Corporate Financial Strategy
4th edition
Dr Ruth Bender
Chapter 1
Corporate financial strategy: setting the
context
Corporate Financial Strategy
Setting the context: contents
 Learning objectives
 Risk and return
 The two-stage investment process
 What does ‘good’ look like?
 NPV illustration (Working Insight 1.3)
 Value is created ‘above the line’ (Figure 1.4)
 Individuals have different risk appetites (Figure 1.5)
 The seven drivers of value
 Economic profit (Working Insight 1.5)
 Total shareholder return (Working Insight 1.6)
 The value matrix (Figure 1.6)
 Stakeholders are important
 Agency and double agency
Corporate Financial Strategy
2
Learning objectives
1. Understand what financial strategy is, and how it can add value.
2. Explain why shareholder value is created by investments with a
positive net present value.
3. Appreciate how the relationship between perceived risk and required
return governs companies and investors.
4. Differentiate the different models of measuring shareholder value.
5. Explain why share price is not necessarily a good proxy for company
value.
6. Outline how agency theory is relevant to corporate finance.
Corporate Financial Strategy
3
Risk and return
Required
return
Perceived risk
Corporate Financial Strategy
4
The two-stage investment process
Shareholders
(and others)
invest in the company
Company invests in a
portfolio of projects
Corporate Financial Strategy
5
What does ‘good’ look like?
Is it a good
Is it a good
Product?
Product?
Is it a good
Business
?
Is it a good
Company
?
Is it a good
Investment?
Corporate Financial Strategy
6
Value is created above the line
Required
return
Increase return
more than risk
X
Reduce risk
more than
return
Perceived risk
Corporate Financial Strategy
7
Individuals have different risk appetites
Required
return
Longserving
manager
Venture
capital fund
Welldiversified
institutional
investor
Perceived risk
Corporate Financial Strategy
8
The seven drivers of value
1. Increase sales growth
More profit
2. Increase operating profit margin
3. Reduce cash tax rate
Out of fewer
assets
4. Reduce working capital as % of sales
At lower risk
6. Reduce weighted average cost of
capital
For as long as
possible
7. Increase timescale of competitive
advantage
5. Reduce fixed assets as % of sales
Rappaport, Creating Shareholder Value, 1998
Corporate Financial Strategy
9
Economic profit
Operating profit after tax
Capital employed
Cost of capital
£2,400
£20,000
10%
Operating profit after tax
2,400
less cost of capital (20,000 x 10%)
2,000
Economic profit
400
Return on capital employed (2,400/20000)
Spread
2%
Economic profit (2% x 20,000)
Corporate Financial Strategy
12%
400
10
Total Shareholder Return (TSR)
Share price at 1 January
Share price at 31 December
100
110
Capital gain in the year
Dividend paid in the year
10
5
Total return
15
Total shareholder return (TSR)
15%
Corporate Financial Strategy
11
Figure 1.5 The value matrix
> 1.0
Value multiple
Market value
÷
Fair value
= 1.0
< 1.0
Negative
Corporate Financial Strategy
Economic profit
12
Positive
Stakeholders are important
Shareholders
Investment institutions, family
members, prospective
investors
Community
Local community, environmental
bodies, public at large
Debt holders
Banks, investment
institutions, individuals
Customers
Direct customers, end consumers,
consumer groups
Business and
Financial
strategy
Managers
Board of directors, senior managers,
other managers
Government and regulators
Tax authorities, trade department,
employment department, governance
regulators
Employees
Individuals, unions / staff
associations, pensioners
Corporate Financial Strategy
Suppliers
Long term suppliers, raw material
suppliers, sub-contractors
13
Agency and double agency
Net assets
Debt
Fixed assets
Current assets
less current
liabilities
Non-operating
assets
Fund
managers
Equity
Management
Employees
Corporate Financial Strategy
14
Individual
shareholders
and
pensioners