One: An Introduction

An Overview

Introduction

Irrespective of the research area (whether in the physical or social sciences) a logical procedure when constructing theoretical models has always been to make simplifying assumptions to improve our understanding of the real world. As a convenient benchmark, all the texts in my book boon series (referenced at the end of this Chapter) therefore begin with an idealized picture of investors (including management) who are rational and risk-averse, operating in reasonably efficient capital markets. With a free flow of information and no barriers to trade, they can formally analyze one course of action in relation to another for the purpose of wealth maximization with a degree of confidence.

In a sophisticated mixed economy, summarized in Figure 1.1 below, where the ownership of corporate assets is divorced from control (the agency principle), we can also define and model the normative goal of strategic financial management under conditions of certainty as:

o The implementation of investment and financing decisions using net present value (NPV) maximization techniques to generate money profits from all a firm's projects in the form of retentions and distributions. These should satisfy the firm's existing owners (a multiplicity of shareholders) and prospective investors who define the capital market, thereby maximizing share price.

Figure 1.1: The Mixed Market Economy

Over their life, individual projects should eventually generate cash flows that exceed their overall cost of funds (i.e. the project discount rate) to create wealth. This positive net terminal value (NTV) is equivalent to a positive NPV, defined by a recurring theme of strategic financial management, namely the time value of money (i.e. the value of money over time, irrespective of inflation) determined by borrowing and lending rates.

If we now relax our assumptions to introduce an element of uncertainty into management's project brief, policies designed to maximize wealth therefore comprise two distinct but nevertheless inter-related functions.

o The investment function, which identifies and selects a portfolio of investment opportunities that maximize expected net cash inflows (ENPV) commensurate with risk.

o The finance function, which identifies potential fund sources (equity and debt, long or short) required to sustain investments, evaluates the risk-adjusted return expected by each, then selects the optimum mix that will minimize their overall weighted average cost of capital (WACC).

o Companies engaged in inefficient or irrelevant activities, which produce losses (negative ENPV) are gradually starved of finance because of reduced dividends, inadequate retentions and the capital market's unwillingness to replenish their asset base, thereby producing a fall in share price

Figure 1.2 distinguishes the "winners" from the "losers" in their drive to create wealth by summarizing in financial terms why some companies fail. These may then fall prey to take-over as share values plummet, or even become bankrupt and disappear altogether.

Figure 1:2: Corporate Economic Performance - Winners and Losers.

Figure 1.3 summarizes the strategic objectives of financial management relative to the inter-relationship between internal investment and external finance decisions that enhance shareholder wealth (share price) based on the law of supply and demand to attract more rational-risk averse investors to the company.

Figure 1.3: Corporate Financial Objectives

The diagram reveals that a company wishing to maximize its wealth using share price as a vehicle, must create cash profits using ENPV as the driver.

Management would not wish to invest funds in capital projects unless their marginal yield at least matched the rate of return prospective investors can earn elsewhere on comparable investments of equivalent risk

Cash profits should then exceed the overall cost of investment (WACC) producing a positive ENPV, which can either be distributed as a dividend or retained to finance future investments