Formulation of Financial Strategy -...

Part 1

Formulation of FinancialStrategy

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1

Objectives ofOrganisations

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5

Objectives ofOrganisations

Exam focus

You should understand the primary objective of companies, the assumption of whichunderlies the rest of the syllabus. You should also be able to discuss other stakeholders andtheir objectives, particularly in the context of corporate governance.

Key points

Primary objective

In financial management we will assume that the primary aim of the organisation is tomaximise shareholders’ wealth. As shareholders own shares, this is accomplished by maxi-mising the share price. In theory, the share price should be, depending on the efficiency ofthe market, the present value of the cash flows paid to the shareholders.

Practical problems

In practice the information shareholders have is limited, and many of the estimates will be veryrough approximations. Traditionally, managers were rewarded for producing strong profits,but this often led to short-term behaviour and did not necessarily result in a high share price.

Shareholder value analysis (SVA) tried to reward managers for improving the share priceby identifying seven factors under the control of the management which influenced theshare price:

• sales growth• profit margin• marginal cash tax-rate• investment needed in fixed assets• investment needed in working capital• cost of capital (to reflect risk)• the competitive advantage period.

Various performance models have been developed to set objectives and reward managersaccordingly.

1

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6 Exam Practice Kit: Management Accounting Financial Strategy

Other stakeholders

The theoretical approach ignores other stakeholders, such as employees, society, customers,suppliers and lenders.

Different countries build in the concerns of other stakeholders to a greater or lesser extent,depending on their culture and/or legislation.

In the UK, corporate governance is a mixture of legislation and voluntary codes. Itmostly deals with the way in which companies are controlled and run, and as suchtends to protect the shareholders’ interests and to some extent that of the lenders andsuppliers.

There are moves, however, to a wider social awareness and some companies are now pro-ducing environmental and social performance reports with objectives and achievements innumerous areas.

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Objectives of Organisations 7

Questions

Question 1 – Objectives

This question concerns two organisations, one in the private sector and one in the public sector.

Organisation 1This is a listed company in the electronics industry. Its stated financial objectives are:

• to increase earnings per share year on year by 10% per annum; and• to achieve a 25% per annum return on capital employed.

This company has an equity market capitalisation of £600m. It also has a variety of debtinstruments trading at a total value of £150m.

Organisation 2This organisation is a newly established purchaser and provider of healthcare services in thepublic sector. The organisation’s legal status is a trust. Its total income for the current yearwill be almost £100m. It is considering funding the building of a new healthcare centre viathe Private Finance Initiative (PFI). The total debt will be £15m. Capital and interest will berepaid over 15 years at a variable rate of interest, currently 9% each year. The trust’s solefinancial objective states simply ‘to achieve financial balance during the year’. Its other objec-tives are concerned with qualitative factors such as ‘providing high quality healthcare’.

Requirements

(a) Discuss

(i) the reasons for the differences in the financial objectives of the two types oforganisation given above; and

(ii) the main differences in the business risks involved in the achievement of theirfinancial objectives and how these risks might be managed.

Use the scenario details given above to assist your answer wherever possible.(18 marks)

(b) Explain how the financial risks introduced into the public sector organisation by theuse of PFI might affect the achievement of its objectives and comment on how theserisks might be managed.

(7 marks)

Note: Candidates from outside the UK may use examples of private financing of publicsector schemes in their own country in answering part (b) of this question if they wish.

(Total � 25 marks)

Question 2 – Educational

(a) You are a newly appointed Finance Manager of an Educational Institution that ismainly government funded, having moved from a similar post in a service companyin the private sector. The objective, or mission statement, of this Institution is shownin its publicity material as:

To achieve recognised standards of excellence in the provision of teaching andresearch.

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The only financial performance measure evaluated by the government is that theInstitution has to remain within cash limits. The cash allocation each year is determinedby a range of non-financial measures such as the number of research publications theInstitution’s staff have achieved and official ratings for teaching quality.

However, almost 20% of total cash generated by the Institution is now from theprovision of courses and seminars to private sector companies, using either its ownor its customers’ facilities. These customers are largely unconcerned about researchratings and teaching quality as they relate more to academic awards such asdegrees.

