Financial strategy formulation: formula sheet

Key formulas

Total shareholder return (TSR)

TSR = (P1 − P0 + D1) ÷ P0

P0 is opening share price, P1 closing price, D1 dividend received in the period. Compare with the cost of equity.

Earnings per share (EPS)

EPS = (Profit after tax − preference dividends) ÷ weighted average number of ordinary shares

Accounting measure. It ignores risk and the capital used.

Return on capital employed (ROCE)

ROCE = Operating profit (PBIT) ÷ Capital employed × 100%

Capital employed is usually total assets less current liabilities, or equity plus long-term debt. State your definition.

Economic value added (EVA)

EVA = NOPAT − (WACC × Capital employed at start of year)

NOPAT is net operating profit after tax, adjusted for items such as R&D or other accounting distortions. A positive EVA means value is created.

Market value added (MVA)

MVA = Market value of the firm's capital − Capital invested

Present value of future EVAs equals MVA.

Dividend cover

Dividend cover = Profit after tax ÷ Ordinary dividends

Shows how safely dividends are covered by earnings.

Shareholder return

Total shareholder return = (P1 − P0 + D) ÷ P0

P0 and P1 are opening and closing share price, D is dividends in the period. Useful as a bonus or performance measure.

Economic Value Added (EVA)

EVA = NOPAT − (WACC × capital employed)

Positive EVA means value is created after charging for capital. Often suggested as a manager performance measure.

Agency cost categories

Agency costs = monitoring costs + bonding costs + residual loss

A framework to list, not a calculation. Use it to structure discussion.

Market value of share (dividend valuation model)

P0 = D0(1 + g) ÷ (Ke − g)

Shows that share price depends on dividends, growth and risk. Use to test whether a strategy raises shareholder wealth.

Economy

Economy = actual cost of inputs compared with budget or benchmark cost, for the same quality

A lower cost for equal quality is better. Always state the quality condition.

Efficiency

Efficiency = outputs ÷ inputs (or cost per unit of output = total cost ÷ outputs)

Compare with prior periods, budget or similar bodies. Higher output per input, or lower cost per output, is better.

Effectiveness

Effectiveness = outcomes achieved ÷ outcomes targeted (or actual result against objective)

Measures whether the objective was met, not how cheaply. Outcomes are often qualitative.

Link between the 3Es

Inputs → (economy) → process → (efficiency) → outputs → (effectiveness) → outcomes

Use this chain to place any measure under the correct E.

M&M value of geared firm (no tax)

Vg = Vu

Value does not depend on gearing in a perfect market with no tax.

M&M cost of equity (no tax)

Ke(g) = Ke(u) + (Ke(u) − Kd) × D ÷ E

Ke(u) is the ungeared cost of equity. Kd is the cost of debt, assumed risk-free in the basic model.

M&M value of geared firm (with tax)

Vg = Vu + T × D

T is the corporate tax rate. D is the market value of permanent, irredeemable debt. T × D is the tax shield.

M&M cost of equity (with tax)

Ke(g) = Ke(u) + (Ke(u) − Kd) × (1 − T) × D ÷ E

Kd here is the pre-tax cost of debt. Use it with the permanent debt assumption.

WACC (with tax, M&M)

WACC = Ke(u) × (1 − T × D ÷ (D + E))

Valid with the M&M tax assumptions. WACC falls as gearing rises.

Ungeared cost of equity (with tax)

Ke(u) = [E × Ke(g) + D × Kd × (1 − T)] ÷ [E + D × (1 − T)]

Use to strip out financial risk. Equivalent to the formula for Ke(g) rearranged.

Weighted average cost of capital

WACC = Ke × E ÷ (E + D) + Kd × (1 − T) × D ÷ (E + D)

Use market values. Kd is the pre-tax cost of debt and the tax adjustment is applied here.

Dividend cover

Dividend cover = Earnings after tax ÷ Dividends

Shows how easily the dividend is paid from profit. Payout ratio is the inverse.

Gearing ratios

Debt ÷ Equity or Debt ÷ (Debt + Equity)

State which definition you use, and say whether you use book or market values.

Interest cover

Interest cover = Profit before interest and tax ÷ Interest

Measures ability to service debt.

