MODULE 1 - Introduction to Strategic Financial Management PDF

PALAWAN STATE UNIVERSITY College of Business and Accountancy Department of Financial Management, Human Resource Management and Business Economics Puerto Princesa City MODULE 1: STRATEGIC FINANCIAL MANAGEMENT (INTRODUCTION) COURSE CODE: BMEC2 1st Semester | SY: 2...

PALAWAN STATE UNIVERSITY College of Business and Accountancy Department of Financial Management, Human Resource Management and Business Economics Puerto Princesa City MODULE 1: STRATEGIC FINANCIAL MANAGEMENT (INTRODUCTION) COURSE CODE: BMEC2 1st Semester | SY: 2024-2025 BSBA FM  Republic of the Philippines PALAWAN STATE UNIVERSITY Puerto Princesa City APPROVAL SHEET This module in BMEC 2 – STRATEGIC FINANCIAL MANAGEMENT covering lessons for the 1st Semester SY 2024-2025, prepared by DONNA MAY A. ROXAS, LARA MAE GRECIA, AND LHYNETTE T. ZAMBALES has been reviewed and evaluated and is hereby recommended for utilization. INSTRUCTIONAL MATERIALS DEVELOPMENT REVIEW COMMITTEE Local Evaluation Committee College of Business and Accountancy -Financial Management Reviewed by: LUNINGNING S. TAHA, MBA Program Coordinator YVETTE J. DAQUIOAG, Ph.D. Chairperson Dept. of Human Resource Management, Financial Management and Economics Recommending Approval: CORAZON T. VILLEGAS, CPA Curriculum and Instructional Materials Development Coordinator This module in P4318 – STRATEGIC FINANCIAL MANAGEMENT is approved for utilization for the 1st Semester of SY 2021-2022. EVELYN B. TOMAS, Ph.D. Dean, College of Business and Accountancy Date: __________________ Doc Ref.No.: Revision Level: Effective Date: Aug. 12, 2024 Page Number 1 of 1 00 P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western TABLE OF CONTENTS Title Page of Module 1 Approval Sheet 2 Table of Contents 3 Overview 4 Course Outcome 4 Learning Outcomes 4 Course Content: Module 1: The Strategic Financial Management a. Introduction to Strategic Financial Management 4 Definitions Features Importance Nature, Significance and Scope Activity 1 6 b. Role of Finance in Strategic Planning and Decision-Making Process 7 Activity 2 10 c. Investment Decisions 11 d. Financing Decisions 12 e. Dividend Decisions 12 Activity 3 15 References: 1) https://corporatefinanceinstitute.com/resources/knowledge/strategy/strategic-financial- a. management/ 2) EasyBiz > Finance > Financial Management Strategies 3) https://courses.lumenlearning.com/boundless-finance/chapter/overview-of-the-working- capital-financing-decision/ 4) (https://gbr.pepperdine.edu/2010/08/the-role-of-finance-in-the-strategic-planning-and-decision- making-process/) Pre-Assessment: Answer this before you proceed. Link for the Pre-Assessment will be posted in Google Classroom assigned in this Subject. Question: What do you think is/are the role/s of finance in the corporate world in terms of strategic-planning and decision-making process? P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western  MODULE 1 | Part 1 Strategic Financial Management I. Overview The course enables students to have an integrated view of the management of a financial institution. In this module, you will be introduced to the Introduction of Strategic Financial Management. The definition, features, importance, nature, significance and scope of Financial Management; the role of finance in Strategic Planning and Decision-Making and the different Strategic Financial Decisions. II. Course Outcome: Intended Learning Outcomes: At the end of this module, you are expected to: Discuss the nature, significance, and scope of Financial Management; Identify different roles of Finance in the Strategic Planning and Decision- Making Process Discuss the Decision-Making Process Aligned with the course outcomes, you are expected to: CO1 - Assess the effects of the changing environment of financial management on organizations and their strategic responses. III. Topics: PART I. STRATEGIC FINANCIAL MANAGEMENT (INTRODUCTION) Definitions Features of Strategic Financial Management Importance of Strategic Financial Management Nature, Significance and Scope of Financial Management MODULE 1 Part 1 Strategic Financial Management Financial management means the management of finance of a business or an organization in order to achieve the financial objectives. In an organization, the key objectives of financial management is to create wealth for business, generate cash and gain maximum profits from the investments of the business considering the risks involved. Good financial management is very important for an organization. It brings economic growth and development through investments, financing, and dividend and risk management decision which help companies to undertake better projects. Lack of financial management in business will lead to losses and closure of business. The object of this MODULE is to enable the students discuss – Nature, Significance, and Scope of Financial Management – Financial Management Decisions - Investment, Financial and Dividend – Decision Making Process – Objective of Financial Management Role and Function of Finance Managers A. Definitions: What is Strategic Financial Management? Strategic financial management is a term used to describe the process of managing the finances of a company to meet its strategic goals. It is a management approach that uses different techniques and financial tools to devise a