ICSAN Financial Strategy cheat sheet

Shareholder wealth maximisation is measured by NPV of expected future cash flows discounted at the cost of capital; profit maximisation ignores timing, risk and capital employed.

Agency problem: managers (agents) may pursue perquisites, empire-building or risk-avoidance; mitigation tools are performance-related pay, share options, debt covenants and the threat of takeover.

Financial strategy links three decisions: investment (where to deploy capital), financing (debt/equity mix) and dividend (distribution) policy; all three must be internally consistent.

The finance function's roles: stewardship and control, funding, risk management, decision support, and strategic business partnering.

Sustainable growth rate g = retention ratio b x return on equity, or b x (net profit/sales) x (sales/assets) x (assets/equity) using the DuPont identity.

Value drivers: sales growth, operating margin, capital intensity (sales/capital employed) and cost of capital; firm value rises when ROIC exceeds WACC and growth is funded at that spread.

Free cash flow to the firm = EBIT(1-t) + depreciation - capital expenditure - increase in working capital.

Balanced scorecard perspectives: financial, customer, internal process, learning and growth; financial measures are lagging, non-financial drivers are leading.

Stakeholder map: shareholders, lenders, employees, customers, suppliers, regulators, government, local community; each has differing claims on cash flow and risk appetite.

Corporate governance codes generally separate the roles of chair and CEO, require independent non-executive directors, and mandate audit and remuneration committees.

Agency costs of debt: asset substitution (risk-shifting), underinvestment and claim dilution; lenders price these in or impose covenants.

Covenants are affirmative (maintain insurance, report accounts) or negative/restrictive (limit further debt, dividends, asset sales); breach triggers default or renegotiation.

Stakeholder vs shareholder models: shareholder primacy maximises equity value; stakeholder/pluralist models balance employee, creditor and community interests.

Regulatory environment affects cost of capital via disclosure requirements, listing rules, competition law and tax treatment of debt interest.

Principal-agent monitoring devices: audited financial statements, independent board committees, disclosure rules and incentive alignment.

Signalling theory: dividend increases and debt issuance signal management's private information about future cash flows.

NPV = sum of CFt/(1+r)^t minus initial outlay; accept if NPV > 0. NPV is additive and uses cash flows, not accounting profit.

IRR is the discount rate at which NPV = 0; decision rule IRR > cost of capital, but IRR can give multiple answers with non-conventional cash flows and ignores scale.

Payback period ignores cash flows after the cut-off and the time value of money; discounted payback corrects the latter only.

Profitability index = PV of future cash flows / initial investment; useful when capital is rationed (rank by PI).

Relevant cash flows are incremental and after tax; exclude sunk costs, allocated fixed overheads and financing costs already captured in the discount rate.

Tax-allowable depreciation (capital allowances) creates a tax shield: tax saving = allowance x tax rate, added to cash flow in the year claimed.

Replacement decisions compare equivalent annual cost = NPV of the asset's life-cycle cost / annuity factor for its life.

Sensitivity of a project = NPV / PV of the variable's cash flows; expresses the percentage change in a variable that makes NPV zero.

WACC = (E/V) x Ke + (D/V) x Kd x (1 - t), using market values of equity and debt.

CAPM: Ke = Rf + beta x (Rm - Rf); beta measures systematic risk only; unsystematic risk is diversifiable and not priced.

Dividend growth model: Ke = D1/P0 + g, where g = b x ROE (b = retention ratio).

Debt cost is the yield to maturity on traded debt, or the coupon adjusted for issue costs; interest is tax-deductible so use the after-tax cost.

Modigliani-Miller without tax: firm value is independent of gearing; with tax: value rises by t x D (tax shield), offset by financial distress costs.

Trade-off theory: optimal gearing balances the tax shield against expected bankruptcy and agency costs of debt.

Pecking order: firms prefer internal funds, then debt, then new equity, due to information asymmetry and issue costs.

Asset beta vs equity beta: relever with beta_e = beta_a x [1 + (1 - t) x D/E]; use asset beta to compare projects in different industries.

Equity sources: retained earnings, rights issue (pre-emptive, discounted), placing (fast, institutional), public offer; issue costs and dilution differ by method.

Debt sources: bank term loans, overdrafts, bonds/debentures, convertible bonds, mezzanine; convertibles lower coupon but dilute if converted.

