Strategic financial management

1
Strategic Financial Management
By
Binoy john varghese

Strategic financial management refers to both,
financial implications or aspects of various
business strategies, and strategic management
of finance.
It is an approach to management that relates
financial techniques, tools and methodologies to
strategic decisions making to have a long-term
futuristic perspective of financial well being of the
firm to facilitate growth, sustenance and
competitive edge consistently.

An approach to management that applies
financial techniques to strategic decision
making.
Definition: “the application of financial
techniques to strategic decisions in order to
help achieve the decision-maker's
objectives”
Strategy: a carefully devised plan of action to
achieve a goal, or the art of developing or
carrying out such a plan

refers to both, financial implications or
aspects of various business
strategies, and strategic management
of finances.

Strategic Financial Decisions
Strategic Financial Management Deals with:
1. Investment decisions
 Long Term Investment Decisions
 Short Term Investment Decision
1. Financing Decisions
 Best means of financing- Debt Equity Ratio
1. Liquidity Decisions
 Organization maintain adequate cash reserves or
kind such that the operations run smoothly
1. Dividend Decisions
 Disbursement of Dividend to Share holder and
Retained Earnings
5. Profitability Decisions

Strategic Financial Decisions
Strategic Financial Management also Deals with:
1. Valuation of the firm
2. Strategic Risk Management
3. Strategic investments analysis and capital budgeting
4. Corporate restructuring and financial aspects
5. Strategic financial evaluation
6. Strategic capital restructuring
7. Strategic international financial management
8. Strategic financial engineering and architecture
9. Strategic market expansion planning
10.Strategic compensation planning
11.Strategic innovation expenditure
12.Other business challenges

Investment decisions
The investment decision relates to the selection of
assets in which funds will be invested by a firm. The
assets which can be acquired fall into two broad
groups: (a) long-term assets (Capital Budgeting) (b)
short-term or current assets (Working Capital
Management).
(a) Long Term Investment Decisions
Capital Budgeting Capital budgeting is probably the
most crucial financial decision of a firm. It relates to the
selection of an asset or investment proposal or course
of action whose benefits are likely to be available in
future over the lifetime of the project.
Capital Budgeting decisions
Use Pay Back period, NPV, IRR, etc. for evaluation

Investment Decisions
(b)Short Term Investment Decision
Working Capital Management : Working
capital management is concerned with the
management of current assets. It is an
important and integral part of financial
management as short-term survival is a
prerequisite for long-term success.
Fixed Part of working capital –managed from
long term funds
Fluctuating Part of Working Capital –managed
from short term funds

Financing Decisions
The second major decision involved in financial
management is the financing decision. The investment
decision is broadly concerned with the asset-mix or the
composition of the assets of a firm. The concern of the
financing decision is with the financing-mix or capital
structure or leverage. There are two aspects of the
financing decision.
First, the theory of capital structure which shows the
theoretical relationship between the employment of debt
and the return to the shareholders. The second aspect of
the financing decision is the determination of an
appropriate capital structure, given the facts of a particular
case. Thus, the financing decision covers two interrelated
aspects: (1) the capital structure theory, and (2) the capital
structure decision.

Dividend Decisions
Two alternatives are available in dealing with
the profits of a firm.
(1)They can be distributed to the shareholders
in the form of dividends or
(2)They can be retained in the business itself.
It depends on the dividend-pay out ratio, that
is, what proportion of net profits should be
paid out to the share holders.
It depends upon the preference of the
shareholders and investment
opportunities available within the firm

Profitability Management
The source of revenue has to be
pre-decided to obtain profits in
future.
It is closely related to investment
decisions as revenue generation
will be from operations,
investments and divestments.

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Working Capital Decision
Gross working capital (GWC)
GWC refers to the firm’s total investment in
current assets.
Current assets are the assets which can be
converted into cash within an accounting year
(or operating cycle) and include cash, short-
term securities, debtors, (accounts receivable
or book debts) bills receivable and stock
(inventory).

13
Concepts of Working Capital
Net working capital (NWC).
NWC refers to the difference between current
assets and current liabilities.
Current liabilities (CL) are those claims of
outsiders which are expected to mature for
payment within an accounting year and
include creditors (accounts payable), bills
payable, and outstanding expenses.
NWC can be positive or negative.
Positive NWC = CA > CL
Negative NWC = CA < CL

14
Concepts of Working Capital
GWC focuses on
– Optimization of current investment
– Financing of current assets
NWC focuses on
– Liquidity position of the firm
– Judicious mix of short-term and long-tern
financing

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Operating Cycle
Operating cycle is the time duration required
to convert sales, after the conversion of
resources into inventories, into cash. The
operating cycle of a manufacturing company
involves three phases:
– Acquisition of resources such as raw material, labour,
power and fuel etc.
– Manufacture of the product which includes conversion
of raw material into work-in-progress into finished goods.
– Sale of the product either for cash or on credit. Credit
sales create account receivable for collection.

Working Capital Management
Receivables Management
Investment in receivable
• volume of credit sales
• collection period
Credit policy
• credit standards
• credit terms
• collection efforts
Cash Management

Inventory Management
Stocks of manufactured products and
the material that make up the product.
Components:
• raw materials
• work-in-process
• finished goods
• stores and spares (supplies)

Cash Management
Cash management is concerned with the
managing of:
– cash flows into and out of the firm,
– cash flows within the firm, and
– cash balances held by the firm at a point of
time by financing deficit or investing
surplus cash

Functions of Financial Manager
1. Financial Forecasting and
Planning
2. Acquisition of funds
3. Investment of funds
4. Helping in Valuation Decisions
5. Maintain Proper Liquidity

Financial Policy
Criteria describing a corporation's choices
regarding its debt/equity mix, currencies of
denomination, maturity structure, method of
financing investment projects, and hedging
decisions with a goal of maximizing the
value of the firm to some set of
stockholders.
Hedging: A strategy designed to reduce investment risk
using call options, put options, short-selling, or futures
contracts. Its purpose is to reduce the volatility of a
portfolio by reducing the risk of loss.

Strategic planning
Strategic planning is an organization's
process of defining its strategy, or direction,
and making decisions on allocating its
resources to pursue this strategy, including
its capital and people.
Various business analysis techniques can be used in
strategic planning, including SWOT analysis (Strengths,
Weaknesses, Opportunities, and Threats ), PEST analysis
(Political, Economic, Social, and Technological), STEER
analysis (Socio-cultural, Technological, Economic,
Ecological, and Regulatory factors), and EPISTEL
(Environment, Political, Informatic, Social, Technological,
Economic and Legal).

Strategic planning
Strategic planning is the formal consideration of an
organization's future course.
All strategic planning deals with at least one of three key
questions:
"What do we do?"
"For whom do we do it?"
"How do we excel?"
In business strategic planning, some authors phrase the
third question as "How can we beat or avoid competition?".
(Bradford and Duncan, page 1). But this approach is more
about defeating competitors than about excelling.

Strategic planning
In many organizations, this is viewed as a process for
determining where an organization is going over the next
year or - more typically - 3 to 5 years (long term), although
some extend their vision to 20 years.
In order to determine where it is going, the organization needs
to know exactly where it stands, then determine where it wants
to go and how it will get there. The resulting document is called
the "strategic plan."
It is also true that strategic planning may be a tool for effectively
plotting the direction of a company; however, strategic planning itself
cannot foretell exactly how the market will evolve and what issues will
surface in the coming days in order to plan your organizational
strategy. Therefore, strategic innovation and tinkering with the
'strategic plan' have to be a cornerstone strategy for an organization to
survive the turbulent business climate.

Characteristics of Strategic planning
Successful Strategic planning constitutes
the following features. It should:
1. Exhibit impacts in daily routine
2. Facilitate dynamic, forward and backward thinking process
3. Counters repetitive patterns of mistakes, especially human
tendencies
4. Remain clear and simple
5. Ensure planning is complete only when it is properly
implemented
6. Designate a core planning team with a level of autonomy
7. Constitute collective leadership and involvement of key
stakeholders in decision making

Mission and Vision
Mission: Defines the fundamental purpose
of an organization or an enterprise,
succinctly describing why it exists and what
it does to achieve its Vision
A Vision statement outlines what the
organization wants to be, or how it wants
the world in which it operates to be. It
concentrates on the future. It is a source of
inspiration. It provides clear decision-
making criteria.

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Finance Functions
Investment or Long Term Asset Mix
Decision
Financing or Capital Mix Decision
Dividend or Profit Allocation Decision
Liquidity or Short Term Asset Mix
Decision

Strategic Financial Planning
A Financial Plan is statement of what is to
be done in a future time.
Most decisions have long lead times,
which means they take a long time to
implement.
In an uncertain world, this requires that
decisions be made far in advance of their
implementation

It formulates the method by which financial
goals are to be achieved.
There are two dimensions:
1. A Time Frame
– Short run is probably anything less than a year.
– Long run is anything over that; usually taken to be a two-
year to five-year period.
2. A Level of Aggregation
– Each division and operational unit should have a plan.
– As the capital-budgeting analyses of each of the firm’s
divisions are added up, the firm aggregates these small
projects as a big project.

