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F3, F2 and P3
Financial Strategy,
Advanced Financial
Reporting and
Risk Management
The previous articles in this series,
published in December 2014 and January
2015, covered methods of determining an
entitys weighted-average cost of capital
(WACC) and related calculations. Now lets
try applying these to a numerical scenario
By John B Riordan FCMA, CGMA
I have segmented my WACC analysis of the following
scenario into logical steps based on the key information
provided. Candidates should note that the same material
could be presented in a number of formats in an exam.
My approach is broken down into six steps:
Evaluate a simplified statement of financial position and
statement of profit or loss and other comprehensive income
for an entity, along with additional information thats
typically provided eg, variables relevant to the capital
asset pricing model (CAPM). This is the key starting point,
at which candidates are given guidance notes on how to

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approach summary financial data when they are

specifically addressing the WACC, especially where the
most appropriate way of determining the cost of each
element of the entitys capital structure isnt clear.
Make big-picture calculations addressing return on
capital employed (ROCE) and gearing for both book and
market valuations of debt and equity. Neither figure is
needed specifically to calculate the WACC, but both will
enable us to check that were heading in the right direction.
Calculate the cost of debt for the entitys various debt
instruments, taking into account market values where
applicable, as well as any relevant redemption criteria
concerning such debt.
Calculate the cost of equity. This will initially entail
evaluating the equity base in terms of valuation and returns
eg, dividend and earnings yields, both of which can be
simple surrogates for ke. We then expand this to take into
account dividend growth and distribution policy, which can
have an impact on the assessment of g for growth
models. Then we evaluate the CAPM approach separately.
Calculate the WACC itself, allowing for all that can be
derived above. The calculation will be presented in a
tabular format in this case, making it easier to ensure that
all relevant items, by market value (to enable weightings)
and relevant cost, are included.
Extend the WACC method into the approach proposed by
Merton Miller and Franco Modigliani, with a link on how to
approach adjusted present value (APV) calculations.
The scenario
The following information is provided in this case:
Extracts from the entitys statement of profit or loss and
other comprehensive income.
An extract from its statement of financial position.
Six years worth of historical financial data covering the
entitys dividends and earnings history.

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Other data, including the entitys most recent ex-dividend

share price.
The information is presented in tabular form. In each
table I have noted down my initial observations, proposing
possible applications for various figures where appropriate.
Extracts from the statement of profit or loss and other comprehensive income
Parameter

Sales

550

Cost of sales

(390)

Initial observations
These first three entries are standard items in a statement of
profit or loss and other comprehensive income, with limited
applicability to capital instruments in terms of immediate returns
(accepting fully that Ebit values will ultimately be the original drivers
of returns to capital providers).

Earnings before
interest and tax (Ebit)

160

Finance costs

(25)

This is the first case of where a return to providers of capital arises.

It rationally arises here because debt attracts a higher priority in the
cash flow waterfall, whereby interest is paid before any distributions
to equity providers. We now need to watch out for the kinds of debt
that may trigger the finance costs.

Tax

(50)

Interest payments will in themselves reduce taxable profit, which is

reflected in tax shield discussions below.

Profit after tax

85

This is the first instance in which distributable earnings arise, but

there may be an order of priority applying to such distributions.

Distributions to
preference
shareholders

(7)

Preference share capital is invariably first in line for subsequent

distributions. Watch out here for the coupon or dividend policy
applying to preference share capital.

Earnings available
for distribution to
ordinary shareholders

78

This is an important value on any statement of profit or loss and

other comprehensive income. Its relevant to business valuations and
earnings per share and price/earnings calculations.

Dividends to ordinary
shareholders

(31)

From this line we can derive the pay-out ratio and dividend per share.
If the right historical data is provided, we can also use it to estimate
dividend growth.

47

Retained earnings

In effect, this is the undistributed element of distributable earnings.

Note that this is not necessarily cash, because its derived from
accruals accounting principles and simply added to the book value
of equity/retained reserves.

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Extracts from the statement of financial position

Capital
instrument

Associated
information provided

Initial
observations

Long-term
bank borrowings

300

Floating rate, priced at

Libor + 1%, secured on
non-current assets. Assume
12-month Libor to be 4.5%.

This is a standard variable rate loan that is

priced at a total interest cost of 5.5%. The
associated cost of debt for this component
of the capital structure will simply be this rate
net of tax.

Redeemable
bonds

100

5% coupon, due in 5 years,

trading at 92 per 100
bond unsecured, but with
a cross-default clause.

The cost of debt of a redeemable bond, also

known as yield to maturity, is the internal rate of
return of the relevant cash flows underpinning
the bond, taking into account the market value,
coupon (net of tax) and redemption value
(assume redemption at a par value of 100).

