MAC3702

Managerial Finance
Seventh Edition
Managerial Finance
Seventh Edition
FO Skae (Volume editor)

M Com; MBA
FAA Vigario
B Com; CA (SA)
FJC Benade
B Sc; B Com (Hons); CA (SA)
A Combrink
B Com(Hons); CA (SA)
A de Graaf
M Com (Accounting); CA (SA)
L Esterhuyse
Com (Fin Man); CA (SA)
WD Jonker
B Compt (Hons); MBA
S Klopper
B Com (Acc) (Hons); CA (SA)
S Ndlovu
B Acc (Hons); MBL; ACMA; FCCA
AE Nobyati
B Com (Acc) Hons; CA (SA); RA; MBA
GJ Plant
BCom (Acc) (Hons); CA (SA); ACMA
BL Steyn
B Sc (Maths); B Compt (Hons); M Com (Accounting); D Com; CA (SA)
M Steyn
M Compt; CA (SA)
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© 2014
ISBN 978 0 409 12002 8

E-book ISBN 978 0 409 12000 4
First Edition 1999 eprinted 2005, 2006

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Preface
We find ourselves in a financial world that is in turmoil today. The c mplexity of the modern business environ-
ment is imposing an ever-growing demand on management, which requires a scientific approach to business
decisions. Consequently, managerial financing principles are used to an increasing extent to assist in the pro-
cess of decision-making. The managerial finance field continues to experience exciting change and growth,
while the future promises to be an even more exciting ti e for finance professionals.
There is a vast amount of knowledge required in the field of financial anagement. This textbook is aimed at
students undertaking an introductory or intermediate course in corporate finance looking for a single book that
will assist them from second year until their Qualifying Exam (QE). The primary objective of the book is to pro-
vide one “digestible”, affordable, South African textbook which can be used for more than one year by
students with limited time at their disposal.
The subject of Managerial Finance is fundamental to understanding and running a company. The subjects dealt
with in this textbook include strategy, the time value of money; risk; cost of capital; portfolio management and
the Capital Asset Pricing Model; the investment and financing decision; financial analysis; valuations; take-
overs, mergers, acquisitions and restructuring; working capital management; foreign exchange markets and
currency risk; money and capital markets; and interest rates and interest rate risk.
These topics form an integrated whole. Time value of money concepts, the analysis of financial statements and
failure prediction are essential pre-requisites for the valuation of business enterprises, while liquidations and
restructuring are the result of prolonged financial distress. These topics should be considered within the con-
text of the risk involved, working capital requirements and global and international developments in money
and capital markets.
The needs of South African universities have been taken into account in the compilation of this book. The text-
book has been updated to include sections on all the topics set out in SAICA’s syllabus and Competency
Framework. We wish to thank the various academics who have prescribed Managerial Finance for their valua-
ble input and sugg stions. The book could however also serve as a valuable reference aid to practicing finance
professionals.
The assistance of Robe t Skae and Lynette van den Heever in researching and compiling certain information is
acknowledged.
The Authors
Pretoria 2014
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Contents
Page
Chapter 1 The meaning of financial manage ent

1.1 Financial management........................................................................................................................ 1
1.2 Goal of an entity ................................................................................................................................. 2
1.2.1 Shareholder wealth maximisation ...................................................................................... 2
1.2.2 Stakeholder theory ............................................................................................................. 3
1.3 Business model or value creation model of an entity ........................................................................ 4
1.4 Stakeholders of an entity .................................................................................................................... 5
1.4.1 Key stakeholder groups ....................................................................................................... 6
1.4.2 Governance principles of stakeholder relations ................................................................. 6
1.4.3 Stakeholder engagement .................................................................................................... 7
1.4.4 Reporting to stakeholders ................................................................................................... 8
1.5 Risk and return of investors ................................................................................................................ 9
1.5.1 Business risk ........................................................................................................................ 9
1.5.2 Financial risk........................................................................................................................ 10
1.6 Overview of financial management.................................................................................................... 11
1.6.1 The investment decision ..................................................................................................... 12
1.6.2 The finance decision ........................................................................................................... 14
1.6.3 The management decision .................................................................................................. 17
1.7 Capital markets ................................................................................................................................... 17
1.7.1 Raising quity finance on the Johannesburg Securities Exchange ...................................... 17
1.7.2 Sustainability and responsible investment in the capital markets ..................................... 18
1.8 Valuation of a ompany ...................................................................................................................... 20
Practice Questions ......................................................................................................................................... 23
Chapter 2 Strategy and risk

2.1 Strategy and the business environment ............................................................................................. 28
2.2 The external environment .................................................................................................................. 29
2.2.1 The political environment ................................................................................................... 29
2.2.2 The economic environment ................................................................................................ 30
2.2.3 The social environment ....................................................................................................... 30
2.2.4 The technological environment .......................................................................................... 30
2.2.5 The regulatory environment ............................................................................................... 30
2.2.6 The market for the product or service ................................................................................ 31
2.2.7 The competitive environment ............................................................................................ 31
2.2.8 Understanding the market and customer needs ................................................................ 32
2.2.9 The natural environment .................................................................................................... 32
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2.3 Internal environment.......................................................................................................................... 32
2.3.1 Value chain analysis ............................................................................................................ 33
2.3.2 Product life cycle analysis ................................................................................................... 34
2.3.3 BCG Matrix .......................................................................................................................... 34
2.3.4 Resource audit .................................................................................................................... 35
2.4 SWOT and gap analysis ....................................................................................................................... 35
2.5 Selecting appropriate strategies ......................................................................................................... 36
2.5.1 Product-market strategies .................................................................................................. 37
2.5.2 Competitive strategies ........................................................................................................ 37
2.5.3 Growth strategies ............................................................................................................... 38
2.6 Implementing the strategies ............................................................................................................... 38
2.6.1 Aligning organisational performance with strategy ............................................................ 38
2.6.2 Measurement of performance and reporting against strategic objectives ........................ 39
2.7 Risk and the business environment .................................................................................................... 41
2.7.1 Risk management................................................................................................................ 41
2.7.2 Risk appetite ....................................................................................................................... 41
2.7.3 Risk management strategy .................................................................................................. 42
2.8 Governance principles relating to risk management .......................................................................... 42
2.9 Risk identification ............................................................................................................................... 44
2.10 Risk assessment and evaluation ......................................................................................................... 45
2.11 Risk responses..................................................................................................................................... 45
2.11.1 Risk avoidance..................................................................................................................... 45
2.11.2 Risk acceptance................................................................................................................... 45
2.11.3 Risk mitigation..................................................................................................................... 45
2.12 Monitoring and reporting on risks ...................................................................................................... 46
2.13 Enterprise risk management (ER ) .................................................................................................... 46
Practice questions .......................................................................................................................................... 47
Chapter 3 Present and future value of money

3.1 Time value of money .......................................................................................................................... 61
3.2 Future value ........................................................................................................................................ 62
3.2.1 Compound interest formula ............................................................................................... 63
3.2.2 Solving for interest rate (i) and number of periods (n) ....................................................... 64
3.2.3 Introducing periods of time compared to years ................................................................. 65
3.2.4 Future value of an annuity .................................................................................................. 66
3.3 Present value ............................................................................................................................................. 68
3.3.1 Pr s nt value of a perpetuity .............................................................................................. 73
3.3.2 Periodic payment of a loan ................................................................................................. 75
3.3.3 Present value of a perpetuity .............................................................................................. 76
3.4 Present value of shares ....................................................................................................................... 77
3.5 Present value of debt .......................................................................................................................... 81
Practice q estions .......................................................................................................................................... 85
Chapter 4 Capital structure and the cost of capital

4.1 Debt advantage................................................................................................................................... 92
4.2 Debt disadvantage .............................................................................................................................. 93
4.3 Financial gearing ................................................................................................................................. 95
4.4 Debt as part of the capital structure ................................................................................................... 97
4.5 Compensating providers of capital ..................................................................................................... 97
4.6 Traditional capital structure theory .................................................................................................... 98
4.7 The Miller and Modigliani theory ....................................................................................................... 101
4.8 The arbitrage process ......................................................................................................................... 102
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4.9 Optimal capital structure – traditional world ..................................................................................... 106
4.10 The cost of capital ............................................................................................................................... 107
4.10.1 Ordinary equity ............................................................................................................. ...... 108
4.10.2 Retained earnings ........................................................................................................... .... 109
4.10.3 Preference shares ........................................................................................................... .... 109
4.10.4 Debt..................................................................................................................................... 110
4.11 The Weighted Average Cost of Capital ............................................................................................... 110
4.12 Calculating the growth rate ................................................................................................................ 113
4.13 Cost of capital for foreign investments .................................................................... ........................... 115
4.13.1 Discount rate for a foreign investment ............................................................................... 115
Chapter 5 Portfolio management and the Capital Asset Pricing Model

5.1 Background to portfolio theory .......................................................................................................... 143
5.2 The concept of risk and return ........................................................................................................... 144
5.2.1 Investors’ attitudes to risk .................................................................................................. 145
5.2.2 Probabilities and expected values ...................................................................................... 145
5.2.3 Single-asset risk measures .................................................................................................. 146
5.2.4 Comparing the risk of two stand-alone assets/projects ..................................................... 149
5.3 Portfolio risk and return ..................................................................................................................... 150
5.3.1 Two-asset portfolio risk and return .................................................................................... 150
5.3.2 The efficient frontier ...................................................................................................... ..... 153
5.4 Diversification ..................................................................................................................................... 154
5.4.1 Systematic versus unsystematic risk ................................................................................... 154
5.5 The securities market line (SML) ........................................................................................................ 155
5.6 The capital asset pricing model (CAP ) ............................................................................................. 155
5.7 CAPM applications .............................................................................................................................. 159
5.7.1 CAPM and weighted average cost of capital (WACC) ......................................................... 160
5.7.2 CAPM and the investment appraisal decision .................................................................... 161
5.7.3 Limitations in using CAPM in investment appraisal decisions ............................................ 164
Chapter 6 The investment decision

6.1 Capital budgeting................................................................................................................................ 182
6.2 Correct WACC to be us d ................................................................................................................... 182
6.3 Traditional m thods of inv stment appraisal ..................................................................................... 184
6.3.1 Payba k period method ...................................................................................................... 184
6.3.2 Dis ounted payback period ................................................................................................. 185
6.3.3 Net p esent value method (NPV) ........................................................................................ 186
6.3.4 Net p esent value index method (NPVI) ............................................................................. 189
6.3.5 Different project life cycles ............................................................................................... .. 190
6.3.6 Internal rate of return (IRR) ............................................................................................... . 192
6.3.7 Comparative example of NPV and IRR ................................................................................ 193
6.3.8 Modified internal rate of return (MIRR) ............................................................................. 194
6.4 The investment decision ..................................................................................................................... 196
6.4.1 Inflation ............................................................................................................................... 196
6.4.2 Relevant costs and revenues .............................................................................................. 198
6.4.3 Opportunity costs and revenues ......................................................................................... 200
6.4.4 Discount rate (cost of capital) ............................................................................................. 200
6.4.5 Changes in working capital requirements ........................................................................... 201
6.4.6 The financing of the project ................................................................................................ 201
6.4.7 Tax losses ............................................................................................................................ 201
6.4.8 Recoupment/scrapping allowances .................................................................................... 201
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6.4.9 Taxation time lags ............................................................................................................... 201
6.4.10 Tax allowances .................................................................................................................... 201
6.5 The keep versus replacement investment decision ............................................................................ 205
6.6 Investing in an asset via an operating lease ....................................................................................... 213
6.7 Uncertainty and risk ............................................................................................................................ 215
6.7.1 Investment decision under conditions of uncertainty ........................................................ 216
6.7.2 Probability theory ............................................................................................................... 216
6.7.3 Decision trees...................................................................................................................... 217
6.8 Qualitative (non-financial) factors ...................................................................................................... 217
6.9 International capital budgeting .......................................................................................................... 218
6.9.1 Foreign direct investment ................................................................................................... 218
6.9.2 Direct and indirect quotes of exchange rates ..................................................................... 218
6.9.3 Purchasing power parity and the impact on future currency exchange rates .................... 218
6.9.4 International capital budgeting ........................................................................................... 219
Practice questions ..........................................................................................................................................
220
Chapter 7 The financing decision

7.1 Finance the lifeblood .......................................................................................................................... 249
7.2 Which form of finance? ...................................................................................................................... 250
7.3 Classification of different forms of finance ......................................................................................... 250
7.3.1 Tailor-made finance ............................................................................................................ 250
7.3.2 Sources of finance ............................................................................................................... 251
7.4 Equity as a source of finance .............................................................................................................. 251
7.4.1 Obtaining equity funds ........................................................................................................ 251
7.4.2 Stock market listing ............................................................................................................. 251
7.4.3 Rights issues ........................................................................................................................ 252
7.5 Preference shares ............................................................................................................................... 254
7.6 D e b t .......................... ................. ................. ................. ................ ................. ................. ................. ....
254
7.6.1 Bank loans ........................................................................................................................... 254
7.6.2 Loan capital ......................................................................................................................... 255
7.6.3 Advantages and disadvantages of debt compared to equity .............................................. 255
7.7 Convertible securities ......................................................................................................................... 255
7.8 Criteria applied by providers of finance/investors ............................................................................. 256
7.9 Overview of sources and forms of finance ......................................................................................... 256
7.10 Deciding on the b st financing option ................................................................................................ 257
7.11 Interaction b tw n the finance and investment decisions .............................................................. 258
7.11.1 Differen es between the investment decision and the financing decision ........................ 258
7.11.2 General prin iples ............................................................................................................... 259
7.12 Dete mining the most cost-effective form of finance ........................................................................ 259
7.13 Impact of section 24J of the Income Tax Act on the financing decision ............................................. 260
7.14 The lease or b y decision ................................................................................................................... 266
7.14.1 Types of leases .................................................................................................................... 266
7.14.2 The financing decision for leases ........................................................................................ 267
7.15 Cheap finance .....................................................................................................................................
270
7.16 Foreign finance ...................................................................................................................................
270
Appendix 1 .....................................................................................................................................................
271
Practice questions ..........................................................................................................................................
275
Ch pter 8 Analysis of financial and non-financial information

8.1 Financial reports .................................................................................................................................
279
8.2 Objectives and users of financial and non-financial analysis .............................................................. 280
8.2.1 Users of financial information ............................................................................................. 280
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8.3 Techniques used for financial and non-financial analysis ................................................................... 281
8.3.1 Comparative financial statements ...................................................................................... 282
8.3.2 Indexed financial statements .............................................................................................. 282
8.3.3 Common size statements.................................................................................................... 282
8.3.4 Financial analysis................................................................................................................. 282
8.3.5 Non-financial analysis ......................................................................................................... 314
8.3.6 The balanced scorecard ...................................................................................................... 315
8.4 Limitations of accounting data ............................................................................................ 315
8.5 Limitations of ratio analysis ................................................................................................ 316
Chapter 9 Working capital management

9.1 Levels of working capital ..................................................................................................................... 333
9.1.1 Permanent working capital ................................................................................................. 333
9.1.2 Temporary working capital ................................................................................................. 334
9.1.3 Net working capital ......................................................................................................... .... 334
9.2 Hedging or matching finance .............................................................................................................. 334
9.2.1 Perfect hedge ............................................................................................................... ....... 335
9.2.2 Conservative hedge............................................................................................................. 335
9.2.3 Appropriate forms of finance .............................................................................................. 336
9.2.4 The effects of conservative and aggr ssive financing ......................................................... 336
9.3 Cash management .............................................................................................................................. 337
9.3.1 Liquidity preference ........................................................................................................ .... 337
9.3.2 Cash operating cycle/business cycle ................................................................................... 337
9.3.3 Forecasting – asset requirements ....................................................................................... 338
9.3.4 Strategies to reduce the duration of cash cycles ................................................................ 340
9.3.5 The Baumol model for cash management .......................................................................... 340
9.3.6 The Miller-Orr model ...................................................................................................... .... 342
9.4 Debtors’ management ........................................................................................................................ 343
9.4.1 Credit policies...................................................................................................................... 343
9.4.2 Credit decisions and trade-offs ........................................................................................... 344
9.4.3 Collection policy ........................................................................................................... ....... 346
9.4.4 Evaluating credit on a Net Present Value (NPV) approach ................................................. 346
9.4.5 Debtor factoring.................................................................................................................. 348
9.5 Inventory management ...................................................................................................................... 348
9.5.1 The Economic Order Quantity (EOQ) .................................................................................. 350
9.5.2 Re-order point and safety inventory ................................................................................... 352
9.5.3 Just in Time (JIT) inventory and manufacturing .................................................................. 353
Chapter 10 Valuations of preference shares and debt

10.1 Reasons for unde taking valuations of preference shares or debt .................................................... 383
10.2 The disco nted cashflow method ....................................................................................................... 384
10.2.1 Drivers of value when using the discounted cashflow method .......................................... 384
10.2.2 Riskiness and the required rates of return on debt and preference shares. ...................... 385
10.3 Valuati n of preference shares .......................................................................................................... 386
10.3.1 Drivers of value ............................................................................................................ ....... 386
10.3.2 Types of preference shares, rights and attributes .............................................................. 386
10.3.3 Tax treatment and valuation inputs .................................................................................... 387
10.3.4 Valuing non-redeemable (perpetual) preference shares .................................................... 388
10.3.5 Valuing redeemable preference shares .............................................................................. 389
10.3.6 Valuing cumulative non-redeemable preference shares .................................................... 389
10.3.7 Valuing non-cumulative redeemable preference shares .................................................... 391
10.4 Valuation of debt ................................................................................................................................ 392
10.4.1 Drivers of value ............................................................................................................ ....... 392
10.4.2 Forms of debt and their characteristics .............................................................................. 392
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10.4.3 Tax treatment and valuation inputs .................................................................................... 393
10.4.4 Valuing bonds...................................................................................................................... 397
10.4.5 Valuing convertible debt ..................................................................................................... 400
Practice question ........................................................................................................................................... 402
Chapter 11 Business and equity valuations

11.1 Some of the intricacies of value .......................................................................................................... 408
11.2 Reasons for undertaking business and equity valuations ................................................................... 409
11.3 Underlying valuation theory ............................................................................................................... 409
11.3.1 Different definitions of value .............................................................................................. 409
11.3.2 Principles of financial reporting vs business valuation principles ....................................... 412
11.3.3 Valuation approaches, methodologies, methods and models ........................................... 415
11.4 Factors affecting the value of a business or equity interest ............................................................... 416
11.4.1 The relationship between value, risk and return ................................................................ 416
11.4.2 The business model............................................................................................................. 417
11.4.3 The going concern............................................................................................................... 417
11.4.4 Growth and the return that is derived from the assets ...................................................... 418
11.4.5 The business vehicle ........................................................................................................... 418
11.4.6 Investment in equity or net assets of a business (Inter ediate) ........................................ 420
11.4.7 Level of control (Intermediate) ........................................................................................... 421
11.4.8 Shares publicly traded on a securiti s xchange ................................................................ 422
11.4.9 Hidden factors .................................................................................................................... 422
11.5 Other valuation matters ..................................................................................................................... 423
11.5.1 Valuation premiums and discounts .................................................................................... 423
11.5.2 Generally accepted valuation standards ............................................................................. 424
11.5.3 Valuation report.................................................................................................................. 425
11.6 Discussion of certain valuation methodologies, methods and models .............................................. 425
11.6.1 Price of recent investment .................................................................................................. 426
11.6.2 Earnings multiples ............................................................................................................... 428
11.6.3 Market price multiples ........................................................................................................ 444
11.6.4 The Gordon Dividend Growth Model .................................................................................. 445
11.6.5 Models based on Free Cashflow ......................................................................................... 448
11.6.6 Model based on EVA®/MVA............................................................................................... 457
11.6.7 Net assets............................................................................................................................ 462
Appendix 1 .....................................................................................................................................................
464
Appendix 2 .....................................................................................................................................................
472
Chapter 12 Mergers and acquisitions

12.1 Strategic ontext ................................................................................................................................. 499
12.1.1 Fo ms of mergers and acquisitions ..................................................................................... 499
12.1.2 Reasons for takeovers and mergers .................................................................................... 501
12.1.3 Why mergers sometimes fail .............................................................................................. 503
12.1.4 Legal implications................................................................................................................ 504
12.1.5 Behavioural implications..................................................................................................... 504
12.2 Valuati n considerations .................................................................................................................... 505
12.2.1 Difference between ‘normal’ valuations and ‘merger/takeover’ valuations ...................... 505
12.2.2 Minimum share value ......................................................................................................... 506
12.2.3 Maximum share valuation .................................................................................................. 506
12.2.4 Fair share valuation ............................................................................................................. 506
12.2.5 Various forms of synergy benefits (financial and operational) ........................................... 507
12.2.6 Dividend valuation versus earnings valuation .................................................................... 507
12.3 Financial effects of acquisition ........................................................................................................... 507
12.3.1 Earnings growth .................................................................................................................. 508
12.3.2 The smart argument ........................................................................................................... 509
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12.4 Funding for mergers and acquisitions ................................................................................................ 511
12.4.1 Impact on capital structure ................................................................................................. 511
12.4.2 Methods of payment: cash versus share exchange ............................................................ 511
12.4.3 Management buy-outs........................................................................................................ 513
Chapter 13 Financial distress

13.1 Companies Act 71 of 2008 .................................................................................................................. 537
13.1.1 Business Rescue .................................................................................................................................. 538
13.2 Reorganisations (business rescue proceedings) ................................................................................. 542
13.2.1 Conditions for a reorganisation scheme ............................................................................. 543
13.2.2 Structure of a reorganisation scheme................................................................................. 546
13.2.3 Accounting entries .............................................................................................................. 548
13.3 Liquidations......................................................................................................................................... 551
13.3.1 Types of liquidations ........................................................................................................... 551
13.3.2 Rights of shareholders ........................................................................................................ 551
13.3.3 Accounting entries .............................................................................................................. 552
13.3.4 Simultaneous liquidation of crossholding co panies (Advanced) ..................................... 555
Chapter 14 The dividend decision

14.1 Dividend payment methods ............................................................................................................... 567
14.1.1 Constant dividend/earnings method .................................................................................. 568
14.1.2 Stable dividend payment method ....................................................................................... 568
14.1.3 Bonus issues/share splits and dividend reinvestment plans ............................................... 569
14.2 Dividend policy as “irrelevant in a perfect capital market” ................................................................ 570
14.3 Dividend decisions in an imperfect market ........................................................................................ 573
14.3.1 Statutory requirements ...................................................................................................... 573
14.3.2 Clientèle requirements ....................................................................................................... 574
14.3.3 Dividend stability and information content ........................................................................ 577
14.4 Alternative forms of dividend payment .............................................................................................. 577
14.4.1 Special dividend .................................................................................................................. 577
14.4.2 Capitalisation issues ............................................................................................................ 578
14.4.3 Share repurchases............................................................................................................... 578
14.5 Dividend policy in practice .................................................................................................................. 579
Chapter 15 The functioning of the foreign exchange markets and currency risk
15.1 Currency risk defined .......................................................................................................................... 584
15.1.1 Catego ies of currency risk .................................................................................................. 584
15.1.2 T ansaction risk ................................................................................................................... 584
15.1.3 Translation risk.................................................................................................................... 585
15.1.4 Economic risk ...................................................................................................................... 585
15.1.5 Other risks related to foreign currency transactions .......................................................... 586
15.2 Different currency quotes in the currency market ............................................................................. 586
15.2.1 Spot rates ............................................................................................................................ 586
15.2.2 Forward rates ...................................................................................................................... 589
15.3 Theories for determining forward exchange rates ............................................................................. 592
15.3.1 Interest rate parity theory .................................................................................................. 592
15.3.2 Purchasing power parity theory .......................................................................................... 594
15.3.3 International Fisher Effect ................................................................................................... 595
15.3.4 Expectations theory ............................................................................................................ 595
15.4 Factors influencing exchange rates .................................................................................................... 595
15.5 Hedging of currency risk ..................................................................................................................... 597
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15.6 Money market hedges ........................................................................................................................ 598
15.6.1 Money market hedges: hedging a foreign payment ........................................................... 599
15.6.2 Money market hedges: hedging a foreign receipt .............................................................. 601
15.7 Using forward exchange contracts (FECs) to hedge currency risk ...................................................... 602
15.8 Using foreign exchange futures contracts to hedge currency risk ..................................................... 605
15.8.1 The mechanics of a forex future ......................................................................................... 605
15.8.2 Forex futures – market data ............................................................................................... 607
15.9 Using foreign exchange option contracts to hedge currency risk ...................................................... 610
15.9.1 Over-the-counter (OTC) options versus traded options ..................................................... 610
15.9.2 Forex options trading in the JSE Currency Derivatives m rket ........................................... 610
15.10 Using currency swaps to hedge currency risk ................................................................................. .... 613
15.10.1 Long-term currency swaps.................................................................................................. 613
15.10.2 Short-term currency swaps................................................................................................. 614
15.11 Valuing forward exchange contracts (FECs) ....................................................................................... 615
Chapter 16 Interest rates and interest rate risk

16.1 Interest rate risk defined .................................................................................................................... 627
16.1.1 Interest bearing debt and interest rate risk ........................................................................ 628
16.1.2 Interest bearing investments and int r st rate risk ............................................................ 628
16.1.3 Listed interest bearing debt and int r st b aring investments .......................................... 629
16.2 The interest rate mechanism and the different interest rate base rates ........................................... 629
16.2.1 Repo rate............................................................................................................................. 629
16.2.2 JIBAR.................................................................................................................................... 629
16.2.3 Prime rate ........................................................................................................................... 629
16.3 The capital, debt and money markets ................................................................................................ 630
16.3.1 Money market..................................................................................................................... 630
16.3.2 Debt market ........................................................................................................................ 630
16.3.3 Capital market..................................................................................................................... 630
16.4 The level of interest rates in the financial markets ............................................................................ 630
16.4.1 Key general factors impacting on interest rates ................................................................. 630
16.4.2 The term structure of interest rates and other factors impacting on interest rates .......... 631
16.4.3 The interest yield curve ....................................................................................................... 632
16.4.4 Managing interest rate risk ................................................................................................. 632
16.4.5 The inter-relatedness between interest rate risk and other risks ...................................... 633
16.4.6 Derivative instruments which can be used to hedge interest rate risk .............................. 633
16.5 Treasury Bills............................................................................................................... ........................ 633
16.5.1 The t nd r................................................................................................................... ........ 634
16.5.2 Trading in Treasury Bills ...................................................................................................... 634
16.5.3 Trading when interest rates are declining .......................................................................... 634
16.6 Banke s’ Acceptances ......................................................................................................................... 635
16.6.1 T ading in Bankers’ Acceptances ........................................................................................ 636
16.6.2 Trading when interest rates are declining under a normal yield curve .............................. 636
16.6.3 Trading when interest rates are declining under an inverse yield curve ............................ 637
16.7 Neg tiable Certificates of Deposit ...................................................................................................... 637
16.7.1 Trading in Negotiable Certificates of Deposit ..................................................................... 638
16.7.2 Calculating the selling price ................................................................................................ 638
16.8 Forward rate agreements ..................................................................................................... .............. 639
16.9 Interest rate futures contracts ............................................................................................. ............... 641
16.9.1 Short-term interest rate (STIR) futures contracts ............................................................... 642
16.9.2 Bond futures contracts........................................................................................................ 644
16.10 Using interest rate options to hedge interest rate risk ....................................................................... 645
16.10.1 Options terminology ........................................................................................................... 646
16.10.2 Interest rate options ........................................................................................................... 646
16.10.3 Interest rate put options – payoff diagram ......................................................................... 651
xiv
Contents
Page
16.10.4 Traded interest rate options ............................................................................................... 652
16.10.5 Advantages and disadvantages of interest rate options ..................................................... 653
16.10.6 Valuation of interest rate options ................................................................................. ...... 654
16.11 Interest rate swap agreements ........................................................................................................... 654
16.12 Valuing interest rate swaps ................................................................................................................ 657
Practice Questions ......................................................................................... ................................................ 660
Chapter 17 Business plans

17.1 Purpose and sources of financing ....................................................................................................... 667
17.2 Intended audiences and their information needs .............................................................................. 668
17.3 Role players and components of the business plan ........................................................................... 669
17.3.1 Executive summary ............................................................................................................. 669
17.3.2 Business description............................................................................................................ 669
17.3.3 Ownership and management team .................................................................................... 670
17.3.4 Product/service offered ...................................................................................................... 670
17.3.5 Market/industry analysis and sales strategy ....................................................................... 670
17.3.6 Facilities and resources ....................................................................................................... 671
17.3.7 Business model ................................................................................................................... 671
17.3.8 Capital required and milestones ......................................................................................... 672
17.3.9 Financial data and forecasts ................................................................................................ 672
17.3.10 Stakeholders and sustainability .......................................................................................... 673
17.3.11 Risks and risk management ................................................................................................. 674
17.3.12 Appendices.......................................................................................................................... 674
17.4 Conclusion........................................................................................................................................... 674
Appendix A .....................................................................................................................................................
675
Practice questions .......................................................................................................... ................................ 675
Appendix 1: Selected concepts, acronyms and terminology ................................................... 683
Appendix 2: PV and FV tables ............................................................................................................ 687
Bibliography ..............................................................................................................................................
691
Table of statutes ...................................................................................................................................... 695
Index ............................................................................................................................................................
697
xv
Chapter 1
The meaning of
financial man gement
AFTER STUDYING THIS CHAPTER, THE STUDENT SHOULD BE ABLE TO –
explain the meaning of ‘financial management’ and the role of the financial manager;
describe the goal of entities;
explain how stakeholder theory as well as sustainability aspects influence the goal of an entity;
explain the meaning of the business model or value creation model of an entity;
outline the focus of the financing and investment decision;
identify key stakeholders of both private and public sector non-profit entities;
describe the role of stakeholders and the relationship of the entity to its stakeholders;
explain the governance principles pertaining to stakeholder relations;
describe the concepts of stakeholder engagement as well as the benefits of such engagement;
identify stakeholder needs, interests and expectations in relation to these respective entities;
describe the relationship of investment risk to return;
describe the concepts of business and financial risk; and
explain the overall functioning of the capital markets.
The purpose of this chapter is to give the student an overview of what finance is about and provide him or her
with a point of ref r nce as the subject is studied, topic by topic. In so doing, the student is shown the entire
financial managem nt puzzle b fore actually building it, chapter by chapter. The student is not expected to fully
understand the fundamental principles of financial management after studying this chapter; however, the
student should have a good idea of the aims of the subject, and the route that will be followed in exploring the
relevant issues. This chapter gives the student an overview of financial management, and indicates how all its
parts fit together.
The textbook is largely written from the premise of the profit seeking entity, but at times it highlights financial
management decisions that pertain to a non-profit entity as well.
1.1 Financial management

Financial management as a discipline seeks to optimise the financial resources (of) and returns (to) the entity,
by optimi ing two primary activities, namely –
financing activities, by deciding which sources of funding (debt or equity) should be used by the entity nd
what the optimal proportion is for the various sources used; and
investing activities, by deciding which investments should be undertaken by the entity within the limita-
tions of available funds and the identified feasible (can it be done?) and viable (does it derive a positive
return?) investment projects.
1
Chapter 1 Managerial Finance
If both funding and investing activities are optimised, the value of the entity will increase, and hence share-
holder’s wealth optimised over the long-term, which is an important outcome of financial management. How-
ever, value is also created by the entity in a variety of ways for stakeholders other than just the shareholders . It
is therefore also important to understand the needs, interests and expectations of stakeholders in relation to
the entity, as well as how value for each stakeholder group is derived and measured.
1.2 Goal of an entity

The key goal of any entity is to create long-term sustainable value for its stakeho ders. In the private sector,
this involves the objectives of optimising long-term shareholder or owner returns on a sustainable basis, whilst
tak-ing cognisance of the responsibility of the entity to create value for all m jor st keholders, as well as the re-
sponsibility of minimising or avoiding negative impacts on the natural environment s well as society (the so-
called triple bottom line of people, profit and planet).
In a non-profit or government entity, the key goal remains to create alue for stakeholders by achieving the
objectives of economic, efficient and effective (the so-called three or 3Es) utilisation of resources under the
control of the non-profit entity. ‘Economic’ refers to the acquisiti n f res urces at the lowest possible cost;
‘efficiency’ refers to how well the resources have been utilised (d ing things correctly), while ‘effectiveness’
refers to how well resources have been deployed to achieve the set goals (doing the correct things).
Shareholder wealth maximisation

In the 1990s, business entities often cited their main goal as maximising of shareholder wealth, and it became
common for company boards to focus on sharehold r valu , th reby maximising returns to shareholders. The
shareholder wealth theory assumes the following:
The purpose of business is to maximise shareholder wealth by generating profit thus creating capital, this
profit and capital being the property right of shareholders or owners of the business.
Business is subject to contractual relations, as well as legal and moral boundaries within society which
allows it to operate.
People and the natural environment are seen instrumentally as resources to be used for the generation of
profits for shareholders.
The justification for the shareholder wealth maximisation objective in the context of the interests of society at
large is mainly that through the workings of efficient markets, wealth maximisation will benefit not only share-
holders, but society as well due to a ‘trickle down’ or ‘spill -over effect’. However, global events in the past dec-
ade have resulted in debate and fundamental questioning of the shareholder wealth maximisation paradigm as
the prime goal or objective of business entities. Critics of shareholder wealth maximisation cite this paradigm
as morally deficient and a key contributor to contemporary corporate ethics scandals, since it encourages
short-term thinking and a bias towards certain stakeholder groupings at the expense of others. The net effect is
that externalities are d ni d or avoided (such as engaging with the impact the entity has on the natural envir-
onment) with long run negative consequences for the firm and society.
However, business entities today face a global environment with challenges of rapidly declining natural re-
sources (wate , bio-dive sity, minerals, marine life) and an ever increasing population competing for these re-
sources whe e social inequality and poverty still prevail for many. It has therefore become evident that it is
appropriate and necessary that entities today pursue goals that result in the long-term sustainability of the
entity, instead of foc ssing on short-term business gains/profits that are gained at the expense of harm being
done to people and the planet. This argument also puts forward the idea that there are more business oppor-
tunities to be had by considering new ways of doing business, rather than carrying on business as usual.
Any entity can be described as being sustainable if its activities can be continued for the long-term without
exhau ting natural resources or causing ecological damage to the environment, thus creating sustainable pros-
perity for ociety at large. Sustainability can be achieved by an entity if awareness exists of its impact on society
and the natural environment, by active engagement of the entity with its key stakeholders and exercising re-
sponsible business practices that do no harm. The notion is that entities recognize that stakeholders are the
ultim te compliance officer and it is these stakeholders who give the firm the licence to operate.
2
The meaning of financial management Chapter 1
In conclusion, the appropriate goal of a business entity in the modern environment is therefore creating sus-
tainable long-term shareholder wealth, taking into account the impact on stakeholders, including society and
the environment. This perspective to the goal of any entity is consistent with the principles of the stakeholder
theory.
Stakeholder theory
The stakeholder theory, which had its origins in R. Edward Freeman’s 1984 book, Strategic Management: A
Stakeholder Approach can be described as a key rival to the traditional shareholder wealth maximisation para-
digm. Stakeholders can be described as any group or individual that can affect or is affected by the achieve-
ment of an entity’s objectives. According to Freeman, firms should identify their stakeholders, and perform a
value analysis as part of the process. The requirements of legitimate m jor st keholders are taken into account
in the strategic choices that an entity makes, and therefore in the objective(s) th t it pursues.
Although not widely regarded as a theory, but rather a framework or approach, the stakeholder theory has laid
the foundation for explaining the relationships between business and its stakeholders other than shareholders,
and for explaining that an entity may choose to satisfy objectives ther than economic objectives. For example,
an entity may choose to voluntarily invest in social spending such as an employee housing scheme, which may
reduce profitability and shareholder wealth in the short-term, but which may improve productivity and em-
ployee morale and attract higher level of skills to the business in the longer term, resulting in improved longer
term sustainability of the entity.
Other emerging perspectives on the purpose and goal of a business entity in modern society include the stew-
ardship model, and conscious capitalism. The stewardship mod l aligns the goal of an entity with the 8 UN Mil-
lennium Development Goals (UNMDG) (which are, radicating xtreme poverty and hunger; achieving univer-sal
primary education; promoting gender equality and empowering women; reducing child mortality; improving
maternal health; combatting HIV/Aids, malaria and other diseases; ensuring environmental sustainability and
having a global partnership for development) and with the sustainability movement’s emphasis on people and
planet. According to the stewardship model, the purpose and role of business is to serve by contributing to the
advancement of humankind. Profit is not identified as a purpose but as an outcome and there is a strong em-
phasis on corporate responsibility and business ethics centred on doing business virtuously by acting as stew-
ards. Conscious capitalism embodies the idea that profit and prosperity go hand in hand with social justice and
environmental stewardship, and entities that practise conscious capitalism have a higher purpose than maximi-
sation of shareholder returns. Society is seen as the ultimate stakeholder, and profit is viewed as a natural out-
come flowing from doing the right things.
From the above it can be seen that entities may vary in the main objective and goal that are pursued. However,
regardless of the goal that an entity pursues, all entities, whether a profit seeking or non -profit entity, should
strive to operate according to the values of good corporate citizenship. This entails sound governance; making
responsible strategic choices and ensuring accountable stewardship of the resources it has at its disposal.
Entities have a responsibility to make ethically sound strategic choices, since they have social, cultural and envi-
ronmental responsibiliti s towards the community in which they operate, as well as economic and financial
responsibilities towards its shar holders.
Practical example
A practical example of short-term emphasis on profit maximisation which had undesirable consequences for an entity,
occurred on 20 April 2010, when the largest offshore oil spill in US history occurred in the Gulf of Mexico, with
devastating environmental and economic consequences for thousands of people. The investigation revealed that in
spite f the British energy company having had excellent governance mechanisms in place, the accident ultimately
ccurred due to the fact that short-term profit objectives, (increasing profit and therefore shareholder wealth and the
share price), t ok precedence over implementing environmental safety precautions. These precautions were
recommended but not undertaken in order to save costs and meet profit targets, resulting in the accident. The cost to
the company in terms of reputational loss as well as cost to clean up the environment subsequent to the spill was by
far, more than it would have been to undertake the environmental safety precautions, however, emphasis on the
pursuit of short-term profits and maximising shareholder wealth in the management decisions of the company
significantly contributed to this ecological and economic disaster. Four years later, the company is still dealing with the
neg tive effects of this.
3
1.3 Business model or value creation model of an entity

Entities can describe the manner in which value is created for shareholders and major stakeholders by their
business model, or value creation model. Value can only be created for stakeholders if the entity has a clear
strategy that takes the external and internal business environment as well as the role and needs of each of the
stakeholder groups of the entity into consideration. The business model or value creation model therefore pro-
vides a design or brief description, which explains the company’s overall organisational activities and process
which is undertaken in order to achieve sustainable value for shareholders and major stakeholders.
Although value is created within an entity, the ability of any entity to create va ue is argely dependent on the
following factors –
the external environment within which the entity operates;
the relationships with stakeholders, which includes, employees, p rtners, networks, suppliers, customers;
and
the availability, affordability, quality and management of various resources, or ‘capitals’.
These ‘capitals’ or resources that entities depend on to create value, and that the entity influences in the pro-
cess of creating such value, have been defined by the Internati nal Integrated Reporting Council (IIRC, 2013: 11-
12) and can be categorised as:
Financial capital – the pool of funds that is available to the entity through debt and equity sources.
Manufactured capital – buildings, equipment, infrastructure, plant and machinery and other tangible as-
sets.
l Human capital – the competencies, capabiliti s and xp ri nce of the management and staff available to the
entity. This would include inter alia people’s skills, experience, leadership and other abilities, motiva-tions
to innovate and their ethical value systems.
Intellectual capital – the knowledge based intangibles available to the entity that provide a competitive
advantage such as intellectual property (patents, copyrights, software, licences and rights), organizational
knowledge (systems, processes, procedures and protocols) and other accumulated intangible investments
and resources (brands, goodwill and technological advances).
Natural capital – the renewable and non-renewable environmental resources and processes that provide
goods and services that support the value creation of the entity. This would include inter alia air, water,
land, minerals, biodiversity and eco-system health.
Social and relationship capital – the relationships established within and between institutions, communi-
ties, group of stakeholders and other networks which enhance individual and collective wellbeing. This in-
cludes relationships with customers, suppliers and partners.
These are referred to as the ‘six capitals’.
The business mod l or value cr ation model explains how these capitals are used to create sustainable value for
stakeholders, and also xplains the influence of the entity on these capitals.
Business models are ontinuously evolving in a fast changing economy and it can launch a new entrepreneur’s
idea or readjust an existing business model based on this changing environment. Existing businesses need to
reassess their business models especially following a decision to make greater use of underutilised assets, new
products or se vices to customers, a change in customers or services, or general changes expected in the mar-
ket or c stomer needs. Osterwalder and Pigneur (2010) suggest a framework to capture the nine essential
components of a b siness model. This “Business Model Canvas” describes the nine building blocks of a business
as the f ll wing:
Value pr p sitions – the
grouping or bundles of benefits that can be offered to customers by the entity.
Cu tomer
segments – the grouping of the types of customers the business seeks to service. Cu tomer
relationships – the different ways to serve distinct market segments.
Channels – the best ways to communicate value propositions to customers and to market, sell and deliver
products and services.
Key activities – critical tasks that
engage customers and result in value creation.
Key resources – the key
resources, which includes financial, manufactured (whether owned, leased or rented), human,
intellectual, natural or social & relationship capitals that are available to the entity.
4
l Key partn ersh ips – the key su pplier link, joint v en ture s and stra teg ic a lliances th at can ex pand and or p ro-
tec t m ark et share, espe cially in a co mpe titive indu stry.
l Revenu e stre ams – the key typ es of inco me strea ms, which ma y require d iffe ren t pricing mec ha nism s.
l Cost struc tur – cos t str ucture is det erm ined by th e n atu re of t he bus ines s as either a cos t drive n b usin ess
(co ntain cost s to drive valu e) or a value driv en bu sine ss (spe nd what i s ne ces sary to get va lue ).
According to O ster walde r & Pigneu r ( 2010) busine ss mod els ten d to fi nd certai n co nc ept ual styl es, ex amp les
ar e th e f ollowing:
l The fre e busi nes s mode l ce ntres on givi ng p ro ducts and ser vice s to customers i n or der to att ract ot hers. A
goo d exa mpl e of this is the fre e G oo gle search en gine w her e p id advertisin g is dis pla ed .
l The lo ng tail business mod el pro vid s f or the sale of a vari ety of pers on liz ed pro ducts to a ma ss market
of small-quan tity buyers.
The open business m odel c ent res on pa rtne rsh ips tha t e xpand producti ity a nd red uce costs.
The IIRC has also describ ed a nd de f ine d a busin e ss model as “the c hosen syst em of inputs, bu siness act
ivities, outpu ts and outcome s that aims to cr eat e va lue over the sho rt, medium a nd lon g term ”. IIR C, 201
3:1) and is pr esented visua lly as follo ws :
Source: C op yright© Ma rch 2013 by t he Int ern ational Integr ated R eportin g Coun cil.
Fig ur 1. 1: The IIRC ’s usines s M odel
1.4 S tak eh ol de rs of an en tity

The operati ons of the entity m ay affect ma y d iffere t stak eho lders directly or ind irectly. ‘Stakeho lders’ are
entiti es o r in dividuals tha t can a ffect o r ar e affected by the ac ivities and actio ns o f th e entit y.
5
The following diagram illustrates the key stakeholders of a private sector entity:
• Shareholders • Lenders
E
N
Supplies the company
V Supplies the company
with loan finance in S
exchange for interest
I with equity in exchange
for a fair rate of return
charges, fees and O
security
R C
Suppliers of Customers
O the COMPANY of the I
N company Supplies the company company E
M Supplies the company
with skills & labour in
with infrastructure,
legislative & T
E exchange for salaries,
wages, job security and
macro-ec n mic climate
in exchange for Y
N intrinsic satisfaction responsible behaviour
and taxes
T
• Employees • Government
Figure 1.2: The key stakeholders of a private sector entity
Key stakeholder groups

Stakeholders can be grouped into the following main groups –
shareholders or owners of the entity;
lenders and suppliers of borrowings;
employees, including directors, managers;
government;
society; and
the natural environment.
In the case of shar hold rs, l nd rs and employees, customers and suppliers, the relationship with the entity will
be mostly based on a legal contractual obligation. However, in the case of government, and the natural
environment, legislation, or industry standards, for example environmental compliance standards and tax legis-
lation will dete mine the framework and obligations of the entity and therefore govern the stakeholder rela-
tions with the entity.
Although an entity does not have a legal contract with society, an entity relies on the on-going approval within
the local comm nity that it operates and where main activities take place and impact on the community. This
broad social acceptance is most frequently referred to as the entity’s social ‘license to operate’.
Governance principles of stakeholder relations

The Integrated Reporting Committee of South Africa (IRC) views a company’s ability to create and sustain value
as dependent on the quality of its leadership, and how the entity is governed. In terms of good governance
practice, and consistent with ‘The King Code of Governance Principles for South Africa of 2009’ (King III), the
foundation of good corporate governance is seen to be ‘intellectual honesty’, with its supporting pillars being
‘responsibility’, ‘accountability’, ‘fairness’ and ‘transparency’ (RAFT). Consequently, ethical leadership is para-
mount. Leaders and managers employed by the entity are required to formulate and implement strategies
based on their reflections of the social, environmental, economic and financial impacts of the entity. This is
undertaken by engaging with the entity’s stakeholders and communicating their strategic choices and impact.
6
The company’s board of directors is accountable to the company and through the company to the sharehold-
ers. The board is also responsible and responsive to the stakeholders, who represent the ultimate compliance
officer. The governance principles relating to stakeholder relations of companies found in the King III Report
can be summarised as follows:
The company conducts it affairs on a ‘apply or explain’ basis.
The board of directors should take account of the legitimate interests of stakeholders in its decisions.
The company should proactively manage the relationships with its stakeholders.
The company should identify mechanisms and processes that promote enhanced levels of constructive
stakeholder engagement.
The board of directors should strive to achieve the correct bal nce between its various stakeholder
groupings, in order to advance the interests of the company.
Companies should ensure transparent and effective communication with stakeholders to build trust and
improve the reputation of the company.
The above sound governance principles, although intended for c mpanies, can be applied to any entity, includ-
ing public sector and non-profit entities.
Stakeholder engagement
A strategic dimension to corporate social responsibility not only includes corporate social responsibility aspects
as an essential element of company strategy, but also ncompasses the building of relations with stakeholders
and the creation of effective channels for communication and innovation, as well as continuous management
of stakeholder relations (Mallin 2009:99). The aim of stakeholder dialogue is to investigate interests and issues
concerning the company and the stakeholders, exchange opinions, clarify expectations, enhance mutual under-
standing and, find innovative solutions (Pohl & Tolhurst 2010:17).
Stakeholder engagement can therefore be described as the process used by an entity to engage relevant stake-
holders for a clear purpose to achieve accepted outcomes. Stakeholder engagement is recognised as a funda-
mental accountability mechanism since it obliges entities to involve stakeholders in identifying, understanding
and responding to sustainability issues and concerns, and to report, explain and be answerable to stakeholders
for decisions, actions and performance of the entity. Stakeholder engagement is an on -going process and the
information gathered from stakeholders will be an important aspect in forming strategic choices of the entity.
Practical example
Stakeholder engagement and its success often rely on creating appropriate feedback and communication channels
with stakeholders. In South Africa, a large platinum producer, recently found that a particularly effective means for al-
lowing the public to r port conc rns or complaints relating to the operations of the entity – especially with regard to
environmental, health and saf ty, community, and security issues – has been a toll-free telephone hotline established
by the company. A r gist r is k pt of the complaints and any responses provided. In addition, regular meetings are ar-
ranged with spe ific sub-groupings of affected stakeholders to discuss particular problem areas, for example, noise and
vibration asso iated with new open-cast mining operations. Stakeholders are also invited to raise more general
concerns in egular stakeholder forum meetings involving management and key stakeholder groups. This is an example
of a consultative level of engagement with the broader stakeholder groups that may be affected by the surroundings
and environment of the operations of the entity.
Stakeh lder engagement is important because it enables –

the entity to better understand the operating environment and requirements of stakeholders;
more effective management of risk and reputation of the
entity; equitable social investment and development;
product, service and process improvements by information gained from stakeholders.
Entities should therefore engage responsibly with their stakeholders and communicate and report on activities
and performance, and be responsive to the views and interests of their stakeholders. In terms of sound gov-
ernance principles the benefits more than outweigh the costs.
7
Reporting to stakeholders
Sustainability reporting
Historically, corporate reporting in the form of annual financial statements focused mainly on financial perfor-
mance, and reports were prepared mostly for the information needs of investors and shareholders. However,
along with the movement of business towards more stakeholder-oriented approaches, reporting on sustaina-
bility performance, and reporting to stakeholders has become more prominent. The relevance and importance
of corporate sustainability reporting in advancing sustainable development was elevated globally by the inclu-
sion of Global Reporting Initiative’s (GRI) sustainability version G4 guidelines, reporting as a key priority at the
United Nations Conference on Sustainable Development (Rio+20). The United Nations acknowledges the im-
portance of corporate sustainability reporting, and encourages entities to consider integrating sustainability
information into their reporting, and encourages governments to develop best pr ctice models and facilitate
action for the integration of sustainability reporting.
The GRI, which issues internationally accepted guidelines on sustainability reporting (most recent of which is
the G4 guidelines), recognises that transparency about economic, en ironmental and social impacts is a fun-
damental component of effective stakeholder relations. The GRI was f rmally launched in 1997, and was soon
aligned with the International Accounting Standards Board (IASB) and the Financial Standards Board (FASB).The
GRI Reporting Framework, the latest version of which provides a generally accepted framework for reporting
on an entity’s economic, environmental and social perfor ance. The Reporting Framework sets out the princi-
ples and performance indicators that entities can use to easure and report economic, environmental and
social performance. The GRI Reporting Framework mandates a clear stakeholder orientation both in the pro-
cess required for stakeholder engagement in order to pr pare the sustainability report, and in addressing the
information needs of stakeholders in the report cont nt. The framework describes sustainability reporting as
the practice of measuring and disclosing performance and being accountable to internal and external stake-
holders for performance towards the goal of sustainable development.
The number of companies worldwide that publish sustainability reports disclosing their impact and initiatives
with regard to societal and environmental issues has grown substantially in the past decade. This provides evi-
dence of the relevance and imperatives of corporate responsibility in the society in which they operate. There
is therefore a growing appreciation of the fact that while protecting and enhancing shareholders’ wealth re-
main an important objective, the aspirations of other stakeholder groups need to be factored in.
Integrated reporting
Integrated reporting is an evolving concept which, in the South African context, has its origin in the governance
principles relating to integrated thinking in King III. Following the incorporation of King III requirements into the
Johannesburg Securities Exchange (JSE) Listings Requirements, listed companies are required to issue an inte-
grated report for financial years commencing on or after 1 March 2010 on a ‘apply or explain’ basis (as
opposed to a ‘comply or explain’ basis, which was the basis of King II).
Integrated reporting combin s the different strands of reporting (financial, management commentary, govern-
ance and remuneration and sustainability reporting) into a coherent whole that explains an entity’s ability to
create and sustain value. The information that is expected to be included in the integrated report should ena-
ble a meaningful assessment of the long-term viability of the entity’s business model and strategy. The inte-
grated repo t included eporting on the strategy, performance and activities of the company in a manner that
enables stakeholde s to assess the ability of the company to create and sustain value, based on financial, social,
economic and environmental factors over the short-, medium-, and long-term.
Integrated reporting includes the requirement to communicate the future strategy choices of the entity in the
rep rt, as well as disclosing the key performance indicators (KPIs) that the entity will measure in future periods.
Furtherm re, integrated reporting requires the disclosure of economic, environmental and social impacts of
companies. This is included in the international framework on integrated reporting of the International Inte-
grated Reporting Committee (IIRC) which requires performance information, including a description of the enti-
ty’s view of its major external economic, environmental and social impacts and risks up and down the value
chain, a ong with material quantitative information. The final version of the International Integrated Reporting
Fr mework was published in December 2013. On 18 March 2014, the Integrated Reporting Committee of South
Africa (IRC) announced its endorsement of the recently published International Integrated Reporting Frame-
work of the IIRC. Thus South Africa now subscribes to the international framework.
It is stated in this International Integrated Reporting Framework, that integrated reporting aims to enhance
accountability and stewardship for the resources or capitals that entities control, as well as to advance
8
integrated thinking, decision-making and actions that focus on creating value over the short, medium and long
term (IIRC 2013:1). Furthermore, one of the key objectives of integrated reporting is stated as reporting that
focusses on the ability of the entity to create value in the short, medium and long term, and, in doing so, em-
phasises the importance of integrated thinking within the entity.
Integrated thinking is described in the framework as the active consideration by an entity of the relationships
between its various operating and functional units and the six capitals that the entity uses or affects (IIRC
2013:11-12). These six capitals were described earlier in section 1.3.
The guiding principles which underpin the preparation and presentation of the integrated report are listed be-
low:
Strategic focus and future orientation – providing insight into the entity’s strategy, and how the capitals
listed above are affected by its use in the long, medium and short term.
Connectivity of information – the report should present a holistic overview of the entity and how it cre-
ates value over time, explaining the interdependencies between factors that affect the entity’s ability to
create value.
Stakeholder relationships – the report should provide insight into the nature and quality of the entity’s key
stakeholder relationships.
Materiality – the integrated report should disclose infor ation about matters that substantively affect
the entity’s ability to create value over the short, edium and long term.
Conciseness.
Reliability and completeness.
Consistency and comparability.
The Chief Financial Officer (CFO) is not only integral both in directing, selecting and overseeing the execution
and performance measurement of strategy in the business with the other board members, but also in the inte-
grated reporting process. CFO’s are informed by the corporate governance rules King III, which holds the board
and audit committee accountable for the integrity of the integrated report and overseeing the compilation
process. As the management representative on the audit committee, this accountability lies with the CFO.
1.5 Risk and return of investors

When shareholders take up shares in a company, they are exposed to risk. Shareholders do not necessarily
earn a fixed dividend, and capital growth of the share is not certain. To explain the concept of investment risk,
assume that Mr A has recently inherited R500 000 and has decided to start a business manufacturing and sup-
plying security fencing. He invests his entire inheritance in the business and does not use any form of debt fi-
nance. By investing in the business, what kind of risk (if any) is Mr A subject to?
Business risk
By investing in a business, Mr A has exposed himself to business risk. Business risk is the risk that relates to the
operating activities of a ompany.
The following could go w ong with his new business –
there co ld be no demand for the product;
competitors co ld under-cut his prices;
he might be unable to secure supplies of raw material;
the machinery in use could be inefficient;
he could experience employee problems;
or debtors could fail to pay on time.
Assume now that, as an alternative to investing his money in a business, Mr A had invested it on call with a b
nk, at a return of 10% with little or no risk. The business that he might have started has a greater business risk
than investing his money in a bank call account would have had. Mr A would therefore require, and indeed
expect, to make a return on his R500 000 business investment far in excess of that on a 10% no-risk
investment. The return required by an investor for investing in a business is known as ‘business risk’ and is
dependent on the level of risk directly related to that business.
9
Companies can be classified in terms of their level of business risk:

High risk Medium risk Low risk
Mining Restaurant Supermarket
Chemical Security Household products
Speciality products Building Residential housing
The return required from a company (investment) will depend on the level of business risk.
For the sake of simplicity, ignore any tax implications and assume that Mr A requires a minimum return of 20%
from his company. The return required commensurate with the level of business risk is known as ‘ke’ or the
‘shareholder’s required return’. At the present moment, his required return of 20% is for business risk only.
1.5.2 Financial risk

One year has now passed. Mr A has made a profit of R100 000 on his R500 000 investment (i.e. a 20% return),
which has been paid out as a dividend. He now wants to expand and has approached a bank for a R500 000
loan, which has been approved. The loan will cost Mr A 10%. His financial position and expected return will
now be as follows:
Investment
Own investment R500 000
Loan R500 000
R1 000 000
Return from the business

Profit before interest (20% × R1 000 000) = R200 000
Less interest (10% × R500 000) = R50 000
Net profit R150 000
Return on the investment: R150 000 / R500 000 = 30%

By increasing his investment base through borrowing, Mr A has been able to increase his return on a personal
investment of R500 000 from R100 000 (20% return) to R150 000 (30% return) without putting in additional
funds of his own.
Is debt (gearing) a good idea?

Advantages Disadvantages
Creates wealth Fixed annual interest
Promotes growth in company Repayment of capital
Higher net return Financial risk
Interest is tax d ductible Lose knee-caps if debt is not repaid!
Cheaper than quity finance
From the above example, it would appear that debt is a wonderful way of increasing one’s wealth, because the
cost of debt is lower than the return offered by the business. One could conclude that gearing (taking on debt)
in the above example gives an additional return of R50 000 without increasing the level of business risk.
Note However, there is a down-side that could (and often does) lead to business failure.
If a pers n invests his own money, or even money from other shareholders, he expects to receive ‘interest’ or
its equivalent in the form of a dividend, as well as an increase in the value of the shareholder contribution over
a peri d f time. If, however, he borrows money, he has to pay interest every year, regardless of how well or
poorly the business is performing. On top of that, he may also have to make an annual capital repayment. If he
cannot, the bank will foreclose on the loan and repossess the assets that have been given as security for the
oan in the event that that debt cannot be repaid. In short:
Debt = Financial risk
It is often said that debt is good because it is an expense that is allowed as a tax deduction, and as such its rela-
ive cost is low. That may be true, but so is the other side of the coin; by taking on debt, one takes on financial
risk, which is often forgotten. In essence, if an entity has no debt, it has no financial risk. Consequently a debt
free entity is only faced with business risk.
10
Therefore, in the above example, it is incorrect to assume that the shareholders’ return of 20% will not be af-
fected by the debt finance. The fact is that the shareholders’ return will increase to 20% plus financial risk. The
businessman (Mr A) or his shareholders may therefore end up with the following required return, or k e:
Business risk 20%
Plus Financial risk 5%
Required return 25%
ke now equals 25%.

So, in this example, if the shareholders’ required return is 25% because of financial risk, is debt finance still a
good idea?
Solution:
Investment R1 000 000
Net profit, or return R150 000
(after charging interest)
Required return is 25% or
R500 000 (shareholders’ investment) × 25% = R125 000
Conclusion:
Debt is worthwhile in this example, as the sharehold rs are making a return equal to R150 000 / R500 000, that
is 30%, which is higher than the 25% required return.
Chapter 4 (Capital structure and the cost of capital) demonstrates that taking on debt does, in fact, increase the
shareholders’ required return. The question that needs to be answered though is: To what extent does debt
finance increase the shareholders’ required return?
If one accepts that taking on debt increases the shareholders’ required return, is there any advantage in taking
on debt? In the above example, if ke increases to 25% it is still advantageous to take on debt.
One school of thought suggests, however, that financial risk is never advantageous, as the financial benefit will
be equal to the risk disadvantage. In the above example, it would be suggested that ke would increase to 30%,
and that there is therefore no benefit from taking on debt. We tend to agree with this view, as the advantage
of debt is almost always nullified by the risk disadvantage.
Important: Every time ke (shareholders’ required return) is given in an exam question, if the company has
any form of debt, then:
ke = Business risk + Financial risk
If there is no debt in the financial structure, then k e equals business risk only.
1.6 Overview of financial management

The following diag am illustrates the key aspects of financial management that are dealt with in this book. The
key objective of financial management is the creation of responsibly derived shareholder value whilst
managing and mitigating the risks faced by the entity. The value of shares in a company as an investment is
measured by three key components, namely –
an increase in the value of the company shares held by the shareholder (capital growth);
and dividends received by the shareholder (dividend yield); and
the attitude towards risk and how the company mitigates the possible downside risk factors that could
have a detrimental impact on value creation (for example, increased competition, thereby reducing mar-
ket share) and takes advantage of the upside risk factors, which have a positive impact on value creation
(for example, investment into new products that increase market share). In short, if investors believe that
the entity is managing its risks appropriately relative to its peers, then the value of the company is likely
to increase, which will manifest itself in higher capital growth or dividend yield or a combination of the
two.
11
FINANCIAL STRATEGY
Objective: Creating long-term sustainable shareholder’s wealth that is responsibly derived for benefit of all
stakeholders
FINANCING DECISIONS INVESTMENT DECISIONS

Objective: Responsibly obtaining funds with Objective: Responsibly investing in projects
minimum cost and appropriate risk with maximum returns and appropriate risk
SOURCES OF SOURCES OF INVESTMENT

EQUITY FINANCE LOAN FINANCE OPPORTUNITIES
(ke) (kd) – Capital assets
– Issued share – Debentures – Replacement of
capital assets
– Long-term loans
– Distributable – Mergers
– Lease finance
reserves – Acquisitions
– Preference shares
– Non-distributable – Restructuring
reserves – Mortgage bonds
– Retained income – Any form of long-
term finance that
– Any form of debt
does not have an
that has a conver-
option to convert to
sion option to ordi-
ordinary shares
nary shares
Techniques: Techniques:
• Cost of capital • Valuation methods
• Capital structure • Capital budgeting
DIVIDEND DECISION
Objective: Responsibly optimising shareholder’s dividend requirements as well as business funding req
irements in order to ensure responsible maximum long-term sustainable shareholder’s wealth
Figure 1.3: Key aspects of financial management
The investment decision

The inve tment decision looks at the investment in an asset that yields future cash flows. If the cash flows are
equal to, or greater than, the company’s required return, then the investment should be accepted, as it will
increase shareholders’ wealth. The investment decision is also referred to as ‘capital budgeting’. The required
inputs are future cash flows and the Weighted Average Cost of Capital (WACC) or ‘discount rate’. The deriva-
ion of WACC is discussed in chapter 4 (Capital structure and the cost of capital), while the investment decision
is discussed in chapter 6 (The investment decision).
As investing in a company is done with the sole purpose of responsibly increasing shareholder wealth, and as
the increase in shareholder wealth is derived from the payment of dividends, as well as from the increased
12
value of a share, it is necessary to derive a model that values a company. Share valuation of a company, as with
the investment decision, is dependent on future cash flows to the shareholders and the return required by the
shareholders. This is discussed in chapter 10 (Valuations of preference shares and debt) and chapter 11 (Busi-
ness and equity valuations ), while aspects unique to mergers and acquisitions are discussed in chapter 12
(Mergers and acquisitions).
Example: The investment decision

Company A is contemplating investing in a machine to manufacture product X. The details are as follows:
Investment required (I0) – R1 million
Life of the project – 3 years
At the end of 3 years, the asset will be sold for R500 000 (disposal value)
Year 1 cash flow after tax will equal R300 000
The company is currently financed equally (50:50) by debt and equity
ke (cost of equity) 20%
kd (cost of debt) 10% after tax.
Required:
Evaluate whether the company should invest in the ass t.
This illustrative example opens up many issues that must be fully understood before attempting to answer the
question. These issues are explored more comprehensively as we move through this textbook.
Required knowledge
The discount rate/target Weighted Average Cost of Capital (WACC)
In order to evaluate an investment, one needs to know the company’s required return. This is the optimal
rate required by the company that uses both debt and equity to finance its operations. The company above
is currently financed half by debt and half by equity (50% D: 50% E). This is not necessarily the correct target
weighting to use in the evaluation of the investment decision, but assume for the purpose of this illustration
that it is.
Note: In the next example, WACC can be calculated according to market value, book value and target
value. The financing component has two main sources, namely debt and equity. Refer to the ex-
ample of Company Z below for an explanation.
Relevant cash flows including tax payments

When evaluating an investment, one needs to know the relevant cash flows over the period of the invest-
ment after tax, in o der to ascertain whether the cash flows that result from the investment are sufficient to
cover the dividends paid to the providers of equity and the interest paid to the providers of debt.
How the project will be financed

A project will be financed using debt finance or equity finance. The WACC discount rate will not be affected
if the c mpany chooses either one of the two options available or a mix of both. The finance methods cho-
sen will, h wever, affect future sources funding of other projects.
Pre ent value

The value of any investment, or valuation of a company, is always the present value (PV) of future cash
flows. Comparing the sum of PV future cash flows to the initial investment (I0) results in the derivation of
the net present value (NPV). If the NPV is positive, then the project should be accepted. If it is negative,
then it should be rejected.
13
Solution:
Discount rate (20% [ke] × 50%) + (10% [kd] × 50%) = 15% WACC
*PV factor
15% R
Year 0 Investment R1 000 000 1 (1 000 000)
Year 1 Cash flow + R300 000 0,8696 260 880
Year 2 Cash flow + R250 000 0,7561 189 025
Year 3 Cash flow + R200 000 0,6575 131 500
Year 3 Sale of asset + R500 000 0,6575 328 750
Net present value (89 845)
The time value of money and calculating present values and future v lues, which is the basis of net present
value calculations, are discussed in chapter 3.
Conclusion:
The investment does not yield a sufficient return to cover the debt repayment as well as the dividend pay-
ments required, and should therefore not be accepted. This is clear since the NPV is negative.
How do we know that the cash flows will not cover the required pay ent of debt interest + dividends? We know
because the discount rate of 15% incorporates the pay ent of interest + dividends (i.e. the returns re-quired by
the providers of capital). As the net present cash flows are negative, we know that the return offered by the
project is lower than that required to cover d bt and quity commitments.
The finance decision

The other side of the coin to the investment decision is the analysis of how a company should be financed and
how the method of finance affects the calculations of investment and value. There are two types of finance –
equity finance, which is provided by the owners of the company; and
debt finance, which is provided by lenders who do not and cannot make decisions on how the company
should be run.
Figure 1.3 shows the different types of debt finance and the elements that constitute equity finance. This is
discussed in chapter 2 (Strategy and risk) and chapter 4 (Capital structure and the cost of capital), while the
financing aspects of capital budgeting are discussed in chapter 7 (The financing decision). Chapter 17 (Business
plans) elaborates on the purpose and components of a business plan.
Example: Capital structure, the finance decision

Company Z has the following capital structure:
R
Ordinary share apital – 100 000 shares 500 000
Retained in ome 500 000
Long-te m debt 1 000 000
Capital employed 2 000 000
The shareholders’ required return, ke, is 20%. Annual dividends are R400 000.
The interest on long-term debt is 10% per annum (i.e. R100 000) and the capital amount of the loan (R1 000
000) is repayable in four years’ time. Similar debt is currently available from the banks at 14% per annum.
The directors are of the opinion that the debt to equity (D:E) ratio should be a target of 40:60 (i.e. 40% of
the firm’s total capital structure should be debt and 60% should be equity).
Required:
( ) Calculate the appropriate discount rate (WACC) of Company Z to be used in the evaluation of new in-
vestments. Ignore tax considerations. Base the calculations on the book value of capital.
Discuss how new investments should be financed.
14
What is the purpose of determining the WACC?

The WACC represents the company’s required return for investments and incorporates finance from share-
holders (equity) and debt providers (debt) . The WACC means that a company has taken the decision to finance
the business operations using both equity and debt. (Whether debt finance is a good idea or not is dealt with in
chapter 4: Capital structure and the cost of capital). Having taken this decision, the company now needs to de-
termine the appropriate WACC that will be used to discount future cash flows when evaluating a new invest-
ment. As both debt and equity will be used in the finance formula, the cost to the company will be the
weighted average of the two (referred to as the WACC).
Solution:
(a) Options available
1 Book value method
Cost of equity = 20%
Book value of equity = 500 000 + 500 000 = R1 000 000
Note: Retained income belongs to the shareholders and is theref re part of equity. Any form of reten-
tion, such as non-distributable reserves, distributable reserves and share issue expenses, are also
part of equity.
Cost of debt = 10%
Book value of debt = R1 000 000
WACC = (20% × 1/2) + (10% × 1/2) = 15%
In other words, the company is financed equally by d bt and equity; consequently, the required return is
15%. As will be seen in future chapters, this method is totally inappropriate, because one cannot simply
take book values to determine the D:E ratio.
2 Market value method
The market value method recognises that the true value of equity and debt is based on current market val-
ues, not on historical values. It further recognises that the appropriate discount rates are current market
rates, not the historical cost of equity or of debt.
Current market value of equity = 20%
Current market value of debt = 14%
Market value of equity
R400 000 (Dividends)
Present value of future cash flows =
0,2 (ke)
= R2 000 000
Market value of d bt
Present value of future ash flows of debt interest at a discount rate of 14%
100 000 100 000 100 000 100 000 1 000 000
= + + + +
(1 + 0,14)
2 (1 + 0,14)
3 (1 + 0,14)
4 4
(1 + 0,14)
(1 + 0,14)
= 87 719 + 76 947 + 67 497 + 59 208 + 592 080
R883 450
Market value (MV) of company
MVE + MVD
R2 000 000 + R883 451
R2 883 450
Weighted Average Cost of Capital (WACC)
2 000 000 883 450
= (20% × 2 883 450 ) + (14% × 2 883 450 )
= 13,87% + 4,29% = 18,16%
15
Target WACC method

The target WACC recognises that, as a company takes on more debt, the cost of equity increases, due to
financial risk. This means that every time a company takes on debt, the D:E ratio changes and as a result,
the shareholders’ required return also increases. The cost of debt also increases if the lender perceives
that the risk of loan repayment has increased. A company therefore needs to assess the different mixes
of D:E and determine the appropriate mix that will have the lowest WACC.
In this example, WACC is given as:
40% debt : 60% equity
The target WACC = (14% × 40/100) + (20% × 60/100)
= 5,6% + 12% = 17,6%
This is, in fact, the appropriate rate to use in all investment decisions.
How should the investment be financed?
When a company takes on a new investment, it will finance the in estment through equity funding or by
borrowing. How it finances a project will have an impact n the financial risk of the company, which will
increase as debt finance increases or decreases as equity finance is used.
Does the method of finance have an impact on the WACC? The short answer is: ‘No!’ If one accepts that
there is a target D:E ratio and that a company will at all ti es attempt to move towards that target, then
how a company is financed is not an issue.
In deciding on how to finance a project, all calculations must be done at market values. In fact, in finance
one must always look at the market values of d bt (kd) and quity (ke), and never at book values.
Current market value of equity = R2 000 000
Current market value of debt = R883 451
Target D:E ratio = 40:60
At the present moment the ratio is 883 450 to 2 000 000, or 30:70. In other words, the company can take
on more debt in order to move closer to the target ratio.
Now, assuming that the company needed R500 000 to finance a new project, what kind of finance should
it use?
Answer:
R
Current market value of equity 2 000 000
Current market value of debt 883 450
Required new funds 500 000
Total 3 383 450
Target 40:60
Therefore Debt = 40% of R3 383 450 =1 353 380 (maximum allowed)

Equity = 60% or R3 383 450 =2 030 070 (maximum allowed)
Debt Equity
Target available 1 353 380 2 030 070
Current funding 883 450 2 000 000
New finance 469 930 30 070
The company has sufficient debt capacity to finance the entire project through debt. If the project is accepted,
the R500 000 required should be financed using debt.
Note: A company tends to finance a project entirely by debt or by equity. The logic here is that new projects
are normally for a small amount relative to the total value of debt and equity, and the method of fi-
nance will not have a major effect on financial risk. There are also cost implications in using a variety
of sources. The intention is to try to reduce the possibility of incurring double flotation costs by using
one source of finance only.
16
The management decision

Financial managers have to plan, monitor and control. It is important, therefore, that the outcomes of the fi-
nancing and investment decisions are effectively and efficiently managed.
Strategy and risk is covered in chapter 2. Managing risk according to specific financial management skills is dis-
cussed in chapter 5 (Portfolio management and the Capital Asset Pricing Model) and chapter 8 ( Analysis of fi-
nancial statements). Chapter 9 (Working capital management) covers key aspects of day-to-day operating re-
quirements. Chapter 13 (Financial distress) considers the implication of firms facing financial difficulties. Chap-
ter 14 (The dividend decision) highlights the basis on which the dividend decision should be applied. Chapter 15
(The functioning of the foreign exchange markets and currency risk) considers specific financial management
areas when operating in an international context and lastly chapter 16 (Interest rates and interest rate risks)
addresses different sources of finance and highlights key risk aspects in rel tion to these sources.
1.7 Capital markets

The capital markets are the markets which trade in long-term finance. In S uth Africa, the Johannesburg Secu-
rities Exchange (the JSE) provides the marketplace for primary finance (the primary market), in other words
companies wishing to list on the stock exchange or issue new capital may raise primary finance from investors
through the JSE. The JSE also provide a trading forum for the secondary markets, where existing investors
(shareholders) can sell their shares. This secondary trade in shares takes place between investors, and the
company whose shares are traded do not share in the proceeds of this trade. The secondary market simply
serves the purpose of making listed shares as an inv stm nt a fairly liquid asset to investors by providing a
trading place where the supply and demand for shar s by inv stors can be met.
The advantages of raising finance on a stock exchange include access to a wider pool of finance, enhanced rep-
utation of the company, access to growth opportunities by having more capital, and the owners of the original
shares realising profits on their share value once listed. However, the obligation of a public listing is greater
regulation, accountability and scrutiny, as well as cost implications including:
Underwriting costs – the direct fees paid by the issuing company to the underwriters (brokers, merchant
banks, etc.) which may be up to 2,5% of the amount of capital raised.
Other direct expenses – these do not form part of the fees of the underwriters and can include listing
fees, documentation fees, fees of professional advisors, printing fees and creation of share-capital fees.
Indirect expenses – these include cost of management time spent working on the new issue of shares.
Underpricing – determining the correct offering price is extremely difficult, and losses frequently arise
from underpricing, that is, selling/offering the shares at below the correct, true market price.
Investors in stock markets range from individuals, to banks, insurance companies, pension funds as well as unit
trust and investment trusts. The stock exchange is also the market for dealing in government bonds and securi-
ties.
A stock exchange can th r fore be described as a capital market in which securities can be freely traded in a
regulated environment. However, before shares can trade on the JSE, a company needs to be listed on the JSE
and comply with the minimum listing requirements, and, thereafter, the shares must be issued to the public.
Raising equity finance on the Johannesburg Securities Exchange

The JSE has three main markets where public companies may be listed, namely the JSE Main Board, the Africa
Board which attracts listings from the rest of the African continent, and the Alternative Exchange (AltX) or de-
vel pment capital market, which is aimed at smaller businesses which do not yet comply with the listing re-
quirements f the JSE Main Board. The most important requirements, which apply in most instances, for a list-
ing on the Main Board of the JSE at present are:
Sub cribed capital of at least R25 million in the form of at least 25 million issued shares.
Satisfactory profit history for the last three years, with reported and audited profits of at least R8 million
before tax in the year prior to the application for a listing.
The public should hold at least 20% of each class of shares.
There must be at least 300 public ordinary equity shareholders.
It is compulsory to publish financial results in the press.
17
The purpose of the AltX Board or development capital market is to facilitate the trading of shares of companies
that do not meet the minimum criteria for a primary listing on the JSE. The AltX Board enables the public to
invest in younger, smaller companies and the criteria for listing on the AltX Board, which is done though an
appointed Designated Advisor (DA), are:
Subscribed capital of at least R2 000 000 (including reserves but excluding minority interests).
Need not have a profit history, but its analysis of future earnings should indicate above average returns
on capital.
The public should hold at least 10% of each class of shares.
There must be a minimum of 100 shareholders.
Directors are required to complete the ALTX Directors Induction Programme and at least 3 directors, or
25% of directors must be non-executive directors.
There must be a suitably qualified and experienced executive fin nci l director appointed and approved by
the audit committee of the entity.
50% of the shareholding of each director and the DA must be held in trust by the applicant’s auditors or
attorneys to prevent these shares from being traded publicly.
An initial public issue of shares (called an initial public offering r IPO) is usually sold directly to the public, often
with the help of underwriters. However, if the new issue of shares is to be sold to the existing shareholders
only, it is called a rights offer. With the approval of the existing shareholders, the company can also make a
general cash offer of shares, whereby the company raises capital from investors who are not existing share-
holders. In the case of a rights offer in which existing shareholders are invited to subscribe for new shares, the
existing shareholders may waive their rights, and th n the company may seek the additional capital outside of
its shareholders through an issue of shares for cash to the public.
The book value of equity is the share capital on the statement of financial position plus shareholder’s reserves.
This must be contrasted with the market value of shares, which are largely determined by the expectations of
investors in respect of future earnings of the company, and represents the price at which a share trades on the
stock exchange at any given point in time. In theory, a realistic price for a share will be the discounted value at
the shareholder’s cost of capital (based on a required rate of return), of the future dividends and expected cap-
ital growth which is expected to be received by the shareholder.
Sustainability and responsible investment in the capital markets

Most entities rely on shareholder or equity funds as a source of capital in order to operate the business and
expand. Shareholders or institutional investors, for example fund managers of unit trusts or pension funds that
invest a portion of their assets and income on behalf of their members, are becoming more selective and cir-
cumspect towards investing funds in entities that sufficiently address environmental, social and governance
(ESG) considerations into the strategy and business model or value creation model of the entity.
This is due to increased awareness of the importance of sustainability and the prominence of global initiatives
such as the United Nations’ backed Principles for Responsible Investment (UNPRI). These are guidelines for
investors in selecting ntiti s that are ethical and responsible in its business practices. Many international banks
are also restri ted to provide borrowings to projects in terms of the Equator Principles on Financial Insti-tutions
(EPFIs) to proje ts where the borrower will not or is unable to comply with their respective social and
environmental policies and procedures.
On 19 July 2011, South Africa became the second country after the UK to launch its own voluntary code for
institutional investors, the Code for Responsible Investing in South Africa (CRISA) issued by the Institute of Di-
rectors in So th Africa (IoDSA) . Its principles are aligned with those of the UN Principles for Responsible Invest-
ing (UNPRI), as well as King III. CRISA is specifically targeted at institutional investors providing a framework for
integrating ESG issues into investment and ownership decisions. One of its core principles is the consideration
of material ESG risks and opportunities in investment decisions. This approach differs from ethical, targeted or
ocially re ponsible investing, which aligns the investment decision to desired ethical or social outcomes. For
examp e, investors with a particular ethical or moral standpoint would choose companies that are seen to have
a positive social agenda (building affordable housing) as opposed to those that are involved in alcohol, ciga-
rettes or gambling which are seen to contribute to social ills.
The five key principles are that an institutional investor should adhere to in terms of the CRISA code, are de-
scribed as:
Incorporate sustainability considerations, including ESG, into its investment analysis and investment activ-
ities.
18
Demonstrate its acceptance of ownership responsibilities in its investment arrangements and investment
activities.
Introduce controls to enhance a collaborative approach to promote acceptance and implementation of
the sound governance principles.
Recognise the circumstances and relationships that hold a potential for conflicts of interest and should
pro-actively manage these when they occur, including the prevention of insider trading as defined by the
Security Services Act.
Be transparent about the content of their policies, how the policies are imp emented and how CRISA is
applied to enable stakeholders to make informed assessments.
In addition, the South African Pension Funds Act was amended during 2011 to include a fiduciary duty of pen-
sion funds, representing a substantial component of institutional investors in South Africa, to giving appropri-
ate consideration to any factor which may materially affect the sustainable long-term performance of a fund’s
assets, including environmental, social and governance factors. Globally, institutional investors are increasingly
becoming signatories to initiatives such as the Carbon Disclosure Project (CDP), which includes evidence and
insight into companies’ practices around natural capitals (Deegan 2010). C nsequently, investor needs are in-
creasingly dictating the adequate disclosure of ESG informati n as well as key strategies, risks and opportuni-
ties for investor decision-making purposes, which ties in with the report content of the integrated report.
Many of the worlds leading stock exchanges also rate and rank listed companies on their ability to incorporate
social, environmental and governance aspects into the entities strategy and activities. Examples are the Dow
Jones Sustainability Index, the FTSE4Good Index, and in South Africa the JSE SRI Index. The JSE SRI Index aims to
contribute towards the development of responsible busin ss practice by identifying the listed companies that
integrate good governance as well as social and environm ntal aspects into their business practices. The fol-
lowing diagram (Figure 1.4) lists the main areas of measurement on which these companies are measured and
assessed for rating on the JSE SRI Index.
Addressing all key environmental issues

Environmental
Working towards environmental sustainability
Training & Development

Employee Relations
Health and Safety
Society Equal Opportunities
Stakeholder Engagement
Black Economic Empowerment
HIV/Aids
Board Practice
Ethics
Governance and related
Indirect Impacts
sustainability concerns
Business Value and Risk Management
Broader Economic Issues
l Managing and reporting on efforts to reduce carbon

C imate change emissions and deal with the anticipated effects of climate
change
Source: Johannesburg Stock Exchange: Background and Selection Criteria 2011

Figure 1.4: Measurement aspects of the JSE SRI Index
19
1.8 Valuation of a company

Every company will at some stage ask: What is the company worth? The valuation of companies for whatever
reason is very important in business. Many students have a problem in understanding the concept of value, but
simply stated
Value = Present value of future cash flows
The valuation of a company refers in most cases to the value of the ordinary shares. After all, it is the share-
holders who want to know what the shares are worth. One could, however, say that the value of ordinary
shares equals
Value of company – Value of debt = Value of shares (or equity)
The valuation of equity shares is therefore dependent on the payment of dividends. Now we have another
problem:
Should a company pay dividends and (if not) does the non-payment affect the alue of the company?
The payment of dividends is covered in chapter 14. This issue is n t discussed at this point, except to say that if
one purchases shares in a company, one would expect to either –
receive a dividend (dividend yield); or
the market value of the shares should increase (capital growth).
Return on an investment comes from the receipt of a dividend and/or from the increase in the market value of
the shares.
If the company invested in does not pay a dividend, is the inv stor worse off, compared to investing in a com-
pany that does pay a dividend? No, he is not, as his reward will come from an increase in the share value; thus,
whether he receives a dividend or not, he is no better or worse off.
Example: Share value

Shareholder X purchased shares in Company A at a price of R78 per share two years ago. At the end of the cur-
rent financial year, he received a dividend of R12 per share.
The company’s annual financial statements stated that dividends have increased at a rate of 5% per annum and
that future dividends are expected to continue to grow at the same rate.
Shareholder X has a required rate of return (ke) of 20%.
Required:
Determine the value per share of Company A at the present time.
Solution:
Value = Present value of future cash flows
The future cash flows will be dividends. We need to determine the dividend in one year’s time (D1) as well as all
future dividends to infinity.
Dividend today (D0) = R12
F t re dividend in one year’s time (D1) = R12 × 1,05 = R12,60
The dividend rate or required return = 20%
The f rmula f present value of future dividends to infinity, based on the dividend valuation model, is:
D1
ke – g
Where:
D1 = Dividend in 1 year’s time
ke = Shareholder’s required return
g = growth to infinity
12,60
Value = = R84
(0,20 – 0,05)
20
Conclusion:
The value per share in company A is R84. Should shareholder X wish to sell his shares today, he should sell at a
price of R84.
Example: Incorporating the fundamental aspects of finance

Company X has the following statement of financial position at 30 September 20X1:
STATEMENT OF FINANCIAL POSITION AT 30 SEPTEMBER 20X1
R’000
Ordinary share capital 100 000 shares 1 000
Non-distributable reserves 500
Distributable reserves 500
Preference shares 1 000 shares 500
Debentures 1 000 500
Long-term loan 500
Capital employed R 3 500
Employment of capital
Fixed assets 3 000
Current assets 500
R 3 500
The following additional information is provided:
1 Shareholders’ required return (ke) = 20%.
2 Shareholders have recently been paid a dividend of 5 per share. Dividends are expected to increase by 4%
annually.
Preference shares do not have an option to convert to ordinary shares. Preference dividends are R60 per
share. Similar preference shares are trading at 9% per share.
Debentures are indefinite. Annual interest is R66,67. Similar debentures are trading at 12,5%.
Long-term loans mature in three years’ time. Annual interest is 15% per annum. Appropriate long-term rate
is 12,5%.
Tax rate is 28%.
Target D:E ratio is 30:70.
Required:
Determine the value of the ordinary shares.
Calculate the WACC for investment decisions.
Assuming that the company intends to take on a new project for R500 000 that has a positive NPV, de-
termine how the p oject should be financed.
Solution:
(a) Value f shares based on the dividend valuation model
D1
=
ke – g
5(1,04)
= × 100 000
0,20 – 0,04
= 32,5 × 100 000 = R3 250 000
21
(b) Target D:E ratio 30:70
ke = 20%
kp Preference shares* = 9%
kd Debentures = 12,5% × (1 – 0,28) = 9%
kd Long-term loans = 12,5% × (1 – 0,28) = 9%
Preference shares are debt as they have no conversion option to ordinary shares. Cost of debt is always
after tax. As interest on debt and long-term loans is tax deductible, the appropriate cost is calculated
after tax. Hence, the calculation is kd before tax x (1 minus tax rate) = kp
WACC = (9% × 30/100) + (20% × 70/100)

= 2,7 + 14 = 16,7%
How financed?
Value of equity shares = R3 250 000
Value of preference shares
Dividend = R60 (after tax)
kd = k p = 9%
Value = 1 000 × 60/0,09 = R666 666
Value of debentures
Interest after tax R66,67 × (1 – 0,28) = R48
Current cost after tax 12,5% × (1 – 0,28) = 9%
Value = 1 000 × 48/0,09 = R533 333
Value of long-term loan
Interest after tax = R500 000 × 15% × (1 – 0,28) = R54 000
54 000 54 000 54 000 500 000

Value = + + +
(1 + 0,09)
2 (1 + 0,09)
3 (1 + 0,09)
3
(1 + 0,09)
= 49 541 + 45 451 + 41 698 + 386 092 = R522 782
Market value of equity 3 250 000
Market value of preference shares 666 666
Market value of debentures 533 333
Market value of long-t rm loans 522 782
New investm nt 500 000
5 472 781
70% equity 5 472 781 × 70% = R3 830 947

30% debt 5 472 781 × 30% = R1 641 834
Finance
Equity Debt
Optimal 3 830 947 1 641 834
Current – 3 250 000 1 722 781
Finance 580 947 – 80 947
Conc usion:
The company should finance the new investment via equity. It should not use debt, as it already has more than
he optimal level.
22
Practice questions
Question 1–1: Responsibilities of the Chief Financial Officer (CFO) (Fundamental)
Required:
Discuss the main responsibilities of the Chief Financial Officer (CFO) in the entity.
Solution:
The Chief Financial Officer is responsible for all aspects of financial strategy (financing, investment) in the enti-
ty, as well as managing all financial functions within the entity, which includes:
financial accounting functions;
management accounting functions;
cost accounting functions; and
tax functions.
The CFO is also responsible for managing the following risks:
debt risks (level and repayment);
all controls, procedures and systems which have a financial i plication (for example, payment to credi-
tors, payments from debtors);
interest rate risks; and
foreign exchange risks.
The CFO is furthermore responsible for managing the following assets:
working capital;
cash resources; and
short, medium and long term investments.
In addition, the CFO is responsible for making recommendations to the board in respect of various funding and
capital raising options, investment decisions as well as dividend and capital retention decisions.
The CFO will also be the management representative on the audit committee as described in King III. The audit
committee is accountable for the integrity of the integrated report, overseeing the process of compiling the
integrated report, and for recommending the integrated report to the board of the entity for approval. In this
regard the CFO will have specific responsibilities in relation to both the internal and external auditors regarding
the discharge of their duties.
Question 1–2: Stak hold r ngagement (Intermediate)

The International Integrated Reporting Framework describes stakeholder relationships as a guiding principle of
integrated epo ting. The nature and quality of the key stakeholder’s relationships and the responsiveness to
the legitimate needs, interest and expectations of the stakeholders by the entity must furthermore be dis-
closed in the integrated report.
Required:
Describe the three underlying principles of effective stakeholder engagement.
List the five levels of stakeholder engagement and list a method for each level of engagement.
So ution:
( ) The recent AA1000 Stakeholder Engagement Standard (AA1000SES), which was also developed and is-sued
in 2011, provides a standard principles-based framework for quality stakeholder engagement. The three
key principles in stakeholder engagement are inclusivity, materiality and responsiveness, as follows:
Inclusivity – Participation of stakeholders in developing and achieving an accountable and strategic
response to sustainability.
23
Materiality – The materiality process determines the most relevant and significant issues for an or-
ganisation and its stakeholders, recognising that materiality may be stakeholder specific.
Responsiveness – This includes the decisions, actions, performance and communications related to
those material issues.
The stakeholder engagement levels can be described as:
Consult – Limited two way engagement between stakeholders and the entity. Examples include sur-
veys, focus groups, public meetings, online feedback facilities.
Negotiate – Collective bargaining, for example workers with trade union bargaining.
Involve – Two-way or multi -way engagement, including multi-stakeho der forums, consensus
building processes, advisory panels.
Collaborate – Joint learning, decision making by both stakeholders nd the entity, for example joint
projects, partnerships or multi-stakeholder initiatives.
Empower – Delegating decision making to stakeholders and allowing stakeholders to actively partici-
pate in governance by integrating stakeholders into g vernance, strategy and operations manage-
ment.
Question 1–3: Share valuation (Intermediate)

Cessa Ltd currently pay a dividend of R0.36 per share. The earnings of the company is expected to grow at a
rate of 14% per annum over the next 5 years. After this period, the growth will reduce to a constant rate of
10% per annum.
Required:
Calculate the value of a share in Cessa Limited from the perspective of a shareholder who requires a 16% per
annum return.
Solution:
Year 1 2 3 4 5
Cash flows 0,410 0,467 0,533 0,608 0,693 + 10% growth to infinity
Value of investment growth as at Year 5 (i.e. P5 = D6 / (ke – g))
0,693(1,10)
0,16 – 0,10
12,708 [ Formula D 1 / Ke – g ]
0,410 + 0,467 + 0,533 + 0,608 + 0,693 + 12,708
(1 +0,16)
2 (1 +0,16)
3 (1 +0,16)
4 (1 +0,16)
5 (1 +0,16)
5
Present value = (1 +0,16)
= 0,353 + 0,347 + 0,341 + 0,336 + 0,330 + 6,051
= R7,58
Financial calculator instructions:

CFj0 = 0
CFj1 = 0,410
CFj2 = 0,467
CFj3 = 0,533
CFj4 = 0,608
CFj5 = 0,693 + 12,708
I/YR = 16
NPV = 7,758
24
Question 1–4: Disclosure of the business model (Intermediate)

Stakeholders of any entity need to assess the ability of the entity to create value over the short, medium as
well as long term. Key to such assessment for stakeholders is considering the business model of the entity and
the environment in which the entity functions. The Integrated Reporting Framework of the IIRC (2013) de-
scribes the content elements that should be contained in the integrated report, which includes the content
element of the business model of the entity.
Required:
Describe the concept of the business model as defined by the framework.
Explain how the business model as content element of the integr ted report should be disclosed in the
integrated report.
Explain how an entity with multiple business models should disclose these in the integrated report.
Solution:
The entity’s business model is described in the framework as the system of transforming inputs through
its business activities into outputs that aims to fulfil the entity’s strategic purposes and create value over
the short, medium and long term.
The description of the entity’s business model should include the key factors of inputs, business activities
as well as outputs and outcomes, as follows:
Inputs relate to explaining how the mat rial k y inputs (resources) relate to the capitals that the
entity depends on. The capitals include the six capitals of financial capital, manufactured capital, in-
tellectual capital, human capital, social and relationship capital and natural capital.
Business activities relate to explaining how the inputs are transformed to outputs (key products and
services). This can include a description of how the entity differentiates itself in the market by
unique products, services, distribution networks and marketing.
Outputs relate to explaining the key products and services offered by the entity.
Outcomes relate to describing the internal outcomes (revenues generated, employee satisfaction)
as well as external outcomes (customer satisfaction, social and environmental impacts). It also in-
cludes describing positive and negative outcomes in respect of the capitals. Examples of a positive
outcome can include increased skills following staff training initiatives (value of the human capital
increased), and a reduction in natural resources (e.g. water used or contaminated) is an example of
a negative outcome (the quantity and quality of available natural capital decreased.)
It is important to explain the different business models separately in the integrated report by disaggregat-
ing the entity into its k y components where an entity has multiple operations that function inde-
pendently. The int grat d report should also explain the connection between these various business
models or functional units, where there is a connection between these.
25
Chapter 2
Strategy and risk
describe the key strategic management concepts of ‘strategy’, ‘ ission’, ‘vision’, ‘goals’, ‘objectives’,
‘action plans’ and ‘key performance indicators’;
explain the strategic planning process within an entity;
explain the relationship between the entity’s mission, vision and strategies and its external and internal
environment, as well as the opportunities and risks to which it is exposed;
identify and describe the external (opportunities and threats) and internal (strengths and weaknesses)
influences on the operations of an entity;
evaluate the competitive environment of the industry in which the entity operates and briefly describe
appropriate competitive positioning strategies that may be applied;
evaluate the internal environment of an entity by applying value chain analysis, product life cycle
analysis, BCG matrix and resource audits;
perform a SWOT analysis and a gap analysis for an entity based on the information gathered from the
external and internal analysis;
recommend appropriate strategic choices (including product market strategies, competitive strategies,
growth strategies as well as sustainability strategies) to an entity given the risks and opportunities
identified from analysis of the internal and external environment within which the entity operates;
evaluate the implementation of strategy, the appropriateness of performance measures and key
performance indicators (KPI’s) selected, as well as the effectiveness of performance measurement and
reporting syst m of an ntity;
explain the conc pts of ‘financial risk’ and ‘business risk’ in the context of the overall risk to which an
equity investor (shareholder) of a company is exposed;
explain the on epts of risk, risk appetite, management and risk management strategy;
describe the isk management process, including risk identification, risk assessment and risk responses;
explain the governance principles relating to the risk management process;
describe the responsibilities of the various role players in the risk management process;
evaluate the adequacy of the risk identification process, the appropriateness of the risk responses, risk
mitigati n, and risk monitoring and reporting processes; and
explain the fundamental principles of enterprise risk management (ERM).
Understanding the competitive and changing nature of the business environment, as well as a solid
ppreciation of appropriate business and strategic responses to risks and opportunities faced by business, is
essential to finance students and business leaders today. A clear grasp of the strategic planning process as well
s enterprise risk management (ERM) is necessary to determine the role of the finance function and its
contribution to the entity within the latter’s broader operating context. In this chapter, the environment in
which entities function, the role of strategy and strategic planning, and how the strategy of the entity interacts
with the decision-making process are considered. This chapter also addresses theories on strategy, the
27
strategic planning process, governance aspects of risk management, as well as the risk management process
and ERM.
2.1 Strategy and the business environment

Entities function in an increasingly challenging and rapidly changing environment. Globalisation and the
reduction in trade barriers have dramatically increased competition, and fast changing technology has not only
changed the way in which businesses operate, but has created business opportunities in markets for
technologically driven products and services that did not exist until fairly recent y. The global financial crisis, the
persistence of socio-economic challenges, inequities and inequalities in achieving sustainable human
development in the midst of environmental upheaval such as clim te ch nge, ever-diminishing natural resources
and so-called ‘ecological overshoot’ have added to the complexity of business environment that is without
precedent. Without a clear strategy, mission, vision and a good underst nding of the external and internal
business environment, a company is not likely to succeed in creating alue on a sustainable basis for
shareholders and major stakeholders.
Value can only be created for shareholders and stakeholders if the entity has a clear strategy that takes the
external and internal business environment as well as the role and needs f each of the stakeholder groups of
the entity into consideration. Furthermore, shareholder value in a company can only be created if the
strategies of the company aim to achieve a return on the capital e ployed that exceeds the cost of the capital
employed. Strategy therefore provides a unified and consistent approach, which details the company’s
organisational decisions and activities in order to achieve sustainable value creation for shareholders and major
stakeholders. Strategic management, and the sel ction of appropriate strategies and supporting plans, are
therefore fundamental to the success of any entity, r gardl ss of whether it is a public or private sector entity, a
non-profit company or a non-governmental entity (NGO).
Strategy can be described as a process by which an entity deploys its resources and capabilities within its
business environment to achieve its goals and meet stakeholder needs, interests and expectations. Corporate
strategy is concerned with where a company competes (e.g. products and markets), whilst business strategy is
concerned with how a company competes (e.g. differentiation or cost).
Strategic planning is the business enterprise’s long-term plan, which includes the specific plans, actions and
policies to be followed in order to achieve enterprise’s specific goals. Strategic planning is a continual process
and strategy may change if external factors change. For example, if a new competitor enters the market and
the enterprise’s profit margins begin shrinking due to the change in the market, an evaluation of alternative
strategies or plans of action will be necessary in order to maintain profits and create long-term sustainable
value for shareholders and stakeholders.
The strategic planning process takes place in four phases, namely –
strategic analysis;
selecting appropriate strat gies;
implementation of the strategies; and
measurement of performance against strategic objectives.
Strategic analysis entails the formulation of a mission and vision for the entity, the setting of goals and
objectives, and analysing the external and internal environment. In short, once the strategic analysis has been
completed and the strategy outlined, it informs stakeholders how the company intends to fulfil its mission and
achieve its vision.
The missi n r purpose of the entity describes the reason for the existence of the enterprise and the key values
that it subscribes to. It tells the stakeholders why the entity exists.
The vi ion of the enterprise is a future-orientated statement of the position that the entity is planning to take in
the future, in other words, what it intends to be in the long-term.
Goa s are derived from the mission and vision of the business enterprise and relate the mission and vision to e
ch stakeholder group. This requires a stakeholder analysis and a clear understanding of each stakeholder group
and the needs and requirements of each group. These articulate where the entity intends to be in the long-
term.
Objectives provide clarity in specific, measurable, attainable, realistic and timely (SMART) terms, in respect of
when specific activities which lead to the achievement of the goals will be undertaken.
28
Strategy and risk Chapter 2
Action plans detail who will be responsible for achieving these objectives.
Key Performance Indicators (KPIs) are quantifiable measurements, indicating which data and information is
required to assess progress towards the achievement of the stated goals and objectives. Therefore clearly
articulated intended outcomes based on these goals and objectives to be achieved must be monitored and
evaluated on an on-going basis to ensure proper strategy implementation.
Strategic analysis must be done in the context of the external as well as the internal environment in which the
entity functions. The external and internal environment can be assessed and evaluated by undertaking a SWOT
(Strengths, Weaknesses, Opportunities and Threats) analysis, which identifies the strengths and weaknesses of
the entity (its internal environment), as well as the opportunities and threats it faces (its external
environment). This evaluation will enable the enterprise to identify strategies which wi build on its strengths,
improve its weaknesses or shortcomings, exploit the opportunities avail ble, nd counter the threats that may
exist in the external environment. A SWOT analysis requires a thorough n lysis of the political and economic
environment, market, products and services offered, distribution channels, financial situation, human
resources and skills, raw materials and assets (to name but a few).
2.2 The external environment

Companies function in a globally challenging and fast changing environment where opportunities have to be
identified quickly and acted upon in a responsible anner for the enterprise to remain competitive, profitable
and sustainable on a long-term basis. An entity can only succeed if it is able to understand and suitably respond
to the political, economic, social, t chnological, legal, environmental, global and ethical (PESTLEGE)
environment within which it functions.
Entities exist within an environment which influences what they do and whether they are able to survive and
prosper on a sustainable business in the long-term. Globalisation and technology has resulted in markets for
products and goods that constantly change. Customers develop new needs and wants, and new competitors
enter the market and introduce new technologies and products. Consequently, entities that have an
competitive advantage and are able to create sustainable wealth on a long-term basis, are most often those
entities that are able to understand the impact of these changes and trends on the entity and are able to select
and effectively pursue strategies that are appropriate to their changing environment.
The key issues confronting the current external business environment that may influence strategic choices
therefore include:
Globalisation results in products and services increasingly being distributed across continents, which
increases competition and necessitates product innovation and creative and innovative strategies.
Technological advances results in the life cycle of products becoming shorter.
Knowledge and information is increasingly accessible and freely available to everybody and hence the
management and utilisation of information is becoming a key aspect of organisational success.
Sustainability asp cts of business entities on an environmental, social and governance (ESG) basis added
to which is economic priorities and incorporating these sustainability aspects into strategy choices and
business pra ti es is fast becoming the norm in business, as a result of the global challenges faced in
respect of the natu al and social environment.
Innovation and finding new ways of thinking and adapting business processes to meet the future
demands to increase productivity and new product development has become increasingly prominent in a
competitive b siness environment.
These issues create both risks and opportunities in the business environment. Understanding the external envir
nment in which the entity operates, and how these factors impact on the entity and its future strategy ch ices,
may therefore require an analysis of some or all of the following factors, which may be general factors
affecting all entities, or industry specific factors in the external environment.
The political environment

The political environment, degree of political stability and expected future changes to this environment will
influence strategy choices. For example, political instability in a region may affect the ability of an entity to
conduct activities in that region. Political risk includes war, corruption and potential nationalisation.
Governments are responsible for creating a stable business environment by implementing suitable economic
and other policies and creating and maintaining infrastructure.
29
The political environment and its expected future stability, as well as government policies, for example
government policy on B-BBEE (Broad-Based Black Economic Empowerment) that may influence the industry
within which the entity functions, is a key aspect to be considered in the strategy choices of an entity.
The economic environment

The economic environment in a country as well as the global economy, and anticipated changes must be
considered. This will include the following –
exchange rates, and expected fluctuations in the exchange rate. This wi determine the cost of imports
and the revenue earned from exports;
interest rates and expected cycle of the interest rate. The interest r te me sures the cost of borrowing,
and influences the return that shareholders expect on their investment;
inflation and expected inflation rates, which will influence cost of production and selling prices;
economic growth rate per region, country as well as globally and expected business cycles;
government incentives applicable to the industry, for example incentives offered to the automotive
industry in South Africa; and
access to capital markets.
The social environment

The social environment has a bearing on the custom r base of the entity, as well as on employment and skills
retention. This includes, for example, the demographic composition of society (age, geographic location,
economic status, ethnicity, employment rate, household and family structures and gender), which may
influence the type of products and services that will be important to consumers in the future. Changes to
demographics of society may also influence the recruitment and human resource policies of the entity, for
example if the average population age increases, it might be necessary to consider increasing the retirement
age and retaining the skills of experienced workers.
Social trends, for example consumers that are increasingly conscious of environmental conservation matters,
will influence the type of products and service that consumers choose to buy in future and that will be in
demand. Analysing social trends will provide significant insights into current and expected trends in both
products and markets which will be important considerations for future strategy choices.
The technological environment

The technological environment and possible impact of technological advancement to products, markets and
the operating environment will impact on the strategy choices of an entity. Business entities in the technology
industry are reliant on innovation and new technological advancement in order to remain competitive, which
will influence strat gic choic s and the resources allocated to research and new product design.
Technological advan es an also impact on the cost and efficiency of products and services of an entity.
Technological advan es may include communications, data and information processes which impact on the
overall productivity of the entity as well as the ways in which products are made, services are rendered, entities
are managed as well as the way in which markets are identified.
The reg latory environment

The legislative and regulatory environment has an important bearing on entities and the strategic choices that
they make. These regulations attempt to promote an equitable economic environment and responsible
behaviour in the business environment. It can also levy penalties or fees to ensure entities act ethically or
properly re pond to consumer issues in the business environment.
Regu ations can include the following:
Tax regulations such as legislation governing income tax, value-added tax (VAT), import duties, rates and
the like. Income tax rates, and the introduction of new tax provisions and tax incentives, for example tax
incentives to attract businesses to certain areas or development zones may influence the entities choice
of where it chooses to locate activities. Another example is the carbon emission tax on new passenger
vehicles introduced by government, which may have significant cost implications for entities that operate
large motor vehicle fleets.
30
Competition regulations such as the Competition Act 89 of 1998, regulates restrictive business practices,
abuse of dominant positions and mergers in order to achieve equity and efficiency in our economy. This
prevents monopolistic enterprises and encourages socio-economic equity and development.
Exchange control regulations of the Reserve Bank govern the flow of funds and investments to other
countries.
Environmental regulations, for example allowable standards of environmental atmospheric pollution and
protection of sensitive bio-diverse systems are governed by legislation such as the National
Environmental Management Act 107 of 1998.
Health and safety regulations govern minimum standards that entities have to comply with in ensuring
the health and safety of employees, such as the Occupational Health and Safety Act 85 of 1993.
Employment law governs minimum wages and working conditions, for ex mple the Skills Development
Act 97 of 1998 aims to improve skills and increase productivity in order for South African companies to
effectively compete in the global economy.
Consumer protection regulation such as the Consumer Pr tecti n Act 68 of 2008 promotes a fair, accessible
and sustainable marketplace for consumer products and services.
The market for the product or service

The market comprises the customers or potential custo ers who have needs or wants which is satisfied by a
product or service. The market for the product or service, the size of the market share, the proportion of the
market share gained or lost by the entity, as well as and curr nt market trends and expected trends in the
market in which the business functions will have to be analys d.
Market segmentation recognises that every market comprises potential buyers with different needs and
different buying behavior. Each market segment can become a target market for an entity. Segmentation
can take place according to demographic aspects or behavioral aspects of consumers. Identifying market
segments can result in better satisfaction of customer needs, higher customer retention, as well as
targeted communication and marketing unique to each market segment.
Undifferentiated marketing aims to produce a single product for the entire market and therefore
disregards segmentation.
Concentrated marketing aims to produce the ideal product for a specific segment of the market. This
increases the business risk since reliance is placed on a single segment of the market.
Differentiated marketing aims to produce several versions of the product or service, each aimed at a
different segment of the market. This increases product cost as well as marketing costs.
The competitive environment

The competitive position of the ntity can be described as the market share, costs, prices, quality as well as
accumulated experien e of the entity in producing a product compared to its competitors. Analysing
competitors and the ompetitive environment therefore includes an analysis and identification of key
competitors and their competitive strategies, including potential new entrants to the market. It will also include
identifying, potential substitutes for products or services, and analysing the bargaining power of customers.
The competitor can be analysed in the following areas –
prod cts and services offered;
research and innovation;
techn l gy employed (manufacturing and business systems);
di tribution methods and channels;
financial performance and financial structure;
organisational structure and organisational flow chart;
leadership style and abilities; and
abilities for expanding or increasing market share.
This information can be obtained by financial statement analysis, information from customers and suppliers,
and product inspection.
31
Understanding the market and customer needs

Understanding customer needs and future requirements from customers is vital to business success and it is
therefore necessary to determine what innovation and future research and development would be required for
the business enterprise to satisfy customer needs and maintain or increase market share. It is therefore
important to determine the needs, wants and values of a target market and to respond to these needs and
wants on an ongoing basis in order to deliver products and services that meet the needs and wants of
customers more economically, effectively and efficiently than its competitors.
Marketing and marketing strategy entails the following possible actions in respect of the demand for the
products and services that the entity supplies –
create a demand;
develop a latent demand;
revitalise a sagging demand; and
sustain a buoyant demand.
Consideration should be given to the target markets to be devel ped, and how to maintain a competitive
advantage in the product and service offering of the entity compared to that f its competitors.
Customer analysis can be used where a relatively small nu ber of customers allow analysis on a per customer
basis. This will entail accumulation of data per customer, including customer history, the relationship of the
customer to the product, as well as financial performance of the custo er.
Customer profitability analysis entails the analysis of profit p r customer (revenue per customer or customer
groups less costs per customer or customer group) in ord r to identify the relative profitability of customers,
taking into account volume discounts, customer specific costs, agreed selling prices. This can be useful in
understanding the relationship between customers or customer groups and overall profitability, and may
therefore influence strategy choices.
The natural environment

This entails analysing the impact of changes in the natural environment on the entity. Expected changes in
climate patterns and the quality of air and water may have significant impact on the ability of an entity to
conduct business activities.
An example of the impact of the natural environment on business is detailed in South Africa’s first Water
Disclosure Report, which was issued in 2011. The report reveals that 85% of water-intensive users among
the JSE Top 100 companies are exposed to water-related risk, and that 70% of companies could face risks to
their direct operations due to uncertainty of expected future water quality and supply within the next five
years.
2.3 Internal environment

The internal envi onment can be described as the current resources of the entity. These resources include the
enterprise’s human resources, customers, structures and systems. Understanding the internal environment in
which the enterprise operates may require an analysis of some or all of the following factors –
leadership style and capability of senior management, whether the Chairman, Board, CEO and other
Executive managers are seen to be a visionary, strategic, participative and inclusive leaders as opposed to
auth ritarian and task oriented;
management capabilities, skills and recruitment and the suitability of the management style to the bu ine
s enterprise;
corporate culture of the enterprise, the key values of the entity and whether it fosters innovation,
flexibility and creativity or is more conservative and work-to-rule based;
governance regime, whether it is perceived to be more quantitative in its commitment to how it is
directed and controlled (i.e. a so-called ‘tick-box’ mentality) or more qualitative, which implies an
inclusive and integrated approach;
32
the products or services that it supplies, including an analysis of sales, product margins, product quality;
the life cycle of the products and services, and the price elasticity of demand for products and services;
marketing and the use of advertising, potential market growth for products and services, customer
satisfaction levels, potential new products and services;
distribution facilities and the efficiency thereof;
financial resources available for future investments and expansion;
labour force and skills requirements;
business management including the organisational structure, information systems and technology; assets,
plant, equipment and production capacities; and
suppliers, raw materials, and inventory holding policies.
There are various tools available that can assist with the analysis of the internal environment. These include –
value chain analysis;
product life cycle analysis;
BCG Matrix; and
resource audit.
The application of these methods as analytical tools is considered below.
Value chain analysis

The value chain model of activities, developed by Michael Porter, describe the key activities of the entity and
how it creates value. According to this model, competitive advantage arises from the way in which the entity
organises and performs various activities to create value.
An example of Porter’s value chain analysis for a business can be set out as follows:
SUPPORT ACTIVITIES
FIRM INFRASTUCTURE
HUMAN ESOURCE MANAGEMENT
TECHNOLOGY DEVELOPMENT
PROCUREMENT
INBOUND OPERATIONS OUTBOUND MARKETING SERVICE

LOGISTICS LOGISTICS AND SALES
PRIMARY ACTIVITIES
Figure 2.1: P rter’s Value Chain
Performing a value chain analysis for an entity serves to:

Identify the interdependencies between various activities and the potential for structuring activities more
efficiently.
Identify the interdependencies between various activities and the potential for structuring activities more
efficiently.
33
Product life cycle analysis

Innovation in new products, product design and features and in services, adds to the competitive advantage of
any entity. However, as newer versions of the same product, or new products or services become available,
products and services that have an established customer base may become less popular as customers start
switching to these new products or services. It therefore follows that each product has a ‘lifetime’, starting with
development of the product phase, through to the decline in sales phase (Figure 2.2 below). The duration of
the product life cycle will depend on factors such as how many competitors are in the market, the type of
product and consumer, and the frequency of new innovations. Typically technology items such as cell phones,
televisions and computers have a very short product life cycle due to the rapid advancement in technology,
which constantly improves on the features of new products, rendering the o der version of the same products
almost redundant.
It is important to understand the market requirements and the role of technology nd competitors, in order to
establish the expected life cycle of a product. Where a product is expected to ha e a short product life cycle, it
is paramount that the research and development cost of the product is reco ered by profits from sale of this
product in the shortest possible time span, since the risk exists that competitors may launch new improved
products before sufficient quantities of the product has been s ld by the entity to recover such costs.
MATURITY
INTRODUCTION
DEVELOPMENT
GROWTH
DECLINE
SALES VOLUME
TIME
Figure 2.2: Product life cycle analysis
BCG Matrix
The Boston Consulting Group (BCG) developed a matrix which classifies an entity’s products in terms of
potential profitability (cash g n rated less cash expenditure). This enables the entity to identify products that
are not actively contributing towards profit and that should possibly be rationalised. Products can be classified
in the following ategories:
Stars a e p odu ts that require high capital expenditure in excess of the cash generated, but have the
potential to become cash cows (generating high cash income). As market growth slows down, they then
descend into the cash cow quadrant.
Cash cows are products that require little capital expenditure and generate high levels of cash. Their
excess f nds should possibly be invested into ‘question marks’.
Questi n marks are products that may potentially justify additional capital expenditure (from cash cows)
in pursuit f additional market share, or may potentially be nearing the maturing phase in the product life
cycle.
Dogs are products that may have been cash cows but are no longer contributing towards cash generation
anymore. They should probably be terminated.
34
This can be illustrated as follows:
MARKET SHARE
HIGH LOW
MARKE
TGRO
WTH
HIGH STARS QUESTION MARKS
LOW CASH COWS DOGS
Figure 2.3: Boston Consulting Group (BCG) Matrix
Resource audit
This entails analysing the resources required, availability of suppliers and the future availability of raw materials
and other resources or capitals (natural, human, financial, social, anufactured and intellectual capital)
necessary for the entity to produce products and services. This is an internal view. The M’s model is often used
to describe the various resources that have to be consid r d.
Resource Aspects to be considered

Machinery Age, technological advancement, utilisation, replacement schedules
Make-up Culture of the entity and organisational structure
Management Structure, compensation structure, loyalty, skills
Management innovation Information systems and technology
Markets Products and customers, value of relationships with customers
Materials Availability, cost, sources and suppliers, relationships with suppliers
Methods Activities and relationships
Money Gearing levels, profit levels
Men Labour force, skills, efficiency, relationship with trade unions
A resource audit allows the entity to consider the effective utilisation of resources, in addition to the quality
and timeliness of information as well as the quality of the relationships with labourers, management, suppliers
and customers.
2.4 SWOT and gap analysis

Once the analysis of the external environment as well as the internal environment has been completed, it is
possible to do a SWOT and gap analysis.
SWOT analysis entails an assessment of the strengths, weaknesses (internal environment) as well as the
opport nities and threats (external environment) of the entity.
N te Risk assessment is a critical component of the SWOT analysis. It is also important to bear in mind that
risk management does not always have negative connotations from the perspective of weaknesses
and threats only, but it can provide a positive platform to consider opportunities and the potential for
the entity to capitalise on its strengths as well.
The next tep is to analyse the extent to which new strategy choices are required for the entity to achieve its
objectives.
G p nalysis is a comparison between the objectives of the entity, and the expected performance of the entity
given the information gained by the SWOT analysis.
The benefits of performing a gap analysis is that it allows for the entity to consider to what extent current
strategies and business activities will result in the objectives of the entity being met, and to identify the need
for strategy choices that will enhance the achievement of these objectives.
35
2.5 Selecting appropriate strategies

After considering the external and internal environment, strategic options must be identified and the most
appropriate strategic options selected. Strategic options can include –
product and market strategies;
competitive strategies; and
growth strategies.
Various strategies could be under consideration and assessment by the company. Ensuring shareholder’s long-
term sustainable returns requires that the company creates, evaluates and se ects strategies that will increase
the value of the company. It is therefore important that the financial implic tion of e ch strategy as well as the
impact on all stakeholders is evaluated before selecting appropriate str tegies.
The strategies that are selected therefore have to be acceptable from a feasibility (can it be done?), viability
(does it generate positive cash flows?) and sustainability (does it endure o er the long-term?) perspective. The
financial perspective will question if the strategy results in the achievement of financial objectives such as an
acceptable Return on Capital Employed (ROCE) and a positive Net Present Value (NPV). The latter, takes into
consideration Discounted Cash Flows (DCF), which means that the future cash flows generated by the entity are
discounted at the required rate of return and when added together, should exceed the cost of the investment
today. Other considerations that need to be taken into account are –
l impact on existing or potentially acquired resources of the fir ;
impact on stakeholders and stakeholder relations;

how competitors are likely to respond;
risk associated with the strategy; and
impact of the strategy on environmental and social measures and KPIs.
It is becoming increasingly important for entities to incorporate sustainability aspects of ESG into strategy and
business activities for various reasons. In a world where business often face public scrutiny for its actions, and
where consumers are increasingly becoming better informed of product content and how products are made, it
has become essential to address sustainability aspects of ESG in strategy choices. The effects of climate change,
pollution and environmentally damaging greenhouse gasses as well as the decline in natural resources,
necessitate responsible stewardship in business practices, and entities risk losing their good reputation and
their customer base if business practices or activities are considered potentially harmful to people (social
welfare) or the planet (natural environment). The advent of social media, for example Facebook and twitter,
has provided a basis for easy dissemination of information and conversations between stakeholders, which can
easily highlight firms who do not operate as responsible corporate citizens.
Furthermore, this is essential in order to attract funding in the form of equity as well as loans for any entity, for
profit seeking and non-profit entities alike. The question often arises how much should be invested in
stakeholder manag m nt in the pursuit of shareholder maximisation, since quite often a trade-off must be made
between profits and the interests of stakeholders, society, or the natural environment.
Laszlo’s Sustainable Value Matrix (Figure 2.4) attempts to explain that increasing shareholder value at the
expense of dest oying stakeholder value (upper-left quadrant of the sustainable value matrix) is unsustainable,
since it is likely to esult in reputational damage, customer loss, or penalties in a regulated environment. In
contrast, increasing stakeholder value at the expense of shareholder value (bottom right quadrant of the
matrix) is ns stainable since it decreases company resources and competitiveness, threatening the overall
existence and profitability of the company. Laszlo therefore proposes that companies strive to operate in the
sustainable value quadrant (top right quadrant of the matrix) by actively incorporating and selecting strategies
that benefit b th stakeholders and shareholders in a win-win approach. This will improve corporate reputation,
increase cost efficiency, lead to new product innovation, and increase the number of loyal customers and
engaged employees, while improving constructive relations with stakeholders.
36
Shareholder Value
+
Unsustainable
(Value Transfer) Sustainable Value
– + Stakeholder Value
Unsustainable
Unsustainable
(Value Transfer)
–
Figure 2.4: Laszlo’s Sustainable Value Matrix
Laszlo’s matrix highlights the need for entities today to derive inno ati e solutions and make strategy choices
that benefit both shareholders and other stakeholders in order to achieve long-term sustainability, by striving
to operate in the top right quadrant of the matrix.
Product-market strategies
These strategies will determine which products and services the business enterprise sells, and the markets to
which it is aiming to sell the products or services. At the broadest level, these are often translated into the so-
called ‘corporate’ strategy efforts of the firm, as th y indicate the firm’s preference for whether it should
concentrate on specific products or markets, wheth r it should embark on backward or forward integration
(taking over suppliers or buyers) or which geographies it should focus on. It will also have an impact on how the
firm structures itself, for example by function, division or Strategic Business Units (SBUs).
The Ansoff’s Growth Vector Matrix is a tool that can be useful in strategy selection for market growth and
products. Ansoff’s product/market growth matrix suggests that a business’ attempts to grow depend on
whether it markets existing or new products in existing or new markets (see Figure 2.5).
Product
Existing New
l Market penetration (for
growth); or Product development
Existing l Consolidation (to maintain
position); or
Market l Withdrawal
Diversification into:
New Market development l Related product markets; or
l Unrelated product market areas
Figure 2.5: Igor Ansoff’s Growth Vector Matrix
Competitive strategies
Michael P rter f the Harvard Business School is recognised as having developed the so-called ‘generic’ business
strategies, which determine how the business enterprise will compete. Competitive advantage is anything
which gives a company a real advantage over its competitors. Business strategies seeking competitive
advantage may include –
cost leadership, by aiming to be the lowest-cost producer of the products or services in the industry;
differentiation, by aiming to provide a unique product or service; or
focus strategy, by aiming to concentrate on a specific segment of the market, which can be achieved by
aiming to be a cost leader for a chosen segment or aiming to pursue differentiation for a chosen segment.
37
Porter also developed a framework for industry analysis and business strategy development referred to as the
‘Five Forces Framework’. These forces are the external and internal influences of an industry, which impact on
profitability and for which a strategy must be selected in order to increase and maintain shareholder value. The
five forces are –
the threat of new entrants to the industry;
the threat of substitute products or services;
the bargaining power of customers;
the bargaining power of suppliers; and
the rivalry amongst current competitors in the industry.
Pricing strategies for products and services must also be considered. Pricing str tegies will not only affect
profitability, but can be an important competitive tool for differenti ting product and a company, and utilising
opportunities in the market. Pricing strategies will depend on the type of product or service as well as the
market for the product or services. Possible pricing strategies may include –
price skimming, that is, setting a high selling price for a unique pr duct to maximise short-term profits;
l predatory pricing, that is, setting a low selling price for the pr duct r service in order to gain market share;
selective or discriminatory pricing, that is, setting different selling prices for the same product or service
in different markets; or
market pricing, that is, setting a selling price for the product or service based on the perceived value to
the customer.
Growth strategies
Growth strategies will include how the business will grow, for example by acquisition of a competitor; by
strategic alliances, or by expanding products into new markets and growing the company internally.
A strategy of organic growth seeks to grow the company internally with the existing resources and expertise, by
increasing market share or entering new markets and optimising product and service ranges.
A strategy of acquisition seeks to acquire existing businesses.
A strategy of alliances may include working together in a variety of ways, for example joint ventures and
strategic alliances.
2.6 Implementing the strategies

The selected strategi s will have different implications for various divisions of the entity, and will have to be
translated into obj ctiv s or k y performance areas for each level of the operational goals. For example, a cost
reduction strategy will r sult in activities and objectives such as more efficient processes resulting from an
investment in new plant and machinery in the manufacturing plant, in contrast to a reduction in headcount in
the administ ative fun tion of the company.
Communication and quantification of the strategies where possible, and translating them into clear objectives
is a key aspect of implementing the selected strategies. Critical success factors (CSFs) can be set by identifying
objectives and goals, based on the strategy selected, and determining which factors are critical for
accomplishing each objective. These factors can be measured by performance indicators.
The c st and benefit of establishing performance indicators must be weighed up (so-called ‘cost/benefit
analysis’) and the performance indicators must be relevant to the way the company operates.
Aligning organisational performance with strategy

Performance measurement can be described as communicating the selected objectives and strategies
throughout the entity, and monitoring the progress of each business or functional unit on an ongoing basis
owards these objectives. Strategy choices should translate into clearly defined objectives, which are then
quantified as measurable key performance indicators (KPIs). These KPIs should be aligned with the strategy and
objectives of the entity, and will be measured and reported on at regular intervals in order to assess the
progress of the entity towards the stated objectives. The benefit of measuring a specific dimension of
38
performance of the entity by defining a KPI should, however, always exceed the cost of measurement. The KPIs
selected for measurement should also reflect a balance between financial and non-financial measures, and
should ideally be focused on measures that are aimed at achieving long-term sustainability of the entity.
The measures selected should reflect the key strategy choices of the entity, in order to ensure that collective
and individual responses and decisions taken throughout the entity are aimed at or aligned with achieving the
desired outcomes for the entity. There are various mechanisms that may be employed to encourage
managerial behaviour and decision making that corresponds with and leads to the objectives of the entity
being achieved, such as linking the remuneration of managers with specific KPIs. Although incentivising
managers to achieve the objectives of the entity by monetary reward is a powerful mechanism to achieve a
desired outcome, it is important that the emphasis of remuneration-based performance schemes should be on
balanced, long-term performance measures of the entity, which includes measures of social and environmental
measures in addition to financial measures. Remuneration-based perform nce incentive schemes are often
criticised for incentivising managers to take short- term decisions that benefit m n gers, but which may be
harmful to the entity in the long-term. This is a risk where managers are measured mostly on financial
measures (e.g. divisional profits) which may lead to managers optimising short-term monetary gains which may
not be conducive to the long-term sustainability of the entity.
Measurement of performance and reporting against strategic objectives

The objective of strategic control, or measuring perfor ance, is to review the long-term indicators of
achievement of the selected strategies. Performance measure ent is the process of measuring the proficiency
with which a company succeeds in achieving its financial and non-financial objectives.
Examples of financial measures include –
profit;
return on capital employed (ROCE);
costs;
share price; and
cash flow.
Non-financial measures are often more challenging to develop since measurement of these may be subjective
(e.g. customer satisfaction) or it may be very costly to accumulate data for measurement (carbon footprint or
water footprint for an entity). It has however become increasingly important to incorporate non-financial
measures into performance management systems for entities to achieve long-term sustainability.
Objectives and performance targets should be linked to the strategy choices of the entity as well as the risks
and opportunities faced by the entity. A practical example of a non-financial objective which relates to risks
identified is where water scarcity is an external risk factor for a beverage manufacturer. In this case, a strategic
choice of reduction of the amount of water per final product manufactured may be appropriate. This can be
converted into an obj ctive of improving water utilisation efficiency during the manufacturing process by a
certain percentage in a sp cifi d number of years, which in its turn can be measured by a KPI, such as litres of
water consumed per litre beverage manufactured. This KPI can then be measured on an on-going basis to
determine the progress of the entity towards the objectives set.
The following ext act was made from the website of SABMiller, a South African based brewery, which has
identified water scarcity as a significant risk to the long-term viability of the entity:
‘Water scarcity represents a potentially significant risk to parts of our business. Water is vital not only in
the brewing pr cess but also in growing the crops used to make our beer and even in generating electricity
to p wer ur breweries. We aim to use water as efficiently as possible and have set ourselves the demanding
target of reducing our water use per hectolitre of lager by 25% between 2008 and 2015. During the la t
year we used four litres of water to produce one litre of lager.’
39
Examples of non-financial areas that an entity may select to assess, and measurable dimensions, which will be
based on the strategy choices and objectives set, include:
Area assessed Examples of measurable dimension

Production performance l Set up times
l Output per hour
l Output per employee
l Percentage downtime
l Percentage of products requiring rework
l Material yield percentage
Customer satisfaction l Percentage of returning customers
l Customer wait time
l Number of complaints
l Customer satisfaction indicator (customer survey)
Marketing effectiveness l Trend in market share
l Number of customers
l Number of units sold
Personnel satisfaction l Staff turnover
l Number of days training attended
l Days abs nt ism
l Numb r of staff complaints
The selection of KPIs will vary from entity to entity, depending on the industry, objectives of the entity, and its
ability to select appropriate and cost-effective measures that will enable the management of the entity to track
the performance of the entity towards set long -term objectives. Communicating the KPIs throughout the entity
and incorporating these into the performance measurement system is necessary for the entity to achieve its
objectives. The most important KPIs of the entity, as well as the progress of the entity in achieving these, is also
communicated to the stakeholders in the Integrated Report to enable stakeholders to assess whether the
strategy choices of the entity, and the dimensions measured in its selected KPIs, sufficiently reflects the risks
and opportunities faced by the entity, including social, environmental and economic matters. Although
performance measurement may be considerably more challenging in non-profit entities and public sector
enterprises, it is equally important in these entities. The lack of a predominant profit motive, complicated
delivery chains and multiple stakeholders, unclear cause and effect relationships, as well as delayed impacts of
achievements towards public sector objectives, often result in difficulty not only in identifying suitable
measurable KPI’s, but also in accurately measuring these. For example, it may be simple to measure the
number of students that complete secondary schooling (school leaver output rates) however, to measure the
relevance and applicability of the knowledge gained (outcomes of the schooling system) to be prepared to
study in a university is far more challenging.
David Norton and Robert Kaplan’s Balanced Scorecard (BSC) is an approach which attempts to ensure that an
entity pays attention to all of the measures outlined above. It does so by considering four perspectives, namely
–
the financial perspective (profit, returns etc.);
the c stomer perspective (customer satisfaction etc.);
the internal process perspective (systems, logistics, production processes etc.); and
the learning and growth perspective (leadership and human capital development).
Their e ential argument is that ‘You can’t manage what you can’t measure and you can’t measure what you
can’t de cribe’. Further, they stress that there are the so-called intangible factors (such as leadership and
human capital development) which ultimately determine the tangible success measures of the firm (such as
profitability and cashflow).
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2.7 Risk and the business environment

Risk can be described as the potential to have a possible deviation from a planned outcome. The greater the
magnitude of the possible deviation, the higher the risk. As entities operate in a world that does not remain
static, uncertain future events that could potentially influence the achievement of the goals and objectives of
an entity (negatively and/or positively) are a reality. Hence, any activity of the entity will to some degree
expose the entity to consequential risks, and it is inevitable that risks flow from the pursuit of value creation for
stakeholders. Risk may be incurred in order to gain a competitive advantage and to increase profits of the
entity.
Risk management
Risk is inherent to the operating environment within any entity functions, since the outcome of events cannot
always be predicted with accuracy, and a certain degree of uncertainty in the en ironment with regards to the
future in respect of economy, markets, products, consumer trends, to name but a few, is inevitable.
Furthermore, entities are exposed to risk arising from unexpected events such as fraud, errors, natural
disasters, and accidents. The greater the degree of uncertainty, the greater the extent of the risk will be. Risk
and uncertainty is therefore interrelated. This uncertainty is in respect f whether an outcome will occur, (the
likelihood of the loss) and if it does, what the extent will be of the loss (impact of the loss), financial and
otherwise.
Risk management essentially entails minimising the possibility that adverse or loss producing events will occur,
as well as minimising the adverse effects, should the event occur. It also entails, measuring the impact that
these events could have on the firm. This is done by a syst matic approach that aligns strategy, processes,
people, technology and knowledge with the purpose of ass ssing, evaluating and managing the risks in order to
create value for stakeholders. Risk management seeks to firstly control (prevent, mitigate or limit) unforeseen
events, and secondly to address the financial consequences of these events (insurance cover, hedging,
diversification).
Risk appetite
Entities may vary in the degree of risks that it is willing to accept in the pursuit of value. This degree of risk is
referred to as risk appetite. An entity may have one of the following attitudes towards risk:
Risk averse describes an attitude towards risk that seeks to avoid risk.
Risk neutral describe an attitude towards risk that is balanced, in other words a moderate amount of risk
is assumed by the entity.
Risk seeking describes an attitude towards risk that seeks risks.
The risk appetite of an entity will influence the operating style and decisions that are taken. To illustrate this,
take the example of an ntity or project which bears a particularly high overall risk, and for which funding in the
form of a loan is r quir d. A financial institution (Bank A) that has a higher risk appetite, might be willing to
provide loan finan e to this entity or project, that Bank B, with a moderate or low risk appetite, will not be
willing to provide, sin e the degree of credit or repayment risk that will be assumed for Bank B is not within
acceptable levels given the lower risk appetite assumed by Bank B.
In Chapter 1 we consider the relationship between risk and return, and it is important to bear in mind that the
entity sho ld only assume risk in any decision or activity if the degree of risk is commensurate with the expected
ret rn. In other words, in the example, Bank A will charge a high interest rate on the loan since Bank A is exp
sed to high repayment risk, this being compensation to Bank A for the high degree of risk assumed. Risk
appetite for any entity is developed by the management of an entity, and is reviewed, overseen and appr ved
by the Board of Directors. Risk appetite should also be well communicated throughout any entity through the
stated strategies and objectives.
The ri k appetite of any entity will depend on the following factors:
Risk capacity, in other words the maximum risk that the entity can assume.
Risk culture, that is, the entities’ overall approach to risk, including the shared attitudes, values and
practices towards risk in the entity.
41
Risk management strategy

Risk management can be described as the management function aimed at protecting the entity and its assets
against the consequences of risks by planning, coordinating and monitoring the risk to which the entity is
exposed. The goals and objectives of risk management should be aligned with the mission, goals, and objectives
of the entity. The key activities in the risk management process are:
Risk identification, by reviewing all information internal as well as external to the entity in order to
identify potential events that may affect the achievement of the objectives of the entity.
Risk assessment, estimating the impact of these potential events on the entity in terms of financial and
other losses, as well as estimating the likelihood that these potential events wi have on the entity.
Risk responses or risk mitigation by selecting and implementing me sures to modify risk by risk avoidance,
reduction or transfer of risk to another entity.
The risk management strategy is the approach adopted for managing of risks and will be based on and
supported by the objectives and strategies of the entity.
Residual risk is the risks that remain after taking into considerati n the effectiveness of the entities responses to
risk.
The risk management goals and objectives must be aligned with the goals and objectives of the entity. These
objectives should be set out in a documented risk manage ent policy that describes the aims and objectives of
the risk management policy. The risk management policy assigns responsibility for performing key activities and
accountability, determines risk authorities in the entity, sets li its and boundaries, as well as the reporting
channels.
2.8 Governance principles relating to risk management

The board of directors (and the company’s management) are accountable to the company and through the
company to the shareholders who are the owners and suppliers of risk capital to the entity. The board of
directors and management has the responsibility to achieve a key outcome of creating long-term sustainable
wealth for the shareholders, with due regard to the interests of major stakeholders. This implies that a certain
degree of risk will be assumed in the pursuit of the objectives of the entity. The key role-players in determining
the risk appetite of the entity, and for giving the assurance that appropriate risk management processes are in
place to mitigate and limit losses due to risks, are the board of directors, management, the audit committee as
well as the internal audit function .
The King Code of Governance Principles for South Africa of 2009 (King III), sets out the governance principles
relating to risk management. The code emphasises that risk management is inseparable from the strategic and
business processes. Furthermore, in terms of the code, risks are viewed as an inevitable part of value creation,
and the board of directors should mitigate its exposure to losses by responsible risk taking and well- defined
risk strategies, which are align d with the objectives of the entity. The code furthermore sets out the obligations
and the responsibiliti s of the board of directors, management and internal audit. Note that King III makes
provision for certain specific responsibilities to be delegated to a risk committee of the board.
There are however a number that cannot be delegated. Figure 2.6 outlines a number of obligations and
responsibilities of va ious role-players and the extent of overarching responsibility of the board.
42
Board of Risk Manage- Internal

Obligations and responsibilities: directors Committee ment audit
Overall responsibility to oversee the risk x
management process
Approval of risk appetite, risk philosophy, risk policy x
and risk bearing capacity
Approval of key risk indicators for each risk as well as x
tolerance limits for key risks
Performing risk assessments on an ongoing basis x
Approval of a documented risk management plan x
Approval of the disclosure reports to third parties x
Designing, implementing and monitoring the process x x
of risks management and integration into the
business activities of the entity
Overseeing the IT strategy, governance and risk x x
management
Ensuring that key risks are quantified and responded x
to
Monitor the risk management process x x
Protection of the reputational risk of the entity x
Ensure that the risks relating to sustainability are x x
suitably identified and reported upon
Evaluate the register of risks, estimated cost of x x
losses, changes to the risk profile and risk financing
arrangements
Ensure that the information technology (IT) is aligned x x
with the business objectives
Report on the effectiveness of risk management x x
processes in terms of adequacy of risk identification
Report on the adequacy and effectiveness of risk x x
management process in terms of adequacy and
effectiveness of risk mitigation and residual risk
assessment
Ensure that risk ass ssm nt, risk r ports and x x
assurance on risks are r f rr d to r levant board
committees
Provide independent assu ance on the effectives of x
the risk management p ocess
Advise the Board regarding the effectiveness of risk x
management process including adequacy of the risk
identification process
Figure 2.6: Resp nsibilities of the various role players in the governance of risk management
43
2.9 Risk identification

Risk identification can be described as the process of finding, recognising and describing various risks that the
entity is exposed to. The risks identified at this point are inherent risks, which is the risk (and risks) exposure of
the entity before control measures are taken into account.
Macro risks are major risks that may have a significant impact on the ability of the entity to achieve its goal (for
example, the acute shortage nationally of skilled labour), whilst micro risks are sub-risks within the major risk
classes (for example, the risk that the entity will not be able to recruit a suitable engineer or that the
immigration authorities will not process the work permit in time for an expatriate with special skills needed in
the entity).
It is unlikely that a single method will suffice to identify all risks, and the entity therefore relies on a variety of
sources and methods that assess the external as well as the intern l environment during the process of
identifying risks. This will include consultation with a wide variety of line managers within the entity in order to
establish and identify potential risks. Potential sources of information and resultant warning signs or ‘red flags’
during the risk identification process include:
PESTLEGE analysis of all the Political, Economic, Social, Techn l gical, Legal, Ecological (environmental),
Global and Ethical factors that could affect the entity.
SWOT analysis as discussed in section 2.4 above in order to evaluate the strengths, weaknesses,
opportunities and threats.
Porter’s Five Forces Model discussed in section 2.5.2 above to assist in identifying market risks relating to
competitors and products.
Stakeholder engagement in respect of specific areas of concern and perceptions of stakeholders.
Techniques involving data collection and could include the survey of stakeholders by interview or
questionnaire.
Benchmarking against similar entities in the same industry could be applied to risk management as
management identifies the best risk management practices in their industry.
Organisational charts and flowcharts detailing the reporting structure and activities of various functions
or business units within the entity.
Flowcharts of business processes which may identify consequential losses due to interruption risks, and
highlight the interdependencies and interaction between various processes, suppliers, stages of
production and customers.
Entity charts and flowcharts that indicate the processes/divisions of the entity and assist to identify
human factor risks (for example too many reporting lines to a single manager, or inadequate skills to
perform the required tasks) as well as indicate risk concentrations and dependencies (excessive reliance
on a unit for strat gic support services).
Financial stat m nts and management accounts which may provide information on the sources of income
as well as potential liabilities and how well the assets of the entity are utilised. Analysis of the financial
statements is also useful in identifying asset values that are at risk, possible legal exposures or
contractual liabilities (on the statement of financial position), and/or to indicate sources of income and
losses (statement of profit or loss and other comprehensive income).
Physical inspection of assets, equipment, hazard and safety audits.
Results of quality control checks, inspections and audit findings will assist with the identification of risks
that manifest in the ‘price of non-conformance’, for example cancelled orders.
Compliance audits of relevant legislation and regulations that apply to the entity provide information on
ri ks relating to non-compliance, and quality assurance risks.
Se f-assessments completed by management. This is a tool to assess management's perception of
perceived strengths, risks, weaknesses within the business processes and the adequacy and effectiveness
of the external and internal controls designed to mitigate the risks and achieve business objectives.
‘Diagnostics’ is a term used in risk management to refer to methodologies measuring specific risk
exposures.
Insurance reviews which identifies insured as well as uninsured risks.
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2.10 Risk assessment and evaluation

Risk evaluation can be described as the quantification of the inherent risk and determination of its potential
impact on the entity. This includes evaluating risks to determine the potential severity and the likelihood of risk
events, as well as the adequacy of the risks control. The result of the evaluation is the residual risk. The
purpose is to quantify the size of the various risks and their impact on the KPIs of the entity, such as profit,
return on equity, as well as non-financial indicators.
Risks are analysed by considering two dimensions, namely the likelihood of the event occurring and its impact
(potential damage or loss). This is used as a basis for determining how the risk shou d be managed on both an
inherent (gross) and residual (net) basis.
l Inherent risk involves the assessment of risk before the application of ny risk responses. Risk responses
can include the introduction of internal controls, the transfer of the risk or m n gement responses.
Residual risk involves the assessment of risk after taking into account the application of any controls,
transfer or management responses to reduce the risk.
The residual risk rating will indicate whether the remaining risk is within the entity's risk appetite. Risk
responses are discussed below. The process to assess risks thr ugh the likelihood or impact matrix is called risk
mapping.
2.11 Risk responses

Risk responses can be described as the actions tak n by an entity to limit, reduce or illuminate the
consequences from risk events. The response to each risk will vary depending on various factors, such as the
risk and return relationship, the cost to transfer the risk (e.g. by hedging the risk) versus the potential risk
exposure, and the expected cost of risk control measures compared to the benefits. An entity may accept
potential risks that have an insignificant financial impact, such as minor inventory losses due to inventory
becoming obsolete, or employee theft, but may choose to insure the entity (transfer of the financial
consequences of the risk) against risks events with a significant impact, such as natural disasters.
2.11.1 Risk avoidance

This response is to illuminate or highlight activities that lead to the risk exposure and then avoid them. This is
however often not possible, since risk is an inherent part of business and creating value. An example is an
entity that is exposed to currency fluctuations due to international trade. By buying forward on certain
transactions, the risk of the currency value moving against the entity can be avoided.
2.11.2 Risk acceptance

This response is wh re the xp cted return compensates for the expected risk. This is also referred to as risk
retention, and this ntails making provision in the form of an accounting provision or reserve for acceptable
losses.
2.11.3 Risk mitigation

Risk mitigation also accepts the risk, but every attempt is made to minimise its impact. Risk mitigation is the
process of selecting and implementing measures to modify risk (avoidance, risk reduction and risk transfer).
Risk mitigati n c mprises of two aspects:
Risk c ntr l is the design and implementation of a risk management programme which aims to reduce the
magnitude as well as the frequency of the potential loss, as well as dealing and recovering from loss-
producing occurrences.
Risk financing aspects have the objective of ensuring that the cost of risk management does not exceed
the benefits. Risk financing ensures that provision is made for acceptable losses encountered in the
operations of the entity, as well as for the cost of control measures aimed at loss mitigation.
Examples of risk financing are the cost of insurance premiums to insure the entity against the financial losses of
a risk, the cost of potential uninsured losses, the cost of risk control and risk prevention systems, as well as
administrative costs relating to the above. It remains an overriding principle that the cost of any control
measure or insurance premium should be weighed up against the expected benefit derived from such cost. The
45
long-term cost of the cost of risk to an entity should therefore be optimised, which means minimising both the
cost of risk and the level of risk that the entity is exposed to.
Risk control and risk financing should both be undertaken within the broader corporate financial objectives and
constraints.
2.12 Monitoring and reporting on risks

Risk monitoring entails a continual evaluation of the business operations to ensure the adequacy of the control
measures and the identification of new risk exposures to the entity.
The risk register contains a summary of identified risks, which are listed, described and assessed (measured),
based on their potential impact and likelihood.
Risk reporting involves the collating of relative information and producing risk reports for management. The
general principles that apply in respect of any reporting in the entity, also apply in respect of risk reports. These
principles applied to the information content of the reports are rele ance, accuracy, and timelines and should
include all the information required for managers to base their decisi ns n in respect of the risk management
process.
2.13 Enterprise risk management (ERM)

The corporate governance principles contained in King III require that risk management be integrated in the
management processes of the entity, since risk is inh r nt to the value creating process. ERM aims to fully link or
embed risk management into core business process s and structures of an entity instead of risk management
functioning as a standalone function within the entity.
The Committee of Sponsoring Organisations of the Treadway Commission (COSO) describes ERM in its
Enterprise Risk Management Framework (2004) as a process, effected by an entity’s board of directors,
management, and other personnel, applied in strategy setting and across the enterprise, designed to identify
potential events that may affect the entity, and manage risk to be within the risk appetite, to provide
reasonable assurance regarding the achievement of the entities objectives.
The framework comprises eight interrelated activities and components:
Activity Components
Internal environment l isk appetite and the entity’s view on risk
l Values of the entity including integrity, ethical values, attitudes
towards risk
Objective setting l Set objectives aligned with the entity’s mission
l Align objectives with the risk appetite
Event identification l Identify external and internal events that can affect achievement
of the entity’s objectives
l Identify risks as well as opportunities
Risk assessment l Analyse risks, considering likelihood as well as impact
l Assess risks on an inherent as well as on a residual basis
Risk response l Develop a set of responses (avoiding reducing, transfer)
l Ensure that actions/responses align with the entity’s risk
tolerances and risk appetite
C ntr l activities l Establish and implement policies and procedures to ensure the
risk responses are implemented
Information and l Identify relevant information and communicate and report to
communication and from various responsible persons
Monitoring l Monitor ERM on an ongoing basis and continually evaluate the
adequacy of the risk management process of the entity
An ERM approach to risk management can be implemented in any entity over a period of time by initially
focusing on the strategic risks that are deemed critical to the entity achieving its objectives, and then expanding
the focus with time to encompass a fully integrated and comprehensive ERM process within the entity.
46
Practice questions
Question 2–1: Developing a corporate strategy (Intermediate)
Required:
Discuss the main issues which need to be addressed in developing a corporate strategy for the following:
a bank
a building society
a college
a national charity
a retail store
a local authority.
Source: CIMA study text 2008
Solution:
Developing a corporate strategy
All entities need to plan. Strategic planning is the proc ss th y use to select goals and determine how to achieve
them. A corporate strategy is a plan for the future of the entity.
Developing a corporate strategy involves top management taking a view of the entity, and the future that it is
likely to encounter, and then attempting to organise the structure and resources of the entity accordingly.
Policies must be formulated and a set of medium- /long-term plans (probably 2–5 years ahead) developed.
The issues that need to be addressed and questions to be asked are:
What is our business and what should it be?
Who are our customers and who should they be?
Where are we heading?
What major competitive advantages do we enjoy?
In what areas of competence do we excel?
Developing the strategy involves a process of strategic planning. The plan must embrace strategies covering
funding, markets, products, technology and resources.
Developing a corporate strat gy mbraces the following:
Setting the orporate/strategic objectives which need to be expressed in quantitative terms with any
constraints identified.
From (a), establishing the corporate performance required.
Internal appraisal, by means of assessing the entity’s current state in terms of resources and performance
(SWOT analysis).
(d) External appraisal, by means of a survey and analysis of the entity’s environment, including the
c mpetitive environment.
Forecasting future performance based on the information obtained from (c) and (d) initially as purely
pa ive extrapolations into the future of past and current achievements.
Analysing the gap between the results of (b) and (e). This is referred to as gap analysis.
Identifying and evaluating various strategies to reduce this performance gap in order to meet strategic
objectives.
Choosing between alternative strategies.
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Preparing the final corporate plan, with divisions between short-term and long-term as appropriate, and
selection of appropriate KPIs for on-going measurement and reporting.
Evaluating actual performance against the corporate plan.
Senior managers must be actively involved in developing the corporate strategy. This should create a unified
direction and guide the deployment of resources.
A bank
The prime corporate objective of a bank will be financial (growth in profits). Banks are expected to uphold a
high standard of ethical behaviour towards customers.
Clearing banks are very sizable, and so the problems of creating an effective, co-ordin ted planning process are
complex and large. It is difficult to involve all the local branch managers in the corpor te planning process, and
so getting the commitment of branch managers to the bank’s objectives may also be difficult.
Clearing banks are traditionally fairly staid and bureaucratic, but they ha e been faced with rapid changes in
recent years, and this is likely to continue in the future.
Examples of change include:
New technology – home banking, cell phone banking and internet services.
Changes in the law – banks can provide more financial services, but so too can building societies.
Opportunities must be actively sought. A defensive corporate strategy of reacting to competition will
prove to be ineffective.
Changes in the economy – for example, future bank l nding will be dependent to some extent on future
interest rates. Environmental analysis is required.
Regulatory changes, for example latest Basel III capital adequacy requirements and the influence of
applying the equator principles on the business model and future profitability.
Innovative thinking is essential for banks to maintain their status in financial markets.
A building society
Note Building societies do not exist in South Africa anymore. However, the main commercial banks have
assumed this role.
The principal purposes of building societies are to raise funds, primarily from their members, to make advances
to members secured upon land and buildings for their residential use.
Objectives to be met are:
Protection of the investments of its shareholders and depositors.
Promoting and s curing financial stability.
Competing successfully with banks, insurance companies, estate agents and other building societies.
A corporate strategy must over the change in the law and the widening of both the range of services to be
offered and the activities of competitors.
A college
The prime objective of a college should be to provide education. In the corporate planning process, the college
sh uld give th ught to the following issues:
H w much and what sort of education should it provide?
To whom should it offer education?
What tandard of education should it provide?
Who is the customer – student, employer or government?
A loc l college of education, for example, could offer a wide range of courses. It will need funding.
How much finance will it need – say for new buildings, equipment, etc.?
How much funding does it expect to receive? What constraints will be attached?
Can it supplement funding from the government with donations and grants from private companies?
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Further information needed by a college is:

What will be the likely size and pattern of demand for education by students?
What will be the demand for qualified students by employers?
How will students want to study – part time, full time, by distance learning?
Will rival colleges or universities offer similar courses of a better standard?
How fast is the rate of change in demand for education, and how is this demand changing?
A private college will supply educational services and fix fees to meet market demand. Its strategy may be to
earn an acceptable return on capital.
A national charity
The purpose and values of a national charity will largely be social and ethical (i.e. values based). Emphasis will
be placed on developing a strategy covering the following:
The type and quality of service provision.
Identifying worthwhile outlets for funds.
Identifying potential sources of funds and developing fund raising activities.
Arguing the case for political and social change to achieve the objectives of the charity.
Attracting managers, employees and unpaid helpers who hold the same values as the charity’s patrons,
sponsors and staff.
Generating good morale amongst the workforce.
A retail store
The strategic aim is to sell a wide range of merchandise to individuals. To be able to do this a retail store should
aim to –
increase turnover and volume of sales, in total and per area of selling space;
control costs and stocks;
earn a return on capital;
predict what is going on in the market place – identify changes, growth in mail-order business, falling
market share;
develop a profile of what competitors are doing and selling. Undertake market research and collect sales
intelligence;
decide on price, products and sales promotions.
A local authority
The prime obje tive should be to provide services to meet needs. The authority must consider the following:
The range and quality of services to be provided (some will be mandatory and others discretionary).
How much finance will be needed to meet expenditure?
How m ch f nding will it receive, or should it raise from government grants, community charges and direct
charges to service users?
The auth rity must develop a corporate strategy within a framework of political, legal, social and financial
constraints. It must plan to provide cost-effective services whilst taking account of conflicting objectives.
Environmental appraisal is a crucial element in developing a strategy. Key factors include the following:
Government policies, inflation and interest rates.
Media and public opinion.
Size/composition of the labour market.
Likely demand for services of different types.
Potential sources of finance.
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Question 2–2: Corporate strategy practical application (Foundation)

Value and growth over the longer term is often measured by the growth in share price of an entity. It is
inevitable that corporate strategy, which essentially maps the future direction of the entity, will have a direct
bearing on both the growth and value of the entity, if measured by changes to the share price over a period of
time. Although many factors may influence share prices at any given point in time, the success of the corporate
strategy over the medium and long term is likely to be the key factor in creating and sustaining shareholder
value.
The following three real South African scenarios of listed companies are described below. Carefully consider
the facts and circumstances in each case presented.
Case 1 – Woolworths Ltd

The market capitalisation of Woolworths during 2004 was R6 billion. A dec de l ter this amounts to R51 billion,
this decade including a time at which the South African economy was hard hit by the global recession.
Traditionally Woolworths is an established brand in the wealthier consumer food market. Surprisingly, the
success of the company in the past decade has been due to a strategy to expand its customer base to include
the lower end of the market, without losing market share in the wealthier consumer market. This strategy of
having polarised target markets appears contradictory, but the unique S uth African consumer base and the
company’s understanding and of the dynamics that drive consu er spending in the South African economy has
been a key factor in driving this success. Firstly, South Africa has a large growing middle class, and Woolworths
as a brand is viewed as an aspirational brand. By using aggressive weekly store promotions of basic food
products at prices which are often lower than the prices offered by Shoprite, Pick and Pay and Spar,
Woolworths have succeeded in expanded their custom r base to the aspiring lower and middle end of the
consumer market, without compromising on their xisting customer base, the latter which buy the luxury
product offering in store.
Case 2 – FirstRand Ltd

A comparison of share price growth across the well- established South African banks (Absa, FirstRand, Nedbank
and Standard Bank) for the 10 years 2004 to 2014 reveals increases ranging from 116% (Nedbank R81,90 to
R177,10) to 410% (R5,90 to R30,14) in the case of FirstRand Ltd. FirstRand achieved this remarkable growth by
the strategy of technological innovation, driven by the CEO of First National Bank (FNB). FNB pioneered the first
internet-based commercial bank in South Africa. They also pioneered the first virtual currency rewards
programme by a bank, eBucks, which, at the time, was considered a revolutionary idea and was soon followed
by similar programmes by competitors. FNB also became the largest vendor of iPads and iPhones in the country
through smart device offering to their banking clients. The latest advances include being the first South African
bank to launch a banking application (“app”), the first bank in South Africa to facilitate incoming foreign
currency through the PayPal portal. FNB was also crowned the most innovative bank in the world at the 2012
Global Banking Innovation Awards.
Case 3 – Investec Ltd

Investec, the South African sp cialist bank and asset manager listed on both the JSE as well as the London Stock
Exchange, had a share pri e of R104 in 2004. A decade later, the same share is trading for substantially less at
R77. The company has been following a strategy for the past 20 years of aggressively growing the business by
investing substantial capital into new business acquisitions, many of them outside of South Africa. This strategy
was aimed at g owing the international business, of which several of these acquisitions subsequently proved to
be business fail res; in many instances as a result of the unforeseen often volatile international economy and
global economic crisis of the past decade.
Required:
Identify and briefly explain for each of the three cases:
The strategy employed by the company;
The impact on the value of the company as a result of the chosen strategy; and
The reasons why you consider the strategy to have succeeded or failed.
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Solution 2-2:
Case 1 – Woolworths Ltd
The company employed a competitive strategy, specifically a focus strategy, by aiming to concentrate on a
specific segment of the market, which can be achieved by aiming to be a cost leader for a chosen segment
or aiming to pursue differentiation for a chosen segment. In this case the company targeted both the
lower end of the market by aiming to be the cost leader for certain basic foodstuffs, whilst simultaneously
offering unique (differentiated) luxury food items for the upper end of the market.
The market capitalisation of Woolworths Ltd during 2004 was R6 billion. A decade later this amounts to
R51 billion, representing a 23,86% annual growth in the share price.
The success of the strategy is a result of the company underst nding the dynamics of a divided and unequal
society in South Africa and understanding the corresponding divergent consumer needs. Although many
other factors may influence the share price, over the long term, the success of this unique corporate
strategy which is aimed at two specific segments of the market, is clearly reflected in the growth in
market capitalisation and share price.
Case 2 – FirstRand Ltd

This is an example of a competitive strategy, namely a differentiation strategy, in other words a strategy of
gaining market share by providing a unique product or service by the company’s unique technology
offerings (eBucks, PayPal, internet banking, smart device offerings, banking “app”).
The share price increased from R5,90 to R30,14 ov r a 10 year period. This represents an increase (growth)
of 17,71% p.a. in the share price.
The success of the strategy is a result of the company strategy of encouraging and fostering technology
innovation. Although many other factors may influence the share price, over the long term, the success of
this unique corporate strategy is evident in the remarkable corresponding increase in the share price of
the company, when compared to those of competitors (other banks) in the same industry.
Case 3 – Investec Ltd

This is an example of a growth strategy, specifically an acquisition strategy, which is aimed at growing the
business by acquiring interests in other established businesses.
(b) The share price decreased from 104 to R77 over a 10 year period. This represents negative growth of
2,96% p.a. in the value of the shares.
The strategy of utilising acquisitions to grow the business was not successful in this case. Although many
other factors may influence the share price, over the long term, the success of this strategy of
aggressively acquiring high risk businesses which frequently turned out to be subsequent business
failures, has r sult d in a declining share price as well as a likely loss of reputation for the entity as an
investment option for long term investors. Some of the less successful acquisition decisions were often
followed by business failures of these acquisitions, amplified by the unexpected volatile international
economy and global e onomic crisis of the past decade.
Question 2–3: P oduct market strategy (Intermediate) Source: CIMA study text 2008
It has been stated that an industry or a market segment within an industry goes through four basic phases of
development. These four phases – introduction, growth, maturity and decline – each has an implication for an
organisati n’s development of growth and divestment strategies.
The f ll wing brief profiles relate to four commercial organisations, each of which operates in different indu
tries.
Company A. Established in the last year and manufactures state-of-the-art door locks which replace the
need for a key with computer image recognition of fingerprint patterns.
Company B. A biotechnological product manufacturer established for three years and engaged in the
rapidly expanding animal feedstuffs market.
Company C. A confectionery manufacturer, which has been established for many years and is now
experiencing low sales growth but high market share in a long-established industry.
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Company D. A retailing organisation which has been very profitable but is now experiencing a loss of
market share with a consequent overall reduction in turnover.
Required:
Explain:
The concept of the industry life cycle, and
The phase of development in which each of the industries served by the four companies is positioned.
Discuss how the firms may apply Ansoff’s product market growth vector matrix to develop their growth and
divestment strategies.
Solution 2-3:
Product market strategy
1 (a) Industries follow a similar pattern to the life cycle of pr ducts f introduction, growth, maturity and decline,
as follows:
Introduction
A new industry product takes time to find acceptance by would-be purchasers and there is a slow
growth in sales. Unit costs are high because of low output and expensive sales promotion. There may
be early teething troubles with technology. The industry for the time-being is a making a loss.
Growth
During this stage:
With market acceptance, sales will eventually rise more sharply, and profits will rise.
Competitors are attracted. As sales and production rise, unit costs fall.
Maturity
During this stage:
The rate of sales growth slows down and the industry reaches a period of maturity, which is
probably the longest period of a successful industry’s life.
Innovation may have slowed down by this stage.
Most products on the market will be at the mature stage of their life. Profits are good.
Decline
During this stage:
Sales will b gin to d cline so that there is over-capacity of production in the industry.
Severe ompetition occurs, profits fall and some producers leave the market.
The emaining producers seek means of prolonging product life by modification and searching for
new ma ket segments.
Many producers are reluctant to leave the market, although some inevitably do because of market
fragmentation and falling profits.
The industries in which each of the companies appears to be operating are as follows:
C mpany A. This company is operating in the introductory phase of what is a very new innovation, but
this innovation is located within a very old industry.
Company B. This company is positioned in a rapidly expanding and relatively young industry,
experiencing a growth phase.
Company C. This company is in a mature industry, as witnessed by the low growth but high market
share. Profits are likely to be good.
Company D. While the retailing industry itself is not in decline, this company appears to be, as it is
losing ground to competitors in what is a highly competitive industry. The competitors may be larger
companies and able to compete more effectively on marketing mix issues such as price.
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Ansoff drew up a growth vector matrix, describing a combination of a firm’s activities in current and new
markets, with existing and new products. The matrix can be represented diagrammatically as follows.
Product
Present New
Market penetration;
Present (for growth) or consolidation Product development
Market (to maintain position) or withdrawal
New Market development Diversification
Company A
Company A is involved with launching a very innovative product to revolutionise an existing market (home
security). Such product development forces comp titors to innovate and may provide initial barriers to entry,
with newcomers to the industry being discouraged. This will give Company A the chance to build up rapid
market penetration, but as competitors enter the market, it must make sure that it keeps household and
commercial customers interested via constant innovation. The drawback to this is the related expense and risk.
Company A must also make sure that it has enough resources to satisfy demand so that competitors cannot
poach market share.
Product improvements will be necessary to sustain the market, so Company A must make sure that enough
resources are given to research and development of new technologies (and hence new products) in its field, as
well as to maintaining sufficient production capacity to satisfy current demand.
Company B
Company B is engaged in a rapidly expanding market that is likely to attract many competitors keen for their
own share of the market and profits. The growth strategy is limited to the current agricultural market, so
referring to the Ansoff matrix above, the company is going to be mainly concerned with market penetration
and product development, with an emphasis on the latter to make life more difficult for new competitors. By
investing in product d v lopm nt, the company will see a necessary expansion in its R&D facility. To keep the
new products and the company itself in the public eye, it may need to invest more in marketing and
promotion.
With market penet ation, the company will aim to achieve the following:
Maintain or inc ease its share of the current market with its current products, for example through
competitive pricing, advertising, sales promotion and quality control.
Sec re dominance of the market and drive out competitors.
Increase usage by existing and new customers. The customer base is likely to be expanding.
Company C
Company C is in the mature phase of its life cycle. As the current market is mature, the company can achieve
growth via the investigation of new markets . Referring to the Ansoff matrix, this means pursuing a strategy of
m rket development. Seeing as the current market is mature, with satisfied customers and little innovation,
there is small scope for market development, unless it is via short-term aggressive tactics such as cuts in prices.
Selling current products to new markets is likely to be more successful, and may include one or more of the
following strategies.
1 New geographical areas and export markets.
53
Different package sizes for food and other domestic items.

New distribution channels to attract new customers.
Differential pricing policies to attract different types of customer and create new market segments.
Mass marketing techniques that encourage customers to switch brands.
The company may also investigate the possibility of developing new products to make up for those that are in
the decline phase of the life cycle. This may lead to the creation of more cash cows.
Company D
Company D is in a difficult position, with a weak position in a well-est blished m rket. It needs to undertake
some rigorous analysis of costs. A strategy of divestment may be advised to en ble it to reduce costs and
concentrate on more profitable areas of activity. Resource limitations me n th t less profitable outlets or
products may have to be abandoned. This could involve analysis of indi idual contributions, perhaps using
direct product profitability techniques.
The market has become less attractive and Company D needs to assess its image and profitability. It is likely
that customers have become more discerning on price, as has happened in the UK retailing sector in the past
few years. When some product areas have been divested, the co pany may find that it has the resources to
pursue strategies of market penetration for some products and new product development to improve its
image with customers.
A strategy of total withdrawal, and diversification into wholly new industries, is not seen as appropriate for
any of the companies described in the question. It could not be r commended because of the attendant risks.
Company D needs to be careful, and it is facing the most difficult situation of all the companies that have been
discussed. It is one thing to eliminate unprofitable products but will there be sufficient growth potential among
the products that remain in the product range?
In addition, new products require some initial capital expenditure. Retained profits are by far the most
significant source of new funds for companies. A company investing in the medium- to long -term which does
not have enough current income from existing products will go into liquidation, in spite of its future prospects.
Question 2–4: Measurement of performance and reporting against strategic objectives

(Intermediate)
Healthlife Ltd recently established a large private hospital facility in Gauteng. The CEO, Dr Khumalo, has
requested your assistance in establishing and suggesting suitable performance measures at the hospital. Four
key performance areas, as well as the objectives for each performance area have been identified by the board
of directors.
Required:
Suggest key performan e indicators (KPI’s) for the following performance areas and objectives:
Performance a ea Objectives identified
Financial Generate sufficient return on investment/assets
Customer Maintain competitive position
Maintain high levels of service
Create new mechanisms and new products
Knowledge and improvement of customer satisfaction
Internal processes Maintenance of high levels of productivity
Development of appropriate protocols and procedures
Le rning and growth Personnel training
Satisfied and motivated personnel
54
Solution 2-4:
Performance Objectives Measure Key Performance Indicators
area (Targets should be established for
each KPI)
Financial Generate sufficient return on Net income in relation to Target percentage:
investment/assets total equity employed
– return on equity
– return on net assets
Customer Maintain competitive Occupancy rate Target bed occupancy rate
position
Maintain high levels of Satisfaction of discharged T rget customer satisfaction index
service patients with service and
costs
Create new mechanisms: Number of new pr ducts Target number of new products
products offered ffered per year
Knowledge and improvement Number of custo ers Target percentage survey coverage
of customer satisfaction surveyed
Internal Maintenance of productivity Ratio of personnel to Target ratio of staff to patients
processes duration of hospital stay
Development of protocols New protocols and Target number of new protocols
and procedures procedures developed and and procedures developed and
implemented implemented per year
Learning and Personnel trained Number of persons Target number of persons
growth trained per year trained per year
Satisfied and motivated Number of persons Target number of persons evaluated
personnel evaluated and employee
Target employee satisfaction index
satisfaction index
Question 2–5: Development of performance measures for a service delivery programme

(Intermediate)
The Comprehensive Plan for Sustainable Human Settlement (CPSHS) of in South Africa introduced a variety of
programmes which provide poor South African households access to adequate housing. The policy principles
aim to provide poor households with houses as well as basic services such as potable water and sanitation on
an equitable basis, within the constraints of limited available government resources. The overall objective of
the CPSHS is describ d as providing proper housing structures to communities in the next five years. Service
standards are often utilised in the public sector to measure performance, outcomes and outputs of a specific
service delivery programme or directorate. These service standards may also be benchmarked to comparable
programmes in other pa ts of the country or internationally.
Required:
S ggest meas res for the Department of Human Settlements to determine the service standards for the
CPSHS pr gramme under the following headings:
C st f services;
Quality of services; Quantity of
services; and
Client satisfaction.
Explain the factors that should be taken into account when developing service standards for the CPSHS.
55
Solution 2-5:
Aspects of Service Delivery Suggested Indicators
Costing of Services l Cost per household of benefits supplied under the housing scheme.
l Cost of processing each application.
Quality of Services l Availability of applications in the eleven official languages.
l Average waiting period from lodge of application to allocation of
benefits.
l % of target population not receiving the service
l % of population qualifying for low-cost housing that has lodged an
application, or that has received the benefits under the scheme.
l Number of locations where applications can be made.
Quantity of Services l Number of applicati ns pr cessed.
l Number of households that received benefits under the scheme.
l % of qualifying households that have received benefits under the
scheme.
Client satisfaction Extent to which:
Applicants und rstood the working of the scheme, (procedures for
application, r quir m nts, and benefits).
Expectations created were satisfied in terms of:
– Waiting period for process of duplication;
– Actual benefits received
Staff were helpful and friendly
Assistance was granted to illiterate applicants to successfully lodge
an application and receive benefits.
Important factors to be taken into account when developing service standards:
Knowing your clients, services and service
partners This entails identifying the following:
Clients – Who are the clients we service?
Service – What are the range of services provided?
Who are our partners – This may be other departments, private sector or other levels of governm
nt. R cognising partners means recognising that partners in turn, must understand what is
required of them and who is accountable.
How a e we doing now? In order to set service standards, it is important that the organisation’s
ability to meet expectations is known. This may be determined by conducting customer surveys to
recipients of CPSHS benefits.
What do services cost? Cost information provides an essential component in the decision making
pr cess and will aid in setting service standards that relate both to high quality, and to cost
efficiency of delivery the service.
2 Consult with clients and staff
The following questions may be asked:
Clients – What are the most important features of the CPSHS service provided?
– Where can improvement initiatives be focused?
– What is working well?
Staff – Staff have the best knowledge of customer expectations, systems and procedures, and
procedures, and it is paramount that staff are involved with the process from the start.
56
3 Empower and train service providers

To be effective service providers, staff need the authority and ability to make decisions that matter to
clients. Staff need to be properly equipped and trained to be able to make necessary decisions.
Communicate Service Standards and Report and Performance
For the public to fairly assess the CPSHS service that the government provides, they must be familiar
with the service standards it has set. Consequently, communicating its CPSHS service standards by
means of brochures, websites, billboards and other methods of communication to the public is an
important step in the evaluation process, as it provides for the mechanism to ensure non-compliance
to standards is reported. CPSHS service standards should be well pub icised before service delivery,
and must be clear and easy to understand. The procedure for the pub ic to follow in the event of
service standards not being met must also be communicated nd publicised. A public service that is
responsive and client focused must provide an easy, clear nd effective way for the public to complain.
Manage the Organisation Based Service Standard

Service standard should form an integral part of the management and evaluation process, and a
culture of continuous improvement must become the n rm. Setting client driven standards and
measuring how well an organisation is doing against the , is a continuous process which will lead to
higher service standards. Ideally, managers should be held accountable for their specific area of
control and this should be linked to the organisational service standards. However, this is challenging
in the public sector environment where co plicated delivery chains and multiple stakeholders, unclear
cause and effect relationships as w ll as d layed impacts of achievements towards public sector
objectives often result in difficulty not only in identifying suitable measurable KPI’s (in this instance
service standards), but also in accurately measuring these.
Question 2-6: Identifying risks and evaluating business models and strategy (Advanced)
Source: SAICA Qualifying Examination Part II 2014: Adapted
Cheslin Transport Ltd (‘Cheslin’) is a company listed in the industrial transportation sector on the Johannesburg
Securities Exchange (JSE). The company provides a range of logistical services to customers in Southern Africa,
including the following:
Distribution and transportation of third party goods;
Clearing, forwarding and warehousing of third party goods; and
Vehicle renting and leasing.
Poor economic conditions and increased competition in the markets in which the company operates have
resulted in subdued earnings growth for Cheslin over the past three years. The board of directors of Cheslin has
been considering various alt rnatives over the past two years to diversify operations and to increase earnings
growth. The most promising growth opportunity identified is a start-up operation involved in the rental tuk-
tuks for the purpose of transporting passengers.
A tuk-tuk is a spe ial onstructed motor tricycle, which can transport two or three passengers and a limited
amount of their luggage. Tuk-tuks have three wheels and can reach a maximum speed of 70 km per hour,
although the maxim m recommended speed for urban areas is 45 km per hour. These vehicles are ideal for
transporting paying c stomers over short distances (between two and eight km) in cities – for example from
their homes to resta rants or form transport hubs (train stations and bus deports) to their homes.
Sh rt Haul Transport (Pty) Ltd

Che lin has incorporated a wholly- owned subsidiary called Short Haul Transport (Pty) Ltd (‘SHT’). SHT is current
y dormant but will be used to carry out the new business venture if it is approved by the board of directors of
Cheslin.
There are numerous tuk- tuk operations in Johannesburg, Cape Town and Durban and these are generally
owned by individuals who have fleets, ranging between two and 20 tuk-tuks. Currently the demand for the taxi
service provided by tuk-tuks exceeds the supply in these cities. According to recent market research, customers
opt for tuk-tuks services because of their lower fares and the novelty of travelling in a three-wheel vehicle. The
market research also revealed that the taxi fare charged by a conventional taxi (four-wheel sedan) is R15 per
km in Johannesburg while tuk-tuks charge an average fare of R5 per km.
57
SHT will not provide tuk-tuks taxi services directly to the public but instead will rent tuk-tuks to licensed taxi
drivers on a daily basis. The board of directors of Cheslin is interested in the opportunity for various reasons:
It will leverage existing infrastructure as Cheslin currently rents out commercial passenger vehicles, light
delivery, light delivery vehicles (1-8 tons) and refrigerated trucks to include tuk-tuks, is within the group’s
expertise.
The tuk-tuks rental operation could add significantly to the group’s profitability.
There is an opportunity to become the first major transport group to expand into this sector. Cheslin could
have the first mover advantage and dominate the industry. Other transport groups are likely to pursue this
opportunity if Cheslin does not rapidly move into this high growth industry.
Financial viability of SHT

The chief financial officer (CFO) of Cheslin, Ms Laura Brown, has prepared det iled business plan for SHT. The
new company will not conduct any other business apart from renting out tuk-tuks. Ms Brown proposed that
the new business venture be housed in a separate company, so as to limit Cheslin’s exposure should there be
any public liability claims: for example, the risk that passengers injured in an accident involving a tuk-tuk could
claim damages from Cheslin or its insurers.
SHT is to rent out tuk-tuks to taxi drivers on a daily basis. SHT is in the process of finalizing an agreement with
Baobab Ltd (‘Baobab’), a major financial services group in South Africa, to place Baobab’s logo and
advertisements on the exterior of SHT’s tuk-tuks (i.e. ‘brand’ the tuk-tuks). Baobab is very excited about the
opportunity, as it will give their group enormous mobile exposure in Johannesburg, Cape Town and Durban.
The cost of advertisements on tuk-tuks is also much more affordable than outdoor, radio and television
advertisements.
SHT is planning to place Baobab’s advertisement on 240 tuk- tuks at the start of year 1 and on a further 160 tuk-tuks
at the start of year 2. Since these advertising rates are slightly higher than market rates, SHT has agreed not to allow
any other company (except for the Cheslin group itself) to place advertisements on their tuk-tuks.
Cheslin will be responsible for providing all finance, administration, human resources, marketing and
managerial services to SHT. The CFO of Cheslin is of the opinion that Cheslin should make a reasonable return
on the services it provides. Furthermore, the managers of Cheslin would be prejudiced in their performance
evaluations if Cheslin did not make a profit on the services it provides.
SHT is to outsource the call centre operations to Skyworks Ltd (‘Skyworks’), an independent provider.
Skyworks’s call centre agents will answer all incoming calls on behalf of SHT and route requests for taxi services
to the closest tuk-tuks driver. Skyworks will, at its cost, install a global positioning system (GPS) in each tuk-tuk
to enable call centre agents to track and identity the closest tuk-tuks to the customer. Skyworks will charge a
fixed annual fee to SHT based on the number of dedicated call centre agents who answer SHT’s incoming calls
and refer taxi service requests. These fees are designated as ‘call centre costs’ in the financial forecasts above.
The tuk-tuks branding costs represent the cost to Cheslin of designing and printing its own advertising material
for placement on the tuk-tuks. Baobab will pay for the development of its own advertisements and affixing
them to the tuk-tuks. SHT will be responsible for licensing each tuk-tuk and renewing such licenses annually.
Tuk-tuk taxi drivers will be r quired to pay rental fees due to SHT in advance on a daily basis. Taxi drivers will be
responsible for petrol used by tuk-tuks.
Alternative business model

The board of directors has asked the CFO to investigate the feasibility of an alternative business model. The
changes s ggested are as follows:
Introduction of an exclusive membership scheme whereby only members thereof will be transported in
SHT’s tuk-tuks:
– Members of the public will be offered the opportunity to become members of the scheme;
– Members will pay monthly fees upfront for travelling up to a maximum number of kilometers;
– Members will pay additional amounts if they exceed the maximum number of kilometers purchased on
a monthly basis; and
– Members will be entitled to cancel the contract by providing six months’ written notice.
SHT will own and operate a tuk-tuk taxi service as opposed to renting out tuk-tuks to licensed taxi drivers.
It would then have to employ tuk-tuk taxi drivers to ensure a reliable service for its members. Should SHT
introduce the above proposals, this would entail a fundamental change to the way it intends to operate.
58
Press article – Tuk-tuks

The board of directors of Cheslin noted an article published recently in a leading financial magazine in South
Africa which inter alia stated the following:
‘……… the big question is whether the tuk-tuk industry is sustainable. Tuk- tuks are a global phenomenon
and can be profitable if they stick to niche markets. However, tuk -tuks suffer from limited capacity (they
can only transport two or three passengers at a time) and, hence, struggle to generate the returns of mini-
buses, which can cram in 20 to 25 passengers. Furthermore, if mini-buses perceive tuk-tuks to be a threat to
their livelihood, it could lead to outbreaks of violence …..’
Required:
Assuming that the original business model of renting out tuk-tuks is to be pursued,
identify and explain the key business risks to which SHT will be exposed; and
critically discuss the strategy of Cheslin to enter the tuk-tuks market.
Identify and discuss the merits and challenges, from the perspective f SHT, of offering a membership-based
service to passengers who make use of the tuk-tuks taxi service.
Solution 2-6:
1 (i) Introduction
Any new venture or change to an existing busin ss will have resulting changes to the risks that the
business is exposed to. These risks will have to be w ighed up against the resulting expected increase
in revenue. The key business risks to be considered are as follows:
Increased government regulations on passenger transport and safety regulations of tuk-tuks
specifically could render the venture unprofitable.
Financial forecasts could prove to be inaccurate or incomplete (for example, the demand for
services may be over-estimated, or costs could be underestimated).
Increased competition or new entrants to the market could make the venture unprofitable.
There is an increased financial risk associated with obtaining additional loan finance. Interest rate
risk is also a factor to bear in mind especially in an inflationary economy such as the South African
economy.
Dependency exists on the advertising revenues to make the business model sustainable. This
increases the risk since advertising contracts may not be renewed.
Adverse exchange rate movements could result in higher tuk-tuk acquisition costs.
The call c ntre op rator may not provide the required service levels, which could result in custom
rs opting for competitor offerings.
Labour unrest, stayaways and possible widespread strike action could mean that SHT does not ea
n any in ome during strike periods due to non-rental by taxi-drivers who have no customers.
The tuk-tuks are very specialised vehicles, which may make them difficult to re-sell if the venture
proves to be unsuccessful, resulting in a failure to recover the initial investment.
Being associated with Baobob may have positive or negative reputational implications, depending
n Baobab’s conduct.
Cheslin may not understand the market or its customers, since transporting passengers is not the
same business as transporting cargo. The company does not have experience in this business
which creates business risk.
There is a risk of not getting the tuk-tuks, from the Thailand supplier in time, or the necessary
licenses, in order to start the operations as predicted. This will result in start-up delays and lost
revenue.
Threat of violence from taxi drivers could disrupt operations.
There is a reputational risk associated with the risk that tuk-tuk drivers could drive irresponsibly,
overcharge passengers and there is an inherent safety risk relating to transporting passengers.
59
Conclusion
Since the tuk-tuk concept is relatively new in the country, and still unregulated, significant risks are
associated with entering this new market, especially since expertise within the company may be
lacking. The dependency on advertising revenue as well as uncertainty regarding the response of the
taxi industry to the new entrant to the market does pose risks. However, the benefits of starting up
the new business may still outweigh the risks, provided that proper risk management processes are in
place to continually assess and respond to the risks involved.
Any new venture or change to an existing business will have resulting changes to the risks that the
business is exposed to. These risks will have to be weighed up against the resu ting expected increase
in revenue. Renting tuk-tuks instead of providing a holistic taxi service may be advisable, as it transfers
the risk of obtaining sufficient passenger numbers to tuk-tuk drivers. Operating the business through a
separate company will also protect Cheslin directly from lawsuits (for ex mple, due to motor vehicle
accidents.) Furthermore, requiring taxi drivers to pay daily rent l upfront reduces the credit risk.
However, it may prove difficult to penetrate the market as a new entrant to the market. Entering the
tuk-tuk market to prevent competitors from doing so is not an ad isable strategy, since, given the high
margins in renting out tuk-tuks, Cheslin’s competitors will enter the market and erode margins
through price cutting.
Renting tuk-tuks is similar to renting out light commercial delivery vehicles. therefore Cheslin should
have the expertise to manage the new operation, and could ake use of existing systems. Starting up a
new venture instead of acquiring existing players is a cheaper alternative, but it may take longer to
reap benefits. Furthermore, using SHT tuk-tuks to advertise the Cheslin brand may prove to be a cost-
effective marketing tool. At the same time advertising expenditure is kept in-house which could
improve group profitability and therefore prove to be advantageous.
Cheslin should be aware of the higher risks associated with utilizing outsourced drivers since it is
difficult to impose policies on outsourced drivers as opposed to employees. It would therefore be
essential to clear drivers and impose minimum standards (for example, ensuring that each driver has a
valid driver’s license) to protect itself from the reputational risk mentioned above.
Merits
Members may not use the full kilometres paid for every month resulting in a windfall gain for SHT.
Furthermore, it will be advantageous to ‘lock in’ customers to use SHT services by the membership scheme.
This will also enable both SHT as well as Cheslin to develop a database of members that it could use to sell
other services or sell data to external parties for marketing purposes.
Another potential merit of a membership scheme is the potential that exists for the utilisation of third-party
loyalty benefits to members, which could expand the membership base if employed. For example, card
holders of an institution pay for a drinking and driving benefit for its members and SHT could provide such
service.
The membership scheme will be beneficial to the cash flow position of the company since SHT is to receive
revenue upfront, which improves its cash flow position. Furthermore, imposing policies and regulations on
drivers as employ s will be a less challenging task and will improve the quality of the service to customers.
The membership sch me will have less cash transactions which reduces the risk for drivers carrying large
amounts of ash.
Challenges
SHT will be eliant on taxi drivers to provide details of kms travelled (which may not be accurate) in order to
manage members’ benefits and additional payments. SHT will therefore also have to monitor the drivers’
movements, as the risk exists that they could drive non-members for a cash payment if this is not well
controlled. In addition, there will be some credit risk associated with collecting amounts for ‘excess’ kms
travelled.
The c sts associated with this alternative may be higher. This is as a result of increased costs of admini
tration and compliance in respect of employees (UIF, PAYE), higher operating leverage due to higher fixed
employee costs, as well as marketing costs. Marketing costs for new members could be expensive and,
furthermore it could be difficult to achieve critical mass of members to make the business viable. Initially,
SHT may have to offer discounted rates per km to members to induce them to join which will affect
profitability in the early stages.
Many users of transport may be occasional users of transport for example, foreign tourists in which case
the membership will be limited to frequent users of this type of transport. As a result, SHT will lose all once-
off customers, who may only be interested in using the service on an occasional basis.
60
Chapter 3
Present and future

value of money
explain the meaning of and apply formulae to calculate th :

– future value of a cash flow;
– future value of an annuity;
– present value of cash flows; and
– present value of an annuity;
solve for interest rate and number of periods in a present value equation;
apply formulae where the number of periods is less than a year;
evaluate options at a future date;
calculate the value of shares with and without growth; and
calculate the value of debt.
A clear understanding of the value of money over a period of time is essential to the understanding of finance.
This chapter deals with the elementary theory of interest. Once the student has grasped it, he or she will find
that the chapters that follow are relatively simple. The authors have in the past assumed that students fully
understand the conc pt of ‘time value of money’, only to discover that they struggle with the basics of present
and future value. The value of shares, debentures, and loans, as well as the derivation of the Weighted Average
Cost of Capital (WACC) is based on the concept of ‘present value’ (PV). This is the future value of an instrument
expressed in today’s terms or money. ‘Future value’ (FV), in turn, is the mirror image of ‘present value’ (PV) i.e.
today’s value of an inst ument calculated to what it will be in the future.
3.1 Time val e of money

Invest rs in a firm, both shareholders and lenders, expect to be compensated for both the time delay in waiting
for the returns n their investments (the opportunity cost), and for the risk to which they expose their
investment capital. Furthermore, when prices in general are rising (inflation), these investors also expect to be
compen ated for the erosion in the value of their investment capital.
When money is borrowed, the borrower must pay interest to the lender for the use of the money. The
borrower pays this interest because the potential value created by the use of the money (e.g., investing in vi
ble projects) exceeds the cost of borrowing. The lender makes the money available because the return e rned
on the lending will exceed the return from alternative investment opportunities at lower risk, as the lender will
normally require security or collateral to be provided by the borrower. The supply and demand for the lending
and borrowing of this money is in effect a money market and the cost of this use is the prevailing interest rates.
61
From this, the three elements of interest rates can be established, namely:
Compensation for the time value of money. From the lender’s point of view, this represents the
opportunity cost of forfeiting alternative investment opportunities, and from the borrower’s point of
view, the cost of being able to receive/use the money now rather than later.
Compensation for risk. From both the lenders’ and borrowers’ points of view, this is consistent with the
essence of financial management, that is, any finance or investment decision must be in agreement with
the fundamental principle that return on investment has a relationship to the risk involved (in this case,
the default risk), namely, the risk that the loan will not be repaid.
Compensation for inflation. In times of inflation, the spending power of money decreases over time and
lenders would expect to be compensated for this decline in spending power. If the interest rate did not
compensate for the effect of inflation, the lender would be worse off by the time the loan is repaid than
when the loan was made.
If money expended later is more favourable than money spent today, due to the eroding effects of inflation,
the same principle applies in reverse to moneys receivable. Money recei ed today is more favourable than
money received later, since that money can be invested today and interest earned over time. To determine the
value of money in current (or today’s) terms, one discounts the future cash flows it generates to the present
value using an appropriate discount rate. This is called the present value of a cash flow. The opposite of
discounting is compounding; in other words, if one wanted to deter ine the value of money at a future date,
one would compound the current (or today’s) value to deter ine the future value of a cash flow.
The financial calculator instructions have been included below the calculations in this chapter since many
students may prefer to use a financial calculator inst ad of using the formulae or tables in Appendix 2 of this
textbook, which may be time-consuming, especially in an xam setting. Students must make sure that they know
how their specific financial calculators operate and clearly document their steps. Also remember that it is
important to understand the calculations and the theory behind time value of money before using a financial
calculator. The calculator is just a tool; the student still needs to have a good understanding of the time value
of money since it is used in many of the calculations in this textbook.
3.2 Future value

The future value of an amount is derived using the following formulae:
FV = PV(1 + i) [One year or one period]
n
PV(1 + i) [Multiple years or periods]
FV =
Where:
FV = Future value
PV = Pr s nt value
i = Int r st rate
n = Number of years/periods
Mr C invests R1 000 at 10% with a bank. How much does he expect to receive at the end of one year?
FV = PV(1 + i)
FV = 1 000(1 + 0,10) = R1 100
How much d es he expect to receive at the end of two years?
FV = 1 100(1 + 0,10) = R1 210

PV = 1 000
I/YR = 10
N = 2
FV = 1 210
62
Present and future value of money Chapter 3
How much does he expect to receive at the end of three years?

The effect over a three-year period is that interest is compounded at 10%.
FV = 1 210(1 + 0,10) = R1 331

PV = 1 000
I/YR = 10
N = 3
FV = 1 331
Compound interest formula

n
FV = PV(1 + i)
The compound interest formula can be broken down over a three-year peri d at 10% to:
FV = PV(1 + 0,10)(1 + 0,10)(1 + 0,10)
This is the same as was done in the example above over a period of three years by re-calculating the future
value each year.
In this example, the FV can be calculated as:
FV = 1 000(1 + 0,10)(1 + 0,10)(1 + 0,10) = R1 331
or
3 =
FV = 1 000(1 + 0,10) R1 331
1 000 × 1,1 = 1 100 or PV = 1 000
2ndF I/YR = 10
y 3
x
N = 3
= 1 331 FV = 1 331
Key assumptions:
The compound interest formula assumes that the interest receivable at the end of the year is reinvested at
the same interest rate.
2 It is safe to assume that the nd of any year is treated the same as the beginning of the next year; in other
words, a ash flow at 31st December 20Y2 (end of 20Y2) is treated the same as a cash flow at
1st Janua y 20Y3 (beginning of 20Y3) for purposes of time value of money calculations.
3 The value of money today (present value) is referred to as Year 0 in time value of money calculations.
Assume that the f t re value (FV) of R1 000 at the end of five years must be determined, using a factor of 10%
which is compo nded annually. The interest is paid on the last day of each year. Using a future value table, the
answer w uld be as follows:
Year (1 + i) *Factor Future value of R1 000
0 (1 + 0) = 1 R1 000
1
1 (1 + 0,10) = 1,1 R1 100
2
2 (1 + 0,10) = 1,21 R1 210
3
3 (1 + 0,10) = 1,331 R1 331
4
4 (1 + 0,10) = 1,4641 R1 464
(1 + 0,10)
5
5 = 1,6105 R1 610
* Factors can be found in the tables in Appendix 2
63
Financial calculator instructions (year 5):

PV = 1 000
I/YR = 10
N = 5
FV = 1 610
3.2.2 Solving for interest rate (i) and number of periods (n)
Example: Solving for interest rate (i)
Ms A can invest R1 000 today for a period of three years. At the end of three ye rs, her investment will have
grown to R1 331. Interest is compounded annually.
Required:
Calculate the annual interest rate.
Solution:
n
FV = PV(1 + i)
3
1 331 = 1 000(1 + i)
1 331
3
1 000 = (1 + i)
3
1,331 = (1 + i)
To solve for i, do a trial and error calculation, for example:
(1 + 0,05)
3
Try 5% = 1,1576
(1 + 0,08)
3
Try 8% = 1,2597
(1 + 0,10)
3
Try 10% = 1,331
The answer must be 10%, as the factor of 1,331 is the same as FV divided by PV, that is, 1 331 / 1 000 = 1,331.
Alternatively, go to the future value tables and look along the 3-year row for the future factor of 1,331 (Tables
Appendix 2). Why the 3-year row? Because the power of 3 means 3 years or 3 periods.

PV = 1 000
FV = – 1 331
N = 3
I/YR = 10
Example: Solving for number or periods (n)

Ms A can invest R1 000 today at 10% per annum to receive R1 331 at a future date.
Required:
Calculate the number of years required for the investment to reach R1 331.
So ution:
n
FV = PV(1 + i)
n
1 331 = 1 000(1 + 0,10)
1 331
n
1 000 = (1 + 0,10)
n
1,331 = (1 + 0,10)
64
Or, solve for n (the number of years) by trial and error for example:
(1 + 0,10)
1
= 1,1
(1 + 0,10)
2
= 1,21
(1 + 0,10)
3
= 1,331
Alternatively, go to the PV tables in Appendix 2, look for the 10% column and then go down to the 1,331 factor;
then move to the left to read off the number of years.

PV = 1 000
FV = – 1 331
I/YR = 10
N = 3
Note: The above two examples show how to solve for the interest rate and for the number of years.
Students are required to do these calculations in future chapters. They are expected to be able to do
all PV and FV calculations by creating the required factors on a calculator. The student should also be
able to use PV and FV tables. Students should only use progra mable calculators if they understand
the calculations and the theory behind the ti e value of oney very well. They should not simply read
off the final answer from the calculator.
Introducing periods of time compared to years

n
The formula FV = PV(1 + i) assumes that n refers to a year or years. It also assumes that interest (i) is
compounded annually. What happens if interest is compounded bi-annually (every six months), or quarterly
(every three months), or monthly (every month)?
Example:
Ms B has a sum of R10 000 which she wishes to invest for a period of three years. She has the following
investment choices over the three-year investment period:
Invest at 10% per annum.
Invest at 9,2% per annum, compounded bi-annually.
Invest at 9% per annum, compounded quarterly.
Invest at 8,4% per annum, compounded monthly.
Required:
Advise on the best investment option.
Solution:
In the form la, n refers to the number of periods, but is calculated on the basis of one year. The way to adapt
the form la to provide for multiple periods within a year, is to:
Divide the annual investment rate by the number of interest payments within a period of one year.
Calculate the number of interest payments over the period required (this is referred to as ‘equivalent year
’).
The conversion translates the payments to the equivalent of annual payments at a lower equivalent interest
rate.
(i) i = 10% / 1 = 10% per period (1 year)
n = 3×1 = 3 equivalent years
PV = R10 000
3
FV = R10 000(1 + 0,10) = R13 310
65

Mode: 1 P/YR
PV = 10 000
I/YR = 10
N = 3
FV = 13 310
(ii) i = 9,2% / 2 = 4,6% per period (6 months)

R10 000(1 + 0,046)
6
FV = = R13 097,55
or Mode: 2 P/YR
PV = 10 000 PV = 10 000
I/YR = 9,2/2 I/YR = 9,2
N = 6 N = 6
FV = 13 097,55 FV = 13 097,55
(iii) i = 9% / 4 = 2,25% per period (3 months)

R10 000(1 + 0,0225)
12
FV = = R13 060
or Mode:4 P/YR
PV = 10 000 PV = 10 000
I/YR = 9/4 I/YR = 9
N = 12 N = 12
FV = 13 060,5 FV = 13 060,5
(iv) i = 8,4% / 12 = 0,7% per period (1 month)

n = 3 × 12 = 36 equivalent years
R10 000 × (1 + 0,007)
36
FV = = R12 855
or: Mode:12 P/YR
PV = 10 000 PV = 10 000
I/YR = 8,4/12 I/YR = 8,4
N = 36 N = 36
FV = 12 854,67 FV = 12 854,67
Conclusion:
Invest at 10% per annum to receive the highest future value of R13 310.
F t re value of an annuity
An annuity is the receipt or payment of a fixed amount over a number of years or periods. For example, if R1
000 was invested at the end of every year over a period of ten years, the investment would be described as a
ten-year annuity investment.
The timing of the annuity can take place either at the end of a period or at the beginning of a period. Where
payment is made at the beginning of a period it is called an ‘annuity due’. If payment is made at the end of the
ye r or end of a period it is called a ‘regular’, ‘ordinary’ or ‘deferred’ annuity.
Example:
Mr A will invest R1 000 per year over a period of three years at a return of 10% per annum.
66
Required:
Determine the future value at the end of three years if the investment is made:
at the end of the year (regular, ordinary or deferred annuity).
at the beginning of the year (annuity due).
Solution:
(i) End of year (i.e. beginning of the following year)
Today
Year-end 0 1 2 3
Investment – 1 000 1 000 1 000
Interest from Year 1 investment – – 100 110
Interest from Year 2 investment – – – 100
– 1 000 1 100 1 210
Future value 1 000 + 1 100 + 1 210 = R3 310

1 000 (1 + 0,10)
2
Or: Year 1 Investment = 1 210
Year 2 Investment 1 000 (1 + 0,10) = 1 100
Year 3 Investment 1 000 = 1 000
R3 310
Or using the tables: R 1 000 × 3,31 (annuity factor for 10% interest for 3 years) = R 3 310
Or: FV(Annuity) Constant amount × Future value factor of an annuity
(1 + i) – 1
n
FVA = I×[ ]
i
= 1 000 × [
(1 + 0,1)3 – 1 ]
FVA
0,1
= 1 000 × [
1,331 – 1 ]
FVA
0,1
FVA = 1 000 × 3,31 = R3 310

PMT = 1 000
I/YR = 10
N = 3
FV = 3 310
(ii) Beginning of year (i.e. end of the previous year)
Today
Year-end 0 1 2 3
Investment 1 000 1 000 1 000 –
Intere t from Year 1 investment – 100 110 121
Intere t from Year 2 investment – – 100 110
Interest from Year 3 investment – – – 100
1 000 1 100 1 210 331
67
Future value 1 000 + 1 100 + 1 210 + 331 = R3 641

1 000 (1 + 0,10)
3
Or: Year 0 Investment = 1 331
2
Year 1 Investment 1 000 (1 + 0,10) = 1 210
Year 2 Investment 1 000 (1 + 0,10) = 1 100
R3 641
Or: FV(Annuity) = Constant amount × Future value factor of an annuity

n
(1 + i) – 1
FVA = I×[ ] (1 + i)
i
3
(1 + 0,1) – 1
FVA = 1 000 × [ ] (1 + 0,1)
0,1
FVA = 1 000 × [ 1,331 – 1 ] (1,1)

0,1
FVA = 1 000 × 3,31 × 1,1 = R3 641

Or using the tables: R 1 000 × 3,31 (annuity factor for 10% interest for 3 years) × *1,1 = R 3 641
*Important note: The annuity tables assume that the annuity is a regular ordinary annuity payable at
the end of the year. For paym nts at the beginning of the year, multiply the answer by
(1 + i).
2
ND FUNCTION BEG/END
PMT = 1 000
I/YR = 10
N = 3
FV = 3 641
Note: For the purpose of this textbook, students are not required to manually calculate future value
annuities. If required, annuity tables will be provided. Students are expected to familiarise
themselves with the tables, which are provided in Appendix 2.
3.3 Present value

Present value al ulations and PV tables are the inverse of future value. All the remaining chapters of this
textbook deal almost ex lusively with present value calculations. If the student understands the concept of
present value, he will have little problem with finance.
Present val e represents the value today of future cash flows. It is very important because the value of a project
or company or investment is
Present value of future cash flows
The value of a share in a company, for instance, is based on the present value of all future cash flows, which for
an inve tor is often in dividends. The underlying assumption of the calculations below is that cash flows take p
ace at the end of the year.
If FV = PV(1 + i) [One year or one period]

n
FV = PV(1 + i) [Multiple years or periods]
68
Making PV the subject results in the PV formula, as follows:

FV
PV =
(1 + i)
n
The present value factors are therefore the inverse of the future value factors.
Years 10% FV factors 10% PV factors
1 1,1 1 / 1,1 = 0,909
2 1,21 1 / 1,21 = 0,826
3 1,331 1 / 1,331 = 0,7513
4 1,4641 1 / 1,4641 = 0,6830
5 1,6105 1 / 1,6105 = 0,6209
Hint: The PV factor tables will have to be calculated manually many times from now on. The easiest way to
create them is as follows:
Creating a 10% PV table:

Year 1 1 / 1,1 = 0,9090
Dividing 1 by 1,1 on the calculator results in the figure of 0,9090. Do not clear the calculator. Now press ÷
followed by 1,1 followed by = . The result will be 0,8263.
Year 2 0,9090 / 1,1 = 0,8263
Continue dividing by 1,1 followed by = for all other factors, as follows:
Financial calculator
instructions
1 (Year 5): or:
F = 1
, V
2
1 I = 1
n
y / 0
d
x N
Y = 5
F5= R
P = 0
V ,
0 6
, 2
Example 6 1: Single future 0
payment 2 9
An 0 ive R1 100 in one
investor 9 year’s time.
R
will rec
e
Calculate
q the value of the R1 100 today if the interest
rate
u is 10%.
i
r
e
d
:
Year 3 0,8263 / 1,1 = 0,7513

Year 4 0,7513 / 1,1 = 0,6830
Year 5 0,6830 / 1,1 = 0,6209
Solution:
FV
PV = n
(1 + i)
1 100 1 100
PV = = = R1 000
(1 + 0,10) (1,1)

FV = 1 100
I/YR = 10
N = 1
PV = 1 000
69
Example 2: Multiple future payments

Mr A has recently inherited money which will be paid out as follows:
Year 1 10 000
Year 2 12 000
Year 3 8 000
Year 4 6 000
Year 5 4 000
Assume that each payment will take place at the end of the corresponding year, and that the annual discount
rate is 10%.
Required:
Calculate the present value of the future cash payments.
Solution:
Present day Year Year Year Year Year
Year-end 0 1 2 3 4 5
Cash-flow 10 000 12 000 8 000 6 000 4 000
(1 + 0,10)
2 3 4 5
PV factor (1 + 0,10) (1 + 0,10) (1 + 0,10) (1 + 0,10)
10 000 12 000 8 000 6 000 4 000
Present value = + + + +
(1 + 0,10)
2 3 4 5
(1 + 0,10) (1 + 0,10) (1 + 0,10) (1 + 0,10)
10 000 12 000 8 000 6 000 4 000
= + + + +
1,10 1,21 1,331 1,4641 1,6105
= 9 090,91 + 9 917,35 + 6 010,52 + 4 098,08 + 2 483,70
= R31 600,56

CFj0 = 0
CFj1 = 10 000
CFj2 = 12 000
CFj3 = 8 000
CFj4 = 6 000
CFj5 = 4 000
I/YR = 10
NPV = 31 600,55
Example 3: Compa ing options

Ms A will receive R20 000 at the end of Year 3 and R10 000 at the end of Year 4. She then has the option to
receive R50 000 at the end of Year 5, or no payment at the end of Year 5, but two equal payments of R28 000
at the end f Years 6 and 7 respectively.
Required:
Determine the present value today of both options at a discount rate of 10%.
70
Solution:
Option 1
Year 3 Year 4 Year 5
Cash-flow 20 000 10 000 50 000
3 (1 + 0,1)
4 (1 + 0,1)
5
PV factor (1 + 0,1)
20 000 10 000 50 000
Present value = + +
(1 + 0,1)
3 (1 + 0,1)
4 (1 + 0,1)
5
= 15 026 + 6 830 + 31 046
= R52 902

CFj0 = 0
CFj1 = 0
CFj2 = 0
CFj3 = 20 000
CFj4 = 10 000
CFj5 = 50 000
I/YR = 10
NPV = 52 902
Option 2
Year 3 Year 4 Year 5 Year 6 Year 7
20 000 10 000 0 28 000 28 000
3 (1 + 0,1)
4 6 (1 + 0,1)
7
PV factor (1 + 0,1) (1 + 0,1)
Present value 20 000 10 000 28 000 28 000
= + + +
1,331 1,4641 1,7715 1,9487
= 15 026 + 6 830 + 15 806 + 14 368
= R52 030

CFj0 = 0
CFj1 = 0
CFj2 = 0
CFj3 = 20 000
CFj4 = 10 000
CFj5 = 0
CFj6 = 28 000
CFj7 = 28 000
I/YR = 10
NPV = 52 030
Which option is better? R50 000 at the end of Year 5 (Option 1), or two equal payments of R28 000 at the end
of Years 6 and 7 (Option 2)?
71
Answer:
One can either discount the cash flows for Years 6 and 7 to Year 5 values (Method 1 below) or discount the cash
flows for Years 5, 6 and 7 to present (Year 0) values (Method 2 below). Once the cash flows are discounted to
the same year values, the two options can be compared, to decide which is more advantageous.
Method 1: Compare the two options at Year 5
Note: Where there is an option at a particular point in time, it is always preferable to compare the two
options at that point in time. In this example, as the option takes p ace at the end of Year 5, the
choices can be shown as:
R50 000 today; or
R28 000 in Year 1 plus R28 000 in Year 2
Option 1’s value at the end of Year 5 equals R50 000
Option 2’s value at the end of Year 5:
Year 6 Year 7
Cash flow 28 000 28 000
(1 + 0,1)
2
PV factor (1 + 0,1)
28 000 28 000
Present value = +
1,1 1,21
= 25 454 + 23 140 = R48 594
The factors for Years 6 and 7 are shown as Year 1 and Year 2 factors relative to Year 5. In other words, the cash
flows are 1 and 2 years away. Once these cash flows are converted to Year 5 values, they can be compared.
Since the Year 5 value of the Years 6 and 7 cash flows is R1 406 (R50 000 – R48 594) less than the Year 5 cash
flow of R50 000, this option is better.

