Corporate Financial Strategy 4 th edition

Transcription

1 Corporate Financial Strategy 4 th edition Ruth Bender Routledge (October 2013) ISBN: , 390 pages Theme of the Book The book provides a practical guide to the way in which the appropriate use of financial strategy can add value to the overall corporate strategy adopted by an organization. The relevant theories of corporate finance are considered but their more important applications in the real world represent the primary focus of the book. A major contention of the book is that shareholder value can be significantly improved by implementing the most appropriate financial strategy in each business context. Knowledge Interchange Book Summaries Cranfield University

2 Key Learning Points The ultimate aim of a company is the creation of long-term shareholder value, and to achieve this it will need to take account of other stakeholders. Shareholder value represents the excess of the actual rate of return over the required rate of return and it is only created by investments that generate positive net present value for the business. The management of cost of capital is a primary objective of corporate financial strategy, and involves balancing the use of the various types of financial instrument. A basic tenet of financial strategy is that financial risk, for example, the level of borrowing a company has, should be in inverse proportion to business risk. Business risk will progressively decrease over the product life cycle, and financial risk should increase. Investors required return is positively correlated with their perception of risk. The building blocks of financial instruments are risk, yield and capital gain. As a company grows, its need for funds might lead it to market its shares on the public stock markets. Once the decision to float is made, this becomes a marketing exercise rather than a financing exercise. Acquisitions need to be judged in the light of the value they create, and evaluated specifically in terms of the way in which they change value drivers. This is the true meaning of synergy. Knowledge Interchange Book Summaries Cranfield University

3 Contents Preface PART 1 PUTTING FINANCIAL STRATEGY INTO CONTEXT 1. Corporate Financial Strategy: Setting the Context 2. What does the Share Price tell us? 3. Executive Summary: Linking Corporate and Financial Strategies 4. Linking Corporate and Financial Strategies 5. Financial Strategies over the Lifecycle 6. Corporate Governance and Financial Strategy PART 2 FINANCIAL STRATEGY AND THE CORPORATE LIFE CYCLE 7. Start-Up Businesses and Venture Capital 8. Growth Companies 9. Mature Companies 10. Declining Businesses: A Case for Euthanasia? PART 3 FINANCIAL INSTRUMENTS 11. Financial Instruments: The Building Blocks 12. Types of Financial Instrument 13. Dividends and Buybacks PART 4 TRANSACTIONS AND OPERATING ISSUES 14. Valuations and Forecasting 15. Floating a Company 16. Acquisitions and Selling a Business 17. Restructuring a Company 18. Private Equity 19. International Corporate Finance 20. Strategic Working Capital Management Appendix 1: Review of Theories of Finance Appendix 2: Valuing Options and Convertibles Knowledge Interchange Book Summaries Cranfield University

4 KEY LEARNING POINTS FROM CHAPTERS 1. Corporate Financial Strategy: Setting the Context Financial strategy concerns how companies raise and deploy their funds. The investor s required return can be mapped against their perceived risk. Delivering value for shareholders - which is the main financial objective of a company - means giving them an above-the-line return. A company can be valued by discounting its expected future cashflows at an appropriate cost of capital. Value arises from creating competitive advantage through successful business strategy, in combination with a successful financial strategy, to increase those cash flows and reduce the cost of capital. Markets are not perfect, nor totally efficient. Often, they are not rational. Companies and investors can create value in the market imperfections. Ideally, a company s market value should reflect its fundamental value. If this is not the case, one or more groups of stakeholders will suffer. Shareholder value can be calculated using various methods, each of which measures different attributes. Agency theory, which discusses the difference in objectives between managers and owners, can be used to explain many aspects of corporate finance. Stakeholder management is an important part of long-term shareholder value creation. Although accounting results are not necessarily an indicator of shareholder value, companies spend much time and effort on ensuring that the accounting results look good, sometimes to the detriment of long-term value. Knowledge Interchange Book Summaries Cranfield University

5 2. What does the Share Price tell us? A company s share price reflects the market s risk-adjusted expectations of its future performance, thus it varies with changes in perceived risk and growth. The higher the share price relative to current earnings (as measured by the P/E ratio), the harder the management will have to work to achieve the growth inherent in the share price. One way of calculating the expected growth uses the Dividend Growth Model, taking the cost of equity as calculated by the Capital Asset Pricing Model, and feeding in the known dividend and share price. Merely achieving the growth inherent in the share price does not generate shareholder value; value is created when the growth requirement is exceeded. Because companies cannot grow at a high rate forever, P/E ratios will reduce over time. This means that eps growth has to exceed the required share price growth in order to generate the expected return. Steady state a theoretical concept can be used to calculate what the company s share price would be if it were to remain at the same profit level forever. The difference between the current share price and the steady state price reflects the Present Value of Growth Opportunities (PVGO). 3. Executive Summary: Linking Corporate and Financial Strategies These few pages set out the core messages of chapters 4 and Linking Corporate and Financial Strategies Risk relates to the volatility of expected results. It can arise from the characteristics of the business, or the chosen financial strategy. Financial strategy covers four decisions: How much shall we invest in assets? How shall we finance the business? What dividend policy is appropriate? Shall we raise new equity? A company s choice of financial strategy must relate to its business strategy, its business risk, and the cash flows it is expected to generate. Companies with high business risk should adopt a low-risk financial strategy, and vice versa. Knowledge Interchange Book Summaries Cranfield University