The Head of the Institution aims to increase the percentage of income coming fromthe private sector to 50% over the next five years. She has asked you to advise onhow the management team can evaluate progress towards achieving this aim as wellas meeting the objective set by government for the activities it funds.

Requirement

Discuss the main issues that an institution such as this has to consider when settingobjectives.

Advise on

• whether a financial objective, or objectives, could or should be determined; and• whether such objective(s) should be made public.

(9 marks)

(b) The following is a list of financial and non-financial performance measures that werein use in your previous company:

Financial Non-financial

Value added Customer satisfactionProfitability Competitive positionReturn on investment Market share

Requirement

Choose two of each type of measure, explain their purpose and advise on how they couldbe used by the Educational Institution over the next five years to assess how it is meetingthe Head of the Institution’s aims.

(16 marks)

Note: A report format is NOT required in answering this question.(Total � 25 marks)

Question 3 – Police

A regional police force has the following corporate objectives:

• to reduce crime and disorder;• to promote community safety;• to contribute to delivering justice and maintaining public confidence in the law.

The force aims to achieve these objectives by continuously improving its resources man-agement to meet the needs of its stakeholders. It has no stated financial objective other thanto stay within its funding limits.

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The force is mainly public-funded but, like other regional forces, it has some commercialoperations, for example policing football matches when the football clubs pay a fee to thepolice force for its officers working overtime. The police force uses this money to supplementthe funding it receives from the government. The national government is proposing to priva-tise (i.e. sell off) these commercial operations and has already been in preliminary discussionswith an international security company. This company’s stated financial objectives are:

• to increase earnings per share year on year by 5% per annum; and• to achieve a 20% per annum return on capital employed.

Arguments put forward by government in favour of privatisation focus on the conflict of objec-tives between mainstream operations and commercial activities, and savings to the taxpayer.However, the proposals have met with strong opposition from most of the force’s stakeholders.

Requirements

(a) Discuss the reasons for the differences in the objectives of the two types of organ-isation given above. Use the scenario details given above to assist your answerwherever possible.

(12 marks)

(b) Discuss the influence the commercial operations might currently have on the policeforce’s ability to meet its stated objectives. Include in your discussion an evaluation ofthe possible effects on mainstream services and the various stakeholder groups if thecommercial operations were to be privatised.

(13 marks)(Total � 25 marks)

Question 4 – Healthcare

Two senior executives have recently met on a course where they were being taught aboutsetting financial objectives and the three key policy decisions listed below:

1 the investment decision;2 the financing decision;3 the dividend decision.

One of the executives works for a large healthcare company listed on the stock exchange,the other works in the public sector health service where all services are provided free ofcharge to users at the point of delivery. The public sector health service is financed throughan annual cash budget funded entirely by taxes and government borrowing and has notreasury department.

The following extracts are from their conversation after the course:

Healthcare company executiveLife must be so much easier for you. We have to raise finance from various sources tofund any new investment. We also have to ensure that we pay a dividend that keepsour shareholders happy.

Public sector health service executiveI don’t think you would find a cash-constrained life, as we experience it, very easy.I would like to be able to raise money on the stock market to fund our business require-ments. I would also much prefer to have my own treasury department to go to at any timerather than having to wait and see what we have been allocated in our annual budget.

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Requirements:

(a) Identify in which of the three key policy decisions listed above the public sector healthservice would have least involvement, and explain why. Additionally, identify inwhich of the three key policy decisions listed above a treasury department wouldhave most involvement, and explain why.

(8 marks)

(b) Describe each of the three key policy decisions listed and discuss the importance ofeach of them to the shareholders in the healthcare company.

(9 marks)

(c) Describe the main methods of raising new equity finance and recommend the mostappropriate method for the healthcare company to raise equity finance on the stockmarket.


Question 5 – Financial Objectives

When determining the financial objectives of a company, it is necessary to take three typesof policy decision into account: investment policy, financing policy and dividend policy.

Requirements

(a) Discuss the nature of these three types of decision, commenting on how they areinter-related and how they might affect the value of the firm (that is the present valueof projected cash flows).

(12 marks)

(b) Describe the different functions of the treasury and financial control departments ofan organisation and comment on the relative contributions of these two departmentsto policy determination and the setting and achievement of financial objectives.


