Component 5 - Slides

COMPONENT 5 – FINANCING DECISION
Photo by Stefan Els
Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

1. INTRODUCTION
• Statement of Financial Position
• What type of capital?

• In what form?

2. TYPES OF FINANCING (p. 66)
Shareholders' equity Debt Capital

• Degree of permanency • Must be repaid
• Costs (financing cost)
• Costs (dividends) are not
legally compelled legally enforceable
• Costs paid from before tax
• Costs covered by after tax
profit
profits
SELF STUDY: P. 66 - 69
3. PARTIAL OR TOTAL FINANCING (p. 69)
• Partial financing
• Finance obtained for a specific asset or group of assets
• Period of finance is the same as lifespan of asset
• Usually debt finance
• Total financing
• Compares investment plan with current financing
• Financing of all the assets owned by the company
• Combination of equity and debt finance

4. THE SIGNAL THEORY (p.70)
Signal theory: Method of financing sends a certain signal to existing and

potential shareholders.
The Pecking order theory:

o Retained earnings (internal equity)
o Debt
o Issuing of new shares (external equity)

5. RETAINED EARNINGS AS SOURCE OF FINANCE (p.71)
• Internal equity utilised first

• Delivers highest earnings per share
Ro x Kinv = EBIT
EPS = (1-t)(RoKinv – RvKv)
# ordinary shares
Rv x Kv = Finance cost
Kinv = investment amount
t = tax rate Assume: no investment income and
Ro = return on assets no preference dividends.
Rv = cost of debt
Kv = amount of debt included in the investment

Ro x Kinv = EBIT

• Existing number of issued ordinary shares = 100 000

• Investment amount R400 000, t= 40%, Ro= 5%, Rv= 7%
EPS (1)= (1-t)(RoKinv – RvKv)

# ordinary shares
= (1-0,4)[(5% x 400 000) – (7% x 100 000)]

(100 000 + 30 000)
Option 1 Option 2 Option 3
= 6 cents
Ordinary shares 30 000@R10
Debt capital R100 000 R250 000
Retained earnings R150 000 R400 000
EPS 6c 1,5c 12c
6. DEBT AS A SOURCE OF FINANCING (p.72)
• Short-term sources (CL) – money market

• Long-term sources (NCL) – capital market
• Cost of long-term sources usually lower than short term,
but bound for longer period
• If we only finance with debt, we need to make a decision on
what combination of debt finance we will use
• For this discussion assume that the enterprise utilises only

debt capital
• Conservative vs aggressive approach
Total capital
requirement
Current Non-current Total assets Permanent Variable
assets (CA) assets (NCA)
Permanent capital requirement
January 10 000 50 000 60 000 60 000 0
February 20 000 50 000 70 000 60 000 10 000
= Minimum total capital
requirement
March 25 000 50 000 75 000 60 000 15 000
April 40 000 50 000 90 000 60 000 30 000 OR
May 35 000 50 000 85 000 60 000 25 000 = NCA + min CA
June 20 000 50 000 70 000 60 000 10 000
July 15 000 50 000 65 000 60 000 5 000
August 25 000 50 000 75 000 60 000 15 000 Variable capital requirement
September 30 000 50 000 80 000 60 000 20 000 = Total capital requirement –
October 40 000 50 000 90 000 60 000 30 000 permanent capital
November 25 000 50 000 75 000 60 000 15 000
December 15 000 50 000 65 000 60 000 5 000 Total variable capital
Total 180 000 requirement for year
12
=15 000 Avg variable capital
GRAPH (p. 74)

GRAPH (p. 74)

TWO FINANCING APPROACHES (p.74)
6.1 Aggressive approach
• Borrow minimum (permanent capital with long-term sources
& variable capital with short-term sources)
R60 000 X 8% p.j. = R4 800
R180 000/12 X 12% p.j. = R1 800
Assume: = R6 600
Long-term credit rate = 8%
Short-term credit rate= 12%
TWO FINANCING APPROACHES (p.74)
6.2 Conservative approach

• Borrow maximum with long-term sources
= R7 200
Advantages/Disadvantages?
- ST-credit available for emergencies/opportunities
- Unused capital in certain months – pay finance cost
- Low risk; Low profitability

