Chapter 3 Development of financial strategy By the end of this session you should be able to: evaluate the inter relationship between investment, financing and dividend decisions for an incorporated entity advise on the development of financial strategy for an entity taking into account taxation and other external influences and answer questions relating to these areas.

Chapter 3

Chapter 3 1 Investment, financing and dividend decisions 1.1 Three interrelated decisions investment decision – what projects should be undertaken? Financing decision – how should the necessary funds be raised? Dividend decision – how much cash should be paid out to shareholders? These three areas are very closely interlinked.

Chapter 3 1.2 Links between these three decisions When deciding which investments to undertake, the entity needs to decide how finance will be raised. If large amounts of finance are available, this will enable the entity to undertake more/better investments. If investments generate lots of cash, this will enable the entity to pay large dividends. If more equity finance is raised, higher cash levels will be needed for dividends to satisfy

Chapter 3 The impact of investment, financing and dividend decisions on ratios 2 It is important to consider the interrelationship between investment, financing and dividend decisions when assessing the impact of the decisions on the entity's ratios. Examples of interrelationships  An investment decision to undertake a profitable project, financed by raising new debt or equity finance, may impact several important investor and lender ratios such as earnings per share, earnings yield and interest cover.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Chapter 3 Examples of interrelationships  Financing requirements and cash available for payment of dividends are determined based on the overall consideration of the forecast future cash flows arising from investment decisions, business strategy and forecast business and economic variables.  A change in dividend policy can have an immediate impact on some investor ratios such as dividend cover and dividend yield. However, there may also be other, less obvious, impacts. For example, reducing the level of dividend paid out one year could increase the amount of funds available for reinvestment, so there might well be an increased level of growth in profit which could impact ratios such as earnings per share. Illustrations and further practice Now try TYU questions 3 and 4, and illustration 2 from Chapter 9 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Chapter 3 3 The impact of external forces on financial strategy 3.1 External influences on financial strategy When setting the company's financial strategy the financial manager is often influenced by external economic forces. The main influences are: The need to maintain good investor relations Limited access to sources of finance either due to weak creditworthiness or lack of liquidity in the banking sector and capital market Gearing level – introducing borrowings into the capital structure attracts tax relief on interest payments, but it introduces financial risk into the entity Debt covenants Government influence Regulatory bodies Major economic influences such as interest rates, growth in GDP, inflation rates and exchange rates. Accounting concepts

Chapter 3 3.2 The impact of taxation on financial strategy Domestic tax implications Profits generated by a new investment project will be taxable (net of tax allowable depreciation). Debt interest is tax deductible. Using debt to finance new investments, gives tax savings when the interest is paid. Dividends to shareholders will be taxed under income tax rules, but share price rises due to good investments will be taxed under capital gains tax rules (when the shares are sold).

Chapter 3 3.2 The impact of taxation on financial strategy (continued) International tax implications Additional tax consideration – how to minimize the overall tax liability of the international entity? For example, a decision will need to be made as to where the head office of the entity should be located. Multinational companies are often attracted to set up their operations in a low tax economy

Chapter 3 4 The lender’s assessment of creditworthiness 4.1 Introduction When an entity (a borrower) is seeking to raise debt finance, the lender (for example the bank) will carry out an assessment of the borrower to decide whether to lend. 4.2 Information presented by the borrower to the lender Business plan Contents include: the purpose, amount and duration of the borrowing detailed cash flow forecasts, showing the likely cash flows of the borrower and aiming to show the lender that the prospects for the borrower are good an explanation of how the borrower is proposing to repay the borrowing.

Chapter 3 Detailed review of the potential borrower 4.3 Assessment of creditworthiness by the lender Detailed review of the potential borrower analysis of business plan assessment of business prospects security available credit rating other borrowings / covenants

Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Chapter 3 Illustrations and further practice Now try TYU questions 4, 6, 7 and 8 from Chapter 2 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Chapter 3 OT Questions You should now be able to answer all the TYU questions from Chapter 3 in the Study Text and questions 33 to 41 inclusive, and 112, 113, 115 and 120 from the Exam Practice Kit. For further reading, visit Chapters 3 and 9 from the Study Text.