Chapter 1 Corporate financial strategy: setting the context

1. Corporate Financial Strategy4th edition Dr Ruth Bender Chapter 1Corporate financial strategy: setting the context

2. 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

3. Learning objectives • Understand what financial strategy is, and how it can add value. • Explain why shareholder value is created by investments with a positive net present value. • Appreciate how the relationship between perceived risk and required return governs companies and investors. • Differentiate the different models of measuring shareholder value. • Explain why share price is not necessarily a good proxy for company value. • Outline how agency theory is relevant to corporate finance.

4. Risk and return Required return Perceived risk

5. The two-stage investment process Shareholders (and others) invest in the company Company invests in a portfolio of projects

6. What does ‘good’ look like? • Is it a good Product?

7. Value is created above the line Required return Increase return more than risk X Reduce risk more than return Perceived risk

8. Individuals have different risk appetites Long-serving manager Venture capital fund Required return Well-diversified institutional investor Perceived risk

9. The seven drivers of value Rappaport, Creating Shareholder Value, 1998

10. Economic profit Operating profit after tax £2,400 Capital employed £20,000 Cost of capital 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) 12% Spread 2% Economic profit (2% x 20,000) 400

11. Total Shareholder Return (TSR) Share price at 1 January 100 Share price at 31 December 110 Capital gain in the year 10 Dividend paid in the year 5 Total return 15 Total shareholder return (TSR) 15%

12. Figure 1.5 The value matrix > 1.0 A B Value multiple Market value ÷ Fair value = 1.0 D C < 1.0 Negative Positive Economic profit

13. Business and Financial strategy Stakeholders are important Shareholders Investment institutions, family members, prospective investors Community Local community, environmental bodies, public at large Debt holders Banks, investment institutions, individuals Suppliers Long term suppliers, raw material suppliers, sub-contractors Customers Direct customers, end consumers, consumer groups 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

14. Agency and double agency Net assets Fixed assets Current assets less current liabilities Non-operating assets Debt Individual shareholders and pensioners Fund managers Equity Management Employees