CFj0 = 0
CFj1 = 28 000
CFj2 = 28 000
I/YR = 10
NPV = 48 595
Conclusion:
Choose R50 000 at the end of Year 5.
Method 2: Compa e the options as at Year 0

Option 1 Cash-flow of R50 000 at Year 5
50 000 50 000
Present value to Year 0 = = = R31 046
(1 + 0,1)
5
1,6105

FV = 50 000
I/YR = 10
N = 5
PV = 31 046
72
Option 2 Cash-flows equal R28 000 at the end of Years 6 and 7

28 000 28 000
Present value to Year 0 = +
1,7715 1,9487
= 15 805 + 14 368 = R30 173

Year 6:
FV = 28 000
I/YR = 10
N = 6
PV = 15 805
Year 7:
FV = 28 000
I/YR = 10
N = 7
PV = 14 368
Note: Method 1 shows that the option of receiving R50 000 is better by 50 000 – 48 594 = R1 406 as at
Year 5. The present value of R1 406 as at Y ar 0 is R873, which is the same as the result achieved
using Method 2: R31 046 – R30 173 = R873. Both methods result in the same conclusion, namely
that receiving R50 000 is better by a value (present value at Year 0) of R873.

or: 1,1
FV = 1 406 2ndF
I/YR = 10 x
y 5
N = 5
x 1 406
PV = 873
= 873
Present value of an annuity

The term annuity refers to a stream of equal payments in the future. If the payments take place at the end of
each year/period, it is called an ‘ordinary annuity’. When the amount payable is paid at the beginning of a
period, it is called an ‘annuity due’.
Note: Virtually all xampl s assume payment at the end of a period, that is, an ordinary annuity.
Example 1: Ordinary annuity (end of the year)

Mr A will receive R1 000 at the end of Years 1, 2 and 3.
Required:
Calculate the present value today of the cash flows.
S luti n:
Year end Today Year 1 Year 2 Year 3
Ca h-f ow 0 1 000 1 000 1 000
(1 + 0,1)
2 (1 + 0,1)
3
Present value factor (1 + 0,1)
1 000 1 000 1 000
Present value = + +
(1 + 0,1)
2 (1 + 0,1)
3
(1 + 0,1)
= 909 + 826 + 751
= R2 486 (rounded off)
73
Or: PV(Annuity) = Constant amount × present value factor of an annuity

1
1– n
(1 + i)
PVA = I×[ ]
i
1
1– 3
(1 + 0,1)
= 1 000 × [ ]
0,1
1 – 0,7513
= 1 000 × [ ]
0,1
= 1 000 × [ 0,2487 ]
0,1
1 000 × 2,487
R2 487 (rounded off)
Or: Using the tables: R 1 000 × 2,487 (annuity factor for 10% interest f r 3 years) = R 2 487

PMT = 1 000
I/YR = 10
N = 3
PV = 2 487
Example 2: Present value of an annuity due (beginning of the year)

Mr A will receive three instalments of R1 000 payable now, at the end of Year 1, and the end of Year 2.
Required:
Calculate the present value of the annuity.
Solution:
The payments are receivable at the beginning of the year (Year 0), therefore the first cash flow does not have
to be discounted to present value; it is receivable today. The second cash flow is receivable at the beginning of
Year 2, which is treated the same as a cash flow receivable at the end of Year 1.
Year-end Today 1 2
Cash-flow 1 000 1 000 1 000
(1 + 0,1)
2
PV factor 1 (1 + 0,1)
1 000 1 000 1 000
PV = + +
1 1,1 1,21
= 1 000 + 909 + 826
Or: PV(Ann ity) = Constant amount × present value factor of an annuity
1
n
1 – (1 + i)
PVA = I×([ ] + 1)
i
1
1– 2
= 1 000 × ( [ (1 + 0,1) ] + 1)
0,1
1 – 0,8264
= 1 000 × ( [ ] + 1)
0,1
1 000 × (1,736 + 1)
74
Or: Using the tables: R 1 000 × 2,487 (annuity factor for 10% interest for 3 years) × 1,1 = R 2 735,70.
Alternatively: R 1 000 × (1,7355 + 1) (annuity factor for 10% interest for 2 years +1) = R 2 735,70.
2
ND FUNCTION BEG/END
or CFj0 = 1 000
PMT = 1 000 CFj1 = 1 000
I/YR = 10
CFj2 = 1 000
N = 3 I/YR = 10
PV = 2 736 NPV = 2 736
Periodic payment of a loan

The present value of an annuity formula can be used to compute the peri dic payment of a loan.
1
1– n
PVA = I × ( [ (1 + i) ])i
Making I the subject, that is, the periodic payment, one gets:
1
PVA × i = I × [ 1 – (1 + i)n ]
I = PVA × i
[ 1 – 1 / (1 + i) ]
n
Example:
Mr A borrowed R10 000 today at an annual interest rate of 10% per annum. The loan is repayable in two equal
instalments at the end of Years 1 and 2.
Required:
Calculate the periodic annuity instalment.
Solution:
10 000 × 0,1
I =
[ 1 – 1 / (1 + 0,1) ]
2
1 000 1 000
= =
1 – 0,82645 0,17355
= R5 762
Financial calc lator instructions:

PV = 10 000
I/YR = 10
N = 2
PMT = 5 762
Examp e:
Mr A borrowed R10 000 today at an annual interest rate of 12% per annum. The loan is repayable in equal
monthly instalments over a period of two years.
Required:
Calculate the periodic monthly annuity instalment.
75
Solution:
I = 12% / 12 = 1%
N = 2 × 12 = 24
10 000 × 0,01
I =
24 ]
[ 1 – 1 / (1 + 0,01)
100
– 0,7876
100
0,2124
R470,81
Note: Where the periodic payments are for periods less than one year, one must calculate the equivalent
annual payments and at the same time divide the annual interest rate by the number of annual
interest payments.
In the above example:

Number of equivalent periods: 2yrs × 12 = 24
Equivalent interest rate per period = 12% / 12 = 1%
Using PV annuity tables

The above example has been illustrated without the use of tables. Clearly, it is preferable to use PV annuity
tables, or a programmable calculator.
Using tables to find the PV annuity factor, simply go to the column showing the interest rate required; in this
example the 1% column. Next, go down to the number of periods; in this case 24. Read off the PV annuity
factor; in this example shown as 21,243.
PVA
Therefore I =
Factor
10 000
=
21,243
= R470,74

Mode:12 P/YR or Mode:1 P/YR
PV = 10 000 PV = 10 000
I/YR = 12 I/YR = 12/12
N = 24 N = 24
PMT = 470,74 PMT = 470,74
Present value of a perpetuity

A perpetuity is the same as an annuity with an infinite life.
Examp e:
Mr A has invested an amount of money at 10% to receive R1 200 annually in perpetuity (indefinitely).
Required:
Calculate the present value of the perpetuity.
76
Solution:
I
PVp =
i
Where: I = Periodic payment

i = interest rate
1 200
0,1
R12 000
Present value of shares

No growth
As previously stated, the value of an investment or project, or company or company shares is the present
value of future cash flows. If one is valuing a share, and if the share pays regular dividends, then the value
of a share, where dividend value is unchanged from one year to the next, that is, no growth, is:
Do
Value =
ke
Where:
Do = Current dividends, or Year 0 dividends
ke = Shareholders’ required return or discount rate
ke is the same as i in the PV formula
Example 1: No growth
Mr A holds 1 000 shares in Company X. He receives an annual dividend of R100 per share and his required
return is 20%.
Required:
Calculate the value of the shares held by Mr A.
Solution:
Do = R100
ke = 20%
100
Value =
0,20
= R500
Total value = R500 × 1000 shares = R500 000 ex-dividend (excluding the dividend)
N te: The shareholder receives a dividend today. Is that dividend included in the valuation?
It depends on whether or not it is cum-div or ex-div. The above solution assumes that today’s
dividend is excluded, hence the word ‘ex-dividend’. If the requirement was to include the dividend,
one would be asked to do a ‘cum-dividend’ valuation and in the above example the answer would
have been as follows:
R100
= R100 + = R600
0,2
77
Where the question is silent as to dividends received or receivable today, one must do an ex-dividend
valuation.
Important: Another reason for doing an ex-dividend valuation (unless otherwise asked) is that present value
assumes that the first cash flow will take place at the end of a period/year.
Example 2: No growth
Mr A holds 1 000 shares in Company X. He receives an annual dividend of R100 per share and has a required
return of 20%. At the end of three years, he intends selling his shares at a price of R480 each.
Required:
Calculate the value of Mr A’s shareholding.
Solution:
Year 1 Year 2 Year 3
Cash flows – dividend 100 100 100
Cash flows – sale – – 480
100 100 580
100 100 580

Valuation = + +
(1 + 0,2)
2 (1 + 0,2)
3
(1 + 0,2)
= 83,33 + 69,44 + 335,65
= 488,42
Total value = R488,42 × 1 000 = R488,42
CFj0 = 0
CFj1 = 100
CFj2 = 100
CFj3 = 580
I/YR = 20
NPV = 488,43
(ii) Constant Growth

Where the dividend from a share increases every year by a fixed or constant amount, the formula is:
D1
Value =
Ke – g
Where:
D1 = Dividend at the end of the year
ke = Shareholders’ required return
g = Growth in annual dividends
This formula is referred to as the dividend growth model.
Examp e 1: Constant growth and shares held to infinity (∞)

Mr A owns 1 000 shares in Company X. He has recently received a dividend of R100 per share. He expects the
dividend to grow by 5% per annum. His required return, k e, is 20%.
78
Required:
Calculate the value of Mr A’s shareholding.
Solution:
D1 = R100 × 1,05 = R105
ke = 20%
g = 5%
105
Valuation = = R700
(0,20 – 0,05)
Total value = 1 000 × R700 = R700 000
Example 2: Constant growth but shares held for a finite time

Use the same information as provided for Example 1, except that Mr A will sell his shares at the end of three
years at a price of R480 per share.
Required:
Calculate the value of the shareholding at the end of three years.
Solution:
Year 1 2 3
Cash flows – dividend (100 × 1,05) 105 (105 × 1,05) 110,25 (110,25 × 1,05) 115,76
Sell – – 480,00
105 110,25 595,76
105 110,25 595,76

Present value = + +
(1 + 0,2)
2 3
(1 + 0,2)
(1 + 0,2)
= 87,50 + 76,56 + 344,77
= R508,83
Total value = 1 000 shares × 508,83 = R508 830
CFj1 = 0
CFj1 = 105
CFj2 = 110,25
CFj3 = 595,76
I/YR = 20
NPV = 508,83
Example 3: C nstant growth shares to be bought at a future date

Mr B has c ntracted to purchase 1 000 shares from Mr A in Company X at the end of three years at a price of
R480 per hare. The dividend today in Company X is R100 per share and Mr A expects the dividend to grow by
5% per annum. Mr B has a required return, ke, of 20%.
Required:
C lculate the market value per share in three years’ time when Mr B purchases the shares, and state whether
or not it is a good buy.
79
Solution:
D4
Value of the shares at Year 3 =
ke – g
The dividend that must be used in the dividend growth model will be the expected dividend in Year 4.
(Remember cash flow must be one year in the future).
Year 0 1 2 3 4 to infinity
Dividend 100 105 110,25 115,76 121,55 + 5% growth to infinity
Valuation date Year 3
100 (1 + 0,05)
4
D4 =
= 100 × 1,2155
= 121,55
121,55
Value at Year 3 =
(0,20 – 0,05)
= R810,33
Mr B will pay R480 per share in three years’ time. The shares will, however, have a market value of R810,33
each, assuming that the dividends continue to grow at 5% and the shareholders’ return remains at 20%. If he
chooses to sell the shares on the day he buys them, he will make a profit of R810,33 – R480 = R330,33 per
share.
Example 4: Non-constant growth and share held to infinity

Mr A holds 100 shares in Company Z. He has recently received a dividend of R15 per share. He expects the
dividend to grow at 10% for the next two years, and thereafter to grow at 5%. His required return is 20%.
Required:
Calculate the value of Mr A’s entire shareholding today.
Solution:
g = 10% g = 5%
Year 1 2 3 to infinity
Dividend 16,50 18,15 19,06 g = 5%
Year 1 dividend = 15 × 1,10 = 16,50
Year 2 dividend = 16,50 × 1,10 = 18,15
Year 3 dividend = 18,15 × 1,05 = 19,06
The value of the share PV of PV of PV of
at Year 0 = Year 1 + Year 2 + D3
dividend dividend ke – g
Value 16,50 18,15 19,06
= + 2
2 + [ (0,20 – 0,05) ] / (1 + 0,2)
(1 + 0,2) (1 + 0,2)
16,50 18,15 127,07
= + +
(1,2)
2 (1 + 0,2)
2
(1,2)
= 13,75 + 12,60 + 88,24 = R114,59
Total va ue = 100 × R114,59 = R11 490
Note: The above valuation is done in 3 steps.
Step 1 Determine the cash flows receivable in each year. At the end of Year 1, the shareholder will receive a
dividend of R16,50 and at the end of Year 2, a dividend of R18,15.
S ep 2 Determine the terminal share value as at the end of Year 2. The share value is based on the next
dividend (Year 3), taking into account growth at 5% to infinity (in perpetuity). At the end of Year 2,
80
D1 equals R18,15 × 1,05 = R19,06 (Year 3 dividend). The value of a share as at the end of Year 2
equals:
19,06
= R127,07
(0,20 – 0,05)
Therefore the annual cash flows from dividends and the value of the shares at the end of Year 2 are:
Year 1 2
Cash flow – dividend 16,50 18,15
Share value 127,07
16,50 145,22
Step 3 Calculate the present value of future cash flows, that is, discount to the present value using the required
return.
16,50 145,22
= +
(1 + 0,2)
2
(1 + 0,2)
= 13,75 + 100,84 = R114,59

CFj0 = 0
CFj1 = 16,5
CFj2 = 145,22
I/YR = 20
NPV = 115
3.5 Present value of debt

Debt in the context of a company can be defined as ‘any form of outside finance that is not an ordinary share’
or that ‘does not have an option to convert to ordinary shares’.
The following are classified as debt:

Long-term loans – Interest is tax-deductible
Debentures – Interest is tax-deductible
Mortgage bonds – Interest is tax-deductible
Preference shares – ividends after tax
The authors’ definition of debt is rather simplistic, as there are certain grey areas where debt is partly debt and
partly ordinary share equity. For the purposes of this text, all forms of finance other than ordinary share equity,
or debt that has an option to convert to ordinary shares at a future date, are classified as debt.
All calculations of pr s nt value that involve debt must be done at cash flows after tax, with the discount rate
also after tax.
Example 1: I edeemable debt

Company A discloses a long-term loan of R1 000 000 in its statement of financial position. The company pays an
annual interest of 12% before tax. The loan is for an indefinite period with no fixed redemption date. Current
company income tax rate is 28%. Similar long-term loans can be raised today at an interest rate of 16%.
Required:
Ca cu ate the present value of the loan.
Solution:
Annu l interest payable after tax = R1 000 000 × 12% × (1 – 0,28) = R86 400
Discount rate (market rate) = 16% × (1 – 0,28) = 11,52%
Cash flow
Present value =
kd
81
Where kd is the after-tax cost of debt today. (Note the after-tax cost of debt is used, as interest payments are
deductible from income when calculating net income for tax purposes.)
86 400
Value = = R750 000
0,1152
Note: The book value of debt in the balance sheet is R1 000 000. The company is, however, only paying 12%
interest when it should in fact be paying 16% interest. In real terms, the company has less debt than
is shown in the balance sheet. In this example, the equivalent market value of debt is R750 000.
Example 2: Redeemable debt

Use the same information as in Example 1 above, except that the loan is rep y ble in three years’ time.
Required:
Calculate the market value of the loan today.
Solution:
Year 0 1 2 3
Interest after tax – 86 400 86 400 86 400
Capital repayment – – – 1 000 000
Total cash flow – 86 400 86 400 1086 400
86 400 86 400 1 086 400

(1 + 01152)
2 3
Present value = (1 + 01152) + + (1 + 0,1152096)
86 400 86 400 1 086 400
= + +
1,1152 1,1152 1,1152
= 77 475 + 69 472 + 783 306
Market value = R930 253
CFj0 = 0
CFj1 = 86 400
CFj2 = 86 400
CFj3 = 1 086 400
I/YR = 11,52
NPV = 930 253
Example 3: Preference share with non-constant growth

The statement of financial position of Company A shows 10 000 preference shares at a price of R200 each. The
annual preference dividend is 20% per share per annum, which is expected to remain the same for the next
two years. Thereafter, dividends will increase to R45 per share. Similar preference shares are trading at a return
to shareh lders of 18%.
Required:
Va ue the preference shares and state whether they are debt or equity.
Solution:
The preference shares do not have a conversion option to ordinary shares. They are therefore debt.
82
The valuation of preference shares is the present value of future cash flows, discounted at the current required
return of 18%.
Valuation Year 1 Year 2 Year 3 to infinity
Dividend (200 × 20%) 40 40 45 (market value R250 in Year 2)
Market value 250 (see below)
40 290
Note: There is no tax on preference shares, therefore no adjustment is required.
Step 1 Calculate the value of the shares as at the end of Year 2, based on future dividends from Year 3 to
infinity.
R45
Value = = R250
0,18
Step 2 Calculate the market value as at Year 0

40 290
= +
(1 + 0,18)
2
(1 + 0,18)
= 33,90 + 208,27
= 242,17
Total value 242,17 × 10 000
= R2 421 700
Market value of debt is R2 421 700
CFj0 = 0
CFj1 = 40
CFj2 = 290
I/YR = 18
NPV = 242,17
Example 4: ‘Convertible’ debentures

Company A has 1 000 d b ntur s in issue at a book value of R1 000 each. The current coupon (interest) paid
equals R150 per deb nture b fore tax. The debentures fall due for ‘conversion’ (Note: normally this pertains to
conversion to equity, but the same principles apply) in two years’ time. The debenture-holders have the option
of:
receiving a payout equal to the book value (face value or par value) of the debentures, or
converting to new debentures at an indefinite coupon of R175 per debenture (irredeemable debent res),
assuming an after-tax interest cash flow of R126 p.a. per debenture (i.e. R175 × (1 – 28%)), or
c nverting to new five-year debentures at a coupon rate of 17,92% before tax per debenture (redeemable
debentures), assuming an after-tax rate of 12,9% (i.e. 17,92% × (1 – 28%)).
The current tax rate is 28%, and similar debentures are trading at a yield-to-maturity (YTM) of 12% after tax.
Required:
C lculate the current value of the ‘convertible’ debentures today.
83
Solution:
Evaluate the three options at the end of Year 2
Option (i) Value 1 000 × R1 000 = R1 000 000
Option (ii) Value 1 000 × R1 050 = R1 050 000
Interest after tax R126 ×
Required return = 12%
126
Value = R1 050
0,12
Option (iii) Value 1 000 × R1 032,427
= R1 032 427
Interest rate after tax 12,9%
Interest after tax 12,9% × R1 000 = R129
129 129 129 129 129 1 000
Present value = + 2 + 3 + 4 + 5 + 5
1,12 1,12 1,12 1,12 1,12 1,12
= 115 + 103 + 92 + 82 + 73 + 567,427
1 032,427 × 1 000
R1 032 427
Or Present value factor of a 5-year annuity @ 12% = 3,605
Present value factor of 12% at the end of 5 years = 0,567
Present value of a debenture
Interest 129 × 3,605 = 465
Capital 1 000 × 0,567 = 567
1 032
Total value 1 000 × R1 032 000
CFj0 = 0
CFj1 = 129
CFj2 = 129
CFj3 = 129
CFj4 = 129
CFj5 = 1 129
I/YR = 12
NPV = 1 032
Choice?
Debenture- holders will choose to convert to indefinite debentures as they have the
highest va ue of R1 050 000.
84
Practice questions
The following questions are intended to reinforce the important concepts that have been introduced in this
chapter. Do not proceed to the next chapter before grasping the following questions.
Question 3–1: Present Value (Fundamental)

Which amount is worth more at 9%?
R1 000 today or
R2 000 after 8 years
Solution:
2 000 2 000
Present value of R2 000 today = = = 1 003,71
(1 + 0,09)
8
1,9926
R2 000 after 8 years is worth more by R3,71

FV = 2 000
I/YR = 9
N = 8
PV = 1 003,71
Question 3–2: Present Value (Fundamental)

Mr B’s friend wants to borrow a sum today at 8% interest and repay R20 000 in three years’ time. How much
will Mr B be willing to lend?
Solution:
20 000 20 000
Present value = = = R15 876,80
(1 + 0,08)
3
1,2597

FV = 20 000
I/YR = 8
N = 3
PV = 15 875,8
Questi n 3–3: Future Value (Intermediate)

Mr B needs R120 000 at the end of four years. He knows that the best he can do is to make equal payments
into a bank account on which he can earn 10% interest compound annually.
His first payment will be made at the end of the first year.
Required:
Determine what amount he must invest annually to achieve his objective.
If he made one lump-sum payment today, how much would he need to invest to achieve his objective?
85
Solution:
(1 + i) – 1
n
(i) FVA = I×[ ]
i
(1 + 0,1) – 1
4
120 000 = I×[ ]
0,1
120 000 = I × [ 1,4641 – 1 ]

0,1
120 000 = I × 4,641
I = 120 000 / 4,641
= R25 856,50

PV = 120 000
I/YR = 10
N = 4
PMT = 25 856,50
FV
(ii) PV =
(1 + i)
n
120 000 120 000

PV = =
(1 + 0,1)
4
1,4641
= R81 961

PV = 120 000
I/YR = 10
N = 4
PV = 81 961
Question 3–4: Present Value (Advanced)

Mr B is conside ing th ee investment opportunities, A, B and C.
A is expected to pay R800 a year for three years, followed by R1 000 a year for four years, followed by R2 000
at the end of the eighth year.
B is expected to pay R3 000 at the end of the fourth year followed by R400 indefinitely.
Investment C will pay R1 000 at the end of Year 2, R500 at the end of Year 3, followed by R400 at the end of
Year 4 which will grow by 2% indefinitely.
Mr B has a required return of 10%.
Required:
For Investment A, calculate the present value of future cash flows as at the end of Year 3.
Calculate the present value of Investment A as at Year 0.
Calculate the present value of Investment B as at Year 0.
Calculate the present value of Investment C as at Year 0.
86
Solution:
(i) Investment A at the end of Year 3
Year 4 5 6 7 8
Cash flows 1 000 1 000 1 000 1 000 2 000
4
[1 – 1 / (1 + 0,1) ] 2 000
Present value = 1 000 × +
(1 + 0,1)
5
0,1
2 000
= 1 000 × 3,17 +
1,6105
= 3 170 + 1 241,85
= R4 412
CFj0 = 0
CFj1 = 1 000
CFj2 = 1 000
I/YR = 10
NPV = 4 412
(ii) Investment A
Year 1 2 3
Cash flows 800 800 800
Future cash flow 4 412
800 800 5 212
800 800 5 212

Present value = + +
(1 + 0,1)
2 (1 + 0,1)
3
(1 + 0,1)
= 727,27 + 661,16 + 3 915,85
= R5 304
CFj0 = 0
CFj1 = 800
CFj2 = 800
CFj3 = 5 212
I/YR = 10
NPV = 5 304
87
Investment B
Year 0 1 2 3 4 5 to infinity
Cash flow 3 000 400 to infinity
PV at Year 4 of future cash flows
400
=
0,1
= 4 000
Cash flow at Year 4 = 3 000 + 4 000
= 7 000
7 000
Present value at Year 0
(1 + 0,1)
4
7 000
=
1,4641
= R4 781

FV = 7 000
N = 4
I/YR = 10
PV = 4 781
Investment C
Year 1 2 3 4
Cash flows 1 000 500 400 + 2% growth to infinity
Value of investment growth as at Year 3
400
=
0,10 – 0,02
5 000 [ Formula D1 / Ke – g ]
Present value = 1 000 + 500 + 5 000

(1 +0,1)
2 (1 + 0,1)
3 (1 + 0,1)
3
= 826 + 376 + 3 756
= R4 958
Financial calc lator instructions:
CFj0 = 0
CFj1 = 0
CFj2 = 1 000
CFj3 = 500 + 5 000
I/YR = 10
NPV = 4 959
88
Question 3–5: Future Value (Intermediate)

Mr A will invest R10 000 today, followed by four equal amounts at the beginning of each year. Interest rate is
10%.
Required:
Calculate the future value of the annuity if interest is compounded annually.
Calculate the future value if interest is compounded bi-annually.
Re-calculate (a) if the investments of R10 000 were made at the end of the year.
Solution:
5
(1 + 0,1) – 1
(a) FVA = 10 000 × [ ] × (1 + 0,1)
0,1
= 10 000 × 6,1051 × 1,1
= R67 156

PMT = 10 000
N = 5
I/YR = 10
FV = 67 156
(1 + 0,05)
10 – 1
2
(b) FVA = 5 000 × [ 0,05 ] × (1 + 0,05)
= 5 000 × 12,5779 × 1,1025

= R69 336
Note: The assumption has been made that since the interest is compounded bi-annually, the amount
invested is R5 000 per six-month period.
5
(1 + 0,1) – 1
(c) FVA = 10 000 × [ ]
0,1
= 10 000 × 6,1051
= R61 051
Question 3–6: Value of preference share (Intermediate)

An investor holds indefinite non-cumulative preference shares. No dividends have been paid in the current year
and no dividends are expected to be paid in the next two years.
The company has announced that it will pay a dividend of R38 per share at the end of Year 3, R40 at the end of
Year 4 and R48 per share thereafter. Dividends are not expected to increase above R48.
The invest r h lds 1 000 shares. Return on debentures is 12%.
Required:
Ca cu ate the value today of the investor’s preference shareholding.
89
Solution:
Year 1 2 3 4 5 to infinity
Dividends – – 38 40 48 to infinity
Value of shares as at Year 4

= 48
0,12
= R400
38 40 400
+ +
(1 + 0,12)
3 (1 + 0,12)
4 (1 + 0,12)
4
Present value at Year 0 =
= 27,05 + 25,42 + 254,20
= R306,67
Total value = R306,67 × 1 000
= R306 670

CFj0 = 0
CFj1 = 0
CFj2 = 0
CFj3 = 38
CFj4 = 40 + 400
I/YR = 12
NPV = 306,67
90
Chapter 4
Capital structure and the

cost of capital
AFTER STUDYING THIS CHAPTER,THE STUDENT SHOULD BE ABLE TO –
explain the advantages and disadvantages of debt finance in terms of financial risk and increased return
to shareholders;
explain the meaning and importance of the Weighted Average Cost of Capital (WACC);
explain the mechanics of the Traditional theory;
explain the mechanics of the Miller and Modigliani theory;
show how a shareholder can benefit through arbitrage;
explain how the optimal capital structure is derived under the Traditional theory;
calculate the value and required return for equity and debt; and
calculate the Weighted Average Cost of Capital (WACC).
When you consider all the debate around the business failure of 1Time Airlines, load-shedding by Eskom and
the Gauteng e-tolling issue you will realise how important it is to be able to obtain and structure adequate debt
levels to refinance aircraft which are cost efficient, to improve electricity supply and to finance upgrades to
provincial roads. Such issues will be addressed in this chapter.
Increasing the value of the firm sustainably is one of the main objectives of a financial manager. When valuing
a firm (i.e. determining shar hold rs’ wealth), which will be dealt with later under valuations in chapters 10 and
11, we find that risk, cashflow and growth are major determinants of the value of an organisation.
Of these determinants, risk has already been partly discussed in chapters 1 and 2. In this chapter risk will be
further analysed with eference to capital structure and the relationship between risk and required returns. You
will lea n how to determine the optimal capital structure of an organisation, identify suitable forms of long-
term finance in the context of capital structure theory, and how to calculate the weighted average cost of
capital (WACC) for a given structure, taking cognisance of financial and business risk. Growth is discussed in the
final section of this chapter.
The relati nship between risk and required returns will be revisited and dealt with further under portfolio the ry
in chapter 5. The importance of cash flows will be demonstrated in more detail under the investment deci ion
in chapter 6, while suitable forms and sources of long-term financing will be discussed under the finance
decision in chapter 7. The analysis of financial statements to evaluate risk is handled in chapter 8, whi st the
significance of growth as an important determinant of valuation is revisited in chapter 11.
The ‘capital structure’ of a company refers to its long-term financing. Companies are financed by owners’
equity, or by a mixture of owners’ equity plus debt. When asked whether debt or equity is cheaper, many
people respond that equity is cheaper. The assumption being made here is that equity is ‘free’ as it has been
given by the owners of the business, whereas if the firm takes on debt it is obliged to pay interest to the bank
as well as provide security.
91
The question is: Should a company have debt as part of its capital structure?
Put another way, does a company gain any advantage by using debt finance?
4.1 Debt advantage

Contrary to the belief that equity might be cheaper than debt, it is important to note that there are three
reasons why equity is more expensive than debt:
Who carries the highest risk when providing capital to a firm? The answer is the ordinary shareholders, or
the providers of equity. Should the firm face insolvency, the ordinary shareho ders stand at the back of the
queue in respect of getting their money back.
2 Who expects and requires a higher level of return? Notwithstanding the risk spect, ordinary shareholders
are the most demanding of all when it comes to getting a return on their funds. After all, this is the reason
that they have invested in the company.
3 What achieves the best tax advantage? From the perspective f the firm, all forms of debt (borrowing), other
than preference shares, are tax-deductible. This is ften referred to as the tax-shield advantage of using debt
to fund operations.
In light of the reasons mentioned above, debt is therefore considered to be cheaper than equity.
Example:
Company A requires R1 million to finance a new proj ct. The cost of equity, ke, is 20%. The cost of debt is 25%
before tax. The tax rate is 40%.
Required:
Determine which form of finance is cheaper.
Solution:
The above example clearly illustrates that ordinary shareholders require a return of 20% after tax. If the
company borrows at 25%, the effective cost of debt finance is:
25% × (1 – 40% tax rate) = 15%
If the investment promised an expected return of R400 000 before tax, the return to the shareholders would be
as follows:
Equity financed Debt financed
R1 million R1 million
Investment
Cash flow 400 000 400 000
Debt interest – 250 000
Return before tax 400 000 150 000
Tax @ 40% 160 000 60 000
Return after tax 240 000 90 000
In this example, if the shareholders provide the funding, they will receive a return
of: 240 000/1 000 000 = 24%, which is 4% above the required return of 20%.
However, if the project is financed using debt, the company will make a profit of R90 000 without the
hareholders making any personal investment. Shareholders will make what appears to be a risk-free return of
R90 000 without making any additional investment (i.e. their personal investment is zero).
Fin ncial gearing improves shareholder return

Financial gearing refers to the benefit of using debt finance to improve or gear-up the existing return on
shareholder investment. Even though the return after tax for equity financed is greater than the debt financed
option, the point is that the R90 000 return after tax is without any further shareholder investment.
92
Capital structure and the cost of capital Chapter 4
Example:
Company A is currently financed by R1 000 000 equity only. Company returns after tax equal R240 000. The
company wants to expand by investing a further R1 million in a project that promises an expected return of
R400 000 before tax.
The shareholders required return ke = 20%, while the cost of debt is 25% before tax. The tax rate is 40%.
Required:
Compare the return to shareholders, when the investment is financed by new equity as opposed to debt
finance.
Solution:
Equity financed Debt financed
Cash flow 400 000 400 000
Debt interest – 250 000
Tax @ 40% 160 000 60 000
Existing return after tax 240 000 240 000
Total return 480 000 360 000
Shareholders’ investment 2 million R1 million

Shareholders’ return 480 000/2m 360 000/1m
= 24% = 36%
Conclusion:
It would appear that the ordinary shareholders would be better off financing the project using debt finance, as
their return on investment has increased to 36% without any personal financial investment.
4.2 Debt disadvantage

Financial risk of the company increases as the company takes on debt finance
There are two types of risk: business (operation) risk and financial risk. Business or operation risk emanates
from the uncertainty attached to the many factors that influence the ability of a company to generate earnings.
Clearly, some busin ss s are more risky than others. Operating an oil-rig, for instance, is more risky than running
a supermark t. It th r fore stands to reason that shareholders will expect a return (ke) equal to the level of
business risk. When a company is financed by equity only, ke = business risk.
Business risk is dependent on the nature of the business, the operating leverage, that is, whether it is capital-
intensive (meaning that it has a high fixed cost and a low variable cost structure) or labour-intensive (low fixed
cost and high va iable cost), the state of the physical assets, competition, product substitution, etc. It should be
noted, however, that it is debatable whether labour cost in general and especially in South Africa can be
treated as variable cost. An enterprise’s future annual earnings may be regarded as a probability distribution.
The wider the dispersion of the possible earnings, the higher the operating risk.
93
Relatively low
business risk
Probability
Re ative y high
business risk
Expected earnings
Figure 4.1: Business risk curves
Financial risk is the risk that relates to the borrowing of long- and sh rt-term debt. By financing a part of the
company’s assets by borrowing money, a company becomes liable f r making –
monthly or annual interest payments; and
capital repayments.
The objective of using financial gearing is to increase the return to the shareholders, as it is anticipated that the
cost of debt will be lower than the returns offer d by the assets purchased with the borrowed funds. A
company therefore takes the risk that funds will be available to r pay both the interest and the capital liability.
It is therefore faced with default risk, which could be avoided if it chose to use equity finance only.
Where a company takes on financial risk, there is no doubt that the shareholders’ required return, ke, will
increase to a certain extent, due to financial risk.
Example:
Company A is currently financed by R1 000 000 equity only. Company returns after tax equal R240 000. The
company wants to expand by investing a further R1 million in a project that promises an expected return of
R400 000 before tax.
The shareholders required return, ke = 20%, while the cost of debt is 25% before tax. The tax rate is 40%.
Required:
Compare the return to shareholders when the investment is financed by new equity rather than debt finance.
Solution:
The shareholders’ required return of 20% refers to business risk only, as the company is financed by equity
only. Assuming that the new investment is an expansion of existing business risk, the shareholders’ return of
20% will not change, as long as the new investment continues to be financed by equity.
However when the new investment is financed by debt, the shareholders’ risk increases due to financial risk.
This means that shareholders will demand a higher return for financial risk, which could wipe out the benefits
of cheap debt finance.
Equity financed Equity financed plus
debt financed
Ca h flow 400 000 400 000
Debt intere t – 250 000
T x @ 40% 160 000 60 000
Existing return after tax 240 000 240 000
Total return 480 000 360 000
94
Shareholders’ investment R2 million R1 million

Shareholders’ return 480 000/2m 360 000/1m
Expected return, ke = 24% = 36%
Required return, ke = 20% = ?
Shareholders required return for equity and debt financed companies

= Business risk + Financial risk
= ke + ?
Assuming that in this example, financial risk as perceived by the shareho ders equa s 6%, then the required
return will equal 26% (20% + 6%).
If, on the other hand, financial risk is equal to (say) 15%, then the required return will be 35% (20% + 15%), and
as the expected return is 36%, the shareholders will receive a return of only 1% bove the required return.
However, if the project is financed via equity finance, the shareholders can expect a return of 24%, which is 4%
above the required return.
Important: ke always equals Business risk + Financial risk

ke
Required
return
Financial risk
Business risk
Business + Financial risk
Business Assume Assume

risk only 70% Business risk + 50% Business risk +
30% Financial risk 50% Financial risk
Figure 4.2: Required return and risk
Note: If a company has no debt and the cost of equity, k e, is 30%, then business risk equals 30%. If the
company does have debt in its capital structure, then one can expect the k e to be higher than 30%
(40%, say) as this will r present business risk + financial risk.
4.3 Finan ial gearing

Financial gea ing desc ibes the proportion of debt compared to the proportion of equity financing. It is a
measure of financial leverage, showing the degree to which a firm's operations are funded by debt as opposed
to equity. High financial gearing means that a company places a heavy reliance on debt financing, while low
financial gearing means that the firm is heavily reliant on equity financing. Generally speaking, a company with
high financial gearing will show a higher earnings per share in times of economic upturn, compared to a
company with a low gearing. In times of an economic downturn, high gearing companies will do worse than
companies with low gearing. High financial gearing also implies increased risk. High risk-takers will do well in
good times and show below average returns in bad times.
Note: It is important to distinguish between three important ratios.

l Gearing ratio: Long-term debt/(Long-term debt + Equity)
l Debt (solvency) ratio: Total debt/Total assets
l Debt to equity (D:E) ratio: Non-current liabilities to Equity
95
Example:
Three companies have the following financial structure:
Company A Company B Company C
Total assets R2,0m R2,0m R2,0m
Issued shares (R1 each) R1,5m R1,0m R0,5m
Total debt R0,5m R1,0m R1,5m
All the companies are in the same type of industry and equally efficient. The cost of debt is 15% and the tax
rate is 40%.
Consider the following three situations:

Situation 1 operating profit before tax is R150 000
Required:
Calculate the earnings per share in Companies A, B, and C for each of the above economic situations.
Solution:
Low gearing Company A
Operating income
Situation 1 Situation 2 Situation 3
R R R
Profit before interest and tax 150 000 300 000 600 000
Interest (75 000) (75 000) (75 000)
Taxable profits 75 000 225 000 525 000
Tax payable 30 000 90 000 210 000
Earnings available to ordinary shareholders R45 000 R135 000 R315 000
Earnings per share (1 500 000 shares) R0,03 R0,09 R0,21
Medium gearing Company B

Operating income
R R R
Interest (150 000) (150 000) (150 000)
Taxable profits Nil 150 000 450 000
Tax payable Nil 60 000 180 000
Earnings available to ordinary shareholders Nil R90 000 R270 000
Earnings per sha e (1 000 000 shares) Nil R0,09 R0,27
High gearing Company C

Operating income
R R R
Interest (225 000) (225 000) (225 000)
Taxable profits (75 000) 75 000 375 000
Tax payable Nil 30 000 150 000
Earnings available to ordinary shareholders (R75 000) R45 000 R225 000
Earnings per share (500 000 shares) (R0,15) R0,09 R0,45
96
In the above example, shareholders of the highly-geared company will benefit when operating profits are
above R300 000 (15% return on assets), that is, the break-even point.
Companies with high gearing have greater financial risk because the interest charge is fixed, that is, it must be
paid, regardless of the level of company profits. The key ratio in this instance is interest cover, that is, the
number of times that Earnings before Interest and Tax (EBIT) cover interest. The higher the interest charge or
the lower the EBIT, the higher the company risk.
The important question in the long-term financing decision is whether the cost of capital for a company is
dependent on its financial structure (i.e. how it is funded). If long -term debt does affect the cost of capital,
then the company should minimise its cost of capital by borrowing an amount of debt capital that will give the
company the lowest cost of capital.
4.4 Debt as part of the capital structure

The following have been established:
The cost of debt is lower than the cost of equity due to l wer risk, lower expected returns and tax
advantages.
Introducing debt finance into the firm’s capital structure brings with it financial risk which increases the
cost of equity, ke.
Financial gearing (taking on debt finance) improves the return to shareholders in good economic times,
but may lower the return when the economy is struggling.
The question that must now be answered is: ‘Should a company take on debt, and if so, how much?’ There
are two schools of thought on whether there is any advantage of debt financing. The Traditional theory takes
the viewpoint that debt finance is acceptable and will lower the overall company cost of finance as long as the
company does not take on too much debt.
The second theory, that is, the Miller and Modigliani theory, states that debt finance brings with it financial
risk such that the cost of equity, ke, will increase, leaving the Weighted Average Cost of Capital (WACC, see
section 4.11) of a company equal to the cost of business risk, which is the required rate of return for the all-
equity funded company. Whether a company takes on debt or not, it cannot lower the overall cost of finance
below the required return associated with the business risk.
4.5 Compensating providers of capital

WACC represents the return that a company needs to achieve in order to fully compensate the debt providers
as well as the equity providers.
Example:
Company A is financ d 60% through equity and 40% via debt. The shareholders’ required return, ke = 20%,
while the debt providers require an interest payment equal to 25% before tax. Tax rate is 40%. The market
value (MV) of equity equals R600 000, while the market value (MV) of debt equals R400 000.
Required:
Calculate the WACC for Company A and show how much profit must be generated to fully satisfy both the debt
and equity providers.
Soluti n:
The co t of equity of 20% represents both the business risk and financial risk of equity shareholders, because
the company already has debt in its capital structure.
WACC = 20% × 60/100 + (25% × 60% × 40/100)
= 12% + 6%
= 18%
Interest = R400 000 × 25%
= R100 000
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Equity return = R600 000 × 20%

= R120 000
Cash flow before tax = 120 000/60%
= R200 000
Interest = R100 000
Required profit before tax = R200 000 + R100 000
= R300 000
Proof: Profit before tax 300 000
Interest (400 000 × 25%) 100 000
Profit before tax 200 000
Tax (@ 40%) 80 000
Profit after tax 120 000
Return to ordinary shareholders = 120 000/600 000

20%
Traditional capital structure theory

The traditional, or generally believed, theory of capital structure assu es that an optimal capital structure does
exist and depends on the level of gearing. The company cannot maximise shareholders’ wealth unless the
optimal WACC is achieved. In short, it assumes that the firm’s cost of capital is dependent on its capital
structure.
Because debt capital has a lower after-tax cost than equity capital, as it is moderately increased, the WACC
falls. The moderate increase in debt does not increase the overall risk of the firm and therefore the company
does not have to offer a higher return to shareholders to compensate for the increased risk. As debt capital is
further increased, the WACC will continue to fall, up to a certain point. After this optimal level is reached, any
further increase in debt capital will increase the risk of the firm and the shareholders will demand a higher
yield.
ke
(cost of
Cost of equity)
capital
WACC
kd
(cost of
debt)
D:E ratio
Figure 4.3: Diagrammatic representation of the traditional capital theory
The extreme left of the horizontal axis represents the all-equity firm, while the extreme right represents the fu
y-geared company (high proportion of debt to equity). It is assumed that the cost of debt remains constant, a
though in practice, it will probably rise, as lenders may require a higher return for higher risk as the proportion
of borrowing increases. The traditional view, then, is that up to a moderate level of gearing, the fin ncial risk is
minimal and only a small increase in the return on equity is required. The cheap debt will lower he WACC. As
the firm continues to increase debt, shareholders become more aware of financial risk and as a result require
additional returns on equity capital.
The Traditional theory concludes that there is an optimal or target capital structure for every company. The
optimal D:E ratio is determined at the lowest average cost of capital, as shown in Figure 4.3. It is also important
98
to note that at this point, the overall value of the company is maximised, simply because it has obtained the
most optimal financing mix. In practice, it is difficult for a company to determine the target D:E ratio, but it will
be guided by the capital structure of similar quoted companies. It must be understood that different business
sectors will have different capital structures.
Alternative diagram
It is assumed in Figure 4.4 that the shareholders in an all-equity company require a return, ke, equal to business
risk. As the company takes on financial risk, it can be assumed that the shareholders will initially continue to
require a return, ke, equal to business risk and it is only as financial risk increases significantly that k e starts to
increase to compensate for increased financial risk.
There is nothing wrong however, with making the assumption that k e incre ses s soon as debt finance is taken
on by the company. The key question is: ‘What happens to the WACC?’ If the WACC decreases to an optimal
point before it starts to increase, the representation is still classified as the Traditional theory.
Cost of ke = Business +
capital Financial risk
Increase due to
financial risk
WACC
ke
(business kd
risk)
Equity finance Equity/Debt finance
Figure 4.4: Optimal WACC
The WACC can be described as

ve vd
WACC = ke × + kd ×
ve + vd ve + vd
Where:
ke = quity-holders’ required rate of return
kd = debt-holders’ required rate of return after tax
ve = MV of equity
vd = MV of debt
Note that the value of the company = ve + vd
Example:
C mpany A has determined that the cost of equity ke increases as the company takes on debt finance as foll ws:
MV MV kd after
of equity of debt tax ke WACC
100% 0% – 20% 20,0%
80% 20% 12% 21% 19,2%
60% 40% 12% 22% 18,0%
50% 50% 12% 25% 18,5%
40% 60% 14% 28% 19,6%
20% 80% 17% 30% 20,0%
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Required:
Show how the WACC has been calculated and determine the optimal D:E ratio.
Solution:
D:E ratio kd ke WACC
0:100 – 20 20 = 20,0%
20:80 12 21 (12 × 20/100) + (21 × 80/100) = 19,2%
40:60 (optimal) 12 22 (12 × 40/100) + (22 × 60/100) = 18,0%
50:50 12 25 (12 × 50/100) + (25 × 50/100) = 18,5%
60:40 14 28 (14 × 60/100) + (28 × 40/100) = 19,6%
80:20 17 32 (17 × 80/100) + (32 × 20/100) = 20,0%
The company should finance its long-term activities by using a target D:E ratio of 40% debt to 60% equity.
Note: The optimal D:E ratio is a target that the company should stri e for. In the short-term, the company
will always be in a position of disequilibrium, as it will s metimes use debt finance and on other
occasions equity finance. The market value of both debt and equity will also change in value daily,
due to market forces.
Market value of a company

The market value of a company = Market value of quity + Market value of debt
The market value of equity can be calculated as:
MVe = D1 (where the company has zero growth)

ke
D1
–g
Or MVe = ke (where the company grows at a constant rate)
The market value of debt can be calculated as:
Interest paid after tax
MVd =
Current cost of debt after tax
where debt is for an indefinite period (i.e. a perpetuity).
The market value of a company, Vo, will therefore equal
Vo = Dividend + Debt interest (after tax)

k kd
Divid nd + Debt interest
Or Vo = (after tax)
WACC
Note: kd will be the cu rent market required rate of return, not the historical cost of debt.
In the event that the amount of dividends or interest to be paid is unknown, an alternative way to work out
the market val e of the company is:
V = Annual EBIT × (1 – Tax rate)

WACC
Conc u ion:
The gearing ratio that minimises the WACC, maximises the total market value of the firm, and thus maximises
the market value of equity capital.
100
4.7 The Miller and Modigliani theory

In 1958, Miller and Modigliani proposed that there is no optimal capital structure, because the advantage of
debt would be exactly counteracted by an increase in ke, such that the WACC would always equal business risk.
Miller and Modigliani, however, made certain assumptions as follows:
investors are rational;
all investors have the same expectation about the future;
capital markets are perfect;
all relevant information is freely available;
there are no transaction costs;
there is no taxation, or no distinction between company and personal tax;
firms can be grouped into business risk or operating risk classes; and
individuals and firms can borrow at the same rate, and pers nal gearing is assumed to be a perfect
substitute for company gearing.
Miller and Modigliani argued that the cost of capital is independent of the capital structure, and hence the
value of the firm is independent of the proportion of debt to total capitalisation.
Note: The Traditional theory argues that the cost of capital is dependent on the capital structure.
As debt financing increases, the initial effect would be to low r the WACC, thus increasing the value of the firm.
Miller and Modigliani, however, argue that the incr as d gearing results in shareholders requiring an increased
return to balance out the increased risk. The change in the required equity return will just offset any possible
saving or loss on the interest change. As gearing increases (or decreases), the WACC will remain constant,
therefore no optimal level of capital gearing exists. In effect, Miller and Modigliani argue that a firm should be
indifferent as to whether it is funded by debt or equity. Further, they argue that it is the assets that determine
the value of the company, not the manner in which those assets are financed.
In the Miller and Modigliani theory, the equilibrium factor that restores the WACC to equal the k e of the all-
equity funded firm is the arbitrage process. The arbitrage process takes place where two firms of identical
income and risk exist, but one is funded solely by equity and the other has a mixture of debt and equity. The
D:E-funded company has a temporarily higher value than the all -equity funded company, due to a lower cost
of capital. The investors would arbitrage in order to equalise the values of the two companies. This is achieved
when the WACC of the D:E-funded company equals the ke of the all-equity funded company.
Miller and Modigliani stated that the market value of the firm equals
Y ko
Vo
MV of the firm
Where: Vo dividend + interest
Y WACC
ko Any change in the mix of D:E finance will have no effect on the value of Y.
Very important: ko and Vo will also remain constant.
The gearing mix will result in a change of the dividend/interest mix only.
101
ke
Cost of (cost of equity)
capital
WACC equals
ke of an all-equity
company
kd
(cost of debt)
D:E ratio
Figure 4.5: Diagrammatic representation of the Miller and Modigliani theory
4.8 The arbitrage process

The arbitrage process is a term used to describe how an investor in a company that has both debt and equity
finance will only be satisfied if he is receiving a return (k e) that fully co pensates him for financial risk. If he is
not adequately compensated, he will invest in an all- quity financed company and increase his return by taking
on personal financial risk by borrowing at a cost equal to the corporate borrowing rate.
Example:
Two companies, A and B, operate the same type of business and have identical levels of business risk.
Company A has the following capital structure:
Book value of equity = R1 500 000
MV of equity = R3 000 000
Cost of equity capital = 12%
Issued shares = 12 000 000
Current dividends = R360 000
Company B has the following capital structure:
Book value of equity = R4 000 000
MV of equity = R6 000 000
Book and MV of debt = R6 000 000
Cost of equity capital = 14%
Cost of debt (aft r tax) = 6%
Issued shares = 6 000 000
Current dividends = R840 000
Required:
Calculate the WACC of the two companies and state whether the companies are operating in a
traditional or Miller and Modigliani world.
Ass ming that the two companies are operating in a Miller and Modigliani world, discuss the advice that c
uld be given to the shareholders of Company B.
Calculate the equilibrium cost of equity, ke, for Company B shareholders, and the equilibrium market
value of Company B shares, assuming that the market value of Company A shares and the market value
of Company B debt are correct.
So ution:
(i) WACC – Company A
Company A is all-equity financed. The cost of equity, ke, is 12%. Assuming that the market value of R3 000 000
for equity is correct, then the WACC will be 12%.
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WACC – Company B
Company B is financed 50% equity + 50% debt
ke = 14%
kd = 6%
WACC = 14% × 50% + 6% × 50%
= 10%
The Traditional theory states that as a company takes on debt, the WACC will decrease and the company
should finance its operations at the target D:E ratio. In this example, Company B has taken on debt which has
resulted in the WACC dropping from 12% to 10%. It would appear that the company is operating in a
traditional world.
Which shareholder is better off; Company A shareholder or Company B sh reholder? One would be tempted to
state that the shareholders of Company B are better off than Company A sh reholders as they are receiving a
return which is 2% higher (14% vs. 12%).
Important: Company B shareholders are exposed to financial risk and it is appropriate that they should be
compensated for such risk by receiving a higher return. This means that the 14% return for
Company B is not necessarily better than the 12% f r C mpany A. The question that needs to be
answered is: ‘Are the shareholders of Company B adequately c mpensated for the financial risk?’
If the answer is ‘No’, they will sell their shares in Co pany B and invest in Company A.
It has been stated that it appears that Co panies A and B are operating in a traditional world.
This is not necessarily the correct answer. Miller and Modigliani would argue that Company B is
in a temporary position of disequilibrium, and that the shareholders of Company B are not
adequately compensated for their lev l of financial risk. Arbitrage will take place to ensure that
the return for shareholders of Company B will incr ase until the WACC of Company A equals the
WACC of Company B.
Possible answers:
(a)
Cost of
capital
ke Co A = 12%
14% ke Co B = 14%
ke 12%
10% WACC = 10%
Co B
6% kd = 6%
D:E ratio
Figure 4.6: Traditional capital theory
103
(b)
Cost of y
capital ke equilibrium
ke Co A = 12%
14% ke Co B = 14%
x
ke 12% WACC = 12%
WACC = 10%
6% kd = 6%
D:E ratio
Figure 4.7: Miller and Modigliani theory in disequilibrium
Note: ke of Company A = Business risk only

kd of Company B = Business risk plus financial risk
In a Miller and Modigliani world, the critical factor is the WACC, which must always equal the business risk of
an all-equity company.
In this example, business risk = 12%
Therefore WACC = 12% at all D:E ratios
Company B (refer to Figure 4.7), has a WACC of 10%. Miller and Modigliani would argue that the shareholders’
return of 14% is in temporary disequilibrium, as the WACC should equal 12%. As debt is correctly valued, the
shareholders of Company B are not adequately compensated for financial risk. In the short-term, Miller and
Modigliani would expect ke to increase to the point Y, and the WACC to increase from 10% to 12% at the point
X in Figure 4.7 above.
Note: Market value of Company B shares = Dividend/ke
The dividend of Company B, that is, R840 000, cannot change, as it is derived from business operations and is
not dependent on the market value of shares or shareholders’ required return. For there to be an increase in
ke, it is necessary for the mark t value of the shares to drop. In other words, the share value of Company B is
overstated and the share price must drop.
If the value of a share in reases, the cost of equity will drop

For example:
MV = 6 000 000
D1 = 840 000
ke = 14%
If the market value dropped to R5 000 000, the following would result:
MV = D1/ keMaking ke the subject, then
ke = D1/ MV
840 000/5 000 000
0,168 or 16,8%
If the market value increased to R7 000 000, the following would
result ke = D1/MV
840 000/7 000 000
0,12 or 12%
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(ii) Advice to the shareholders of Company B

If the two companies are operating in a Miller and Modigliani world, the WACC of both companies should equal
the business risk of an all-equity company. Company A is an all-equity company with a ke or WACC equal to
12%.
The WACC of Company B is currently 10%, which means that the return of 14% for shareholders is too low. The
company is in temporary disequilibrium and the share value is too high. k e must increase such that WACC will
equal 12%. For ke to increase, the share price must drop. The shareholders of Company B should be advised to
borrow an amount equal to the D:E ratio of Company B and invest the total amount in Company A, to receive a
return higher than the existing 14%.
Assuming that the ordinary shares in Company A are correctly valued at 25 cents, as well as the debt in
Company B, investors in Company B will wish to sell their shares and re-invest in Company A. As a result, buying
pressure will be placed on Company A’s shares.
Assuming an investor in Company B holds 100 shares in that company, the market value is R100 and the annual
dividend R14. By holding 100 shares in the company, the investor is exposed to financial risk. He can improve
his return by selling his shares in the company, borrowing an am unt f money that will give him the same
financial risk as he presently holds, and investing the proceeds in C mpany A.
Is the shareholder better off by investing in Company A?

Total cash
Sell 100 shares at market price R100
Borrow to retain 50:50 gearing R100
Total cash R200
Purchase 800 shares in Company A.
Current risk/return situation

The investor will have the same risk profile as he previously had with his investment in Company B by
borrowing R100 and investing the proceeds of R200 in Company A shares.
His return is now
Total cash
Dividends from Company A R24
Interest on borrowing (after tax) (R6)
Net return R18 or 18/100
= 18%
This represents a gain of R4 p r year over the income received as a shareholder in Company B, while retaining
the same finan ial risk.
Miller and Modigliani state that the share price of Company B will move towards an equilibrium, which will be
reached when the WACC of the two companies is the same and no further arbitrage gains can be made.
Note: Shareholders in Company B can improve their return, for the same level of financial risk, from 14% to
18%.
D es this mean that 18% is the equilibrium return that will yield a WACC for Company B of 12%? No. If
ke f r C mpany B increases to 18%, it will mean that the market value of equity will drop such that the
D:E ratio will no longer be 50:50 as at the present moment.
Equilibrium ke and market value of shares in Company

B ke and WACC for Company A equals 12%
Company value = Dividend + debt interest

WACC
105
Equilibrium value of Company B

840 000 + 360 000
=
0,12
= R10 000 000
MV of Company B debt = R6 000 000
Therefore equilibrium value of Company B equity = R10 000 000 – R6 000 000
= R4 000 000
Equilibrium ke
Dividend = 840 000
Equity MV = 4 000 000
D1
ke =
MV
= 840 000
4 000 000
= 21%
This results in the following:

Debt MV = 6 000 000 kd = 6%
Equity MV = 4 000 000 ke = 21%
WACC of Company B = 6% × 6/10 + 21% × 4/10 = 12%
Review the steps again, to make sure you follow the logic:
The investor always starts off by owning shares in the D:E funded company, in this case Company B.
Believing that she can receive a higher return from the all equity funded company, the investor sells her
shares in Company B worth R100 and borrows an amount at the SAME D:E ratio (50:50) as Company B. In
other words, she now substitutes Company B’s gearing with her own personal gearing. It stands to reason
that this is a rational move, as she can obtain a higher return from Company A with the same level of risk as
investing in Company B.
She now takes her own funds (R100) plus the borrowed funds (R100) and invests the total amount (R200) in
the all equity funded company.
Even after paying the interest, she still receives a higher return from Company A than Company B (R18 vs.
R14).
As Miller and Modigliani assumed that all investors are rational, everybody will take advantage of this
arbitrage opportunity. Hence by selling Company B shares and buying Company A shares, the price of B will
go down and A will go up, thereby restoring the equilibrium to the point that the WACC of Company B will
equal the ke of Company A.
Concl sion:
In a Miller and Modigliani (1958) world, the above example illustrates temporary market disequilibrium.
Market f rces w uld ensure that the market values of both companies will move to a point where they will be in
equilibrium. There will thus be no financial advantage for an investor to sell his shares and purchase similar
shares in another company, as his return will not improve.
4.9 Optimal capital structure – traditional world

It h s been established that there is no optimal capital structure in a Miller and Modigliani (1958) world.
Miller and Modigliani made a correction to their theory by incorporating tax in 1963, in an article titled
Corporate income taxes and the cost of capital: a correction, which was published in the American Economic
Review 53 (3):433–443. According to this view, the value of a company is maximised by taking on maximum
106
debt. On the other hand, low debt levels have sometimes proved to be indispensable when a company needs
to raise cash.
Later research, which incorporated bankruptcy costs and agency theory, led to a theory where an optimal
capital structure is obtained where the WACC is at a minimum.
As the assumptions of a Miller and Modigliani world seldom (if ever) apply to South Africa, it is safe to conclude
that the traditional view more closely resembles the real world, and that companies should lower their WACC
by taking on an amount of debt such that the WACC reaches the optimal level. This reverts to the traditional
capital structure theory.
Does that mean that all companies should have debt in their capital structure?
Certain authors believe that individuals and companies should be debt free. However, GB Stewart (1993) is a
supporter of aggressive debt in his book The Quest for Value. Whether the view of the authors of this
publication is followed or not ultimately boils down to one’s personal affinity for risk. Debt will always increase
the shareholder’s risk in the manner stated by Miller and Modigliani. E en in a world that does not conform to
the Miller and Modigliani assumptions, the WACC will not decrease bel w business risk. The student is invited
to come to his or her conclusions. It is this trying to get to grips with the the ry of capital structure that makes
what happens in the so-called ‘real world’ so interesting.
For the purposes of this textbook, the traditional theory assu ptions as they pertain in a South African context
will be followed.
The firm
Debt Equity
Debentures Long-term Ordinary shares

loans Leases Reser ves
Mortgage bonds Retained income
Share issue costs
Preference
shares
Figure 4.8: Sources of finance
It is not always clear whether a particular security is debt or equity. Companies will sometimes create hybrid
securities that look like equity but are called debt for tax-benefit purposes. In the authors’ opinion, only
ordinary shares (or any security that has conversion rights to ordinary shares) should be classified as equity.
A preference share is a debt instrument that entitles the holder to a pre-determined dividend distribution
before dividends are paid to ordinary shareholders. These shareholders do not, however, participate in
decision-making, ass t own rship or in the distribution of super profits. In the event of liquidation, they also
have preference rights ov r company assets. Preference shares have all the characteristics of debt, but unlike
debt, the dividend cannot be d ducted as an interest expense when calculating taxable income.
Preference shares without the option of conversion to ordinary shares should be classified as mezzanine or
hybrid capital (Annexu e A, chapter 7).
Accepting that the e is an optimal capital structure, one can assume that a company is currently structured at
the target D:E ratio at market value, or that it is in temporary disequilibrium. Where a company is in temporary
disequilibri m, it will, in the long-term, finance its capital needs in order to move towards the target D:E ratio.
This means that a company can at any point in time have too much debt, or a debt capacity that is under-
utilised. As l ng as a company sets its sights on the long-term target D:E ratio, it is acceptable to have too much
debt at a pecific point in time, on the assumption that the target ratio will be achieved at some future date.
Important: When calculating the current WACC of a company or the WACC after taking on a new
investment, all calculations must be made at MARKET VALUES, NOT AT BOOK VALUES.
4.10 The cost of capital

When appraising a capital investment project, a discount rate is required. The rate used to evaluate the capital
investment must reflect the risk of the project. The target WACC (see section 4.11 below) rate is the correct
rate for capital appraisal, as it reflects the desired capital structure of the firm and the return required by the
107
shareholders after allowing for risk. The WACC is the rate that combines the expected returns at a firm’s target
D:E capital ratio. The firm’s existing capital structure at market values can be used where it reflects the optimal
mix.
There are three assumptions behind the use of a firm’s current WACC as the discount rate in investment
appraisal, :
The firm will retain its existing proportion of debt to equity capital (i.e. current = target).
The project is marginal. Most investments are indeed small, relative to the total capital value of the firm.
The project has the same level of risk as the firm’s existing activities. If the project has a risk structure that
differs from that of the existing activities, an appropriate risk-adjusted rate must be used.
Before calculating the current WACC, it is necessary to calculate or ascert in the current market -determined
returns on the various types of company capital, as applicable. (For purposes of this chapter you can assume
that the market values of the instruments are given, but because they are often not readily available and have
to be calculated in practice, these market-value calculations have been included in this chapter to be able to
answer some of the questions at the end of the chapter where they appear as integrated parts of a whole
question).
4.10.1 Ordinary equity

There are various ways to calculate the value of business enterprises as are discussed in Chapter 11 (Business
and equity valuations). These include the Free Cash Flow ethod, ethods utilising the Capital Asset Pricing Model
(CAPM), Gordon’s Dividend Growth Model, tc. It is g n rally accepted that dividends are one of the major
determinants of equity value regarding listed inv stm nts; consequently Gordon’s model will be used as the
criterion for this section as it doesn’t require l ngthy xplanations. The dividend valuation model states that the
market value of an ordinary share represents the expected future dividend flow discounted to present value
and is expressed as:
∞
P = Dt
Σ (1 + ke)
t
t=1
Where: P = MV of share
Dt = net dividend per share in time t
ke = The cost of equity capital.
Two dividend equations can be derived from the above equation, as follows –
dividends expected to remain constant; and
dividends expected to grow at a constant annual rate of growth
Constant divid nds

Assuming that dividends remain constant (i.e. there is no growth) in perpetuity, the value of the firm can
be exp essed as:
D1
P =
ke
As the market price of the shares and the dividend is easily determined, the cost of equity capital is:
D1
ke =
P
Example:
A company pays an annual dividend of 12 cents per share. The market price for the share is 82 cents.
Calculate the cost of equity capital.
12
ke = = 14,63%
82
108
The share price will change where –

expected dividend flow changes without a change in risk;
company risk changes without a change to the expected dividend flow; or
general economic expectations change, altering the equity holder’s required return.
Dividends grow at a constant annual rate

According to Gordon’s Dividend Growth Model the assumption is that dividends will grow at a constant
compound annual rate. The equation is:
D1
P =
ke – g
Where: D1 = D(1 + g)
D0 = dividend today
P = MV of share
ke = cost of equity capital
g = constant growth in perpetuity
Example:
A company’s shares are quoted at R41 per share. The curr nt dividend of R6 is expected to grow by 10% in
perpetuity. Calculate the cost of equity capital.
Re-write equation:
D0(1 + g)
ke = + g
P
6(1 + 0,1)
= + 0,1
41
0,261or 26,1%
Determination of growth
In the equation share value P = D1 / (Ke – g) one of the components is growth that is, g.
It is important to note that g implies growth in perpetuity and consequently cannot be too high to be
sustainable for v r. Usually sustainable long-term growth cannot be more than population growth plus
inflation.
The cost of equity ould however also have been calculated utilising other methods like the Capital Asset Pricing
Model (CAPM) whi h are explained in more detail in Chapter 5 (Portfolio management and the Capital Asset
Pricing Model).
4.10.2 Retained earnings

Companies ften fund their operations from retained earnings by retaining a proportion of after-tax profits in
the business, f rming part of shareholders’ capital. As retained earnings form part of ordinary shareholders’
equity, the required return for retained earnings is exactly the same as the cost of equity capital, as calculated
earlier.
4.10.3 Preference shares

Preference shares carry a fixed commitment on the part of the firm to make annual fixed interest payments. In
he event of liquidation, the claims of the preference shareholders take precedence over those of ordinary (or
common) equity shareholders.
109
The preferred yield or cost of debt is calculated using the equation:

D
Preferred yield =
MV
Where: D = annual dividend

MV = market value
No adjustment is made for tax, as dividends are an after-tax payment.
Example:
Company A issued preference shares at a par value of R100 five years go. A dividend of 15% is paid annually.
The preference shares are not redeemable and are currently trading at R92.
Required:
Calculate the cost of the preference dividends and the debentures.
Solution:
Cost of the preference shares
15
kp =
92
= 0,163 or 16,3%
The cost of preference shares is 16,3%.
Any new issues would have to be made at a price of R92.
4.10.4 Debt
Example: Debentures
Debentures mature in three years’ time at a discount of 5%.
Similar debentures are trading at 12%.
Tax rate: 35%
Required:
Calculate the cost of the d b ntures.
Solution:
Cost of debentu es:
kd = 12% × (1 – 35%) The
cost of debt is 7,8% after tax.
N te: The c st of debt is the current after-tax cost of debt, not the cost of debt at which the company riginally
acquired the debt.
4.11 The Weighted Average Cost of Capital

The ssumptions behind the use of the Weighted Average Cost of Capital (WACC) are mentioned in section 4.10.
The assumption that the project is marginal (i.e. relatively small in relation to the total capital s ructure) is
important, as the market valuations of debt and equity are based on the current capital holding. Any major
change in the existing amount and proportion of debt to equity will alter the required return characteristics of
the equity shareholder, as well as the debt-holder, due to the change in risk.
110
The cost of capital used for any particular project is not the cost of a specific type of capital, but the cost of the
firm’s pool of capital – the target WACC.
The WACC can be described as:

ve vd
WACC = ke x + kd ×
ve + vd ve + vd
Where:
ke = equity-holders’ required rate of return
kd = debt-holders’ required rate of return after tax
ve = MV of equity
vd = MV of debt
Note that the value of the company = ve + vd
Illustrative example of company structure:

EXTRACT FROM THE STATEMENT OF FINANCIAL POSITION OF COMPANY A:
R’000
Ordinary issued shares 5 000
Retained income 400
Irredeemable 15% preference shares 2 000
Long-term loans 1 000
Bank overdraft 300
Deferred taxation 600
9 900
The company has 1 000 000 shares in issue, and is currently paying a dividend of R2 per share with a growth of
5%. The shareholders’ required rate of return is 24%. The preference shares have no conversion rights and
carry a preference dividend payout ratio of 15%. Similar preference shares are currently trading at 12%. The
long-term loan matures in ten years’ time and carries an interest rate of 16%. The current long-term interest
rate for a similar loan is 18,34%. The bank overdraft rate is 20% and the tax-rate is 40%.
Required:
Calculate the current WACC at (i) book value and (ii) market value.
Calculate the target WACC if the optimal D:E ratio is ordinary shares 60%, preference shares 20% and long-
term loans 20%.
Solution:
(a) (i) WACC at book value:
Value Cost Weighted cost
R’000
Ordinary shares 6 000 0,24 0,16
Preference shares 2 000 0,15 0,03
Long-term loans 1 000 0,096 0,01
9 000 0,20
WACC = 20%
Note:
The ordinary issued shares, non-distributable reserves and retained income are included in the
book value of the ordinary shares.
Why are the bank overdraft and the deferred tax not shown as part of the capital structure?
As the bank overdraft is short-term finance used to finance short-term movements of current
assets, it is not deemed to be part of the firm’s permanent capital structure. However, when a
111
company uses bank overdrafts as a form of long- term financing, the portion that is used as long-
term should be brought into the capital structure.
Deferred taxation is not included because the timing of tax payments is accounted for when
evaluating the project investment decision.
The WACC at book value has little value and should not be used to evaluate future capital
investments.
WACC at market value

Market value of equity:
D1
MV =
ke – g
R2,10
0,24 – 0,05
R11,052631
Market value of equity R11 052 631
Market value of preference shares:

300 000
0,12
R2 500 000
Market value of long-term loans:

Annual interest (after tax) = R96 000
Current after-tax interest = 18,34% × 60%
= 0,11004 or 11%
PV of 10-year interest annuity at 11%
R96 000 × 5,8892 = 565 363
Redemption 1 000 000 × 0,3522 = 352 200
R917 563
WACC at market values:

Value Proportion × Cost Weighted cost
E: Ordinary shares 11 052 631 E/V × 0,24 = 0,183
+ P: Pr f r nce shares 2 500 000 P/V × 0,12 = 0,021
+ D: Long-term loans 917 563 D/V × 0,11 = 0,007
= V: Value 14 470 194 0,211
WACC = 21%
(Note that kd is after tax)
WACC at target ratios:

Target % Cost Weighted cost
E: Ordinary shares 60 0,24 0,144
0,12
P: Preference shares 20 0,11 0,024
D: Long-term loans 20 0,022
100 0,19
WACC = 19%
112
Conclusion:
In this example, the target rate of 19% should be used to evaluate new investments. Where the target is not
given, assume that the current D:E ratio at market value represents the target WACC to evaluate new
investments.
Note: Where a holding company/subsidiary company set-up exists, one should not use the holding
company’s WACC. Use the WACC for each individual company in the group, as the companies
operate in different industries with different risk structures.
4.12 Calculating the growth rate

Hitherto we have assumed that the growth rate is either given or is b sed on the growth in dividends. An
alternative method of determining growth (g) can be expressed as:
g = br
Where:
g = long-term growth
b = ploughback or retention ratio
r = return on investment (note, some texts also use return on assets)
Example:
Required:
Calculate the potential internal long-term growth of a company where long-term
ploughback ratio b = 40% and
return on investment r = 10%
Solution:
= br
40% x 10%
4%
Notes:
It is easier to rem mb r that potential growth equals ploughback times return on investment
(i.e. g = br) before going into further details.
The result is that the ompany can only grow by 4% in the long-term, which is the percentage of earnings not
paid out as dividends (i.e. the ploughback) times the return that is generated thereon.
Future rate of investment and the return from that investment

The fut re rate of investment and the return on that investment are the factors which generate future
dividends. The criterion is that a constant proportion of cash earnings per share is reinvested in projects which
pr duce an average rate of return.
The growth g can thus be expressed as:

g = br
where:
Annual earnings after tax and interest – Annual dividends
b =
Annual earnings after tax and interest
Annual earnings after tax and interest + Long-term interest (1 – tax)
r =
Book value of total capital employed
113
The book value of total capital employed may be calculated as the balance at the beginning of the financial
year, or the average assets employed over the year, that is, beginning asset value plus end of year asset value
divided by 2.
Subject to:
Retained earnings being the only source of investment capital.
A constant proportion of earnings being reinvested each year.
The reinvested earnings generating a constant annual rate of return.
Example:
The current year’s after-tax earnings of Company A are R250 000. The comp ny policy is to retain 60% of after-
tax earnings. Company tax rate is 55%.
Statement of financial position at beginning of year:

R’000
Ordinary share capital 3 000
Distributable reserves 1 800
4 800
10% debentures 1 600
6 400
Fixed assets 4 200
Net current assets 2 200
6 400
Required:
Calculate the company growth.
Solution:
250 000 – 100 000 (40% dividend payout)
b =
250 000
= 0,60
250 000 + 160 000 (1– 0,55)
r =
6 400 000
0,05
g = 0,60 × 0,05
= 0,03 or 3%
or Earnings before interest 715 555
Interest 160 000
Earnings after interest 555 555
Taxation 305 555
Earnings after tax 250 000
Dividends 100 000
Retention (60%) = b 150 000
114
715 555 × 0,45

r =
6 400 000
= 322 000
6 400 000
= 0,05
g = 0,60 × 0,05
= 0,03 or 3%
Note: The above example does not take into account the target D:E r tio of the company. It could be
argued that if the company is operating at the optimal D:E ratio, retention of R150 000 means that
the company can borrow at the target D:E ratio and thereby increase the growth rate above 3%.
However, the above method is an estimate done at book alue.
An unnecessary complication in the calculation will be caused by taking the target D:E ratio into
account.
4.13 Cost of capital for foreign investments

The discount rate used for foreign investments should reflect the risk and required rate of return of the
investment in the foreign country, and not necessarily th home country. It is therefore not appropriate to use
the home or domestic discount rate for discounting.
Investment appraisal is usually done in nominal (as opposed to real) terms, especially when including the
effects of inflation. The effect of inflation is therefore reflected in the discount rate used for the investment
decision. Due to the fact that discount rates differ from one country to the next, it would not be appropriate to
use the discount rate applicable in one country in another country.
The relationship between the inflation rate, real rate and nominal rate is as follows:
(1 + ir) × (1 + ii) – 1
= in
Where:
ir = real rate of return
ii = rate of inflation
in = nominal rate
Example:
A company wishes to make a real return of 5% per annum, and the rate of inflation is 10% per annum. The
required rate of return, in nominal terms, can be calculated as follows:
(1 + ir) × (1 + ii) – 1 = in, therefore:
1,05 × 1,1 – 1 = 0,155
15,5%
Disc unt rate for a foreign investment

Example:
A ume a South African company is considering a foreign investment in the United Kingdom, bearing the same
risk as its current operations.
The following applies:
Expected rate of inflation (United Kingdom): 2% per annum
Expected rate of inflation (South Africa): 8% per annum
Nominal discount rate applicable to South African operations: 20%
115
This discount rate can be converted as follows:

l Firstly, determine the real required rate of return
Rearranging the formula above:
(1 + in) / (1 + ii) – 1 = ir
1,2 / 1,08 – 1 = 11,11%
Using the same formula again, substituting the inflation rate:
(1 + ir) × (1 + ii) – 1 = in, therefore:
1,11 × 1,02 – 1 = 13,33%
Practice questions
Question 4–1: Optimal Capital Structure (Fundamental) 14 marks 21 minutes

Company A is currently an all-equity company with a shareholders’ required return of 20%. The company has
determined that if it takes on debt finance, the cost of equity will increase by a factor equal to x, where:
Total MV of debt
x = 10% ×
Total MV of company
The cost of debt after tax is equal to 10%, as long as the D:E ratio does not exceed 50:50. As more debt is taken
on beyond this ratio, the cost of debt increases by 6%.
The following capital structure options are being considered by the company:
100% equity : 0% debt
Required:
Determine the optimal capital structure for Company A, and the WACC.
Solution:
Total market value of company = Market value of debt plus market value of equity.
At 20% debt:
= 10% × 20/100
= 2%
ke= 20% + 2%
= 22%
At 40% debt:
= 10% × 40/100
= 4%
ke= 20% + 4%
= 24%
At 60% debt:
= 10% × 60/100
= 6%
ke= 20% + 6%
= 26%
116
Target structure:
Debt : Equity kd kd WACC
1 0% 100% 10% 20% 20%
2 20% 80% 10% 22% 19,6%
3 40% 60% 10% 24% 18,4%
4 60% 40% 16% 26% 20%
1 WACC 20% × 100% = 20%

2 WACC (10% × 20/100%) + (22% × 80/100) = 19,6%
3 WACC (10% × 40/100%) + (24% × 60/100) = 18,4%
4 WACC (16% × 60/100%) + (26% × 40/100) = 20%
Optimal capital structure is 60% equity:40% debt.
The target WACC is 18,4%.
Question 4–2: Arbitrage (Intermediate) 20 marks 30 minutes

The following information for two companies which trade in a Miller and Modigliani world is provided:
Company A Co pany B
ke 20% 18%
kd 12% –
Dividends 200 000 432 000
Interest after tax 150 000 –
Shares 1 000 1 000
Investor X holds 100 shares in Company A.
Required:
Calculate the WACC for Company A and Company B.
Determine if shareholder X is adequately compensated for financial risk.
Calculate the correct value for Company A shares, assuming that Company B shares are correctly valued.
Solution:
WACC for Company B is 18%
WACC for Company A
200 000
Value of equity =
0,20
= R1 000 000
150 000
Val e of debt =
0,12
= R1 250 000
WACC = (20% × 1/2,25) + (12% × 1,25/2,25)
= 8,89 + 6,67
= 15,56%
As the WACC for Company A is lower than the WACC for Company B, the k e for Company A is too low and
must increase such that the WACC will equal 18%.
117
2 Arbitrage
R
Sell 100 shares in Company A 100 000
Borrow 125 000 (See 1 above regarding the D:E ratio)
Invest in Company B 225 000
Dividend from Company B

(225 000 × 18%) 40 500
Interest 125 000 × 12% (15 000)
Return 25 500
Return on personal investment 25 500/100 000 = 25,5%
Investor X is therefore not adequately compensated for financial risk in Company A; he can receive a higher
return at the same level of financial risk by investing in Company B. He will therefore sell his shares in
Company A and invest the proceeds, together with borr wings equal to the D:E ratio of Company A in
Company B.
3 WACC for Company B = 18%

Therefore the WACC for Company A must also equal 18%.
Divid nd + Int r st
Company value =
WACC
200 000 + 150 000
Company A value =
0,18
= R1 944 444
Value of Co A R1 944 444
Value of debt (R1 250 000)
Value of Equity R 694 444
200 000
Equilibrium cost of equity =
694 444
= 28,8%
Question 4–3: Calculating WACC (Intermediate) 20 marks 30 minutes

The following information pertaining to Company Z is provided:
R’000
Ordina y sha e capital – 25 000 shares 1 000
Reserves 1 000
Preference shares – 1 000 shares 1 000
Debent res 1 000
4 000
Tax rate is 40%

Preference dividends R150 000
Debenture interest R200 000 (before tax)
ke 21%
growth 3%
Do R20 per share
Preference shares current market return is 16%
118
1
Debentures current market return is 18 /3%
Preference shareholders have the option of converting their shareholding to 8 500 ordinary shares in
three years’ time, or continuing with indefinite preference shares at 18% dividend per annum. Debentures
mature in three years’ time.
Required:
Determine the current WACC.
Solution:
Equity
ke = 21%
D1
Value =
ke – g
20 × 1,03
=
0,21 – 0,03
= 114,44
Total value = 25 000 × 114,44
= R2 861 000
Debentures
kd = 18 1/3 × 60%
= 11%
Interest after tax = 200 000 × 60%
= 120 000
120 000 120 000 1 120 000
Value + +
(1,11)
2 (1,11)
3
(1,11)
= 108 108 + 97 395 + 818 934
= R1 024 437
Preference shares
Option 1 – Ordinary shar s in Year 3
= 20(1 + 0,03)
4
D4 = 22,51
22,51
Value as at end of Year 3 =
0,21 – 0,03
= 125,056
Total share val e 125,056 × 8 500 = R1 062 980
Opti n 2 – Indefinite preference shares

kd = 16%
Dividend = 1 000 000 × 18%
= 180 000
Value as at end of Year 3 = 180 000

0,16
= R1 125 000
Preference shareholders will choose the new preference shares.
119
Present value of preference shares today
150 000 150 000 150 000 1 125 000

= + + +
(1,16)
2 (1,16)
3 (1,16)
3
(1,16)
= R1 057 623
Note: Assuming that the ordinary shares had the highest value, then the present value (PV) calculation
would be exactly the same as shown above, except that the terminal value would be R1 062 980. The
discount rate would still be 16%. However, the PV would then be c assified as ordinary shares with a
ke of 21%.
Current WACC
Value Cost WACC
Equity – ordinary shares 2 861 000 21% 12,15
Debt – preference shares 1 057 623 16% 3,42
Debt – debentures 1 024 437 11% 2,28
4 943 060 17,85%
The WACC for Company Z is 17,85%.
Question 4-4: Calculating WACC (Fundam ntal) 14 marks 21 minutes

Mr Pillay, the financial director of Shingalana Ltd, wants to determine the WACC of the company to help
management decide whether to replace an existing machine or not (a topic which is dealt with in more detail in
chapter 6 (The investment decision)).
EXTRACT FROM THE STATEMENT OF FINANCIAL POSITION OF SHINGALANA (PTY) LTD:

R’000
Ordinary issued shares 2 000
Retained income 700
Preference shares 1 000
Debentures 500
Bank overdraft 300
4 800
The company has 1 000 000 shares in issue with a market value of R3 500 000. The shareholders require a
rate of return of 24%.
The preferen e shares have no conversion rights, a market value of R1 166 667 and carry a dividend
payout ratio of 14%. Similar preference shares are currently trading at 12%.
The debentu es with a market value of R515 318 mature in ten years’ time and carry an interest rate of
16%. The cu ent long-term interest rate for similar loans is 15,27%.
The bank overdraft rate is 10%.
The tax rate is 28%.
Required:
A i t Mr Pillay to determine the WACC of Shingalana Ltd.
120
Solution:
Weighted
WACC: MV Weight Cost cost
R % %
Ordinary shares 3 500 000 67,54% 24% 16,21%
Preference shares (1) 1 166 667 22,51% 12% 2,70%
Debentures (2) 515 318 9,94% 11% 1,09%
5 181 985 100,00% 20,01%
Notes:
(1) Preference shares
MV:
= (R1 000 000 × 14%)/ 0,12
= R1 166 667
(2) Debentures
MV:
Annual interest after tax = R500 000 × 16% × 72% = R57 600
Current after tax interest rate = 15,27% × 72% = 11%
Interest at 11% annuity factor for 10 years = R57 600 × 5,8892 = 339 218
Redemption R500 000 R500 000 × 0,3522 = 176 100
515 318
The WACC of Shingalana Ltd is 20%
Question 4–5: Cost of preference shares and debentures (Fundamental) 10 marks

15 minutes
Ms Dulamo, managing partner in Nzinga & Dulamo Inc, wants to determine the cost of the preference shares
and debentures in Excalibur Holdings. Details are as follows:
The preference shares

Excalibur Holdings issued 10 000 100 preference shares without conversion rights at a discount of 5% when it
was incorporated six years ago. The dividends of 11% per annum are payable every six months in arrears.
Similar preference shares are currently trading at R96. The tax rate is 28%.
The debentures
The debentures in Excalibur Holdings carry an interest rate of 14% and mature in eight years’ time at a discount
of 6%. The current long-t rm int rest rate for a similar debenture is 12%.
Required:
Assist Ms Dulamo to determine the cost of the preference shares and debentures in Excalibur Holdings.
Solution:
C st f the preference shares

11
kp =
96
0,115 or 11,5%
The cost of preference shares is 11,5% per annum payable half-yearly.
2
= (1 + 0,0575) – 1
Therefore the effective annual cost
= 11,8%
The cost of the preference shares is 11,8%.
121
Cost of the debentures

kd = 12% × (1 – 28%)
The cost of debt is 8,6% after tax.
Note: The cost of debt is the current after-tax cost of debt, not the cost of debt at which the company
originally acquired the debt.
Question 4–6: Capital Structure (Fundamental) 40 marks 60 minutes

Zambezi (Pty) Ltd is a company which is financed entirely by ordinary shares.
Zambezi has the opportunity to invest in a major new investment project which h s the same business risk as
the existing operations of the company. The project requires an immedi te outl y of R1,4 million and is expected
to produce annual cash inflows of R210 000 indefinitely, the first receipt arising in one year’s time.
The company has distributed an annual ordinary dividend of R600 000 for many years, and is expected to
continue doing so. Two million shares are in issue and the current market price is R2,30 cum div. The next
annual dividend payment of R600 000 is due shortly.
The financial director of Zambezi believes that the value of the co pany could be increased by the introduction
of debt finance into the company’s capital structure. By introducing debt into the capital structure of the
company, he suggests that the new investment project should be accepted and financed by the issue of debt
capital and partly by a reduction in the current dividend.
The introduction of debt will cause the existing shar hold rs to r quire an increase of k on their existing return
to compensate them for the increased financial risk created by gearing.
The value of k is given by
Total MV of debt
k = 5% ×
Total MV of debt plus equity
The financial director also believes that the cost of debt depends on the ratio of the total market value of debt
to the total market value of equity capital, as follows:
Total MV of debt
Ratio =
Total MV of equity
Ratio Cost of debt
0,00 –
0,10 9,0%
0,20 9,5%
0,30 10,0%
0,40 11,0%
Required:
(a) Briefly explain what is meant by ‘the traditional capital structure theory’ (8 marks)
Calc late the optimal gearing ratio (i.e. the ratio of the total market value of debt to the total market val e
of eq ity) for Zambezi (Pty) Ltd, assuming that one of the ratios given in the question is adopted.
(14 marks)
Calculate h w much of the capital required for the new project should be raised by debt and how much by
reducti n in the current dividend, if Zambezi (Pty) Ltd is to achieve the optimal gearing ratio calculated
in (b) above. (7 marks)
(d) Ca culate the gain to ordinary shareholders if the new project is accepted and financed in the manner
ca culated in (c) above. (6 marks)
(e) Calculate the gain to the company. (5 marks)
Ignore taxation.
122
Solution:
The Traditional theory of capital structure assumes that an optimal capital structure exists and depends on
the level of gearing. The company cannot maximise shareholders’ wealth unless the optimal WACC is
achieved.
Because debt capital has a lower after-tax cost than equity capital as it is moderately increased, the
WACC of capital falls. The moderate increase in debt does not increase the overall risk of the firm and
therefore the company does not have to offer a higher return to shareholders to compensate for the
increased risk. As debt capital is further increased, the WACC will continue to fall, up to a certain point.
After the optimal level is reached, any further increase in debt capital wi increase the risk of the firm and
the shareholders will demand a higher yield.
ke (cost of equity)
Cost of
capital
k (WACC)
kd (cost of equity)
Gearing
A
Optimal WACC
30
(b) Existing cost of equity = 200
= 15%
Proportion of debt to equity Cost of equity Cost of debt
(i) 0,00 15% 0%
10
(ii) 0,10 15% + 5% × = 15,455% 9%
110
20
(iii) 0,20 15% + 5% × = 15,833% 9,5%
120
30
(iv) 0,30 15% + 5% × = 16,154% 10%
130
40
(v) 0,40 15% + 5% × = 16,429% 11%
140
WACC
15%
100 10
(ii) 15,455 × + 9 × = 14,868%
110 110
100 20
(iii) 15,833 × + 9,5 × = 14,777%
120 120
100 30
(iv) 16,154 × + 10 × = 14,734%
130 130
100 40
(v) 16,429 × + 11 × = 14,878%
140 140
The optimum gearing proportion is 0,30.
123
(c) Current MV R4 000 000

Funds required R1 400 000
Debt and equity R5 400 000
D:E ratio = 0,30 or debt = 30:equity = 100

30
Debt = 5 400 000 × = 1 246 153,8
130
Equity = 4 153 846,2
The company must therefore raise R1 250 000 debt and reduce the dividend by R150 000 (rounded to the
nearest R50 000).
New dividend to shareholders

R(600 000 + 210 000) – 10% × R1 250 000 = R685 000
R R
MV of equity at 16,154% 4 240 436
Less: Dividend foregone 150 000
Previous MV 4 000 000
4 150 000
Gain to shareholders R90 436
(e) Gain to the company

Company WACC = 14,734%
NPV of investment
Year 0 – 1 400 000
Cash flow 210 000/0,14734 1 425 275
25 275
Question 4–7: Miller & Modigliani (Intermediate) 35 marks 52 minutes

Elvis is a citizen of Utopia, a country where personal (and company taxation) is set at 10% of taxable income.
There are no transaction costs on share purchases or sales and all investors are rational.
Individuals and companies can borrow at the same rate and both are allowed to claim loan interest as a
deduction against taxable income, provided the loan is used to finance equity investments or capital
expenditure.
In 20X0, Elvis pur hased 1 000 shares in Graceland Ltd at a price of R100 per share. Over the past four years, his
dividend income f om this investment has been growing at a rate of 2% per annum.
The following is a s mmary of Graceland Ltd’s statement of financial position as at 31 May 20X4:
R’000
Ordinary shares (10 000 issued) 1 000
L ng-term loan (indefinite) 9% 700
Capital employed 1 700
Earnings per share R30

Dividend per share R24,706
The required rate of return of Graceland’s shareholders is 22% per annum and long-term loans are available at
10% per annum.
Elvis has been advised by his broker to sell his shares in Graceland Ltd and invest in Y’Ono Ltd, a company
identical to Graceland Ltd, but with no debt in its capital structure. Y’Ono Ltd also has 10 000 shares in issue,
which are currently trading at R100 per share. The required rate of return of Y’Ono shareholders is 20% per
124
annum and dividend income has been growing at a rate of 2% per annum. The latest dividend at 31 May 20X4
was R17,65 per share.
Elvis is convinced that his broker has been giving him bad information as he is currently receiving a return of
22% from his investment in Graceland Ltd which is 2% higher than Y’Ono Ltd, and has approached an
accountant for advice. The accountant’s investigations of market prices and yields on the Utopia stock
exchange have revealed that Y’Ono Ltd shares are correctly priced in terms of its business and financial risk.
Required:
Calculate whether Elvis should sell all his shares in Graceland Ltd and invest the proceeds in Y’Ono Ltd in
order to improve his return and yet retain his current risk profile. The ca cu ations must compare the
expected returns in the two companies as at 31 May 20X5. (14 marks)
Calculate the equilibrium market value of Graceland Ltd shares th t would equ te to its current degree of
financial risk. (5 marks)
Discuss whether companies operating in Utopia should use debt as a form of finance and the advantages
to them (if any). (10 marks)
What investment advice would an accountant give to Elvis if pers nal tax, ability to borrow, or debt rates
were different for individuals as compared to companies? (6 marks)
Solution:
Equity market value
Do = 24,706
g = 2%
ke = 22%
D1
MV =
ke – g
24,706 × 1,02
=
0,22 – 0,02
= 126
10 000 shares × 126 = R1 260 000
Debt market value

After-tax inter st R700 000 × (9% × 90%) = R56 700
Current mark t value R56 700  (10% × 90%) = R630 000
Elvis will sell 1 000 shares for R126 per share and borrow an amount in order to have the same financial
risk st uctu e as that of Graceland Ltd.
Sale R126 000
Borrow R63 000
R189 000  R100
= 1 890 shares
Dividend at D1
R17,65 × 1,02 = R18,00
Total dividend R18,00 × 1 890 = R34 020
Interest after tax(R63 000 × 10% × 90%)= (R5 670)
Net return R28 350
125
Return
D1
MV =
ke – g
ke = D1/MV + g
(R28 350  R126 000) + g
= 0,225 + 0,02
= 0,245 or 24,5%
Comparative return in Graceland Ltd

1 000 shares × (24,706 × 1,02) = R25 200
Conclusion:
Elvis should sell his shares in Graceland and purchase shares in Y’Ono.
Shareholders in Graceland Ltd will sell their shares and invest in Y’Ono Ltd as the return is higher in Y’Ono
Ltd.
As the market price of Y’Ono shares is correctly valued, one would expect the value of Graceland shares
to decrease until there are no arbitrage benefits from switching to Y’Ono shares.
Ko Graceland = ko Y’Ono = 20%
Dividend + Debt interest
From Vo =
WACC
247 060 + 56 700
We get Vo =
0,20
Vo = 1 518 800
Vd = 630 000 [ 700 000 × 9%  10% ]
∴ Ve = 888 800 and v = R88,88 per share
ke = 247 060 / 888 800 = 27,8%
∴ MV = 88,88 per share
More correctly: (ke – 0,02) = 252 000 / 888 800
ke = 0,30 or 30%
Companies operating in Utopia will not be able to decrease their WACC as individual investors are able to
borrow at the same rate as companies and so create their own portfolios with gearing advantages.
Utopia is repr s ntative of a Miller and Modigliani world where –
all investo s have the same expectations about the future;
capital ma kets are perfect;
all relevant information is freely available;
there are no transaction costs;
there is no taxation or no distinction between company and personal tax;
firms can be grouped into business risk or operating risk classes;
there is no limited liability; and
individuals and firms can borrow at the same rate and personal gearing is assumed to be a perfect
substitute for company gearing.
Miller and Modigliani argued that the WACC is independent of the capital structure; hence the value of
the firm is independent of the proportion of debt to total capitalisation. As debt financing increases, the
initial effect would be to lower the WACC, thus increasing the value of the firm. The model, however,
argues that increased gearing results in shareholders requiring an increased return to balance the
126
increased risk. The change in the required equity return will just offset any possible saving or loss on the
interest change. Therefore, as gearing increases, the WACC will remain constant and so no optimal level
of capital gearing exists.
The equilibrium factor in the Miller and Modigliani theory is the arbitrage process. The arbitrage process
takes place where two firms of identical income and risk exist and where one of the firms has a
temporarily higher value, due to the different D:E ratios of the two firms. The investors would arbitrage in
order to equalise the values of the companies.
If Elvis was not able to borrow on the same basis or at the same rate as companies in Utopia, then he
would not be able to improve his return through arbitrage.
Graceland would borrow funds in order to lower the WACC and the return to shareholders would be
superior to that offered by Y’Ono Ltd. The traditional view of capit l structure would apply.
The traditional, or generally believed theory of capital structure, assumes that an optimal capital
structure exists and depends on the level of gearing. The company cannot maximise shareholders’ wealth
unless the optimal WACC is achieved.
Because debt capital has a lower after-tax cost than equity capital as it is moderately increased, the
WACC falls.
The moderate increase in debt does not increase the overall risk of the firm; therefore the company does
not have to offer a higher return to shareholders to co pensate for the increased risk. As debt capital is
further increased, the WACC will continue to fall, up to a certain point. After this optimal level is reached,
any further increase in debt will increase the risk of the firm and the shareholders will demand a higher
yield.
The Traditional theory concludes that there is an optimal or target capital structure for every company.
The optimal D:E ratio is determined at the lowest average cost of capital. In practice, it is difficult for a
company to determine the target D:E ratio, but it will be guided by the capital structure of similar quoted
companies.
Question 4–8 (Fundamental & Intermediate) 30 marks 45 minutes

Rosina Ltd is at the present time an all- equity-financed company with a cost of capital of 12,5%. The manager,
Basilio, is considering whether it might be desirable to issue some debt capital. Debt is currently yielding 5% per
annum (p.a.) and may be assumed to be risk-free for all firms which issue it (or may wish to issue it). To this
end, Basilio has collected data on four other companies, each of which falls into one of two industrial sectors (A
and B). The data that he has collected is summarised below:
Industrial Anticipated growth of earnings/ Ex div. market Dividend
Company :E ratio
sector dividends price per share per share
X A 0 0 R1 10c
Y A 1:1 0 R2 30c
T B 0 0 R2 30c
U B 1:4 0 R2 35c
Required:
(a) Explain what the terms ‘business risk’ and ‘financial risk’ mean to an investor. (5 marks)
Describe the f ndamental elements of the Traditional theory and the Miller and Modigliani theory.
(5 marks)
Advise Basilio on the capital structure policy which he should follow, explaining and justifying the figures.
(15 marks)
Indicate how that advice might be modified if corporate taxes were introduced into the analysis.
(5 marks)
Note: Ignore taxation for requirement (c).
Solution:
Operating (or business) risk comes from the uncertainty attached to the many factors which influence the
ability of the company to generate earnings (e.g. the state of world trade, the national economy, the
127
prosperity of the company’s business sector, consumer tastes, technology changes, etc.). A company’s
future annual earnings may be regarded as a probability distribution. The wider the dispersion of the
possible earnings the higher the operating risks. The following diagrams illustrate two companies with the
same average (expected) earnings but different levels of operating risk.
Probability
Possible earnings
Probability
Possible earnings
Expected earnings
Financial risk: The variability of equity earnings will be relatively higher than the variability of earnings
before interest for a company which has debt in its capital structure. This is because the debt interest
must be paid before any dividend is paid to shareholders.
Theory of capital structure

Traditional theory
The ‘traditional view’ may be briefly described and illustrated as follows:
As debt is introduced into the capital structure, the WACC is reduced. The shareholders require increased
compensation for financial risk, but this is relatively small at low gearing levels. Eventually, however, their
financial risk premium is such that it outweighs the effect of further cheap debt. There is an optional
capital structure, at point A on the diagram:
ke (cost of equity)
Cost of
capital
ko (WACC)
kd (cost of debt)
Gearing
A
The company should therefore aim for the point where WACC is at a minimum.
128
Miller and Modigliani theory

The Miller and Modigliani view (ignoring taxation) predicts that the two effects of debt will exactly
balance out, so that WACC remains equal to the cost of equity in an ungeared firm at all levels of gearing.
There is therefore no optimal level of gearing. Unlike the traditional view, this is a normative theory which
follows directly from a set of assumptions, and is explained in the following diagram.
ke (cost of equity)
Cost of
capital
ko (WACC)
kd (cost of debt)
Gearing
The assumptions made by Miller and Modigliani can be bri fly stated as follows –
all investors make the same predictions about the possible earnings of firms in terms of expected
value and dispersion about that value;
there are no impediments to trading in the capital market, that is, investors behave rationally;
there are no transaction costs, and investors and firms can borrow and lend at the same rate;
(iv) there is no difference between corporate and personal borrowing in terms of risk (e.g. no limited
liability advantage for companies); and
no company taxes exist, or there is no differentiation between company and personal tax.
Advice to Basilio
It is generally assumed that the higher the risk attached to an investor’s earnings, the higher the average
return he will expect as compensation will be.
An equity investor will therefore expect a higher return if the operating risk of this company is higher, and
a higher return in a g ar d company than in an ungeared company.
Comparing Rosina with the two other all-equity companies, it can be seen that Rosina is midway in terms
of operating risk when omparing industrial sector A to industrial sector B.
Company Cost of equity

X (sector A) 10%
Rosina 12,5%
T 15%
If c mpanies in the same industrial sector may be assumed to be subject to the same level of operating
risk, the effect of gearing on the cost of equity may be seen.
Indu trial Sector A D:E ratio Cost of equity
0 10%
1:1 15%
Industrial Sector B D:E ratio Cost of equity
0 15%
1:4 17,5%
129
Computing the WACC

Cost of equity
Company D:E ratio Cost of debt WACC
(div per share – ex div price)
Industrial Sector A
X 10% 0 N/A 10%
Y 15% 1:1 5% 10%
WACC = (0,5% × 15%) + (0,5 × 5%)
Industrial Sector B
T 15% 0 N/A 15%
U 17,5% 1:4 5% 15%
WACC = (1/5 × 5%) + (4/5 × 17,5%)
Conclusion:
WACC differs according to industrial sector (because of perating risk differences) but companies in the
same industrial sector appear to have the same WACC.
On the basis of these figures, there is no advantage or disadvantage to debt financing. Basilio may follow
any capital structure policy he likes, with no effect on the value of the firm.
Introduction of company taxes into the analysis

Miller and Modigliani originally ignored company tax s in their analysis. The effect of introducing taxation
is as follows:
There is no effect on optimal capital structure if taxation is introduced, but debt interest is not an
allowable expense against company tax.
If debt interest is tax deductible and the company is earning sufficient taxable profits to take full
advantage of the tax relief, then there is no way in which the arbitrage process can compensate for
the fact that a company can obtain tax relief by borrowing whereas an individual cannot. It now
makes sense for a company to borrow as much as possible. Basilio should aim for a very high level
of gearing because WACC falls as gearing increases up to the optimum D:E ratio.
If the company is prevented from taking full advantage of tax relief on debt interest, for instance
because it is not earning sufficient profits or because it has very high capital allowances, then the
advantage of gearing is reduced, and completely removed if no effective tax relief is possible. This
last extreme case, which is fairly common in practice, means that the WACC would behave as in the
original Miller and Modigliani theory.
If individuals and firms can both obtain tax relief on borrowings, then the advice depends on the
differential tax rat s. If both are subject to the same tax rate, then there is no optimal capital stru
ture. If the ompany tax rate is higher than the personal tax rate, the company should borrow as mu
h as possible, but if the reverse is the case it should remain ungeared.
Question 4–9 (Advanced) 40 marks 60 minutes

The Board of Directors of Lekker Fruit Ltd requires R12 million for expansion of existing business activities and
is discussing whether to finance the project through debt financing.
A summary f Lekker Fruit’s current statement of financial position as at 30 September 20X4 shows:
Capital employed R’000
R10 ordinary shares 12 000
Share premium 1 000
Non-distributable reserves 3 000
Shareholder’s interest 18 000
130
R’000
10% preference shares (R5 issue price) 4 000
16% debentures (indefinite) 14 000
Long-term loan 20 000
56 000
Employment of capital
Fixed assets 42 000
56 000
Statements of Comprehensive Income 20X2 20X3 20X4

R’000 R’000 R’000
Operating income 11 412 11 858 12 340
Debenture interest 2 240 2 240 2 240
Long-term loan interest 3 600 3 600 3 600
Income before taxation 5 572 6 018 6 500
Dividend per share R2,14 R2,31 R2,50

Dividend yield 0,11 0,11 0,111111
The following information is also available:

Long-term debentures similar to those issued by L kk r Fruit Ltd are currently yielding a return of 22%.
The 10% preference shares carry an option of conversion into ordinary shares on 30 September 20X7. The
offer is on the basis of one ordinary share for every four preference shares held by the preferential
shareholders. The preference shareholders have indicated that they are likely to take up the option.
Preference shares are currently trading at 18%.
The long-term loan matures on 30 September 20X8. Long-term loans are currently being offered at a yield
to maturity of 20%.
The finance required for expansion will be raised through a long-term loan at the current ruling interest
rate.
The current company tax rate is 40%.
The financial director of Lekker Fruit believes that the market price of the existing ordinary shares and the cost
of existing debt finance will not change as a result of the proposed issue of a long-term loan.
Required:
(a) Evaluate the ff ct on the current WACC of Lekker Fruit Ltd if the company raises the required finance
through a long-t rm loan and there is no change in the current market value of all securities.
All relevant al ulations must be shown. (27 marks)
Discuss why the finan ial director of Lekker Fruit Ltd might be wrong in his belief that the market price of
the company’s sha es and securities will not change, and conclude what changes might occur. (13 marks)
Solution:
Calculation of current WACC
Equity valuation
Dividend yield = 0,1111
Market value of shares
DIV
DY =
MV
2,50
0,111111 =
MV
MV = R22,50 × 1 200 000 shares = R27 000 000
131
Shareholders’ required return

Growth
20X2 – 20X3 20X3 – 20X4
6018 – 5572 6500 – 6018
5572 6018
= 8% = 8%
Dividend
Do = R2,50
D1 = R2,50 × 1,08 = R2,70
D1
M =
ke – g
2,70
22,50 =
ke – 0,08
22,50 ke – 1,8 = 2,70
ke = 20%
Preference share valuation

Step 1: Share value at 30 September 20X7
Dividend at 30 September 20X8 is equal to 2,50 × (1 + 0,08)

4
= R3,4012
ke = 20% g = 8%
R3,4012
Share value at 20X7 = = R28,344
(0,20 – 0,08)
Share exchange 4:1
Preference shares 4 000 000  5 = 800 000

800 000  4 = 200 000 ordinary shares
Valuation at 20X4 200 000 × R28,344 = R5 668 800
Step 2: Preference share valuation at 30 September 20X4 will equal

400 000 400 000 400 000 5 668 800
+ + +
(1 + 0,18)
2 (1 + 0,18)
3 3
(1 + 0,18)
(1 + 0,18)
= 338 983 + 287 274 + 243 452 + 3 450 207 = 4 319 916
Debentu e valuation: 16% indefinite debentures

Ann al interest 14 000 000 × 16% × 60% = 1 344 000
C rrent interest rate 22% before tax
1 344 000
Valuati n = 10 181 818
0,22 × 60%
Long-term loan valuation

Book value R20 000 000
Annual interest 3 600 000
Current interest rate 3 600 000 / 20 000 000 = 18%
Market rate: 20% before tax
After-tax interest 3 600 000 × 60% = R2 160 000
After-tax required return 20% × 60% = 12%
132
2 160 000 2 160 000 2 160 000 22 160 000

PV = + + +
(1,12)
2 (1,12)
3 4
(1,12)
(1,12)
= 1 928 571 + 1 721 939 + 1 537 445 + 14 083 080
R19 271 035
Current WACC MV Required WACC
R’000 return
Equity – Ordinary shares 27 000 0,20
– Preference shares 4 320 0,20
31 320 0,20 0,103
Debt – Debentures 10 182 0,132 0,022

– Long-term loans 19 271 0,12 0,038
29 453 0,163
Current WACC is 16,3%

New WACC MV Required WACC
R’000 return
Equity 31 320 0,20 0,086
Debentures 10 182 0,132 0,018
Long-term loans 31 271 0,12 0,052
72 773 0,156
New WACC is 15,6%

If Lekker Fruit’s financial director believes that the price of the firm’s securities will not change, he is
inferring that, irrespective of the level of gearing, the cost of debt and equity will remain the same. This
would imply that by continually gearing up, and substituting cheap debt capital for expensive equity
capital, a continual decrease in the WACC may be obtained. This situation seems unlikely, to say the least.
All the major theories of capital structure recognise that the cost of equity finance will increase (with a
resultant change in equity value) as financial risk is increased. The main subject for debate is the size of
the change.
In a world without taxation, Miller and Modigliani argue that as gearing increases, so the cost of equity
rises; the cost of debt remains constant (except at extreme levels of gearing) and the overall cost of
capital remains constant. The overall value of the company remains unchanged but the value of equity
will fall, up to a point.
In a world with corporate taxes, Miller and Modigliani argue that the cost of equity will rise, and the cost
of debt will r main constant, but the overall cost of capital will fall due to the benefit of the tax shield on
debt interest paym nts. Once again, the market value of equity will fall.
The Traditional theory argues that the cost of equity (and eventually debt) will rise as gearing increases,
which results in either a reduction or an increase in the overall cost of capital (depending on the level of
gearing of the company), and a change in the value of equity (and ultimately debt), for example the use of
more debt will inc ease the risk to shareholders and lead to a fall in share price, but the expected return
on eq ity normally increases with the use of debt, which tends to increase share price. The overall effect
co ld be either a rise or fall in share price.
When bankruptcy costs, agency costs and other costs of high gearing are also considered, the likelihood f
a change in the value of equity and debt becomes even greater as gearing increases.
The financial director is, therefore, likely to be wrong in his belief that the market price of the company’s
exi ting shares debentures and long-term loans will not change.
The value of existing equity is as likely to drop sharply as the level of debt is to rise sharply with new debt
being introduced. The existing D:E ratio is 29:31, while the new ratio will be 41:31 at current values. The
most likely scenario is that the shareholders’ required return will increase substantially as financial risk is
increased.
It is also probable that the issuers of debt will see the increased debt as giving them more risk and will
therefore require a higher return.
133

Wishbone (Pty) Ltd is a holding company with investments in various industries. Its directors are currently
considering several projects which will increase the range of the business activities undertaken by Wishbone
(Pty) Ltd, the holding company. The directors would like to use discounted cash-flow techniques in their
evaluation of these projects, but as yet no WACC has been calculated.
Wishbone (Pty) Ltd has an authorised share capital of 10 million 25 cent ordinary shares, of which 8 million
have been issued. The current ex div market price per ordinary share is R1,10; a dividend of R0,10 per share
having been paid recently. The company’s project analyst has established the following information:
The current long-term gilt yield is 12% per annum.
Wishbone’s historic beta has been calculated at 1,5.
The Johannesburg Stock Exchange market required return is 16%.
Extracts from the latest statements of financial positions for both the group and the holding company are given
below:
Wishbone (Pty) Ltd Wishbone
consolidated (Pty) Ltd
state ents of
financial position
R’000 R’000
Issued share capital 3 000 3 000
Share premium 500 500
Reserves 7 400 900
Shareholders’ funds 10 900 4 400
Wishbone (Pty) Ltd Wishbone

consolidated (Pty) Ltd
statements of
financial position
R’000 R’000
4% irredeemable preference shares 2 800 1 400
10% irredeemable debentures 3 600 1 500
12% bank loans 3 200 2 000
Overdraft 800 50
Total liabilities 10 400 4 950
All debt interest is payable annually and all the current year’s payments will be made shortly. The current
market yields on pr f r nce shar s and debentures are 8% and 14% respectively.
The 12% bank loans are not traded on the open market, but the project analyst estimates that their effective
pre-tax cost is 2% above overdraft rate (which is currently 14%), and they are repayable in five years. The
effective company tax ate is 50%.
Required:
(a) Calc late the effective after-tax WACC as required by the directors. (20 marks)
Outline the fundamental assumptions that are made whenever the WACC of a company
is used as the discount rate to evaluate investments in new projects. (9 marks)
(c) Di cu what is meant by a ‘target WACC’ and how a company should decide on
how to finance an investment project that has a positive NPV. (11 marks)
Solution:
The valuation of WACC cannot be done on the consolidated statements of financial position figures as each
company in the group will have its own financial structure and business risk, which will be different to every
other company and different to the holding company’s average.
134
(i) Cost of equity capital

ke = Rf + β (Rm – Rf)
12 + 1,5 (16 – 12)
18%
Equity value:
8 000 000 × R1,10 = R8 800 000
(ii) Preference shares required return 8%
4
MV: 1 400 000 ×
8
R700 000
Debentures required return 7% after tax
5
MV: 1 500 000 ×
7
R1 071 428,50
Loans required return 8% after tax
Market value
Interest after tax 120 000
5 year PV factor at 8% = 3,991
(Year 1 – 0,926; Year 2 – 0,857; Year 3 – 0,794; Year 4 – 0,735; Year 5 – 0,681)
120 000 × 3,991 = R478 920
Redemption value R2 000 000 × 0,681 = 1 362 000
Market value = R478 920 + R1 362 000 = R1 840 920
Basis for weighting
V Weighting Required return WACC

Ordinary shares 8 800 000 71% 18% 12,78
Preference shares 700 000 5,5 8 0,44
Debentures 1 071 428 8,5 7 0,60
Loans 1 840 920 15 8 1,20
12 412 348 100 15,02
The effective after-tax WACC is 15%.
(i) Only und r conditions of capital market perfection will the costs of capital calculated represent the true
opportunity costs of funds used.
The proje t must be small relative to the size of the company (i.e. it represents a marginal
investment). This is because the costs of capital calculated refer to the minimum required return of
ma ginal investors, and therefore are only appropriate for the evaluation of marginal changes in the
company’s total investment.
Using the existing market value mix of funds as weights in the calculation assumes that in the long-
term f nds will be raised in this proportion (i.e. in the long-term the capital structure of the
c mpany will remain unchanged). This implies that the current gearing ratio is regarded as optimal.
In the short- or medium-term, funds will not be raised in the exact proportion of existing market
values. Hence no attempt is made to match a project with a particular issue of funds. All funds are
regarded as forming a pool out of which all projects are financed (the ‘pool’ concept).
The project is of average risk for the firm and will cause no change in the risk of the firm as
perceived by investors. This is because the cost of capital estimate is only valid for the existing level
of risk in the firm.
The ‘target WACC’ implies that a company will have an optimum D:E ratio that is derived from a pool of
funds. The target WACC is based on long-term expectations, both economic and political. It is further
assumed that a company will attempt to move towards the optimum D:E ratio when new funds are
raised.
135
Where a company has a positive net present value (NPV) and the company wishes to invest in the project,
management must consider the present D:E ratio in relation to the optimum or target D:E ratio. Where a
company has too much debt at current market value of debt and equity, the company will have to use
equity funding.
Equity debt increases both the company risk and the shareholders’ required return.

Grove Ltd is considering rapid expansion in a range of differing activities in the near future.
The directors have been advised that discounted cash flow techniques provide the most acceptable appraisal
methods for their needs.
Grove Ltd has the following statement of financial position taken from its dr ft ccounts:
R’000
Authorised share capital 15 000 000 at 50c 7 500
Issued share capital 10 000 000 at 50c 5 000
Share premium 2 340
Revaluation reserve 1 610
Other reserves 4 615
Shareholders’ funds 13 565
12% irredeemable debentures 2 500

10% redeemable debentures 2 000
14% long-term loan 3 000
7 500
Grove Ltd’s shares have a current market value of R1,56 cum div. A dividend of 18c is due to be paid shortly. All
debt interest is paid annually in arrears and has just been paid. The company has been growing at a rate of 5%.
This growth should be maintained in the foreseeable future.
The 12% debentures have a market value of R80,00 per cent. The 10% debentures are to be redeemed in eight
years’ time at R95 per R100 nominal. The company has a current market required return of 16,67% before tax.
The 14% loan is not traded on the open market, but its effective pre-tax cost has been estimated at 18%. It is
redeemable at par in three years’ time.
The company tax rate for Grove Ltd is 40%.
Required:
(a) Calculate the after-tax WACC of Grove Ltd. (28 marks)
Outline the fundam ntal assumptions that are made whenever the WACC is used as a discount rate in NPV
calculations. (12 marks)
Solution:
Equity value: 10 000 000 × (R1,56 – 0,18)
R13 800 000
Shareh lders’ required return:
D1
Value =
ke – g
0,18 (1 + 0,05)
1,38 =
ke – 0,05
0,189
ke = + 0,05
1,38
ke = 18,7%
136
12% irredeemable debentures:

Interest (1 – T)
kd =
Ex-interest market value
12 × (1 – 0,40)
kd =
80
= 9% after tax
Market value: R80/100 × 2,5 million = R2 000 000
10% redeemable debentures
kd = 16,67% × 60% = 10%
Market value = PV of interest + PV at redemption
Interest after tax = R6 (per R100 nominal)
Redemption value = R95
Years 1–8 = R6 × 5,335 = 32,01
Year 8 = R95 × 0,467 = 44,365
R76,375
Market value: R76,375 × R2 million = R1 527 500

14% loan:
kd = 18% × 60% = 10,8%
Annual interest after tax: R8,40 (per R100 nominal)
Redemption value R100
Years 1–3 = R8,40 × 2,4523 = R20,60
Year 3 = R100 × 0,7352 = R73,52
R94,12
Market value: R94,12/100 × 3 million = R2 823 600
WACC
MV % weight Required return WACC
Equity 13 800 000 68% 18,7 12,716
12% debentures 2 000 000 10% 9 0,9
10% debentures 1 527 500 8% 10 0,8
14% loan 2 823 600 14% 10,8 1,512
20 151 100 15,928
WACC = 16%.
Assumptions underlying the use of WACC as a discount rate:
It can be shown that, in a perfect capital market in which the market value of an ordinary share is the
discounted p esent value of the future dividend stream, acceptance of a project which has a positive NPV
when disco nted at the WACC will result in the share price increasing by the amount of the NPV. It is this
relationship between the NPV and the market value which is the basis of the rationale for using the WACC
in c njunction with the NPV rule. However, the use of the WACC in this way depends upon a number of
assumpti ns as follows:
The objective of the firm is to maximise the current market value of the ordinary shares. If the firm
is pursuing some other objective, for example sales maximisation subject to a profit constraint, ome
other discount rate may be more appropriate.
The market is perfect and the share price is the discounted present value of the dividend stream.
Market imperfections may undermine the relationship between NPV and the market value, and cast
doubt upon the usefulness of WACC as a discount rate. Furthermore, if the market values shares in
some other way (earnings multiplied by a PE ratio) then the link will also be broken.
The current capital structure is to be maintained and the existing capital structure is optimal.
137
The risk of projects to be evaluated is the same as the average risk of the company as a whole. The
discount rate has two components, namely the risk-free rate and a premium for risk. The WACC
incorporates a risk premium which is appropriate to the risk of the company as a whole, that is, the
average risk of all its existing assets and projects. Where a project is to be considered which has a
different level of risk, the WACC is not the appropriate rate.
Thus for Grove Ltd, where expansion is being considered across a range of differing activities, the WACC is
unlikely to be appropriate, particularly if the investments are large relative to the size of the company.
Note: It would be inappropriate here to launch into a deep analysis of the Capital Asset Pricing Model
(CAPM) as a means of obtaining a risk adjusted discount rate for project appraisal purposes. It is not
asked for by the question and a brief mention is all that should be made.

Jasmond (Pty) Ltd is a holding company owning shares in various subsidiary companies. Its directors are
currently considering several projects which will increase the range of the business activities undertaken by
Jasmond (Pty) Ltd and its subsidiaries. The directors would like to use disc unted cash-flow techniques in their
evaluation of these projects, but as yet no WACC has been calculated.
Jasmond (Pty) Ltd has an authorised share capital of 10 illion 25 cent ordinary shares, of which 8 million have
been issued. The current ex div market price per ordinary share is R1,10, with a dividend of R0,10 per share
having been paid recently. The company’s Project Analyst has calculated that 18% is the most appropriate
after-tax cost of equity capital. Extracts from the latest state ents of financial position for both the group and
the holding company are given below:
Jasmond (Pty) Ltd Jasmond (Pty) Ltd
and subsidiaries
’000 R’000
Issued share capital 2 000 2 000
Share premium 1 960 1 960
Reserves 3 745 708
Shareholders’ fund 7 705 4 668
Minority interests 895 –
3% irredeemable debentures 1 400 –

9% redeemable debentures 1 500 1 500
6% loan stock 2 000 2 000
Bank loans 1 540 600
Total long-term liabilities 6 440 4 100
All debt interest is payable annually and all the current year’s payments will be made shortly. The current cum
interest market price for R100 nominal value 3% debentures is R31,60, while the 9% debentures have a value of
R103,26. Both the 9% debentures and the 6% loan are redeemable at par in ten years’ time. The 6% loan is not
traded on the open market, but the analyst estimates that its effective pre- tax cost is 10% per annum. The
bank loans bear inte est at 2% above bank rate (which is currently 11%) and are repayable in six years. Jasmond
(Pty) Ltd’s effective company tax rate is 46%.
Required:
Calculate the effective after-tax WACC of Jasmond (Pty) Ltd and its subsidiaries as required by the
direct rs. [Fundamental] (20 marks)
(b) Di cu the problems that are encountered in the estimation of a company’s WACC when the following
are u ed as sources of long-term finance: [Intermediate]
(i) Bank overdraft.
(ii) Convertible long–term loans. (10 marks)
Outline the fundamental assumptions that are made whenever the WACC of a company is used as the
discount rate in NPV calculations. [Fundamental] (10 marks)
Note: Ignore personal taxation.
138
Solution:
Effective after-tax WACC
Capital MV Proportion Cost Proportion × cost
R % %
Ordinary shares 8 800 000 0,6364 18,00 11,46
3% debentures 400 400 0,0290 5,66 0,16
9% debentures 1 413 900 0,1023 5,72 0,59
6% loan 1 672 800 0,1210 5,40 0,65
Bank loans 1 540 000 0,1113 7,02 0,78
R13 827 100 1,0000 13,64%
The WACC is approximately 14%.
Workings
1 3% irredeemable debentures
Ex interest MV per R100 nominal = R(31,60 – 3) = R28,60
Total market value = R1,4m × 0,2860 = R400 400
3(1 – 0,46)
Net of tax cost =
28,60
= 5,66% or 3 / 28,60
= 0,1049 × 54%
= 5,66%
2 9% redeemable debentures
Ex interest MV per R100 nominal = R(103,26 – 9) = R94,26
Total market value = 1,5m × 0,9426 = R1 413 900
Annual net of tax interest = 9(1 – 0,46) = R4,86
Time Cash 5% PV 10% factors PV

flow factors
R R R
0 (94,26) 1,00 (94,26) 1,00 (94,26)
1 – 10 4,86 7,72 37,52 6,14 29,84
10 100,00 0,61 61,00 0,39 39,00
4,26 25,42
4,26
By interpolation, net of tax cost = 5% + 4,26 + 25,42 × (10 – 5)% = 5,72%
(Interpolation gives only an approximate cost)
3 6% l an
After-tax interest R6 × 54% = R3,24
Pre ent value of future cash flows discounted at after tax cost
10% × 0,54 = 5,4%
1–10 yrs R3,24 × PV annuity at 5,4% of 7,5740 = R24,54
Year 10 R100 × PV at 5,4% of 0,5910 = R59,10
R83,64 per R100
Total market value = R2m × 0,8364 = R1 672 800
139
4 Bank loans
Cost = (11 + 2)% gross of tax, that is, 13% × (1 – 0,46) net of tax = 7,02%
Note: The correct WACC is the WACC for each company in a group of companies and not an overall
WACC as calculated above, as each company will have a different business and financial risk
which will lead to a different but appropriate WACC.
Assumptions made
1 The effective rate of company tax applies to the whole Jasmond group, not just the holding company.
2 The bank loans and 3% irredeemable debentures are liabilities of who y-owned subsidiaries.
Problems of estimation
Bank overdraft
The rate of interest payable on a bank overdraft will fluctuate with general changes in interest rates.
For example, it is likely to be granted at a given percentage rate abo e the bank’s base rate. Thus,
unlike a fixed interest loan, if interest rates fluctuate while the funds are being used, the interest
payments vary. It is necessary to estimate these p ssible interest rate changes in computing the
overdraft rate to be included in the WACC.
Overdrafts are normally regarded as a short-term source of funds because (technically) they are
repayable on demand. However, the reality for any s aller firms is that the overdraft is a major long-
term source of funds. Such a firm should atte pt to identify its ‘core’ overdraft (i.e. the amount
which is expected to be outstanding for many years) separately from the variable portion which
results from fluctuations in working capital. Only the core overdraft should be included in the WACC
calculation.
Convertible long-term loan
The holder of a convertible loan receives fixed interest for a number of years, whereafter he may
convert his holding to ordinary shares at a predetermined conversion price over a range of possible
dates. Alternatively, he may prefer redemption of the loan at a fixed price on the due date.
The problems of estimation are uncertainties in the time of conversion, the proportion converting
and the value of equity at the date of conversion.
The discount rate will be the discount rate which equates to the current market value of the loan
with the following stream of cash flows –
l annual net of tax interest to redemption/conversion; l
redemption proceeds for those not converting; and l
market value of shares received by those converting.
The cash-flows should always be discounted at the after-tax cost of the convertible loan.
The cost of the liability will be the current market value of debt where the conversion is not taken
up, or the ost of equity where the debt-holders take up the conversion option.
Fu ther un e tainties are posed by the fact that the company may have the right to redeem the loan
over a ange of dates (a ‘stick’ to encourage conversion) or may offer different conversion prices at
different dates (a ‘carrot’).
The f ndamental assumptions behind the use of WACC as a discount rate
(i) Only under conditions of capital market perfection will the cost of capital calculated represent the
true pportunity cost of funds used, that is, all shareholders have the same k e, because all have
perfect information and make the same assessments.
The project must be small relative to the size of the company.
Using the existing market value mix of funds as weights in the calculation assumes that in the long-
term funds will be raised in this proportion (i.e. in the long-term, the capital structure of the
company will remain unchanged). This implies that the current gearing ratio is regarded as optimal.
In the short- or medium-term, funds will not be raised in the exact proportion of existing market
values. Hence no attempt is made to match a project with a particular issue of funds. All funds are
regarded as forming a pool out of which all projects are financed (the ‘pool’ concept).
140
The project is of average risk for the firm and will cause no change in the risk of the firm as
perceived by investors. This is because the cost of capital estimate is only valid for the existing level
of risk in the firm.
Question 4–13 (Fundamental) 10 marks 18 minutes

Maranta Ltd, a profitable company, is currently evaluating its capital structure. The management of Maranta
have asked you to advise it on the ideal capital structure for the company.
You have estimated that the market relationship between debt (after tax) and equity for companies similar to
Maranta Ltd is as follows;
Debt : Equity Kd % Ke %
0 : 100 – 22
20 : 80 12,5 23,125
40 : 60 12,5 25
50 : 50 16 28
60 : 40 19 34
Required:
Determine the optimum capital structure for Maranta Ltd.
Solution:
Long-term WACC:
Debt : Equity Kd % Ke % WACC

(weighting)
0 : 100 – 22 22%
20 : 80 12,5 23,125 21%
40 : 60 12,5 25 20%
50 : 50 16 28 22%
60 : 40 19 34 25%
The lowest WACC at different ebt-Equity (D : E ratios) is 20%. The company should use this as the rate to
evaluate capital decisions. The company should finance its projects in order to move towards a D : E ratio
of 40 : 60.
141
Chapter 5
Portfolio management
and the Capit l Asset
Pricing Model
understand the background to portfolio theory;

explain the investor’s attitude to risk;
explain the investor’s expected return, required return and how these are influenced by risk;
distinguish between single-asset and portfolio risk and return;
illustrate the use of the probability distribution and expected values in risk management;
assess the risk and return of a two-asset portfolio;
illustrate graphically the combination of two or more portfolios;
explain the effects of diversification on portfolio risk;
explain the derivation and rationale of the securities market line (SML);
explain the derivation of the capital asset pricing model (CAPM);
discuss and illustrate the various applications of the CAPM; and
discuss the limitations of CAPM for capital budgeting decisions.
The modern con ept of portfolio theory was introduced by Henry Markowitz in a paper entitled ‘Portfolio
selection’ published in the Journal of finance in 1952. At the root of portfolio theory is the concept of risk and
return. He p oposed that investors should focus on selecting portfolios (not individual shares) based on the risk
– reward cha acte istics of each portfolio.
5.1 Backgro nd to portfolio theory

The risk f a p rtfolio is measured by the portfolio standard deviation of its expected returns. The expected
returns f a p rtfolio include increases (or decreases) in the value of the portfolio as well as income from the
portfolio in the form of dividends received or interest earned. From a universe of possible portfolios, there is a
e ection of those portfolios that will optimally balance risk and reward and these are referred to as ‘efficient
frontier of portfolios’.
The important criteria for any investment are:
the expected return from the investment;
the variation in that return (risk) – which can be measured by the standard deviation; and
the association between the return for an investment and that for every other investment.
143
The theory for portfolio selection is thus dependent on the expected return of a portfolio, in conjunction with
its risk. Investors are assumed to be rational; therefore when comparing investment choices, they will choose
those investments which give greater return when investment risk is equal, and lower risk when investment
return is equal. Efficient portfolios can be identified by examining the expected return (mean) of the individual
shares (or securities) comprising the portfolio, the risk measured by the standard deviation of the portfolio’s
return, and the relationship between all the shares comprising the portfolio (coefficient of correlation).
5.2 The concept of risk and return

The principal objective for a rational investor is to maximise the return on an investment or a portfolio of
investments for a given level of risk. For most securities (shares, bonds, debentures nd the like), the compo-
nents of return are the expected capital appreciation/gains in the investment together with dividends/interest
arising from the investment. In other words for a share, this would be the c pit l growth plus the dividend yield.
It is therefore important that the investor clearly understands the following key issues arising from the
investment process:
What risk and return are.
The origins of the said risk and return.
How risk and return are measured.
Return may be defined in terms of:
l Realised return, that is, the return which has b n arn d; and
Expected return, that is, the return which the inv stor anticipates to earn over a defined investment
horizon in the future.
The expected return is a forecast return and may or may not occur. The realised return is a historic return that
allows an investor to estimate cash inflows in terms of capital gains (or losses), dividends and/or interest
available to the holder of the investment. The return can be measured as the total gain or loss to the holder
over a given period of time and may be defined as a percentage return on the initial amount invested. With
reference to investment in equities, the realised return consists of the capital gain (or loss) plus the dividend at
the time of disposal of the investment.
The risk associated with an investment means that future returns from the investment are unpredictable. The
concept of risk may be defined as the probability that the actual return may not be the same as what is ex-
pected. In other words, risk refers to the chance that the actual outcome (return) from an investment will differ
from an expected outcome. With reference to a firm, risk may be defined as the possibility that the actual
outcome of a financial decision may not be the same as estimated. The risk may be considered as a chance of
variation in returns. Investments having a greater chance of variation are considered riskier than those with a
lesser chance of variation. Between equity and bonds, the former tends to be riskier than the latter as there are
many more variabl s that impact on a share price than on a bond value.
There is a trade-off b tw n risk and return. The higher the risk of an investment, the higher the return that is
expected. Conversely, the lower the risk from an investment, the lower the return. In practice taking on higher
risk may not esult in higher returns. A portfolio consisting of equities (shares listed on the JSE) and derivative
instruments (e.g. options and futures) may yield attractive returns over time but the investor takes on signifi-
cant risk. On the other hand investments in government bonds (e.g. RSA treasury bonds) will yield low returns
for moderate risk. The risk – return trade-off is illustrated in Figure 5.1 below.
144
Portfolio management and the Capital Asset Pricing Model Chapter 5
Equities/ Derivatives
Risk – Pro Investor
Risk – Averse Investor

% Return
RSA Government Bonds
Risk (Standard Deviation)
Figure 5.1: Risk – Return Trade-Off
Investors’ attitudes to risk

Investors that require low -risk investments (and as a consequence of such a selection – low returns) are said to
be ‘risk-averse’. Investors with an appetite for higher returns will incur higher risk and are said to be ‘risk-pro’.
In practice investors are constantly on the lookout for either the same risk for a larger return, or the same
return for lower risk. Doing so ensures that enough return is realised for a given level of risk or alternatively, an
appropriate level of risk (deemed to be not excessive) is borne given the expected return of an investment. The
positioning of investors along the risk – return curve is a matter of choice from investor to investor and such a
decision is influenced by a number of factors peculiar to the investor. Risk tolerance depends on the investor’s
goals, income, personal situation, even their egos.
Probabilities and expected values

For a single stand-alone asset
It is assumed that a rational investor invests for capital gains + dividend yield in a given security or portfolio.
Both the dividend income and capital gains are uncertain. Dividend income is dependent on company profita-
bility and whether or not the directors will declare one. Both these outcomes are uncertain. The capital gain is
dependent on the mark t b ing bullish (i.e. the expectation is that share prices will increase, as opposed to a
bear market, where it is anticipated that share prices will decline). Again, quite often, markets are unpredicta-
ble and hence apital gains are not guaranteed. Both the capital gain and the dividend income constitute the
return to the investor. The expected return on a given stand-alone asset security is the average (mean) of the
probability dist ibution of possible future returns, calculated by using the following formula:
n
E (R) = ∑ Pi × R i
i=1
Where:
E (R) = The expected return on the security

Pi = The probability factor
Ri = The observed return
n = The number of observations
145
Example: Expected return on a stand-alone asset

You own a share that has the following probability/return characteristics, based on future scenarios regarding
the state of the economy:
State of economy Probability Rate of return

%
Recession 0,30 –7
Normal 0,60 13
Boom 0,10 23
What is the expected return on the share? (Note: This is referred to as an ex-ante ana ysis, as it is concerned
with future states).
Solution:
Expected return = (0,30 × – 7%) + (0,60 × 13%) + (0,10 × 23%) = 8%
For a portfolio consisting of two assets

The formula for calculating the expected return on a two-asset portfolio is:
E(RP) = WAE(RA) + WBE(RB)
Where:
E(RP) = The expected return on the portfolio
WA = The proportion of the portfolio invested in stock A
E(RA) = The expected return on stock A
WB = The proportion of the portfolio invested in stock B
E(RB) = The expected return on stock B
Example: Expected return on a portfolio consisting of two assets

The probability distribution of the returns of a two asset portfolio is as follows:
Year Probability Return A Return B

1 0,20 5% 50%
2 0,30 10% 30%
3 0,30 15% 10%
4 0,20 20% – 10%
There is a 50:50 split between A and B in the portfolio.
Required:
Calculate the expected return on a two-asset portfolio.
S luti n: Expected return on a two-asset portfolio
WA = 0,50
E(RA) = 0,20(5%) + 0,30(10%) + 0,30(15%) + 0,20(20%) = 12,5%
WB = 0,50
E(RB) = 0,20(50%) + 0,30(30%) + 0,30(10%) + 0,20(–10%) = 20,0%
The formula = E(RP) = WAE(RA) + WBE(RB)
E(RP) = 0,50(12,5%) + 0,50(20,0%) =16,25%
146
Single-asset risk measures

Balancing risk and return is important for any investor and hence it is critical to have a proper approach to
portfolio risk management. To better understand the latter, the risk dynamics as applied to stand-alone assets
are first explored. This requires the student to have a grasp of the concept of the normal curve and the statisti-
cal measures of variance, standard deviation, covariance and correlation coefficient.
The normal distribution curve

The normal curve is a symmetrical distribution of scores with an equal number of scores above and below the
midpoint of the horizontal axis of the curve. Since the distribution of scores is symmetrical, the mean (the
average value), median (the middle value), and mode (the most frequent va ue) are a at the same point. In
other words, in a normal curve, the mean = the median = the mode. The following illustrations are based on
population data.
Two Std Deviations below mean μ = 52

σ = 12
Mean
Standard Deviation
16 28 40 52 64 76 88
Figure 5.2: Illustrated example of the normal curve (mathematics results of a matric class)
If we divide the distribution into the standard deviation units, a known proportion of scores lies within each
portion of the curve.
X
μ – 3σ μ – 2σ μ – 1σ μ μ + 1σ μ + 2σ μ + 3σ
68,27%
95,45%
99,73%
Figure 5.3: Percentages of areas under the normal curve
Interpretation: Within a random sample of say 100 pupils 68,27% of them (68 students) will have a math result
of between 40 and 64 (i.e. between one standard deviation to the left and right of the mean) and 95,45% of the
tudents (95 students) will have scores of between 28 and 76 (i.e. between two standard deviations to the left
and right of the mean).
The v riance: The variance and the closely-related standard deviation are measures of how dispersed (spread
out) the distribution of variables (e.g. scores, points, values or results) are around the mean. In other words,
they are measures of variability. The greater the dispersion, the higher the variance. The variance is computed
as the average of the sum of the squared deviation of each observation from the mean.
147
The formula for the variance computed from population data is:
∑(X – µ)2
σ
2 =
N
Where:
σ2 Population variance
X Observed variable (students’ maths score)
µ Population mean
N Number of subjects under analysis
The formula for the variance computed from sample data is:
2 ∑(X – M)2
S =
N
Where:
S2 Sample variance
X Observed variable (students’ maths score)
M Sample mean
N Number of subjects under analysis
The standard deviation (σ):

The standard deviation measures the spread of data around the mean value. It is useful in comparing data sets
which may have the same mean but a different range. For example, the mean of the following two data sets is
the same: 15, 15, 15, 14, 16 (by adding them up and dividing by 5, a mean of 15 is obtained) and 2, 7, 14, 22, 30
(by adding them up and dividing by 5, a mean of 15 is derived). However, the second is clearly more spread out
(hence more risky). If a data set has a low standard deviation, the values are not widely dispersed. The standard
deviation is often used by investors to measure the risk of a share or a share portfolio. The basic idea is that the
standard deviation is a measure of volatility; the more a share’s returns vary from the share’s average return,
the more volatile the share is in relation to its price movements.
The formula for the standard deviation computed from population data is:
∑(xi – µ )2
i
σ =
N
Where:
= Population standard deviation
xi = Obse ved variable (students’ maths score)
= Population mean
= N mber of subjects under analysis
The form la for the standard deviation computed from sample data is:
∑(xi – µ )2
i
S =
n–1
Where:
= Sample standard deviation
xi = Observed variable (students’ maths score)
= Sample mean
n = Number of subjects under analysis
148
Example: Calculating the mean, variance and standard deviation from sample historic data
(Ex-post)
You have observed the following returns on Memeza Limited’s share price:
Year Returns
20X7 6%
20X6 – 10%
20X5 4%
20X4 23%
20X3 12%
Required:
Calculate the average return (mean) on the share over the past five years.
Calculate the variance and standard deviation on the share over the past fi e years.
Solution: Calculating the mean, variance and standard deviati n fr m sample historic data
(Ex-post)
Using the Sharp EL 738 calculator:
Operation 1 Operation 2 Result
MODE 1 0 STAT 0
2ndF M – CLR 0 0 Clear Registers
6 ENT 1
10 +/– ENT 2
4 ENT 3
23 ENT 4
12 ENT 5
ALPHA x = 7
ALPHA sx = 12,04
2ndF X2 = 145
2
From the above calculations, the mean return (x) over the five-year period is 7%, the variance (X ) is 145 and
the standard deviation (sx) is 12,04. Notice that the standard deviation is the square root of the variance.
Comparing the risk of two stand-alone assets/projects

In assessing the risk of stand-alone projects, a situation may arise where there is need to compare the risk
among two stand-alone proj cts. In addition to calculating the variance and standard deviation, the coefficient
of variation (CV) may prove us ful in the decision making process. The latter measures the risk per R1 of return.
Example:
A company is conside ing two independent investment opportunities as follows:
Project A Project B
Investment capital R500 000 R500 000
Project life 1 year 1 year
Estimated cashflows
Probability Cashflow Probability Cashflow
0,25 600 000 0,25 200 000
0,50 700 000 0,50 800 000
0,25 800 000 0,25 1 000 000
Required:
Determine which investment the company should choose.
149
Solution:
The calculated mean return, standard deviation and CV are as follows:
Probability Project A (R000s) Project B (R000s)

2
(RA – RA) × P
2
(RB – RB) × P
RA RA × P (RA – RA) RB RB × P (RB – RB)
0,25 600 150 (100) 2 500 200 50 (500) 62 500
0,50 700 350 0 0 800 400 100 5 000
0,25 800 200 100 2 500 1 000 250 300 22 500
Expected mean (RA) 700 700
2 5 000 90 000
Variance (σ )
Standard deviation (σ) 70,71 300
CV (70,71 / 700) 0,10 (300 / 700) 0,43
The calculation of the expected mean return indicates that both projects yield a positive return of R700 000, or
a net value of R200 000, being the difference between the return and the investment outlay of R500 000.
The standard deviation measures the dispersion around the mean. In the ab ve example, Project A has a lower
standard deviation of R70 711, which means it has a lower risk in comparison to Project B, which has a standard
deviation of R300 000. This is indicated by the range of cash flows for Project A, which is between R600 000 and
R800 000, whereas for Project B it is between R200 000 and R1 000 000.
The company should therefore choose Project A.

In order to compare two projects with different m an valu s, one must calculate the coefficient of variation (CV)
which measures the risk per R1 of return, that is the CV standardises the risk per R1 of return. In the above
example, the CV of Project A is only 0,10, compared to a high CV of 0,43 for Project B. To obtain the CV, one
merely has to divide the standard deviation by the expected mean return.
The correct method of evaluating two separate projects or investments is to use the mean variance approach
as developed by Markowitz in 1952. This states that:
Given a choice of two projects (or portfolios) with the same return but different risk, an investor will
choose the one with the lower risk, in this case Project A.
Alternatively, where two projects (or portfolios) have the same risk but different returns, an investor will
choose the one with the higher return.
5.3 Portfolio risk and return

Most investors invest in a collection of two or more assets. Such a collection of assets held by an investor is
known as a portfolio. It is often assumed that a rational investor will build a portfolio that will give him or her
maximum possible r turns for a given risk profile remembering that the greater the returns the greater the risk.
The components of the total risk of a portfolio is the systematic (market) and unsystematic (asset specific) risk.
The former affe ts all market participants and is due to changes in economic fundamentals (e.g. interest rates,
exchange rates, inflation, consumer demand, the price of oil, etc). Systematic risk cannot be eliminated or
minimised by managerial intervention. The latter is associated with the basic functions of the organisation (e.g.
information technology, innovation, better production processes, financing, leadership, etc). Managerial
intervention can minimise this type of risk.
Two-asset portfolio risk and return

At least two shares constitute a portfolio. A two-asset portfolio is unlikely to achieve sufficient diversification of
ri k and can therefore not constitute an efficient portfolio. However, the principles being explored here are the
ame irre pective of the number of shares that comprise a portfolio. The expected return on a portfolio of two
assets is explained and calculated under section 5.2. The primary objective of this sub-section is to explore
ways of assessing the risk of a two-asset portfolio. The primary risk measures of a two-asset portfolio are the
following –
the portfolio variance; and
the portfolio standard deviation.
150
The portfolio variance:

This is a measure of the risk (volatility) of a portfolio, and it takes into consideration the combination of the
variance and co-variance of each security and its proportion in that portfolio – not just the weighted average of
all security variances.
There are two variations of the formula used to calculate the portfolio variance, namely:
One that relies on the covariance of returns of the assets in the portfolio.
The other that relies on the correlation coefficient of the returns of the assets in the portfolio.
The statistical formula for the portfolio variance based on the covariance is:
2
σ p
2 2 2 2
W xσ x + W yσ y + 2WxWy x COVxy
=
Where:
2
σ p = The portfolio variance
Wx and Wy = The proportions invested in Share X and Share Y respectively
2
σ x and σ y
2
= The variance on shares X and Y respectively
Cov (x,y) = Covariance of X and Y
The statistical formula for the portfolio variance based on the correlation coefficient is:
2
σ p =
2 2
W xσ x
2 2
+ W yσ y + 2WxWy Pxyσx σy
Where:
2
σ p = The portfolio variance
Wx and Wy = The proportions invested in X and Y respectively
2 2
σ x and σ y = The variance on shares X and Y respectively
σx and σy = The standard deviation on shares X and Y respectively
Pxy = The correlation coefficient on shares X and Y
The covariance:
The covariance is a multi-variable statistical measure (as opposed to single statistical measures such as the
mean, standard deviation and variance). It is a measure of the degree to which returns on two risky assets
move in tandem. A positive covariance means that asset returns move together. A negative covariance means
returns move invers ly. If share A’s return is high whenever share B’s return is high and the same can be said for
low returns, th n th se shar s are said to have a positive covariance. If share A’s return is low whenever share
B’s return is high then these stocks are said to have a negative covariance. If the covariance is zero there is no
relationship between the variables.
The statistical fo mula for the covariance is:
Cov (x,y) = Pxyσxσy
Where:
C v (x,y) = Covariance of X and Y
Pxy = Correlation co-efficient of X and Y
σx = Population standard deviation of X
σy = Population standard deviation of Y
The correlation coefficient:

In probability theory and statistics, correlation (often measured as a correlation coefficient), indicates the
strength and direction of a linear relationship between two random variables. The calculated value lies be-
tween – 1 and + 1. Although the covariance measures the degree to which returns on two risky assets move in
tandem, it does not explain the strength of the relationship.
151
If x and y have a strong positive linear correlation, r (the correlation coefficient) is close to + 1. An r value of
exactly + 1 indicates a perfect positive fit. Positive values indicate a relationship between x and y variables such
that as values for x increase, values for y also increase.
If x and y have a strong negative linear correlation, r is close to – 1. An r value of exactly – 1 indicates a perfect
negative fit. Negative values indicate a relationship between x and y such that as values for x increase, values
for y decrease.
If there is no linear correlation or a weak linear correlation, r is close to 0. A value near zero means that there is
a random, nonlinear relationship between the two variables. A perfect correlation of ± 1 occurs only when the
data points all lie exactly on a straight line. If r = + 1, the slope of this line is positive. If r = – 1, the slope of this
line is negative.
The statistical formula for the correlation coefficient is:
Cov (x,y)
Pxy =
σ xσy
Where:
Pxy = The correlation coefficient between X and Y
Cov (x,y) = Covariance between X and Y
σx = Population standard deviation of X
σy = Population standard deviation of Y
Example: Calculating the portfolio variance

Two shares offer the following four historical % returns:
Return X Return Y
20% 40%
24% 12%
10% 20%
26% 24%
Required:
Calculate the correlation coefficient of the shares.
Calculate the portfolio variance.
Calculate the portfolio standard deviation.
Solution: Cal ulating the portfolio variance (based on the correlation coefficient)
The following answer is based on the financial calculator – Sharp EL738:

MODE 11 STAT 1
20 (x,y) 40 ENT Data Set = 1
RCL σx 6,16
RCL σy 10,20
RCL r (correlation coefficient) – 0,0318
152
Input the calculator variables into the formula:

2 2
W xσ x (0,60)(0,60) × (37,95) 13,66
2 2
W yσ y (0,40)(0,40) × (104,04) 16,65
2WxWyPxyσxσy 2(0,60)(0,40)(– 0,0318)(6,16)(10,20) – 0,96
2
σ portfolio 13,66 +16,65 – 0,96 29,35
σ portfolio Square root of 29,35 5,42
1 The correlation coefficient (r) of the shares = – 0,0318
2 The portfolio variance = 29,35
3 The portfolio standard deviation = 5,42
Interpretation:
l The correlation is negative and very weak. The variables pp se each ther but the magnitude of change of
one variable is not matched by the change in the other variable.
The standard deviation of 5,42% is an indication of the risk of the portfolio. It is only useful if compared
with the standard deviation of another portfolio or the standard deviation of the current portfolio if its
asset composition is changed.
The efficient frontier

Investors often hold a set of portfolios. For each portfolio there is need to balance the risk of the portfolio to
the expected return. Overall, the investor strives to balance the risk of all portfolios to the attendant return. To
achieve this, the investor needs to select the most efficient set of portfolios in terms of the risk – return trade-
off. The process of assessing the risk and return of a portfolio of say 50 shares or five sets of portfolios consist-
ing of 50 shares each is the same as the procedure we employed in assessing the risk and return of a two asset
portfolio. The portfolio selection process is as follows:
For any level of volatility, consider all the portfolios which have the same or similar risk. From among those
portfolios, select the one which has the highest expected return.
Alternatively, for any expected return, consider all the portfolios which have the same or similar expected
return. From among those portfolios, select the one which has the lowest risk.
As the number of shares in a portfolio or the number of portfolio sets increases, the resultant calculations
become more complex, but can be done with the aid of appropriate computer models. Calculations for analys-
ing portfolios that contain more than two shares are outside of the scope of this textbook.
The concept of the ffici nt frontier is illustrated below in Figure 5.4.
15%
Efficient portfolios curve
10%
Expected Retrn
5%
Inefficient
portfolios
(inside the curve)
0%
– 5%
0% 5% 10% 15% 20%
Risk (Return Volatility)
Figure 5.4: Graphic illustration of efficient frontier
Conclusion: An investor should select a portfolio that lies on the efficient frontier curve.
153
5.4 Diversification
Diversification is a strategy designed to reduce exposure to risk by combining, in a portfolio, a variety of in-
vestments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal
of diversification is to reduce unsystematic risk in a portfolio. Volatility is limited by the fact that not all asset
classes or industries or individual companies move up and down in value at the same time or at the same rate.
Diversification reduces both the upside and downside potential and allows for more consistent performance
under a wide range of economic conditions. Mathematically, the purpose of diversification is to reduce the
standard deviation of the total portfolio. As you add securities, you expect the average covariance for the
portfolio to decline, but not to disappear since correlations are not perfect y negative. It is thought that a
portfolio of not less than 20–30 shares will approximate the market in terms of systematic risk. (Satrix’s JSE top
40). But one needs a ‘balanced’ portfolio – avoid putting one’s golden eggs in one b sket. One should structure
the portfolio so that some shares are positively correlated to the market (m rket cycles) and some are nega-
tively correlate to it in terms of returns.
Systematic versus unsystematic risk

Total risk = Market risk (systematic) + firm-specific (unsystematic) risk
Market risk (systematic): Risk that affects all players in the arket place is called ‘market risk’ or ‘systematic
risk’. Changes in economic fundamentals (interest rates, exchange rates, inflation, consumer demand, the price
of key commodities such as oil, etc.). Market risk is measured by the beta co-efficient. The market (JSE) has a
beta of 1, the market’s riskiness relative to itself. Shares/portfolios with a beta greater than 1 (say 1,2) face a
bigger risk than the market. Shares/portfolios with a b ta l ss than 1 (say 0,8) face a smaller risk than the
market.
Firm-specific risk (unsystematic): Risk associated with the basic functions of the organisation (information
technology, production processes, product-markets, innovation, financing, leadership, human skills, etc.). This
is operational/business risk. It is often assumed that management can eliminate this risk by diversification or
simply managing better.
In theory, if it were possible to eliminate firm-specific risk, the total risk facing the firm would be the market
risk. In practice, however, a firm, as a going concern, is faced with a dynamic and ever changing environment
and therefore cannot totally eliminate firm-specific risk but can minimise it.
A graphic illustration of total firm risk is shown in Figure 5.5 below.
Unsystematic risk
(Firm-specific risk)
Total risk
Standard deviation of the market

Systematic risk portfolio
Number of Shares in portfolio
Figure 5.5: Graphic Illustration of total firm risk
154
5.5 The securities market line (SML)

In 1958, James Tobin expanded on the work of Markowitz, by adding a risk-free asset to the analysis. This led
to the notions of a super-efficient portfolio and the capital market line. With the aid of the risk-free asset, an
investor could be able to better portfolios on the efficient frontier. The introduction of the risk-free asset had
the following implications to an investor:
The return required of any risky asset is determined by the prevailing level of risk-free interest rates plus a
risk premium.
Investors require returns that are commensurate with the risk level they perceive.
The security market line (SML) indicates the going required rate of return on a security in the market for a given
amount of systematic risk. The SML intersects the vertical axis at the risk-free r te, indicating that any security
with an expected risk premium equal to zero should be required to e rn return equal to the risk-free rate. The
slope (gradient) of the security market line will increase or decrease with uncertainties about the future
economic outlook and/or the degree of risk aversion of investors.
Return on the security J

SML
Return on the market – JSE
15%
Risk premium
12%
B ta of security JSE
8%
Beta of security J
Risk-free return
0 1,0 1,3 Market risk = Beta

Figure 5.6: Graphic illustration of the S L (figures are imaginary)
5.6 The capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) is derived from the securities market line (SML) and is based on the
concept that a security’s required rate of return is equal to the risk -free rate of return plus a risk premium that
reflects the riskiness of the security after diversification. The key components of the CAPM are the risk-free
rate of return, the beta coefficient and the market risk premium.
The following is the mathematical equation for the
CAPM: E(Ri) = Rf + βi[E(Rm) – Rf]
Where:
E(Ri) = Required rate of return on security i
Rf = Risk free rate of return
βi = Systematic risk for security i (Beta)
E(Rm) = Return on the market portfolio
E(Rm) – Rf = The risk premium
Expected return (E(Ri))

We dealt with the concept of expected return under section 5.2 above. The positioning of the investor on the
SML determines the investors’ risk and return trade off. A risk averse investor who prefers minimal or close to
zero risk has government bonds as a possible investment choice. In this situation government bonds are as-
sumed to be free of default risk. In practice, there are instances where states have defaulted on their debt (the
Russi n default of 1998 is a case in point) but the probabilities of such occurrences is negligible.
The risk-free rate of return (Rf)
This is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the return an
investor would expect from an absolutely risk-free investment over a specified period of time. In theory, the
155
risk-free rate is the minimum return an investor expects for any investment because he or she will not accept
additional risk unless the potential rate of return is greater than the risk -free rate. In practice, however, the
risk-free rate does not exist because even the safest investments carry a very small amount of risk. The yield
(required return) on a ten -year government bond is often used as an approximation of the risk-free rate of
return.The risk-free rate of return is the sum of two components –
real rate of return; and
expected inflation premium.
The inflation premium compensates investors for the loss of purchasing power due to inflation.
The beta coefficient (βi)

The slope of the SML line is a measure of market risk. It relates the movement of company’s stock relative to
the market. A beta of 1 indicates that the security’s price will move with the m rket. A beta of less than 1 means
that the security will be less volatile than the market. A beta of greater than 1 indicates that the securi-ty’s
price will be more volatile than the market. For example, if a stock’s beta is 1,2, it is theoretically 20% more
volatile than the market. If the correlation between the security and the market index is negative the regres-
sion line would slope downward, and the beta would be negative. A negative beta is mathematically possible
but highly unlikely in practice (except for gold as an asset.)
The beta (β) is measured
by: COVARiM
SM
2
Where:
COVARiM = The covariance of returns of stock i with those of the market
SM
2
= The variance of market returns
Example 1: Calculating the beta coefficient

The following information relates to the return of Kwangena Limited’s stock and the return on the JSE index
over a five-year period:
Year X Variable: Y Variable:
Market Return Stock Return
E(R m) E(Ri)
% %
20X1 23,8 38,6
20X2 (7,2) (24,7)
20X3 6,6 12,3
20X4 20,5 8,2
20X5 30,6 40,1
Solution: Calculating the beta coefficient

The following answer is based on the financial calculator – Sharp EL738

MODE 11 STAT 1
23,8 (x,y) 38,6 ENT Data Set = 1
– 7,2 (x,y) – 24,7 ENT Data Set = 2
6,6 (x,y) 12,3 ENT Data Set = 3
20,5 (x,y) 8,2 ENT Data Set = 4
30,6 (x,y) 40,1 ENT Data Set = 5
RCL σx 13,52
RCL σy 23,73
RCL r (correlation coefficient) 0,91
156
Input the calculator variables into the formula:

Cov (x,y) r σ x σy 291,95
σx
2
Variance of X 182,79
Variance of Y σy (SM2)
2
563,11
β Cov (x,y)/ SM2 (291,95/182,79) 1,60
Note: The beta can be calculated directly from the calculator by pressing RCL and “b” after imputing Data
Set 5.
Example 2: Calculating the beta coefficient

The Arjent Co wishes to purchase 100% of Murcury.
Arjent Co Murcury Market
Expected returns 10% 16% 14%
Standard deviation of returns 5% 7% 4%
Expected returns correlation with market + 0,3 + 0,6 1
The risk-free rate is 6%, while the correlation between Arjent and Murcury is + 0,1.
If Murcury is taken over, it will account for 20% of the value of the new company.
i.e. Argent = 80% Murcury = 20%
Required:
Calculate the beta for both Arjent and Murcury.
Calculate Arjent’s existing cost of equity.
Calculate the risk and return of Arjent after accepting the takeover of Murcury.
Calculate Murcury’s required return based on CAPM.
Solution:
1 Beta = covariance with the market/variance of the market
5 × 0,3
Arjent = = 0,375
4
Murcury = 7 × 0,6 = 1,05

4
2 Cost of equity
ke = Rf + βi(Rm – Rf)
= 6 + 0,375 (14 – 6)
9%
3 Risk and ret rn
Return f Arjent after taking over Murcury
= (0,8 × 10% ) + (0,2 × 16%) = 11,2%
Ri k of Arjent after the takeover:
2 2 2 2
wA σA + wB σB + 2wAwBCOV(A,B)
σp =
2 2 2 2
(0,8 × 5 ) + (0,2 × 7 ) + (2 × 0,8 × 0,2 × 5 × 7 × 0,1)
σp =
= 4,37
The weighted average risk for the new company is calculated as [80% × 5%] + [20% × 7%] = 5,4.
157
As expected, portfolio risk (4,37%) is less than weighted average risk (5,4%), as the two companies have a
correlation of almost zero (+ 0,1) with each other.
What is interesting to note is that despite Murcury having a higher standard deviation than Arjent, once
combined, the resultant risk is less than both of their respective standard deviations.
Why?
This is significantly less than + 1 (perfect positive correlation) and hence in terms of the portfolio theory,
the combination is highly advantageous.
To reconfirm – this is due to them having an almost zero correlation with each other.
4 Murcury’s required return

Rp = Rf + βp(Rm – Rf)
= 6 + 1,05 (14 – 6) = 14,4%
Murcury
%
16
14,4
Market
Arjent
10
0 0,37 Beta 1,0 1,05
Figure 5.7: Risk/Return profile

In the above example, both Arjent and Murcury have expected returns that exceed the required return (see
Figure 5.7). Both returns will drop to the SML due to market forces until the expected return equals the re-
quired return. At the mom nt, Murcury should be accepted, as the returns are above the SML.
Risk and return for Arj nt as calculated in (iv) above will improve, but only in the very short-term. Market forces
will bring the values into equilibrium once the information is available to the market. At the present moment, A
jent should invest in Murcury, as the share value of Murcury is less than the required market value and the retu
n is above the market required return.
Equity vers s asset betas

The eq ity beta (also called geared or levered beta) is the beta of the company that takes into account the
capital structure effects (financial risk) as well as the systematic effects related to market conditions. The asset
beta (also called ungeared or unlevered beta) is the beta of the company without the effects of the capital
tructure. If one was calculating the required return for an unlisted (private) company without an equity beta,
one would have to use a ‘proxy’ beta of a similar listed company. The challenge of using the ‘borrowed’ equity
beta is that it probably comes from a company with a different capital structure from the one we are analysing.
The fo owing steps would have to be undertaken to the proxy equity beta before we can use it:
Ungear the proxy beta.
Re-gear the proxy beta.
158
Ungear the proxy beta: This means removing the capital structure effects of the listed company from the
proxy beta. This turns an equity beta into an asset beta. The formula to use to ungear the equity beta is the
following
E
(β) ungeared = (β) geared × E + D(1 – t)
Where:
(β) geared The equity beta of the listed company (the borrowed/proxy beta).
(β) ungeared The asset beta of the listed company after ‘stripping’ it of its capital structure
E Equity % in listed company (40% will be written s 40 only)
D Debt % in listed company (60% will be written s 60 only)
t The tax rate of the public company (40% will be written as 0,40).
The tax rate applies to the debt (D) only.
Regear the proxy beta: This means effecting the capital structure effects of the private company on the
asset beta calculated under 1 above. This turns the asset beta into an equity beta of the new firm. The for-
mula to use to re-gear the asset beta is the following:
E + D(1 – t)
(β) Geared = (β) ungeared ×
E
Where:
(β) geared The equity beta of the private company (target beta)
(β) ungeared The asset beta of the listed company after ‘striping’ it of its capital structure
E Equity % in private company (40% will be written as 40 only)
D Debt % in private company (60% will be written as 60 only)
t The tax rate of the private company (40% will be written as 0,40).
The tax rate applies to the debt (D) only.
After undertaking the adjustments in 1 and 2 above, the proxy beta can be used in the CAPM equation in
calculating the cost of equity (required rate of return) of the private company.
The risk premium

The risk premium is the additional return over and above the risk-free rate needed to compensate investors for
assuming an average amount of risk. Its size depends on the investors’ perceived risk of the stock market and
the investors’ degree of risk aversion.The risk premium assigned by an investor to a given security in determin-
ing the required rate of r turn is a function of several different risk elements. These risk elements (premiums)
include –
maturity risk premium;
default isk p emium;
seniority isk p emium; and
marketability risk premium.
Risk premium (Rp) = Return on the market portfolio (R m) – Risk-free return (Rf)
5.7 CAPM applications

There are a number of significant contributions of portfolio theory to the study and practice of financial man-
agement. Two of the most important of these contributions are the following:
It helps us understand the relationship between risk and return; what part of the total risk we can
manage through diversification and what part we cannot.
It is also the basis for estimating the required rate of return by equity investors (cost of equity) through the
SML and the CAPM.
159
CAPM and weighted average cost of capital (WACC)

An equity investor in a company requires a return as compensation for the risk he/she bears for putting his/her
capital at the disposal of the firm. In turn the company compensates the investor for his/her capital invest-
ment. The later compensation equals the risk-free rate of return plus a risk premium as discussed under sec-
tion 5.6 above. The equity investor’s required rate of return therefore equals the firms cost of equity capital.
The CAPM is used in capital markets to define the required rate of return by equity investors and hence the
firm’s cost of equity capital.
Example: CAPM and WACC

Bulelwa Limited has 7 million ordinary shares of R1 each in issue, 5 million 6% preference shares of a par value
of R1 each, 100 000 9% semi-annual bonds with a par value of R1 000 e ch. The sh res currently sell for R30 per
share and have a beta of 1,0. The preference shares are currently selling for 110 cents per share and the bonds
have 15 years to maturity and currently sell for 89% of par. The market risk premium is 8%, the ten-year
treasury-bonds are yielding 7% and the company’s tax rate is 40%.
Required:
Calculate Bulelwa Limited’s WACC
Solution: CAPM and WACC

Calculate the required rate of return by equity hold rs (cost of quity)
Ke + Rf β(Rm – Rf) = 7% + 1,0 (8%) = 15%
Calculate the required rate of return by preference shareholders (cost of preference shares)
Kp = D/P0 = 6/110 = 5,45%
Calculate the required rate of return by bondholders (yield on the bonds)

Using the Sharp EL738:
– 890 PV
45 PMT [0,09 × R1 000/2]
30 N [15 × 2]
1000 FV
COMP I/Y
Answer: 5,23%
Calculate market valu s of funding sources:

Equity = 7m × R30 = R210m
Preferen e shares = 5m × R1,10 = R5,10m
Bonds = 100 000 × R890 = R89m
Calculate the WACC

F nding So rce Market Capital Cost of WACC
Value Structure Source
Rm % %
Equity 210,00 0,69 15,00 10,35
Preference shares 5,10 0,02 5,45 0,11
Bonds 89,00 0,29 5,23 1,52
304,10 1,00 11,98
The WACC is 11,98% (say 12%).

The calculation of the WACC was included in this section only as an illustration of the application of the CAPM
to the estimation of the cost of equity. (See chapter 4 Capital structure and the cost of capital for a detailed
analysis of these concepts.)
160
CAPM and the investment appraisal decision

The discount rate for capital projects in a levered firm (has debt as part of its capital structure) is the WACC.
The use of the WACC to discount the projects in a levered firm is based on the assumption that the projects will
have the same business risk as the current portfolio of projects, meaning the project will not result in the
alteration of the existing capital structure and hence the overall financial risk. The WACC will comprise the
weighted average of the respective debt and equity components. The cost of equity could be estimated using
the CAPM. In a non-levered firm the WACC will equal the cost of equity. In the latter case, the required return
on projects will equal the required return by equity holders only.
Example: Project evaluation in a non-levered firm

A manufacturing company with a beta of 1,2 wishes to diversify into the food ret iling business.
Quoted companies involved in food retailing have a beta of 0,9.
The market required return is
18%. The risk-free rate is 9%.
Required:
Determine the rate at which the new project should be evaluated.
Solution: Project evaluation in a non-levered firm

When a company is not quoted or wishes to diversify, it is suitable to use the β of a similar quoted company in
that particular industry.
In the above example, the correct rate is calculated as:
Project required return = 9% + 0,9 (18% – 9%) = 17,1%
17,1% is the required return for any investor in this sector, based on the risk of the project relative to the
overall market, and accepting that the company is all-equity.
Note: The CAPM measures both business and financial risk through the use of the equity beta. Therefore,
shareholders in an all-equity firm are only concerned with the business risk associated with a particu-
lar industry.
Example: Project evaluation and the CAPM

Penholt Limited is considering investing R100 000 in one of two projects. Both projects have a life of one year
only and the potential return is dependent on the following economic states:
State 1 State 2 State 3
Probability 0,4 0,3 0,3
Net cash return: Proje t A R35 000 R20 000 R0
Net cash return: Proje t B R5 000 R30 000 R30 000
Net cash etu n f om existing activities (R20 000) R100 000 R300 000
The company has a c rrent market value of R1 million. The Directors of Penholt believe that the risk return per
R1 of c rrent market value of their existing activities is virtually the same as those for the stock market as a
whole, incl ding general economic risk. The current risk-free rate on short-dated government investments is
10%.
Required:
Ignoring taxation, determine which of the two projects the company should accept.
161
Solution:
Calculating rate of return:
State 1 State 2 State 3
35%
*
Project A 20% 0%
Project B 5%** 30% 30%
– 2%
***
Existing operations 10% 30%
* R35 000/R100 000 = 35%
** R5 000/R100 000 = 5%
*** (R20 000)/R1 000 000
Expected return and standard deviation:

Project A 0,35 × 0,4 = 0,14
0,20 × 0,3 = 0,06
0,0 × 0,3 = 0,00
0,20
Expected return 0,20 or 20% standard deviation = 0,1449

Project B 0,05 × 0,4 = 0,02
0,30 × 0,3 = 0,09
0,30 × 0,3 = 0,09
0,20
Expected return 0,20 or 20% standard deviation = 0,1225

Existing operations – 0,02 × 0,4 = – 0,008
0,10 × 0,3 = 0,03
0,30 × 0,3 = 0,09
0,112
Expected return 0,112 or 11,2%standard deviation = 0,1327

Both Projects A and B have the same expected return of 20%, with Project B having a lower risk in com-
parison to Project A.
On this basis, it would appear that Project B should be selected.
Using the CAPM model, one can evaluate Projects A and B using the formula:
Ri = Rf + βi (Rm – Rf)
Calculate the beta for Projects A and B as follows:
Step 1 Calculate the ovariance for Projects A and B:
Covariance: P oject A
Use the following formula:

~ ~
(RA – RA) (RO – RO) P
Where:
R~A Project A expected return
R~A Project A mean return
RO Existing operations expected return
RO Existing operations mean return
P Probability factor
To calculate the covariance: Project B, use the same formula as above, but replace A with B.
162
Covariance: Project A:
0,15* × – 0,132
****
× 0,4 = – 0,00792
0** × – 0,012***** × 0,3 = 0
– 0,20*** × 0,188****** × 0,3 = – 0,01128
Covariance (RA,RO) = – 0,0192
*
0,35 – 0,20 = 0,15
**
0,20 – 0,20 = 0
***
0 – 0,20 = – 0,20
****
– 0,02 – 0,112 = – 0,132
*****
0,10 – 0,112 = -0,012
******
0,30 – 0,112 = 0.188
Covariance: Project B
– 0,15 × – 0,132 × 0,4 = 0,00792
0,1 × – 0,012 × 0,3 = – 0,00036
0,1 × 0,188 × 0,3 = 0,00564
Covariance (RB,RO) = 0,0132
Step 2 Calculate beta: (note this is an alternative for ula to that shown earlier in section 5.6)
σi
βi = CORim
σm
Correlation of project A to existing operations

COV(A,O)
Correlation coefficient ρAO =
σAσO
= – 0,0192 / (0,1449 × 0,1327)
= – 0,9985
Correlation of project B to existing operations

COV(B,O)
Correlation coefficient ρBO =
σBσO
= 0,0132 / (0,1225 × 0,1327)
= 0,8120
Beta for project A

βA = (– 0,9985 × 0,1449) /0,1327 = – 1,0903
Beta for project B

βB = (0,8120 × 0,1225) / 0,1327 = 0,7496
Step 3 Calc late required return:

Pr ject A return = 0,10 + [– 1,0903(0,112 – 0,1)]
= 0,10 – 0,0131
= 0,0869 OR 8,69%
Project B return = 0,10 + 0,7496(0,112 – 0,1)
= 0,10 + 0,009
= 0,109 OR 10,90%
Conclusion:
Although Project A has the greater amount of total risk its required return is below that of Project B. Most of
the risk of Project A is eliminated due to its favourable correlation (i.e. away from + 1) with existing operations.
Project A is thus preferred as it provides a better return per R1 risk.
163
Limitations in using CAPM in investment appraisal decisions

The use of CAPM in investment appraisal lies in the inherent weaknesses of the CAPM as a model for estimat-
ing the cost of equity. Some of the assumptions are as follows:
The CAPM is a single-period model. Thus, when using the rate as determined from the SML to evaluate a
project, one is assuming that the beta, risk-free rate and the expected market return will remain constant
over the life of the project.
The use of the beta as a measure of systematic risk assumes total diversification of unsystematic risk,
resulting in total risk being equal to systematic risk. In practice, firms are unab e to eliminate all unsys-
tematic risk.
The assumption that the government bonds are risk free, though l rgely true, may not be always the
case. Government bonds in some instances do carry a small amount of risk (infl tion is a case in point and
in some countries default risk).
The assumption of perfect capital market: This assumption means that all securities are valued correctly
and that their returns will plot onto the SML. In the real w rld capital markets are clearly not perfect.
When analysing projects in private companies there may be difficulties in finding suitable proxy betas,
since proxy companies very rarely undertake only one business activity.
Practice questions
Question 5–1 (Fundamental) 40 marks

An investor wishes to invest in two shares that have the following risk/return profiles:
Economic State Probability Expected return Expected return
Share A Share B
1 0,3 2% 15%
2 0,5 10% 22%
3 0,2 12% – 2%
The following information is available:

The risk-free rate is 3%.
The market return is 12%.
The standard deviation of expected market returns is 6%.
The covariance of Share A r turns with those of the market is 25,2.
The covariance of Share B r turns with those of the market is 39,6.
Required:
Calculate the expected returns for Shares A and B; the covariance of returns between the two shares, and
the correlation between Share A and Share B. (8 marks)
Determine the expected return of a portfolio consisting of 40% Share A and 60% Share B together with
the risk of the portfolio and discuss whether you would advise the investor to purchase the port-
f lio. (5 marks)
Calculate the required return for Shares A and B according to the Capital Asset Pricing Model, and discuss
whether you would advise the investor to invest in either Share A or Share B. (8 marks)
I ustrate your answer to (c) above by showing the position of Shares A and B in relation to the Securities
Market Line. (4 marks)
(e) Briefly explain why the CAPM measures return versus beta, rather than standard deviation. (8 marks)
(f) Briefly describe the limitations of using the CAPM for capital budgeting decisions. (7 marks)
164
Solution 5–1
Calculate the expected returns for Shares A and B; the covariance of returns between the two shares,
and the correlation between Share A and Share B.
Share A
P(return – mean)
2
Probability Return Mean Variance
2
0,3 × 2 = 0,6 0,3( 2 – 8) = 10,8
2
0,5 × 10 = 5,0 0,5(10 – 8) = 2
0,2(12 – 8)
2
0,2 × 12 = 2,4 = 3,2
σ
2
8,0 16,0
σ = 4
Share B
P(return – mean)
2
Probability Return Mean Variance
2
0,3 × 15 = 4,5 0,3(15 – 15,1) = 0
2
0,5 × 22 = 11,0 0,5(22 – 15,1) = 23,81
0,2(– 2 – 15,1)
2
0,2 × –2 = – 0,4 = 58,48
σ
2
15,1 82,29
σ = 9,07
Expected return for investment A = 8%
Expected return for investment B = 15,1%
Covariance of returns
0,3 (2 – 8)(15 – 15,1) = 0,18
0,5 (10 – 8)(22 – 15,1) = 6,9
0,2 (12 – 8)(– 2 – 15,1) = – 13,68
Cov – 6,6
Covariance between A and B = – 6,6

– 6,6
Correlation between A and B = = – 0,1819
4 × 9,07
Determine the expected return of a portfolio consisting of 40% Share A and 60% Share B together with
the risk of the portfolio and discuss whether you would advise the investor to purchase the portfolio.
Return on portfolio
(0,4 × 8) + (0,6 × 15,1) = 12,26%
Standard deviation of portfolio
2 2 2 2
wA σA + wB σB + 2wAwBCOV(A,B)
σp =
2 2
0,4 × 16 + 0,6 × 82,29 + 2 × 0,4 × 0,6 × – 6,6
σp =
σp = 2,56 + 29,62 – 3,168
5,38%
165
The portfolio consists of 40% investment in Share A and 60% investment in Share B, with a return of
12,26% and a risk of 5,38%. The return is greater than the market return of 12% and the risk is lower than
the market risk of 6%.
The investor should be advised to invest in Shares A and B. Another good reason to invest in the Shares is
because they are negatively correlated; consequently there is a substantial reduction in risk per R1 re-
turn.
Note: It is impossible for an investor to get a return higher than market return with a risk lower than
market risk. The above calculations show that the expected return for the shares is probably higher
than the required return, which means that they are in temporary disequi ibrium.
Calculate the required return for Shares A and B according to the C pit l Asset Pricing Model, and
discuss whether you would advise the investor to invest in either Sh re A or Share B.
Share A
Required return
COV(RA,Rm)
βA =
2
σ m
25,2
βA = 0,7
6
2
l RA = Rf + β(RM – Rf)
l RA = 3% + 0,7(12 – 3) 9,3%
The required return for Share A is 9,3% while the expected return is only 8%. This means that the share is
in temporary disequilibrium and in the short run the return is likely to increase. The shareholder should
be advised not to purchase Share A.
Share B
Required return
COV(RB,Rm)
βB =
2
σ m
39,6
βB = 1,1
6
2
l RB = Rf + β(RM – Rf)
l RB = 3% + 1,1(12 – 3) 12,9%
The requi ed etu n for Share B is 12,9% while the expected return is 15,1%. This means that the share is in
tempo a y disequilibrium and in the short run the return is likely to decrease. The shareholder should be
advised to purchase Share B.
166
Illustrate your answer to (c) above by showing the position of Shares A and B in relation to the Securi-
ties Market Line.
15,1 SML
B
12,9
12
% Return
9,3
A
8
0 0,7 B ta 1 1,1
(e) Briefly explain why the CAPM measures return versus beta, rather than standard deviation.
The major determinant of the required return on an asset is its degree of risk. Risk refers to the probabilities
that the returns, and therefore the values of an asset or security, may have alternative outcomes. The measure
of risk is generally accepted as the standard deviation (σ) of an asset or security.
Two types of risk are identified or associated with a security –

unsystematic (avoidable) risk; and
systematic (unavoidable) risk.
Unsystematic risk may be referred to as the internal risk of a company. It represents those financial
management, legal or worker decisions that affect the profitability of the company. An investor can
therefore reduce the unsystematic risk by holding a diversified portfolio. Empirical studies show that
most of the unsystematic risk is eliminated by portfolios consisting of as few as ten securities.
Systematic risk cannot be avoided by diversification. Systematic risk is the fundamental risk that a share’s
possible return is xpos d to, and is caused by general economic trends, political or social factors affect-ing
all companies simultaneously. Therefore, the relevant risk for an investment is the systematic risk.
The riskiness of assets or securities can be measured by their contribution to the portfolio risk. This
relationship is measured by the covariance of the security return with market returns. The CAPM is de-
veloped from portfolio theory and explains the relationship between the risk of a security and the re-q
ired risk adj stment factor.
As the market represents a portfolio of all available securities, the market return represents the average
yield with a given average systematic risk. The market is the benchmark; consequently we say that R m is
the market return, with a systematic risk factor of 1 or beta = 1. From this relationship we draw the SML,
which is a line joining the risk-free rate to the market return and beyond. All securities on the SML line are
efficient and yield a return that equates to its covariance with the market return, R m.
Briefly describe the limitations in using the CAPM for capital budgeting decisions.
Using the rate as determined from the SML to evaluate a project means that one is assuming that the beta,
risk-free rate and expected market return will remain constant over the life of the project.
The assumptions of the CAPM model, especially ‘borrowing and lending can be made at the risk-free rate’.
At high levels of gearing, debt will not be risk free. The problem is that M and M assume that risk is
167
measured entirely by variability of cashflows. At high gearing, there will be fears of bankruptcy which will
increase the cost of both debt and equity resulting in an increased WACC.
Tax implications change for different categories of investors. Tax relief is available on debt interest as long
as taxable profits are high enough. Not all companies will be able to obtain this advantage, and the proba-
bility of taxable profits being high enough decreases with increasing gearing. Therefore, at high gearing, the
debt is not so attractive. However, since capital allowances will be lower in future, there is more chance of
debt interest being advantageous, albeit at a lower company tax rate.
Risk is regarded as an increasing function over time (risk is compounded over time).
Major shareholders are institutions, some of whom are able to obtain tax re ief on borrowings (e.g. invest-
ment trusts). This removes the advantage of company borrowing.
Question 5–2 (Intermediate) 35 marks

Marine Fisheries is an established company which is looking to expand its fishing interests by purchasing a
100% interest in Shark Bait. The management of Marine Fisheries believes that the expected returns from the
acquisition of Shark Bait are dependent on the state of the econ my.
The following information is made available:
Estimated return
State of the Probability Marine Shark The
economy of occurrence Fish ri s Bait market
Favourable 0,3 16% 20% 14%
Neutral 0,4 10% 12% 8%
Unfavourable 0,3 2% 0% 6%
Book value in million 12m R8m –
Market value in million R8m R12m –
Standard deviation of returns 5,4% 7,8% 3,2%
Covariance with the market 0,0024 0,0023 –
The risk-free rate is 5% and there is no company or personal taxation.
Required:
Determine whether Marine Fisheries should acquire Shark Bait in line with the portfolio theory.
(13 marks)
Illustrate and explain what the term ‘risk premium’ means in the context of the portfolio theory and
calculate the required return for a portfolio that has the same return/risk characteristics as Marine Fisher-
ies. (8 marks)
Calculate, in line with the portfolio theory, how an investor can move along the capital market line to a
point that gives him a standard deviation equal to 6,4%. (Ignore Marine Fisheries and Shark Bait.)
(6 marks)
Determine whether Marine Fisheries and Shark Bait are a good investment in the context of the Capital
Asset Pricing Model. (8 marks)
Solution 5–2
(a) Determine whether Marine Fisheries should acquire Shark Bait in line with the portfolio theory.
Marine Fi heries expected return
State Return Expected
Mean
0,3 × 0,16 = 0,048
0,4 × 0,10 = 0,04
0,3 × 0,02 = 0,006
Mean 0,094 or 9,4%
σ 0,054 or 5,4%
168
Shark Bait expected return

State Return Expected
Mean
0,3 × 0,20 = 0,06
0,4 × 0,12 = 0,048
0,3 × 0 = 0
Mean 0,108 or 10,8%
σ 0,078 or 7,8%
Covariance: Marine Fisheries/Shark Bait
State Deviation Covariance
0,3 (0,16 – 0,094)(0,20 – 0,108) = 0,0018216
0,4 (0,10 – 0,094)(0,12 – 0,108) = 0,0000288
0,3 (0,02 – 0,094)(0 – 0,108) = 0,0023976
0,004248
Return: Marine Fisheries &Shark Bait combined

8* 12
× 9,4% + × 10,8% = 10,24
20** 20
Market value of Marine Fisheries
Combined market values of Marine Fisheries and Shark Bait
Risk =
2 2 2 2
0,4 × 0,054 + 0,6 × 078 + 2 × 0,4 × 0,6 × 0,004248
= 0,069 or 6,9%
The return of Marine Fisheries has increased by only 0,84%, while the risk has increased by 1,5%. The returns of
Marine Fisheries and Shark Bait are positively correlated; consequently one would not expect a reduction in risk.
The CV for Marine Fisheries is:
9,4
= 1,74
5,4
While that for the new company is:
10,24
= 1,48
6,9
which once again shows that Marine Fisheries offers a better return per R1 of risk.
Illustrate and explain what the term ‘risk premium’ means in the context of the portfolio theory and
calculate the required return for a portfolio that has the same return/risk characteristics as Marine
Fisheries.
Risk premium represents the required return above the risk-free rate that should be required on a portfolio
where risk is greater than zero.
It is expressed as:
σp (Rm – Rf)
σm
The required return for a portfolio with the same characteristics as Marine Fisheries is:
5,4
Rf + 3,2 (Rm – Rf)
5,4
= 5 + (9,2* – 5)
3,2
12,0875%
169
Market returns = (0,30 × 14%) + (0,40 × 8%) + (0,30 × 6%) = 9,2%
CML
Return
M
Rm
Risk Premium
Rf
σm
Risk
Calculate, in line with the portfolio theory, how an investor can move along the capital market line to a
point that gives him/her a standard deviation equal to 6,4%. (Ignore Marine Fisheries and Shark Bait.)
σi
Rf + (Rm – Rf)
σm
6,4
= 5 + (9,2 – 5)
3,2
= 13,4%
As the required risk is twice the market risk, an investor would have to borrow an amount equal to his/her
investment in the market portfolio at the risk-free rate and invest the whole amount in the market.
i.e. Borrow 1
Own capital 1
Invest in the market 2
Market return 9,2 × 2 = 18,4

Cost 5
Return 13,4%
Determine wh th r Marine Fisheries and Shark Bait are a good investment in the context of the Capital
Asset Pricing Mod l.
The required return for both ompanies is determined by:
ke = Rf + β (Rm – Rf)
β for Marine Fisheries β for Shark Bait
0,0024 0,0023
2 2
= 0,032 = 0,032
= 2,34 = 2,25
Marine Fisheries Shark Bait

Required return 5 + 2,34 (9,2 – 5) 5 + 2,25 (9,2 – 5)
= 14,828% = 14,45%
Expected return
= 9,4% = 10,8%
Both companies offer a return well below their required return. This means that both returns are below the
SML and are over-priced.
170

Bean Ltd is a division of Earl Enterprises and has been allocated R5 million for capital expansion in the forth-
coming year. The management of Bean Ltd believes that the company must spread its risk by investing in
projects with different risk profiles and has identified two possible investments.
The capital available to Bean Ltd is sufficient to invest in only one of the projects. The following information has
been made available:
Estimated return %
Economic growth Probability of Existing
(annual average) occurrence Project 1 Project 2 investments
Zero 0,3 14 8 6
3% 0,4 10 16 12
6% 0,3 8 22 16
Book value R5m R5m R10m
Market value R5m R5m R15m
The division manager has requested the accountant to determine which f the two projects should be accepted
using the portfolio theory to make the selection.
Required:
(a) Using the above information, calculate which invest ent Bean Ltd should select in line with the portfolio
theory. (20 marks)
Identify and describe the kind of risk the manag m nt of B an Ltd wishes to spread by investing in differ-
ent investments and state whether they should be concerned about reducing such risk. (8 marks)
(c) Explain how Bean Ltd could use the CAPM to evaluate the investment options available. (7 marks)
Solution 5–3
Using the above information, calculate which investment Bean Ltd should select in line with the portfo-
lio theory.
Project 1
(Return deviations)
2
Return % Probability Return deviations
× probability
14 × 0,3 = 4,2 3,4 3,468
10 × 0,4 = 4,0 – 0,6 0,144
8 × 0,3 = 2,4 – 2,6 2,028
M an 10,6 Variance 5,64
σ 2,37
Project 2
8 × 0,3 = 2,4 – 7,4 16,428
16 × 0,4 = 6,4 0,6 0,144
22 × 0,3 = 6,6 6,6 13,068
Mean 15,4 Variance 29,64
σ 5,44
Exi ting
6 × 0,3 = 1,8 – 5,4 8,748
12 × 0,4 = 4,8 ,6 0,144
16 × 0,3 = 4,8 4,6 6,348
Mean 11,4 Variance 15,24
σ 3,9
171
Covariance Project 1 + existing
Probability Return deviations Return deviations

Project 1 Existing
0,3 × 3,4 × – 5,4 = – 5,508
0,4 × – 0,6 × 0,6 = – 0,144
0,3 × – 2,6 × 4,6 = – 3,588
Covariance = – 9,24
Covariance Project 2 + existing

0,3 × – 7,4 × – 5,4 = + 11,988
0,4 × 0,6 × 0,6 = + 0,144
0,3 × 6,6 × 4,6 = + 9,108
Covariance = + 21,24
Expected return:
Project 1 + existing investments
5 15
10,6 × + 11,4 ×
20 20
= 11,2%

5 15
15,4 × + 11,4 ×
20 20
= 12,4%
Risk – Standard deviation of Projects + existing investments

2 2 2 2
w σ + w σ + 2w w COV
=
σp A A B B A B (A,B)
σp = 0,25 × 0,25 + 5,64 + 0,75 × 0,75 × 15,24 + 2 × 0,25 × 0,75 × – 9,24
2,34%
σp = 0,25 × 0,25 + 29,64 + 0,75 × 0,75 × 15,24 + 2 × 0,25 × 0,75 × 21,24
4,29%
The ab ve calculations indicate that Project 2 offers a higher return in comparison with Project 1 and has the
effect f increasing the portfolio return from 11,4% to 12,4%. However, the risk of the new portfolio (consisting
of Pr ject 2 + existing) increases from 3,9% to 4,29%. The combination of Project 1 plus existing reduces the
return by 0,2%, but has a significant effect on reducing the overall risk to 2,34% as the covariance is negative.
The company is advised to accept Project 1 on the basis of the significant risk reductions.
Identify and describe the kind of risk the management of Bean Ltd wishes to spread by investing in
different investments and state whether they should be concerned about reducing such risk.
The major determinant of the required return on an asset is its degree of risk. Risk refers to the probabilities
that the returns, and therefore the values of an asset or security, may have alternative outcomes. The measure
of risk is generally accepted as the standard deviation (σ) of an asset or security.
172
Two types of risk are identified or associated with a project –

unsystematic (avoidable) risk; and
systematic (unavoidable) risk.
Unsystematic risk may be referred to as firm specific risk. It is risk associated with the company’s func-
tions in the main areas of strategy, leadership, innovation, skills, processes, product- markets, capital
structure, etc. An investor can therefore reduce the unsystematic risk by holding a diversified portfolio.
Empirical studies show that most of the unsystematic risk is significantly reduced by portfolios consisting
of as few as ten securities.
Systematic risk cannot be avoided by diversification. Systematic risk is the fundamental risk that a share’s
possible return is exposed to, and is caused by general economic trends, po itical or social factors affect-
ing all companies simultaneously. Therefore, the relevant risk for n investment is the systematic risk.
As stated above, an investor has the ability to diversify away unsystematic risk and it is up to the investor
(not a company) to spread the investment in different companies in order to reduce his overall risk. A
company should concentrate its efforts on maximising its profits to the benefits of its shareholders.
(c) Explain how Bean Ltd could use the CAPM to evaluate the investment ptions available.
Given certain assumptions (including perfect capital markets and homogeneous investor expectations) the
CAPM states that the required rate of return on an invest ent is the risk- free rate plus a premium for system-
atic (un-diversifiable) risk expressed in terms of the market-risk pre ium. Systematic risk is measured by beta,
which relates the covariance between the expected return on the investment and expected return on the
market portfolio to the variance of the market portfolio. The model may be used in the determination of an
appropriate WACC to use as a discount rate in a capital inv stm nt. A discount rate is a rate which takes into
account the specific systematic risk of the project concerned. The model is, however, subject to criticism with
respect to its theoretical assumptions and practical application.
Bean Ltd should use the CAPM to determine the required rate of return for the two investments and compare that
return to the expected return. If the required return is lower than the expected return, the investment should be
accepted. If the required return is higher than the expected return, the investment should be rejected.
Diagrammatic illustration
If Project 1 has a beta of X and offers a return of A it should be rejected as it is below the SML. It is irrelevant
that it has a negative covariance with existing investments and that the overall risk is reduced. The CAPM
model states that at a level of systematic risk equal to X an investment must offer a return that is on the SML
line. If the investment had an expected return equal to B it should be accepted.
Return
SML
M Line
X
Beta
173

United Brew Limited is considering whether to accept one of two major new investment opportunities, Pro-ject
1 and Project 2. Each project would require an immediate outlay of R400 000 and United Brew expects to raise
sufficient funds to undertake one of the projects only.
The Directors of United Brew Limited believe that returns from existing activities and from the new projects
will depend on which of three economic environments prevails during the coming year. They estimate returns
for the coming year and the probabilities of the three possible environments as follows:
A B C
Probability of environment 0,3 0,4 0,3
% % %
Returns from Project 1 25 25 –5
Returns from Project 2 0 17,5 30
Aggregate returns from existing
Portfolio of projects – 10 20 30
The Directors of United Brew Limited are of the opinion that the risk and returns per R of market value of their
existing activities are similar to those for the stock market as a wh le, including their dependence on whichever
economic environment prevails.
The current rate of return on short-term government bonds and Treasury Bills is 10% per annum.
Required:
Calculate, for Projects 1 and 2:
The covariance with the market.
The beta values.
(iii) The required returns using the CAPM model. (18 marks)
Write a brief report to the Directors of United Brew Limited showing which, if either, of the two proposed
projects should be accepted in terms of the Portfolio theory and the CAPM. Explain the CAPM principles
used in arriving at the recommendation. (17 marks)
Solution 5–4
(i) Expected rates of return from Project 1, Project 2 and the company’s existing portfolio
Environment P Project 1 Project 2 Existing portfolio

A 0,3 0,25 0 – 0,1
B 0,4 0,25 0,175 0,2
C 0,3 – 0,05 0,3 0,3
Expected return 0,16 0,16 0,14
Variance of the ma ket

This can be estimated as the variance of the company’s existing portfolio.
p(rm – rm)
2
Environment P rm – rm
A 0,3 – 0,24 0,01728
B 0,4 0,06 0,00144
C 0,3 0,16 0,00768
σ
2
Variance 0,02640
Standard deviation σ 0,16248
174
Covariance of project returns with the market

Project 1 Project 2
Environment P (r1 – r 1) p(r1 – r1)(rm – rm) (r2 – r 2) p(r2 – r 2)(rm – rm)
A 0,3 0,09 – 0,00648 – 0,16 0,01152
B 0,4 0,09 0,00216 0,015 0,00036
C 0,3 – 0,21 – 0,01008 0,14 0,00672
Covariance – 0,01440 0,01860
(ii) The beta values of Projects 1 and 2
Covariance (Project 1 and Market)

β Project 1 =
Market variance
– 0,01440
= 0,02640 = – 0,545
(Note that as this is a negative β Project 1 is inversely related to the rest of the market)
Covariance (Project 2 and Market)
β Project 2 =
Market variance
0,01860
= = + 0,7045
0,02640
(iii)Required rates of return on each project
Project 1 = rf + β (rm – rf)

10% – 0,545 (14% – 10%)
7,82%
Project 2 = rf + β (rm – rf)
10% + 0,7045 (14% – 10%)
12,82%
Report to Directors of United Brew Limited

TO:
FROM:
DATE:
The acceptance of Project 1, rather than Project 2 is recommended. Both projects offer an expected return of
16%, but Proje t 1 only requires a return of 7,82% on a CAPM required return basis, in comparison with Pro-ject
2 which equi es a eturn of 12,82%.
Principles involved in the investment recommendation

The recommendation that Project 1 should be undertaken is made after taking into consideration the risk and
the expected return of the two projects, and how this relates to the company’s (and the stock market’s) exist-
ing risk and expected return relationship. It is based on the principles and conclusions of the portfolio theory.
This theory, under a set of restrictive assumptions, shows that when risky investments (i.e. investments whose
outcomes are uncertain) are combined (into a portfolio), the expected return that results is a simple weighted
average of the expected returns of the individual investments. However, the risk of the resulting combinations
(measured by the standard deviation or variance of the possible returns), may be less than, or equal to, the
weighted average of the risk of the individual investments. The actual outcome depends upon the sign and the
m gnitude of the correlation coefficients of the possible returns of the combined investments.
Therefore, when considering the addition of a new investment to an existing collection of investments, the
effect of the action on the company’s overall risk level is the point of importance in determining the required
return from the new investment. As a result, the required returns from the two investment projects under
175
consideration are determined not by their own overall risk levels (i.e. their standard deviations of possible
returns) but by the effect each would have (if accepted) on the overall risk level of the company.
One way of utilising this result is to divide an investment project’s overall risk level into two components, that
is, systematic and unsystematic risk. Systematic risk is, in effect, that part of an investment’s total risk which
actually affects the existing risk level of the company. Unsystematic risk is the residual part which can effective-
ly be ignored as it does not affect the company’s existing risk (it is in fact eliminated through the combining
process).
Therefore, in order to choose between the two projects, their respective levels of systematic risk have to be
found and used to estimate their required returns. These are then judged against their actual expected returns.
This procedure was carried out for the two investment projects under consideration, and it appears that both
produce an expected return above the level required by the systematic risk of e ch. However, the greatest
excess of expected return is likely to be provided by Project 1. Therefore this is deemed to be the preferred
alternative. This excess return should translate itself into an increased market price of the company’s equity
and enhance the shareholders’ wealth.
Two further points of importance need to be made to present a m re c rrect picture of the principles used when
arriving at the recommendation. Firstly, although the reas ning has been couched in terms of the rela-tionship
between project risk and the risk of the company, in truth the relationship of importance is between project
risk and general stock market risk. However, it is correct for United Brew to view the relationship in terms of
the project and the company, because the co pany’s risk and return is thought to reflect the risk and return of
the market as a whole.
The second point is that the portfolio theory is construct d und r a number of strict assumptions which may not
hold in the real world. However, its general conclusions are logically sound and probably form useful guidelines
for investment decision-making in practice. Of particular importance is the idea that an investment project’s
return should not be viewed in terms of its own overall risk level, but in terms of the effect of combin-ing it
with other investments on the overall risk of that combination.
Important: A company should only invest in projects that are in the same risk class as existing investments. It
would appear that Project 1 is in a different risk class; therefore it would be up to the shareholder
(not the company) to diversify.

