strategic financial management-30.07.10

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Strategic Financial

Management

30th July 2010


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Financial Strategy

Functional Strategies are drawn to Support thebusiness plan

The strategy is to maximize the return to the

shareholders

Operating &

Investment Decisions

Financing & Funding

Decisions

Cash Flow Cost of CapitalValue to

Shareholders


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Shareholder Value Analysis

Key decisions impacting Shareholder Value

Investment Strategy Invest only when the asset is expected to earn more than

the minimum acceptable return ( hurdle rate ) Capital Investments , Acquisitions & Working Capital

Financing Strategy Capital Structure to optimize the cost of capital

Borrowing Strategy & credit rating

Pay-out Strategy Combination of incremental dividend and plough back for

capital appreciation


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Investment Strategy

Cost of Capital What it should be ?

The composite cost of capital of both (equity & debt )

needs to be lower / = the Hurdle rate

Investors expect returns over the time horizon of theirholdings

Hurdle Rate is the minimum rate of return which

investor would make elsewhere on similar

investments

Both equity and debt have an element of risk , which

is added to the cost of the respective source of capital


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The basics of Risk

Specific Risks : Variability in the return due tofactors unique to a Project/ Company , having

impact on sales and earnings

Operational Risks associated with the powerprojects

Regulatory regime capping the returns

Systematic Risk : Variability in the return due tofactors that influence return on all traded security

Macro economic conditions

Swings in Interest Rates & Exchange Rates


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The basics of Risk

Systematic Risk is measured by Beta

Beta establishes relationship between the excess

returns of an individual asset to that of the market

portfolio , where the beta of the market portfolio is 1Beta is the covariance of the asset with the market

divided by the variance of market portfolio

Covariance measures the tendency of any pair ofrandom variables to move together

Assets having betas in excess of 1 are riskier than

the market portfolio and vice versa


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Determinants of Beta

The Beta of a firm is determined by 3 variables

The type of business ( degree of sensitivity to

overall economic scenario )

Degree of Operating Leverage of the firm (

Relationship between fixed costs and total

costs HOL -> High Beta )

Degree of Financial Leverage of the firm (Equity Beta of an un-levered firm is lower than

the levered firm )


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Determinants of Beta

Degree of Operating Leverage is a function of

the cost structure of the firm .

It is defined in terms of relationship between

fixed costs and total costs

A firm having HOL ( high fixed cost relative to

total cost

The beta of such firms will be High

Higher degree of financial leverage increases the

equity beta , other things remaining equal


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Cost of Capital

We source capital needs from both equity and debtCost of equity ( Ke) = Risk free return + Riskpremium* beta => R f + beta ( Rm- Rf)

Where R f = Risk free rate

R m = Expected Return on market portfolioCost of Debt => Post tax cost of debt = Interest

Rate * ( 1- tax rate )Wtd Avg Cost of Capital =( Proportion of debt* Posttax Interest Rate ) + (Proportion of Sh. Capital* Ke)

WACC ( .70 gearing) = [0.70*10%* (1-.3399)] +(0.30*20 % ) = 10.62 %


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Capital Allocation Rules

Cost of Capital represents the hurdle rate

of the firm to which project specific risk

premium is added to arrive at project

specific hurdle rate Expected Return on Capital > Cost of

Capital ( Project is viable )]

Pay back Period is a measure of howquickly the cash flows generated can

cover the initial investment


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Capital Allocation Rules

Profitability Index : It is the ratio of the

present value of project benefits to

present value of initial costs or outlay

PI = NPV / PV of Outlays

If PI > 1 , accept the project

Accounting Rate of Return is also known as

return on capital Employed

ARR = PBIT / Capital Employed


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Which method to follow

DCF is superior for longer time horizon ,

since it captures the Time value of Money

In case of variable discount rates select

NPV

In case of Unconventional Cash flows ,

use NPV

Beware of very high IRR , since thereinvestment assumptions could lead to

serious errors


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Financial Leverage - Capital Structure

