Mancosa MBA Managerial finance. July 2012

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1 Mancosa MBA Managerial finance July 2012

2 Assignment requirements

3 Assignment requirements due 25 September 2012 Question 1: Lease or buy Question 2: Capital budgeting Question 3: Gearing Question 4: Working capital management EOQ

4 Further workshops

5 Further workshops Saturday 14 July 2012 (Pretoria) starter Sunday 22 July 2012 (Johannesburg) maths Saturday 28 July 2012 (Johannesburg) extra tuition workshops start (additional fee) Saturday 8 September 2012 (Johannesburg) - enrichment Saturday 15 September 2012 (Pretoria) - enrichment November 2012 additional exam prep workshops (additional fee) Saturday 10 November 2012 (Johannesburg & Pretoria) exam prep Wednesday 21 November 2012 exam

6 Course structure

7 Course structure Introduction Capital budgeting Business risk Long-term sources of finance Cost of capital Gearing and shareholders wealth Dividend policy Foreign risk management and project evaluation Working capital management Valuation, mergers and acquisitions

8 Section 1 - Introduction

9 Chapter outline The three types of firms Ownership versus control of corporations Financial markets

10 The three types of firms Sole proprietorship Easy to create Limited life Unlimited personal liability Business is owned and run by one person sole beneficiary of all profits and losses Not a separate legal entity Partnership Between two and 20 partners sharing profits and losses Unlimited personal liability for all partners Not separate from partners as individuals

11 The three types of firms Company Limited liability, legal entity separate from owners Private company Between one and fifty shareholders Participation by invitation Public company More than fifty shareholders May be listed or unlisted Close corporation 10 or fewer members Membership by invitation Reduced regulatory requirements

12 Shares and shareholders Capital of company divided into shares owned by shareholders Share capital calculated as: number of issued shares x par value

13 Shares and shareholders Share value The par value of a share is the price at which the shares were first registered. Market value of listed shares is at market trading price Directors value of unlisted shares determined by directors No par value shares are issued at a price specified by the directors Authorised share capital: share capital that company can acquire Issued share capital: shares issued (sold) multiplied by the par value Share premium: difference between par value and price

14 Shares and shareholders Classification of shares Preference shares Fixed dividend Preference right to dividends Dividends paid out if profits sufficient and depending on company s dividend policy Ordinary shares Considered for dividends after the preference dividends paid No fixed percentage; amount can vary from year to year

15 Shares and shareholders Reserves Profits and gains made by company forming part of shareholders claims Held in reserve Represent a source new finance Equity Equity is the value of ordinary shares and reserves of a company

16 Ownership versus control - agency relationship Ownership and control In a corporation, there may be thousands of shareholders, many with different priorities. Owners and managers have an agency relationship Managers may operate in their own interests rather than in the interests of shareholders

17 Goals of private sector companies Maximise profit Maximise shareholder wealth Corporate governance and ethics Social responsibility

18 Financial institutions and markets Financial institutions as intermediaries Financial markets Money market short-term funding Capital market long-term funding

19 Section 2 - Capital budgeting and cash flows

20 Capital budgeting and cash flows Techniques for making capital budgeting decisions Accounting profits Cash flows Accounting rate of return (ARR) Payback period Discounted payback period Net present value (NPV) Internal rate of return (IRR)

21 Capital budgeting Undertaking projects for future cash flows Affects expected profits Affects risks Expansion or major change of direction Increase revenues Decrease costs/improve efficiency Capital budgeting decisions exclude: Methods of finance Methods of working capital management

22 Techniques for making capital budgeting decisions Project evaluation/cost-benefit analysis Some basic techniques: Accounting rate of return (ARR) Payback period Discounted payback period Net present value (NPV) Internal rate of return (IRR)

23 Accounting profits Accounting profits affected by assumptions and distortions Assume profits before taxation

24 Cash flows To get from profit to cash flow: Add back non-cash items: Depreciation Amortisation Provisions, accruals Timing differences

25 Accounting rate of return (ARR) ARR is the average accounting profit as a percentage of the average project investment ARR % = average annual profits average investment 100 Where average investment = (book value at project start+book value at project end Compare calculated ARR to target ARR 2

26 Payback period Amount of time required to recover initial investment from cash inflows Annuity: divide initial investment by annual cash inflow Mixed stream of cash inflows: accumulate cash inflows until initial investment is recovered Compare payback period to acceptable payback period

27 Discounted payback period Time required for sufficient discounted cash flows to recover the initial cost of the investment. Use weighted average cost of capital for discounting Compare discounted payback period to acceptable payback period

