Line Share Trading Depository Service. 9. (a) Mutual Funds: Regulatory framework, formulation, monitoring and evaluation of various schemes of Mutual funds, Money market mutual funds. (b) Exchange Traded Funds.

10. Money Market operations 11. (a) Foreign Direct Investment, Foreign Institutional Investment. Raising of capital abroad - American Depository Receipts, Global Depository Receipts, External Commercial Borrowings and Foreign Currency Convertible Bonds International Capital Budgeting International Working Capital Management. 12. Foreign Exchange Exposure and Risk Management Exchange rate determination, Exchange rate forecasting Foreign currency market Foreign exchange derivatives Forward, futures, options and swaps Management of transaction, translation and economic exposures Hedging currency risk. 13. Mergers, Acquisitions and Restructuring Meaning of mergers and acquisition, categories, purposes Process of mergers and acquisition Identification and valuation of the target, acquisition through negotiation, due diligence, post merger integration Legal and regulatory requirements Merger and Acquisition agreement Reverse merger Potential adverse competitive effects of mergers Corporate Takeovers: Motivations, Co-insurance effect, Cross-border takeovers, Forms of takeovers, Takeover defenses Going Private and Other Control Transactions: Leveraged Buyouts (LBOs), Management Buyouts (MBOs), Spin Offs and Asset Divestitures Corporate Restructuring : Refinancing and rescue financing, reorganizations of debtors and creditors, Sale of assets, targeted stock offerings, downsizing and layoff programmes, negotiated wage give-backs, employee buyouts. (b) International Financial Management

CONTENTSCHAPTER 1 FINANCIAL POLICY AND CORPORATE STRATEGY 1.1 2.0 3.0 Strategic Management Decision Making Frame Work ......................................... 1.1 Interface of Financial Policy and Strategic Management .................................. 1.5 Balancing Financial Goals vis-a-vis Sustainable Growth ................................ 1.12

CHAPTER 2 PROJECT PLANNING AND CAPITAL BUDGETING 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 13.0 14.0 Feasibility Study ............................................................................................ 2.1 Contents of a Project Report ........................................................................ 2.13 Social Cost Benefit Analysis - What it is?...................................................... 2.19 Elements of a Network ................................................................................. 2.22 Critical Path Analysis................................................................................... 2.27 Project Cost by CPM ................................................................................... 2.48 Capital Budgeting under Risk and Uncertainty .............................................. 2.60 Selection of Projects.................................................................................... 2.70 Capital Budgeting under Capital Rationing .................................................... 2.72 Capital Budgeting under Inflation.................................................................. 2.74 Decision Trees ............................................................................................ 2.79 Capital Asset Pricing Model Approach to Capital Budgeting ........................... 2.81 Replacement Decision ................................................................................. 2.84 Real option in Capital Budgeting .................................................................. 2.87

CHAPTER 3 LEASING DECISIONS 1.0 2.0 3.0 4.0 5.0 6.0 7.0 Leasing ........................................................................................................ 3.1 Types of Leasing ........................................................................................... 3.1 Advantages ................................................................................................... 3.3 Disadvantages .............................................................................................. 3.4 Financial Evaluation ...................................................................................... 3.4 Cross Border Leasing .................................................................................. 3.19 Hire Purchase ............................................................................................. 3.22

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CHAPTER 4 DIVIDEND DECISIONS 1. 2. 3. 4. Introduction ................................................................................................... 4.1 Dividend Policy.............................................................................................. 4.1 Practical Considerations in Dividend Policy..................................................... 4.2 Theories on Dividend Policies ........................................................................ 4.7

CHAPTER 5 INDIAN CAPITAL MARKET 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. Overview of Indian Financial System .............................................................. 5.1 Capital Markets/Securities Market .................................................................. 5.1 Stock Market and its Operations..................................................................... 5.4 Settlement and Settlement Cycles ................................................................ 5.12 Clearing Houses .......................................................................................... 5.14 Management of Issues, Fixed Deposits, Inter Corporate Loans, International Finance .................................................................................. 5.17 Promoters Participation in Excess of Required Minimum ............................... 5.22 Issue Advertisement .................................................................................... 5.24 Issue of Debt Instruments ............................................................................ 5.25 Green Shoe Option ...................................................................................... 5.29 100% Book Building Process........................................................................ 5.30 IPO through Stock Exchange On-line System (E-IPO) ................................... 5.31 Issue of Capital by Designated Financial Institutions ..................................... 5.31 OTCEI Issues .............................................................................................. 5.33 Appointment of Intermediaries...................................................................... 5.35 Underwriting................................................................................................ 5.36 Offer Document made Public........................................................................ 5.36 Despatch of Issue Material........................................................................... 5.36 No Complaints Certificate ............................................................................ 5.37 Mandatory Collection Centres ...................................................................... 5.37 Abridged Prospectus ................................................................................... 5.37 Post Issue Obligations ................................................................................. 5.37 Inter Corporate Loans and Deposits ............................................................. 5.40 International Finance ................................................................................... 5.40

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25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43.