Scenario Analysis
Each division might be asked to prepare three
different plans for the near term future:
1. A Worst Case- This plan would require making the worst
possible assumptions about the companies products and
the state of the economy
2. A Normal Case- This plan would require making the most
likely assumptions about the company and the economy
3. A Best Case- Each divisions would be required to work out
a case based on optimistic assumptions. It could involve
new products and expansion.

Components of Financial Strategy
Start-Up Costs
A new business venture, even those started by existing
companies, has start-up costs. An existing manufacturer
looking to release a new line of product has costs that
may include new fabricating equipment, new packaging
and a marketing plan. Include your start-up costs in your
financial strategy.
Competitive Analysis
Your competition affects how you make money and how you spend
money. The products and marketing activities of your competition
should be included in your financial strategy. An analysis of how the
competition will affect revenue needs to be included in your
planning.

Ongoing Costs
These include labor, materials, equipment maintenance,
shipping and facilities costs, such as lease and utilities.
Break down your ongoing cost projections into monthly
numbers to include as part of your financial strategy.
Revenue
In order to create an effective financial strategy, you
need to forecast revenue over the length of the project. A
comprehensive revenue forecast is necessary when
determining how much will be available to pay your
ongoing costs, and how much will remain as profit.

Objectives and Goals
Goal: The Financial Goal of the firm
should be shareholder’s wealth
maximization, as reflected in the market
value of the firm’s share.
Firms’ primary objective is maximizing the
welfare of owners, but, in operational terms,
they focus on the satisfaction of its
customers through the production of goods
and services needed by them

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Objectives Of Financial Management
The term objective is used to in the sense of a
goal or decision criteria for the three decisions
involved in financial management
The goal of the financial manager is to maximise
the owners/shareholders wealth as reflected in
share prices rather than profit/EPS maximisation
because the latter ignores the timing of returns,
does not directly consider cash flows and
ignores risk.
As key determinants of share price, both return and risk
must be assessed by the financial manager when
evaluating decision alternatives. The EVA is a popular
measure to determine whether an investment positively
contributes to the owners wealth.

1-34
However, the wealth maximizing action of
the finance managers should be
consistent with the preservation of the
wealth of stakeholders, that is, groups
such as employees, customers, suppliers,
creditors, owners and others who have a
direct link to the firm.

35
Finance Manager’s Role
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets
Financial Goals
• Profit maximization (profit after tax)
• Maximizing Earnings per Share
• Shareholder’s Wealth Maximization

36
Profit Maximization
Maximizing the Rupee Income of Firm
– Resources are efficiently utilized
– Appropriate measure of firm performance
– Serves interest of society also

37
Objections to Profit Maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit
maximization is regarded as
Unrealistic
Difficult
Inappropriate
Immoral.

38
Maximizing EPS
Ignores timing and risk of the expected
benefit
Market value is not a function of EPS. Hence
maximizing EPS will not result in highest
price for company's shares
Maximizing EPS implies that the firm should
make no dividend payment so long as
funds can be invested at positive rate of
return—such a policy may not always work

39
Shareholders’ Wealth
Maximization
Maximizes the net present value of a
course of action to shareholders.
Accounts for the timing and risk of the
expected benefits.
Benefits are measured in terms of cash
flows.
Fundamental objective—maximize the
market value of the firm’s shares.

40
Risk-return Trade-off
Risk and expected return move in tandem;
the greater the risk, the greater the
expected return.
Financial decisions of the firm are guided
by the risk-return trade-off.
The return and risk relationship:
Return = Risk-
free rate + Risk premium
Risk-free rate is a compensation for time
and risk premium for risk.

41
Managers Versus Shareholders’ Goals
A company has stakeholders such as employees, debt-
holders, consumers, suppliers, government and society.
Managers may perceive their role as reconciling conflicting
objectives of stakeholders. This stakeholders’ view of
managers’ role may compromise with the objective of SWM.
Managers may pursue their own personal goals at the cost
of shareholders, or may play safe and create satisfactory
wealth for shareholders than the maximum.
Managers may avoid taking high investment and financing
risks that may otherwise be needed to maximize
shareholders’ wealth. Such “satisfying” behaviour of
managers will frustrate the objective of SWM as a normative
guide.

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Financial Goals and Firm’s Mission
and Objectives
Firms’ primary objective is maximizing the welfare
of owners, but, in operational terms, they focus on
the satisfaction of its customers through the
production of goods and services needed by them
Firms state their vision, mission and values in broad terms
Wealth maximization is more appropriately a decision
criterion, rather than an objective or a goal.
Goals or objectives are missions or basic purposes of a
firm’s existence

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Financial Goals and Firm’s Mission and
Objectives
The shareholders’ wealth maximization is the
second-level criterion ensuring that the
decision meets the minimum standard of the
economic performance.
In the final decision-making, the judgement
of management plays the crucial role. The
wealth maximization criterion would simply
indicate whether an action is economically
viable or not.

What Will the Planning Process Accomplish?
Interactions
The plan must make explicit the linkages between
investment proposals and the firm’s financing choices.
Options
The plan provides an opportunity for the firm to weigh its
various options.
Feasibility- The different plans must fit into the overall
corporation objective of maximizing shareholder
wealth
Avoiding Surprises
One of the purpose of financial planning is to avoid surprise.

Strategic Planning
Strategic Planning relates to planning
in advance for a long period of time.
This facilitates predicting the future
and devising a course of action well
in advance.
It deals with future course of action
consistent with the business
environment changes.

Components of Strategic Planning
1. Vision- Organization visualizes what it would like to in
future
2. Mission- Deals with distinctive purpose which an
organization is striving for. It declares the main
concerns or priorities and principles of the business
firm.
3. Goals – They are concrete aims which enhance the
motivation of organization teams which prepare
themselves in specific aspects.
4. Objectives- intend to put forward in precise terms
what an organization wants to achieve, where it
wants to be in future, what are the tasks that needs
to be achieved in short spans of time.

Process of Strategic Planning
1.Visualizing ideal future
2.Identifying critical success factors
3.Analyzing the present status of the company both
internal and external
4.Identifying core areas and core competencies and
opportunities available in the environment
5.Focusing on core areas and devising strategy
accordingly
6.Designing of long-range plan
7.Implementing plans and transition management
8.Reviewing and redesigning and updating and checking
discrepancies
9.Achieving desired outcomes

Benefits of Strategic Planning
1. Development and articulation of the vision into
mission
2. Standardization and innovation in the dimensions get
included for the analysis for decision making
3. More acceptance throughout the organization and
from stakeholders
4. Results into a more tolerant, enduring and dynamic
organization
5. Opportunities in external environment can be tapped
6. Identifies competitive position and enables
competitive advantage through growth and sustenance

Benefits of Strategic Planning
7. Cross functional approach integrates the systems for
implementation
8. Flow of vision and its orientation to all levels and
departments in an organization
9. Well-directed inputs to reduce wastage are
encouraged
10. Facilities prioritization and utilization of resources
11.Empowerment leads to commitment and contribution
of ideas at all levels
12. The broad view of strategic level is transferred to
narrower levels of the organization

Financial Planning Model:
The Ingredients
1. Sales forecast
2. Pro forma statements
3. Asset requirements
4. Financial requirements
5. Plug
6. Economic assumptions

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1. Sales Forecast
 All financial plans require a sales
forecast.
 Perfect foreknowledge is impossible
since sales depend on the uncertain future
state of the economy.
 Businesses that specialize in
macroeconomic and industry projects can
be help in estimating sales.

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2. Pro Forma Statements
 The financial plan will have a forecast
balance sheet, a forecast income
statement, and a forecast sources-and-
uses-of-cash statement.
 These are called pro forma statements
or pro formas.

3-54
3. Asset Requirements
 The financial plan will describe
projected capital spending.
 In addition it will the discuss the
proposed uses of net working capital.

3-55
4. Financial Requirements
 The plan will include a section on
financing arrangements.
 Dividend policy and capital structure
policy should be addressed.
 If new funds are to be raised, the plan
should consider what kinds of securities
must be sold and what methods of
issuance are most appropriate.

3-56
5. Plug
 Compatibility across various growth targets will
usually require adjustment in a third variable.
 Suppose a financial planner assumes that
sales, costs, and net income will rise at g1. Further,
suppose that the planner desires assets and
liabilities to grow at a different rate, g2. These two
rates may be incompatible unless a third variable is
adjusted.
For example, compatibility may only be reached if
outstanding stock grows at a third rate, g3.
 Compatibility across various growth targets will
usually require adjustment in a third variable.
 Suppose a financial planner assumes that
sales, costs, and net income will rise at g1. Further,
suppose that the planner desires assets and
liabilities to grow at a different rate, g2. These two
rates may be incompatible unless a third variable is
adjusted.
For example, compatibility may only be reached if
outstanding stock grows at a third rate, g3.

3-57
6. Economic Assumptions
The plan must explicitly state the
economic environment in which the firm
expects to reside over the life of the
plan.
Interest rate forecasts are part of the
plan.
The plan must explicitly state the
economic environment in which the firm
expects to reside over the life of the
plan.
Interest rate forecasts are part of the
plan.

