TYBMS SEM 6 Financial: Strategic Financial Management (Most Imp Write Short Notes with Solution)

  Paper/Subject Code: 86011/Finance: Strategies Financial Management

TYBMS SEM 6

Financial: 

Strategic Financial Management

(Most Imp Write Short Notes with Solution)

Q.5 C) Write Short Notes on: (Any three)        (15)

1. Market Value Added

Market Value Added (MVA) is a financial metric that measures the difference between the market value of a company and the capital invested in it. In other words, MVA shows how much wealth a company has created or destroyed for its shareholders. If the MVA is positive, it indicates that the company has generated value over and above the cost of capital invested by its shareholders. Conversely, a negative MVA suggests that the company's performance has not met the expectations of its investors.

MVA is calculated as:

$$\text{MVA }= \text{Market Value of the Firm }- \text{Total Capital Invested}$$

Where:

• Market Value of the Firm includes the current market price of the company's equity and debt.
• Total Capital Invested refers to the sum of funds raised by the company through debt and equity financing.

MVA is a critical tool for assessing the effectiveness of a company's management in generating shareholder value over time. It reflects how well a firm has performed relative to the expectations of its investors, providing an insight into its long-term financial health and strategic success.

2. NPA and their Provisioning

Non-Performing Assets (NPA) refer to loans or advances given by financial institutions, such as banks, that have not been repaid by the borrower as per the agreed terms. In other words, an NPA is a loan where the principal or interest has been overdue for a specified period, typically 90 days or more. NPAs are a significant concern for banks as they represent assets that are not generating income and can impact financial stability and liquidity.

Provisioning for NPAs is the process by which banks set aside a certain percentage of their income to cover potential losses due to NPAs. This is done to maintain the financial health of the bank and ensure that it has enough reserves to absorb potential losses without affecting its operations. The amount of provisioning depends on the classification of the NPA:

1. Standard Assets: These are loans that are performing well and not overdue. Provisioning for these is minimal, usually around 0.25% to 1%.
2. Substandard Assets: Loans overdue for 90 days to 1 year. Banks must provision a higher percentage, typically between 10% and 15% of the outstanding amount.
3. Doubtful Assets: Loans overdue for more than 1 year and have higher risk factors. Provisioning for these is more significant, ranging from 20% to 100%, depending on the age of the overdue period.
4. Loss Assets: These are considered irrecoverable, and banks must make 100% provision for these assets.

Provisioning helps banks stay solvent during periods of economic stress by building a financial buffer. It is also a regulatory requirement in many countries, ensuring that banks can withstand unexpected credit losses and maintain investor and public confidence.

3. Types of Mergers

Types of Mergers refer to the different ways in which companies combine to form a single entity, driven by strategic objectives such as growth, diversification, or increased market share. The main types of mergers include:

1. Horizontal Merger: This occurs between companies operating in the same industry and at the same stage of production. The aim is usually to increase market share, reduce competition, and achieve economies of scale. For example, when two car manufacturers merge, they can strengthen their position in the automotive industry.

2. Vertical Merger: Involves the merging of companies at different stages of the production process within the same industry. This type of merger helps streamline operations and create efficiencies by integrating supply chains. For instance, a car manufacturer merging with a parts supplier is a vertical merger that can lead to cost savings and better control over production.

3. Conglomerate Merger: This type of merger happens between companies that operate in completely different industries. The goal is often diversification, allowing the merged entity to reduce risk by spreading its operations across different markets. An example is a technology company merging with a food and beverage company, expanding its portfolio and reducing dependency on a single market.

4. Concentric Merger: This involves companies that are in related industries but do not offer the same products or services. The companies merge to create a synergy that enhances their ability to compete in the market. For example, a company making computer hardware merging with one specializing in software solutions to offer comprehensive technology packages.

5. Market Extension Merger: This type involves companies that sell the same products or services but operate in different geographical areas. Merging allows them to expand their market reach and increase customer base. For instance, a regional clothing retailer merging with a similar company operating in another region can expand its presence and brand recognition.

6. Product Extension Merger: This happens when companies that sell related but not identical products merge to increase their product lines and market penetration. For example, a company that makes kitchen appliances merging with one that produces small cooking tools expands their product range, attracting a broader consumer base.

These mergers are driven by strategic reasons such as growth, diversification, risk management, and synergy creation. Each type of merger carries specific benefits and challenges, impacting market structure, competition, and regulatory considerations.

