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CHAPTER 1

DIVIDEND POLICY DECISION

A dividend is a payment made out of the firm’s earnings to its owners, in the
form of either cash or shares (stock).

The policy decision required applies to ordinary shares, as these are the ones
whose dividends are not defined and are determined by management.
Preference shares carry a fixed rate of dividend that has to be paid whenever
a dividend would have been declared.

Forms of dividend
There are primarily three forms of dividend, cash dividend, stock dividend and
dividend in kind.

Cash dividend This is the most common form of dividend. The declared
dividend is paid out as cash for example $30,00 per share for each share that
is outstanding.

Stock dividend (Scrip) It is a dividend in the form of stock (shares). It is


usually the preferred option if an organisation is experiencing liquidity
problems.

Dividend in kind This is the use of a company’s products as dividend. This


type of dividend is not common in Zimbabwe. A wine producing concern for
example, may distribute wine as dividend to its shareholders.

Dividend payment procedures


The board of directors makes a dividend declaration. Once declared dividends
become a debt to the firm, which cannot be easily rescinded. The following
example illustrates the procedures to be followed from when dividends are
declared until they are finally paid.

EXAMPLE The directors of A Ltd have proposed a final dividend number 65


of $40,00 per share to be paid to shareholders registered in the company’s
books on 8 July 2004. Dividend payment will be made on or about 15 July
2004. The company’s register will be closed between 4 July and 8 July 2004.

By order of the company

30 May 2004

The following time line can be used to illustrate the sequence of specific dates
that are of interest when looking at dividends. It is important to note the
activities that take place at each respective date and how they are related to
those that follow and precede each specified activity.

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Share trades cum – div that is Share trades ex – div that is
cumulative of dividend excluding dividend

30 May 2004 4 July 2004 8 July 2004 15 July 2004


Declaration date Ex – dividend date Record date Payment date

Declaration date This is the date on which the board of directors passes a
resolution to pay a dividend.

Ex – dividend date It is the date before the date of record, establishing those
individuals entitled to a dividend. In Zimbabwe the period is four business
days and in the United States two business days.

Record date This is the date at which a holder must be on record in order to
be designated to receive a dividend.

Payment date It is the date when the dividend cheques are posted or in
cases where funds are transferred electronically, it is the date when the
electronic funds transfer is effected.

DIVIDEND POLICIES
Dividend policy refers to a firm’s plan of action to be followed whenever a
decision concerning dividends must be made. The policy should be
formulated with the following two objectives in mind:
1. Maximisation of shareholder wealth and
2. Provision of sufficient financing.

There are generally three broad dividend policies that could be pursued by
firms.

POLICY I – CONSTANT/TARGET PAYOUT RATIO


A firm pursuing this policy pays out a constant percentage of net earnings as
dividend to shareholders. With such a policy dividend payments fluctuate
proportionately with earnings. The dividends become volatile in keeping with
fluctuations in earnings.
($)
DPS
& EPS
EPS
DPS

Time (Years)

Fig. Dividend payment under a constant/target payout ratio

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POLICY II – CONSTANT DIVIDEND PER SHARE
A firm pursuing this policy pays a certain fixed amount per share as dividend
for example $25,00. This amount is paid out year after year regardless of the
level of earnings. This might even mean the payment of a dividend even when
the company has incurred a loss. This policy does not mean that the amount
of dividend is fixed for all times to come. As earnings grow the dividend is
increased and once increased it is maintained at the new level. While
earnings may fluctuate yearly, the dividend per share remains constant.
EPS

($)
DPS
&
EPS DPS

Time (Years)

Fig. Dividend payment under a constant dividend per share

POLICY III – LOW REGULAR DIVIDEND PER SHARE PLUS EXTRA


DIVIDEND
A firm pays out a low and sustainable dividend to shareholders every year.
During years of marked prosperity the firm pays an extra dividend over and
above the regular dividend.

DIVIDEND THEORIES
Management has to decide whether dividends are an active variable or a
passive residual. This in turn depends on whether management believes that
dividends have any effect on the value of the firm.

There are conflicting opinions regarding the impact of dividends on the


valuation of the firm.

The irrelevance of dividends (general theory)


The argument in support of the general theory on irrelevance is that the
dividend policy of the firm is part of its financing. As part of the financing
decision of the firm, the dividend policy of the firm is a residual decision and
dividends are a passive residual.

When a firm has sufficient investment opportunities it will retain earnings to


finance the investments. If acceptable investments were inadequate, earnings
would be distributed to shareholders.

If a firm can earn a higher return than its cost of capital it will retain the
earnings to finance investment projects. If retained earnings fall short of the
funds required it will raise external funds, both equity and debt to make up the
shortfall. If retained earnings exceed the requirements of funds to finance

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acceptable investment opportunities the excess earnings would be distributed
as dividends.

The amount of dividend will fluctuate year – by – year depending on available


acceptable investment opportunities. The dividend payout ratio can be zero or
100%.

The general theory of the irrelevance argument assumes that investors are
indifferent between dividend and capital gains. If the firm can earn more than
the equity capitalization rate (ke) investors would be content with the firm
retaining earnings. If the return were less than the ke, investors would prefer
to receive the earnings (dividends).

The irrelevance of dividends: MM hypothesis


Franco Modigliani and Morton Miller give a comprehensive argument in
support of the irrelevance of dividends.

They argue that given a firm’s investment decision, a firm has two options – to
retain its earnings to finance the attractive investments or to distribute the
earnings as dividends and raise an equal amount through the sale of new
shares to finance its investment programme. When dividends are paid out the
market price of the shares will increase. However, the additional shares
issued will decrease the terminal value of the shares. What the investors
would have gained will be neutralized completely by a reduction in the
terminal value of the shares. This situation creates indifference between
dividend and retention of earnings MM argue.

In other words their argument is that investors are indifferent between


dividend and retention of earnings. This they argue is because of the
balancing nature of internal financing (retained earnings) and external
financing (dividend payment).

The argument presented by MM is based on the following assumptions:


1. Perfect capital markets. This is a market that is characterised by the
following:
 Rational investors
 Free information available to all
 Zero transaction costs
 Infinitely divisible securities
 Zero floatation costs
 No large enough investor to influence security market prices
2. No taxes. Alternatively they assume that there is no difference in tax
rates applicable to capital gains and dividends.
3. A given investment policy not subject to change.
4. Perfect certainty as future investments and profits of the firm.

A critique of the MM hypothesis


The MM proposition is based on unrealistic assumptions. The proposition can
therefore be viewed as untenable because of the following arguments.

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Taxes The MM argument that rates of tax levied as capital gains tax and on
dividend income are the same is not always true. Dividend withholding tax is
levied at a higher rate than capital gains tax (for shares that are quoted on the
stock exchange). This arrangement may create a situation where those in a
high-income bracket (those receiving taxable dividends) may prefer retention
of earnings to postpone tax and pay it as capital gains tax on disposal of
shares.

Floatation costs The presence of floatation costs (underwriting commissions,


brokerage and other expenses) affects the balancing nature of internal
financing (retention of earnings) and external financing (dividend of payment).
The two methods of financing are not perfect substitutes because of floatation
costs. The costs reduce the net proceeds from the sale of new shares leaving
them less than the face value of shares issued. To be able to make use of
external funds, equivalent to the dividend payment, the firm would have to sell
shares for an amount in excess of the retained earnings. External financing
through the issue of shares will be more costly than financing via retained
earnings.

Transaction costs It is also unrealistic to assume that if the shareholder


desires current income when they sell part of their shareholding they incur no
transaction costs. To get current income equivalent to the dividend if paid, the
investor would have to sell securities in excess of the income that he will
receive (to cater for transaction costs).

Uncertainty Uncertainty makes the dividend decision relevant. MM argue that


shareholders are indifferent between a dividend now (a near dividend) and
retention of earnings to be received in future in the form of an increase in
share price (a distant or future dividend). Myron Gordon and John Lintner
argue that because of uncertainty investors are not indifferent, they prefer
near dividends. The amount to be paid in future cannot be forecast with
precision.

Informational content of dividends/Financial signaling Payment of a


dividend contains vital information to investors. This information is usually
related to profitability or vice versa. If a firm used to pay a stable dividend and
suddenly increases its dividend payout this signifies improved future
profitability. The dividend policy is likely to change the market price of the
shares.

Relevance of dividends: The Gordon model


The Gordon model considers the dividend decision to relevant. It considers
the dividend decision to be an active variable in determining the value of the
firm.

The Gordon argument is based on the following assumptions:


1. Investors are risk – averse and
2. Investors put a premium on returns that are certain and
discount/penalize returns that are not certain.

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Investors being rational want to avoid risk (the possibility of not getting a
return on investment). Payment of a current dividend removes any chance of
risk. If a firm retains its earnings in order to pay a future dividend this
introduces uncertainty as to the amount of the dividend and its timing.
Rational investors penalize future dividends because of uncertainty, as they
prefer near dividends, which are certain.

Determinants of Dividend Policy


The dividend policy of a concern is a function of a number of factors.

Dividend Payout ratio If a firm has a long established dividend payout ratio;
it becomes bound by the ratio, as shareholders would be expecting that ratio
to be paid out.

Stability of dividends Investors prefer stable dividend in as much as they


prefer a stable dividend payout ratio.

Desire for current income Investors such as retired persons and widows
regard dividends as a source of funds to meet their current expenses. If
dividends were to be reduced they sell their shares. They dig deep into their
principal to sustain themselves. It would be preferable if they were to dig deep
into their pockets rather than principal.

Informational contents/Financial signaling Investors use dividends and


changes in dividends as a source of information about the firm’s profitability.
They know that the firm will only change dividends if management foresees a
permanent earnings change.

Requirements of institutional investors Institutional investors are only


required to invest in companies that have a record of continuous and stable
dividend. Because of the large size of funds they have available for
investment their demand for shares will have an enhancing – effect on its
price thereby increasing shareholders wealth.

Legal requirements Legal requirements specify the conditions under which


dividends must not be paid.
a) Cash dividends cannot be paid out of paid up capital as this amounts to
a reduction of capital (capital impairment rule).
b) Legislation restricts the dividend to be paid to be paid out of the firm’s
current profits plus past accumulated retained earnings.
c) If a firm is technically or legally insolvent it cannot legally pay cash
dividends.

Contractual requirements These are important when a company accepts


external loans, preference share capital or lease contracts as part of its
financing. The restrictions can limit the payment of cash dividends. The
restrictions can take any of the following forms:
I. Prohibition of payment of dividend in excess of a defined
percentage for example 30 per cent of distributable profits.

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II. A defined amount of profits to be paid as dividends may be
stipulated for example $40 million.
III. Insisting upon a defined minimum amount of earnings having to
be retained.

Growth prospects This refers to the investment opportunities available to the


concern. For a growing concern, the availability of external funds and its
associated cost have a significant bearing on the firm’s dividend policy.

Financial requirements A firm’s financial requirements are directly related to


its investment needs. Dividend policy should be formulated on the basis of
foreseeable investment needs. Abundant investment opportunities will
normally lead to a low payout ratio and vice versa.

Liquidity (Availability of funds) Liquidity as used in this context refers to the


availability of funds. Dividend policy should be developed after considering the
firm’s ability to raise funds and the promptness with which that financing can
be obtained.

Stability of earnings Generally the more stable the income stream of a


concern, the higher the dividend payout ratio and vice versa. Growing firms
with stable earnings can raise debt funds at a relatively lower cost because of
a smaller total risk (business and financial).

Control considerations Management may employ dividend policy as an


effective instrument to maintain its position and control. Management may opt
for a low dividend payout and high retention ratio to finance investment (to
avoid debt finance with covenants or equity capital which may dilute control).

Access to capital markets If a firm has easy access to capital markets


(because of size or financial strength), it may follow a liberal dividend policy. If
a firm has limited access to capital markets, it is likely to adopt a low dividend
payout ratio since the firm relies heavily on retained earnings as a source of
financing investment opportunities.

USEFUL RATIOS AND FORMULAE


The following ratios and formulae are useful when one is looking at dividends
and dividend policy.

Dividend payout = Total dividend to ordinary shareholders (cash dividends)


Total net earnings belonging to equity holders

If the payout is needed as a percentage, the above formula is multiplied by 100

OR

Dividend payout = Dividend per ordinary share (DPS)


Earnings per share (EPS)

DPS = Net profit after interest and preference dividend paid to ordinary shareholders
Number of ordinary shares outstanding

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OR

DPS = Total ordinary cash dividend paid


Number of ordinary shares in issue

Dividend cover = Earnings available to ordinary shareholders


Ordinary dividend

OR

Dividend cover = EPS (Earnings per shares)


DPS (Dividend per share)

Dividend Yield = Dividend per share * 100


Market price per share

Earnings Yield = Earnings per share * 100


Market price per shares

Yield is expressed as a percentage

Price Earnings ratio = Market price per share


Earnings per share

BONUS SHARES (STOCK DIVIDENDS) AND STOCK (SHARE) SPLITS


STOCK DIVIDEND
A stock dividend is a payment made by the firm to its owners in the form of
stock, diluting the value of each share outstanding. The stock issued is issued
on a pro rata basis. The stock issue is expressed as a percentage for
example 20 percent. This would mean one (1) additional share would be
issued for every five (5) existing shares.

Stock splits and dividends have the same impact on the corporation and the
shareholders:
1. They increase the number of shares outstanding and
2. They reduce the value per share.

STOCK SPLIT
This is the subdivision of a firm’s stock that leads to an increase a firm’s
outstanding shares without any change in owner’s equity. A stock split is
expressed as a ratio instead of a percentage for example a three for one
stock split. This would mean a share is split into three new shares.

EXAMPLE (STOCK DIVIDEND)


The following information is given:
$
Common stock ($1,00 par 10 000 outstanding shares) 10 000,00
Share premium 20 000,00
Retained earnings 70 000,00
100 000,00

The stock is currently trading for $5,00. Assume a 10 percent stock dividend.

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Present the shareholders equity after the stock dividend.

Solution
A 10 percent stock dividend brings in 1 000 additional ordinary shares at
$5,00.

$
Common stock ($1,00 par 11 000 outstanding shares) 11 000,00
Share premium [20 000 + (1 000 * $4,00)] 24 000,00
Retained earnings ($70 000 - $5 000) 65 000,00
100 000,00

EXAMPLE (STOCK SPLIT)


Referring to the above example and assume a two – for – one stock split.

Show the owner’s equity after the stock split.


Solution
$
Common stock ($0.50 par 20 000 shares outstanding) 10 000,00
Share premium 20 000,00
Retained earnings 70 000,00
100 000,00

Rationale for a stock split


1. Stock splits bring the market price of shares within a more popular
range as a result of a larger number of shares outstanding.
2. The larger number of outstanding shares will also promote more active
trading in the share due to availability of floating stock.

Rationale for a bonus offer


1. A bonus offer leads to conservation of corporate cash.
2. Bonus/split announcements improve the prospects of raising additional
funds especially through the issue of convertible debentures.

PRACTICE PROBLEMS ON DIVIDENDS


PROBLEM 1
A firm has had the earnings per share over the past 10 years shown in the
following table.
Year Earnings per share
1988 $4.00
1987 3.80
1986 3.20
1985 2.80
1984 3.20
1983 2.40
1982 1.20
1981 1.80
1980 -0.50
1979 0.25

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If the firm’s dividend policy was based on a constant payout ratio of 40
percent for all years with positive earnings and a zero payout otherwise,
determine the annual dividend for each year.

If the firm had a dividend payout of $1,00 per share, increasing by $0,10 per
share whenever the dividend payout fell below 50 percent for two consecutive
years, what annual dividend did the firm pay each year?
If the firm’s policy was to pay $0.50 per share each period except when
earnings per share exceeds $3,00, when an extra dividend equal to 80
percent of earnings beyond $3,00 would be paid, what annual dividend did the
firm pay each year?

Discuss the pros and cons of each dividend policy described in a through c.

PROBLEM 2
A firm has the following information at the end of two financial periods:

2003 2004
$ $
EBIT 70 000 100 000
Taxation for the year 10 000 30 000
Interest 10 000 10 000
Dividend paid 30 000 40 000
Number of ordinary shares 100 000 110 000
Current market price of a share $5 $6

At the end of the trading period 2002 the firm’s share price was $5,50.
Calculate for the two years the following:

Earnings per share (2 marks)


Price Earnings ratio (2 marks)
Earnings yield (2 marks)
Dividend per share (2 marks)
Dividend yield (2 marks)
Dividend cover (2 marks)
Interest cover (2 marks)
Holding period returns (6 marks)

PROBLEM 3
X and Y are two fast growing companies in the engineering industry. They are
close competitors and their asset composition, capital structures, and
profitability records have been very similar for several years. The primary
difference between the companies from a financial management perspective
is their dividend policy. Company X tries to maintain a non – decreasing
dividend per share, while company Y maintains a constant dividend payout
ratio. Their recent earnings per share (EPS), dividend per share (DPS), and
share price (P) history are as follows:

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Company X ($) Company Y ($)
Year EPS DPS P (range) EPS DPS P (range)
1 9.30 2.00 75 – 90 9.50 1.90 60 – 80
2 7.40 2.00 55 – 80 7.00 1.40 25 – 65
3 10.50 2.00 70 – 110 10.50 2.10 35 – 80
4 12.75 2.25 85 – 135 12.25 2.45 80 – 120
5 20.00 2.50 135 – 200 20.25 4.05 110 – 225
6 16.00 2.50 150 – 190 17.00 3.40 140 - 180
7 19.00 2.50 155 - 210 20.00 4.00 130 - 190

Determine the dividend payment ratio (D/P) and price to earnings ratio (P/E)
for both companies for all the years.
Determine the average D/P and P/E for both the companies over the period 1
through 7.
Management of company Y is puzzled as to why their share prices are lower
than those of company X, in spite of the fact that profitability record of
company Y is slightly better (particularly for the past three years). As a
financial consultant, how would you explain the situation?

