F M NEW SYLLABUS STUDY...ii This study material has been prepared by the faculty of the Board...

Final Course (Revised Scheme of Education and Training)

Study Material

PAPER 2

Strategic Financial

Management

BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

© The Institute of Chartered Accountants of India

ii This study material has been prepared by the faculty of the Board of Studies. The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge in the subject. In case students need any clarifications or have any suggestions for further improvement of the material contained herein, they may write to the Director of Studies. All care has been taken to provide interpretations and discussions in a manner useful for the students. However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees. Permission of the Institute is essential for reproduction of any portion of this material.


All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior permission, in writing, from the publisher. Edition : August, 2019

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BEFORE WE BEGIN…

The ICAI has recently revised its course curriculum. The course has been changed keeping in view the modern requirements of Finance. Strategic Financial Management (SFM) is one of the core papers for students appearing in Final Level of Chartered Accountancy Course. The present study material is meant for the students appearing in SFM paper.

As you all are aware that SFM is a blend of Strategic Management and Financial Management. Recently, it has gained significance due to growing globalization and continuous cross border flow of capital.

Moreover, some chapters have been excluded from the study material which was there in the previous edition of August 2017. These are enumerated as follows:

(i) Indian Financial System

(ii) International Financial Centre (IFC)

(iii) Small and Medium Enterprises

Further, there are several significant characteristics of this study material which are outlined as below:

(i) It comprehensively covers the course requirements of students preparing for SFM paper.

(ii) It is written in a very simple and lucid manner to make the subject understandable to the students.

(iii) At the beginning of each chapter, learning outcomes have been given so that the students have some sort of idea about what he will learn after going through the chapter.

(iv) At the end of each chapter, the caption, “Test your Knowledge” is given. Basically, the purpose is to motivate the students to recapitulate the chapter which they have already read.

(v) While preparing the study material, it has been kept in mind that students understand the study material. Therefore, every effort has been made to keep the chapters concise, giving appropriate headings, sub-headings and mentioning examples at suitable places.

We are confident that this study material will prove to be extremely useful to the students.


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Although, sincere efforts have been made to keep the study material error free, it is possible that some error might have inadvertently crept in. In this respect, students are encouraged to highlight any mistake they may notice while going through the study material by sending an e-mail at: [email protected] or write to the Director of Studies, The Institute of Chartered Accountants of India, A-29, Sector-62, Noida-201309.

Happy Reading and Best Wishes!


mailto:[email protected]:[email protected]

v

SYLLABUS

PAPER 2: STRATEGIC FINANCIAL MANAGEMENT (One paper – Three hours – 100 marks)

Objective:

To acquire the ability to apply financial management theories and techniques in strategic decision making.

Contents:

(1) Financial Policy and Corporate Strategy

(i) Strategic decision making framework

(ii) Interface of Financial Policy and strategic management

(iii) Balancing financial goals vis-à-vis sustainable growth.

(2) Risk Management

(i) Identification of types of Risk faced by an organisation

(ii) Evaluation of Financial Risks

(iii) Value at Risk (VAR)

(iv) Evaluation of appropriate method for the identification and management of financial risk.

(3) Security Analysis

(i) Fundamental Analysis

(ii) Technical Analysis

a) Meaning

b) Assumptions

c) Theories and Principles


vi

d) Charting Techniques

e) Efficient Market Hypothesis (EMH) Analysis

(4) Security Valuation

(i) Theory of Valuation

(ii) Return Concepts

(iii) Equity Risk Premium

(iv) Required Return on Equity

(v) Discount Rate Selection in Relation to Cash Flows

(vi) Approaches to Valuation of Equity Shares

(vii) Valuation of Preference Shares

(viii) Valuation of Debentures/ Bonds

(5) Portfolio Management

(i) Portfolio Analysis

(ii) Portfolio Selection

(iii) Capital Market Theory

(iv) Portfolio Revision

(v) Portfolio Evaluation

(vi) Asset Allocation

(vii) Fixed Income Portfolio

(viii) Risk Analysis of Investment in Distressed Securities

(ix) Alternative Investment Strategies in context of Portfolio Management


vii (6) Securitization

(i) Introduction

(ii) Concept and Definition

(iii) Benefits of Securitization

(iv) Participants in Securitization

(v) Mechanism of Securitization

(vi) Problems in Securitization

(vii) Securitization Instruments

(viii) Pricing of Securitization Instruments

(ix) Securitization in India

(7) Mutual Fund

(i) Meaning

(ii) Evolution

(iii) Types

(iv) Advantages and Disadvantages of Mutual Funds

(8) Derivatives Analysis and Valuation

(i) Forward/ Future Contract

(ii) Options

(iii) Swaps

(iv) Commodity Derivatives

(9) Foreign Exchange Exposure and Risk Management

(i) Exchange rate determination


viii

(ii) Foreign currency market

(iii) Management of transaction, translation and economic exposures

(iv) Hedging currency risk

(v) Foreign exchange derivatives – Forward, futures, options and swaps

(10) International Financial Management

(i) International Capital Budgeting

(ii) International Working Capital Management

a) Multinational Cash Management

- Objectives of Effective Cash Management

- Optimization of Cash Flows/ Needs

- Investment of Surplus Cash

b) Multinational Receivable Management

c) Multinational Inventory Management

(11) Interest Rate Risk Management

(i) Interest Rate Risk

(ii) Hedging Interest Rate Risk

a) Traditional Methods

b) Modern Methods including Interest Rate Derivatives

(12) Corporate Valuation

(i) Conceptual Framework of Valuation

(ii) Approaches/ Methods of Valuation

a) Assets Based Valuation Model


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b) Earning Based Models

c) Cash Flow Based Models

d) Measuring Cost of Equity

- Capital Asset Pricing Model (CAPM)

- Arbitrage Pricing Theory

- Estimating Beta of an unlisted company

e) Relative Valuation

- Steps involved in Relative Valuation

- Equity Valuation Multiples

- Enterprise Valuation Multiple

f) Other Approaches to Value Measurement

- Economic Value Added (EVA)

- Market Value Added (MVA)

- Shareholder Value Analysis (SVA)

g) Arriving at Fair Value

(13) Mergers, Acquisitions and Corporate Restructuring

(i) Conceptual Framework

(ii) Rationale

(iii) Forms

(iv) Mergers and Acquisitions

a) Financial Framework

b) Takeover Defensive Tactics


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c) Reverse Merger

(v) Divestitures

a) Partial Sell off

b) Demerger

c) Equity Carve outs

(vi) Ownership Restructuring

a) Going Private

b) Management/ Leveraged Buyouts

(vii) Cross Border Mergers

(14) Startup Finance

(i) Introduction including Pitch Presentation

(ii) Sources of Funding

(iii) Startup India Initiative


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CONTENTS

CHAPTER 1 – FINANCIAL POLICY AND CORPORATE STRATEGY

1. Strategic Financial Decision Making Frame Work ......................................................... 1.1

2. Strategy at Different Hierarchy Levels .......................................................................... 1.3

3. Financial Planning ....................................................................................................... 1.4

4. Interface of Financial Policy and Strategic Management ............................................... 1.5

5. Balancing Financial Goals vis-à-vis Sustainable Growth ............................................... 1.7

CHAPTER 2 – RISK MANAGEMENT

1. Identification of types of Risk faced by an organization ................................................. 2.1

2. Evaluation of Financial Risk ........................................................................................ 2.4

3. Value-at-Risk (VAR) ..................................................................................................... 2.4

4. Appropriate Methods for Identification and Management of Financial Risk ..................... 2.5

CHAPTER 3 – SECURITY ANALYSIS

1. Fundamental Analysis .................................................................................................. 3.2