Stock Futures .............................................................................................. 5.40 Introduction to Capital Market Instruments .................................................... 5.42 Capital Market Instruments .......................................................................... 5.43 Introduction to Commodity Derivatives.......................................................... 5.92 Necessary Conditions to Introduce Commodity Derivatives ............................ 5.92 The Indian Scenario .................................................................................... 5.94 Investing in Commodity Derivatives .............................................................. 5.96 Commodity Market....................................................................................... 5.98 Commodity Futures ..................................................................................... 5.99 Commodity Swaps ......................................................................................5.101 Hedging with Commodity Derivatives ...........................................................5.102 Introduction to OTC Derivatives ..................................................................5.104 OTC Interest Rate Derivatives.....................................................................5.104 Forward Rate Agreements ..........................................................................5.105 Interest Rate Swaps ...................................................................................5.106 Swaptions ..................................................................................................5.113 Interest Rate Caps .....................................................................................5.119 Interest Rate Collars...................................................................................5.125 The Indian Scenario ...................................................................................5.127

CHAPTER 6 SECURITY ANALYSIS 1. 2. 3. 4. Introduction .................................................................................................. 6.1 Fundamental Analysis.................................................................................... 6.1 Technical Analysis....................................................................................... 6.12 Bond Valuation ............................................................................................ 6.31

CHAPTER 7 - PORTFOLIO THEORY 1. 2. 3. 4. 5. Introduction ................................................................................................... 7.1 Portfolio Theories .......................................................................................... 7.2 Portfolio Management .................................................................................. 7.32 Equity Style Management ............................................................................ 7.49 Principles and Management of Hedge Funds ................................................ 7.53

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6.

International Portfolio Management .............................................................. 7.66

CHAPTER 8 FINANCIAL SERVICES IN INDIA 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 13.0 14.0 15.0 Investment Banking ....................................................................................... 8.1 Merchant Banking Services ........................................................................... 8.9 Underwriters................................................................................................ 8.16 Bankers to an Issue ..................................................................................... 8.17 Brokers to the issue..................................................................................... 8.18 Registration to an Issue and Share Transfer Agents ...................................... 8.19 Debenture Trustees ..................................................................................... 8.20 Portfolio Managers ...................................................................................... 8.21 Credit Rating - What it is? ............................................................................ 8.23 Consumer Finance - What is it? ................................................................... 8.28 Introduction to Housing Finance ................................................................... 8.32 Asset Restructuring/Management Company .................................................. 8.35 Depository Services - What it is?.................................................................. 8.43 Debit Cards - What is it? .............................................................................. 8.46 Online Share Trading................................................................................... 8.49

CHAPTER 9 - MUTUAL FUNDS 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 Introduction ................................................................................................... 9.1 Mutual Funds could be the Best Avenue for the Risk-Averse Investors ............. 9.3 Key Players in Mutual Funds .......................................................................... 9.5 Classification of Mutual Funds........................................................................ 9.6 Advantages of Mutual Funds .......................................................................... 9.7 Regulation of Mutual Funds ........................................................................... 9.8 Operations of Mutual Funds ......................................................................... 9.10 Mutual Fund Drawbacks............................................................................... 9.16 Evaluating Performance of Mutual Funds ...................................................... 9.16 The Criteria for Evaluating the Performance.................................................. 9.20 Factors Influencing the Selection of Mutual Funds ........................................ 9.22 Signals Highlighting the Exist of the Investor from the Mutual Fund Scheme... 9.23

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13.0

Money Market Mutual Funds ........................................................................ 9.23

CHAPTER 10 - MONEY MARKET OPERATIONS 1.0 2.0 3.0 4.0 5.0 6.0 Introduction ................................................................................................. 10.1 Institutions .................................................................................................10.11 Instruments ................................................................................................10.12 Determination of Interest Rates ...................................................................10.35 Future Possibilities .....................................................................................10.36 Recent Development in Money Market.........................................................10.36

CHAPTER 11 - FOREIGN DIRECT INVESTMENT (FDI), FOREIGN INSTITUTIONAL INVESTMENT (FIIs) AND INTERNATIONAL FINANCIAL MANAGEMENT PART - A 1.0 2.0 Costs Involved............................................................................................. 11.1 Foreign Institutional Investment.................................................................... 11.3

PART B 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 13.0 Introduction ................................................................................................11.23 Instruments of International Finance............................................................11.26 Financial Sector Reforms in India ................................................................11.27 International Financial Instruments and Indian Companies ...........................11.28 Foreign Currency Convertible Bonds ...........................................................11.28 Global Depository Receipts .........................................................................11.29 Euro-Convertible Bonds ..............................................................................11.32 American Depository Receipts ....................................................................11.32 Other Sources ............................................................................................11.37 Euro-Issues................................................................................................11.38 Cross-Border Leasing .................................................................................11.67 International Capital Budgeting ...................................................................11.68 International Working Capital Management ..................................................11.72

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CHAPTER 12 - FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Introduction ................................................................................................. 12.1 Foreign Exchange Market ............................................................................ 12.2 Exchange Rate Determination ...................................................................... 12.3 Exchange Rate Forecasting ......................................................................... 12.5 Exchange Rate Theories .............................................................................. 12.6 Risk Management .......................................................................................12.10 Risk Considerations....................................................................................12.12 Foreign Exchange Exposure .......................................................................12.14 Types of Exposures ....................................................................................12.15 Techniques for Managing Exposure .............................................................12.17 Strategies for Exposure Management ..........................................................12.29 Hedging Currency Risk ...............................................................................12.31 Conclusion .................................................................................................12.34

CHAPTER 13 MERGERS, ACQUISITION & RESTRUCTURING 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 13.0 14.0 15.0 Introduction ................................................................................................. 13.1 Compromise & Arrangement ........................................................................ 13.2 Reasons and Rationale for Mergers and Acquisitions .................................... 13.6 Method of Amalgamation ............................................................................. 13.8 Need for Amalgamation ............................................................................... 13.8 Gains from Mergers or Synergy .................................................................... 13.9 Accounting for Amalgamations ....................................................................13.11 Problems for M & A in India.........................................................................13.12 Mergers in Specific Sectors.........................................................................13.12 Acquisition and Takeover ............................................................................13.13 The Evolution of Takeovers, Principles and Enforcement- The Indian Scenario ....................................................................................................13.13 Takeover by Reverse Bid ............................................................................13.15 The Acquisition Process .............................................................................13.19 Defending a company in a Takeover Bid ......................................................13.20 Legal Aspects of M & As. ............................................................................13.21

