Advanced Corporate Finance 125.

732 | Week 4 Study Notes

ADVANCED CORPORATE FINANCE

125.732 | Master of Applied Finance
WEEK 4 STUDY NOTES
Financial Planning & Forecasting | Multinational Financial Management
Chapters 12 & 17

📋📋 WEEK 4 SCOPE

Chapter 12: Financial Planning — AFN equation, forecasted financial statements, self-supporting
growth, financing feedbacks
Chapter 17: Multinational Financial Management — exchange rates, international monetary systems,
interest rate parity, purchasing power parity, foreign project NPV

MAF 125.732 | Week 4 | Chapters 12 & 17 | For exam preparation use only
Advanced Corporate Finance 125.732 | Week 4 Study Notes

MODULE 1: Financial Planning & Forecasting (Chapter 12)

1.1 Purpose of Financial Planning

Financial planning is the process of projecting future financial performance to identify capital needs,
evaluate strategic alternatives, and align operating decisions with the objective of intrinsic value
maximisation.
The Intrinsic Value Framework remains the governing model:
• Forecast FCF under alternative operating plans
• Determine capital required to support those plans
• Identify internal funding vs. required external financing (AFN)
• Evaluate outcomes: do projected FCFs, discounted at WACC, exceed invested capital?

⭐ EXAM TIP

Financial planning is NOT separate from valuation. Every forecast feeds back into the DCF model:
FCF/(1+WACC)^t.

Always connect planning outputs to the fundamental question: does ROIC exceed WACC?

1.2 Elements of Strategic Plans

Element Description Finance Implication

Mission statement Defines company's reason for being Sets the value-creation objective

Corporate scope Defines Determines capital intensity

products/markets/geographies
Corporate objectives Quantitative targets (ROIC, EVA) Benchmarks for financial
planning

Corporate strategies How objectives will be achieved Drives operating assumptions

Operating plan Detailed operational actions Inputs for IS and BS forecasts

Financial plan Funding strategy and capital structure Determines WACC and AFN

1.3 DuPont Decomposition — Diagnosing Performance Before Forecasting

Before forecasting, benchmark the firm against industry using the DuPont equation to diagnose value
drivers:

📐📐 DuPont Equation

ROE = (NI / Sales) × (Sales / Total Assets) × (Total Assets / Equity)

= Profit Margin × Asset Turnover × Equity Multiplier

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Advanced Corporate Finance 125.732 | Week 4 Study Notes

Hatfield example:

ROE_Hatfield = 1.2% × 1.67 × 2.4 = 4.8%

ROE_Industry = 2.74% × 2.0 × 2.13 = 11.6%

Hatfield Weakness Interpretation

Lower profit margin (1.2% vs 2.74%) Higher interest expense erodes NI; also weak cost
control
Lower asset turnover (1.67 vs 2.0) Excessive receivables and inventory tying up capital

Higher leverage (×2.4 vs ×2.13) More debt than industry; increases financial risk

🔑🔑 CRITICAL INSIGHT

DuPont identifies WHERE value is leaking before you build the forecast.

Restoring profit margin and asset efficiency simultaneously boosts ROE and ROIC — and reduces
AFN.

1.4 The Additional Funds Needed (AFN) Equation

The AFN equation is a first-pass estimate of how much external capital the firm must raise to support
projected sales growth.

📐📐 AFN Equation

AFN = (A₀* / S₀)ΔS − (L₀* / S₀)ΔS − M × S₁ × (1 − POR)

Where:

A₀*/S₀ = Capital intensity ratio (assets required per $1 of sales)

L₀*/S₀ = Spontaneous liabilities ratio (A/P + accruals per $1 of sales)

ΔS = Change in sales = S₁ − S₀

M = Profit margin = Net Income / Sales

POR = Dividend payout ratio = Dividends / Net Income

S₁ = Projected next-year sales

Hatfield example (15% sales growth, S₀ = $2,000M):

AFN = (1,200/2,000)(300) − (100/2,000)(300) − 0.012(2,300)(0.625)

= $180 − $15 − $17.25

MAF 125.732 | Week 4 | Chapters 12 & 17 | For exam preparation use only
Advanced Corporate Finance 125.732 | Week 4 Study Notes

