Chapters 13 & 14

Sources of Finance
& Capital Structure
 Chap 13 Learning Outcomes
• Types of financial markets.
• Role of the JSE in raising finance.
• Listing criteria of the JSE and ALTX
• Types of financial institutions.
• Types of financial instruments.
• Equity and debt-instruments.
• Evaluate sources of finance.
2
 Financial Markets
MONEY MARKETS
– Mainly for ST (<3 yrs) finance and mostly over
the phone
– Include investment & commercial banks &
finance houses
– Money markets deal in financial instruments
with a life of less than three years
CAPITAL MARKETS
– Mainly for LT (> 3yrs) finance (e.g. JSE and ALTX -
shares and debenture issues)
3
 Primary, Secondary & Formal
Markets
• Primary markets - New share/debenture
issues (e.g. new JSE listing)
• Secondary market – Deals in previously
issued securities (e.g. buying/selling of
shares on JSE)
• Formal markets – E.g. JSE, ALTX, SAFEX &
Bond Exchange of SA are highly regulated,
specialising in a narrow range of
standardised instruments accessible to
small investors 4
Informal Over-the-Counter (OTC) Markets
• Informal deals on OTC markets occur across a
desk or by using computer terminals &
telephones.
• Most formal exchanges started as informal OTC
markets
• Informal/OTC markets permit innovation/
flexibility according to needs of parties
• Standardised instruments (e.g. OTC trading of
currencies) do not need formal exchanges to
trade efficiently
5
 Spot and Derivative Markets
 SPOT MARKETS trade instruments at agreed prices immediately
 DERIVATIVE MARKETS defer settlement to a future date
 Derivatives are used to manage risk (hedge), speculate &
arbitrage
 They are Flexible, have Low cost and offer significant Leverage
and Liquidity
 Exchange traded derivatives.
 Options and warrants are traded on the JSE and futures and
options on SAFEX.
 Have Standardised contracts, marking to market and high levels of
liquidity.
 Non-exchange traded derivatives are
 Negotiated and customised, non-standardised and not traded on
an exchange. Examples are forward contracts, forward rate 6
 Interaction between market
classifications
• Markets classifications do not make them
mutually exclusive. E.g. The sale of 1000
Barloworld shares could be designated to
the following markets:
– capital – shares are long-term
instruments;
– secondary – money is exchanged for
shares (Barloworld is not involved)
– spot – money is exchanged and the scrip
delivered immediately;
– formal – shares are sold through a broker
on the JSE. 7
 JSE Securities Exchange (JSE)
• The JSE was formed as a market for shares of the many
mining and financial companies formed after the
discovery of gold in SA
• The JSE is SA’s only stock exchange and governed by the
Securities Services Act, 2004 and its own rules and
directives
• Trading on the JSE was in the form of an auction involving
brokers
• In 1996 the JSE introduced electronic share trading (JET)
system
• From July 1999 JSE introduced the Share Transaction
Totally Electronic (STRATE) project, allowing transactions
to be settled and traded electronically
• From Feb 2002 all JSE counters had moved to STRATE 8
 JSE Listing Requirements – Main Board
• Subscribed capital at least R25m (not <25m shares)
• Audited 3 year profit history – last < R8m NPBT
• Not <500 public shareholders (not employees/
associates)
• Not <20% of shares to be held by the public
• Compliance with King II on Corporate Governance
– Audit committee / remuneration committee
/separate chair & CEO
• Compliance with International Reporting Standards
• New requirements on auditors
• Independent directors
• Related party transactions
• Disclosure of director share trading activities
• Directors to ensure compliance with listing requirements
9
Placement of Shares (vs public offer)
• Ordinary shares are sold directly to a
group of institutional investors
• Proportionate ownership may be
diluted
• No underwriting - quicker than rights
issue or public offer
• Control and strategic allocation of
shares
• No prospectus required 10
 Alternative Exchange - ALTX

• AltX is a division of the JSE.