DEBT FINANCING
• Aggressive – more profitable but higher risk

• Conservative – more expensive but lower risk
Comparison of two approaches (p.75)
Financing plan Risk Total financing Profitability

costs
Aggressive Highest R 6 600 Highest
Conservative Lowest R 7 200 Lowest

• TOTAL CAPITAL REQUIREMENT per month
= Current assets + Non-current assets
• PERMANENT CAPITAL REQUIREMENT per month

= Minimum total capital requirement (in total assets column) OR
= Non-current assets + minimum of current assets
IN SUMMARY
• VARIABLE CAPITAL REQUIREMENT per month

= Total capital requirement – permanent capital requirement
• AGGRESSIVE APPROACH
• Permanent capital requirement LT credit
• Variable capital requirement ST credit
• CONSERVATIVE APPROACH
• Maximum capital requirement LT credit
• Permanent capital requirement – LT credit
6.3 Critical period (p.76)
 What if unused capital is re-invested for periods of non-utilisation?

• Some of the finance costs can be recovered and reduce the effective cost of
finance
 Return on re-investment will be low – money needs to be liquid
 By re-investing the unutilised capital, you decrease the finance cost
 Acceptability of effective cost depends on the period of non-utilisation
 Utilised for longer – long-term option becomes more advantageous

Current Non-current Total assets Permanent Variable
assets (CA) assets (NCA)
Permanent capital
January 10 000 50 000 60 000 60 000 0
= Minimum total
February 20 000 50 000 70 000 60 000 10 000 capital
March 25 000 50 000 75 000 60 000 15 000
OR
April 40 000 50 000 90 000 60 000 30 000
May 35 000 50 000 85 000 60 000 25 000
= NCA + min CA
June 20 000 50 000 70 000 60 000 10 000
July 15 000 50 000 65 000 60 000 5 000
August Variable capital =
25 000 50 000 75 000 60 000 15 000
Total capital –
September 30 000 50 000 80 000 60 000 20 000 permanent capital
October 40 000 50 000 90 000 60 000 30 000
November 25 000 50 000 75 000 60 000 15 000
December 15 000 50 000 65 000 60 000 5 000
Total 180 000
12
=15 000

EFFECTIVE PERIOD OF USE(n)
n = 6 months
2 WAYS TO CALCULATE THE EFFECTIVE PERIOD OF
USE (n)
• Method 1 :
• Method 2 :

CRITICAL PERIOD (p.77)
 Effective cost of variable capital requirement financed with long-term

credit (Example pg. 77-78)
rℓ = PL + 12 – n (PL – PC)%
n
rℓ = the effective cost of the LT credit

PL = LT interest per year
PC = Interest rate that can be earned during period of non-requirement
n = Period that LT credit will be used for (period of utilisation)
12-n = Period of non-requirement

Example: Long term capital can be borrowed at 8% p.a. (PL), and short term
at 12% p.a (PK). Unutilised capital is reinvested at 6% p.a (PC). Variable
capital requirement is equal to R30 000 for 3 months.
rℓ = PL + 12 – n (PL – PC)%
n
rℓ = 8 + 12 – 3 (8 – 6)%
3
= 14%
AGGRESSIVE VS CONSERVATIVE with REINVESTMENT

rℓ > PK Aggressive approach better (fin. costs lower)
rℓ < PK Conservative approach better (fin. costs lower)

Example
Long term capital can be borrowed at 8% p.a., and short term at 12% p.a.
Unutilised capital can be reinvested at 6% p.a.
Variable capital requirement is R30 000 for 9 months (n=9)

Example: Long term capital can be borrowed at 8% p.a. (PL), and short term at 12% p.a
(PK). Unutilised capital is reinvested at 6% p.a (PC). Variable capital requirement is equal
to R30 000 for 9 months.
rℓ = PL + 12 – n (PL – PC)%
n
rℓ = 8 + 12 – 9 (8 – 6)%
9
= 8.67%
AGGRESSIVE VS CONSERVATIVE with REINVESTMENT

rℓ > PK Aggressive approach better (fin. costs lower)
rℓ < PK Conservative approach better (fin. costs lower)