The Directors of Marshall (Pty) Ltd are currently evaluating the investment in a new project and have extracted
the following information:
Marshall (Pty) Ltd Project Market
Expected returns 16,4% 28% 24%

Standard deviation of r turns 4% 6% 3%
Correlation of expected returns
with return on the market portfolio + 0,4 + 0,7
The cu ent isk-f ee rate is 8%.
The Directors of Marshall (Pty) Ltd have also established that the correlation between the returns of the project
and that of the company’s existing projects is + 0,1. If the project is accepted it would account for 10% of the
value of Marshall (Pty) Ltd after investing in the project.
Required:
Calculate the existing beta value and systematic risk of Marshall (Pty) Ltd and that of the proposed pro-
ject.
Ca culate Marshall (Pty) Ltd’s equity required return.
Calculate the company return of Marshall (Pty) Ltd after accepting the project and the standard deviation
using a two-asset portfolio formula.
Determine the project required return using the CAPM model, and briefly explain why the calculations in
(c) above appear to give conflicting project appraisal when compared to the result of using the CAPM
model.
176
Solution 5–5
Calculate the existing beta value and systematic risk of Marshall (Pty) Ltd and that of the proposed
project.
correlation × σp
Beta =
σm
4% × 0,4
Marshall = = 0,53
3%
6% × 0,7
Project = = 1,40
3%
Systematic risk
Marshall = 4 × 0,4 = 1,6%
Project = 6 × 0,7 = 4,2%
Calculate Marshall (Pty) Ltd’s equity required return.

Return = Rf + β(Rm – Rf)
= 8% + 0,53(24% – 8%) = 16,48%
Calculate the company return of Marshall (Pty) Ltd aft r accepting the project and the standard devia-
tion using a two-asset portfolio formula.
Return = (0,9 × 16,4%) + (0,1 × 28%) = 17,56%
Standard deviation of a two-asset portfolio
2 2 2 2
wM σ M + wP σ P + 2w wPCOV(M,P)
σm =
Where:
M = Marshall
P = Project
W = Weighting
As the covariance of Marshall and the project is not an available one can substitute covariance for correlation
multiplied by the standard deviation of Marshall and standard deviation of the Project.
σm =
2 2 2 2
0,9 × 4 + 0,1 × 6 + 2 × 0,9 × 0,1 × 4 × 6 × 0,1
13,752
3,71%
Note: Using the CAPM, the beta of Marshall + project
= (0,9 × 0,53) + (0,1 × 1,4) = 0,617
Required return: 8% + 0,617(24 – 8) = 17,872%
Determine the project required return using the CAPM model, and briefly explain why the calculations in
(c) above appear to give conflicting project appraisal when compared to the result of using the CAPM
model.
Project required return
8% + 1,4 (24% – 8%)
30,4%
177
30
28 30,4
Return 28%
% Project
24 Market
16,48 Marshall
Beta 0,53 0,617 1 1,4
As one can see from (c) above, the acceptance of the n w proj ct increases the expected return from 16,4% to
17,56%, and simultaneously reduces risk from 4% to 3,71%. This would appear to make the project highly
attractive to investors in Marshall. However, the required return from the project, based on the CAPM is
30,4%. Since the project is only expected to produce a 28% return, this would indicate rejection.
How can these apparently conflicting positions be reconciled? The answer lies in the distribution between
systematic and unsystematic risk. Systematic risk is that part of the risk of a particular security (i.e. variability in
return) that can be explained in terms of movements in the market. Unsystematic risk is that part of the varia-
bility in return that is due to events specific to the individual security. The CAPM ignores unsystematic risk
because it can be eliminated by diversification.
While acceptance of the project reduces the total risk of Marshall, it does not reduce the systematic risk; on
the contrary it increases it.
This may be demonstrated as follows:
Systematic risk
Beta =
Risk of the market
Beta Marshall (pre-proj ct) = 0,53

Beta project = 1,4
Beta of Marshall post-project = 0,9 × 0,53 + 0,1 × 1,4 = 0,62
Systematic isk post-project = 3 × 0,62 = 1,86%
Systematic isk p e-project = 1,60%
Increase in systematic risk = 0,26%
Req ired increase in return = 0,26% × (24 – 8) / 3 = 1,39%
Act al increase in return = (17,56% – 16,4%) = 1,16%
The increase in return is inadequate; therefore the project should be rejected
OR Beta of Marshall post-project 0,617
Beta of Marshall pre-project 0,53
Increased Beta 0,087
Required increase in return 0,087(24 – 8) = 1,392%

Actual increase = 1,16%
178

ABC (Pty) Ltd is a company operating in the retail industry in two cities within the province of Gauteng. The
company is privately owned with a staff complement of 100. The company is 60% debt funded.
DEF Ltd is a company that is also operating in the retail industry. The company is operating across South Africa
and has eight boards of directors. The company also has a staff compliment of 2 500. DEF Ltd is 80% debt
funded and has a beta of 0,7.
Additional information:
The market rate of return is 13%.
ABC (Pty) Ltd debt consists of a bank loan at 8,5% interest per annum.
Five-year Government Bonds are currently trading at 7%.
The tax rate in South Africa is 28%.
Required:
You are the FD of ABC (Pty) Ltd, and have been instructed by the MD to write a report covering the following
(show all your workings in an appendix to the report):
Calculate a suitable beta for ABC (Pty) Ltd, factoring in both financial and non-financial factors. (8 marks)
Discuss the difference between systematic and non-syste atic risks, and their impact on the beta of a
company. (5 marks)
(c) Calculate the cost of equity of ABC (Pty) Ltd. (6 marks)
(d) Calculate the weighted average cost of capital of ABC (Pty) Ltd. (6 marks)
The company has an opportunity to invest in a project yielding an annual return of 13% per annum.
Should the company embark on this project? (5 marks)
Solution 5–6
Calculate a suitable beta for ABC (Pty) Ltd, factoring in both financial and non-financial factors.
The beta of DEF would be used as a proxy beta. Since the company is a public company, has governance struc-
tures in place, a bigger staff complement than ABC and a larger foot print in terms of product markets its beta
would be lower than that of ABC.
The first step would be to ungear the beta of DEF using its own capital structure:
The formula to use is:
E
(β) ungeared = (β) g ar d ×
E + D(1 – t)
20
= 0,70 ×
20 + (80)(0,72)
= 0,18
The second step wo ld be to re-gear the beta of DEF using ABC’S capital structure:
The f rmula to use is:
E + D(1 – t)
(β) geared = (β) ungeared ×
E
40 + (60)(0,72)
= 0,18 ×
40
= 0,40
179
Discuss the difference between systematic and non-systematic risks, and their impact on the beta of a
company.
Systematic risk or market risk is risk that affects all market participants and is measured by the beta coefficient.
Economic fundamentals such as inflation, interest rates, foreign exchange, the price of key commodities such
as oil, consumer demand, etc., contribute to systematic risk. Unsystematic risk or firm specific risk is risk that is
peculiar to an individual firm. Issues such as leadership, innovation, capital structure, product/portfolios,
production processes, skills, etc., contribute to unsystematic risk. Systematic risk cannot be diversified away
but unsystematic risk can be diversified through managing effectively. Theoretically, since unsystematic risk can
be diversified away, total risk would be composed of market risk which is measured by the beta. Increasing
systematic risk increases the beta. The reverse is true.
Calculate the cost of equity of ABC (Pty) Ltd.
Using the CAPM:

Ke = Rf + β (Rm – Rf)
Ke = 7% + 0,4 (13% – 7%)
Ke = 9,4%
Calculate the after tax cost of debt:

Cost of ABC bank loan = 8,5%
The tax rate = 28%
The after-tax cost of debt = 8,5% (1 – 0,28)
Kd = 6,12%
Calculate the weighted average cost of capital of ABC (Pty) Ltd.
Funding Source Proportion Cost WACC

% %
Equity 0,40 9,4 3,76
Debt 0,60 6,12 3,67
Total 1,00 7,43
The company has an opportunity to invest in a project yielding an annual return of 13% per annum.
Should the company embark on this project?
Since the return of 13% on the project is higher than the cost of funds at 7,43, the company should invest in the
project provided the following is met:
The risk of the project is similar to the risk of the current portfolio of projects that the company currently is
invested in.
The funding of the project will not alter the capital structure of the company. Altering the capital structure
w uld pr bably increase the weighted average cost of capital.
180
Chapter 6
The investment
decision
apply different capital budgeting techniques to evaluate capital projects, asset acquisitions and
replacements;
appraise capital investment opportunities;
evaluate an investment decision and determine whether new capital assets should be acquired;
evaluate an investment decision and determine whether an existing capital asset should be replaced;
evaluate an investment decision and determine whether an existing capital asset should be abandoned
without replacing it with a new asset; and
calculate the following:
– payback period;
– discounted payback period;
– Net present value (NPV);
– Net present value Index (NPVI);
– Internal Rate of Return (IRR);
Modified Internal Rate of Return (MIRR); and
taking into consid ration the following:
– the treatm nt of taxation;
– the treatment of Inflation;
– the t eatment of un ertainty and risk;
– the t eatment of projects with different life cycles;
– capital rationing; and
take q alitative factors into account and consider the so-called ESG (environment, social and
governance) issues and equator principles;
perf rm sensitivity analyses;
appreciate the importance of sustainability as part of the investment decision; and
prepare International capital budgeting appraisals.
Adequate electricity supply, the Gauteng e-tolling issue and the failure of 1Time Airlines have highlighted the
importance of long-term capital budgeting. This is, however, just as applicable to small, medium and micro
businesses (SMMEs) when budgeting for plant, machinery, vehicles, office buildings and other expansions.
This chapter relies heavily on knowledge of the time value of money which was dealt with extensively in
chapter 3, while capital structure and the importance of WACC have been emphasised in chapter 4.
181
Companies regularly replace existing productive assets or purchase new assets to expand their business
operations. Both decisions require the company to evaluate the future cashflows to decide whether or not the
investment will increase the value of the company. The method used to evaluate investments is called capital
budgeting.
Capital budgeting forms part of the master budget and involves the planning for longer term projects, which
stretches out over more than one year. It is formulated within the framework of the strategic plan and involves
strategic decisions normally taken by senior management. There is often significant risk involved as the
monetary implications can be enormous, the entity is committing known resources today to an unknown and
uncertain future and once the decision has been made it is often irreversib e. Hence, capital budgeting
decisions should not be taken lightly!
6.1 Capital budgeting

The technique takes all future cashflows that are derived from the in estment and discounts them to Year 0 at
the target weighted average cost of capital (WACC), less the investment cost at Year 0. If the resultant net
present value (NPV) is positive, the investment is undertaken.
The first problem associated with a capital budgeting exercise is determining the basis of the investment
decision, by considering assumptions such as:
determining the appropriate discount rate, the target WACC;
estimating future sales, demand and cost structures;
the length of time that the project will run for; and
the value of the assets at the end of the project.
It is clear that a capital budgeting exercise requires an enormous amount of guess-work; therefore one must be
careful when evaluating the calculated NPV of a project.
The second problem that needs to be addressed when looking at new investment projects is how to finance
the investment. This is the subject of chapter 7 (The financing decision).
The two choices for finance are debt and equity. The important issue is whether the company has the capacity
to take on debt finance. In other words, the company must establish what it considers to be the optimal debt
to equity (D:E) ratio, determine how much debt and equity it currently has in issue and then decide whether it
already has too much debt or whether it is in a position to take on more debt to finance the new project.
There are various schools of thought on the correct WACC to be used when evaluating new investment
decisions, and whether the finance decision should be made before or after the investment decision.
6.2 Correct WACC to be used

The following views have b n put forward by various authors:
The method of finan e should be determined first, because the correct rate to evaluate the investment
decision is the rate attributable to the method of finance.
The method of finance should be determined first, because the correct WACC required to evaluate a new
investment is the marginal WACC, which incorporates the current WACC plus the new proportion of
finance to be acquired.
All investments should be evaluated at the target WACC and, if the investment yields a positive NPV, then
the c mpany must determine the correct financing strategy that will move towards the target D:E ratio in
the l ng-term.
The authors are of the opinion that the only acceptable method is (c), as this method ensures that all projects
of equal bu iness risk are evaluated on an equal basis without prejudice to the method of finance.
Examp e: Cost of capital and financing position

A company has two divisions; one in Pretoria and the other in Cape Town. All capital requirements are handled
by the Head Office, which is situated in Durban. The current capital structure of the company at market value is
as follows:
Equity R3 000 000 Required return 20%
Debt R2 000 000 Required return 12%
182
The investment decision Chapter 6
The company believes that the optimal capital structure for the type of business that it is involved in is 50%
equity and 50% debt. It does however accept that from time to time the capital structure will be in dis-
equilibrium, but it will in the long- term strive towards a target of 50% debt:50% equity. Its target WACC is
therefore 16% (50% × 20% ke + 50% × 12% kd).
The Pretoria division requires R1 500 000 for a new capital project that will yield a return of 16%.
The Cape Town division requires the same capital amount for an identical project yielding a return of 16%.
Required:
Determine the correct cost of capital that should be used to evaluate the two projects, and how they should be
financed.
Solution:
Evaluating the projects at the rate used to finance the project
Head Office would look at the required R1,5 million from the Pret ria divisi n and decide that it would finance
the project (if accepted) using debt, because it is the cheapest f rm f finance and the company has the capacity
to take on debt finance as it is currently below the target of 50:50.
The required return from the Pretoria investment, if evaluated at the cost of debt rate, would be 12%;
therefore, as the project yields a return of 16%, it would be accepted.
When Head Office looks at the identical investment in the Cape Town division, it may decide as follows:
Current equity R3 000 000
Current debt R3 500 000 (after Pretoria investment).
As the company has too much debt relative to the target ratio, it may decide to finance the new project using
equity funding. If the company evaluates the project at the equity required return of 20%, it would reject the
project because it only yields a return of 16%.
The above argument is incorrect as it is evaluating two identical projects at different required returns. This is
inconsistent with the principle of divisional performance evaluation where the required return should be the
same for identical business operations.
Evaluating the projects at the Weighted Marginal Cost of Capital (WMCC)

Once again, because the Pretoria division requested the finance first, Head Office would use debt financing as it
is cheaper than equity to fund the Pretoria project, and calculate the cost of capital as:
Return Proportion WMCC
Equity R3 000 000 20% R3,0m / R6,5m 9,23%
Debt R2 000 000 12% R2,0m / R6,5m 3,69%
Debt (Pretoria) R1 500 000 12% R1,5m / R6,5m 2,77%
R6 500 000 15,69%
As the project yields a eturn higher than 15,69%, it would accept the Pretoria project.
As the company now has too much debt in its capital structure, a decision would now be made to finance the
Cape Town project sing equity funds; therefore the new WMCC would be determined as follows:
Return Proportion WMCC
Equity R3 000 000 20% R3,0m / R8,0m 7,5%
Equity(Cape) R1 500 000 20% R1,5m / R8,0m 3,75%
Debt R3 500 000 12% R3,5m / R8,0m 5,25%
R8 000 000 16,5%
The required return is now 16,5%, but as the Cape Town project only offers a return of 16%, it would be
rejected. Again identical investments are being evaluated at different rates, yielding inconsistent results and
creating problems in evaluating divisional performance. The WMCC allows the type of finance to influence the
cost of capital and is no better than evaluating an investment at the required rate of return equal to the
method of finance.
183
The correct method – evaluating the projects at a target WACC
The target WACC is:

Ratio Return WACC
Equity 50% 20% 10%
Debt 50% 12% 6%
16%
Using the target cost of capital of 16% to evaluate the two identical projects wi yie d consistent decisions and
allow both divisions’ performance to be evaluated on an equitable basis.
Assuming that both investments are accepted, the financing decision would be c rried out as follows:
Current equity R3 000 000
Current debt R2 000 000
Required finance R3 000 000
R8 000 000
Optimal capital structure Current capital Finance capacity

Equity R4 000 000 – R3 000 000 = R1 000 000
Debt R4 000 000 – R2 000 000 = R2 000 000
R8 000 000 – R5 000 000 = R3 000 000
The company may therefore opt to finance the new investments by raising R1 million equity and R2 million
debt. It may also decide to finance solely by debt, with the next project to be financed by equity. This is to
avoid the costs or raising both debt and equity simultaneously, as it may be desirable to minimise these so-
called ‘double flotation’ costs.
Note: It is not necessary for a company to be at its target structure at any particular point in time, but it
should strive towards the target in the long-term.
Notes regarding the investment decision versus the financing decision:

It is important to note that financing costs are excluded from calculations under the investment decision,
but included in calculations under the financing decision.
Under the investment decision cashflows are discounted at the WACC, while under the financing decision
cash flows are discounted at the after-tax cost of debt.
Depreciation is not a cashflow, but indeed a component of the cashflow of taxation payable.
6.3 Traditional methods of investment appraisal

Before doing an in-depth analysis of evaluating an investment project by discounting the future cashflows at an
appropriate ta get WACC, other methods that may be used to evaluate an investment are considered.
Payback period method

The payback period method represents a simple calculation or estimate of how long it will take a company to
get the investment cost repaid. It is a simple method that gives an investor a gut-feel for risk over a period of
time. The longer it takes to break even, the higher the risk associated with the project.
The payback period is only useful as a crude method of estimating how long a company will be in the red
before it can start to make some money. The lower the payback period, the lower the ‘time-risk’ of the project.
The method is intuitive and simple to understand.
The severe down-side of the payback period method is that it ignores inflation and the cost associated with
ime. There is a risk associated with receiving money later rather than sooner. That risk has a cost which is
measured using the WACC, which allows for business risk as well as financial risk requirement. Allowing for
business and financial risk means that the payback period could be considerably longer.
184
In comparing investments under the payback period method, one simply determines the number of years it
will take to recover the initial investment.
Example: Payback
Year Investment A Investment B
0 Capital outlay (30 000) (50 000)
1 Expected cash inflow 4 000 15 000
6 Expected cash inflow 4 000 –
Investment A’s payback period is 3,75 years;
Investment B’s payback period is 4 years.
This is derived by adding up the cash inflows and determining the p int in time at which the inflows equals the
initial outlay.
In the case of A, this would be 4 000 (Y1) + 8 000 (Y2) + 12 000 (Y3) + 6 000 (Y4) = 30 000.
This calculation indicates that the project pays for itself so eti e in Year 4. The question is: how long into Year 4?
Note that the total inflow in Y4 is 8 000, and 6 000 of this 8 000 is required to total the initial outlay of 30 000.
So the ‘proportion of time’ is 6 000 / 8 000 = 0,75 of a year. Therefore the payback is 3,75 years.
In the case of B, this would be 15 000 (Y1) + 15 000 (Y2) + 10 000 (Y3) + 10 000 (Y4) = 50 000. The calculation
reveals that the project pays for itself in exactly four years.
On the basis of the payback period method, Investment A is better than Investment B as it pays itself off in a
shorter time.
Companies sometimes set a limit for a project to break even. Small projects may have a two- or three-year
required payback before a project is accepted. Large projects may allow for longer payback periods, as long as
they offer higher returns once they break even. However, this method is simplistic and has a major weakness in
that it ignores the time value of money. It also ignores the cashflows after the payback period. Nevertheless, it
can be a useful starting point or screening mechanism.
Discounted payback period method

When using the discounted payback period method, one takes into account the time value of money, that is
one discounts back any future cashflows to a present value and then compares the investments on a payback
basis.
This method simply states that R1 today is worth more than R1 at the end of the year. The risk associated with
time must be ompensated at a rate that equals business plus financial risk. This rate is called the weighted
average cost of capital (WACC).
Example: Disco nted payback

If a company has a WACC of 10%, this means that R10 invested today is expected to grow to R11 after a period
of 1 year r (in reverse) R11 at the end of 1 year has a present value of 11 / (1 + 0,1) = R10 today.
The example presented above indicates the following assessment, assuming that the company has a WACC of
8%.
185
For the above example, if the time preference rate is 8%, then the investment appraisal is as follows:
Year Investment Investment PV PV ‘A’ PV ‘B’
factor
A B 8%
0 (30 000) (50 000) 1 (30 000) (50 000)
1 4 000 15 000 0,9259 3 704 13 888
2 8 000 15 000 0,8573 6 858 12 860
3 12 000 10 000 0,7938 9 526 7 938
4 8 000 10 000 0,7350 5 880 7 350
5 5 000 15 000 0,6806 3 403 10 209
6 4 000 – 0,6302 2 521 –
1 892 2 245
Investment A’s discounted payback period is 5,25 years.

Investment B’s discounted payback period is 4,75 years.
Note that to derive the PV factors, enter 1 / 1,08 for Year 1 n the calculator, and thereafter divide each answer
by 1,08. Thus:
Y1 1 / 1,08 = 0,9259
Y2 0,9259 / 1,08 = 0,8573
Y3 0,8573 / 1,08 = 0,7938
Y4 0,7938 / 1,08 = 0,7350
Y5 0,7350 / 1,08 = 0,6806
and so on.
The discounted payback period method is useful in assessing the amount of time it will take to break even in
terms of cashflow. It allows for risk to be evaluated over a time frame. Once again, it is a good starting point,
but it should never be used as the sole method of analysing an investment. Its major drawback is that it ignores
the cashflows after the payback period.
Net present value method (NPV)

Shareholders are a key stakeholder constituent since they provide equity and hence the entity should
compensate its shareholders for the risks associated with the business and to yield a return higher than the
assessed business risk. This method is generally accepted as the correct conceptual method of analysing an
investment decision and is seen to be superior to other methods based on the assumptions that it makes. As
with any business assessment, it relies on (at best) accurate data, which is not always available, or at least well
researched data. Busin ss is not an exact science and any attempt to treat it as such will lead to bad decisions.
Important assumptions
The NPV method assumes that all cashflows that are received as a result of an investment will be used by the
company to yield a etu n equal to the WACC. Where, for example, a company receives R10 000 at the end of
Year 1 with a p oject life of five years, one assumes that from Year 2 to Year 5 the R10 000 will be invested at
the WACC.
4
= R10 000 × (1,10)
Or F t re val e = R14 641
(where WACC is equal to 10%)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Actual – R10 000
Equiva ent – – – – – R14 641
R10 000 at the end of Year 1 is equivalent to R14 641 at the end of Year 5.
R14 641
Proof : Present value at t1 = = R10 000
(1 + 0,10)
4
186
Calculating the present value back to Year 0 reveals that
Actual R10 000 = R9 090,91

(1 + 0,10)
Equivalent at Year 5 R14 641 = R9 090,91

5
(1 + 0,10)
Conclusion:
All intermediate cashflows are assumed to be re-invested at the company’s WACC.
The NPV is the present value of future returns discounted at the company’s t rget WACC, minus the cost of the
investment. For independent investments, if the NPV is positive, the project should be accepted; if it is
negative, the project should be rejected. If two projects are mutually exclusi e, the one with the higher NPV
index should be chosen. When a company accepts a project with a positi e NPV, the value of the company
increases by that amount. Therefore the NPV method chooses pr jects to maximise share value.
Key concepts and terminology

Note that in the conclusion section above, reference is ade to projects that are independent and mutually
exclusive. At this point it would therefore be useful to define unique ter s relevant to capital budgeting:
Independent events
Two events are independent of each other wh n the occurrence of one event has no influence on the
probability of the other event occurring. For example, a change in the gold price isn’t likely to determine
the success of our sporting teams. However, should the rand weaken against the United States dollar, this
will have a positive impact on South Africa’s export prices and make the gold mines more profitable.
Independent projects
The acceptance or rejection of one project has no bearing or influence on the acceptance or rejection of
any other project. In short, you can choose or reject either or both projects.
Mutually exclusive events
Mutually exclusive events are those that cannot occur simultaneously. For instance, it is not possible for
the rand exchange rate to strengthen and weaken simultaneously against the dollar. The foreign
exchange market does not work like that. However, it is possible that the rand can strengthen against the
euro and weaken against the dollar or vice versa, or weaken or strengthen against both. Hence, the
rand/dollar and the rand/euro exchange rate movements are not mutually exclusive events. Are they
independent events though? Over the long-term, probably not. This is due to the South African inflation
rate exceeding that of both the USA and Europe. Hence, the expectation is that the rand will weaken
against both of th se curr ncies.
Mutually ex lusive projects
Mutually ex lusive projects are projects where only one of several alternatives may be chosen at a time.
Rolling a ‘six’ or a ‘two’ with a die represents mutually exclusive events. A six and a two cannot be rolled
simultaneously, so the probability of both happening together equals nil. In effect, if two projects are m t
ally excl sive and they both meet the minimum financial return criteria, the acceptance of one
immediately (and automatically) leads to the rejection of the other.
Capital rationing refers to the situation where an enterprise is unable to initiate all available apparently
viable pr jects because of limited funds. Consequently choices have to be made as to which combination
of projects derive the total highest return subject to the funds available.
Single-period capital rationing
Single-period capital rationing refers to the situation where the shortage of funds is limited to the present
period only, while it is anticipated that sufficient funds will be available in subsequent periods.
Multi-period capital rationing
Multi-period capital rationing refers to the situation where the shortage of funds is expected to extend
over a number of periods.
187
Divisible projects
Divisible projects are projects where the whole project or any fraction thereof may be initiated. In other
words, the project can be reduced or increased in size, or broken into smaller projects.
Indivisible projects
Indivisible projects are those where a whole project must be undertaken in its entirety or not at all. In
other words, such a project cannot be broken into smaller sizes, or scaled up or down.
Example:
Period Project A Project B Project C
0 (50 000) (30 000) (40 000)
1 14 000 4 000 20 000
2 20 000 8 000 20 000
3 26 000 12 000 5 000
4 5 000 10 000 –
5 – 9 000 –
Assume the WACC to be 8%.
Required:
Calculate the NPV.
Solution:
NPV Project A
Period Cashflow Factor PV
0 (50 000) 1 (50 000)
1 14 000 0,9259 12 962
2 20 000 0,8573 17 146
3 26 000 0,7938 20 639
4 5 000 0,7350 3 675
NPV R4 422
NPV Project B 3 563

NPV Project C R(367)
The above example has two potential problems:
The investment amounts are different for each project
Can one compare Proj ct A to Project B when one project requires an investment of R50 000 while the other
only requir s R30 000?
Yes, one can, and one an further conclude that Project A is better than Project B as it has a higher NPV.
Howeve , it may be argued that Project B only requires R30 000, which leaves the company with an extra
R20 000 to invest elsewhere. That is correct, but one should assume that the extra R20 000 will be invested
at the company’s WACC and yield a nil NPV (i.e. actual return equals WACC, which is the required return).
Project A R50 000 Net return R4 422
Pr ject B R30 000 Net return R3 563
+ R20 000 Net return Nil
Total R50 000 R3 563
If it were possible to invest in multiple/divisible amounts of Project B, then the solution would be as fo
ows:
Project A R50 000 Net return R4 422
Project B R30 000 Net return R3 563
+ R20 000 Net return 2 375 [3 563 × 2 / 3]
Total R50 000 R5 938
188
In this case, if one can invest in 1,6667 of Project B (R30 000 × 1,6667 = R50 000), the new NPV derived
from B is greater than simply investing R50 000 in Project A. Thus, it makes sense to scale up Project B from
R30 000 to R50 000. (Note this is only possible as B is divisible).
2 The lives of the projects are different

All three projects have different lives.
Project A = 4 years
Project B = 5 years
Project C = 3 years
Can the three projects be compared?
Yes, if one assumes that cashflows from Projects A and C are re-invested in the company at the WACC of the
company. In other words, future benefits have a nil NPV.
Net present value index method (NPVI)

Advantages and disadvantages of NPV
NPV and IRR are often referred to as discounted cashflow techniques as they focus on cashflow rather than
profit.
NPV assumes that –
investors seek to maximise their wealth in terms of cash;
capital markets are perfect; and
investors are risk-averse.
The assumption that capital markets are perfect does not hold in the real world, due to uncertainty. Perfect
capital markets imply that future outcomes and events are known, and the capital market rate would reflect
the future outcomes. NPV also assumes that the risk of a particular project can be identified and reflected in
the appropriate discount rate. Real world situations show that risk cannot be identified accurately.
Note: The discount rate used in all NPV appraisals assumes that all cash received before the end of the
project can be re-invested at the discount rate.
This is sometimes referred to as the profitability index (PI). Net present value index (NPVI) is defined as the
ratio of (Initial investment + NPV) / Initial investment. NPVI is a method used when projects with different
initial outlays are compared and capital rationing is applicable. The ratio results in the NPV per R1 investment:
Single-period capital rationing
In situations wh re capital rationing is applicable, the rule of accepting all projects with positive NPVs no
longer applies. The NPVI method is then used to choose between the various projects. Projects with the
highest NPVI are favoured, subject to the funding constraints.
Note, howeve , that selection based on relative NPVI ranking may not be optimal. One should allocate
scarce funds amongst a combination of projects that collectively derive the highest NPV.
M lti-period capital rationing
Divisible projects subject to multi-period capital rationing can be ranked using linear programming
techniques, by optimising NPV per limiting factor, which is scarce capital in this case. Indivisible projects
subject to multi-period capital rationing can be ranked by using integer programming techniques, which
fall outside the scope of this book.
As per the previous example, since the initial capital outlay is different and the possibility of capital rationing
exists, the decision should be based on NPVI.
Project A 54 422 ÷ 50 000 = 1,09
Project B 33 563 ÷ 30 000 = 1,12
Project C 39 633 ÷ 40 000 = 0,99
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Therefore B is preferred, even though NPV A > NPV B.

Note: The ranking of Project B above Project A can only be used where there are several projects available
with a positive NPV and one is attempting to maximise return, and available capital is rationed.
Therefore, projects will need to be placed in order of preference to ensure best utilisation of scarce
funds.
Example 1: Capital rationing

A company has R50 000 available and can choose from the following three projects:
Investment NPV NPV index Ranking
A 50 000 4 422 1,09 2
B 30 000 3 563 1,12 1
C 20 000 1 437 1,07 3
To maximise return, the company must invest in Projects B and C.

Investment NPV
B 30 000 3 563
C 20 000 1 437
5 000
Why should the company invest in B and C?

The total investment for B + C = 50 000, which falls within the capital rationing constraint.
The total NPV for A + B = 7 985; however, the total investment required is 80 000.
The total NPV for A + C = 5 859; however, the total investment required is 70 000.
What if there was no investment constraint (i.e. no capital rationing)?

Then all three projects should be accepted, because they all generate a positive NPV.
Example 2: Indivisible projects

A company has R50 000 available and can choose from the following three projects, all of which are indivisible,
implying that only part of the investment cannot be undertaken:
Investment NPV NPV index
A 50 000 4 422 1,09
B 30 000 3 563 1,12
C 40 000 – 367 0,99
Solution:
Take Project A only, be ause it generates the highest absolute NPV. Even though its NPVI is lower than Project
B’s, Project B cannot be s aled up, because the projects are indivisible.
All projects with a positive NPV should be accepted. This assumes that all desirable projects can be funded by
the company. This is not always the case, however, as cash is not necessarily available. Equity providers are not
an instant so rce of funding and may not have funds available at a particular point in time. They may also be
reluctant to seek f nding from new shareholders as it may dilute their personal holdings. Company growth must
be managed and shareholders are often reluctant to see a company expanding too fast as it may increase
company risk.
Debt providers may have certain criteria that the company needs to meet before they are willing to provide
further funding. High debt ratios will restrict further borrowing to finance projects with positive NPV.
Different project life cycles

Replacement chains
Where mutually exclusive projects with different lives exist, one uses the technique of replacement chains,
where one calculates the NPV with infinite replicated cashflows.
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The calculation is carried out by dividing the NPV of the project by the product of the present value of an
annuity at the given rate for the cashflow period of the project and the discount rate.
Calculated NPV
NPV to ∞ =
PV(annuity) × r
Where:
PV(annuity) = the annuity for a period equal to the cashflow years
r = the discount rate
Example: Different lives

Two mutually exclusive investments have the following cashflows:
Cashflow Cashflow
Project A Project B
Year 0 (10 000) (10 000)
Year 1 2 300 1 100
Year 2 3 000 1 600
Year 3 3 500 2 000
Year 4 3 400 2 300
Year 5 3 100 2 500
Year 6 2 900
Year 7 3 100
Year 8 4 000
NPV @ 12% 857 1 049
PV(annuity) 3,605 4,968
(12%, 5 years) (12%, 8 years)
Required:
Determine the NPV to ∞ for each project.
Solution:
NPV to ∞ for Project A – i.e. a perpetuity of 238 (the equivalent annual income – see below) at 12%
857
= = 1 981
3,605 × 0,12
NPV to ∞ for Project B – i.e. a perpetuity of R211 (the equivalent annual income – see below) at 12%
1 049
= = 1 760
4,968 × 0,12
Applying the NPV rule would result in Project B being chosen in preference to Project A, on the basis that
Project B’s NPV of 1 049 is greater than Project A’s 857. However, using the NPV to ∞, Project A is superior to
Project B, on the assumption that in the long-term both projects can be replaced to ∞ at the same
replacement cost and same expected cashflows.
Note also that the projects are mutually exclusive and thus only one project can be chosen.
Equivalent annual income (i.e. maximising NPV per annum)

Where mutually exclusive projects with unequal useful lives have to be considered, one could maximise the
NPV per limiting factor, namely time, by utilising the equivalent annual income method.
According to this method, the NPV of each alternative investment opportunity is divided by the present value
of R1 per period factor (i.e. the PV of an annuity factor).
Alternative solution to the previous example

Equivalent annual income for Project A = 857 / 3,605 = R238
Equivalent annual income for Project B = 1 049 / 4,968 = R211
As in the previous example, Project A is superior to Project B – by determining the NPV per annum in this case.
191
Internal rate of return method (IRR)

The IRR is the cost of capital that equates the present value of the expected future cashflows or receipts to the
initial cash outlay. The IRR formula is the same as the NPV formula, except that it sets the NPV at nil and solves
for the discount rate. In short, the IRR is the cost of capital, where the NPV of the project is equal to nil. The IRR
must be found by trial and error unless the expected cashflows are equal and can be treated as an annuity. For
independent projects, if the IRR is greater than the WACC, the value of the company increases and the project
should be accepted. If it is equal to the WACC, the company breaks even; if the IRR is less than the WACC, the
project should be rejected. If two projects are mutually exclusive, the one with the higher IRR should be
accepted.
Example: IRR
Period Project A Project B
0 (20 000) (5 000)
1 10 000 1 000
2 10 000 3 000
3 4 000 3 000
Required:
Calculate the IRR for Projects A and B.
Solution:
Project A at 12%
Period Cashflow PV factor NPV
0 (20 000) × 1 = (20 000)
1 10 000 × 0,8929 = 8 929
2 10 000 × 0,7972 = 7 972
3 4 000 × 0,7118 = 2 847
NPV (252)
Project A at 10%
0 (20 000) × 1 = (20 000)
1 10 000 × 0,9091 = 9 091
2 10 000 × 0,8264 = 8 264
3 4 000 × 0,7513 = 3 005
NPV 360
IRR = approximately 11%.
Interpolation
A more acc rate res lt (although not an absolutely correct one) can be obtained in the above example by using a
techniq e known as interpolation.
The f rmula f r interpolation is: A + [P / (P + N) × (B – A)]
Where:
A = Di count rate which gives a + NPV
B = Di count rate which gives a – NPV
P = Positive NPV
N = Negative NPV
Thus interpolating for the example above, that is between 10% and 12% is: 10%
+ [ 360 / (360 + 252) × (12% – 10%) ] = 11,1765% (round to 11,2%)
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Alternatively, one can show as follows:
Discount rate 10% ? 12%

NPV + R360 0 (R252)
In effect, one is attempting to solve for the ‘?’, which is the discount rate where the NPV = 0. Decreasing the
discount rate increases the NPV, whereas increasing the discount rate decreases the NPV. By establishing that
10% derives a positive NPV (+R360) and 12% a negative NPV (–R252), we know that the IRR is between 10% and
12%.
1
IRR = 10% + [(360 – 0) / (360 + 252)*] × (12% – 10%) = 11,2% (rounded to /10 of a %)
(*Strictly speaking, this should read (360 – – 252). But as two negative signs re +, we add the two NPVs).
Project B at 16%
0 (5 000) × 1 = (5 000)
1 1 000 × 0,8621 = 862
2 3 000 × 0,7432 = 2 230
3 3 000 × 0,6407 = 1 922
NPV 14
Project B at 18%
0 (5 000) × 1 = (5 000)
1 1 000 × 0,8475 = 847
2 3 000 × 0,7182 = 2 154
3 3 000 × 0,6086 = 1 825
NPV (174)
Therefore IRR = approximately 16%.
Advantages and disadvantages of I

IRR’s main advantage is the fact that a project is appraised in terms of rate of return – a concept which has
wide acceptance with management. The IRR assumes that all cash receipts can be re-invested at the IRR.
However, the re-investment rate is often lower than the IRR, thus invalidating the investment choice arrived at
using IRR.
A further problem is that a proj ct may have more than one IRR. Where the cashflows are standard (only one
change in the cash-flow sign) th re will be only one IRR. Where the cashflows are non-standard (more than one
change in the ash-flow sign), the project will have multiple internal rates of return. As a general rule, a project
will have as many inte nal rates of return as its cashflow has changes of sign.
Comparative example of NPV and IRR

Two m t ally excl sive projects (A and B) are being considered. The discount rate (target WACC) for both pr jects
is 10% and all funds can be invested at that rate. The following table shows the initial outlay and cashfl ws
which ccur at the end of the year.
Year Project A Project B
0 Cashflow (50 000) (50 000)
1 Cashflow 25 000 Nil
2 Cashflow 20 000 8 000
3 Cashflow 20 000 25 000
4 Cashflow 15 000 65 000
Required:
Determine which of the two projects should be selected using the NPV and IRR techniques.
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Solution:
NPV calculation at 10%
Project A Project B
NPV + R14 527 + R19 790
IRR calculation
IRR 24% 21%
Using the NPV rule, Project B should be chosen, whilst the IRR method favours Project A. This shows a conflict
in the ranking. What should one do if the projects are mutually exclusive?
Reason for the difference:

Examining the two projects reveals that Project B’s cashflow takes place towards the end of the project. This
means that interest on early cashflows has very little influence on the total income generated by the project. By
contrast, Project A generates most of its income in the early years and the interest received on early cashflows
is very substantial.
If one looks at terminal values, one sees this more clearly, as follows:
Assuming that interim cashflows are re-invested at 10% (i.e. the WACC).
Proj ct A Project B
Outlay (50 000) (50 000)
Cashflow 80 000 98 000
Interest on interim cashflows 14 475 4 180
Net return Year 4 44 475 R52 180
At the low re-investment rate, Project B is preferable to Project A.
Assuming a re-investment rate of 20% (i.e. closer to the IRR)

Project A Project B
Outlay (50 000) (50 000)
Cashflow 80 000 98 000
Interest on interim cashflows 28 950 8 360
Net return Year 4 R58 950 R56 360
At the higher re-investment rate (which is closer to the IRR), the early cashflows from Project A substantially
increase the interest factor, showing Project A to be preferable to Project B.
The IRR technique assumes that early cashflows can be re-invested at the IRR rate. This assumption is only
correct where the NPV rate (which considers risk) is the same as the IRR rate.
Conclusion:
The NPV method is s perior to the IRR method, as the NPV method assumes that all cashflows are re-invested
at the WACC and not the project’s IRR.
M dified internal rate of return method (MIRR)

The NPV method of investment evaluation assumes that all cashflows will be re-invested at the WACC to the
end of the project life. This assumption is acceptable as it assumes that a company is able to yield a return
equal to the optimal business plus finance risk or target WACC.
The IRR method makes the erroneous assumption that cashflows are re-invested at the IRR. To correct the re-
investment problem, one may use the MIRR, which is consistent with NPV.
The MIRR takes all intermediate cashflows and calculates the future value to the end of the project at a re-
investment rate equal to the WACC.
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To simplify: the first step is to calculate the future value (using the WACC) of the sum of the cash inflows for
each year to the end of the project and then compute the NPV and the IRR in the normal way. The revised
cashflow will now show an outlay in Year 0 and the sum of the total cash inflows as a lump sum in the final
year, with nil cashflows in between. This is better explained by working through an example:
Example: Modified internal rate of return (MIRR)

Using the figures in the previous example, one has:
WACC = 10%
Year Project A Project B
0 Cashflow (50 000) (50 000)
1 Cashflow 25 000 Nil
2 Cashflow 20 000 8 000
3 Cashflow 20 000 25 000
4 Cashflow 15 000 65 000
Pr ject A Project B
NPV + R14 527 + R19 790
IRR 24% 21%
Required:
Calculate the MIRR where WACC = 10%.
Solution:
Project A Future value at Year 4
Year 0 (50 000) 3
Year 1 25 000 25 000 × (1,1) = 33 275
2
Year 2 20 000 20 000 × (1,1) = 24 200
Year 3 20 000 20 000 × 1,1 = 22 000
Year 4 15 000 15 000 × 1 = 15 000
94 475
The results are:

Year 0 (50 000)
Year 1 0
Year 2 0
Year 3 0
Year 4 + 94 475
NPV = 14 527
MIRR = 17,2429% (Calculated IRR on adjusted cashflows)
Project B Future value at Year 4
Year 0 (50 000)
Year 1 – 2
Year 2 8 000 8 000 × (1,1) = 9 680
Year 3 25 000 25 000 × 1,1 = 27 500
Year 4 65 000 65 000 × 1 = 65 000
102 180
This re ults in the following:
Year 0 (50 000)
Year 1 0
Year 2 0
Year 3 0
Year 4 + 102 180
NPV = 19 790
MIRR = 19,564% (Calculated IRR on adjusted cashflows)
195
Conclusion:
Project B now shows a higher NPV as well as MIRR in comparison to Project A.
MIRR is consistent with the NPV calculation.
6.4 The investment decision

All investment decisions should be evaluated at the target WACC. Where the target is assumed to be the
current WACC of the company at market values, one further assumes that –
all projects being evaluated are of the same risk class;
(b) the project is marginal and will not alter the value of the company subst nti lly; nd
current WACC = target WACC.
Most investment decisions involve the investment in new capital equipment or the replacement of existing
equipment.
Inflation
Concepts and terminology
General inflation
General inflation can be defined as the incr ase in the average price of goods and services, normally
linked to the retail price index (RPI), which is bas d on a basket of consumer goods.
Synchronised inflation
Synchronised inflation occurs when all costs and revenues rise at the same rate as general inflation.
Differential inflation
Differential inflation relates to the more common situation where the various costs and revenues do not
all rise at the same rate as general inflation, for example the cost of capital equipment, labour and
medical aid revenues.
Money cashflow
Money cashflows refer to cashflows to which an amount is added to compensate for the effects of
inflation.
Money rate of return
The money rate of return or nominal rate is defined
as: [(1 + R) (1 + i)] – 1
Where:
R = R al rate of return; and
i = Inflation
Money cashflows should be discounted at the money rate of return, while real cashflows should be discounted
at the real ate of etu n. It might be preferable to use money cashflows and money rates of return, because
taxation incentives are usually expressed as money flows.
The current shareholders’ required return, ke, as well as the current cost of debt, kd, includes inflation. The m
ney rate r n minal rate is the current rate that includes inflation. The real rate is the required rate where inflati
n is nil.
The relationship between the money (nominal) rate, real rate and inflation is as
follows: (1 + M) = (1 + R)(1 + i )
From which follows that the money rate (nominal rate)
M = [(1 + R) (1 + i)] – 1
Where:
M = Money (nominal) rate
R = Real rate
i = inflation.
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Example: Money rate of return (nominal rate)

Inflation is running at 6% and an investor requires a real return of 10%.
Required:
Calculate the required money (nominal) rate M.
Solution:
Nominal rate M = [(1 + 0,10)(1 + 0,06)] – 1
(1,10)(1,06) – 1
0,166 or 16,6%
Notes:
The nominal rate of 16,6% is nearly, but not exactly 16% (10% + 6%).
It is important to note that when discounting at the money (n minal) rate, inflation must be included in the
estimated future cashflows.
Example: Real rate of return

Inflation is running at 5% and an investor requires a nominal return of 15%.
Required:
Calculate the required real rate of return R.
Solution:
(1 + M) = (1 + R) / (1 + i ) per definition
Therefore (1 + R) = (1 + M) / (1 + i ))
= (1 + 0,15) / (1 + 0,05)
= (1,15) / (1,05)
= 1,0952
Therefore R = 1,0952 – 1 = 0,0952 = 9,52%
Notes:
The real rate of 9,52% is almost, but not exactly 10% (15% – 5%).
It is important to note that when discounting at the real rate of return, inflation must NOT be included in
the estimated future ashflows.
Example: Comparing calculations with real and nominal rates of return

The req ired real rate of return is 10%. Inflation is currently 5%.
Evaluate a pr ject that will cost R500 000 today and offers the following cashflows at today’s prices:
Year 1 + 180 000
Year 2 + 300 000
Year 3 + 200 000
Required:
Ev lu te the investment at:
Real rates of return.
Nominal rates of return.
197
Solution:
Real rates of return
The information provided above clearly states that all cashflows are at today’s prices, that is, inflation has
not been taken into account. The required return is also stated at the real rate of return (also known as
the clean return) and represents the required return excluding inflation.
Note: If one discounts the future cashflows at the real rate of return and ignores the effect of inflation
altogether, per the figures below, one will obtain exactly the same NPV as if one had included
the effects of inflation in the cashflows and discounted at the nominal rate.
PV factors calculated at (1 + 0,10)
PV 10% PV
Year 0 (500 000) 1 (500 000)
Year 1 + 180 000 0,909 163 620
Year 2 + 300 000 0,826 247 800
Year 3 + 200 000 0,751 150 200
NPV + 61 620
Conclusion:
Accept the investment as it offers a positive NPV.
Nominal rates of return

Always assume that the shareholders’ required rate of return, ke, as well as the debt-providers’ required
return, kd, as given in a question, represent the nominal rate of return unless the question specifically
states that the required return excludes inflation. Assume further that the cashflows as given include
inflation and no adjustments are required unless otherwise stated.
In this example, one must allow for inflation when determining the nominal discount rate as well as the
future cashflows in order to apply the nominal discount method.
Nominal rate = [(1 + 0,10) (1 +0,05)] – 1
= 0,155 or 15,5%
Discount rate = 15,5% or (1 + 0,155)
PV 15,5% PV
Year 0 (500 000) × 1 = (500 000) 1 (500 000)
Year 1 180 000 × 1,05 = 189 000 0,866 163 674
Year 2 300 000 × (1,05)2 = 330 750 0,749 247 731
3
Year 3 200 000 × (1,05) = 231 525 0,649 150 260
NPV 61 665
Conclusion:
Accept the investment as it offers a positive NPV.
Note: The difference of R45 when comparing (a) to (b) above is due to rounding off of the PV factors.
Relevant costs and revenues

In apprai ing any project, care must be taken that only those cashflows which would arise as a result of the
investment decision are taken into consideration. Any costs that have already been incurred, such as product
or market research, are sunk costs and should be ignored.
Example: Relevant costs

To date, a company has spent R3 million on research and development on a product. The company is now
considering whether it should proceed with the investment. If it does, it will incur further cash outflows of
198
R1 million in Year 0 and R2 million in Year 2. It will also need to utilise employees currently employed who are
performing tasks at a cost of R200 000 per annum, whereas employing new employees would only cost R50
000 per annum. The company has the following raw materials:
A 100 000 kgs cost R5 million Realisable value R2 million
Replacement value R7 million
B 100 000 kgs cost R3 million Realisable value R1 million
Replacement value R2 million
C 100 000 kgs cost R2 million Realisable value (R1 mi ion)
Replacement value R1 mi ion
The company requires:

150 000 kgs
50 000 kgs
20 000 kgs this year and 50 000 kgs next year.
A is not regularly used, and B and C have no further use if not used f r this pr ject.
Note: C will incur a disposal cost of R1 million.
Required:
Determine the relevant cost for each cost item above.
Solution:
Research and development of R3 million
The question states that the company is currently considering whether it should proceed with the investment
or abandon it. In this instance, the R3 million is a sunk cost (it has already been spent) and must be excluded.
However, when the question states that a company is considering an investment that will require R3 million
research and development expenditure (it is still to be spent), after which the company will invest X and receive
Y cashflows; then the R3 million is relevant.
Further investments of R1 million in Year 0 and R2 million in Year 2

The cashflows are relevant and must be included, as they can be avoided (i.e. not incurred) if one chooses not
to undertake the investment, but are outflows if the investment is accepted.
Labour costs
The company is curr ntly paying R200 000 to employees who can be replaced with new employees at a cost of
only R50 000. The existing employees can then be re-deployed to a new project. The relevant cost is R50 000,
as this represents the in remental (or additional) cost to the company. Students often struggle with this
concept. Note that as the existing employees will be re-deployed, the company will continue to pay their
salaries and so nothing changes insofar as the R200 000 to existing employees are concerned. Hence the R200
000 is not relevant to the decision. (Assuming that the existing employees were NOT re-deployed, then what?
The project would now generate a cost-saving of R150 000, that being the difference between the existing labo
r costs of R200 000 and the new labour costs of R50 000.)
Raw materials
A R2 million for the first 100 000 kgs, (not regularly used so relevant cost is realisable value)
50 000
R7 million × for next 50 000 kgs (use replacement value)
100 000
50 000
B R1 million × (replacement cost – not relevant)
100 000
20 000
C This year ‘saving’ of × R1 million = R 200 000 positive cashflow
100 000
199
Assuming that the balance of 80 000 kgs is disposed of in the current year, next year’s required 50 000 kgs will
cost R500 000.
However, if raw material C is still available, the relevant cost is a saving
of: 50 000 / 100 000 × R1 million = R500 000 positive cashflow.
Opportunity costs and revenues

Only the incremental costs and revenues that arise as a result of a project should be included in the cashflows
that are appraised. The marginal analysis should be used.
Example:
A company is currently manufacturing a product that requires five machine hours of manufacturing time per
unit. The product generates a contribution of R50 per unit. The machine is operating at full capacity.
The company is now considering the manufacture of a new product that has the following cashflows:
Selling price R100
Materials (30)
Labour (20)
Allocated overheads (10)
Profit R40
The product requires two hours of machine time.
Required:
Determine the relevant cashflow if the new product is manufactured.
Solution:
As machine time is fully utilised, the company would have to produce less of the existing product to enable it to
produce the new product.
For every hour of machine time that is used to produce the new product, the company will have to forego or
‘lose’ R50 / 5 = R10 per machine hour.
The opportunity cost of utilising machine time is therefore R10 × 2 = R20 for each unit of the new product.
Relevant cashflow
Selling price R100
Material (30)
Labour (20)
Opportunity ost (20)
Relevant ost R30
Note: The R10 allocated overhead has been left out as it is assumed that there is no incremental overhead
cost if the new product is undertaken (in other words, the R10 is a sunk cost).
However, if the question is clear that the company will incur additional overheads of R10 per unit, then they
must be included.
If the R10 overhead was in fact a variable machine cost, that is R5 per hour, the question would be tricky, as the
overhead cost of R10 would have to be included, as well as the opportunity cost of R20.
Discount rate (cost of capital)

The discount rate used in appraising a project should be the company’s cost of capital calculated on the basis of
he company’s risk profile, as well as that of the project.
An implicit assumption of importance is that the new project does not alter the basic risk structure of the
company.
200
Changes in working capital requirements

Any annual increase or decrease in stock, debtors or creditors must be accounted for. As sales increase (or
decrease), one must assume that working capital will increase (or decrease) by the same ratio.
Example: Working capital changes

A company is considering an investment that offers the following cashflows before taking into account working
capital requirements:
Year 1 R1 million
Year 2 R1,2 million
Year 3 R1,5 million
Working capital equal to 20% of cashflow will be required at the ‘beginning’ of e ch year.
Required:
Calculate the working capital cashflows.
Solution:
Year 0 (200 000) [ R1m × 20% ]
Year 1 (40 000) [ (R1,2m – R1m) × 20% ]
Year 2 (60 000) [ (R1,5m – R1,2m) × 20% ]
Year 3 + 300 000
As cashflows increase due to increased sales, one can assume that debtors and stock will also increase and
need to be financed. The question states that the cashflow for working capital is required at the beginning of
the year, thus the one-year time lag. The R300 000 at the end of Year 3 occurs as the project ends and working
capital is realised (i.e. stock is sold, and debtors pay).
The financing of the project

All financing considerations must be ignored. This means that interest expenditure which is tax deductible must
also be ignored in the cashflows. The reason is that the interest has already been accounted for in the cost of
capital; one would thus be double counting if it was included in the calculation for the investment decision.
Tax losses
When a company has a tax loss and as a result of utilising that loss it has no further tax liability during the life
of the project being evaluated, the question arises of whether that tax loss should be brought to account.
In theory, the answ r is ‘no’, because the investment should stand or fall on its own. The fact that the
investment is being partially financed by a tax loss should not cloud the decision about whether it passes the
critical test of giving a return greater than the WACC.
It may however be a gued that the tax loss cannot be utilised unless the company accepts the investment being
evaluated. Under such extenuating circumstances, the tax loss should be brought to account. Note, however,
that the principle is to evaluate an investment free of all financing considerations.
Recoupment/scrapping allowances
Calculate the rec upment or scrapping allowance at the end of the project.
Taxation time lags

Where there is a tax time lag, ensure that you allow for it. Where a question is silent about the timing of tax p
yments, you must assume that the taxation is paid in the same year as the cashflows occur.
6.4.10 Tax allowances

The question should indicate how to account for the tax allowances. However, if the question is silent on tax
allowances, one must assume that the current tax allowances as per current tax legislation are applicable.
201
Example: Opportunity costs plus tax consequences

A close corporation has an asset with a nil tax value. The company has decided to sell the asset for R20 000 and
replace it with a new asset at a cost of R100 000. The new asset will be written-off for tax purposes as allowed
by the SARS as follows:
Year 1 70%
Year 2 30%
At the end of Year 5, the new asset will be sold for R40 000.
Tax rate 40%
Target WACC 10%
Required:
Show the consequences of replacing the asset on an NPV value basis where there is –
no tax lag; and
a one-year tax lag.
Solution:
When a company replaces one asset with another, one ust be very careful to keep the two transactions
separate.
The company may, in fact, have three choices –

sell the asset and stop manufacturing altogether; or
continue manufacturing with the old asset; or
replace the old asset with the new asset.
Insofar as option 1 is concerned, the company may have no intention whatsoever of selling the asset, and
discontinuing operations altogether. Nevertheless, this option 1 gives rise to an opportunity cost.
Evaluating option 2 with no tax lag

If the company continues with the existing machine, there is an opportunity cost of selling the machine.
In this case, the solution is as follows:
PV PV
10%
Year 0 Sell – opportunity sales value (20 000) 1 (20 000)
Year 0 Opportunity r coupment 20 000 × 40% = 8 000 1 8 000
NPV (12 000)
If the company sells the asset, one must ask why the sale is treated as a negative cashflow. The reason is
that in doing so, the company is foregoing the opportunity of selling the asset altogether. If it did sell the
asset, it would receive + R12 000 after tax. Not selling the asset means that the company must make at
least R12 000 to be better off as a result of continuing to use the asset. Opportunity costs are always
treated as the opposite of the actual cashflow, that is if the actual cashflow is + R10 000 then the
pp rtunity cost (or cashflow foregone) is – R10 000. If the cashflow were – R10 000, then the
rtunity cost would be + R10 000.
Evaluating option 2 with a tax lag

PV PV
10%
Year 0 Sell – opportunity sales value (20 000) 1 (20 000)
Year 1 Opportunity recoupment 20 000 × 40% = 8 000 0,909 7 272
NPV (12 728)
202
(c) Evaluating option 3

PV PV
10%
Year 0 Purchase (100 000) 1 (100 000)
Year 1 Wear-and-tear 100 000 × 70% × 40% = 28 000 0,909 25 452
Year 5 Sell 40 000 0,621 24 840
Year 5 Recoupment 40 000 × 40% = (16 000) 0,621 (9 936)
NPV (49 732)
If one were to compare option 2 with option 3, the conclusion would be th t it is better to continue with
the old machine as there is a R37 732 saving, that is:
– R12 000 – (– R49 732) = R37 732
This assumes that other cashflows would be the same under both considerations.
Evaluating option 3 with a tax lag

PV PV
10%
Year 0 Purchase (100 000) 1 (100 000)
Year 5 Sell 40 000 0,621 24 840
Year 6 Recoupment 40 000 × 40% = (16 000) 0,564 (9 024)
NPV (52 044)
An alternative calculation, combining the two choices (i.e. continue and replace), that is, a marginal
analysis, without a tax lag:
PV PV
10%
Year 0 Sell – Opportunity sales value = –20 000 1 + 20 000
Year 0 Opportunity recoupment 20 000 × 40% = – +8 000 1 – 8 000
Year 0 Purchase = –100 000 1 – 100 000
Year 1 Wear-and-tear100 000 × 70% × 40% = 28 000 0,909 + 25 452
Year 2 Wear-and-tear100 000 × 30% × 40% = 12 000 0,826 + 9 912
Year 5 Sell 40 000 0,621 + 24 840
Year 5 Recoupment40 000 × 40% = –16 000 0,621 – 9 936
NPV – 37 732
The opportunity cost is now a positive R20 000 and the recoupment a negative of R8 000, because this is
a marginal analysis, that is, one is calculating the net investment in comparison to selling the machine
outright.
Note: (ve y impo tant): Doing a marginal analysis creates a new problem, as two decisions have been
combined. If doing a marginal analysis results in a positive NPV, all that is being said is that it is
better to replace than to continue ‘as is’ The new investment must still be evaluated on its own,
to see whether it provides a positive NPV on its own merits. If it does not, it is better to sell the
machine outright.
Example: New investment

Govender & Naidoo Incorporated is considering a new project that will require an investment of R1 million in
new machinery. The machinery will be depreciated over the five-year life of the project.
For t x purposes, SARS will allow a wear-and-tear allowance of 60% at the end of the year in which the m chine
is first used. A 40% wear-and-tear allowance will be made at the end of the second year.
The project will last five years. The equipment will be sold for R300 000 at the end of the project. The new
equipment will be financed by way of a loan at a cost of 10% per annum. The capital will be repaid over the
period of the project.
203
Working capital requirements:

Beginning of the project R200 000
End of Year 1 Increase by R80 000
End of Year 3 Decrease by 20%
The company has a tax loss of R100 000 but it is making positive cashflows from other projects.
Year 1 Statement of Comprehensive Income R
Sales 1 200 000
Variable costs (720 000)
Fixed costs (280 000)
Depreciation (200 000)
Interest (100 000)
Profit (100 000)
Sales are expected to increase by 10% for the first two years and stabilise thereafter.
Assume the following:

1-year tax lag
ke = 20%
kd = 10%
Tax = 40%
Current D:E ratio 30:70
Target D:E ratio 40:60
Required:
Evaluate the project investment.
Solution:
kd after tax = 10% × 60% 6%
Target WACC = 40:60 (6% × 40%) + (20% × 60%)
14,4%
Cashflow calculation (R000s)

Sales 1 200
Variable costs (720)
Contribution 480 + 10% 528 + 10% 580,8 580,8 580,8
Fixed costs (280) (280) (280) (280) (280)
Cashflow 200 248 300,8 300,8 300,8
Working capital: Remember to liquidate the working capital at the end of the project, that is:
200 000 + 80 000 – 56 000 = R224 000
Ignore the tax loss of R100 000. The question states that the company has other positive cashflows. Assume
that cashfl w will cover the tax loss.
N te: Evaluate the investment on a stand-alone basis.
It might be easier and clearer to show your workings, limit mistakes and check yourself by doing the ca cu
ations in columns per year, especially when utilising spreadsheets.
204
Investment evaluation:
YEARS
0 1 2 3 4 5 6
R R R R R R R
Investment (1 000 000)
Sale at end of life 300 000
Working capital (200 000) (80 000) 56 000 224 000
Cashflows 200 000 248 000 300 800 300 800 300 800
Taxation 1 160 000 60 800 (120 320) (120 320) (240 320)
Net cash
in-/outflow (1 200 000) 120 000 408 000 417 600 180 480 704 480 (240 320)
Factor @ 14,4% 1,000 0,874 0,764 0,668 0,584 0,510 0,446
NPV p.a. (1 200 000) 104 880 311 712 278 957 105 400 359 285 (107 183)
Total NPV (146 949)
1 Taxation:
YEARS
0 1 2 3 4 5 6
R R R R R R
Cashflows 200 000 248 000 300 800 300 800 300 800
Wear-and-tear 2 (600 000) (400 000)
Recoupment on
sale 300 000
(400 000) (152 000) 300 800 300 800 600 800
Taxation @ 40% 160 000 60 800 (120 320) (120 320) (240 320)
There is a tax lag of one year.
2 Wear-and-tear % of investment: 60% 40%
Conclusion:
Reject the project as it does not meet the required return of 14,4%.
6.5 The keep versus replacement investment decision

Many capital budgeting problems involve the consideration of continued operation with existing machines, or
replacement with a new machine, or discontinued operations.
The decision process is as follows:

Determine whether the marginal revenues and costs from the replacement of the new machine will yield
a positive NPV.
This may be done in one of two ways. Either calculate the marginal NPV or calculate the total NPV for
contin ed prod ction and the NPV for replacement. The resultant difference should be positive.
Having determined that replacement is better than continued operation, consider whether it would be
preferable to discontinue production altogether.
Example 1: Keep, replace or shutdown

Exi ting machine: Book value =0 Current realisable (market) value = R10 000
Rep acement machine: Current cost = R20 000
Net total positive cashflows over the life of the assets have been determined as a present value of R7 000 for
he existing machine and R18 000 for the new machine. The cashflows do not include the investment cost.
Assume that there is no taxation.
205
Required:
Determine whether the company should continue as is with the existing machine, replace it with the new
machine, or cease operations altogether.
Solution:
Many students have difficulty in evaluating the replacement of an existing investment. Often this analysis is
done incorrectly as follows:
Cost of new machine (20 000)

Sale of old machine 10 000
Cashflows from new machine 18 000
NPV (positive therefore accept) 8 000
Why is the above calculation incorrect? In short, we want to analyse the in estment decision on its own merits,
irrespective of how it is to be financed. By selling the old machine and using the proceeds to finance the sale of
the new machine, we are mixing the investment and financing decisi n t gether. This is incorrect.
The best way of evaluating this type of decision is to:
1 Evaluate the continuation of the existing machine without the new investment.
2 Evaluate the new investment on its own, without accounting for the existing value of the asset that will be
sold or the existing cashflows from that asset.
3 Choose either 1 or 2 based on the option that shows the highest NPV. If both have a negative NPV, then
cease operations. The options are therefore:
1 Existing machine:
Opportunity cost (10 000)
Existing cashflows 7 000
NPV (3 000)
The existing machine has a nil book value, but it can be sold for R10 000, therefore the company must
choose between selling the machine and having R10 000 now, or continuing with the machine, which gives
an equivalent value (today) of 7 000. The company is therefore R3 000 worse off if it continues as is. The
current market value of R10 000 represents the opportunity foregone of selling the machine.
Note: Opportunity costs represent positive cashflows for a particular decision. Since the company has
opted not to go with that decision (sell in this case) the amount must be charged as a negative
cashflow (opportunity cost) to continuing as is.
2 New investment: (as a stand-alone):
Cost (20 000)
Cashflows 18 000
NPV (2 000)
The new machine yields a negative NPV and must also be rejected.
Conclusion:
In this example, the third option prevails as the company will be better off if it discontinues production alt
gether, as b th choices yield a negative NPV.
However, if the company replaces the existing machine, it will sell the old machine for R10 000. To reinforce
what was di cussed earlier, because the sale of the old machine is a finance issue, one must omit the R10 000 sa
e. Whether one finances the new machine with new money or with money from the sale of an existing asset, it
shou d have no influence or effect on the investment decision. For instance, the company may choose to use
the c sh from the sale of the asset to pay a dividend and finance the new investment from the issue of new sh
res or from debt finance.
The calculations above show that the new machine will reduce the loss from R3 000 to R2 000. The new
machine is better than the old machine by a marginal amount of R1 000.
206
Alternative evaluation method – marginal analysis

This method is not recommended unless the incremental or marginal cashflows are provided.
The marginal analysis method combines the evaluations of the existing machine and the new machine. The
above solution shows that the new investment is marginally better by R1 000, which is the expected result of
the marginal analysis. Where a marginal analysis is undertaken, two valuations are required –
evaluate the new investment on an incremental cash-flow basis; and
evaluate the new investment on its own.
Step 1 Marginal analysis

Sell existing machine + R10 000
New machine (R20 000)
Net cost (R10 000)
Cashflows R11 000
NPV R1 000
Conclusion:
The new machine is better than the old machine by R1 000. As de onstrated earlier, this is due to the new
machine having a negative NPV of (R2 000) compared with the existing machine having a negative NPV of (R3
000).
Note: Repeating what was shown earlier, the analysis above is often done in error as follows:
Sell existing machine + 10 000
New machine ( 20 000)
Net cost (R10 000)
Cashflows R18 000
NPV R8 000
Incorrect conclusion:
The new machine is better than the old machine by R8 000.
Step 2Evaluate the new machine on its own

Cost (20 000)
Cashflows 18 000
NPV (2 000)
Conclusion:
Although the new machine is better than the existing machine due to incremental positive cashflows, the
investment m st be rejected, because the new machine has a negative NPV. The company will be better off if it
discontin es operations altogether.

Nutcracker Company is considering replacing an existing machine with a tax value of R50 000 for a new, more
efficient machine at a cost of R250 000. The old machine can be sold for R60 000 today or for R10 000 after five
years. The e timated useful life of the new machine is five years, after which it will be sold for R40 000.
Current New machine
(per annum)
Sales R100 000 R140 000
Cost of sales
Variable R56 000 R42 000
Fixed R30 000 R30 000
207
Depreciation has not been included in the above costs. Interest repayment on the new machine will be R10 000
per annum. The company will borrow 50% of the cash required at 16% from its bankers. The cost of capital is
13%.
The current tax rate is 40%; assume that there is a one-year lag in the payment of tax.
Also assume that the wear-and-tear for both the existing machine and the new machine is to be written off in
full at the end of Year 1.
Required:
Determine whether the company should replace the existing machine, close down or continue production on
the current basis.
Solution (on a total basis):

Every capital budgeting question requires an evaluation of certain fundamental principles. It is therefore better
to address these principles one by one and present in a logical order. Consider the following issues and
associated principles, which are addressed in the solution that f ll ws:
Issues – Principles
Asset purchase – Opportunity cost (do you forgo the opportunity to sell the existing asset? If so,
this gives rise to an opportunity cost)
– Opportunity recoupm nt on sale of asset (by forgoing the opportunity of selling
the existing asset now, m ans that the tax on recoupment that would be payable
is now avoided)
– Wear-and-tear (ignored when computing operating cashflows, but relevant for
the tax computation)
– Sale of asset (if there are cash proceeds from the sale of the asset, it must be
included, but only when actually sold)
– Scrapping/recoupment on sale of asset and tax implications thereof (if the sale
proceeds exceeds the tax value, this gives rise to recoupment. If the reverse then
a scrapping allowance is applied)
Cashflows – After-tax cashflows that emanate from the project (as tax is payable, the after-tax
cashflows must be derived)
– Relevant revenues and costs only (for instance overhead costs that don’t change
are not relevant)
– Depreciation ignored (non-cashflow expense)
– Int rest ignored (accounted for in the discount rate, that is, the target WACC)
Working apital – Working capital ‘returns’. (Note: the sum of all changes must equal nil)
Tax – Take cognisance of tax losses
– Time lags (tax payments made or refunds due aren’t necessarily paid in the
period they pertain to)
208
Keep Existing machine
YEARS
0 1 2 3 4 5 6
R R R R R R R
Opportunity cost:
Current realisable
value forfeited (60 000)
Working capital 0 0
Cash flows 14 000 14 000 14 000 14 000 14 000
Taxation 1 3 000 10 800 (4 200) (4 200) (4 200) (7 200)
Net cash in/outflow (60 000) 17 000 24 800 9 800 9 800 19 800 (7 200)
Factor @ 13% 1,0000 0,8850 0,7831 0,6931 0,6133 0,5428 0,4803
NPV pa (60 000) 15 045 19 421 6 792 6 010 10 747 (3 458)
Total NPV (5 442)
1 Taxation for Keep:
YEARS
0 1 2 3 4 5 6
R R R R R
Opportunity benefit:
Tax recoupment
avoided 2 (10 000)
Tax recoupment on
sale 10 000
Cash flows 14 000 14 000 14 000 14 000 14 000
Wear and tear 3 (50 000)
Taxable income (10 000) (36 000) 14 000 14 000 14 000 24 000
Taxation @ 30% 3 000 10 800 (4 200) (4 200) (4 200) (7 200)

2 Taxable amount reduced by not selling existing machine = R60 000 – R50 000 = R10 000.
3 Wear and tear % of inv stm nt: 100% in second year.
Acquire New machine
YEARS
0 1 2 3 4 5 6
R R R R R R R
Investment (250 000)
W rking capital 0 0
Cash fl ws 68 000 68 000 68 000 68 000 68 000
Taxation 1 54 600 (20 400) (20 400) (20 400) (32 400)
Net ca h in/outflow (250 000) 68 000 122 600 47 600 47 600 87 600 (32 400)
Factor @ 13% 1,0000 0,8850 0,7831 0,6931 0,6133 0,5428 0,4803
NPV pa (250 000) 60 180 96 008 32 992 29 193 47 549 (15 562)
Total NPV 360
209
1 Taxation for New:
YEARS
0 1 2 3 4 5 6
R R R R R R R
Cash flows 68 000 68 000 68 000 68 000 68 000
Tax recoupment on
sale 40 000
Taxable income (182 000) 68 000 68 000 68 000 108 000
Taxation @ 30% 54 600 (20 400) (20 400) (20 400) (32 400)

2 Wear and tear % of investment: 100% in second year.
Solution on a marginal basis
(i.e. it combines the Keep and New)
YEARS
0 1 2 3 4 5 6
R R R R R R R
Net investment 2 (190 000)
Sale at end of life 3 30 000
Working capital 0 0
Cash flows 4 54 000 54 000 54 000 54 000 54 000
Taxation 1 (3 000) 43 800 (16 200) (16 200) (16 200) (25 200)
Factor @ 13% 1,0000 0,8850 0,7831 0,6931 0,6133 0,5428 0,4803
NPV pa (190 000) 45 135 76 587 26 199 23 183 36 802 (12 104)
Total NPV 5 802
1 Taxation:
YEARS
0 1 2 3 4 5 6
R R R R R R R
Cash flows 4 54 000 54 000 54 000 54 000 54 000
Tax recoupment on
sale 30 000
Oppo tunity benefit:
Tax ecoupment
avoided 6 10 000
10 000 (146 000) 54 000 54 000 54 000 84 000
Taxati n @ 30% (3 000) 43 800 (16 200) (16 200) (16 200) (25 200)
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Supporting calculations:

New Existing Combined*
2 Net investment (250 000) less (60 000) equals (190 000)
3 Sale at end of life 40 000 less 10 000 equals 30 000
3 Tax recoupment (12 000) less (3 000) equals (9 000)
4 Cash flows 68 000 less 14 000 equals 54 000
4 Tax on cash flow (20 400) less (4 200) equals (16 200)
5 Wear and tear 8 (250 000) less (50 000) equals (200 000)
5 30% x Wear and tear 75 000 less 15 000 equals 60 000
6 Opportunity benefit:
Tax recoupment avoided 0 less 3 000 equals (3 000)
7 Total NPV* as above 360 less (5 442) equals 5 802
* NPV calculation of R5 802 :
Figures as per last column above: Factor NPV*

2 Net investment (190 000) 1,0000 (190 000)
3 Sale at end of life 30 000 0,5428 16 284
3 Tax recoupment (9 000) 0,4803 (4 323)
4 Cash flows 54 000 3,5173 189 934
4 Tax on cash flow (16 200) 3,1126 (50 424)
1
5 Wear and tear (200 000) N/A
5 30% x Wear and tear 60 000 0,7831 46 986
6 Opportunity benefit:
Tax recoupment avoided (3 000) 0,8850 (2 655)
7 Total NPV* of R 5 802 as above 5 802
1 Not a cash flow, only the taxation thereon is
Conclusion:
The new machine should therefore replace the old machine, although the NPV is only marginally positive. The
disadvantage of the marginal approach is that the combined NPV may be positive even when the new machine
reduces the loss, but not earning 13%. In such a case where the NPV of the new machine is negative, the old
machine should be disposed of without acquiring the new machine.
Note (very important):

By doing a marginal analysis, we are creating a new problem, as we have combined two decisions into one. If,
as a result of doing a marginal analysis, we come to a positive NPV, all we are saying is that it is better to
replace than to ontinue as is.
We still need to evaluate the new investment on its own to see whether it provides a positive NPV on its own
merits. If it does not, we conclude that we are better off by simply selling the existing machine without
replacing it. Hence it is preferable to do the two calculations separately.
Additional notes:
Be careful that you don’t omit a negative sign in the formulas, for example when calculating tax from
taxable income.
Check that taxable income and taxation have opposite signs.
Wear and tear has a negative sign because it decreases taxable income.
In the case of the existing machine the current selling price of R60 000 is forfeited, therefore reducing
inflows by R60 000, resulting in a negative inflow.
In the tax calculation of the existing machine the tax recoupment of R10 000 has been avoided, therefore
decreasing the taxable income (accompanied by a negative sign).
211

A company is considering replacing an existing machine with a nil tax value with a new machine that has a
greater capacity and lower operating costs. The existing machine and the new machine each have a life of five
years.
Existing machine New machine
Current market value R250 000 Purchase price R400 000
Sale value in 5 years R40 000 Sale value in 5 years R100 000
Annual cashflows R50 000 Annual cashflows R110 000
Assume no tax. Target WACC is 20%.
The company accountant evaluated the two options as

follows: Keep existing machine
Discount
20% PV
Year 1–5 Annual cashflows 50 000 2,99 149 500
Year 5 Sell machine 40 000 0,40 16 000
NPV 165 500
Replace with new machine

Discount
20% PV
Year 0 Sell existing machine 250 000 1 250 000
Year 0 Buy new machine (400 000) 1 (400 000)
Year 5 Sell new machine 100 000 0,40 40 000
NPV 218 900
The accountant concluded that the company should replace the existing machine with the new machine as the
new machine has a higher NPV value.
Required:
Evaluate the investment in the new machine.
Solution:
There are three options available to the company –
sell the machine and discontinue operations altogether; or
continue with the existing machine; or
purchase the new machine.
There are several methods for evaluating the three options.
Evaluation: Option 2 (Continue)

Discount
20% PV
Year 0 Opportunity cost – sale (250 000) 1 (250 000)
Year 5 Sell existing machine 40 000 0,40 16 000
NPV (84 500)
Recommendation: Option 2
The existing machine does not provide a positive NPV and must therefore be sold or replaced by the new
machine.
212
Evaluation: Option 3
Discount
20% PV
NPV (31 100)
Recommendation: Option 3
The new machine also yields a negative NPV and must not be purchased. The best choice is to sell the existing
machine and discontinue operations, that is, option 1.
Alternative evaluation of new machine on a marginal basis

Step 1
Discount
20% PV
Year 0 Sell existing machine 250 000 1 250 000
Year 5 Opportunity cost – sell old machine (40 000) 0,40 (16 000)
Year 1–5 Incremental cashflows 60 000 2,99 179 400
NPV 53 400
Conclusion (marginal analysis):

The new machine is better than the old machine by R53 400; however, one must establish whether it provides
a positive NPV.
Step 2 Evaluate the new machine on its own

The calculations above indicate that the new machine has a negative NPV of R31 100.
Final conclusion:
Sell the existing machine and discontinue operations.
Note: The positive NPV of R53 400 is equal to the difference between the loss from the old machine and the
loss from the new machine.
R
Existing ma hine (84 500)
Less: New ma hine (31 100)
Net imp ovement 53 400
In other words, the loss has been reduced by R53 400.
6.6 Investing in an asset via an operating lease

When a company is considering an investment in a new project, it has the choice of buying the required assets
outright, renting them, or investing via an operating lease.
If the company is very confident that the investment will result in a favourable NPV, it is always preferable to
buy the asset outright and obtain the tax benefits. There are, however, some situations where the investment c
rries a very high risk of failure, and the last thing a company requires is to discover after a year or two that he
project is not going to work but it is saddled with an asset it cannot use or sell at a reasonable price.
Under such circumstances, it might be better to rent the assets or enter into an operating lease arrangement.
The advantage of an operating lease is that a company can terminate the lease after a short period of time,
normally one year. The company is in effect able to cut its losses early. An operating lease will always be more
213
expensive in the long-term compared to buying the assets outright, but it offers short-term benefits if the
project fails and the company wishes to terminate the investment.
As such, an operating lease is not a form of finance; it is an alternative method of investing in an asset. To
evaluate an operating lease, one must compare the investment to an outright purchase. The appropriate
discount rate is the target WACC.
A financial lease, on the other hand, is a form of finance which is discussed in chapter 7, The financing decision
where the appropriate discount rate is the after-tax cost of debt.
Example:
A hospital is considering investing in an X-ray machine. The cost of purchasing the machine is R10 million. The
asset will have a five-year life with a nil resale value. The wear- and-tear allowance is 50% for Year 1 and Year 2.
Alternatively, the hospital can enter into an operating lease arrangement, where the cost is R3 million for Year
1, payable in advance. The operating lease cost increases by 10% per nnum thereafter.
WACC = 10%
Tax rate = 40%
Required:
Compare the two investment options.
Solution:
Investment in the machine
PV
10% PV
Year 0 Buy (10) million 1 (10)
Year 1 Wear-and-tear R10m × 50% × 40% = 2 million 0,909 1,818
Year 2 Wear-and-tear R10m × 50% × 40% = 2 million 0,826 1,652
NPV (6,53)
Operating lease
PV
10% PV
Year 0 Cost (3) million 1 (3)
Year 1 Tax allowance R3 × 40% = 1,2 million 0,909 1,09
Year 1 Cost (R3) × 110% = (3,3) million 0,909 (3)
Year 2 Tax allowance R3,3 × 40% = 1,32 million 0,826 1,09
Year 2 Cost (R3,3) × 110% = (3,63) million 0,826 (3)
Year 4 Tax allowan e R3,993 × 40% = 1,597 million 0,683 1,09
(Ro nded off) NPV (9,55)
Conclusi n:
The operating lease is more expensive in the long-term. However, in the short-term, it gives the company the
option to continue, close down the operation, or terminate the lease agreement and buy the asset outright if it
is now confident that future cashflows are strong.
Fin ncial leases are discussed in chapter 7, The financing decision.
214
6.7 Uncertainty and risk

Concepts
Uncertainty
In the case of decision-making based on uncertainty, insufficient information is available to the decision-
maker to enable him to assign a probability to the outcome of an event. In short, uncertainty cannot be
measured.
Risk
In the case of decision-making based on risk, enough information is avai ab e to the decision-maker to
enable him to assign a probability to the outcome of an event. In short, risk can be measured.
Probability
A probability is represented by a ratio, usually in decimal form, between 0 and 1 (i.e. 100%). This ratio is
the proportion of the number of favourable events to the total number of possible events and is
determined by dividing the favourable events by the possible events.
Sensitivity analysis
Sensitivity analyses are performed by continuously changing one or more of the variables in a model one
at a time and noting the results and influence thereof. So eti es it is undertaken by asking the question
‘What if?’.
Simulation
Simulation is the process by which a model is xp rim nt d upon and the results of various alternatives are
examined. Simulation is used where analytical quantitative models are not available or too complex or
costly to develop, for example in intricate queuing processes at a toll gate at various times of the year.
Random numbers
Random numbers are numbers of which the components are selected randomly, for example by
computer or tables of random numbers.
Monte Carlo analysis
Where variables are changed one at a time asking ‘what if?’ questions in sensitivity analysis, in Monte
Carlo simulation the effect on all possible values and combinations of variables are investigated. This
enables the construction of a probability distribution where the mean and standard deviation can be
calculated.
Simulation based on random computer-generated numbers, for example the number of arrivals at a toll
gate within a given time frame at various times of the year, is known as Monte Carlo analysis. The
probable occurrence of events based upon probabilities is allotted to random numbers with the purpose
of simulating the outcomes.
The incorporation of Monte Carlo analytical techniques are now also required for IFRS 13 share
valuations. The us fuln ss of the analyses lies therein that a spread of the different values for an enterprise
an be determined, so that probabilities for the maximum and minimum values can be ascertained.
Example:
A Monte Carlo simulation exercise is applied to assist in a feasibility study regarding the possible constr
ction of a toll gate in a rural area. The arrival times between 6:00 and 9:00 have been observed in a
sample as in the table below:
Time Number of Probability Cumulative Random

arrivals observed probability Numbers
6:00–6:30 50 0,05 0,05 1–5
6:30–7:00 100 0,10 0,15 6–15
7:00–7:30 220 0,22 0,37 16–37
7:30–8:00 300 0,30 0,67 38–67
8:00–8:30 180 0,18 0,85 68–85
8:30–9:00 150 0,15 1,00 86–100
1000 1,00
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Say, for example, the computer selects a random number of 72 when applying Monte Carlo analysis: That
would represent an arrival time between 8:00–8:30 as in the table (random numbers between 68–85).
The next random number selected might be 37 and would represent an arrival of between 7:00 and 7:30
(random numbers between 16–37) etc.
The algorithm is then repeated a couple of hundred or preferably a few thousand times with a computer
program. The results are then compared to the initial probabilities which have been calculated from the
observations with the sample. These probabilities can subsequently be adjusted if necessary. The
program enables the construction of a visual graph representing the probability distribution from which
the mean and standard deviation can be calculated and probabilities for the maximum and minimum
arrivals in half-hour periods in peak hour traffic can be determined.
Investment decision under conditions of uncertainty

If one assumes the certainty of cashflows and an ability to calculate the cost of capital, it is relatively simple to
determine the NPV for a project. The basic assumption is, however, that the new project does not alter the
basic risk structure of the company.
When a project is perceived to increase the overall risk of the c mpany, the discount rate should be adjusted
upwards. Assuming that a company’s WACC is 13%, a hierarchy of interest rates may be constructed as follows:
Risk class Type of product Discount rate
(NPV)
A Replacement of existing equipment 13
B New venture – usual mark ts and products 18
C New venture – either usual mark ts or usual products 23
D New venture – neither usual markets nor usual products 28
Methods allowing for project uncertainty include –

comparing the payback periods;
increasing the risk premium by raising the discount rate above the cost of capital for later years or more
risky projects;
ignoring project results beyond a certain period, say seven years, called the finite horizon;
utilising probability based methods, whereby probability theory is applied to different possible estimates
to calculate an expected value instead of using a single value;
applying sensitivity analysis, simulation and Monte Carlo analysis; and
incorporating statistical models utilising discrete and continuous probability distributions.
Probability th ory
Characteristi s of a probability
A probability is ep esented by a ratio, usually in decimal form, between 0 and 1 (i.e. 100%).
This ratio is the p oportion of the number of favourable events to the total number of possible events and
is determined by dividing the number of favourable events by the number of possible events.
Independent and dependent events
Two events are independent of each other when the occurrence of one event has no influence on the pr
bability of the other event occurring.
Two events are dependent on each other when the occurrence of one event has an influence on the
probability of the other event occurring.
Expected value
One of the most frequently used techniques involves the calculation of an expected value from various possible
values, instead of using only one value.
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Example:
A manager previously used R450 000 as a possible cash inflow in his calculations, but is now tempted to
incorporate probability theory to determine the most likely outcome by calculating the expected value from
optimistic, most likely and pessimistic values. He is of the opinion that the probabilities of various alternative
revenue cash inflows are as follows:
Alternatives Cashflows in R Probability Cashflows × Probability
Optimistic 600 000 10% 60 000
Most likely 450 000 65% 292 500
Pessimistic 300 000 25% 75 000
Expected value 100% 427 500
Therefore, R427 500 would be the more scientific estimate of the expected revenue inflow out of a range of
possible outcomes than using the single most likely estimate of R450 000.
Decision trees
A decision tree is a diagrammatical representation of a decision-making pr blem.
Decision trees highlight the possible alternative actions as well as the events that may result if a particular
decision should be made. The optimum alternative is deter ined by calculating the expected value in respect of
each alternative.
The topics linear programming, sensitivity analysis, simulation, Monte Carlo analysis, probability theory,
probability distributions (especially the normal distribution) and decision trees are usually covered under
Management Accounting in textbooks and not under Financial Management. For a more comprehensive
treatment of these topics please refer to textbooks on Management Accounting, and more specifically to
decision-making.
6.8 Qualitative (non-financial) factors

Qualitative factors should of course also be taken into account, over and above the financial figures/
calculations, even if the project shows a positive NPV. For example, when evaluating whether to buy or not buy
a new machine, the following factors should be considered –
the reliability of the machine;
its lifespan;
the availability of spare parts;
guarantees given;
technological improv m nts in the pipeline;
the reliability of suppliers;
the quality of the products manufactured;
growth in the ma ket for the products to be manufactured;
the choice of capital intensive versus labour intensive operations;
the availability of skilled staff;
envir nmental aspects like global warming, gas emissions and pollution;
s cial aspects like labour relations, job losses, housing and employee satisfaction;
ethical considerations like purpose of products manufactured;
good corporate governance like purchasing process; and
governmental aspects like legislation, by-laws and legal requirements.
In this regard special attention should be given to the so- called ESG (environmental, social and governance)
principles, as well as Equator Principles. Equator Principles (EP) is a risk management framework, adopted by
financial institutions for determining, assessing and managing environmental and social risk in projects. It is
primarily intended to provide a minimum standard for due diligence to support responsible risk decision-
making as pertain to project finance.
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If involved in large projects, it is required that one should determine if it is consistent with Equator Principles,
which can be viewed at http://www.equator-principles.com/index.php/about-ep/about-ep.
EP III was effective from 4 June 2013. Interestingly South Africa is not a designated country, meaning its policies
are not deemed robust enough.
Examples:
In this regard, reflect on the impact of ESG and Equator Principles on the following:
Erecting a coal or nuclear power station in South Africa
Deciding between labour intensive or capital intensive operations in platinum mines
Implementing an e-tolling system in Gauteng
Allowing Aardgas cracking operations in the Karoo
Developing super building structures near the coast at Plettenberg Bay
l Implementing measures to safeguard beaches against oil leaking f ships
Manufacturing gasoline driven or more energy efficient automobiles
International capital budgeting
Foreign direct investment

The term foreign direct investment (FDI) is used for the establishment of new overseas facilities or the
expansion of existing overseas facilities by an investor. The purpose of setting up subsidiaries abroad, include
the location of new and/or growing markets, addressing the need for a sales organisation in another country,
the opportunity to produce goods more cheaply, the need to avoid import controls, obtain access to raw
materials and the availability of grants and tax concessions.
Alternatives to FDI include exporting and licensing of products or services.
Direct and indirect quotes of exchange rates

The exchange rate between currencies can be quoted ‘directly’ or ‘indirectly’. This distinction is important in
order to apply the purchasing power formulas correctly.
Direct quote: Example, from a South African perspective: $1 = R7,00.
Indirect quote: Example, from a South African perspective: R1 = $0,1429.
The international conv ntion is to place the stronger currency first. When comparing the Rand to the United
States Dollar, South Africans will use direct quotation, whilst the USA would use indirect quotation. Both
countries will therefore use the convention $1 = R7.
Pu chasing power parity and the impact on future currency exchange rates
Different inflation rates in different countries are the determining factor in what one would expect spot rates
to be at a f t re date (purchasing power parity). (Note the spot rate is the immediate settlement rate.)
The expected future spot rate between two currencies can be determined as follows:
1 + if
Future sp t rate = Current spot rate ×
1 + ih
Where:
if is the rate of inflation in the foreign country ih
is the rate of inflation in the home country
The spot rate is expressed as the relation foreign currency to one unit of home currency.
218
In certain cases it may be more practical to use the direct quotation method, and hence the formula to be
applied is as follows:
1 + ih
Future spot rate = Current spot rate ×
1 + if
Where:
if is the rate of inflation in the foreign country ih
is the rate of inflation in the home country
Example:
Assume the current spot rate between the USA Dollar ($) and the South Afric n Rand (R) is $1 = R7. The
respective inflation rates for the foreseeable future are as follows:
RSA: 8%
USA: 3%
Required:
Calculate the expected spot rate in two years’ time.
Solution:
2 2
$1 = R7 × 1,08 /1,03
R7,70
The currency with the higher inflation rate must always lose value against the currency with the lower inflation
rate.
International capital budgeting

There are basically two approaches to international capital budgeting:
Keep the currency cashflows in the foreign currency, and discount at a rate appropriate to that currency to
obtain a NPV in the foreign currency. Convert this NPV into the home currency NPV using the spot rate of
exchange.
Convert the currency cashflows from the project for each year into the home currency, and then discount
at a local discount rate to generate a home currency NPV.
Of the two methods above, the first is the recommended approach. The reason for this is that there is already a
considerable amount of unc rtainty involved in projecting future cashflows. By converting every year’s cashflow
into the home curr ncy, the uncertainty increases because now the home currency/foreign currency exchange
rate at future dates must also be predicted.
Example:
A local company, XYZ Ltd, is investigating the viability of a project in the United Kingdom. The following
information applies:
Projected cashflows:
Year 0 1 2 3
£’000 £’000 £’000 £’000
Initial investment (1 000)
Net cashflow 500 600 700
Current spot rate: £1 = R12
Expected rate of inflation (United Kingdom): 2% per annum
Expected rate of inflation (South Africa): 8% per annum
Estimated risk adjusted foreign discount rate (applicable in the United Kingdom): 15%
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Required:
Apply both approaches to international capital budgeting to determine whether the project should render a
positive NPV in South African Rand.
Solution:
Approach 1: Maintain cashflows in the foreign currency
Year 0 1 2 3
£’000 £’000 £’000 £’000
(1 000) 500 600 700
NPV at 15% = £348,730

= R4 184 762 using the current spot rate of R12.
Approach 2: Convert future foreign cashflow to predicted home currency
Year 0 1 2 3
£’000 £’000 £’000 £’000
Total (1 000) 500 600 700
R14,24
(1)
Expected exchange rate R12 12,71 13,45
Cashflow R’000 R’000 R’000 R’000
(12 000) 6 353 8 072 9 971
NPV at 21,76%
(2) = R4 184 762
3 3
R12 × 1,08 /1,02 – the purchasing power parity principle
1,15 × 1,08/1,02 – 1 = 21,76% – substituting the South African rate of inflation for the United
Kingdom rate of inflation, while maintaining the project’s real discount rate.
Practice questions
Question 6–1 (Fundam ntal) 30 marks 45 minutes

Mr Kumalo’s enterprise is onsidering replacing an existing machine with a tax value of R50 000 for a new, more
efficient ma hine at a cost of R250 000. The old machine can be sold for R49 900 today or for R5 000 after five
yea s. The estimated useful life of the new machine is five years, after which it will be sold for R50 000.
Current New machine

(per annum)
Sales R100 000 R140 000
C st f sales
Variable R56 000 R42 000
Fixed R30 000 R30 000
Depreciation has not been included in the above costs. Interest repayment on the new machine will be R10 000
per annum. The enterprise will borrow 50% of the cash required at 16% from its bankers. The cost of capital is
14%.
The current tax rate is 28%; assume that there is a one-year lag in the payment of tax.
Also assume that the wear-and-tear for both the existing machine and the new machine is to be written off in
full at the end of Year 1.
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Required:
Determine whether the company should replace the existing machine, close down or continue production on
the current basis.
Solution:
Existing machine
YEARS
0 1 2 3 4 5 6
R R R R R R R
Opportunity cost:
current
realisable value
forfeited (49 900)
Working capital 0 0
Cash flows 14 000 14 000 14 000 14 000 14 000
Taxation 1 (28) 10 080 (3 920) (3 920) (3 920) (5 320)
Factor @ 14% 1,000 0,877 0,769 0,675 0,592 0,519 0,456
NPV pa (49 900) 12 253 18 518 6 804 5 967 7 827 (2 426)
Total NPV (957)
1 Taxation:
YEARS
0 1 2 3 4 5 6
R R R R R R R
Opportunity cost:
Scrapping allowance
not claimed 2 100
Tax recoupment on sale 5 000
Cash flows 14 000 14 000 14 000 14 000 14 000
Taxable income 100 (36 000) 14 000 14 000 14 000 19 000
Taxation @ 28% (28) 10 080 (3 920) (3 920) (3 920) (5 320)
There is a tax lag of one y ar.

2 Taxation s rapping allowance not claimed by not selling: R50 000 – R49 900 = R100
3 Wear and tear % of investment: 100% in second year
New machine
YEARS
0 1 2 3 4 5 6
R R R R R R R
Working capital 0 0
Ca h flows 68 000 68 000 68 000 68 000 68 000
Taxation 1 50 960 (19 040) (19 040) (19 040) (33 040)
Factor @ 14% 1,000 0,877 0,769 0,675 0,592 0,519 0,456
NPV pa (250 000) 59 636 91 480 33 048 28 984 51 360 (15 066)
Total NPV (557)
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1 Taxation:
YEARS
0 1 2 3 4 5 6
R R R R R R R
Cash flows 68 000 68 000 68 000 68 000 68 000
Tax recoupment on sale 50 000
Taxable income (182 000) 68 000 68 000 68 000 118 000
Taxation @ 28% 50 960 (19 040) (19 040) (19 040) (33 040)

2 Wear and tear % of investment: 100% in second year
Although the new machine reduces the loss by R400 (957 – 557), the existing machine should strictly speaking
be sold since both alternatives yield a negative NPV. The negative value f R557 in respect of the new machine is
however so insignificant, that other qualitative factors sh uld determine whether the new machine is purchased
or the existing machine sold.
Notes:
Be careful that you don’t omit a negative sign in the formulas, for example when calculating tax from
taxable income.
Check that taxable income and taxation have opposite signs.
Wear and tear has a negative sign because it decreases taxable income.
In the case of the existing machine the current selling price of R49 900 is forfeited, therefore reducing
inflows by R49 900, resulting in a negative inflow.
In the tax calculation of the existing machine the scrapping allowance of R100 is not claimed, therefore
increasing the taxable income (accompanied by a positive sign).
Compare the above to example 2 in the keep versus replacement investment decision (section 6.5) where
the tax recoupment of R10 000 has been avoided, therefore decreasing the taxable income (accompanied
by a negative sign).

Capstar Ltd is a mining company that is currently evaluating two independent projects.
The following financial and busin ss information is available:
Capstar Ltd Similar quoted companies

Market return – 21,33%
Risk-f ee ate 8% 8%
Standa d deviation of returns 5% 4%
Correlation with similar companies 0,6 1
Target D:E ratio 4:6 4:6
Capstar Ltd is reluctant to take on both of the available projects; therefore the decision has been made to
accept nly ne. The cashflows relating to each project, and the NPV calculated at different discount rates are as
follows:
Project A Project B
R’000 R’000
Cashflows
Year 0 (6 000) (6 548)
1 1 500 8 000
2 2 000 4 000
3 3 000 –
4 3 000 (6 000)
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NPVs
Discount rate 18% + R81 + R40
Discount rate 20% – R754 R Nil
Capstar’s commercial manager favours Project A as it has a more consistent cashflow over the four-year period,
although he does concede that Project B has a higher IRR of 20% compared to Project A.
The managing director also favours Project A, as he believes that the pay-back period is the important criterion
in project evaluation. In addition, in view of the fact that Project B has a negative payment in Year 4, he is
reluctant to accept Project B. He is also surprised that Project B has an IRR of 20%, since it clearly has a negative
accounting return.
Assume no taxation.
Required:
Explain the meaning of the NPV and IRR measures. Outline the major comparative advantages and
disadvantages of the two methods for the appraisal of investment pr jects. (12 marks)
Determine which project Capstar Ltd should accept and draw a diagram showing the NPV for each project
at different discount rates. (18 marks)
(c) List the limitations of using the CAPM for capital budgeting decisions. (5 marks)
Explain the significance of the SML and how one would use it for an investment appraisal exercise.
(5 marks)
Solution:
NPV and IRR are often referred to as discounted cashflow techniques as they focus on cashflow rather
than profit.
NPV assumes that –
investors seek to maximise their wealth in terms of cash;
capital markets are perfect; and
investors are risk-averse.
The assumption that capital markets are perfect does not hold in the real world, due to uncertainty.
Perfect capital markets imply that future outcomes and events are known and the capital market rate
would reflect the future outcomes. NPV also assumes that the risk of a particular project can be identified
and reflected in the appropriate discount rate. Real-world situations show that risk cannot be identified
accurately.
The NPV is the present value of future returns discounted at the company’s cost of capital minus the cost
of the investment. For independent investments, if the NVP is positive, the project should be accepted; if
it is negative, the project should be rejected. If two projects are mutually exclusive, the one with the
higher NPV index should be chosen. When a company accepts a project with a positive NPV, the value of
the company increases by that amount. Therefore, the NPV method chooses projects to maximise share
val e.
N te: The discount rate used in all NPV appraisals assumes that all cash received before the end of the
project can be re-invested at the discount rate.
The IRR is the interest rate that equates to the present value of the expected future cashflows or receipts
to the initial cash outlay. The IRR formula is the same as the NPV formula, except that it sets the NPV at
nil and solves for the discount rate. The IRR must be found by trial and error unless the expected
cashflows are equal and can be treated as an annuity. For independent projects, if the IRR is greater than
the WACC, the value of the company increases and the project should be accepted. If it is equal to the
WACC, the company breaks even, and if the IRR is less than the WACC, the project should be rejected. If
two projects are mutually exclusive, the one with the higher IRR should be accepted.
223
The IRR has few real advantages over the NPV, but the following might be claimed:
There is no need to precisely calculate the cost of capital of the project. Nevertheless, some
estimate is required to compare against the IRR.
Managers find IRR easier to understand.
The disadvantages of IRR include:

IRR can signal incorrect rankings for mutually exclusive projects.
Decisions based on percentage returns (as with IRR) can be misleading.
IRR can be difficult to interpret when a project has multiple IRRs, whereas NPV gives a clear
indication of a project’s acceptability.
The NPV method assumes that interim cashflows are reinvested at the cost of capital, whereas the
IRR method assumes that they are reinvested at the IRR. The former assumption is theoretically
correct.
NPVs are additive when combining projects, but IRRs are n t.
For independent projects with conventional cashflows, IRR and NPV will signal the same decisions,
provided that no capital rationing exists.
Calculating the WACC for Capstar Ltd

σi
β = Corim
σm
0,05
= 0,6 × = 0,75
0,04
R = Rf + βi (Rm – Rf)
= 8% + 0,75 (21,33% – 8%) = 18%
Weighted average cost of capital

4 6
(8% × ) + (18% × ) = 14%
10 10
Discounting both projects at 14% results in the following:
Discount rate 14% Project A Project B

Year PV Factor R’000 R’000
0 1 (6 000) (6 548)
1 0,877 1 315,5 7 016
2 0,769 1 538 3 076
3 0,675 2 025 –
4 0,591 1 773 (3 546)
+ 651,5 –2
Project A has an IRR of +/– 19%. Project B has two IRRs of 14% and 20% respectively. Where the WACC
falls between 14% and 20%, Project B will show a positive NPV.
As Pr ject A shows a higher NPV than Project B at the company’s WACC, Project A should be accepted.
224
Diagrammatic representation of NPV at different discount rates
Project A Project B
NPV NPV
+ +
19% Discount rate

Nil Nil
Discount rate 19% 20%
– –
Limitations of using CAPM for capital budgeting d cisions

In using the rate determined from the SML to evaluate a project, one is assuming that the β, risk-free
rate and the expected market return will remain constant over the life of the project.
The assumptions of the CAPM model, especially ‘borrowing and lending can be made at the risk-free
rate’.
Tax implications change for different categories of investors.
Risk is regarded as an increasing function over time (i.e. risk is compounded over time).
The SML is a line that joins the risk-free rate to the market portfolio and beyond. The market represents a
portfolio of all available securities with a given average yield and a given average systematic risk equal to
a β value of one. All securities on the SML line are efficient and yield a return that equates to their co-
variance with the market return.
Shares with β values greater than one are termed ‘aggressive shares’ because they can be expected to
fluctuate more than the all-share index return, both upwards and downwards.
All securities above the SML line out-perform the market, while all shares below the SML line are
inefficient and und r-p rform the market. It must however be noted that returns above or below the SML
line are in temporary dis quilibrium.
(England & Wales 1981)

Stadler is an ambitio s young executive, who has recently been appointed to the position of Financial Director
of Paradis Ltd, a small listed company. Stadler regards this appointment as a temporary one, enabling him to
gain experience before moving to a larger organisation. His intention is to leave Paradis Ltd in three years’ time,
with its hare price standing high. As a consequence, he is particularly concerned that the reported profits of
Paradis Ltd hould be as high as possible in his third and final year with the company.
Paradis Ltd has recently raised R350 000 from a rights issue, and the directors are considering three ways of
using these funds. Three projects (A, B and C) are being considered, each involving the immediate purchase of
equipment costing R350 000. Only one project can be undertaken. The equipment for each project will have a
useful life equal to that of the project, with no scrap value. Stadler favours Project C, because it is expected to
show the highest accounting profit in the third year. However, he does not wish to reveal his real reasons for
225
favouring Project C; therefore, in his report to the chairman, he recommends Project C because it shows the
highest IRR. The following summary is taken from his report:
Net cashflows (R’000) Internal rate
Years of return
Project 0 1 2 3 4 5 6 7 8 %
A – 350 100 110 104 112 138 160 180 – 27,5
B – 350 40 100 210 260 160 – – – 26,4
C – 350 200 150 240 40 – – – – 33,0
The chairman of the company is accustomed to projects being appraised in terms of payback and ARR, and he
is consequently suspicious of the use of IRR as a method of project selection. Accordingly, he has asked for an
independent report on the choice of project. The company’s cost of capit l is 20% nd a policy of straight-line
depreciation is used to write off the cost of equipment in the financial st tements.
Required:
(a) Calculate the payback period for each project. [Fundamental] (5 marks)
(b) Calculate the accounting rate of return for each project. [Fundamental] (8 marks)
Prepare a report for the chairman with supporting calculations indicating which project should be
preferred by the ordinary shareholders of Paradis Ltd. [Funda ental] (19 marks)
(d) Discuss the assumptions about the reactions of the stock arket that are implicit in Stadler’s choice of
Project C. [Intermediate] (8 marks)
Note: Ignore taxation.
Solution:
Payback period for each project, that is time taken to repay original outlay of R350 000
Project A R’000
Cash in first 3 years 314
Balance required 36
350
Cash in 4th year 112

Payback = 3 years + 36 / 112 years = 3,32 years
Project B
Cash in first 3 years = R350 000
Payback = 3 years
Project C
Cash in first 2 years = R350 000
Payback = 2 years
(b) ARR for each p oject

Project Project Project
A B C
R’000 R’000 R’000
T tal cashfl w 904 770 630
Less: T tal depreciation (no scrap value) 350 350 350
Total accounting profit 554 420 280
Project life (years) 7 5 4
Average profit per year (R’000) (1) 79,14 84 70
(350)
Average capital employed (2) 175 175 175
2
ARR [(1) divided by (2)] 45,2% 48% 40%
Alternatively, ARR could be computed as average
profit divided by initial capital employed, giving) 22,6% 24% 20%
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To:P Aranoid Esq.

Chairman, Paradis Ltd
From: A Shrink & Co, Financial Consultants
Report on the choice of capital investment project to be financed by proceeds of recent rights issue
Terms of reference
To provide an independent report on which of three projects, A, B and C, should be preferred by the
ordinary shareholders of Paradis Ltd.
Introduction
This report examines the strengths and weaknesses of various project ppr is l techniques which are in
common use, determines how the three projects stand up in the light of e ch method, and reaches a
conclusion about the best choice of project.
Conclusion:
It is recommended that the NPV method of project appraisal sh uld be used. On this basis, Project A
appears to be the best, being marginally better than Project B. However, it is suggested that further
investigations into the uncertainty of the cashflow esti ates for Projects A and C are undertaken.
Traditional appraisal methods

Since you are familiar with both the payback and the ARR methods, this report deals immediately with
their advantages and limitations.
Payback
The payback method is easy to calculate and to understand. It is useful as it shows how long
investors have to wait before their initial investment is repaid. Given that no future results are
known with certainty, it gives investors an idea of how long their money will be at risk, and since
uncertainty usually tends to increase the further into the future one looks, a short payback period is
taken to mean low risk as well as quick returns.
The weakness of using the payback method in isolation is that it does not in any sense measure
profitability or increase in investor wealth.
For example, refer to the payback periods of Projects A, B and C (in part (a) of the Appendix* to this
report).
Project C has the shortest payback period, and Project A has the longest.
However, the cashflows of Project A last much longer than those of Project C, which may make
Project A more profitable in the long run.
ARR
This method giv s a measure of relative project profitability by comparing the average accounting
profit per annum oming from the project with the average capital employed in it. Its advantages are
that it is relatively easy to understand, it measures profitability of returns compared with outlay, and
it gives an indication of whether the company’s target return on capital employed is exceeded.
Its main weaknesses are:
It pays no attention to the timing of project returns. Cash received at an early stage is more valuable
than the same cash received in a few years’ time, because it can be reinvested to earn interest. For
example, Project C returns cash very quickly compared with Project B, but this effect is lost in the pr
cess of averaging profits. Thus Project B has a higher ARR than Project C, even though its IRR (see
later) is lower.
It is a relative rate of return, rather than an absolute measure of gain in wealth. All rate of return
methods ignore the size of the project.
The timing of the cashflows is important because early cash can be reinvested to earn interest.
The technique of discounting reduces all future cashflows to equivalent values now (present values) by
allowing for the interest which could have been earned if the cash had been received immediately.
There are two possible techniques, that is NPV and IRR.
227
NPV
This is simply the net of the present values of the project cashflows after allowing for reinvestment at the
company’s ‘cost of capital’ (i.e. the average required return (ARR), which is set by the market for the
company’s operations considering the risk of those operations).
Provided that the project is of average risk for the company, and that there is no shortage of capital, the
NPV gives a best estimate of the total increase in wealth which accrues to the shareholders if the project
is accepted. This should be reflected in an increased market value of the shares.
NPV computations are attached as an Appendix* to this report. On this basis, Project A gives the greatest
increase in shareholder wealth.
IRR
This is defined as the discount rate which gives the project a NPV of nil. When looking at a single project,
the IRR will give the same decision as the NPV (i.e. if the project’s NPV is greater than nil, its IRR is higher
than the cost of capital).
However, the IRR can give an incorrect signal when it is necessary to rank projects in order. Like all rate of
return methods, it ignores the size of the project, and thus the abs lute gain in wealth to come from it. For
example, Project C has the highest IRR, but although the original outlay is as high as that of the other two
projects, it returns most of that outlay after one year, and thereafter effectively becomes a smaller
project with a high rate of return.
The IRR also makes an incorrect assumption about the rate at which cash surpluses can be reinvested. It
assumes they are reinvested at the IRR. For xampl , it assumes that cash from Project C can be reinvested
at 33%, but cash from Project A is r inv st d at 27,5%. Both of these assumptions are wrong: the 20% cost
of capital figure is more appropriate. The I R is therefore not good for comparing projects.
The best appraisal method

Given the arguments above, the best appraisal method is the NPV approach, because it takes the time
value of money into account in a way that indicates the absolute gain which will be made by shareholders
as a result of accepting the project.
On this basis, Project A should be accepted, with Project B just second. However, it should be noted that
there are many other factors that affect the decision which have been left out of this report. The most
obvious of these is an assessment of project risk. For example, it may be that Project A is regarded as
riskier than Project C, simply because it takes longer to pay back. It can then be argued that Project A
should be discounted at a higher rate than Project C. This may give it a lower NPV than that of Project C.
We must therefore recommend that further analysis is made of the uncertainty attached to the cashflows
of Projects A and C.
Important: As the proj cts are of unequal lives, it is assumed that cash available from Projects B and C
can be re-inv st d at the company’s WACC of 20% up to the end of Year 7.
Equivalent annual annuity
If Projects A, B and C an be continuously replaced in the future, the correct project comparison is to
restate the NPV as an equivalent annual annuity. The company would be indifferent between the NPV for
the projects and the annuity in such a situation.
Project A B C
Life (years) 7 5 4
Disc unt rate 20% 20% 20%
Annuity factor 3,59 2,98 2,58
NPV 81,4 62,8 77,9
U ing formula NPV / PF(Annuity) + r, then:
Annuity 113,37 105,37 150,97
Ranking 2 3 1
The equivalent annual annuity method will tend to favour projects with high IRRs.
* Appendix: Project NPV
228
Year 20% factor Project A PV Project B PV Project C PV

0 1,00 (350) (350,0) (350) (350,0) (350) (350,0)
1 0,83 100 83,0 40 33,2 200 166,0
2 0,69 110 75,9 100 69,0 150 103,5
3 0,58 104 60,3 210 121,8 240 139,2
4 0,48 112 53,8 260 124,8 40 19,2
5 0,40 138 55,2 160 64,0
6 0,33 160 52,8
7 0,28 180 50,4
81,4 62,8 77,9
Stadler’s assumptions about the reactions of the stock market

Stadler’s real reason for selecting Project C is that it will increase the company’s profits in Years 1, 2 and 3
by a greater amount than the other projects. He is therefore assuming that historical reported profits are
the chief determiners of share prices.
However, the ‘efficient market hypothesis’ states that share prices adjust very swiftly and correctly to all
new information. Of the three forms of ‘efficient market hyp thesis’, two are worth discussing here.
The ‘strong’ form of the efficient market hypothesis states that share prices adjust very swiftly to all new
relevant information, both public and private. If this form were true, then, as soon as the new project was
accepted, the company’s shares would speedily reflect the expected gain from the NPV of the project.
Subsequent reported profits would only affect share pric s if they were different from expectations.
The ‘semi-strong’ form of the efficient market hypoth sis says that share prices adjust very swiftly to all
new relevant information which is made public. Whether the share price reflects the NPV of the new
project depends on whether the project forecasts are released.
Empirical evidence tends to confirm the ‘efficient market hypothesis’ in its ‘semi-strong’ form, but not in
the ‘strong’ form. Stadler must therefore be taking one of two positions:
Either (a) he is ignorant of or does not believe the efficient market hypothesis
Or (b) he does not believe any information about the project will find its way onto the market until the
reported accounting results are realised.
Although it is unlikely that detailed cash-flow forecasts will be published by the company, it will probably
announce details of the nature of the project fairly soon after making the decision to start it. From this,
investors will soon be able to make predictions of the project’s lifespan. In a market where 50% of shares
are in the hands of institutions that make it their business to analyse information, Stadler’s hope that the
market will not know at Year 3 that the project is virtually finished is very unlikely to be fulfilled.
Question 6–4 (Int rm diat ) 40 marks 60 minutes

Trident Ltd manufactur s a single product called ‘Gino’. The company uses absorption costing as a basis for
valuing its sto k of finished goods. Based on its production of 100 000 units in 20X0, the manufacturing costs
per unit are as follows:
R
Raw materials 10
Labo r 12
Overheads 8
30
The above costs exclude depreciation.

The Management Accountant has estimated that the production costs excluding depreciation at a production
evel of 150 000 units would be as follows:
R
Raw material 1 500 000
Labour 1 550 000
Overheads 950 000
4 000 000
229
Trident Ltd sold 100 000 units of Gino in 20X0 and the demand for the product is expected to rise by 10 000
units per annum for the next five years.
Trident is considering replacing the existing machine with a larger, more efficient machine that can keep pace
with demand.
Details of the existing and new machine are as follows:

Existing machine New machine
Cost 1 000 000 2 000 000
Book value 400 000 –
Tax value 200 000 –
Market value 700 000 2 000 000
Value at the end of remaining life 200 000 500 000
Remaining useful life 5 yrs 5 yrs
Annual depreciation 100 000 200 000
Annual machine capacity 4 000 hours 4 000 hours
Machine production time per unit 2 minutes 1 minute
The selling price per unit of Gino is set by the market at R30 per unit, and no sales price increase is anticipated.
Manufacturing costs are expected to remain the same over the next five years for the existing machine. The
new machine is less labour-intensive and a saving of R5 per unit is expected. Fixed costs will, however, increase
by R200 000 per annum.
The existing and new machines are used in a proc ss r gard d by the SARS as being in the process of
manufacture and are written off on a straight-line basis of 20% p r annum.
Trident Ltd believes that the product will become obsolete after five years, as new technology will make the
current product unmarketable. The division manufacturing the Gino is one of several divisions within the
Trident group.
The group is currently financed through debt and equity as follows:
R
Issued share capital 1 000 000 shares 500 000
Debt capital 21% (indefinite) 4 000 000
The current market value of the shares is 6 per share.
Dividends have been growing at 8% and the latest dividend paid was 60c per share. Should the company
purchase the new machine, it will be financed with long-term debt at a current cost of 20%.
Current company tax rate is 40%.
Assume that the purchase of the new machine or the sale of the existing machine will take place at the
beginning of the financial y ar. All other transactions will take place at the end of the year. There is no tax lag.
Required:
Evaluate the investment options available to the company and write a report to management advising them on
what course of action they should follow. This report must state clearly the assumptions made.
Solution:
REPORT TO: Management
FROM:
DATE:
I have evaluated the replacement of the existing machine used in the manufacture of Gino and would advise
the company to consider replacing the existing machine.
Alternatives available to the company –
keep the existing machine; or
scrap the existing machine and acquire the new machine; or
stop production altogether.
230
Keep the existing machiness

The returns offered by retaining the existing machine are a negative of R32 760. The discount rate of 16%
used to evaluate the investment assumes that the current WACC of the company at market value reflects
the long-term capital structure for Trident. The existing machine does not offer the required 16% and the
company would be better off scrapping it. A proviso, however, is that the R1 000 000 fixed costs will be
eliminated. Should the R1 000 000 fixed costs continue to be incurred by the company, then keeping the
existing machine is a better option.
Scrap the existing machine and acquire the new machine
My evaluation of acquiring a new machine to replace the existing machine shows that the projected
cashflows will increase by a present value amount of R86 030. The new machine yie ds an NPV of R53 270,
which shows that the company will make a return in excess of 16%.
My advice to purchase the new machine assumes, however, that s les will increase by 10 000 units per
annum. The increased annual cashflows resulting from the increased sales of 10 000 units per annum are
R150 000. If the anticipated increase of 10 000 units does not materialise, a substantial loss will occur.
Further, the new machine is under-utilised; therefore the company should investigate the possibility of
utilising the machine to its full potential by manufacturing s me ther pr duct, if possible.
The company has decided to finance the new machine thr ugh the use f debt capital which indicates that
the company probably has the capacity to increase its gearing without an increased return being required
by the equity shareholders. If this is the case, then the target WACC may be lower than 16%, which would
reduce the overall risk of acquiring the new machine.
Stop production altogether
The opportunity cost of stopping production altog th r is + R500 000. This option should only be considered
if the fixed costs are specific to the existing machine and the risk of taking on the new machine is high on
the basis of uncertainty in increased sales levels.
Calculations:
Cost determination
Utilising the high-low method:
Marginal V/C F/C
Units 100 000 150 000 50 000
Raw materials 1 000 000 1 500 000 500 000 10 –
Labour 1 200 000 1 550 000 350 000 7 500 000
Overheads 800 000 950 000 150 000 3 500 000
20 1 000 000
Machine capacity
Existing 4 000 × 60 ÷ 2 = 120 000 units
New 4 000 × 60 ÷ 1 = 240 000 units
WACC
Equity
Market val e R6 × 1 000 000 = R6 000 000
Share-holders’ req ired return ke
D1
MV =
ke – g
60 (1 + 0,08)
6 =
ke – 0,08
0,648 + 0,48
ke =
6
0,188 or 18,8%
231
Debt
21% × 60% × 4 000 000
Market value
20% × 60%
= 4 200 000
kd = 20% × 60%
= 12%
WACC
MV Cost WACC
Equity 6 000 000 18,8% 11,06%
Debt 4 200 000 12% 4,94%
10 200 000 16,00%
Current machine
Contribution R30 – R20 = R10 per unit
Fixed costs = R1 000 000
Annual after-tax revenue
Year Units Contribution fixed cost After tax
1 110 000 × 10 = 1 100 000 – 1 000 000 = 100 000 × 60% = 60 000
2 120 000 × 10 = 1 200 000 – 1 000 000 = 200 000 × 60% = 120 000
3 120 000 × 10 = 1 200 000 – 1 000 000 = 200 000 × 60% = 120 000
4 120 000 × 10 = 1 200 000 – 1 000 000 = 200 000 × 60% = 120 000
5 120 000 × 10 = 1 200 000 – 1 000 000 = 200 000 × 60% = 120 000
NPV calculation
Year Value PV 16% NPV
0 Opportunity cost (700 000) 1 (700 000)
0 Opportunity – recoupment 500 000 × 40% 200 000 1 200 000
1 Wear-and-tear 200 000 × 40% 80 000 0,862 68 960
5 Sell asset 200 000 0,476 95 200
5 Recoupment on sale (200 000 × 40%) (80 000) 0,476 (38 080)
1 Cash from Gino sales 60 000 0,862 51 720
5 Cash from Gino sal s 120 000 0,476 57 120
(32 760)
New machine
Contribution R30 – (R20 – R5) = R15
Fixed costs R1 000 000 + 200 000 = R1 200 000
Annual after-tax revenue
Year Units Contribution fixed cost After tax
1 110 000 × 15 = 1 650 000 – 1 200 000 = 450 000 × 60% = 270 000
2 120 000 × 15 = 1 800 000 – 1 200 000 = 600 000 × 60% = 360 000
3 130 000 × 15 = 1 950 000 – 1 200 000 = 750 000 × 60% = 450 000
4 140 000 × 15 = 2 100 000 – 1 200 000 = 900 000 × 60% = 540 000
5 150 000 × 15 = 2 250 000 – 1 200 000 = 1 050 000 × 60% = 630 000
232
NPV calculation
Year Value PV 16% NPV
0 Purchase of asset (2 000 000) 1 (2 000 000)
1 Wear-and-tear 400 000 × 40% 160 000 0,862 137 920
2 Wear-and-tear 400 000 × 40% 160 000 0,743 118 880
3 Wear-and-tear 400 000 × 40% 160 000 0,641 102 560
4 Wear-and-tear 400 000 × 40% 160 000 0,552 88 320
5 Wear-and-tear 400 000 × 40% 160 000 0,476 76 160
5 Sale of asset 500 000 0,476 238 000
5 Recoupment (500 000 × 40%) (200 000) 0,476 (95 200)
+ 53 270

(SAICA 1995)
Roebuck Ltd is listed in the clothing, footwear and textile sector of the Johannesburg Stock Exchange. The
company specialises in comfortable sports clothing and manufactures a fairly wide range, which it distributes
through a network of stores.
The company is considering expanding its product range to include sports shoes. The marketing department
estimates that 7% market share is attainable in the first year. With aggressive marketing, the market share is
expected to grow by approximately 4% (of the total market) annually. The research team believes that the
market share of the company will not exceed 20% at any time.
The following are extracts from a report prepared by the marketing department in collaboration with other
departments:
1 Cost structure
R
Variable manufacturing costs per unit produced 20
Fixed manufacturing costs per annum 850 000
Fixed sales costs per annum 600 000
Variable sales costs per unit sold 8
Fixed manufacturing costs include depreciation on machinery at 15% per annum, determined on the
straight-line m thod, and r ntal of R600 000 per annum for additional factory buildings. Since the sports
shoes will be sold in xisting stores, 60% of the fixed sales costs comprises apportioned rental of the existing
stores.
The machinery used in the manufacture of the shoes will cost R1 million and will have no value after five
years.
Turnover in the footwear industry for the 20X4 calendar year was estimated as follows:
Number of pairs 700 000
Val e R43 680 000
It is estimated that 40% of the volume relates to sports shoes.
The f twear market is estimated to grow at a rate of 4% per annum.
Sports hoes are, on average, 10% more expensive than other shoes.
Financing costs
Mr McIntosh, the financial director, calculated the pre-tax cost of financing for Roebuck Ltd as follows:
%
Ordinary shareholders’ equity 20
Preference shares 9
Long-term loan 14
Debentures 12
233
Capital structure
The following is an extract from the audited Balance Sheet of Roebuck Ltd at 30 June 20X4:
Capital employed: R’000
Ordinary shares of R2,00 each 100 000
Retained income 47 000
12% preference shares of R2,50 each 10 000
157 000
Debentures bearing interest at 12% per annum 7 000
Long-term loan bearing interest at 16% per annum 20 000
Deferred taxation 6 000
190 000
The ordinary shares and preference shares currently trade at R2,35 and R2,65 per share respectively. The
long-term loan is repayable after eight years. Current interest rates on loans approximate 14% per annum.
Trademark
Preliminary discussions have been held with an American sports shoe manufacturer to acquire the right to
use their trademark exclusively in South Africa. The cost of acquiring the right of use is expected to amount
to R2,5 million, payable in advance.
The right of use can be sold and is expected to retain its arket value at that level.
The SARS has indicated that the trademark could be writt n-off over four years.
An additional R300 000 will have to be invested in net working capital.
According to Mr McIntosh, the company will still have taxable income after taking any additional tax
charges and allowances arising from the project into account.
The Directors of Roebuck Ltd have approached an accountant to assist them with the decision regarding
diversification.
During the accountant’s preliminary investigation, he holds discussions with Mr Pienaar, the marketing
director, who reacts as follows to the suggestion that a NPV calculation will be necessary:
‘I cannot understand why, in addition to a profit analysis of the project, a further NPV calculation is also
necessary. If the project generates profit, it will have to be acceptable on the basis of the NPV method. I
always maintain that as long as we make a profit, we keep the shareholders happy, and this project will
make a profit.’
Required:
(a) Determine an appropriate discount rate for the NPV calculation. (10 marks)
Determine whether Roebuck Ltd should proceed with the planned diversification assuming that produc-
tion will ommen e on 30 June 20X5. (22 marks)
(c) Discuss any other factors that should be taken into consideration in assessing the project. (8 marks)
(d) Discuss the statement made by Mr Pienaar. (5 marks)
Calculations sho ld be to the nearest R’000.
For the purp ses of the analysis, assume an effective tax rate of 40% and use a five-year planning period. The
effect f inflati n need not be considered.
Solution:
WACC
There is no information in the question about the target WACC for a company such as Roebuck Ltd. The
ccountant will therefore assume that the current weighting of D:E at market value is representative of
the target WACC.
234
Ordinary shares
Required return 20%
Value 50 000 × R2,35 = R117 500
Preference shares
Required return 9%
10 000
Value × R2,65 = R10 600
2,50
Long-term loan
Required return 14% × 60% = 8,4%
Value
Annual interest after tax 20 000 × 16% × 60% = 1 920
Capital at the end of 8 years = 20 000
After tax interest rate 14% × 60% = 8,4%
8-year annuity at 8,4% = 5,6603
PV at Year 8 at 8,4% = 0,5245
Present value = (1 920 × 5,6603) + (20 000 × 0,5245)
= R21 358
Debentures
Required return 12% × 60% = 7,2%
Value R7 000
WACC
Market % Cost Weighted
value weighting % cost
Ordinary shares 117 500 75,1 20,0 15,02
Preference shares 10 600 6,8 9,0 0,61
Long-term loan 21 358 13,7 8,4 1,15
Debentures 7 000 4,4 7,2 0,32
156 458 100 17,10
Consideration may be given to adjusting the calculated WACC of 17,10% to allow for a new product that is
similar to current products manufactured, but competing in a different sector. It may be argued that the
new product will increase the risk of the company.
In the accountant’s opinion, a discount rate of 17% is considered appropriate.
Investment decision as at 30 June 20X5
Workings Selling price (Note 3)
Number of pairs 700 000
40% sports 280 000
60% other 420 000
As spo ts shoes a e on average 10% more expensive, the equivalent number of sports shoes is:
280 000 + (10% × 280 000) = 308 000
Therefore eq ivalent total 420 000 + 308 000 = 728 000
Selling per nit R43 680 000 ÷ 728 000 = R60
Theref re sports shoes R60 + (10% × R60) = R66
C ntributi n (Note 1)
R
Se ling 66
Variable manufacturing 20
Variable selling 8
Contribution 38
235
Fixed costs
R
Fixed manufacturing cost 850 000
Less: Depreciation (150 000) (i.e. 1 000 000 × 15%)
Net 700 000
Selling costs 600 000
Less: Allocated (360 000)
Net 240 000
Total fixed costs R940 000
Market share (Note 3)
Total market 4% growth ½ Year
20X4 280 000
20X5 291 200 145 600
20X6 302 848 151 424
20X7 314 962 157 481
20X8 327 560 163 780
20X9 340 663 170 332
20X10 354 289 177 144
Roebuck Ltd Sales
Total
contribution
20X5/X6 145 600 + 151 424 = 297 024 × 7% = 20 791 × 38 = 790 058
20X6/X7 151 424 + 157 481 = 308 905 × 11% = 33 980 × 38 = 1 291 240
20X7/X8 157 481 + 163 780 = 321 261 × 15% = 48 189 × 38 = 1 831 182
20X8/X9 163 780 + 170 332 = 334 112 × 19% = 63 481 × 38 = 2 412 278
20X9/20X10 170 332 + 177 144 = 347 476 × 20% = 69 495 × 38 = 2 640 810
Investment decision
17% R
Year 0 Investment (1 000 000) 1 (1 000 000)
Year 0 Trade mark (2 500 000) 1 (2 500 000)
Year 0 Working capital (300 000) 1 (300 000)
Year 5 Trade mark 2 500 000 0,4561 1 140 250
Year 5 Working capital 300 000 0,4561 136 830
Year 1 Contribution/Tax (790 058 × 60%) 474 035 0,8547 405 158
Year 2 Contribution/Tax (1 291 240 × 60%) 774 744 0,7305 565 950
Year 3 Contribution/Tax (1 831 182 × 60%) 1 098 709 0,6244 686 034
Year 1–5 Fixed osts/Tax (940 000 × 60%) (564 000) 3,199 (1 804 236)
Year 1–5 Wear-and-tear 200 000 × 40% 80 000 3,199 255 920
Year 1–4 Trade mark 625 000 × 40% 250 000 2,743 685 750
Year 5 Trade mark
Recoupment (2 500 000 × 40%) (1 000 000) 0,4561 (456 100)
NPV (689 300)
As the project yields a negative NPV of R689 300, it should not be accepted.
Financial risk
The company must assess whether the financial risk of the company will be increased or decreased by
taking on the new project. A reduction in financial risk may decrease the required return, while an
increase in financial risk will increase the required return.
Product risk
It may be argued that the new product is not in the same line of business as existing activities and that it
will therefore increase the risk to the company. However, one may argue that risk is reduced through
236
diversification. It is important to note, however, that it is the shareholders that should diversify, not the
company. No benefits resulting from the use of current structures such as transport, advertising,
increased sales of existing products etc. have been accounted for. It is possible that such synergies will
reduce costs. The information also assumes that the life of the product is only five years and that the
asset purchased will have a nil value at the end of five years. An increase in product life, together with a
positive value for the assets, will reduce the negative NPV.
The estimated future sales of the shares excludes the effects of inflation. Consideration should be given
to increasing the future sales by an inflation-adjusted figure. The accountant also assumes that there are
no opportunity costs involved in manufacturing the new product. It is possib e that by producing the new
product, the company is foregoing other opportunities, in which case the negative NPV will be increased.
(d) Mr Pienaar’s statement that a positive annual profit is giving the sh reholder n increased return ignores
the following points:
A new investment will increase the business risk, and possibly the financial risk. The shareholders
and debt-holders will therefore require compensation for such risk by way of a return equal to ke for
shareholders and kd for debt-holders. The WACC disc unt rate takes into account such required
return, and a negative NPV of R689 300 means that the investment does not yield an acceptable
return.
(ii) Accounting profits ignore the time value of oney. Future cashflows are worth less than current
cashflows, due to inflation.
Accounting profits can be substantially different to actual cashflows, depending on the accounting
policy used.
Question 6-6 (Intermediate) 40 marks 60 minutes

Maranta Ltd is a profitable company and is currently evaluating a project that, if accepted, will potentially
increase sales and profit.
The management of Maranta has asked you to advise it on the ideal capital structure for the company, the
desirability of accepting the project and how the project, if accepted, should be financed.
Statement of Financial Position: Maranta Ltd as at 31 July 20X1:
Assets R’000
Non-current assets
Property, plant and equipment 7 600
Current assets
Inventory 800
Accounts receivable 600
Short term investments 1 000
Total assets R10 000
Equity and liabilities

Capital and reserves
Issued capital (Note 1) 2 400
Accumulated profits 3 600
N n-current liabilities
Long-term loans (Note 2) 2 100
Preference shares (Note 3) 900
Current liabilities
Accounts payable 500
B nk overdraft 500
R10 000
237
The following information is also available:

Issued share capital represents shares issued at R10 par value. The shareholders’ required rate of return is
23,125% and a dividend of 484 cents per share has been paid. Dividends have been growing at 8% and are
expected to continue to do so in the foreseeable future.
The long-term loan matures in three years’ time. Interest after tax for the year ended 31 July 20X1 was R187
500.
Preference shareholders have recently been paid their fixed annual dividend of R62 500. Preference shares
are indefinite, have no conversion rights and trade at a market required return of 12,5%.
Project information
Project cost is R1 800 000, payable at the start of the project.
Project life is 4 years.
Project assets will be sold for R400 000 at the end of f ur years.
(d) SARS will allow Maranta Ltd to write-off the full cost f the pr ject equally over two years (ie at the
end of years 1 and 2).
(e) Short-term investments valued at R500 000 will be sold at the beginning of the year. The funds
generated will be used to partly finance working capital require ents.
Inventory, accounts receivable and current liabiliti s will double at the beginning of the project and will
remain at that level over the life of the proj ct.
The company has an accumulated tax loss of 100 000 which has arisen as a result of temporary
differences.
Annual after-tax cash-flows from the project excluding items (a) to (g) above will be R540 000 per
annum for 4 years.
All cash-flows take place at the end of the financial year unless otherwise stated.
Maranta Ltd has been advised by lenders of long-term funds that they are prepared to finance the project
at the current long-term loan rate of 20% before tax. Funds can also be raised from ordinary shareholders
at the appropriate rate.
The tax rate is 37,5% and you are to assume that there is no tax lag.
You have estimated that the market relationship between debt (after tax) and equity for companies similar
to Maranta Ltd is as follows;
Debt : Equity Kd % Ke %
0 : 100 – 22
20 : 80 12,5 23,125
40 : 60 12,5 25
50 : 50 16 28
60 : 40 19 34
You are required to:

Evaluate the project and advise Maranta Ltd whether or not the investment should be accepted.
(15 marks)
A uming that Maranta Ltd will invest in the project, evaluate how the project should be financed.
(15 marks)
“The return from any portfolio is a function of the risk free rate and a premium for risk. The return from
ny investment is a function of the risk free rate and a premium for risk.”
On the basis of the above statement, draw a diagram and explain how the ‘portfolio’ theory derives
the required return for a portfolio.
238
Draw a diagram and explain how the capital asset pricing model derives the required return for an
investment. Briefly explain the similarities and differences between the ‘portfolio’ theory and the
capital asset pricing model. (10 marks)
Note: You are not required to list the assumptions for CAPM.
Solution:
Long-term WACC:
Debt : Equity Kd % Ke % WACC
(weighting)
0 : 100 – 22 22%
20 : 80 12,5 23,125 21%
40 : 60 12,5 25 20%
50 : 50 16 28 22%
60 : 40 19 34 25%
The lowest WACC at different D : E ratios is 20%. The c mpany sh uld use this as the rate to evaluate
capital decisions. The company should finance its projects in order to move towards a D : E ratio of 40 : 60
Investment dcision:
PV 20%
Year 0 Investment (1 800 000) 1 (1 800 000)
Year 1 Wear-and-tear (900 000 × 37,5%) 337 500 0,8333 281 239
Year2 Wear-and-tear (900 000 × 37,5%) 337 500 0,6944 234 360
Year 4 Sell assets 400 000 0,4823 192 920
Year 4 Recoupment (400 000 × 37,5%) (150 000) 0,4823 (72 345)
Year 0 Working capital (800 000 + 600 000 – 500 000) (900 000) 1 (900 000)
Year 4 Working capital (800 000 + 600 000 – 500 000) 900 000 0,4823 434 070
Year 1 Cash-flows 540 000 0,8333 449 982
Year 2 Cash-flows 540 000 0,6944 374 976
Year 3 Cash-flows 540 000 0,5787 312 498
Year 4 Cash-flows 540 000 0,4823 260 442
Net present value (231 858)
The sale of short-term investments of R500 000 will not affect the investment decision.
Assessed loss is not accounted for as it is assumed that the company will utilise the tax loss regardless of
whether the project is accepted.
Conclusion: The inv stm nt has a negative net present value when discounted at the target required
turn of 20% and should not be accepted.
Financing de ision:
Equity
Number of shares 2 400 000 / R10 = 240 000
D1 4,84 (1,08)
Val e = =
ke – g 23125 – 0,08
= R34,56 per share
Total value R34,56 × 240 000 = R8 294 400
Debt: Long-term loans
187 500 187 500 2 287 500
+ +
(1 + 12,5%)
2 (1 + 12,5%)
3
(1 + 12,5%)
= 166 667 + 148 148 + 1 606 584
R1 921 399
12.5% after tax is arrived at as (20% × 62,5%)
239
Preference shares
Dividend
Value =
Kd
62 500
=
0,125
= R500 000
Total debt = R1 921 399 + 500 000

= R2 421 399
Market value equity = 8 294 400
Market value debt = 2 421 399
New investment = 2 700 000 [ 1 800 000 + 900 000 ]
Finance 13 415 799
Equity Debt Total

60% 40%
Total 8 049 479 5 366 320 13 415 799
Existing 8 294 400 2 421 399 10 715 799
Required – 244 921 2 944 921 2 700 000
Based on the current value of debt and equity, the ntire amount can be financed by debt. The total
required is R2 700 000. The company has taken the decision to use R500 000 from the sale of investments
to partly finance the required funds. The balance required, (R2 200 000) should be financed through long-
term loans or preference shares.
(i) Portfolio theory states that an investor will minimise risk by selecting a well-balanced, diversified
portfolio. The required rate of return is equal to a risk-free rate plus a risk premium. The extent of
the risk premium depends on the level of risk associated with the portfolio:
Rp = f+P
where: Rp = required return (portfolio)

Rf = risk-free rate
P = risk premium
CML
R turn
M
Rm
Rf
σm
Risk
The required return for a portfolio on the CML line is expressed as:
(Rm – Rf) σp
Rp = Rf +
σm
Portfolio theory derives the required return by assessing the level of risk required for a portfolio in
relation to the risk of the market portfolio.
240
The major determinant of the required return on an asset is its degree of risk. Risk refers to the
probabilities that the returns, and therefore the values of an asset or security, may have alternative
outcomes. The measure of risk is generally accepted as the standard deviation (σ) of an asset or
security.
The CAPM assumes that all investors are diversified and as a result are subjected to systematic risk
only. Systematic risk cannot be avoided by diversification. This is the fundamental risk that a share’s
possible return is exposed to, and caused by general economic trends, political or social factors
affecting all companies simultaneously. Therefore, the relevant risk for an investment is the
systematic risk.
Return SML
R%
26%
22%
18%
10%
1 1,5 2
Beta (systematic risk)
The CAPM equation is defined as:

Ri = Rf + βi(Rm – Rf)
where: Ri = required return for security i
Rf = risk-free rate
βi = systematic risk of security i
Rm = expected return from the market
The CAPM is derived from portfolio theory. The SML line represented in CAPM is the same as the
capital market line in terms of the portfolio theory. The risk-free rate is also the same for both
CAPM and the portfolio theory. The major difference is that risk under the portfolio theory is
measured as a standard deviation while under the CAPM, it is measured as beta, which represents
systematic risk only.

Mr Skosana was p esented with the following investment opportunity for his SME enterprise.
The after-tax cashflows of the project are as follows:
R R R R R R
Year 0 1 2 3 4 5
Cashfl ws (750 000) 250 000 200 000 270 000 260 000 150 000
The following criteria are applied by Mr Skosana’s enterprise to assist in investment decision-
making: Capital investments are to be recovered within four years.
A return above the weighted average cost of capital (WACC) of 16% is required when discounted
cashflows methods are employed.
241
Required:
Calculate the following and state whether the project is acceptable according to this method:
(a) Pay-back period (4 marks)
(b) Discounted payback period (6 marks)
(c) Net Present Value (NPV) (6 marks)
(d) Internal rate of return (IRR) (6 marks)
(e) Modified internal rate of return (MIRR) (6 marks)
(f) Net Present Value Index (NPVI) (3 marks)
Solution
Pay-back period
R R R
Year 0 Outflow
Investment = (750 000)
Inflows Per annum Cumulative Investment
Year 1 250 000 250 000 ‹ 750 000
Year 2 200 000 450 000 ‹ 750 000
Year 3 270 000 720 000 ‹ 750 000
Year 4 260 000 980 000 › 750 000
Let x be part of the caashflow of year 4:
250 000 + 200 000 + 270 000 + 260 000x = 750 000
720 000 + 260 000x = 750 000
260 000x = 750 000 – 720 000
x = 30 000/260 000 = 0,12
Therefore the payback period equals 3,12 years which is less than four years and the project is therefore
acceptable.
(b) Discounted payback period
YEARS
0 1 2 3 4 5
R R R R R R
Cash inflows 250 000 200 000 270 000 260 000 150 000
Factor @ 16% 1,000 0,862 0,743 0,641 0,552 0,476
NPV pa (750 000) 215 500 148 600 173 070 143 520 71 400
Total NPV 2 090
R R R
Outfl w
Di counted
Inflows Per annum Cumulative Investment
Year 1 215 500 215 500 ‹ 750 000
Year 2 148 600 364 100 ‹ 750 000
Year 3 173 070 537 170 ‹ 750 000
Year 4 143 520 680 690 ‹ 750 000
Year 5 71 400 752 090 › 750 000
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Let x be part of the cashflow of year 5:

215 500 + 148 600 + 173 070 + 143520 + 71 400x = 750 000
ˆ 680 690 + 71 400x = 750 000
ˆ 71 400x = 750 000 – 680 690
ˆ x = 69 310 / 71 400 = 0,97
Therefore the discounted payback period equals 4,97 years which is more than four years and therefore
the project is not acceptable.
Net present value (NPV)
The NPV equals a positive R2 090 as calculated per (b) above and the project is therefore acceptable,
although barely profitable.
Internal rate of return (IRR)
Method 1 (by means of interpolation):

Notes:
1 The NPV @ 16% equals a positive R2 090 and has already been calculated in (b) above.
2 To obtain a NPV of zero, one would have to discount at a higher interest rate for interpolation
purposes.
3 In the case of a negative NPV, one would have to discount at a lower interest rate to obtain a NPV of
zero.
4 The next higher available interest rate per tables at the back of the book is 18%.
5 Also refer to 6.3.6.
NPV at 18%:
YEARS
0 1 2 3 4 5
R R R R R
Cash inflows 250 000 200 000 270 000 260 000 150 000
Factor @ 18% 1,000 0,847 0,718 0,609 0,516 0,437
NPV pa (750 000) 211 750 143 600 164 430 134 160 65 550
Total NPV (30 510)
The NPV @ 18% quals a negative (R30 510) as calculated above.

An approximate IRR by interpolating between 16% and 18% to get to a zero NPV (see 6.3.6)
16% + [2 090 / (2 090 + 30 510) x (18% – 16%) ]
16% + (2 090/32 600) x 2%
16,13%
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Method 2 (much quicker by means of a financial calculator):

Note:
1 Also refer to time value of money calculations with a financial calculator in chapter 3.

CFj0 = –750 000
CFj1 = 250 000
CFj2 = 200 000
CFj3 = 270 000
CFj4 = 260 000
CFj5 = 150 000
IRR = 16,13%
The IRR exceeds the required return of 16% and the pr ject is therefore acceptable, although barely
profitable.
Modified internal rate of return (MIRR)
YEARS
0 1 2 3 4 5
R R R R R R
Cash inflows 250 000 200 000 270 000 260 000 150 000
Factor @ 16% 1,000 1,811 1,561 1,346 1,160 1,000
Values at end* 452 750 312 200 363 420 301 600 150 000
Total of inflows 1 579 970
Outflow (750 000)
* Value of inflows at the end of year 5 at WACC of 16%

PV = –750 000
FV = 1 579 970
N = 5
I/YR = 16,07%
Note:
The MIRR of 16,07 is very near to the IRR of 16,13% and the WACC of 16% because the NPV is
relatively small with no huge initial inflows which are assumed to be reinvested at a higher IRR than
16,07%.
The MIRR exceeds the required return of 16% and the project is therefore acceptable, although barely
profitable.
Net present value index (NPVI)
NPVI is defined as
NPVI = (Initial investment + NPV) / Initial investment
(750 000 + 2 090) / 750 000
1,003
The NPVI equals more than 1 and the project is therefore acceptable, although barely profitable.
244
Question 6–8 (Intermediate) 45 marks 68 minutes

Mr Du Toit has read about the treatment of uncertainty in investment appraisals and wants to incorporate risk
in his investment decision-making.
Required:
Show ways how Mr Du Toit can incorporate risk in his investment decision-making.
Solution:
Time based methods of incorporating risk
Payback
Introduce payback periods as a safety net in risk reduction.
Finite horizon
Ignore project results beyond a certain period, say seven years, called the finite horizon to reduce
risk.
Risk premium
Increase the discount rate to compensate for increased risk.
l Such an inflated discount rate rais s the hurdle rate for the investment decision, and deals with
risk as a function of time as illustrat d b low.
l Note that later cashflows are more heavily discounted.
Illustration:
YEARS
0 1 2 3 4 5
R R R R R R
Cash flows 250 000 200 000 270 000 260 000 150 000
Factor @ 16% 1,000 0,862 0,743 0,641 0,552 0,476
NPV pa (750 000) 215 500 148 600 173 070 143 520 71 400
Total NPV 2 090
YEARS
0 1 2 3 4 5
R R R R R R
Cash flows 250 000 200 000 270 000 260 000 150 000
Factor @ 18% 1,000 0,847 0,718 0,609 0,516 0,437
NPV pa (75s0 000)211 750 143 600 164 430 134 160 65 550
Total NPV (30 510)
Result:
NPV ' @ 16% 215 500 148 600 173 070 143 520 71 400
NPV ' @ 18% 211 750 143 600 164 430 134 160 65 550
Difference: 3 750 5 000 8 640 9 360 5 850
Reduction in NPV 2% 3% 5% 7% 8%
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Probability based methods of incorporating risk:

Expected value
Utilise probability based methods, whereby probability theory is applied to different possible
estimates to calculate an expected value instead of using a single value.
Illustration:
Instead of using the R300 000 below as the sales figure in an investment appraisal, by incorporating
probability theory to determine the expected value of R275 000 might lead to a better more realistic
estimate.
Sales in R Probability Sales × Probabi ity
100 000 10% 10 000
200 000 25% 50 000
300 000 50% 150 000
400 000 10% 40 000
500 000 5% 25 000
Therefore, R275 000 would be a more scientific esti ate of the expected sales revenue out of a
range of possible outcomes than using the single ost likely estimate of R300 000.
Optimistic, most likely and pessimistic views
Utilise probability theory to determine diff r nt possible estimates from optimistic, most likely and
pessimistic outcomes to calculate an exp ct d value instead of using a single value.
Illustration:
Instead of using say R450 000 as a possible cash inflow in an investment appraisal, incorporate
probability theory to determine the expected value from optimistic, most likely and pessimistic
values.
Alternatives Cashflows in R Probability Cashflows × Probability
Optimistic 600 000 10% 60 000
Most likely 450 000 65% 292 500
Pessimistic 300 000 25% 75 000
Therefore, R427 500 would be a more scientific estimate of the expected revenue inflow out of a
range of possible inflows than using the single most likely estimate of R450 000.
Other methods
Apply s nsitivity analysis, simulation and Monte Carlo analysis:
By varying the value of the key factors in an appraisal, the more sensitive elements can be
determined and the effect thereof considered.
By simulation and Monte Carlo analysis the initial estimated probabilities could be re-evaluated.
Incorporate statistical models utilising discrete and continuous probability distributions.
By establishing cashflow means and standard deviations, statistical methods can be utilised to
estimate the variability of a project – applications of the Normal Distribution is especially
beneficial in this regard (see chapter 5).
These would enable Mr Du Toit to estimate:
The mean NPV.
The standard deviation from the mean NPV.
Limits within which parameters ( NPV, cashflow etc) would lie, say the estimated NPV within
R10 000 above or below the mean value at a confidence level of say 10%.
The probability of obtaining a negative NPV or NPV exceeding R1 500 000.
246

A large consortium is considering an investment opportunity to invest in a new platinum mine in South Africa.
Required:
List some of the aspects, including ESG* principles, that should be considered over and above the number
crunching.
(*Refer to Chapter 2 for environment, social and governance principles.)
Solution:
Consider the following:
The demand for platinum on the world market.
Anticipated future exchange rates.
The best suitable form of financing of the project.
The risk involved and the political security in the country.
l The influence of a mine on the environment and cli ate change.
l Restructuring the environment at the end of the lifeti e of the ine.
The influence of labour unions and strikes.
Capital versus labour intensive operations.
Location of the site and the transport of raw materials and platinum ore.
Availability of qualified mining engineers.
Availability of sufficient underground mining operators.
Availability of sufficient housing, transport, nearby schools and medical facilities for staff.
Royalties payable to the trust for the indigenous inhabitants.
Sustainability aspects.
Equator requirements.
.
247
Chapter 7
The financing decision
detail the most prominent forms of finance available to business entities in South Africa;
for each form of finance, describe the typical business entities that make use of it, typical sources of (or
investors in) these forms of finance, and typical associated requirements;
understand the suitability of different forms of finance to different types of business entities, different
types of assets financed, and different intend d purpos s;
determine the most appropriate form of finance for a South African business entity, given a specific
scenario, by performing appropriate calculations for various financing options and by considering other
relevant factors; and
compare and critically evaluate the choice between debt and lease finance.
The previous chapter ( The investment decision) considered the issue of capital budgeting, or whether it is
worthwhile to invest in an asset. This chapter (The financing decision) considers the next important question,
namely, if a capital investment will be beneficial, how best should the asset be financed? It must be noted that
this chapter does overlap with chapter 10 (Valuations of preference shares and debt), which addresses
principles and knowledge linked to the valuation of debt. This chapter will explore the prominent forms of
finance available to business entities in South Africa, and the suitability of each of the various circumstances. It
further explains and illustrates calculations to determine the most cost-effective form of finance. It also
illustrates the complications associated with a lease versus buy decision.
7.1 Finance the lif blood

Finance represents the lifeblood that enables a business to grow, expand, thrive and sometimes, merely
survive. Raising finan e is therefore a very important aspect for any business enterprise.
For the new, smaller business it is often a case of using whatever form of finance is available, at whatever cost.
The National Credit Act 34 of 2005 may have discouraged unfair credit lending practises but, in this process,
this Act f rther red ced the available sources of finance to the small business.
In contrast, a larger business – with track record – can often apply more of the knowledge and skills highlighted
in this chapter to secure the right form of finance, at the right time, and at the right cost.
The financial crisis of the past number of years has not only restricted the access to finance for many business
entitie , but placed renewed focus on the risk of using excessive debt finance. This hard-won lesson underlines
the ink between new forms of finance and the capital structure of a business (refer to chapter 4 Capital
structure and the cost of capital).
This chapter highlights important matters surrounding sources and forms of finance, and the cost thereof.
249
7.2 Which form of finance?

In deciding on a form of finance, an enterprise should consider several factors, including the following:
Suitability to the type of business and/or asset financed – a general principle is that the useful life of the
asset and the payback period of the finance (if applicable) should match.
True cost – debt, often bearing lower risk to the investor and being tax deductible, is usually a cheaper
source of finance than equity.
Impact on cashflow – debt has a significant impact on the cashflow position of a company, but the
associated interest and capital repayments are usually agreed on in advance. If would therefore be
sensible to structure financing in such a way that the expected cash outflows strongly correlate with the
expected cash inflows from the investment.
Associated constraints – the providers of debt may impose certain lending conditions, such as debt
covenants (agreed upon conditions), or requirements for collateral or security.
Impact on the overall risk profile – a company with high debt levels bears increased risk. This increased
risk stems from the possible impact of uncertainties, such as an increase in interest rates or an
unexpected deterioration in a company’s cashflow positi n, which w uld make it increasingly difficult to
meet the fixed capital and interest payments normally associated with debt finance.
Control – the issue of new shares to investors could dilute the existing shareholding and might impact on
the control over the company.
How it pairs with existing finance – will it for instanc , change the capital structure such that the
weighted average cost of capital (WACC) chang s? Will it assist the business entity to move closer to a
target capital structure, or further away from it?
Availability – will the specific entity have access to a specific form of finance or will investors be
interested to invest?
7.3 Classification of different forms of finance

Notwithstanding the effects of the financial crisis and new legislation, several forms of finance are nonetheless
available to the South African business, from several sources. In this section we briefly revisit the various forms
of finance and explain some associated attributes – specifically from a South African perspective.
Forms of finance can firstly be classified as short-term (less than one year), medium-term (one to five years) or
long- term (more than five years; although it must be noted that the exact number of years associated with
each category is sometimes blurred).
Finance can be described as secured or unsecured. Secured finance has a first claim over some specified
asset(s), such as prop rty (as in the case of a mortgage loan, which is long-term finance), or equipment (as in
the case of hire-purchas , which is medium-term finance) and debtors (as in the case of factoring, which is short
-term finan e). In the event of default on the finance terms, the secured finance provider normally has the right
to lay immediate laim over the specified asset(s) in order to recover outstanding debt. In contrast, the
providers of unse u ed finance cannot lay claim to a specific asset in the case of default. Unsecured finance
providers a e, howeve , not totally without recourse as the name might imply: they can normally instigate
actions to recover a portion of outstanding debt; though these actions, including application for the liquidation
of the defa lter, will be impacted by the new business rescue procedure contained in the Companies Act 71 of
2008.
Forms f finance can further be classified as debt, equity, hybrid capital (also known as quasi-equity, with pr
perties f debt and equity), or mezzanine finance. The term mezzanine finance is associated with the Italian
word for ‘middle’, implying that the claim of the holder of mezzanine finance ranks in between equity (
ometimes also unsecured trade debt) and all other forms of finance. Upon liquidation, mezzanine finance will
therefore rank junior (below) all other finance, except equity (and occasionally, unsecured trade debt).
Tailor-made finance
Different forms of finance are better suited to different business entities and to different intended purposes.
When charting this suitability, numerous classifications may be used. One possibility is to segregate entities in
terms of size, development stage, and purpose. The latter can then be further separated in terms of financing
of specific assets (e.g., property, vehicles or aircraft), or a Black Economic Empowerment (BEE) transaction.
250
The financing decision Chapter 7
Sources of finance
Finance can be sourced from the money and capital markets. Money market refers to the short-term financial
market (usually repayable in less than one year) where borrowers and lenders are brought together by banks
and other financial institutions.
The capital market refers to the longer term market for securities whereby entities can raise or invest in debt
and equity. The capital market can further be segregated into the primary market (the market where new
securities are sold) and the secondary market (where existing securities are sold by one investor to another);
the latter is facilitated by a formal market (a securities exchange) or over the counter (OTC) trading by dealers.
Obviously, a cost-effective and liquid secondary market will indirectly enhance a primary market.
A multitude of entities operate within these markets and, in the end, these entities are the true sources of
finance, or investors in securities.
7.4 Equity as a source of finance

Obtaining equity funds
A company may either use its own funds in the form of retained earnings, or source funds from external
investors. Retained earnings are past profits that were ploughed back into the company. This is not a free
source of finance, as existing shareholders will expect a return on funds invested in the organisation.
The presence of retained earnings in the financial statements does not necessarily imply that there is cash
available for expansion, as the retained earnings may be ti d up in existing non-current assets such as plant or
property. Deciding on dividend policy is therefore one of the important roles of the financial manager, as the
payment of dividends reduces the amount of retained earnings. Company managers find the use of retained
earnings an attractive source of funding as they do not have to involve shareholders or outsiders such as banks.
There are also no issue costs involved and no change in control is possible.
Equity funds can also be sourced through the capital markets. This can be done by issuing new shares in the
company, or by rights issues whereby existing shareholders have the opportunity to take up additional shares
in the company. This is usually done at a discounted price. Capital markets can also be used to source certain
forms of debt, for example where interest-bearing debentures are issued to the public.
Factors to consider when issuing shares are the cost involved, the income that can be distributed to investors
and the effect that the issue of new shares may have on existing control in the company. Obtaining funds
through a stock market could be a costly exercise as there are considerable marketing expenses and
professional fees that will have to be paid.
Other sources of equity funds include venture capital and international sources. Venture capital involves a
venture capitalist investing funds. The venture capitalist’s aim is usually to make a significant profit in a
relatively short period, and to xit again after a few years. Venture capital can therefore be regarded as an
expensive source of finance.
Stock market listing

Reasons for seeking a stock market listing
There are several reasons why companies seek stock market listings:
It gives them access to a wider pool of finance, making it easier to obtain funds.
Shares bec me more marketable, which will in turn increase the share price.
Enhanced public image and more exposure in the media.
A tock market listing can be used by the original owners of the business as an exit strategy, or to realise
ome of their shareholding. Sometimes they regard it as a step to the next level where a stronger
management team can be recruited.
Original owners wish to sell their shareholding to obtain funds for other projects.
Listed companies find it easier to seek growth by acquisition than unlisted companies.
251
The methods used to obtain a listing

There are usually two methods used to obtain a listing. The first is an offer for sale. In this case the investors
can tender for shares which will then be allocated to them. A second, cheaper method is to make use of a
placing. A placing is where a number of specific investors such as pension funds or business associates are
invited to take up the shares.
Underwriting
Underwriters are financial institutions that agree (in exchange for a fixed fee, usually a percentage of the
finance to be raised) to buy any securities which are not subscribed for by the investing public at the issue
price. This removes the risk of the share issue being under-subscribed.
Rights issues
Capital is raised by giving existing shareholders the right to subscribe to new shares in proportion to their
current shareholding. These are usually issued at a discount to market price to make it more attractive to the
investor. A shareholder not wishing to take up a rights issue may sell these rights.
Advantages of a rights issue

A rights issue is cheaper than an offer for sale to the general public. Administration costs are cheaper and
the company does not need a prospectus. The expenditure on arketing will also be reduced since the
investors are familiar with the company.
If shares are offered at a discount it is an attractive inv stm nt opportunity to the existing shareholders.
The existing voting rights and therefore control over the company are unaffected if all shareholders
exercise their rights.
The capital raised can be used to repay debt, therefore strengthening the financial position of the
company.
Example 1: A rights issue

Ndlovu Enterprises Limited can achieve a profit after tax of 20% on capital employed. The company’s capital
structure is as follows:
R million
40 million ordinary shares of R1 each 40
Retained earnings 20
60
The directors intend to raise an additional R25 million from a rights issue for the construction of a new factory
in the Eastern Cape. The curr nt market price is R1,80 per share.
Calculate the number of shares that should be issued if the rights price is respectively R1,60; R1,50; R1,40;
R1,20. Also cal ulate the dilution in earnings per share in each case.
Solution:
Earnings at present is R12 million (20% × R60 million). Earnings per share (EPS) is R12 million/40 million = 30
cents. After the rights issue earnings will be R17 million (20% × R85 million)
Rights price No of new shares (million) EPS (17 m / total Dilution
R R25 m / rights price no of new shares) cents
1,60 15,625 30,6 + 0,6
1,50 16,667 30,0 0
1,40 17,857 29,4 (0,6)
1,20 20,833 27,9 (2,1)
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The market price of a share after a rights issue: the theoretical ex-rights price
If new shares are issued at a discount to the existing share price, there should theoretically speaking be a
dilution of the share price. The theoretical share price immediately after the rights issue is known as the
theoretical ex-rights price and can be determined as follows:
1
Theoretical ex-rights price = N+1 ((N × cum rights price) + issue price)
Where:
N = number of shares required to buy one new share
Example 2: Theoretical ex-rights price

Ndlovu Enterprises Limited has 40 million ordinary shares of R1 in issue, which have a market price on 1 March
of R1,80 per share. The company has recently decided to make a rights issue, and offers its shareholders the
right to subscribe for one new share at R1,55 each for every four shares already held. The market value just
before the rights issue is known as the cum rights price. What is the the retical ex-rights price?
Solution
Applying the formula above:
(1/(4 + 1)) × ((4 × R1,80) + R1,55) = R1,75
The value of a right

The value of a right is the ‘value’ the shareholder will lose by not exercising his right. This is also the market
value of the right – the value at which the right can be sold to another party. The value of a right is the ex-rights
price less the issue price.
In the above example it would be: R1,75 – R1,55 = R0,20 per new share or 5 cents per existing share. You
require four existing shares to acquire one new share.
Possible course of action open to shareholders in the case of a rights issue

There are four possible actions a shareholder could follow in the case of a rights issue:
Take up or exercise the rights. The shareholder will retain the same relative voting rights in the company
as before.
Renounce the rights and sell them on the market. The shareholder will dilute his/her shareholding slightly,
but will be compensated in the form of cash received for the sale of the rights.
Renounce part of the rights and take up the remainder. The rest can be sold.
Do nothing – this is a bad option, as the shareholder will experience a dilution in share value without the
compensation he/she ould have received by selling the rights.
Warrants
A warrant is a right given by a company to an investor, allowing him to subscribe for new shares at a future
date at a fixed, pre-determined price, called the exercise price. Warrants are usually issued as part of a package
with unsecured l an stock (debt security or debentures), to make the loan stock more attractive.
Advantages f warrants to the company:
It does not involve payments of dividends or interest.
It makes loan stock more attractive.
It generates additional equity funds.
253
7.5 Preference shares

Preference shares are a form of hybrid instrument, with characteristics of both equity and debt. Preference
shares normally carry a fixed rate of dividends. The holders of the preference shares have a preference claim to
distributable earnings over ordinary shareholders. This means that no dividends may be distributed to ordinary
shareholders before the preference shareholders have received their preference dividends. In the event of
winding up the company, the preference shareholders usually have a senior claim over the ordinary
shareholders to the repayment of capital.
In the case of cumulative preference shares, the dividends accumulate if in a given year there is not enough
cash available to pay dividends that is the dividend is passed. These dividends wi then be paid in a later year,
together with the dividends of that year.
Participating preference shares have an additional entitlement to ordin ry dividends over and above the
preference dividend.
Why do companies issue preference dividends?
l Dividends do not have to be paid in a year when profits are p r, which is not the case with interest on
loans.
Preference shareholders do not have voting rights and therefore no control. Ordinary shareholders
maintain full control over the company unless preference dividends are in arrears.
Preference shares will lower the company’s gearing, unless they are redeemable. In the latter case it is
treated as debt when calculating gearing.
Preference shares do not increase the company’s g aring, allowing it to borrow more in future.
A disadvantage of preference shares is that preference dividends are not tax deductible, as in the case of
interest payments.
7.6 Debt
Broadly speaking there are two categories of debt – funds provided by banks or other financial institutions,
such as a loan, and funds provided directly by individual investors through their investment in marketable
securities issued by a business entity (debtor), such as medium term notes and bonds. (Refer to the concept of
securitisation as described in Appendix A Selected concepts, acronyms and terminology.)
Appendix 1 to this chapter lists several examples of different forms of debt. The most common forms of a loan,
and the associated advantages and disadvantages are described below.
Bank loans
Bank loans are a source of m dium-term finance, usually linked with the purchase of specific assets. The
interest rate can eith r be fix d for the period of the loan, or it can be linked to the prime rate of interest. The
latter is more widely applied in South Africa. The fact that interest rates could increase at any time during the
period of the loan in reases the risk to the company, and a company needs to take steps to hedge itself against
this risk.
The advantages of a bank overdraft (short-term) over a loan (medium-term) are as follows:
The c stomer only pays interest when his bank account is overdrawn.
The bank has the flexibility to review the facility from time to time.
The facility can be renewed when it comes up for review – it can therefore become a permanent
arrangement without the commitment to repay the capital component.
A bank overdraft is regarded as part of working capital and therefore analysts will be less inclined to con
ider it in their calculation of the company’s gearing.
The advantages of a loan:
The repayment schedule (capital as well as interest) is fixed in advance, which facilitates planning.
The bank has the right to reduce or withdraw an overdraft facility, which may impact on the company’s
cashflow planning.
A loan usually bears a lower rate of interest than a bank overdraft.
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Loan capital
Loan stock (debentures) is issued on a capital market to interested investors. As in the case of shares, a
secondary market exists for these securities, meaning that the securities can exchange ownership between the
date of issue and settlement. The exchange will have no effect on the company’s financial position. The
securities have a nominal value, and interest is paid at a stated coupon on this amount. If the coupon is 8% of
the nominal value, the company will have to pay R8 per annum on R100 loan stock.
Advantages and disadvantages of debt compared to equity

Advantages of debt
Debt is generally a cheaper form of finance as the investor bears lower risk.
Interest is tax deductible, reducing the effective cost to the company.
Debt can be secured against the assets of the company, making it more attractive to investors.
Debenture holders rank above shareholders in the case of liquidati n.
Issue costs of debt are usually lower than that of shares.
l Debt has no immediate impact on the control structure of the co pany.
l The issue of debt instruments or bank borrowing has no i ediate impact on dilution in earnings and
dividends per share. Interest may however impact on the profitability of a company.
Disadvantages of debt
Interest has to be paid, regardless of profitability. Capital also has to be repaid in terms of an agreed
repayment schedule. This could impact negatively on the company’s cashflow, and might even lead to
bankruptcy.
Shareholders are likely to demand a higher return due to increased risk.
7.7 Convertible securities

Convertible loan stock gives the holder the right to convert to other securities, normally ordinary shares, at a
pre-determined price or rate and time. The current market value of ordinary shares into which a unit of stock
may be converted is known as the conversion value. The conversion value will be below the value of the stock
at the date of issue, but will be expected to increase as the date for conversion approaches on the assumption
that the market value of the company’s shares will increase over time. The difference between the issue value
of the stock and the conversion value as at the date of issue is the implicit conversion premium.
Convertible instrum nts have c rtain advantages to ordinary loan stock, making it attractive for both the
company and investor:
An investor will a ept a lower initial interest rate, hoping to participate in an increase in the share price in
the futu e.
The company will often pay a lower interest rate, which is positive for cashflow and profitability.
Even if the share price does not increase to expectation, the company may still issue at the price and rate
determined beforehand.
The pr visi ns may allow for the capital amount to be repaid if the share price does not perform as
expected.
I ue costs are only paid once in respect of debt and shares issued.
The company’s gearing ratio is reduced when conversion takes place, allowing further borrowing.
The disadvantages of convertibles:
Upon conversion, the company is likely to effectively issue shares at a lower price than market value. This
will be the case where there was a significant increase in the share price.
Depending on the provisions, debt has to be repaid if the share price does not increase to expectation.
The low initial yield may be unattractive to investors.
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The exercise of convertibles does not provide extra funds upon conversion.
Conversion to ordinary shares will impact on control.
7.8 Criteria applied by providers of finance/investors

The business seeking new finance/investors may obtain insight by first exploring the criteria applied by the
financiers/investors. The providers of debt finance – typically banks – pay particular attention to the following
areas, before granting debt finance to a business:
Affordability – is the borrower’s risk profile such that they are able to afford the new debt to be granted?
Companies classified as higher risk, attract higher borrowing costs.
Sustainability – will the borrower generate sufficient income over the long-term such that they can fulfil
all their existing operational and financial obligations on the business plus the cost of the new debt to be
granted?
Liquidity and cashflow – how liquid is the business? What is the current and expected trend for the
business in terms of cash inflows and outflows (before the granting f the finance)? How will this change
given the new debt to be granted? How can the repayment terms on the new debt to be granted
accommodate the cashflow profile of the specific business? (For asset-based lending the asset normally
dictates the term and rate of finance.)
Creditworthiness history – is there evidence of a negative business credit report? Have the
owners/management been sequestrated in the past or do they have a negative credit rating?
Security – in the case of secured debt, the realisable value from the underlying asset should be sufficient
to cover the debt in the case of default; in the case of unsecured debt, closer attention is paid to the
aforementioned criteria.
National Credit Act (NCA) requirements – the credit provider has to comply with additional requirements
when granting credit to the smaller business or it may be guilty of ‘reckless lending’, with associated
penalties and other repercussions. (The NCA requirements apply to credit granted to a consumer and the
smaller business (currently defined as a business with an asset value or annual turnover equal to R1
million or less).)
Several investors in equity or hybrid capital do not seek an active role in the business investment. (Their
services, however, often include advisory services.) Such investors include venture capital funds, private equity
houses, merchant banks and developing finance institutions. These investors often look for the following,
before investing funds –
an equity interest held by management;
a strong management team;
significant growth pot ntial; and
available exit rout s within a number of years, such as opportunity of a management buyout or for an
initial public offering.
A useful ac onym (PARTS) for memorising the most important criteria that lenders will consider when an
organisation applies for finance, is the following:
P – P rpose
A – Amo nt
R – Repayment
T – Term
S – Security
7.9 Overview of sources and forms of finance

Appendix 1 to this chapter offers a useful overview of typical elements associated with different forms of
finance in the South African business context, including typical users, attributes, sources/investors and
requirements. It is suggested that you work through the table on a line-by-line basis, in order to confirm your
understanding and to identify areas requiring further study.
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Note that this table is not intended to be all -encompassing or relevant under all circumstances. Appendix 1
excludes forms of finance used by specialised entities such as government entities, non-profit entities, banks,
and donor institutions (but may include these as the possible providers of finance). Short-term finance is
included for the sake of completeness, but its learning outcomes and content are primarily addressed as part of
working capital management. Due to a tenuous link, specialised nature or coverage elsewhere in the textbook,
Appendix 1 further excludes –
all forms of derivative instruments;
specialised finance (such as securitisation and project finance); and
grants, such as those offered by the Department of Trade and Industry (the dti) to promote investment in
certain industries, infrastructure and other specified areas. (These do not represent typical finance
instruments and may, under certain circumstances, be viewed as don tions.)
7.10 Deciding on the best financing option

The aim of the financing decision is to decide on the best financing pti n for a proposed investment. In choosing
this several factors have to be considered, including:
Financing options – what are the available options, including asset-specific finance (e.g. leasing)?
l Capital structure – does the business have capacity for ore debt? How close is the business to its optimal
(or target) capital structure? Is there an opportunity to ove closer to the target level?
Cost considerations – which viable financing option is the most cost effective?
Impact – what is the impact of each viable choice in finance on the business? (E.g., the impact on control,
and the impact of debt covenants.)
Matching – is there a proper match between expected investment cash inflows and finance cash outflows?
The available financing options will depend on the exact circumstances; Appendix 1 summarises many of the
possible forms of finance. The learning outcomes and content relating to capital structure is addressed in
chapter 4 (Capital structure and the cost of capital).
The financing of a project must be considered in relation to the existing market value of equity and debt in
comparison to the market mix. When a company is already over-geared, it does not matter that the company
would like to finance through cheaper debt or lease. The company has no alternative but to use equity finance
so that it can bring the debt to equity ( :E) ratio more in line with the target ratio.
Example: The financing decision

The current market capitalisation of a company is as follows:
Equity R6 000 000
Debt R8 000 000
The company wishes to invest R3 000 000 in a new project. It has evaluated the project at the target WACC,
which showed a positive NPV. The company now wishes to know how it should finance the project given that
the target D:E ratio is 50:50.
Required:
Determine h w the project should be financed.
Solution:
Current value of the company R14 000 000
New investment R3 000 000
Company capitalisation after investment R17 000 000
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Desired D:E ratio 50:50.

Debt Equity Total
R R R
New capitalisation 8 500 000 8 500 000 17 000 000
Existing capitalisation 8 000 000 6 000 000
Finance 500 000 2 500 000
The above calculations show that the company should consider financing the new project using equity finance,
or a mix that moves towards the desired D:E ratio.
Note: This is not a science. The above calculation serves to indicate the capacity for debt financing, but
does not prescribe the exact financing proportions.
7.11 Interaction between the finance and investment decisions

The financing decision normally takes place after a capital investment appraisal, where the investment
appraisal indicated that a particular investment should be made (usually acc mpanied by a positive net present
value or an internal rate of return in excess of the weighted average cost of capital).
The only exception is where there is a particular cheap form of finance available and this form of finance is
directly linked to the particular investment (e.g. a favourable leasing option of a particular asset). In this case
the financing decision can influence the outcome of an invest ent decision, because here the cheap finance and
asset are intricately linked. In such a case the favourable ass t-specific finance could provide an additional
advantage (this extra benefit may, e.g., turn a capital-inv stm nt decision’s negative net present value, into a
positive).
This principle can be explained by the following analogy: certain automobile manufacturers entice buyers to
purchase their vehicles by offering exceptionally low interest rates on their financing options. Say you originally
established that you can just afford a new vehicle with a purchase price of R200 000; with the associated cheap
finance however, you now consider ‘investing’ in a vehicle with a higher purchase price, say R220 000.
7.11.1 Differences between the investment decision and the financing decision
The major differences between the investment and financing decisions are summarised below.
The investment decision:
The net present value of cashflows associated with the investment is calculated.
The discount rate to be employed is the weighted average after-tax cost of capital, adjusted for risk.
All cashflows associated with the investment are included in the cashflow projection.
Financing-relat d cashflows are excluded from the cashflow projection. One therefore excludes e.g.
interest, capital r paym nts, and lease payments.
It follows that, the tax benefits related to each financing option are also excluded.
The tax advantage of wear-and-tear (and not the wear-and-tear itself) is to be included in the cashflow
projection. In other words, it is assumed that the asset will be acquired for cash.
The financing decision (which will not affect ownership):

The calculation normally compares the after-tax yields to maturity (internal rates of return) of various
financing ptions. This calculation requires a present value (initial funds to be received) and future
cashflows linked to each financing option.
As an alternative, the net present cost of various financing options could be calculated and compared,
using the after-tax cost of new debt as the discount rate (unless risk profile linked to the various financing
options vary to a significant degree). This ignores the initial funds received, but discounts all other
projected financing-related cashflows, linked to each financing option.
All cashflows associated with the investment are excluded from in the cashflow projection.
It follows that the tax benefits associated with the investment are also excluded (e.g. the tax advantage of
wear-and-tear).
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Financing-related cashflows are included in the cashflow projection. One therefore includes the relevant
cashflow linked to the specific financing option, which could include e.g. interest and capital repayments.
It follows that, the tax benefits related to each financing option must also be included.
Forms of finance affecting ownership

Certain forms of finance, such as finance leases, would affect ownership. It would thus also affect the
associated tax benefit of ownership incorporated in the investment decision (e.g. wear and tear allowances). As
a result, these forms of finance cannot be compared directly to forms of finance where ownership is obtained.
These forms of finance would therefore require the application of different princip es. Refer to section 7.14.
7.11.2 General principles

It is customary to separate the investment and financing decisions, as these are in fact two different
considerations.
l The first decision is whether to invest or not, after which ne decides (second decision) how to finance the
investment, if applicable. The purchase cost of an asset is n t dependent on how it is financed.
Alternatively, one could view this in the context that the investment decision should be considered
irrespective of how the asset should be financed.
Depreciation is not a cashflow in itself and is therefore not included in cashflow statements.
Due to the nature of the financing cashflows (initial positive, where after negative), the greater the internal
rate of return linked to a financing option, the more expensive it would be.
Similarly, the greater the net present cost of the financing option, the more expensive it would be.
The financing decision

The amount which is financed, the repayments thereof, interest payable and the taxation benefits thereof only
appear in the cashflow projection of the financing decision.
The investment decision

The cost of the investment; income and operating expenditure and associated changes in working capital; and
the taxation implications of wear-and-tear, only appear in the cashflow projection of the investment decision.
7.12 Determining the most cost-effective form of finance

When comparing the cost of several viable financing options, it is important to compare like with like.
Therefore, a financial manag r should attempt to compare the cost of different financing options where these
have similar conditions, s curity requirements and covenants. If the options are not directly comparable in this
way, these factors should be adjusted in the calculation (which may involve a great deal of subjective
adjustment, whi h in turn, will reduce the reliability of the results).
In deciding on the most cost-effective form of finance, you should calculate and compare the following for each
viable finance option –
the internal rate of return (IRR) per annum of the associated finance-related cashflows (including the
implications of taxation linked to the financing option); or
the net present cost (NPC) (also known as the net present value (NPV) method) of the associated finance-
related cashflows (including the implications of taxation linked to the financing option), using an
appropriate risk-adjusted rate that is usually based on the business entity’s after-tax cost of new debt.
Due to the pecialised nature of taxation and the different effects this may have on various businesses, analysts
in practice frequently choose to perform a financing decision on a pre -tax basis (i.e. to determine the IRR
nd/or NPC using pre -tax cashflows and where relevant a pre -tax rate). Following this approach, it is in fact
possible to achieve, in most instances, an answer leading to the same outcome as when using an approach that
does incorporate the effects of taxation. However, for purposes of this course you should be able to
incorporate the effect of taxation, as described in the following section.
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The differences between the two methods

The internal rate of return method (IRR) assumes that –
the cashflow can be re-invested at the internal rate of return;
percentages are compared; and
the percentage internal rate of return is quantified, but not the monetary advantage or disadvantage of
the alternative.
The net present cost method (NPC) assumes that –
the cashflow can be re-invested at the fair rate of return which was used for discounting;
Rand values are compared; and
the monetary advantage or disadvantage is quantified, but not the rate of return percentage.
7.13 Impact of section 24J of the Income Tax Act n the financing decision
When incorporating the effects of taxation (applicable to a business) into the financing decision, we have to
incorporate the effect of taxation into the financing related cashflows (when determining the NPC or IRR)
and/or the discount rate (when determining the NPC).
An intricate knowledge of taxation, including all exceptions and rules, is not within the scope of this textbook.
However, it is important for a student to be able to int grate the important sections of taxation, specifically
where these have a direct bearing on the topics includ d in Managerial Finance. For purposes of the financing
decision, the student should be able to integrate the effects of section 24J.
In terms of current South African tax law, interest is normally deductible by the debtor (borrower) and
represents income in the hands of the creditor (lender). In this regard, section 24J of the Income Tax Act is
important, as it is the main section under which interest will be either deductible or included in income.
Stiglingh, Koekemoer and Wilcocks, (2013:742) describes the role of section 24J of the Income Tax Act, as
follows:
Section 24J regulates the timing of the accrual and incurral of interest. In general terms, it spreads the
interest (and any premium or discount) over the period or term of the financial arrangement by com-
pounding the interest over fixed accrual periods using a predetermined rate referred to as the ‘yield to
maturity’. The section also governs the inclusion of interest accrued in a taxpayer’s gross income and the
deduction of interest incurred from income.
Section 24J identifi s thr diff rent methods to calculate the spread of the interest, but for purposes of this
chapter only the principl , yi ld to maturity method is considered.
Yield to maturity method

The yield to matu ity method helps to prevent tax avoidance and is also known as the accrual method. Yield to
maturity method sp eads the full interest over the full term (therefore also considering any premium or
discount), by compo nding the interest over fixed accrual periods using a predetermined rate referred to as the
‘yield to mat rity’ (Stiglingh, 2013).
The f ll wing f rmula has to be applied per section 24J of the Income Tax Act:
A=B×C
Where:
= the accrual amount to be included in the taxation calculation (apportioned on a day-to-day basis, if
not for a full year);
=the yield to maturity on the instrument on a pre-tax basis; and
= the adjusted initial amount (issue price plus prior accrual amounts, less prior interest payments
made).
260
During the term of the debt, if there are changes that would affect the yield to maturity, such as changes in the
interest rate or the term, the calculation will have to be performed again.
Example (1): Impact of section 24J of the Income Tax Act on the cost of debt (Fundamental to
Intermediate)
A company is intending to raise additional capital and is currently considering various financing options. One
alternative is to issue medium-term notes.
The medium-term notes will be issued with the following terms and conditions:
The notes have a face value of R1000 each.
The notes pay a variable coupon rate equal to 10% per annum at year-end te coinciding with the company’s
(this is similar to interest, which accrues and is payable once ye r).
The maturity date will be in four years’ time.
The notes will be redeemed at face value.
It is expected that there will only be sufficient demand f r the n tes if they are issued at a discount of 10%.
Required:
Determine the cost of the notes, using two steps:
Step 1 Determining the yield to maturity on the instrum nt on a pre-tax basis (variable 'B' of section 24J)
(Fundamental)
Step 2 Determining the after-tax cost of the debt (incorporating the effects of section 24J) (Intermediate)
The company has a marginal income tax rate equal to 28%.
The bond qualifies as an instrument per section 24J of the Income Tax Act (the yield to maturity method
will apply).
The formula to be applied per section 24J of the Income Tax Act is:
A=B×C
Where:
A = the accrual amount;
B = the yield to maturity on a pre-tax basis; and
C = the adjust d initial amount.
Solution:
Part (a)(i)
Step 1
Determine the yield to maturity on the instrument on a pre-tax basis
0 1 2 3 4
Present value
[R1 000 × (100%-10%)] 900
Coupon payment (10% of R1 000) (100) (100) (100) (100)
Redemption (1 000)
Finance-related cash flows
before-tax 900 (100) (100) (100) (1 100)
IRR (pre-tax) 13,3892%
(This percentage will be used as the pre-tax YTM [variable "B" in the formula of section 24J]).
261
Or using calculator inputs:
PV = 900
PMT = (100)
FV = (1 000)
P/YR = 1
N= 4
Determine I/YR 13,3892
Or 900 CFj (0)
(100) CFj (1)
(100) CFj (2)
(100) CFj (3)
(1 100) CFj (4)
13,3892 Calc IRR
(Refer to your calculator manual if these steps are unclear.)

Step 2
Determining the after-tax cost of the debt (incorporating the effects of section 24J)
0 1 2 3 4
Present value
[R1 000 × (100%-10%)] 900
Redemption (1 000)
900 (100) (100) (100) (1 100)
Taxation at 28% (A × 28%) 34 35 35 36
Accrual amount (A) (A = B × C) (N2) 120,50 123,25 126,36 129,89
Pre-tax YTM (B) = 13,3892% 13,3892% 13,3892% 13,3892%
Adjusted initial amount (C) = 900,00 920,50 943,75 970,11
Initial amount 900,00 900,00 900,00 900,00
Plus: prior accrual
amounts 0,00 120,50 243,75 370,11
Period 0 0,00 0,00 0,00 0,00
Period 1 120,50 120,50 120,50
Period 2 123,25 123,25
Period 3 126,36
Less: prior payments 0,00 (100,00) (200,00) (300,00)

Period 0 0,00 0,00 0,00 0,00
Period 1 (100,00) (100,00) (100,00)
Period 2 (100,00) (100,00)
Period 3 (100,00)
Finance-related cash flows

after-tax 900 (66) (65) (65) (1 064)
IRR (after-tax) 9,640%
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Notes:
Figures may not total due to rounding.
The accrual amount (A) could also be determined using the amortisation-function on a financial
calculator.
Calculator inputs
PV = 900
PMT = –100
FV = –1000
P/YR = 1
N= 4
I/YR = 13,3892
1 Input Amort (Period 1-1)
Interest 120,50
Interest 123,25
Interest 126,36
Interest 129,89
(Refer to your calculator manual if these steps are uncl ar.)
Example (2): Calculating the cost of debt (Fundamental to Intermediate)

A company is intending to raise additional capital and is currently considering various financing options. One
alternative is to issue medium-term notes.
The medium-term notes will be issued with the following terms and conditions:
The notes will have a face value of R1000 each.
The notes will pay a variable coupon rate equal to 12% per annum at a date coinciding with the company’s
year-end.
Transaction costs will equal 3% of the face value (payable on issue).
Based on current market conditions, the company expects that there will be a demand for the notes only if
issued at a 9% discount.
Required:
Determine the annual percentage cost of the medium-term note in order to compare the cost of the note
with other finan ing options, by calculating:
The after-tax IRR using only pre-tax finance-related cashflows. (Fundamental)
The after-tax Internal Rate of Return (IRR) based on post-tax finance-related cashflows.
(Intermediate) Ass me the following:
l The company has a marginal income tax rate equal to 28%.
l The bond qualifies as an instrument per section 24J of the Income Tax Act (the yield to maturity
method will apply).
l The formula to be applied per section 24J of the Income Tax Act is:
A=B×C
Where:
C = the adjusted initial amount.
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Explain the reason for the difference obtained in (a)(i) and (ii) and motivate which option provides the
more accurate answer. (Fundamental)
Solution:
Part (a)(i)
Determine after-tax YTM by calculating the Internal Rate of Return (IRR) based on pre-tax finance-
related cashflows
Step 1
Determine the yield to maturity on the instrument on a pre-tax basis (incl. ll fin nce-related cashflows)
Amounts in Rand 0 1 2 3 4
Note market value (R1000 × [100% – 9% discount]) 910
Issue costs (3% of R1 000) (30)
Coupon payment ([12% × R1 000) (120) (120) (120) (120)
Redemption (1 000)
Finance-related cashflows before-tax 880 (120) (120) (120) (1 120)
IRR (pre-tax) Note the inclusion of 16,316%

transaction cost here.
Calculator steps
880 CFj (0)

(120) CFj (1)
(120) CFj (2)
(120) CFj (3)
(1 120) CFj (4)
16,316 Calc IRR
Step 2
Multiply by (1 – marginal tax rate)
16,316% × (1–28%)
11,748%
Conclusion:
Using this simplified approa h, the after-tax YTM of the medium-term note equals 11,748% per annum.
Part (a) (ii)

Determine after-tax YTM by calculating the Internal Rate of Return (IRR) based on post-tax finance-related
cashflows
Step 1
Determine the yield to maturity on the instrument on a pre-tax basis (incl. all finance-related cashflows falling
within the ambit of section 24J; thus excluding upfront transaction costs)
264
Present value (R1000 × [100% – 9%]) 910
Coupon payment (12% × R1 000) (120) (120) (120) (120)
Redemption (1 000)
Finance-related cashflows before tax 910 (120) (120) (120) (1 120)
IRR (pre-tax) 15,163% (Refer to your calculator manual for the steps)
Note the exclusion of transaction cost
for purposes of determining the YTM
as intended by section 24J
(transaction cost does not fall within
the ambit of section 24J).
(This percentage will be used as the pre-tax YTM (variable ‘B’ in the formula of section 24J))
Step 2
Determine the after-tax YTM (by incl. all finance-related cashfl ws; thus incl. upfront transaction costs and
taxation)
Present value
(R1000 × [100% — 9%]) 910,00
Issue costs (3% of R1 000) (30,00)
Coupon payment
(12% × R1 000) (120,00) (120,00) (120,00) (120,00)
Redemption (1 000,00)
Note the inclusion of 880,00 (120,00) (120,00) (120,00) (1 120,00
transaction cost here.
Note the tax treatment of
transaction costs, separate
from section 24J
Taxation at 28% on issue

costs (28% × R30) 8,40
Taxation effect of section 24J
at 28% (A × 28%) 38,64 39,40 40,28 41,29
Section 24J accrual amount
(A) (A = B × C) (N1) 137,98 140,71 143,85 147,47
Finance-related
cashflows after tax 880,00 (72,96) (80,60) (79,72) (1078,71)
IRR (after tax) 11,702%
Calculator steps
880,00 CFj (0)

(72,96) CFj (1)
(80,60) CFj (2)
(79,72) CFj (3)
(1 078,71) CFj (4)
11,702 Calc IRR
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Notes:
In this case a financial calculator was used to determine the accrual amounts (A). Refer to example (1) in
this section for an illustration of the full calculation using the long method.
Calculator inputs:
PV = 910
PMT = (120)
FV = (1 000)
P/YR = 1
N= 4
I/YR = 15,163
Interest 137,98
Interest 140,71
Interest 143,85
Interest 147,47
(Refer to your calculator manual if these steps are

unclear.) 2 Figures may not total due to rounding.
Conclusion: The after-tax YTM of the medium-term note equals 11,702% per annum.
Part (b) Reason for the difference and superior approach

The reason for the difference is the tax effect of the upfront transaction fees. If there were no such fees, or if
these were insignificant, the answers per section (a)(i) and (ii) would have been identical or very close to each
other.
The superior approach, when there is a transaction fee involved, is the long approach per section (a)(ii), which
includes the taxation cashflows. (This approach takes all the variables and cashflow timing effects into
account.)
7.14 The lease or buy decision

The lease or buy decision is a most controversial subject in the investment and finance area.
Leases are a form of finance affecting ownership. Since the default assumption in making an investment
decision is that the firm would take ownership and enjoy the associated tax benefits (e.g. wear and tear
allowances), the de ision to lease (here the firm does not obtain legal ownership) could therefore not be
compared dire tly to a de ision to finance the asset using e.g. a loan (here the firm obtains legal ownership).
In other wo ds, the default finance decision principles, as described earlier in this chapter, cannot be applied in
the case of leases.
7.14.1 Types of leases

The classificati n as either a finance lease or operating lease is, likewise, a matter of contention.
The exi ting accounting models for leases require lessees and lessors to classify their leases as either a finance
(capital) lea e or an operating lease, and account for those leases differently. At present, accounting models
norma y classify a lease as a finance lease if substantially, all the risks and rewards of ownership are
transferred (e.g. covers most of the asset’s life). All other leases are classified as operating leases. These
models then require an asset and liability to be recognised for a finance lease, but not so for an operating le se.
However, these accounting models have been criticised for failing to meet the needs of users of financial
statements because they allow financing liabilities to remain hidden in certain cases (so-called ‘off-balance
266
sheet financing’) . As a result, the Financial Accounting Standards Board (FASB) and International Accounting
Standards Board (IASB) have issued a joint Exposure Draft (2013) revisiting the accounting treatment of leases.
At present, the matter remains unresolved.
In recent decades, there has been an increasing trend in the leasing of certain assets, such as aircraft and ships,
as opposed to outright purchase. Even though leasing is generally more expensive than outright purchase – if
assets are kept for most of their expected life – leasing is often preferred because it helps to mitigate risk.
However, leasing could also be beneficial for purposes of tax planning.
Airlines, in particular, are increasingly using operating leases to in effect rent aircraft for a few years at a time,
with a leasing company bearing the risks of ownership, such as a reduction in second-hand values. Industry
specialists explain that this is mainly due to the high risk, short-term nature of the modern airline business;
large, stable airlines remain better off buying aircraft and then keeping them for their full lifespan (The
Economist, 2012).
7.14.2 The financing decision for leases

Due to the controversial nature of the lease vs buy decision, there is also wide ranging treatment of leases
when performing an associated financing decision.
No single approach seems to be ideal. However, should one choose not to tamper with the existing investment
decision principles as already explained in chapter 6 and as revised in this chapter, then the following sequence
is suggested:
Perform an investment decision as described (this assum s ownership and incorporates the tax benefits of
wear and tear allowances).
If the investment decision indicates that investment would be beneficial, then perform a financing
decision by calculating the internal rates of return of the various financing options available:
For financing that does not affect ownership: apply the financing decision principles as explained in section
7.10.
For leases: apply the financing decision principles as explained in section 7.10, but add back the tax
benefits of ownership forfeited in this case.
Example: Lease vs buy decision

A company is considering a new investment in machinery which has the following associated cashflows:
Cash price today R10 000 000
Wear-and-tear allowances for taxation purposes are 50% in Year 1, 30% in Year 2, and 20% in Year 3.
The machinery is expected to have no value at the end of three years.
The cashflows from the inv stm nt, excluding wear-and-tear, are:
Year 1 R6 000 000
Year 2 R7 000 000
Year 3 R5 000 000
The company has two financing options:
A new loan sec red over the machinery bearing interest at 12% per annum, repayable in three an annual
payments of R4 163 490.
A finance lease at an annual cost of R4 000 000 payable over three years.
Assume the f ll wing:
The company has a weighted average cost of capital equal to 20%.
Additional debt would not result in a significant deviation in the company's target capital structure.
All cashflows during a year take place at the end of the financial year.
The loan will qualify as an instrument per section 24J of the Income Tax Act (the yield to maturity method
will apply).
267
A=B×C
Where:
C = the adjusted initial amount.
From an Income Tax perspective, ownership of the leased asset will vests in the essor. The lessee will be
allowed to deduct the finance lease payments in terms of section 11 (a).
Required:
Determine whether the company should invest in the new machinery.
Which financing option would be the most cost efficient.
Describe other matters which could affect the choice in finance.
Solution:
Part (a)
Investment decision
Year: 0 1 2 3
R'000 R'000 R'000 R'000
Investment (10 000)
Net cashflow 6 000 7 000 5 000
Cash tax effect at 28% (1 400) (840) (560)
Effective net tax income / (deduction) 1 000 4 000 3 000
Net income 6 000 7 000 5 000
Wear-and-tear allowance (50/30/20) (5 000) (3 000) (2 000)
(10 000) 4 600 6 160 4 440
Discount factors 16% 1,0000 0,8621 0,7432 0,6407
Net present value (NPV) 1 388 (10 000) 3 966 4 578 2 84

Conclusion: The investment will be beneficial as it yields a positive NPV of R1 388 000.
Part (b)
Financing decision (loan)
In the case of a simple loan agreement, without transaction costs, the IRR after tax would simply represent the
interest rate × (1 – tax ate).
In this case, IRR after tax equals 12% × (1 – 0,28)
= 8,64%
268
Alternative: Financing decision (loan) – long method incorporating the effect of section 24J of the Income Tax
Act
Step 1
Determine the yield to maturity on the instrument on a pre-tax basis
0 1 2 3
R'000 R'000 R'000 R'000
Present value 10 000
Payments (4 163,49) (4 163,49) (4 163,49)
Finance-related cash flows before-tax 10 000 (4 163,49) (4 163,49) (4 163,49)
IRR (pre-tax) 12%

(This percentage will be used as the pre-tax YTM [variable "B" in the formula of Section 24J])
Step 2
Determine the expected after-tax cash flows
0 1 2 3
R'000 R'000 R'000 R'000
Present value 10 000,00
Payments (4 163,49) (4 163,49) (4 163,49)
Taxation benefit of interest at 28% (24J: A × 28%) 336,00 236,43 124,91
Accrual amount (A) (A = B × C) (N1) 1 200,00 844,38 446,09
Finance-related cash flows after-tax 10 000,00 (3 827,49) (3 927,06) (4 038,58)

Note: Figures may not total due to rounding.
N1
Calculator inputs:
PV = 10000,00
PMT = (4163,49)
FV = 0,00
P/YR = 1
I/YR = 12%
Interest 1200,00
Interest 844,38
3 Input Amort (P riod 3-3)
Interest 446,09
(Refer to your al ulator manual if these steps are unclear.)