strategic plan. Strategic financial management ensures that the strategy chosen is implemented to achieve the desired goals. P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western Other DEFINITION OF FINANCIAL MANAGEMENT Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm. The term financial management has been defined by different experts as under: “It is concerned with the efficient use of an important economic resource namely, capital funds”. – (Solomon) “As an application of general managerial principles to the area of financial decision- making. – (Howard and Upton) “Is an area of financial decision-making, harmonizing individual motives and enterprise goals”. – Weston and Brigham “Is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations? – Joseph and Massie Thus, financial management is broadly concerned with raising of funds, creating value to the assets of the business enterprise by efficient allocation of funds. It is the study of integration of the flow of funds in the most optimal manner to maximize the returns of a firm by taking proper decisions in utilizing the funds. In other words, raising of funds should involve minimum cost and to bring maximum returns. Features of Strategic Financial Management 1. It focuses on long-term fund management, taking into account the strategic perspective. 2. It promotes profitability, growth, and presence of the firm over the long term and strives to maximize the shareholders’ wealth. 3. It can be flexible and structured, as well. 4. It is a continuously evolving process, adapting and revising strategies to achieve the organization’s financial goals. 5. It includes a multidimensional and innovative approach for solving business problems. 6. It helps develop applicable strategies and supervise the action plans to be consistent with the business objectives. 7. It analyses factual information using analytical financial methods with quantitative and qualitative reasoning. 8. It utilizes economic and financial resources and focuses on the outcomes of the developed strategies. 9. It offers solutions by analysing the problems in the business environment. 10. It helps the financial managers to make decisions related to investments in the assets and the financing of such assets. Importance of Strategic Financial Management ✓ The approach of strategic financial management is to drive decision making that prioritizes business objectives in the long term. ✓ Strategic financial management not only assists in setting company targets but also creates a platform for planning and governing plans to tackle challenges along the way. It also involves laying out steps to drive the business towards its objectives. ✓ The purpose of strategic financial management is to identify the possible strategies capable of maximizing the organization’s market value. ✓ Also, it ensures that the organization is following the plan efficiently to attain the desired short-term and long-term goals and maximize value for the shareholders. ✓ Strategic financial management manages the financial resources of the organization for achieving its business objectives. NATURE, SIGNIFICANCE AND SCOPE OF FINANCIAL MANAGEMENT In modern times, we cannot imagine a world without the use of money. In fact, money is the life-blood of business in the present day world because all our economic activities are carried out through the use of money. For carrying on business, we need resources which are pooled in terms of money. It is used for obtaining physical and material resources for carrying out productive activities and business operations which affect sales and pay compensation to P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western suppliers of resources, physical as well as monetary. Hence, financial management is considered as an organic function of a business and has rightly become an important one. A group of experts defines Financial Management as simply the task of providing funds needed by the business or enterprise on terms that are most favourable in the light of its objectives. The approach, thus, is concerned almost exclusively with the procurement of funds and could be widened to include instruments, institutions and practices through which to raise funds. It also covers the legal and accounting relationship between a company and its sources of funds. Financial Management is certainly broader than procurement of funds and there are other functions and decisions too. Other set of experts assume that finance is concerned with cash. Since every business transaction involves cash directly or indirectly, finance may be assumed to be concerned with everything that takes place in the conduct of a business. Obviously, it is too broad. The third set of people whose point of view has been widely accepted considers Financial Management as procurement of funds and their effective utilizations in the business; though there are other organisations like schools, associations, government agencies etc., where funds are procured and used. So, Financial Management has not only to see that funds can be raised for installing plant and machinery at a cost; but it has also to see that additional profits adequately compensate for the costs and risks borne by the business while setting up the project. Thus, from the point of view of a corporate unit, financial management is related not