Strategic Financial Management | Free Essay Example

Strategic Financial Management

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Topic: Business & Economics
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Introduction

Valuation is an important concept in finance. Studies on this subject have contributed to the existing knowledge on financial decisions in different firms. Valuation approaches are deeply rooted in literature where many researches and theories have been formulated to address the same topic. The relationship between the capital structure of an organisation and its value has also been a subject of many studies over the past years. As the paper will confirm, several researchers have suggested the possibility of little, if any, the impact of capital structure on a firm’s value in a perfect market.

However, most researchers confirm that financial position and decision-making processes in a firm affect its valuation. Taxes, asymmetric information, and agency costs are some of the imperfections that exist in contemporary business environments. These imperfections maintain a constant relationship between valuation and capital structure in a firm. The association between this assessment and financial decisions in organisations dictates some of the business interventions in the present-day business environment. This paper examines the link between valuation and financial decisions in businesses. The aim is to evaluate whether there is any relationship between the two aspects.

Valuation

The valuation of any organisation allows future decision-making to ensure that it is operating as per the expectations. Different methods are used in valuation, including those that are supported by theories and contemporary methods. The present models that are deployed in the evaluation process are a product of extensive research, with many researchers describing them before their application in management and finance. What are the motives of company valuation? Different schools of thought exist as to why company valuation is important.

One of the motives for the evaluations of a company is to make decisions in the organisation. Depending on the decision that is reached after valuation, the involved individuals may decide on the future of the organisation and the interventions for the areas that are found faulty.

Motives in company valuation may be characterised in different ways, including decision-dependent and decision-independent motives (Ishakian, Knebusch & Rowen 2013). The other category of motives is the transaction based vs the non-transaction-based motives (Ishakian, Knebusch & Rowen 2013). The other class of motives, as described throughout the literature on valuation, is the dominated vs the non-dominated decision (Ishakian, Knebusch & Rowen 2013).

Valuation serves different functions depending on the concerned firm or organisation. These functions can be categorised further into minor and major functions. The main functions of valuation in organisations include decision-making and consultation. According to Ishakian, Knebusch, and Rowen (2013), managers and other stakeholders use valuation information in an organisation to make decisions on the future of the organisation with the aim of improving the organisational performance. Different firms operate on different grounds. They use different methods of valuation to make financial and other forms of decisions in the organisation.

The other function of valuation, according to Koziol (2014), is mediation where the firm uses information from valuation to mediate between concepts, decisions, and individuals. Hundsdoerfer, Kruschwitz, and Loren (2008) assert that mediation in an organisation provides crucial information on the financial position of the organisation. Valuation also serves as a means of argumentation. Using information from valuation, managers and other organisational stakeholders can argue on the position of the organisation. The information is used to provide details on the organisational performance, which is important in making a case for any argument.

Apart from the main functions of valuation, valuation serves other auxiliary functions. One of these auxiliary functions is information where the parties within an organisation gather information on this organisation, including its performance and future expectations. Valuation may also be used as a means of tax measurement where authorities determine the tax that an organisation should forward over a given period. Many organisations where valuation has been conducted were found to have some tax measurements, not in line with the expected values (Mian & Velez-Pareja 2007). Valuation also serves the function of contract configuration where employees and other parties in the organisation can have their contracts configured with the expectations of the organisation.

Valuation Methods

Different valuation methods are in use in many organisations. Each of these methods provides different results. The decision to use one of them is dependent on the firm that is being evaluated, the financial methods in place, and the preferred approach. The most popular approach depends on the organisation and the region where these organisations exist. Different methods that are used in valuation are shown below.

An Overview of Valuation Methods
Figure 1: An Overview of Valuation Methods (Source Mian & Velez-Pareja 2007)

Different models that are applied during a valuation in organisations lead to a common result where the organisations are able to plan for future decisions and changes. The valuation that is obtained in organisations, irrespective of the method used, provides crucial information on the financial status of the organisation. However, valuation within organisations also allows the inception of changes whenever they are needed.

Financial Decisions

Organisations face challenges in financing, with one of the most common of them being the outcomes of financial decisions. Competitiveness in organisations is influenced by the financial decisions that managers and other stakeholders make. In any industry, financial decisions affect the outcomes of the interactions between different factors. The financial decisions in an organisation are also under the influence of other factors such as the valuation in these organisations. A business in any industry or market must use capital as one of the main factors in its operations, with this strategy bringing about the cost of capital.

Currently, there are no perfect markets in contemporary organisations. Hence, capital is not always put to the intended use. A perfect business environment is the only place where capital can be put to its planned use. However, conditions that are necessary for a perfect market are hard to achieve. Nevertheless, if it were possible, the perfect world would have an excess supply of capital. A perfect capital market might mean that the available unlimited capital is only dependent on the risk of the project being undertaken (Spiegel, & Tookes 2013).

