MBA 8 Year 2 Managerial Finance January 2020

MANAGERIAL FINANCE
STUDY GUIDE
PROGRAMME : MBA Final Year
CREDIT POINTS : 20 points
NOTIONAL LEARNING : 200 hours over 1 semester
TUTOR SUPPORT : manfin@mancosa.co.za
Copyright © 2018
MANAGEMENT COLLEGE OF SOUTHERN AFRICA
All rights reserved; no part of this book may be reproduced in any form or by any means, including
photocopying machines, without the written permission of the publisher. Please report all errors and omissions
to the following email address: modulefeedback@mancosa.co.za
Managerial Finance
AIMS OF THE UNIT
This unit builds on work you have already completed in the Accounting Unit:
 Analysis of past performance by ratio and cash flows

 Budgeting and decision-making in the short term
 Introduction to methods of investment appraisal
This module will evaluate the financial well-being of the firm and its shareholders by
investigating the management of long-term and working capital, and the financial
measurement and choice of projects to invest in.
After working through this guide, you should be able to:
 Estimate a project’s cash flow and business risk, and its suitability for inclusion in a
firm’s portfolio of investments
 Recognise the variety of sources of finance that exist, and appreciate the implications
of this
 Make long-term decisions on the acceptability of projects using investment appraisal
techniques
 Use various methods to assess the cost of capital
 Appreciate the problems of exchange-rate fluctuations and the avoidance of exchange
rate risk and interest rate risk
 Understand in more detail the management of working capital
 Consider the implications of valuations, acquisitions and mergers to organisations
MANCOSA - MBA FINAL YEAR 1

Managerial Finance
THE SECTIONS OF THIS GUIDE
SECTION TITLE PAGE
INTRODUCTION 3
1 INTRODUCTION TO MANAGERIAL FINANCE 6
2 CAPITAL BUDGETING 22
3 BUSINESS RISK 46
4 LONG TERM SOURCES OF FINANCE 69
5 COST OF CAPITAL 96
6 GEARING AND SHAREHOLDERS WEALTH 119
7 DIVIDEND POLICY 148
8 FOREIGN RISK MANAGEMENT AND PROJECT EVALUATION 169
9 WORKING CAPITAL MANAGEMENT 199
10 VALUATION, MERGERS AND ACQUISITIONS 228
BIBLIOGRAPHY 265

Managerial Finance
INTRODUCTION
This study guide on managerial finance has been devised in line with your syllabus and the
latest developments in the field of Managerial Finance. The structure of the guide is very
simple and user- friendly.
This module assumes that you are familiar with the accounting concepts which you have
encountered in your first year of studies. However, the first two sections of this study guide
are written from an accounting perspective to help you recall some of the accounting
concepts, which you may have forgotten. It also serves to assist those students who do not
have a financial background, to cope better without being disadvantaged. It is important to
note that these two sections overlap with the sections of managerial finance all the time and a
thorough knowledge and understanding of these concepts is critical for the successful
understanding of managerial finance.
HOW TO USE THIS GUIDE

The guide must be used in conjunction with the prescribed textbook and other recommended
readings. You should read about the topic that you intend to study from the guide before you
start reading it in detail in the textbook. At the beginning of each section you will find a list
of learning outcomes. These outcomes are the main points that you should understand and
aim to achieve once you have completed the section. It is also very important that you are
able to work through all the Self-Check activities contained in the guide. This will help you
prepare for your assignments and examinations. However, it is not sufficient to only work
through these Self-Check activities but it is also necessary to work through the examples that
appear in your textbook.
Do not try to complete the unit in a few long sessions. You will study more effectively if you
divide your study into two-hour sessions. If you want to take a break it would be a good idea
to stop at the end of a section.

Managerial Finance
As you work through the unit you will come across three different types of exercises:
SELF-ASSESSMENT ACYIVITY
Self-Assessment Activity ask you to stop and relate what you have learned to a specific case
situation
THINK POINT
Think Points ask you to stop and think about a particular point or concept and how it applies
to your work as a manager
SELF-CHECK QUESTION
You will also come across Self-Check Questions which test your understanding of what you
have learned so far. The answers to these questions are also given

Managerial Finance
READING
Figure
1 unit
This has been designed to be read in conjunction with the following textbooks:
Prescribed
Ross, SA; Westerfield, RW; Jordan, BD and Firer, C (2012) Fundamentals of Corporate
Finance, 5th South African Edition, Australia: McGraw-Hill, Inc.
Recommended
1. Brealey, RA; Myers, SC; Marcus, AJ (2004) Fundamentals of Corporate Finance,

4th International Edition, New York: McGraw-Hill, Inc.
2. Correia, C; Flynn, D; Vliana, E and Wormald, M (2000) Financial Management,
4th Edition, Juta Publishing.
3. Gitman, LJ (2003) Principles of Managerial Finance, 10th Edition, Boston, United States:
Pearson Education, Inc.

Managerial Finance
SECTION 1
INTRODUCTION TO
MANAGERIAL FINANCE

Managerial Finance
LEARNING OUTCOMES
On completion of this section, you should be able to display knowledge of:
 The fundamental concepts related to Managerial Finance
 The importance of study of Managerial Finance
 The different career opportunities in Managerial Finance
 The function of Managerial Finance in the business world
 The goals of Managerial Finance
 The role of Managerial Finance in the market place.

Managerial Finance
(1) FINANCE AND BUSINESS
The field of finance is broad and dynamic. It directly affects the lives of every person and
every organization. There are many areas and career opportunities in the field of finance.
Basic principles of finance, such as those you will learn in this guide, can be universally
applied in business organizations of different types.
1.1 WHAT IS FINANCE?
Finance can be defined as the art and science of managing money. Finance is concerned
with the process, institutions, markets, and instruments involved in the transfer of money
among individuals, businesses, and governments.
1.2 MANAGERIAL FINANCE
Managerial finance is concerned with the duties of the financial manager in the business
firm. Financial managers actively manage the financial affairs of any type of business. They
perform such varied financial tasks as planning, extending credit to customers, evaluating
proposed large expenditures, and raising money to fund the firm’s operations.
(Gitman, 2003: 4)
(2) LEGAL FORMS OF BUSINESS ORGANISATIONS
The 3 most common legal forms of business organization are the sole proprietorship, the
partnership and the company. Other forms of business organization also exist. The sole
proprietorship is the most common. However, companies are dominant with respect to their
contribution of revenue and profits in a given economy.
2.1 Sole Proprietorships
A sole proprietorship is a business owned by one person who operates it for his or her own
benefit. The typical sole proprietorship is a small business, example a plumber. The sole
proprietor has unlimited liability; his or her total wealth can be taken to satisfy creditors.

Managerial Finance
2.2 Partnerships
A partnership consists of 2 or more owners not exceeding 20 in number, doing business

together for profit. Partnerships account for 10% of all businesses. They are usually larger
than sole proprietorships. Finance, insurance and real estate firms are the most common
types of partnership. Most partnerships are established by a written contract. They have
unlimited liability, and each partner is legally liable for all the debts of the partnership.
2.3 Companies
A company is an artificial being created by law. Often called a “legal entity”, a company has
the powers of an individual in that it can sue and be sued, make and be party to contracts, and
acquire property in its own name.
Normally companies are owned by at least two people. The owners are known as
shareholders. The ownership of a company is divided into a number of shares, each of equal
size. Each shareholder owns one or more shares in the company.
 Perpetual life
When an owner (shareholder) of the company dies, that persons shares passes to the
beneficiary of his or her estate.
 Limited liability
Shareholders can limit their losses to that which they have paid or agreed to pay for the
shares.
 Management of companies
The shareholders elect directors to manage the company on a day-to-day basis on behalf of
those shareholders.

Managerial Finance
 Private and public companies
o Private company
According to the Companies Act, a private company exists when the right to transfer shares
is limited and the number of shareholders is limited to a maximum of 50. Shares may not be
offered to the general public.
o Public company
Is an association of at least seven persons. There are basically no limits to the number of
shareholders. A public company can offer its shares for sale to the general public.
 Shares and shareholders
When considering the (public) company, which enables thousands of people to invest as joint
owners, it is not practical for each owner to have his/her own capital account in the books of
the business. To overcome this problem, the company divides its own capital into smaller
portions, known as SHARES. The owners of these shares are called SHAREHOLDERS.
Ownership of these shares can easily be exchanged, especially if a company’s shares are
listed on a stock exchange.
Par value vs. market value/directors value
The SHARE CAPITAL of a company can be calculated as follows:
Number of issued shares x par value
The PAR VALUE of a share is the price at which the shares were first registered. The prices
of shares do not stay constant. They may change when shares are split. This is the reason
why share capital must be stipulated at the par-value cost of the shares. Remember: a
shareholder’s stake in a company is not determined by the amount of money he contributed,
but by the number of shares he has bought (relative to the number issued). If a company has
issued 500 000 shares, and one shareholder holds 100 000 thereof, he has 20% shares in the
company, irrespective of how much he paid for his shares.

Managerial Finance
As soon as the company reaches the second market (e.g. JSE), the price of shares will vary
according to changes in demand and supply, market sentiment, and other factors. The price,
at which the shares of a public company trade at a given point in time, is called the
MARKET VALUE (only public companies can be listed on a stock exchange). In the case
of unlisted public companies and private companies, the value of the shares will also change,
but the price of the shares will be determined by the directors of the company, and thus called
DIRECTOR’S VALUE.
 No par value shares
Such shares do not have a nominal value and are issued at a price, which is considered
appropriate by the directors of the company.
 Authorised vs. issued share capital
The share capital that a company can acquire according to its memorandum of association is
called the AUTHORISED SHARE CAPITAL. The authorized shares are seldom issued in
full to the potential shareholders. Those shares, which have actually been issued (sold),
multiplied by the par value per share equals ISSUED SHARE CAPITAL. The difference
between the authorized and issued share capital is called the “reserve capital”.
 Share premiums
Assume that a company issues 10 000 shares at a price of R2 each. Given a par value of
R1.50 per share, the “premium” per share is 50c. Therefore, the amount that will be regarded
as a premium for the issue of the shares will be R5 000.00.

Managerial Finance
 Classification Of Shares
There are two basic types of shares, namely “preference shares” and “ordinary shares”
o Preference Shares
Preference shares carry a fixed dividend, and provide a preference right to the holders
thereof with regards to dividends. Preference shareholders can only receive dividends if
there happens to be sufficient profits available for distribution.
o Ordinary Shares
Ordinary shares are considered for dividends; only after the preference dividends have
been recommended. In contrast to preference shares capital, a fixed percentage is NOT
paid out as ordinary dividends. The amount paid out can vary from year to year. This
will depend on profits, and the decisions made by the directors of the company.
 RESERVES
Reserves are profits and gains, which, have been made by the company and which still form
part of the shareholders claims, because they have not been paid out to the shareholders.
These profits and gains are in a reserve, which represent a source of new finance for the
companies.
 EQUITY
Equity is the value of ordinary shares and reserves of a company.

Managerial Finance
THINK POINT
Which forms of business organisation might best suit the following:
a) A consulting firm with several senior consultants and support staff

b) A house painting company owned and operated by a college student who hires some
friends for occasional help
c) A manufacturing company with sales of R2 billion and 3 000 employees.
(3) STUDY OF MANAGERIAL FINANCE
Most business decisions are measured in financial terms, the financial manager plays a key
role in the operation of the firm. People in all areas of responsibility – accounting,
information systems, management, marketing, operations etc. need a basic understanding of
the managerial finance function.
All managers in the firm, regardless of their job descriptions, work with financial personnel
to justify labour power requirements, negotiate operating budgets, deal with financial
performance appraisals, and sell proposals at least partly on the basis of their financial merits.
Clearly, those managers who understand the financial decision-making process will be better
able to address financial concerns and will therefore more often get the resources they need to
attain their own goals.

Managerial Finance
(4) CAREER OPPORTUNITIES IN MANAGERIAL FINANCE
 Financial analyst
 Capital expenditures manager
 Project finance manager
 Cash manager
 Credit analyst/manager
 Pension fund manager
 Foreign exchange manager
(5) THE MANAGERIAL FINANCE FUNCTION
5.1 ORGANISATION OF THE FINANCE FUNCTION
The importance of the managerial finance function depends on the size of the firm. In small
firms, the finance function is generally performed by the accounting department. As a firm
grows, the finance function evolves into a separate department linked directly to the company
president or CEO through the chief financial officer (CFO).
The treasurer and the controller are required to report to the CFO. The treasurer (the chief
financial manager) is responsible for handling financial activities, such as financial planning
and fund raising, making capital expenditure decisions, managing cash, managing credit
activities, managing the pension fund, and managing foreign exchange. The controller (the
chief accountant) handles the accounting activities such as corporate accounting, tax
management, financial accounting and cost accounting. The treasurer’s focus tends to be
more external, the controller’s focus more internal.
A trained financial manager is able to monitor and manage the firm’s exposure to loss from
currency fluctuations of international sales and purchases.

Managerial Finance
5.2 RELATIONSHIP TO ECONOMICS
The field of finance is closely related to economics. Financial managers must understand the
economic framework and use such theories as guidelines for efficient business operations.
Examples include supply and demand analysis, profit maximising strategies and price theory.
The primary economic principle used is marginal analysis in managerial finance. The
principle that applies is that financial decisions should be made and actions taken only when
the added benefits exceed the added costs.
5.3 RELATIONSHIP TO ACCOUNTING
The firm’s finance (treasurer) and accounting (controller) activities are closely related. In
small firms, the controller carries out the finance function, and in large firms accountants are
closely involved in various finance activities. There are 2 basic differences between finance
and accounting; one is related to the emphasis on cash flows and the other to decision
making.
5.4 PRIMARY ACTIVITIES OF THE FINANCIAL MANAGER
In addition to financial analysis and planning, the financial mangers primary activities are
making investment and financing decisions. Investment decisions determine the mix and the
type of assets held by the firm. Financing decisions determine both the mix and type of
financing used by the firm.
THINK POINT
What is the relationship of the Managerial Finance function to economics and accounting?

Managerial Finance
(6) GOALS OF MANAGERIAL FINANCE FUNCTION
The owners of a company are distinct from its managers. Actions of the Financial Manager
should be in accordance with meeting the objectives of the firm’s owners; its shareholders.
6.1 MAXIMISE PROFIT
Most financial managers believe that maximising profit is the firm’s objective. To do this, the
Financial Manager must take certain actions that are expected to make a major contribution to
the firm’s overall profits. For each alternative considered, the Financial Manager would
select the one that is expected to result in the highest monetary return. A Company measures
profits in terms of earnings per share (EPS).
6.2 MAXIMISE SHAREHOLDER WEALTH
The goal of the firm is to maximise the wealth of its owners for whom it is being operated.
The wealth of the company’s owners is measured by the share price of the share, which in
turn is based on the timing of returns (cash flows), their magnitude, and their risk.
Financial Financial Return ? Increase Yes Accept

Manager decision, Return? Risk ? Share Price
AlternativeRisk?
or
Action
No
Reject
(Gitman, 2003: 15)

Managerial Finance
THINK POINT
What are some of the aspects that wealth maximisation takes into consideration which is
ignored by the goal of profit maximisation.
6.3 THE ROLE OF ETHICS
This involves the standards of conduct or moral judgement. The ethics of actions taken by
certain businesses have received major media attention. The business community and the
financial community are developing and enforcing ethical standards. The goal is to motivate
business and market participants to adhere to both the letter and the spirit of laws and
regulations concerned with professional practice. Businesses actually strengthen their
competitive positions by maintaining high ethical standards.
6.4 SOCIAL RESPONSIBILITY
A firm, in principle, has a responsibility towards the community and their employees. It
should be seen from the outside as an organ of society, which should serve the interests of
society. This means that the goal of the firm is to encourage and achieve the greatest possible
socio-economic wealth. This serves as a criterion for the evaluation of the actions of the
firm. A firm is not an isolated cell living somewhere in a vacuum in space. It is part of a
greater whole, and it should serve that whole. From the perspective of social responsibility,
the firm is a social entity within society which:
 Should satisfy society’s needs for goods and services

 Should provide job opportunities and job satisfaction
 Should improve the welfare (material and other) of society by using entrepreneurship,
capital, human resources and raw materials economically.

Managerial Finance
Service to society is therefore a primary goal, while profitability still remains an important
consideration. A firm therefore also pursues social goals such as: a high standard of living,
economic progress and stability, personal and national security, improved living conditions
on both local and national levels serve its community by maintaining a high standard of
education, participating in local government through town planning and the provision of
recreational facilities. Service to the community could also be expressed in an firm’s product
range, quality policy, research and product development programmes and employment
policy.
THINK POINT
In some countries such as Japan and Germany, business organisations develop close long-
term relationships with one bank and rely on that bank for a large part of their financing
needs. In the United States, companies are more likely to shop around for the best deal. Do
you think that this practice is more or less likely to encourage ethical behaviour on the part of
the business organisations?
(7) AGENCY COSTS
The relationship between shareholders and management in a firm is called an agency

relationship. Such a relationship exists whenever someone (the principal) hires another (the
agent) to represent his or her interests.
To see how management and shareholder interests might differ, imagine that the firm is
considering a new investment. The new investment is expected to have a favourable impact
on the share value, but it is also a relatively risky venture. The owners of the firm will wish
to take the investment (because the share value will rise), but management may not because
there is the possibility that things will turn out badly and management jobs will be lost. If
management does not make the investment, then the shareholders may have lost a valuable
opportunity. This is one example of an agency cost.

Managerial Finance
More generally, agency costs refer to the costs of the conflict of interest between
shareholders and management. These costs can be indirect or direct. An indirect agency cost
is a lost opportunity, such as the one we have just described.
Direct agency costs come in two forms. The first type is a corporate expenditure that benefits
management but costs shareholders. Perhaps the purchase of a luxurious and unneeded
corporate jet would fall under this heading. The second type of direct agency cost is an
expense that arises from the need to monitor management actions. Paying outside auditors to
assess the accuracy of information in financial statements could be one example.
It is sometimes argued that, left to themselves, managers would tend to maximise the amount
of resources over which they have control or, more generally, corporate power or wealth.
This goal could lead to an overemphasis on corporate size or growth. For example, cases
where management is accused of overpaying to buy up another company just to increase the
size of the business or to demonstrate corporate power are not uncommon. Obviously, if
overpayment does take place, such a purchase does not benefit the shareholders of the
purchasing company.
Our discussion indicates that management may tend to overemphasise organisational survival
to protect job security. Also, management may dislike outside interference, so independence
and corporate self-sufficiency may be important goals.
(8) FINANCIAL INSTITUTIONS AND MARKETS
Most firms have an ongoing need for funds. They can obtain funds from external sources in
3 ways viz.
 Financial institutions: These institutions accept savings and transfer them to those that
need funds.
 Financial markets: These are organised forums in which the suppliers and users of
various types of funds can make transactions.
 Private placement: This involves the sale of a new security issue, typically bonds or
preferred share, directly to an investor or group of investors such as insurance
companies or pension fund. They have an unstructured nature.

Managerial Finance
8.1 FINANCIAL INSTITUTIONS
These serve as intermediaries by channelling the savings of individuals, businesses, and

governments into loans or investments. Many financial institutions directly or indirectly pay
interest on deposited funds; others provide services for a fee (for example, checking accounts
for which customers pay service charges). Some financial institutions accept customer’s
savings deposits and lend this money to other customers or to firms; others invest customers’
savings in earning assets such as real estate or shares and bonds.
8.2 FINANCIAL MARKETS
These are forums in which suppliers of funds and users of funds can transact business
directly. Suppliers in the financial markets know where their funds are being lent or invested.
Two key financial markets are the money market (i.e. short-term debt instruments or
marketable securities) and the capital market (long-term securities – bonds and shares.)
8.3 THE RELATIONSHIP BETWEEN INSTITUTIONS AND MARKETS
Financial institutions actively participate in the financial markets as both suppliers and users
of funds.
8.3.1 The Money Market
This is created by a financial relationship between suppliers and users of short-term funds
(funds with maturities of one year or less). The money market exists because some
individuals, businesses, governments, and financial institutions have temporarily idle funds
that they wish to put to some interest-earning use. Most money market transactions are made
in marketable securities – short-term debt instruments. By definition, the duration of
transactions is up to one year.
8.3.2 The Capital Market
The capital market is a market that enables suppliers and users of long-term funds to make
long-term transactions. Included are securities issues of business and government. The
backbone of the capital market is formed by various securities exchanges that provide a
forum for bond and share transactions.

Managerial Finance
(9) CONCLUSION
This chapter highlights the fundamental concepts of Managerial Finance. It is also important
to note that the goal of the financial manager is to maximise the owner’s wealth. Profit
maximisation ignores the timing of returns, does not directly consider cash flows, and ignores
risk. The wealth maximising actions of financial managers should also reflect the interest of
shareholder’s and groups who have a direct economic link to the firm. Positive ethical
practices help the firm and its managers to achieve the firm’s goal of owner wealth
maximisation.

Managerial Finance
SECTION 2
CAPITAL BUDGETING
& CASH FLOWS

Managerial Finance
LEARNING OUTCOMES
On completion of this learning module, you should be able to calculate:
 Accounting Profits
 Cash Flows
 Accounting Rates of Return (ARR)
 Payback Periods
 Discounted Payback Periods
 Net Present Values (NPV)
 Internal Rates of Return (IRR)

Managerial Finance
(1) INTRODUCTION
Investment decisions influence the ability of a firm to generate future cash flows, hence
undertaking projects that generate higher future cash flows will lead to maximisation of the
value of a firm. The investment decision, also called capital budgeting is without a doubt the
most important decision a financial manager can make. The capital budgeting decision of a
firm is essentially an irreversible commitment of a comparatively large proportion of the
firm’s resources to various projects over long periods of time. This commitment is made in
the expectation of securing generally uncertain future cash flows and has a direct effect on
the future profitability of the firm. The decision may result in a major departure from what
the company is currently doing and can significantly affect both expected profits (returns)
and the risk to which profits will be subjected. The capital budgeting decisions made over
time determine the type of business in which a company is involved, not the methods of
finance or its working capital management. The capital budgeting decisions are typically
aimed at an increase in revenues, a decrease in costs or improvements in both areas lead to
higher efficiency. An increase in revenues is usually achieved by expansion of current
production facilities or an expansion into different product/industries of setting up completely
new or self-contained projects. Cost decreases and increased efficiency are often a
consequence of improvement in production technologies and typically involve the
replacement of, or improvements to, assets or groups of assets already in use.

Managerial Finance
(2) TECHNIQUES FOR MAKING CAPITAL BUDGETING DECISIONS
Considering the importance of the capital budgeting decision, it is essential that a thorough
evaluation of the available investment opportunities is carried out. The focus of capital
budgeting is to find a way to determine whether the benefit (additional value) associated with
the project exceeds the cost associated with the development and running of the project. The
concern is not only the absolute value of the profits, but also profitability – i.e. the ratio of
benefits and costs. Project evaluation may be on a “stand-alone” basis (accept/reject
decision) or on a comparative basis, requiring a comparison and choice between alternatives
projects (either/or decision).
There are a number of methods available for making capital budgeting decisions, but they all
have one characteristic in common – they require the determination of the expected future
cash outflows and inflows a project will generate.
THINK POINT
What is capital budgeting? How does capital expenditure relate to the capital budgeting
process?
Some basic techniques:
2.1 Accounting Rate of Return (ARR)

2.2 Payback Period
2.3 Discounted Payback Period
2.4 Net Present Value (NPV)
2.5 Internal Rate of Return (IRR)

Managerial Finance
(3) CALCULATION OF ACCOUNTING PROFITS
EXAMPLE YEAR 2
TURNOVER R200 000

COST OF SALES 20 000
GROSS PROFIT 180 000
EXPENSES 110 000
NET PROFIT BEFORE TAX 70 000
TAX 21 000
NET PROFIT AFTER TAX 49 000
Note 1:
Accounting profits can be subjected to a number of different assumptions and
distortions (For example depreciation, taxation and inflation), and it is relatively easy to
arrive at different profit levels depending upon the accounting policies adopted.
The most common definition is to take profits before taxation.
In this case the accounting profits will be R70 000.
Note 2:
Expenses include a depreciation charge of R10 000.
(4) CALCULATION OF CASH FLOWS
NET PROFIT BEFORE TAX R70 000

ADD BACK DEPRECIATION 10 000
THEREFORE CASH FLOWS R80 000

Managerial Finance
Note:
1. Depreciation is a mere BOOK ENTRY for tax purposes – no money leaves the
company, therefore depreciation does not affect the cash flow.
2. Normally the current year tax is paid in the next financial year.
For example: assume that Year1 tax was R18 000, then this amount will be paid in
Year 2, and Year 2 tax will be paid in Year 3. Therefore, if all information is supplied,
then the Cash Flow will be:
R70 000 + R10 000 – R18 000 (Year 1 tax) = R62 000
(5) ACCOUNTING RATE OF RETURN (ARR)
The accounting rate of return method takes the average accounting profit that the investment
will generate and expresses it as a percentage of the average investment in the project as
measured in accounting terms.
Thus,
ARR = Average annual profits x 100%

Average investment* 1
* Initial capital employed + residual value

2

Managerial Finance
Let us consider the following example:

Stoney Limited is considering investing in a new project, the details are as follows:
Project Life : 5 years

Project costs : R50 000
Residual value at the end of project : R10 000
Estimated net profits before tax : YEAR 1 12 000
YEAR 2 18 000
YEAR 3 30 000
YEAR 4 25 000
YEAR 5 5 000
TOTAL PROFITS 90 000
Average annual profits = R90 000  5

= R18 000
Average Investments = R50 000 + R10 000 ÷ 2

= R30 000
Thus, the ARR of the investment is:
ARR = R18 000 x 100%

R30 000 1
= 60%

Managerial Finance
The Decision Criteria
To decide whether the 60% return is acceptable, we shall have to compare the percentage
with the minimum required by the business.
If the firm has a target ARR less than 60%, then this investment is acceptable, otherwise not.
The ARR rule is thus,
Based on the Accounting Rate and Return Rate, a project is acceptable if its Accounting
Rate of Return exceeds a target Accounting Rate of Return.
THE ARR CAN BE SUMMARISED AS FOLLOWS:
ADVANTAGES DISADVANTAGES
1. 1. Needed information will usually 1. 1. Not a true rate of return – time value of
be
available. 2. money is ignored.
3.
2. 4. 2. Based on accounting book value, not
2. 2. Easy to calculate. 5. cash flows and market values.
The ARR is not suitable for capital budgeting purposes.
(6) PAYBACK PERIOD
Payback periods are commonly used to evaluate proposed investments. The payback period is
the exact amount of time required for the firm to recover its initial investment in a project as
calculated form cash inflows. In the case of an annuity, the payback period can be found by
dividing the initial investment by the annual cash inflow. For a mixed stream of cash
inflows, the yearly cash inflows must be accumulated until the initial investment is recovered.
Although popular, the payback period is generally viewed as an unsophisticated capital
budgeting technique, because it does not explicitly consider the time value of money by

Managerial Finance
discounting cash flows to find present value. Also, it does not measure profitability.
(Brealey, 2004: 185)
Let us consider the example of Stoney Limited:
Calculation of Depreciation (Straight Line Method)
= Project investment - Residual value  Number of years

= R50 000 - R10 000 5
= R8 000
Year Accounting + Depreciation = Cash

Profits Inflows
1 R12 000 R8 000 R20 000
2 R18 000 R8 000 R26 000
3 R30 000 R8 000 R38 000
4 R25 000 R8 000 R33 000
5 R5 000 R8 000 + residual value R10 000 R23 000
PROJECT INVESTMENT (R 50 000)

YEAR 1 CASH FLOWS R 20 000
(R 30 000)
(R 4 000)
4000 X 12 = 1.263 months

38 000 1
0.263 X 30 d = 8 days
Therefore, the payback is 2 years 1 month and 8 days

Managerial Finance
When the payback period is used to make accept-reject decisions, the decision criteria are as
follows:
 If the payback period is less than the maximum acceptable payback period, accept the
project.
 If the payback period is greater than the maximum acceptable payback period, reject the
project.
THE PAYBACK PERIOD CAN BE SUMMARISED AS FOLLOWS:
1. Widely used by large firms 1.
to 1. It cannot be specified in light of the
evaluate small projects. 2. wealth maximisation goal because it is not
3. based on discounting cash flow to
2. Widely used by small firms 4.
to determine whether they add to the firm's
evaluate most projects. 5. value.
3. Simple to use and takes into 2. It fails to take fully into account the time
account cash flows. factor in value of money.
The Payback method is not suitable for capital budgeting purposes.
What weaknesses are commonly associated with the accounting rate of return and the
payback period to evaluate a proposed investment?

Managerial Finance
(7) DISCOUNTED PAYBACK PERIOD
The discounted payback period method is an attempt to overcome some of the problems
associated with the payback period. Specifically, it considers the time value of money and
the risk associated with the expected cash flows. The discounted payback period of
investment is defined as the length of time required for the generation of sufficient discounted
cash flows to recover the initial cost of the investment. The appropriate rate for which future
cash flows are discounted is usually the weighted average cost of capital of the company,
since it is the rate that reflects the risk associated with the company. The discounted payback
decision rule is that an investment should be accepted if its discount payback period is less
than some pre-specified number of years. If a choice between projects must be made, the one
with the shortest payback must be undertaken. Although the discounted payback period
method is an improvement on ordinary payback, the problem with the arbitrary choice of cut-
off remains, while the attractive features of the payback method – simplicity and ease of use
– are lost.
Let us consider the following example of Stoney Limited:
YEAR CASH FLOW DISCOUNT FACTOR (10%) PRESENT VALUE (PV)

0 (50 000) 1.00 (50 000)
1 20 000 0.9091 18 182
2 26 000 0.8264 21 486
3 38 000 0.7513 28 549
4 33 000 0.6830 22 539
5 23 000 0.6209 14 281
NP V 55 037
PROJECT INVESTMENT (50 000)

YEAR1 DISCOUNTED CASH FLOW 18 182
(31 818)
YEAR 2 DISCOUNTED CASH FLOW 21 486
(10 332)
YEAR 3 DISCOUNTED CASH FLOW 28 549
Therefore, the Discounted payback period is 2 years, 4 months and 10 days.
Compared with the payback period, the Discounted payback period takes about 3 months longer.

Managerial Finance
(8) NET PRESENT VALUE
The net present value (NPV) is considered a sophisticated capital budgeting technique,
because it gives explicit consideration to the time value of money. All such techniques in one
way or another discount the firm’s cash flows at a specified rate. This rate – often called the
discount rate, required return, cost of capital, or opportunity cost – refers to the minimum
return that must be earned on a project to leave the firm’s market value unchanged.
The Net Present Value (NPV) is found by subtracting a project’s initial investment from the
present value of its cash flow, discounted at a rate equal to the firm’s cost of capital. By
using NPV, both inflows and outflows are measured in terms of present Rand. Because we
are dealing only with investments that have conventional cash flow patterns, the initial
investment is automatically stated in terms of today’s Rand. If it were not, the present value
of a project would be found by subtracting the present value of outflows from the present
value of inflows. (Brealey, 2004: 180)
Let us consider the example of Stoney Limited.
Let us assume that the firm’s cost of capital is 15%
YEAR CASH FLOWS PRESENT VALUE INTEREST PRESENT

FACTOR 15% VALUE
0 (50 000) 1.00 (50 000)
1 20 000 0.8696 17 392
2 26 000 0.7561 19 659
3 38 000 0.6575 24 985
4 33 000 0.5718 18 869
5 23 000 0.4972 11 436
Net Present Value (NPV) 42 341
The investment would be accepted because it has positive Cash flows.

Managerial Finance
When NPV is used to make accept-reject decisions, the decision criteria are as follows:
 If the NPV is greater than 0 Rands, accept the project.

 If the NPV is less than 0 Rands, reject the project.
If the NPV is greater than 0 Rands, the firm will earn a return greater than its cost of capital.
Such action should enhance the market value of the firm and therefore the wealth of its
owners.
1. The use of net cash flows emphasises the 1. Some difficulty may be encountered
importance of liquidity. in estimating the initial cost of the
project and the time periods in
2. The time value of money is taken into which instalments must be paid
account. back.
3. It is easy to compare the NPV of different 2. It is difficult to estimate accurately

projects and to reject projects that do not the net cash flow for each year of
have an acceptable NPV. the project’s life.
What is the NPV of an investment and how do you calculate it?

Managerial Finance
(9) INTERNAL RATE OF RETURN (IRR)
The internal rate of return (IRR) is probably the most used sophisticated capital budgeting
technique for evaluating investment alternatives. The internal rate of return (IRR) is the
discount rate that equates the present value of cash inflows with the initial investment
associated with a project. The IRR, in other words, is the discount rate that equates the NPV
of an investment opportunity with 0 Rands (because the present value of cash inflows equals
the initial investment). It is the annual compound rate of return that the firm will earn if it
invests in the project and receives the given cash inflows. (Brealey, 2004: 188)
Let us consider the example of Stoney Limited to calculate the IRR.
You will recall that when we discounted the cash flows of Stoney Limited at 15%, we
found that the NPV was a positive figure of R42 341. This implies that the rate of
return that the project generates is more than 15%. The fact that the NPV is a pretty
large figure implies that the actual rate of return is quite a lot above 15%. We should
increase the size of the discount rate to reduce NPV because a high discount rate gives
a lower discount factor.
The IRR can be found either by using trial and error techniques or with the aid of a
sophisticated financial calculator or a computer. Here we demonstrate the trial and
error approach:

Managerial Finance
YEAR CASH DISCOUNT PRESENT DISCOUNT PRESENT DISCOUNT PRESENT

FLOW FACTOR VALUE FACTOR VALUE FACTOR VALUE
40% 44% 45%
0 (50 000) 1 (50 000) 1 (50 000) 1 (50 000)
1 20 000 0.7143 14 286 0.6944 13 888 0.6897 13 794
2 26 000 0.5102 13 265 0.4823 12 540 0.4756 12 366
3 38 000 0.3644 13 847 0.3349 12 726 0.3280 12 464
4 33 000 0.2604 8 593 0.2326 7 676 0.2262 7 465
5 23 000 0.1859 4 276 0.1615 3 715 0.1560 3 588
NPV 4 267 545 (323)
At 40% we still have a positive NPV of R4 267 and at 44% the NPV is still a positive
R545 and at 45% the NPV is negative R323. The IRR is therefore between 44 and
45%. The IRR that we are seeking is a discount rate for the NPV that is closest to 0
Rands. At 45% the NPV is closer to 0 Rands than 44%, so we will use 45% as the
IRR. By interpolation we will get the exact IRR –
= 44 + 545
1 868
= 44 + 0.63
= 44,63
By using the IRR, we find the rate of interest that will give us a NPV of zero for a
particular project. If it is much higher, (15% 45%) then we know by how much our
cost of capital could increase before the project would cease to be viable, and it is this
information that could be considered of the greatest use to managers faced with
uncertainties. If there is a large gap between the projects IRR and the firm’s cost of
capital, then, even if the cash flows prove inaccurate, the project would probably be
profitable.

Managerial Finance
DECISION CRITERIA
When IRR is used to make accept-reject decisions, the decision criteria are as follows:
 If the IRR is greater than the cost of capital, accept the project.
 If the IRR is less than the cost of capital, reject the project
These criteria guarantee that the firm earns at least its required return. Such an outcome
should enhance the market value of the firm and therefore the wealth of its owners.
THINK POINT
How the IRR of a project calculated and what must one look out for when using the IRR?
FACTORS AFFECTING CASH FLOW
 Relevant cash flows – one must adjust if necessary for such things as accruals, pre-payments
and depreciation.
 Sensitivity – the sensitivity of the cash flows to changes in its individual components i.e.
sales, variable and fixed costs.
 Profitability – cash flows might be altered due to delays in receiving monies from debtors or
payments made to creditors is too soon or both.
 Overseas projects – tax allowances, tax rates, timing of tax payments, exchange rate
fluctuations and inflation will affect cash flow

Managerial Finance
(10) CHOOSING BETWEEN NPV AND IRR
Both the NPV and IRR are sophisticated capital budgeting techniques for evaluating
investment alternatives. They take into account the basic characteristics of the discounted
cash flow techniques, such as:
 The time value of money is taken into account.

 The use of net cash flows and there is no distinction between capital and revenue to
emphasise the importance of liquidity.
 The emphasis is on the entire life of the project.
 The accrual concept is not used in capital budgeting.
Which method should Financial Managers choose? It is difficult to choose one method over
the other because of the theoretical and practical strengths they offer.
On a purely theoretical basis, the NPV is the better approach. The NPV assumes that any
intermediate cash inflows generated by an investment are reinvested at the firm’s cost of
capital. The use of IRR assumes the reinvestments at the often higher rate as specified in the
IRR.
The cost of capital is a reasonable rate at which the firm could actually reinvest immediate
cash inflows. Therefore, in theory, the NPV with its more conservative and realistic
reinvestment rate is preferable.
From a practical point of view, Financial Managers prefer the use of IRR. This is due to the
fact that Financial Managers look towards rates of return rather than actual Rand returns.
Because of interest rates, profitability is expressed as annual rate of return, therefore, the use
of IRR makes sense to financial decision makers. Furthermore, IRR measures the benefits
relative to the amount invested.

