Financial Policy and Corporate Strategy: formula sheet

Key formulas

Three core strategic financial decisions

Investment decision + Financing decision + Dividend decision

Each must support the objective of shareholder wealth maximisation within risk and stakeholder limits.

Value-creation test (spread)

Value is created when Return on capital employed > Cost of capital

Use this to link any strategic choice to value. It is a decision rule, not a guarantee, as it depends on correct estimates.

Project acceptance rule

Accept if NPV > 0

NPV is the usual way to test whether an investment decision fits the value objective.

Investment acceptance rule

Accept if NPV > 0, or if IRR > cost of capital (for a conventional project)

The hurdle rate must reflect the project's risk, not just the firm's average cost.

Funds available for investment from internal sources

Retained earnings = Profit after tax − Dividends

Higher payout means lower retention, so more external financing is needed for the same investment.

Weighted average cost of capital

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

E and D are market or target-weight values; V = E + D; t is the tax rate.

Dividend payout ratio

Payout ratio = Dividend ÷ Earnings = DPS ÷ EPS

Retention ratio = 1 − payout ratio.

Value maximisation link

Firm value rises when returns on investment exceed the cost of capital and risk is controlled

Use this line to tie all three decisions to the shareholder wealth objective.

Retention ratio (b)

b = 1 − Dividend payout ratio = Retained earnings ÷ Net profit

Payout ratio is dividend ÷ net profit.

Return on equity (DuPont)

ROE = Net profit margin × Asset turnover × Equity multiplier

Equity multiplier = Total assets ÷ Equity.

Sustainable growth rate (on opening equity)

g = ROE × b, where ROE = Net profit ÷ Opening equity

Use when ROE is computed on beginning-of-period equity.

Sustainable growth rate (on closing equity)

g = (ROE × b) ÷ (1 − ROE × b), where ROE = Net profit ÷ Closing equity

Use when ROE is on year-end equity. Both versions give the same g for the same data.

Required external funds (growth gap)

Required new equity ≈ Opening equity × (target g − SGR), at constant leverage

This is an approximation. It holds the debt-equity ratio constant and uses opening equity as the base, so it equals the equity needed beyond retained earnings.

NOPAT

NOPAT = EBIT × (1 − tax rate)

Use operating profit before interest. Interest is not deducted because the capital charge already covers financing cost.

Economic Value Added

EVA = NOPAT − (WACC × Invested Capital)

Invested capital is usually opening capital employed, unless the question says otherwise. Use the capital definition given in the question.

EVA using spread

EVA = (ROCE − WACC) × Invested Capital, where ROCE = NOPAT ÷ Invested Capital

Shows that EVA is positive only when return exceeds cost of capital.

Market Value Added

MVA = Market value of the firm (equity + debt) − Capital invested

Capital invested is the book value of debt plus equity, with equity including reserves (that is, capital employed). If only equity is considered: MVA = Market value of equity − Book value of equity (including reserves).

Link between MVA and EVA

MVA = Present value of all future EVAs, discounted at WACC

A theoretical relationship. For a constant EVA lasting forever, MVA = EVA ÷ WACC.

Total shareholder return

TSR = (Dividend + Closing price − Opening price) ÷ Opening price

Measures the actual return to shareholders over the period.

Three strategy levels

Corporate (which businesses?) → Business (how to compete?) → Functional (how to execute?)

Use this chain to structure any answer on levels. Finance is a functional strategy that serves the other two.

Typical planning process

Objectives → Environment and internal analysis → Fund forecast → Evaluate alternatives → Implement → Monitor and revise

Order matters in a 'steps' question. Present it as a continuing cycle with feedback.

Financial policy areas

Investment policy + Financing policy + Dividend policy + Liquidity/working capital policy + Risk policy

Link each policy to the strategy level being discussed.

Risk-return alignment

Higher-growth strategy → higher funding need, risk and required return

This is a general tendency, not a fixed rule. Judge each case on its facts.

Quick revision

• The three core financial decisions are investment, financing and dividend.
• Financial decisions must support corporate strategy, not stand apart from it.
• The goal of financial management is usually stated as maximising shareholder wealth, not just profit.
• Profit maximisation ignores the timing of returns, risk and the value to shareholders.
• Sustainable growth needs a balance between growth, financing, risk and payout.
• Value creation measures compare returns earned with the cost of the capital used.
• EVA is generally computed as NOPAT minus a capital charge (capital employed × cost of capital).
• A positive EVA means returns exceed the cost of capital; a negative EVA means value is being eroded.
• MVA is generally the market value of the firm's capital minus the capital invested in it.
• Corporate strategy is usually discussed at corporate, business and functional levels.
• Financial strategy is a part of functional-level strategy and must align with the higher levels.
• In a numerical answer, show the formula, the working and the interpretation.

Common mistakes

• Treating financial policy and corporate strategy as the same thing. Fix: Say strategy decides what the firm wants to achieve and finance decides how to fund and control it. Show the two-way link.
• Listing the CFO's duties as only accounting and reporting. Fix: Include strategic roles: capital allocation, capital structure, risk management and advising on strategy.
• Treating the three decisions as independent topics. Fix: Always add a sentence on how one decision constrains the others, such as payout and retained funds.
• Confusing financial policy with corporate strategy. Fix: Strategy is about businesses and competitive position. Financial policy is the guidelines on funding, capital allocation and payout that support it.
• Using ROE × b when ROE is based on closing equity. Fix: Check the equity date. Closing equity needs the (1 − ROE × b) denominator.
• Using the payout ratio instead of the retention ratio. Fix: Always compute b = 1 − payout before multiplying.
• Deducting interest from EBIT before computing NOPAT. Fix: Start from EBIT and apply tax to get NOPAT. If you start from PAT, add back interest net of tax. Subtract the capital charge only afterwards, to get EVA.
• Using pre-tax cost of debt in WACC. Fix: Always use Kd × (1 − t) in WACC for EVA.
• Mixing up corporate-level and business-level strategy. Fix: Corporate asks which businesses to be in. Business asks how to win in one business. Test every case with these two questions.
• Treating financial policy as only a dividend or financing topic. Fix: List all policy areas: investment, financing, dividend, liquidity and risk, and tie each to the strategy.

Exam tips

• In case questions, tie every point to a fact from the scenario. Generic answers lose marks.
• Structure written answers as objective, decision, options, recommendation, CFO role.
• For MCQs, first spot the decision type (investment, financing or dividend), then eliminate options that mismatch it.
• Use bullet points and short headings in the answer. Examiners reward clear structure.
• Always give a final recommendation, even if the case data is incomplete.
• Structure theory answers by decision: define, factors, interaction, conclusion. Examiners reward clear headings in your answer.
• In case-based MCQs, look for the one fact that changes the answer, such as growth stage, earnings stability or leverage level.
• Always write the interaction point. It is what separates a good answer from a textbook copy.