PROBLEM 4
The following is the earnings per share (EPS) record for ABC Ltd over the
past 10 years:

Year EPS ($) Year EPS ($)


10 20.00 5 12.00
9 19.00 4 6.00
8 16.00 3 9.00
7 15.00 2 -2.00
6 16.00 1 1.00

Required:
Determine the annual dividend paid each year in the following cases:
If the firm’s dividend policy is based on a constant dividend payout ratio of
50% for all years.
Pay a dividend of $8.00 per share increasing to $10.00 per share when
earnings exceed $14.00 per share for two consecutive years.
Pay a dividend of $7.00 per share each year except when EPS exceeds
$14.00 per share, when an extra dividend equal to 80% of earnings beyond
$14.00 would be paid.
Which type of dividend policy will you recommend to the company and
Why?

PROBLEM 5

What is a dividend?
What is a stable dividend? Why should a firm follow such a policy?
The abbreviated income statement of MTB Limited for 2004 is as follows:
Turnover $28 772 000
Profit before Taxation $ 3 299 000
Profit after Taxation $ 1 737 000

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Number of shares 14 131 124
Price per share $ 0,47

If the company is planning to purchase new equipment worth $5 million and


the firm wants 25% of the cost to be financed by current income, what will be
the dividend cover?
If the company has a policy of paying 50 percent of its net income as
dividend:
What will the dividend per share of the company be?
If the firm still has to finance the equipment purchase in (i) what is the amount
of external financing that it will have to seek?
If the company always pays a dividend of 1 cent per share plus a bonus and
the bonus is any earnings per share over 10 cents, what is the total dividend
that will be paid by the firm
What is a bonus stock dividend?
What would be the rationale for such a dividend?
In relation to dividend payment procedures, explain the following:
Declaration date
Ex – dividend date
Record date
Payment date

PROBLEM 6
(a) Muzanzi Ltd’s expected net income for next year is $1 million. The
company’s target and current capital structure is 40% debt and 60% common
equity. The optimal capital budget for next year is $1.2 million. If Muzanzi Ltd.
uses the residual theory of dividends to determine next year’s dividend pay
out, what is the expected payout ratio?
(b) Shingai Ltd. has a current and target capital structure of 30% debt and
70% equity. This past year the company, which uses a residual dividend
theory, had a dividend payout ratio of 47.5% and net income of $800 000.
What was the company’s capital budget?

(c) Kuvharwa Ltd’s optimal capital structure calls for 40% debt and 60%
equity. The interest rate on debt is a constant 12%; its cost of equity from
retained earnings is 16%; its cost of equity from new stock is 18%; and its
marginal tax rate is 40%. The company had the following investment
opportunities:

Project A: Cost = $5 million: IRR = 22%


Project B: Cost = $5 million: IRR = 14%
Project C: Cost = $5 million: IRR = 11%

Kuvharwa Ltd expects to have a net income of $7 million. If the company


bases its dividends on the residual policy, what will its payout ratio be?

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CHAPTER 2

WORKING CAPITAL MANAGEMENT

Working capital can be looked at from a gross or net perspective. Gross


working capital is the total of an organisation’s current assets. Net working
capital can have two meanings:
1. Net working capital can be looked at as the difference between current
assets and current liabilities.
2. Net working capital can also be looked at as that portion of a firm’s
current assets financed by long – term funds

Objective of working capital management The goal of working capital


management is to manage a firm’s current assets and current liabilities so as
to maintain a satisfactory level of working capital. This level of working capital
will ensure sufficient liquidity in the operation of the business as measured by
the current ratio, acid – test ratio and net working capital.

Firms should operate with some net working capital. The amount of net
working capital required differs from firm to firm. Net working capital provides
a margin of safety where cash inflows and outflows do not coincide. If there is
little or no working capital, there is a higher risk of technical insolvency.

PERMANET/FIXED WORKING CAPITAL


Firms require some defined minimum amount of working capital to keep their
operations running. This minimum level of working capital that is necessary on
a continuous basis is the permanent or fixed working capital.

TEMPORARY/FLUCTUATING/SEASONAL/ VARIABLE WORKING


CAPITAL
In addition to the minimum working capital required on an ongoing basis, firms
also require additional working capital during certain periods like the festive
season. This additional working capital that is needed to meet fluctuations in
demand as result of seasonal changes is the variable working capital.

Amount of Temporary working


Working capital ($) capital

Permanent working
Capital

Time in months

Fig. Components of working capital

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DECISIONS TO BE MADE CONCERNING WORKING CAPITAL
The management of working capital requires management to make two very
important decisions.

DECISION I
TRADE – OFF BETWEEN PROFITABILITY AND RISK (INVESTMENT
DECISION)
When evaluating a firm’s net working capital attention must be paid to the
trade – off between profitability and risk. The level of a firm’s net working
capital has a bearing on its profitability as well as risk. Profitability will be
measured by profit after expenses while risk would be the probability that the
firm would become technically insolvent and fail to meet its obligations when
they become due for payment.

Evaluation of the trade – off


To make an evaluation of the trade – off that exists between profitability and
risk, the following assumptions will be made:
1. The firm being evaluated is a manufacturing concern. A manufacturing
concern is chosen here because of the amount of working capital
investment carried by such firms.
2. Current assets are less profitable than fixed assets.
3. Short – term funds are less expensive than long – term funds.

The evaluation can be illustrated by computing the ratio of current assets to


total assets. Some firms maintain a ratio of current assets to total assets. The
ratio indicates the percentage of total assets represented by current assets. A
change in the ratio will reflect a change in the amount of current assets.

EXAMPLE
MUNHUMUTAPA INVESTMENTS LTD.

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BALANCE SHEET AT 30 DECEMBER 2004
ASSETS $
Non – current assets 860 000
Property, plant and equipment 860 000

Current assets 540 000


Current assets 540 000
1 400 000
TOTAL ASSETS

EQUITY AND LIABILITIES


Capital and reserves 600 000
Capital 600 000
Non – current liabilities 480 000
Long – term debt 480 000

Current liabilities 320 000


Current liabilities 320 000
1 400 000
TOTAL EQUITY AND LIABILITIES

Assume that the company earns approximately 4 percent on its current assets
and 10 percent on non – current assets.
1. Compute the current profitability, net working capital and current
assets/total assets ratio.
2. Assume an additional investment of $60 000,00 in current assets other
things being equal. Calculate profitability, net working capital and
current/assets ratio.
3. Now assume an increase in the level of investment in fixed assets of
$60 000,00, other things being equal. Re – calculate profitability, net
working capital and ratio of current assets/total assets.

Solution
Current position
Profitability: Current assets = 4/100 * $540 000 = $21 600
Non – current assets = 10/100 * $860 000 = $86 000
$107 600

Net working capital = $540 000 - $320 000


= $220 000

Current assets/total assets ratio = $540 000/$1 400 000


= 0.39

An increase in the ratio of current assets to total assets


An additional investment of $60 000,00 in current assets other things being
equal reduces non – current assets by the same amount.

Profitability: Current assets = 4/100 * $600 000 = $24 000


Non – current assets = 10/100 * $800 000 = $80 000

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$104 000

Net working capital = $600 000 - $320 000


= $280 000

Current assets/total assets ratio = $600 000/$1 400 000


= 0.43

An increase in the ratio of current assets to total assets decreases profitability


because current assets are assumed to be less profitable than non – current
assets. The increase in the ratio also decreases the risk of technical
insolvency because an increase in current assets, assuming no change in
current liabilities will increase net working capital.

A decrease in the ratio of current assets to total assets


An increase in the level of investment in non – current assets (a decrease in
the ratio of current assets to total assets) of $60 000,00, other things being
equal, reduces current assets by the same amount.

Profitability: Current assets = 4/100 * $480 000 = $19 200


Non – current assets = 10/100 * $920 000 = $92 000
$111 200

Net working capital = $480 000 - $320 000


= $160 000

Current assets/total assets ratio = $480 000/$1 400 000


= 0.34

A reduction in the ratio of current assets to total assets increases profitability


and risk. Profitability increases because non – current assets (more profitable
than current assets) increase. Risk increases because a decrease in current
assets (with current liabilities remaining constant) reduces net working and
hence increases risk.

Effects of changes in current assets of Munhumutapa Ltd


Initial Value after Value after
Value Increase Decrease
($) (+) ($) (-) ($)
Ratio of current assets to total assets 0.39 0.43 0.34
Profit on total assets 107 600 104 000 111 200
Net working capital 220 000 280 000 160 000

DECISION 2
DETERMINING THE FINANCING MIX (FINANCING DECISION)
Other than the profitability – risk trade – off, another important consideration is
determining the appropriate mode of financing the current assets. There are
two sources of finance:
 Short – term sources (current liabilities)
 Long – term sources (share capital and long – term borrowings)

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The question to be answered is how much finance should be short – term and
how much should be long – term? The answer to this question depends on
which approach to financing current assets is adopted.

THE HEDGING APPROACH/MATCHING APPROACH/AGGRESSIVE


APPROACH
The hedging approach suggests that long – term funds should be used to
finance permanent working capital requirements while short – term sources of
finance should be used to finance temporary or seasonal working capital
requirements. When this approach to financing current assets is adopted,
short – term financing requirements (current assets) will just be equal to the
short –term financing available (current liabilities). This effectively means that
there will be no working capital, which is a very risky arrangement.

Diagrammatical illustration of the hedging approach

Total working capital requirements

Required Total funds requirement


Funds Short – term funds
($)

Seasonal working capital


Requirement

Long – term finance Permanent working capital requirement

Time in months

THE CONSERVATIVE APPROACH


This method of financing suggests that the estimated financial requirement
(projected funds requirement) should be made from long – term sources of
funds. Short – term sources are used for emergency situations only or when
there is an unexpected outflow of funds.

17
Diagrammatical illustration of the approach

Total working capital requirement

Total funds requirement


Funds
Required
($)

Seasonal working capital requirement

Long – term finance Permanent working capital requirement

Time in months

EXAMPLE
The projected total funds requirements for Gobvu Investments for the year
2005 are given as follows:

Total funds Permanent Seasonal


Required Requirements Requirements
Month ($) ($) ($)
January 85 000 69 000 16 000
February 80 000 69 000 11 000
March 75 000 69 000 6 000
April 70 000 69 000 1 000
May 69 000 69 000 0
June 71 500 69 000 2 500
July 80 000 69 000 11 000
August 83 500 69 000 14 500
September 85 000 69 000 16 000
October 90 000 69 000 21 000
November 80 000 69 000 11 000
December 75 000 69 000 6 000
116 000

Assuming that short – term finance cost 3 percent and long – term finance 8
percent:
1. Compute the cost of financing associated with the hedging approach.
2. Compute the cost of financing associated with the conservative
approach.
3. Indicate the risk considerations associated with the two approaches of
financing.
4. Compute the cost of financing associated with the middle of the road
approach.

18
Cost considerations
The cost of a financing plan has a bearing on the profitability of a concern.

Cost of short – term funds = average annual short – term loan * interest rate

Where average annual short – term loan = total monthly seasonal requirements
Number of months

Cost of long – term funds = average annual long – term funds requirements * interest
rate

Cost of short – term funds = ($116 000/12) * 3/100


= $9 666,66667 * 3/100
= $290,00

Cost of long – term funds = [$69 000 * 12] * 8/100


12
= $69 000 * 8/100
= $5 520,00

Total cost of financing = Cost of short – term finance + cost of long – term finance

Cost of financing for the Hedging approach = $290,00 + $5 520,00


= $5 810,00

Cost of financing (Conservative) approach = Highest projected funds requirements *


interest rate

Cost of financing: Conservative approach = $90 000,00 * 8/100


= $7 200,00

Risk considerations
The hedging approach is more risky when compared to the conservative
approach because of the following reasons:
1. The hedging approach has no net working capital since current assets
just equal current liabilities. There is therefore no margin of safety.
Again no long – term finances are used to finance seasonal working
capital requirements.
2. The hedging approach involves an almost full utilization of the capacity
to use short – term funds and in emergency situations it may be difficult
to satisfy the short – term needs of the organisation. The conservative
approach conserves an organisation`s short – term borrowing capacity
for unexpected needs to avoid technical insolvency. It however
exhausts an organisation`s capacity to utilize long – term finance.

The hedging approach can therefore be argued to be a high profit (because of


low cost) – high risk (because there is no working capital) approach to
financing current assets while the conservative approach can be argued to be
a low profit (because of high cost) – low risk (because of high working capital)
approach to financing current assets.

19
TRADE – OFF BETWEEN THE HEDGING AND CONSERVATIVE
APPROACHES/MIDDLE OF THE ROAD/COMPROMISE APPROACH
This financing approach strikes a balance between the two extreme methods
of financing current assets that is the hedging approach and the conservative
approach. The exact trade – off between risk and profitability will differ from
case to case depending on the risk preference of the decision – maker. One
possibility is to take the average of the maximum and minimum monthly
working capital requirements of the concern. This may then be financed
through long – term sources of finance with short – term sources for additional
fund requirement.

In the above example the revised amount to be financed through long – term
financing can be re – computed as follows:

Permanent working capital = $90 000 + $69 000


2
= $79 500,00

This would be the amount of funds the firm would use each month in the form
of long – term funds. Additional funds, if needed, should be from short – term
sources of finance.

The previous example can be re – visited and the total funds requirement
broken down into revised permanent and variable working capital
requirements.
Estimated total funds requirement: Compromise approach
Total funds Long – term Short – term
Requirement Funds Funds
Month ($) ($) ($)
January 85 000 79 500 5 500
February 80 000 79 500 500
March 75 000 79 500 0
April 70 000 79 500 0
May 69 000 79 500 0
June 71 500 79 500 0
July 80 000 79 500 500
August 83 500 79 500 4 000
September 85 000 79 500 5 500
October 90 000 79 500 10 500
November 80 000 79 500 500
December 75 000 79 500 0
27 000

No short – term sources of funds are required in March, April, May June and
December as long – term sources available exceed total requirements of
funds. For the other months short – term sources of finance should be
arranged.

20
Cost of financing under the compromise approach

Cost of short – term funds = [$27 000,00/12] * 3/100


= $2 250,00 * 3/100
= $67,50

Cost of long – term funds = [$79 500,00 * 12] * 8/100


12
= $79 500,00 * 8/100
= $6 360,00

Total cost of financing = $67,00 + $6 360,00


= $6 427,50

Summary
Maximum
Net working Degree of Total cost Level of
Capital Risk Of financing Profitability
Financing plan ($) ($)
Hedging 0.00 Highest 5 810,00 Highest
Compromise 10 500,00 Intermediate 6 427,50 Intermediate
Conservative 21 000,00 Lowest 7 200,00 Lowest

Concluding generalisation
The lower the net working capital, the higher the risk for technical insolvency
and the higher the expected profits.

FACTORS BRINGING ABOUT CHANGES IN WORKING CAPITAL


A number of factors can explain the variations that take place to the amount of
working capital that the entity experiences.

Changes in sales and operating expenses


Higher levels of cash, inventories and debtors to support the increase in sales
accompany an increase in sales volume. A decline in sales has the opposite
effect. An increase in operating expenses must also be supported by a larger
amount of working capital and vice versa.

Policy changes
Some firms relate their current assets volume (current assets policy). A policy
change affects the level of working capital. A change from a conservative
policy (high level of current assets to sales) to an aggressive policy will have
an impact on the level of working capital.

Technology changes
Technological developments can shorten the operating cycle. This reduces
the need for working capital and vice versa.

DETERMINANTS OF WORKING CAPITAL

21
The objective of working capital management is to have neither too much nor
too little working capital. The following factors determine the amount of
working capital required by a business.

General nature of business


Businesses conducting their operations on a cash basis and service
concerns, do not need to maintain large inventories as is required by
businesses conducting their operations on credit. Manufacturing concerns
require huge amounts of working capital.

Production cycle
The larger the production cycle, the larger will be the funds tied up and the
larger the working capital needed and vice versa. A good example will be
distilleries. Organisations having shorter production cycles for example
bakeries do not need a huge investment in working capital.

Business cycle
Business fluctuations lead to cyclical changes and shifts in working capital
especially seasonal working capital. During a boom, there is greater need for
additional working capital to meet increased demand. A decline in business
activity is followed by a decrease in demand and a fall in inventories and book
debts.

Production Policy
A steady production policy independent of shifts in demand leads to an
accumulation of inventories during the off – season. This has to be supported
by an additional investment in working capital, which remains tied up in
inventories. Production matched to demand policy reduces the time working
capital is tied up in inventories hence a reduction in investment in working
capital.

Credit policy
The credit given by a firm to its debtors affects working capital. A liberal credit
policy increases book debts and increases the need for additional working
capital. This need is, however, reduced if the firm in turn is given liberal terms
by its suppliers.

Growth and expansion


Other things being equal, firms in growth industries require more working
capital than static firms.

Vagaries in the availability of raw materials


The availability of core raw materials on a continuous basis without
interruption affects the requirement for working capital. If the raw material is
not readily available, it may be necessary to build up inventories. This creates
a need for additional working capital and vice versa.

