MASTER OF BUSINESS ADMINISTRATION Financial Management

Transcription

1 MASTER OF BUSINESS ADMINISTRATION Financial Management Contact details: Regenesys Business School Tel: +27 (11) Fax: +27 (11)

2 Version Control: 5.9_e_f Date of Publication: July, 2014 Publisher: Regenesys Management Place of Publication: Sandton Document Change History Date Version Initials Description of Change 22 August CT Revised referencing 27 August _f FVS Formatting 4 September BT/CT Incorporating of SME comments 4 September e CK/CT Incorporating of SME comments 6 September _e_f FVS Formatting 19 February _e_f FVS Updating template 01 July _e_f CT Emerald articles 02 July _e_f SK Final Formatting This study guide highlights key focus areas for you as a student. Because the field of study in question is so vast, it is critical that you consult additional literature. Copyright Regenesys, 2014 All rights reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording or otherwise) without written permission of the publisher. Any person who does any unauthorised act in relation to this publication may be liable for criminal prosecution and civil claims for damages.

3 CONTENTS 1. WELCOME TO REGENESYS INTRODUCTION TEACHING AND LEARNING METHODOLOGY ALIGNING ORGANISATIONAL, TEAM AND INDIVIDUAL OBJECTIVES ICONS USED IN THIS STUDY GUIDE STUDY MATERIAL FOR THE MODULE RECOMMENDED RESOURCES RECOMMENDED BOOKS RECOMMENDED ARTICLES RECOMMENDED MULTIMEDIA ADDITIONAL SOURCES TO CONSULT LEARNING OUTCOMES CONTENT SCOPE AND LEARNING GUIDANCE GOALS OF STRATEGIC FINANCIAL MANAGEMENT PURPOSE FOR STRATEGIC FINANCIAL MANAGEMENT THE SARBANES-OXLEY ACT, KING III REPORT RISK AND RETURN CONCEPTS AND PRINCIPLES RISK, RISK PREFERENCES AND RETURNS DEFINED SOURCES OF RISK RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM) EVALUATION TECHNIQUES AND TIME VALUE OF MONEY FUNDAMENTALS OF PRESENT VALUE (PV) AND FUTURE VALUE (FV) NOMINAL VS. REAL INTEREST RATES (FISHER EFFECT) NOMINAL VS. EFFECTIVE INTEREST RATES THE ROLE OF TIME VALUE OF MONEY IN FINANCIAL MANAGEMENT LONG-TERM INVESTMENT DECISIONS THE CAPITAL BUDGETING DECISION-MAKING PROCESS CAPITAL BUDGETING TECHNIQUES THE COST OF CAPITAL AND LEVERAGING THE CAPITAL STRUCTURE CAPITAL STRUCTURING (LEVERAGE) DIVIDEND POLICY SHORT-TERM FINANCIAL DECISIONS WORKING CAPITAL MANAGEMENT SHORT-TERM FINANCIAL MANAGEMENT (CURRENT LIABILITIES) OVERVIEW OF MERGERS AND INTERNATIONAL MANAGERIAL FINANCE TERMINOLOGY RELATING TO MERGERS TRENDS IN MERGERS ACROSS THE WORLD STRATEGIC AND FINANCIAL REASONS FOR MERGERS INTERNATIONAL FINANCE REFERENCES APPENDIX A: SOLUTIONS

4 List of Tables TABLE 1: TIMING, CASH FLOWS AND RISK AS THEY RELATE TO WEALTH MAXIMISATION TABLE 2: SOURCES OF RISK TABLE 3: EXAMPLE OF MIXED STREAM CASH FLOWS TABLE 4: TIME VALUE OF MONEY IN FINANCIAL DECISION MAKING TABLE 5: CAPITAL BUDGETING TERMINOLOGY TABLE 6: INITIAL INVESTMENT AND OPERATING CASH FLOWS TABLE 7: CALCULATION OF PAYBACK PERIOD FOR PROJECT B TABLE 8: DECISION CRITERIA FOR PAYBACK PERIOD TABLE 9: DECISION CRITERIA FOR NPV TABLE 10: DECISION CRITERIA FOR IRR TABLE 11: DECISION CRITERIA FOR PI TABLE 12: ASSESSMENT UNDER THE SEVEN CS OF CREDIT TABLE 13: TRENDS IN MERGERS TABLE 14: THREE TYPES OF FOREIGN EXCHANGE RISK List of Figures FIGURE 1: MAXIMISING SHAREHOLDER WEALTH FIGURE 2: RETURNS ON EQUITIES VERSUS BONDS FIGURE 3: THE RELATIONSHIP BETWEEN RISK CATEGORIES FIGURE 4: GRAPHIC DERIVATION OF BETA FOR ASSETS R AND S FIGURE 5: EXAMPLE OF A TIMELINE OF CASH FLOWS FIGURE 6: FUTURE VALUE TECHNIQUE USES COMPOUNDING FIGURE 7: TIMELINE EXAMPLE FIGURE 8: CALCULATING THE PRESENT VALUE OF AN ORDINARY ANNUITY FIGURE 9: TIMELINES FOR THE CASH FLOWS OF PROJECTS A AND B FIGURE 10: NPV OF PROJECTS A AND B FIGURE 11: EXAMPLE OF AN NPV PROFILE... 56

5 1. WELCOME TO REGENESYS Have a vision. Think big. Dream, persevere and your vision will become a reality. Awaken your potential knowing that everything you need is within you. Dr. Marko Saravanja At Regenesys we help individuals and organisations achieve their personal and organisational goals by enhancing their management and leadership potential. We approach education and development holistically, considering every interaction not only from an intellectual perspective but also in terms of emotion and spirituality. Our learning programmes are designed to transform and inspire your mind, heart and soul, and thus allow you to develop the positive values, attitudes and behaviours required for success. Having educated more than students based in highly reputable local and international corporations across more than 160 countries since the inception of Regenesys in 1998, we are now one of the fastest-growing and leading institutions of management and leadership development in the world. Regenesys ISO 9001:2008 accreditation bears testimony to our quality management systems meeting international standards. Regenesys is accredited with the Council on Higher Education. Our work is rooted in the realities of a rapidly changing world and we provide our clients with the knowledge, skills and values required for success in the 21st century. At Regenesys you will be treated with respect, care and professionalism. You will be taught by business experts, entrepreneurs and academics who are inspired by their passion for human development. You will be at a place where business and government leaders meet, network, share their experiences and knowledge, learn from each other and develop business relationships. You will have access to a campus in the heart of Sandton, with the tranquillity of a Zen garden, gym and meditation room. We encourage you to embark on a journey of personal development with Regenesys. We will help you to awaken your potential and to realise that everything you need to succeed is within you. We will be with you every step of the way. We will work hard with you and, at the end, celebrate your success with you. Areas of Expertise Regenesys Business School 1

6 2. INTRODUCTION Welcome to the module on strategic financial management. We trust that you will find this module exciting and challenging. Financial management is a discipline that affects every area of business it is central, in particular, to the processes of resource transformation and shareholder value. At the heart of these processes is money, which fulfils three functions: It is a medium of exchange (e.g. acquisition of inputs and sale of outputs) It is a store of value (e.g. shareholder value) It is a unit of account (e.g. provides a comprehensive framework for comparing values of different resources and activities) The observations of the economist Geoffrey Crowther (1941:16) still hold true: Any substance or commodity that is to serve as money must perform these three functions. Together they constitute the invention of money. All later developments are merely refinements upon the primitive essentials. Money is one of the most fundamental of all Man s inventions. Every branch of knowledge has its fundamental discovery. In mechanics it is the wheel, in science fire, in politics the vote. Similarly, in the whole commercial side of Man s existence, money is the essential invention on which all the rest is based. In addition to the functions of money, this module is concerned with the relationship between the business and the providers of financial resources. Whilst business is concerned with several relationships e.g. with customers, employees its relationships with the providers of finance are central to the strategic decision-making process. Whether activities are located in the private sector or the public sector capital is required: Private sector: The capital required to exploit opportunities (e.g. economies of scale) is typically far beyond the resources of, say, the typical entrepreneur and his/ her immediate funds. Therefore, the financial markets, together with other funders (e.g. banks), provide such the necessary financial means. They are willing (according to their required levels of risk) to provide financial resources to the business without having to participate in the management of the business. Public sector: Governments face a constant mismatch between their own spending needs and funds raised through taxation. This means that governments, too, need funding mechanisms to tap the surplus savings in the economy (borrowing during times of fiscal deficit and repaying during times of surplus). Regenesys Business School 2

7 To gain the full benefit of this module (especially if you are not directly involved with financial management in your job), refer to and examine sources of financial information as they apply throughout the module; these include: Stock exchanges and other funding mechanisms worldwide; Financial information provided by listed companies (available on their websites); Financial news (online and print media); and The suggested reading provided in this study guide. Furthermore, be aware that there is nothing more constant in business than change. Be alert to these changes think systemically about their implications on the strategic financial management of your entity (e.g. the effect of crashing economies, changes in legislation, fluctuations in exchange rates, and changes in other key economic indicators, etc.). 2.1 TEACHING AND LEARNING METHODOLOGY Regenesys uses an interactive teaching and learning methodology that encourages self-reflection and promotes independent and critical thinking. Key to the approach utilised is an understanding of adult learning principles, which recognise the maturity and experience of participants, and the way that adult students need to learn. At the core of this is the integration of new knowledge and skills into existing knowledge structures, as well as the importance of seeing the relevance of all learning via immediate application in the workplace. Practical exercises are used to create a simulated management experience to ensure that the conceptual knowledge and practical skills acquired can be directly applied within the work environment of the participants. The activities may include scenarios, case studies, self-reflection, problem solving and planning tasks. Training manuals are developed to cover all essential aspects of the training comprehensively, in a user-friendly and interactive format. Our facilitators have extensive experience in management education, training and development. Please read through this study guide carefully, as it will influence your understanding of the subject matter and the successful planning and completion of your studies. Regenesys Business School 3

8 2.2 ALIGNING ORGANISATIONAL, TEAM AND INDIVIDUAL OBJECTIVES This module will draw on a model developed by Regenesys Management, demonstrating how the external environment, the levels of an organisation, the team and the components of an individual are interrelated in a dynamic and systemic way. The success of an individual depends on his or her self-awareness, knowledge, and ability to manage these interdependent forces, stakeholders and processes. The degree of synergy and alignment between the goals and objectives of the organisation, the team and the individual determines the success or failure of an organisation. It is, therefore, imperative that each organisation ensures that team and individual goals and objectives are aligned with the organisation s strategies (vision, mission, goals and objectives, etc); structure (organogram, decision-making structure, etc); systems (HR, finance, communication, administration, information, etc); culture (values, level of openness, democracy, caring, etc). An effective work environment should be characterised by the alignment of organisational systems, strategies, structures and culture, and by people who operate synergistically. Regenesys Integrated Management Model Regenesys Business School 4

9 3. ICONS USED IN THIS STUDY GUIDE Icons are included in the study guide to enhance its usability. Certain icons are used to indicate different important aspects in the Study Guide to help you to use it more effectively as a reference guide in future. The icons in this Study Guide should be interpreted as follows: Definition The definitions provide an academic perspective on given terminology. They are used to give students a frame of reference from which to define a term using their own words. Examples The example icon is used to indicate additional text that illustrates the content under discussion. This includes templates, simple calculations, problem solutions, etc. Video clip or presentation This icon indicates a hyperlink to a video clip or presentation on the subject matter for discussion. It is recommended that students follow the link and listen to or read the material it provides. Interesting source to consult The source icon is used to indicate text sources, from the internet or resource centre, which add to the content of the topic being discussed. In a nutshell This icon indicates a summary of the content of a section in the workbook and is used to emphasise an important issue. Calculations This icon indicates mathematical or linguistic formulae and calculations. Self-reflection Students complete the self-reflection activities in their own time. It requires students to think further about an issue raised in class or in the learning material. In certain instances students may be required to add their views to their assignments. Tasks The task icon indicates work activities that contact students must complete during class. These tasks will be discussed in class and reflected upon by students and facilitators. E-learning students can use these tasks simply to reinforce their knowledge. Note This icon indicates important information of which to take note. Regenesys Business School 5

10 4. STUDY MATERIAL FOR THE MODULE You have received material that includes the following: Study guide Recommended reading Assignment These resources provide you with a starting point from which to study the contents of this module. In addition to these, other resources to assist you in completing this module will be provided online via the link to this module. Guidance on how to access the material is provided in the Academic Handbook that you receive when you register for this module. 5. RECOMMENDED RESOURCES A number of recommended resources have been identified to assist you in successfully completing this module. 5.1 RECOMMENDED BOOKS The following book is highly recommended for this module: Gitman, L.J. 2010, Principles of Managerial Finance: Global and Southern African Perspectives, Cape Town: Pearson Education South Africa (Pty) Ltd. The following books also provide useful learning (available in the Regenesys Library): Marx, J., de Swardt, C., Beaumont Smith, M., and Erasmus, P. 2009, Financial Management in Southern Africa. 3 rd ed., Cape Town: Pearson Education South Africa. Firer, C., Ross, S.A., Westerfield, R.W., and Jordan, B.D. 2012, Fundamentals of Corporate Finance. 5 th South African ed., UK: McGraw-Hill Education (UK) Ltd. Please ensure that you order books well in advance to ensure that you do not delay the commencement of your studies for this module. It is highly recommended that you order and purchase all your books at the beginning of the year, immediately after registration. Regenesys Business School 6

11 5.2 RECOMMENDED ARTICLES The following articles are available on Emerald: Abor, J., and Fiador, V. 2013, 'Does corporate governance explain dividend policy in Sub-Saharan Africa?' International Journal of Law and Management, 55 (3), Britzelmaier, B., Kraus, P., Häberle, M., Mayer, B., and Beck, V. 2013, 'Cost of capital in SMEs', EuroMed Journal of Business, 8 (1), Lawrence, S.R., Botes, V., Collins, E., and Roper, J. 'Does accounting construct the identity of firms as purely self-interested or as socially responsible?' Meditari Accountancy Research, 21 (2), Lee, S.M., Noh, Y., Choi, D., and Rha, J.S. 2014, 'The effect of ISO on equity structure', Industrial Management and Data Systems, 114 (6), Olsen, R.A. 2014, 'Financial risk perceptions: a consciousness perspective', Qualitative Research in Financial Markets, 6 (1), Orobia, L.A., Byabashaija, W., Munene, J.C., Sejjaaka, S.K., and Musinguzi, D. 2013, 'How do small business owners manage working capital in an emerging economy?' Qualitative Research in Accounting & Management, 10 (2), Rashid, A. 2014, 'Firm external financing decisions: explaining the role of risks', Managerial Finance, 40 (1), Sirait, F., and Siregar, S.V. 2014, 'Dividend payment and earnings quality: evidence from Indonesia', International Journal of Accounting and Information Management, 22 (2), Talonpoika, A., Monto, S., Pirttilä, M., and Kärri, T. 2014, 'Modifying the cash conversion cycle: revealing concealed advance payments', International Journal of Productivity and Performance Management, 63 (3), The following articles are available online: Abraham, A. 2012, 'Replacement Chain Analysis NPV Method', (accessed 4 February 2013). Business Dictionary, 2013a, 'Discount Rate', (accessed 9 January 2013). Business Dictionary, 2013c, 'Opportunity Cost', (accessed 9 January 2013). Daily Finance, 2014, 'Cisco Systems Inc.', (accessed 2 July 2014). Regenesys Business School 7

12 Merger Market, 2012, 'Press Release: Mergermarket M&A Round-up for Q1-Q3 2012', (accessed 9 January 2013). Pettinger, T. 2012, 'Pros and Cons of Mergers', (accessed 4 February 2013). Raputsoane, L. 2009, 'The Risk-Return Relationship in the South African Stock Market', 14 th Annual conference of the African Econometrics Society on econometric modelling in Africa, Abuja, Nigeria, (accessed 15 December 2011). Additional articles that may prompt discussions and further assist you in completing this module will be saved on Regenesys Online under the relevant module. Please visit the site regularly to access these additional sources. 5.3 RECOMMENDED MULTIMEDIA The following links provide useful overviews of key topics in this study guide: Shszewczyk, 2012, 'Risk and Return Part 1: Individual Securities', [video] (accessed 28 January 2012). Du Plessis, K. 2011, 'Understanding Portfolio Beta', [video] (accessed 29 January 2012). Wall St. Training Self-Study, 2008, 'WST: 3.2 Finance 101 CAPM Simplified', [video] (accessed 28 January 2012). Wall St. Training Self-Study, 2008, 'WST: 3.4 Finance 101 WACC Defined and Calculated', [video] (accessed 28 January 2012). Bracker*, K. 2009, 'Expected Risk of Two Stock Portfolio', [video] (accessed 28 January 2012). Bracker*, K. 2012a, 'Capital Budgeting Part One, Introduction and Payback Period', [video] (accessed 28 January 2012). Bracker*, K. 2012b, 'Capital Budgeting Part Two (HP10BII) Calculating Internal Rate of Return Capital budgeting Internal Rate of Return (IRR)', [video] (accessed 28 January 2012). Bracker*, K. 2012c, 'Capital Budgeting Part Three (TI-BAII+) Calculating Net Present Value', [video] (accessed 28 January 2012). Bracker*, K. 2012d, 'Financial Ratios Gathering the Data', [video] (accessed 28 January 2012). Regenesys Business School 8

13 TeachMeFinance.com, 2008, 'Probability Distribution', [video] (accessed 28 January 2012). *It would be greatly beneficial to view the other multimedia in this series by Kevin Bracker. 5.4 ADDITIONAL SOURCES TO CONSULT As a higher education student, you are responsible for sourcing additional information that will assist you in completing this module successfully. Below is a list of sources that you can consult to obtain additional information on the topics to be discussed in this module: Emerald: NetMBA: MindTools: Brunel Open Learning Archive: ProvenModels: 12manage.com: Alliance Online: The Free Management Library: The Charity Village: Business Dictionary Business Day Live This is an online database containing journal articles that are relevant to your modules. Please refer to the attached Emerald manual to assist you to download required articles. Information on how to access Emerald is provided to you in your Academic Handbook. You will receive access to the database once you register as a student. This is one of several web addresses that provide a selection of MBA constructs and discussion. It is one of the better of these addresses. MindTools.com is a very useful source of ideas, constructs, management models, etc. with even more useful commentary and description. A Brunel University support-site that provides an easily accessible library of ideas, concepts, constructs techniques, tools, models, etc. ProvenModels' Digital Model Book presents digitalised management models categorised in a clear, consistent and standardised information structure to improve the usability and reusability of management literature. Management models are important generalisations of business situations when applied in context and are powerful tools for solving business issues. This is a website on which one can access numerous models as well as global comments on the models and principles. This could also serve as a place where you could voice your ideas and get feedback from all over the world. The Alliance for Non-profit Management's general introduction to strategic planning is built around 15 questions that cover just about all aspects in brief. (Click on Strategic Planning ) The Free Management Library can be used to improve your organisation, and for your own personal, professional and organisational development. This is by far the most comprehensive overview of all aspects of strategic planning covering all stages of the process. A series of twelve very short articles, by Ron Robinson, an independent Canadian consultant, appeared on Charity Village between November 2001 and October These articles are refreshing in that they do not advocate a one best way for all types of non-profit organisations. They discuss various way of approaching the strategic planning process. This site is useful for general terms and concepts. Enter your word or phrase in the search function (no need to log in) To keep up to date with business news National and World go to this site. Other useful selections include Opinions and Analysis, Markets, Economy, and Personal Finance. Regenesys Business School 9