Financing decision: Finance lease
0 1 2 3
R'000 R'000 R'000 R'000
Present val e 10 000,00
Lease payments (4 000,00) (4 000,00) (4 000,00)
Cash tax effect at 28% (280,00) 280,00 560,00
Effective net tax income / (deduction) 1 000,00 (1 000,00) (2 000,00)
Lea e payments (4 000,00) (4 000,00) (4 000,00)
Wear-and-tear forfeited1 5 000,00 3 000,00 2 000,00
Fin nce-related cash flows after-tax 10 000,00 (3 280,00) (4 720,00) (5 440,00)

Note: Figures may not total due to rounding,
269
Note
Only where the financing option has an impact on ownership, such as in the case of this finance lease, will
this adjustment be required.
Conclusion
The loan will be the most cost efficient as it bears a lower effective cost of finance (IRR after tax) of 8,640%
versus 14,989% linked to the finance lease.
Part (c)
Security offered: As the loan would be secured over the asset, it would be comparable to the finance
lease. In both cases failure to meet payment terms might result in the asset being reclaimed.
Flexibility: Depending on the detail clauses included in the contract, the finance lease might be more
flexible by allowing the company to cancel the contract bef re the end f the three years. This could help f
mitigate risks where the company is unsure of the success the business venture and/or the use of the
asset for its full life expectancy.
Other benefits included in the finance lease: If the finance lease includes other benefits such as repairs
and maintenance, or insurance (which is not included if the asset is purchased using the loan), then the
associated (after-tax) benefits should be incorporated in the projected cashflows linked to the finance
lease in part (b). (The example specified no such b n fits and these are therefore excluded here.)
Cashflow timing: The associated cashflows will differ between the two financing options and should be
compared with the company’s overall cashflow situation in order to see if one would be more beneficial
than the other.
Cheap finance
When a company has an opportunity to finance a project using cheaper than normal debt financing, it should
still consider its existing D:E ratio in comparison to the target before evaluating the project. In other words, if
the company already has too much debt, it will not be in a position to borrow further, even if it is offered the
finance at a cheaper rate. Cheap finance is highly exceptional and should not be seen as the norm.
7.16 Foreign finance

A business entity might consider foreign finance where these offer financing opportunities not available locally,
or where these off r (an xp ct d) lower cost.
Usually only larger busin ss ntities have access to foreign finance (with a few exceptions, such as
crowdfunding). Appendix 1 to this chapter lists several sources and forms of foreign finance.
However, the pitfall of foreign finance is frequently linked to the additional foreign currency risk linked to it
such as inte est and capital repayable in a foreign currency. Usually these are factored into the finance decision
by making ass mptions on future exchange rates.
Alternatively, foreign exchange risks (linked to future cash outflows in foreign currency) might automatically be
hedged in the case of the entity earning foreign currency income, or might specifically be hedged using one of
several hedging techniques (e.g. forward exchange contracts, options and futures), which would give greater
certainty f the future financing-related cashflows. Specific hedging techniques would, however, drastically
increa e the effective cost of the finance.
The ri ks linked to foreign finance is especially evident when there is a strong, unexpected devaluation in the
ocal currency, as opposed to a gradual change predicted by measures such as purchasing power parity (PPP).
The r nd recently showed such a devaluation, in depreciating by nearly 25% against the US dollar and nearly
30% gainst the Euro during the course of 2013. As a result, several South African companies refinanced their
foreign debt during the course of 2013 and 2014.
270
Appendix 1
Sources and forms of new finance: An overview of typical characteristics and elements in the SA business
context
Typically used by the
following entities:
1 2
Forms of new finance Term Up- BEE SMME Large En- Typical source of Typical requirements / purpose
available to the SA start incl. entity finance / investor / detail
business (a selection) (seed / develop- tity listed (South African,
early ment (un- on unless indic ted
stage) (with list- JSE otherwise)
track ed)
record)
DEBT
Secured (typically)
l Debtor finance, e.g. S    C mmercial banks Secured over debtors. Numerous
factoring or invoice requirements and options.
discounting
l Short-term loan S    Co ercial banks,
3
DFIs
l Revolving credit S, M    Commercial banks A facility allowing repeated use
due to automatic renewal
following repayment of a portion
of capital.
l Vehicle and asset M    Commercial banks, Secured over the asset financed.
finance, e.g. leases, dedicated
hire purchase companies
l Medium/ long-term M, L  Investment banks BEE entity uses the finance to
loan (often combined obtain shares in a company
with a small equity (often at a discount); these
stake in the BEE shares serve as security for the
entity) loan. Interest may not be tax
deductible.
M, L   Commercial banks,
3
DFIs, private equity
funds
M, L  Banks
3 3
l Foreign currency M, L   DFIs, foreign DFIs, Numerous requirements, also by
loan foreign banks the SARB. Implies foreign
exchange risk.
M, L  Foreign banks SARB requirements. Implies
foreign exchange risk.
l Mortgage loan L    Commercial banks Secured over fixed property.
Unsec red (typically)
l Customer finance, S    Clients Advance for product to be
e.g. advances manufactured, interest free.
l Accruals and trade S    Employees, SARS, Spontaneous finance, interest
credit trade creditors free (but trade credit may have
high effective cost if settlement
discounts not taken).
Banker acceptance S   Commercial banks Strict credit criteria. Mainly for
(a company’s bill of seasonal working capital
exchange is sold to requirements. To diversify
bank which then sources of finance.
agrees to honour it)
271
Typically used by the following

entities:
1 2
early ment (un- on unless indicated
track ed)
record)
l Bill of exchange S   Institutional and In simp ified terms, a bill of
8
retail investors, exchange is similar to a cheque.
corporations
l Commercial paper S   Institutional nd A short-term promissory note.
8
retail in estors,
corporations
a
l Bank overdraft (also S, M    C mmercial banks For unforeseen expenses,
often secured) working capital requirements.
l Medium term M   Institutional and In simplified terms, a promissory
notes, incl. retail investors,8 note is a note promising to pay,
6
promissory notes underwriter if similar to a R200 note issued by
(also often secured) under subscribed the SARB. Credit rating by rating
(issued on the agency required. May be listed
10 9
primary market ) on BESA.
l Foreign, medium M   Foreign institutional Credit rating by rating agency
term notes (also and retail investors8, required. May be listed on a
6
often secured) underwriter if foreign securities exchange, e.g.
(issued on the under subscribed London Stock Exchange (LSE).
10
primary market ) Implies foreign exchange risk.
l Crowdfunding M  Internationally, from The ‘crowd’ provides credit to
(credit-based) a large number of fund a creative project, service,
people and non- product or cause, through a
banks via the crowdfunding platform such as
Internet the Lending Club.
l Debenture (also L    Institutional and Often with restrictive covenants.
8
often secured) retail investors
l Bonds (also L   Institutional and Credit rating by rating agency
secured) (issued on retail investors,8 required. Bonds may be listed on
the primary underwriter6 if BESA.9
10
market ) under subscribed
l Foreign bonds (also L   Foreign institutional Credit rating by rating agency
secured) (issued on and retail investors,8 required. Foreign bonds are
the primary underwriter6 if denominated in the currency of
market10) under subscribed the foreign country of issue (e.g.
11
USD if issued in the USA). May
be listed on a foreign securities
exchange. Implies foreign
exchange risk. SARB
requirements.
l Eur b nds (also L   Foreign institutional Credit rating by rating agency
secured) (issued on investors,8 required. May be listed on a
the primary underwriter6 if foreign securities exchange, e.g.
10
market ) under subscribed London Stock Exchange.
Eurobonds are denominated in a
foreign currency that is not used
in the country of issue (e.g. in
12 11
EUR or USD, if issued in the
UK).
Implies foreign exchange risk.
SARB requirements.
272

entities:
1 2
track ed)
record)
MEZZANINE CAPITAL
l Unsecured, M, L  Venture capit l L rge equity interest held by
subordinated loan houses m n gement.
5
M, L  Vendor financing, BEE entity uses this finance to
banks obtain shareholding in a
company seeking BEE
shareholding.
M, L  Shareh lders,
private equity
3
houses, DFIs
l Preference shares M, L  Venture capital Large equity interest held by
houses management.
5
M, L  V ndor financing, BEE entity uses this finance to
company seeking BEE
shareholding.
M, L   Private equity Large equity interest held by
houses, merchant management.
banks
M, L  Institutional and
8
retail investors
l Unsecured, M, L  Venture capital Large equity interest held by
subordinated, houses management. Growth potential.
convertible debt
5
M, L  Vendor financing, BEE entity uses this finance to
company seeking BEE
shareholding.
M, L  Private equity Large equity interest held by
houses management. Growth potential.
HYBRID CAPITAL
l Shareholders loan M, L Refer to unsecured subordinated loan under mezzanine
finance
l Preference sha es M, L Refer to preference shares under mezzanine finance
l Convertible M, L  Venture capital Large equity interest held by
3
debent res or loan houses, DFIs management, growth potential.
l Royalty financing M, L  Venture capital Royalty is payable based on % of
funds turnover (therefore linked to
equity). Sometimes combined
with other forms of finance.
l Convertible M, L   Private equity Large equity interest held by
preference shares houses, merchant management, growth potential.
banks
l Crowdfunding M, L  Internationally, from The ‘crowd’ funds a creative
(reward-based) a large number of project, service, product or
people and non- cause, through a crowdfunding
banks via the platform such as Kickstarter, in
Internet return for rewards such as
discounted products.
273

entities:
1 2
track ed)
record)
EQUITY
l New ordinary L  Entrepreneur Growth potential, strong
shares issued (personal m n gement team.
investment), friends,
family, angel
investors, enture
capital funds
L  Investment banks, Growth potential, strong
merchant banks. management team.
(S all shareholding
in BEE entity, often
acco panied by
loan finance)
L  Existing owners, Growth potential, strong
mployees, clients, management team, available
merchant banks, exit routes.
private equity funds,
DFIs3, foreign direct
7
investors
L   Existing owners, (Differentiate between primary
10
directors, and secondary markets, and
employees, clients, listing on local or foreign stock
institutional and exchanges).
8
retail investors,
foreign direct
investors,7
6
underwriter if
under subscribed
l Rights issue L    Existing
shareholders
l Initial Public L   Institutional and To obtain a listing on the JSE –
8
Offering (IPO) retail investors, conditions to be met.
corporates, 6
underwriter if
under subscribed
l Crowdfunding L  Internationally, from The ‘crowd’ provides equity to
(equity-based) a large number of fund a creative project, service,
people and non- product or cause, through a
banks via the crowdfunding platform such as
Internet Kickstarter.
NOTES
1 Sh rt-term finance (S) is normally repayable or has a maturity date of less than one year, or less than one operating
cycle of the business. Medium-term finance (M) may be repayable or may have a maturity date of on year up to
roughly ten years; long-term finance typically more than ten years, or is not repayable. (Oftentimes the exact year-
di tinction between S, M and L is not clear-cut).
2 SMME is an acronym for Small-, Medium- and Micro-sized Entities.
3 DFI is an acronym for Development Finance Institution. South African DFIs include the Industrial Development
Corporation (IDC) and the Development Bank of South Africa (DBSA). DFIs normally have specific mandates and
several qualifying criteria coupled to development goals for empowerment, entrepreneurship, and specific industries.
5 In this context, the vendor represents the company seeking a BEE shareholder; vendor financing is where the
financing (in whatever form) is provided by the vendor to a BEE entity.
continued
274
An underwriter (usually an investment bank or a syndicate of banks) pursues investors on behalf of entities issuing
new debt or equity, and takes up self-ownership in the case of under subscription.
Foreign direct investors are investors from beyond the borders of South Africa investing in (e.g.) the ordinary shares
of the South African entity.
Institutional investors represent organisations investing funds on behalf of other parties. These organisations include
banks, pension funds, insurance companies, and investment funds. Retail investors represent individual investors.
BESA is an acronym for the Bond Exchange of South Africa, a subsidiary of the JSE Limited.
A primary market is where new securities (debt or equity) are sold on the capital market, often with the help of an
underwriter. The secondary market is not a source of new finance, but the market where existing securities are sold
by one investor to another; this is facilitated by a securities exchange, such as BESA or JSE, or over the counter (OTC)
trading.
USD is an acronym for the United States dollar currency.
EUR is an acronym for the euro currency.
a Sometimes used also as medium-term finance, especially by SMMEs.
Practice questi ns

ElectriBolt Ltd (‘ElectriBolt’) is an independent electricity supplier with various power-generation operations
throughout South Africa. ElectriBolt is listed on the main board of the Johannesburg Securities Exchange. The
company’s most recent financial reporting date was 31 D c mb r 2011.
On 31 December 2011 Electribolt acquired the Augrabies division of PowerSmart Ltd (‘PowerSmart’), a large
electricity supplier, for R16 million. The Augrabies division operates a hydro-electricity plant and has a contract
to continue for another 4 years. The division was acquired by Electribolt as a going concern, including all assets
and liabilities except for cash and cash equivalents and taxation liabilities. The Augrabies division is expected to
receive constant cash inflows and to incur constant operating cash outflows for the remainder of its contract.
No significant further capital expenditure is expected. However, the Augrabies division is required to
rehabilitate the site where the hydro-electricity is generated, in 4 years’ time.
ElectriBolt is currently considering the following financing alternatives for the transaction:
Obtaining a R16 million medium-term loan from ElectriBolt’s bankers. The loan is to bear interest at 1%
above the prevailing prime overdraft rate. The loan is to be repaid in one bullet payment at the end of
four years. Interest is to be calculated and compounded annually in arrear, and capitalised into the
outstanding loan balance. Transaction costs of 1% of the principal amount will be payable at the inception
of the medium-term loan. The interest to be incurred on such a long-term loan is deductible for taxation
purposes in terms of section 24J of the Income Tax Act; or
The issue of compulsory convertible preference shares with a par value of R16 million. Preference
shareholders will be ntitl d to an annual dividend calculated as 88% of the prevailing prime overdraft rate
multipli d by the par value of shares held. ElectriBolt is required to pay preference dividends annually in
arrear and has no discretion with regard to declaring these dividends. Each preference share will
automati ally onvert into one ordinary share after four years. Analysts predict that the value of the conve
ted sha es at the end of year four will amount to R17 800 000.
The current prime overdraft rate is 9% per annum (nominal and pre-tax) and this rate is not expected to change
significantly over the next couple of years.
(Assume the current date is 1 January 2012 and that the choice in finance should be finalised on this same date.
Further assume that the financing amount will also be received on this date in order to pay the purchase
considerati n to PowerSmart.)
(Ignore econdary tax on companies, dividend tax and any possible impact of section 8 of the Income Tax Act.)
Required:
( ) With regard to ElectriBolt Ltd evaluating the financing of the acquisition of the Augrabies division of
PowerSmart Ltd through obtaining the medium-term loan or through the issue of the preference shares:
(i) Calculate and determine which instrument will be more cost effective for ElectriBolt Ltd to use; and
(10
marks) (ii) Discuss any other factors ElectriBolt Ltd should consider in deciding which instrument to use.
(5 marks)
275
(Extract from 2010 Qualifying Examination Part 1, updated and slightly adapted (SAICA, 2010))
Solution:
Part (a)(i)
1 January: 2012 2013 2014 2015 2016
Year: 0 1 2 3 4
Medium-term loan % / R’000 R’000 R’000 R’000 R’000 R’000
Calculate the internal rate of
return (IRR):
Initial advance 16 000,0
Transaction fees (160,0)
Tax on transaction fees (R160k × 28%) 44,8
Tax effect of section 24J at 28% (A [Calc. 1] × 28%) 448,0 492,8 542,1 596,3
Bullet payment (PV = 16 000; I/YR
= 10% (9% + 1%); N = 4; Calculate FV) (23 425,6)
15 840,0 492,8 492,8 542,1 (22 829,3)
IRR per annum 7,39% (This equals the after tax cost of new debt [kd].)
Calculation 1: Section 24J effect

24J accrual amount (A = B × C) 1 600,0 1 760,0 1 936,0 2 129,6
Pre-tax YTM (B) should equal the variable interest rate = 10% 10% 10% 10%
Test
Determine all cashflows that fall within the ambit of Section 24J (thus ignore transaction fees):
Calculate bullet payment amount: PV = 16 000; I/YR = 10% (9% + 1%); N = 4; Calculate FV (this should
equal 23 425,60). Now calculate the IRR: CF0 = 16 000; CF4 = – 23 425,60; Calculate IRR/YR (this
should equal 10,00%)
Adjusted initial amount (C) 16 000,0 17 600,0 19 360,0 21 296,0
Initial amount 16 000,0 16 000,0 16 000,0 16 000,0
Plus: prior accrual amounts 0,0 1 600,0 3 360,0 5 296,0
Period 1 (e.g. 16 000 × 10%) 1 600,0 1 600,0 1 600,0
Period 2 (e.g. 16 000 × 10%) 1 760,0 1 760,0
Period 3 (e.g. 16 000 × 10%) 1 936,0
Less: prior interest payments 0,0 0,0 0,0 0,0
In this case we do not have to calculate a net present cost (NPC) using k d, as it will result in a NPC equal
to the initial advance (but n gativ ). The calculation is shown for the sake of illustration only:
Net cashflows above, ex luding initial advance (160,0) 492,8 492,8 542,1 (22 829,3)
Factors 1,000 0,931 0,867 0,807 0,752
NPC, discounted at kd 7,39% (16 000,0) (160,0) 458,9 427,3 437,7 (17 163,9)
Preference shares
Calculate the internal rate of return (IRR):
Preference share issue 16 000,0
Preference share dividends (1 267,2) (1 267,2) (1 267,2) (1 267,2)
C nversi n into equity (17 800,0)
16 000,0 (1 267,2) (1 267,2) (1 267,2) (19 067,2)
IRR per annum 10,33%
Or lternatively,
Net cashflows above, excluding initial advance 0,0 (1 267,2) (1 267,2) (1 267,2) (19 067,2)
Factors 1,000 0,931 0,867 0,807 0,752
NPC, discounted at kd 7,39% (17 637,3) 0,0 (1 180,0) (1 098,8) (1 023,1) (14 335,4)
276
Note: figures may not total correctly due to rounding.

Discussion of the value of equity at end of Year 4: amount is an estimate of the value of the share on that date
only – sensitivity analysis should be performed.
Conclusion:
Cost of medium term loan is much cheaper than preference share based on info provided. (Candidate
compared like with like [IRR with IRR, or NPC with NPC] and offered a conclusion in line with this.)
277
Chapter 8
Analysis of financial and

non-financial information
describe the various financial reports used to communicate basic financial information;
identify the objectives of financial and non-financial analysis;
identify the different users (stakeholders);
describe the different analysis areas and information requirements each user is typically interested in;
describe the different techniques used for financial and non-financial analysis (comparative financial
statements, indexed financial statements, common size statements, financial analysis, non-financial
analysis and balanced scorecard);
perform financial analysis calculations for each financial analysis area (profitability, capital structure and
solvency, liquidity, return on invested capital, financial market / investor, cashflow related and
performance related) based on user needs;
provide users with insightful comments based on financial analysis comparisons between historical,
budgeted, industry or competitor financial information at a fundamental, intermediate or advanced
difficulty level;
perform non-financial analysis calculations for social, environmental and other entity specific analysis
area;
provide users with insightful comments relating to the non-financial comparisons between historical,
budgeted, industry or competitor non-financial information;
describe the purpose of a balanced scorecard;
tabulate a balance scor card worksheet;
describe the limitations of accounting data; and
describe the limitations of ratio analysis.
Evaluating an entity’s financial position and performance is critical in ensuring the financial sustainability of the
organization. Historically, the main emphasis has been on the financial information, but with the advent of the
integrated report, this has been extensively broadened to include non-financial information as well. The purp
se f this chapter is to provide a comprehensive overview of how this information should be analysed, for wh m
and m st importantly how it should be interpreted.
8.1 Financial reports

An nnual integrated report is arguably the single most important report that entities provide to their users (st
keholders). An integrated report is a concise communication about how an organisation’s strategy (refer to S
rategy and risk in Chapter 2), governance, performance and prospects, in the context of its external
environment, leads to the creation of value in the short, medium and long term (IIRC, 2014) . It reports on the
financial and sustainability performance within the business process of the entity. In addition to the
279
all-important annual financial statement performance, users are also interested in the entity’s non-financial
performance such as environmental impact, governance practices and social outcomes. Integrated reporting is
recommended for all entities, however, it is only mandatory for those entities listed on the Johannesburg
Securities Exchange of South Africa in terms of King III’s “apply or explain” basis.
The annual financial statements of an entity should be in compliance with International Financial Reporting
Standards (IFRS), fairly present the state of affairs of the entity and the results of its operations for the financial
year. The annual financial statement of an entity will include the Statement of financial position, Statement of
profit or loss and other comprehensive income, Statement of changes in equity, Statement of cash flows and
Notes (summary of accounting policies and other explanatory information).
8.2 Objectives and users of financial and non-financi l n lysis

An analysis provides users with meaningful information and enables users (stakeholders) to interpret the
financial and non-financial information provided and make informed decisions. The process of analysis and
interpretation is aimed at establishing trends for the particular enterprise over a period. By comparing the
results and trends revealed by the analysis with those of c mpetit rs and the benchmarking against the
industry, current strengths and weaknesses as well as appropriate measures to enhance those strengths and
correct any weaknesses are identified. It may also provide a basis to consider opportunities and threats,
consistent with a SWOT analysis.
The objective of analysing financial statements and non -financial information is to determine the entity’s
performance, future prospects and financial structure. Th obj ctives of financial and non-financial analysis are
closely related to the needs of the users of the financial stat m nts and non-financial information, which will
now be discussed in more detail.
Users of financial information

In reality, users (stakeholders) of financial and non-financial information have different information
requirements. Typical users include investors / shareholders, financiers, creditors, employees, management,
auditors, government agencies, customers, general public, etc.
l Investors / shareholders (current and potential)
Current investors
Shareholders will receive dividends only after loan providers’ claims (interest) have been met. They would
therefore be interested in the risk involved in retaining their investments as opposed to liquidating it, the
entity’s current profitability and the expected earnings and capital value growth. These investors are typically
interested in the Return on Invested Capital ratios (refer to box IV in the Financial analysis outline presented in
section 8.3.4.1) amongst others.
This group of users include anoth r type of investor / shareholder, namely the potential investor. Whether the
object is a small inv stm nt, a total buy-out, a merger or a takeover, the basic requirement is the same as for
the current shareholder, which is to determine a value for the business based on the determination of risk,
profitability and growth. A valuation of a business cannot be performed until the soundness of the business
has been dete mined th ough the use of various analysis techniques. These investors are typically interested in
the Financial ma ket / investor ratios (refer to box V in 8.3.4.1 Financial analysis outline) amongst others.
Financiers
Financiers (loan providers) are interested in ratios analysing whether their investment (loan) will be repaid in
full and n time. Financiers utilise these ratios to perform an initial assessment of the entity’s finance risk, which
affects the interest charged on the loan and loan covenants imposed. Loan providers are typically intere ted in
the Capital structure and solvency ratios (refer to box II in 8.3.4.1 Financial analysis outline) among t others.
Creditors
Tr de creditors are concerned about the short-term liquidity of the firm and are typically interested in the
Liquidity ratios (box III), especially working capital ratios, Cash flow-related ratios (box VI) and especially cash
flow projections (refer to boxes III and VI respectively in 8.3.4.1 Financial analysis outline) amongst others.
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Analysis of financial and non-financial information Chapter 8
Employees
Employees are concerned about the profitability of the entity as this impacts their future job security. In
addition they will be interested in operational performance (such as divisional or product performance), as well
as retirement benefits and remuneration. Trade unions would perform an analysis to determine whether they
consider that their members are being fairly compensated or not. They are particularly interested in the
relationship between profits, payments to shareholders, senior management and employees and non-financial
information such as number of equity appointments, amongst others. An increasingly contentious issue is the
pay disparity between the highest and lowest paid employees of the entity.
Management
Management is concerned with analysing and interpreting the financial and non-financial information that
becomes available in order to exercise control. These users typically include the board of directors, the
members, partners, sole owners, management accountants and the m n gers of the various departments. All
areas of financial and non-financial analysis are required due to the interrelationships of all the various
business aspects, as it helps management to identify changes in operations timeously and take appropriate
action.
It is important to note that the financial statements often identify sympt ms as opposed to causes. A good
example is the impact of increased debtors’ days. The symptoms of this would be increased strain on short-
term borrowings (i.e. access to overdraft facility). This sy ptom would have to be investigated to discover that
the cause is ineffective credit-control policies being enforced.
Auditors
The external auditor’s role is to express an opinion on the fair pr sentation of the annual financial statements
(which in the case of integrated reporting includes non-financial information). Analysis and interpretation of
financial statements, coupled with the auditor’s knowledge of the firm under review and the industry in which
it operates, would place the auditor in a better position to detect material errors and reportable irregularities
allowing them to express an opinion of whether or not the financial statements present an accurate picture of
the entity's financial state. With the implementation of the Companies Act 71 of 2008, the importance of
financial analysis was emphasised as many smaller entities may only require an independent review which is
less costly but provides limited assurance. The independent review focusses on inquiry and analytical
procedures which include financial analysis. It is also important to acknowledge the ever increasing role and
importance of the internal auditor from a risk management perspective.
Other interested parties
There are various other stakeholders such as government agencies, customers and the general public who may
have an interest in the entity’s financial and non-financial information. The South African Revenue Service
(SARS) will use financial statement analysis to assess the reasonableness of income tax and VAT returns.
Customers with limited suppliers may be interested in the entity’s financial information to the extent it will
influence future business continuance. Perhaps one of the most influential users is the general public and
specifically environm ntalists who are specifically interested in social and environmental aspects typically
disclosed in an annual int grat d report.
8.3 Techniques used for financial and non-financial analysis

There are vario s techniques that can be utilised to arrive at a conclusion about financial and non-financial
results and s ch conclusions are always based on comparison. Whether the comparison is with industry
averages, other similar firms, past results or budgeted (projected) results, financial and non-financial analysis
can never be d ne in isolation.
The vari us techniques used in financial analysis are the following:
Comparative financial statements;
Indexed financial statements;
Common size statements;
Financial analysis;
Non-financial analysis; and
Balanced scorecard.
The first three techniques are concerned with redrafting the financial statements in slightly different formats in
order to achieve meaningful comparisons, the fourth and fifth comprise a fundamental analysis of financial and
281
non-financial data in order to produce meaningful insights into comparative financial and non-financial
information and the sixth measures performance against strategic objectives. Whichever technique is utilized
though, it is essential that the financial manager is able to interpret what this information is conveying. It is not
enough to just ‘do the numbers’ and leave the users to interpret this for themselves. Consequently interpreting
is just as important as calculating.
Comparative financial statements

The comparison of financial statements over a period of five to ten years is carried out to establish a trend and
to project future income, expenditure and statement of financial position. An entity simply tabulates its
financial results over the desired period and then reviews the changes over the years, identifying trends and
making future forecasts.
Indexed financial statements

This involves setting one year as the base year which should preferably be at the beginning of the period. This
provides the best overview of the results, but any other year can be ch sen to suit a particular need. The figures
for the base year are all shown in the tabulated financial statements as 100 and all prior and / or subsequent
figures are shown as percentages of that year.
Common size statements

These statements are also sometimes referred to as normalis d statements. This analytical technique redrafts
the statement of financial position to express each it m on the statement of financial position as a percentage
of total assets. In the common size statement of profit or loss and other comprehensive income, all items are
expressed as a percentage of sales revenue.
Financial analysis
Financial analysis is largely based on the financial statements of entities. It is therefore useful to examine the
basic information available from these statements. In addition to calculating and commenting on these ratios
over a period of time, it is important to compare the entity’s performance with industry norms and its
competitors. To provide insightful comments it is necessary for the analyst to have a basic knowledge of the
local and global economic and political environment within which the entity operates.
One of the challenges that financial managers and students often encounter is the inconsistency in utilisation
of ratios in different texts and used by different entities. It is therefore important to be consistent in an
analysis. Even more important is the interpretation of the ratios that are calculated. A common problem is to
simply state that a certain ratio has increased (or decreased) from one year to the next which is insufficient, as
value adding comments should be provided. This includes an explanation of why this has happened and what
impact this is likely to hav , as w ll as what remedial action may be required to address it.
Finan ial analysis outline

The outline is intended as an overall guideline to the different, specific ratios and other analysis calculations
belonging to the diffe ent areas of financial analysis. This outline should form the foundation of your financial
analysis knowledge which will be built on throughout this Chapter.
This o tline sho ld nonetheless not be taken as being complete or absolute (different ratios or calculations could
be included in each area of analysis; in practice, business enterprises frequently use different variations, or
permutati ns f ratios and other analysis calculations, to best serve an intended purpose). In addition, other
sources frequently list different formulas to the ratios or calculations indicated here.
282
FINANCIAL ANALYSIS OUTLINE
1
Key financial analysis ratios and other calculations – per area of analysis
1Note formula/method for ratio/calculation are shown in 8.3.4.2
(I) PROFITABILITY: (II) CAPITAL STRUCTURE AND SOLVENCY: (III) LIQUIDITY:

These ratios/calculations analyse the entity’s ability to The capital structure refers to the composition In this context, liquidity measures the entity’s
Analysis of financial and non-financial information

generate income, to effectively control its expenses and to of an entity’s capital. Forms of capital include ability to pay its debts as and when they fall
generate an acceptable profit compared to the performance ordinary shares, interest-bearing debt and due.
of the prior year, budget, the industry and competitors. hybrid capital.
As an entity’s working capital directly affects its
Ratios / calculations (in usual order of preference): An entity also frequently uses other forms of short- term cash flow from the ordinary course
finance that arise in the routine course of of business, it is closely linked to liquidity.
Specific ratios based on supplied information (you have
business – such as trade accounts payable –
to determine this based on the scenario) Ratios / calculations (in usual order of
which do not constitute capital and is therefore
l Change in Revenue (%) l preference):
not considered here. Solvency is a measure of an
Gross Profit margin (%)
entity’s ability to meet its long -term expenses, l Specific ratios based on supplied
l Change in gross profit (GP) (%) l
and to accomplish long-term expansion and information (you have to determine this
Operating Profit margin (%)
growth. based on the scenario)
l Earnings Before Interest and Tax (EBIT) margin (%)
l Current ratio (x:1)
l Earnings Before Interest, Tax, Depreciation and Ratios / calculations (in usual ord of preference):
l Acid-test (quick) ratio (x:1)
Amortisation (EBITDA) margin (%)
l Inventory turnover (times)
l Operating costs as percentage of revenue (%) l Specific ratios based on supplied l entoryIn-days (days)
Major operating expenses as percentage of revenue (%)
information (you have to determine this l Trade and other receivables-days (days) l
(segregate into fixed and variable cost components, if
based on the scenario) Trade and other payables-days(days)
possible)
l Capital gearing ratio (x:1) Operating cyce or Cash conversion cycle
l Change in operating expenses (%)
l Interest-bearing debt to equity ratio (x:1) (days)
l Operating cashflow to operating profit (x:1) l
Net interest-bearing debt to equity ratio (x:1) l Cash ratio (x:1)
Degree of operating leverage (x:1)
l Comparison of capital structure of the entity Operating csh fow to current liabilities (x:1)
l Change in other income, expenditure items (%) l
to the target structure (considering the
Effective interest rate (%)
industry/competitors)
l Net Profit margin (%) l
l Net interest-bearing debt to EBITDA (x:1) l
Change in net profit (%)
Total debt ratio (%)
l Earnings per share (cents)
l Interest cover (x:1) or times interest earned
l Headline Earnings Per Share (HEPS) (cents)
Common size statement of profit and loss and other
comprehensive income
Chapter 8
283
Chapter 8
284
Key financial analysis ratios and other calculations – per area of analysis (continued)
(IV) RETURN ON INVESTED CAPITAL: (V) FINANCIAL MARKET / INVESTOR: (VI) CASH FLOW-RELATED:
These ratios/calculations analyse the entity’s ability These ratios/calculations analyse the For this area of analysis you should customise other
to generate a return relative to an investment base performance of the entity from the ratios and calculations in order to highlight a specific
(e.g. invested capital, equity, or assets) and to perspective of the financial market, and could cash flow effect. In addition, focus on information in
minimise non-essential payments. also indicate capital investment potential. the statement of cash flows.
Ratios / calculations: Ratios / calculations: No entity is able to operate as a viable going concern if
Managerial Finance
Specific ratios based on supplied information (you l Specific ratios based on supplied it is not generating cash (positive cash flows). If
have to determine this based on the scenario) information (you have to determine this turnover is not efficiently converted into cash, the
l Return on Invested Capital (ROIC) (%) l based on the scenario) entity will have to increase its financial risk by
Compare ROIC to WACC over time l Return P/E-multiple over time or Earnings-yield borrowing, until the day of reckoning arrives and it is
on Equity (ROE) (%) over time called upon to repay the debt. Hence, ‘Cash is king’ .
l Return on capital employed (ROCE) (%) l Enterprise value (EV)/EBITDA-multiple over
Ratios / calculations:
Return on total assets (%) time
l Specific ratios based on supplied information (you
l Asset turnover l ROIC vs. WACC over time
have to determine this based on the scenario)
l Dividend payout ratio (%) l l Economic Value Added (EVA ®) l
Refer to the statement of cash flows to assess
Effective tax rate (%) Change in share price (%)
whether there are specific areas to be analysed
l Price / Sales multiple l
further.
EV / Sales multiple
Ratis and calculations from other areas of analysis
(VII) PERFORMANCE-RELATED: l Price / Book value multiple l
Dividend yield over time (%) (these may be customised using a cash-fcus, and
This area of analysis depends on the specific area will frequently include the area of liquidity)
Dividend cover over time (times)
of performance to be analysed. It draws heavily
from the other areas indicated in this table and
could therefore include several ratios or In additin, you may:
calculations specified there. Compare likely csh inflows to likely non-
It could also refer to divisional performance discretionary csh outfows (including cash interest
measurement. and cpitl repayable on debt)
Business failure prediction models such as the Z- When performing a financial Further analyse operating activities
score and the A-score incorporates various other analysis and commentary based on – Operating cash flows to income
areas of analysis. your interpretation, it is important – Operating cash flows to total debt
l DuPont analysis incorporates operational to always apply the information – Cash revenue to reported revenue l
efficiency, asset utilisation and financial provided in the scenario. Further analyse financing activities
leverage. – Cash interest cover
– Cash dividend cover
Formulae to financial analysis calculations

(i) PROFITABILITY:
The ratios covered in this area focus on measuring the entity’s ability to generate income, to effectively control
its expenses and to generate an acceptable profit. Most other sources, however, include Return on Assets
(ROA), Return on Equity (ROE) and Return on Capital Employed (ROCE) as part of profitability as these ratios
measure the entity’s ability to generate a return relative to an investment or asset. In this Chapter, these ratios
are covered separately as part of IV) Return on Invested Capital, but should you be tested on profitability only
these ratios should be included here.
a Change in Revenue (%) = (Current year Revenue – Prior year Revenue) /

Prior year Revenue
b Gross Profit margin (%) = (Revenue – Cost of s les) / Revenue
c Change in gross profit (GP) (%) = (GP current year – GP prior year) /
GP prior year
d Operating Profit margin (%) = Operating pr fit / Revenue
e Earnings Before Interest and Tax (EBIT) = EBIT / Revenue
margin (%)
a
f Earnings Before Interest, Tax, Depreciation = EBITDA / Revenue
and Amortisation (EBITDA) margin (%) A ortisation
g Operating costs as percentage of revenue (%) = Op rating Cost / Revenue
h Major operating expenses as percentage of For ach major operating expense:
revenue (%) = Operating expense / Revenue
i Change in operating expenses (%) For each major operating expense:
= (Expense current year – Expense prior year) /
Expense Prior year
j Operating cash flow to operating profit (x:1) = Net cash flows from operating activities / Operating
profit
k Degree of operating leverage (x:1) = Total contribution / Operating profit
or
= % Change in operating profit /
% Change in revenue
l Change in other income, expenditure items For each major other income and expenditure item:
(%) = (Figure current year – Figure prior year) /
Figure Prior year
m Effective inter st rate (%) = Total finance cost / Total interest-bearing debt at
end of previous period (or average)
n Net Profit margin (%) = Total net profit for the year / Revenue
o Change in net p ofit (%) = (Net profit current year – Net profit prior year) /
Net profit prior year
p Earnings per share (cents) = Profit attributable to equity holders /
Weighted Average number of ordinary shares
x 100 (to convert rand to cents)
q Headline Earnings Per Share (HEPS) (cents) = Headline Earnings / Weighted average number of
ordinary shares × 100 (to convert rand to cents)
r Common size statement of profit and loss All items are expressed as a percentage of sales
and other comprehensive income revenue
Note:
EBIT or EBITDA does not include other income as this normally does not form part of the operating
activities.
285
(II) CAPITAL STRUCTURE AND SOLVENCY RATIOS:
These ratios assess how much debt an entity is carrying, relative to its ability to repay the interest expense as
well as the capital. One therefore considers the amount of debt in the statement of financial position and the
entity’s repayment ability in the statement of profit or loss and other comprehensive income.
Shareholders can achieve the following through debt financing:
Obtain finance without losing control of the entity.
Leverage the return on owners’ equity if the entity derives a higher return on borrowed funds than it pays
in interest.
Financial leverage or gearing can sometimes cause financial distress for an entity experiencing poor business
conditions such as lower sales and higher costs than expected. The cost of lo n is contractually fixed and has to
be repaid, which could cause financial distress for an entity with limited c sh vailable. Entities should therefore
be careful in balancing their desire for higher expected returns against the increased financial risk associated
with debt.
Note: Where fair market values of assets / liabilities / any form f capital are available or could be calculated
this should be used instead of carrying amounts.
a
a Capital gearing ratio (x:1) = Total Interest bearing debt (short – and long-term) /
(Total shareholder’s equity (including reserves)
+ Total Interest bearing debt)
a
b Interest-bearing debt to equity ratio (x:1) = Total int rest-bearing debt (short – and long-term) /
Total shareholder’s equity (including reserves)
a
c Net interest-bearing debt to equity ratio = (Total interest-bearing debt (short – and long-
(x:1) term) – Cash and cash equivalents) /
Total shareholder’s equity (including reserves)
d Comparison of capital structure of the entity Compare the actual capital composition to the target
to the target structure structure
a
e Net interest-bearing debt to EBITDA (x:1) = (Total interest-bearing debt (short – and long-
term) – Cash and cash equivalents) / EBITDA
f Total debt ratio (%) = Total debt / Total assets
g Interest cover (x:1) or times interest earned = EBIT / Total finance cost
Note:
Bank overdraft is normally utilised for short-term working capital purposes and does not form part of an
entity’s perman nt source of funding (unless stated or implied otherwise) and is thus excluded from total
interest bearing d bt for the purpose of capital structure ratios.
(III) LIQUIDITY:
An entity de ives cash p imarily from converting its current assets (inventory and receivables) in order to meet
its current obligations. Current assets are more liquid (easily converted to cash) than long-term assets. Working
capital represents operating liquidity available to a business and working capital management involves the
management of trade debtors, creditors, inventory and cash and thus evaluates management’s efficiency.
a Current ratio (x:1) = Current assets / Current liabilities

a
= (Current assets – Inventory ) / Current liabilities
b Acid-test (quick) ratio (x:1)
= Cost of sales / Inventory
b
c Inventory turnover (times)
= Inventory
b / Cost of sales × 365 c
d Inventory-days (days)
f
Trade and other receivables -days (days) = Trade and other receivables
b / Credit sales d × 365 c
e
f
Trade and other payables -days (days) = Trade and other payables
b / Credit purchases e × 365 c
f
g Operating cycle or Cash conversion cycle = Trade and other receivable-days + Inventory-days –
(days) Trade and other payables-days
continued
286
h Cash ratio (x:1) = (Cash and Cash equivalents + Marketable securities) /

Current liabilities
i Operating cash flow to current liabilities = Net cash flows from operating activities / Current
(x:1) liabilities
Note:
Based on current assets less inventory and less any other illiquid current asset.
In practice the use of average balances is recommended, however, for the purpose of this chapter you
should use closing balances, unless otherwise stated.
Average balances = (Opening balance + Closing balance) / 2
In practice 360 days is often used, however for the purpose of this ch pter you should use 365 days per
year, unless otherwise stated.
For the purpose of this chapter use total sales if there is insufficient credit sales details available.
For the purpose of this chapter use total cost of sales if there is insufficient credit purchase details available.
Alternatively analyse trade account balances.
(IV) RETURN ON INVESTED CAPITAL:
Note: Where fair market values of assets / liabilities / any form of capital are available or could be calculated
this should be used instead of carrying amounts.
a
a Return on Invested Capital (ROIC) (%) N t op rating profit less adjusted taxes (NOPLAT ) /
Inv st d Capital
Where: = Operating profit less recalculated operating taxes
NOPLAT
a
(excluding the effect of interest and non-operating items)
[giving operating profit available to all investors]
Invested Capital = When viewed from a perspective of where the capital has
been invested in operations:
= Operating assets – operating liabilities
= (Property, plant and equipment + (current assets – excess
b
cash) + goodwill + intangible assets ) – current liabilities
b
Or when viewed from a perspective of what capital has been
invested in operations:
= (Debt capital + equity and equity equivalents +
preference share capital) – (excess cash – non-operating
assets and investments)
= (Interest-bearing debt (short and long-term) + equity
c
capital (including reserves and retained earnings ) +
preference share capital) –
(excess cash – non-operating assets and investments)
b Compa e ROIC to Weighted Average If correctly calculated ROIC is comparable to the entity’s
Cost of Capital (WACC) over time WACC
c Ret rn on Eq ity (ROE) (%) = Profit attributable to equity holders / Shareholders’
d
funds or
= EPS / Market price per share or
= HEPS / Market price per share
= EBIT / Capital employed
e
d Return on capital employed (ROCE) (%)
= EBIT / Total assets
f
e Return on total assets (%)
= Revenue / Total assets
f
f Asset turnover
g Dividend payout ratio (%) = Dividend per share / Earnings per share
h Effective tax rate (%) = Income tax expense / Earnings before income tax
Other references may use the acronym ‘NOPAT’ for the same concept.
Deferred tax could be removed here when viewed as an equity-equivalent (advanced).
Deferred tax could be added here as an equity-equivalent (advanced).
287
Shareholders’ funds = Normal share capital + reserves.

Capital employed = Shareholders' funds + interest-bearing debt (or = Total Assets – Current Liabilities).
Averages can be used in practice however for this Chapter you should use closing balance figures.
Note: ROE only analyses profitability related to an entity’s shareholders’ funds whereas ROCE considers
shareholders' funds and interest-bearing debt as well, thus providing a better indication of financial
performance for entities with significant interest-bearing debt.
(V) FINANCIAL MARKET / INVESTOR:

Financial market value ratios reflect investors’ perception of future prospects. The market value ratios relate
the entity’s share price to its earnings and book value per share. These ratios will be high for a financially sound
entity and the share price will reflect this.
Note: This area has strong overlap with the topic of valuations (refer to Business and equity valuations in
Chapter 11 for more detail).
a P / E multiple = Market price per share / HEPS

(This multiple c uld be calculated in several other ways)
b Earnings-yield (%) = HEPS / Market price per share
c EV / EBITDA multiple = (Current full arket capitalisation a + estimated value of
debt capital) / EBITDA for one year
d ROIC vs. WACC over time Compare ROIC vs. WACC over time
e EVA® (Economic Value Added) = Adjust d NOPLAT – (Adjusted Invested capital × WACC)
f Change in share price (%) = (Current – prior year share price) / Prior year share price
g Price / Sales multiple = Current full market capitalisation a / Revenue for one year
h EV / Sales multiple = (Current full market capitalisation a + estimated value of
debt capital) / Revenue for one year
i Price / Book value multiple = Current full market capitalisation a / carrying value of
shareholders’ equity
j Dividend yield (%) = Dividend per share b / Market price per share
b
k Dividend cover (times) = Earnings per share / Dividend per share
Note:
Full market capitalisation = Total number of issued shares × Market price per share. It is important
to r m mb r that this replaces capital and reserves.
In terms of divid nd p r share, shares are classified cum div in the period between declaration of the
dividend and the last day to register for the dividend. If sold cum div the right to the next dividend is
passed to the buyer. A person who purchases shares listed as ex div will not receive the next dividend
payment if the dividend has been declared but not yet paid.
Financial analysis example

Ratios are dealt with under the following analysis areas:
Pr fitability;
Capital structure and solvency ratios;
Liquidity;
Return On Invested Capital;
Financial market / Investor;
Cash flow-related; and
Performance-related.
The financial analysis example below covers in detail, ratio analysis areas I) to V), which is based on extracts of
he consolidated financial statements of Funky Junk Ltd Group. The Cashflow- related analysis is only dealt with
in part and Performance – related analysis draws heavily from the other areas indicated in the financial analysis
outline and could therefore include several ratios or calculations included under categories I) to VI).
288
This example will indicate three difficulty levels namely: Fundamental, Intermediate and Advanced. Students
who are at a Fundamental level are expected to comment only on a Fundamental level, students who are at an
Intermediate level are expected to comment on a Fundamental and Intermediate level and students at an
Advanced level are expected to comment on a Fundamental, Intermediate and Advanced level.
At an advanced difficulty level you should be able to calculate all market values (refer to Chapter 10 for
Valuations of preference shares and debt and to Chapter 11 for Business and equity valuations). Furthermore
a financial analysis question of this nature requires students to manipulate the financial information in a
meaningful manner and provide insightful comments (simply indicating an increase or decrease is not
sufficient).
Funky Junk financial analysis example:

The following are extracts of the consolidated financial statements of Funky Junk Ltd Group for the year
ended 30 June 20X4:
EXTRACT OF THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20X4
20X4 20X3
R'000 R'000
ASSETS
Non-current assets
Property, plant and equipment 183 700 109 000
Intangible assets 30 200 26 800
Listed investment (marketable securities) 10 000 10 000
Financial asset 28 000 0
Goodwill 0 7 000
Investment in associate 0 20 230
251 900 173 030
Current assets
Inventories 94 000 65 600
Trade and other receivables 131 000 98 000
Cash and cash equivalents 4 590 10 220
229 590 173 820
Total assets 481 490 346 850
EQUITY AND LIABILITIES

Equity attributable to owners of the parent
Share capital 180 000 150 000
Retained earnings 166 310 92 100
Revaluation surplus 14 400 0
Total equity 360 710 242 100
Non-current liabilities
Long-term loan 100 700 92 400
Total non-cu ent liabilities 100 700 92 400
Current liabilities
Trade and other payables 9 500 4 000
Short-term portion of long-term loan 9 780 7 350
Pr visi n 800 1 000
Total current liabilities 20 080 12 350
Total liabilities 120 780 104 750
Total equity and liabilities 481 490 346 850
289
EXTRACT OF THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE

INCOME FOR THE YEAR ENDED 30 JUNE 20X4
20X4 20X3
R'000 R'000
Revenue 916 440 783 282
Cost of sales (537 600) (425 870)
Gross profit 378 840 357 412
Other income 2 600 1 800
Other expenses (assume operating) (249 000) (200 000)
Finance costs (17 000) (12 000)
Share of profit of associate 2 320 2 000
Profit before tax 117 760 149 212
Income tax expense (29 600) (34 397)
PROFIT FOR THE YEAR 88 160 114 815
Other comprehensive income

Items that will not be reclassified to profit or loss
Revaluation surplus 20 000 0
Tax on revaluation surplus (5 600) 0
Other comprehensive income for the year, net of tax 14 400 0
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 102 560 114 815
EXTRACTS OF THE CONSOLIDATED STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 30 JUNE 20X4
Share Revaluation Retained
Capital surplus earnings Total
R R R R
Balance at 1 July 20X3 150 000 0 92 100 242 100
Changes in equity for 20X4
Total comprehensive income for the year 0 14 400 88 160 102 560
Profit for the year 0 0 88 160 88 160
Other comprehensive income 0 14 400 0 14 400
Dividends 0 0 (13 950) (13 950)
Issue of shares 30 000 0 0 30 000
Balance at 30 June 20X4 180 000 14 400 166 310 360 710
EXTRACT OF THE CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 30 JUNE 20X4
R'000
20X4
Net cash from ope ating activities 10 190
Net (decrease) in cash and cash equivalents (5 630)
Cash and cash eq ivalents at beginning of period 10 220
Cash and cash eq ivalents at end of period 4 590
Industry averages and comparatives for the 20X4 financial year:
Revenue increase from previous year 12%

Gross profit margin 43%
Operating profit margin 18%
E rnings growth over the past two years 15%
continued
290
Price earnings multiple 10

Enterprise Value / EBITDA multiple 6
Dividend cover 8 times
Current ratio 4:1
Quick ratio 2,5:1
Inventory days 55 days
Debtor days 38 days
Creditor days 62 days
Assumptions:
The inflation rate is 6%.
The prime interest rate is 9%.
l For all debt, other investments and intangible assets their b k value approximates their market value.
Funky Junk’s target debt to equity ratio is 23:77 or 0,30:1.
Funky Junk’s WACC is 30%.
l At the end of 20X3 there were 100 000 shar s in issue and from the beginning of 20X4 there were 120 000
shares in issue. The 20X3 closing share price was R3,30 per share while the 20X4 closing share price was
R2,50 per share. Assume that the additional shares issued at the beginning of 20X4 were issued at a
discount and that the issue price was 1,50 per share.
Note that Funky Junk doesn’t have any non- controlling interests per the statement of financial position
or statement of profit or loss and other comprehensive income as it owns 100% of its subsidiary.
All amounts per the analysis below are in R’000 and rounding differences may occur.
You are required to calculate the various ratios and provide insightful comments to the following
analysis areas:
Profitability ratios;
Capital structure and solvency;
Liquidity;
Return on invested capital;
Financial mark t / inv stor;
Cashflow-r lat d; and
Performan e-related.
Solution to Funky Junk example:

(1) PROFITABILITY
Change in revenue (%)
(916 440 – 783 282) / 783 282
17% increase
Advanced calculation
Real growth rate (Based on the Fisher equation):
1 + nominal rate = (1 + inflation rate) × (1 + real
rate) 1 + 0,17 = (1 + 0,06) × (1 + real)
1,17 = (1,06) × (1 + real rate)
Real growth rate = 10%
291
Difficulty level Comment

Intermediate Funky Junk showed a good growth in revenue of 17% from 20X3 to 20X4.
Revenue also grew at a faster / better rate than industry’s growth of 12%.
Increase in Funky Junk’s revenue could be due to increased market share or
effective marketing of the sales department.
This is good considering that revenue grew in excess of inflation of 6% and
Advanced with a real growth per annum equal to 10 %.
Gross profit margin (%)
20X4 20X3
= (916 440 – 537 600) / 916 440 = 357 412 / 783 282
= 41% = 46%
(c) Change in gross profit (%)
= (378 840 – 357 412) / 357 412
= 6% increase
Difficulty level Comment (b and c)
Fundamental Funky Junk’s gross profit margin is expected to remain fairly constant from year to
year and revenue increases are expected to result in other cost of sales efficiencies
such as bulk discounts, tc. Th se bulk discounts are as a result of economies of
scale.
Intermediate Funky Junk’s gross profit margin worsened from 46% (20X3) to 41% (20X4) and the
20X4 results are also inferior compared to the industry average of 43%.
Advanced Cost of sales or gross profit margin did not display the expected improvement due
to the increase in scale of operations. Revenue increased and with that we would
expect greater quantity discounts, lower inventory holding cost per unit, etc. This
could indicate improper inventory management / weaknesses in the purchasing
department and / or that the mark-up on sales was reduced in an effort to drive
sales.
To fully understand the reason for this weakening in gross profit margin, additional
information such as inventory valuation method, allocation of overhead costs,
discounts and wastage, etc. should be investigated.
(d), (e) and (f)
For the purpose of this example operating profit = EBIT. As no additional information regarding
depreciation or amortisation was provided EBIT = EBITDA. All three ratios therefore provide the same
answer.
Operating profit margin (%)
Earnings Befo e Interest and Tax (EBIT) margin (%)
Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) margin (%)
20X4 20X3
= (378 840 – 249 000) / 916 440 = (357 412 – 200 000) / 783 282
= 14% = 20%
Difficulty level Comment (d, e and f)
Intermediate It is concerning that operating profit margin decreased from 20% (20X3) to
14% (20X4) despite the increase in revenue.
Operating profit results are also inferior to the industry operating margin of 18%.
Additional comments relating to operating profit margin are integrated with operating expenses ratios
below.
292
Operating costs as percentage of revenue (%)

20X4 20X3
= 249 000 / 916 440 = 200 000 / 783 282
= 27% = 26%
Comments relating to g) are provided with the comments to i) below.
Operating expenses as percentage of revenue (%) – for each major operating expense
For the purpose of this example no additional information was provided to segregate operating expenses
into fixed or variable cost components and no additional information was provided to identify major
operating expenses within total operating costs.
Change in operating expenses (%)
(249 000 – 200 000) / 200 000
25% increase
Difficulty level Comment (g and i)
Intermediate Its concerning to observe operating c sts as a percentage of sales increase from
26% (20X3) to 27% (20X4) despite the increase in sales.
Advanced Once again we would expect a decrease in Funky Junk’s operating costs or an
increase in operating profit argin as percentage of sales due to economies of
scale, but this was not the case here.
This could indicate a gr at r l v l of inefficiencies in Funky Junk’s management of
operations.
Operating costs increased (25%) at a faster rate than sales (17%) – this explains the
decline in operating profit, EBIT and EBITDA margins. This may also be as a result of
lower murk-up in an effort to drive sales.
Operating cash flows to operating profit (x:1)
20X4 20X3
= 10 190 / (378 840 – 249 000) Comparatives not provided
= 0,08 :1
Fundamental Funky Junk’s operating cash flows indicate whether they were able to generate
sufficient cash flow to maintain and grow their operations, or whether external
financing will be necessary.
Advanced This ratio is not good as it indicates that only 8% of Funky Junk’s operating profit
was converted into operating cash flows in 20X4.
Industry and previous year should also be compared.
(k) Degree of operating leverage (x:1)
The example below is only applicable to k) and illustrates the degree of operating leverage.
Note: This example does not form part of the Funky Junk example, which is continued in ratio l) below.
Entity A (model car shop):
Number Rand
of units per unit R
Sales 100 000 120 12 000 000
Variable cost 10 (1 000 000)
Contribution 11 000 000
Fixed Cost (9 000 000)
Operating profit 2 000 000
293
Entity B (refreshment shop):

Number Rand
of units per unit R
Sales 1 000 000 12 12 000 000
Variable cost 9 (9 000 000)
Contribution 3 000 000
Fixed Cost (1 000 000)
Calculation of the degree of operating leverage (x:1)

Entity A Entity B
= 11 000 000 / 2 000 000 = 3 000 000 / 2 000 000
= 5,5:1 or 550% = 1,5:1 or 150%
Fundamental Operating leverage measures the extent to which an entity (or project) incurs a
mixture of fixed and variable costs.
By comparing two similar co panies within the same industry (unlike Entity A, a
model car shop, and Entity B, a refresh ent shop) the entity with the lower
operating leverage (higher variable portion and lower fixed cost) will be less
strained to achieve break v n point.
Intermediate Entity A sells fewer units (100 000), with each sale providing a very high
contribution margin of 92%. It is therefore very important for Entity A to correctly
forecast its sales to ensure sufficient cash, etc.
Entity A has a higher proportion of fixed costs (R 9 000 000) and a lower
proportion of variable costs (R 1 000 000) and thus has a high operating leverage.
Entity B sells more units (1 000 000), with each sale contributing a very low
contribution margin of 25% and thus Entity B has a low operating leverage / Entity
B has a lower fixed costs (R 1 000 000) and higher variable costs (R9 000 000) and
thus has a low operating leverage.
Entity A has a higher operating leverage than entity B.
Change in other income (%)
(2 600 – 1 800) / 1 800
44% increase
Difficulty lev l Comment
Intermediate Other income has improved significantly from 20X4 with a 44% growth rate.
Advanced More information should be obtained to determine the reason, however Funky
Junk’s other income forms an insignificant portion of the net profit.
Effective inte est ate (%)
17 000 / (92 400 + 7 350)
17%
Intermediate The effective interest rate of 17% indicates a high (expensive) finance cost as this
rate is far above the current prime rate of 9%.
Advanced This is an indication of a high finance risk as financiers want to be compensated for
their risk in Funky Junk (refer to II) Capital structure for a discussion of the finance
risk).
Net Profit margin (%)
20X4 20X3
= 88 160 / 916 440 = 114 815 / 783 282
= 10% = 15%
294
Change in net profit (%)

(88 160 – 114 815) / 114 815
Negative 23%
Difficulty level Comment (n and o)
Fundamental Net profit margin is a poor financial indicator as different accounting policies are
used by different entities, etc. which complicates and compromises its
comparability. Between the gross profit and the net profit there is a lot of ‘noise’,
that is expenditure or income items that vary from year to year or that do not
relate to operating profits. Entity growth, for instance, can be financed by either
debt or equity. If it is financed by equity, there wi be no effect on expenditure
between the gross profit figure and the net profit figure. However, if it is financed
by debt, there will be a major effect on the interest cost nd a subsequent effect on
the net profit margin. The net profit margin ratio is hard to analyse or discuss
because of the ‘noise’ factor.
Intermediate The 23% decline in the net profit ratio indicates poor performance (many of the
reasons for this poor performance was already identified and discussed above).
Earnings per share (cents)
20X4 20X3
= 88 160 / 120 000 × 100 = 114 815 / 100 000 × 100
=74 cents = 115 cents
Earnings decline rate
(88 160 –114 815) / 114 815
– 23% decline
Fundamental This ratio indicates the profits available for distribution or generated per share.
Shareholders will refer to this ratio to determine the performance of their shares in
terms of earnings.
Intermediate Overall earnings performance has weakened from 20X3 to 20X4 with a R26 655 or
a 23% decline.
Earnings growth is inferior to the industry growth of 15% and is even inferior to
inflation growth of 6%.
Advanced The comparison of EPS is complicated as the number of shares increased from
100 000 in 20X3 to 120 000 at the beginning of 20X4 this is called earnings dilution.
Since earnings have declined with 23% compared to the number of shares which
incr ased with 20% (100 000 to 120 000), the money raised from the share issue
was not applied successfully.
For additional comments relating to share price value dilution refer to V) Financial
Market / Investor ratios commentary. Also refer to IAS 33 for the detailed
calculation of earnings per share including the weighted average number of
ordinary shares.
Headline Earnings Per Share (HEPS) (cents)
Fundamental In South Africa entities listed on the Johannesburg Securities Exchange are required
to provide headline earnings per share information in accordance to SAICA’s
Circular 2 / 2013. Additional information is required to calculate HEPS and where
insufficient information is provided earnings per share should be used.
Also refer to Business and equity valuations in Chapter 11 – Valuation method
based on a P / E multiple for Headline earnings discussion.
295
Common size statement of profit and loss and other comprehensive income
Extract of the Common size statement of profit or loss and other comprehensive income to indicate the
simplicity in which it demonstrates how revenue was utilised.
20X4 20X3
Revenue 100% 100%
Cost of sales (59%) (54%)
Gross profit 41% 46%
Other income 0% 0%
Other expenses (assume operating) (27%) (26%)
Finance costs (2%) (2%)
Profit before tax 13% 19%
Income tax expense (3%) (4%)
PROFIT FOR THE YEAR 10% 15%
(2) CAPITAL STRUCTURE AND SOLVENCY RATIOS:
Calculation of market capitalisation (Market value of equity which includes reserves)

20X4 20X3
= R2,5 × 120 000 = R3,30 × 100 000
= R 300 000 = R 330 000
Comments to ratio a), b) and c) are included with ratio d) b low.
Capital gearing ratio (x:1)
Intermediate – Book value
20X4 20X3
= (100 700 + 9 780) / (360 710 + 100 700 + 9 780) = (92 400 + 7 350) / (242 100 + 92 400 + 7 350)
= 0,23:1 = 0,29:1
Advanced – Market value
20X4 20X3
= (100 700 + 9 780) / (300 000 + 100 700 + 9 780) = (92 400 + 7 350) / (330 000 + 92 400 + 7 350)
= 0,27:1 = 0,23:1
Interest-bearing debt to equity ratio (x:1)
20X4 20X3
= (100 700 + 9 780) / 360 710) = (92 400 + 7 350) / 242 100
= 0,31:1 = 0,41:1
20X4 20X3
= (100 700 + 9 780) / 300 000 = (92 400 + 7 350) / 330 000
= 0,37:1 = 0,30:1
Net interest-bearing debt to equity ratio (x:1)
Intermediate –Book value
20X4 20X3
= (100 700 + 9 780 – 4 590) / 360 710 = (92 400 + 7 350 – 10 220) / 242 100
= 0,29:1 = 0,37:1
20X4 20X3
= (100 700 + 9 780 – 4 590) / 300 000 = (92 400 + 7 350 – 10 220) / 330 000
= 0,35:1 = 0,27:1
296
Comparison of capital structure of Funky Junk to the target structure

Difficulty level Comment (relating to a, b, c and d)
Fundamental The capital structure usually refers to the debt-to-equity ratio, which serves as a
risk indicator. If an entity is heavily financed with debt, it generally indicates
a greater financial risk or a higher gearing.
An entity’s target (optimum) capital structure balances business and finance risk
and is based on industry averages.
Gearing shows the degree to which an entity’s activities are funded by the owners’
(equity) funds versus loan providers.
Intermediate Based on book values Funky Junk’s interest-be ring debt to equity ratio of 0,31:1
(20X4) is moving closer to its target debt to equity r tio of 0,30:1 from 0,41:1
(20X3) and has thus showed an improvement.
The decrease in Funky Junk’s market capitalisation is concerning as the value has
decreased from R 330 000 (20X3) to R 300 000 (20X4), which is an indication of the
market’s lack of confidence in Funky Junk’s future growth prospects and indicates
an increase in risk of investment.
Advanced Based on market values Funky Junk’s interest-bearing debt to equity ratio (similarly
its gearing and net interest-bearing debt ratio) has worsened from 0,30:1 (20X3) to
0,37:1 (20X4). Funky Junk’s capital structure is also moving further away from its
target capital structure of 30:1.
This is an indication of higher gearing and increased financial risk which leads to a
higher finance cost.
When analysing an entity’s capital structure the proportion of short and long-term
debt must also be considered. This will indicate issues such as inappropriate
financing policy where short-term debt is utilised to finance non-current assets.
Net interest-bearing debt to EBITDA (x:1)
20X4 20X3
= (100 700 + 9 780 – 4 590) / (378 840 – 249 000) = (92 400 + 7 350 – 10 220) / (357 412 – 200 000)
= 0,82:1 = 0,57:1
Fundamental The net interest-bearing debt to EBITDA ratio is especially important to financiers
as it considers the entity’s ability to repay its debt.
Generally a high ratio of above 4 indicates that an entity is less likely to repay its
d bt, however current loan covenants and industry averages should be considered.
Advanced This ratio has worsened from 0,57:1 to 0,82:1 as a combined effect of Funky Junk’s
net interest-bearing debt increasing and its EBITDA decreasing from the previous
year, indicating that it will take longer to repay their debt.
This will increase Funky Junk’s finance risk for which financiers may want to receive
compensation through increased finance costs and financiers may impose
additional loan covenants.
T tal debt ratio %
20X4 20X3
= 120 780 / 481 490 = 104 750 / 346 850
= 25% = 30%
Market value of Assets = Market value of Equity + Market Value of Liabilities
297
20X4 20X3
Market value of Assets:
= 300 000 + 120 780 = 330 000 + 104 750
= 420 780 = 434 750
20X4 20X3
= 120 780 / 420 780 = 104 750 / 434 750
= 29% = 24%
Fundamental This ratio measures the percentage of assets financed by borrowings. Generally a
low debt ratio is preferred as it reduces the risk of potential losses in the event of
liquidation. A high debt ratio there against indic tes too much debt which leads to
an increase of the finance risk.
Intermediate Based on book value Funky Junk’s debt ratio seems to have improved from 30%
(20X3) to 25% (20X4).
Advanced Based on market value Funky Junk’s debt ratio has actually worsened from 24%
(20X3) to 29% (20X4). It is concerning that alm st a third of Funky Junk’s assets are
financed by debt. This is also an indication of higher gearing and increased
financial risk.
(g) Interest cover (x:1)
20X4 20X3
= (378 840 – 249 000) / 17 000 = (357 412 – 200 000) / 12 000
= 7.64 = 13,12
Fundamental The times interest earned ratio indicates the likelihood of the entity to default on
loan interest payments.
A high ratio shows that the entity can easily repay its loan obligations. A low ratio
indicates an increased risk of defaulting on interest repayment.
The times interest earned must also be viewed in conjunction with the cash flow
statement as it is possible to have a high ratio but a negative cash flow, indicating
that the entity is unable repay its interest commitment.
Intermediate The interest cover has deteriorated from 13,12 (20X3) to 7,64 (20X4) indicating
that Funky Junk is now more likely to default on their loan interest repayment than
in 20X3. This can be attributed to the increases in long-term loans and finance
charges and decrease in EBIT.
D spite the decrease, an interest cover of 7,64 indicates that Funky Junk can still
cover the finance cost with relative ease.
Advanced This, combined with the overall increase in finance risk, probably led to the greater
premium charged for the finance rate (refer to effective interest rate per I)
Profitability analysis).
(3) LIQUIDITY:
(a) Current ratio (x:1)
20X4 20X3
= 229 590 / 20 080 = 173 820 / 12 350
= 11,43: 1 = 14,07: 1
Fundamental This ratio indicates the entity’s ability to utilise current assets to repay current
liabilities. Trade and other payables (creditors), bank managers, etc. will utilise this
ratio to determine if an entity may have difficulty meeting its short-term ob-
ligations. An indication of concern will be if the current ratio is too low or current
liabilities exceed current assets (current ratio is below 1). Acceptable current ratios
vary from industry to industry and are generally between 1,5:1 and 3:1.
298
As an example of deviation from this norm, supermarket stores have low ratios of
0,7:1 and creditors are still prepared to finance these stores because of its high
cash flow.
On the other hand, if the current ratio is too high it may indicate inefficient
utilisation of current assets or short-term financing facilities which indicates
inefficient working capital management.
Intermediate / When compared to industry norm of 4:1 Funky Junk’s current ratio of 11:1 (20X4)
Advanced is considered too high.
This ratio has improved slightly from 14:1 (20X3) to 11:1 (20X4) as it is now more
in-line with the industry norm of 4:1.
This is an indication of ineffective working c pit l m n gement as creditors are not
willing to provide Funky Junk with sufficient short-term financing. This may be an
indication that Funky Junk has a poor credit history or a poor credit rating (refer to
trade and other payables below) or ineffecti e use of current assets.
Acid-test (quick) ratio (x:1)
20X4 20X3
= (229 590 – 94 000) / 20 080 = (173 820 – 65 600) / 12 350
= 6,75:1 = 8,76:1
Fundamental This short-term liquidity ratio indicat s whether Funky Junk’s will be able to repay
its current liabilities out of “quick” assets. These assets are either cash or quickly
convertible into cash. This ratio is inappropriate for service entities with limited
inventory.
The quick ratio should be compared with industry average.
A quick ratio below 1:1 may indicate that the entity relies too much on inventory
(or other illiquid current assets) to pay its short-term liabilities.
If the quick ratio is higher than industry average, Funky Junk’s cash on hand may be
too high and Funky Junk may be experiencing difficulty with debtors’ collection or
obtaining credit from suppliers.
Intermediate / When compared to industry norm of 2,5:1, Funky Junk’s quick ratio of 6,75:1 is
Advanced considered too high.
This ratio has improved slightly from 8,76:1 (20X3) to 6,75:1 (20X4) as it is now
more in-line with the industry norm of 2,5:1.
Funky Junk’s acid ratio remains too high which indicates that Funky Junk’s
management is experiencing debtors’ collection difficulty (with high trade and
other receivable balances) and difficulty obtaining credit from suppliers (with low
trade and other payable balances).
Also refer to Trade and other receivables-days and Trade and other payable days
below.
Inventory t rnover (times)
20X4 20X3
= 537 600 / 94 000 = 425 870 / 65 600
= 5,7 times = 6,5 times
Difficulty level Comment (c and d)
Fundamental Inventory turnover indicates the number of times an entity's inventory is sold and
replaced over a period.
As sales increase an increase in inventory holding is expected to ensure that the
entity doesn’t incur inventory shortages. The problem with holding inventory is
that holding costs must be financed. An entity should thus aim to hold just enough
inventory to meet its sales. The difficulty with this Just in Time strategy is that if
inventory shortages occur, sales may be lost.
299
Intermediate / Inventory turnover has worsened from 6,5 times (20X3) to 5,7 times (20X4) and
Advanced should be compared to industry averages.
This lower turnover implies relatively poor sales compared to inventory and
therefore poor inventory management as excess inventory leads to additional
holding and financing costs and represent a poor investment (providing a no or low
return). Excess inventory may also lead to obsolete inventory and thus Funky
Junk’s inventory policy requires attention.
Also refer to comment d) below.
Inventory-days
20X4 20X3
= 94 000 / 537 600 × 365 = 65 600 / 425 870 × 365
= 64 days = 56 days
Difficulty level Comment (c and d)
Fundamental Inventory days indicate the number f days it takes Funky Junk to turn its inventory
(including work in progress) from purchase to sales.
The shorter the number of days, or the higher the turnover rate, the more efficient
the inventory management process.
However a too short period can be an indication of insufficient inventory and
inventory shortages.
Intermediate / Inventory days have wors n
d from 56 days (20X3) to 64 days (20X4) and it moved
Advanced even further away from the industry average of 55 days.
Evidently managements’ strategy to move inventory through increase sales has not
had the desired effect (also refer to I) Profitability).
Funky Junk is now holding inventory for a longer period which increases their
holding and finance costs.
This ratio indicates that Funky Junk is experiencing difficulties in selling their
inventory or ineffective inventory purchasing. This raises the concern of obsolete
inventory included in closing inventory.
Trade and other receivables-days (debtors’ collection period)
20X4 20X3
= 131 000 / 916 440 × 365 = 98 000 / 783 282 × 365
= 52 days = 46 days
Note: For the purpose of this example total sales was used as there is insufficient credit sales details
available.
Increase in trade and other receivables balance
(131 000 – 98 000) / 98 000
34%
F ndamental This ratio indicates the time
it takes Funky Junk’s debtors to pay their accounts or
the time it takes for credit sales to be transformed into cash. In general the shorter
the debtors’ collection period the better.
There is no norm for this ratio as it will vary considerably from industry to industry.
A retail business will have a period of around 30 days as customers pay as they
receive their monthly statements. Where credit cards are used it takes around 60
days. Manufacturers would usually only be paid at around 90 days.
Taking longer than industry averages may become challenging, as it implies that
debtors may become irrecoverable, meaning that debtors default on payment and
a bad debt is incurred.
In general the positive side to increased credit sales is increased profit (earnings
per share). The negative side is that increased credit sales lead to increased debtors
300
which reduces the cash available from sales and may be expensive to collect. The
percentage increase in accounts receivable should match the percentage increase
in sales or cost of sales.
In an effort to increase sales with 17% additional credit was provided to debtors
Intermediate /
(34% increase), which has resulted in a deterioration of debtors’ days from 46
Advanced
days (20X3) to 52 days (20X4).
Funky Junk also performed worse than industry average of 38 days in both years.
Debtors where allowed excessive credit and debtors management seems
ineffective as debtors may become irrecoverab e.
This increase in the debtors’ days may lead to Funky Junk having to finance debtors
with debt such as an overdraft.
Trade and other payables-days
20X4 20X3
= 9 500 / 537 600 × 365 = 4 000 / 425 870 × 365
= 6 days = 3 days
Note: For the purpose of this example total cost of sales are assu ed to be on credit as insufficient credit
purchase details are available.
Fundamental This ratio indicates the time it tak s an entity to pay its creditors. There is no norm,
but creditors are usually paid at b tween 30 and 90 days and industry averages
should be considered.
The higher the creditors’ days, the longer the entity takes to pay its creditors, the
more cash they have on hand, which is generally considered good for working
capital and cash flow purposes.
However, if the entity takes too long to pay its creditors, the creditors will become
dissatisfied. Creditors may be reluctant to extend credit in the future, or they may
offer more expensive credit terms. Early settlement discounts may also be
forfeited and the cost of lost discount should be considered. This is not the case for
Funky Junk as their creditors’ days are considered too short.
Funky Junk’s creditors have to wait 3 days longer for their money than during the
Intermediate / previous year, making it only slightly more in-line with industry creditors’ days of
Advanced 62. espite this slight improvement from the prior year from 3 days to 6 days, it
remains far too short compared to industry’s creditors’ days of 62.
This increase of 3 days from 20x3 is less than expected as inventory days increased
with 8 days and debtors days increased with 6 days.
This indicates ineffective creditors’ management and may be an indication of
suppliers’ hesitance to extend Funky Junk’s credit terms as a result of Funky Junk’s
poor credit history and poor credit rating.
Funky Junk should consider negotiations with creditors to delay payment as this
may improve Funky Junk’s cash flow, especially as the current cash balance of R 4
590 is considered low. If Funky Junk pays its suppliers a little later, they could use
the cash to invest in the business and generate more profits. Simultaneous
consideration should be given to the effect on cost of lost discount, increased
credit costs and the relationship with their creditors (suppliers).
Operating cycle or Cash conversion cycle (days)
20X4 20X3
= 64 days + 52 days – 6 days = 56 days + 46 days – 3 days
= 110 days = 99 days
Industry cash conversion cycle (days)
55 days + 38 days – 62 days
31 days
301

Fundamental The operating cycle indicates the time it takes cash to circulate through the
business operating activities until it is converted into cash again.
Funky Junk’s inventory is purchased, and lies in the warehouse for 6 days after
which creditors are paid (cash outflow). It takes Funky Junk 64 days to sell the
inventory and after that debtors take a further 52 days before paying (cash inflow).
Cash has therefore been out of the business for 110 days in 20X4.
Generally when the operating cycle decreases, it appears that to be positive as it
takes less time for goods to be purchased, so d and converted into cash than
before. However, should the debtors’ days and inventory days remain unchanged
and only the creditors’ days increase, the oper ting cycle will decrease, but this
decrease will generally be undesirable. Note, however, that Funky Junk’s situation
is different as their creditors’ days are already too short and should be extended.
In general when the decrease in the operating cycle is due to a decrease in the
debtors’ days or inventory days, this is a p sitive occurrence which leads to
improved cash flow and a possible decrease in creditors or debts.
Intermediate / The cash conversion cycle has worsened from 99 days (20X3) days to 110 days
Advanced (20X4) and is even further out of line with industry average of 31 days.
other payables days above for the co ents provided).
Cash ratio (x:1)
20X4 20X3
= (4 590 + 10 000) / 20 080 = (10 220 + 10 000) / 12 350
= 0,73: 1 = 1,65:1
Fundamental This short-term liquidity ratio measures Funky Junk’s ability to utilise its cash and
cash equivalents to pay its current financial obligations.
Creditors are typically interested in this ratio before providing credit.
Intermediate / The cash ratio has worsened from 1,65:1 (20X3) to 0,73:1 (20X4) as a result of
Advanced decreased cash and cash equivalents combined with an increase in current
liabilities.
As a result of this poor liquidity indicator creditors may not be willing to provide
Funky Junk with additional credit or improved credit terms (as discussed above per
trade and other payable days).
Operating cash flow to curr nt liabilities (x:1)
20X4 20X3
= 10 190 / 20 080 Comparatives not provided
= 0,51: 1
F ndamental This measures the ease with which current liabilities are covered by net cash flow
from operating activities.
Additional commentary is not possible as cash flow comparatives and industry
averages were not provided.
(4) RETURN ON INVESTED CAPITAL:

Return on Invested Capital (ROIC)
(%) l NOPLAT:
20X4 20X3
= (378 840 – 249 000) × 0,72 = (357 412 – 200 000) × 0,72
= 93 485 = 113 337
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Invested capital:
20X4 20X3
= 100 700 + 9 780 + 360 710 – 4 590 = 92 400 + 7 350 + 242 100 – 10 220 –10 000
– 10 000 – 30 200 – 28 000 – 26 800 – 7 000 – 20 230
= 398 400 = 267 600
20X4 20X3
= 100 700 + 9 780 + 300 000 – 4 590 = 92 400 + 7 350 + 330 000 – 10 220 – 10 000
– 10 000 – 30 200 – 28 000 – 26 800 – 7 000 – 20 230
= 337 690 = 355 500
ROIC – Book value:
20X4 20X3
= 93 485 / 398 400 = 113 337 / 267 600
= 23% = 42%
ROIC – Market value:
20X4 20X3
= 93 485 / 337 690 = 113 337 / 355 500
= 28% = 32%
(b) Compare ROIC to WACC over time
Difficulty level Comment (a and b)
Fundamental Return On Invested Capital ( OIC) provides an indication of how efficiently Funky
Junk has invested the capital under their control.
The WACC represents the minimum rate of return to compensate for risk at which
Funky Junk creates value for its investors (refer to WACC per Capital structure and
the cost of capital in Chapter 4).
Comparing Funky Junk’s ROIC with its WACC indicates whether an appropriate
return on invested capital was generated for the year.
Intermediate Based on book values, Funky Junk’s ROIC deteriorated from 42% (20X3) to 23%
(20X4), thus indicating that their invested capital (excluding cash and non-operating
assets and investments) was utilised ineffectively.
Advanced Based on market values, Funky Junk’s ROIC deteriorated from 32% (20X3) to 28%
(20X4), thus indicating that their invested capital (excluding cash and non-operating
ass ts and investments) was utilised ineffectively.
In 20X3 the ROIC of 32% was superior to Funky Junk’s WACC of 30% indicating that
Funky Junk was creating value for their investors. However, from 20X4 their ROIC of
28% is below its WACC of 30% indicating that Funky Junk’s value is being depleted
and investors may seek other investment opportunities.
Funky Junk’s WACC rate of 30% is also considered high as this may indicate a
decrease in value and an increase in risks.
Return n Equity (ROE) (%)
20X4 20X3
Alternative 1
= 88 160 / 360 710 = 114 815 / 242 100
= 24% = 47%
= 88 160 / 300 000 = 114 815 / 330 000
= 29% = 35%
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Alternative 2 – Market value

= 74 cents / 250 cents = 115 cents / 330 cents
= 30% (rounding difference) = 35%
Fundamental Return on equity (ROE) provides an indication of how effective shareholders
utilised gearing (debt) to increase their own returns or how effective the entity
utilised its shareholders’ investment to generate a profit. Simplified, the return on
equity indicates the portion of profit generated by Funky Junk which is allocated to
its shareholders.
Intermediate Based on book values, the ROE indicates that Funky Junk’s growth has deteriorated
as it declined from 47% (20X3) to 24% (20X4) nd th t Funky Junk’s shareholders
are receiving a lower profit on their investment. Some shareholders may find the
risk of their investment in Funky Junk now exceeds their return.
Advanced Based on market values, the ROE indicates that Funky Junk’s growth has
deteriorated as it declined from 35% (20X3) to 29% or 30% (20X4) and that Funky
Junk’s shareholders are receiving a l wer pr fit n their investment.
This is as a result of lower earnings attributable to shareholders and poor market
perception affecting Funky Junk’s share price. Some shareholders may find the risk
of their investment in Funky Junk now exceeds their return.
Return on capital employed (ROCE) (%)
20X4 20X3
= (378 840 – 249 000) = (357 412 – 200 000)
(360 710 + 100 700 + 9 780) (242 100 + 92 400 + 7 350)
= 28% = 46%
20X4 20X3
= (378 840 – 249 000) / = (357 412 – 200 000) /
(300 000 + 100 700 + 9 780) (330 000 + 92 400 + 7 350)
= 32% = 37%
Fundamental Return on capital employed (ROCE) provides an indication of how effective Funky
Junk’s capital was employed or assets were utilised.
Intermediate Bas d on book values, the ROCE declined from 46% (20X3) to 28% (20X4) indicating
that capital or assets were utilised less efficiently than in 20X3. Investors may
prefer other investment opportunities with steady or increasing ROCE as opposed
to the Funky Junks volatile ROCE.
Advanced Based on market values, the ROCE declined from 37% (20X3) to 32% (20X4)
indicating that capital or assets were utilised less efficiently than in 20X3.
Investors may prefer other investment opportunities with steady or increasing
ROCE as opposed to the Funky Junks volatile ROCE.
Return n total assets
20X4 20X3
= (378 840 – 249 000) / 481 490 = (357 412 – 200 000) / 346 850
= 27% = 45%
Fundamental This ratio examines how effective assets have been utilised to generate a profit
(EBIT).
A high ratio generally indicates that the entity has managed to increase its revenue
without investing in assets (or increasing the fixed cost expenditure). Therefore, an
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entity can increase its profits (EBIT) by increasing its revenue without increasing its
asset base. The problem with this ratio is that an entity with an older deteriorated
asset base may have a high ratio, but may require significant maintenance and
improvements.
Intermediate Funky Junk’s ROA has deteriorated from 45% (20X3) to 27% (20X4).
This decline is an indication that managements utilisation of assets to generate

EBIT has become inefficient.
This ratio must be compared to competitors and industry as it will vary significantly
depending on the industry.
Advanced Since 20X4 Funky Junk either has unutilised c p city, or it has over-invested in
total assets as the increase in total assets of R 134 640 resulted in a decrease in
profit (EBIT) of R 27 572. To improve this ratio, Funky Junk must increase its profit
by effectively managing its costs, or reduce the level of assets invested by
identifying and selling assets which are inefficient.
(f) Asset turnover
20X4 20X3
= 916 440 / 481 490 = 783 282 / 346 850
= 1,9 = 2,3
Fundamental Asset turnover indicat s how ff ctive assets have been utilised to generate
revenue.
Intermediate / Asset turnover has deteriorated from 2,3 (20X3) to 1,9 (20X4) as a result of total
Advanced assets increasing with 39% and revenue with only 17%, indicating that assets are
being utilised less effectively for revenue generation purposes.
This ratio must be compared to competitors and industry as it will vary significantly
depending on the industry.
Dividend payout ratio (%)
20X4 20X3
Dividend per share in cents:
= 13 950 / 120 000 × 100 Dividends not available
= 12 cents
Dividend payout ratio
= 12 / 74 Dividends not available
= 16%
Dividend over (times)
Note: Dividend over is the inverse of dividend payout ratio and also forms part of V) Financial market /
Investor atios. It is however discussed here as the commentary is the same.
20X4 20X3
= 74 / 12 Dividends not available
= 6,17 times
Difficulty level Comment (Dividend payout ratio and dividend cover)
Fundamental l Dividend payout ratio measures the percentage of earnings that is being paid
out as dividends.
Dividend cover indicates the ease with which dividends can be covered by
earnings generated in the year.
A high dividend cover indicates a high earnings retention rate. Thus instead of
paying a high percentage of earnings out as a dividend, it is retained and reinvested
in the entity’s operations for future growth purposes. The opposite is true for a low
dividend cover.
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Return consists of dividend and / or capital growth and management should

decide which portion of earnings to reinvest for future expansion purposes and
which portion to distribute as a dividend as the markets perception will affect
their share price (refer to Chapter 14 – The dividend decision).
Traditionally shareholders believe that an entity’s earnings and growth potential
must be confirmed by its dividend payout (also known as the information content
or signalling effect).
In reality shareholders are not indifferent to the form of return and thus
shareholder preference needs to be considered.
Intermediate Funky Junk distributed 16% of its earnings as dividends to shareholders in 20X4 and
retained the remaining 84% for operating and reinvestment purposes.
A dividend cover of 6,17 is considered safe and indicates that dividends can be
covered with ease by earnings generated in the year. This doesn’t, however,
guarantee that Funky Junk will always ha e sufficient cash available to maintain the
dividend.
Advanced Funky Junk’s dividend cover of 6,17 is bel w the 8 of industry and although a high
dividend payment will benefit shareholders in the short-term, over the longer term
it will compromise Funky Junk’s growth prospects.
Funky Junk may have used debt to pay the ost recent dividend, which may create
a need to raise additional d bt (which will increase financial risk) or equity to fund
its operations.
As Funky Junk’s profits are volatile, dividends are also expected to be more
irregular than those of steady dividend policies and thus a long-term trend needs
to be analysed.
As Funky Junk’s earnings have declined with 23% the dividend paid may not be
sustainable. However an earnings growth and dividend growth trend should also
be established to determine if the dividend paid is sustainable.
Given Funky Junk’s poor overall performance management should consider
reinvesting for capital growth, cash flow and other purposes and should not pay
out any dividend.
This may however cause a negative dividend signalling or information content
effect and cause the share price to decline.
Effective tax rate (%)
20X4 20X3
= 29 600 / 117 760 = 34 397 / 149 212
= 25% = 23%
Intermediate / In both years Funky Junk’s effective tax rate is below the marginal tax rate of 28%
Advanced which indicates possible effective tax planning or tax savings.
Unfortunately this rate has increased from 23% (20X3) to 25% (20X4), however to
be analysed further, Funky Junk’s income tax return must be scrutinised.
(5) FINANCIAL MARKET / INVESTOR:
(a) P / E multiple
20X4 20X3
= 2,50 / 0,74 = 3,30 / 1,15
= 3,4 = 2,9
Or
= 300 000 / 88 160 = 330 000 / 114 815
= 3,4 = 2,9
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Earnings-yield (%)
Note: Earnings-yield (%) is the inverse of the P / E multiple
20X4 20X3
= 0,74 / 2,50 = 1,15 / 3,30
= 30% = 35%
Difficulty level Comment (a and b)
Fundamental The Price / Earnings (P / E) ratio reflects the amount investors are willing to pay for
Funky Junk’s shares per rand of reported profits. Entities with high growth
prospects have higher P / E ratios than the riskier entities, thus incorporating
growth and risk factors.
Increase in P / E may indicate that investors h ve been influenced by the signalling
effect / information content of a possible increase in dividend per share / earnings
per share or expected future earnings.
Intermediate The P / E multiple indicates that invest rs are willing to pay 3,4 times the most
recent historical EPS, for a Funky Junk share.
At first glance it appears as though the P / E multiple has strengthened from 2,9
(20X4) to 3,4 (20X4) (also refer to advanced comment below*), but remains
significantly inferior to the industry P / E of 10.
Generally an increased P / E indicates that investors are likely to expect higher
relative-growth in future arnings and / or that an investment risk has reduced
relative to the previous period. This is, however, highly unlikely for Funky Junk.
Advanced Overall Funky Junk’s P / E of 3,4 is performing far worse than industry P / E of 10
which indicates higher risk and lower growth expectations than industry.
In addition industry’s earnings grew with 15% whereas Funky Junk’s earnings
diminished with 23% indicating inferior growth and growth prospects.
In reality Funky Junk’s P / E increased as a result of total earnings declining with
23% which is more than the full market capitalisation decrease of 9% ((300 000 –
330 000) / 330 000) and doesn’t reflect higher future growth or lower risk and may
indicate that its shares may be over-priced*.
Valuation methods are often based on a P / E multiple or a forward P / E multiple
(refer to Business and equity valuations in Chapter 11).
EV / EBITDA multiple
20X4 20X3
= (300 000 + 100 700 + 9 780) / = (330 000 + 92 400 + 7 350) /
(378 840 – 249 000) (357 412 – 200 000)
= 410 480 / 129 840 = 429 750 / 157 412
= 3,2 = 2,7
Diffic lty level Comment
F ndamental Enterprise value includes the equity (current full market capitalisation) and debt
(estimated current value of debt capital) which an acquirer will take over, thus an
entity with a low EV / EBITDA multiple becomes susceptible to take overs.
Advanced At first glance Funky Junk’s EV / EBITDA multiple has improved from 2,7 (20X3) to
3,2 (20X4).
However the increased EV / EBITDA is as a result of Funky Junk’s enterprise value
decline (5%) trailing the decline in EBITDA (18%) , thus indicating that Funky Junk
may be overvalued or that shareholders are expecting improved future earnings
growth.
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Compared to industry EV / EBITDA multiple of 6 indicates that Funky Junk has more
risk and lower future expected growth.
Valuation methods are often based on an EV / EBITDA multiple or a forward EV /
EBITDA multiple (refer to Business and equity valuations in Chapter 11).
ROIC vs. WACC over time
Refer to IV) Return on Invested Capital ratios above.
EVA®
Note: This example illustrates only some of the basic principles of EVA®. Adjustments such as
accounting distortions, reclassifying expenses as investments, etc. is not incorporated for simplicity
reasons.
l NOPLAT:
20X4 20X3
= (378 840 – 249 000) × 0,72 = (357 412 – 200 000) × 0,72
= 93 485 = 113 337
Invested capital – Book value
20X4 20X3
= 100 700 + 9 780 + 360 710 = 92 400 + 7 350 + 242 100
= 471 190 = 341 850
Alternative – Book value
Invested capital = Total assets less non-interest-bearing current liabilities
20X4 20X3
= 481 490 – 9 500 – 800 = 346 850 – 4 000 – 1 000
= 471 190 = 341 850
Invested capital– Market value
20X4 20X3
= 100 700 + 9 780 + 300 000 = 92 400 + 7 350 + 330 000
= 410 480 = 429 750
Alternative – Market value
Market value of Total assets = Market value of Equity + Market Value of Liabilities
20X4 20X3
= 300 000 + 120 780 = 330 000 + 104 750
= 420 780 = 434 750
Invested capital = Total assets less non-interest-bearing current liabilities
20X4 20X3
= 420 780 – 9 500 – 800 = 434 750 – 4 000 – 1 000
= 410 480 = 429 750
EVA® – Book value:
20X4 20X3
= 93 485 – (471 190 × 30%) = 113 337 – (341 850 × 30%)
= – 47 872 = 10 782
EVA®– Market value:
20X4 20X3
= 93 485 – (410 480 × 30%) = 113 337 – (429 750 × 30%)
= – 29 659 = – 15 588
Fundamental Economic Value Added (EVA®) is the intellectual property of Stern Stewart & Co
and is a registered trademark. It is interesting to note that when top management
is setting corporate strategies or evaluating performance, value created is almost
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never part of the measurement indicators. Traditional accounting-based decision-

making tools, for example earnings per share (EPS), return on equity (ROE), return
on assets (ROA), or return on sales, are always present when performance is
evaluated. The EVA® however, focuses on creation of shareholder wealth over
time. EVA® differs from the accounting profit as the cost of equity capital is also
deducted (not only cost of debt, as in accounting profit) and thus EVA® estimates
pure economic profit and thus the economic value added.
EVA® directs managers’ attention to both earnings (NOPLAT) and investment.
Advanced Based on market values, Funky Junk’s management has not been able to add
economic value in 20X3 or 20X4 as both years have a negative EVA® which
indicates that Funky Junk is unable to cover its WACC of 30%.
Management of Funky Junk should identify fewer ssets which can generate the
same level of earnings (NOPLAT). This will reduce capital required and WACC
which will create value in terms of EVA®.
Managers will therefore focus on assets and earnings (NOPLAT) to increase EVA®.
Change in share price (%)
(2,50 – 3,30) / 3,30
24% decline
Fundamental An entity’s share price will change as a result of supply and demand which is
affected by the market’s perception based on earnings growth and earnings
growth prospects, etc.
Intermediate Funky Junk’s share price is not performing well as it declined with 24% from 20X3
to 20X4, this is however not directly comparable as the number of shares increased
from 100 000 (20X3) to 120 000 (20X4).
When comparing the full market capitalisation it decreased with 9% ((300 000 –
330 000) / 330 000) indicating that value was not created during 20X4, but
diminished.
Advanced The share price has declined as a result of value dilution due to the increase in
number of shares and the market’s negative perception of Funky Junk’s future
growth and earnings.
Price / Sales multiple
20X4 20X3
= 300 000 / 916 440 = 330 000 / 783 282
= 0,33 = 0,42
(h) EV / Sales multiple
20X4 20X3
= (300 000 + 100 700 + 9 780) / 916 440 = (330 000 + 92 400 + 7 350) / 783 282
= 0,45 = 0,55
Diffic lty level Comment (g and h)
Advanced These multiples are often used for comparing the valuation of early-stage entities
that have revenues but are not yet profitable and should be compared to industry
to determine possible over or undervaluation.
The Price / sales multiple and the EV / sales multiple valuation methods are often
used as reasonability checks (refer to Business and equity valuations in Chapter 11).
Price / Book value multiple
20X4 20X3
= 300 000 / 360 710 = 330 000 / 242 100
= 0,83 = 1,36
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Fundamental The market to book value multiple is similar to the P / E ratio as it gives an
indication of the market’s perception of the entity. High growth entities will sell at
higher Price / Book value multiples.
Advanced Funky Junk’s Price / Book value multiple has declined from 1,36 (20X3) to 0,83
(20X4) indicating that there is something fundamentally wrong and that this has
affected the market’s perception.
The Price / Book multiple is often used as a reasonabi ity check (refer to Business
and equity valuations in Chapter 11).
(j) Dividend yield (%)
20X4 20X3
= 17 cents / 250 cents Not available
= 6,8%
Fundamental This ratio indicates the return that invest rs derive on their investment and
investors preference towards dividend or capital growth should be considered as
investors preferring high cash flow from dividends will require a higher dividend
yield.
Intermediate It is important to refer to IV) R turn on Invested Capital for dividend payout ratio
Advanced and dividend cover for r lat d comm nts and also refer to The dividend decision
in Chapter 14.
Dividend cover (times)
Refer to (IV) Return on Invested Capital ratios and comments.
(6) CASH FLOW-RELATED

Cash flow to total debt
This ratio measures the entity’s ability to generate cash flow from its operations in relation to its total
debt.
Cash flow from operations
=
Total debt
20X4 20X3
10 190
= Not available
120 780
= 8%
Fundamental This financial distress indicator indicates the entity’s ability to cover its total debt
with cash flow derived from its operations. A high ratio indicates that the entity will
be able to cover its total debt.
Advanced This ratio shows that Funky Junk has not generated sufficient cash flow in relation
to its total debt in 20X4. This ratio further suggests that Funky Junk may suffer from
potential financial distress in future, as reflected by II) Capital structure and
solvency ratios.
This ratio should also be compared to historic ratios to determine a trend and
identify distress signs.
Operating cash flow to operating profit (x:1)
Refer to (I) Profitability for ratio and comment.
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(7) PERFORMANCE-RELATED
This area of analysis depends on the specific area of performance to be analysed (refer to several other analysis
areas I) to VI) already dealt with above). The Z-score, the A-score and DuPont analysis below rely on various
performance-related areas of the financial analysis. The Z-score incorporates profitability, capital structure,
liquidity (working capital) and return on invested capital, the A- score incorporates qualitative factors
associated with business failure and the DuPont analysis incorporates operational efficiency, asset utilisation
and financial leverage.
Business
Failure prediction models
Although the failure prediction models go a long way towards elimin ting void which had existed and although
they should occupy an important place in the “tool box” of the n lyst (being a management “tool”), sole
reliance should not be placed on a model alone, but all other aspects of analysis should also be considered. A
model should be used as an early warning device which directs attention towards the potential for bankruptcy
so that more thorough and detailed analysis can be carried out and corrective measures can be taken.
The Z-score model

The Z-score is a multivariate predictor developed in the late ’60s and early ’70s by Edward Altman, an author
on failure prediction. The multivariate discriminate analysis (MDA), a statistical technique based on regression
analysis is used to classify certain variables (financial ratios in the case of financial statements analysis) as
either failed or non-failed (bankrupt or non-bankrupt). It furth r establishes coefficients for the ratios that
reduce misclassification.
Altman selected five ratios that appear to have the best overall significance in predicting whether an entity
faces possible bankruptcy. The equation reads as follows:
Z = 0,012a + 0,014b + 0,033c + 0,006d + 0,999e
Where:
= working capital / total assets
= retained earnings / total assets
= earnings before interest and taxes (EBIT) / total assets
= market value of equity / total liabilities
= sales / total assets.
The resulting Z scores are interpreted as follows:

Z < 1,81 shows a high risk of short-term failure
Z > 2,99 shows a low risk of failure
1,8 ˂ Z < 2,99: is known as the grey area in which the entity is potentially at risk.
The accuracy of this Z-s ore model is 96% on data one year before bankruptcy and 72% on data two years
before bank uptcy. Any period longer than two years before bankruptcy is too inaccurate to consider. A later
(1977) refinement of this model, the ZETA-model, proved to have far higher accuracy over a longer period.
You are required to calculate the Z-score and provide insightful comments.
The Z-sc re f r Funky Junk is calculated as follows:

= working capital / total assets
(229 590 – 20 080) / 481 490
43,5%
= retained earnings / total assets
166 310 / 481 490
34,5%
= earnings before interest and taxes (EBIT) / total assets
(378 840 – 249 000) / 481 490
27%
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= market value of equity / total liabilities

300 000 / 120 780
248%
= sales / total assets
916 440 / 481 490
1,903 times
= 0,012a + 0,014b + 0,033c + 0,006d + 0,999e
0,012(43,5) + 0,014(34,5) + 0,033(27) + 0,006(248) + 0,999(1,903)
0,522 + 0,483 + 0,891 + 1,488 + 1,901
5,285
Advanced Despite Funky Junk’s generally negative perform nce based on historical and
industry comparisons, Funky Junk’s Z score of 5,277 is considered safe with a low
risk of business failure.
Sole reliance should not be placed n this m del, but all other aspects of analysis
should be considered. This model sh uld be used as an early warning device.
The A-score model

The A-score model was developed by John Argenti and exa ines qualitative factors that lead to corporate
failure. Argenti identified style and competence as important factors in addition to accounting systems and
responses to change. He also identified the three bigg st mistakes that often contributed to failure, namely
overtrading, gearing and taking on big projects. One of the criticisms of the Argenti system is that it requires a
subjective assessment of the key areas considered. Errors in judgement will lead to invalid conclusions.
A-score analysis:
Possible Actual
score score
Management
Autocratic chief executive 8
Chief executive is also chairman 4
Passive, weak Board of Directors 2
Unbalanced skills / knowledge of Board 2
Weak finance director 2
Lack of management depth 1
Accounting
Lack of budgetary control 3
No cash flow plans 3
No costing syst ms 3
Ineffective response to change in
markets, produ ts, employees, etc. 15
Total 43
*Positive esult 10 or less
Mistakes
High level of loan borrowing 15
Expanding too fast (overtrading) 15
Failure f big project 15
T tal 45
*P sitive result 15 or less
Failure symptoms
Deteriorating Z-scores 4
Financial accounting window-dressing 4
Declining quality, morale, market share 3
Resignations and rumours of failure 1
Total 12
Grand total 100
*Overall positive result 25 or less
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How to score:
If the observer can see any of the above features in the entity being evaluated, he must award full marks. If
they are not observed, he awards a score of 0. There are no intermediate scores.
How to interpret results:

If the overall score is 25 or less, then the entity is not in danger of failing.
If the score is higher than 25, then the entity is likely to fail. The higher the score, the faster the failure will
occur.
If the score for management / accounting is greater than 10, then the entity is under threat due to poor
management.
If the entity scores less than 10 for management / accounting but more th n 15 for mistakes, it means that the
management is competent but at some risk.
DuPont analysis
The DuPont analysis was created by the DuPont Corporation in the 1920’s. This analysis examines the return on
equity (ROE) by analysing its:
operational efficiency (as measured by profit attributable to equity holders = net profit after tax / revenue);
asset use efficiency (as measured by total asset turnover = revenue / total assets); and
financial leverage (as measured by the equity multipli r = total assets / shareholders’ equity).
The DuPont system is based on the assumption that w akn ss s in operating assets and / or inefficient asset use
will yield diminished returns on assets, resulting in a lower ROE. By increasing the debt, the lower ROE can be
leveraged up. However, an increase in debt leads to an increase in interest payments which reduces profit
margins, thereby lowering ROE. This therefore means that these two factors, namely the return on assets and
the financial leverage constitute the return on equity. This relationship can be illustrated by the following
formula:
Profit attributable to equity holders
Return on Equity (ROE) =
Shareholders’ funds
You are required to calculate the 20X4 OE of Funky Junk based on market values utilising the DuPont
analysis.
20X4
Return on Equity (ROE)
88 160 / 300 000
29%
The above formula breaks down further to:
Net p ofit after tax Revenue Total Assets
ROE = Revenue × Total Assets × Shareholders' Equity
Operational efficiency Asset utilisation Financial leverage
88 160 916 440 481 490

ROE = × ×
916 440 481 490 300 000
ROE = 0,0962 × 1,903 × 1,605

ROE = 29%
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For comments provided on ROE refer to (IV) Return on Invested Capital , for operational efficiency comments
refer to (I) Profitability ratios, for asset utilisation comments refer to (IV) Return on Invested Capital ratio (asset
turnover) and for financial leverage comments refer to (II) Capital structure ratios.
Non-financial analysis
In addition to insight provided by financial analysis and its comments, stakeholders are interested in the
entity’s governance practices and its environmental and social performance.
Non-financial analysis example

This example illustrates a few of the environmental and social issues which stakeholders are generally
interested in.
Non-financial information of Hoi Polloi 20X4 20X3
Production volume (units ’000) 350 390
Number of injuries 10 10
Total amount spent on corporate social responsibility (R’000) 95 000 100 000
Total carbon emissions (tons) 19 20
Total sales (R’000) 2 000 000 2 200 000
You are required to calculate and provide insightful co ents based on the non-financial performance of
Hoi Polloi
Calculations:
Decrease in production volume of 40 000 units or 10%.
Total number of injuries remained unchanged.
Injuries per production volume:
20X4 20X3
= 10 / 350’ = 10 / 390’
= 0,029’ = 0,026’
Total spent on corporate social responsibility decreased with R 5 000’ or 5%.
Total spent on corporate social responsibility as a percentage of sales:
20X4 20X3
= 95 000 / 2 000 000 = 100 000 / 2 200 000
= 4,8% = 4,5%
l Total carbon missions (tons) decreased with 1 ton.
Carbon emission per production volume :
20X4 20X3
= 19 / 350’ = 20 / 390’
= 0,054’ = 0,051’
Diffic lty level Comment
Advanced Number of injuries remained unchanged at 10, however as production volume has
decreased with 10% one would expect a decrease in the number of injuries. The
increase of injuries per production volume from 0,026’ (20X3) to 0,029’ (20X4)
indicates Hoi Polloi’s poor safety measures. Hoi Polloi should improve its safety
procedures perhaps by employing a safety officer and training staff on safety
measures.
Total spent on corporate social responsibility decreased with R 5 000’ or 5% from
20X3 to 20X4. A decline is expected as Hoi Polloi produced and sold fewer units
and thus have less profit available to distribute to social projects. Hoi Polloi’s
corporate social responsibility contribution as a percentage of sales of 4,8% is
higher than the previous year’s contribution of 4,5%, indicating that Hoi Polloi
cares about its social impact and is socially responsible.
314
Total carbon emissions decreased with 1 ton. Although the overall negative impact
on the environment has decreased one would expect a larger decrease due to the
decrease in production units of 10%. Carbon emissions per product volume has
increased from 0,051’ (20X3) to 0,054’ (20X4) indicating less efficient production
processes as Hoi Polloi is polluting more per unit.
The balanced scorecard

The balanced scorecard was developed by Robert Norton and David Kaplan (1996) as a strategic measurement
and management system to assist entities in aligning their business activities with the entity’s vision, mission
and strategy by measuring its performance against its strategic goals. By inc uding non-financial performance
measures this framework provides a “balanced” view of the entity’s fin nci l nd non-financial performance. The
balanced scorecard consists of the following four balanced perspectives:
Financial;
Customers;
Internal business processes; and
Learning and growth.
In addition to assessing the entity’s financial performance, this system enables an entity to monitor its progress
in creating and acquiring intangible assets required for future growth.
Example of a balanced scorecard worksheet:
Customer Objectives M asur s Targets Initiatives

To achieve our Deliver on time, 1 Delivery time 1 95% delivery 1 Customer
vision of customer with correct 2 Quality rate engagement
excellence, we quality and specifications, lead 2 Zero defects 2 Quality
should: price time, etc. reports
This management system assists in matching the entity’s short-term actions with its long-term strategy.
The processes are:

Objectives and measures which defines the entity’s success drivers are set based on its vision, mission and
strategy.
Communicating strategies up and down the business hierarchy by the different managers. This helps to link
departmental and individual objectives with the long-term strategy of the entity.
This scorecard enables managers to ensure that the whole entity understands its long-term strategic
objectives.
The business planning proc ss enables the entity to combine its business and financial plans.
Feedback and learning processes are enhanced by the scorecard because short-term results can now be
monitored and imp oved based on what has been learned. Changes can be implemented.
8.4 Limitations of accounting data

As a result f the limitations inherent to accounting data.
The maj r limitations can be listed as follows:
Inflation: Financial statements are prepared on a historical basis, and inflation is seldom (if ever)
accounted for. As a result, the market value of owner’s equity, long-term debt, fixed assets and
investments might not be anywhere near the value disclosed in the statement of financial position. Any
ratio or assessment based on the historical value of statement of financial position items will be incorrect
nd distort the analysis.
Inflation causes a reduction in the purchasing power and so reduces the value of the domestic currency
against other countries with a lower inflation rate.
315
Advanced: To overcome this limitation the financial analysis should be based on market values instead of
book values (refer to Valuations of preference shares and debt in Chapter 10 and Business and equity
valuations in Chapter 11) and profitability ratios should compare the actual growth rate to the inflation
and real growth rate.
Non-monetary items: Financial statements often do not reflect the value of non-monetary items such as
goodwill, patents, brands, trademarks, technology, breadth of product range, management, etc which
may be substantial. These items may, to a large extent, be discounted by market forces when arriving at
the market value of equity shares, but they are certainly ignored in the financial statements. Hence the
problem of using ratios that rely on historical statement of financial position va ues alone.
Advanced: IFRS deals with the valuation of intangible assets such as goodwi , trademarks, etc. Ensuring
that your annual financial statements are in compliance with IFRS will en ble more realistic analysis.
Market forces: The statement of profit or loss and other comprehensive income and statement of
financial position do not disclose future expectations in the market. One cannot know whether next
year’s market share will increase or decrease, whether a competitor is likely to take away part of the
current sales, or whether a substitute product will erode the entity’s current market share. Labour union
militancy is not reflected; neither are economic conditi ns such as f reign exchange factors. The future
management team may change, and this is also not reflected.
Advanced: The entity’s integrated report will include forecast projections, allowing users to draw a
conclusion on its future prospects.
Accounting policies: The analysis of financial state ents often relies on the comparison of an entity’s
performance with that of other similar entiti s in the industry. The problem is that not only are two
similar entities structured differently, but th ir accounting policies, such as depreciation policy and
inventory valuation methods are likely to differ. Comparisons that are taken for granted on the basis of
published industry averages could therefore be meaningless.
Advanced: When comparing the results of different entities, any differences in their accounting policies in
this regard will have to be taken into consideration. Preferably the financial analysis should be based on
market values instead of book values (refer to Valuations of preference shares and debt in Chapter 10 and
Business and equity valuations in Chapter 11).
8.5 Limitations of ratio analysis

Financial ratio analysis are as follows:
Ratio analysis is more useful when analysing small focused entities instead of large diversified entities.
The latter operates in different industries which makes it difficult to determine comparative industry
averages.
The industry av rage may not be the best measure for a high performing entity. In this situation an analyst
will be b st advis d to consider the industry leaders’ ratios.
Inflationary effe ts on the statement of financial position amounts may distort the ratios as these
amounts a e on historic basis. Profits may be affected as well because inflation impacts both depreciation
and invento y costs. For instance, it might be meaningless to compare the ROA of an entity with old and
depreciated fixed assets to an entity with newer assets which still have higher book values.
Application of different accounting policies can render the comparisons between and amongst entities
meaningless.
It is difficult to tell whether a ratio is good or bad as this is subjective. One analyst may consider a high
ROA ‘bad’ as it reflects the inability of the entity to replace its old fixed assets and is thus under-
capitalised. Another may consider it ‘good’ because it is showing superior returns. It is always important
that in this instance the analyst attempt to show ‘both sides of the story’.
Firms can manipulate their financial statements just to reflect a strong financial position at year end. This
is often referred to as ‘window-dressing’ or ‘creative accounting’.
316
Practice questions
Question 8 – 1 (Advanced) 32 marks 48 minutes

Ithemba Engineering (Pty) Ltd
(Source: SAICA June 2013 ITC paper 2 – adapted and extracted)
Ithemba Engineering (Pty) Ltd (‘Ithemba’) manufactures and distributes specialised products to customers in
the construction industry. Every year, Ithemba invests significantly in research and development to improve
existing product designs and to develop new products. Many of its products and designs have been patented to
protect the company’s intellectual property.
Ithemba focuses on supplying South African customers. It has supported customers’ expansion into the rest of
Africa and the Middle East and exports represent approximately 10% of annual re enue. Foreign subsidiaries of
South African groups are invoiced in US dollar.
The construction industry in South Africa has been under significant pressure in recent years due to the
slowdown in the global economy and limited infrastructure spend by the g vernment. As a result, Ithemba has
struggled to grow revenue during the past three financial years. Steel is the major raw material used by
Ithemba in its manufacturing processes. The volatility of this co odity’s price in recent years has placed
additional pressure on the company’s gross profit margin.
Because of this situation working capital management has become increasingly important for Ithemba. More
and more customers are placing orders at the last mom nt, which is forcing Ithemba to hold larger inventories.
Customers are also delaying payment of accounts b cause of cash flow pressures. All sales are on credit and
Ithemba allows customers 60 days from invoice to pay amounts due. The result is that Ithemba’s overdraft
balance has steadily increased in recent years, to the extent that this has become a permanent source of
finance. Ithemba currently pays interest on its overdraft at 10% per annum, compounded monthly.
Apart from the overdraft, Ithemba has had no other debt facilities since 20X9. Bankers are reluctant to grant
Ithemba longer term finance due to concerns about the company’s cash flow generation and the negative
outlook for the construction industry in general.
The following are extracts from the annual financial statements of Ithemba for the year ended 30 November
20Y2:
EXTRACT FROM THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEAR ENDED 30 NOVEMBER 20Y2
20Y2 20Y1
R’000 R’000
Revenue 248 230 241 000
Cost of sales (157 580) (144 400)
Gross profit 90 650 96 600
Bad debts (5 100) (4 500)
Depreciation (19 800) (20 100)
Resea ch and development costs (10 200) (11 100)
Other operating costs (28 750) (26 700)
Operating profit 26 800 34 200
Finance charges (12 750) (10 800)
Pr fit bef re tax 14 050 23 400
EXTRACTS FROM THE STATEMENT OF FINANCIAL POSITION AS AT 30 NOVEMBER 20Y2

20Y2 20Y1
R’000 R’000
Trade receivables 51 000 42 900
Total assets 279 900 264 900
Shareholders’ equity 152 200 142 100
Bank overdraft 127 500 102 800
Inventory 28 060 21 750
317
Marks
REQUIRED
Sub-total Total
Analyse and discuss the profitability and working capital management of Ithemba
during the financial years ended 30 November 20Y1 and 20Y2. Support your
answer with relevant calculations and ratios. (30)
(Mark allocation: 10 for analysis and 20 for discussion) (2)
Communication skills – layout and structure; clarity of expression (32)
Note:
Bank overdraft must be included in your analysis and discussion as it norma y
forms part of working capital.
Assume 365 days in a year and round all days up to the next whole day.
Solution 8 – 1
Analyse and discuss the profitability and working capital management f Ithemba during the financial years
ended 30 November 20Y1 and 20Y2, supported with calculati ns and rati s.
20Y1
a
Summary of ratios Calculation 20Y2
Revenue growth 1 3,0% (½)
Gross profit margin 2 36,5% 40,1% (1)
Bad debts / Revenue 3 2,1% 1,9% (1)
Operating costs / Revenue 4 11,6% 11,1% (1)
Change in operating costs: b
Research and Development 5 (8,1%) (½)
b
Depreciation (1,5%) (½)
Other operating costs 6 7,7% (½)
Total operating costs 7 2,3% (½)
EBITDA / Revenue 8 18,8% 22,5% (1)
b
Change in EBITDA 9 (14,2%) (½)
c
Effective interest rate (%) 10 10,0% 10,5% (1)
b
Change in profit before tax (40%) (½)
Inventory days 11 65 days 55 days (1)
Or inventory turnover 5,6 times 6,6 times
Trade receivable days 12 75 days 65 days (1)
d
Return on total assets 13 9,6% 12,9% (1)
d
ROE 14 6,6% 11,9% (1)
ROCE
d; e
15 9,6% 14,0% (1)
Calculation – maximum (10)
Note:
Extracts from Ithemba’s financial statements allow you to calculate comparative ratios which you must
utilise in your discussion.
Direction (signs( + / – )) must be correct to earn marks.
Effective interest was not based on the total interest-bearing debt at end of previous period (or average) as
interest on bank overdraft is charged on a fluctuating balance.
Return on Assets (ROA), Return on Equity (ROE) and Return on Capital Employed (ROCE) are included as
part f pr fitability ratios as these ratios measure the Ithemba’s ability to generate a return relative to an
investment r asset and Return on Invested Capital ratios were not required specifically.
Ba ed on Ithemba’s scenario, assume that bank overdraft deviates from the norm and forms a permanent
part of Ithemba’s financing and capital structure.
Supporting calculations – %’s rounded to once decimal

20Y2 20Y1
248 230 – 241 000
1. Revenue growth
241 000
= 3,0%
318
90 650 96 600
2 Gross profit margin
248 230 241 000
= 36,5% 40,1%
5 100 4 500
3 Bad debt / Revenue
248 230 241 000
= 2,1% 1,9%
4 Other operating costs / 28 750 26 700

=
Revenue 248 230 241 000
= 11,6% 11,1%
5 Change in Research and 10 200 – 11 100

=
development costs 11 100
= – 8,1%
6 Change in other operating 28 750 – 26 700

=
costs 26 700
= 7,7%
Change in total operating (90 650 – 26 800) – (96 600 – 34 200)

=
costs 96 600 – 34 200
= 63 850 – 62 400
62 400
= 2,3%
(26 800 + 19 800)* (34 200 + 20 100)**

EBITDA / Revenue =
248 230 241 000
= 18,8% 22,5%
46 600* – 54 300**
Change in EBITDA =
54 300**
= – 14,2%
12 750 10 800
Effective inter st rate (%) =
127 500 102 800
= 10% 10,5%
28 060 21 750
Invento y days =
157 580 × 365 144 400 × 365
= 65 days 55 days
157 580 144 400
= 21 750
28 060
6,6 times
Or Invent ry turnover 5,6 times
51 000 42 900
248 230 × 365 241 000 ×
Trade receivables
75 days 365 = 65 days
26 800 34 200
13 Return (EBIT) on total assets =
279 900 900
= 9,6% 12,9%
319
14 050 × 0,72 23 400 × 0,72

14 ROE (Equity given) =
152 200 142 100
Assuming a 28% tax rate = 6,6% = 11,9%
26 800 34 200
15 ROCE =
152 200 + 127 500 142 100 + 102 800
= 9,6% = 14,0%
Note: Showing calculations are necessary to earn part marks (if applicable) and characterises good examination
technique.
Discussion
Revenue
A growth rate of 3% in 20Y2 indicates a slowdown in the construction industry, global economy and
limited spending of government on infrastructure. (1)
l It is concerning that this growth rate is also below the Consumer Price Index (or inflation rate). (1)
Invoicing in US dollar may contribute to reduced revenue if the price is set in US dollar and the Rand
strengthens. (1)
Gross profit margin

l The decline from 40,1% to 36,5% is a concern, giv n the limited revenue growth. (1)
l There is a possibility that steel price volatility played a role in declining margins. (1)
l Decline in Gross Profit margin due to Ithemba’s lack of economies of scale. (1)
(Ithemba’s gross profit margin is expected to remain fairly constant from year to year and revenue
increases are expected to result in other cost of sales efficiencies such as bulk discounts, etc. These bulk
discounts are as a result of economy of scale, which did not occur in Ithemba’s case. This could indicate
improper inventory management or a weakness in the purchasing department which will be investigated
under working capital below.)
Operating costs
The 8,1% decline in spending on research and development is a concern, as Ithemba should continue
investing to boost future revenue growth through improved product design and new product
development. (1)
Bad debts have increased relative to revenue from 1,9% (20Y1) to 21% (20Y2), which is indicative of credit
issues within ith r the customer base or construction industry, or both. (1)
Depreciation has also d clined, which could be indicative of less investment in infrastructure and / or
older asset base. (1)
Other ope ating osts increased by 7,7%, which may reflect wage pressure and inflationary increases.
(1)
Total operating costs increased with 2,3% which is marginally better than the revenue increase of 3%,
indicating operating cost efficiencies / Total operating cost to revenue remained constant at 26% from
20Y1 to 20Y2. (1)
Financing
l The overdraft has increased, which indicates that there was negative cash flow generation in 20Y2. (1)
This is supported by the decline in EBITDA (which excludes non-cash items such as depreciation and
amortisation). (1)
Based on Ithemba’s scenario bank overdraft is considered a permanent source of finance, and thus the
gearing (or debt; equity) of Ithemba has deteriorated, which indicates a higher finance risk profile. (1)
The totals for equity plus overdraft amounts to 279 700 (20Y2) and 244 900 (20Y1) compared to total
assets 279 900 (20Y2) and 264 900 (20Y1), would indicate high settlement of trade creditors,
contributing to the increase in the bank overdraft. (1)
320
Operating profit has decreased by 22% while Profit Before Tax declined by 40% indicating the large extent
to which finance costs is depleting profits. (1)
The large finance costs could be attributed to the fact that Ithemba makes use of short term debt only,
which indicates an inappropriate financing policy. (1)
l Overdraft is costly due to less security offered and also as a result of their increased finance risk. (1)
Working capital
Inventory days have worsened from 55 days (20Y1) to 65 days (20Y2) as a resu t of the pressure from
customers to hold more inventory. (1)
l Increasing inventory days increases Ithemba’s inventory holding and fin nce costs. (1)
The issue of obsolete inventory is less of a concern in the construction industry due to the nature of
products. (1)
Trade receivable days has worsened from 65 days to 75 days, reflecting cash flow pressures faced in the
construction industry. (1)
This together with the increase in bad debt relative to revenue raises the concern of irrecoverable debt
as a result of excessive credit to Ithemba’s clients due to pressures in the construction industry. (1)
In both periods receivable days (75 and 65 days) exceeds the allowed credit period of 60 days which is an
indication of inefficient debtors management. (1)
Return on assets / equity

ROE has worsened which indicates that Ithemba’s growth has deteriorated as it declined from 11.9%
(20Y1) to 6,6% (20Y2) and that their shareholders are receiving a lower profit on their investment. Some
shareholders may find the risk of their investment in Ithemba now exceeds their return. (1)
Both Return on total assets and ROCE deteriorated indicating that capital and assets were utilised less
efficiently than in 20Y1. Investors may prefer other investment opportunities with steady or increasing
Return on total assets or ROCE. (1)
The decline in profit before tax of 40% is the key reason for the low return on investment and asset
base. (1)
Discussion max (20)
Communication skills (2)
Question 8 – 2 (Advanced) 16 marks 24 minutes
Tip Top Transport Limit d

(Source: SAICA Jan 2013 ITC Paper 3 Question 2 –adapted and extracted)
Tip Top Transpo t Ltd (‘TTT’) is a logistics group listed on the Johannesburg Securities Exchange. TTT has the
following ope ating divisions:
Division Focus area

Commercial Goods This division services the retail industry and is responsible for the transport of fast
moving consumable goods.
Fuel L gistics This division transports petrol and diesel from refineries and oil depots to
forecourts of fuel retailers.
Agricu tural This division services the agricultural industry by transporting wheat, maize, rice,
Logistics sunflower seeds, sugar and flour.
F stLiner This division operates a fleet of luxury buses which transports paying customers
between major cities in South Africa.
Servicing and This division is responsible for all servicing and maintenance of TTT’s
Maintenance trucks and buses.
321
Return on investment (ROI) is one of the group’s key performance measures and divisional management is
incentivised on the basis of divisional ROI. TTT’s overall ROI has declined in recent years mainly as a result of
the challenging economic conditions and operating cost increases. The operating divisions have been asked to
propose initiatives to improve ROI as part of the group’s efforts to enhance shareholder value and returns.
TTT expects each operating division to generate a ROI in excess of 25% on a before tax basis. TTT’s operating
divisions are also expected to generate returns in excess of the group’s adjusted weighted average cost of
capital (WACC) of 20% when making capital investments. TTT’s actual WACC is lower than 20%. The operating
divisions do not have control over the payment of income tax and therefore tax cash flows are ignored when
evaluating returns. As a result, operating divisions are given a higher hurdle rate to compensate for ignoring
income tax in capital investment decision making.
Commercial Goods Division: Replacement of truck fleet and budgeted perform nce
The Commercial Goods Division (‘CGD’) is planning to replace its entire fleet of 70 trucks in the financial year
commencing on 1 January 20X4. The fleet is standardised and each new truck is forecast to cost R900 000.
The proposed acquisition of the 70 trucks is a significant capital investment for CGD and the TTT group. CGD
has prepared an analysis of the proposed capital expenditure and the average operating performance of each
truck, which is summarised in the table below, for considerati n and approval by TTT’s Board of Directors.
You may assume that the mathematical calculations in the average profitability analysis table below are
correct.
Year ending 31 December 20X4 20X5 20X6 20X7 20X8

Average profitability
Note R R R R R
analysis per truck
Total revenue 1 404 000 1 466 600 1 609 200 1 701 000 1 792 800
Revenue 1 1 080 000 1 115 600 1 231 200 1 296 000 1 360 800
Fuel recovery charges 2 324 000 351 000 378 000 405 000 432 000
Operating costs (1 312 741) (1 380 207) (1 446 172) (1 511 807) (1 579 084)
Fuel costs 3 (360 000) (390 000) (420 000) (450 000) (480 000)
Insurance – vehicles 4 (45 000) (47 250) (49 615) (52 095) (54 700)
Other insurance costs 4 (65 000) (68 250) (71 665) (75 250) (79 015)
Driver costs 5 (120 000) (128 400) (137 400) (147 000) (157 200)
Back-up driver costs 5 (60 000) (64 200) (68 700) (73 500) (78 500)
Servicing and 6 (180 000) (192 000) (203 000) (213 000) (223 000)
maintenance
Allocated overheads 7 (125 000) (135 000) (145 800) (157 500) (170 100)
Other operating costs 8 (156 000) (165 600) (174 000) (182 400) (192 000)
Depreciation 9 (135 000) (135 000) (135 000) (135 000) (135 000)
Financing costs 10 (66 741) (54 507) (40 992) (26 062) (9 569)
Operating profit 11
per truck 91 259 86 393 163 028 189 193 213 716
Notes:
Each tr ck travels on average 108 000 km per annum transporting customer goods (‘productive km’). It is
budgeted that c stomers will pay a fixed fee of R10 per km, excluding fuel costs, to CGD in the 20X4
financial year for the transportation of goods. Although the fee per km will escalate in future years, the
average pr ductive km per truck travelled is assumed to be 108 000 km in each year of the budgeted peri d.
Fuel co ts incurred are billed separately to customers. All routes have been mapped and standard distances
agreed with customers. The average fuel consumed per km travelled by trucks on each route is also agreed
with customers. CGD invoices customers the prevailing fuel cost per litre, multiplied by the pre-agreed
number of litres consumed per km on routes. CGD does not mark up fuel costs when invoicing customers.
For a variety of reasons, fuel costs are forecast to be higher than that invoiced to customers. The most
common reason is that drivers deviate from pre-agreed routes or take detours. In addition trucks have to
travel from CGD depots to the TTT Servicing and Maintenance Division’s workshops on a regular basis for
servicing, repairs and maintenance. Each truck is forecast to travel an average of 120 000 km annually,
which is consistent with distances travelled during prior years.
322
CGD insures trucks against theft and accident damage which is budgeted to cost R45 000 per truck in the
20X4 financial year. In line with customer requirements, CGD also insures itself against potential liability in
the event of environmental damage as well as third party claims for injury and consequential losses
suffered as a result of negligence of truck drivers, mechanical breakdown or truck malfunction. This
insurance is estimated to amount to R65 000 per truck in the 20X4 financial year.
Drivers are budgeted to be paid R120 000 per annum on a cost to company basis in the 20X4 financial year.
Their salaries are expected to increase by approximately 7% per annum thereafter. There is a pool of back-
up drivers on standby, in the event that any of the primary drivers become ill or to accompany drivers on
long-distance trips. Back-up drivers are full-time employees of CGD.
Each truck is required to be serviced after every 10 000 km travelled. The Servicing and Maintenance
Division marks up the costs of servicing and maintaining the CGD trucks by 50% in order to generate a
reasonable return on its assets and efforts.
CGD analyses costs and allocates these to trucks using activity based costing principles. The allocated costs
in the budget represent divisional expenses incurred in dealing with customers (e.g. scheduling deliveries,
customer service, complaints and queries), invoicing and c llecting amounts from customers, human
resource management, and general management and contr l f perati ns.
Other operating costs relating to the operation of trucks are variable in nature.
The acquisition costs of trucks less estimated residual values are depreciated evenly over five years.
10 Financing costs have been correctly calculated on a onthly basis for the period 20X4 to 20X8 based on
the proposed agreement with VIS.
11 Operating profit is analysed before taxation as CGD has no control over group tax planning.
Marks
REQUIRED
Sub-total Total
(a) Calculate the forecast ROI per truck used by CGD for each year over the
period 20X4 to 20X8 and the average ROI over the period, assuming that the
division acquires the 70 trucks. (6) (6)
(b) Identify and explain the potential merits and pitfalls of using ROI as a
measure to evaluate the performance of management. (9)
Communication skills – clarity of expression (1) (10)
Solution 8 – 2
Part (a)
20X4 20X5 20X6 20X7 20X8

Operating profit 91 259 86 393 163 028 189 193 213 716 (1)
Financing costs
a
66 741 54 507 40 992 26 062 9 569 (1)
b
Adjusted Ope ating P ofit 158 000 140 900 204 020 215 255 223 285
Truck balance (year-end) 765 000 630 000 495 000 360 000 225 000 (1)
c
Truck balance (average) 832 500* 697 500 562 500 427 500 292 500 (1)
*(R 900 000 + R 765 000) / 2
ROI (year-end) 20,7% 22,4% 41,2% 59,8% 99,2% (1)
c
ROI (average) 19% 20,2% 36,3% 50,4% 76,3% (1)
Average ROI ver period [(158 000 + 140 900 + 204 020 + 215 255 + 223 258) / 5] /
[(765 000 + 630 000 + 495 000 + 360 000 + 225 000) / 5]
= 38,0% (1)
Maximum (6)
Note:
All costs except financing costs form part of the operating profit per truck calculation and thus only
financing costs are added back.
323
Taxation for TTT is not considered as CGD has no control over group tax planning.
Average ROI was specifically required.
Part (b)
Merits
l Non accountants are able to understand this ratio as it is user friendly. (1)
l Enables easy comparison of performance between divisions and external benchmarking. (1)
Linked to assets under control of division which may be more informative than simply evaluating
profits and cash flows in isolation. (1)
l Widely used in practice. (1)
Pitfalls
ROI results can vary depending on which valuation basis is used f r assets (opening or average or
closing balances). (1)
l Accounting treatment of assets may impact on ROI eg. i pair ent of assets could lead to higher ROI in
future. (1)
ROI as an evaluation tool may lead to non-congruent behaviour; CGD may not act in best interests of the
TTT group as a whole. (1)
Positive NPV projects may be rejected for example wh re ROI doesn’t exceed 25% but does exceed WACC
of 20%. Where the ROI exceeds WACC value is being added and these projects should be undertaken. (1)
Many projects take time to deliver attractive returns. Focusing on ROI in the short term may result in
viable long term projects being rejected. During 20X4 and 20X5 the ROI was below 25% and would be
rejected. Subsequently (20X6 to 20X8) ROI did exceed the required 25% indicating that invested capital
was utilised more effectively in the long-term. (1)
l Purely a financial measure and ignores qualitative issues. (1)
ROI does not take into account the risks of a division / project in measurement / evaluation of
performance. (1)
ROI is not suited to service based industries or divisions such as CGD as capital investment may be
limited. (1)
l Divisions may be evaluated based on non-controllable costs if these are included in ROI. (1)
Clarity of expression (1)
Maximum (10)
Question 8 – 3 (Advan ed) 70 marks 105 minutes

Catcon (Pty) Ltd
(Source: SAICA 2011 QE II Question 1 – adapted and extracted)
CatCon (Proprietary) Limited (‘CatCon’) manufactures ceramic catalytic converters for use in petrol and diesel-
powered passenger vehicles and light-duty commercial vehicles. Catalytic converters are able to destroy most
harmful substances produced by vehicle engines, such as carbon monoxide, unburnt hydrocarbons and nitr gen
xides, which are present in vehicle exhaust emissions.
Ba ically, catalytic converters consist of a ceramic structure coated with a metal catalyst which is attached to a
vehic e’s exhaust system. Metal catalysts generally consist of a combination of the platinum group metals
(PGMs), namely platinum, palladium and rhodium.
C tCon is based in Port Elizabeth and sources the majority of the components required for the manufacture nd
ssembly of catalytic converters from suppliers in close proximity to its operations. CatCon derives the vast
majority of its revenue from exporting its converters to European-based automotive assemblers. Exports of
catalytic converters are a significant revenue stream for South Africa, generating almost as much revenue as
the export of passenger vehicles.
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The South African government introduced the Motor Industry Development Programme (MIDP) in 1995 to
stimulate the local manufacture and export of vehicles and automotive components. The MIDP provided the
springboard for the rapid expansion of the South African catalytic converter industry, as these components
have a relatively high value. South Africa’s rich platinum resources also assisted in developing the catalytic
converter industry, for it provided an opportunity for local manufacturers to add value to this precious metal
prior to it being exported.
The local catalytic converter industry experienced significant growth in production volumes in the period from
20W0 to the middle of 20W8. The industry produced a record 17,3 million catalytic converters for export in the
20W8 calendar year. However, the financial crisis which started in ate 20W8 had a significant adverse impact
on passenger vehicle sales globally. Demand for cata ytic converters decreased by approximately 40% in 20W9.
Although sales of new passenger vehicles recovered in 20X0 and 20X1, global volumes have still not equalled
the peak levels reached in 20W8.
CatCon spent R150 million in 20W6 on the expansion of its manufacturing facilities to cater for an anticipated
growth in demand. The company raised a foreign loan of US $60 million in 20W6 to fund not only this capital
expenditure but also expected future working capital requirements. The foreign loan, which bears interest at a
fixed rate of 7% per annum, is repayable in equal annual instalments, payable in arrears. The first instalment
was paid on 1 July 20W7 and the final instalment is due n 1 July 20X3.
Manufacturing operations
CatCon manufactured 4,5 million catalytic converters in the financial year ended 30 June 20X1. The production
capacity is eight million units per annum, and hence the co pany is currently operating well below capacity. In
the financial year ended 30 June 20W8, CatCon manufactured 5,5 million catalytic converters and the decision
to expand operations during 20W6 app ar d to be sound.
Despite the significant reduction in production and sales of catalytic converters in the 20W9 financial year,
CatCon was able to report earnings before interest and taxation (EBIT) of R555 million. Profitability has been
declining since 20W9 and management is concerned about this trend. There have been many challenges for
CatCon management over the past three years including the following:
Production was increased in 20X0 to meet resurging demand. Inventory levels were low at the time and
management was stretched to ensure that production and inventory levels rapidly increased to meet the
higher demand;
Platinum prices have been very volatile over the period from January 20W8 to June 20X1. In May
20W8 the price of platinum was US $2 060 an ounce. This price declined to approximately US $850 in
December 20W8 following fears that demand for this precious metal would decline as a result of the
state of the global economy. Platinum prices slowly recovered during 20W9 and 20X0, and by June 20X1
the prevailing platinum price was US $1 830 an ounce;
PGMs used by CatCon in the manufacture of catalytic converters represent between 60% and 70% of total
manufacturing costs; and
CatCon retrench d 20% of its manufacturing work force in early 20W9 in response to the declining demand
for atalytic onverters. Employee morale suffered following the retrenchments and relations between
workers and management remain strained.
Revenues
Global passenger vehicle sales declined in 20W9 following the economic crisis in late 20W8. Lower demand was
driven by limited access to vehicle finance and nervousness regarding economic conditions by consumers.
CatC n’s sales v lumes declined from a high of 5,2 million units in the 20W8 financial year to 3,6 million units in
20W9. Unit sales in the 20X0 financial year were 3,9 million and 4,4 million in the 20X1 financial year. Ongoing
challenges facing CatCon include –
pricing pressure from European customers who are reluctant to accept price increases in line with the
increasing input costs (mainly PGM costs); and
the strength of the rand against the US dollar. The prices of exported catalytic converters are quoted in US
dollar and a strengthening rand has an adverse impact on CatCon’s revenues.
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Financial performance
Extracts from CatCon’s recent annual financial statements and further details are set out below:
CATCON (PROPRIETARY) LIMITED

EXTRACTS FROM STATEMENTS OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEARS ENDED 30 JUNE
Notes 20X1 20X0
R mi ion R million
Revenue 1 5 852 5 039
Cost of sales 2 (5 389) (4 354)
Gross profit 463 685
Operating costs (350) (345)
Profit from operating activities 3 113 340
Finance costs 4 (39) (31)
Profit before taxation 74 309
Taxation (21) (89)
Profit attributable to shareholders 53 220
Notes:
The average selling price per catalytic converter was US $170 in 20X0 and US $190 in 20X1. The average R :
US $ exchange rate during 20X1 was 7,00 : 1,00 (20X0: 7,60 : 1,00).
Cost of sales comprised the following:
20X1 20X0
R million R million
Opening inventories (raw materials, work in progress and finished
goods) 839 406
PGM costs 3 812 3 288
Other manufacturing costs 1 726 1 479
Depreciation of manufacturing plant and equipment 25 20
Closing inventories (raw materials, work in progress and finished
goods) (1 013) (839)
Cost of sales 5 389 4 354
PGM costs are pric d in US dollar. All other manufacturing costs are priced in rand.
Inventories of finished goods and units manufactured:
20X1 20X0
Units Units
Opening inventories 700 000 400 000
Units man fact red 4 500 000 4 200 000
Units s ld (4 400 000) (3 900 000)
Cl sing inventories 800 000 700 000
CatCon used a consistent quantity and mix of PGMs per unit in the manufacture of catalytic converters in
the 20X0 and 20X1 financial years.
C tCon uses the first-in-first-out (FIFO) basis to record inventories in its enterprise management system nd
accounting records.
The R : US $ exchange rate at 30 June 20X1 was 6,80 : 1,00 (20X0: 7,65 : 1,00).
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3 Profits from operating activities were arrived at after (crediting) / charging the following:
20X1 20X0
R million R million
Movement in provisions 5 10
Total depreciation (including manufacturing plant and equipment) 32 26
Foreign currency translation gain: Foreign loan (25) (13)
4 Finance charges comprise the following:
20X1 20X0
R million R million
Interest on foreign loan 14 20
Interest on bank overdraft 25 11
39 31
The bank overdraft bears interest at the prevailing prime verdraft interest rate (assume 9%).
CATCON (PROPRIETARY) LIMITED

EXTRACTS FROM STATEMENTS OF FINANCIAL POSITION AS AT 30 JUNE
20X1 20X0
R million R million
Non-current assets 195 170
Property 15 15
Plant and equipment (manufacturing and non-manufacturing) 180 155
Current assets 1 895 1 667
Inventories 1 013 839
Trade receivables 882 828
Total assets 2 090 1 837
Issued ordinary share capital 100 100
Equity attributable to shareholders 807 754
20X1 20X0
Non-current liabiliti s R million R million
Interest-bearing liabilities 52 123
Current liabilities 1 231 960
Trade payables 759 587
Provisions 45 40
Taxation 3 13
C rrent portion of interest-bearing liabilities 85 101
Bank verdraft 339 219
T tal equity and liabilities 2 090 1 837
Rai ing of capital

AZN Bank has been CatCon’s commercial bank since the latter’s inception. On 31 July 20X1 the account
executive at AZN Bank responsible for the CatCon account, Ms Beezbubble, informed the directors of CatCon h
t the overdraft facility would be reduced to R50 million with effect from 31 December 20X1. According o Ms
Beezbubble, her credit committee was uncomfortable with various issues, including the following:
The fact that AZN Bank financed the repayments of the foreign loan, as CatCon is not generating sufficient
cash flows to service this themselves;
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The debt : equity ratio of CatCon is far too high in the current economic climate; and
The declining gross profit margin of CatCon, which is placing the business at risk.
Marks
REQUIRED
Sub-total Total
(a) Prepare a pro forma statement of cash flows for the financial year ended
30 June 20X1 and state whether AZN Bank’s contention that it is
financing the repayment of the foreign loan is correct or not. (14) (14)
(b) Debate and conclude whether you believe CatCon’s gearing leve s were
too high at 30 June 20X1. (10) (10)
(c) Discuss possible reasons for the deterioration of CatCon’s gross
profit margin percentage during the financial year ended 30 June 20X1.
You should perform detailed calculations to support your arguments
including –
l an analysis of revenue and the components f c st f sales on a
per unit basis for the 20X0 and 20X1 financial years; and (10)
l an analysis of the components of cost of sales as a percentage of
revenue on a per unit basis for the 20X0 and 20X1 financial years. (20) (30)
(d) Outline possible actions that CatCon could take to i prove the
company’s financial performance and cash flow generation. (12) (12)
Presentation marks: Arrangement and layout, clarity of xplanation, logical
argument and language usage. (4) (4)
Solution 8 – 3
Part (a)
Pro forma statement of cash flows for the year ended 30 June 20X1 R million
Profit before taxation 74
Add back non-cash items:
l Depreciation 32 (1)
l Movement in provision (45 – 40) increase Cr = inflow 5 (1)
l Foreign loan translation differences (25) (1)
Taxation paid [–21 SCI tax + (3 – 13 SFP decrease Cr = outflow)] (31) (2)
Working capital mov m nts
l Inventories (1013 – 839) increase Dr = outflow (174) (1)
l Depreciation movement through inventories 1 (2)
[(R25m / 4,5m units) × 0,8m units] –[(R20m / 4,2) × 0,7m units]
l Trade receivables (882 – 828) increase Dr = outflow (54) (1)
l Trade payables (759 – 587) increase Cr = inflow 172 (1)
Capital expenditure [180 + 32 – 155] increase Dr = outflow (57) (2)
Repayment of interest bearing debt [(52 + 85 + 25) – (123 + 101)] (62) (2)
decrea e Cr = outflow
Net increase in bank overdraft (*assume: rounding difference) (119)* (1)
Conclusion: Yes, AZN Bank is correct, it is financing the repayment of the foreign loan. (1)
Maximum (14)
Note: Direction of cash flows (signs ( + / – )) must be correct to earn marks.
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Part (b)
20X1 20X0
Interest cover (113 / 39); (340 / 31) 2,9:1 11:1 (1)
Interest bearing debt to equity ratio (including bank overdraft**) 59% 59% (1)
[(52 + 85 + 339) / 807]; [(123 + 101 + 219) / 754]
Or capital gearing ratio 37% 37%
[(52 + 85 + 339) / (52 + 85 + 339 + 807)];
[(123 + 101 + 219) / (123 + 101 + 219 + 754]
Total debt ratio [(52 + 1231) / 2 090]; [(123 + 960) / 1 837] 61% 59% (1)
l Interest cover ratio worsened mostly due to decrease in profitability. (1)
l This raises a major concern re the declining profitability, especially the gross profit margin. (1)
Interest bearing debt to equity (or gearing) ratio remained c nstant because foreign loan payments are
funded by bank overdraft (refer to part (a) above). (1)
l CatCon is not generating positive cash flow which indicates a ajor liquidity problem (refer part (a)
above). (1)
l Foreign loan is repayable within the next 2 years which will free up cash flow for other uses. (1)
Initially utilising foreign loan for working capital r quir ments and now utilising bank overdraft as a
permanent source of finance indicates an inappropriate financing policy as a non-current loan should be
utilised to finance non-current assets. (1)
The interest charged on the bank overdraft (9%) is more expensive than the interest charged on the
foreign loan (7%) due to less security offered and also as a result of their increased finance risk. (1)
l Total debt ratio remains fairly stable due to overdraft funding asset increase. (1)
l Overdraft can be revoked at any time. CatCon should thus not be overly reliant. (1)
l Ratios at face value don’t indicate major gearing issue. (1)
rd
l Bankers have however raised concerns re gearing (3 party confirmation). (1)
l Conclusion: Consistent with analysis and appropriate. (1)
Maximum (10)
Note**: Bank overdraft should be included under the interest bearing debt as it is used to finance more than
just working capital as indicated by Ms Beezbubble that “AZN Bank financed the repayments of the foreign
loan, as CatCon is not g n rating sufficient cash flows to service this themselves”.
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Part (c)
Per Unit 20X1 20X0
R million R million
Revenue (5 852 / 4,4); (5 039 / 3,9) 1 330,00 1 292,05 (1)
COS per unit including inventory movement (1 224,77) (1 116,41) (1)
(5 389 / 4,4); (4 354 / 3,9)
COS per unit manufactured (3 812 + 1 726 + 25) / 4,5); (3 288 + 1 479 + 20) / (1 236,23) (1 139,76) (1)
4,2)
PGM costs (3 812 / 4,5); (3 288 / 4,2) (847,11) (782,86) (1)
Other manufacturing costs (1726 / 4,5); (1 479 / 4,2) (383,56) (352,14) (1)
Depreciation (25 / 4,5); (20 / 4,2) (5,56) (4,76) (1)
Inventory movements (balancing figure*) (1 224,77 – 1 236,23); 11,46* 23,35* (1)
(1 116,41 – 1 139,76)
Gross profit per unit sold including inventory (463 / 4,4); (685 / 3,9) 105,23 175,64 (1)
Alt: GP excluding inventory movements (1 330 – 1 236,23);
(1 292,05 – 1 139,76) 93,77 152,29 (1)
Opening inventory cost per unit (839 / 0,7); (406 / 0,4) 1 198,57 1 015,00 (1)
Closing inventory cost per unit (1 013 / 0,8); (839 / 0,7) 1 266,25 1 198,57 (1)
Gross profit % (105,23 / 1330,00); (175,64 / 1 292,05) 7,9% 13,6% (1)

Alt: Cost of sales as a % of revenue per unit
(incl. inventory movements)
(1 224,77 / 1 330,00);(1 116,41 / 1 292,05) 92,1% 86,4%
% increase in total revenue (5 852 – 5 039) / 5 039 16,1% (½)
% increase in total COS (5 389 – 4 354) / 4 354 23,8% (½)
% increase in total PGM costs (3 812 – 3 288) / 3 288 15,9% (½)
% Increase units sold (4,4m-3,9m) / 3,9m 12,8% (½)
% change per unit:
Revenue increase (1 330 – 1 292,05) / 1 292,05 2,9% (½)
PGM costs increase (847,11 – 782,86) / 782,86 8,2% (½)
Other manufacturing costs increase (383,56 – 352,14) / 352,14 8,9% (½)
Gross profit per unit sold decrease (105,23 – 175,64) / 175,64 (40,1%) (½)
COS as a % of per unit revenue

Revenue 100,0% 100,0%
PGM costs (847,11 / 1 330); (782,86 / 1 292,05) (63,7%) (60,6%) (1)
Other manufacturing costs (383,56 / 1 330);(352,14 / 1 292,05) (28,8%) (27,3%) (1)
Depreciation (5,56 / 1 330); (4,76 / 1 292,05) (0,4%) (0,4%) (1)
Change in inventory levels (11,46 / 1 330); (23,35 / 1 292,05) 0,9% 1,8% (1)
Gross profit (105,23 / 1 330); (175,64 / 1 292,05) 7,9% 13,6% (1)
Cost of sales as a % of evenue per unit (excluding inventory)
(1 236,23 / 1 330); (1 139,76 / 1 292,05) 92,9% 88,2% (1)
Strengthening of Rand against US $ (7,00 – 7,60) / 7,60 7,9% (½)
US $ terms: Reven e per unit
((1 330 / 7) – (1 292,05 / 7,6)) / (1 292,05 / 7,6) 11,8% (½)
US$ increase: PGM costs p.u. manufactured
(847 / 7 – 783 / 7,6) / (783 / 7,6) 17,4% (½)
Maximum (20)
Note:
Limited rounding differences may occur.
Direction ito increase or decrease (signs ( + / – )) must be correct to earn marks.
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Discussion
l 20X1 revenue levels are worse due to strengthening Rand as prices are quoted in US$. (1)
It is concerning that cost of sales in total increased with 23,8% [(5 389 – 4 354) / 4354] which exceeds the
16% increase in revenue increase. (1)
This indicates lack of economy of scale and inventory inefficiencies which lead to the 32% [(463 – 685) /
685] decrease in total gross profit. (1)
CatCon is unable to recover cost increases from customers which is the key reason for decrease in
GP%. (1)
PGM costs per units increased with 8,2% (or 17,4% in US$ terms) while revenue increased with only 2,9%
(or 11,8% in US$ terms). (1)
l Thus PGM cost increases were at least partly off-set by strengthening rand. (1)
PGM quantities and mix were consistent over the 2 years indicating no PGM production inefficiencies or
mix variance occurred. (1)
l Other manufacturing costs are Rand-based thus no impact f changing exchange rates.
l The 8,9% increase in Other manufacturing costs above CPI (or inflation) is concerning. (1)
Increase in Other manufacturing costs may indicate wage pressure, high electricity increases and
inflationary increases. (1)
Increase in inventory levels increases the Gross profit which defers fixed cost to the next year. (1)
l In terms of the FIFO system cheap inventory is sold first which increased the gross profit margin. (1)
l CatCon is operating below capacity making it difficult to recover overheads. (1)
Maximum (10)
Part (d)
l Increasing selling price may not be possible due to pricing pressures from European customers. (1)
General cost control (improve efficiencies) to reduce spending in an effort to increase cash flows and
profit. (1)
l Pass PGM cost increases onto customers. (1)
Hedge commodity prices by setting a price for PGM thus reducing losses from price fluctuations. (1)
l Find ways to limit Other manufacturing cost increases by cost cutting or outsourcing. (1)
l Use LED lights to r duce l ctricity costs. (1)
l Explore ways to improve mployee morale which leads to higher productivity and innovation in the work
place. (1)
l Improve design of onverters by using a different mix of PGMs. (1)
l Use spa e capacity to manufacture another product and diversify their operations. (1)
l Sell s rpl s assets, if any. (1)
l Sale and leaseback of property plant and equipment. (1)
l Impr ve inventory management to reduce inventory-holding cost (e.g. use JIT). (1)
l Factor debtors to increase cash flows and to redirect focus on production. (1)
Providing settlement discounts to improve cash flow. Operating profit margins may however be
affected. (1)
Maximum (12)
(Source: IIRC 2014. About <IR>. Available from: http://www.theiirc.org/about/(accessed 19 May 2014).)
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Chapter 9
Working capital
man gement
describe how a company should manage cash;

explain the advantages and disadvantages of s lling on cr dit and how debtors should be managed;
calculate the advantages of increasing credit terms;
calculate the Economic Order Quantity (EOQ) with and without discount allowances, and the economic
safety inventory level; and
discuss the meaning of Just in Time (JIT) inventory holding.
Managing a company’s working capital (liquidity) involves the simultaneous matching of decisions about cur-
rent assets and current liabilities. Working capital is the Rand amount of a company’s current assets and in-
cludes cash and short-term investments, accounts receivable and inventories. Hence, these are of short-term
duration.
The choice available to financial managers is to finance working capital through long- term finance (such as
debt or equity) or through short-term financing. The use of short-term finance increases the insolvency risk, as
the ability to borrow is restricted. Long-term financing limits the insolvency risk, as interest payment on debt is
only periodic and the capital amount is not repayable until maturity. However, using long-term finance to fi-
nance working capital is not always seen to be prudent as the firm’s permanent sources of capital are then be-
ing utilised to finance short-t rm activities thereby compromising the ability of the firm to acquire investments
for long-term growth and comp titiveness.
Current assets an represent a significant proportion of total assets (e.g., a retailer who leases premises may find
their total assets being almost solely current assets); therefore it is important that careful planning is car-ried
out, especially because of the volatile nature of the assets involved. An important consideration in setting a
financial policy is the relationship between the growth in sales and the growth in working capital. As sales
increase, the need to hold a higher level of inventory also increases, as does the investment in debtors. This
could lead to a negative cash-flow situation as the inventory and debtors have to be financed until converted
into cash. Unless the firm accesses a facility to cover the negative cash flow, the situation could prove disas-tr
us, especially for a fast-growing business. Firms that grow too quickly are characterised as ‘overtrading’ and the
resultant cash-flow deficit has seen the demise of many promising entities!
9.1 Levels of working capital

Different levels of working capital can exist in companies, depending on their attitude to risk, access to re-
sources and industry dynamics.
Permanent working capital

Permanent working capital is the Rand amount that persists over time, regardless of fluctuations in sales.
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Temporary working capital

Temporary working capital is the additional current assets required to meet the variations in sales above the
permanent level.
Net working capital

Net working capital is the difference between current assets and current liabilities. It is a financial indicator that
should be used in conjunction with other financial indicators, such as the current ratio (current assets ÷ current
liabilities), to gauge the liquidity of business concerns.
The matching principle of equating the cash flow generating characteristics of an asset with the maturity of the
source of financing used to finance its acquisition is known as hedging. Most comp nies experience seasonal
demand, requiring an expansion in inventories which should be financed by short-term loan or current liabili-
ties. For example in the build-up to the December period, a retailer will ha e to ‘stock up’ to take advantage of
anticipated increased sales volumes. Funds are needed for a limited period of time and when that time has
passed, the cash needed to repay the loan facility will be generated by the sale of finished inventory (refer Ex-
ample: Bidvest below).
If the deficit is financed from a long-term source, the company will have excess liquidity until the seasonal de-
mand occurs again. This may result in the overall lowering of profits, as the long-term interest payments are
likely to be higher that the short-term interest receipts.
The idea of maturity-matching in the hedging principle is clarified by looking at the distinction between perma-
nent and temporary investment in assets. A perman nt inv stment in an asset takes place when a company
expects to hold that asset for a period of longer than one y ar. Permanent investments include not only fixed
assets, but also the company’s minimum level of current assets. Temporary asset investments, by contrast,
comprise of current assets that will be liquidated and not replaced within the current year.
Figure 9.1: Net working capital versus cash generated

Source: Bidvest
9.2 Hedging or matching finance

The term hedging as used here means matching expected cash inflows from assets with outflows from their
respective sources of financing.
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Working capital management Chapter 9
Perfect hedge
The perfect hedge consists of financing temporary current assets with short-term sources of funds and fixed
assets, and permanent current assets with long-term sources of funds. The basic strategy of the perfect hedge
is to match the expected inflows and outflows of funds. This method is considered sound financing, because
the inflows of funds from the sale of assets are being used to repay the loans that financed their acquisition.
Rand
Short-term
financing
Seasonal current assets
Permanent current assets Long-term

financing
Fixed assets
Time
Source: Bidvest
Figure 9.2: Diagrammatic representation of a perfect hedge
Conservative hedge
All of the fixed assets, permanent current assets, and part of the temporary current assets are financed with
long-term sources of funds. This method is considered conservative, because the firm only needs to finance a
small portion of its temporary current assets with short -term funds. The major advantage of this method is
that during periods of credit restraint, the firm already has most of the funds that it needs to finance its
activities. Hopefully, the long-term funds were obtained at a time when their cost was favourable to the firm.
Short-term
financing
Rand
Seasonal current assets
Long-term
financing
Permanent current assets
Fixed assets
Time
Figure 9.3: Diagrammatic representation of a conservative hedge
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Appropriate forms of finance

The conservative hedge implies that there will be surplus cash available over peak seasonal fluctuations, and little or
no cash borrowing during trough or down periods. The problem with this strategy is that there will be a high cost of
borrowing and low earning potential on short- term investments. The perfect hedge strategy means that short-term
assets will be financed using short- term borrowing. This type of financing strategy requires frequent borrowing
adjustments and is risky because short-term rates are more volatile than long-term rates.
It is important, however, to bear in mind that, on average, short-term interest rates are lower than longer term
rates (normal yield curve) which means that a firm will maximise returns by using more short-term finance. The
firm must also assess the risk associated with the various financing strategies when deciding which method
suits its needs.
The effects of conservative and aggressive financing

Conservative financing takes place where financing is of a permanent long-term nature.
Aggressive financing exists where a permanent reliance is placed n sh rt-term funds. Under a normal yield
curve (short-term rates lower than long -term rates), the company will maximise profits by using short-term
finance. However, a change in the yield curve to inverse will result in the company incurring heavy interest
charges.
Example:
Assets R
Current assets 100
Fixed assets 100
Total assets 200
Financing
Conservative Aggressive
R R
Short-term debt (7%) 25 100
Long-term debt (12%) 125 50
Equity 50 50
Total liabilities and equity 200 200
Income and expenses

Conservative Aggressive
Earnings before interest and tax 50,00 50,00
Interest 16,75 13,00
Taxes (28%) 9,31 10,36
Net income R23,94 R26,64
Financial indicato s
Current ratio (CA : s/t debt) 4:1 1:1
Net working capital (CA less s/t debt) R75 R0
Rate of ret rn on eq ity (Net Y : Equity) 47,9% 53,3%
N te: The trade -off should be kept in mind when firms change their financing patterns as they respond to
changing business conditions. For example, aggressive hedging should be used when firms are ex-
panding their working capital during the recovery and prosperity phases of a business cycle.
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9.3 Cash management

Liquidity preference
Uncertainty about interest rates and investor psychology are important determinants of the amount of liquid
assets one holds. Liquidity preference depends on:
Transaction motive
Cash to carry out day-to-day transactions. The amount of cash held also depends on the regularity of re-
ceipts and disbursements.
A retail business is likely to have a high cash to sales ratio or cash to total assets ratio, as sales are random
and possible seasonal fluctuations increase the cash required.
Precautionary motive
Precautionary balances are those set aside because cash inflows and outflows are not synchronised. They
are required to meet unanticipated expenses.
The amount required for the precautionary motive is influenced by a company’s ability to borrow on
short notice. Companies will often hold assets that can easily be liquidated, such as Treasury Bills or
Bankers’ Acceptances. It must, however, be noted that such assets are expensive, as their return is usually
well below the company’s cost of capital.
Speculative motive
Some firms hold practically no speculative balanc s, while others hold large speculative balances because
they are aggressively seeking acquisitions or ‘good buying opportunities’ for commodities that they use in
their operations.
The firm expects to pay out cash for its inputs/manufacturing process and to receive cash for its output
sales. The cash operating cycle is descriptive of the time elapsed between the payment for raw material
and the final receipt of cash for items sold. The longer the cycle, the more cash (liquidity) the company
will require to finance the day-to-day running of the business. It is important to analyse the firm’s turno-
ver rates, to determine the number of days lag between cash out and cash in.
Cash operating cycle/business cycle

Debtors’ time-lag
The average number of days that elapse between the sale of output goods and the resulting cash
inflow: Debtors’ balance × 365
Total sales r v nue
Raw material time-lag
The average length of time that raw material is kept in inventory before being used in the production
process:
Raw mate ials inventory × 365
Total p rchases
Creditors’ time-lag
The number of days between the receipt of inputs and the cash payment:
Creditors’ balance × 365
Total purchases
Work-in-progress time-lag
The average length of production:
Work-in-progress × 365
Total production costs
337
(e) Fini she d g oo ds time -la g

Ave rage time tha t output is h eld in i nve ntory b efo re bei ng sold:
Finish ed goods × 36 5
C ost of sale s
The cash operating cycle i s de fin ed as the ove rall tim e-lag betwe en the cash paym ent fo r in pu ts and the
cas h re ceipts for ou tpu t, a nd is e qual to (b) + ( d) + (e) + (a) (c ).
Fig ur 9.4: N et wo rking c apital d ays

So urce: Bidve st
9.3.3 Fo recas in g – asset requireme nt s

As sales increase, i t is reasonabl e to assum e that wo rki ng c apital requir eme nts will also increase. A n i ncr eas e in
cr edit sal es will lea d to an in cre ase in de bto rs, inve nt ry and credi tors . If a compan y i s at full ca pa city , it will
re quir e an in jectio n of new capit al – either d ebt or equ ity, or retain ed inco me, to inc rea se the fix ed asse
t base and s ubsequ ent ly incr as sa l s.
Company gr owt h t hus impacts o n the liquidity re qu ire men ts o f a co mp any an d it is nece ssary for a co
mp an y to m onit or the eff e ts on wo rki ng api tal when sales in crease.
There is no sing le mo del that a com pany ma y us e to a ccu rate ly f ore cas t working ca pital re quirem en ts
as s ales inc rea se. A s im ple model is to determine a fa ir o r opti mal level o f fi xed as sets pl us curr ent ass
ets to sal es, and based on this re lations hip, to cal culate workin g capi tal req uire ments as sale s in cre ase .
Exam ple : F r ecasti ng

The f ollowin g stat em nt of fina ncial p ositio n of Ca ble Lt d, a m anufac tur er o f electron ic om po nen ts, is p re-
ented:
Fun ds employed R’000
Sha re capital 4 80
Sha reh old ers’ in tere st 1 0 00
Lon g-term lo ans 3 00
R 1 3 00
338
R’000
Represented by
Non-current assets 800
Inventory 500
Debtors 250
Cash 50
1 600
Current liabilities
Creditors 300
R1 300
The annual sales are R5 000 000 spread evenly over the year. The after-t x profit margin on sales is 6%, of
which 50% is retained within the company.
The company plans to increase its sales to R8 000 000 in the forthcoming year.
Required:
Estimate the additional working capital required to support the increased sales.
Assuming that the company has no spare capacity, calculate how much the company needs to invest in
both fixed and current assets.
Solution:
Working capital requirements
An increase in sales from R5 million to R8 million will lead to an increase in debtors, inventory holding
and creditors.
Assumption – current sales are all credit sales and the increase in sales will also be on
credit. Debtors – current ratio of debtors:sales
Debtors = R250 000
Sales = 5 000 000
Ratio = 250 000 / 5 000 000 = 5%
An increase in sales by R3 000 000 should increase debtors by the same ratio.
= R3 000 000 × 5% = R150 000 increase in debtors

Inventory – the calculation is the same as for debtors
Current ratio = 500 000 / 5 000 000 = 10%
Increase in sal s = R3 000 000
Increase in inventory = R3 000 000 × 10% = R300 000
Cash – is an inc ease in cash needed? The question states that part of the profit is retained in the
company, that is cash.
Therefore, retained income = R3 000 000 × 6% × 50% = R90 000

Cash will therefore increase from R50 000 to R140 000
Credit rs
Current ratio = 300 000 / 5 000 000 = 6%
Increa e in sales = R3 000 000
Increase in creditors = R3 000 000 × 6% = R180 000
Net working capital required

Debtors + Inventory – Creditors – Retained income (cash)
= R150 000 + R300 000 – R180 000 – R90 000 = R180 000
339
Investment in non-current assets and current

assets Non-current assets
If the company does not have sufficient capacity to generate more sales, it will need to increase its non-
current asset requirements. It is impossible to calculate the non-current asset increase required, as it
does not necessarily follow that the existing ratio of non-current assets:sales will continue. The current
non-current asset value also represents the Net Book Value (NBV) and it is possible that at current costs,
the non-current assets required will be considerably higher.
Assumption: Non-current assets and current assets increase will remain at the current ratio of fixed
assets:sales.
Existing non-current assets R800 000
Sales R5 000 000
Ratio = 800 000 / 5 000 000 = 16%
Required R3 000 000 × 16% = R480 000
Current assets
Working capital required will be as per (a) above.
Strategies to reduce the duration of cash cycles

Delay paying the accounts payable, but still take advantage of cash discounts on purchased goods.
The practice of stretching accounts payable may damage the company’s credit reputation. These costs
are difficult to quantify, but could result in the suppli r increasing future costs of goods supplied. A se-
cond cost of delaying the payment of accounts is the loss of discounts offered. These costs can be high
and are experienced as follows:
Annual cost of missed discount
Cash discount% 360 days 100
= 100 – cash discount % × number of days payment made after the discount period × 1
Collect accounts receivable as soon as possible.
Increase inventory turnover: This can be achieved by increasing sales or reducing the amount of invento-
ry that is held.
Operations: Operating decisions to expand, contract, change product mix, etc. will have a direct effect on
cash flow.
Capital expenditure: The acquisition or disposal of plant, equipment or other assets of a long-lasting na-
ture will have an immediate effect on cash, resulting in a depreciation (non-cash) charge against future
profits.
Tax on profits: Tax on profits or income payable at certain dates is predetermined by law, but may be
influenced, to some extent, by management.
Financial obligations: Interest and dividend payments, plus any contractual repayments of capital arising
from past financial decisions. Managers should be aware of the impact of these decisions on the cash
flow of the gro p, and develop cash reporting systems to ensure that their effect is properly recognised
and planned for.
There are a number of procedures that can be employed by a company to reduce the cost of holding
cash. H wever, a company should compare the cost of reducing cash to the marginal savings in holding a l
wer cash balance. Economies of scale are present, and it is likely that only large companies will benefit
from ophisticated cash-control systems.
The Baumol model for cash management

Investments in cash and marketable short-term assets are the same in practice as investing in inventory. Both
require a minimum level of inventory/cash holding to balance outflows. Safety inventory is required to meet
unexpected demand, and additional amounts may be required for future growth.
340
Example: Mr Price – Liquidity management

The Group manages liquidity risk by maintaining adequate reserves, banking facilities and by continuously
monitoring forecast and actual cash flows. The Group has significant cash reserves and minimal borrowing
which will enable it to borrow funds externally should it require to do so to meet any working capital or possi-
ble expansion requirements.
In managing cash, a minimum amount is required to meet the transaction requirements. Marketable assets are
held as a safety inventory against cash requirements or investment opportunities. If a high level of cash is held,
the cost will equal the opportunity cost of investing the funds to yield a return equal to the cost of capital. The
cost of holding too low an amount of cash will equal the opportunity foregone of taking discounts, borrowing
funds or converting assets into cash.
The opportunity cost of holding cash rises as cash is held. If insufficient c sh is held, the transaction costs of
converting assets to cash will rise. There is an optimal level of holding c sh versus converting assets to cash
that will yield a minimum cost of managing cash.
The Baumol model was developed in 1952, and is very similar to the Economic Order Quantity (EOQ) model
used for inventory models.
The model establishes the annual cash required by a firm, and assumes that the cash requirement will be used
up by withdrawing an economic amount as needed over the year. The firm would pay a fixed transaction cost
and forego the interest rate on the marketable securities (opportunity cost of holding cash).
Total cost of holding cash = Ordering cost + Opportunity cost
B(T) I(Q)
+
Q 2
Where: B = Fixed transaction cost of converting marketable securities into cash
T = The annual cash demand (or period demand)
Q = The optimal withdrawal size
I = The opportunity cost of holding cash, that is the interest rate on marketable securities.
The optimal withdrawal size that minimises the total cost is determined by:
2BT
Q =
I
Example: Baumol model

Merton Company knows that the total demand for cash (T) next month will be R300 000 and that the fixed cost
per order of converting marketable securities into cash (B) is R50. The interest rate on short-term marketable
securities (I) is 20% per annum.
Required:
Calculate the optimal withdrawal size.
Solution:
As a one-month period is specified, the equivalent monthly interest rate (I) will be determined as follows:
20% ÷ 12 months = 1,67 %
The ptimal withdrawal size is:
2 (50 × 300 000)

= R42 427
0,01667
Limitations of the Baumol model

The model assumes that a firm will have a constant cash requirement; this is not necessarily the case in
practice.
Cash inflows are not accounted for in the model.
The model does not cater for uncertainty in cash flows.
341
The Miller-Orr model
Cash
A
Time
Figure 9.5: The Miller-Orr model
The Miller-Orr model accounts for fluctuating cash inflows and outflows over time. The model assumes a nor-
mal distribution of daily net cash flows. The above diagram represents the Miller-Orr model, and sets a target
cash level of Z and allows for cash fluctuation between points A and B.
When the cash flows reach the upper limit line (A), the firm will invest an amount equal to AZ in marketable
securities such as Treasury Bills or Bankers’ Acceptanc s, and hold a cash balance equal to Z. When cash bal-
ances reach the lower limit of B, the firm will sell securities to generate sufficient funds to return the cash hold-
ing to the target level Z. The lower limit of cash is a function of the firm’s attitude to risk.
The model assumes that the transaction costs of buying and selling investments are fixed, and that the oppor-
tunity cost of holding cash is equal to the short-term investment rate. The Miller-Orr model is based on a cost
function similar to the Baumol model.
The model assumes that the transaction costs of buying and selling investments are fixed, and that the oppor-
tunity cost of holding cash is equal to the short-term investment rate. The Miller-Orr model is based on a cost
function similar to the Baumol model.
3bσ
2
Z = + B
4i
Upper Limit = 3Z – 2B
4Z – B
Average cash balance =
3
Where:
Z = Optimal return point
b = Cost per o der of converting marketable securities into cash or cash into marketable securities
σ2 = The va iance of daily cash balances
i = The daily interest rate on short-term marketable securities
B = The lower cash limit
Example: Miller-Orr model

Company A invests all its surplus cash at an annual rate of 20% and incurs costs of R50 per buying and selling
tran action. The expected daily balances and probability distributions are estimated as follows:
Cash Probability
R8 000 10%
R9 000 20%
R10 000 40%
R11 000 20%
R12 000 10%
The acceptable lower limit of cash holding is R2 000.
342
Required:
Determine the target cash level Z and the average cash balance.
Solution:
(Cash-mean)
2 P(Cash-mean)
2
Cash × P Cash-mean
800 – 2 000 4 000 000 400 000
1 800 – 1 000 1 000 000 200 000
4 000 – – –
2 200 1 000 1 000 000 200 000
1 200 2 000 4 000 000 400 000
σ
2
Mean = 10 000 1 200 000
3 × 50 × 1 200 000
Z = 3 + 2 000
4 × 0,00055
Z = 4 341 + 2 000 = 6 341
A = (3 × 6 341) – (2 × 2 000) = 15 023
B = 2 000
Note: The daily interest rate is arrived at by 20% / 365 = 0,00055

Average cash balance = (4 × 4 015) – 2 000 = 4 687
3
9.4 Debtors’ management

In general terms, the granting of credit to customers leads to an increase in sales and hence, increased profits.
The granting of credit has the same effect as giving the customer an interest-free loan. The cost to the lending
firm will equal the cost of borrowing such funds that may be used to extend credit facilities to customers. Gen-
erally, the level of debtors should be determined on the basis of the volume of credit sales and the average
period between sales and collections.
Credit policies
Credit policies are management guidelines concerning the extension of trade credit and the management of
accounts receivable. Cr dit policies influence the level of sales, profits, and the form of assets. The long- term
objective of credit polici s is to increase shareholder wealth. In the short-term, however, credit policies may
focus on maximising sales, increasing collections, or something else.
Example: Mr P i e – C edit management

Before accepting any new credit customer, the Group uses an external credit scoring system to assess the po-
tential c stomer’s credit quality and defines credit limits by customer, while ensuring compliance with the re-
quirements of the National Credit Act 34 of 2005 (NCA). Limits and scoring are reviewed at least annually in
accordance with the requirements of the NCA and upon request by a customer. Due to the nature of the busi-
ness, there are no customers that represent more than 5% of the total balance of trade receivables. The Group
d es n t have any balances which are past due date and have not been provided for, as the provisioning meth-
odology applied takes the entire debtor population into consideration.
Examp e: Truworths – Credit enabling sales growth

The Group uses credit as an enabler of retail sales. Customer behaviour patterns have shown that if the right f
shion merchandise is available, customers will pay their accounts to be able to purchase more merchandise on
credit. Managing the risk of credit is therefore closely aligned with managing the risk of fashion. Credit in the
Group is offered to customers in South Africa, Namibia and Swaziland, but is not currently offered in the other
African countries in which the Group operates. Three credit payment plans are offered across the
343
portfolio: 6 months interest free (unless in arrears and only available to Truworths customers) and 9 and 12
months interest- bearing. During the reporting period customers have continued to move, at their choice, to
the longer term 12-month payment plans, which make their purchases more affordable in terms of lower
monthly instalments. This trend, which is supported by national credit data, further indicates that credit af-
fordability is under pressure for consumers in South Africa.
The decision may involve a trade-off between increased credit sales and profits. The extension of credit to
boost sales and so keep the sales people happy may have an adverse effect on profit if the sales result in
‘bad debt’ losses. Overly restrictive credit policies may result in lost sales and foregone profits.
The granting of credit can be thought of as a trade-off between holding inventory and holding accounts
receivable. Similarly, the collection of credit can be thought of as a trade-off between holding cash and
holding accounts receivable.
Credit decisions and trade-offs

Decisions Trade-offs
1 Level and risk of accounts receivable Credit sales versus profit
2 Form of assets Grant credit Inventory versus accounts receivable
Collect credit Cash versus accounts receivable
Credit terms and elasticity

The extent to which sales will increase as a result of the price (net discount) depends on the elasticity of de-
mand for the product. Price elasticity measures the r sponsiv n ss of the demand for a product to a change in
price. If, for example, the price of suits was reduced by 15% and as a result the demand increased by 20%, the
demand for suits is said to be elastic. However, if the price of toothpicks was reduced by 15% and the demand
remained the same, then the demand for that product is said to be inelastic.
Credit terms and profit

Does an increase in sales necessarily lead to an increase in profit?
Example: Mr Price – Trade receivables

20X2 20X1
R’000 R’000
Gross trade receivables 1 223 831 835 187
Impairment provision (113 879) (74 270)
Net trade receivables 1 109 952 760 917
The aging of the gross trade receivables is as follows: Days from

transaction
Current 30 893 395 631 053
Status 1 60 170 902 108 509
Status 2 90 68 030 42 695
Stat s 3 120 44 522 25 576
Stat s 4 150 31 193 17 784
Status 5 180 15 789 9 570
1 223 831 835 187
Intere t is charged on outstanding accounts in accordance with the National Credit Act (NCA) and has fluctuat-
ed in accordance with legislated changes to the repo rate.
The Group has provided for receivables in all ageing status levels based on estimated irrecoverable amounts
from the sale of merchandise, determined by reference to past default experience.
Comment: Higher interest income on debtors’ accounts should be compared to charges related to the
provision of credit.
Analysts note: Gross debtors book up 9% year on year credit in SA: mortgages 4%, secured 12% and unse-
cured 53% (Source – NCR).
344
Example: Truworths – Impact of interest rates

The 18% increase in interest income on the debtors’ book is attributable to more customers selecting longer
term interest-bearing payment options and a higher proportion of the portfolio moving to the South African
National Credit Act (NCA) regulated interest rate, which is higher than the former Usury Act 73 of 1968 regulat-
ed accounts. The maximum usury interest rate for accounts of R10 000 or less is 18% compared to the maxi-
mum NCA rate of 22,1% (based on the repo rate of 5,5%).
Companies correctly target sales as a means to increase profitability. When sales increase and are paid for in
cash, the company benefits from an increase in profit. The only down-side is that the inventory of goods sold
increases due to increased sales.
However, when an increase in sales occurs as a result of increased credit terms, the gains in sales revenue will
be off-set by:
increased debtors–cost of holding debtors
– cost of financing debtors
bad debts that are incurred
increased inventory holding costs
cash effect which may require additional borrowing
increase in creditors.
Comparing the impact of cash, 30 days net, 2% discount if paid within 10 days, or 30 days net:
P = Sn – Cn – ARC
Where: P = gross profit
S = selling price per unit
C = cost of goods sold per unit
n = number of units
ARC = cost of accounts receivable.
Example: Impact on profit

A company is budgeting to sell 1 000 units of a product at a selling price of R50 per unit. The manufacturing
cost is R25 per unit.
When a sale is made on credit, the company will incur a collection cost of approximately R1 per unit sold. The
Weighted Average Cost of Capital (WACC) for the company is 15%.
Required:
Calculate the profit to the company if –
all sales are for ash;
sales a e made on credit and accounts are paid in 30 days; and
sales are made on credit and a 2% discount is granted if accounts are paid in ten days. 50% of debtors take
advantage of the discount.
S luti n:
(a) Selling price = R50
Co t = R25
Sa es = 1 000 units
Profit = (R50 – R25) × 1 000 = R25 000
345
(b) Gross profit = (R50 – R25) × 1 000 = R25 000

Cost of carrying debtors
(i) Holding cost = 1 000 × R1 = R1 000
(ii) Finance cost @ 15%
= R50 × 1 000 × 15 / 100 × 30 / 365 = R616,44
Net profit = R25 000 – R1 000 – R616 = R23 384
Note: The cost of carrying the debtors has been calculated on the se ing price as the profit has been
recognised in the income statement. It could be argued that the cost of carrying the debtors for
30 days is equal to the cost of goods sold, that is R25 per unit.
(c)Gross profit = R25 000

Sales where debtors pay in 10 days
Discount allowed = R50 × 50% × 2% × 1 000 = R500
Cost of carrying debtors 1 / 2 for 10 days
1 / 2 for 30 days
= (R50 × 500 × 15 / 100 × 10 / 365) + (R50 × 500 × 15 / 100 × 30 / 365)
= R102,74 + R308,22 = R410,96
Holding costs = R1 × 1 000 = R1 000
Net profit = R25 000 – R500 – R411 – R1 000 = R23 089
Collection policy
As a general rule, the more quickly accounts receivable are converted into cash, the greater the profits will be.
However, if collection policies are too harsh, some potential customers may deal elsewhere. Therefore, finan-
cial managers must consider the trade-offs of increased sales versus profit, and holding accounts receivable
instead of cash when establishing collection policies. A collection policy is important for the following reasons:
Delinquent accounts become increasingly difficult and costly to collect as time passes.
Sales to slow-paying customers are inhibited by slow collections.
The reputation for stringent credit policies discourages some customers from becoming delinquent.
Delinquent receivables add to the volume of working capital that must be financed.
Evaluating cr dit on a Net Present Value (NPV) approach

The granting of credit can be vi wed as an investment decision where a company makes an investment in in-
ventory, debtors and a ruals in return for an increased cash flow from extra sales. The NPV formula is:
NPV = After-tax ash flow Investment (I)
WACC
where a positive NPV would indicate an acceptable decision. The above formula assumes that the after-tax
cash flow is constant and continues into perpetuity, hence a discount rate at WACC.
The new credit decision will result in incremental investments (I) equal to –
increased debtors associated with original sales (i.e. increased payment period);
incremental investment in debtors as a result of new
sales; increased investment in inventory; and
increase in creditors (i.e. reduction in funds required);
346
Example: Changing credit policy

A company is considering a change in credit terms that should increase sales. At present, no discounts are of-
fered, and debtors are granted 30 days credit. There are no bad debts. The new proposal is to grant credit on
2/15 net 60 (i.e. 2% discount if pay on or before 15 days, otherwise pay 60 days). Current annual credit sales
are R1,5 million and debtors take 40 days on average to pay their accounts. The company anticipates that un-
der the new terms, 60% of current debtors will take the discount and the balance will pay in 60 days.
The company anticipates that sales will increase by R500 000 to new customers. The new sales will result in
50% taking the discount and the balance paying within 75 days. Inventory is expected to increase by R80 000,
while creditors and accrual expenses will increase by R30 000. Bad debts amounting to R50 000 are expected
from the increased sales. The contribution ratio is 30%, the tax rate is 28%, and WACC is 20%.
Required:
Calculate the annual before-tax and after-tax cash flow benefit of changing the credit policy.
Solution:
‘Credit 2/15 net 60’ means that a 2% discount is granted if the acc unt is paid in 15 days. If not, the account
must be paid in 60 days.
Calculation before tax

Current New policy Increased sales
Sales R1 500 000 R1 500 000 R500 000
Cash Nil Nil Nil
Discount Nil 2% on 60% of sales 2% on 50% of sales
Pay in 15 days – 60% 50%
40 days 100% – –
60 days – 40% –
75 days – – 50%
Bad debts Nil Nil R50 000
WACC = 20%
Contribution = 30%
Note Current New policy Increased sales
1 Contribution 450 000 450 000 150 000
2 Discount Nil (18 000) (5 000)
Bad debt Nil Nil (50 000)
3 Holding cost (32 877) (7 397) (2 055)
Holding cost (19 726) (10 274)
4 Inventory holding Nil Nil (16 000)
5 Creditors Nil Nil + 6 000
417 123 404 877 72 671
R477 548
Net benefit R477 548 – R417 123 = R60 425
Note 1 Contrib tion 30%
Current = R1 500 000 × 30% = R450 000
Increased sales = R500 000 × 30% = R150 000
Note 2 Discount 2%
New policy 1 500 000 × 60% × 2% = 18 000
Increased sales 500 000 × 50% × 2% = 5 000
Note 3 Holding cost
Existing 1 500 000 × 40 / 365 × 20% = R32 877
New 1 500 000 × 60% × 15 / 365 × 20% = R7 397
1 500 000 × 40% × 60 / 365 × 20% = R19 726
Extra 500 000 × 50% × 15 / 365 × 20% = R2 055
500 000 × 50% × 75 / 365 × 20% = R10 274
347
Note 4 Inventory holding Cost @ 20% WACC for one year

Increase 80 000 × 20% = R16 000
Note 5 Creditors Cost @ 20% WACC for one year
Increase 30 000 × 20% = R6 000
After tax
The only figures that are affected in the calculations after tax are the contribution, the discount and the bad
debt.
Current after tax

Existing (450 000 × 72%) – 32 877 = R291 123
New option
Contribution (450 000 + 150 000) × 72% = + 432 000
Discount (18 000 + 5 000) × 72% = – 16560
Bad debt 50 000 × 72% = – 36 000
Holding cost (7 397 + 19 726 + 2 055 + 10 274) = – 39 452
Inventory holding = – 16 000
Creditors = + 6 000
R329 988
Net benefit R329 988 – R291 123 = R38 865
Debtor factoring
Factoring is essentially a debtor administration and collection facility providing a source of short-term finance.
The factor and the client agree on credit limits for each customer and on the average collection period. The
client then notifies each customer that the factor has purchased the debt. Thereafter, a copy of the invoice is
sent to the factor. The client pays the factor directly and the factor pays the client as follows:
On day of acquisition of invoice
Net invoice value before settlement discount 100%
Less: Service charge (up to 2,5%) assume (2%)
Less: Retention held until invoice is settled (between 20–25%) (25%)
Payment to client 73%
On invoice settlement date
Payment of retention 25%
Less:
Discount charge (the discount charge is based on the funds
advanced to the cli nt and is normally 2% above overdraft rate)
Assuming the overdraft rate is 14% and the
debt is settled after 90 days:
90 (3%)
16% × × 75%
365
Total net amo nt received by client 95%
Most South African factoring contracts are on a with- recourse basis, which means that the ultimate bad-debt
risk remains with the client. The factor has recourse to sell back to the client any debt it considers uncollectible.
9.5 Inventory management

There are three kinds of inventory, namely raw materials, work-in-progress and finished goods. The holding of r
w materials is dependent on the sources of supply and production scheduling. Work- in-progress is regulated
by the production run. A decrease in production time will increase inventory turnover. The control of finished
goods is governed by the link between production and sales. An increase in credit sales will transfer inventory
to debtors. Direct sales will reduce inventory holding. However, the level of inventory holding is governed, to a
large extent, by the level of sales. Increased sales normally require a higher holding of all levels of inventory.
348
The amount of materials that a firm holds depends on the following factors –
frequency of use;
sources of supply;
lead time;
physical characteristics;
cost; and
technical considerations.
Example: Mr Price – Long-term project to reduce country risk

Reduce dependence on China in favour of Bangladesh, Cambodia, Vietn m, M uritius and RSA.
Increased factory direct imports by 72% in last year.
Pre-season briefing and collaboration with certain key suppliers reduced their lead times from 4 to 3
months and improving on time in full deliveries.
Strengthened relationship with RSA manufacturers –
– Increased locally purchased units by 21% in last year;
– R10m enterprise development loan to key supplier to expand operations.
Cycles
The level of sales generally conforms to the level of business activity. Therefore, one strategy for managing
inventories is to increase or decrease inventories as sales rise or fall. This strategy results in a constant invento-
ry to sales ratio, which means that inventory is (say) 170% of sales.
In general, the inventory to sales ratio is low at cyclical peaks because sales increase relatively more than in-
ventory. It is high at the trough for the opposite reason.
Investment
Managing inventories means keeping the total investment in inventory at the lowest possible levels to enhance
the long-run profitability of the firm and shareholder wealth.
Example: Shoprite – Inventories

Trading inventories are stated at the lower of cost, using the weighted average cost formula, and net realisable
value. The weighted average cost formula is determined by applying the retail inventory method. The cost of
merchandise is the n t of invoice price of merchandise; insurance; freight; customs duties; and appropriate
allocation of distribution costs; trade discounts; rebates and settlement discounts. The retail method approxi-
mates the weighted average cost and is determined by reducing the sales value of the inventory by the appro-
priate percentage gross margin. The percentage used takes into account inventory that has been marked down
below original selling p i e. An average percentage per retail department is used. Net realisable value is the
estimated selling p ice in the ordinary course of business.
Example: Different Inventory turns

20X2/X1 20X1/X0
Sh prite 8,4 times 8,8 times
Mr Price 6,5 times 6,6 times
Truworths 6,4 times (11) 6,9 times (10)
Be equipment 1,9 times (11) 2,0 times (10)
Comment: Inventory turn is dependent on the type of product being sold and its associated profit margins.
349
The Economic Order Quantity (EOQ)

Assumptions
Annual demand for the inventory item is known and constant over the period.
No time-lag between the placing of the order and the arrival of the inventory.
The cost of ordering can be quantified and is constant regardless of order size.
The cost of holding one unit of inventory per period is constant. Costs include warehousing costs and cost
of capital employed.
The cost per purchase item is constant (no discounts).
Relevant costs for inventory decisions include:

Acquisition costs
Ordering costs –
l cost of placing order or production set-up costs; l
shipping and handling costs; and
l quantity discounts taken or lost.
Carrying costs –
l storage costs; l
insurance;
l cost of capital; and
l depreciation and obsolescence.
Costs related to safety inventory –
loss of sales;
loss of customer goodwill; and
production disruptions.
Order costs = O(D) ÷E
Carrying costs = H(E) ÷2
Where:
O= fixed cost per order
= quantity used in units per period (annum)
= quantity of units p r order (economic order quantity)
H = annual cost of carrying one unit of inventory for one year.
Cost Total
cost
R
Holding
cost
Ordering
cost
E.O.Q.
Order quantity
Figure 9.6: The Economic Order Quantity
350
The EOQ is determined at the level where order costs equal carrying costs:
OD HE
+
E 2
2OD
Solving: E =
H
EOQ in production
The EOQ can be used effectively to determine the optimal length of production runs. The objective is to deter-
mine how many units must be produced per production run. The equation would re d as follows:
2DS
EOQ =
H
Where:
D=S= annual demand of units

set-up costs such as incremental labour, material, achine downtime and other costs related to
setting up a production run
H = holding costs
Quantity discounts
When a firm is able to purchase goods in large quantities and thereby receive a quantity discount it will save
through –
purchase price reductions; and
lower ordering costs.
However, as the firm is ordering higher quantities, the holding costs will increase.
Example: Calculating EOQ

The following information is provided:
Annual demand 80 000 units
Unit cost R3,60
Fixed cost per order R18
Annual carrying cost p r unit 15% of unit cost
The supplier announc s a discount scheme, as follows:
Discount Order size
Nil 0– 4 000
5% 4 001– 8 000
6% 8 001– 40 000
7% 40 001
Required:
Determine –
(i) the EOQ; and
(ii) the EOQ where discounts are available.
351
Solution:
2OD
(i) EOQ =
H
2 × 18 × 80 000
EOQ =
0,54
= 2 309 units
1 At 5% discount
E’ (new order quantity) = 4 001
E (EOQ) = 2 309
H (Holding cost) = (3,60 × 0,15) = 0,54
H’ (Holding cost) = (3,60 × 0,95 × 0,15) = 0,513
O (Order cost) = 18
D (Demand) = 80 000
E’H’ EH
(a) Marginal holding cost = –
2 2
4001 × 0,513 2309 × 0,54
= –
2 2
= R402,83
O(D) O(D)
(b) Savings in ordering costs = – = R263,74
E E’
18 (80 000) 18 (80 000)
–
2 309 4 001
(c) Discount savings = 80 000 × (3,60 × 5%) = R14 400
(d) Net saving = R14 400 + R264 – R403 = R14 261
2 At 6% discount
(a) Marginal holding cost (1 407,22)
(b) Savings in ordering cost 443,65
(c) Discount savings 17 280,00
Net R16 316,43
3 At 7% discount
(a) Marginal holding cost (9 420,82)
(b) Savings in ordering cost 587,65
(c) Dis ount savings 20 160,00
Net R11 326,83
The greatest benefit will accrue if the company takes advantage of the 6% discount and purchases in batches of
8 001 nits.
Re- rder point and safety inventory

Where a firm knows with certainty the number of units it uses or sells on a daily basis, the re-order point will
equa :
Aver ge lead time × Average daily usage,

where lead time is the number of days required for goods to be delivered.
Where uncertainty exists and a firm is unable to accurately determine the daily usage, it runs the risk of being
out of inventory and thus incurring the opportunity cost of lost sales and customers.
352
In such a situation, a firm will hold a safety inventory to counteract the possibility of being out of inventory.
The re-order point will in such a situation equal:
Average lead time × Average daily usage + Safety inventory.