22
Inflation
Inflation necessitates the use of additional funds for maintaining even the
existing level of activity. For the same level of working capital, higher cash
outlays will be required. Thus inflation will create the need for a change in
working capital.

Operational efficiency
Changes in operational efficiency also affect working capital. An improvement
in operational efficiency produces more for a given level of inputs.
Requirements for working capital will therefore be reduced and vice versa.

PRACTICE PROBLEMS

PROBLEM 1
Santo Gas has forecast its total funds requirements for the coming year as
follows:

Month Amount
January $7 400 000
February 5 500 000
March 5 000 000
April 5 300 000
May 6 200 000
June 6 000 000
July 5 800 000
August 5 400 000
September 5 000 000
October 5 300 000
November 6 000 000
December 6 800 000

3. Divide the firm’s monthly funds requirement into a permanent and a


seasonal component and find the monthly average for each of these
components.

4. Describe the amount of long-term and short-term financing used to


meet the total funds requirement under (1) an aggressive strategy and
(2) a conservative strategy.

5. Assuming short-term funds cost 10 percent annually and long-term


funds cost 16 percent annually, use the averages found in a to
calculate the total cost of each of the strategies described in b.

Discuss the profitability-risk trade-offs associated with the aggressive strategy


and the conservative strategy.

PROBLEM 2
What is working capital management?
What is the objective of working capital management?

23
P Ltd has investigated the profitability of its assets and the cost of its funds.
The results indicate:
Current assets earn 1%
Non – current assets earn 13%
Current liabilities cost 3%
Average cost of long – term funds 10%

The current balance sheet is as follows:


$
ASSETS
Non – current assets 30 000
Current assets 10 000
40 000
LIABILITIES
Non – current liabilities 35 000
Current liabilities 5 000
40 000

What is the net profitability?


The company is contemplating lowering its net working capital to $3 500 by (i)
either shifting $1 500 of current assets into non – current assets, or (ii) shifting
$1 500 of its Non – current liabilities into current liabilities. Work out the
profitability for each of these alternatives
Which alternative do you prefer? Why?
(d) Can both these alternatives be implemented simultaneously? How would it
affect the net profitability?

PROBLEM 3

How are net working capital, liquidity, technical insolvency, and risk related?
Why is an increase in a firm’s ratio of current to total assets expected to
decrease both profits and risk as measured by net working capital
Halgera Investment Limited has forecast its total fund requirements for the
coming year as follows:

Month Amount ($) Month Amount ($)


January 30 000 July 200 000
February 30 000 August 180 000
March 40 000 September 110 000
April 60 000 October 70 000
May 100 000 November 40 000
June 150 000 December 20 000

The firm’s cost of short term and long – term financing is expected to be 4%
and 10% respectively.
What is the basic premise of the hedging approach for meeting a firm’s funds
requirements? What are the effects of this approach on the firm’s profitability
and risk?

24
Calculate the cost of financing using the hedging approach
What is the conservative approach to financing a firm’s funds requirements?
Calculate the cost of financing using the hedging approach
Indicate the basic profitability – risk trade – off associated with each of the
these plans
Calculate the cost of financing using the compromise approach
Indicate any two factors that explain variations to the amount of working
capital of an enterprise
List any four determinants of a company’s working capital requirements

PROBLEM 4
Jena limited forecast its seasonal financing needs for the next year as given
below. Assuming that the firm’s permanent funds requirement is $4 million,
calculate the total annual financial costs using the aggressive strategy and
conservative strategy, respectively. Recommend one of the strategies under
each of the following conditions:

Short-term funds cost 9% annually, and long-term funds cost 15 percent


annually.
Short-term funds cost 10% annually, and long-term funds cost 13 per cent
annually.
Both short term and long term funds cost 11 % annually

Month Seasonal requirements


$
January 0
February 300 000
March 500 000
April 900 000
May 1 200 000
June 1 000 000
July 700 000
August 400 000
September 0
October 200 000
November 700 000
December 300 000

CHAPTER 3

CASH AND LIQUIDITY MANAGEMENT

25
Basic objective
The basic objective of cash management is to keep the investment in cash as
low as possible while keeping the firm operating efficiently and effectively.

Motives for holding cash


There are three main motives for holding cash.

Speculative motive
This is the need for the organization to hold cash to take advantage of
additional investment opportunities such as bargain purchases.

Precautionary motive
This is the need to hold cash as a safety margin. The cash balances held will
act as a financial reserve.

Transaction motive
This is the need to hold cash to satisfy normal disbursement and collection
activities associated with the firm’s ongoing operations.

LIQUIDITY MANAGEMENT
Liquidity management is concerned with the establishment of optimal quantity
of liquid assets a firm should have on hand. It is one particular aspect of
current asset management.

CASH MANAGEMENT
Cash management is concerned with optimising mechanisms for collecting
and disbursing cash.

No discussion on cash management can be meaningful without highlighting


the concept of float and how it is managed.

FLOAT
Float is the difference between book cash (ledger balance) and bank cash
(available or collected balance). The difference represents the net effect of
cheques in the process of clearing. There is a disbursement float and a
collection float.

Disbursement float
This float emanates from cheques written by the firm. The cheques written
decrease the firm’s book balance but with no immediate change to its
available balance.

Collection float
Collection float emanates from cheques deposited by the firm. It increases the
firm’s book balance but with no immediate change to its available balance.
Float management
This involves controlling the collection and disbursement of cash. When
collecting cash, the objective is to speed up collection and reduce the lag
between the time customers pay their bills and the time it becomes available.

26
The objective of cash disbursement is to control payments and minimize the
firm’s costs associated with making payment.

The disbursement float has three parts:


Mailing time This is the time when cheques are trapped in the postal system.

Processing delay It is the time it takes the receiver of a cheque to process


the payment (issuing a receipt) and depositing it in a bank for collection.

Availability delay This is the time required to clear a cheque through the
banking system.

Systematic over drafting/cheque kiting


This refers to the use of funds that are not yet available. (Issue of cheques
against uncollected cash). It is illegal.

COLLECTION AND CONCENTRATION


Earlier own it was indicated that the objective of cash collection is to speed up
collections and reduce the lag between the time customers pay their bills and
the time cash becomes available. To understand the techniques involved, it is
preferable to highlight how cash is collected first and then illustrate how the
collection itself can be speeded up.

Cash collection process

Customer Company Company Cash


makes receives deposits becomes
payment payment payment available

Time

Mailing processing availability


Time delay delay

Collection time

LOCK BOX COLLECTION SYSTEM


Employing the lock box collection system can speed up cash collections. The
system requires the setting up of special post office boxes to intercept
payments for accounts receivable. A local bank maintains a lock box. The
bank collects cheques several times a day and deposits them directly to the
company’s account.

Customer customer customer customer


Payments payments payments payments

27
Post office post office
Box 1 box 2

Local bank collects funds from


Post office boxes

Envelopes opened, deposit slip


Prepared

Details deposit of cheques


Receivables into bank account
Sent to firm

Firm processes bank cheque clearing


Receivables system

Fig. Overview of the lock box processing

Advantages of the lock box arrangement


 The lock box system reduces mailing time as cheques are received at
a nearby post office instead of head office.
 Processing time is also reduced.

CASH CONCENTRATION
This is another technique that can be adopted to speed up collections. Cash
concentrations are procedures for moving cash from multiple banks into the
firm’s main accounts. A concentration bank pools the funds obtained from
local banks contained within some geographic area.

Customer customer
Payments payments

28
Firm sales
Office

Customer
Payments

Local bank Post Office


Deposits lock box receipts

Customer
Payments

Concentration
Bank

Firm Cash
Manager

Maintenance Disbursements Short term Maintenance


Of cash reserve activities investments compensating
Of cash balances at
Creditor bank

Fig. Lock boxes and concentration banks in cash management system

Advantages of cash concentration


1. Cash collections end up in many different banks and bank accounts.
By routinely pooling its cash the firm simplifies its cash management by
reducing the number of accounts to be tracked.
2. By having a large pool of funds available, the firm can negotiate better
rates on short – term investments.

Increasing disbursement float


The following techniques can be used to increase the disbursement float. It
should be borne in mind that one of the objectives of disbursement
management is to delay making a payment as long as is legally and

29
practically possible. In pursuing this objective the firm should not compromise
its relationship with the suppliers as these may withdraw trade credit.
 Writing out cheques on a geographically distant bank.
 Mailing checks from remote post offices.

These two techniques are an example of what is sometimes referred to as


“playing the float game”

CONTROLLING DISBURSEMENTS
The general idea of disbursement management is to have no more than the
minimum amount necessary to pay bills held in the company’s disbursement
accounts. The following two approaches can be adopted to achieve this
objective.

Zero – balance accounts


This sis a disbursement account in which the firm maintains a zero balance,
transferring funds in from a master account only as needed to cover cheques
to be presented for payment. This way a safety balance is only maintained in
the master account. The arrangement frees up cash to be used elsewhere.

No zero – balance accounts Two zero – balance accounts

Payroll Supplier Master account


Account Account Safety
balance

******** ******* *****************

cash cash
transfer transfer

safety balances

payroll supplier
account account

Fig. Zero – balance accounts

Controlled disbursements accounts


These are accounts to which the firm transfers an amount that is sufficient to
cover demands for payment. Amounts to be paid that day are known in
advance and the bank notifies the firm to effect the necessary funds transfer.

CASH OPERATING CYCLE


A cash operating cycle can be defined as the period from payment for raw
materials to receipt of money from debtors. The period represents the time
that the firm’s cash is tied up in its operations. The basic strategy behind the

30
cash operating cycle is to reduce the cash operating cycle as much as is
possible without adversely affecting the operations of the firm.

Computation of the cash operating cycle


A cash operating cycle is made up of conversion periods. The starting point
would be to calculate the various conversion periods and finally calculate the
cash operating cycle.

The conversion periods are calculated as follows:

Raw materials conversion time (RMCT) This is the average time from
purchase of raw materials to when they actually enter the production process.

RMCT = Value of raw materials in stock


Raw materials consumed per day

Creditors conversion time (CCT) This is the period from purchase of raw
materials on credit to when the firm actually makes cash payment for the raw
materials.

CCT = Value of creditors


Purchases of raw materials per day

Work – in –progress conversion time (WIPCT) It is the average time taken


to convert raw materials into a finished product. It is also known as the
average production period.

WIPCT = Value of work – in – progress


Cost of goods manufactured per day

Finished goods conversion time (FGCT) It is the average time taken to sell
goods that have come out of the production line.

FGCT = Value of finished goods


Cost of goods sold per day

Debtors conversion time (DCT) This is the period from when goods are sold
to when the firm receives payment from debtors. It is also known as the
average credit period taken by debtors.

DCT = Value of debtors


Value of sales per day

COC = RMCT – CCT + WIPCT + FGCT + DCT

CCT is deducted because during that period the firm would not have been
paid cash for raw materials.

EXAMPLE

31
The following information has been collected for the purpose of calculating the
cash operating cycle.

31 December
2000 2001
$ $
Credit sales 3 240 000 3 600 000
Purchases of raw materials 1 125 000 1 687 500
Raw materials consumed 1 080 000 1 440 000
Cost of goods manufactured 2 160 000 2 880 000
Cost of goods sold 1 800 000 2 700 000
Debtors 540 000 800 000
Creditors 156 250 375 000
Stocks: Raw materials 90 000 60 000
Work in progress 60 000 120 000
Finished goods 25 000 75 000

Assuming a 360 day year calculate the cash operating cycle for both years.
Comment on the change that you arrive at.

Solution
2000 2001
RMCT = $90 000/($1 080 000/360) = $60 000/($1 440 000/360)
= $90 000/3 000 = $60 000/4 000
= 30 days = 15 days

CCT = $156 250/($1 125 000/360) = $375 000/($1 687 000/360)


= $156 250/3 125 = $375 000/$4 687,50
= 50 days = 80 days

WIPCT = $60 000/($2 160 000/360) =$120 000/($2 880 000/360)


= $60 000/6 000 = $120 000/8 000
= 10 days = 15 days

FGCT = $25 000/($1 800 000/360) = $75 000/($2 700 000/360)


= $25 000/5 000 = $75 000/7 500
= 5 days = 10 days

DCT = $540 000/($3 240 000/360) = $800 000/($3 600 000/360)


= $540 000/9 000 = $800 000/10 000
= 60 days = 80 days

COC2000 = 30 – 50 + 10 + 5 + 60 COC2001 = 15 – 80 + 15 + 10 + 80
= 55 days = 40 days

CASH MANAGEMENT MODELS


There are two main cash management models, the Baumol – Allais – Tobin
(BAT) model and the Miller – Orr model.

32
BAUMOL – ALLAIS – TOBIN (BAT) MODEL
The aim of this model is to calculate the optimal amount of marketable
securities to be liquidated whenever the concern requires cash. The
calculated level of marketable securities will maximise interest received on
marketable securities while minimising the cost of selling marketable
securities.
Assumptions
The BAT model is based on the following two assumptions:
a) Cash is instantaneously replenished.
b) There is a gradual use of cash.

Cash ($)

C/2
(average cash)

Time
Fig. The Baumol – Allais – Tobin model

As can be seen from the above diagram, the BAT model is based on the
inventory management’s economic order quantity (EOQ)

Optimal replenishment for the firm

= 2 * annual cash disbursement * cost of sale of securities


Interest rate

EXAMPLE
A company has an average cash disbursement of $1 200 000,00 per year.
The company holds its monetary resources as cash or marketable securities.
The marketable securities carry an interest rate of 20 percent and it costs the
company $15,00 to convert any amount of marketable securities into cash.

Compute the optimal amount of marketable securities to be converted into


cash whenever securities are sold.

Solution
Marketable securities to be liquidated = 2 * $1 200 000,00 * $15,00
0.20

= $13 416,41

Marketable securities worth $13 416,41 should be sold at each liquidation.

33
Problems with the BAT model
The model has two main problems emanating from the underlying
assumptions of the model.
 Cash is not always instantaneously replenished.
 Cash is also not gradually used. Cash movements are generally
random.

MILLER – ORR MODEL


The Miller – Orr model is a stochastic model that aims at determining the
amount of marketable securities to be sold or purchased whenever there is
need for such transactions. A stochastic model is a model based on real life
assumptions.

The model indicates that the firm sells marketable securities when a lower
limit of cash is reached. Marketable securities are purchased when the upper
limit of cash is reached as it becomes necessary to reduce cash.

Cash ($)

Purchase marketable securities

Maximum cash

Return point

Spread

Minimum cash

Sell marketable securities

Time
Fig. The Miller – Orr model

 Begin by determining the lower limit of cash. This is the preferred


minimum cash balance and it could be the cash that may be required
for precautionary purposes for example.
 Calculate the spread. The spread is the difference between the upper
limit and lower limit of cash. It is obtained by using the following
formula:

Spread = 3 * 3 ¾ * Transaction costs * daily variance of cash flows


Daily interest rate

34
 Calculate the maximum cash (upper cash limit). To obtain the
maximum cash use the following approach:

Maximum cash = Minimum cash + Spread

 Calculate the return point. The return point is the point to which the
cash balance should return when marketable securities are purchased
or sold.

Return point = Lower Limit + [Spread/3]

When these values are known, the amount of marketable securities to be


bought or sold can now be established.

Cash replenishment (Value of marketable securities to be sold) = Return


Point – Lower Limit.

Cash reduction (Value of marketable securities to be bought) = Upper


Limit – Return Point.

EXAMPLE
A company has a minimum balance of $15 000,00 and a standard deviation of
daily cash flows of $5 000,00. An annual interest rate of 9 percent can be
obtained on marketable securities. Transaction costs for sale or purchase of
securities is $15,00.

Assuming a 360-day year what amount of marketable securities should the


firm sell or buy whenever such transactions are required?

Solution
Variance = Standard Deviation2
= $5 000,002
= $25 000 000,00

Daily interest rate = 0.09/360


= 0.00025

Spread = 3 3 ¾ * $15,00 * $25 000 000,00


0.00025

= $31 201,26

Upper limit = $15 000,00 + $31 201,26


= $46 201,26

Return point = [$15 000,00 + ($31 201,26/3)]


= [$15 000,00 + $10 400,42]

35
= $25 400,42

Marketable securities to be purchased = $46 201,26 - $25 400,42


= $20 800,84

Marketable securities to be sold = $25 400,42 - $15 000,00


= $10 400,42

Problem with the miller – Orr model


The problem with the Miller – Orr model lies in the determination of the firm’s
daily cash flow variance.

BANKING POLICY
Organisations that make regular bank deposits should come up with a
banking policy. The objective of coming up with such a policy is to establish
an optimal banking frequency. Greater banking frequency brings in more
interest but it results in higher banking costs such as transportation, labour,
security and stationery.

EXAMPLE
Gore Ltd has annual cash receipts of $50 000 000,00 that are spread evenly
over the 50, 5 day working weeks in a year. Within each week, receipts on
Monday, Thursday and Friday are twice as much as those on Tuesday and
Wednesday. At present all monies are banked on Friday. A daily banking
proposal has been made. The firm estimates that the total cost of each
banking is $600,00. The firm always maintains a credit balance that is
presently receiving interest at 36 percent per annum.