Managerial Finance
(11) CAPITAL BUDGETING TECHNIQUES USED BY SOUTH

AFRICAN COMPANIES
The financial executives making major investment decisions have a wide variety of capital
budgeting tools from which to choose. Each has their own assumptions, strengths,
weaknesses and degrees of complexity. A survey was undertaken which sought to answer the
following questions:
 How advanced are South Africa’s financial decision makers in using the available tools?
 Is there significant correlation between the sophistication of the capital budgeting
techniques adopted by the firms and their economic variables?
11.1 METHODS IN ACTUAL USE
Methods used can be divided into two categories, namely, those commonly used by financial
managers and those involving more exotic extensions of established techniques.
The research concentrated on the methods commonly used by Financial Managers and
include the payback period, ARR, NPV, Profitability index and IRR.
The research showed that the most popular method used is the payback period – rated in
theory as being unsophisticated and definitely a poor technique for use as the sole means of
evaluating investments. However, the discounting methods (IRR, NPV and profitability
index) received considerable support. The usage of several methods was common – the
average number of techniques used per firm was 2.31. Other techniques used include the
CAPM, MAPI and assessments of dividend and earnings yield were most common.
The survey also found that presently the methods of evaluation used moved away from the
less sophisticated methods to the more sophisticated time – weighted methods of NPV and
IRR. The sample revealed that 57,3% use time –weighted methods as the most important
basis for evaluation.

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Of particular interest is the fact that although the payback period was used by 68,6% of the
respondents, only 26,5% used it as the prime method of evaluation.
In comparison with American usage in the early 1970’s, the payback period was more
popular in South Africa in 1982, both as a primary and combined evaluation technique.
11.2 TREATMENT OF RISK AND UNCERTAINTY
Of the firms responding, 76.8% made some explicit adjustments to account for risk and
uncertainty. Hence, nearly a quarter of the firms are ignoring a critical factor in assessing
major investments.
11.3 THE EFFECTS OF INFLATION
It is essential that cash flows be adjusted for the effects of inflation when assessing major
investments – yet over 40% of the respondents make no such allowance. Several firms
inflated items in their cash flows for a specific number of years and then continued cash
flows un-inflated for the remainder of the life of the project. The average period of inflation
allowance for these firms was 6,75 years. The shortest being 2 years and the longest 10 years.
11.4 RATE OF RETURN ON REINVESTMENT
The use of time value of money methods entails an implicit assumption that cash flow from
any investment will be reinvested at some rate implied specifically by the model being used.
For example, the IRR measures the relative profitability of investments by identifying the
return on the declining balance of funds invested. Inherent in the technique is the assumption
that immediate cash flows generated in each period are reinvested at the IRR. In contrast, the
NPV, which uses a particular discount rate, assumes actual attainable reinvestment of cash
flows generally at that rate of return. The use of the IRR will maximise net worth if the
actual attainable reinvestment rate is equal to or greater than that of discount which equates
the present values of project cash flows with the investment outlay.

Managerial Finance
Thus, a “reinvestment rate problem” arises because the mathematical models used by the
discounted cash flow techniques assume a single reinvestment rate as well as the magnitude,
duration and pattern of the cash flows. From a practical point of view, the policies and
circumstances faced by a particular firm will almost certainly invalidate such an assumption.
Respondents to the survey were asked whether they made any explicit assumption about the
rate of return to be earned on reinvested funds. Only 17% of those who answered the
question made an assumption regarding reinvestment rates of return. In most cases, this was
their cost of capital rate which is implicitly assumed in the NPV model in any event.
www.moneymax.co.za

Managerial Finance
(12) CONCLUSION
SELF-CHECK QUESTION 1
The management of Bongani Wholesalers are considering two mutually exclusive investment
projects. The following data are available for each project:
Project A Project B
(Rand) (Rand)
Cost of plant and equipment 90 000 60 000
Salvage value nil nil
Expect profit/loss
Year 1 25 000 7 500

Year 2 (17 500) 10 750
Year 3 22 500 14 750
Bongani Wholesalers uses the straight line method of depreciation for all fixed assets.
The estimated cost of capital is 10% p.a.
Required: Calculate for each project
1.1 The Accounting Rate of Return.

1.2 The Payback Period
1.3 The Discounted Payback Period
1.4 The Net Present Value
1.5 The Internal Rate of Return
1.6 Which project would be chosen and why?

Managerial Finance
SOLUTION TO SELF-CHECK QUESTION 1
CALCULATION OF CASH FLOWS:
PROJECT A PROJECT B
YEAR PROFIT/ DEPRECIATION CASH YEAR PROFIT/ DEPRECIATION CASH
LOSS FLOW LOSS FLOW
1 25 000 30 000 55 000 1 7 500 20 000 27 500
2 (17 500) 30 000 12 500 2 10 750 20 000 30 750
3 22 500 30 000 52 500 3 14 750 20 000 34 750
1.1 ARR
ARR = AVERAGE PROFITS X 100

AVERAGE INVESTMENTS 1
= 10 000 X 100 = 11 000 X 100

45 000 1 30 000 1
= 22.2% = 36.7%
1.2 PAYBACK PERIOD
Investment (90 000) Investment (60 000)

Cash Flow Y1 55 000 Cash Flow Y1 27 500
(35 000) (32 500)
(22 500) ( 1 750)
2 Years 5 Months & 4 Days 2 Years & 18 Days

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1.3 DISCOUNTED PAYBACK PERIOD
YEAR CASH DISCOUNT PRESENT YEAR CASH DISCOUNT PRESENT

FLOW FACTOR VALUE FLOW FACTOR VALUE
10% 10%
0 (90 000) 1.0000 (90 000) 0 (60 000) 1.0000 (60 000)
1 55 000 0.9091 50 001 1 27 500 0.9091 25 000
2 12 500 0.8264 10 330 2 30 750 0.8264 25 412
3 52 500 0.7513 39 443 3 34 750 0.7513 26 108
NPV 9 774 NPV 16 520
Investment (90 000) Investment (60 000)

Discounted Cash Flow Y1 50 001 Discounted Cash Flow Y1 25 000
39 999 35 000
29 669 9 588
2 Years 9 Months 1 Day 2 Years 4 Months 12 Days
1.4 NPV
YEAR CASH DISCOUNT PRESENT YEAR CASH DISCOUNT PRESENT

FLOW FACTOR VALUE FLOW FACTOR VALUE
10% 10%
0 (90 000) 1 (90 000) 0 (60 000) 1 (60 000)
1 55 000 0.9091 50 001 1 27 500 0.9091 25 000
2 12 500 0.8264 10 330 2 30 750 0.8264 25 412
3 52 500 0.7513 39 443 3 34 750 0.7513 26 108
NPV 9 774 NPV 16 520

Managerial Finance
1.5 IRR
PROJECT A
15% 16% 17%
0 (90 000) 1.00 (90 000) 1.00 (90 000) 1.00 (90 000)
1 55 000 0.8696 47 828 0.8621 47 416 0.8547 47 009
2 12 500 0.7561 9 451 0.7432 9 290 0.7305 9 131
3 52 500 0.6575 34 519 0.6407 33 637 0.6244 32 781
NPV 1 798 343 (1 079)
The IRR we are seeking is a discount rate for which the NPV is closest to 0 Rands.
At 16% the NPV is closer to 0 Rands. To be exact, by interpolation -
16 + 343
1 1 422
The IRR will be 16.24%
PROJECT B
20% 25% 24%
0 (60 000) 1.00 (60 000) 1.00 (60 000) 1.00 (60 000)
1 27 500 0.8333 22 916 0.8000 22 000 0.8065 22 179
2 30 750 0.6944 21 353 0.6400 19 680 0.6504 20 000
3 34 750 0.5787 20 110 0.5120 17 792 0.5245 18 226
NPV 4 379 (528) 405
The IRR that we are seeking is a discount rate for which the NPV is closest to 0 Rands.
At 24% the NPV is closer to 0 Rands. To be exact, by interpolation
= 24 + 405
1 933
= 24,43%
1.6 In all the investment appraisals, Project B has the better returns. Project B also
has a superior NPV than Project A. Using the IRR, Project B’s cost of capital
can go up to 24% before it can be rejected.

Managerial Finance
SECTION 3
BUSINESS RISK

Managerial Finance
LEARNING OUTCOMES
On completion of this learning module, you should be able to understand:
 Distinguish between types of business risk
 Calculate returns of different share portfolios
 Describe the risks associated with different portfolios
 Display knowledge of total risk
 Explain the effect of standard deviations on different asset portfolios
 Describe the effect of the co-efficient of variance on different asset portfolios
 Evaluate CAPM as a measure of risk

Managerial Finance
(1) INTRODUCTION
To maximise share price, the financial manager must learn to assess risk and return. Each
financial decision presents certain risk and return characteristics, and the unique combination
of these characteristics has an impact on share price.
Definition:
Risk: The chance of financial loss i.e. assets having greater chances of loss are viewed as
more risky than those with lesser chances of loss. (Flynn, 2000: 285)
THINK POINT
How does risk relate to financial decision-making?
(2) TYPES OF RISK
2.1 Business Risk
Business risk arises from the nature of the environment in which a company operates. It is
primarily determined by the general economic conditions to which the firm is exposed and
the type of industry in which a company is involved. General economic conditions refer to
variables such as inflation, political stability and government regulations. These factors
affect all companies within a country. Industry factors are variables that affect specific
sectors of the economy, for example, the price of gold bullion has a major impact on the gold
mining sector, but relatively little influence on the wine producing industry. It is important to
note that the management of the firm has very little control over the business risk of a firm.

Managerial Finance
2.2 Operating Risk
Operating risk arises from the nature of the operating activities of the firm. The type of
industry often determines the general cost structure of a firm (proportions of fixed and
variable costs, capital- or labour- intensive production processes) and/or the pattern of sales
revenue. The total costs of production are usually divided into fixed and variable costs and
the measurement of operating risks are based on the proportion of fixed costs to total
production costs. Fixed costs can act as a “lever”, whereby a small change in sales revenue
can be magnified into a larger change in profits. The financial manager of a company can use
methods such as Cost-Volume-Profit (CVP) analysis to assess the operating risk of the firm.
However, a comparison between companies in the same industry on the basis of CVP
analysis shows that differences exist. This indicates that management has some degree of
control over the cost structure of the company.
2.3 Financial Risk
Financial risk arises from the extent to which a firm relies on debt to finance its operations.
When a firm borrows, it is liable for the interest payments of debt. Whilst operating risk
refers to the proportions of the firm’s fixed total production costs, financial risk is essentially
illustrated by the proportion of debt capital to the total capital of the firm. Interest payments
can be thought of as the firm’s fixed cost of finance. Financial risk is entirely under the
control of the firm’s management.
2.4 Total Risk
The total risk of a company is a combination of business, operating and financial risks.
Controlling the degree of total risk is an important managerial function. The financial risk is
the one variable that a firm can influence. However, business risk is determined by the
economic environment and is not subject to managerial control whilst operating risk is
determined by the nature of the firm’s business activities, hence it is hard to control.
Practical experience shows that companies with a high degree of business and operating risks
usually have a low degree of financial risk, while companies with a low degree of business
and operating risk have more scope for using debt capital.
One of the most important uses of assessing operating and financial risks, is the analysis of
the firms’ characteristics relative to other firms in the same industry and the analysis of

Managerial Finance
changes in risk and its components over time. Comparison with other firms allows the
assessment of both the risk inherent in an industry and the risk specific to each firm.
Analysing changes in risk components and total risk over time illustrates the firm’s
performance over time and gives an indication of changes in the cost and financial structures
that occur within a company.
The existence of any firm depends on the availability of capital, which the firm employs in
order to achieve its strategic objectives. The question of capital availability requires that
financial managers are aware not only of the different sources of capital, but also of where
such capital can be obtained.
(3) RISK MANAGEMENT
The measure of risk most commonly used in finance is the variance and its square root, the
standard deviation. The standard deviation measures the dispersion around the expected
value. The larger the standard deviation, the higher the risk of an investment is considered to
be, as a higher standard deviation infers that there is a greater probability of returns below the
expected return. Consider the normal distributions for the returns of two different assets A
and B illustrated in the figure. Both have been constructed using 100 data readings of past
returns.
f f
ASSET A ASSET B
0
RETUR
3 6 9 12 15 18 21 24 27 0 3 6 9 12 15 18 21 24 27
NS OF
PERCENTAGE ANNUAL RETURN PERCENTAGE ANNUAL RETURN
The summary statistics of Asset A and Asset B are given as follows:
ASSET A ASSET B
Arithmetic mean (expected return) 15% 12%
TWO
Standard deviation (risk) 5% 3% (Flynn, 2000: 283)

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It is apparent from the summary statistics and from the graphical representation that asset A
carries more risk as there is a higher chance of earning below the expected return of 15%.
Asset B has much tighter distribution, with a standard deviation of only 3% and a much lower
chance of earning below 12%. Asset A has a greater risk because it has a higher standard
deviation.
What is also apparent is that asset A offers an average return of 15% while asset B only offers
an average return of 12%. This is not by chance. Investors demand a higher return on an
asset, which carries risk. This accords with intuition and market forces ensure that this
relationship is maintained. Assume for example that both assets had the same expected
return, but that asset A has greater risk as measured by the standard deviation. Rational
investors will sell shares in asset A in preference for shares in asset B. This will result in a
decline in the share price of asset A (and resultant higher returns for investors who purchase
at the lower price) and an increase in the share price of asset B (and resultant lower returns
for investors who purchase at the higher price). The market forces will thus lead to returns,
which are consistent with those illustrated.
THINK POINT
What does the standard deviation of asset returns indicate? What relationship exists between
the size of the standard deviation and the degree of asset risk?
The coefficient of variation (CV), is also used to measure the relative dispersion which is
useful in comparing the risk of assets with differing expected returns. In the above example,
the CV for share in asset A is 0.33 (5 ÷ 15) and share in asset B is 0.25 (3 ÷12).
The higher the CV, the greater the risk. On the other hand, let us assume that the CV for
Asset A is 0.2 and Asset B is 0.3. Based solely on their standard deviations, the firm would
prefer Asset B because it has a lower standard deviation.

Managerial Finance
However, management would be making a serious error in choosing Asset B over Asset A.
This is because the relative dispersion – the risk of the assets as reflected in the CV is lower
for A than B (0.2 vs. 0.3). Clearly, the use of the CV to compare asset risk is effective
because it also considers the relative size or expected return, on the asset.
THINK POINT
When is the co-efficient of variation preferred over standard deviation for comparing asset
risk?
(4) RISK IN A PORTFOLIO OF INVESTMENTS
Every financial manager of a business will consider the total risk of the business carefully
and attempt to manage the risk in such a way that shareholders receive the best advantage.
From an investment analysis point of view, investors consider the most effective way of
investing funds. It is well known that placing all one’s funds in one investment only is more
risky than spreading the funds. This is known as diversification and the different
investments, into which one diversifies is known as a portfolio of investments.
4.1 Portfolio Theory
In the early 1970’s there was considerable interest in portfolio theory as an investment
strategy. This theory has been developed further in recent years. The theory holds that
rational investors all hold a portfolio rather than investing in a single investment. The effect
of this is that risk is reduced through holding a portfolio.
The portfolio theory identifies two types of risk: systematic and unsystematic risk.
Systematic risk relates to the economy and the stock market as a whole. Share prices
generally are subject to fluctuations. Any investor who invests in these markets must thus be
subject to this risk as it cannot be eliminated through diversification. Unsystematic risk

Managerial Finance
relates to specific investment. This risk can be eliminated through investing in a portfolio.
Quite simply, it is based on the principle that some companies will perform well when others
do badly and vice versa. The differences between company risk can be eliminated but the
overall market risk cannot.
The above can be explained by using the diagram below: Let us consider what happens to
the risk of a portfolio consisting of a single security (asset), to which we add securities
randomly selected from, say the population of all actively traded securities.
Diversifiable Risk
Portfolio Risk
Total Risk
Non-diversifiable Risk
1 5 10 15 20 25
Number of Securities (Assets) in Portfolio
Using the standard deviation of return, to measure the total portfolio risk, the diagram depicts
the behaviour of the total portfolio risk (y axis) as more securities are added (x axis). With
the addition of securities, the total portfolio risk declines, as a result of the effects of
diversification, and tends to approach a lower limit. Research has shown that, on average,
most of the risk-reduction benefits of diversification can be gained by forming portfolios
containing 15 to 20 randomly selected securities.

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The total risk of a security can be viewed as consisting of two parts:
Total security risk = Non-diversifiable risk + Diversifiable risk
Diversifiable risk (sometimes called unsystematic risk or specific risk) represents the portion
of an asset’s risk that is associated with random causes that can be eliminated through
diversification. It is attributable to firm-specific events, such as strikes, lawsuits, regulatory
actions, and loss of a key account. Non-diversifiable risk (also called systematic risk) is
attributable to market factors that affect all firms; it cannot be eliminated through
diversification. Factors such as war, inflation, international incidents, and political events
account for non-diversifiable risk. Because any investor can create a portfolio of assets that
will eliminate virtually all diversifiable risk, the only relevant risk is non-diversifiable risk.
Any investor or firm therefore must be concerned solely with non-diversifiable risk. The
measurement of non-diversifiable risk is thus of primary importance in selecting assets with
the most desired risk-return characteristics. (Gitman, 2003: 233-234)
THINK POINT
How are total risk, non-diversifiable risk and diversifiable risk related? Why is non-
diversifiable risk the only relevant risk?
4.2 Allowing for Systematic risk
To consider this, we need first to note that there is an efficient frontier for investments as a
whole. In the diagram below, each point on the line representing this frontier corresponds to a
portfolio made up of some of the securities available in the capital market, with all specific
risk diversified.

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If there were any remaining specific risk in any of these portfolios, it would be possible to
move this efficient frontier further upwards to the left, that is to a position with less risk for
the return indicated.
The Efficient Frontier

EXPECTED RETURN %
2 3
C
2
B
1 1
A
0 1 2 3
RISK (STANDARD DEVIATION)
EFFICIENT FRONTIER
Source: Mancosa Managerial Finance Study Guide,( 2002: 14)
The points marked on the efficient frontier correspond to the positions of three different
investors, each of whom prefers the level of return and risk associated with the chosen point
to any other on the frontier. Each investor has a series of indifference curves, and will choose
to be situated on the highest indifference curve that is tangential to the best available
investment opportunities.
The average investor is risk averse, and so will only support more risky undertakings if the
reward for doing so is at a suitably high level, hence the slope of these indifference curves.

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The most advantageous result an investor can obtain would therefore be where one of his/her
indifference curves is tangential to the efficient frontier, for at that point all specific risk
would have been removed, and no greater utility could be derived from moving to any other
position.
 An investor choosing position A does not wish to be exposed to too much risk, and is
therefore satisfied with a limited expected return.
 An investor choosing position B is willing to take on more risk, for an additional return.
 An investor choosing position C is less risk averse still, but must be compensated by a
higher return than investor B.
No investor would wish to remain in a position to the right, or below, the efficient frontier as
in that case specific risk would still exist. No opportunities currently exist to the left, or
above, the frontier.
Note: the efficient frontier is a curve, because the extra return for accepting extra risk is not
constant – eventually no additional return will be on offer, no matter what the risk, so the
curve flattens.
4.3 The Capital Market Line (CML)
We now introduce a straight line in addition to our efficient frontier curve. Remember that
the efficient frontier represents portfolios with all specific risk diversified away, but the
systematic risk is still present. However, there exist completely risk-free, opportunities to
invest, for example, in RSA government stocks. Our new line, referred to as the capital
market line or CML, reflects the assumption that there is a given risk-free rate, rf, at which all
investors may lend or borrow any amount they choose.
The CML, as you will notice, starts from rf. It then slopes upwards to the right, indicating
that, in return for accepting any risk, investors must be compensated – the greater the risk, the
greater the reward – in other words, they must receive a premium in addition to the risk-free
rate for investing in risky securities. (Should interest rates change, then the CML would start
at a different percentage).

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All investors would therefore wish to locate on this risk-free line, which is in reality the new
“efficient frontier”. According to the pattern of their indifference curves, they could choose
whether to invest only in risky assets, or partly in risk-free and partly in a portfolio of risky
securities. The only risky portfolio that now gives the highest utility is M, as all other risky
portfolios lie below the CML and are thus inefficient:
 Some would choose to invest partly in M and could then invest (lend) their additional
funds, for example X –A, at risk-free rate. Note that these investors would now be on a
higher indifference curve than in our first diagram.
 Other investors, who seek greater risks, could seek to borrow at the risk-free rate in
order to support a portfolio such as Y. This gives greater satisfaction than portfolio C
originally did, as these investors also would now be on a higher indifference curve than
previously.
 Some investors highest possible indifference curve remains tangential to the efficient
frontier in the same place as previously, coinciding with the one point where the CML is
itself tangential to the efficient frontier. Such investors will invest all of their own funds
solely in risky securities – portfolio M, which corresponds to portfolio B in our first
diagram.
EFFICIENT FRONTIER & CML
Y
C
EXPECTED RETURN %
rm M
rf x
m
RISK (STANDARD DEVIATION)
EFFICIENT FRONTIER
---------------------- CAPTIAL MARKET LINE
Source: Mancosa Managerial Finance Study Guide ,(2002: 17)

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Portfolio M is considered to represent a proportion of all securities in the capital market, and
is thus referred to as the market portfolio. Strictly speaking, other capital assets should also
be considered, such as precious stones and antiques – potential substitutes for securities. No
one actually holds every security in existence, but in practice a well-diversified portfolio is
likely to correspond to the All Shares Index in its weighting of various market sectors.
The premium for risk required for the market portfolio, rm – rf, will vary according to the
perceived riskiness of M.
We can now go one step further, and compare the amount of this premium with that required
to invest in an individual risky security or project.
4.4 Using CAPM to measure Systematic Risk
Providing M will have the systematic risk that relates to the market as a whole – average
systematic risk. Investors in individual shares (or companies investing in projects) will want
a premium to compensate them for the amount of systematic risk they face in buying that
particular share. The required return for a share could be higher or lower than the average
market return.
Investors would be expected to:
 Require a higher return than rm if the systematic risk of a share is higher than the risk of
portfolio M.
 Need only a lower return than rm if their shares are lower in systematic risk than
portfolio M.
By plotting points representing the returns for the market portfolio M, and an individual share
over a period of time as a scatter graph, and drawing a line of best fit, we can show the
relationship between the market return rm and rs, (the return on an individual security). This
tells us that:
 There is a linear relationship between expected returns from the market and the expected
return from a share.
 These returns are positively correlated – an increase in rm would be accompanied by an
increase in rs.
 We can measure the relationship between rm and rs.

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The way we do this is to use the Capital Asset Pricing Model (CAPM). The CAPM, which is
mathematically derived form the CML, tells us that the expected return from a risky asset
depends on rf, the risk-free rate of interest rm, the expected return from M, the market
portfolio, and the degree of correlation between rs and rm. This last item is known as the beta
factor.
The beta measures the volatility of the returns of the share relative to the overall market,
which has a beta of 1. A company with a beta greater than one is more volatile (risky) than
the average, while a beta of lower than 1 indicates less volatility. The CAPM is defined as
follows:
Re = Rf + (Rm - Rf)
Where,
Re = the return expected from the share

Rf = the risk free state of return
Rm = the return expected from the market as a whole
 = the beta (relative volatility) of the share
The beta of a company requires statistical calculation of the covariance of the share relative
to that of the market as a whole. A number of investment analysts offer the service of
calculating and providing company betas.
Let us use an example
Globe Rand Limited has a beta of 1.2. Calculate the required return of an investment if the
average market return is 26% and the risk free rate of 14%.
Using the formula
Re = Rf + (Rm - Rf)
= 14% + 1.2(26% - 14%)
= 28,4%
The returns of Globe Rand Limited are expected to be more volatile than the average share on
the market. It thus has a beta in excess of 1. Because of this risk, an investor who considers
holding this share within a portfolio requires the return, which is higher than market average.

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The beta of a share is a measure of the volatility of its returns compared with that of the
market. The market return is considered to have a beta of 1. So a share that has an above-
average response to changes in economic circumstances will have a beta greater than 1,
whereas any share which has below-average change will have a beta less than 1.
It is possible to have negative betas if we consider that some economic changes which
adversely affect most firms could be beneficial to others. However, in practice several
factors that influence returns seem to occur at once, and so overall shares are likely to have
positive betas.
If an investor has a portfolio such that specific risk has been diversified , each of the
securities making up that portfolio could have different systematic risks. The beta for any
portfolio of securities will therefore be the weighted average of the betas of the components
of that portfolio.
THINK POINT
What risk does beta measure? How can you find the beta of a portfolio?
4.5 The Security Market Line (SML)
We can draw another diagram to show the relationship between expected returns and risk,
represented this time by beta instead of by standard deviation. We have a straight line,
representing a linear relationship, starting from rf which we can refer to as the Security
Market Line or SML.

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EXPECTED RETURN % THE SECURITY MARKET LINE
rf
RISK (BETA)
SML
Source: Mancosa Managerial Finance Study Guide ,(2002: 19)
You should note that, while high betas correspond to high-expected returns, this does not
necessarily mean that these returns will be achieved.
4.6 CAPM and Investment Projects
We can now apply what we have learned about CAPM, betas and shares to the cost of capital
used to appraise investment projects.
It would seem sensible to include in this cost of capital an allowance for systematic risk, if
the beta of the shares of our company enables us to calculate the return required for investing
in our risky shares.
However, we should note that the value of the beta, and therefore Re, is based on existing
perceived systematic risk. If we change the nature of our business or the way it is financed
we are also changing systematic risk, and thus beta.

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So, when we need to appraise a project, which does not fit in our usual type of business, we
could use, instead of the beta already given for our company’s activities, the beta relating to
companies already dealing in projects of the type we are now considering.
For example, if a furniture manufacturer were contemplating a project in market gardening,

the average beta for market gardening firms could be used to estimate a cost of capital (the
required return) rather than the beta of the furniture manufacturer at this date. If the project
has a positive NPV when discounted at the cost of capital so calculated, then it would be
acceptable, and its systematic risk would have been allowed for.
4.7 Does CAPM Work?
There are a number of assumptions behind the derivation of CAPM, some of which we shall
be referring to again when looking at a firm’s gearing and its dividend policy. The problem
areas are:
 There are no taxes

 There are no charges for dealing in securities
 All investors and lenders can borrow as much as they like at the risk-free rate
 All investors have the same perceptions of each security/project.
As these assumptions are not true in real life, some managers may well decide that CAPM is
flawed and thus not worth using.
Many researchers have carried out tests to see how well CAPM can explain and predict event.
For example, by calculating betas for securities based on monthly returns (dividends and
capital gains) for those securities compared to those for the market portfolio, it is possible to
assess whether CAPM adequately explains the returns for the securities for the period in
question. Most tests until relatively recently obtained results which supported CAPM.
However, more recent research has suggested that, while there is a correlation between
expected returns and beta, other factors such as the size of the company are also important.

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There are also difficulties in measuring the expected market return (over what period? Which
starting point should we take?) and deciding what can be taken as a risk-free asset to identify
the risk-free rate. (Note: CAPM is derived post-tax – it is important to ensure that rf as well
as rm is a post-tax figure.)
While there are undoubtedly imperfections in the CAPM assumptions (more complicated
models have been derived to try to compensate for these) it is certainly worth considering as a
practical method with a logical background for financial managers to use to determine the
cost of capital.
THINK POINT
Why do financial managers have some difficulty applying CAPM in financial decision-
making? Generally, what benefits does CAPM provide them?
4.8 Assessing Business Risk in Practice
So what do practising financial managers actually use to assess business risk? In a survey by
Pike and Ho (1991), on a scale ranging from 1 (never) to 6 (very often) subjecting
judgement/intuition came top of the list!
Subjective/intuitive assessment 3.94

Sensitivity analysis 3.84
Probability 2.46
CAPM 1.66
Risk (computer) simulation 1.47
Many companies probably use more than one method, and sensitivity analysis in particular is
often combined with other methods.
It might be interesting for you to see what risk assessments are used in your own
organisation!

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(5) CONCLUSION
A firm’s risk and expected return directly affect its share price. Risk and return are the two
key determinants of the firm’s value. It is therefore the financial manager’s responsibility to
assess carefully the risk and return of all major decisions in order to make sure that the
expected returns justify the level of risk being introduced.
The way the financial manager can expect to achieve the firm's goal of increasing its share
price (and thereby benefiting its owners) is to take only those actions that earn returns at least
commensurate with their risk. Clearly, financial managers need to recognise, measure, and
evaluate risk-return tradeoffs in order to ensure that their decisions contribute to the creation
of value for the organisation.
Suppose Goldie Company and Chicklet Company have experienced the following returns for
the last four years.
Year Goldie Returns Chicklet Returns

(Rand) (Rand)
2000 0.50 0.09

2001 -0.20 0.05
2002 0.30 -0.12
2003 0.10 0.20
Calculate:
1.1 The Average returns

1.2 The Variance
1.3 The Standard Deviation
1.4 Which investment was more volatile?

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1.1 To calculate the average returns, we add up the returns and divide by four, i.e.:
Goldie average return = 0.70/4 = 0.175

Chicklet average return = 0.22/4 = 0.055
1.2 Variance for Goldie
YEAR ACTUAL AVERAGE DEVIATION SQUARED

RETURN RETURNS DEVIATION
2000 0.50 0.175 0.325 0.105625
2001 -0.20 0.175 -0.375 0.140625
2002 0.30 0.175 0.125 0.015625
2003 0.10 0.175 -0.075 0.005625
TOTAL 0.70 0.000 0.267500
The variance can now be calculated by dividing the sum of the squared deviations, by
the number of returns less one. Let Var ( R ) or Q2 (read this sign as “sigma squared”)
stand for the variance of the return.
Var ( R ) = Q2 = 0.2675 = 0.0892

4-1
Variance for Chicklet
YEAR ACTUAL AVERAGE DEVIATION SQUARED

RETURN RETURNS DEVIATION
2000 0.20 0.055 0.145 0.021025
2001 0.05 0.055 -0.005 0.000025
2002 0.09 0.055 0.035 0.001225
2003 -0.12 0.055 -0.175 0.030625
TOTAL 0.000 0.0529
Var ( R ) = Q2 = 0.0529 = 0.0176

3

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1.3 STANDARD DEVIATION (Q)
Goldie 0.0892 = 0.2987 = 29.87%
Chicklet 0.0176 = 0.1327 = 13.27%
1.4 The standard deviation for Goldie is very much higher than Chicklet.
Thus, Goldie Company is a more volatile investment.

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Suppose we have the following investments:
SHARE AMOUNT PERCENTAGE EXPECTED BETA

INVESTED RETURN
V R1 000 10% 8% 0.80
X R2 000 20% 12% 0.95
Y R3 000 30% 15% 1.10
Z R4 000 40% 18% 1.40
TOTAL R10 000 100%
Calculate:
2.1 The expected return on the portfolio
2.2 The Beta of the portfolio
2.3 Does the portfolio have more or less systematic risk than an average risk?

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2.1 Expected Return
E (RP) = 0.10 X E (RV) + 0.20 X E (RX) + 0.30 X E (RY) + 0.40 E (RZ)

= 0.10 X 8% + 0.20 X 12% + 0.30 X 15% + 0.40 X 18%
= 0.8 + 2.4 + 4.5 + 7.2
= 14.9%
2.2 The Portfolio Beta
BP = 0.10 X BV + 0.20 X BX + 0.30 X BY + 0.40 X BZ

= 0.10 X 0.80 +0.20 X 0.95 + 0.30 X 1.10 + 0.40 X 1.40
= 0.08 + 0.19 + 0.33 + 0.56
= 1.16
2.3 Since the Beta is higher than 1.0, this portfolio has a greater systematic risk than an
average asset.

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SECTION 4
LONG-TERM SOURCES OF FINANCE

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LEARNING OUTCOMES
On completion of this learning module, you should be able to:
 Describe the sources of long-term financing


 Distinguish between equity financing and non-equity financing

 Display knowledge of retained earnings and debt financing as sources of finance

 Consider lease or Buy decisions

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(1) INTRODUCTION
The weighted average cost of capital reflects the risk associated with the long-term use of
funds and is based on the long-term target mix between debt and equity. This implies that
companies should finance every project by using the tagged mix, but this is not practical.
There are a number of reasons for this, but the most significant consideration is the costs
associated with issuing financial securities – registration and administration fees,
commissions earned by merchant bankers, lawyers, company advisors etc. As a result,
companies will often alternate between the issue of debt and equity, and as a result the actual
capital structure will often deviate from the target until the next project needs to be financed.
Therefore, the aim is to achieve the optimal target debt-equity mix over a long-term, as
illustrated by the average debt-to-equity ratio over a number of years.
A further detailed discussion on the sources of capital and their characteristics is warranted,
since an awareness of the issues concerning the use of different sources has a major impact
on the ability to maximise the value of the firm. More specifically, the capital structure
decision determines the financial risk of the company. This is the only component of the
total risk of a company that is under the complete control of management. The other two
components, business and operational risk, are outside management control. The sources of
capital of a company can be divided into long-term sources, affecting the long-term capital
structure, and short-term sources, affecting the working capital decision.
The discussion between short, medium and long-term finance is not well defined but, as a
guide, short-term is up to one year, medium-term is from one to five years, and long-term is
from five years upwards.

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(2) SOURCES OF LONG-TERM CAPITAL
2.1 Equity Financing
2.1.1 Ordinary Shares
Equity is the capital provided to a firm by its owners, thus equity’s most important
characteristic is that it represents an ownership claim. Equity is often defined as the residual
value of the company i.e. the difference between the value of a firm’s total assets and total
liabilities. Equity holders are entitled to the residual assets of a firm on dissolution, but
otherwise equity finance is not repayable.
In the process of ordinary business, shareholders have a claim on the residual earnings of a
firm, after all expenses, including interest, have been paid. Shareholders may receive these
residual earnings in the form of dividends, but a firm is not obliged to automatically pay
dividends.
Dividends are only payable after the firm has declared a dividend payment. The amount of
the dividend is neither fixed nor tax deductible and it is determined by the firm’s
management. Shareholders cannot force a firm into liquidation if it has not paid dividends.
Equity holders, being the owners of the company, have the right to control the firm and do so
through voting for and choosing directors/managers who run the company on their behalf. In
addition, shareholders have the right to vote on major decisions affecting the firm, such as
merger and take-over offers, or the sale of subsidiaries. The ownership of a significant
proportion of the total equity in a company allows a considerable control over the company.
For example, ownership above a specified percentage allows the blocking of special
resolutions, gives effective control over the Board of Directors and allows the passing of
special resolutions without restraint.

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2.2 Non-Equity Financing
2.2.1 Preference Shares
In addition to ordinary shares, companies may also issue preference shares, which have some
of the characteristic of ordinary equity and some of the characteristics of debt. Preference
shares typically have stated fixed dividend and can be redeemable, thus resembling debt as
far as the firm has a fixed commitment and the original capital can be repaid. Alternatively,
preference shares may be participating, which means that preference shareholders are entitled
to a share of the residual earnings of a firm. Some preference shares may have a
convertibility provision, which allows them to be converted into ordinary shares under certain
circumstances. For tax purposes, preference shares are treated, as equity and preference
dividends are not tax-deductible. Preference shares present an ownership claim, but have a
reduced risk in comparison to ordinary shares. The trade-off is often a limitation on the
amount of control preference shareholders have on the company. As a general rule,
preference shareholders have no voting rights.
2.3 New Issues
Additional equity capital is obtained via the sale of new shares. Access to equity capital is
easiest to obtain if a company is listed on the JSE Securities Exchange, South Africa’s most
important financial market. The JSE is divided into 3 sections, allowing companies of
different size and characteristics to obtain a listing. The main board of the JSE has stringent
listing criteria, which can typically be met only by relatively large companies.
The Development Capital Market (DCM), Venture Capital Market (VCM) and Alternative
Exchange (ALTX) provide opportunities for smaller companies to access capital. The
Development Capital Market sector of the JSE was established to facilitate trading of shares
of companies that do not meet the criteria for a primary listing. Smaller, growing companies
in need of finance can list on the DCM. This enables the public to invest in younger, more
venturesome companies. The Venture Capital Market was introduced as a sector of the JSE
to encourage entrepreneurship and to give investors the opportunity to participate in high risk,
speculative projects. In addition to the criteria listed below, there are another three
requirements of the VCM, designed to protect investors from unscrupulous management.