4. Commercial Paper

Commercial Paper (CP) is a short-term, unsecured debt instrument issued by corporations to raise funds for short-term financial needs, such as working capital, inventory financing, or bridging cash flow gaps. Typically, commercial papers have maturities ranging from a few days up to 270 days, with most falling between 30 and 90 days. They are usually issued at a discount to their face value, and the investor receives the full face value at maturity, with the difference representing the interest earned.

Commercial papers are typically issued by large, financially stable corporations with high credit ratings, as they do not require collateral. This makes them an attractive option for companies seeking to borrow money at a lower interest rate compared to traditional bank loans. Investors, on the other hand, are often attracted to CPs for their relatively higher yields compared to other short-term investments like Treasury bills, though they come with higher risk due to the lack of government backing.

CPs are usually sold through a direct placement to institutional investors such as banks, mutual funds, and money market funds. To mitigate the risk of default, many issuers maintain a backup credit line with a bank. Regulatory oversight of commercial paper varies by country, but in general, issuing firms are required to have high creditworthiness, and the instruments must comply with specific rules for disclosure and rating.

5. Factors determining working capital requirements

Factors Determining Working Capital Requirements are critical in determining the amount of capital a business needs to finance its day-to-day operations. Adequate working capital ensures a company can maintain its liquidity, meet short-term obligations, and support its operational activities. Key factors that influence working capital requirements include:

1. Nature of the Business: Companies in industries that have longer production cycles or sales cycles, such as manufacturing, typically require more working capital compared to service-based or retail businesses, which have shorter cycles.

2. Business Size: Larger companies often need more working capital due to higher volumes of transactions and greater operational complexity, while smaller businesses may require less.

3. Production Cycle: The length of time it takes for raw materials to be converted into finished goods impacts working capital. Industries with longer production periods need more working capital to fund inventory during the production phase.

4. Sales Volume and Growth: A company with high sales volume or rapid growth will need more working capital to manage the increased demand for inventory and receivables.

5. Credit Policy: Companies that extend generous credit terms to customers will need more working capital to manage the lag between the time a sale is made and when payment is received. Conversely, a strict credit policy can reduce the working capital requirement.

6. Inventory Management: The amount of inventory held impacts working capital. Companies that maintain high inventory levels need more working capital, whereas efficient inventory management that minimizes stock can reduce these needs.

7. Supplier Terms: Favorable terms with suppliers, such as extended payment periods, can reduce working capital needs, as companies can delay cash outflows.

8. Seasonal Fluctuations: Businesses that experience seasonal demand spikes need higher working capital during peak seasons to maintain operations and build inventory.

9. Economic Conditions: Broader economic conditions, such as inflation or a recession, can affect the cost of goods and the availability of credit, impacting working capital requirements.

10. Cash Conversion Cycle: This is the period it takes for a company to convert its investments in inventory and receivables into cash flows from sales. A shorter cash conversion cycle can reduce working capital needs, whereas a longer cycle requires more working capital to bridge the gap.

6. Corporate Governance

Ans: 

Corporate governance refers to the system of rules, practices, and processes by which a company is directed and controlled. It's essentially the framework that establishes who has power, how decisions are made, and how stakeholders' interests are balanced. 

• Accountability: The board of directors and management are accountable to shareholders and other stakeholders for the company's performance and actions.
• Transparency: Companies should be transparent in their financial reporting, business practices, and decision-making processes.
• Fairness: All stakeholders, including shareholders, employees, customers, and the community, should be treated fairly.
• Responsibility: Companies have a responsibility to act ethically, sustainably, and in the best interests of all stakeholders.
• Risk Management: A strong governance framework includes effective risk management practices to identify, assess, and mitigate potential risks to the company.

Benefits of Good Corporate Governance:

• Increased Investor Confidence: Strong governance practices can attract investors by demonstrating a company's commitment to transparency and accountability.
• Improved Decision-Making: Clear processes and structures can lead to better decision-making by management.
• Reduced Risk: Effective risk management helps companies avoid scandals, financial losses, and reputational damage.
• Enhanced Long-Term Value: Good governance practices contribute to a company's long-term sustainability and value creation.

Challenges in Corporate Governance:

• Balancing Interests: Balancing the needs of different stakeholders can be challenging.
• Regulation vs. Flexibility: Striking a balance between necessary regulations and allowing companies flexibility to operate efficiently.
• Enforcement: Ensuring that governance rules and practices are effectively enforced.