Matt H. Evans, matt@exinfm.com
Strategic Planning Model

9S Model of SFM
Nine S Model combines the quantitative and
qualitative skills of a strategist.
1.Sanctity
2.Selectivity
3.System
4.Strategic Cost Management
5.Sensitivity
6.Sustainability
7.Superiority
8.Structural Flexibility

9S Model of SFM
1. Sanctity refers to the ‘ethical economics’ of
business. This approach offers a long-term,
sustainable ‘brand-equity’ to the enterprise
which ultimately reduces every cost at every
stage of a product life cycle.
2. Selectivity refers to the most appropriate
business choices based on an enterprise's
core competence. SFM should concentrate on
building up a most flexible core competence
together with strategic cost mangement.

9S Model of SFM
3. System- emphasizes the need for a supportive
mechanism to make ‘SFM’ a continued success. It
refers to the technological, accounting, information
and operational systems of an enterprise.
4. Strategic Cost Management- is the micro-level
strategic analysis of various cost-structure and cost
implications. Some of costing methods are; Activity
Based Costing (or Objective Based Costing), Life
Cycle Costing, Notional Cost Benefit Analysis, Cost
analysis for establishing the validity of a certain
value-chain of an enterprise, etc.

9S Model of SFM
5.Sensitivity- It is to know the strategic use of
every piece of information. It convert
technical data into commercial data.
Sensitivity depends on the capacity to
transform ‘x’ information into ‘y’ in minimum
possible amount of cost and time.
6. Sustainability- of performance is a matter of
long-term strategic planning. Strategic plan
requires a very careful combination of ‘business
strategy ‘ and ‘business funding strategy’. It also
means ‘managing new competitors’ with extra
cost on sustenance’.

9S Model of SFM
7. Superiority- refers to the position of
‘Leadership’ that an enterprise must attain in the
market. SFM should aim at maintaining both
positions in the same market and little
paradoxical.
8. Structural Flexibility- It is the sum total of the
qualitative and quantitative adaptability and
adjustability of an organization. Sunk cost,
Committed cost, Engineered cost, Capacity
Costa, Burden costs and corrective cost could be
huge if structural flexibility is absent.

9S Model of SFM
9. Soul Searching- It is based on continuous
bench marking and requires a tremendous
amount of financial alertness, innovation and
total exposure to new variables and parameters.
It also refers to establishing new heights of
achievement and newer core-competences.
The 9 references of SFM ultimately aim for,
‘Wealth Maximization through the
accelerating Effect’.

Strategic planning
Strategic planning is an organization's
process of defining its strategy, or
direction, and making decisions on
allocating its resources to pursue this
strategy, including its capital and
people.

Strategic planning
Various business analysis techniques can be
used in strategic planning, including SWOT
analysis (Strengths, Weaknesses,
Opportunities, and Threats ), PEST analysis
(Political, Economic, Social, and
Technological), STEER analysis (Socio-
cultural, Technological, Economic,
Ecological, and Regulatory factors), and
EPISTEL (Environment, Political, Informatic,
Social, Technological, Economic and Legal).

Characteristics of Strategic planning
Successful Strategic planning constitutes the following
features. It should:
1. Exhibit impacts in daily routine
2. Facilitate dynamic, forward and backward thinking
process
3. Counters repetitive patterns of mistakes, especially
human tendencies
4. Remain clear and simple
5. Ensure planning is complete only when it is properly
implemented
6. Designate a core planning team with a level of
autonomy
7. Constitute collective leadership and involvement of key
stakeholders in decision making

Vision Goals
Components of
Strategic planning or
Strategic Intent
Mission Objectives

Vision
A Vision statement outlines what the
organization wants to be, or how it
wants the world in which it operates to
be. It concentrates on the future. It is a
source of inspiration. It provides clear
decision-making criteria.
Every organization visualizes what it would
like to be in future.
Vision describes a wishful long-term desire of
the company with out mentioning the steps or
plans to be used in order to set the target.

Mission
Mission: Defines the fundamental
purpose of an organization or an
enterprise, describing why it exists and
what it does to achieve its Vision.
Mission deals with a distinctive Purpose
which a organization is striving for. A
well defined mission statement declares
the main concerns or priorities and
principles of the business firm

Objectives
Objectives intend to put forward in
precise terms what an organization
wants to achieve where it wants to be in
future, what are the tasks that needs to
be achieved in short spans of time to
achieve the future objectives and goals.

Goals
Goals are the concrete aims or targets
which enhance the motivation of the
organizational teams which prepare
themselves in specific aspects.
Goals provide the benefit of breaking
down or fragmenting the broader
mission into more concert and clear
tasks that are understandable, and
responsibilities are allocated to
individuals and teams in the
organization.

Financial Objectives and
Goals
Goal: The Financial Goal of the firm
should be shareholder’s wealth
maximization, as reflected in the market
value of the firm’s share.
Firms’ primary objective is maximizing the
welfare of owners, but, in operational terms,
they focus on the satisfaction of its
customers through the production of goods
and services needed by them

1-77
The term objective is used to in the sense of a
goal or decision criteria for the three decisions
involved in financial management
The goal of the financial manager is to maximise
the owners/shareholders wealth as reflected in
share prices rather than profit/EPS maximisation
because the latter ignores the timing of returns,
does not directly consider cash flows and
ignores risk.
As key determinants of share price, both return and risk
must be assessed by the financial manager when
evaluating decision alternatives. The EVA is a popular
measure to determine whether an investment positively
contributes to the owners wealth.

1-78
However, the wealth maximizing action of
the finance managers should be
consistent with the preservation of the
wealth of stakeholders, that is, groups
such as employees, customers, suppliers,
creditors, owners and others who have a
direct link to the firm.

79
Finance Manager’s Role
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets
Financial Goals
• Profit maximization (profit after tax)
• Maximizing Earnings per Share
• Shareholder’s Wealth Maximization

Start-Up Costs
A new business venture, even those started by existing
companies, has start-up costs. An existing manufacturer
looking to release a new line of product has costs that may
include new fabricating equipment, new packaging and a
marketing plan. Include your start-up costs in your financial
strategy.
Competitive Analysis
Your competition affects how you make money and how you
spend money. The products and marketing activities of your
competition should be included in your financial strategy. An
analysis of how the competition will affect revenue needs to
be included in your planning.

85
Objections to Profit Maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit
maximization is regarded as
Unrealistic
Difficult
Inappropriate
Immoral.

86
Maximizing EPS
Ignores timing and risk of the expected
benefit
Market value is not a function of EPS. Hence
maximizing EPS will not result in highest
price for company's shares
Maximizing EPS implies that the firm should
make no dividend payment so long as
funds can be invested at positive rate of
return—such a policy may not always work

87
Shareholders’ Wealth
Maximization
Maximizes the net present value of a
course of action to shareholders.
Accounts for the timing and risk of the
expected benefits.
Benefits are measured in terms of cash
flows.
Fundamental objective—maximize the
market value of the firm’s shares.

88
Risk-return Trade-off
Risk and expected return move in tandem;
the greater the risk, the greater the
expected return.
Financial decisions of the firm are guided
by the risk-return trade-off.
The return and risk relationship:
Return = Risk-
free rate + Risk premium
Risk-free rate is a compensation for time
and risk premium for risk.

89
Managers Versus Shareholders’ Goals
A company has stakeholders such as employees, debt-
holders, consumers, suppliers, government and society.
Managers may perceive their role as reconciling conflicting
objectives of stakeholders. This stakeholders’ view of
managers’ role may compromise with the objective of SWM.
Managers may pursue their own personal goals at the cost
of shareholders, or may play safe and create satisfactory
wealth for shareholders than the maximum.
Managers may avoid taking high investment and financing
risks that may otherwise be needed to maximize
shareholders’ wealth. Such “satisfying” behaviour of
managers will frustrate the objective of SWM as a normative
guide.

90
Financial Goals and Firm’s Mission
and Objectives
Firms’ primary objective is maximizing the welfare
of owners, but, in operational terms, they focus on
the satisfaction of its customers through the
production of goods and services needed by them
Firms state their vision, mission and values in broad terms
Wealth maximization is more appropriately a decision
criterion, rather than an objective or a goal.
Goals or objectives are missions or basic purposes of a
firm’s existence

91
Financial Goals and Firm’s Mission and
Objectives
The shareholders’ wealth maximization is the
second-level criterion ensuring that the
decision meets the minimum standard of the
economic performance.
In the final decision-making, the judgement
of management plays the crucial role. The
wealth maximization criterion would simply
indicate whether an action is economically
viable or not.

Costs and Benefits
Financial executives do financial cost benefit
analysis. IRR is a method of cost analysis in
certain cases and Economic Rate of Return
(ERR) should replace the IRR for adequate and
rational appraisal of the same project in both
the economy.
Indicative Cost –Benefit-Analysis may be
useful for highly subjective decisions or
judgments.
The indicative or relative significance of
various variables deciding the ultimate
outcome of the decision making process can
be used for approximate cost benefit analysis.

Costs and Benefits
Ongoing business processes require a
quick ‘incremental Cost-Benefit analysis’ for
quick conclusions.
As long as incremental profit exceeds
incremental costs, the project is worth
while.
Sustainable Net incremental Benefit is very
often a strategic decision. It also require a
lot of strategic analysis based on a long-
tem appraisal of the uncertainty involved.

Costs and Benefits
The long term project will have to be
assessed with an average Cost Benefit
Analysis (CBA) for the project’s life cycle.
CBA with strategic perspective is of vital
significance.
Multi-product or multi-locational enterprises
always makes use of CBA in totality.
LIFE CYCLE COASTING (LCC) is
commonly used of the ‘life-cycle strategy
formulations of a project.

