Financial Strategy- utilization of capital, sources of funds & distribution to shareholders have significant impact on value creation.
Does your organization use optimal Financial Strategy for value creation? Normally organization gives more emphasis on operational strategy to improve operational efficiencies and altogether ignore systematic approach towards Financial Strategy. In order to fulfill shareholders expectation & value creation organization needs to properly align Operational & Financial Strategy.
In order to develop optimal Financial Strategy organization needs to develop Financial Strategy framework for sources & uses of fund.
There are 3 steps that need to be followed to develop optimal Financial Strategy-
- Establish an appropriate Capital Structure
- Understand whether the organization is undervalued or overvalued in the market
- Develop a Financial Strateg
Establish an Appropriate Capital Structure
Capital structure is often viewed as a minefield of finance theory. Because of this, many executives default to the status quo that, given changing circumstances over time, rarely results in full value creation. An important key to solving the capital structure puzzle is remembering that equity funds (even for private companies) are not free – in fact, they are very expensive. While there is not a contractual obligation to pay shareholders in the same manner as there is for debt holders, there is a very real opportunity cost inherent in equity funds. The cost of equity is high because shareholders bear the systematic risks of being in a particular industry and will suffer the most in a bankruptcy. In comparison, debt financing is less costly because, being subject to contractual obligations – paying interest and repaying principal – debt holders exchange more certainty for a lower expected yield. Additionally, debt is in a preferred position in a bankruptcy and is tax deductible, further reducing its cost to the company. While this favors using leverage, doing so increases financial risk, the cost of debt, and the cost of equity. How do these and other factors interact to determine an appropriate capital structure for a company?
One of the organizations suffering from excess cash availability & undervaluation by market uses the following strategy to develop appropriate capital structure–
Downside cash flow scenario modeling - A capital structure is derived from a set of downside cash flow scenario forecasts. This yields a capital structure that can withstand the shocks of the downside scenarios.
Peer group analyses - Peers’ current capital structures and trends are analyzed for insights into operating characteristics that might indicate the ability to support more or less debt.
Bond rating analysis – The debt capacity within given debt ratings is assessed.
Establishing base case and downside scenario cash flows changes the exercise from a theoretical discussion to an intuitive one because it permits the inclusion of risks, management preferences, and cash flows into the decision.
To understand the magnitude and volatility of cash available for debt service, the first step is to build a base case cash flow forecast for the next three to five years. Collaborating with management, a number of key risks were identified and quantified to develop a series of downside cash flow scenarios. In each scenario, decisions were made about the level of capital investment that would be made and whether the dividend should be changed in order to work from a realistic set of forecasts.
With the downside cash flow scenarios quantified, the next steps were to:
- Identify repayment terms for debt that were realistic in a downside scenario.
- Value the potential for making acquisitions and keeping some “dry powder.”
- Discuss with management the safety margin that would appropriately balance shareholder value with the risks in the business.
- Calculate the amount of debt that met the cash flow constraints and made full utilization of the interest tax shield.
Understand whether the organization is undervalued or overvalued in the market
By comparing investors’ expectations of performance of a company’s value drivers – sales growth, operating profit margins, cash tax rate, incremental fixed and working capital investment to management’s expectations, it is possible to pinpoint the areas where they differ and investigate how they can be addressed, what are investors expectation. Once differences in investors & management’s expectation identified then the next step is to bridge the valuation gap.
Taking the same example, The organization suffering from undervaluation & excess cash availability observes that there are no major investment opportunity available and company is under levered and can generate debt at choice in future, if required urgently, investors expects that the company should return excess cash to investors.
In order to find out how much money company should return to investors & by which means money should be returned e.g. Nominal Dividend, Special Dividend, Share repurchase etc. organization need to develop Financial Strategy Framework.
Develop Financial Strategy
Scenario developed from capital structure serves as a basis for quantifying the amount of excess cash expected to generate from the business.
Definition of Excess Cash
+ Depreciation & Amortization
+ Difference between Book Tax and Cash Tax
– Incremental Working Capital
– Capital Expenditures
+ Proceeds from Exercise of Options
= Excess Cash
In the normal circumstances organization return excess cash by paying debt however in the above mentioned example organization is already under levered so excess cash need to be return to shareholders and share repurchase option ideally suited due to following-
- Creates value for remaining share holders as the stock is undervalued.
- Signals to the market that the stock is undervalued, helping to raise the stock price closer to management’s valuation.
- Returns cash to the shareholders who want to sell their stock, thereby not imposing a possible taxable event on those who do not want one, as would be the case with a dividend.
- Provides flexibility to distribute cash as fits the company’s circumstances.
- Can return larger amounts of cash to shareholders than an increase in regular dividends.
Management and Investors consideration along with market condition should be considered before finalizing amount of repurchase.
Boards of Directors and management that are sharply focused on maximizing the value of the firm will recognize the importance of reviewing and adjusting their financial strategy just as rigorously and frequently as their operating strategy. The latter supports the former, but many companies stop after having addressed only their operating strategies, leaving on the table the opportunity to create even more value.
Communicating both internally within the company and externally to investors can help refine a financial strategy and possibly avoid costly missteps. Creating a common framework within Board could discuss financial strategy in a holistic manner proved to be constructive and avoided endless debates. While financial strategy is just part of a broad arsenal of tools available to enhance shareholder value, it is an important one because it provides a number of levers that can be fine tuned on a regular basis. Its effectiveness relies on management teams and Boards willingness to evaluate and adjust those levers as frequently as they do those of their operating strategies.