• Market for small/medium sized companies.
• Listing requirements less onerous and include:
– Share capital of R2m
– Public ownership = 10%
– Designated Advisor
– Induction programme for directors
• Market Capitalisation of ALTX = R5bn. At Jan
2007 30 companies listed on AltX 11
 JSE Liquidity
• What does market liquidity mean? Buy/sell large #
shares quickly at current price on secondary market.
• Why is market liquidity important? A primary market
(new issues) will not exist without efficient and liquid
secondary market
• Significant increase in market liquidity from 5% in early
1990s to about 42% in 2006
Equity Capital Raised on the JSE (Rbn)

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

28 50 67 39 71 22 101 23 42 82 87
12
 Capital is raised on the JSE?

• New equity issues relate to asset

acquisitions and restructurings
• The number of new listings has fallen.
• Many de-listings on JSE in recent years.
• JSE is still ranked 19th of world’s
exchanges ito market capitalisation
(US$)
• 32nd in terms of market liquidity. 13
 No. of companies listed on the JSE
• Number of JSE listed companies fallen
significantly, mainly due to:
– restructuring by groups,
– unbundling,
– winding-up and
– mergers and acquisitions.
• Delisted in recent years: I&J, BOE, McCarthy,
Genbel, Cadbury Schweppes, Safren, LTA
• New listings 2006: Massmart, Kumba Resources,
Spar. Listing of Hulamin (Huletts Aluminium)
14
 Instruments traded on the JSE
• Shares - Approx. 400 companies are listed on JSE
• Warrants
– Warrants are similar to options. Their values dependent on
the volatility of the underlying share, time to expiry, interest
rates and exercise price
– Expire from 3-36 months
– Mainly issued by Deutsche Bank, Investec, ABSA, Standard
Bank and SG Securities - The issuer is also the market maker
– Bid-offer spreads are 0,5%
– Warrant positions are hedged directly in the share or options
markets
– Conversion ratio indicates how many warrants are required to
acquire 1 underlying share.
• Other securities traded include preference shares and fixed
income securities (YIELDX)
15
 The South African Futures Exchange (SAFEX)

• Merged with JSE in 2001 – SAFEX is a division of JSE

• It trades derivatives (futures/options)
• Futures include Financial & Commodity Contracts
• Financial Futures contracts include futures
contracts on ALSI40 index, other indices and on
individual highly traded shares.
• Agricultural markets division of SAFEX offers futures
contracts on beef and maize.

16
 Bond Exchange of South Africa
• Lists debt securities issued by government,
parastatals and large companies.
• Fixed & floating rate securities & Zero coupon
bonds
• Interest normally payable semi-annually
• CPI linked bonds
• Highly liquid – turnover about 13 times in a year
• Trading volume about R8-10 trillion pa (over R35
billion per day)(JSE turnover R6-9 billion pd).
• Why is the market favourable for the issue &
listing of new corporate bonds?
17
 Rights Issues
• Inviting existing shareholders to subscribe for new
shares
• % ownership remains constant if all shareholders
take up their rights
• Issue price at a discount to current listed price
• Example
– Co. has 9m shares in issue. The current price is R6 and the
company wishes to raise R5m. The Co. plans to issue 1m
shares at R5. What is the value of a right?
– Current price is R6 and rights issue at R5 per share. Is the
value of each right R1?
– What is value of the company after the rights issue? PTO
18
 Rights issue
No. of shares Price R

Existing 9,000,000 x 6.00 = 54,000,000

New 1,000,000 x 5.00 = 5,000,000
10,000,000 59,000,000

Theoretical value of shares after the rights issue = 59,000,000

10,000,000

= 5.90

• Value of each right is 5,90 – 5,00 = R0,90

• What is the signalling effect of rights issue?
19
 Valuation of Rights
Alternatively, the value of a right may be stated as follows;

 N ( Mc  S ) 
Value of right =  N 1 
 
Where,
N = number of shares required to acquire 1 right
Mc = market price per share
S = subscription price per share

 9(6.00  5.00) 
=  
 10 

Value of right = 0.90

20
 Financial Institutions
• Markets require borrowers and lenders
• Financial institutions act as
intermediaries and tend to offer a global
package of services. Distinction between
types of institutions is fading
• Commercial banking provides a variety
of services e.g. overdraft facility (ST
finance), LT mortgages, Etc.
21
 Investment Banking
• Corporate finance – services relating to
mergers , corporate restructuring and raising
of finance
• Lending of a short-or medium-term nature
• Money-market – actively trading in money &
forex markets for clients and for own account
• Public issues and the private placing of shares
• Large amounts of loan finance can be raised