28 Net present value (NPV) Subtracting project s initial investment from present value of its cash flows Discounted cash flows at a rate equal to the firm s cost of capital Measures both inflows and outflows in terms of present value

29 Internal rate of return (IRR) Discount rate that equates present value of cash inflows with the initial investment ie NPV = zero Annual compound rate of return earned

30 Factors affecting cash flow Relevant cash flows adjust for accruals, prepayments and depreciation Sensitivity of cash flows to changes in individual components eg Sales, variable and fixed costs Profitability delays in payments from debtors or payments to creditors Overseas projects tax allowances, tax rates, timing of tax payments, exchange rate fluctuations and inflation will affect cash flow

31 Practice question: capital budgeting (workbook page 4)

32 Practice question: capital budgeting

33 Practice question: capital budgeting

34 Practice question: capital budgeting

35 Practice question: capital budgeting

36 Practice question: capital budgeting

37 Practice question: capital budgeting

38 Section 3 - Business risk

39 Business risk Types of business risk Calculate returns of different share portfolios Risks associated with different portfolios Effect of standard deviations on different asset portfolios Effect of the co-efficient of variance on different asset portfolios CAPM as a measure of risk

40 Definition Risk: The chance of financial loss, ie assets having greater chances of loss are viewed as more risky than those with lesser chances of loss. (Flynn, 2000: 285)

41 Types of risk Business risk Arises from business environment Affects all companies in environment Management has very little control over business risk Operating risk Arises from operating activities Management has some control over operating risk Financial risk Relates to financing of firm Ability to repay debt Ability to repay interest on debt Total risk Combination of business, operating and financial risk

42 Risk management Use standard deviation and coefficient of variation (measures of dispersion) Systematic (entire system) vs unsystematic (specific investment) risk

43 Unsystematic risk The beta measures the volatility of the returns of the share relative to the overall market, which has a beta, β, of 1. A company with a beta greater than one is more volatile (risky) than the average, while a beta lower than 1 indicates less volatility.

44 Unsystematic risk CAPM (capital asset pricing model): R e = R f + (R m - R f ) Where, R e = return expected from share R f = risk free state of return (eg what a bank would pay, treasury bills) R m = return expected from market as a whole = beta (relative volatility) of share Beta requires statistical calculation of covariance of the share relative to whole market.

45 Business risk practice question (workbook page 13)

46 Business risk practice question

47 Business risk practice question

48 Business risk practice question

49 Business risk practice question

50 Business risk practice question (workbook page 16)

51 Business risk practice question

52 Business risk practice question

53 Section 4 - Long-term sources of finance

54 Long-term sources of finance Sources of long-term financing Equity financing and non-equity financing Retained earnings and debt financing as sources of finance Lease or buy decisions

55 Sources of long-term capital Equity financing Ordinary shares Owner capital Residual value: difference between total assets and total liabilities Not repayable except on dissolution Residual earnings after expenses and interest Not tax-deductible Shareholders have right of control

56 Sources of long-term capital Non-equity financing Preference shares Some of characteristics of ordinary equity and some of debt Typically have stated fixed dividend and can be redeemable (like debt) May be participating May have convertibility provision Not tax-deductible Ownership claim with reduced risk Generally have no voting rights

57 Sources of long-term capital New issues Sale of new shares Rights issues Gives existing shareholders opportunity to purchase shares Share splits and bonus issues Issued without payment to holders of existing ordinary shares

58 Sources of long-term capital Retained earnings Funds retained from cash flows generated during course of business May be paid as dividends or retained as source of finance

59 Sources of long-term capital Debt financing Borrowings for limited period of time No ownership claim on a firm Contractual agreement Has interest and capital payments Interest payments are tax-deductible

60 Sources of long-term capital Debentures Debt document or loan share Interest paid ahead of other dividends Future repayment Can be traded May be secured or unsecured

61 Sources of long-term capital Convertibles May be converted into ordinary shares under specific conditions Unsecured

62 Sources of long-term capital Loans Private contracts Secured by specific assets Or unsecured but with higher interest rate

63 Sources of long-term capital Warrants options to buy shares at given price within given period Can be traded

64 Sources of capital (more short-term) Bank overdrafts Expensive May require security Interest rate may fluctuate Bank loan Cheaper than overdraft but less flexible

65 Sources of capital Leases Funding of movable assets Lease vs buy: Lease: Lease payments are tax-deductible No legal ownership Buy: Requires funding with associated repayments Depreciation is tax-friendly Interest payments are tax-deductible