2. Technical Analysis ..................................................................................................... 3.13

3. Difference between Fundamental Analysis and Technical Analysis .............................. 3.27

4. Efficient Market Theory .............................................................................................. 3.27

CHAPTER 4 – SECURITY VALUATION

1. Overview of Valuation .................................................................................................. 4.1

2. Return Concepts .......................................................................................................... 4.2


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3. Equity Risk Premium .................................................................................................... 4.4

4. Required Return on Equity ........................................................................................... 4.6

5. Discounts rates selection in relation to cash flows ........................................................ 4.6

6. Valuation of Equity Shares ........................................................................................... 4.7

7. Valuation of Preference Shares .................................................................................. 4.15

8. Valuation of Debentures and Bonds ........................................................................... 4.15

9. Arbitrage Pricing Theory ............................................................................................ 4.23

CHAPTER 5 – PORTFOLIO MANAGEMENT

1. Introduction ................................................................................................................. 5.2

2. Phases of Portfolio Management .................................................................................. 5.4

3. Portfolio Theories ...................................................................................................... 5.10

4. Risk Analysis ............................................................................................................. 5.11

5. Markowitz Model of Risk-Return Optimization ............................................................. 5.31

6. Capital Market Theory ................................................................................................ 5.34

7. Capital Asset Pricing Model ....................................................................................... 5.35

8. Arbitrage Pricing Theory Model .................................................................................. 5.43

9. Sharpe Index Model ................................................................................................... 5.44

10. Formulation of Portfolio Strategy ................................................................................ 5.49

11. Portfolio Rebalancing ................................................................................................. 5.52

12. Asset Allocation Strategies ......................................................................................... 5.56

13. Fixed Income Portfolio ............................................................................................... 5.56

14. Alternative Investment Strategies in context of Portfolio Management ......................... 5.59


xiii CHAPTER 6 – SECURITIZATION

1. Introduction ................................................................................................................. 6.1

2. Concept and Definition ................................................................................................. 6.2

3. Benefits of Securitization.............................................................................................. 6.2

4. Participation in Securitization ....................................................................................... 6.3

5. Mechanism of Securitization ......................................................................................... 6.5

6. Problems in Securitization ............................................................................................ 6.6

7. Securitization Instruments ............................................................................................ 6.7

8. Pricing of Securitized Instruments ................................................................................ 6.8

9. Securitization in India ................................................................................................... 6.9

CHAPTER 7 – MUTUAL FUNDS

1. Introduction ................................................................................................................. 7.1

2. Evolution of the Mutual Fund Industry ........................................................................... 7.3

3. Classification of Mutual Funds ...................................................................................... 7.5

4. Types of Schemes ....................................................................................................... 7.8

5. Advantages of Mutual Fund ........................................................................................ 7.12

6. Drawbacks of Mutual Fund ......................................................................................... 7.13

7. Terms associated with Mutual Funds .......................................................................... 7.14

CHAPTER 8 – DERIVATIVES ANALYSIS AND VALUATION

1. Introduction ................................................................................................................. 8.1

2. Forward Contract ......................................................................................................... 8.2

3. Future Contract ............................................................................................................ 8.3

4. Pricing / Valuation of Forward / Future Contracts .......................................................... 8.5


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5. Types of Future Contracts ............................................................................................ 8.8

6. Options ...................................................................................................................... 8.17

7. Option Valuation Techniques ..................................................................................... 8.21

8. Commodity Derivatives .............................................................................................. 8.31

9. Embedded Derivatives ............................................................................................... 8.38

CHAPTER 9 – FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

1. Introduction ................................................................................................................. 9.1

2. Nostro, Vostro and Loro Accounts ................................................................................ 9.2

3. Exchange Rate Quotation ............................................................................................ 9.4

4. Exchange Rate Forecasting ....................................................................................... 9.10

5. Exchange Rate Determination .................................................................................... 9.11

6. Exchange Rate Theories ............................................................................................ 9.12

7. Foreign Exchange Market .......................................................................................... 9.17

8. Foreign Exchange Exposure ...................................................................................... 9.18

9. Hedging Currency Risk .............................................................................................. 9.21

10. Forward Contract ....................................................................................................... 9.25

11. Future Contracts ........................................................................................................ 9.36

12. Option Contracts ........................................................................................................ 9.37

13. Swap Contracts ......................................................................................................... 9.39

14. Strategies for Exposure Management ......................................................................... 9.40

15. Conclusion ................................................................................................................ 9.42

CHAPTER 10 – INTERNATIONAL FINANCIAL MANAGEMENT

1. International Capital Budgeting ..................................................... ……………………..10.1


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2. International Sources of Finance .................................................................. ………..10.15

3. International Working Capital Management............................................................... 10.20

CHAPTER 11 – INTEREST RATE RISK MANAGEMENT

1. Introduction ............................................................................................................... 11.1

2. Hedging Interest Rate Risk ........................................................................................ 11.5

CHAPTER 12 – CORPORATE VALUATION

1. Conceptual Framework of Valuation ........................................................................... 12.2

2. Important terms associated with Valuation .................................................................. 12.2

3. Approaches/ Methods of Valuation ............................................................................. 12.4

4. Measuring Cost of Equity ......................................................................................... 12.11

5. Relative Valuation .................................................................................................... 12.14

6. Other Approaches to Value Measurement ................................................................ 12.17

7. Arriving at Fair Value ............................................................................................... 12.23

CHAPTER 13 – MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

1. Conceptual Framework .............................................................................................. 13.2

2. Rationale for Mergers and Acquisition ........................................................................ 13.4

3. Forms (Types) of Mergers .......................................................................................... 13.7

4. Financial Framework .................................................................................................. 13.9

5. Takeover Defensive Tactics ..................................................................................... 13.11

6. Reverse Merger ....................................................................................................... 13.13

7. Divestiture ............................................................................................................... 13.14

8. Financial Restructuring ............................................................................................ 13.17


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9. Ownership Restructuring .......................................................................................... 13.20

10. Premium and Discount ............................................................................................. 13.23

11. Case Studies ........................................................................................................... 13.24

12. Mergers and Acquisitions Failures ............................................................................ 13.32

13. Acquisition through Shares ...................................................................................... 13.33

14. Cross-Border M&A ................................................................................................... 13.37

CHAPTER 14 – STARTUP FINANCE

1. The basics of Startup Financing ................................................................................. 14.1

2. Some of the innovative ways to Finance a Startup ...................................................... 14.2

3. Pitch Presentation ...................................................................................................... 14.3

4. Mode of Financing for Startup .................................................................................... 14.6

5. Startup India Initiative .............................................................................................. 14.13


1

FINANCIAL POLICY AND CORPORATE STRATEGY LEARNING OUTCOMES

After reading this chapter student shall be able to understand:

Strategic Financial Decision Making Frame Work

Strategy at different hierarchy levels

Financial Planning

Interface of Financial Policy and Strategic Management

Balancing Financial Goals vis-à-vis Sustainable Growth

1. STRATEGIC FINANCIAL DECISION MAKING FRAME WORK

Capital investment is the springboard for wealth creation. In a world of economic uncertainty, the investors want to maximize their wealth by selecting optimum investment and financial opportunities that will give them maximum expected returns at minimum risk. Since management is ultimately responsible to the investors, the objective of corporate financial management should implement investment and financing decisions which should satisfy the shareholders by placing them all in an equal, optimum financial position. The satisfaction of the interests of the shareholders should be perceived as a means to an end, namely maximization of shareholders’ wealth. Since capital is the limiting factor, the problem that the management will face is the


1.2 STRATEGIC FINANCIAL MANAGEMENT

strategic allocation of limited funds between alternative uses in such a manner, that the companies have the ability to sustain or increase investor returns through a continual search for investment opportunities that generate funds for their business and are more favourable for the investors. Therefore, all businesses need to have the following three fundamental essential elements:

• A clear and realistic strategy,

• The financial resources, controls and systems to see it through and

• The right management team and processes to make it happen. We may summarise this by saying that:

Strategy + Finance + Management = Fundamentals of Business

Strategy may be defined as the long term direction and scope of an organization to achieve competitive advantage through the configuration of resources within a changing environment for the fulfilment of stakeholder’s aspirations and expectations. In an idealized world, management is ultimately responsible to the investors. Investors maximize their wealth by selecting optimum investment and financing opportunities, using financial models that maximize expected returns in absolute terms at minimum risk. What concerns the investors is not simply maximum profit but also the likelihood of it arising: a risk-return trade-off from a portfolio of investments, with which they feel comfortable and which may be unique for each individual.