Requirement
Using simple daily interest and weekly analysis, should the new proposal be
adopted?
Solution
Weekly cash receipts = $50 000 000,00/50
= $1 000 000,00
Daily rate of interest = 36/360/100
= 0.00100
Breaking down the weekly sales into daily sales
Day Factor Receipts
Monday 2 2/8 * ($1 000 000,00) = $250 000,00
Tuesday 1 1/8 * ($1 000 000,00) = $125 000,00
Wednesday 1 1/8 * ($1 000 000,00) = $125 000,00
Thursday 2 2/8 * ($1 000 000,00) = $250 000,00
Friday 2 2/8 * ($1 000 000,00) = $250 000,00
8

Computation of interest lost


Lost interest: Friday banking (current policy)
Idle
Day Receipts ($) Days Lost interest

36
Monday 250 000,00 4 0.00100 * $250 000,00 * 4 =$1 000
Tuesday 125 000,00 3 0.00100 * $125 000,00 * 3 = $ 375
Wednesday 125 000,00 2 0.00100 * $125 000,00 * 2 = $ 250
Thursday 250 000,00 1 0.00100 * $250 000,00 * 1 = $ 250
Friday 250 000,00 0 0.00100 * $250 000,00 * 0 = $ 0
$1 875

Total cost = Banking cost + Lost interest

Total cost (current policy – Friday banking)


Banking cost = $600,00 * 1 = $600,00
Lost interest = $1 875
Total cost associated with current policy = $600,00 + $1 875,00
= $2 475,00

Total cost – Proposed policy (Daily banking)


Banking cost = $600,00 * 5 + $3 000,00
Lost interest = NIL (as all proceeds will be banked daily)
Total cost = $3 000,00 + $0
= $3 000,00

The new proposal (daily banking) should be rejected as it has higher costs.

PRACTICE PROBLEMS ON CASH AND LIQUIDITY MANAGEMENT

PROBLEM 1
The managing director of your company has seen a statement in the financial
press which suggests that at all times, but particularly when liquidity is a
problem, management should pay particular attention to the cash operating
cycle.

6. What is a cash operating cycle?


7. From the information given below, prepare a memorandum for the
managing director, commenting on the cash operating cycle and
suggesting how it might be improved.

Year 1 Year 2
Stock – Raw materials 20 000 27 000
8. Work in progress 14 000 18 000
9. Finished goods 16 000 24 000
Purchases 96 000 130 000
Cost of goods sold 140 000 180 000
Sales 160 000 200 000
Debtors 32 000 48 000
Creditors 16 000 19 500
PROBLEM 2
Gamwa Ltd is a company that operates a retail outlet, oil processing and
bakery at Nyaningwe Growth point. The growth point is 60 kilometers away

37
from Masvingo, which is the nearest place, where banking facilities can be
obtained.

The current practice is to bank the receipts for the previous day on a daily
basis, i.e. 6 times a week. The company would like to review the situation
given the costs that are involved in daily banking.

It ahs been established that the company spends $100,00 on fuel and pays a
security guard $200,00 for each banking. In addition, it is estimated that the
company incurs $300,00 in lost profit because the truck is being used for
banking duties instead of other deliveries.

The proposal under review is that the company banks only on Tuesday and
Friday. On these days the company has a larger truck, which goes to
Masvingo to collect goods, therefore there would be no additional costs to the
firm in terms of furl and lost profit. The company is currently not utilizing this
truck to carry cash. If the two day banking is adopted the company would still
be required to pay the guard $200,00 for the 6 days because of a contract that
the company has with the security firm although he will be idle.

The company makes daily cash receipts of $160 000,00, 7 days a week and
any money banked is used to reduce an overdraft facility which carries an
interest rate of 36%

Requirement
10. Should the company change its banking policy?
11. What other factors would you have to take into account before making
a final decision on whether or not to change the banking policy?

PROBLEM 3
The cash balances of Northlea Investments Ltd have declined significantly
over the last 12 months. The following financial information is provided:

Year to December
2002 2003
$ $
Sales 573 000 643 000
Purchases of raw materials 215 000 264 000
Raw materials consumed 210 000 256 400
Cost of goods manufactured 435 000 515 000
Cost of goods sold 420 000 460 000
Debtors 97 100 121 500
Creditors 23 900 32 500
Stocks:
12. Raw materials 22 400 30 000
13. Work in progress 29 000 34 300
- Finished goods 70 000 125 000

All purchases and sales are made on credit.

38
Calculate the cash operating cycle for 2002 and 2003.
State the strategies that Northlea Investments Ltd can use to reduce the cash
operating cycle.
Is having knowledge on the cash operating cycle likely to be of value to an
organization? Briefly explain.

CHAPTER 4

MANAGEMENT OF DEBTORS

39
There are two important issues to look at when one looks at the management
of debtors from a financial management point of view. The first issue deals
with what the organisation looks at before granting credit to prospective
clients. The other deals with the nature of evaluation to be undertaken before
the organization can change its credit policy.

Credit granting decisions


Before the organization can grant credit to an applicant, it has to consider five
(5) “Cs”.

Character
The organisation conducts an analysis to determine if the prospective
customer will try to honour an obligation. The organization looks at the
applicant’s payment record with other entities to get an indication of the
applicant’s character.

Capacity
Capacity is the ability of an applicant to pay the obligation. To get an
indication of the applicant’s capacity the organization looks at the income
generating capacity of the applicant.

Capital
Capital in this context will be the net worth and financial position of the
applicant. Ratio analysis will be used by the organization when evaluating the
applicant.

Collateral
Collateral refers to the assets pledged by the applicants as security for the
credit facility. The organisation looks at the value and liquidity of the assets
pledged by the applicant.

Conditions
These are general macroeconomic conditions prevailing. These affect the
applicant’s ability to honour an obligation.

Credit terms
Credit terms reflect the business conditions that the organisation will have
agreed with its customers.

Consider the following: 2/10 net 30

This statement means that a debtor obtains 2 percent discount on the invoice
price if they pay within 10 days otherwise the full invoice price is due within 30
days.

Effective discount

40
Firms should set cash discounts carefully. If the cash discount is high, less
cash is received from a given sale. To establish if the discount is acceptable,
the firm has to compute the effective discount rate.

The effective discount is computed as follows;

Effective discount = Discount percentage * 365


(100 – discount percentage) (Credit period – discount period)

A firm should not give discounts whose effective rate is higher than the return
on invested funds.

EXAMPLE
A firm considers a return on investment of 35 percent as adequate. Given this
required rate of return, are the following credit terms: 2.10 net 30 acceptable?

Solution
Compute the effective discount rate and compare it with the required rate of
return.

Effective rate = 2/[100 – 2] * 365/[30 – 10]


= 2/98 * 365/20
= 0.0204 * 18.25
= 37.24%

These credit terms are unacceptable as the effective discount rate is higher
than the required rate of return on investment.

CHANGING CREDIT TERMS


Credit terms in operation at one time may not always remain ideal terms for all
times to come. Because of changing circumstances, it may become
necessary to evaluate the need to change credit terms.

The following circumstances may trigger the need for change of policy:
1) Customer complains.
2) Changes in environment and competition.
3) Observation from the credit control department.

EXAMPLE
Management of Jive Investments Ltd is considering changing the credit policy
to attract customers who have moved to competitors with more favourable
terms. The firm, which sells all goods on credit, presently sells 135 000 units
at a price of $20,00 per unit. The change in credit policy would result in an
increase in the number of units sold to 160 000 but the price will remain the
same.

The present terms offered by the firm are 1/10 net 20. The suggested credit
terms are 3/15 net 45. At present 25 percent of the customers take advantage
of the 1 percent discount. With the new policy it is expected that 30 percent of
the customers will take advantage of the new discount.

41
The average collection period is expected to increase from the current 18
days to 45 days. The variable cost ratio is 80 percent and is expected to
remain unchanged. The bad debt loses are expected to change from 5
percent to 1.5 percent of sales for which cash discounts are not taken. The
opportunity cost associated with an investment in working capital is 30
percent per annum.

Required
Evaluate the proposal and indicate to management if the new policy should be
implemented.

Solution
A change in policy affects sales, debtors, bad debts and cash discounts.

Sales
The organisation should be interested in a change in contribution.
Computation of contribution per unit:
Unit selling price $20,00
Unit variable cost (80% * $20,00) 16,00
Contribution per unit 4,00

Change in contribution = Change in units * contribution per unit


= 25 000 * $4,00
= $100 000,00

Bad debts
Bad debts = Credit sales for which discount is not taken * bad debt percentage (%)
= Sales * (1 - % of customers taking discount) * Bad debt percentage

Bad debts before change


Credit sales = 135 000 * $20,00
= $2 700 000,00

Bad debts = $2 700 000,00 * (1 – 0,25) * 5/100


= $2 700 000,00 * (0.75) * (0.05)
= $101 250,00

Bad debts after change


Credit sales = 160 000 * $20,00
= $3 200 000,00

Bad debts = $3 200 000,00 * (1 – 0.30) * 1.5/100


= $3 200 000,00 * (0.70) * (0.015)
= $33 600,00

Decrease in the level of bad debts = $101 250,00 - $33 600,00


= $67 650,00

Cash discounts

42
Cash discount = Sales * Percentage of customers taking discount * discount
percentage.

Discounts before change = $2 700 000,00 * 25/100 * 0.01


= $6 750,00

Discounts after change = $3 200 000,00 * 30/100 * 0.03


= $28 800,00

Change in discount = $6 750,00 - $28 800,00


= ($22 080,00)

Carrying cost of debtors


The carrying cost of debtors is computed in two parts: the carrying cost of
incremental sales and the carrying cost of old sales.

Carrying cost of incremental sales


Carrying cost of incremental sales = (New ACP/365) * cost of incremental sales *
opportunity cost of funds.

Cost of sales = Change in sales * variable cost ratio


= $500 000,00 * 0.80
= $400 000,00

Carrying cost of incremental sales = 45/365 * 4400 000,00 * 0.30


= ($14 794,52)

Carrying cost of old sales = (Change in ACP/365) * old sales * opportunity cost

Carrying cost of old sales = (45 – 18)/365 * $2 700 000,00 * 0.30


= 27/365 * $2 700 000,00 * 0.30
= ($59 917,81)

Change in debtor carrying cost = ($14 794,52) + ($59 917,81)


= ($74 712,33)

Summary
$
Change in contribution 100 000,00
Change in debtor carrying costs (74 712,33)
Change in bad debts 67 650,00
Change in cash discounts 22 050,00
70 887,67

The policy should be implemented.

43
PRACTICE PROBLEMS ON MANAGEMENT OF DEBTORS

PROBLEM 1
The directors of Tawedzerwa Ltd are considering changing their credit policy
to attract customers who have moved to their competitors with favourable
credit terms.

The current policy calls for 3/15 net 30. Of the current $2,6 million sales, $2,4
million are on credit and 70 per cent of the customers take advantage of the 3
per cent discount. The new credit policy would call for 5/10 net 60 and only 60
per cent of the customers are expected to take advantage of the cash
discount. The average collection period is expected to increase from the
current 20 days to 30 days. Sales are expected to increase to $2,9 million if
the new credit terms are used, with cash sales remaining constant. The gross
profit margin of 20 per cent is expected to remain unchanged, as well as the
bad debt losses which amount to 2 per cent of sales for which cash discounts
are not taken.

The opportunity cost associated with an investment in working capital is 20


per cent per annum.

Requirement
Make calculations to show the effect of these changes, and to advise the
directors whether they would be financially justified to change the policy, and
State what factors should the directors consider before changing the credit
policy.

PROBLEM 2
A firm is trying to decide whether to change its credit policy in order to meet
increased foreign competition. The present credit terms of the firm are 2/5 net
30. The firm makes sales of $2 400 000 annually, the average collection
period is 36 days and 20% of customers take the discount. The bad debts are
1.5% of sales for which a discount is not taken.

The alternative that is being considered by the firm is to change the credit
terms to 3/15 net 45. This is expected to increase sales to $3 000 000
annually, increase the average collection period to 48 days, decrease bad
debts by 0.5% and increase customers taking discount to 40%.

In addition it is expected that because of the increased sales the amount of


cash held by the firm will increase by $50 000 and the amount of inventories
by $100 000.

If the cost of the short term financing is 30% and the firm’s variable cost ratio
is 75% determine whether the firm should adopt the new policy.

CHAPTER 5

44
INVENTORY MANAGEMENT
Inventories are idle goods in storage waiting to be used. They include raw
materials, work in progress and finished goods.

Importance of inventories
1. Inventories act as a buffer to decouple or uncouple the various
activities of the firm so that all do not have to be pursued at exactly the
same rate. These activities are purchasing, production and selling.
2. Inventories smooth out time gap between supply and demand.
3. Holding inventories may contribute to lower production costs. This is as
a result of bulk purchases.
4. Inventories provide a way of “storing” labour (make more now, free up
labour later).
5. Inventories can provide quick customer service (convenience).

Objective of inventory management


The basic objective of inventory management is to establish optimal levels of
investment in inventories.

Inventory management techniques/models

ABC Classification
Storeroom inventory is classified into categories called ABC.

“A” These are items of the highest priority. They are outstandingly important
and require the tightest controls. They require close follow up and accurate
records. 10 percent of the category A items volume accounts for 70 percent of
the total inventory value.

“B’’ These are items of average importance. The items are the priority when
low or out of stock. Normal controls are used and good records should be
maintained for these items. ‘’B’’ items account for 20 percent of the total
inventory value and 20 percent of the inventory volume.

“C” These are relatively unimportant items. They are items of lowest priority.
They require the simplest methods of control. Minimum/Maximum controls
can be used for ordering these items. The items are usually expensed, as
there are no records for them. These items represent 10 percent of the total
value and 70 percent of the volume.

Managing inventories by ABC


ABC analysis is the method of classifying items involved in a decision
situation on basis of their relative importance. Its classification may be on the
basis of monetary value, availability of resources, and variations in lead – time
or part criticality to running of a facility. Management needs to look at a
descending dollar and volume chart in order to make decisions on ABC
analysis.

45
Economic Order Quantity (EOQ)/Re- order Quantity
The economic order quantity is the amount of orders that minimizes total
variable costs required to order and hold inventory. This decision requires a
trade off illustrated below:

Trade offs
Ordering more frequently Vs. Ordering less frequently

Higher ordering costs Lower ordering costs


Smaller average inventory Larger average inventory
Lower inventory holding costs Higher inventory holding costs

Costs of holding inventory

Ordering costs/acquisition/set – up costs


These are costs involved in preparing a purchase order or requisition form
and receiving, inspecting and recording of goods received to ensure both
quantity and quality.

Carrying costs
They are storage costs like depreciation, warehouse insurance, insurance of
inventory against fire and theft, clerical and accounting costs and opportunity
cost of funds.

EOQ Model
For every two items held in inventory, two questions have to be asked.
a) When should a replenishment order be placed?
b) How much should be ordered?

The EOQ model answers these questions.

EOQ Assumptions
There are three main assumptions associated with the EOQ model:
 There is a single product with a constant and known demand rate.
 Goods arrive at the same day they are ordered.
 No shortages are allowed. The organisation re – orders inventory when
the inventory reaches zero (0).

Q* = 2C0D
CH

Where C0 = ordering cost (fixed cost to place an order).


D = annual demand in units.
CH = holding cost per item per unit of time (e.g. per year).
Q* = optimal quantity to be ordered (EOQ).

EXAMPLE

46
A firm’s inventory planning period is one year. Its inventory requirement for
this period is 1 600 units. Assume that its acquisition costs are $50,00 per
order. The carrying costs are expected to be $1,00 per unit per year for an
item.

The firm can produce inventories in various lots as follows:


1. 1 600 units
2. 800 units
3. 400 units
4. 200 units
5. 100 units.

Which of these order quantities is the EOQ?

Method 1

Number of orders = Total inventory requirement


Order size

Average inventory = Order size


2

Inventory cost for different order quantities


1 Size of order (units) 1 600 800 400 200 100
2 Number of orders 1 2 4 8 16
3 Cost per order $50,00 $50,00 $50,00 $50,00 $50,00
4 Total ordering cost (2 * 3) 450,00 $100,00 $200,00 $400,00 $800,00
5 Carrying cost per unit 41,00 $1,00 $1,00 $1,00 $1,00
6 Average inventory (units) 800 400 200 100 50
7 Total carrying cost (5 * 6) $800,00 4400,00 $200,00 $100,00 $50,00
8 Total cost (4 + 7) $850,00 $500,00 $400,00 $500,00 $850,00

The economic order quantity is 400 units as this is the one that minimizes
total costs.

Method 2

Short – cut approach (Mathematical approach)

EOQ = 2 * 1 600 * $50,00


1
= 400 units

MATERIAL REQUIREMENT PLANNING (MRP)


This is a scheduling procedure for production processes that have several
levels of production. Given information describing the production requirements
of the several finished goods of the system, the structure of the production
system, the current inventories for each operation and the lot sizing procedure

47
for each operation, MRP determines a scheduling for the operations and raw
material purchases.

MRP is a system that dissects products into materials and parts necessary for
purchasing, inventorying, and priority planning purposes. By using a computer
a manager can analyse product design specifications to pinpoint all the
materials and parts necessary to produce the finished product. Merging this
information with computer inventory records assists management to know the
quantities of each part in inventory and when each is likely to be used. MRP
ensures that the right materials are available when needed.

MANUFACTURING RESOURCE PLANNING (MRP II)


MRP II is a well – defined formal system used in manufacturing. It is a
philosophy, which brings together all parts of the organisation using tools to
plan activities rather than reacting to circumstances.

MRP II is an established technique for making materials and other production


resources available in harmony with the organization`s production plan. It is a
system that ensures that inventory is balanced in demand. The MRP II routine
draws information from many other areas of the organization`s system, to
make suggestions about purchase and works orders that need to be placed,
and others that should be cancelled or re – scheduled. The system can run as
often as the organization wishes, and is frequently run as a daily routine.

