Strategies at different levels are the outcomes of different planning needs. At the corporate level planners
decide about the objective or objectives of the firm along with their priorities. And based on objectives,
decisions are taken on participation of the firm in different product fields. Basically a corporate strategy
provides with a framework for attaining the corporate objectives under values and resource constraints, and
internal and external realities. It is the corporate strategy that describes the interest in and competitive
emphasis to be given to different businesses of the firm. It indicates the overall planning mode and
propensity to take risk in the face of environmental uncertainties. There are two extreme modes of planning
namely proactive mode and reactive mode. Actual mode of functioning of a firm may lie in between these
two extremes. Similarly; value system of the top executives in respect of risk may be described with
reference to two extreme states, viz. high risk taking state and low risk taking state. For example, in a
turbulent environment the preferred mode of planning is the proactive mode that assumes high propensity to
take risk. For a nearly stable environment a reactive mode of functioning may yield better result than a
proactive mode of functioning.
Plan at this apex level not only deals with product mix, customer mix, competitive emphasis and geographic
boundaries of the market but also assigns priorities for allocation of corporate resources among the various
business units. Specially, the deployment of critical resources among the business units is closely related
with corporate achievement and needs close attention of the top management. It also acts as an instrument
for resolution of conflicts.
Business strategy, on the other hand, is the managerial plan for achieving the goal of the business unit.
However, it should be consistent with the corporate strategy of the firm and should be drawn within the
framework provided by the corporate planners. Given the overall competitive emphasis, business strategy
specifies the product market power i.e. the way of competing in that particular business activity. It also
addresses coordination and alignment issues covering internal functional activities. The two most important
internal aspects of a business strategy are the identification of critical resources and the development of
distinctive competence for translation into competitive advantage. According to Prahalad and Hamel, it is the
proper nurturing of the core competence of a firm that leads to long lasting competitive advantage in the
market. Over the years core competence becomes the key weapon of a firm that cannot be easily copied by
the rival players. It gives business, reduced cost, improves quality and leads to product development.
Functional strategy is the low level plan to carryout principal activities of a business. In this sense, functional
strategy must be consistent with the business strategy, which in turn must be consistent with the corporate
strategy. Thus strategic plans come down in a cascade fashion from the top to the bottom level of planning
pyramid and performances of functional strategies trickle up the line to give shape to the business
performance and then to the corporate performance. This close interlink between functional plans and
corporate plan demands for close interaction between functional planning and corporate planning.
Among the different functional activities viz production, marketing, finance, human resources and research
and development, finance assumes highest importance during the top down and bottom up interaction of
planning. Corporate strategy deals with deployment of resources and financial strategy is mainly concerned
with mobilization and effective utilization of money, the most critical resource that a business firm likes to
have under its command. Truly speaking, other resources can be easily mobilized if the firm has adequate
monetary base. To go into the details of this interface between financial strategy and corporate strategy and
financial planning and corporate planning let us examine the basic issues addressed under financial
planning.
Conversely borrowing will be extremely difficult if the industry enters into a declining stage of life cycle curve.
Since bankers and investors are generally interested in long run results and benefits and are willing to forego
short run benefits, choice of the business field is very important for attracting investors and creditors. Thus to
be in or not be in is dependent on cash flow position and credit position of the firm and these are in turn
dependent on the position of the offer in respect of the life cycle curve, market demand and available
technology is main.
Liquidity position of the business describes the extent of idle working capital. It measures the ability of the
firm in handling unforeseen contingencies. Firms into major investments in fixed assets are likely to enjoy
less liquidity than firms with lower level of fixed assets. The liquidity of the firm is measured in terms of
current assets and current liabilities. If the current assets are more than the current liabilities the firm is said
to be liquid. For example a drop in demand due to sudden arrival of competitive brand in the market may
cause a crisis for liquid cash. In case the firm has excess current assets which are easily encashable, it will
be able to overcome the crisis in the short run and draw new strategic plan and develop new strategic
posture to rewinover the competitors in the long run.
2.0 INTERFACE OF FINANCIAL POLICY AND STRATEGIC MANAGEMENT
The inter face of strategic management and financial policy will be clearly understood if we appreciate the
fact that the starting point of an organization is money and the end point of that organization is also money
again. Offer of the organization is only a vehicle that links up the starting point and the end point. No
organization can run the existing business and promote a new expansion project without a suitable internally
mobilized financial base or both internally and externally mobilized financial base.