Aside from the perfect capital market, uncertainties, variables, and friction characterise the existing real-world capital markets. The availability of tax as one of the variables in an imperfect world ensures that organisations adopt strategies such as debts. An example of such strategies is when an organisation operates in a capital structure with about 100% of debt because of the positive corporate tax rate (Spiegel, & Tookes, 2013). Other factors that exist in an imperfect world to introduce a relationship between valuations and financing include agency costs, financial distress costs, and information asymmetries (Spiegel, & Tookes, 2013).

The financial position of an organisation ensures that the organisation can persist in an environment where competition is an evident factor. Valuation effects that financial position of an organisation. The reverse is also true. The decisions made in an organisation relating to the financial positions of the organisation may be based on the valuation that is provided for this organisation.

Weighted Average Cost of Capital

The calculation of the cost of capital is an intricate process that requires the participation of all stakeholders. The cost of capital is calculated through the estimation of the proportion of debt that a project consumes against the equity that is absorbed in the respective project (Massari, Roncaglio & Zanetti 2008). The weighted average cost of capital (WACC) is calculated through a formula that incorporates the market value of equity and debt (Massari, Roncaglio & Zanetti 2008). These values are adjusted using the costs of debt and equity. For a single firm, the WACC is calculated as a single unit where the firm is the reference. The organisation, in this case, is considered a single unit, with the results being for a single project.

The Weighted Average Cost of Capital is an indicator of the financial performance of an organisation because it indicates the financial position of the organisation under discussion. Any organisation with sound financial decisions has a favourable WACC, which is considered a strength in these organisations. The calculation and use of WACC in financial discussions and problem-solving is challenging for some financial analysts and other financial decision-makers in organisations. Therefore, it is important to have a discussion on the correct use of WACC and its implications on the financial decisions in organisations.

The other difficulty in the calculation and use of WACC is tax calculation. Different finance officers use different methods of calculating the variables (Sabalı 2009). Financing and investment decisions interact through taxes. WACC is an important concept in evaluating this interaction. The formula that is used in the calculation of WACC refers to the organisation of company as a whole upon incorporating the different aspects in financial decisions in the firm.

Therefore, this formula is effective for the “average project” where the right discount rate is produced (Massari, Roncaglio & Zanetti 2008). Hence, the formula is incorrect when used in the calculation of WACC for the safer and riskier projects (Magni 2012). The inaccuracy while using this formula mainly stems from the different sections that individuals calculate in an organisation, especially where the organisation has different departments.

Capital Structure and Valuations

Capital structure in a firm is a factor that affects valuations in these organisations. The effects depend on the existing capital structure. According to Sabalı (2009), financing decisions typically affect value within organisations. Some of the ways that boost value in a firm with respect to its financing decisions is through the adjustment of the discount rate and the present value (Massari, Roncaglio & Zanetti 2008).

The discount rate in most organisations is typically adjusted downwards, with the aim being to account for the existing tax shields (Massari, Roncaglio & Zanetti 2008). Financing decisions also affect value in organisations through adjusting the present value in these organisations (Massari, Roncaglio & Zanetti 2008). According to Spiegel and Tookes (2013), the base case is first calculated with the assumption that it is all equity financed.

Capital structure in organisations affects the value of the organisation from its first year of operation. The capital structure in organisations is variable depending on several factors such as the capital debt and the type of industry within which a firm is located. The tax on a firm is a major factor with reference to its capital value, especially because the tax determines the debt status of an organisation (Sabalı 2009).

The initial cash that is invested into a firm in the first year affects the value of an organisation during this year. Most of the organisations that invest significant amounts of capital into their operations end up being successful in the first year. Over the years that follow, the WACC formula is highly applicable, as the organisational debts and equities change.

Capital structure in most organisations is affected by the financial decisions made by the executive. Hence, the value of organisations is dependent on the type of managers that an organisation keeps. The value of organisation changes with any financial decision made, since the debt and equities change with these decisions (Massari, Roncaglio & Zanetti 2008).

The value of a firm may be calculated through the estimation of the WACC, which is later used to discount the FCFF from the debt holders and equity capital contributors (Massari, Roncaglio & Zanetti 2008). The use of WACC in the estimation of a firm’s value is very effective by far compared to other methods of value estimation. This finding indicates a relationship between the value of organisations and the WACC. The WACC is in turn related to the financial decisions in an organisation. Hence, valuation is related to the financial decisions in the organisation.

