MAC3702
MAC3702
Seventh Edition
Managerial Finance
Seventh Edition
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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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
v
Contents
Page
vii
Contents Managerial Finance
Page
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
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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
Practice questions .......................................................................................................................................... 116
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Contents Managerial Finance
Page
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
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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
Practice questions .......................................................................................................................................... 317
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Page
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
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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
Practice questions .......................................................................................................................................... 515
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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Page
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
Practice questions .......................................................................................................................................... 617
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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
Bibliography ..............................................................................................................................................
691
Index ............................................................................................................................................................
697
xv
Chapter 1
The meaning of
financial man gement
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
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.
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
Chapter 1 Managerial Finance
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.
5
Chapter 1 Managerial Finance
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
6
The meaning of financial management Chapter 1
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.
7
Chapter 1 Managerial Finance
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
The meaning of financial management Chapter 1
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.
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
Chapter 1 Managerial Finance
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
The meaning of financial management Chapter 1
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%
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.
11
Chapter 1 Managerial Finance
FINANCIAL STRATEGY
Objective: Creating long-term sustainable shareholder’s wealth that is responsibly derived for benefit of all
stakeholders
Techniques: Techniques:
• Cost of capital • Valuation methods
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
12
The meaning of financial management Chapter 1
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).
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.
13
Chapter 1 Managerial Finance
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 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
The meaning of financial management Chapter 1
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
Chapter 1 Managerial Finance
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
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 meaning of financial management Chapter 1
17
Chapter 1 Managerial Finance
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.
18
The meaning of financial management Chapter 1
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.
Board Practice
Ethics
Governance and related
Indirect Impacts
sustainability concerns
Business Value and Risk Management
Broader Economic Issues
19
Chapter 1 Managerial Finance
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.
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
The meaning of financial management Chapter 1
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.
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
21
Chapter 1 Managerial Finance
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
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
The meaning of financial management Chapter 1
Practice questions
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.
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
Chapter 1 Managerial Finance
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.
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 ]
(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
24
The meaning of financial management Chapter 1
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
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
Chapter 2 Managerial Finance
strategic planning process, governance aspects of risk management, as well as the risk management process
and ERM.
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).
29
Chapter 2 Managerial Finance
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.
30
Strategy and risk Chapter 2
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.
31
Chapter 2 Managerial Finance
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.
32
Strategy and risk Chapter 2
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.
FIRM INFRASTUCTURE
TECHNOLOGY DEVELOPMENT
PROCUREMENT
PRIMARY ACTIVITIES
33
Chapter 2 Managerial Finance
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
Strategy and risk Chapter 2
MARKET SHARE
HIGH LOW
MARKE
TGRO
WTH
HIGH STARS QUESTION MARKS
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.
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Strategy and risk Chapter 2
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
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.
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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.
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Strategy and risk Chapter 2
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.
‘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.’
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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:
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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Strategy and risk Chapter 2
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.
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Figure 2.6: Resp nsibilities of the various role players in the governance of risk management
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Strategy and risk Chapter 2
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Chapter 2 Managerial Finance
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.
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.
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Strategy and risk Chapter 2
Practice questions
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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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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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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Strategy and risk Chapter 2
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.
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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Strategy and risk Chapter 2
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
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.
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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.
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
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Strategy and risk Chapter 2
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
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.
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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
Strategy and risk Chapter 2
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.
57
Chapter 2 Managerial Finance
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.
58
Strategy and risk Chapter 2
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
Chapter 2 Managerial Finance
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
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.
61
Chapter 3 Managerial Finance
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.
62
Present and future value of money Chapter 3
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
Chapter 3 Managerial Finance
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.
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
Present and future value of money Chapter 3
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.
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.
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
Chapter 3 Managerial Finance
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
Present and future value of money Chapter 3
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
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
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
Chapter 3 Managerial Finance
*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.
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.
68
Present and future value of money Chapter 3
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:
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
:
69
Chapter 3 Managerial Finance
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
Required:
Determine the present value today of both options at a discount rate of 10%.
70
Present and future value of money Chapter 3
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
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
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
Chapter 3 Managerial Finance
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.
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.
Conclusion:
Choose R50 000 at the end of Year 5.
50 000 50 000
Present value to Year 0 = = = R31 046
(1 + 0,1)
5
1,6105
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Present and future value of money Chapter 3
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.
Note: Virtually all xampl s assume payment at the end of a period, that is, an ordinary annuity.
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)
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Chapter 3 Managerial Finance
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
R2 735 (rounded off)
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)
R2 736 (rounded off)
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Present and future value of money Chapter 3
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
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
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.
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Chapter 3 Managerial Finance
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.
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
Present and future value of money Chapter 3
Solution:
I
PVp =
i
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
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Chapter 3 Managerial Finance
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
CFj0 = 0
CFj1 = 100
CFj2 = 100
CFj3 = 580
I/YR = 20
NPV = 488,43
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.
78
Present and future value of money Chapter 3
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
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
CFj1 = 0
CFj1 = 105
CFj2 = 110,25
CFj3 = 595,76
I/YR = 20
NPV = 508,83
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
Chapter 3 Managerial Finance
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.
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
Present and future value of money Chapter 3
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
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
Chapter 3 Managerial Finance
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.
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
CFj0 = 0
CFj1 = 86 400
CFj2 = 86 400
CFj3 = 1 086 400
I/YR = 11,52
NPV = 930 253
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.
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Present and future value of money Chapter 3
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
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
CFj0 = 0
CFj1 = 40
CFj2 = 290
I/YR = 18
NPV = 242,17
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
Chapter 3 Managerial Finance
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
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.
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Present and future value of money Chapter 3
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.
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
Solution:
20 000 20 000
Present value = = = R15 876,80
(1 + 0,08)
3
1,2597
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
Chapter 3 Managerial Finance
Solution:
(1 + i) – 1
n
(i) FVA = I×[ ]
i
(1 + 0,1) – 1
4
120 000 = I×[ ]
0,1
FV
(ii) PV =
(1 + i)
n
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
Present and future value of money Chapter 3
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
CFj0 = 0
CFj1 = 800
CFj2 = 800
CFj3 = 5 212
I/YR = 10
NPV = 5 304
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Chapter 3 Managerial Finance
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
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 ]
CFj0 = 0
CFj1 = 0
CFj2 = 1 000
CFj3 = 500 + 5 000
I/YR = 10
NPV = 4 959
88
Present and future value of money Chapter 3
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
(1 + 0,05)
10 – 1
2
(b) FVA = 5 000 × [ 0,05 ] × (1 + 0,05)
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
Required:
Ca cu ate the value today of the investor’s preference shareholding.