LIFE CYCLE COASTING (LCC)
LCC involve the analysis of the following
cost:
1.Cost of Launching
2.Cost of early corrections
3.Cost of take of
4.Cost of consolidation
5.Cost of leadership
6.Cost of Sustainance
7.Cost of Revival
8. Cost of withdrawal from market

97
RISK AND UNCERTAINTY
There are two types of expectations
individuals may have about the future-
– Certainty, and
– uncertainty
Risk describes a situation where there is not just
one possible outcome, but an array of potential
returns. Also there are various probabilities for
each of the probable returns.
Risk refers to a set of unique outcomes for a given
event which can be assigned probabilities while
uncertainty refers to the outcomes of a given event
which are too unsecure to be assigned probabilities.

12 - 98
Risk and Uncertainty
Risk refers to the variability in the actual
returns vis-à-vis the estimated returns, in
terms of cash flows.
Risk is an integral part of investment
decision. The uncertainty related with the
returns from an investment brings risk
into an investment.
The possibility of variation of actual
return from the expected return is known
as risk.

12 - 99
Definition of Risk
Risk may be defined as “ the chance of
future loss that can be foreseen”
Risk is the potential for variability in
return.
Risk involved in capital budgeting can be
measured in absolute as well as relative
terms. The absolute measures of risk
include sensitivity analysis, simulation
and standard deviation. The coefficient
of variation is a relative measure of risk.

100
Nature of Risk
Risk exists because of the inability of the
decision-maker to make perfect forecasts.
In formal terms, the risk associated with an
investment may be defined as the variability
that is likely to occur in the future returns from
the investment.
Three broad categories of the events influencing
the investment forecasts:
– General economic conditions
– Industry factors
– Company factors

101
Types of Risk
Risk
1. Business Risk
a) Internal Business Risk
b) External Business Risk
2. Financial Risk
Unsystematic Risk
1. Interest Rate Risk
2. Market Risk
3. Purchasing Power Risk
4. Exchange Rate Risk
Systematic Risk

12 - 102
Types of Risk
It is classified into mainly two types.
1. Systematic Risk
2. Unsystematic Risk
Systematic Risk is the risk which is directly related
with overall movement in general market or
economy. This type of risk covers factors which are
external to a particular company and are
uncontrollable by the company.
Unsystematic Risk refers to variability in returns
caused by unique factors relating to that firm or
industry like management failure, labor strikes, and
shortage of raw material. There are two source of
unsystematic or unique risk –business risk and
financial risk.

12 - 103
Unsystematic Risk
1. Business Risk
2. Financial Risk
1. Business Risk is the variability in operating income due
operating conditions of the company. This can be divided
into two types
a. Internal Business Risk
Factors affecting Internal Business
Risk are:
Fluctuation in Sale
Research and development
Personnel management
Fixed cost
Single product
b. External Business Risk
Result of operating conditions
imposed on the firm circumstances
beyond its control.
Social and regulatory factors
Political Risk
Business cycle

12 - 104
Unsystematic Risk
2. Financial Risk
It refers to the variability in return due to
capital structure.
The use of debt with owned funds to increase the return of
shareholders is known as financial leverage.
If the earnings are low, it may lead to bankruptcy to equity
shareholders.
Financial risk considers the difference between EBIT and
EBT
Business risk causes the variation between revenue and
EBIT.
Financial risk can be avoided by management by reducing
borrowed funds

12 - 105
Risk refers to situation in which the
decision maker knows the possible
consequences of an investment decision
whereas Uncertainty involves a situation
about which the likelihood of possible
outcome is not known.
Risk is the consequence of making
wrong decision and due to this, the
decision that is made is uncertain.
The bigger the risk, the greater the
uncertainty.

12 - 106
Types of Uncertainty
Uncertainty can be classified into the following
categories.
1.Market Uncertainty- caused by factors which are
external to the economy.
2.Technical Uncertainty- caused by technical
factors like size of production or change in
technology
3.Competitive Uncertainty- due to action of
competitors
4.Technological Uncertainty- non availability of
technology
5.Political Uncertainty- Due to Unstable political
system

12 - 107
Source of Uncertainty
1.Information incomplete
2.Reliability of source of Information
3.Variability- Parameters which change over time
4.Linguistic imprecision- People using imprecise terms and
expression in communication
Causes or Reasons of Risk and Uncertainty
1. Nature of investment
2. Maturity period
3. Amount of investment
4. Bias in data and its
assessment
5. Misinterpretation of data
6. Non-availability of
managerial talents
7. Method of investment
8. Nature of Business
9. Terms of lending
10. Wrong timing of investment
11. Nature of calamities (disasters)
12. Wrong investment decision
13. Creditworthiness of issuer
14. Obsolescence
15. Salvage ability of
investment

12 - 108
Investment Decision Under
Types of Investment Decision
1.Certainty (No Risk)-The estimated returns are equal
to the actual return
2.Uncertainty- An uncertain situation in one when
probabilities of occurrence of a particular event are
not known. In the case of uncertainty, future loss
cannot be foreseen. So, it cannot be planned in
advance by management
3.Risk- A risky situation is one in which the
probabilities of a particular event’s occurrence are
known. In the case of risk, chance of future loss can
be foreseen due to past experiences.

12 - 109
TECHNIQUES OF INVESTMENT DECISIONS
Investment decision techniques refer to the
choice by several decision makers of possible
outcomes and probabilities of their
occurrence under risk and uncertainty.
An investment decision always involve a
trade-off between risk and return.
Assessing risk and incorporating the same in
the final decision is an integral part of
financial analysis.

12 - 110
TECHNIQUES OF INVESTMENT DECISIONS
The main techniques of decision making
under the conditions of risk and uncertainty:
1.Risk-adjusted discount rate
2.Certainty equivalent method or approach
3.Statistical Methods
a) Standard deviation method
b) Coefficient of variation method
c) Sensitivity analysis
d) Simulation method
e) Probability and expected value method
f) Decision Tree analysis

12 - 111
Risk Adjusted Discount Rate
In this approach a risk premium is added to
the risk free discount rate. Risk adjusted
discount rate is than used to calculate net
present value in the normal manner.
Drawbacks of risk-adjusted discount rate
method : Risk-adjusted discount rate
method relies on accurate assessment of
the riskiness of a project. Risk perception
and judgment are subjective and
susceptible to personal bias.

112
Risk-Adjusted Discount Rate
Risk-adjusted discount rate, will
allow for both time preference
and risk preference and will be a
sum of the risk-free rate and the
risk-premium rate reflecting the
investor’s attitude towards risk.
Under CAPM, the risk-premium
is the difference between the
market rate of return and the
risk-free rate multiplied by the
beta of the project.
=0
NCF
NPV =
(1 )
n
t
t
t k+
∑
f rk = k + k

12 - 113
Risk Adjusted Discount Rate (RADR)
A project is required to invest Rs. 1,10,000 and is expected to generate
cash flows after tax over its economic life of 5 years of Rs. 20,000, Rs.
30,000, Rs. 35000, Rs. 55,000 and Rs. 10,000. Risk free interest rate is 7%,
and risk premium 3%. Calculate NPV using RADR method.
RADR=Risk free rate + risk premium=7+3=10%
Years CFAT
Discount Factor
(10%) PV
1 20000 0.909 18181.82
2 30000 0.826 24793.39
3 35000 0.751 26296.02
4 55000 0.683 37565.74
5 10000 0.621 6209.21
Total Present Value of Cash Inflow 113046.18
110000.00
3046.18
Cash Out Flow
NPV

114
Evaluation of Risk-adjusted Discount Rate
The following are the advantages of risk-adjusted discount
rate method:
– It is simple and can be easily understood.
– It has a great deal of intuitive appeal for risk-averse businessman.
– It incorporates an attitude (risk-aversion) towards uncertainty.
This approach, however, suffers from the following
limitations:
– There is no easy way of deriving a risk-adjusted discount rate. As
discussed earlier, CAPM provides for a basis of calculating the
risk-adjusted discount rate. Its use has yet to pick up in practice.
– It does not make any risk adjustment in the numerator for the cash
flows that are forecast over the future years.
– It is based on the assumption that investors are risk-averse.
Though it is generally true, there exists a category of risk seekers
who do not demand premium for assuming risks; they are willing
to pay a premium to take risks.