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16.0 17.0 18.0 19.0 20.0 21.0 22.0 23.0 24.0 25.0

Due Diligence.............................................................................................13.24 Target Valuation for M & A ..........................................................................13.25 Corporate Restructuring..............................................................................13.34 Financial Restructuring ...............................................................................13.41 Merger Failures or Potential Adverse Competitive Effects.............................13.44 Maximum Purchase Consideration...............................................................13.45 Safeguards in Takeover Process .................................................................13.52 M&As: Tread with Caution...........................................................................13.53 Cross-border M&A ......................................................................................13.56 Decade of Corporate Churning and Change .................................................13.56

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1FINANCIAL POLICY AND CORPORATE STRATEGY1.0 STRATEGIC MANAGEMENT DECISION MAKING FRAME WORKStrategic management intends to run an organization in a systematized fashion by developing a series of plans and policies known as strategic plans, functional policies, structural plans and operational plans. It is a system approach, which is concerned with where the organization wants to reach and how the organization proposes to reach that position. In other words, it deals with aims and means of a corporate enterprise by following a unified secondgeneration planning technique. By second generation planning we mean assessment of the likely states of environment, development of plans according to different states of the environment and the objective(s) and also contingency plans for switching over from plan to another in case of a change in the state of the environment, Thus the strategic plan is comprehensive and integrated too according to planning approach of Glueck. There is an emergent approach according to Mintzberg who believes that strategy is a pattern, observed in a stream of decisions or actions of a firm. In this sense, strategy is not confined to what an organization intends or plans to do; it embraces what an organization also does. This approach stresses upon the need for recognizing the fact that strategies are mostly emergent in nature and the top management needs to nurture potentially good emergent strategies and block the bad ones. Strategic management is basically concerned with futurity of the current decisions without ignoring the fact that uncertainty in the system is to be reduced, to the extent possible, through continuous review of the whole planning and implementation process. This highlights on importance of internal adjustment according to external environmental changes. It has been observed over years that those organizations which refuse to listen to environmental changes and act accordingly, either go out of business in the long run or experience dramatic downward shift in market share. It is therefore necessary for an organization interested in long run survival and command over the market, should go for strategic planning and the planning process must be holistic, a periodic, futuristic intellectual and creative with emphasis given on critical resources of the firm otherwise, the organization will fall in the traps of tunneled vision, inertia myopia frenzy and dilution. In this era of discrete changes, no firm can afford to be late runner. A late runner, according to Miles and Friesen, when swings up stream becomes a failing archetype. A successful archetype is an adaptive firm which plans or pro acts and not reacts only.

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STRATEGY AT DIFFERENT LEVELS:

Strategies at different levels are the outcomes of different planning needs. At the corporate level planners decide about the objective or objectives of the firm along with their priorities. And based on objectives, decisions are taken on participation of the firm in different product fields. Basically a corporate strategy provides with a framework for attaining the corporate objectives under values and resource constraints, and internal and external realities. It is the corporate strategy that describes the interest in and competitive emphasis to be given to different businesses of the firm. It indicates the overall planning mode and propensity to take risk in the face of environmental uncertainties. There are two extreme modes of planning namely proactive mode and reactive mode. Actual mode of functioning of a firm may lie in between these two extremes. Similarly; value system of the top executives in respect of risk may be described with reference to two extreme states, viz. high risk taking state and low risk taking state. For example, in a turbulent environment the preferred mode of planning is the proactive mode that assumes high propensity to take risk. For a nearly stable environment a reactive mode of functioning may yield better result than a proactive mode of functioning. Plan at this apex level not only deals with product mix, customer mix, competitive emphasis and geographic boundaries of the market but also assigns priorities for allocation of corporate resources among the various business units. Specially, the deployment of critical resources among the business units is closely related with corporate achievement and needs close attention of the top management. It also acts as an instrument for resolution of conflicts. Business strategy, on the other hand, is the managerial plan for achieving the goal of the business unit. However, it should be consistent with the corporate strategy of the firm and should be drawn within the framework provided by the corporate planners. Given the overall competitive emphasis, business strategy specifies the product market power i.e. the way of competing in that particular business activity. It also addresses coordination and alignment issues covering internal functional activities. The two most important internal aspects of a business strategy are the identification of critical resources and the development of distinctive competence for translation into competitive advantage. According to Prahalad and Hamel, it is the proper nurturing of the core competence of a firm that leads to long lasting competitive advantage in the market. Over the years core competence becomes the key weapon of a firm that cannot be easily copied by the rival players. It gives business, reduced cost, improves quality and leads to product development. Functional strategy is the low level plan to carryout principal activities of a business. In this sense, functional strategy must be consistent with the business strategy, which in turn must be consistent with the corporate strategy. Thus strategic plans come down in a cascade fashion from the top to the bottom level of planning pyramid and performances of functional strategies trickle up the line to give shape to the business performance and then to the corporate performance. This close interlink between functional plans and corporate plan demands for close interaction between functional planning and corporate planning. 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. Corporate strategy deals with deployment of resources and

Financial Policy and Corporate Strategy

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financial strategy is mainly concerned with mobilization and effective utilization of money, the most 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 financial planning and corporate planning let us examine the basic issues addressed under financial planning.

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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 overall planning framework. Outcomes of the financial planning are the financial objectives, financial decision-making and financial 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. 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 the future 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 with the 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 reverse case, short run shortcomings may have telling effects on the organizational performance 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 consideration has 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 risk consideration 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 are unequal 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 consideration effects 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 a benefit of an amount Ak received 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 a firm than the former one. Unfortunately profit maximization or benefit maximization approach fails to discriminate between these two alternatives and remains indifferent.

