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Finance Theory and Financial Strategy

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“Finance Theory and Financial Strategy”. Interfaces, 14. Introduction This journal explained how to bridge the gap between strategic planning and finance theory. Myers wrote this journal to explain why finance analysis had only slight impact on strategic planning, even though strategic planning needs finance. Strategic and financial analysis are not reconciled. When low net present value (NPV) projects are nurtured “for strategic reasons,” the strategic analysis overrides measures of financial value, and vice versa. Relevant Financial Theory

The financial concepts most relevant to strategic planning are those dealing with firms’ capital investment decisions.

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To select the projects to be financed, we calculate net present value by subtracting project’s present value with required investments. Projects with positive or higher NPV should be preferred than those with negative or smaller NPV. However, the theory is usually boiled down to a single model, discounted cash flow (DCF): PV= t=1TCt(1+r)t with PV = present value, Ct = forecasted incremental cash flow, t = project life, and r = the opportunity cash capital.

The Gaps Myers argued that the gaps between strategic and financial analysis are caused by: * Finance theory and traditional approaches to strategic planning may be kept apart by differences in language and “culture. ” Managers worry about projects’ book rates of return or impacts on book earnings per share. They worry about payback, even for projects that clearly have positive NPVs. They try to reduce risk through diversification. * Discounted cash flow analysis may have been misused, and consequently not accepted, in strategic applications.

Competing projects are often ranked on internal rate of return rather than NPV. Thus make small and short lived projects are preferred than long lived projects. Inflation are not consistently calculated in DCF calculations. Management often sets unrealistic high discount rates to avoid optimistic bias from managers. * Discounted cash flow analysis may fail in strategic applications even if it is properly applied. There are several problems when dealing with DCF calculations: * There are few problems in using DCF to value safe flows, for example, flows from financial leases. DCF is readily applied to “cash cows” ? relatively safe businesses held for the cash they generate, rather than for strategic value. It also works for “engineering investments,” such as machine replacements, where the main benefit is reduced cost in a clearly-defined activity. * DCF is less helpful in valuing businesses with substantial growth opportunities or intangible assets. In other words, it is not the whole answer when options account for a large fraction of a business’ value. * DCF is no help at all for pure research and development. The value of R&D is almost all option value.

Intangible assets’ value is usually option value. The Bridges The task of strategic analysis is more than laying out a plan or plans. When time-series links between projects are im portant, it’s better to think of strategy as managing the firm’s portfolio of real op tions [Kestler 1982]. The process of finan cial planning may be thought of as: (1) Acquiring options, either by investing directly in R&D, product design, cost or quality improvements, and so forth, or as a by-product of direct capi tal investment (for example, investing in a Stage 1 project with negative NPV in order to open the door for Stage 2). 2) Abandoning options that are too far “out of the money” to pay to keep. (3) Exercising valuable options at the right time ? that is, buying the cash producing assets that ultimately pro duce positive net present value. There is also a lesson for current appli cations of finance theory to strategic is sues. Several new approaches to financial strategy use a simple, traditional DCF model of the firm, [For example, Fruhan 1979, Ch. 2].

These approaches are likely to be more useful for cash cows than for growth businesses with substantial risk and intangible assets. The option value of growth and intangibles is not ignored by good managers even when conventional financial techniques miss them. These values may be brought in as “strategic factors,” dressed in non-financial clothes. Dealing with the time series links between capital investments, and with the option value these links create, is often left to strategic planners. But new developments in finance theory promise to help. Conclusion

Myers argued that the standard discounted cash flow techniques will tend to understate the option value attached to growing, profitable lines of business. To bridge the gap between strategic planning and finance theory, Myers suggested that the financial theorist need to apply existing finance theory correctly and extend the theory on real option pricing to model time-series interactions between investments. Both sides should reconcile financial and strategic analysis to uncover hidden assumptions to have deeper understanding on strategic choices.

Cite this Finance Theory and Financial Strategy

Finance Theory and Financial Strategy. (2016, Sep 16). Retrieved from https://graduateway.com/finance-theory-and-financial-strategy/

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