89
Chapter 3 Managerial Finance
Solution:
Year 1 2 3 4 5 to infinity
Dividends – – 38 40 48 to infinity
90
Chapter 4
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.
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Chapter 4 Managerial Finance
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?
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).
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
Return before tax 400 000 150 000
Tax @ 40% 160 000 60 000
Return after tax 240 000 90 000
Existing return after tax 240 000 240 000
Total return 480 000 360 000
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.
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Chapter 4 Managerial Finance
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
Return before tax 400 000 150 000
T x @ 40% 160 000 60 000
Return after tax 240 000 90 000
Existing return after tax 240 000 240 000
Total return 480 000 360 000
94
Capital structure and the cost of capital Chapter 4
Required
return
Financial risk
Business 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.
95
Chapter 4 Managerial Finance
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%.
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
96
Capital structure and the cost of capital Chapter 4
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.
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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Chapter 4 Managerial Finance
ke
(cost of
Cost of equity)
capital
WACC
kd
(cost of
debt)
D:E ratio
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
Capital structure and the cost of capital Chapter 4
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)
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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Chapter 4 Managerial Finance
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.
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:
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.
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Capital structure and the cost of capital Chapter 4
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.
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Chapter 4 Managerial Finance
ke
Cost of (cost of equity)
capital
WACC equals
ke of an all-equity
company
kd
(cost of debt)
D:E ratio
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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Capital structure and the cost of capital Chapter 4
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
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Chapter 4 Managerial Finance
(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
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.
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Capital structure and the cost of capital Chapter 4
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.
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Chapter 4 Managerial Finance
= 840 000
4 000 000
= 21%
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.
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Capital structure and the cost of capital Chapter 4
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
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.
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Chapter 4 Managerial Finance
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).
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
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
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Capital structure and the cost of capital Chapter 4
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).
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Chapter 4 Managerial Finance
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.
110
Capital structure and the cost of capital Chapter 4
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 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
Chapter 4 Managerial Finance
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 = 21%
(Note that kd is after tax)
112
Capital structure and the cost of capital Chapter 4
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.
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.
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Chapter 4 Managerial Finance
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%.
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
Capital structure and the cost of capital Chapter 4
= 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.
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%
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Chapter 4 Managerial Finance
Practice questions
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
80% equity : 20% debt
60% equity : 40% debt
40% equity : 60% 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
Capital structure and the cost of capital Chapter 4
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%
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%.
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Chapter 4 Managerial Finance
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
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.
= 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%
118
Capital structure and the cost of capital Chapter 4
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
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Chapter 4 Managerial Finance
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 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
Capital structure and the cost of capital Chapter 4
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 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:
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Chapter 4 Managerial Finance
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.
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.
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Capital structure and the cost of capital Chapter 4
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.
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Chapter 4 Managerial Finance
The company must therefore raise R1 250 000 debt and reduce the dividend by R150 000 (rounded to the
nearest R50 000).
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
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Capital structure and the cost of capital Chapter 4
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
= 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
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Chapter 4 Managerial Finance
Return
D1
MV =
ke – g
ke = D1/MV + g
(R28 350 R126 000) + g
= 0,225 + 0,02
= 0,245 or 24,5%
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 –
investors are rational;
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
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Capital structure and the cost of capital Chapter 4
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.
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
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Chapter 4 Managerial Finance
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.
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.
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Capital structure and the cost of capital Chapter 4
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.
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Chapter 4 Managerial Finance
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.
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Capital structure and the cost of capital Chapter 4
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
Net current assets 14 000
56 000
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
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Chapter 4 Managerial Finance
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%
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Capital structure and the cost of capital Chapter 4
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Chapter 4 Managerial Finance
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
Capital structure and the cost of capital Chapter 4
135
Chapter 4 Managerial Finance
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’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%
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Capital structure and the cost of capital Chapter 4
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.
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Chapter 4 Managerial Finance
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.
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)
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Capital structure and the cost of capital Chapter 4
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%
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
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
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Chapter 4 Managerial Finance
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).
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Capital structure and the cost of capital Chapter 4
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.
Required:
Determine the optimum capital structure for Maranta Ltd.
Solution:
Long-term WACC:
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.
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Chapter 5
Portfolio management
and the Capit l Asset
Pricing Model
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.
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Chapter 5 Managerial Finance
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).
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Portfolio management and the Capital Asset Pricing Model Chapter 5
Equities/ Derivatives
n
E (R) = ∑ Pi × R i
i=1
Where:
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Chapter 5 Managerial Finance
Solution:
Expected return = (0,30 × – 7%) + (0,60 × 13%) + (0,10 × 23%) = 8%
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
Required:
Calculate the 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%
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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%
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.
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Chapter 5 Managerial Finance
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
∑(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
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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.
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.
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Chapter 5 Managerial Finance
Solution:
The calculated mean return, standard deviation and CV are as follows:
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.
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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:
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
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Chapter 5 Managerial Finance
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
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:
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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.
15%
Efficient portfolios curve
10%
Expected Retrn
5%
Inefficient
portfolios
(inside the curve)
0%
– 5%
0% 5% 10% 15% 20%
Risk (Return Volatility)
Conclusion: An investor should select a portfolio that lies on the efficient frontier curve.
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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.
Unsystematic risk
(Firm-specific risk)
Total risk
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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Chapter 5 Managerial Finance
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.
SM
2
Where:
COVARiM = The covariance of returns of stock i with those of the market
SM
2
= The variance of market returns
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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
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.
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Chapter 5 Managerial Finance
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.
Market
Arjent
10
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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.
Risk premium (Rp) = Return on the market portfolio (R m) – Risk-free return (Rf)
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Chapter 5 Managerial Finance
Required:
Calculate Bulelwa Limited’s WACC
Calculate the required rate of return by preference shareholders (cost of preference shares)
Kp = D/P0 = 6/110 = 5,45%
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Portfolio management and the Capital Asset Pricing Model Chapter 5
Required:
Determine the rate at which the new project should be evaluated.
Required:
Ignoring taxation, determine which of the two projects the company should accept.
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Chapter 5 Managerial Finance
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
Covariance: P oject A
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.
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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
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.
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Chapter 5 Managerial Finance
Practice questions
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)
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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
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%
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 =
5,38%
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Chapter 5 Managerial Finance
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.
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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.
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
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Chapter 5 Managerial Finance
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.
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%
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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%
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Chapter 5 Managerial Finance
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
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
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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
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Chapter 5 Managerial Finance
Expected return:
Project 1 + existing investments
5 15
10,6 × + 11,4 ×
20 20
= 11,2%
2,34%
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.