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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 terms of 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 term solvency and viability. It can be used, as a decision criterion in a precisely defined manner and 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 critical considerations. 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 those that 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 on new investments and borrowings. A substantially positive cash flow may enable the firm to fund 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 an attractive 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 activities that 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 capacity for meeting the increased demand are the key operational requirements during the stage 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 the industry 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. In case 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 of strengthening 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 For example if awareness can be created in the mind of the investors and others about quick and high 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.


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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 and benefits 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 position of the offer in respect of the life cycle curve, market demand and available technology is main. 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 fixed assets 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 assets are 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. In case 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.

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INTERFACE OF FINANCIAL POLICY AND STRATEGIC MANAGEMENT

The inter face 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 again. Offer of the organization is only a vehicle that links up the starting point and the end point. No organization can run the existing business and promote a new expansion project without a suitable internally mobilized financial base or both internally and externally mobilized financial base. Following is a list of some standard questions, which are to be examined by the planners for drawing the policy framework. Q1. From where do we propose to get additional funds to grow internally or externally or both? If the answer to the above question describes an internal dependence then comes the question Will this affect the performance of the existing business? If the answer to the question Q1.favours an external search then follows the question Q3. Q4. Q.5. Q.6. Q.7. Q8. Q9. How do we propose to mobilize that additional fund? What policy of capital structure do we propose to follow? Minimum debt or highly leveraged structure? How much liquid cash or current assets do we propose to keep in hand? What will be effect of growth on cash flow? What accounting system and policy do we like to use and why? What austerity measures are to be undertaken for generating more funds if needed? What financial measures are to be taken into consideration for loss making units?

Q2.

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Q10. To whom do we propose to sell the loss making units in case internal turnaround does not work and spinning off fails? While most of the questions are relevant for growth or stable growth strategy, a few questions are related to turn around and retrenchment strategies. Mainly one is concerned with generation of resources, mobilization of resources, structuring of resources, allocation of resources and proper utilization of resources. 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 activity of firm. The generation of funds may arise out of ownership capital and or borrowed capital. A company may issue equity shares and / or preference shares for mobilizing ownership 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 preference shares like cumulative convertible preference shares which are convertible into equity shares between 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 borrowed capital. 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, cash credits, 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 debt equity ratio. These are aimed at minimizing the risks of excessive loans, for public sector organizations 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 planning mode of the organization under study. For capital intensive industries, the proportion of debt to equity is much more 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 regulating investments in fixed assets and for restraining of current assets. Investment proposals mooted by 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 to increase 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 project evaluation and project selection are the two most important jobs under fund allocation. Planners task is to make the best possible allocation under resource constraints.


1.7

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 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 the point 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 dividend payment is a desirable consideration that can have a positive impact on share price. The alternative 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 lesser risk for the investors. Yet some other companies follow a different alternative. They pay a minimum dividend per share and additional dividend when earnings are higher than the normal 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 cash dividend 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 discursions 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. These polices being related to external 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 minds of 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 later stage but during the stage of corporate planning itself. The nature of interdependence is the crucial 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 the cause 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.

2.1

SOME SPECIFIC ISSUES OF FINANCIAL POLICY:

There are three major issues to be addressed while working out the financial policy of a firm. These are investment, financing and dividend as may be clear from the discussions made so far. Let us examine them in brief to give an idea about various intricacies involved in strategic planning .We have already discussed on divided policy. 2.1.1 Investment planning: Investment planning as already pointed out is the key-planning task for an organization because resources are available in limited quantities and number of alternative investment proposals is that way unlimited. Given the financial objectives and their respective priorities and given the objective of optimization and or minimum / maximum attainment, a planner faces problem with the resource constraints that limit the feasible region of operation and choice. This calls for making a balanced decision i.e. balancing between aim and ability of the company.

1.8


Let us examine how strategic decision can be taken for capital expenditure projects. Capital expenditure project can be evaluated in many ways and once the evaluation methods have been decided upon different proposals can be evaluated and can be arranged in order of preference. Final choice will be dependent on maximization of firms value subject to resource constraints. One such method for evaluating a project is economic evaluation. Under economic evaluation, capital budgeting technique is being used where marginal increase in revenue is being matched with marginal increase in cost. A firm should opt for acquisition of a capital asset if the marginal revenue exceeds marginal cost. By capital budgeting technique, we mean net present value technique or internal rate of return technique or pay back method. Choice of the technique depends on the knowledge, experience and value system of the policy planner and hence some subjective elements may enter into the system of planning. Sometimes a minimum rate of return is being fixed so that if a project is to be feasible it should not only provide a positive rate of return but also cross the hurdle rate i.e., minimum rate, to make the proposal an attractive one. This determination of attractiveness of a project is very important and useful than determination of the rank of a project. For example, none of a set of projects may be attractive from the point of view of hurdle rate but if they are ranked at least one project will come out with rank one i.e., the best project. The term best is measure wise meaningful but strategically it is of no use. Thus concept of hurdle rate is very important and it is to be prefixed by the planners based on both internal and external considerations. The main idea is to decide about this cut-off rate based on cost of capital, the rate of return the firm must pay to the providers of capital. This cost of capital is determined by the nature of different types of funds to be used by the firm and their costs. A weighted average of those costs is the basis for determination of cut-off rate or hurdle rate for the company. Some experts are of the opinion of inclusion of intangible costs and intangible benefits for arriving at the hurdle rate and deciding about the fate of a project. Sometimes a mark up principle is used to arrive at the cut-off point . If the cost of capital is , cut-off point may be fixed at (1+) where is commonly taken 0.10 i.e. 10% mark up. This mark up takes care of uncertainty involved in the determination of the cost of capital, variation in business risk, unforeseen internal problems and so on. The method of calculation, use of different types of funds, and choice of are all choices of the planners, i.e., strategic choices. Crossing the hurdle rate makes a project attractive. But choice of projects, as pointed out earlier, depends on total investment outlay planned at the corporate level. This restriction in terms of the total outlay is known in management parlance as capital rationing. By arranging the attractive projects in descending order of magnitude in respect of profitability index to select the project may not always serve the purpose because planners are interested in maximization of benefits subject to budget/outlay constraint. It may so happen that cumulative requirement of investment outlay may not exactly match with available fund for investment. The left over fund may not support the next project if one goes by the profitability index consideration. Example can always be constructed to show that two smaller projects that may exhaust the total outlay may result in more benefit than a single larger project that fails to exhaust the total outlay.