Critical period (CP)
Period where the cost of the long-term credit and short-term credit is the
same:
Critical period = (PL – PC) x 365 days (12 months)

(PK – PC)
If n > CP: Conservative approach with reinvestment better

If n < CP: Aggressive approach better

• Critical period (CP) = (PL – PC) x 12 months

(PK – PC)
= (8 – 6) x 12 months
(12 – 6)
= 4 months
Eg. n = 9 (3) & CP = 4

n (9) > CP (4) Conservative approach with reinvestment
n (3) < CP (4) Aggressive approach better

Exercises
• Additional exercises: Problem 1

• Class exercises 1 & 5 (Sondertyd Ltd)

WHAT HAVE WE DONE SO FAR?
PECKING ORDER THEORY

o Debt capital
o Issuing of new equity (external equity)
o Preference shares
o Ordinary shares

7. PREFERENCE SHARES AS SOURCE OF FINANCING
(p.79)
Please read section 7 on page 79:
• Cumulative preference shares sometimes seen as semi-debt because

dividend rate is fixed.
• Dividend rate pre-tax: = Preference dividend rate

(1 - t)
• If pre-tax dividend rate < = positive leverage effect

7. PREFERENCE SHARES AS SOURCE OF FINANCING
(p.79)
Example:
6% Preference shares
Tax rate = 40%
Dividends rate pre-tax = Preference dividend rate

(1 - t)
=
= 10% (compare with Ro)
Advantages and disadvantages of preference share capital over debt

Exercises

WHAT HAVE WE DONE SO FAR?
PECKING ORDER THEORY

o Debt capital
o Issuing of new equity (external equity)

o Preference shares
o Ordinary shares
o Study maximization of shareholders’ wealth from the viewpoint of 1) functioning of financial
leverage and 2) calculation of indifference point.
Examples focus on combination between ordinary share capital and debt capital

8. ORDINARY SHARES AS A SOURCE OF FINANCING
(p.79)
8.1 Financial leverage and ordinary shareholders’ equity
Financialleverage
Financial leveragefactor:
factor:
= Return on equity (Re) >1 + fin. leverage Ro > Rv and Re > Ro
Return on total assets (Ro)
Return on ordinary shareholders’ equity

Rb at various Ro and Rv (p.80)
Return on ordinary shareholders’ equity (Rb) with debt (Kv)
as % of total capital
Ro 0 20 40 60 80
16 16 18 21,3 28 48
12 12 13 14,7 18 28
Rv 8 8 8 8 8 8
4 4 3 1,3 -2 -12
Rb = Ro + Kv (Ro – Rv) Rb = 12% + 60 (12%-8%) = 18%
0 0K -2 -5,3 40 -12 -32
b
Attracting Kv over
Economic and Management
the LT beneficial to ordinary shareholders as long as Ro > Rv
Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe
8.2 Point of indifference (p.81)
Ro = 12% Ro = 5%

8.2 Point of indifference formula (p.82)
• Provides an indication of how far the expected operating profit
can decrease to the point where no benefit from the financial
leverage is obtained.
• Indifference point : EPS of A = EPS of B
+ Investment income
+ (-) Gain (loss) from the disposal of PPE
EPS: A EPS: B
(Operating profit – Fin. costs)(1-t) – PS div = (Operating profit – Fin. costs)(1-t) – PS div
Number of ordinary shares issued Number of ordinary shares issued

Recap: Table 2 on page 81
Ro = 12% Ro = 5%
Co A Co B Co A Co B
Operating profit 600 600 Operating profit 250 250
Finance costs 0 (280) Finance costs 0 (280)
Profit before tax 600 320 Profit before tax 250 (30)
Tax (40%) (240) (128) Tax (40%) (100) (0)
Profit after tax 360 192 Profit after tax 150 (30)
# shares 5 000 1 000 # shares 5 000 1 000
EPS 7,2c 19,2c EPS 3c -3c
Positive financial leverage: Negative financial leverage:

Ro > Rv Ro < Rv
Operating profit > Indifference point
Exercises

• Class exercise 2 (Excelle Ltd.)