only to ‘fund-raising’ but encompasses wider perspective of managing the finances for the company efficiently. Financial Management, to be more precise, is, thus concerned with investment, financing and dividend decisions in relation to objectives of the company. Such decisions have to take care of the interests of the shareholders. Nature of Financial Management therefore can be judged by the study of the nature of investment, financing and dividend decisions. ----------------------------------------------------------------------------------------------------------------------------- Activity 1: TRUE OR FALSE Instruction: In the google classroom, open the activity and answer the following by writing TRUE if the statement is true, write FALSE if it is false (the activity may be done through face to face). Please Refer to the Google Form Sheet uploaded B) THE ROLE OF FINANCE IN THE STRATEGIC-PLANNING AND DECISION- MAKING PROCESS The fundamental success of a strategy depends on three critical factors: a firm’s alignment with the external environment, a realistic internal view of its core competencies and sustainable competitive advantages, and careful implementation and monitoring. This module discusses the role of finance in strategic planning, decision making, formulation, implementation, and monitoring. Any person, corporation, or nation should know who or where they are, where they want to be, and how to get there. The strategic-planning process utilizes analytical models that provide a realistic picture of the individual, corporation, or nation at its “consciously incompetent” level, creating the necessary motivation for the development of a strategic plan. The process requires P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western five distinct steps outlined below and the selected strategy must be sufficiently robust to enable the firm to perform activities differently from its rivals or to perform similar activities in a more efficient manner. A good strategic plan includes metrics that translate the vision and mission into specific end points. This is critical because strategic planning is ultimately about resource allocation and would not be relevant if resources were unlimited. This article aims to explain how finance, financial goals, and financial performance can play a more integral role in the strategic planning and decision-making process, particularly in the implementation and monitoring stage. The Strategic-Planning and Decision-Making Process 1. Vision Statement The creation of a broad statement about the company’s values, purpose, and future direction is the first step in the strategic-planning process. The vision statement must express the company’s core ideologies—what it stands for and why it exists—and its vision for the future, that is, what it aspires to be, achieve, or create. 2. Mission Statement An effective mission statement conveys eight key components about the firm: target customers and markets; main products and services; geographic domain; core technologies; commitment to survival, growth, and profitability; philosophy; self-concept; and desired public image. The finance component is represented by the company’s commitment to survival, growth, and profitability. The company’s long-term financial goals represent its commitment to a strategy that is innovative, updated, unique, value-driven, and superior to those of competitors. 3. Analysis This third step is an analysis of the firm’s business trends, external opportunities, internal resources, and core competencies. For external analysis, firms often utilize Porter’s five forces model of industry competition, which identifies the company’s level of rivalry with existing competitors, the threat of substitute products, the potential for new entrants, the bargaining power of suppliers, and the bargaining power of customers. For internal analysis, companies can apply the industry evolution model, which identifies takeoff (technology, product quality, and product performance features), rapid growth (driving costs down and pursuing product innovation), early maturity and slowing growth (cost reduction, value services, and aggressive tactics to maintain or gain market share), market saturation (elimination of marginal products and continuous improvement of value-chain activities), and stagnation or decline (redirection to fastest-growing market segments and efforts to be a low- cost industry leader). Another method, value-chain analysis clarifies a firm’s value-creation process based on its primary and secondary activities. This becomes a more insightful analytical tool when used in conjunction with activity-based costing and benchmarking tools that help the firm determine its major costs, resource strengths, and competencies, as well as identify areas where productivity can be improved and where re-engineering may produce a greater economic impact SWOT (strengths, weaknesses, opportunities, and threats) is a classic model of internal and external analysis providing management information to set priorities and fully utilize the firm’s competencies and capabilities to exploit external opportunities, determine the critical weaknesses that need to be corrected, and counter existing threats. 