Structuring Corporate Financial Policy
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Successful diagnosis and prescription depend heavily on thoughtful creativity and careful judgment. Three basic stages in that process:
1. Description : the ability to describe a firm’s financial policies is an essential foundation of diagnosis and prescription
2. Diagnosis : benchmark perspectives, then one compares the idealized and actual financial structures, looking for opportunities for improvement
3. Prescription : action recommendations should spring from the insights gained in description and diagnosis
PART I : IDENTIFYING CORPORATE FINANCIAL POLICY : THE ELEMENTS OF ITS DESIGN
The first task for financial advisors and decision makers is to understand the firm’s current financial policy. Part I presents an approach for identifying the firm’s financial policy.
The Concept of Corporate Financial Policy
Financial policy is a matter of managerial choice. “Corporate financial policy” is a set of broad guidelines or a preferred style to guide the raising of capital and distribution of value.
Policies should be set to support the mission and strategy of the firm. Policies are products of managerial choice rather than dictates of an economic model. Policies change over time.
The Elements of Financial Policy
1. Mix of classes of capital : mix may be analyzed through capitalizations ratios, debt-service coverage ratios, and the firm’s sources-and-uses-of-funds statement
2. Maturity structure of the firm’s capital : to describe the choices made about the maturity of outstanding securities is to be able to infer the judgements the firm made about its priorities. The standard measures of maturity are term to maturity, average life, and duration.
3. Basis of the firm’s coupon and dividend payments : basis addresses the firm’s preference for fixed or floating rates of payment and is a useful tool in fathoming management’s judgment regarding the future course of interest rates
4. Currency : the global aspect of a firm’s financial opportunities (management of the firm’s exposure to foreign exchange rate fluctuations and exploitation of unusual financing possibilities in global capital markets)
5. Exotica : this element considers management’s relative preference for financial innovation
6. External control : how management structures control triggers or forestalls discipline can reveal insights about management’s fears and expectations
7. Distribution : to determine any patterns in (a) the way the firm markets its securities and (b) the way the firm delivers value to its investors
PART II : GENERAL FRAMEWORK FOR DIAGNOSING FINANCIAL POLICY OPPORTUNITIES AND PROBLEMS
The perspectives of competitors, investors, and senior corporate managers :
1. Does the financial policy create value?
From the standpoint of investors, the best financial structure will (a) maximize shareholder wealth, (b) maximize the value of the entire firm and (c) minimize the firm’s weighted-average cost of capital
2. Does the financial policy create competitive advantage?
In short, this line of thinking seeks to evaluate the relative position of the firm in its competitive environment on the basis of financial structure
3. Does the financial policy sustain the vision of senior management?
The analyst begins with an assessment of corporate strategy and the resulting stream of cash requirements and resources anticipated in the future
The investor’s view looks at the economic consequences of a financial structure; the competitor’s view considers strategic consequences; the internal view addresses the survival and ambitions of the firm.
The analyst develops a concept of the best financial structure by a process of triangulation. Triangulation involves weighing the importance of each of the perspectives as complements rather than as substitutes, identifying points of consistency, and making artful judgments where the perspectives diverge.
PART III : ANALYZING FINANCIAL POLICY FROM THE INVESTORS VIEWPOINT
The investor’s perspective is a rigorous approach to evaluating financial structures: valuation analysis of the firm and its common stock under existing and alternative financial structures.
Careful analysis does not rest with a final number, but rather considers a range of elements:
1. Cost of debt : the analysis focuses on yields to maturity and the spreads of those yields over the treasury yield curve
2. Cost of Equity : uses many approaches, including the capital-asset pricing model, the dividend-discount model, the financial-leverage equation, etc
3. Debt/Equity Mix : the relative proportions of types of capital in the capital structure are important factors in computing the weighted-average cost of capital.
4. Price/Earnings Ratio, Market/Book Ratio EBIT Multiple : comparing these values to average levels of the entire capital market or an industry group can provide an alternative check on the valuation of the firm
5. Bond Rating : simple ratio analysis can reveal a firm’s likely rating category and its current cost of debt
6. Ownership : the relative mix of individual and institusional owners and the presence of block holders with potentially hostile intentions can help shed light on the current pricing of a firm’s securities
7. Short Position : short-sale position on the firm’s stock can indicate that some traders believe a decline in share price is imminent
PART IV : ANALYZING FINANCIAL POLICY FROM A COMPETITIVE PERSPECTIVE
The competitive perspective matters to senior executives for two important reasons. First, it gives an indication about (1) “standard practice” in the industry and (2) the strategic position of the firm relative to the competition. Second, it implies rightly that finance can be a strategic competitive instrument.
The ratios and data to be used will depend on the course of analysis. An analyst could start with the following general types of measures with which to compare a competitor group :
1. Size : sales, market value, number of employees or countries, market share
2. Asset productivity : ROA, return on invested capital, market to book value
3. Shareholder wealth : price/earnings, return on market value
4. Predictability : beta, historical trends
5. Growth : 1-10 years compound growth of sales, profits, assets, market value of equity
6. Financial flexibility : debt-tp-capital, debt ratings, cash-flow coverage, estimates of cost of capital
7. Other significant industry issues : capacity, environmental liabilities, etc
PART V : DIAGNOSING FINANCIAL POLICY FROM AN INTERNAL PERSPECTIVE
The essence of this approach is a concern for (a) the preservation of the firm’s financial flexibility, (b) the sustainability of the fir’s financial policies and (c) the feasibility of the firm’s strategic goals.
Financial flexibility is easily measured as the excess cash and unused debt capacity on which the firm might call.
Financial flexibility = Excess cash + (Debt at minimum rating – Current debt outstanding)
This formula indicates the financial reserves on which the firm can call to exploit unusual surprising opportunities or to defend against unusual threats.
This model is based on one key assumption : over the forecast period, the firm sells no new shares of stock.
Self-sustainable growth rate of assets = ROE x (1 – DPO)
The test of feasibility of any long-term plan involves comparing the growth rate implied by this formula and the targeted growth rate dictated by a management plan.
Management policies can be modeled finely by recognizing that ROE can be decomposed into various factors using two classis formulas :
DuPont System of Ratios : ROE = P/S xS/A x A/E
Financial-Leverage Equation : ROE = ROTC + ((ROTC-Kd) x (D/E))
The self-sustainable growth rate model tests the internal consistency of a firm’s operating and financial policies.
PART VI : WHAT IS BEST ?
The key elements of evaluation are :
1. Flexibility : the ability to meet unforeseen financing requirements as they arise-these requirements may be favorable or unfavorable. Flexibility can be measured by bond ratings, coverage ratios, capitalization ratios, liquidity ratios, and the identifications of the salable assets
2. Risk : the predictable variability in the firm’s business
3. Income : this compares financial structures on the basis of value creation. Measures such as DCF value, projected ROE, EPS< and cost of capital.
4. Control : alternative financial structures may imply changes in control or different control constraints on the firm as indicated by the percentage distribution of share ownership and by the structure of debt covenants
5. Timing : asks the question of whether the current capital market environment is the right moment to implement any alternative financial structure, and what the implications for future financings will be if the proposed structure is adopted
The flexibility, risk, income, control, and timing framework can be used to indicate the relative strengths and weaknesses of alternative financing plans.