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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
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Chapter 5 Managerial Finance
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
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Portfolio management and the Capital Asset Pricing Model Chapter 5
– 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
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Chapter 5 Managerial Finance
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.
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.
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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 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%
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Chapter 5 Managerial Finance
30
28 30,4
Return 28%
% Project
24 Market
16,48 Marshall
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
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Portfolio management and the Capital Asset Pricing Model Chapter 5
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
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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.
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.
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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.
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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!
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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.
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.
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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
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.
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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
2 Expected cash inflow 8 000 15 000
3 Expected cash inflow 12 000 10 000
4 Expected cash inflow 8 000 10 000
5 Expected cash inflow 5 000 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.
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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
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
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The investment decision Chapter 6
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.
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Chapter 6 Managerial Finance
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
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
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The investment decision Chapter 6
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).
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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Chapter 6 Managerial Finance
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.
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The investment decision Chapter 6
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
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.
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Chapter 6 Managerial Finance
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%
Period Cashflow PV factor NPV
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
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%
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The investment decision Chapter 6
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%
Period Cashflow PV factor NPV
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%
Period Cashflow PV factor NPV
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)
Required:
Determine which of the two projects should be selected using the NPV and IRR techniques.
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Chapter 6 Managerial Finance
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?
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 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.
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The investment decision Chapter 6
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:
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
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Chapter 6 Managerial Finance
Conclusion:
Project B now shows a higher NPV as well as MIRR in comparison to Project A.
MIRR is consistent with the NPV calculation.
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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The investment decision Chapter 6
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.
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.
Required:
Ev lu te the investment at:
Real rates of return.
Nominal rates of return.
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Chapter 6 Managerial Finance
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.
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.
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The investment decision Chapter 6
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
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.
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
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Chapter 6 Managerial Finance
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.
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
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.
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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).
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.
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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.
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.
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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.
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.
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Sales are expected to increase by 10% for the first two years and stabilise thereafter.
Required:
Evaluate the project investment.
Solution:
kd after tax = 10% × 60% 6%
Target WACC = 40:60 (6% × 40%) + (20% × 60%)
14,4%
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.
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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%.
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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:
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.
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The investment decision Chapter 6
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.
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.
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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.
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Investment evaluation:
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)
Sale at end of life 10 000
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)
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)
YEARS
0 1 2 3 4 5 6
R R R R R R R
Investment (250 000)
Sale at end of life 40 000
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
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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
Wear and tear 2 (250 000)
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)
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)
Net cash in/outflow (190 000) 51 000 97 800 37 800 37 800 67 800 (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
Wear and tear 5 (200 000)
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:
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.
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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.
Recommendation: Option 2
The existing machine does not provide a positive NPV and must therefore be sold or replaced by the new
machine.
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Evaluation: Option 3
Discount
20% PV
Year 0 Buy new machine (400 000) 1 (400 000)
Year 5 Sell new machine 100 000 0,40 40 000
Year 1–5 Annual cashflows 110 000 2,99 328 900
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.
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
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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 3 Tax allowance R3,63 × 40% = 1,452 million 0,751 1,09
Year 3 Cost (R3,63) × 110% = (3,993) million 0,751 (3)
Year 4 Tax allowan e R3,993 × 40% = 1,597 million 0,683 1,09
Year 4 Cost (R3,993) × 110% = (4,392) million 0,683 (3)
Year 5 Tax allowance R4,392 × 40% = 1,757 million 0,621 1,09
Year 5 Cost (R4,392) × 110% = (4,832) million 0,621 (3)
Year 6 Tax allowance R4,832 × 40% = 1,933 million 0,564 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.
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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:
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Chapter 6 Managerial Finance
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.
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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The investment decision Chapter 6
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.
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Chapter 6 Managerial Finance
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
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.
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The investment decision Chapter 6
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
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.
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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Chapter 6 Managerial Finance
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
Initial investment (1 000)
Net cashflow 500 600 700
(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
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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The investment decision Chapter 6
Required:
Determine whether the company should replace the existing machine, close down or continue production on
the current basis.
Solution:
Investment evaluation:
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)
Sale at end of life 5 000
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)
Net cash in/outflow (49 900) 13 972 24 080 10 080 10 080 15 080 (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
Wear and tear 3 (50 000)
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)
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Chapter 6 Managerial Finance
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
Wear and tear 2 (250 000)
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)
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).
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The investment decision Chapter 6
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 are rational;
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
Chapter 6 Managerial Finance
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.
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
The investment decision Chapter 6
Project A Project B
NPV NPV
+ +
– –
225
Chapter 6 Managerial Finance
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
226
The investment decision Chapter 6
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.
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
Chapter 6 Managerial Finance
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.
228
The investment decision Chapter 6
229
Chapter 6 Managerial Finance
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.
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
The investment decision Chapter 6
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%
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Chapter 6 Managerial Finance
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
2 Cash from Gino sales 120 000 0,743 89 160
3 Cash from Gino sales 120 000 0,641 76 920
4 Cash from Gino sales 120 000 0,552 66 240
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
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The investment decision Chapter 6
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)
1 Cash from Gino sales 270 000 0,862 232 740
2 Cash from Gino sales 360 000 0,743 267 480
3 Cash from Gino sales 450 000 0,641 288 450
4 Cash from Gino sales 540 000 0,552 298 080
5 Cash from Gino sales 630 000 0,476 299 880
+ 53 270
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Chapter 6 Managerial Finance
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.
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The investment decision Chapter 6
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
Chapter 6 Managerial Finance
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 4 Contribution/Tax (2 412 278 × 60%) 1 447 367 0,5337 772 460
Year 5 Contribution/Tax (2 640 810 × 60%) 1 584 486 0,4561 722 684
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
The investment decision Chapter 6
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.
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
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
Chapter 6 Managerial Finance
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
238
The investment decision Chapter 6
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%)
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Chapter 6 Managerial Finance
Preference shares
Dividend
Value =
Kd
62 500
=
0,125
= R500 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
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 investment decision Chapter 6
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)
241
Chapter 6 Managerial Finance
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
Investment (750 000)
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
Investment (750 000)
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
242
The investment decision Chapter 6
NPV at 18%:
YEARS
0 1 2 3 4 5
R R R R R
Investment (750 000)
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)
243
Chapter 6 Managerial Finance
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
Investment (750 000)
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)
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
The investment decision Chapter 6
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
Investment (750 000)
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
Investment (750 000)
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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Chapter 6 Managerial Finance
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
Expected value 100% 427 500
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.