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 The majority of directors and managers should have successful track records.
 Disposing of assets to anyone associated with the control of the company will require
the consent of the company in a general meeting, with the controlling shareholder not
voting at the meeting.
 The company must display in bold block letters, at the beginning of its prospectus or
pre-listing statement, a warning of the speculative nature of investment in such a
company.
The following table of primary requirements for a listing of the JSE Main Board, DCM,
VCM and ALTX provides an overview:
Listing Requirements Main Board DCM VCM ALTX

Share capital R25 million R0.5 million R1 million R2 million
Profit history 3 Years None 1 Year None
Pre-tax Profit R8 million N/A N/A N/A
Shareholder spread 20% 10% 10% 10%
Number of Shareholders 500 75 75 100
Sponsor/DA Sponsor Sponsor Sponsor Designated adviser
Publication in the press Compulsory Compulsory Compulsory Voluntary
Number of transaction 3 3 3 2
categories
Special requirements N/A N/A N/A Financial Director
Annual Listing fee 0.04% of average 0.04% of average 0.04% of average R20 000 (including
market capitalisation market capitalisation market VAT)
with a minimum of with a minimum of capitalisation with
R26 334 and a R26 334 and a a minimum of
maximum of R121 700 maximum of R121 700 R26 334 and a
(including VAT) (including VAT) maximum of
R121 700
(including VAT)
Education Requirements N/A N/A N/A All directors to
attend Directors
Induction
Programme
(http://www.altx.co.za)

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2.4 Rights Issues
In a rights issue, the company sets out to raise additional funds from its existing shareholders.
It does this giving them the opportunity to purchase additional shares. These shares are
normally offered at a price lower than the current share price quoted, otherwise shareholders
will not be prepared to buy, since they could have purchased more shares at the existing price
anyway. The company cannot offer an unlimited supply at this lower price; otherwise the
market price would fall to this value. Accordingly, the offer they make to the existing
shareholders is limited. For example, they may offer one new share for every four held.
Assuming this rights issue is taken up by the existing shareholders, the market price of the
shares will readjust to a value above that of the rights issue but below the original market
price. All things being equal, the new value of the shareholders’ investment should equal the
original value plus the money paid for the shares in the rights issue. If a shareholder ignores
the rights issue, the number of shares held will have remained the same but the value of each
will have dropped. So ignoring the rights issue is not a recommended course of action. The
normal thing to do in these circumstances is to sell all or part of the option to acquire new
shares at the lower price. If the option on all the new shares is sold, then the result is some
cash and a holding of less value than hitherto. In theory, the cash should compensate for the
loss in value of the previously. It is possible to sell only part of the option and to use the
money received to purchase the unsold part. In this way the value of the original holding can
be maintained. Dealing charges will be payable to a sharebroker or bank for doing this.
Say for example, a company’s shares are trading at 400c each, and the directors announce a 1
for 4 rights issue at 300c. After the issue, the company’s shares can be expected to fall to ( 4 x
400c + 1 x 300 c)/5 = 380c. This means that the right to buy 1 new share at 300c is worth 380c –
300c i.e. 80c. This will determine the value of the rights in the market place. The company
will sell any rights not taken up, and compensate the shareholders accordingly.
If the company had 100 million old shares in existence, it will raise R75 million by way of
the rights issue. Clearly, it does not really matter whether this is called 25 million @ 300c,
50 million @ 150c or any other feasible combination. The directors’ freedom will be
restricted by the number of authorised but unissued shares in existence, and the nominal
value of the shares, but even these are variable in the long run. Merchant bankers normally

Managerial Finance
advise only a small discount from the prevailing price, but that may simply be to make their
underwriting business look justified. The real question is whether the R75 million will be
invested wisely, but this tends to be squeezed out by futile debate as to what the price should
be.
2.5 Share Splits And Bonus Issues
These are shares issued without payment to holders of existing ordinary shares. They are
issued because the price of the existing shares has become too high. Bonus issues are at the
initiative of the company directors, with the subsequent approval of the shareholder.
Obviously these additional shares are normally accepted by the shareholder, but they are not
getting something for nothing even though they are called bonus shares. This is because if all
other things are unchanged, the value of the company remains unaltered. Accordingly, if
before the bonus issue, there were 1 million shares each valued at 220 cents, then if there was
a one for one bonus resulting in the number of shares increasing to 2 million, the price of the
shares would fall to 110 cents. Thus the shareholders would have twice as many shares each
with half the value. In many cases, bonus issues are made in different ratios of new shares to
each existing share but the same principle that the value of the holding is unchanged remains.
Consequently selling the shares from the bonus issue reduces the value of the individual’s
holding. Usually bonus issues are of ordinary shares but the issue can be in the form of
preference shares. The primary reason for issuing bonus shares is to conserve cash by not
paying cash dividends.
THINK POINT
Discuss your company’s capital make-up in terms of equity financing and non-equity
financing.

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2.6 Retained Earnings
The equity capital used by a firm effectively comes from 2 sources: funds directly raised by
the firm through the sale of newly issued shares, and funds retained from the cash flows
generated during the course of business. The latter is commonly known as retained income
(earnings), and represents the accumulated funds that the company chooses not to distribute
to shareholders in the form of dividends. The decision as to the proportion of cash flows
generated every year that are retained as opposed to being paid out as a dividend to
shareholders, is known as the “dividend decision” of the firm. Retained income is part of
shareholders’ funds, hence from the shareholders’ point of view, the company must still
generate the required rate of return on these funds. Shareholder effectively have to forego
current dividends in the expectation of future growth, and the company has the use of this
equity capital without having to incur the expense of issuing new shares. Retained income
often provides the necessary equity proportion for the undertaking of new projects.
Successful companies tend to generate cash flows in excess of their capital budgeting needs,
and excess is typically distributed to shareholders as dividends. However, even the most
profitable companies may require additional new equity capital, especially when a major
expansion is considered.
2.7 Debt Financing
Debt is generally referred to as the capital that a firm borrows for a limited period of time.
The most important characteristic of debt is that it does not constitute an ownership claim on
a firm. A debt obligation is a contractual agreement, which usually states the amount
borrowed, the interest payable and the dates at which interest payments and capital
repayments are due. An important feature of debt financing is that interest payments are tax-
deductible i.e. the firm’s tax liability is calculated only after interest payments have been
deducted from the firm’s earnings.
2.7.1 Debentures
A debenture is a document issued by a company containing an acknowledgement of debt. It

need not give, although it usually does, a charge on the assets of the company. The
Companies Acts define “debenture” as including debenture stock and bonds, it is quite
common for the expressions “debenture” and “bond” to be used interchangeably. Company
debentures can also be referred to as “loan share”.

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Usually a debenture is a bond given in exchange for money lent to the company. Debentures
can be offered to the public only if the application form is accompanied by a prospectus. The
company agrees to repay the principal to the lender by some future date, and in each year up
to repayment it will pay a stated rate of interest in return for the use of the funds. A
debenture holder is a creditor of the company and the interest has to be paid each year before
a dividend is paid to any class of shareholder.
2.7.2 Secured or unsecured
Debentures and debenture share can be secured or unsecured. It is usual, however, to use the
expression “debenture” when referring to the more secure form of issue, and “loan share” for
less secure issues. When secured this is by means of a trust deed. The deed is usually in
favour of the trustees and may be the whole or part of the property of the company. The
advantage of a trust deed are that a prior charge cannot be obtained on the property without
the consent of the debenture holders, the events on which the principal is to be repaid are
specified, and power given for the trustees to appoint a receiver and in certain events to carry
on the business and enforce contracts.
The debentures can be secured by a charge upon the whole or a specified part of a company’s
assets, or they can be secured by a floating charge upon the assets of the company. In this
latter case, the company is not precluded from selling its assets. The latter case is known as a
general lieu, whereas the debenture issued on the security of a specific asset is a mortgage
debenture or mortgage bond. With a floating charge, when the company makes a default in
observing the terms of the debentures, a receiver may be appointed and the charge becomes
fixed, with the power to deal in the assets passing into the hands of the receiver. Such
restrictions are referred to as “covenants”.
2.7.3 Convertibles
Convertible loan share is a loan share, which, at the option of the holder, may be converted
into ordinary shares in the company under specific conditions.
One advantage, which is often quoted for convertible debt, is that it is cheaper than ordinary
debt finance since the conversion option allows the security to be issued with a lower coupon

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rate than would otherwise be the case. Although it is true that the coupon on convertibles is
lower, this does not mean that the overall cost is lower since one must also consider the
expected cost of the conversion option.
The lower coupon rate of a convertible may, however, be advantageous from a liquidity point
of view. This form of finance may suit a project where the cash inflows are expected to be
low in the early years.
Prior to conversion, the security will represent debt finance and will therefore increase the
level of gearing of a company. However, the increase in gearing will not be as great as for
ordinary debt because of the lower coupon rate. It is for this reason that convertible securities
are often issued in cases of companies already being highly geared and not wanting to raise
straight equity finance.
Convertibles are seen as a way of issuing deferred equity. This may be particularly
advantageous if existing shareholders want to minimise any loss of control since the number
of shares issued via a convertible (assuming conversion takes place) will be smaller than if
straight equity were issued.
A useful aspect of convertibles is that, assuming the company’s share price rises sufficiently
to force conversion, the debt is self-liquidating. Since it is replaced by equity, conversion
will reduce the level of gearing and thereby enable the company to issue further debt finance.
While convertibles remain as debt, the interest is tax deductible. This gives rise to the tax
advantage, which also accompanies other forms of debt finance. However, since the coupon
rate on this security is lower than that associated with normal debt, the tax advantage is
consequently reduced also.
Unlike most debentures, convertibles are often not secured upon the assets of the company.
When they exist in this form they are known as convertible unsecured loan shares. This may
be particularly advantageous if a company does not have assets appropriate for use as
security, or if the assets have already been used up with other debt finance.

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Example
Molly Limited has in issue convertible loan share with a coupon rate of 10%. Each R100
nominal is convertible into 20 ordinary shares. The market price of the convertible is
R108, while the current ordinary share price is R4.80. Calculate:
1. the conversion premium

2. the conversion value
Solution
The conversion terms are R100 loan share = 20 ordinary shares. This is known as the
conversion ratio.
The conversion terms could also be expressed as: R5 loan = one ordinary share.
1. The conversion premium measures how much more expensive it is to buy the
convertible loan share than the underlying ordinary share.
The cost of buying R5 loan share is:
R5 x 108 = R5.40
100
Compared to the cost of buying one ordinary share R4.80

The conversion premium is therefore:
5.40 – 4.80 = 12.5%

4.80
In this case, it is more expensive to purchase the loan share and convert, than to
purchase one ordinary share directly.

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2. The conversion value is calculated as the market value of ordinary shares that
is equivalent to one unit of the convertible.
Conversion value = conversion ratio x market price per ordinary share

= 20 x R4.80
= R96
Note that from this calculation of conversion value, the conversion premium may also
be stated as:
R108 – R96 = 12.5%

R96
2.7.4 Loans
Long term loans are private contracts, usually between a company and a financial institution,
secured by specific assets, so that if the company is liquidated, the creditor has a preferential
claim over the specified asset, often some fixed property of the company.
The amount that can be raised through a secured loan depends on how much value the
financial institution involved attaches to the specific property. Unsecured debt has no
preferential claim over assets and it is therefore more risky and carries a higher interest rate
than secured loans. In the case of liquidation, unsecured creditors have a claim only on the
assets of the company remaining after search claims have been satisfied. Long-term loans
can have a fixed interest rate for the duration of the loan or they can bear a variable interest
rate. Variable interest debt means that interest payments fluctuate with changes in market
rates. A familiar example is a mortgage bond, where the amount of interest payable is tied to
a specified reference rate such as the Prime Rate.
2.7.5 Warrants
Warrants are options to buy shares in the company at a given price within a given period.
They can be traded on the market and are sometimes issued with loan stock as a “sweetener”.

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Share warrants issued in conjunction with a debt security will put the holder in an overall
position, which is very similar to that of a convertible holder. Thus it follows that the holder
has both debt and equity interest in the issuing firm. However, it may be argued that
investors will find warrants more attractive than a convertible since they can sell warrants
separately whereas the conversion option is an integral part of securities.
The warrant, like the conversion option, will enable this coupon rate to be reduced on the
debt instrument. The amount of this reduction will depend upon the value of the warrant.
Unlike a convertible, the debt issued with warrants will run to maturity, thus maintaining the
tax deduction. The warrants, if exercised, will also result in the new capital being raised; this
may be useful if expansion of the project, which was originally undertaken, is being
contemplated. However, the timing of the exercising of warrants is determined by investors
and may not result in extra capital when needed by the company.
Debt issued with warrants is not self-liquidating and therefore additional finance will be
needed for redemption.
The use of both convertibles and warrants represents an attempt to make debt capital more
attractive to investors; they also have characteristics which may make them useful to a
company as part of its financing. (Brealey, 2004: 359)
THINK POINT
Distinguish between the effects of warrants and those of convertibles on the firm’s capital
structure and its ability to raise new capital?
2.7.6 Bank Overdrafts
This is obviously a very common form of finance. However, it should be a short-term

source, and should not be applied to finance long-term projects, as some firms have
undoubtedly done and got away with! It is expensive, and bank managers are liable to
require not merely security for the overdraft, but those other conditions (e.g. stated liquidity
ratios) should be adhered to if the overdraft is to continue. The rate of interest can vary
(floating rate).

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2.7.7 Bank Loan
Bank loans are cheaper than overdrafts, but less flexible, as they will be for specific sums at
given rates of interest. They are normally used for longer-term finance. They may be
repayable by instalments or at the end of the loan period. They are cheaper to arrange
compared with other long-term funds, but cannot be traded.
2.7.8 Leases
Lease agreements are common source of finance for the funding of moveable assets. Under
the terms of a lease agreement, the lessor retains ownership of the asset; the lessee has use of
the asset for the duration of its useful life, in exchange for a computed lease payment. There
are various types of lease agreements, which differ mainly with regard to the ownership of
the asset at the end of the lease agreement. However, the common characteristic of all types
of leases is that they offer more flexibility than a direct purchase of the asset. Please note that
leases are financing decisions, not capital budgeting decisions. The decision whether an asset
should be obtained in the first place has to be made using the traditional capital budgeting
techniques, preferably the net present value method. Once such a decision is made,
alternative-financing options can be explored.
The financing decision in this case is effectively a comparison between leasing an asset, and
borrowing in order to purchase it. Since the choice is between these two alternatives, the
appropriate discount rate to use in the evaluation of leases is the after-tax cost of debt which
represents the real cost of financing.
Lease payments, similarly to interest payments, are known in advance hence the degree of
risk associated with future cash flows (lease or interest payments) is the same. Furthermore,
lease payments, just as interest payments, are a tax-deductible business expense, making the
after-tax cost of leasing relevant.
The comparison between leasing and borrowing requires a careful consideration of the cash
flows associated with each financing alternative. The cash flows associated with leasing are
the amount of each lease payment and the tax shield associated with each payment. The cash
flow associated with borrowing and purchasing the asset are somewhat more complex

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because purchasing means ownership, hence the asset can be depreciated, implying an annual
depreciation tax shield. In addition, borrowing means interest payments, which are tax-
deductible hence the interest tax shield is a relevant cash flow. The determination of the
annual interest tax shield is not always easy, because most loans used for this type of asset
purchase are amortised over the life of the asset. Amortisation means that periodic payments
of equal amounts are made, whereby part of each payment covers interest due and the
remainder reduces the capital amount owing, so that by the end of the loan period the amount
owing is reduced to zero. The most familiar example of these kinds of amortised loans are
the monthly car payments that most of us make.
The distinguishing feature of a lease is that one party (the lessee) obtains the use of an asset
for a period of time, whereas the legal ownership of the asset remains with the other party
(lessor). The leasing agreement does not give the lessee the right to final ownership. Leasing
is common in aircraft, vehicles, plant and machinery, computers and other office equipment.
More recently, it has been touted as a means of bringing private finance into public sector
projects, e.g. transport and health care sectors. (Ilkova, 2001: 68)
2.7.8.1 Finance Leases
Finance leases are essentially term loans. These have to be shown in the lessee’s accounts as
assets and liabilities, and the depreciation and financing charged against profits.
The terms of the lease normally extends over the full useful life of the asset. The lessor
therefore receives lease payments, which will fully cover the cost of the asset. The
agreement will usually not be cancellable and will not provide any maintenance of the asset.
The leasing company is not normally involved in dealing with the assets themselves, being a
bank or finance company. The asset is selected by the firm which will use it, and negotiates
price, delivery etc. The leasing company simply buys the asset and arranges a lease contract
with the lessee. At the end of the lease period there will usually be an agreement where the
sale proceeds from the asset are shared between the lessor and lessee, or if the lessee desires
it can carry on using the asset for the payment of a nominal amount each year, called a
peppercorn rent.

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2.7.8.2 Sale and Leaseback
Companies can use what is known as a sale and leaseback arrangement in order to convert
certain assets, which the company owns, into funds and for the company to still continue to
use the assets. For example, if a building is sold to an insurance company or some other
financial intermediary and then leased back from the purchaser, the company has secured an
immediate cash inflow. The only cash outflow is the rental payments that it now has to
make. These rental payments are allowed as a tax-deductible expense. However, the
company may be subject to capital gain tax, which will arise if the sale price is in excess of
the written down value agreed by the tax authorities.
It must be remembered, however, that the leased asset no longer belongs to the company; the
lease may one day come to an end and then alternative assets will have to be obtained. This
financing possibility is particularly applicable to assets, which appreciate in value, such as
land, buildings or some form of property. It is particularly appropriate to companies owning
the properties freehold, and to institutions such as insurance companies or pension funds,
which are interested in holding long-term, secure assets. The property is leased back at a
negotiated annual rental, although with long leasebacks there will need to be a provision for
the revision of the rental at certain intervals of time.
Clearly the sale and leaseback releases funds, which can be used for some other investment.
In the 1950’s a number of takeovers were financed by this means. Assets were sold and
leased back; the cash obtained from the sale was used to finance the purchase of another
company. If the acquired company had substantial property so much the better, for this
property could then be sold to an insurance company and leased back.
2.7.8.3 Operating Leases
Operating leases are treated very much like contract hire. They do not appear on the lessee’s
balance sheet, and the fee for the hire is charged directly against profits. These agreements
will usually not last for the full life of an asset. They are offered by companies who
manufacture or deal in the particular product, often incorporating maintenance and other
services. The lease can be cancelled and the equipment returned. Operating leases are
common for office and business equipment, e.g. typewriters and photocopiers, computers and

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motor vehicles. The lessor will not recover his full investment on any one lease but will hope
to lease a particular asset several times.
Operating leases are particularly useful for industries where there is a rapid change in
technology, which makes it necessary to have the latest equipment, e.g. computers.
THINK POINT
What is leasing? Define, compare and contrast finance leases and operating leases.
2.7.9 Hire Purchase
We’ve already made reference to hire purchase in considering leases. When a firm buys an
asset on hire purchase it is in fact obtaining long-term credit, and it is really perceived that it
is gaining the advantage of not having to pay the full cost of the asset at once.
An asset bought on hire purchase is defined as a tangible non-current asset for balance sheet
purposes, since the company that chooses to “buy” the asset in this way will eventually
become the owner. So the legal form of a hire purchase agreement is different from that of a
leasing agreement, although the economic substance may be the same.
A requirement of nearly all hire purchase agreements is that a deposit will be paid (this is not
the case for a lease), followed by instalments which include interest charges – which is
similar to leasing-payments).
As the asset appears as a tangible non-current asset in the balance sheet of the firm buying the
asset, it must be depreciated in the usual way; for tax purposes, the firm can therefore claim
capital allowances appropriate to the asset. The interest paid on the agreement is an
allowable expense for tax purposes.

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Should the asset become obsolete earlier than anticipated (i.e. before the end of the hire
purchase payments), the purchasing firm will have to bear the consequences.
Whether to lease or buy is therefore a complex problem, which needs careful evaluation,
preferably using discounted cash flows.
2.7.10 Franchising
A company could consider franchising, which would enable it to expand with less of its
capital.
If a franchising agreement is made, our company, the franchisor, will be paid by another, the
franchisee, for the right to operate a business under the franchisor’s business name or trade
name. The franchisor will pay certain costs (e.g. some establishment costs and for support
services) while receiving regular payments normally based on a percentage of the
franchisee’s turnover. An initial fee will also be received to cover set up costs.
2.7.11 Grants
These may be obtained from RSA government or local authorities. They will be for a
designated purpose, such as energy conservation or investment in a new plant, and may only
apply to specific geographical areas. For some firms, the amounts involved may be
substantial.
2.7.12 Venture Capital
Venture capital is a much more risky business for the investor. It may be money put into a
new business, which is obviously unproved, and there is obvious danger of losing all the
money invested if the venture is not a success. Other possibilities are venture capital to
support a management buyout or for a large expansion scheme for a small business.
Venture capital is considered too risky for normal bank-lending, and the investors usually
expect an equity stake and some control – for example, a representative on the board of

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directors. This could extend to the appointment of actual managers, and the imposition of
covenants (for example concerning dividends).
Suppliers of venture capital do not consider their investments as long-term; periods of three
to seven years are common. Therefore, lenders want to be sure that they will be able to
obtain their original investment, and their profits, at a suitable time. One possible way of
doing this would be to require the borrowing company to apply for Stock Exchange listing
after a stated time, so that the venture capitalists can then sell their shares to others.
This may seem to limit the flexibility of action of the company once it has succeeded in
obtaining venture capital – while this may be true, don’t forget that the company would
probably have found itself unable to obtain capital from other sources, either because the
costs of obtaining funds by other methods are too high, or because the security demanded is
greater than the company is able to provide. (Ross, 2001: 410-411)
THINK POINT
How do venture capital firms design successful deals?
2.8 Lease-Or-Buy Decisions
In an examination question you might be asked to choose, for example, between buying an
asset or leasing it. You will normally be told what writing-down allowance; tax rate and
discount rate are to be used.

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(3) CONCLUSION
The primary responsibility of the financial manager is to explore and initiate investment
projects which are consistent with the objectives of the company and which offer returns at
least equal to the cost of capital. As new projects are accepted, financing must be found in
order to proceed. There are various methods, which can be used to finance such projects, the
choice of which has significant implications for both risk and return of the business.
Before deciding upon the source of finance, it is necessary to note the sharp distinction which
must be drawn between the investment and the financing decision. The investment decision
is based on the profitability of the project, the financing decision is based on the need to
retain an optimal capital structure.
The most frequently tapped sources of long-term finance are share capital, retained earnings
and secured loans and debentures. Leasing and sale and leaseback are also popular methods
of financing. The leasing decision is a choice between alternative methods of financing and
is not an investment choice. As leasing is equivalent to debt, the lease decision should only
be made if the net present cost of leasing is lower than the borrowing option. Short-term
finance is mainly obtained from warranties, bank overdrafts and short-term bank loans.

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Self-Check Question 1
Suppose Kitchen Studio is considering the purchase of a plant for R500 000, a loan could be
obtained at an effective rate of 15% repayable annually in arrears over 5 years to cover the
purchase price of the machine. Alternatively, the machine could be leased on a 5-year
contract for R125 000 per year, payable annually in arrears. If the machine is owned, service
and maintenance charges will be R5 000 per annum, whereas the lease charge includes
maintenance and servicing. The salvage value of the machine in 5 years’ time is expected to
be R20 000. The company is allowed a straight-line tax write off of 20% per annum.
Assume that Kitchen Studio has a tax rating of 30%, and the after-tax cost of 9%.
1.1 Calculate the cost of leases.

1.2 Calculate the cost of owning.
1.3 In your opinion, which is the best option, give an explanation for your choice.
Consider the discounted cash outflows (or inflows) in order to determine the best
alternatives.

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ANSWER TO SELF-CHECK QUESTION 1
Answering this question requires first the determination of relevant cash inflows and the
appropriate discount rate. Since this is a financing decision, not a capital budgeting one, the
relevant discount rate is the after-tax cost of debt, 9%
The relevant cash flows associated with leasing are the lease payments of R125 000 and the
tax shield of R37 500 they generate (=R125 000 x 0.3). The net present cost of leasing can be
calculated as follows:
1.1 Cost of leases
Y1 Y2 Y3 Y4 Y5
Lease payments (125 000) (125 000) (125 000) (125 000) (125 000)
Tax shield 37 500 37 500 37 500 37 500 37 500
Net Cash Flow (87 500) (87 500) (87 500) (87 500) (87 500)
P.V. factor @ 9% 0.9174 0.8417 0.7722 0.7084 0.6499
P.V. Cash Flows (80 273) (73 649) (67 568) (61 985) (56 866)
NPV (340 341)
The relevant cash flows, associated with borrowing and purchasing the asset fall into 2
categories – cash flows related to borrowing (capital repayment, interest payments and
interest tax shield) and cash flows related to owning the asset (depreciation and the
depreciation tax shield).
The loan requires amortisation over 5 years; hence an amortisation schedule must be drawn
up, in order to determine the interest tax shield for each year of the repayment period. The
first step is to determine the annual instalments on this loan. This is done using the familiar
formula for calculating the present value of an annuity and solving the equation for the equal
annual instalments.
 1 
1  (1  r ) n  Where
PVA = 1X   PVA = R 0.5 million
 r 
  r = 15%
  n = 5 years
Since the discount rate of 15% can be found in the present value tables provided, we can read
the present value of annuity investment factor, where the PVAIF15% 5 years = 3.3522
500 000= 1 x 3.3522 so I = 500 000/3.3522 = 149 156 annual instalment

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Loan Repayment Schedule

YEAR BY AMOUNT PAYMENT INTEREST PORTION REP. OF PRINCIPAL
1 500 000 149 156 75 000 74 156
2 425 844 149 156 63 877 85 279
3 340 565 149 156 51 085 98 071
4 242 494 149 156 36 374 112 782
5 129 712 149 156 19 457* 129 699*
* Accumulated rounding- off
The second step is to determine the depreciation tax shield associated with owning the
asset, since depreciation itself is not an actual cash flow. The machine will cost R500 000
depreciated straight line over 5 years at a rate of R96 000
[500 000-20 000 (salvage value) ÷ 5]
The last step is to calculate the net present cost of borrowing and purchasing by
discounting all relevant cash flows at the appropriate discount rate of 9%
1.2 Cost of Owning

DETAIL Y1 Y2 Y3 Y4 Y5
Loan payments (149 156) (149 156) (149 156) (149 156) (149 156)
Service (5000x0.7) (3 500) (3 500) (3 500) (3 500) (3 500)
Dep. Tax shield (96000 x 0.3) 28 800 28 800 28 800 28 800 28 800
Int. tax shield (0.3 of Int.) 22 500 19 163 15 326 10 912 5 837
Salvage value 20 000
Net Cash Flow (101 356) (104 693) (108 620) (112 944) (98 019)
PV Factor @9% 0.9174 0.8417 0.7722 0.7084 0.6499
PV Cash Flow (92 984 (88 120) (83 876) (80 010) (63 703)
NPV = R(408 693)
1.3 The cost of leasing is better, because the cash outflow is smaller
i.e. 408 693 – 340 341 = R68 352.

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Leasing vs. Owning
Raymond Transport is considering the purchase of a tanker for R400 000 cash. Alternatively,
the tanker could be leased on a 5-year contract for R110 000 per year.
If the tanker is owned, the service and maintenance charges will be R16 000 per annum,
whereas the lease charge includes maintenance and servicing.
The salvage value of the tanker in 5 years time is expected to be nil. The company uses the
straight-line method of depreciation.
The company’s tax rate is 30% and the pre-tax cost of debt is 10%.
Required:
2.1 Calculate the cost of owning, use the discounted cash flow method
2.2 Calculate the cost of leasing; use the discounted cash flow method.
2.3 Advise on the option to be adopted. Justify your answer.

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2.1 OWNING
DETAIL Y0 Y1 Y2 Y3 Y4 Y5
Purchase price (400 000)
Service charge 16000 x 0.7 (11 200) (11 200) (11 200) (11 200) (11 200)
Dep. Tax shield 80000 x 0.3 24 000 24 000 24 000 24 000 24 000
Net Cash Flow 12 800 12 800 12 800 12 800 12 800
PV Factor @ 7% 0.9346 0.8734 0.8163 0.7629 0.7130
PV Cash Flow (400 000) 11 963 11 180 10 449 9 765 9 126
NPV = R(347 517)
2.2 LEASING
DETAIL Y1 Y2 Y3 Y4 Y5
Lease payments (110 000) (110 000) (110 000) (110 000) (110 000)
Tax shield 0.3 33 000 33 000 33 000 33 000 33 000
Net Cash Flow (77 000) (77 000) (77 000) (77 000) (77 000)
PV Factor @ 7% 0.9436 0.8734 0.8163 0.7629 0.7130
PV Cash Flow (71 964) (67 252) (62 855) (58 743) (54 901)
NPV = R(315 715)
2.3 It is an advantage to lease rather than own. The NPV of Cash Outflows is greater
for owning by (R31 802).

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ALTERNATIVE ANSWER TO SELF-CHECK QUESTION 2
2.1 Owning
After tax cost of Debt = 10% (1 – 0.3) = 7%
Yo Purchase price = ( 400 000)

Y1 to Y5 Service charge 16 000 x 0.7 x 4.1002 = ( 45 922)
Y1 to Y5 Depreciation tax shield 80 000 x 0.3 x 4.1002 = 98 405
NPV of Owning R(347 517)
2.2 Leasing
Y1 to Y5 Lease payments 110 000 x 4.1002 = ( 451 022)
Y1 to Y5 Tax shield 110 000 x 0.3 x 4.1002 = 135 307
NPV of Leasing R(315 517)
2.3 It is an advantage to lease rather than own.

The NPV of Cash Outflows is greater for owning by (R31 802).

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SECTION 5
COST OF CAPITAL

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LEARNING OUTCOMES
 Explain the Capital Asset Pricing Model
 Explain the Gordon Growth Model
 Calculate the Weighted Average Cost of Capital (WACC) using the Traditional
Approach
 Calculate WACC using the Conventional Approach
 Describe adjustments made to the WACC using the CAPM and Gordon Growth
Model

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(1) INTRODUCTION
From the discussion in the previous chapter, it becomes clear that investors will be prepared
to provide capital to a company only if the company can provide an adequate compensation
for risk to which such capital is exposed. The Capital Asset Pricing Model (CAPM)
illustrated one of the methods investors can use to determine the required rate of return on
equity capital. However, modern companies use ordinary equity, preference shares and debt
as sources of capital, therefore it is necessary to find a suitable measure of the overall rate of
return required on all capital used by a company. This measure is known as the cost of
capital of a company. From the point of view of the financial manager, the rate of return
investors require as a compensation for risk, is the cost of using and attracting capital. Hence
the terms “required return” and “cost” are used interchangeably because they refer to the
same rate; it is only the viewpoint that differs.
Given the fundamental relationship between risk and return, it is obvious that the overall cost
of capital will depend on the level of total risk associated with the firm. If a firm uses only
ordinary equity as a source of capital, the risks to which a company is exposed are only
business and operational risk. However, if a firm uses ordinary, preference and debt capital,
then it will also be exposed to financial risk. Under such circumstances, the required rate of
return on each source of capital will depend on the specific risk to which each source is
exposed, hence the overall cost of capital will be a combination of the costs of these three
sources. Required rates are determined by three variables: expected inflation, the time value
of money, and risk. The first variable that determines rates is expected inflation – a rand
today is worth more than a rand in a year’s time because purchasing power is eroded over
time by inflation. Therefore, the minimum rate investors will demand is the inflation rate.
The time value of money represents an opportunity cost – it is better to receive an amount of
money now than in the future, because money received now can be invested and a return
earned. The opposite is true for cash payments – they represent an opportunity cost, the cost
of giving up the opportunity to invest and earn a return. The third factor that determines
required rates is the risk, i.e. the probability that the original capital will be lost or that the
actual return on investment will differ from the expected return. The higher the perceived
risk, the higher the required rate, because investors demand compensation commensurate
with the risk they bear.

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The determination of the overall cost of capital requires calculation not only of the cost of
each source, but also a calculation of the value of each source of capital. Each of these
sources will contribute to the overall cost of capital in proportion to the total capital of the
firm financed by each source. One way to determine the value of capital is to examine the
financial statements of the company, specifically the balance sheet.
The problem with the balance sheet is that it reflects historical information rather than current
market values. Since the focus of business finance is on future cash flows, not the past, a
forward-looking approach is needed. This approach is based on estimating the current market
value of each source of capital. The current market value of any financial asset is represented
by the price at which such an asset can be traded. The general valuation principle is that the
value of any financial asset in any point in time can be viewed as the sum of expected cash
flows, discounted at an appropriate discount rate that reflects the risk associated with these
expected cash flows. The “appropriate discount rate” is simply the required rate of return of
each financial asset. (Ilkova, 2001: 22)
THINK POINT
What is the cost of capital? What role does it play in long-term investment decisions?

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(2) THE TRADITIONAL APPROACH - WACC
WACC stands for Weighted Average Cost of Capital. To start with, we shall assume that
dividends on ordinary shares are expected to remain at their current rate during the lives of
the projects we need to appraise. We shall also assume that preference shares and debentures
are irredeemable.
The cost of equity capital will, therefore be based on the current rate of dividend but, as it is
extremely unlikely that equity and debt are in equal proportions, we shall need to calculate a
weighted average.
We need to know the market prices of the different sources of capital. There is no market
price for a bank loan, for example, but there is for shares and debentures. The market prices
measure what the investors could get if they sold their shares or debentures. Their investment
must be sufficient to persuade them to retain their investments. If we add the market prices
of equity capital and debt capital, and express each type of capital as a proportion of this
overall figure, the total should add up to 1, or 100% if we use percentages. We then multiply
the cost of the relevant type of capital by this weighting.
Imagine that our firm has the following capital structure (ignoring reserves):
Equity : 5,000,000 R1 ordinary shares, market price currently R1.70
Preference : 2,000,000 R0.50 10% preference shares, market price currently R0.55
Debentures : R2,000,000 15% debentures, market price currently R1.08
Bank loan : R1,000,000 12% bank loan.
The current and expected rate of ordinary share dividend is 20%, and corporation tax is 33%.

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What are the implications of this information and how can we turn it into one ‘cost of capital’
figure?
Firstly, we need to calculate the overall market value of these investments, by multiplying
the original values by the market price divided by the nominal value in each case. The total of
the individual investment values constitutes the overall market value.
R
E R5,000,000 x 1.7/1 8,500,000
P R1,000,000 x 0.55/0.50 1,100,000
D R2,000,000 x 108/100 2,160,000
BL R1,000,000 (not traded) 1,000,000
Overall market value 12,760,000
Now let’s find the proportion of this total represented by each type of capital:
Equity: 8,500,000/12,760,000 = 0.6661 Or 66.61%

Preference: 1,100,000/12,760,000 = 0.0862 Or 8.62%
Debentures: 2,160,000/12,760,000 = 0.1693 Or 16.93%
Bank loan: 1,000,000/12,760,000 = 0.0784 Or 7.84%
1.00 Or 100.0%
What are the returns to each type of capital?
Equity (think of divided yield!): 20 x 1 = 11.76%

1.7
Preference shares: 10 x 50 = 9.09%

55
Debentures: 15 x 100 = 13.89%

108
Bank Loan : 12% (not traded)

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These proportions must now be multiplied by the relevant returns to arrive at the Weighted
Average Cost of Capital ie.
Equity: 0.6661 x 11.76% = 7.83

Preference: 0.0862 x 9.09% = 0.784
Debentures: 0.1693 x 13.89 x 67/100 = 1.576
Bank loan: 0.0784 x 12% x 67/100 = 0.63
10.82%
This would be the minimum rate to apply for investment appraisal, assuming that all projects
to be evaluated bear the same risk, and that finance would be raised in the same proportions
as they currently exist.
You may be wondering why the calculation for the debentures and the bank loan interest is
multiplied by 67%? Think back to profit and loss accounts. Debenture and bank-loan
interest comes before profit before tax, and so do not bear tax – the same is not true of
dividends. In order to equalise the tax effect, the debenture and bank-loan interest weighting
is reduced, by multiplying it by 1 minus the current company tax rate (33%).
The reason we ignored the resources in the company’s capital structure is that we are using
the market price for equity. This covers not only the face value of the shares, but also the
proportion of the accumulated reserves that would belong to each equity holder if the firm
were to be wound up at its current face value.
Tigerbrand Ltd has the following capital structure:
Equity: 2,000,000 R2 ordinary shares, market price R2.50

Preference: 1,000,000 12% R1 preference shares, market price R1.20
Reserves: R1,500,000
Bank loan: R500,000 15% bank loan
Debentures: R1,750,000 16% Debentures, market price 110
(a) The current and expected future rate of ordinary share dividend is 20% and the
company tax rate is 33%.
(b) What is the firm’s weighted average cost of capital?