6 The appropriate business strategy takes account of strategic analysis in the light of the seven drivers of value. Companies often follow a pecking order of funding, preferring sources with lower information asymmetry (i.e. internal funds, then debt) over expensive equity. 5. Financial Strategies over the Lifecycle The life cycle model shows how business risk is likely to change as a company develops, and, accordingly, how financial strategy should develop. Start-ups and growth companies are usually high-risk businesses strapped for cash, and should adopt low-risk financing structures, primarily equitybased. Dividends should not be paid. Mature companies are generally cash-generative low-risk businesses, which can improve their return to shareholders by increasing their financing risk, taking on debt and paying dividends. Businesses in managed decline, where the cashflows are clearly understood, should pay out as much in dividend and borrow as much as they are able. As a business progresses through the life cycle, its P/E ratio should fall, meaning that eps needs to rise, to provide the investors required return. 6. Corporate Governance and Financial Strategy Corporate governance relates to accounting and management systems, as well as to the composition of the board. It can be a means of reducing business risk. The ownership life cycle takes a business from sole trader through to various forms of corporate ownership and direction. As an organisation moves through this cycle, different aspects of governance become more important. An investor s or lender s perception of the governance regime under which a company operates will significantly affect their perception of risk, and thus their required cost of capital. Knowledge Interchange Book Summaries Cranfield University

7 7. Start-Up Businesses and Venture Capital Start-ups carry a high business risk and so their financial strategy should be low risk. This means equity finance, by venture capital investors, with no dividend payout but seeking a high capital gain. In evaluating risky investments, probability-adjusted cash flows can be discounted at a normal cost of capital. Failing this, the base forecast cash flows should be discounted at a cost of capital that has been increased to allow for the risk. Although this latter method is the most common, the former is intellectually more attractive and leads to fewer errors. Venture capital can come from specialist investment funds, from commercial companies in the form of corporate venturing, or from individuals, known as business angels. Companies raising venture capital can expect to have to give special protections to their investors, via the share agreement. Such protections include anti-dilution and liquidation preference clauses. The termsheet should be negotiated to balance investors protections with the entrepreneur s ability to make a fair return. 8. Growth Companies Business risk remains high during a company s growth stage, so its financial risk should be low. This means an equity funding strategy, and minimal dividend payments, if any. Equity at this stage will be from investors who require a lower return than the venture capitalists who funded the launch stage. This might be through an initial public offering on a stock exchange, or via a private placement to a group of investors. 9. Mature Companies As companies approach maturity the level of business risk reduces and so it is appropriate to take on more financial risk: debt should increase. Also, with fewer growth opportunities, the dividend payout should also increase. Investors return in this stage comes more from dividends and less from expected capital growth. Knowledge Interchange Book Summaries Cranfield University

8 As a company increases its dividend payout, the theoretical cost of equity and expected share price can be recalculated. The nature of project finance means that start-up infrastructure projects are often, correctly, financed as mature businesses once the initial construction phase is complete. 10. Declining Businesses: A Case for Euthanasia? No further investment should be made in declining businesses, so the cash flows will be neutral or positive. The low business risk means that funding should be through debt. Dividend payout should be the maximum possible, constrained only by the availability of retained profits or cash generation. If the company has taken on too much debt, value can be created by reducing the level of gearing. Raising equity for an over-geared company can reduce its WACC, as the resulting lower risk reduces the costs of both debt and equity. 11. Financial Instruments: The Building Blocks Financial instruments need produce a return to match the investors perceived risk. This return comes from a mixture of yield and capital gain. The capital gain can be market-generated or can be pre-agreed by the investee company, or a mixture of both. The yield can be fixed, or can be at a variable, floating rate. Risk can be mitigated by having covenants to protect the investor s position, or by taking security over assets of the company. Low-risk instruments tend to give all of their return as yield, for example as interest payments. High-risk instruments give their return as gain. In the middle of the risk-return continuum, instruments can be structured giving a combination of the two. Interest rate management tools such as caps and collars or swaps can be used by the company to protect its position in the event of an increase in reference rates.. Knowledge Interchange Book Summaries Cranfield University