The following illustrative example shows how a firm can determine the most economic level of safety inventory
that will maximise profits.
Example: Safety inventories

Company A is situated in Durban, while its supplier is in Johannesburg. The company has an agreement with
the supplier that all goods will be delivered within a period of ten days.
The daily demand for the product has been estimated by Company A as follows:
Daily demand 50 70 100 130 150
Probability 0,10 0,20 0,40 0,20 0,10
The estimated ‘stock-out’ cost is R10 per unit.
Holding cost is R2 per unit over the ten-day period.
Required:
Determine the most cost-effective level of holding saf ty inv ntories.
Solution:
The expected demand over the ten-day lead time is:
Usage R500 R700 R1 000 R1 300 R1 500
Probability 0,10 0,20 0,40 0,20 0,10
Average demand is thus 1 000 units, and the re-order point will be equal to average demand plus safety inven-
tory.
The following tabulation shows the stock-out cost versus the holding cost at various levels of safety inventory:
Expected
Average Safety Re-order Inventory- Inventory- Holding Total
Probability inventory-
usage inventory point out out cost cost cost
out cost
1 000 0 1 000 300 3 000 0,20 600 0
500 5 000 0,10 500 0
1 100 1 100
1 000 300 1 300 200 2 000 0,10 200 600 800
1 000 500 1 500 Nil Nil Nil Nil 1 000 1 000
In this example, the company should hold a safety inventory of 300 units to minimise its costs. It is important,
however, to unde stand that it is impossible in practice to assess the opportunity cost of lost future orders re-
sulting from dissatisfied customers. This cost could be considerably higher than the estimated stock-out cost
per unit.
Just in Time (JIT) inventory and manufacturing

The traditional manufacturing environment is symbolised by companies producing products in large batches
and with high set-up costs.
High inventory levels of raw materials, work-in-progress and finished goods are considered vital in order to –
satisfy customer demand;
avoid shutting down manufacturing facilities;
take advantage of discounts; and
hedge against future price increases.
353
High inventory levels of finished goods are seen as necessary to counteract the possibility of demand exceeding
supply, or possible machine breakdowns. Inventory is necessary as a buffer that provides customers and manu-
facturing facilities with the required products that may otherwise not have been available.
Technological advances in the last 10 to 15 years have been such that companies are now required to increase
product diversity, shorten product life-cycles, improve quality and lower production costs. Just in Time (JIT) is
best described as a management philosophy in pursuit of the elimination of all non-value- added activities to
reduce cost and time. JIT focuses on the principle that products should be pulled through the system by de-
mand, rather than pushed through, where workers are encouraged to manufacture as much as possible and
rewarded accordingly. JIT is a simple theory that is not easily applied in practice.
The main objection to JIT is the possibility of a problem occurring with the order of raw materials, production
or labour problems. It is therefore important, when a company uses such system, that all potential problems
are eliminated. It is necessary to redesign the production facilities so th t b tch size reduces to a single unit.
Labour needs to be able to handle a greater number of related tasks and w ste needs to be eliminated. Suppli-
ers are required to supply defect-free materials at the precise time that they are required. Recent non-
controllable events have led to a derivative form of JIT incorporating buffer or safety stock.
JIT process
JIT offers increased cost-efficiency and has the flexibility to resp and nd to cust mer demand for improved quality
variety. Quality, flexibility and cost-efficiency are the require ents for success in the international market.
JIT can only succeed where:
(i) Non -value-added activities are eliminated. The anufacturing of a product involves the cost of holding
raw materials in inventory; transferring those mat rials to production; queuing a batch for production;
transferring a product to inventory, and som tim s re-working a particular product. With the exception of
the manufacturing process (which adds value to a product), all other activities simply add cost.
JIT changes the production process by re-arranging the manufacturing facilities from a batch set-up to a
single product set-up. In other words, the ideal batch size is one unit. This requires companies to switch
from a departmental, functional layout with centralised stores, to a cellular manufacturing layout with
materials located next to the work area itself. Products manufactured are grouped into families of similar
products. These product families are then manufactured on a flow-line. For each product line, the ma-
chines required are arranged in a manner that reduces flow time and work-in- progress lead times. Pro-
ducts are produced with zero defect and are not returned to storage until they are complete. JIT directly
addresses plant layout, process design, quality standards and inventory. The plant layout must be simple
and efficient. No product is to be re-worked and inventory must be reduced to insignificant levels.
Zero inventory
Inventory is normally held to avoid being out of inventory, to take advantage of discounts, and as a
hedge against price increases. JIT requires that long-term contracts be negotiated with a few suppliers
that are located close to the manufacturing facilities and are able to offer quality and delivery. The bene-
fits from long-t rm contracts are –
l suppliers are s n as partners;
confiden e and trust are established;
p ices a e p e-negotiated and quality ensured;
order costs are reduced;
red ction in supplier base; and
c st of poor input material is reduced or eliminated.
The quest for zero defect
Defective products cost the company a lot of money, as the production flow is interrupted and re-
working is required. The need to eliminate defects is strongly emphasised and encouraged. Machines are
a so maintained on a preventative maintenance principle that encourages a zero break-down policy. The
nature of a pull-through philosophy means that there will be times when workers are idle. Workers are
encouraged and trained to carry out preventative maintenance on the machines under their control dur-
ing idle periods.
354
Producing the single unit

One of the problems of producing large batches is that products often have to be stored for long periods
of time at a high cost. By contrast, the production of small batches is expensive, due to the high cost of
setting up the machines, cleaning and re-setting for the next batch. JIT encourages a change in layout
that reduces set-up costs or totally eliminates them. As set-up time approaches zero, there is no ad-
vantage in producing large batches that are stored at a high cost. A system that is able to manufacture
one unit at a time is able to react more easily to changes in product specifications and demand.
Customer delivery service
Traditional systems encourage a high inventory holding to ensure that customers receive their products
on time. High inventory holding is also an insurance against the production faci ities breaking down for
whatever reason and causing an inventory shortage. The JIT solution is to reduce lead times. Shorter lead
times increase the company’s ability to meet a delivery date and lso to respond to changes in market
needs, thus improving competitiveness. Lead times are reduced by reducing set-up times, improving
quality and using cellular manufacturing. Research has shown that many companies have experienced a
reduction in lead time of up to 90% by implementing JIT manufacturing.
Accounting for JIT

JIT emphasises total quality control, total customer satisfaction, continuous improvement, cellular manufactur-
ing, zero inventory and employee involvement. Assuming that current anagement control systems were de-
signed to deal with traditional manufacturing systems, does it stand to reason that they are inappropriate for a
JIT system? Does the current management system in fact motivate behaviour that is not consistent with the JIT
philosophy?
Consider a conventional, standard costing system. It has been stated that efficiency reporting and variance
analysis are impediments to continuous improvement. For example, it is argued that the material price vari-
ance encourages low quality and large purchase quantities, in contravention of the JIT philosophy of quality-
control and zero inventory. As workers become more multi-disciplinary and are trained to do a variety of tasks,
labour standards become less meaningful. The labour efficiency variance encourages over-production, as
workers are rewarded for quantity, not quality. The materials usage variance provides an incentive for low
quality rather than total quality control. Currently attainable standards encourage inefficiencies instead of con-
tinuous improvement, zero inventories, total quality control and total preventative maintenance. It is argued
that pressure to meet standards will create dysfunctional behaviour.
Now consider the absorption costing system. It has been stated that managers who are rewarded on a profit
basis will seek to increase inventory rather than reduce it, as company profits increase as inventory levels in-
crease. In this situation, the accounting system will be in direct opposition to JIT. Traditional management ac-
counting systems have been criticised as they fail to report on important issues such as quality, lead times, reli-
ability or customer satisfaction.
The problem with conv ntional management accounting systems such as standard costing is not that they are
dysfunctional in relation to a JIT system, but that they can be a hindrance if used in an inappropriate manner.
JIT does not eliminate the need to plan a budget. In fact, it makes planning and budgeting easier and more
meaningful. However, it is important to understand that financial statements and standards are more relevant
to upper management than to line management.
Line management and workers should be motivated and rewarded more on qualitative and quantitative factors
such as n mber of nits required and the quality thereof, rather than on the financial cost aspects of whether JIT
is used. Standard costing systems have never been successful when used as the basis of employee rewards and
motivation, but they have enabled financial managers to identify possible problems that require investiga-ti n.
It is correct to argue that workers should be set standards, and that performance should be evaluated on sim-
ple non-financial measures that are directly related to what is being manufactured and provide effective feed-
back. Greater emphasis is required on control through direct observation, by training workers to monitor quali-
ty, production flow and set-up times.
355
Practice questions
Question 9–1 (Fundamental and Intermediate) 40 marks 60 minutes

Runswick Ltd is a company that purchases toys from abroad for resale to retail stores. The company is con-
cerned about its inventory management operations. It is considering adopting an inventory management sys-
tem based upon the EOQ model.
The company’s estimates of its inventory management costs are shown below:
Percentage of purchase cost of toys per year
Storage costs 3
Insurance 1
Handling 1
Obsolescence 3
Opportunity costs of funds invested in inventory 10
‘Fixed’ costs associated with placing each order for inventory are R311,54.
The purchase price of the toys to Runswick Ltd is R4,50 per unit. There is a two-week delay between the time
that new inventory is ordered from suppliers and the ti e that it arrives.
The toys are sold by Runswick at a unit price of R6,30. The variable cost to Runswick of selling the toys is R0,30
per unit. Demand from Runswick’s customers for the toys averages 10 000 units per week, but recently this has
varied from 6 000 to 14 000 units per week. On the basis of r c nt evidence, the probability of unit sales in any
two-week period has been estimated as follows:
Sales (units) Probability
12 000 0,05
16 000 0,20
20 000 0,50
24 000 0,20
28 000 0,05
If adequate inventory is not available when demanded by Runswick’s customers in any two-week period, ap-
proximately 25% of orders that cannot be satisfied in that period will be lost, and approximately 75% of cus-
tomers will be willing to wait until new inventory arrives.
Required:
Ignoring taxation, calculate the optimum order level of inventory over a one-year planning period using
the EOQ model (Fundamental)
2OD
EOQ =
H
Where: O is the fixed cost per order
D is the annual sales
H is the cost of carrying a unit of inventory per period expressed as a percentage of its pur-
chase cost multiplied by the purchase price per unit of inventory. (5 marks)
(b) Estimate the level of safety inventory that should be carried by Runswick Ltd. (9 marks)
If Runswick Ltd were to be offered a quantity discount by its suppliers of 1% for orders of 30 000 units or
m re, evaluate whether it would be beneficial for the company to take advantage of the quantity dis-
count. Assume for this calculation that no safety inventory is carried. (6 marks)
E timate the expected total annual costs of inventory management if the EOQ had been (i) 50% higher,
and (ii) 50% lower than its actual level. Comment upon the sensitivity of total annual costs to changes in
the economic order quantity. Assume for this calculation that no safety inventory is carried. (7 marks)
Discuss briefly how the effect of seasonal sales variations might be incorporated within the model.
(5 marks)
(f) Assess the practical value of this model in the management of inventory. (8 marks)
ACCA
356
Solution:
Expected demand per two-week period
Sales Probability Total
12 000 0,05 600
16 000 0,20 3 200
20 000 0,50 10 000
24 000 0,20 4 800
28 000 0,05 1 400
20 000
Annual demand 20 000 × 26 (two-week periods) = 520 000 units

Holding cost per unit = 18% × R4,50 = R0,81
Percentage holding cost = 3% + 1% + 1% + 3% + 10% = 18%
Economic order quantity
2 × 520 000 × 311,54

EOQ =
0,81
20 000 units
The EOQ is 20 000 units. The lead time is two w ks, which means that if weekly demand remained con-
stant at the average usage of 10 000 units per w k, the re-order point would be 20 000 units, and inven-
tory would be replenished when the inventory l v l had fall n to zero.
However, as demand varies between 12 000 and 28 000 units per two-week period, there is a 25%
chance that a stock-out will occur.
Holding costs per unit per week

R0,81 ÷ 52 = R0,01558
As the lead time is two weeks, the holding costs per unit over this period would be
R0,01558 × 2 = R0,03116
Stock-out cost per unit

R6,30 – R4,50 – R0,30 = R1,50
Optimal safety inventory (2-week period)

Expected
Safety Re-order Stock- 25% Stock-out Holding Total
Probability stock-out
Stock point out stock-out cost cost cost
cost
0 20 000 4 000 1 000 1 500 0,20 R300 R0
8 000 2 000 3 000 0,05 R150 R0
R450 R450
4 000 24 000 4 000 1 000 1 500 0,05 R75 R125 R200
8 000 28 000 0 0 0 0 0 R249 R249
Recommended level of safety inventory is 4 000 units.
(c) Purchase saving 520 000 units per annum × R4,50 × 1% = R23 400
Savings in order costs
Order costs at an EOQ of 20 000 units
= 520 000 ÷ 20 000 = 26 orders × R311,54 = R8 100,04
Order costs at an order level of 30 000 units
= 520 000 ÷ 30 000 = 17,333 × R311,54 = R5 400,03
Saving in order costs = R8 100,03 – R5 400,02 = R2 700
357
Holding costs
Holding cost at 20 000 unit order
10 000 average inventory × R4,50 × 18% = R8 100
Holding cost at 30 000 unit order
Revised purchase price = R4,50 × 99% = R4,455
15 000 average inventory × R4,455 × 18% = R12 028
Incremental holding cost = R12 028 – R8 100 = R3 928
Overall saving
R23 400 + R2 700 – R3 928 = R22 172
It would therefore be beneficial to take advantage of the quantity discount.
Total relevant costs would be as follows:

50% higher (30 000 units) = R0,81 × (30 000 / 2) + R311,54 × (520 000 / 30 000)
= R17 550
50% lower (10 000 units) = R0,81 × (10 000 / 2) + R311,54 × (520 000 / 10 000)
= R20 250
Original EOQ (20 000 units) = R0,81 × (20 000 / 2) + R311,54 × (520 000 / 20 000)
= R16 200
Total annual costs are 8,3% higher than the original EOQ at the 30 000 units order level, and 25% higher
at the 10 000 units order level. Therefore, inventory management costs are relatively insensitive to sub-
stantial changes in the EOQ.
It would be necessary to establish seasonal periods where sales are fairly constant throughout each peri-
od. A separate EOQ would then be established for each distinct season throughout the year.
The EOQ model is a model that enables the costs of inventory management to be minimised. The model
is based on the following assumptions:
1 Annual demand for the inventory item is known and constant over the period.
2 There is no time-lag between the placing of the order and the arrival of the inventory.
3 The purchase price remains constant.
4 The cost of ordering can be quantified and is constant regardless of order size.
5 The cost of holding one unit of inventory per period is constant.
Recently, some compani s have adopted Just in Time (JIT) purchasing techniques, enabling them to nego-
tiate reliable and fr qu nt deliveries. This has been accompanied by the issue of blanket long-term pur-
chase orders and a substantial reduction in ordering costs. The overall effect of applying the EOQ formula
in this situation ties in with the JIT philosophy, that is more frequent purchases of smaller quantities.

Beach is a wholly-owned subsidiary of Adams and currently depends entirely on Adams for any necessary
finance.
Adams, h wever, has its own cash-flow problems and cannot permit Beach temporary loan facilities in excess of
R50 000 at any time, even though the business of Beach is highly seasonal and is in a period of growth.
358
Beach has just prepared its cash budget for the year ahead, details of which are as follows:
All figures are in R’000s

Month 1 2 3 4 5 6 7 8 9 10 11 12
Debtors’ payments 230 250 120 50 60 75 80 90 110 150 220 320
Dividend on investment 45
Cash inflows 230 250 120 50 60 75 125 90 110 150 220 320
Payments to creditors 80 80 88 88 88 92
Wages and other expenses 102 77 58 103 79 59 105 80 62 108 83 63
Payments for fixed assets 70 10 15 5
Dividend payable 80
Company tax 120
Cash outflows 102 157 138 253 89 147 120 168 182 196 88 155
Net in or (out) 128 93 (18) (203) (29) (72) 5 (78) (72) (46) 132 165
Bank balance/(overdraft)
Opening 30 158 251 233 30 1 (71) (66) (144) (216) (262) (130)
Closing 158 251 233 30 1 (71) (66) (144) (216) (262) (130) 35

Two months’ credit (on average) is granted to d btors.
Production is scheduled evenly throughout the y ar. Y ar- nd inventory of finished goods are forecast to be
R114 000 higher than at the beginning of the year.
Purchases of raw materials are made at two -monthly intervals. Three months’ credit, on average, is taken
from suppliers.
The capital expenditure budget is as follows:
New equipment for planned production Month 4 R70 000
Routine replacement of motor vehicles Month 5 R10 000
Progress payment on building extensions Month 6 R15 000
Office furniture and equipment Month 11 R5 000
Required:
Review this information and advise the management of Beach on possible actions it might take to improve its
budgeted cash-flow for the year and avoid any difficulties that can be foreseen.
Solution:
It should be fairly lear from the figures in the question that Beach has a very serious cash-flow problem, and
that there are no easy or ready- made solutions to the problem. One might think that the question ought to be
answered by w iting down brief ideas about what should be done and then producing a revised cash-flow fore-
cast with an ove d aft limit never higher than R50 000. It would probably be more appropriate, however, to
discuss vario s options at some length, suggest whether these options might work, and then (if there is time),
re-draft a cash b dget to see whether Beach’s problems would be overcome.
It w uld seem that Beach relies entirely on Adams for finance, and so cannot raise money from a bank loan or
overdraft. The maximum loan from Adams is R50 000, but the cash budget projects an ‘overdraft’ of up to R262
000 (m nth 10).
359
Beach would appear to be profitable and growing. A very rough estimate of profits in the year could be made
by preparing a sketchy funds flow statement in reverse.
R’000
Increase in bank balance (35 – 30) 5
Increase in finished goods inventory 114
Net increase in debtors and raw materials
inventory less creditors X
Purchases of fixed assets (70 + 10 + 15 + 5) 100
Dividend paid 80
Tax paid 120
419 + X
Less: Depreciation Y
Profit before tax 419 + X – Y
A combination of seasonal business, growth in trading and fixed asset purchases would appear to be the reason why
Beach is only expected to increase its cash balance by R5 000 ver the whole year, in spite of these profits.
The options for reducing the overdraft which might be possible are:
(a) Do not pay the dividend to Adams in Month 3. However, Ada s is short of cash, and is probably relying on
the dividend income. It would therefore seem likely that Ada s would agree either to cancel the divi-dend
or to lend more than R50 000.
Delay the payment of company tax from Month 9. The SARS might allow Beach to do this, although there
may be a penalty ‘interest’ charge for the delay.
Inventory control. The total quantity of finished goods is unknown, but inventory levels will rise by R144
000 in the year. Clearly, the increase in inventory is expected because of the company’s sales growth.
However, some reductions in the investment in inventory might be possible without prejudice to sales, in
which case the cash-flow position would be eased by the amount of the value of the stores re-duction.
Creditors’ control. Three months’ credit is taken from suppliers, but raw material purchases are every two
months. The credit period already seems generous, and some suppliers are probably making a second de-
livery of materials before they are paid for the first. Taking longer credit would be difficult to negotiate.
However, if Beach is on very good terms with its suppliers, and is a valued customer of those suppliers, it
might be possible to defer payment of amounts payable in Month 6, 8 and 10 by a further one month,
which covers the cash-crisis period.
Debtors’ control. Two months’ credit is allowed to customers. If all sales are on credit, customers are like-
ly to be commercial or industrial buyers, who expect reasonable credit terms. A shortening of the credit
period is probably not possible without damaging goodwill and sales prospects, unless an incentive is of-
fered for early paym nts in the form of a discount. The discount would have to be sufficiently large to
persuade ustomers to take it. Suppose, for example, that from Month 5’s sales onwards, a 10% discount
were offered for payments inside a month. (10% would be very generous and unrealistic perhaps, but is
used he e for illust ation). If all customers accepted the offer, this would affect cash flows from Month 6
on, as follows:
Original Revised Net
Month
budget budget change
R’000 R’000 R’000
6 75 + (90% of 80) 147 + 72
7 80 – 80 + (90% of 90) 81 +1
8 90 – 90 + (90% of 110) 99 +9
9 110 – 110 + (90% of 150) 135 + 25
10 150 – 150 + (90% of 220) 198 + 48
11 220 – 220 + (90% of 320) 288 + 68
12 320 ? ? ?
The effects on cash flow would then be substantial, although the cost of the discounts would reduce prof-
its by a substantial amount too.
360
Postponing capital expenditure. Since the company is growing, the option to postpone capital expendi-
tures on new equipment, building extensions and office furniture is probably unrealistic. The routine
replacement of motor vehicles should be deferred, but this would only ease the cash situation by R10
000.
Beach has an investment which will pay a dividend of R45 000 in Month 7. This is obviously a fairly large
investment. If Beach’s cash-flow problems are insuperable by any other means, the company’s Directors
might have to consider whether this investment could be sold to raise funds.
Summary:
Beach is a profitable company, but is faced with serious cashflow problems which would seem to be difficult
to overcome without drastic measures being taken. Because Beach is profit ble, closure of the company is
unthinkable, and it would be against the company’s long-term interests to b ndon its plans for growth. Adams
is acting as a serious constraining influence on Beach.
However, the sort of radical action and response outlined above for debtors, coupled with a postponement of
the tax payment by three months or so, and a deferral of R10 000 in m t r vehicle purchases until next year,
would be virtually sufficient to overcome the firm’s cash-flow pr blems in the year, with a slight problem still in
Month 8 – see workings below.
Month
5 6 7 8 9 10 11 12
Postpone purchase of vehicles 10
Defer tax payment 120 (120)
Discounts for early payment
by debtors – possible effect 72 1 9 25 48 68 ?
Change 10 72 1 9 145 48 68 ?
Cumulative change 10 82 83 92 237 285 353 ?
Original cash budget 1 – 71 – 66 – 144 – 216 – 262 – 130 35
Revised cash budget balances 11 11 17 –52 21 23 223 ?
If Beach is to overcome its problems within the constraints set by Adam’s financial policy, it is likely that action
on debtors is the key to a practical solution.

Squeezy Toys Ltd manufactures toys which it sells to the retail market. It has been expanding very rapidly and
has been forced to use expensive overdraft financing for most of its working capital needs. The annual
overdraft rate paid by the company is 18%. In order to relieve the need for overdraft financing and to improve
profitability, the manag m nt accountant has prepared a package of proposals. You have been asked to eval-
uate the proposals and have b n presented with the following information:
Extract from the statement of financial position as at 31 December 20X2

Current assets R
Inventory: Raw materials (the raw materials comprise 40% of the total cost of sales) 3 408 000
Work-in-progress 4 260 000
Finished g ds 12 780 000
Current liabilities
Trade payables (purchases on credit average 50% of the total cost of sales) 4 260 000
Extract from the statement of comprehensive income for the year ended 31 December 20X2
Sa es 2 85 200 000
Cost of sales 51 120 000
Notes:
Trade receivables
10% of the sales are cash sales to retailers with poor payment records. The balance of the sales are on
credit. At present, bad debts amount to 5% of the credit sales (on average). No discounts are offered.
361
Sales
Although the company has been expanding rapidly, it does not anticipate any growth in sales quantities
in future at the current selling prices.
In an effort to improve the profitability and liquidity of the company, the management accountant has
put forward the following proposals and related estimates:
l Enter into an agreement with the suppliers of raw materials to shorten the lead time for delivery of raw
materials. This would have the effect of decreasing the average raw material holding period by 75%. In
return, these suppliers will insist on payment within 30 days.
l Improve production scheduling at an annual cost of R320 000, which wi result in a decrease of 75%
in the work-in-process cycle.
Improve the inventory handling system at an annual cost of R480 000, which will result in the
finished goods inventory turnover rate trebling.
Employ an additional debtor’s clerk at a salary of R180 000 per annum to improve the collection of
receivables. At the same time, offer a discount of 3% f r payment within ten days and try to enforce
a 30-day payment period for customers not taking advantage f the discount. Customers who were
previously paying cash will be allowed to pay within ten days – these customers will not be granted
any early settlement discount however. The anticipated effect of this will be as follows:
– Sales should increase by 1% as a result of the discount offered.
A further 20% of customers will take advantage of the discount and pay on the tenth day after pur-
chase.
– The bad debts will decrease to 3% of the total sales.
– The rest of the customers will pay as follows:
Payment on the 30th day after purchase: 55%
Payment on the 60th day after purchase: 12%
Required:
Evaluate the effect on profitability and liquidity of adopting all the recommendations of the management
accountant. Use a 360-day year in your calculations, and assume a tax rate of 28%. (34 marks)
Squeezy Toys Ltd has traditionally paid dividends based on a cover of three times. Management has
decided to increase the cover to five times due to the current troubled financial times. Based on the old
working capital and historical dividend polices versus the new working capital and dividend policies, illus-
trate the impact on Squeezy Toys Ltd. (6 marks)
Companies frequently have large amounts of capital invested in net working capital. Reducing the work-
ing capital cycle can r duce this investment. Discuss ways in which the working capital, with specific ref-
erence to debtors, work-in-progress and creditors, can be reduced, and the advantages and disad-
vantages of such a reduction. Your discussion should be brief and done under the headings: ‘Strategy’
and ‘Effect of strategy’. (10 marks)
(Rhodes Unive sity: adapted)
362
Solution:
(a) Reconstruction for No Days 20X2 20X3 Change
year ended/ending 0 1 assumptions
31 December R R R
Sales(85 200kx 1,01) 85 200 000 86 052 000 852 000 (1)
Cost of sales 60,00% (51 120 000) (51 631 200) (511 200) Assume same GP% (1)
Gross profit 34 080 000 34 420 800 340 800 (1)
Bad debts 5, 11 (3 834 000) (2 581 560) 1 252 440 (1)
Production 8 0 (320 000) (320 000) (1)
scheduling
Improve inventory
handling system 0 (480 000) (480 000) (1)
Debtors clerk 0 (180 000) (180 000) (1)
Debtors discount 0 (516 312) (516 312) (1)
PBIT 12 30 246 000 30 342 928 96 928 (1)
Interest saving (C1) 4 691 732 Assume stay in (1)
@ 18% overdraft
PBT 4 788 660
Taxation @ 28% (1 340 825) Assume has taxable (1)
income (Any tax)
PAT 3 447 835
(Refer to calculation 11)
Debtors Debtors Sales

balance
Total sales increase by 1%
(all now on credit) 86 052 000
To receive discount 20% of sale 478 067 10 17 210 400
Bad debts 3% of total sales 2 581 560 360 2 581 560
Sales to debtors with poor
payments record 10% of sales ½ each max 
239 033 10 8 605 200
Pay on 30th day 55% 3 944 050 30 47 328 600
Pay on 60th day 12% 1 721 040 60 10 326 240
Ave debtor 8 963 750
Change in wo king Balance Balance

capital: 2008 2009
Trade receivables 11 22 365 000 8 963 750 13 401 250 Inflow (1)
Raw materials (25%) 6 3 408 000 852 000 2 556 000 Inflow (1)
WIP (25%) 9 4 260 000 1 065 000 3 195 000 Inflow (1)
Finished g ds(x4/12) 10 12 780 000 4 260 000 8 520 000 Inflow (1)
Trade payables
relating to raw
material purchases 7 * 3 408 000 1 704 000 (1 704 000) Outflow (1)
Other (3 408+852) 11  852 000 852 000 0 No change (1)
25 968 250
Effect on cash flow 29 416 085 Improvement (1)
363
Calculations
1 C1 Interest assume stay

in overdraft 4 691 732 Interest @ 18%
On R26 065 178

(25 968 250+ 96 928) ×
18%)
Creditors
Total credit 50% of total
COS (R51,12m) (25 560 000)
Current creditor payment (1)
days = 4 260 000 / credit 60,00 (1)
purchases
Creditors’ balance 4 260 000 (1)
*
3 WIP 4 260 000
4 Finished goods
Current inventory days 90,00
Turnover (times per 4,00
year) [Given]
[51 120 ÷ 12 780]
5 Debtors 22 365 000
Sales 85 200 000
Cash sales 10% 8 520 000
Credit sales 105,00 76 680 000
Bad debts 5% of credit
sales 3 834 000
Effect of supplier R R
agreement
6 Shorten delivery time of
raw material purchases
Holding period and
investment reduced by 2 556 000
75% (R3 408 000 × 0,75)
7 Creditor balance relating
to raw material purchas s 3 408 000
Current creditor days 60,00
Now: 30,00
Effect on ash flow (1 704 000)
8 Production scheduling – (320 000)
Cost
9 WIP Cycle Holding period
and Investment reduced 3 195 000
by 75% (4 260 000 × 0,75)
10 Invent ry Finished goods (480 000)
– Co t
Turnover trebling New bal 4 260 000
(i.e. now 12 times) Old bal 12 780 000 8 520 000
364
11 Debtor
Clerk – Cost (180 000)
Debtor Sales
balance
Total sales increase by
1% (all now on credit) 86 052 000 852 000
To receive discount 478 067 10 17 210 400 (516 312) Not assume previous
20% of sale Sales re
Bad debts 3% of total
sales 2 581 560360 2 581 560 1 252 440 Decrease
Sales to debtors with
poor payment record ½ each
10% of sales 239 033 10 8 605 200 Max 
Pay on 30th day 55% 3 944 050 30 47 328 600
Pay on 60th day 12% 1 721 040 60 10 326 240
Ave debtor balance 8 963 750 13 401 250 Decrease
Increase in cost of
sales due to 1%
increase in sales (511 200)
Increase in cash flow
26 065 178 for next year
Max 34
Improving cash flow

For every R3m (assumed) in existing profit after tax, a change in cover from 3 to 5 will decrease the
dividend (R1m to R0,6m) by 40%. (2)
This impact will also apply to the additional profit (R3,4m) generated by the new policy and will be
sustainable for as long as the high cover is retained. (2)
The working capital has resulted in a net improvement of R29,4m in cash flow; this is however a
once-off improvement which will not be sustainable to the same extent. (2)
Max 6
Reduction of net working capital
Category Strategy Effect

Debtors l Off r discounts Reduces profitability (2)
l Strict r credit policy May lose sales (2)
l Switch to cash sales Improve cash flow (2)
Clients may not afford this and fall away (1)
W-I-P l Delivery Just in Time May have stock-out (2)
l Build time lag in process May lose order/customers (2)
Creditors l Extend payment period Lose discount, get higher price (2)
l Supply JIT Production schedules must match, higher cost? (2)
Interruption impact (1)
Max 10
365

Buyers Incorporated Limited (BIL) trades in the retail clothing sector and is listed on the general retail sector of
the JSE Securities Exchange SA. The company focuses on the youth market. Their unaudited results for the year
ended 31 August 20X9 are shown below:
Statement of comprehensive income for the years ending 31 August

20X9 20X8
Note
R’000 R’000
Turnover 1 613 450 528 836
Cost of sales 364 340 310 916
Opening inventory 140 820 135 800
Purchases 2 373 870 315 936
Closing inventory (150 350) (140 820)
Gross profit 249 110 217 920

Operating expenses 199 370 175 050
Operating profit 49 740 42 870
Dividend received 5 3 000 3 000
Finance charges (net) 3 (3 640) (6 210)
Profit before tax 49 100 39 660
Taxation 4 16 115 13 950
Profit after tax 32 985 25 710
Number of issued shares 50 000 000 50 000 000

Closing share price (cents) 840 560
Dividends (cents per share)
Interim – paid 10 10
Final – paid – 10
Statement of financial position at 31 August
Assets
Non-current assets 5 189 760 202 020
Current assets 284 415 258 190
Inventory 150 350 140 820
Cash balances and investments 108 835 100 850
Total assets 474 175 460 210
Equity and liabilities

Equity 7 175 745 147 760
Share capital and premium 71 000 71 000
Accum lated reserves 104 745 76 760
Non-current
liabilities L ng-term l 6 100 000 120 000
an Current liabilities 198 430 192 450
Trade payables 184 960 176 025
Other payables and provisions 13 470 16 425
Total equity and liabilities 474 175 460 210
Notes
60% of the turnover in 20X9 was cash sales, down from 70% in 20X8. Management has taken a conscious
decision to extend their credit facilities, as they believe that is the future growth area. The intention is to
bring cash sales down to a 50% level from 20X0 onwards.
366
All inventory purchases are made on credit.

Finance charges are made up as follows:
R’000
Interest paid on long-term loans (Note 6) 13 000
Interest paid – other 452
Interest received (9 812)
3 640
The company tax rate is 28%. STC is provided at 10%. No STC credits were brought forward from 20X8.
As part of its strategy and youth focus BIL took up 18% of the shares in Music Distributors Ltd (MDL). MDL
owns a CD manufacturing press and several music retail outlets. BIL h s been receiving dividends from this
investment for the last four years. The investment is included in non-current assets.
6 The R5 long-term loan bears interest at prime plus 2%. All interest is paid up to date. On
1 September 20X8, R20 million of the loan was repaid.
BIL has a stated return on equity of 16% per annum.
The budgeted turnover for 20X10 is R705 550 000.
9 Prima Ltd is a major player in the retail clothing sector. Pri a Ltd’s shares currently trade on the JSE Secu-
rities Exchange SA at 12 000 cents per share and a P/E ratio of 15. Prima Ltd’s earnings have grown at 20%
per annum over the last ten years.
The average PE for the general retail sector on the JSE S curities Exchange SA has come down from 14,8 on
31 May 20X9 to 11,6 on 31 August 20X9.
Required:
Assess Buyers Incorporated Limited’s performance in respect of –
(i) profitability (8 marks)
(ii) financial structure. (2 marks)
The final dividend for 20X9 has not yet been declared. Assume the dividend cover for 20X8 remains intact
for 20X9. Calculate the final dividend per share for 20X9. (Round to the nearest cent). (5 marks)
Use your answer for (b) above, linked to the question information, to calculate the additional STC as a
result of the final dividend. (5 marks)
Buyers Incorporated Ltd generates a fair amount of cash per annum. Recommend with supporting moti-
vation, two uses for the cash balances held by Buyers Incorporated Ltd. (4 marks)
(e) Evaluate Buy rs Incorporat d Ltd’s share assessment. (4 marks)
Estimate the additional working capital required to support the increased sales budgeted for 20X10.
(8 marks)
Prima Ltd has publicly offered the shareholders of Buyers Incorporated Ltd 8 (eight) Prima shares for eve-
ry 100 sha es held in Buyers Incorporated Ltd. Advise the shareholders of Buyers Incorporated Ltd as to
the reasonability of the offer. List all issues to be considered. (10 marks)
(h) List the specific factors that make Buyers Incorporated Ltd attractive for take-overs. (4 marks)
367
Solution:
(a) (i) Profitability
20X9 20X8
249 110 217 920
Gross profit %
613 450 528 836
= 40,6% = 41,2% (2)
49 740 42 870
Operating profit %
613 450 528 836
= 8,1% = 8,1% (2)
32 985 25 710
Net profit %
613 450 528 836
= 5,4% = 4,9% (2)
613 450 – 528 836
Change in turnover (1)
528 836
PAT
= 16,0% (1)
Return on equity = Equity
Ratios max 5
Turnover increased by more than inflation targ t range which is acceptable (industry growth?). (1)
l Although GP margin weakened, the operating margin is unchanged. (1)
l Net profit improved as a result of much lower finance charge – due to interest earned. (1)
l Bulk of the profit will be of a cash nature, which lowers risk profile. (1)
Max 8
(ii) Financial structure
l Debt to equity improved [or for calc]. (1)

l In terms of book values fairly secure as debt only (100/275) 36%. (1)
l WACC will be between 9,36% (cost of debt) and 16% 13m
(cost of equity). × 0,72 (2)
100m
[General comment without %’s = 1]
= 9,36%
or
Prime (10,5%+2%) × 0,72
= 9%
In te ms of market values, market capitalisation is 50m × 8,40 = 420m with low debt, thus debt
to equity will decline.↓ (2)
Debt Equity D:E Max 2
31/08/X8 120 280 0,43
31/08/X9 100 420 0,23
31/08/09 100 420 0,23
20X8
Earnings per share 25 710
000
51,4 cps (1)
Total dividend 20,0 cps [Rounding will cause

declared ∴ Cover 2,6 times difference below] (1)
2,57
368
20X9
Earnings per share 32 985
50 000
= 66,0 cps (1)
Cover 2,6 times
Total dividend [OR R12,3m] 25 cps OR R12 500 000 (1)
Interim dividend [R7,83m] 10 cps
Final dividend 15 cps OR R 7 500 000 (1)
5
(c) Dividends – ordinaries (25c × 50m) OR [12,69] 12 500 000 [m rk for b number] (1)
Dividends received (3 000 000) (1)
9 500 000
STC @ 10% 950 000 [mark for 10% calc] (1)
Tax per I/S 16 115 000
Company tax 29% × 49 100 000 13 748 000 (1)
Already provided 2 367 000
Overprovided 1 417 000 (1)
5
Note: STC is now replaced by Dividends Tax at 15%. Investigate the use of STC credits in the new
dispensation.
(d) l Buyback of shares (1)

– Shares to be bought on open market will support/improve share price; shares held can be used for
corporate transactions, for example take-over, incentive scheme; form of dividend payment
to sellers (1)
l For corporate transaction, for example take-over, investment, expansion (1)
– Cash is a good bargaining tool; BIL already has investment showing returns, niche market (1)
l Repayment of capital (1)
– Strong balance sheet, continued profitability and cash generation (1)
l Dividend payout already low – paying high dividend (1)
l Special divid nd only when attacked (1)
l Stick to long-term loan repayment terms (1)
∴ Market assessment fair to good Max 4
(e) 2009 2008

l Earnings per share (per b) (1) 66,0 51,4
Share price (2) 840 560
PE ratio (2 ÷ 1) 12,7 10,9 (1)
B k value per share (cps) 351 296 OR (1)
Market to book (840 ÷ 351) (560 ÷296) 2,4 1,9 (1)
l Share price (closing) rose by 50% due to favourable history and prospects (1)
PE ratio slightly ahead of sector average (1)
Market to book ratio however not too high, although increasing (1)
∴ Market assessment fair to good Max 4
369
Working capital requirement:

Trade receivables (debtors) 25 230
Credit sales 613 450 × 40% 245 380
Ratio 25 230 / 245 380 = 10,3% (1)
New credit sales 705 550 × 50% 352 775 (1)
Increased debtors (352 775 – 245 380) × 10,3% = 11 061 (1)
Inventory:
Current ratio (150 350 / 613 450) = 24,5% (1)
Increase (705 550 – 613 450) × 24,5% = 22 564 (1)
Cash:
(Cash profit % (a(i))5,4% (1)
Profit retained (66 – 25) / 66 = 60% (1)
∴ Additional 92 100 × 5,4% × 0,6 = 2 984 (1)
Creditors:
Ratio 184 960 / 613 450 = 30,1% (1)
Additional 92 100 × 30,1% = (27 722) (1)
Net working capital 8 887 (1)
Max 8
Advice should deal with an improvement or not for BIL

shareholders. To be considered:
Share value: 8 × 12 000 → 100 × 840 OR R1,20 per share
OR R120
96 000 → 84 000 = 12 000 Cents (2)
P/E ratio: 15 → 12,7 + (1)
EPS: 6 400 → 6 600 – 214 (1)
Growth: 20% → 16% + (1)
Unknown
l Is Prima Ltd a strategic investment choice for BIL shareholders? (do they want out of BIL?) (1)
l Dividend policy of Prima Ltd (1)
l Underlying asset value of Prima Ltd (1)
l Value of BIL’s investment (1)
l How sustainable are the growth rates/cash flows (1)
l Synergi s to be cr at d by such a take-over (1)
Offer is reasonable BUT (1)
The offer be omes a choice between the capital value in Prima Ltd versus the earnings
(dividends) generated by BIL and the needs of the individual shareholder (3)
Max 10
(h) Specific factors
l Cash balances / cash generation (1)
l Access to debt or good (low) gearing (1)
l Low number of issued shares (1)
Growth (1)
l Profitability (1)
l Niche market (1)
l Low share price / PE (1)
Max 4
370
Question 9–5 (Advanced) 100 marks

Kasbian Ltd (‘Kasbian’) operates steel foundries in the Gauteng Province of South Africa. The manufacturing
processes involve melting scrap steel and other alloys in furnaces and then pouring the melted product into
casting moulds. Thereafter the resultant castings are cleaned and heat-treated. Castings produced by Kasbian
include pumps, valves and pipes, which are supplied to mining customers who use these products in platinum
and gold mining operations.
Scrap steel is purchased from various scrap metal dealers in Gauteng. Scrap steel prices vary according to the
quality of the material and the prevailing steel commodity prices. Scrap metal dealers supply the South African
market and also export to foreign customers. They determine the selling price of scrap steel in US dollars and
then convert this into Rand, based on the exchange rate on the date of sale to South African customers. Scrap
steel prices increased in 20X7 and 20X8 due to the high demand for steel glob lly.
Listing on the Johannesburg Securities Exchange

Kasbian listed on the Alternative Exchange (AltX) of the Johannesburg Securities Exchange in October 20X6. The
company raised R50 million prior to listing through a private placement f two million shares with a par value of
1c each, issued at a premium of R24,99 per share. Upon listing, Kasbian had ten million shares in issue. At the
end of October 20X6 the share price had increased from the listing price of R25 per share to R27 per share.
Acquisition of Solar Foundries (Pty) Ltd

Kasbian acquired the business of Solar Foundries (Pty) Ltd (‘Solar Foundries’) as a going concern with effect
from 1 October 20X7 for a purchase consideration of R49 900 000. Kasbian settled the purchase price through
a cash payment of R40 million and the issue of 360 000 shar s at the prevailing market price of R27,50.
Goodwill arising on the purchase of Solar Foundries amounted to 17 500 000. On 1 October 20X7 Kasbian
obtained a R40 million loan from RBZ Bank to fund the cash portion of the purchase consideration. The loan
from RBZ Bank is repayable annually in arrears in four equal instalments. The first instalment of R13 587 727,60
was paid on 30 September 20X8. The loan bears interest at a fixed rate of 13,5% per annum.
Global economic crisis

The global economic crisis in late 20X8 precipitated a slowdown in consumer demand. Mining output dropped
in the fourth quarter of 20X8 and this trend has continued in 20X9. Steel commodity prices declined as demand
for this base metal product decreased among most industrialised nations.
While gold mining production declined during the period October 20X8 to September 20X9, the gold price has
risen during this period mainly as a result of the perception of gold as a ‘safe haven’ investment. Unfortunately
the platinum mining sector did not escape as lightly as the gold mining industry. Platinum is used mainly in the
automotive and jewellery industries and there was a significant decline in demand for this precious metal dur-
ing the past year, which has led to a decline in platinum mining activities.
Kasbian’s revenue for the y ar nded 30 September 20X9 dropped by 36% from the prior year, as the lower
mining production translated into lower demand for castings.
371
Trial balances
The trial balances of Kasbian for the financial years ended 30 September 20X8 and 20X9, together with explan-
atory notes, are set out on the next page.
Kasbian Ltd Trial Balances at 30 September
20X9 20X8
Notes Dr Cr Dr Cr
R’000 R’000 R’000 R’000
Revenue – South African customers 2 144 000 240 000
Revenue – exports 2 67 200 90 000
Cost of sales 188 304 223 916
Opening inventories of finished goods and raw materials 5 69 630 49 936
Scrap steel purchases 3, 7 98 880 152 475
Other raw material purchases 7 15 960 21 535
Direct labour expenses 8 37 500 41 250
Electricity 9 15 444 14 850
Depreciation: Manufacturing plant and equipment 6 100 6 000
Other overheads 6 500 7 500
Closing inventories of finished goods and raw materials 6 61 710 69 630
Other income 11 650 3 250
Selling and administrative expenses 34 900 38 600
Retrenchment costs 8 1 800 –
Depreciation: Non-manufacturing equipment 2 180 2 200
Interest paid: RBZ Bank 4 295 5 400
Interest on bank overdraft 3 616 2 450
Normal income tax 0 16 992
Secondary tax on companies 0 1 500
Net loss/profit for the year 23 245 42 192
Share capital 104 104
Share premium 59 876 59 876
Retained earnings – beginning of the year 78 801 51 609
Dividends declared 12 15 000
Loan from RBZ Bank 22 520 31 812
Trade payables 13 25 729 16 686
Tax owing to SARS 0 5 748
Shareholders for dividends 0 15 000
Bank overdraft 14 40 614 17 500
Plant and equipment 15
Furnaces, moulding lin s and oth r manufacturing
equipment 72 600 75 500
Non-manufacturing equipment 15 520 16 500
Goodwill 17 500 17 500
Inventory
Finished goods 42 570 52 080
Raw materials 19 140 17 550
Other receivables 2 350 2 250
Cash and cash equivalents 0 750
227 644 227 644 240 527 240 527
Notes
The above trial balances do not include any adjustments and entries to appropriately account for the im-
pairment of assets (IAS 36) and financial instruments (IAS 39). No provisions have been raised against in-
ventories either. Any such entries are processed after year-end for the purposes of Kasbian’s annual re-
ports.
372
2 Tonnages of castings sold and related sales prices are summarised in the table below:
20X9 20X8
Tonnes of castings sold
South African customers 30 000 40 000
Export customers 12 500 15 000
Average price per tonne sold
South African customers R4 800 R6 000
Export customers US $640 US $750
Exchange rates US $1 = ZAR
Average rate during the financial year R8,40 R8,00
Exchange rate at year end R7,70 R8,05
Kasbian experienced increased competition from certain Chinese foundries in the latter part of the 20X9
financial year. These Chinese foundries targeted Kasbian’s international customer base and offered them
discounted prices to secure their business.
Kasbian entered into a two-year supply agreement with EDC Scrap Metal (Pty) Ltd (EDC Scrap Metal) with effect
from 1 October 20X7. The company undertook to purchase a minimum of 15 000 tonnes of scrap steel annually
from EDC Scrap Metal at a fixed price of US $350 per tonne (to be invoiced in rand, based on the prevailing
exchange rate at the date of supply). EDC Scrap Metal is a South African based company. Kasbian entered into
the agreement in 20X7, as it was concerned about escalating scrap steel prices.
Manufacturing volumes and utilisation of raw mat rials during the 20X8 and 20X9 financial years are
summarised below:
20X9 20X8
Tonnes Tonnes
Finished goods (castings) manufactured 40 000 60 000
Raw materials used in manufacturing processes 40 000 60 000
Scrap steel purchased from EDC Scrap etal 12 500 13 500
Scrap steel purchased from other local suppliers 23 500 40 500
Other raw materials 4 000 6 000
Manufacturing volumes were evenly spread throughout the 20X8 financial year. In the 20X9 financial
year, Kasbian manufactured 13 000 tonnes of castings in the first quarter and 9 000 tonnes in each of the
next three quarters.
5 Opening inventories comprised the following:
20X9 20X8
Tonnes Tonnes
Scrap steel: EDC S rap Metal 1 500 0
Scrap steel: Other lo al s rap steel suppliers 3 700 6 700
Other aw mate ials 600 700
Cost of opening inventories per tonne R R
Scrap steel: EDC Scrap Metal 2 800 0
Scrap steel: Other local scrap steel suppliers 3 000 2 780
C st f inventories reflected in trial balances
Scrap teel: EDC Scrap Metal 4 200 0
Scrap teel: Other local scrap steel suppliers 11 100 18 626
69 630 49 936
373
6 Closing inventories comprised the following:

20X9 20X8
Tonnes Tonnes
Scrap steel: EDC Scrap Metal 4 000 1 500
Other raw materials 800 600
Average cost of inventories per tonne R R
Cost of inventories reflected in trial balances R’000 R’000
61 710 69 630
Kasbian uses a first-in, first-out system with regard to all categories of inventories.
7 Raw material purchases during the 20X8 and 20X9 financial years are summarised in the table below:
20X9 20X8
Raw materials purchased during the year Tonnes Tonnes
Scrap steel purchased from EDC Scrap Metal 15 000 15 000
Average purchase cost per tonne of raw materials R R
Scrap steel purchased from EDC Scrap etal 2 940 2 765
Purchases reflected in trial balances R’000 R’000
Scrap steel purchased from EDC Scrap Metal 44 100 41 475
98 880 152 475
Kasbian retrenched 10% of its direct labour force at the end of December 20X8 in response to the
declining production and sales volumes. The once-off cost of retrenching these employees amounted to
R1 800 000.
The company used 20% less electricity for the purposes of manufacturing in the 20X9 financial year. De-
spite this edu tion in electricity consumption, the electricity expense for the year was higher than in 20X8
because of Eskom’s 30% tariff increase.
The costs per tonne of finished product manufactured in the 20X8 and 20X9 financial years are set out in
the table below:
20X9 20X8
R R
Scrap steel 2 453,00 2 596,68
Other raw materials 378,25 362,25
Direct labour 937,50 687,50
E ectricity 386,10 247,50
Depreciation 152,50 100,00
Other overheads 162,50 125,00
4 469,85 4 118,93
374
Other income represents settlement discounts received from suppliers. Kasbian is entitled to a 2,5%
settlement discount from all raw material suppliers if it pays amounts owing within 30 days of the date of
the statement.
Kasbian declared a R15 million dividend to all registered shareholders on 15 September 20X8. The divi-
dend was paid to shareholders on 30 November 20X8.
Kasbian experienced significant cash-flow difficulties during the 20X9 financial year. The company has
been stretching the trade creditor repayment period by delaying payments to them. A number of Kasbi-
an’s raw-material suppliers have expressed concern about overdue amounts as they are also
experiencing cash-flow pressures.
Africa Commerce Bank has been Kasbian’s commercial bankers for ten years. Africa Commerce Bank in-
creased the company’s overdraft facility limit to R45 million on a tempor ry b sis during 20X9. However,
they are concerned about Kasbian’s operating losses and poor cash-flow gener tion and, in a letter dated
27 September 20X9 addressed to the Chief Executive Officer of Kasbian, ga e the company an ultimatum
to reduce the amount owing on overdraft to R20 million by 15 December 20X9. It further stated that the
bank would withdraw the entire overdraft facility if Kasbian Ltd did n t meet this target.
Interest on the overdraft is charged at the prevailing prime verdraft interest rate, which was 10,5% on 30
September 20X9 (30 September 20X8: 13,5%).
15 There were no disposals of plant and equipment during the 20X9 financial year.
Banking facilities and potential recapitalisation

The board of directors of Kasbian is concerned about the ability of the company to trade out of its current pre-
dicament. The directors believe that sales volumes will increase significantly in the 20X10 financial year, based
on feedback from their major customers. It is difficult to predict commodity prices but Kasbian’s directors have
noticed that steel prices have stabilised recently, which is indicative of the end of the current trend of declining
prices.
In view of the threat by Africa Commerce Bank and the potential threat that certain creditors may demand
immediate repayment of outstanding amounts, the major concern of the directors of Kasbian is whether the
company will be able to continue trading until volumes increase.
Kasbian is presently negotiating with Dinkum Partners, a hedge fund based in London. Dinkum Partners has
expressed interest in investing in Kasbian on the following terms and conditions:
Dinkum Partners will advance a loan of US $6 million to Kasbian bearing interest at a fixed rate of 8% per
annum. The loan is repayable annually in arrears in equal instalments over a three-year period.
Dinkum Partners will be entitled to appoint a director to the board of Kasbian for the duration of the loan
agreement.
Kasbian will be r quir d to pay Dinkum Partners an annual fee of US $200 000 for the next three years.
Kasbian is to grant Dinkum Partners an American call option to subscribe for two million Kasbian ordinary
shares at a strike pri e of R4,50 per share. The call option is exercisable at any time during the next three
years.
No dividends may be declared or paid to shareholders until Kasbian has repaid the loan in full.
The weighted average share price of Kasbian over the 30-day period ended 31 October 20X9 was R4 per share.
The board of directors has approached various banks for funding facilities to replace those of Africa Commerce
Bank. All f the banks approached expressed reluctance to extend an overdraft and/or medium-term facilities to
Kasbian in view of the company’s exposure to the mining industry.
The major hareholders of Kasbian are its executive directors, who do not at present have the financial ability to
ub cribe for new shares in the company and/or to advance monies to the company.
The board of directors believes that it may not have any other option in the short term but to enter into the rr
ngement with Dinkum Partners outlined above.
375
Required:
Calculate the annual change in revenue derived from sales to South African customers and export reve-
nue for the year ended 30 September 20X9 in volume terms, price per tonne and overall change
(6 marks)
Calculate and estimate the impact of entering into the supply arrangement with EDC Scrap Metals
(Pty) Ltd on the profits and cash flows of Kasbian Ltd for the year ended 30 September 20X9 (9 marks)
Identify, with the necessary calculations, and explain the key reasons for the lower profitability of Kasbian
Ltd for the year ended 30 September 20X9 (15 marks)
Calculate the relevant working capital ratios of Kasbian Ltd at 30 September20X8 and 20X9. You should
base your calculations of the relevant ratios for finished goods and c tegories of raw materials on –
volumes and not Rand amounts; and
l year-end inventories as opposed to average inventories during the period (15 marks)
Critically comment on the management of inventories by Kasbian Ltd during the 20X9 financial year
(5 marks)
Identify and discuss the potential adverse consequences that delaying payments to trade creditors could
have for Kasbian Ltd (10 marks)
Critically analyse and discuss the terms of investment proposed by Dinkum Partners from the perspective
of the shareholders of Kasbian Ltd (14 marks)
Identify and discuss the critical factors which may influ nce the future cash-flow generation of Kasbian
Ltd (15 marks)
Critically discuss the actions of the directors of Kasbian Ltd in declaring and paying a dividend in 20X8
(6 marks)
Presentation: Arrangement and layout, clarity of explanation, logical argument and language usage (5 marks)
(SAICA FQE2)
Solution:
(a) 20X8 20X9
Change
R’000 R’000
Revenue volumes
– SA customers 40 000 30 000 (25,0%)
– exports 15 000 12 500 (16,7%)
Average price per tonne
– SA customers R6 000 R4 800 (20,0%) (1)
– export price US$750 US$640 (14,7%) (1)
– exports (ex hange rate effect) 8,00 8,40 5,0%
– overall export pri e R6 000 R5 376 (10,4%) (1)
Total evenue (R000s) (1)
– SA custome s 240 000 144 000 (40,0%) (1)
– exports 90 000 67 200 (25,3%) (1)
Available (1)
Maximum (1)
376
(b)
EDC Other Difference
Unit cost per tonne
– opening inventories 2 800 3 000 200 (1)
– purchases 2 940 2 490 (450) (1)
– closing inventories 2 750 2 300 (450) (1)
Volumes
– opening inventories 1 500 (1)
– purchases 15 000 (1)
– closing inventories (4 000) (1)
COS impact
– opening inventories [1500 × 200] (1)
– purchases [15000 × -450]
– closing inventories [4000 × 450] (2)
Cash flow impact [15000 × R450]
R’000 R’000
Revenue volumes
– SA customers 40 000 30 000 (25,0%)
– exports 15 000 12 500 (16,7%)
Average price per tonne R6 000 R4 800 (20,0%)
– SA customers US$750 US$640 (14,7%)
– export price 8,00 8,40 5,0%
– exports (exchange rate effect) R6 000 R5 376 (10,4%)
9
(c) 20X8 20X9 Change

Revenue
– lower volumes sold (22,7%) (1)
– lower unit selling price (17,2%) (1)
Total change in revenue (36,0%) (1)
Impact on EBIT
– lower volumes (GP terms) (24 110) (1)
– lower average selling price (14 080) (1)
(38 190)
Gross profit
Calculation of gross profit amount 106 084 22 896 (78,4%)
Gross profit % 32,2% 10,8% (66,3%)
Decline in GP amount (44 998)
Decline in av rage GP p r unit sold
Impact on EBIT of low r GP margin
Manufacturing ost per tonne
– scrap steel (2 597) (2 453) (5,5%) (1)
– other aw mate ials (362) (378) 4,4% (1)
– labour (688) (938) 36,3% (1)
– electricity (248) (386) 55,7% (1)
– depreciation (100) (153) 53,0% (1)
– ther verheads (125) (162) 29,6% (1)
(4 120) (4 470) 8,5% (2)
377
20X8 20X9 Change
Selling and administration costs (80,0%) (1)

Other income (9,6%) (1)
Finance charges 0,8% (1)

EBIT (122,4%) (1)
Profit before tax (138,3%)
Overall impact on FY20X9 profits
Lower revenue (38 190)
Declining GP% (44 998) (1)
Other income (2 600)
Retrenchment costs (1 800) (1)
Selling and administration costs 3 700
Other (depreciation and finance charges) (41)
Lower PBT in FY20X9 compared to FY20X8 (83 929) (1)
Maximum 9
Revenue
l Decline in revenue was a major factor in lower profits in FY20X9 (1)
l Decline attributable to lower demand from mining customers due to global economic crisis (1)
l Lower selling prices per unit a result of dropping commodity prices (scrap steel) (1)
l Increasing competition from Chinese foundries also affected export sales (1)
l Export revenue prices declined by less than local sales which mitigated overall revenue drop (1)
Gross profit margin

l COS declined by 15,9% which is much lower than revenue drop of 36% (1)
l Scrap steel costs per tonne manufactured declined by 5,5% yet selling priced by 17,2% (1)
l EDC supply contract affected input costs (as calculated in (b) above) (1)
l Direct labour costs per tonne manufactured increased indicating largely fixed labour cost (1)
l Electricity tariff increases eroded margins (1)
l Retrenchments may have affected employee morale (1)
Other factors
l Selling and administration expenses declined softening blow of lower GP’s (1)
l Other income (s ttl ment discounts) declined because of cash-flow constraints (1)
l Retrenchm nt costs of R1,8m reduced profits (1)
15
(d) – 1 mark for co ect answer/1 mark for attempt 20X8 20X9 (2)
Inventory days (finished goods) (3)
Calc lation: 9900 / 42500 × 365 [12400 / 55000*365] 82 days 85 days
Annualised manufacturing in last quarter
– scrap steel 32 400
– other raw materials 3 600
Inventory days (scrap steel)
Calculation: 6200 / 32400 × 365 [5200 / 54000 × 365] 35 days 70 days
378
Alternative 1:
EDC 41 117 (1)
Other scrap metal suppliers 33 34 (1)
Alternative 2: Based on unit sales
Scrap metal inventory days 38 59 (2)
Inventory days (other raw materials)
Calculation: 800 / 3600 × 365 [600 / 6000 × 365] 37 days 81 days (3)
Alternative: Based on unit sales 46 52 (2)
Trade receivables days 48 days 60 days (2)
Calculation: 34719 / 211200 × 365 [43397 / 330000 × 365]
Trade payables days
Calculation: 25729 / 114840 × 365 [16686 / 174010 × 365] 35 days 82 days (2)
Alternative: Based on total COS 27 50 (2)
Current ratio 2,1 1,5 (2)
Alternatives: Exclude O/D in current liabilities 3,1 3,8 (2)
Quick ratio 0,8 0,6 (2)
Alternative: Exclude OD from current liabilities 1,2 1,4 (2)
Quick ratio Maximum 15
(e) – Inventory discussion

Inventory days of finished goods remained consistent in FY20X9 from FY20X8 which reflects lower
manufacturing volumes (1)
Management should have reduced finished goods inventories more given declining sales volumes (2)
Inventory days of scrap steel increased from 35 days to 70 days at 20X9 year-end which indicates
poor management as declining demand was evident in FY20X9 (1)
EDC supply contract may have forced Kasbian to purchase more than required (1)
However, total raw materials used in manufacturing in FY20X9 was 36 000 tonnes significantly more
than 15000 fixed supply contract (2)
Inventory days of other raw materials also increased significantly in FY20X9 – poor (1)
Manufacturing volumes declined by 33% in FY20X9 yet raw material inventory levels increased! (2)
Any obsolete or slow moving inventories giving rise to higher stock holdings? (1)
Maximum 5
(f) – Identification and explanation

l Produ t quality and service received from suppliers may deteriorate if not paid promptly (2)
l No longer able to claim discounts for prompt settlement (2)
l Suppliers may start to charge higher prices to compensate for perceived higher credit risk (2)
l Risk of being placed into provisional/final liquidation if creditors insist on immediate payment (2)
l Creditors may insist on COD thereby removing benefit of interest free funding (2)
l Creditors may start to charge interest on overdue amounts (2)
l Increased time spent by Kasbian staff in dealing with credit-control divisions of suppliers (2)
l Suppliers could discontinue supplying Kasbian thereby crippling business (2)
Credit rating of Kasbian may be deteriorate resulting in suppliers not doing business with them (2)
l Legal costs incurred from defending legal action/summons (2)
Maximum 10
379
(g) – Amount of loan

l US$6m = R46,2m at year-end exchange rate (1)
O/D needs to be reduced to R20m using R20,6m of loan advance leaving R25,6 to reduce
creditors and fund operations (1)
l Dinkum loan appears sufficient to meet immediate needs and fund operations in the short (1)
term
Interest rate
l Nominal annual rate = 12,7% including annual fees paid (2)
Interest rate is high
– Kasbian’s current O/D rate is 10,5% (1)
– Global interest rates currently much lower than 12,7% (1)
l Fixed interest rate means certainty re payments however, could be expensive if rates decline (1)
Exchange rate risks
l Hedging cost of repayments (interest + capital)? Three year hedging required (1)
Failure to hedge exchange rate exposure could exp se Kasbian to significant risk given ZAR
Volatility (1)
l Extent of natural hedging from Kasbian’s export activities? (1)
Annual fee/non-executive director
l What will Kasbian receive in return for annual f ? (1)
l Any remuneration payable to Dinkum appoint d dir ctor? (1)
l Dinkum appointee be constructive or interfering and protecting their rights? (1)
Option
l Option entitles Dinkum to 16,2% shareholding interest post subscription (1)
l Strike price is very low compared to listing price and October 20X7 (R27,50) (1)
l Strike price is at 12,5% premium to weighted average 30-day period October 20X9 (1)
l Three years is an extended period to exercise option – could be valuable if Kasbian recovers (1)
l Kasbian should obtain independent advice re option price (value using Black Scholes etc.) (1)
Gearing levels
l Kasbian’s debt equity ratio currently = 55% (1)
l Using part of loan advance to reduce creditors will increase debt equity ratio (1)
l Kasbian incurring operating loss therefore insufficient to meet interest payments (1)
l Will Kasbian be able to meet capital and interest repayments over next three years? (1)
Clarification of loan t rms
l Early settlement option possible? (1)
l Fu ther loan ovenants besides dividend restriction? (1)
l Secu ity for loan? (1)
Other considerations
l Tax ded ctibility of interest and annual fees? (1)
l Dividend restrictions for three years may unduly harsh on current shareholders (1)
l SARB approval required to enter into foreign loan agreement (1)
l Kasbian has no other funding alternatives so may be forced to accept Dinkum loan (1)
14
380
(h) – Revenue
FY 20X9 revenue below break even therefore increasing revenue in FY 20X10 critical
l Increasing mining production and hence, demand for Kasbian products (1)
l Reducing reliance on platinum mining customers or increasing demand for this precious (2)
metal
l General global economic recovery will be NB to stimulate consumer demand for gold/platinum (1)
l Increasing competition from Chinese foundries may reduce revenues (1)
l ZAR/US$ exchange rate fluctuations – 30% of revenue exports (1)
l Steel commodity prices – major input cost and higher prices = more revenue for Kasbian (2)
Gross profit margin
l EDC Metal contract terminated at end of FY20X9, Kasbian should improve GP as a result (1)
l Increased sales and production volumes NB to cover fixed costs (labour etc.) and improve GP% (2)
l Future Eskom tariff increases could GP margins (1)
l Generally, improving GP% from 10,8% back to >30% will have NB impact on cash flows (1)
Working capital
l Reducing inventory levels (particularly raw aterials) will release significant cash (1)
l Trade debtors days much higher in FY20X9, these will boost cash flows (1)
l Creditors stretched in FY20X9, Kasbian will need a ounts owed, using cash (1)
l Continued support from creditors NB, discontinuing supply etc. will have major impact (2)
l If demand increases, Kasbian will need to fund working capital build up (2)
Gearing
l Interest rate movements will affect cash-flow payments (1)
l Equity injection would affect debt repayments over next three years (1)
Other factors
l Reducing selling and admin overheads, fixed costs (1)
Maximum 15
(i) – Dividend impact

Dividend amount was reasonable in relation to reported profits (36% of PAT or 2,8 times
cover) (1)
Kasbian had >R49m debt in Oct 20X8 directors should rather have reduced debt than pay
dividends (2)
Kasbian’s cash-flow g n ration in FY20X7/20X8 poor so paying dividends exacerbated issue (1)
Debt to equity ratio after dividend declaration at 20X8 year end was 47%, not too high (1)
Impact of global slowdown was evident before dividends paid, directors should have reversed
decision (2)
Directors sho ld have considered solvency and liquidity (over next 12 months as well) of Kasbian
prior to declaring and paying dividends (2)
Failure to pay dividends may have had signalling effect (1)
Maximum 6
381
Chapter 10
Valuations of preference
shares nd debt
outline reasons for undertaking valuations of pr f r nce shares or debt;

identify and explain the various drivers of value and the int raction between them, when using a valua-
tion method based on discounted cashflow;
value different types of preference shares using a discounted cashflow method; and
value different forms of debt using a discounted cashflow method.
This chapter introduces the interesting, although sometimes bewildering, topic of valuations. It aims to break
down the uncertainty experienced by many students in this area by concentrating on core principles. This
chapter focuses on the valuation of the main forms of capital used by South African entities, other than ordi-
nary equity (which is covered in chapter 11) – that is, preference shares and debt.
This chapter further serves as both an introduction and precursor to chapter 11 (Business and equity valua-
tions), which builds on the concepts introduced here. This chapter is also closely linked to chapter 7 (The
financing decision), which evaluates different forms of finance from an associated, but slightly different per-
spective.
The chapter addresses a mix of topics with a difficulty level ranging from fundamental to intermediate. For
convenience, the int rm diate areas are labelled as such. (Unlabelled areas therefore represent basic, funda-
mental knowledge ar as.)
This chapter explores valuations of preference shares and debt using a universal discounted cashflow valuation
method. It fi st explains the various drivers of value – and the interaction between them – when using a dis-
counted cashflow method.
As a second phase, it applies the discounted cash flow method to illustrate and explore the valuation of differ-
ent types of preference shares, and different forms of debt. Throughout the chapter, the aim is to promote the
understanding and application of sound valuation principles. This chapter does not address derivative financial
instruments r specialised forms of finance, including Islamic finance structured in accordance to Shariah rules.
10.1 Reasons for undertaking valuations of preference shares or debt

Appraisers in South Africa may be called upon to perform valuations of debt or preference shares for many
different reasons, including –
valuations for taxation purposes;
valuations for financial reporting purposes;
383
when determining the weights of debt and preference shares relative to the fair market value of total
capital employed by a business enterprise, upon calculation of the current weighted average cost of capi-
tal of the firm;
when valuing debt and preference shares separately, as part of an encompassing business valuation (refer
to chapter 11 (Business and equity valuations));
in case of a business rescue reorganisation; and
where a firm issues new preference shares or new debt in the form of securities directly to investors. (I.e.,
a bank does not serve as an intermediary and will thus not offer the service of inking the value of the
form of finance to a fair return.) Investors will not invest in a new security un ess its future benefits will
offer a fair, risk-adjusted return;
where an investor seeks to purchase from another investor previously issued, unlisted preference shares
or debt securities. In this case, the valuation will indicate a fair market value at that point in time, given
the specified future benefits, and a fair, risk-adjusted return.
10.2 The discounted cashflow method

This chapter makes exclusive use of a discounted cash-flow ethod to value preference shares and different
forms of debt. This important valuation method belongs to the inco e approach and is but one of several
methods; this and other valuation methods are discussed in chapter 11 (Business and equity valuations) along
with other important valuation theories.
The discounted cashflow method is suitable to the valuation of most forms of debt and preference shares,
since these forms of capital normally have specified amounts payable at specified intervals. Future cashflows
could thus be projected accurately in a discounted cashflow analysis.
The risk associated with the cashflows could then be incorporated in the required return.
The fundamental principle when determining the fair market value of preference shares or debt, using a dis-
counted cashflow method, is that the expected after-tax cashflows belonging to the specific form of capital
should be discounted at a fair after-tax rate. This principle also predicts that there should be certain drivers of
value when using this method of valuation.
10.2.1 Drivers of value when using the discounted cashflow method

Based on the fundamental principle, for each specific form of debt or preference share, there is an intricate link
between its fair market value, the expected future cashflows and their timing, and the level of risk associated
with the future cashflows incorporated in the required after-tax rate of return.
Note: For purpos s of this chapter, valuations are usually performed from the perspective of the entity using
the pr f r nce shares or debt as finance (the debtor), unless specified that it should be from the
perspective of the creditor. (Unqualified use of the terms ‘issuer’ and ‘holder’ are purposely ignored
in the urrent chapter to avoid confusion with the somewhat contradictory terminology used in the
taxation dis ipline.) This valuation perspective should be kept in mind when considering ex-pected
cashflows and the required rate of return.
Expected cashflows and timing

The cashflows expected to be paid (or sometimes received) at a certain time should consider three compo-
nents:
the expected pre-tax cashflow and its expected timing;
a weighting of probabilities; and
the expected cashflow linked to the associated tax implication and its expected timing.
It is important to realise, however, that the associated tax treatment of preference shares and especially debt is
specialised area, with a number of exceptions and with many changes in recent years. In depth knowledge of
the tax treatment is normally not required for purposes of Financial Management and hence is beyond the
scope of this book.
384
Valuations of preference shares and debt Chapter 10
To promote a greater level of integrated knowledge, though, this chapter describes and illustrates the princi-
ple, basic tax treatment, regulated by the tax legislation current at the time of this publication.
The following examples illustrate the three components to be considered in determining an expected cashflow:
The directors of a company expect that there is a 60% probability that a non-cumulative dividend (see
section 10.3.2 for definition of a non-cumulative preference share) of R1 000 will be declared and paid in
one year’s time. This means also, there is a 40% probability that it will be missed (i.e. won’t be paid). Con-
sequently, the probability-weighted expected cashflow in Year 1 of a discounted cashflow analysis is thus
a pre-tax outflow of R600 ([60% × – R1 000] + [40% × R0]). Next, one should consider and incorporate the
cashflow tax implication. (Normally in the case of dividends paid there wou d presently be no tax implica-
tion in the hands of the issuer of the shares.)
The directors of a company expect that a non-cumulative dividend of R1 000 per annum will be declared
and paid for future periods. The probability-weighted expected c shflow in Ye r 1 of a discounted cash-
flow analysis is thus an outflow of R1 000 (100% × – R1 000). (For a case like this it is not necessary to
show this calculation as the probability weighting is implicit.) Next, one should consider and incorporate
the cashflow tax implication. (Again, there is unlikely to be a tax implication in the hands of the issuer of
the shares.)
The required rate of return

The required rate of return equals a fair, after -tax rate of return which considers the risks inherent in the after-
tax expected cashflows associated with either the preference share or form of debt being valued.
Note that there is a direct link between the differ nt driv rs of value: the higher the risk of not receiving or d
being able to pay the specific cashflow, the higher the r quir rate of return.
10.2.2 Riskiness and the required rates of return on debt and preference shares.
The main risk that should be adjusted for in the required rate of return is credit risk – the risk that the inves-
tor/provider of debt will not receive the specified cashflows at the specified intervals.
Generally, preference shares are more risky than debt, but less risky than ordinary equity.
The reasons for this are, firstly, in the case of a liquidation of a firm, the claim of the holders of preference
shares will rank in the middle, between ordinary equity (although sometimes also unsecured trade debt) and all
other forms of finance – mainly interest-bearing debt. (Preference shares are normally classified as mezzanine
finance; the term mezzanine, in turn, is associated with the Italian word for middle.) The preference shares will
therefore usually rank, what is called, senior to ordinary equity, but junior to debt. This implies that, all other
factors being equal, preference shares are more risky than debt.
Secondly, unlike interest on debt, the entity issuing preference shares is also not obligated to pay a dividend.
This further increases the risk associated with preference shares.
Since preference shar s are normally more risky than debt, the required rate of return on preference shares
should be higher than the required rate of return on debt. Furthermore, more risky debt should offer a higher
return than less risky debt. In this regard one can compare the yields to maturity (similar to internal rates of
return) of va ious listed preference shares and bonds.
The following actual examples were taken at roughly the end of the second quarter of 2012: Standard Bank has
in issue non-redeemable, non-cumulative preference shares listed on the JSE, which yields 6,33%. Standard
bank f rther has in issue a listed bond due in 2019, offering a yield to maturity of roughly 8,8%. The yield to
maturity on the R207 government bond maturing in the beginning of 2020 is equal to 7,1%.
Clearly, when c mparing only the pre-tax yields and ignoring the effect of tax, the risk-return relationship does
not h ld f r this preference share. (Due to risk, the yield on the preference share should be higher than the
yields on the Standard Bank bond and the government bond; the yield on the Standard Bank bond is, as ex-
pected, higher than that of the government bond.)
If one then adjusts for taxation, assuming a typical local company investor, the Standard Bank preference share
will offer a rate of return equal to 6,33% (6,33% × 100%, since no Dividends Tax would be payable); the Stand-
rd B nk bond will offer a rate of return equal to 6,3% (8,8% × [1 – 28%]); and the R207 government bond will
offer a rate of return equal to 5,1% (7,1% × [1 – 28%]). (Note: 28% is the current corporate tax rate.)
Assuming a typical local investor who is a natural person, paying the maximum marginal rate of Income Tax, the
Standard Bank preference share will offer a rate of return equal to 5,38% (6,33% × [1 – 15%], to account for
385
Dividends Tax); the Standard Bank bond will offer a rate of return equal to 5,3% (8,8% × [1 – 40%]); and the
R207 government bond will offer a rate of return equal to 4,3% (7,1% × [1 – 40%]). (Note: 40% is currently the
highest marginal tax rate for a natural person.)
Due to the different tax treatment of preference shares and debt in South Africa, one therefore preferably has
to compare after-tax rates of return.
Still, things are not always what they seem; sometimes, and often by design, one form of capital could show
characteristics of another. Under these circumstances, tax authorities may label it a ‘hybrid instrument’, in
which case alternative tax treatment to the norm could be prescribed.
Several other factors could also influence the risk associated with preference shares or debt. These matters are
discussed separately below for each form of capital.
10.3 Valuation of preference shares

As per the fundamental principle of discounted cashflow, the drivers of value of a preference share are the
after-tax expected amounts, their intervals, and the after-tax expected rate f return.
10.3.1 Drivers of value

Amounts payable and their intervals are usually readily available as the dividends payable are specified in a
prospectus and Memorandum of Incorporation of a co pany, for example. The expected amounts and their
intervals will be based on the specified dividend amounts, but may have to be adjusted based on expectations.
The taxation treatment is as per the current tax legislation.
When valuing unlisted preference shares, the expected rate of return is not readily available and hence normal-
ly has to be determined based on information available in the market place. Accordingly, this share’s required
rate of return is frequently determined based on the yields offered by preference shares listed on the JSE, with
similar terms and conditions, and then adjusted for differences in risk between the comparator (i.e. listed)
share and the unlisted share being valued.
Differences in risk that have to be adjusted for, either as part of the fair rate of return or as a separate dis-
count, include: Differences in credit risk and the level of marketability of each share. (The concept of a valua-
tion discount is merely introduced here. Examples below assume that risk is adjusted as part of the discount
rate; a comprehensive description of valuation premiums and discounts can be found in chapter 11 (Business
and equity valuations).)
Usually the date of selling a preference share does not exactly coincide with the date of the payment of a
preference dividend. Furthermore the date that a dividend is declared also does not coincide with the date that
it is paid. If a preference share is sold, the value of the share will be affected by whether or not the new owner
will also receive the currently declared dividend.
In this regard a pr f r nce share may be classified ‘ex-div’ or ‘without dividend’ after a certain date, implying that
if a new owner purchased the share ex-div, she would not be entitled to receive the currently declared
dividend; it would be paid to the previous owner.
Furthermore, a p efe ence share may be classified ‘cum- div’ or ‘with dividend’ up to certain date, implying that
if a new owner pu chased the share cum-div, she would be entitled to receive the currently declared dividend
also.
10.3.2 Types of preference shares, rights and attributes

The type f preference shares, its associated rights, and its attributes may further affect its valuation.
Rights
The fo owing applies to most South African preference shares –
preference dividend does not have to be declared;
where a preference dividend is not declared, no ordinary dividends may be declared;
unless voting rights are specifically attached to the preference shares, holders of preference shares are
only entitled to vote in cases where dividends declared remain in arrears for a certain period after the
due date, or a resolution is proposed that affects the rights of the preference shareholders.
386
Attributes linked to the various types of preference shares

The following specific attributes (or a combination of them) may be attached to a preference share:
Non-cumulative preference shares, implying that if a dividend is missed (i.e. not paid) it is never paid
(thereby increasing risk).
Cumulative preference shares, implying that if a dividend is missed it accumulates to be declared and paid
in the future.
Non-redeemable (perpetual) preference shares, implying that there is no maturity date and that the entity
issuing preference shares is not required to buy back the shares. (Depending on the marketability of the
share, it may still be readily sold between investors.) Non-redeemab e preference shares are less
common since, in an effort to limit credit risk, many funds and other investors have a policy to not invest
in non-redeemable preference shares.
Preference shares may carry either a fixed or variable dividend (the latter linked to the prime interest rate,
Johannesburg interbank agreed rate (JIBAR), or some other floating rate). When comparing a pref-erence
share paying a fixed rate to a share paying a variable rate, the ariable option is likely to reflect less
disparity over time between its fair market value and its issue c nsideration. (Over time market forc-es are
likely to change the underlying floating rate to which a variable dividend is linked, and will there-fore help
to better align the future benefits paid and its fair rate of return; differences can and probably will still
exist, however.) For this reason many funds and other investors have a policy to not invest in preference
shares paying a fixed dividend.
Convertible preference shares, implying that the preference shares are convertible in the future to, for
example, ordinary equity. This may help to incr ase the attractiveness of the preference share. Shares
may be convertible at the option of either the hold r of the shares or the entity issuing the shares.
10.3.3 Tax treatment and valuation inputs

Preference share attributes and its tax treatment will affect the inputs of a valuation based on discounted
cashflow, some of which are illustrated in the following sections.
In terms of current South African tax law, dividends are not subject to income tax, but are subject to dividends
tax instead. In basic terms, current legislation stipulates that dividends tax is borne by a shareholder at a rate of
15%, but that the entity declaring the dividend must withhold the dividend tax on payment.
Moreover, in terms of current South African tax law, only individual shareholders (natural persons, as the final
benefactors of the dividend) effectively pay dividends tax; local legal entities are exempted (with some excep-
tions). Tax on dividends in specie (i.e. not in cash), however, remains the liability of the entity declaring the
dividend.
Furthermore, any capital gains tax (CGT) on the redemption or conversion of preference shares, if any, will be
payable by the holder of the shares.
Note: As indicat d, for purpos s of this chapter, valuations are usually performed from the perspective of the
entity using the preference shares or debt as finance (debtor). This implies that currently, when
valuing preferen e shares, one normally does not make a specific adjustment for the effect of income
tax (including CGT) or dividends tax. (The effect of any possible tax should already be incorporated in
the equi ed ate of return.)
Hybrid instr ments for income tax purposes (Intermediate)

Sometimes preference shares may display characteristics of debt. At the date of this writing, section 8E of the
Inc me Tax Act may label preference shares a ‘hybrid instrument’ in some cases, for example where:
the issuer of the share must redeem the share within three years of issue; or
the holder of the preference share has the right (option) to have the share redeemed within three years
of issue, or
display a few other characteristics of debt as defined in the Act.
In b sic terms, section 8E then prescribes that a dividend on such an instrument be treated as interest for tax
purposes, but only at the level of the recipient. The result is punitive, since the entity declaring the dividend
shall not be entitled to a tax deduction on the dividend declared (as per the normal rules), but the recipient will
be taxed on this amount as if it was interest income.
387
10.3.4 Valuing non-redeemable (perpetual) preference shares

Valuing non-redeemable preference shares is fairly simple: The perpetuity of future preference dividends is
capitalised or discounted at a fair rate of return.
Example: Valuing non-redeemable preference shares (Fundamental)

A company has in issue 1 000 000 non-redeemable preference shares with a nominal value of 100c each. These
shares carry a fixed dividend of 11%, which is payable annually in arrears. (A dividend has just been paid.) The
required rate of return on these shares is equal to 8%.
Required:
Determine the current fair market value of the 1 000 000 non-redeem ble preference shares, whilst ignoring
any potential impact of section 8 of the Income Tax Act.
Solution:
(Intermediate: Even if the impact of section 8E of the Income Tax Act had to be considered in this case, it would
not apply as the shares do not display characteristics of debt, as described in the Act.)
Basic method
Expected perpetual future preference dividend: R110 000 (11% × 1 000 000 shares × R1 each)
Fair rate of return: 8%
Present cost of a R110 000 dividend, paid every year ad infinitum, at 8%:
(R110 000) / 8%
(R1 375 000)
Thus, the fair market value of the 10 000 non-redeemable preference shares is R1 375 000. One can further link
this simple example to the Gordon Dividend Growth odel.
Gordon Dividend Growth Model

The model formulated by Gordon eloquently captures, in a single formula, the present value of a stream of
future cashflows from the investment (in this case dividends), which are growing at a constant rate. (The
Gordon Dividend Growth Model is merely introduced here, but comprehensively discussed in chapter 11
(Business and equity valuations).)
The Gordon Dividend Growth Model formula is:
D1
P0 =
r–g
Where:
P0 = the p esent value of the future dividends (date of valuation taken as ‘year 0’)
D1 = the expected dividend at the end of Year 1, sometimes expressed as D 0 (1 + g)
r = req ired rate of return
g = the expected constant dividend growth rate.
C ntinuing with the earlier example, one can apply the Gordon Growth Model as follows:
D1
P0 =
r–g
R110 000 (as a dividend has just been paid this amount is expected in one year)
P0 =
(8% – 0%) (no growth in dividends is expected, therefore 0%)
P0 = R1 375 000
388
10.3.5 Valuing redeemable preference shares

In valuing redeemable preference shares, the present value of the expected future preference dividends and
preference capital are calculated by discounting these cashflows at a fair rate of return.
Example: Valuing redeemable preference shares (Fundamental)

A company has in issue 1 000 000 redeemable preference shares that have just paid a dividend. These shares
have a nominal value of 100c each and carry a variable dividend equal to 70% of the prime interest rate, which
is payable annually in arrears. The shares are redeemable in full in five years from today at the issue considera-
tion. A fair rate of return on the shares is equal to 7,5%. The current prime interest rate is equal to 9%.
Required:
Determine the current fair market value of the 1 000 000 redeemable preference shares, whilst ignoring any
potential impact of section 8 of the Income Tax Act.
Solution:
Year: 0 1 2 3 4 5
(current date) R R R R R
Expected dividend
([70% × 9%] × 1 000 000 × R1) (63 000) (63 000) (63 000) (63 000) (63 000)
Redeem capital (1 000 000 × R1) (1 000 000)
(63 000) (63 000) (63 000) (63 000) (1 063 000)
Fair rate of return 7,5% 0,9302 0,8653 0,8050 0,7488 0,6966

R
Net present cost (951 492) (58 603) (54 514) (50 715) (47 174) (740 486)
General note: Figures may not total correctly due to rounding.
(Intermediate: Even if the impact of section 8E of the Income Tax Act had to be considered in this case, it
would not apply as the shares are not redeemable within three years of issue and therefore do not display
characteristics of debt, as described in the Act.)
Conclusion:
The current fair market value of the 1 000 000 redeemable preference shares is equal to R951 492. The reason
why the fair market value (R951 492) is below the nominal value (R1 000 000) is because these preference
shares have an exp ct d r turn (70% of 9% = 6,3%) that is lower than the required return (7,5%).
10.3.6 Valuing umulative non-redeemable preference shares

A cumulative p efe en e share means that any dividend that is missed must be paid at a later date.
When valuing cumulative non-redeemable preference shares, one again calculates the perpetuity of future
preference dividends (where these are expected to be declared and paid), capitalised at a fair rate of return.
However, one has to consider the probability that a dividend will be missed, and the expected period in which
the missed dividend will be declared and paid.
Where dividends are missed, normal discounted cash-flow techniques are recommended for the periods of
instability, with the Gordon Dividend Growth Model only used for the later periods once the normal dividend
paying chedule is resumed.
Examp e: Valuing cumulative non-redeemable preference shares (Intermediate)

A company has in issue 100 000 non-redeemable preference shares, which were issued at R110 each. The
shares carry a fixed, cumulative dividend of 7% of the issue consideration. (The shares have just paid a divi-
dend.) Due to temporary financial difficulty the directors expect that the next year’s dividend will be missed.
Dividends for Year 2 onwards are expected to continue per the normal schedule. The required rate of return is
equal to 9%.
389
Required:
Determine the current fair market value of the 100 000 cumulative non-redeemable preference shares, whilst
ignoring any potential impact of section 8 of the Income Tax Act.
Solution:
Year: 0 1 2
Alternative 1 (current date) R R
Year 1 dividend (not declared or paid) 0
Year 1 dividend (paid in Year 2: 7% × 100 000 × R110) (770 000) (N1)
Present value of R770 000 per annum ad infinitum, at 9%
Apply the Gordon Dividend Growth Model:
Standard formula: P0 = D1 / (r – g), but adjust for the appropriate year:
P1 = D(1+1) / (9% – 0%) (N2)
P1 = D2 / 9%
= R770 000 / 9% (8 555 556) (N3)
Note: When using this model, P1 implies inclusion (8 555 556) (770 000)
always ensure that the timing of the in the colu n for
price (Px) precedes the dividend Year 1
(Dy) by one year
Fair rate of return 9,0% 0,9174 0,8417

R
Net present cost (N4) (8 496 976) (7 848 867) (648 109)
Alternative 2 R R
Year 1 dividend (not declared or paid) 0
Year 1 dividend (paid in Year 2: 7% × 100 000 × R110) (770 000) (N1)
Year 2 dividend (7% × 100 000 × R110) (770 000)
Present value of R770 000 per annum ad infinitum, at 9%
Apply the Gordon Dividend Growth Model:
Standard formula: P0 = D1 / (r – g), but adjust for the appropriate year:
P2 = D(2+1) / (9% – 0%)
(N2)
P2 = 3 / 9%
= R770 000 / 9% (8 555 556) (N3)
Note: When using this model, always P2 implies 0 (10 095 556)
ensure that the timing of the price (Px) inclusion in the
precedes the divid nd (Dy) by one year column for Year 2
Fair rate of return 9,0% 0,9174 0,8417

R
Net present cost (N4) (8 497 429) 0 (8 497 429)
(The net present cost differs from that in Alternative 1 only due to rounding.)
General n te: Figures may not total correctly due to rounding.
Intermediate: Even if the impact of section 8E of the Income Tax Act had to be considered in this case, it would
not apply as the shares are non-redeemable and therefore do not display characteristics of debt, as described
in the Act.)
Conclusion:
Assuming that the dividend is NOT missed, the value of the preference share today would be R770 000 / 9% =
R8 555 556.
As the dividend is now to be missed in Year 1, the fair market value of the 100 000 cumulative redeemable
preference shares is R8 496 976 (or R8 497 429 – again, the difference is due to rounding).
390
Specific notes:
N1 In the case of preference shares paying cumulative dividends, missed dividends accumulate, and are
declared and paid later. (This is better understood in Alternative 2 above, which shows no dividend being
paid in Year 1 and a double dividend being paid in Year 2.)
N2 In the Gordon Dividend Growth Model, the dividend represents the cashflow for one period after the
date of valuation. If the valuation date equals P0, then one uses D1; if the valuation equals P1, one uses
D2; and if the valuation date equals P2, one uses D3; etc.
N3 One places the value at the end of the indicated year per Gordon’s model in the appropriate column, for
example P1 in the column representing the end of Year 1, P2 in the co umn representing the end of Year
2, etc.
N4 The difference in value is merely due to rounding. (The answers should be ex ctly the same otherwise.)
10.3.7 Valuing non-cumulative redeemable preference shares

A non-cumulative preference share means that any dividend that is missed will not necessarily be paid or made
up at a later date.
When valuing non-cumulative redeemable preference shares one again calculates the present value of the
expected future preference dividends and preference capital, by discounting these cashflows at a fair rate of
return. In this case however, one has to consider the probability that a dividend will be missed and incorporate
this probability in the forecast expected dividends.
Example: Valuing non-cumulative redeemable pr f r nce shares (Fundamental)

A company has in issue 100 000 preference shares with a nominal value of R100 each that have just paid a
dividend. The shares carry a fixed, non-cumulative, semi-annual dividend of 4,5% of the nominal value. The
shares are redeemable in two years’ time at the nominal value.
Due to expected financial difficulty in the future there is a 50% expected possibility that the second-last divi-
dend will not be declared and a 25% possibility that final dividend will also not be declared. It is expected that
the other dividends will be declared and paid, and that the shares will be redeemed at the specified date. The
required rate of return is equal to 8% APR (an annual percentage rate).
Required:
Determine the current fair market value of the 100 000 non-cumulative preference shares, whilst ignoring any
potential impact of section 8 of the Income Tax Act.
Solution:
Six-monthly intervals: 0 1 2 3 4
(current date) R R R R
Period 1 and 2:
Expected dividend (4,5% × 100 000 × R100) (450 000) (450 000)
Period 3: Expe ted dividend ([1 – 50%] × 4,5% × 100 000 × R100) (225 000)
Period 4: Expected dividend ([1 – 25%] × 4,5% × 100 000 × R100) (337 500)
Redeem capital (100 000 × R100) (10 000 000)
(450 000) (450 000) (225 000) (10 337 500)
Fair rate f return (six-monthly rate) 4,0% 0,9615 0,9246 0,8890 0,8548
(8% / 2) , in order to make the rate applicable to six-monthly intervals
R
Net present cost (9 885 265) (432 675) (416 070) (200 025) (8 836 495)

(Intermediate: If section 8E of the Income Tax Act had to be considered in this case, the shares would have
been classified as a hybrid instrument as these are redeemable within less than three years of issue. Nonethe-
less, it would not have a specific bearing on the net present cost indicated above as here it is determined from
the perspective of the entity using the preference shares as finance (debtor). The effect of any possible tax
should already be factored into the required rate of return which was provided.)
391
Conclusion:
The current fair market value of the 100 000 non-cumulative redeemable preference shares is R9 885 265.
10.4 Valuation of debt

As per the fundamental principle of discounted cashflow, the drivers of the value of debt are the after-tax
expected amounts, their intervals, and the after-tax expected rate of return.
10.4.1 Drivers of value

The pre-tax amounts payable on debt and their intervals are usually re dily v il ble. (These are e.g. contrac-
tual amounts specified in bond and loan agreements.) The expected amounts nd their intervals will normally
be based on the contractual amounts. The taxation treatment is as per the current tax legislation.
When valuing debt, the required rate of return is often not readily a ailable and normally has to be determined
based on information available in the market place. Accordingly, the debt’s after-tax required rate of return is
frequently determined based on a risk-free rate, to which a premium is added for additional risk, and then
adjusted for the effect of tax.
The additional risk consists mainly of credit risk. As the provider of debt finance, a bank usually assesses credit
risk. However, the process of securitisation allows an entity to bypass a bank as intermediary in order to obtain
debt finance directly through the issue of a marketable security – such as commercial paper, medium term
notes or bonds – to investors. The credit risk linked to th se d bt securities are frequently assessed by a formal
credit-rating agency, such as Standard & Poor’s, Fitch or Moody’s.
One way of determining the additional risk premium on bonds, for instance, is to refer to the published yield
spreads between bonds with different formal credit ratings. For example, a bond with a ‘BB+’ credit rating
(indicating a speculative grade, below investment grade) may reflect a spread of 900 basis points (or 9%) over a
risk-free, rand-denominated bond with the same maturity date (such as a SA government bond).
If the yield to maturity on a SA government bond is equal to, say, 8% then a required rate of return on another
bond, also denominated in rand, with a similar maturity date but with a ‘BB+’ credit rating, would be 17% (8% +
9%), before accounting for the effect of tax.
10.4.2 Forms of debt and their characteristics

The recent financial crisis that started in 2008 has not only restricted the access to finance for many business
entities worldwide, but placed renewed focus on the risk inherent to debt finance. In South Africa, new legisla-
tion also affected both the providers and users of debt finance.
The National Credit Act 34 of 2005, which placed additional requirements on the provider of credit to the
smaller business, may have discouraged unfair credit lending practises but, in this process, it further reduced
the available sourc s of finance to the small business.
1 Forms of debt
Notwithstanding these effects, various different forms of debt finance exist in South Africa, ranging from
secured sho t-te m loans, to mortgage loans, to long-term unsecured bonds. The most prominent forms of debt
and their characteristics are described in chapter 7 (The financing decision).
An in-depth review of securitised debt, such as notes, bonds and debentures, is beyond the scope of this text b
k. Its sc pe further excludes Islamic finance and other specialised forms of debt.
2 Characteristics of debt
A defining characteristic of debt is that it represents an obligation owed by a debtor to a creditor (or a borrow-
er to a ender). Normally this allows the creditor a claim on a specified stream of cashflows, generally consisting
of the original amount plus interest, with the claim being repayable regardless of the financial performance of
the debtor. When these underlying characteristics do not hold, the finance should be classified as one of the o
her forms, including mezzanine, hybrid or equity finance.
392
3 Factors affecting the riskiness of debt

Interest and interest-rate risk
Debt can be charged a fixed or floating rate of interest, exposing the debtor to interest-rate risk. As future
interest rates are uncertain, debt bearing interest at a floating rate exposes the debtor to changes in future
cash-flow obligations.
In comparison, when interest rates change, debt bearing interest at a fixed rate will still require the same cash-
flow obligation, but this may affect the fair market value of the debt. For example, if interest rates should fall
whilst holding fixed-rate debt, the fair market value of the debt will increase in va ue.
Debt bearing interest at a floating rate is expected to display less disparity over time between its fair market
value and its outstanding principal amount, when compared to a fixed-r te lo n. (As discussed under prefer-
ence shares, in this case market forces are again likely to change the underlying flo ting rate, and will therefore
help to better align the future interest paid and its fair rate of return; again, differences can and probably will
still exist.)
Security offered
The risk associated with debt finance and its impact on a required return can further be linked to the security
offered on the debt. Security can take various forms, including surety offered by another related entity, the
underlying asset(s) being financed with the debt, or other asset(s).
Even though the new business rescue procedure contained in the Co panies Act 71 of 2008 has to a certain
extent reduced the benefit of security offered to cr ditors, uns cured debt is nonetheless viewed as more risky
than secured debt. All other factors being equal, uns cur d d bt providers therefore require a higher return.
In the case of default on the repayment terms of unsecured debt, the holder will have to initiate cumbersome
actions to recover a portion of outstanding debt, such as an application for the liquidation of the defaulter
(further complicated by the new business rescue procedure).
In the case of default on secured debt, the holder will normally have the right to lay claim on the asset(s)
offered as security, following the institution of legal proceedings relating to the default (although this, too, may
be impacted by the business rescue procedure).
Debt covenants
The risk associated with debt finance and its impact on a required return is further impacted by the presence of
debt covenants. Debt covenants are conditions stipulated in a debt contract, which may decrease the credit risk
of the creditor. Debt covenants may include requirements to maintain certain ratios and clauses prohibit-ing
certain actions, such as the payment of dividends to ordinary shareholders or the sale of certain assets.
Examples of ratios specified as debt covenants include (1) a maximum debt-to-equity ratio, (2) a maximum
ratio of debt to Earnings B fore Tax, Depreciation and Amortisation ratio (Debt-to-EBITDA), and (3) a minimum
ratio of EBITDA-to-N t-Int r st.
10.4.3 Tax treatment and valuation inputs

The characte istics of the debt and its tax treatment will also affect the inputs of a valuation based on dis-
counted cashflow
To repeat, the tax treatment of interest is a specialised area with many complications. A detailed exploration of
the tax treatment linked to interest is therefore beyond the scope of this publication. This chapter only de-
scribes and illustrates the principle, basic tax treatment of interest. It further provides a brief summary of the
alternative tax treatment in the case of certain forms of debt.
The mo t important sections of the Income Tax Act affecting interest is described below.
1 Section 24J of the Income Tax Act (Intermediate)

In terms of current South African tax law, interest is normally deductible by the debtor (borrower) and repre-
sents income in the hands of the creditor (lender). In this regard, section 24J of the Income Tax Act is im-
portant, as it is the main section under which interest will be either deductible or included in income.
393
Stiglingh, Koekemoer and Wilcocks, (2013:742) describes the role of section 24J of the Income Tax Act, as
follows:
Section 24J regulates the timing of the accrual and incurral of interest. In general terms, it spreads the in-
terest (and any premium or discount) over the period or term of the financial arrangement by com-
pounding the interest over fixed accrual periods using a predetermined rate referred to as the ‘yield to ma-
turity’. The section also governs the inclusion of interest accrued in a taxpayer’s gross income and the de-
duction of interest incurred from income.
Section 24J identifies three different methods to calculate the spread of the interest, but for purposes of this
chapter only the principle, yield to maturity method is considered.
Yield to maturity method

The yield to maturity method helps to prevent tax avoidance and is also known as the accrual method. Yield to
maturity method spreads the full interest over the full term (theref re also considering any premium or dis-
count), by compounding the interest over fixed accrual periods using a predetermined rate referred to as the
‘yield to maturity’ (Stiglingh, 2013).
The following formula has to be applied per section 24J of the Inco e Tax Act:
A=B×C
Where:
= the accrual amount to be included in the taxation calculation (apportioned on a day-to-day ba-sis,
if not for a full year);
=the yield to maturity on the instrument on a pre-tax basis; and
= the adjusted initial amount (issue price plus prior accrual amounts, less prior interest payments
made).
During the term of the debt, if there are changes that would affect the yield to maturity, such as changes in the
interest rate or the term, the calculation will have to be performed again.
Note: As indicated, for purposes of this chapter, valuations are usually performed from the perspective of
the entity using the preference shares or debt as finance (debtor). (Unqualified use of the terms ‘is-
suer’ and ‘holder’ are purposely ignored in the current chapter to avoid confusion with the somewhat
contradictory terminology used in the taxation discipline.) This implies that specific adjustment nor-
mally has to be made for the fact that interest may be deducted for purposes of income tax in terms
of section 24J – affecting cashflows, and further for the tax-deductibility of interest at the required
discount rate.
Example: Impa t of se tion 24J of the Income Tax Act on the valuation of debt (Fundamental to
Intermediate)
As part of its capital st ucture a company has in issue medium-term notes with the following particulars:
The notes have a face value of R1000 each.
The notes pay a variable coupon rate equal to 10% per annum at a date coinciding with the company’s
year-end (this is similar to interest, which accrues and is payable once a year).
The notes will be redeemed at face value.
A market-related interest rate on notes with similar risk equals 13,3892% before tax.
Required
Determine the present fair market value of the notes by:
Determining the value of the instrument on a pre-tax basis. (Fundamental)
Determining the present value of the expected after-tax cash flows. (Intermediate)
394

The bond qualifies as an instrument per section 24J of the Income Tax Act (the yield to maturity
method will apply).
A=B×C
Where:
B = the yield to maturity on a pre-tax basis;
and C = the adjusted initial amount.
Solution
Part (a) Determine the value of the instrument on a pre-tax basis
Year: 0 1 2 3 4
(Valuation
date)
Redemption (1 000)
Finance-related cash flows before-tax (100) (100) (100) (1 100)
Fair rate of return 13,3892% 0,88192 0,77778 0,685938 0,604941
Net present cost (900) (88) (78) (69) (665)
Or using calculator inputs:

I/YR 13,3892%
PMT = (100)
FV = (1 000)
P/YR = 1
Determine PV = (900)
Note: Pre-tax cashflows r quir s a pre-tax discount rate.
395
Part (b) Determine the present value of expected after-tax cash flows
Year: 0 1 2 3 4
(Valuation date)
Redemption (1 000)
(100) (100) (100) (1 100)
Taxation at 28% (A × 28%) 34 35 35 36
Accrual amount (A) (A = B × C) (N1) 120,50 123,25 126,36 129,89
Pre-tax YTM (B) = 13,3892% 13,3892% 13,3892% 13,3892%
Adjusted initial amount (C) = 900,00 920,50 943,75 970,11
Initial amount 900,00 900,00 900,00 900,00
Plus: prior accrual amounts 0,00 120,50 243,75 370,11
Period 0 0,00 0,00 0,00 0,00
Period 1 120,50 120,50 120,50
Period 2 123,25 123,25
Period 3 126,36
Less: prior payments 0,00 (100,00) (200,00) (300,00)
Period 0 0,00 0,00 0,00 0,00
Period 1 (100,00) (100,00) (100,00)
Period 2 (100,00) (100,00)
Period 3 (100,00)
Finance-related cash flows after-tax (66) (65) (65) (1 064)
Fair rate of return

after tax 9,640% 1,09640 1,20209 1,31798 1,44503
[0,133892 × (1-0,28)]
Net present cost ( 900) (60) (54) (49) (736)
Note:
After-tax cashflows requires an after-tax discount rate
Figures may not total due to rounding.
To better understand the different perspectives applied in the financing decision and as part of the valua-
tion of debt, compare the methodology used above (to determine net present cost) with the example con-
tained in chapt r 7, s ction 7.13 (to determine the internal rate of return)
N1 The accrual amount (A) could also be determined using the amortisation-function on a financial calculator
Calculator inputs:
PV = 900
PMT = (100)
FV = (1 000)
P/YR = 1
N= 4
I/YR = 13,3892
Interest 120,50
Interest 123,25
Interest 126,36
Interest 129,89
396
Note: In this case the answer to part (b) approximates the answer to part (a). However, In order to deter-
mine the exact treatment to be followed in a test or exam, a student should refer to the exact word-
ing of the required-section and the number of marks awarded. It is generally better to make use of
an approach as per part (b), since it will provide a more accurate answer in certain cases.
2 Hybrid instruments for income tax purposes (Intermediate)
On occasion, debt may also display characteristics of a share. The treatment of hybrid debt instruments and
hybrid interest is regulated by sections 8F and 8FA of the Income Tax Act. Current tax legislation identifies
hybrid debt instruments, including (but with exceptions):
debt convertible into shares at a predetermined ratio or by ignoring market va ues (thus not if the market
value of shares is directly linked to the outstanding capital balance);
debt instruments paying dividend-like interest, such as interest linked to the debtor’s profits or with a
conditional obligation to pay (exceptions apply); and
debt instruments between connected persons with terms of 30 years or longer.
In terms of the current legislation, interest payable on hybrid debt instruments will be classified as a dividend in
specie in the hands of both the debtor and creditor. This basically implies that the debtor (the borrower) will be
denied an interest deduction and will be subject to 15% dividends tax. (The regular treatment of a dividend in
specie was described in section 10.3.3.)
To reiterate, the examples in this chapter assume that section 8 of the Income Tax Act does not apply.
3 Limitation on interest deductions (Intermediat )
Current South African tax law also specifies several circumstances that would limit the deductibility of an
interest expense and is regulated by section 23 of the Income Tax Act. Currently interest deductions are limited
in certain cases of:
Interest payable to connected persons who are not subject to tax; and
Interest payable in respect of reorganisation transactions (intra-group or liquidation transactions) and
acquisition transactions (to acquire shares).
Valuing bonds
What is a bond?
A bond is a type of interest-bearing security. The worldwide market for bonds is enormous and forms one of
the backbones of the modern economy. Bonds form part of the market for capital, with maturity rates in excess
of one year, and is normally used as medium- to long-term finance.
Bonds encompass several securities which may be referred to as bonds, notes, debentures and other names.
Bonds are typically uns cur d and are therefore normally issued by entities with stronger credit ratings, such as:
sovereign (self-determining) governments – for example the South African R186 government bond (alt-
hough SA’s edit ating was downgraded in recent years, with the main reasons cited as slow growth,
protracted st ikes and concerns over political leadership);
l state-owned tilities – such as the ES26 bond issued by Eskom (although the electricity public utility’s
credit rating, too, was downgraded recently, mainly due to the country’s downgrade and its inability to
reco p operating losses due to a government-imposed limitation on higher increases in electricity tariffs);
l cal g vernments – such as a municipal bond issued by the City of Johannesburg; and
large c rp rations – such as a bond issued by Shoprite-Checkers.
Bonds may, however, also be secured.
In ear ier days, bonds used to pay fixed coupons (which are similar to interest) – thereby earning a name that
stuck: fixed-income instruments. Nowadays, though, bonds offer fixed or floating rates of interest. Interest is
not lways paid periodically, however, such as in the case of zero-coupon bonds. As the name implies, zero-
coupon bonds pays no coupons, but are issued at a discount to its principle value and redeemed at the maturi-y
date at the principle value – the difference representing interest. Many other exotic forms of bonds exist.
397
What is a security?
Securities are instruments issued directly to investors, called the primary market transaction, thereby bypass-
ing a bank as an intermediary finance provider. Previously issued bonds may be traded between investors,
called a secondary market transaction, a process which is usually facilitated by a securities exchange, such as
the Bond Exchange of South Africa – a division of the JSE. Since a securities exchange will make trading a lot
easier, aiding liquidity, numerous bonds are listed on these exchanges.
Investigating the process of valuing bonds will illustrate most of the considerations underlying the valuation of
debt in general.
Sold with or without interest

The date of selling a bond usually does not coincide with the date of the p yment of coupon. If a bond is sold,
the value of the bond will be affected by whether or not the new owner will lso receive the current coupon.
Similar to preference shares, the bond may be classified ‘ex-coupon’ or ‘ex- interest’ after a certain date, imply-
ing that if a new owner purchased the bond ex-interest, s/he would not be entitled to receive the current
coupon; it would be paid to the previous owner.
Furthermore, a bond may be classified ‘cum-interest’ up to certain date, implying that if a new owner pur-
chased the bond cum-interest, s/he would be entitled to receive the current coupon also.
Example: Valuing a fixed-rate bond (Fundamental to Inter ediate)

A company intends to raise additional debt capital through the issue of bonds. The bonds to be issued will be
unsecured bonds with a total nominal value of R100 million, paying a fixed 8% coupon annually in arrears. The
bonds will mature in five years’ time. A market-related interest rate on bonds with similar risk is equal to 9%
before tax.
Required:
Determine the price at which the bonds should be issued to ensure sufficient demand from investors,
ignoring the effect of tax, whilst ignoring any potential impact of section 8 of the Income Tax Act. (Fun-
damental.)
Determine the price at which the bonds should be issued to ensure sufficient demand from investors,
incorporating the effect of tax in the calculation, whilst ignoring any potential impact of section 8 of the
Income Tax Act. (Intermediate.)
l The company has a marginal income tax rate equal to 28%.
The bond qualifies as an instrument per section 24J of the Income Tax Act (the yield to maturity
method will apply).
The formula to be applied per section 24J of the Income Tax Act
is: A = B × C
Whe e:
A = the accr al amount;
B = the yield to maturity on a pre-tax basis;
and C = the adjusted initial amount.
398
Solution:
(Intermediate: Even if the impact of section 8 of the Income Tax Act had to be considered in this case, it would
not apply as the debt does not display characteristics of a share, as defined in the Act.)
Part (a) Year: 0 1 2 3 4 5
(issue date) R’m R’m R’m R’m R’m
Coupons (8) (8) (8) (8) (8)
Amount redeemed (100)
(8) (8) (8) (8) (108)

R’m
Net present cost (NPC) (96,11) (7,34) (6,73) (6,18) (5,67) (70,19)
Note: Figures may not total correctly due to rounding.
Conclusion:
The bonds should be issued at a discount to its nominal value, equal to a consideration of R96,11 million, to
ensure sufficient demand from investors.
Part (b) Year: 0 1 2 3 4 5

(issue date) R’m R’m R’m R’m R’m
Coupons (8,00) (8,00) (8,00) (8,00) (8,00)
Amount redeemed (100,00)
Tax effect of section 24J (A × 28%) 2,42 2,44 2,46 2,48 2,50
Section 24J Accrual amount (A)
(A = B × C) (N1) 8,65 8,71 8,77 8,84 8,92
(5,58) (5,56) (5,54) (5,52) (105,50)

= 9% × (1 – 28%)
R’m
Net present cost (96,11) (5,24) (4,90) (4,59) (4,29) (77,08)
General notes:
Figures may not total corr ctly due to rounding.
Part (b) requires inputs from the calculation performed in part (a).
In this case the answer to part (b) approximates the answer to part (a). However, in order to determine the
exact treatment to be followed in a test or exam, a student should refer to the exact wording of the re-
quired-section and the number of marks awarded. It is generally better to make use of an approach as per
part (b), since it will provide a more accurate answer in certain cases.
C nclusi n:
The b nds sh uld be issued at a discount to its nominal value, equal to a consideration of R96,11 million (the
ame value as that obtained in part (a)), to ensure sufficient demand from investors.
Specific notes:
N1 In this case a financial calculator was used to determine the accrual amounts (A). Refer to example in-
cluded in section 10.4.3 for an illustration of the full calculation using the long method.
399
Calculator inputs:
PV = 96,11
PMT = (8)
FV = (100)
P/YR = 1
N= 5
I/YR 9

Interest 8,65
Interest 8,71
Interest 8,77
Interest 8,84
Interest 8,92
10.4.5 Valuing convertible debt

Certain forms of debt may be converted into, for instanc , ordinary equity at a future date. As for convertible
preference shares, this may help to increase the attractiveness of the debt. The debt may be convertible at the
option of either the debtor or the creditor.
Valuing convertible debt

To value convertible debt (or convertible preference shares for that matter), one follows the usual processes
already described, but additionally, one has to determine the value of the most likely option linked to the
conversion, and include this as part of the projected cashflows.
To determine the value of the most likely option, one first determines the value of each option linked to the
conversion, such as –
Option 1 – the value of the equivalent number of shares that the debt could be converted into (using
some appropriate valuation method); and
Option 2 – the value if the debt is redeemed.
The most likely option is the rational choice that would be followed by the holder of the conversion option, for
example –
if the creditor has the option to convert the debt into, for example ordinary shares, and the value of this
option is higher than the alternative options, then this would represent the most likely option that
would be exer ised by said creditor; or
if the debtor has the option to convert the debt into, for example ordinary shares, and the value of this
option is higher than the alternative options, then this would represent the least likely option to be ex-
ercised by said debtor. The debtor will exercise the option with the lowest value, thereby minimising
cost.
Example: Valuing convertible debt (Fundamental)

A company intends to raise additional debt capital through the issue of convertible bonds. The bonds to be i
ued will be 1 000 000 unsecured bonds with a total nominal value of R1 each, paying a fixed 9% coupon annua
y in arrears. The coupon rate is considered to be market-related.
The bonds will be convertible in four years’ time at the option of the holder.
400
On the conversion date two options exist, namely:

Convert each bond into a single ordinary share at its then fair market value. (A cluster of ordinary shares
recently traded at 90c per share between non-related parties. At present, there is a 50% probability allocat-
ed to a pessimistic scenario, where the ordinary shares show no growth in their fair market value over the
next few years; with a 50% probability allocated to a more optimistic scenario, where the shares will show a
10% growth in fair market value, per annum.)
Redeem the bonds at their nominal value.
Required:
Determine the likely fair market value of the 1 000 000 convertible bonds on the issue date, ignoring the effect
of tax, whilst ignoring any potential impact of section 8 of the Income T x Act.
Solution:
(Intermediate: Even if the impact of section 8 of the Income Tax Act had to be considered in this case, it would
not apply as the convertible debt here is linked to the market value f a share, and therefore the debt does not
display characteristics of a share, as defined in the Act.)
Step 1: Determine the likely value of each conversion option at the conversion date
Conversion option 1: Convert into ordinary shares
Determine the likely fair market value of 1 000 000 ordinary shar s in 4 years’ time:
Present fair market value: 90 c × 1 000 000 = R900 000
Year: 0 1 2 3 4
(issue date)
R R R R R
Pessimistic: fair market
900 000 900 000 900 000 900 000 900 000
value
Optimistic: fair market
900 000 990 000 1 089 000 1 197 900 1 317 690
value
= 900 000 × 1,1= 990 000 × 1,1 = 1 089 000 × 1,1 = 1 197 900 ×1,1
Year: 4
Probability weighted Probability R
Pessimistic: 50% × R900 000 (pessimistic scenario) 50% 450 000
Optimistic: 50% × R1 317 690 (more optimistic scenario) 50% 658 845
1 108 845
Conversion option 2: R d m bonds at nominal value
Redeem bonds at nominal value
Year: 4
R
R1 × 1 000 000 1 000 000
Step 2: Determine the appropriate value at the conversion date, to be included in discounted cashflow calcula-
tion
Since c nversi n is at the option of the entity holding the debt (creditor), the creditor will choose the option
likely to pr vide the greatest cashflow benefit in Year 4: Option 1 – conversion into ordinary shares. (At this
time the value is likely to equal R1 108 845, which is more than R1 000 000.)
401
Step 3: Determine the likely fair market value of the bonds from the perspective of the entity issuing the bonds
(debtor), using a method based on discounted cashflow
Year: 0 1 2 3 4
(issue date) R R R R
Coupons (1 000 000 × R1 × 9%) (90 000) (90 000) (90 000) (90 000)
Conversion value (1 108 845)
Based on the likely choice of the entity holding
the debt (creditor), the valuation from the
perspective of the debtor will have to include
the highest cost option (90 000) (90 000) (90 000) (1 198 845)
Fair rate of return 9,00% 0,9174 0,8417 0,7722 0,7084

R
Net present cost (1 077 079) (82 566) (75 753) (69 498) (849 262)
Conclusion:
The likely fair market value of the 1 000 000 convertible bonds on the issue date is R1 077 079.
Practice qu stion
Question 10–1 (Fundamental to Intermediate) 25 marks 38 minutes

Sungura Limited (‘Sungura’) is a company that is listed on the JSE. Sungura plans to spend R100 million on
expanding its existing business. It has been suggested that the money could be raised by issuing 9% loan notes
redeemable in ten years’ time. Current financial information on Sungura is as follows (not yet prepared on the
basis of IFRS).
Condensed Statement of Profit/Loss and Other Comprehensive
Income for the most recent financial year ended:
R’m
Profit before interest and tax 70,0
Interest (actual expense) (5,0)
Profit before tax 65,0
Tax (19,5)
Profit for the p riod 45,5
Condensed Statement of Financial Position at the end of the most recent financial year
ASSETS R’m
Non-cu ent assets 200
C rrent assets 200
TOTAL ASSETS 400
EQUITY and LIABILITIES

Share capital and reserves
Ordinary shares without par value issued at R10 each 50
9% non-redeemable preference shares with a nominal consideration of R10 each 25
Interest bearing liabilities
10% loan notes 50
Current liabilities 50
TOTAL EQUITY and LIABILITIES 400
402
The current ex- div (i.e. without dividend) ordinary share price is R45 per share. An ordinary dividend of 350
cents per share has just been paid and dividends are expected to increase by 4% per year for the foreseeable
future. The current ex-div preference share price is 762 cents. The loan notes are secured on the existing non-
current assets of Sungura and are redeemable at par in eight years’ time. They have a current ex-interest
market price of R1 050 per R1 000 loan note. Sungura pays tax on profits at an annual rate of 30%.
The expansion of business is expected to increase profit before interest and tax by 12% in the first year. Sun-
gura has no overdraft.
Average sector ratios:

Interest coverage ratio: 12 times
Required:
Calculate the current weighted average cost of capital of Sungura Ltd using the fair market values of the
different forms of capital as the weights. (Use a simplified method to determine the after-tax cost of debt,
without incorporating the effects of section 24J of the Inc me Tax Act.) (14 marks)
Discuss whether financial management theory suggests that Sungura Ltd can reduce its weighted average
cost of capital to a minimum level. (8 marks)
Evaluate and comment on the effects, after one year, of the loan-note issue and the expansion of busi-
ness on the interest coverage ratio. (3 marks) (Source: ACCA, ACCA pilot paper, 2012 – slightly adapt d)
Solution:
Calculation of WACC
Note: figures may not total due to rounding.
Market values
Fair market value of ordinary shares = 5m × R45 = R225 million
Fair market value of preference shares = 2,5m × R7,62 = R19,05 million
Fair market value of 10% loan notes = 50 000 × R1 050 = R52,5 million
Total fair market value = 225m + 19,05m + 52,5m = R296,55 million
Required rates of return

Cost of equity using dividend growth model
D1
P0 = r – g or
D1
P0 = ke – g now rearrange the variables
1 D1 1
P0 × D1 = ke – g × D1
P0 1
=
D1 Ke – g
D1 Ke – g
=
P0 1
D1
+g = Ke – g +g
P0
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D1
+g = Ke
P0
D1
Ke = +g
P0
Thus:
R3,50 × 1,04
Ke = + 4%
R45
Ke = 12,08%
Cost of preference shares = (9% × R10) / 7,62 = 11,81%
Cost of the loan notes:

0 1 2 3 4 5 6 7 8
R’m R’m R’m R’m R’m R’m R’m R’m
Current fair market value 52,5
Interest (5,0) (5,0) (5,0) (5,0) (5,0) (5,0) (5,0) (5,0)
Redeemed (50 000 × R1 000) (50,0)
52,5 (5,0) (5,0) (5,0) (5,0) (5,0) (5,0) (5,0) (55,0)
Calculate IRR using a financial calculator

IRR = 9,09% Before tax
9,09% × (1 – 30%)
= 6,37% After tax
Calculation of WACC
Form of capital Fair market Proportion Required Weighted
value return
’m % % %
Ordinary shares 225,00 75,9 12,08 9,17
Preference shares 19,05 6,4 11,81 0,76
Loan notes 52,50 17,7 6,37 1,13
296,55 100,0 11,06
Part (b) discussion

Sungura Ltd has long-t rm finance provided by ordinary shares, preference shares and loan notes. The rate of
return required by ea h sour e of finance depends on its risk from an investor point of view, with equity (ordi-
nary shares) being seen as the most risky and debt (in this case loan notes) seen as the least risky. Ignoring
taxation, the weighted average cost of capital (WACC) would therefore be expected to decrease as equity is
replaced by debt, since debt is cheaper than equity – that is, the cost of debt is less than the cost of equity.
However, financial risk increases as equity is replaced by debt and so the cost of equity will increase as a
company gears p, offsetting the effect of cheaper debt. At low and moderate levels of gearing, the before-tax
cost of debt will be constant, but it will increase at high levels of gearing due to the possibility of bankruptcy. At
high levels f gearing, the cost of equity will increase to reflect bankruptcy risk in addition to financial risk.
In the traditional view of capital structure, ordinary shareholders are relatively indifferent to the addition of
mall amounts of debt in terms of increasing financial risk and so the WACC falls as a company gears up. As
gearing up continues, the cost of equity increases to include a financial risk premium and the WACC reaches a
minimum value. Beyond this minimum point, the WACC increases due to the effect of increasing financial risk
on the cost of equity and, at higher levels of gearing, due to the effect of increasing bankruptcy risk on both the
cost of equity and the cost of debt. On this traditional view, therefore, Sungura can gear up using debt and
reduce its WACC to a minimum, at which point its market value (the present value of future corporate cash-
flows) will be maximised.
404
In contrast to the traditional view, continuing to ignore taxation but assuming a perfect capital market, Miller
and Modigliani demonstrated that the WACC remained constant as a company geared up, with the increase in
the cost of equity due to financial risk exactly balancing the decrease in the WACC caused by the lower before-
tax cost of debt. Since in a prefect capital market the possibility of bankruptcy risk does not arise, the WACC is
constant at all gearing levels and the market value of the company is also constant. Miller and Modigliani
showed, therefore, that the market value of a company depends on its business risk alone, and not on its
financial risk. On this view, therefore, Sungura cannot reduce its WACC to a minimum.
When corporate tax was admitted into the analysis of Miller and Modigliani, a different picture emerged. The
interest payments on debt reduced tax liability, which meant that the WACC fe as gearing increased, due to the
tax shield given to profits. On this view, Sungura could reduce its WACC to a minimum by taking on as much
debt as possible.
However, a perfect capital market is not available in the real world and t high levels of gearing the tax shield
offered by interest payments is more than offset by the effects of bankruptcy risk and other costs associated
with the need to service large amounts of debt. Sungura should therefore be able to reduce its WACC by
gearing up, although it may be difficult to determine whether it has reached a capital structure giving a mini-
mum WACC.
(c) Interest coverage ratio

Current interest coverage ratio = R70m / R5m = 14 ti es
Increased profit before interest and tax = R70m × 1,12 = R78,4m
Increased interest payment = (R100m × 9%) n w int rest + R5m existing interest = R14m
Interest coverage ratio after one year = R78,4/ R14 m = 5,6 times.
The current interest coverage of Sungura is higher than the sector average and can be regarded as fairly safe.
Following the new loan note issue, however, interest coverage is less than half of the sector average, perhaps
indicating that Sungura may not find it easy to meet its interest payments.
(Source: ACCA, ACCA pilot paper, 2012 – slightly adapted)
405
Chapter 11
Business and equity

v luations
identify and explain the different definitions of valu ;

clearly differentiate between financial reporting principl s and business valuation principles;
display a clear understanding of the various valuation approaches, methodologies, methods and models,
and the linkages between them;
critically reflect on the circumstances in which different valuation approaches, methodologies, methods
and models will be suitable in a valuation;
correctly incorporate the appropriate types of valuation premiums and discounts into a valuation
method or model;
use a range of specialised skills to perform, and professionally present, a comprehensive business or
equity valuation using the following methodologies, methods or models: Price of recent investment,
earnings multiples (including the P/E multiple and MVIC/EBITDA multiple), market price multiples, the
Gordon Dividend Growth Model, models based on Free Cashflow, a model based on EVA/MVA, and net
assets;
critically reflect upon the assumptions and information that underlie a valuation;
critically review a valuation performed by a third party; and
identify and d scribe factors affecting the value of a business or equity shareholding, and offer a
recommendation on the choice of action, based on a scenario.
This chapter further explores the stimulating topic of valuations by concentrating on business and equity
valuations. Mo e specifically, the focus of this chapter is on the valuation of South African, private equity
business ente p ises (i.e. unlisted entities), or a majority or minority shareholding in such a business.
It is important to realise from the outset that this chapter does not represent an exhaustive guide to business
and eq ity val ations; it covers only a limited number of valuation methodologies, methods and models; but
aims to include those that are most academically sound, widely used in practice today and that are increasing
in p pularity.
As uch, this chapter builds on the concepts introduced in chapter 10 (Valuations of preference shares and debt),
and conveys essential knowledge that will serve as a stepping-stone towards a student’s ability to master va
uations in the context of Mergers and acquisitions (chapter 12), and Interest rates and interest rate risk
(chapter 16). In this process the chapter addresses a mix of fundamental, intermediate and advanced topics.
For convenience, the intermediate and advanced areas are labelled as such. (Unlabelled areas therefore repre-
sent basic, fundamental knowledge areas.)
This chapter will first traverse basic valuation concepts, including: (1) different definitions of value; (2) differ-
ences between financial reporting principles and business valuation principles; (3) different valuation ap-
proaches, methodologies, methods and models, and the appropriate circumstances under which they could be
407
used; and also (4) different valuation premiums and discounts, and the circumstances under which they should
be applied.
As a second phase, this chapter will apply the basic concepts to illustrate and explore the valuation process
using several methods and models, including: (1) the P/E multiple, (2) the MVIC/EBITDA multiple, (3) the
Gordon Growth Model, (4) models based on Free Cashflow, and (5) a model based on EVA/MVA.
Thirdly, this chapter will consolidate all that was learned to support critical reflection on: (1) valuations per-
formed by others, and (2) factors affecting the value of a business or equity shareholding.
Throughout the chapter, the aim is to promote the application of sound va uation principles, based on proper
understanding; the application of quick valuation ‘recipes’ or the short-term memorisation of ‘shortcuts’ are
therefore strongly discouraged.
11.1 Some of the intricacies of value

The obvious starting point to business and equity valuations is their basic building block: value. Of course, the
way in which value is created and measured has already been c ntemplated for centuries. A few more recent
examples will hopefully jumpstart the learning process
in the late 1990s, only to disappear or shed most value when the ‘Internet’ or ‘.com bubble’ burst after the turn
of the millennium. Was this reduction in value because the Internet was not as revolutionary as people
thought, or were those Internet companies themselves not really as promising as they claimed to be? and help
to unpack some of the intricacies of value.
Consider the following examples.
The value of shares in South African platinum mining companies fell in recent years. Since platinum is a
rare precious metal used in several applications – including catalytic converters (an automobile compo-
nent), lab equipment, electronics and jewellery – has there been a reduction in worldwide demand for
these goods or has platinum been substituted by other materials? Is the fall in value of the shares in these
mining companies due to the waves of debilitating industrial action that hit South Africa in recent years or
the deadly Marikana mining strikes of 2012? Is this fall due to the severe slump in platinum production
that followed these strikes or the cyclical nature of mining? Finally, is it due to the uncertain fiscal policies
in South Africa, with the ruling party seeking greater rents (mining royalties) from the mining companies,
or actually, a combination of all these factors?
The value of Internet companies grew substantially.
Today’s major Internet companies, such as Facebook, Inc and Twitter, Inc – that recently obtained listings
on US stock exchanges – have not yet delivered much in terms of earnings or cash flows, given their sub-
stantial market valuations. Will these companies live up to their lofty promises or are they, too, overval-
ued? Are these companies different from those that came in the 1990s or is yet another Internet bubble
forming?
A man owns a family-run green-grocer, which is barely profitable, and is situated on a prime piece of real
estate. Why would this man refuse to sell, even if offered a large amount of money by a property devel-
oper? Is the man i ational or does he possibly value family tradition and a passion for his business more
highly than money?
Two appraisers will seldom obtain exactly the same value for a business enterprise. Is the one right and
the other wrong? Are both wrong, or can both be right?
These questi ns obviously raise a few interesting points. Certainly an appraiser must have a good awareness of
ec n mic and ther developments, and their implications on the business being valued. (It is therefore essen-tial f
r an appraiser – and by implication a student studying the topic of business valuations – to read business article
, and to read widely.) An appraiser would therefore be wise not to lose sight of the fundamental drivers of va
ue, no matter the latest fads, or the complexity of a particular valuation model.
The term value obviously also does not have the same meaning to all persons and in all circumstances. From
the questions it is also clear that value is not always measured in monetary terms. Likewise, Albert Einstein
summed up his sentiments thus: ‘Everything that can be counted does not necessarily count; everything that
counts cannot necessarily be counted.’. This is true of course; nevertheless, one should remember that valua-
ion for purposes of this chapter is essentially the act whereby monetary value is estimated.
408
Business and equity valuations Chapter 11
It has further been said that valuation is highly subjective and is more of an art than a science. Assuming this is
true, how then can valuation possibly be taught to managerial finance students? It can, but only if one demysti-
fies both the concept and the uncertainties surrounding it. Here, the following words may serve as a first step
on this journey:
‘Valuation is a prophecy as to the future and must be based on the facts available at the required date of
appraisal.’ (Larry Kasper, 1997:5).
11.2 Reasons for undertaking business and equity valuations

Appraisers in South Africa are called upon to perform valuations for many different reasons, all of which may
require different assumptions and methodologies. These reasons can include –
l an acquisition or disposal of an entire business, a minority interest or m jority interest in a business
enterprise from its present owners, not part of a merger or acquisition by another business;
an acquisition or disposal of an entire business, a minority interest or a majority interest in a business
enterprise from its present owners, part of a merger or acquisiti n by another business (necessitating ad-
ditional considerations, which are addressed in chapter 12 (Mergers and acquisitions));
further equity investment (capital injection) in a business enterprise;
valuation for taxation purposes (e.g. for purposes of donations tax, estate duty or capital gains tax);
valuation for financial reporting purposes;
an initial public offering, as part of a new company listing; and
as security for a loan, including management buy-outs.
Since this chapter does not aim to be an exhaustive guide to valuations, or to explore valuations for all the
purposes mentioned above, it does not address all valuation methodologies, methods and models. For in-
stance, this chapter does not address the valuation of financial institutions and other specialised business
entities with unique requirements.
11.3 Underlying valuation theory

This section considers the essential theory of valuations, including different definitions of value, a comparison
to financial reporting principles, and different valuation approaches.
11.3.1 Different definitions of value

Why are there so many diff r nt definitions of value and what is meant by the word ‘value’? Firstly, it im-
portant to realise that the r ason for the valuation could affect the definition of value (e.g. a valuation for
financial reporting purpos s may require the use of certain fixed definitions of value, such as fair value and
historical cost).
Secondly, one should ealise that the same business could also have different values to different parties. It is
therefore vital to think about the party for whom the valuation is prepared and to then use the correct ‘think-
ing hat’ and val e definition.
There are many different definitions of value, including: historical cost, market value, fair market value, intrin-
sic value, market capitalisation, and liquidation value. For purposes of this chapter ‘fair market value’ and
‘market capitalisation’ are the most important.
Historical cost
Simp y tated, historical cost represents the original monetary sum paid for something. Historical cost is fixed at
a certain point in the past and therefore has the limitation that it does not account for any changes in the v lue
of money over time.
This concept of value has historically been applied extensively in the financial reporting field, but is increasingly
being modified for certain items accounted for at fair market value. Unadjusted historical cost has little rele-
vance in business and equity valuations.
409
Market value
Market value is often simply defined as the price the buyer is willing to pay and the seller is willing to sell for
something as determined by demand and supply considerations. It represents a general definition, with other
definitions (e.g. fair market value, intrinsic value and market capitalisation) being more clearly defined sub-
definitions.
Fair market value

For purposes of this chapter fair market value is defined as follows:
the amount for which a business enterprise, or shareholding in such enterprise, can be exchanged;
l involving a (hypothetical) willing buyer and (hypothetical) willing seller (thus, ny possible bidder – even if
they don’t really exist – and not a specific buyer);
where both parties have reasonable knowledge of the relevant facts;
considering the highest and best use of the business, or its underlying assets;
with the transaction representing an arm’s-length transacti n (between independent parties who are on
equal footing).
Clearly the definition of ‘fair market value’ shows strong rese blance to that of ‘fair value’, as used in Interna-
tional Financial Reporting Standards. However, the guidelines on fair value measurement are increasingly
tailored for purposes of financial reporting. This chapter therefore refers to ‘fair market value’ in order to
promote the use of an appraiser’s ‘thinking hat’ – as oppos d to a financial reporting one – and to avoid confu-
sion.
Certain concepts are closely associated with the definition of fair market value and are further described
below.
Synergy benefits (Advanced for purposes of this chapter)

Research demonstrates that mergers and acquisitions of business entities may create synergy benefits –
frequently referred to as the ‘2 + 2 = 5 effect’ (i.e. the sum is greater than the individual components) –
but, notably, that this is by no means guaranteed. Synergy benefits are frequently overestimated, but
could exist thanks to efficiencies, economies, and other benefits that are realised when bringing together
two disparate business entities.
A merger between two automobile manufacturers, for example, could lead to synergy benefits, in the
form of economies of scale in production, where these manufacturers could better share vehicle plat-
forms and therefore move closer to an efficient scale in production. Nonetheless, the numerous unsuc-
cessful mergers between automobile manufacturers (e.g. the merger between Daimler-Benz and Chrysler
in 1998, which failed mainly due to corporate culture clashes) testify to the difficulty in realising synergy
benefits.
When determining the fair market value of a business enterprise an appraiser must consider the afore-
mentioned five elements and may therefore only incorporate synergy benefits – if any – that could exist
between the business enterprise being valued and (hypothetical) buyers in general (i.e. not a specific ac-
quirer). Unique synergy benefits that could exist only between the business being valued and a specific
buyer (i.e. the benefits unavailable to others) must therefore be ignored.
For exam p rposes, unless specific information is available to determine the value of general synergies
for p rposes of determining the fair market value of a business or equity interest, one should ignore
synergy benefits. However, synergy benefits are more likely to feature as part of valuations for purpos-
es f mergers and acquisitions. The intricacies of synergies are explored further in Mergers and Acquisi-ti
ns (chapter 12).
Highe t and best use
When applying the fair market value definition, an appraiser should consider the highest and best use of
the business, or its underlying assets, obtainable from:
l the value in its continued use as a going concern; or
l the value in exchange, as part of an orderly sale (not a forced liquidation).
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When determining the fair market value, for example, of the family-run green grocer situated on prime
real estate, mentioned in one of the introductory statements to this chapter, one must therefore consider
the price that will possibly be offered by a (hypothetical) buyer.
In this case, the highest and best use is probably from the value in exchange (due to a buyer being willing
to pay more for the land), not the continued use of the business as a going concern (since the green gro-
cer business offers only meagre returns). In this example, one could say that the current owner may be
unwilling to sell; the second-generation may well be willing to sell and invest the money elsewhere; and, a
cynic may say that the third-generation will spend all the money and then have nothing left!
Preferred valuation inputs (Intermediate)

A valuation using the fair market value definition should, if possible, use the v lue of an identical asset
traded in an active market with a quoted price as an input. This would only be possible in limited circum-
stances, such as when valuing a minority share in a listed company where an appraiser could use the un-
adjusted quoted price on the valuation date as such a preferred input.
Failing this, a valuation should obtain its inputs from similar assets with market information, requiring
modest adjustment. A similar business entity could be listed n the JSE in South Africa, but if not availa-ble,
an appraiser could search for similar entities listed internati nally, e.g. on the New York Stock Ex-change,
NASDAQ, or the London Stock Exchange. (If valuation inputs are taken from internationally listed business
entities this would complicate a valuation and necessitate further adjustments, such as an ad-justment
for country risk factors.)
However, most business enterprises – even those op rating in the same principal business arena – will
often display significant differences in areas such as siz , growth prospects, returns on invested capital,
financing structures, and auxiliary business operations. In addition, few listed entities would have a single
or ‘pure play’ business focus. These factors imply that the ideals of finding an identical or similar compar-
ator entity are difficult to achieve in practice.
In practice most business valuations will therefore have to make significant adjustments to observable
market data or use unobservable inputs. This is one of the reasons for the popularity of valuation mod-
els based on Free Cash Flow, as described later in this chapter.
Intrinsic value
Intrinsic value is often described as the most basic value of a business. It is principally based on the net present
value of expected future cashflows and should be viewed independently of any merger or acquisition transac-
tion (Eccles, Lanes and Wilson, 1999). Intrinsic value should therefore ignore the effect of any possible synergy
benefits.
Market capitalisation
Full market capitalisation is an indication of the fair market value of all equity and is essentially derived by using
the following formula:
Full market apitalisation = Price per share (quoted on a Securities Exchange) × the number of
group shares in issue
~ Fair market value of equity
However, f ll market capitalisation calculated in this way will not always be an accurate representation of the
fair market val e of equity. In some cases adjustments will have to be made for some or all of the following
matters.
C ntr l premium (Intermediate)
There is a contested argument that full market capitalisation possibly does not represent the fair market
value of all equity (implying a controlling shareholding) as it could apply the price at which a non-
controlling share is traded, to all issued shares. It is therefore recommended that each listed company’s
market capitalisation be viewed on a case-by-case basis, and that a control premium (discussed later in
this chapter) be added only if appropriate. If warranted, the following formula should then be applied:
Fair market value of equity = Full market capitalisation + control premium
411
Convertible securities (Intermediate)

Convertible securities, such as convertible preference shares and convertible debt, described in Valuations
of preference shares and debt (chapter 10), should be treated as part of the value of equity where these
are likely to be converted to equity. If warranted, the following formula should then be applied:
Fair market value of equity = Full market capitalisation + value of preference shares and debt
likely to be converted to equity
Share options (Advanced)
The fair market value of equity should include the value of all equity c aims on the business entity. Where
there are share options outstanding , the following formula should be app ied:
Fair market value of equity = Full market capitalisation + the v lue of sh re options
Treasury shares (Advanced)
The total number of shares in issue is complicated in the case of share buybacks – so-called treasury
shares – where the group repurchases some of its own shares (thr ugh a subsidiary) and keeps them for
resale or reissue, instead of cancelling them. In such a case the number of shares per the calculation of
the usual full market capitalisation should be adjusted, as f ll ws.
Fair market value of equity = Price per share (quoted on a Securities Exchange) × (the number of
company shares in issue – the number of treasury shares)
Liquidation value
A liquidation value is the amount that could be realis d if a group of assets of a company are sold separately.
Here the sum of the likely proceeds from all assets is reduced by the liabilities outstanding, and the difference
represents the liquidation value of the company.
Note that liquidation can be either voluntary or forced. In the case of voluntary liquidation the liquidation value
could be close to a fair market value for some businesses, such as property-holding companies.
Conversely, in the case of a forced liquidation, where a seller is compelled to sell the assets as part of a dis-
tressed sale, a willing buyer and willing seller are not involved. Therefore, in such circumstances, a liquidation
value cannot be described as a fair market value. Fittingly, the term ‘fire sale’ is commonly used to refer to the
sale of assets at a very low price when the seller is facing bankruptcy or where the seller is desperate to dispose
of certain assets quickly to get cash.
11.3.2 Principles of financial reporting vs business valuation principles

To better understand business valuations it is important to contrast its principles against those applied in
financial reporting. The following table underscores the principle differences.
Financial reporting principl s Business valuation principles
Measure value using mixed definitions, including Measure market value, normally defined as fair
historical ost, arrying (or book) value, fair value market value;
and de ivatives the eof;
Records items meeting prescribed recognition Value incorporates all components of the
criteria (as a result, several items are not recog- business;
nised – most notably – internally developed in-
tangible assets);
Valuati n, if required, normally occurs after the fact Valuation usually occurs in advance, before a
(ex p st); transaction takes place (ex ante);
Focus on the parts (using a bottom-up approach) Focus on the whole (using a top-down ap-
whereby the values of the individual assets and li- proach) whereby the value of the overall firm
abilities are determined. or equity interest is appraised directly.
A helpful tool to move from a financial reporting mind- set to that of an appraiser, is to reorganise a traditional
s atement of financial position (compiled for purposes of financial reporting) and to then compile an apprais-
er’s balance sheet. Note that an IFRS-based statement of financial position would not equal an appraiser’s
version, as numerous items would be excluded, and the items included would be recognised using a muddled
mix of valuation definitions (e.g. historical cost and fair value).
412
Illustrative example: Statement of financial position – moving from financial reporting to business
valuations (Fundamental, except where otherwise indicated)
Assume that a business entity has a carrying value (the original cost minus accumulated depreciation) of total
assets equal to R1 050 000, but that it has an overall firm value of R2 000 000, measured at fair market value.
The following condensed statement has been prepared in accordance with IFRS. It includes notes and repre-
sents the position as at the most recent financial year-end.
Statement of financial position

R’000 R’000
ASSETS EQUITY
Non-current assets Share capit l 10
Non-current tangible assets 550 Retained e rnings 540
Intangible assets and goodwill (some) 100
Investments (non-operating assets) 200 LIABILITIES
Current assets N n-current liabilities 400
Cash (assume the entire amount 50 Current liabilities (50+50) 100
represents excess cash in this example)
Other current assets 150
TOTAL ASSETS 1 050 TOTAL EQUITY AND LIABILITIES 1 050
Required:
Trace the illustrative values included in the traditional statement of financial position through to the next
version shown in the various steps below. Take cognisance of changes in the illustrative values, additional
items included in each step, and the various explanatory notes.
Explain the principle differences between a traditional statement of financial position (as provided) and an
appraiser’s version in your own words.
Step 1: Reorganise the traditional statement of financial position (illustrative values only)
(Carrying values) R’000 (Carrying values) R’000
NET OPERATING ASSETS EQUITY
Non-current tangible assets 550 Share capital 10
Intangible assets and goodwill (some) 100 Retained earnings (balancing figure) 540
Other current assets 150 DEBT CAPITAL
Non-debt current liabilities (50)* Non-current liabilities 400
NON-OPERATING ASSETS Short term portion of debt (100-50*) 50
Investments 200
Cash (excess cash) 50
EMPLOYMENT OF CAPITAL 1000 CAPITAL EMPLOYED 1000
Note: Only excess cash

represents a non-operating asset.
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Step 2: Compile an appraiser’s balance sheet (illustrative values)

Replace the values in the reorganised, traditional statement of financial position with fair market values and
include unrecognised items.
(Fair market values) R’000 (Fair market values) R’000
NET OPERATING ASSETS MARKET VALUE OF EQUITY 1 400
Non-current tangible 570
assets Intangible assets 1 000 DEBT CAPITAL
(all) Other current assets 150 Non-current debt 445
Non-debt current liabilities (50) Short term portion of debt 55
Other liabilities linked to operations (20) Note: Accounting reserves are
(Intermediate – e.g. a contingent legal excluded here as these represent
cost liability, previously unrecorded) only ccounting entries
VALUE OF OPERATIONS 1 650
Note: Additional items are
NON-OPERATING ASSETS included here
Investments 300
Excess cash 50 OFF-BALANCE SHEET DEBT 100
(Advanced)
VALUE OF OPERATIONS AND
NON-OPERATING ASSETS 2 000 OVERALL FIRM VALUE 2 000
Note: Certain fair market values Not : This is an advanced area and should be ignored
will differ little from the for purposes of basic courses. Off-balance sheet debt
corresponding carrying values could include operating leases and debt linked to
possible non-consolidated entities
Step 3: Compile an appraiser’s balance sheet: Different slices of the same ‘cake’ (1)
Non-current tangible assets 570
Intangible assets (all) 1 000 DEBT CAPITAL
Other current assets 150 Non-current debt 445
Non-debt current liabilities (50) Short term portion of debt 55
Other liabilities linked to operations OFF-BALANCE SHEET DEBT
(Intermediate) (20) (Advanced) 100
Less: NON-OPERATING ASSETS
Investments (300)
Excess cash (50)
VALUE OF OPERATIONS 1 650 MVIC (market value of invested capital) 1 650
Note: MVIC equals the value of operations (viewed from the basis of the left column).
Alte natively, MVIC equals the market value of equity plus the value of debt less the value of non-
ope ating assets (viewed from the basis of the right column). One could also state that MVIC equals
the val e of equity plus the value of net debt (debt after theoretically selling non-operating assets
and sing the proceeds to settle debt).
414
Step 4: Compile an appraiser’s balance sheet: Different slices of the same ‘cake’ (2)
Non-current tangible assets 570
Intangible assets (all) 1 000
Other current assets 150
Non-debt current liabilities (50)
Other liabilities linked to operations
(Intermediate) (20)
VALUE OF OPERATIONS 1 650
NON-OPERATING ASSETS
Investments 300
Excess cash 50
Less: DEBT CAPITAL
Non-current debt (445)
Short term portion of debt (55)
Less: OFF-BALANCE SHEET DEBT
(Advanced) (100)
VALUE OF OPERATIONS AND
NON-OPERATING ASSETS LESS DEBT 1 400 MARKET VALUE OF EQUITY 1 400
11.3.3 Valuation approaches, methodologies, methods and models

Before any valuation calculations can be performed it is important to understand what is meant by the encom-
passing terms of valuation approaches, methodologies, methods and models. It is further important to clearly
differentiate between these concepts.
Valuation approaches
Basic valuation approaches can be grouped into several categories, but for purposes of further discussion here
the following categories are used: the replacement cost approach, the market comparable approach and the
income approach. An appraiser will have to take the circumstances of each case into account and then apply
the necessary judgement to determine which valuation approach to apply. When determining the value of, or
shareholding in, a private equity enterprise in South Africa, an appraiser will often make use of both the in-
come approach and the market comparable approach in the valuation – the one will represent the main valua-
tion approach, while the other will serve as a reasonability test.
Note: A private equity busin ss or enterprise refers to an enterprise that is not listed on a securities ex-
change, and should be cl arly differentiated from a private equity fund or house – a dedicated pool of funds
– targeting investm nt in th se private equity businesses, in all stages of development.
The three approa hes are described as follows:
The replacement cost approach
Here the q estion ‘What will it cost today to acquire a similar asset?’ is asked. For example, a three-year-
old man fact ring machine could be valued by obtaining the replacement cost of the same machine when
new and depreciating it to some degree to reflect its current state. This approach is less relevant in a
business valuation, or in determining the value of a shareholding in such a business.
The market comparable approach
Here the question ‘What is an identical or similar asset actually selling for in the market?’ is asked. Within
this approach, there are many valuation methods that compare the entity to a comparable entity in the
market, making use of an earnings multiple. As mentioned previously, the main problem here is the lack
of directly comparable entities, with the result that a significant amount of adjustment is necessary –
thereby compromising the purity of the approach.
The income approach
In this case, the question ‘What is a buyer willing to pay for an asset in today’s monetary terms, with a
given income (or cashflow) stream in the future, adjusted for perceived risks?’ is asked. Part of this
415
approach is to use a discounted-cash-flow method. This approach also makes use of inputs based on in-
formation available in the market, including information from directly comparable entities. As in the case
of the market comparable approach, a lack of directly comparable entities will reduce the reliability of the
approach (albeit to a lesser extent).
Valuation methodologies
Simply put, valuation methodology describes the system of methods that could be applied in performing a
valuation. Several methodologies exist, some of which could be clearly linked to a specific valuation approach,
others less so.
Some of the principle valuation methodologies include –
price of recent investment (linked to the market comparable appro ch);
l industry valuation benchmarks (linked to the market comparable ppro ch);
multiples (linked to the market comparable approach);
discounted cashflows from the investment (linked to the income approach);
discounted cashflows of the underlying business enterprise (linked to the income approach); and
net assets (which may be linked to different valuation approaches).
In selecting the most appropriate valuation methodology for a specific assignment, the appraiser should apply
his/her judgement. However, the principal valuation ethodology is often supplemented by another meth-
odology, used as a reasonability test.
Valuation methods and models

By unpacking the valuation methodologies, one could identify the underlying methods and models. Some of
the principle valuation methods and models include –
earnings multiples (linked to the multiples methodology);
market price multiples (linked to the multiples methodology);
the Gordon Dividend Growth Model (linked to a discounted-cash-flow-from-the-investment methodology);
models based on Free Cashflow (linked to a discounted cash-flow methodology – either cashflows availa-
ble to the investment or the underlying business enterprise); and
models based on EVA®/MVA (linked to a discounted cash-flow methodology – from the underlying busi-
ness enterprise).
11.4 Factors affecting the value of a business or equity interest

The value of a business enterprise or equity interest is dependent on a number of factors. It is not possible to
list and describe all the factors to be considered in all circumstances, as they will differ on a case-by-case basis.
However, in this section a f w g neral factors affecting value are discussed, including –
the relationship between value, risk and return;
the business model applied;
whether the b siness is a going concern;
growth and ret rn of the business;
the business vehicle;
investment in equity or net assets of a business;
the level of control;
shares publicly traded on a Securities Exchange; and
hidden factors (often examined as part of due diligence investigations).
11.4.1 The relationship between value, risk and return

The intricate link between an investment’s value, the risk attached to it, and the required rate of return on this
investment, is demonstrated in chapter 10 (Valuations of preference shares and debt). The link between two of
416
the variables, risk and return, could easily be explained by the behaviour of a rational investor: investing in a
risk -free investment demands a minimum required rate of return equal to a risk-free rate, to compensate for
the time value of money. However, investing in a more risky investment demands a required rate of return in
excess of a risk-free rate, to not only compensate for the time value of money, but also the probability of not
actually receiving future benefits related to the investment.
Continuing with this line of thought, the link between value and risk could similarly be explained by the behav-
iour of a rational investor: in deciding on a price to pay for two investments, each identical except for the fact
that one is more risky than the other, this investor would surely pay less for the investment carrying the higher
risk.
These linkages are easy to draw when valuing, for instance, preference shares or debt, with predictable cash-
flows. When valuing a business or an equity interest, however, the vari bles re more difficult to define. For
instance, what would the expected future benefits be? Here different investors m y define it differently –
perhaps as the uncertain amount of future ordinary dividends that may, or may not, be declared; perhaps as
the uncertain earnings that may be attributable to the shareholding; or perhaps, as the uncertain cashflow that
may be free for distribution, after other required payments and investments ha e been made?
Following the contemplation of the expected future benefits, as part f the valuation of a business or an equity
interest, one should consider what the required rate of return sh uld be. Again, it is easy to determine the
required rate of return on an investment in a debt security, for instance, by linking the return to the yield to
maturity of a similar security that is quoted on a securities exchange. Since a very similar business or equity
interest, quoted on a stock exchange, is unlikely to exist, how then does an investor determine a required rate
of return?
These dilemmas led to the development of ever more intricate valuation methods and models – some of which
are explored later in this chapter. But no matter how complex the valuation method or model, it would be wise
for an appraiser – and, by implication, a student – to not forget that there should always be a link between
value, risk and return.
11.4.2 The business model

The business model followed can influence the value of an entity in several ways. When following an income
approach to valuation by employing a discounted-cash-flow method, for example, the specific business model
followed and its effect on future cashflows is often considered. This method assists in obtaining an entity’s
intrinsic value.
Intrinsic value often equals an entity’s fair market value, but in some cases they could differ. For instance,
market participants interested in the business entity could be of the opinion that the current business model is
inferior, or that current management is inefficient, and that they could improve on these matters. In such a
case, the fair market value might exceed the entity’s intrinsic value.
Furthermore, the value of modern business entities stems increasingly from the use of intangible assets, rather
than tangible ones. The industrial revolution led to large-scale mechanisation, offering great benefits over the
earlier labour-intensive proc ss s. As a result, the main source of value to entities in earlier days lay in the
tangible factories and ma hinery, and the processes whereby they were used.
In contrast, the mode n e onomy is increasingly knowledge-based; businesses are ever more subject to severe
change and entities a e exposed to competition from all over the world. The use of information and communi-
cation technology (ICT) also increasingly influences modern business models and the value of these entities.
11.4.3 The going concern

M st valuati n methodologies value the business enterprise in its continued use as a going concern and there-
fore do not merely focus on the value of the net assets. The going concern of the enterprise is therefore an
important consideration and is influenced by a number of factors, including:
State of the assets
One must form an opinion of the current state of the assets. Are they in a good physical state; have they
been replaced regularly and maintained? What is the average age of the assets compared to the norm for
the industry?
417
Demand for the products and services of the company

It is possible that historical profits were strong; however, the value of a company is based on future
profits (or cash flows), not past profits. One must therefore assess whether the type of business a com-
pany is involved in is still viable. Is there a continuing demand for the products and services of the com-
pany, or are they becoming redundant? Is technology making the offerings obsolete? Is the business
changing with the times? (Consider the case of Eastman Kodak Company, the well-known manufacturer
of photographic film, which failed due to not having implemented sufficient measures to adapt to chang-
ing technologies.)
Competition
Business is very competitive; therefore one must assess one’s competition. How many competitors is the
company faced with; do they supply similar services or products in the s me m rket and are they a threat
to the business?
For instance, the emergence of cheap imports such as clothing, shoes and other consumer products from
China makes the viability of companies in South Africa that manufacture similar products challenging.
Suppliers
How reliant is the company on local or foreign supplies? What is the viability of those suppliers?
Debt capacity
How indebted is the company? Does the debt to equity (D:E) ratio show that the company has a high
level of debt? Consider the times interest earned ratio – is the company able to repay interest and capital
commitments easily? What is the expectation for int r st rates? Are they rising or dropping?
Most companies operate in a debt environment; therefore one must establish whether the company is
carrying too much debt. The most essential question to be asked in the final analysis is, given the indus-
try, the company-specific factors and future expectations, is the company’s capital structure at its target
level?
Business environment
The local, national and world business environment as it affects the company must be assessed. Political
considerations are also important, as they will have either a favourable or a negative impact on the busi-
ness being valued. Empowerment or affirmative aspects of business can also add value, or reduce the
value of a company or its ability to operate as a viable going concern.
SWOT
All of the above aspects that affect the going concern aspects of a company can be summarised in a
SWOT-analysis: the appraiser needs to consider the internal strengths and weaknesses of a company and
also evaluate the external opportunities and threats before carrying out a valuation that assumes a viable
going concern.
11.4.4 Growth and the return that is derived from the assets
It is often a gued that g owth adds value. This is true; however, growth will only add value if an entity is also
generating a sufficient eturn on invested capital. The minimum required return of an entity is its Weighted
Average Cost of Capital (WACC).
11.4.5 The business vehicle

Business vehicles normally influence the value of ownership through different levels of taxation, the types of
inve tors allowed, and restrictions placed on the sale and transfer of ownership, or its effect on personal
liability. (A closely related concept is owner level discounts, including a marketability discount and BEE lock-in
di count.)
Currently the choice of business vehicle in South Africa includes: a company, an existing close corporation, a
business trust, a partnership, a sole proprietor, or a member firm of a Swiss Verein. More information on the
specific types is presented below (adapted and updated from a 2011 online publication by law firm DLA Clive
Dekker Hofmeyer).
418
Company
Larger profit-seeking businesses often operate as a company, unless specific benefits of a different vehicle are
sought. For this reason, the main focus in this chapter is on businesses operating as companies.
A company can consist of one of the following types –
public company (identified by the word ‘Limited’ or its abbreviation, ‘Ltd.’ in the company name);
private company (identified the expression ‘Proprietary Limited’ or its abbreviation, ‘(Pty) Ltd.’);
personal liability company (identified by the word ‘Incorporated’ or its abbreviation ‘Inc.’);
a non-profit company (identified by the expression ‘NPC’); or
a state-owned company (identified by the expression ‘SOC Ltd.’).
Public companies represent the flagship business vehicle available to the larger business as they offer many
benefits, normally including the following –
the company is a separate legal entity;
there is segregation between management and shareholders;
it allows for an unlimited number of shareholders;
there is no limitation on transferability of shares;
capital can be raised from the public; and
public companies alone may be listed on the JSE.
As is usually the case, with increased benefits, there are normally increased responsibilities and associated
costs (although this is connected to a company’s ‘public interest score’ as described in the Companies Act 71 of
2008). A private company is usually subject to more restrictions, including the transferability of its shares and
the raising of capital from the public. A personal liability company is often reserved for professional and other
organisations seeking personal liability.
Except for companies that qualify as small business corporations or micro-businesses in terms of tax legislation,
companies currently have the same income tax rate.
Close corporation
A close corporation is identified by the expression ‘Close Corporation’ or its abbreviation, ‘CC’ in its name. A
close corporation is to some degree comparable to a private company, but is normally only suited to a smaller
business as it involves even more restrictions, such as –
a limited number of members (maximum of ten);
greater fiduciary r sponsibilities of members; and
limitations on the type of members (limited to natural persons). This limitation makes close corporations
unsuitable for orporate investors.
In terms of cu ent legislation, existing close corporations are allowed to continue, but no new registrations are
allowed.
Except for close corporations qualifying as small business corporations or micro-businesses in terms of tax
legislation, close corporations currently have the same income tax rate as companies.
Business trust
A business trust makes it possible for the trustees to conduct business for the benefit of nominated trustees. A
tru t offers limited liability to both trustees and beneficiaries. Although not a specific requirement, a trust is u
ua y formed by way of a trust deed. A trust has separate tax rates, requirements and benefits.
Partnership
A p rtnership usually involves two to twenty partners. A partnership does not have to be registered and there
are no specific formalities that have to be complied with to form a partnership. Although not a specific re-
quirement, an agreement is often entered into to regulate the partnership. Partnerships are flexible and often
serve as the vehicle for joint ventures. Except for limited partnerships, partners are jointly and severally liable
for the debts and obligations of the partnership.
419
Sole proprietorship
A sole proprietorship exists where an individual conducts business in his personal capacity. A sole proprietor is
taxed as a natural person. Due to its nature, it is obviously not available to corporate investors.
Member firm of a Swiss Verein (Intermediate)

A Swiss Verein is a special form of overarching business organisation, in which member firms have no liability
for the actions of other member firms. As control is decentralised to the member firm, the firm is usually only
subject to the laws and regulations of the specific country in which it operates. Swiss Vereins are often used by
multinational professional firms, for example Deloitte Touche Tomatsu, to imit their global accountability.
(Remember the recent public debacles, such as the Arthur Andersen/Enron-case, which placed shared liabilities
of professional firms under renewed scrutiny.)
11.4.6 Investment in equity or net assets of a business (Intermediate)

When investing in a business, an investor may choose to –
l invest in the equity of the company (i.e. buy the shares); r to
purchase the net assets (together constituting a business) of the company.
The inherent differences between these two options may have an i pact on the distribution of value between
the buyer, seller and taxation authorities. The differences between the two options include –
l the level of investment (when investing in equity it is asi r to obtain an investment in the business below a
100% interest);
continuity of existing business contracts and agreements (more certain when investing in the equity);
the buyer may be able to select only the exact assets required (when acquiring the assets);
the buyer may inadvertently acquire a hidden liability (predominantly when acquiring the equity); and
different tax treatments.
The tax implications of either option will depend on the specific circumstances of each case. The discussion
below demonstrates that taxation often has a major impact on the buyer and seller. Taxation should therefore
receive careful consideration by the parties involved, and assistance by a tax specialist and reference to a
dedicated source may be required.
The brief outline is based on generalised circumstances and information available at the time of publication of
this edition. It assumes a normal sale of a private equity South African business in an arm’s-length transaction
and does not address exceptional circumstances, including: shares representing trade-stock, employee share
incentive schemes, or corporate restructuring events.
The following taxation tr atm nts usually apply in the case of investment in/sale of net assets (constituting a
business):
For the buyer –
there may be a step-up in the tax values of the assets (from the existing tax values to the newly-allocated
purchase p ice), allowing higher wear-and-tear allowances to be claimed by a new company holding the
business;
any assessed tax loss cannot be transferred to a buyer; and
in terms of value-added tax (VAT), the sale of net assets may still meet the requirements of the sale of a g
ing-c ncern business at a zero rate (in which case the seller does not raise output tax and the buyer d es n
t claim input tax) thereby offering the buyer upfront cash-flow relief.
For the eller –
there may be a recoupment on the sale of the assets (for the company);
there may be capital gains tax (CGT) implications (also for the company); and
possible dividends tax, where the remaining proceeds are paid in cash to the shareholder.
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By contrast, the following taxation treatments usually apply in the case of investment in/sale of equity, where
the company holds only the business in question:
For the buyer –
wear-and-tear allowances on assets will continue as in the past, where assets still have sufficient remain-
ing tax value;
latent CGT of the company at the transaction date will be acquired;
latent dividends tax may be acquired (indirectly, by the new shareholders);
any assessed tax loss may, however, be transferred to the buyer; and
in terms of VAT, the sale of the equity may also meet the requirements of the sale of a going concern
business at a zero rate, allowing the same cash-flow benefits to the buyer s mentioned earlier.
For the seller –
there may be CGT on the sale of the equity; and
there may be securities transfer tax, if this also represents the market value (payable by the shareholder).
Given these implications, it is often more beneficial in terms of taxation for a buyer to acquire the net assets
(constituting a business), but for a seller to sell the shares.
11.4.7 Level of control (Intermediate)

The level of control has a direct influence on value on two fronts: value of the entire business enterprise,
through control of entity level factors, and the value of ownership, through control of owner level factors.
Entity level factors that fall under the powers of control may include –
the ability to make policy and strategy decisions;
control over the selection of customers and suppliers;
influence over remuneration policies; and
the ability to revise the memorandum of incorporation and rules.
Furthermore, control extends to owner level factors, such as –
control over the dividend policy; and
the ability to revise the Memorandum of Incorporation (MOI) and rules (the latter might affect the entity
and/or the owners).
An important related matter is owner level premiums and discounts that are linked to the level of control.
These include the control pr mium and minority discount. Both may be applied in some cases and depend on
the method of valuation. The marketability discount is also indirectly related to the level of control as it is
usually easier to sell, for example, a controlling interest in a private-equity business than a minority share.
These adjustments are dis ussed further under the heading: ‘Valuation premiums and discounts’.
A dominant, but not exclusive, indicator of control is the level of ownership. In South Africa, legislation and
other regulations often influence key shareholding levels, which, in turn, affect the level of control. For exam-
ple, the Companies Act 71 of 2008 dictates typical key shareholding levels for a company, based on the level of
votes req ired to pass certain decisions. Based on this Act, as of this writing, the typical key shareholding levels
for a company and corresponding reasons are:
Typical Reason – should shareholders hold and exercise votes equivalent to
key shareholding level their shareholding:
0,01% – 25% Lowest level of control for shareholder.
25,01% – 50% Shareholder does not control the company, but has enough votes to
stop a special resolution.
50,01% – 74,99% Shareholder controls the entity and has enough votes to pass ordinary
resolutions.
75% – 100% Shareholder has the highest level of control of the company as has
enough votes to pass a special resolution.
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Note that, as of this writing, the Companies Act 71 of 2008 allows for changes to the typical key shareholding
levels and other protection measures for shareholders, which include changes to the MOI (see section 65 of the
Act), whereby –
the minimum 50,01% votes to pass an ordinary resolution may be increased; and
the minimum 75% votes to pass a special resolution may be increased or decreased; but
a 10% margin between the minimum voting levels required to pass an ordinary and special resolution
must remain.
It is important to realise that the spread of the shareholding for a specific case is a more relevant indicator of
control, and that the shareholding percentages above are not required in a instances. It is therefore more
important to analyse the exact shareholder composition for each case nd to identify a shareholder’s ability to
pass an ordinary or a special resolution.
The Companies Act 71 of 2008 further prescribes ‘affected transactions’, including certain mergers and acquisi-
tions, where certain ownership percentages could have an impact on the alue of shares through prescribed
mandatory offers, compulsory acquisitions and other actions.
Other matters affecting control include contractual agreements and the acquisition of a minority interest with a
swing vote potential (Pratt, 2001), for example a company could have three shareholders who hold, respec-
tively, 40%, another 40% and 20% of the shareholding. (There are no other contractual arrangements affecting
control in this case.) If one of the holders of a 40% shareholding were to acquire the 20% shareholding, this
minority holding could represent a swing vote (it would increase this shareholding to 60%) and could therefore
dictate either a lower minority discount on the 20% share (compared to a controlling share), or a control
premium on the 20% share (compared to a minority share without swing vote potential).
11.4.8 Shares publicly traded on a securities exchange

Publicly trading securities, for example on the JSE, may enhance the value of public companies by offering
several benefits, including –
access to large amounts of new capital to facilitate growth, such as equity finance (e.g. ordinary classified
shares), or debt finance (e.g. through bonds that may also be quoted on an exchange, such as the Bond
Exchange of South Africa, a division of the JSE); and
facilitating the easy transfer of ownership of previously issued securities (referred to as the secondary
market), which also enhances their marketability.
Market data and compulsory disclosures by quoted companies provide an additional benefit of access to
information, which may be of value to many role -players, including investors, analysts and the financial media.
Note that marketability also affects the value of ownership in a private equity business. As shareholding in a
private equity business is less marketable, one often applies a marketability discount to the value of these
shares (discussed below) when utilising public data available for a quoted company to value ownership in a
private equity busin ss.
Publicly trading se urities also have disadvantages, including –
high cost (in luding the cost to prepare compulsory disclosures and to meet additional legal require-
ments);
increased level of scrutiny; and
increased press re to meet projections.
For this reas n, not all large companies decide to publicly trade their securities; some companies even decide to
delist in s me cases, for example through a leveraged buyout.
11.4.9 Hidden factors

‘Buyer: beware the hidden flaws.’ Even if there is an increased focus on consumer protection and corporate
governance today, these cautionary words are unfortunately still relevant. Knowingly or unknowingly, sellers
re f r more likely to emphasise the positives of a transaction than the negatives.
Hidden factors may therefore directly affect the value of a business, for example, the value of its assets may be
overstated, or the business may have a hidden liability that may also inadvertently be assumed by a buyer as
part of the transaction. For these reasons, a buyer has to apply a certain standard of care before investing in a
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business, especially when investing in the equity of a business. The application of this standard of care by the
buyer is often facilitated by so-called due diligence investigations.
Due diligence investigations

Due diligence investigations represent a specialist area and may cover many areas, including financial matters,
legal matters, environmental matters, ICT system matters, or even compatibility matters which involve investi-
gating the strategic match of parties to an intended merger or acquisition. The areas of emphasis in due dili-
gence investigations are often linked to the specific business, for example a waste-disposal company may have
higher risks related to environmental matters than ICT system matters.
11.5 Other valuation matters
11.5.1 Valuation premiums and discounts

Valuation premiums and discounts are much debated, firstly because they exist as a result of using imperfect
data in a valuation, and secondly, because they often have a significant effect on the end value. Imperfect data
is often used due to a lack of alternatives because appraisers ften need to ‘measure value in one type of market
based on the actions of buyers and sellers in a different type of market’ (Pratt, 2001: xxi). (The chosen valuation
methodology will therefore also impact on the pre ium or discount, as illustrated in later examples.)
By contrast, empirical data exists to support, at least, the concept of certain premiums and discounts (e.g.
Business Valuation Resources, 2009).
Several different premiums and discounts have been d scrib d. These fall into two main categories –
entity level premiums and discounts (e.g. key person risk or concentrated customer base), which are
usually dealt with as part of the usual processes of the chosen methodology of valuing a business enter-
prise; and
owner level premiums and discounts (e.g. control premiums, minority discounts and marketability
discounts), which, if appropriate, are preferably applied to the market value of equity separately at the
end of the ‘usual’ valuation steps (e.g. after discounting entity cashflows or after multiplying earnings
with an adjusted earnings multiple).
The overall recommendation in this chapter is that the relevance of valuation premiums or discounts be as-
sessed for each business on a case- by-case basis. This section briefly describes the more prominent owner
level premiums and discounts, including the ones that are most prominent in a South African context.
Owner level premiums and discounts (Intermediate)

Minority discount
A minority discount is the p rc ntage deducted from the pro rata value of a 100 % controlling interest in a ct
business enterpris , to r fl the absence of the powers of control applicable to a minority interest (Pratt,
2001).
Cont ol p emium
The control premium is the inverse of the minority discount. A control premium thus reflects the percentage
added to the pro rata value of a non-controlling interest to reflect the powers of control (Pratt, 2001).
Marketability discount
A marketability discount, also known as an illiquidity discount, is the percentage deducted from the value of a
shareholding to reflect the shares’ lack of liquidity (or the difficulty to convert them into cash). It is not to be
confu ed with the minority discount, but the level of shareholding could influence the marketability discount, as
a 100% hareholding in a private equity business is generally easier to sell than a 20% shareholding, for examp e.
Other factors affecting the marketability discount include:

the cost of achieving an initial public offering (IPO) in South Africa;
the cost of preparing a sales transaction; and
the possibility of receiving deferred transaction proceeds (PwC, 2010).
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Black Economic Empowerment (BEE) lock-in discount

Broad-Based Black Economic Empowerment (B-BBEE) remains a central component in transformation in South
Africa. In an endeavour to ensure longer-term commitment and benefits, BEE structures typically contain
clauses restricting the transferability of these shares for a certain period (commonly referred to as a lock-in
period).
BEE lock- in discounts remain a contentious issue and are not to be confused with the usual marketability
discount. However, the majority of South African valuation practitioners have indicated that they applied a BEE
lock-in discount to value an existing BEE shareholding, where such a condition existed (PwC, 2010).
In an appendix to this chapter there is a summary of average owner level premiums and discounts applied in
practice.
Example: Owner level premiums and discounts (Intermediate)

Assume that there are two identical companies, except for the fact that one is listed on a Securities Exchange,
while the other represents a private equity business.
Assume further that shares in the listed company trades for R100 per share and that market conditions make
this price reflective of a controlling interest value.
Required:
Determine the fair market value per share belonging to:
a non-controlling share in the private equity company; and
a non-controlling share in the private equity company belonging to a Broad-Based Black Economic Em-
powerment (B-BBEE) shareholder with a lock-in period.
Solution: Value per share

R
Price of a single share in the listed company (reflective of a controlling 100
interest) Less: Minority discount, for lack of control (e.g. 16% × R100) (16)
Value of a single share in the private equity company (adjusted for lack of control, but not
for lack of marketability) 84
Less: Marketability discount (e.g. 14% × R84) (12)
(a) Value of a single share in the private equity company (belonging to a non-controlling
shareholder) 72
Less: BEE lock-in discount (e.g. 7% × R72) (5)
(b) Value of a single share in the private equity company (belonging to a BEE non-controlling
shareholder, with a lock-in discount) 67
Note: Figures may not orre tly total due to rounding.
Note: For examination purposes the exact discount percentage used in the example is not particularly
important; more important is the principle of when to apply a premium or discount.
Remember that a minority discount is the inverse of a control premium. If one were to value the price
of a single controlling share in the listed company (if the R100 price was not provided), but had been
supplied with the price of a single share in the private equity company equal to R84 (as shown ab ve),
the calculation would be as follows: R84 × (1 + 19%) = R100, or R84 + R16 control premium = R100.
Therefore both the minority discount and control premium result in a difference of R16, but the
percentages differ due to the different bases to which they are applied (a 16% minority discount is
applied to R100, but a 19% control premium is applied to R84).
11.5.2 Generally accepted valuation standards

A valuation practitioner is expected to comply with certain professional valuation standards. These standards
include standards of planning, supervision, professional care, independence, use of reliable and relevant
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information, the following of appropriate procedures, using appropriate methodologies, keeping adequate
records, and standards of reporting.
In this regard, the International Valuation Standards Council is a well-established international standard setter
for valuation. Through its International Valuation Standards Board, the International Valuation Standards
Council develops and maintains generally accepted valuation standards, which has been published since 1985.
11.5.3 Valuation report

A valuation report is usually a substantial document and forms an integral component of generally accepted
valuation standards. Typical elements are highlighted here to serve main y as a point of reference, but the
exact content will differ depending on the facts and circumstances of every case. A complete valuation report is
seldom required for examination purposes; students should therefore p y p rticul r attention to the exact
wording of the required section and the number of marks allowed.
A useful sample valuation report is provided by Reilly and Schweihs (1999) and contains most of the following
elements:
1 an introduction;
2 the terms of reference, including a description of the assign ent and the sources of information;
a summary description of the business enterprise;
a description of the definition of value used;
a brief description of the economic indicators of the countri s in which the business enterprise operates;
a history and description of the business enterprise, including industry factors;
a financial statement analysis, including ratio analysis, for a few years;
a discussion of the valuation methodology, method and model used;
a description of the key input variables to the valuation model, including the discount rate (where appro-
priate);
a discussion of the key discounts and premiums applied;
a reasonability test;
a valuation conclusion; and
appendices to the valuation report, which may include amongst others:
– a statement of limiting conditions, for example that the appraiser relied on inputs provided by man-
agement, or an indication of where a limited due diligence investigation was performed;
– an appraisal c rtification, for example an indication of the exact assets that were physically inspected, a
certification that the appraiser does not hold a personal interest in the assets or business, and a
certifi ation that the fees are not contingent on the outcome of the valuation; and
– a des ription of the qualifications of the principal analyst and appraiser.
Disc ssion of certain valuation methodologies, methods and models

Before valuation methodologies, methods and models can be discussed it is important to first differentiate
between the c ncepts of overall firm value, MVIC (Market Value of Invested Capital), and the value of equity;
and sec ndly, to understand whether a specific method or model is designed to directly determine overall firm
value, MVIC and the value of equity.
Overa firm value represents the value of an entire business enterprise, whereas MVIC represents the value of
operations (this will equal overall firm value if there are no non-operating assets) . The value of equity is that
which remains of the overall firm value after the values of senior-ranking forms of capital have been deducted
(such as preference shares and debt).
When determining the value of equity by using a valuation method or model designed to directly determine
the MVIC (e.g. a method based on a MVIC/EBITDA multiple or a Free Cashflow model) an appraiser will have to
add the value of non-operating assets and deduct the value of other senior-ranking forms of capital in order to
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determine the value of equity. In contrast, certain valuation methods or models determine the value of equity
directly (e.g. the price of a recent equity investment or a method based on a P/E multiple).
A selection of methodologies, as well as some of the methods and models relating to them, is discussed below.
11.6.1 Price of recent investment

A valuation method based on the price of recent investment applies the following basic formulae:
Value of an 100% Price of recent investment 100%
equity shareholding = (excluding transaction costs) × % shareholding obtained in recent investment
Post-money Total post investment shares outstanding

= new investment ×
valuation Shares issued for new investment
Post-money
= Pre-money valuation + new investment
valuation
The price paid for a recent investment in a business enterprise c uld pr vide a good starting point for valuing a
follow-on (subsequent) investment in the same enterprise. For valuation purposes, the price of recent invest-
ment should exclude transaction costs as this is not considered a characteristic of an asset (Equity and Venture
Capital Valuation Board (IPEV), 2012).
Usually a young company receives several rounds of financing. Here a ‘pre-money valuation’ refers to the
valuation of the business enterprise before a new round of inv stment/financing. It follows that a ‘post-value
valuation’ refers to the value after the new round of inv stm nt/financing.
The price paid for a recent investment in a business enterprise could further also provide a good starting point
for valuing an investment in a similar enterprise – although here information could be hard to come by.
Moreover, the price of recent exits from an investment (e.g., an investment made and then sold by a private
equity fund or venture capital house) could also give an indication of the later value of a similar enterprise that
is in an earlier stage of its development. In this case, however, significant adjustments would be required,
thereby reducing its reliability.
In all cases the background of the transaction, level of the investment, and changes in risk and prospects
should be considered to ensure comparability. In addition, the transaction date of this investment should be
fairly close to the date of the current valuation, otherwise the passage of time would reduce the suitability of
this methodology.
Application of this methodology

This methodology is often applied to value a business enterprise with the following characteristics –
l a business in the arly stag s of its life (especially early stage technology businesses and those involved in
scientific innovation); and
where a re ent investment was made (at a certain price); and
where the e is little or no historical earnings and cash-flow information; and/or
where it is difficult to project earnings or cashflows for the entity.
Other considerations
An appraiser sh uld consider other factors, including typical milestones, benchmarks and key market drivers for
such a business enterprise, where these factors could influence the value of the business compared to the
recent transacti n. These factors could include measures such as revenue growth, patent approvals, customer
urveys and assessment of market share (IPEV, 2010).
Examp e (Fundamental)
An existing company has received a capital injection as recently as six months ago (a so-called Round B invest-
ment), whereby an existing shareholder invested R10m in return for an additional 8% equity stake in the
business. At the time this was considered a fair price, representative of an arm’s length transaction. (This
shareholder remains a minority shareholder). The total number of equity shares in issue after the round B
investment was 100 shares.
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The company now requires R5m expansion capital (Round C investment). The company’s risk profile and
market prospects remained similar over the past six months. Transaction costs linked to the issue of new shares
will equal roughly 0,5% of the investment.
Required:
Ignoring any possible control premium for purposes of this example:
Determine the present market value of an 100% equity shareholding in the company based on the price of
recent investment (before Round C investment).
Explain whether the price of recent investment would be a reasonab e basis for determining a market
price in part (a).
Determine a current pre-money valuation (before Round C investment).
Determine a post-money valuation following Round C investment.
Calculate a fair number of shares to be issued to the Round C investor.
Part (a)
Recent investment R10m
In return for an equity stake of 8%
Market value of 100% equity (R10m × (100%/8%) R125m (Here implying a minority perspective)
Part (b)
The price of recent investment would be a reasonable indicator of the current market value of all equity in this
case because:
originally, it was priced at arm’s length;
the company’s risk profile and market prospects remained fairly similar in this case; and
time value of money would not have a significant impact on this (rand denominated) value as six months is
a relatively short period.
Had the period been more than six months or did the other circumstances not apply, this valuation method
would become less reliable due to the impact of time value of money, a higher probability of changes in cir-
cumstances, and an unreasonable starting point.
Part (c)
Pre-money valuation (before Round
C investment) equals the same value as in part (a) R125m (Here implying a minority perspective)
Note: transaction costs are included in this and later calculations.
Part (d)
Post-money valuation = Pre-money valuation + new investment
Pre-money val ation R125m
New investment (Ro nd C investment) R5m
P st-m ney valuation after Round C investment R130m (Here also implying a minority perspective)
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Part (e)
Total post investment shares outstanding
Post-money valuation = new investment ×
Shares issued for new investment
Let X be the new number of shares to be issued, then:
R130m = R5m × (100shares + X) / X
R130m / R5m = (100 + X) / X
26 = (100 + X) / X
26X = 100 + X
26X-1X = 100
25X = 100
X = 4 shares
Thus, four new shares will have to be issued to the Round C investor.
11.6.2 Earnings multiples

This method forms part of the valuation methodology based n multiples and the market comparable ap-
proach. In an appendix to this chapter, valuation outlines that can be used by a student when applying this
method in an examination are supplied.
Listed companies trade in an active market and therefore have a published market price for their shares. One
can then calculate earnings multiples as a function of these arket prices. These earnings multiples, in turn, can
then serve as a reference that could be adjusted to value a similar entity, without a known market price.
A valuation method based on earnings multiples appli s the following basic formula:
Value = maintainable earnings for a single year × adjusted earnings multiple
Application of a method based on earnings multiples

Earnings multiples can be applied to value a private equity business enterprise, a majority shareholding in such
an entity, or a minority shareholding.
Some business appraisers argue that this method should not be used to value a minority shareholding in a
business. However, in principle it should be possible to value a majority or minority shareholding using this
method – provided appropriate adjustment is made for owner level differences (between the owners of share-
holding being appraised and the owners of the comparator entity). (Refer to the section entitled ‘Valuation
premiums and discounts’.)
Such an application is supported by the valuation methodology survey conducted by PwC (2010). This survey
indicates that earnings multiples are used by valuation practitioners in South Africa to value both majority and
minority equity shareholdings in a business, but that appropriate owner level premiums and discounts are then
incorporated.
More reliable results will be obtained from this method where the following conditions are met –
the business enterprise is a going concern;
the business ente prise is already established;
there is an earnings history;
contin ing earnings are expected to be maintainable;
the maintainable earnings are expected to be positive (i.e. not a loss);
a similar c mparator listed entity is available;
non-operating assets of the entity are valued separately; and
when used to value a multi-business entity, each business is treated separately.
Selection of a comparator entity

In order to value a private equity business entity using this method, a comparator listed company should be
identified with similar risk attributes, as well as similar prospects for return on invested capital and growth in
earnings.
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This is more likely to be the case where both businesses have similar business activities, are serving similar
markets, operate in the same areas and are of the same size.
When using this method, a comparator entity’s earnings multiple is taken as a reference, to which certain
adjustments are applied, before multiplying it with the maintainable earnings of an entity to eventually obtain
a value. The purpose of the initial aim – to find a similar listed company – is to reduce the number of adjust-
ments to be made to the comparator earnings multiple. (These adjustments are not only difficult to make, they
are often subjective, sensitive, and normally have a big effect on value.)
When valuing a South African business enterprise, a listed South African entity with similar business activities
might be difficult to find. As a result, foreign listed companies are sometimes used as the comparator entity.
Notice that in the latter case, adjustments could still be required for the other differences, including country
risk.
Available comparator earnings multiples

Several comparator earnings multiples exist that could be applied, including –
Price/Earnings (P/E) multiples;
Market Value of Invested Capital/Earnings Before Interest, Tax, Depreciation and Amortisation
(MVIC/EBITDA) multiples;
Market Value of Invested Capital/Earnings Before Interest and Tax (MVIC/EBIT) multiples; and
Market Value of Invested Capital/Earnings Before Interest, Tax and Amortisation (MVIC/EBITA) multiples.
Of these, the first two comparator multiples are more commonly used and are discussed further below. Since
many of the principles apply equally to all earnings multipl s, the bulk of the discussion is placed with the P/E
multiple method. It is therefore not repeated unnecessarily when discussing the MVIC/EBITDA multiple meth-
od.
In practice, MVIC is sometimes referred to as Enterprise Value (EV) – a term that has been used in prior edi-
tions of this text. However, EV is frequently calculated using different formulas, which may cause confusion.
The term MVIC is therefore preferred and is used in this chapter.
Note that earnings multiples could be described in different ways, depending on the use of different denomina-
tors (the figure below the line), as follows:
A ‘historical’ or ‘trailing’ multiple, where its denominator is based on historical earnings for one financial
year (this is the default) (Fundamental);
A ‘current’ multiple, where the denominator is based on current, annualised earnings of a financial year
not ended yet (Intermediate); or
A ‘forward’ multiple, where the denominator is based on projected earnings, e.g. from analysts’ consen-
sus forecast (Int rm diat ).
Example: Trailing, current and forward multiples

The current market pri e of a listed company is 1 010 cents per share. The company’s latest annual financial
statements for the year ended 20X2 reported earnings of 120 cents per share.
Interim financial statements for the first six months of the current financial year ending 20X3 reported earnings
of 65 cents per share, whereas the up-to-date management accounts of the company for the second six
months of 20X3, which is just about to end, has indicated earnings of 66 cents per share.
In line with these results, it was not necessary for the company to publically issue any profit warning. Generally,
the c mpany’s earnings do not vary significantly from month to month.
Recent analysts’ consensus forecast for the company indicated expected earnings of 140 cents per share for
the future year ending 20X4.
Assume that the formula for the P/E multiple is:
Current market price per share
P/E = 1
Earnings per share
1 Either for the most recent (single) historical year, for the current year (annualised), or a (single) forecast year
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Required:
Determine the company’s trailing P/E multiple at the end of the current financial year ending 20X3.
(Fundamental)
Determine the company’s current P/E multiple at the end of the current financial year ending 20X3,
assuming insider information. (Intermediate)
Determine the company’s current P/E multiple at the end of the current financial year ending 20X3,
making use of only publically-available information. (Intermediate)
Determine the company’s forward P/E multiple at the end of the current financial year ending 20X3.
(Intermediate)
Solution:
Trailing P/E multiple (Fundamental)
Trailing P/E multiple = Current market price per share / earnings per share for the historical year
20X2
= 1 010 c / 120 c
= 8,4
This implies that the current market price would be recovered in 8,4 years by earnings of 120 cents per
annum.
Current P/E multiple, with insider information (Int rm diate)

Current P/E multiple = Current market price per share / earnings per share for the current year 20X3
with insider information (annualised)
= 1 010 c / (65 c + 66 c)
= 1 010 c / 131 c
= 7,7
annum. Notice that the earnings per share of 131 cents above are already reflective of a period of 12
months and therefore does not have to be annualised.
Current P/E multiple, without insider information (Intermediate)

Current P/E multiple = Current market price per share / earnings per share for the current year 20X3
calculated based on publically available information (annualised)
= 1 010 c / (65 c × 12/6)
= 1 010 c / 130 c
= 7,8
This implies that the urrent market price would be recovered in 7,8 years by earnings of 130 cents per
annum. Noti e that the earnings per share per the interim results of 20X3 are for six months and there-
fore have to be annualised. In this case it is merely multiplied by 2 (or multiplied by 12 divided by 6), since
no profit warning was issued and since results generally do not vary significantly from month to month.
Forward P/E m ltiple (Intermediate)

F rward P/E multiple = Current market price per share / forecast earnings per share for the future year
20X4
1 010 c / 140 c
7,2
nnum.
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Maintainable earnings
When using earnings multiples to value a business enterprise or equity shareholding, a comparator listed
entity’s earnings multiple is taken as a reference, to which certain adjustments are applied, before multiplying
it with the maintainable earnings of the subject entity.
Example
In this process the maintainable earnings figure of the business entity being valued should also be comparable
to the adjusted earnings multiple used in the valuation. When applying an adjusted trailing P/E multiple, for
instance, one normally uses the historical, maintainable headline earnings for one year. Furthermore, when
applying a forward MVIC/EBITDA multiple, for example, one should use the forecast, maintainable EBITDA of
the entity for one year.
Ensuring reliability and relevance

In determining maintainable earnings it is important that the appraiser ensures that the maintainable earnings
figure is as reliable and relevant as possible. Historical audited inf rmati n should of course be reliable in a
historical context, but might be less indicative of the future, which is better captured in a forecast earnings
figure. The appraiser therefore has to apply some judge ent to deter ine the appropriate trade-off between the
reliability and relevance of the earnings figure.
Ensuring sustainability
Moreover, a maintainable earnings figure will have to be sustained in the future. Adjustments will therefore
have to be made for certain items, which may include: Exc ptional events, adjustment of expenditure to
realistic levels (such as management fees), non -recurring items, discontinued business operations, adjustment
of income and expenditure that does not relate to the main business operations (and which is valued separate-
ly), and adjustment to current tax rates (where this may have changed).
Determining a trend
Even after all these adjustments are made to an earnings figure (either historic, current or forecast), it is still
not always clear whether this figure is likely to be maintainable in future. For this reason, a number of year’s
earnings figures are adjusted for the items indicated above; these are then compared side-by-side in order to
identify a trend.
Although not always a best valuation practice, appraisers frequently estimate maintainable earnings based on
trends, as follows –
in the case of a consistent upward trend over the years analysed – use the latest earnings figure as the
maintainable earnings;
in the case of a consist nt downward trend over the years analysed – use the latest earnings figure as the
maintainable arnings, but in this case, it should be questioned whether the entity should in fact be val-
ued using a method based on an earnings multiple as the going concern assumption may not hold;
in the case of no lear trend over the years analysed – use a weighted average of the earnings figures as the
maintainable earnings.
The o tline provided as an annexure later in this chapter provides further guidance in this regard.
Example: Maintainable earnings (Fundamental)

Three separate c mpanies reported the following historical earnings figures:
20X0 20X1 20X2
R’000 R’000 R’000
Company A: Earnings 1 000 1 100 1 200
Company B: Earnings 1 000 900 800
Company C: Earnings 1 000 900 1 100
431
All earnings figures are free from the effects of exceptional events, non-recurring items, and discontinued
business. All expenditure included in the reported earnings is at realistic levels (e.g. market- related manage-
ment fees were charged). Furthermore, all income and expenditure relates only to the main business opera-
tions.
Required:
Provide an estimate of the likely maintainable earnings for Company A, B and C if no further information is
available.
Solution:
Company Trend in Likely maintainable Maintainable Calculation
earnings earnings earnings
estimate
R’000
A: Upwards That of the latest year 1 200,0 –
B: Downwards That of the latest year 800,0 –
C: No trend Weighted average 1 016,7 (1 × 1 000) + (2 × 900) + (3 × 1 100)

(1 + 2 + 3)
6 100
=
6
Valuation method based on a P/E multiple

The P/E multiple has historically been applied extensively, but it is sensitive to differences between the entities,
including differences in financial gearing, the age of the underlying assets (affecting the depreciation charge),
and effective tax rates.
A P/E multiple for the comparator listed entity is often supplied by the financial press. Although not always
specified as such, it usually represents a trailing P/E multiple, or where interim results were published, a cur-
rent (annualised) P/E multiple. As highlighted, it could also be based on a forecast year in which case it is called
a forward P/E multiple.
Using these inputs, it is calculated as follows:
P/E = Closing market price per share
Diluted headline earnings per share (for one year) or
P/E = Current full market capitalisation
Total dilut d h adline earnings (for one year) or
P/E = 1
Earnings yield percentage
The earnings yield pe centage (EY%) is closely related to the P/E multiple. It is usually calculated as follows:
EY% Dil ted headline earnings per share (for one year)
= × 100 or
Closing market price per share
EY% Total diluted headline earnings (for one year)
= × 100 or
Current full market capitalisation
EY% 1
= P/E × 100
In order to avoid confusion it is recommended that students focus on the P/E multiple, not the EY%, and if
provided with a comparator EY% in a test or examination, to convert it into a P/E multiple using the relevant
formula above.
An outline is provided as an annexure to this chapter to guide a student in applying this method in an examina-
tion context. Other relevant matters are discussed in this section, including examples illustrating the concepts.
432
Headline earnings (Intermediate)

As indicated, the P/E multiple of a comparator listed entity in South Africa is usually calculated using headline
earnings. If this P/E multiple is to serve as the starting point in valuing a private equity business entity, then it is
important to understand how it is calculated. A detailed exploration of the calculation of headline earnings falls
beyond the scope of this text, but further details can be found in Circular 2/2013, published by SAICA (2013).
The JSE specifies the calculation of headline earnings as part of its listings requirements, in order to provide an
earnings figure to the users of financial statements that better reflects the operating/trading earnings of the
entity, after interest and tax.
‘The operating/trading items are essentially those that reflect performance in the current period (sales, sala-
ries, etc.) and that can be extrapolated . . . into the future’ (SAICA, 2013:5) . In the calculation of headline
earnings, re-measurements of a capital nature (such as gains on the dispos l of pl nt and equipment or im-
pairment of these types of assets) are thus ignored, but re-measurements rel ting to the operations of the
entity (such as impairment of the carrying value of inventories) are incorporated (SAICA, 2013).
Typical adjustments made to the comparator P/E multiple

Since a comparator entity is unlikely to be identical in all respects to the entity being valued, certain adjust-
ments will have to be made.
Remember: one always aims to compare like to like (this applies to all atters relating to this valuation meth-od,
including the way in which the comparator P/E multiple is calculated, timing, quality of earnings, riskiness, and
growth expectations. To reiterate: Accurately adjusting for differences is not only very difficult, but often highly
subjective; the greater the number and lev l of th se adjustments, the more unreliable this valuation method
will become.
Nonetheless, typical adjustments made to the comparator P/E multiple include:
Adjustment for differences in business and finance risk, due to:
(Occasional adjustments)
– the level of borrowing (only if not accounted for in maintainable earnings);
– level of excess cash and non-operating assets (only if not valued separately and/ or not adjusted for at
the comparator P/E multiple);
– relative age of non-current assets and need for reinvestment in assets (only if not adjusted for in
maintainable earnings);
(Regular adjustments)
– difference in the level of competition;
– the relative size of the entities;
– access to finance;
– the reliance on a small number of key employees;
– the diversity of the product ranges; and
– differen e in the quality of earnings.
Adjustment for differences in the expectations of growth in maintainable earnings.
Example: P/E m ltiples (1) (Fundamental to Intermediate)

Assume there are two hypothetical South African business enterprises: Company Subject (‘S’) and Company C
mparat r (‘C’).
Further assume that these two companies operate in the same industry and that they are identical in all re-
pect , except as indicated in the mutually exclusive scenarios (1 to 4) below:
There are no differences between Company S and C.
The market views Company S as being slightly more risky than Company C (on an entity level).
The market expects slightly higher growth in the earnings of Company S over the next few years, when
compared to Company C.
Company C is listed on the JSE, whereas Company S is not listed on a stock exchange.
433
Further assume the following additional information applies:

At present, Company C has a published trailing P/E multiple of 10.
At present, Company C has a full market capitalisation of R500 million (due to large block of shares
recently traded, this is reflective of the value of a 100% equity shareholding).
Company S has earned maintainable headline earnings during the most recent financial year equal to R50
million.
Required:
Indicate which companies normally have published P/E multiples. (Fundamenta )
Indicate for each of the mutually exclusive scenarios (1 to 4), with re sons, whether the current fair
market value of equity in Company S is expected to be the same, higher or lower than that of Company C.
(Fundamental)
For each scenario (1 to 4), determine the value of an 100% equity share in Company S by applying a
valuation method based on a P/E multiple and by using illustrative figures. Indicate and discuss all ad-
justments made (show positive and negative adjustments). (Fundamental, but Scenario 4 is at an Inter-
mediate level)
Solution:
Part (a)
Only companies listed on a stock exchange would normally have published P/E multiples. In such a case, recent
trades in the shares, made on the stock exchange, will indicate a market price for a share. This, in turn, will
allow a P/E multiple to be calculated as follows:
Closing market price per share (Trading information)
l P/E = Diluted headline earnings per share (for one year) (E.g. from the most recent audited or
financial statements)
Current full market capitalisation (Market price per share × all issued shares)
l P/E = Total diluted headline earnings (for one year) (E.g. from the most recent audited financial
statements)
Part (b)
Scenario Expectation of the Reason
fair market value
of equity
1 The same The companies are identical in all respects.
2 Company S < Since Company S is viewed as lightly more risky than C, a rational investor
Company C will be inclined to pay less for a shareholding in Company S, compared to a
shareholding in Company C. (There is a greater chance of not receiving the
same future benefits, such as dividends, from a shareholding in Company S.)
3 Company S > A rational investor will be inclined to pay more for a shareholding in Compa-
Company C ny S, compared to a shareholding in Company C. (There is a greater chance of
receiving more future benefits from a shareholding in Company S, such as
dividends, which may be declared due to higher levels of future earnings.)
4 Company S < On an entity level the companies are identical, which should not result in a
Company C difference in market value. However, on a shareholder level, shares in Com-
pany S would be more difficult to sell than those in Company C, due to the
lack of a stock exchange listing. This ‘marketability discount’ results from
several factors, including the higher costs to sell (e.g. marketing costs) and
the likelihood of a longer wait for the compensation (‘time is money’ and
there may be deferred proceeds, etc.).
434
Part (c)
Scenario 1: No difference in the two companies
Step 1: Determine the maintainable headline earnings of the subject entity R’ million
Maintainable headline earnings of Company S 50
No adjustments are necessary here as already a maintainable figure
This figure is a historical figure for the most recent financial year and is thus compatible with
the way the comparator P/E multiple of Company C was calculated (a trailing multiple, also
expressed in terms of the most recent – historical – headline earnings)
Step 2: Adjust the comparator P/E multiple for differences in risk and growth f ctors on an entity P/E
level
Comparator P/E multiple of Company C 10
Adjustment for differences in business and finance risk, and growth expectations
l No differences None
Adjusted P/E multiple applicable to S 10
Step 3: Determine the value of an 100% equity shareholding in the subject entity R’ million
Maintainable earnings of Company S × adjusted P/E multiple = R50 illion × 10 500
Adjust for owner (shareholder) level differences None
Fair market value of an 100% equity shareholding in Company S 500
(This value is the same as the value of an 100% shareholding in Company C, as expected (per part b))
Scenario 2: S more risky than C P/E

Maintainable headline earnings of Company S (same as for Scenario 1) 50
Step 2: Adjust the comparator P/E multiple for differences in risk and growth factors on an entity P/E
level
l Company S is more risky This is a negative factor for Company S, thus: (–)
Adjusted P/E multiple applicable to S Less than 10, say: 9 9
Maintainable earnings of Company S × adjusted P/E multiple = R50 million × 9 450
Fair market value of an 100% equity shareholding in Company S 450
(This value is less than the value of an 100% shareholding in Company C, as expected (per part b))
Scenario 3: S has higher growth in earnings than C P/E

evel
Higher growth in earnings expected for Company S
This is a positive factor for Company S, thus: (+)
Adjusted P/E multiple applicable to S More than 10, say: 11 11
435
Fair market value an 100% equity shareholding in Company S 550

(This value is more than value of an 100% shareholding in Company C, as expected (per part b))
Scenario 4: C is listed and S is not P/E

level
Adjustment for differences in business and finance risk, and gr wth expectati ns
l No differences on an entity level None
Adjusted P/E multiple applicable to S 10
Step 3: Determine the value of an 100% equity shar holding in the subject entity R’ million
Adjust for owner (shareholder) level differences
Marketability discount, say 5% (5% × R500 million) (25)
Fair market value an 100% equity shareholding in Company S 475
(This value is less than value of an 100% shareholding in Company C, as expected (per part b))
Note: For this example it is critically important to be able to correctly adjust for differences between the
subject entity and the comparator entity – that is, to correctly make either a positive or negative ad-
justment. At this stage, the size of each adjustment is less important.
Example: P/E multiples (2)

An appraiser of the value of the shares in a private equity company has already determined the following:
The trailing earnings yield percentage of a similar listed company equalled 8,333% on the valuation date
(based on available information for the specific listed company, this should be reflective of a controlling
shareholding).
The comparator P/E multiple should be reduced by 20% to account for differences in entity level risk and
growth prospe ts between the entities.
The private equity company should be able to maintain the historical earnings of R100 000 in the future.
Shareholder level differences between the entities could be resolved by applying a discount of 5% to the val
e of the shareholding in the private equity business to account for the necessary differences in market-
ability of the shares.
Required:
A i t the appraiser by calculating the market value of all equity shares in the private equity business by
applying a method based on a trailing P/E multiple. (Fundamental)
Determine the fair market value of all equity shares by incorporating the effect of shareholder level
differences. (Intermediate)
436
Solution:
Part (a)
First translate the earnings yield percentage to a P/E multiple
(This is recommended practice when dealing with this type of valuation methods.)
Maintainable historical earnings of the subject entity = R100 000
Comparator trailing P/E multiple = 1 / earnings-yield
percentage
= 1 / 8,333%
Multiple
= 12,0
Adjusted for entity level differences (20% × 12) (2,4)
Adjusted P/E multiple 9,6
Value of all equity in the subject entity based on the adjusted P/E multiple = R100 000 × 9,6
Market value of equity (before adjusting for shareholder level differences) = R960 000
Part (b)
Continued from part a)
Market value of equity (before adjusting for shareholder level differences) = R960 000
Adjust for shareholder level differences (5% × R960 000) (R48 000)
Market value of all equity shares in the subject ntity R912 000
Note that some textbooks co-mingle the adjustments for entity level and shareholder level risks, by incorporat-
ing the effect of both when adjusting the comparable P/E multiple. (If performed correctly, this should result in
the same answer. However, it is better to keep these adjustments separate – as treated above – as this should
allow for more accurate adjustments in most cases.)
Example: P/E multiples (3) – determining maintainable earnings (Fundamental)

The following information on financial performance and some additional information relates to a private
company. Financial information was compiled based on IFRS for SMEs, unless otherwise indicated.
An extract from the:

Statement of Profit/Loss and Other Comprehensive Income for the year ended 28 February
20Y9 20X0 20X1 20X2
R’000 R’000 R’000 R’000
Earnings before xc ptional items (1) 1 636 1 694 2 770 2 847
Exceptional it ms (2) 750
Earnings before interest and tax 1 636 1 694 2 770 3 597
Interest expense (3) (20) (20) (30) (30)
Earnings befo e tax 1 616 1 674 2 740 3 567
Income tax expense (4) (662) (670) (959) (926)
Earnings for the year from continuing operations 954 1 004 1 781 2 641
Pr fit n / (loss on closure of) discontinued operations 115 110 15 (90)
Earnings f r the year 1 069 1 114 1 796 2 551
437
1 Earnings before exceptional items were calculated after taking the following into account:
20Y9 20X0 20X1 20X2
R’000 R’000 R’000 R’000
Investment income other than interest: Dividends received on listed
investments 10
Director’s remuneration (5) (900) (900) (900) (900)
Operating lease (6) – actual amounts paid (240) (240) (240) (240)
Impairments
Trade receivables 0 0 0 (5)
Plant and equipment (20) 0 0 0
Exceptional items
The exceptional item relates to profit on the disposal of land.
Interest expense
Amounts shown represent actual interest amounts paid. Interest is payable on an intercompany loan, which
bears preferable interest rates.
20Y9 20X0 20X1 20X2
R’000 R’000 R’000 R’000
A market-related interest expense on the loan would have been: 30 30 40 40
4 Income tax
20Y9 20X0 20X1 20X2
% % % %
Actual income tax rates for the year 40 40 35 28
Capital gains tax inclusion rate for the year 20X2 is equal to 66,67%.
5 Directors’ remuneration
20Y9 20X0 20X1 20X2
R’000 R’000 R’000 R’000
Fair directors’ remuneration would be: 1 000 1 080 1 166 1 260
6 Operating lease
Premises are leased from a related company.
20Y9 20X0 20X1 20X2
R’000 R’000 R’000 R’000
Fair operating lease amounts on these premises on a straight line
basis would have b n: 360 360 360 360
Required:
Determine the company’s maintainable earnings at the end of the 20X2 financial year, to be used in determin-
ing the fair ma ket value of equity using a method based on a trailing P/E multiple.
438
Solution:
Determine the adjusted, headline earnings figures for each year provided:
20Y9 20X0 20X1 20X2
R’000 R’000 R’000 R’000
Earnings before exceptional items 1 636 1 694 2 770 2 847
Adjust for:
Investment income – exclude as not of an operating/trading (10)
nature and investment is to be valued separately using another
method
Fair directors’ remuneration: additional amounts above R900’ pa (100) (180) (266) (360)
Fair operating lease amount: additional amounts above R240’ pa (120) (120) (120) (120)
Impairments: Trade receivables – do not add back as of an
operating/trading nature –
Impairments: Plant and equipment – add back as not of an
operating/trading nature 20
Adjusted earnings before exceptional item 1 436 1 394 2 384 2 357
Exceptional items – exclude as not of an operating/trading nature –
Interest expense – adjust to market-related figures (30) (30) (40) (40)
Adjusted earnings before tax 1 406 1 364 2 344 2 317
Income tax expense at 28% (i) (394) (382) (656) (649)
Profit/loss on discontinued operations – exclude (ii) – – – –
Adjusted earnings for the year 1 012 982 1 688 1 668
Movement – 3,0% + 71,9% – 1,2%
Determine maintainable earnings:

Analysing the adjusted earnings for the past four years display no clear trend. Further investigation is required
to ascertain whether the major increase that occurred in the 20X1 year is sustainable.
If it is clearly sustainable, then calculate the weighted average adjusted earnings as follows:
20Y9 20X0 20X1 20X2 Result
R’000 R’000 R’000 R’000
Adjusted earnings for the relevant years 1 688 1 668
Weight 1 2 3
Weighted × 1/3 × 2/3
563 1 112 1 675
Thus, if the increase in arnings for 20X1 is likely to be sustainable, then the maintainable earnings at the end of
the 20X2 finan ial year equals R1 675 000.
If it is not clear whether this increase will be sustainable, then calculate the weighted average adjusted
earnings as follows (Inte mediate):
20Y9 20X0 20X1 20X2 Result
R’000 R’000 R’000 R’000
Adjusted earnings for the relevant years 1 012 982 1 688 1 668
Weight 1 2 3 4 10
Weighted × 1/10 × 2/10 × 3/10 × 4/10
101 196 506 667 1 470
Thus, if the increase in earnings for 20X1 is not clearly sustainable, then the maintainable earnings at the end
of the 20X2 financial year equals R1 470 000.
Note: Since the maintainable earnings figure will be used as a variable in determining the fair market value
of equity, and since its calculation excluded income from non-operating assets, for example, one should make
a mental note that these items should be valued separately. Note: Figures may not total correctly due to
rounding.
439
Notes on adjustments made:

The income tax expense is restated at the current rate. Non-taxable/non-deductible items have already
been adjusted for (assuming impairment on trade receivable qualify as a tax deduction).
The profit/loss on discontinued operations is excluded as this will not be sustained into the future, and is
therefore not maintainable.
Example: P/E multiples (4) – determining the fair market value of a shareholding (Intermediate)
Shield Industrial (Pty) Ltd manufactures garden furniture and swimming pool safety fences. An extract from the
management accounts (prepared on a historical cost convention) is shown be ow:
Summarised Statement of Financial Position as at 31 December 20X2

R
Share capital 200 000
Reserves 400 000
Debt 1 200 000
Total capital and debt R1 800 000
Summarised Statement of Profit/Loss for the year ended 31 Dece ber 20X2
R
Net operating income 600 000
Less: Interest on borrowings (120 000)
Net profit before tax 480 000
Less: Taxation (134 400)
Net profit after taxation R345 600
Information relevant to a similar listed entity in the industry:

1 Trailing P/E multiple of a similar listed company in this sector 9
(Based on available information this is not reflective of a controlling shareholding)
2 D:E ratio based on market values
(This ratio is close to the optimal for this industry.) 1:1
3 Cost of debt (before tax) 10%
Information relevant to Shield Industrial:
Interest on borrowings would have totalled approximately R100 000 before tax for the year ending 31 De-
cember 20X2, if the company had a D:E ratio, based on market values, similar to that of the listed entity.
Differences in entity level business risks and growth prospects between Shield Industrial and the similar
listed company should equate to a reduction of 25% in the comparable P/E multiple.
Differences in sha eholder level risks to the similar listed company should result in a control premium to the
value of 20%.
Differences in shareholder level risks to the similar listed company should result in a marketability discount
to the val e of 5% of the equity value adjusted for entity and other shareholder differences.
Required:
Determine the fair market value of an 100% equity shareholding in Shield Industrial (Pty) Ltd.
440
Solution:
Adjustment to earnings for difference in D:E ratio: R
Net operating income 600 000
Interest expense with a D:E ratio of 1:1 (based on market values) (100 000)
Net profit before tax 500 000
Less: Taxation (rate = 28% [134 400 / 480 000]) (140 000)
Adjusted historical earnings 360 000
Multiple
Comparator trailing P/E multiple 9,00
Adjusted for differences in entity level business risk (25% × 9) (2,25)
Subtotal 6,75
Adjusted for differences in entity level finance risk –
(not performed as the maintainable earnings were
adjusted) Adjusted trailing P/E multiple 6,75
R
Value of all equity based on adjusted P/E multiple (6,75 × R360 000) 2 430 000
Adjustment for immediate equity injection required to repay debt
(in order to obtain a D:E ratio of 1:1) (200 000)
Interest expense is too high by R20 000 (R120 000 – R100 000).
The value of the equivalent ‘excess’ debt could be stimat d as follows:
Interest expense after tax / cost of debt (after tax)
R20 000 × (100% – 28%) / [10% × (100% – 28%)]
R14 400 / 7,2%
R200 000
Thus D:E equals (1X + 200 000):1X, but should equal 1X:1X, that is the company
requires an equity injection equal to R200 000 to bring the ratio to (1X + 200 000): (1X +
200 000), and would then use the R200 000 equity to pay off excess debt, which gives:
(1X + 200 000 – 200 000):(1X + 200 000 – 200 000), or just 1X:1X
R
Value of all equity assuming no shareholder level differences 2 230 000
Control premium (20% × R2 230 000) 446 000
Subtotal 2 676 000
Marketability discount (5% × R2 676 000) (133 800)
Fair market value of equity 2 542 200
Conclusion
The fair ma ket value of a 100% shareholding in Shield Industrial (Pty) Ltd equals R2 542 200 at the valuation
date, and was dete mined using a valuation method based on a P/E multiple.
Val ation method based on an MVIC/EBITDA multiple

In recent years, many appraisers started to favour a valuation method based on an MVIC/EBITDA multiple over
other multiples. This is because a valuation method based on an MVIC/EBITDA multiple has certain benefits
over ther multiples, but this will only be the case if used in the right circumstances, and with the necessary skill
and understanding.
Benefits and drawbacks

As valuation method, the MVIC/EBITDA multiple has the benefit of being less sensitive to differences be-tween
the target entity and comparator entity, in terms of:
the level of financial gearing, and
effective tax rates and depreciation policies (which often vary in time and especially between different
countries)
441
The MVIC/EBITDA multiple has the drawback of being sensitive to differences between entities in terms of
required fixed asset investment (capital intensity).
To reiterate: one always aims to compare like to like (this applies to all matters relating to this valuation meth-
od, including the way in which the comparator MVIC/EBITDA multiple is calculated, timing, quality of the
earnings (EBITDA), riskiness, and growth expectations. Here, too, it is very difficult to accurately adjust for
differences. As a consequence, the greater the number and level of these adjustments, the more unreliable this
valuation method, too, will become.
Note: EBITDA is frequently described as a readily available proxy for operating cash flow. However, it is not
necessarily equal to operating cash flow as it is still an accounting figure.
Calculation
An MVIC/EBITDA multiple is usually calculated for the comparator entity s follows:
Market Value of In ested Capital
MVIC/EBITDA = Operating Earnings Before Interest, Tax, Depreciation and Amortisation for one year
MVIC
MVIC/EBITDA = Operating EBITDA for one year
Where:
MVIC = Market value of equity plus mark t value of debt less value of non-operating assets
(refer to section 11.3.2)
Operating = Operating revenue less all operating expenses plus depreciation and amortisation
EBITDA expense, or
Profit for the year plus taxation expense plus finance cost plus depreciation and
amortisation expense less finance income (the latter normally represents a non-
operating income and is therefore excluded)
A valuation outline is provided in an appendix to this chapter to guide students in applying this method in an
examination context. In this section, a few other relevant matters are discussed, including examples illustrating
the concepts.
Example: MVIC/EBITDA multiples

An appraiser of the value of the shares in a private equity company has already determined the following:
The trailing MVIC/EBIT A multiple of a similar listed company currently equals 7 based on operating EBITDA
earned for the financial year just ended.
The forward MVIC/EBITDA multiple of a similar listed company currently equals 6, based on its forecast
operating EBITDA for the n xt 12 months.
Based on available information, the market value of equity of the comparator entity, included in its MVIC,
is reflective of a ont olling shareholding.
The private equity company and the listed entity are very similar, but differences include –
– the listed company has higher financial gearing;
– the listed company is significantly larger; and
– the private equity company relies more on a group of key employees.
The private equity company earned operating EBITDA over the most recent 12 months equal to R2,8 million
(this is considered to be maintainable).
The private equity company is forecast to earn operating EBITDA over the next 12 months equal to R3,2
million (this is considered to be maintainable).
Debt capital in the private equity company has an estimated value of R2 million.
The private equity company’s non-operating assets have a current value of R200 000.
442
Required:
Estimate the current market value of equity in the private equity business enterprise, without adjusting for
shareholder level differences, using a valuation method based on a trailing MVIC/EBITDA multiple.
(Fundamental.)
Estimate the current fair market value of equity in the private equity business enterprise using a valua-tion
method based on a forward MVIC/EBITDA multiple. (Intermediate.)
Note: One should compare like to
Solution: like – in this case, historical
earnings; and a trailing multip e
Part (a)
Maintainable historical operating EBITDA of the private equity business enterprise R2 800 000
Comparator trailing MVIC/EBITDA multiple 7
Adjusted for: Note: One should compare like to
like – in this case, historical
– Relative size Reduce
earnings; and a trailing multiple
– Dependence on a group of key employees Reduce
(Note that one should not adjust for differences in financial gearing as the numerator
and denominator of this multiple are not affected by financial gearing.)
Adjusted trailing MVIC/EBITDA multiple (acceptable range ± 4 to 5) Say: 4
R
MVIC of the company (4 × R2 800 000) before adjusting for shar holder level differences 11 200 000
Value of non-operating assets 200 000
Overall firm value 11 400 000
Market value of debt (2 000 000)
Value of equity (before adjusting for shareholder level differences) 9 400 000
Conclusion
The market value of equity in the entity equals R9,4 million (excluding adjustment for shareholder level differ-
ences), and was determined using a valuation method based on a MVIC/EBITDA multiple.
Note: At this stage it is important to realise that a valuation method based on an MVIC/EBITDA multiple, as
the name implies, provides the MVIC (Market Value of Invested Capital), whereas a valuation
method based on a P/E multiple provides the value of equity. Thus, when applying a method based
on an MVIC/EBIT A multiple, one therefore has to make further adjustments to the MVIC in order to
obtain the value of equity (as shown in the example).
Part (b) Note: One should compare like to

like – in this case, forecast
earnings; a forward multiple; and a
controlling basis
Maintainable fo ecast operating EBITDA of the private equity business enterprise R3 200 000
Comparator forward MVIC/EBITDA multiple Note: One should compare like to 6
Adj sted for: like – in this case, forecast
earnings; a forward multiple; and a
– Relative size Reduce
controlling basis
– Dependence on a group of key employees Reduce
(N te that ne should not adjust for differences in financial gearing as the numerator
and denominator of this multiple are not affected by financial gearing.)
Adju ted forward MVIC/EBITDA multiple (acceptable range ± 3,3 to 4,3) Say: 3,5
443
Note: This value should be very close to the

comparable MVIC determined in part a) R
MVIC of the company (3,5 × R3 200 000) before adjusting for shareholder level differences 11 200 000
Value of non-operating assets Note: One should compare like to like – in this
200 000
Overall firm value case, forecast earnings; a forward multiple; and a 11 400 000
controlling basis
Market value of debt (2 000 000)
Value of equity before adjusting for shareholder level differences 9 400 000
Adjusted for shareholder level differences
– Control premium (not applicable as comparator multiple already reflective of Nil
controlling interest)
– Marketability discount (acceptable range 3%-15% of R9 200 000; here
e.g. 5% × 9 400 000) (470 000)
Note: Again, one should compare like to like – this
Fair market value of equity adjustment is necessary because a shareh lder in the 8 930 000
private business will find it more difficult to sell their
shareholding that a shareholder in the listed comparator
entity
Conclusion
The fair market value of equity in the entity equals R8 930 000, and was determined using a valuation method
based on a MVIC/EBITDA multiple.
Note: As the question does not contain specifics, the value and adjustments made are indicative only. In
this case, the direction of adjustments (positive or negative) is therefore more important than the
exact figures or percentages.
11.6.3 Market price multiples

This method, forming part of the valuation methodology based on multiples and the market comparable
approach, often serves mainly as a reasonability check to a valuation performed using another methodology.
These multiples can be useful in some industries.
The following market price multiples are described further: Price/Sales multiple, MVIC/Sales multiple and the
Price/Book multiple.
11.6.3.1 Price/sales (p/s) multiple

This multiple is usually calculat d as follows:
Curr nt full mark t capitalisation
P/S = or
Annual revenue
P/S = Cu ent market value of 100% equity

Annual revenue
A P/S m ltiple can serve as a reasonability test, but is more useful where there is an observable trend between
its variables for entities within a specific industry. As such, the IPEV Board (2010) recommends its use in the foll
wing sect rs: financial services, information technology and long-term contract services.
Where an entity has incurred losses that are considered to be of a temporary nature, this ratio can be used in
tead of an earnings multiple. The usefulness of this multiple is reduced when comparing entities with differ-ent
capital tructures because its numerator incorporates only one form of capital: equity.
444
11.6.3.2 MVIC/Sales (MVIC/S) multiple

This multiple is usually calculated as follows:
Market Value of Invested Capital
MVIC/S = or
Annual revenue
Market Value of Invested Capital
MVIC/S =
Annual revenue
An MVIC/S multiple is similar to the P/S multiple, but uses a different numerator (the term of a fraction above
the line). It is often used in similar circumstances, but has the benefit of ower sensitivity to differences in
capital structures between the compared entities.
Price/Book (P/B) multiple

The Price/Book multiple, also known as the Price-to-Book ratio and Market-to-Book ratio, is usually calculated
as follows:
Current full market capitalisation
P/B = r
Carrying value (book value) of shareholders’ equity
Current market value of 100% equity
P/B =
Carrying value (book value) of shareholders’ equity
This multiple will display large differences among industri s, but could also differ among companies within an
industry where some have grown organically and oth rs through mergers and acquisitions. Current IFRS re-
quirements usually result in a lower carrying value for companies growing organically, as intangible assets are
normally not capitalised in this case, whereas business combinations result in the capitalisation of certain
qualifying tangible and intangible assets at fair market value. Capital-intensive industries will typically display
lower P/B multiples compared to companies in the service industry.
11.6.4 The Gordon Dividend Growth odel

This model forms part of the valuation methodology based on discounted cashflows from the investment, and
the income approach.
Where a shareholder is entitled to future dividends only, the correct valuation method would be to discount
the future expected dividend payments at the appropriate shareholders’ required return. Which shareholders
would be entitled only to future dividends? These shareholders would normally represent minority sharehold-
ers, unable to control the business enterprise. The type of entity and its dividend policy will also have an impact
here.
The model formulat d by Gordon captures, in a single formula, the present value of a stream of future cash-
flows from the investm nt (in this case dividends), which are growing at a constant rate.
D1
P0 =
–g
Where:
P0 = the present value of the future dividends
D1 = the expected dividend at the end of Year 1, sometimes expressed as D 0(1 + g)
r = the required rate of return, in the case equal to the cost of equity (k e)
g = the expected, constant, sustainable dividend growth rate.
Application of this model

The Gordon Dividend Growth Model can be applied to value a minority share in a private equity business
enterprise. More reliable results will be obtained from this model where the following conditions are met –
the source of value to the shareholder is essentially only the future stream of dividends;
445
D1 represents a sustainable dividend (thus considers the growth in earnings and the required investment
to support the dividend growth rate); the dividends are expected to grow by a constant rate that is likely
to be sustainable into the future (for this reason this method is sometimes described as the Gordon Con-
stant Growth Model); and
the expected dividend growth rate (g) is lower than the discount rate (k e). (This model cannot be used
where this is not the case.)
Determining the discount rate (ke)

When determining the value of a shareholding using this model in an examination, the calculation of the cost
of equity (ke) will probably represent a large proportion of the available marks. The cost of equity is essentially
derived from public security-exchange market data (Pratt, 2001).
The two main approaches to determine the cost of equity are –
deductive methods, which use market data (such as dividends paid) to determine an implied cost of
equity; and
risk-return methods, which use a base rate and add a premium to this rate for specific risks.
The deductive method should sound familiar and, indeed, the Gordon Growth Model forms part of this meth-
od. (If one transposes the variables of the Gordon Growth Model, one obtains k e = D1 / P0 + g.) Obviously, one
cannot apply the data of the entity being valued in this deductive odel, because the intention is to use it to
determine P0; P0 is therefore not a known variable. One can, of course, apply this model to a similar listed
entity to obtain the cost of equity (ke).
The Capital Asset Pricing Model (CAPM), as discuss d in chapt r 5 (Portfolio management and the Capital Asset
Pricing Model), forms part of the risk- return method and is the predominant model applied by valuation
practi-tioners in South Africa in recent years (PwC, 2010).
In spite of its popularity, the CAPM is not an ideal model. It has been criticised for a few limitations, including
its inability to explain the observed phenomenon whereby smaller business entities often obtain higher re-
turns, known as the ‘small firm effect’ (PwC, 2010:25). To address this matter, most valuation practitioners in
South Africa add an additional ‘small stock premium’ to the cost of equity (ke) of a smaller entity, when calcu-
lated using the CAPM (PwC, 2010). Note that the use of such a premium is in fact contested and not universally
accepted (PwC, 2010).
Furthermore, when applying the CAPM to determine the cost of equity (k e) of a private equity business enter-
prise, there should be interdependence between the applied risk-free rate, market risk premium and underly-
ing index used in estimating the Beta (β) coefficient.
The Fama-French Three-Factor Model (first described by Fama and French, 1992) is a different model that
takes cognisance of such excess returns and is gaining popularity in determining the cost of equity (ke).
Example: The Gordon Divid nd Growth Model: Constant Growth (1) (Fundamental)
A minority shareholder holds 1 000 shares in a private company, which consistently pays annual dividends
growing by 5% per annum. The recently paid annual dividend equalled 50 cents. The minority shareholder
expects a rate of etu n of 18%.
Required:
Calculate the market value of the minority shareholding, using:
The G rd n Dividend Growth Model.
A spreadsheet to discount the future dividends for 100 years.
446
Solution:
Valuation using the Gordon Dividend Growth Model
D1
P0 = ke – g
P0 = 1 000 × R0,50 × 1,05

18% – 5%
R525
13%
R4038,46
Valuation using a spreadsheet

There is insufficient space to display the entire spreadsheet calculation (columns F:CW are not show), but
an extract appears below:
A B C D E CX CY
1 Future year: 1 2 3 4
2 Total future dividends 525,00 5551,25 62619,65 65750,63
3
4 Discount rate 18%
5
6 Net present value R 4 038,43
1
A selection of the formulas applied, using for example Microsoft Excel , is shown below (‘drag’ the
formu-las from cell E2 to cell CY2 to simplify the process).
Microsoft and Excel are registered trademarks of the Microsoft Corporation, registered in the US and
other countries.
A B C D E CX CY
1 Future year: 1 2 99 100
2 Total future dividends =1000*0,5*1,05 =D2*1,05 =CW2*1,05 =CW2*1,05
3
4 Discount rate 0,18 Note: The discount rate excludes growth
5 as this is incorporated in the forecast
dividend of every year (in row 2)
6 Net present value =NPV(B4, 2:CY2)
The results make it vid nt that both options provide similar results, as long as a sufficient number of years
are includ d in the spreadsheet calculation.
Example: The Gordon Dividend Growth Model: Non-constant growth (2) (Fundamental)
The following info mation relates to a private South African company:
The company j st paid a dividend of R1 000 000 to an ordinary shareholder who holds 10% of equity.
The expected ann al growth in ordinary dividends (in years from the present date) is –
Year 1: 20%
Year 2: 15%
Year 3: 10%
Year 4 and thereafter: 6%.
3 The required rate of return of the minority ordinary shareholder is 20%.
447
Required:
Calculate the market value of the 10% ordinary shareholding in the South African private company, based on
available information.
Solution:
R R R R
Expected dividend to the minority shareholder
Year 1: R1 000 000 × 1,2 1 200 000
Year 2: R1 200 000 × 1,15 1 380 000
Year 3: R1 380 000 × 1,10 1 518 000
Year 4: R1 518 000 × 1,06 1 609 080
Gordon Dividend Growth Model (Note):

P0 = D1 / (Ke – g),but adjust for appropriate year:
P3 = D(3+1) / (Ke – g), thus:
P3 = (R1 609 080) / (20% – 6%)
P3 = (R11 493 429) 11 493 429
1 200 000 1 380 000 13 011 429
Note:
Fair rate of return 20% 0,8333 0,6944 0,5787 this
figure is
R not
included
Net present value 9 487 946 999 960 958 272 7 529 714
in the
total
Conclusion
Thus, the market value of the 10% ordinary shareholding in the South African private company, equals R9 487
946. (Owner level differences are not accounted for here, as the discount rate equals exactly the return
required by the minority shareholder in this case.)
Note: The Gordon Dividend Growth Model supplies the value of a growing perpetuity at the beginning of a
period, where the payment is receivable at the end of the first year following this date. Since the val-
ue calculated using this model encapsulates the value of all future dividends incorporated in the
model, the value of the dividend receivable in Year 4 is not included for further discounting. (Includ-
ing it would oth rwise r sult in double-counting.)
11.6.5 Models based on Free Cashflow

Models based on F ee Cashflow forms part of the income approach, and are valuation methodologies based on
discounted cashflows emanating from either the underlying business enterprise or from the investment.
If Free Cashflow is taken as the cashflow available to the business enterprise then this model would form part
of the disco nted-cash-flows-from-the-underlying-business-enterprise-methodology. However, if Free Cash-
flow is taken as the cashflow available to holders of equity then this model would form part of the discounted-
cash-fl ws-fr m-the-investment-methodology.
Model based on Free Cashflow available to the business enterprise

Of the two available models based on Free Cashflow, this model is the more popular. It is therefore explored in
greater detail below. A valuation outline in an appendix to this chapter offers additional guidance on the use of
this model.
() Application of a model based on Free Cashflow available to the business enterprise
A model based on Free Cashflow available to the business enterprise, can be used to value a private
equity business enterprise, a majority shareholding, or a minority shareholding in such an entity.
448
A similar argument as was made with the earnings multiple method is put forth here: in principle it is
possible to value a majority or minority shareholding using a model based on Free Cashflow available to
the business enterprise – provided owner level differences are adjusted for appropriately.
Likewise, South African valuation practitioners indicated that an income approach (incorporating this
model by implication) is used to value both majority and minority shareholdings, and that appropriate ad-
justment is then made for owner level differences (PwC, 2010).
More reliable results will be obtained from this model where the following conditions are met –
the expected Free Cashflow of the entity can be reliably forecast for a projection period;
the entity maintains, and will continue to maintain, a stable c pit l structure based on a target level,
allowing the use of a single discount rate – the Weighted Aver ge Cost of C pital (WACC) (McKinsey,
2010);
non-operating assets of the entity are valued separately; and
when used to value a multi-business entity, each business is treated separately.
Steps in applying a model based on Free Cashflow available to the business enterprise
The following steps are usually applied in this model:
Calculate the WACC of the business enterprise based on co parable market data at the valuation date
and adjust for enterprise-specific factors.
2 Project the expected future Free Cashflows from th business enterprise for an explicit period, during
which Free Cashflows are likely to be unstable. The explicitly forecasted period should include years
with negative Free Cashflows and years of ‘super growth’. (In deciding on the number of years to in-
clude, in an examination, students must be guided by the question; in real world practice it is usually
less than ten years.)
Calculate the enterprise’s continuing value, or alternatively, if the entity is not expected to survive for
longer than the specific projection period, calculate the appropriate terminal value (usually by esti-
mating the value to be realised at that point in time from closing the business).
Calculation of the Weighted Average Cost of Capital (WACC)
The calculation of the WACC is described in chapter 4 (Capital structure and the cost of capital). Only a
few important concepts are revisited here. Essentially, WACC represents a business enterprise’s com-
bined opportunity cost linked to all the forms capital invested. WACC should further be reflective of the
risk involved in using the funds, even though it is calculated from the perspective of the source of funds.
To determine the WACC, one has to calculate three main components, namely the –
cost of equity;
after-tax cost of debt; and
appropriate weight of the capital structure (normally based on a target structure or fair market values of
the invested capital).
For a private equity business enterprise, these components are normally based, to some extent, on
information relevant to a peer group of listed entities. Adjustments should therefore be made for enter-
prise-specific factors, including differences in target financial gearing.
Determining the Free Cashflow available to the business enterprise
When applying a model based on Free Cashflow available to the business enterprise, the free cashflow
repre ents operational cashflow that is ‘free’ for distribution to all providers of capital that is it is inde-
pendent of the way the business is financed.
As a result, Free Cashflow available to the business enterprise must exclude–
non-operational cash inflow (e.g. interest income, dividends received and rental income to a manu-
facturing firm), as non-operating assets should be valued separately; and
finance related cash outflows (e.g. interest expenditure on loan capital and dividend payments).
449
Free Cashflow available to the business enterprise must further include –

the effects of capital expenditure and working capital investment that are necessary to sustain the
future projected Free Cashflows; and
the taxation effect of the cashflows included.
Example: Free Cashflow available to the business enterprise (Fundamental)

The following information has been forecast in respect of a company for the year ending 28 February 20X4:
R
Earnings before tax 10 000 000
Depreciation 2 000 000
Interest expense 1 000 000
Cash required to be ploughed back as new investment and for increased working capital 3 300 000
Income tax rate 28%
Allowances for income tax purposes are expected to equal the acc unting depreciation.
Required:
Determine the Free Cashflow available to the business enterprise for the year ended 28 February 20X4.
Solution: Calculation of Free Cashflow available to the business enterprise:

R
Earnings before tax 10 000 000
Add back: Depreciation (non-cashflow included in earnings above) 2 000 000
Add back: Interest expense (included in earnings above) 1 000 000
Adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) 13 000 000
Recalculated tax (3 080 000)
Tax on EBITDA at 28% (3 640 000)
Tax allowances’ effect (R2 000 000 × 28%) 560 000
Gross cashflow 9 920 000
Gross investment (3 300 000)
Free Cashflow available to the business enterprise 6 620 000
Thus, the Free Cashflow available to the business enterprise for the year ended 28 February 20X4, equals
R6 620 000.
(e) Model based on Fr Cashflow available to the business enterprise: preparing the explicit forecast
Projected Free Cashflows are usually based on formal management projections, but these should be
checked for reasonability. Often the enterprise’s historical information is analysed using trend analysis,
regression analysis and other techniques, to establish trends and relationships that could be applied to
check (or di ectly p oject) future Free Cashflows. External data should be used, where possible, to verify or
support the projections (e.g. industry reports and economic reports).
The following important matters should be remembered when preparing the forecast:
The pr jected figures and the discount rate should be comparable. As the WACC represents a nomi-
nal percentage in its standard form (i.e. it includes the effect of inflation), the forecast Free Cashflows
sh uld also incorporate the effect of inflation. This approach is usually followed, as the various ele-
ments included in the Free Cashflow are generally subject to different rates of inflation and also sub-
ject to different rates of inflation over the different years.
However, a limiting assumption could be made that a single specific rate of inflation could be applied to ll
projected Free Cashflows, in which case one could exclude the effect of inflation from the Free Cash-
flows and exclude the effect of inflation from the WACC, by applying the following formula:
(1+R)
(1+ r) =
(1+h)
450
Where:
R = the nominal rate
r = the real rate
h = the inflation rate.
The projected figures and the discount rate should not duplicate the effect of risk. As described, this model
essentially discounts the expected Free Cashflows available to the enterprise, using the WACC (a risk-
adjusted rate). Where expected Free Cashflows are subject to a large degree of uncertainty, this risk
should be incorporated either at the cash-flow level (not preferred), or at the discount-rate level by
increasing the WACC by a specific risk premium (preferred), but not at both levels.
Note that the application of probability weightings to expected scenarios (best case, worst case, etc)
for future Free Cashflows is merely a more sophisticated way of obt ining expected Free Cashflows. It
therefore does not imply that the risk of a large degree of uncert inty h s been adjusted for here. In
order to properly adjust cashflows for such a risk, certain-equi alent cashflows will have to be deter-
mined, which are then to be discounted at an appropriate rate that does not duplicate the effect of
this risk, for example, a risk-free rate (depending on the techniques applied). (The latter is not ex-
plored further in this textbook).
As mentioned earlier, Free Cashflow should include the effects of capital expenditure and invest-ments in
working capital. This implies inclusion of the cashflows invested in (or recovered from) these
elements, not the balances of these elements. (This is a co on error made by students in examina-
tions.)
(f) Model based on Free Cashflow available to the busin ss nterprise: determining continuing value
The continuing value (CV) of a business enterprise can be determined in a number of ways, including:
l The Gordon Growth Model
This model is similar to the Gordon Dividend Growth Model (described earlier) and is used most
often by South African appraisers (PwC, 2010). It is calculated based on the following formula:
FCFt+1
CVt =
WACC – g
Where:
CVt = the continuing value at the end of the final year of the explicit forecast
FCFt+1 = the estimated Free Cashflow one year after the final year of the explicit forecast
WACC = Weighted Average Cost of Capital
g = the expected constant growth rate in Free Cashflows.
Guidelines wh n using this model to determine the continuing value:
Growth rate (g): McKinsey & Company (2005) suggests that the growth rate be set equal to the expe
ted long-term rate of consumption growth for the industry (a real rate), plus expected inflation. If not
available, the expected nominal growth in gross domestic product (GDP) of South Africa, where this is
the main country of operation, could be used. Only in exceptional cases, where there is a sus-tainable
sou ce of further competitive advantage (such as a strong brand), can a higher rate be used.
(Remember to exclude inflation from the growth rates when using a WACC that has been restated as
a real rate.)
The net investment made in capital expenditure and working capital, as part of the calculation of
FCFt+1, must be sufficient to support the growth rate (g).
Exit multiples
In this instance, one can apply an earnings multiple or market price multiple (as described earlier) as
an exit multiple at the end of the explicitly forecast period. Note that it is difficult to accurately pre-
dict an exit multiple as one cannot directly apply multiples existing on the valuation date because
these will include some of the effects already captured in the explicitly forecast Free Cashflows.
451
The McKinsey Convergence Value-Driver Formula (Advanced)

This is calculated based on the following formula:
NOPLATt+1
CVt =
WACC
Where:
CVt = the continuing value at the end of the final year of the explicit forecast
NOPLATt+1 = the estimated Net Operating Profit Less Adjusted Taxes (NOPLAT) – thus
after deducting depreciation, but before gross investment in working capital
and non-current operational assets – one year after the final year of the ex-
plicit forecast
WACC = Weighted Average Cost of Capital.
(McKinsey, 2005:228)
This formula assumes that the entity operates in a competiti e industry and that the competition will
erode any excess returns after the explicitly forecast peri d, so that the company will only earn a re-
turn equal to WACC on new invested capital. Note that this f rmula appears deceptively simple, but it
does not ignore growth (in NOPLAT); instead the effect of growth is cancelled out by the required
investment rate (to be deducted from NOPLAT to obtain Free Cashflow, but not shown in this simpli-
fied formula).
Model based on Free Cashflow available to the business enterprise: things to remember
When applying any valuation method, but this mod l in particular, an appraiser should keep the following
points in mind:
The model should be ‘stress tested’ by applying sensitivity analyses of certain key variables. (This is
relatively easy to do when using a spreadsheet.)
Valuation is an iterative process: a change to one input often triggers a re-evaluation of other inputs
and a recalculation of the result. (This also favours the use of a spreadsheet.)
When using a spreadsheet in a valuation, specific attention should be paid to formulas and cell
referencing, as any error can have significant repercussions.
Where an entity consists of more than one business, each should be valued separately, taking cogni-
sance of the specific risks and circumstances of each; from this cumulative value one must deduct a
negative value for the corporate head office function, calculated as the present value of its cash out-
flows and then add the value of non-operating assets and excess cash to obtain the overall firm value.
The final valuation amount should be checked for reasonability, by using other valuation methodolo-
gies, for example an earnings multiple method.
Advantages and disadvantages
This model fo uses on the value of the operations of a business entity and is especially useful in valuing an
entity onsisting of more than one business (McKinsey, 2005).
Howeve , this model does not clearly display in which years value is added, for example a year with a
negative p ojected Free Cashflow can indicate either poor performance or investment for future years.
Example: Model based on Free Cashflow available to the business enterprise (1)
The f ll wing inf rmation has been determined for a private equity business enterprise:
The f recast Free Cashflow available to the business enterprise has been calculated as:
for the year ending 28 February 20X4: R2 200 000;
for the year ending 28 February 20X5: (R200 000);
for the year ending 29 February 20X6: R1 500 000;
for the year ending 28 February 20X7 and onwards it is expected to grow at a constant 4% per annum from
each previous year.
The WACC equals 22% (calculated based on market information of a listed peer group).
452
The fair market value of debt on 28 February 20X3 equals R2 500 000.
The cash balance in excess of operational requirements on 28 February 20X3 equals R450 000.
Required:
Determine the market value of an 100% ordinary shareholding at 28 February 20X3, without adjusting for
shareholder level differences. (Fundamental)
Determine the fair market value of a 25% ordinary shareholding at 28 February 20X3. (Intermediate)
Solution:
Part (a)
Determine the present value of Free Cashflows for the explicit forecast and the continuing value
20X4 20X5 20X6 20X7
R’m R’m R’m R’m
-------- (Explicit f recast) --------- CV base
Free Cashflow 2,20 (0,20) 1,50 1,56
1,50 × 1,04
Note: this
Continuing value: P20X6 = FCF20X7 / (WACC – g) figure is not
= 1,56 / (22% – 4%) 8 ,67 included in
the total
Free Cashflow with continuing value 2,20 (0,20) 10,17 below
Net present value discounted at WACC (22%) = 7,27 million (in examination, show discount factors with
their calculations, or calculator steps, e.g.: CF1 2,20; CF2 –0,20; CF3 10,17; I / YR 22%; P / YR 1; NPV)
Determine the fair market value of a 25% equity shareholding

20X3
R’m
Value of operations / MVIC 7,27
Value of non-operating asset: Excess cash 0,45
Overall firm value (assuming no shareholder level differences to peer group) 7,72
Value of debt (2,50)
Value of 100% equity (assuming no shareholder differences to peer group) 5,22
Valuation con lusion:

A 100% equity sha eholding in the private business enterprise (excluding adjustment for shareholder level
differences) has a ma ket value of R0,98 million at 28 February 20X3, determined by using a model based on
the Free Cashflow Model available to the business enterprise.
Part (b)
Continued fr m Part (a)
Value f 100% equity (assuming no shareholder differences to peer group) – from part a) 5,22
Adju tment for shareholder level differences
– Minority discount (say 15%) (0,78)
– Marketability discount (say 10%) (0,52)
Value of 100% equity (adjusted for shareholder level differences) 3,92
Value of a 25% equity shareholding (multiplied by the percentage shareholding (25%) 0,98
453
Valuation conclusion:
A 25% equity shareholding in the private business enterprise has a fair market value of R0,98 million at 28
February 20X3, determined by using a model based on the Free Cashflow Model available to the business
enterprise.
Example: Model based on Free Cashflow available to the business enterprise (2)
Company Z (Pty) Ltd is an unlisted South African company, which relies not only on tangible assets, but also
unrecognised, internally-generated intangible assets to generate income.
Forecast financial statements of Company Z are available. These are presented in a condensed format, but
otherwise applied IFRS for SMEs applicable on the valuation date (recognition criteria are indicated in brackets
where appropriate).
Forecast Statement of Financial Position at
20X3 20X4 20X5

R’m R’m R’m
ASSETS
Non-current assets
Property, plant and equipment
(at cost less accumulated depreciation) 80 100 110
Other investments (at cost) 20 20 20
Current assets
Inventory 40 50 65
Trade and other receivables 30 45 60
Cash and cash equivalents 7 17 15
TOTAL ASSETS 177 232 270
EQUITY
Total shareholders’ equity 109 145 185
LIABILITIES
Borrowings (at amortised cost) 58 67 65
Current liabilities
Trade and other payables 6 14 13
Borrowings (current portion) 1 2 2
Current income tax liabilities 3 4 5
TOTAL EQUITY and LIABILITIES 177 232 270
Forecast Stat m nts of Profit/Loss and Other Comprehensive Income for the year ending
20X3 20X4 20X5
R’m R’m R’m
Gross p ofit 188 247 289
Depreciation (8) (12) (14)
Other administration and operating expenses (60) (70) (80)
Dividends received 2 2 3
Pr fit bef re interest 122 167 198
Finance cost (6) (6) (7)
Profit before tax 116 161 191
Taxation (32) (45) (53)
Profit for the year 84 116 138
Dividends paid (50) (80) (98)
Increase in reserves 34 36 40
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Other information pertaining to Company Z:

Gross cashflow before investments in 20X6 is expected to be 6% higher than in 20X5 and should grow at the
same annual rate in later periods.
Gross investment in working capital, and property, plant and equipment should be 40% of gross cashflow
before investment in the year 20X6, to ensure that future growth can be sustained.
The carrying amount of borrowings approximates its fair market value.
Depreciation amounts approximate income tax allowances.
The company’s D:E ratio is managed to a target level and any variance in this ratio is considered temporary
and purely due to practical considerations.
6 The other investment represents a small shareholding of 2 000 000 sh res in listed company. These shares
had a closing price equal to 1 200 cents at the end of 20X2.
7 Relevant rates:
l WACC – calculated based on market information of a listed peer gr up 18%
l Income tax rate 28%
8 Carrying values at the end of 20X2:
l Property, plant and equipment R50 m
l Borrowings (non-current portion) R58 m
l Borrowings (current portion) R1m
l Inventory R35m
l Trade receivables R25m
l Cash R5m
l Trade payables R4m
l Current income tax liability R1m
Required:
Calculate the fair market value of a 75% equity shareholding in Company Z at the end of 20X2, using a model
based on Free Cashflow available to the business enterprise.
455
Solution:
Determine the present value of Free Cashflows for the explicit forecast and the continuing value
20X3 20X4 20X5 20X6
-------- (Explicit forecast) --------- CV base
Dividends received (excluded as valued separately) – – –
Add back: Non-cash item (depreciation) (Note 1) 8 12 14
Adjusted EBITDA 128 177 209
Recalculated income tax: (33,6) (46,2) (54 ,6)
Tax on adjusted EBITDA at 28% (35,8) (49,6) (58 ,5)
Tax effect of allowances (equal to depreciation) at 2,2 3,4 3,9
28% (Note 1)
Gross cashflow 94,4 130,8 154,4 163 ,7
154,4 × 1,06
Gross investment: (65 ,5)
163,7 × 40%
Change in working capital requirements
Change in non-excess cash current assets (Note 2) (10) (25) (30)
Opening 60 70 95
(20X3: Inventory R35m + Receivables R25m) Note:
this
Closing (20X3:40 + 30; 20X4:50 + 45; 70 95 125 figure
20X5:65 + 60) is not
in-
Change in non-debt current liabilities (Note 3) 4 9 0 cluded
in the
Opening (20X3: Payables R4m + Tax liability R1m) 5 9 18
total
Closing (20X3:6 + 3; 20X4:14 + 4; 20X5:13 + 5) 9 18 18
Capital investment (Note 4) (38) (32) (24)
Free Cashflow 50,4 82,8 100,4 98,2
Continuing value: P20X5 = FCF20X6 / (WACC – g)
= 98,2 / (18% – 6%) 818 ,3
Free Cashflow with continuing value 50,4 82,8 918,7
Net present value discounted at WACC (18%) = R661,3 m (in examination, show discount factors with
their calculations, or calculator steps, e.g.: CF1 50,4; CF2 82,8; CF3 918,7; I / YR 18%; P / YR 1; NPV)
Note: Figur s may not total correctly due to rounding.

Note 1: Depre iation
In the example above, depreciation is added back as it represents non-cashflow; the income tax allow-
ances a e then used separately to determine its effect on the tax cashflow. For examination purposes,
students are recommended to always show their calculations in this fashion, with appropriate descrip-
tions. In this case, the tax allowances and depreciation are the same amount. This allows a simpler treat-
ment, whereby the tax is calculated directly from operating profit (which includes the effect of depreciati
n). (Note that the simpler treatment is possible only where depreciation is equal to the in-c me tax
allowances.) Following such a simplified treatment in an examination is, however, unadvised but, if f ll
wed, a short explanation is warranted to clearly indicate to the examiner that knowledge was indeed
applied correctly.
Note 2: Non-excess cash
All cash is viewed as excess cash due to the high working capital ratio.
Note 3 : Non-debt current liabilities
There is an argument that the income tax liability might include a portion relating to items excluded from
the Free Cashflow (e.g. other investments and finance cost), which, in theory, should be removed here.
456
This example applied a common simplified approach of including the entire movement as the effect
should be minor.
Note 4: Capital investment
20X3 20X4 20X5
R’m R’m R’m
Carrying value beginning 50 80 100
Carrying value end 80 100 110
Movement in carrying value 30 20 10
Depreciation included here 8 12 14
Total cash movement 38 32 24
Determine the fair market value of a 75% equity shareholding

20X2
R’m
Value of operations 661,3
Value of non-operating asset: Excess cash end of 20X2 5
Value of other non-operating assets: Investment (2m shares × R12) 24
Overall firm value (assuming no shareholder level differences to peer group) 690,3
Value of debt (carrying amount approximates fair arket value) (R58m + R1m) (59,0)
Value of 100% equity (assuming no shareholder differences to peer group) 631,3
Minority discount (not applicable in this case as a majority shareholding is being valued) –
Marketability discount (say 5%) (31,6)
Value of 100% equity (adjusted for shareholder level differences) 599,7
Multiplied by percentage shareholding (75%) 449,8

Reasonability test:
No reasonability test will be performed here as there is not enough information to apply another valua-
tion methodology. Net assets could be calculated, but will add little value here as market values are not
available for property, plant and equipment, and other intangible assets.
Valuation conclusion:
A 75% equity shareholding in Company Z has a fair market value of R449,8 million at the end of 20X2,
determined by using a model based on Free Cashflow available to the business enterprise.
Model based on Free Cashflow available to equity holders

Of the two available mod ls bas d on Free Cashflow, the model based on Free Cashflow available to equity
holders is less popular. It is th refore not explored in much detail within this text. In theory, a similar value
should be obtained when using either model.
In many rega ds it is similar to the model that uses Free Cashflow available to the business enterprise, but with
differences in a few key areas. Differences include the way in which Free Cashflow is calculated and the dis-
count rate sed.
Free Cashflow available to the equity holders
Simply put, when an equity approach is selected, Free Cashflow is the cashflow that is ‘free’ for distribu-ti
n to equity holders, that is usually after interest expenditure.
Di count rate
In this case the required return of the holders of ordinary equity is the cost of equity (ke), not the WACC.
11.6.6 Model based on EVA®/MVA (Advanced)

EVA®(Economic Value Added) is registered trademark of the firm, Stern, Steward & Co. (registered in the US
and in other countries). MVA (Market Value Added) has been described by the same firm and is a measure that
is closely linked to EVA.
457
Thanks in part to successful implementation at high-profile companies and effective self-promotion, EVA has
become a popular tool in measuring performance. In recent years, valuation models based on EVA and MVA
have also increased in popularity.
EVA®
EVA is described in the context of performance measurement, in chapter 8 (Analysis of financial
statements). EVA can be defined as follows:
EVA = NOPLAT – (Invested capital × WACC)
Where:
NOPLAT = (Adjusted) net operating profit after adjusted t x
Invested capital = (Adjusted) carrying value of net operating assets: oper ting (PPE) assets plus
non-excess cash current assets less non-debt current liabilities
WACC = Weighted Average Cost of Capital
The full EVA product prescribes several adjustments to correct f r acc unting distortions and conservatisms; the
more critical being:
l Investment in goodwill, research and development and arketing are to be capitalised as part of assets (to
be less conservative).
Depreciation/amortisation should be adjusted to reflect the usage of the assets.
Removal of general provisions, such as provisions for bad debts and for warranties (these allow for
accounting manipulation).
MVA
MVA could be defined as –
MVA = Present value of expected EVA for future years, discounted at the firm’s WACC
Since MVA represents, in essence, the market value added over and above a business enterprise’s existing
(adjusted) carrying value of invested capital, it follows that –
l Market value of a business enterprise = MVA + current (adjusted) carrying value of invested capital; or
l Market value of a business enterprise = Present value of expected EVA for projected future years,
discounted at the firm’s WACC + current carrying value of in-
vested capital
11.6.6.3 Steps in applying a valuation model based on EVA/MVA

A valuation model based on EVA/MVA usually applies the following steps:
Calculate the WACC of the business enterprise based on comparable market data at the valuation date and
adjust for enterprise-specific factors.
Determine the adjusted invested capital balance at the valuation date and for explicitly forecast years.
Calculate adjusted NOPLAT for the explicitly forecast years and for years after this until a steady-state
position is obtained.
Determine the EVA for each of these years.
Determine the MVA by discounting each of the EVA amounts, using the WACC.
Add to the MVA the adjusted invested capital balance on the valuation date.
Add the value of non-operating assets in order to obtain the overall firm value (this does not yet account for
hareholder level differences to peer group).
458
Example: Valuing a business using a model based on EVA/MVA (Advanced)

The following condensed historical and forecast financial statements are available for Evagreen (Pty) Ltd, an
unlisted South African company:
Statement of Financial Position at
Historical ----------------- Forecast ---------------
20X3 20X4 20X5 20X6
ASSETS Non-
current assets
Property, plant and equipment (PPE) 80,00 85,00 90,90 96,70
Opening carrying amount 80,00 80,00 85,00 90,90
Net capital expenditure 16,00 23,00 26,00 28,00
Depreciation for the year (16,00) (18,00) (20,10) (22,20)
Closing carrying amount 80,00 85,00 90,90 96,70
Current assets
Trade and other receivables 6,67 7,50 11,67 8,92
Cash and cash equivalents 20,00 22,61 24,35 25,57
TOTAL ASSETS 106,67 115,11 126,92 131,19
EQUITY
Total shareholders’ equity 96,33 104,36 114,08 119,73
LIABILITIES
Long-term debt 7,00 7,00 7,00 7,00
Current liabilities
Trade and other payables 3,34 3,75 5,84 4,46
TOTAL EQUITY and LIABILITIES 106,67 115,11 126,92 131,19
Statements of Profit/Loss and Other Comprehensive Income for the year ended/ending
Historical ----------------- Forecast ---------------
20X3 20X4 20X5 20X6
Gross profit 40,00 45,00 70,00 53,50
Depreciation (16,00) (18,00) (20,10) (22,20)
Other administration and operating expenses (4,00) (4,20) (4,41) (4,63)
Operating profit 20,00 22,80 45,49 26,67
Net finance costs (0,50) (0,50) (0,50) (0,50)
Profit before tax 19,50 22,30 44,99 26,17
Taxation (5,46) (6,24) (12,60) (7,33)
Net p ofit 14,04 16,06 32,39 18,84
Other information relevant to the

company: 1 Relevant rates:
WACC – calculated based on market information
f a listed peer group 20%
l Income tax rate 28%
The market value of debt on the last day of the 20X3 year equalled its carrying value.
Depreciation amounts are reflective of the true usage of the assets.
Net operating profit after adjusted tax (NOPLAT) is expected to grow by 5,373% per annum for the year
20X7 and the following years.
Free cashflow for the 20X7 year is expected to equal 73,14% of NOPLAT in order to account for the appro-
priate gross investment.
459
Required:
Calculate the fair market value of a 51% equity shareholding in Evagreen (Pty) Ltd at the end of the
financial year ended in 20X3, based on available information and using a model based on Free Cashflows
available to the business enterprise.
Calculate the fair market value of a 51% equity shareholding in Evagreen (Pty) Ltd at the end of the
financial year ended in 20X3, based on available information and using a model based on EVA/MVA.
Compare the answers obtained using the two different models and highlight the benefit (if any) of the
model based on EVA/MVA.
Solution:
Valuation based on Free Cashflow (FCF) available to the business enterprise:
20X3 20X4 20X5 20X6 20X7
= 19,2 × 1,05373%
NOPLAT 16,42 32,75 19,20 20,23
Add back: Depreciation (non-cashflow) 18,00 20,10 22,20
Gross cashflow 34,42 52,85 41,40
Gross investment (23,42) (28,08) (26,63)
Investment in working capital
Change in non-cash current assets (0,83) (4,17) 2,75
Change in non-debt current liabilities 0,41 2,09 (1,38)
Net capital expenditure (23,00) (26,00) (28,00)
FCF 11,00 24,77 14,77 14,80

= 20,23 × 0,7314
20X3 20X4 20X5 20X6 20X7

Calculate the continuing value (CV)
CV20X6 = FCF20X7 / (WACC – g)
= 14,8 / (0,20 – 0,05373) 101,16
11,00 24,77 115,93
20% 0,8333 0,6944 0,5787

R’m
Value of operations (MVIC [market value of invested
capital]) 93,46 9,17 17,20 67,09
Add non-ope ating assets: Excess cash 20,00
Overall firm val e (assuming no shareholder level
differences to peer group) 113,46
Val e of debt (7,00)
Value f 100% equity (assuming no shareholder
differences to peer group) 106,46
Minority discount (not applicable in this case as a
majority shareholding is being valued) (0,00)
Value of 100% equity (adjusted for shareholder level
differences) 101,13
Fair market value of a 51% equity shareholding
(subtotal multiplied by 51%) 51,58
460
Conclusion:
Thus, the value of a 51% shareholding in Evagreen (Pty) Ltd is equal to R51,58 million, using a model based on
Free Cashflow available to the business enterprise.
Valuation using a model based on EVA/MVA:
1 Determine the adjusted invested capital balance at the valuation date and for explicitly forecast years
INVESTED CAPITAL (ADJUSTED) 20X3 20X4 20X5 20X6
PPE 80,00 85,00 90,90 96,70
Trade and other receivables 6,67 7,50 11,67 8,92
Excess cash (see note) – – – –
Current liabilities (3,34) (3,75) (5,84) (4,46)
At year-end 83,33 88,75 96,73 101,16
Note: The cash and cash equivalents are excluded from the calculati n f adjusted invested capital where
this represents excess cash and is thus not an operating asset n which a return equal to WACC is to be
earned. In line with other operating assets – generally their ass ciated benefits are excluded (in this case
interest income excluded in net finance cost) and the asset valued separately using another methodology.
The argument could be made that excess cash should be distributed back to the shareholders, since the
business may not earn an appropriate return on these funds. (However, counter arguments exist for keep-
ing some excess cash, including its lowering eff ct on risk, and its availability to replace debt, should new
debt not be available in these troubled times).
Calculate adjusted NOPLAT for the explicitly forecast years and for years after this until a steady-
state position is obtained
20X3 20X4 20X5 20X6 20X7
R’m R’m R’m R’m R’m
(Steady-state)
Gross profit 40,00 45,00 70,00 53,50
Depreciation (16,00) (18,00) (20,10) (22,20)
Other administration and operating ex-
penses (4,00) (4,20) (4,41) (4,63)
Adjusted tax at 28% (5,60) (6,38) (12,74) (7,47)
Add back: Depreciation 16,00 18,00 20,10 22,20
Deduct: Tax allowance
(in this case equal to d pr ciation) (16,00) (18,00) (20,10) (22,20)
Adjusted taxable income link d to
operations 20,00 22,80 45,49 26,67
Net ope ating p ofit after adjusted tax

(NOPLAT) 14,40 16,42 32,75 19,20 20,23
19,2 × 1,05373
Note: In this case this is equal to WACC
Determine ret rn on invested capital (ROIC)
ROIC = NOPLAT/Invested capital (beginning of year) 19,7% 36,9% 19,8% 20,0%
461
3 Valuation based on EVA/MVA

20X3 20X4 20X5 20X6 20X7
NOPLAT 16,42 32,75 19,20 20,23
Required return (WACC × Adjusted Invested Capital) (16,67) (17,75) (19,35) (20,23)
WACC 20% 20% 20% 20%
Adjusted invested capital at beginning of the year 83,33 88,75 96,73 101,16
EVA for the year (0,25) 15,00 (0,15) (0,00)
Note: No EVA is created for this year and onwards as ROIC = WACC
20% 0,8333 0,6944 0,5787 0,4823

R’m
MVA 10,13 (0,20) 10,42 (0,08) (0,00)
Opening adjusted carrying value of IC 83,33
Add non-operating assets: Excess cash 20,00
Overall firm value (assuming no shareholder Note: The overall firm
level differences to peer group) 113,46 value is the same value as
that obtained using the
Value of debt (7,00) model based on Free
Cashflow
Value of 100% equity (assuming no
shareholder differences to peer group) 106,46
Minority discount (not applicable in this case
as a majority shareholding is being valued) 0,00
Note: The fair market
Value of 100% equity (adjusted for value of a 51% equity
shareholder level differences) 101,13 share is the same as that
obtained using the model
Fair market value of a 51% equity based on Free Cashflow
shareholding (subtotal multiplied by 51%) 51,58

Thus, the value of a 51% shareholding in Evagreen (Pty) Ltd is equal to R51,58 million, using a model
based on EVA/MVA.
Comparison
Identical answers are obtained using these two different models.
Conclusion:
The benefit of the model based on EVA/MVA is that it clearly highlights the exact year(s) in which value is
added, whe eas the model based on Free Cashflow does not. For example, value in excess of carrying value is
created only in year 20X5 (see positive EVA for this year only).
11.6.7 Net assets

This valuati n methodology determines the value of a business entity as a function of its net assets, by calculat-
ing the value f its assets less the value of its liabilities.
A net a ets methodology is sometimes linked to a liquidation value, which as described earlier, could repre-ent
fair market value for some businesses in the case of voluntary liquidation, but not in the case of forced
iquidation.
To offer any meaningful results, regardless of the definition of value, the value of assets and liabilities cannot
be expressed in terms of unadjusted historical cost.
462
Application of this methodology

This methodology may be used to determine the fair market value of a business enterprise only in the follow-
ing circumstances or for the following purposes –
where the value of a business is principally represented by the underlying fair market value of its assets,
rather than its earnings or future operating cashflows, such as a property-holding company or an invest-
ment fund-of-funds (examples by IPEV Board, 2010); or
where the business enterprise does not generate a sufficient return on its assets, where a higher value can
be obtained by closing the business and selling the assets; or
as a reasonability check to the main valuation performed using another va uation methodology.
Which assets and liabilities?

When determining the value of net assets, one has to ask the question: which assets and liabilities should be
included? All liabilities, generally, have to be included in the initial aluation. However, the assets to be included
will depend on the prospects of the business entity, and whether liquidation is considered or may be enforced.
In order to determine which assets to include, one may ask the questi n: is there a market for the asset? For
instance, there is usually a market for most fixed assets (such as property, plant and equipment) and current
assets (such as accounts receivable and inventory). However, if these assets are highly specialised, the market
may be small, which may reduce their value in some cases.
Moreover, the market for intangible assets (such as brands, trademarks and customer relationships) often
depends on the future prospects of the entity. Wh re one xp cts a greater value from closing a business and
selling the assets, rather than continuing to use all the ass ts in a business, or in the case of liquidation, the
intangible assets are likely to have little or no value.
A few examples
Methodologies for the calculation of the fair market value of debt are discussed earlier in this book. The meth-
odologies described in this chapter may be used to value individual assets; however, the variables to be includ-
ed usually differ from those used to value a business or equity share. Some examples follow.
Property
The fair market value of property is usually determined by a registered property appraiser. SAICA has
compiled a guide on the measurement of assets for the purposes of financial reporting on a business
combination (2006), but its principles are equally relevant here.
In this guide, SAICA suggests that the fair market value of property (consisting of land or built-on property) is
preferably determined using a market approach, by determining prices paid for similar properties that have
been sold in recent transactions, with adjustments for differences in qualities. In cases where built-on prop-erty
differs significantly from those included in recent transactions (such as in the layout, age and condition of the
building), the built-on property value is then normally determined using an income approach, on the basis of
the discount d pr s nt value of the rental that could be derived from it (SAICA, 2006).
Plant and equipment
The fair ma ket value of non-specialised plant and equipment is usually determined based on a market
approach, with eference to recent selling prices of similar assets. Where such market transactions are not
available, or where the plant and equipment are specialised, a replacement cost approach is often used,
by obtaining the new replacement cost for the asset from a supplier and then deducting deprecia-tion to
reflect its current state, or by indexing its historical purchase price (SAICA, 2006).
Brands
The fair market value of brands can be valued using a relief-from-royalty-method as described by SAICA
(2006). Here one must ask what the equivalent royalty would be if the entity did not own the brand, but
made use of a similar brand belonging to a third party. The present value of the royalty saved is then
equal to the fair market value of the brand.
Contingent liabilities
The fair market value of a contingent liability is ‘measured at the amount that an unrelated third party
would demand for assuming the contingent liability’ (SAICA, 2006:14). When considering what an unre-
lated third party would demand, one often has to consider different scenarios and then weigh the out-
come of each based on an estimate (SAICA, 2006).
463
Appendix 1
Valuation outlines (Intermediate)

These outlines are intended to provide guidance to students when applying these methods of valuation in an
examination context.
Students are reminded that examination questions on valuations vary considerably. Inevitably, these templates
cannot therefore be viewed as all-inclusive or valid in all circumstances. Particular attention should thus be paid
to the exact wording of the ‘required’ section and the number of marks a ocated, and answers should be
carefully planned before being executed.
OUTLINE: METHOD BASED ON A P/E MULTIPLE

Assume one uses a comparator P/E multiple of reference listed company (A) to determine the fair market value of a
private equity business enterprise (B). Entity A is to be as similar as possible to entity B, so that fewer adjustments
are required.
Steps
Determine whether some of the initial steps of valuation are required and address these (refer to elements 1–
8 as discussed earlier in this chapter, in the section entitled: ‘Valuation report’ (section 11.5.3)).
Determine the maintainable annual earnings of entity B:
2.1 When applying historical multiples and historical arnings:
Adjustments to all years for the purposes of trend analysis

<- Previous financial years ended (FYE)
Years to analyse FYE FYE FYE
(let the question be the guide): Most recent Most recent Most recent
–2 –1
E.g. starting with: Earnings before interest, tax,
depreciation and amortisation (EBITDA)
Adjust for
– Non-operating income
– Non-maintainable items
Adjusted EBITDA
Do not include income from other investments
here (e.g. rentals, dividends or interest) where
these are valued separately
Deduct recalculated interest expense (so that
gearing ratio is comparable to that of entity A),
but adjust for *.
Deduct restated depreciation/amortisation
expense (required to ensure the asset base can
support maintainable earnings)
Adjusted ea nings before tax
Recalculated tax expense
Adj sted earnings
Analyse the trend in historical earnings:

– If inclining or declining trend: use most recent adjusted figure
– If no clear trend: use a weighted average of adjusted earnings
– Analyse growth percentages in adjusted figures (for use below when adjusting the P/E multiple)
(Assume the maintainable historical earnings equal R1 million)
464
2.3 When applying forward multiples and projected earnings:

<-Historical / Current Forecast ->
Years to analyse FYE FYE Most Current 12 months
(let the question be the guide ): Most Most recent year forward the
recent recent FYE (annualised) valuation date
–2 –1 (possibly)
Adjusted earnings (calculate as above)
Evaluate reasonability of forecast earnings:
– Analyse trend in earnings over time
– Consider other evidence (industry forecasts, market research, competitor ana ysis, etc)
– Analyse growth percentages in adjusted figures (for use below when djusting the P/E multiple)
– Use forecast earnings only if they appear reasonable
(Assume the maintainable forecast earnings equal R1,060 million)
3 Adjust the comparator P/E multiple for differences in risk and growth factors. Historical/ Forward P/E
current P/E
(Example) (Example)
Comparator P/E multiple of A (based on market capitalisation representing a 10,00 9,30
controlling basis, based on headline earnings)
– Sometimes the comparator multiple is adjusted by re oving excess cash and
investments**
Adjusted for entity level differences between the comparator entity and the entity
being valued:
[Always consider the way the above P/E multiple was calculat d before making
adjustments here]
Adjustment for business and finance risk: (–) B has higher risk; (+) B has lower risk
– The level of borrowing (only if not accounted for in maintainable earnings)
– Level of excess cash and non-operating assets (only if not valued separately
and/or not adjusted for above)**
– Relative age of non-current assets and need for reinvestment in assets
(only if not adjusted for in maintainable earnings)
– Difference in the level of competition
– Country risk
– The relative size of the entities
– Access to finance
– The reliance on a small number of key employees
– The diversity of the product ranges
– Difference in the quality of earnings
– Specific differences mentioned in the question
Maintainable arnings long-t rm growth expectations:
(–) B has low r growth xp ctations; (+) B has higher growth expectations
Assume adjustments equalled: (5,50) (5,05)
Adjusted P/E multiple applicable to B 4,50 4,25
465
4 Determine value of a 100% equity shareholding in entity B (first assuming no owner level differences to comparator).
Either
method
R
Maintainable earnings × adjusted P/E multiple = (R1m × 4,5) or (R1,060m × 4,25) Note: 4 500 000
Figures may not total correctly due to rounding.
Adjustment for required (injection)/reduction in debt to equal gearing-ratio in B*
(assume injection of R300 000 required in this case) (300 000)
E.g. if entity A has too much debt on valuation date, the recalculated interest expense at
maintainable earnings based on the gearing ratio of entity B would result in ess interest and
higher earnings. The resulting value above will thus be inflated. Here one must reduce the
value again by the required equity capital injection to obtain this level of ge ring.
Value of excess cash and other investments** (if valued separately, assume v lue is R800 000 in
this case) 800 000
Value of a 100% equity shareholding in entity B (assuming no shareholder le el differences to
comparator) 5 000 000
5 Further steps depending on required:

[Always remember here to compare like to like: compare the shareholder of the comparator
entity (incorporated in the comparator P/E multiple) to the shareholder in the entity being valued.]
– e.g. determine overall firm value of entity B R
Value of a 100% equity shareholding in entity B (assuming no shareholder level differences
to comparator) from above 5 000 000
Shareholder level premiums and discounts (compar d to shar holders in entity A):
– Control premium (possible, but not in this case as comparator P/E is already representative
of a controlling share) Nil
Subtotal 5 000 000
– Marketability discount (applicable as this share in entity B is less marketable)
(e.g. 5% × 5 000 000) ( 250 000)
Value of a 100% equity shareholding in entity B (adjusted for shareholder level differences in
this case) 4 750 000
Value of actual debt on the valuation date (valued separately, assume value is R2 000 000
in this case) 2 000 000
Fair market value: Overall firm value of entity B 6 750 000
– e.g. determine the fair market value of a 74% shareholding in entity B

Value of a 100% equity shareholding in entity B (assuming no shareholder level differences
to comparator) 5 000 000
Shareholder l vel pr miums and discounts (compared to shareholders in entity A):
– Control pr mium (possible, but not in this case as comparator P/E is already representative
of a ontrolling share) Nil
Subtotal 5 000 000
– Ma ketability discount (applicable as this share in entity B is less marketable)
(e.g. 8% × 5 000 000) ( 400 000)
Val e of a 100% equity shareholding in entity B (adjusted for shareholder level differences in
Multiplied by percentage shareholding 74%
Fair market value of a 74% equity shareholding in entity B (adjusted for shareholder 3 404 000
level differences)
466
– e.g. determine the fair market value of a 20% shareholding in entity B R

Value of a 100% equity shareholding in entity B (assuming no shareholder level differences to
comparator) 5 000 000
Shareholder level premiums and discounts (compared to shareholders in entity A):
– Minority discount (necessary as comparator P/E is (e.g. 16% × 5 000 000)
representative of a controlling share) ( 800 000)
Subtotal 4 200 000
– Marketability discount (applicable as this share in entity B is less (e.g. 20% × 4 200 000)
marketable) ( 840 000)
Value of a 100% equity shareholding in entity B (adjusted for shareholder level differences in this
case) 3 360 000
Fair market value of a 20% equity shareholding in entity B (adjusted for shareholder level
differences) 672 000
6 Reasonability test
Based on a different valuation methodology, if possible.
7 Valuation conclusion
OUTLINE: METHOD BASED ON AN MVIC/EBITDA MULTIPLE
Assume one uses a comparator MVIC/EBITDA multiple of r f r nce list d company (entity A) to determine the fair
market value of a private equity business enterprise (entity B). Entity A is to be as similar as possible to entity B, so that
fewer adjustments are required.
Steps
Determine if some of the initial steps of valuation are required and address these (refer to elements 1–8 as
discussed earlier in this chapter, in the section entitled: ‘Valuation report’ (section 11.5.3)).
Determine maintainable annual EBITDA of B:
When applying historical multiples and historical EBITDA:
Adjustments to all years for the purposes of trend-analysis <- Previous financial
years ended (FYE)
Years to analyse FYE FYE FYE
(let the question be the guide): Most Most Most recent
recent recent
–2 –1
Ensure that
E.g. starting with: Earnings before interest, non-operating
tax, depr ciation and amortisation income is
(EBITDA) excluded
Adjust for
– Non-maintainable items
Note: finance
Adjusted EBITDA cost excluded

– If inclining, or declining trend: use most recent adjusted figure
– If no clear trend: use a weighted average of adjusted earnings
– Analyse growth percentages in adjusted figures (for use below when adjusting the MVIC/EBITDA
multiple)
(Assume the maintainable historical EBIDTA equals R2 million.)
467
When applying current multiples and current EBITDA

(annualised):
Adjustments to all years for the purposes of trend-analysis <- Previous years Current
financial year
Years to analyse FYE FYE Most recent Current year
(let the question be the guide): Most Most FYE (annualised)
recent recent
–2 –1

– As above
2.3 When applying forward multiples and projected EBITDA:

<-Historical / Current Forecast ->
FYE FYE Most Current year 12 months
Most M st recent FYE (annualised) forward the
recent recent (possibly) valuation date
–2 –1
Years to analyse
(let the question be the guide):
Adjusted earnings (calculate as above)
Evaluate reasonability of forecasted earnings:
– Analyse trends in EBITDA over time
– Consider other evidence (industry forecasts, market research, competitor analysis, etc)
– Analyse growth percentages in adjusted figures (for use below when adjusting the MVIC/EBITDA multiple)
– Use forecasted EBITDA only if it appears reasonable
(Assume the maintainable forecast EBITDA equals R2,12 million)
3 Adjust the comparator MVIC/EBITDA multiple for differences in risk and growth Historical/ Forward
factors current MVIC/EBITDA
MVIC/EBITDA
(Example) (Example)
Comparator MVIC/EBITDA multiple of entity A (based on market capitalisation 5,00 4,65
representing a controlling basis)
– (Note: The comparator’s multiple would exclude excess cash and investments
from MVIC)
Adjusted for entity level differences between the comparator entity and
the entity being valued:
[Always consider the way the above multiple was calculated before making
adjustments h r ]
Adjustment for busin ss and finance risk: (–) B has higher risk; (+) B has lower risk
– Relative age of non- urrent assets and need for reinvestment in assets
– Differen e in the level of competition
– Count y isk
– The elative size of the entities
– Access to finance
– The reliance on a small number of key employees
– The diversity of the product ranges
– Differences in the quality of EBITDA
– Specific differences mentioned in the question
[Note that one does not adjust for differences in borrowing,
or non-operating assets here]
Maintainable EBITDA long-term growth expectations:
(–) B has lower growth expectations; (+) B has higher growth expectations
Assume adjustments equalled: (1,75) (1,58)
Adjusted MVIC/EBITDA multiple applicable to entity B 3,25 3,07
468
Determine the overall firm value of entity B (assuming no owner level differences to comparator)
Either method
R
Determine the MVIC
Maintainable EBITDA × adjusted MVIC/EBITDA multiple = (R2m × 3,25) or (R2,12m × 3,07) 6 500 000
(Note: Figures may not total due to rounding.)
Value of excess cash and other investments (assume this was valued separately at this value) 800 000
Overall firm value of entity B (unadjusted - assuming no shareholder level differences to comparator) 7 300 000
5 Further steps depending on required:

[Always remember here to compare like to like: compare the shareholder of the comp r tor entity
(incorporated in the comparator P/E multiple) to the shareholder in the entity being v lued.]
– e.g. determine overall firm value of entity B R
Overall fir m value of entity B (assuming no shareholder level differences to comparator) 7 300 000
Value of debt (valued separately, assume value is R2 000 000 in this case)
#
(2 000 000)
Value of 100% equity (assuming no shareholder level differences) 5 300 000
Shareholder level premiums and discounts (compared to shareh lders in entity A):
– Control premium (possible, but not in this case as co parator ultiple is already based on
the value of a controlling share) Nil
Subtotal 5 300 000
– Marketability discount (applicable as this share in B is l ss
marketable) (e.g. 6% × 5 300 000) ( 318 000)
Value of a 100 % equity shareholding in B (adjusted for shareholder level differences in this
case) 4 982 000
Value of actual debt on the valuation date (as above, add back again)
#
2 000 000
Fair market value: Overall firm value of entity B 6 982 000
[Note that shareholder level differences are preferably adjusted directly to the value of equity,
but if it is not possible to determine the value of debt (e.g. R2 000 000 in this case), then the
premium and discounts could be adjusted directly to overall firm value, although not ideal.]
– e.g. determine the fair market value of a 40% shareholding in B R
Overall firm value of entity B (assuming no shareholder level differences to comparator) 7 300 000
Value of debt (valued separately, assume value is R2 000 000 in this case) (2 000 000)
Shareholder level premiums and discounts (compared to shareholders in entity A):
– Minority discount (necessary as comparator multiple is
representative of a controlling share) (e.g. 14% × 5 300000) (742 000)
Subtotal 4 558 000
– Marketability discount (applicable as this share in entity B is less
marketable) (e.g. 15% × 4 558000) ( 683 700)
Value of a 100 % equity shareholding in entity B (adjusted for shareholder level differences in
Fair market value of a 40% equity shareholding in entity B (adjusted for shareholder level
differences) 1 549 720
6 Reas nability test

Ba ed on a different valuation methodology, if possible.
7 Va uation conclusion
469
OUTLINE: MODEL BASED ON FREE CASHFLOW AVAILABLE TO THE BUSINESS ENTERPRISE

(Using a simplified tax treatment – Refer to Question 11-5 for an illustration of both a long and a short method)
Steps:
Determine whether some of the initial steps of valuation are required and address these (refer to elements 1–8
as discussed earlier in this chapter, in the section entitled: ‘Valuation report’ (section 11.5.3))
Calculate the Weighted Average Cost of Capital (WACC). Refer to chapter 4 (Capital structure and the cost of capital).
Determine the present value of Free Cashflows (FCF):
Explicit forecast for non-steady state Continuing

Valuation (for number of years to inc ude et the value base
date question be the guide) (steady state)
Year: 0 1 2 3 4
Revenue XXXXX XXXXX XXXXX
Cost of sales (XXXX) (XXXX) (XXXX)
Gross profit XXXX XXXX XXXX
Do not include non-operating income here
(associated assets are valued separately) – – –
Selling, general and administration (XXX) (XXX) (XXX)
Operating EBIT XXX XXX XXX
Exclude depreciation and non-cash items add/deduct add/deduct add/deduct
Adjusted EBITDA XXX XXX XXX
Recalculated tax add/d duct add/deduct add/deduct
Operating EBITDA × cash tax rate Tax add/deduct add/deduct add/deduct
allowances effect × cash tax rate XX XX XX
Assessed losses × cash tax rate (if applicable) XX XX XX
Growth from
Gross cashflow XX XX XX previous year
Gross investment:
Change in working capital requirements add/deduct add/deduct add/deduct normally deduct
Change in non-excess cash current asset balance: normally
increase: deduct / decrease: add add/deduct add/deduct add/deduct deduct
Change in non-debt current liabilities: increase:
add / decrease: deduct add/deduct add/deduct add/deduct normally add
Capital investment
Change in non-current assets balance: increase: normally
deduct / decreas : add add/deduct add/deduct add/deduct deduct
(include change in additional ass ts to increase
capacity)
FCF X X X X
Note:
Continuing value (CV3) = FCF4/(WACC – g) placement XXX
FCF with CV X X XXX
Note: FCF of continuing value

Disc unt using WACC (show calculator steps) base not included with totals
Value of operations (MVIC) XXX
Add va ue of non-operating assets:
Excess cash at valuation date X
Other non-operating assets (valued
separately) X
Overall firm value (unadjusted) 8 000 000 (example)
470
Further steps depending on required:

– e.g. determine overall firm value of the entity R
Overall firm value (assuming no shareholder level differences to peer group 8 000 000
used to calculate WACC)
Value of debt (valued separately, assume value is R2 500 000 in this (2 500 000)
##
case) Value of 100% equity (assuming no shareholder level differences) 5 500 000
Shareholder level premiums and discounts:
– Control premium (no, as FCF normally determined from the perspective of a –
controlling party)
– Marketability discount (applicable as this share is less marketable)
(e.g. 6% × 5 500 000) (330 000)
Value of a 100% equity shareholding (adjusted for shareholder 5 170 000
level differences in this case)
Value of actual debt on the valuation date (as above, add back 2 500 000
##
again) Overall firm value of enterprise B 7 670 000
[Note that shareholder level differences are preferably adjusted directly to
the value of equity, but if it is not possible to determine the value of debt
(e.g. R2 500 000 in this case), then the premium and discounts could be
adjusted directly to overall firm value, although not ideal.]
– e.g. determine the fair market value of a 30% shareholding in the entity R
Overall firm value (assuming no shareholder lev l diff r nc s to peer group used
to calculate WACC) 8 000 000
Value of debt (valued separately, assume value is 2 500 000 in this case) (2 500 000)
Shareholder level premiums and discounts:
– Minority discount (necessary as FCF normally determined from the perspec-
tive of a controlling party) (e.g. 18% × 5 500 000) (990 000)
Subtotal 4 510 000
– Marketability discount (applicable as this share is less marketable)
(e.g. 16% × 4 510 000) (721 600)
Value of a 100% equity shareholding (adjusted for shareholder
level differences in this case) 3 788 400
Fair market value of a 30% equity shareholding (adjusted for shareholder
level differences) 1 136 520
Reasonability test
Based on a differ nt valuation methodology, if possible.
Valuation con lusion
471
Appendix 2
Summary of the average owner level premiums and discounts applied by most
South African appraisers in 2012 (Intermediate)
The tables contained in this appendix have been recalculated and compiled based on the information in PwC’s
Valuation Methodology Survey (2012), and is presented here with permission. These tables summarise the
average adjustments for owner level premiums and discounts, made by most survey respondents in 2012 when
using a specific valuation approaches. It is therefore a useful indication of actual South African valuation prac-
tice.
Note that these average percentages fail to highlight the large vari tion in responses. This summary also cannot
do justice to the full report; interested parties should refer to the det iled report. Further note that these
averages are grouped into key shareholding interest levels, affecting control of companies. However, the
Companies Act 71 of 2008 (which became effective in 2011) offers possibilities to change key shareholding
interest levels affecting the level of control. In addition, where control is affected by other factors (e.g. an
agreement), shareholder interest levels are less relevant in this c ntext.
A special note to students: due to the nature of this course it is n t necessary to memorise these percentages.
Trends and observations as described below are, however, i portant.
Average adjustments to the market value of equity for owner level differences when using an income
approach
Shareholding interest
1–24% 25–49% 50–74% 75–100%
Percentage of value per share % % % % % %
MVE with no shareholder level
differences to comparator
quoted entity used in the cal-
culation of the discount rate 100 100 100 100
Minority discount – 18 – 14 0 0
MVE adjusted for the above 82 100 86 100 100 100
Marketability discount – 15 – 18 – 13 – 15 – 10 –8

Average adjustments to the market value of equity for owner level differences when using a
methodology based on multiples – part of the market comparable approach
Shareholding interest
1–24% 25–49% 50–74% 75–100%
Percentage of value per share % % % % % %
MVE assuming no shareholder
level differences to
comparator quoted entity 100 100 100 100
Control premi m 0 0 19 22
Marketability discount – 15 – 13 – 10 –8 –8 –7
Notes
Figures may not total correctly due to rounding.
Percentages have been rounded to the nearest percentage point.
472
Observations
A minority discount is normally applied only when using the income approach. For the income approach
this makes sense as it usually involves a discounted cashflow method where the forecast cashflows are
frequently determined on an enterprise level – implying control.
A minority discount decreases in steps as the shareholding increases, up to below a 50% interest, which
makes sense as the lack of control progressively decreases up to this point. (With the absence of other in-
fluences, control effectively starts with a shareholder owning 50% plus one share).
A control premium is normally applied only when using a market mu tip e approach. This makes sense only
where the comparator multiple (e.g. P/E multiple) belongs to an entity of which the quoted market share
price is reflective of a non-controlling share. Since this practice is not universally accepted, the rec-
ommendation is to evaluate the comparator entity on a case-by-c se b sis. B sed on the survey, the con-
trol premium increases in steps as the interest is increased from 50%, since these incremental levels each
represent a key level allowing increasing authority in decision-making.
A marketability discount decreases as the shareholding increases, which makes sense as it should be
relatively easier to sell a larger shareholding than a lesser ne.
Practice questions

The following extract from the management accounts of a family-run retailer is available. The information was
compiled on a historical-cost convention and all figures have been indexed and adjusted to reflect the value of
money at the end of the financial year ended 20X1.
Statement of Profit/Loss (In constant 20X1 money)
Historical Historical Historical Forecast
year 20X1 year 20X2 year 20X3
(most recent)
Turnover 2 000 000 1 800 000 2 100 000 2 520 000
Cost of sales 1 110 000 1 160 000 1 180 000 1 350 000
Gross profit 890 000 640 000 920 000 1 170 000
Sale of assets – 120 000 – –
Depreciation (50 000) (50 000) (50 000) (50 000)
Interest (200 000) (200 000) (200 000) (200 000)
Other expenses (270 000) (300 000) (280 000) (280 000)
Investment income 80 000 120 000 120 000 120 000
Foreign exchange loss (150 000) – – –
Earnings before tax 300 000 330 000 510 000 760 000
The following information is also available (figures in 20X1 monetary terms):

The drop in sales for year 20X2 was due to strike action.
The foreign exchange loss occurred as no forward cover was taken on exports. It is now company policy to
take o t forward cover.
In the year 20X2 the company incurred legal costs of R50 000 (included under other expenses) as a result of
c ntesting an unfair dismissal case.
Mr I Jones holds 70% of the shares in the company. He manages the company and receives an annual salary
of R80 000. If the company employed a suitably qualified manager, the annual cost would be R200 000.
The property, plant and equipment of the company are old and need to be replaced to sustain the business.
Asset replacement would result in increased depreciation of R100 000 per annum if operations are to be
sustained at historical levels, but would have to increase by R125 000 to facilitate the forecast figures.
The forecast above was prepared by Mr Jones, based on indications of a strong demand for the company’s
products. Specific industry information is not available, but the current order book has grown compared to
a year ago. Discussions with Mr Jones indicate that the company has obtained new contracts, thereby
473
slightly increasing its market share, but the overall market seems to have grown in line with the economy.
Mr Jones views the increased sales as sustainable.
The effective tax rate on income before tax of the company is 28%.
Inflation equalled roughly 5% per annum over the past number of years.
Required:
Determine the maintainable earnings to be used for the purposes of determining the fair market value of
equity shares, using a P/E multiple method. Mention and discuss the matters of contention and perform addi-
tional calculations to support your final answer. (22 marks)
Solution:
Maintainable earnings
In this example there are some obvious factors that need to be addressed, such as:
Sale of assets
Foreign exchange loss
Managerial salary.
Then there are those factors that are not as obvious, such as:
Legal costs – must one adjust for the R50 000?
Depreciation – does one update and, if one does, to what l v l?
Drop in Year 2 sales – what does one do?
Are financial adjustments made to all three years, or do some adjustments relate to Year 3 or the forecast
only?
Contentious issues include:

Does one determine historical maintainable earnings (to be used with an adjusted trailing P/E multiple) or
forecast maintainable earnings (to be used with an adjusted forward P/E multiple)?
Does one adjust for the effect of inflation and, if so, where is the adjustment made?
Are the increased sales, as included in the forecast, maintainable? (Here one must analyse the new con-
tracts, as well as the prospects for the industry and economy in general.)
Is the forecast cost reasonable compared to sales, given the fixed and variable nature of the company’s
cost?
Analysis of the comparator listed entity, to determine other possible adjustments to be made, including
adjustments for diff r nc s in gearing.
If investment in ome is removed from the maintainable earnings calculation, one has to value the invest-
ment separately.
474
Calculation of adjusted earnings (in constant 20X1 money):

Historical Historical Historical Forecast
Year 20X1 Year 20X2 Year 20X3
R R R
Gross profit 890 000 640 000 920 000 1 170 000
Other expenses (270 000) (300 000) (280 000) (280 000)
Adjusted for:
– Legal cost (Note 1) – 50 000 – –
– Market-related salary (Note 2) (120 000) (120 000) (120 000) (120 000)
Sale of assets (Note 3) – 0 – –
Depreciation (updated) (Note 4) (150 000) (150 000) (150 000) (175 000)
Interest (200 000) (200 000) (200 000) (200 000)
Investment income (Note 5) – – – –
Foreign exchange loss (Note 6) 0 – – –
Adjusted earnings before tax 150 000 (80 000) 170 000 395 000
Taxation (28%) (42 000) 22 400 (47 600) (110 600)
Adjusted earnings 108 000 57 600 122 400 284 400
Or alternatively:
Earnings before tax 300 000 330 000 510 000 760 000
Adjustments
Sale of assets (Note 3) – (120 000) – –
Investment income (Note 5) (80 000) (120 000) (120 000) (120 000)
Foreign exchange loss (Note 6) 150 000
Legal costs (Note 1) 50 000
Increased salary (Note 2) (120 000) (120 000) (120 000) (120 000)
Depreciation (Note 4) (100 000) (100 000) (100 000) (125 000)
Restated earnings 150 000 (80 000) 170 000 395 000
Taxation (28%) (42 000) 22 400 (47 600) (110 600)
Adjusted earnings (in 20X1 money) 108 000 57 600 122 400 284 400
Growth (46,7%) 112,5% 132,4%

Adjusted earnings increased by inflation 108 000 60 480 134 946 329 229
× 1,05
1 × 1,05
2 × 1,05
3
× 1,00
Growth (44,0%) 123,1% 144,0%
Notes
1 Assuming that the l gal costs were once-off costs, add them back.
2 A normal arm’s-length salary is R200 000 per annum. An adjustment of R120 000 is therefore re-
qui ed.
Sale of assets here does not represent income from operating/trading performance – therefore ignore
it.
The depreciation adjustment is required, as the current state of the assets cannot maintain profitabil-
ity.
Investment income must be excluded here as it is not part of the normal business operations. This
does not mean that one should ignore it altogether. In this instance, calculate the market value of the
investments held, and add it to the value of the earnings valuation. Note that one does not treat long-
term debt (and the related interest expense) similarly as a P/E multiple is based on (net) earnings,
which includes the interest expense. Note that the capital structure (i.e. the debt to equity (D:E) ratio)
of the entity should be similar to that of the comparable entity, otherwise this should be adjusted for
as well.
Where an entity engages in transactions in foreign currency as part of operations, the effects of for-
eign exchange movements are normally included in maintainable earnings. In this case, however, it is
clear that it was an exceptional expense as the company now hedges this risk.
475
Discussion of maintainable earnings

Additional procedures will have to be performed to confirm the reasonability of the forecast earnings, especial-
ly considering the large increase on the historical results. These procedures should include:
Analysing the new sales contracts, and investigating the prospects for the industry and economy in
general, to confirm if the increased level of sales is maintainable.
Analysing the forecast cost (in 20X1 money), including its fixed and variable components (using a high-low
method or regression analysis) to confirm the reasonability of the forecast cost. Here an appraiser should
also be mindful of semi-variable costs and stepped-fixed costs. (The execution of such a step in an exami-
nation will depend on the exact instructions and the number of marks.)
High-low
Change in turnover (R2 100 000 [highest from 20X3] – R1 800 000 [lowest from 20X2]) R300 000
Change in adjusted earnings (R122 400 [20X3] – R57 600 [20X2]) R64 800
Variable earnings per R1 turnover (R64 800 / R300 000) 0,2160
Total variable earnings highest point (R2 100 000 × 0,2160) R453 600
Fixed cost therefore (R453 600 – R122 400) (R331 200)
Projected sales R2 520 000
Therefore – projected adjusted earnings in 20X1 money (R2 520 000 × 0,2160 – R331 200) R213 120
3
Therefore – projected adjusted earnings (also adjusted for inflation: × 1,05 ) R246 713
Linear regression will result in a similar picture (Intercept = – 338 914; Slope = 0,2211; Correlation coeffi-
cient = 0,9928. When applied to projected sal s of R2 520 000 it gives projected adjusted earnings of R218
366). Students should refer to the owner’s manual of their financial calculators for the steps.
These results would not be distorted by the effect of inflation as all figures reflect 20X1 money (if figures
were not already indexed and adjusted, this step will have to be performed in addition). These results are
limited, however, due to the low number of historical years included in the analysis. Nonetheless, the re-
sults do suggest that the projected adjusted earnings are optimistic. Further consideration should be giv-
en to the scale of operations. Where this will increase, an additional fixed-cost component might also be
warranted.
Additional procedures will have to be performed to confirm the reasonability of the historical earnings, espe-
cially considering the strike action in year 20X2, as follows:
Analyse the industry and company to determine the incidence of strikes, the strength of labour unions,
typical recent wage rate increases and the ability of the company to afford them.
Analyse the new equipment to be obtained by the company and confirm whether it will reduce the
reliance on labour.
Students faced with such a situation in an examination could take different views, but must motivate their
choice, for example bas d on one of the following arguments:
l The forecast arnings of R329 229 (R284 400 before adjustment for inflation) seems to be optimistic, based
on analysis of the fixed and variable components of the cost structure (more procedures should ideally be
pe fo med to analyse this). A figure of roughly R246 713 might be more realistic as forecast maintainable
ea nings. This earnings figure is to be used with an adjusted forward P/E multiple, and the investment is
to be valued separately and added to the value obtained.
The forecast earnings of R329 229 (R284 400 before adjustment for inflation) seems to be maintainable,
based on the information supplied (including information from Mr Jones), even though more procedures
sh uld ideally be performed to confirm this. This earnings figure is to be used with an adjusted forward
P/E multiple, and the investment is to be valued separately and added to the value obtained.
Due to the lack of sufficient information, more reliance should be placed on the adjusted historical earn-
ings. In this case, one should ideally perform further procedures to analyse the likelihood of strikes in fu-
ture (as described above), but strike action seems to be common in many industries today and could
therefore occur again in future. Consequently, a weighted average of the adjusted historical earnings (al-
so adjusted for inflation) is calculated to obtain the maintainable earnings: (R108 000 × 1 / 6) + (R60 480 ×
2 / 6) + (R134 946 × 3 / 6) = R105 633. This earnings figure is to be used with an adjusted trailing P/E mul-
tiple, and the investment is to be valued separately and added to the value obtained.
In summary, the most important aspect to remember is that students should apply their knowledge to the
scenario.
476

PreFab (Pty) Ltd (‘PreFab’) manufactures, sells and rents out prefabricated units, and is the leading manufac-
turer of these products in South Africa. Units are manufactured at its factory situated in Centurion, Gauteng.
2 2
PreFab’s individual units vary from 12 m to 612 m , and because of the modular format of units, can be sized
according to customer requirements.
PreFab supplies significant volumes to various South African government departments, which accounted for
22% of the company’s revenue in the 2007 financial year. The government uses PreFab’s units for new schools
and in low-cost housing developments. Various government departments have also embarked on an extensive
infrastructural development programme and PreFab is confident that it wi benefit from increasing expendi-ture
by them.
The rest of PreFab’s customer base is diversified and no single customer ccounts for more than 10% of the
company’s total revenue. Some of these customers, for example South Afric n nd African mining groups
involved in exploration projects and new mining projects, use prefabricated units to provide temporary ac-
commodation for staff. Others use the units for office accommodation on a temporary or permanent basis. The
construction industry is undergoing a major growth phase and many f the major construction groups use
PreFab’s units as temporary offices and residential accommodati n n c nstruction sites.
PreFab also rents out units to customers, and the demand for rental units is increasing. The minimum rental
period is three months, and monthly rentals of units are deter ined as the historical cost of the unit divided by
24. In order to keep up with customer demand for rental units, PreFab has utilised most of its historical cash
flows and raised term loans from banks to fund the acquisition of units by the Rental division. The Rental
division was started in January 2006.
Steven Hamilton founded PreFab in 1996 and is still the Chi f Executive Officer (CEO) of the company. Mr
Hamilton’s family trust, The Hamilton Family Trust, owned 100% of the shares in issue until July 2007. The
Hamilton Family Trust advanced a R35 million loan to PreFab in 2000 which loan bears interest at 13% per
annum, payable annually in arrears, and has no fixed date of repayment.
Effective from 1 July 2007, BBZ Holdings, a broad-based black economic empowerment (B-BBEE) investment
group, acquired a 30% interest in the company and advanced an interest-bearing shareholder’s loan of R15
million to PreFab on the same date. The terms and conditions of the loan are the same as those applicable to
The Hamilton Family Trust loan.
The PreFab shareholders’ agreement contains a clause that provides that if any shareholder disposes of its
equity to a third party, the purchase consideration would first be allocated to shareholder loan accounts and
thereafter to the shares.
Xtatic Ltd (‘Xtatic’), a company listed on the JSE Limited, has recently approached the shareholders of PreFab
with an offer for the acquisition of a 100% shareholding in the company. Xtatic is in the process of formulating
an offer price for PreFab shares and has indicated that a key condition of the acquisition would be that Steven
Hamilton remains CEO of PreFab for three years after the acquisition. Xtatic has indicated that it will pay cash
for the shareholding in Pr Fab. Xtatic is a major manufacturer and supplier of mining and construction capital
equipment, and is aggr ssiv ly growing through acquisitions.
477
Abridged historical and forecast income statements of PreFab

Prefab (Pty) Ltd
Income Statements for the Years Ended/Ending 31 December
Notes Actual Forecast
2006 2007 2008
Rmillion Rmillion Rmillion
Revenue 94,1 147,0 197,4
Manufacturing division 84,1 122,0 152,4
Rental division 1 10,0 25,0 45,0
Cost of sales (56,9) (86,8) (113,4)

Manufacturing division (53,4) (78,0) (97,6)
Rental division 2 (3,5) (8,8) (15,8)
Gross profit 37,2 60,2 84,0

Operating costs (20,9) (24,7) (27,7)
BEE transaction costs 3 – (12,4) –
Unusual entertainment costs 4 – (2,4) –
Contract penalties 5 – (1,8) –
Depreciation (1,8) (2,2) (2,3)
Profit before interest and tax 14,5 16,7 54,0
Finance charges (0,5) (2,1) (3,8)
Interest on shareholders’ loans (4,6) (5,5) (7,0)
Interest income 0,3 1,0 1,9
Profit before tax 9,7 10,1 45,1
Tax 6 (2,8) (6,5) (13,1)
Profit after tax 6,9 3,6 32,0
Notes
The periods of rental agreements vary from 3 to 12 months with the option to renew. PreFab has a long
waiting list for rental units and accordingly plans to acquire further units to rent over the next three years.
Cost of sales for the Rental division comprises mainly depreciation, maintenance and servicing costs of
units. Rental assets are depreciated on a straight-line basis over ten years. Depreciation amounted to R2
million in the 2006 financial year. The Rental division purchases prefabricated units from the Manufac-
turing division at the same prices at which units are sold to external customers, which in total amounted to
R30 million in 2007 (2006: R20 million). It is forecasting acquisitions of R40 million in the 2008 financial year.
The Manufacturing division revenue shown in the income statements includes sales at market value to the
Rental division.
The auditors of PreFab recommended that a once-off cost associated with the B-BBEE deal in July 2007 be
recognised in the ompany’s annual financial statements. The auditors are of the opinion that the differ-ence
between the fair market value of shares acquired by BBZ Holdings and the actual cost of their share
subscription (which was a nominal amount) should be accounted for based on their interpretation of IFRS 2,
Share-based payment, and AC 503, Accounting for black economic empowerment (BEE). The following jour-
nal entry, which can be assumed to be correct, was processed at year-end:
Rmillion Rmillion
BEE transacti n costs 12,4
Share premium 12,4
PreFab invited various client representatives to accompany them to the Rugby World Cup held in France in
October 2007. The company deemed this to be a non-recurring expenditure and therefore disclosed it sepa-
rate y in the income statement.
PreFab incurred a penalty due to the late supply of prefabricated units to Galaxy Mining. Such a penalty has
never previously been incurred, because PreFab generally refuses to include a late supply clause in supply
contracts. The late supply occurred as a result of disruptions caused by a ten-day strike by PreFab manufac-
turing employees over proposed wage increases. The strike took the executive directors of PreFab by sur-
prise, as no such incident had occurred in the preceding three years.
478
The company’s effective normal tax rate has historically been 29%. In the 2007 financial year, the effective
tax rate increased due to the non-deductibility of the B-BBEE transaction costs.
PreFab’s budgeting for and forecast of earnings have generally been highly accurate. Steven Hamilton is
confident that forecast profit after tax of R32 million will be achieved in the year ending 31 December 2008,
particularly given that the 12-month forward order book at the end of February 2008 exceeded R100 mil-
lion.
Abridged historical and forecast cashflow statements
Prefab (Pty) Ltd

Cashflow Statements for the Year Ended/Ending 31 December
Actual Forec st
2007 2008 2009 2010
Rmillion Rmillion Rmillion Rmillion
Profit before interest and tax 16,7 54,0 78,7 105,1
Depreciation
Property, plant and equipment 2,2 2,3 2,2 2,2
Rental fleet 5,0 9,0 14,0 19,0
B-BBEE transaction costs 12,4 – – –
Net interest (6,6) (8,9) (8,7) (6,6)
Tax (5,6) (11,5) (18,5) (26,5)
Working capital
Inventories (4,7) (4,3) (4,3) (5,1)
Accounts receivable (6,7) (6,1) (7,6) (8,4)
Trade and other payables 4,4 2,9 2,9 3,5
Capital expenditure
Property, plant and equipment (2,5) (2,0) (2,1) (2,2)
Rental units (30,0) (40,0) (50,0) (50,0)
(15,4) (4,6) 6,6 31,0
Interest-bearing debt
(net movement) 16,6 4,9 (10,1) (3,6)
Shareholders’ loans 15,0 – – –
Net cash movement for the year 16,2 0,3 (3,5) 27,4
The above cash-flow forecasts have been reviewed and approved by the Board of Directors of PreFab.
Additional information
1 The total interest-bearing liabilities and cash balances were as follows at 31 December 2007:
Rmillion
Long-term inter st-b aring borrowings 20,4
Shareholders’ loans 50,0
Short-term borrowings 4,0
Cash and cash equivalents 20,4
The following information is available regarding companies listed on the JSE Limited which operate in the
same ind stry as PreFab –
their average increase in headline earnings per share in the 2007 calendar year was 25% and they are
expecting similar increases in 2008;
their average price earnings multiple, based on 2007 reported profits, is currently 12,0;
their average total revenue in the 2007 calendar year was R175 million; and
they all have BEE shareholders.
479
Required:
Assuming that the accountant was tasked to perform an earnings-based valuation of Prefab (Pty) Ltd
based on the profits achieved in the 2007 financial year –
state, with reasons, what adjustments, if any, he would make to the reported profit after tax for the
effects of the transfer pricing arrangement between the Manufacturing and Rental divisions;
(8 marks)
state, with reasons, what other adjustments he would make to the reported 2007 profit after tax in
order to derive a sustainable earnings figure for the purposes of your valuation; and (8 marks)
indicate, with reasons, what price earnings multiple he would use to va ue PreFab (Pty) Ltd.
(6 marks)
Perform a Free Cashflow valuation of PreFab (Pty) Ltd in order to v lue 100% of the shares in issue of the
company and the shareholder loan accounts. For the purposes of the v lu tion –
assume that PreFab (Pty) Ltd’s weighted average cost of capital (WACC) is 17,5%;
base the valuation on information from 1 January 2008; and
assume that the company’s annual growth in Free Cashfl ws will be 2% from the 2011 financial year
onwards.
State any additional assumptions that have been ade. (10 marks)
(c) Identify and describe five key business risks faced by PreFab (Pty) Ltd. (10 marks)
(Source: SAICA, 2008 Qualifying Examination Part 1; Pap r 2; Qu stion 2 – an extract, slightly adapted)
Solution:
(i) Adjustments for transfer pricing arrangement
For the purposes of determining sustainable earnings, recognising sales from Manufacturing to
Rental division after internal mark-up is incorrect. The gross profit has not yet been earned
from an external party. Instead, internal sales should be recognised at cost and reflected as an
asset for rental to customers.
To derive sustainable earnings, the gross profit in respect of the interdivisional sales or the
transfer transaction must be reversed.
The reversal would be effected as follows: 2007
– Inter-divisional revenue – 30,0
– Cost of sales [78 / 122 × 30] 19,2
– 10,8
The d pr ciation acknowledged on the unit transferred with the internal sale must also be decr
as d. The r ntal asset value is inflated with the profit of the interdivisional sale: the asset should
be stated at cost price, and therefore the depreciation on the ‘profit part’ must be re-versed.
Alte native to the discussion above, a calculation of the depreciation to be adjusted

could have been presented, as follows:
Adj stment to depreciation: 2007
Act al cost of units
2006: (53,4 / 84,1) × 20,0 12,70
2007: (78 / 122) × 30,0 19,18
31,88
Correct depreciation (31,9 × 10%) – 3,18
Prefab’s depreciation policy is to amortise for a full year irrespective of
the acquisition date: Compare R5 depreciation on R50 purchases
Depreciation as per income statement 5,00
1,82
480
No tax adjustment is required as the profit on the interdivisional sale is a notional profit.
Effective tax of 29% may need to be taken into account if the profit was included in the audited
income statement. Tax would have to be adjusted by (– 10,80 + 1,82 = – 8,98 × 29%) if the prof-
it was included in taxable income.
An assumption may be made that the internal transfer is in one direction only, that is the manufacturing
division sells to the rental division, but the rental division does not rent any units to the
manufacturing division, and therefore no adjustment to the rental income of the rental division
is required.
Other adjustments required to profit after tax
The future sustainable earnings must be calculated, as follows:
Add back the B-BBEE transaction costs.
(The B-BBEE transaction has no impact on actual profits/non-recurring item)
Add back the unusual entertainment expenditure.
(Based on management representations, these c sts are non-recurring. However, all the
entertainment may not be unusual: some entertainment expenditure may well be expected in
the future – it would make sense to nor alise this expense).
Add back interest on the shareholders’ loans.
(The capital structure of the business should not affect the overall firm value or the sharehold-
ers’ loan agreement stipulates that loans and shares are treated indivisibly).
Add back penalty payments or do not add back penalty payments.
(Add back penalty payments: non -recurring, unusual expense; or do not add back penalty
payments: although unusual, the payments are a cost of doing business and cannot be regard-
ed as exceptional).
Adjust the tax charge for the effect of the above adjustments, excluding the B-BBEE costs which are noted
as being non-deductible.
(iii) Appropriate P/E multiple
Average of similar listed companies 12,0
Adjustments to the P/E multiple to account for entity level differences
(must be described):
Discount for size: R147m (before adjustment for transfer price profit) turnover, compared – 1,0
to average of R175m.
2,4
Premium for high r PAT growth of PreFab, say 20%
[Average listed company growth: 25% in 2007 (and 2008); Calculation of
PreFab growth rate (various options available)]
l Significant business risk: reliance on government for 22% of turnover – 1,0
l Strong government contracts which may give a competitive edge 1,0
l Possible key-man risk: reliance on Steve Hamilton – 1,0
l Capital structure in comparison to similar listed companies? 1,0
Similar listed companies may use external debt with fixed repayments.
[Additional comment: this is adjusted here as there is not enough information
on the debt to equity (D:E) ratio of the comparator entities to allow for
adjustment in PreFab’s maintainable earnings, or to determine a required capital
injection.]
Other valid comments:
– PreFab is South Africa’s leading manufacturer 1,0
– May lose B-BBEE status on take-over of company – 2,0
– More diverse client base/business profile compared to industry 1,0
481
Additional comment: an allowed, but non-suggested treatment is to include an ad-

justment for shareholder level differences here (but only if motivated and stated that
later adjustments to the calculated overall firm value should, in this case, not include
a marketability discount or control premium.) Adjustment for shareholder level
differ-ences (included in the suggested solution of SAICA):
l Discount for unlisted status: lack of tradability/marketability of shares – 3,0
l Control premium (say 20%) 2,4
Conclusion: Appropriate P/E multiple for PreFab 7–14
(b)
2008 2009 2010
R’m R’m R’m
Net cash movement 0,3 – 3,5 27,4
Adjustments for:
l Interest 8,9 8,7 6,6 (1)
l Tax effect of interest added back – 2,6 – 2,5 – 1,9 (1)
l Movement in interest bearing debt – 4,9 10,1 3,6
Free Cashflow 1,7 12,8 35,7 (1)
Or alternatively:
Earnings before interest and tax 54,0 78,7 105,1
Add back: Depreciation – PPE 2,3 2,2 2,2
Add back: Depreciation – rental 9,0 14,0 19,01
Interest – no adjustment (EBIT used) – – –
Tax – per cashflow statement – 11,5 – 18,5 – 26,5
Tax – interest adjustment – 2,6 – 2,5 – 1,9
Working capital (sum of movements) – 7,5 – 9,0 – 10,0
Capital expenditure (sum of movements) – 42,0 – 52,1 – 52,2
Interest bearing debt – should not be included – – –
Free Cashflow 1,7 12,8 35,7
2008 2009 2010

R’m R’m R’m
R’m
Discounted cashflows 2008-2010 at 17,5% 32,7 1,45 9,27 22,01 (1)
Terminal value
Formula to estimate terminal value
(R35,7 × 1,02) / (17,5% – 2%) 234,9
Discounted using 17,5% as at end 2010 144,8
482
FCF valuation summary R’m

Discounted cashflows 2008-2010 32,7
Terminal value 144,8
Cash resources 12/2007 (excess cash) 20,4 (1)
The cash balance could also have been reduced if the assumption had been made that a
portion of the amount is required for operations and this has been motivated.
Additional comment: if a portion of the cash balance is directly associated with operations,
this represents non-excess cash and, in such a case, the movement in this portion of the cash
balance should be included in the projected cashflows.
Overall firm value (unadjusted) 197,9
Interest bearing debt 12/2007 – 24,4 (1)
The short-term debt may have been excluded (if it was assumed to be p rt of operations),
but such an exclusion must be motivated.
Value of 100% equity shareholding (assuming no shareholder le el differences) 173,5
Additional comment: if we assume that the 17,5% WACC was calculated based on inputs
from comparable listed companies, we suggest the f ll wing further shareholder level
adjustment:
Marketability discount (say 5%) – 8,7
Value of 100% equity shareholding (adjusted) 164,8 (1)
(c) (1 mark for identifying key risk and 1 mark for xplaining risk)
Over reliance on government for revenue – PreFab derives 22% of its revenue from government
departments. These may be separate departments but failure by PreFab to perform on a particular
contract may jeopardise overall business with government.
Over reliance on government – government is known to be a slow payer. Payment delays may have a
negative impact on PreFab’s cash-flow position.
Liquidity risk – historical cashflows have been used to finance the rental division, or impact on the
company’s cashflows of shareholders requiring immediate repayment of the shareholder loans, or
potential funding problems of the business given the high revenue growth, or liquidity problems as a
result of rising interest rates.
Foreign exchange risk resulting from the invoicing of foreign customers in their own currencies.
Risk of losing BEE status when 100% of shares are taken over by Xtatic Ltd (depending on Xtatic
shareholding): may hamper growth and lead to the loss of future government contracts.
Risk of continued demand for rental units subsiding if and when construction and government spend-
ing boom abat s – Pr Fab will be left with units that cannot be rented out.
Risk that future growth may not be sustainable due to energy crisis (ESKOM load-shedding) – energy
crisis ould affe t PreFab in the production of its units, and also affects PreFab’s clients, that is mines,
which have been hard-hit by rolling blackouts.
Cont act penalties – as it was an issue in 2007, it may now become a regular occurrence where
PreFab is exposed to penalties for late or non-delivery of units.
Risk of f rther labour unrest and strikes – could be very disruptive to manufacturing operations.
Key-man risk – Steven Hamilton started business and is CEO. Steven leaving the employ of PreFab due
to illness, retirement or any other reason may negatively impact the company.
Reputation risk – resulting from the company’s inability to meet the ever-growing forward order
book in future.
Operational risk – resulting from dysfunctional decisions/lower employee morale should disputes
arise between the manufacturing and rental divisions regarding the pricing of sales to the rental divi-
sion.
Risk of new competition entering the market due to high demand and profitability – PreFab may
struggle to remain market leader and maintain high growth.
483
The company may struggle with its infrastructure/capacity constraints – due to extremely fast
growth.
Any other valid comment.
(Source: SAICA, with minor adjustments and additional commentary)
Amounts in the question exclude VAT, except where indicated.

ElectriBolt Ltd (‘ElectriBolt’) is an independent electricity supplier with various power generation operations
throughout South Africa. ElectriBolt is listed on the main board of the JSE. The comp ny’s most recent financial
reporting date was 31 December 2009.
Background
On 1 January 1999, ElectriBolt entered into a unique hydro-electricity supply licence agreement with the South
African government (‘the government’). The licence agreement entitled ElectriBolt to install three turbines at
the Augrabies Waterfall, which is situated in the Augrabies National Park, and generate and supply electricity
for a period of 15 years. The licence agreement provides that –
l ElectriBolt is required to pay the government a fixed instal ent of R800 000 annually in arrear for the right
to use the site to generate electricity; and
the agreement is not renewable at the end of the 15-y ar t rm.
ElectriBolt decided to grant the right of use of the abovementioned supply licence, from the inception date of
the agreement with the government (1 January 1999), to PowerSmart Ltd (‘PowerSmart’), a large electricity
supplier, for a period of 15 years. All licensing rights granted to ElectriBolt by the government were transferred
to PowerSmart in exchange for a fixed annual instalment of R1 million, payable in arrear to ElectriBolt. By law,
the final operator of an electricity supply business is solely responsible and liable for any related environmental
site rehabilitation. PowerSmart may not transfer or sell the supply licence to any other party. A cancellation
penalty of R900 000 is payable by PowerSmart to ElectriBolt should PowerSmart at any stage unilaterally decide
on the early cancellation of the agreement.
On 1 January 1999, ElectriBolt did not recognise any assets or liabilities in respect of the hydro- electricity
supply licence with the government and the right of use of the licence granted to PowerSmart. The R800 000
per annum for the supply licence is expensed on an annual basis and the R1 million per annum receipt from
PowerSmart is recognised as revenue on an annual basis. This accounting policy is acceptable in terms of
International Financial Reporting Standards.
Feasibility study on Pow rSmart’s Augrabies operations

ElectriBolt recently stablish d that PowerSmart is underperforming at the Augrabies site and believes that
significantly more ele tri ity an be generated during the last four years of the supply licence. The major reason
for PowerSmart’s disappointing performance is the regular labour disputes experienced at the Augrabies
operation. Elect iBolt conducted a feasibility study in December 2009 to evaluate the possible acquisition of
PowerSmart’s Aug abies operations.
Following this feasibility study, ElectriBolt proposed acquiring the PowerSmart Augrabies division as a going
concern, incl ding all assets and liabilities of this division except for cash and cash equivalents and taxation
liabilities. The licensing agreement between ElectriBolt and PowerSmart would be terminated as part of the
acquisiti n.
484
The Chief Financial Officer (CFO) of ElectriBolt prepared the following cashflow projections, following a detailed
review of historic financial information of the Augrabies division of PowerSmart and its budgets for the next
four years, for the purposes of valuing the Augrabies division:
Year ending 31 December Notes 2010 2011 2012 2013
R R R R
Turnover 1 18 000 000 18 000 000 18 000 000 18 000 000
Operating costs 1 (4 500 000) (4 500 000) (4 500 000) (4 500 000)
Opportunity cost 2 (1 000 000) (1 000 000) (1 000 000) (1 000 000)
Supply license agreement
instalments (800 000) (800 000) (800 000) (800 000)
Operating cost savings 3 300 000 300 000 300 000 300 000
Cost of helicopter lease 4 (480 000) (480 000) (480 000) (480 000)
Depreciation: Turbines (700 000) (700 000) (700 000) (700 000)
Interest on long-term loan 5 (897 536) (712 469) (503 344) (267 032)
Environmental site rehabilita-
tion costs 6 – – – (2 500 000)
Pending legal claim 7 – – – –
Taxation 8 (2 778 290) (2 830 109) (2 888 664) (2 254 831)
Net cashflows 7 144 174 7 277 422 7 427 992 5 798 137
Related calculations Notes

Weighted average cost of capital (WACC) 9 23,00%
Net present value of the future cashflows of the Augrabi s
division of PowerSmart 9 R17 143 393
Notes to the cashflow projections

Projected turnover includes a conservative estimate of the additional electricity that ElectriBolt could
generate and supply, assuming it acquired control of the operations. Operating costs exclude annual supply
licence payments due by PowerSmart to ElectriBolt.
Opportunity cost represents annual instalments in terms of the supply licence agreement, to which Electri-
Bolt will no longer be entitled.
PowerSmart incurred research and development costs during the period 2007 to 2009 aimed at improving
operating efficiency. As a result thereof, PowerSmart expects a possible annual operating cost saving of
R300 000 from 2010 to 2013. The CFO of PowerSmart is of the opinion that the cost-saving is only 45%
probable, resulting in the development costs not meeting the recognition criteria in terms of IAS 38, Intan-
gible assets, for recognition as an intangible asset. It follows that development costs were immediately ex-
pensed when incurred.
PowerSmart leas s an x cutive helicopter from Fly-with-Me Airways (Pty) Ltd at a fixed instalment of R360
000, payable annually in arrears. The lease agreement was correctly classified as an operating lease in
terms of IAS 17, Leases. The lease agreement commenced on 1 January 2008 and ends on 31 December
2012. On 31 December 2009, it was reliably established that similar executive helicopters can be leased at a
ma ket-related fixed instalment of R480 000, payable annually in arrears.
5 PowerSmart obtained a long-term loan of R15 million on 1 January 1999 to finance this particular opera-
tion. The long-term loan is repayable in 15 equal annual instalments, which commenced on 31 December
1999. The loan bears interest at a fixed rate of 13% per annum. The loan agreement provides that the l an
cannot be repaid earlier than the agreed repayment profile. On 31 December 2009, long-term l ans with a
similar risk profile and remaining maturity were available at a fixed rate of 12% per annum.
This amount has been reliably estimated by an independent environmental rehabilitation expert.
Labour unrest increased after the recent dismissal of a number of PowerSmart’s employees as a result of
increased operational inefficiency. The trade union to which these employees belong has instituted a legal
cl im against PowerSmart on behalf of the employees on the grounds of unfair dismissal. The legal advisers
of PowerSmart are of the opinion that –
the dismissed employees have a valid claim against PowerSmart for unfair dismissal;
the trade union will not be able to prove the claim for unfair dismissal in court, due to a lack of evidence;
and
485
it is possible, but not probable, that the court will require PowerSmart to make a financial settlement to
the dismissed employees.
The CFO did not include any amount relating to the legal claim in the forecast cashflows. Should such a
claim be successful, any amount paid by PowerSmart will not be deductible for tax purposes. The fair mar-
ket value of the legal claim at 31 December 2009, as reliably determined by an experienced actuary, is R450
000.
All items in the cash-flow budget have been assumed to be taxable or deductible for income tax purposes,
except as per point 7 above.
The nominal WACC of ElectriBolt is 23% and the forecast cashflows have been discounted using this rate.
Financing alternatives
On 31 December 2009, the Augrabies division of PowerSmart was acquired by ElectriBolt as a going concern,
including all assets and liabilities of the division except for cash and cash equi alents and taxation liabilities. The
purchase consideration of R16 million was paid by ElectriBolt on 31 December 2009. It was correctly
established that the transaction between ElectriBolt and PowerSmart c nstitutes a ‘business combination’ as
defined in IFRS 3, Business Combinations.
ElectriBolt is considering various financing alternatives for the business combination transaction –
payment out of existing cash reserves of R16 million; or
obtaining a R16 million medium-term loan from ElectriBolt’s bankers. The loan is to bear interest at 1%
above the prevailing prime overdraft rate. This is th company’s incremental cost of borrowing. The loan is
to be repaid in one bullet payment at the end of four y ars. Interest is to be calculated and compound-ed
annually in arrears, and capitalised into the outstanding loan balance. Transaction costs of 1% of the
principal amount will be payable at the inception of the medium-term loan. The interest to be incurred on
such a long-term loan is deductible for taxation purposes in terms of section 24J of the Income Tax Act; or
the issue of compulsory convertible preference shares with a par value of R16 million. Preference share-
holders will be entitled to an annual dividend calculated as 80% of the prevailing prime overdraft rate
multiplied by the par value of shares held. ElectriBolt is required to pay preference dividends annually in
arrears and has no discretion with regard to declaring these dividends. Each preference share will auto-
matically convert into one ordinary share after four years. Analysts predict that the value of the convert-
ed shares at the end of Year 4 will amount to R17 800 000.
Draft statement of financial position of the Augrabies division of PowerSmart as at 31 December 2009
The information below represents an extract from the draft statement of financial position of the Augrabies
division of PowerSmart as at 31 December 2009, which contained inter alia the following:
Notes R
ASSETS
Non-current assets
Property, plant and equipment 1 9 750 000
Current assets
Invento ies 2 750 000
Trade receivables 3 300 000
LIABILITIES
N n-current liabilities
L ng-term borrowings 4 5 480 535
Deferred tax 5 592 200
Long-term provisions 6 –
Current liabilities
Trade payables 7 435 000
Current portion of long-term borrowings 4 1 423 590
South African Revenue Service (SARS) 115 000
486
Notes
Items of property, plant and equipment are subsequently measured according to the cost model in terms
of IAS 16, Property, plant and equipment. The market value of the property, plant and equipment as at 31
December 2009 was R14 million.
The fair market value of inventories was reliably determined at R800 000 as at 31 December 2009.
The balance of net trade receivables comprised the following as at 31 December 2009:
R
Gross trade receivables 480 00
Less: Allowance for doubtful debts* (180 000)
300 000
* The SARS grants a tax deduction of 25% of the allowance for doubtful debts for t x tion purposes.
The fair market value of trade receivables as at 31 December 2009 was reliably determined at R400 000.
Long-term borrowings are subsequently measured acc rding to the amortised cost model in terms of IAS
39, Financial Instruments: Recognition and Measurement. L ng-term borrowings consisted of the fol-
lowing as at 31 December 2009:
R
Long-term loan 6 904 125
Less: Current portion of long-term borrowings (1 423 590)
5 480 535
The deferred tax balance as at 31 December 2009 was calculated as follows:

Asset/liability Carrying Tax base Temporary
amount difference
R R R
Property, plant and equipment 9 750 000 7 500 000 2 250 000
Inventories 750 000 750 000 –
Trade receivables 300 000 435 000 (135 000)
Long-term loan 6 904 125 6 904 125 –
Trade payables 435 000 435 000 –
Taxable temporary differences 2 115 000
Deferred tax calculated at 28% 592 200

No provision has been made in the statement of financial position of PowerSmart in respect of the envi-
ronmental site rehabilitation. 70% of the damage caused to the environment occurred when the turbines
were installed, while the r maining 30% of the damage to the environment is caused evenly over the du-
ration of the contract. No environmental rehabilitation activities had been undertaken by 31 December
2009, and the CFO therefore holds the opinion that no provision should be recognised in the statement of
finan ial position until the electricity supply operation ceases. The SARS will allow the amount in u ed in
respect of environmental rehabilitation costs as a deduction for taxation purposes when it is actually
paid.
The fair market value of trade payables as at 31 December 2009 was reliably determined at R500 000.
The s pply licence, the use of which was granted by ElectriBolt, had a fair market value of R4 500 000 at 31
December 2009 based on the terms of the licensing agreement between ElectriBolt and PowerSmart. If a
similar right with payments at market rates were granted at 31 December 2009, it would have a fair
market value of R5 million.
Where appropriate and unless stated otherwise, the SARS accepts the acquisition date fair market values of
ssets and liabilities for taxation purposes.
The current prime overdraft rate is 10% per annum, nominal and pre-tax.
487
Required:
Identify, with reasons, any errors in and omissions from the cash-flow forecasts and discounted future cashflows
of the Augrabies division of PowerSmart Ltd as prepared by the CFO of ElectriBolt Ltd. (16 marks)
Identify and describe any advantages and disadvantages of ElectriBolt Ltd settling the purchase consider-
ation due to PowerSmart Ltd using its own cash resources. (6 marks)
Presentation marks: Arrangement and layout, clarity of explanation, logical argument and language
usage. (2 marks)
(Source: SAICA, 2010 Qualifying Examination Part 1; Paper 2; Question 3 – an extract, s ight y adapted)
Solution:
(a)
Errors/omissions Reasons
No indication of perspective of valuation: fair PowerSmart may not transfer supply licence
market value, or intrinsic value? that is no ther potential bidders. Power-S
art’s alternative to selling to ElectriBolt is
intrinsic value (current management with
future expectations as originally anticipated),
that is quantifying intrinsic value.
Projected turnover includes additional electricity Sp cific synergies should be quantified s
generated and supplied (thus incorporating parately, but excluded from the intrinsic
efficiencies/synergy contributed by ElectriBolt). valuation. (Synergies preferably not paid for
as fully contributed by ElectriBolt.) [Addition-
al comment: this is included here for the sake
of completeness, but synergies are addressed
as part of mergers and acquisitions
(chapter 12)]
Forecast revenues and operating costs do Revenues and/or costs are likely to change
not change over forecast period. annually due to inflation/tariff increas-
es/rain-fall expectations etc.
Or Or
A nominal WACC has been used to Cashflows have not been adjusted for infla-
discount future real cashflows. tion and are real cashflows. A real WACC
should be used to determine the net
present value.
Including R1m and R800 000 outflow relating to Business of PowerSmart is being valued
supply licenc ; d scription of ‘opportunity cost’. hence, only costs and revenue relevant to
this business should be included in Free
Cashflow (only R1m outflow)
Operating costs savings included. Probability of achieving cost savings – 45%,
insufficient to justify including in Free Cash-
flow
Or
(45% × 300 000 = 135 000) But rather include
this potential in a sensitivity analysis.
Helicopter lease payments included at market va PowerSmart has negotiated a contract,
ue. therefore use actual contractual cashflows
Question unclear as to what will happen to the until expiry of contract (end of 2012). There-
lease on acquisition/will probably be transferred. after, use estimated costs for 2013 at fair
market values.
Depreciation included in forecasts, is not a cash- Wear-and-tear should be included.
flow item.
488
Errors/omissions Reasons
Interest on long-term loan included. Interest should be excluded as these cash-
flows should exclude all finance costs, as it
should be distributable to all capital provid-
ers/interest is incorporated in WACC. Market
value of long-term debt should be deducted
from discounted cashflows to derive equity
value.
Taxation projections will be incorrect due to Estimated tax to be paid should be based on
changes in cashflows indicated here. amended forecasts taking into account
adjustments.
No inclusion of terminal values for assets and Cashflows for s le of ssets and payment of
liabilities. liabilities should be included in cashflow.
Changes in working capital ignored. Forecasts should include estimated changes
in invent ries, accounts receivable and
trade payables as these are cashflows.
Recoup ent of working capital should be
included.
PowerS art’s WACC should be estimated.
ElectriBolt’s WACC used to discount cashflows.
Or
El ctribolt’s WACC should be adjusted for
higher risk associated with Augrabies
operation/smaller size.
Or
WACC appear to be too high, not explained
why.
Potential costs associated with labour action To be conservative, estimated costs of
ignored. settling dispute should be included as a cash
outflow. Use actuarial calculated value (R450
000).
Other valid points (must be core).
Advantages
Interest returns on cash are currently low, therefore utilising cash for acquisitions should yield a higher
return on equity than having cash on deposit.
The Pow rSmart division should generate positive cashflow, therefore using cash to settle purchase
consideration should not have an adverse impact on overall cash resources/cash required for day-to-
day requirements.
Less time and effort is devoted to reviewing loan agreements/drafting preference share agreements and
obtaining necessary approvals from shareholders/JSE Limited.
Cash p rchase will avoid dilution in control from convertible preference shares.
Disadvantages
Using cash will void the opportunity to move closer to target WACC (where it minimises finance cost). Or a
reasonable degree of overall leverage lowers WACC and enhances shareholder value (using cash will
negate this).
Preserving cash allows more flexibility to pursue growth/acquisitions.
In the current liquidity crisis/recessionary environment, the company should be retaining cash for liquidity
strength in a period where it is costly and difficult to obtain finance.
(Source: SAICA, with minor editorial adjustments and additional commentary)
489

The Directors of Blue Bowl Ltd are considering the acquisition of the entire share capital of Wagtail (Pty) Ltd, a
private limited company which manufactures a range of engineering machinery. Both companies are all-equity
firms. The Directors of Blue Bowl believe that, if Wagtail is taken over, the business risk of Blue Bowl will not be
affected. Wagtail’s year-end date is 30 June and its statement of financial position as on 30 June 20X8, pre-
pared on a historical cost convention, is expected to be as follows:
R R
Issued ordinary shares of R1 each 105 000
867 000
Represented by:
Non-current assets (carrying value)
Plant and machinery 252 000
Motor vehicles 186 000 438 000
Current assets
Inventory – finished goods 261 000
Inventory – work-in-progress 315 000
Debtors 462 000 1 038 000
Current liabilities
Creditors 401 000
Bank overdraft 208 000 (609 000)
867 000
Wagtail’s summarised financial record for the three years to 30 June 20X8 is as follows:
20X6 20X7 20X8
Year ended 30 June (estimated)
R’000 R’000 R’000
Sales 5 117 4 774 6 357
Cost of sales 4 000 3 600 5 000
Gross profit 1 117 1 174 1 357
Expenses 810 822 1 022
Net operating income 307 352 335
Taxation 142 180 140
Net income 165 172 195
Dividends 40 44 49
Effect on retailed income 125 128 146
The following additional information is available:

1 There has been no change in the issued share capital of Wagtail during the past three years.
2 The estimated values of Wagtail’s non-current assets, finished goods and work-in-progress as at
30 J ne 20X8 are:
Replacement cost Realisable value

R R
Plant and machinery 542 000 189 000
Motor vehicles 205 000 180 000
Work-in-progress 342 000 392 000
Blue Bowl will be able to achieve distribution cost savings for Blue Bowl of R22 000 per annum in 20X8’s
monetary terms, which is unlikely to be achievable by other market participants.
Directors’ emoluments currently paid to Wagtail management are considered to be below market-related
salaries, and will have to be increased by R15 000 per annum in 20X8’s monetary terms.
490
Wagtail retains roughly 20% of net income (in addition to the depreciation charge) to maintain and replace
its assets at current operating efficiencies.
During the year ended 30 June 20X7, the company received a claim amounting to R42 000 for allegedly
faulty work carried out by the company. The claim was disputed and no provision was made for any possi-
ble loss at the year-end. Settlement was subsequently reached, and during December 20X7 the company
paid an amount of R26 000 to the customer. This expense was charged to operating income. Measures were
immediately put in place to avoid similar incidences in future.
The current P/E multiple of Blue Bowl is 12. Quoted companies with business activities and profitability
similar to those of Wagtail have P/E multiples of approximately 10, although these companies tend to be
much larger than Wagtail.
Assume the company tax rate is 50%.
Assume the company’s cost of equity (ke) equals 15% and that the 20X8 dividend will be paid shortly after
year-end.
Required:
Estimate the value of the total equity of Wagtail (Pty) Ltd as on 30 June 20X8 by determining or using:
Historical net asset value (Fundamental)
Replacement cost (Fundamental)
Net realisable value (Fundamental)
The Gordon Dividend Growth Model (Fundam ntal)
(v) Fair market value based on the forward P/E multiple method (Intermediate) (22 marks)
Explain the role and limitations of each of the above five valuation bases in the process by which a price
might be agreed for the purchase by Blue Bowl of the total equity capital of Wagtail. (Fundamental)
(15 marks)
State and justify briefly the approximate range within which the purchase price is likely to be agreed.
(Fundamental)
(8 marks)
Solution:
(i) Historical net asset value = R867 000
Replacement cost value
= 867 000 + (542 000 – 252 000) + (205 000 – 186 000)
+ (256 000 – 261 000) + (342 000 – 315 000) = R1 198 000
Net realisable value
= 867 000 + (189 000 – 252 000) + (180 000 – 186 000)
+ (250 000 – 261 000) + (392 000 – 315 000) = R864 000
Gordon’s Dividend Growth Model
Analysing dividend growth for three years
20X6 20X7 20X8
40 44 49
10% 11%
Assume a growth of (say) 10,5%
Dividend in 1 year (20X9)

Then MV cum div = + current dividend (20X8)
0,15 – g
49 000 (1,105)
= + 49 000 = R1 252 222
0,15 – 0,105
491
(v) P/E multiple model

An average forward P/E multiple for similar quoted companies is 10
Adjustments for entity level differences:
The company is small when compared with similar listed companies.
This increases risk (1)
Adjusted forward P/E multiple 9
Determine maintainable forecast earnings
20X6 20X7 20X8
R R R
Net income 165 000 172 000 195 000
Adjustments excluding synergy benefits (13 606) (14 286) 0
Director’s emoluments – adjust to market
related (13 606) (14 286) (15 00)
(assume a 5% annual rate of inflation) R14286 / 1,05 R15000 / 1,05
Add back: Claim 26 000
Impairment – finished goods (Note 1) ? ? (11 000)
R250k – R261k
Taxation on adjustments (50%) 6 803 7 143 0
Adjusted earnings 158 197 164 857 195 000
Less income required to maintain
earnings (20%) (Note 2) (31 639) (32 971) (39 000)
Adjusted net income after tax 126 558 131 886 156 000
Notes:
The impairment on inventory items is included here as it has an effect on the operating/trading
performance of Wagtail, but any possible impairment on plant and machinery and motor vehi-
cles is ignored, as these represent non-current (capital) assets. Here one must consider the guid-
ance on calculating headline earnings as P/E multiples of the listed entities are normally
calculated using this basis.
This additional reduction to the net income after tax, in a sense, represents an adjustment to
depreciation, which is understated. (No additional tax effect was assumed, but this is debatable.)
Matters of concern include the impairment on finished goods. Is this reflective of problems in
the sale of engineering equipment, or changes in technology? Assuming that this was a once-off
event, the forecast net income after tax appears to be maintainable given historical growth.
Maintainable for cast earnings are therefore equal to R156 000.
[Additional not : if the number of marks allowed for this, one could have analysed the fixed and
variable omponents in calculating earnings, and other factors, to ensure the reasonability of the
fore ast.]
Value excluding synergies not available to market participants:

R
Maintainable earnings × adjusted forward P/E multiple R156 000 × 9 1 404 000
[Additional note: no adjustment is made for the bank overdraft as interest expense is
already captured in adjusted earnings.]
Value of a 100% equity shareholding in Wagtail (assuming no shareholder level
differences to comparator) 1 404 000
Shareholder level premiums and discounts
Control premium (possible, but insufficient detail provided on the quoted companies;
assume therefore that the comparator multiple already reflects a controlling basis) 0
Subtotal 1 404 000
Marketability discount (e.g. 8% × 1 404 000) (112 320)
Adjusted value of a 100% equity shareholding 1 291 680
492
The fair market value of total equity of Wagtail is equal to R1 291 680 using a method based on a
forward P/E multiple.
[Additional note: The fair market value normally excludes the value of synergies unavailable to
market participants. If synergies were available to other market participants, then that portion could
create a market of its own and that portion would then be included in the fair market value. Syner-
gies are discussed here for the sake of completeness, but are addressed as part of mergers and ac-
quisitions (chapter 12).]
(i) Historical net asset value

Unless both parties are financially naive, the balance sheet value wi not p ay a part in the negotia-
tion process. Historical costs are not relevant to a decision on the future v lue of the company.
Replacement cost
This gives the cost of setting up a similar business. The cost is lower than the dividend or P/E valua-
tion and suggests that there is some goodwill. Although it may seem attractive to start up an identi-
cal company, Blue Bowl will have to consider that it will be g ing into competition with Wagtail and
that it may take a long period of time to build up a pr fitable c mpany.
Net realisable value
This shows the cash price which the shareholders in Wagtail could get by liquidating the business. It
is therefore the minimum price they would accept. The valuation indicates that a price well above
the realisable value would be accepted by the shar holders of Wagtail.
Methods (i) to (iii) suffer from the limitation of not looking at the going concern value of the busi-
ness as a whole, or its fair market value. Methods (iv) and (v) do consider this value. However, the
realisable value is of use in assessing the risk attached to the business as a going concern, as it gives
the base value if things go wrong and the business has to be abandoned.
Gordon Dividend Growth Model
The dividend model is useful when valuing a minority shareholding where the shareholders do not
have a say in the running of the company. The valuation in the question is clearly a majority valua-
tion; therefore the method based on the P/E multiple is more useful. One of the main limitations of
the Dividend Growth Model is the estimate of the future growth of g.
Forward P/E multiple method
This method attempts to establish the value that a market participant (willing buyer) would put on a
company like Wagtail. It does provide an external yardstick, but is a very crude measure. As already
stated, the P/E multiple which applies to larger quoted companies must be lowered to allow for the
size of Wagtail, and further adjustments are required for the non-marketability of its shares. Anoth-
er limitation of P/E multiples is that it is very dependent on the expected future growth of the firm.
It is ther fore not asy to find a P/E multiple of a ‘similar firm’. However, in practice, the P/E multi-ple
method may well feature in the negotiations over price, simply because it is an easy to under-stand
yardsti k.
The range within which the purchase price is likely to be agreed will be the minimum price the sharehold-
ers of Wagtail will accept and the maximum price the Directors of Blue Bowl will pay.
The minim m price that the Wagtail shareholders are likely to accept depends on the alternatives open to
them. Are there other interested buyers? Do they want to continue with the business? The shares are less
marketable; therefore they must consider the break-up value of the business of R864 000 if they wish to
liquidate the holding. However, if they are happy to continue running the business, the going concern
value must be considered, including the R1 252 222 obtained when using the Gordon Dividend Growth
Model, and the fair market value of R1 291 680 determined using the P/E multiple method.
From the point of view of Blue Bowl, the upper range of a price would be between R1 198 000 (the
replacement cost), R1 291 680 (the fair market value based on a P/E multiple method), with the absolute
maximum price incorporating the full value of synergies, the sum total equal to R1 382 760 (R1 291 680 +
R91 080 (calculation 1)).
493
Blue Bowl should, however, be wary of paying in excess of the R1 291 680 (fair market value) as the
synergies are unlikely to be realised by other market participants and therefore probably represent
unique benefits brought on board by Blue Bowl.
The approximate range within which the purchase price is likely to be agreed is between R1 198 000 and
R1 382 760.
Calculation 1 – Full value of synergies is calculated as follows:
R
Distribution cost savings 22 000
Taxation on adjustment (50%) (11 000)
Net saving (that will form part of Blue Bowl’s earnings) 11 000
Effect on earnings × adjusted forward P/E multiple R11 000 × 9 99 000

(Additional full value of synergy before premiums and discounts)
Shareholder level premiums and discounts
Control premium 0
Marketability discount (e.g. 8% × 99 000) (7 920)
Full value of synergy after adjustments 91 080
[Additional note: synergies are discussed here for the sake of co pleteness, but are addressed principally
as part of mergers and acquisitions (chapter 12).]

USE Ltd is a South African manufacturing company that has been in existence for more than a decade. Its most
recent and forecast financial results for the company are summarised below:
Summarised Statements of Financial Position of USE Ltd
As at 30 June
Historical Forecast Forecast Forecast
20X4 20X5 20X6 20X7
R’000 R’000 R’000 R’000
ASSETS
Non-current assets 29 329 20 000 19 500 38 000
Current assets 14 365 13 900 12 500 14 850
• Inventories 5 312 4 500 5 000 6 000
• Trade and other r c ivabl s 6 131 5 900 7 100 8 500
• Cash and cash equival nts 2 922 3 500 400 350
Total assets 43 694 33 900 32 000 52 850

Total equity and non-cu ent liabilities 33 522 25 116 20 120 41 050
Current liabilities 10 172 8 784 11 880 11 800
• Trade and other payables 6 745 6 000 4 900 5 800
• Pr visi ns f r other liabilities 750 950 740 780
• Current inc me tax liability 650 514 440 520
• Borrowings 2 027 1 320 5 800 4 700
Total equity and liabilities 43 694 33 900 32 000 52 850
494
Summarised Statements of Comprehensive Income of USE Ltd

For the years ended/ending 30 June
Historical Forecast Forecast Forecast
20X4 20X5 20X6 20X7
R’000 R’000 R’000 R’000
Revenue 104 280 109 000 112 000 140 000
Cost of sales (82 900) (86 500) (88 600) (114 000)
Gross profit 21 380 22 500 23 400 26 000
Operating costs (12 055) (14 200) (12 400) (13 300)
Depreciation (4 690) (5 300) (4 040) (5 500)
Operating profit 4 635 3 000 6 960 7 200
Net finance cost ( 748) ( 256) ( 812) (1 750)
Profit before income taxation 3 887 2 744 6 148 5 450
Taxation (1 049) (768) (1 721) (1 526)
Profit for the year 2 838 1976 4 427 3 924
Additional information relating to USE Ltd

l The forecast operating costs for 20X5 includes a loss of R2,5 illion relating to the discontinuance of a
subassembly line which the company intends outsourcing. The carrying value of non-current assets to be
disposed of as part of this process amounts to R5,0 million – roughly the same amount that USE (Pty) Ltd
expects to realise.
USE (Pty) Ltd plans to extend its main manufacturing plant in 20X7 and this will represent major capital
expenditure for the company. The company is likely to require a capital injection in a few years’ time to
help finance this expansion, with the present shareholders and the company’s bankers indicating that this
should be possible, in principle.
The gross cash flows of 20X7 are expected to show a sustainable growth in 20X8 and beyond equal to 2%
above the South African forecast Producer Price Index (PPI). This will only be achieved if 38% of gross cash
flows be reinvested in working capital and non-current assets. PPI is expected to stabilize at 5% per an-
num from 20X8.
Company income tax is currently 28%.
USE Ltd has 12 000 ordinary shares in issue.
A small shareholding was recently traded between non-connected, existing shareholders at 242 000 cps
(an over-the-counter trade).
Future income tax allowances are expected to approximate the depreciation expenses.
The cash balance at 30 June 20x4 represents excess cash.
At 30 June 20x4 the arrying value of non-current borrowings was R9 842 000.
USE Ltd’s p esent apital structure is close to a target capital structure for a company of its nature and size.
The company’s current weighted average cost of capital equals 17%.
Required:
Marks
Sub-total Total
(a) Ca culate the fair market value of a 51% shareholding in USE Ltd as at 19
30 June 20X4, based on available information and using a model based on Free
Cash Flow available to the business enterprise. Show all supporting calculations.
Communication skills – layout and structure
1 20
495
Solution:
Part (a)
Determine the present value of Free Cashflows (FCF) – short method (Fundamental):
20X5 20X6 20X7 20X8
-------------Explicit forecast ------------- CV base Note: Simplified
R’000 R’000 R’000 R’000 tax treatment
results in slightly
Operating profit 3 000 6 960 7 200 different values
Add back: Depreciation 5 300 4 040 5 500 compared to
Subtotal 8 300 11 000 12 700 long method
Recalculated tax
(simplified treatment) (840) (1 949) (2 016)
Subtotal × 28% (2 324) (3 080) (3 556) Interest must be
excl in subtotal
Tax allowances:
depreciation × 28% 1 484 1 131 1 540
Gross cash flow 7 460 9 051 10 684 11 432

Growth = (1,02 × 1,05) –
1 (Intermediate) or ~ (2% + 5%) 10684 × (1,00+0,07)
Change in working
capital requirements 896 (1 432) (2 014)
Change in non-cash
current asset balance 1 043 (1 700) (2 400)
Opening balance 11 443 10 400 12 100
Closing balance 10 400 12 100 14 500
Change in non-debt
current liabilities (681) (1 384) 1 020
Opening balance 8 145 7 464 6 080
Closing balance 7 464 6 080 7 100
Capital investment 4 029 (3 540) (24 000)

Opening balance 29 329 20 000 19 500
Depreciation (5 300) (4 040) (5 500)
Closing balance (20 000) (19 500) (38 000)
Gross investment required (4 344)
(11432 x38%
Free Cash Flow
(FCF) 11 851 2 427 (14 696) 7 088
Continuing value (CV) 71 596 Incl in 2016
CV20X7 = FCF20X8 / (WACC-g) 7 088

17% (0,17 – 0,071)
= (1,02 × 1,05) –
1 (Intermediate)
r ~ (2% + 5%) 8,1%
If no value incl
FCF with CV 11 851 2 427 56 900 in year 2017
Di count factor 17% 0,85470 0,73051 0,62437

R’000
Factors or calc
V lue of steps shown
operations 47 429 10 129 1 773 35 527 for 17% rate
Note: Figures may not total correctly due to rounding
496
Determine the present value of Free Cashflows (FCF) – long method (alternative, Intermediate):
20X5 20X6 20X7 20X8
-------------Explicit forecast ------------- CV base
R’000 R’000 R’000 R’000
Gross profit 22 500 23 400 26 000
Operating cost (14 200) (12 400) (13 300)
Depreciation (non-cash items must Note: this
tax
not be included) – – –
treatment
Add back: Change in provisions actually
(incl in operating costs) 200 (210) 40 provides the
Opening balance 750 950 740 superior
result
Closing balance 950 740 780
Adjusted EBITDA 8 500 10 790 12 740

Recalculated tax ( 976) (2 022) (1 936)
Current income tax liability -
opening bal (650) (514) (440)
Tax per statement of
comprehensive income (768) (1 721) (1 526)
Tax linked to interest (at 28%) (72) (227) (490)
Current income tax liability –
closing bal 514 440 520
Gross cash flow 7 524 8 768 10 804 11 560

Growth = (1,02 × 1,05) -1 (Intermediate) or
~ (2% + 5%) 10804 × (1,00+0,07)
Change in working capital
requirements
Change in inventory balance 812 (500) (1 000)
Change in trade and other
receivables 231 (1 200) (1 400)
Change in trade and other
payables ( 745) (1 100) 900
Capital investment ( 971) (3 540) (24 000)
Opening balan e 29 329 20 000 19 500
Depreciation (5 300) (4 040) (5 500)
Disposal (5 000) – –
Closing balance (20 000) (19 500) (38 000)
Only if excl at
Infl w fr m disp sal 5 000 capex
Gr ss investment required (4 393)
(11560) × 38%
497
20X5 20X6 20X7 20X8

-------------Explicit forecast ------------- CV base
R’000 R’000 R’000 R’000
Free Cash Flow (FCF) 11 851 2 428 (14 696) 7 167
Continuing value (CV) 72 394 Incl in 2016
CV20X7=FCF20X8 / (WACC-g) 7 167
17% (0,17-0,071)
= (1,02 × 1,05) -1
(Intermediate) or ~
(2% + 5%) 7,1% If no value incl
FCF with CV 11 851 2 428 57 698 in year 2017
Discount factor 17% 0,85470 0,73051 0,62437

R’000
Factors or calc
Value of opera- steps shown
tions 47 928 10 129 1 774 36 025 for 17% rate
Note: due to the different tax treatment the final value also differs
somewhat to the answer per the short ethod

R’000
Value of operations 47 429 (Implying a control perspective)
Excess cash at valuation date 2 922
Overall firm value 50 351
Value of debt (11 869)
(R2 027k+R9 842k)
Value of 100% equity (assuming no s/h diff) 38 482
Marketability discount (say 10%) (3 848) (Intermediate) Any % deducted
Value of 100% equity (adj for s/h diff) 34 634

Shareholding 51%
Fair market value of 51% shareholding based
on FCF model 17 663
Reasonability test
Based on price of recent trades
Recent over-the-count r trade 242 000 cps
Total number of shar s 12,000
R’000
Value of 100% equity 29 040 (Implying a minority perspective)
Shareholding 51%
Value of 51% eq ity (assuming minority
perspective) 14 810
Control premium (say 20%) 2 962 (Intermediate) Any % added
Fair market value of 51% shareholding based

n recent trades 17 772

The reasonability test offers a value 1% higher, and provides a level of comfort as to the value obtained using
the FCF model.
Conclusion
The fair market value of a 51% shareholding in USE Ltd as at 30 June 20X4, based on available information and
using a model based on Free Cash Flow available to the business enterprise, is equal to R17 663 000.
498
Chapter 12
Mergers and
acquisitions
differentiate between the various forms of m rg rs and acquisitions;

understand the reasons for mergers and acquisitions;
understand why mergers and acquisitions sometimes fail;
discuss the various regulatory mechanisms for mergers and acquisitions;
discuss the behavioural implications of mergers and acquisitions;
understand the valuation considerations around mergers and acquisitions;
understand the financial effects of mergers and acquisitions;
discuss the advantages and disadvantages of the various forms of funding mergers and acquisitions; and
discuss the advantages and disadvantages of a management buy-out.
Most, if not all companies cannot grow indefinitely relying on organic growth alone. Sooner or later other
options for growth must be considered as slowing market demand or increased competition impacts on sales.
After all there is a limit to which growing the customer base or taking market share away from existing compe-
tition can be achiev d. Th se oth r options are the focus of this chapter.
12.1 Strategic ontext

If companies cannot g ow sufficiently by organic means, then they will pursue growth strategies by either
merging with other companies or taking them over. This is often seen to be a very exciting and interesting part
of a financial manager’s role, especially when it comes to evaluating the financial benefits and costs in under-
taking s ch an event.
12.1.1 F rms of mergers and acquisitions

Takeover
A takeover refers to the purchase of a controlling interest in one company by another. The acquiring company
ret ins its name and its identity, but brings the separate identity of the purchased company to an end. A t
keover often results in the rationalisation of the target company’s governance structures (board and senior
management team). Some senior managers of the target company often resign or are dismissed in such an
event.
499
Example
Company A buys out 100% of the shares of the targeted company from shareholder T.
Before takeover:
(i) Shareholder A (ii) Shareholder T
100% shareholding 100% shareholding
Company T
Company A
(Target company)
After takeover:
(i) Shareholder A (ii) Shareholder T
100% shareholding
No relationship with T company
exists after the takeover
Company A
(Holding company)
100% shareholding
Company T (Target
company) (Subsidiary
company)
Figure 12.1: Form of a tak ov r
Me ger
A merger is very similar to a takeover, except that an entirely new company is formed. The shareholders of
both companies s rrender their shareholding in the companies to be merged and a new company is formed,
giving the shareholders an interest in the combined entity. This means that no resources leave the companies
at the time f the merger. As is the case with a takeover, a merger is often accompanied by the realignment of
the b ard, the senior management team and in the majority of cases, the corporate strategy of the merged
entity.
Examp e
Company A with Mr A as 100% shareholder and Company B with Mr B as 100% shareholder decided to amal-g
m te their respective business concerns into one. A new company, C, will be incorporated for this purpose.
500
Mergers and acquisitions Chapter 12
Before amalgamation
(i) Shareholder A (ii) Shareholder B
100% shareholding 100% shareholding
Company A Company B
After amalgamation
Shareholders A and B
100% shareholding
Company C
100% of assets and liabilities 100% of assets and liabilities

transferred transferred
Wound-up � Company A Company B Wound-up
Figure 12.2: Form of a takeover
12.1.2 Reasons for takeovers and mergers

Acquisitions
Acquisitions can be classifi d into three types:
(a) The horizontal a quisition
This occurs whe e a company (the acquirer) acquires a competitor (target) in the same industry. An example is
the acquisition of Massmart by Wal-Mart. This often results in an enlarged organisation and industry concen-
tration. The latter is often frowned upon by the Competition Commission as it is contrary to consumer inter-
ests. The acq isition can be hostile, in which case the acquiring company is referred to as the predator. The
target company often “fends” off the attack by various defensive tactics. One of these might include portray-
ing, in the pen press, the acquirer as a “socially irresponsible “company.
(b) The vertical acquisition

Occurs where a company on a given chain of supply acquires another company up or down the same chain, for
examp e ESKOM (a key consumer of coal) taking over a coal mine upstream, in order to ensure its supplies of
the commodity. This is known as backward integration. Forward integration is the expansion of activities
downstream. An example would be a clothing manufacturer acquiring a clothing retail chain.
501
(c) Conglomerate acquisition

This situation occurs where two companies trade in unrelated markets and merge, or one takes over the other.
A company would merge or take over another where it believes that –
the two companies are worth more together than apart; or
the company it wishes to acquire can be purchased at a price below its true value.
The financial management theory is that a merger or takeover is justified where the present value (PV) of
future cash flows of the combined companies is greater than the present value of each separate company.
PVAB = PVA + PVB + Net Synergy gains
Where:
PVAB = Present Value of future cash flows for the combined comp ny fter the merger
PVA = Present Value of future cash flows of company A before the merger
PVB = Present Value of future cash flows of company B before the merger
Relevant economic arguments

Economies of scale
Bigger facilities and equipment result in a decrease in unit cost (often through fixed costs); alternatively,
duplicated facilities are rationalised, for example two accounting departments are amalgamated thereby
resulting in cost savings. Economies of scale are a function of increased production output in industries
where operating leverage is high (steelworks, airlin s and rail companies are a case in point).
Synergy
This takes place where the combination of resources increases output, and is known as the 2 + 2 = 5
effect, where the end result is greater than the sum of the parts. The synergies are operational (e.g. ac-
quisition of new technologies, rare skills, etc) and financial (cost savings, tax savings, etc). Combined re-
sources increase the business base and thus the potential for growth, profit and free cash flows.
Marketing gains
The combination of companies often results in improved marketing techniques through stronger and
expansive distribution networks, a balanced product - portfolio mix and greater advertising muscle.
Leadership
The acquisition may improve the overall management team, refocusing the strategy thus ensuring con-
tinued growth, especially where one of the companies has aggressive and competent managers. This con-
cept is often referred to as ‘differential efficiency’.
Entry into new mark ts
Acquisitions can provide quick entry into new markets and industries. If a company finds itself in a declin-
ing industry or market, it will acquire new technologies to improve growth prospects. For example, a
company may be producing custom-made products for its current market. It may wish to move into a new
ma ket that equires mass-produced items. To do this, it will need to acquire the technological skills of
mass-p oduction. This skill may be obtained through a merger.
Financial reasons
If a company is competing in a risky industry with a high level of earnings to assets, it may wish to reduce
its risk pr file by acquiring a company with substantial assets and a less risky earnings profile. A company
may also wish to improve its liquidity or leveraged position by acquiring a more financially stable comp-
any. For example, a company with high gearing may wish to take over a company with little or no gearing
o the latter will improve its ability to raise additional finance at more competitive rates.
Strategic benefits
Strategic benefits comprise an opportunity to take advantage of the competitive environment. For exam-
ple, backward integration towards the source of supply may put a company in an advantageous position
relative to its competitors. Another strategic benefit occurs where a company increases its market share
as a result of a takeover, and so is able to reduce competition.
502
Investment opportunities
Cash rich companies may acquire another company as a way of utilising their excess cash resources.
There has been an increase of this practice in the last decade. Recent examples include the acquisition of
Skype by Microsoft as well as the acquisition of Instagram by Facebook.
Asset stripping
A predator acquires a company whose assets as per the statement of financial position are undervalued
relative to their true market values. The assets are then sold for a profit.
Share price
Companies involved in long-term investment programs may find themse ves in a situation where, because
they initially published low earnings and dividend yields, their market r ting is low. For the interim period
they might become the target of a takeover or merger bid by a knowledge ble bidder.
Technology
Owing to the fact that it is sometimes expensive and time-c nsuming to develop and implement new
technology, it is understandable that companies that are leaders in their industry may become targets for
takeovers or mergers. Google has achieved substantial gr wth ver time through acquisitions. In April 2003
it acquired Neotonic Software, an acquisition which laid the foundation for the creation of Gmail as we
know it today.
12.1.3 Why mergers sometimes fail

Many acquisition problems arise simply because the buy r ov r-estimates the value of particular assets, for
example inventory may be unsaleable or some receivables uncollectable. Other difficulties arise when the
buyer overlooks hidden liabilities such as an inadequately funded pension plan or an outstanding obligation on
a contract.
The most serious problems are often the administrative ones. Differences in administrative procedures, ac-
counting methods, productive processes and standards are all common sources of difficulty. Problems may also
stem from the fact that the entrepreneurial qualities needed to build a small company are not necessarily
identical to the qualities needed to direct a major concern. Other common post-merger problems arise in the
wider area of personnel management. News of a pending merger may create considerable unease among
employees, as well as problems resulting from differences in remunerations levels, pay scales and fringe bene-
fits.
In summary, the key reasons why mergers and acquisitions fail are the following:
Lack of managerial fit: Lack of fit manifests itself in terms of conflicting management styles or corporate
cultures. In some cases, it could be the product portfolios that could be incompatible.
Lack of industrial or comm rcial fit: In vertical or horizontal takeovers the target company may not have the
product rang , mark t position or technological niche that was predicted by the initial appraisal.
Lack of goal ongruen e: Disputes about how to proceed with the acquired company in critical functional
areas may ompromise an otherwise good investment.
Bargain pu chases: Turnaround costs may add substantially to the price paid for the company as the acq
irer battles to rectify anomalies in key functional areas (product design, head count, IT, etc.).
Paying too m ch: A premium is paid that does not match the future value creation to the shareholders.
Failure to integrate the entities successfully: Proper fit does not guarantee success. Management could still
fail to translate visible synergies into shareholder value.
Inability to manage change: The board must drive change management by being prepared to depart from
established routines and practices in favour of those routines and practices that will substantially add to
shareholder value. Companies often have different “firm specific cultures” and a failure to manage the
differences often contributes to a failed merger.
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12.1.4 Legal implications

Mergers are regulated by the following bodies:
The Competition Commission of South Africa (established by the Competition Act 89 of 1998). The Com-
mission approves mergers and acquisitions after considering a number of issues all aimed at preventing
what the act calls ‘Abuse of dominance’. It also requires that employees and unions be consulted and be
part and parcel of the negotiations. Visit http://www.compcom.co.za for more details.
The Companies Act 71 of 2008 came into effect on 1 May 2011 and replaces the former Companies Act 61
of 1973 (as amended by the Corporate Laws Amendment Act 26 of 2006) and also amends the Close
Corporation Act 69 of 1984. The Act contains sections that deal with issues relevant to mergers and
acquisitions such as provisions governing offers of shares to the public, the introduction of a shareholder
appraisal rights regime for dissenting minority shareholders, the limit tion of the role of the court in
schemes and the introduction of a new regulator for mergers and cquisitions (M&A) to replace the Secu-
rities Regulation Panel (SRP) with the Takeover Regulations Panel (TRP).
The Securities Regulation Panel (SRP) regulates certain acquisitions and takeovers of public companies in
which the shareholders’ interests exceed R20 000 000. The new C mpanies Act seeks to replace the SRP
with the TRP.
The Johannesburg Stock Exchange (JSE) lays down rules regarding disclosures and procedures to be
followed in relation to transactions affecting listed co panies. These include cautionary announcements
which must be made to shareholders in certain circu stances, and suspensions of listing when certain
types of takeover bids are in progress.
The Securities Services Act 36 of 2004, which, amongst oth r things, regulates insider trading and market
manipulation, practices.
The Exchange Control Department of the South African Reserve Bank (SARB) gives consideration to M&A
transactions that have implications for Exchange Control Regulations. The primary objective of the SARB
is to encourage capital inflows into the capital account of the balance of payments account but also bal-
ance the latter against inflows that may result in increased volatility of South Africa’s currency, the rand.
12.1.5 Behavioural implications

Mergers and acquisitions often give rise to significant changes in many areas of governance and operations
within the affected entities. Such changes often threaten existing interests of key stakeholders. Key stakehold-
ers with vested interests include the following:
The target and acquiring company’s shareholders
Shareholders may be concerned about their wealth; therefore the key indicators they monitor to deter-
mine whether they will decrease, be maintained or increase are –
l the share pric ;
l earnings per share;
l the Pri e Earnings (P/E) ratio; and l
the dividend per share.; and
l the dividend yield.
If projections indicate that there is bound to be a decrease in the above key indicators, the shareholders
may v te against an acquisition or merger. Their cooperation hinges on these key parameters experienc-
ing gr wth in future.
The target and acquiring company’s management
Executives are agents (agency theory in corporate governance) for shareholders and are concerned about
the following –
l the share price, mostly for their share options and stock market rankings; l
whether the earnings per share will be maintained or increased;
l whether the P/E ratio will be maintained or increased; and
l how their management positions will be affected by the new governance structure.
504
Senior managers resist mergers or takeovers if they perceive that the above issues will be adversely
affected.
Employees of both companies
Employees are concerned about the following –
l whether conditions of service will be maintained or changed; l
whether jobs can be guaranteed; and
l whether the new management will be receptive to their needs.
Employees (through unions) resist mergers or takeovers if they perceive that the above issues will be
adversely affected.
The state
The state acts through various organs (for example, the Department of Trade and Industry (DTI), the
Competition Commission and the Reserve Bank). Its concerns are primarily with the preservation of the
‘public interest’, which often includes the following issues –
l whether jobs can be guaranteed; and
l whether competition is being encouraged.
l whether the entity would promote the state’s e power ent policies for designated groups.
Any merger or acquisition should therefore try to balance these often conflicting interests. Any agree-
ment reached should be a win-win situation, but in some cases stakeholders make sacrifices to ensure
that progress is made, or benefits such as technology transf r are seen to materialise in the long-term.
12.2 Valuation considerations

The principles introduced in chapter 11 (Business and equity valuations) on how to value a company using
various valuation methods are equally applicable to this chapter.
12.2.1 Difference between ‘normal’ valuations and ‘merger/takeover’ valuations

Valuations, as introduced in the Chapter 11, require a shareholding to be valued from the perspective of a
shareholder or group of shareholders with identical share value requirements. The valuation examines the
shares being valued on the basis of an arm’s length transaction and arrives at a single valuation instead of
multiple valuations.
Acquiring 100% Target

company company
Existing Shareholders Existing shareholders

l Majority? l Majority?
l Minority? l Minority?
Figure 12.3: Merger/takeover valuation
Figure 12.3 indicates that there are two parties to a takeover bid, namely the acquiring company and the
current hareholders of the target company. The perceived value of the target company can be totally different
when seen from the perspective of the acquiring company as opposed to the existing target company share-
holders.
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When valuing a takeover, one should first establish whether the shares are being valued from the perspective
of –
the existing shareholders;
the acquiring shareholders; or
both.
12.2.2 Minimum share value

If the valuation is being carried out for the benefit of the existing shareholders in the target company, one must
consider the minimum value for which the shareholders are prepared to sell their shares. The valuation is an
arm’s length valuation where the value does not take into account any potenti l synergies that may arise. This is
a conservative approach since synergic benefits are uncertain.
The approach is to determine –
the percentage shareholding held by the individual shareh lder; and
the method of valuation.
Where the shareholder or shareholders of the target co pany are inority shareholders, the appropriate method
would be to value the ‘going concern’ shareholding on a dividends basis, where the cost of equity (k e) for a
similar quoted company is used as the required return and adjusted for business and financial risk perti-nent to
the target company. If the shareholding being considered is a majority, then it would be appropriate to do
earnings or free cash flow valuation.
Although one is considering the value of 100% of the shares, one must nevertheless consider who the share-
holders are and how many shares each of them own. The appropriate method is often a minority valuation, as
no shareholder may be able to influence the distribution of the earnings. In such a case, the valuation is done
by using the Gordon Dividend Growth Model but no allowance may be made for benefits that will be derived
by the acquiring company (synergies). If the target company is not considered to be a viable going concern, it
would be appropriate to do an asset or liquidation valuation depending on the information provided in the
scenario.
Note: A takeover question will state that ‘certain synergy benefits will accrue as a result of the takeover’.
Such benefits will affect future cash flows of the combined entity. These benefits must not be includ-
ed in a minimum share valuation exercise.
12.2.3 Maximum share valuation

From the point of view of the acquiring company, one must determine the maximum price that the sharehold-
ers of the acquiring company are willing to pay for the target company. One must take into account the synergy
benefits that will be d riv d as a result of the acquisition. These are normally synergies that are directly at-
tributable (specific) to the acquir r and target company.
Synergy benefits refers to the combination of complementary resources and implies that using the resources of
the two firms together will in rease the value of the firm going forward.
12.2.4 Fair share valuation

The fair val e of a financial asset or firm is its value in the open market. The “open market” principle implies
competiti n am ng bidders for the financial assets or firm. The estimated synergy benefits available are those
that are kn wn by all bidders (assuming an efficient market). In carrying out a fair valuation it is these synergies
that are included rather than the attributable (specific) synergies. The concept of fair valuation relies heavy on
the concept of “market efficiency”. The latter implies bidders have the same information set as far as it relates
to the target company. If information flows are distorted then individual bidders would come up with differing
va ues for synergy benefits and hence differing valuations for the target firm.
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12.2.4 Various forms of synergy benefits (financial and operational)

Financial synergies
Revenue enhancement
Marketable gains – It is claimed that mergers can produce greater operating revenues from improved
marketing, such as better advertising efforts, the strengthening of the distribution network and a
more balanced product- portfolio mix.
Strategic benefits – This is the opportunity to take advantage of the competitive environment.
Market or monopoly power due to reduction in competition. Monopo ises arise due to such factors as
legislation (ESKOM), first mover advantage in technology (Microsoft/Windows) and scale economies
(Intel and Samsung in the manufacture electronic chipsets).
Cost reduction
Efficiencies may result due to economies of scale, the sharing of complementary resources, the elimina-
tion of duplicate functions and availability of cheaper sources f funding.
Tax gains
Possible tax gains can come from –
l the use of tax losses from net operating losses; l
the use of unused debt capacity; and/or
l the use of surplus funds.
Operational synergies
The operational synergies are often related to the functional areas of the organisation and may include the
following –
acquisitions intended for geographical expansion (Wal-Mart’s acquisition of Massmart);
acquisitions intended for complementary resources (Microsoft’s acquisition of Skype); and
acquisitions intended for production processes and patents (Google’s acquisition of Motorola).
12.2.5 Dividend versus earnings and cash valuation

From the perspective of the acquiring company, which is taking over a majority stake in the target company,
one could argue in favour of earnings (Price to Earning or Earnings Yield) or free cashflow valuation (Free cash
flow due to operations or free cash flow due to equity). There is one problem, however. Who are the share-
holders of the acquiring company? If the shareholders consist of a majority shareholder and a number of small
minority sharehold rs, it is appropriate to do a majority valuation (earnings or cash). However, where the
shareholders of the a quiring company are all small minority shareholders, it would be appropriate to do a
minority valuation (Gordon Dividend Growth model).
The method of pu chase price settlement constitutes another point that must be taken into account when
trying to decide whether the acquiring company shareholders are minorities or a majority. It often happens
that some kind of a share-swap of target company shares for acquiring company shares takes place, in which
case the shareholders of the acquiring company will include new minority shareholders. The purpose of this
chapter is to c ntextualise the theoretical aspects of mergers and acquisitions, hence a brief appraisal of valuati
n aspects as they relate to this area. For a detailed discussion on valuation methodologies students are referred
to chapter 11.
12.3 Financial effects of acquisition

Why would a company want to take over another company? Surely it is going to buy more problems than the
keover is worth, when negative factors such as management hostility and employee animosity from merging
different company cultures may be encountered.
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Companies are always very keen to take over other companies because –
compared to organic growth it is an easy way to expand;
it eliminates competition;
the acquiring company can purchase assets for a bargain price; and
it can buy into new ideas.
The main reason however, is that the company believes that by simply taking over another company, it will
create value on a P/E ratio basis. One must however, ask how this will be achieved?
Example: Effect of takeover

Let’s assume that Company A has a market value of R100 million and e rnings of R10 million. The P/E ratio is
therefore 100m / 10m = 10x.
Company B, a similar company in the same industry, has a market alue of R50 million and earnings of R10
million. The P/E ratio is therefore 5x.
Required:
Determine what the effect will be of Company A taking over Co pany B for R50 million.
Solution:
There are several factors that one needs to consid r, but the most important factor is that Company A, the
acquiring company, has a P/E ratio of 10. Assuming that after the takeover, the P/E ratio of Company A remains
at 10 and the earnings of Company B remain at 10 million:
m
Effective value of Company B = 10 × 10m = 100
Less: Acquisition price (50)
Premium on takeover 50
Assuming that a P/E ratio of 10 is valid, the market value of the enlarged company has increased by R50 million,
even before any synergistic benefits, which will further increase the premium on takeover, have been
considered. In practice, negative investor sentiments may drastically reduce the post- acquisition P/E hence
reducing the value of B and the resultant takeover premium. If investors are bullish about the perfor-mance of
the combined entity going forward, the P/E may rise.
12.3.1 Earnings growth

Stock markets in g n ral attach considerable importance to earnings per share when arriving at a company’s
stock-market rating. Companies will normally increase the earnings per share by normal manufacturing, trading
and selling cycles, but another method of increasing earnings per share is simply by acquiring companies.
For example, whe e two more-or-less identical companies exist and one has a higher market capitalisation by
virtue of its pe ceived g owth potential, it is able to purchase the other company on advantageous terms.
Example: Acq iring company – higher P/E ratio

Two c mpanies (A and B) each have issued share capital of 2 million shares. The financial position of the two
companies is sh wn below:
Company A Company B
Earnings per share R20 R20
Market price per share R320 R180
P/E ratio 16 9
Company A Company B
Number of shares 2 million 2 million
Total earnings R40 million R40 million
Value (P/E × Total earnings) R640 million R360 million
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Company A has a higher P/E ratio than B because the market believes that A has greater growth prospects.
Company A will take over Company B at its current value of R360 million by issuing Company A shares to
Company B shareholders.
The combined companies will derive no additional value from the takeover.
Required:
Calculate the price per share for Company A after the takeover.
Solution:
Company A purchases Company B. The market value of Company B is R360 million, nd Company A will have to
offer 1,125 million of its shares (R360m ÷ R320) to the shareholders of Comp ny B.
The position of Company A after the purchase is:
Total earnings R80 million [40m + 40m]
Number of shares 3,125 million [2m + 1,125m]
Earnings per share R25,60
The earnings per share has increased, purely because of the purchase of Company B.
Since the price of a share is related to the earnings p r shar , if the P/E ratio and the earnings are known, then
price equals P/E ratio multiplied by earnings (Price = P/E × Earnings).
If the market believes that the management of the purchasing company will use its abilities to achieve a similar
growth rate on the assets of the purchased company as it has on its own assets, then the market would keep
the same P/E ratio (assuming that the risk of the purchasing company remains the same).
The position of Company A after the merger is:
Earnings per share R25,60
P/E ratio 16
Market price per share 409,60 (16 × 25,60)
Number of shares 3,125 million
Total earnings R80 million
Value R1,28 billion (80m × 16)
The shareholders of Company A have gained, because the market price is up from R320 to R409,60. The wealth
of the shareholders of Company B has increased by R100,8 million.
Before merger 2m shares × R180 R360 million
After merger 1,125m shares × R409,60 R460,8 million
This is because they now hold shares in a company with higher growth prospects.
12.3.2 The smart argument

One can argue that the market value of the combined firm is R1 billion (R640m + R360m), which is the sum of
the values of the separate companies before the merger. The market is smart, and realises that the value of the
combined company is the sum of the values of the separate companies. The price per share is thus R320 (R1 bi
ion ÷ 3,125 million shares).
Because the share price of Company A after the takeover is the same as before the takeover, the P/E ratio must
f ll to 12,5 (320 / R25,60). The earnings will however, rise from R20,00 per share to R25,60 per share. The e
rnings growth creates the illusion that the shareholders of Companies A and B have received something for
nothing. Although this illusion may work for a while, in the long run the value per share will decline.
However, if Company A can bring the growth of Company B up to its level by increasing the growth of earnings
attributable to Company B, then the market value of the combined company should increase.
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In practice, the stock market tends to attach a higher P/E ratio to the company after the acquisition than would
be expected from the above logical analysis. This is because investors tend to have optimistic expectations after
a merger, as they hope economies of scale, improved management, forecast synergistic benefits and the like
will lead to improved performance.
Example: Acquiring Company – lower P/E

Biglad agrees to take over the shares of Tiddler in a share exchange arrangement. The financial position of the
two companies is as follows:
Biglad Tiddler
Earnings per share R40 R20
Market price per share R600 R400
P/E ratio 15 20
Number of shares 8 million 5 million
Total earnings R320 million R100 million
Value R4,8 billion R2,0 billion
Biglad acquires Tiddler by offering two shares in Biglad for every three shares in Tiddler. Biglad’s directors
report that the earnings per share will increase as a result of the acquisition of Tiddler, because the current
earnings of both companies will increase by 10% due to synergistic benefits.
Required:
Calculate the earnings per share accruing to the shar hold rs of Biglad and Tiddler assuming that –
the takeover results in total increased earnings of 10%; and
the takeover does not increase the reported earnings.
Solution:
Number of new shares
Total
Biglad 8m
Tiddler (2 for 3) (5m / 3 × 2) 3,333m
11,333m
(a) Previous earnings

Rm
Biglad 320
Tiddler 100
420
10% increase 42
New earnings 462
Earnings per sha e R462m ÷ 11,333m = R40,8

Earnings per share Biglad Tiddler
Previo s R40 R30 [R20 × 3 / 2]
New R40,8 R40,8
(b) Current earnings
Rm
Biglad 320
Tiddler 100
420
Earnings per share R420m ÷ 11,333m = R37,06

Earnings per share Biglad Tiddler
Previous R40 R30
New R37,06 R37,06
510
Conclusion:
Where a company acquires another company with a higher P/E ratio than itself, it is essential for continued
positive effect on earnings per share, and the return on shareholder’s capital that both companies promise to
offer prospects of strong profit growth going forward. Of late, there has been an increase in incidences of cash
– rich companies buying target companies on a cash basis. (Microsoft’s purchase of Nokia’s hand-set division in
2013 for USD 7,2 Billion)
12.4 Funding for mergers and acquisitions

When a company takes over another company, the payment to the shareho ders wi be in –
cash;
a share exchange; or
a combination of cash and a share exchange.
Most takeover bids incorporate some measure of share exchange between the acquiring company and the
target company, notwithstanding the increase in cash only acquisiti ns highlighted earlier.
12.4.1 Impact on capital structure

How a company pays for the shares of the target company will have a significant effect on the resultant capital
structure of the acquiring company. If a company d cid s to pay cash for the shares, it will have to either issue
new shares or raise debt finance (unless it has a pile of xc ss cash). It also has to consider the D:E ratio of the
target company and the effect that the combination of the two companies will have on the new statement of
financial position of the acquiring company.
If the company decides to go the share-exchange route, it has to consider the effect of a dilution in the share-
holding of existing shareholders.
12.4.2 Methods of payment: cash versus share exchange

The choice between a cash offer and a share offer depends on the perceptions of the shareholders and manag-
ers of the acquiring company on the one hand, and the view taken by the shareholders of the target company
on the other.
Cash offers
Effects on the shareholders of the target company
Generally, the shareholders of the target company are unlikely to prefer cash if they become liable to any
taxation on profits th y make on the sale of the shares. The advantage of a cash offer, however, is the
certainty of the amount r ceived. With a share offer, the amount received is uncertain, because of the
possible volatility in the share price, which will affect the value of their holdings.
A cash offer will also allow the shareholders to choose their own investment portfolio in line with invest-
ment oppo tunities. The critical consideration for shareholders of the target company is the potential tax
liability as a result of a cash sale. Where a large tax liability exists, the shareholders will prefer a share ex-
change. Where the tax liability is small, the shareholder will prefer cash.
(b) Effects n the shareholders of the acquiring company

The main advantage of a cash transaction is that the acquiring company may claim tax deductions on the
a ets purchased. The bidding company’s share equity value will not be affected which means that its
control remains intact.
A cash deal financed by a debt issue is cheaper to the acquiring company, as the interest is allowable as a
tax deduction. A dilution of earnings can also be avoided as the number of shares in issue does not
change. A major disadvantage of a cash transaction is the gearing position. Increased debt will alter the
D:E ratio, which could change the financial risk profile of the company. Private companies would prefer to
offer cash as a means of payment to prevent voting power shifting to outsiders. Private companies would
also have difficulty in valuing their own shares in a share deal, due to the lack of marketability.
511
Share offers
Effects on the shareholders of the target company
The main advantage is that any potential capital gains tax (CGT) is deferred. The shareholders will also
continue to have a financial interest in the company sold, with potential of increased earnings and market
share value.
Effects on the shareholders of the acquiring company

One of the advantages of a share offer (as previously discussed) is the effect of increased earnings per
share if the acquiring company has a higher P/E ratio than the target company. The uncertainty of the ef-
fect of the share price must also be taken into account as the number of issued shares increases.
A big disadvantage of a share-for-share offer is the dilution in the equity holding of the company’s original
shareholders. The dilution of the equity holding may cause the bidding company’s share price to fall. One of the
potential problems is that, after the share-for-share transaction has taken place, a large number of shares may
trade on the market, forcing a drop in share price as a result of supply and demand.
The main advantage of a share transaction is that the initial cost is relatively l w from a cash flow point of view,
as no money passes to the company being taken over.
A further problem of a share-for-share transaction is the level of dividends per share and dividend cover ex-
pected by shareholders of the acquiring company and those of the target company. Once the arrangements
take place, there will be a single dividend policy, whereas previously there may have been two separate poli-
cies.
Example: Takeover consideration

Company A has a market value of R6 billion and an issued share capital of 60 million shares. Company B, a
company in the same industry as Company A, has an issued share capital of 20 million shares and a market
value of R1 billion. Company A wishes to take over Company B, and believes that the combined company value
will be R8 billion. Company B has agreed to a takeover value of R1,5 billion.
Required:
Discuss the effect(s) the takeover of Company B will have on the existing shareholders of Company A, if Com-
pany B is acquired by –
an issue of new shares to existing shareholders;
an issue of shares to new shareholders;
borrowing; or
a share exchange.
Solution:
Issue new sha es to existing shareholders
Assuming a new issue will be made via a rights issue or a new share issue at the current market share
value, the effect wo ld be as follows:
Market val e before acquisition R6 billion
Number f shares 60 million
Price per share R100 (R6 billion /60 million shares)
New issue of shares R1,5 billion / R100 = 15 million new shares
Market value of combined company R8 billion
Total shareholding 75 million shares (60 m + 15 m)
Value per share R8 billion / 75 million = R106,67
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Increase in value to existing shareholders
75 million × 6,67 (R106,67 – R100 = R6,67) = R500,25 million [Say R500 million]
As the existing shareholders financed the new issue, they benefit from the increased value of
R500 million. Their shareholding has not been diluted.
(ii) Issue of shares to new shareholders
Existing shareholders 60 million shares
New shareholders 15 mi lion shares
Gain per share R6,67
Existing shareholders benefit by R 6,67 × 60 million = R400 million
In this situation, there will be a dilution in value to existing shareholders, as the benefit from the acquisi-
tion is shared with new shareholders.
(iii) Borrowing
R
New market value 8 billion
Increased debt (1,5 billion)
Net value 6,5 billion
Number of shares 60 million
Value per share (R6,5 billion /60 million shares) 108,33
Net value attributable to existing shareholders = 8,33 × 60 million (R108,33 – R100,00 =
500 million
R8,33)
The benefit to existing shareholders is the same as financing the new acquisition via a rights issue, or a
new issue of shares to existing shareholders.
(iv) Share (R6 billion /60 million shares) exchange

Market value R8 billion
Existing shareholders – shares 60 million
New shareholders – shares 15 million
New shareholders = R1,5 billion market value / R100 per share = 15 million shares
Value per share R8 billion / 75 million = R106,67
Net benefit to xisting shar holders = R400 million
Net benefit to Company B shareholders = R6,67 × 15 million = R100 million
Company B shareholders have gained twice over. The market value of Company B was R1 billion before
the takeover. The agreed sale value was R1,5 billion. The shareholders of Company B gained R500 million
on acquisition date.
F rther gain on share exchange = 15 million × R6,67 = R100 million
Total gain R500 million + R100 million = R600 million
The ab ve calculations show that Company A’s shareholders will gain more if the acquisition is for cash
and the funds are financed via a new issue of shares to existing shareholders or by debt financing. If the
finance f the acquisition is made via a new issue of shares to new shareholders or by a share exchange of
Company A shares for Company B shares, the current shareholders of Company A will not receive the full
benefit of acquiring Company B and the value of their shares will be diluted.
12.4.3 Management buy-outs

A management buy-out (MBO) is the purchase of all or part of a business from its owners by the executive
managers. The success of a company after a buy-out is very high. Research has shown that as many as 97% of
MBO companies succeed.
513
Reasons for MBOs

A large company decides to sell or close a division or subsidiary because –
the division may have become peripheral to the company’s mainstream activities and no longer fits in to
the group’s overall strategy;
the company may wish to sell off a loss-making subsidiary or a division that is not showing a sufficient
return or generating sufficient cash;
the holding company may have recently acquired a group of companies and now wishes to sell unwanted
elements; or
the holding company needs cash.
A private company decides to sell a division or subsidiary because –
shareholders believe that the business is no longer profitable for them;
shareholders may wish to retire; or
shareholders may require quick cash.
The management team would buy out the business because –
it gives them a chance to run their own business;
it leaves them free from interference from Head Office executive directors; or
it secures their position with the company which could be taken over.
Why buy-outs usually succeed

One of the major reasons why MBOs succeed is because the new owners will have an incentive to succeed –
their future wealth and employment prospects depend on the company’s success. The company is also more
flexible, as decision-making is quicker and improvements can take place on pricing and debt collection.
The customers of the company will gain, as continuity of supply will carry on under the same management
team. The employees may also benefit, as they will continue to deal with managers who are known to them.
How-ever, it often happens that some redundancies take place after a buy-out, in order to cut running costs.
The purchase price

If a company is showing poor results, the price is usually based on the net book value of the assets acquired.
However, if the company can be sold as a successful going concern business, the price will be based on normal
valuation techniques. It is often possible to predict future cash flows with more confidence as new manage-
ment will have a cl ar r id a of future prospects. In such situations a free cash flow (FCF) valuation would be
considered appropriate.
Often the managers will invest their own funds (albeit a small percentage of the total capital required) into
purchasing the ompany (an incentive in itself for them to ensure the business succeeds), and borrow the
balance. As a esult, in a buy-out situation, the company’s gearing level in the early years is often high. Debt to
equity (D:E) atios of 10:1 are not uncommon. The gearing will tend to fall as future cash distributable profits are
retained in the b siness and debt is repaid.
Management buy-out finance

The financing f an MBO is normally in the form of long-term loans financed by banks, pension funds, or insur-
ance companies and of late, private equity.
In titutions providing the required finance often require board representation or equity. The employees in-vo
ved in the MBO often have to put up substantial personal guarantees and offer their private property as coll
teral to support the loan finance.
Where the purchasing parties have insufficient personal funds to purchase the required equity, they may use
mezzanine finance. This type of finance normally has little or no asset backing and falls behind ‘senior debt’ in
erms of claim on income. This type of higher risk finance will carry a higher interest rate, and some participa-
tion in the equity of the company. The use of this ‘quasi debt’ allows the management to hold a higher equity
percentage. The repayment period for this type of debt is often about ten years.
514
Practice questions

Empirical research has it that, in the main, mergers and acquisitions are extremely difficult to conceive. Ex-
pected synergies may not be realised and in the majority of cases the merger is considered a failure. The
reasons for failure are often many and differ from case to case.
Required:
List and briefly explain at least 6 reasons why mergers and acquisitions fail.
Solution:
Lack of managerial fit: Lack of fit manifests itself in terms of conflicting management styles or corporate
cultures. In some cases, it could be the product portfolios that could be incompatible.
Lack of industrial or commercial fit: In vertical or horizontal take vers the target company may not have the
product range, market position or technological niche that was predicted by the initial appraisal.
Lack of goal congruence: Disputes about how to proceed with the acquired company in critical functional
areas may compromise an otherwise good investment.
Bargain purchases: Turnaround costs may add substantially to the price paid for the company as the
acquirer battles to rectify anomalies in key functional ar as (product design, head count, IT, etc.).
Paying too much: A premium is paid that does not match the future value creation to the shareholders.
Failure to integrate the entities successfully: Proper fit does not guarantee success. Management could still
fail to translate visible synergies into shareholder value.
Inability to manage change: The board must drive change management by being prepared to depart from
established routines and practices in favour of those routines and practices that will substantially add to
shareholder value. Companies often have different “firm specific cultures” and a failure to manage the dif-
ferences often contributes to a failed merger.

You are a junior consultant at an investment firm situated in Jabulani. Your senior partner has recently attend-
ed a seminar on mergers and acquisitions where a number of themes were discussed. Although she is up to
date on the subject of mergers and acquisitions, she would like to “test” your understanding of the concepts of
synergies and diversification. She has asked you to draft notes on the following:
What synergi s may arise in mergers and acquisitions?
What challenges you foresee in the achievement of synergies under (a) above?
Can mergers and a quisitions be undertaken to achieve corporate diversification?
Solution:
What synergies may arise in mergers and acquisitions.
Operating synergies:
l Impr ved productivity as a result of the merger or acquisitions. l
The merged entity may experience economies of scale or scope.
Increased product – market scope.
l The elimination of inefficiencies that previously existed in the target company. l
Better use of previously underutilised talent.
l In horizontal mergers, the elimination of competitors may contribute to economic value addition to the
new firm.
515
Vertical mergers between customers and suppliers can create value by enhancing value within the
supply chain
Note: This list is not exhaustive. What additional points can you add?
Financial synergies:
Cost savings as a result of the rationalisation of operations. This may entail the elimination of duplicate
service functions in the areas of finance, procurement, human resources, etc.
Tax savings, whereby the merged entity is able to fully utilise tax allowances or tax losses.
Diversification reduces firm specific risk, making the company more attractive to investors and
reducing the company’s weighted average cost of capital.
Note: This list is not exhaustive. What additional points can you dd?
What challenges you foresee in the achievement of synergies under (a) abo e?
l The acquisition decision is based on incomplete or incorrect information resulting in synergies not being
fully realised.
l Synergies may prove difficult to value.
Business combinations often result in a nu ber of proble s often around corporate culture and
organisational politics. In resolving these issues, additional costs may be incurred which tend to “eat”
into synergy gains.
Managers are not given suitable inc ntiv s to achieve maximum synergies.
Can mergers and acquisitions be undertaken to achieve corporate diversification?
l Borrowing capacity and access to differing forms of financing is often increased. This lowers the firm’s
cost of capital as cited above hence contributing to the minimisation of firm specific risk.
l The merger or acquisition often minimizes the risk of corporate failure.
l A company overly reliant on one core business area may acquire other businesses (Conglomeration) in
order to reduce the risk of over reliance on a single sector (Bidvest is a case in point).
l Empirical research suggests that in some instances investors can diversify far more efficiently through
their portfolios than the company. In such a situation a company may be forced to return cash to the
shareholders by declaring a cash dividend.

Access the internet and s arch for 10 (ten) local and 10 (ten) foreign business combinations in the form of
mergers and a quisitions that took place in the last ten years. In your selection of the candidates for analysis
ensure, where possible, that 70% are acquisitions and the balance are mergers. For each candidate indicate the
following:
The natu e (fo ms) of the merger or acquisition.
The rationale (reasons) for the combination (pronouncements by the parties and analysts are required
here).
Legal issues that arose as a result of the combination (what regulatory or state bodies were involved, who
were the litigants, what was/were the basis of the litigation and what were the outcomes of such litiga-
tion?)
The ocial, cultural and political issues that arose as a result of the combination and how these were
resolved (if at all).
From a review of literature and in your own opinion would you say the combination was successful?
516
Solution:
This mini case study has no solution. Students will be required to derive the answers based on their own
research. Academics may use each mini case study to assess students’ ability to access and analyse information
from the internet and only present information that is tailored to the requirement.

The following is a summary of the Statement of Financial Position of Banco Ltd at 31 December 20X1:
Rm
ASSETS
Plant and machinery 240
Current assets 75
Inventories 5
Trade receivables 20
Cash equivalents 50
TOTAL ASSETS 315

Total equity 210
Issued capital 140
Reserves 100
Retained earnings/(losses) (30)
Non-current liabilities 35
Long-term borrowings 35
Trade payables 60
Short-term borrowings 10
Astra Ltd offers to take over all the assets at book value and to discharge some of Banco Ltd’s liabilities.
Trade creditors will be tak n over and paid by Astra Ltd. Astra Ltd will be able to negotiate a 15% discount
from creditors and imm diat ly pay them.
Banco Ltd will repay its bank overdraft of R10 million and redeem the long-term borrowing of R35 million at
a premium of 6%.
The sha e capital of Banco Ltd consists of –
Rm
Ordinary shares of R1 each 80
12% Preference shares of R1 each 30
15% Preference shares of R1 each 30
140
The hareholders of Banco Ltd will exchange their respective shares in Banco Ltd for ordinary shares in Astra
Ltd at the following ratios –
Banco shares for Astra shares
Ordinary shareholders 5 1
12% Preference shareholders 5 1
15% Preference shareholders 6 2
Astra Ltd’s shares are valued at R6,00 per share.
517
Liquidation charges payable by Banco Ltd amounts to R2, 9 million

50% of Banco Ltd’s Trade receivables are considered to be irrecoverable, and its plant to be worth 5% less
than the reflected book value.
Banco Ltd will transfer its cash investment of R50 million into its bank account.
Required:
Prepare the ledger accounts of Banco Ltd reflecting the finalisation of the above absorption.
Solution:
Bank
Rm Rm
Cash equivalents 50 Balance 10
Liquidation charges 2,9
Long-term b rr wing 37,1
50 50
Trade payables
Rm Rm
Liquidation account 60 Balance 60
Cash equivalents
m Rm
Balance 50 Bank 50
Long -term borrowing

Rm Rm
Bank 37,1 Balance 35
Liquidation account (premium) 2,1
37,1 37,1
Ordinary shares
Rm Rm
Shares for Astra 96 Balance 80
Profit on liquidation 16
96 96
12% Preference shares

Rm Rm
Balance 30
Shares for Astra 36 Profit on liquidation 6
36 36
15% Preference shares

Rm Rm
Balance 30
Sh res for Astra 60 Profit on liquidation 30
60 60
518
Liquidation account
Rm Rm
Plant and machinery 240 Payables 60
Bank (liquidation charge) 2,9 Reserves 100
Inventory 5 Purchase price 192
Long-term borrowing – premium 2,1
Retained loss 30
Profit – ordinary 16
– 12% Preference 6
– 15% Preference 30
352 352
Sundry shareholders
Rm Rm
Liquidation account 192 Shares in Astra:
Ordinary holders 96
12% Preference holders 36
15% Preference holders 60
192 192
Purchase price
Rm
Ordinary shareholders
80m × 1/5 R6,00 96
12% Preference shareholders
30m × 1/5 R6,00 36
15% Preference shareholders
30m × 2/6 R6,00 60
Purchase price of net assets 192
Payables (creditors) 60
Purchase price of total assets 252
519

Refer to Question 12–4 above.
Astra Ltd
Statement of Financial Position at 31 December 20X1
Rm
ASSETS
Plant and machinery 220
Current assets 220
Inventory 100
Cash equivalents 60
TOTAL ASSETS 440

Total equity 385
Issued capital 250
Reserves 15
Trade payables 30

The issued capital consists of – Ordinary shares of R1 each R250m
Required:
Prepare the Statement of Financial Position of Astra Ltd after the absorption has taken place.
Solution:
Astra Ltd
Rm
ASSETS
Non-current ass ts
Plant and machinery [(240 – 5%) + 220] 448
Current assets 184
Invento ies [5 + 100] 105
Cash equivalents [60 – 51] 9
Trade receivables [(20 – 50%) + 60] 70
TOTAL ASSETS 632

T tal equity 577
I ued capital [250 + 32] 282
Share premium [15 + 160] 175
Trade payables [(60 – 15%) – 51 + 30] 30
520
Journal Entry
Rm Rm
Opening entries:
Plant and machinery [240 – 5%] Dr 228
Inventory Dr 5
Trade receivables [20 – 50%] Dr 10
Payables (Creditors) [60 – 15%] 51
Share capital 32
Share premium 160
Payables (Creditors) Dr 51
Cash 51
Calculation of share premium

Purchase price R192m
Value of shares  R6
Number of shares = 32m
Nominal value of shares R1

Share premium R5
Share premium = R5 × 32 000 R160 million
Comments:
In this question the values of the assets purchased w re xactly the same as the purchase price. If the purchase
price was higher, goodwill would have been creat d in the books of Astra Ltd. The lower the goodwill the
bigger the tax benefit for the buyer as the depreciable asset values for tax purposes are higher. The converse
applies to the seller since higher asset values create bigger taxable recoupments.

Costa Ltd and Delta Ltd decided to amalgamate their companies at 31 December 20X1. The following infor-
mation is presented to you:
Costa Ltd
ASSETS Rm
Property 300
Current assets 367
Inventory 102
Trade receivabl s 125
Cash and ash equivalents 140
TOTAL ASSETS 681

Total eq ity 338
Iss ed capital – R1 shares 400
Retained earnings/(losses) (62)
N n-current liabilities 145
Deferred tax 20
Trade payables 138
Short-term borrowings – Bank 10
Provision – Bad debt 50
521
Delta Ltd
Rm
ASSETS
Property 120
Current assets 175
Inventory 100
Cash and cash equivalents 25
TOTAL ASSETS 305

Total equity 170
Issued capital – R1 shares 150
Retained earnings/(losses) 20
Trade payables 135
A new company Delcosta Ltd was incorporated with an authorised ordinary share capital of 700 000 ordi-
nary shares of R1 each for purpose of this amalgamation.
Delcosta Ltd took over all the assets and liabilities of both companies at book value except for in the case of:
Costa Ltd:
Liquidation costs of R5 million
Long-term borrowings
Bank overdraft
Delta Ltd:
Liquidation costs of R5 million
Cash on hand
3 Purchase consid ration:
Shares held in Shares in Delcosta Ltd
Costa Ltd:
Ordina y sha eholders 10 for 7
Cash R55 million
Delta Ltd:
Ordinary shareholders 1 for 1
Required:
Draw up the statement of financial position of Delcosta after the amalgamation has taken place.
So ution:
Costa Ltd – Calculation of purchase price
R400m
Shares to be issued: x7= 280m shares
10
522
Purchase price:
Rm
Shares of R1 each 280
Cash 55
335
Assets and liabilities taken over:

Rm
Current assets 227
Inventory 102
Cash –
Balances 140
Liquidation expenses (5)
Borrowings (125)
Bank (10)
Deferred tax (20)

Current liabilities
Trade payables (138)
Provision for bad debt (50)
333
Goodwill paid for by Delcosta Ltd:

Rm
Purchase price 335
Value of Assets 333
Goodwill 2
Delta Ltd
Purchase price
Rm
Shares of R1 each 150
150
Assets and liabiliti s tak n ov r

Rm
Current assets 150
Invento y 100
Cash –
Balance 25
Liquidati n expenses (5)
Payment to shareholders (20)
Current liabilities
Trade payables (135)
145
523
Goodwill paid for by Delcosta Ltd

Rm
Purchase price 150
Value of Assets 145
Goodwill 5
Delcosta Ltd
Rm
ASSETS
Property (300 + 120) 420
Plant and equipment (14 + 10) 24
Goodwill (2 + 5) 7
Current assets 377
Inventories (102 + 100) 202
Trade receivables (125 + 50) 175
Cash and cash equivalents –
TOTAL ASSETS 828

Total equity 430
Issued capital (280 + 150) 430
Long-term borrowings –
Deferred tax 20
Trade payables (138 + 135) 273
Bank overdraft 55
Provision– Bad debt 50
Question 12– 7 (Int rm diate) 35 marks 52 minutes

A client, Tebbitt (Pty) Limit d, has been negotiating with Thatcher (Pty) Limited for the purchase of one of its
manufacturing divisions. The statement of income for the year just ended and the current statement of finan-
cial position are summarised as follows:
Thatcher (Pty) Ltd

Abridged Statement of Income
R’000 R’000
Sales All to external customers 376
Less: Materials and components – external 52
Materials and components – internal 43
Manufacturing labour 124
Depreciation on plant and equipment 15
Other manufacturing overheads incurred in division 64
Administrative overheads incurred in division 38
Share of Head Office costs 24 360
Operating profit 16
524
Abridged Statement of Financial Position

R’000
Plant and equipment – cost less depreciation 34
Inventories at cost – finished goods 72
– raw materials 26
186
Less: Trade payables 32
Head Office capital employed 154

‘Materials and components – internal’ represents items transferred from another division. Under Thatcher’s
transfer pricing policy, these items are priced at variable cost plus 30% to cover fixed overheads. Tebbitt
would manufacture the items concerned itself under similar conditions to Thatcher in terms of costs.
Tebbitt would take over all the assets of the division and discharge the trade payables. However, the plant
and equipment is believed to be obsolete. It would be sold f r scrap at R10 000 and replaced by equipment
leased on an annual contract for an initial rental of R25 000 per annum.
Tebbitt believes that inventories of finished goods could be reduced to 50% of their present level. The
reduction would be effected by a special sale immediately after the acquisition, in order to realise R40 000.
‘Share of Head Office costs’ represents an allocation of administrative costs on the basis of divisional sales.
The acquisition would cause Tebbitt’s costs of g n ral manag ment to increase by R8 000.
It is expected that all items of cost and revenue for the division and all working capital items would increase
at 15% per annum, in line with the retail price index for the indefinite future. Tebbitt requires a rate of re-
turn of 21% per annum on new investments.
Assume that all receipts and payments arise at annual intervals.
Required:
Prepare a calculation that will guide Tebbitt in its decision on the maximum sum it should pay for the
division of Thatcher. (25 marks)
(b) Add a brief note on other factors that might influence the decision in practice. (10 marks)
Ignore taxation.
Solution:
1 Evidently the price paid will d pend upon the present value of cash flows stemming from the purchase.
Tebbitt (Pty) Limited
R’000
(i) Annual cash flows (at current prices)
Net p ofit per Thatcher (Pty) Ltd’s accounts 16
Add: Depreciation (Note 2) 15
Internal components (Note 1) 10
Share of Head Office costs (Note 3) 24
65
Le s: Increase on general management cost (8)
Annual lease rental (25) 33
Annual cash flows 32
This annual cash flow is in current purchasing power terms and is expected to rise in line with the
rate of inflation, thus the figure derived must be discounted at the equivalent real rate of interest.
525
The equivalent real rate (r) is found from the money rate (m) (nominal rate) and the rate of inflation
(i) (inflation premium) by using the formula (Exact Fisher)
(1 + m) 1,21
(1 + r) = = = 1,0521739
1+I 1,15
Since this annual cash flow is to arise for the ‘indefinite future’, one should assume that it will arise
to infinity (non growth perpetuity). The present value is thus:
32
PV = = 613 333 (say R613 000)
0,0521739
32(1 + g) 32(1 + 0,15)

or = = R613 333
ke – g (0,21 – 0,15)
Assumption:
Tebbitt’s required return of 21% represents the shareh lders’ required return. Assume therefore
that it is an all-equity company. Assume further that no cash-fl w retentions are required to
maintain the annual dividend payment of R32 000. There is no c mpany business growth as no cash
flows are retained for growth.
Notes:
‘Material and components – internal’. The fix d cost loading has been removed on the assump-
tion that capacity is already available to cop , as follows:
R
Internal components – per Q 43
100
Before fixed costs = 43 × (33)
130
Costs not incurred 10
Depreciation is removed since it involves no cash flow. It is effectively replaced by the annual
lease rental.
‘Share of Head Office costs’ must clearly be replaced by Tebbitt’s assessment of the increase in
its own costs arising from the acquisition.
Once-off cash flows:

In addition to the annual flows, one must consider the once-and-for-all flows envisaged as follows:
R
Sale of plant and quipment 10
Sale of xc ss inv ntories 40
50
Notes:
Since these cash flows arise immediately, they do not require discounting.
No account has been taken of the receipt of accounts receivables or payment of accounts
payables which will be taken over. This is based on the assumption that, together with the nec-
essary inventories, they represent a reasonable level of investment in working capital, which
would otherwise be needed.
Total cash flows
The total present value of future cash flows arising from the purchase is therefore:
R’000
PV of annual flows 613
PV of immediate cash flows 50
Total PV 663
It would thus appear that Tebbitt should not be prepared to pay more than R663 000 for this acqui-
sition, since a negative NPV would result.
526
Other factors which may influence the decision include:

The method and timing of payment
The above computation assumes immediate payment for cash. If payment was spread over a period
of time, the price would be higher (PV of cash payment R663 000). Similarly, if payment was in any
form other than cash (e.g. share or debt issue) this may affect the decision.
The reason for the purchase
The above computations assume that acquisition of this new enterprise will in no way affect Teb-
bitt’s existing operations. If this is not the case, account will need to be taken of the effect on those
operations. For example, acquisition of this new division may provide additional outlets for Tebbitt’s
current production, enabling this to be increased.
In similar vein – if purchase of this division represents the remov l of significant competitor, the
price may well be higher than that computed on the existing basis.
Management confidence/efficiency
The computations above assume that the division in questi n will continue to operate at its existing
capacity and efficiency. If the management of Tebbitt believes it can improve on this state of affairs,
the price might also be higher.
Competition
Allied with the points already mentioned, the price Tebbitt is prepared to pay may be influenced by
who else is in the market for the purchase of this business and what the effect on Tebbitt’s existing
operations would be if someone else acquir d the nt rprise.
Reason for sale
Given that Thatcher is apparently quite prepared to sell an apparently profitable division, it may be
pertinent to consider why this is so and how the sale would affect Thatcher’s future operation, par-
ticularly if Thatcher is in direct competition with Tebbitt.
Diversification
Apart from the direct interaction with existing operations, Tebbitt should give consideration to the
possible change in overall risk associated with its total operations before and after the acquisition. If
the proposed acquisition constitutes a beneficial diversification in the sense of reducing the risk of
the consequent total operations, then a higher purchase price may be justified.