Following is a list of some standard questions, which are to be examined by the planners for drawing the
policy framework.
Q1. From where do we propose to get additional funds to grow internally or externally or both? If the
answer to the above question describes an internal dependence then comes the question
Q2. Will this affect the performance of the existing business? If the answer to the question Q1.favours an
external search then follows the question
Q3. How do we propose to mobilize that additional fund?
Q4. What policy of capital structure do we propose to follow? Minimum debt or highly leveraged structure?
Q.5. How much liquid cash or current assets do we propose to keep in hand?
Q.6. What will be effect of growth on cash flow?
Q.7. What accounting system and policy do we like to use and why?
Q8. What austerity measures are to be undertaken for generating more funds if needed?
Q9. What financial measures are to be taken into consideration for loss making units?
Q10. To whom do we propose to sell the loss making units in case internal turnaround does not work and
spinning off fails?
While most of the questions are relevant for growth or stable growth strategy, a few questions are related to
turn around and retrenchment strategies. Mainly one is concerned with generation of resources, mobilization
of resources, structuring of resources, allocation of resources and proper utilization of resources.
Sources of finance and capital structure are the most important dimensions of a strategic plan. We have
already emphasized on the need for fund mobilization to support the expansion activity of firm. The
generation of funds may arise out of ownership capital and or borrowed capital. A company may issue equity
shares and / or preference shares for mobilizing ownership capital. Preference Share holders as the name
stands enjoy preferential rights in respect of dividend and return of capital. Holders of equity shares do not
enjoy any such special right regarding dividend and return of capital. There are different types of preference
shares like cumulative convertible preference shares which are convertible into equity shares between the
end of the third year and the fifth year. Rate of dividend paid till conversion into equity shares remains
constant. Debentures, on the other hand, are issued to raise borrowed capital. These are of varying terms
and conditions in respect of interest rate, conversion into shares and return of investment. Public deposits,
for a fixed time period, have also become a major source of short and medium term finance. Organizations
may offer higher rates of interest than banking institutions to attract investors and raise fund. The overdraft,
cash credits, bill discounting, bank loan and trade credit are the other sources of short term finance.
Along with the mobilization of funds, policy makers should decide on the capital structure to indicate the
desired mix of equity capital and debt capital. There are some norms for debt equity ratio. These are aimed
at minimizing the risks of excessive loans, for public sector organizations the norm is 1:1 ratio and for private
sector firms the norm is 2:1 ratio. However this ratio in its ideal form varies from industry to industry. It also
depends on the planning mode of the organization under study. For capital intensive industries, the
proportion of debt to equity is much more higher. Similar is the case for high cost projects in priority sectors
and for projects in under developed regions.
Another important dimension of strategic management and financial policy interface is the investment and
fund allocation decisions. A planner has to frame policies for regulating investments in fixed assets and for
restraining of current assets. Investment proposals mooted by different business units may be divided into
three groups. One type of proposal will be for addition of a new product to the fold of offer of the firm.
Another type of proposal will be to increase the level of operation of an existing product through either an
increase in capacity in the existing plant or setting up of another plant for meeting additional capacity
requirement. There is yet another type of proposal. It pleads for cost reduction and efficient utilization of
resources through a new approach and or closer monitoring of the different critical activities. Now, given
these three types of proposals a planner should evaluate each one of them by making within group
comparison in the light of capital budgeting exercise, In fact project evaluation and project selection are the
two most important jobs under fund allocation. Planner’s task is to make the best possible allocation under
resource constraints.
Dividend policy is yet another area for making financial policy decisions affecting the strategic performance
of the company. A close interface is needed to frame the policy to be beneficial for all. Dividend policy
decision deals with the extent of earnings to be distributed as dividend and the extent of earnings to be
retained for future expansion scheme of the firm. From the point of view of long term funding of business
growth, dividend can be considered as that part of total earnings, which cannot be profitably utilized by the
company. Stability of the dividend payment is a desirable consideration that can have a positive impact on
share price. The alternative policy of paying a constant percentage of the net earnings may be preferable
from the point of view of both flexibility of the firm and ability of the firm. It also gives a message of lesser risk
for the investors. Yet some other companies follow a different alternative. They pay a minimum dividend per
share and additional dividend when earnings are higher than the normal earnings. In actual practice,
investment opportunities and financial needs of the firm and the shareholders preference for dividend against
capital gains resulting out of share are to be taken into consideration for arriving at the right dividend policy.