Long-dated
bonds (treated
as irredeemable)

100

Coupon 3.5%, trading at

5 per 100 bond,
secured by a floating charge
on working capital.

This is included here for illustrative purposes

but not used in practice. The associated cost
of debt will be the coupon payment net of tax
relative to the market price of the instrument.

Preference
share capital

100

7% coupon, trading at par.

The cost of preference share capital is

calculated in a similar way to that of
irredeemable bonds, except there is no tax
adjustment, because the coupon is in effect
a dividend.

Ordinary
share capital

300

Nominal value 1 per share.

Several approaches available to calculate the

cost of ordinary share capital (ke) using (for
example) the dividend growth model and the
CAPM. This is our first indication of the number
of shares in issue, which will be relevant to the
calculation of the entitys market capitalisation
(share price given below).

Retained
reserves

600

Total equity
and liabilities

This figure is part of the book value of equity,

but its not to be double counted when
calculating the market value of equity (ie,
the market capitalisation).
In effect, this total figure is the combined value
of the capital structure, which enables us to
initially gauge the relative proportions of
debt/equity instruments while remembering
that the WACC will (where possible) be based
on market values.

1,500

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Historical financial data

Earnings and dividend history

T0 T1 T2 T3 T4 T5

Profit after tax (m)

78 74 72 67 60 55

Dividends (m)

31 30 28 26 24 21

Initial observations
The T0 values are consistent with those in the statement of profit or loss and other comprehensive income,
where profit after tax equates to earnings available for distribution to ordinary shareholders. With these
figures, we can calculate historical dividend pay-out ratios as well as earnings and dividend growth trends.
Note that, while six years worth of data is presented, we need to use the 5th root for compound annual
growth rate calculations, on the understanding that dividend growth will be key in our calculation of ke.

Other data
Parameter

Value
4

Most recent share

price (ex-dividend)

1.3

Equity beta (eg) of

comparable competitor
Competitors gearing

45%

Initial observations and/or likely applications

Market capitalisation, dividend valuation model, dividend and earnings
yields. (Always seek to use the ex-dividend value.)
Both of these parameters will be used to establish the ungeared beta
for the competitor or proxy entity ie, to work out the business risk
component of the beta coefficient (eu). We can assume that the gearing
is given by market values and is net of tax.

Estimated beta of
(non-risk-free)
debt instruments (d)

0.2

This figure is relevant to the expanded ungearing formula in the CAPM.

We can also use the CAPM to calculate the cost of debt (as a last resort
if nothing else is available).

Estimated return on
UK government gilts

3%

This is the Rf component of the CAPM. Its described in many ways, but
in essence its risk-free.

Estimated return on
the market portfolio

9%

This is the Rm component of the CAPM. Note that Rm Rf is known as

the market risk premium (so dont mix them up). In this case that figure
would be 6%.

Visualising the bigger picture before jumping in

WACC calculations typically refer to the market value of
the relevant instruments in the entitys capital structure.
At this point, therefore, you should seek to distinguish
between the book values presented (in the statement

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of financial position) and the market values, which can

be derived from the observations in the following table.
Distinguishing book values from market values
Book
value

Market
value

Observations /
basis for calculation

Long-term bank
borrowings

300m

300m

These values are the same (ignoring the existence

of any secondary market for such debt).

Redeemable bonds

100m

92m

Reflecting discount to 92 per 100 bond.

Long-dated bonds
(irredeemable)

100m

95m

Reflecting discount to 95 per 100 bond.

Preference share capital

100m

100m

Ordinary share capital (1

nominal value of shares)

600m

1,200m

Reserves

300m

The share price is 4, so the market cap is

1.2bn, assuming that 300 million shares are in
issue. Reserves are priced into the market cap,
so we need to avoid double counting.

1,500m

1,787m

This sum of equity and debt values is sometimes

known as enterprise value.

10.7%

8.9%

This assumes that the Ebit is 160m. The ROCE in

market-value terms will usually be lower than the
book-value ROCE purely because of the size of the
denominator. The figure can be used for g = r x b
calculations concerned with earnings retention.

500 1,500
= 33%

487 1,787
= 27%

This assumes that preference share capital is

considered equity. The figure will be relevant when
were approaching the CAPM and the regearing
of beta, while noting that the debt values will be
diluted by the (1 t) factor.

33:67

27:83

Instrument / initial
calculation parameters

Total in effect, capital

employed (Vd + Ve)
Return on capital
employed: Ebit (Vd + Ve)

Gearing: Vd (Vd + Ve)

Debt/equity ratio: Vd Ve

Trading at par, so book value equals market value.

This enables us to see that the entity is relatively

equity-rich, meaning that the WACC is more likely
to be biased in the direction of ke.