= $147.75 million

AFN Key Factors — Direction of Effect

Factor Increases Effect on AFN

Sales growth rate (g) AFN INCREASES — more assets needed

Capital intensity (A₀*/S₀) AFN INCREASES — more assets per dollar of sales

Spontaneous liabilities ratio (L₀*/S₀) AFN DECREASES — suppliers finance more

Profit margin (M) AFN DECREASES — more retained earnings

Dividend payout ratio (POR) AFN INCREASES — less retained earnings

⭐ EXAM TIP

The three MINUS terms reduce AFN — spontaneous liabilities and retained earnings are 'free'
financing sources.
A higher payout ratio forces MORE reliance on external capital — classic trade-off between dividends
and growth.

Note: AFN equation assumes constant ratios. The full forecasted financial statement model may give
a different result.

1.5 Asset-to-Sales Ratio Relationships

A critical assumption in the AFN equation is how assets scale with sales. Three scenarios:

Relationship Description Implication for AFN

Constant A*/S Every $1 of new sales requires same Simple — AFN equation applies
proportional investment in assets directly

Economies of scale Asset needs grow slower than sales A*/S ratio falls as sales grow —
(base stock effect) AFN overstated by simple
equation

Lumpy increments Assets added in large discrete steps Excess capacity region followed
(e.g., a new plant) by sudden large investment —
AFN is irregular

1.6 Self-Supporting Growth Rate

The self-supporting growth rate is the maximum sales growth achievable with zero external financing
(AFN = 0).

📐📐 Self-Supporting Growth Rate

M(1 − POR) × S₀

g* = ──────────────────────────────

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Advanced Corporate Finance 125.732 | Week 4 Study Notes

A₀* − L₀* − M(1 − POR)S₀

Hatfield example:

g* = (0.012)(0.65)(2,000) / [1,200 − 100 − (0.012)(0.65)(2,000)]

= 15.60 / 1,084 = 1.44%

Interpretation: If sales grow < 1.44%, Hatfield needs NO external capital.

🔑🔑 CRITICAL INSIGHT

Self-supporting growth is inversely related to capital intensity.

A firm with high A*/S (asset-heavy) has a very LOW self-supporting growth rate — it quickly needs
external capital as it grows.

This is why ROIC > WACC must accompany growth — otherwise growth destroys value AND requires
costly external financing.

1.7 Forecasted Financial Statements

Two scenarios are commonly built:
• Steady Scenario: operating ratios held constant; gap filled by line of credit or surplus paid as
special dividend
• Target Scenario: ratios adjusted toward industry benchmarks, modelling a turnaround
Key assumptions for the Steady Scenario:
• Operating ratios remain unchanged from prior year
• Interest rate on all debt = 10%
• No new notes payable, LT bonds, or equity issued
• Line of credit (LOC) used as the 'plug' variable for any shortfall
• LOC tapped on last day of year (no extra interest in current year)
• Surplus funds returned as special dividend
• Regular dividends and sales both grow at 15%

Key differences between AFN equation result ($147.75M) and forecasted statements ($142.4M):
• Profit margin is NOT constant in the detailed model (interest expenses differ)
• Full model captures feedback loops that the simple equation cannot

1.8 Financing Feedbacks & Circularity

Financing feedbacks occur when new external financing (the LOC) adds interest costs that change NI,
retained earnings, and the balance sheet — requiring even more financing.

Step Event Consequence

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Advanced Corporate Finance 125.732 | Week 4 Study Notes

1 New LOC drawn down Additional interest expense incurred

2 NI falls due to higher interest Additions to retained earnings fall

3 RE on balance sheet declines Balance sheet no longer balances

4 More LOC needed to balance Cycle repeats (circularity)

Solutions to circularity:
• Manual iteration — repeat until balance sheet converges
• Excel Iteration feature — enable circular reference calculation
• Excel Goal Seek — find exact AFN that makes balance sheet balance
• Algebraic adjustment formula — quick approximation

1.9 Multi-Year Forecasts & Capital Structure Decisions

If multi-year forecasts show continuous LOC buildup, the board must intervene with structural decisions:
• Issue long-term debt (replaces short-term LOC with permanent capital)
• Issue equity (dilutes existing shareholders but reduces financial risk)
• Cut dividends (retains more earnings internally — reduces AFN)
• If surplus exists: buy back shares, purchase ST securities, pay down debt, or make acquisitions

⭐ EXAM TIP

The financial planning model is iterative — not a one-shot calculation.