7. Decision Tree Analysis

Ans: 

Decision tree analysis is a valuable tool used in various fields, including finance, business, and project management. It helps visualize and analyze complex decision-making processes with multiple possible outcomes. 

• A flowchart-like diagram representing different decision points, potential outcomes, and associated probabilities.
• Branches represent choices or events that can occur.
• Leaves represent the final results or consequences of each decision path.

Benefits:

• Clarity and Organization: Simplifies complex decisions by structuring them visually.
• Identification of Trade-offs: Helps identify potential risks and rewards associated with different choices.
• Improved Risk Management: Allows for assessing the likelihood of different outcomes and making risk-adjusted decisions.
• Quantitative Analysis: Probabilities and values can be assigned to outcomes, enabling a more objective evaluation of options.

Steps involved:

1. Define the problem or decision.
2. Identify potential solutions or courses of action.
3. Determine the possible outcomes for each decision.
4. Assign probabilities to each outcome (if possible).
5. Estimate the value or cost associated with each outcome.
6. Analyze the tree and choose the option with the most desirable outcome.

Applications:

• Capital budgeting: Evaluating investment projects and choosing the most profitable option.
• Product development: Deciding on features and marketing strategies for a new product.
• Risk management: Identifying potential risks and developing mitigation plans.
• Marketing campaigns: Choosing the most effective channels and strategies for a marketing campaign.

8. Advantages of XBRL (extensible Business Reporting Language)

Ans: 

XBRL is a digital format for business reporting that offers significant advantages over traditional methods like PDFs or spreadsheets. Here are some key benefits of using XBRL:

• Transparency and Accuracy: Financial data is tagged with specific definitions, ensuring clarity and reducing errors due to manual data entry.
• Improved Comparability: Data from different companies becomes easily comparable because it uses standardized tags and definitions. Investors and analysts can readily assess financial performance across companies.
• Automation and Efficiency: XBRL enables automated data analysis and processing, saving time and resources for both preparers and users of financial information.
• Reduced Costs: Streamlining reporting processes with XBRL can lead to cost savings for companies in terms of preparation, filing, and analysis.
• Enhanced Decision-Making: Easier access to accurate and comparable data empowers better financial decisions for investors, regulators, and company management.
• Flexibility: XBRL can accommodate various reporting requirements, making it adaptable to different industries and regulations.

9. Commercial Paper

Ans: Commercial paper is a short-term, unsecured debt instrument issued by large corporations and financial institutions. Here's a breakdown of its key characteristics:

• A promissory note sold by companies to raise funds.
• Similar to an IOU, but issued in a formal financial setting.

features:

• Short-term: Maturities typically range from a few weeks to 270 days (less than a year).
• Unsecured: Not backed by any collateral, so the issuing company's creditworthiness is crucial.
• Discount issuance: Usually sold at a discount to its face value, reflecting prevailing market interest rates. Investors earn a return by the difference between the purchase price and the face value redeemed at maturity.
• Large denominations: Minimum denominations are typically high (e.g., $100,000) and only accessible to institutional investors or wealthy individuals.
• Funding needs: Used to finance short-term liabilities like payroll, accounts payable, or inventory purchases.

Benefits for issuers (companies):

• Relatively cheap source of funding: Compared to other options like bank loans, commercial paper can be a lower-cost way to raise short-term capital.
• Flexibility: Maturities can be tailored to specific funding needs.

Benefits for investors:

• High liquidity: Can be easily bought and sold in the secondary market before maturity.
• Relatively safe: Issued by reputable corporations with high credit ratings, reducing default risk.
• Attractive returns: Can offer competitive returns compared to other short-term investments like money market accounts.

10. Importance of Corporate Governance

Ans: 

Corporate governance establishes the framework for how a company is directed and controlled. It's essentially the system of rules, practices, and processes that ensure responsible and ethical business conduct. Here's why it's crucial for any organization:

Building Trust and Confidence:

• Strong governance fosters transparency and accountability, leading to greater trust from investors, customers, and other stakeholders.
• Transparent financial reporting and ethical business practices create a positive reputation, attracting investments and partnerships.

Enhanced Decision-Making:

• Clear roles and responsibilities within the board of directors and management lead to better informed and well-considered decisions.
• Effective risk management practices help identify and mitigate potential problems before they escalate.

Long-Term Value Creation:

• Responsible and ethical business practices minimize the risk of scandals, financial losses, and reputational damage.
• A focus on sustainability and social responsibility attracts environmentally and socially conscious investors and customers.

Improved Performance and Efficiency:

• Clear governance structures and streamlined processes help companies operate more efficiently and effectively.
• Strong corporate governance can lead to better access to capital and lower borrowing costs.

Challenges and Considerations:

• Balancing the interests of different stakeholders (shareholders, employees, customers, community) can be complex.
• Striking a balance between necessary regulations and allowing companies flexibility to operate efficiently is important.
• Enforcement of governance rules and practices is essential for effectiveness.

11. Challenges in Banking Industry

Ans: 

Challenges Facing the Banking Industry: A Landscape in Transformation

The banking industry is undergoing significant transformations, driven by technological advancements, changing customer expectations, and a dynamic regulatory environment. Here's a glimpse into some of the key challenges banks are facing:

• Fintech Disruption: Fintech startups are offering innovative financial products and services, challenging traditional banking models. Customers are increasingly opting for convenient and user-friendly digital solutions.
• Cybersecurity Threats: As banks become more reliant on technology, they become more vulnerable to cyberattacks. Protecting sensitive customer data and financial systems is a constant concern.
• Regulatory Compliance: The regulatory landscape remains complex and evolving, requiring banks to invest heavily in compliance measures to avoid hefty fines and reputational damage.
• Low-Interest Rate Environment: Sustained low-interest rates can squeeze profit margins for banks, making it difficult to generate income from traditional lending activities.
• Changing Customer Expectations: Customers today expect a seamless, personalized, and omnichannel banking experience (accessible through various channels like mobile apps, online banking, and physical branches).
• Economic Uncertainty: Global economic uncertainty can lead to an increase in bad loans and loan defaults, impacting bank profitability.
• Competition from Non-Banks: Non-bank institutions are entering the financial services space, offering alternative financial products and services, putting pressure on traditional banks.
• Talent Management: Attracting and retaining skilled professionals with expertise in technology, data analytics, and cybersecurity is crucial for banks to compete effectively in the digital age.

Overcoming the Challenges:

Banks can navigate these challenges by:

• Embracing Technology: Investing in digital transformation, offering innovative products and services, and leveraging data analytics to personalize customer experiences.
• Enhancing Cybersecurity Measures: Implementing robust cybersecurity frameworks and investing in advanced security solutions.
• Optimizing Operations: Streamlining processes and adopting automation to improve efficiency and reduce costs.
• Building a Strong Digital Presence: Offering a user-friendly and secure online and mobile banking experience.
• Strengthening Customer Relationships: Focusing on customer needs and providing personalized financial solutions.
• Staying Agile and Adaptable: Continuously monitoring industry trends and adapting business models to remain competitive.

12. Merger

Ans: 

Mergers: Combining Forces

A merger occurs when two companies join together to form a single new legal entity. It's a strategic decision undertaken to achieve various goals, such as:

• Increased Market Share: Merging with a competitor can create a larger market presence and greater bargaining power.
• Economies of Scale: Combining resources and operations can lead to cost savings and improved efficiency.
• Expansion into New Markets: Merging with a company in a different market allows for broader reach and access to new customer segments.
• Product or Service Diversification: Combining product lines or service offerings can create a more diverse and competitive portfolio.
• Enhanced Innovation and Capabilities: Merging can bring together complementary skills and resources, fostering innovation and technological advancements.

Types of Mergers:

Mergers can be classified based on the relationship between the merging companies:

• Horizontal Merger: Involves companies competing in the same industry and product/service market.
• Vertical Merger: Combines companies at different stages of the production process (upstream or downstream).
• Conglomerate Merger: Involves companies in unrelated industries or markets.

Process of a Merger:

A merger typically involves a series of steps:

1. Initiation: Negotiations between the companies and agreement on terms.
2. Due Diligence: Investigating each other's financial health and legal standing.
3. Regulatory Approvals: Obtaining necessary approvals from government agencies if required.
4. Valuation and Share Exchange: Determining the value of each company and how ownership will be divided in the merged entity.
5. Integration: Combining operations, management teams, and cultures.

13.  Sources of Working Capital

Ans: 

Working capital, as we know, keeps the wheels of a business turning. To maintain adequate working capital, companies can leverage various internal and external sources. Here's a breakdown of the primary categories:

1. Internal Sources:

These are generated through a company's own operations and require no external financing.

• Retained Earnings: Profits that are not distributed as dividends but rather reinvested back into the business. This is a significant source of working capital for established companies.
• Depreciation: The non-cash expense reflecting the wear and tear of assets. Though not actual cash flow, depreciation charges increase retained earnings, which can be used for working capital needs.
• Reduction of Unnecessary Expenses: Streamlining operations and cutting unnecessary costs can free up cash for working capital purposes.
• Prompt Collection of Debts: Efficiently collecting payments from customers improves cash flow and reduces the need for external financing.

2. External Sources:

These involve obtaining funds from external parties.

• Short-Term Loans: Banks and financial institutions offer various short-term loans specifically designed to meet working capital needs. Examples include lines of credit and commercial paper.
• Trade Credit: Suppliers may extend credit to companies by allowing them to delay payment for purchased goods or services. This provides a short-term source of working capital but requires careful management to avoid late payment penalties.
• Factoring: Companies can sell accounts receivable to a third-party factor at a discount to receive immediate cash. This can be a beneficial option when dealing with slow-paying customers.

3. Spontaneous Sources:

These arise naturally from a company's business operations.

• Accounts Payable: When a company purchases goods or services on credit, it creates accounts payable. This essentially represents a short-term, interest-free loan from the supplier, albeit with a limited payment window.
• Accrued Expenses: Expenses incurred but not yet paid, such as salaries or utilities, also contribute to working capital. Similar to accounts payable, they provide a temporary source of financing.

Choosing the Right Source:

The optimal source of working capital depends on various factors like:

• Cost: Some options like short-term loans may have higher costs compared to internal sources like retained earnings.
• Flexibility: Lines of credit offer more flexibility than commercial paper, which has fixed borrowing terms.
• Company Size and Stage: Smaller companies may rely more on trade credit, while established companies may have access to diverse financing options.

Effective working capital management involves utilizing a combination of these sources to maintain a healthy balance between liquidity and profitability.

14. Maximum Permissible Bank Finance

Ans: 

Maximum Permissible Bank Finance (MPBF) is a concept used in banking to determine the maximum amount of credit that a bank can extend to a borrower based on certain predetermined criteria. It is also known as the maximum credit limit or maximum loan limit.

The calculation of MPBF involves a thorough assessment of the borrower's financial position, creditworthiness, and the value of the assets offered as collateral. Banks consider factors such as the borrower's cash flow, profitability, liquidity, leverage, and repayment capacity while determining the MPBF.

Various guidelines and regulations issued by regulatory authorities, such as the Reserve Bank of India (RBI) in India, govern the calculation of MPBF. These guidelines aim to ensure prudence, transparency, and risk mitigation in lending practices.

MPBF serves as a crucial tool for banks to manage credit risk effectively. By setting a maximum limit on the amount of credit extended to a borrower, banks can mitigate the risk of default and maintain a healthy loan portfolio. It also helps in maintaining regulatory compliance and ensures that banks operate within the prescribed limits to safeguard the interests of depositors and maintain financial stability.

15. Capital Rationing

Ans: 

Capital rationing is a financial concept employed by companies to manage their investment projects when there's a limited availability of funds. In essence, it involves restricting the amount of capital allocated to various investment opportunities within a company. This constraint may arise due to internal factors such as budgetary limitations, risk aversion, or strategic priorities, or external factors like market conditions or regulatory constraints.

The primary objective of capital rationing is to optimize the allocation of limited financial resources among competing investment opportunities to maximize shareholder wealth. By carefully selecting and prioritizing projects based on their expected returns, risk profiles, and alignment with strategic goals, companies can ensure that the available funds are allocated to the most promising ventures.

There are two main types of capital rationing: hard capital rationing and soft capital rationing. Hard capital rationing refers to situations where external factors impose strict limits on the availability of capital, such as borrowing constraints or regulatory requirements. Soft capital rationing, on the other hand, involves internal policies or preferences that limit capital allocation, even when external funds are readily available.

To effectively implement capital rationing, companies typically employ various financial evaluation techniques, such as net present value (NPV), internal rate of return (IRR), and profitability index (PI), to assess the potential returns and risks associated with each investment opportunity. Projects that offer the highest returns relative to their risk are given priority within the constrained budget.