Chapter 2 - Strategic Financial Policy Decisions

Question 1

Framework for maximising shareholder wealth:

Answer 1

• Investment decision
• Financing decision
• Dividend decision

Question 2

Investment decision - Financial Managers role in decisions cover:

Answer 2

• Identifying investment opportunities

* Evaluation & decisions regarding optimum allocation of scarce funds available

Question 3

Investment decisions could cover:

Answer 3

• Undertaking of new projects within existing business, takeover of, merger with, another company or the selling of part of business
• Strategic considerations = internal expansion (investment) or external expansion (expansion)

Question 4

Financing decisions cover:

Answer 4

• Decisions focuses on how much debt should be used and aim to minimise the cost of capital.
• The currency and maturity of debt will also have to be carefully managed.

Question 5

Dividend decisions - considerations:

Answer 5

• Amount of surplus paid out as dividends will have direct impact on finance available for investment
• Funds available from retained earnings may be needed If debt finance is unavailable or more debt could expose entity to more risk

Question 6

Dividend decisions could cover:

Answer 6

• How much is paid out to shareholders to keep them happy

* Level o funds retained in business to invest in projects that will yield long-term income

Question 7

Financial strategy in the context of international operations - fourth element of financial strategy:

Answer 7

• Risk management is main concern and could be considered to be a fourth element of financial strategy

Question 8

Investment decisions in the context of international operations:

Answer 8

Investments cover more risk:

• Political risk = risk of adverse effect from gov action or changing political relationships
• Translation risk = risk of overseas assets reducing in value as a result of currency weakening
• Economic risk = risk that org economic value may fall due to a loss in competitive strength caused by exchange rate movements

Question 9

Financing decisions in the context of international operations:

Answer 9

• International investments are often financed with high levels of overseas debt to reduce risks associated with investing overseas

Question 10

Types of debt to be considered for financing in the context of international operations:

Answer 10

• Loan from local bank = reduce entity’s net assets in foreign currency and reduce economic risk by reducing the net foreign currency inflows
• Overseas gov loan = offered at a low rate to attract inward investment
• Currency swap = entity borrows in local currency and then swaps the loan with a foreign company who has overseas debt (a merchant bank normally underwrites loan)

Question 11

Dividend decisions in the context of international operations:

Answer 11

• Careful consideration to dividends should be given in addition to other considerations
• In some countries tax is paid on dividends that are remitted back to the parent company. This encourages firms to build up large cash stockpiles abroad.
• The existence of withholding tax on dividends may also influence dividend policy

Question 12

Interrelationship between three key decisions:

Answer 12

1. Investment decision:
High growth companies
* High levels of capital investment
Mature companies
* Moderate to low levels of capital investment

2. Financing decision:
High growth companies
* Low levels of debt finance
Mature companies
* High levels of debt finance 

3. Dividend decision:
High growth companies
* Low or zero dividend
Mature companies
* High dividend pay-outs

Question 13

Impact of key decisions on forecast financial statements - Ratios:

Answer 13

ROCE:

• ROCE should ideally be increasing
• If static or reducing = need to determine due to reduced profit margin (bad news) or asset turnover (reflect impact of recent investment)

Question 14

ROCE formula:

Answer 14

PBIT / Capital Employed

• Capital employed = shareholders funds + long-term debt finance

Question 15

Liquidity ratio - current ratio formula:

Answer 15

current assets / current liabilities

Question 16

Shareholder investment ratios:

Answer 16

• Dividend yield

* P/E ratio

Question 17

Dividend yield formula:

Answer 17

Dividend per share / market price per share

x 100

Question 18

P/E Ratio formula:

Answer 18

Market price per share / EPS

Question 19

What is the P/E ratio?

Answer 19

Market perception of the company’s current position and future prospects

Question 20

Sensitivity of forecasts to changes in financing decisions:

Answer 20

Changes in any key decision elements can significantly impact financial forecasts and may influence a company’s ability to achieve its stated financial objectives

Question 21

Lenders assesses credit worthiness using the information from the following sources:

Answer 21

• Business plan
• Financial ratios
• Cashflow forecasts
• Credit ratings from credit agencies

Question 22

Details of the business plan (PARTS):

Answer 22

Purpose = lender will assess the risk of the project and the abilities of the management team

Amount = lender will consider the amount of the loan relative to the financial resources of the borrower

Repayment = repayments of the loan will either be at the end of the term or in installments during the loan period

Time period = the longer the time period, the riskier the loan

Security = if there are no assets available against which the loan can be secured, this will increase the risk to the lender