Compensation plans should be tied to long-run value creation (EVA, ROIC), NOT to short-run
accounting metrics.

The model can be modified to maintain a target capital structure by adjusting LT debt and equity each
year.

MAF 125.732 | Week 4 | Chapters 12 & 17 | For exam preparation use only
Advanced Corporate Finance 125.732 | Week 4 Study Notes

MODULE 2: Multinational Financial Management (Chapter 17)

2.1 Why Multinationals Exist

Motivation Example

Seek new markets Expanding into emerging economies

Access raw materials Mining/oil firms operating in resource-rich regions

Gain new technologies Acquiring tech startups in foreign markets

Production efficiencies Lower-cost labour or specialised infrastructure

Avoid political/regulatory obstacles Manufacturing in low-tax jurisdictions

Diversify risk Geographic diversification reduces earnings volatility

2.2 Factors That Make Multinational Finance Different

Seven major complicating factors beyond domestic finance:

Factor Implication

Currency differences Cash flows denominated in multiple currencies; exchange rate risk

Language & cultural differences Negotiation, governance, and reporting complexities

Economic & legal systems Different accounting standards, contract enforcement, property
rights

Taxation Varying rates; double taxation treaties; transfer pricing

Government intervention Capital controls, price controls, subsidies, FDI restrictions

Political risk Expropriation, corruption, profit repatriation restrictions

Terrorism & crime Operational risk in certain regions

2.3 Exchange Rate Mechanics

2.3.1 Direct vs. Indirect Quotations
📐📐 Exchange Rate Quotations

Direct Quotation = Units of HOME currency per unit of FOREIGN currency

= 'How many dollars to buy 1 euro?' (e.g., $1.2500 per €)

Indirect Quotation = Units of FOREIGN currency per unit of HOME currency

= 'How many kronor does $1 buy?' (e.g., 7.00 SEK per $)

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Advanced Corporate Finance 125.732 | Week 4 Study Notes

Relationship: Direct = 1 / Indirect

e.g., Indirect for euro = 1/1.25 = 0.80 euros per $

Direct for kronor = 1/7.00 = $0.1429 per kronor

2.3.2 Cross Rates

📐📐 Cross Rate Calculation

Cross Rate (foreign₁ per foreign₂) = (foreign₁ per $) × ($ per foreign₂)

Example — kronor per euro:

Spot: 7.00 SEK per $ and $1.25 per €

Cross rate = 7.00 × 1.25 = 8.75 SEK per €

Euros per kronor (reciprocal) = 1/8.75 = 0.1143 €/SEK

⭐ EXAM TIP

Cross rates should be calculated from UNROUNDED direct/indirect rates to avoid rounding errors.

If both rates are reported, use reported cross rate directly — don't introduce extra rounding.

2.3.3 Currency Appreciation vs. Depreciation

📐📐 Appreciation / Depreciation

To measure whether currency X has appreciated vs. currency Y:

→ Express rate as units of Y per unit of X

→ If Y/X increases: X has APPRECIATED (buys more Y)

→ If Y/X decreases: X has DEPRECIATED

IMPORTANT: % appreciation of X ≠ % depreciation of Y (asymmetric).