4. Strategy Formulation To formulate a long-term strategy, Porter’s generic strategies model is useful as it helps the firm aim for one of the following competitive advantages: a) low-cost leadership (product is a commodity, buyers are price-sensitive, and there are few opportunities for differentiation); b) differentiation (buyers’ needs and preferences are diverse and there are opportunities for product differentiation); c) best-cost provider (buyers expect superior value at a lower price); d) focused low-cost (market niches with specific tastes and needs); or e) focused differentiation (market niches with unique preferences and needs). P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western 5. Strategy Implementation and Management In the last ten years, the balanced scorecard (BSC) has become one of the most effective management instruments for implementing and monitoring strategy execution as it helps to align strategy with expected performance and it stresses the importance of establishing financial goals for employees, functional areas, and business units. The BSC ensures that the strategy is translated into objectives, operational actions, and financial goals and focuses on four key dimensions: financial factors, employee learning and growth, customer satisfaction, and internal business processes. The Role of Finance Financial metrics have long been the standard for assessing a firm’s performance. The BSC supports the role of finance in establishing and monitoring specific and measurable financial strategic goals on a coordinated, integrated basis, thus enabling the firm to operate efficiently and effectively. Financial goals and metrics are established based on benchmarking the “best- in-industry” and include: 1. Free Cash Flow This is a measure of the firm’s financial soundness and shows how efficiently its financial resources are being utilized to generate additional cash for future investments. It represents the net cash available after deducting the investments and working capital increases from the firm’s operating cash flow. Companies should utilize this metric when they anticipate substantial capital expenditures in the near future or follow-through for implemented projects. 2. Economic Value-Added This is the bottom-line contribution on a risk-adjusted basis and helps management to make effective, timely decisions to expand businesses that increase the firm’s economic value and to implement corrective actions in those that are destroying its value. It is determined by deducting the operating capital cost from the net income. Companies set economic value-added goals to effectively assess their businesses’ value contributions and improve the resource allocation process. 3. Asset Management This calls for the efficient management of current assets (cash, receivables, inventory) and current liabilities (payables, accruals) turnovers and the enhanced management of its working capital and cash conversion cycle. Companies must utilize this practice when their operating performance falls behind industry benchmarks or benchmarked companies. 4. Financing Decisions and Capital Structure Here, financing is limited to the optimal capital structure (debt ratio or leverage), which is the level that minimizes the firm’s cost of capital. This optimal capital structure determines the firm’s reserve borrowing capacity (short- and long-term) and the risk of potential financial distress. Companies establish this structure when their cost of capital rises above that of direct competitors and there is a lack of new investments. 5. Profitability Ratios This is a measure of the operational efficiency of a firm. Profitability ratios also indicate inefficient areas that require corrective actions by management; they measure profit relationships with sales, total assets, and net worth. Companies must set profitability ratio goals when they need to operate more effectively and pursue improvements in their value-chain activities. 6. Growth Indices Growth indices evaluate sales and market share growth and determine the acceptable trade-off of growth with respect to reductions in cash flows, profit margins, and returns on investment. Growth usually drains cash and reserve borrowing funds, and sometimes, aggressive asset management is required to ensure sufficient cash and limited borrowing. Companies must set growth index goals when growth rates have lagged behind the industry norms or when they have high operating leverage. P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western 7. Risk Assessment and Management A firm must address its key uncertainties by identifying, measuring, and controlling its existing risks in corporate governance and regulatory compliance, the likelihood of their occurrence, and their economic impact. Then, a process must be implemented to mitigate the causes and effects of those risks. Companies must make these assessments when they anticipate greater uncertainty in their business or when there is a need to enhance their risk culture. 