9. RIGHTS ISSUE (p.83)
• Company wants to increase ordinary share capital
• Existing shareholders preferential right to additional shares
• Existing shareholders must participate to retain existing % shareholding
• Issue price usually lower than current market price

9. RIGHTS ISSUE (p.83)
• Issue Ratio = N
Number of new shares =
Issue Ratio (N) =
• Issue Price = offered price of new shares

EXAMPLE (p. 83)
Enterprise currently has 1 000 000 issued ordinary shares. The company
requires a further R6 000 000, and plans a rights issue at R15 per share.
What is the issue ratio?
Number of new shares: Issue ratio (N)
= Capital required = Existing number of issued shares

Issue price Number of new shares
= R 6 000 000 = 1 000 000

R15 400 000
= 400 000 (new shares) = 2.5
1 new share for every 2.5 existing shares held

EXAMPLE (p. 84)
Issued ordinary share capital of a company is 26 500 000 shares.

Present market price = R 9,50 and planned issue price of R 8,50.
New capital of R17 million is required.
Number of new shares

= R17 000 000
R8,50 = 2 000
000 (new shares)
Issue ratio (n)

= 26 500 000
2 000 000
= 13,25
9.1 ADVANTAGES AND DISADVANTAGES FOR INVESTORS
(p.84-85)
Advantages Disadvantages
• Expansion: increase in • To maintain proportional

shareholding shareholders
value of firm
must buy new shares
• Issue price < current MP • Negative effect on EPS
• Underwriting of rights issue

DEFINITIONS (p. 84)
• Cum-rights period:
• period between formal announcement and last day of cum-rights trading
• Purchaser of share obtains both the existing share and the preference right on the
new shares
• Ex-rights period:
• Date following last day of cum-rights trading until closing date of offer
• Shares and rights trade individually
• Purchaser of existing shares has no right to the new shares

VALUE OF PREFERENCE RIGHTS (p. 85)
Cum-rights period:

Ex-rights period Theoretical market price of the share during ex-rights
• M* = [(number of existing shares in the issue ratio x cum-rights MP) +

(number of new shares in the issue ratio x issue price)] / [new shares +
existing shares in issue ratio]
OR
• M* = cum-rights MP – V (value of right)

EXAMPLE (p. 86)
The shares of a company presently trade at R15. The company considers

a rights issue of 1 new share for every 2 existing shares (N = 2) at an
issue price of R9 per share. Calculate the theoretical value of the rights
during the cum rights period. Value during cum-rights period :
Cum-rights period:
V=M–S
N+1
V = R15 – R9
2+1
V = R2
EXAMPLE (p. 86)
The shares of a company presently trade at R15. The company considers a
rights issue of 1 new share for every 2 existing shares (N = 2) at an issue
price of R9 per share. Calculate the theoretical value of the rights during
the ex rights period. Value during ex-rights period :
Ex-regte periode
V = M* – S
N
M* = M – V = R15 – R2 = R13
V = R13 – R9
2
V = R2
IN SUMMARY
Issuing further ordinary shares by a rights issue:

Number of new shares =
Issue Ratio (N) =
Cum-rights period: V= M–S

N+1
Ex-rights period: V= M* – S
N
M* = cum-rights MP – V (value of right)
Exercises:

• Class exercise 3: Highway Ltd.

10. SUSTAINABLE GROWTH RATE (p.86)
Maximum growth rate – without affecting Rb, solvency and

liquidity
2 Assumptions:
Combination of debt and equity is optimal – company wants to

maintain this optimal financing mix (debt-to-equity ratio) when
financing is required.
 Growth in total capital

10. SUSTAINABLE GROWTH RATE (p.86)
Function of:
1. Re (Return on equity)
2. % of attributable earnings not paid out as dividends - Factor B

B = Attributable earnings – Ordinary dividends
Attributable earnings
• Retained earnings is the preferred financing source according to pecking order theory – refer to
the table on page 89.
g = Re B

Operating profit
10. Volhoubare groeikoers (bl.86)
100 000
+ Investment income 5 000
EBIT 105 000
- Fin. costs (15 000)
Profit before tax 90 000
- Tax (36 000)
Profit after tax 54 000
- Preference share dividends (4 000)
Attributable earnings 50 000
- Ordinary dividends (10 000)
Retained earnings 40 000
B = 50 000 – 10 000 = 80%

50 000
B = (1 – dividend payout ratio)

SUSTAINABLE GROWTH RATE (p.87 & 88)

How much additional equity (Ke) and additional debt capital (Kv) is
required to grow at the sustainable growth rate?
(R600 x 13.65%)
Kt = R81,90
Ke = R? Kv = R?