115
Certainty Equivalent
Certainty-equivalent is a common procedure for dealing with
risk in capital budgeting to reduce the forecast the cash flows
to some conservative levels.
There is a certainty-equivalent cash flow for all projects.
Certainty-equivalent approach may be expressed as:
Where NCF= the forecasts of net cash flow with out risk-
adjustment
α= the risk adjustment factor or certainty equivalent coefficient
k- risk free rate assumed to be constant for all period
=0
NCF
NPV =
(1 )f
n
t t
t
t k
α
+
∑

116 Financial Management, Ninth
Edition © I M Pandey
Certainty-equivalent coefficient α assumes a value between 0
and 1
If the investor feels that only 80% of expected cash flow is
certain, the Certainty-equivalent coefficient will be .80
Certainty-equivalent coefficient can be determined as a
relationship between the certain cash flows and risky cash
flows. That is
If expected cash flow is 80,000 and certain cash flow is 60,000
the
Certainty-equivalent coefficient α= 60,000/80,000=0.75
*
NCF Certain net cash flow
=
NCF Risky net cash flow
t
t
t
α =

117
Reduce the forecasts of cash
flows to some conservative
levels.
The certainty—equivalent
coefficient assumes a value
between 0 and 1, and varies
inversely with risk.
Decision-maker subjectively or
objectively establishes the
coefficients.
The certainty—equivalent
coefficient can be determined as
a relationship between the
certain cash flows and the risky
cash flows.
=0
NCF
NPV =
(1 )f
n
t t
t
t k
α
+
∑
*
NCF Certain net cash flow
=
NCF Risky net cash flow
t
t
t
α =

118
Sky Way Ltd. is considering an investment proposal which
requires 20 lakhs. The expected cash inflow and certainty
coefficients are given below: Risk Free interest rate is 6%.
Determine NPV of proposal
Year Cash Inflow
Certainty
Coefficient
1 600000 0.90
2 300000 0.85
3 700000 0.80
4 800000 0.75
5 900000 0.65

119
Certainty Equivalent (NPV)
Sky Way Ltd. is considering an investment proposal which
requires 20 lakhs. The expected cash inflow and certainty
coefficients are given below: Risk Free interest rate is 6%.
Determine NPV of proposal
Year
Cash
Inflow
Certainty
Coefficient
Certain Cash
In Flow
Discount
Factor (6%)
Present
Value
1 600000 0.90 540000 0.94 509433.96
2 300000 0.85 255000 0.89 226949.09
3 700000 0.80 560000 0.84 470186.80
4 800000 0.75 600000 0.79 475256.20
5 900000 0.65 585000 0.75 437146.03
2118972.08
2000000.00
118972.08
Present Value of Cash Inflow
Present Value of Cash Outflow
Net Present Value

120
Certainty Equivalent (IRR)
A company is considering an investment proposal
whose cost is Rs. 10000 and its economic life is 4
years. Expected cash flow and certainty factor is given.
Determine IRR.
Year Cash Inflow
Certainty
Coefficient
1 6667 0.90
2 2500 0.80
3 2000 0.50
4 12500 0.40

121
Certainty Equivalent (IRR)
(10841-10000) 841
IRR=12+ ------------------- x 2= 12 + ----- x 2
(11274-10841) 432.92
=12+3.886=15.886%
Year Cash Inflow
Certainty
Coefficient
Certain
Cash In Flow
D.F
(10%) P V
D.F
(12%) P V
1 6667 0.90 6000 0.909 5454.82 0.893 5357.41
2 2500 0.80 2000 0.826 1652.89 0.797 1594.39
3 2000 0.50 1000 0.751 751.31 0.712 711.78
4 12500 0.40 5000 0.683 3415.07 0.636 3177.59
11274.09 10841.17Present Value of Cash Inflow

122
Evaluation of Certainty—Equivalent
This method suffers from many dangers in a
large enterprise:
– First, the forecaster, expecting the reduction that
will be made in his forecasts, may inflate them in
anticipation.
– Second, if forecasts have to pass through several
layers of management, the effect may be to greatly
exaggerate the original forecast or to make it ultra-
conservative.
– Third, by focusing explicit attention only on the
gloomy outcomes, chances are increased for
passing by some good investments.

123 Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
Risk-adjusted Discount Rate Vs. Certainty–
Equivalent
The certainty—equivalent approach recognises risk in
capital budgeting analysis by adjusting estimated cash
flows and employs risk-free rate to discount the
adjusted cash flows. On the other hand, the risk-
adjusted discount rate adjusts for risk by adjusting the
discount rate. It has been suggested that the certainty
—equivalent approach is theoretically a superior
technique.
The risk-adjusted discount rate approach will yield the
same result as the certainty—equivalent approach if
the risk-free rate is constant and the risk-adjusted
discount rate is the same for all future periods.

© Tata McGraw-Hill Publishing Company Limited, Financial Management
12 - 124
Statistical Methods
Statistical techniques are analytical tools for
handling risky investments. This enable the
decision-maker to make decisions under risk or
uncertainty.
The concept of probability is fundamental to the
use of the risk analysis techniques.
Probability may be described as a measure of
someone’s opinion about the likelihood that an
event will occur .
Most commonly used method is to use high,
low and best guess estimates

12 - 125
Measurement of Risk
Statistical Methods
a) Standard deviation method
b) Coefficient of variation method
c) Sensitivity analysis
d) Simulation method
e) Probability and expected value method
f) Decision Tree analysis

© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 126
Measurement of Risk
Risk involved in capital budgeting can be
measured in absolute as well as relative terms.
The absolute measures of risk include
Sensitivity analysis,
Simulation, and
standard deviation.
The coefficient of variation is a relative measure
of risk.

Sensitivity Analysis
Sensitivity analysis provides information as to
how sensitive the various estimated project
parameters, namely selling price, cash flows, cost
of capital, unit sold, and project’s economic life
about estimation errors. Sensitivity analysis is
essentially a ‘what if’ analysis.
For example what if labor costs are 5% lower?
What if raw material double its price?, etc.
By carrying out a series of calculations it is
possible to build up a picture of the nature of
the risks facing the project and their impact on
project profitability.

Advantageous of Sensitivity analysis:
Information for decision making
To direct search – sensitivity analysis points to some
variables being more crucial than others
To make contingency plans –managers can make
contingency plans if the key parameters differ significantly
from the estimates
Drawbacks of Sensitivity analysis:
The absence of any formal assignment of probabilities
to the variations of the parameters is a potential
limitation of sensitivity analysis
Another criticism of sensitivity analysis is that each
variable is changed in isolation while all other factors
remain constant. In practice factors change
simultaneously

Sensitivity analysis provide information about
cash flows normally made under three
assumptions:
1) The most pessimistic – the worst
2) The most likely – the expected
3) The most optimistic- the best
the outcomes associated with the project

12 - 130
Example 1 From the under mentioned facts, compute the net present values
(NPVs) of the two projects for each of the possible cash flows, using
sensitivity analysis.
Particulars Project X Project Y
(’000) (’000)
Initial cash outlays (t = 0) Rs 40 Rs 40
Cash inflow estimates (t = 1 – 15)
Worst 6 0
Most-likely 8 8
Best 10 16
Required rate of return 0.10 0.10
Economic life (years) 15 15
Solution
The NPV of each project, assuming a 10 per cent required rate of return, can
be calculated for each of the possible cash flows. Table A-4 indicates that
the present value interest factor annuity (PVIFA) of Re 1 for 15 years at 10
per cent discount is 7.606. Multiplying each possible cash flow by Present
Value Interest Factor Annuity (PVIFA), we get, (Table 1):

© Tata McGraw-Hill Publishing Company Limited,
Financial Management 12 - 131
Table 1: Determination of NPV
Project X Project Y
Expected
cash inflows
PV NPV PV NPV
Worst
Most likely
Best
Rs 45,636
60,848
76,060
Rs 5,636
20,848
36,060
Nil
Rs 60, 848
1,21,696
(Rs 40,000)
20,848
81,696
Table 1 demonstrates that sensitivity analysis can produce some very useful
information about projects that appear equally desirable on the basis of the
most likely estimates of their cash flows. Project X is less risky than
Project Y. The actual selection of the project (assuming that the projects are
mutually exclusive) will depend on the decision maker’s attitude towards
risk. If the decision maker is conservative, he will select Project X as there
is no possibility of suffering losses. On the other hand, if he is willing to
take risks, he will choose Project Y as it has the possibility of paying a very
high return as compared to project X. Sensitivity analysis, in spite of being
crude, does provide the decision maker with more than one estimate of the
project’s outcome and, thus, an insight into the variability of the returns.

Assigning Probability
It has been shown above that sensitivity analysis provides more than one
estimate of the future return of a project. It is, therefore, superior to single-
figure forecast as it gives a more precise idea regarding the variability of the
returns. But it has a limitation in that it does not disclose the chances of
occurrence of these variations. To remedy this shortcoming of sensitivity
analysis so as to provide a more accurate forecast, the probability of the
occurring variations should also be given. Probability assignment to expected
cash flows, therefore, would provide a more precise measure of the variability
of cash flows. The concept of probability is helpful as it indicates the
percentage chance of occurrence of each possible cash flow.
For instance, if some expected cash flow has 0.6 probability of occurrence, it
means that the given cash flow is likely to be obtained in 6 out of 10 times (i.e.
60 per cent). Likewise, if a cash flow has a probability of 1, it is certain to
occur (as in the case of purchase–lease capital budgeting decision that is, the
chances of its occurrence are 100 per cent). With zero probability, the cash
flow estimate will never materialise. Thus, probability of obtaining particular
cash flow estimates would be between zero and one.

12 - 133
The procedure for assigning probabilities and determining the expected
value is illustrated in Table 2 by using the NPVs for projects X and Y of
Example 1.
TABLE 2 Calculation of Expected Values
Possible NPV Probability of the
NPV occurrence
NPV (×)
Probability
Project X
Rs 5,636 0.25 Rs 1,409
20,848 0.50 10,424
36,060 0.25 9,015
1.00 Expected NPV 20,848
Project Y
(40,000) 0.25 (10,000)
20,848 0.50 10,424
81,696 0.25 20,424
1.00 Expected NPV 20,848
The mechanism for calculating the expected monetary value and the NPV of
these estimates is further illustrated in Example 2.