9 12. Types of Financial Instrument There is a lot more to financial instruments than just debt and equity. When selecting or evaluating a source of finance there are several important things to remember. Keep it simple. If it is possible to structure the deal using plain vanilla debt or equity, this is probably the best thing to do. Generally, fancy financial structures mostly benefit the investment banks who sell them (or the academics who write about them). The financial instrument chosen should have a risk profile to complement the company s business risk profile. Companies with low business risk can afford to take on high risk debt instruments, to lower their average cost of capital. High risk companies are best to stick to equity instruments. Cash requirements and profitability will also affect the choice of instrument. The accounting treatment of financial instruments may not be a good indicator of the true situation. Use option theory to help classify the instrument. The continuum of financial instruments indicates that there is no single definition of gearing. The gearing of a company is the relationship between its debt and its equity; the continuum shows that there are few absolutes, but a lot of grey areas. When calculating gearing, always do it from the point of view of a particular security: other securities to the left of it in the continuum count as debt as far as it is concerned, as they have better rights against the company s assets. Securities to the right on the continuum line have fewer rights, and can be treated as equity. 13. Dividends and Buybacks Dividends and share buybacks both involve giving cash to the shareholders. Dividends paid by issuing more shares, rather than being paid in cash, may have advantages in some circumstances. The level of dividend payout should increase over the company s lifecycle, with payments increasing as the company matures and has more cash and profits available. Knowledge Interchange Book Summaries Cranfield University

10 Many companies are reluctant to reduce dividends year on year, even over the economic cycle. However, in some jurisdictions, dividend policies based on a minimum payout ratio are the norm. Various theoretical arguments are advanced to explain dividend policy. These include tax reasons; protecting surplus cash from poor management decisions; and as a signalling mechanism to the market. Buybacks may be undertaken for these reasons, and also to increase earnings per share or change the relative holdings of shareholders. Buybacks are also commonly used to re-gear a company, reducing the overall cost of capital. A share buyback can be a useful way to return cash to shareholders whilst not raising expectations of future dividends. It may also carry tax advantages. The signal given by increasing dividends or organizing a buy-back can suggest that the company expects to have growing profits and cash flow, and so can spare the extra money. Or it can suggest that the company has run out of suitable investment ideas. The context of the payout decision is important to the markets. The impact on eps of a share repurchase can be positive or negative. Usually, the positive impact of reducing the number of shares more than compensates for the negative impacts of reducing interest income. 14. Valuations and Forecasting Valuation is an art, not a science. There is no one value that can be attributed to a company it depends on who is going to own it, and what they plan to do with it. There are several different methods that can be used to value a company. Valuation on fundamentals (discounted cash flow) is probably the most useful; valuation on multiples probably the most widely-used. It makes sense to conduct a valuation using several different methods. Financial forecasts need to be prepared properly, and incorporate an income statement, cash flow and balance sheet. Sensitivity analysis is vital, to understand the key drivers of a forecast and appreciate the margin for error. Knowledge Interchange Book Summaries Cranfield University

11 Forecasts depend on assumptions, and human beings are hard-wired to be irrational in our assumptions. Behavioural finance highlights some of the issues we need to consider. 15. Floating a Company An Initial Public Offering is a useful means for a growing company to raise money (a cash-in float) or a more mature one to provide an exit for some of its shareholders ( a cash-out float). Companies that are already listed raise money through a Seasoned Equity Offering. A cash-out IPO might not provide a full exit for shareholders, as they might be obliged (for legal or market reasons) to retain some of their shares for a further period. The decision as to whether to float is a financial one, but the flotation (IPO) itself is a marketing exercise, with the product in question being the company and its shares. The choice of which stock market to use is dependent on various factors including the company s home and trading region(s), its size, and its industry. Some companies chose to have a secondary listing on another market, to access a wider pool of investors. Different stock markets have different regulatory requirements. Stronger regulation might give more confidence to investors (meaning lower perceived risk and therefore a lower cost of capital and more potential players in the market). In order to list its shares, a company will have to meet its market s requirements, which often include matters such as its trading record, structure and reporting systems. The listing process can be time-consuming. It will almost certainly be expensive, with many advisors and much documentation. The method by which the shares are listed will also have an impact on the cost. Price-setting for a listing is an art rather than a science. A successful float will result in the company s share price at the end of the first day being slightly higher than the listing price. Many boards choose to de-list their shares, taking the company private. This may be because there is no longer a need to raise money, or because they are disappointed at the price the market is attributing to their business. Knowledge Interchange Book Summaries Cranfield University