Modigliani and Miller ( M & M )

propagated the theory of capital

structure

Market Value of the firm is constant ,

regardless of the leverage Proposition I

The expected return on Equity is an

increasing function of firms leverage

Proposition II


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Capital Structure

Capital Gearing ( CG) is the ratio of all long

term liabilities to the shareholders funds as

shown in the Balance Sheet

It is often referred as DE Ratio

=

Long Term Loans / Shareholders funds


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Cost of Capital

Particulars Zero gear Geared

PBIT ( in Mlns) 1000 1000

Less : Interest 0 300

PBT 1000 700Less : Tax @ 30 % 300 210

PAT 700 490

Total to Investors 700 790

So , the tax advantage on debt returns more to the investors


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Bad ( p =0.10) Normal ( p =0.70) Excellent ( p= 0.20)

Net Operating Income ( Before Interest ) 5 20 35

Zero Gearing ( Rs. 100 mln , Rs.0 mln )

Interest 0 0 0

Shareholders' earnings 5 20 35

Return on Equity 5% 20% 35%

25 % Gearing ( Rs. 75 mln , Rs. 25 mln)

Interest on 10 % 2.5 2.5 2.5

Shareholders' earnings 2.5 17.5 32.5


50 % Gearing ( Rs.50 mln , Rs. 50 mln )

Interest on 10 % 5 5 5

Shareholders' earnings 0 15 30


Capital Structure V Return on Equity


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Tata Steel Group - Stand Alone

Ratios [Value in Rupees Crores]YearEnds (Months) 200803(12) 200703(12)

OPM (%) 41.94 39.61

NPM (%) 23.43 23.53

Reported EPS 63.85 72.74

Return on net worth 21.52 30.71

Debt/Equity 1.08 0.69

Financial charges coverage ratio 9.25 29.45

Current ratio 3.92 1.77

Dividend pershare 16 15.5


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Dividend Policy

How do the firms decide dividend pay out ? Expected return on investment = Dividend yield+ price

appreciation

Dividend Yield = Annual Dividend per Share / Price pershare

Dividend payout ratio =Dividend Paid/ PAT

Company may pay out less Retain cash for reinvestment

To build up a cash cushion to take care of bad periods

Retain cash to smooth out dividend over time To enhance the value of the firm

Retain if good projects are in hand

Pay out if reinvestment opportunities are less attractive


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Financing Power Projects

Financing ofProject

Equity30%

Debt70%

ECB40%

DB30%


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Borrowing Strategy

Selection of Source will depend upon

Cost of funds

Maturities

Moratorium period matching Project Schedule. Flexibility in availment

Credit rating & Cost benefit

Secured Vs Unsecured

Pool of Currency & Hedging Strategy

Mix of Floating & Fixed rate loans


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31-Mar-04 31-Mar-05 31-Mar-06 31-Mar-07 31-Mar-08 31-Mar-09

(Rs. in Crores)

Shareholders' Funds

Share Capital 7,812.50 8,245.50 8,245.50 8,245.50 8,245.50 8,245.50

Reserves and Surplus 27,737.60 33,530.80 36,713.20 40,351.30 44,393.10 49,124.60

35,550.10 41,776.30 44,958.70 48,596.80 52,638.60 57,370.10

Loan Funds

Secured Loans 4,584.40 4,440.70 5,732.70 6,822.90 7,314.70 8,969.60

Unsecured Loans 10,868.40 12,647.10 14,464.60 17,661.50 19,875.90 25,598.20

15,452.80 17,087.80 20,197.30 24,484.40 27,190.60 34,567.80

Other Sources of Funds 537.60 337.50 440.90 656.80 1,628.90 2,598.30

Total Sources of Funds 51,540.50 59,201.60 65,596.90 73,738.00 81,458.10 94,536.20

SOURCES OF FUNDS of NTPC LIMITED AS ON

51,540.50

59,201.6065,596.90

73,738.00

81,458.10

94,536.20

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

2004 2005 2006 2007 2008 2009

Total Sources of Funds


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Working Capital Strategies

Active working capital management is anextremely effective way to increaseenterprise value.

