Financial Management Policy Decisions

1 Introduction

Chapters 1 and 2 were about the objectives a financial manager is set. This chapter is about the decisions taken to meet them, and about the world outside the business that constrains those decisions.

There are three policy decisions, and the syllabus is emphatic that they cannot be taken one at a time: investment, financing and dividends, plus the interrelationships between them. Section 1 takes each in turn and then puts them together. Sections 2 to 4 work the three things the syllabus wants the decisions tested against — the entity's cash needs, the sensitivity of the forecast financial statements and future cash position, and the interests of stakeholders. Section 5 is the measurement: the ratios and covenants by which a proposed decision is judged before it is taken.

Section 6 is a different subject and a whole lead outcome of its own: the external influences on financial strategy — what lenders require, what tax regimes do to the numbers, and what an industry regulator can do to a company's freedom of action. None of these is within the financial manager's control, and all of them change which decisions are open.

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2 The three policy decisions and how they interlock

A financial manager is responsible for choosing what the business invests in, for raising the money to pay for it, and for deciding how much of the resulting cash goes back to the shareholders. Each decision changes the other two.

The dashed border on the diagram is the fourth thing the financial manager is responsible for. Every one of the three decisions is taken on cash flows that are forecast rather than known, and those cash flows vary with interest rates, exchange rates and prices. Reducing that variability is hedging, and it is a large enough subject to have its own section of the syllabus: Chapters 8 to 10 take the sources and types of financial risk, how they are quantified, and the instruments and internal techniques used to manage them. This chapter assumes only that the risk is there and that it constrains all three decisions.

2.1 The investment decision

The investment decision asks which projects the business should undertake — new non-current assets, a new product, an expansion, an acquisition. The financial test is net present value: a project with a positive net present value is expected to be worth more than it costs, and therefore to increase shareholder wealth.

Two consequences reach the financial statements immediately, and both are examinable:

• revenue is expected to rise, but not at once — most projects cost money before they earn it, so the early years usually show the cost and not the benefit;

• the assets acquired are depreciated, and the depreciation charge reduces reported profit for the whole of the asset's life, which can make a value-creating project look like a profit-destroying one in the first year or two.

A non-financial test sits alongside the financial one. A project with a positive net present value may consume non-renewable resources, damage relationships with a local community, or make an emissions objective unreachable — so it may increase shareholder wealth and still fail the objectives set in Chapters 1 and 2. Expanding an airport is the standard illustration: it maximises the owners' wealth and imposes noise, pollution and displacement on the people who live under the flight path.

2.2 The financing decision

The financing decision asks how the investment is to be paid for. There are three sources, and each hits a different part of the statement of financial position:

The choice is not free. Debt is cheaper than equity, because interest is contractually due and is normally deductible for tax, whereas a dividend is neither; but debt brings fixed commitments that must be met whatever the cash flows do, and it brings covenants. Chapters 4 to 6 take the capital structure and the individual instruments in full.

2.3 The dividend decision

The dividend decision asks how much of the cash generated is paid out to shareholders and how much is retained. Chapter 7 develops it; what matters here is that it is inseparable from the other two.

A dividend can only be paid if there are both distributable profits and the cash to pay it. Cash paid out as a dividend is cash not available for investment, so a company that restricts its dividend has more to invest and needs less new external finance; and retained earnings are the cheapest source of equity finance, because they carry no issue costs. A company that increases its dividend has made a financing decision as surely as if it had repaid a loan.

2.4 The interrelationships

Follow the loop in the diagram once and the interdependence is obvious. The investment decision determines how much finance is needed; the financing decision determines what has to be paid out of the project's cash flows before the shareholders see any of it; what is left sets the dividend decision; and what is not paid as a dividend is retained and funds the next investment.

The chain runs backwards as well as forwards, and this is where exam scenarios live:

• a poor investment decision produces too little cash — the interest still has to be paid, so the shortfall falls entirely on the shareholders and the dividend is cut;

• a financing decision that takes on too much debt raises the finance cost, which reduces distributable profit and so caps the dividend, and may breach a covenant;

• a dividend decision that is too generous leaves too little retained, so the next positive net present value project has to be financed externally — or is not undertaken at all, which is a lost investment decision caused by a dividend decision.

3 Using the policy decisions to meet the cash needs of the entity

The three decisions are the levers a financial manager has when the business needs cash. Cash is needed for a defined set of reasons — to fund the working capital cycle, to pay interest and repay debt as it falls due, to pay tax and dividends, to fund committed capital expenditure, and to hold a buffer against the variability the diagram calls risk.

When forecast cash is short of what is needed, each policy decision offers a response, and each response costs something:

The order in that table is not accidental. The first two levers are usually the biggest and the quickest; the last two are usually the ones a company reaches for when the first three are closed to it, and a scenario in which a company is selling assets to pay a dividend is telling you something.

4 Sensitivity of the forecast financial statements and the future cash position

A policy decision is judged before it is taken, which means it is judged on forecasts. The method is always the same: build the forecast statement of profit or loss, statement of financial position and cash flow forecast with the decision in them, and compare with the position without.

What each decision does to the forecasts:

The forecasts are then stress-tested. Sensitivity analysis asks how far a single assumption can move before the conclusion changes — how far revenue can fall before interest cover breaches its covenant, how far the interest rate can rise before the project's net present value turns negative, how far the exchange rate can move before the forecast cash position runs out. The answer is expressed as the percentage change in the variable that takes the measure to its limit, and the smaller that percentage, the more critical the assumption.

5 The interests of stakeholders

A policy decision that satisfies the shareholders can be blocked, resisted or punished by somebody else. The syllabus therefore requires the interests of stakeholders to be considered as part of each decision, not as an afterthought.

These interests conflict — a dividend cut that reassures a lender disappoints a shareholder; a cost reduction that protects a covenant may cost the human capital that produced the earnings. Balancing them rather than optimising any one is the satisficing introduced in Chapter 1, and a good answer names the trade-off rather than pretending every group can be satisfied at once.

6 Assessing the impact of a policy decision

Before a decision is taken, its effect is measured on four things. The first two are ratios already met in Chapter 1; the third is contractual; the fourth is what the whole exercise is for.

1. Investor ratios — earnings per share, dividend cover, dividend yield, the price/earnings ratio. These say what the decision does to the shareholders' position and so, in a quoted company, to the share price.

2. Lender ratios — gearing and interest cover. These say what the decision does to the risk the lenders are carrying, and therefore to the cost and availability of the next loan.

3. Compliance with debt covenants — the contractual limits attached to existing borrowings. A ratio can worsen without consequence until it crosses a covenant, at which point the consequence is abrupt.

4. Attainment of the financial objectives — the targets set in Chapter 1. A decision that improves every ratio and still misses the stated earnings growth objective has to be explained.

The two lender ratios:

Interest cover is the number of times the profits would have covered the interest bill. The higher it is, the safer the lender's interest is; a covenant therefore sets a minimum interest cover, and the company must stay above it. Gearing is the other way round — a covenant sets a maximum.

7 External influences on financial strategic decisions

Everything so far has been within the financial manager's control. This section is not. Three external forces determine which decisions are open to a company at all, and each of them can close off an option that the internal analysis says is the right one.

7.1 Market requirements: how lenders assess creditworthiness

A company can only borrow if somebody will lend to it, and at a price the project can bear. Lenders form a view of creditworthiness — the likelihood of being repaid in full and on time — and that view sets three things: whether credit is available at all, at what margin over the benchmark reference rate, and on what conditions.

What a lender looks at is conventionally summarised as the five Cs:

The same analysis is carried out formally by credit rating agencies for companies that issue traded debt. A rating is a published opinion on the likelihood of default, split between investment grade and sub-investment grade (also called high yield, or speculative). The split matters commercially as well as technically: many institutional investors are restricted to investment grade, so a downgrade across the boundary removes a large part of the buyer base at once and widens the margin sharply — sometimes more than the change in default risk alone would justify.

The lender's conclusions are written into the loan agreement as covenants, which is where this section meets section 5: a covenant is the contractual form of the lender's assessment. Chapter 5 takes the covenants themselves.

7.2 Taxation: domestic and international tax regulations

Tax is not a detail of the financial statements; it changes which financing and investment structures are worth using. Four effects matter at this level.

1. Interest is normally deductible and dividends are not. That is the tax shield which makes debt cheaper than equity, and it is the foundation of the capital structure theory in Chapter 4. The value of the shield depends on the tax rate and on the company having taxable profits to shield — a company with tax losses gets no benefit from it, and its optimal capital structure is different in consequence.

2. Tax relief on capital expenditure changes a project's cash flows. Most regimes give tax depreciation on qualifying assets, often faster than accounting depreciation, which brings forward the tax saving and raises the net present value of an investment. The timing of the relief is as important as its amount.

3. Cross-border operations face more than one tax regime. Profits earned abroad may be taxed where they are earned and again where the parent is resident; double tax relief, usually under a treaty between the two jurisdictions, exists to prevent that, most often by giving credit for the overseas tax against the domestic charge. Withholding taxes may be deducted at source from dividends, interest and royalties paid across a border, which reduces the cash a parent actually receives from a subsidiary and so bears directly on where a group holds its debt and how it repatriates cash.

4. Anti-avoidance rules limit what a group may do. Groups have an obvious incentive to book profits in low-tax jurisdictions and interest deductions in high-tax ones, and tax authorities have rules against it: transfer pricing rules requiring intra-group transactions to be priced as if between unconnected parties; interest restriction or thin capitalisation rules capping the interest a company may deduct; and controlled foreign company rules taxing the parent on profits diverted to a low-tax subsidiary. Internationally, an agreed minimum effective rate of tax for large groups has been introduced in many jurisdictions, which narrows the benefit of locating profits in low-tax territories.

The strategic consequence is that the after-tax cost of finance and the after-tax cash flows of a project are what count, and both depend on rules the company does not set and that change. F3 does not examine the tax law of any country; it examines the ability to say what a stated tax rule does to a financing or investment decision. Chapter 5 develops the tax considerations attaching to debt and Chapter 11 the tax implications of an acquisition.

7.3 Regulatory requirements: industry regulation

Some industries are regulated in a way that reaches directly into financial strategy — typically those with natural-monopoly characteristics, where the infrastructure is expensive and duplicating it makes no sense, so a single supplier serves an area and customers cannot shop elsewhere. Energy and water networks, telecommunications, rail and airports are the usual examples.

Because competition cannot do the work, a regulator does it instead. Two instruments matter for F3.

Regulation reaches the other two policy decisions as well. A licence may restrict the structure of the regulated entity, cap its gearing, or require it to maintain an investment grade credit rating; regulators have restricted or blocked dividends where a company's financial position or service performance is poor; and a regulator's assessment of the allowed cost of capital effectively fixes the return the company is permitted to earn, so the discount rate used in the investment decision is not entirely the company's own.

The strategic reading is that a regulated business trades return for certainty. Revenue is capped, so the upside is limited; but revenue is also comparatively predictable, which is why regulated utilities characteristically carry more debt, pay higher and steadier dividends, and are valued on a lower cost of capital than a business of similar size in a competitive market. The risk that remains is regulatory risk: the possibility that the next periodic review, or a change of policy, resets the terms.

8 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.