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Tigerbrand Ltd
Market Value:
R
Ordinary shares 4,000,000 x R2.50/2 = 5,000,000
Preference shares 1,000,000 x 1.20/1 = 1,200,000
Bank loan = 500,000
Debentures 1,750,000 x 110/100 = 1,925,000
Total 8,625,000
Proportions:
%
Ordinary shares 5,000,000/8,625,000 = 57.97
Preference shares 1,200,000/8,625,000 = 13.91
Bank loan 500,000/8,625,000 = 5.80
Debentures 1,925,000/8,625,000 = 22.32
Total 100.00
Relevant returns:
%
Ordinary shares 20 x 2/2.50 = 16.00
Preference shares 12 x 1/1.20 = 10.00
Debentures 16 x 100/110 = 14.55
Weighted average cost of capital:

%
Ordinary shares 57.97 x 16 = 9.28
Preference shares 13.91 x 10 = 1.39
Bank loan 5.80 x 15 x 67/100 = 0.58
Debentures 22.32 x 14.55 x 67/100 = 2.18
Total 13.43

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(3) THE CONVENTIONAL APPROACH (MODERN APPROACH) - WACC
3.1 MARKET VALUES
3.1.1 Market value of ordinary equity:
The total market value of Tango Company equity is equal to the market price per
share multiplied by the number of shares issued by the company, therefore:
E = PO X Number of shares = R5.00 X 1 million shares = R5 000 000
3.1.2 Market value of preference capital:
The total market value of preference capital is equal to the market price per share
multiplied by the number of shares issued by the company, therefore:
P = PO X Number of shares = R10.00 X 200 000 shares = R2 000 000
3.1.3 Market value of debt:
Here we make use of the Discounted Cash Flow (DFC). Current market value of debt
is equal to the present value of the interest payments plus the present value of the
capital repayment. These future cash flows must be discounted at the current required
rate of return given in the question as a current yield-to-maturity. Suppose a company
has R2 million, 8% debentures due in 5 years with a current yield-to-maturity of 10%.
The interest payment (coupon rate) made by the company is equal to R160 000 (8% x
R2,000,000). Notice that the same amount will be paid every year, hence we are dealing with
an annuity. The current market value of debt can be calculated as follows:
D = Present value of annuity (PVA) of interest + PV of capital repayment amount

D = R160,000 x PVAIF5YEARS, 10% + R2 000,000 x PVIF5 YEARS, 10%
10% is the current yield-to-maturity

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Using PVAIF and PVIF at the back of the book to obtain the PVA and PV investment
factors:
D = R160,000 X 3.7908 + R2 000,000 X 0.6209

= R606 528 + R1 241 800
= R1 848 325
3.1.4 Market value of the firm:
The total market value of the firm is the sum of the market values of equity,
preference capital and debt.
Current market Rands

Ordinary equity (E) R 5 000 000
Preference share capital (P) R 2 000 000
Debt (D) R 1 848 328
R8 848 328
3.2 PROPORTIONS
Ordinary equity (E) 0.56

Preference share capital (P) 0.23
Debt (D) 0.21
1.00
3.3 COST OF EQUITY
Imagine a firm is financed with ordinary equity, preference shares and debt capital, the
required cost on each source of capital will be the return investors demand as compensation
for the expected inflation, the time value of money, and the risk to which their investment is
exposed. The major difference between the three sources is the risk associated with each
source. The two generally recognised methods for determining the required return on equity
are the Dividend Valuation Model (DVM) and the Capital Asset Pricing Model (CAPM).

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3.3.1 The Dividend Valuation Model (DVM) - (Gordon Growth Model)
The easiest way to estimate the cost of equity capital is to use the dividend growth model.
Since RE, is the return that shareholders require, it can be interpreted as the firms cost of
equity capital.
To illustrate how we estimate RE, suppose Tango Company paid a dividend of R0.20 per
share last year and the share price is currently R5 and the expected growth is 8% p.a. Using
the dividend growth model, the expected dividend for the coming year is:
DI = Do x (1 + g)
= R0.2 x 1,08
= R0.216
Given this, the cost of equity, RE, is:
RE = DI + g or = DO (1 + g) + g
= PO PO
= R0.216 + 0.08 = 0.2 (1.08) + 0.08
R5 5
= 12.32% = 12.32%
Where: RE = cost of equity

DO = last dividend paid
g = estimated growth
PO = current market price of share

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3.3.2 The Capital Asset Pricing Model (CAPM)
CAPM allows investors to determine the required rate of return on a share, based on the risk
associated with that share. The expected return on a risky investment depends on three
things:
1. Rf = rate of return on risk-free investments

2.  = beta coefficient, systematic (market) risk of equity
3. Rm - Rf = market risk premium
Suppose Tango Company has a beta factor of 1.4, a market return of 12% and a risk free
return of 8%.
Given this, the cost of equity, RE, is:
RE = Rf +  (Rm – Rf)
= 8 + 1.4 (12 – 8)
= 8 + 1.4 (4)
= 13.6%
The choice between the two methods of calculating the cost of equity is usually determined
by the information supplied.
3.4 COST OF PREFERENCE SHARES
Preference shares have some debt characteristics. Specifically, the dividend payable is
usually a fixed amount, the same way as interest on a typical debenture is fixed.
Suppose Tango Company paid a dividend of R1 on the current market price and its
preference share of R10.

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Given this, the cost of preference shares, RP, is:
RP = D
Where,
PO RP = cost of preference shares
= 1 Po = current market price
D = dividend
10
= 10%
3.5 COST OF DEBT

Interest rates represent the price paid for the use of borrowed capital. They represent the
compensation lenders demand for letting somebody else temporarily use their funds. The
determination of the cost of debt in a company appears as a deceptively easy task – a quick
look at the financial statements of a company shows the interest rates, which the firm pays on
its debentures and long term-loans. The problem with this approach is that financial
statements reveal a historical cost (coupon rate) – the cost at which the company borrowed
when a debenture was issued or the loan taken – not the current required rate of return on
debt. From the point of view of a company, the cost of debt is the current market interest rate
– the rate at which the company could borrow today. This current interest rate, called the
current yield-to-maturity (YTM) of the company’s debt, can be determined by observing the
current market price at which the firm’s existing debentures are trading. Yield-to-maturity is
defined as the interest rate that will make the present value of a debentures remaining cash
flows (if held to maturity) equal to its current market price. (Ilkova, 2001: 25)
From the example given on the market values of the debenture on page 112, paragraph 3.1.3,
the following information is extracted:
Coupon rate of interest is 8%
Due in 5 years
Current yield to maturity is 10%
The YTM on the debt is given at 15%, but the cost from the company’s point of view is the
after-tax cost:
RD = YTM (1 – Tc) Where,

RD = cost of debt
= 10 (1 – 0.30) YTM = yield-to-maturity
= 7% Tc = tax rate

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3.6 WACC (PROPORTION X COST)
Ordinary shares (using CAPM) 0.56 x 13.6 = 7.6

Preference shares 0.23 x 10 = 2.3
Debt 0.21 x 7 = 1.47
11.37%
3.7 THE WEIGHTED AVERAGE COST OF CAPITAL (WACC)
(Using A Comprehensive Example)
Imagine you are the financial manager of Sola Company Limited. Your company has
2 million ordinary share in issue, and the current market price is R10 per share. The
company also has 400 000 preference shares in issue and has a market price of R15.
The dividend paid on preference share is R3 per share. The company’s outstanding
debentures have ten years to maturity, a face value of R5 million, that pays an interest
rate of 10% p.a. and are currently trading at a yield-to-maturity (YTM) of 12%.
Additional Information:
 The risk-free rate is 8% and the expected return on the market is 17%.
 Sola Company has a beta of 1.2, and the company tax rate of 30%.
Calculate the WACC.

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PART A
3.7.1 Market Values
Ordinary shares 2 000 000 x R10 = R20 000 000

Preference shares 400 000 x R15 = 6 000 000
Number of shares issued x the current market price
The current market value of the debt can be calculated as follows:
Present value of annuity (PVA) of interest payment + PV of capital repayment amount
Po = R500 000 x PVAIF 10 years, 12% + R5 000 000 x PVIF 10 years, 12%
= R500 000 x 5.6502 + R5 000 000 x 0.3220
= R2 825 100 + R1 610 000
= R4 435 100
where Po = market value
Therefore the total market value of the firm is the sum of the market value of each element
i.e. R30 435 100
3.7.2 Proportions
o
/s 20 000 000 = 0.66
30 435 100
P
/s 6 000 000 = 0.20
30 435 100
D 4 435 100 = 0.14

30 435 100
1.00

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3.7.3 Cost
Ordinary shares – Using CAPM
RE = Rf + B (Rm – Rf)
= 8 + 1.2 (17 – 8)
= 8 + 1.2 (9)
= 8 + 10.8
= 18.8%
Preference shares
Rp = D
PO
= 3 X 100
15 1
= 20%
Debt
RD = YTM (1-Tc)
= 12% (1 – 0.30)
= 8.4%
3.7.4 WACC = (Proportion x Cost)

O
/s = 0.66 x 18.8% = 12.41
P
/s = 0.2 x 20% = 4.00
D = 0.14 x 8.4% = 1.18
17.59%

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PART B
Assume that the dividend paid on equity (ordinary shares) is 30 cents per share
and the expected growth is 20%.
Show how the WACC can be adjusted by using the Gordon Growth Model.
Expected dividend is DI = DO X (1 + g)
= 0.30 x (1.20)
= 0.36
Therefore, RE = DI + g
Po
= 0.36 + 0.20
10
= 23.6%
Adjusted WACC
O
/s = 0.66 x 23.6 = 15.58
P
/s = 0.20 x 20% = 4.00
D = 0.14 x 8.4 = 1.18
20.76%
Note: CAPM & Gordon Growth Model only affects Equity capital

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THINK POINT
How does the traditional WACC differ from the modern approach?
(5) CONCLUSION
The cost of capital is the return, expressed as a percentage of the funds used by the company,
which must be earned in order to adequately compensate investors in all categories, in
accordance with the risk of their investment. Most companies finance their operations from a
combination of equity in the form of shares and debt in the form of loans. In order to
calculate the cost of capital, the weighted average of the costs of different sources of finance
must be determined. As financing is raised to fund future projects, the appropriate cost is that
of future funding. This is fully described as the weighted average cost of capital.
Failure to earn the cost of capital will, at best, result in a decline in the share price. At worst
it will lead the business to eventual financial failure. Success in earning in excess of the cost
of capital will cause the share price to increase as real value has been added to the business
after adequately rewarding all the providers of capital.

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Suppose Spur Ranch Company has a debenture capital of R1m, issued at R1 000 par value
per debenture. The company rate on the debt is 20% and has 18 years to maturity. The
current yield-to-maturity (YTM) is 18%. However, the interest payment must be made semi-
annually. Calculate the market value of the debenture using the DFC method.
Annual Interest payment = 20% X R1 000

= R200
However, the interest payments are made semi-annually, so an amount of R100 will be paid
every six months. Thus, the number of periods will be 18 x 2 times per year = 36 periods.
The discount rate for these payments must be the current YTM, and not the historical cost
(coupon rate) of the debentures i.e. 18% ÷ 2 = 9%
Therefore,
Po = 1000 [R100 x PVAIF 36 periods, 9% + R1 000 x PVIF 36 periods, 9%]
= 1000 [R100 x 10.6118 + 1 000 x 0.0449]
= 1000 [R1061.18 + 44.9]
= 1 000 x R1 106.08
= R1 106 080

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Suppose Spur Ranch Company has a beta of 0.9. The risk free return is 10% and the return
of the market is 16%. Spur Ranch’s last dividend was R4 per share, and the expected
dividend growth is 15%. The shares currently sell for R60.
Calculate Spur Ranch’s cost of equity capital using:
3.1 Gordon Growth Model

3.2 Capital Asset Pricing Model (CAPM)
3.1 Gordon Growth Model RE = DI + g

Po
= R4.60 + 0.15
R60
= 22.67%
3.2 CAPM RE = Rf + B (Rm – Rf)

= 10 + 0.9 (16 – 10)
= 10 + 0.9 (6)
= 15.4%

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James Brown Limited has one million ordinary shares in issue, 500 000 6% preference shares
in issue, and 200 9% bonds outstanding, par value R1 000 each. The equity shares currently
sell for R2 each and have a beta of 1,0 and the preference shares currently sell for R3 per
share, and the bonds have 10 years to maturity and the yield-to-maturity is 12% (YTM). The
market risk premium is 8%, T-bills are yielding 7%, and James Brown’s tax rate is 30%.
Use the Discounted Cash Flow (DCF) technique to calculate the weighted average cost of
capital.
Calculation
Interest on bonds = 1 000 x 9

100
= R90
No. of periods = 10 periods

YTM = 12%
Po = 200 [90 x PVAIF 10 years, 12% + 1 000 x PVIF 10 years, 12%]

= 200 [90 x 5.6502 + 1 000 x 0.3220]
= 200 [508.52 + 322]
= 200 [830.52]
= R166 104

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Market Value
Ordinary shares 1 000 000 x 2 = 2 000 000

Preference shares 500 000 x 3 = 1 500 000
Bonds = 166 104
R3 666 104
Proportion
O
/s 2 000 000 = 0.546
3 666 104
P
/s = 0.409
B = 0.046
1.000
Cost
O
/s using CAPM
RE = Rf + B (Rm – Rf) (Rm – Rf) = Risk premium
= 7 + 1.0 (8)
= 15%
P
/s
Rp = D
Po
= 0.06 x 100
3 1
= 2%
RD = 12% (1 – 0.3)
= 8.4%

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WACC = PROPORTION X COST

O
/s = 0.546 x 15 = 8.19
P
/s = 0.409 x 2 = 0.82
D = 0.046 x 8.4 = 0.39
9.40%

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SECTION 6
GEARING AND SHAREHOLDERS’ WEALTH

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LEARNING OUTCOMES
 Determine the effect that earnings per share has on long-term loans
 Determine the effect that gearing has on share prices and WACC.
 Explain the traditional view of gearing on cost of capital (Ke) and WACC
 Display knowledge of the MM (Modigliani and Miller) view of gearing as (Ke) and
WACC pre-taxation and post-tax
 Explain the relationship between bankruptcy, cost of capital and gearing
 Describe the actual capital structure of a firm

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(1) INTRODUCTION
The major difference between debt and equity is that while equity holders have a residual
claim on the firm’s earnings and assets, debt holders are legally entitled to periodic interest
payments (coupon payments) and the repayment of their original capital. Therefore, they
have a senior claim on the firm’s assets and cash flows equal to the outstanding obligation. If
a firm does not meet its obligations on the set payment dates, debt holders have the legal right
to demand payment and can force a firm into liquidation, if necessary.
(2) THE ASSOCIATED RISK
Due to the different legal rights associated with debt and equity, the risk attached to these two
types of finance differs. From the point of view of capital providers, debt has low risk
because the interest payment and the repayment are fixed, both in terms of size and timing.
However, from the point of view of the company, debt has high risk because the firm must
ensure that fixed repayments are met, irrespective of the level of earnings in any given year.
Equity finance, in comparison, does not require fixed cash flow commitment and thus carries
a lower risk. From the point of view of equity capital providers, equity has high risk because
there is no certainty that dividends will be received and the original capital is not repayable.
The possibility of a capital loss is another risk associated with equity.
(3) THE DECISION
In making the decision whether the company should be financed through equity or debt, and
in what proportions, the financial manager should consider the following 3 factors:
3.1 Return
The interest charged on debt is tax deductible, dividends are not, and so the use of equity
does not offer tax relief to a firm. However, debt has a fixed interest charge, while equity has
no such commitment. The company benefits through the use of debt when it is doing well

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and earnings substantially exceed the interest charge. All cash flows generated above the
interest charge accrue to shareholders, increasing their wealth. However, if the company
does not generate sufficiently high earnings, most of the available cash flow is used for
meeting the interest obligations, and very little remains for distribution to shareholders. The
amount of earnings before interest and taxes, over which the use of debt is preferred to the
use of equity, is considered the financial break-even point of the company.
3.2 Risk
Interest payments must be made, regardless of the level of profits, as must capital repayments
– this can lead to a strain on liquidity if the company has performed poorly. There is a limit
to how much debt can be raised before the market reassesses the risk profile of the company,
leading to an increase in the costs of both equity and debt. Raising debt reduces the
company’s ability to raise future debt finance.
3.3 Control
Raising finance through the issue of equity reduces the proportion of the firm owned by
existing shareholders, if they are unwilling or unable to purchase additional shares. New
equity issues dilute the control existing shareholders have over the decision making process
of a firm, while the use of debt finance does not dilute control.
(4) THE EFFECT OF LONG-TERM LOAN ON EARNINGS PER SHARE
4.1 When operating profits are high, shareholders in high geared firms do very well, because
there are fewer of them to share the additional profits (debt holders are only entitled to a
fixed rate of interest)
4.2 When operating profits are low, shareholders in high-geared firms suffer, because loan
interest will absorb most or all of the operating profit.

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In the example below, the geared firm has R5 million of 10% debentures and R5 million of
equity. The low-geared firm has a zero debt - in fact it is ungeared, and has equity of R10
million.
GEARED UNGEARED
RAND RAND
Operating profit 2 000 000 2 000 000
Interest (500 000) (NIL)
Profit before tax 1 500 000 2 000 000
Tax (30% (450 000) (600 000)
Profit after tax 1 050 000 1 400 000
1 050 000 1 400 000

5 000 000 10 000 000
EPS (high profits-good year) = 21 cents = 14 cents
Operating profits 600 000 600 000

Interest (500 000) (NIL)
Profit before tax 100 000 600 000
Tax (30%) (30 000) (180 000)
Profit after tax 70 000 420 000
70 000 420 000
5 000 000 10 000 000
EPS (low profits-bad year) = 1.4 cents = 4.2 cents
Clearly the shareholders in the geared company are experiencing greater volatility in EPS,
and greater financial risk. We’ve only looked at two levels of profit here – obviously we
could have looked at more. What we should find is that there would be a wider dispersion of
possible results for the geared company, so that increased risk-averse investors would require
a greater return to compensate them for the increased risk of a very low result.

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On the other hand, the fact that loan interest is tax deductible lowers the firm’s tax bill, and
leaves a larger sum overall to be distributed to the providers of capital. It seems therefore
that many companies will want to make use of debt – so how do shareholders perceive their
situation?
Debt is cheaper than equity where the level of risk to debt holders is low. We have seen that
most debt is secured on a company’s assets; whereas ordinary shareholders are last in the
queue for return of their investment if problems arise, secured debt holders can arrange to
have assets sold of to meet the sums they have invested. So the risk for debt is less than that
for equity.
This doesn’t mean that all debt has equally low risk – lenders will be influenced by:
 The apparent risk of the project for which they are being asked to put up money
 The overall perceived risk of the company
 The existing level of gearing.
They will tend to charge more for projects with higher risk, and to companies who are
already seen as bearing greater risk or with existing high levels of gearing, because they wish
to protect their regular receipts of interest and the repayment of their capital.
EPS is one of the factors we need to calculate the P/E ratio for a firm, and is another way of
expressing the return on equity. So what about share price? How will it be affected by
changes in EPS, and, more importantly for this section, by changes in the level of gearing?

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(5) DOES GEARING AFFECT SHARE PRICE AND WACC ?
We have seen that, when we calculate the firm’s WACC, we use market value of securities
and relate these Ke (cost of equity) and Kd (cost of debt). If the market value of the share price rises, Ke
will actually fall – the expected return divided by the higher market value gives a lower yield.
If Kd remains constant, this would result in a lower WACC. Alternatively, if there is a
change in the expected return, this will also affect WACC – if, because of the nature of a
firm’s new projects, the expected return rises, unless share price also rises, there will be an
increase in Ke and WACC.
For example, Sukati Limited, with 500 000 shares, has an EPS of 15 cents and a market share
price of R1. Its Ke is therefore 15% (assuming that all earnings are distributed), which is also
its WACC. If share price rises to R1.25, Ke would fall to 12%.
Earning = 500 000 x 0.15

= R75 000
Therefore EPS = 75 000
500 000
= 15c
Market value of share = 500 000 x 1.25

= R625 000

625 000
= 12c
If however the EPS rises to 18 cents with the share price constant at R1, Ke will rise to 18%.
Earnings = 500 000 x 0.18

= R90 000

500 000
= 18c

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If Kd is zero or constant, WACC will fall or rise respectively, so that the appraisal of the
firm’s projects would be affected favourably or adversely.
Now what might happen if we introduce gearing (ignoring tax and the differences in the cost
of actually raising debt compared to equity). Suppose that Sukati, which was previously
ungeared, decides to finance a new project by borrowing R500 000. The cost of this debt is
9%. Sukati’s EPS rises to 20 cents as a result of the project.
If the secondary capital market considers that because of the new gearing a different return
from Sukati’s equity is required, for example 17%, the share price would become R0.20/0.17,
or R1.18.
Market value of share is 500 000 x R1.18 = R590 000

Therefore Total Capital 590 000 + 500 000 = 1 090 000
WACC would fall to:
17% * 590 000/1 090 000 + 9% * 500 000/1 090 000 = 13,32%
If instead the requirement of the capital market for equity were 24%, share price for Sukati
would change to R0.20/0.24 or R0.83.
Market Value of share 500 000 x 0.83 = R415 000
WACC would rise to:
24% * 415 000/915 000 + 9% * 500 000/915 000 = 15,85%
Sukati’s EPS rises to 30 cents as a result of the new project, for which it borrows R500 000 at
12%.
What would happen to WACC if the capital market decides that the expected return from
Sukati’s equity should be:
(a) 1.1 15%

(b) 1.2 28%

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1.1 Share price = R0.30/R0.15 = R2.00

WACC will fall to: = 15 x 1 000 000 + 12 x 500 000 = 10 + 4 = 14%
1 500 000 1 500 000
1.2 Share price = R0.30/0.28 = R1.07

WACC will raise to = 28 x 535 000 + 12 x 500 000 = 14.5 + 5.8 = 20.3%
1 035 000 1 035 000
Equity holders will therefore be interested in the price that the secondary capital market puts
on their shares after the introduction of new debt capital and the expected return for all types
of capital.
(6) THE TRADITIONAL VIEW
The traditional view of the effect of gearing on Ke and WACC is:
 At relatively low levels of gearing, shareholders do not require a substantial premium

for the additional financial risk involved.
 Therefore, as debt capital is cheaper, the overall WACC will fall as larger quantities of
debt are introduced
 The cost of debt will rise gradually as gearing increases, but more rapidly once high
levels are reached
 At such levels, shareholders are demanding a higher rise in their own returns, so
WACC starts to rise again
 At intermediate levels of gearing there is a plateau corresponding to the optimum
gearing level shown in the following diagram. Here WACC will be at a minimum, and
so projects could be appraised at the lowest cost of capital; more would give positive
NPV’s and could be accepted, increasing shareholders’ wealth.

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This can be represented on a diagram:
COST OF CAPITAL
TRADITIONAL VIEW
Ke
Cost of capital %
WACC
Kd
Optimal gearing level
0
Gearing % (Debt/Equity Ratio)
(7) MM (MODIGLIANI AND MILLER)
MM stands for Modigliani and Miller, who published research in 1958 reasoning that, if
security prices have been set by efficient secondary capital markets, companies are unable to
increase their market value (which would happen if WACC were to be lowered) simply by
borrowing money. They considered that the ability of the firm to produce income was not
dependent on how projects were financed. WACC would therefore remain constant at all
levels of gearing. The cost of debt would remain constant until very high gearing levels,
offsetting rises in the cost of equity because of its comparative cheapness (debt to equity)

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MM argued that shareholders’ wealth should not change just because of different methods of
financing by a company:
 The value of a geared firm should be the same as that of an ungeared firm with the same
expected cash flows
 This value should depend on these cash flows and their business risk
 WACC should therefore remain unchanged as the level of gearing rises; although Ke
would increase as soon as gearing is introduced, and continue to rise as financial risk
increases, the increasing levels of cheaper debt would offset this. There would be no
plateau, and no point after which both Ke and Kd would rise sharply.
(If the value of companies with the same expected cash flows was seen to be different,
arbitrage would occur. This means trading in securities in order to profit from the different
security prices for different firms. So the situation would change as demand for the cheaper
securities forces their price up, while selling of the more expensive ones causes their price to
fall, until equilibrium is reached).
They also asserted that, because shareholders can, if they wish, lend or borrow in the same
way, and at the same rates as companies, they themselves could gain any advantages or
disadvantages of having a particular level of debt.
In other words, shareholders who wanted a certain level of gearing could obtain it
themselves, by changing their portfolios, without the company needing to worry about how
individual projects should be financed.
For example, suppose that Benjamin holds 25% of the shares in Sukati Limited. The new
project has gone ahead, EPS is 25 cents, and share price is R1. Benjamin’s investment is
therefore R125 000 (500 000 x 25/100 = R125 000) and his income is R31 250 (125 000 x 0.25 = R31
250).
We now have to imagine that there exists a firm identical to Sukati in all respects, except that
it has chosen to finance an identical project with an additional 500 000 shares. This firm is
called Annet.

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If we remember that Sukati has achieved an EPS of 25 cents after paying interest of (500 000
* 9%) R45 000, we realise that that it must have achieved an operating profit of (500 000 *
25 cents) + R45 000, that is R170 000. Annet would also achieve this operating profit, but as
it has one million shares its EPS is 17 cents.
Benjamin could therefore:
 Use R125 000 obtained from selling his 25% of Sukati shares
 Borrow 25% of the amount of Sukati’s debt, that is R125 000 at 9%
 Invest the total of R250 000 in 25% of Annet’s shares, that is 250 000 shares at R1
 Obtain total earnings per share of R42 500 (250 000 * 17 cents)
 Out of this he would have to pay interest on his borrowing of R11 250
(R250 000 x 9/100) leaving him with R31 250 – or the sum he would receive from
Sukati.
If Benjamin can obtain an identical income whichever way the project is financed, it should
not matter to the companies how they choose to fund a project.
William is a shareholder of 25% of the shares in Annet. He would prefer to invest in Sukati
but does not like the idea of its gearing. Work out:
2.1 His present investment and income

2.2 How he could buy the same percentage of shares in Sukati and ungear his investment,
assuming that he could lend money at 9%

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SUGGESTED ANSWER FOR SELF-CHECK QUESTION 2
2.1 Present investment is R250 000.

William’s current income is 250 000 * 17 cents = R42 500.
2.2 If he sells his shares in Annet, he will have R250 000 (250 000 shares at R1 each). If
he buys 25% of the shares in Sukati for R1 each, that will cost him R125 000. He can
therefore lend R125 000 at 9%. His total income will be:
 125 000 shares with an eps of 25 cents each = R31 250

 interest on R125 000 at 9% = R11 250
 Total income R42 500
To summarise, the value of an ungeared firm is equivalent to the value of a geared firm:
VU = VG
value of ungeared firm = value of geared firm
Note: the value of the geared firm is made up of the total value of the equity plus the total
value of the debt.
As the firm’s value is not affected by it’s financing, cost of capital is not affected by gearing.
Although Ke will rise because of financial risk, this rise will always be offset by the relative
low cost of the increasing amounts of debt.
MM held that the relationship between the capital market’s expectations of the return on a
share in a geared company and the level of gearing is:
E(rEG) = 17 + (17 – 9) * 500 000/500 000
25 = 17 +(8*1)
WACC for Annet would be 17% that is the same as Ke.
For Sukati it would be: 0.25 * 0.5 + 0.9 * 0.5 = 17%
We can see from this formula that E(rEG) will be greater the higher the level of gearing.

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Suppose Sukati had financed its new project equally with debt at 9% and additional equity.
What would its expected return and WACC be?
SUGGESTED ANSWER FOR SELF-CHECK QUESTION 3
E(rEG) = 17 + (8 * 250/750)
= 17 + 2.67
= 19.67%
This is less than the 25% we had originally.
WACC would be 19.67 * 750/1 000 + 9 * 250/1 000, which still comes to 17%.

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We can represent MM’s original view graphically – we shall refer to it as “pre-tax” for
reasons you will discover shortly.
COST OF CAPITAL
MM pre-tax view
Ke
Cost Of Capital %
WACC = RA (i.e. the required

return on the firm’s
WACC = overall assets.
Kd
Kd
0 Gearing % (D/E Ratio)
MM’s original article was based on several assumptions, some of which seem questionable:
 There are no transaction costs; we know, however, that buying and selling securities
does involve such costs, so shareholders cannot switch costlessly between securities
 Borrowing and lending occur at the same rates of interest for individuals and companies;
borrowing is usually more expensive than the reward for lending, and individuals are
rarely offered the same rates as companies
 Bankruptcy costs do not exist – in other words, if a firm were to be wound up,
shareholders would receive the market value of their shares. This ignores disposal and
legal costs, and the fact that the value of assets to the seller and buyer may be very
different
 Kd does not increase as gearing rises until a very high level; to offset this increase MM
considered that there would be a fall in Ke as risk-seeking purchasers entered the market.
This sounds highly illogical to may people!
 There is no taxation.

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MM POST-TAX
This last assumption caused the greatest argument, and MM eventually (1963) restated their
findings to take taxation into consideration. Their new equation, post-tax, asserted that the
value of the geared company was equal to the value of the ungeared company plus the value
of the geared company’s borrowings multiplied by the tax rate applied to the interest.
VG = VU + T * LG
Where T is the company tax rate applicable to interest on debt.
The value of the geared firm is therefore increased by the tax shield on debt interest, and will
increase as the level of debt increases.
The relationship between the expected return on a share in a geared company and the level of
gearing becomes:
E(rEG) = E(rEE) + (E(rEE) – rL) LG (1 – t)

SG
Where rL must be the gross, i.e. before tax, interest cost.
If the company tax rate applied to debt interest is 33%, E(rEG) (or Ke) for Sukati would
become:
17 + (17 – 9) * 335/500 = 22.36%
WACC reduces to 22.36 * 0.5 + 9 * 0.67 * 0.5 = 14.2%
This would mean that WACC would be at a minimum when debt provides all the capital
invested in a firm. Graphically, as the cost of debt has now been reduced by tax, this will
more than offset the needs of equity for higher returns, so WACC becomes a downwards-
sloping line:

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COST OF CAPITAL
MM POST-TAX VIEW
Cost of capital %
Ke Ke
WACC
WACC Kd = (1 - Tc)
Kd
0 Gearing % (D/E Ratio)
While this appears logical up to certain levels of debt, it does not make sense to consider that
lenders will provide increasing amounts of capital at no extra cost – their security is
diminishing, and projects are likely to be of higher risk. Kd must increase eventually, even
allowing for tax shields.
If this is so, WACC could only continue to fall if the rate of increase of Ke diminishes, which
seems even less likely! So the post-tax proposition also has flaws.
Miller also wrote about tax effects in 1977, this time focusing on whether all companies
could actually take advantage of tax shields. Because there is no guarantee of a particular
profit level, neither is there any guarantee of the size of the tax shield. Also, taxation bases
differ from country to country, and tax regulations may allow for the bringing forward of past
losses or the offset of profits and losses between companies in the same group, and large
initial allowances for the purchase of non-current assets – any of which may result in there
being little taxable profit for the tax shields to reduce!
Miller referred to the clientele effect, which we shall be looking at again when we study the
dividend situation in the next section. It may be that individuals do prefer different levels of
gearing; they may invest in a particular company because of its existing capital structure. If
this structure is changed, they may need to move from such a company to one with a gearing

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structure that suits them better. Because transaction costs do exist, this will disadvantage
them – not a good example of maximisation of these particular shareholders’ wealth! So a
company may be reluctant to change the weighting of its capital.
THINK POINT
Explain the main differences between MM’s proposition of pre-tax and post-tax with regards
to borrowing.
(8) WHAT IS DONE IN PRACTICE?
It would seem that most firms have gearing greater than zero. Presumably they therefore
believe that this will improve shareholder’s wealth and lower WACC. They choose to
undertake the gearing, rather than leaving their individual shareholders to do so.
Firms with very high levels of gearing are not very common in the UK, although they are in
some other countries, such as Germany and Japan, where the pattern of business ownership
differs. So it seems that businesses do not think that very high gearing will maximise their
value – they will be bearing in mind that interest and capital have to be paid/repaid on time,
and that the risk of not being able to do so is obviously greater as gearing rises.
We have discussed the fact that Kd must rise as gearing increases. When we reach a point
where both equity and debt holders perceive a big increase in their risk, the slope of the lines
representing both Ke and Kd will become steeper. WACC can no longer fall, despite the
possibility of increasing tax shields, and will start to rise sharply. This therefore suggests that
there is a level of gearing which will result in the lowest possible WACC for any particular
firm, and which financial managers will hope to use.

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(9) DIGRESSION – COMPARING ROE WITH ROA IN A GEARED FIRM
Once a decision on investment has been made, we may want to see whether shareholders are
benefiting from the use of borrowed money.
The profit generated by using our assets is ROA, return on assets:
Operating profit
Total assets
We could also call this ROI, return on (all) investment in a business.
The profit generated by the owners’ investment is ROE, return on equity:
Profit after tax

Equity
Now, how efficiently is the firm employing the owner’s stake? Naturally, as owners are only
entitled to post-tax profit (less any deductions for preference share dividend and/or minority
interest share) we would expect ROE to be less than ROA. However, if we adjusted ROA or
ROE by using the same numerator, will there be a difference between the results produced by
the two formulae?
So how has the firm chosen to finance its assets? Has it managed to invest any borrowed
money at a higher rate than the interest rate (i), which has to be paid for that borrowing (Is
ROA > i?). Does the firm have a positive financial leverage?
We know that A = L
(Assets) (Liabilities)
Restated, we could consider that L consists of equity, E, plus debt, D:
A=E+D

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We could now express the amount of the owners’ profit as:
(ROA X A) – (i x D)
or
ROA X (E + D) – (i x D)
If we divide both sides of the equation by E, we have:
Profit = ROA X E + ROA X D - iD

E E E E
Or
ROE = ROA + D(ROA – i) (= financial leverage),

E
i.e. ROE = ROA + financial leverage
This has a similar pattern to MM’s E(rEG) formula, except that here we are dealing with one
firm’s ROE and ROA instead of the expected return of a geared and an ungeared company.
Now let’s see how this works in practice. Remember that we must compare like with like, so
ROA, i and ROE must all be either pre-tax or post-tax.
First, we need to know whether the company has borrowed any money or not. If not, D will
be zero, and the financial leverage must also be zero. Therefore ROE will be equal to ROA.
If we now look at companies that borrow money, we could have three cases:
ROA = i
ROA < i
ROA > i

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If ROA and i are identical, financial leverage is again zero, so ROA will equal ROE.
Let’s put some numbers into the equation to look at the remaining two cases.
Let’s suppose ROA is 15%, i is 18%, debt is 50 and equity 100:
ROE = 15 + 50(15 – 18)

100
= 13.5%
So if ROA < i, there is negative financial leverage, and ROE is less than ROA. Shareholders
are worse off because of the use of borrowed money.
Now let’s suppose that all the values we have just used are the same except for i, which is
now 10%.
ROE = 15 + 50(15 – 10)

100
= 17.5%
So if ROA > i, there is positive leverage, and ROE is greater than ROA. Shareholders are
better off because of the company’s use of borrowed funds.
Obviously, the greater the difference between ROA and i, the bigger the difference between
ROA and ROE.
So what about the debt/equity ratio? Let’s change D to 75, and keep all the other values as in
our last example.
ROE = 15 + 75(15 – 10)

100
= 18.75%

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From this, we can see that the greater the difference between ROA and i, and the higher
the gearing ratio, the greater the difference between ROA and ROE.
A firm can strive to improve its ROA, although it’s unlikely to be able to influence changes
in i. We have already suggested that there may be an optional gearing level for a firm, but
companies will not always seek to borrow/expand up to this optimal point.
They may prefer to:
 Have a “reserve” of borrowing ability ready to use if the right project comes along, or if
they need to top up existing borrowing in an emergency
 Turn down current investment opportunities in the belief that better opportunities lie
ahead.
A company that has high business risk, competes in a market where there is a lot of
competition, easy entry for new firms and the possibility of substitutes is unlikely to seek
high financial risk. Such firms may well prefer to remain lowly geared.
Let’s return to Sukati and Annet. If we assume that company tax is 33%, does Sukati enjoy
positive financial leverage? Does Annet’s post-tax ROA equal ROE?

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Calculation
Sukati and Annet had operating profits of R170 000. Sukati has interest of R45 000.
SUKATI ANNET
Operating profit 170 000 170 000

Interest (45 000) NIL
Profit before tax 125 000 170 000
Tax (41 250) (56 100)
Profit after tax 83 750 113 900
ROA 170 000 170 000
1 000 000 1 000 000
= 17% = 17%
Post-tax ROA 17 * (l –t) = 17 * 0.67 = 11.39% for both
ROE 83 750 113 900

500 000 1 000 000
16.75% 11.39%
ROA + (ROA – i)D/E 11.39 + (11.39 – 6.03) * 1 11.39 + 0

= 16.75% = 11.39%
(post-tax i = 9 * 0.67 = 6.03)
Sukati’s shareholders are benefiting from the borrowed money, which is producing a
return in excess of the borrowing cost – a positive financial leverage. Annet has not
borrowed, so, hardly surprisingly, ROE = ROA.