66 Sources of capital Grants and subsidies Venture capital

67 Practice question long term sources of finance: lease vs buy decision (workbook page 19)

68 Practice question long term sources of finance: lease vs buy decision

69 Practice question long term sources of finance: lease vs buy decision

70 Practice question long term sources of finance: lease vs buy decision (workbook page 21)

71 Practice question long term sources of finance: lease vs buy decision

72 Practice question long term sources of finance: lease vs buy decision

73 Practice question long term sources of finance: lease vs buy decision

74 Section 5 - Cost of capital

75 Cost of capital Capital asset pricing model (CAPM) Gordon growth model Weighted average cost of capital (WACC) Traditional approach Conventional approach Adjustments made to WACC using CAPM and Gordon growth model

76 WACC Traditional approach: Use market prices of source of capital Express all debt and capital as proportion of total Multiply cost of each source against weighting Conventional approach: As above, but debt is discounted

77 The capital asset pricing model (CAPM) CAPM allows investors to determine required rate of return on a share, based on risk associated with share. Expected return on risky investment depends on: R f = rate of return on risk-free investments = beta coefficient, systematic (market) risk of equity R m - R f = market risk premium Given this, cost of equity, R e, is: R e = R f + (R m R f )

78 Practice question on cost of capital: WACC (workbook page 33)

79 Practice question on cost of capital: WACC

80 Practice question on cost of capital: WACC

81 Practice question on cost of capital: WACC

82 Practice question on cost of capital: WACC

83 Practice question on cost of capital: WACC

84 Section 6 - Gearing and shareholders wealth

85 Gearing and shareholders wealth Effect of earnings per share on long-term loans Effect of gearing on share prices and WACC

86 MM (Modigliani and Miller) Theory based on efficient secondary capital markets Shareholders wealth should not change because of different methods of financing by a company: Value of a geared firm should be same as ungeared firm with the same expected cash flows Value should depend on these cash flows and business risk

87 MM s assumptions No transaction costs Borrowing and lending occur at same rates of interest for all Bankruptcy costs do not exist if a firm is wound up, shareholders receive market value shares K d does not increase as gearing rises until a very high level; to offset this increase there is a fall in k e There is no taxation (MM later considered taxation in their theory)

88 Optimal capital structure At low debt levels: Probability of bankruptcy and financial distress is low Benefits from debt outweigh the cost as firm benefits from interest tax shield At very high debt levels: Possibility of financial distress is great Benefits from debt financing may be off-set financial distress costs Optimal capital structure exists somewhere between extremes

89 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.

90 Leverage Amount of leverage (fixed-cost assets or funds) employed by firm directly affects risk, return, and share value Higher leverage raises risk and return Lower leverage reduces, risk and return Operating leverage is concerned with level of fixed operating costs Financial leverage focuses on fixed financial costs: eg interest on debt and preferred share dividends. Determined by capital structure mix of long-term debt and equity Major decisions need to focus on impact on the firm s value Only those leverage and capital structure decisions consistent with the firm s goal of maximising its share price should be implemented

91 Practice question on gearing: gearing & EPS (workbook page 49)

92 Practice question on gearing: gearing & EPS

93 Practice question on gearing: gearing & EPS

94 Practice question on gearing: gearing & EPS (workbook page 51)

95 Practice question on gearing: gearing & EPS

96 Practice question on gearing: gearing & EPS

97 Practice question on gearing: gearing & EPS

98 Section 7 - Dividend policy

99 Dividend policy Factors affecting dividend policy Dividend payment Other forms of dividends The relevance of dividend policy Types of dividend policies

100 Factors affecting dividend policy Legal constraints Contractual constraints Internal constraints Growth prospects Owner considerations Market considerations The clientele effect Signalling Agency considerations

101 Dividend payment Cash dividend payment Dividend reinvestment plans (DRP)

102 Section 8 - Foreign risk management and project evaluation

103 Foreign risk management and project evaluation Interest risk management Foreign exchange risk management Political risk Inflation Sunk cost Government intervention

104 Practice question on project evaluation (workbook page 52)

105 Practice question on project evaluation

106 Practice question on project evaluation

107 Section 9 - Working capital management

108 Working capital management The working capital cycles: operating cycle, cash cycle Working capital financing policies Management of working capital components Factoring Accounts payable management and inventory management Economic order quantity for inventory management

109 The working capital cycle Operating/working capital cycle Purchase of inventory Sale of product Payment received from customer Accounts payable period Inventory period Accounts receivable period Cash cycle Time Inventory paid for