Example: SEK/$ goes from 7.0 to 9.0

Dollar appreciated: (9−7)/7 = +28.6%

Krona depreciated: (0.1111−0.1429)/0.1429 = −22.2%

MAF 125.732 | Week 4 | Chapters 12 & 17 | For exam preparation use only
Advanced Corporate Finance 125.732 | Week 4 Study Notes

2.4 International Monetary Systems — Historical Evolution

Era / System Key Features & Outcome

Gold Standard (pre-1932) Paper money redeemable in gold at fixed price; required
international cooperation; FAILED due to WWI, Great Depression,
WWII
Bretton Woods (1944–1971) USD fixed to gold at $35/oz; other currencies fixed to USD; IMF
created; FAILED as countries could not maintain fixed rates

Post-1971: Floating Rates Market determines exchange rates with varying degrees of
government intervention
Pegged Systems ~70 countries fix their rate to another currency (e.g., Saudi Arabia
pegs to USD; Denmark to euro)

Managed Arrangements Country intervenes discretely (e.g., China pegs to undisclosed

basket)

Monetary Unions Multiple countries share one currency (e.g., EU/Euro since 2002;
European Central Bank controls policy)

Currency Convertibility
Type Definition Examples

Fully convertible (hard Freely traded at market rates; government All free-floating currency
currency) redeems at market prices nations

Partially convertible Actively traded but with government India, China

restrictions on amounts or purposes

Nonconvertible Not traded in FOREX markets due to Cuba, North Korea

(soft/blocked) government restrictions

🔑🔑 CRITICAL INSIGHT

Non-convertible currencies are a major barrier to MNC operations — firms cannot easily repatriate
profits.
Firms often resort to bartering goods for export when currencies are blocked.

2.5 Spot Rates vs. Forward Rates

Rate Type Definition & Use

Spot Rate Exchange rate for IMMEDIATE currency delivery; used in current
transactions

Forward Rate Rate agreed today for currency delivery at a FUTURE date; locks in
price, hedges exchange rate risk
Forward Premium Foreign currency is more expensive in forward market (indirect: forward
rate < spot rate); foreign currency is APPRECIATING

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Advanced Corporate Finance 125.732 | Week 4 Study Notes

Forward Discount Foreign currency is cheaper in forward market (indirect: forward rate >
spot rate); foreign currency is DEPRECIATING

⭐ EXAM TIP

Example: Spot = 110 ¥/$ and Forward = 100 ¥/$.

Dollar buys fewer yen forward → yen is APPRECIATING → yen sells at a FORWARD PREMIUM.

Remember: Premium/discount is described from the perspective of the FOREIGN currency.

2.6 Interest Rate Parity (IRP)

IRP states that identical-risk securities in all countries should yield the same return after accounting for
exchange rate movements. If parity breaks, arbitrage restores it.

📐📐 Interest Rate Parity — Single Period

Forward Rate (direct) 1 + r_h

─────────────────────── = ────────

Spot Rate (direct) 1 + r_f

r_h = periodic interest rate in HOME country

r_f = periodic interest rate in FOREIGN country

Implied Forward Rate = Spot Rate × [(1 + r_h) / (1 + r_f)]

Example (euro vs. USD, 180-day period):

Spot = $1.2500/€, r_h = 3% (US 6% annualised), r_f = 2% (France 4% annualised)

Implied Forward = 1.25 × (1.03/1.02) = $1.2623/€

Observed Forward = $1.2700/€ → Parity DOES NOT hold (arbitrage possible)

📐📐 Interest Rate Parity — Multi-Period (for Foreign Project Analysis)

Expected Future Exchange Rate ( 1 + r_h )^t

────────────────────────────── = ( ─────────── )

Spot Rate ( 1 + r_f )

Use this to convert projected foreign cash flows to home-currency equivalents.

MAF 125.732 | Week 4 | Chapters 12 & 17 | For exam preparation use only
Advanced Corporate Finance 125.732 | Week 4 Study Notes

Arbitrage When IRP Fails

When the observed forward rate ≠ implied forward rate, arbitrageurs can earn riskless profit:
• Borrow in the low-rate country
• Convert at spot rate
• Invest in the high-rate country
• Simultaneously lock in the forward rate to convert back
• Repay the loan; keep the spread as profit
Market pressure from arbitrage pushes spot rates, forward rates, and interest rates back toward parity.

🔑🔑 CRITICAL INSIGHT

IRP is the bridge between interest rates and exchange rates.

If a country has HIGHER interest rates → its currency must be expected to DEPRECIATE (otherwise
arbitrage would occur).