14 There are many more sites and articles available that can help you to successfully complete module. You are encouraged to post the website addresses or URLs of any additional interesting sites that you come across on the Regenesys Learning Platform. In this way, you can assist other students to access the same wonderful information that you have discovered. A word of caution not all information available on the Internet is necessarily of a high academic standard. It is therefore recommended that you always compare information that you obtain with that contained in accredited sources such as articles that were published in accredited journals. 6. LEARNING OUTCOMES Upon completing this module, participants should be able to: Explain the principles of strategic financial management, control management and operational control frameworks; Describe and critically examine the fundamental roles and responsibilities of the financial manager of a listed company; Differentiate between business risk, financial risk and investment risk and apply tools to manage risk appropriately; Understand and critically examine the importance of the cost of capital in business decision making and outline the various methods of financing of capital and their respective impact on risk and return; Evaluate the impact of diversification on the expected return and risk of a portfolio of shares; Apply and critically examine valuation techniques used in calculating value; Synthesise concepts around international finance and its impact on business enterprises; Examine the context of credit policy, credit worthiness, debt collection and cash discount policy; Analyse the investment strategies followed by different companies; Critically analyse financial statements; Examine different types of mergers and debate the pros and cons of each; Demonstrate an analytical understanding of financial structuring; and Apply principles of sound financial management and corporate governance. Regenesys Business School 10

15 7. CONTENT SCOPE AND LEARNING GUIDANCE A number of topics will be covered to assist you in successfully achieving the learning outcomes of this module. It is important to study each of these sections to ensure that you expand your knowledge in the subject and are able to complete the required assessments. The sections that will be dealt with include: Section 1 Section 2 Section 3 Section 4 Section 5 Section 6 Goals of Strategic Financial Management Risk and Return Concepts and Principles Evaluation Techniques and Time Value of Money Long-Term Investment Decisions Short-Term Financial Decisions Overview of Mergers and International Managerial Finance A detailed framework of what is required for each of these topics follows under each section heading. A number of questions to probe discussion and guide you towards comprehension and insight are also provided. The timetable under each section heading provides guidance on the time to be spent to study each section. It is recommended that you follow the given timetable to ensure that you spend the appropriate amount of time on each section. Following the timetable will ensure that you have covered the required sections relevant to each assignment and have appropriate time to prepare for the examination. Regenesys Business School 11

16 7.1 GOALS OF STRATEGIC FINANCIAL MANAGEMENT Timeframe: Learning outcomes: Minimum 10 hours Describe and critically examine the fundamental roles and responsibilities of the financial manager of a listed company Explain the principles of strategic financial management, control management and operational control frameworks; Apply principles of sound financial management and corporate governance. Chapter 1 in Gitman, L.J. 2010, Principles of Managerial Finance: Global and Southern African Perspectives, Cape Town: Pearson Education South Africa (Pty) Ltd. Recommended reading: Chapters 1, 2 and 5 in Marx, J., de Swardt, C., Beaumont Smith, M., and Erasmus, P. 2009, Financial Management in Southern Africa. 3 rd ed., Cape Town: Pearson Education South Africa. Lawrence, S.R., Botes, V., Collins, E., and Roper, J. 'Does accounting construct the identity of firms as purely self-interested or as socially responsible?' Meditari Accountancy Research, 21 (2), Section overview: The objective of this opening section is to set the scene for the remainder of the study guide. As in all our other modules, we encourage you to think systemically and work on the principle of theory, application, reflection, and insight. Keep in mind that, at a strategic level, there may not always be absolute right answers, but rather decisions arrived at through best practice calculations and the weighing up of multiple factors in the best interest of the owners (shareholders) of the firm. Whilst the learning outcome apply principles of sound financial management and corporate governance is listed under this section, bear in mind that this is applicable throughout this module Purpose for Strategic Financial Management The goal of strategic financial management is to increase the value of the firm, thereby increasing the wealth of its owners (Marx et al., 2009:7). This is achieved through investment in assets that will add value to the firm and by keeping the firm s cost of capital as low as possible. As we progress through this module, you will become familiar with the decisions involved in achieving both of these goals. Regenesys Business School 12

17 Accountant versus Financial Manager It is useful to start by discussing the differences between the accountant and the financial manager ; as both have important roles to perform in the achievement of increased wealth. The financial manager and the accountant have diametrically opposed perspectives finance is about the future and accounting is concerned with the past. Therefore, the financial manager will make decisions about the future (future investment strategies including methods of financing with consideration for risks and returns) and the accountant will manage the firm s accounts (in which, the director s account to the owners for their past stewardship of the firm s assets and operations). Whilst the responsibilities of these two individuals are diametrically opposed, they are also interdependent rational decisions about the future rest on a rigorous analysis of the past. Hence, financial analysis is an important component of strategic financial management. A further polarity relates to the difference between the primarily inward-looking focus of the accountant and the primarily outward-looking focus of the financial manager; i.e. one deals in the outside world (particularly with financial markets) and one is constantly in touch with changes taking place in the environment. From the above, we can deduce that the financial management position is strategic in nature concerned with the direction and scope of the firm over the short to long term; which will, through its configuration of resources, add shareholder value. Roles and Responsibilities of the Financial Manager The Board, in consultation with management, sets the strategic, ethical, and financial module for the firm, with investors relying on management to implement that chosen module. The financial manager, together with the rest of the management team, must then communicate, to its investors and the public, the firm s performance, its financial condition, and any changes in strategy or corporate initiatives in a complete, effective and timely manner (according to International Accounting Standards). The roles and responsibilities of the financial manager are extensive. In the main, they include the following three broad areas (Kuhlemeyer, 2004): Investment decisions: o What is the optimal firm size? o What assets should be acquired? o What assets (if any) should be reduced or eliminated? Financing decisions (determine how the assets will be financed how the one half of the balance sheet will be financed by the other half of the balance sheet): o What is the best type of financing? o What is the best financing mix? o What is the best dividend policy (dividend pay-out ratio)? o When and how will the funds be physically acquired? Asset management decisions: o How do we manage existing assets efficiently? Regenesys Business School 13

18 The share price serves as a barometer for these business decisions together with the subsequent business performance. As you will see, return and risk are the key determinants of share price, which represents the wealth of the owners (shareholders) of the firm. Managers act as agents for the owners (shareholders) of the firm and, as such, the financial manager is also an agent of the firm. Agency theory suggests that agents will act in their own best interests. For example, if the financial manager s incentives are linked to profit maximisation then he/she may, for instance, defer maintenance costs, or make financing decisions based on profits with little regard for risk. Refer to The Agency Issue on pp in Principles of Managerial Finance (Gitman, 2010) Refer to The Agency Problem on pp in Financial Management in Southern Africa (Marx et al., 2009) Is it the financial manager s goal to maximise profits? The following example demonstrates why the firm s objective may not be to maximise profits (Gitman et al., 2010:12-14). Nick Dlamini, the financial manager of Neptune Manufacturing, a producer of marine engine components, is choosing between two investments Rotor and Valve. The following table shows the earnings per share (EPS) that each investment is expected to have over its three-year life. Remember, EPS is the amount earned during the period on behalf of each issued ordinary share, calculated by dividing the period s total earnings available for the firm s ordinary shareholders by the number of ordinary shares issued. Earnings per share (EPS) Investment Year 1 Year 2 Year 3 Total for years 1 to 3 Rotor R1.40 R1.00 R0.40 R2.80 Valve R0.60 R1.00 R1.40 R3.00 In terms of a profit maximisation goal, Valve would be preferred over Rotor, because it results in higher total earnings per share over the three-year period (R3.00 EPS compared with R2.80 EPS). However, is profit maximisation a reasonable goal in this case? No, it fails for a number of reasons - it ignores: The timing of returns Cash flows available to shareholders Risk. Gitman et al., (2010:12-14) highlight these concerns as shown in the table below. These three concepts timing, cash flow, and risk are vitally important, as you will see throughout this module. Regenesys Business School 14

19 Table 1: Timing, Cash Flows and Risk as they relate to Wealth Maximisation Timing Funds received sooner rather than later are preferred because the firm can earn a return on funds received earlier (the larger returns in Year 1 could be reinvested to provide greater future earnings). Profits do not necessarily result in cash flows available to shareholders (i.e. dividends or proceeds from selling shares for a higher price than initially paid). Greater EPS does not necessarily mean the firm s board of directors will vote to increase dividend payments. Cash flows Higher earnings per share (EPS) do not necessarily translate into a higher share price firms sometimes experience earnings increases without any correspondingly favourable change in share price. Only when earnings increases are accompanied by increased future cash flows, would a higher share price be expected. For example, a firm may reduce its maintenance expenditures and thereby increase profits, but because the reduced maintenance will result in lower product quality the firm will impair its competitive position and its share price will drop (many well-informed investors sell shares in recognition of lower future cash flows). In this case, the earnings increase is accompanied by lower future cash flows and, therefore, a lower share price. Profit maximisation also disregards risk (the chance that actual outcomes may differ from expected outcome). Remember, a trade-off exists between return (cash flow) and risk return and risk are in fact the key determinants of share price, which represents the wealth of the owners in the firm. Risk Higher cash flow is generally associated with a higher share price, but higher risk tends to result in a lower share price. In general, shareholders are risk-averse (they want to avoid risk). However, when risk is involved, shareholders expect to earn higher rates of return on investment. Hence, the differences in risk can significantly affect the value of an investment. (Adapted from Gitman et al., 2010:13) Task Question Select an investment decision made by your financial manager (or the financial manager in a firm with which you are familiar). Evaluate the decision in terms of timing, cash flows, and risk. Determine whether the decision was based on profit maximisation or wealth maximisation. What have you learned from this task? We can conclude that, because profit maximisation does not necessarily achieve the objectives of the firm s owners (shareholders), it should not be the primary goal of the financial manager: When considering each financial decision alternative or possible action in terms of its effect on the price of the firm s shares, financial manager should accept only those actions that are expected to increase share price. (Gitman et al., 2010:14) Regenesys Business School 15

20 The process below illustrates the above statement note that return (cash flows) and risk are the key decision variables in maximising owner wealth. Figure 1: Maximising Shareholder Wealth Financial Manager Financial decision alterna0ve or ac0on Return? Risk? Increase share price? No Yes REJECT ACCEPT (Gitman et al., 2010:14) Principals must provide incentives so that management can act in the principals best interests and then monitor results. Incentives may include, for example, stock options. In addition to these considerations, wealth maximisation does not preclude the financial manager from being ethically and socially responsible. Corporate governance is the system through which firms are managed and controlled in this regard The Sarbanes-Oxley Act, 2002 The Sarbanes-Oxley Act came into force in July 2002 and introduced major changes to the regulation of corporate governance and financial practices for companies listed in the USA (Sarbanes-Oxley, 2006; Gitman et al., 2010: 15). The Act emerged as a consequence of fraudulent disclosures and conflicts of interest. Task Research Review the information provided by Soxlaw.com ( on the Sarbanes-Oxley Act, 2002 as it relates to financial management. Identify the specific requirements as they relate to financial managers. Regenesys Business School 16

21 7.1.3 King III Report The King III Report rests with the Institute of Directors and includes: Ethical leadership and corporate citizenship; Boards and directors; Audit committees; The governance of risk; The governance of information and technology; Compliance with laws, rules, codes and standards; Internal audits; Governing stakeholder relationships; and Integrated reporting and disclosure. Refer to Appendix 1.1 on pp (responsibilities and frameworks for role players in improving corporate governance) in Financial Management in Southern Africa (Marx et al., 2009) Read the following journal article: Lawrence, S.R., Botes, V., Collins, E., and Roper, J. 'Does accounting construct the identity of firms as purely self-interested or as socially responsible?' Meditari Accountancy Research, 21 (2), Recap Questions 1. Consider the differences in the publicising of annual reports between private and listed companies; how listed companies are beholden to their shareholders (e.g. quarterly dividends in the USA); and other defining features between private and listed companies. Then discuss how the fundamental roles and responsibilities of the financial manager of a listed company differ from those of a private company. 2. Profit maximisation is a short-term approach, while wealth maximisation is based on long-term prospects. Discuss this statement, using examples to demonstrate an insightful understanding of the goals of strategic financial management. 3. Profit maximisation is not a reasonable goal. Critically evaluate this statement. 4. Discuss the King III Report in terms of providing an operational control framework. 5. Discuss the key differences between the King III Report and the Sarbanes-Oxley Act. 6. Describe the role of corporate ethics policies and guidelines and then discuss the relationship that is believed to exist between ethics and share price. Regenesys Business School 17

22 7.2 RISK AND RETURN CONCEPTS AND PRINCIPLES Timeframe: Learning outcomes: Minimum 20 hours Differentiate between business risk, financial risk and investment risk and apply tools to manage risk appropriately; Evaluate the impact of diversification on the expected return and risk of a portfolio of shares. Chapter 5 in Gitman, L.J. 2010, Principles of Managerial Finance: Global and Southern African Perspectives, Cape Town: Pearson Education South Africa (Pty) Ltd. Chapter 6 in Marx, J., de Swardt, C., Beaumont Smith, M., and Erasmus, P. 2009, Financial Management in Southern Africa. 3 rd ed., Cape Town: Pearson Education South Africa. Recommended reading: Olsen, R.A. 2014, 'Financial risk perceptions: a consciousness perspective', Qualitative Research in Financial Markets, 6 (1), Raputsoane, L. 2009, 'The Risk-Return Relationship in the South African Stock Market', 14 th Annual conference of the African Econometrics Society on econometric modelling in Africa, Abuja, Nigeria, (accessed 15 December 2011). Rashid, A. 2014, 'Firm external financing decisions: explaining the role of risks', Managerial Finance, 40 (1), Multimedia: Section overview: TeachMeFinance.com, 2008, 'Probability Distribution', [video] (accessed 28 January 2012). Bracker, K. 2009, 'Expected Risk of Two Stock Portfolio', [video] (accessed 28 January 2012). In this section, we will explore the fundamentals of how risk is measured and the methodologies to be utilised to minimise risk in a portfolio. When one is analysing projects within a firm and what the effect on the firm s net income will be, a clear understanding is required of the relationship between risk and return and how riskier projects undertaken can impact on the stability of the firm s reported net income. Remember that, although we are looking primarily from the perspective of a public company, the same principles and practices apply fully to any size and type of business Risk, Risk Preferences and Returns Defined Risk and Uncertainty The term risk is often used in the context of a potential hazard resulting from a chosen course of action. In terms of a financial management perspective, the degree of risk indicates the probability (or, in other words, the chance) that the actual outcome (or actual returns of a project) might differ from the expected outcome. Regenesys Business School 18

23 The terms risk and uncertainty are often used interchangeably but there is a difference between the two: Uncertainty infers that all of the possible outcomes of a project cannot be identified or that no probability can be attached to the possible outcomes of the alternatives. Risk implies that it is possible to attach probabilities to identified expected outcomes. Financial risk is: The possibility that shareholders will lose money when they invest in a company that has debt, if the company s cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors will be repaid before its shareholders if the company becomes insolvent. Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which would cause those bondholders to lose money. (Investopedia, 2013b) From the perspective of an investor, investment opportunities can be classified into two categories: Investment opportunities with certain outcomes (there is no expectation that actual outcomes and expected outcomes will differ) Investment opportunities with uncertain outcomes (some probability that the actual outcome and expected outcome will differ) An example of certain outcomes would be the investment in an 8%-one-year fixed deposit account with an established South African bank or, alternatively, investing in 6% RSA Retail Bonds which mature in five years time. Investment in RSA bonds may be viewed by some as having a measure of uncertainty in the event that the State does not honour its obligations, but this would imply that all other investments would be affected to the same degree. The State has the power to manage the economy through control of the money supply and other macroeconomic policies, and is therefore generally accepted as the benchmark of riskiness in a reasonably stable economy. Examples of investments with riskier outcomes could include the purchase of shares on a Stock Exchange or investment in the Greek economy (given its current economic state). Regenesys Business School 19

24 Risk Preferences and Return At this stage, a relevant question would be: Why would an investor prefer a risky investment to one that is essentially risk free? The answer lies in the concept of return. Total return can be defined as: The total gain or loss, over time, that is the result of a certain investment (the return includes the income, i.e. interest and/ or dividends and the capital gains relative to the investment). Return is retrospective or backward looking it describes what an investment has concretely earned. (Investopedia, 2013d) Note: yield, by contrast, is prospective or forward-looking. It measures the income (interest and/ or dividends) that an investment earns over a time period, and then annualised, and ignores capital gains with the assumption that the interest or dividends will continue to be received at the same rate (often used to measure bond performance). (Investopedia, 2013d) The most common measure of return (or return on investment) looks at the cash distributions received over the life of the investment as well as the change in value in that investment, expressed as a percentage of the initial investment value at the beginning of the period. An investor would be willing to invest in a higher risk investment to receive a higher return. However, this is not the only possible explanation for an investor choosing a higher-risk investment whilst other investors avoid these risky investments at all costs. The preference for risk is generally accepted to be a function of the utility that an investor derives from that particular investment. Historical Returns Returns on investments will vary over time and obviously between different types of investments. By averaging the returns received over a period of time, it becomes possible to eliminate the impact of market as well as other types of risk. Below is a table of returns on equities versus bonds for various countries from 1900 to 2007; sourced from the 2008 Annual Global Investment Returns yearbook, which is produced by ABN Amro Bank NV in association with the London School of Economics. Regenesys Business School 20

25 Figure 2: Returns on Equities versus Bonds (Dimson, March and Staunton, 2008:4) If we are to assess the risk of an investment based on the variability of the return for that investment, we need to be certain of what the return on that investment is, and exactly how to measure it. Let us recap what return means: Return is the total gain or loss experienced on investment over a given period of time; it is commonly measured as cash distributions during the period plus the change in value. It is expressed as a percentage of the beginning of the period investment value. Return can be expressed by the following formula (Gitman, 2010:207): r! = C! + P! P!!! P!!! Where: r! = Actual, expected, or required rate of return during period t C! = Cash flow received from the asset investment in the time period t 1 to t P! = Price (value) of asset at time t P!!! = Price (value) of asset at time t 1 Regenesys Business School 21

26 Consider the following example: Vicky s Vending Machines purchased its first food vending machine, The Fat Dispenser, on 1 January 2012 for R As at 31 December 2012 (one year later), the market value of The Fat Dispenser was R During 2012, the machine generated after-tax cash receipts of R Required: Calculate the annual rate of return (r) for the Fat Dispenser vending machine. Solution: Firstly, let us extract the values needed from the scenario above to calculate r using the formula above. From the information given: C! = Cash flow received from asset investment in the time period t 1 (1/1/2012) to t (31/12/12) = R2 000 P! = Price (value) of asset at time t = R P!!! = Price (value) of asset at time t 1 = R To calculate r for The Fat Dispenser =!!!!!!!!!!!!!! =!"!!!!(!"#!"#!!"#!!!)!"#!!! = = 11.5 % Regenesys Business School 22

27 Risk Preferences Perceptions of risk will vary between different firms and the executives who manage those firms. However, the three fundamental risk preferences are as follows: Risk-indifferent (or risk neutral) Risk-averse Risk-seeking Task questions 1. What are your risk preferences both as individual and as a manager and decision maker in your organisation? 2. How do you believe these preferences affect your decision-making rationale? 3. As a manager and employee, do you have a risk preference congruent with that of your organisation? The following graph and accompanying explanation illustrate the relationship between the three different risk preference categories: Figure 3: The Relationship between Risk Categories (Gitman et al., 2010:211) Regenesys Business School 23