Profitability index (single-period rationing)

PI = NPV ÷ capital invested in the rationed period

Rank divisible projects by PI, highest first, and fund down the list until the money runs out. The last project is taken in part.

Total NPV with a partial project

NPV of partial project = fraction funded × full NPV

Assumes the project is divisible and that its NPV scales in proportion. State this assumption.

Retention ratio

b = 1 − dividend payout ratio = (PAT − dividends) ÷ PAT

b is the share of profit kept in the business.

Return on equity

ROE = profit after tax ÷ shareholders' equity

Use the same equity basis (opening or closing) throughout. Say which you use.

Sustainable growth rate

g = b × ROE

Growth in equity and earnings that can be funded from retained profit, if ROE and gearing stay constant. It is an estimate, not a limit that can never be passed.

Rule for rationing type

Hard = imposed externally; Soft = imposed internally

Under single-period rationing, the NPV rule changes from accept all positive-NPV projects to maximise total NPV within the limit.

Quick revision

• The senior adviser gives reasoned, scenario-based advice to the board, not a list of theory.
• Shareholder wealth is driven by dividends and share price growth, so decisions are judged by their effect on both.
• Profit and earnings per share can be manipulated, so wealth-based measures are usually preferred for decisions.
• Agency problems arise when managers' interests differ from owners' interests; remedies include incentives, monitoring and governance.
• Lenders, employees, customers and society are stakeholders whose aims may conflict with shareholders.
• Not-for-profit bodies use value for money: economy, efficiency and effectiveness.
• Capital structure and dividend choices should fit the firm's objectives, risk and investment needs.
• Hard capital rationing is imposed externally; soft rationing is imposed inside the firm.
• Under single-period rationing with divisible projects, rank by profitability index; indivisible projects need combinations.
• Ethical and governance issues can justify rejecting an option that looks best on numbers.
• Always link advice to a fact in the scenario and give a clear recommendation.

Common mistakes

• Writing a generic list of the adviser's duties without applying it to the scenario. Fix: Tie each point to scenario facts such as the countries, currencies or stakeholders named in the case.
• Giving calculations with no recommendation. Fix: End with a clear recommendation. State what the board should do and why, based on your results.
• Using EPS growth as proof that shareholder wealth has increased. Fix: Explain that EPS ignores risk, capital invested and timing. Wealth needs share price and dividends compared with the required return.
• Calculating TSR without including the dividend, or dividing by the closing price. Fix: Use (P1 − P0 + D1) ÷ P0. Always divide by the opening price.
• Listing stakeholders and their aims without linking to the scenario. Fix: Use the company's name, facts and figures in every point. Each point should only be possible for this case.
• Describing the agency problem but offering no solutions. Fix: Always follow each problem with a specific control and say how it reduces the conflict.
• Saying an NFP body has no financial objectives. Fix: State that finance is a constraint and a means. The body must stay solvent and stay within its funding while delivering its mission.
• Mixing up efficiency and effectiveness. Fix: Efficiency is output per input. Effectiveness is whether the objective was achieved. Check which one the measure tests.
• Reciting M&M theory without linking it to the company. Fix: Keep theory short. For each point, say how it applies to this company's tax, cash, investor base or investment plans.
• Saying M&M proves that the best gearing is 100% debt, or that gearing never matters. Fix: State which version you use. Without tax, gearing is irrelevant. With tax, value rises with debt. Then explain real-world limits such as distress costs.

Exam tips

• Look at the requirement verb and the named reader, then match your format and tone to them.
• Link every point to the scenario. Generic role descriptions earn little.
• Finish with a clear recommendation. Include a condition or limitation to show judgement.
• Show professional skills deliberately: structure, analysis, scepticism about forecasts, and commercial awareness.
• Allocate time by marks. Do not spend most of the time on calculations when a large share of the marks is for advice.
• Always show formulas and state your assumption on capital employed or share counts so you can earn method marks even if an input differs.
• After every calculation, write a sentence of interpretation. Numbers alone score few marks in AFM.
• Discuss limitations of each measure, especially accounting distortion and short-termism. Examiners often ask for critical evaluation.