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Now suppose that Sukati borrowed only R250 000 and raised additional equity of R250 000 –
is there still positive financial leverage?
Calculation
Sukati had operating profits of R170 000.
Operating profit 170 000

Interest (22 500)
Profit before tax 147 700
Tax (48 675)
Profit after tax 98 825
ROA 170 000

1 000 000
= 17%
Post-tax ROA 17 * 0.67 = 11.39%
ROE 98 825
750 000
= 13.18%
ROA + (ROA – i)D/E 11.39 + (11.39 – 6.03) * 1 * 250/750

= 13.18%
Sukati’s shareholders still benefit from positive financial leverage, but to a lesser extent
with a lower level of gearing.

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(10) BANKRUPTCY COSTS
A limiting factor that affects the amount of debt a firm might use comes in the form of
bankruptcy costs. As the debt/equity ratio rises, so too does the probability that the firm will
be unable to pay its bondholders. Ultimately, when this happens, the ownership of the firm’s
assets is transferred to the bondholders.
A firm becomes bankrupt when the value of its assets is equal to the value of its debt. The
value of equity becomes zero and the bondholders control the firm.
There are legal and administrative costs to bankruptcy. Because of these expenses, the
bondholders will not get all that they are owed. These are called direct bankruptcy costs.
A firm will spend resources to avoid filing for bankruptcy because it is expensive. A firm
that is having problems in meeting its outstanding debt is said to be experiencing financial
distress. These costs are called indirect bankruptcy costs. The term financial distress is
referred to as the direct and indirect costs associated with going bankrupt and or avoiding a
bankruptcy filing.
Whether or not the firm goes bankrupt, the net effect is a loss of value because the firm
chooses to use debt in its capital structure. It is this possibility of loss that limits the amount
of debt that a firm will choose to use. (Ross, 2001: 457-458)
THINK POINT
For which of the following companies would the costs of financial distress be most serious?
Why?
a) A 3 year old biotech company. So far the company has no products approved for sale,
but its scientists are hard at work developing a break through drug
b) An oil production company with 50 producing wells and 20 million barrels of
proven oil reserves.

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(11) OPTIMAL CAPITAL STRUCTURE
At low debt levels, the probability of bankruptcy and financial distresses is low and the
benefits from debt outweigh the cost as the firm also benefits from the interest tax shield. At
very high debt levels, the possibility of financial distress is great, so the benefits from debt
financing may be more than off-set by the financial distress costs. It would then appear that
an optimal capital structure exists somewhere in between these extremes.
11.1 The Static Theory of Capital Structure
This theory states that the firms borrow up to a point where the tax benefits from an extra
rand in debt is exactly equal to the cost that comes from the increased probability of financial
distress. It is called the static theory because it assumes that the firm is fixed in term of its
assets and operations and it only considers possible changes in the debt/equity ratio.
The static theory is depicted in the graph below:
Value of firm Vg = Vu + Tc x D
(Vg)
Maximum firm Financial distress cost

Value Vg1 D1
Present value
of tax shield
on debt
Vu Value of firm with
no debt
Total Debt (D)

D1
Optimal amount of debt
The Y axis plots the value of the geared firm (Vg) and the X axis the total debt.

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The first is M & M Proposition with no taxes. This is the horizontal line Vu (ungeared firm),
and it indicates that the value of firm is unaffected by its capital structure. The second is M
& M Proposition with company taxes, given by the upward-sloping straight line. In the third
scenario, the value of the firm rises to a maximum and then declines beyond that point. The
maximum value of the geared firm Vg1 is reached at D1, so this is the optimal amount of
borrowing. We can say the firm’s optimal structure is composed of D1 / Vg1 in debt and (1 –
D1/Vg1) in equity.
We also notice the difference between the value of the firm in our static theory and M & M
value of the firm with taxes is the loss in value from the possibility of financial distress.
Finally, also the difference between the static theory value of the firm and the M & M value
with no taxes is the gain from leverage, net of distress costs.
11.2 Optimal Capital Structure and Cost of Capital
The capital structure that maximises the value of the firm is also the one that minimises the
cost of capital. The graph below illustrates the static theory of capital structure in terms of
the WACC and the Cost of Debt and Equity.
COST OF CAPITAL (%) Ke
Ru
(Ungeared cost Ru
of capital)
WACC
D1/E1
WACC
Ru Kd X (1 – Tc)
WACC
Debt/equity
D1/E1 Ratio (D/E)

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The figure, which corresponds to the static theory, shows the WACC which declines at first.
This occurs because the after-tax cost of debt is cheaper than equity, so, at least initially, the
overall cost of capital declines.
At the same point, the cost of debt begins to rise and the fact that debt is cheaper than equity
is more than off-set by the financial distress costs. At this point, further increases in debt
actually increases the WACC. As illustrated, the minimum WACC occurs at the point D1/E1.
(Ross, 2001: 458-460)
THINK POINT
Explain the optimal capital structure using a graphical view of the firm’s cost of capital
function.
(12) CONCLUSION
The amount of leverage (fixed-cost assets or funds) employed by a firm directly affects its
risk, return, and share value. Generally, higher leverage raises, and lower leverage reduces,
risk and return. Operating leverage is concerned with the level of fixed operating costs;
financial leverage focuses on fixed financial costs, particularly interest on debt and any
preferred share dividends. The firm’s financial leverage is determined by its capital structure
– its mix of long-term debt and equity. The value of the firm is clearly affected by its degree
of operating leverage and by the composition of its capital structure. The financial manager
must therefore carefully consider the types of operating and financial costs the firm incurs,
recognising that with greater fixed costs comes higher risk. Major decisions with regard to
both operating cost structure and capital structure must therefore focus on their impact on the
firm’s value. Only those leverage and capital structure decisions that are consistent with the
firm’s goal of maximising its share price should be implemented.

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The MM theory indicates that managers of the firm cannot change its value by repackaging
the firm’s securities. The MM theory also implies that a firm’s capital structure is irrelevant.
The firm’s capital structure is brought about by random managerial decisions about how
much to borrow and how many shares to issue.

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SECTION 7
DIVIDEND POLICY

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LEARNING OUTCOMES
On completion of this learning module, you should be able to understand:
 Outline the key factors involved in formulating a dividend policy
 Describe cash dividend payments and the role of dividend reinvestment plans
 Explain the motives for using share dividends, share splits and share repurchases
 Explain the residual theory of dividends
 Outline the key arguments with regard to dividend irrelevance and relevance.
 Outline the 3 basic types of dividend policies

Managerial Finance
(1) INTRODUCTION
Dividends are non-contractual payments to owners and shareholders as compensation for

their investment. The expected cash dividends are the key return variable from which owners
and investors determine share value. They represent a source of cash flow to shareholders
and provide information about the firm’s current and future performance. Because retained
earnings – earnings not distributed as dividends - are a form of internal financing, the
dividend decision can significantly affect the firm’s external financing requirements. In other
words, if the firm needs financing, the larger the cash dividend paid, the greater the amount
of financing that must be raised externally through borrowing or through the sale of ordinary
or preference share. (Remember that although dividends are charged to retained earnings,
they are actually paid out of cash.) Interim dividends are declared and paid during the cause
of the year and a final dividend is declared at the end of the financial year. The sum of the
interim and final dividend is the total dividend for the year.
(2) FACTORS AFFECTING DIVIDEND POLICY
Before discussing the basic types of dividend policies, we should consider the factors
involved in formulating dividend policy. These include legal constraints, contractual
constraints, internal constraints, the firm’s growth prospects, owner considerations, and
market considerations.
2.1 Legal Constraints
We’ll start by looking at actual restrictions on payment of dividends.
 While dividends can be paid from past and present earnings, they cannot be paid from
any capital reserve.
So, if any funds have been transferred from income statements, or another revenue
reserve, into a capital reserve, such as a capital redemption reserve, then this reserve
is not available for payment of cash dividends.

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This rule also covers funds, which have been entered directly into a capital reserve,
and have never come from the income statement, such as share premium and
revaluation reserves. As we have already seen, such reserves may be used for the
issue of bonus shares, which may be considered to take the place of cash dividends in
a particular year.
 Companies that are insolvent cannot legally pay dividends; that is, if their external
liabilities exceed their assets.
 Companies with various kinds of debt capital may in fact have agreed to restrictions
on dividend payments to protect long-term creditors.
 A company with a loan requiring redemption may need to retain funds for this
purpose.
2.2 Contractual Constraints
Often, the firm’s ability to pay cash dividends is constrained by restrictive provisions in a
loan agreement. Constraints on dividends help to protect creditors from losses due to the
firm’s insolvency.
2.3 Internal Constraints
The firm’s ability to pay cash dividends is generally constrained by the amount of excess
cash available rather than the level of retained earnings against which to charge them.
Although a firm may have high earnings, its ability to pay dividends may be constrained by a
low level of liquid assets (cash and marketable securities).
2.4 Growth Prospects
The firm’s financial requirements are directly related to the anticipated degree of asset
expansion. If the firm is in a growth stage, it may need all its funds to finance capital
expenditures. Firms exhibiting little or no growth may nevertheless periodically need funds
to replace or renew assets.

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A firm must evaluate its financial position from the standpoint of profitability and risk to
develop insight into its ability to raise capital externally. It must determine not only its
ability to raise funds, but also the cost and speed with which financing can be obtained.
Generally, a large, mature firm has adequate access to new capital, whereas a rapidly growing
firm may not have sufficient funds available to support its numerous acceptable projects. A
growth firm is likely to pay out only a very small percentage of its earnings as dividends. A
more stable firm that needs long-term funds only for planned outlays is in a better position to
pay out a large proportion of its earnings, particular if it has ready sources of financing.
2.5 Owner Considerations
In establishing a dividend policy, the firm’s primary concern should be to maximize owner
wealth. Although it is impossible to establish a policy that maximizes each owner’s wealth,
the firm must establish a policy that has a favourable effect on the wealth of the majority of
owners.
One consideration is the tax status of a firm’s owners. If a firm has a large percentage of
wealthy shareholders who are in a high tax bracket, it may decide to pay out a lower
percentage of its earnings to allow the owners to delay the payment of taxes until they sell the
share. Of course, when the share is sold, if the proceeds are in excess of the original purchase
price, the capital gain will be taxed, possibly at a more favourable rate than the one applied to
ordinary income. Lower-income shareholders, however, who need dividend income, will
prefer a higher payout of earnings.
A second consideration is the owners’ investment opportunities. A firm should not retain
funds for investment in projects yielding lower returns than the owners could obtain from
external investments of equal risk. The firm should evaluate the returns that are expected on
it’s own investment opportunities and, using present value techniques, determine whether
greater returns are obtainable from external investments such as government securities or
other corporate stocks. If it appears that the owners have better opportunities externally, the
firm should pay out a higher percentage of its earnings and vice versa.
A final consideration is the potential dilution of ownership. If a firm pays out a higher
percentage of earnings, new equity capital will have to be raised with ordinary shares, which

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may result in the dilution of both control and earnings for the existing owners. By paying out
a low percentage of its earnings, the firm can minimize such possibility of dilution. (Gitman,
2003:568)
2.6 Market Considerations
An awareness of the market’s probable response to certain types of policies is helpful in

formulating a suitable dividend policy. Shareholders are believed to value a fixed or
increasing level of dividends as opposed to a fluctuating pattern of dividends. This belief is
supported by the research of John Lintner, who found that corporate managers are averse to
changing the rand amount of dividends in response to changes in earnings, particularly when
earnings decline. In addition, shareholders are believed to value a policy of continuous
dividend payment. Because regularly paying a fixed or increasing dividend eliminates
uncertainty about the frequency and magnitude of dividends, the earnings of the firm are
likely to be discounted at a lower rate. This should result in an increase in the market value
of the share and therefore increased owner’s wealth.
A final market consideration is the informational content of dividends. As indicated earlier,

shareholders often view the firm’s dividend payment as a signal relative to its future success.
A stable and continuous dividend is a positive signal that conveys to the owners that the firm
is in good health. If the firm skips a dividend payment in a given period due to a loss or to
very low earnings, shareholders are likely to interpret this as a negative signal. The non-
payment of the dividend creates uncertainty about the future, and this uncertainty is likely to
result in lower share value. Owners and investors generally construe a dividend payment
during a period of losses as an indication that the loss is merely temporary. (Gitman, 2003:
569)
2.7 Market Friction
The scenario above ignores several important aspects:
 Taxation
 Costs of buying and selling shares
 Issue costs for new capital

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If we consider taxation, we should note that its impact is caused not only by the rates of tax
on income and capital gains, but the type of tax system in force in a particular country. Taxes
on income tend to be higher than those on capital gains, and, of course, in most countries
capital gains are only taxable when realised. Tax systems can involve the payment of tax by
the company and the shareholder on the same amount of money (the dividend) – this is
double taxation and happens in countries using the classical system. In the case of the UK,
the system is an imputation system, where shareholders are given a tax credit for part of the
amount of tax already paid by the company, and so do not pay additional income tax unless
they are chargeable at a higher rate. (The partial nature of the credit is due to the differences
between company tax rates and income tax rates.)
2.8 The Clientele Effect
Do companies resort to particular dividend policy because of the type of shareholder they
have? Some shareholders might, for example, prefer low dividends because of their tax
position. Remembering that many shares are today held by pension funds and insurance
companies, who would like a steady stream of ready cash inflows to balance their outflows,
there may be a requirement from other shareholders for a high level of dividend, preferably a
steady one.
So if different shareholders have different requirements, and prefer not to create their own
dividends as already described, because of the costs or effort involved, maybe they have
bought shares in particular companies because of the observed dividend policies of those
companies? In this case, firms should maintain their dividend policies or risk antagonising
their existing shareholders – also, the lack of an observable policy might put off new
shareholders. This could have a bad effect on share price and therefore cost equity.
Research tends to show that firms are loath to change dividend patterns, particularly
downwards! Gentle growth seems to be the target – too rapid growth might not be
sustainable.
Some evidence of a clientele effect has been found by various research studies.

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2.9 Signalling
It is possible that when a dividend is announced, particularly if there is a significant rise in its
level, the firm is trying to signal its confidence in its future? If so, and if the stock market
reacts favourably to this ‘information’, there is an implication that some information
available to the management of the company is not already incorporated in the share price,
i.e. the stock market is ‘strong form’ efficient. In an efficient market the stock market reacts
only to the unexpected changes in the dividend policy.
It is noticeable that, in a hostile takeover bid, the target company often announces a higher
dividend level in its efforts to prevent its shareholders from accepting an offer from a
predator. Researchers have found evidence that the stock market takes notice of dividend
announcements as information on which to base the level of share prices.
THINK POINT
Why may dividends be used by management to signal the prospects of a firm?
2.10 Agency Considerations
The interests of shareholders, managers and creditors do not necessarily coincide. Managers
who are interested in their own careers, which may not necessarily involve one firm for more
than a few years, are likely to favour short-term as opposed to long-term growth. Creditors
are interested in safeguarding their interest and original loans.
Do dividends have a part to play in the possible conflict of interest between shareholders and
managers? If dividends are paid, assets shift from the control of management to that of the
individual shareholder.

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They also move out of the reach of creditors. Sometimes companies repurchase some of their
shares. Various reasons may be given for this, but an obvious result is to provide a final ‘cash
dividend’ to those shareholders whose shares are repurchased (as the shares will usually be
repurchased in the open market, it is very unlikely that a proportion of all shareholders’
interests will be bought.) Recent examples of share repurchase have cited over-capitalisation
as the reason for the reduction in shares; certainly the funds used to repurchase such shares
are no longer available to creditors.
In summary, there is no clear evidence that share price is influenced by dividend policy. So
company directors must try to balance all the points we have covered, and try to ensure that
shareholders receive a realistic amount that will satisfy their expectations.
Finally, although shareholders have votes, and the proposed final dividend has to be approved
at the annual general meeting, most companies have articles of association, which restrict the
powers of shareholders to reducing, rather than increasing, the dividend. In practice,
shareholders will usually accept the dividend that has been proposed.
(3) DIVIDEND PAYMENT
3.1 Cash Dividend Payment
The payment of cash dividends to shareholders is decided by the firm’s board of directors.
The directors normally meet on a quarterly or semi-annually basis to determine whether and
in what amount dividends should be paid. The past period’s financial performance and future
outlook, as well as recent dividends paid, are key inputs to the dividend decision. The
payment date of the cash dividend, if one is declared, must also be established.
3.2 Dividend Reinvestment Plans (DRP)
Today many firms offer dividend reinvestment plans (DRP), which enable shareholders to
use dividends received on the firm’s share to acquire additional shares at little or no
transaction (brokerage) cost. Dividend reinvestment plans can be handled by a company in
either of two ways. Both allow the shareholder to elect to have dividends reinvested in the

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firm’s shares. In one approach, a third party trustee is paid a fee to buy the firm’s outstanding
shares in the open market on behalf of the shareholders who wish to reinvest their dividends.
This type of plan benefits participating shareholders by allowing them to use their dividends
to purchase shares generally at a lower transaction cost than they would otherwise pay.
The second approach involves buying newly issued shares directly from the firm without
paying any transaction costs. This approach allows the firm to raise new capital while
permitting owners to reinvest their dividends, frequently at about 5% below the current
market price. The firm can justify the below-market sale price economically because it saves
the under-pricing and flotation costs that would accompany the public sale of new shares.
Clearly, the existence of the DRP may enhance the appeal of a firm’s shares.
(Gitman, 2003: 560 – 561)
THINK POINT
How are dividends paid and how do companies decide on dividend payments?

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(4) OTHER FORMS OF DIVIDENDS
A number of other forms of dividends are also available, namely:
4.1 Share Dividends
A share dividend is the payment to existing owners of a dividend in the form of shares.
Often, firms pay share dividends as a replacement for or a supplement to cash dividends.
Although share dividends do not have a real value, shareholders may perceive them to
represent something they did not have before and therefore to have value.
4.2 Share Splits
Although not a type of dividend, share splits have an effect on a firm’s share price similar to
that of share dividends. A share split is a method commonly used to lower the market price
of a firm’s share by increasing the number of shares belonging to each shareholder. Quite
often, a firm believes that its share is priced too high and that lowering the market price will
enhance trading activity. Share splits are often made prior to issuing additional shares to
enhance its marketability and stimulate market activity.
A share split has no effect on the firm’s capital structure. It commonly increases the number
of shares outstanding and reduces the par value of the shares.
4.3 Share Repurchases
Over the past 20 or so years, firms have increased their repurchasing of outstanding ordinary
shares in the market place. The practical motives for share repurchases include obtaining
shares to be used in acquisitions, having shares available for employee share option plans, or
retiring shares. The recent increase in frequency and importance of share repurchases is due
to the fact that they either enhance shareholder value or help to discourage an unfriendly
takeover.

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Share repurchases enhance shareholder value by:
4.3.1 reducing the number of shares outstanding and thereby raising earnings per share,
4.3.2 sending a positive signal to investors in the market place that management believes
that the share is undervalued, and
4.3.3 providing a temporary floor for the share price, which may have been declining.
The use of repurchases to discourage unfriendly takeovers is predicated on the belief that a
corporate raider is less likely to gain control of the firm if the are fewer publicly traded shares
available. Here we focus on retiring shares through repurchase, because this motive for
repurchase is similar to the payment of cash dividends. (Gitman, 2003: 572 – 575)
THINK POINT
Explain share splits and share repurchases and the firm’s motivation for undertaking each of
them.

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(5) THE RELEVANCE OF DIVIDEND POLICY
Numerous theories and empirical findings concerning dividend policy have been reported in
financial literature. Although this research provides some interesting insights about dividend
policy, capital budgeting and capital structure decisions are generally considered far more
important than dividend decisions. In other words, good investment and financing decisions
should not be sacrifices for a dividend policy of questionable importance.
A number of key questions have yet to be resolved: Does dividend policy matter? What
effect does dividend policy have on share price? Is there a model that can be used to evaluate
alternative dividend policies in view of share value? Here we begin by describing the
residual theory of dividends, which is used as a backdrop for discussing dividend irrelevance
and dividend relevance.
5.1 The Residual Theory
One school of thought, the residual theory of dividend, suggests that the dividend paid by a
firm should be viewed as a residual – the amount left over after all acceptable investment
opportunities have been undertaken. If the available retained earnings are in excess of this
need, the surplus amount, ie. the residual, should be distributed as dividends.
5.2 Dividend Irrelevance Theory
The residual theory of dividends implies that if the firm cannot earn a return (IRR) from
investment of its earnings that is in excess of weighted average cost per capital, its should
distribute the earnings by paying dividends to shareholders. This approach suggests that
dividends are irrelevant – that they represent an earnings residual rather than an active
decision variable that affects the firm’s value. Such a view is consistent with the dividend
irrelevance theory postulated by Merton H. Miller and Franco Modigliani. M and M’s theory
shows that in a perfect world (certainty, no taxes, no transactions costs, and no other market
imperfections), the value of the firm is unaffected by the distribution of dividends. They
argue that the firm’s value is determined solely by the earning power and risk of its assets

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(investments) and the manner in which it splits its earnings stream between dividends and
internally retained (and reinvested) funds does not affect this value.
However, studies have shown that large dividend changes affect share price in the same
direction – increases in dividends result in increased share price, and decreases in dividends
result in decreased share price. In response, M and M argue that these effects are attributable
not to the dividend itself but rather to the informational content of dividends with respect to
future earnings. In other words, it is not the preference of shareholders for current dividends
(rather than future capital gains) that is responsible for this behaviour. Instead, a change in
dividends, up or down, is viewed as a signal that management expects future earnings to
change in the same direction. An increase in dividends is viewed as a positive signal that
causes investors to bid up the share price; a decrease in dividends is a negative signal that
causes a decrease in share price.
M and M further argue that a clientele effect exists: a firm attracts shareholders whose
preferences with respect to the payment and stability of dividends correspond to the payment
pattern and stability of the firm itself. Investors desiring stable dividends as a source of
income hold the share of firms that pay about the same dividend amount each period.
Investors preferring to earn capital gains are more attracted to growing firms that reinvest a
large portion of their earnings, resulting in a fairly unstable pattern of dividends. Because the
shareholders get what they expect, M and M argue that the value of the firm’s share is
unaffected by dividend policy.
In summary, M and M and other dividend irrelevance proponents argue that, all else being
equal, an investor’s required return – and therefore the value of the firm – is unaffected by
dividend policy for three reasons:
5.2.1 The firm’s value is determined solely by the earning power and risk of its assets.
5.2.2 If dividends do affect value, they do so solely because of their informational content,
which signals management’s earnings expectations.
5.2.3 A clientele effect exists that causes a firm’s shareholders to receive the dividends they
expect.

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These views of M and M with respect to dividend irrelevance are consistent with the residual
theory, which focuses on making the best investment decisions to maximise share value. The
proponents of dividend irrelevance conclude that because dividend is irrelevant to a firm’s
value, the firm does not need to have a dividend policy. Although many research studies
have been performed to validate or refute the dividend irrelevance theory, none has been
successful in providing irrefutable evidence.
THINK POINT
Respond to the following comment: “It’s all very well saying that I can sell shares to cover
cash needs but that may mean selling at the bottom of the market. If the company pays a
regular dividend, investors avoid the risk”.
5.3 Dividend Relevance Theory
The key argument in support of dividend relevance theory is attributed to Myron J. Gordon
and Jon Lintner, who suggest that there is, in fact, a direct relationship between the firm’s
dividend policy and its market value. Fundamental to this proposition is their bird-in-the-
hand argument, which suggests that investors are generally risk-averse and attach less risk to
current dividends than to future dividends or capital gains. Current dividend payments are
therefore believed to reduce investor’s uncertainty, causing investors to discount the firm’ s
earnings at a lower rate and all else being equal, to place a higher value on the firm’s share.
Conversely, if dividends are reduced or not paid, investor uncertainty will increase, raising
the required return and lowering the share’s value.
Although many other arguments relating to dividend relevance have been put forward,
numerous empirical studies fail to provide conclusive evidence in support of the intuitively
appealing dividend relevance argument. In practice, however, the actions of financial
managers and shareholders alike often tend to support the belief that dividend policy does
affect share value. Because our concern centres on the day-to-day behaviour of business
firms, the remainder of this section is consistent with the belief that dividends are relevant –
that each firm must develop a dividend policy that fulfils the goals of its owners and
maximises their wealth as reflected in the firm’s share price. (Gitman, 2003: 562 – 566)

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(6) TYPES OF DIVIDEND POLICIES
This firm’s dividend policy represents a plan of action to be followed whenever the dividend
decision must be made. The dividend policy must be formulated with two basic objectives in
mind: maximizing the wealth of the firm’s owners and providing for sufficient financing.
These two interrelated objectives must be fulfilled in light of a number of factors – legal,
contractual, internal, growth, owner-related, and market-related – that limit the policy
alternatives. Three of the more commonly used dividend policies are described in the
following sections. A particular firm’s cash dividend policy may incorporate elements of
each.
6.1 Constant-Payout-Ratio
One type of dividend policy occasionally adopted by firms is the use of a constant payout
ratio. The dividend payout ratio, calculated by dividing the firm’s cash dividend per share by
it earnings per share, indicates the percentage of each rand earned that is distributed to the
owners in the form of cash. With a constant-payout-ratio dividend policy, the firm establishes
that a certain percentage of earnings are paid to owners in each dividend period.
The problem with this policy is that if the firm’s earnings drop or if a loss occurs in a given
period, the dividends may be low or even nonexistent. Because dividends are often
considered an indicator of the firm’s future condition and status, the firm’s share price may
thus be adversely affected by this type of action.
6.2 Regular Dividend Policy
Another type of dividend policy, the regular dividend policy, is based on the payment of a
fixed-rand dividend in each period. The regular dividend policy provides the owners with
generally positive information, indicating that the firm is okay and thereby minimising their
uncertainty. Often, firms using this policy increase the regular dividend once a proven
increase in earnings has occurred. Under this policy, dividends are almost never decreased.
Often, a regular dividend policy is built around a target dividend – payment ratio. The firm
attempts to pay out a certain percentage of earnings, but rather than let dividends fluctuate, it
pays a stated rand dividend and adjusts it towards the target payout as proven earnings
increases occur.

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6.3 Low-Regular-and-Extra Dividend Policy
Some firms establish a low-regular-and-extra dividend policy, paying a low regular dividend,
supplemented by an additional dividend, when earnings warrant it. When earnings are higher
than normal in a given period, the firm may pay this additional dividend, which is designated
an extra dividend. By calling the additional dividend an extra dividend, the firm avoids
giving shareholders false hopes. The use of the “extra” designation is especially common
among companies that experience cyclical shifts in earnings.
By establishing a low regular dividend that is paid each period, the firm gives investors the
stable income necessary to build confidence in the firm, and the extra dividend permits them
to share in the earnings from an especially good period. Firms using this policy must raise
the level of the regular dividend once proven increases in earnings have been achieved. The
extra dividend should not be a regular event, or it becomes meaningless. The use of a target
dividend-payout ratio in establishing the regular dividend level is advisable.
(Gitman, 2003: 570 – 573)
THINK POINT
Why would dividend policy not affect the firm’s value in an ideal world?

Managerial Finance
(7) DIVIDEND POLICY BY MAJOR SOUTH AFRICAN COMPANIES
With the introduction of the exchange control in the 1960’s, South African companies
operating in specific sectors, soon found themselves with growing cash piles and only local
market growth potential. Unable to utilise off-shore opportunities, there was only the
domestic investment option available to companies with growth aspirations. Many firms,
unwilling to pay out their excess cash dividends, diversified into other, non-core sectors of
the economy. These conglomerates encountered severe difficulties in operating in non-core
areas.
Anglo American, SAB, Federable Mynobou and Barlow Rand were all prime examples of
local companies that felt themselves compelled to diversify into areas outside their scope of
expertise.
Most of these companies have subsequently streamlined their operations by chopping off
non-core businesses. Formerly an industrial equipment distributor Barlow Rand delved into,
amongst other things, mining, buying into Rand Mines. In the early 1990’s, the company
group started to unbundle non-core businesses and a more focused and streamlined Barlow
Limited was born. Now known as Barloworld, it is a good example of a company that has
rediscovered its focus and has become a true global player in core-business areas.
Fedmyn and General Mining went on to accumulate a swathe of inappropriate non-mining

interests that often proved to be millstones. Of course this did not matter to men who were
determined that at any cost, control of vast sectors of the economy were to be wrested from
“Engelse” hands to be controlled by the “volk”. Size and control of large parts of the
economy were seen as more important than sound profits.
Those non-core assets have all gone since Afrikaner financial powerhouse Sanlam bit the
bullet and allowed Derek Keys and Brian Gilberston to set in a move that led to the eventual
focus that was BHP Billiton – a major mining group headquartered outside South Africa.
Anglo American has done the same and is now off-shore, with only Mondi as an appreciable
non-mining asset.

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Most financial companies on the JSE Securities Exchange have generated healthy cashflows
out of the good macroeconomic conditions. As a result many are now pregnant with surplus
cash. Savvy investors are standing in line for a share of the bounty, in the form of higher
ordinary dividends or one-off special dividends.
Dividends hold a double attraction for shareholders: they are not taxable and, unlike cash
investments, dividends from good companies will increase every year. So investigate the
financial sector: as an example, Microlender, African Bank Investment Limited (ABIL) is
believed to be sitting on about R1-billion of surplus cash.
CEO Leon Kirikinis said earlier this year ABIL was unlikely to acquire anything, so it was
likely to return capital to shareholders. It has already made one special dividend payment in
the past year. Kirikinis said: “ We don’t see much point in holding surplus capital – if you
can’t use it, give it back.” Standard Bank and Liberty Life are under pressure to adopt more
aggressive dividend policies, as are life assurer Sanlam and its short-term insurance arm,
Santam. They cannot afford to sit on their cash forever if they want to avoid investors’
disapproval. Special dividends are a possibility in all four cases. RMB Holdings’ disposal of
its Global Resorts casino interests has left it with R500 million to return to shareholders.
(Business Times Money 24 October 2004)
The first foreign listing in South Africa may not be far off after finance minister Trevor
Manuel lifted the limits on how much South Africans could invest in foreign companies that
list on the JSE Securities Exchange. Officials said they did not expect a massive outflow of
funds because many investors now realised the risks attached to investments abroad, while at
the same time major new investment opportunities had opened up in South Africa.
(Daily News, 26 October 2004)
Iscor-plat shareholders were unhappy that their were only paid 100c as the final dividend
(total 400c). They expected the directors to pay out a special dividend, as the company as
surplus cash.
Isplat Iscor is now known as Mittal Steel S.A.

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1. Discuss factors affecting Dividend Policy under the following headings:
 Legal constraints
 Growth prospects
 Market consideration
 The Clientele effect
 Signalling
 Agency Considerations
 Dividend payments (Interim and Final)
2. Modigliani and Miller (M & M) and others have discussed various approaches to
Dividend Policy. Discuss Dividend Policy, explaining why it is so important for the
management of a company to arrive at the right approach for their company.
3. The directors of a company constantly have to manage dividend policy between the
needs of the company and the needs of the shareholders. Explain how managers make
decisions on dividend policy, and how these help them to make better “investment
decisions.”
Answers can be determined by reading the chapter as well as the text.

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(9) CONCLUSION
Cash dividends are the cash flows that a firm distributes to its common shareholders. A share
of common stock gives its owner the right to receive all future dividends. The present value
of all those future dividends expected over a firm’s assumed infinite life determines the
firm’s share value.
Dividends not only represent cash flows to shareholders but also contain useful information
with regard to the firm’s current and future performance. Such information affects the
shareholder’s perception of the firm’s risk. A firm can also pay share dividends, initiate
share splits, or repurchase shares. Each of these dividend-related actions can affect the firm’s
risk, return, and value as a result of their cash flows and informational content.
Although the theory with regard to the relevance of dividends is still evolving, the behaviour
of most firms and shareholders suggests that dividend policy affects share prices. It is
therefore believed to be important for the financial manager to develop and implement a
dividend policy that is consistent with the firm’s goal of maximising share price.

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SECTION 8
FOREIGN RISK MANAGEMENTAND

PROJECT EVALUATION

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LEARNING OUTCOMES
 Explain why companies hedge to reduce risk
 Describe the types of risk which can be hedged
 Explain how companies manage foreign exchange risk
 Evaluate investments in foreign countries.
 Describe the implications of inflation, sunk costs and government intervention on

investment considerations.
 Distinguish between exchange rate risk and political risk.

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(1) INTRODUCTION
There is some vocabulary, which is common to both interest risk and foreign exchange risk.
First, let’s consider what is meant by exposure – vulnerability to risk. For interest rates, this
will occur because any rise in interest rates will mean that total interest charges will rise.
This doesn’t simply affect a company with floating interest-rate debt; it could also apply to a
company that needs to issue new debt to redeem maturing debt – if interest rates rise sharply
just before this is due to take place, such a company could find it impossible to continue with
the new debt issue.
Foreign exchange exposure will affect importers and exporters. However carefully they
arrange documentation, unless goods are paid for immediately, which is rare, changes in
exchange rates will leave traders vulnerable to losses. (On the bright side, it is equally
possible that there could be gains!)
Therefore, in order to reduce the firm’s exposure to rate fluctuations, hedging is undertaken
to reduce this exposure. There are many different types of hedging and many different
techniques. Frequently, when a firm desires to hedge a particular risk, there will be no direct
way of doing so. The financial manager’s job in such cases is to create a way by using
available financial instruments to create new ones. This process has come to be called
financial engineering.
(2) INTEREST RISK MANAGEMENT
One useful thing that a company can do to minimise interest risk is to ensure that all its debt
capital is not repayable at the same time, and preferably not within one financial year either.
In other words, a company should seek a maturity mix.
Another is to have fixed some interest and some floating interest obligations. Firms dislike
fixed-interest debt when market rates are falling, but obviously favour them if rates rise.
Conversely, floating interest-rates are favoured if rates fall, and avoided when rates are rising.

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2.1 Hedging With Swap Contracts
As the name suggests, a swap contract is an agreement by two parties to exchange or swap
specified cash flows at specified intervals. Swaps are relatively recent innovation; they were
first introduced to the public in 1981. The market for swaps has grown tremendously since
that time. In principle, most swap contracts could be tailored to exchange just about
anything. In practice, most swap contracts fall into one of the three categories: interest rate
swaps; currency; and commodity swaps.
2.1.1 Interest Rate Swaps
Imagine a firm that wishes to obtain a fixed-rate loan, but can only get a good deal on a
floating-rate loan, that is, a loan where the payments are adjusted periodically to reflect
changes in interest rates. Another firm can obtain a fixed-rate loan, but wishes to obtain the
lowest possible interest rate and is therefore willing to take a floating-rate loan. (Rates on
floating-rate loans are generally lower than rates on fixed-rate loans). Both firms could
accomplish their objectives by agreeing to exchange loan payments; in other words, the two
firms undertaken to make each others loan payments. This is an example of an interest rate
swap; what is really being exchanged is a floating interest rate for a fixed one.
2.1.2 Currency Swaps
With a currency swap, two companies agree to exchange a specific amount of one currency
for a specific amount of another at specific dates in the future. For example, suppose a US
firm has a South African subsidiary and it wishes to obtain debt financing for an expansion of
the subsidiary’s operations. Because most of the subsidiary’s cash flows are in rands, the
company prefers the subsidiary to borrow and make payments in rands, thereby hedging
against changes in the rand/dollar exchange rate. Unfortunately, the company has good
access to US debt markets, but not South African debt markets.
At the same time, a South African would like to obtain US Dollar financing. It can borrow
cheaply in rands, but not in dollars. Both firms face a similar problem. They can borrow at
favourable rates, but not in the desired currency. A currency swap is a solution. These two
firms simply agree to exchange dollars for rands at a fixed rate at specific future dates (the

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payment dates on the loans). Each firm thus obtains the best possible rate and then arranges
to eliminate exposure to exchange rate changes by agreeing to exchange currencies.
2.13 Commodity Swaps
As the name suggests, a commodity swap is an agreement to exchange a fixed quantity of a

commodity at fixed times in the future. Commodity swaps are the newest type of swap, and
the market for them is small relative to other types. The potential for growth is enormous,
however.
Swap contracts for oil have been developed. For example, an oil user has a need for 20 000
barrels every quarter. The oil user could enter into a swap contract with an oil producer to
supply the needed oil. What price would they agree on? As we mentioned above, they
cannot fix a price forever. Instead, they could agree that the price will be equal to the average
daily oil price from the previous 90 days. By using an average price, the impact of the
relatively large daily price fluctuations in the oil market will be reduced, and both firms
benefit from a reduction in transactions exposure.
2.1.4 The Swap Dealer
Swap contracts are not traded on organised exchanges. Instead, the swap dealer (often a
merchant bank) plays a key role in the swaps market. (Ross, 2001: 622-624)
Example: Interest Rate Swaps
To get a better understanding of swap contracts and the role of the swap dealer, we consider a
floating-for-fixed interest rate swap. Suppose Main Tin Limited can borrow at a floating rate
equal to prime plus 1 per cent or at a fixed rate of 10 per cent. Reef Coast Limited can
borrow at a floating rate of prime plus 2 per cent or at a fixed rate of 9,5%. Main Tin Limited
desires a fixed-rate loan while Reef Coast Limited desires a floating–rate loan. Clearly, a
swap is in order.
Main Tin Limited contracts a swap dealer, and a deal is struck. Main Tin Limited borrows
the money at a rate of prime plus 1 per cent. The swap dealer agrees to cover the loan

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payments, and, in exchange, the company agrees to make fixed-rate payments to the swap
dealer at a rate of say 9,75%. Note that the swap dealer is making floating-rate payments and
receiving fixed-rate payments. The company is making fixed-rate payments, so it has
swapped a floating payment for a fixed one.
Reef Coast Limited also contacts a swap dealer. The deal here calls for Reef Coast to borrow
the money at a fixed rate of 9,5%. The swap dealer agrees to cover the fixed loan payments,
and the company agrees to make floating-rate payments to the swap dealer at a rate of prime
plus say 1,5%. In this second arrangement, the swap dealer is making fixed-rate payments
and receiving floating-rate payments.
What is the net effect of these transactions? First, Main Tin Limited gets a fixed-rate loan at
9,75%, which is cheaper than the 10% rate it can obtain on its own. Second, Reef Coast gets
a floating-rate loan at prime plus 1,5 instead of prime plus 2. The swap benefits both
companies.
The swap dealer also wins, he receives (from Main Tin Limited) fixed-rate payments at a rate
of 9,75% and makes fixed-rate payments (for Reef Coast) at a rate of 9,5%. At the same
time, it makes floating-rate payments (for Main Tin Limited) at a rate of prime plus 1% and
receives floating-rate payments at a rate of prime plus 1,5% (from Reef Coast Limited).
Notice that the swap dealer’s book is perfectly balanced, in terms of risk, and it has no
exposure to interest rate volatility.
2.2 Forward Interest-Rate Agreements (FRA)
There are many other applications of interest rate swaps. A company can make an agreement
with a swap dealer concerning the interest on future borrowing, or for future deposits. Such
an agreement is often referred to as an FRA. If an FRA for borrowing has been drawn up,
and the interest on the future date is higher than that stated in the agreement, the bank must
pay the company the difference in the interest rates. However, if the interest rate is lower, the
company must pay the bank the difference in the interest rates. An FRA is an agreement on
interest rates only, not an agreement actually to lend or deposit money.