Question 6 – HG

HG is a privately owned toy manufacturer based in a country in the European Union, butwhich is not in the European Common Currency Area (ECCA). It trades internationallyboth as a supplier and a customer. Although HG is privately owned, it has revenue andassets equivalent in amount to some public listed companies. It has a large number ofshareholders, but has no intention of seeking a listing at the present time. In fact, the majorshareholders have often expressed a wish to buy out some of the smaller investors.

The entity has a long history of sound, if unspectacular, profitability. The directors andshareholders are reasonably happy with this situation and are averse to adopting strategiesthat they think might involve a substantial increase in risk, for example, acquisition or set-ting up manufacturing capability overseas, as some of HG’s European competitors havedone. As a consequence, HG accepts its growth rate will be relatively low, compared withsome of its competitors.

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The entity is financed 70% equity and 30% debt (based on book values). The debt is amixture of secured and unsecured bonds carrying interest rates of between 7% and 8.5%and repayable in 5 to 10 years’ time. Inflation in HG’s country is near zero and interestrates are low and possibly falling. The Company Treasurer is investigating the opportuni-ties for, and consequences of, refinancing.

HG’s main financial objective is simply to increase dividends each year. It has one non-financial objective, which is to treat all stakeholders in the organisation with “fairnessand equality”. The Board has decided to review these objectives. The new Finance Directorbelieves maximisation of shareholder wealth should be the sole objective, but the otherdirectors do not agree and think a range of objectives should be considered, for exampleprofits after tax and return on investment and performance improvement across a numberof operational areas.

Requirements

(a) Evaluate the appropriateness of HG’s current objectives and the Finance Director’s sug-gestion, and discuss the issues that the HG Board should consider when determiningthe new corporate objectives. Conclude with a recommendation.

(15 marks)

(b) Discuss the factors that the treasury department should consider when determiningfinancing, or re-financing strategies in the context of the economic environmentdescribed in the scenario and explain how these might impact on the determination ofcorporate objectives.


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Answers

Question 1 – Objectives

(a) (i) Differences in financial objectives

Objectives in the private and public sectors have come closer together in recentyears, as private companies appreciate the needs of other stakeholders apartfrom shareholder, and the public sector concentrates more on value for moneyand the best use of the financial resources.

However, the financial objectives remain the key areas for the private sector,whose primary responsibility is to their shareholders, and the public sector’sprimary objectives are the provision of a quality service.

In addition, the private sector will generally set their objectives, by reference tothe needs of their stakeholders, while the public sector organisation will havemany of its objectives imposed by the government.

EPSEarnings per share are used by shareholders to judge the growth achieved. Whileit can be misleading, it gives an idea of the profits generated in the year. Thepublic sector generally does not have such a financial measure but concentratesmore on the service provided.

ROCEThe private sector company has to give a sufficient return to its investors for therisk they perceive in the investment. This can be approximated by tracking thereturn on capital employed.

In the public sector, to convince the ‘investors’, usually the government, torelease funds and not to withdraw resources, the organisation needs to persuadethem that the activities represent value for money. This is often politically drivenrather than being based on long-term financial analysis.

Cash limitsThe public sector has a major objective to achieve financial balance during theyear, as it is unable to raise more during the year. The private sector chargescustomers and can raise more revenue by selling more.

(ii) Business risks and management

A major difference between the two is how risk in the organisation is built intothe objective. A private sector company has the risk that it may fail to attract anycustomers and hence any revenue. Hence the objectives are focused around therevenues and profits generated.

In the trust, the ‘customers’ have little choice in the healthcare in the area, so thereis little risk to the trust in terms of the quantity of service required dropping.However, there is a major risk in terms of the quality of service delivered, so themain objectives relate to this. This is bound to be more difficult to measure, so anumber of targets have been developed by government to assess progress in theseareas.

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Generally, we could say the main risk to a private sector organisation is thatdemand for the product falls, while for a public sector one, demand for the serviceincreases beyond what can be managed within its resources.

The private sector company could manage its major commercial risk by:

• maintaining and monitoring its quality• analysing customers and competitors• ensuring against risks where possible.

The public sector trust has to manage the risk that it fails to give a service ofsufficient quality within its financial constraints, by:

• monitoring value for money of the services provided, both internally andexternally

• ensuring that services bought are the most effective• using private finance where possible to ease financial constraints.