28 With the risk-indifferent manager, the required return does not vary between the points of X 1 and X 2. In other words, as the risk increases, the required rate of return remains the same. In the real world of financial management, this approach would be totally unrealistic (particularly as far as the firm s shareholders are concerned). With regard to the risk-averse manager, the required (expected) return increases as the risk level moves right from X 1 to X 2. Due to the fact that they are averse to risk exposure, risk-averse mangers expect higher returns as compensation for the increased risk exposure. Finally, for the risk-seeking manager, the required return decreases for an increase in risk. Of course, in reality, this kind of behaviour may be detrimental to the organisation. In practice, most managers (investors/ shareholders) are risk averse and expect a higher return for a higher risk. When we study risk and return, we use this underlying (and realistic) assumption Sources of Risk The following are the broad categories of sources of risk facing financial managers and shareholders. Table 2: Sources of Risk Business Risk The probability (or chance) that the firm will not be able to cover its operating costs. This stems from the nature of the business itself, and includes the uncertainty inherent in the industry in which it operates. This is reflected by the variability of sales and the firm s fixed versus variable cost structure. This is known as the degree of operating leverage (DOL). The probability (or chance) that the firm will be unable to cover its financial obligations. This results from the practice of financing a part of the firm s assets with interest bearing debt, with the objective of increasing the return to the ordinary shareholders. The level of risk is driven by both its operating cash flows and the fixed cost financial obligations that the firm must meet. Financial Risk Total Company Risk As a result, the firm that faces fixed interest payment obligations is exposed to the risk of default versus the firm that is funded solely by shareholders funds. For example, if the firm is experiencing high sales, the return on assets invested is likely to be higher than the cost of debt. The result of this is that positive financial leverage is experienced, which enhances the return on equity. In recessionary times, the opposite occurs, which can result in the possibility of defaulting on creditor payments. This is known as the degree of financial leverage (DFL) Operating leverage and financial leverage combine to create what is termed the degree of combined leverage (DCL). Go to Popular sources of risk affecting financial managers and shareholders page 208, Table 5.1 in Principles of Managerial Finance (Gitman, 2010) Chapter 5: Risk and Return. Regenesys Business School 24

29 Risk of a Single Asset We will now begin to develop a conceptual framework of risk by firstly studying a single asset, and assuming that this asset is held in isolation. We will study the expected return behaviours to assess risk and finally utilise statistical models to measure that risk. Two tools that can be utilised to assess risk in any given asset are Scenario Analysis and Probability Distributions. Scenario Analysis This uses several possible outcomes (or scenarios) to assess the variability of returns. The analyst can possibly consider the following scenarios and their respective returns associated with each possible set of outcomes. Pessimistic (worst possible) scenario; Most likely scenario; and Optimistic (best possible) scenario. The range of the expected returns is used to measure the asset s risk. The range can be calculated by subtracting the return associated with the worst possible scenario (pessimistic) from the returns expected from the best scenario (optimistic). The greater the range, the more variability or risk associated with the asset. Consider the following example: Federal Investments Ltd faces a choice of two investments, X and Y. They would obviously prefer to choose the better of the proposed investments. Both investments require an initial investment of R , and they both have a most likely annual return of 12%. Management has brainstormed a list of three scenarios, which range from pessimistic through most likely to optimistic, as well as the expected annual returns associated with each possible scenario (remember the formula for expected rate of return above and the methodology used to calculate the return). The estimated returns associated with the three possible scenarios for assets X and Y are detailed in the table below. Asset X Asset Y Initial Investment: R R Annual Rate of Return: Pessimistic 11% 5% Most Likely 13% 13% Optimistic 15% 21% Range 4% 16% Regenesys Business School 25

30 In this example, looking at the ranges, Asset X has a range of 4% versus 16% for asset Y. This indicates that asset Y is far riskier than Asset X. The range indicates the variability of returns. The risk-averse manager would prefer Asset X because it offers the same most likely return as Asset Y, but with a lower associated risk. This methodology of scenario analysis and range is very unsophisticated and subjective, but it can help the decision maker to get an intuitive feel for the possible risks involved. Probability Distributions View the following video clips: TeachMeFinance.com, 2008, 'Probability Distribution', [video] (accessed 28 January 2012). Bracker, K. 2009, 'Expected Risk of Two Stock Portfolio', [video] (accessed 28 January 2012). Go to pages (explanation of probability distributions) in Financial Management in Southern Africa (Marx et al., 2009) Measures of Risk There are several statistical measures that can be used to quantitatively measure risk: Expected return, the standard deviation and the coefficient of variation (Marx et al., 2009: ; Gitman et al., 2010: ). Expected Return! Where: Expected return (r) = r!!!! p! n = number of possible states r! = the rate of return associated with the i th possible state p! = the probability of the i th state occurring Regenesys Business School 26

31 Standard Deviation The most common statistical indicator of an asset s risk is standard deviation, which measures the dispersion around the expected value (Marx et al., 2009: 110). Note: The higher the standard deviation, the higher will be the risk. The formula for standard deviation is as follows (Marx et al., 2009:110): σ = Where: σ = the standard deviation r = the expected return r i = the outcome associated with the i th state P = the probability associated with the i th outcome n i = 1 ( r i r ) 2 P i Coefficient of Variation The coefficient of variation (CV) measures the relative dispersion and can be utilised to compare the risks of assets and their respective expected returns (the standard deviation divided by the expected return). The CV measures the amount of risk per unit of expected return. The formula for coefficient of variation is as follows (Gitman et al., 2010:216): CV = σ! r Before starting with the following section on portfolio risk, please make sure you are comfortable with the concepts and calculations presented thus far. Refer to the recommended reading for supplementary information and examples. Regenesys Business School 27

32 Portfolio Risk In the real world of business, a single investment would not be viewed in isolation as done in the previous section. This was intended to simplify the situation for illustration and learning purposes. Any decision on a new investment must always be viewed in the context of its impact on the risk and return of the total portfolio of assets. The chief goal of a financial manager is to create and maintain an efficient portfolio. An efficient portfolio is one that Provides the greatest expected return for a given level of risk, or equivalently, the lowest risk for a given expected return (also called optimal portfolio). (InvestorWords, 2013). We will look at measuring the returns and the standard deviation of a portfolio of assets; and then we will investigate the concept of correlation and how to use this statistical measure to ensure risk diversification and, ultimately, develop an efficient portfolio. Portfolio Return and Standard Deviation The return on a portfolio is the weighted average of the returns on the individual assets that make up the portfolio. We use the equation below to calculate the weighted average (Marx et al., 2009: ; Gitman et al., 2010: ): R! = W! x r! + W! x r! + + (W! x r! ) Where: R p = the expected rate of return on a portfolio W A W Z = the proportion of the portfolio devoted to Securities A through Z (the sum of the W s = 1.0) r A r Z = the expected rates of return on Securities A through Z Consider the three shares C, D and E, with expected returns of 14%, 12% and 16%, respectively, in a portfolio comprised of 50% Share C, 25% Share D, and 25% Share E. The expected return on this portfolio is: R p= (W C x r C )+ (W D x r D) + (W E x r E) R P= [(0,50 14) + (0,25 12) + (0,25 16)]% = ( )% = 14% The standard deviation of a portfolio is calculated by taking into account the weights of the assets in the portfolio and the standard deviation of the assets as well as the correlation between the assets (the formula is not covered in this module). Regenesys Business School 28

33 Correlation, Diversification, Risk and Return Correlation can be defined as: A statistical measure of the relationship between two variables. Possible correlations range from a perfect positive correlation of +1 through to a perfect negative correlation of -1. A correlation of 0 indicates that there is absolutely no relationship between the variables: A correlation of -1 indicates a perfect negative correlation; meaning that, as one variable goes up, the other goes down. A correlation of +1 indicates a perfect positive correlation; meaning that both variables move in the same direction. Correlation between any two assets in a portfolio is calculated as: Correlation coefficient = COV!" σ! σ! Consider the following example: A portfolio has three assets: A, B and C. The table below represents the forecasted returns of the assets for the next five years, as well as their expected values and standard deviations. Forecasted Returns (Expected values and standard deviations for assets A, B, & C and Portfolios AB and AC) Assets Portfolios Year A B C AB (50% A & 50% B) AC (50% A & 50% C) % 24% 12% 18% 12% % 21% 15% 18% 15% % 18% 18% 18% 18% % 15% 21% 18% 21% % 12% 24% 18% 24% Statistics Expected Value 18% 18% 18% 18% 18% Standard Deviation % 4.74% Regenesys Business School 29

34 Notes on simplifying assumptions: 1. For the purposes of simplification and to clearly illustrate the concepts, identical returns flows are used but it is important to note that return flows do not have to be identical to be perfectly correlated. 2. It has been assumed that assets are divisible; that is, they can be divided and combined in the different portfolios this is for illustrative purposes only. Analysis: 1. As can be seen from the table above all assets have an equal return and equal risk (note the statistics section where the expected value and the standard deviations are identical). 2. The expected returns of A and B have a perfectly negatively correlated relationship their movement is exactly opposite; i.e. as A increases by 3% per annum, B decreases by 3% per annum. 3. The expected returns of A and C have a perfectly positively correlated relationship they move in exactly the same direction. 4. Portfolio AB has been created by combining the same proportions of A and B. The risk in this portfolio has been reduced to 0% (note the standard deviation of 0%) whilst the expected return has remained the same at 18%. Whenever returns on assets are negatively correlated, there is an optimal portfolio mix where the resulting standard deviation is equal to zero. 5. Portfolio AC is created by combining equal proportions of A and C, which are perfectly correlated assets. The risk in this portfolio (note the standard deviation is unchanged at 4.78) remains at 4.7% and the expected return value remains at 18% Risk and Return: The Capital Asset Pricing Model (CAPM) From an organisation s point of view, the composite risk of the firm as perceived by investors is the most critical aspect. The theoretical model for assessing risk is the capital asset pricing model (CAPM). Before we study the actual model, we must be clear about the two types of risk. Types of Risk The total risk of a security can be divided into two types of risk non-diversifiable risk and diversifiable risk. Diversifiable risk (or unsystematic risk) is the portion of an asset s risk associated with random causes that can be eliminated through diversification. This risk is firm-specific and examples include industrial action, regulatory constraints or the loss of a significant contract. Non-diversifiable risk (or systematic risk) is associated with market factors that affect all firms, and, most importantly, it cannot be eliminated through diversification. Examples of nondiversifiable risk could include recent events such as the unrest in Libya, inflation, and political events. Regenesys Business School 30

35 Due to the fact that investors can create a portfolio to eliminate most of the diversifiable risk, the only relevant risk to consider is non-diversifiable risk. Consequently, the investor or, alternatively, the firm must only be concerned with non-diversifiable risk; and this type of risk is therefore critical in selecting assets with the appropriate risk and return characteristics. The Capital Asset Pricing Model (CAPM) The CAPM links the non-diversifiable risk and the return on assets. [CAPM is] a model that describes the relationship between risk and expected return it is used to price securities. The general idea behind CAPM is that investors need to be compensated for investing their cash in two ways: (a) time value of money and (b) risk. (TheFreeDictionary, 2013b) Before we consider the model, it is important that we understand the function of the beta coefficient. From there, we will turn to the CAPM equation. Beta coefficient (βor b) The first component of the model is the beta coefficient. The beta coefficient is a relative measure of non-diversifiable risk. It is an index, which measures the movement of an asset s return as a response or reaction to changes in the market return. The market return: The return on the overall theoretical market portfolio, which includes all assets weighted for value. (Business Dictionary, 2013b) Beta coefficient: Refer to the following: A measure of sensitivity of a share price to movement in the market place. It measures systematic risk, which is the risk inherent in the whole financial system (cannot be diversified away). A beta of 1 means that the security or portfolio is neither more nor less volatile or risky than the wider market. A beta of more than 1 indicates greater volatility and conversely a beta of less than 1 indicates less volatility. For example a beta of 1.5 forecasts a 1.5% change in the return on an asset for every 1% change in the return on the market. (The Free Dictionary, 2013a) Raputsoane, L. 2009, 'The Risk-Return Relationship in the South African Stock Market', 14 th Annual conference of the African Econometrics Society on econometric modelling in Africa, Abuja, Nigeria, (accessed 15 December 2011). Regenesys Business School 31

36 The beta coefficient is calculated via a study of the historical return. When an asset s historical return is graphically represented, the historical data is plotted on a graph according to the coordinates of the actual returns as a percentage and the market return as a percentage at various points in time (Gitman et al., 2010:227). See the figure below. The figure shows the relationships between the returns of two assets (R and S) and the market return (horizontal x-axis). The vertical y-axis measures the individual asset s historical returns. Figure 4: Graphic Derivation of Beta for Assets R and S (Gitman et al., 2010:227) Beta is derived from the coordinates for the market returns and asset returns at various points in time. These market and asset coordinates are shown for asset S only for the years 2002 through 2009 (e.g. in 2009 asset S s return was 20% when the market return was 10%). The characteristic line that best explains the relationship between the asset return and the market return coordinates is fixed to the data points (Gitman et al., 2010:227). Interpretation of Beta The market beta is always considered to be 1. This is because we utilise beta as a relative measure to the market. All other betas are studied relative to this market value. Most beta values fall between 0.5 and 2.0. For example, Standard & Poor s 500 Index (S&P 500) has a beta coefficient (or base) of 1 (if the S&P 500 moves 2% in either direction, a stock with a beta of 1 would also move 2%). Regenesys Business School 32

37 Task Question Fill in the missing words: If a share has a beta of, it is half as responsive for each 1% change in the market. A share that has a beta of is twice as responsive as market changes and is expected to change by % for each change of 1% in the market. Calculation of Portfolio Betas The following formula is used to estimate the beta of a portfolio of assets (by using the betas of the individual assets): b! = W! x b! + W! x b! + + (W! x b! )! = W!!!!!!! Where: bp = the portfolio beta or volatility of the entire portfolio relative to the market A to Z = number of securities in the portfolio wj = proportion of the portfolio s total rand value represented by asset j bj = beta for security j Personal Finance Example (Gitman et al., 2010:229): Chris Oosthuizen, an individual investor, wishes to assess the risk of two small portfolios he is considering V and W. Both portfolios contain five assets, with the proportions and betas shown in the table below. Chris Oosthuizen s portfolios V and W Portfolio V Portfolio W Asset Proportion Beta Proportion Beta Totals Calculate the betas for the two portfolios b v and b w by substituting data from the table into the formula on the previous page. Regenesys Business School 33

38 b v = (0.10 x 1.65) + (0.30 x 1.00) + (0.20 x 1.30) + (0.20 x 1.10) + (0.20 x 1.25) = = b w = (0.10 x 0.80) + (0.10 x 1.00) + (0.20 x 0.65) + (0.10 x 0.75) + (0.50 x 1.05) = = 0.91 Portfolio V s beta is about 1.20 and portfolio W s beta is These values make sense because portfolio V contains relatively high beta assets, and portfolio W contains relatively low beta assets. Chris s calculations show that portfolio V s returns are more responsive to changes in market returns and are therefore more risky than portfolio W s. He must now decide which, if either, portfolio he feels comfortable adding to his existing investments. If Chris feels that the market is likely to perform well, then he is better off investing in Portfolio V since it will yield better returns than the market. However, if Chris feels that the market is likely to decline the Portfolio W will be a better investment since it will decline by less than the market decline. The CAPM Equation Now you have an understanding of the function of the beta coefficient (measures the nondiversifiable risk) we can move onto the capital asset pricing model (CAPM). r! = R! + b! r! R! Where: r! = required rate on asset j (weighted average cost of capital) R! = risk free rate of return (usually measured by a Government Treasury bill) b! = beta coefficient or index of the non-diversifiable risk for asset j r! = market return (return on the market portfolio of assets) Explanation of Components of Risk in the CAPM The risk components of the CAPM model can be divided into two components (Gitman et al., 2010: 230): Risk-free rate of return (R f ); Market risk premium (r m -R f ). The risk-free rate of return (R f ) is the required rate on a risk free asset (for example, a threemonth RSA Treasury bill, T-Bill). The market risk premium (r m -R f ) is the portion of the risk premium that investors must receive for taking the average amount of risk associated with holding the market portfolio of assets. Regenesys Business School 34

39 Example (Gitman et al., 2010: 230): Bhata Company, a growing computer software developer, wishes to determine the required return on an asset Z, which has a beta of 1.5. The risk-free rate of return is 7%; the return on the market portfolio as assets is 11%. Substituting b z = 1.5; R F = 7%; and r m = 11% into the CAPM yields a required return of: R z = 7% + [1.5 x (11% - 7%)] = 7% + 6% = 13% The market risk premium of 4% (11% - 7%), when adjusted for the asset s index risk (beta) of 1.5, results in a risk premium of 6% (1.5 x 4%). That risk premium, when added to the 7% risk-free rate, results in a 13% required return. The Security Market Line (SML) When the CAPM is depicted graphically, it is termed the security market line. This will be a straight line and reflects the required return for each level of non-diversifiable risk (beta). The risk, as measured by beta, is plotted on the x-axis and the required returns are plotted on the y-axis. The risk-return trade-off is represented by the coordinate points on the SML. Changes in the SML The SML is not static or stable over time. Shifts in the SML may be affected by two major market forces risk aversion and inflationary expectations (Marx et al., 2009: ). Factors that can affect a firm s beta could include external factors not within the management s sphere of control or, alternatively, changes over time in the firm s asset mix. Inflationary Expectations The equation for the risk-free rate of return is: Where: r = Real rate of interest IP = Inflation premium R! = r + IP Assuming a constant real rate of interest, changes in inflation premium will cause changes to the risk-free rate. Changes in the inflation premium can be the result of an event such as significant changes in, for example, the South African reserve bank policy and will obviously cause a shift in the SML. Regenesys Business School 35

40 Final thoughts on the CAPM CAPM mostly relies on historical data, so the betas might not always reflect the future variability of returns (the last few years of volatility in the world markets might bear testimony to this). These rates of return must be seen as approximations and often, in practice, subjective adjustments are made to take account of variable factors in the current market space. The second major underlying assumption is that the model is based on an efficient market (i.e. many smaller investors who have the same expectations and information with regard to securities, as well as having no restrictions on investment and are rational and risk averse). In addition, the model does not take account of factors such as transaction costs and taxes. Notwithstanding its limitations, the model is a useful analytical tool for evaluating and linking risk and return, and helps to offer a conceptual framework to create awareness of this trade-off that all investors ultimately face. Read the following journal articles: Olsen, R.A. 2014, 'Financial risk perceptions: a consciousness perspective', Qualitative Research in Financial Markets, 6 (1), Rashid, A. 2014, 'Firm external financing decisions: explaining the role of risks', Managerial Finance, 40 (1), Recap Questions 1. What is risk in the context of financial decision-making? 2. Define return, and describe how to find the rate of return of an investment. 3. Compare and contrast the three different risk preferences. 4. Explain how range is used in scenario analysis. 5. What relationship exists between the standard deviation and the degree of asset risk? 6. Explain why the correlation between asset returns is important in the context of asset valuation. 7. How are total risk, non-diversifiable risk and diversifiable risk related? Explain why non-diversifiable risk is the only relevant risk. 8. What risk does beta measure? How do you find the beta of a portfolio? 9. List and discuss each variable in the capital asset pricing model. Describe the market security line. Regenesys Business School 36