Question 23

Financial ratio info to be used to assess credit worthiness

Answer 23

• Lenders will perform ratio analysis on the borrower’s financial statements (in particular liquidity and gearing ratios)
• Interest cover ratio will give an indication of the borrower’s ability to meet interest payments when profits are decreasing
• Stock market ratio’s (P/E ratio) give an indication of the risk of lending to a company as this provides an indication of how the entity is perceived by the market

Question 24

Cash flow forecasts to be used to assess credit worthiness:

Answer 24

• Lenders will expect a cash flow forecast to demonstrate the company’s liquidity and ability to meet payments due

Question 25

Credit agencies:

Answer 25

* Credit agencies can provide the lender with an indication of the likelihood that a company will repay its debts * Triple A rating is considered the best rating given by a credit agency – such a high rating is considered as very low credit risk * Lenders charge lower interest rates to companies with higher credit ratings

Question 26

Credit agencies rate companies based on factors such as:

Answer 26

* Quality of management team * Financial position * Business plans and forecasts * Financial ratios * Political and regulatory risks * Industry strengths and trends

Question 27

Regulatory Requirements and their influences on financial strategy policy decisions:

Answer 27

* Compliance with legislation may involve extra costs, including extra procedures and investments necessary to conform to safety std’s, staff training costs and legal costs. * Higher costs of compliance and labour may mean that companies relocate to countries where costs and regulatory burdens are lower * Compliance & labour costs can also act as a significant barrier to entry – benefiting companies already in the industry * Government can influence the market through the use of industry regulators * Where markets are not competitive, industry regulators have the role of ensuring consumers interests are not subordinated to those of other stakeholders such as employees, shareholders and tax authorities. * Actively promoting competition by encouraging new firms in the industry and preventing unreasonable barriers to entry. * Addressing quality and safety issues and considering the social implications of service provision and pricing.

Question 28

Methods of regulating uncompetitive industries:

Answer 28

* Price control | * Profit control

Question 29

What is price control?

Answer 29

Price control: * Regulator agrees the output prices with the industry * The prices are progressively reduced in real terms each year by setting price increases at a rate below inflation * This method can be confrontational

Question 30

What is profit control?

Answer 30

Profit control * Regulator agrees the max profit the industry can make * Fix max profit at x% of capital employed * Does not provide any incentive to making more efficient use of assets – the higher the capital employed, the higher the profit

Question 31

Impact of taxation on financial strategy - Domestic tax considerations:

Answer 31

Payment of taxes * Deadlines for payment of taxes need to be factored into cash flow forecasts to ensure entity has sufficient cash to meet deadlines and avoid penalties * This will have an effect on the company’s working capital management Tax relief incentives * Companies can reduce their tax bill by taking advantage of tax relief schemes such as capital allowances (tax allowable depreciation) * Tax relief is also provided on debt finance, but not equity finance, which will be a factor in the entity’s financing decisions

Question 32

Impact of taxation on financial strategy - International tax considerations:

Answer 32

1. Tax regime and dividend payments 2. Tax heavens 3. Transfer pricing 4. Thin Capitalisation 5. Double tax treaties

Question 33

International tax considerations - Tax regime and dividend payments:

Answer 33

Parent may reduce overall tax liability by receiving larger dividends from subsidiaries in countries where undistributed profits would otherwise be taxed.

Question 34

International tax considerations - Tax heavens:

Answer 34

* Countries with lenient tax rules or low tax rates designed to attract foreign investment * Multinational companies may shift profits to these countries through use of, for example, transfer pricing

Question 35

International tax considerations - Transfer pricing

Answer 35

* Company in the low tax regime charges fees at a high rate to another group company in a higher tax jurisdiction to shift profits to the lower tax jurisdiction * Companies have exploited the use of management charges and royalties between group companies to reduce tax. * Tax authorities may impose limits on transfer prices to prevent exploitation for tax purposes * Profit shifting can also be done through intercompany loans and charging high rates of interest to the company whose country has high tax rates – this shift profits and the company can also claim tax relief from interest payments.

Question 36

International tax considerations - Thin capitalisation

Answer 36

* Companies with significantly higher proportions of debt finance to equity finance – excessive tax relief on interest payments as a result of thin capitalisation * There are rules in many tax jurisdictions that limit the amount of interest that can be claimed for tax relief

Question 37

International tax considerations - Double tax treaties

Answer 37

* There may be different tax rates for two companies in the same group so in order to help avoid double taxation between countries a double tax treaty is drawn up between the two countries * Agreements state that tax payable on profits made by an overseas subsidiary may be deductible against tax on the same profits in another company