In equilibrium: high r_h → forward rate > spot rate (home currency depreciates forward).

2.7 Purchasing Power Parity (PPP)

📐📐 Purchasing Power Parity

P_h = P_f × Spot Rate

Or equivalently: Spot Rate = P_h / P_f

Where P_h = home-country price, P_f = foreign-country price

Example: Jerky costs $2.00 in US, spot = $1.25/€

PPP price in France: P_f = $2.00 / $1.25 = €1.60

Parity Condition What it equates

Interest Rate Parity (IRP) Return on similar-risk bonds across countries (via forward rates)

Purchasing Power Parity (PPP) Price of identical goods across countries (via spot rates)

Link between them Countries with higher inflation → higher interest rates → currency
expected to depreciate

2.8 International Financial Markets

Market / Instrument Description

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Advanced Corporate Finance 125.732 | Week 4 Study Notes

Eurodollar market USD held and traded outside the US (mainly Europe); large short-
term loan market for MNCs

Foreign bonds Bonds issued by a foreign borrower denominated in the LOCAL

currency (e.g., Yankee bond = foreign issuer in USD)
Eurobonds Bonds issued in a country OTHER THAN the one in whose
currency they are denominated (e.g., USD bond issued in Japan)

Capital structure variation Early research suggested wide variation across countries;
controlled studies show more similarity than initially thought

2.9 Risks Specific to Multinational Operations

Exchange Rate Risk
• Short-term: mitigated using forward contracts to lock in rates
• Long-term: harder to hedge; firm remains exposed to multi-year rate movements
• Strengthening home currency → foreign profits worth less when repatriated

Political Risk from Host Country

• Restrictions on converting local currency (profits trapped)
• Government price controls on subsidiary's products
• Expropriation — seizure of the subsidiary's assets
• Corruption — demands for bribes by government officials

Taxation Risk
Period Tax Treatment of Foreign Earnings

Pre-2018 Foreign earnings brought back to US taxed at US rates; high rates made
repatriation very costly; ~$2.6T trapped offshore

TCJA 2017 (one-time) Tax on all accumulated foreign earnings since 1986: 15.5%
(cash/equivalents), 8% (other); paid over 8 years

Post-2018 (ongoing) No US tax on future foreign earnings — territorial tax system

2.10 Foreign Project Analysis — NPV in Foreign Currency

Approach: project cash flows in foreign currency → convert to home currency using IRP → discount at
risk-adjusted cost of capital for equivalent domestic project.

📐📐 Foreign Project NPV — Step-by-Step Method

Step 1: Forecast cash flows in foreign currency (e.g., ¥)

Step 2: Use multi-period IRP to find expected exchange rates at each period:

E(rate)_t = Spot × [(1 + r_h) / (1 + r_f)]^t

Step 3: Convert CF_t(¥) to CF_t($) = CF_t(¥) × E(rate)_t

MAF 125.732 | Week 4 | Chapters 12 & 17 | For exam preparation use only
Advanced Corporate Finance 125.732 | Week 4 Study Notes

Step 4: Discount dollar CFs at domestic risk-adjusted WACC

Example — US project in Japan:

CF₀ = −¥1,000M, CF₁ = ¥500M, CF₂ = ¥800M

Spot = 0.009091 $/¥ (= 1/110), r_h(US) = 2.0%/2.8%, r_f(JP) = 0.05%/0.26%

E(rate)₁ = 0.009091 × (1.02/1.0005) = 0.009268 $/¥

E(rate)₂ = 0.009091 × (1.028/1.0026)² = 0.009557 $/¥

CF₀($) = −¥1,000M × 0.009091 = −$9.09M

CF₁($) = ¥500M × 0.009268 = $4.63M

CF₂($) = ¥800M × 0.009557 = $7.65M

NPV = −9.09 + 4.63/1.10 + 7.65/1.10² = $1.44M ✓ (Accept project)

⭐ EXAM TIP

Use MULTI-PERIOD IRP — not a single forward rate — when cash flows span multiple years.

The risk-adjusted WACC used is the DOMESTIC equivalent project rate, not the foreign country rate.

This method implicitly assumes that all exchange rate risk is priced into the IRP relationship.