We call this overall approach strategic financial management and define it as being the application to strategic decisions of financial techniques in order to help achieve the decision-maker's objectives. Although linked with accounting, the focus of strategic financial management is different. Strategic financial management combines the backward-looking, report-focused discipline of (financial) accounting with the more dynamic, forward-looking subject of financial management. It is basically about the identification of the possible strategies capable of maximizing an organization's market value. It involves the allocation of scarce capital resources among competing opportunities. It also encompasses the implementation and monitoring of the chosen strategy so as to achieve agreed objectives.

1.1 Functions of Strategic Financial Management: Strategic Financial Management is the portfolio constituent of the corporate strategic plan that embraces the optimum investment and financing decisions required to attain the overall specified objectives. In this connection, it is necessary to distinguish between strategic, tactical and operational financial planning. While strategy is a long-term course of action, tactics are intermediate plan, while operations are short-term functions. Senior management decides strategy, middle level decides tactics and operational are looked after line management. Irrespective of the time horizon, the investment and financial decisions involve the following


FINANCIAL POLICY AND CORPORATE STRATEGY 1.3

functions1: • Continual search for best investment opportunities;

• Selection of the best profitable opportunities;

• Determination of optimal mix of funds for the opportunities;

• Establishment of systems for internal controls; and

• Analysis of results for future decision-making.

Since capital is the limiting factor, the strategic problem for financial management is how limited funds are allocated between alternative uses.

The key decisions falling within the scope of financial strategy include the following:

1. Financing decisions: These decisions deal with the mode of financing or mix of equity capital and debt capital.

2. Investment decisions: These decisions involve the profitable utilization of firm's funds especially in long-term projects (capital projects). Since the future benefits associated with such projects are not known with certainty, investment decisions necessarily involve risk. The projects are therefore evaluated in relation to their expected return and risk.

3. Dividend decisions: These decisions determine the division of earnings between payments to shareholders and reinvestment in the company.

4. Portfolio decisions: These decisions involve evaluation of investments based on their contribution to the aggregate performance of the entire corporation rather than on the isolated characteristics of the investments themselves.

You have already, learnt about the Financing, Investment and Dividend decisions in your Intermediate (IPC) curriculum, while Portfolio decisions would be taken in detail later in this Study Material.

2. STRATEGY AT DIFFERENT HIERARCHY LEVELS Strategies at different levels are the outcomes of different planning needs. There are three levels of Strategy – Corporate level; Business unit level; and Functional or departmental level.

2.1 Corporate Level Strategy Corporate level strategy fundamentally is concerned with selection of businesses in which a company should compete and with the development and coordination of that portfolio of businesses. 1 Strategic Financial Management: Exercises, Robert Alan Hill.



Corporate level strategy should be able to answer three basic questions: Suitability Whether the strategy would work for the accomplishment of common

objective of the company. Feasibility Determines the kind and number of resources required to formulate and

implement the strategy. Acceptability It is concerned with the stakeholders’ satisfaction and can be financial

and non-financial.

2.2 Business Unit Level Strategy Strategic business unit (SBO) may be any profit centre that can be planned independently from the other business units of a corporation. At the business unit level, the strategic issues are about practical coordination of operating units and developing and sustaining a competitive advantage for the products and services that are produced.

2.3 Functional Level Strategy The functional level is the level of the operating divisions and departments. The strategic issues at this level are related to functional business processes and value chain. Functional level strategies in R&D, operations, manufacturing, marketing, finance, and human resources involve the development and coordination of resources through which business unit level strategies can be executed effectively and efficiently. Functional units of an organization are involved in higher level strategies by providing input to the business unit level and corporate level strategy, such as providing information on customer feedback or on resources and capabilities on which the higher level strategies can be based. Once the higher-level strategy is developed, the functional units translate them into discrete action plans that each department or division must accomplish for the strategy to succeed.

Among the different functional activities viz production, marketing, finance, human resources and research and development, finance assumes highest importance during the top down and bottom up interaction of planning. Corporate strategy deals with deployment of resources and financial strategy is mainly concerned with mobilization and effective utilization of money, the most critical resource that a business firm likes to have under its command. Truly speaking, other resources can be easily mobilized if the firm has adequate monetary base. To go into the details of this interface between financial strategy and corporate strategy and financial planning and corporate planning let us examine the basic issues addressed under financial planning.

3. FINANCIAL PLANNING Financial planning is the backbone of the business planning and corporate planning. It helps in defining the feasible area of operation for all types of activities and thereby defines the overall planning framework. Financial planning is a systematic approach whereby the financial planner


http://www.1000ventures.com/business_guide/strategy_hierachical_levels.html#BLS#BLShttp://www.1000ventures.com/business_guide/crosscuttings/sca_main.htmlhttp://www.1000ventures.com/business_guide/process.htmlhttp://www.1000ventures.com/business_guide/im_value_chain_main.htmlhttp://www.1000ventures.com/business_guide/mgmt_stategic_resource-based.html


helps the customer to maximize his existing financial resources by utilizing financial tools to achieve his financial goals.

There are 3 major components of Financial planning:

• Financial Resources (FR)

• Financial Tools (FT)

• Financial Goals (FG)

Financial Planning: FR + FT = FG

For an individual, financial planning is the process of meeting one’s life goals through proper management of the finances. These goals may include buying a house, saving for children's education or planning for retirement. It is a process that consists of specific steps that helps in taking a big-picture look at where you financially are. Using these steps you can work out where you are now, what you may need in the future and what you must do to reach your goals.

Outcomes of the financial planning are the financial objectives, financial decision-making and financial measures for the evaluation of the corporate performance. Financial objectives are to be decided at the very outset so that rest of the decisions can be taken accordingly. The objectives need to be consistent with the corporate mission and corporate objectives. Financial decision making helps in analyzing the financial problems that are being faced by the corporate and accordingly deciding the course of action to be taken by it. The financial measures like ratio analysis, analysis of cash flow statement are used to evaluate the performance of the Company. The selection of these measures again depends upon the Corporate objectives.

4. INTERFACE OF FINANCIAL POLICY AND STRATEGIC MANAGEMENT

The interface of strategic management and financial policy will be clearly understood if we appreciate the fact that the starting point of an organization is money and the end point of that organization is also money. No organization can run an existing business and promote a new expansion project without a suitable internally mobilized financial base or both i.e. internally and externally mobilized financial base.

Sources of finance and capital structure are the most important dimensions of a strategic plan. The need for fund mobilization to support the expansion activity of firm is very vital for any organization. The generation of funds may arise out of ownership capital and or borrowed capital. A company may issue equity shares and/or preference shares for mobilizing ownership capital and debentures to raise borrowed capital. Public deposits, for a fixed time period, have also become a major source of short and medium term finance. Organizations may offer higher rates of interest than banking institutions to attract investors and raise fund. The overdraft, cash credits, bill



discounting, bank loan and trade credit are the other sources of short term finance.