8. Tax Optimization Many functional areas and business units need to manage the level of tax liability undertaken in conducting business and to understand that mitigating risk also reduces expected taxes. Moreover, new initiatives, acquisitions, and product development projects must be weighed against their tax implications and net after-tax contribution to the firm’s value. In general, performance must, whenever possible, be measured on an after-tax basis. Global companies must adopt this measure when operating in different tax environments, where they are able to take advantage of inconsistencies in tax regulations. Conclusion The introduction of the balanced scorecard emphasized financial performance as one of the key indicators of a firm’s success and helped to link strategic goals to performance and provide timely, useful information to facilitate strategic and operational control decisions. This has led to the role of finance in the strategic planning process becoming more relevant than ever. Empirical studies have shown that a vast majority of corporate strategies fail during execution. The above financial metrics help firms implement and monitor their strategies with specific, industry-related, and measurable financial goals, strengthening the organization’s capabilities with hard-to-imitate and non-substitutable competencies. They create sustainable competitive advantages that maximize a firm’s value, the main objective of all stakeholders. ----------------------------------------------------------------------------------------------------------------------------- P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western Activity 2: Application Type Activity: If possible, put your activity in a Power point Presentation and submit it to your instructor via google classroom. Refer to the enclosed rubric. Do the following task: 1. Make a group with three (3) members, not, 2, not 4. 2. Make an Infographic presentation explaining the strategic -planning and decision-Making processes and the role of Finance in Strategic-planning and decision-making process. 3. Create Mission and Vision Statement of a business of your own choice. Make sure that it is not an already established business. Performance level 4 Performance level 3 Performance level 2 Performance Infographic Rubric Score level 1 5 4 3 2 The topic is clearly Student is missing one Student is missing two Student is Defining the infographic communicated through the size, component of PL4. components of PL4. missing three or topic position, and wording of the title more (5 points) and subtitle. The topic is closely components of related to the ADAS model. PL4. All infographic content is relevant Student is missing one Student is missing two Student is Collecting and presenting to the topic and accurate. Content component of PL4. components of PL4. missing three or content is presented with a balance more and data between words, short lines of components of (10 points) text, and numerical data and/or PL4. charts. 9-10 7-8 5-6 3-4 At least 10 graphics are used to Student has at least 8 Student has at least 6 Student has at Enhancing and supporting support content and data. All graphics and all are graphics and all are least 4 graphics content and data with graphics are relevant to the relevant to the content relevant to the content OR and all are graphics content and data presented. (Use OR there are 10 there are 10 graphics, but relevant to the (10 points) discretion here and award full graphics, but 1 or 2 are 3–4 are not relevant to the content OR there marks if the product is not relevant to the content. are 10 graphics, outstanding with fewer than 10 content. but 5–6 are not graphics.) relevant to the content. 9-10 7-8 5-6 3-4 The design is appropriate for the Student has one Student has two sections Student has topic of the infographic. The section on the on the infographic that do three or more order in which content is infographic that does not seem to flow well with sections on the Communicating presented is logical and helps the not seem to flow well the overall design or layout infographic that ideas effectively through the audience understand the topic. with the overall design of the infographic. do not seem to design and layout or layout of the flow well with (10 points) infographic. the overall design or layout of the infographic. 5 4 3 2 All information is presented using Student has 1–2 Student has 3–4 grammar Student has 5 or Writing with correct correct grammar and spelling grammar and/or and/or spelling mistakes. more grammar grammar and spelling spelling mistakes. and/or spelling (5 points) mistakes. Total Score: P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western C) INVESTMENT DECISIONS Investment ordinarily means utilization of money for profits or returns. This could be done by creating physical assets with the money and carrying on business or purchasing shares or debentures of a company or sometimes, though erroneously, purchasing a consumer durable like building. In an economy, money flows from one type of business to another depending upon profits expected or in a capital market securities of a concern are purchased or sold in the expectation of higher or lower profits or gains. However, within a firm, a finance manager decides that in which activity resources of the firm are to be channelized and more important who should be entrusted with the financing decisions. A marketing manager may like to have a new show room, a production manager a new lathe and a personnel manager higher wages for labour, which may lead to regular and efficient production. Over and above, the top management may like to enter an entirely new area of production like a textile company entering electronics. All these are the ventures which are likely to increase