1.9

If PIk is the profitability index of the K-th project with investment requirement as IK, K ranging from 1 to n, when n is the total number of attractive projects, then net present value of the k-th project works out as NPVk = (PIk 1) Ik, K = 1, 2, n If total investment outlay is Io, then the task is to solve the following integer programming problem:

Max

k =1

x k ( PI k 1) I kk =1

n

St

( i)

xk

n

I k I0

(ii) x k = 0 or 1, k = 1, 2,........... nRisk factor should also draw the attention of the planners because investment decisions are closely coupled with the factor of uncertainty. Rather than having an initial check with respect to rate of return only one may think of a double check one with respect to rate of return and another with respect to degree of risk. If a project is attractive from both these considerations then only the capital rationing can be employed for arriving at the strategic choice via mathematically programming. In the case of risk there should be a maximum limit below which a project will be acceptable and above which a project will be rejected during the first stage of screening. Mostly we determine risk by examining the variation in the benefit value and one may take help of statistical distributions for different inflows and out flows of the project and calculate for the random net present benefit - the overall variance. Thus variance value or its square root, i.e., the standard deviation can be used for working out the degree of risk of a project. Some other experts believe in adjustment of expected net present benefit by a risk factor and propose a single initial screening in the line of hurdle rate. Here again, the choice of approach itself becomes a strategic choice. The subsequent decisions may be largely objective in nature. 2.1.2 Planning for Current Assets: The planning need here is to allocate funds among cash, receivables and inventories so as to facilitate the accomplishment of financial objectives in particular and corporate objectives in general. Basically, there are two issues, which are polar opposite in nature, and one has to strike a strategic balance between them. These issues are profitability and liquidity and the balancing instrument is the risk preference. Cash is a type of current asset that a firm wants to receive in the quickest possible manner but does not like to keep it in that form for a long period. In fact, keeping excess stock of cash amounts to mis-utilization of an important resource and loss of additional income from a possible investment of the same. However, having shortage of cash may affect the strength of the firm in handling unexpected adversities and in getting credit facilities. Also ability of the firm in enjoying trade discounts may get disturbed if cash in hand is less. Thus, high liquidity means

1.10


low profitability and over investment for high profitability means poor liquidity for the company. This calls for a strategic planning for deciding upon the level of cash conservation and optimum investment of idle cash. If the inflow and outflow of cash can be predicted with certainty they can be so adjusted that zero stock of cash may be aimed at. But in reality business environment is unpredictable. Hence inflows and outflows can hardly be matched and zero stock of cash is more of a concept than of a reality. There are different methods for working out the optimum level of cash. One such method, known as Economic order quantity (EOQ), can be used for arriving at optimum level of cash. According to the EOQ model one can work out the optimum level of cash, C0, based on the cost of acquisition, cost of carrying cash inventory, i.e., the interest rate on marketable securities, cost of shortage of cash, rate of cash replenishment and total amount of transaction demand. Under the policy that minimizes the total cost, we have

C0 =where

2A (I + S) IS

dr rd

A = acquisition cost I = inventory cost of carrying cash S = Shortage cost of cash r = replenishment rate of cash d = demand rate of cash In case the shortage cost is very high and cash shortage cannot be tolerated the model can be simplified.0 C1

=

2A I

dr r d

by allowing S tending to infinity. If the rate of cash replenishment is instantaneous one may have further simplification, under r tending to infinity, as

C0 = 2

2Ad I C0 = 3 2Ad (I + S) IS

Alternatively under infinite rate of replenishment when cash shortage is admissible we have

It may be kept in mind that for a stable situation where stochastic variation in respect of the stated parameters of the models are negligible the above four models work well under


1.11

respective set up. However, in case of stochastic flows of cash, control of cash is to be made based on 3 upper and lower limits. According to control chart technique when cash balance reaches the upper control limit a part of cash should be transferred to investment account and when the cash balance reaches the lower control limit a portion of investment should be liquidated to generate cash. The upper limit normal level of cash and lower limit can be expressed in terms of fixed cost associated with security transaction variance of daily net cash flows and interest rate per day on marketable securities. Once the cash balance starts crossing the normal level of cash, purchase of marketable securities starts and once cash balance starts falling below the normal level of cash, selling of marketable securities starts. When the cash balance crosses the upper limit one can think of investment plans. There are strategies that work well with cash projection planning. Basic objective of those strategies is to ensure cash conservation through acceleration of cash inflow and retardation of cash out flow rate. Under acceleration strategy a company shortens the time gap between payment and its encashment for redeployment, quickens the process of collection through multiple collection centers. The concept of rebate in payment may accelerate cash inflow but before the introduction of such rebate one should go for in depth cost benefit analysis to measure the net effect. Under retardation strategy a company widens the time gap between receipt of bills and their payments by availing the last date for no-cost period, makes the payroll periods less frequent and so on. 2.1.3 Inventory planning: The maximum part of current assets of a company is usually in the form of inventory provided the stock of inputs and or outputs are feasible. So, for a better financial performance there is a need to manage inventories in the best possible way. Efficient inventory management calls for striking an optimum balance among different costs of conflicting nature. It also demands for different levels of control for different types of stocks. For example, for voluminous low cost items a close monitoring may not be needed or may become costly. Routine decision taking system in terms of mathematical models can be employed for those items. The polar opposite approach needs to be adopted for high cost low volume items. Close monitoring may reduce the cost of inventory as well as cost of shortage. For items which fall in between those two extreme categories one may apply a mixture of these two controlling approaches, i.e. partly routine and partly close monitoring. The related issues of importance are optimum size of production run, reordering time or reordering level, size of buffer stock and inventory turnover. When reordering is needed one has to indicate how many units are to be ordered or produced, as the case may be. One may either place order according to a fixed size of the lot or after a fixed period of time. Problem mainly arises out of stochastic nature of the rate of demand, rate of replenishment and lead time. It is very difficult to predict fluctuations in demand. Mostly, variance is the observed set of demand along with the expected demand jointly throws light on the extent of fluctuation in demand. Similar are the cases for variation in lead time and production rate. Sometimes the shelf life also adds to the problem of variation. Prescriptive measures for fixing turnover norms for inventory can put pressure on slow moving items and also on obsolete stock. Addition to slow and obsolete stocks only adds to the cost of the system and reduces the benefit of the system. So pressure for their disposal can be of