The information provided by MRP II helps to strengthen the team – working


between production and purchasing. Panic buying and overstocking can
become a thing of the past leading to predictable prices and smoother
production. MRP II calculates requirements for goods, sub – assemblies and
raw materials and links back to the purchase order schedule.

MRP II can lead to improved inventory management and a cut in overall


programme costs.

JUST IN TIME (JIT)/ LEAN MANUFACTURING


Just in time is a manufacturing philosophy, which leads to the production of
the necessary units in necessary quantities at the necessary time with the
required quality. It is an approach to achieving excellence in the reduction of
or total elimination of waste. Waste here refers to non – value added
activities. The waste takes the following forms: overproduction, unneeded
inventory, defective products, transport and waiting time.

JIT manufacturing can be referred to as a system of enforced problem


solving. It is referred to as such since managers have the choice between
putting a huge effort in finding and solving causes of production problems, or
they can live with an intolerable level of interruptions in production. This is a
situation where one has to put huge efforts (money and personnel) and is
highly undesirable and is therefore an enforced system.

PRACTICE PROBLEMS ON INVENTORY MANAGEMENT

48
PROBLEM 1
Manikai Ltd has just been awarded a five year contract with its only customer
to buy up to 20 000 tonnes of the customer’s black peppercorn each year.
The contract allows Manikai Ltd to take delivery of any multiple of 1000
tonnes it likes at any time during the year. The supply contract stipulates,
however, that the peppercorn cannot be resold but must be used in the
company’s production of peppers. This process is carried out continuously
throughout the year.

The company estimates that ordering and receiving costs per batch of
peppercorns will amount to $500 per batch irrespective of the batch size. In
addition to the above, before the peppercorns are stored they must be
sprayed with a preserving chemical at a cost of $20 per tonne.

The peppercorns will be stored in special silos with a capacity of 1 100


tonnes. Each silo will cost $9 500 and incurs maintenance costs of $100 per
annum. The silos will have a life of five years. Other stock holding costs will
amount to $5 per tonne per annum.

The company’s cost of capital is 10%

Requirement
14. Calculate the economic order quantity, ignoring the silo costs and state
the number of orders that will be placed each year.
15. Calculate the total costs of stock holding and stock ordering per
annum.
16. Calculate how many silos should be built if it is the company’s
objective to minimize overall costs. You may assume that all cash flows
except the costs of constructing the silos occur at the end of the
relevant years. Ignore inflation and taxation.
17. Discuss the disadvantages of using the simple economic order quantity
formula.

CHAPTER 6

49
SOURCES OF FINANCE
This section looks at medium to long – term sources of finance available to
organizations.

EQUITY

Fundamental rights and privileges of equity holders


Limited liability Shareholders cannot lose more than they have
invested in organization.
Transfer rights Shareholders may give away or sell shares to
anyone they chose.
Dividends Shareholders share the profits of the company if
dividends are declared. There is no guarantee of
dividend.
Pre - emptive Shareholders have the right to subscribe
proportionately to any new share issue.
Voting Shareholders have the right to vote at annual
general meetings.
Residual claims to On cessation, shareholders have the right to
assets corporate assets after claims and other security
holders` claims are satisfied.

The advantages and disadvantages of the sources of finance will now be


discussed. The advantages and disadvantages will be looked at from the
perspective of the company since it is the company that will be in need of
financing.

Advantages of equity

Fixed contractual payment


With equity there is no fixed contractual payment. Dividend payment is not a
right to shareholders. This gives flexibility to the company in using corporate
funds.

Maturity
Perpetual equity has no maturity dates. The company need not save money
for redemption of equity.

Restrictive covenants
Debt agreements place restrictions on the company’s operations. Equity has
no such restrictions.

Disadvantages of equity

Diversity of shareholders
Each new issue brings additional owners. This increases the diversity of
interests that the company has to accommodate.

Income dilution

50
Existing shareholders share the income with new shareholders. This dilutes
earnings of present shareholders if the additional funds are not used to
generate additional income.

Non – tax deductibility of dividends


Unlike interest on debt, dividends are not tax deductible. Other things being
equal equity therefore becomes more expensive compared to debt.

Cost
A new share issue is usually more expensive than debt. This is because with
each new issue, floatation costs, underwriting and legal fees are incurred.

PREFERENCE SHARES
Preference shares are generally used because of their flexibility. Preference
dividends can be passed unlike interest on debt. In addition, issuing
preference shares does not dilute ownership.

Advantages of preference share capital

Passing dividends
Preference dividends can be passed without penalty unlike debt.

Ownership dilution
Unlike equity, preference shares do not dilute ownership.

Indenture terms
Unlike debentures, preference shares do not carry strict restrictions. This
gives flexibility to the organization, as there will not be too many restrictive
covenants.

Maturity
For perpetual preference shares there is no need to set aside funds for
redemption.

Disadvantages of preference share capital

Cost
Preference shares have a higher yield than debentures because they are
more risky than debentures.

Taxation
Dividends are not tax deductible. Interest on debt is tax deductible.

Accumulation
Passed dividends are usually cumulative.

DEBT FINANCING

51
Features
1. It carries a fixed rate of interest.
2. Interest on debt has to be paid whether profits are earned or not.
3. Debt has a preferential claim to assets in the event of liquidation.

Advantages of debt financing


Fixed cost
Interest on debt is fixed. Being fixed, debenture holders do not participate in
any residual income.

Lower yield
Yield on debentures is usually lower than that on preference shares because
of lower risk. This means that the use of debentures lowers the firm’s
weighted average cost of capital.

Control
The use of debt instead of instead of ordinary shares does not dilute control.
This is because debenture holders are lenders and are not involved in the
management of the organization unless the organisation is not up to date
obligation payments.

Taxation
Cost of debt is lowered because interest on debt is a tax – deductible
expense. This leads to tax savings by the company.

Disadvantages of debt financing


Contractual obligation
A contractual obligation (interest payment) is entered into and this results in
financial risk. There is no flexibility in terms of interest payments. Non –
payment of interest can lead to bankruptcy.

Fixed maturity
Debt financing is usually of fixed maturity and the principal has to be repaid.
This can create serious cash flow problems for the organisation when the debt
matures unless the organisation would have created a sinking fund
investment arrangement.

Restrictive covenants
Debenture agreements can stifle the company’s operations. The provisions on
dividends and further borrowing could run contrary to corporate policy.

LEASE FINANCING
A lease is a contractual arrangement under which the owner of an asset (the
lessor) agrees to allow the use of his assets by another party (the lessee) in
exchange for periodic payments (lease – rents) for a specified period of time.

Types of leases

52
Operating lease
This is an arrangement in which the lessee acquires the use of an asset on a
period – to - period basis. The period is relatively short for example 6 months
to 1 year. The lease can be cancelled at the option of the lessee. The
operating lease is generally more expensive than a financial lease.
Financial lease
A financial lease is an arrangement that involves a relatively longer – term
commitment on the part of the lessee. The lease cannot be cancelled. The
lessee is responsible for maintenance so this arrangement is less expensive
from the lessor`s point of view.

Sale and lease back


The firm sells an asset it already owns to another party and leases (hires) it
back from the buyer. It is an option preferred by firms facing liquidity
problems. This is the option that was taken by OK with their first street
building.

Direct lease
The lessee identifies the asset they would want to use and arranges for a
leasing contract with the manufacturer. The manufacturer will be the lessor
with this type of lease.

Leveraged lease (Third party lease)


The lessor borrows funds from the lender, who will normally be a financial
institution. The funds are needed to fund acquisition of the asset. The lessor
then services the debt using the lease payments charged to the lessee.

Leasing as a financing decision


Lessee’s point of view
The evaluation of leasing as a source of finance decision will be looked at
from the point of view of the lessee since it is the lessee who would be in
need for finance.

Evaluation procedure
(a) Determine the after tax cash outflows for each year under the lease
alternative. This will be arrived at by multiplying the lease payment with
the tax adjustment.

After tax lease rental = L (1 – t)

(b) Determine the after tax cash outflows for each year under the buying
alternative based on borrowing. The amount = Loan instalment (Gross
cash outflow) less tax advantage of interest (I * t) less tax shield due to
depreciation allowance.

(c) Compare the present value of the cash outflows associated with
leasing and buying alternative by employing after tax cost of debt as
the discount rate for the purpose.

53
(d) Select the alternative with a lower present value of cash outflow.

EXAMPLE
Hot Spot Ltd wishes to access a machine for 5 years. Financial institutions are
prepared to arrange a lease or lent the required amount at 14 percent to
acquire the machine.

The firm’s tax rate is 50 percent.

If leasing is chosen the organization will pay annual end of year lease rentals
of $120 000,00 for 5 years. All maintenance, insurance and other costs are to
be borne by the lessee.

If the machine is bought, at a cost of $343 300,00, the firm would have a 14
percent five year loan to be paid in five equal annual instalments, each
instalment becoming due at the end of each year. The machine would be
depreciated on a straight – line basis with no salvage value.

Required
Advise the company which option to choose assuming lease rentals are paid:
a. At the end of the year
b. In advance.

Solution
a. After tax lease payment = $120 000,00 * (1 – 0,50)
= $120 000,00 (0.50)
= $60 000,00

b. After tax cost of debt (ki) = kd (1 – t)


= 14%(0.50)
= 7%
a) Year end payments
Present value of cash outflows (leasing alternative)
After – tax lease
Year - end payment Discount factor @7% Present value
1-5 $60 000,00 4.100 $246 000,00

Borrowing alternative
Computation of loan instalment

Loan instalment = Amount of loan


PVIFA 5 years @ 14%
= $343 300,00
3.433

= $100 000,00

Determination of the interest and principal components of the loan instalment


Principal

54
Loan at the Payment outstanding at
Year Loan beginning of the Interest Principal the end of the
end instalment year on loan repayment year
1 2 3 4 (3 * 14%) 5[(20 – (4)] 6[(3) – (5)]
1 100 000,00 343 300,00 48 062 51 938 291 362
2 100 000,00 291 362,00 40 791 59 209 232 153
3 100 000,00 232 153,00 32 501 67 499 164 654
4 100 000,00 164 654,00 23 052 76 948 87 706
5 100 000,00 87 706,00 12 294* 87 706 -

*Balancing item
Depreciation = $343 300
5
= $68 660

Tax shield on depreciation = $68 600 (0.50)


= $34 330

Present value of cash outflows (Borrowing option)


Tax advantage Tax
on interest adjustment Discount
Year - Loan payment on Net cash factor Present
end instalment depreciation outflow @7% value
1 100 000 24 031 34 330 41 639 0.935 38 916
2 100 000 20 395 34 330 45 275 0.873 39 543
3 100 000 16 250 34 330 49 420 0.816 40 342
4 100 000 11 526 34 330 54 144 0.763 41 306
5 100 000 6 147 34 330 59 523 0.713 42 440
202 547

Recommendation
The organization should buy the asset outright because the present value of
buying is less than the present value of leasing.

b) Present value of cash outflows when cash lease payments are made in
advance.
If this is the arrangement, the first lease payment will be made at time zero
(now) but the tax benefit will only be enjoyed the following year.

Cash flows Discount Present


Year Lease payment Tax shield after taxes factor value ($)
0 120 000 - 120 000 1.000 120 000
1–4 120 000 60 000 60 000 3.3872 203 232
5 - 60 000 (60 000) 0.7130 (42 780)
280 452

Recommendation
It is still cheaper to borrow the funds and buy the asset outright when lease
rentals are made in advance.

55
PRACTICE PROBLEMS ON SOURCES OF FINANCE
PROBLEM 1
Water Glass enterprises (Pvt) Ltd is considering installing a computer. It is to
decide whether the computer is to be purchased outright (through 14%
borrowings) or to be acquired on lease rent basis.

The firm is in the 50% tax bracket. The other data available are:

Purchase of Computer:

Purchase price $2 000 000


Annual maintenance $50 000 per year
(to be paid in advance)
Expected economic useful life 6 years
Depreciation Straight-line method
Salvage value $200 000

Leasing of Computer:
Lease charges $450 000
(To be paid in advance)
Maintenance expenses To be borne by lessor

Payment of loan: 6 year- end equal


installments of $514 271

Requirement
Advise the company as to whether it should purchase the computer or acquire
it on lease.

PROBLEM 2
Mupunga Ltd is an industrial concern that desires to acquire a diesel
generating unit costing $2 000 000 which has an economic life of ten years at
the end of which the asset is not expected to have any residual value. The
concern is considering the alternative choices of:

taking the machinery on lease, or


purchasing the asset outright by raising a loan.

Lease payments are to be made in advance and the lessor requires the asset
to be completely amortised over its useful period and the asset will yield a
return of 10%.

The cost of debt is worked at 16% per annum. The lender requires the loan to
be repaid in 10 equal annual installments, each installment becoming due at
the beginning of the year. An Average rate of tax of 50% is to be assumed. It
is expected that operating costs would remain the same under either method.
The firm follows straight-line method of depreciation.

Requirement
As a financial consultant, indicate what your advice will be.

56
PROBLEM 3
Murambatsvina Investments is expanding its facilities. In the coming year, the
company will either purchase or lease equipment, which it plans to use for 4
years and then, replace with new equipment. Its current tax bracket is 50%.
The other data are as follows:

Purchase
The purchase price of the equipment is $4 000 000
The expected salvage value after 4 years is $1 000 000
The equipment is subject to straight line method of depreciation
Funds to finance the equipment can be obtained at 16%
The loan is to be repaid in 4 equal annual installments due at the end of each
year
The equipment will increase annual revenues by $3 000 000 and increase
annual non-depreciation operating costs by $2 000 000.

Leasing
The annual lease rent is $1 000 000
The lease rent is payable at the end of each year for 4 years
The equipment will increase annual revenues by $3 000 000 and increase
annual non-depreciation operating costs by $1 900 000 as the lessor will pay
$100 000 for the maintenance costs associated with the equipment.

Requirement
Determine whether the company should purchase or lease the equipment.

CHAPTER 7

MERGERS AND ACQUISITIONS

57
A MERGER
A merger is the joining together of two previously separate corporations. A
true merger in the legal sense occurs when both businesses dissolve and fold
their assets and liabilities into a newly created third entity. This entails the
creation of a new entity.

A TAKEOVER
A takeover is the acquiring of control of a corporation, called a target, by stock
purchase or exchange, either hostile or friendly. A friendly takeover is a
takeover, which supports the wishes of the target company’s management
and board of directors. A hostile takeover is a takeover, which goes against
the wishes of the company’s management and board of directors.

AN ACQUISITION
An acquisition is the taking possession of another business. It is the same
thing as a takeover or buyout.

RELATED TERMS – DEFINITIONS


A JOINT VENTURE
A joint venture occurs when two or more businesses join together under a
contractual agreement to conduct a specific business enterprise with both
parties sharing profits and losses. The venture will be for one specific project
only, rather than a continuing business relationship as in a strategic alliance.

A STRATEGIC ALLIANCE
A strategic alliance is a partnership with another business in which the parties
combine efforts in a business effort involving anything from getting a better
price for goods by buying in bulk together to seeking business together with
each of the parties providing part of the product. The basic idea behind
alliances is to minimize risk while maximizing leverage.

PARTNERSHIP
This is a business in which two or more individuals carry on a continuing
business for profit as co – owners. Legally, a partnership is regarded as a
group of individuals rather than as a single entity, although each of the parties
files their share of profits on their individual tax returns.

Climate for merger activity


There are certain conditions when mergers flourish. Propensity to merge
increases when industrial activity/economic activity is either high or low.

A C

58
Economic
Activity E F

B D

Business cycles

Time

A lot of mergers take place at points ABCD. In other words there is a high
incidence of merger activity at points ABCD. At points E and F there is
relatively less merger activity.

Points A and C
Once the business cycle comes up, general demand increases, increasing
business confidence. The increase in general demand creates large reserves
of capital for discretionary spending. These discretionary resources are often
used to finance expansion. At these points mergers are conducted with
aggressive intent.

Points B and D
During a recession general demand decreases. This reduces the level of
business confidence. The decline general demand reduces profit levels.
Organisations become unsure of what the future holds: hence they grow in
size for security. They want to safeguard themselves from being taken over by
other entities. At these points mergers are conducted with defensive intent.

Types/Categories of mergers
HORIZONTAL MERGER
A horizontal merger occurs when two firms in the same industry and in the
same line of business combine to form one large company essentially doing
the same business as before. Thus mergers take place between firms that are
actual or potential competitors occupying similar positions in the chain of
production.

VERTICAL MERGER
This occurs when two firms in related industries combine. The firms could be
at different levels of production or at different levels of the distribution channel.
Vertical mergers therefore take place between firms at different levels in the
chain of production for example a manufacturer and a retailer. Vertical
mergers can be defined as being either forward or backwards.

Backward integration/merger
This is a merger that is motivated by the desire to secure a source of raw
materials.

Forward integration/merger

59
This is a merger that is motivated by the desire to control a distribution
system.

CONGROMERATE MERGER This is a result of a combination of firms in


unrelated businesses.

REVERSE TAKE OVER (RTO)


Two definitions can be provided for what a reverse takeover is.

A reverse takeover occurs when a company buys out a larger company. This
is what often happens when a private company takes over a publicly listed
company. Typically, a public company that is taken over by the private
company will remain listed, and the private company will use the acquisition
as a means of gaining a listing. Reverse takeovers are usually very rare
events.