110 The working capital cycle Operating cycle from when inventory is purchased to collection of payment from the customer = Inventory period + accounts receivable period Inventory period from procurement of inventory to sale of the end-product Accounts receivable period from sale of the end-product to receipt of payment from customer Cash cycle from when inventory is paid for to when the customer pays. Operating cycle - cash cycle = accounts payable period Accounts payable period from when inventory is procured to when inventory is paid for. Working capital management relates to time lag between cash outflows and cash inflows. (Ilk ova, 2001: 36)

111 Working capital requirements Firms require positive operating and cash cycle Require finance for inventories and receivables Need to monitor both cycles: Longer cycle may indicate slow-moving stock or collection inefficiencies Can be hidden by increased payables period Goal should be to shorten operating cycle without compromising efficiency Measures to ensure a shorter cycle: Reducing manufacturing and selling period Reducing accounts receivable period Lengthening accounts payable period

112 Working capital financing policies Forecast sales levels permanent and seasonal Need mix of short and long-term finance Three basic approaches: Conservative Aggressive Moderate

113 Conservative approach to working capital finance Long-term finance used to finance both permanent and proportion of seasonal current assets Little use made of short term finance eg trade creditors Relatively low investment in current assets eg debtors and inventory Can lead to stock-outs and the loss of credit customers Long-term finance is less easily raised, with more stringent repayment terms than short-term finance

114 Aggressive approach to working capital finance Short-term credit used to finance all seasonal and some permanent, current asset needs Investment in current assets is high with heavy reliance on trade creditors Can lead to opportunity costs involved in high inventory levels, bad debts due to large debtor book, and penalties for late payment or withdrawal of credit facilities by creditors Short-term debt interest rates lower than long-term rates Short-term funding easier to negotiate Repayment terms more flexible Short-term funding considered more risky as overdrafts are repayable on demand and interest rates can fluctuate

115 Moderate approach to working capital financing Firm attempts to match maturity of funding with lifespan of asset being financed Non-current assets and permanent current assets are financed by long-term finance; fluctuating seasonal current asset needs are financed through short-term funding Minimises the risk of not being able to meet maturing obligations Optimal policy lies somewhere in between conservative and aggressive approaches Management should attempt to reduce level of current assets as long as returns are greater than expected losses that could result from low investment in current assets ie strike balance between risk and return (Ilk ova, 2001: 38-39)

116 Cash management Cash and marketable securities are most liquid working capital items, but also most unproductive Cash on hand earns no income Marketable securities earn relatively low interest Reasons for holding cash or near-cash Transaction motive: to meet ordinary day-to-day payments Precautionary motive: reserves to cover unforeseen events Speculative motive: to take advantage of any unexpected discounts or bargain prices Loan covenants imposed by lenders, such as minimum cash balances in account, or required level of liquidity as a pre-requisite for loan Costs involved in maintaining cash or near-cash balances Opportunity cost of foregoing other more lucrative investments Cost of short-term funding required due to cash/near-cash being used for reasons above and not available to close gap between cash inflows and outflows. Can minimise financing requirements by speeding up collections and slowing down payments

117 Cash budget Primary tool in short-term financial planning Starting point of cash management decisions Forecast of cash receipts and cash payments for next planning period Estimates of timing and size of expected cash inflows and outflows and resultant cash surplus or deficit Enables firm to make timely arrangements with creditors or investment institutions when cash deficit is forecast and with investment advisors to invest forecasted surplus cash Enables firm to maintain optimal levels of cash Cash budgets can be prepared on daily, weekly, monthly, quarterly, bi-annual or annual basis Budgeted figures need to be reviewed regularly

118 Sources of short-term funding Bank overdraft: short-term bank loan with limit Letters of credit: used for international transactions, whereby issuing bank guarantees payment to third party Secured loans: loans secured by items such as book debts, a lien over stock, or personal guarantees Trade credit: repayment terms given by suppliers Acceptance credits: for larger companies to finance large trade transactions using bills of exchange (Ilk ova, 2001: 40) Factoring book debts; can include management of entire debtors collection process

119 Working capital management Credit management (management of debtors book) Inventory management Accounts payable management

120 Inventory management Three categories of inventory: Raw materials Work-in-progress (unfinished product) Finished goods The economic order quantity (EOQ) model: Frequent, smaller orders drive up ordering costs Less frequent, larger orders drive up costs of holding stock Model serves to establish optimal inventory level and re-order frequency, where total carrying and shortage costs of inventory are minimised, ie where carrying costs equal shortage costs Based on assumption that inventory is sold off at steady rate until zero stock Firm will restock back to optimal level of inventory Basic model can be adapted to accommodate reorder point, based upon safety (or buffer ) stock level and time for delivery