Alternatives like cash dividend and stock dividend are also to be examined while working out an ideal
dividend policy that supports and promotes the corporate strategy of the company.
It may be noted from the above discursions that financial policy of a company cannot be worked out in
isolation of other functional policies. It has a wider appeal and closer link with the overall organizational
performance and direction of growth. These polices being related to external awareness about the firm,
specially the awareness of the investors about the firm, in respect of its internal performance. There is
always a process of evaluation active in the minds of the current and future stake holders of the company.
As a result preference and patronage for the company depends significantly on the financial policy
framework. And hence attention of the corporate planners must be drawn while framing the financial policies
not at a later stage but during the stage of corporate planning itself. The nature of interdependence is the
crucial factor to be studied and modelled by using an in depth analytical approach. This is a very difficult task
compared to usual cause and effect study because corporate strategy is the cause and financial policy is the
effect and sometimes financial policy is the cause and corporate strategy is the effect. This calls for a bipolar
move.
2.1.1 Investment planning: Investment planning as already pointed out is the key-planning task for an
organization because resources are available in limited quantities and number of alternative investment
proposals is that way unlimited. Given the financial objectives and their respective priorities and given the
objective of optimization and or minimum / maximum attainment, a planner faces problem with the resource
constraints that limit the feasible region of operation and choice. This calls for making a balanced decision
i.e. balancing between aim and ability of the company.
Let us examine how strategic decision can be taken for capital expenditure projects. Capital expenditure
project can be evaluated in many ways and once the evaluation methods have been decided upon different
proposals can be evaluated and can be arranged in order of preference. Final choice will be dependent on
maximization of firm’s value subject to resource constraints. One such method for evaluating a project is
economic evaluation.
Under economic evaluation, capital budgeting technique is being used where marginal increase in revenue is
being matched with marginal increase in cost. A firm should opt for acquisition of a capital asset if the
marginal revenue exceeds marginal cost. By capital budgeting technique, we mean net present value
technique or internal rate of return technique or pay back method. Choice of the technique depends on the
knowledge, experience and value system of the policy planner and hence some subjective elements may
enter into the system of planning.
Sometimes a minimum rate of return is being fixed so that if a project is to be feasible it should not only
provide a positive rate of return but also cross the hurdle rate i.e., minimum rate, to make the proposal an
attractive one. This determination of attractiveness of a project is very important and useful than
determination of the rank of a project. For example, none of a set of projects may be attractive from the point
of view of hurdle rate but if they are ranked at least one project will come out with rank one i.e., the best
project. The term best is measure wise meaningful but strategically it is of no use. Thus concept of hurdle
rate is very important and it is to be prefixed by the planners based on both internal and external
considerations. The main idea is to decide about this cut-off rate based on cost of capital, the rate of return
the firm must pay to the providers of capital. This cost of capital is determined by the nature of different types
of funds to be used by the firm and their costs. A weighted average of those costs is the basis for
determination of cut-off rate or hurdle rate for the company. Some experts are of the opinion of inclusion of
intangible costs and intangible benefits for arriving at the hurdle rate and deciding about the fate of a project.
Sometimes a mark up principle is used to arrive at the cut-off point α. If the cost of capital is β, cut-off point
may be fixed at (1+β)α where β is commonly taken 0.10 i.e. 10% mark up. This mark up takes care of
uncertainty involved in the determination of the cost of capital, variation in business risk, unforeseen internal
problems and so on. The method of calculation, use of different types of funds, and choice of β are all
choices of the planners, i.e., strategic choices.
Crossing the hurdle rate makes a project attractive. But choice of projects, as pointed out earlier, depends on
total investment outlay planned at the corporate level. This restriction in terms of the total outlay is known in
management parlance as capital rationing. By arranging the attractive projects in descending order of
magnitude in respect of profitability index to select the project may not always serve the purpose because
planners are interested in maximization of benefits subject to budget/outlay constraint. It may so happen that
cumulative requirement of investment outlay may not exactly match with available fund for investment. The
left over fund may not support the next project if one goes by the profitability index consideration. Example
can always be constructed to show that two smaller projects that may exhaust the total outlay may result in
more benefit than a single larger project that fails to exhaust the total outlay.