So far, we can infer that this appears to be an entity

characterised by low to moderate gearing ie, about
30 per cent. The eventual validity of this conclusion would
depend on the industry concerned and particularly on

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the volatility of the businesss cash flow and earnings.

There does seem to be a degree of debt capacity ie,
its likely that the company could, if it needed to, raise
additional debt funding and/or refinance existing debt
relatively easily.
Equally, we can see that the return on capital
employed is at a reasonable level of about 10 per cent.
These considerations will be useful when were working
through the detail below to calculate the WACC,
especially the costs of its various components.
Calculating the cost of debt
The first instrument is bank borrowings. Libor is set at
4.5 per cent in this case and the borrowing carries a
margin of 1 per cent, so the total pre-tax cost of debt is
5.5 per cent. On a post-tax basis, where the corporate tax
rate is assumed to be 30 per cent, the borrowing simply
carries a cost of 5.5% x (1 0.3) = 3.85%.
The second instrument is redeemable bonds. The
calculation of the cost (yield to maturity of a redeemable
bond is the applicable internal rate of return (IRR) after tax
based on the market value of the bond, assuming that the
bondholder is purchasing today, and its redemption value
(assume this is 100 if its not given), net of tax cash flows
in between (interest coupon after tax).
The IRR can be calculated by using simple net
present value (NPV) techniques, with cash flows shown
from the perspective of the bondholder (assume the same
tax rate as the entity). In this case we have a redeemable
bond trading at 92 per 100 bond, redeemable in five
years time at 100 (par) and paying a 5 per cent coupon
before tax ie, 3.5 per cent after tax. The figures required
are derived using the table on the next page.
The IRR is calculated using the following formula:
IRR = L + [(NPVL {NPVL NPVH})(H L)], where L is the
low discount rate and H is the high discount rate.

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Calculating high and low NPVs from the redeemable bond cash flows
T0 T1 T2 T3 T4 T5
Investment
(92m)
Interest flows after tax 3.5m 3.5m 3.5m 3.5m 3.5m
Redemption value

100m

Net cash flow

(92m) 3.5m 3.5m 3.5m 3.5m 103.5m

Discount factor @ 10%

1.000 0.909 0.826 0.751 0.683 0.621

Discounted cash flow @ 10%

(92m) 3.18m 2.89m 2.63m 2.39m 64.27m

NPV @ 10%(16.64m)
Discount factor @ 3%

Discounted cash flow @ 3%

(92m) 3.40m 3.30m 3.20m 3.11m 89.28m

0.971 0.943 0.915 0.888 0.863

NPV @ 3%

10.29m

In the expectation that the answer will fall logically

between 3 per cent and 10 per cent, the IRR is as follows:
3% + [(10.29 {10.29 16.64})(10% 3%)] = 5.67%,
noting that the two minuses convert into a plus.
A similar approach would apply to convertible bonds.
The difference is that the relevant redemption value of the
convertible is its potential equity value at the time the
conversion option is exercised.
The third instrument is long-dated bonds, for which the
maturity date is far enough away for us to treat them as
irredeemable and still obtain a reasonable approximation
of the cost of debt. The key here is to use the market
value of the bond (95 per 100 bond) as the basis for
calculating the cost/yield of the debt instrument. Here
we can apply the typical exam formula kd = (l[1 t]) P0.
In this case, therefore: kd = (3.5[1 0.3]) 95 = 2.58%.
Interim conclusion about the entitys cost of debt
What we have established here is that the three debt
instruments in the capital structure under consideration
are demonstrating a post-tax cost of debt (yield to

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John B Riordan is a
freelance lecturer and
specialist in corporate
finance with First
Intuition Ireland

maturity, where applicable) in the range of 2.58 per cent

to 5.67 per cent. This seems reasonable and its important
that candidates perform such sense-checks occasionally.
One way of doing so might be to apply the CAPM to
calculating kd, given that we are provided with the
requisite ingredients namely: kd = Rf + d (Rm Rf).
This would typically be a last resort for calculating the
cost of debt, because it relies on the availability and value
of the beta of debt coefficient (assuming that debt is a
marketable instrument) as well as of Rm and Rf both of
which are historical estimates. Note also that the beta of
debt instruments is anticipated to be relatively low. This is
because debt carries a lower risk profile than equity, as it
ranks higher in the cash flow waterfall. In this case the
beta is 0.2, with Rm and Rf given as 9% and 3% respectively.
Applying the CAPM formula to the numbers provided, we
have kd = 3% + 0.2 (9% 3%) = 4.2%, which is within the
range of values we have calculated above.
The fourth and final part of this complex series will cover
how to calculate our entitys cost of equity and, lastly, the
WACC itself.