1.12


extreme help for the attainment of financial objectives of the organization. 2.1.4 Management of Receivables: An important marketing strategy is to offer credit facilities to wholesalers, retailers and even customers. This increases sales of the firm. But weak management of the receivable may, in fact, put the firm into more trouble than ease. Credit worthiness of the involved parties must be ascertained first before offering credit facilities. This involves additional cost burden for the firm. There are other costs too. Cost of collecting receivables, cost of delinquency and opportunity costs are to be taken into consideration and matched against the increase in sales to arrive at a critical appreciation of credit facilities. If the credit facilities come out with net positive benefit only then they can be adopted for implementation. Strategic decision to be taken herein is the assessment about the significance of the net positive benefit. Many sales oriented organisations with unplanned credit facilities put themselves into loss trap and leave the business in the long run. Similar cautions should be taken while deciding about the discount facilities, the seasonal dating facilities and the bank loan facilities.

3.0

BALANCING FINANCIAL GOALS VIS--VIS SUSTAINABLE GROWTH

Question concerning right distribution of resources may take a difficult shape if we take into consideration the rightness not for the current stakeholders 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 to cater 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 the usual 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 as a 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 very weak idea of sustainability requires that the overall stock of capital assets should remain 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 is concerned 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 economic person. 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 growth in 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 is unrealistic 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


1.13

3.1

PRINCIPLES 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 for sustainability 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 curve approach by either making use of expressed preferences or making use of revealed preference. Pricing method is a non demand curve approach that takes into consideration either opportunity costs or alternative costs or shadow projects or government payments or those response method depending on the nature of the problem and environmental situation. Valuation methods are in general more complex in implementation than pricing methods. But demand 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 the conventional 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 allocation of resources for maximizing internal benefit. It has no in built sustainability criterion to guarantee that a constant stock of natural resources will be passed between current and future 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 a stock of natural assets which no smaller than the stock in the possession of current users. According to them Hicks Kaldor potential compensation rule should be extended further so that 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 efficiency if 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 the resources are not renewable is 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 preserved in constant quantity across time. But the services that oil provides to current users must be provided 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

1.14


Self-examination Questions 1. 2. 3. 4. 5. 6. What is Strategic Management? Outline the assumptions and limitations of corporate finance theory. How the interface between financial policies and corporate strategy is done. What type of interaction between various financial policies exists? Comment on shareholders value creation? What type of relationship exists between growth, economic profitability and the shareholder value?

2PROJECT PLANNING AND CAPITAL BUDGETING1.0 FEASIBILITY STUDY Project feasibility is a test by which an investment is evaluated. There are three types of feasibilities evaluated for a project viz. 1) market feasibility 2) technical feasibility and 3) financial feasibility. For projects evaluated by government, economic and social feasibility is also considered. 1.1 MARKET FEASIBILITY:

Products having high sales potential are less risky to invest in. For conducting market feasibility study, the type of proposed product is important. Indicators of buyer behavior in response to a new product have to be taken into account for estimating the potential demand. A proposed product, if new in a country, but successfully marketed in other countries, then its market feasibility is assessed through comparison of some broad economic and cultural indicators in both the countries. Each country will experience an identical buying pattern and preference for products, if the economic indicators are comparable. Cultural differences should be adjusted so as to draw conclusions about the demand, per-capita incomes, income disparity levels, pattern indicating shifts in consumption, literacy level and other economic factors indicating the potential demand for a particular product. A proposed project for an addition to the existing capacity, the task of market feasibility study shall be different. Historical data analysis and study of factors influencing consumption trends become essential. The market feasibility study for a product already selling in the market consists of (a) study of economic factors and indicators (b) demand estimation (c) supply estimation (d) identification of critical success factors (e) estimation of demand-supply gap. (a) Economic Indicators: A change in demand and a change in one or some economic indicators may take place simultaneously.

2.2


(b) Demand Estimation: Projection of demand is most important step in project feasibility study. These include: End-user profile Study of influencing factors Regional, national and export market potential Infra-structure facilities facilitating or continuing demand Demand forecasting

(c) End-user profile: A product may have different uses and end-users. Total demand is made up of different end-users. Different market segments may not be interlinked. Demand for cement is divided into two categories, housing/ maintenance and infrastructure viz. irrigation, canal, railways, road and ports. The end-users are also classified into government and non-government demand, urban and rural demand. (d) Influencing Factors Demand for a product is a derived demand. Demand for fertilizer sales is dependent on monsoons while sale of steel and industrial growth are associated with each other. (e) Market Potential Regional, national and export market potential of a product may be different. Study of national demand may not be adequate due to regional imbalances caused by several constraints. Assessment of export potential is another important exercise. Economic distance to which a product can be exported must be evaluated. Importing countries must be identified, and countries that have no exportable surplus. Cost and quality aspects of goods must be compared with other potentially exporting countries. International relations, import and export barriers in countries, and other factors need to be understood. (f) Infrastructure Facility It needs to be assessed properly. Exportability depends more on high cost of transportation.