Exercises:

• Class exercise 4: Winpro Ltd.

11. TOTAL LEVERAGE FACTOR (p. 88)
Financial leverage factor (financial risk)

= Return on equity
Return on total assets
= 2 (if Ro increases with 10% Re will increase with 20%)
Operating leverage factor (operational risk)

= % Change in operating profit
% Change in turnover
= 1,5 (If revenue increases with 10% profit will increase with 15%)

11. TOTAL LEVERAGE FACTOR (p. 88)
Financial leverage factor (financial risk)

= Return on equity
Return on total assets
= 2 (if Ro increases with 10% Re will increase with 20%)
Operating leverage factor (operational risk)

= % Change in operating profit
% Change in turnover
= 1,5 (If revenue increases with 10% profit will increase with 15%)
Total leverage factor (total risk)

= Financial X Operating leverage factor = 2 x 1,5
= 3 (If revenue increases by 10%, Return on equity will increase by 30%

Return on equity is 20% and R0 is 8%. Revenue increases with 8% and operating profit
with 12%. Calculate the total leverage factor.
Financial leverage factor

= Rentabiliteit van ekwiteit = 20 = 2.5
Ondernemingsrentabiliteit 8
Operating leverage factor

= % Verandering in bedryfswins
% Verandering in verkope
= 12
8
= 1.5
Total leverage factor If revenue increases with 10%, the return on equity will
= 2.5 x 1.5 increase by 37.5%
Exercises:

12. INFLUENCE OF FINANCING DECISIONS (p. 89)
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COMPONENT 5 – FINANCING DECISION

Photo by Stefan Els

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

• Statement of Financial Position

• What type of capital?

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Shareholders' equity Debt Capital

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Signal theory: Method of financing sends a certain signal to existing and

The Pecking order theory:

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

• Internal equity utilised first

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

• Existing number of issued ordinary shares = 100 000

EPS (1)= (1-t)(RoKinv – RvKv)

= (1-0,4)[(5% x 400 000) – (7% x 100 000)]

• Short-term sources (CL) – money market

• For this discussion assume that the enterprise utilises only

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

R60 000 X 8% p.j. = R4 800

R180 000/12 X 12% p.j. = R1 800

6.2 Conservative approach

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

• Aggressive – more profitable but higher risk

Financing plan Risk Total financing Profitability

Aggressive Highest R 6 600 Highest

Conservative Lowest R 7 200 Lowest

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

• PERMANENT CAPITAL REQUIREMENT per month

• VARIABLE CAPITAL REQUIREMENT per month

 What if unused capital is re-invested for periods of non-utilisation?

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

 Effective cost of variable capital requirement financed with long-term

rℓ = the effective cost of the LT credit

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

AGGRESSIVE VS CONSERVATIVE with REINVESTMENT

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

AGGRESSIVE VS CONSERVATIVE with REINVESTMENT

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Critical period = (PL – PC) x 365 days (12 months)

If n > CP: Conservative approach with reinvestment better

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

• Critical period (CP) = (PL – PC) x 12 months

Eg. n = 9 (3) & CP = 4

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

• Additional exercises: Problem 1

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

PECKING ORDER THEORY

o Issuing of new equity (external equity)

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Please read section 7 on page 79:

• Cumulative preference shares sometimes seen as semi-debt because

• Dividend rate pre-tax: = Preference dividend rate

• If pre-tax dividend rate < = positive leverage effect

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe

Dividends rate pre-tax = Preference dividend rate

Advantages and disadvantages of preference share capital over debt

Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe