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
Net Income
+ Depreciation & Amortization
+ Difference between Book Tax and Cash Tax
– Incremental Working Capital
– Capital Expenditures
– Acquisitions
– Dividends
+ 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.
Conclusion
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.
Tags: Corporate Finance, Corporate Strategy, Corporate Structure, Finance Strategy, Return to Shareholders, Share Repurchase, Shareholders Value, Shareholders Value Creation, Valuation Gap, Value Creation
January 19, 2011 at 1:56 PM |
Thanks so much for posting this!
January 18, 2011 at 7:01 PM |
Hi….thanks for this good information.I’m so happy because it’s very useful for my thesis research.I hope you will keep updating your content constantly as you have one dedicated reader here 🙂
January 18, 2011 at 10:27 AM |
Pretty insightful post. I never thought it was this simple after all. I had spent a lot of my time looking for anyone to explain this topic clearly and you are the only one that ever did that. Kudos to you! Keep it up
January 17, 2011 at 6:20 PM |
Great information here, i’ll tell my friends about this blog so they can benefit from all the information stated here, keep up making good posts like this, thank you very much sir.
January 17, 2011 at 4:32 PM |
Hey, I simply hopped over for your site by means of StumbleUpon. Now not one thing I would typically learn, but I appreciated your emotions none the less. Thank you for making something value reading.
January 17, 2011 at 1:46 PM |
I guess my hunting was a success in that I discovered your fascinating blog while hunting for articles that deal with life in the US. I manage a small dental practice in Spring, Texas. You could say I’m the Spring TX dentist. Keep up the good work with your blog.
January 17, 2011 at 10:35 AM |
Hey, extremely good website. We actually discovered this on yahoo, and im happy I did. I’ll definitely be returning…
January 17, 2011 at 7:34 AM |
I simply couldnt leave your website before telling you which i really enjoyed the quality information you offer for your visitors Is going to be back often to check on new posts
January 17, 2011 at 12:59 AM |
Fanstastic information. I will inform about it my to father! Grafik Komputerowy.
January 16, 2011 at 4:45 AM |
Good article. Keep doing great job
January 15, 2011 at 11:41 PM |
email email I really like your blog. Thrust into the top issues in this subject. It seems to me that you have many wise words to say and not afraid to speak aloud their sentences. Keep up the invite to your blog pozycjonowanie stron
January 15, 2011 at 9:21 PM |
Great post. Quite interesting to learn to read. I usually usually do not read your website, but this post definatelly caught my attention.
January 15, 2011 at 6:37 PM |
It’s super site, I was looking for something like this
January 15, 2011 at 12:48 PM |
Interesting story. I have seen the link to it on Facebook.
January 15, 2011 at 12:04 PM |
As a Newbie, I am always searching online for articles that can help me get further ahead
January 15, 2011 at 9:05 AM |
hi everyone, I was just checkin’ out this site and I really admire the foundation of the article, and have nothing to do, so if anyone wants to have an interesting conversation about it, please contact me on AIM, my name is adam oiutale
January 14, 2011 at 8:09 PM |
I found your blog on bing. I think it’s pretty cool.
January 14, 2011 at 7:15 AM |
I need to admin that I am suprised to find such a good article
January 14, 2011 at 6:27 AM |
Amazing informations I will inform about it my dad as he is interested in it. Best Regards Bukmacherzy Promocje.
January 13, 2011 at 7:52 PM |
🙂
January 13, 2011 at 8:11 AM |
I like what you guys are up too. This sort of clever work and exposure! Keep up the very good works guys I’ve incorporated you guys to my blogroll.
January 13, 2011 at 3:17 AM |
Pretty section of content. I just stumbled upon your web site and in accession capital to assert that I get actually enjoyed account your blog posts. Any way I will be subscribing to your feeds and even I achievement you access consistently fast.
January 12, 2011 at 10:15 PM |
Helpful blog, saved the site for interest to see more information!
January 12, 2011 at 5:09 PM |
Hi….thanks for this good information.I’m so happy because it’s very useful for my thesis research.I hope you will keep updating your content constantly as you have one dedicated reader here 🙂
January 12, 2011 at 10:08 PM |
Thanx. Did you see my new presentation “Shareholders Value Creation – How to use TSR Sustainable matrix to play your strategy as per investors eye”? If you didn’t then pls. see and let me have your feedback.
