Functional strategies - finance

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Functional strategies - finance

• Alan Eardley/Geoff Leese
• November 2006, revised July 2007, August 2008,
  August 2009

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Introduction

• Reminder of study of functional strategies
• Financial strategy issues
• Financial strategy objectives
• Capital structure (inc gearing)
• Capital types
• Sources of capital
• International differences
• Problems of short-termism

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Functional Strategies
Top level or SBU strategy
Corporate strategy
Finance Strategy (week 7)
Marketing Strategy (week 7)
HRM Strategy (week 8)
Manufacturing Strategy (week6)

• Examples of functional strategies
• depends on level of SBU
• depends on type of business
• depends on organisation

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Finance strategy

• Issues covered by a typical financial strategy
• Raising capital and sources of funding
• Long-term financial planning
• Functional or departmental budgeting
• Capital structuring ( and gearing)
• Cash management
• Reinvesting profits and cash surpluses
• Capital investment appraisal
• All are more complicated for multinational
  corporations
• Manufacturing companies face particular problems

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Finance strategy

• A good finance strategy helps the company to
• Replace and renew capital assets
• Pay interest, share dividends and loans
• Make sure funds are available
• At the right time
• At the lowest cost
• Build up and manage reserves
• To enable capital renewals (e.g. plant, vehicles)
• To cover unforeseen events (e.g. shortages)
• Enable long term growth
• Fend off or enable take-overs

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Capital Structure

• How public limited companies obtain capital
• Shares (flexibility vs loss of control)
• Debentures (secured loans)
• Can be repaid from profits or reserves
• Loans and overdrafts (can be recalled)
• Retained profits
• No interest payments, recall or loss of control
  but
• Can reduce share price encourage take-over
• Value of company exceed value of shares
• Capital structure needs to balance certain
  factors

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Capital Structure

• Factors determining the choice of capital
  structure
• The risks inherent in the companys markets
• Ability to generate new profit/earning
  opportunities
• Estimates of future costs, profits and
  investments
• Confidence and attitudes of major shareholders
• Attitudes of the companys management
• Tax liabilities
• Need for flexibility
• Note the classic example of the decline of GEC
  from
• 70s to the Marconi era from cash mountain
  to
• over-investment and decline in valuation

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Gearing

• A very important factor in capital structuring
• The ratio of borrowings to total share capital
• Affects the firms risk in various financial
  conditions
• High geared risky for shareholders, but high
  return
• More capital from borrowings
• Less capital in shares
• Low geared safe for shareholders, but lower
  return
• More capital in shares
• Less capital from borrowings
• Borrowings includes debentures and loans, etc.

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Capital types

• Firms use two types of capital
• Fixed capital (spent on fixed assets)
• Land and buildings, plant etc.
• Working capital (spent on consumables)
• Stock, wages, operating expenses etc.
• These two are inter-related
• FC investment creates profits
• allows investment in WC
• WC can be invested in fixed assets
• There is often a gap between investment and
  profit
• that the company has to cover
• Short and long term finance sources
• Cash flow

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Capital types

• Short term finance
• To cover cash flow gap (trading cycle)
• Overdraft, fixed-term loans, credit, debt
  factoring
• Long term finance
• To finance long-lived assets
• Term should equate to expected life of asset
• Debentures and shares

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Share dilution

• One way to raise more capital is to issue more
  shares to finance
• expansion, take over or profit-making activities
• BUT
• This can have negative consequences, such as
• Profits must be spread among more shareholders
• Reduced dividend payable on each share
• This is share dilution, and can result in
• A decline in the market price of the shares
• Vulnerability to take over
• Lack of confidence in the management
• Lower credit rating (poorer borrowing prospects)
• This is over capitalisation - under
  capitalisation is the opposite

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Sources of capital 1

• Shares (Ordinary and Preference)
• Public quotation on the UK Stock Exchange (SE)
• Restrictions on listing
• Ready source of finance (when earnings high)
• Improved public image (when successful)
• Can make take over easier (and being taken over)
• Shows worth of company on the market
• Reduces dependency on banks and lenders
• Alternative Investment Market (AIM)
• Second-level securities market
• Less restrictions than SE

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Sources of capital 2

• Venture capital
• Shares taken by a finance company
• Takes dividend profit for defined period
• Usually sells shares back at end of period
• Usually goes with rapid company expansion
• Drawbacks of venture capital include
• Relatively high cost of capital (may be gt 30)
• Need to account to venture capitalist
• Restrictions on further borrowing (gearing)
• Possibility of loss of control of targets not met
• At a price agreed in the original agreement
• May be said to encourage short termism in UK
  industry

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Sources of capital 3

• Overseas other EU stock markets (e.g. France)
• Traditionally capital is in form of borrowings
• Some German firms have only 5 share capital
• Banks and institutional investors are entrenched
• Therefore equity investment into UK is attractive
• New affluence in unified Europe
• Lack of opportunities in local equity markets
• EU banks have limited capacity for loans
• Generally new EU investors are not risk averse
• Share investment is becoming fashionable
• Development of EU stock markets (bourses)

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Problems with short termism

• The Continental system favours long term
  investment
• Reinvest profits without worrying about share
  price
• Less worries about hostile take over activity
• The opposite (short termism) has some problems
• Failure to develop new infrastructures
• Failure to exploit new technologies
• Continuation of outdated production methods
• Countermeasures may make things worse
• Cutting back on advertising and promotions
• Running down RD projects
• Skimping on maintenance and training etc.

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Summary

• Reminder of study of functional strategies
• Financial strategy issues
• Financial strategy objectives
• Capital structure (inc gearing)
• Capital types
• Sources of capital
• International differences
• Problems of short-termism

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Further reading

• Bennett chapter 10
• Finance - follow the link!
• American, but some good articles here!
• Advice for small businesses - follow the link!
• Lots of useful stuff here. Follow the link to
  Finance and Grants this week.