Chapter 3. Financial policy

Corporations usually have some guidelines they use for financial management, such as dividend payout amounts or payout ratios, debt-to-equity ratios, accounts receivable-to-revenue ratios, and so on. As competition gets harder, simple rules-of-thumb or directionally right benchmarks are increasingly sub-optimal for corporate management purposes. Beyond the analytical techniques, however, optimal financial policy making involves superior insights into financial market dynamics, so that anticipated losses can be averted with appropriate risk management initiatives, and new market opportunities capitalized upon.

In this chapter, we discuss and demonstrate advanced quantitative techniques that are used to reach optimal financial policy decisions, and how they can be modified over time for dynamic optimization. We review issues around capital structure and show a quantitative model of how a theoretically optimal capital structure can be derived. Contingent convertibles are discussed as an example of recent innovations in derivatives used for leverage optimization. We review various asset- and liability-linked structured financing vehicles that are applied in practice, including alternative financing vehicles such as revolving lines of credit, banker’s acceptances, commercial paper, reverse repurchase agreements, revolving credit agreements, capital and operating leases, and mezzanine financing. We review operating leverage optimization through outsourcing. We discuss issues around dividend policy optimization. For example, the impact of share buybacks as an effective means of correcting under-pricing, and other dividend policy optimization issues. We discuss the issue of optimal pricing strategy, and how it differs from strategic pricing. We review absorption cost versus variable cost pricing models, and present a systems context for price response estimation.

Next, tax planning issues are discussed, including tax arbitrage methods, the SAVANT tax planning model, and other issues around global tax policy optimization. We look at effective tax rates of IBM, DaimlerChrysler, Procter & Gamble and Toyota, and discuss Nestlé’s tax planning including treatment of deferred taxation. We also review some of GlaxoSmithKline’s tax planning issues. We review capital investment policy, and take a look at how “real options” methodology is applied to a numerical example of a capital investment. We review the traditional discounted cash flow model of net present value (NPV), and how that is modified with the value of an expansion option, a contraction option, and a real option to choose. Real options analysis extends the traditional NPV estimate to an expanded NPV (ENPV).

We conclude this chapter with a review of merger and acquisition (M&A) policy, and discuss why such a large portion of M&A deals do not deliver the anticipated “synergies.” We look at IBM’s acquisition of PricewaterhouseCoopers, Glaxo Wellcome’s merger with SmithKline Beecham, and Exxon’s merger with Mobil.