121 EOQ formula EOQ = 2TF CC Where T = total unit sales F = fixed cost per order CC = carrying cost per unit

122 ABC inventory management Divide all inventory items into three or more groups, in terms of inventory value, order lead time, shortage consequences and managerial effort: A group comprises all high value inventories Keep stocks down to a minimum Strictly monitored and tightly controlled Precision ordering is important B group items are of medium value Requires average-scale monitoring and control C group inventory comprise basic, inexpensive items Ordered in large quantities to ensure continuity of supply Monitoring and control is of least importance

123 Just-in-time (JIT) inventory management Goal of JIT is to minimise dependent inventories, thereby maximising turnover Have only sufficient inventory on hand to meet immediate production needs Inventory is reordered frequently Requires a high degree of co-operation from reliable suppliers Suppliers must be able to meet firm s needs at short notice Manufacture goods only when ordered by customer Required purchases are only made for particular order No stock problems arise; stock levels not an issue (Ross, 2001: 595)

124 Practice question on working capital management: working capital cycles (workbook page 67)

125 Practice question on working capital management: working capital cycles

126 Practice question on working capital management: working capital cycles

127 Practice question on working capital management: factoring (workbook page 73)

128 Practice question on working capital management: working capital cycles

129 Practice question on working capital management: working capital cycles

130 Practice question on working capital management: working capital cycles

131 Section 10 - Valuation, mergers and acquisitions

132 Valuation, mergers and acquisitions Valuation of target market Techniques used in asset based valuation Value the shares of a company using calculations related to EPS, ARR, dividend-yield and discounted cash-flow Mergers and acquisitions Methods of mergers and acquisitions Types of mergers and acquisitions Techniques used in evaluating mergers and acquisitions

133 Asset-based valuation: balance sheet valuation model Balance sheet valuation model: Provide fair reflection of the current circumstances Give reasonable indication of future prospects Show the net asset value (NAV): value of a business as difference between value of assets and value of liabilities Assets valued in balance sheet at book value not market value

134 Asset-based valuation: replacement cost valuation method Balance sheet valuations replaced my replacement cost values, ie market value Intangible assets don t have identifiable replacement costs, eg patents Represents the cost of establishing similar new company Can serve as the maximum value of a business

135 Asset-based valuation: realisable value method Often determines minimum value of business Realisable value of assets represents amount that can be received if business is closed down and assets sold off, after payment of any expenses associated with sale Often referred to as liquidation value Represents worst-case scenario where whole company is worth less than sum of assets Value of certain assets cannot be established until sale is made (Ilk ova, 2001: 73)

136 Earnings basis Price/earnings ratio Current market price of share Earnings per share Ie Market value of share = EPS PE ratio Can use expected future EPS, to give higher value to the shares PE valuation method requires estimate of projected earnings for the next year Listed companies have observable PE ratios Can apply to private companies by using listed company comparison with downward adjustment: Investment in private companies is riskier because of lower marketability of shares, implying that risk is not easily diversifiable. Pe ratio applicable to a private company reflects some unsystematic risk, and not only systematic risk Comparison to listed company may not be precise

137 Accounting rate of return Formula: Estimated future profits Required return on capital employed

138 Dividend yield Useful when dealing with unquoted companies Small shareholders don t have influence to affect decisions on future earnings; more likely to be interested in real return on investment, ie dividend yield Will want suitable price for giving up future dividends Assume future dividends will be constant, ie no expected dividend growth Formula: Divident in cents Market value = Expected dividend yield % Use dividend yields of some quoted companies in the same line of business

139 Discounted cash-flow Can calculate maximum price by estimating future cash flows and discounting Basic principles of investment apply, ie takeover needs to maximise shareholder wealth

140 Types of mergers and acquisitions Mergers Acquisition Proxy content Leveraged buyouts Management buyouts

141 Acquisition classification Horizontal merger Vertical merger Conglomerate merger 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) Synergy Positive incremental net gains associated with combination of two firms through merger or acquisition

142 Expected gains from mergers and acquisitions Revenue enhancement Marketing gains Strategic benefits Market power Cost reduction Economics of scale Economies of vertical integration Complementary resources Lower financing costs Lower taxes Net operating losses Unused debt capacity Asset write-ups Reduction in capital needs

143 Financing mergers Cash Cost of merger not affected by size of merger gains Shares Cost depends on gains because gains show up in post-merger share price

144 Practice question mergers & acquisition (workbook page 90)

145 Practice question mergers & acquisition

146 Practice question mergers & acquisition

147 Practice question mergers & acquisition

148 Enjoy and good luck!

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