Example 2
The following information is available regarding the expected cash flows generated,
and their probability for company X. What is the expected return on the project?
Assuming 10 per cent as the discount rate, find out the present values of the
expected monetary values.
Year 1 Year 2 Year 3
Cash flows Probability Cash flows Probability Cash flows Probability
Rs 3,000
6,000
8,000
0.25
0.50
0.25
Rs 3,000
6,000
8,000
0.50
0.25
0.25
Rs 3,000
6,000
8,000
0.25
0.25
0.50
Solution
TABLE 3 (i) Calculation of Expected Monetary Values
Cash
flows
Proba
bility
Monetar
y values
Cash
flows
Probab
ility
values
Monetar
y
Cash
flows
Proba
bility
values
Monet
ary
Rs 3,000
6,000
8,000
Total
0.25
0.50
0.25
Rs 750
3,000
2,000
5,750
Rs 3,000
6,000
8,000
0.50
0.25
0.25
Rs 1,500
1,500
2,000
5,000
Rs 3,000
6,000
8,000
0.25
0.25
0.50
Rs
750
1,500
4,000
6,250

(ii) Calculation of Present Values
Year 1 Rs 5,750 × 0.909 = Rs 5,226.75
Year 2 5,000 × 0.826 4,130.00
Year 3 6,250 × 0.751 4,693.75
Total 14,050.50

Sensitivity analysis
Sensitivity analysis can also be used to
ascertain how change in key variables (say,
sales volume, sales price, variable costs,
operating fixed costs, cost of capital and so
on) affect the expected outcome (measured
in terms of NPV) of the proposed
investment project.
For the purpose of analysis, only one
variable is considered, holding the effect of
other variables constant, at a point of time.

Example 6.1
Acmart plc has developed a new product line called Marts. The likely demand is
1,00,000 per year at a price of Rs. 1 for the 4 year period.
Cash Flows of Mart
Initial Investment Rs. 800,000
Cash Flow per unit Rs.
Sale Price 1.00
Costs
Labour
Material
Overhead
Cash Flow Per unit
0.20
0.40
0.10
0.70
0.30
Required rate of return is 15%
Solution
Annual Cash Flow =.30x1,00,000=Rs. 300,000
Present Value of annual cash flows=300,000xannuity factor for 4 years @ 15%
=300,000x2.855 =856,500 -
Initial Investment =800,000
Net Present Value =+56,500

What if the price is only 95 ps
Annual Cash flow= .25x1,00,000=Rs. 250,000
Present Value of annual cash flows=250,000x2.855 =713,750-
Net Present Value =-86,250
What if the price rose by 1%
What if the quantity demanded is 5% more
Present Value of annual cash flows=315,000x2.855 =899.325-
What if the quantity demanded is 10% less than expected
Annual Cash flow= .30x 90,000=Rs. 270,000
Net Present Value =-29,150

What if discount rate is 20% more than what is originally expected ( 15*1.2=18%)
Present Value of annual cash flows=300,000xannuity factor for 4 years @ 18%
=300,000x2.6901 =807,030 -
Net Present Value =+ 7,030
What if discount rate is 20% lower than what is originally expected ( 15*.8=13.5%)
Present Value of annual cash flows=300,000xannuity factor for 4 years @ 13.5%
=300,000x2.9438 =883,140 -
Net Present Value =+ 83,140

Break-Even NPV
The Break-Even point is where NPV is zero. If the NPV is
below zero the project is rejected, if it is above zero, it is
accepted

Scenario Analysis
With Sensitivity Analysis we change one variable at a time
and look at the result.
Managers are often interested in situation where a number
of factors change.
They are interested in worst-case and best-case scenario.
That is, what NPV will result if all the assumptions made
initially turned out to be too optimistic? And what would be
the result if, in the event, matters went extremely well on all
fronts.

Simulation
Simulation is a statistically based behavioral
approach used in capital budgeting to get a feel
for risk by applying predetermined probability
distributions and random numbers to estimate
risky outcomes.
A Simulation Model is akin (similar) to sensitivity analysis
as it attempts to answer ‘what if’ question.
Advantage of simulation is that it is more comprehensive.
Instead of showing impact on NPV for change in one key
variable, simulation enables the distribution of probable
values for change in all key variables.
Simulation requires sophisticated computing

143
Simulation Analysis
• The Monte Carlo simulation or simply the simulation
analysis considers the interactions among variables and
probabilities of the change in variables. It computes the
probability distribution of NPV. The simulation analysis
involves the following steps:
– First, you should identify variables that influence cash inflows and
outflows.
– Second, specify the formulae that relate variables.
– Third, indicate the probability distribution for each variable.
– Fourth, develop a computer programme that randomly selects one
value from the probability distribution of each variable and uses
these values to calculate the project’s NPV.

144
Techniques for Risk Analysis
• Statistical Techniques for Risk Analysis
–Probability
–Variance or Standard Deviation
–Coefficient of Variation
• Conventional Techniques of Risk Analysis
–Payback
–Risk-adjusted discount rate
–Certainty equivalent

© Tata McGraw-Hill Publishing Company Limited, Financial Management
12 - 145
Statistical Methods
Statistical techniques are analytical tools for
handling risky investments. This enable the
decision-maker to make decisions under risk or
uncertainty.
The concept of probability is fundamental to the
use of the risk analysis techniques.
Probability may be described as a measure of
someone’s opinion about the likelihood that an
event will occur .
Most commonly used method is to use high,
low and best guess estimates

Probability
• A typical forecast is single figure for a period. This is
referred to as “best estimate” or “most likely” forecast:
– Firstly, we do not know the chances of this
figure actually occurring, i.e., the uncertainty
surrounding this figure.
– Secondly, the meaning of best estimates or
most likely is not very clear. It is not known
whether it is mean, median or mode.
• For these reasons, a forecaster should not give just
one estimate, but a range of associated probability–a
probability distribution.
• Probability may be described as a measure of
someone’s opinion about the likelihood that an event
will occur.

Assigning Probability
• The probability estimate, which is based on a
very large number of observations, is known as
an objective probability.
• Such probability assignments that reflect the
state of belief of a person rather than the
objective evidence of a large number of trials
are called personal or subjective
probabilities.

148
Expected Net Present Value
• Once the probability
assignments have been
made to the future cash
flows the next step is to
find out the expected net
present value.
• Expected net present value
= Sum of present values of
expected net cash flows.
=0
ENPV =
(1 )
n
t
t
ENCF
k+
∑
ENCF = NCF ×t jt jtP

149
Variance or Standard Deviation
• Simply stated,
variance measures
the deviation about
expected cash flow
of each of the
possible cash flows.
• Standard deviation
is the square root of
variance.
• Absolute Measure
of Risk.
2 2
=1
(NCF) = (NCF – ENCF)
n
j j
j
Pσ ∑

Independent Cash Flows Over Time The mathematical
formulation to determine the expected values of the
probability distribution of NPV for any project is:
The above calculations of the standard deviation and the
NPV will produce significant volume of information for
evaluating the risk of the investment proposal. The
calculations are illustrated in Example 6.

12 - 151
Example 6
Suppose there is a project which involves initial cost of Rs 20,000 (cost
at t = 0). It is expected to generate net cash flows during the first 3
years with the probability as shown in Table 7.
TABLE 7 Expected Cash Flows
Probability Net cash
flows
flows
flows
0.10 Rs 6,000 0.10 Rs 4,000 0.10 Rs 2,000
0.25 8,000 0.25 6,000 0.25 4,000
0.30 10,000 0.30 8,000 0.30 6,000
0.25 12,000 0.25 10,000 0.25 8,000
0.10 14,000 0.10 12,000 0.10 10,000

12 - 152
Solution
Table 8 Calculation of Expected Values of Each Period
Time
period
Probability
(1)
Net cash flow
(2)
Expected value (1 × 2)
(3)
Year 1
Year 2
Year 3
0.10
0.25
0.30
0.25
0.10
0.10
0.25
0.30
0.25
0.10
0.10
0.25
0.30
0.25
0.10
Rs 6,000
8,000
10,000
12,000
14,000
4,000
6,000
8,000
10,000
12,000
2,000
4,000
6,000
8,000
10,000
Rs 600
2,000
3,000
3,000
1,400
= 10,000
400
1,500
2,400
2,500
1,200
= 8,000
200
1,000
1,800
2,000
1,000
= 6,000
(3) NPV = Rs 10,000 (0.909) + Rs 8,000 (0.826) + Rs 6,000 (0.751) – Rs
20,000 = Rs 204.

12 - 153
Solution
1 . Expected Values: For the calculation of standard deviation for
different periods, the expected values are to be calculated first. These
are calculated in Table 8.

154
Coefficient of Variation
Relative Measure of Risk
It is defined as the standard deviation of the
probability distribution divided by its
expected value:
Coefficient of Variation (CV)=
Standard deviation/Expected Value

155
Coefficient of Variation
• The coefficient of variation is a useful
measure of risk when we are comparing
the projects which have
– (i) same standard deviations but different expected
values, or
– (ii) different standard deviations but same
expected values, or
– (iii) different standard deviations and different
expected values.