The directors of Townsend (Pty) Limited are currently considering the acquisition of Babs (Pty) Limited, a family
company that manufactures packaging products.
Townsend has accumulat d distributable cash profits of R1,5 million which it may use to increase dividends or
invest in new projects. The dir ctors are reluctant to increase dividends as they are of the opinion that share-
holders would interpret the increase in dividends as being maintainable in the future. The resultant increase
would therefore lead to a substantial increase in the share price of Townsend, and the market is likely to
assume that futu e dividends would be maintained at the current level.
Babs Limited has been targeted by Townsend (Pty) Limited as its manufacturing activities are in a different
industrial sector and therefore presents an opportunity to diversify.
The f ll wing information relevant to the operation of Townsend (Pty) Limited is available:
Dividend gr wth rate 6%
Cum-div market value R5,62 per share
Current proposed dividend R1,04
The current yield on short-term government bonds is 12% and the market return of the industrial share index is
22%. It has been estimated by the financial accountant that the relative systematic risk of Babs Limited is such
hat its beta (β) is approximately 50% of that of Townsend (Pty) Limited.
527
The following information relevant to Babs Limited is available and shows the following comparative values of
historical, replacement and market asset values:
Cost of starting Value of
Historical
up an equivalent assets sold
asset cost
company piecemeal
R’000 R’000 R’000
Land and buildings 252 749 575
Plant and equipment 350 540 440
Net current assets 165 165 165
The following information relevant to Babs Limited is available:

Quoted companies similar to Babs Limited have P/E ratios of 11.
If Townsend started up an equivalent company, it would save R200 000 on plant and equipment, as it
currently holds similar equipment that could be used in the Babs Limited operation.
The current tax rate of Babs Limited is 40% and current earnings after tax are R210 000. Townsend (Pty)
Limited would be in a position to save R30 000 on operating c sts annually.
Expected future growth of Babs Limited is 7% per annum.
80% of Babs Limited’s post-tax earnings are distributed as dividends.
Required:
Calculate
The shareholders’ required rate of return for Townsend (Pty) Limited.
(ii) The beta (β) values of Townsend (Pty) Limited and Babs Limited. (5 marks)
Write a report to the directors of Townsend (Pty) Limited indicating the maximum price that they should
be prepared to pay for Babs Limited and the minimum price that the shareholders of Babs Limited are
likely to accept. The report must explain the principles underlying the recommendation and the problems
associated with CAPM based valuations. (23 marks)
Discuss how the shareholders of Townsend (Pty) Limited might view the proposed acquisition with regard
to –
diversification of Townsend (Pty) Limited;
synergistic benefits; and
(iii) future dividend payments. (12 marks)
Solution:
(i) Sharehold rs’ r quir d rate of return
D1
Market pri e =
ke – g
5,62 – 1,04 = 1,04 (1,06)

ke – 0,06
1,1024
ke – 0,06 =
4,58
ke = 0,24 + 0,06 = 0,30
Beta value of Townsend (Pty) Ltd
Using ke = Rf + β(Rm – Rf)
30% = 12% + β(22% – 12%)
= 1,8
The β of Babs Limited is 50% that of Townsend (Pty) Limited
Beta = 0,9
Required rate of return for Babs Limited
= 12 + 0,9 (22 – 12) = 21%
528
Workings
Valuation of Babs Limited using a dividends growth model
Current dividends R210 000 × 80% = R168 000
Growth = 7% ke = 21%
168 000 (1,07)

Value = = R1 284 000
(0,21 – 0,07)
Earnings valuation
Profit after tax R210 000
Add back: Savings R18 000
Earnings R228 000
P/E ratio for similar quoted companies 11

Adjust for
No stringent corporate governance –1
Credit rating may be low –1
Unquoted share trading difficult –1
Comparable P/E ratio 8
Note: Adjustments to the P/E ratio must be justifi d by factors contributing to risk and those mitigat-
ing against it.
Value R228 000 × 8 = R1 824 000
Asset valuations
Historic Replacement Liquidation
R’000 R’000 R’000
Land and buildings 252 749 575
Plant 350 540 440
Current assets 165 165 165
767 1 454 1 180
Report to the directors of Townsend (Pty) Limited

Subject: Valuation of Babs Limited Prepared by: Jabu Uys
In evaluating the maximum price to pay for Babs Limited, one must consider –
the epla ement value of assets; and
the ea nings potential of Babs Limited.
Townsend (Pty) Limited may invest in a company similar to Babs Limited by purchasing its own land and b
ildings. The disadvantage of doing this is that it lacks expertise and would in future be competing with
Babs Limited. The replacement value of R1 454 000 given above is assumed to be the amount required for
any c mpany wishing to start up an equivalent operation. As Townsend (Pty) Limited already has certain
assets available, the cost of starting up a similar business would be R1 254 000 (R1 454 000 – R200 00).
The earnings valuation of R1 824 000 is probably too high when compared to the dividend valuation or a
et valuation. There is insufficient information about Babs Limited to assess a reasonable P/E ratio. In-
formation required includes gearing, liquidity, growth prospects and production and marketing strategies
s compared to similar quoted companies. Further problems are the reliability of maintainable earnings
nd the anticipated savings.
The directors should also consider any assets that may be superfluous after the takeover. Certain assets
may be liquidated, and the funds used to finance the takeover. A maximum price of approximately R1 500
000 is recommended.
529
The minimum amount that the shareholders of Babs Limited are likely to accept depends on the alterna-
tives open to them. The shares are relatively unmarketable; therefore they must consider the liquidation
value of the business, which is R1 180 000.
However, if they are happy to continue in business, the valuation of R1 284 000 is likely to be more
relevant. This price is based upon future dividends discounted according to their level of systematic risk.
In this situation, much will depend upon the validity of the calculated beta (β ) factor of 0,9. Secondly, the
CAPM is a single-period model, and caution must be exercised in applying it in a multi-period context. It
must be remembered that the beta (β) factor for Babs Limited is only an estimate, and no supporting evi-
dence is provided. As a result, the valuation should be used with caution. A minimum selling price of R1
200 000 is recommended.
Overall, in determining maximum and minimum prices for the firm, the bove figures are only as good as
the techniques employed and the data provided. In reality, much will depend upon how badly Babs Lim-
ited wishes to sell, and upon how important the directors of Townsend (Pty) Limited perceive the takeo-
ver to be. In the end it comes down to negotiation between the parties.
(c) The directors of Townsend (Pty) Limited see the acquisiti n f Babs Limited as an opportunity to diversify. In
itself, this justification for the takeover is unlikely to be interesting to the existing shareholders. If they
hold well diversified portfolios, they can achieve the benefits f diversification just as well by investing the
excess funds for themselves. Such an arrange ent would probably be less costly when the usual premiums
for takeover bids are considered, and it would also offer greater flexibility to the shareholders. Although
the shares of Babs Limited are unlikely to be available to them, they should easily be able to lo-cate
securities with similar levels of systematic risk. In addition, if given the cash and allowed to make their
own investment decisions, they could sel ct s curiti s for investment most suitable to their own risk to
return preferences. However, if Townsend (Pty) Limit d’s equity-holders are not well diversified, they
might welcome the risk reduction effects of the takeover. This might be the case, particularly if the undi-
versified shareholders would be subject not only to brokerage costs on liquidating their investment in
Townsend and investing it elsewhere, but also subject to tax on any past unrealised increases in the value
of their holdings. In this situation, corporate diversification could be more cost effective than personal di-
versification.
The proposed acquisition might reduce the variance of the operating income of the combined companies
and hence reduce the financing costs of the firm. This, together with the attendant reduction in expected
bankruptcy costs, could be of interest to even well diversified shareholders.
Shareholders will also be attracted by any synergistic effects of the takeover. As the two firms are en-
gaged in different activities, the chances of synergistic effects in the areas of production and marketing
seem remote; however, administration and financial savings could result. For example, the R30 000 tax
reduction in operating costs could mean increased returns to shareholders. The possibility of further op-
erating economies should be investigated.
Any impact on the future dividend policy of Townsend (Pty) Limited will also be of interest to existing
shareholders. As Babs Limit d’s growth rate is higher than that of Townsend (Pty) Limited, the firm’s abil-
ity to stick to its chos n dividend policy of 6% growth per annum might be improved.
In the final analysis, much will depend upon the terms of the takeover and the alternatives open to
Townsend (Pty) Limited. If a substantial premium is paid for the shares in Babs Limited, and it outweighs
any of the benefits outlined above, a transfer of value will take place between Townsend (Pty) Limited’s
and Babs Limited’s shareholders. This is unlikely to be an attractive proposition. However, it must be con-
sidered in the light of the alternatives available. If, for example, the cash were to remain as an idle asset,
the shareholders would still suffer a substantial loss. Alternatively, if the cash were paid out as a dividend,
the shareh lders must consider the transaction costs of investing the surplus cash.
Que tion 12–9 (Advanced) 40 marks 60 minutes

The directors of Elisa Ltd are considering the acquisition of the entire share capital of a private limited compa-
ny, Aminta (Pty) Ltd, both companies being wholly financed by equity capital. Elisa Ltd prepares annual ac-
counts to 31 December and the takeover would take place on 1 January 20Y3. A project analyst, charged with
the t sk of collecting sufficient relevant information, has discovered that Tamiri Ltd is the public company most
closely resembling Aminta (Pty) Ltd. It has an equity cost of capital of 19,3% and a P/E ratio of 7,9. Tamiri Ltd is
530
engaged in the same line of business as Aminta (Pty) Ltd, and has very similar business and financial risk charac-
teristics. The following details relating to Elisa Ltd and Aminta (Pty) Limited has been provided by the Analyst:
Elisa Ltd has an equity cost of capital of 15,85%. The analyst estimates that, if Aminta (Pty) Limited is
acquired, the cash flow of Elisa Ltd for the year to 31 December 20Y3 will be increased by an amount
equal to 105% of the 20Y2 net profit of Aminta (Pty) Limited before deducting directors’ emoluments.
These additional cash flows will amount to 30% of the combined cash flows of the enlarged Elisa Ltd for
20Y3. The analyst does not expect any economies of scale from the takeover, and predicts that the cash
flows of Elisa Ltd will increase by 5% per annum compound in 20Y4 and subsequent years, regardless of
whether Aminta (Pty) Limited is acquired.
Aminta (Pty) Limited produces annual accounts to 31 December which show the following net profit
figures (after deduction of directors’ emoluments):
Year R
20X7 619 000
20X8 600 000
20X9 524 000
20Y0 604 000
20Y1 628 0198
20Y2 (estimated) 790 000
The draft 20Y2 annual accounts also show that the net assets of Aminta (Pty) Limited are R3 618 000 on
an historic cost basis and R6 375 000 on a replacement cost basis. The analyst estimates that the assets of
Aminta (Pty) Limited would realise approximately 4 000 000 on liquidation. The two directors and only
shareholders are Mr and Mrs Alessandro, whose emoluments appear to average 10% of the net profit
figures, after deducting those emoluments.
Required:
Explaining the underlying principles –
calculate the maximum sum that the directors of Elisa Ltd should be willing to pay for the share capital of
Aminta (Pty) Ltd; and (24 marks)
calculate the minimum sum that Mr and Mrs Alessandro would be willing to accept for their shareholding
in Aminta (Pty) Ltd. (16 marks) Ignore taxation.
(ICAEW)
Solution:
Maximum sum that the directors of Elisa Ltd should be willing to pay for the share capital of Aminta
(Pty) Limited
The maxim m s m which the directors of Elisa Ltd should pay for the share capital of Aminta (Pty) Limited
is eq al to the increase in the wealth of Elisa Ltd’s shareholders as a result of the acquisition. This in-
crease in wealth will come from the extra cash flows which the acquisition will generate for the acquiring
shareh lders, either as an income-producing going concern, or by the sale of its assets, or by some com-
binati n f the two.
The maximum going concern value of Aminta (Pty) Limited can be estimated as the present value of the
additional cash generated by its earnings to perpetuity. The appropriate discount rate must depend on
the attached to these earnings. Elisa Ltd’s existing cost of capital is not relevant, unless the new company
is not expected to alter the risk of Elisa Ltd (which is unlikely, given that it will constitute 30% of the new
com-pany).
A more suitable discount rate can be found by examining the cost of capital of a quoted company which closely
resembles Aminta (Pty) Ltd in terms of business and financial risk characteristics. Tamiri Ltd is such a company.
No extra risk premium need be added to this discount rate because, although Aminta (Pty) Ltd is
531
a smaller private company, the combined cash flows will be those of a public company. Thus, using the fi-
nancial analyst’s estimates:
R
20Y2 net profit of Aminta (Pty) Limited 790 000
Add: Directors’ emoluments (10%) 79 000
R869 000
Additional cash for Elisa Ltd in 20Y3 (105%) R912 450
Approach A
Assuming a 5% growth rate and a 19,3% discount rate appropriate to the risk of the cash flows
R912 450
Present value of additional cash receipts = = R6 380 769
0,193 – 0,05
Approach B
An alternative (and possibly better) approach uses the fact that the additional cash flows will amount to
30% of the combined company.
The appropriate discount rate for the cash flows of the co bined company will be the weighted average of
Elisa Ltd’s present cost of capital, that is 15,85% and the rate appropriate to the new cash flows, that is
19,3%. Thus, (0,7 × 15,85%) + (0,3 × 19,3%) = 16,89%.
20Y3 cash flows from Aminta (Pty) Limited = R912 450
100
Thus, 20Y3 combined cash flows of firm = 30 = × R912 450 = R3 041 500
Present value of combined firm to perpetuity, assuming 5% growth

R3 041 500
= = R25 580 319
0,1689 – 0,05
20Y3 cash flows from Elisa Ltd above = 0,7 × R3 041 500 = R2 129 050
Present value of Elisa Ltd to perpetuity, assuming 5% growth
R2 129 050
= = R19 622 580
0,1585 – 0,05
Increase in value of firm following the combination with Aminta (Pty) Limited
R25 580 319 – R19 622 580 = R5 957 739
The two approach s produce different answers because the calculation of the weighted average discount
rate in Approach B does not involve the 5% growth rate. Both methods would produce the same solution
if no growth in earnings was expected, or if discount rates were calculated in real terms.
It is the efo e difficult to say which (if either) method is superior, but it was indicated previously that
Approach B is p eferred.
F rther notes to the solution:

P rtf lio effects of risk reduction by combining the two sets of cash flows have been ignored, as there is
no basis on which to make estimates. It is likely, however, that the new cost of capital of the en-larged
Elisa Ltd will be lower than the weighted average of 15,85% and 19,3%.
The analyst expects no economies of scale. His estimate of extra cash flows resulting from the acquisi-
tion of Aminta (Pty) Limited really amounts to an assumption that Aminta (Pty) Limited’s profits be-
fore directors’ emoluments are equal to distributable cash, which will grow at 5% per annum. These
assumptions can be challenged, as follows –
there may be economies of scale;
profits are likely to be greater than distributable cash when there is growth;
Elisa Ltd may not be able to save all of the directors’ emoluments; and
532
5% may not be an appropriate growth figure. Some of these reservations are expanded below
(see 4, and (b)).
Past growth of Aminta (Pty) Limited

If “g” is the average annual growth rate in profits for the last five years, then
5 = 790
(1 + g) 619 = 1,276
From compounding tables, g = 5% per annum.

This average growth rate hides a slump in profits between 19X7 and 19X9, but a high growth rate
thereafter. If g = growth rate for the last three years, then
3 = 790
(1 + g) 524 = 1,508
From compounding tables, g approximates 15% per annum.

It may be that Aminta (Pty) Limited has recovered fr m previ usly ailing profits and will show a growth
rate higher than 5% in the future.
4 Valuation by P/E ratio

The P/E ratio of the similar public company, Ta iri Ltd, is 7,9. Applying this multiple to the current
ings of Aminta (Pty) Limited before directors’ earn-molum nts gives
R869 000 × 7,9 = R6 865 100
However, a P/E ratio taken from one company cannot be blindly applied to another, even if it has the
same business and financial risk characteristics, because the expected growth rate of Tamiri Ltd might
be very different from that of Aminta (Pty) Limited.
The directors of Elisa Ltd should have more confidence in the Discounted Cash Flow (DCF) valuation
than the P/E valuation.
Sales of assets
If Aminta (Pty) Limited was acquired and then sold, its assets would realise R4 000 000. It would not
therefore be acquired for this purpose, but as a going concern.
Conclusion:
The maximum sum which should be paid by the directors of Elisa Ltd is approximately R6 million.
The minimum sum which Mr. and Mrs. Alessandro should be willing to accept for their shares
This depends on the alternatives to accepting an offer from Elisa Ltd. The minimum sum to be accepted
from Elisa should be equal to the highest of these alternatives.
It is not clear how much of the directors’ emoluments paid to Mr and Mrs Alessandro is pure emolument
in retu n for wo k done, and how much is (in effect) payment for capital invested. This would have a bear-
ing on what salaries would have to be paid to managers to run the business, which would enable Mr and
Mrs Alessandro to retire but to remain as shareholders. Also relevant would be the salaries they could
earn elsewhere if they were to sell out of Aminta (Pty) Limited.
Furtherm re, it is not known whether they need to sell out at present and, for example, retire or whether
they are quite happy to remain in the business for a number of years.
Any calculations must therefore be speculative. Some possible alternatives are as follows:
Retire or find employment elsewhere, but remain shareholders, appointing directors to run the
business at total annual emoluments equal to those of Mr and Mrs Alessandro.
This would produce income of R790 000 × 105% in 20Y3, growing at 5% per annum. Discounted at
19,3%, this has a present value of:
R790 000 × 1,05
= R5 800 700
0,193 – 0,05
533
There are many assumptions and problems behind this calculation, including –
a growth rate of 5% to perpetuity is again assumed;
the discount rate of 19,3% applies to a quoted company. This should possibly be raised to
account for the lesser marketability of shares if the company remains private; and
Mr and Mrs Alessandro are unlikely to find employment elsewhere at their present salaries if
the business is specialised; however, they may not wish to continue working, and retire instead,
or, they may wish to use their time to develop a new business.
The company could become a public limited company with the aim of having the shares quoted by
the stock exchange or introduced into the unlisted securities market. This would give the shares a
marketable value more like the R6,38 million figure discussed in (a), Approach A. There would, how-
ever, be significant costs incurred in the flotation.
The sale of some of the company assets. This is the rock-bottom alternative, and would raise R4 000
000.

Doc Ltd, a manufacturer of patent medicines and personal hygiene products, was finding it expensive to pro-
mote this range of items through established retailers. It therefore, so e ten years ago, acquired a well-known
chain of retail chemists and modernised its shops. This expansion enabled Doc Ltd to enter a new segment of
the market.
Several of the company’s directors now believe that this policy did contribute to increased sales, but that
neglect of its traditional business allowed competitors to attack its own brands. This has led to a less than
expected return on its operating capital.
In order to rectify this situation, it has now been proposed that Doc Ltd should enter into negotiations with
Health Ltd, a family-controlled pharmaceutical supplier which imports unbranded drugs. Its premises are
equipped as a warehouse and distribution centre.
Extracts from the annual returns are summarised as follows:

Abridged Statement of Income
Doc Ltd Health Ltd
20X1/X2 20X2/X3 20X1/X2 20X2/X3
R’000 R’000 R’000 R’000
Sales 200 854 230 985 62 400 63 835
Cost of sales 158 343 178 568 44 050 43 768
42 511 52 417 18 350 20 067
Interest (net) 4 779 5 238 1 250 1 100
37 732 47 179 17 100 18 967
Taxation 10 320 13 210 5 472 5 690
27 412 33 969 11 628 13 277
Dividends 14 835 15 000 9 800 10 700
Retained 12 577 18 969 1 828 2 577

Doc Ltd Health Ltd
20X1/X2 20X2/X3 20X1/X2 20X2/X3
R’000 R’000 R’000 R’000
Issued shares 100 000 100 000 100 000 100 000
Share premium 25 110 25 110 3 000 3 000
Retained profit 80 217 99 186 2 750 5 327
205 327 224 296 105 750 108 327
Loan capital 28 000 28 000 8 500 9 000
233 327 252 296 114 250 117 327
534
Over the last three months, the ordinary shares in the two companies have been traded within the following
price ranges:
Doc Ltd (25 cent par value share) 237 to 251 cents
Health Ltd (R1,00 par value share) 180 to 195 cents
30% of Health Ltd’s shares are in the hands of financial institutions; 15% are owned in small lots, and the
remaining shares are in trust for various members of the founder’s family. Many of the trust’s beneficiaries
have made it known that they would press for a reasonable bid to be accepted.
Required:
Advise Doc Ltd’s directors whether a merger with Health Ltd would be to the advantage of Doc Ltd’s
shareholders. (10 marks)
Calculate the highest and lowest bid price for Health Ltd between which Doc Ltd can negotiate, and
recommend an appropriate bid price that, in addition to being satisfactory to the trust’s beneficiaries,
would also be of interest to the financial institutions. (13 marks)
Discuss the reasons why a company with a high P/E ratio believes that it can increase its share value by
simply acquiring a similar company with a lower P/E ratio. (12 marks)
Solution:
(a) In advising Doc Ltd’s directors about the benefits of a erger with Health Ltd, a number of factors need to
be considered:
The most apparent one is that of the price to be paid for Health Ltd. There have been a number of repu-
table empirical studies which indicate that mergers are not financially worthwhile for the acquiring com-
pany; therefore the price assumes even more importance. As Doc Ltd is intending to enter into
negotiations with Health Ltd, there is a possibility that a merger that is recommended by Health Ltd’s
board may result, and this is likely to prove cheaper than a contested bid.
It is noticeable that Doc Ltd, both ten years ago and now, has sought the answer to its difficulties by
pursuing a policy of external acquisition. Such a policy has its attractions, for example it offers the pro-
spect of rapid growth, but it also has inherent difficulties, such as the absorption of an ‘alien’ organisa-
tion.
Given that some of Doc Ltd’s directors have questioned the success of the previous acquisition, it may
prove instructive to carry out a post-audit on that acquisition, and to try to relate that experience to the
proposed acquisition of Health Ltd (this procedure may have already been carried out if Doc Ltd has an
established corporate planning function).
Other benefits may arise incidental to the main purpose of the acquisition, for example Health Ltd may
have under-exploit d brands or assets (such as land). Doc Ltd may be in a position, because of its greater
financial resourc s, to xploit these assets.
It may be thought that, as Doc Ltd and Health Ltd distribute related products, there is an opportunity for
some operating synergies. In reality, such operating synergies are difficult to realise, although financing
synergy is mo e likely.
It is difficult to be prescriptive about the potential benefits which should be apparent to Doc Ltd’s board;
b t it m st weigh these against the potential disadvantages.
A consideration of the financial data may be useful in establishing some parameters for the bid price.
A traditi nal yardstick in such a situation is to calculate the P/E ratio, as this reveals the market’s capitali-
sati n f the company’s earnings at a specific point in time. In order to simplify the analysis, it is assumed
that both Doc Ltd’s and Health Ltd’s earnings are of the same risk class.
Doc Ltd Health Ltd
Earnings after interest and tax: 20X2/3 R33 969 R13 277
Number of shares 400 000 100 000
Earnings per share 8,5c 13,3c
251c 180c
8,5 13,3
P/E = 29,5 13,5
535
Thus, one parameter could be established: if Health Ltd’s earnings stream were to be incorporated within
Doc Ltd’s and if Doc Ltd’s P/E ratio were maintained, this would imply a price per Health Ltd share in the
region of 13,3c × 29,5 = 292c.
In reality, an efficient market is unlikely to apply Doc Ltd’s capitalisation rate to Health Ltd’s earnings,
simply because the legal entities have merged.
However, the disparity in rating between the two companies implied by the respective P/E ratios may
have arisen because of the nature of Health Ltd’s ownership. Currently, control resides with the trust,
which owns 55% of the equity. The remaining 45% is not a coherent bloc. It is possible that, in the past,
Health Ltd may have followed policies which suited the beneficiaries of the trust, but were not in sympa-
thy with market sentiment. If Health Ltd became part of Doc Ltd and market oriented policies were fol-
lowed, the value of each share would rise accordingly.
An ‘appropriate bid price’ would seem to lie between the current 180c to 195c and an upper limit of
R3,72. If further information were available, then a realisation or ‘break-up’ value per share could be cal-
culated, and this could provide a new floor value. This value is likely to differ from the value revealed by
the current statement of financial position.
A final consideration that will influence the price Doc Ltd is willing to pay is the value of Health Ltd’s
potential and assets not revealed in its accounts, for example the value of Health Ltd’s brands (if any),
scope for expansion offered by the merger, any operational econo ies arising from the merger.
Where two comparatively identical companies exist, the P/E ratio should be identical for both companies.
However, if one of the companies has a higher P/E ratio, the resultant higher stock market value could be
due to its perceived higher growth potential.
The acquiring company with the higher P/E ratio (Doc Ltd in this instance) will negotiate the purchase
price at the current market value of the company being acquired (Health Ltd).
Where settlement is effected by means of a share issue, the resultant total shares and total earnings will
be such that the new earnings per share will be higher than the previous earnings per share. Since the
price of a share is related to the earnings per share, if the P/E ratio and the earnings are known, then
price equals P/E ratio multiplied by earnings.
If the market believes that the management of the purchasing company will use its abilities to achieve a
similar growth rate on the assets of the purchased company as it has on its own assets, then the market
would keep the same P/E ratio, which will result in a higher value per share.
One could argue that the market value of the combined firm is the sum of the values of the separate
companies before the merger, and that the result of the merger will be to lower the P/E ratio of the new
company in comparison to the P/E ratio of the purchasing company.
In practice, the stock market tends to attach a higher P/E ratio to the company after the acquisition than
would be expected from the above logical analysis, as investors tend to have optimistic expectations after
a merger (they hope conomies of scale or improved management will lead to improved performance.
536
Chapter 13
Financial distress
calculate the realisable value of an enterprise;

design a reorganisation scheme;
determine the capital requirements in order to effect a turn-around;
determine the capital contributions of different parti s;
calculate the cost of bankruptcy;
calculate the rehabilitated value of an enterprise;
do the liquidation accounting entries;
calculate a crossholding;
understand the winding up of a company; and
calculate the profit or loss on a liquidation.
The biggest risk that any company may face is that it will fail financially. If such a failure is terminal and the
company cannot be rescued then ity will be declared insolvent and will face liquidation. If the financial condi-
tion is not terminal it means that it is possible to rescue the company if it receives the correct remedies from
competent experts.
13.1 Companies Act 71 of 2008

The previous Compani s Act 61 of 1973 made provision for judicial management to save companies in financial
distress from being wound-up. This approach had major drawbacks though, which necessitated an overhaul of
the system. For instan e, ex ept where the directors may have been held personally liable as a result of breach
of sections of the Companies Act (and presuming they were able to make adequate restitution in any case),
employees and c edito s had no choice but to wait in line for their proportionate share of whatever could have
been realised by the judicial manager, leading in turn to great dissatisfaction and often no incentive to work
towards the b siness being rescued.
537
The new Companies Act 71 of 200 8 now makes provision f or t wo po ssi bilities (see diag ram be low ) w hen a
company finds itself in a p ositio n of busine ss fail ure:
Fig ur 13 .1: Bu sine ss faili ng financi ally
The f ollowin g sections of th e C om panies Act 71 of 20 8 a re particu lar y i mp rtant wh en onside ring poss ible
busin ess failure:
Companies Act 71 Cha pte r T opi c
Chapter 1 (s ection 4) Relat es to the solven cy and liq uid ity test. T his now h as wid er app lica tion t han
th e p rev ious C om pani s Act.
Chapter 2 (s ections 44-47) M atters su ch a s finan cial assistanc , loan s or o the r fin an cial ass ista nc e to dir ec-
to rs and relate d a nd inter-r elated compani es, dist rib utio n to s hareho lders, the
offering of a c ash al ter ative in p lace o f c apitalisati on, sha res and share b uy-
backs or buy-in s.
Chapter 5 (s ection 113 ) Amalga mations or m erg rs.
Chapter 6 Busi es s rescue a nd c om pro mi ses with cr editors.
Chapter 12 Liquidation.
In th e fo llo wing section we will look in m ore detail int o t he princi ples for busi nes s r scu e as set ou t in
Chapter 6 of th e Co mp anies Act.
13 .1. 1 Busine ss Res cue

Chapter 6 of th e Co mp anies A ct dea ls with the fo llo wing matt ers and is divided in to f ive parts:
Part A C om pany r soluti o ns to ent er into b usin ess re scu e p roc eeding s, and eff ects on e mpl oyees, sha re-
h olde rs and dir cto rs of busi nes s r esc ue o pe rations.
Part B A ppoint me nt and functio ns of a busin ess rescue pra cti tion er.
Part C T e righ ts of affec ted per son s duri ng b usiness re scu e proceed ing s.
Part D T e d ev elop me nt and approval of t he bus iness rescue pla n.
Part E T e compro mis e betw een th e compan y and its c red itors.
What is financi al distress?

In rd er f r a b u sin ess re scu e to be imple me nte d, t he part icular com pany mu st be finan cially d ist ress
ed, wh ich m ean t h at it i s re aso na bly unlikely t o p ay all of its debts as th ey fall du e a nd pa yable o r t hat
it is li kely to beco me inso lvent with in the ens uing six m on ths.
M eaning of bus iness rescue

A busine ss rescue can be described as th e pr oc eeding s to re habilita te a c om pany th at is f na ncially distressed
by provi d ing f or t he te m po rary su spe nsion of the compan y’s man ag em ent of its own affairs, bus iness and pr
ope rty . This i mplies a t mp or ry mo rat rium o n the righ ts of claim ants and the devel opm en t an d i mplemen-ta
tion of a plan to res cue th e co mp any by re structurin its aff air s in a m anner th at m aximi ses the lik elihoo d of th
e co mp an y co ntinui ng on a so lvent b asis a nd if not possible the li quid ation of the com pany. Th e intentio n of
538
Financial distress Chapter 13
the moratorium is to give the company the best chance to implement its plan and to allow the company suffi-
cient time to restructure its affairs and particularly its liabilities, so as to enable it to return to a sustainable
solvent position and to continue as a going concern.
Once a business rescue order is obtained a temporary moratorium for application for liquidation takes
effect. The figure below sets out the role-players in the business rescue process:
Share
HARE
holders
HOLDERS
DIRECTORS
POST POST
COMMENCE-
Directors Commencement
MENT
FINANCIERSCIERS
Business
BUSINESS
EMPLOYERS RESCUE
Employers RESCUE
PRACTITIONER
COMPANY
Court Company Credito rs
OURT REDITORS
ATTORNEY
Attorney
Security
SECURITY
HOLDERS
RS
Trade
ADE
UNIONN
Figure 13.2: Role-players in Business Rescue
Summary of the process

The company through a board resolution or an affected person or through a court order can apply for a busi-
ness rescue. A rescue practitioner is then appointed who:
takes control of the books and records of the undertaking;
receives a statement of affairs from the directors;
l arranges a first m ting of creditors;
prepares and publishes the Business Rescue Plan; and
arranges a meeting to onsider and vote on the Business Rescue Plan presented at the meeting.
The approved plan then has to be implemented.
Business Resc e Plan Layout

The business resc e plan must contain all the information reasonably required to facilitate affected persons in
deciding whether or not to accept or reject the plan, and must be divided into three main parts, as follows:
Part A – Background
Part B – Proposals
Part C – Assumptions and conditions
C se Study: Actual Business Rescue of a Medicine Manufacturing Company

Background
The company was established in 1998. Its core business was to provide total healthcare support solutions
(medical, surgical, dental and pharmaceutical products) to the public and private healthcare sectors in South
539
Africa and SADC countries. During the latter part of 2011 severe cash flow difficulties forced the company to
consider the options of liquidating or restructuring its business activities. On 24 February 2012, the company
filed a notice to commence a Business Rescue in terms of section 129 of the Companies Act. On 1 March 2012.
Piers Marsden , an Executive Director at Matuson and Associates, was appointed as the Business Rescue
Practitioner of the company. At a meeting of creditors on 12 March 2012, the practitioner presented initial
findings in support of his expressed opinion, ie that there was a reasonable prospect of a Business Rescue
being successful. The company had the added benefit that the shareholders also owned the building from
which it was trading at that stage.
Reasons for distress:

Debt administration and trade
– Non-profitable agencies that were financially supported through the supply of inventory on credit,
promotional material, helpline services, etc, but the income kept l gging behind the expenses.
– Deterioration of government debt repayments.
This resulted in up to 50% of debtors’ books being in arrears for more than 120 days.
Production
Legal requirements regarding good manufacturing practice (GMP) . In order to comply with GMP the
manufacturing facility had to be closed down for refurbish ent. The factory was closed during September
2011 with the expectation to be back on-line in June 2012.
Management
Top management did not anticipate the result of not impl menting adequate financial controls. Share-
holders took corrective action by appointing a n w managing and financial director to manage the com-
pany going forward.
Immediate actions taken by the Business Rescue Practitioner:

Organising Preferential Capital Funds (PCF)
It was evident that without PCF, the company would not be able to continue trading and would ultimately
face liquidation. The following PCF was secured:
– Bank funding: In addition to retaining the current overdraft facility, an additional funding line was
arranged with the company’s bankers, First National Bank.
– Supplier funding: Agreements were reached with certain suppliers to continue supplying the company
with raw materials, capital equipment and services which were considered critical to ongoing trading.
Payment terms were agreed depending on the type of supply and the suppliers’ own circumstances.
Smaller suppliers were given the benefit of being paid on delivery.
– Shareholder funding: Shareholders’ loans were subordinated and partially converted to equity, there-by
reinforcing the statement of financial position. Shareholders also agreed to forego rental and man-
agement f s ov r the BR period.
Organising Working Capital Funding
The Industrial Development Corporation (IDC) was approached to provide the company with working
capital finance in o der to keep daily operations going. The process was as follows:
– After submission of the application a due diligence process was requested which turned out to be nq
alified and the application was then presented to the credit committee of the IDC for final ap-
proval.
– The ab ve process resulted in delays in the Business Rescue time-line and the Business Rescue Practi-ti
ner submitted an application for an extension for the publishing of the plan by 35 days, which was
granted.
– The IDC required the latest set of audited financial statements before final approval of the application
could be considered. The financial statements reflected a qualified opinion and included an emphasis
of matter as a result of the existence of material uncertainty which has cast significant doubt on the
company’s ability to continue as a going concern.
– The Business Rescue Practitioner was now confronted with the question of how to get around this
situation.
540
Business Rescue Plan:

The Plan
Business Rescue Liquidation

The negative impact of the plan on In a liquidation, 146 people will lose their
employees is limited to a possible jobs and would receive the preferential
Employees retrenchment of 25 people who will portion of approximately R28 000,
receive full retrenchment packages. significantly less than what would be
received in business rescue.
Suppliers would continue to service the The services of 174 suppliers will be
company, and would prosper with the termin ted, with ten suppliers facing
Suppliers
growth of the company. possible business f ilures as a result of
losing their major customer.
The company will quickly resume the The closure of local manufacturing facilities
supply of essential healthcare products will l wer the barriers to entry for foreign
to the public sector, thereby limiting the players in the local pharmaceutical market
South African negative impact on patient care. and will give them an opportunity to
Healthcare and Furthermore, should the company further entrench themselves in the local
Opportunities continue to trade, there are a nu ber of economy. Increased pricing by foreign
exciting opportunities in the immediate co petitors with high cost bases will be
future, particularly in the manufacturing detrimental to the affordability of general
sector given its compliance with GMP. healthcare for South Africans.
Dividend to Business rescue will enable creditors to A liquidation of the company would result
Concurrent realise 50% of their debt. in concurrent creditors receiving virtually
Creditors zero returns.
Initiation
Interested parties notified that the moratorium was activated and operational.
Concurrent creditors (also referred to as unsecured creditors, for example trade creditors)
– Calculations based on the scenario that the company would be liquidated indicated that a 50% reduc-
tion in their debt would be a fair assumption.
– The creditors agreed to this write off and also the remaining balance of 50% to be repaid over a three-
year period.
Secured creditors (for example, banks who have securities against the loan)
– For the period of Business Rescue, the bank agreed to retain its current overdraft exposure with no
fixed repaym nt t rms.
Statement of financial position
– Restoring solven y and liquidity (see section 4 of the Companies Act).
– Conve ting sho t-term obligations to long-term debt in order to spread the repayments and improve sho
t-te m cash flow.
B siness initiatives
– Foc sing the marketing drive on the more profitable and cash-flush private sector.
– Reducing the dependency on government business.
– Changing the way the company does business with government (i.e. managing the debtors’ book in
terms of account limits and terms of repayment).
– Diversifying into export markets.
– Improving efficiencies and reducing the cost base.
– Restructuring the workforce without unnecessarily reducing the number of workers.
– Managing working capital in terms of stock turnover, debt settlement and debt collection.
Operational initiatives
– Ensuring that the new facility is approved by the Medicines Control Council and opened for produc-tion
on the planned date.
541
– Closing down of non-profitable agencies and restructuring relationships with profitable agencies where
possible in order to ensure sustainable future profitability.

Before After
Dr Cr Dr Cr
R’m R’m R’m R’m R’m R’m
Current assets 48,8 10 5 63,8
138,8 153,8
Equity (8,6) 15,4 19,8 26,6

Shareholder’s loans 29,8 19,8 10
Other long-term debt 57,2 10 67,2
Concurrent creditors 30,8 15,4 15,4
Other preferential creditors 29,6 5 34,6
138,8 153,8
Adjustments
l IDC loan (R10m) and FNB (R5m) R15 million r ceived and reflected under current assets
l Concurrent creditors’ reduction R15,4 million written off against equity
l Shareholder loan 19,8 million converted into equity
Results
The writing off of 50% of the concurrent creditors’ debt reduced current liabilities by R15,4 million, thus
greatly improving the company’s liquidity position and enabling the restructuring to continue. It was writ-
ten off against equity, thus improving solvency.
Loan finances of R10 million from the IDC and R5 million from FNB increased current assets by
R15 million, other long-term debt by 10 million and current liabilities (other preferential creditors) by R5
million.
Solvency of the group improved by R35,2 million.
13.2 Reorganisations (business rescue proceedings)

There are normally two r asons why a company will consider reorganisation.
Scenario A:
A company may find itself in a position where it has been operating at a loss over a period of time, but the
operating and manage ial factors responsible for the losses no longer exist. With the factors that had a nega-
tive infl ence on its b siness out of the way, the company could be profitable in future. The problem is that by
this time the financial resources of the company would have been eroded to the point where it can no longer
continue to operate effectively. The company could be technically insolvent. The danger is that if concrete
steps are n t taken to pay debts owed and dividends are not declared soon, the company could be forced into
liquidati n.
Scenario B:
A company may be profitable and growing but may have reached the stage where it has insufficient capital avai
ab e to finance capital expansion and/or working capital requirements to accommodate its growth.
In both the scenarios described above, some sort of reorganisation is needed to get the company onto a sound
fin ncial footing. The focus of this section will be on scenario A as we are dealing with companies that are in
financial distress.
542
When a reorganisation scheme is implemented, the control of the company usually remains in the hands of the
present controlling members of the company. The changes effected by the scheme usually relate to existing:
shareholders;
long-term credit suppliers;
bondholders;
debenture holders;
short-term credit suppliers; and
other stakeholders, i.e. employees, etc.
13.2.1 Conditions for a reorganisation scheme

It is of the utmost importance that it be determined whether the business entity concerned is able to begin
operating profitably immediately after a reorganisation scheme is undertaken. Before implementing such a
scheme a pre-assessment should be done. The reorganisation scheme sh uld not merely postpone the inevita-
ble liquidation of the company but should be the reason why the c mpany will be profitable in the future.
In essence, a reorganisation involves the scaling down of clai s against the company that is being reorganised.
Prerequisites for scaling down are:
the process must be fair to all parties concerned; and
the reorganisation process must be financially f asible.
Financial decisions
If a company is failing, a decision must be made whether to liquidate it or to keep it active through a business
rescue scheme (reorganisation) . This decision depends on the value of the firm if it is rehabilitated (reorgan-
ised) versus the value realised if it is liquidated.
Determination of the liquidation value
The liquidation value depends on the realisable values of the assets to be sold as well as liquidation costs such
as legal costs, administrative expenses, liquidator’s fees, accounting fees and business rescue practitioner’s
fees.
A reorganisation scheme also involves some additional expenses. Normally, there might be capital expenditure
(to upgrade existing plant and machinery or technology), obsolete inventory must be disposed of and replen-
ished where necessary, and the quality of management must be evaluated and if necessary changed if it feasi-
ble to do so.
In determining the final value of the company to be reorganised, the following elements should be considered
and valued:
The value of the ompany if it was totally financed by means of own capital
Net P esent Value (NPV) of the assessed loss of the company
P esent Value (PV) benefits that are derived from outside funding
Q antified PV benefits of managerial changes
Q antified PV benefits of changes in strategies, policies and structures of the company
– PV f bankruptcy costs irrespective of the value of the company
One hould also evaluate the expected increase in income and possible dividends the reorganisation scheme
would generate for the shareholders of the company if successfully implemented. If the outcome is negative
the possibility of liquidating the company should be seriously considered. If positive the rescue of the company
is feasib e.
C pit l requirements
Enough working capital must be accessed and generated by the scheme to put the company on a sound and
liquid footing. This is necessary because historical losses would have created illiquidity in the company.
543
Facts to be borne in mind when considering capital requirements are:

enough cash should be generated to finance inventory and debtors at higher levels of sales;
long-term assets should not be financed by short-term credit;
enough cash should be provided for in order to pay dividends as soon as possible after profits are gener-
ated;
current and acid-test ratios should be at the same level as that of the industry in which the company is
operating; and
assets in excess of the needs of the company should be sold in order to e iminate unused capital and
capacity.
Capital contribution
Besides outside funding, other sources of capital could be the sale of redundant or surplus assets and the
raising of new share capital. It is desirable that new share issues should as far as possible be limited to the
existing shareholders in order to protect the control of the principal shareh lders.
It is important to note that an existing shareholder would only accept a re rganisation proposal and commit
further funds to the company in distress if the NPV of future expected dividends and market value added
exceeds the expected liquidation dividends and additional cash invest ent required of them.
Example: Revised capital structure or liquidation (Int rm diate)

Mr Alberts owns 10 000 ordinary shares of R2 each in A Ltd. He has been called upon to accept a proposal
whereby his share capital will be reduced to 10 000 ordinary shares of R1 each and to take up an additional 10
000 ordinary shares of R1 each. The liquidation dividend, if the liquidation is enforced, will amount to a once
off, 70c per share. If the reorganisation proposal is accepted by interested parties the effect will be as follows:
New capital structure
– 1 000 000 ordinary shares of R1 each
– 100 000 10% preference shares of R1 each
A market value per share of:
– 258c (after 10 years)
– 454c (after 20 years)
An annual dividend of 7c per share
Mr Alberts considers 15% to be a fair return on any investment he makes. He can at present invest his cash
resources on a fixed deposit for 10 years at 16% per annum at PSA Bank.
Solution:
Value of the company if the ompany is reorganised:
Cash Factor
NPV
flow @ 15%
R R
Reorganisation offer accepted
Liq idation dividend forfeited (10 000 × 70c) (7 000) 1,000 (7 000)
Additi nal shares purchased at R1 each (10 000) 1,000 (10 000)
Expected income (for 10 years) (20 000 × 7c) [dividends] 1 400 5,019 7 027
Shares sold (after 10 years) (20 000 × 258c) 51 600 0,247 12 745
Po itive cash inflow 2 772
544
Value of the company if it is liquidated:

Cash Factor
NPV
flow @ 15%
R R
Liquidation
Liquidation dividend (10 000 × 70c) (7 000) 1,000 (7 000)
Fixed deposit at PSA Bank [if does not take up the shares] (10 000) 1,000 (10 000)
Expected income (for 10 years) (R17 000 × 16%) 2 720 5,019 13 652
Capital refund (after 10 years) 17 000 0,247 4 199
Positive cash inflow 851
Comparison in value:
Value if company is reorganised R2 772
Value if company is liquidated: R851
Difference in value (positive) R1 921
Other matters to consider when making the decision:

In addition to the above financial assessment, Mr Alberts should consider the additional risks involved in a
company engaged in trade activities versus a relative risk-free invest ent in PSA bank.
Statement of financial position adjustments

Statement of financial position entries where the amounts are not realistically reflected at carrying amount
should be revalued. Accumulated losses should be written off against capital or reserves. This will enable the
company to start declaring dividends as soon as profits are made. The same applies to intangible or fictitious
assets, such as goodwill, that serve no purpose under the prevailing circumstances. This will also give recogni-
tion to the fact that capital has been lost because of the losses incurred.
The resultant financial picture of the company’s statement of financial position should reflect a going concern
on a sound financial footing. This will enhance ratio analysis calculations and ensure that future results are not
negatively evaluated or influenced by poor historic results.
Cost of bankruptcy:
The direct costs of a bankruptcy consists of legal fees, accounting fees, business rescue practitioner’s fees,
liquidation fees and administrative expenses. There are many parties involved in the process of bankruptcy, all
of whom charges fees at professional rates and this could add up to a significant amount.
The indirect costs could r ach v n greater proportions. Generally, these are the opportunity costs imposed on
the company because financial distress changes the way a business operates. Factors contributing to these
costs are:
the company loses the right to make certain decisions without specific approval from the court or other
outside inte ested parties;
customers of the company are scared off because they do not know for how long the company will still
be a reliable s pplier of goods and services;
the uncertainty motivates competent and valued employees to leave the service of the company as soon
as ther g d employment opportunities arise;
suppliers to the company start dealing on a strict COD basis, which strains the cash flow position of the
company even more;
management becomes so involved in managing the financial distress problem that their normal duties
are adversely affected; and
the negative effects on the businesses of suppliers and customers could even force some of them into
financial distress.
Studies have shown that the total direct and indirect bankruptcy costs of a company could be in the order of
20% to 25% of the net worth of a company that files for bankruptcy.
545
13.2.2 Structure of a reorganisation scheme

Capital lost
This amount is determined by considering and quantifying the following items:
accumulated losses;
deferred expenses;
goodwill;
any costs in connection with the implementation of the reorganisation scheme;
preliminary expenses; and
amounts by which assets are over-valued.
Sharing in lost capital

It should always be borne in mind that the alternative to a re rganisati n is to liquidate the company. The
parties standing to lose if a company is liquidated should be willing to carry some of the losses in a reorganisa-
tion process if the loss distribution is fair.
Trade payables (creditors)

If they stand to lose part or all of their claims against the company if it were to become insolvent, then the
creditors should also be willing to write off a similar amount in a r organisation effort.
Secured payables
The same applies to secured payables as to trade payables.
Preference shareholders
The main issue here would be whether any preference rights exist in respect of repayment of capital in the
event of liquidation. If a preference right does exist, the right will be partly or totally lost. The preference
shareholders should therefore be willing to write off an amount equal to the anticipated loss they would
sustain under liquidation. If they have no preference rights they will have to share proportionally in the loss
together with the ordinary shareholders. It might be necessary to adjust (increase) their preference dividend
rate to ensure the same preference right to income which they had before the reorganisation scheme was
implemented.
The preference shareholders’ arrear preference dividends would, however, be lost.
Ordinary sharehold rs
In the final instance, ordinary shareholders’ equity forms a cushion to absorb losses. The larger the ordinary
shareholders’ equity, the more creditors will be inclined to advance credit to the company.
Since the o dina y sha eholders are the ultimate risk takers they would be the biggest losers if the company
were to be liquidated. They should therefore be willing to carry at least the same losses under a reorganisation
effort.
Although they carry the biggest burden as far as write-offs and losses are concerned, it must be borne in mind
that they will receive the biggest benefit if the company is rehabilitated. The alternative is that they will lose b
th their future dividend and the capital invested in the equity.
546
Example: Revised statement of financial position (Intermediate)

The following is the statement of financial position of Msizi Ltd.
Msizi LTD
STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X3
20X3
R’000
ASSETS
Property, plant and equipment 250
Goodwill 10
Current assets 165
Inventory 100
425
Total equity 260
Issued share capital 150
Trade payables 100
Bank overdraft 15
425
The current ratio of the company is 1,43:1, which is low in comparison to the rest of the industry it is trad-
ing in.
There is an immediate need for the purchase of inventory to the value of R100 000.
A bank is willing to advance the R100 000 if the company makes a capitalisation issue of R100 000 to its
present shareholders.
Required:
Prepare the statement of financial position of Msizi Ltd after the capitalisation issue has been completed and
the inventory pur hased.
547
Solution:
MSIZI LTD
STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X3
20X3
R’000
ASSETS
Property, plant and equipment 250
Goodwill 10
Current assets 265
Inventory (100 + 100) 200
525
Total equity 260
Issued capital (150 + 100) 250
Retained earnings (110 – 100) 10
Trade payables 100
Bank overdraft (15 + 100) 115
525
Comments:
The current ratio of Msizi Ltd has deteriorated from 1,43:1 to 1,23:1 because of the additional debt incurred.
The reason why the bank was willing to advance funds under these circumstances is because an additional
buffer capital of R100 000 was created. The creation of this buffer gives the bank greater security in that the
directors can now only alienate 10 000 of the company’s reserves in the form of dividends where previously
they could have reduced the company’s reserves by R110 000 leaving no buffer reserves. The solvency test
must be applied before issuing capitalisation shares.
12.2.3 Accounting entries

The basic accounting ntri s are as follows:
All losses and fi titious assets are transferred to a reorganisation account.
Expenses and fees in onnection with the reorganisation scheme are posted directly to the reorganisation
account.
The balance on the reorganisation account, if a loss, is transferred to the respective share capital ac-co
nts and reserves. If for any reason a profit is made it should be transferred to a capital reserve fund.
548
Example: Revised statement of financial position (Intermediate)

The abridged statement of financial position of Amber Ltd is as follows:
R’000
ASSETS
Current assets 40 000
Receivables 23 000
Inventory 17 000
Preliminary expenses 100
88 100
Share capital
Issued ordinary shares (100 million) 100 000
5% Preference shares (5 million) 5 000
Accumulated loss (50 000)
Current liabilities 33 000
Bank overdraft 18 000
Creditors 15 000
88 100
It is estimated that if at least R34 million cash could be found to restructure the company it could produce
estimated profits of between R25 and R40 million per annum in future.
Preference shares have preferential rights in respect of dividends and capital. Dividends have been in
arrears for three years.
Preference shareholders are willing to forfeit their preference dividends, and to convert 50% of their capital
into ordinary shares of R0,50 each, and the balance into 10% preference shares of R0,50 each. They will also
take up five million new preference shares at R0,50 each for cash.
Ordinary shareholders are willing to write off 51% of their shares off. They will also inject cash into the
company by taking up 100 million shares at a share price of R0,51.
Reorganisation expenses will amount to R1 million.
All other values on the Statement of Financial Position are fair.
Required:
Draw up the statement of financial position after the reorganisation has taken place.
Solution:
Reorganisation account
R’000 R’000
Accumulated loss 50 000 Ordinary share capital 51 000
Preliminary expenses 100 Capital reserve 100
Reorganisation expenses 1 000
51 100 51 100
Old ordinary share capital

Reorganisation account 51 000 Opening Balance 100 000
New ordinary shares 49 000
100 000 100 000
549
New ordinary share capital (R0,50)

R’000 R’000
Balance c/f 102 500 Bank 51 000
Old ordinary shares 49 000
Old preference shares 2 500
102 500 102 500
Balance b/f 102 500
5% Old preference share capital (R1,00)
New ordinary shares 2 500 Opening Bal nce 5 000

New preference shares 2 500
5 000 5 000
10% New preference share capital (R0,50)
Balance c/f 5 000 Old preference shares 2 500

Bank 2 500
5 000 5 000
Balance b/d 5 000
Bank
New preference shares 2 500 Balance 18 000

New ordinary shares 51 000 Expenses 1 000
Balance 34 500
53 500 53 500
Balance 34 500
STATEMENT OF FINANCIAL POSITION AFTER THE REORGANISATION
R’000
Fixed assets 48 000
Bank 34 500
Debtors 23 000
Inventory 17 000
122 500
Share capital
Ordinary sha e capital 102 500
Preference share capital 5 000
Current liabilities payables 15 000
122 500
Bu ine trategy
When a company finds itself in a situation where it is financially distressed and needs to reorganise to rescue
itself from liquidation, the business strategy must be revisited. This will require considering both the short and
long term business strategy. The business rescue plan discussed earlier in this chapter will link directly to the
short term strategy whereas the long term strategy will focus on long term sustainability and to prevent any
further financial difficulties in the future.
550
13.3 Liquidations
The liquidation of a company is the process of terminating the existence of that company. At the inception of
the liquidation process a liquidator is appointed to oversee the liquidation process. This liquidator is also
responsible for the distribution and transfer of the residual value of the company being liquidated to interested
parties. This section focuses on the winding up of solvent companies specifically because of its relevance to
mergers.
13.3.1 Types of liquidations

Voluntary
A voluntary liquidation of a company may be instituted by either:
the company
the creditors of the company, or
by court order.
Chapter 2 of the Companies Act, sections 79–83, deals with the voluntary winding-up of a solvent company.
Absorptions and amalgamations (mergers)

Where the winding up of a company is activated because of a merger having taken place, there are two possi-
ble methods of transferring or selling assets, i.e. eith r by cash and/or shares. The liquidator sells the assets to
the acquiring company for cash and/or shares as stipulat d in the agreement of sale.
13.3.2 Rights of shareholders

The rights of each class of ordinary shareholder, preference shareholder, and trade payables must be investi-
gated and properly dealt with in the liquidation process.
The Memorandum of Incorporation

This document provides the details of the rights of each class of shares of the company.
Common law
If the sales agreement or articles make no reference to the under-mentioned items, common law principles are
applicable.
Preference shares have no preference rights as far as capital is concerned. This means that preference share-
holders will pari passu (ie side by side) bear any loss incurred during the liquidation together with ordinary
shareholders.
If preference shares had vested rights in respect of the protection of their capital, they would only become
liable to cont ibute towa ds any loss after the entire ordinary share capital had been absorbed by the loss.
Loss upon liq idation

Example: Final distribution (Intermediate)
Li n Ltd was liquidated at 28 February 20X1. At that date, before the distribution had taken place, the trial
balance was as f llows:
Dr Cr
R R
20 000 Ordinary share capital 20 000
20 000 10% Preference share capital 20 000
Liquidation loss 30 000
Cash on hand 10 000
40 000 40 000
551
Required:
Calculate the final distribution of cash between ordinary and preference shareholders if:
no special rights were attached to preference shares; and
preference shares had a preference right regarding the repayment of capital.
Solution:
(i) Ordinary Preference
shareho ders shareholders
R R
Balance at 28/2/20X1 20 000 20 000
Loss (50:50) (15 000) (15 000)
5 000 5 000
Cash distribution (5 000) (5 000)
– –
(ii) Ordinary Preference

shareholders shareholders
R R
Balance at 28/2/20X1 20 000 20 000
Loss (100:0) (30 000) –
(10 000) 20 000
Transfer of balance of loss to preference shareholders 10 000 (10 000)
– 10 000
Cash distribution – (10 000)
– –
Profit upon liquidation

If a profit was realised upon the liquidation of a company, the profit will be to the benefit of ordinary share-
holders.
Preference dividends
In the absence of a specific indication to the opposite effect, dividends payable to preference shareholders are
cumulative. Arrear dividends do not constitute a claim against a company in liquidation unless such dividends
have already been d clar d.
13.3.3 Accounting entries

These accounting ent ies are mainly applicable in a situation where an absorption or amalgamation has been
undertaken and the liquidation of a company is imminent.
Transfer all assets and liabilities to be taken over to the liquidation account.
All reserves are transferred to the liquidation account. It is sometimes reasoned that reserves could be
directly credited to ordinary shareholders as they represent the profits of ordinary shareholders that
have n t been distributed to them. This reasoning is valid if the company has no preference shareholders
without preference rights regarding their capital, as a resulting loss because of the reserves not being
credited to the liquidation account will be to their detriment. This is so because the liquidation account
does not reflect the real loss of the liquidation process.
Any pure provision, for instance a provision for bad debt, must be transferred back to its corresponding
sset before the asset is transferred to the liquidation account.
Any liquidation costs paid should be directly posted from the cash book into the liquidation account.
Fictitious assets which include accumulated losses and preliminary expenses must also be transferred to
the liquidation account.
552
The liquidation account is credited with the purchase price as reflected in the sales agreement and the
purchaser is debited.
The balance in the liquidation account will reflect the profit or loss on liquidation. Transfer this profit to
the sundry shareholders’ accounts on the basis of the articles of the company, the sales agreement or
common law principles.
The receipts from the purchase are debited against the bank or shares receivable accounts and credited to
the purchaser’s account.
Pay debt not taken over by the purchaser.
Distribute the balance of cash and shares received to sundry shareho ders’ accounts in order to close off
the books of the company.
Example: Liquidation account (Intermediate)

The statement of financial position of Lion Ltd at 28 February 20X1 is as follows:
R
Assets
Preliminary expenses 3 000
89 000
Equity
Ordinary share capital (30 000 issued shares) 34 000
Preference share capital (5 000 issued shares) 5 000
Retained earnings 50 000
89 000
Lion Ltd received an offer of R100 000 from Amber Ltd for the business of the company, which they accepted.
Liquidation costs amounted to R5 000.
Required:
Draw up the liquidation account, shareholders’ accounts, bank account and the purchaser’s account
for a cash offer of R100 000; and
for a cash offer of R50 000 and 50 000 R1 ordinary shares in Amber Ltd for the balance.
Solution:
(i)
Liquidation account
R R
Liq idation costs 5 000 Retained earnings 50 000
Fixed assets 30 000 Purchaser 100 000
Net c rrent assets 56 000
94 000 150 000
Profit to ordinary shareholders 56 000
150 000 150 000
553
R R
Bank 90 000 Balance (Shares) 34 000
Liquidation account (Profit) 56 000
90 000 90 000
R R
Bank 5 000 Balance (Shares) 5 000
Bank
R R
Purchaser A Ltd 100 000 Liquidation costs 5 000
Preference shareholders 5 000
100 000 100 000
Purchaser (A Ltd)
R R
Liquidation account 100 000 Bank 100 000
(ii)
Liquidation account
R R
Liquidation costs 5 000 Retained earnings 50 000
Fixed assets 30 000 Purchaser 100 000
94 000 150 000
Profit to ordinary shareholders 56 000
150 000 150 000
R R
Bank 40 000 Balance 34 000
Share a ount A Ltd 50 000 Liquidation account (Profit) 56 000
90 000 90 000
R R
Bank 5 000 Balance 5 000
Bank
R R
A Ltd 50 000 Liquidation costs 5 000
Preference shareholders 5 000
50 000 50 000
554
Share account (A Ltd)

R R
Purchasers
(50 000 ordinary shares) 50 000 Ordinary shareholders 50 000
Purchaser
R R
Liquidation account 100 000 Bank 50 000
Share account 50 000
13.3.4 Simultaneous liquidation of crossholding companies (Ad anced)

A problem may arise where companies have shares in each other (crossholding) and are liquidated at the same
time (simultaneous liquidation). The reason for this is that the liquidati n values of the two companies are
interdependent. The problem can be solved by drawing up two equati ns and solving them simultaneously.
Example: Liquidation dividend

The trial balances of A Ltd and B Ltd are as follows:
A Ltd B Ltd
R R
Fixed assets 14 000 8 000
Other investments:
– 2 000 shares in B Ltd 2 000
– 1 000 shares in A Ltd 1 000
16 000 9 000
Share capital
– Shares (10 000) 10 000
– Shares (5 000) 5 000
Retained earnings 6 000 4 000
16 000 9 000
Both the companies are liquidated at the same date. The value of the fixed assets of both companies is consid-
ered to be fair.
Required:
Calculate the amounts payable as a liquidation dividend to the shareholders of both companies.
Solution:
(i) Value of:
2 000
A Ltd = R14 000 + × B Ltd
5 000
B Ltd = R8 000 + 1 000

× A Ltd
10 000
2/5 B
A = R14 000 +
1/10 A
B = R8 000 +
2/5 (R8 000 + 1/10 A)
A = R14 000 +
2
R3 200 + /50 A
A = R14 000 +
2
A – /50 A = R17 200
555
48/50 A
= R17 200
A = R17 917
1/10 (R17 917)
B = R8 000 +
B = R8 000 + R1 792
B = R9 792
Note to solution:
As each company has shares in the other company, the value of each company should be calculated to
enable the corresponding value of the shares held in the other company to be determined respectively.
(ii) Schematically the situation is as follows:
Shareholders of A Ltd Shareholders of B Ltd
90% 60%
10% (1/10)
B Ltd
A Ltd
Value:
Value:
R9 792
R17 917
40% (2/5)
In order to determine the final liquidation dividends to be paid out to the shareholders of A Ltd and B
Ltd, the following calculation must be done.
Shareholders Shareholders
A Ltd B Ltd
R R
Total value (including crossholding) 17 917 9 792
B Ltd’s share in A (R17 917 × 10%) (1 792)
A Ltd’s share in B (R9 792 × 40%) (3 917)
Value (excluding crossholding) 16 125 5 875
556
Practice questions

The following is the statement of financial position of Manta Ltd, a listed company.
ABRIDGED STATEMENT OF FINANCIAL POSITION AT 28 FEBRUARY 20X1

R’000
ASSETS
Non-current assets
Property and equipment 453 000
Inventory 250 000
Trade receivables 150 000
Total assets 853 000

Total equity 510 000
Issued capital 200 000
Bank overdraft 32 000
Total equity and liabilities 853 000

Manta Ltd needs R150 000 for the purchase of inventories. The bank is willing to advance that amount on
condition that the company makes a capitalisation issue of R200 000. It was decided to comply with the bank’s
request regarding the capitalisation issue.
Required:
Draw up the statement of financial position of Manta Ltd after all the transactions have taken place and discuss
the effect of the above transactions.
Solution:
ABRI GED STATEMENT OF FINANCIAL POSITION AT 31 JULY 20X1
R’000
ASSETS
Non-current ass ts
Property and quipm nt 453 000
Inventory (250 000 + 150 000) 400 000
Trade e eivables 150 000
Total assets 1 003 000

EQUITY AND LIABILITIES 510 000
Total eq ity
Issued capital (200 000 + 200 000) 400 000
Retained earnings (310 000 – 200 000) 110 000
Bank overdraft (32 000 + 150 000) 182 000
Total equity and liabilities 1 003 000

The c pital and reserves of R510 000 have stayed the same but after the capitalisation issue only R110 000 may
be declared as a dividend. Manta Ltd can now only declare R110 000 instead of the previous R310 000 of its
reserves as a dividend. Alienation of any part of the R400 000 amounts to a reduction of share capital and may
not take place without the consent of the client. The ‘cushion’ which external parties rely on has been
strengthened.
557

The abridged statement of financial position of Zastro Ltd at 31 December 20X1 is as follows:
ABRIDGED STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X1
R
ASSETS
Non-current assets
Land and buildings
Total assets 305 500
Total equity (138 500)
Accumulated loss (299 000)
Current liabilities
The sole shareholder of the company is considering the liquidation of Zastro Ltd. The following information is
provided:
The trade creditors are prepared to enter into a compromise with the company in order to prevent its
liquidation.
A reasonable market value for the assets is equal to their respective book values.
Anticipated future profit amounts to R250 000 per annum which makes the company’s continued existence
attractive.
The company has an assessed loss of R250 000.
Current rate of taxation is 30%.
The sole shareholder has indicated that he is considering buying the land and buildings from the company’s
liquidator if the liquidation is to go through.
Required:
Determine whether the company should be liquidated or whether it should rather embark upon a reconstruc-
tion scheme.
Solution:
1 Determination of the ompromise with trade creditors
R
Total value of assets 305 500
Creditors’ claims (444 000)
Possible loss creditors may suffer (138 500)
Credit rs sh uld therefore be willing to settle for a repayment of 69c in the Rand.
444 000 – 138 500
444 000
2 Co t to the sole shareholder if the company is wound up.
Purchase price of land and buildings (market value) R295 000
558
3 Advance by the sole shareholder if the company is not wound up.

R
Repayment of creditors (444 000 – 10 500 – 138 500) 295 000
Saving of taxation on future profits [(R250 000 – R138 500) × 30%] (33 450)
Loan from sole shareholder 261 550
It will be more beneficial to enter into a compromise with the creditors and therefore not to liquidate the
company.
Note: The assessed loss must be reduced by the amount of any compromise which is entered into with
payables in terms of section 20(1)(a)(ii) of the Income Tax Act 58 of 1962.

The abridged statement of financial position of Baxter Ltd, a listed company, is as follows:
20X1
R
ASSETS
Non-current assets 390 000 000
Property, plant and equipment 310 000 000
Goodwill 80 000 000
Current assets 281 000 000
Inventories 201 000 000
Trade receivables 70 000 000
Cash and cash equivalents 10 000 000
Total assets 671 000 000

Total equity 422 000 000
Issued capital 200 000 000
Reserves 112 000 000
Retained earnings 110 000 000
Non-current liabilities 137 000 000
Long-term borrowings 137 000 000
Current liabilities 112 000 000
Trade payabl s 100 000 000
Short-term borrowings 12 000 000
Total equity and liabilities 671 000 000
Additional info mation:

1 Property plant and equipment
R
Land and buildings at cost 250 000 000
Plant and equipment 60 000 000
Co t 100 000 000
Accumulated depreciation (40 000 000)
310 000 000
2 Liquidation costs amount to R20 000 000
559
3 Issued capital
R
Ordinary share capital (100 000 000 issued shares) 100 000 000
7% Preference share capital (100 000 000 issued shares) 100 000 000
200 000 000
Required:
Prepare the liquidation account, shareholders’ accounts and bank account if a cash offer amounting to
R442 000 000 was accepted for the net assets of the company.
Prepare the same ledger accounts as in (a) with a purchase offer of R200 000 000 of which R120 000 000
is payable in cash and R80 000 000 in shares.
Solution:
(a)
Liquidation account
R’m R’m
Land and buildings 250 Reserves * 112
Plant and equipment 60 R tained earnings * 110
Current assets 281 Borrowings 137
Goodwill 80 Current liabilities 112
Bank – liquidation charge 20 Selling consideration 442
Ordinary shareholders’ profit 222
913 913
Bank 322 Balance 100

Liquidation account ** 222
322 322
Bank 100 Balance 100
Bank
Selling consideration 442 Liquidation charge 20

Preference shareholders 100
Ordinary shareholders 322
442 442
These items are not taken over by the purchaser but are inducted in order to determine the profit or
loss realised.
Since no reference was made to preference shareholders participating in profits on liquidation only the
ordinary shareh lders will share in the profits.
560
(b)
Liquidation account
R’M R’M
Land and buildings 250 Reserves 112
Plant and equipment 60 Retained earnings 110
Current assets 281 Borrowings 137
Goodwill 80 Current liabilities 112
Bank – liquidation charge 20 Selling consideration 200
Ordinary shareho ders ( oss) 20
691 691
Share allocation 80 Balance 100

Loss 20
100 100
Bank *** 100 Balance 100
Bank
Part selling price 120 Liquidation charge 20

Preference shareholders 100
120 120
Share allocation account
Part selling price (shares) 80 Ordinary shareholders 80

The following information relates to on Ltd:
ABRIDGED STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X1
20X1
R’000
ASSETS
Prope ty, plant and equipment 5 196
Goodwill 54
C rrent assets 1 140
Inventories 545
Prepayments 45
Total a sets 6 390
561
ABRIDGED STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X1 – continued

20X1
R’000
Total equity 5 065
Reserves 500
Trade payables 271
Bank 354
1 Preference shares have preference in respect of repay ent of capital.
Preference dividends have not been paid from 1 January 20X1 up to 31 December 20X1.
Deferred shares participate in ordinary dividends aft r ordinary shares have first been paid a dividend at 10c
per share. All other rights are the same as ordinary shares.
4 Long -term borrowings consist of 700 10% debentures of 1 000 each repayable on demand. A premium of
10% is payable on redemption.
5 Issued capital consists of:
2 000 000 ordinary shares issued at a cost of R1 each
500 000 deferred shares issued at a cost of R1 each
500 000 7% preference shares issued at a cost of R1 each.
Preston Ltd, a listed company, made the following offer to purchase all the assets and liabilities of Don Ltd,
which was accepted:
l The total purchase price amounts to R5 500 000.
l Payment will be made in cash (40%) and shares of Preston Ltd (60%). l
Preference shares will be redeemed in cash at R1,10 per share.
l An arrear preference dividend will be declared and taken over as a liability by Preston Ltd.
Liquidation charg s amount to R25 000 and will be paid by Preston Ltd on behalf of the liquidator.
Deferred shareholders not in favour of the transaction will be paid R1,50 per share. The holders of 250 000
shares obje ted to the transaction.
Preston Ltd holds 100 000 preference shares as well as 500 000 ordinary shares in Don Ltd.
Required:
Prepare the f ll wing accounts in the books of Don Ltd in conclusion of the liquidation:
Liquidati n account.
Pre ton Ltd.
Share accounts.
Account of objectors to the transaction.
Bank.
New shares account.
Work to the nearest full percentage when calculating the respective share in profits of each type of shareholder.
562
Solution:
Liquidation account
R’000 R’000
Property, plant and equipment 5 196 Preference dividends 35
Goodwill 54 Debentures 700
Inventories 545 Other payables 271
Other receivables 550 Bank 354
Prepayments 45 Reserves 500
Preston Ltd (liquidation charges) 25 Retained earnings (1 565 – 35) 1 530
Realised loss on the preference shares 50 3 390
Realised loss on deferred shares 125 Preston Ltd (selling price) 5 500
6 590 8 890
Profit 2 300
Ordinary shares (67%) 1 541
Ordinary shares (22%) 506
Deferred shares (11%) 253
100%
8 890 8 890
Pr ston Ltd
’000 R’000
Liquidation amount 5 500 Liquidation account
(liquidation charges) 25
Preference shares (100 000 × R1,10) 110
Ordinary shares 1 006
New shares (60%) 2615,4
Bank (40%) 1 743,6
5 500 5 500
New shares account (Preston)

Preston 2 615,4 Deferred shares account 371,2
Ordinary shares account 2 244,2
2 615,4 2 615,4
Ordinary shares
Preston Other Preston Other
Liquidation a ount Balance 500 1 500
Preston Ltd 1 006 – Liquidation account
Bank – 796,8 Preston 506 –
New share acco nt 2 244,2 Other – 1 541
1 006 3 041 1 006 3 041
Preference shares
Pre ton Ltd 110 Balance 500
Bank 440 Liquidation account (realised loss) 50
550 550
563
Deferred shares
Against Other Against Other
Bank 375 – Balance 250 250
Bank – 131,8 Liquidation account
New shares 371,2 (Realised loss) 125 –
Liquidation account – 253
375 503 375 503
Bank
Preston Ltd 1 743,6 Preference shares 440
Deferred sh res 375
Deferred sh res * 131,8
Ordinary shares * 796,8
1 743,6 1 743,6
* Cash balance distribution of R928 600
3 041
Ordinary R928 600 × = R796 804
3 544
503
Deferred R928 600 × = R131 796
3 544
Notes
The 10% premium payable at redemption of debentures is only payable at redemption and therefore not for
the account of Don Ltd.
Provision for preference dividend
R500 000 × 7% = R35 000
Retained profits Dr 35 000
Arrear dividends 35 000
Realised profit/loss on preference shares
500 000 shares × R0,10 = R50 000
Liquidation amount Dr 50 000
Preference shares 50 000
Realised profit/loss Deferred shareholders not agreeing with transaction
250 000 shar s × R0,50 = R125 000
Liquidation account Dr 125 000
Deferred share a ount 125 000
l Profit sha ing
Shares
Total shareholder – Ordinary 2 000 000
Sharing in liq idation profits – Deferred 500 000
2 500 000
Deferred shareholders against transaction (250 000)
2 250 000
564
Percentage of profit sharing
1 500
Ordinary – Other 67%
2 250
500
Ordinary – Preston 22%
2 250
250
Deferred – Other 11%
2 250
New shares
R
Purchase price Liquidation 5 500 000
charges Preference shares (25 000)
Ordinary shares – Preston (110 000)
Share in profit – Preston (500 000)
(506 000)
4 359 000
Cash 40% 1 743 600
Shares 60% 2 615 400
4 359 000
565
Chapter 14
The dividend decision
l explain the different methods a company may choose when paying dividends; l
explain why the dividend policy is irrelevant in a perfect capital arket;
calculate how a shareholder may borrow or sell shares in lieu of a dividend payment without losing
investment value;
discuss the dividend decision in an imperfect mark t; and
explain alternative dividend payment methods.
The dividend policies of various firms have been extensively researched, and divergent theories have been
proposed on the effect of specific dividend policies on the value of the firm. No definite conclusions have been
formulated, and it would appear that many managers are primarily interested in giving the shareholders a fair
level of dividends based on a long-term target payout rate.
Shareholders’ return consists of both capital gain and dividend return. It has been argued that investors should
not be concerned about the dividends received, but they should be concerned with the total return (capital
gains plus dividend). Managers, in turn, are concerned with the on-going financing of the firm and are faced
with the decision to:
retain whatever earnings are necessary to finance growth and pay out any residual cash dividend; or
increase dividends and then (sooner or later) issue new shares to make up the shortfall in equity capital.
As the firm is inter st d in maximising shareholder wealth, the question of whether a stable dividend policy
maximise equity share value must be asked. On logical grounds, evidence indicates that a stable dividend policy
leads to a higher share value. Shareholders view a fluctuating dividend policy as more risky than stable div-
idends which they are more likely to receive. The result is that the shareholders will require a higher rate of
return from fi ms with fluctuating dividends, in contrast to those with a stable dividend policy and the same
average amount of dividends that is the cost of capital of companies with a stable dividend policy is lower than
those with a fl ct ating or no dividend policy.
14.1 Dividend payment methods

Dividend policies differ from company to company and often take into account the needs of the shareholders.
Where company directors perceive that shareholders want dividends, they will choose to make a dividend di
tribution. However, where they perceive that shareholders are indifferent between a dividend or capital
appreciation, they may embark on a residual payment method.
567
14.1.1 Constant dividend/earnings method

This method pays shareholders a dividend which is calculated at a constant percentage of earnings.
Earnings
Rand
Dividends
Time
Figure 14.1: A diagrammatic representation of the constant divid nd/earnings method
Illustration:
A company has a dividend payment policy of paying out a dividend equal to 60% of earnings after tax.
20X1 20X2 20X3 20X4
Earnings 1 000 1 150 950 1 200
Dividends 60% 600 690 570 720
This method is not too popular, as dividends fall when earnings decline. Management is always reluctant to
decrease dividends as it perceives that the shareholders react negatively to declining dividend payments.
14.1.2 Stable dividend payment method

This method attempts to pay a level of dividends that is sustainable. Dividends are held at a constant level and
only increased when earnings show an upward increase that is sustainable in the long-term.
Earnings
Rand
Dividends
Time
Figure 14.2: A diagrammatic representation of the stable dividend payment method
568
The dividend decision Chapter 14
14.1.3 Bonus issues/share splits and dividend reinvestment plans

When a company makes a bonus issue in lieu of paying a dividend, it is simply increasing the number of shares
in issue. The shareholder does not benefit from such a policy, as he will still retain exactly the same percentage
of issued share capital. The total market value of his shareholding will, however, increase as the company re-
invests surplus funds in the business.
Example: Bonus Issue

A shareholder holds 100 shares in a company that has an issued-share capital of 1 000 shares.
Required:
Determine the effect of the company making a bonus issue of one share for every ten held.
Solution:
Current position
Company Shareh lder
Shares 1 000 100
Shareholder holds 10% of issued share capital

New position
Company Shareholder
Shares 1 100 110
Shareholder still holds 10% of issued share capital
A share split occurs when a company issues new shares to existing shareholders in proportion to the existing
shares held in a company. For example, a company may double the number of shares in issue and distribute
them to existing shareholders. This strategy is often used where the value of a share has increased substantially
and trading is difficult because of the high value of buying or selling a share. Where, for example, a 1:1 share
split is carried out, a shareholder will hold double the number of shares at half the previous value per share.
The total value of his shareholding will, however, remain the same.
Example: JSE Ltd – Share Split

Note: Aug 06 Shareholders should note that the Dec 04 pro forma EPS and HEPS figures were restated in line
with the JSE’s share split on a 10 for 1 basis on listing on 5 June 06.
Comment: Subsequ nt to the above, share splits have been scarce. This may be ascribed to listed companies
with high share pric s not wishing to attract small individual shareholders eg Naspers. The opposite of a share
split is a share consolidation. For example, Super Group in December 2011 consolidated 10 ordinary shares into
1.
Dividend reinvestment plans are slightly different. The method of dividend distributions gives the shareholder
a choice of accepting a cash dividend or choosing a bonus issue of shares (refer to section 14.4.2, under the
sub-heading ‘Scrip dividend’), or by reinvesting in the company.
If all existing shareholders choose the bonus issue, their position is the same as it would be if the company had
a b nus share issue. However, if some shareholders choose a bonus issue, while others opt for a cash dividend,
the shareh lders choosing the bonus issue will end up with a greater proportion of the shares in issue after the
re-investment plan than the shareholders who opted for the cash dividend.
Examp e: Anglo American – Reinvestment plan

A dividend reinvestment plan is available through Equiniti in the UK and Link market Services in South Africa.
This plan enables shareholders to reinvest their cash dividends in the purchase of Anglo American ordinary sh
res.
569
14.2 Dividend policy as ‘irrelevant in a perfect capital market’

The controversial question of how dividend policy affects value is illustrated in the three divergent groups of
opinion. One group believes that an increase in dividend payout increases company value. The more radical
group believes that an increase in dividend payout reduces the value of the company.
The middle-of -the road group, founded by Miller and Modigliani, believes that the dividend decision in a
perfect capital market (no taxes, transaction costs or other market imperfections) is irrelevant, as investors are
indifferent to returns in the form of dividends or capital gains. The Miller and Modigliani argument is generally
accepted as correct, and the emphasis has now shifted to the validity of the theory in an imperfect world of
taxes and other market imperfections. The Miller and Modigliani theory states that management should use
the company’s earnings (which is cheaper than issuing new shares) to invest in projects with positive net
present values. If all suitable projects have been taken up and retained e rnings re still available, the balance
should be paid out as a dividend. Where no retained earnings are left over, no dividend is paid. The dividend
decision is then a residual of the investment decision.
Example: Financing a missed dividend

The ‘Rational’ company has an issued share capital of 1 000 R5 shares. Its investments generate a perpetual
income of R2 000 per annum after taxes, which is paid out by way of a dividend before dividend tax of 15%. The
company’s cost of capital is 17%.
An investment project requiring a R1 700 investment one year from today (at t1), will become available. The
investment has the same level of risk as the company’s pr vious investments and will generate an after tax
return of R5 000 before dividend tax after one year (at t 2). The company wishes to finance the project by using
the retained earnings available at t1 (amounting to R2 000). It will then pay out an additional dividend equal to
the project return in Year t2, and thereafter the dividend will be R2 000 per annum in perpetuity.
Required:
Determine whether the investment decision is in the shareholders’ best interests.
Investor A, holds 50% of the issued share capital in the ‘Rational’ company, and relies on his dividend
income to supplement his pension income.
Show how Investor A can replace the desired dividend and still retain the same share value by –
borrowing;
selling part of his shareholding.
Solution:
(a) Current value of mark t quity at t0
Ve = R1 700 = R10 000

0,17
(See sha e valuation based on zero growth – valuation section.)
Market val e of equity after investment

Revised dividend flow at t1 0
at t2 7 000(ADT 4 250)
at t3 2 000
t0 t1 t2 t3
(1 700) 4 250
Current (ADT) 1 700 1 700 1 700 1 700 to infinity
New N/A Nil 5 950 1 700 to infinity
570
Ve (post investment) = present value of future cash flow at t0

1 700
PV value at t2 = 5 950 + = 15 950
0,17
15 950
PV value at t0 = = R11 651,69
(1 + 0,17)
2
Ve (post investment) = 11 651,69

Ve (net) = 11 651,69 – 10 000 = R1 651,69
The value of the company has risen by R1 651,69 as a result of accepting the investment.
The conclusion is that new investments should be accepted when the alue of the firm post investment is
greater than the value at the present time, that is when
Ve (post investment) > Ve (existing)
Alternative valuation of investment

Year 1 (1 700) × 0,8547 = (1 453)
Year 2 4 250 × 0,7305 = 3 105
+ 1 652
Note: The present value factors have been determined back to Year 0: that is the R2 000 investment
required is at the beginning of Year 1. The factor of 0,8547 is one year away from Year 0.
(i) Borrowing to replace his dividend

Given a perfect capital market, the investor will borrow R850 at 17% at t1 and repay the loan at t2.
At t0, the investor’s wealth in terms of share value is
R10 000 × 50% = R5 000 and will receive a dividend of R1 700 × 50%
Changes in shareholder wealth as a result of borrowing
t1 t2 t3
R R R
Revised dividend flow Nil 2 975 850

Bank borrowing 850 – 995 Nil
Revised cash flow 850 1 980 850
Less:
Existing ash flow 850 850 850
Net change Nil +1 130 Nil
1 130
Present value to t0 = = R825,48
(1 + 0,17)
2
C nclusion:
Shareholder wealth will increase by R825,48
Note: The cost of borrowing has been taken as 17%, which is equal to the cost of equity. This is
correct if one takes the view that the cost of borrowing equals the opportunity cost of uti-
lising the dividend received. In other words, when a shareholder receives a dividend, he
could re-invest the funds in the company to earn a further 17%, which must be the oppor-
tunity cost of money to the shareholder.
571
or:
The investor is taking on debt. The cost of equity, k e, must therefore increase but the weighted
average cost of capital (WACC) will remain at 17% (Miller and Modigliani assumption). The equiva-
lent or opportunity cost therefore equals 17%.
Selling shares to replace a missed dividend

According to the Miller and Modigliani theory, once the ‘Rational’ company has announced its
intentions, the ‘perfect capital market’ will not perceive that the company risk structure has
changed as a result of a change in dividend policy and will continue to require a 17% return on in-
vestment.
The revised total market value of Investor A’s shares at t0 will therefore equal R5 825,48.
Market value at t1 based on discounted future dividends will equal

PV at t2
(1 + 0,17)
5 950 1 700
PV at t1 = + ÷ 1,17
1,17 0,17
= 5 085,47 + 8 547,01
= 13 632,48 ÷ 1 000 shares
Value per share = R13,632
Shareholder requires R850 cash, therefore he will sell 63 shares

(63 × R13,632 = R858,82)
His shareholding, after sale of shares at t1, is now 43,7%.

Dividend at t2 = 5 950 × 43,7% = R2 600
1 700
Total share value at t2 (ex-dividend) = = R10 000
0,17
or R10 per share
At t2, the shareholder will purchase 63 shares at R10 each to recover his original shareholding.
Resultant cash flows

t1 t2 t3
R R R
Revised dividend flow Nil 2 600 850
Sale/pu hase of shares + 858,82 – 630 Nil
Revised cash flow 858,82 1 970 850
Less:
Existing dividend flow 850,00 850 850
Additional cash + 8,82 + 1 120 Nil
The equivalent present value at t0 of resultant cash flows is

8,82 1 120
+ = R825,72
(1+0,17)
2
(1,17)
Therefore, in theory, a loss in dividend as a result of a change in the payment policy of a company
should not be relevant to the shareholder as he can sell shares or borrow funds to restore lost divi-
dends. The net result will always be that his wealth will increase and the dividend decision is irrele-
vant. (Note that the assumption is that shareholders do not require more than a 17% return as a
result of a change in dividend policy.)
572
The Miller and Modigliani dividend theory follows from their capital structure theory, which states
that a firm’s WACC is unaffected by changes in its gearing ratio and it makes no difference whether
a project is financed by debt or by equity capital.
If it is true that an investor is no worse off, regardless of whether a dividend is paid by the investor’s
company, one must ask what would happen if the company increased the dividend payment with-
out changing the investment and borrowing policy.
As the company has fixed its investment policy, it will have to raise funds to finance projects, and as
retained earnings are not available due to the dividend payout, it will have to raise the required
funds either by borrowing or issuing new shares. Borrowing is limited by the debt to equity (D:E) ra-
tio, so the company will eventually have no option but to issue new shares.
The company therefore prints new shares and sells them to new sh reholders who are prepared to
pay what the share is worth. However, one must query how the sh res c n be worth anything if the
assets, earnings, investment opportunities and market value are unchanged?
The answer is that a transfer of value takes place from the old shareholders to the new. The market
value per share is therefore diluted as a result of the new issue and the old shareholders will incur a
capital loss which is offset by the extra dividend they received. The two methods of ‘cashing in’, that
is selling shares to replace dividends, or receiving a higher dividend and incurring a subsequent capi-
tal loss, have the same fundamental effect. Value is transferred from existing shareholders to new
shareholders either by reducing the number of shares held or by a market dilution of share value.
In conclusion, as long as investment policy and borrowing are held constant, the firm’s overall cash-
flows are the same, regardless of payout policy. The risks borne by all shareholders are likewise
fixed by its investment and borrowing polici s, and unaffected by dividend policy.
14.3 Dividend decisions in an imperfect market

There are a number of situations that suggest that dividend decisions may be affected by a variety of factors
that make dividend policy relevant.
Example: MTN – Declaration of interim ordinary dividend

Notice is hereby given that a gross interim dividend No. 3 of 321 cents per share for the six months ended 30
June 2012 has been declared payable to shareholders of MTN’s shares. The dividend has been declared out of
income reserves. The number of ordinary shares in issue at the date of this declaration is 1 884 968 549
(including 22 337 752 treasury shares). The dividend will be subject to a maximum local dividend tax rate of
15% which will result in a net dividend to those shareholders that bear the maximum rate of dividend withhold-
ing tax of 276,61346 cents per share after dividend withholding tax of 44,38654 cents per share and STC credits
amounting to 25,08974 cents per share will be utilised.
Comment:
Dividends may be half-yearly or annually.
14.3.1 Statuto y equirements

In South Africa, the financial manager is restricted to a certain extent by the Companies Act 71 of 2008 and the
Income Tax Act 58 of 1962.
The C mpanies Act states that ‘no dividend shall be paid otherwise than out of profits’. Dividends may
theref re nly be paid out of current and previously accumulated earnings.
This restriction exists to prevent companies from paying dividends in a manner that would effectively
reduce the company’s paid-up share capital or share premiums (sections 46 to 48).
Prior to 1 April 2012, secondary tax on companies (STC) was levied on companies at the rate of 10% of
dividends paid. The intention at that time was to encourage companies to distribute little or no dividends,
nd to use the funds for re-investment. With effect from 1 April 2012, STC was replaced by dividend tax
(DT) at the rate of 15% payable by the recipient of the dividend. The reason for the change was to bring
South Africa in line with international norms of who pays the tax and also to eliminate the perception that
South Africa had a higher overall corporate tax rate. For the legislative basis for DT, refer to section 64D
to 64N of the Income Tax Act.
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Example: Remgro – STC Credits Take off the borders

On 31 December 2011, Remgro and its wholly-owned subsidiaries had STC credits of R8 790 million
(31 March 2012: R9 544 million estimated) to be utilised by 31 March 2015.
Comment:
With effect 1 April 2012 STC was replaced by a dividend tax (DT) at a rate of 15%. DT is based on the gross
outflow of dividends with no reference to the period. The beneficial owner of the dividend (share) is liable for
the tax except in the case of a dividend in specie (distribution of assets) when the liability remains with the
company. STC credits must be utilised by 31 March 2017.
Financial managers in an imperfect market do not have all the inform tion ssumed in theory; therefore,
judgement must be exercised, especially in the area of the tax positions of both the shareholder and the
company.
14.3.2 Clientèle requirements
Certain shareholders prefer high dividend-paying shares as a s urce f cash to live on. Some financial institu-tions
are restricted from holding shares that lack established dividend rec rds, while Trust and Endowment Funds
prefer dividend shares, which they view as disposable income, over a capital gain, which is not disposa-ble. This
gives rise to the so-called ‘clientèle effect’, whereby certain investors based on their risk to return profile,
investments needs and stage (age) in life will be drawn to particular companies.
Although the ideal dividend policy should be dictated by the owners of the company, this is unrealistic for large
companies with widely-dispersed ownership. The argum nt th refore arises that a firm should have a stable
dividend policy appropriate for its activities. Investors will th n choose investments that have a dividend policy
that meets their particular requirement (consider the examples of Mondi, Mr Price, MTN, Remgro and Sasol
below). Pensioners for example will be drawn to companies that have a stable dividend policy and a high
dividend yield (consider the example of high yielding companies below). Investors, who are in pursuit of high
growth shares, would be far less interested in receiving dividends and hence would prefer that the company
pays no dividends (consider the example of Calgro M 3 below). Then there is also the so- called ‘bird-in-hand
versus two-in-the-bush theory’, that states that some investors would prefer to receive a known payment
today (bird-in-hand), rather than wait for an uncertain capital growth in the future (two-in-bush).
Example: Mondi – Dividend policy

Mondi intends to pursue a dividend policy that reflects its strategy of disciplined and value creating investment
and growth with the aim of offering shareholders long-term dividend growth. The Group will target a dividend
cover range of two to three times on average over the cycle, although the payout ratio in each year will vary in
accordance with the business cycle. The payment of dividends will be conditional on the Group having suffi-
cient distributable reserves. Ordinary dividends paid by Mondi plc will generally be paid in Euros and ordinary
dividends paid by Mondi Limited will generally be paid in Rand. The Directors intend that the final and interim
dividends will gen rally be paid in May and September in the approximate proportions of two thirds (final
dividend) and one-third (int rim dividend).
Example: Mr P i e G oup – Dividend policy and final cash dividend

The Group seeks to maintain a balance between –
maintaining a strong balance sheet by having adequate cash resources;
returning funds to shareholders in the form of dividends; and
funding the required level of capital expenditure to maintain and expand its operations.
The Group business model is cash generative. However, after taking into consideration the increased invest-
ments detailed above, the dividend cover of 1,6 times (or alternatively the dividend payout ratio of 63,0%) has
been maintained. This will be evaluated at least annually. The final gross dividend has increased by 18,4% to
314,0 cents per share and total dividends for the year by 21,1% to 482,0 cents per share, with a closer align-
ment of interim and final dividends.
Comment:
Cash generating companies will tend to have a low dividend cover or alternatively a high payout ratio.
574
Example: MTN – Distribution to shareholders

A final gross dividend of 665 cents per share payable to 1873,3m issued shares (including 22,3m treasury
shares) in respect of the financial year ended 31 December 2013 was declared on 5 March 2014, payable to
shareholders registered on 20 March 2014.
Before declaring the final dividend, the board –
applied the solvency and liquidity test on the Company; and
reasonably concluded that the Company will satisfy the solvency and liquidity test immediately after
payment of the final dividend.
The final dividend will be paid within 120 days of the board’s performance of the solvency and liquidity
test.
The company showed a table of different tax rates applicable to shareholders as a result of various double
taxation agreements as well as dividend tax exemptions.
Interim dividend:
An interim gross dividend of 445 cents per share in respect f the half year period ended 30 June 2014 was
declared on 7 August 2014, paid to shareholders registered on 22 August 2014.
Dividend payment policy adjustment:

Due to the Group’s strong financial position, the board approv d an increase in the dividend payment policy in
2011. The dividend payment policy was increased to 70% of annual adjusted headline earnings per share (EPS).
The interim dividend was based on 30% of the prior year’s adjusted headline EPS.
The payments of future dividends will depends on the board’s on-going assessment of the Group’s earnings,
financial position, cash needs, future earnings prospects and other factors.
Comment:
The dividend cover decreased from 4,2 in 2009 to 2,2 in 2010 and then to 1,7 in 2011. Treasury shares are not
entitled to dividends.
Example: Remgro – Distribution to shareholders

Dividends to shareholders are funded from dividend income and interest received at the centre.
In terms of normal dividends to shareholders, it is the Company’s objective to provide shareholders with a
consistent annual dividend flow which at least, protects them against inflation, throughout the cycles. As in the
past, in special circumstances, the Company will consider other distributions in the form of special dividends or
the unbundling of inv stm nts to shareholders.
Note: The examples above illustrate some of the drivers of dividend policy.
Example: Sasol – Dividend history

The dividend is decla ed and paid out in Rand for the holders of ordinary shares. For investors in the depositary
receipt (ADR) on the NYSE, the dividends are paid out in US dollars. Sasol declares dividends semi-annually in
March and September respectively.
The salient dates for FY 2012 final dividend are:
Declaration Last date Ex-dividend Record Payment
date to trade date date date
Ordinary shares 10 Sep 2012 05 Oct 2012 08 Oct 2012 12 Oct 2012 15 Oct 2012
Declaration Date of currency Ex-dividend Record Payment
date conversion date date date
American Depository
Receipts
1
10 Sep 2012 10 Oct 2012 12 Oct 2012 26 Oct 2012
1 All dates are approximate as the NYSE approves the record date after receipt of the dividend declaration.
575
Details on recent dividends paid are included below:

Dividend history Date paid Dividend number SA cents US cents
FY12 final dividend 15 October 2012 66 1 180 144
26 October 2012
FY13 interim dividend 15 April 2013 67 570 67

25 April 2013
FY13 final dividend 14 October 2013 68 1 330 135

25 October 2013
FY14 interim dividend 14 April 2014 69 800 79

24 April 2014
Comment:
On 8 October 2012 the share price fell by 778 cents per share, shad wing the share going ex-dividend of 1 180
cents per share. This is a quite normal occurrence on the ex-dividend date. The record date of 12 October is the
last date to register as a shareholder in order to receive the dividend, one week after the last date to trade. A
shareholder holding 100 Sasol shares will encounter the following on his investment statement:
15 October: Dividend received 1 180 cps
15 October: Dividend tax paid 177 cps
Example: High dividend yielding companies

2012 2014
Dividend Yield Dividend Yield
Astral 7,8% 2,4%
Kumba 7,7% 10,2%
Metmar 7,7% 0,0%
Winhold 7,6% 0,0%
Phumelela 7,4% 3,9%
Vodacom – 5,2%
Lewis Group – 7,4%
Comment:
The yield is driven by the dividend paid and the share price. The yield shown is now higher than what the
beneficiary receives on a n t basis by 15%. The consistency in paying dividends should be considered. For the
above examples, yi lds on pr f rence shares (often linked to the prime rate) and on property companies
(including an interest component) are excluded. Yields have come down since 2011. A high yield may also be
indicative of the share pri e not yet reacting to poor results or bad news.
Example: Calg o M3 – Dividends

No dividends have been declared for the period. The Board is of the opinion that the Group must continue to
conserve cash to maintain the present growth and create shareholder value.
C mment:
The company operates in the construction and property development sectors and had projects in excess of R8
bi ion in the pipeline.
576
14.3.3 Dividend stability and information content

Investors favour companies with established dividend records, as it can be argued that investors receive little
information about a company’s earnings potential because of the creative accounting techniques used in many
subsidiary-layered companies. Investors believe that the only way to separate a marginally profitable company
from a profitable one is to look at the dividends. Investors would tend to refuse to believe a company’s earn-
ings announcement unless the announcement was backed by an appropriate dividend payment policy.
A stable, steadily growing dividend record over an extended period is one of the distinctive characteristics of a
successful company.
The information content of dividend policies suggests that investors look to the evel and consistency of divi-
dend payments as a guide to the company’s future potential. A reduction in dividends in order to finance an
investment project may be viewed as a sign of company difficulties, and m y result in the market decline of the
share price.
Example: Anglo American – Skipped dividend

Dividend hist ry Share price in
(cps) January (cps)
2008 Interim: 324,9 41 940

2009 14 241
2010 Interim: 183,1 32 850
Comment:
The company skipped their dividend payment in 2009, due to liquidity and high capital expenditure issues with
a resumption only due in 2014/15. Another recent example is Palabora Mining Company, which after yielding
an average 3,6% per annum over a five-year period, opted to not pay a dividend in 2012, which caused the
share price to halve. This decline is partly ascribed to the (reverse) impact of clientele requirements. Share
prices will take some time to recover: in the case of Anglo American who will now resume paying dividends, the
price is still below the 2010 recorded price.
Miller and Modigliani regard the information content of dividends as temporary. Where the market price of a
share increases as a result of high dividend payment, they believe that the increase would have happened
anyway, as information about future earnings filters through the market.
Example: Pinnacle Holdings – Policy suspended
Comment:
The company susp nd d its policy of paying 20% of headline earnings as a dividend and the share price dropped
by 22% to R10,51 in S ptember 2014 when this was announced.
14.4 Alte native forms of dividend payment

Dividend payments can be made in a variety of forms. The most common ones are –
special dividend;
capitalisati n issues; and
share repurchases.
14.4.1 Special dividend

In addition to normal dividend payments, a company may declare an ad hoc special dividend to registered sh
reholders on a designated date. The company will usually have high cash reserves and may have made a
decision not to buy back its own shares. By implication, such a decision will indicate that the company does not
anticipate any immediate investment opportunities to present.
577
Example: Old Mutual – Dividends and share consolidation

‘As well as the 18p per share special dividend that is to be paid following the completion of the Nordic sale, we
have announced a significantly increased final dividend for the year of 3,6p per existing share, equivalent to
4,0p per new ordinary share once our shares have been consolidated. The final dividend will be paid on 7 June
2012 at the same time as the special dividend and I would draw to your attention the full timetable for the final
and special dividends and the share consolidation, which is set out in the Shareholder Information section of
this document. We anticipate further progression in our ordinary dividends over the coming years. In light of
the complexity involved in our share consolidation, we have decided not to offer a scrip dividend alternative for
this year’s final dividend and the Board will decide later this year whether to offer such an alternative for the
2012 interim dividend.’
14.4.2 Capitalisation issues

Capitalisation issues or scrip dividends take place when the company is concerned about its liquidity or antici-
pates new investment project(s) which will require cash. It may then decide not to skip a dividend, but rather
issue a paper dividend in the form of additional shares. Shareh lders will usually receive an option to (specifi-
cally) elect a cash payment or the share alternative. Shareholders will be enc uraged to rather select the script
offered, by building a premium above the cash option into the script pti n. This premium may be up to 10%
above the cash dividend. Refer Bidvest Group results for the year ended 30 June 2014: in the ratio of 1,55
shares for every 100 shares held on the record date, the equivalent of 436,0 cents per share versus a gross cash
dividend of 432 cents per share.
Example: Scrip dividend

A company’s share price is currently R100. The company proposes a net cash dividend of R2,50 per share held or
scrip shares to all shareholders holding 100 shares or more on the basis of 2,8 shares for every R250 of cash
dividends or 100 shares held. Fractions of shares to be converted to cash credits held on behalf of shareholders.
Solution:
A shareholder holding 100 shares will be entitled to a cash dividend of 100 × R2,50 = R250 and can thus pur-
chase 2,5 new shares in the market (brokerage and taxes ignored). The alternative is two new shares with a
credit for the 0,8 shares due.
A shareholder holding 1 000 shares will be entitled to a cash dividend of 1 000 × 2,50 = R2 500 or a purchase of
25 new shares. The alternative in this case will be 28 new shares being issued (2,8 shares for 100 shares held =
28 new shares).
The accounting entry for the scrip dividend will be a credit to the issued share capital and share premium
account and a corresponding debit to the retained reserves in the statement of equity. For the example above,
assume ordinary shar s have a nominal value of R5, then:
Retained profit R2 800
Nominal share apital R 140 (28 shares × R5)
Share premium (R100 – R5) R2 660 (28 shares × R95)
14.4.3 Share repurchases

Share rep rchases or buybacks are practised by the majority of listed companies on a continuous basis. The
process is driven by a company sitting on a cash pile with –
no immediate investment prospects;
a perception that the market share price does not reflect the value of the company;
as a protective measure against corporate activity; or
management’s objectives in terms of incentives or a combination of the above.
The company requires shareholders’ approval for this process and must demonstrate solvency and use its own
c sh for this purpose. As buybacks usually take place in the market, the share price tends to stabilise or in-
crease. The shares bought back may be cancelled (which happens very seldom) or be held as treasury shares, or
by a subsidiary company.
578
Example: MTN – Share repurchase

Integrated Report YE 31/12/13:
The group did not buy back any shares in the year, after spending approximately R3 billion in 2012 and 2011 on
buybacks in the open market. Buybacks will be considered on an opportunistic basis.
Example: Vodacom – Share repurchase

Integrated Report YE 31/03/14:
Vodacom Group Ltd acquired 3709419 shares in the (open) market during the year at an average price of
R112,48 per share. Share repurchases did not exceed 1% of VGL’s issued share capital
Comment:
Companies will limit the % shareholding that may be repurchased. In Vodacom’s case this is currently 5% of
issued ordinary shares. The Vodacom share prices varied between R111,40 and R139,7 for this period.
Note: All the company-specific examples given in this chapter illustrate particular aspects and are based on
financial information gleaned from the 2014 integrated financial reports and other public documenta-
tion of the stated companies.
Holding the shares means that they can be used again as part of a corporate transaction (e.g. doing a take-over
or BEE transaction), issued in lieu of staff compensation sche es or even be sold back into the market at an
opportune time. Shares bought back do not qualify for divid nds and are excluded from all earnings per share
calculations. A side effect of the share buyback will thus be to increase the earnings per share, all things being
equal.
For shares held and not cancelled, the accounting entry will be:
Investment at cost Dr amount
Bank Cr amount
14.5 Dividend policy in practice

It would appear that financial managers favour a fair level of dividends payment policy, with a long-term target
payout rate. In moving towards the long-term payout rate, dividends are increased slowly, in order to avoid
wild fluctuations.
When a large dividend increase takes place, shareholders will interpret the move as an optimistic sign of future
performance. There is little doubt, therefore, that sudden shifts in dividend policy will directly affect the share
price.
The dividend policy in a p rf ct world has no effect on market value. However, in an imperfect world, where
dividends and (often) capital gains are taxed, investors would require a higher before-tax return on high-payout
shares to compensate for their tax disadvantage. High-income investors would gravitate toward the low-payout
firms. It is impossible to provide a formula that can be used to establish the correct dividend payout ratio for
any given situation. Financial managers will always have to exercise their judgement while taking the following
factors into conside ation –
the tax position of shareholders;
the tax position of the firm;
the cash p sition of the firm and debt repayment schedule;
the rate of growth and profit level;
the tability of earnings; and
the maintenance of a target dividend policy.
579
Practice questions

Hantam Ltd, a company listed in the Hotels and Leisure sector of the JSE Securities Exchange South Africa,
published their results for the year ended 30 September 2012.
Mr Mabundla, the managing director, made the following comments:
The company grew spectacularly with EBITDA increasing by 34,2%
Headline earnings per share increased by 31,0%
Distributions to shareholders increased by 31,6%
Good further growth is expected in the tourism industry of Southern Africa.
Hantam Ltd provides operating services to the hotel and gaming industry. The acquisitions during 2012 relate
to companies organising conferences, which is regarded as the first step in becoming a fully integrated player in
the hotels and leisure sector.
The distributions to shareholders comprise a final dividend of 3 cents per share and a capital repayment of 50
cents per share being the balance of the share premium and an interim dividend of 2 cents per share and
capital of 20 cents per share which were paid during the year.
Supplementary Information to the Group Stat ment of Comprehensive Income

2012 2011
Headline earnings per share (cents) 224,1 171,1
Basic earnings per share (cents) 209,7 171,1
Diluted earnings per share (cents) 204,7 166,9
Distributions to shareholders
– Per share (cents) 75,0 57,0
Shares in issue 28 018 27 865
– Total (000) 30 526 30 353
– Held by subsidiary company (000) (2 508) (2 488)
Weighted average number of shares in issue

– Basic (000) 27 892 29 682
– Diluted (000) 28 586 30 436
Required:
A financial report obs rv d: ‘N w Horizons Ltd decreased their dividend to shareholders by 28%.’ Evaluate this
remark critically. (5 marks)
Solution: C itical evaluation of ‘. . . decreased their dividend to shareholders by 28%.’
Check to see that the decrease is correct. Determine what the shareholders received.
l Dividend per share decreased from 7c to 5c (28%) (1)
l Distributi n increased from 57c to 75c (32%) (1)
l Capital repayment a form of dividend, statement not true (1)
Both dividend and capital not subject to tax (if capital scheme implemented before cut-off date) (1)
Capital repayment to non-resident emigrant shareholders considered to be blocked rand. (1)
max (5)
580

Hennops Ltd has made a profit after tax of R23,4 million in their current financial year, with a commensurate
growth in their cash reserves of R26,1 million. They are considering a new capital project of R28 million, which
the operations director has suggested be funded as follows: R14 million in cash and R14 million by way of a
long-term loan with a fixed interest rate of 15% per annum.
The financial director is aware that Hennops Ltd should continue paying a dividend, as not doing so may impact
negatively on their current share price of 800 cents per share, trading at twice the current net asset value.
Hennops Ltd paid a dividend of 30 cents per share in respect of their previous financial year. Their 15 million
shares in issue (in terms of number) have remained unchanged for the last three years.
Required:
The financial director is considering a number of dividend options for the current year:
Growing the previous dividend by 10%
Applying a dividend cover of 4
Issuing a script dividend on a 1 for 20 basis assuming all shareh lders accepts the offer
Repurchase 1 million shares at the current market price on a pro-rata basis.
Show the impact of each of the above per share and on Hennops Ltd’s balance sheet. (12 marks)
Solution:
Apply the option guideline and then consider the impact, usually cash and equity.
Hennops Ltd
(a) Dividend per share = 30 × 1,10 = 33 cps (1)
Total dividend = 15m × 0,33 = 4,95m (1)
Cash and retained earnings (statement of equity) will decrease (1)
(b) Equity per share = 23,4 ÷ 15 = 156 cps (1)

Dividend per share = 156 ÷ 4 = 39 cps (1)
Total dividend = 15m × 0,39 = 5,85m (1)
Cash and retained earnings will decrease (1)
(c) Share price 800 cents per share

On a 1 – 20 basis
Value per share 40 cents per share (1)
Total value 15m × 0,4 = R6m or (1)
15m ÷ 20 × R8 = R6m
Decrease retained earnings and increase equity (1)
(d) Total value 1m × 8 = 8m (1)

Equity per sha e will increase 23,4 ÷ 14m (assuming no growth) = 167 cps (1)
Cash will decrease and equity will decrease; or
share held/invested will increase (1)
max 12
581
Chapter 15
The functioning of the

foreign exchange markets
and currency risk
distinguish between the three types of currency risk;

distinguish between direct and indirect currency quotes;
distinguish between spot and forward exchange rates;
discuss interest rate parity and purchasing power parity principles;
calculate the annual premium or discount at which a currency is being quoted;
discuss the factors influencing the exchange rate mechanism;
calculate forward rates using interest rate parity and purchasing power parity principles;
calculate the cost of hedging and resulting ‘manufactured’ forward rate using a money-market hedge;
calculate the cost of hedging using a forward exchange contract (FEC);
set up a currency hedge using foreign exchange futures contracts and calculate the outcome thereof;
set up a currency hedge using a foreign exchange options contract (both over-the-counter and traded
currency/exchange contracts) and calculate the outcome thereof;
l distinguish b tw n long and short-term currency swaps and explain their respective functioning; and l
value forward ex hange contract for financial reporting purposes.
The objective of this chapter is to explain the relationship between currencies as they pertain to the short- and
medium-term movement of money between countries in settlement of underlying transactions. The intention
is to give the st dent a fundamental understanding of the principles, not an in-depth explanation of the
complex principles of international finance.
As trade takes place between two countries, there is a need for a mechanism to facilitate the settlement of
these transacti ns in the foreign exchange markets. For example, if a South African based company purchases a
product from a German based company, the South African company will need to buy foreign currency (Euros)
in order to pay the supplier in Germany. The foreign exchange rate represents the conversion relationship
between currencies, and depends on demand and supply between the currencies of the two relevant countries,
in this case South Africa (Rand) and Germany (Euros). The foreign exchange rate is the quotation of one
currency in terms of another.
583
15.1 Currency risk defined

Currency risk or foreign exchange rate risk can be defined as the potential for financial losses for an enterprise
due to adverse movements in the foreign exchange rate(s) when it is involved in an international transaction.
An enterprise will be exposed to such risks when it finds itself in any of the following positions:
The enterprise (being an exporter) sells goods to foreign customers or renders a service to a foreign
customer, and the foreign customer is invoiced in their own currency.
An importer of foreign goods or services, which is invoiced in the currency of the seller of the particular
goods or provider of the particular service.
Any enterprise owning assets that are located overseas.
Any enterprise which has borrowed funds overseas.
Any enterprise which has foreign operations which take place through an entity located overseas, in
which the enterprise owns part of the equity of said entity, or through a branch of the entity located
overseas.
Three categories of currency risk exist, arising from the scenari s identified above, which are discussed below.
15.1.1 Categories of currency risk

The following diagram indicates the three forms of currency risk:
Curr ncy risk
Transaction risk Translation risk Economic risk
Figure 15.1: Categories of currency risk
We will now have a look at each of these forms of currency risk and its implications for the enterprise.
15.1.2 Transaction risk

Transaction risk results from adverse changes in the exchange rates between the date of entering into a
transaction and the s ttl m nt date for the transaction – in other words the date on which the cashflow occurs.
An enterprise an be exposed to transaction risk from either the perspective of a supplier or a customer:
Foreign supplie s Foreign customers

The enterp ise will have purchased goods or services Exporters are exposed to currency risk when they
from a foreign s pplier and been invoiced in a invoice their foreign customers, in a foreign
foreign c rrency (the currency of the supplier or the currency (either the currency of their customer or
US Dollar). the US Dollar).
Transacti n risk arises when the enterprise’s Transaction risk arises when the enterprise’s func-
functi nal currency depreciates or weakens against tional currency appreciates (strengthens) against the
the currency in which they have been invoiced currency in which the foreign customer has been
between entering into the transaction and making invoiced, between entering into the transaction and
payments in respect of the amount owing to its amounts being received from the foreign customer.
foreign supplier.
Result: Due to its functional currency losing ground Result: Due to its functional currency gaining ground
(we kening) against the foreign currency in which (strengthening) against the foreign currency in
he payment has to be made, the goods or services which they will be paid, the enterprise receives less
purchased end up costing the enterprise more. local currency when amounts are received from the
foreign customer.
584
The functioning of the foreign exchange markets and currency risk Chapter 15
Example: Calculating foreign exchange gain/loss

ABC Manufacturers imported 10 000 components at a cost of €50 each from its German supplier. On
30 June 20X2, when the goods were loaded onto a cargo vessel in Hamburg harbour, the exchange rate
between the South African Rand (ZAR) and the Euro (€) was R10,06/€1, while on 31 July 20X2, when ABC
Manufacturers physically purchased Euros in the currency market in South Africa to settle the amount owing to
ABC Manufacturers, the exchange rate was R10,26/€1.
Required:
How much was the foreign exchange loss which resulted for ABC Manufacturers?
Solution:
On 30 June 20X2 the cost of components was:
10 000 components × €50 each × R10,06 = R5 030 000
Given that the ZAR depreciated against the Euro, the actual payment made amounted
to: 10 000 components × €50 each × R10,26 = R5 130 000
The foreign exchange loss amounted to R100 000 (being the additional amount that had to be paid resulting
from the Rand weakening from R10,06/€1 to R10,26/€1. (Assu ing that the Euro had weakened against the
ZAR, for example R9,50/€1, there would have been a foreign exchange gain).
15.1.3 Translation risk

Translation risk arises for any enterprise falling into the following categories:
Any enterprise owning assets located overseas which it needs to recognise in its own statement of
financial position as an asset but the value thereof needs to be reported in its own functional currency.
Any enterprise which has borrowed funds overseas would need to recognise this debt as a liability in its
own statement of financial position. The fair value of the foreign borrowing however needs to be
reported in its own functional currency. The same will be the case for any financial asset reported by the
entity, but which is denominated in a foreign currency.
Any enterprise which has foreign operations which take place through an entity located overseas, in
which the enterprise owns part of or all of the equity of said entity, or through a branch located overseas.
The financial results of these foreign operations as well as the assets and liabilities of these foreign
operations need to be accounted for in the financial statements of the local enterprise.
All of the cases identified above have one thing in common – they all require translating an amount of foreign
currency into local currency for financial reporting purposes. IAS 21 and IFRS 9 determine the translation of
financial assets and financial liabilities from one financial reporting period to the next. IAS 21 prescribes the
translation of the financial r sults and assets and liabilities of foreign operations and foreign subsidiaries. The
commonality is that diff r nc s arising from one financial reporting date to the next, can in certain cases impact
on the earnings of the enterprise, but will not have a cashflow implication. As a result the need to hedge
translation risk is in no way as important as the need to hedge transaction risk.
15.1.4 Economic risk

The third category of currency risk is economic risk. The performance of a country’s currency relative to other
currencies has a direct impact on how competitive an enterprise will be internationally. An enterprise will very
often price the g ods or services it exports in foreign currency to stimulate the demand for its products abroad.
If the enterprise’s own currency strengthens, the cost of its goods becomes more expensive for its foreign cu
tomers. The result of such a strengthening (appreciation) in their own functional currency relative to various
foreign currencies can ultimately result in the foreign customers replacing the enterprise with a supplier in
another country with a weaker currency.
The South African Rand (ZAR) (hereafter referred to as the Rand) has traded at relatively strong levels in recent
ye rs making exports more expensive for foreign customers. The result of this has been calls for a weakening of
he South African Rand to stimulate the export market and in so doing, creating jobs locally. Regardless of
whether or not such an action might be noble and socially responsible, it is important to remember that
commodities such as oil trade in US Dollars in the international markets and a weaker Rand would negatively
impact on the fuel price locally.
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Example: Impact on exports

One of the industries impacted on by a strong Rand, is the South African wine industry. The strong Rand has
resulted in an increase in the landed cost of the wine in foreign markets. Wines sourced from countries whose
currencies have not experienced the same strengthening (appreciation) as that of the Rand, are consequently
at a competitive advantage in the foreign markets.
Economic risks are therefore viewed as being a strategic type of risk and can have a long-term impact on the
enterprise. These risks can also impact on the value of an exporter as future cashflows are likely to reduce on
the back of a stronger Rand.
15.1.5 Other risks related to foreign currency transactions

The student should also be aware of two other risks related to foreign currency tr ns ctions:
Counterparty risk: As is seen later in this chapter, many enterprises, in trying to reduce their exposure to
currency risk, will enter into hedging agreements with a hedge counterparty. Should the counterparty not
perform according to the hedging agreement, then the enterprise will remain exposed to currency risk. It
is therefore important for an enterprise to assess, before entering into a hedging agreement, the risk of
the counterparty defaulting in future.
Dealer risk: Losses can arise for an enterprise if the dealer with whom they transact, does not perform as
expected. An example of dealer risk is an instance where an enterprise needs to make a foreign payment
and places an order with the international banking division of its local bank. The bank does not process
the order timeously as requested. The delay in proc ssing the order may result in the foreign currency
purchased by the enterprise costing it more, as the local currency has depreciated in the interim.
15.2 Different currency quotes in the currency market

The buying and selling of currency takes place in the currency markets. With the exception of certain currency
derivatives, the buying and selling of currency takes place through over-the-counter (OTC) transactions.
This section takes a closer look at the different kinds of currency quotes.
15.2.1 Spot rates

A spot rate in respect of currency is the rate which applies to immediate delivery of the specified amount of
currency. In essence it applies only on that given day at that given time. The currency markets make a
distinction between spot buying and selling rates. The buying rate (also referred to as the bid price) is the rate
at which a bank will buy currency at, from a client. On the other hand the selling rate (also referred to as the
ask price) of the bank is the rate at which the bank will sell currency to its clients at.
Applying this practically:
Example: Selling rate

South African Ai ways purchases four new Airbus engines from Airbus manufacturers in Europe. Airbus invoices
South African Ai ways in Euros. As the functional currency of South African Airways is the Rand, the airline will
need to p rchase E ros from its local bank to pay Airbus. South African Airways will be selling the Rand
equivalent to the bank in exchange for Euros.
At what rate will the transaction take place?

It is imp rtant to remember that when determining whether the buying or selling rate will apply, one needs to
focus on what the bank will be doing. In this case the bank will be selling foreign currency (this is the service
which the bank is offering South African Airways) and as such the transaction will take place at the selling rate
(the ask price).
Ex mple: Buying rate

Paarl Wine Cellars has just received a Euro-denominated payment from its customers located in Europe. Paarl
Wine Cellars will need to convert this Euro amount into Rand.
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At what rate will the transaction take place?

In this case the bank will be buying foreign currency and as such the transaction will take place at the buying
rate (bid price).
The second distinction made in the currency markets in respect of currency quotes, is between direct and
indirect quotes. These can be described as follows:
In a direct quote, a number of units of the local currency are quoted relative to one unit of a foreign
currency. For example: ZAR13,0243/GBP1 would be a direct quote as the Rand is being quoted relative to
one unit of British Sterling/Pound. In this quote, the Rand (ZAR) is the ‘term’ or ‘reference’ currency and
the Pound (GBP) is the ‘base’ currency.
The base currency is always fixed (hence it is always quoted as one unit of the specific currency). It is the
term or reference currency which moves relative to the base currency. As result, the movement (gain or
loss) resulting from a movement in the currency will always be in the term/reference currency. In the
currency quote above, any movement or change would be a Rand mo ement.
Note: The amount of foreign currency will always be multiplied by a direct quote to convert the
foreign currency to the equivalent local amount.
In an indirect quote, a number of units of a foreign currency are quoted relative to one unit of the local
currency. For example: CHF0,1178/ZAR1 would be an indirect quote as the Swiss Franc (CHF) is being
quoted relative to one unit of the local currency, na ely the Rand (ZAR).
In this currency quote above the term or reference currency would be the Swiss Franc while the Rand
would be the base currency.
Note: The amount of foreign currency will always be divided by an indirect quote to convert the
foreign currency to the equivalent local amount.
Standard Bank
FOREX CLOSING INDICATION RATES FOR 26 September 2012 as at 16:00
Rates for amounts up to R 200 000
2012-09-26 16:00:40.0 Load

Closing rate history for date :
Bank Buying Bank Selling
Country Cur T/T Cheques Foreign Cheques Foreign
Notes and T/T Notes
QUOTATIONS ON BASIS RAND PER UNIT FOREIGN CURRENCY
BRITISH STERLING GBP 13,0243 12,9940 12,9018 13,5409 13,6359
EURO EUR 10,3547 10,3259 10,2302 10,8013 10,8313
UNITED STATES DOL USD 8,0634 8,0271 8,0559 8,3809 8,3809
QUOTATIONS ON BASIS FOREIGN CURRENCY PER R1
ARAB EMIRATES DIR AED 0,4779 0,4617 0,4125 04367
ANGOLAN KWANZA AOA 10,4652
AUSTRALIAN DOLLAR AUD 0,1216 0,1232 0,1226 0,1128 0,1118
BOTSWANA PULA BWP 0,9831 0,9895 0,9831 0,8723 0,8723
CANADIAN DOLLAR CAD 0,1265 0,1270 0,1295 0,1119 0,1119
SWISS FRANC CHF 0,1178 0,1181 0,1288 0,1103 0,1063
CHINESE YUAN CNY 0,8190 0,7813 0,7094 0,7370
Figure 15.2: Extract from the currency quotes published by Standard Bank
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The table above indicates the rate which will apply to transactions up to an equivalent of R200 000. The rates
applicable will differ depending on the form in which the foreign currency is, which could be: physical cash in
the form of notes (foreign currency services do not entail buying and selling of foreign coins), foreign cheque or
a foreign transfer (T/T = telegraphic transfer).
How will this table be applied, assuming a foreign payment and a foreign receipt respectively?
Example: Foreign exchange transactions

Stellenbosch Wineries has two foreign exchange transactions that need to be converted:
Transaction one: They need to settle an amount of €18 500 owing to the German Manufacturer of a machine,
which they purchased from the German M nuf cturer. Stellenbosch Wineries would like to
transfer the money electronically to the German Manufacturer’s bank account held in
Frankfurt, Germany with a local Germ n b nk.
Transaction two: A payment of CHF2 680 was received by means of a foreign cheque from a Swiss customer
(debtor) of Stellenbosch Wineries.
Required:
Assuming Stellenbosch Wineries wish to make the pay ent in ter s of transaction one on 26 September 20X2
and to convert the amount from the Swiss debtor (transaction two) on the same date, what will the Rand
amount of each transaction be?
Solution:
Transaction one:
As a foreign payment needs to be made, the service offered by the bank is the selling of foreign currency to
Stellenbosch Wineries. Therefore the bank’s selling rate (ask price) will be used. As the payment will be made
by means of an electronic transfer, the following rate will apply: R10,8013/€1. Will the Euro amount be
multiplied or divided by this rate in order to convert the Euro amount to Rand?
As the foreign exchange quote between the Rand and the Euro is a direct quote in the currency market in South
Africa (i.e, quoted as the number of and per Euro 1), we will multiply by the rate as follows:
EUR18 500 × ZAR10,8013 = 199 824,05
Transaction two:
As a foreign receipt needs to be converted into Rand, the bank will in this case be buying the foreign amount
from Stellenbosch Wineries, and therefore the bank’s buying rate (bid price) will be used. Which rate will
apply? As the Swiss Franc amount is in the form of a foreign cheque, the rate applicable will be:
CHF0,1181/ZAR1.
In this case, the foreign ex hange quote is between the Swiss Franc (CHF) and the Rand which is an indirect
quote (the rate is quoted as the number of Swiss Franc per Rand 1). Due to this being an indirect quote, we will
divide the Swiss F anc amount by the exchange rate as follows:
CHF2 680
= ZAR22 692,63
CHF0,1181
You will also need to be able to interpret the following notations, which we illustrate using information
contained in the table earlier:
ZAR/EUR1: ZAR10,2302 – ZAR10,8313
The above also indicates the buying and selling rates between the Rand and the Euro. Which amount reflects
which rate? As the Rand is being quoted relative to one unit of the Euro, the quote is a direct quote. Applying
the following principle to a direct quote, one can identify the buying and selling rate: in respect of a direct
quote, the bank always buys low and sells high. This means then that the ZAR10,2302/EUR1 is the buying rate
and the ZAR10,8313/EUR1 is the selling rate.
What about in the following case? The quote is CHF/ZAR1: CHF0,1288 – CHF0,1063.
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The quote above is referred to as an indirect quote as the Swiss Franc is being quoted relative to one unit of the
Rand, the latter being the local currency. In respect of an indirect quote, the bank always sells low and buys
high. This means that the CHF0,1288/ZAR1 would be the buying rate and the CHF0,1063/ZAR1 would be the
selling rate.
The bid-ask spread or margin

Referring to the table provided earlier (Figure 15.2), it can be seen that the bank’s ZAR/EUR1 buying rate (for
T/T transactions) and the bank’s ZAR/EUR1 selling rate (cheques and T/T transactions) is ZAR10,3547/EUR1 and
ZAR10,8013/EUR1 respectively. Why do the two rates differ?
The difference between the buying and selling rates is due to the existence of the bid-ask spread or the profit
margin which the foreign currency dealer makes through trading in a particul r currency. The size of the spread
will depend on a number of factors, including–
the volume of transactions in the local currency market in that particular currency; and
the volatility of the currencies represented in the particular exchange rate.
Where the currencies are very volatile the spread tends to increase. The v lume of transactions in the currency
market tends to have the opposite effect. The larger the volume f transactions in a particular currency, the
lower the spread tends to be.
Other important rates: mid-rates and cross-rates

Before having a look at forward rates quoted in the curr ncy markets, two other terms need to be identified
and explained:
Mid-rates Cross-rates
The mid-rate is the average rate between the buying As all global currencies will at a minimum be quoted
and selling rates of a particular currency quote – relative to the US Dollar, one can determine a
alternatively stated it is the mid-point between the currency quote between any two currencies using
two quotes and is calculated as follows: the cross-rate mechanism.
buying rate  selling rate

= mid-rate For example:
2
You need to be aware of the above calculation Assuming the ZAR/USD1 buying rate is ZAR8,0559
however you will not be expected to apply this rate while the buying rate for the GBP/USD1 is
regularly. GBP0,66623, calculate the buying rate in terms of
ZAR/GBP1:
The mid-rate of the Rand/Euro currency quotes As ZAR8,0559 = USD1 = GBP0,66623 then ZAR8,0559
explained above would be: = GBP0,66623 resulting in:
ZAR8,0559
ZAR10,2302 ZAR10,8313 = ZAR10,5308/EUR1 0,66623 = GBP1 or ZAR12,0918/GBP1
2
In this example both quotes needed to be in terms
of USD1 to use the cross-rate mechanism.
Figure 15.3: Mid-rates and cross-rates
15.2.2 F rward rates

If a sp t rate is the rate applicable today for immediate delivery of currency, what does a forward rate refer to?
A forward rate is in essence a rate determined and quoted ‘today’ for settlement on a future date. The various
ways of predicting forward rates are discussed later in this chapter under the so-called ‘parity theories’.
A forward rate will be quoted at either a discount or premium to the spot rate. If quoted at a discount, the
currency (base currency) in which the exchange rate is quoted, is expected to depreciate (lose value) in future.
Should a currency (base currency) be quoted at a premium, then it indicates that the base currency is expected
o appreciate (increase in value) in future. The example below illustrates:
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Example: Premium or discount?

The following information is available in terms of the Rand/US Dollar exchange rate on 25 September 20X2:
ZAR/USD1
Spot rate 8,3809
Forward rate (90 days) 8,5060
The 90-day forward rate is the forward rate for 24 December 20X2.
Required:
Identify whether the US Dollar (USD) is being quoted forward at a premium or discount relative to the South
African Rand (ZAR).
Solution:
The base currency is the US Dollar in this case. It is evident that the 90-day forward rate for the ZAR/USD1 is
more than the spot rate on 25 September 20X2. This indicates that the Rand is expected to weaken and in turn
the US Dollar is expected to strengthen, in the forward market. The US D llar is therefore being quoted at a
premium to the South African Rand in the forward market.
What does this imply about the South African Rand? The above quote is a US Dollar quote given that the US
Dollar is the base currency. The South African Rand is expected to depreciate in future and hence the forward
market will be quoting ZAR at a discount to the US Dollar.
It is important that one be able to calculate the annual discount or premium that a currency is being quoted at.
The discount or premium will be calculated by determining the difference between the spot and forward rates
for a particular currency quote, converting it to a percentage and ultimately annualising it. This will indicate
theannual weakening expected in the currency being quoted at a discount or the expected annual
strengthening in the currency being quoted at a premium.
The annualised premium that the US Dollar is being quoted at in the preceding example will be calculated as
follows (this is a direct quote in South Africa):
Formula to annualise a premium/(discount):
Forward rate – Spot rate 360

× × 100 = … %
Spot rate n
Note that the annualisation of the premium above is based on days. The annualisation can however also be
based on months. Based on days, the answer is:
ZAR8,5060 – ZAR8,3809 360
× × 100 = 5,97%
ZAR8,3809 90
The US Dollar is quoted at an annual premium of 5,97% to the South African Rand (ZAR).This means that the
spot rate at whi h the US Dollar is being quoted at relative to the South African Rand is expected to appreciate
by 5,97% over the ou se of the year. It is important to note that the premium is positive.
The annualised discount that the South African Rand is being quoted at in the preceding example will be
calculated sing the following formula (as the currency quote is in US Dollar terms, the formula needs to change
in order to express the premium or discount in ZAR terms):
Sp t rate – Forward rate 360
× × 100 = … %
F rward rate n
ZAR8,3809 – ZAR8,5060 360

× × 100 = (5,88%)
ZAR8,5060 90
As expected, the South African Rand is being quoted at a discount. The answer using the formula is a negative
number hence it is shown in brackets.
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How is the forward rate calculated?

One way of calculating a forward rate would be to use a spot rate and to adjust the spot rate for the forecasted
discount or premium applying to the currency quote. As a forward rate applies to a specific date in future, the
discount or premium needs to apply to the specific time interval between spot (‘today’) and the date to which
the forward rate will apply.
The following example illustrates the concept of using a discount or premium (as applicable) supplied by a
foreign exchange dealer such as the foreign exchange division of a commercial bank, and adjusting the spot
rate accordingly.
Example: Calculating the forward rate using spot rate and adjusting it for a discount or premium
The following information is provided in respect of the ZAR/USD1 quoted in the South African currency market
on 25 September 20X2:
ZAR/USD1
Spot rate (bank’s selling rate) 8,3809
The foreign exchange division of a local bank informs you that the annual premium at which the US Dollar is
being quoted forward relative to the South African Rand is 5,98%.
Required:
Calculate the forward rates (ZAR/USD1) for the following dates:
25 September 20X3; and
24 December 20X2.
Solution:
As 25 September 20X3 is one year on from the date of the spot rate which will be used as the basis for the
calculation of the forward rate, no time adjustment needs to be made to the premium. The forward rate
will therefore be:
Spot rate + premium or – discount
R8,3809 + (5,98% of R8,3809) = 8,8821 (rounded to four decimals)
The spot rate is quoted in US Dollars and the premium is also in US Dollar terms. The spot rate is adjusted
by adding on the effect of the forecasted premium.
In calculating the premium adjustment careful consideration must be given to the days:
The number of days between the spot date (25 September 20X2) and the forward date
(24 December 20X2) is 90 days. The annual premium will need to be adjusted accordingly.
90
R8,3809 + (R8,3809 × 5,98% × ) = R8,5062 (rounded to four decimals)
360
(Note that this fo ward rate differs slightly from the one given in the previous examples. The forward
rates a e both for the same date. The reason is due to rounding differences.)
Alternatively the bank could quote the premium as a point (decimal) difference in a particular currency. In
the previo s example, the bank could have quoted that US Dollar at a premium of ZAR0,1253/USD1
for 24 December 20X2. What would the forward rate be in that case? Following a similar process:
R8,3809 + R0,1253 = R8,5062.
The student will also need to be able to deal with the following situation.
Examp e: Forward selling rate

The following spot exchange rate has been given by the bank (ZAR/USD1): ZAR8,0559 – ZAR8,3809 with the US
Doll r being quoted forward at a premium of ZAR0,0500 – ZAR0,1253 for 24 December 20X2.
Required:
What is the forward selling rate for 24 December 20X2 that the bank is quoting?
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Solution:
Firstly, which rate represents the bank’s spot selling rate? Remember, the quote above is a direct quote with
the bank always selling high. Therefore ZAR8,3809 would be the bank’s selling rate.
Secondly, which premium will apply? In the notation ZAR0,0500 – ZAR0,1253, the first value quoted would be
the premium for the buying rate of the bank with the ZAR0,1253 being the premium relating to the selling
rate (note that the order that the premium is quoted in the same order in which the buying and selling rates
are quoted). Therefore the forward rate will be:
ZAR8,3809 + ZAR0,1253 = ZAR8,5062
If a currency is quoted forward at a discount, then the discount would be deducted from the relevant spot rate
to calculate the forward rate.
15.3 Theories for determining forward exchange rates

There are two theories that the student is required to address, namely the interest rate parity theory and the
purchasing power parity theory. These will be dealt with in turn.
15.3.1 Interest rate parity theory

This theory states that the difference between the spot and forward rates for a currency quote can be
attributed to the difference between the expected int r st rat s (known as the interest differential) of the two
countries whose currencies are present in a particular xchange rate, during a particular period of time.
Countries with higher interest rates normally have higher inflation rates and weaker currencies (relatively
speaking), whilst countries with lower inflation rates normally also have lower interest rates prevailing and
stronger currencies (relatively speaking).
If interest rate parity exists then a very important principle needs to be noted – all else being equal, you are not
likely to gain by borrowing in one country (normally the country with a lower interest rate) and investing in
another country (normally the country with higher deposit rates) as what is gained through the interest rate
mechanism will in all likelihood be lost through currency differences. The country with the higher deposit rates
will have a weaker currency, which will be expected to depreciate in future. The gain from borrowing at a lower
interest and investing at a higher interest rate will in all likelihood be eliminated through a foreign exchange
loss on the investment in future.
In terms of interest rate parity theory, the following formula exists:
1 + interest rate in reference currency country
Forward rate = Spot rate ×
1 + interest rate in base currency country
Please note that int r st rate parity is normally used to determine forward rates over the short- term. To
determine medium- to long r t rm rates, the purchasing power parity theory (which is discussed in the next
section), is used.
The example below takes a simplified view of this theory. (Note: Later in the chapter, money-market hedges,
which are based on the interest rate parity theory are discussed. At that point this theory will be revisited.)
Example: Forward rate using interest parity principles

Assume the following spot rate applies in the South African currency market on 25 September 20X2:
ZAR/USD1
Sp t rate 8,3809
The following details are known regarding interest rates in South Africa and the United States of
America: South African interest rates = 8% per annum
United States interest rates = 2% per annum.
Required:
Using interest rate parity principles, determine a forward rate 90 days hence (i.e. for 24 December 20X2).
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Solution:
Firstly, ‘disentangle’ the spot rate given: ZAR8,3809/USD1 (Note that the Rand (ZAR) is the term/reference
currency and the Dollar (USD) is the base currency.)
Now apply the formula:

90
1 + (0,08 × 360 )
Forward rate (ZAR/USD1) = R8,3809 × = ZAR8,5060
90
1 + (0,02 × 360 )
The question that begs asking is whether one would ever gain through borrowing in one country and investing
in another? Does as an arbitrage opportunity (the chance to make a risk-free profit through exploiting price
differences between two or more markets) exist? Let us have a look at the following scenario:
Assume that the US Dollar is being quoted forward at a premium of 5% relati e to the South African Rand while
the interest differential between South Africa and the United States of America is 5% (i.e. South African interest
rates exceed those of the United States of America by 5%). Assume further that an investor intends borrowing
USD from a bank in the United States of America, exchanging the USD into Rand and investing the Rand in a
South African bank. In so doing, the investor would gain 5% per annum through investing in South Africa at a
higher interest rate than is being borrowed at in the United States. However, as the US Dollar is expected to
strengthen by 5% per annum against the Rand, the interest rate gain is eliminated through the Rand (in which
the interest will be earned) depreciating against the US Dollar. The investor is no better or worse off!
How would the investor’s attitude change if the int r st rate differential was 6% while the premium that the US
Dollar is being quoted at forward relative to the Rand is 5%? Now it would make sense for an investor to:
On day 1:
Borrow money in the United States of America (at the lower interest rate).
Convert the US Dollar amount into South African Rand.
Invest the Rand amount (at the higher interest rate) in South Africa.
Reduce the risk of losing value at the end of the transaction by hedging their position – through buying
forward cover and fixing the rate at which they will sell Rand and buy US Dollars at on the future date.
If we are considering this transaction over the course of a year then:
1 Year from now:

The South African investment pays the investor one year’s return.
The principal sum and interest thereon are converted into US Dollars (in terms of the forward cover bought
it will be at a more favourable rate than the market rates at that stage).
The US Dollar amount on conversion should exceed (>) the US Dollar borrowing at that point (principal sum
plus one year’s interest at US interest rates thereon).
Assuming then that all possible investors had access to this information, then clearly every investor would try
to take advantage of this arbitrage opportunity and borrow funds in the United States of America, invest them
in South Africa and repatriate the proceeds back to the United States of America at a later date. Sounds too
good to be tr e, b t assuming that there is an efficient market the promised gains will not materialise. Why?
The arbitrage opportunity is a temporary one – the following actions will be taken in the United States of
America and S uth Africa respectively:
With the inflow of funds into South Africa, the spot ZAR/USD1 exchange rate on day 1 should see the Rand
trengthening and the US Dollar weakening as the USD are sold (causing an excess of USD on the market)
and converted to Rand (causing a shortage of ZAR on the market).
In the forward market, the US Dollar will appreciate given the demand which investors have to preserve
the value of their investments and to limit the effect of US Dollar appreciation in future. In short, the
investor does not want the USD to appreciate, as when the time comes to convert the Rand back to USD
they will have to use more Rand to acquire USD. As investors buy US Dollars forward to hedge
themselves, the US Dollar strengthens in the forward market. This is exactly what we had expected; the
USD was being quoted forward at a premium. The USD premium will now increase given the demand for
the USD in the forward market.
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The USA authorities, given the outflow of funds from the USA, will increase interest rates to stem the
borrowing of funds in the USA with the subsequent movement offshore.
In South Africa, the authorities (South African Reserve Bank) will react by reducing interest rates given
the inflow of funds from abroad.
The result of the last two bullets is that the interest rate differential will shrink, and together with the
increase in the forward USD premium, will restore interest parity to the market.
15.3.2 Purchasing power parity theory

This theory states that the difference between a spot and forward rate in the currency markets of the two
countries can be explained by the inflation rate differential. In other words, price level changes in the two
countries are represented in the exchange rate. Whereas interest rate p rity theory attempts to explain the
impact of interest rate changes on exchange rates in the short-term, purchasing power parity theory applies to
longer term changes in exchange rates.
The formula for the purchasing power parity theory is very similar to the interest rate parity theory formula:
1 + inflation rate in reference currency c untry

Forward rate = Spot rate ×
1 + inflation rate in base currency country
Example: Forward rate using purchasing parity principles

Assume the following spot rate applies in the South African curr ncy market on 25 September 20X2:
ZAR/USD1
Spot rate 8,3809
The following details are known regarding inflation rates in South Africa and the USA respectively:
South African inflation rate = 6% per annum.
United States inflation rate = 1,5% per annum.
Required:
Using the purchasing power parity theory, determine a forward rate for 24 December 20X4 (i.e. two years
hence).
Solution:
Firstly, ‘disentangle’ the spot rate given: ZAR8,3809/USD1 (the ZAR is the term/reference currency and the
USD is the base curr ncy).
Now the formula can be applied:
(1,06)
2
Forwa d ate (ZAR/USD1) = R8,3809 × 2
= ZAR9,1405
(1,015)
It is important to note from the example above a forward rate for a future date in two years’ time, has to be
calculated. As a consequence, the inflation rates have been squared in the formula. The reason for this is that
inflation has a compounding effect. So for a forward rate two years from now, the inflationary impact will need
to be squared and not doubled.
The purchasing power parity theory is closely linked to the law of one price. The law of one price allows one to
calculate the price of a single commodity in one country by using the price of the commodity in another
country and adjusting it for the relevant exchange rate. For instance: if a Big -Mac burger costs R28 in South
Africa, and the ZAR/USD1 exchange rate is ZAR8,2500 today, then what would the US Dollar price of a Big-Mac
burger in New York be?
R28
Solution: = USD3,39
R8,2500
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If one now was to say that a Big-Mac costs R28 in Johannesburg (South Africa) and USD4 in New York (USA),
what could one now deduce about the implicit ZAR/USD1 exchange rate between the two countries?
ZAR28
The aforementioned results in a theoretical exchange rate (ZAR/USD1) of: = ZAR7,0000/USD1
USD4
This would indicate that the South African Rand currently is undervalued if the exchange rate in the currency
market is ZAR8,2500/USD1 as opposed to a theoretical exchange rate of ZAR7,0000/USD1.
15.3.3 International Fisher Effect

Essentially, the International Fisher Effect integrates the interest rate parity theory and purchasing power
parity theory into a single model. According to the International Fisher Effect, the difference between spot and
forward rates can be attributed to the expected changes in nominal interest r tes. This model states that the
spot rate is expected to change in future (going forward) to the same extent but in the opposite direction to the
expected change in nominal interest rates. The real rates of return earned in the two respective countries
equalise, as changes in inflation rates normally result in changes in the nominal interest rates which in turn
results in the spot exchange rate changing. Two very important aspects that this model stresses, which you
should be aware of are:
l A country with relatively high interest rates will nor ally experience relatively high levels of inflation and
will have a weaker currency.
l A country with relatively low interest rates will nor ally experience relatively low levels of inflation and
will have a stronger currency.
The International Fisher Effect can be expressed as follows:
1 + interest rate in reference currency country 1 + inflation rate in reference currency country
=
1 + interest rate in base currency country 1 + inflation rate in base currency country
15.3.4 Expectations theory

This theory also attempts to explain the difference between spot and forward exchange rates. It proposes that
it is the expectations relating to exchange rates, interest rates and other factors impacting on the exchange
rates, which explain the change in the spot rate in future.
If we expect the local currency to weaken, we would typically want to pay our foreign creditors earlier, given
the expectation of a weakening local currency. In buying foreign currency and in the process selling off local
currency, the local currency weakens. This depreciation is as expected. In effect the way in which participants
in the market react to expectations in the market, results in the expectation becoming a reality.
15.4 Factors influ ncing exchange rates

Before we have a look at mitigating or reducing currency risk through different types of currency hedges, we
need to reflect on the fa tors which impact on exchange rates and through the changes in these rates how they
ultimately d ive cu ency risk. These factors include amongst others the following:
Imports: The economic principle of supply of, and demand for, a particular currency. If South African
Airways for instance purchases (imports) a new fleet of aircraft from Airbus Manufacturers in Europe and
with the acquisition taking place in Euros, then on the settlement date, given the high value of the
transacti n, the Rand is likely to weaken and the Euro to strengthen, given the demand for Euros and
ver supply of Rand in the currency market, on settlement of the transaction.
Exports: Similarly, when South African exporters, who invoice their foreign customers in foreign currency,
receive payment from these foreign debtors of theirs, they will need to convert the foreign currency into
Rand. On the day on which they sell this foreign currency to a local bank in exchange for Rand, a demand
for the Rand arises, with an oversupply of foreign currency arising in the market. The result: the Rand will
strengthen and the foreign currency will weaken.
Interest rates: In the earlier discussion of interest rate parity theory it was pointed out that interest rates
also impact on exchange rates. In terms of this theory, it is the difference in interest rates that results in
the spot exchange rate changing in future. From time to time, an arbitrage opportunity can exist in the
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market whereby it is worthwhile for investors to borrow in one country (at a lower interest rate) and to
invest in another country (at a higher interest rate). This arrangement only works when the difference in
interest rates is greater than the discount at which the latter country’s exchange rate is being quoted in
the market. The country in which the investment will be made experiences a demand for its currency, and
will see the spot exchange improving.
If a country’s central bank (such as the South African Reserve Bank in the case of South Africa), increases
interest rates for instance to curb inflationary pressures in the country, this will create a demand for the
local currency from foreign investors who see the higher interest rates as a good investment opportunity.
In buying up local currency, this drives the demand for local currency resu ting in a strengthening of the
local currency (strengthening of the spot rate).
Inflation rates: An increase in inflation rates results in local buying power reducing, which in turn will lead
to a weakening of the local currency as investors sell off investments denomin ted in local currency so as
to protect value by investing their funds elsewhere in the world. The opposite will occur where inflation
rates decrease. If you refer back to our discussion of purchasing price parity theory, you will see that it is
the difference in inflation rates which causes spot rates to change in future.
l Intervention by the central bank: In certain countries, it is the p licy f the central bank that monetary
policy may dictate, that in order to protect the currency f that c untry the central bank may, from time
to time, intervene in the currency market by either buying local currency and in doing so, sell off reserves
of foreign currency (often held in US Dollars) so as to strengthen the local currency. Alternatively, the
central bank may wish to weaken the local currency to create a competitive advantage for local exporters.
It can do so by buying foreign currency and therefore investing in foreign reserves. This will weaken the
local currency.
Speculative transactions: In the free market system, as long as foreign exchange regulations permit it,
speculators may buy and sell currency in order to make a speculative profit. When the speculator targets
a specific currency and starts buying it, a demand for that currency arises and the currency is expected to
strengthen. When the speculator at a later date starts selling off their stock pile of said currency, an
oversupply of the currency arises in the currency market, resulting in the currency weakening.
Investor sentiment: Sentiment in the market in respect of a particular country will also impact on the
exchange rate. This will very often be linked to factors such as political risk. Incidents in a country, such as
long protracted strikes or strikes which turn violent, are viewed in a negative light by foreign investors,
who sell off local investments and invest in other parts of the world in what they see to be safer
investments. This results in a depreciation of the local currency.
Local economic conditions: The health of the local economy, as evidenced by key economic indicators, will
also impact on exchange rates. The key economic indicators, and the impact thereof on the local
currency, are discussed briefly below:
– Current account: The current account balance reflects the net amount of all inflows into South Africa
and all outflows from South Africa and is derived from the value of all goods and services exported
from a country and the value of goods and services imported into a country. Transfer payments into
and out of a country are also taken into account in the current account. Transfer payments into South
Africa would in lude amounts payable to foreign employees working in South Africa paid by the
foreign government or entity, as well as payments, for instance, to the South African government
from a fo eign government. Transfer payments out of South Africa would include payments to South
Af icans wo king overseas but paid from South Africa, payments by the South African government to
foreign institutions such as the United Nations (UN), International Labour Organisation (ILO) and
World Health Organisation (WHO). A drop in the current account balance will result in a weakening of
the l cal currency whereas a strengthening in the current account balance will result in the local
currency strengthening. Within the current account, the trade balance is also calculated. The trade
balance indicates the difference between the export from and imports into a country. A trade deficit
(exports < imports) will generally see a weakening in the value of the local currency.
– Capital account: Capital inflows into or outflows from a country are accounted for in the capital account
of that country. Obviously, where more capital is flowing into a country than out of the country, it will
result in an appreciation of the local currency. One of the main objectives of South African exchange
controls in the past has been to curb capital outflows from South Africa. This protectionist policy
resulted in the Rand trading at stronger levels in the past and a sentiment that the Rand is not able to
derive its true value.
The difference between the current and capital accounts is known as the official reserves of the
country. As the official reserves increase, it is likely that the local currency will strengthen.
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These three accounts discussed above are collectively referred to as the balance of payments. An
improvement in the balance of payments will be reflected in a strengthening of the local currency, or
vice versa.
The following diagram ties together all of the factors identified above and will assist you in remembering them:
Supply and
demand
Interest Inflation
rates r tes
Factors
affecting
exchange
Monetary
policy rates Speculators
Balance of
Senti ent
payments
Figure 15.4: Factors affecting exchange rates
15.5 Hedging of currency risk

In preceding sections, the existence of three forms of currency risk in the market is identified as –
transaction risk;
translation risk; and
economic risk.
An enterprise will generally want to reduce its exposure to these risks. The technique applied is what is known
as hedging which in risk-management terms is seen to be a risk reducing strategy.
Various hedging strategies exist:
A defensive strategy which entails hedging any foreign exchange transaction – whether currency risk exists
in resp ct of the transaction or not. This is a risk-averse strategy and is very costly.
A predictive strat gy which entails only identifying those transactions where currency risk exists and only
hedging them. This is a more cost-effective approach than a defensive strategy.
A maximum limit strategy which entails setting a maximum limit of foreign currency exposure. In short, the
ente p ise will determine the amount of foreign exchange exposure it is willing to tolerate. It absorbs any
cu ency losses on this amount. However, exposure beyond this amount is hedged. For example, Company
A is willing to at any time be exposed to the equivalent of R5 million’s worth of foreign currency
transactions. On 2 October, the treasury division of Company A measures that it is exposed to R8 million’s
worth of foreign currency transactions. Company A will then hedge the equivalent of R3 million of the R8
milli n in terms of this type of hedging strategy. The upside to this strategy is that a limit can be set to the
c st f hedging. The downside is you can suffer currency losses on the portion (the maximum limit) not
hedged.
An off etting or matching strategy which entails matching foreign receipts denominated in the same
currency as the foreign payment and only hedging the net amount, if currency risks exists in respect of
the net amount. This strategy is also known as natural hedging.
A diversification strategy applies particularly to economic risk exposure. Enterprises with a diverse foreign
customer and foreign supplier base are less susceptible to currency risk as not all currencies move in the
same direction at the same time. Similarly, enterprises importing and exporting in a range of currencies
will also hedge themselves to a certain extent, as would having foreign assets and foreign debt
denominated in a range of foreign currencies.
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As mentioned under the offsetting or matching strategy, an enterprise will as far as possible always apply
matching of foreign receipts and foreign payments, foreign assets and foreign debt, where they are
denominated in the same foreign currency. The reason being that this form of hedging, known as a natural
hedge arises automatically from the operations, investing and financing activities of the enterprise and is free
of charge – the hedging does not carry a cost and as such hedging costs will be limited. Natural hedging will be
used as far as possible to reduce the cost of hedging.
Before discussing the more complex hedges, the table below elaborates on a few basic forms of hedging to
reduce currency risk.
Form of risk reduction Explanation

Currency of invoice A local exporter may decide to invoice their foreign sales in Rand and not in
foreign currency. In doing so, they are passing the exposure to transaction risk
on to the foreign customer. The benefit is th t the loc l supplier does not incur
hedging costs – the local supplier might howe er lose foreign customers who
are not willing to take on the foreign exchange exposure.
A local importer might convince their f reign suppliers to invoice all
goods/services supplied to the l cal imp rter, in Rand rather than in foreign
currency. The local importer will benefit from not being exposed to foreign
currency risk.
Leading and lagging A local enterprise may elect to pay its foreign suppliers earlier than the credit
terms granted by them require, thereby reducing its transaction risk. They will
effectively buy curr ncy imm diately (at a cheaper rate) than they would
otherwise have done, had th y paid their foreign creditors later. This is known
as leading.
Another form of leading is convincing foreign debtors to pay earlier than the
credit terms granted to them require, if the expectation is that the local
currency of the enterprise is going to strengthen against the currency of the
foreign debtor in future. This reduces currency risk but would come at the cost
of either having to offer a discount or souring the relationship with the foreign
debtor (a strategic risk for the enterprise).
Lagging on the other hand entails delaying a foreign payment if it is expected
that the local currency is going to strengthen against the foreign currency, or
delaying a foreign receipt (getting a foreign debtor to rather pay later). The
latter would be the case where the local currency is expected to weaken in
future.
Netting This occurs in respect of inter-company transactions. Amounts owing by
divisions in a group are typically matched against amounts owing to the
different divisions. The result is that only the net amounts owing by or owed to
a particular division need to be settled. This reduces the currency risk exposure
as only the net amount needs to be hedged, as well as reducing bank charges
on foreign currency transactions as only the net amount needs to be purchased
or sold.
Two important requirements exist for netting to be effective:
l Netting will be more effective where a centralised treasury division exists.
l One single currency will need to apply to all transactions – the functional
currency of the enterprise (or the US Dollar) will be applied, with all foreign
amounts being converted into this single currency in order for netting off to
occur.
Figure 15.5: Forms of risk reduction
15.6 Money-market hedges

A money-market hedge entails making use of money market instruments (short-term borrowing facilities and
short-term investments) to create or manufacture a foreign currency hedge. Money- market hedges are based
on interest rate parity theory, which states that the spot exchange rate will change in future, given the interest
rate differential between the two countries involved in the exchange rate.
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Money-market hedges can be cheaper than other forms of hedging given that currency dealers are by-passed
when final cashflow settlement of the transaction needs to take place.
Setting up a money- market hedge will differ depending on whether the objective of the money-market hedge
is to hedge a foreign receipt or foreign payment. These are discussed separately below.
15.6.1 Money-market hedges: hedging a foreign payment

In setting up a money-market hedge, an enterprise will effectively borrow money in one currency, and
immediately thereafter (on day 1 of the transaction) convert the borrowed funds into a different currency and
invest the funds in a different country.
Where a foreign payment is to be made, it would make no sense borrowing funds overseas, converting the
borrowed funds into Rand and investing the funds locally in South Africa. The foreign exchange risk remains – it
is merely shifted from the foreign creditor to the foreign borrowing. The process is depicted diagrammatically
below:
On day 1:
borrow funds locally
On day 1:
convert into for ign curr ncy
(at the bank’s s lling rate)
On day 1:
invest the foreign currency in
a foreign deposit account
On cashflow settlement date –

pay the foreign creditor using the
amount invested in that country
Figure 15.6: Hedging foreign payments using money-market hedges
The diagram above needs to be applied in the example which follows.
Example: Money-market hedge – foreign payment

ABC Limited (‘ABC’) is a lo al South African company with the South African Rand as functional currency. ABC
imports a component that it uses in its local manufacturing process, from a United States supplier. On 26
September 20X2 the company received an invoice for USD100 000 payable on 25 November 20X2.
ZAR/USD1
Sp t rate (bank’s selling rate in South Africa) 8,3809
The f ll wing details are known regarding interest rates in South Africa and the United States of America:
South African borrowing rates (for a 60-day borrowing) = 8% per annum
South African investment rates (for a 60-day investment) = 4% per annum
United States borrowing rates (for a 60-day borrowing) = 2% per annum
United States investment rates (for a 60-day investment) = 1% per annum.
Interest on the borrowings and investments is determined and added to the borrowing/investment at the end
of the term.
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Required:
Using a money-market hedge, determine:
The Rand-amount of the payment on 25 November 20X2.
The effective exchange rate applicable to the transaction on 25 November 20X2.
Solution:
Setting up the hedge Calculations

On 26 September 20X2 ABC will borrow funds locally
in South Africa. How much needs to be borrowed? As interest will only be added at the
end of the period an ‘n’ of 1 is used.
On 25 November 20X2 ABC needs USD100 000 in Calculation of present alue

the investment account in the USA. How much does Using the following inputs into your calculator:
ABC need to invest on 26 September 20X2 for 60
days, which will earn a return of 1% per annum, so 60
that on 25 November 20X2, USD100 000 is FV = USD100 000; n = 1; i = 1% × 360 ; COMP PV
available? Note: if you have an HP then you need to set the
P/YR to 6
Bank’s selling rate is used as ABC
PV = USD99 833,61 will need to buy USD.
This needs to be converted into South African and

at the bank’s selling rate on 26 September 20X2
USD99 833,61 × ZAR8,3809/USD1 = ZAR836 695,51
ABC will need to borrow ZAR836 695,51 on
On 26 November 20X2 the SA borrowing’s value will
26 September 20X2 from a local bank. What will the
be:
amount of the South African borrowing be on
25 November 20X2? 60
PV = ZAR836 695,51; n = 1; i = 8% × 360 ; COMP FV
The effective exchange rate ‘manufactured’ on FV = ZAR847 851,45
25 November 20X2 is: ZAR847 851,45
ZAR/USD1: = ZAR8,4785/USD1
USD100 000,00
The investment in US ollars will yield precisely the USD100 000 required to pay the US creditor on
25 November 20X2 so the transaction risk has been eliminated. On 25 November 20X2 the investment will yield
a Rand amount so no transaction risk exists on this leg of the money-market hedge either. The only risk which
does exist is that int r st rat s could change after setting up the money-market hedge. As the money-market
hedge will be short-term in nature, the interest rates on the borrowing and investment can be fixed up-front to
remove the possible interest rate risk which could arise.
Having had a look at setting up a money-market hedge using interest rate parity theory principles, these
principles will now be applied to the interest parity formula referred to earlier. When setting up a money-
market hedge to hedge a foreign payment, it will be recalled that money was borrowed locally, converted at
the bank’s selling rate and invested abroad. Using the information provided in the example above, the rate of
exchange is derived as follows:
60
1 + (0,08 × 360 )
ZAR8,3809 × = ZAR8,4785/USD1
60
1 + (0,01 × 360 )
This is identical to the rate calculated when setting up
a money-market hedge – it is the bank’s selling rate
which was calculated.
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15.6.2 Money-market hedges: hedging a foreign receipt

In this case, where a foreign amount is to be received in future which the receiving enterprise would like to
hedge using a money-market hedge, it would now make sense to borrow funds overseas as the amount owing
on the foreign borrowing can be repaid using the foreign receipt denominated in the same currency. If the
funds are now borrowed overseas then they would need to be invested locally in South Africa in terms of a
money-market hedge. To eliminate currency risk, the money-market hedge will be set up as follows:
On day 1:
borrow funds in the country from which the
foreign receipt will be received in future
On day 1:
convert into the local currency
(at the bank’s buying rate)
On day 1:
invest the Rand-amount locally in a
local inv stm nt account
On cashflow settlement date – receive

the foreign amount from the foreign
debtor and repay the foreign borrowing
Figure 15.7: Hedging foreign receipts using money-market hedges
The example below illustrates how a money-market hedge is set up to hedge a foreign receipt.
Example: Money-market hedge – foreign receipt

ABC Limited (‘ABC’) is a local South African company which exports goods to customers based in the United
States of America. As per the sales agreement entered into with the United States customers, these customers
are invoiced in US Dollars for all goods sold to them and they are granted 60 days credit from the date of sale.
On 26 September 20X2, ABC sold USD50 000 worth of goods to a customer based in Dallas, Texas, and invoiced
them immediately.
ZAR/USD1
Spot rate (bank’s selling rate in South Africa) 8,3809
Spot rate (bank’s buying rate in South Africa) 8,0559
The f ll wing details are known regarding interest rates in South Africa and the United States of America:
S uth African borrowing rates (for a 60-day borrowing) = 8% per annum
South African investment rates (for a 60-day investment) = 4% per annum
United States borrowing rates (for a 60-day borrowing) = 2% per annum
United States investment rates (for a 60-day investment) = 1% per annum.
Interest on the borrowings and investments is determined and added to the borrowing/investment at the end
of the term.
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Required:
Using a money-market hedge, determine:
The Rand-amount of the receipt on 25 November 20X2
(b) The effective exchange rate applicable to the transaction on 25 November 20X2.
Solution:
Setting up the hedge Calculations
On 26 September 20X2 ABC will borrow funds in the

As interest will only be added at the
United States of America. How much needs to be
end of the period an ‘n’ of 1 is used.
borrowed?
Calculation of present alue
Using the following inputs into your calculator:
On 25 November 20X2, ABC expects to receive
USD50 000 from the US debtor. ABC will therefore
60
have USD50 000 available on said date to repay the FV = USD50 000; n = 1; i = 2% × ; COMP PV
US borrowing. Interest will be added to the capital 360
on 25 November 20X2 such that the total Note: if you have an HP then you need to set the
outstanding on the borrowing after 60 days will be P/YR to 6
USD50 000. Hence ABC will need to borrow the
present value of this amount on 26 September 20X2 Bank’s buying rate is used as
in the USA. PV = USD49 833,89 ABC will need to sell USD.
This needs to be converted into South African and

at the bank’s buying rate on 26 September 20X2.
USD49 833,89 × ZAR8,0559/USD1 = ZAR401 456,81
ABC will invest ZAR401 456,81 on that date with a

On 26 November 20X2 the SA investment’s value
local South African bank. What will the amount of
will be:
the South African investment be on
25 November 20X2? 60 ; COMP FV
PV = ZAR401 456,81; n = 1; i = 4% ×
360
Effective exchange rate on 25 November 20X2 is: FV = ZAR404 133,19
ZAR/USD1: ZAR404133,19 = ZAR8,0827/USD1

USD50 000,00
We can now revisit the interest rate parity theory formula, and apply the same principles in setting up a
money-market hedge for a foreign receipt, forecast the bank’s buying rate for 25 November 20X2:
60 This is identical to the rate calculated when

1 + (0,04 × 360 ) setting up a money-market hedge – it is the
ZAR8,0559 × = ZAR8,0827/USD1
60 bank’s buying rate which was calculated.
1 + (0,02 × 360 )
15.7 U ing forward exchange contracts (FECs) to hedge currency risk

A forward exchange contract (or FEC as they are commonly known) allows an enterprise to fix the rate at which
they wi buy foreign currency from, or sell foreign currency to a foreign exchange dealer, on a future date. The
following important aspects relating to an FEC need to be taken note of:
An FEC is a binding contract between the enterprise and the foreign exchange dealer (normally a bank).
This means that on the future date (‘settlement date’) referred to above, both parties to the contract
must perform in terms of the contract. If by settlement date the enterprise no longer needs to buy/sell
the specified amount of foreign currency, the FEC requires them to contractually still perform accordingly.
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The FEC specifies the foreign amount to be bought or sold, the rate at which the transaction will take place
(being the rate built into the contract) and the date on which the transaction will take place (the cashflow
settlement date).
The greatest benefit of entering into an FEC is it removes the uncertainty as to what the rate might be in the
currency market, on the date in future when the enterprise needs to convert local currency into foreign
currency or vice versa.
The disadvantages associated with an FEC would include the following:
The cost (premium) incurred in using an FEC as a hedge. The enterprise wi have to pay the bank for
removing the uncertainty referred to above and for the bank to transfer the currency risk onto the bank.
As mentioned above, should something unforeseen have taken pl ce nd th t by cash settlement date the
enterprise no longer needs to purchase/sell the amount of foreign currency specified in the FEC, then the
enterprise will still have to deliver in terms of the agreement. This issue is discussed in more detail below.
To determine the Rand-equivalent of the future payment or receipt, when using an FEC is relatively easy. The
bank that the enterprise enters into the FEC with, will normally qu te a premium above the spot exchange rate
applicable on the date on which the FEC is entered into, in determining the rate which is to apply on the cash
settlement date. The student must be able to deal with each of the following scenarios:
Scenario 1:
The FEC rate is given and hence the student just ne ds to apply it.
Scenario 2:
The student needs to calculate the FEC rate, by applying the following principle:
FEC rate = spot exchange rate (on date of entering into FEC) + FEC premium
Note: If the premium quoted by the bank is an annual premium, the pro-rata equivalent for the period of
time covered by the FEC, will need to be calculated.
Example: Forward exchange contract

ABC Limited (‘ABC’) is a local South African company with the South African Rand as functional currency. ABC
imports a component that it uses in its local manufacturing process, from a United States supplier. On 26
September 20X2 the company received an invoice for USD100 000 payable on 25 November 20X2. The chief
financial officer (CFO) of ABC has indications that the Rand is likely to depreciate against the US Dollar in the
near future. To reduce this currency risk, the CFO of ABC has decided that the enterprise should enter into a
forward exchange contract (FEC) with its local bank. The FEC will be entered into on 26 September 20X2.
Assume the following spot rate applies in the South African currency market on 26 September
20X2: ZAR/USD1: 8,0559 – 8,3809
ABC’s bankers are quoting the FEC rates for 25 November 20X2 at a premium
of: ZAR/USD1: 0,1268 – 0,1976.
Required:
Calculate the c st in Rand terms, of settling the foreign creditor on 25 November 20X2 using an FEC.
Solution:
USD100 000 × (ZAR8,3809 + ZAR0,1976) = ZAR857 850
Comment:
The b nk’s selling spot rate is used as the basis for the calculation –remember that with a direct quote which his
is, the bank always sells high. Furthermore, the premium is quoted in the same notation – hence, the second
premium in the notation provided (which also happens to be the bigger premium) will apply to the selling rate.
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As mentioned previously, the enterprise might no longer wish to buy/sell the amount of foreign currency on
the agreed on date, for one of the following reasons:
The transaction for which the foreign currency was to be bought or sold has been cancelled.
The goods received by the local enterprise, for which payment needs to be made, are not according to
specification and the local enterprise does not want to pay for these goods.
The foreign supplier made a short delivery meaning that the local enterprise received fewer goods than
had been ordered and they only wish to pay for the goods received.
The shipment of the goods to the local enterprise is delayed and due to this, it would delay the payment
of the foreign creditor.
The local enterprise disputes the amount owing and would like to del y the payment to the foreign
creditor, which might also be for an amount which will differ from th t greed to in the FEC.
The foreign debtor whose payment is being hedged by means of the FEC defaults and does not pay the
local enterprise.
The foreign debtor might delay the payment to the local enterprise as the delivery of the order has been
delayed.
The goods received by the foreign debtor are not according to specification and consequently the foreign
debtor does not make the expected payment to the local enterprise.
The foreign debtor might dispute the amount owing to the local enterprise. Payment is consequently
delayed and when payment does take place, it might be for a different amount.
The foreign debtor might make a short payment due to having received fewer goods than had been
ordered.
In respect of any of the preceding cases, the local enterprise will still need to close out the FEC. Assuming there
was one case that required the buying of foreign currency and another case the selling of foreign currency,
each case would entail the following:
Case 1: The enterprise had agreed to buy a fixed amount of foreign currency from the local bank. In this
case, the bank will sell the fixed amount of currency to the local enterprise as agreed in terms of the FEC.
This will happen at the rate agreed to in the FEC.
In terms of the FEC, the enterprise will now have to sell the foreign currency back to the bank at the
prevailing spot buying rate of the bank as the enterprise does not need the foreign exchange. In the
process, the enterprise is expected to incur additional costs which would otherwise have been avoided.
Case 2: The enterprise had agreed to sell a fixed amount of foreign currency to the bank on a specified
date. As the enterprise does not receive the foreign currency from the foreign debtor they cannot supply
the local bank with the foreign currency.
Consequently th y will n d to buy the foreign currency from the local bank at the bank’s prevailing spot
selling rate. Now they can deliver the foreign currency to the bank as agreed to in the FEC. They would
then be required to sell the foreign currency to the bank at the FEC rate. Again, it is likely that the enterp
ise will in ur additional costs which would otherwise have been avoided.
Example: Closing o t the FEC

imp rts a c mponent that it uses in its local manufacturing process from a United States supplier. On 26
September 20X2 the company received an invoice for USD100 000 payable on 25 November 20X2. The chief
financial fficer (CFO) of ABC decides to enter into a forward exchange contract (FEC) with its local bank on 26
September 20X2 due to currency risk which exists. The FEC rate applicable to this transaction is
ZAR8,5785/USD1 (i.e. as per previous example ZAR8,3809 + ZAR0,1976).
By 25 November 20X2, when payment needs to be made in terms of the FEC, ABC has returned the goods to
the United States supplier given that they are defective and as a result, ABC no longer needs to make the
USD100 000 payment to the United States supplier.
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On 25 November 20X2, the following rates apply in the local currency market:
ZAR/USD1
Spot rate (bank’s selling rate in South Africa) 8,5950
Spot rate (bank’s buying rate in South Africa) 8,1626
Required:
Indicate the net cost of closing out the FEC for ABC.
Solution:
In terms of the FEC on 25 November 20X2: USD100 000 × (ZAR8,3809 + ZAR0,1976) = ZAR857 850
ABC will then sell the USD100 000 back to the bank: USD100 000 × ZAR8,1626 = ZAR816 260
The net loss resulting for ABC from the transaction is (ZAR857 850 – ZAR816 260) ZAR41 590.
The local enterprise, as soon as it becomes aware of the fact that it will not be able to perform in terms of the
FEC, can hedge itself against the transaction risk exposure which n w arises by doing the following:
In respect of Case 1 above: Enter into an additional FEC with the local bank to sell the same amount of
currency on the same date, as they would be buying from the bank in terms of the existing FEC. The
benefit of this is the rate at which they would be selling the currency back to the bank, will be fixed in
advance.
In respect of Case 2 above: Enter into an additional FEC with the local bank to buy the same amount of
foreign currency on the same date from the local bank, as had been agreed to in terms of the existing
FEC. The benefit of this is that the rate, at which the local enterprise would be buying the foreign currency
in future, will be fixed into the additional FEC.
15.8 Using foreign exchange futures contracts to hedge currency risk

A foreign exchange futures contract (‘forex future’) is a standardised contract which allows the parties to the
contract to buy or sell a fixed amount of foreign currency at a fixed rate in future. The following aspects
regarding forex futures need to be emphasised for the student to understand how they function:
An investor will either invest in a forex futures contract to hedge currency risk or to speculate. The
investor’s intention will in both cases be to make a gain on the futures contract.
Forex futures contracts trade in the derivative market. This means that the value of the contract is derived
from the change in value of an underlying asset (such as a share or index) or commodity (such as gold) or
the foreign exchange rate (the change in the exchange rate at which the forex future is quoted). This
means that the inv stor makes a gain or loss (depending on the position they have taken up in respect of
the futur s contract) as the price of the contract changes. As mentioned, this price change occurs as the
price of the underlying asset from which the instrument is derived, changes.
In South Afri a, forex futures contracts trade in the currency derivative market of the JSE Securities
Exchange – this ma ket is known as the Yield-X.
As forex futu es contract trade, it implies that these contracts must be bought and sold by an investor. J st
as an electronic goods retailer cannot expect to profit by not selling a TV set bought from a supplier onto
a c stomer, so too can an investor in a forex future not expect to gain (or make a loss for that matter)
unless they buy and sell the contract.
15.8.1 The mechanics of a forex future

The inve tors into a futures contract will take up one of the two positions identified above. The currency
derivatives market brings the buyer and seller together, who then enter into a contract of a standard size:
One of the two contracting parties will be buying the contract. Those buying take up a long position in the
futures market. They remain invested in the contract until they decide to close out their position by
finding a buyer to whom they can sell the contract or on the date on which the futures contract officially
closes out on the currency derivatives exchange. On this date, all parties who have bought futures
contracts must sell them.
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One of the two contracting parties will take up a selling position and sell the futures contract to the other
contracting party who is the buyer of the futures contract. This seller has taken up a short position. They
are selling something they do not own yet. To close out their position they will either have to find an
investor to take up their position in the derivatives market or on close out date of the futures contract
they will have to buy the contract.
Which position should one take up? If one wishes to gain from changes in price in the futures market, then one
needs to take up the correct position. All currency futures trading in the South African currency derivatives
market are denominated in a foreign currency, with Rand movements creating a gain or loss for an investor.
Example: Currency appreciation or depreciation

Scenario 1 Scenario 2
ZAR/USD1 ZAR/USD1
Quoted on 26 September 20X2 8,2808 8,2808
Quoted on 11 October 20X2 8,7652 8,1856
Required:
In each of the two scenarios illustrated above, which currency appreciated (increased in value) and which
currency depreciated (lost value)?
Solution:
Scenario 1: On 11 October 20X2 it is clear that more Rand would be needed to buy a US Dollar or alternatively
stated, the US Dollar buys more Rand on 11 October 20X2 than on 26 September 20X2. The US Dollar has
strengthened (appreciated) while the Rand has weakened (depreciated).
Currency quotes in the futures market will indicate how the exchange rate is expected to move. If the Rand is
forecasted to depreciate, one would gain by taking up a long position – buying the future now (low) and selling
it later (high). The pattern illustrated by Scenario 1 would be the case then.
Scenario 2: On 11 October 20X2 it is clear that less Rand would be needed to buy a US Dollar or alternatively
stated, the US Dollar buys less Rand on 11 October 20X2 than on 26 September 20X2. The US Dollar has
weakened (depreciated) while the and has strengthened (appreciated). In this case, one would gain by taking
up a short position – selling the future now (high) and buying it later (low). The pattern illustrated by Scenario 2
would be the case then.
In both cases above, the expectation of how the respective currencies are going to perform in future will guide
investors as to which position to take up in the futures market.
Forex futures are cash settled, meaning that an investor buying a forex futures contract does not have to
deliver the physical value in cash of the contracts being bought. In other words when buying 10 000 USD
contracts of USD1 000 ach, the investor does not pay the Rand equivalent of USD10 million to the trader. On
selling the contra t, the seller of the forex futures contract would also not be required to physically deliver the
sum of curren y that they are selling to the buyer of the contract. The Currency Derivatives Market of the JSE
Securities Exchange p escribes two margins which need to be deposited:
Initial ma gin: This margin represents only a percentage of the value of the contracts and is paid when
taking p either a long or short position. This is paid in Rand and is deposited with the clearing house. This
red ces risk and creates liquidity in the market.
Variati n margin: Each day the difference in value of the contract(s) will be revalued or marked-to-market
(M-T-M). Any gain will be paid to the investor whose contract(s) increased in value since the previous
measurement (M-T-M) while investors making losses, have to make good their loss by paying the amount
of the loss to the clearing house.
The fact that forex futures are cash settled and trade in the derivative market has one further very important
implication, which is addressed in more detail later.
Note: As the physical delivery of the currency is not required, on settling the underlying transaction (paying
or receiving foreign currency), the enterprise will need to buy or sell the foreign amount in the
currency market at the spot rate on that date. The physical currency bought or sold to settle the
transaction does not take place at the rate being quoted in the futures market.
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Only the following parties (referred to as qualifying clients) may invest in currency futures contracts traded in
the currency derivatives market in South Africa –
South African individuals or corporates with no limits applicable;
a South African financial services provider or South African collective investment scheme insofar as their
foreign portfolio allowances permit;
a South African pension fund subject to their foreign portfolio allowance;
a South African short-term or long-term insurer subject to their foreign portfolio allowance; and
a foreign individual or foreign corporate with no limits applicable.
15.8.2 Forex futures – market data

The following table has been constructed from the market data provided by the JSE Securities Exchange
Currency Derivative Market:
Bid Offer Latest Open

Contract Bid Offer High Low Volume
qty qty trade interest
14 DEC 12
AU$/R 250 8,9595 8,9705 250 8,9541 0 0 0 10 636
18 MAR 13
AU$/R 200 9,0035 9,0215 200 9,0031 0 0 0 4 458
14 JUN 13
AU$/R 150 9,0465 9,0685 150 9,0471 0 0 0 11
16 SEP 13
AU$/R 100 9,0785 9,13 100 9,0933 0 0 0 2 150
14 DEC 12
CAD/R 50 8,919 8,962 50 8,9613 0 0 0 25
18 MAR 13
CAD/R 50 9,007 9,054 50 9,0545 0 0 0 0
14 DEC 12
YUAN/R 0 0 0 0 1,3899 0 0 0 0
18 MAR 13
YUAN/R 0 0 0 0 1,3966 0 0 0 0
14 DEC 12
€/R 100 11,321 11,3362 11,3438 11,3438 11 259 370 73 915
Figure 15.8: Currency derivatives market data
The data contained in the table is interpreted as follows:

Contract: this indi ates the contract type. Various currency futures are available for trade in the JSE
Securities Ex hange Currency Derivatives market. They include: Australian Dollar (AU$), Canadian Dollar
(CAD), New Zealand Dollar (NZ$), US Dollar ($), Euro (€), British Pound (£), Japanese Yen (¥), Swiss Franc
(CHF) and Chinese Yuan (Yuan) amongst others.
The standard size of each contract is 1 000 units of the foreign currency. For example the Euro
denominated contract’s standard size is € 1 000. A $/R Maxi contract is also available. This contract t
gether with the ¥/R contact are the only contracts where the standard contract size differs from the
standard f 1 000 units of foreign currency – the standard contract size is USD100 000 per contract and
¥100 000 per contract respectively.
When reading the table the notation used thus far in this chapter must be amended. For the AU $/R as
quoted here, the currency on the left of the quote is the base currency. This is still a direct quote and in
terms of the format used thus far it can also be quoted as R/AU$1.
Each contract type has a date. This date will either be in March, June, September or December and is the
date on which the contract expires. Contract close out (expiry date) is always two business days before
the third Wednesday of that particular month.
Bid quantity: Bid quantity refers to the number of contracts sold by investors.
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Bid and Offer: The Bid price is the price at which the market buys a contract; alternatively the price at
which the investor will sell the contract. The Offer price is the price at which the market will sell a
contract to an investor or alternatively the price at which the investor buys a contract.
The price quoted in the JSE Securities Exchange Currency Derivatives market is the amount of Rand per
one unit of the foreign currency. The denomination of all contracts listed on said exchange is in the
foreign currency. This means that the price movement will be in Rand terms resulting in the gain or loss
when re-measuring the futures contract being in Rand.
Note: The currency quotes in the table above, as well as in Figure 15.2 ear ier are indicated to four decimal
points. This fact is very important when dealing with forex futures as we as forex option contracts.
Offer quantity: Offer quantity refers to the number of contracts bought by investors.
Latest trade: Refers to the price at which the latest trade took place, while the High and Low refers to the
highest price and lowest price applicable to trades on the day.
Volume: Refers to the number of contracts traded on the particular day.
Open interest: Refers to any long (or equivalent short) p siti ns existing which have not yet been closed
out.
‘Pip’, ‘Point’ or ‘Tick’ size: This is not specifically shown in the table, but is derived from it. The smallest
change to an exchange rate is a change in the fourth deci al of the exchange rate being quoted. If the
ZAR/USD1 exchange rate today is ZAR8,7000 then the s allest change from today to tomorrow would be
one movement up or down resulting in the xchange rate being ZAR8,7001/USD1 or ZAR8,6999/USD1
tomorrow.
A one decimal (fourth decimal) movement in the exchange rate is referred to as a pip/point/tick movement in
the exchange rate. This one decimal movement will create a gain or loss for the investor. The value of such a
pip/point/tick movement is calculated as follows:
Standard contract size × 0,0001 = value per pip/point/tick
Example: Tick movement

Use the €1 000 contract trading on the JSE Securities Exchange Currency Derivative market.
Required:
What will the currency of this pip/point/tick movement be?
Solution:
It will always be in the t rm/r ference currency. €1 000 × ZAR0,0001/€1 = ZAR0,10 per one pip/point/tick
movement on the contract.
Example: Hedge urren y derivative

imports clothing f om an Australian supplier, and retails these clothes through its South African operations. On
26 September 20X2, ABC received an invoice for AU$52 600 payable on 25 November 20X2. The chief financial
officer (CFO) of ABC is concerned that given the depreciating Rand at present, ABC will need to hedge this
payment, and has decided to make use of forex futures trading on the JSE Securities Exchange Yield-X market
(Currency Derivatives market).
The following rates apply in the local currency market:
26 September 20X2 25 November 20X2
AU$/ZAR1 AU$/ZAR1
Spot rate (bank’s selling rate in South Africa) 0,1128 0,1096
Spot rate (bank’s buying rate in South Africa) 0,1216 0,1122
Assume that the data provided in Figure 15.8 applies on 26 September 20X2, and assume also that on 25
November 20X2, ABC is able to close out the contracts at ZAR9,02 (ZAR/AU$1).
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Required:
Calculate the net outcome of the hedge in South African Rand (ZAR).
Solution:
Issue Solution
Which contract will ABC use? As they need to settle an Australian Dollar amount owing,
they will match this with the available contracts – namely
AU$/R.
The 14 DEC 12 (14 December 20X2) contracts will be
chosen. (Note 1)
What position should ABC take up (long or short)? The risk is that the R nd will we ken – this will mean that
the number of Rand required per AU$ will INCREASE – this
will be evidenced in the exchange rate. ABC will want to
take up a l ng p siti n and buy AU$ contracts.
How many contracts will they want?