Alternatively a reverse takeover could be viewed as one way for a company to


become publicly traded, by acquiring a public company and then installing its
own management team and renaming the acquired company. A reverse
takeover is also known as a reverse acquisition.

Motives for expansion


Economies of scale
Economies of scale are all about spreading fixed cost. Mergers can bring
about economies of scale. Economies of scale can be found in all the three
types of merger. Savings will come from sharing central units such as
management and accounting services.

Merging is not always the best way of achieving economies of scale – It is


easier to buy another entity than to integrate it with existing operations
afterwards. (Century disposed Orion Insurance)

Improving efficiency
For most firms improving operations for example financial management could
increase earnings. Firms like these become targets for acquisition by other
firms with better management. If a firm is not doing well this will be reflected in
a lower share price that could encourage a takeover bid.

Inefficiencies can be ironed out by other methods that are not easy for
example sackings. These are easier after a restructuring because managers
do not generally demote or sack themselves.

Tax relief
A company may be unable to claim tax relief through not generating profits. It
may therefore wish to combine with another firm or firms, which are
generating taxable profits.

Profitable investment opportunities

60
A firm may be generating a substantial amount of cash but having a few
profitable investment opportunities (investments which yield more than the
opportunity cost of capital). This firm could therefore use the surplus cash to
acquire another company. This is because if the company does not make an
acquisition, someone else may acquire the company instead, because of its
lucrative cash resources, and re - deploy the organisation`s cash resources
for them.

Using complementary resources


Many small firms may have a unique product but lack the engineering and
sales organizations necessary to produce and market it on a large scale.
Such firms may merge with a larger company. Both companies benefit. The
small firm has an instant engineering and marketing department and the
larger company obtains the revenue and benefits, which the unique product
can bring.

Diversification
Mergers can result in risk reduction because when diversifying firms combine
with those having returns that are negatively collated to their revenue
streams.

But others argue that this is spurious (dubious and not genuine) as the major
objective should be wealth maximization and not risk reduction. Remember
risk reduction leads to reduced profits. In any case critics argue that
shareholders themselves could do that diversification.

Lower cost of finance


By pooling their sources of funds, one or more companies may reduce their
costs. The cost of raising a new issue of equity or debt can be high. A small
company may have profitable investment opportunities, which it cannot
support due to inability to gain access to the capital markets. In such cases a
merger may be an attractive proposition.

Unused debt capacity


It is also suggested that a firm becomes vulnerable to a takeover if it does not
make full use of its borrowing capacity. This is because of considerable
advantages to borrowing through the tax deductibility of interest. The tax
deductibility of interest increases the value of the firm.

Undervalued securities
One reason also given to justify a merger is that the securities of the acquiree
are “undervalued”. The proposition is however dangerous. If management
believes that they can identify such companies, which are undervalued, they
should buy such shares in a wide variety of such companies. It is not
necessary to have to acquire and manage other companies merely to take
advantage of any under valuation.

Other reasons for expansion

61
(a) To increase market power
(b) To build an empire
(c) To expand production without price reduction
(d) To acquire capacity at reduced prices (acquisition of undervalued
shares)
(e) Quicker entry into new market
(f) To acquire key personnel on sites

VALUATION OF THE TARGET FIRM


The valuation of the target firm is needed because it provides the basis for
negotiating the price to be paid at acquisition. There are two approaches that
could be used to value a target firm.

Use of market values


For a quoted company the current market values can be used. When this
approach is adopted, the value of the firm will be obtained as follows:

Value of target firm = Current price per share * number of outstanding shares

EXAMPLE
The following information is given:
Current market value of share $37,00
Number of shares in issue 12 000 000
What is the value of the firm?

Solution

Value of the firm = $37,00 * 12 000 000


= $444 000 000

The Net Asset value method


The value for each share for purposes of negotiation will be arrived at as
follows:

Value per share = Total Assets (at revised book values) – total liabilities assumed
Number of shares in issue

EXAMPLE

62
C Ltd. is considering acquiring D Ltd. The owners of D Ltd. Have supplied C
Ltd. with the following balance sheet data to help in the valuation process.
D Ltd.

Balance Sheet as at 31 December 2003


Assets: Land and buildings 5 000 000
Plant and machinery 12 000 000
Investments 2 000 000
Goodwill 500 000
19 500 000

Current assets: Cash 60 000


Debtors 5 000 000
Stock 2 500 000
7 560 000
Current liabilities: Creditors (3 600 000)
Bank overdraft (1 250 000)
Net current assets 2 710 000
22 210 000

Financed by: Ordinary shares of $0.50 each 4 000 000


Reserves 9 500 000
15% Preference shares 2 210 000
12% Debentures 6 500 000
22 210 000

1.The land and buildings can be rented at a current rental of $1.6million per
annum in perpetuity. The required rate of return on such property is 20%.
2.The plant and machinery can only be liquidated at a price of $10million but
have a replacement value of $20million.
3.The debentures are irredeemable, have a par value of $100.00 and their
current required rate of return is 20%
4.Preference shares are trading at 75 cents and have a par value of $1.00.
5.The firm’s investments are for speculative purposes and have a current
market value of $1.35million.
6. $500 000.00 worth of debts are thought to be irrecoverable.
7.A stock check revealed that the stock is actually worth $2 2500 000.00.
8.The bank could still advance the overdraft in case of a take over.

Requirement
How much should C Ltd. Offer as a minimum price for each ordinary share in
D Ltd?

Solution

63
$
ASSETS
Land and buildings $1 600 000/0.20 8 000 000
Plant and machinery 10 000 000
Investment 1 350 000
Cash 60 000
Debtors $5 000 000 - $500 000 4 500 000
Stock 2 250 000
26 160 000
LIABILITIES (10 407 500)
Creditors 3 600 000
Bank overdraft 1 250 000
Preference shares 2 210 000 * $0.75 1 657 500
Debentures [12/100 * $6 500 000]/(0.20) 3 900 000
15 752 500
Ordinary shares outstanding 8 000 000
Value per share $1,97

METHOD OF PAYMENT
Payment for a merger can be by cash, ordinary shares, debentures and
preference shares.

Cash offers
Cash is paid to shareholders of the target firm.

Advantages to the shareholders of the target firm


(a) The price they will receive is obvious. In a share offer the movement in
share price will affect their wealth.
(b) Use of cash gives shareholders the freedom to invest in any alternative
investment without incurring transaction costs of selling shares.

Disadvantages to the shareholders receiving the cash


i. They immediately become liable to any capital gains tax that
may have arisen. This is not the case if they receive shares in
exchange.
ii. They may well receive less in a cash offer from a share issue.
Empirical evidence suggests this. This is the case if the value of
the share increases after the takeover.

Advantages to the purchasing company


1. It often represents the only quick, reasonable approach to use when
resistance is expected.
2. It normally increases its own earnings per share.
3. It causes less dilution of ownership.

Disadvantages for the purchasing company


a) Its liquidity is reduced. Sometimes a company’s liquidity position may
be low and during times of a financial squeeze, there may be no credit
available.

64
b) If a cash purchase is considered when liquidity is poor, the company
may have to sell more assets in order to realize the needed funds.

MERGER AS A CAPITAL BUDGETING DECISION


A merger decision is a capital budgeting decision. Being a capital budgeting
decision appropriate capital budgeting evaluation techniques have to be used
to evaluate a potential take over. This section will highlight how the net
present value technique can be used to make such an evaluation.

EXAMPLE
The summarized Balance Sheet of Target Ltd as at 31 December 2003 is
given below.

BALANCE SHEET AT 31 DECEMBER 2003


$
ASSETS
Non – current assets 2 000 000
Property, plant and equipment 1 900 000
Investments 100 000

Current assets 1 000 000


Inventories 500 000
Debtors 400 000
Bank 100 000
3 000 000
TOTAL ASSETS

EQUITY AND LIABILITIES


Capital and reserves 2 500 000
200 000Ordinary shares of $10,00 each 2 000 000
Retained earnings 400 000
13% Preference shares 100 000
300 000
Non – current liabilities 300 000
12% Debentures
Current liabilities 200 000
Current liabilities 200 000
3 000 000
TOTAL EQUITY AND LIABILITIES

Negotiations for the take over of Target Ltd result in its acquisition by A Ltd.
The purchase consideration consists of:
(a) $330 000 13% Debentures of A Ltd for redeeming the 12% Debentures
of Target Ltd.
(b) $100 000 12% Convertible preference shares in A Ltd for the payment
of the preference share capital of Target Ltd.
(c) 150 000 equity shares in Target Ltd to be issued at its current market
value of $15,00.
(d) A Ltd would meet dissolution expenses estimated to cost $30 000.

65
The break – up figures of eventual disposition by Target Ltd of its unrequired
assets and liabilities are:
(iii) Investments $125 000
(iv) Debtors $350 000
(v) Inventories $425 000
(vi) Payment of current liabilities $190 000.

The project is expected to generate operating cash flow after tax of $700 000
for 6 years. It is estimated that fixed assets of Targets Ltd would fetch $300
000 at the end of year 6.

The firm’s cost of capital is 15%.

Requirement
As a financial consultant, comment on the financial prudence of the merger
decision by A Ltd.

Solution
Computation of the cost of acquisition
$
13% Debentures 330 000
12 % Convertible preference shares 100 000
Equity share capital (150 000 * $15,00) 2 250 000
Dissolution expenses 30 000
Payment of current liabilities 190 000
(2 900 000)
Proceeds from sale of assets 1 000 000
Investments 125 000
Debtors 350 000
Inventories 425 000
Bank balance 100 000
($1 900 000)

Benefits of acquisition
Cash flow after tax (1 – 5) $ 700 000
Cash flow after tax (6) ($700 000 + $300 000) $1 000 000

Present value computation


Discount factor Present
Year Cash flow ($) @15% Value ($)
0 (1 900 000) 1.0000 (1 900 000)
1–5 700 000 3.3522 2 346 540
6 1 000 000 0.4323 432 300
878 840

R Ltd is expected to benefit from the merger of Target Ltd, as the NPV is
positive.

66
SHARE SWAP
Where the mode of payment is a share swap, a suitable exchange ratio is
needed. The market price per share (if available) or the earnings per share
may be used to establish the exchange ratio.

EARNINGS PER SHARE


XYZ Company wants to acquire ABC Ltd by exchanging its 1.6 shares for
every share of ABC Ltd. XYZ anticipates to maintain the existing price
earnings ratio subsequent to the merger also. The relevant financial data are
furnished below:

XYZ Company ABC Ltd


Earnings after taxes (EAT) $1 500 000 $450 000
Number of equity shares outstanding (N) 300 000 75 000
Market price per share (MPS) $35,00 $40,00

Requirement
- What is the exchange ratio of market prices?
- What is the pre- merger EPS and the P/E ratio for each company?
- What was the P/E ratio used in acquiring ABC Ltd?
- What is the EPS of XYZ Company after the acquisition?
- What is the expected market price per share of the merged
company?
Solution
(a) Exchange ratio = Market price of Acquirer
Market price of acquiree
= [1.6 * $35]
1 * $40
= 1.40

(b) EPS and P/E ratio


XYZ Company ABC Ltd
(a) EAT $1 500 000 450 000
(b) N 300 000 75 000
(c) EPS (a)/(b) $5,00 $6,00
(d) P/E ratio (MPS/EPS) 7 times 6,67 times

(c) Implied P/E ratio in acquisition of ABC Ltd.

= Market price offered to acquiree


Current EPS of Acquiree

= $56,00 (1,6 * $35,00)


6
= 9,33 times

(d) EPS of XYZ Company after merger

67
= $1 500 000 + $450 000
300 000 + 120 000 (1,6 * 75 000)

= $1 950 000
420 000

= $4,64

(e) Expected market price after merger

= $4,64 * 7 times

= $32,48

FIGHTING OFF A HOSTILE OFFER


A hostile offer is an unwelcome offer. The following techniques can be used to
fight a hostile offer.

Use of proxies
The acquiring firm asks individual shareholders to sign over their proxies. The
proxies are then used at a shareholders meeting discussing the proposed
take – over. The directors of the acquiree on the other hand would seek
proxies to fight the take over. This results in a proxy war.

Direct discouragement of shareholders


Shareholders of the target firm are discouraged from accepting the offer.
Media space or individual letters are written to shareholders discouraging
them from accepting the take over.

Increasing dividend paid by the firm


The directors of the target firm can increase dividends to entice shareholders
from parting with their investment (shares).

Disclosure of more information


The directors of the target firm can disclose information like revised profit
forecast having higher profitability levels or assets may be revalued upwards.

Issuing bonus shares


The directors of the target firm can also issue bonus shares. This increases
the number of shares shareholders from the target firm would be having. This
may compel them to think twice before deciding to support a potential take –
over.

Initiating a share split


Sometimes the directors can also initiate a stock split. This increases the
number of shares in circulation making it difficult fir the acquirer to gain
control.

68
Finding external help (White knight)
The target firm may look for a white knight. This is a company, which the
company approaches with the aim of being taken over.

Raising legal issues


If the intended merger creates a monopoly, the target firm may raise
regulatory issues and use these to fight off the intended acquisition.

Issuing more shares


The greater the number of shares, the more difficult it is to gain control of the
company.

Changing articles
A change from a simple majority to a super majority may be effected to the
articles to make it difficult to get the support to sanction the transaction.

Poison pills
A poison pill is a suicidal move that makes the firm unattractive to purchase.
The following are examples of the poison pills.
i. Borrowing at terms that require immediate payment of debt if the firm is
involved in a merger.
ii. Selling of some of the company’s most prized assets (crown jewels)
making the firm unattractive without the assets.
iii. Granting golden parachutes to its executives in case of a take over. A
golden parachute is a large cash drain on the firm if it is involved in an
acquisition.

REASONS FOR BUSINESS FAILURE


In general terms a failing business is one which is failing to meet its financial
obligations. Businesses fail because of a number of reasons.

Poor marketing
Successful businesses are those that understand and meet their customer’s
requirements. Detailed market research is essential for new and expanding
businesses. Details relating to potential size of the market, extent of
competition, customer preferences and tastes are important. Lack of market
research when entering new markets results in poor sales and return on
investment.

Cash flow problems


Many businesses struggle because of poor cash flow management. It is not
enough to have a good idea and a good product without the necessary short-
term finances. Many businesses try to grow too quickly and end up borrowing
too much money externally resulting in crippling interest payments and
repayment charges.

Poor business planning

69
A business plan should cover aspects such as marketing, finance, sales and
promotional plans as well as detailed breakdowns of costings and profit
predictions. Failing to plan is planning to fail.
Lack of finance
Insufficient finance means that the business will be unable to take
opportunities that are available to them.

Failure to embrace new technologies and new developments


In a fast changing world businesses that succeed are the ones that make best
use of advanced modern technologies in an appropriate way. If a business
operates with outdated technologies and methods frequently it finds itself at a
cost disadvantage hence it cannot compete with its more dynamic rivals.

Poor management
Weak and inexperienced management is one of the major causes of business
failure. Managers need to understand their customers, make correct financing
decisions and understand the business that they are in if they are to be
successful.

Poor human resource relations


Poor human resource relations can be a cause for failure. Successful
businesses motivate their employees to work hard to help the business to
succeed.

Lack of clear objectives


Successful businesses have clearly focused and communicated objectives
that enable everyone in the organization to pull in the same direction.

Failure to pay taxes

Overspending
Spending too much on frivolous luxuries instead of products or services that
improve the bottom line can lead to business failure.

Lack of innovation
Some businesses never change; they lose their market share when a new
company comes along with a new way of doing things.

Growing too quickly or too slowly


Growing too quickly leads to overtrading (getting too much stock). Growing
too slowly leads to under trading (too little stock).

Signs of business failure


The following are signs of business failure:
Diminishing bank balances
Hiding or ignoring problems
Product failure or service quality
Lack of specialist staff
- Poor or lack of communication with banks

70
PREDICTION OF BUSINESS FAILURE

When financial ratios are used correctly they can act as very powerful
indicators in the interpretation of financial statements. In the analysis of
corporate stability and the detection of potential corporate failure ratios can
also be used as Z- scores.

Z- Scores A Z – score equation consists of a number of ratios, which are


weighted according to their perceived usefulness and then added together.
When the equation is applied to a company’s financial statements it will result
in a single value, which is the Z – score.

The Z- score for any given company can be compared with the threshold
value above which the company can be classified as safe but below which it
should be considered as candidate for failure. This threshold is applicable to
companies in many different industries.

It is generally accepted that Z-score do exhibit some predictive power of


corporate failure. There are a number of equations in existence:

(a) Altman’s Z – score


(b) Robertson’s Z - score

THL LTD: Profit and loss account for the year ended 31 December 1997

19x7 19x6
$000 $000
Turnover 15 955 17 160
Cost and expenses (15 093) (15 458)
Depreciation (429) (483)
Profit on sale of Investments 85 -
Interest receivable 545 520
Government grants 41 83
Profit before taxation 1 104 1 822
Taxation (416) (542)
Profit on ordinary activities after tax 688 1 280
Dividends (552) (535)
Retained Profit 136 745

71
Balance sheet as at 31 December 1997

19x7 19x6
$000 $000
Fixed assets:
Tangible fixed assets 3 249 2 722

Current assets:
Stocks 2 624 2 255
Debtors 2 878 3 678
Investments - 406
Cash at Bank and in Hand 7 072 6 726
Total current assets 12 574 13 065

Current liabilities:
Creditors 4 116 3 890
Net current assets 8 458 9 175
Net capital employed 11 707 11 897

Capital and Reserves:


Called up share capital 1 424 1 424
Share premium account 15 15
Revaluation Reserve 1 249 1 258
Other Reserves 333 334
Profit and loss account 7 965 7 908
Shareholders’ funds 10 986 10 939
Provision for liabilities and charges
Deferred taxations 630 830
Deferred income
Government grants 91 128
Net Capital employed 11 707 11 897

1. ALTMAN’S Z – SCORE

Professor Altman devised the original Z – Score equation in 1968:

Z = 1.2x1 + 1.4x2 + 3.33+ 0.6x4 + 1.0x5

Where Altman selected ratios are:

X1 = Working capital
Total Assets

X2 = Retained earnings
Total Assets

72
X3 = Profit before Interest and Tax
Total Assets

X4 = Market Capitalisation
Book value of Debts

X5 = Sales
Total Assets

Definitions used in the ratios are as follows:

Working capital = Current assets less current liabilities.