Optimising working capital results in

a rapid release of liquid resources

improvement in free cash flow

permanent reduction in inventory and capital

costs, Increased liquidity for strategic investment

and debt reduction.


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Net Working Capital =

Current Assets - Current Liabilities.

Gross Working Capital

The firms investment in current assets.

Where Current assets are the assets that

can be converted into cash within an

accounting year & include cash , debtorsetc.

Working Capital Concepts


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Impact on Expected Profitability

Return on InvestmentReturn on Investment =

Net ProfitNet Profit

Total AssetsTotal Assets

CurrentCurrent AssetsAssets = (Cash +

Receivables + inventories.)

Return on InvestmentReturn on Investment=

Net ProfitNet Profit

CurrentCurrent + Fixed AssetsFixed Assets

Optimal Amount (Level) of Current Assets

0 25,000 50,000Sales (units)

AssetLevel(Rs)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B


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Profitability Analysis

PolicyPolicy ProfitabilityProfitability

AA LowLow

BB AverageAverage

CC HighHigh

As current asset levels

decline, total assets will

decline and the ROI will

rise.

Optimal Amount (Level) of Current Assets

0 25,000 50,000Output (units)

As

setLevel(Rs)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on Expected Profitability


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Important Financial

Ratios


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Analysis of the Financial Ratios

Ratio analysis can be broken down into variouscategories:

Profitability Ratios indicate show the return on

capital employed.

Operating Margin = Operating Income/ Net Sales Net Margin = Net Profit / Net Sales

Return on Equity (ROE) = Net Income / Equity

Asset Management Ratios show how efficient a

company is in its operations and use of assets. Inventory Turnover = Cost of goods sold / Inventory

Fixed Asset Turnover = Sales / Fixed assets.


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Liquidity Ratios give a picture of a company's shortterm financial situation or solvency

Current Ratio Current Asset / Current Liability

Working Capital =Current Assets-Current Liabilities

Debt Management Ratios show the extent of use of

debt in a company

Debt-Equity Ratio = Total Debt / Total Equity

Times Interest Earned = EBIT / Interest

Debt Service Coverage Ratio = EBIT / (Interest +

Repayments )


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Predictor Ratios indicate the

potential forgrowth orfailure. Price / Book , PE Ratio ,

EPS


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DuPont System of Analysis

ROE = Profitability x Efficiency x Leverage

= Return on Sales x Asset turnoverx Assets-to-

Equity Ratio

= Net Profit x Sales x AssetsSales Assets Equity


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Strategies to improve ROE

Reduce the amount and cycle of working capital

Power

generation

Realization

&

Payments

Coal/ Oil

Spares

Receivables

Metering &

Billing

Reduce the Cost of Generation Efficient use of fuel , power and other resources

Reduction in Project Cost

Reduction in Financing Cost

Reduction in Project implementation time


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Drivers Of Value Creation

Key drivers of value creation are :Return on Invested Capital ( ROCE)

ROCE = PBIT( 1- Tax rate ) / Invested CapitalWhere,

Invested Capital = Net fixed Assets + Net Current

Assets

The Growth Rate = GeWhich depends on the reinvestment rate


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EVA A Measure of Shareholder Value

EVA = NOPAT WACC*Invested Capital

Where , NOPAT = PAT + Interest *( 1-tax rate )

Cost of Eq =16 % ;Cost of Debt = 7 %

DE = 70 : 30WACC = 70*7 % + 30 * 16 % =9.7 %

Equity =60 mln, Debt = 140 mln, PBIT = 70mln

EVA = 70*( 1-.3) 9.7 %*200

= 49 -19.40=29.60 mln


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strategic financial management-30.07.10

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