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Example:
Suppose that current rates in the swap market are “prime for 8% fixed”. This means that the
firm can enter into a swap agreement to pay 8% on “notional principal” of say, R100 million
to a swap dealer and receive payment of the prime rate on the same amount of notional
principal. The firm pays the swap dealer 0.08 x R100 million and receives prime x R100
million. The firm’s net cash payment to the dealer is therefore (0.08 – prime) x R100 million.
(If prime exceeds 8%, the firm receives money from the dealer; it is less than 8%, the firm
pays money to the dealer). The table below illustrates the cash flows paid by the firm and the
swap dealer.
PRIME RATE
7.5% 8.0% 8.5%
Interest paid on floating-rate bonds R7 500 000 R8 000 000 R8 500 000
(= Prime x 100 million)
+ Cash payments on swap 500 000 NIL (500 000)
[= 0.08 – prime x notional principal
of R100 million]
Total Payment R8 000 000 R8 000 000 R8 000 000

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Consider the portfolio manager who is holding a R100 million portfolio of long-term 8%
coupon bonds and wishes to reduce price risk by transforming the holdings into a synthetic
floating-rate portfolio. Assume the portfolio currently pays an 8% fixed rate and that swap
dealers currently offer terms of 8% fixed on prime. What swap would the manager establish?
Show the total income of the funds in a table
The manager should enter a swap to pay an 8% fixed rate and receive prime on notional
principal of R100 million. The cash flows will then rise in tandem with the prime rate:
PRIME RATE
7.5% 8.0% 8.5%
Interest paid on fixed-rate bonds R8 000 000 R8 000 000 R8 000 000
(= 0.08 x 100 million)
+ Cash flow on swap (500 000) NIL 500 000
[= prime - 0.08) x notional principal
of R100 million]
Total Payment R7 500 000 R8 000 000 R8 500 000

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2.3 Interest-Rate Guarantee
A more expensive version of this is an interest-rate guarantee, where an agreement could be

made with swap dealer that the maximum borrowing rate that would apply in three months
time would be 12,5%. If the rate then turns out to be 13%, the dealer must pay the firm the
difference. However, if the rate turns out to be 12%, the firm does not have to borrow at
12,5% - it can still borrow at the market rate, and abandon the guarantee. This explains why
it will be charged more for the guarantee in the first place than the arrangement fee for a
forward interest-rate agreement.
THINK POINT
How do financial managers try to minimise international interest risk?
Benson Limited makes a forward interest-rate borrowing agreement with its swap dealer.
The terms of the agreement are an interest rate of 10% for an amount of R150 000 in six
months from the date of the agreement.
What will the situation be if the interest-rate is 12% in six months time? And if it is 9%?
Suppose that the arrangement contained an interest-rate guarantee that the maximum rate to
be applied would be 11% - what then?

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If interest rate is 12%, dealer pays R3 000 to Benson.
If interest rate is 9%, Benson pays R1 500 to the dealer.
With a guarantee of 11%
If interest rate is 12%, dealer pays R1 500 to Benson.
If interest rate is 9%, Benson does not have to borrow at 11% - it can abandon the
guarantee
(3) FOREIGN EXCHANGE RISK MANAGEMENT
3.1 Exchange Rates
An exchange rate is simply the price of one country’s currency expressed in terms of another
country’s currency. In practice, almost all trading of currencies takes place in terms of the
US dollar. For example, the South African rands are traded with their prices quoted in US
dollars.
Any company which purchases or sells in a foreign currency, and does not make or receive
immediate payment, is liable to the risk of changes in exchange rates. (There are also the
costs of exchange to meet, but this is a normal business cost, not an increase in risk.)
3.2 Exchange Rate Quotations
A foreign exchange dealer will quote both buying (or bid) rate and a selling (or ask) rate for a
currency. The difference represents the dealer’s profit margin when buying and selling
currencies. For example the American dollar (USD) may be quoted in rand (internationally
referred to as ZAR) as:
Bid ZAR 6.583 Ask ZAR 6.585

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If the dealer buys from an exporter and then sells to an importer, 1 USD million, the exporter
will receive from the dealer ZAR 6 583 000 for his dollars and the importer will pay ZAR 6
585 000 for her dollars. The dealer will therefore make a profit of ZAR 2 000 on the two
transactions.
THINK POINT
Explain how differing inflation rates between two countries affect their exchange rate over
the long term.
3.3 Types of Transactions
There are two basic types of trades in the foreign exchange market: spot trades; and forward
trades.
3.3.1 Spot Trade Rates
A spot trade is an agreement to exchange currency “on the spot” which actually means that
the transaction will be completed or settled within two business days. The exchange rate on a
spot trade is called the spot exchange rate. Implicitly, all the exchange rates and transactions
discussed so far have referred to the spot market. So, if you are quoted a spot rate for Euro of
8.3155 – 8.3205, you could buy at the first price and sell at the second.
3.3.2 Forward Exchange Rates
A forward trade is an agreement to exchange currency at some time in the future. The
exchange rate that will be used is agreed upon today and called the forward exchange rate. A
forward trade will normally be settled sometime in the next 12 months.
Thus, you can buy a US dollar today at R6,583 or you can agree to take delivery of a US
dollar in 180 days and pay R6,725 at that time. Notice that the US dollar is more expensive

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in the forward market (6,725 versus R6, 583). Since the US dollar is more expensive in the
future than it is today, it is said to be selling at a premium relative to the rand. For the same
reason, the rand is said to be selling at a discount relative to the US dollar. We calculate the
six-month forward premium as follows:
Forward – Spot = 6.725 – 6.583

Spot 6.583
= 0.222 or 2.2%
It is worth noting that the premium/discount depends, amongst other things, on the length of
the forward agreement. (Ross, 2001: 705-706)
THINK POINT
Use examples to distinguish between spot exchange rate and forward exchange rate.
Suppose you were expecting to receive a million British pounds in three months, and you
agree to forward trade to exchange your pounds for rands. How many rands will you get in
three months? Is the pound selling at a discount or a premium relative to the rand? Assume
that the spot exchange rate and the 90-day forward rate in terms of rand per pound are ZAR
10.125 = GBP1 and ZAR 10.225 = GBP1, respectively.

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If you expect GBP1 million in 90 days, then you will get GBP1 million at ZAR 10.225/GBP
= ZAR 10.225 million. Since it is more expensive to buy a pound in the forward market than
in the spot market (ZAR 10.225 versus ZAR 10.125), the pound is selling at a premium
relative to the rand (of 1%)
i.e. 10.225 – 10.125
10.125
= 1%
3.4 Forward Exchange Contracts
Such contracts allow importers and exporters to arrange for dealers to sell to them or buy
from them a specified amount of a foreign currency at a given future date at an agreed
exchange rate – that is, the rate is decided upon now, not when the need to deal in the
currency arrives. If the rate of exchange for the dollar strengthens, the firm is protected from
this change. If it should happen to weaken, then the firm is unable to profit from this, but has
swapped this possible profit for the certainty of knowing at what rate it will be able to obtain
the necessary dollar. Naturally, a forward exchange contract will cost money to arrange.
3.4.1 Determination of forward exchange rates
So how are forward exchange rates determined by the dealers? First, we need to know the
spot price of the currency in question, and to this is added or subtracted an interest
differential for the period of the contract, which will obviously be calculated with reference
to the way the exchange rate is expected to move. (The purchasing-power parity theorem
indicates why). It is not an estimate of what the spot rate will turn out to be. This means that
the forward rate may be higher or lower than the present spot rate, i.e. the currency will be
cheaper or more expensive than the spot rate.

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For example, if the US dollar is quoted to the British pound as follows:
 Spot rate 1.4378 – 1.4388
 Three months’ forward rate 1.4580 – 1.4590
Then a company could sell 3 000 dollars for:
Spot rate Forward rate

3 000/1.4388 3 000/1.4590
£2085 £2056
It could buy 3 000 dollars for:
Spot rate Forward rate

3 000/1.4378 3 000/1.4580
£2087 £2058
The dollar is being quoted forward at a higher, cheaper rate compared with the spot rate, or
“at discount”. If the rates quoted were lower, the dollar would be more expensive forward in
terms of the pound sterling, and is therefore quoted “at a premium”.
It may seem strange to talk about a higher figure being at a discount, whereas a lower figure
is at a premium, but if you examine the example carefully you will see that this is true.
In our example, we gave an actual rate for the forward rate. However, it is often not
expressed like this – we have to work it out! The spot rate is given, together with either the
discount or the premium on this spot rate, which we then have to add or subtract accordingly.
The other factor that influences the forward rate should be obvious – the longer the period,
the higher the discount or premium will be.

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A company needs to deal in South African rand, and is currently quoted as follows:
 Spot rate 7.09 – 7.91
 Three months’ forward rate 8.044 – 8.054
What would it cost the company to buy R250 000, and what would it obtain if it sold the
same amount, at the spot rate and at the three months’ forward rate?
Spot Forward
Buy R250 000 $35 260 $31 079
(250 000/7.09) (250 000/8.044)
Sell R250 000 $31 606 $31 040
(250 000/7.91) (250 000/8.054)

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3.5 Leading and Lagging
Companies not wishing to make forward exchange contracts, and preferring to be involved in
the currency market directly, could make payments in advance or try to delay payments
beyond their official date in order to benefit from exchange rate movements. This is
speculating as to what the currency movements will be. These techniques are referred to as
leading and lagging. A lead payment costs the company the interest on the money used to
make the payment.
Example:
Suppose a South African importer owes R500 000, payable in 30 days, to a French supplier.
The company’s financial director is certain that the exchange rate, currently R7,90/ € when
buying, will move adversely. This is because he has noted that the forward rate for 1-month-
buying is quoted at a premium. He therefore advises paying the debt now, at a cost of
500 000/7.90 i.e. € 63 291. This payment could have been delayed for 30 days, and so will
cost € 63 291 x the company’s borrowing rate/12. If he is right, and the rate does strengthen,
it would need to strengthen sufficiently to offset this interest cost if his move is to be
successful.
Consistently lagging payments will not make you popular with your suppliers, just as we
found when looking at creditors’ payments periods in ratio analysis. It also means that you
could miss out on future discounts.
An exporter can try to speculate against adverse currency movements by borrowing an

amount in a foreign currency now, converting this into domestic currency at the present sport
rate, and then repaying the loan with interest out of the foreign currency that will eventually
be received. If, in the meantime, the currency rate has moved against him, he will hope that it
will be by a greater amount than the interest rate he will have to pay on the loan!
An importer could buy currency now at spot rate, lend it until it was needed to pay the
supplier, and use the interest received plus the amount originally invested to pay the supplier
if the rate has moved against the importer. The cost is having to find the sum to buy the
currency now.

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There are obviously costs involved here, but there were costs in forward exchange contracts
as well – getting rid of risk is not costless! The cost differences between the two methods are
not usually great, and reflect the fact that premiums and discounts on forward exchange rates
are based on the different interest-rates applying in the various countries.
THINK POINT
What role does leading and lagging play in the fund raising activities of the finance manager?
3.6 Currency Options
We’ve looked at interest-rate options and forward exchange option contracts. Now the term
occurs again – what are we looking at this time?
A currency option is an agreement for the opportunity to buy/sell an amount of a particular

currency at a given rate of exchange at a stated time in the future. When this time arrives,
there is no obligation to honour the option – it can be abandoned. For this privilege, the
option must be bought.
The reason for wishing to participate in such agreements is again to reduce/eliminate risk in
exchange rate movements, and they are very useful for companies wishing to have price lists
expressed in foreign currencies, or for those tendering for overseas contracts in a foreign
currency. What these companies don’t know is whether they will be receiving any foreign
currency income – the sales have yet to be made, and the tenders to be awarded. Therefore, if
they try to make forward exchange contracts, they will be taking more risks, so they could
buy an option instead.

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We need a little specialised vocabulary to explore this further.
 A call option is an option to buy currency

 A put option is an option to sell currency
 An American option is any option than can be used at any time during the period stated
 A European option can only be used at the end of the period
 An over-the-counter option is tailor-made to the specific needs of a particular company.
 An exchange-traded option, or standard option, can be obtained in some designated
currencies from an option exchange. In the UK we can use the Stock Exchange and
LIFFE (London International Financial Futures Exchange). Other exchanges are in the
US, Canada and Amsterdam.
The price of an option could be:
 The same as the spot rate – at the money

 More favourable than the spot rate – in the money
 Less favourable than the spot rate – out of the money.
What are the drawbacks to currency options? So far, this seems a great idea, because you can
abandon them – so why don’t we all use them?
 Cost! The exact cost will depend on the expected fluctuations in the exchange rate
concerned. This has to be paid now, not when the option date arrives.
 Over-the-counter options, i.e. the ones that have been specially arranged for individual
companies, cannot be negotiated successfully to other companies.
 The traded options are obviously negotiable, but aren’t available in all currencies.
THINK POINT
How can a firm use currency options to hedge foreign currency exposure resulting from
international transacting? Describe the key benefit and key drawback of using currency
options rather than forward contracts.

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3.7 Financing Overseas Subsidiaries
What about companies who expand by buying or setting up overseas subsidiaries? Apart
from the financing problems faced by any business, an extra dimension emerges – should the
subsidiary be funded with home or foreign currency?
The parent company must decide:
 Whether the purchase of the subsidiary will be funded directly from equity or by
borrowing
 Whether the subsidiary should be allowed to expand gradually, or whether any profit
must go straight to the parent
 When more money is required by the subsidiary, should it borrow itself, or should the
parent lend it the money?
 What currencies should be used for this finance?
If the parent has a large investment in the subsidiary, either through shares or long-term
loans, as opposed to letting the subsidiary be financed through external debt-capital and
short-term loans, it is likely that the subsidiary is viewed as a long-term investment. The
parent will already have investigated how best to make money from the subsidiary – and this
will not necessarily be in the form of profits. Some countries limit the amount that can be
withdrawn by means of dividends to another country; in that case, the parent could arrange
that the subsidiary paid a royalty for a process, or a management fee for parent-company
administration, or simply arrange the transfer price if goods or services change hands
between the two companies so that it is advantageous to the group as a whole. Levels and
rules of taxation will also influence these decisions. The parent could also lend money
directly to the subsidiary, and obtain interest on this loan.
A British Company borrows money in a foreign currency, then apart from raising a loan in
sterling and then purchasing foreign currency with it, the parent could use the eurocurrency
markets – a term describing banks and other institutions providing currencies other than their
own. So, for example, our parent company could borrow euro from a French bank or a UK
bank as a Eurocurrency loan. This could be described as a “euro loan”. This is normally for
short-term loans. London is a Eurocurrency lending centre, and besides the possibility of
raising loans from individual banks, there is the possibility of using a syndicate formed to
provide the necessary funds for larger loans.

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Interest rates on the euro loan are not necessarily the same as the domestic interest-rates in
the currency, but are usually similar.
Alternatively, the parent can use the markets for eurobonds and euro-commercial paper – in
other words, raising foreign currency directly from investors rather than borrowing through
banks; they can issue bonds, notes or other commercial paper. Obviously, interest is then
paid directly to many investors rather than to a bank.
Often a bank will act as go-between, finding investors with money to invest.
Issuing a Eurobond through a European capital market will involve raising loans in more than
one country at once, usually for between ten and fifteen years; the eurobonds can be resold.
The bond is often denominated in a currency differing from that of its country of issue.
This method will work for companies of sufficient size and with a good enough credit rating
to attract purchasers.
Its very useful if there are exchange controls to avoid – if a company in one country raises
funds in another, this will not be subject to the exchange controls in its home country, as the
funds will never return and repayment will be made in that other country. There is often a
“queue” of companies wishing to issue domestic debt in the UK, but Eurobond issues can be
made at any time favourable to the company.
Euro-commercial paper is short-term debt which is negotiable, i.e. it can change hands. It is
usually in US dollars. Companies use dealers to issue this paper, maybe worldwide. Any
period of maturity can be arranged, so euro-commercial paper is flexible.
3.8 Exchange Rate Risk
Exchange rate risk is the natural consequence of international operations in a world where
relative currency values move up and down. Managing exchange rate risk is an important
part of international finance. There are 3 different types of exchange rate risk or exposure:
short-run exposure; long-run exposure; and translation exposure.

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3.8.1 Short-Run Exposure
The day-to-day fluctuations in exchange rates create short-run risks for international firms.
Most such firms have contractual agreements to buy and sell goods in the near future at set
prices. When different currencies are involved, such transactions have an extra element of
risk.
3.8.2 Long-Run Exposure
In the long run, the value of foreign operation can fluctuate because of unanticipated changes
in relative economic conditions. For example, imagine that we own a labour-intensive
assembly operation located in another country to take advantage of lower wages. Through
time, unexpected changes in economic conditions can raise the foreign wage levels to the
point where the cost advantage is eliminated or even becomes negative.
Hedging long-run exposure is more difficult than hedging short-term risks. For one thing,
organized forward markets do not exist for such long-term needs. Instead, the primary option
that firms have is to try to match up foreign currency inflows and outflows. The same thing
goes for matching foreign currency-dominated assets and liabilities. For example, a firm that
sells in a foreign country might try to concentrate its raw material purchases and labour
expense in that country. That way, the rand value of its revenues and costs will move up and
down together.
Similarly, a firm can reduce its long-run exchange risk by borrowing in the foreign country.
Fluctuations in the value of the foreign subsidiary’s assets will then be at least partially offset
by changes in the value of the liabilities.
3.8.3 Translation Exposure
When a South African company calculates its accounting net profit and EPS for some period,
it must “translate” everything into rands. This can create some problems for the accountants
when there are significant foreign operations.

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In particular, two issues arise:
1. What is the appropriate exchange rate to use for translating each balance sheet account?
2. How should balance sheet accounting gains and losses from foreign currency translation
be handled?
The current approach to translation gains and losses is based on rules set out in International
Accounting Rules/Standards. For the most part, it is required that all assets and liabilities be
translated from the subsidiary’s currency into the parent’s currency using the exchange rate
that prevails on the balance sheet date. Income statement items are translated at the exchange
rates at the dates of the transactions or at an appropriate weighted average exchange rate for
the period.
Any translation gains and losses that occur are accumulated in a special non-distributable
reserve account within the shareholders equity section of the balance sheet, which is usually
designated as a “foreign currency translation reserve”. As a result, the impact of translation
gains and losses will be recognised explicitly in the income statement until the underlying
assets and liabilities are sold or otherwise liquidated.
3.9 Hedging Exchange Rate Risk
Firms with international operations are subject to exchange rate risk. As exchange rates
fluctuate, the dollar value of their revenues or expenses also fluctuate. It helps to distinguish
two types of exchange rate risk: transaction risk and economic risk.
3.9.1 Transaction Risk
This arises when the firm agrees to pay or receive a known amount of foreign currency. For
example, a US importer of a TV was committed to pay ¥100 million at the end of 12 months.
If the value on the yen appreciates rapidly over this period, it will cost more dollars than the
firm expected.

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3.9.2 Economic Risk
This arises because exchange rate fluctuations can affect the competitive position of the firm.
For example, during 2000 and 2001 the Japanese yen fell in value relative to the US dollar.
As a result Toyota and Nissan were able to compete much more vigorously in the US market.
The Big Three US producers claimed that the changed exchange rate gave the Japanese
producers an unfair advantage and (unsuccessfully) lobbied President Bush to take up their
cause during his visit to Japan. Thus, American producers and their dealers in the United
States were exposed to the fall in value of the yen even though they had no obligation to
make any yen payments. Of course, economic risk can cut both ways. In a year or so it may
be the dollar that is weak and it will then be the turn of the Japanese producers and their
dealers to cry “foul”.
The South African Airways also experienced a huge loss of about R6 billion in 2003/4 as a
result of some hedging that went badly wrong. During September 2002 the rand/dollar
exchange reached a high of about R12/$1. SAA took a ruinously high bet that the rand would
continue getting weaker, instead, it got stronger and in July 2004, the exchange rate touched
R6/$1. Hence, if more attention had been paid to the improvements in macro-economic
fundamentals, SAA would not have been blinded to the possibility that the rand might not
recover.
(4) POLITICAL RISK
One final element of risk in international investing concerns political risk. Political risk
refers to changes in value that arise as a consequence of political actions. This is not purely a
problem faced by international firms. For example, changes in South African tax laws and
regulations may benefit some South African firms and hurt others, so political risks exist
nationally as well as internationally.
Some countries do have more political risk than others, however. In such cases, the extra
political risk may lead firms to require higher returns on overseas investments to compensate
for the risk that funds will be blocked, critical operations interrupted and contracts abrogated.
In the most extreme case, the possibility of outright confiscation may be a concern in
countries with relatively unstable political environments.

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Political risk also depends on the nature of the business; some businesses are less likely to be
confiscated because they are not particularly valuable in the hands of a different owner. An
assembly operation supplying sub-components that only the parent company uses would not
be an attractive “takeover” target, for example. Similarly, a manufacturing operation that
requires the use of specialised components from the parent is of little value without the parent
company’s cooperation.
Natural resource developments, such as copper mining or oil drilling, are just the opposite.
Once the operation is in place, much of the value is in the commodity. The political risk for
such investments is much higher for this reason. Also, the issue of exploitation is more
pronounced with such investments again, increasing the political risk.
Political risk can be hedged in several ways, particularly when confiscation or nationalisation
is a concern. The use of local financing, perhaps from the government of the foreign country
in question, reduces the possible loss because the company can refuse to pay on the debt in
the event of the unfavourable political activities. Based on our discussion above, structuring
the operation such that it requires significant parent company involvement to function is
another way to reduce political risk.
THINK POINT
Why do some countries have more political risk than others?

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(5) INFLATION
Capital projects are generally long term investments and inflation is likely to occur during the
project life. It is possible that the impact of inflation will cancel out any gains and that the
required rate of return will also shift with inflation.
Interest rates in South Africa, where inflation has been significant for a number of decades,
were historically much higher than in the major economies of the world. Nominal rates must
therefore include an adjustment for expected inflation.
(6) SUNK COST
A sunk cost is a cost that has already been incurred and cannot be removed and therefore
should not be considered on investment decision i.e. to accept or reject a project.
Suppose the South African Maize Board is considering building a new maize silo to store
their maize. Should a portion of the Maize Board’s existing overhead costs be allocated to
the proposed new silo? If the overhead costs are truly sunk and independent of the new
project, the answer is NO. But if the new silo requires additional maintenance, supervision or
cleaning, these overheads should be part of the project analysis.
Let’s take another example, suppose the Airport Company of South Africa hires a consultant
to evaluate a feasibility study to build a new international terminal in Kwa-Zulu Natal. The
consulting fee is a sunk cost, because the consulting fee must be paid whether or not a
decision is taken to undertake the project. (Brealey, 2004: 215)
(7) GOVERNMENT INTERVENTION
Governments offer incentives to promote certain types of capital investments and include
grants, investment tax credits and subsidised loans. Since these change a project’s cash flow,
they must be factored into capital budgeting analysis.

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(8) A COMPREHENSIVE EXAMPLE FOR EVALUATING FOREIGN INVESTMENT
This is an example of evaluating a foreign investment projects, taking into consideration all
aspects discussed above:
Skylink Industries is a South African based manufacturer of “Solasheet”, an award-winning

skylight. The company is currently investigating two investment projects. The information is
given below:
Project 1
Involves extending the company’s production facility at New Germany, Kwa-Zulu Natal.
The plant will cost R32 million and is expected to create an additional annual profit of R2.26
million for the 8 years life of the project.
The following expenses were included in the annual profit:
 Depreciation was calculated on the straight-line method, over the life of project.
 Share of existing overheads, borne by head office amounting t
 o R0,3 million p.a.
Project 2
Involves setting up an independent manufacturing facility in Taiwan. The cost of the facility
would be an initial outlay 105.40 million Taiwan dollars. This would result in annual sales of
44.8 million Taiwan dollars, for the 8 years of the project. The annual fixed costs and
variable costs are 4.3 million and 10.6 million Taiwan dollars respectively.
Note:
1. Skylink Industries current cost of capital is 12%.
2. The Taiwanese inflation is expected to exceed the South African inflation by 2% p.a.
throughout the life of the project.
3. The current spot rate exchange is 3.7 Taiwan dollars to the Rand.
Required:
Compute the necessary calculations and advise Skylink Industries if it is worth investing in
neither, in one or both of these two opportunities.

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EXPECTED SOLUTION
PROJECT 1 Rand Rand

(m) (m)
Cost of plant (32.0)
Annual profits 2.26
Add back depreciation 4.00
existing overheads 0.30
Cash flows 6.56 (32.0)
Annuity factor @ 12% for 8 years 4.9676 32.59
NPV 0.59
R590 000
PROJECT 2 Taiwan Dollar Taiwan Dollar

(m) (m)
Cost of capital = 12 + 2 = 14%
Outlay (105.40)
Annual Sales 44.8
Annual Fixed Cost (4.3)
Variable cost (10.6)
Cash Flows 29.9 (105.40)
NPV 33.3
Exchange rate 3.7 Taiwan dollars to the Rand

33.3m ÷ 3.7 = R9 000 000
Both Projects can be accepted, as both have positive NPV’s
However, Project 2 has an NPV, which exceeds Project 1 by almost R8.4 million.
Therefore accept Project 2.

Managerial Finance
Power Tools is a South African based manufacturer of hand-held tools. The company is
seeking to expand its operations, and it has the opportunity to acquire a Mauritian company,
Belle Mare Ltd., or set up a new division in its home market.
Money symbol : R South African Rand

Rs Mauritian Rupee
The relevant figures for these two options are:
Acquisition Rs
Redundancy costs 8 500 000
Cost of licence 900 000
Annual sales 9 800 000
Consultants fees 3 400 000
Annual variable costs 5 500 000
Annual fixed costs 700 000
Set up division R
Cost of land and buildings 9 000 000
Cost of machinery 7 400 000
Annual sales 8 500 000
Annual variable costs 4 300 000
Annual fixed costs 2 400 000
Share of existing head office expenses 1 800 000
Additional information:
 Power tools, current cost of capital is 11%
 The project is expected to last for 10 years
 The Mauritian inflation is expected to be above South African inflation by 1% per year,
throughout the life of these investments
 The current spot exchange rate is Rs 3.4 to the R.
Required:
5.1 Make the necessary calculations for the two options
5.2 Advise Power Tools, if it is worth investing in neither, in one or in both of these two
opportunities

Managerial Finance
5.1 Cost of capital = 11 + 1 = 12%
ACQUISITION Rs Rs
(m) (m)
Redundancy costs (8.5)
Cost of licence (0.9)
Annual Sales 9.8
Annual variable costs (5.5)
Annual fixed costs (0.70
Cash flows 3.6 (9.4)
NPV Rs10.94
Exchange rate = Rs 3.4 to the R
= 10.94m ÷ 3.4 = R3 217 647
SET UP DIVISION R R
(m) (m)
Cost of land and buildings (9.0)
Cost of machinery (7.4)
Annual Sales 8.5
Annual variable costs (4.3)
Annual Fixed Cost (2.4)
Cash Flows 1.8 (16.4)
NPV R(5.8)
5.2 The acquisition has a positive NPV, whereas the set up at home is negative.
Therefore it is not worth setting up the division at home.
Power Tools should therefore acquire Belle Mare Ltd.

Managerial Finance
(9) CONCLUSION
The growing interdependence of world markets has increased the importance of international
finance in managing the multinational company (MNC). International factors related to
ownership, capital markets, accounting, and foreign exchange risk create both challenges and
opportunities for the international financial manager. The MNC may have obligations,
operations, customers, suppliers, employees, creditors, and owners in more than one country.
As a result, the financial manager must deal with international issues related to taxes,
financial markets, accounting and profit measurement and repatriation, exchange rate risks
caused by doing business in more than one currency, political risks, inflation, sunk cost,
government intervention, financing (both debt and equity) and, cash management issues
related to hedging and adjustments in operations.
The complexity of each of these issues is significantly greater for the multinational firm than
for a purely domestic firm. Just as in a purely domestic firm, action should be undertaken
only after the financial manager has determined that it will contribute to the parent
company’s overall goal of maximising the owners’ wealth as reflected in its share price.

Managerial Finance
SECTION 9
WORKING CAPITAL MANAGEMENT

Managerial Finance
LEARNING OUTCOMES
 Calculate the length of the operating cycle and the length of the cash cycle
 Describe the different working capital policies and their impact on risk and return
 Explain cash management and credit management
 Outline how to factor the bad debts of a firm
 Explain accounts payable management and inventory management.
 Determine the economic order quantity for inventory management
 Display knowledge of other inventory management techniques

Managerial Finance
(1) INTRODUCTION
The day-to-day complexities of working capital management consume large amounts of

management time, involving more frequent decision-making. Furthermore, poor working
capital management can lead to the cessation of trading, whilst poor long-term investment
and financing decision-making may only have a temporary adverse effect on the value of the
firm. It is working capital management that enables a firm to function on a daily basis.
Working capital management, also known as short-term financial management, involves

management of the firm’s current assets and current liabilities. Current assets are those assets
which can be converted to cash within a year, for example: Cash, Marketable Securities,
Accounts receivable (debtors) and Inventory (stock). Current liabilities are short-term
obligations payable within one year, for example: Accounts payable (creditors), Accrued
Wages and Taxes. Net Working Capital refers to the difference between Current Assets and
Current Liabilities. It is that portion of a firm’s current assets generally financed with long-
term funds, the other portion having been financed with current liabilities.
The decision to invest in working capital items such as cash, debtors and stock, leads to a
conflicting situation: these investments tie up valuable capital at a generally low (or zero) rate
of return, yet a shortage in any of these items can threaten the continued existence of the firm.
Effective working capital management therefore involves deciding on the optimal investment
in current assets and liabilities, so-as-to minimise this conflict.
(2) THE WORKING CAPITAL CYCLE
Working capital management can be further analysed by examining the Working Capital or
Operating Cycle, and the Cash Cycle of a firm. Let us imagine a typical manufacturing firm:
raw materials are procured on credit (creating an accounts payable); the raw materials are
transformed into an end-product by the manufacturing process; at some stage the raw
materials are paid for; the end-product is sold to the customer on credit (creating an accounts
receivable); and finally the customer pays for the end-product. This process can be illustrated
by the following figure.

Managerial Finance
OPERATING/ WORKING
CAPITAL CYCLE
PURCHASE OF SALE OF PAYMENT RECEIVED

INVENTORY PRODUCT FROM CUSTOMER
INVENTORY PERIOD ACCOUNTS RECEIVABLE PERIOD
TIME
ACCOUNTS
PAYABLE PERIOD CASH CYCLE
Inventory
Paid for
Figure 1
The Operating Cycle begins when inventory is purchased, and ends with the collection of
payment from the customer. It is the sum of the Inventory Period, which begins with the
procurement of inventory and ends with the sale of the end-product, and the Accounts
receivable period which begins with the sale of the end-product and ends with the receipt of
payment from the customer. Closely linked is the Cash Cycle, which begins when inventory
is paid for and ends when the customer pays. The difference between the operating cycle and
cash cycle is the Accounts Payable Period, which starts when the inventory is procured and
ends when the inventory is paid for. The need for working capital management is indicated
by the time lag between cash outflows and cash inflows. (Ilkova, 2001: 36)

Managerial Finance
Assume the following financial statement information:
ITEM AMOUNT ®
Inventory 30 000
Receivables (debtors) 21 270
Payables (creditors) 14 850
Cost of Sales 146 000
Credit Sales 390 000
Credit Purchases 175 000
2.1 Calculating the Operating Cycle
 Calculate the Inventory period:

Inventory x 365 days = 30 000 x 365 days = 75 days
Cost of sales 146 000
 Calculate the Accounts Receivable period:

Receivables x 365 days = 21 270 x 365 days = 20 days
Credit Sales 390 000
 Operating Cycle
Inventory Period + Accounts Receivable Period
75 + 20 = 95 days
2.2 Calculating the Cash Cycle

 Calculate the Payables Period:
Payables x 365 days = 14 850 x 365 days = 31 days

Credit purchases 175 000
 Cash Cycle
Operating cycle - Payables Period
95 - 31 = 64 days

Managerial Finance
Note: Average inventory receivable and payable figures should be used in the above
calculations (given consecutive Balance Sheet figures, add the opening and closing figures
and divide by two). The reason for this is that the Balance Sheet represents a “snap-shot” of
the firm’s financial position at a specific point in time, hence the Balance Sheet figures per se
are not necessarily a true reflection of the usual level of current assets and liabilities.
On average, during the period in question, this firm’s inventory stays on the premises for 75
days, the firm collects on sales in 20 days, and pays it bills after 31 days. 95 days lapse from
the time that inventory is purchased until payment is received from the customer, and 64 days
pass between the time that inventory is paid for, and payment is received from the customer.
Firms differ with respect to “norms” for the particular market in which they operate. Most
important is the trend in these figures over time, given the nature of the business.
Most firms require a positive operating and cash cycle, as they are unlikely to purchase
inventory, manufacture the end-product, pay for the inventory, sell the product and receive
cash for the product, all within a single day! Thus, most firms require finance for their
inventories and receivables. The longer the operating and cash cycles, the more financing is
required, hence the importance of monitoring both these cycles. A lengthening in either cycle
may indicate slow-moving stock or collection inefficiencies. Such problems can be hidden
by an increased payables period, so the payables period also requires close attention.
Management’s goal should be to shorten the operating cycle as far as possible without
compromising efficiency. Examples of measures that can be taken to ensure a shorter cycle
would be; reducing the manufacturing and selling period (without compromising product
quality); reducing the accounts receivable period (without antagonising customers); and
lengthening the accounts payable period (without losing suppliers and getting a poor credit
rating).
THINK POINT
What is the difference between the operating cycle and the cash cycle?