41 7.3 EVALUATION TECHNIQUES AND TIME VALUE OF MONEY Timeframe: Minimum 10 hours Learning outcome: Apply and critically examine valuation techniques used in calculating value. Chapter 4 in Gitman, L.J. 2010, Principles of Managerial Finance: Global and Southern African Perspectives, Cape Town: Pearson Education South Africa (Pty) Ltd. Recommended reading: Chapter 7 in Marx, J., de Swardt, C., Beaumont Smith, M., and Erasmus, P. 2009, Financial Management in Southern Africa. 3 rd ed., Cape Town: Pearson Education South Africa. Business Dictionary, 2013c, 'Opportunity Cost', (accessed 9 January 2013). Business Dictionary, 2013a, 'Discount Rate', (accessed 9 January 2013). Section overview: The challenge that financial managers and investors face is to invest available funds and earn a positive rate of return on these investments. This can result from investment in financially attractive projects or investment in interest-bearing securities or deposits. The timing of cash in- and outflows is an integral part of the decision criteria and can have significant economic implications. Time value of money is based on the fundamental belief that a Rand/ Dollar received today is worth more than a Rand/ Dollar received at some point in the future. We will begin by studying two perspectives of time value future value and present value. In addition, we will use this as a basis to study computational tools and also the basic patterns of cash flow in financial decision-making Fundamentals of Present Value (PV) and Future Value (FV) Present Value vs. Future Value Present value techniques measure cash flows at the start of a project s life (time zero). Future value is the cash you will receive at a given future date versus present value, which is cash that you have in your hands today. Timeline A timeline is a horizontal line that depicts events from time zero. The timeline in the figure overleaf shows a project of four years that starts with cash out flow at time zero of R5 000 (denoted by a minus sign). The positive values show cash inflows at year-end for Years 2, 3 and 4. Regenesys Business School 37

42 Figure 5: Example of a Timeline of Cash Flows (Gitman et al., 2010:146) Due to the fact that money has a time value, the cash flows depicted above must be measured at some point in time at either the end or the beginning of an investment s life. The future value technique uses compounding to find the future value of each cash flow and then sums up all these values to find the investment s future value. The figure below demonstrates this, with the arrows denoting the cash flows being compounded and summed at the end of the investment s life. The present value technique uses discounting to find the present value of each cash flow at time zero. This is depicted by the arrows flowing from each cash flow to the beginning of the project. In the solving of problems involving time value of money, it is always useful to draw a timeline to have an overview of the timing of the cash flows and assist in the calculation of the solution. Figure 6: Future Value Technique uses Compounding (Gitman et al., 2010:147) Regenesys Business School 38

43 Basic Patterns of Cash Flows Cash inflows and outflows can be classified as follows: 1. Single Amount a lump sum amount currently held or expected at some future date. 2. Annuity a level periodic cash-flow stream (we will work primarily with annual flows). 3. Mixed Stream a cash-flow stream that is not an annuity and consists of flows that do not follow any pattern. Single Amounts Future Value of a Single Amount Future value can be defined as the value at a given future date of a present amount placed on deposit today and earning interest at a specified rate. This can be calculated by applying compound interest over a specified period of time. Compound interest is the amount of interest earned on a given deposit that has become part of the principal amount at the end of the specified period. The term principal refers to the amount of money on which the interest is paid. R1 000 deposited into a saving account with a 10% rate of return, compounded annually, would result in an amount of R1 100 at the end of the first year. This is calculated as follows: Future value at the end of Year 1 = R1 000 x ( ) = R If the principal amount of R1 100 was left in the savings account for Year 2, the future value at the end of Year 2 would be calculated as follows: Future value at the end of Year 2 = R1 100 x ( ) = R The equation for the future value at the end of period n is as follows: FV = PV 1 + i! Where: FV = future value at the end of period n PV = initial principal amount, or present value. i = annual rate of interest paid n = number of periods. Regenesys Business School 39

44 Present Value of a Single Amount The concept of present value involves solving the following question: If I have the opportunity of earning i percent interest on my money, what would be the most I would be willing to pay now to receive FV Rand n periods from today? Remember, this process is the inverse of the compounding interest calculation. Now we are determining the present value of a future amount, assuming that we will earn a certain return on the money invested. This annual rate of return is referred to as: the discount rate, required return, opportunity cost, and cost of capital. Task Research Make sure you are familiar with the following terms as they apply to calculating value: Discount rate Opportunity cost We will explore cost of capital as it applies to the discount rate in more detail further on in this study guide. Familiarise yourself with the following terms 'Discount Rate': Business Dictionary, 2013a, 'Discount Rate', (accessed 9 January 2013). 'Opportunity Cost': Business Dictionary, 2013c, 'Opportunity Cost', (accessed 9 January 2013). Joe Smith has an opportunity to earn R1 000 one year from now. If Joe can earn 10% on his investment normally, what should he pay now for this investment opportunity? In order to solve this question, Joe must calculate how much he would have to invest at 10% today to earn a R1 000 in one year s time. If PV is equal to this unknown amount, and using the future value calculation as a basis, then: PV x ( ) = R Solving for this equation: PV = R1 000 = R ( ) The present value (value today) of R1 000 received in a year s time at a 10% opportunity cost is R What this means is that an investment of R today would result in a return of R1 000 in a year s time. Regenesys Business School 40

45 The equation for present value is as follows: PV = FV 1 + i! The following example further illustrates the use of this equation: Thabo would like to find the present value of R that will be received in five years time. Thabo s opportunity cost is 10%. FV 5 = R n = 5 i = 0.10 PV n = FV (1 + i) n = (1.10) 5 = R Task Question Compile a timeline to show the present value of Years 0 to 5 in the above example. Annuities An annuity is a stream of equal periodic cash flows over a specific period of time. Usually annual, these flows can also occur monthly (for example rent, car payments). These flows may be inflows or, alternatively, outflows. There are two types of annuities, namely an ordinary annuity (the cash flow occurs at the end of the period) or annuity due (the cash flow occurs at the beginning of the period). Calculating the Future Value of an Ordinary Annuity Consider that John wishes to calculate how much money he will receive at the end of five years if he invests in an ordinary annuity, which requires annual payments of R at the end of each of the five years into a savings account, paying 10% annual interest. Regenesys Business School 41

46 Let us start off by drawing a timeline: Figure 7: Timeline Example As the timeline demonstrates, John will have R in his account at the end of Year 5. The future value of the annuity can be calculated using the following formula: FVA! = PMT x FVIFA!,! Where: FVA! = future value of an annuity FVIFA!,! = future value interest factor of an annuity (refer to annuity tables) Therefore using the data from the example above: = R x 6,105 = R Calculating the Present Value of an Ordinary Annuity Consider that Angela would like to calculate the most she should pay to purchase an ordinary annuity that consists of payments of R at the end of each year for five years. She requires the annuity to provide her with a minimum of a 10% return. Let us start off, as usual, by drawing a timeline to illustrate the problem. Regenesys Business School 42

47 Figure 8: Calculating the Present Value of an Ordinary Annuity As the time line depicts, Angela should pay R The present values have been calculated using the formula for present value (PV) introduced above. The present value of the annuity can be calculated using the following formula: PVA! = PMT x PVIFA!,! = R x 3,790 = R The PVIFA can be found in the respective tables. Mixed Stream A mixed stream does not reflect any pattern (irregular cash flows). To find the present value of a mixed stream of cash flows, you must present value each amount in the manner described above and then add all the individual values to find the present value of the stream. Assume, for example, that you are planning on investing in a product that will provide the following revenue streams, each with different present value interest factors (Marx et al., 2009: ): Period Cash Inflow (R) Table 3: Example of Mixed Stream Cash Flows Present Value Interest Factors (12%) Present Value (R) Total Regenesys Business School 43

48 You should be able to complete calculations such as these using a financial calculator. Refer to page 149 in Financial Management in Southern Africa (Marx et al., 2009) Nominal vs. Real Interest Rates (Fisher Effect) The nominal interest rate is the annual rate by which many loans and financial instruments are quoted. However, this rate does not account for inflation (or deflation). Consider the following example. Suppose the inflation rate is 2% for the year. You can buy a basket of goods today and it will cost $100, or you can buy the same basket of goods next year and it will cost $102. If you buy a bond with a 5% nominal interest rate for $100 and sell it after a year, you will get $105 and buy the basket of goods for $102, you will have $3 left over. So, after factoring in inflation, your $100 bond will earn you $3 in income; a real interest rate of 3% (and not 5%). The relationship between the nominal interest rate, inflation, and the real interest rate is described by the Fisher Equation: Real Interest Rate = Nominal Interest Rate Inflation Nominal vs. Effective Interest Rates Another important concept to keep in mind is the difference between nominal and effective interest rates (Marx et al., 2009: ). The annual rate at which many loans and financial instruments are quoted is the nominal interest rate. However, the effective interest adjusts the nominal rate based on the frequency of compounding employed (e.g. quarterly, monthly, daily, etc.). i!"" = [1 + i!"# m ]! 1 Where: i!"" = The effective annual rate of interest i!"# = The nominal annual interest rate m = The number of compounding intervals per year Regenesys Business School 44

49 This is best explained in an example as shown below (Marx et al., 2009:158). A financial manager is evaluating two loans. Bank A quotes a nominal annual rate of 16.5% compounded semi-annually. Bank B quotes a nominal annual rate of 16.4% compounded daily. Which of the two loans should the financial manager select in order to obtain the lowest effective before-tax cost? Bank A: Bank B: i!"" = [ = x 100 = 17.18% ]! 1 i!"" = [ ]!"# 1 = x 100 = 17.81% Based on the objective of obtaining the lowest effective cost of financing, the loan offered by Bank A should be used, even though the nominal rate is higher. Task Questions 1. If you purchase a bond with a nominal interest rate of 9% and inflation is 5%, what is the real interest rate? 2. Consider a savings account that pays a nominal interest at 8% per annum, paid quarterly. Calculate the interest amount that is paid each quarter and the effective annual interest rate. Regenesys Business School 45

50 7.3.4 The Role of Time Value of Money in Financial Management The following table summarises the role of the time value of money in financial management decision-making. Table 4: Time Value of Money in Financial Decision Making Investment decisions Financial decisions Working capital management Valuation The initial outlay and subsequent cash flows associated with investment decisions are impacted by the time value of money employ capital budgeting techniques including the following, all of which employ time value of money techniques: Payback period Net present value Profitability index Internal Rate of Return (IRR) We will look more closely at these in the subsequent sections. When: Applying the EBIT-EPS approach to capital structure and Making decisions to lease or buy The business uses working capital, the excess of which should not lie idle (the investment of excess cash, the minimisation of inventories, or the stocking of faster moving inventories, the speedy collection of receivables, and the elimination of costly short-term financing all contribute to maximising the value of the business by taking the time value of money into consideration). The basic valuation model calculates the present value of the sum of all net cash inflows expected for the duration of the investment The value of and The value of ordinary and preference shares (Marx et al., 2009: ) Recap Questions 1. Describe the difference between future value and present value. 2. Describe the three basic cash-flow patterns: single amount, annuity and mixed stream. 3. How is the future and present value of mixed streams of cash flow calculated? 4. How would you calculate the growth rate on a series of cash flows? 5. Discuss the role of time value in finance, the use of computational tools, and basic patterns of cash flow. 6. Discuss how a firm s dividend policy may be affected by the time value of money. Should the postponement of cash dividends be considered (given our prior discussions on wealth maximisation versus profit maximisation)? Regenesys Business School 46

51 7.4 LONG-TERM INVESTMENT DECISIONS Timeframe: Learning outcomes: Minimum 30 hours Understand and critically examine the importance of the cost of capital in business decision making and outline the various methods of financing of capital and their respective impact on risk and return Demonstrate an analytical understanding of financial structuring Analyse the investment strategies followed by different companies Chapters 8-13 in Gitman, L.J. 2010, Principles of Managerial Finance: Global and Southern African Perspectives, Cape Town: Pearson Education South Africa (Pty) Ltd. Chapters in Marx, J., de Swardt, C., Beaumont Smith, M., and Erasmus, P. 2009, Financial Management in Southern Africa. 3 rd ed., Cape Town: Pearson Education South Africa. Recommended reading: Abor, J., and Fiador, V. 2013, 'Does corporate governance explain dividend policy in Sub- Saharan Africa?' International Journal of Law and Management, 55 (3), Abraham, A. 2012, 'Replacement Chain Analysis NPV Method', (accessed 4 February 2013). Britzelmaier, B., Kraus, P., Häberle, M., Mayer, B., and Beck, V. 2013, 'Cost of capital in SMEs', EuroMed Journal of Business, 8 (1), Lee, S.M., Noh, Y., Choi, D., and Rha, J.S. 2014, 'The effect of ISO on equity structure', Industrial Management and Data Systems, 114 (6), Sirait, F., and Siregar, S.V. 2014, 'Dividend payment and earnings quality: evidence from Indonesia', International Journal of Accounting and Information Management, 22 (2), In this section, we will learn about capital budgeting methods including cash flows. This data will be used in monitoring existing projects and as a basis for decision-making regarding investment in potential projects. Section overview: We will revisit risk and returns caused by the variability of cash flows and study techniques to calculate the cost of capital and understand the impact of financial and operating leverage in strategic financial decision-making. Other important decisions, including those regarding financial structuring and dividend policy, to be taken by financial managers are explored. Regenesys Business School 47

52 7.4.1 The Capital Budgeting Decision-Making Process Capital budgeting is the process of evaluating and ultimately selecting long-term investments projects that are consistent with the firms overall strategic goal of maximising shareholder wealth. In this section, we concentrate on evaluating investments in non-current assets, which can include property and plant and equipment, and which are ultimately revenue-generating assets that earn value for the firm. By capital expenditure, we mean expenditure outlay that is expected to yield profits over a longer timeframe (i.e. greater than one year). Steps in the Capital Budgeting Process The capital budgeting process consists of separate, but interrelated steps. Firstly, proposal generation is required, which entails the financial manager receiving proposals from different functional areas of the organisation and the review of these. Secondly, analysing the proposals to ascertain whether they are economically feasible and whether they are congruent with the strategic objectives of the organisation. Once the proposals have been analysed, they are then submitted to the executive management level to initiate the decision-making process. Following the decision-making process, and once approval has been granted, the implementation and monitoring phase begins. Basic Terminology used in the Capital Budgeting Process Before we start looking at the techniques of the capital budgeting process, we need to understand some basic terminology. Regenesys Business School 48

53 Table 5: Capital Budgeting Terminology Independent versus mutually exclusive projects Unlimited funds versus capital rationing Accept-reject criteria versus ranking approaches Conventional cash-flow patterns versus nonconventional cash-flows Sunk costs versus opportunity costs Independent projects are those where cash flows are completely unrelated and the acceptance of one project does not preclude acceptance of another project. Mutually exclusive projects can be described as competing projects ; in other words, the acceptance of one project eliminates or precludes acceptance of the other projects. Unlimited funds assumes that a firm has unlimited funds for investments, which makes capital budgeting a simple process. Under this scenario, all independent projects will be automatically accepted. In reality, however, the firm will typically operate under situations where constraints of capital exist and face a situation of capital rationing. This means that the firm has limited capital resources and projects compete for that pool of capital. The accept-reject approach involves making a decision on a project based on the project meeting certain criteria. On the other hand, the ranking approach involves ranking projects based on predetermined criteria (this could be, for example, the rate of return). Only acceptable projects should be ranked and this method is useful when selecting from a group of mutually exclusive projects, under a situation of capital rationing. A conventional cash-flow pattern consists of an initial outflow and the subsequent series of inflows. A non-conventional cash-flow pattern consists of an initial outflow and then a pattern of subsequent inflows and outflows. Sunk costs are cash outlays that have already been made, and therefore must not be taken into account when calculating the incremental cash flows of a current project. Opportunity costs represent cash flows that will not be realised as a result of employing the asset in the proposed project Identifying the Relevant Cash Flows In order to evaluate capital expenditure decision alternatives, the firm must ascertain what relevant cash flows actually are. Relevant cash flows can be defined as the incremental cash outflows and subsequent cash inflows. The term incremental means that these cash flows are additional cash out- and inflows. In other words, this encompasses the additional cash flows that are a direct result of the capital investment. Regenesys Business School 49

54 7.4.2 Capital Budgeting Techniques Once the firm has identified relevant cash flows, as discussed above, the cash flows are analysed to assess whether the projects are acceptable or not and to rank the projects. Capital budgeting techniques are available for performing such analyses. We will use the Smart Manufacturing case study to demonstrate the process and some of the techniques. To begin, we summarise the data. Smart Manufacturing Co is currently considering two projects: Project A and Project B: Project A requires an initial investment of R and Project B requires one of R The cash flows exhibit conventional cash-flow patterns. We will also assume the same level of risk and equal usable lives. The data is presented in the table overleaf and illustrated in the figure that follows. Table 6: Initial Investment and Operating Cash Flows Initial Investment Project A R Project B R Year Operating Cash Flows Operating Cash Flows 1 R R R R R R R R R R Figure 9: Timelines for the Cash Flows of Projects A and B Regenesys Business School 50

55 Now that the cash flows have been summarised, we can use various techniques to analyse the data. Payback Period The payback period is the time it takes the firm to recover its initial investment, as calculated from the cash inflows. In the case of Project A, the payback period is calculated as follows: Initial investment Annual cash flows = = 3 years The revenue stream will carry on into the future; however, after three years, the initial outlay will be recovered. Project B consists of mixed cash flow streams, so the calculation is not as simple. Table 7: Calculation of Payback Period for Project B Initial Investment Cash Inflows Balance Outstanding of Initial Investment Year 0 -R R Year 1 R R Year 2 R R Year 3 50% of R inflow Nil Therefore, the payback period on Project B is 2.5 years (Year 1 and Year 2 plus ½ of year 3). Note you only need R from the R in Year 3 as such you only need half of the third year to recover the rest of the investment. Table 8: Decision Criteria for Payback Period Accept the Project If the payback period is less or equal to the maximum acceptable payback period. Reject the Project If the payback period is greater than the maximum acceptable period. Pros and Cons of Payback Period Method This method is very appealing from an intuitive point of view as well as for ease of calculation. In addition, it considers cash flows and not accounting profits. It also highlights the risk element of the firm having to wait for payback of its initial investment. On the negative side, it is a highly unsophisticated method and does not take into account the time value of money and the cash flows that occur after the payback period. Regenesys Business School 51

56 The longer the firm must wait to recover its invested funds, the greater the possibility of a potential disaster from which it may not be able to recover. Therefore, the shorter the payback period, the lower the firm s exposure to such risk. The payback approach is typically used as a precursor to other techniques (screening method). Task Question Evaluate Projects A and B described above. What other data/ information would you need to make an informed decision? Would you accept Project B based on the data and payback method provided? Net Present Value (NPV) The NPV is the present value of cash inflows less the initial investment it reflects the amount of income that the project will produce at a pre-determined rate of return. It is calculated by subtracting the project s initial investment from the present value of the project s cash flows, discounted at a rate equal to, for example, the firm s cost of capital. NPV, because it takes into account the time value of money, is considered a more sophisticated capital budgeting technique than the payback method. The formula is as follows (Marx et al., 2009:304): NPV = n t = 1 CF t 1+ k ( ) t II Where: CF = cash flow k = discount rate (cost of capital) II = the initial investment Accept the project If the NPV is greater than 0 Reject the project If the NPV is less than 0 Table 9: Decision Criteria for NPV Regenesys Business School 52

57 If the NPV is greater than 0, the firm will earn a return greater than its cost of capital (because the cost of capital is the discount rate used to find NPV). If more than one project is being evaluated and they all have NPVs greater than zero, the projects can then be ranked according to further criteria. We will continue to use the Smart Manufacturing Company case study (refer to the data given under the payback method). The figure overleaf shows the NPV for both Projects A and B: R for Project A R for Project B Both projects are acceptable because their NPVs are greater than R0. If the projects were being ranked, Project A would be considered to be superior due to the fact that it enjoys a higher NPV. Pros and Cons of NPV Method This method has the advantage of providing the forecasted financial value/ contribution to shareholders. However, it does not show the return on funds invested as you will see with the Internal Rate of Return (IRR) method that follows (some managers prefer to see the rate of return). A disadvantage of the NPV method is that it requires you to make predictions, which means that, in most cases, the NPV calculation will not be 100% correct. Projects do encounter unforeseen costs (and windfalls) that will affect profitability. Figure 10: NPV of Projects A and B Regenesys Business School 53