2.11 International Working Capital Management

Area Key Difference vs. Domestic Practical Consideration

Cash management Larger distances; access to more Netting across currencies reduces
loan/investment markets; multi-currency transaction costs
cash pools

Credit management More critical in trade with less-developed Export credit risk insurance;
countries; credit extended in foreign exchange rate exposure on
currency receivables
Inventory Multiple storage locations; shipping times; Safety stock decisions more
management import duties; exchange rates affect cost complex; local sourcing may
of goods reduce FX risk

MAF 125.732 | Week 4 | Chapters 12 & 17 | For exam preparation use only
Advanced Corporate Finance 125.732 | Week 4 Study Notes

MASTER FORMULA REFERENCE — Week 4

📐📐 1. AFN Equation

AFN = (A₀*/S₀)ΔS − (L₀*/S₀)ΔS − M × S₁ × (1 − POR)

📐📐 2. Self-Supporting Growth Rate

g* = M(1−POR)S₀ / [A₀* − L₀* − M(1−POR)S₀]

📐📐 3. DuPont Equation

ROE = (NI/S) × (S/TA) × (TA/E) = Profit Margin × Asset Turnover × Equity Multiplier

📐📐 4. Cross Rate

Cross Rate (currency A per currency B) = (A per $) × ($ per B)

📐📐 5. Currency Appreciation (% change)

% change in X vs Y = (New Y/X rate − Old Y/X rate) / Old Y/X rate

📐📐 6. Interest Rate Parity — Single Period

Forward Rate / Spot Rate = (1 + r_h) / (1 + r_f)

Implied Forward = Spot × (1 + r_h) / (1 + r_f)

📐📐 7. Interest Rate Parity — Multi-Period

Expected Future Rate_t / Spot Rate = [(1 + r_h) / (1 + r_f)]^t

📐📐 8. Purchasing Power Parity

Spot Rate = P_h / P_f (or equivalently: P_h = P_f × Spot Rate)

📐📐 9. Foreign Project NPV

CF_t($) = CF_t(foreign) × E(rate)_t

NPV = Σ [CF_t($) / (1 + r_domestic)^t]

MAF 125.732 | Week 4 | Chapters 12 & 17 | For exam preparation use only
Advanced Corporate Finance 125.732 | Week 4 Study Notes

CONCEPTUAL CONNECTIONS — Weeks 1–4

Week 4 extends the core valuation framework established in Weeks 1–3 in two key directions:

Week 4 Concept Connection to Prior Weeks

AFN & Financial Planning The planning model is a forward-looking FCF and WACC model —
directly feeding the DCF formula from Week 1 (Value =
ΣFCFt/(1+WACC)^t)

ROIC > WACC in growth context Growth adds value ONLY if ROIC > WACC — first introduced with
Computron (Week 1); reinforced in self-supporting growth and
forecasting scenarios

DuPont decomposition Links to NOPAT and NOA concepts from Week 1 — NI/S relates
to operating profitability; S/TA relates to capital requirement ratio
(CR = OpCap/Sales)

Financing feedbacks & capital Previews Module 4 on capital structure; connects to WACC (Week
structure 2/3) — new debt changes both r_d and the WACC

Interest Rate Parity Extension of bond valuation (Week 2) to international context —

bonds in different countries must offer same risk-adjusted return
(else arbitrage)
Foreign Project NPV Same DCF methodology from Weeks 1–3, with extra step of
converting foreign CFs to home currency using IRP before
discounting at domestic WACC
Exchange Rate Risk Adds a new dimension to the risk side of the WACC framework —
affects both FCF (revenue/cost) and discount rate (required return)

🔑🔑 CRITICAL INSIGHT

The fundamental question never changes: Value = Σ FCFt / (1+WACC)^t.

Chapter 12 determines the NUMERATOR (forecast FCFs via operating plan).

Chapter 17 complicates BOTH numerator (foreign currency CFs) and denominator (global risk factors
affecting WACC).

Both chapters ultimately serve the goal of maximising intrinsic firm value — which is the primary
objective introduced in Week 1.

— End of Week 4 Study Notes —

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