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The investment decision Chapter 6
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.
.
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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.
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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.
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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.
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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.
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
Solution
Applying the formula above:
(1/(4 + 1)) × ((4 × R1,80) + R1,55) = R1,75
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.
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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.
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.
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The exercise of convertibles does not provide extra funds upon conversion.
Conversion to ordinary shares will impact on control.
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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.)
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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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.
7.11.1 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.
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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.
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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.
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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)
Assume the following:
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)
(This percentage will be used as the pre-tax YTM [variable "B" in the formula of section 24J]).
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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
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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
2 Input Amort (Period 2-2)
Interest 123,25
3 Input Amort (Period 3-3)
Interest 126,36
4 Input Amort (Period 4-4)
Interest 129,89
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:
A = the accrual amount;
B = the yield to maturity on a pre-tax basis; and
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)
Calculator steps
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.
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)
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The financing decision Chapter 7
Amounts in Rand 0 1 2 3 4
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)
Amounts in Rand 0 1 2 3 4
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
Finance-related
cashflows after tax 880,00 (72,96) (80,60) (79,72) (1078,71)
Calculator steps
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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
1 Input Amort (Period 1-1)
Interest 137,98
2 Input Amort (Period 2-2)
Interest 140,71
3 Input Amort (Period 3-3)
Interest 143,85
4 Input Amort (Period 4-4)
Interest 147,47
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
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The financing decision Chapter 7
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).
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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 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)
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%
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The financing decision Chapter 7
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)
N1
Calculator inputs:
PV = 10000,00
PMT = (4163,49)
FV = 0,00
P/YR = 1
I/YR = 12%
1 Input Amort (Period 1-1)
Interest 1200,00
2 Input Amort (Period 2-2)
Interest 844,38
3 Input Amort (P riod 3-3)
Interest 446,09
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Chapter 7 Managerial Finance
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.
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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. en- tity 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)
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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
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)
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Chapter 7 Managerial Finance
(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].)
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)
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)
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The financing decision Chapter 7
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
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.
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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).
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.
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Chapter 8 Managerial Finance
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.
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.
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
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
Analysis of financial and non-financial information Chapter 8
Note:
EBIT or EBITDA does not include other income as this normally does not form part of the operating
activities.
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Chapter 8 Managerial Finance
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.
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Analysis of financial and non-financial information Chapter 8
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.
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).
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Chapter 8 Managerial Finance
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.
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Analysis of financial and non-financial information Chapter 8
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).
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
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Chapter 8 Managerial Finance
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
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Analysis of financial and non-financial information Chapter 8
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%.
Additional information:
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.
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Chapter 8 Managerial Finance
292
Analysis of financial and non-financial information Chapter 8
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
Difficulty level Comment
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
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Chapter 8 Managerial Finance
294
Analysis of financial and non-financial information Chapter 8
295
Chapter 8 Managerial Finance
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%
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Analysis of financial and non-financial information Chapter 8
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Chapter 8 Managerial Finance
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%
Difficulty level Comment
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
Difficulty level Comment
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
Difficulty level Comment
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.
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Analysis of financial and non-financial information Chapter 8
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
Difficulty level Comment
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.
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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%
Difficulty level Comment
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
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Analysis of financial and non-financial information Chapter 8
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.
Difficulty level Comment
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
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Invested capital:
Intermediate – Book value
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
Advanced – Market value
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
Intermediate – Book value
= 88 160 / 360 710 = 114 815 / 242 100
= 24% = 47%
Advanced – Market value
= 88 160 / 300 000 = 114 815 / 330 000
= 29% = 35%
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Analysis of financial and non-financial information Chapter 8
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).
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(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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Analysis of financial and non-financial information Chapter 8
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
Advanced – Market value
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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Chapter 8 Managerial Finance
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
Difficulty level Comment
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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Chapter 8 Managerial Finance
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Analysis of financial and non-financial information Chapter 8
(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.
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.
You are required to calculate the Z-score and provide insightful comments.
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Analysis of financial and non-financial information Chapter 8
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.
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
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Chapter 8 Managerial Finance
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.
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.
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Analysis of financial and non-financial information Chapter 8
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.
This management system assists in matching the entity’s short-term actions with its long-term strategy.
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Chapter 8 Managerial Finance
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).
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Analysis of financial and non-financial information Chapter 8
Practice questions
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
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Chapter 8 Managerial Finance
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.
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Analysis of financial and non-financial information Chapter 8
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%
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%
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Chapter 8 Managerial Finance
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)
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)
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Analysis of financial and non-financial information Chapter 8
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)
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Chapter 8 Managerial Finance
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.
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
Analysis of financial and non-financial information Chapter 8
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)
Note:
All costs except financing costs form part of the operating profit per truck calculation and thus only
financing costs are added back.
323
Chapter 8 Managerial Finance
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)
324
Analysis of financial and non-financial information Chapter 8
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.
325
Chapter 8 Managerial Finance
Financial performance
Extracts from CatCon’s recent annual financial statements and further details are set out below:
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).
326
Analysis of financial and non-financial information Chapter 8
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)
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%).
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
327
Chapter 8 Managerial Finance
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)
328
Analysis of financial and non-financial information Chapter 8
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”.
329
Chapter 8 Managerial Finance
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)
Note:
Limited rounding differences may occur.
Direction ito increase or decrease (signs ( + / – )) must be correct to earn marks.
330
Analysis of financial and non-financial information Chapter 8
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).)
331
Chapter 9
Working capital
man gement
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!
333
Chapter 9 Managerial Finance
334
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
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
Long-term
financing
Permanent current assets
Fixed assets
Time
335
Chapter 9 Managerial Finance
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
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.
336
Working capital management Chapter 9
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.
337
Chapter 9 Managerial Finance
338
Working capital management Chapter 9
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.
339
Chapter 9 Managerial Finance
340
Working capital management Chapter 9
2BT
Q =
I
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:
341
Chapter 9 Managerial Finance
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
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Working capital management Chapter 9
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
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.
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Chapter 9 Managerial Finance
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.
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).
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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
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Chapter 9 Managerial Finance
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.
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.
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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.
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Chapter 9 Managerial Finance
After tax
The only figures that are affected in the calculations after tax are the contribution, the discount and the bad
debt.
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.
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Working capital management Chapter 9
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.
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.
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Chapter 9 Managerial Finance
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
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Working capital management Chapter 9
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:
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.
Required:
Determine –
(i) the EOQ; and
(ii) the EOQ where discounts are available.
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Chapter 9 Managerial Finance
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.
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Working capital management Chapter 9
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:
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.