22
 Venture Capital and Private Equity
• Venture capital and private equity assist with
launching and developing business
• Venture capital and private equity markets are less
efficient than the public markets
– Transaction costs are far higher
– There are a small number of buyers and sellers
– There are no reporting requirements – info is
not freely available
– There are different investment objectives of
venture capitalists and private equity investors
– The risk of failure is higher than in formal
markets
23
 Private Equity
• Major private equity firms include;
– Brait
– Ethos
– Venfin
– Investec
– Foreign private equity funds are entering the market
• Shoprite, Consol Glass, Alexander Forbes and even
Edcon were private equity targets. Companies will be
unlisted if a private equity transaction goes ahead.
• Private equity firms provide expertise, organise
financing and often increase the debt levels of firms
• Private Equity firms have a limited time horizon and
will exit by listing or selling the firm (ex. BTR Dunlop
sold to a foreign firm) Venfin sold its stake in Vodacom
to Vodaphone. 24
Industrial Development Corporation
• The IDC expects a meaningful contribution from
the owner
• The owner must share the risk by funding 33% of
total assets
• The IDC considers loan finance which is equal to
owner’s interest in the business
• Development is emphasized
• Empowerment related financial buy-ins or
takeovers
• Focus on fixed assets and “greenfield” projects
• Impact on job creation and exports
• Ex. Sasol / Iscor
25
 Business Partners
• Business Partners was formed to
guide and promote entrepreneurship

• Focus on small business

• It will invest between R150 000 and
R15m depending on the owner’s
contribution, risk and collateral
• Insist on Equity participation
26
 Public enterprises
• Public Investment Corporation
– Increased profile / active shareholder
– Assets under management > R600
billion
– Financing of BEE transactions
– Isibaya Fund
• National Empowerment Fund (NEF)
• Khula Enterprise Finance
27
 Equity-Related Instruments
Ordinary share issue (Ks)or use retained earnings (Kr)
ORDINARY SHARES KE = (D1/P0)+g (Issue cost P0= P0(1-F)
Or KE = Rf + ß(Rm - Rf)
• Offer capital growth (P1- P0) and dividends (D1) income

•Return (dividends plus capital growth) exceeds that on

interest-bearing instruments (Kd). Why? Higher risk
•Most investors tend to be pension funds and insurance
companies
•Share Issue Expenses include: Listing fee, Advertising,
brochures/prospectuses, Professional fees (legal, audit,
stock broker and JSE fees), Banker’s Fee, Underwriting
28
Commission (2-3%, Taxes and Duties
 Retained Earnings
• KE = (D1/P0)+g (No issue cost)
Cost of retained earnings = the cost of new equity
• Retained earnings vs dividends (dividend cover/payout ratio)
• Immediate source of finance with no flotation/issue cost
• Shareholders will forego dividend if expected future growth

Preference shares
• Hybrid of equity and debt
• Fixed dividend – payment not compulsory
• Nominal rate may be based on after-tax rate for LT debt (No tax)
• Preference shares are useful when tax positions of parties differ.
– Participating (fixed dividend plus share in remaining profits)
– Redeemable or Indefinite
– Convertible to ordinary shares
– Banks may subscribe at rate equal to 70-74% of the prime rate.(STC
credit).

29
 Debt-Related Instruments
• MT finance = 1 to 3 years
• Long-term finance 5 and 10 years
• Classification of Debt :
– Fixed Interest, e.g. debentures
– Variable interest fluctuates with market forces- e.g.
mortgage bonds
– Secured debt
– Debt covenants (Debt/Quick ratios, overall debt,
dividend payments/cover)
– Unsecured debt
– Covertible, redeemable, indefinite & participating
30
 Structuring the repayment of loans
• Instalments versus Bullet (Residual) payment.
E.g. Loan of R8m at 11% repayable in
instalments or single pmt at end. Cash flows?
Cash Flows 0 1 2 3 4 5
Loan with equal instalments R8m/3,696 -2,164,562 -2,164,562 -2,164,562 -2,164,562 -2,164,562
or 11% x R8m = R880 000
Loan with capital payable at end of term -880,000 -880,000 -880,000 -880,000 -8,880,000

