7th December , 2013
The chapter describes a relationship between Financial Theory and Financial Strategy and initiates the discussion with defining stratgy planning as a process of deciding how to committ the firm’s resources across different line of business while the financial side of strategic planning allocates a particular resource and capital. Although finance theory has made major advances in their applicability over the financial markets and although the financial tools like discounted cash flow valuation is widely used, there are still relevant differences between finance theory and strategic planning and the chapter deals with this discussion primarily. In nutshell, the chapter offers three explanations:
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- Finance theory and traditional approaches to strategic planning may be kept apart by differences in languages and culture.
- Discounted cash flow analysis may have been misused and consequently not accepted, in strategic applications
- Even if the discounted cash flow analysis are applied correctly, it may fail at the time of applicability in strategic applications.
Two Cultures and One Problem:
Directing the first cause of difference between strategic planning and financial theory, author cites both as two cultures looking at one common problem, however, the only difference between languages and approach make both incomparable. Although the gap between them can be bridged with better communication and with efforts to reconcile them, and in the absence of which a standard DCF valuation might go wrong in the following ways:
- There is 50% probability of a positive NPV for a border line project and thus firms have to take a guard against these errors dominating the project choice.
- Since all projects are having zero NPV in long run competitive equilibrium, thus a positive NPV factor has to be explained by the managers by a short term deviations from equilibrium or by some competitive advantage and in the absence of such explanation even a positive NPV is a suspect and vice versa for a negative NPV factor.
In other words, a prudent financial manager will not accept any NPV factor whetehr positive or negative unless he could explain it and that explanation is not possible without strategy planning which itself comes with random error. Thus, the author concludes that the gap between financial theory and strategy planning is more than just ‘’two cultures and one problem’’.
Misuse of financial theory:
Even correct DCF Valuation may not be correct:
- Estimating the correct discount rates
- Estimating the project’s future cash flows
- Estimating the project’s impact on firm’s other assets cash flow
- Estimating project’s impact on firm’s future investment opportunities.
Finally, author concludes the chapter with the idea that, strategy planning needs finance and finance needs strategy planning and thus corporate finance theory should now bridge the gap between two of them by applying finance theory correctly and by using option price theory to deal with real options.
Works Cited
Myers, S. (1988). Finance Theory and Financial Strategy. In Risk Management (pp. 54-63). Massachusetts: Massachusetts Institute of Technology.
