Strategic Financial
Management
An Overview
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Introduction
• Finance is the middle ground between theoretical
economics and the accounting world of numbers.
Finance is applied economics.
• From another view, while accounting is the language of
business, finance is the literature.
• Financial implications are at the heart of every business
transaction and decision.
Introduction
• Finance is not an end in and of itself. It is a tool, a most
valuable tool used to communicate, judge, and monitor
the results of business decisions. It is a tool well-suited
for the boardroom as well as the shop floor; from the
executive suite to the distribution center; from corporate
and divisional staff offices to a distant sales office.
• In a world of geo-political, social and economic
uncertainty, strategic financial management is in a
process of change, which requires a reassessment of
the fundamental assumptions that cut across the
traditional boundaries of the subject.
Objectives of a Firm
• All the traditional finance literature confirms that
investors should be rational, risk-averse individuals who
formally analyze one course of action in relation to
another for maximum benefit, even under conditions of
uncertainty.
• What should be (rather than what is) is what we term
normative theory.
Normative financial theory dictates what financial
managers "ought to do" when faced with financial
decisions. Positive, or descriptive, financial theory
includes both research designed to find relationships
among variables and surveys designed to find out
what financial managers are actually doing. Positive
studies have revealed that financial managers do not
always act in the way that normative theories would
say is appropriate for the situation.
• It represents the foundation of modern finance within
which:
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 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.
• Thus, in a sophisticated mixed market economy where
the ownership of a company’s portfolio of physical and
monetary assets is separated from its control, it follows
that:
The normative objective of financial management should
be:
To implement investment and financing decisions using
risk-adjusted wealth maximizing criteria, which satisfy the
firm’s owners (shareholders) by placing them all in
equal, optimum financial position.
• Of course, we should not underestimate a firm’s
financial, fiscal, legal, and social responsibilities to all its
other stakeholders. These include alternative providers
of capital, creditors, employees and customers, through
to government and society at large. However, the
satisfaction of their objectives should be perceived as a
means to an end, namely, shareholder wealth
maximization.
• As employees, management’s own satisficing behavior
should also be subordinate to those to whom they are
ultimately accountable, namely their shareholders, even
though empirical evidence and financial scandals have
long cast doubt on managerial motivation.
• In our ideal world, firms exist to convert inputs of physical
and money capital into outputs of goods and services that
satisfy consumer demand to generate money profits.
Since most economic resources are limited but society’s
demand seems unlimited, the corporate management
function can be perceived as the future allocation of
scarce resources with a view to maximizing consumer
satisfaction. And because money capital (as opposed to
labor) is typically the limiting factor, the strategic problem
for financial management is how limited funds are
allocated between alternative uses.
• The pioneering work of Jenson and Meckling resolves
this dilemma by defining corporate management as
agents of the firm’s owners, who are termed the
principals. The former are authorized not only to act on
the behalf of the latter, but also in their best interests.
• Armed with agency theory, you will discover that the
function of strategic financial management can be
deconstructed into 4 major components based on the
mathematical concept of expected net present value
(ENPV) maximization:
The investment, dividend,
financing, and portfolio decision
• Explained simply, the market price equity (shares) acts
as a control on management’s actions because if
shareholders (principals) are dissatisfied with managerial
(agency) performance they can always sell part or all of
their holding and move funds elsewhere.
Axioms of Financial Management
Axiom 1: The risk-return tradeoff
• We won’t take additional risk unless we
expect to be compensated with additional
return. Almost all financial decisions
involve some sort of risk-return trade off.
Axiom 2: The time value of
money
• A dollar received today is worth more than
a dollar received in the future
Axiom 3: Cash-Not Profits-is King
• In measuring value we will use cash flows
rather than accounting profits because it is
only cash flows that the firm receives and
is able to reinvest.
Axiom 4: Incremental cash flows
• It is only what changes that counts. In
making business decisions we will only
concern ourselves with what happens as a
result of that decision.
Axiom 5: The Curse of
competitive markets
• Why it’s hard to find exceptionally
profitable projects.
• In competitive markets, extremely large
profits cannot exist for very long because
of competition moving in to exploit those
large profits. As a result, profitable
projects can only be found if the market is
made less competitive, either through
product differentiation or by achieving a
cost advantage.
Axiom 6: Efficient capital markets
• The markets are quick and the prices are
right
Axiom 7: The agency problem
• Managers won’t work for the owners
unless it’s in their best interest.
• The agency problem is a result of the
separation between the decision makers
and the owners of the firm. As a result,
managers may make decisions that are
not in line with the goal of maximization of
shareholder wealth.
Axiom 8: Taxes bias business
decisions
Axiom 9: All risk is not equal
• All risk is not equal since some risks can
be diversified away and some cannot. The
process of diversification can reduce risk,
and as a result, measuring a project’s or
an asset’s risk is very difficult.
Axiom 10: Ethical dilemmas are
everywhere in finance
• Ethical behavior is important in financial
management, just as it is important in
everything we do. Unfortunately, precisely
how we define what is and what is not
ethical behavior is sometimes difficult.
Nevertheless, we should not give up the
quest.