156
Scenario Analysis
• One way to examine the risk of
investment is to analyse the impact of
alternative combinations of variables,
called scenarios, on the project’s NPV
(or IRR).
• The decision-maker can develop some
plausible scenarios for this purpose. For
instance, we can consider three
scenarios: pessimistic, optimistic and
expected.

Shortcomings
• The model becomes quite complex to
use.
• It does not indicate whether or not the
project should be accepted.
• Simulation analysis, like sensitivity or
scenario analysis, considers the risk of
any project in isolation of other projects.

158
Capital Asset Pricing Model
CAPM deals with how the assets or securities should be
priced in capital market. CAPM attempts to understand
the behavioural aspects of the capital markets. It is a
conservative but balanced approach.
It provides theoretical linear relationship between risk
return trade-offs of individual securities/assets to market
returns.
CAPM relates returns on individual stock and stock
market returns over a period of time.

Capital Asset Pricing Model
• Risky asset i:
• Its price is such that:
E(return) = Risk-free rate of return + Risk premium specific to asset i
= Rf + (Market price of risk)x(quantity of risk of asset i)
CAPM tells us 1) what is the price of risk?
2) what is the risk of asset i?

11-160
CAPITAL ASSET PRICING MODEL (CAPM)
APPROACH
The CAPM describes the relationship between the required rate of return or
the cost of equity capital and the non-diversifiable or relevant risk of the
firm as reflected in its index of non-diversifiable risk, that is, beta.
Symbolically,
Ke = Rf + b (Km – Rf ) (14)
Rf = Required rate of return on risk-free investment
b = Beta coefficient**, and
Km = Required rate of return on market portfolio, that is, the average
rate or
return on all assets
M = Excess in market return over risk-free rate,
J = Excess in security returns over risk-free rate,
MJ = Cross product of M and J and
N = Number of years
( )∑
∑
−
−
= 22
MNM
JMNMJ
b

Introduction
• Corporate restructuring includes
mergers and acquisitions (M&As),
amalgamation, takeovers, spin-offs,
leveraged buy-outs, buyback of shares,
capital reorganisation etc.
• M&As are the most popular means of
corporate restructuring or business
combinations.

Financial Management, Ninth Edition © I M Pandey
Motives and Benefits of Mergers and
Acquisitions
 Utilise under-utilised resources–human and
physical and managerial skills.
 Displace existing management.
 Circumvent government regulations.
 Reap speculative gains attendant upon new
security issue or change in P/E ratio.
 Create an image of aggressiveness and
strategic opportunism, empire building and to
amass vast economic powers of the
company.

163Financial Management, Ninth Edition © I M Pandey
Benefits of Mergers and
Acquisitions
 The most common advantages of M&A
are:
 Accelerated Growth
 Enhanced Profitability
 Economies of scale
 Operating economies
 Synergy
 Diversification of Risk

Acquisitions
 Reduction in Tax Liability
 Financial Benefits
 Financing constraint
 Surplus cash
 Debt capacity
 Financing cost
 Increased Market Power

Costs of Mergers and
Acquisitions External growth could be expensive if the
company pays an excessive price for merger.
Price may be carefully determined and
negotiated so that merger enhances the value of
shareholders.

166
9-166
A Cost to Stockholders from Reduction in
Risk
In a firm with debt, the gains are likely to
be shared by both bondholders, and stock
holders. The benefit gained by bond
holders are on the expense of stock
holders.
The gains to the creditors are at the expense
of the shareholders if the total value of the firm
does not change.
An acquisition can create an appearance of
earnings growth, which may fool investors into
thinking that the firm is worth than it really is.

9-167
A Cost to Stockholders from
Reduction in Risk
 The Base Case
 If two all-equity firms merge, there is no transfer of
synergies to bondholders, but if…
 One Firm has Debt
 The value of the levered shareholder’s call option
falls.
 How Can Shareholders Reduce their Losses from
the Coinsurance Effect?
 Retire debt pre-merger.

AcquisitionsThe most common advantages of M&A are:
 Accelerated Growth
A company can achieve its growth objective by:
 Expanding its existing markets
 Entering into new markets
Mergers results into accelerated growth
 Enhanced Profitability
Combination of two or more companies may result in more
than the average profitability due to cost reduction and
efficient utilization of resources. This may happen
because of the following reasons:
 Economies of scale
 Operating economies
 Synergy

AcquisitionsEconomies of scale
Economics of scale arises when increase in the volume of production
leads to the decrease in cost of production per unit. Mergers may
help to expand volume of production without a corresponding
increase in fixed cost. It also helps in
 Optimum utilization of management resources and systems and
planning
 Budgeting
 Reporting and control
Operating economies
A combine firm may avoid or reduce overlapping functions and
facilities
It can consolidate functions such as manufacturing, marketing, R&D
and reduce operating costs
Vertical integration (backward integration or forward integration) leads
to better business operations- purchasing, manufacturing, and
marketing.

AcquisitionsSynergy
Synergy implies a situation where the combined firm is
more valuable than the sum of the individual combining
firms. Operating economics are one form of synergy
benefit. There is also
 enhanced managerial capabilities,
 Creativity,
 Innovativeness
 R&D and market coverage capacity

Acquisitions Diversification of Risk
Diversification implies growth through the combination
of firms in unrelated businesses. Such mergers are
called conglomerate mergers. Such mergers results in
reduction in non- systematic risks –company related
risks with out taking any efforts by the investors to
diversify their portfolio.
 Reduction in Tax –liability
A company is allowed to carry forward their accumulated
loss. The combined company can make use of this carry
forward facility of the loss of loss making company after
merger.

Acquisitions Financial Benefits
A merger may help in :
 Eliminating the financial constraint
 Deploying surplus cash
 Enhancing dept capacity
 Lowering the financial cost
 Increased Market Power
 A merger can increase the market share of the merged
firm that will improve the profitability
 The bargaining power vis-a-vis labour, suppliers, and
buyers is also increased
 Exploit technological advantage

Corporate Restructuring
Corporate restructuring implies activities related to
expansion/ contraction of a firm’s operations or
changes in its assets or financial or ownership
structure.
The most common forms of corporate restructuring are
mergers/amalgamations and acquisitions/takeovers,
financial restructuring, divestitures/demergers and
buyouts.

FORMS OF EXPANSION
 Internal Expansion
Gradual increase in the activities of the concern –
expand production capacity by adding m/c etc.
 External Expansion or Business Combinations
Two or more companies combine and expand their
business activities. The ownership and control of the
combining concerns may be undertaken by single
agency.

FORMS OF COMBINATIONS
Merger or Amalgamation
A merger is a combination of two or more
companies into one company. It may be in the
form of one or more companies being merged into
an existing company or a new company may be
formed to merge two or more existing companies.
 Absorption
A combination of two or more companies into an
existing company is known as absorption.
 Consolidation
A consolidation is a combination of two or
more companies into a new company.

Acquisition and Take-over
Acquiring company takes over the ownership of
one or more other companies and combine their
operations. The control over management of
another company can be acquired through either
a ‘friendly take-over’ or through ‘forced’ or
‘unwilling acquisition’.
Holding Companies
A holding company is a form of business
organization which is created for the purpose of
combining industrial units by owning a controlling
amount of their share capital.
FORMS OF COMBINATIONS ..

Acquisition
A transaction where one firm buys another firm
with the intent of more effectively using a core
competence by making the acquired firm a
subsidiary within its portfolio of businesses

Takeover vs. Acquisitions
Takeover – The term takeover is understood
to connote hostility. When an acquisition is a
‘forced’ or ‘unwilling’ acquisition, it is called a
takeover.
A holding company is a company that holds
more than half of the nominal value of the
equity capital of another company, called a
subsidiary company, or controls the
composition of its Board of Directors. Both
holding and subsidiary companies retain their
separate legal entities and maintain their
separate books of accounts.

Takeover vs. Acquisitions
Acquisition may be defined as an act of
acquiring effective control over assets or
management of a company by another
company without any combination of
businesses or companies.
A substantial acquisition occurs when an
acquiring firm acquires substantial quantity of
shares or voting rights of the target company.

Types of Business
CombinationMerger or Amalgamation
– Merger or amalgamation may take two forms:
• Absorption is a combination of two or more
companies into an existing company.
• Consolidation is a combination of two or more
companies into a new company.
– In merger, there is complete amalgamation of the assets
and liabilities as well as shareholders’ interests and
businesses of the merging companies. There is yet
another mode of merger. Here one company may
purchase another company without giving proportionate
ownership to the shareholders’ of the acquired company
or without continuing the business of the acquired
company.

Types of Business
CombinationForms of Merger:
–Horizontal merger - Combination of two
or more firms in similar type of
production, distribution, or area of
business
–Vertical merger - Combination of two or
more firms involved in different stages
of production or distribution.
–Conglomerate merger - Combination of
firms engaged in unrelated lines of
business activity.

Mergers and Takeovers
When two companies join to form one
new firm, it can be:
voluntary, also known as a ‘merger’
or
forced, when it is known
as a ‘takeover’

Merger
A transaction where two firms agree to integrate
their operations on a relatively coequal basis so
they have resources and capabilities that
together may create a stronger competitive
advantage
Merger activity is an example of ‘integration’
taking place within industries.