profits. But resources are limited. Hence, the problem of accepting one proposal and leaving other persists. Capital budgeting is a major aspect of investment decision making process. Investment decisions and capital budgeting are considered as synonymous in the business world. Investment decisions are concerned with the question whether adding to capital assets today will increase the revenue of tomorrow to cover costs. Thus investment decisions are commitments of monetary resources at different times in expectation of economic returns in future. Choice is required to be made amongst available resources and avenues for investment. As such investment decisions are concerned with the choice of acquiring real assets, over the time period, in a productive process. In making such a choice consideration of certain aspects is essential viz., need for investment, factors affecting decisions, criteria for evaluating investment decisions and selection of a particular alternative from amongst the various options available. Investment decisions have, thus, become the most important area in the decision making process of a company. Such decisions are essentially made after evaluating the different proposals with reference to growth and profitability projections of the company. The choice helps achieve the long term objectives of the company i.e., survival and growth, preserving market share of its products and retaining leadership in its production activity. The company likes to avail of the economic opportunity for which investment decisions are taken viz., (1) Expansion of the productive process to meet the existing excessive demand in local market, exploit the global market, and to avail of the advantages and economies of the expanded scale of production. (2) replacement of an existing asset, plant and machinery or building, necessary for taking advantages of technological innovations, minimising cost of production by replacing obsolete and worn out plants, increasing efficiency of labour, etc. (3) The choice of equipment establishes the need for investment decisions based on the question of quality and latest technology. (4) Re-allocation of capital is another area of investment, to ensure asset allocation in tune with the production policy. (5) Mergers, acquisitions, re-organizations and rehabilitation are all concerned with economic and financial involvement and are governed by investment decisions. Thus, investment decisions encompass wide and complex matters involving the following areas: Capital budgeting Cost of capital Measuring risk Management of liquidity and current assets Expansion and contraction involving business failure and re-organisations Buy or hire or lease an asset. P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western Factors affecting investment decisions are essentially the ingredients of investment decisions. Capital is a scarce resource and its supply cost is very high. Optimal investment decisions need to be made taking into consideration such factors as are given below viz: 1. Estimation of capital outlays and the future earnings of the proposed project focusing on the task of value engineering and market forecasting; 2. availability of capital and considerations of cost of capital focusing attention on financial analysis; and 3. A set of standards by which to select a project for implementation and maximising returns therefrom focusing attention on logic and arithmetic. D) FINANCING DECISIONS Financing decision is the next step in financial management for executing the investment decision once taken. A look at the balance-sheet of a sample company indicates that it obtains finances from shareholders, ordinary or preference, debenture holders on long-term basis, financial institutions as long-term loans, banks and others as short-term loans and the like. There are variations in the provisions governing the issue of preference shares, debentures, loan papers, etc. Financing decisions are concerned with the determination of how much funds to procure from amongst the various avenues available i.e. the financing mix or capital structure. Efforts are made to obtain an optimal financing mix for a particular company. This necessitates study of the capital structure as also the short and intermediate term financing plans of the company. In more advanced companies, financing decision today has become fully integrated with top- management policy formulation via capital budgeting, long-range planning, evaluation of alternate uses of funds, and establishment of measurable standards of performance in financial terms. Financial decision making is concerned more and more with the questions: How cost of funds be measured, proposals for capital using projects be evaluated, or how far the financing policy influences cost of capital or should corporate funds be committed to or withheld from certain purposes and How the expected returns on projects be measured. Optimal use of funds has become a new concern of financing decisions and top managements in corporate sector are more concerned with planning the sources and uses of funds and measuring performance. New measurement techniques, utilising computers, have facilitated efficient capital allocation through financing decisions. Both Investment decision and financial decisions are jointly made as an effective way of financial management