58 Internal Rate of Return (IRR) Unlike the NPV method that provides a financial amount, the IRR determines the rate of return that equates to the investment opportunity of R0 (the present value of cash flows equals the initial investment). It is the compound annual rate of return that the firm will earn if it invests in the project and receives the value of IRR. n t = 1 CF t 1+IRR ( ) t = II Or as shown below: n CF t = 0 1+IRR t = 1 ( ) t II Accept the project Reject the project Table 10: Decision Criteria for IRR If the IRR is greater than cost of capital If the IRR is less than cost of capital This guarantees that the business is earning at least its required rate of return and ensures that the market value of the business will increase (or at least remain unchanged). Calculating IRR Manually calculating IRR is a tedious and cumbersome process. It involves a trial-and-error routine that eventually finds a discount rate that causes the project s present value of cash inflows to equal the initial investment (or, in other words, NPV to be equal to R0). Fortunately, most financial calculators, as well as spread sheets such as those in Microsoft Excel, have a pre-programmed IRR function. Using a financial calculator or an Excel spread sheet, the Smart Manufacturing Co illustration example is as follows: IRR for Project A = 19.99% IRR for Project B = 21.7% Comparing the two projects from an IRR perspective, and assuming the projects are mutually exclusive, Project B would be preferable. Regenesys Business School 54

59 Pros and Cons of IRR Method It is said that managers prefer to see the result of return as a percentage rather than a financial amount (better for comparative purposes). In some cases, where there are positive and negative cash flows in a project, the IRR method may yield more than one IRR. This is not a disadvantage if the calculations are performed correctly. Modified Internal Rate of Return (MIRR) As we saw with the IRR, it is assumed that the cash flows from a project are reinvested at the IRR. However, the modified IRR (MIRR) assumes that positive cash flows are reinvested at the firm s cost of capital, and the initial outlays are financed as the firm s financing cost (Investopedia, 2013c). Therefore, MIRR more accurately reflects the cost and profitability of a project. The formula for MIRR is: MIRR =! FV (Positive Cash Flows, Cost of Capital) PV (Initial Outlays, Financing Cost) 1 For example, assume that a two-year project with an initial outlay of $195 and a cost of capital of 12% will return $121 in the first year and $131 in the second year. To find the IRR of the project (i.e. NPV = 0): NPV = 0 when IRR = 18.66% calculated as follows: /(1 + IRR) + 131/(1 + IRR) 2 = 0 To calculate the MIRR of the project, we have to assume that the positive cash flows will be reinvested at the 12% cost of capital. So the future value of the positive cash flows are computed as: $121(1.12) + $131 = $ = future value of positive cash flows at t = 2 Now you can divide the future value of the cash flows by the present value of the initial outlay, which is $195, and find the geometric return for 2 periods. = sqrt($266.52/195) -1 = 16.91% MIRR As you can see, the 16.91% MIRR is materially lower than the IRR of 18.66%. In this case, the IRR gives a too optimistic picture of the potential of the project, while the MIRR gives a more realistic evaluation of the project. (Investopedia, 2013c) Regenesys Business School 55

60 Net Present Value Profile The NPV profile is a useful way of summarising the profitability characteristics of an investment in chart form. On the horizontal axis, you measure the different discount rates (cost of capital %); on the vertical axis, you measure the NPVs of the project/ investment. Since the IRR is the discount rate where the NPV of a project equals zero, the point where the NPV crosses the x-axis is also the project s IRR. Figure 11: Example of an NPV Profile (Investopedia, 2013a) Note that the crossover rate is where both projects have the same NPV and IRR. Profitability Index (PI) Also known as the cost-benefit ratio, this method measures the present value return per unit of currency invested. PI = Total present value of the net cash values Initial investment Regenesys Business School 56

61 Table 11: Decision Criteria for PI Accept/ reject the project Accept the project Reject the project If PI = 1, then the slightest change in any of the figures used for calculating the PI would cause you to either accept or reject the project. When PI is greater than 1, the acceptance of the project will enhance the value of the business. When PI is less than 1, the acceptance of the project will reduce the value of the business. Task Questions 1. Evaluate Projects A and B described above using the PI method. What conclusions can you draw? 2. Identify a range of projects in your organisation which method(s) would lead to the best decisions? Consider both the theoretical and practical implications of the methods. 3. Argue why financial managers might prefer/ not prefer the IRR method in your organisation. General points to consider: At high discount rates, a project s early year cash inflows count most in terms of its NPV. In general, the greater the difference between the magnitude and timing of cash inflows, the greater the likelihood of conflicting rankings. NPV and IRR are the generally preferred capital budgeting techniques, as both use the cost of capital as the required return. The appeal of NPV and IRR stems from the fact that both indicate whether a proposed investment creates or destroys shareholder value. In the decision between NPV and IRR, NPV is the theoretically preferred approach, whereas IRR is preferred because of its intuitive appeal. Financial values should not be used in isolation; due regard should be given to, for example, environmental factors, ethical issues, etc. Go to the following link to find out about Replacement Chain Analysis (the method of evaluating capital budgeting proposals with unequal or different lifespans): Abraham, A. 2012, 'Replacement Chain Analysis NPV Method', (accessed 4 February 2013). Task Questions Regenesys Business School 57

62 After completing these questions, refer to Appendix A for example responses. 1. What is NPV in finance? 2. What does NPV tell us/ show us? 3. What does an NPV of zero mean? 4. What is NPV analysis? 5. What is an NPV test? 6. What is an NPV profile? 7. What is NPV in financial management? 8. Explain IRR and compare this approach to NPV. 9. Discuss why NPV and IRR conflict. 10. Discuss the Payback approach. 11. What is MIRR? 12. Discuss why NPV is a better method to evaluate capital investments as compared to other methods. Mini Case Study Complete the following mini case study and then refer to Appendix A for a worked solution. Fitch Industries is in the process of choosing the better of two equal-risk, and mutually exclusive capital expenditure projects H and N. The relevant cash flows for each project are shown in the following table. The firm s cost of capital is 14%. Project H (Rand) Initial investment: Year Cash inflows Project N (Rand) 1. Calculate each project s payback period. 2. Calculate the NPV for each project. 3. Calculate the IRR for each project. 4. Summarise the preferences dictated by each measure you calculated, and indicate which project you would recommend. Explain why. 5. Draw the net present value profiles for these projects on the same set of axes, and explain the circumstances under which a conflict in rankings might exist. (Gitman et al., 2010:397) Regenesys Business School 58

63 7.4.3 The Cost of Capital and Leveraging the Capital Structure Defining the Cost of Capital The cost of capital is the rate of return that a firm must earn, on the projects in which it invests, to maintain the market value of its shares. In other words, it is the rate of return required by suppliers of capital to attract funds to the firm. Assuming risk is held constant, projects with a rate of return above the cost of capital will increase the value of the firm; for projects with a rate of return below the cost of capital, the converse will be true. Cost of capital is a critical financial concept and is the linkage mechanism between the firm s longterm investment decision and the wealth of its shareholders. Conceptual Framework for the Cost of Capital The cost of capital, estimated at a given point in time, reflects the expected average future cost of funds over the long term. Remember that, although capital is often raised in blocks, the cost of capital must reflect the interrelatedness of the capital structure. Firms, in practice, attempt to maintain an optimal level of debt and equity called the target capital structure. Basic Sources of Long-Term Funds The following are the basic sources of long-term funds: Long term debt Preference shares Ordinary shares Retained earnings The specific cost of each source is the after-tax cost of obtaining the funding today not the historically based cost. Cost of Long-Term Debt The cost of long-term debt ( ) is the cost today of raising long-term funds through borrowing. We will assume that the funds are raised through the sale of bonds and that the bonds pay annual interest. Regenesys Business School 59

64 Net Proceeds The net proceeds from the sale of a bond (or any security) are the funds actually received from the sale (the costs of the bond issue reduce the net proceeds). These costs include two components: Underwriting costs Administrative costs Before-Tax Cost of Debt There are three ways to obtain the before tax cost of debt: Method 1: Using cost quotations Method 2: Calculation Method 3: Approximation Method 1: Using Cost Quotations When the net proceeds from the sale of a bond equals its par value, the before-tax cost just equals the coupon interest rate. For example, a bond with a 105 coupon interest rate with net proceeds equal to the bonds R1 000 par value would have a before-tax cost ( ) of 10%. Another quotation that is utilised is the Yield to Maturity (YTM) on a similar risk bond. For example, if a similar risk bond has an YTM of 8%, then this can be used as the before tax cost of debt. Method 2: Calculating the Cost The before-tax cost of debt is found by calculating the internal rate of return (IRR) on the bond s cash flows. From the issuing firm s point of view, this value is the cost to maturity of the cash flows (payments) associated with this debt. For example, consider that Shoprite Holdings is investigating selling R10 million worth of 20-year, 9% coupon (stated annual interest rate) bonds, each with a par value of R Because similar risk bonds earn a return greater than 9%, the firm must sell the bonds for R980 to compensate for the lower coupon interest rate. The flotation costs are 2% of the par value of the bond (0.02 x R1 000 = R20). The net proceeds to the firm from the sale of the bond will be R960 (R980 R20). The calculation of the annual cost involves working out the cash inflows and outflows and then calculating IRR (remember: the discount rate that equates the present value of the outflows to the initial inflow). Regenesys Business School 60

65 The cash flows are as follows:- End of Year(s) Cash Flow Year 0 R960 (inflow) Years R90 (Interest payment outflows) 20 - R1000 (repayment of principal) Your financial calculator and an Excel spread sheet will reveal that the IRR is 9.452%. Method 3: Approximating the Cost The before-tax cost of debt ( following equation: ) for a bond with a R1 000 par value can be approximated using the R! = I +!!"""!!!!!!!!!"""! Where: I = annual interest in Rand N d = net proceeds from the sale of debt (i.e. bond) n = number of years to the bonds maturity For example, using the data from Shoprite example: R! = I + (!!"""!!! )! (!!!!!""" )! R! = R90 + (!!"""!!!"#)!!!"#!!!"""! R90 + R2 R! = ( R980 ) R! = 9.4% Regenesys Business School 61

66 After-Tax Cost The specific cost of financing must be stated on an after-tax basis. So far, we have calculated a before-tax cost. The reason for calculating an after-tax cost is that the interest payable on debt is a tax-deductible expense that reduces income for purposes of tax computations. The formula for calculating after-tax cost of debt ( ) is: r! = r! 1 T Where: r! = Before-tax cost of debt T = Tax Rate Assuming Shoprite Holdings pays tax at the rate of 30%, the after tax cost of the bond will be equal to: r! = = x 0.70 =6.6% Cost of a Preference Share The preference shareholders enjoy the right to receive their stated dividends before the firm can distribute any earnings to ordinary shareholders. Preference Share Dividends Preference shares can be stated as a Rand amount, for example R10 preference share. This means that the shareholder expects to receive R10 dividend for each year that they hold the shares. Preference shares can also be stated as an annual percentage rate. This rate represents the percentage of the shares par, (or face value), that equals the annual dividend. For example, an 8% preference share with a R50 par value would be expected to pay an annual dividend of R4 per share (8% x R50 par = R4). Note, however, that before the cost of a preference share is calculated, any dividends stated as a percentage should be converted into annual Rand dividends. Regenesys Business School 62

67 The equation for calculating the cost of a preference share r! is as follows: r! = D! N! Where: D! = Annual Rand dividend N! = Net proceeds from the sale of the share As an example, consider the following case: Shoprite is considering issuing a 10% preference share that is expected to sell for its par value of R87. The cost of issuing the share is R5. To calculate the cost of the share: Step 1: Calculate the Rand amount of the annual preference dividend (D! ). 10% x par value of R87 = 0.10 x R87 = R8.70 Step 2: Calculate the net proceeds per share that will be realised (N! ). Sales price minus flotation costs = R87 R5 = R82 Using formula given above: r! = D! N! r! = R8.70 R % Cost of an Ordinary Share The cost of an ordinary share is the return required on the share by investors in the market place. Regenesys Business School 63

68 Calculating the Cost of Ordinary Share Equity The cost of ordinary share equity is the rate at which investors discount the expected dividends of the firm to determine the share value. Two methodologies are used to calculate the cost of ordinary share equity: The constant growth model Capital Asset Pricing Model (CAPM) The Constant-Growth Model The value of a share is equal to the present value of all future dividends, which, in the Gordon Growth model, is assumed to grow at a constant rate. The equation for this model is as follows: P! = D! r! g Solving for r! = D! Where: P! + g Explanation of formula: = value of ordinary share = per-share dividend expected at the end of the year = constant growth rate in dividends = required rate of return on ordinary share The formula above shows that the cost of ordinary share equity is found by dividing the dividend expected at the end of Year 1 by the current share price (i.e. the dividend yield), and adding the expected growth rate (the capital gains yield). Note: Because ordinary share dividends are paid from after-tax income no tax adjustment is required. Regenesys Business School 64

69 For example, Shoprite Holdings wishes to calculate the cost of the ordinary share capital. The market price of the share is currently R50 per share. The firm is expecting to pay a dividend at the end of Year 1 of R4 per share. The dividend paid on the share in the last six years is as follows: Year Dividend per share 2009 R R R R R R2.97 Step 1: Calculate the growth rate over the last six years. Using a financial calculator, and using the earliest value (2004) as PV and using the latest value (2009) as FV we calculate the growth rate as 5.05% (round this to 5%). Step 2: Substitute the values into the formula given. r! = D! + g = R = = 0.13 = 13% P! R50 Assuming flotation costs of 11% per share, the cost of new shares will be given by: r! = D! P! F + g = R = = 0.14 = 14% R50 R5.56 Where F = Flotation costs in Rand Capital Asset Pricing Model (CAPM) Remember the formula we learnt earlier for the CAPM: r! = R! + b! r! R! Where: r! = required rate on asset j (weighted average cost of capital) R! = risk-free rate of return (usually measured by a Government Treasury bill) b! = Beta coefficient or index of the non-diversifiable risk for asset j r! = market return (return on the market portfolio of assets) Regenesys Business School 65

70 For example, Shoprite Holdings wants to calculate the cost of the ordinary share capital r! by using the CAPM model. The risk free rate (R f) is ascertained at 7%, the firm s beta (β) = 1.5. The market return (r m) is 11%. Using the formula for CAPM and substituting the values above, the company estimates the cost of ordinary share capital to be: r! = R! + b! r! R! r! = 7% % 7% r! = 7% + 6% r! = 13% Cost of Retained Earnings Dividends are paid out of a firm's earnings; therefore, this payment will reduce the firm s retained earnings. If a firm requires ordinary share equity financing, it has two choices: It can issue additional ordinary shares and still pay dividends to shareholders out of retained earnings; It can increase ordinary share equity by retaining the earning (i.e. not paying the cash dividends). Therefore, the cost of retained earnings is equivalent to the cost of a fully subscribed issue of ordinary shares and, therefore, the cost of retained earnings is: r r = r s In our example of Shoprite Holdings, the value of r r = 13%. Regenesys Business School 66

71 Weighted Average Cost of Capital (WACC) Now that we have learnt to calculate the cost of each specific source of financing, we can now determine the overall cost of capital. WACC (ra) is the expected average future cost of funds over the long term. It is calculated by weighting the cost of each specific type of capital by its proportion in the firm s total capital structure. WACC is calculated using the following formula (Gitman et al., 2010: 463): r! = w! + r! + w! + r! + w! + r!!"! Where: w! = proportion of long-term debt in capital structure w! = proportion of preference shares in capital structure w! = proportion of ordinary share equity in capital structure w! + w! + w! = 1.0 (i. e. the sum of the weights must be equal to 100%) Important points to remember: For ease of calculation, it is best to convert the weights into decimal form and leave specific costs in percentage terms. The sum of the weights must equal 1.0; meaning that all capital structure components must be accounted for. The firm s ordinary share equity weight, w!, is multiplied by either the cost of retained earnings, r r, or the cost of new ordinary share r n. Which cost is used depends on whether the firm s ordinary share equity will be financed using retained earnings r i, or new ordinary share r n. Make sure that you complete all of the recommended reading, including the worked examples. Regenesys Business School 67

72 For example, in the preceding sections we calculated the costs of the various types of capital as follows: Cost of debt (r i) = 6.6% Cost of preference share (r p) = 10.6% Cost of retained earnings (r r) = 13% Cost of new ordinary share = 14% The company uses the following weights in calculating its WACC: Source of Capital Weight Long-term debt 40% Preference share 10% Ordinary share capital 50% TOTAL 100% Since the firm expects to have a substantial amount of retained earnings available (R ), it plans to use its cost of retained earnings (r r) as the cost of ordinary equity. The calculations of WACC are as follows: r! = w! + r! + w! + r! + w! + r!!"! r! = % % % r! = 2.6% + 1.1% + 6.5% = 10.2% Read the following journal article: Britzelmaier, B., Kraus, P., Häberle, M., Mayer, B., and Beck, V. 2013, 'Cost of capital in SMEs', EuroMed Journal of Business, 8 (1), Regenesys Business School 68

73 7.4.4 Capital Structuring (Leverage) The capital structure of a firm is represented in the framework of various types of financing employed to acquire and support resources necessary for its operations. These include the longterm financing we have discussed above together with the short-term loans such as overdrafts and short-term liabilities (e.g. trade credit). Manipulating the capital structure: Each of the components of the capital structure bears a cost. By manipulating the composition of its capital structure, a firm can either raise or lower its WACC (Weighted Average Cost of Capital). For example, by including more of the cheaper debt capital in the capital structure, a firm may lower its WACC, even at the cost of increasing its financial risk. The lower the WACC can be made to be, and the higher the ROI above the WACC, the greater will be the value of the firm and hence the owners stake in the firm. The likelihood of the firm operating profitably will also increase accordingly. (Lovemore and Brummer, 2009:169) Make sure that you complete all of the recommended reading, including the worked examples, as they relate to leverage and capital structure. Read the following journal article to understand the systemic nature of management decisions: Lee, S.M., Noh, Y., Choi, D., and Rha, J.S. 2014, 'The effect of ISO on equity structure', Industrial Management and Data Systems, 114 (6), Regenesys Business School 69

74 7.4.5 Dividend Policy The dividend decision represents one of the most important financial decisions a business needs to take. The dividend decision can: Dividend policy is a decision about the amount of a business distributable profits paid to its shareholders the amount reinvested in the business itself. The business financing and investment policies will, to some extent, determine the formulation of the dividend policy and in turn, the dividend policy will also influence these two policies after being implemented. (Marx et al., 2009:404) 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 it must raise externally through borrowing or through the sale of ordinary preference shares. (Gitman et al., 2010:535) According to Marx et al. (2009: 405), the value of the business shares is not determined by its dividend policy. The market value is seen as a function of the earning potential and the risk of the business. Consider the extract below from the Shell Global website: Dividend Policy at Shell (Shell Global, 2013): Our policy of growing the US dollar dividend at least in line with inflation changed at the beginning of The new policy is to grow the US dollar dividend in line with our view of the underlying earnings and cash flow of Shell. When setting the dividend, the Board of Directors looks at a range of factors, including the macro environment, the current balance sheet and future investment plans. In addition, we may choose to return cash to shareholders through share buybacks, subject to the capital requirements of Shell. It is our intention that dividends will be declared and paid quarterly. Dividends are declared in US dollars and we announce the euro and sterling equivalent amounts at a later date. Dividends declared on Class A shares are paid by default in Euros, although holders of Class A shares are able to elect to receive dividends in sterling. Dividends declared on Class B shares are paid by default in sterling, although holders of Class B shares are able to elect to receive dividends in Euros. Dividends declared on ADSs are paid in US dollars. In September 2010, Shell introduced a Scrip Dividend Programme that enables shareholders to increase their shareholding by choosing to receive any dividends declared by the Board in the form of new shares instead of cash. Under the Scrip Dividend Programme, shareholders can increase their shareholding in Shell by choosing to receive new shares instead of cash dividends if declared by Shell. Regenesys Business School 70