n k=1
If PIk is the profitability index of the K-th project with investment requirement as IK, K ranging from 1 to n,
when n is the total number of attractive projects, then net present value of the k-th project works out as
NPVk =(PIk –1)Ik,K=1,2,.........n
If total investment outlay is Io, then the task is to solve the following integer programming problem:
n Max ∑xk (PIk −1)Ik
k=1 St (i)∑xkIk≤I0
(ii) xk =0or1, k=1,2,...........n
Risk factor should also draw the attention of the planners because investment decisions are closely coupled
with the factor of uncertainty. Rather than having an initial check with respect to rate of return only one may
think of a double check one with respect to rate of return and another with respect to degree of risk. If a
project is attractive from both these considerations then only the capital rationing can be employed for
arriving at the strategic choice via mathematically programming. In the case of risk there should be a
maximum limit below which a project will be acceptable and above which a project will be rejected during the
first stage of screening. Mostly we determine risk by examining the variation in the benefit value and one
may take help of statistical distributions for different inflows and out flows of the project and calculate for the
random net present benefit - the overall variance. Thus variance value or its square root, i.e., the standard
deviation can be used for working out the degree of risk of a project. Some other experts believe in
adjustment of expected net present benefit by a risk factor and propose a single initial screening in the line of
hurdle rate. Here again, the choice of approach itself becomes a strategic choice. The subsequent decisions
may be largely objective in nature.
2.1.2 Planning for Current Assets: The planning need here is to allocate funds among cash, receivables
and inventories so as to facilitate the accomplishment of financial objectives in particular and corporate
objectives in general. Basically, there are two issues, which are polar opposite in nature, and one has to
strike a strategic balance between them. These issues are profitability and liquidity and the balancing
instrument is the risk preference. Cash is a type of current asset that a firm wants to receive in the quickest
possible manner but does not like to keep it in that form for a long period. In fact, keeping excess stock of
cash amounts to mis-utilization of an important resource and loss of additional income from a possible
investment of the same. However, having shortage of cash may affect the strength of the firm in handling
unexpected adversities and in getting credit facilities. Also ability of the firm in enjoying trade discounts may
get disturbed if cash in hand is less. Thus, high liquidity means
low profitability and over investment for high profitability means poor liquidity for the company. This calls for a
strategic planning for deciding upon the level of cash conservation and optimum investment of idle cash.
If the inflow and outflow of cash can be predicted with certainty they can be so adjusted that zero stock of
cash may be aimed at. But in reality business environment is unpredictable. Hence inflows and outflows can
hardly be matched and zero stock of cash is more of a concept than of a reality. There are different methods
for working out the optimum level of cash. One such method, known as Economic order quantity (EOQ), can
be used for arriving at optimum level of cash. According to the EOQ model one can work out the optimum
level of cash, C0, based on the cost of acquisition, cost of carrying cash inventory, i.e., the interest rate on
marketable securities, cost of shortage of cash, rate of cash replenishment and total amount of transaction
demand. Under the policy that minimizes the total cost, we have
C0 =
2A (I + S)dr
IS r−d
where A = acquisition cost
I = inventory cost of carrying cash S = Shortage cost of cash r = replenishment rate of cash d = demand rate
of cash
In case the shortage cost is very high and cash shortage cannot be tolerated the model can be simplified.
2A dr I r−d
C10 = by allowing S tending to infinity.
If the rate of cash replenishment is instantaneous one may have further simplification, under r tending to
infinity, as
C 03 =
2Ad I
C02 = Alternatively under infinite rate of replenishment when cash shortage is admissible we have
2Ad(I+S) IS
It may be kept in mind that for a stable situation where stochastic variation in respect of the stated
parameters of the models are negligible the above four models work well under
respective set up. However, in case of stochastic flows of cash, control of cash is to be made based on 3 σ
upper and lower limits. According to control chart technique when cash balance reaches the upper control
limit a part of cash should be transferred to investment account and when the cash balance reaches the
lower control limit a portion of investment should be liquidated to generate cash. The upper limit normal level
of cash and lower limit can be expressed in terms of fixed cost associated with security transaction variance
of daily net cash flows and interest rate per day on marketable securities. Once the cash balance starts
crossing the normal level of cash, purchase of marketable securities starts and once cash balance starts
falling below the normal level of cash, selling of marketable securities starts. When the cash balance crosses
the upper limit one can think of investment plans.
There are strategies that work well with cash projection planning. Basic objective of those strategies is to
ensure cash conservation through acceleration of cash inflow and retardation of cash out flow rate. Under
acceleration strategy a company shortens the time gap between payment and its encashment for
redeployment, quickens the process of collection through multiple collection centers. The concept of rebate
in payment may accelerate cash inflow but before the introduction of such rebate one should go for in depth
cost benefit analysis to measure the net effect. Under retardation strategy a company widens the time gap
between receipt of bills and their payments by availing the last date for no-cost period, makes the payroll
periods less frequent and so on.