Along with the mobilization of funds, policy makers should decide on the capital structure to indicate the desired mix of equity capital and debt capital. There are some norms for debt equity ratio which need to be followed for minimizing the risks of excessive loans. For instance, in case of public sector organizations, the norm is 1:1 ratio and for private sector firms, the norm is 2:1 ratio. However this ratio in its ideal form varies from industry to industry. It also depends on the planning mode of the organization. For capital intensive industries, the proportion of debt to equity is much higher. Similar is the case for high cost projects in priority sectors and for projects in under developed regions.

Another important dimension of strategic management and financial policy interface is the investment and fund allocation decisions. A planner has to frame policies for regulating investments in fixed assets and for restraining of current assets. Investment proposals mooted by different business units may be divided into three groups. One type of proposal will be for addition of a new product by the firm. Another type of proposal will be to increase the level of operation of an existing product through either an increase in capacity in the existing plant or setting up of another plant for meeting additional capacity requirement. The last is for cost reduction and efficient utilization of resources through a new approach and/or closer monitoring of the different critical activities. Now, given these three types of proposals a planner should evaluate each one of them by making within group comparison in the light of capital budgeting exercise. In fact, project evaluation and project selection are the two most important jobs under fund allocation. Planner’s task is to make the best possible allocation under resource constraints.

Dividend policy is yet another area for making financial policy decisions affecting the strategic performance of the company. A close interface is needed to frame the policy to be beneficial for all. Dividend policy decision deals with the extent of earnings to be distributed as dividend and the extent of earnings to be retained for future expansion scheme of the firm. From the point of view of long term funding of business growth, dividend can be considered as that part of total earnings, which cannot be profitably utilized by the company. Stability of the dividend payment is a desirable consideration that can have a positive impact on share prices. The alternative policy of paying a constant percentage of the net earnings may be preferable from the point of view of both flexibility of the firm and ability of the firm. It also gives a message of lesser risk for the investors. Yet some other companies follow a different alternative. They pay a minimum dividend per share and additional dividend when earnings are higher than the normal earnings. In actual practice, investment opportunities and financial needs of the firm and the shareholders preference for dividend against capital gains resulting out of share are to be taken into consideration for arriving at the right dividend policy. Alternatives like cash dividend and stock dividend are also to be examined while working out an ideal dividend policy that supports and promotes the corporate strategy of the company.



Thus, the financial policy of a company cannot be worked out in isolation of other functional policies. It has a wider appeal and closer link with the overall organizational performance and direction of growth. These policies being related to external awareness about the firm, especially the awareness of the investors about the firm, in respect of its internal performance. There is always a process of evaluation active in the minds of the current and future stake holders of the company. As a result preference and patronage for the company depends significantly on the financial policy framework. Hence, attention of the corporate planners must be drawn while framing the financial policies not at a later stage but during the stage of corporate planning itself. The nature of interdependence is the crucial factor to be studied and modelled by using an in depth analytical approach. This is a very difficult task compared to usual cause and effect study because corporate strategy is the cause and financial policy is the effect and sometimes financial policy is the cause and corporate strategy is the effect.

5. BALANCING FINANCIAL GOALS VIS-A-VIS SUSTAINABLE GROWTH

The concept of sustainable growth can be helpful for planning healthy corporate growth. This concept forces managers to consider the financial consequences of sales increases and to set sales growth goals that are consistent with the operating and financial policies of the firm. Often, a conflict can arise if growth objectives are not consistent with the value of the organization's sustainable growth. Question concerning right distribution of resources may take a difficult shape if we take into consideration the rightness not for the current stakeholders but for the future stakeholders also. To take an illustration, let us refer to fuel industry where resources are limited in quantity and a judicial use of resources is needed to cater to the need of the future customers along with the need of the present customers. One may have noticed the save fuel campaign, a demarketing campaign that deviates from the usual approach of sales growth strategy and preaches for conservation of fuel for their use across generation. This is an example of stable growth strategy adopted by the oil industry as a whole under resource constraints and the long run objective of survival over years. Incremental growth strategy, profit strategy and pause strategy are other variants of stable growth strategy.

Sustainable growth is important to enterprise long-term development. Too fast or too slow growth will go against enterprise growth and development, so financial should play important role in enterprise development, adopt suitable financial policy initiative to make sure enterprise growth speed close to sustainable growth ratio and have sustainable healthy development.



What makes an organisation financially sustainable? To be financially sustainable, an organisation must:

have more than one source of income;

have more than one way of generating income;

do strategic, action and financial planning regularly;

have adequate financial systems;

have a good public image;

be clear about its values (value clarity); and

have financial autonomy.

Source: CIVICUS “Developing a Financing Strategy”.

The sustainable growth rate (SGR), concept by Robert C. Higgins, of a firm is the maximum rate of growth in sales that can be achieved, given the firm's profitability, asset utilization, and desired dividend payout and debt (financial leverage) ratios. The sustainable growth rate is a measure of how much a firm can grow without borrowing more money. After the firm has passed this rate, it must borrow funds from another source to facilitate growth. Variables typically include the net profit margin on new and existing revenues; the asset turnover ratio, which is the ratio of sales revenues to total assets; the assets to beginning of period equity ratio; and the retention rate, which is defined as the fraction of earnings retained in the business.

SGR = ROE x (1- Dividend payment ratio)

Sustainable growth models assume that the business wants to: 1) maintain a target capital structure without issuing new equity; 2) maintain a target dividend payment ratio; and 3) increase sales as rapidly as market conditions allow. Since the asset to beginning of period equity ratio is constant and the firm's only source of new equity is retained earnings, sales and assets cannot grow any faster than the retained earnings plus the additional debt that the retained earnings can support. The sustainable growth rate is consistent with the observed evidence that most corporations are reluctant to issue new equity. If, however, the firm is willing to issue additional equity, there is in principle no financial constraint on its growth rate. Indeed, the sustainable growth rate formula is directly predicted on return on equity.

Economists and business researchers contend that achieving sustainable growth is not possible without paying heed to twin cornerstones: growth strategy and growth capability. Companies that pay inadequate attention to one aspect or the other are doomed to fail in their efforts to establish practices of sustainable growth (though short-term gains may be realized). After all, if a company has an excellent growth strategy in place, but has not put the necessary infrastructure in place to execute that strategy, long-term growth is impossible. The reverse is also true.


http://www.answers.com/topic/dividend-payouthttp://www.answers.com/topic/gearinghttp://www.answers.com/topic/total-asset-turnoverhttp://www.answers.com/topic/retentionhttp://www.answers.com/topic/dividend


The very weak idea of sustainability requires that the overall stock of capital assets should remain constant. The weak version of sustainability refers to preservation of critical resources to ensure support for all, over a long time horizon. The strong concept of sustainability is concerned with the preservation of resources under the primacy of ecosystem functioning. These are in line with the definition provided by the economists in the context of sustainable development at macro level.

What makes an organisation sustainable? In order to be sustainable, an organisation must:

have a clear strategic direction;

be able to scan its environment or context to identify opportunities for its work;

be able to attract, manage and retain competent staff;

have an adequate administrative and financial infrastructure;

be able to demonstrate its effectiveness and impact in order to leverage further resources; and

get community support for, and involvement in its work.

Source: CIVICUS “Developing a Financing Strategy”.

The sustainable growth model is particularly helpful in situations in which a borrower requests additional financing. The need for additional loans creates a potentially risky situation of too much debt and too little equity. Either additional equity must be raised or the borrower will have to reduce the rate of expansion to a level that can be sustained without an increase in financial leverage.