Impact of Tax Shields on WACC

According to Massari, Roncaglio, and Zanetti (2008), tax is a variable in an organisation that affects the value of these organisations. Interest in organisations is one of the expenses that are usually considered as tax-deductible expense (Massari, Roncaglio & Zanetti 2008). The calculation of WACC incorporates tax as a major form of expense. This strategy determines the value of organisations. However, tax shields in organisations may affect the calculation of WACC. The effects of tax shields on WACC depend on the business and individuals who are responsible for financial management in the respective institutions.

The tax shields cause changes on WACC in a number of ways. However, while these effects are dependent on the type of organisation, the main effect is that the WACC increases with a reduction in tax shields. Most organisations seek tax shields to lower their WACC and in effect influence the value and competitiveness of their respective industries. A common result of tax shields is a downward adjustment of the discount rate to account for any changes in this area (Massari, Roncaglio & Zanetti 2008). The downward adjustment of discount rates in organisations allows decisions to be made on the WACC and its overall effect on the firm’s value.

Tax shields help organisations save their available financial resources, including the provision of future resources. In areas where tax shields are effectively applied, firms report better results, performance, and competitiveness compared to areas where these policies are scantily applied. Adjusting the discount rate downwards is one of the ways that tax shields are accounted for. The result of this case is a change on the value of firms (Massari, Roncaglio & Zanetti 2008).

The relationship between value of an organisation and tax shields may be demonstrated by the inherent differences between organisations that operate in different regions with different tax shield regimens. According to Massari, Roncaglio, and Zanetti (2008), adjustment of WACC should affect the value of a firm through the effect of this move on the value of the organisation. Therefore, managers should make sound decisions when it comes to applying for tax shields in their area.

How Tax Shields affect Firm Value

Tax shields in an organisation affect the firm’s value in a number of ways as indicated above. A common understanding is that tax is one of the factors that affect WACC, and in effect the value of an organisation. The worth of any business is affected by the financing decisions in the organisations, including the availability of tax shields. The discount rate constitutes one of the factors that may be adjusted to accommodate changes in the value of organisations. Mintz and Currim (2013) observe that downward adjustment of discount rate accounts for tax shields. This downward adjustment results in the increase in value of organisations.

Organisations that use the discount rate to effect changes in their firm value often report success in the use of the method. When an organisation is awarded tax shields, the value changes to correspond to the changes introduced through the adjustment of the discount rates. Most organisations can be described as having debts because of the tax shields that they intend to acquire.

Therefore, contemporary organisations are prone to debts in their quest to attain tax shields from the respective authorities. The differences in the contemporary organisations arise from the different capabilities in the use of their debts. Most organisations whose debt status is high attain significant tax exemptions. They are valued at higher rank compared to organisations that have a lower debt position. The tax shields in an organisation, therefore, affect the firm value in organisations.

Mistakes in Using WACC

Several mistakes are established in literature in the use of WACC. The first mistake is in the calculation of this variable. In fact, some individuals use variables that are not commonly applied in the formula. The computation of WACC is tedious due to the many variables that are necessary for the calculation process. This situation makes the calculation difficult to the extent that some individuals opt for shortcuts that may not be accurate. The other mistake is that some individuals assume that the formula may be used in the calculation of WACC for a particular section of the organisation. They forget that this formula considers the firm a single unit (Mian & Velez-Pareja 2007).

WACC is useful in providing discount for businesses only where they are applied to organisations or projects with a similar undertaking to the firm under consideration. For organisations that differ from the firm under consideration, the formula may not be applicable or provide useful results. WACC may be useful in most of the calculations where the firm under consideration has the same size as that of other firms that were initially considered. For projects that are safer or riskier compared to the original organisation, the calculated WACC may be inaccurate and in some cases incorrect.

The other mistake that individuals make in the use of WACC is the assumption that it can be applied as a single variable in the determination of a firm’s value. According to Mian and Velez-Pareja (2007), organisations require the use of many variables to calculate their value. A single variable may be deceptive depending on the industry within which the firm is located. Therefore, there is a need to consider a number of variables in the calculation of a firm’s value as using WACC alone may be inaccurate. Some of the other mistakes that individuals make in the use of WACC include miscalculation of the debt and equities that are eventually used in the calculation of this variable.

Adjusting the WACC

The adjustment of WACC may be done through a number of ways depending on the debt ratios and the business risks (Mintz & Currim 2013). Adjusting the WACC when the risk of the firm’s debt ratio and the business risk differ from those of the new project is important in the calculation of a business’ WACC.

The adjustment of WACC is important when the debt ratios and business risks differ in organisations. The differences between these two variables result from the changes that are inherent in the organisations. The three main steps that should be followed when adjusting the WACC include calculation of the opportunity cost, estimation of the cost of the organisations debt, and recalculation of the WACC using the obtained new values (Mian & Velez-Pareja 2007).

The adjustment of this value allows the correct calculations where the estimated WACC is obtained against the real WACC. In cases where the WACC is adjusted, the value of the firm’s debts and opportunity costs are considered the main reasons for the adjustments. There are many reasons for the adjustments, with the main one being to increase the accuracy of the final WACC that is obtained for any given firm. WACC is an indicator of the financing side effect in an organisation. It is a good indicator of value in organisations (Mintz & Currim 2013). These financing side effects include the value of interest tax shields on debts (Massari, Roncaglio & Zanetti 2008). Adjustment of the WACC is also important where the actual value of a firm is to be estimated.

Valuation in Organisations

Valuation affects the financial decisions that are made in organisations. Most of the decisions that are important in organisations are made only through the consideration of the value of the organisation since most managers tend to focus on increasing this value. The many valuation approaches that are currently in use stem from the extensive research done in this area. These approaches affect the financing decisions in organisations. The methods of valuation affect the final variable.

Hence, most of these methods have sub approaches within them. Discounted cash flow is among the most popular methods that are used in the valuation. This strategy focuses on the financing decisions in the organisation (Massari, Roncaglio & Zanetti 2008). According to Dong, Hirshleifer, and Teoh (2012), the main ways of estimating the discounted cash flow include discounting the cash flow at a risk-adjusted discount (Sabalı 2009). This formula is one of the four main methods that are used in the discounting cash flows. Using these methods produces significant results.

Although different methods are in use in the valuation of companies, the same results may be achieved if the assumptions are withheld for each of the methods. The similarity of these methods ensures that the result is compatible with the businesses for which it was attempted first. The different proponents for the different approaches in the valuation methods assume that their methods are the most accurate. The results indicate that these methods are closely similar. In relative valuation, which is considered one of the most important valuation methods, the researchers who proposed the method adopted the assumption of individual assets. However, these methods have similar results when the different assumptions are withheld.

Conclusion

In conclusion, based on the detailed expositions that have been made in the paper, it is clear that valuation and financing are closely related when consideration for the financial state of an organisation is made. Valuation may be estimated in organisations using several methods. Some of these methods have been stated in this essay. The existence of valuation in financial decisions allows the organisations to make decisions that coincide with their immediate needs.

The paper has proposed that a relationship between valuation and financial decisions in organisations. This relationship is affected by other factors such as taxation. The WACC is an important factor to consider when deducing the relationship between valuation and financial decisions. The available research proves that this concept is applicable in an organisation’s financial decisions. The essay has looked at the relationship between WACC and valuation in organisations and the relationship that exists between these two variables and financial decisions in an organisation. The paper has proved a positive relationship between these concepts.

References

Dong, M, Hirshleifer, D & Teoh, S 2012, ‘Overvalued Equity and Financing Decisions’, Review Of Financial Studies, vol. 25 no. 12, pp. 3645-3683.

Hundsdoerfer, J, Kruschwitz, L & Lorenz, D 2008, ‘Investment Valuation with Tax-optimised Financing Decisions and a Tax-optimised Default Alternative’, Business Research, vol. 1 no. 1, pp. 9-24.

Ishakian, Z, Knebusch, M & Rowen, L 2013, ‘Dominance and Transmissions in Supertropical Valuation Theory’, Communications In Algebra, vol. 41 no. 7, pp. 2736-2782.

Koziol, C 2014, ‘A simple correction of the WACC discount rate for default risk and bankruptcy costs’, Review Of Quantitative Finance & Accounting, vol. 42 no. 4, pp. 653-666.

Magni, C 2012, ‘In Search of the “Lost Capital”. A Theory for Valuation, Investment Decisions, Performance Measurement’, Frontiers In Finance & Economics, vol. 9 no. 1, pp. 87-147.

Massari, M, Roncaglio, F & Zanetti, L 2008, ‘On the Equivalence between the APV and the WACC Approach in a Growing Leveraged Firm’, European Financial Management, vol. 14 no. 1, pp. 152-162.

Mian, M & Velez-Pareja, I 2007, ‘Applicability of the Classic WACC Concept in Practice’, Latin American Business Review, vol. 8 no. 2, pp. 19-40.

Mintz, O & Currim, I 2013, ‘What Drives Managerial Use of Marketing and Financial Metrics and Does Metric Use Affect Performance of Marketing-Mix Activities?’, Journal Of Marketing, vol. 77 no. 2, pp. 17-40.

Sabalı, J 2009, ‘On the Applicability of WACC for Investment Decisions’, GCG: Revista De Globalisación, Competitividad & Gobernabilidad, vol. 3 no. 2, pp. 80-88.

Spiegel, M & Tookes, H 2013, ‘Dynamic Competition, Valuation, and Merger Activity’, Journal Of Finance, vol. 68 no. 1, pp. 125-172.