Evaluating strategic options Evaluating and ultimately choosing the best strategic option is an art as much as it is a science and ultimately based on experience and instinct. QUALITATIVE EVALUATION OF STRATEGIC CHOICE Consistency Validity Feasibility Business risk Flexibility
Accounting principles Consistency Strategic alternatives must be consistent with achieving the business’s vision, mission and goals. Validity The assumptions behind the strategic options must be valid. These assumptions may include the future business environment, the competition, customers and suppliers and how they will react to alternative strategies. i.e. A strategic option that involves lowering prices but does not recognise the possibility that competitors may lower their prices may not be valid.
Accounting principles Feasibility A strategy may, in theory, be capable of delivering the business’s vision, mission and goals, but in practice it must also be feasible. In other words, the business must have (or be capable of acquiring) the financing, resources, assets, experience, culture and skills to carry it out. Business risk Return on investment is related to risk, and all strategic options carry some form of risk. They should also include ways of minimising the potential risk. The evaluation should aim to determine whether the residual risk of a strategic option is at a level commensurate with the anticipated return.
Accounting principles Flexibility In today’s rapidly changing business world, a strategy must have enough flexibility to work if circumstances change. If it can be broken down into a series of options that can be chosen, depending on circumstances, this is a considerable advantage.
EVALUATING THE BUSINESS DESIGN The business design defines how the business makes profit. The design must be customer centric, focused on sustainable profitability and internally consistent. the four strategic components of a business design: Customer selection Value capture Strategic control Scope Slides by Payman Shafiee
BUSINESS VALUATIONS Providers of equity capital to a business want to see an increase in the value of their investment. The future value of the business’s equity under each strategic option should be calculated. This is done is by assessing the trade-off between the risks of a particular strategy and the anticipated returns. Limitations: the underlying forecast on which it is based and the assumptions used in the chosen valuation technique
LIMITATIONS OF BUSINESS VALUATIONS the underlying forecast on which it is based and the assumptions used in the chosen valuation technique. Valuations are based on cash flows, and what is included in the cash flows will determine whether an enterprise or an equity value is calculated. Enterprise value If the cash flows used are before the payment of interest charges, they represent the monies that will ultimately flow to the providers of debt (via interest and principal repayments) and the providers of equity (via dividends). These cash flows represent the flow of cash to all providers of capital to the enterprise
LIMITATIONS OF BUSINESS VALUATIONS Equity value Equity value is the value today of all future cash flows that flow only to the equity holders. These cash flows are called the free cash flow to equity. Equity Value= Enterprise value – today’s value of future interest and principal payments Equity Value= Enterprise value – net debt
Approaches to valuation Value of an asset: The value of an asset is what someone else would be prepared to pay for it. When purchasing a used car you would check prices on similar vehicles on your local newspaper and find out what others paid. The equivalent for Business Valuation would be stock market and most recent corporate transactions.
Valuation techniques involving comparable businesses Price/earnings ratio Presumption: a comparable business must be identified, similar in terms of its market, customers, products, business design and growth prospects Business A is to be valued using a comparable business, Business B, which currently trades at $2.34 per share and has an EPS of $ The PE ratio for Business B is: $2.34 ÷ $0.083 = 28 Slides by Payman Shafiee
DISCOUNTED CASH FLOWANALYSIS Principles of discounted cash flow 1. $1 today is worth more than $1 tomorrow 2. A safe $1 is worth more than a risky $1 Risk and reward Investors must be compensated for the time value of money and the additional risk associated with investing in a company this is compared to: the risk free rate of return: In theory, the risk-free rate is the minimum return an investor expects for any investment because he or she will not accept additional risk unless the potential rate of return is greater than the risk-free rate. In practice, however, the risk-free rate does not exist because even the safest investments carry a very small amount of risk. Thus, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate.
the risk premium Defined as the additional return to compensate for the extra risk associated with an investment. This is called the risk premium.
Funding issues TYPES OF FINANCE: Debt and Equity Finance Debt finance Debt finance can be obtained from a number of sources but is often provided by a bank requires a business to pay an agreed, regular interest charge The interest charges have to be paid irrespective of the business’s performance Interest payments can be charged in the profit and loss account and so can reduce a business’s tax liability
Funding issues Equity finance The shareholders of a business (who can range from private individuals to large institutions) provide equity finance Equity also includes any retained profits of the business Equity shares, unlike debt, represent ownership of a business Unlike interest, dividends are paid after tax and are a less tax efficient form of financing Shareholders right: In the event of liquidation, shareholders only have a claim on what is left after all other creditors have been satisfied the providers of equity take the highest risk of all finance providers Slides by Payman Shafiee
A debenture is usually unsecured in the sense that there are no liens or pledges on specific assets. It is however, secured by all properties not otherwise pledged. In the case of bankruptcy debenture holders are considered general creditors.liensbankruptcycreditors
TERM OF DEBT short, medium and long term definition can vary depending on the nature of the business short term – up to 1 year; medium term – 1–10 years; long term – more than 10 years
Different forms of equity An equity share represents a share of a business’s assets and also a share of any profits it generates. There are different classes of equity, each with different rights that relate to dividends, voting and the return of capital in the event of liquidation Ordinary shares Preferred ordinary shares Non-voting shares Slides by Payman Shafiee
Different forms of equity Ordinary shares or common stock in the United States, are the last to be paid in terms of distributing profits and in the event of liquidation. They carry voting rights, and the owners of ordinary shares can gain value from their ownership through both a stream of dividends and a capital gain on the value of the shares themselves. The capital gain can be realised by selling the share in a stock market, through the business repurchasing its own shares or through the business being acquired by another business. Slides by Payman Shafiee
Different forms of equity Preferred Ordinary shares rank above ordinary shares and attract an agreed rate of dividend Non-voting shares rank in the same way as other classes of equity but they do not allow the holders of these shares to vote. Non-voting shares are typically issued in family businesses where family members do not wish to see a loss of control despite the need to raise additional capital. Slides by Payman Shafiee
Different forms of Debt Short- and medium-term debt finance Bank overdrafts Term loans Finance and operating leases Factoring Project finance Long-term debt finance Preference shares Debentures Unsecured loan stock Convertible unsecured loan stock
Other features of debt instruments Fixed and floating rates Redeemable and irredeemable Coupon rates Deep discounting Deeply discounted loans have a low coupon rate at issue and are issued at prices considerably below par or the face value of the loan Call provisions Restrictive covenants Lenders often include restrictive covenants in their loan agreements in order to provide additional security for their loans and to limit a business’s ability to take a course of action that could damage the security of the loan Chart 19.3 Repayment arrangements p.231 Slides by Payman Shafiee