Mature firms often have actual growth rates that are less than the sustainable growth rate. In these cases, management's principal objective is finding productive uses for the cash flows that exist in excess of their needs. Options available to business owners and executives in such cases includes returning the money to shareholders through increased dividends or common stock repurchases, reducing the firm's debt load, or increasing possession of lower earning liquid assets. These actions serve to decrease the sustainable growth rate. Alternatively, these firms can attempt to enhance their actual growth rates through the acquisition of rapidly growing companies.

Growth can come from two sources: increased volume and inflation. The inflationary increase in assets must be financed as though it were real growth. Inflation increases the amount of external financing required and increases the debt-to-equity ratio when this ratio is measured on a historical cost basis. Thus, if creditors require that a firm's historical cost debt-to-equity ratio stay constant, inflation lowers the firm's sustainable growth rate.



Mitsubishi Corporation (MC): New Strategic Direction (charting a new path toward sustainable growth)

Mitsubishi Corporation has abolished its traditional "midterm management plan" concept of committing to fixed financial targets three years in the future, in favour of a long-term, circa 2020 growth vision. The "New Strategic Direction” consists of basic concepts on management policy together with business and market strategies. It seeks to recognize the Company’s value and upside potential as a sogo shosha capable of "providing stable earnings throughout business cycles by managing a portfolio diversified by business model, industry, market and geography". MC remains dedicated to sustainable growth but as evidenced by its guiding philosophy, the "Three Corporate Principles", its business activities are even more committed to helping solve problems in Japan and around the world. Its chief goal is to contribute to sustainable societal growth on a global scale.

The summary of this New Strategic Direction is:

Future pull approach eyeing 2020 with a vision to double the business by building a diversified but focussed portfolio.

Clear portfolio strategy: Select winning businesses through proactive reshaping of portfolio.

Grow business and deliver returns while maintaining financial discipline.

TEST YOUR KNOWLEDGE

Theoretical Questions 1. Explain the Interface of Financial Policy and Strategic Management.

2. Write a short note on Balancing Financial Goals vis-a-vis Sustainable Growth.

Answers to Theoretical Questions 1. Please refer paragraph 4

2. Please refer paragraph 5


2

RISK MANAGEMENT LEARNING OUTCOMES After going through the chapter student shall be able to understand: Identification of types of Risk faced by an organization Evaluation of Financial Risks Value at Risk (VAR) Evaluation of appropriate method for the identification and management

of financial risk.

1. IDENTIFICATION OF TYPES OF RISK FACED BY AN ORGANIZATION

A business organization faces many types of risks. Important among them are discussed as below:

1.1 Strategic Risk A successful business always needs a comprehensive and detailed business plan. Everyone knows that a successful business needs a comprehensive, well-thought-out business plan. But it’s also a fact of life that, if things changes, even the best-laid plans can become outdated if it cannot keep pace with the latest trends. This is what is called as strategic risk. So, strategic risk is a risk in which a company’s strategy becomes less effective and it struggles to achieve its goal. It could be due to technological changes, a new competitor entering the market, shifts in customer demand, increase in the costs of raw materials, or any number of other large-scale changes.

We can take the example of Kodak which was able to develop a digital camera by 1975. But, it considers this innovation as a threat to its core business model, and failed to develop it. However, it paid the price because when digital camera was ultimately discovered by other companies, it


2.2 STRATEGIC FINANCIAL MANAGEMENT failed to develop it and left behind. Similar example can be given in case of Nokia when it failed to upgrade its technology to develop touch screen mobile phones. That delay enables Samsung to become a market leader in touch screen mobile phones.

However, a positive example can be given in the case of Xerox which invented photocopy machine. When laser printing was developed, Xerox was quick to lap up this opportunity and changes its business model to develop laser printing. So, it survived the strategic risk and escalated its profits further.

1.2. Compliance Risk Every business needs to comply with rules and regulations. For example with the advent of Companies Act, 2013, and continuous updating of SEBI guidelines, each business organization has to comply with plethora of rules, regulations and guidelines. Non compliance leads to penalties in the form of fine and imprisonment.

However, when a company ventures into a new business line or a new geographical area, the real problem then occurs. For example, a company pursuing cement business likely to venture into sugar business in a different state. But laws applicable to the sugar mills in that state are different. So, that poses a compliance risk. If the company fails to comply with laws related to a new area or industry or sector, it will pose a serious threat to its survival.

1.3 Operational Risk This type of risk relates to internal risk. It also relates to failure on the part of the company to cope with day to day operational problems. Operational risk relates to ‘people’ as well as ‘process’. We will take an example to illustrate this. For example, an employee paying out ` 1,00,000 from the account of the company instead of ` 10,000.

This is a people as well as a process risk. An organization can employ another person to check the work of that person who has mistakenly paid ` 1,00,000 or it can install an electronic system that can flag off an unusual amount.

1.4 Financial Risk Financial Risk is referred as the unexpected changes in financial conditions such as prices, exchange rate, Credit rating, and interest rate etc. Though political risk is not a financial risk in direct sense but same can be included as any unexpected political change in any foreign country may lead to country risk which may ultimately may result in financial loss.

Accordingly, the broadly Financial Risk can be divided into following categories.

1.4.1 Counter Party Risk This risk occurs due to non-honoring of obligations by the counter party which can be failure to deliver the goods for the payment already made or vice-versa or repayment of borrowings and interest etc. Thus, this risk also covers the credit risk i.e. default by the counter party.


RISK MANAGEMENT 2.3 1.4.2 Political Risk Generally this type of risk is faced by and overseas investors, as the adverse action by the government of host country may lead to huge loses. This can be on any of the following form.

• Confiscation or destruction of overseas properties.

• Rationing of remittance to home country.

• Restriction on conversion of local currency of host country into foreign currency.

• Restriction as borrowings.

• Invalidation of Patents

• Price control of products

1.4.3. Interest Rate Risk This risk occurs due to change in interest rate resulting in change in asset and liabilities. This risk is more important for banking companies as their balance sheet’s items are more interest sensitive and their base of earning is spread between borrowing and lending rates.

As we know that the interest rates are two types i.e. fixed and floating. The risk in both of these types is inherent. If any company has borrowed money at floating rate then with increase in floating the liability under fixed rate shall remain the same. This fixed rate, with falling floating rate the liability of company to pay interest under fixed rate shall comparatively be higher.

1.4.4 Currency Risk This risk mainly affects the organization dealing with foreign exchange as their cash flows changes with the movement in the currency exchange rates. This risk can be affected by cash flow adversely or favorably. For example, if rupee depreciates vis-à-vis US$ receivables will stand to gain vis-à-vis to the importer who has the liability to pay bill in US$. The best case we can quote Infosys (Exporter) and Indian Oil Corporation Ltd. (Importer).

1.4.5 Liquidity Risk

Broadly liquidity risk can be defined as inability of organization to meet it liabilities whenever they become due. This risk mainly arises when organization is unable to generate adequate cash or there may be some mismatch in period of cash flow generation.

This type of risk is more prevalent in banking business where there may be mismatch in maturities and receiving fresh deposits pattern.



2. EVALUATION OF FINANCIAL RISK The financial risk can be evaluated from different point of views as follows:

(a) From stakeholder’s point of view: Major stakeholders of a business are equity shareholders and they view financial gearing i.e. ratio of debt in capital structure of company as risk since in event of winding up of a company they will be least prioritized.

Even for a lender, existing gearing is also a risk since company having high gearing faces more risk in default of payment of interest and principal repayment.

(b) From Company’s point of view: From company’s point of view if a company borrows excessively or lend to someone who defaults, then it can be forced to go into liquidation.