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Chapter 9 Managerial Finance
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.
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Working capital management Chapter 9
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.
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Chapter 9 Managerial Finance
Practice questions
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
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Working capital management Chapter 9
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
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.
(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
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Chapter 9 Managerial Finance
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.
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.
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Working capital management Chapter 9
Beach has just prepared its cash budget for the year ahead, details of which are as follows:
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).
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Chapter 9 Managerial Finance
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.
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Working capital management Chapter 9
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 cash- flow 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.
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.
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Chapter 9 Managerial Finance
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)
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Working capital management Chapter 9
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
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
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Chapter 9 Managerial Finance
Calculations
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Working capital management Chapter 9
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 560360 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
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Chapter 9 Managerial Finance
Assets
Non-current assets 5 189 760 202 020
Current assets 284 415 258 190
Inventory 150 350 140 820
Trade receivables 25 230 16 520
Cash balances and investments 108 835 100 850
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
Working capital management Chapter 9
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
Chapter 9 Managerial Finance
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
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)
368
Working capital management Chapter 9
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.
369
Chapter 9 Managerial Finance
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
Working capital management Chapter 9
371
Chapter 9 Managerial Finance
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.
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
Trade receivables 34 719 43 397
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
Working capital management Chapter 9
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
Finished goods 12 400 7 400
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
Finished goods 4 200 3 900
Scrap steel: EDC Scrap Metal 2 800 0
Scrap steel: Other local scrap steel suppliers 3 000 2 780
Other raw materials 3 750 3 500
C st f inventories reflected in trial balances
Finished goods 52 080 28 860
Scrap teel: EDC Scrap Metal 4 200 0
Scrap teel: Other local scrap steel suppliers 11 100 18 626
Other raw materials 2 250 2 450
69 630 49 936
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Chapter 9 Managerial Finance
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
Scrap steel purchased from other local suppliers 22 000 37 500
Other raw materials 4 200 5 900
Average purchase cost per tonne of raw materials R R
Scrap steel purchased from EDC Scrap etal 2 940 2 765
Scrap steel purchased from other local suppliers 2 490 2 960
Other raw materials 3 800 3 650
Purchases reflected in trial balances R’000 R’000
Scrap steel purchased from EDC Scrap Metal 44 100 41 475
Scrap steel purchased from other local suppliers 54 780 111 000
98 880 152 475
Other raw materials 15 960 21 535
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
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Working capital management Chapter 9
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.
375
Chapter 9 Managerial Finance
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
Working capital management Chapter 9
(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
377
Chapter 9 Managerial Finance
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)
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
Working capital management Chapter 9
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
379
Chapter 9 Managerial Finance
380
Working capital management Chapter 9
(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
381
Chapter 10
Valuations of preference
shares nd debt
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.
383
Chapter 10 Managerial Finance
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.
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.
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.)
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
Chapter 10 Managerial Finance
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.
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
Valuations of preference shares and debt Chapter 10
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.)
387
Chapter 10 Managerial Finance
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.
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
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Valuations of preference shares and debt Chapter 10
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)
(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%).
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Chapter 10 Managerial Finance
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
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
(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
Valuations of preference shares and debt Chapter 10
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.)
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)
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Chapter 10 Managerial Finance
Conclusion:
The current fair market value of the 100 000 non-cumulative redeemable preference shares is R9 885 265.
392
Valuations of preference shares and debt Chapter 10
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.
393
Chapter 10 Managerial Finance
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.
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 maturity date will be in four years’ time.
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
Valuations of preference shares and debt Chapter 10
Solution
Part (a) Determine the value of the instrument on a pre-tax basis
Year: 0 1 2 3 4
(Valuation
date)
Coupon payment (10% of R1 000) (100) (100) (100) (100)
Redemption (1 000)
Finance-related cash flows before-tax (100) (100) (100) (1 100)
395
Chapter 10 Managerial Finance
Part (b) Determine the present value of expected after-tax cash flows
Year: 0 1 2 3 4
(Valuation date)
Coupon payment (10% of R1 000) (100) (100) (100) (100)
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)
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
1 Input Amort (Period 1-1)
Interest 120,50
2 Input Amort (Period 2-2)
Interest 123,25
3 Input Amort (Period 3-3)
Interest 126,36
4 Input Amort (Period 4-4)
Interest 129,89
(Refer to your calculator manual if these steps are unclear.)
396
Valuations of preference shares and debt Chapter 10
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.
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Chapter 10 Managerial Finance
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.
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.)
Assume the following:
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
Valuations of preference shares and debt Chapter 10
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)
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.
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
Chapter 10 Managerial Finance
Calculator inputs:
PV = 96,11
PMT = (8)
FV = (100)
P/YR = 1
N= 5
I/YR 9
400
Valuations of preference shares and debt Chapter 10
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
Chapter 10 Managerial Finance
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)
Conclusion:
The likely fair market value of the 1 000 000 convertible bonds on the issue date is R1 077 079.
Practice qu stion
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
402
Valuations of preference shares and debt Chapter 10
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.
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
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
403
Chapter 10 Managerial Finance
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%
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
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Valuations of preference shares and debt Chapter 10
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.
405
Chapter 11
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
Chapter 11 Managerial Finance
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.
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).
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.
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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.
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Business and equity valuations Chapter 11
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!
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
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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.
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Business and equity valuations Chapter 11
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.
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
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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)
(Fair market values) R’000 (Fair market values) R’000
NET OPERATING ASSETS MARKET VALUE OF EQUITY 1 400
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).
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Step 4: Compile an appraiser’s balance sheet: Different slices of the same ‘cake’ (2)
(Fair market values) R’000 (Fair market values) R’000
NET OPERATING ASSETS MARKET VALUE OF EQUITY 1 400
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
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
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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.
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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.
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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).
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Business and equity valuations Chapter 11
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.
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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.
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Business and equity valuations Chapter 11
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.
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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).
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Business and equity valuations Chapter 11
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.
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.
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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.
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).
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Business and equity valuations Chapter 11
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.
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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.
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.
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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Business and equity valuations Chapter 11
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.
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Business and equity valuations Chapter 11
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.
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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.
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Business and equity valuations Chapter 11
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 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.
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Chapter 11 Managerial Finance
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 –
6 100
=
6
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Business and equity valuations Chapter 11
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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.).