Rights issue price and terms: theoretical ex-rights price = (market value before + proceeds) / shares after; value of a right = TERP - subscription price.

Leasing vs buying: compare the after-tax cost of borrowing on the asset against lease rentals, both discounted at the after-tax borrowing rate.

Short-term finance: trade credit, bank overdraft, commercial paper, invoice discounting and factoring; factoring transfers administration and credit risk.

Islamic finance prohibits interest (riba); common structures include murabaha (cost-plus sale), mudaraba (profit-sharing) and sukuk (asset-backed certificates).

Efficient market hypothesis: weak form (past prices), semi-strong (public information), strong (all information including private); most evidence supports semi-strong.

Venture capital and private equity supply equity to unlisted firms; exit routes are IPO, trade sale, secondary buyout or recapitalisation.

Free cash flow to equity = net income + depreciation - capex - increase in working capital + net new debt; discount at Ke to get equity value.

Free cash flow to firm discounted at WACC gives enterprise value; subtract net debt to get equity value.

P/E valuation: value = sustainable earnings x appropriate P/E; the P/E must reflect growth, risk and payout of the target.

Dividend valuation model: P0 = D1/(Ke - g); valid only when g < Ke and growth is sustainable.

Net asset valuation suits asset-holding or property companies; it ignores going-concern earnings and intangible value.

Synergy value = value of combined entity minus sum of standalone values; acquirer premium should not exceed synergy value.

Merger defences: white knight, poison pill, staggered board, crown-jewel sale, share buyback; acquisition accounting vs merger accounting affects reported goodwill.

Restructuring types: divestment/spin-off, management buyout (MBO), leveraged buyout (LBO), demerger, and recapitalisation.

Forward contract: binding obligation to buy/sell at a fixed price on a future date; zero upfront cost but counterparty credit risk.

Future: exchange-traded, standardised, marked to market daily with margin calls; basis risk = spot price minus futures price.

Call option gives the right, not the obligation, to buy at the strike; put gives the right to sell; buyer pays a premium, seller bears unlimited risk (calls).

Interest rate swap: exchange fixed for floating payments; used to convert fixed-rate debt to floating or vice versa without refinancing.

Forward rate agreement (FRA) fixes an interest rate for a future borrowing period; settlement is the discounted interest differential.

Money market hedge: borrow or lend in the foreign currency now to lock the domestic value of a future foreign cash flow.

Purchasing power parity and interest rate parity link exchange rates to inflation and interest differentials; forward rate = spot x (1 + r_domestic)/(1 + r_foreign).

Value at risk (VaR) estimates the maximum loss over a given horizon at a stated confidence level; it says nothing about losses beyond the threshold.

Dividend irrelevance (Modigliani-Miller): in perfect markets, dividend policy does not affect shareholder wealth; it is a residual of investment policy.

Residual dividend policy: pay dividends only after funding all positive-NPV projects at the target capital structure.

Clientele effect: different investor groups prefer different payout patterns (income vs growth); changing policy may shift the shareholder base.

Lintner model: dividend change = adjustment factor x (target payout ratio x earnings - previous dividend).

Working capital cycle = inventory days + receivable days - payable days; shortening it releases cash.

Economic order quantity EOQ = square root of (2 x annual demand x order cost / holding cost per unit).

Credit policy decision: relax credit terms only if the incremental contribution exceeds the cost of extra receivables, bad debts and discount taken.

Miller-Orr model sets upper and lower cash limits; return point = lower limit + (3/4) x spread, where spread depends on transaction cost and variance of cash flows.

Percentage-of-sales forecasting: forecast sales, then scale variable costs and working capital with sales; fixed costs and depreciation stay constant unless capacity changes.

Cash budget records receipts and payments when they occur, not when earned or incurred; it identifies short-term funding needs.

Sustainable growth rate = (ROE x retention ratio) / [1 - (ROE x retention ratio)] in the balance-sheet-consistent form.

ROCE = operating profit / capital employed; ROE = net income / equity; decompose ROE via DuPont: margin x asset turnover x leverage.

EVA = NOPAT - (WACC x invested capital); positive EVA means returns exceed the cost of capital.

Residual income = operating profit - (required return x capital employed); used to evaluate divisional managers on value creation.

Variance analysis: flex the budget for actual volume, then split the difference into price and quantity/efficiency variances.

Non-financial performance indicators (quality, cycle time, customer retention, employee turnover) are leading indicators of future financial results.