in corporate units. No doubt, the purview of these decisions is separate, but they affect each other. Financial decisions, as discussed earlier, encompass determination of the proportion of equity capital to debt to achieve an optimal capital structure, and to balance the fixed and working capital requirements in the financial structure of the company. This important area of financing decision making, aims at maximising returns on investment and minimising the risk. The risk and return analysis is a common tool for investment and financing decisions for designing an optimal capital structure of a corporate unit. It may be mentioned that debt adds to the riskiness of the capital structure of a firm. This part of financial management is the analysis of company through earnings before interest and taxes, variable costs, contribution. It is called a study of operating leverages. Further, the earnings per share to be given to shareholders is analysed through the technique of financial leverage. When study of both these aspects is made it is known as combined leverage. E) DIVIDEND DECISIONS The dividend decision is another major area of financial management. The financial manager must decide whether the firm should distribute all profits or retain them or distribute a portion and retain the balance. Theoretically, this decision should depend on whether the company or its shareholders are in the position to better utilise the funds, and to earn a higher rate of return on funds. However, in practice, a number of other factors like the market price of shares, the trend of earning, the tax position of the shareholders, cash flow position, requirement P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western of funds for future growth, and restrictions under the Companies Act etc. play an important role in the determination of dividend policy of business enterprise. The finance manager has to take a decision regarding optimum dividend payout ratio, he also has to take decisions relating to bonus issue and interim dividend. DECISION CRITERIA Decision criteria depend upon the objective to be achieved through the instrumentality of decision making process. The main objectives which a business organization pursues are maximization of return and minimisation of costs. A fair decision criterion should distinguish between acceptable and unacceptable proposals and solve the problem of selection of the best alternatives from amongst the various alternatives available in a given situation to achieve the above objectives. A fair decision criterion should follow the following two fundamental principles i.e. (1) The “Bigger and Better” principle; (2) “A Bird in Hand is Better than Two in the Bush” principle. The first principle suggests that bigger benefits are preferable to smaller ones; whereas the second one suggests that early benefits are preferable to later benefits. Both the above principles are based on the assumption “other things are being equal” which is a rare reality. But in practice the decision process very much adheres to these principles particularly in the areas of capital budgeting decisions and determining the cost of capital in project financing proposals. Decision criteria in financial management can be studied under two separate heads viz. 1. The criteria for investment decisions; 2. And the criteria for the financing decisions. Criteria for investment decisions are mainly concerned with planning and control of capital expenditure through budgeting process following the tools of analysis viz. i. payback period, ii. accounting rate of return, iii. Discounted cash flow methods e.g., iv. Net present value method, etc. We shall discuss these methods for evaluating investment decisions in detail in the study relating to capital budgeting. However, the essence and the inherent spirit in these techniques is based on logic which helps in the decision making process. As a matter of fact, these techniques have been founded on the following decision criteria: 1. Urgency: The use of ‘urgency’ is treated as criterion for selection of investment projects in many corporate units/ business enterprises/government set up. Urgency is assessed on the following basis: (a) it provides sufficient justification for undertaking a project; (b) it provides immediate contribution for attainment of objectives of the project; and (c) It maximizes profits. Although urgency as criterion lacks objectivity, being non-quantifiable, yet it definitely provides an ordinal ranking scale for selection of projects on preferential pre-exemption basis. 2. Pay back: Time is of essence while selecting this criterion for investment decisions. The decision is taken on the basis of quickness in pay off of the investments. Pay back simply measures the time required for cash flows from the project to return the initial investment P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western  to the firm’s account. Projects, on the basis of this criterion, having quicker pay backs are preferred. Pay back decision criterion does not follow the principles laid down above viz. “the bigger and better” and “bird in hand”. It ignores the first principle completely as it does not take into account the cash flows after investment has been recovered. It also does not satisfy entirely the second principle as it assigns zero value to the receipts, subsequent to recovery of the amount. 