(c) From Government’s point of view: From Government’s point of view, the financial risk can be viewed as failure of any bank or (like Lehman Brothers) down grading of any financial institution leading to spread of distrust among society at large. Even this risk also includes willful defaulters. This can also be extended to sovereign debt crisis.

3. VALUE-AT-RISK (VAR) As per Wikipedia, VAR is a measure of risk of investment. Given the normal market condition in a set of period, say, one day it estimates how much an investment might lose. This investment can be a portfolio, capital investment or foreign exchange etc., VAR answers two basic questions -

(i) What is worst case scenario?

(ii) What will be loss?

It was first applied in 1922 in New York Stock Exchange, entered the financial world in 1990s and become world’s most widely used measure of financial risk.

3.1 Features of VAR Following are main features of VAR

(i) Components of Calculations: VAR calculation is based on following three components :

(a) Time Period

(b) Confidence Level – Generally 95% and 99%

(c) Loss in percentage or in amount

(ii) Statistical Method: It is a type of statistical tool based on Standard Deviation.

(iii) Time Horizon: VAR can be applied for different time horizons say one day, one week, one month and so on.


RISK MANAGEMENT 2.5 (iv) Probability: Assuming the values are normally attributed, probability of maximum loss can

be predicted.

(v) Control Risk: Risk can be controlled by selling limits for maximum loss.

(vi) Z Score: Z Score indicates how many standard Deviations is away from Mean value of a population. When it is multiplied with Standard Deviation it provides VAR.

3.2 Application of VAR VAR can be applied

(a) to measure the maximum possible loss on any portfolio or a trading position.

(b) as a benchmark for performance measurement of any operation or trading.

(c) to fix limits for individuals dealing in front office of a treasury department.

(d) to enable the management to decide the trading strategies.

(e) as a tool for Asset and Liability Management especially in banks.

3.3 Example: The concept of VAR can be understood in a better manner with help of following example:

Suppose you hold ` 2 crore shares of X Ltd. whose market price standard deviation is 2% per day. Assuming 252 trading days a year, determine maximum loss level over the period of 1 trading day and 10 trading days with 99% confidence level.

Answer Assuming share prices are normally for level of 99%, the equivalent Z score from Normal table of Cumulative Area shall be 2.33.

Volatility in terms of rupees shall be:

2% of ` 2 Crore = ` 4 lakh The maximum loss for 1 day at 99% Confidence Level shall be:

` 4 lakh x 2.33 = ` 9.32 lakh, and expected maximum loss for 10 trading days shall be:

√10 x ` 9.32 lakh = 29.47 lakhs

4. APPROPRIATE METHODS FOR IDENTIFICATION AND MANAGEMENT OF FINANCIAL RISK

As we have classified financial risk in 4 categories, we shall discuss identification and management of each risk separately under same category.



4.1 Counter Party risk: The various hints that may provide counter party risk are as follows:

(a) Failure to obtain necessary resources to complete the project or transaction undertaken.

(b) Any regulatory restrictions from the Government.

(c) Hostile action of foreign government.

(d) Let down by third party.

(e) Have become insolvent.

The various techniques to manage this type of risk are as follows:

(1) Carrying out Due Diligence before dealing with any third party.

(2) Do not over commit to a single entity or group or connected entities.

(3) Know your exposure limits.

(4) Review the limits and procedure for credit approval regularly.

(5) Rapid action in the event of any likelihood of defaults.

(6) Use of performance guarantee, insurance or other instruments.

4.2 Political risk: From the following actions by the Governments of the host country this risk can be identified:

1. Insistence on resident investors or labour.

2. Restriction on conversion of currency.

3. Repatriation of foreign assets of the local govt.

4. Price fixation of the products.

Since this risk mainly relates to investments in foreign country, company should assess country risk

(1) By referring political ranking published by different business magazines.

(2) By evaluating country’s macro-economic conditions.

(3) By analyzing the popularity of current government and assess their stability.

(4) By taking advises from the embassies of the home country in the host countries.

Further, following techniques can be used to mitigate this risk.

(i) Local sourcing of raw materials and labour.

(ii) Entering into joint ventures


RISK MANAGEMENT 2.7

(iii) Local financing

(iv) Prior negotiations

4.3 Interest Rate Risk: Generally, interest rate Risk is mainly identified from the following:

1. Monetary Policy of the Government.

2. Any action by Government such as demonetization etc.

3. Economic Growth

4. Release of Industrial Data

5. Investment by foreign investors

6. Stock market changes

The management of Interest risk has been discussed in greater detail in separate chapter later on.

4.4 Currency Risk: Just like interest rate risk the currency risk is dependent on the Government action and economic development. Some of the parameters to identity the currency risk are as follows:

(1) Government Action: The Government action of any country has visual impact in itscurrency. For example, the UK Govt. decision to divorce from European Union i.e. Brexitbrought the pound to its lowest since 1980’s.

(2) Nominal Interest Rate: As per interest rate parity (IRP) the currency exchange rate dependson the nominal interest of that country.

(3) Inflation Rate: Purchasing power parity theory discussed in later chapters impact the valueof currency.

(4) Natural Calamities: Any natural calamity can have negative impact.

(5) War, Coup, Rebellion etc.: All these actions can have far reaching impact on currency’sexchange rates.

(6) Change of Government: The change of government and its attitude towards foreigninvestment also helps to identify the currency risk.

So far as the management of currency risk is concerned, it has been covered in a detailed manner in a separate chapter.



TEST YOUR KNOWLEDGE Theoretical Questions 1. Explain the significance of VAR.

2. The Financial Risk can be viewed from different perspective. Explain.

Practical Questions 1. Consider a portfolio consisting of a ` 200,00,000 investment in share XYZ and a

` 200,00,000 investment in share ABC. The daily standard deviation of both shares is 1% and that the coefficient of correlation between them is 0.3. You are required to determine the 10-day 99% value at risk for the portfolio?

ANSWERS/ SOLUTIONS Answers to Theoretical Questions 1. Please refer paragraph 3.2

2. Please refer paragraph 2

Answers to the Practical Questions 1. The standard deviation of the daily change in the investment in each asset is ` 2,00,000 i.e.

2 lakhs. The variance of the portfolio’s daily change is

V = 22 + 22 + 2 x 0.3 x 2 x 2 = 10.4

σ (Standard Deviation) = 10.4 = ` 3.22 lakhs Accordingly, the standard deviation of the 10-day change is

` 3.22 lakhs x 10 = ` 10.18 lakh From the Normal Table we see that z score for 1% is 2.33. This means that 1% of a normal

distribution lies more than 2.33 standard deviations below the mean. The 10-day 99 percent value at risk is therefore

2.33 × ` 10.18 lakh = ` 23.72 lakh


3

SECURITY ANALYSIS LEARNING OUTCOMES After going through the chapter student shall be able to understand: Fundamental Analysis Technical Analysis

(a) Meaning (b) Assumptions (c) Theories and Principles (d) Charting Techniques (e) Efficient Market Hypothesis (EMH) Analysis

INTRODUCTION Investment decision depends on securities to be bought, held or sold. Buying security is based on highest return per unit of risk or lowest risk per unit of return. Selling security does not depend on any such requirement. A security considered for buying today may not be attractive tomorrow due to management policy changes in the company or economic policy changes adopted by the government. The reverse is also true. Therefore, analysis of the security on a continuous basis is a must.

Security Analysis involves a systematic analysis of the risk return profiles of various securities which is to help a rational investor to estimate a value for a company from all the price sensitive information/data so that he can make purchases when the market under-prices some of them and thereby earn a reasonable rate of return.