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Business and equity valuations Chapter 11
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))
Step 2: Adjust the comparator P/E multiple for differences in risk and growth factors 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 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
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 million × 9 450
Adjust for owner (shareholder) level differences None
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))
Step 2: Adjust the comparator P/E multiple for differences in risk and growth factors on an entity P/E
evel
Comparator P/E multiple of Company C 10
Adjustment for differences in business and finance risk, and growth expectations
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
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Chapter 11 Managerial Finance
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 million × 11 550
Adjust for owner (shareholder) level differences None
Step 2: Adjust the comparator P/E multiple for differences in risk and growth factors on an entity P/E
level
Comparator P/E multiple of Company C 10
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
Maintainable earnings of Company S × adjusted P/E multiple = R50 million × 10 500
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.
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)
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Business and equity valuations Chapter 11
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.)
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Chapter 11 Managerial Finance
Additional information:
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.
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Business and equity valuations Chapter 11
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
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.
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Chapter 11 Managerial Finance
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 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
Required:
Determine the fair market value of an 100% equity shareholding in Shield Industrial (Pty) Ltd.
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Business and equity valuations Chapter 11
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.
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Chapter 11 Managerial Finance
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.
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Business and equity valuations Chapter 11
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).
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
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Chapter 11 Managerial Finance
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.
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Business and equity valuations Chapter 11
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Chapter 11 Managerial Finance
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.)
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.
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Business and equity valuations Chapter 11
Solution:
Valuation using the Gordon Dividend Growth Model
D1
P0 = ke – g
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%.
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Chapter 11 Managerial Finance
Required:
Calculate the market value of the 10% ordinary shareholding in the South African private company, based on
available information.
Solution:
Year 0 Year 1 Year 2 Year 3 Year 4
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
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.)
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Business and equity valuations Chapter 11
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 business enterprise is a going concern;
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).
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Chapter 11 Managerial Finance
Required:
Determine the Free Cashflow available to the business enterprise for the year ended 28 February 20X4.
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)
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Business and equity valuations Chapter 11
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.
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Chapter 11 Managerial Finance
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).
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Business and equity valuations Chapter 11
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)
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Chapter 11 Managerial Finance
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
EQUITY
Total shareholders’ equity 109 145 185
LIABILITIES
Non-current 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)
Operating profit 120 165 195
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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Business and equity valuations Chapter 11
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.
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Chapter 11 Managerial Finance
Solution:
Determine the present value of Free Cashflows for the explicit forecast and the continuing value
20X3 20X4 20X5 20X6
R’m R’m R’m R’m
-------- (Explicit forecast) --------- CV base
Operating profit 120 165 195
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)
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Business and equity valuations Chapter 11
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
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Chapter 11 Managerial Finance
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
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Business and equity valuations Chapter 11
Statements of Profit/Loss and Other Comprehensive Income for the year ended/ending
Historical ----------------- Forecast ---------------
20X3 20X4 20X5 20X6
R’m R’m R’m R’m
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
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Chapter 11 Managerial Finance
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
R’m R’m R’m R’m
= 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)
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Business and equity valuations Chapter 11
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
R’m R’m R’m R’m
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)
Operating profit 20,00 22,80 45,49 26,67
Adjusted tax at 28% (5,60) (6,38) (12,74) (7,47)
Operating profit 20,00 22,80 45,49 26,67
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
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Chapter 11 Managerial Finance
Note: No EVA is created for this year and onwards as ROIC = WACC
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).
462
Business and equity valuations Chapter 11
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).
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Appendix 1
464
Business and equity valuations Chapter 11
465
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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
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Business and equity valuations Chapter 11
6 Reasonability test
Based on a different valuation methodology, if possible.
7 Valuation conclusion
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
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468
Business and equity valuations Chapter 11
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
7 Va uation conclusion
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Chapter 11 Managerial Finance
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
470
Business and equity valuations Chapter 11
Reasonability test
Based on a differ nt valuation methodology, if possible.
471
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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
MVE adjusted for the above 67 82 73 85 90 92
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
MVE adjusted for the above 100 100 119 100 122 100
Marketability discount – 15 – 13 – 10 –8 –8 –7
MVE adjusted for the above 85 87 109 92 114 93
Notes
Figures may not total correctly due to rounding.
Percentages have been rounded to the nearest percentage point.
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Business and equity valuations Chapter 11
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
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Chapter 11 Managerial Finance
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?
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Business and equity valuations Chapter 11
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
× 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.
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Business and equity valuations Chapter 11
477
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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.
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Business and equity valuations Chapter 11
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.
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.
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Chapter 11 Managerial Finance
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.
480
Business and equity valuations Chapter 11
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
Chapter 11 Managerial Finance
(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
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
Business and equity valuations Chapter 11
(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
Chapter 11 Managerial Finance
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)
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.
484
Business and equity valuations Chapter 11
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
485
Chapter 11 Managerial Finance
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
Cash and cash equivalents 250 000
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
Business and equity valuations Chapter 11
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
Additional information
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
Chapter 11 Managerial Finance
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
Business and equity valuations Chapter 11
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
Chapter 11 Managerial Finance
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
490
Business and equity valuations Chapter 11
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%
49 000 (1,105)
= + 49 000 = R1 252 222
0,15 – 0,105
491
Chapter 11 Managerial Finance
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.]
492
Business and equity valuations Chapter 11
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).]
493
Chapter 11 Managerial Finance
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
[Additional note: synergies are discussed here for the sake of co pleteness, but are addressed principally
as part of mergers and acquisitions (chapter 12).]
494
Business and equity valuations Chapter 11
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
Chapter 11 Managerial Finance
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
496
Business and equity valuations Chapter 11
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
497
Chapter 11 Managerial Finance
Note: due to the different tax treatment the final value also differs
somewhat to the answer per the short ethod
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
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.
499
Chapter 12 Managerial Finance
Example
Company A buys out 100% of the shares of the targeted company from shareholder T.
Before takeover:
Company T
Company A
(Target company)
After takeover:
100% shareholding
No relationship with T company
exists after the takeover
Company A
(Holding company)
100% shareholding
Company T (Target
company) (Subsidiary
company)
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
Company A Company B
After amalgamation
Shareholders A and B
100% shareholding
Company C
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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
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Mergers and acquisitions Chapter 12
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.
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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.
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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Chapter 12 Managerial Finance
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.
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Mergers and acquisitions Chapter 12
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).
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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?
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.
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Mergers and acquisitions Chapter 12
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:
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:
P/E ratio 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.
This is because they now hold shares in a company with higher growth prospects.
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Chapter 12 Managerial Finance
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.
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
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Mergers and acquisitions Chapter 12
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)
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.
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Chapter 12 Managerial Finance
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.
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:
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Mergers and acquisitions Chapter 12
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.
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.
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Practice questions
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.
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.
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Chapter 12 Managerial Finance
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.
