Finance Theory and Financial Strategy

1. Finance Theory and Financial Strategy Emmanuel Akuamoah | Ahmed Arafat Kurt Feir | Jennifer Ho | Yuhong Wu

2. Introduction • Strategic Planning: the process of where the firm is going and how. The process is based on four steps: • Where are we now? • Where do we want to get to? • How are we going to get there? • How will we know when we have got there? • Financial theory is achieving the goals set by strategic planning by allocating financial and human resources and placing the appropriate investment and equipments.

3. The Finance Theory • The theory is based mostly on the DCF model: • Firms consist of tangible and intangible assets and growth opportunity as well. • Firms group similar projects in risk classes. • Cost of capital & the use of funds • Firms opportunity comparing to the market securities.

4. The Gap between Finance Theory & Strategic Planning • Different in culture and language • Managers know that NPV equals zero in long-run equilibrium and they accept positive NPV only by short-run deviation from equilibrium or some competitive advantages. • DCF as a significant industrial difficulty • Inflation is not considered with DCF, led to overvalued income. • DCF might be misused in strategic planning • Even if applied properly, DCF may still fail in strategic planning • Misrepresenting in the investment period (Long-term investment) • Strategic planning sometimes ignores the capital market

5. The Gap between Finance Theory & Strategic Planning • Finance theory concentrates on the financial world, capital markets, in considering new investments while strategic planning adopts the PEST approach. • Managers concern of EPS which is a short-term approach while financial planners see it irrelevant if the plan adds value to the firm. • Some managers pursue diversification to reduce risk as they see (corporate diversification) while in capital market diversification is cheap and easy.

6. Misuse of Finance Theory Ranking on internal rate of return • Competing projects ranked on IRR rather than NPV is difficult because a percentage increase in IRR at a low return ( 2% to 3%) has a greater value than a percentage increase at a high return (30% to 31%) • Short-term investments have a high IRR that led long-term investments to be down the list even if they have high NPV • NPV per dollar invested should be used even if a firm has a limited pool of capital.

7. Misuse of Finance Theory Inconsistent Treatment of Inflation • Cash flows are not fully adjusted for future inflation, making projects with accelerated inflation look less attractive even if their real value is unaffected. Unrealistically High Rates • Unrealistically high discount rates are used by some firms • Premiums are tacked on for risks that can be easily diversified • Rates are raised to offset optimistic biases of managers sponsoring the projects • Some projects are only “high-risk” during the start-up phase

8. Finance Theory May Have Missed the Boat Correct application of discounted cash flow may still encounter the following problems: 1. Estimating the Opportunity Cost of Capital • Opportunity cost of capital is difficult to measure as no long-run trends exist and past average rates of return are used. 2. Estimating the Project’s Future Cash Flows • Operating manager is expected to see further into the future than they are used to • Forecasts are expressed in accounting variables rather than operating • It is difficult to incorporate macroeconomic variables forecasts

9. Finance Theory May Have Missed the Boat 3. Estimating Cross-Sectional Relationships Between Cash Flows • Inappropriate project definitions or boundaries for lines of businesses increases the difficulties of tracing cross-sectional relationships between project cash flows 4. Estimating the Project’s Impact on the Firm’s Future Investment Opportunities • Since tomorrow’s opportunities depend on today’s decisions, there is a time-series link between projects. Second stages of projects (additional investments) are options based on the status of the first stage

10. The Limits of Discounted Cash Flow 1. DCF is standard for valuing fixed-income securities (bonds, preferred stock, etc.) 2. DCF is sensible in valuing relatively safe stocks that pay regular dividends 3. DCF is not helpful in valuing companies with significant growth opportunities 4. DCF is never used for traded call or put options.

11. Problems in Using DCF to Value Safe Flows • DCF is readily applied to “cash cows” (safe businesses held for the cash generated rather than strategic value) and investments where the main benefit is reduced cost in a clearly defined area • DCF is less helpful in valuing businesses with substantial growth opportunities or intangible assets • DCF is not applicable to pure research and development A mixture of DCF and option valuation models will describe the time-series links between projects. It also makes estimating the value of particular strategic options possible.

12. Conclusion It is better to look at strategy as managing a firm’s portfolio of real options. 1. Acquire options 2. Abandon options 3. Exercise valuable options at the right time In order to bridge the gap between finance theory and strategic planning, the existing finance theory needs to be applied correctly and applied extensively; that is in conjunction to the option pricing theory. Both sides need to make an effort to reconcile financial and strategic analysis.