3.2 STRATEGIC FINANCIAL MANAGEMENT Two approaches viz. fundamental analysis and technical analysis are in vogue for carrying out Security Analysis. In fundamental analysis, factors affecting risk-return characteristics of securities are looked into while in technical analysis, demand/ supply position of the securities along with prevalent share price trends are examined.

1. FUNDAMENTAL ANALYSIS Fundamental analysis is based on the assumption that the share prices depend upon the future dividends expected by the shareholders. The present value of the future dividends can be calculated by discounting the cash flows at an appropriate discount rate and is known as the 'intrinsic value of the share'. The intrinsic value of a share, according to a fundamental analyst, depicts the true value of a share. A share that is priced below the intrinsic value must be bought, while a share quoting above the intrinsic value must be sold.

Thus, it can be said that the price the shareholders are prepared to pay for a share is nothing but the present value of the dividends they expect to receive on the share and this is the price at which they expect to sell it in the future.

As a first step, to arrive at a compact expression, let us make a simple assumption, that the company is expected to pay a uniform dividend of ` D per share every year, i.e.,

D(1) = D(2) = D(3) = … = D, (1)

The Eq., would then become:

P(0) = 2 3D D D + + + ... + ...

(1+ k) (1+ k) (1+ k) (2)

But it is unrealistic to assume that dividends remain constant over time. In case of most shares, the dividends per share (DPS) grow because of the growth in the earnings of the firm. Most companies, as they identify new investment opportunities for growth, tend to increase their DPS over a period of time.

Let us assume that on an average the DPS of the company grows at the compounded rate of g per annum, so that dividend D(1) at the end of the first period grows to D(1)(1+g), D(1)(1+g)2, etc, at the end of second period, third period, etc. respectively. So we must have:

P(0) = 2

2 3D (1) D (1) (1 g) D (1) (1 g) ... ...(1 k) (1 k) (1 k)

+ ++ + + +

+ + +(3)

which is a perpetual geometric series.

If growth rate in dividends, g, is less than the desired rate of return on share, k, we must have:

P(0) = D(1) (k g)−

(4)


SECURITY ANALYSIS 3.3

or

P(0) = D(0)(1 g)

(k g)+

− (5)

Since D(1) may be approximated as D(0)(1+g), D(0) being the DPS in the current period (0).

When growth rate in dividends, g, is equal to or greater than the desired rate of return on share, k, the above model is not valid, since the geometric series leads to an infinite price. The condition that g be less than k is not very restrictive, since the long-term growth in dividends is unlikely to exceed the rate of return expected by the market on the share.

The above result [Eq.(4)] is also known as Gordon’s dividend growth model for stock valuation, named after the model’s originator, Myron J. Gordon. This is one of the most well known models in the genre of fundamental analysis.

In equation (5), if “g” is set at zero, we get back equation (2).

1.1 Dividend Growth Model and the PE Multiple Financial analysts tend to relate price to earnings via the P/E multiples (the ratio between the market price and earnings per share).

If a company is assumed to pay out a fraction b of its earnings as dividends on an average (i.e. the Dividend Payout Ratio = b), D(1) may be expressed as b E(1), where E(1) is the earning per share (EPS) of the company at the end of the first period. Equation (4) then becomes:

P(0) = bE(1) (k g)−

(6)

or

P(0) = bE(0) (1 g) (k g)

+−

(7)

The fundamental analysts use the above models or some of their variations, for estimating the fundamental or intrinsic price or the fundamental price-earnings multiple of a security. Towards this end, they devote considerable effort in assessing the impact of various kinds of information on a company’s future profitability and the expected return of the shareholders. If the prevailing price or the P/E multiple of a security is higher than the estimated fundamental value (i.e. if the security appears to be overpriced), they recommend a selling stance with respect to that security, since once the information becomes common knowledge, the price of the security may be expected to fall. On the other hand, if the security is under-priced in the market, the prevailing price (or the P/E multiple) of the security being lower than the estimated fundamental value, they recommend buying the security, counting upon a price rise.

Because of these inherent complex interrelationships in the production processes, the fortunes of each industry are closely tied to those of other industries and to the performance of the economy as


3.4 STRATEGIC FINANCIAL MANAGEMENT a whole. Within an industry, the prospects of a specific company depend not only on the prospects of the industry to which it belongs, but also on its operating and competitive position within that industry. The key variables that an investor must monitor in order to carry out his fundamental analysis are economy wide factors, industry wide factors and company specific factors. In other words, fundamental analysis encompasses economic, industrial and company analyses. They are depicted by three concentric circles and constitute the different stages in an investment decision making process.

1.2 Economic Analysis Macro- economic factors e. g. historical performance of the economy in the past/ present and expectations in future, growth of different sectors of theeconomy in future with signs of stagnation/degradation at present to be assessed while analyzing the overall economy. Trends in peoples’ income and expenditure reflect the growth of a particular industry/company in future. Consumption affects corporate profits, dividends and share prices in the market.

1.2.1 Factors Affecting Economic Analysis Some of the economy wide factors are discussed as under:

(a) Growth Rates of National Income and Related Measures: For most purposes, what is important is the difference between the nominal growth rate quoted by GDP and the ‘real’ growth after taking inflation into account. The estimated growth rate of the economy would be a pointer to the prospects for the industrial sector, and therefore to the returns investors can expect from investment in shares.

(b) Growth Rates of Industrial Sector: This can be further broken down into growth rates of various industries or groups of industries if required. The growth rates in various industries are estimated based on the estimated demand for its products.

(c) Inflation: Inflation is measured in terms of either wholesale prices (the Wholesale Price Index or WPI) or retail prices (Consumer Price Index or CPI). The demand in some industries, particularly

Economy Analysis

Industry Analysis

Company Analysis


SECURITY ANALYSIS 3.5 the consumer products industries, is significantly influenced by the inflation rate. Therefore, firms in these industries make continuous assessment about inflation rates likely to prevail in the near future so as to fine-tune their pricing, distribution and promotion policies to the anticipated impact of inflation on demand for their products.

(d) Monsoon: Because of the strong forward and backward linkages, monsoon is of great concern to investors in the stock market too.

1.2.2 Techniques Used in Economic Analysis Economic analysis is used to forecast national income with its various components that have a bearing on the concerned industry and the company in particular. Gross national product (GNP) is used to measure national income as it reflects the growth rate in economic activities and has been regarded as a forecasting tool for analyzing the overall economy along with its various components during a particular period.

Some of the techniques used for economic analysis are:

(a) Anticipatory Surveys: They help investors to form an opinion about the future state of the economy. It incorporates expert opinion on construction activities, expenditure on plant and machinery, levels of inventory – all having a definite bearing on economic activities. Also future spending habits of consumers are taken into account.

In spite of valuable inputs available through this method, it has certain drawbacks:

(i) Survey results do not guarantee that intentions surveyed would materialize.

(ii) They are not regarded as forecasts per se, as there can be a consensus approach by the investor for exercising his opinion.

Continuous monitoring of this practice is called for to make this technique popular.

(b) Barometer/Indicator Approach: Various indicators are used to find out how the economy shall perform in the future. The indicators have been classified as under:

(i) Leading Indicators: They lead the economic activity in terms of their outcome. They relate to the time series data of the variables that reach high/low points in advance of economic activity.

(ii) Roughly Coincidental Indicators: They reach their peaks and troughs at approximately the same in the economy.

(iii) Lagging Indicators: They are time series data of variables that lag behind in their consequences vis-a- vis the economy. They reach their turning points after the economy has reached its own already.

