CH3 – Development of

F3 – Financial Strategy
financial strategy

Chapter 3
Development of financial strategy

Chapter learning objectives:

Lead Component Indicative syllabus content

A.2 Analyse strategic (a) Evaluate the • Use of policy decisions to meet cash needs of
financial policy decisions. interrelationship between entity.
investment, financing and
dividend decisions for an • Sensitivity of forecast financial statements and
incorporated entity. future cash position to these policy decisions.

• Consideration of the interests of stakeholders.

A.3 Discuss the external Discuss the influence of • Lenders’ assessment of creditworthiness.
influences on financial the following on financial
strategic decisions. strategic decisions • Consideration of domestic and international tax
regulations.
(a) Market requirements
(b) Taxation • Consideration of industry regulations such as
(c) Regulatory price and service controls.
requirements

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financial strategy

1. Key decisions for financial strategy

Strategy is a course of action, including the specification of resources required, to
achieve a specific objective. (CIMA Official terminology)
Strategic Financial Management is the identification of the possible strategies capable
of maximising an entity’s net present value, the allocation of scarce capital resources
among competing opportunities and the implementation and monitoring of the chosen
strategy so as to achieve stated objectives. (CIMA Official terminology)

• Entities usually have financial objectives that encourage investment and growth.
• Financial strategies depend upon the financial objectives of the entity.
• The financial managers are required to design financial strategies to manage
finance in the most beneficial way possible.

• The three decisions are all interrelated.

Investment decisions
• Investment decisions (in projects, takeovers) need to be analysed to ensure
that they are beneficial for the investor.
• Financial managers are responsible for identifying and evaluating investment
opportunities that will fulfil the financial objectives of the entity.
• The implications of a potential investment should be considered, as it is likely to
affect:
- The cash inflow and outflow of the entity, thus influencing liquidity.
- The future profit and earnings.
- The financial ratios.
- The variability in cash flows and earnings. Investments with greater variability of
return are high-risk investments.
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• If investment plans are well received (e.g. estimated to deliver +NPV), then they are
a key mechanism for increasing the share price and delivering increased
shareholder wealth (discussed in paper P3).

Financing decisions
• Financing decisions focus on how much debt an entity should use and aim to
minimise the cost of capital.
• Investments in both capital structure and working capital require financing, and in
order to fund investments, the finance managers must evaluate the sources of funds
available.
• The sources of funds evaluated will include both internal and external sources.
- External sources include debt finance and equity finance, affecting gearing.
- Internal sources involve funding from the organisation’s operations and so will
affect dividend decisions.
• For working capital management, decisions will involve deciding whether long-term
or short-term finance should be availed.
• The financial manager will have to consider:
- how much cash should be held to meet unexpected costs,
- the expected costs of the sources of finance - debt finance may be cheaper,
especially if the interest is tax-deductible,
- ensuring that balance is maintained between equity capital and borrowings,
- risks related to the priority rights of lenders,
- risks related to foreign operations,
- the fact that that funding requires higher cash inflows and not profit,
- matching the financing profile to the assets being funded, for example, financing
long-term assets through long-term finance.

Dividend decisions
• Should the company pay out a dividend to shareholders or reinvest in
projects?
• Shareholder returns consist of dividends and increases in the share price.
• The greater the risk involved in an investment, the greater will be the return expected
by the shareholders.
• However, a business might prefer to retain cash to finance business needs.
• Thus, decisions about dividends are based on a balance between:
- the expectations of the shareholders, and
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- the needs of the business.

Decisions about investment, financing and dividends will affect investor and lender ratios.

2. Influences on financial strategy

External influences on financial strategy

• Economic influences such as fluctuations in exchange rates, interest rates and
inflation.
• Sources of finance not being easily accessible.
• The level of gearing – borrowings can provide tax relief but also increase financial
risk.
• The need to provide a satisfactory return to investors.
• Debt covenants will be a major factor in deciding on the sources of finance to be
availed.
• Laws and policies, such as employment and taxation policies set by the government.
• Controls imposed by the regulatory authorities. The regulatory authorities are
generally focused on:
- promoting competition,
- regulating industry monopolies,
- promoting social and macroeconomic objectives.

Tax implications
• Tax implications will have to be taken into account when setting a financial strategy.
• A multinational company will have to consider both domestic and international tax
implications.

Domestic tax implications

• Profits from new projects will be taxable.
• Tax-deductible depreciation will be available on purchased assets.
• Debt interest is tax-deductible. Dividends to shareholders are not tax-deductible.
• Increases in share price will be taxed under the Capital Gains Tax rules.
• Tax relief may be available to the investors on certain investments if the company
meets certain conditions.

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International tax implications

• The main objective of an entity is to keep the additional tax to a minimum.
• Entities look to establish their head offices in low-tax regions.
• Transfer pricing is an important issue, as tax authorities only allow transfer prices
that are fair and at arm’s length.

Assessing creditworthiness
• The entity will have to present a business plan to the lender.
• The business plan will include:
- Cash flow forecasts
- An explanation of the amount of money to be borrowed and loan duration
- An explanation of how the money would be used and how it will be repaid
• The lender will assess the borrower’s creditworthiness by considering certain
factors:
- Analysis of the business plan
- Assessment of the risk profile of the company, the quality of its management and
the prospects for success in the industry sector
- Assessment of the assets of the borrower that can be secured against the loan
- The credit rating of the borrower
- The level of gearing, as highly geared companies are considered riskier
- The level and priority of covenants on current borrowings

Use of ratio analysis

• Lenders will assess the borrower’s ability to pay the interest and repay the capital
on time.
• The ratios that they are most likely to consider are:
- the interest cover, with many preferring to use EBITDA instead of profit
- stock market ratios such as the P/E ratio
- the gearing ratio
Credit rating agencies
• Lenders will usually consider the credit ratings issued by the credit rating agencies
for the borrower before deciding to lend.
• A company with a low credit rating will have difficulty repaying the debt and so will
be considered a high-risk company.

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• A lender will set high interest rates on a loan to low-rated entities if they are willing
to lend at all.
• A credit rating agency will assess a company based on its plans and forecast, the
quality of the management team, its financial position, financial ratios and attitude to
risk, and the strengths and trends of the industry as a whole.

3. Chapter summary

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