75 Shareholders who do not join the Scrip Dividend Programme will continue to receive in cash any dividends declared by Shell. Task Question Reflect on Shell s dividend policy as shown above. Critically evaluate why Shell have adopted the Scrip Dividend Programme. Use your recommended reading to support your evaluations (see below). Refer to Factors affecting dividend policy on pages in Principles of Managerial Finance (Gitman, 2010). Refer to The factors that influence dividend policy on pages in Financial Management in Southern Africa (Marx et al., 2009). Read the following journal articles: o Abor, J., and Fiador, V. 2013, 'Does corporate governance explain dividend policy in Sub-Saharan Africa?' International Journal of Law and Management, 55 (3), o Sirait, F., and Siregar, S.V. 2014, 'Dividend payment and earnings quality: evidence from Indonesia', International Journal of Accounting and Information Management, 22 (2), Recap Questions 1. What are the five steps involved in the capital budgeting process? 2. Differentiate between the following sets of terms used in capital budgeting: 2.1. Independent vs. mutually exclusive projects; 2.2. Unlimited funds vs. capital rationing; 2.3. Accept-reject versus ranking approach; 2.4. Conventional vs. non-conventional cash flows. 3. How are the incremental (relevant) cash inflows that are associated with a replacement decision calculated? 4. Describe each of the following budgeting techniques as well as its strengths and weaknesses: 4.1. Pay Back Period; 4.2. Net present Value; 4.3. IRR. 5. Describe the importance of recognising risks in the analysis of capital budgeting projects. 6. Describe how to determine the cost of long-term debt and cost of preference shares. 7. Calculate the cost of ordinary share capital and convert it to cost of retained earnings. 8. Describe the term leverage, from the viewpoint of operating leverage, financial leverage and total leverage. 9. Discuss the key factors involved in establishing a dividend policy. 10. Describe the cash dividend payment procedures and the tax treatment of dividends. Regenesys Business School 71

76 7.5 SHORT-TERM FINANCIAL DECISIONS Timeframe: Learning outcomes: Minimum 20 hours Examine the context of credit policy, credit worthiness, debt collection and cash discount policy; Critically analyse financial statements. Chapters 14 & 15 in Gitman, L.J. 2010, Principles of Managerial Finance: Global and Southern African Perspectives, Cape Town: Pearson Education South Africa (Pty) Ltd. Chapters 3, 4, 9, 10 & 11 in Marx, J., de Swardt, C., Beaumont Smith, M., and Erasmus, P. 2009, Financial Management in Southern Africa. 3 rd ed., Cape Town: Pearson Education South Africa. Recommended reading: Daily Finance, 2014, 'Cisco Systems Inc.', (accessed 2 July 2014). Orobia, L.A., Byabashaija, W., Munene, J.C., Sejjaaka, S.K., and Musinguzi, D. 2013, 'How do small business owners manage working capital in an emerging economy?' Qualitative Research in Accounting & Management, 10 (2), Talonpoika, A., Monto, S., Pirttilä, M., and Kärri, T. 2014, 'Modifying the cash conversion cycle: revealing concealed advance payments', International Journal of Productivity and Performance Management, 63 (3), Section overview: In this section, we will study working capital management from the perspective of two fundamental areas of short-term financial management: current asset and current liabilities management. In particular, our focus is on credit policy, credit worthiness, debt collection and cash discount policies. The analysis of financial statements using ratio analysis will also be covered in the final part of this section this is key to determining financial performance and the condition of the business Working Capital Management Short-Term Financial Management Current Assets The goal of short-term financial management is to manage each of the firm s current assets (which can consist of inventories, accounts receivable, cash and short-term investments) and current liabilities (accounts payable, accruals and short-term borrowings) in order to achieve a balance between profitability and risk. Regenesys Business School 72

77 Net Working Capital Current assets (or working capital) represent the portion of investment in the firm that circulates from one form to another. For example, cash gets converted into inventories, which then get sold to customers on credit. The inventory has then been converted into accounts receivable. After an agreed period, the customer then pays the debt to the firm, and the accounts receivable then gets converted into cash again. The essence of working capital management is to manage this circulation process. Net working capital can be defined as the difference between the firm s current assets and its current liabilities. Current liabilities are normally easy to manage and forecast. A liability that is incurred is normally subject to an agreement, which states when the cash out flow will have to take place. The process of converting current assets (e.g. accounts receivable) into cash (i.e. to allow for cash inflows that will be used to pay the current liabilities) is not always easy to predict, and leads to a level of uncertainty of cash inflows. The more predictable the cycle, the less net working capital the firm requires. Because of the difficulty of matching cash in- and outflows, the firm must ensure that it has more current assets than current liabilities. This will ensure that the firm can pay the accounts payable when they fall due. Trade-Off between Risk and Return A trade-off exists between a firm s profitability and its risk. Profitability can be defined as the relationship between revenue and costs generated using the firms fixed and current assets. A firm can increase profits by increasing revenue or decreasing costs. Risk, from the perspective of short-term financial management, is the possibility that a company will not be able to pay accounts payable as they fall due. A firm in this predicament is described as being technically insolvent. The higher the net working capital; the more liquid the firm and the lower the risk exposure. Changes in Current Assets When current assets (expressed as a percentage of total assets) increase, profitability decreases. The underlying reason for this is that current assets are less profitable than non-current assets. Non-current assets are more profitable because they add more value to the product. The firm could not produce output without non-current assets. Regenesys Business School 73

78 Changes to Current Liabilities If we study the ratio of current liabilities to total assets, we see an indication of the amount of total assets that have been financed with current liabilities. When the ratio of current liabilities to total assets increases, the profitability increases. This is because only short-term borrowings attract interest cost. The other current liabilities (for example, trade payables) do not attract a cost (assuming of course, that the payables are paid on time and punitive interest is not charged). This occurs because the firm uses more of the less expensive current liabilities for financing. From a risk perspective, when the current liabilities increase, the risk of technical insolvency increases. The risk of increasing current liabilities is that the net working capital also decreases. Operating Cycle (OC) The firms operating cycle (OC) is the time elapsed from the production of the product to the collection of cash from the finished product. Two major components of this cycle are inventories and accounts receivable. Calculating the Operating Cycle (OC) OC = AAI + ACP Where: OC = operating cycle ACP = average collection period the average time it takes to collect trade receivables AAI = average age of inventory Funding Requirements of the Operating Cycle Permanent versus Seasonal Funding If a firm s sales are constant, then investment in operating assets should also be fairly constant and the firm should have only permanent funding requirements. By contrast, if the firm experiences cyclical sales, then this will result in fluctuations in operating assets. The result will be that the firm has seasonal funding requirements in addition to the permanent requirements needed for minimum operating assets. Regenesys Business School 74

79 Aggressive versus Conservative Seasonal Funding Strategies Under a conservative funding strategy, the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt. In the case of an aggressive funding strategy, the firm funds both its seasonal and permanent requirements with short-term debt. Short-term funds are normally less expensive than long-term funding. However, long-term funds allow the firm to lock in its cost of funds (cost of capital) over a longer period of time, and thus avoid the risk of increases in short-term interest rates (ensures the firm has the required funds when needed). With short-term funds, the firm faces the risk that it may not be able to access funds to cover seasonal fluctuations. Strategies for managing the Operating Cycle The overriding objective is to minimise the length of cash conversion cycle, which minimises negotiated liabilities. This goal may be achieved through the use of the following strategies: 1. Turn inventory over as quickly as possible, but do not run out of inventory. 2. Collect trade receivables as quickly as possible, but do not lose business through unnecessary high-pressure tactics. 3. Pay trade receivables as slowly as possible, but do not ruin the firm s reputation. 4. Ensure effective administration procedures are in place to expedite collection and delivery systems. Cash Conversion Cycle (CCC) The following explains the process of how to calculate the cash conversion cycle. The Calculation To calculate CCC, you need several items from the financial statements: Revenue and cost of goods sold (COGS) from the income statement Inventory at the beginning and end of the time period Accounts Receivable (AR) at the beginning and end of the time period Accounts Payable (AP) at the beginning and end of the time period The number of days in the period (year = 365 days) Inventory, AR and AP are found on two different balance sheets. If the period is a quarter, then use the balance sheets for the quarter in question and the ones from the preceding period. For a period of a year, use the balance sheets for the quarter (or yearend) in question and the one from the same quarter a year earlier. Regenesys Business School 75

80 This is because, while the income statement covers everything that happened over a certain period of time, balance sheets are only snapshots of what the company was like at a particular moment in time. For things like AP, you want an average over the period of time you are investigating, which means that AP from both the time period's end and beginning are needed for the calculation. Calculating the Cash Conversion Cycle (CCC): CCC = AAI + ACP APP = OC APP (remember OC = AAI + ACP) Where: APP = average payment period Calculate the Cash Conversion Cycle The data below is from Barnes & Noble's 10-K reports filed for the fiscal years ending January 28, 2006 (fiscal year 2005) and January 29, 2005 (fiscal year 2004). All numbers are in millions of Dollars. Item Fiscal Year 2005 Fiscal Year 2004 Revenue Not needed COGS Not needed Inventory AR AP Average Inventory ( ) / 2 = Average AR ( ) / 2 = 95.3 Average AP ( ) / 2 = Now, using the above formulas calculate the Cash Conversion Cycle (CCC): Answer Days Inventory Outstanding (DIO) = $ / ($ / 365 days) = days Days Sales Outstanding (DSO) = $95.3 / ($ / 365 days) = 6.8 days Days Payable Outstanding (DPO) = $787.0 / ($ / 365 days) = 81.3 days CCC = = 59.2 days Inventory Management One of the critical elements of the cash conversion cycle is average age of inventory. The objective is to turn the inventory as quickly as possible, but guard against stock outs. Regenesys Business School 76

81 Techniques for Managing Inventory The following techniques are commonly used for managing inventory: ABC System Economic Order Quantity (EOQ) Just-in-time (JIT) Computerised systems for inventory control ABC System The inventory is divided into three basic groups on the criteria of monitoring levels and size of investment. The A Group receives the most intensive monitoring because of the high investment and is normally monitored on a perpetual stock system. The B Group is monitored on a periodic monitoring basis, perhaps weekly, with the C Group being monitored less frequently. This method ensures that management resources are utilised more effectively, efficiently and economically by focusing on the more critical inventory items (Marx et al., 2009: ). Economic Order Quantity (EOQ) The economic order quantity (EOQ) model determines the optimal order size for inventory items. It takes into account various inventory costs and then calculates what inventory costs minimises these costs. The costs are divided into order costs, carrying costs, and stock-out costs. Carrying Costs are the variable costs per unit of holding inventory for a specified period of time. These can include storage costs, insurance costs, costs of deterioration, obsolescence and the opportunity costs of investing funding inventory. Carrying costs are stated as costs per Rand per unit per period. Order Costs include fixed clerical costs of placing and receiving orders, cost of placing purchase orders and the cost of receiving an order and checking against delivery documentation. Order costs are stated as Rand per order. As the order size increases, carrying costs increase and order costs decrease. Calculation variables include: S = Usage in units per period O = Order cost per order C = Carrying Costs per unit per period Q = Order quantity in units Shortage or stock-out costs refer to profit losses caused by out-of-stock situations such as loss of sales, extra costs of ordering at short notice, and (for example) the potential cost of lost customers. Regenesys Business School 77

82 For the purposes of this discussion we include total ordering and total inventory costs into our calculations. Step 1: Calculating Carrying or Storage Costs " S % $ ' # N & Average inventory = 2 Where: A is the average inventory on hand S is the number of units sold per year N is the number of equal-sized orders placed per year Step 2: Calculating Ordering Costs Total ordering cost = F S 2A Where: F is the fixed cost associated with each order placed S is the number of units sold per year A is the average inventory on hand Step 3: Calculate Total Inventory Costs Total Inventory Cost = Total Carrying Cost + Total Ordering Cost TIC = TCC + TOC Step 4: Solving the Economic Order Quantity EOQ = 2 (F S) C P Where: EOQ is the economic ordering quantity, or the optimum quantity, to be ordered with each order placed F is the fixed costs of placing and receiving an order S is the annual sales in units C is the carrying costs expressed as a percentage of inventory value P is the purchase price per unit Regenesys Business School 78

83 Step 5: Work out the Reorder Point Reorder point = lead time in days x daily sales Task Questions 1. Using the examples from your recommended reading to guide you through the process, select an inventory item in your organisation and plan the Economic Order Quantity and reorder point. 2. Work through Safety Stock Analysis in Financial Management in Southern Africa (Marx et al, 2009: ) or another credible source and, using the task you have just completed, calculate the different safety levels. Ensure that you understand the principles behind quantity discounts (cumulative and noncumulative) and other factors contributing to inventory management as explained in the recommended reading: Financial Management in Southern Africa (Marx et al, 2009). Consider too, that there may be alternatives to holding inventories including entering into future contracts to hedge against possible fluctuations in prices of merchandise; offering longer sales terms or reduced prices as an alternative to immediately availability of merchandise; and reducing buffer stock holdings through using more reliable production methods. Read the following journal articles: Orobia, L.A., Byabashaija, W., Munene, J.C., Sejjaaka, S.K., and Musinguzi, D. 2013, 'How do small business owners manage working capital in an emerging economy?' Qualitative Research in Accounting & Management, 10 (2), Talonpoika, A., Monto, S., Pirttilä, M., and Kärri, T. 2014, 'Modifying the cash conversion cycle: revealing concealed advance payments', International Journal of Productivity and Performance Management, 63 (3), Regenesys Business School 79

84 Trade Receivables Management The second component of the cash conversion cycle is the average collection period. This collection period is the average length of time from when a sale occurs on credit to when the payment becomes usable funds for the firm. The first part of this period is from the sale to when the customer sends the cheque, and the second part is when the firm has the cleared funds in the bank. In the age of electronic banking, the second part of the cycle has been shortened to either an instantaneous transaction or, at most, two to three days. A common practice, in the case of cheques, is to physically collect the cheque and not have the risk of lengthening the first part of the cycle with inefficient mail delivery. The first part of the average collection period involves credit management, and the second part of the period involves collection and processing of payments. The first part of the average collection period is the most critical. Once goods have been sold on credit to a customer whose credit rating is dubious or has a bad payment credit record, it can become very time consuming and expensive to collect. Therefore, we will firstly concentrate on the credit management strategies and management. Credit Selection and Maintenance of Standards This process involves the application of techniques to determine the risk profile of potential and existing customers. The credit worthiness of customers is measured against predetermined standards. One of these techniques is shown in table 12. Regenesys Business School 80

85 Table 12: Assessment under the Seven Cs of Credit Character Capital Capacity or means Conditions or ability to service the account Collateral or insurance Credit history Common sense Consumer is measured by his/ her mental and moral qualities, e.g. an unspoilt record of honesty, integrity, responsibility, trustworthiness, etc. Judgement of character must be based on evidence, such as a consistent record of payment to other creditors. Other elements of character can be found in positions of trust held in a business, or social/ professional organisation; stability of residence; and employment and business connections. Experience has revealed that a person who has established a good credit record seldom deviates from his/ her paying pattern and vice versa. This is the financial strength (net worth) of a consumer. For a corporate consumer, net worth is important, but it is equally important to study the employment of capital in the business. The capital structure of the business must be balanced and leave sufficient liquidity in the business for working capital. It is also useful to look at the ratio of owner s capital employed against borrowed capital. For private consumers, you can look at the market value of fixed property against the balance outstanding on mortgage bonds; current bank and savings balances; equity in pension and mutual funds; and cash value of insurance policies not already ceded to other creditors. This refers to the ability to pay, e.g. employment that shows the capacity to make regular payments as they fall due. Creditworthiness extends to the macro business environments in which the consumer lives, e.g. political, legal, economic, social, and technological. Many of these factors are beyond the control of the individual consumer (e.g. technological issues may arise as a consequence of poor Internet access to make payments timeously in rural areas; and changing legislation as with the Consumer Protection Act in South Africa). This is some form of a tangible asset, owned by the consumer, that he/ she may offer as additional security to reduce credit risk (e.g. payment guarantees in the construction industry; mortgage bonds over fixed property; a notarial bond may be registered over the moveable assets of a business or the entrepreneur; cession of a fixed deposit at a bank; cession of insurance policies with a surrender value; pledges such as those of unit trusts, shares or gold coins; and liens). This can be confirmed through trade and business references, credit bureau reports, and bank reports. Sound and reasonable decision making, given the risk, and following the investigation and verification of all the credit information. (Jordaan and Jordaan, 2007:35-38) The firm must continually re-examine its policies and strategies and realign them to meet the challenging needs of its markets. Note, too, that all interest charges and processes for the collection of bad debts must comply with legislation as applicable to the country in which business is being conducted. Other considerations include the credit limit, reductions and increases to credit limits with the agreement of the consumer, and credit terms, and cash discount policies. Regenesys Business School 81

86 7.5.2 Short-Term Financial Management (Current Liabilities) Spontaneous Liabilities These categories of current liabilities occur in the normal course of business. The two major sources of spontaneous liabilities are trade payables and accruals. As the firm s sales rise, the resultant increased purchases cause an increase in liabilities and also liabilities such as wages, taxes and other activity-driven costs causing an increase in accrued liabilities. These forms of current liabilities are termed unsecured short-term liabilities and, although they do not attract any explicit cost, they do involve implicit costs. Trade and other Payables Management Trade and other payables are a major source of unsecured short-term financing. These forms of current liabilities are the final component of the conversion cycle discussed above. The major part of this cycle component is the time that the firm purchases the raw materials to the time that the payment is made. The goal of the firm is to pay as slowly as possible, without damaging the firm s credit worthiness. This is determined by the payment terms that the firm negotiates with its suppliers. The ideal situation to strive for, as a financial manager, is to manage the payment cycle so that the receipts from accounts receivable and the payments to the suppliers are matched as closely as possible. In effect, you financially engineer a situation in which you use your customer s money to pay your supplier. Credit terms and Cash Discounts The length of time for which a firm can delay payments is linked to the credit terms that are negotiated. If a supplier offers cash discounts for early payment, the firm must decide whether to pay earlier and take advantage of the saving. If the firm decides not to pay earlier and to forego the opportunity to take the discount, the firm needs to weigh up the interest saved versus the discount foregone. Task Questions Reflect critically on the following statements: 1. If a business offers you discount for paying early, always take it, or pay as close as possible to the net period expiration. 2. The cost of the foregone discount decreases as the number of days beyond the discount period increases. Develop an argument to support the above statements. Regenesys Business School 82