All these approaches suggest direction of change in the aggregate economic activity but nothing about its magnitude. The various measures obtained form such indicators may give conflicting


3.6 STRATEGIC FINANCIAL MANAGEMENT signals about the future direction of the economy. To avoid this limitation, use of diffusion/composite index is suggested whereby combining several indicators into one index to measure the strength/weaknesses in the movement of a particular set of indicators. Computation of diffusion indices is no doubt difficult notwithstanding the fact it does not eliminate irregular movements.

Money supply in the economy also affects investment decisions. Rate of change in money supply in the economy affects GNP, corporate profits, interest rates and stock prices. Increase in money supply fuels inflation. As investment in stocks is considered as a hedge against inflation, stock prices go up during inflationary period.

(c) Economic Model Building Approach: In this approach, a precise and clear relationship between dependent and independent variables is determined. GNP model building or sectoral analysis is used in practice through the use of national accounting framework. The steps used are as follows:

(i) Hypothesize total economic demand by measuring total income (GNP) based on political stability, rate of inflation, changes in economic levels.

(ii) Forecasting the GNP by estimating levels of various components viz. consumption expenditure, gross private domestic investment, government purchases of goods/services, net exports.

(iii) After forecasting individual components of GNP, add them up to obtain the forecasted GNP.

(iv) Comparison is made of total GNP thus arrived at with that from an independent agency for the forecast of GNP and then the overall forecast is tested for consistency. This is carried out for ensuring that both the total forecast and the component wise forecast fit together in a reasonable manner.

1.3 Industry Analysis When an economy grows, it is very unlikely that all industries in the economy would grow at the same rate. So it is necessary to examine industry specific factors, in addition to economy-wide factors.

First of all, an assessment has to be made regarding all the conditions and factors relating to demand of the particular product, cost structure of the industry and other economic and Government constraints on the same. Since the basic profitability of any company depends upon the economic prospects of the industry to which it belongs, an appraisal of the particular industry's prospects is essential.

1.3.1 Factors Affecting Industry Analysis The following factors may particularly be kept in mind while assessing the factors relating to an industry.


SECURITY ANALYSIS 3.7 (a) Product Life-Cycle: An industry usually exhibits high profitability in the initial and growth

stages, medium but steady profitability in the maturity stage and a sharp decline in profitability in the last stage of growth.

(b) Demand Supply Gap: Excess supply reduces the profitability of the industry because of the decline in the unit price realization, while insufficient supply tends to improve the profitability because of higher unit price realization.

(c) Barriers to Entry: Any industry with high profitability would attract fresh investments. The potential entrants to the industry, however, face different types of barriers to entry. Some of these barriers are innate to the product and the technology of production, while other barriers are created by existing firms in the industry.

(d) Government Attitude: The attitude of the government towards an industry is a crucial determinant of its prospects.

(e) State of Competition in the Industry: Factors to be noted are- firms with leadership capability and the nature of competition amongst them in foreign and domestic market, type of products manufactured viz. homogeneous or highly differentiated, demand prospects through classification viz customer-wise/area-wise, changes in demand patterns in the long/immediate/ short run, type of industry the firm is placed viz. growth, cyclical, defensive or decline.

(f) Cost Conditions and Profitability: The price of a share depends on its return, which in turn depends on profitability of the firm. Profitability depends on the state of competition in the industry, cost control measures adopted by its units and growth in demand for its products.

Factors to be considered are:

(i) Cost allocation among various heads e.g. raw material, labors and overheads and their controllability. Overhead cost for some may be higher while for others labour may be so. Labour cost which depends on wage level and productivity needs close scrutiny.

(ii) Product price.

(iii) Production capacity in terms of installation, idle and operating.

(iv) Level of capital expenditure required for maintenance / increase in productive efficiency.

Investors are required to make a through analysis of profitability. This is carried out by the study of certain ratios such as G.P. Ratio, Operating Profit Margin Ratio, R.O.E., Return on Total Capital etc.

(g) Technology and Research: They play a vital role in the growth and survival of a particular industry. Technology is subject to change very fast leading to obsolescence. Industries which update themselves have a competitive advantage over others in terms of quality, price etc.


3.8 STRATEGIC FINANCIAL MANAGEMENT Things to be probed in this regard are:

(i) Nature and type of technology used.

(ii) Expected changes in technology for new products leading to increase in sales.

(iii) Relationship of capital expenditure and sales over time. More capital expenditure means increase in sales.

(iv) Money spent in research and development. Whether this amount relates to redundancy or not?

(v) Assessment of industry in terms of sales and profitability in short, immediate and long run.

1.3.2 Techniques Used in Industry Analysis The techniques used for analyzing the industry wide factors are:

(a) Regression Analysis: Investor diagnoses the factors determining the demand for output of the industry through product demand analysis. Factors to be considered are GNP, disposable income, per capita consumption / income, price elasticity of demand. For identifying factors affecting demand, statistical techniques like regression analysis and correlation are used.

(b) Input – Output Analysis: It reflects the flow of goods and services through the economy, intermediate steps in production process as goods proceed from raw material stage through final consumption. This is carried out to detect changing patterns/trends indicating growth/decline of industries.

1.4 Company Analysis Economic and industry framework provides the investor with proper background against which shares of a particular company are purchased. This requires careful examination of the company's quantitative and qualitative fundamentals.

(a) Net Worth and Book Value: Net Worth is sum of equity share capital, preference share capital and free reserves less intangible assets and any carry forward of losses. The total net worth divided by the number of shares is the much talked about book value of a share. Though the book value is often seen as an indication of the intrinsic worth of the share, this may not be so for two major reasons. First, the market price of the share reflects the future earnings potential of the firm which may have no relationship with the value of its assets. Second, the book value is based upon the historical costs of the assets of the firm and these may be gross underestimates of the cost of the replacement or resale values of these assets.

(b) Sources and Uses of Funds: The identification of sources and uses of funds is known as Funds Flow Analysis. One of the major uses of funds flow analysis is to find out whether the firm has used short-term sources of funds to finance long-term investments. Such methods of financing increases the risk of liquidity crunch for the firm, as long-term investments,


SECURITY ANALYSIS 3.9

because of the gestation period involved may not generate enough surpluses in time to meet the short-term liabilities incurred by the firm. Many a firm has come to grief because of this mismatch between the maturity periods of sources and uses of funds.

(c) Cross-Sectional and Time Series Analysis: One of the main purposes of examining financial statements is to compare two firms, compare a firm against some benchmark figures for its industry and to analyze the performance of a firm over time. The techniques that are used to do such proper comparative analysis are: common-sized statement, and financial ratio analysis.

(d) Size and Ranking: A rough idea regarding the size and ranking of the company within the economy, in general, and the industry, in particular, would help the investment manager in assessing the risk associated with the company. In this regard the net capital employed, the net profits, the return on investment and the sales figures of the company under consideration may be compared with similar data of other companies in the same industry group. It may also be useful to assess the position of the company in terms of technical know-how, research and development activity and price leadership.

(e) Growth Record: The growth in sales, net income, net capital employed and earnings per share of the company in the past few years should be examined. The following three growth indicators may be particularly looked into: (a) Price earnings ratio, (b) Perc

F M NEW SYLLABUS STUDY...ii This study material has been prepared by the faculty of the Board...

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Transcript of F M NEW SYLLABUS STUDY...ii This study material has been prepared by the faculty of the Board...

F M __ NEW SYLLABUS __ STUDY...ii This study material has been prepared by the faculty of the Board...

Documents

Transcript of F M __ NEW SYLLABUS __ STUDY...ii This study material has been prepared by the faculty of the Board...

F M NEW SYLLABUS STUDY...ii This study material has been prepared by the faculty of the Board...

Transcript of F M NEW SYLLABUS STUDY...ii This study material has been prepared by the faculty of the Board...