3. Rate of return: It provides another decision criterion based on accounting records or projected statements to measure profitability as annual percentage of capital employed. Rate of return is arrived at following two different methods for treating income in the analysis which give different results. In the first case, average income generated from investment is taken after deduction of depreciation charge. In second case, the original cost is taken as denominator rather than average investment. This gives the simple yearly rate of return. This is based on “bigger and better” principle. This criterion can be applied either against average investment in the year selected for study or simply against initial cost. 4. Undiscounted benefit-cost ratio: It is the ratio between the aggregate benefits and the cost of project. Benefits are taken at face value. The ratio may be “gross” or “net”. It is “gross” when calculated with benefits without deducting depreciation. In the net version, depreciation is deducted from benefits before computing the results. Both ratios give identical ranking. Net ratio equals the gross ratio minus 1. This relationship makes it simple to calculate gross ratio and then to arrive at net ratio. This criterion is compatible with the “bigger and better” principle. But it does not follow the second principle of “bird in hand” as early receipts are given identical weights to later receipts in the project’s life. 5. Discounted benefit-cost ratio: This ratio is more reliable as it is based on present value of future benefits and costs. It may also be gross or net like the one discussed earlier. It takes into account all incomes whenever received and to this extent complies with “bigger and better” principle. Early receipts are given more weight than late receipts on account of introduction of discount factor. This ratio satisfies the requirements of both the principles and is a good criterion for decision making. 6. Present value method: This concept is useful as a decision criterion because it reveals the fact that the value of money is constantly declining as a rupee received today is more in value than the rupee at the end of a year. Besides, if the rupee is invested today it will fetch a return on investment and accumulate to Re. 1 (1+i) at the end of ‘n’ period. Hence a rupee received at the end of ‘n’ period is worth 1/(1+i)n now. Investment decisions require comparison of present value with the cost of assets, and if the present value exceeds the cost, the investment is rendered acceptable. Another off-shoot of this criterion is net present value method which is closely related to cost-benefit ratio. It takes into account all income and its timing with appropriate weights. Here difference of present value of benefits and costs is considered as against the ratio in cost-benefit analysis. This criterion is useful for acceptance of projects showing positive net present value at the company’s cost of capital rate. It can be used for choosing between mutually exclusive projects by considering whether incremental investment yields a positive net present value. P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western  7. Internal rate of return: It is a widely used criterion for investment decisions. It takes interest factor into account. It is known as marginal efficiency of capital or rate of return over cost. It stipulates rate of discount which will equate the present value of the net benefits with the cost of the project. This method satisfies both these principles. The criteria used in financing decisions, with particular reference to capital structure of a corporate unit can be discussed here precisely. The capital structure of a corporate unit contains two important parameters viz., the owners’ capital known as equity and the debt which represents interest of debenture holders in the assets of the company. The factors responsible for inclusion of debt in the capital structure of a company are tax-savings, easier to sell, lower cost of floatation and services, lower cost of capital, the advantage of leverage, no dilution of equity and probable loss of control, logical to consolidate and fund short-term indebtedness by a bond issue, advantageous in the inflationary trends of rising interest rates and improvement in financial ratios. There is no alternative for a company to equity financing to meet its requirement for funds. Debt can be raised by a company only on an adequate equity base which serves as a cushion for debt financing. The study of effect of leverage is the main focus point to determine the best mix of debt and equity sources of funds. It is, therefore, desired to consider this criterion for financing decision making in relation to leverage and cost of capital. ----------------------------------------------------------------------------------------------------------------------------- Activity 3: Answer the question in not less than 200words through the google docs enclosed in the classwork/activity in your classroom. Discuss the Investment, Financing, and Dividend Decision-Making Process. P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western LEARNING ACTIVITY:. ***End of Module 1*** P4218 Strategic Financial Management Application of Corporate Finance Samuel C. Weaver/J Fred Weston Thomson South Western