87 Unsecured Sources of Short-Term Loans There are two major sources of unsecured loans: banks and sales of commercial paper. As compared to spontaneous loans, these types of liabilities are carefully negotiated with the various suppliers of short-term credit. Bank Loans Banks are a major source of short-term loans to businesses. The majority of these loans are short-term, self-liquidating loans. There are three types of this category of loan: Single payment notes Lines of credit Revolving credit arrangements Loan Interest Rates The interest rate on a bank loan can be a fixed or a floating rate, which is normally based on the current prime rate. The prime rate is the lowest rate of interest charged on business loans, and the actual rate charged will vary according the risk profile of the firm. Secured Sources of Short-Term Loans In the case of secured short-term loans, specific assets are pledged as security in relation to the amount borrowed. An example of this could be an overdraft extended to the firm, and secured by a collateral agreement. The risk to the firm is that, if they default on the repayment terms, the bank can claim ownership and liquidate the assets pledged, to recover at least part of the loan outstanding. Collateral and Terms Trade Receivables as Collateral The two common forms of obtaining finance are pledging trade receivables and factoring trade receivables. Pledging Trade Receivables The lender evaluates the receivables accounts to determine their attractiveness as collateral. The lender then calculates the realistic returns that can be expected on the selected accounts. This percentage then represents the amount (expressed as a percentage of the collateral) that the lender is willing to advance. A charge (a pledging cost) is levied by the lending institution in addition to the interest rate charged. Regenesys Business School 83

88 Factoring Trade Receivables Factoring involves selling the trade receivables book, at a discount, to a factoring institution that will then collect the outstanding amounts. From a risk perspective, the factoring institution will often agree to a non-recourse arrangement. This is where the risk of default passes to the factoring institution. Frequently, the factor will not have to pay the firm until the outstanding amounts have been collected. Where a factor advances amounts, this will attract an interest charge (normally above prime). A commission is also levied based on a percentage of the value of the accounts being factored. Even though factoring is not a cheap source of funding, it is attractive to many firms because the cash becomes available sooner, and also it introduces a certainty of cash flows, which can assist in working capital management. Another advantage could be that, if this is an on-going strategy, personnel cost can be saved through the rationalisation of collection departments. Analysis of Financial Statements (Ratio Analysis) Ratio analysis can be utilised by all stakeholders (including potential stakeholders) to analyse financial statements and gain a useful picture of the firm s financial and operating health. Primarily, the financial manager will analyse the financial statements from the perspective of increasing shareholder wealth. However, s/ he will also consider the financial statements through the lenses of other interested parties (e.g. lenders needing to confirm and monitor a borrower s ability to pay interest and repay debt). For this reason, there are various categories of ratio analyses: liquidity, activity, debt, profitability and market ratios. We will study each of these categories in the remainder of this section. Keep in mind that the financial manager will not look at these in isolation s/ he will combine and compare analyses of the financial data both within the firm and across the industry where such data exists. Financial statements used in ratio analyses include: Statement of comprehensive income (profit and loss statement) Statement of financial position (bank statement) Statement of cash flows (cash-flow statement) Statement in changes in equity Ensure that you are fully conversant in the contents of the above statements and the concepts of: money measurement; conservatism; the consistency concept; materiality; historic cost; the doubleentry system; the going-concern; accounting period; the realisation principle; and the accrual principle. Liquidity Ratios The liquidity of a firm is measured by its ability to pay its short-term obligations as they fall due. These ratios can be utilised to forewarn of any potential liquidity problem that could be imminent. Regenesys Business School 84

89 Current Ratio Current ratio = current assets current liabilities Generally, the higher the current ratio, the more liquid the firm is. Normally a ratio of 2 is said to be acceptable, but this can depend on the industry in which the firm operates. Quick (Acid Test) Ratio This ratio is similar to the current ratio, but excludes inventory, which is considered to be the least liquid current asset. In other words, inventory is not always easy to liquidate in the short term. Consider that trade receivables, as discussed earlier, could be factored to increase liquidity. Quick ratio = current assets inventory current liabilities Quick ratios of 1.0 and above are considered acceptable, but this depends on the industry norms. Activity Ratios Activity ratios measure the speed with which various accounts are converted into sales or cash. Inventory Turnover Inventory turnover = cost of sales average inventory To be meaningful, this ratio must be compared to those of other firms in the same industry. This ratio is converted to average age of inventory by dividing the result into 365 days. Average Collection Period This ratio is useful in evaluating credit management strategies and policies. As you work through this section, think back to the section where we dealt with the cash conversion cycle and the effect of average collection and payment periods. Regenesys Business School 85

90 Average collection period = trade and other receivables credit sales 365 Average Payment Period Trade payables The average payment period = Annual purchases 365 Total Asset Turnover As you work through this section, think back to the section where we dealt with the cash conversion cycle and the effect of average collection and payment periods. This ratio measures the efficiency with which the firm uses its assets to generate sales. Sales Total asset turnover = Total assets Generally, the higher the ratio, the better its asset utilisation is. Debt Ratios The more debt a firm uses in relation to its total assets, the greater the financial leverage. Financial leverage can be defined as magnification of risk and return through the use of fixed cost financing, such as debt and preference share capital. The more fixed-cost debt the firm uses, the greater will be its risk and expected return. Debt Ratio Debt ratio measures the proportion of total assets financed by firm s creditors. Total liabilities Debt ratio = Total assets The higher this ratio, the more financial leverage is present. Regenesys Business School 86

91 Times Interest Earned (or Interest Coverage Ratio) This ratio measures the ability of the firm to make contractual interest payments. Earnings before interest and tax (EBIT) Times interest earned = Interest Normally, a value of between four and seven is recommended. Profitability Ratios Gross Profit Margin The gross profit margin measures the percentage of each sales Rand that remains after the firm has paid for its goods. Sales Cost of goods sold Gross profit margin = Sales x 100 Gross Profit Gross profit margin = Sales x 100 Operating Profit Margin This ratio measures the percentage of each sales Rand remaining after all costs and expenses (other than interest, taxes and preference share dividends) are deducted. It represents pure profit. Operating profit Operating profit margin = x 100 Sales Regenesys Business School 87

92 Net Profit Margin This measures the percentage of each sales Rand that remains after all costs are deducted. The preference share dividends are listed in the statement of changes in equity and must be subtracted from the profit for the year as per statement of comprehensive income. The amount can also be referred to as earnings available for ordinary shareholders (Gitman et al., 2010:58). 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑥 100 𝑆𝑎𝑙𝑒𝑠 Earnings per Share (EPS) The earnings per share represents the number of Rand earned during a financial period on behalf of each issued ordinary share (thus available after preference share dividends have been deducted). 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑 EPS is closely watched by the investing public and is considered important as an indicator of the firm s success. Return on Total Assets (ROA) The ROA ratio is often termed the return on investment (ROI). This measures the firm s effectiveness in generating profits with the assets available. 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑥 100 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 Return on Common Equity (ROE) This ratio measures the return earned on the ordinary shareholder s investment in the firm. 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑥 100 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 Regenesys Business School 88

93 Keep in mind that the content and context of the ratios varies from one situation to another and the analyst may make changes to the structure of the ratio in order to include or exclude specific factors for the purposes of analysis. Market Ratios Market ratios relate to the firm s market value and give insight to the investor on how the firm is doing from the perspective of risk and return. Price/ Earnings Ratio (P/E) This measures the amount that investors are willing to pay for each Rand of a firm s earnings, and indicates the level of confidence that investors have in the firm s future performance. The higher the P/E ratio, the greater the investor s confidence is likely to be. Market price per ordinary share Price/earnings ratio = Earnings per share For example, a P/E ratio of R12 means that investors are paying R12 for each R1 of earnings. This is most informative when applied in cross-sectional analysis using an industry average or the P/E ratio of a competitor s firm. Market/ Book Ratio (M/B) The market to book ratio provides an assessment of how investors view the firm s performance. It relates the market value of the firms shares (i.e. number of shares x share price) to their book (i.e. accounting) value. First Step Find the Book Value per Ordinary Share: Total equity Preference share capital Book value per ordinary share = Number of ordinary shares outstanding Regenesys Business School 89

94 Second Step Calculate M/B Ratio: Market price per ordinary share Market to book ratio = Book value per ordinary share Go to the following link to find a full set of data for Cisco: Daily Finance, 2014, 'Cisco Systems Inc.', (2 July 2014). (All listed companies on the New York Stock Exchange are listed on this site. Explore the site and make comparisons between the data. Note, particularly, how this changes from one industry to another.) In terms of analysis, reflect on the following statements: The underlying accounting rules adopted impact upon comparisons. The economic environment should not be excluded. The relative health of the industry environment must be considered. Although Porter s Five Forces Model was originally intended as a framework for understanding firm strategy, it is widely used by financial managers to provide a background for ratio analysis. Ratio analysis allows you to evaluate what has been achieved relative to what your analysis of the economic and industrial environment suggests is possible or normal. The complex analytical task can be simplified by dividing the analysis into segments operating efficiency, financial structure, observing the foregoing as reflected in the firm s profitability and evaluating the cash flows generated by the firm relative to its cash obligations. Important questions emerge as a consequence of ratio analysis including: How have the ratios changed over time? How do the ratios compare with those reported by similar firms? Do the ratios make sense? How do the ratios compare with budgeted forecasts? Long-term debt is generally cheaper than equity, particularly for tax-paying firms, but it brings with it the requirement to make interest payments and principal repayments at set times. Equity, while requiring greater return to compensate for the greater risk of its junior status in a liquidation, carries no obligation to provide returns at a set time. In consequence, the greater the variability in a company s performance the more the requirement for long-term finance should be met through equity rather than debt; that is the riskier the business the greater the dependence on equity rather than debt. Use the following tasks to test your knowledge and analytical skills. systemically avoid using data in isolation of other related factors. Remember to think Regenesys Business School 90

95 Mini case study You have been hired as an analyst for Mellon Bank and your team is working on an independent assessment of Fresh Food Inc. (FF Inc.) FF Inc. is a company that specialises in the production of freshly imported farm products from France. Your assistant has provided you with the following data for this company and their industry. Ratio Industry Average Long-term debt Inventory Turnover Depreciation/Total Assets Days sales in receivables Debt to Equity Profit Margin Total Asset Turnover Quick Ratio Current Ratio Times Interest Earned Equity Multiplier Before you begin your analysis, ensure that you have a thorough understanding of each ratio. 1. In the annual report to the shareholders, the CEO of FF Inc. wrote, 2010 was a good year for the firm with respect to our ability to meet our short-term obligations. We had higher liquidity largely due to an increase in highly liquid current assets (cash, account receivables and short-term marketable securities). Is the CEO correct? Explain and use only relevant information in your analysis. 2. What can you say about the Company s asset management? Be as complete as possible given the above information, but do not use any irrelevant information. 3. You are asked to provide the shareholders with an assessment of the firm's solvency and leverage. Again, be as complete as possible given the above information, but do not use any irrelevant information. A sample analysis is provided in Appendix A. Regenesys Business School 91

96 Task Questions 1. Obtain a copy of your firm s financial statements, together with relevant industry data (e.g. liquidity ratios, P/E ratios, etc.) and direct competitor data (financial statements if they are a listed company). 2. Analyse your firm s financials in the context of the industry and direct competitors and draw conclusions and recommendations. 3. Reflect on the broad economic indicators and incorporate these into your analysis. 4. Arrange a meeting with other members of your financial management team to discuss your findings and increase your understanding of the business. Recap Questions 1. Why is short-term financial management one of the most important and time consuming activities of the financial manager? What is net working capital? 2. What is the relationship between the predictability of a firm s cash flow and its required level of net working capital? 3. How are net working capital, liquidity, and risk of technical insolvency related? 4. Why does an increase in the ratio of current assets to total assets decrease both profits and risk as defined by net working capital? How do changes in the ratio of current liabilities to total assets affect profitability and risk? 5. What are the two major sources of spontaneous short term financing? How do their levels react to fluctuations in sales? 6. Is there a cost associated with either taking up a cash discount on payables, or giving up a discount to stretch terms? 7. What does it mean to stretch trade payables? 8. Describe the chief sources of unsecured short-term loans. 9. Why do you think that a firm would pursue secured, rather than unsecured sources of short-term financing? 10. What are the cautions that need to be observed when using ratio analysis? 11. Name the five basic categories of ratio analysis. Describe the ratios in each category: concentrating on the purpose of each of these ratios. 12. How might ratio analysis differ from goods to service-based firms? Regenesys Business School 92

97 7.6 OVERVIEW OF MERGERS AND INTERNATIONAL MANAGERIAL FINANCE Timeframe: Learning Outcomes: Minimum 10 hours Examine different types of mergers and debate the pros and cons of each; Synthesise concepts around international finance and its impact on business enterprises. Chapters 17 & 18 in Gitman, L.J. 2010, Principles of Managerial Finance: Global and Southern African Perspectives, Cape Town: Pearson Education South Africa (Pty) Ltd. Recommended reading: Merger Market, 2012, 'Press Release: Mergermarket M&A Round-up for Q1-Q3 2012', (accessed 9 January 2013). Pettinger, T. 2012, 'Pros and Cons of Mergers', (accessed 4 February 2013). Section overview: The purpose of this section is not to cover the two topics of mergers and international managerial finance in detail (as these are offered as electives), but to highlight important concepts and issues for the financial manager Terminology Relating to Mergers It is useful to begin by defining mergers, particularly in the context of financial management: A merger occurs when two or more forms are combined and the resulting firm maintains the identity of one of the firms. [For example, Nedcor s acquisition of BoE. Hence the term acquisition is synonymous with merger.] Consolidation, by contrast, involves the combination of two or more firms to form a completely new corporation. For example, the consolidation of Volkskas, United, Allied and Trust banks to form ABSA. Friendly merger: A merger transaction endorsed by the target firm s management, approved by its shareholders, and easily consummated. Hostile merger: A merger transaction that the target firm s management does not support, forcing the acquiring company to try to gain control of the firm by buying shares in the marketplace. Financial merger: A merger transaction undertaken with the goal of restructuring the acquired company to improve its cash flow and unlock hidden value. (Gitman et al., 2010: ) Regenesys Business School 93

98 7.6.2 Trends in Mergers across the World The table below summarises some of the important reasons for the worldwide growth in mergers over the last decade. However, bear in mind that mergers and acquisitions have seen a significant decline in the past two years with all the uncertainty on the macro level, many corporations are adopting a wait-and-see attitude. Table 13: Trends in Mergers China India USA Europe Africa Mergers (and acquisitions) have grown significantly in China in recent years mostly attributable to economic reforms and China s accession to the WTO. However, government agencies in China continue to play a strong supervisory role in the approval of mergers. India has emerged as one of the top countries with respect to the volume of merger and acquisition deals. Sector wise, large volumes have occurred in finance, telecoms, FMCG, construction materials, automotive, and metals. More mergers and acquisitions take place in the USA than in any other country real estate, finance and insurance are among their top sectors in terms of mergers. The effects of mergers on the jobs, business, and overall US economy have been substantial (e.g. some downsizing has taken place in large firms that were taken over; conversely, there have been signs of rapid job creation leading to higher employment). 2011/ 2012 were the quietest years for European mergers and acquisitions the sovereign debt crisis including economic and regulatory factors are likely to dominate the agenda for some time. Mergers and acquisitions have been an important channel for investment in Africa for both global and local market players (in particular market access). Nevertheless, the African M&A market is still comparatively very small (3% of global M&A market). The attractiveness of the African continent for M&A deals is mainly underpinned by the relatively high economic growth and the buoyant energy, mining and utilities sector. (Adapted from Finance Maps of World, n.d.; African Development Bank, 2013) Go to Mergermarket.com for latest statistics on M&As per country and per industry: Merger Market, 2012, 'Press Release: Mergermarket M&A Round-up for Q1-Q3 2012', (accessed 9 January 2013). Regenesys Business School 94

99 7.6.3 Strategic and Financial Reasons for Mergers There are many reasons for mergers; however, in the main they fall into two broad categories: Strategic Financial Strategic versus Financial Aim of the Merger Strategic mergers aim to achieve objectives relating to economies of scale (technical, financial, organisational, bulk-buying, etc.), market share/ footprint, distribution networks, diversification, increased managerial skill or technology, tax considerations, defence against takeover, and increased goodwill, etc. The overriding objective is to achieve performance that is greater than the sum of the independent firms. Sometimes, mergers only include the purchase of specific product lines (rather than the whole company); for example, Telkom s acquisition of MWEB Africa (excluding its South African unit) from Naspers. In a financial merger, where the aim is largely financial, restructuring is highly likely, e.g. to improve cash flows. Unproductive and/ or non-compatible assets will be sold off to increase the cash flow. The belief is that, through re-structuring, hidden value can be unlocked. Advantages and Disadvantages of Mergers Whilst our discussion above shows that there are important benefits to be achieved through mergers; notwithstanding that one firm s gain may lead to another s loss, there are also potentially harmful effects of mergers, e.g. higher prices, less choice, job losses, diseconomies of scale due to faulty implementation and mismanagement of the larger entity, etc. The following links provide insightful knowledge of the pros and cons of mergers: Pettinger, T. 2012, 'Pros and Cons of Mergers', (accessed 4 February 2013). Regenesys Business School 95

100 For the purposes of this study guide we have selected several case studies for discussion and debate, critical reflection and analysis. Case Study 1: Virgin Atlantic is increasing efforts to block the takeover of BMI (British Midland Airways) by its arch rival IAG the parent group of British Airways by making a formal complaint to the European Commission claiming the merger would create local monopolies and drive up fares. IAG, which owns BA and the Spanish airline Iberia, beat Virgin to the acquisition of BMI from Lufthansa in a 172.5m deal last December that would give it more than half of the take-off and landing slots at Heathrow. Virgin's new submission to the commission, which has responsibility for competition matters in the EU, says the takeover would leave three key domestic routes as BA monopolies, allowing the airline to increase fares dramatically in the absence of an alternative carrier for passengers. BMI is the second-largest airline flying out of Heathrow. According to Virgin, since BMI withdrew its flights to Glasgow in 2011, leaving BA as the sole operator on the route, fares have risen by 34% and the number of flights have nearly halved. BA said it had added 4000 seats a week on Heathrow-Glasgow services last year. Sir Richard Branson, president of Virgin Atlantic, said: "This takeover would take British flying back to the dark ages. BA has a track record of dominating routes, forcing less flying and higher prices. This move is clearly about knocking out the competition. The regulators cannot allow British Airways to sew up UK flying and squeeze the life out of the travelling public. It is vital that regulatory authorities, in the UK as well as in Europe give this merger the fullest possible scrutiny and ensure it is stopped". Virgin fears that connecting passengers who currently change at Heathrow from BMI on to other airlines would be shepherded on to BA flights once the deal goes through. The commission could give the go-ahead to the merger in mid-march or defer a decision. IAG said on Thursday it was confident that the authorities would approve the deal, and pointed out that its biggest European rivals had a greater share of slots at their respective national hub airports. A spokesman said: "Selling BMI to IAG offers the best solution for British consumers and UK PLC, securing more jobs than if the airline was broken up and sold off for its Heathrow slots. This deal is the only option for safeguarding services to the UK regions". (Topham, 2012) The deal was concluded, however, the European Commission granted remedies. 1. What were the likely key issues that the financial managers of Virgin Atlantic had to consider with the impending takeover of BMI by IAG? 2. What is the purpose of a Competitions Board and other structures to ensure fair practice? 3. Assume you are a financial manager at IAG what would you hope to achieve by the takeover? Regenesys Business School 96