Principle: Consider risk & cash flows from

underlying asset.
31
 Debentures
• Debenture trust deed specifies terms (payments, interest,
security)
• Trustees represent debenture holders
• Restrictive covenants (PTO)

Mortgage bonds
• LT loan secured over fixed property
• Terms vary
• Restrictive covenants

32
 Credit Ratings
• Standard & Poor / Moody – provide independent
ratings of the risk of bond issues
• If a bond issue is rated AAA – what is the
probability of default?
• What is the spread on the Barloworld bond issue?
Go to www.bondexchange.co.za. Check up BAW1
under Data services MTM report. Ex. On 1 Feb
2007, yield is 8.86% which is at a premium of 80
basis points (0.8%) above the R153 (govt. bond)
yield.
• What will Barloworld do with its divisions?.

33
 Leases
• Commonly used to fund movable assets
• Lessor retains legal ownership of the asset until paid
• Lessee has use of the asset for part or full useful life
• Lease payments include capital plus TVM (return)
ST Debt
• ST finance matches seasonal/cyclical Wcap cycle
• ST finance = form of bridging finance
• AP provide part of seasonal/cyclical finance needs
• Short-term finance = higher risk than long-term finance
• Sources: Overdraft, BA (90 day Acceptances)
• Bills and Notes
• Foreign loans – interest rates < RSA – Cost of forward
cover could eliminate cost advantage 34
 Debt & Equity
– Equity has a residual right to income & Ke>Kd
– Cost of debt is tax deductible
– Debt - contractual right to capital/interest when
due, profit or not & restrictive covenants
– STC payable on net dividends paid-personal, not RI
– Debt tends to have a finite life – no affect on %SH
– Life of equity= life of the firm
– Equity holders control the entity
– Cap. structure = debt & equity (Risk profile →Ke/d)
– Debt increases risk (fin. Distress) & return (leverage
when ROA >Kd)
– Signalling effects of a rights issue may be negative35
 BEE Financing structures
• Industry charters
• Section 38 Now financial assistance to
buy shares
• Source of financing for BEE entities
– Vendor financing (shares, prefs, loans or
bonds)
– BEE entity issues pref shares to banks at
70-74% of prime & use entity assets as
security or Initial public Offering(IPO)
36
 BEE Financing structures
BEE Holdings Ltd

100%
R30m

Original
SPV Ltd Prefs
shareholders R510m

49% 51%

Metro Ltd

37
 Alternative BEE Financing structure
• Company sells “business” to “Newco”. Old SH
retain 70% or more in Newco
• Coy retains direct ownership of operations
• No dilution of BEE ownership in the future
Metrix Holdings BEE Co.
75% 25%

Loan (from
NEWCO Bank or
R960m Metrix)
Assets (Rm) Equity/Liabilities (Rm) Interest tax deductible
1,000 40 Bought assets/operations
38
960
 Levels of Equity Control
– 75% of share capital allows passing of special
resolutions
– 50% + share - enables the passing of ordinary
resolutions
– 20% or 30% of share capital = effective
control listed coy
– 35% = effective control in terms of the
Takeover Code
– Control of the board
– Default – Arrears Pref dividends have voting
rights 39
Chapter 14

Capital structure
 Learning outcomes
• Leverage increases return (if ROA>Kd) - potential loss to
SHs
• Debt increases financial risk.
• No optimal capital structure under certain assumptions.
• Inclusion of tax, distress and other costs alters optimal
capital structure.
• Theory of capital structure - practical situations.
• Pecking order approach.
• Effect of inflation on the cost of debt.
• Optimal capital structure and need for flexibility.
• Tax shield makes debt more attractive within risk
attitudes
41
 Financing Decision
• Separate Investment and financing
decisions
• Balance Sheet: Assets = Equity + Liabilities
(mainly debt)
• Financing of assets (D/E ratio) is a strategic
decision (+types of debt & equity →
capital structure.
• Big Q uestion? Does capital structure
affect entity value?
42
 Business Risk
• Determined by operating activities, industry and
product range, e.g. retail store vs software
developer
• Risk = level of fixed to variable costs i.e. operating
leverage = Total contribution/EBIT
• Balancing Business and Financial risk
– Match long-term assets with long-term finance