Mergers
While a merger is a combination of two or more firms
in which the resulting firm maintains the identity of one
of the firms only, an amalgamation involves the
combination of two or more firms to form a new firm. In
the case of merger/absorption, the firm that has been
acquired/absorbed is known as the target firm and the
firm that acquires is known as the acquiring firm. There
are three types of mergers:
1) Horizontal,
2) Vertical and
3) Conglomerate.

Horizontal merger is a merger when two or
more firms dealing in similar lines of activity
combine together.
Vertical merger is a merger that involves two
or more stages of production/distribution that
are usually separate.
Conglomerate merger is a merger in which
firms engaged in different unrelated activities
combine together.

Why Integrate?
Firms are sometimes keen to
merge when:
 they can make savings from being bigger
 this is known as gaining ‘economies
of scale’
 they can compete with larger firms
or eliminate competition
 they can spread production over
a larger range of products or services

Economics of Merger
The major economic advantages of a merger are:
1) Economies of scale,
2) Synergy,
3) Fast growth,
4) Tax benefits and
5) Diversification.
Synergy takes place as the combined value of the merged firm is
likely to be greater than the sum of individual business entities.
The combined value = value of acquiring firm, VA + value of target
firm, Vt + value of synergy, ΔVAT. (1)
In ascertaining the gains from the merger, costs associated with
acquisition should be taken into account. Therefore, the net gain
from the merger is equal to the difference between the value of
synergy and costs:
Net gain = ΔVAT – costs (2)

Economies of Scale
There are several types of economy
of scale:
 technical economies, when producing the good by
using expensive machinery intensively
 managerial economies,
by employing specialist managers
 financial economies, by borrowing
at lower rates of interest
 commercial economies,
by buying materials in bulk
 marketing economies, spreading the cost of
advertising
and promotion
 research and development economies, from
developing better products

Economies of Scale
There are sometimes problems
that can affect integrated firms. These are
known
as ‘diseconomies of scale’
 firms are too big
to operate effectively
 decisions take too long to make
 poor communication occurs

Mergers, Acquisition and Takeovers
The two terms - ‘mergers’ and ‘acquisition’
represent the ways by strategies used by
companies to buy, sell and recombine
businesses. In the present day when there exists
cut throat competition in every sphere, not all
mergers and acquisitions are consensual and
peaceful.
The concept of takeovers without consent have,
therefore been ideally termed “hostile takeovers”.
no consented.

Legal and Regulatory Framework for
Takeovers in India
The term “acquirer” means any person
who, directly or indirectly, acquires or
agrees to acquire control over the target
company, or acquires or agrees to acquire
control over the target company, either by
himself or with any person acting in
concert with the acquirer

Tender Offer and Hostile
Takeover
 A tender offer is a formal offer to purchase a
given number of a company’s shares at a
specific price.
 Tender offer can be used in two situations.
 First, the acquiring company may directly
approach the target company for its takeover. If
the target company does not agree, then the
acquiring company may directly approach the
shareholders by means of a tender offer.
 Second, the tender offer may be used without any
negotiations, and it may be tantamount to a
hostile takeover.

Permission for merger
Information to the stock exchange
Approval of board of directors
Application in the High Court
Shareholders’ and creditors’ meetings
Sanction by the High Court
Filing of the Court order
Transfer of assets and liabilities
Payment by cash or securities
Legal Procedures for merger

1. Permission for merger
Two or more companies can amalgamate only when
amalgamation is permitted under their memorandum of
association. Also, the acquiring company should have
the permission in its object clause to carry on the
business of the acquired company.
2. Information to the stock exchange
The acquiring and the acquired companies should inform
the stock exchanges where they are listed about the
merger
3. Approval of board of directors
The board of directors of the individual companies should
approve the draft proposal for amalgamation and
authorize the management of companies to further
persue the proposal.
Legal Procedures for merger

Legal Procedures for merger ..
4. Application in the High Court
An application for approving the draft amalgamation
proposal duly approved by the boards of directors of the
individual companies should be made to the high court.
High court would convene a meeting of the shareholders
and creditors to approve the amalgamation proposal.
5. Shareholders’ and creditors’ meetings
At least 75% of shareholders and creditors in separate
meeting, voting in person or by proxy, must accord their
approval to the scheme
6. Sanction by the High Court
After the approval of shareholders and the creditors, on
the petitions of the companies, the High court will pass
order sanctioning the amalgamation scheme after it is
satisfied that the scheme is fair and reasonable.

Legal Procedures for merger ..
7. Filing of the Court order
After the court order, its certified true copies will be filed
with the Registrar of companies.
8. Transfer of assets and liabilities
The assets and liabilities of the acquired company will be
transferred to the acquiring company in accordance
with the approved scheme, with effect from the specified
date
9. Payment by cash or securities
As per the proposal, the acquiring company will
exchange shares and debentures and/or pay cash for the
shares and debentures of the acquired company. These
securities will be listed on the stock exchange.

Accounting for Mergers and
Acquisitions
Pooling of Interests Method
 In the pooling of interests method of accounting, the
balance sheet items and the profit and loss items of the
merged firms are combined without recording the effects
of merger. This implies that asset, liabilities and other
items of the acquiring and the acquired firms are simply
added at the book values without making any
adjustments.
Purchase Method
 Under the purchase method, the assets and liabilities of
the acquiring firm after the acquisition of the target firm
may be stated at their exiting carrying amounts or at the
amounts adjusted for the purchase price paid to the
target company.

Takeovers in India
The term “acquirer” means any person who,
directly or indirectly, acquires or agrees to
acquire control over the target company,
either by himself or with any person acting in
concert with the acquirer.

The Takeover Code makes it difficult for the hostile
acquirer to just sneak up on the target company. It
forewarns the company about the advances of an
acquirer by mandating that the acquirer make a
public disclosure of his shareholding or voting rights
to the company if he acquires shares or voting
rights beyond a certain specified limit.
The Takeover Code also imposes a prohibition on the certain
actions of a target company during the offer period, such as
transferring of assets or entering into material contracts and
even prohibits the issue of any authorized but unissued
securities during the offer period. However, these actions
may be taken with approval from the general body of
shareholders.
Takeovers in India

Takeovers in India
The regulation provides for certain exceptions such as
the right of the company to issue shares carrying
voting rights upon conversion of debentures already
issued or upon exercise of option against warrants,
according to pre-determined terms of conversion or
exercise of option. It also allows the target company to
issue shares pursuant to public or rights issue in
respect of which the offer document has already been
filed with the Registrar of Companies or stock
exchanges, as the case may be.
Further the law does not permit the Board of Director, of the
target company to make such issues without the shareholders
approval either prior to the offer period or during the offer period
as it is specifically prohibited under Regulation 23.

Takeovers in India
The Takeover Code is required to be read with the
SEBI (Disclosure & Investor Protection) Guidelines,
which are the nodal regulations for the methods and
terms of issue of shares/warrants by a listed Indian
company.
Under the DIP guidelines, issuing shares at a
discount and warrants which convert to shares at a
discount is not possible as the minimum issue price
is determined with reference to the market price of
the shares on the date of issue or upon the date of
exercise of the option against the warrants.

Takeovers in India
Also, the FDI policy and the FEMA Regulations
have provisions which restrict non-residents from
acquiring listed shares of a company directly from
the open market in any sector, including sectors
falling under automatic route. There also exist
certain restrictions with respect to private acquisition
of shares by non-residents. This has practically
sealed any hostile takeover of any Indian company
by any non-resident

Reasons for strategic failures of
merger/acquisition
1. The strategy is misguided- Strategic plans which turned out
to be value destroying rather creating
2. Over optimism - Acquiring managers have to cope with
uncertainty about the future potential of their acquisition. It
is possible for them to be over optimistic about the market
economics, the competitive position and the operating
synergies available
3. Failure of Integration Management- One problem is the over-
rigid adherence to prepared integration plans. Usually the
plans require dynamic modification in the light of experience
and altered circumstances. The integration programme
may have been based on incomplete information and may
need post-merger adaptation to the new perception of
reality.

Reasons for strategic failures of
merger/acquisition
Most common causes of failure Most common causes of success
Target management attitudes
and cultural difference
Little of no post-acquisition
planning
Lack of knowledge of industry
or target
Poor management and poor
management practices in the
acquired company
Little or no experience of
acquisitions
Detailed post-acquisition
plans and speed of
implementation
A clear purpose for
making acquisitions
Good cultural fit
High degree of
management co-opertion
In-depth knowledge of the
acquiree and his industry

Reasons for failures of
merger/acquisition
There are several reasons merger or an acquisition failures. Some
of the prominent causes are summarized below:
 If a merger or acquisition is planned depending on the (bullish) conditions
prevailing in the stock market, it may be risky.
There are times when a merger or an acquisition may be effected for the
purpose of "seeking glory," rather than viewing it as a corporate strategy to
fulfill the needs of the company.
Regardless of the organizational goal, these top level executives are more
interested in satisfying their "executive ego."
Failure may also occur if a merger takes place as a defensive measure to
neutralize the adverse effects of globalization and a dynamic corporate
environment.
Failures may result if the two unifying companies embrace different
"corporate cultures.“
The primary issue to focus on is how realistic the goals of the prospective
merger are

207
Financing a Merger
Cash or exchange of shares or combination of
cash, shares and debt can finance a merger
or acquisition.
The means of financing may change the debt-
equity mix of the combined or acquired firm
after merger.

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