Managerial Finance
Assume the following financial statement information:
ITEM AMOUNT (R000’s)

Inventory 350
Receivables (debtors) 280
Payables (creditors) 230
Cost of Sales 480
Credit Sales 700
Credit Purchases 520
1.1 Calculate the operating cycle.
1.2 Calculate the cash cycle.
1.1 Calculating the operating cycle:
Inventory period:
Inventory x 365 days = 350 x 365 days = 266 days

Cost of sales 480
Debtors period:
Debtors x 365 days = 280 x 365 days = 146 days

Credit sales 700

Managerial Finance
Operating cycle:
= Inventory period + Debtors period

= 266 + 146
= 412 days
1.2 Calculating the Cash Cycle
Creditors period:
Creditors x 365 days = 230 x 365 days = 161 days

Credit purchases 520
Cash Cycle:
= operating cycle - creditors period

= 412 days – 161 days
= 251 days

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(3) WORKING CAPITAL FINANCING POLICIES
Forecasted sales levels have a major impact on the required level of working capital. As
sales increase, so too will purchases and inventory, creditors, cash and debtors. In a sales
growth situation, an increasing portion of the firm’s current assets will become permanent
(remain constant throughout the year), along with the firm’s fixed assets. Seasonal needs,
however, are those current levels that fluctuate throughout the year. The firm’s working
capital policy will be defined by the manner in which it finances its permanent and seasonal
current asset requirements, through a mix of long- and short-term finance. There are 3 basic
approaches in this regard, each with a different risk and return impact on the firm:
3.1 The Conservative Approach
Long-term finance will generally be used to finance both permanent and a proportion of
seasonal current assets. Little use is made of short term finance such as trade creditors.
There will be a relatively low investment in current assets such as debtors and inventory,
which can lead to stockouts and the loss of customers to firms who offer more attractive
credit terms. Long-term finance is also less easily raised, with more stringent repayment
terms than short-term finance.
Short - Term Financing
Rand
Seasonal current asset
requirement
Permanent Current Assets

Long-term financing
Non - current Assets
Time
Figure 2
(Ilkova, 2001: 38)

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3.2 The Aggressive Approach
Short-term credit will be used to finance all seasonal, and some permanent, current asset
needs. Investment in current assets is generally high, with a resultant heavy reliance on trade
creditors. This can lead to opportunity costs involved in high inventory levels, bad debts due
to large debtor book, and penalties for late payment or the withdrawal of credit facilities, by
creditors. Short-term debt interest rates are generally lower than long-term rates, short-term
funding is often easier to negotiate, and repayment terms are more flexible. On the other
hand, short-term funding is considered more risky as overdrafts are repayable on demand and
interest rates can fluctuate widely.

Rand requirement
Short-term financing

Long-term financing
Non - Current Assets
Time
(Ilkova, 2001: 39) Figure 3
3.3 The Moderate Approach
This is where the firm attempts to match the maturity of the funding with the lifespan of the
asset being financed. Non-current assets and permanent current assets will be financed by
long-term finance, and fluctuating seasonal current asset needs will be financed through
short-term funding. This minimises the risk of not being able to meet maturing obligations.
This makes sense as a firm can hardly be expected to pay off a machine with a useful life of 5
years, after one year only. The optimal policy lies somewhere in between the conservative
and aggressive approaches. Management should attempt to reduce the level of current assets
as long as the returns from this action are greater than the expected losses that could result
from a low investment in current assets. i.e. strike a balance between risk and return. (Ilkova,
2001: 38-39)

Managerial Finance
Short-term financing
Rand

requirement

Long-term financing
Non - Current Assets
Time
(Ilkova, 2001: 39) Figure 4
THINK POINT
Compare and contrast the effects that the different working capital financing policies have on
a firm’s profitability and risk.
(4) THE MANAGEMENT OF WORKING CAPITAL COMPONENTS
4.1 Cash Management
Cash and marketable securities are the most liquid working capital items, but also the most
unproductive for a firm. Cash on hand earns no income at all whilst marketable securities
such as treasury bills, negotiable certificates of deposit, and banker’s acceptances earn
relatively low interest.

Managerial Finance
Reasons for holding cash or near-cash
 The transaction motive: to meet ordinary day-to-day payments, such as wages and
payment to suppliers
 The precautionary motive: reserves to cover unforeseen events, such as machinery
malfunction
 The speculative motive: to take advantage of any unexpected discounts or bargain
prices.
 Loan covenants imposed by lenders, such as minimum cash balances in an account, or
a required level of liquidity as a pre-requisite for a loan.
These sound reasons for holding cash must be weighed up against the costs involved in
maintaining cash or near-cash balances. These costs would include an opportunity cost of
foregoing other more lucrative investments, or the cost of short-term funding required due to
the fact that cash/near-cash is being utilised for the reasons stated above and not available to
close the gap between cash inflows and outflows.
We saw from the operating and cash cycle diagram that a firm can minimise its financing
requirements by speeding up collections and by slowing down payments to creditors. There
are certain specific methods that can be used in this regard, from a cash management point of
view. These include using electronic payments to effect payment to suppliers on the very last
due date, and requesting customers to settle their accounts in the same way. This is to avoid
postal delay of cheques and the processing delay both at the firm’s premises and the bank.
4.1.1 The Cash Budget
This is a primary tool in short-term financial planning and the starting point of cash
management decisions. It is the forecast of cash receipts and cash payments for the next
planning period. It provides an estimate of the timing and size of expected cash inflows and
outflows, and the resultant cash surplus or deficit. More companies are liquidated because
they run out of cash than due to poor cash management. The cash budget enables a firm to
make timeous arrangements with creditors or investment institutions when a cash deficit is
forecast and with investment advisors to invest any forecasted surplus cash. If a continuous
deficit is forecast, the firm might address its cash flow problem through extending creditor

Managerial Finance
payments or speeding up collections. The cash budget will enable the firm to maintain
optimal levels of cash i.e. by maintaining a balance between cash shortages and cash
surpluses. Financial institutions abhor surprises, hence the firm’s bankers need to be
provided with a continuously updated cash budget at all times. Cash budgets can be prepared
on a daily, weekly, monthly, quarterly, bi-annual or annual basis. Budgeted figures need to
be compared with actual figures on an ongoing basis, and updated and adjusted as new
information comes to light and as time passes.
4.1.2 Sources of Short-term Funding
The following can be used to finance temporary shortfalls:
 Bank Overdraft: a short-term bank loan with a pre-arranged upper limit.

 Letters of credit: used for international transactions, whereby the issuing bank
guarantees payment to a third party, provided the foreign goods arrive as prearranged.
 Secured Loans: loans secured by items such as book debts, a lien over stock, or
personal guarantees (all considered second class forms of security).
 Trade Credit: repayment terms given by a firm’s suppliers e.g. 30 days to pay for raw
materials.
 Acceptance credits: for larger companies to finance large trade transactions using bills
of exchange e.g. bankers’ acceptances. (Ilkova, 2001: 40)
 Factoring: an advance of funds against a firm’s book debts. The factoring of debts is
another method of providing extra short-term finance. There are several different
ranges of services that a factoring firm may provide.
;’
THINK POINT
Why is short term financing management one of the most important and time consuming
activities of the financial manager?

Managerial Finance
It can arrange to send out invoices, collect debts and look after credit control. This leaves the
client company to concentrate on its own business, and removing the administrative costs of
maintaining the sales ledger, particularly where turnover is rising fast. Because the factoring
company is concentrating on credit control and debt collection, it will itself obtain economies
of scale, and thus the fee charged to its clients will probably be within the region of 0.75 to
2%, depending on the nature of the client and its customers.
Factors may not be interested in the following:
 Companies with relatively low turnover – a turnover of less than R250 000 is usually
insufficient to attract factors, so this is probably not a source of short-term finance
available to very small businesses
 Newly-established companies
 Those with a recent history of bad debts
 Companies in high risk markets
 Those selling small items by mail order.
Factors can also underwrite debts on behalf of clients. This takes the risk of bad debts away
from companies. Because factors are specialists, they will have adequate information to
assess the risks of giving credit to customers in the first place. They can then monitor
customer’s accounts, and take appropriate action if need be.
It is also possible to arrange for factors to advance money to companies before collecting
debts from customers. This will be particularly useful where turnover, and therefore debtors,
are rising rapidly. It will be equally useful where long credit periods are customary. Usually
a maximum of 80% of the invoice values can be advanced to finance the extra inventory and
debtors required for expansion; the clients pay commission and interest to the factors. The
balance of the debt will be paid to the company after the customers have settled their debts.
Many factors will also agree to purchase specific invoices for a cash advance, naturally at a
discount. In such a case, the company is still responsible for collecting the debts, and for the
administration of sales ledger. This could help to provide finance for a temporary cash
shortage. From the factor’s point of view, this is a risky process, and so will usually only be
entered into with well-established and reliable firms.

Managerial Finance
Example:
Thembi Limited is considering factoring its accounts. It sells on credit only and its collection
period is not more than 60 days. The firm has been experiencing severe cash flow problems
lately and is advised to consider factoring its debtors. An institution is prepared to offer our
company the following factoring terms:
50% on each invoice will be paid immediately and interest will be charged at 2% above the
current prime rate of 15,5%. Service fee will be charged at 2% of total sales. Suppliers offer
the firm a discount at 2% for cash settlement. Sales subject to discount amount to 50% of its
total sales. If the firm were to factor it is believed that it will save the firm approximately R40
000 in expenses. Its total sales are R6 million.
Required:
1. Calculate the effective cost of factoring

2. Is this form of financing effective in this case? Explain?

Managerial Finance
Solution
1. Total sales per annum = R6m

Average collection period = 60 days
Therefore average on hand = 6 000 000 x 60/365
= R986 301
% that can be drawn/ paid immediately = 50%

= 986 301 x 50/100
= R493 151
Interest = 15.5 + 2% = 17.5%
Finance charges 493 151 x 17.5% = 86 301

Service fees R6m x 2% = 120 000
Actual cost of factoring = R206 301
Cash discount for early settlement = 6 000 000 x 50 x 2

100 100
= 60 000
Expenses saved = + 40 000
= R100 000
Therefore net cost of factoring = 206 301 – 100 000

= R106 301
The effective cost of factoring = 106 301 x 100 = 21.55

493 151 1
= 21.6%
2. No, the effective cost of factoring, when taking the anticipated savings into account, is
higher than the straight interest rate charge of 17.5%.

Managerial Finance
THINK POINT
What are the basic features of factoring?
Phiri Limited is considering factoring its accounts. It sells on credit only and its collection
period is not more than 60 days. The firm has been experiencing severe cash flow problems
lately and is advised to consider factoring its debtors. An institution is prepared to offer the
following factoring terms:
75% on each invoice will be paid immediately and interest will be charged at 1% above the
current prime rate of 18.5%. Service fee will be charged at 1.5% of total sales. Suppliers
offer the firm a discount at 2% for cash settlement. Sales subject to discount amount to 40%
of its total sales. If the firm were to factor it is believed that it will save the firm
approximately R35 000 in expenses. Its total sales per annum are R4 million.
Instructions:
2.1 Calculate the effective cost of factoring

2.2 Is this form of financing effective in this case? Explain?

Managerial Finance
2.1 Total sales per annum = R4 million

Average collection period = 60 days
Therefore average on hand = 4 000 000 x 60/365
= R657 534
Amount that can be drawn = R657 534 x 75/100

= R493 150
Interest = 18.5 + 1% = 19.5%
Finance charges 493 150 x 19.5% = 96 164

Service fees R4m x 1.5% = 60 000
Actual cost of factoring = R156 164
Cash discount for early settlement = 4 000 000 x 40 x 2

100 100
= R32 000
Expense saved = R35 000
= R67 000
Therefore net cost of factoring = 156 164 – 67 000

= R89 164
The effective cost of factoring = 89 164 x 100 = 18.1%

493 150 1
2.2 The effective cost of factoring is lower than the straight interest rate charged.
Therefore, the factoring is approved.

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4.2 Credit Management or (Debtors or Receivable Management)
Most firms would prefer to make sales on a cash-only basis, but competition in the market
has pressurised firms into offering credit facilities. Through extending credit a firm can
achieve higher sales, but there are costs involved i.e. the administrative costs of managing
debtors, the financing costs of debtors and the potential cost of bad debts. These costs need
to be weighed up against the possible loss of sales should terms not be granted. Sometimes it
is more cost-effective for a firm to pay independent debt collectors, or a factoring
organisation to perform one or more aspects of the credit function, thereby avoiding the costs
of running a full-blown credit and collections department.
When credit is granted, an accounts receivable is created. Exactly how much money the firm
has tied up in accounts receivable depends upon:
 The amount of credit sales

 The average collection period
Then accounts receivable = average daily credit sales x average collection period. For
example, if a firm sells on average R3 000 per day on credit, and takes an average 30 days to
collect on these sales, then at any given time there will be R3 000 x 30 = R90 000 worth of
sales outstanding. Just by collecting 1 day faster, the firm could free up R3 000 for use
elsewhere, or save having to finance that R3 000. In effect, by extending credit, a firm is
lending money on an interest-free basis to its customers.
4.2.1 The Firm’s Credit Policy
Should a firm decide to grant credit to its customers, then, it has to formulate a credit policy.
This credit policy would comprise three main components:
 The terms of sale: how the firm intends to sell its goods and services.
 Credit analysis: procedures to distinguish between those who will or will not pay.
 Collection Policy: how to collect cash when it falls due.

Managerial Finance
4.2.2 The Terms of Sale
Terms of “net 30” means customers must pay within 30 days of statement date. Settlement
discounts may be offered by a firm to encourage early payment. These will be indicated, for
example as “3/15, net 30”, which means customers will receive a 3% discount on the
invoiced amount if they pay within 15 days, otherwise the full amount within 30 days.
The credit period is the length of time for which credit is granted. It has two components:
The net credit period (30 days in the above examples), and the cash discount period (15 days
in the above example). Penalty interest is usually charged on all payments made beyond the
credit period.
A change from “net 30”, to “3/15, net 30” would attract customers who consider discounts to
be a form of price reduction, and cause a reduction in the accounts receivable period which
will free up cash for other uses (shorten the working capital cycle).
Let us take a look at the cost of not taking advantage of a discount on offer. Assume terms
2/10 net 30, and an order of R500. The customer can pay R490 within 10 days (98% of the
order amount), or pay R500 after a further 20 days. In the latter case, the customer will
effectively be “borrowing” R490 for a 20 day period, and paying R10 “interest” on this
“loan”. The cost of this “loan” will be 10/490 = 2.0408% for a 20-day period, or 0.020408 x
365/20 = 37.24% as an annual percentage rate! This means that the cost of ignoring the
seemingly low discount of 2%, is 37.24%! The customer would even benefit by borrowing
the R490 at the prevailing cheaper interest rates. On the other hand, it would definitely be in
the firm’s interest for customers to ignore discounts offered.

Managerial Finance
Suppose Marworld Traders who supplies to Wing Limited, have recently offered their
customers an incentive to pay promptly. All companies settling their invoices within 15 days
of the invoice date are offered 2.5% cash discount on the invoice price. Normally, customers
are expected to settle their invoices within 60 days. Wing has just received an invoice for R7
500 and has the cash available to settle the invoice promptly, if this would be beneficial. The
current short-term deposit interest is 14% p.a.
Advise Wing Limited as to what they should do.
R 7500 x 2.5
Cash discount =
100
= R187.50
Investment Amount = R7500 – 187.50 = R7 312.50

Period = 60 days – 15 days = 45 days
Therefore Interest = R7 312.50 x 45 x 14
365 100
= R126.22
It would therefore be worth paying promptly if funds are readily available, and if the
company is unlikely to have an immediate need for them.

Managerial Finance
4.2.3 Credit Analysis
If credit is refused, the customer may shop elsewhere. If credit is granted, there is always the
risk of non-payment, hence the importance of gathering credit information on a customer, and
evaluating their creditworthiness. The most important sources of credit information are:
 The customers’ financial statements (ratio analysis).

 Credit reports on the customers, based upon their payment record with other firms
(Credit Bureau checks).
 Bank reports: banks may provide information regarding another party’s
creditworthiness.
 Customers’ payments history with your firm (most obvious source)
The traditional approach to evaluate the creditworthiness of a potential customer, uses the so-
called 7 C’s namely:
1. Capital: the financial strength of the customer. Data can be obtained from the
customer’s annual financial statements. The customer’s liquidity and solvency ratios
would be particularly pertinent.
2. Collateral: the security available from the customer in the event of non-payment. The
debt of secured creditors will always be settled first, hence the importance of this issue.
3. Character: the willingness of the customer to repay, as indicated by his credit track-
record.
4. Capacity: the ability of the customer to repay by due date, as evidenced by profit
history, cash budgets and management and operational efficiency.
5. Conditions: the relevant political and economic conditions relating to the customer’s
particular line of business or industry in which they operate.
6. Credit history: the applicant’s history of making payment.
7. Common sense: the sound judgement of the person analysing the credit data. (Ilkova,
2001: 43-44)

Managerial Finance
4.2.4 Collection Policy
The final element of a credit policy involves monitoring receivables to highlight problem
areas, and laying down procedures to obtain payment on overdue accounts. In monitoring
receivables, the average collection period needs to be monitored over time. Unexpected
increases in the average collection period (0ver and above seasonal fluctuations), would be
cause for concern. Customers may be taking longer to pay generally, some accounts may be
seriously overdue, and the collection process may be experiencing inefficiencies for various
internal reasons. The underlying reasons need to be identified and attended to. Many firms
prepare a debtors age-analysis, which is a compilation of accounts receivable by the age of
each account, for example:
AGE OF ACCOUNT AMOUNT ® % OF TOTAL DEBTORS

0-20 days 200 000 50
21-30 days 140 000 35
31-60 days 40 000 10
over 60 days 20 000 5
Total 400 000 100
If the credit terms were net 30 days, then 15% of accounts are overdue, 5% of which are
likely to be irrecoverable. The aim of the firm would be to monitor the 15% closely, and
manage this percentage downwards.
A common procedure to attempt to collect on overdue accounts is as follows:
 Telephone the customer: be confident, firm, polite, prepared with the facts and speak to
the right person. Keep a record of all calls.
 Send a delinquency letter.
 Send a second, more strongly-worded letter, by registered post
 Call the customer’s top management, who may be unaware of inefficiencies in their
accounts department.
 Notify the customer that their purchasing status has been amended to cash-on delivery,
until all outstanding amounts have been settled.
 For large amounts, institute legal proceedings (costly option) and for smaller amounts
employ a collection agency (cheaper option)

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THINK POINT
How do firms decide whether it makes sense to grant credit to a customer?
4.3 Inventory Management
Inventory is the least liquid of all current assets, and consequently requires careful
management. Like receivables, inventory represents a sizeable investment for most firms.
Inventory levels depend heavily upon sales and sales forecasts. The credit policy and
inventory policy of a firm are closely linked. If the firm relaxes its credit policy to stimulate
sales, there will have to be a coordinated effort to increase inventory levels to accommodate
the expected sales increase.
Excessive stocks erode profit margins as they reduce asset-use efficiency, and involve high
carrying costs. These costs include the opportunity cost of capital tied up in stock, warehouse
space rental, insurance, theft, obsolescence and shrinkage. On the other hand, a stock
shortage could lead to a disruption in production and an inability to meet demand, which in
turn would lead to lost sales and customer goodwill. Again, it is the costs of carrying too
much stock, which must be weighed up against the costs of a stockout.
There are 3 categories of inventory:
 Raw materials
 Work-in-progress (unfinished product)
 Finished goods (Ross, 2001: 586-587)
4.3.1 The Economic Order Quantity (EOQ) Model
The underlying formula of this model is based on the notion that frequent, smaller orders
drive up the ordering costs. Less frequent, larger orders drive up the costs of holding stock.
The model serves to establish the optimal inventory level and re-order frequency, which

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exists where the total carrying and shortage costs of inventory are minimised. It is at this
same point where carrying costs equal shortage costs. It is based on the assumption that a
firm’s inventory is sold off at a steady rate, until zero stock remains. At this stage, the firm
will restock back to an optimal level of inventory. This assumption is not altogether realistic
due to the fact that very few firms will allow stock levels to reach zero before reordering.
This basic model can however be adapted to accommodate a reorder point, based upon a
safety (or “buffer”) stock level and time for delivery. We will confine our discussion to the
basic EOQ model.
The economic order quantity (EOQ) equation is as follows:
Where,
T = total unit sales
2TF F = fixed cost per order
EOQ = CC = carrying cost per unit
CC
Example
Exotic Timbers uses 4 000 cubes of timber per week, and then re-orders another 4 000.
If the carrying cost per cube is R20 and the fixed cost is R1 000, is Exotic’s inventory
policy optimal?
Is the inventory policy optimal?
What would be the optimal order quantity and frequencies?

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Solution
In the case of Exotic Timbers, the optimal inventory policy is where the total carrying
cost and ordering costs are at a minimum, i.e. where carrying cost = ordering cost.
Carrying cost = Average stock x carrying cost per unit

= R4 000/2 x R20
= R40 000
Ordering cost = Number of order per annum x fixed order cost

= 52 x 1000
= R52 000
The inventory policy is not optimal as the above cost is not equal. The order quantity
is too low (order costs are higher than carrying costs). Using the EOQ formula, the
optimal order quantity is:
2(52 )( 4000 )(1000 )

EOQ =
20
416000000
=
20
= 20800000
= 4 561 cubes
4000 x52
No. of orders per annum = = 46 times
4561

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4.3.2 ABC Inventory Management
The basic idea is to divide all inventory items into 3 or more groups, in terms of their
inventory value, order lead time, shortage consequences and managerial effort.
 The A group would comprise all high value inventories. The idea would be to keep
stocks of these items down to a minimum. To do this, these items must be strictly
monitored and tightly controlled. Precision ordering is important.
 B group items would be of medium value, therefore requiring average-scale monitoring
and control.
 C group inventory comprise basic, inexpensive items. These items will be ordered in
large quantities to ensure continuity of supply. Monitoring and control is of least
importance here.
The ABC approach can be represented graphically as follows:
100
VALUE OF
INVENTORY (%)
50
GROUP A
GROUP B
57% GROUP C
27%
16%
0
10%
40%
50%
INVENTORY
HOLDING (%) 50
FIGURE 5
100
(Ross, 2001: 588)

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4.3.3 Just-In-Time (JIT) Inventory Management
The goal of JIT is to minimise dependent inventories, thereby maximising turnover. The idea
is to have only sufficient inventory on hand to meet immediate production needs. Inventory
is therefore reordered frequently. This method requires a high degree of co-operation from a
pool of reliable suppliers. These suppliers must be able to meet the firm’s needs at little or
zero notice. The JIT philosophy is to manufacture goods only when they have been
specifically ordered by the customer. These purchases are only made for a particular order.
Hence, no stock problems arise, stock levels are not an issue.
(Ross, 2001: 595)
THINK POINT
Why is an understanding of inventory management useful for cash management?
4.4 Accounts Payable Management
Just as a firm has accounts receivables on its books, so is the firm an accounts receivable in
the books of its supplier firms. Much of what has been learned under section 4.2, has
reference to accounts payable management. A firm’s suppliers would also prefer to receive
cash for their sales, but are forced into providing terms to their customers. Discounts are
made available for early payment, and should be seriously considered due to the cost
involved in ignoring the discount. On the other hand, the firm is attempting to shorten the
operating and cash cycle, hence the motivation to keep suppliers waiting as long as possible
without incurring penalty interest, or losing the supplier due to late payment.

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(5) CONCLUSION
The management of working capital has significant implications for the profitability and
liquidity of a company. A small investment in working capital places less demands on capital
funding required and therefore on returns which must be generated to reward the providers of
capital. However, if a company has insufficient funds invested in current assets, it is likely
that its effectiveness will be impaired. For example, if stock levels are too low, sales, which
may otherwise have been concluded will be forfeited. If debtors are not granted the required
credit, they may take their custom elsewhere. In addition, cash resources should be readily
available to meet the daily operating expenses of the company such as the payment of wages,
salaries, expenses and creditors.
The financial manager is required to assess the business environment and make strategic
decisions regarding the quantum to be invested in working capital items and the methods,
which will be used to finance these assets. Of particular importance is the extent to which
finance from trade creditors will be used. The operating cycle can be determined in order to
assess the length of time during which funds are tied into working capital. The shorter this
cycle becomes, the greater will be the prospects for growth and profitability. The cash cycle
is equally significant and can be managed by regularly monitoring the turnover rate of each
item constituting working capital.
The working capital policy of a company is a key strategic factor in its success. Both over
and under investment in working capital are potentially harmful to the profitability and
liquidity of the business and may lead to lower profits than could have been achieved
otherwise.

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SECTION 10
VALUATION,
MERGERS AND ACQUISITIONS

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LEARNING OUTCOMES
 Outline the different techniques used in asset based valuation
 Undertake calculations related to EPS, ARR, Dividend-yield and Discounted cash-flow in

order to value the shares of a company
 Describe the different methods of mergers and acquisitions.
 Outline the types of mergers and acquisitions
 Explain the different techniques used in evaluating mergers and acquisitions

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(1) INTRODUCTION
In an earlier chapter of this module, it was mentioned that in order to assess how well a firm
is succeeding in the maximisation of shareholder’ wealth, the company value needs to be
measured. The approaches in the preceding chapters have focused exclusively on market
valuations, based on the current market prices of ordinary shares, preference shares and debt.
The valuations we have done so far have been an application of the discounted cash flow
(DCF) method, but this is not the only way in which companies can be valued. Alternative
methods of valuation use the information provided by the annual financial statements of a
company.
(2) VALUATION OF TARGET MARKET
2.1 Asset Based Valuations
Financial statements serve as the starting point of any asset-based valuation since they can
provide a fair reflection of the current circumstances of a business and, after appropriate
adjustments, can give a reasonable indication of future prospects. The financial statements of
a company show the value of a business as the difference between the value of assets and the
value of liabilities. The difference is known as Net Asset Value (NAV).
2.1.1 The Balance Sheet Valuation Method

The most basic approach to valuation is the calculation of NAV on the basis of the figures
reflected in the annual financial statements. The problem with this calculation is that the
accounting numbers in the balance sheet show assets on the basis of their historic cost
(original price when purchased) less accumulated depreciation. These “book” values are
rarely a reflection of the current market value of the assets, especially with regard to fixed
assets purchased in the more distant past. For example, imagine that a company owns a piece
of land that was purchased 20 years ago. If nothing else, the rate of inflation over the past 20
years would ensure that the nominal value (in rands) of the same land today far exceeds the
original cost. Yet, financial statements, unless adjusted, will still reflect the historic purchase
price. Even more recent purchases, such as computer equipment, are unlikely to reflect
current market values. Currently, computer equipment can be depreciated straight-line over 3
years, but an attempt to sell last year’s top-of-the range laptop at two-thirds of purchase price
is unlikely to succeed, given the technological improvements make over a year.

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2.1.2 The Replacement Cost Valuation Method

A significant improvement on historic cost valuations is the replacement cost valuation
approach. This approach requires that balance sheet items are shown at the current cost of
replacing them with identical assets. While a replacement cost valuation obviously reflects
the current market value of each asset, it is difficult to implement in practice. Certain assets
are likely to have easily identifiable replacement costs, such as tangible assets like delivery
vehicles, but other assets are not publicly traded. For example, an asset such as a patent on a
medicine, does not have a readily identifiable approximate cost. The replacement cost
valuation method essentially represents the cost of establishing a similar new company, and
the result of such a valuation can serve as the maximum value of a business.
2.1.3 The Realisable Value Method

While the replacement cost valuation establishes the maximum value of a business, the
realisable value method often determines the minimum value of a business. The realisable
value of assets represents the amount that can be received if the business is closed down and
the assets sold off, after payment of any expenses associated with the sale. This net value is
often referred to as the “liquidation” value since it fundamentally represents the “worst-case”
scenario where a whole company is worth less than the sum of its assets. The problem with
this method is similar to the problem with the replacement costs – the value of certain assets
cannot be established until a sale is made. (Ilkova, 2001: 73)
Suppose that the Target Company has this abridged Balance Sheet
R
Net non-current tangible assets 2 100 000
Net current assets 700 000
Net assets 2 800 000
Equity: R1 ordinary shares 2 200 000

Reserves 600 000
2 800 000
Each ordinary share should then be
valued at 2800000/2200 000 = R1.27

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2.2 The Earnings Basis
We learned that the price/earnings ratio was found by the formula:
Current market price of share

Earnings per share
We could rearrange this to say that:
The market value of a share = EPS x p/e ratio
The EPS figure is not necessarily the one calculated form the latest income statement. It
could be an expected future EPS, which, could obviously give higher value to the shares.
The P/E valuation method requires that an investor estimates a company’s projected earnings
for the next year and then the latest P/E ratio is applied to value the share. For example, if the
last P/E ratio of a company is 15, i.e. the current market price of a share is 15 times its current
earnings per share then the estimated earnings per share for next year (estimated earnings/no.
of shares) multiplied by 15 will constitute a fair estimate of the future price of the share.
The market price of shares in listed companies is observable, hence P/E ratios are easily
observable and published daily in the financial press. Privately held companies, however,
have no observable P/E ratio. Arguably, the most important application of the P/E method is
in valuing private company shares. Private companies can be valued by applying the P/E
ratio of a similar listed company, typically adjusted downwards, to the forecasted earnings of
the private firm. The reasons for adjusting the P/E ratio are few, but they revolve around 2
major issues.
The first one is that investment in private companies is riskier than that investment in
identical listed firms because of the lower marketability of the shares, implying that risk is
not easily diversifiable. As a result, the P/E ratio applicable to a private company would
reflect some unsystematic risk, and not only systematic risk. The second reason is that it is
unlikely to find a listed company that has exactly the same characteristics as the private firm
valued.

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Suppose the Acquiring Company has looked at the earnings of the Target Company for the
past 5 years. (It has not been able to obtain an estimate for the next year).
YEAR EARNINGS (R)
2000 150 000
2001 170 000
2002 180 000
2003 190 000
2004 245 000
On looking at the p/e ratios of quoted companies in the same industry, we find that the
average is 12. Those companies most similar are:
 Silverman which has recently grown rapidly, and also has good growth prospects. Its
p/e ratio is 16.
 Pinch which has recently had poor profits, so its p/e ratio is only 9.
The easiest starting-point might be to take average earnings over the 5 years. This would give
us a figure of (935000/5) = R187 000. If we look at the last 3 years, we would get (615
000/3) = R205 000. However, the profits for the last year has risen substantially – we might
wish to make a separate calculation using R245 000 to see how this would affect our result.
We could not compare the Target Company p/e ratio directly with Silverman’s - not only is
Silverman quoted, but it has very good growth prospects and we don’t know enough about the
Target Company. However, it has a better profit record than Pinch and, presumably, better
expectations. We might therefore decide to take the industry average, and reduce it as the
Target Company is unquoted. If we were optimistic, we could take 70%; if pessimistic 50%.
So, we could come up with 2 versions for the market value of The Target Company’s shares:
 If we take high earnings and high P/E ratio 8.4 (70% of 12) :
R 245 000 = 0.11 EPS

2 200 000
Market price per share = 0.11 x 8.4 = 0.924 cents per share.
Therefore, total market value will be R 2 032 800.

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If we take the last 3 years average earnings and the pessimistic P/E ratio 6 (50% of 12) :
R 205 000 = 0.093 EPS
2 200 000
Market price per share = 0.093 x 6 = 0.558 cents per share.
Therefore, the total market value will be R 1 227 600.
Whatever p/e ratio proportion is decided upon, the initial choice of share price will probably
need revising as the Target Company shareholders will be after all they can get out of the
Acquiring Company. (Ilkova, 2001: 75)
2.3 Accounting Rate of Return
Now let’s consider another technique for valuing shares that is the ARR (Accounting Rate of
Return) method.
We shall need to use the formula:
Estimated future profits

Required return on capital employed
Suppose that the Target Company’s last recorded profit of R245 000 and allows for a 10%
increase, giving R269 500. It might then decide that there would be an increase in directors’
emoluments of R40 000, but a reduction in loan interest of R25 000 and in audit fees of R20
000. Goods and services traded between the companies would allow profits to increase by a
further R50 000. Our revised figure would then be R324 500. The Acquiring Company
expects a return on capital employed of 16%. Therefore, the maximum valuation it would
place on the Target Company would be
R324 500/16% = R2 028 125.
Having established this upper limit, we can see that it falls nearer to the result given by our
higher p/e ratio than to the lower one.

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2.4 Dividend Yield
Now let’s look at something else you’ve encountered before in ratio analysis, and use it for
share valuation – the dividend yield.
This will be extremely useful when we are dealing with unquoted companies, especially
where there are a lot of small shareholders who will need to be convinced of the merits of
selling their shares! It’s based on the expectation that, as small shareholders don’t have the
influence to affect decisions on future earnings, they are more likely to be interested in the
real return on their investment – in other words the dividend yield. So the Acquiring
Company will want to offer them a suitable price for giving up their future dividends.
If we assume that future dividends will be constant, i.e. that there is no expected dividend
growth, then we could value the Target Company using the formula:
Market value = Dividend in cents

Expected dividend yield %
However, as the Target Company has no current market share price, we can’t work out the
dividend yield, or indeed an expected dividend yield, directly. What we need are the dividend
yields of some quoted companies in the same line of business. Suppose that we know that the
dividend yields of Silverman and Pinch have been as follows:
SILVERMAN PINCH
CURRENT 14 8
LAST YEAR 12 8
TWO YEARS AGO 10 8
AVERAGE 12 8
It would be even better if we had figures for more quoted companies, because the
performance of Silverman is known to be different from that of Pinch. The Target
Company’s profits are expected to continue to grow so, if we were to simply average the

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dividend yield of Silverman and Pinch this would probably be pessimistic. As the Target
Company is a private company, a higher yield may be necessary as the shares are not quoted.
Suppose, we take a yield of 11 for the Target Company. We now need to know the latest
dividend form the Target Company. Latest earnings figures are R245 000 so, if the Target
Company had distributed 75% of this, we would have R183 750 or 8.35% as our dividend.
This is 8.35 cents per ordinary share. Our market value would then be 8.35/0,11% or 75.91
cents per share or R1 670 020, which is between our optimistic and pessimistic p/e ratio
valuation.
If we wanted to use anticipated dividend growth instead of simply the last dividend, and
supposed that if profit was going to rise by 10% a slightly higher dividend per share could be
paid, we might anticipate a 2% growth rate. Using this formula, we would get:
Market value = D1
r–g
So, we would have:
Market Value = 8.35 x 1.02

(0,11 – 0,02)
= 94.63 cents per share, a total valuation of R2 081 860.
2.5 Discounted Cash-Flow
If the Acquiring Company wanted to make extra investment in The Target Company once the
takeover was complete, and is able to estimate the future net cash-flows of the Target
Company, and discount them using its own cost of capital, it could calculate the maximum
price it would be willing to pay for Target Company now.
Suppose the Acquiring Company calculates that, immediately on taking over the Target
Company, it would invest a further R200 000 to improve its profitability. It has already
calculated that the profits of the Target Company would increase under its management, but
now it perceives an additional 10% increase. Of course, we now have to add back a figure for
depreciation to the profits, and also allow for tax, if we are to find a net cash-flow figure.

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The Acquiring Company expects all its investments to pay back after 4 years. Its cost of
capital is 14%. Estimated profits for The Target Company are R324 500 plus another 10%,
plus depreciation, say R300 000, less tax – say R170 000 – gives an estimated cash flow for
year 1 of R486 950. The Acquiring Company estimates that this figure will increase over 4
years by a further 8% per annum.
Ye a r Net cash-flows Discounted cash-flow at 14%
0 (200 000) (200 000)
1 486 950 427 153
2 525 906 404 685
3 567 978 383 385
4 613 417 363 204
Net present value 1 378 427
So R1 378 427 would be the maximum The Acquiring Company would be prepared to pay
under these circumstances. (note: the cash flows ignore the purchase price, so that the
maximum price to be paid must be that which would give an NPV of zero at 14%)
However, the Acquiring Company is ignoring the cash flows that would undoubtedly occur
after year 4. It would be useful to calculate and add on to the PV of the four years cash flow
an end value, indicating the continuing nature of the cash flows. If the Acquiring Company
did not stipulate a four-year cut off point (and it may seem unrealistic for it to do so, as the
value of the Target company at the end of year 4 wouldn’t be zero, like a fully depreciated
machine), we could use:
Net cash flow in year 4

Discount rate
That is: R613 417 = R4 381 550

0.14
and then discount this using the year 4 discount factor at 14%, giving R2 594 316 to add to
the R1 378 427 previously found. The purchase price could then be up toR3 972 743.
This method does assume that net cash flows after year 4 will continue to be high – of course,
more uncertainty exists the further into the future we look.

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THINK POINT
Briefly describe the different procedures that an acquirer can use to value a target firm.
(3) MERGERS AND ACQUISITIONS
3.1 TYPES OF MERGERS AND ACQUISITIONS
In recent years the scale and pace of merger activity have been remarkable. During periods
of intense merger activity, financial managers spend considerable time either searching for
firms to acquire or worrying whether some other firm is about to take over their company.
When one company buys another, it is making an investment, and the basic principles of
capital investment decisions apply. You should go ahead with the purchase if it makes a net
contribution to shareholders’ wealth. But mergers are often awkward transactions to evaluate,
and you have to be careful to define benefits and costs properly. Many mergers are arranged
amicably, e.g. the $3 billion merger of Goldfields South Africa with Iamgold, the Canadian
mining group during August 2004, but in other cases one firm will make a hostile takeover
bid for the other. E.g. the AM Moolla Group successfully fought off a hostile bid by the
Coastal Group in 1998; also the failed bid by Nedcor of its rival banking Stanic in 1999.
An acquisition can also be called off, if a company is being disadvantaged, for example, the
richest overseas soccer club, Manchester United, called off talks with US sports tycoon
Malcolm Glazer regarding his proposed offer for the club, but did not close the door to
further discussions. The debt-free club said that while it had a definite offer from Glazer; it
had held talks regarding the potential structure of any offer and was not in favour of a large
level of debt to finance any takeover: “The board has decided to inform all shareholders that
it would regard an offer which it believes to be overly leveraged as not being in the best
interests of the company”, the firm said in a statement.