AU$52600 = 52,6 contracts rounded off to 53. (Note 2)
AU$1000
What is the pip/point/tick size? ZAR0,0001/AU$1
What is the value per pip/point/tick? AU$1 000 × ZAR0,0001/AU$1 = ZAR0,10
Note 1: As a rule the contract chosen should either close out on the cash settlement date of the underlying
transaction or thereafter BUT not before as the transaction will not be effectively hedge.
Note 2: We always round this number off according to our normal rounding rules.
Outcome of the hedge:
ZAR
Sold each contract at 9,0200
Bought each contract at 8,9705
Gain per contract 0,0495
Total gain (53 contacts × 495 pips/points/ticks × ZAR0,10 2623,50

Payment to the Australian supplier (AU$52 600/AU$0,1096) 479927,01
Less: gain made in the forex futures market – 2623,50
Net payment 477303,51
Further notes:
As the Rand is depre iating, ABC went long. This means that it initially bought contracts (the market would sell
the contracts to them f om the market’s perspective at the offer price on Day 1, namely 26 September 20X2. To
close out the cont act, ABC would need to sell the contracts (the market would be buying them at the bid
price).
The difference between the price at which ABC bought and sold the contracts = ZAR0,0495 per contract.
Reading from right to left results in decimal movement of 495 (pips/points/ticks) per contract. This multiplied
by the pip/p int/tick value multiplied by the number of contracts = the total gain or loss.
Finally, ABC still needed to buy (the bank would be selling) the physical Australian Dollars in the currency
market. The currency quote in the currency market is an indirect quote (hence divide the Australian Dollar
amount by the currency quote AND NOT multiply which would have been done had it been a direct quote).
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15.9 Using foreign exchange option contracts to hedge currency risk

The biggest drawback of both a forward exchange contract (FEC) and a foreign exchange futures contract is
that they contractually require settlement on a future date, regardless of whether the underlying transaction
has changed or possibly been cancelled. Note the following:
FEC: The party being hedged needs to buy or sell foreign currency at the FEC rate.
Futures contract: On closing out the contract, the opposite of what was initially taken up must now be
done. Hence sell if initially had taken up a long position, or buy if initially taken up a short position.
What is the solution then? A party wishing to hedge an underlying transaction wou d ike the flexibility to be
able to decide on settlement date, whether they still would like to hedge or not. A foreign exchange option
contract (‘forex options’) provides this flexibility.
The following sets out the main attributes of a foreign exchange options contract:
It gives the option holder the right to exercise (but not the obligation) to buy or sell an amount of foreign
currency on a future date.
l The option to buy an amount of foreign currency is known as a call ption whilst the option to sell a fixed
amount of foreign currency is known as a put option.
The date on which the option may be exercised is known as the strike or exercise date and is fixed when
the option is written or created.
The rate built into the call or put option at which the fix d amount of currency will be bought or sold in
future is referred to as the strike or exercise rate.
Before an option can be used, it has to be bought and so on acquiring the option (on day 1); the hedging
party will need to pay a premium to buy the option. This results in an immediate cash outflow for the
relevant party. Even if the hedging party does not exercise the option, they will still have incurred the
premium.
Over-the-counter (OTC) options versus traded options

An enterprise wanting to hedge itself using foreign exchange option contracts, against currency risk, may use
one of two kinds of options:
An over-the-counter (OTC) option is a customised option created specifically for the party wanting to
hedge in the particular currency, for the exact settlement date and exact amount of foreign currency as
needed by the hedging party.
Traded options trade in the currency derivatives market, and like forex futures, are of a standardised size,
apply to a specific period of time (in terms of strike date) and are only written for selected currencies.
They are ther fore l ss fl xible than an OTC option. However, a traded option can be sold after having
been bought on the xchange, hence it is marketable.
The advantage of the OTC option is that it brings flexibility, but in so doing a premium must be paid. The
premium in urred on an OTC option will be higher than that incurred when purchasing traded options.
15.9.2 Forex options trading in the JSE Securities Exchange Currency Derivatives market
The following table is a summary of the attributes of traded currency options in South Africa:
Attribute Explained
Currency derivative market Trade on the Yield-X (just as currency futures do)
Strike/exercise price Yield-X allows for a strike/exercise price in intervals of ZAR0,05
Contracts The following exist:
US Dollar, British Pound, Euro, Australian Dollar, Canadian Dollar and
Japanese Yen
Exercise dates March, June, September and December (two business days before the
third Wednesday of these months)
Figure 15.9: Attributes of foreign currency option contracts
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The same criteria as listed under foreign exchange futures contracts apply on the Yield-X regarding the use of
currency options.
A traded call option gives the investor the right to buy a foreign exchange futures contract on a fixed date in
the future at the strike price. A traded put option gives the investor the right to sell a foreign exchange future
contract on a fixed date in the future at the strike price.
An option has two values:
Values Explanation
Intrinsic A call option has intrinsic value (positive value) where the spot rate in the market exceeds the
strike rate (said to be in-the-money).
A put option has intrinsic value (positive value) where the spot r te in the market is less than
the strike rate (said to be in-the-money).
Time The time value of an option is the amount an investor is willing to pay (premium) above the
intrinsic value of an option. If the intrinsic value is nil, then the time value of the option will
always equal the premium payable.
This aspect of the value of an option is driven by the elements of the Black and Scholes pricing
model and include the following for a currency option:
l Changes in the value of the underlying currency: As the value of the underlying currency, on
which the option is written changes in the arket, so will the value of the option.
l Volatility of the underlying currency: Options written on currencies which are very volatile
(value of currency is volatile or chang s r gularly) will always have a higher value than
options written on less volatile curr nci s.
l Strike price: The value at which the holder can strike or exercise the option will also impact
on the value of the option.
l Time to expiry or exercise: The longer the time to expiry, the greater the chance of the
underlying currency changing to such an extent that the holder will exercise the option.
Therefore the greater the time factor, the bigger the time value of the option.
l The risk-free rate: The model used to value an option discounts the exercise price from a
future date to today to value the option. The risk-free rate is the discount rate used. If the
risk-free rate decreases, then the value of the put option will increase and a call option will
decrease. If the risk-free rate of return increases, then it has the opposite effect.
Figure 15.10: Factors affecting the value of currency options
Let us look at the following example to see how a foreign currency option contract will function.
Example: Foreign curr ncy option contract

imports clothing from an Australian supplier, and retails these clothes through its South African operations. On
26 September 20X2, ABC re eived an invoice for AU$52 600 payable on 14 December 20X2. The chief financial
officer (CFO) of ABC is concerned that given the depreciating Rand at present, ABC will need to hedge this
payment, and has decided to make use of foreign currency option contracts, by firstly weighing up the OTC
options and traded options before selecting the most optimal solution.
The following rates apply in the local currency market:
26 September 20X2 14 December 20X2
AU$/ZAR1 AU$/ZAR1
Spot rate (bank’s selling rate in South Africa) 0,1128 0,1080
Spot rate (bank’s buying rate in South Africa) 0,1216 0,1102
Assume that a foreign exchange option contract exists for December 20X2, with the following strike/exercise r
tes:
Call option Put option
ZAR/AU$1 9,03 8,00
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The premium for a December call option is ZAR0,52/AU$1 while the premium on the December put option is
ZAR0,20/AU$1. Assume a spot rate in the currency market of ZAR9,1000 on strike/exercise date.
A local bank, for a premium of ZAR0,65 per AU$1 is willing to create an OTC currency option for ABC for 14
December 20X2. The bank is offering ABC a call option at ZAR9,08/AU$1 and a put option of ZAR8,10/AU$1.
Required:
Calculate the net outcome of each of the proposed hedges in South African Rand (ZAR).
Solution:
Issue Solution
Which contract will ABC use? As they need to settle an Australian Dollar amount
owing, they will match this with the available
contracts, namely AU$/R. The December option
contract is ch sen since this is when the payment
needs to be made.
Call or put option? The risk is that the Rand will weaken while the
Australian Dollar will strengthen – ABC will want the
right to buy AU$ contracts as they will need to
physically buy AU$ in the market. Therefore they
would want a call option on the AU$.
How many contracts will they want? AU$52600
2
AU$1000 = 52,6 contracts rounded off to 53
What is the pip/point/tick size? ZAR0,0001/AU$1

What is the value per pip/point/tick? AU$1 000 × ZAR0,0001/AU$1 = ZAR0,10
What is the premium on the contract? ZAR0,52/AU$1 × AU$1 000 = R520 per contract
Outcome of the traded option hedge:

On 14 December 20X2, the option holder will strike/exercise as the spot rate exceeds the strike price of the call
option. The outcome will be as follows:
ZAR
Total gain (53 contacts × 700 pips/points/ticks × ZAR0,10 3 710,00
Payment to the Australian supplier (AU$52 600/AU$0,1080) 487 037,04
Premium (ZAR0,52/AU$1 × AU$1 000 × 53 contracts) 27 560,00
Less: gain made in the for x futures market – 3 710,00
Net cost 510 887,04
OTC option alte native:

The over-the- counter currency option will entail a physical delivery of the underlying currency. On strike date,
14 December 20X2, the spot rate in the market is AU$0,1080/ZAR1 or ZAR9,2593/AU$1. Hence ABC will strike
and physically b y the Australian Dollars at ZAR9,08 each.
ZAR
AU$52 600 × R9,08 per AU$1 477 608,00
Premium (ZAR0,65/AU$1 × AU$52 600) 34 190,00
511 798,00
The OTC hedge above is customised for the exact amount of the exposure, in the same currency as the
exposure – not like the currency futures where the standard size contract of AU$1 000 exists and 53 contracts h
d to be used.
Furthermore, a physical delivery will take place; the foreign currency is physically purchased at the strike rate.
Given the added flexibility, the OTC transaction will normally be more costly than using traded currency
options.
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15.10 Using currency swaps to hedge currency risk

A currency swap entails an agreement entered into between two parties to contractually swap an amount (of
cash) denominated in one currency for an equivalent amount (of cash) denominated in another currency.
Currency swaps are over-the -counter transactions – in other words, this form of currency derivative does not
trade on an exchange, which is the case with currency futures and trade currency options. A currency swap will
typically be regulated by means of an ISDA agreement (a standard type of agreement drafted by the
International Swaps and Derivatives Association). Currency swaps normally entail physically swapping a
principal amount denominated in one currency for a principal amount denominated in another currency.
It is important to note that counterparty risk exists in respect of a currency swap. Counterparty risk is the risk
that one of the two contracting parties (in this case the parties to the swap agreement), do not perform in
terms of the contractual agreement and as such, the hedge becomes ineffective. It is therefore important to
consider (amongst other issues) the creditworthiness of the counterparties in ensuring that an effective hedge
arises.
We discuss two broad categories of currency swaps in the following two sub-sections.
15.10.1 Long-term currency swaps

A long-term currency swap, also often referred to as back-to-back loans, entails a contractual agreement
between two parties, to hedge their exposure to currency risk over the long term. The drivers of a long-term
currency swap are –
firstly, to minimise borrowing costs; and
secondly, to hedge currency exposure.
Example: Long-term currency swap

Amanzi Limited (Amanzi), a listed South African company has identified an investment opportunity in the
United States of America (USA), which will cost the company USD10 million. Amanzi Limited can borrow locally
at 8% per annum in Rand terms or borrow in the USA at 2% plus a 2% premium (in US Dollar terms) as the
company is foreign. Water-Works Incorporated (Water-Works) is a US company which intends investing
ZAR83,5 million into a South African investment. Water-Works can borrow at 2% per annum (in US Dollar
terms) in the USA or borrow at 8% plus a premium of 2% per annum in South Africa.
Required:
Show how the long-term currency swap arises and how the different cashflows are swapped during the
duration of the swap agreement.
Solution:
From a cost effe tiveness perspective, it would make sense for Amanzi to borrow in South Africa where they are
known to the market, while in the case of Water-Works, it would make sense, for the same reason, to borrow
in the USA. The problem arises though that neither enterprise will be receiving the borrowed funds in the
currency of the country into which these funds need to be invested. The solution for the two companies is to
enter into a c rrency swap agreement (on the assumption that the two enterprises are aware of the other
party’s needs) . Note however that each of the respective parties remains indebted to their respective banks in
respect of the borrowings incurred by them. They cannot swap out this indebtedness.
Assume that n the date of inception of the currency swap agreement, the ZAR/USD1 exchange rate is
ZAR8,350. The f llowing takes place in terms of the swap:
Amanzi pays ZAR83,5 million to Water-Works pays USD10 million to

Day 1
Water-Works and in exchange Amanzi and in exchange receives
(Year 0)
receives USD10 million ZAR83,5 million
The two parties now have the correct amount of foreign currency to be able to make the respective
investments. Amanzi and Water-Works agree to the following in terms of the swap agreement:
Amanzi will pay Water-Works interest at 2% per annum in US Dollar terms on the US Dollar amount it
received from Water-Works. This will take place annually in arrears.
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Water-Works will in turn pay Amanzi interest at 8% in Rand terms, on the Rand amount swapped with
Amanzi.
The parties agree that the exchange rate which will apply on the interest swap dates will be the spot
exchange rate on each cash settlement date.
The term of the currency swap will be six years.
On each interest payment date, the following will take place:
Amanzi pays USD10 million × Water-Works pays ZAR83,5 million ×

Years 1–6 2% = USD200 000 to Water- Works at the 8% = ZAR6 680 000 to Amanzi at the
spot exchange rate and receives nd in exch nge receives USD200 000
ZAR6 680 000 at the spot exchange rate t the spot exchange rate
Assume that at the end of Year 1, the spot exchange rate is ZAR8,80/USD1. Con erting the USD amount owing
by Amanzi, they would owe ZAR1 760 000, while Water-Works w uld we Amanzi ZAR6 680 000. In practice, the
swap would entail netting the two amounts off against each ther, resulting in Water-Works having to purchase
ZAR4 920 000 and paying this amount over to Amanzi. The benefit for the two parties – through the netting off,
Amanzi is saved from having to purchase any foreign currency, while the currency which Water-Works needs to
purchase is limited, limiting the transaction costs as well.
At the end of the term of the currency swap agreement, the two parties will swap back the initial principal
swapped; this taking place at the exchange rate which pr vail d at the inception of the agreement – in this case
at ZAR8,3500/USD1.
And so, at the end of the six-year term, the following cashflow takes place:
Amanzi pays USD10 million to Water-Works pays ZAR83,5 million to

Year 6 Water-Works and in exchange Amanzi and in exchange receives
receives ZAR83,5 million USD10 million
15.10.2 Short-term currency swaps

These would typically be used by banks where a mismatch occurs on a forward exchange contract (FEC), forcing
the bank’s client to have to close out the forward contract. This would typically be the case where a client (a
local exporter) has entered into a forward exchange contract with the bank to sell foreign currency on a future
date to the bank at a specified rate. On settlement date, the client has however not received the foreign
amount due to a delayed payment from the foreign debtor. The local exporter therefore has to close out the
contract by purchasing the for ign amount from the local bank at spot and selling it back to the bank at the FEC
agreed rate. What probl m do s this create for the bank?
It creates a liquidity issue for the bank – the bank would need to plug a temporary hole which arises in having
to deliver the foreign amount to the local exporter before the exporter can sell it back to the bank. The result is
that the bank will bo ow the foreign amount from a foreign bank and swap this amount with the local exporter.
Two c ucial things happen now:
The local exporter will now deliver the foreign currency in terms of the FEC.
In terms of the swap, the local bank retains the Rand amount which it has to pay to the local exporter in
terms f the FEC and invests it in local deposit account.
On the date n which the local exporter finally receives the payment from the foreign debtor, they swap this
amount with the local bank in exchange for the amount in the Rand deposit account. The swap has allowed the
bank to manage two issues:
The liquidity problem arising due to the local exporter not being able to perform in terms of the FEC.
Eliminating the need to rollover the FEC. The swap (in essence a short-term back-to-back loan) fulfils the
role which the rolling of the FEC would do.
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15.11 Valuing forward exchange contracts (FECs)

Given that forward exchange contracts (FECs) are the most widely used foreign exchange hedges in South
Africa, it is important that the reader be aware of the process of valuing these contracts for financial reporting
purposes. The purpose of this section is to explain how these contracts create or destroy value over time and
based on the valuation, whether the contract would be reported as a financial asset or financial liability.
As point of departure, we need to revisit the functioning of forward exchange contracts. These contracts are
entered into between the party seeking the hedging and their bank. The FEC fixes the rate in advance, at which
the party seeking a hedge will buy a fixed amount of foreign currency from the counterparty (the bank) or sell a
fixed amount of foreign currency to the counterparty (the bank), on a specified future date.
How then does the contract create or destroy value for the hedged p rty? On entering into the FEC, the hedged
party’s rate at which they will buy or sell foreign currency from/to the counterparty, is fixed. After this date
however the forward rate at which the hedged party could buy the s me mount of foreign currency from the
counterparty at, or sell the same amount of foreign currency to the counterparty at, on the same date as that
specified in the existing FEC, differs from that set in the existing FEC as forward rates fluctuate in the currency
market resulting from changing conditions in said market. The value created by the FEC is therefore the
difference between the rate fixed in terms of the FEC and the f rward rate on valuation date at which the
hedged party could enter into an FEC for the same date and same am unt f foreign currency, as the existing FEC.
Given that the difference between the forward rate fixed into the FEC and the forward rate (on valuation date)
applicable to the same future settlement date, relates to a future point in time, one needs to consider whether
or not this difference would need to be discounted in fair valuing the FEC. The answer to this lies in the time to
settlement of the hedged transaction. It can be argu d that as in most cases the time to settlement will be
short-term (less than one year), this difference would not need to be discounted as the time value of money
can be ignored over the short-term. The reader must however be alerted to the fact that if settlement of a FEC
were to take place in the medium term, in other words on a date exceeding 12 months from valuation date, it
would be advisable to discount this benefit in calculating the fair value of the hedge.
International Financial Reporting Standards (IFRS) dictate the treatment of hedges. In terms of IFRS, the hedge
could either be a cash flow hedge or a fair value hedge. This classification would determine the treatment of
the hedge as either being processed through profit and loss (through the Statement of Profit and Loss and
other comprehensive income) or affecting the equity of the company.
The following two examples clarify the various issues relating to the valuation of FEC hedges.
Example: Fair value ignoring time value of money

Toys-Galore imports a range of toys from the United States of America. Desiree De Weer, the chief financial
officer of Toys-Galore has just become aware of an order amounting to USD101 684,25. The invoice will need
to be settled on 15 February 20X5. On 11 November 20X4, the day on which Desiree becomes aware of the
transaction, the spot ZAR/USD1 xchange rate is R11 3573. Given that indications in the forward market are that
the South African Rand is xpected to depreciate against the US Dollar going forward, she enters into a FEC with
the local bankers of Toys -Galore. In terms of this FEC, Toys-Galore will purchase USD101 684,25 from the bank
on 15 February 20X5 at a rate of R11 3840. The financial year-end of Toys-Galore is 31 December. On 31
December 20X4, the lo al bank quotes a rate of R11 4360 to sell the amount of US Dollars to Toys-Galore on 15
February 20X5 in te ms of a FEC.
The following wo ld represent the various values at which the FEC would need to be accounted:
On 11 November 20X4
The fair value f the hedge will be Rnil (the rate at which the FEC has been entered into and the FEC rate qu ted f
r 15 February 20X5 on that date, are the same).
On 31 December 20X4
On the assumption that the time value of money can be ignored, the FEC will be valued
at: USD101 684,25 × (R11 4360 – R11 3840) = R5 287 58
The r te built into the FEC is more beneficial to Toys-Galore than the rate would be on valuation date if they
were to enter into a FEC on that date. As a result, Toys-Galore’s FEC would be accounted for as a financial asset
in their accounting records.
Toys-Galore would account for the fair value of the FEC at R5 287 58 on 31 December 20X4.
615
Example: Fair value incorporating time value of money

The following example deals with a scenario where ignoring the time value of money in determining a fair value
for a FEC would be incorrect.
Utility Corporation of South Africa (U-Corp) is in the process of constructing a new electricity generating plant,
which needs to join the electricity grid at the end of March 20X6. In order for the plant to be functional, a piece
of equipment will have to be imported from France. On 31 May 20X4, an order was placed with the French
supplier of the equipment. Delivery of the equipment is set for the end of December 20X5. Delivery date and
settlement date for the acquisition price are one in the same.
Given the high cost overruns on the project already, the head of the treasury division of U-Corp has insisted
that U-Corp enter into a forward exchange contract (FEC) with its bankers. This was done on that date on which
the part was ordered. The piece of equipment costs EUR50 000 000. The loc l b nk fixes a rate of R15 40 per
EUR1 into the FEC on 31 May 20X4.
On 30 June 20X4, the first financial year-end of the public utility after entering into the FEC, the local bank
quotes an FEC rate of R15 22 for a settlement date of 31 December 20X5.
What is the fair value of the FEC which U-Corp has entered into?
As the rate quoted on 30 June 20X4 is less than that fixed into the FEC, the FEC will be a financial liability in the
annual financial statements of U-Corp. U-Corp will exposed to a loss on that date of:
EUR50 000 000 × (R15 22 – R15 40) = R9 000 000
As this loss relates to the settlement date of 31 D c mb r 20X5, this difference should be discounted to valuation
date in order to fair value the FEC. Assuming that a 1-month JIBAR on valuation date is 8% per annum, and that
interest on medium-term debt and investments is compounded monthly, the fair value of the FEC would be
calculated as follows:
Set financial calculator on 12 P/YR
FV = R9 000 000
N = 18
I/YR = 8%
SOLVE: PV = R7 985 463 36
Important note:
Given that the rate to be used should be compounded monthly, the number of periods (n) is represented by
the number of months from valuation date to cash settlement date. Discounting the value to a fair value on
this basis accommodates a compounding of the rate.
JIBAR is used as risk-free rate. As the FEC rates would accommodate counterparty risk already, the discount
rate should exclude risk (otherwise a double counting of risk would arise in the valuation process). You should
remember from the arli r chapters dealing with valuations, that risk can either be accommodated into the cash
flows/returns b ing valu d or into the rate used in the valuation, but never in both.
616
Practice questions
Question 15–1: Translating foreign amounts (Fundamental)

Moto Manufacturers (Moto) has the following transactions all taking place on 11 November20X4:
Transaction 1: Receives EUR120 668 48 from a French debtor in full settlement of their account.
Transaction 2: Moto need to pay GBP5 600 00 to Stratham Manufacturers in the United Kingdom.
Transaction 3: Moto needs to pay Dietikon GmBH in Switzerland CHF8 904 22 to settle an invoice received from
them.
The following currency quotes have been provided by Moto’s bankers on 11 November 20X4:
Currency quotes/Exchange rates Bank’s buying rate Bank’s selling rate
ZAR per British Sterling (GBP) 1 17 3624 17 8779
ZAR per Euro (EUR) 1 13 7447 14 1892
CHF per ZAR1 0 0893 0 0825
Required:
Calculate the equivalent South African Rand (ZAR) amount for each transaction.
Solution 15–1
Transaction 1
This is a direct quote against the Euro. As Moto received Euros from the French debtor they will be selling them
to the bank (from the bank’s perspective they will be buying them). As such Moto will translate the foreign
amount by multiplying it by the bank’s buying rate.
EUR(€)120 668 48 × R13 7447 = R1 658 552 06
Transaction 2
This is a direct quote against the British Sterling and as a result the foreign amount will be multiplied by the
bank’s selling rate given that Moto need to purchase GBP (the bank will be selling GBP):
GBP5 600 × R17 8779 = R100 116 24
Transaction 3
As this is an indirect quot , the Swiss Franc amount will be divided by the bank’s selling rate as Moto needs to
purchase Swiss Francs.
CHF8 904.22
= R107 929 94
CHF0.0825
Question 15–2: T anslating foreign amounts (Fundamental)

Mr Keelan Pillay is the chief financial officer of Data-Trix Limited (Data-Trix), located in Johannesburg. The
company specialises in developing enterprise -wide IT- platforms for large corporate customers. As part of the
pr cess f devel ping such an IT-platform for SA Bank Limited (SA Bank), Keelan has to travel to Europe. While on
his trip he will be visiting the offices of Technik GmBH in Frankfurt, Germany, as well as the offices of Springli
GmBH located in Zurich, Switzerland. Keelan has asked the finance department of Data-Trix to purcha e the
following cash amounts of each of the respective foreign currencies:
€500 (being EUR 500)
CHF300 (being Swiss Franc 300)
SA B nk will supply Data-Trix with the foreign exchange on 13 November 20X4. SA Bank’s commission charged
on the sale of all foreign exchange in notes (cash) amounts to 2,5% of the South African Rand amount.
617
Required:
Calculate, using the details provided in the table below, the amount in South African Rand (ZAR) which Data-
Trix will need to pay SA Bank for the purchase of the foreign currency.
Standard Bank
FOREX CLOSING INDICATION RATES FOR 13 November 20X4 as at 16:00
2014-08-07 16:17:38.0 Load


Notes and T/T Notes

BRITISH STERLING GBP 17.3624 17.3220 17.2399 17.8779 17.9729
EURO 1 EUR 13.7447 13.7045 13.6182 14.1892 14.2149
UNITED STATES DOL USD 11.0398 10.9901 11.0323 11.3573 11.3573
QUOTATIONS ON BASIS FOREIGN CURRENCY PER R1
ARAB EMIRATES DIR AED .3587 .3425 .2957 .3199
AUSTRALIAN DOLLAR AUD .1061 .1076 .1071 .0978 .0968
BOTSWANA PULA BWP .8850 .8907 .8850 .7708 .7708
CANADIAN DOLLAR CAD .1078 .1082 .1108 .0939 .0939
SWISS FRANC CHF .0893 .0896 .1003 .0825 .0785
‘Cheques’ denotes Travellers cheques, Personal cheques, Drafts and Clean items.
Exchange rates supplied by Corporate and Investment Banking Division
(Source: Standard Bank)
Solution 15–2
As the South African Rand is quoted per Euro, this would be a direct quote and as such the Euro amount needs
to be multiplied by the curr ncy quote to translate it into South African Rand:
€500 × R14 2149 = R7 107 45
The Swiss F an /Rand quote is an indirect quote – given this, the Swiss Franc amount needs to be divided by the
currency quote as follows:
CHF300
CHF0.0785 = R3 821 66
The t tal am unt owing to SA Bank can now be calculated as follows:
R
Euros purchased 7 107 45
Swi Francs purchased 3 821 66
10 929 11
Commission (2,5% on Rand total above) 273 23
Total owing to SA Bank 11 202 34
618
Question 15–3: Identifying foreign exchange risk (Intermediate)

R-AND- G METAL (PTY) LTD (R&G) is located in Johannesburg. R&G manufactures different products using metal
sheets. The production process is reasonably automated. On 11 November 20X4, R&G placed an order with the
distributors of a sheet metal pressing machine. The distributor is located in the United States of America and the
machine costs USD1 000 000. R&G will be invoiced in US Dollars (USD) once the machine is loaded on a ship destined
for South Africa. Payment is likely to be made three months from the date of ordering the machine.
Mr Thabo Mokoena, the financial manager of R&G, on paging through a local newspaper on the
11 November 20X4, came upon the following table:
FORWARD RATES
Currency Spot rate 1M 3M 6M
USD 11,2198 11,2816 11,4179 11,6140
EUR 14,0034 14,0839 14,2613 14,5173
GBP 17,8417 17,9362 18,1466 18,4414
JPY 10,19 10,13 10,00 9,83
Thabo is uncertain as to what the implications of the infor ation provided in the table are and what his
response should be.
Required:
Advise Thabo on what his response to this information should be.
Solution 15–3
R&G will be exposed to foreign currency risk (more specifically transaction risk) in respect of the machine which
the company has ordered from the United States supplier. This is the case given that the 3-month forward rate
is R11 4179 while the spot rate (the rate on 11 November 20X4) is R11 2198. This indicates that the South
African Rand is expected to depreciate within the next three months.
The South African Rand is currently being quoted at a premium in the forward market, amounting to:
R11.4179-R11.2198 12
× = 7,06% per annum
R11.2198 3
This indicates that the South African Rand is expected to depreciate at a rate of 7,06% per annum against the
US Dollar. Hence, the South African Rand is being quoted as a premium to the US Dollar.
Given the above, R&G will nd up paying more in South African Rand terms for the acquisition. On 11 November
20X4, the cost of the machine is USD1 000 000 × R11 2198 = R11 219 800 (at the spot rate). The 3-month
forward rate on said date is R11 4179 and based on this exchange rate, the expected cash flow on settlement
date (three months hence) is USD1 000 000 × R11 4179 = R11 417 900, resulting in an additional payment of
R198 100.
Thabo’s response should be to hedge against the transaction risk by using any form of foreign exchange hedge.
Question 15–4: Money market hedge (Intermediate)

LCM Radi l gists operate a radiology practise in Pretoria. The partners in the practice have just decided to
replace the s nar machine which they use in their practise with a new machine which they are importing from
Germany. The cost of the machine is €1 200 000 and the practise will be invoiced in Euros (€) for the
equipment.
On 13 November 20X4, the date on which the order for the new machine was placed with the German supplier,
the spot ZAR/€1 exchange rate was R13 7447 (bank buying rate) and R14 1892 (bank selling rate). The practise
will h ve to settle the outstanding amount on 12 January 20X5, which is 60 days after the date on which the
order was placed. The financial advisor of the practise is concerned that the Rand will weaken during the period
leading up to the settlement of the outstanding amount and has recommended that the partners hedge the
outstanding amount.
619
On 13 November20X4, the date on which the hedge is to be set up, the following details are known regarding
interest rates in Europe and South Africa:
Europe South Africa

Borrowing rate (per annum) 1,5% 9%
Deposit rate (per annum) 0,5% 4,5%
Required:
Assuming that the practise makes use of a money market hedge and sets this up on 13 November 20X4,
determine the amount which the practise will pay in South African Rand for the new sonar machine. Work on a
360-day year basis.
Solution 15–4
In setting up the money market hedge, the point of departure will be to identify that LCM Radiologists will be
making a foreign payment and as such the money market hedge will be c nstructed as follows:
Borrow the ZAR equivalent of Convert the proceeds of the

the present value of the EUR ZAR a ount borrowed into EUR
amount on 13 November 20X4 on 13 November 20X4
Deposit the EUR amount into

a EUR deposit account on
13 November 20X4
Settle the outstanding amount

owing to the German supplier
on 12 January 20X5 using the
proceeds from the deposit
account
Step 1: determine the amount to be borrowed in South Africa

Set the financial al ulator on 6 P/YR
FV = €1 200 000
N = 1
I/YR = 0,5% (European deposit rate)
SOLVE: PV = €1 199 000 83
Step 2: c nvert the Euro amount into South African Rand (on 13 November 20X4)
€1 199 000 83 × R14 1892 (the bank selling rate) = R17 012 862 61
Step 3: determine the value of the South African borrowing on 12 January 20X5
Set the financial calculator on 6 P/YR
PV = R17 012 862 61
N = 1
I/YR = 9% (South African borrowing rate)
SOLVE: FV = R17 268 055 55
620
Note:
Although not required in terms of answering the question, the effective exchange rate (also referred to as
the manufactured exchange rate) can be calculated as follows:
R17268 055.55 = R14
3900 €1200 000
Remember that this rate is calculated in the same format as the exchange rate used – namely South African
Rand / Euro.
Question 15–5: Foreign currency futures contract (Intermedi te)

Lombela Concession Company (Lombela) owns the rights to operate the Rapid Train Link (RPL) linking Pretoria,
Johannesburg and OR Tambo Airport. Lombela’s directors recently decided to acquire a number of new train
carriages at a total cost of GBP4 402 300 from the Great British Train Manufacturers (GBTM) located in Leeds,
England. The order was placed on 13 November 20X4 when the bank’s selling rate for the South African Rand
(ZAR) per British Sterling (GBP) was quoted at R17 8779. Settlement needs to take place on 15 February 20X5.
Cindy Mabena, the chief financial officer of Lombela, is concerned given media reports, that the South African
Rand is likely to weaken further given the market’s assess ent of the political risk in South Africa.
Cindy has therefore decided that an appropriate risk response would be to hedge against the foreign exchange
risk (transaction risk) and has identified the following Rand/British Sterling foreign currency futures contracts
which trade in the currency derivative market of the Johann sburg Stock Exchange:
R/GBP1
December 20X4 R/GBP1 contract 17 8244
March 20X5 R/GPB1 contract 18 0788
June 20X5 R/GBP1 contract R18 1805
The standard size of the ZAR/GBP contracts is GBP1 000.
Required:
Set up the hedge using the foreign currency futures and determine the outcome of the hedge and net cost of
the train carriages if the following applies:
The exchange rate in the futures market on the day on which Lombela close out the contracts is R18 1544.
The following spot rates exist in the currency market on 15 February 20X5 when settlement occurs:
Bank buying rate (ZAR/GBP1): R18 0844
Bank selling rate (ZAR/GBP1): R18 2312
Solution 15–5
Firstly, the hedge needs to be set up as follows:
Which contracts?
As settlement will occur on 15 February 20X5, the March 20X5 contracts will be chosen as these close out after
settlement date and Lombela will be hedged at least until settlement date.
As the exposure is in British Sterling, it would be appropriate to use ZAR/GBP contracts to hedge the exposure.
Po ition to be taken up in the futures market

Long position
(As the Rand is expected to depreciate against the British Sterling, the latter will increase in value – so by going
long and buying the contracts initially and selling the futures on close out, Lombela should gain from a long
position)
621
How many contracts should be used?

GBP4 402300
= 4 402 3 contracts (rounded down) 4 402 contracts
GBP1000
Tick/pip size:
R0,0001/GBP1
Tick/pip value:
GBP1 000 × R0 0001/GBP1 = R0 10
Outcome of the hedge

Sell futures R18 1544
Bought futures R18 0788
Gain per contract in ticks R0 0756
This translates into 756 ticks per contract

Total gain: 4 402 contracts × 756 ticks × R0,10 per tick = R332 791 20
Net payment for the machine

R
Purchase GBP4 402 300 in the currency mark t at R18 2312 80 259 211 76
Gain from futures market –332 791 20
Net cost of the machine 79 926 420 56
Note:
Although not required in terms of answering the question, it is important to note that had Cindy not
hedged the payment, Lombela would have ended up paying R80 259 211 76 for the new train carriages.
Question 15–6: Hedging by weighing up various hedging alternatives (Advanced)

Stereo Corporation Limited (Stereo Corp) is a retailer of televisions, sound equipment and other household
appliances. An order was placed with a supplier in China for 500 television sets at an average price of USD180
per set. Jiangtsu Suppliers, located in Nanjing, China, will be invoicing Stereo Corp in US Dollars for the
consignment.
622
On the date on which the order was confirmed, 11 November 20X4, the following spot rates applied in the
currency market in South Africa:
SA Bank
FOREX CLOSING INDICATION RATES FOR 11 November 20X4 as at 16:00
2014-09-22 16:01:07.0 Load


Notes and T/T Notes
BRITISH STERLING GBP 17.3624 17.3220 17.2399 17.8779 17.9729
EURO 1 EUR 13.7447 13.7045 13.6182 14.1892 14.2149
UNITED STATES DOLLAR USD 11.0398 10.9901 11.0323 11.3573 11.3573
‘Cheques’ denotes Travellers cheques, Personal ch qu s, Drafts and Clean items.
Exchange rates supplied by Corporate and Investm nt Banking Division
Lindsay Smith, the chief financial officer of Stereo Corp, developed a hedging policy a number of years ago. In
terms of this policy, if rates in the forward market indicate the likely depreciation of the South African Rand
(ZAR), then any one of the following hedges can be used, with the pre-requisite being that the cheapest
hedging alternative be selected:
A forward exchange contract (FEC);
A money market hedge;
Leading; or
Traded foreign exchange options trading in the currency derivatives market of the Johannesburg Stock
Exchange.
Lindsay accessed the following information which will allow her to set up the hedge:
Forward exchange contract

SA Bank, Stereo Corp’s bank, have quoted a forward rate of R11 48 per USD to hedge Stereo Corp’s exposure to
the US Dollar, given a payment settlement date of 19 March 20X5.
Traded currency options

The following t aded US Dollar currency options are available on 11 November 20X4:
Premium ZAR per USD

ZAR/USD1 option contracts with a strike date of Strike rate (ZAR/USD1)
Call Put
17 December 20X4 25 04c 12 25c 11 2500
19 March 20X5 28 25c 13 50c 11 4500
17 June 20X5 30 40c 14 25c 11 6500
The standard size of the US Dollar currency futures trading on the Johannesburg Stock Exchange’s currency
deriv tive market is US1 000.
623
The normal nominal borrowing cost of Stereo Corp is 11% per annum.
The following interest rates apply:
United States of America South Africa

Borrowing rate (per annum) 1,75% 11%
Deposit rate (per annum) 0,4% 4%
Required:
Calculate which option is the most cost of effective to hedge the exposure to the US Dollar on the
Jiangtsu Suppliers order. Assume on the strike date chosen that the US Dollar currency futures are trading
at R11 50 (selling) and R11 40 (buying).The bank’s selling rate in the currency market on 19 March 20X5 is
R11 5850 per USD and its buying rate is R11 4850. Work on a 365-day year.
On the assumption that Stereo Corp decided to enter into a f rward exchange contract (FEC) with SA
Bank at the rate identified in the scenario, determine the fair value f the FEC for financial reporting
purposes, if the financial year end of Stereo Corp is 31 Dece ber. On valuation date being 31 December
20X4, Stereo Corp could enter into an FEC with SA Bank at R11 54 per USD to hedge its exposure.
Solution 15–6
Approach to answering this part of the question
A difference in cash flow dates exists – the lead and the premium on the currency options takes place
immediately on 11 November 20X4, while the strike on the currency options and FEC take place on 19
March 20X5. The money market hedge has cash flows on both of these dates. In order to compare the
different hedging options, the approach taken in the solution is to compare the options on 19 March
20X5.
Using an FEC
Invoice amount: 500 television sets × USD180 = USD90 000
Cost in terms of the FEC: USD90 000 × 11 48 = R1 033 200 (on 19 March 20X5)
Money market hedge

As a foreign payment needs to be made in US Dollars, Stereo Corp would need to borrow locally, the
South African Rand equivalent of the US Dollars which need to be invested in a US Dollar deposit on 11
November 20X4.
Assuming that no compounding of interest takes place, the n to be used in the calculation is one period,
and as a result the interest rate needs to be adjusted as follows:
128
US deposit ate: 0,4% × = 0,14%
365
128
SA borrowing rate: 11% × = 3,86%
365
Step 1: Am unt to be invested in the USA

FV = USD90 000
N = 1
I = 0,14%
SOLVE: PV = USD89 873 93
Step 2: ZAR equivalent

USD89 873 93 × R11 3573 = R1 020 725 19
624
Step 3: Value of the South African borrowing

PV = R1 020 725 19
N = 1
I = 3,86%
SOLVE: FV = R1 060 100 01 (on 19 March 20X5)
Leading
Leading would involve making an immediate payment, given an expected depreciation in the South
African Rand. This would entail Stereo Corp immediately purchasing the required US Dollar amount:
USD90 000 × R11 3573 (bank’s selling rate) = R1 022 157
This however represents the value on 11 November 20X4 and so in order to compare values, the
assumption is made that Stereo Corp would need to borrow R1 022 157 on 11 November 20X4 at 11% for
128 days resulting in the following future value on 19 March 20X5:
PV = R1 022 157
N = 1
I = 3,86%
SOLVE: FV = R1 061 587 06
Traded currency options

As Stereo Corp needs to purchase US Dollar and th curr ncy options are US Dollar options, Stereo Corp
will need a call option. As Stereo Corp needs to s ttle the outstanding amount on 19 March 20X5, a strike
date of 19 March 20X5 is required. As a result, Stereo Corp should select the March contracts.
USD90 000
Number of currency option contracts required: USD1000
= 90 contracts Premium payable immediately on 11 November 20X4:
R0 2825 × USD1 000 × 90 contracts = R25 425
Assuming that Stereo Corp needs to borrow these funds in order to be able to pay the premium, the
value of the borrowing would be as follows on 19 March 20X5:
PV = R35 425
N = 1
I = 3,86%
SOLVE: FV = R26 405 78
On 19 March 20X5, the strike date, the following will take place:
As Stereo Corp can strike at R11 45 while the futures are trading at R11 50 per USD (Stereo Corp can buy
a future on that date at R11 50 per USD), they would gain by striking at R11 45.
The gain resulting from this is as follows:
R
Buy futu es contract in the market at 11,50
Strike at 11,45
Gain 0,05
This represents a 500 tick/pip movement

Value per tick/pip: USD1 000 × R0,0001/USD = R0,10
Outcome of the option:
R
Purchase UD90 000 at spot rate of R11,5850 1 042 650 00
Less: gain from the traded option (90 × 500 ticks × R0,10) -4 500 00
Plus: cost of premium 26 405 78
Total cost 1 064 555 78
625
Recommendation:
The cheapest alternative is to enter into an FEC with SA Bank at a forward rate of R11,48 per USD.
As Stereo Corp has already entered into an FEC at R11,48 this creates a benefit of R0,06 per USD for the
company – if they had to enter into an FEC on valuation being 31 December 20X4, this would be at
R11,54.
The FEC is therefore a financial asset for Stereo Corp and would be valued as follows (ignoring the time
value of money effect):
Fair value: USD90 000 × (R11,54 – R11,48) = R5 400
626
Chapter 16
Interest rates and

interest rate risk
identify the factors impacting on interest rates;

identify the factors impacting on the term structure of int r st rates;
discuss the interest rate yield curve and distinguish between a normal and inverted yield curve;
distinguish between the capital, debt and money markets;
discuss the functioning of a number of key money market instruments;
discuss the different techniques which an enterprise can apply in managing its exposure to interest rates
(natural hedges);
discuss the use of forward rate agreements (FRAs) in hedging interest rate risk and perform relevant
calculations to calculate the outcome of a FRA when being used as a hedge;
differentiate between short-term interest rate futures and bond futures;
set up an interest rate hedge using short-term interest rate futures as well as bond futures;
discuss the use of options when hedging interest rate risk;
calculate the outcome when hedging interest rate risk using an option (both traded as well as over-the-
counter options);
discuss the use of an int r st rate swap as hedging technique; and
construct an int r st rate swap and split the gain arising from an interest rate swap between the coun-
terparties to the swap agreement.
The purpose of this chapter is to make the student aware of how the interest rate mechanism functions, the
different base interest rates which exist in South Africa and how, in particular, the Johannesburg Inter-bank
Agreed Rate (JIBAR) is determined. It also defines interest rate risk and illustrates its existence under various
conditi ns. Further, a discussion of the nature and characteristics of some of the securities that are traded in
the m ney market, the method of trading and the advantages of dealing in some of the securities is also under-
taken. Examples are presented to highlight trading techniques used when interest rates are rising and declin-
ing. Finally, different techniques to manage interest rate risk are discussed, in particular the use of derivative in
truments to hedge this form of risk.
16.1 Interest rate risk defined

Interest bearing investments, as well as interest bearing debt instruments, have the potential to expose an en-
terprise to interest rate risk. The treasury function of an enterprise will need to monitor the enterprise’s expo-
sure to interest rates and where appropriate, hedge the enterprise against this risk.
627
Interest rate risk is the risk of financial loss resulting from changes in interest rates.
The extent of the exposure to interest rates will depend on whether we are looking at interest bearing invest-
ments or interest bearing debt or a combination of the two. Furthermore one would need to know whether the
interest rate being earned on the interest bearing investments is fixed or floating (variable). Similarly, in
respect of interest bearing debt, one would need to know whether the interest rate applicable to the
borrowing is fixed or floating.
Any enterprise which borrows or lends money has to consider the following:
Interest rate
risk
Interest rate Interest rate

is floating is fixed
Cashflow Fair value

risk adjust ents
Figure 16.1: Impact of interest rate risk
In considering Figure 16.1 above, the key question is how much interest rate risk the enterprise is exposed to.
The level of interest rate risk exposure will normally be determined using what is commonly referred to as
stress testing. Stress testing involves using scenario analysis to determine the impact of various percentage (%)
changes in interest rates on the profitability of an enterprise. The bigger the impact of such a change, the more
sensitive the enterprise is to changing interest rates. This would also indicate the need of the enterprise to
hedge itself against interest rate risk. This hedging could entail making use of natural hedges or using derivative
instruments.
The benefit of natural hedges is that they are free as is highlighted in the previous chapter. These should al-
ways be considered when faced with interest rate risk as the profits of the enterprise would not drop given
that the cost of hedging in this context would be zero.
16.1.1 Interest bearing debt and interest rate risk

An enterprise fund d by floating rate debt will be exposed to interest rate risk when interest rates increase. The
higher interest rat s r sult in a higher cash outflows. If the enterprise had however fixed its interest rate it
would not be exposed to interest rate risk as the rate at which the enterprise pays interest, is fixed regardless
of what movements o ur in the interest rates in the market.
If however ma ket ates should reduce, then an enterprise with floating rate debt would benefit from lower
finance cha ge cashflows. If the enterprise however has fixed rate debt, the rate at which the enterprise will
have to pay interest would remain unchanged. In the case of the latter, the enterprise would be exposed to
interest rate risk.
16.1.2 Interest bearing investments and interest rate risk

When the interest being earned on an investment is at a floating rate, the enterprise will be exposed to
interest rate ri k when interest rates decrease. If at the same time the enterprise has floating rate debt, they
would benefit from declining interest rates.
The converse would be true when interest rates increase – in such a case the enterprise benefits from higher
fin nce income being earned on its investments but would incur higher finance charges on its borrowings.
As interest on investments can also be earned at a fixed rate, the enterprise would be exposed to interest rate
risk when interest rates increase as they would not benefit from the increasing interest rate. The opposite
would hold true where the interest rate earned on the investment is fixed and interest rates start declining.
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Interest rates and interest rate risk Chapter 16
16.1.3 Listed interest bearing debt and interest bearing investments

An enterprise with listed debt instruments in issue, in respect of which fixed interest rates apply, is not subject-
ed to a cashflow risk resulting from a change in interest rates, but would rather be exposed to the risk of fair
value adjustments having to be made in respect of the fair value at which the debt is accounted for in the
financial statements. This form of interest rate risk impacts on the assets and liabilities (Statement of Financial
Position) whereas the other forms of interest rate risk referred to earlier directly affect the profit and loss of
the enterprise (Statement of Comprehensive Income).
16.2 The interest rate mechanism and the different interest rate base rates
All floating rates are quoted relative to a base rate. This base rate can be the repo r te (repurchase rate), JIBAR,
or the prime rate. Interest rate risk therefore arises when changes to the pplic ble b se rate occurs.
The following is an explanation of the three different base rates that exist in the South African interest rate
market that the student needs to be aware of:
16.2.1 Repo rate

The repo rate is the rate at which the South African Reserve Bank (SARB) lends to local banks at. A specified
portion of all local banks funding is borrowed by the local banks from the SARB.
The Monetary Policy Committee (MPC) of the SARB meets on a regular basis and reviews this benchmark rate.
The MPC is committed to managing inflation and as such the committee may decide from time to time to ad-
just this rate. If inflation is climbing then the MPC may d cide to hike the repo rate in order to dampen demand
for credit, thereby easing inflationary pressures. If inflation is dropping, then the MPC may decide to lower the
repo rate to increase demand for credit thereby stimulating the economy. Movements in the repo rate are ex-
pressed in ‘basis points’, with 100 basis points equating to 1%.
The prime rate is determined from the repo rate. The prime rate at end of 2012 was 8,50% while the repo rate
was 5,00%. Local banks therefore lend at a rate of 3,50% above repo to local clients (minimum differential)
than they borrow at from the SARB.
16.2.2 JIBAR
This is the base rate for corporate lending. JIBAR is the benchmark rate for money market interest rates in
South Africa. JIBAR is calculated on a daily basis, with the following rates being published: one-month, three-
month, six-month and 12 -month JIBAR. As the money market is the market providing financing for short-term
funding needs (up to one year), the rates quoted are all short-term rates.
Five local banks and four foreign banks operating in South Africa are involved in the setting of JIBAR (hence
nine contributors). The input th y provide is bid and offer quotes on tradable instruments, like negotiable cer-
tificates of deposit (NCD’s). The offer quote indicates the rate at which the bank is willing to sell the instrument
at to a client, whilst the bid quote, is the rate that the bank is willing to buy the tradable instrument at. An av-
erage rate is determined between the bid and offer quotes per contributor. The contributions from the nine
contributors a e anked from highest to lowest. The highest and lowest contributions are then eliminated and
the remaining seven contributions are averaged, to calculate the relevant JIBAR rate. The JSE Securities Ex-
change (JSE), a self-regulatory organisation, oversees the process.
It is important to note that, whereas similar benchmark rates overseas like LIBOR (London Interbank Offered
Rate) are set according to the rates which the banks believe they will borrow at from each other, or lend to
each ther at, JIBAR is based on the actual rates that the tradable instruments will trade at in the South African
ney market.
Prime rate
This is the base rate for consumer lending. Individuals seeking financing from a local bank will borrow at a r te
derived from the prime rate. Depending on the risks which the bank will be exposed to in respect of the
particular client, they will determine an interest rate by adjusting the prime rate.
629
16.3 The capital, debt and money markets

A distinction is made between the following three markets:
Markets
Capital Debt Money
Figure 16.2: Markets making up the financial markets
16.3.1 Money market

All short-term investing and short-term funding is addressed by the oney market. Money market instruments
therefore include all short-term investments (investments ature within a 12-month period) and funding
needs of up to 12 months are addressed in this market.
16.3.2 Debt market

All listed bonds (listed debt instruments) with a term of longer than one year are normally said to trade in the
debt market. Corporate bonds issues are listed on the JSE’s Interest Rate Market where these instruments
trade. Most corporate bonds have a term of three to five years and would be classified as medium-term fund-
ing and medium-term investment instruments.
16.3.3 Capital market

All long-term instruments, which include listed debt instruments with a term of more than seven years as well
as equity, trade in the capital market. The JSE’s Equity Market and the JSE’s Interest Rate Market are the con-
stituents of the capital market.
A number of instruments trading in the money market will now be discussed, once the factors impact on inter-
est rates have been identified and discussed.
16.4 The level of interest rates in the financial markets

Understanding the caus s of int rest rate fluctuations and how interest rates change through the use of the
interest rate me hanism as a monetary policy instrument is a complicated exercise. A full analysis of this is out-
side of the scope of this textbook, however the student is required to have a basic understanding of the key
factors as well as how yields over the longer term are likely to have an impact.
16.4.1 Key general factors impacting on interest rates

Inflation
An increase in the inflation rate is generally coupled with an increase in interest rates:
Fir tly, as mentioned previously, the MPC of the SARB uses the interest rate mechanism to control infla-
tion. As price levels increase, the committee may decide to increase interest rates to curb inflation. It
then becomes more expensive to borrow money to fund demand – people buy less and this impacts on
the inflation rate.
Secondly, as inflation increases, investors’ returns in real terms decrease. To satisfy the need of an inves-
tor for a real return, interest rates will need to increase. The real return required by an investor will how-
ever depend on the amount of risk the investor is taking.
Thirdly, greater uncertainty regarding future inflation rates can also drive interest rates upwards.
630
The primary factor impacting on the rate of interest charged is the risk that the lender takes – the higher the
risk that they might not be repaid, the higher the rate of interest which they will charge. However, a second
factor also drives risk – time. As risk and time correlate, the longer the term of the loan the higher the rate of
interest which the lender will expect. The preference for liquidity (discussed below) is also addressed in the
process.
Preference for liquidity

Investors will always prefer a shorter payback period on an investment to a longer one. We therefore say that
they have a preference for liquidity. Investors need to be compensated for investing surplus funds for longer
periods of time. As such, longer term investments and longer term borrowings tend to be subject to higher
rates of interest.
Demand for credit

As consumer and corporate demand for credit facilities increases, interest rates will tend to also increase. The
MPC carefully monitors the demand for credit in the market – upward trends signal alarm bells and can result
in an increase in the repo rate and subsequently the prime rate. It then becomes more expensive to borrow
and the demand for credit starts reducing.
Exchange rates
If the Rand weakens, all imported goods start costing ore and inflation starts to creep upwards. Continued
Rand weakness can result in the MPC increasing the interest rates (as referred to above) in order to curb the
local demand for goods and services thereby reducing imports and hence lessening the demand for foreign
exchange. This in turn will lead to a strengthening of the Rand, which will in turn fuel a rise in imports. From
this one can see how it ends up being a continuous circle as the strengthening of the Rand will once again lead
to an increased demand for imports thereby having the potential to fuel inflation.
Monetary policy of the central bank

As mentioned previously, the MPC uses the interest rate mechanism to manage the inflation rate in South Afri-
ca. This objective is part of the SARB’s monetary policy.
Trends in international interest rates

South African interest rates tend to follow a similar pattern/trend that foreign interest rates do. If foreign in-
terest rates increase, it would cause an outflow of capital from South Africa, with investors seeking higher re-
turns overseas. To limit an outflow of capital, local interest rates would adjust upwards, resulting in the capital
remaining invested in the South African market.
16.4.2 The term structure of interest rates and other factors impacting on interest rates
Whilst it is important to und rstand the factors that cause a general shift in interest rates, one must also con-
sider how interest rat s are charged to specific or individual borrowers.
Risk
The primary factor impacting on the rate of interest charged is the risk that the lender takes – the higher the
risk that they might not be repaid, the higher the rate of interest which they will charge. However, a second
factor also drives risk – time. As risk and time correlate the longer the term of the loan the higher the rate of
interest which the lender will expect, therefore incorporating the preference for liquidity.
If s me f rm f security is required by the lender (such as a mortgage bond being registered over a property
financed by the bank), this reduces risk as well as the interest rate charged. This explains why long-term debt is
cheaper than short-term debt. It all revolves around the provision of security to reduce risk over the long-term.
Term of the loan/borrowing

As mentioned above, the longer the term to maturity of the loan/borrowing, the higher the interest rate will
tend to be.
The amount of the borrowing

The amount borrowed as well as transaction costs to be incurred will also impact on the effective interest rate
applicable to the facility.
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16.4.3 The interest yield curve

The interest yield curve (a graph) indicates the yields earned over different periods of time for a similar interest
bearing security. As mentioned previously, the interest earned on an interest bearing security will depend
amongst others on the term to maturity of the investment – in other words the length of time before the in-
vestment matures.
The yield curve should normally be an upward sloping curve – the longer the term to maturity, the higher the
interest rate applicable to the investment. This results in the following pattern:
Interest rate
(%) Yield curve (normal)
Inverted yield curve
Term to maturity (t)
Figure 16.3: Interest yield curve
How does the inverted yield curve (short-term interest rates > long-term interest rates) arise?
It revolves around the expectation regarding the future trend in interest rates. An expectation of a slow-down
in the economy in future will result in lower interest rates in future. This can result in long-term interest rates
dropping below the level of short-term interest rates.
16.4.4 Managing interest rate risk

An enterprise can manage its exposure to interest rate risk using the following techniques:
Maintaining a portfolio of interest bearing debt and interest bearing investments

The impact of changing int r st rates on an enterprise’s debt portfolio will to some extent be offset against the
impact of increasing int r st rat s on the portfolio of interest bearing investments. If interest rates increase,
then the increased finan e income can be offset against the higher finance charges being incurred. This hedg-
ing technique is referred to as matching.
The enterp ise will need to match term and duration of the debt and investments as far as possible for hedging
benefits to arise. The enterprise would also need to be in a position of having both floating rate debt and float-
ing rate investments, for natural hedging to arise.
Maintaining a mix of floating and fixed rate debt

By maintaining a mix of floating and fixed rate debt, the enterprise would only be exposed to interest rate risk
on one portion of its debt portfolio. For instance during a period of increasing interest rates, the enterprise will
only be exposed to interest rate risk on its floating rate debt – there will be no exposure on the fixed rate por-
tion of the debt portfolio. This hedging technique is referred to as smoothing.
Simil rly, the same principles would apply to maintaining a mix of floating and fixed rate investments.
Pooling of cash surpluses within a group

A further hedging technique is that of pooling. Pooling would apply to a group scenario, where the treasury
function (typically located at head office – in other words a centralised treasury), would be able to monitor
cash balances and overdraft facilities. Treasury would be able to channel cash surpluses in one
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subsidiary/division in the group, by means of a loan account, to a subsidiary/division experiencing cash short-
ages. In this way the group would not expose itself unnecessarily to interest rate risk as they would not be en-
tering into loan agreements unnecessarily. This would reduce the exposure of the group to interest rate risk in
the process.
Group treasuries can also borrow in bulk and invest in bulk resulting in more favourable interest rates being
negotiated with financial institutions.
Pooling, like matching and smoothing, is considered to be a natural form of hedging.
16.4.5 The inter-relatedness between interest rate risk and other risks
The inter-relatedness between interest rate risk and the following risks needs to be explored:
Currency risk
Borrowing funds in a foreign currency creates an additional risk. Not only would the enterprise be exposed to
interest rate movements in the foreign country where the funds were borrowed, but the enterprise would also
be exposed to currency fluctuations – movements in the exchange rate between the enterprise’s functional
currency and the currency in which payments on the borrowing need to be made. Currency risk would amplify
the effect on the enterprise’s profitability of increased interest rates.
As a result, funding should only be obtained abroad if the enterprise earns returns in the same currency as the
currency of the borrowing so that matching can be applied.
Credit risk
A further risk exacerbated by interest rate risk is credit risk. An enterprise providing credit facilities to its cus-
tomers will be exposed to a heightened level of credit risk when interest rates are on the increase. Customers
are under pressure when having to make payments on their accounts as the higher interest rates result in
higher repayments. This can inevitably result in increased bad debts.
Liquidity (cashflow) risk

Increasing interest rates have a negative impact on the cashflows of the company. If nothing is done to hedge
the enterprise against interest rate risk then the enterprise could eventually achieve ‘financial distress’ status.
16.4.6 Derivative instruments which can be used to hedge interest rate risk
The following derivative instruments can be used to hedge against interest rate risk:
Forward rate agreements (FRAs).
Interest rate futures contracts.
Interest rate option contract.
Interest rate swap agreements.
Each of these inst uments are discussed and illustrated with an example AFTER the conventional instruments
(Treasury Bills, Banke s’ Acceptances and Negotiable Certificates of Deposit) have been discussed. These follow
in the next sections.
16.5 Treasury Bills

A Treasury Bill is a negotiable instrument issued by National Treasury and is normally made out to Bearer. They
erve as a ource of liquidity for government. The Bill represents an obligation of the government to pay the
bearer holding the instrument a fixed amount on date of maturity, usually 91 days from the date of issue. As
such Treasury Bills are short-term debt instruments on the part of the issuer (government) and hence they
trade in the money market.
Tre sury Bills are issued weekly on a competitive tender basis, and the return obtained is the difference be-
ween the purchase price and the face value of the Bill. Under the tender system, Treasury Bills are made avail-
able by the Reserve Bank in denominations of R10 000, R20 000, R50 000, R100 000, R200 000, R500 000, R1
million and R2 million. Any person or institution may tender for the Bills, which are offered on a Friday. Ten-
ders must, however, cover a minimum amount of R100 000 for any one bid.
633
The successful tenderers are then required to take up and pay for their Bills on any day from Monday to Friday
following the tender day. An important advantage is the tradability of Treasury Bills - Discount Houses have to
hold large quantities of Treasury Bills to help balance their books. The Reserve Bank offers an accommodating
facility to the Discount Houses, whereby Treasury Bills are re-discounted by the Reserve Bank in multiples of
R100 000 to liquidate any daily shortage they may experience. Consequently, Discount Houses are willing buy-
ers and sellers of Treasury Bills of varying length, which can at any time be sold to or purchased from the Re-
serve Bank.
16.5.1 The tender

To obtain Treasury Bills directly from the Treasury, an investor applies to the Reserve Bank on a Friday, stating
the amount of Bills he wishes to take up, the price which he is prepared to p y nd the day in the following week
upon which he wishes to take up the Bills.
Example:
Investor A tenders for R1 000 000 Treasury Bills at a price of R96,05; R600 000 to be taken up on the Wednes-
day following the tender and the remaining on the Thursday.
If his tender is successful, he will be required to pay R576 300 on the Wednesday following the tender day and
R384 200 on the Thursday. On maturity, the Reserve Bank will redeem the Bills for R600 000 and R400 000 re-
spectively.
Tender price R96,05
Discount rate 15,84%
3,95 365 100
× × = 15,84%
100 91 1
Interest R39 500
The tender price is another way of stating the discount rate, which is always lower than the effective yield on a
particular investment.
Example:
Tender price Discount rate Effective yield
R97,15 11,43 11,77
R96,05 15,84 16,49
R95,85 16,64 17,36
16.5.2 Trading in Tr asury Bills

The main advantag s of trading in Treasury Bills from an investor’s point of view are:
There is an extremely a tive market for Treasury Bills.
Investo s can buy and sell in bundles as small as R10 000.
Treasury Bills have a low risk profile.
Treasury Bills are always traded at a discounted rate, not on the effective yield to maturity basis. Although
Treasury Bills are normally held for the full 91 days to maturity by most investors, the yield on a Bill can be im-
pr ved by trading in times of declining interest rates.
16.5.3 Trading when interest rates are declining

Investor A successfully tendered for R1 000 000 in Treasury Bills on 24/9/20X2 at a price of
95,93. M rket discount rates over the period of maturity were
24/09/20X2 16,32%
24/10/20X2 15,65%
24/11/20X2 14,55%
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The options open to Investor A are –

to hold investment until maturity; or
to trade before maturity.
If held until maturity

Price R959 300
Effective yield 17,01%
40 700 365 100
17,01%
× × =
959 300 91 1
If sold after 30 days at a discount rate of 15,65%

Purchase price R959 300
Selling price R973 845
1 000 000 – (1 000 000 × 15,65% × 61/365) = R973 845
Interest for 30 days R14 545
Yield for period held 18,45%
14 545 365 100
× × = 18,45%
959 300 30 1
The shorter the period one holds an investment wh n int r st rates are declining, the greater the capital gain will
be.
If sold after 61 days at a discount of 14,55%

Purchase price R959 300
Selling price R988 041
1 000 000 – (1 000 000 × 14,55% × 30/365) = R988 041
Interest for 61 days R28 741
Yield for period held 17,93%
Although the discount rate moved down faster between October and November than it did between Septem-
ber and October, the best trading day was 24/10/20X2. The reason for this statement is that by selling on
24/10/20X2, one will make a 61-day capital gain, whereas by selling on 24/11/20X2, one only makes a 30-day
capital gain. However, if interest rates are rising, selling a Treasury Bill before maturity will result in a capital
loss or a decrease in the effective yield over the period held.
16.6 Bankers’ Acc ptances

A Bankers’ Acceptan e is a bill of exchange drawn on and accepted by a bank, with a stated maturity date. The
bill usually uns for between 90 and 120 days, and is employed to finance the movement of goods within and
between count ies. A bank, by accepting a bill, becomes liable for the bill in the event of default by the party
given the credit.
Bankers’ Acceptances are usually regarded as prime money market instruments on the strength of the bank’s
name, th s making them one of the most actively traded instruments in the money market, and a major asset in
the p rtf lio f financial institutions. The lowest denomination in which Bankers’ Acceptances are normally issued
is R50 000, although there is no statutory regulation governing the amount. Tradability in Bankers’ Ac-
ceptances has always been strong, but it was further strengthened from 1 January 1978, when the SARB intro-
duced a change in the method of assisting the Discount Houses.
In terms of the change, Discount Houses are granted the facility to re-discount liquid Bankers’ Acceptances
which have not more than 91 days to run, in multiples of R50 000, with the SARB for the minimum and maxi-
mum periods of seven and 14 days respectively. The effect of this assistance by the Reserve Bank is that it gives
offici l recognition to the Bankers’ acceptance as an important money market instrument.
635
The two types of acceptances traded are liquid and non-liquid acceptances. In order to qualify as a liquid ac-
ceptance, a Bankers’ Acceptance has to meet, inter alia, the following requirements:
The aggregate amount of an acceptance facility must bear a relationship to the turnover of the drawer
which satisfactorily establishes the self-liquidating nature of the bill, with due allowance for credit which
is obtained by the drawer in other ways or from other sources.
A Bankers’ Acceptance must be drawn under an authority of credit which restricts its use solely to the
provision of working capital required in respect of goods in which the drawer trades in the normal course
of his business, and which he has already bought or sold.
The acceptance must be enclaused, quoting the relevant authority, and stating the nature of the goods
concerned.
The acceptance must be drawn for not more than 120 days, and must be re-discountable by the SARB.
Non-liquid Bankers’ Acceptances take the same form as liquid acceptances and are classified non-liquid be-
cause they do not comply with the conditions specified above, in other words they may be issued for longer
than 120 days. Non-liquid Bankers’ Acceptances are generally issued as a form of a loan. Note that the credit-
worthiness of the client does not affect the classification of a bill as liquid r non-liquid. The market for non-
liquid acceptances is much smaller than the market for liquid acceptances and they also trade above the rate
applicable on liquid acceptances.
16.6.1 Trading in Bankers’ Acceptances

Investing in Bankers’ Acceptances has the following advantag s:
Security: The risk of an investor holding a Bankers’ Acceptance is minimal. If an acceptance is bought via
the money market, it usually bears the names of three institutions which can be held liable to pay, in oth-
er words the drawer, the accepting bank, and the Discount House which endorsed the bill. No capital loss
has ever been incurred by an investor in Bankers’ Acceptances.
Rate: Acceptances are traded at attractive market-related rates. The rate on liquid acceptances might be
lower than on a negotiable certificate of deposit or non-liquid acceptance, but usually compares favoura-
bly with term deposits with the same maturity.
Marketability: There is an active market in acceptances and the maturity structure can be altered to meet
changing requirements and interest rate expectations. A capital profit or loss can however be made by
selling the acceptance before maturity, depending on the movement of interest rates.
Bankers’ Acceptances are traded in the same manner as Treasury Bills, at a discount rate, although capital prof-
its are often better than those achieved on Treasury Bills, due to the length of acceptances.
16.6.2 Trading when interest rates are declining under a normal yield curve
A normal yield curve m ans that the longer the investment period is, the higher the return on that investment
will be.
Discount rates
November December
120 days 15,30% 15,05%
90 days 15,25% 15,00%
60 days 15,20% 14,90%
Invest r A purchases R1 000 000 Bankers’ Acceptances in November for 120 days
C nsiderati n R949 698
Di count rate 15,30%
Yield if held to maturity 16,11%
If so d after 30 days at ruling market rates

New investor pays R963 013
Discount rate to new investor 15,00%
Yield to new investor 15,58%
Interest received by Investor A R13 315 (963 013 – 949 698)
Effective yield to Investor A 17,06%
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16.6.3 Trading when interest rates are declining under an inverse yield curve
An inverse yield curve means that the later the maturity date on an investment, the lower the return on that
investment will be.
In addition to our earlier discussion, the following points are highlighted as reasons for the existence of an
inverse yield curve:
Borrowers’ reluctance to issue long-dated paper, as they feel that interest rates will drop in the near fu-
ture.
Investors taking the view that interest rates will drop, and so increase their demand on longer paper in the
hope of making a capital gain.
Excess liquidity in the market, causing investors to shift part of their funds from short-term instrument into
longer-term investments.
Where one has an inverse yield curve, the yield on an investment can still be improved, as long as all the rates
are moving down.
Discount rates
November Dece ber
120 days 15,30% 15,00%
90 days 15,50% 15,10%
60 days 15,60% 15,30%
Investor A purchases R1 000 000 Bankers’ Acceptanc s in Nov mber for 120 days
Consideration 949 698
Yield if held to maturity 16,11%
If sold after 30 days at ruling market rates

New investor pays R962 767
Discount rate to new investor 15,10%
Yield to new investor 15,68%
Interest received by Investor A R13 069
Effective yield to Investor A 16,74%
Had Investor A purchased a 30-day Bankers’ Acceptance initially, and held it to maturity, his yield would not
have been as high as that achieved by buying longer-dated paper that will give him a capital profit with
declining interest rates. As with Treasury Bills, if interest rates are rising, selling a Bankers’ Acceptance before
maturity will decrease the ff ctive yield over the period held.
16.7 Negotiable Certificates of Deposit

A Negotiable Ce tificate of Deposit (NCD) is an instrument issued by a bank or merchant bank, certifying that a
deposit has been made with it. The certificate is invariably made payable to Bearer, and states the amount
orig-inally invested, the rate of interest, and the amount of capital plus interest payable on maturity. Banks
issue the certificates when they wish to raise funds for periods of between three and 18 months, although they
can be issued f r as l ng as five years when money market conditions are easy.
The interest n a certificate that runs for up to 12 months is normally paid on maturity, while longer certificates
carry a ix-monthly interest payment. Although there is no minimum amount at which an NCD can be issued,
they are eldom placed for less than R250 000. Unlike Treasury Bills and Bankers’ Acceptances, NCDs do not qua
ify as liquid assets in terms of the Banks Act 94 of 1990, nor are they re-discountable by the SARB.
Due to the above constraint on this type of instrument, the rate of interest is more sensitive and reacts more
strongly to changes in the liquidity situation in the money market than is the case with Treasury Bills and Bank-
ers’ Acceptances.
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16.7.1 Trading in Negotiable Certificates of Deposit

The main advantages of investing in this type of asset are that –
an investor who holds an NCD with a five-year maturity date can market the instrument at any time;
interest rates are relatively high, compared to ordinary fixed time deposits; and
liquidity is maintained through secondary market selling.
NCDs are traded on a yield to maturity, not on a discount basis. Where the interest on a certificate is payable at
six-monthly intervals, difficulty is sometimes encountered in calculating the se ing price of the certificates.
16.7.2 Calculating the selling price

The following example illustrates the calculation of the selling price on certific te already in issue, and also the
extent to which capital gains can be made by the seller of the certificate.
Example:
Investor A purchased a R1 000 000 NCD directly from a bank at a yield to maturity of 15,5%; interest payable
semi-annually.
Issue date 08/07/20X1
Redemption date 08/01/20X4
Interest rate 15,5%
Interest payments
08/01/20X2 R77 500
08/07/20X2 R77 500
08/01/20X13 R77 500
08/07/20X13 R77 500
08/01/20X4 R77 500
Investor A sold the certificate on 23/11/20X2 at a rate of 13,45%.
Calculating the selling price

Redemption value on 08/01/20X4 1 077 500
d
using FV = PV(1 + (i × ))
365
where:
FV = Future value
PV = Pr s nt value
I = Interest rate
d = Number of days
R
Redemption value 1 077 500
PV at 08/07/20X13 6 months at 13,45% 1 009 604
Pl s: Ann al interest 08/07/20X13 77 500
1 087 104
Future value at 08/07/20X13 1 087 104

PV at 08/01/20X13 6 months at 13,45% 1 018 603
P us: Annual interest 08/01/20X13 77 500
PV 08/01/20X13 1 096 103
PV at contract date 23/11/20X13
46 days at 13,45% 1 077 833
Therefore the contract selling price of the NCD is R1 077 833.
638
Return to seller
R
Purchase price (1 000 000)
Interest 08/01/20X2 77 500
Interest 08/07/20X2 77 500
Selling price 1 077 833
Return on investment 232 833
Period held 503 days
Yield over period held 16,90%
Capital profit R19 230
Had Investor A held the certificate for a shorter period, the capital profit would h ve been higher.
For example, selling the above investment at a yield to maturity of 13,45% to buyer would have given the
following yields over the period held:
Contract date Selling date Period held Capital profit Yield
08/07/20X1 08/10/20X1 3 months 37 502 30,5%
08/07/20X1 08/01/20X2 6 months 34 936 22,5%
08/07/20X1 08/04/20X2 9 onths 29 853 19,5%
08/07/20X1 08/07/20X2 12 onths 27 035 18,2%
16.8 Forward rate agreements

A forward rate agreement (FRA) is generally an over-the-counter agreement – in other words, forward rate
agreements do not normally trade on an exchange. A forward rate agreement is entered into between the en-
terprise wishing to hedge itself against interest rate risk and a third party (the hedge counterparty), very often
a bank.
Why enter into a forward rate agreement? If an enterprise is going to be borrowing money in future, and indi-
cations are that interest rates are going to increase in future, then the risk exists that before the enterprise
physically borrows the money from the bank that interest rates will have increased, and a higher rate of inter-
est would be paid on the future borrowing. Remember, the enterprise will only be able to fix the rate at which
it borrows on entering into the loan agreement with the bank. Until then they remain exposed to interest rate
risk. Similarly if an investor is concerned that interest rates could drop before they are able to fix the interest
rate on an investment, they could potentially end up earning less interest unless they hedge against the inter-
est rate risk.
What is the solution then? By entering into a forward rate agreement, the rate of interest which will apply on
the future date (normally the date on which the enterprise will borrow the funds from the bank or invest funds
with the bank) is fixed in terms of the agreement. When interest rates are increasing the party wishing to
hedge (the borrow r) will buy a fixed rate in terms of the forward rate agreement. When interest rates are de-
creasing the party wishing to h dge (the investor) will sell a fixed rate in terms of the forward rate agreement.
The counterparties agree as well that the forward rate agreement will apply to a specified notional amount.
This is the nominal value on which the difference in interest rates will be applied. On the future date specified
in the forwa d ate ag eement, the following sequence of events, take place:
Step 1: The two parties compare the difference between the rate fixed into the agreement (FRA) and the
market rate on that date. If market rate > FRA rate, then the third party will settle the difference in
cash with the enterprise.
If h wever the market rate < FRA rate, then the enterprise will have to pay an amount over to the
third party. The preceding is the case for a borrowing being hedged – the opposite decision rules
would apply in the case of an investment.
Step 2: The enterprise physically enters into a loan agreement with the bank and fixes (if it is still concerned
that further interest rate increases could occur) the rate to apply to the borrowing. Alternatively, in
the case of an investment, the investor would enter into an agreement with the bank to fix the rate of
interest to be received on their investment.
639
Some of the key attributes of forward rate agreements are:

They can be arranged with reasonable ease and be tailor-made to meet the precise nominal value of the
future borrowing amount. They can also be customised in terms of the period of time for which hedging
is required.
The cost of hedging is limited as no premium is required when entering into such an agreement.
The agreement is binding – performance has to take place in terms of the contract on termination date of
the contract.
The agreement creates an effective hedge in a case where the interest rate risk materialises as expected
(refer to the first outcome in the example which follows to illustrate this point).
If interest rate risk does not materialise as expected then the enterprise will not be able to benefit from
the more favourable interest rates in the market.
Example: Forward rate agreement

Fashion-ista Limited (‘Fashion-ista’) is a local retailer of clothing apparel. The company intends on building up
inventories for the festive season and intends on borrowing R100 milli n in three months’ time (on 1 July 20X2)
from a local bank.
The head of Fashion-ista’s treasury, Mr Vusi Mahlangu, is concerned that all indications in the market point to
expected increases in interest rates in future. This would have a negative impact on borrowing costs in future.
Mr Mahlangu decides that Fashion-ista should hedge its lf against increasing interest rates by entering into a
six-month forward rate agreement on 31 March 20X2 (today) for a period of six months starting on 1 July 20X2
and ending on 31 December20X2. Cash settlement in terms of the forward rate agreement is set for 1 July
20X2. The forward rate fixed in the contract is 8% per annum. On 1 March 20X2, JIBAR amounted to 7% per
annum.
Required:
Determine the outcome of the forward rate agreement on 31 December 20X2 and the resulting effective inter-
est rate on the loan, if JIBAR is as follows on settlement date:
JIBAR has increased to 8,50% per annum
JIBAR has decreased to 6,50% per annum.
Assume that Fashion-ista enters into a loan agreement with a local bank on 1 July 20X2 for the borrowing of
R100 million.
Solution:
If JIBAR has increas d to 8,50%
The rate locked into the forward rate agreement is 8% per annum. As this is less than the market rate of 8,50%,
Fashion-ista will re eive the following cash settlement from the counterparty on 1 July 20X2 and pay the result-
ing interest on the loan:
(FRArate reference rate) days/basis

Compensation payment = Notional amount ×
1 (referencerate days/basis)
= R100 million ×
(8% 8.5%) 6m/12m = R239 808
15 1 (8.5% 6m/12m)
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In terms of the forward rate agreement, Fashion-ista will receive the present value of the difference between
the rate fixed in terms of the forward rate agreement and the market rate on settlement date. Fashion-ista
reduces the amount which they need to borrow, by the compensation payment received. The result is as fol-
lows:
R
FRA compensation payment 239 808 15
Borrow from the bank on 1 July 20X2 (R100m – R239 808 15) 99 760 191 85
Interest paid on borrowing R99 760 191 85 × 8,5% × 6/12 4 239 808 15
104 000 000 000
R104m 12
This results in an effective interest rate of ( R100 m – 1) × 6 = 8%
Fashion-ista, by means of the forward rate agreement has managed to reduce its borrowing cost from 8,50% to
8% per annum and has effectively fixed the rate on the borrowing n 31 March 20X2.
If JIBAR has decreased to 6,50%

The rate locked into the forward rate agreement (the FRA rate) is 8% per annum. As this is more than the mar-
ket rate of 6,50%, Fashion-ista will have to make a cash pay ent to the counterparty on 1 July 20X2:
(FRArate r f r nce rate) days/basis

(8% 6.5%) 6m/12m

= R100 million × = R726 392
25 1 (6.5% 6m/12m)
Fashion-ista will now not only have to borrow the R100 million from the bank to finance its working capital
needs, but they will also have to borrow the funds to settle the compensation payment.
FRA compensation payment R
726 392 25
Borrow from the bank on 1 July 20X2 (R100m + R726 392 25) 101 726 392 25
Interest paid on borrowing R101 726 392 25 × 6,5% × 6/12 3 273 607 75
104 000 000 000
R104m 12
This results in an ff ctive interest rate of ( R100m – 1) × 6 = 8%
In both cases it would probably be more accurate to use a days’ convention as basis instead of months. How-
ever, no matter whether days or months are used, the same outcome is achieved.
Fashion-ista, has in effect fixed the rate on the borrowing on 31 March 20X2 at 8% per annum when the for-
ward rate agreement is entered into. The interest rate risk which Mr Mahlangu expected to arise never materi-
alised. As a res lt of the hedge, the cost of borrowing of Fashion-ista is more than the market rate. This is ex-
pected as no interest rate risk materialised.
16.9 Interest rate futures contracts

An intere t rate futures contract is a financial derivative, the value thereof being driven by the change in a par-
ticu ar interest rate. The interest rate futures contracts have a standard notional value (in other words contract
size) nd the contracts trade on the Yield-X market of the JSE Securities Exchange (JSE).
641
16.9.1 Short-term interest rate (STIR) futures contracts

The first type of interest rate future that we will look at is what is known as a short-term interest rate (STIR)
future. These contracts are linked to the three-month JIBAR rate and are known as JIBAR futures with the value
of these futures being derived from the movement in the three-month JIBAR rate. The following are the char-
acteristics of JIBAR futures as traded on the Yield-X market:
Characteristic Explanation
Notional size R100000
Quote According to the rate on the 3-month JIBAR (this is known as the yield)
Pricing Priced according to the following formula: 100 – yield = price
Value per basis R2,50 per basis point movement – as interest r tes s norm lly quoted as x,xx% (to
point movement two decimals), the smallest movement in the rate will be a one movement up or
down in the second decimal – this would be a one basis point increase or decrease
Physical delivery of the underlying contract, in other words the R100 000 value of the contract is not required.
Instead an initial margin is paid to a clearing house – this amount is a ‘g d faith deposit’ and is a fraction (per-
centage) of the value of the contract. This margin ensures that the market remains liquid at all times – in other
words that investors into futures contracts who have ade gains, can withdraw their gains from the market
without the market losing liquidity.
Through marking-to-market (M-T-M), the gains or losses on the futures contracts will be measured on a daily
basis. The difference between today’s M-T-M value and the pr vious M-T-M value is known as a variation mar-
gin. Investors making gains will have a positive variation margin which they can withdraw. Where losses are
made the variation margin is negative – these investors will have to ‘make good for their losses’ by depositing
the value of the loss with the clearing house.
Two types of JIBAR-futures contracts exist:
Quarterly contracts – these contracts are quoted for a two-year cycle and close out in March, June, Sep-
tember and December.
Serial contracts – these contracts are in addition to the quarterly contracts indicated above. Four serial
contracts are listed at any given point in time. With the exception of these expiry dates of these con-
tracts, they are identical to quarterly contracts. The only difference – they expire in months other than
the four standard months of March, June, September and December.
The benefit of the serial contracts is they result in a better matching of the futures contracts to the interest
rate risk being hedged. We will however stick to the quarterly contracts from here onwards in this chapter.
Position to be taken up on interest rate futures contract

You will recall from our discussion in the previous chapter, of Forex Futures Contracts, that investors either
take up a long position (buy the future upfront and sell the future on close out or expiry) OR investors take
up a short position (sell the future upfront and buy the future on close out or expiry of the contract). Exact-
ly the same applies to an interest rate futures contract. However, the position to be taken up by an inves-
tor or wishes to hedge using futures, will be determined as follows:
An ente p ise which has borrowed funds and is paying a floating rate will be exposed to interest rate risk
when interest rates are expected to increase in future. If interest rates increase (so would the yield), the
pricing mechanism of interest rate futures results in the value of the interest rate future dropping – to
benefit from the drop in value of the futures contracts one would need to sell the con-tract upfr nt and
buy it later (based on the expectation of increasing interest rates). This means that b rr wers wishing to
hedge interest rate risk (increasing interest rates) will have to go short in the fu-tures market.
An enterprise which has invested money at a floating rate will be exposed to interest rate risk when in-
tere t rates are expected to decrease in future. If interest rates decrease (so would the yield); the pric-
ing mechanism of interest rate futures results in the value of the interest rate future increasing – to
benefit from the increase in value of the futures contracts one would need to buy the contract upfront
nd sell it later (based on the expectation of decreasing interest rates). This means that investors wish-
ing to hedge interest rate risk (decreasing interest rates) will have to go long in the futures market.
Contracts can be closed out by other taking up an opposite position (i.e. if the party hedging went short then
they would need to buy the contract to close out their position or vice versa if they had gone long on the
642
contract) or they could merely let the contract expire – in which case they would be forced to take up the op-
posite position on the contract, to the position they are currently in.
Example: Using STIR futures to hedge interest rate risk

Fashion-ista Limited (‘Fashion-ista’) is a local retailer of clothing apparel. The company intends on building up
inventories for the festive season and intends on borrowing R100 million in six months’ time from a local bank.
The head of Fashion-ista’s treasury, Mr Vusi Mahlangu, is concerned that all indications in the market point to
expected increases in interest rates in future. This would have a negative impact on borrowing costs in future.
Initial dilemma:
Mr Mahlangu is aware the Fashion-ista could make use of interest rate futures (JIBAR futures) as the future
borrowing will be short-term. He, however, is not sure of what position F shion-ista would need to take up in
the interest rate futures market.
Assuming that the three-month JIBAR is quoted at 6,50% at present (known as a spot rate – it is the rate appli-
cable today) and the forward three-month JIBAR rate is quoted at 7,50% f r six months from now, the follow-
ing would happen to the value of the futures contract:
Today: 100 – 6,50 = 93,50
Six months from now: 100 – 7,50 = 92,50
When interest rates are expected to increase, the value of the short-term interest rate futures will decrease in
future and as such to benefit from this, Fashion-ista would need to take up a short position in the interest rate
futures market.
Problem resolved:
Fashion-ista intends entering into the borrowing agreement with the bank on 15 September 20X2 at which
point in time Fashion-ista will fix its rate for the duration of the 12-month term of the borrowing. However Mr
Mahlangu is very concerned that interest rates will increase before then – he wants to hedge against the im-
pact of higher interest rates on the finance charges for the 12-month period. It is currently June, and Fashion-
ista can make use of a three-month JIBAR contract which will close out on 15 September 20X2. Assume that
the yield quoted at present on the three-month JIBAR contract is 6,50% and Fashion-ista lets the contract
expire on 15 September when the yield is 7,25%. Calculate the net borrowing cost on the loan if on 15
September 20X2 they fix the rate of interest on the borrowing at 7,25%.
Look carefully at how an interest rate hedge using interest rate futures would be set up:
Which contract will be used? Risk is short-term – hedge using a short-term interest rate future
(in case of South Africa this would be the three-month JIBAR contract)
Which position (long/short)? Based on our earlier discussion – expectation of higher interest rates – so go short
How many contra ts? Each contract has a notional value of R100 000 and Fashion-ista intends on
borrowing R100 million for 12 months
R100 m 12
R100 000 × 3 = 4 000 contracts
Exposure Term of borrowing versus length of contract
N te: Fr m the above you can see that we try to cover the full exposure of Fashion-ista in terms of the val-
ue f the borrowing and in terms of term (length) of the borrowing.
Value per decimal (tick) movement: R2,50 (as per the Johannesburg Stock Exchange (JSE) derivatives market)
Sold at 6,50% yield (price: 100 – 6,50) 93,50
Bought at 7,25% yield (price: 100 – 7,25) 92,75
Gain 0,75
This equates to a 75 tick movement (0,75% movement in the interest rates) in the price of each contract.
643
Net impact on finance charges:

R
Finance charges: R100m × 7,25% 7 250 000
Gain from futures market: 75 ticks × R2,50 per tick × 4 000 contracts (750 000)
Net finance charges 6 500 000
Comments:
The gain arising in the futures market indicates that the correct position was taken up – to go short – and that
the hedge was effective, as interest rates did increase (as can be seen from the increasing yield on the three-
month JIBAR contract).
With relatively little cost involved (only the initial margin which is a fr ction of the value of each contract),
Fashion-ista was able to hedge itself against the increasing interest rates.
As Fashion-ista was hedging a multiple of the contract size of R100 000, they obtained a perfect match – a per-
fect match in terms of the futures contracts might not always arise and y u will have round off the number of
contracts to be used. This can be to your detriment as you will n t have a perfect hedge.
The period when the exposure ended happened to be the date on which the futures closed out. If they expired
any earlier then a later contract would have to have been used.
Finally, Fashion-ista managed to match the base rate on its borrowing (JIBAR) with a contract quoted using the
same interest rate (JIBAR). If this match did not exist th n the h dge would have been less effective.
16.9.2 Bond futures contracts

A bond futures contract is a contractual obligation in terms of which the contract holder, depending on the
position they have taken up, has to buy or sell a bond (debt instrument similar to a debenture) at a pre-
determined price on a specified future date.
A contract holder who has gone long on a bond future is obliged to buy the underlying bond at the specified
price on expiry of the contract. A contract holder who has taken up a short position is obliged to sell the under-
lying bond at a specified price on expiry of the contract.
Whereas the short-term interest rate futures do not require physical delivery of the underlying asset, a bond
future requires physical delivery of the underlying bond on expiry of the contract.
The following table highlights a number of key attributes of a bond future:
Attribute Explanation
Contract size R100 000 nominal of the underlying bond
Physical delivery date Thr days after expiry of the futures contract – contracts expire in: February,
May, August and November
Mark-to-market Just as is the case with the JIBAR futures, bond futures are marked-to-market
(M-T-M) daily
Underlying bonds Bond futures are offered in respect of the following bonds:
R153, R157, R186, R203, R204, R206 and R209
Quoted Yield-to-maturity basis (IRR) just as the underlying bonds would be
Initial margin Depositing of an initial margin (‘good faith margin’) with a clearing house is
required
Variation margin At each mark-to-marketing the variation margin (gain or loss resulting from a
change in the market price of the future since the previous M-T-M)
The yield-to-maturity quoted on a bond futures contract is converted into an all-in-price. This is normally quot-
ed per R100 000’s nominal value. A decreasing yield-to-maturity which is symptomatic of decreasing interest r
tes results in an increasing all-in-price. As a result, if forecasts indicate a period of decreasing interest rates will
occur, then a long position (buying position) must be taken up. If increasing interest rates are forecasted then a
selling position needs to be taken – in other words going short on the bond futures, as yield-to-maturities will
increase and the all-in-price will decrease.
644
Should the contract holder wish to close out their position before expiry of the contract then they need to take
up the opposite position to their current position on the bond futures contract.
The pricing on a bond futures contract works as follows – the bond futures price is derived from the spot price
of the underlying bond (the price at which the underlying bond is trading) plus cost of carrying the bond (the
interest incurred on funding used to acquire the bond) minus income stemming from the coupon payments
(interest earned on the bond). The closer in time to the physical delivery of the underlying bond in terms of a
bond futures contract we move, the spot price on the bond and the futures price on the bond future tend to
converge.
Bond futures contracts can be used to hedge interest rate risk. The better the match between the choice of
future and the underlying debt or investment being hedged in terms of base rates, the more effective the
hedge will be.
Example: Using bond futures contracts

A Limited invested R10 million surplus cash into R209 bonds. As interest rates appear to be entering a down-
ward spiral, the head of treasury of A Limited has decided to make use f bond futures. Ms Naidoo, head of
treasury, is aware the R209 bond futures trade on the JSE Securities Exchange (JSE) Yield-X interest rate market
and makes the decision to use said bond futures.
She decides to go long and purchase the bond futures – on that day the value per R100 nominal value on the
underlying is R128,68. She purchases an adequate nu ber of futures contracts to cover the investment into the
R209 bonds. One month after having taken up a long position, the value per R100 nominal value on the
underlying is R129,28.
Required:
Calculate the gain or loss made on the bond futures contracts, by firstly setting up the hedge.
Solution:
Which contract will be used? R209 will only be redeemed over the medium- to long-term. As a R209 bond
future is available one can match the investment to the hedge by using said
bond future
Which position (long/short)? As interest rates are entering a downward spiral, any interest rate derivative
will experience an increase in value over time – hence A Limited should enter a
buying position (in other words go long)
How many contracts? Each contract has a value of R100 000
R10 m
R100 000 = 100 contracts
Outcome of the hedg :
R
M-T-M today: 100 ontracts × R100 000 × R129,28 / R100 12 928 000
Previous M-T-M (on entering into the contract): 100 contracts × R100 000 × R128,68 12 868 000
Gain 60 000
This gain arising from using bond futures contracts will be offset against the drop in interest income which A
Limited will earn on its R209 bonds in which it has invested.
16.10 U ing interest rate options to hedge interest rate risk

Options are contracts that grant the holder a right to buy (a ‘call option’) or to sell (a ‘put option’) a particular sset at
a specific price and within a predetermined period of time. In terms of interest rate options, we will focus on the
position of the buyer of an interest rate option. The buyer of an interest rate option will either purchase an option
giving them the right to ‘buy a particular interest rate’, namely a call option, or alternatively
he right to ‘sell a particular interest rate’, a put option.
645
There are two types of options, a ‘call option’ and a ‘put option’ and two parties to a contract, the ‘option sell-
er’ and the ‘option buyer’.
Before explaining options any further, we need to highlight some important terminology relating to options.
16.10.1 Options terminology

Option A negotiable contract in which the writer, for a certain sum of money
called the option premium, gives the buyer the right to demand, within a
specified time, the purchase or sale by the writer of a specified amount of
the underlying asset, at a fixed price ca ed the strike price.
Call option A call option grants the buyer of the option the right to buy a specific asset
within a fixed period of time.
Put option A put option grants the buyer of the option the right to sell a specific un-
derlying asset within a fixed period of time.
Strike price or exercise price The price at which an opti n is exercisable, in other words the interest
rate that the buyer of a call pti n w uld like to fix the interest rate at for
a transaction, or the interest rate that the writer of the option must pay
the holder of a put option at.
Option buyer The individual or financial institution that buys options.
Option writer The individual or financial institution that sells or writes options, giving the
buyer the right to x rcise the option.
Option premium The price of an option contract. The amount payable by the option buyer
for the right accruing to him. This amount is an immediate cash outflow
and takes place at time period 0 (in other words cf0).
Expiration date The date after which an option is void.
European option Exercise date is a specific future date, for example 10 May 2094.
American option Exercise date is during a specific future period, for example within the
next six months.
In the money Where the strike price (interest rate) is more favourable than the market
interest rates.
Out of the money Where the strike price (interest rate) is less favourable than the market
rate interest rates.
16.10.2 Interest rate options

An interest rate option provid s the buyer of the option the right, not the obligation, to transact at a rate or
price (strike rate or exer ise price). The option is the only derivative which provides the buyer of the option
with flexibility. Whe e the option is ‘out of the money’, in other words the strike price is less favourable than
the market ates/p ices, then the buyer will merely let the option lapse and not exercise it. In such a case the
buyer would ather t ansact at the market rate.
Example: Option Scenarios

A Limited b ught an option allowing it to transact at a strike rate of 7,5% to fix the interest on an amount it
intends b rr wing.
Required:
What would A Limited do in each of the following scenarios?
() Scenario 1: interest rates in the market are 7,8% on exercise date
Scenario 2: interest rates in the market are 7,2% on exercise date.
646
Solution:
Scenario 1:
A Limited would exercise the option and fix the interest rate at 7,5% in terms of the strike rate. They would be
in a better position accordingly.
Scenario 2:
A Limited would be worse if they exercised the option to fix the rate at 7,5% where the market rate is only 7,2%
– they would therefore not exercise the option – in other words they would et the option lapse.
Remark:
The flexibility offered by the option does not come free of charge. A Limited will h ve to pay a premium when
buying the option. In terms of hedging costs, this makes the option the most expensive of the different deriva-
tives instruments.
The premium referred to above will always be a cost to the buyer f the ption, while from the option writer’s
perspective, the premium will be income to them.
Option contracts will either be over-the-counter or traded options. An over-the-counter option is an option
specifically customised or tailor-made to hedge the specific risk of the buyer of the option. As the option is tai-
lor-made, the premium payable will be higher than the pre ium paid when purchasing a traded option.
Interest rate options will effectively allow the holder of the option:
In the case of a put option, to set a cap – this is an int r st rate ceiling – the point beyond which the option
holder will not want interest rates to increase. Technically the option would be a put option (the right to sell) as
during periods of increasing interest rates, the value of interest rate derivative instruments drop. The holder
benefits by fixing a maximum interest rate which they would be willing to be exposed to. The writer of the op-
tion would then have to compensate the buyer of the option for the difference between the interest rate cap
and the market rate. The buyer of the option will be paying the market rate on the underlying borrowing, but
will be compensated by the option writer for the difference between the strike rate and the market rate.
In the case of a call option, to set a floor – this is the minimum interest rate which the buyer of the option con-
tract is willing to receive. Technically the option has to be a call option (the right to buy) as when interest rates
fall, the value of interest rate derivatives increases. As a result, in hedge placing the enterprise wanting to
hedge in a buying position would result in the option being ‘in the money’ from the buyer of the option’s per-
spective.
A collar is an option contract which combines the floor and cap into a single option. It entails the buyer of the
option buying a floor (call option) and selling a cap (put option). The buyer of the option will benefit from the
interest rate being capped while the seller benefits from the floor, a minimum rate of interest set.
The following graph indicat s the functioning of a collar option contract:
Interest rate
(%)
9%
Area 1
8% -------------------------------------------------------------------------------------------- Interest cap
7,6%
6% -------------------------------------------------------------------------------------------- Interest floor

Area 2
Time (t)
Figure 16.4: Interest collar contract
647
The buyer of the option will initially pay an interest rate of 7,6% on its borrowings. When interest rates in-
crease beyond 8%, the cap option will be exercised by the buyer of the option. The option writer then compen-
sates the buyer of the option by paying them the difference between the strike rate and the market rates (this
will happen for as long as the market rates exceed the interest cap. When interest rates in the market drop
below the cap the option holder will not benefit from exercising the option – they will pay market rates until
the rates drop below the interest floor. When ‘area 2’ is triggered, the option writer will exercise their rights in
terms of the interest floor which they hold and ‘fix’ the rate of interest they receive at the minimum ‘floor’
rate. The option writer will receive the market related interest rate on the underlying loan, but in addition to
this, they will receive from the buyer of the option, the difference between the market rate and the strike rate,
in this case the interest rate floor. This will continue on each strike date in terms of the option until interest
rates increase in the market and exceed the interest rate floor set in terms of the cap option.
The buyer of the option enjoys the upside of increasing interest rates, while the option writer benefits when
the interest rates decrease to levels below the interest rate floor.
The buyer of the interest rate collar will be paying a premium to buy the right to sell the interest rate it pays on
its borrowings and in doing so sets the interest rate cap. The counterparty to the option contract however buys
the call option to set a minimum – they will have to pay a premium to do so. If these two premiums are equal,
then a zero cost collar contract arises.
Example: Interest rate cap

A Limited is concerned that market indications of increasing interest rates in future could have a significant
impact on the company’s profitability. The company’s tr asury function has advised management of the need
to hedge against rising interest rates and have sugg st d that the company consider buying an interest cap.
A Limited’s bank has indicated that it is willing to write an interest rate cap option subject to the following con-
ditions:
The nominal amount to be hedged is R50 million which is equal to the nominal value of the corporate
bonds which A Limited issued.
The strike rate on the option will be 8% based on the three-month JIBAR. The option will hedge A Limited
against the movement in interest rates over the quarter identified below.
The bank will charge A Limited a premium of 0,15% per annum, which is payable on entering into the op-
tion contract with the bank.
The strike date will be 15 March when the quarterly interest payments on the bonds need to be made.
The interest rate on the corporate bonds is the three-month JIBAR plus 100 basis points. Cashflow set-
tlement will take place immediately on 15 March.
When purchasing the option, the three-month JIBAR was 7%. By 15 March, strike date, the three-month JIBAR
has moved to 8,2%.
Required:
Determine the out ome of the hedge.
Solution:
The interest rate cap option would entail A Limited buying a put option – it wants to set a maximum interest
rate (in terms of JIBAR only) that it will pay. The interest rate cap will hedge the movement in only the three-m
nth JIBAR. The 100 basis point premium is linked to the company’s credit risk and has nothing to do with
interest rate risk. The hedge will therefore be designated as being only the movement in the three-month
JIBAR.
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Will A Limited exercise the option on 15 March? As the three-month JIBAR spot rate of 8,2% exceeds the strike
rate of 8%, the company will definitely exercise the option. This results in the following outcome:
R
3
Interest payable on the bonds: (8,2% + 1%) × R50m × 12 (1 150 000)
3
Cash settlement from the option writer: (8,2% - 8%) × R50m × 12 25 000
3
Premium: 0,2% × R50m × 12 (18 750)
Net finance charges incurred (after hedging) (1 143 750)
The interest rate cap has had the effect of reducing the financing costs through setting a ceiling of 8% beyond
which JIBAR cannot move.
This scenario can be diagrammatically illustrated as follows:
Interest expense 2 4 6 8 JIBAR %

as % of principal
–2
–4
–6
–7
– 7,2
–8 With cap
– 8,2
Without a cap
Figure 16.5: Payoff diagram of an interest rate cap
From the current JIBAR of 7% the interest expense as a % of principal would just continue increasing beyond
the 8% cap – however, no premium 0,2% would be incurred. The premium would be incurred of 0,2% irrespec-
tive of whether or not the option is exercised. The break-even point for A Limited is 8,2% (strike of 8% + 0,2%
premium). As soon as JIBAR exceeds 8,2%, the premium is also covered.
Example: Call option

Investor A holds R1 million nominal stock, with a current market price of R100 and a yield to maturity of 18%.
He expects interest rates to rise to 18,5%, which (if they do) will result in a book loss of R10 000. At the same
time, h wever, he believes that interest rates will not drop below 17,2% within the next six months.
Options available to Investor A:

1 Se the call option with a strike price below the current market price and a high premium; or 2
sell the call option with a strike price equal to the current market price; or
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3 sell the call option with a strike price above current market price, and a small premium.
Market price R100
Strike price R90 R100 R110
Interest 19% 18,5% 18% 17,5% 17,2% 17%

Premium R10 000 R5 000 R2 000
In the At the Out of
Money money money
Option period – six months
Nominal amount – R1 000 000
Sell at a strike price of R90 with an option premium of R10 000

Option seller
If interest rates rise to 18,5% or higher, the option seller will gain R10 000.
If interest rates remain at 18%, then the option buyer will exercise his option, as he will be buying at
the strike price of R90 and then selling on the market at R100. The option seller, however, will receive
R10 000 premium and lose the differential between the strike price of R90 and the current market price
of R100.
If interest rates drop as low as 17,2%, Investor A gains R10 000, but loses on the difference between
the market price of 17,2% yield to maturity and the strike price of R90. If he has correctly calculated the
op-tion premium, he should break even. The buy r of the stock will also break even.
Any drop below 17,2% will result in a loss to the option seller and a profit to the option buyer.
Option buyer
A strike price of R90 with a premium of R10 000 is said to be ‘in the money’, as the buyer of the option
can exercise his option immediately and recover part of the premium. He will buy at R90 and sell at the
current market price of R100. In this example, he would recover R5 000 of the premium paid.
Interest rates will have to drop below 17,2% before he makes a profit. He will exercise his option within
the six-month option period, as long as the market price is higher than R90 (or lower than 18,5% inter-
est).
Sell at a strike price of R100 with an option premium of R5 000
Option seller
l The premium in this situation is only R5 000, compared to the R10 000 at a strike price of R90, as the
option is ‘at the mon y’ (i.e., the strike price is equal to the market price). Any rise in interest rates
above 18% will m an that the option writer makes a profit of R5 000 on the option deal. A drop in in-
terest rates below 18% will reduce the profit on the option. Assuming a break-even rate of 17,2%, a
drop below this rate will mean a loss to the option seller.
Note however that this loss is not on the option premium, but on the opportunity that the holder of the
stock would have had to sell his stock on the market at a high return (i.e. opportunity cost).
Option b yer
l The pti n buyer will exercise his option only if interest rates drop below the strike price of 18%. He
will reduce his R5 000 loss situation up to 17,2% and, if rates drop below this level, he will make a prof-
it. If interest rates rise above 18%, he will not exercise his option, as this would mean buying the stock
at R100 and then selling it on the market at a lower price.
3 Se at a strike price of R110 with an option premium of R2 000
Option seller
The option premium is very low, as the strike price is said to be ‘out of the money’. The seller has re-
duced his risk of an interest rate drop. This risk is only reduced up to 17,5%. As long as interest rates
remain at 17,5% or higher during the option expiration period, the option buyer will not exercise the
option and the option seller will make a profit of R2 000.
650
Option buyer
The option is out of the money to the option buyer, as he must wait for interest rates to drop more than
0,5% before he will recoup any part of the R2 000 premium. The break-even interest rate is 17,2%, after
which any further drop in rates will result in a profit to the option buyer.
The graph that follows illustrates the basic investment characteristics of a call option from the respective view-
points of the buyer and the writer.
15
10
Profit
or Writer’s profit – loss line
loss 5
R’000
0
80 90 100 110 120 130
–5
Purchaser’s profit – loss line
– 10
Stock price at xpiration of the option (Rand)
– 15
Figure 16.6: Profit/loss positions of the buyer and writer of a call option
An option buyer can never lose more than the premium paid for the option contract. However, if the price of
the underlying asset rises substantially (i.e. interest rates fall) over the period of the call option, the buyer’s
potential profit is theoretically unlimited. This is illustrated above by the line labelled ‘Purchaser’s profit – loss
line’.
The ‘uncovered’ call writer’s position is the exact opposite of the call buyer’s position. If the underlying asset’s
price remains the same or drops during the life of the option, then the writer keeps the premium. However, if
the underlying asset’s price rises above the exercise price during the option life, part (or all) of the premium will
be lost. In return for the option premium received, the writer of the call option agrees to sell the underlying
asset at the strike price, no matter how high the underlying asset’s price may go. If the writer does not own the
underlying asset (uncovered call option), his position deteriorates for every R1 increase in the underlying as-
set’s price above the x rcise price.
An uncovered call writ r can arn no more than the option premium but is accepting a highly variable risk. The
call buyer, by ontrast, has a fixed risk equal to the option premium and a profit potential that varies with the
market price.
16.10.3 Interest rate put options – payoff diagram

Much like call options, put options can be traded ‘in the money’, ‘at the money’ or ‘out of the money’. The
buyer f a put ption obtains the right to sell the underlying to the writer of the option at a fixed strike price,
during a fixed period (e.g. six months). The writer undertakes the contingent obligation to purchase the under-
lying ecurity from the option buyer at the exercise price during the duration of the option or on the exercise
date if the option is duly exercised.
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15
10
Profit
or Writer’s profit – loss line
loss 5
R’000 0
80 85 90 100 110 120 130
–5
Purchaser’s profit – loss line
– 10 Stock price at expiration of the option (Rand)
– 15
Figure 16.7: Profit/loss positions of the buyer and writer of a put option
In return for a fixed premium, the buyer of a put option obtains the right to sell the underlying to the option
writer, which increases his reward as the price drops. As can be seen from Figure 16.7, the profit or loss is fixed
to the right of the strike price, while the return to the left of the strike price is variable. Any loss to the option
writer is exactly offset by the profit accruing to the option buy r, and vice versa.
The effect of any option transaction is simply the re-allocation of risk and reward between buyer and seller.
Although it is true that the option writer accepts a risk in return for a premium, in an overall portfolio, the risks
and rewards can change dramatically. An example is where a covered call writer (holding the underlying in-
strument) writes an option, which in effect reduces the volatility or market risk of his portfolio if market prices
decline. His gain is also limited on the up-side, due to his obligation to perform under the contract. Both parties
to a particular option transaction can reduce their portfolio risk simultaneously through a combination of secu-
rities, option, and short-term debt positions.
16.10.4 Traded interest rate options

Traded interest rate options allow the buyer of the option to take up a particular position on a bond futures
contract:
The buyer of a call option would be in a position to buy a bond futures contract at a specified price on a
specified future date.
The buyer of a put option would be in a position to sell a bond futures contract at a specified price on a
specified future date.
To purchase this ight, the buyer will have to pay the option writer a premium. For traded interest rate options
which trade on the JSE Securities Exchange Yield-X, the premium of the option is quoted – it will always equal
the value of the option and is the value at which the option trades on the Yield-X. The more volatile the under-
lying is, the higher the value of the option.
In deciding whether or not to exercise the option, the option holder will compare the strike rate that they have
b ught with the market rate (in this case the market interest rate). If the strike rate is more favourable, they w
uld exercise the option.
Examp e: Traded interest rate option

A Limited intends borrowing R10 million at the beginning of May 2013. This borrowing will be for a period of six
months. The company’s treasurer is concerned that interest rates could increase by then and wishes to make
use of an interest rate cap. He is aware of traded interest rate options which would create an interest rate cap
for A Limited. He has decided that the company should purchase 200 put option contracts, each with a nominal
value of R100 000 per nominal value of the underlying bond. The strike date of the option is 2 May 2013. The
option premium per contract, as quoted on the Yield-X of the JSE Securities Exchange is R110 per contract with
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the strike rate on the option being 7,39%. Assume that the option allows for the fixing of the interest rate on
striking for a period of three months.
On strike date, the actual interest rate in the market is 8%.
Required:
Calculate the effective annual borrowing cost for A Limited if they make use of the traded interest rate option.
Solution:
Important comments to consider:
The 200 option contracts would have been calculated as follows:
R10m 6 months
× = 200 contracts
R100 000 3months
The decision to purchase put options makes sense given the interest rates are decreasing. As the option
gives the holder the right to sell an interest rate future, this is indeed the position the holder would want
to be in – increasing interest rates result in a decrease in the value of interest rate futures – hence you
would want to be in a selling position.
The decision the option holder would take is to exercise the option – and in so doing fix the rate (through
the interest cap at 7,39%). The decision-making criteria would be: market rate of 8% > interest cap of
7,39%.
The effective finance charge would amount to:
R
6
Finance charges resulting from the interest rate cap: 10m × 7,39% × 369 500
12
Premium: 200 contracts × R110 22 000
Net finance charges incurred (after hedging) 391 500
As this represents the finance costs for six months, the annualised cost would be:
12 months R783 000

R391 500 × = 783 000 resulting in an effective cost of = 7,83%
6 months R10m
This includes the hedging costs – the interest rate cap has however reduced the effective cost of the borrowing
to below the 8%, which is the spot rate on exercise date.
16.10.5 Advantag s and disadvantages of interest rate options

The following advantages exist when using options as a hedge:
The buyer of the option has the right but not the obligation to exercise. As risks can change, if the risk
being hedged does not exist when the hedge needs to be effected, the buyer of the option will not want
to exercise the option. They can therefore take advantage of the market (interest rates in this case) hav-
ing moved in their favour.
By making use of over-the-counter options, the option buyer can get a tailor-made solution for the risks
they are exposed to.
Where traded options exist, the cost of the hedge can be limited – this is normally a cheaper alternative
than u ing over-the-counter options.
The fo owing disadvantages exist:
Whether the option is exercised or not, the buyer of the option will have to incur the premium in order to
buy the right in terms of the option.
With a traded option a perfect hedge might not be possible in terms of the contract size of the traded
options and the value being hedged. Furthermore there may not be a perfect match between the base
rate of interest being hedged and the interest rate built into the option.
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Valuation of interest rate options

Options are priced according to the relative supply and demand for specific underlying assets. The most widely
used option pricing model is the Black-Scholes model. The explanation and derivation of the model are beyond
the scope of this text book.
16.11 Interest rate swap agreements

Of all the interest rate derivative instruments discussed, interest rate swap agreements are the most widely
used for hedging purposes, in practice in South Africa. These agreements are entered into between two coun-
terparties, and so, just as is the case with any interest rate hedge, counterp rty risk exists. This is the risk that
one of the counterparties to the agreement does not perform according to the terms of agreement. Before
entering into such an agreement, the credit rating of the counterparty will need to be considered. Very often,
one of the counterparties to the interest rate swap agreement will be a bank.
An interest rate swap agreement entails the swapping of cashflows – this exchanging of cashflows results in
one of the counterparties paying a specified amount through to the ther counterparty in exchange for the
receipt of a cashflow determined on a different basis. An ISDA (Internati nal Swaps and Derivatives Associa-
tion) agreement will regulate the relationship between the counterparties involved in the interest rate swap
agreement.
The construction of the swap will be illustrated in the following exa ple. The swap agreement will ultimately
result in each counterparty to the agreement simulating the other counterparty’s borrowing (or if an invest-
ment is being hedged they would simulate the count rparty’s inv stment).
The following steps would essentially be involved in setting up an interest rate swap agreement:
Step 1: Identify the existence of interest rate risk and that an interest rate swap agreement can be used as
hedging technique.
Step 2: Identify a suitable counterparty to the interest rate swap agreement. This counterparty could typically
be a related party. Unless the counterparty is a bank then the only way that a hedging party would be
aware of a third party having an opposite hedging need would be if they were related parties.
Step 3: What cashflows need to be exchanged? For example: A Limited has a borrowing on which it is paying a
floating interest rate. A Limited’s chief risk officer believes that interest rates are going to increase in
future. Ideally, A Limited should be paying a fixed rate of interest under these conditions. For some or
other reason, B Limited wishes to pay a floating rate of interest on its debt (B Limited could be a bank
that would be willing to do this for a fee).
A Limited would therefore want to pay a fixed rate of interest applied to a notional amount agreed on
by both parties. As an interest rate swap agreement is an exchange of cashflows, A Limited would be
exchanging its paym nt at a fixed rate for receiving a cashflow (or series of cashflows) determined at a
floating rate.
How would this serve as an effective hedge for A Limited? As interest rates increase, so too will the
cashflow re eived by A Limited from B Limited. The increasing cash receipts will be used by A Limited
to se vice the increasing interest payments on its borrowings resulting from increasing interest rates.
Step 4: The counterparties will need to set the fixed and floating rates which will apply to the swap agree-
ment. Swap agreements will normally create an advantage for both parties – in essence by ‘borrowing
from each other’ and not from a bank, the parties’ borrowing costs would reduce. This advantage is
shared between the parties.
This issue is highlighted in the example which follows.
Step 5: Once the agreement has been entered into, the cashflows are exchanged on the date(s) indicated in
the swap agreement.
The fo owing example illustrates the construction of an interest rate swap agreement and the sharing of the g
in rising from the swap, between the swap counterparties.
Example: Using interest rate swap agreements

Fashion-ista Limited (‘Fashion-ista’) can borrow funds at a fixed rate of 8% or at a floating rate of JIBAR (cur-rently
6%) plus a credit risk premium of 200 basis points. Trendy Limited (‘Trendy’), an associate of Fashion-ista,
654
has a lower credit rating. It can borrow at a fixed rate of 9% per annum or at a floating rate of JIBAR plus 260
basis points.
Fashion-ista believes that the likelihood of interest rates decreasing in future is very good and as such it would
ideally need to borrow at a floating rate. A very large portion of Trendy’s debts are floating rate and so to cre-
ate a balanced portfolio of both floating and fixed rate debt, it needs to borrow at a fixed rate.
Both companies need to borrow R50 million.
Required:
Set up a hedge using an interest rate swap agreement and determine the rates at which Fashion-ista and
Trendy will exchange cashflows in terms of this agreement.
Solution:
The following rationale applies to the swap agreement to be entered into. Gi en Fashion-ista’s stronger credit
rating, it would make sense for Fashion-ista to borrow at a fixed rate – it can borrow at 8% per annum whereas
Trendy could only borrow at 9% per annum. As Fashion-ista’s fixed and fl ating rates are the same, they would
be indifferent between a fixed or floating rate in the absence f interest rate risk. Fashion-ista will borrow at a
fixed rate while Trendy would then have to borrow at a floating rate for the swap agreement to make sense.
Fashion-ista and Trendy would then swap cashflows but not the legal obligations with the bank(s) in terms of
the underlying borrowings.
The following loan agreements will be entered into:
Fashion-ista Trendy
Borrows at a fixed rate of Borrows at a floating rate of JIBAR

8% per annum from Bank plus 260 bp per annum from Bank
Bank Bank
Fashion-ista would then through the interest rate swap agreement want to pay floating in exchange for fixed
receipts from Trendy.
The following gain arises:
Fashion-ista Trendy Difference
Borrow at a fix d rate of 8% 9% 1%
Borrow at a floating rate of JIBAR + 200bp JIBAR + 260bp –60bp = –0,6%
0,4%
To create the 1% gain on the fixed rate, Trendy has to borrow at a floating rate – the 0,6% is therefore negative
as Trendy has to bo ow at a higher rate relative to that applicable to Fashion-ista.
The 0,4% difference will be shared between Fashion-ista and Trendy. For purposes of this example it is
assumed that the swap benefit will be shared equally. In setting the terms of the swap, we will essentially
foll w f ur steps:
l Step 1: Identify the party with the better credit rating (i.e. the party which can borrow at the lower
rate ) – in this case that would be Fashion-ista.
Step 2: Identify the swap benefit – in this case the 0,4% identified earlier.
Step 3: Identify the position which each counterparty would like to take up in the swap agreement – in this
case Fashion-ista wants exposure to a floating rate so it must end up paying a floating rate while Trendy
wants to fix its rate – it must end up paying a fixed rate.
Step 4: Reverse engineer the rate which will apply to the counterparty with the weaker credit rating – i.e.
borrow at the higher rate – in this case Trendy.
655
Fashion-ista: Trendy:
Rate Rate
Borrowed floating from bank JIBAR + 200bp Pays the bank on actual borrowing JIBAR + 260bp
Less: swap benefit 20bp Receives from Fashion-ista JIBAR + 180bp
Floating-leg of swap agreement JIBAR + 180bp Discrepancy 80bp
Could borrow at a fixed rate 9,0%
Adjust for:
Swap benefit –0,2%
Discrepancy –0,8%
Fixed-leg of sw p greement 8,0%
The interest rate swap agreement will be structured as follows:
F pays: JIBAR + 180 bp

Fashion - ista (F) Trendy (T)
Borr ows at afixedrate of 8% pe rannu mfro mBank

16.12 Valuing interest rate swaps

The concluding section of this chapter focuses on the valuation of an interest rate swap. Given that interest
rate swaps are the most widely used of the interest rate hedges, the process of determining a fair value for
these swaps needs to be focused on in more detail.
In terms of International Financial Reporting Standards (IFRS), hedges are to be measured and recognised at
fair value. In this section we are firstly going to focus on the drivers of value of an interest swap agreement.
Thereafter we will focus on the process of valuing the cash flows taking place in terms of an interest rate swap
agreement.
In understanding how value is created through an interest rate swap agreement, one needs to revisit the nuts
and bolts making up such an agreement. In essence, any swap agreement ent ils sw pping or exchanging cash
flows. From the perspective of each of the counterparties to a swap agreement, there would be a paying leg
for the swap and a receiving leg being that which the paying leg is being exchanged for. This fair exchange
takes place on the future settlement dates as specified in terms of the swap agreement. Swap agreements take
the form of a standard derivative agreement which is known in practice as an ISDA.
The swap terms set for the paying and receiving legs for each f the c unterparties (as illustrated in the exam-ple
in section 16.11 of this chapter) will be incorporated into this d cument. One key difference will however arise
for valuing the swap for financial reporting purposes. As the credit risk spread incorporated into an inter-est
rate does not represent interest rate risk but rather credit risk, the designated hedge for financial reporting
purposes will exclude the credit risk premium.
So what drives or creates value in terms of an inter st rate swap agreement? The value created for each of the
counterparties will lie in the difference between the two cash flows on a given settlement date – in other words
the difference between the paying and receiving legs. Taking the basic valuation principles which the discount-
ed cash flow approach you used when valuing financial instruments into account, as this net cash flow will arise
on a future date, the difference needs to be discounted to a present value in the process of determining a fair
value for the designated hedge.
Example: valuing an interest rate swap
A Limited and B Limited entered into an interest rate swap agreement to swap cash flows on a number of fu-
ture settlement dates. The terms of the swap agreement are as follows:
Notional amount of the swap: 50 million.
Cash settlement dates: 15 March, 15 June, 15 September and 15 December for the duration of the
agreement.
Termination date: 15 June 20X6.
A Limited will pay B Limited at JIBAR + 20bp while B Limited will pay A Limited a fixed rate of 8,2% per
annum. These rates exclude any credit risk spread.
The floating l g of the swap is pre-fixed and post-paid.
A Limited’s finan ial year-end is 31 December.
The following JIBAR ates are available:
Spot rate Forward rates

31.12.20X4 15.03.20X5 15.06.20X5 15.09.20X5 15.12.20X5 15.03.20X6 15.06.20X6
7,00% 7,25% 7,50% 7,50% 7,75% 8,00% 8,25%
Required:
Determine the fair value(s) of the interest rate swap for purposes of recognising the interest rate swap in the
financial statements of A Limited on 31 December 20X4.
Solution:
Looking into the future on 31 December 20X4, the following are the cash settlement dates which will need to
be valued: 15 March 20X5, 15 June 20X5, 15 September 20X5, 15 December 20X5, 15 March 20X5 and 15 June
20X5, after which the agreement terminates.
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One of the important terms of the agreement is that the swap will be pre-fixed and post-paid. This means that
the floating rate will be set at the start of the period leading up to the cash settlement date – in other words at
the start of each quarter (pre-fixed) while the actual settlement of the difference will take place at the end of
each quarter (post-paid).
This is very important as this will determine which JIBAR rate we will use in the valuation. For purposes of the
example we will assume that a year consists of 12 equal months to keep things simple:
Cash settlement date Floating cash flow
3
15.03.20X5 R50m × (7,00%+0,2%) × m = R900 000
12
3
15.06.20X5 R50m × (7,25%+0,2%) × m = R931 250
12
3
15.09.20X5 R50m × (7,50%+0,2%) × m = R962 500
12
3
15.12.20X5 R50m × (7,50%+0,2%) × = R962 500
12
3
15.03.20X5 R50m × (7,75%+0,2%) × m = R993 750
12
3
15.06.20X5 R50m × (8,00%+0,2%) × m = 1 025 000
12
3
The fixed leg on the swap will result in the following quarterly cash flows: R50m × 8,20% × m = R1 025 000
12
15.03.20x5 15.06.20x5 15.09.20x5 15.12.20x5 15.03.20x6 15.06.20x6

R R R R R
Receiving - fixed 1,025,000.00 1,025,000.00 1,025,000.00 1,025,000.00 1,025,000.00 1,025,000.00
Paying - floating -900,000.00 -931,250.00 -962,500.00 -962,500.00 -993,750.00 -1,025,000.00
125,000.00 93,750.00 62,500.00 62,500.00 31,250.00 -
Present value 359,844.71 240,279.86 151,035.11 91,367.02 30,637.25 -
Future value 365,279.86 244,785.11 153,867.02 93,137.25 31,250.00 -
I (rate) - annual 7.25% 7.50% 7.50% 7.75% 8.00% 8.25%
I (rate) - per discounting p riod 1.51% 1.88% 1.88% 1.94% 2.00% 2.06%
n (number of periods) 1.00 1.00 1.00 1.00 1.00 1.00
A few impo tant comments on the discounting in the table above:

Each cash flow difference needs to be discounted to arrive at a fair value using a JIBAR applicable to that
partic lar date.
Given that any risk relating to the swap will have already been priced into the respective legs of the swap,
JIBAR is used as a risk-free discount rate.
As the forward rates differ, we are confronted with a dilemma for discounting purposes – using multiple
rates. The impact thereof is that we need to discount the last net cash flow back to the point where JIBAR
changed – in other words the previous date on which JIBAR was reset. The future value will there-fore be
the net cash flow for the particular cash settlement date plus the present value of the cash flows
fter the date, which has been discounted to that particular cash settlement date.
The first period is not a full quarter – from 31 December 20X4 to 15 March 20X5 is approximately 75
days. We therefore adjust the discount rate on a days’ basis of 75/90 – in other words the rate for a full
quarter is 7,25%/4 = 1,81% × 75/90 days = 1,51%
The fair value calculated being positive reflects a financial asset.
658
Can you detect anything strange regarding the cash flows and resulting value? Look carefully at the cash flows
relating to the first period! The first 15 days of the cash flow for the first quarter starting building up prior to
valuation date. We therefore say that the fair value we have just calculated is dirty fair value as a portion of
the value relates to the period prior to valuation date. This is known as an all-in value which in this case
amounts to R359 844,71. For financial reporting purposes we however only reflect the fair value arising beyond
valuation date. Hence we need to adjust the cash flows for the first period as follows:
Receiving leg: R1 025 000 × 75/90 days = R854
166,67 Paying leg: R900 000 × 75/90 days = R750 000
The above now reflects the value created after valuation date. Recalculating the fair va ue, yields the following
result:
15.03.20x5 15.06.20x5 15.09.20x5 15.12.20x5 15.03.20x6 15.06.20x6

R R R R R R
Receiving - fixed 854,166.67 1,025,000.00 1,025,000.00 1,025,000.00 1,025,000.00 1,025,000.00
Paying - floating -750,000.00 -931,250.00 -962,500.00 -962,500.00 -993,750.00 -1,025,000.00
104,166.67 93,750.00 62,500.00 62,500.00 31,250.00 -
Present value 339,321.36 240,279.86 151,035.11 91,367.02 30,637.25 -
Future value 344,446.53 244,785.11 153,867.02 93,137.25 31,250.00 -
I (rate) - annual 7.25% 7.50% 7.50% 7.75% 8.00% 8.25%
I (rate) - per discounting period 1.51% 1.88% 1.88% 1.94% 2.00% 2.06%
Note that only the cash flows which have changed have been bolded in the table above – you will see that it will
always only be the first period’s cash flow which is affected by this problem.
The R339 321 36 is the clean fair value of the swap agreement and only includes value originating beyond val-
uation date.
Finally, how would the valuation have differed if the terms of the swap agreement determined that the floating
leg was post-fixed and post-paid?
This would mean that the floating leg is set at the rate applicable at the end of each quarter and not the rate at
the start. The floating legs (we will only look at a clean fair value so note the changes to period 1’s cash flows)
will be:
3
15.03.20X5 R50m × (7,25%+0,2%) × m = R931 250 × 75/90 days = R776 041 67
12
3
15.06.20X5 R50m × (7,50%+0,2%) × m = R962 500
12
3
15.09.20X5 R50m × (7,50%+0,2%) × m = R962 500
12
3
15.12.20X5 R50m × (7,75%+0,2%) × m = R993 750
12
3
15.03.20X6 R50m × (8,00%+0,2%) × m = R1 025 000
12
3
15.06.20X6 R50m × (8,25%+0,2%) × m = R1 056 250
12
659
The valuation is as follows:
15.03.20x5 15.06.20x5 15.09.20x5 15.12.20x5 15.03.20x6 15.06.20x6

R R R R R R
Receiving - fixed 854,166.67 1,025,000.00 1,025,000.00 1,025,000.00 1,025,000.00 1,025,000.00
Paying - floating -776,041.67 -962,500.00 -962,500.00 -993,750.00 -1,025,000.00 -1,056,250.00
78,125.00 62,500.00 62,500.00 31,250.00 - -31,250.00
Present value 197,870.96 122,734.63 62,535.91 1,208.46 -30,018.13 -30,618.49
Future value 200,859.63 125,035.91 63,708.46 1,231.87 -30,618.49 -31,250.00
I (rate) - annual 7.25% 7.50% 7.50% 7.75% 8.00% 8.25%
I (rate) - per discounting period 1.51% 1.88% 1.88% 1.94% 2.00% 2.06%
This represents a financial asset of R197 870,96 for financial rep rting purp ses
This chapter has focused on the interest rate mechanism and which fact rs have an impact on interest rates. A
distinction was made between the repo, JIBAR and prime rates as being the respective base rates which exist in
South Africa. Interest rate risk was defined and different ethods of anaging interest rate risk were discussed
– namely matching, smoothing, pooling and finally, through the use of different derivative instruments, the
different formal hedges were addressed.
Practice questions
Question 16–1: Forward rate agreement (Intermediate)

R&B Investments (R&B) has an investment amounting to R60 million which will mature on 1 April 20X4. Today
is 31 January 20X4 and the chief financial officer (CFO) of R&B is concerned that interest rates in the market are
going to drop by the time the investment will be reinvested. To hedge against this potential interest rate risk,
the CFO enters into a forward rate agreement with a counterparty on 31 January 20X4. The forward rate (FRA
rate) is set at 4% per annum. As the underlying investment will be invested for a period of nine months, the
forward rate agreement will cover the period 1 April 20X4 to 31 December 20X4. Cash settlement in terms of
the forward rate agreement is set for 1 April 20X4. On 1 April 20X4 the market rate for investments for the
same period and amount as that of R&B is 3,5%.
Required:
Determine the outcome of the h dge, both in terms of Rand-value and effective interest rate. Use months as
the basis for the al ulation.
Solution 16–1
(FRArate referencerate) days/basis

= R60 million × (4% 3,5%) 9m/12m = R219 244,82

1 (3,5% 9m/12m)
660
The counterparty will have to make a compensation payment to R&B of R219 244,82 which R&B will invest
together with the amount of the investment which will mature and be reinvested on 1 April 20X4.
R
FRA compensation payment 219 244 82
Invest on 1 April 20X4 (R60m + R219 244,82) 60 219 244 82

Interest received R60 219 244,82 × 3,5% × 9/12 1 580 755 18
Value of the investment 61 800 000
R61,8m 12
This results in an effective interest rate of ( R60 m – 1) × 9 = 4%
Question 16–2: Short-term interest rate futures (Intermediate)

Big Retail Limited (Big) will need to borrow R250 million on 1 N vember 20X4 in order to finance the build-up of
inventory levels and trade receivables during the Christmas peri d. The term of the borrowing will be six
months. Today is 1 June 20X4 when 3-month JIBAR futures are trading at:
%
June contract 7,40
September contract 7,65
December contract 7,90
Big’s head of treasury, is of the opinion that all indications are that interest rates will increase between today
and 1 November 20X4. As such the head of treasury believes that the interest rate risk needs to be hedged and
would like to use the 3-month JIBAR futures to hedge this risk. The notional value of each contract is R100 000
and according to the derivatives market dealers of the Johannesburg Stock Exchange, each decimal movement
in the interest rates on these contracts is worth R2,50 and each contract has a 3-month term.
Required:
Set-up the hedge for the head of treasury and determine the outcome of the futures contracts if at close out,
the 3-month JIBAR was quoted at 8%.
Solution 16–2
Which contract will be used? ecember contracts will be chosen as these contracts expire after the date on
which the borrowing agreement will be entered into
Which position (long/short)? As interest rates are expected to increase (the trend in respect of the interest
quotes on the different contracts confirms this), a short position should be
taken up
How many cont a ts? Each contract has a notional value of R100 000 and Big intends on borrowing
R250 million for six months
R250 m 6
× = 5 000 contracts
R100 000 3
Value per decimal (tick) movement: R2,50 (as per the Johannesburg Stock Exchange (JSE) derivatives market)
So d at 7,90% yield (price: 100 – 7,90) 92,10
Bought at 8% yield (price: 100 – 8,00) 92,00
Gain 0,10
This equates to a 10 tick movement (0,1% movement in the interest rates) in the price of each contract.
661
Net impact on finance charges:

R
Finance charges: R250m × 8% × 6/12m 10 000 000
Gain from futures market: 10 ticks × R2,50 per tick × 5 000 contracts (125 000)
Net finance charges 9 875 000
R9,875m 12
This results in an effective interest rate of R250 m × 6 = 7,9%
Question 16–3: Interest rate swap agreement (Advanced)

Retailer Limited (Retailer) is a large retailer of clothing and foodstuffs. Tru-Ret il Limited (Tru-Retail) is a retail-
er of clothing only. Both companies have a need to manage their interest rate risk and as such they approach
Big Bank Limited (BB) to come up with a solution.
Both companies need to borrow funds in order to bolster their w rking capital levels. Retailer would ideally like
to be exposed to a floating rate of interest while Tru-Retail w uld like to be exposed to a fixed rate of interest.
The following is known regarding the rates at which the two co panies could borrow:
Floating rates Fixed rates

Basis points (bp) %
Retailer JIBAR + 120 R tail r 8,0
Tru-Retail JIBAR + 170 Tru-Retail 9,2
JIBAR is currently 6,5% per annum.

BB has suggested that Retailer borrow at a fixed rate from it and that Tru-Retail borrow at a floating rate and
that through a swap agreement, the two counterparties be placed in the position in which they ultimately
would like to be in terms of interest rate exposure. BB will charge a 10bp fee for structuring the swap.
Required:
Set-up the swap agreement between etailer and Tru-Retail, clearly indicating the respective legs of the swap
and what each party will end up paying the other.
Solution 16–3
The following loan agreements will be entered into:
Retailer Tru-Retail
Borrows at a fixed rate of Borrows at a floating rate of JIBAR

8% per annum from Bank plus 170 bp per annum from Bank
Bank Bank
662
I This net swap bene
n (Tru
A
t
e
s
r
e R
s e
t t
r
a
a i
t l
e e
s r
a
n
h
d a
i
n t
t
e
h
r e
e
s s
t t
r
r
a o
t n
e g
r
s
i
s
t
k
c
C r
h e
a
p
d
t i
e t
r
r
1
6
a
The following swap benefit arises:

i
Retailer Tru-Retail Difference

n
Borrow at a fixed rate of 8% 9,2% 1,2% g
Borrow at a floating rate of JIBAR + 120bp JIBAR + 170bp –50bp = –0,5% ,
Swap benefit 0,7%

Less: structuring fee –0,1%
t
Net benefit arising through the swap 0,6%

h
receives: 8%
Borr ows at a fixed rate o f 8% per a nnum f rom Bank

Each of the counterparties will then pay the bank their portion of the structuring fee – assuming this too is split
50:50, the following would be the resulting impact on their respective parties’ borrowing costs:
Retailer: JIBAR + 85bp (as per the swap) + 5bp (portion of the structuring cost) = JIBAR +
90bp Tru-Retail: 8,85% (as per the swap) + 0,05% (portion of the structuring fee) = 8,9%
The net effect of the swap on each of the two respective parties is that they were able to reduce their borrow-
ing cost by 0,3%, being the net swap benefit.
Question 16–4: Valuation of an interest rate swap (Advanced)

Assume that Retailer Limited (Retailer) and Tru-Retail Limited (Tru-Retail) referred to in Question 16-3 enter
into the following swap fixed for floating interest rate swap agreement:
Notional amount of the swap: R100 million
Cash settlement dates: 15 March, 15 June, 15 September and 15 December for the duration of the
agreement
Termination date: 15 December 20X5
Retailer pays Tru-Retail JIBAR + 90bp while Tru-Retail pays Retailer a fixed rate 8,9%. A credit risk spread
of 80 basis points has been included in each of these rates.
The floating leg of the swap is pre-fixed and post-paid.
Retailers’ financial year-end is 31 December.
The following JIBAR rates are available:
Spot rate Forward rates

31.12.20X4
15.03.20X5 15.06.20X5 15.09.20X5 15.12.20X5
6,75% 7,00% 7,25% 7,50% 7,75%
Required:
Determine a clean fair value for the interest rate swap to be accounted for by Retailer in its annual financial
statements for the year-ended 31 December 20X4.
Solution 16–4
Excluding the credit risk premium, the floating leg will be at JIBAR + 90bp – 80bp = JIBAR + 10bp while the fixed
rate will be 8,9% - 0,8% = 8,1%
Calculation of the floating payments to be made by
3
15.03.20X5 R100m × (6,75%+0,1%) × m = R1 712 500 × 75/90 days = R1 427 083,33
12
3
15.06.20X5 R100m × (7,00%+0,1%) × m = R1 775 000
12
3
15.09.20X5 R100m × (7,25%+0,1%) × m = R1 837 500
12
3
15.12.20X5 R100m × (7,50%+0,1%) × m = R1 900 000
12
3
The fixed leg on the swap will result in the following quarterly cash flows: R100m × 8,10% × 12 m = R2 025 000
664
Calculation of the clean fair value:
15.03.20x5 15.06.20x5 15.09.20x5 15.12.20x5

R R R R
Receiving - fixed 1,687,500.00 2,025,000.00 2,025,000.00 2,025,000.00
Paying - floating -1,427,083.33 -1,775,000.00 -1,837,500.00 -1,900,000.00
260,416.67 250,000.00 187,500.00 125,000.00
Present value 793,392.80 544,546.45 304,416.35 122,624.16
Future value 804,963.11 554,416.35 310,124.16 125,000.00
I (rate) - annual 7.00% 7.25% 7.50% 7.75%
I (rate) - per discounting period 1.46% 1.81% 1.88% 1.94%
n (number of periods) 1.00 1.00 1.00 1.00
The clean fair value of the interest rate swap agreement at 31 December 20X4 from Retailer’s perspective is
R793 392,80.
665
Chapter 17
Business plans
define the purpose of a business plan;

identify suitable sources of financing and relate the context of each source to respective audiences for
whom the plan developed;
l understand the different audiences’ information n ds;
describe the common components of a busin ss plan; and
evaluate a business plan in respect of:
– the business strategy and strategic plan;
– stakeholders;
– strengths and weaknesses;
– risks, including environmental, social and governance issues, and long-term sustainability;
– sources needed to execute the plan;
– calculations regarding input costs and revenue streams; and
– assumptions clearly outlined.
One of the key roles of the professional accountant and financial manager is to develop and evaluate business
plans. Business plans (sometimes called business proposals) are one of the key planning, resource allocation
and communication tools for entrepreneurs and organisations to obtain financing. This can be either for a new
start-up, for major expansions of existing activities or to undertake a merger or acquisition. In this chapter the
purposes, sources of financing, audience and components of a business plan are discussed.
This chapter should also be r ad closely together with chapters 1 and 2 as the role of the financial manager,
establishing strategies, risk identification and risk management techniques are discussed in those chapters and
are relevant to the formulation of a business plan as well. Also refer to chapters 4 and 7 for the detailed discus-
sion on sou ces and fo ms of finance and the advantages and disadvantages of each.
17.1 P rpose and sources of financing

A business plan is a road map or blueprint of how a business intends to achieve its vision and objectives in the
medium term (3–5 years). Standard Bank (2012) defines a business plan as “a detailed overview of the current
po ition of a business, where it wants to go, and how it plans to achieve its goals. It is a summary of a busi-ne ’s
pa t, present and future”. Sanlam (2012, 1) describes the primary purpose of the business plan as “to guide you
in successfully setting up and operating your business. Preparing the plan forces you to consider all aspects of
your business and to confront any problems the plan highlights . . . while your business is still on p per”. There
is an old adage that says: fail to plan and plan to fail! Preparing the business plan therefore forces the owner(s)
or founder(s) to consider all aspects of the business and get their ‘ducks in a row’, meaning hat all possible
issues are thought through and addressed in the plan.
667
The business plan should be distinguished from the annual budget or day-to-day operational plan of an existing
business or other organisation. Business plans are usually developed when an entrepreneur or organisation
wants to obtain financing to –
start-up a new business;
undertake a major expansion in either its existing markets or new markets or launch new products; and
merge with or acquire another entity.
Most small businesses start up with the entrepreneur’s own funds, for example savings, an inheritance or
retrenchment package. Sometimes he/she can obtain additional funding from the three F’s, friends, family and
fools! Depending on the scale of the operations, these funds might not be enough and the initial owners will
have to approach the capital markets for additional funding. This might t ke the form of equity (issuing addi-
tional shares via a private placement or Initial Public Offering (IPO) or p rtnership interests to new investors) or
debt funding (bank loans). Please refer to chapter 7 for further in-depth discussion of sources of funding avail-
able at various stages of the life cycle of the organisation.
These capital providers need to be convinced about the feasibility (can it be done) and viability (is it sustaina-
ble) of the business idea and that they will earn sufficient returns n their investments. This is the primary goal
of the business plan.
That said, once the business or expansion is up and running, the business plan and strategies should be revisit-
ed frequently to make sure the organisation is still on track to eet its objectives. Changes to strategies or
courses of action might be required. The initial business plan eventually becomes embedded as the organisa-
tion’s operational plan takes effect. However, operating in a dynamic business environment means that budg-
ets and forecasts should ideally be prepared on a rolling tw lve-month basis.
17.2 Intended audiences and their information needs

It is very important that the ‘message’ in the business plan is tailored for the audience. If the intended audience
is debt providers, they will need to be convinced that the organisation will earn enough after tax free cashflow
so that their capital (the loan) will be repaid and interest payments will be serviced. The riskier the investment
and longer the loan period, the higher the interest rate would be as uncertainty regarding future cashflows
increases. Debt providers will also be interested in any collateral or security that can be provided by the appli-
cants.
If the intended audience is equity partners/investors, they will need to be convinced that the organisation will
earn enough after tax free cashflow to service debt AND to provide for dividends and future capital growth on
their investment. Remember that in case of liquidation, the capital invested by the owners of the organisation
is only repaid after all debt and other claims have been settled (if at all). For this higher risk, they expect to earn
a higher return.
Although the word ‘busin ss’ is used, the principles pertaining to compiling ‘business plans’, can also be applied
for non-profit organisations and even government programmes. These principles contained in the business plan
stay the same, only the audience (fund providers) will differ. In case of not-for-profit organisations, the
audience will be donor funders and the beneficiaries of the programme. Although donors don’t expect to be
repaid, they a e inte ested in how efficiently the donation will be spent. In the case of government pro-
grammes the audience might be tax-payer associations, civil organisations and international funders such as
the World Bank or International Monetary Fund. The audience will once again be interested in the efficiency
with which the f nds are spent and in the case of loans, the ability to repay it.
Irrespective f the audience, they will primarily be interested in the product/service and its market or benefi-
ciary, the fact rs that should contribute to the success, the needs, interests and expectations of all the stake-h
lders, the p tential risks and the actions taken to manage these risks and the amount and timing of the funding
required. The fund providers want to see a ‘bankable plan’ that provides confidence that –
there is a more than reasonable chance that the business/expansion will succeed given the product and
the market/industry analysis;
there is a reasonable return that is aligned with the risks they will be taking (refer to chapter 5 for a
discussion on risk and return); and
the business will generate cash (not only profits).
The components of the business plan that addresses these information needs are now discussed.
668
Business plansChapter 17
17.3 Role players and components of the business plan

Who are the role players? Compiling the business plan requires a multi-disciplinary task team. Inputs are
required from the –
marketing manager or the marketing firm used by the organisation;
technology and production manager (for manufacturing) or service manager (for services);
human resource manager;
finance manager; and
information technology manager (depending on type and size of business).
Where the business plan is developed for a small start- up, these functions might h ve to be fulfilled by the
original founder only or shared by the owner and his/her partners. Depending on the life- stage of the business,
these functions might eventually be embedded in different specialist managers in the organisation. A large
established business, preparing a business plan for expansion purposes, will normally have such a functional
organisational design.
It is important to note that the business plan is the prime ‘marketing t l’ to the potential providers of capital.
The organisation/entrepreneur has to convince the fund providers that this is a ‘bankable’ plan! It should
reflect care and attention to critical details. Proper research into the product/service and the competitive
environment of the industry is a pre-requisite before one can co ence to write the plan. Generally the soliciting
for funds process gives only one chance to make a good i pression.
Most business plans will have at least the following s ctions –
executive summary;
business description;
ownership and management team;
product/service offered;
market/industry analysis and sales strategy;
facilities and resources;
business model;
capital required and milestones;
financial data and forecasts;
stakeholders and sustainability;
risks and risk manag m nt; and
appendices.
What should be ommuni ated in each section will now be explored. These are not hard and fast rules, but
rather suggestions or guidelines. As long as the issues discussed below is considered and addressed somewhere
(in a logical manne ) in the plan, the plan should serve its purpose.
17.3.1 Exec tive summary

The executive summary is a summary of two to three pages of the salient points of the plan. This is the first
pages that the p tential investors/lenders see and they have to be interested enough to read the rest of the
business plan. It should clearly spell out what the business is about, its markets and marketing/promotional
plan , the competitive advantage, who the management team is and the amount of financing required and how
it will be used.
This is written last, once all the other details have been considered and recorded.
17.3.2 Business description

This section should describe the purpose or mission of the business as well as its long-term vision of where it is
going. Describe the organisation’s objectives and the strategies that will be employed to achieve it. Provide
669
some history and other background to the organisation. Provide some background to the industry: what the
industry is about and how big it is.
Make the business case (why the business will succeed): why is this product/service needed? Who are the
customers/clients? How will this product/service be delivered? What makes the product/service different to
the competitors, that is, unique product, technology, distribution channel or location?
Some of these aspects are described in more detail in further sections of the business plan.
17.3.3 Ownership and management team

Provide details of the legal structure (for example, is it a partnership or a company?) of the business and who
the founders are/were. Indicate the names and percentage ownership of the current owners as well as which
owners are involved in the business and which are deemed ‘silent partners’. The l tter are partners who are not
involved at all in the day to day running of the entity, but have pro ided capital and hence expect a return on
their capital. Details of share incentive schemes for management and employees should also be disclosed.
A very important aspect for potential investors or lenders is the expertise of the management team. Many
businesses fail, not because of the product or lack of finance, but lack f proper leadership and day-to-day
management. The management team is in charge of executing the plan and the investors/lenders trust them
with the funds to be provided. Briefly describe the key attributes/skills/expertise and qualifications of each
member of the management team. It must be clear to the reader how this contributes to the successful execu-
tion of the plan. Detailed Curriculum Vitae should be attached under the appendices section.
Include an organisational chart that indicates how the busin ss will be structured, that is divisional (independ-
ent business units for product ranges or geographic ar as) or functional (sales, production etc. covering all areas
and all products). Indicate the number of support and operating staff in each functional unit.
17.3.4 Product/service offered

This section is used to describe the product or service offered. Point out what makes it unique or why it fills a
gap in the market. Provide evidence of customer requests or feedback from satisfied customers and clients. If it
is protected by patent law, elaborate on this as it is an indication of the security and duration of the future
income streams to be derived from it. Describe the different applications of the product as that indicates the
different customer sections being targeted. Having more than one application for the product might also lessen
the risk of competitors coming to the fore and removing any competitive advantage in that only market.
Provide details of any major contracts already concluded. Copies of contracts can be included in the appen-
dices.
Provide background as to the technology involved to produce the product or deliver the service. This should
also include a discussion on continued investment required into research and development. If the product is
still in prototype stage, illustrate in a schedule how the project will progress until the product is ready for
commercial use and sal s. Id ntify risks, by highlighting the critical paths, constraints and major milestones that
need to be met.
The detailed analysis of the market, the competition and marketing or promotional strategies is discussed
under the next se tion.
17.3.5 Market/industry analysis and sales strategy

The market/ind stry conditions are very important as it has a great influence on the success of the product or
service. Pr vide details regarding the market size, the business’s share of it and the potential for growth. Discuss
new developments in the market, for example new regulation, trends and the like.
Provide an analysis of the competitive environment in which the business will compete. Porter’s Five Forces
(1980) is a very good tool for analysing the market or industry. The questions to ask are:
What are the barriers to entry?
What is the bargaining power of the customers?
What is the bargaining power of the suppliers?
Are there substitute products available to customers?
How fierce are the existing competition between players in this market/industry?
670
Porter also proposes various strategies to gain competitive advantage and for pricing the product/service.
The strategies to achieve growth of the product/service in this market should also be discussed. This can be
done along the lines of the Ansoff’s growth vector matrix which suggests strategies depending on whether the
business intends marketing existing or new products in existing or new markets.
Various tools can be used for the strategic positioning of the organisation’s product/service in its mar-
ket/industry. A few have been briefly highlighted here. For an in depth discussion of these, please refer to
chapter 2 (Strategy and risk). It may also be necessary to provide a life cycle analysis (namely, introduction,
growth, maturity and decline) for the product/service and indicate projected sales volumes at the different
stages. This should tie back to the financial data and forecasts.
Once it is clear how the new business/service will be marketed/positioned, a sa es or promotional plan must
also be put forward. The promotions and advertisements that will be l unched s well as the media channel
should be outlined. Details of the advertising agencies and/or public rel tions firms that the business will use
should be provided. If the business plan revolves around a new product/ser ice, the details of what the actual
launch to the public will entail should be given. Examples of ad ertisements, flyers and packaging can be
included in the appendices.
17.3.6 Facilities and resources

In this section, the facilities and resources required to anufacture or provide the product/service should be
described. The manufacturing process can be visually shown and briefly outlined in layman’s terms. Provide a
value-added analysis and high-level flow charts. If a service is being rendered, describe the steps involved in
providing the service to clients. Describe the most important machines and equipment that are required for the
manufacturing process or those used in the delivery of the s rvice.
The details of the main raw material or components required and the suppliers involved should also be provid-
ed and an indication should be given whether secure agreements have been concluded with the most critical
suppliers. If continuation of supply is an issue, include a brief discussion of Service Level Agreements (SLA)
concluded.
The quality of the human resources required is also critical. In addition to the management team which is
covered in its own section, the skills/qualification/training of other personnel necessary and available should be
outlined. A staffing plan which indicates the job descriptions, salary or wage ranges per post grade and head
count required should be provided as well as an indication as to which of these posts are already filled and
which still need to be filled.
The typical life cycle of the product/service should be given. An overview of the whole supply chain involved in
delivering value to the customer/client is required. Provide a geographic chart which indicates all the facili-
ties/offices of the organisation. escribe what type of support overhead services, that is debtors department,
human resource department and so on, will be provided from a central or head office facility. If information
technology is critical to the functioning of your operations, provide details of main hardware, software and
network requirements.
Provide:
a high-level ost breakdown of the product or service; and
details of long-te m contracts already concluded for leasing of machinery, fleet, factories space, office
space etc.
The information in this section should tie back to the financial data and forecast section.
17.3.7 Business model

The business m del describes how the value will be delivered to the customer or client, how sales will turn into
ca h and how turnover will lead to profits. The business model is derived from the strategy of the business. O
terwalder & Pigneur (2010: 14) defines a business model as the rationale of how an organisation creates, de
ivers and captures value. They have developed a concept called the Business Model Canvas – a visual tem-pl te
for developing new or documenting existing business models. The Business Model Canvas contains nine
building blocks (Osterwalder & Pigneur, 2010: 16–17):
Customer segments: An organisation serves one or several customer segments.
Value propositions: It seeks to solve customer problems and satisfy customer needs with value proposi-
tions.
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Channels: Value propositions are delivered to customers through communication, distribution, and sales
channels.
Customer relationships: Customer relationships are established and maintained with each customer
segment.
Revenue streams: Revenue streams result from value propositions successfully offered to customers.
Key resources: Key resources are the assets required to offer and deliver the previously described ele-
ment.
Key activities: By performing a number of key activities the business model is imp emented.
Key partnerships: Some activities are outsourced and some resources are acquired outside the enterprise.
Cost structure: The business model elements result in the cost structure.
By answering questions posed under each building block, organisations can de elop new or record their exist-
ing business model. Various models are available. The details invol ed with each are beyond the scope of this
book, but a few common business models are –
franchising;
direct marketing and sales;
cutting out the middle man;
bricks and clicks;
subscription; and
virtual stores.
Please refer to Chapter 1 for a more detailed description of a business model.
17.3.8 Capital required and milestones

In this section, the potential fund providers are being informed how much funding is required for the start-up
or expansion. This can be provided in a draw-down table or Gantt chart indicating the milestones (timeline) and
what the money will be used for. The level of funding already being provided by the founders/current owners
and financial institutions should be shown as well as how much additional funding is required.
The information in this section should tie back to the financial data and forecast section.
17.3.9 Financial data and forecasts

The primary responsibility of the financial manager or accountant is the preparation of the financial data and
forecasts. He/she should nsure that all the inputs provided in the other sections of the business plan by the
other experts are conv rt d to Rand and cents and that everything ties together.
Primary assumptions for the forecast years should be provided, such as –
turnover g owth – prices;
turnover g owth – volume;
gross profit percentages;
average interest rates – overdraft;
average interest rates – long-term debt;
tax rates;
any accelerated wear and tear allowances or green fields tax allowances or holidays;
dividend payout ratio;
inflation – Consumer Price Index (CPI) or Producer Price Index (PPI);
industry indices, for example, the Steel and Engineering Industries Federation of South Africa (SEIFSA);
commodity indices, if major impact on your business, for example gold/platinum/copper prices, oil;
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exchange rates, if the business is importing and/or exporting;

cash and operating cycles;
debtors and creditors credit terms;
wage increases;
capacity of plant and machinery; and
billable hours.
The following financial statements should also be provided:
Statement of Profit or Loss and Other Comprehensive Income (‘income statement’).
Statement of Financial Position (‘balance sheet’).
Cashflow Statement.
The income and cashflow statements should be provided for the following periods –
monthly for the first 12 months;
quarterly for Years 2 and 3; and
annually for Years 4 and 5.
The balance sheet is provided at the start (now) and thereafter annually. These timeframes are recommenda-
tions only, but the financial plan is usually not prepar d for p riods less than three years or longer than five
years. Capital-intensive industries might have long r tim fram s as the business cycle may be longer and it takes
longer to recoup huge amounts of investment. The inverse may apply for IT businesses where technology
changes too fast to plan far ahead.
Provide ratio analyses, with comments that will address the main areas, for example, profitability, return,
liquidity, and solvency. Equity providers will mostly be concerned with the ‘return on investment’ and ‘return
on equity’ measures, whilst debt providers will mostly be interested in the debt to equity ratio and the interest
cover ratio. Refer to chapter 8 (Analysis of financial statements) for detail on various ratios and what each
means. These ratios should be benchmarked against main competitors and/or the industry.
In addition to the three regular financial statements provided, the following management information should
also be provided:
Variable costing income statement (reconciling back to the profit before interest and tax in the Statement
of Profit or Loss and Other Comprehensive Income).
Breakeven analysis, safety margins and other margins indicating sensitivity to price or costs.
Other key operational performance measures (critical success factors), for example throughput per hour,
material yields, labour ffici ncies (if not listed under key assumptions).
The amount of detail provid d h re should also be considered. Some consultants advise that only the assump-
tions and highlights should be presented here, and the detailed financial statements are better placed in the
appendices. That might be advisable for large complicated projects.
17.3.10 Stakeholders and sustainability

Any organisation that requires funding from external parties will face a changing business environment in
which the focus is not on profit alone anymore. Organisations should operate in a sustainable manner by taking
acc unt f the three P’s that is people, planet, and profit! Refer to chapter 2 (Strategy and risk) for details on wh
m the external and internal stakeholders of an organisation are and the concept of sustainability.
De cribe the main external and internal stakeholders of the organisation and the manner which they will be
affected by the organisation’s activities, positive and negative. If there are potential negative impacts, describe
how this will be mitigated.
Provide a Value Added Statement. This indicates how the value added by the business (turnover less
products/services bought in) is distributed between employees, equity holders, debt providers, the govern-
ment and other stakeholders.
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17.3.11 Risks and risk management

Assuming that the business plan has done enough to whet the appetite of the potential fund providers, they
will also require assurance that the risks involved have been considered. Some of the risks might already have
come to the fore in the discussion on stakeholders, but nevertheless a complete picture should be provided
here. Risks might be identified with a ‘strengths, weaknesses, opportunities, threats’ (SWOT) analysis. An
alternative method is a political, economic, socio-cultural, technological, legal, environmental, global and
ethical factors (PESTLEGE) analysis. How the risks will be managed, how strengths will be maintained and
opportunities grown should be clearly indicated.
Depending on the size of the business, the organisation may also be required to demonstrate that it has an
official risk management structure in place. Refer to chapter 2 for a detailed discussion on risk identification,
management and risk management structures and frameworks.
17.3.12 Appendices
This section contains details in support of information provided in earlier sections. Some examples are –
product data sheets, including sketches or photos;
patents;
l test results from standard setting organisations, for exa ple South African Bureau of Standards (SABS), or
Council for Scientific and Industrial Research (CSIR);
market research;
advertisements and other promotional material;
management and key personnel profiles;
reviews of the product/service in trade and other magazines;
list of equipment (owned or to be acquired);
floor plans;
copies of leases/rentals;
copies of finance agreements;
detailed financials (if not provided under the finance section); and
attorneys and accountants.
17.4 Conclusion
A suggested format for a g n ral business plan has been presented. In practice, the whole of the plan must be
considered. For instan e, some authors suggest discussing the vision and mission in the executive summary and
others put it in the business description. It must always be remembered that the purpose of the business plan
is to market the business idea and to make the investment/loan attractive for potential fund providers. The
business plan also becomes the road map for the business so it is important that all the aspects discussed
above are addressed somewhere in the plan!
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Appendix A
Online resources for developing business plans

The internet is a vast resource where many additional guidelines for preparing business plans, MS Word tem-
plates and even examples of complete business plans in diverse industries can be found. Here are a few useful
websites from a Google search on ‘business plans’:
http://www.bplans.com
http://www.bplans.com/sample_business_plans.php
http://www.entrepreneur.com/businessplan/index.html
http://bizconnect.standardbank.co.za/start/business-planning/reference-documents/business-
plan-template.aspx
http://southafrica.smetoolkit.org/sa/en/category/2944/Business-Plans
Practice questions
Question 17–1: Knysna Cabinets (Fundamental)

Knysna Cabinets manufactures custom cabinets for r sid ntial, r sort and the commercial market.
The extract from the business plan below is reproduced with the kind permission of Palo Alto Software, Inc.,
1996-2014 All rights reserved. Minor modifications were made for the South African context. The full original
business plan can be accessed at http://www.bplans.com/furniture_manufacturer_business_plan/
company_summary_fc.php#.UJ-uGmcbI c.
Executive Summary
Knysna Cabinets will be formed as a cabinet company specialising in custom cabinets for the high-end
residential, resort, and commercial market. Its founders have extensive experience in the construction
and cabinet industry.
Over some years of being involved with the construction of luxury homes, the company owners have seen
a need for a cabinet line with a broad selection of design choices, high-end finishes, along with top of the
line organisation, customer service, and quality. Knysna Cabinets will meet those customers’ needs. Build-
ing a strong market position in the high-end residential, resort, and commercial development segments,
the company projects revenues to grow substantially between FY 1 and FY 3. By maintaining an average
gross margin of ov r 25%, the company estimates handsome net profits by FY 3.
The company own rs have provided the capital to cover the start-up expenses. The company currently
seeks a three-year ommercial loan to cover the operating expenses.
Objectives
The company objectives are:
To be a top cabinet supplier to luxury homes in the regional market.
Revenues to more than double Year 1 levels by the end of Year 2.
Aim to have 70% of sales in high-end residential customer segment.
20% of sales in mid-range residential customer segment. 10% of
sales in commercial development segment.
To have a showroom within three months in a prominent retail space.
Mission
To deliver a high-quality product, on time and within budget while also providing a fast, error-free order-
ing system.
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Highlights
R1,400,000
R1,200,000
R1,000,000 Sales
Gross Margin
R800,000
Net Profit
R600,000
R400,000
R200,000
R
Year 1 Year Year 3
Required:
Evaluate whether the executive summary satisfies most of the requirements for a standard business plan.
Solution: Knysna Cabinets – Executive Summary

The following are identified from the extract provided –
what the product is about;
the key competitive advantage;
the markets that are targeted;
why the funding is required (its use); and
highlights from the financial data indicating the potential growth and profitability.
The executive summary however, neglects to mention who the owners are and the amount of funding that is
required.
Question 17–2: Rashid’s Catering (Intermediate)

Rashid’s Catering provides Halaal catering for events and functions in the Muslim community.
business plan can be accessed at http://www.bplans.com/catering_company_business_plan/company
summary fc.php#.UJ-xkWcbI_c.
1.0 Company Summary

Rashid’s Catering, lo ated in Durban, KwaZulu-Natal will offer high-end Halaal catering to the Durban
Muslim community. Rashid’s Catering will serve parties of 25–300 people with high-end Halaal foods that
are cu ently only available in Cape Town. Rashid’s Catering will offer a large menu repertoire, from tradi-
tional favo rites to creative inventions.
Rashid’s Catering will rent space for the office and kitchen in an industrial area of Durban. Renting in the
industrial area will significantly lower the cost. Since the space will be used for food production it is not
relevant f r the store front to be aesthetically pleasing, or in a nice neighbourhood. Rashid’s Catering is
f recasted to generate R395 000 in profits for Year 3.
Start-up Summary
Rashid’s Catering will incur the following start-up costs:
Two commercial stoves with ovens.
Dishwasher.
Two sets of cookware.
Two sets of dishware.
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One van with rolling racks built in (a rolling rack is a wheeled rolling cart system that is insulated for both
hot and cold food).
Assorted serving trays and utensils, knives and cutting boards (two each).
Desk and chair.
Computer with printer, CD-RW, Microsoft Office, and QuickBooks Pro.
Internet modem, router and data contract.
Copier and fax machine.
Table: Start-up
Start-up
Start-up expenses
Legal R5 000
Stationery etc. R1500
Brochures R3 000
Rent x 3 months R30 000
Salaries x 1 month R15 000
Total Start-up expenses R54 500
Start-up assets
Cash required R6 700
Non-perishable food inventory R12 000
Non-current assets (equipment etc) R320 500
TOTAL ASSETS R339 200
Total Requirements R393 700
Table: Start-up Funding
Start-up Funding
Total Funding Required R393 700
Less:
Non-current assets – to be funded by leases R320 500
Short-term funding required R73 200
Available from:
Rashid R15 000
Family and fri nds R10 000
Total Ov rdraft funding requested R48 520
Required:
Evaluate whether the business description satisfies most of the requirements for a standard business plan.
Solution: Rashid’s Catering – Business Description

The f ll wing are identified from the extract provided:
What the business will sell.
Its competitive advantage in terms of product (previously only in Cape Town). Its
competitive advantage in terms of cost (low rent in industrial area).
Where the business will operate.
However, the details regarding the start-up expenses, assets required and funding should rather be presented
in the executive summary and the capital required and milestones sections. They could have elaborated a bit
more on the industry and market in general (without too much detail, as the detail is discussed in the product
and market/industry sections).
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There is no description of the business’ objectives and mission, except from the profit that should be generated
by Year 3.
Question 17–3: GreenPET Plastics (Intermediate)

GreenPET Plastics is a recycler of plastic PET bottles, which is then used to manufacture plastic sheets and
strappings.
business plan can be accessed at http://www.bplans.com/plastics recyc ing_business_plan/executive
_summary_fc.php#.UJ_PuWcbI_d.
1.0 Products
GreenPET Plastics will utilise two processes in the same facility to produce:
l Cleaned and recycled plastic PET flake (RPET), recovered fr m p st-consumer beverage bottles and
manufacturing waste produced by its sheet customers.
l Extruded roll stock sheet PET.
Extruded PET high-strength strapping for securing large packages or pallet loads; each using 100% RPET
produced in-house.
Product Description
Roll stock sheet will be sold to custom thermoformers primarily to be used to produce high-visibility
packaging. It will also be sold to manufacturers of laminates and fabricated plastic products.
High strength PET packaging strapping is used to secure packages or pallets in such industries as lumber
milling and corrugated and other paper production.
Both products will be extruded from post-consumer polyethylene terephthalate (PET) bottles. The recy-
cling programs in Gauteng, Mpumalanga and North West collect in excess of 200 000 000 kilograms of
PET bottles per annum. GreenPET’s initial capacity will be 46 000 000 kilograms.
Using a patented process, GreenPET will clean and refine the PET material from the post-consumer bottle
stock and post-industrial manufacturing waste. The PET flake resin produced will be extruded into roll
stock sheet or high-strength strapping.
Although the company expects to convert its entire bottle feed stock into extruded products, any surplus
flake will be sold to outside manufacturers.
Competitive Comparison
While quality and d liv ry are important factors to our potential clients, price is most often the determin-
ing factor in a buying decision. Good-quality packaging products manufactured from recycled (less expen-
sive) resins, as lose as practical to the end customer’s operations, will be most competitive and achieve a
significant ma ket share. These factors have helped to determine the business parameters of GreenPET
Plastics.
1.3 So rcing
In excess f 200 000 000 kilograms of post-consumer PET beverage bottles are collected and available as
feed st ck for manufacturers who can re-process this material into commercial products. The company
has excellent relations with the firms and associations that collect and distribute these materials and has
been a sured that its requirements will be available for the foreseeable future.
The company has entered negotiations with a Gauteng based source of post-consumer bottles and is
confident that sufficient volumes are available on a contract basis from this source to satisfy its require-
ments. In addition, the company intends to purchase production waste from its sheet customers and
blend it into its feed stock.
Currently, the majority of the post-consumer PET bottles collected in Gauteng, North West and Mpuma-
langa are exported to China. The Chinese have absorbed the amounts surplus to the use in South Africa.
Their interest has kept the industry in the position of being able to maintain a steady price range for this
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bottle stock. A significant percentage of all sales of such bottle stock are managed by Plastics Recycling
Corporation of Gauteng (PRCG), an industry funded marketing agency which operates similarly to a co-
operative. They accept bids from potential buyers on behalf of the firms which act as ‘consolidators’,
which accumulate stocks from the smaller, individual bottle-recycling depots. Some amount of the availa-
ble stocks are regularly bought by recyclers in eastern South Africa who focus on the carpet manufactur-
ers who use RPET resin in their process, but the high cost of transport from central South Africa makes
eastern sources more desirable.
GreenPET has a good relationship with company B, one of the larger consolidators in Gauteng. Company
B has indicated a desire to contract to supply GreenPET with all of its raw material needs. They prefer to
deal with a local consumer such as GreenPET, rather than the uncertainty and extra preparation require-
ments of the export market.
There are other sources of post-consumer feed stock known to GreenPET, nd we are confident that we
will have sufficient materials available for our production needs.
1.4 Technology
Sam McGuire, a key member of our Management team, is ne f the riginal innovators of cleaning and
refining technology for post-consumer PET, and we will be utilising his patented process in our recycling
facility. Sam has worked in the establishment and operation of facilities employing similar technologies
over the last several years.
On the manufacturing side, Management has been an integral part of the advancement of industry
practices over the last twenty years or so, and includ s in their knowledge base most, if not all, of the
state-of-the-art available equipment and manufacturing t chniques.
Required:
Evaluate whether the product description satisfies most of the requirements for a standard business plan.
Solution: GreenPET Plastics – Product Description

The following are identified from the extract provided:
What the products are.
Patents involved.
Who the potential customers are.
Where the raw material will be sourced.
Experience with the technology used.
This is a very extensive product d scription and the readers will be well informed. There’s not much that can be
added.
Question 17–4: GreenPET Plastics – continued

We continue with the example of GreenPET. GreenPET Plastics is a recycler of plastic PET bottles, which is then
used to man fact re plastic sheets and strappings.
business plan can be accessed at http://www.bplans.com/plastics_recycling_business_plan/executive
summary fc.php#.UJ PuWcbI_d.
Market Analysis Summary

Strong demand for recycled plastics is working in the industry's favour. Major users of plastic packaging,
pparently responding to consumer desires, have begun incorporating at least some recycled plastic con-
tent in their products as part of the growing interest in recycling. Recycled resin demand is on the rise as
prices for the two major recycled resins, PET and HDPE, continue to hold value or appreciate against their
virgin counterparts.
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In volume, PET is currently the number one recycled resin. Supply of recycled PET is in excess of
800 million kilograms per year. This figure is expected to grow, reaching over 1 billion kilograms during
the next few years. The plastics industry has developed new markets and applications for recycled resins
from both post-consumer and post-industrial sources.
PET leads the recycled recovered resins as the most visible and valuable, and its use is increasing. Of the
total 3,7 billion kilograms of PET consumed in 1997, just 16% was from recycled sources. Of the more
than 90 billion kilograms of plastics produced annually in the RSA, less than 5% is from recycled sources.
Plastics, after aluminium, represent the second highest value material in the waste stream and have the
highest projected growth rate.
Markets and uses for recycled plastics are rapidly expanding. Plastic containers are being collected at the
curb for recycling in nearly 500 communities, representing more th n 4 million households. SA demand for
recycled plastic will continue to expand and new markets will develop s technologies permit the effi-cient
segregation and reprocessing of high-purity resins. Improved quality of resins, environmental issues and
higher prices for virgin resin will contribute to growth.
There is currently no independent extrusion plant of recycled p lyterephthalate (PET) sheet in that
services the roll stock requirements of major custom and pr prietary formers. With the development of
the recycling industry for PET starting in the eastern part f the country, and the preponderance of
consumers of sheet there as well, development of independent extrusion facilities using RPET has been
slow to develop. It appears that in order to attract such co panies, local sources of RPET would have to
available. While there are customers in the central SA for the products, contracting a supply and shipping
it from the east of SA makes the venture unattractive.
Our founders recognise that an opportunity xists and propose a vertically integrated conversion facility
that will employ state-of-the-art technologies to produce extruded sheet and high strength strap-ping
from 100% recycled PET post-consumer bottle stock, cleaned and refined in our own facility.
Target Market Segment Strategy

The company has chosen its target markets because recycled PET (RPET) is in high demand as flake resin
by converters, as roll stock sheet used to produce high visibility packaging and as high strength strapping
for the lumber industry. Sales are price-sensitive, so that proximity to markets and feed stock source pro-
vide a competitive edge. GreenPET Plastics identified an opportunity to take advantage of both circum-
stances in the central RSA.
RPET Flake
Total market demand is reported as 1,2 billion kilograms per year. Since only 800 million kilograms are
processed in the RSA, consumers are forced to look at wide spec virgin PET (virgin resin that is outside of
spec but still usable) which is normally sold at a discount to virgin prices, but still higher than recycled
(RPET) pricing. Some manufacturers are also forced to import materials from Mexico, India and South
America. Some conv rt rs are being forced to use more expensive virgin resin.
The current pricing for virgin resin is R0,65–0,73 per kg and R0,42–0,53 for RPET flake. The spread be-
tween the two has traditionally been maintained at approximately R0,20 per kg.
PET Film and Sheet
The total epo ted market of extruded film and sheet is 872 million kilograms, of which identified industry
usage of RPET is 160 million kilograms.
The reported market demand (to replace virgin PS, PVC and PET) if RPET was available is estimated at 1
billi n kil grams.
Current pricing for RPET sheet is R0,70–0,79 per kg.
RPET Strapping
The total reported domestic plastic strapping market is 240 million kilograms. Of this market, industry
usage of virgin polypropylene is 132 million kilograms and of PET is 108 million kilograms.
It is generally accepted in the industry that less expensive strapping made from RPET could not only take
over the polypropylene strapping market, but convert as much of the much larger and more expensive
steel strapping market as RPET strapping was available.
Current pricing for RPET strapping is R0,90–1,08 per kg.
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1.2 Market Segmentation

The primary market can be broken down as follows.
Consumers of PET in:
Gauteng: 62
North West: 8
Mpumalanga: 9
Consumers of HDPE in:
Gauteng: 73
North West: 10
Mpumalanga: 12
All information is based on industry research, and data provided by the South African Plastics Council.
Table: Market Analysis
Market Analysis
Potential Customers Growth CAGR
Central PET Buyers 1% 79 80 81 82 83 1,24%
Central HDPE Buyers 1% 95 95 95 95 95 0,00%
Total 0,57% 174 175 176 177 178 0,57%
Industry Analysis
Currently there is no direct competition in the central RSA for either of the two divisions of the company.
Any production in the trading area remains captive and not available to our target market.
The ability of the company to obtain a source of post-consumer bottle stock is an integral component of
the strategy to vertically integrate operations and manufacture products in demand by central consuming
industries. Without the cleaning and refining division, it would be difficult to source sufficient RPET flake
resin at costs that would allow the company to be competitive.
Barriers to Entry
Limited supply of raw material
Recycled PET (RPET) resins are in high demand, and demand is currently under-supplied. Many
manufactur rs are delaying expansion because of uncertainty of supply. Entrants would have to
consid r sourcing post-consumer or post-industrial waste and clean and refine it rather than at-
tempting to purchase flake on the open market. Even at that, there is not an over-abundance of
post- onsumer or post-industrial material in the marketplace.
Equipment costs are high and industry specific, resulting in a high exit cost.
Because of the scarcity of RPET flake, entrants may be forced to establish cleaning and refining
facilities for post-consumer bottles. The equipment required is costly and very industry specific. It
wo ld not easily be re-sold as a system.
There is a market for used extrusion equipment, which normally sees 60–70% of new value being
realised.
Vertical integration is an important consideration and difficult to accomplish successfully.
Because of the scarcity of RPET resin, and to maximise profit potential, entrants must consider a
two-stage production facility. Cleaning and refining post-consumer bottles and extruding the re-
sulting flake into commercial products requires a management team such as GreenPET has, with a
broad range of expertise, experience, industry contacts and knowledge in both areas.
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Firm contracts for supply and sales.

GreenPET Management’s industry contacts will allow us to secure contracts for both supply of
feed stock and sale of finished goods.
Freight is a major cost of operations; proximity to source of supply and markets is crucial.
Hauling plastic materials is expensive so entrants will have to consider establishing facilities close
to materials and markets. Entrants with existing operations would have to consider new separate
facilities in many cases, reducing economies of scale and making management more difficult.
Competition and Buying Patterns
There has been a strong demand (sellers’ market) for our products for several years. Traditional
buying patterns in this industry are based on quality, price, reput tion of manufacturer, freight
costs, delivery times and proximity to markets. During such sellers’ m rket, buying patterns are
often more influenced by availability.
Main Competitors
Currently in the central RSA, there is no direct c mpetiti n for cleaning and refining post-consumer
or post-industrial PET. Nor is there any n n-captive extrusion of roll stock sheet.
The extruded sheet required by thermofor ers is currently supplied by:
Advance Extrusion, Edenvale.
Kama, Boksburg.
Plasti-Shell Packaging, Sasolburg.
Petco, Benoni.
Klockner, Benoni.
In a news release dated September 10, 2012, Itec Environmental Group announced their intention
to open a PET and High Density Polyethelene (HDPE) recycling operation in Germiston. The news
release states that the company’s new and yet unproven technology lets it work with bottle
streams others have to reject as too dirty. This company is familiar to our management, and is not
considered a significant factor in any of our markets.
Required:
Evaluate whether the market analysis and sales strategy satisfies most of the requirements for a standard
business plan.
Solution: GreenPET Plastics continued – Market Analysis and Sales Strategy

The following are id ntifi d from the extract provided:
The market size for ea h of the main products.
The potential g owth.
New t ends in ecycling.
Price ranges of the products.
The number of major consumers for each product.
Barriers to entry.
Details of competition.
The market analysis is very extensive and well researched. However, the plan did not expand on the sales
strategy that will be followed for each product.
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Appendix 1
Selected concepts,
acronyms and
terminology
This section contains brief descriptions of a selection of conc pts, acronyms and terminology, which are in-
tended to enhance a student’s knowledge and ability to place sc narios in a context.
Angel funding Finance provided by an individual, known colloquially as an ‘angel investor’, to a
business venture that is generally still in the early phases of its development
where a relatively high degree of risk is involved. The early business phases
include the start-up phase (this type of finance is described as ‘seed capital’), or
early growth phase (‘first stage financing’). Angel investors often invest in equity
capital or mezzanine capital (see below) and, due to the high levels of risk
involved, normally require high levels of return from their investment. Angel
funding is similar to venture capital (see below), but the decision to invest is
normally made by an individual, not a specialised organisation operated as a
house or fund.
Basel III The name given to the latest set of banking reform measures proposed by the
Basel Committee on Banking Supervision, which intends to better prepare the
international banking sector for future financial crises. The Group of Twenty
(G-20), a forum of important industrialised and developing economies – of which
South Africa is a member – has committed itself to adopt Basel III by the end of
2011. The final Basel III reform measures are likely to include, amongst others, a
r quirement to maintain higher levels of Tier 1 capital (comprising essentially
equity and retained earnings) and minimum liquidity standards.
Black Swan Inspired by the graceful birds of this colour (cygnus atratus) – which were once
thought of in the Western world as either non-existent or very scarce – Nassim
Taleb describes a Black Swan (capitalised) as a random event with three
attributes: ‘rarity, extreme impact, and retrospective (though not prospective)
predictability’ (2007:xxi). Examples of Black Swans include the World Wars, the
spread of the Internet, and the 9/11 attacks (Taleb, 2007).
BRICS A grouping acronym for the cooperative formation of emerging economies,
comprising the following members: Brazil, Russian Federation, India, China and
South Africa. The acronym ‘BRIC’ was coined by Jim O'Neill of Goldman Sachs in
the year 2000 to describe the most significant emerging economies, which later
became the first four members of this group. South Africa, a relatively small
emerging economy, was a contentious recent addition following a formal
invitation by the Chinese Chair of this group.
683
Appendix 1 Managerial Finance
Brownfield investment An investment replacing a previously dirty or polluting business venture, e.g. an
office development replacing a refinery, or the upgrade of a factory building
using new technologies that will significantly reduce its level of pollution. The
term ‘brownfield’ therefore hints at the conditions that existed prior to this
investment. Also see ‘greenfield investment’ and ‘greyfield investment’.
Greenfield investment Investment made in manufacturing facilities, offices, or other developments
where no previous facilities existed. The term ‘greenfield’ therefore hints at the
conditions that existed prior to this investment and is an adaptation of a
construction term, where new construction rep aces actual ‘green fields’. Also
see ‘brownfield investment’ and ‘greyfield investment’.
Greyfield investment Investment made in existing real estate th t h s f llen into disuse, such as
shopping malls that have lost key tenants, or industri l areas redeveloped for
mixed use (such as the V&A Waterfront in Cape Town). The term ‘greyfield’
therefore hints at the expanses of concrete and empty tarmac that often
accompany these sites before redevelopment. Also see ‘brownfield investment’
and ‘greenfield investment’.
LIBOR An acronym for the London interbank ffered rate. This is a benchmark rate that
is calculated based on the average rate offered by leading banks in London when
borrowing to other banks.
Mezzanine capital The term ‘mezzanine’ is derived to an extent from the Italian word ‘mezzan’,
meaning ‘middle’. Mezzanine capital, in turn, ranks in the ‘middle’, between
equity capital and oth r d bt, wh n compensating investors and other business
partners in the case of liquidation. (In other words, mezzanine capital ranks
senior to ordinary shares, but junior to all other secured debt and creditors (The
Economist, 1999).) Examples of mezzanine capital include subordinated debt,
subordinated convertible debt and preference shares. Mezzanine capital is often
used by smaller business entities without access to alternative sources of
finance. Due to the inherent risks, mezzanine capital is relatively expensive.
Nominal effective exchange The nominal effective exchange rate is expressed as an index of the weighted
rate of the Rand exchange rate of the Rand measured against a basket of the currencies of South
Africa's fifteen most important trading partners, including the Euro, US dollar
and Chinese yuan (SARB, 2008). This index shows, for example, that the Rand
increased in value over the past (almost) two years, as follows:
Index: June 2011 = 76; Index: July 2009 = 68; where Index: 2000 = 100 (SARB,
2011)
Primary vs. secondary The primary market is the capital market for the issue of new securities (Thus a
market source of new finance, e.g. the issue of new ordinary shares.)
The secondary market allows for the trading of securities after the original issue.
(Thus not a source of new finance, but important for price-setting, marketability
and liquidity within the market. An example of dealings on the secondary market
is for an investor to buy a bond from another investor.)
Prime overd aft ate A benchmark rate used by banks when lending to the public (though usually at a
rate above or below this rate, e.g. an overdraft facility offered at prime plus 6%
to an individual).
Private equity business A business enterprise held by private owners, including individuals and
corporate entities (IPEV Board, 2010:8), which is therefore not publicly owned
and, necessarily, not listed on a Securities Exchange. An example is a private
company.
Private equity investment Investment in a private equity business in all stages of its development, including
early stage ventures, management buyouts, refinancing, growth capital and
development capital (IPEV Board, 2010). Private equity investment is often
made by a private equity fund or house, which is a designated pool of
investment capital (e.g. Ethos Private Equity in South Africa).
Pure play business approach A company devoted to a single business line.
Repo rate Rate at which banks borrow Rand from the South African Reserve Bank.
684
Selected concepts, acronyms and terminology Appendix 1
SABOR An acronym for the South African benchmark overnight rate on deposits. This
rate provides the market with a benchmark for rates paid on overnight
interbank funding in South Africa.
OTC market vs. formal An OTC (over the counter) market is a decentralised market where securities are
market traded by dealers over their ‘counters’ by using telephone, fax, email and other
electronic networks. An OTC market should be clearly differentiated from a
formal market (e.g. a Securities Exchange), which is highly regulated.
Rating agencies Rating agencies offer independent credit ratings for debt issues (e.g. bond
issues) by countries, governments and corporate entities. Even though the three
main rating agencies, comprising Standard & Poor’s (S&P), Fitch Ratings and
Moody’s, came under attack for their possible role in the financial crisis that
started in 2007, they continue to perform this cruci l function. A credit rating, in
turn, often has a direct impact on the interest premium payable by an entity
(usually measured as the number of basis points [100 basis points equals 1%]
above a risk-free rate). Recent newsworthy changes included the downgrade by
S&P of the long-term credit rating f the USA by one notch from AAA (top rating)
to AA+ in 2011, and of Greece fr m CCC (vulnerable) to CC (likely default) in July
2011.
Venture capital Finance provided by a specialised organisation to a business venture that is
generally still in the early phases of its development, including the start-up
phase (this type of finance is described as ‘seed capital’), or early growth phase
(‘first stage financing’), wh re a r latively high degree of risk is involved (The
Economist, 1999). Such a sp cialised organisation is normally operated as a
venture capital house or fund, and venture capital is normally invested in the
form of equity capital or mezzanine capital (see above). Due to the high levels of
risk involved, the providers of venture capital normally require high levels of
return from their investments.
685
Appendix 2
PV and FV tables
687
688
689
690
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693
Table of statutes
Page
Close Corporation Act 69 of 1984 ....................................................................................................................... 504
Companies Act 61 of 1973 .................................................................................................................. 504, 537, 538
Companies Act 71 of 2008 ................................... 250, 281, 393, 419, 421, 422, 504, 537, 538, 540, 541, 551, 573
Competition Act 89 of 1998 .......................................................................................................................... 31, 504
Consumer Protection Act 68 of 2008 .................................................................................................................... 31
Corporate Laws Amendment Act 26 of 2006 ...................................................................................................... 504
Income Tax Act 58 of 1962 .................................................. 260, 261, 263, 267, 268, 269, 275, 387, 388, 389, 390,
391, 393, 394, 395, 397, 398, 399, 401, 403, 486, 559, 573
National Credit Act 34 of 2005 .................................................................................... 249, 256, 343, 344, 345, 392
National Environmental Management Act 107 of 1998 ....................................................................................... 31
Occupational Health and Safety Act 85 of 1993 ................................................................................................... 31
Securities Services Act 36 of 2004 ...................................................................................................................... 504
Skills Development Act 97 of 1998 ....................................................................................................................... 31
Usury Act 73 of 1968 ........................................................................................................................................... 345
695
Index
Page
A
absorptions and amalgamations ......................................................................................................................... 551
acceptance ............................................................................................................................................................ 45
acid-test (quick) ratio .......................................................................................................................................... 286
acquisition ............................................................................................................................................................. 38
advantages of debt ............................................................................................................................................. 255
aggressive financing ............................................................................................................................................ 336
alliances................................................................................................................................................................. 38
Alternative Exchange (AltX) .................................................................................................................................. 17
annuity due ..................................................................................................................................................... 66, 74
annuity ............................................................................................................................................................ 66, 73
Ansoff’s Growth Vector Matrix ............................................................................................................................. 37
apply or explain ................................................................................................................................................... 7, 8
arbitrage process ................................................................................................................................................ 102
A-score model ..................................................................................................................................................... 312
asset beta ............................................................................................................................................................ 158
asset stripping ..................................................................................................................................................... 503
asset turnover ..................................................................................................................................................... 287
asset use efficiency ............................................................................................................................................. 313
attitudes to risk ................................................................................................................................................... 145
avoidance .............................................................................................................................................................. 45
B
backward integration .......................................................................................................................................... 501
balanced score ard .............................................................................................................................................. 315
bank loans ........................................................................................................................................................... 254
banker acceptance .............................................................................................................................................. 271
Baumol model ..................................................................................................................................................... 340
B-BBEE ................................................................................................................................................................... 30
BCG Matrix ............................................................................................................................................................ 34
behavi ural implications ...................................................................................................................................... 504
beta c efficient .................................................................................................................................................... 156
beta ..................................................................................................................................................................... 163
bill of exchange ................................................................................................................................................... 272
bird-in-hand ........................................................................................................................................................ 574
B ack Economic Empowerment (BEE) lock-in discount ....................................................................................... 424
bond .................................................................................................................................................................... 397
bonus issues/share splits .................................................................................................................................... 569
book value method ............................................................................................................................................... 15
brands ................................................................................................................................................................. 463
business model canvas ............................................................................................................................................ 4
business model ............................................................................................................................................... 4, 417
697
Index Managerial Finance
Page
business rescue plan ........................................................................................................................................... 541
business rescue practitioner ............................................................................................................................... 540
business rescue ................................................................................................................................................... 538
business risk ...................................................................................................................................................... 9, 93
business trust ...................................................................................................................................................... 419
business valuation principles .............................................................................................................................. 412
business vehicle .................................................................................................................................................. 418
business............................................................................................................................................................... 311
C
capital asset pricing model.................................................................................................................................. 155
capital budgeting ................................................................................................................................................ 182
capital contribution ............................................................................................................................................. 544
capital gearing ratio ............................................................................................................................................ 286
capital growth ....................................................................................................................................................... 11
capital lost ........................................................................................................................................................... 546
capital market ............................................................................................................................................... 17, 251
capital rationing .......................................................................................................................................... 187, 190
capital requirements ........................................................................................................................................... 543
capital structure and solvency ratios .................................................................................................................. 286
capital structure .............................................................................................................................................. 14, 91
capitalisation issues ............................................................................................................................................ 578
CAPM and the investment appraisal decision .................................................................................................... 161
CAPM and weighted average cost of capital....................................................................................................... 160
carrying value ...................................................................................................................................................... 413
cash offers ........................................................................................................................................................... 511
cash operating cycle ............................................................................................................................................ 337
change in revenue ............................................................................................................................................... 291
cheap finance ...................................................................................................................................................... 270
chief financial officer ............................................................................................................................................... 9
clean fair value .................................................................................................................................................... 661
clientèle effect .................................................................................................................................................... 574
close corporation ................................................................................................................................................ 419
Code for Responsible Investing in South Africa (CRISA) ........................................................................................ 18
coefficient of variation ........................................................................................................................................ 150
collection policy .................................................................................................................................................. 346
Committee of Sponsoring Organisations of the Treadway Commission (COSO) .................................................. 46
common size statements .................................................................................................................................... 282
company.............................................................................................................................................................. 419
comparative financial stat m nts ......................................................................................................................... 282
comparator entity ............................................................................................................................................... 428
competitive environment ..................................................................................................................................... 31
competitive st ategies ........................................................................................................................................... 37
compound inte est fo mula ................................................................................................................................... 63
concentrated marketing ....................................................................................................................................... 31
conditions for a reorganisation scheme ............................................................................................................. 543
conglomerate acquisition ................................................................................................................................... 502
consci us capitalism ................................................................................................................................................. 3
conservative financing ........................................................................................................................................ 336
con ervative hedge .............................................................................................................................................. 335
con tant dividend/earnings method ................................................................................................................... 568
constant growth .................................................................................................................................................... 78
contingent liabilities ............................................................................................................................................ 463
control premium ......................................................................................................................................... 411, 423
convertible debentures ......................................................................................................................................... 83
convertible debt .................................................................................................................................................. 400
convertible securities .................................................................................................................................. 255, 412
convertible .......................................................................................................................................................... 387
698
Index
Page
correlation coefficient ......................................................................................................................................... 151
cost leadership ...................................................................................................................................................... 37
cost of capital for foreign investments ............................................................................................................... 115
cost of capital ...................................................................................................................................................... 107
coupons ............................................................................................................................................................... 397
covariance ........................................................................................................................................................... 151
credit policies ...................................................................................................................................................... 343
critical success factors (CSFs) ................................................................................................................................ 38
crowdfunding .............................................................................................................................................. 272, 274
cumulative non-redeemable ............................................................................................................................... 389
cumulative .......................................................................................................................................................... 387
current multiple .................................................................................................................................................. 429
current ratio ........................................................................................................................................................ 286
customer perspective ........................................................................................................................................... 40
D
David Kaplan ....................................................................................................................................................... 315
David Norton and Robert Kaplan’s Balanced Scorecard (BSC).............................................................................. 40
debt (solvency) ratio ............................................................................................................................................. 95
debt advantage ..................................................................................................................................................... 92
debt covenants ................................................................................................................................................... 393
debt disadvantage................................................................................................................................................. 93
debt to equity (D:E) ratio ...................................................................................................................................... 95
debt ............................................................................................................................................................. 254, 392
debtor factoring .................................................................................................................................................. 348
debtor finance ..................................................................................................................................................... 271
debtors’ management ........................................................................................................................................ 343
decision trees ...................................................................................................................................................... 217
deductive methods ............................................................................................................................................. 446
degree of operating leverage ...................................................................................................................... 285, 293
designated advisor ................................................................................................................................................ 18
different project life cycles ................................................................................................................................. 190
differential inflation ............................................................................................................................................ 196
differentiated marketing ....................................................................................................................................... 31
differentiation ....................................................................................................................................................... 37
direct and indirect quotes of exchange rates ..................................................................................................... 218
dirty fair value ..................................................................................................................................................... 661
disadvantages of debt ......................................................................................................................................... 255
discount rate for a for ign inv stment ................................................................................................................. 115
discount rate ................................................................................................................................................. 13, 200
discounted cashflow ........................................................................................................................................... 384
discounted payba k period method .................................................................................................................... 185
diversification ...................................................................................................................................................... 154
dividend decisions ............................................................................................................................................... 573
dividend payo t ratio ........................................................................................................................................... 287
dividend policy .................................................................................................................................................... 570
dividend stability and information content ........................................................................................................ 577
dividend tax (DT) ................................................................................................................................................. 573
dividend yield ........................................................................................................................................................ 11
divi ible projects .................................................................................................................................................. 188
down ide ri k ......................................................................................................................................................... 11
drivers of value ................................................................................................................................... 384, 386, 392
DuPont analysis ................................................................................................................................................... 313
E
earnings multiples ............................................................................................................................................... 428
earnings per share .............................................................................................................................................. 285
earnings yield percentage (EY%) ......................................................................................................................... 432
699
Page
earnings-yield ...................................................................................................................................................... 288
economic efficiency effectiveness (3 Es)................................................................................................................. 2
economic environment ......................................................................................................................................... 30
economic order quantity .................................................................................................................................... 350
economies of scale .............................................................................................................................................. 502
Edward Altman.................................................................................................................................................... 311
efficient frontier .................................................................................................................................................. 153
enterprise risk management (ERM) ................................................................................................................ 27, 46
entry into new markets ....................................................................................................................................... 502
environmental, social and governance (ESG) ....................................................................................................... 18
Equator Principles on Financial Institutions (EPFIs) .............................................................................................. 18
Equator Principles ............................................................................................................................................... 217
equity beta .......................................................................................................................................................... 158
equity funds ........................................................................................................................................................ 251
equity .................................................................................................................................................................. 274
equivalent annual income ................................................................................................................................... 191
ESG ...................................................................................................................................................................... 217
eurobonds ........................................................................................................................................................... 272
EVA® (Economic Value Added)............................................................................................................ 288, 308, 458
evaluating the projects at the Weighted Marginal Cost of Capital (WMCC) ...................................................... 183
expected return .......................................................................................................................................... 143, 155
expected values .......................................................................................................................................... 145, 216
explicit forecast ................................................................................................................................................... 450
ex-post ................................................................................................................................................................ 149
F
failure prediction models .................................................................................................................................... 311
fair market value of a shareholding .................................................................................................................... 440
fair market value ................................................................................................................................................. 410
Fama-French Three-Factor Model ...................................................................................................................... 446
finance decision .................................................................................................................................................... 14
finance lease ....................................................................................................................................................... 266
financial analysis ......................................................................................................................................... 282, 283
financial decisions ............................................................................................................................................... 543
financial distress.................................................................................................................................................. 538
financial gearing .............................................................................................................................................. 92, 95
financial leverage ................................................................................................................................................ 313
financial measures ................................................................................................................................................ 39
financial perspective ............................................................................................................................................. 40
financial reasons ................................................................................................................................................. 502
financial reporting prin iples ............................................................................................................................... 412
financial risk .................................................................................................................................................... 10, 93
financial strategy ................................................................................................................................................... 12
financing a missed dividend ................................................................................................................................ 570
fire sale ................................................................................................................................................................ 412
firm-specific risk .................................................................................................................................................. 154
Five Forces Framework ......................................................................................................................................... 38
fixed r variable dividend .................................................................................................................................... 387
fixed-rate b nd ..................................................................................................................................................... 398
focus trategy ........................................................................................................................................................ 37
foreign direct investment ................................................................................................................................... 218
foreign finance .................................................................................................................................................... 270
forward integration ............................................................................................................................................. 501
forw rd multiple .................................................................................................................................................. 429
free c shflow ........................................................................................................................................................ 448
future value of an annuity ..................................................................................................................................... 66
future value ........................................................................................................................................................... 62
700
Index
Page
G
G4 guidelines........................................................................................................................................................... 8
gap analysis ........................................................................................................................................................... 35
geared or levered beta ........................................................................................................................................ 158
gearing .................................................................................................................................................................. 10
gearing ratio .......................................................................................................................................................... 95
general inflation .................................................................................................................................................. 196
Global Reporting Initiative ...................................................................................................................................... 8
goals ...................................................................................................................................................................... 28
going concern ...................................................................................................................................................... 417
Gordon dividend growth model .......................................................................................................... 388, 445, 451
growth rate ......................................................................................................................................................... 113
growth strategies .................................................................................................................................................. 38
H
headline earning ................................................................................................................................................. 433
headline earnings per share ................................................................................................................................ 295
hedging ............................................................................................................................................................... 334
hidden factors ..................................................................................................................................................... 422
historical cost ...................................................................................................................................................... 409
historical or trailing multiple ............................................................................................................................... 429
horizontal acquisition.......................................................................................................................................... 501
hybrid capital .............................................................................................................................................. 250, 273
hybrid instruments .............................................................................................................................................. 397
I
income approach ................................................................................................................................................ 415
independent events ............................................................................................................................................ 187
independent projects .......................................................................................................................................... 187
indexed financial statements .............................................................................................................................. 282
indivisible projects ...................................................................................................................................... 188, 190
inflation ............................................................................................................................................................... 196
inherent risks .................................................................................................................................................. 44, 45
initial public offering (IPO) .................................................................................................................................. 274
Institute of Directors in South Africa (Io SA) ........................................................................................................ 18
integrated reporting ............................................................................................................................................... 8
integrated thinking.................................................................................................................................................. 9
Interest and interest-rate risk ............................................................................................................................. 393
interest cover ...................................................................................................................................................... 286
internal process perspe tive .................................................................................................................................. 40
internal rate of return (IRR) ........................................................................................................................ 259, 264
internal rate of etu n method ............................................................................................................................ 192
international capital budgeting ................................................................................................................... 218, 219
International Integrated Reporting Committee ...................................................................................................... 8
International Integrated Reporting Council ............................................................................................................ 4
interpolation ....................................................................................................................................................... 192
intrinsic value ...................................................................................................................................................... 411
invent ry management ........................................................................................................................................ 348
inventory turnover .............................................................................................................................................. 286
inve tment decision ....................................................................................................................................... 12, 196
investment opportunities ................................................................................................................................... 503
IPO ......................................................................................................................................................................... 18
irredeemable debt ................................................................................................................................................ 81
J
Johannesburg interbank agreed rate (JIBAR) ...................................................................................................... 387
Johannesburg Securities Exchange ....................................................................................................................... 17
701
Page
John Argenti ........................................................................................................................................................ 312
JSE SRI Index .......................................................................................................................................................... 19
just in time .......................................................................................................................................................... 353
K
keep versus replacement .................................................................................................................................... 205
King Code of Governance Principles (King III) ................................................................................................... 6, 42
KPIs .............................................................................................................................................................. 8, 29, 38
L
Laszlo’s Sustainable Value Matrix ......................................................................................................................... 36
leadership............................................................................................................................................................ 502
learning and growth perspective .......................................................................................................................... 40
lease or buy decision ................................................................................................................................... 266, 267
level of control .................................................................................................................................................... 421
levels of working capital ...................................................................................................................................... 333
license to operate ................................................................................................................................................... 6
limitations in using CAPM ................................................................................................................................... 164
liquidation value.......................................................................................................................................... 412, 543
liquidity preference ............................................................................................................................................. 337
liquidity ............................................................................................................................................................... 286
loan capital .......................................................................................................................................................... 255
M
macro risks ............................................................................................................................................................ 44
maintainable earnings................................................................................................................................. 431, 437
management buy-outs ........................................................................................................................................ 513
marginal analysis ................................................................................................................................................. 207
marginal WACC ................................................................................................................................................... 182
market capitalisation .......................................................................................................................................... 411
market comparable approach ............................................................................................................................. 415
market price multiples ........................................................................................................................................ 444
market pricing ....................................................................................................................................................... 38
market risk .......................................................................................................................................................... 154
market segmentation ............................................................................................................................................ 31
market value method ............................................................................................................................................ 15
market value ....................................................................................................................................................... 410
marketability discount ........................................................................................................................................ 423
marketing gains ................................................................................................................................................... 502
Markowitz ........................................................................................................................................................... 143
maturity-matching .............................................................................................................................................. 334
McKinsey conve gence value-driver formula ...................................................................................................... 452
mean ................................................................................................................................................................... 149
merger ................................................................................................................................................................. 500
mezzanine capital................................................................................................................................................ 273
mezzanine finance ...................................................................................................................................... 250, 514
Michael P rter ........................................................................................................................................................ 37
micro risks ............................................................................................................................................................. 44
Miller and Modigliani theory ........................................................................................................................ 97, 101
Mi er and Modigliani ........................................................................................................................................... 570
Mi er-Orr model .................................................................................................................................................. 342
minority discount ................................................................................................................................................ 423
mission .................................................................................................................................................................. 28
mitig tion ............................................................................................................................................................... 45
modified internal rate of return method ............................................................................................................ 194
money cashflow .................................................................................................................................................. 196
money market ..................................................................................................................................................... 251
702
Index
Page
money rate of return .......................................................................................................................................... 196
Monte Carlo analysis ........................................................................................................................................... 215
multi-period capital rationing ............................................................................................................................. 187
mutually exclusive events ................................................................................................................................... 187
mutually exclusive projects ................................................................................................................................. 187
MVA .................................................................................................................................................................... 458
MVIC (market value of invested capital) ............................................................................................................. 425
MVIC/EBITDA multiple ........................................................................................................................................ 441
MVIC/Sales (MVIC/S) multiple ............................................................................................................................ 445
N
National Credit Act (NCA) ................................................................................................................................... 256
natural environment ............................................................................................................................................. 32
net assets ............................................................................................................................................................ 462
net present cost (NPC) ........................................................................................................................................ 259
net present value index method ......................................................................................................................... 188
net present value method .................................................................................................................................. 186
net present value .................................................................................................................................................. 13
net working capital ............................................................................................................................................. 334
no growth .............................................................................................................................................................. 77
nominal rates of return ....................................................................................................................................... 198
non-constant growth ............................................................................................................................................ 80
non-cumulative redeemable ............................................................................................................................... 391
non-cumulative ................................................................................................................................................... 387
non-financial analysis .......................................................................................................................................... 314
non-financial measures ......................................................................................................................................... 39
non-redeemable (perpetual) .............................................................................................................................. 388
non-redeemable ................................................................................................................................................. 387
normal distribution curve ................................................................................................................................... 147
O
off-balance sheet financing ................................................................................................................................. 266
open market principle ......................................................................................................................................... 506
operating lease ........................................................................................................................................... 213, 266
operational efficiency ......................................................................................................................................... 313
opportunity costs and revenues ......................................................................................................................... 200
optimal capital structure ..................................................................................................................................... 106
ordinary annuity.................................................................................................................................................... 73
organic growth .............................................................................................................................................. 38, 499
Osterwalder and Pigneur ........................................................................................................................................ 4
owner level premiums and discounts ................................................................................................................. 472
P
P/E multiple................................................................................................................................................. 288, 432
partnership.......................................................................................................................................................... 419
parts .................................................................................................................................................................... 256
payback peri d method ....................................................................................................................................... 184
perfect hedge ...................................................................................................................................................... 335
perpetuity ............................................................................................................................................................. 76
PESTLEGE............................................................................................................................................................... 29
p ant and equipment .......................................................................................................................................... 463
p oughback .......................................................................................................................................................... 113
political environment ............................................................................................................................................ 29
portfolio risk and return...................................................................................................................................... 150
portfolio theory ................................................................................................................................................... 143
portfolio variance ........................................................................................................................................ 151, 152
predatory pricing .................................................................................................................................................. 38
703
Page
preference shares ................................................................................................................................. 82, 254, 386
preferential Ccpital funds.................................................................................................................................... 540
present value of a perpetuity ................................................................................................................................ 76
present value of an annuity .................................................................................................................................. 73
present value of debt ............................................................................................................................................ 81
present value of shares ......................................................................................................................................... 77
present value ........................................................................................................................................................ 68
price of recent investment .................................................................................................................................. 426
price skimming ...................................................................................................................................................... 38
price/book (P/B) multiple ................................................................................................................................... 445
pricing strategies ................................................................................................................................................... 38
primary market ..................................................................................................................................................... 17
principles for responsible investment (UNPRI) ..................................................................................................... 18
probabilities ........................................................................................................................................................ 145
probability theory ............................................................................................................................................... 216
probability ........................................................................................................................................................... 215
product life cycle analysis ..................................................................................................................................... 34
product-market strategies .................................................................................................................................... 37
profitability.......................................................................................................................................................... 285
property .............................................................................................................................................................. 463
public listing .......................................................................................................................................................... 17
publicly trading securities ................................................................................................................................... 422
purchasing power parity ..................................................................................................................................... 218
Q
qualitative (non-financial) factors ....................................................................................................................... 217
R
RAFT ........................................................................................................................................................................ 6
random numbers ................................................................................................................................................ 215
ratios ................................................................................................................................................................... 284
real rates of return .............................................................................................................................................. 198
reasonability test ........................................................................................................................................ 415, 467
recoupment/scrapping allowances ..................................................................................................................... 201
redeemable debt ................................................................................................................................................... 82
redeemable ......................................................................................................................................................... 389
regular ................................................................................................................................................................... 66
regulatory environm nt ......................................................................................................................................... 30
relevant costs and r v nu s .................................................................................................................................. 198
replacement chains ............................................................................................................................................. 190
replacement cost approa h ................................................................................................................................. 415
required rate of etu n.......................................................................................................................................... 155
required retu n ...................................................................................................................................................... 11
residual risk ..................................................................................................................................................... 42, 45
resource a dit ........................................................................................................................................................ 35
responsible investment ......................................................................................................................................... 18
retenti n ratio ...................................................................................................................................................... 113
return n capital employed ................................................................................................................................. 287
return n equity........................................................................................................................................... 287, 313
return on invested capital ................................................................................................................................... 287
return .................................................................................................................................................................. 144
rights issues ......................................................................................................................................................... 252
risk ppetite ........................................................................................................................................................... 41
risk ssessment ...................................................................................................................................................... 42
risk averse ............................................................................................................................................................. 41
risk capacity........................................................................................................................................................... 41
risk committee ...................................................................................................................................................... 42
risk control ............................................................................................................................................................ 45
704
Index
Page
risk culture ............................................................................................................................................................ 41
risk evaluation ....................................................................................................................................................... 45
risk financing ......................................................................................................................................................... 45
risk identification ............................................................................................................................................ 42, 44
risk management policy ........................................................................................................................................ 42
risk management strategy .................................................................................................................................... 42
risk management .................................................................................................................................................. 41
risk mapping .......................................................................................................................................................... 45
risk mitigation ....................................................................................................................................................... 42
risk monitoring ...................................................................................................................................................... 46
risk neutral ............................................................................................................................................................ 41
risk premium ....................................................................................................................................................... 159
risk responses.................................................................................................................................................. 42, 45
risk seeking ............................................................................................................................................................ 41
risk ....................................................................................................................................................................... 144
risk ....................................................................................................................................................................... 213
risk-averse ........................................................................................................................................................... 145
risk-free rate of return ........................................................................................................................................ 155
risk-pro ................................................................................................................................................................ 145
risk-return methods ............................................................................................................................................ 246
Robert Norton ..................................................................................................................................................... 315
role-players in business rescue ........................................................................................................................... 539
S
scrip dividends .................................................................................................................................................... 578
secondary markets ................................................................................................................................................ 17
secondary tax on companies (STC) ..................................................................................................................... 570
section 24J of the Income Tax Act............................................................................................................... 260, 393
secured finance ................................................................................................................................................... 250
securities market line .......................................................................................................................................... 155
security offered ................................................................................................................................................... 393
security ................................................................................................................................................................ 398
selective or discriminatory pricing ........................................................................................................................ 38
sensitivity analysis ............................................................................................................................................... 215
share offers ......................................................................................................................................................... 512
share options ...................................................................................................................................................... 412
share price........................................................................................................................................................... 503
share repurchases ............................................................................................................................................... 578
shareholder wealth maximisation .......................................................................................................................... 2
simulation ........................................................................................................................................................... 215
simultaneous liquidation of rossholding companies.......................................................................................... 555
single-period capital rationing ............................................................................................................................ 187
six capitals ............................................................................................................................................................... 4
skipped dividend ................................................................................................................................................. 577
smart arg ment ................................................................................................................................................... 509
SMART ................................................................................................................................................................... 28
social environment................................................................................................................................................ 30
sole pr priet rship ................................................................................................................................................ 420
sources and f rms of new finance ....................................................................................................................... 271
ources of finance ............................................................................................................................................... 251
South African Pension Funds Act .......................................................................................................................... 19
special dividend .................................................................................................................................................. 577
stab e dividend payment method ....................................................................................................................... 568
st keholder engagement ......................................................................................................................................... 7
s keholder theory .................................................................................................................................................. 3
s andard deviation .............................................................................................................................................. 148
statutory requirements ....................................................................................................................................... 570
Stern Stewart & Co.............................................................................................................................................. 308
705
Page
stewardship model.................................................................................................................................................. 3
stock market listing ............................................................................................................................................. 251
strategic analysis ................................................................................................................................................... 28
strategic benefits ................................................................................................................................................ 502
strategic planning .................................................................................................................................................. 28
strategy ................................................................................................................................................................. 28
sustainability reporting ........................................................................................................................................... 8
sustainable .............................................................................................................................................................. 2
Swiss Verein ........................................................................................................................................................ 420
SWOT .............................................................................................................................................................. 29, 35
synchronised inflation ......................................................................................................................................... 196
synergy benefits .................................................................................................................................................. 507
synergy ........................................................................................................................................................ 410, 502
systematic ........................................................................................................................................................... 154
T
tailor-made finance ............................................................................................................................................. 250
takeover .............................................................................................................................................................. 499
target WACC method ............................................................................................................................................ 16
target WACC ................................................................................................................................................ 182, 184
tax allowances ..................................................................................................................................................... 201
taxation time lags ................................................................................................................................................ 201
technological environment ................................................................................................................................... 30
technology .......................................................................................................................................................... 503
theory .................................................................................................................................................................... 98
time value of money ............................................................................................................................................. 61
total debt ratio .................................................................................................................................................... 286
traditional theory .................................................................................................................................................. 97
traditional.............................................................................................................................................................. 98
treasury shares ............................................................................................................................................ 412, 578
two-in-the-bush theory ....................................................................................................................................... 574
types of liquidations ............................................................................................................................................ 551
U
UN Millennium Development Goals ....................................................................................................................... 3
uncertainty and risk ............................................................................................................................................ 213
uncertainty .......................................................................................................................................................... 213
undifferentiated mark ting .................................................................................................................................... 31
ungeared or unlev r d b ta................................................................................................................................... 158
United Nations Conference on Sustainable Development (Rio+20) ....................................................................... 8
unsecured finan e................................................................................................................................................ 250
unsystematic isk .................................................................................................................................................. 154
upside risk ............................................................................................................................................................. 11
users of financial information ............................................................................................................................. 280
V
valuati n appr aches ............................................................................................................................................ 415
valuati n meth dologies ....................................................................................................................................... 416
valuation outlines................................................................................................................................................ 464
va uation premiums and discounts ..................................................................................................................... 423
va uation report .................................................................................................................................................. 425
va uation ............................................................................................................................................................... 20
v lue analysis ........................................................................................................................................................... 3
v lue chain analysis ................................................................................................................................................ 33
value creation model .............................................................................................................................................. 4
value .................................................................................................................................................................... 408
variance ............................................................................................................................................................... 148
706
Index
Page
vertical acquisition .............................................................................................................................................. 501
vision ..................................................................................................................................................................... 28
voluntary ............................................................................................................................................................. 551
W
WACC .................................................................................................................................................... 15, 182, 418
weighted average cost of capital .................................................................................................................. 12, 110
weighted average risk ......................................................................................................................................... 157
Working capital changes ..................................................................................................................................... 201
Y
yield to maturity method ............................................................................................................................ 260, 394
yields to maturity ................................................................................................................................................ 258
Z
Z-score model ..................................................................................................................................................... 311
707

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Managerial Finance

FO Skae (Volume editor)

ISBN 978 0 409 12002 8

First Edition 1999 eprinted 2005, 2006

Editor: Lisa Sandford

Technical Editor: Liz Bisschoff

Printed in South Africa by Interpak Books Pietermaritzburg

Chapter 1 The meaning of financial manage ent

Chapter 2 Strategy and risk

Chapter 3 Present and future value of money

Chapter 4 Capital structure and the cost of capital

Chapter 5 Portfolio management and the Capital Asset Pricing Model

Chapter 6 The investment decision

Chapter 7 The financing decision

Ch pter 8 Analysis of financial and non-financial information

Chapter 9 Working capital management

Chapter 10 Valuations of preference shares and debt

Chapter 11 Business and equity valuations

Chapter 12 Mergers and acquisitions

Chapter 13 Financial distress

Chapter 14 The dividend decision

Chapter 16 Interest rates and interest rate risk

Chapter 17 Business plans

Appendix 1: Selected concepts, acronyms and terminology ................................................... 683

Appendix 2: PV and FV tables ............................................................................................................ 687

Table of statutes ...................................................................................................................................... 695

AFTER STUDYING THIS CHAPTER, THE STUDENT SHOULD BE ABLE TO –

1.1 Financial management

1.2 Goal of an entity

Shareholder wealth maximisation

1.3 Business model or value creation model of an entity

Fig ur 1. 1: The IIRC ’s usines s M odel

1.4 S tak eh ol de rs of an en tity

Figure 1.2: The key stakeholders of a private sector entity

Key stakeholder groups

Governance principles of stakeholder relations

Stakeh lder engagement is important because it enables –

1.5 Risk and return of investors

Companies can be classified in terms of their level of business risk:

1.5.2 Financial risk

Return from the business

Return on the investment: R150 000 / R500 000 = 30%

Is debt (gearing) a good idea?

ke now equals 25%.

1.6 Overview of financial management

FINANCING DECISIONS INVESTMENT DECISIONS

SOURCES OF SOURCES OF INVESTMENT

• Capital structure • Capital budgeting

Figure 1.3: Key aspects of financial management

The investment decision

Example: The investment decision

Relevant cash flows including tax payments

How the project will be financed

Pre ent value

The finance decision

Example: Capital structure, the finance decision

What is the purpose of determining the WACC?

Target WACC method

Therefore Debt = 40% of R3 383 450 =1 353 380 (maximum allowed)

The management decision

1.7 Capital markets

Raising equity finance on the Johannesburg Securities Exchange

Sustainability and responsible investment in the capital markets

Addressing all key environmental issues