(g) Demand Forecasting It is an important step in the assessment of demand potential. Growth in demand in past can be indicative of future demand. There are various methods of demand forecasting. Some factors influencing consumption behaviour in the past will continue to influence the future, others provide for adjustment of some economic indicators likely to be different in the future. (h) Supply Estimation: Past trends of supply of goods can be studied and further extrapolated. Projections so made need to be adjusted with additional information, projects undertaken in the economy, import possibility as governed by import policy, import tariff and international prices. Information regarding entry barrier is necessary. A long gestation period and a high capital to labour ratio may create a natural entry barrier. Government licensing policy, availability of required input like materials and skilled labour also cause entry on barrier. A product whose entry barrier is high is unlikely to find a sudden spur in supply, offering more comfortable position to existing players.

Project Planning And Capital Budgeting (i)

2.3

Identification of Critical Success Factors: For choice of location and to find the risk of a project, it is necessary to identify critical factors, which determine the success of project. Availability of raw material supply and cost of power, transportation facilities, supply of skilled manpower or other variables could be the critical success factors. They are product and region specific. The right choice of location may reduce the cost of a project and the uncertainty regarding the availability of resources. If some crucial factors are subject to volatile changes, then the impact of their variability on the net profitability of a project has to be separately evaluated. Estimation of the Demand-Supply Gap Demand and supply estimates have to be finetuned with new or changed factors and then compared with each other for determining the gap. The demand-supply gap is fruitful for a geographical territory. The forecast of demand and supply may not be a single point forecast. A multiple point forecast gives the most adverse, most likely and most favourable forecast of demand and supply. To find Demand Supply Gap, Demand Surplus : Likely Minimum = Min demand Max supply = Likely demand Likely supply

(j)

Maximum = Max demand Likely supply 1. 2 Technical Feasibility: The factors considered are: i) ii) Availability of commercially viable technology and its alternatives. Suitability of the technology to local environment and its usefulness is to be assessed by the quality of material, power, skilled labour, environmental conditions, water supply etc. Technological innovation rate of the product. Production processes. Capacity utilization rate and its justification. Availability of raw material and other resources e.g. power, gas, water, compressed air, labour etc.

iii) iv) v) vi)

vii) Plant and equipment with fabrication facilities. viii) Feasible product mix with possibilities of joint and by-products. ix) Facilities for affluent disposal. The commercial side of technical details has to be studied along with the technical aspects so that commercial viability of the technology can be evaluated.

2.4


1.3 Financial Feasibility: Demand and price estimates are determined from the market feasibility study. Project costs along with operating costs are derived from technical feasibility study. The estimates have to be made from (a) tax implications of the prevailing tax laws, (b) financial costs involved from financing alternatives for the project. Financial feasibility study requires detailed financial analysis based on certain assumptions, workings and calculations such as: 1) Projections for prices of products, cost of various resources for manufacturing goods, capacity utilization. The actual data of comparable projects are included in the estimates. Period of estimation is determined on the basis of product life cycle, business cycle; period of debt funds etc. and the value of the project at the terminal period of estimation are forecasted. Financing alternatives are considered and a choice of financing mix made with regard to cost of funds and repayment schedules. Basic workings in different schedules like Interest and repayment schedule, working capital schedule, working capital loan, interest and repayment schedule, depreciation schedule for income tax purposes, depreciation schedule for the purpose of reporting under Companies Act, 1956 (if policy is different from income tax rules). Financial statements prepared in the project feasibility report viz. profit and loss account, balance sheet and cash flow statements for the proposed project. Financial indicators calculated from data available in various financial statements. Basic financial parameters used for judging the viability of the project are debtservice coverage ratio (DSCR), net present value (NPV) or internal rate of return (IRR). Some firms use payback period interest coverage ratio, net present value (NPV), as alternate additional tools.

2)

3) 4)

5) 6)

Interest coverage ratio indicates the safety and timely payment of interest to lenders of money given by Interest coverage ratio =

PAT + Depreciation + Interest Interest

The ratio indicates how many times the operating cash flow before interest is earned against the interest liability. However, it is not an important indicator of project viability. Debt-service coverage ratio (DSCR) uses the same numerator as the interest coverage ratio, but it is compared with the interest payment and principal sum repayment in a year given by

Project Planning And Capital Budgeting

2.5

DSCR =

PAT+ Depreciation + Interest Interest + Pr incipal Sum Re payment

An average DSCR of 1.5 is considered good. It is the safety indicator for lenders of money. A project generating sufficient funds during the period of loan taken for a project is considered good from the business angle. 1.4 Risk Assessment Basic indicators of financial viability use profit and cash flow estimates subject to risk or uncertainty. Evaluation of risk is necessary through the adoption of Break Even and Sensitivity Analysis. 1.5 Financial Projections: In assessing the financial viability of a project it is necessary to look at the forecasts of financial condition and flows viz. 1.6 Projected balance sheet Projected cash flow statement PROJECTED BALANCE SHEET

The balance sheet, showing the balance in various asset and liability accounts, reflects the financial condition of the firm at a given point of time. Format of Balance Sheet Liabilities Share capital Reserves and surplus Secured loans Unsecured loans Fixed assets Investments Current assets, loans and advances Miscellaneous expenditure and losses Assets

Current liabilities and Provisions

Liabilities side of the balance sheet shows the sources of finance employed by the business. Assets side of the balance sheet shows how funds have been used in the business. For preparing the projected balance sheet at the end of year n+1, information about the following is required:

2.6

Strategic Financial Management Balance sheet at the end of year n Projected income statement and the distribution of earnings for year n+1 Sources of external financing proposed to be tapped in year n+1 Expected changes in current liabilities in year n+1 Proposed repayment of debt capital during year n+1 Outlays on and the disposal of fixed assets during year n+1 Changes in level of current assets during year n+1 Changes in assets and certain outlays pre-operative and preliminary expenses during year n+1

Example: The balance sheet at the end of year n is as follows: Rs. in Crores Liabilities Share capital Reserves surplus Secured loans Unsecured loans Current liabilities Provisions and Rs. 100 20 80 50 90 20 360 Assets Fixed assets Investments Current assets Cash Receivables Inventories 20 80 80 360 Rs. 180 180

The projected income statement and distribution of earnings for year n+1 (Rs. in Cr) Sales Cost of goods sold Depreciation Earnings before interest and taxes Interest 400 300 20 80 20

Project Planning And Capital Budgeting Profit before tax Tax Profit after tax Dividends Retained earnings

2.7 60 30 30 10 20

During year n+1 firm plans to raise secured term loan of 20, repay previous term loan to the extent of 5, increase unsecured loans by 10. Current liabilities and provisions expected to remain unchanged. Firm plans to acquire fixed assets worth 30, increase its inventories by 10, Receivables expected to increase by 15, other assets remain unchanged, except cash. Level of cash to be the balancing amount in the projected balance sheet. Projected balances in various assets/liabilities are worked out as follows. Projected Balances in Assets & LiabilitiesRs. in Cr. Account Category Liabilities Share capital Reserved and surplus Secured loan Unsecured loans Current liabilities Provisions Fixed Assets Investments Current assets Cash Inventories Receivables 20 80 80 +10 (Bal. Fig) +10 (Proposed increase) +15 (Expected increase) Total 30 (Bal fig) 90 95 215 405 Opening Balance 100 20 80 50 90 20 180 .. 180 +30 (Additional outlay) -20 (Depreciation) 190 Total +20 (Retained earnings +20 (Additional term loan -5 (Repayment) +10 (Proposed increased) 95 60 90 20 405 Changes during the year Closing Balance 100 40

1.7

PROJECTED CASH FLOW STATEMENT

Cash flow statement shows the sources and disposition of cash and the net change in cash balance.

2.8

Strategic Financial Management Projected Cash Flow statement

(A) Sources of Funds Share issue Profit before taxation with interest added back Depreciation provision for the year Specific Reserves Increase in secured medium and long-term borrowings for the project Other medium/long term loans Increase in unsecured loans and deposits Increase in bank borrowings for working capital Increase in liabilities for deferred payment (including interest) Sale of fixed assets Sale of investments Other income Total (B) Disposition of Funds Capital expenditures for the project Other capital expenditures Increase in working capital Decrease in secured medium and long-term borrowings Financial institutions/Banks Decrease in unsecured loans and deposits Decrease in bank borrowings for working capital Decrease in liabilities for deferred payments (including interest) to machinery Increase in investments in other companies Interest on term loans Interest on bank borrowings for working capital Taxation Dividends Equity/Preference Other expenditures Opening balance of cash in hand and at bank Net surplus/deficit (A-B)

Project Planning And Capital Budgeting Closing balance of cash in hand/at bank Projected Cash Flow Statement

2.9

Rs. (Cr.) (A) Sources of Funds Profit before tax with interest added back Depreciation Increase in secured loans Increase in unsecured loans Total (B) Disposition of Funds Capital expenditure Increase in working capital Interest Taxation Dividends- equity Total Opening balance of cash in hand and at bank Net surplus/deficit (A-B) Closing balance of cash in hand and at bank 30.00 25.00 20.00 30.00 10.00 115.00 20.00 10.00 30.00 80.00 20.00 15.00 10.00 125.00

1.8

COMBINED MULTI-YEAR PROJECTIONS

We take up an illustration showing combined projection of balance sheet, sources and uses of funds statement, and cash flow statement over several years. The expected outlays and proposed financing during the construction and the first two operating years are given hereunder:

2.10

Strategic Financial Management Proposed Outlays and Financing Construction Period Outlays Preliminary and Pre-operative Expenses Fixed assets Current assets (Other than cash) Financing Share capital Term loan Short-term bank Borrowing 120 60 100 150 150 150 75 20 200 200 200 100 100 1 st Operating Year (Rs in Cr) 2 nd operating Year

The projected revenues and costs for the first two operating years are given below. i) ii) iii) iv) the tax rate will be 60 per cent, no deductions (reliefs) are available preliminary and preoperative expenses will not be written off during the first two operating years, and no dividend will be paid in the first two operating years.

Project Planning And Capital Budgeting Projected Revenues and Costs

2.11

(Rs. In Cr.) 1 st operating Year Sales Cost of sales (excluding interest and depreciation) Interest Depreciation Projected Statements The projected income statement (profit and loss statement) is prepared in the following way: Projected Income Statement (Rs. In Cr.) 1 st Operating 2nd Operating Year Sales Cost of sales (excluding Depreciation and interest) Interest Depreciation Losses (absorbed) Profit before tax Tax Profit after tax (68) 48 20 (68) 64 28 68 40 24 16 300 300 Year 600 400 48 20 64 28 300 300 2 nd Operating Year 600 400

From the given, the projected balance sheets and the projected cash flow statements are displayed in the following manner:

2.12

Strategic Financial Management Projected Balance Sheet(Rs. in Cr.)

Liabilities

End Period

of

End of 1 Year

st

End 2nd

of

Assets

End Constn. Period

of

End of 1 year

st

End 2nd

of

Constn.

Operating

Operating

Operating year 250 250 16 Fixed assets Current Assets

Date post:	15-Nov-2014
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Strategic Financial Management

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