(b) Financial risks

The original aim of PFI was to allow services to be expanded and quality enhancedwithout increasing the public funds provided. This was done by private sector provid-ing assets such as the new centre for relatively low financial rates; this is possiblebecause there is much less risk of default on payments and the private sector com-pany is therefore happy with a lower return than normal.

The main risks to the trust’s financial objective from this PFI debt are:

• interest rates might rise and not be matched by government finance• income falls but interest and capital still have to be paid.

However, annual payments will be £15m/8.06 � £1.86m which is less than 2% ofannual income, so it is unlikely that this will be a problem for the trust. If it doesmaterialise, the trust may be able to negotiate longer terms (15 years is shorter thanthe usual PFI).

Question 2 – Educational

(a) Setting objectives

The main issues to consider in setting objectives are:

• deciding who the main stakeholders are• assessing and estimating the level of financial resources which are likely• whether one objective can meet all the needs of the various stakeholders• can the objective be measured• should the objectives and performance be made public.

A financial objective is fairly easy to measure against progress, and performance canalso be compared to other similar educational institutions. However, one objective isprobably not sufficient, given the different nature of the two markets.

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However, other educational institutions may not have the same political influences. Inaddition, the results of the two areas will be affected by the apportionment of costsbetween them. Lastly, the institution may not be in full control of its policies in areassuch as fees and selection, so that it may be misleading to draw conclusions from itsperformance, particularly in comparison with others.

(b) Performance measures

Financial measures were traditionally those used by management, but there has beenan increasing focus on non-financial areas as well in order to judge success in termsof meeting objectives. These will tend to pick up objectives relating to the needs ofdifferent stakeholders.

Financial measures

(i) Value added

This measure looks at the performance of an organisation by trying to identify thevalue added to the service by the organisation’s own efforts. It is more common inthe private sector, but has been introduced in some areas of the public sector to allowbetter comparisons to be made. A school with an intake from a wealthy intelligentbackground would be expected to produce better results than one with a poordeprived intake, but the second school might have added more value in terms ofimproving the level which the children attained between entering and leaving theschool.

The institution could try to look at the background of students and assess theimprovement made, compared with competitors or against expected performancebased on their prior attainment. This would be complicated to undertake and anapproximation might look at the student body for each year as a whole, comparingthe average intake background and attainment to the average results on leaving. Aneven cruder measure would be to look at the average degree class or the percentage offirsts and 2.1s.

This measure is included under financial measures as the private sector often use(Sales value – Cost of purchases and services) to measure it. The public sector is lesslikely to use financial terms to measure it, as seen above.

(ii) Profitability

This measure looks at the profits generated per unit of input (such as per staff member),but does not look at the quality of those profits. It can therefore lead to short-term focus,as the risk to longer-term profits is not considered. In the context of the institution, thismight mean putting a very large number of students in one lecture room in order todecrease cost per student or increase revenue per lecturer.

However, in the long term, results and hence the reputation and recruitment mightsuffer, leading to lower profits.

Used in conjunction with other measures, it can give useful information on how theinstitute compares to others.

This measure does not connect directly to the stated mission statement of the institute,so it may need to rethink its objectives as discussed in part (a) before introducing thismeasure.

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Non-financial measures

(i) Customer satisfaction

This is an important measure because if customers are not satisfied, they could goelsewhere and other potential customers could be discouraged. In the context ofthe institution, the two sets of ‘customers’ are government-funded students andcompanies. Although the first group have limited ability to seek redress if not satis-fied, poor performance in exams could reduce government funding, as could a highpercentage of student drop-out, and reduce applications for courses. The secondgroup could show their disappointment much more quickly by not booking furthercourses or seminars and having an immediate impact on income.

Measuring customer satisfaction can be difficult, but course assessments at the endof every course, quality audits by regulatory bodies, company discussions and peerreviews could help.

(ii) Competitive position

In a competitive marketplace, an organisation needs to be aware of its position inthat market. The institution needs to be aware of how it is doing compared withits competitors. Government funding now partly relies on the level and quality ofresearch, and as this is externally assessed it will make comparisons in this areaeasier. The amount of revenue generated by company work for competitors will beless easy to ascertain. Student courses can be easily compared against competitorsas the number on particular courses are publicly available, and absolute numbersand trends can be compared for all the courses offered.

Question 3 – Police

(a) Differences in objectives

Objectives in the public and private sectors have been coming closer together,as the public sector has become more aware of the need to give value for money,and the private sector has started to recognise other stakeholders apart fromshareholders.

Despite this, the private company’s primary responsibility is to their shareholderswithin the constraints imposed by society and government. Public bodies generallyhave their objectives imposed by government rather than setting their own.

EPSEarnings per share are used by shareholders to judge performance by looking at thegrowth achieved. While it can be misleading, it gives an idea of the profits generatedin the year. The public sector generally does not have such a financial measure butconcentrates more on the service provided. Indeed, some public sector organisationswould consider it a failure to have not spent all the revenue received (i.e. to haveachieved a ‘nil profit’ position).

ROCEThe private sector company has to give a sufficient return to its investors for the riskthey perceive in the investment. This can be approximated by tracking the return oncapital employed.

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In the public sector, to convince the ‘investors’, usually the government, to releasefunds and not to withdraw resources, the organisation needs to persuade them thatthe activities represent value for money. This is often politically driven rather thanbeing based on long-term financial analysis.

Cash limitsThe public sector has a major objective to stay within its cash resources, as it is unableto raise more during the year. The private sector charges customers and can raisemore revenue by selling more.

RiskA major difference between the two is how risk in the organisation is built into theobjectives. A private sector company has the risk that it may fail to attract anycustomers and hence any revenue. Hence the objectives are focused around the rev-enues and profits generated.

In the police force, the ‘customers’ have little choice in the police services in the area,so there is little risk to the police operations in terms of the quantity of the servicerequired falling. However, there is a major risk in terms of the quality of service deliv-ered, so the main objectives relate to this. This is bound to be more difficult to meas-ure, so a number of targets have been developed by government to assess progress inthese areas.

Generally, we could say the main risk to a private sector organisation is that demandfor the service falls, while for a public sector one its demand for the service increasesbeyond what can be managed within its resources.

(b) Influence of commercial operations

The government has argued that there is a conflict of objectives, as they feel that seniorpolice officers may divert resources to activities such as football matches, which willhave a negative impact on the resources available for other mainstream operations, inorder to ease financial constraints.

However, it could be argued that a visible police presence at football matches will helpto maintain public confidence in the law and reduce crime and disorder on the streets.

Additional finance raised could also help the force to meet its other objectives byproviding more resources.

The impact on the various stakeholder groups is likely to be:

• Senior police officers will probably fear a reduction in the financial resources andhence a reduction in mainstream activities, unless the government make up theshortfall.

• Police officers will lose a major opportunity to earn overtime and is likely to be anunpopular move.

• Football clubs and other organisations that have the police force may be concernedthat the quality of service will deteriorate. The police have wide experience ofmanaging crowds at matches and have wider powers than a private company ifthere are problems in surrounding streets.

• The local community is likely to be concerned in a similar way that trouble in thearea on football match days will not be dealt with effectively.

• The government will receive cash for selling the service.

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Question 4 – Healthcare

(a) Key policy decisions

The public sector health service will have little involvement in a dividend decision.This determines how much of the surplus cash is returned to shareholders. As thepublic sector health service does not have shareholders, this is not relevant; surpluscash is used to provide additional services.

A treasury department in a private sector company is likely to have most involvementin the financing decision. Although the department may be involved in the dividenddecision and, to some extent, assessing investment opportunities, this is to the extentthat they impinge on their primary role. This is to ensure that funds are availablewhen needed and that surplus funds are put to good use.

(b) Importance to shareholders

The investment decision considers the benefits of investing cash, either in projects or inworking capital, or even in high yield deposit accounts. This is important to sharehold-ers, as it will determine the cash flows which are generated by the company and willultimately affect the dividends paid and the share price. Assessing projects in the health-care industry can be difficult as large investments are often required which promise thepossibility of returns over many years, making the cash flows hard to estimate.Shareholders will also be concerned to compare the risk as well as the return betweenprofits, as a higher risk investment should carry a higher return to compensate.

The financing decision considers the source of the finance required for the businessoperations. This will be a mixture of equity and long-term debt finance; companiesneed to balance the benefits to their shareholders – debt is a cheaper form of financeas the returns required are lower (due to lower risk) and the debt interest is taxallowable, but excessive gearing can increase the risk to the company, and hence theshareholders, dramatically.

The dividend decision looks at how much of the surplus cash generated should be paidout to the shareholders, and how much retained for future investments. Companiesoften make two payments a year, and shareholders generally prefer a predictable,steadily rising, dividend rather than one, which follows the fluctuations of the profits.A dividend policy is often declared for a number of years to give this predictability.A company which then delivers what it promised will generally be regarded as lessrisky, and hence more valuable, by shareholders.

(c) Raising equity finance

Equity can be raised via a placing, an offer for sale or a public offer.

A placing is when shares are offered to a small number of investors, usually institu-tions. The costs are likely to be lower but will concentrate ownership.

An offer for sale allots shares to an issuing house which then offers them to the public.Issuing costs are higher, but it will create a wider share base.

In a public offer, the company itself offers them to the public. This will involve highissue costs to cover publicity and underwriting.

The healthcare company is already listed on the stock exchange; it is likely that arights issue, in which existing shareholders are given the right to subscribe for more

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shares, will be the method used. The shareholders buy them at a price below the mar-ket price, but can sell these rights if they cannot afford to subscribe. Theoretically,although the proportional shareholdings may change, an investor should be no worseoff or better off whether they take up or sell the rights.

Question 5 – Financial Objectives

(a) Investing, financing and dividend policies

The investment decision considers the benefits of investing cash either in projects or inworking capital or even in high yield deposit accounts. This is important to shareholdersas it will determine the cashflows which are generated by the company and will ulti-mately affect the dividends paid and the share price. Assessing projects can sometimes bedifficult as the returns may be spread over many years making the cashflows harder toestimate. Shareholders will also be concerned to compare the risk as well as the returnbetween profits, as a higher risk investment should carry a higher return to compensate.

The financing decision considers the source of the finance required for the businessoperations. This will be a mixture of equity and long-term debt finance; companiesneed to balance the benefits to their shareholders – debt is a cheaper form of financeas the returns required are lower (due to lower risk) and the debt interest is tax allow-able, but excessive gearing can increase the risk to the company, and hence the share-holders, dramatically.

The dividend decision looks at how much of the surplus cash generated should bepaid out to the shareholders, and how much retained for future investments.Companies often make two payments a year, and shareholders generally prefera predictable, steadily rising, dividend rather than one which follows the fluctuationsof the profits. A dividend policy is often declared for a number of years to give thispredictability. A company which then delivers what it promises will generally beregarded as less risky, and hence more valuable, by shareholders.

The three decisions are, therefore, interrelated as the finance needed for viable projectswill come from both internal funds, which have not been paid out as dividends, andexternally raised finance. The mixture of funds raised and used will then affect thecost of capital, which in turn will affect the viability of investments.

(b) Treasury and Financial Control Departments

A treasurer will be responsible for ensuring that funds are available (at a reasonablecost) when required and that surplus funds are reinvested to gain the maximum bene-fit to the company.

A financial controller is responsible for accounting, reporting and controlling thosefunds.

Therefore, in a large company, the treasury function might include

• Establishing corporate finance objectives• Managing liquid assets• Determining policies and identifying sources of funding• Currency and interest rate hedging.

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The financial control function will more concerned with the recording and reportingof financial information, such as:

• Preparing financial statements• Preparing budgets• Monitoring performance against budget.

While the treasury department sets the objectives and policies in this area, and thefinancial control department implements and monitors these, the relationship is morecomplex. The treasury has responsibility for the financing decision discussed in(a) above, whilst the financial control has responsibility for the investment decision.They are thus inter-related in that the financial control will specify the funds requiredfor treasury to access, but the cost of those funds raised by treasury will then affect theviability of the projects assessed by financial control.

In smaller companies, the two functions may be combined and individual responsi-bilities may be less clear cut.

Question 6 – HG

(a) Evaluation

• Theory supports the Finance Director, suggesting that maximisation of share-holder wealth is the only true objective of the entity – now considered an extremeview – and one which may have contributed to some of the corporate scandalsin recent years that have occasioned the increase in corporate governancerequirements.

• Many entities now establish objectives that aim to maximise shareholder wealthwhile recognising constraints, legally enforceable or voluntary, imposed by society.

• A major problem with this objective in the circumstances of HG is that this is aprivate entity that does not have a quoted share price. Shareholder wealth, astraditionally valued, is difficult to determine.