Note: This list is not exhaustive. What additional points can you add?
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.
Note: This list is not exhaustive. What additional points can you add?
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Mergers and acquisitions Chapter 12
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.
Additional information:
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.
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Chapter 12 Managerial Finance
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
Ordinary shares
Rm Rm
Shares for Astra 96 Balance 80
Profit on liquidation 16
96 96
36 36
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Mergers and acquisitions Chapter 12
Liquidation account
Rm Rm
Plant and machinery 240 Payables 60
Bank (liquidation charge) 2,9 Reserves 100
Inventory 5 Purchase price 192
Trade receivables 20
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
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Chapter 12 Managerial Finance
Solution:
Astra Ltd
Statement of Financial Position at 30 December 20X1
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
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Mergers and acquisitions Chapter 12
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
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Delta Ltd
Statement of Financial Position at 30 December 20X1
Rm
ASSETS
Non-current assets 130
Property 120
Plant and equipment 10
Current assets 175
Inventory 100
Trade receivables 50
Cash and cash equivalents 25
Additional information:
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
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Mergers and acquisitions Chapter 12
Purchase price:
Rm
Shares of R1 each 280
Cash 55
335
Delta Ltd
Statement of Financial Position at 30 December 20X1
Purchase price
Rm
Shares of R1 each 150
150
Current liabilities
Trade payables (135)
145
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Chapter 12 Managerial Finance
Delcosta Ltd
Statement of Financial Position at 30 December 20X1
Rm
ASSETS
Non-current assets 451
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 –
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Mergers and acquisitions Chapter 12
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.
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Chapter 12 Managerial Finance
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
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.
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.
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Mergers and acquisitions Chapter 12
The f ll wing information relevant to the operation of Townsend (Pty) Limited is available:
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.
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Chapter 12 Managerial Finance
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
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
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Mergers and acquisitions Chapter 12
Workings
Valuation of Babs Limited using a dividends growth model
Current dividends R210 000 × 80% = R168 000
Growth = 7% ke = 21%
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
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Chapter 12 Managerial Finance
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.
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Mergers and acquisitions Chapter 12
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
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
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Chapter 12 Managerial Finance
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
532
Mergers and acquisitions Chapter 12
5% may not be an appropriate growth figure. Some of these reservations are expanded below
(see 4, and (b)).
5 = 790
(1 + g) 619 = 1,276
3 = 790
(1 + g) 524 = 1,508
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
Chapter 12 Managerial Finance
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.
534
Mergers and acquisitions Chapter 12
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
Chapter 12 Managerial Finance
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
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.
537
Chapter 13 Managerial Finance
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:
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.
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
539
Chapter 13 Managerial Finance
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.
540
Financial distress Chapter 13
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
Chapter 13 Managerial Finance
– Closing down of non-profitable agencies and restructuring relationships with profitable agencies where
possible in order to ensure sustainable future profitability.
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.
542
Financial distress Chapter 13
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.
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
Chapter 13 Managerial Finance
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.
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
Financial distress Chapter 13
Comparison in value:
Value if company is reorganised R2 772
Value if company is liquidated: R851
Difference in value (positive) R1 921
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
Chapter 13 Managerial Finance
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
Financial distress Chapter 13
Msizi LTD
STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X3
20X3
R’000
ASSETS
Non-current assets 260
Property, plant and equipment 250
Goodwill 10
Current assets 165
Inventory 100
Trade receivables 65
425
EQUITY AND LIABILITIES
Total equity 260
Issued share capital 150
Retained earnings 110
Non-current liabilities
Long-term borrowings 50
Current liabilities 115
Trade payables 100
Bank overdraft 15
425
Additional information:
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
Chapter 13 Managerial Finance
Solution:
MSIZI LTD
STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X3
20X3
R’000
ASSETS
Non-current assets 260
Property, plant and equipment 250
Goodwill 10
Current assets 265
Inventory (100 + 100) 200
Trade receivables 65
525
EQUITY AND LIABILITIES
Total equity 260
Issued capital (150 + 100) 250
Retained earnings (110 – 100) 10
Non-current liabilities
Long-term borrowings 50
Current liabilities 215
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.
548
Financial distress Chapter 13
88 100
Additional information:
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
549
Chapter 13 Managerial Finance
Bank
R’000
Fixed assets 48 000
Current assets 74 500
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
Financial distress Chapter 13
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.
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.
551
Chapter 13 Managerial Finance
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)
– –
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.
552
Financial distress Chapter 13
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.
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
Preliminary expenses 3 000
94 000 150 000
Profit to ordinary shareholders 56 000
150 000 150 000
553
Chapter 13 Managerial Finance
Ordinary shareholders
R R
Bank 90 000 Balance (Shares) 34 000
Liquidation account (Profit) 56 000
90 000 90 000
Preference shareholders
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
Ordinary shareholders 90 000
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
Net current assets 56 000
Preliminary expenses 3 000
94 000 150 000
Profit to ordinary shareholders 56 000
150 000 150 000
Ordinary shareholders
R R
Bank 40 000 Balance 34 000
Share a ount A Ltd 50 000 Liquidation account (Profit) 56 000
90 000 90 000
Preference shareholders
R R
Bank 5 000 Balance 5 000
Bank
R R
A Ltd 50 000 Liquidation costs 5 000
Preference shareholders 5 000
Ordinary shareholders 40 000
50 000 50 000
554
Financial distress Chapter 13
Purchaser
R R
Liquidation account 100 000 Bank 50 000
Share account 50 000
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
555
Chapter 13 Managerial Finance
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.
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
Financial distress Chapter 13
Practice questions
557
Chapter 13 Managerial Finance
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
Financial distress Chapter 13
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.
559
Chapter 13 Managerial Finance
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
Ordinary shareholders
Preference shareholders
Bank
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
Financial distress Chapter 13
(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
Ordinary shareholders
Preference shareholders
Bank
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Chapter 13 Managerial Finance
Additional information:
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.
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Financial distress Chapter 13
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
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
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Chapter 13 Managerial Finance
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
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
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Financial distress Chapter 13
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
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.
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Chapter 14 Managerial Finance
Earnings
Rand
Dividends
Time
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.
Earnings
Rand
Dividends
Time
568
The dividend decision Chapter 14
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
569
Chapter 14 Managerial Finance
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
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
The dividend decision Chapter 14
15 950
PV value at t0 = = R11 651,69
(1 + 0,17)
2
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.
t1 t2 t3
R R R
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
Chapter 14 Managerial Finance
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%.
572
The dividend decision Chapter 14
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.