January 12, 2011 at 2:23 PM |
you’ve got a terrific blog here! would you prefer to make some invite posts on my blog?
January 12, 2011 at 2:13 PM |
Very informative post. Looking more to something similar to this.
January 12, 2011 at 10:04 PM |
Thanx. Did you see my new presentation “Shareholders Value Creation – How to use TSR Sustainable matrix to play your strategy as per investors eye”? If you didn’t then pls. see and let me have your feedback.
January 12, 2011 at 3:31 AM |
Verry useull info, thanks.
January 11, 2011 at 7:24 PM |
Nice!
January 11, 2011 at 12:55 PM |
Im searching on the net trying to find exactly how to begin this blog site thing and your website is nearly certainly really impressive.
January 11, 2011 at 11:28 AM |
Oh gosh, that is a magnificient article. I wish I could write like this. Great job
January 10, 2011 at 6:29 PM |
What a great website. I am happy I found it.It’s nice to read something interesting I cannot find RSS channel
January 10, 2011 at 3:41 PM |
Fantastic post however I was wondering if you could write a litte more on this subject? I’d be very thankful if you could elaborate a little bit more. Thank you!
January 10, 2011 at 6:36 PM |
Few days back I uploaded a presentation on Shareholders Value Creation- A handy e-book on how to create sustainable shareholders value for your organization. Please provide your feedback.
January 10, 2011 at 11:18 AM |
Good stuff. I dont remember reading such a good article. You have to write more on the topic
January 10, 2011 at 6:55 PM |
New presentation on “Shareholders Value Creation- How to use TSR sustainable Matrix to play strategy as per investors eye?” is available on the website. Please provide your feedback.
January 10, 2011 at 10:58 AM |
When I click your Feed it throws up a lot of strange characters, is the problem on my reader?
January 10, 2011 at 6:56 PM |
I did’t receive any complain so far, problem may be at your end.
January 10, 2011 at 9:12 AM |
It’s very interesting. Please write more about it!
Best regards!
Praca
January 10, 2011 at 6:58 PM |
Watch new presentation on Shareholders Value Creation!!! – A must see presentation for corporate & senior executive.
January 10, 2011 at 7:47 AM |
Money is the barometer of a society’s virtue. -Ayn Rand
January 8, 2011 at 6:14 PM |
cool
January 6, 2011 at 11:31 PM |
Excellent to be going to your website again, that continues to be several weeks for me.
January 6, 2011 at 4:52 PM |
I’ve bookmarked that for you so that others can see everything you have to point out.
January 4, 2011 at 9:51 AM |
I’m adding your blog’s rss feed so that I can see your new posts. Keep up the good work!
January 2, 2011 at 8:38 AM |
This is a truly good content. I am definite a lot of people will gain from it. Thanks!
December 28, 2010 at 1:02 PM |
Stopping by your blog reduced the problem to get things i was looking for.
December 28, 2010 at 12:33 AM |
Hi! I found your blog on Google.It’s really well written and it helped me a lot.
Continue the good work!
December 27, 2010 at 2:25 AM |
May this Christmas be bright and cheerful and may the New Year begin on a prosperous note!
January 1, 2011 at 10:34 PM |
Thanks & same to you.
December 24, 2010 at 2:03 PM |
Excellent posting, and she or he made a point. great post continue to keep doing the job
December 22, 2010 at 4:12 PM |
I actually love your blogging site. It’s genuinely useful and informative to whatever My partner and i was looking for. I am going to continue to comeback to check your blog more often. Regards!.
December 22, 2010 at 3:48 AM |
very nice blog! keep up the good work!
November 19, 2010 at 5:26 PM |
give me now
November 14, 2010 at 2:17 PM |
Me & my fellow classmates use your blogs as our reference materials. We look out for more interesting posts from your end about the same topic . Even the future updates about this topic would be of great help.
August 30, 2010 at 5:39 PM |
[…] Optimal Finance Strategy for Shareholders Value Creation (SVC-3) « Deepak's Blog – … […]