Financial risk
• DE ratio i.e. Interest rate and capital risk
• Equity financing → dividends and capital growth
• Debt = LT&ST Contractual interest & capital dues
– Secured or unsecured 43
 Operating Leverage
• Example: FC R100 000 ; V C R4 pu; SP R10 pu; Volume 30 000 Upa
• Contribution: 30 000 x (R10-R4) = R180 000
• EBIT is R80 000 (R180 000 - R100 000)
• Level of Operating Leverage = R180 000/80 000 = 2,25
Every 1% increase (fall) in sales/contribution = a 2,25% increase
(fall) in EBIT.
Current Forecast Increase
Sales 300,000 330,000 10.0%
Variable costs -120,000 -132,000 10.0%
Contribution 180,000 198,000 10.0%
Less: fixed costs -100,000 -100,000
EBIT 80,000 98,000 22.5%
Operating leverage 23% / 10% 2.25
Operating leverage 180,000 / 80,000 2.25
44
 Financial Leverage
• Debt levers net earnings up or down if ROA>Kd
• Example: Co. A is 100% equity financed & Co. B has D:E
of 40:60 Kd =12,5%.
(Rm) Co. A Co. B
Equity 1,000 600
Debt - 400
Total Assets 1,000 1,000

EBIT 400.0 400.0

Interest - -50.0
400.0 350.0
Tax -116.0 -101.5
Net income 284.0 248.5

Return on Assets 28.4% 28.4%

Return on Equity 28.4% 41.4%
Interest rate 12.5%

• As the firm is borrowing at 8.875% (12.5% x 0.71) after tax

and earning a ROA of 28%, this results in an increase in
the ROE to 41.4%.
 Note: ROA = EBIT(1-t)/Total Assets 45
 Degree of Financial Leverage?
• DFL on net income: = EBIT/(EBIT - I)
• E.g.: U se example below plus interest cost of R16 000
– DFL = R80 000/R64 000 = 1,25
When EBIT changes 1% NIBT changes by 1,25%
R000 Current Forecast Change
Sales 300,000 330,000 10.0%
Variable costs -120,000 -132,000 10.0%
Contribution 180,000 198,000 10.0%
Less: fixed costs -100,000 -100,000 X
EBIT 80,000 98,000 22.5%
2,25
Interest -16,000 -16,000 X1,,25
Net Income 64,000 82,000 28.1%
Tax at 29% -18,560 -23,780
Net Income after tax 45,440 58,220 28.1%

DFL = R80 000/R64 000 = 1,25 22,5x1,25=

28,125 46
 Degree of Combined leverage (DCL)
• DCL = combined effect of DOL & DFL
– DCL = Contribution/(EBIT - I) or (DOL x DFL)
Example: DCL = R180 000/R64 000 = 2,8125
Or DCL = DOL(2,25) X DFL(1,25) = 2,8125
+10% in sales = +28,1% NIBT and NIAT
R000 Current Forecast Change
Sales 300,000 330,000 10.0%
Variable costs -120,000 -132,000 10.0%
Contribution 180,000 198,000 10.0%
Less: fixed costs -100,000 -100,000
EBIT 80,000 98,000 22.5%
Interest -16,000 -16,000
Net Income 64,000 82,000 28.1%
Tax at 29% -18,560 -23,780 47
Net Income after tax 45,440 58,220 28.1%
Negative effect of financial leverage?
• Effect of high leverage when economy down
• Co. A & B have operating income of R20m. Co. B
has fixed interest of R44m charge. ROA & ROE?
('Rm) Co. A Co. B
EBIT 20.0 20.0
Interest - -44.0
20.0 -24.0
Tax -5.8 -
Net income 14.2 -24.0

Return on Assets 1.42% 1.42%

Return on Equity 1.42% -4.00%

• EBIT x 0,71 = R14,2/1000 Assets = 1,42%

 ROA = EBIT(1-t)/Total Assets Debt B = 400
 ROE = NIAT/Equity Eq u ity A=1000 & B=600
 Financial leverage & risk
• Avoid debt in uncertainty and variable
operating returns
• Low risk operating cash flows should
encourage higher levels of financial
leverage.
• Match asset terms with finance terms. ST
financing may not be renewed and
compounds financial risk

49
 Capital structure
• Equity
– Share capital
– Reserves
– Outside shareholders interest
– Deferred taxation
• Debt
– Long term liabilities
– Interest bearing debt
– Permanent portion of other current liabilities?