Comment:
Dividends may be half-yearly or annually.
573
Chapter 14 Managerial Finance
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).
Comment:
Cash generating companies will tend to have a low dividend cover or alternatively a high payout ratio.
574
The dividend decision Chapter 14
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.
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.
575
Chapter 14 Managerial Finance
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
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.
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
The dividend decision Chapter 14
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.
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.
577
Chapter 14 Managerial Finance
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)
578
The dividend decision Chapter 14
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
579
Chapter 14 Managerial Finance
Practice questions
Required:
A financial report obs rv d: ‘N w Horizons Ltd decreased their dividend to shareholders by 28%.’ Evaluate this
remark critically. (5 marks)
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
The dividend decision Chapter 14
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)
581
Chapter 15
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
Chapter 15 Managerial Finance
We will now have a look at each of these forms of currency risk and its implications for the enterprise.
An enterprise an be exposed to transaction risk from either the perspective of a supplier or a customer:
584
The functioning of the foreign exchange markets and currency risk Chapter 15
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).
585
Chapter 15 Managerial Finance
586
The functioning of the foreign exchange markets and currency risk Chapter 15
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
Figure 15.2: Extract from the currency quotes published by Standard Bank
587
Chapter 15 Managerial Finance
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?
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.
588
The functioning of the foreign exchange markets and currency risk Chapter 15
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.
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.
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.
589
Chapter 15 Managerial Finance
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):
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.
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.
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.)
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:
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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.
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).
(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.
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
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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
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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.
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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.
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
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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:
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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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
The example below illustrates how a money-market hedge is set up to hedge a foreign receipt.
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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:
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:
1 + (0,02 × 360 )
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.
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.
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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.
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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.
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.
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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
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.
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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.
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
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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15.9.2 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)
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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.
Let us look at the following example to see how a foreign currency option contract will function.
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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
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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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:
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:
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:
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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.
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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.
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Practice questions
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
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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
Rates for amounts up to R 200 000
‘Cheques’ denotes Travellers cheques, Personal cheques, Drafts and Clean items.
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
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The functioning of the foreign exchange markets and currency risk Chapter 15
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.
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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:
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:
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
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The functioning of the foreign exchange markets and currency risk Chapter 15
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.
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.
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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.
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The functioning of the foreign exchange markets and currency risk Chapter 15
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
Rates for amounts up to R 200 000
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:
The standard size of the US Dollar currency futures trading on the Johannesburg Stock Exchange’s currency
deriv tive market is US1 000.
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Additional information
The normal nominal borrowing cost of Stereo Corp is 11% per annum.
The following interest rates apply:
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)
128
US deposit ate: 0,4% × = 0,14%
365
128
SA borrowing rate: 11% × = 3,86%
365
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The functioning of the foreign exchange markets and currency risk Chapter 15
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
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
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Chapter 15 Managerial Finance
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
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Chapter 16
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.
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Chapter 16 Managerial Finance
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
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.
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Interest rates and interest rate risk Chapter 16
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:
16.2.2 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.
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Markets
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Interest rates and interest rate risk Chapter 16
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.
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.
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.
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Interest rate
(%) Yield curve (normal)
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.
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Interest rates and interest rate risk Chapter 16
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.
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.
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Chapter 16 Managerial Finance
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.
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
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Interest rates and interest rate risk Chapter 16
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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.
16.6.2 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%
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Interest rates and interest rate risk Chapter 16
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
Discount rate 15,30%
Yield if held to maturity 16,11%
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.
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Chapter 16 Managerial Finance
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%.
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Interest rates and interest rate risk Chapter 16
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%
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Chapter 16 Managerial Finance
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:
= R100 million ×
(8% 8.5%) 6m/12m = R239 808
15 1 (8.5% 6m/12m)
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Interest rates and interest rate risk Chapter 16
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.
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.
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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.
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
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Interest rates and interest rate risk Chapter 16
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.
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)
Outcome of the hedge:
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.
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Chapter 16 Managerial Finance
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.
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.
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Interest rates and interest rate risk Chapter 16
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.
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.
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Chapter 16 Managerial Finance
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.
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.
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Interest rates and interest rate risk Chapter 16
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%
Time (t)
Figure 16.4: Interest collar contract
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Chapter 16 Managerial Finance
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.
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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Interest rates and interest rate risk Chapter 16
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:
–2
–4
–6
–7
– 7,2
–8 With cap
– 8,2
Without a 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.
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Chapter 16 Managerial Finance
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
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.
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Interest rates and interest rate risk Chapter 16
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.
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Chapter 16 Managerial Finance
15
10
Profit
or Writer’s profit – loss line
loss 5
R’000 0
–5
Purchaser’s profit – loss line
– 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.
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Interest rates and interest rate risk Chapter 16
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:
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Chapter 16 Managerial Finance
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Interest rates and interest rate risk Chapter 16
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
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.
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Chapter 16 Managerial Finance
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%
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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Chapter 16 Managerial Finance
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:
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
658
Interest rates and interest rate risk Chapter 16
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:
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
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Chapter 16 Managerial Finance
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
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
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Interest rates and interest rate risk Chapter 16
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
R61,8m 12
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)
Outcome of the hedge:
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.
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Chapter 16 Managerial Finance
R9,875m 12
This results in an effective interest rate of R250 m × 6 = 7,9%
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
Bank Bank
662
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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.
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
Interest rates and interest rate risk Chapter 16
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
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.
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Chapter 17 Managerial Finance
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.
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Business plansChapter 17
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Chapter 17 Managerial Finance
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.
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Business plansChapter 17
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.
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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.
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Business plansChapter 17
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Chapter 17 Managerial Finance
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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Business plansChapter 17
Appendix A
Practice questions
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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Chapter 17 Managerial Finance
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.
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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Business plansChapter 17
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
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.
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Chapter 17 Managerial Finance
There is no description of the business’ objectives and mission, except from the profit that should be generated
by Year 3.
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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Business plansChapter 17
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.
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Chapter 17 Managerial Finance
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.
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Business plansChapter 17
Market Analysis
Year 1 Year 2 Year 3 Year 4 Year 5
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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Chapter 17 Managerial Finance
Required:
Evaluate whether the market analysis and sales strategy satisfies most of the requirements for a standard
business plan.
682
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
Appendix 2 Managerial Finance
688
Appendix 2 Managerial Finance
689
Appendix 2 Managerial Finance
690
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Mallin CA, Corporate social responsibility: a case study approach (2009)Cheltenham: E gar.
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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
Index Managerial Finance
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
Index Managerial Finance
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
Index Managerial Finance
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
Index Managerial Finance
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