2.1.3 Inventory planning: The maximum part of current assets of a company is usually in the form of
inventory provided the stock of inputs and or outputs are feasible. So, for a better financial performance
there is a need to manage inventories in the best possible way. Efficient inventory management calls for
striking an optimum balance among different costs of conflicting nature. It also demands for different levels of
control for different types of stocks. For example, for voluminous low cost items a close monitoring may not
be needed or may become costly. Routine decision taking system in terms of mathematical models can be
employed for those items. The polar opposite approach needs to be adopted for high cost low volume items.
Close monitoring may reduce the cost of inventory as well as cost of shortage. For items which fall in
between those two extreme categories one may apply a mixture of these two controlling approaches, i.e.
partly routine and partly close monitoring.
The related issues of importance are optimum size of production run, reordering time or reordering level, size
of buffer stock and inventory turnover. When reordering is needed one has to indicate how many units are to
be ordered or produced, as the case may be. One may either place order according to a fixed size of the lot
or after a fixed period of time. Problem mainly arises out of stochastic nature of the rate of demand, rate of
replenishment and lead time. It is very difficult to predict fluctuations in demand. Mostly, variance is the
observed set of demand along with the expected demand jointly throws light on the extent of fluctuation in
demand. Similar are the cases for variation in lead time and production rate. Sometimes the shelf life also
adds to the problem of variation.
Prescriptive measures for fixing turnover norms for inventory can put pressure on slow moving items and
also on obsolete stock. Addition to slow and obsolete stocks only adds to the cost of the system and reduces
the benefit of the system. So pressure for their disposal can be of extreme help for the attainment of financial
objectives of the organization.
The evaluation of sustainable growth strategy calls for interface of financial planning approach with strategic
planning approach. Choice of the degree of sustainability approach for sustainability and modification in the
sustainability principle must be based on financial evaluation of the alternative schemes in terms of financial
and overall corporate objectives. Basically there are two alternative methods for evaluation. One is known as
valuation method and the other one is known as pricing method. Valuation method depends on demand
curve approach by either making use of expressed preferences or making use of revealed preference.
Pricing method is a non demand curve approach that takes into consideration either opportunity costs or
alternative costs or shadow projects or government payments or those response method depending on the
nature of the problem and environmental situation. Valuation methods are in general more complex in
implementation than pricing methods. But demand curve methods are more useful for cases where it seems
likely that disparity between price and value is high.
After the evaluation comes the question of policy choice. In case of sustainable growth the conventional cost
benefit analysis may not be an appropriate tool for making choice decision. This is due to the fact that
conventional cost benefit analysis is based on the principle of allocation of resources for maximizing internal
benefit. It has no in built sustainability criterion to guarantee that a constant stock of natural resources will be
passed between current and future users. This problem comes up because conventional cost-benefit
analysis draws no distinction between natural capital and man made capital and is considered to be
equitable.
One proposed sustainability criterion is due to Turner and Pearce who advocated the constant natural assets
rule. Their compensation principle requires the passing on the future users a stock of natural assets which
no smaller than the stock in the possession of current users. According to them Hicks Kaldor potential
compensation rule should be extended further so that there will be actual compensation rule for natural
resources. Within the constant natural assets rule the extended cost-benefit analysis can still retain the
flavour of economic efficiency if one takes into consideration how resources should be best allocated among
the competing users. The constant natural assets rule is directly applicable for renewable assets. But all the
resources are not renewable is nature. In case of non-renewable assets, actual compensation rule should be
interpreted not in terms of providence of actual assets but in terms of the services rendered by the actual
assets. For example, oil, the black liquid cannot be preserved in constant quantity across time. But the
services that oil provides to current users must be provided in future so that actual compensation remains
the same. These are all high level strategic decisions but come under the purview of financial strategic
planning. Only a close interface can help in arriving at an acceptable situation and plan
Self-examination Questions
1. What is Strategic Management?
2. Outline the assumptions and limitations of corporate finance theory.
3. How the interface between financial policies and corporate strategy is done.
4. What type of interaction between various financial policies exists?
5. Comment on shareholders value creation?
6. What type of relationship exists between growth, economic profitability and the shareholder value?