• Looking only at dividends as an objective has its limitations, for example divi-dends could increase while earnings fall. The dividend ratio therefore needs to beconsidered alongside dividend payout. Alternatives, such as those being consid-ered by other directors, are therefore worth further consideration.

• For example, profitability as measured by returns after tax and return on invest-ment. The main advantages are

• Well-understood measures and recognised guidelines are available in the formof International Accounting Standards.

• Shareholders expect profitability – and indeed the current objective is toincrease earnings.

Disadvantages are

• Accounting ratios are historic and backward-looking;• They are subject to manipulation;• A variety of accounting policies are available – even within Accounting Standards;• Tax can be affected by factors outside the control of managers.

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Recommendation

Maximisation of shareholder wealth, using the theoretical definition, is difficult toapply in the circumstances of HG. As a minimum it would be worth introducing anobjective that incorporates earnings growth as well as dividend growth.

A range of objectives could be considered, such as risk-related returns to investors, butagain this is more difficult with a private entity than one with a share listing.

The entity needs to consult its shareholders and, possibly, consider using a balanced score-card approach to determine a range of objectives appropriate for an entity such as HG.

(b) The scenario in this question concerns a large privately owned entity based in theEU, but outside the ECCA. It trades internationally, both as supplier and customer.Inflation is zero and interest rates are low and, possibly, falling. The treasury depart-ment needs to decide how to deal with the challenges and opportunities the specificset of circumstances provide and evaluate the impact on the entity’s capital structure.

• Finance theory suggests that entities should use a judicious amount of debt intheir capital structure to lower cost of capital. Debt is cheaper than equity becauseinterest payments attract tax relief and are (generally) cheaper than equity. This isbecause interest is (usually) secured and providers of debt do not participate inprofits. Here we have a mixture of secured and unsecured debt, but the entityappears sound and of high credit worthiness so should be able to borrow at com-paratively favourable rates.

• This might even be an argument in favour of increasing gearing which will pro-vide the ability to pay a special dividend or undertake a share buyback, as seemsto be the desire of the major shareholders.

• The opposite argument is that in a period of low and falling interest rates, fixedrate debt becomes a burden. Some of the reasons are as follows:

• The real value of debt is not being eroded when there is low or no inflation, soone of the benefits of debt disappears.

• The return on assets funded by debt will fall and low taxable profits, meaningthe tax benefit of debt is reduced.

• If the growth is low, debt interest may have to be paid out of static (or evenfalling) profits, lowering return to shareholders.

• Although interest rates may fall, they never become negative, so the real cost ofborrowing increases.

• The equity risk premium will tend to be less in inflationary times, so equity isrelatively less expensive.

• Raising equity is safer if profits really dive; dividends do not have to be paidand the shareholders do not get their money back in a liquidation. However,raising new equity in a private entity is more difficult than in a public entity,where shares are listed so there is a ready benchmark for the price of newshares.

• Floating rate debt overcomes some of these concerns, but if markets are efficientthen the interest rate obtainable should reflect expectations.

• In theory (according to MM), the mix of debt and equity does not affect the valueof the entity, other than the value of the tax shield, but it does have an effect on theattribution of profits to three groups of stakeholders: lenders, government (taxers)and owners (shareholders).

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• The main question is therefore what combination of dividend policy and capitalstructure is likely to maximise the present value of cash flows to shareholders. Thisis where the financing strategies adopted contribute to the achievement of theobjectives of the entity.

The treasury department needs to specifically look at:

• Terms of existing borrowing to see if refinancing at lower rates is feasible, recognis-ing any possible penalties for early retirement of loans.

• Discuss with the directors and major shareholders the possibility (or even proba-bility) that returns are likely to be lower; the lower the rate of interest, the lowerthe cost of capital and therefore the return that can be expected – not least becausethe rate sought by competitors will be lower.

• The different threats and opportunities that might be presented if HG’s countryjoins the ECCA. For example, there is a larger market for sourcing funds, whichmay mean increased competition and therefore access to cheaper finance. On thedownside, ECCA rates might increase if this country joins the ECCA and/or if othercountries join from less developed parts of the continent.

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01-H68679.qxd 11/13/07 7:20 AM

Formulation of Financial Strategy -...

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