12 Sometimes, an outside team bids for the company, buying it with private equity backing. The process of privatization is fraught with the potential for conflicts of interest. 16. Acquisitions and Selling a Business Acquisitions, properly planned and executed, can increase shareholder value. In order for this to happen, the protagonists must be clear about how and why this will occur. Synergies can be evaluated using the value drivers model, and due diligence should be focused on the critical areas where value can be gained or destroyed. An acquisition raises performance expectations, as the bidder will generally pay more than market price for the target company, i.e. PVGO will increase. Synergies need to be quantified to support this. Acquisitions can be financed by cash, or through the issue of shares. If the target s shareholders take equity in the bidder, they retain an interest in the ongoing business and must be satisfied that it will perform under the new ownership, and that the bidder is fairly valued. If the deal is for cash, the target s shareholders have a clean exit. Although the choice of deal finance can be used to manipulate earnings per share movements, it should be based on the company s overall financial strategy. Public companies can be subject to takeovers hostile to the management. Various defence strategies are available to protect against such unwanted interest. Not all of these strategies will create value for the shareholders. An earnout can keep key management with the company, and enhance the value the vendor receives. However, such deals can also cause operating problems for the future. Business owners should always be aware of the sale possibilities for their companies. Knowledge Interchange Book Summaries Cranfield University

13 17. Restructuring a Company Financial reorganizations can result from the need to correct external perceptions of the company, or can be because the company needs to revise its financial strategy, generally to correct an over-geared position. Rebalancing the debt-equity mix can be done by retrenching or selling surplus assets; by raising new funds; or by re-negotiating existing borrowings, sometimes swapping them into equity. A reorganization often involves combining several different restructuring strategies. The strategies adopted will reflect the reason for the reconstruction. The process of restructuring is complicated for global companies by the differing legal rights of creditors in different jurisdictions. A demerger can change the market s perception of the company, clarifying the value in each of its parts. This can be done as a spin off (giving the division to existing shareholders, often by way of a dividend) or a carve out (in which the group retains ownership of part of the carved out division, but capital is raised for the group from new shareholders). 18. Private Equity Private equity (PE) is the investment of equity outside a public stock market, in larger transactions. It has played an increasing part in corporate transactions over past decades. PE companies commonly raise funds for investment from groups of institutional investors and wealthy individuals. They might also use their own money or, if they are captives, their parent company s. The funds are generally structured as limited partnerships. In addition to their investment returns, the PE companies receive fees on the funds raised, and carried interest on returns above a hurdle rate. In order for PE to play a part in the economy the supporting infrastructure must contain the other players, such as experienced bankers, financiers and professionals. In addition, the legal and regulatory systems must be strong enough to reduce the perceived risk of investors. PE transactions include management buyouts and buyins, plus various other forms of deal where the ownership of a company changes hands. Often they Knowledge Interchange Book Summaries Cranfield University

14 involve a listed company becoming privately-owned. PE transactions are usually highly geared. Investors make their returns from this gearing, and also from taking a close interest in managing the businesses, and a reduction in agency costs In addition to the gearing of the transaction with several classes of debt, the PE investment itself will be geared up in order to increase management s relative stake in the business. This is often done by using preference shares or a subordinated loan as part of the financing structure. Advantages claimed for PE investors include a reduction of agency costs due to the closeness of the investor to the management and operations of the company. They have the opportunity to add value at every stage of the investment: finding a suitable transaction, evaluating it through due diligence, negotiating and financing the deal, running the business, and the eventual exit. 19. International Corporate Finance The same principles of finance apply to international deals as apply to all other transactions. International corporate finance is more complex than operating within the home country s boundaries. As well as currency issues, management has to understand cultural and legal differences. Post-deal integration will also be more difficult. Currency risk takes three forms: transaction, translation and economic. Companies can choose to take action to reduce each of these risks. Funding an overseas acquisition is more difficult than funding one in the same territory, as the target s shareholders might not wish to hold shares in a foreign country. Raising debt in a currency in which you have no assets or income streams leaves you exposed to movements in exchange rates which would wipe out any temporary benefit of rate differentials. Companies can choose to take a secondary listing through depository receipts, broadening their shareholder base. Knowledge Interchange Book Summaries Cranfield University

15 20. Strategic Working Capital Management Working capital comprises the net of inventories and trade receivables less trade creditors. Working capital represents a substantial investment for most companies, and needs to be managed strategically, to be maintained at the lowest level consistent with value creation. Long-term financial needs, including the core element of working capital, should be funded with long-term finance. Short-term needs should be funded with short-term funding. Factoring and invoice discounting are types of asset finance which can be used to fund working capital (receivables) About the author Dr Ruth Bender is a Reader in Corporate Financial Strategy at Cranfield School of Management. Prior to becoming an academic she was a corporate finance partner with Grant Thornton, one of the UK's larger accounting firms. She has also worked as a private equity manager in the City. Knowledge Interchange Book Summaries Cranfield University