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Glazer, owner of the American Football team Tampa Bay Buccaneers, has steadily built his
stake in the British club to 28.11% in the past weeks, sparking speculation of an imminent bid
which could value it at as much as $1.4 billion. Fans of the 126-year old club have been
particularly hostile to Glazer because of reports that he planned to put the club into debt in
order to finance his takeover.
If the management of one firm observes another firm under-performing, it can try to acquire
the business and replace the poor managers with its own team. Therefore, poorly performing
managers face a greater risk from acquisition.
3.1.1 Mergers
A merger is a process whereby the assets of two or more companies are combined into one
company. A new company is usually formed, the acquired companies cease to exist as
separate entities and the shareholders of the new company are the shareholders of the original
companies.
3.1.2 Acquisition
An acquisition (or takeover) is a transaction in which a company, known as the offeror (or
acquirer) gains control of the management and assets of another company, known as the
offeree (or target), either directly by becoming the owners of these assets or indirectly by
obtaining control of management or by acquiring the majority of the shares.
3.1.3 Proxy content
This occurs when an offeror attempts to gain control of the board of directors by its right to
appoint the board as a result of the extent of its shareholding. For example, in September
2004, LHM Group, headed by multi-billionaire, Lakshmi Mittal obtained 51% of Ispat Iscor.
Subsequently, Ispat Iscor’s top management had to step down in favour of appointees of
major shareholder, LHM Group. They now plan to takeover US-based International Steel
Group Inc., to create the world’s largest steel companies.

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3.1.4 Leveraged Buyouts
Sometimes a group of investors takes over a firm by means of a leveraged buyout, or LBO.
The LBO group takes over the private firm and its shares no longer trade in the securities
market. Usually a considerable proportion of LBO financing is borrowed, hence the term
leveraged buyout.
If the investor group is led by the management of the firm, the takeover is called a
management buyout, or MBO. In this case, the firm’s managers actually buy the firm from
the shareholders and continue to run it. They become owner-managers.
3.2 Acquisition Classification
We now look more closely at mergers and acquisitions and consider when they do and do not
make sense. Mergers are often categorised as horizontal, vertical or conglomerate.
3.2.1 Horizontal Merger
This takes place between two firms in the same line of business. The merged firms are
normally former competitors. These horizontal mergers may be blocked if they are thought
to be anti-competitive or create too much market power.
3.2.2 Vertical Merger
This involves companies at different stages of production. The buyer expands back toward
the source of raw materials or forward in the direction of the ultimate consumer. Thus, a
soft-drink manufacturer might buy a sugar producer (expanding backward) or a fast food
chain as an outlet for its product (expanding forward). A recent example of a vertical merger
is Walt Disney’s acquisition of the ABC television network. Disney planned to use the
network to show its motives to huge audiences.
3.2.3 Conglomerate Merger
This involves companies in unrelated lines of business. For example, the Korean
conglomerate, Daewoo, had nearly 400 different subsidiaries and 150 000 employees. It built

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ships in Korea, manufactured microwaves in France, TVs in Mexico, cars in Poland,

fertilizers in Vietnam, and managed hotels in China and a bank in Hungary.
We have already seen that one motive for a merger is to replace the existing management
team. If this motive is important, one would expect that poorly performing firms would tend
to be targets for acquisitions; this seems to be the case. However, firms also acquire other
firms for reasons that have nothing to do with inadequate management. Many mergers and
acquisitions are motivated by possible gains in efficiency from combining operations. These
mergers create synergies. By this we mean that the 2 firms are worth more together than
apart.
A merger adds value only if synergies, better management, reduced costs, greater profits or
other changes make the 2 firms worth more together than apart. (Gitman, 2003: 717)
3.3 Purchase of shares versus purchases of assets
The offeror can acquire another company’s voting share by purchasing all or part of the
shares, in exchange for cash or other securities. It normally starts with a private offer from
the management of one firm to another and then taken directly to the shareholders.
This can be accomplished by a take-over offer. A take-over offer is a public offer to buy
shares. It is made directly to the shareholders of another firm.
If the shareholders choose to accept the offer, then they tender their shares by exchanging
them for cash or other securities, depending on the offer. A take-over is frequently
contingent on the bidders obtaining some percentage of the total voting shares. If not
enough, shares are tendered, then the offer might be withdrawn or reformulated.
A company can also effectively acquire another company by buying most or all of its assets.
If all the assets are sold, the offeree is either dissolved or sold to an entity wishing to inject
new trading assets into the company. If all or major part of the assets are to be sold, the
directors will require the approval of the shareholders in a general meeting. If only part of the
assets are acquired, the offeree could then continue to trade using its remaining assets.

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Advantages of buying shares in a company include:
 The offeror can deal directly with the shareholders.

 No shareholders meeting has to be held and no vote is required.
 Existing leases need not be transferred, thus no landlord consent is required.
 There is no need to alter the existing employment contract of employees.
Arguments in favour of a purchase of assets include:
 Requires a formal vote of the shareholders.

 In terms of section 38 of the Companies Act, a Company is not permitted to provide any
form of financial assistance to a buyer of its shares. This may prompt the buyer to buy
the assets rather than the company.
 If assets are purchased, the company saves on paying stamp duty on shares.
 If the offeror has a low or zero tax rate, it may choose to buy the assets.
 If the buyer borrows in order to purchase the asset, the interest on the loan is normally
tax deductible.
 Assets can be revolved at a higher value and the firm benefits from the lower taxes
because of the increased depreciation.
3.4 Procedures for obtaining control of a company
An offeror seeking control of a company may use a number of methods to acquire a

controlling interest consisting of shares in the offeree company. In South Africa this is
achieved by means of one of the following three procedures:
1) A takeover pursuant to the provisions of section 440A read together with section 440K
of the Companies Act, section 440K only being relevant if the offeror wishes to
expropriate disagreeing minorities.
2) A scheme of arrangement pursuant to the provisions of sections 311-313 of the Act.
3) The conversion of the minority’s shareholding to redeemable preference shares and the
redemption of such shares in terms of sections 98 and 99 of the Act.

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3.5 Hostile take-overs
Many mergers are arranged amicably, e.g. the $3 billion merger of Goldfields South Africa
with Iamgold, the Canadian Mining group during August 2004.10.27
South Africa has experienced little in the way of hostile takeovers, and those which were
attempted generally failed. The A M Moolla Group successfully fought off a hostile bid by
the Coastal Group in 1998 and also the failed bid by Nedcor of its banking rival Standard
Bank in 1999.
South Africa’s largest gold producer, Harmony Gold Mining made a hostile $8.1 billion bid
for Goldfields, the world’s 4th largest gold company on 18 October 2004. If the bid was
successful, the deal would have created the worlds largest gold company.
The target company states that it will defend itself by focussing shareholders’ attention on the
value it offers. This value would come from the combination of reverse listing its
international assets with Iamgold, and the “continued efficient management” of its South
African units. The CEO of Goldfields, stated that shareholders need to assess the two options
by asking themselves where the most value would come from. He stated that the Harmony
offer, offered cost cutting at the local operations, while the Goldfields offer was a
combination of cost cutting locally and an aggressive international growth strategy.
A hostile takeover may be defined as a situation where a takeover offer is strongly resisted by
the offeree board – perhaps because it does not approve of the offeror company, or because it
does not wish to lose operating autonomy. The takeover code specifically states that during
the course of an offer (0r even before if there is reason to believe that a bona fide offer is
imminent), the offeree board may not take any action which could frustrate the offer or deny
the shareholders the opportunity of deciding on its merits, without the consent of the
shareholders at a general meeting. In particular, the offeree board may not:
 Buy or sell material assets.
 Enter into contracts except in the normal course of business
 Issue any authorised but unissued shares
 Issue any shares carrying rights of conversion or subscription
 Grant options in respect of any unissued shares
 Pay any dividend which is abnormal as to timing or amount without prior approval of
shareholders in general meeting.

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3.6 Takeover defences
The basic philosophy of the Companies Act of 1973, as amended, is that shareholders should
decide on domestic matters relating to their company. The Act therefore makes no provision
for the inclusion or exclusion of anti-takeover amendments. Shareholders can therefore make
anti-takeover amendments to their articles of association if they believe it is in the best
interests of the company to do so.
Thus companies wishing to limit their exposure to a potentially hostile takeover can install
one or more of the following takeover defences prior to a formal bid being imminent,
provided the companies articles of association permit or are amended accordingly and as long
as actions are bona fide in the interests of the company.
 Surplus cash could be eliminated by, for example, paying a large dividend or
committing to a major new project.
 Material assets could be bought or sold. This is sometimes referred to as the “sale of the
crown jewels”, or a “scorched earth” strategy.
 The company could use a tactic known as a poison pill to repel would be suitors. The
term comes from the world of espionage. Agents are supposed to bite a pill of cyanide
rather than permit capture. Presumably, this prevents enemy interrogators from learning
important secrets. In the equally colourful world of corporate finance, a poison pill is a
financial device, which only comes into force if the company is taken over. For
example, shareholders are issued with an option to acquire shares cheaply, the option
only being exercisable in the event of a takeover.
 A firm facing an unfriendly merger offer might arrange to be acquired by a different,
friendly firm. The firm is thereby said to be rescued by a white knight. Alternatively,
the firm may arrange for a friendly entity to acquire a large block of shares. Sometimes
white knights or others are granted exceptional terms or otherwise compensated. BOE
acted as white knight to Norwich when African Life made a hostile bide for Norwich.
 A pyramid structure could be created to entrench control.
 Formal voting agreements between shareholders could be established.
 Interlocking shareholdings could be reconstructed (for example, by cancellation of
certain shares with the approval of 75% of the shareholders)

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 Articles of association may require that large majorities are necessary for changes in
specified company policies.
 Senior executives can be given extended management contracts.
 Some target firms contract to provide large amounts of compensation to top level
management if a takeover occurs. These are called golden parachutes.
 Material contracts with penalty conditions if there is a change in control can be entered
into by the company (for example, rent increases, loss of distribution rights).
 The company could issue a debenture, a condition of which is that it must be repaid in
full if there is a change in control.
 Selected company assets can be placed outside the direct control of shareholders (for
example, disposals could require the consent of the staff pension fund).
Perhaps the best defence of all against potential takeover bids is to make fundamental
improvements to the operations of the company, including improving profitability, making
better use of resources and upgrading the quality of the company’s management..
3.7 Expected gains from Mergers and Acquisitions
To determine the gains from an acquisition, we need to first identify the relevant incremental
cash flows, or the source of value. Acquiring another firm only makes sense if there is some
concrete reason to believe that the offeree firm will be worth more in our hands than it is
worth now. There are a number of reasons why this might be so.
3.7.1 Synergy
Suppose Firm X is contemplating acquiring Firm Y. The acquisition will be beneficial if the
combined firm has a value that is greater than the sum of values of the separate firms. If we
let Vxy stand for the value of the merged firm, then the merger makes sense only if:
Vxy > Vx + Vy when Vx and Vy are the separate values.
The difference between the value of the combined firm and the sum of the value of the firms
as separate entities is the incremental net gains from the acquisition, V:
v = Vxy – (Vx + Vy)

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When V is positive, the acquisition is said to generate synergy. Synergy could thus be
defined as the positive incremental net gains associated with the combination of two firms
through a merger or acquisition.
3.7.2 Revenue Enhancement
The combined firms may generate greater revenues than two separate firms. Increase in
revenue may come from:
3.7.2.1 Marketing Gains
Improved marketing might be made in the following areas:
 Previously ineffective media programming and advertising efforts.

 A weak distribution network
 An unbalanced product mix
3.7.2.2 Strategic benefits
Strategic benefits have the opportunity to take advantage of the competitive environment and
also to enhance management flexibility with regard to future operations. In this regard, a
strategic benefit is more like an option than a standard investment opportunity.
3.7.2.3 Market Power
Firms may merge to increase their market share and market power. Profits can be enhanced
through higher prices and reduced competition. However, if competition is substantially
reduced it may be challenged by the Competition Board.

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3.7.3 Cost Reduction
A combined firm may operate more efficiently than two separate firms in several different
ways, namely:
3.7.3.1 Economics of Scale
This relates to the average cost per unit of producing goods and services. If the per unit cost
of production falls as the level of production increases, then an economy of scale exists.
The phrase “spreading overhead” is used in connection with economics of scale. This
expression refers to the sharing of central facilities such as corporate headquarters, top
management and computer services.
3.7.3.2 Economies of Vertical Integration
Operating economies can be gained form vertical combinations as well as from horizontal
combinations. The main purpose of vertical acquisitions is to make the coordination of
closely related operating activities easier. Benefits from vertical integration are probably the
reason that most forest product firms that cut timber also own sawmills and hauling
equipment.
3.7.3.3 Complementary Resources
Some firms acquire others to make better use of existing resources or to provide the missing
ingredient for success. Think of a glove manufacturer that could merge with a swimming
costume manufacturer to produce more even sales over both the winter and summer seasons,
thereby use their production facilities better.
3.7.3.4 Lower Financing Costs
The cost of capital can often be reduced when one firm acquires another. The costs of issuing
both debt and equity are subject to economies of scale, which lower transactions costs and
results in better coverage of the firm by security analysts. Lower financing costs may be due
to the fact that by combining two companies, each effectively guarantees the debt of the
other, thus reducing the risk to the lenders.

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3.7.4 Lower Taxes
Tax gains often are a powerful incentive for some acquisitions. The possible tax gains from
an acquisition include the following:
3.7.4.1 Net Operating Losses
Firms that lose money at an operating level will not pay taxes. Such firms can end up with
tax losses they cannot use. A firm with net operating losses may be an attractive merger
partner for a firm with significant tax liabilities. Excluding any other effects, the combined
firm will have a lower tax bill than the two firms considered separately. This is a good
example of how a firm can be more valuable merged than standing alone. There is, however,
a qualification to our discussion. The Receiver of Revenue may disallow an acquisition if the
principal purpose of the acquisition is to avoid income tax by acquiring a deduction or credit
that would not otherwise be available.
3.7.4.2 Unused Debt Capacity
Some firms do not use as much debt as they are able to. This makes them potential
acquisition candidates. Adding debt can provide important tax savings, and many
acquisitions are financed with debt. The acquiring company can deduct interest payments on
the newly created debt and reduce taxes.
3.7.4.3 Asset Write-Ups
We have previously observed that, in an acquisition of assets rather than shares, the assets of
the acquired firm can be re-valued. If the value of the assets is increased, tax deductions for
depreciation will be a benefit.
3.7.4.4 Reduction in Capital Needs
All firms must make investments in working capital and fixed assets to sustain an efficient
level of operating activity. A merger may reduce the combined investments needed by the
two firms. For example, Firm A may need to expand in manufacturing facilities while

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Firm B has significant excess capacity. It may be much cheaper for Firm A to buy Firm B
than to build from scratch. In addition, acquiring firms may see ways of more effectively
managing existing assets. This can occur with a reduction in working capital by more
efficient handling of cash accounts receivable, and inventory. Finally, the acquiring firm may
also sell off certain assts that are not needed in the combined firm.
THINK POINT
Why does it make sense for companies to merge?
3.8 Techniques used in Evaluating Mergers and Acquisitions
If you are given the responsibility of evaluating a proposed merger, you must think hard
about the following two questions:
1. Is there an overall economic gain to the merger? In other words, is the merger value-
enhancing? Are the two firms worth more together than apart?
2. Do the terms of the merger make my company and its shareholders better off? There is
no point in merging if the cost is too high and all the economic gains goes to the one
company.
Answering these deceptively simple questions is rarely easy. Some economic gains can be
nearly impossible to quantify, and complex merger financing can obscure the true terms of
the deal. But the basic principles for evaluating mergers are not too difficult.
3.8.1 Mergers Financed by Cash
We will concentrate on a simple numerical example. Your company Jolly Grubber is

considering acquisition of a smaller food company Mo Roadhouse. Jolly Grubber is

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proposing to finance the deal by purchasing all of Mo Roadhouse’s outstanding shares for
R19 per share. Some financial information on the two companies is given below:
Jolly Grubber Mo Roadhouse Combined

Companies
R R
Operating income 150 20 172 (+2)
Operating costs 118 16 132 (-2)
Earnings 32 4 40 (+4)
Cash 55 2.5
Other assets’ book value 185 17.0
Total assets 240 19.5
Price per share 48 16
Number of shares 10.0 2.5
Market value 480 40
EPS R3.2 R1.6
Note : Figures in millions except price per share and EPS
The background: Why would Jolly Grubber and Mo Roadhouse be worth more together than
apart? Suppose the operating costs can be reduced, by combining the companies’ marketing,
distribution, and administration. Operating income can also be increased in Jolly Grubber’s
region. The third column contains projected revenues, costs and earnings for the two firms
operating together: annual operating costs post-merger will be R2 million less than the sum of
the separate companies costs, and revenues will be R2 million more. Therefore the projected
earnings increase by R4 million. We will assume that the increased earnings are the only
synergy to be generated by the merger. The economic gain to the merger is the present value
of the extra earnings. If the earnings increase is permanent (a level perpetuity), and the cost
of capital is 20%,
Economic gain = PV (increased earnings) = 4  0.20 = R20 million
This additional value is the basic motivation for the merger.

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What are the terms of the merger? What are the cost and gains to Jolly Grubber and its
shareholders?
In this case Mo Roadhouse will be paid in cash. The Cash offer is R19 per share, R3 over the
present market price.
Number of shares in Mo Roadhouse = 2.5 m
Amount Jolly Grubber has to pay = 2.5m x R19

= R47,5 m
Value of take-over = R480 + (R40m + R20m)

= R480m + R60m
= R540m
Net Present Value of take-over = R60 – R47.5m

= R12.5m
Take-over Premium = R47.5 – R40

= R7.5 m
Jolly Grubber post-merger share price = R540m – R47.5m

= R492.5m
Post-merger price per share = R492.5m ÷ R10m

= R49.25
Therefore, the merger has increased Jolly Grubber shares by R1.25

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Shark Limited makes a surprise cash offer of R2.50 a share to Goldfish Industries.
Goldfish Industries has 5 000 000 shares selling at R2 a share and has an EPS of R2,8.
Shark Limited has 15 million shares with a market value of R45 million and an EPS of R3,7.
The total synergistic benefit of the merger amounts to R10 million.
Calculate:
1.1 Calculate the value of the take-over.
1.2 Calculate the Net Present Value.
1.3 Calculate the take-over premium.
1.4 Calculate the market price per share after the take-over.
1.5 Calculate the gain/loss per share.
Note: EPS are by convention stated in cents. In this case they are stated in rands.
Therefore, the Rand sign must be inserted.

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1.1 Market value (MV) of take-over = MV of Shark +

(MV of Goldfish + Synergy)
= R45m + (R10m + R10m)
= R45 + R20m
= R65m
1.2 Net Present Value of take-over = (MV of Goldfish + Synergy) – Cash Paid
= R20m – R12.5m
= 7.5m
1.3 Take-over premium = Amount paid – MV of Goldfish

= R12.5m – 10m
= 2.5m
1.4 Post-merger Market Value = MV of take-over – Amount Paid

= R65m – R12.5m
= R52.5m
Therefore, Market Price per share = R52.5m ÷ 15 million shares

= R3.50
1.5 Gain per share = R3.50 – R3.00

= R0.50

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3.8.2 Mergers Financed by Shares
Evaluating the terms of a merger can be tricky when there is an exchange of shares. The
target company’s shareholders will retain a stake in the merged firms, so you have to figure
out what the firm’s shares will be worth after the merger is announced and its benefits
appreciated by investors. Notice that we started with the total market value of Jolly Grubber
and Mo Roadhouse post-merger, took account of the merger terms (207 500 &
1 250 000 new shares issued respectfully), and worked out the division of the merger
gains/losses between the two companies.
There is a key distinction between cash and share financing mergers. If cash is offered, the
cost of the merger is not affected by the size of the merger gains. If share is offered, the cost
depends on the gains because the gains show up in the post-merger share price, and these are
used for the acquired firm.
Suppose, for example, that A overestimates B’s value as a separate entity, perhaps because it
has overlooked some hidden liability. Thus A makes too generous an offer. Other things
equal, A’s shareholders are better off if it is a share rather than a cash offer. With a share
offer, the inevitable bad news about B’s value will fall partly on B’s former shareholders.
3.8.2.1 Mergers Financed by Shares (Using Market Value)
Suppose Jolly Grubber wants to conserve its cash for other investments and therefore decides
to pay for the Mo Roadhouse acquisition with new Jolly Grubber shares? The deal calls for
the exchange ratio to be based on the market value of their respective shares.
Therefore, the exchange ratio = Market Value of Target Company (Mo Roadhouse)
Market Value of the Acquiring Company (Jolly Grubber)
= R16
R48
= 0.333

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No. of Shares to be issued to Mo Roadhouse = 2 500 000 x 0.333

= 832 500
Total number of shares = 10 m + 832 500
= 10 832 500
Combined Market Value: Jolly 10m x R48 = 480 000 000

Mo 2.5m x R16 = 40 000 000
Plus synergy = 20 000 000
= R540 000 000
Post-merger Market Value = 540 000 000

10 832 500
= R49.85
Benefits according to Market Price:
Benefits to Jolly Grubber = 49.85 – 48.00 = 1.85 per share
Benefits to Mo Roadhouse = 49.85 (0.333) = R16.60 – R16
= R 0.60 per share (Gain)

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Use the same example as Self-Check Question 1. Suppose Shark Limited wants to pay for the
acquisition of Goldfish Industries with the issue of new shares. The deal calls for the
exchange ratio to be based on market values of their respective shares.
Calculate:
2.1 The exchange ratio based on market values.
2.2 The post-merger Market price per share.
2.3 Benefits, if any, to the companies

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2.1 The exchange ratio based on market values

= Market Value per share of Target Company (Target Company)
Market Value per share of the Acquiring Company (Acquiring Company)
= 2.00
3.00
= 0.667
2.2 Post-merger market Value

No. of Shares to be issued to Goldfish = 5 000 000 x 0.667
= 3 335 000
Total number of shares = 15 m + 3 335 000
= 18 335 000
Combined Market Value: Shark 15m x R3 = 45 000 000

Goldfish 5m x R2 = 10 000 000
= R65 000 000
Post-merger Market Price = 65 000 000

18 335 000
= R3.55
2.3 Benefits:
Shark Limited gain by = 3.55 – 3.0 = 55 cents
Goldfish Industries gain by = 3.55 (0.667) – 2.0
= R2.37 – R2.00
= 37 cents

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3.8.2.2 Mergers Financed by Shares (Using EPS)
Suppose Jolly Grubber wants to conserve its cash for the investments and therefore decides to
pay for Mo Roadhouse acquisition with new Jolly Grubber shares. The deal calls for the
exchange ratio to be based on the earning per share (EPS) of their respective shares.
The exchange ratio = EPS of Target Company (Mo Roadhouse)

EPS of the Acquiring company (Jolly Grubber)
= 1.6
3.2
= 0.5
No. of Shares to be issued to Mo Roadhouse = 2 500 000 x 0.5

= 1 250 000
Total number of shares = 10 m + 1 250 000
= 11 250 000
Combined earnings: Jolly 10m x 3.2 = 32 000 000

Mo 2.5m x 1.6 = 4 000 000
= 56 000 000
Post-merger Eps = 56 000 000

11 250 000
= R4.98
Benefits to EPs:
Jolly Grubber = 4.98 – 3.2 = R1.78
Mo Roadhouse = 4.98 (0.5) – 1.6
= 89 cents

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THINK POINT
Do mergers increase efficiency? How are the gains from mergers distributed between
shareholders of the acquired and acquiring firms?
Use the same example as Self-Check Question 1. Suppose the deal calls for the exchange
ratio to be based on earnings per share (EPS)
Calculate:
3.1 The exchange ratio based on EPS.
3.2 The post-merger EPS.
3.3 Benefits, if any, to the companies

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3.1 Exchange ratio based on EPS
= EPs of Target Company

EPs of the Acquiring Company
= 2.8
3.7
= 0.76
3.2 Post-merger EPs
No. of Shares to be issued to Goldfish = 5 000 000 x 0.76

= 3 800 000
Total number of shares = 15 m + 3.8m
= R18.8m
Combined earnings: Shark 15m x 3.7 = 55 500 000
Goldfish 5m x 2.8 = 14 000 000
= R79 500 000
Post-merger Eps = 79 000 000

18.8m
= R4.23
3.3 Benefits:
Shark Limited gain by = 4.23 – 3.7 = R0,53
Goldfish Industries gain by = 4.23 (0.76) – 2.8
= R3.21 – R2.80
= 41 cents

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Mandy’s Food Supplies hopes to acquire Picks Pies through a merger. Pick’s management
will consider the offer only if the price is high and management can stay in its present
capacity.
Mandy’s Food Supplies expects to gain operating efficiency from the merger through
purchasing, advertising and distribution economies. It estimated that the synergistic benefits
will amount to R2.4 million.
4.1 Using the table below, calculate exchange ratios based on:
4.1.1 Market values

4.1.2 Most recent earnings per share
4.1.3 Equate Mandy’s Food Supplies most recent earnings to their expected post
merger earnings.
EPS DPS g P No. of shares

Mandy R2,50 R2,00 6% R40 6 million
Picks R1,80 R0,90 2% R18 2 million
Notes:
 EPS= earnings per share

 DPS=dividends per share
 g=growth rate
 P=Price per share
4.2 Irrespective of your answer in 4.1, assume that Mandy’s Food Supplies agrees to a
one-for one exchange of shares. Calculate the expected post-merger EPS.
4.3 Assume a post-merger P/E of 15. Now calculate the expected post-merger market
price and compare it to next year’s expected price without a merger. Should Mandy’s
Food Supplies acquire Picks Pies? (Use EPS derived from Question 4.1.3)

Managerial Finance
4.1.1 The charge ratio based on market values
= Market Value of Target Company (Pick’s Pies)

Market Value of The Acquiring Company (Mandy Foods)
= 18
40
= 0.45
4.1.2 Exchange ratio based on EPS
= EPs of Target Company

EPs of the Acquiring Company
= 180
250
= 0.72
4.1.3 Post-merger EPs
No. of Shares to be issued to Picks Pies = 2m x 0.72

= 1 440 000
Total number of shares = 6 m + 1.44m
= 7.44m
Combined earnings: Mandy 6m x 2.50 = 15 000 000

Picks 2m x 1.80 = 3 600 000
= R21 000 000
Post-merger Eps = R21m

7.44m
= R2.82

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4.1.3 Benefits :
Mandy Foods = 2.82 – 2.50 = R0,32
Picks Pies = 2.82 (0.72) – 1.80
= R2.03 – R1.80
= 23 cents
4.2 Exchange based on one-for-one:
No. of Shares to issue to Picks Pies = 2m

Total Shares = 6m + 2m
= 8m
Combined earnings: = R21 000 000
Post-merger Eps = R21m ÷ 8m

= R2.63
4.3 P/E Ratio = 15

Expected Post-merger market price = 15 x market price
Eps
Market price = 15 x R2.82
= R42.30
Expected growth (No Merger) = 6%

Therefore, market price = price x growth (1 +g)
= R40 x 1.06
= R42.40
No, next years market price is R0.10 more, without the merger

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(4) CONCLUSION
Valuations are necessary whenever an investor wishes to purchase a business, shares in a

business or any other form of financial asset. Valuations relate only to future expectations
and all valuation decisions require predictions about anticipated future events. Once a
valuation has been performed, the value is compared with the price. Only if the value is
greater than the price will the purchase transaction take place.
The different techniques to valuation are useful. Asset based valuation aims to place a Rand
value with reference to an exchange basis such as the net realisable value or the replacement
cost. It identifies the assets of a business, places a value on each and deducts the liabilities in
order to arrive at the net asset value.
The discounted cash flow aims to discount all future cash flows by the required rate of return.
This is absolutely fundamental in all aspects of finance and is conceptually sound and
theoretically correct. It is made difficult, however by the uncertainty surrounding the
predictions of future cash flows and the necessity of determining an appropriate rate of return
with which to discount the stream of predicted cash flows. While alternative formula may be
developed for ease of reference to a particular financial instrument, they are all based on the
identical principle of discounting the future cash flows.
The financial manager is sometimes involved in corporate restructuring activities, which

involve the expansion and contraction of the firm’s operations or changes in its asset or
financial (ownership) structure. Included among corporate restructuring activities are
mergers and acquisitions. A variety of motives, such as synergy, increasing managerial skill
or technology, and defence against takeover, could drive a firm toward a merger, but the
overriding goal should be maximisation of the owner’s wealth. Merger transactions are
heavily debt-financed leveraged buyouts (LBO’s). In other cases, firms attempt to improve
value of divesting themselves of certain operating units that are believed to constrain the
firm’s value, particularly when the break up value is believed to be greater than the firm’s
current value.
Regardless of whether the firm makes a cash purchase or used market values or EPS to
acquire another firm, the analysis should centre on making sure that the risk-adjusted net
present value of the transaction is positive.

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BIBLIOGRAPHY
1. Brealey, RA; Myers, SC; Marcus, AJ (2004) Fundamentals of Corporate Finance,

4th International Edition, New York: McGraw-Hill.
2. Flynn, D (2000) Understanding Finance and Accounting, Durban, Butterworth Publishers

(Pty) Ltd.
3. Gitman, LJ (2003) Principles of Managerial Finance, 10th Edition, Boston, United States:
Pearson Education, Inc.
4. Ilkova, E and Donnelly, S (2001), Basic Principles of Financial Management, Natal

Business School.
5. Managerial Finance Study Guide, (2002), Mancosa
6. Ross, SA; Westerfield, RW; Jordan, BD and Firer, C (2012) Fundamentals of Corporate
Finance, 5th South African Edition, Australia: McGraw-Hill, Inc.
7. Ross, SA; Westerfield, RW; Jordan, BD, (2004) Fundamentals of Corporate Finance, 6th
Edition, New York: McGraw-Hill, Inc.

APPENDIX 1
n
Table 1 : Present value of a regular annuity of $1 per period for n periods : PVFA (k,n) = ∑ =
i=1
Number
of 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
Periods
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6052 1.5852 1.5656 1.5465 1.5278
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.2459 2.2096 2.1743 2.1399 2.1065
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.7982 2.7432 2.6901 2.6386 2.5887
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 3.2743 3.1993 3.1272 3.0576 2.9906
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.6847 3.5892 3.4976 3.4098 3.3255
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 4.0386 3.9224 3.8115 3.7057 3.6046
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 4.3436 4.2072 4.0776 3.9544 3.8372
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.6065 4.4506 4.3038 4.1633 4.0310
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.8332 4.6586 4.4941 4.3389 4.1925
11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 5.0286 4.8364 4.6560 4.4865 4.3271
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 5.1971 4.9884 4.7932 4.6105 4.4392
13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 5.3423 5.1183 4.9095 4.7147 4.5327
14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 5.4675 5.2293 5.0081 4.8023 4.6106
15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 5.5755 5.3242 5.0916 4.8759 4.6755
16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 5.6685 5.4053 5.1624 4.9377 4.7296
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 5.7487 5.4746 5.2223 4.9897 4.7746
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 5.8178 5.5339 5.2732 5.0333 4.8122
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 5.8775 5.5845 5.3162 5.0700 4.8435
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 5.9288 5.6278 5.3527 5.1009 4.8696
25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 8.4217 7.8431 7.3300 6.8729 6.4641 6.0971 5.7662 5.4669 5.1951 4.9476
30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269 8.6938 8.0552 7.4957 7.0027 6.5660 6.1772 5.8294 5.5168 5.2347 4.9789
40 32.8347 27.3555 23.1148 19.7928 17.1591 15.0463 13.3317 11.9246 10.7574 9.7791 8.9511 8.2438 7.6344 7.1050 6.6418 6.2335 5.8713 5.5482 5.2582 4.9966
50 39.1961 31.4236 25.7298 21.4822 18.2559 15.7619 13.8007 12.2335 10.9617 9.9148 9.0417 8.3045 7.6752 7.1327 6.6605 6.2463 5.8801 5.5541 5.2623 4.9995
60 44.9550 34.7609 27.6756 22.6235 18.9293 16.1614 14.0392 12.3766 11.0480 9.9672 9.0736 8.3240 7.6873 7.1401 6.6651 6.2402 5.8819 5.5553 5.2630 4.9999
APPENDIX 2
Table 2 : Present value of $1: PVFA (k,n) =

Number
of 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 25%
Periods
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 0.8000
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944 0.6400
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787 0.5120
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823 0.4096
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019 0.3277
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349 0.2621
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791 0.2097
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326 0.1678
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938 0.1342
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615 0.1074
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346 0.0859
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122 0.0687
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935 0.0550
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779 0.0440
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649 0.0352
16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0930 0.0811 0.0708 0.0618 0.0541 0.0281
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0693 0.0600 0.0520 0.0451 0.0225
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0691 0.0592 0.0508 0.0437 0.0376 0.0180
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0506 0.0431 0.0367 0.0313 0.0144
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0514 0.0433 0.0365 0.0308 0.0261 0.0115
25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923 0.0736 0.0588 0.0471 0.0378 0.0304 0.0245 0.0197 0.0160 0.0129 0.0105 0.0038
30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.0256 0.0196 0.0151 0.0116 0.0090 0.0070 0.0054 0.0042 0.0012
40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221 0.0154 0.0107 0.0075 0.0053 0.0037 0.0026 0.0019 0.0013 0.0010 0.0007 0.0001
50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085 0.0054 0.0035 0.0022 0.0014 0.0009 0.0006 0.0004 0.0003 0.0002 0.0001 *
60 0.5504 0.3048 0.1697 0.0951 0.0535 0.0303 0.0173 0.0099 0.0057 0.0033 0.0019 0.0011 0.0007 0.0004 0.0002 0.0001 0.0001 * * * *
* The factor is zero to four decimal places

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MANAGERIAL FINANCE

PROGRAMME : MBA Final Year

CREDIT POINTS : 20 points

NOTIONAL LEARNING : 200 hours over 1 semester

TUTOR SUPPORT : manfin@mancosa.co.za

AIMS OF THE UNIT

 Analysis of past performance by ratio and cash flows

After working through this guide, you should be able to:

MANCOSA - MBA FINAL YEAR 1

THE SECTIONS OF THIS GUIDE

SECTION TITLE PAGE

MANCOSA - MBA FINAL YEAR 2

HOW TO USE THIS GUIDE

MANCOSA - MBA FINAL YEAR 3

MANCOSA - MBA FINAL YEAR 4

1. Brealey, RA; Myers, SC; Marcus, AJ (2004) Fundamentals of Corporate Finance,

MANCOSA - MBA FINAL YEAR 5

MANCOSA - MBA FINAL YEAR 6

On completion of this section, you should be able to display knowledge of:

 The fundamental concepts related to Managerial Finance

 The importance of study of Managerial Finance

 The different career opportunities in Managerial Finance

 The function of Managerial Finance in the business world

 The goals of Managerial Finance

 The role of Managerial Finance in the market place.

MANCOSA - MBA FINAL YEAR 7

(1) FINANCE AND BUSINESS

1.1 WHAT IS FINANCE?

1.2 MANAGERIAL FINANCE

(2) LEGAL FORMS OF BUSINESS ORGANISATIONS

2.1 Sole Proprietorships

MANCOSA - MBA FINAL YEAR 8

A partnership consists of 2 or more owners not exceeding 20 in number, doing business

MANCOSA - MBA FINAL YEAR 9

 Private and public companies

 Shares and shareholders

Par value vs. market value/directors value

The SHARE CAPITAL of a company can be calculated as follows:

Number of issued shares x par value

MANCOSA - MBA FINAL YEAR 10

 No par value shares

 Authorised vs. issued share capital

MANCOSA - MBA FINAL YEAR 11

Equity is the value of ordinary shares and reserves of a company.

MANCOSA - MBA FINAL YEAR 12

Which forms of business organisation might best suit the following:

a) A consulting firm with several senior consultants and support staff

(3) STUDY OF MANAGERIAL FINANCE

MANCOSA - MBA FINAL YEAR 13

(4) CAREER OPPORTUNITIES IN MANAGERIAL FINANCE

(5) THE MANAGERIAL FINANCE FUNCTION

5.1 ORGANISATION OF THE FINANCE FUNCTION

MANCOSA - MBA FINAL YEAR 14

5.2 RELATIONSHIP TO ECONOMICS

5.3 RELATIONSHIP TO ACCOUNTING

5.4 PRIMARY ACTIVITIES OF THE FINANCIAL MANAGER

MANCOSA - MBA FINAL YEAR 15

(6) GOALS OF MANAGERIAL FINANCE FUNCTION

6.1 MAXIMISE PROFIT

6.2 MAXIMISE SHAREHOLDER WEALTH

Financial Financial Return ? Increase Yes Accept

(Gitman, 2003: 15)

MANCOSA - MBA FINAL YEAR 16

6.3 THE ROLE OF ETHICS