Total Assets = Fixed assets + Investments + Current Assets.
Retained earnings = Accumulated reserves.
Market capitalization = Number of shares x share price (or book value of
equity, reserves and preference if not quoted).
Book value of debt = All debt – short –and long term.

The pass mark for Altman’s Z is stated as 3.0.

Companies scoring above this score are considered safe whilst companies
scoring below 1.8 should be considered potential failures. Altman believes
that the Z score equation can distinguish between ‘safe’ and ‘potential failures’
up to 2 to 3 years before the actual event.

Example of Z score: THL Private Limited Company

19x6 19x7
X1 = Working Capital = 9 175 8 458
Total assets 2 722+ 13 065 3 249 + 12 574
= 0.581 = 0.535

X2 = Retained earnings = 7 908 7 965


Total assets 15 787 15 823
= 0.501 = 0.503

X3 = PBI and Tax = 1 822- 520 1 104 - 545


Total assets 15 787 15 823
= 0.082 = 0.035

X4 = Market Capitalisation = 10 939 10 986


Book value of debt 3 890 + 830 4 116+ 630
= 2.318 = 2.315

X5 = Sales = 17 160 15 955


Total assets 15 787 15 823
= 1.087 = 1.008

Z – Score (19x6) = 1.2 (0.581) + 1.4 (0.50)+ 3.3(0.082)+ 6(2.318) + 1.0(1.087)

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= 0.6972 + 0.7014 + 0.2706 + 1.3908 + 1.087
= 4.147

Z – Score (19x7) = 1.2(0.535)+1.4(0.503)=3.3(0.035)+0.6(2.315)+1.0(1.008)


= 0.642 + 0.7042 + 0.1155 + 1.389 + 1.008
= 3.859

According to the Altman’s pass mark, both the scores imply that THL Private
limited company is safe.

2. ROBERTSON’S Z – SCORE

This score concentrate on the rate of change in the score from one year to
another. To interpret the results of the Z – Score technique Robertson found
that if the score falls by 40% or more in any year, then any changes have
occurred in the financial health of the company. Consequently the company
should carry out immediate investigations to identify the cause of the deadline
and hopefully stop it.

If the score falls by 40% or more for a second successive year, the company
is likely to face liquidation unless major changes are carried out.

Z = 3.0x1 + 3.0x2 + 0.6x3 + 0.3x4 + 0.3x5


Where X1 = (sales – Total assets)
Sales

X2 = Profit before tax


Total assets

X3 = (Current assets – Total Debt)


Current liabilities

X4 = (Equity – Total Borrowings)


Total Debt

X5 = (Liquid assets – Bank Overdraft)


Creditors

19x6 19x7
X1 = (Sales – Total assets) = (17 160 – 15 787) (15 955- 15 823)
Sales 17 160 15 955
= 0.080 = 0.008

X2 = Profit before tax = 1 822 1.104


Total assets 15 787 15 823
= 0.115 = 0.070

X3 = (Current Assets –Total Debt)=(13 065 – 4 746) (12 574-4 720)

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Current liabilities 3 890 4116
= 2.139 = 1.908

X4 = Equity – Total Borrowings = (10 939 – 4 746) (10 986 – 4 720)


Total Debts 4 746 4720
= 1.305 = 1.328

X5 = Liquid assets – Bank O/D = (3 678 + 6 726) (2 878 + 7 072)


Creditors 3 890 4116
= 2.675 = 2.417

Z–Score (19x6) = 3.0 (0.080)+3.0(0.115)+0.6 (2.139) + 0.3(1.305)+0.3(2.675)


= 3.062

Z-Score (19x7)= 3.0(0.008)+ 3.0(0.070)+ 0.6(2.139)+ 0.3(1.305)+0.3(2.675)


= 2.502

The change in the Z Score from 19x6 to 19x7 is a fall of 18.3% (3.062 –
2.502) / 3.062 x 100%. Even though it is a drop in value there is no real cause
for concern as the threshold value is a fall of 40%.

REORGANIZATION PLANS FOR FAILING BUSINESSES


There are a number of reorganization plans or turnaround strategies that can
be adopted to revive failing businesses.

Changing leadership
Old leadership will be associated with failure and new leadership will be
required. In any event old leaders may be unwilling to implement turnaround
strategies.

Redefining strategic focus


Sometimes a reevaluation of a company’s business level strategy may be
undertaken. A failed cost leader may reorient toward a more focused or
differentiated strategy. For a diversified organization redefined strategic focus
means identifying businesses with best long-term profit and growth prospects
and concentrating in these.

Asset sales and closures A failing business can divest as many unwanted
assets as possible. Unwanted but profitable assets may bring in the much-
needed cash, which is then invested in improving the remaining lines of
operation.

Improving profitability
Failing businesses can also try to improve their profitability. Profitability of the
operations that remain may be improved by:
1. Laying off white and blue collar employees
2. Investing in labour saving equipment
3. Tightening financial controls
4. Cutting back on marginal products
5. Reengineering business process to cut costs and boost productivity

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6. Introduction of total quality management processes.

Acquisitions
This may be a surprising strategy but it is a common turnaround strategy.
It involves making acquisitions primarily to strengthen the competitive
position of a company’s remaining core operations.

PRACTICE PROBLEMS ON MERGERS AND TAKE OVERS

PROBLEM 1
You have been provided the following financial statements of two companies:

Trust Ltd Anger Ltd


Earnings after taxes $700 000 $1 000 000
Equity shares outstanding $200 000 $400 000
Earnings per shares $3,50 $2,50
Price-earnings ratio 10 times 14 times
Market price per share $35,00 $35,00

Anger Ltd is the acquiring company, and exchanging its shares on a one-for-
one basis for Trust Ltd’s shares. The exchange ratio is based on the market
prices of the shares of the two companies.

18. What will EPS be subsequent to the merger?


19. What will be the change in EPS for the shareholders of Trust Ltd and
Anger Ltd?
20. Determine the market value of post-merged firm.
21. Ascertain the gain accruing to shareholders of both the firms.

PROBLEM 2
A Ltd decided to take over the business of T Ltd as at 31 December (current
year); the summarized balance sheet of T Ltd as at that date was as follows:

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Assets $
Land and buildings 300 000
Plant and machinery 580 000
Inventories 70 000
Debtors 35 000
Bank 15 000
1 000 000
Liabilities
Equity share capital 500 000
(50 000 shares of $10,00 each)
General reserve 250 000
Profit and loss 120 000
13% Debentures 100 000
Current liabilities 30 000
1 000 000

Additional information
A Ltd agreed to take over all the current assets at their book values but the
fixed assets were to be revalued as under for the purpose:
* Land and buildings, $500 000
* Plant and Machinery, $500 000
* These sums apart, A Ltd is required to pay $50 000 for goodwill
and also to bear dissolution expenses of $10 000 (to be paid
directly by A Ltd).

The expected realization from current assets (other than bank balance) is $90
000.
Purchase consideration was as $130 000 in cash to pay 13% debentures and
other liabilities and the balance is to be paid in equity shares of A Ltd.
Expected benefits (CFAT) accruing to A Ltd are as follows:

Year CFAT
1 $200 000
2 $300 000
3 $260 000
4 $200 000
5 $100 000

Further it is estimated that the market value of T Ltd’s fixed assets would be
$600 000 (Land and buildings) and $40 000 (Plant and machinery) at the end
of 5th year.

The cost of capital of T Ltd is 25%.

Requirement
Do you think A Ltd is likely to be benefited by taking over T Ltd?

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PROBLEM 3
The following is the balance sheet of XYZ Co. Ltd as at 31 December (current
year) as follows:

Assets $
Plant and machinery 250 000
Furniture and fittings 5 000
Inventories 90 000
Debtors 25 000
Bank balance 10 000
380 000
Equity and liabilities
Equity share capital 200 000
(10 000 shares of $20,00 each)
13% Debentures 100 000
Retained earnings 50 000
Creditors 30 000
380 000

The company is absorbed by ABC Co. Ltd at the above date. The
consideration for the absorption is the discharge of debentures at a premium
of 10%, taking over the liability in respect of sundry creditors and a payment
of $14,00 in cash and one share of $10,00 in ABC Ltd at the market value of
$16,00 per share in exchange for one share in XYZ Co. Ltd. The cost of
dissolution of $10 000 is to be met by purchasing company.

Inventories are expected to realize $100 000 and expected collection from
debtors are $20 000.

Expected yearly benefits/CFAT from the business of XYZ Ltd are $150 000 for
five years; Assuming zero salvage value of fixed assets and firm’s cost of
capital of 14%, comment on the financial soundness of the ABC’s
management decision regarding the merger.

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PRACTICE PROBLEMS ON BUSINESS FAILURE
PROBLEM 1
Mouth Ltd is contemplating taking over Teeth Ltd. The following balance
sheet, income statement and notes have been made available:

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Balance Sheet
Assets $
Land and buildings 12 600 000
Plant and equipment 6 400 000
Investments 3 200 000
Total 22 200 000
Current assets
Cash 100 000
Debtors 1 400 000
Stock 800 000
Total 2 300 000

Total assets 24 500 000

Liabilities and Owners Equity

Current liabilities
Creditors 1 600 000
Short term borrowing 900 000
Total 2 500 000

Long term borrowing 8 000 000


Preference stock (22% cumulative) 4 000 000

Ordinary shares (50 cents) 1 500 000


Reserves 8 500 000
Total Equity 10 000 000

Total Liabilities and Owners Equity 24 500 000

Income Statement
$
Turnover 20 000 000
Operating income 3 800 000
Interest 2 500 000
Net income 300 000

Notes:
Land and buildings have a current market value of $15 million.
Equipment has a current value of $2 million but would require $11 million to
replace.
3 Investments are 1 million shares that have just paid an annual dividend of
20 cents per share. The dividend is expected to have a constant growth of
12% for the foreseeable future and the required rate of return on this
investment is 20%.
Long-term borrowing is through $100 par, 20% coupon debentures that have
a current yield of 24%. The debentures have 20 years to maturity.
Preference stock is privately placed and there is $200 000 in accumulated
dividends.

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Calculate the debt to equity ratio (D/E), current ratio (CR), times interest
earned (TIE), and net profit margin (NPM) and comment on the financial
viability of the company given industry average ratios of:
Debt to equity 40%
Current Ratio 2.05
Times Interest Earned 6x
Net Profit Margin 8%

You have determined that the following equation is able to differentiate those
companies that are likely to go bankrupt and those that will not go bankrupt.

Z = -0.01098D/E + 1.25CR + 0.1234TIE + 0.0275NPM

And that a company with a score of less than 2.0 is likely to go


bankrupt.

Determine whether the above company is likely to go bankrupt.

Using the net asset value approach determine the price per share that the
company should be prepared to pay the other company.

CHAPTER 9

INTRODUCTION TO INTERNATIONAL FINANCIAL MANAGEMENT

THE FOREIGN EXCHANGE MARKET


The foreign exchange market provides the physical and institutional
environment in which foreign exchange is traded, exchange rates determined

81
and foreign exchange management is implemented. The foreign exchange
market spans the globe.

FUNCTIONS OF THE FOREIGN EXCHANGE MARKET


The foreign exchange market is the mechanism by which one may transfer
purchasing power between countries, obtain or provide credit for international
trade transactions, and minimize exposure to the risks of exchange rate
changes.

Transfer of purchasing power


Transfer of purchasing power is necessary because International trade and
capital transactions normally involve parties living in countries with different
national currencies. Each party would usually want to hold its national
currency so one or more of the parties must transfer purchasing power to or
from its own national currency. The foreign exchange market provides the
mechanism for carrying out these purchasing power transfers.

Provision of credit
The movement of goods between countries takes time so a means must be
devised to finance inventory in transit. The exporter may provide the finance
or the importer may meet the finance requirements for inventory in transit. The
foreign exchange market provides a third source of credit through specialized
instruments such as banker’s acceptances (A draft accepted by a bank – an
unconditional promise of that bank to honour or make payment on the draft
when it matures) or letters of credit (An instrument issued by a bank at the
request of an importer, in which the bank promises to pay a beneficiary upon
presentation of documents specified in the letter of credit).

Minimizing foreign exchange risk


Neither the importer nor the exporter may wish to carry the risk of exchange
rate fluctuations. Each party may prefer to earn a normal business profit on
the international transaction rather than risk an unexpected change in
anticipated profit should exchange rates suddenly change. The foreign
exchange market provides “hedging” facilities for transferring the foreign
exchange risk to someone else.

MARKET PARTICIPANTS
The foreign exchange market consists of two tiers (layers placed one on top
of the other).

The interbank or wholesale market


This is a market for large sums of foreign exchange usually multiples of
millions of U.S dollars or other currencies.

Client of retail market


This is a market for specific amounts of foreign currency sometimes down to
the last cent.

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Five broad categories of participants operate within these two tiers

Banks and nonblank foreign exchange dealers (traders)


Banks and a few nonblank foreign exchange dealers operate in both the
interbank and client markets. They profit from buying foreign exchange at a
“bid” price and reselling it at a slightly higher “offer” (ask) price. Competition
among dealers keeps the spread between bid and offer thin contributing to the
efficiency of the foreign exchange market.

Individuals and firms conducting commercial and investment transactions


Individuals and firms make use of the foreign exchange market to facilitate
execution of commercial or investment transactions. This group consists of
importers and exporters, international portfolio investors, multinational firms
and tourists.

Speculators and Arbitragers


Speculators and arbitragers profit from trading within the market itself. Their
motive differs from that of dealers in that speculators and arbitragers operate
only in their own interest without a need or obligation to serve clients or to
ensure a continuous market. Dealers seek profit from the spread between bid
and offer and only incidentally seek to profit from a change in general price
levels (exchange rate). Arbitragers seek to profit from simultaneous price
differences in different markets.

A large proportion of speculation and arbitrage is conducted by traders in the


foreign exchange departments of banks on behalf of the bank. Banks act both
as exchange dealers and as speculators and arbitragers but they seldom
admit to speculating – They talk of “taking an aggressive position”.

Foreign exchange brokers (buyers and sellers of foreign exchange for


others)
Foreign exchange brokers are matchmakers who facilitate trading between
dealers without themselves becoming principals in the transaction. They
charge a small commission for their service. They maintain instant access to
hundreds of dealers worldwide via open telephone lines.

Dealers use brokers because they want to remain anonymous. The identity of
the participants may influence short – term quotes (of foreign exchange) for
example large companies may pay heavily because of their ability to pay.

TYPES OF FOREIGN EXCHANGE TRANSACTIONS


Transactions in the foreign exchange market are executed on a “spot”,
“forward” or “swap” basis.

Spot transactions
A spot transaction requires an almost immediate delivery of foreign exchange.
In the interbank market it is the purchase of foreign exchange with delivery
and payment between banks to be completed normally on the second
business day.

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A spot transaction between a bank and its commercial client does not
necessarily involve waiting for two days for settlement.

Forward transactions
A forward transaction requires delivery of foreign exchange at some future
date. It requires delivery at a future value date of a specified amount of one
currency for a specified amount of another currency. The exchange rate is
established at the time the contract is agreed upon but payment and delivery
are not required until maturity. Forward exchange rates are normally quoted
for value dates of one, two, three, six and twelve months.

Swap transactions
A swap transaction is the simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates. The following are types of
swap transactions.

(i) “Spot against forward” swap – The dealer buys a currency in the
spot market and simultaneously sells the same amount back to the
same bank in the forward market. As this is executed as a single
transaction with the same bank, the dealer incurs no unexpected
foreign exchange risk. The difference between the spot and forward
rates is known and fixed.

(ii) “Forward – forward” swap – This is a more sophisticated swap. The


dealer sells a currency forward for delivery at a given value date for
example two months and simultaneously purchases back the
currency forward for delivery at a given value date for example
three months.

FOREIGN EXCHANGE RATES AND QUOTATIONS


A foreign exchange rate is the price of one currency expressed in terms of
another currency. A foreign exchange quotation or quote is a statement of
willingness to buy or sell at an announced price.

Direct quotes
This is a home currency price of one unit of foreign currency for example
Zim$18 000/UK Pound.

Indirect quotes
This is the price of foreign currency to one unit of home currency.

Foreign exchange selling rate quotations are reported daily in the financial
section of most major newspapers.

Bid and offer quotations


Interbank quotations are expressed as bid and offer (ask). A bid is the rate at
which a dealer is willing to buy another currency and an offer is the rate at
which a dealer is willing to sell that currency. Dealers bid (buy) at one price

84
and offer (sell) at a slightly higher price, making their profit from the spread
between the buying and selling prices.