50
 Optimal capital structure?
• Debt-equity ratio with lowest WACC.
• M&M: Capital structure is irrelevant, assuming
– No taxes or transaction costs
– No costs associated with financial distress
– No agency costs
– Individuals & companies borrow/lend at same rate
• Principle: Assets determine V e not mode of finance
• Ve depends on Net operating income (NOI)
• Approached to Cap structure:
– NI approach -financial leverage does not impact Ke/Kd
Thus greater debt = lower WACC and higher value.
– Net operating income approach (MM) - Ke increases
with financial leverage, but Kd & WACC constant.
Thus financial leverage has no impact on value. 51
 Capital structure: Traditional (Trade-off)
approach
• Ke and Kd stay unchanged as Debt ↑so WACC ↓
until Ke and Kd increase from ↑ financial risk.
• Debt ratio with lowest WACC = Optimal capital structure
Effect of NOI approach (M&M) on WACC & Ke?
WACC remains constant and Ke rises as D/E ratio ↑

52
•
M&M and Arbitrage
Co. A and Co. B incomes and values.
Co. A Co. B
Net Operating Income 900,000 900,000
Interest - -300,000
Available to shareholders 900,000 600,000

Value of Equity 4,500,000 3,000,000

Value of Debt 2,000,000
Value of company 4,500,000 5,000,000

• V e = 0,9m/0,2 = R4,5m and 0,6/0,2 = R3m

• V d = 0,3m/0,15 = R2m
• Investor with 10% of B can sell for R0,3m (Ve), borrow
R0,15m and buy 10% in A for R0,45m
Re in A is R67500(R90000–22500 Interest)vs R60 000 in B
with less or equal risk (borrow Ro,2m).
53
M&M - NOT sustainable!?
 M-M and arbitrage
• Investor will earn R67500 in A vs R60000 in B. Why is risk
unchanged?
– Co. B has 40% (2m/5m) gearing. Co. A 0% gearing
– P ersonal gearing 0,15/4,5 (33%) or 0,2m/0,5m (40%) with 50
000 surplus.
• Arbitrage will force the price of B’s shares DOWN (selling) and the
price of A’s shares U P (demand) until the WACC of A=WACC of B
M&M with Taxes
Kd(1-t) increases Re (ROA-Kd)
• V L , with gearing & tax, increases by P V of Ixt
– V L=V U + P V of interest tax shield (or Ixt)
V L = V alue of levered firm
V U = V alue of unlevered firm
54
 M&M with taxes
• With taxes, the WACC falls as D:E increases

• Where is the flaw in this? ↑Ke > ↓Kd(1-t)↑D

55
 M&M with taxes
– Too much debt increases the cost of financial
distress.
– Too much debt could reduce EBIT.
– Too much debt will incur agency costs.
– Too much debt will lead to an increase in Kd
VL = VU + PV I - PVF - PVΔEBIT - PVA - PVD
• P V I = P V of expected interest tax shield
• P V F = P V of expected financial distress
• P V Δ EBIT = Reduction in value from lower EBIT
• P V A = Reduction in value from agency costs
• P V D = Reduction in value from increased cost of debt
56
 Effect of financial leverage on Vo
• Initially, interest tax shield increases returns/value up to point X.
Value starts falling as financial distress and other costs increase

57
Capital stru ct u re: Contemporary approach.
Consistent with M&M, with taxes, and financial distress and
related costs

• Ke↑ as DFL↑ (initially little change).

• D/E ratio influences lenders’ willingness to lend

58
 Pecking Order Theory
• No target capital structure
• Financing follow a preferred hierarchy:
1. RI is 1st preference of financing
2. 2nd debt/loan finance
3. Convertible debt/preference shares
4. Lastly, the issue of new equity
Why? Limit sharing of control and residual income!
• RI has no control or covenant compliance issues
• Debt will result in loan covenants and reporting to lenders
• New equity may impact on control and greater market scrutiny
• Info asymmetry reflects presently mispriced securities
• Issue equity when ordinary share prices are high
59
 Financial leverage and systematic
risk(ß)
ß=systematic risk, affected by financial leverage.
ßL = ßU [1+(D/E)(1-t)] & ßU = ßL/[1+(D/E)(1-t)]
Effect of inflation
Real return(r)=9% & inflation(f)=10%. Nom.rate(Rn)?
• Rn = (1+r)(1+f)–1 = [(1+,09)(1+,1)]–1=0,199 19,9%
Nominal rate(Rn)=19,9% & inflation(f) =10%. r?
• r =[(1+Rn)/(1+f)]–1 and [(1+,199)/(1+,1)]-1=9%
Real rate(r)=9% & nominal rate(Rn) is=19,9%. f?
• f =[(1+Rn)/(1+r)]–1 and [(1+,199)/(1+,9)]-1=10%
• Tax deduction on nominal cost of debt
• High inflation = appreciating assets & ↑Interest 60
 WACC – Some Principles
• Weighted average costs of all finance
sources
• Uses market rates of debt and equity at
target D:E or MV
• Includes corporate tax effects (Kd after tax)
• Ke and Kd include inflation, so should
expected cash flows
• Real Return (r) (14%) = Risk-free (8%) + Risk
(6%)
• Nominal rate (Rn)(21%) =Rf (8%)+Risk (6%)
+Inflation (7%)
• Nominal rate (Rn) = (1 + r)(1 + f) – 1
 From the real world…..
• Grindrod
• Target debt-equity ratio of 100% (50:50.)
Could company keep to this target?
180%

160%
158% Debt
140%
%
120% 107%
106%
100%

80%
61%
60% 53%

40% 29% 33%

20%

0%
1999 2000 2001 2002 2003 2004 2005

• Why not go to www.grindrod.co.za and check for the latest

debt-equity ratio? 62
Capital Structure : Signalling theory

• Management use financing decisions to influence

(signal) market perceptions and value of entity

– issue equity if shares perceived to be overvalued

or market considers debt too high
– Increase debt if market perception is
underlevered

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 Capital restructuring in USA & Ve
• M&M assumes real investment & operating Cflows
unaffected by ∆ D/E ratio i.e. Same operating
decisions if debt is 80% debt or 0%
• In reality dramatic ∆ in D/E and div. payout ratios
directly affects MVe
• LBOs active in late 1980’s (huge debt burden) &
restructured US economy. (disposal of non-core
assets)
• Agency cost of free cash flow? If operating cash ↑
and no +NPV projects need to return cash to SH or
invest in low return projects or diversify and destroy
value.
• Result: MVe ↑ by trillion US dollars. Will same
happen in RSA from BEE?
64
 Effect of debt?
• Compulsory Interest & debt servicing costs versus
optional dividends
• Bankruptcy
• Interest cost effects IS Ke does not. SA entities have too
little debt
• Trend to reduce capital and DOL if DFL ↑.
• Problems of overcapacity lead to consolidation.
• Debt encourages sale of unrelated business entities
(unbundling)
• Concentration of equity in the hands of insiders
• Debt effects sales and implicit product warranties
• Growing entities need constant ↑ in capital – debt is not
appropriate
• Optimal capital structure is achieved with lower ratings
(MV).
65
Why is debt low in SA entities?

• PPC has D/E ratio below 5% based on MV – with cash balances no

debt
• Same is true for Shoprite, Pick n Pay, Alexander Forbes etc.
• SA Companies are buying-back shares for more realistic capital
structures - Not enough.
• The future = private equity firms buying out companies, incurring a
lot of debt, paying large dividends or buy-back share→↑Ve
• E.g. Manchester United. Glaser mostly used Manchester Utd’s
borrowing capacity to buy Manchester Utd. Why? The club was
ungeared.

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