Cross rates
Many currency pairs are not actively traded so their exchange rate is
determined through their relationship to a widely traded third currency. For
example an Australian tourist wants to purchase Danish currency to pay for a
visit to Copenhagen. The Australian dollar (A$) is not actively traded with the
Danish Krone (DKr). Both currencies are actively traded with the US dollar.
Assume the following quotes:

Australian dollar A$1.3806/US$


Danish Krone DKr6.4680/US$

The Australian tourist can exchange 1.3806 A$ for 1US$ and buy 6.4680 DKr.
The cross rate is calculated as follows:

Australian dollars/US dollar = A$1.3806/US$


Danish Krone/US dollar DKr6.4680/US$

= A$0.2135/DKr

INTEREST RATE PARITY (IRP)


The theory of interest rate parity (IRP) provides the linkage between the
foreign exchange markets and the international money markets. The theory
states: “The difference in the national interest rates of securities of similar risk
and maturity should be equal to, but opposite in sign to, the forward rate
discount or premium for the foreign currency, except for transaction costs”.

The theory is only applicable to securities with maturities of one year or less
since forward contracts are not routinely available for periods longer than one
year.

Illustration of Interest Rate Parity (IRP)


Assume the following:
A US investor has US$1 000 000 which he wishes to invest. The US dollar
money market offers an interest rate of 8% per annum. The Yen money
market offers an interest of 4% per annum. The spot exchange rate is
150Yen/$ and the forward 90 day rate is 148.5294 Yen/$. If the investor
chooses to invest in the Yen money market the following will take place:

START END
$1 000 000 Times 1.02 $1 020 000

Dollar money market

85
Times
S = 150Yen/$ 90 days F90 = Yen =148. 5294/$
Divided by

Yen money market

Yen 150 000 000 Times 1.01 Yen 151 500 000

If the investor chooses to invest in the dollar money market he will earn an
interest of $20 000 at the end of 90 days. The investor may choose to invest
in a non-dollar money market instrument of identical risk and maturity for the
same period. If he chooses this option he converts the US dollars into Yen at
the spot rate of exchange (S Yen 150/$), invest the money in the Yen money
market and at the end of the period convert the resulting proceeds back to
dollars. The investor evaluates the returns from the dollar money market and
the Yen money market.

Ignoring transaction costs, if the returns in dollars are equal between the two
alternative money market investments this is interest rate party (IRP). The
transaction is “covered” because there is a guaranteed exchange rate back to
dollars at the end of 90 days.

For the two alternatives to be equal any differences in interest rates must be
exactly offset by the difference between the spot and forward exchange rates.

COVERED INTEREST ARBITRAGE (CIA)


The spot and forward exchange markets are not constantly in a state of
equilibrium described by the interest rate parity. When the market is not in
equilibrium, the potential for “risk less” or arbitrage profit exists. The arbitrager
who recognizes such an imbalance will move to take advantage of the
disequilibrium by investing in whichever currency offers a higher return on a
covered basis. This is called covered interest arbitrage (CIA).

Illustration of CIA
A Hong Kong Investor has 135 000 000 Yen. The spot rate is, S Yen
135.00/$. The 180 day forward rate F180 = Yen 134.50/$. Interest in the Euro
dollar market is 8% per annum. Interest in the EuroYen market is 5% per
annum.

Euro dollar rate = 8.00% per annum

86
$1 000 000 Times 1.04 $1 040 000

Dollar money market

S = Yen 135.00/$ 180 Days Times


Divided by F180 =Yen134.50/$

Yen money market

Yen 139 880 000


Yen135 000 000 Times 1.025 Yen 138 375 000

START Euro yen rate = 5.00% per annum END

The CIA steps


Step 1. Convert 135 000 000 Yen at the spot rate of Yen135.00/$ to obtain
US$1 000 000.
Step 2. Invest the US$1 000 000 in a Euro dollar account for six months
earning 8% per annum (4% for six months).
Step 3.Simultaneously sell the proceeds US$1 000 000 forward for Yen at the
six month forward rate of 134.50 Yen/$. This “locks in” gross Yen revenues of
139 880 000 Yen.
Step 4.Calculate the cost (opportunity cost) of funds used at the Euro yen rate
of 5.00% per annum or 2.50% for six months, with principal and interest then
totaling 138 375 000 Yen. The profit on covered interest arbitrage is 139 880
000 Yen (proceeds) – 138 375 000 Yen (cost) = 1 505 000 Yen.

Covered Interest Arbitrage is a process whereby an investor earns a risk free


profit by (1) borrowing funds in one currency (2) exchanging those funds in
the spot market for a foreign currency (3) investing the foreign currency at
interest rates in a foreign country (4) selling forward at the time of original
investment, the investment proceeds to be received at maturity, (5) using the
proceeds of the forward sale to repay the original loan and (6) having a
remaining profit balance.

FORCES BEHIND EXCHANGE RATE MOVEMENTS


The present international monetary system is characterized by a mix of freely
floating, managed floating and fixed exchange rates therefore no single
general theory is available to forecast exchange rates under all conditions.
There are however certain basic economic relationships, called parity
conditions, which help explain exchange rate movements. These are:

87
Purchasing Power Parity
Fisher effect
International Fisher effect
Interest rate Parity
Forward rate as unbiased predictor of future spot rate.

Under a freely floating exchange rate system, future spot exchange rates are
theoretically determined by the interplay of differing national rates of:
Inflation
Interest rates

Purchasing Power Parity


This is a theory that states that the price of internationally traded commodities
should be the same in every country, and hence the exchange rate between
the two currencies should be the ratio of prices in the two countries.

Fisher effect
This is a theory that states that nominal interest rates in each country are
equal to the required real rate of return to the investor plus compensation for
the expected amount of inflation.

International Fisher Effect


The theory states that the spot exchange rate should change by an amount
equal to the difference in interest rates between two countries.

Interest rate parity


The theory states that the difference in national interest rates for securities of
similar risk and maturity should be equal to but opposite in sign to the forward
exchange rate discount or premium for the foreign currency.

Forward rate as an unbiased predictor


This is a theory by some forecasters that for major freely floating currencies,
foreign exchange markets are efficient and forward exchange rates are
unbiased predictors of future spot exchange rates.

TYPES OF FOREIGN EXCHANGE EXPOSURE

There are three types of exposure, operating exposure, accounting exposure


and transaction exposure.

Conceptual comparison of differences between operating, transaction and


accounting foreign exchange exposure

Movement in time when


Exchange rate changes

Accounting exposure Operating exposure


Accounting – based changes in Change in expected cash flows
Consolidated financial statements arising because of an

88
Caused by a change in exchange unexpected change in exchange
Rates. Rates.

Transaction exposure
Impact of settling outstanding obligations
entered into before change in exchange rates but
to be settled after change in exchange rates

Time

OPERATING EXPOSURE/ECONOMIC EXPOSURE


This is the potential for a change in expected cash flows, and therefore value
of a foreign-based affiliate as a result of an unexpected change in exchange
rates. Operating exposure therefore measures the change in the present
value of the firm that results from changes in future operating cash flows
caused by an unexpected change in exchange rates.

ACCOUNTING EXPOSURE/TRANSLATION EXPOSURE


This is the potential for an accounting derived change in owner’s equity
resulting from exchange rate changes and the need to restate financial
statements of foreign affiliates in a single currency of the parent corporation.

It measures potential accounting - derived changes in owner’s equity that


result from the need to “translate” foreign currency statements of affiliates into
a single reporting currency in order to prepare world wide consolidated
financial statements.

TRANSACTION EXPOSURE
This is the potential for a change in the value of outstanding financial
obligations entered into prior to a change in exchange rates but not due to be
settled until after the exchange rates change. It deals with changes in cash
flows that result from existing contractual obligations.

OPERATING EXPOSURE
Operating exposure is more important for the long – run health of the
business than changes caused by transactions and translation exposure. But
operating exposure is subjective because it depends on estimates of future
cash flow changes over an arbitrary time horizon.
An expected change in foreign exchange rates is not included in the definition
of operating exposure because both management and investors should factor
this information into their evaluation of expected operating results.

MANAGING OPERATING EXPOSURE


The objective of operating exposure management is to anticipate and
influence the effect of unexpected changes in exchange rates on a firm’s
future cash flows rather than merely hoping for the best. To meet this
objective management must not only recognize a disequilibrium condition

89
(among foreign exchange rates, national inflation rates and national interest
rates and product markets) when it occurs but must already have prepared
the firm to react in the most appropriate way. This can be best accomplished if
a firm diversifies internationally both its operations and its financing base.

Diversifying operations
If a firm’s operations are diversified internationally, management is pre –
positioned both to recognize disequilibrium. A disequilibrium occurs when the
purchasing power parity is in temporary disequilibrium. The Purchasing Power
Parity holds that if the spot exchange rate between two countries starts in
equilibrium any change in the differential rate of inflation between them tends
to be offset over the long run by an equal but opposite change in the spot
exchange rate. Management might notice a change in comparative costs in
the firm’s own plants located in different countries. It might also observe
changed profit margins or sales volume in one area compared to another
depending on price and income elasticities of demand and competitor’s
reactions.

Recognizing a temporary change in worldwide competitive conditions permits


management to make changes in operating strategies. Management might
make marginal shifts in sourcing raw materials, components or finished
products. If spare capacity exists production runs can be lengthened in one
country and reduced in another. The marketing effort can be strengthened in
export markets where the firm’s products have become more price
competitive because of the disequilibrium position.

A purely domestic firm does not have the option to react to an international
disequilibrium condition in the same manner as a multinational firm. This is
because it lacks the comparative data from its own internal sources. By the
time external data are available from published sources, it is often too late to
react. Even if the domestic firm recognizes the disequilibrium condition it
cannot quickly shift production and sales into foreign markets in which it has
had no previous presence.

Diversifying financing
If a firm diversifies its financing sources, it will be pre – positioned to take
advantage of temporary deviations from the international Fisher effect.
International fisher effect holds that the spot exchange rate should change in
an equal but opposite direction to the difference in interest rates between two
countries. If interest rate differentials do not equal expected changes in
exchange rates, opportunities to lower a firm’s cost of capital will exist. But to
be able to switch financing sources, a firm must already be well known in
international investment community, with banking contacts firmly established.
This position is not available to a domestic firm that is limited to sourcing
finance from the domestic market.

Multinationals can also reduce default risk by matching the mix of currencies
they borrow to the mix of currencies they expect to receive from operations.
This strategy can be used to neutralize transaction and translation exposure
in addition to operating exposure. This strategy is however difficult to

90
implement in practice because firms cannot predict either the magnitude or
currency of denomination of cash flows very far into the future. Unexpected
changes in exchange rates may alter the very flows management will be
trying to predict thus changing the currency mix to be matched.

MANAGING TRANSACTION EXPOSURE


Transaction exposure measures gains or losses that arise from the settlement
of financial obligations whose terms are stated in a foreign currency.
Transaction exposure arises from:
Purchasing or selling on credit goods or services whose prices are stated in
foreign currencies.
Borrowing or lending funds when repayment is to be made in a foreign
currency.
Being a party to an unperformed foreign exchange forward contract.
Acquiring assets or incurring liabilities denominated in foreign currencies.

Transaction exposure can be managed by contractual techniques and by


adopting certain operating strategies.

CONTRACTUAL TECHNIQUES
Contractual techniques use hedges as well as swap agreements. A hedge is
a contract or arrangement that provides defense against the risk of loss from
a change in foreign exchange rates.

(1) Forward market hedge This involves a forward contract and a source of
funds to fulfill a contract. The forward contract is entered into at the time the
transaction exposure is created. If funds to fulfill the forward contract are on
hand or are due because of a business operation the hedge is considered
“covered”, “perfect”, or “square” because no residual foreign exchange risk
exists. Funds on hand or to be received are matched by funds to be paid.

In some situations funds to fulfill the forward exchange contract are


not already available or due later but must be purchased in the spot
market at some future date. This hedge is “open” or “uncovered”. It
involves considerable risk because the hedger must take a chance on
purchasing foreign exchange at an uncertain future spot rate in order
to fulfill a forward contract. Purchasing of such funds at a later date is
referred to as “covering”.
(2) Money market hedge This also involves a contract and a source of funds
to fulfill that contract. In this instance the contract is a loan agreement. The
firm seeking the money market hedge borrows in one currency and
exchanges the proceeds for another currency. Funds to fulfill the contract –
that is to repay the loan – may be generated from business operations (in
which case the money market hedge is “covered”). Alternatively funds to
repay the loan may be purchased in the foreign exchange spot market when
the loan matures. In this instance the money market hedge is “uncovered” or
“open”.

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Swap agreements A foreign exchange swap is an agreement between two
parties to exchange a given amount of one currency for another and after a
period of time to give back the original amounts swapped.

Back – to – back or Parallel loans This involves two business firms in


separate countries arranging to borrow each other’s currency for a specified
period of time. At an agreed terminal date they return the borrowed
currencies. The operation is conducted outside the foreign exchange market
although spot quotations may be used as the reference point for determining
the amount of funds to be swapped. Such a swap creates a covered hedge
against exchange loss, since each company in its own books borrows the
same currency it repay

Currency swap This resembles a back – to back loan except that it does not
appear on a firm’s balance sheet. Two firms agree to exchange an equivalent
amount of two different currencies for a specified period of time. Currency
swaps can be negotiated for a wide range of maturities up to at least ten
years. If funds are more expensive in one country than another a fee may be
required to compensate for the interest differential.

Credit swap This is an exchange of currencies between a business firm and


a bank (often the central bank) of a foreign country, which is to be reversed at
some future date. A credit swap protects only the principal amount involved. It
does not protect earnings on that principal that might be remitted to the parent
as a return on the parent investment.

OPERATING STRATEGIES
Transaction exposure can be partially managed by adopting strategies that
have the effect of offsetting existing foreign exchange exposure. Two
operating strategies particularly useful in managing transaction exposure are
the use of leads and lags and of re-invoicing centers.

Leads and lags


Firms can reduce transaction exposure by accelerating or decelerating the
timing of payments that must be made or received in foreign currencies. To
lead is to pay early. A firm holding a soft currency and having debts
denominated in a hard currency will lead by using that soft currency to pay the
foreign currency debts as soon as possible, before the soft currency drops in
value. The lag is to pay late. The firm holding a hard currency and having
debts denominated in a soft currency will lag by paying those debts late,
hoping that less of the hard currency will be needed. If possible, firms will also
lead and lag their collection of receivables, collecting soft currency
receivables early and collecting hard foreign currency receivables later.

Leading and lagging may be done between affiliates or with independent


firms. Assuming that payments will be made eventually, leading or lagging

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always results in changing the cash and payables position of one firm, with
the reverse effect on the other firm.

Re-invoicing centers

This is a separate corporate subsidiary that manages in on location all


transaction exposure from intracompany trade. Manufacturing affiliates sell
goods to distribution affiliates of the same firm only by selling to a re-invoicing
center, which in turn resells to the distribution affiliate. Title passes to the re-
invoicing center, but the physical movement of goods is direct from
manufacturing plant to distribution affiliate. Thus the re-invoicing center
handles paperwork but has no inventory.

Re-invoicing centre structure

Korean manufacturing Physical Goods Japanese


Affiliate Sales affiliate
Invoice in Invoice in
Won Yen

Re-invoicing centre
Singapore

The Korean manufacturing unit of a multinational firm invoices the firms


reinvoicing centre in Singapore in Korean won. The reinvoicing centre in turn
invoices the firms’ Japanese sales affiliate in yen. Thus all operating units
deal only in their own currency and all transaction exposure lies with the
reinvoicing centre.

MANAGING ACCOUNTING/TRANSLATION EXPOSURE


Translation exposure results because foreign currency denominated financial
statements of foreign affiliates must be restated into the parent companys’
reporting currency so the parent company can prepare consolidated financial
statements.

Accounting exposure is the potential for a gain or loss in the parent’s net
worth and reported net income that arises because of exchange rates change.
Basic conventions for translation
The current rate method All assets and liabilities are translated at the
current rate of exchange; the rate of exchange in effect on the balance sheet
date. Income statement items are translated at either the actual exchange
rate on the dates the various revenues, expenses, gains and losses are
incurred or at a weighted average exchange rate for the period.

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Monetary/Non monetary method Monetary assets (cash, marketable
securities, Debtors and long term receivables) and monetary liabilities (current
liabilities and long term debt) are translated at current exchange rates, while
all other assets and liabilities are translated at historical rates.

Income statement items are translated at the average exchange rate for the
period, except for depreciation and cost of sales that are directly associated
with non monetary assets or liabilities. These items are translated at their
historical rate.

3.Current/Non current method All current assets and current liabilities of


foreign affiliates are translated into home currency at the current exchange
rate, while non current assets and non current liabilities are translated at
historical rates.

Temporal Method This is a variation of the monetary/non monetary method.


If the foreign affiliate keeps all of its accounts on a historical cost basis, the
temporal method is in fact identical to the monetary/non monetary method. If
the foreign affiliate restates any unexpected assets (eg. Inventory) to market
value, the temporal method provides for their translation at the current
exchange rate.

Managing translation exposure The main technique to manage accounting


exposure is called a balance sheet hedge.

Balance Sheet Hedge This requires an equal amount of exposed foreign


currency assets and liabilities on a firm’s consolidated balance sheet. If this
can be achieved for each foreign currency, net accounting exposure will be
zero. A change in exchange rates will change the value of exposed assets in
an equal but opposite direction to a change in the value of exposed liabilities.
If a firm translates by the monetary/non monetary method, a zero net exposed
position is called monetary balance.
- End of module -

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