101 Case Study 2: Revenue deserves more attention in mergers; indeed, a failure to focus on this important factor may explain why so many mergers don t pay off. Too many companies lose their revenue momentum as they concentrate on cost synergies or fail to focus on post-merger growth in a systematic manner. Yet in the end, halted growth hurts the market performance of a company far more than does a failure to nail costs. Some balance may have to be restored. The belief that mergers drive revenue growth could be a myth. A Southern Methodist University (SMU) study of 193 mergers, worth $100 million or more, from 1990 to 1997 found that revenue growth was fairly elusive. Measured against industry peers, only 36 percent of the targets maintained their revenue growth in the first quarter after the merger announcement. By the third quarter, only 11 percent had avoided a slowdown; the median lag was 12 percent. When McKinsey joined the SMU researchers to take a closer look, it turned out that the targets continuing underperformance explained only half of the slowdown; unsettled customers and distracted staff explained the rest. (Bekier, Bogardus, and Oldham, 2001) 1. Using your knowledge of financial analysis, discuss the challenges around revenue growth anticipated in a merger. 2. What have you learned about using a systemic approach to mergers from the above excerpt? 3. What possible recommendations can you give to financial managers about the important aspect of revenue generation versus cost cutting in mergers? Be prepared to argue for and against this assertion International Finance Capital Markets and Shareholder Value It is worth noting that, in no other area does US financial practice differ more fundamentally from practices in other countries than in the field of mergers (Gitman et al., 2010: 698) including hostile takeovers. In Europe (but to a lesser degree in Great Britain) and in Asia, hostile takeovers are virtually non-existent. In Japan, takeovers of any kind are uncommon. The main reason for this difference is the reliance on public capital markets by the US and Great Britain together with their emphasis on shareholder value. The recent number of hostile takeover bids in South Africa shows that its financial practices are increasingly following the US/ Great Britain example. Since the formation of the European Union (and introduction of the Euro), there are signs of Western Europe moving toward shareholder value and public capital market financing (Gitman et al., 2010: 698) and given their need to develop strategies, including distribution networks across the region, cross border mergers are on the increase. Risks Inherent with International Operations Exchange Rate Risks As with home-based financial decisions, international financial management includes a range of risks; e.g. exchange rate risk as shown in table 14. Regenesys Business School 97

102 Table 14: Three Types of Foreign Exchange Risk Translation exposure or accounting exposure Transaction exposure Economic exposure This is the effect that exchange rates will have on the recorded accounting results of the parent company. The parent company must translate subsidiary results and financial position of the foreign subsidiaries into the parent company s local currency in order to present consolidated financial statements. Translation exposure does not describe what is happening to cash flows just how the parent company s results are perceived (e.g. by shareholders). Up until the last decade, translation exposure has not been important in South Africa since most South African companies have not held material investments in foreign subsidiaries. However, direct foreign investment by South African companies has increased in recent years. This refers to the potential for gains or losses as a result of transactions between currencies; e.g. an exporter sells goods and payment is required at a later stage in foreign currency. Borrowing in different currencies can also lead to transaction exposure. Hedging policies are required to avoid these forms of exposure. Whilst economic exposure also deals with transaction exposure, it looks at the long-term real effects of a change in the exchange rate. For example, it considers the value of a company to be equal to the discounted value of its future revenue streams and how the firm s value will change when there is a change in the exchange rate. Transaction Exposure: A South African company is able to reduce interest rates on borrowings by taking out a loan in Euros. However, the lower interest rate may be offset by the depreciation in the Rand relative to the Euro. Assume the South African company borrows in Euros at an interest rate of 2% for the year while the domestic interest rate is 12%. If the South African exchange rate falls by say 20% within the year, then the firm would lose significantly by borrowing in Euros, despite experiencing interest savings. In a prior section, we looked at the effect of inflation and the Fisher effect. From an international perspective, the International Fisher Effect (IFE) suggests that given interest rates comprise a real rate of return and a premium for anticipated inflation, if investors require the same real return on equivalent investments, then differences in interest rates between two countries will determine the change in the exchange rate between the countries (Gitman et al., 2010: 730). The principle here is that exchange rates should adjust to ensure constant returns on identical investments across different currencies (i.e. interest rate parity) otherwise an arbitrage situation exists. Multinational companies face exchange rate risks under both floating (e.g. US Dollar and UK British Pound) and fixed/ pegged arrangements (e.g. China pegs its currency, the Yuan, to the US Dollar). Most countries try to keep the value of their currency lower than the US Dollar this gives them comparative advantage by making their exports to America cheaper. An example of this is China, which pegs its currency, the Yuan, to the Dollar to maintain competitive pricing. The oil exporting nations in the Gulf must peg their currency to the US Dollar because their primary export, oil, is sold in US Dollars. Regenesys Business School 98

103 Foreign Direct Investment (FDI) FDI is the transfer (by a multinational firm) of capital, managerial, and technical assets from its home country to the host country. The equity participation on the part of an MNC can be 100% (wholly owned foreign subsidiary) or less (joint venture project with foreign participants). FDI ventures are therefore subject to business, financial, inflation and exchange rate risks and notwithstanding these, they are also exposed to political risk. Several factors, unique to the international environment, need to be examined when long-term investment decisions are made. Some of these include: Taxes (e.g. Different definitions of taxable income can for example arise) Cash flows (e.g. In some countries these may be blocked from repatriation) The local cost of equity capital and the appropriate discount rate to be applied given the inherent risks must be evaluated Access to international bond and equity markets provides opportunities Higher agency costs must be considered The need for hedging strategies (e.g. interest rate and currency swaps) The following example provides an indication of the type of decisions that need to be taken in the international market. A multinational plastics company, IM Moulding, has subsidiaries in South Africa (Rand) and Japan (Japanese Yen). On the basis of each subsidiary s forecasted operations the short-term financial needs (in equivalent US Dollars) are as follows: South Africa: $80 million excess cash to be invested (lent) Japan: $60 million funds to be raised (borrowed) On the basis of all the available information, the parent firm has provided each subsidiary with the figures given in the table below for exchange rates and interest rates. The figures for the effective rates are derived using the equation: E = N + F + (N x F)/100 Where: E = Effective interest rate for a specific currency N = Nominal rate F = Forecast percentage change Regenesys Business School 99

104 Currency Item US$ ZAR Spot exchange rates ZAR8.05/US$ /US$ Forecast percent change -6.0% 1.0% Interest rates Nominal Euromarket 3.30% 8.80% 1.50% Domestic 3.00% 8.50% 1.70% Effective Euromarket 3.30% 2.27% 2.52% Domestic 3.00% 1.99% 2.72% From the MNCs point of view, the effective rates of interest, which take into account each currency s forecast percentage change (appreciation or depreciation) relative to the US$, are the main considerations in investment and borrowing decisions (it is assumed here that because of local regulations a subsidiary is not permitted to use the domestic market of any other subsidiary). The relevant question is where funds should be invested and borrowed. For investment purposes, the highest available effective rate of interest is 3.30% in the US$ Euromarket. Therefore, the South African subsidiary should invest the $80 in Rand in US$. To raise funds, the cheapest source open to the Japanese subsidiary is the 2.27% effective rate for the rand in the Euromarket. The subsidiary should therefore raise the $60 million in Rand in the Euromarket. These two transactions will result in the most revenues and least costs respectively. (Gitman et al., 2010: ) Recap Questions 1. Weigh up the pros and cons of a merger between an international construction firm and a locally based construction firm in your country. 2. What are some of the major reasons for the rapid expansion in international mergers? 3. Explain why NPV will differ depending on whether it is measured from the parent MNC s perspective or from that of the foreign subsidiary. 4. Explain how differing exchange rates between two countries affect their exchange rates over the long-term including the concept of arbitrage. 5. Critically review a range of international factors that could cause the capital structures of MNCs to differ from those of purely domestic firms. Regenesys Business School 100

105 8. REFERENCES Abor, J., and Fiador, V. 2013, 'Does corporate governance explain dividend policy in Sub-Saharan Africa?' International Journal of Law and Management, 55 (3), African Development Bank, 2013, 'Mergers and Acquisitions in Africa', (accessed 8 February 2013). Agrawal, A., Ferrer, C., and West, A. 2011, 'When big acquisitions pay off', Mckinsey Quarterly, Nr. 3, Bekier, M.M., Bogardus, A.J., and Oldham, T. 2001, 'Why mergers fail. Is the belief that mergers drive revenue growth a delusion?' McKinsey & Company, (accessed 15 January 2013). Britzelmaier, B., Kraus, P., Häberle, M., Mayer, B., and Beck, V. 2013, 'Cost of capital in SMEs', EuroMed Journal of Business, 8 (1), Business Dictionary, 2013b, 'Market Return', (accessed 9 January 2013). Correia, C., Flynn, D., Uliana, E., and Wormald, M. 2007, Financial Management, 7 th ed., Cape Town: Juta. Crowther, G. 1941, An Outline of Money. London: Thomas Nelson and Sons Ltd. Dimson, E., March, P., and Staunton, M. 2008, Global Investment Returns Yearbook London: London Business School, 786_GIRY2008_synopsis(1).pdf (accessed 15 December 2011). Dyer, J., Kale, P., and Singh, H. 2004, 'When to Ally and when to Acquire', Harvard Business Review, 82(7/8), Finance Maps of World, n.d., 'Mergers and Acquisitions', (accessed 16 January 2013). Gitman L., Smith M., Hall J., Lowies B., Marx J., Strydom B., and van der Merwe A. 2010, Principles of Managerial Finance Global and Southern African Perspectives, Cape Town: Pearson. InvestorWords, 2013, 'Efficient Portfolio', (accessed 9 January 2013). Investopedia, 2013a, 'Corporate Finance - The NPV Profile', (accessed 11 January 2013). Investopedia, 2013b, 'Financial Risk', (accessed 9 January 2013). Regenesys Business School 101

106 Investopedia, 2013c, 'Modified Internal Rate of Return MIRR', (accessed 14 January 2013). Investopedia, 2013d, 'What is the difference between yield and return?' (accessed 9 January 2013). Ismail, A. 2011, 'Does the Management's Forecast of Merger Synergies Explain the Premium Paid, the Method of Payment, and Merger Motives?' Financial Management, 40(4), Jordaan, P., and Jordaan, C. 2007, Applied Credit Management, Pretoria: Van Schaik. Kaiser K., and Young S.D. 2009, 'Need Cash: Look inside your company', Harvard Business Review, 87(5), 69. Kerins F., Smith J., and Smith R. 2004, 'Opportunity Cost of Capital for Venture Capital Investors and Entrepreneurs', Journal of Financial and Quantitative Analysis, 39(2), Kuhlemeyer, G.A. 2004, Fundamentals of Financial Management, 12 th ed., New Jersey, NJ: Pearson Education. Lawrence, S.R., Botes, V., Collins, E., and Roper, J. 'Does accounting construct the identity of firms as purely self-interested or as socially responsible?' Meditari Accountancy Research, 21 (2), Lee, S.M., Noh, Y., Choi, D., and Rha, J.S. 2014, 'The effect of ISO on equity structure', Industrial Management and Data Systems, 114 (6), Lovemore, F.C.H., and Brummer, L.M. 2009, The ABC of Financial Management. 2 nd ed., Pretoria: Van Schaik. Marx, J., de Swardt, C., Beaumont Smith, M., and Erasmus, P. 2009, Financial Management in Southern Africa. 3 rd ed., Cape Town: Pearson Education South Africa. Murphy, H. 2011, Debt Returns to the Private-Equity Party. Chicago, IL: Crain's Chicago Business. Olsen, R.A. 2014, 'Financial risk perceptions: a consciousness perspective', Qualitative Research in Financial Markets, 6 (1), Orobia, L.A., Byabashaija, W., Munene, J.C., Sejjaaka, S.K., and Musinguzi, D. 2013, 'How do small business owners manage working capital in an emerging economy?' Qualitative Research in Accounting & Management, 10 (2), Raiyani, J.R. 2011, 'The Impact of Financial Risk on Capital Structure Decisions in Selected Indian Industries: A Descriptive Analysis', Advances in Management, 4(11), Raputsoane, L. 2009, 'The Risk-Return Relationship in the South African Stock Market', 14 th Annual conference of the African Econometrics Society on econometric modelling in Africa, Abuja, Nigeria, (accessed 15 December 2011). Rashid, A. 2014, 'Firm external financing decisions: explaining the role of risks', Managerial Finance, 40 (1), Regenesys Business School 102

107 Reale, K. 2011, 'Financial Ratios: Understanding This Powerful Tool for Managing for Success', (accessed 8 February 2013). Sarbanes-Oxley, 2006, The Sarbanes-Oxley Act: A Guide to the Sarbanes-Oxley Act, (accessed 5 February 2013). Shell Global, 2013, 'Dividend Policy', (accessed 5 February 2013). Sirait, F., and Siregar, S.V. 2014, 'Dividend payment and earnings quality: evidence from Indonesia', International Journal of Accounting and Information Management, 22 (2), Talonpoika, A., Monto, S., Pirttilä, M., and Kärri, T. 2014, 'Modifying the cash conversion cycle: revealing concealed advance payments', International Journal of Productivity and Performance Management, 63 (3), The Free Dictionary. 2013a, 'Beta', (accessed 10 January 2013). The Free Dictionary, 2013b, 'Capital Asset Pricing Model (CAPM)', (accessed 10 January 2013). Topham, G. 2012, 'Virgin Atlantic complains to European Commission over IAG s purchase of BMI', London: Guardian News and Media Limited, (accessed 15 January 2013). Regenesys Business School 103

108 9. APPENDIX A: SOLUTIONS Sample Answers to Capital Budgeting Questions 1. What is NPV in finance? NPV refers to the net worth of an investment that results when you subtract the sum of discounted costs from sum of discounted benefits. The resulting difference of costs from benefits represents either a loss or profit from an investment in monetary form. This result must represent the monetary amount in present terms, since the face value of money erodes with the passage of time. One can only get a fair picture of the amounts due in the future when those amounts are discounted; i.e. brought back to their present value. NPV is important to an organisation that is about to undertake a capital budgeting project since the organisation will be able to judge how much of its capital investment will make a return on investment. NPV can either mean the present value of a lump sum, the present value of expected payments or the net present value of a capital investment. In case of a lump sum NPV would simply be the present value of the lump sum discounted at the interest rate i for n periods. In case of a series of periodic payments, NPV would mean the sum of discounted periodic payments at interest rate i for time period t where t ranges from 1 to n. In case of capital budgeting, NPV is the difference of sum of discounted costs and sum of discounted benefits. So depending on the context it's used in, NPV can be used in several scenarios. It may also be that NPV refers to the net present value of an infinite stream of payments or receipt usually referred to as perpetuity. 2. What does NPV tell us/show us? NPV tells us the true worth of any money we are promised in the future. Using NPV, we can find the true reflection of money that either we would have to pay or someone would promise to pay us. NPV is the vehicle that eliminates the effects of inflation and interest rates from any sum of money promised at a later date. NPV shows the actual value of an investment. It provides you with a yardstick that lets you measure future investments in its present value. A dollar promised to be paid to you in the future would not buy the same amount of goods as a dollar can buy you today. Thus time value of money dictates that NPV represents the actual worth of money that is due in the future. 3. What does an NPV of zero mean? An NPV of zero (R0) means that you, or an organisation, planning to invest in a capital project stand to make nothing from the investment. You only break even at an NPV of zero; thus, no gains are made from the investment. An investment is only worthwhile if its NPV is a positive amount and the higher the NPV more sense it makes to invest. Regenesys Business School 104

109 4. What is NPV analysis? NPV analysis refers to the set of procedures we follow to find the net present value of an investment. The analysis starts with the steps of finding incremental cash flows. We first use methods to approximate the expected benefits or savings from an investment. Both fixed and variable costs are removed from the expected benefits. Depreciation allowance is subtracted this last amount thus resulting in EBIT or earnings before interest and taxes. The tax expense is removed from EBIT and depreciation is added back to find free cash flows. If there were to be any increase in net working capital that gets added to the initial costs and are finally recovered in the terminal cash flow. NPV analysis requires that an organisation knows how to compute its cost of capital also referred to as the opportunity cost. The cost of capital or the WACC is used as the discount rate when finding net present value from the free cash flows. The resulting amount may be either positive, negative or zero. The acceptance criteria for NPV suggests approval of a capital budgeting project with the highest positive net present value. 5. What is an NPV test? The NPV test is used to analyse capital budgeting projects that are being considered by an organisation. The NPV test is based on discounted cash flow analysis where each of the cash flows in the series of future returns per investment is discounted at the cost of capital. The resulting sum is known as the net present value. The NPV tests would then be used in deciding whether the resulting NPVs are positive and the highest amongst the projects under consideration. The project that passes the NPV test with the highest return will be selected subject to other considerations (e.g. meets the strategic aims of the organisations, ethical issues, etc.). 6. What is an NPV profile? In capital budgeting, net present value is calculated by summing up the series of discounted cash flows. The discount rate that is used in this process is referred to as the cost of capital. IRR is another method used in capital budgeting and it is the interest rate at which net present value results in zero. The NPV profile refers to a visual presentation of NPV and the discount rate. The NPV is represented vertically on y-axis and the discount rate is represented horizontally on x-axis. The resulting line graph is called the NPV profile. NPV profile shows the IRR as a point of intersection on x-axis where NPV is zero. Regenesys Business School 105

110 7. What is NPV in financial management? The term NPV is used interchangeably with net present worth (NPW). NPV and NPW are almost identical in meaning in terms of financial management yet their meaning may refer to two different concepts. In one context, we may only be referring to the present value of expected future payments or receipts. This case can be highlighted with an example where a lottery prize-winner would have to either decide on taking a lump sum of prize money or to take a series of annual payments over time. As there is no outgoing cash flow, the NPV would simply refer to discounting of the series of annual payments to find its present value. In the second context where an organisation takes on capital budgeting projects that incur initial and interim costs, the net present value will refer to the difference between the sum of discounted costs and the sum of discounted benefits. Notably, there is no difference in the method used to calculate NPV in both these instances. However, one thing to point out is the timing of the expected cash flows. If the cash flow occurs at the end of the period, for example, first payment is made at the end of year one and the subsequent payments are made at the end of the each year in the future; such form of payments will be considered an ordinary annuity or simply an annuity. When payments are made at the start of the period for example first payment due today and the subsequent payments are made at the start of each of the years into the future, such an annuity is referred to as annuity due. 8. Explain IRR and compare this approach to NPV. NPV and IRR are two popular methods used by organisations in evaluating investments that require capital budgets. These two techniques are used in conjunction; however, each of these methods has its pros and cons. IRR is an interest rate that provides an organisation with a measure to compare it against its cost of capital. If the IRR is found to be higher than cost of capital, an organisation is likely to accept the project. The NPV on the other hand is the money amount that a company stands to make or lose from an investment. Both methods are widely used and in some instances NPV is seen as a better and superior measure for the reason that in some cases there an IRR may not exist or, if it does, it may not be unique. 9. Discuss why NPV and IRR conflict. NPV and IRR conflict may arise when the timings of cash flows are not on par with each other whilst comparing more than one project. This leads to conflicting results for IRR and NPV where one project seems to have a lower IRR and higher NPV whereas another project has a higher IRR and lower NPV. In such a conflict making a decision based on NPV is more reliable as compared to making one based on the IRR. Regenesys Business School 106

111 10. Discuss the Payback approach. In short, NPV, IRR and Payback are three methods, or capital budgeting techniques, used in evaluating investment projects. The payback period refers to the time period required to recover the initial cost incurred. The time period may refer to days, weeks, months, quarters, or years depending on the frequency of the cash flows. Most importantly the payback period does not take into consideration the time value of money thus it is not a true payback period. A true payback period is referred to as discounted payback period where the expected future cash flows are discounted to reflect their present value. 11. What is MIRR? NPV, IRR and MIRR are techniques used in evaluating capital budgeting projects. MIRR is short for modified internal rate of return; the need for modification arises for the reason that IRR may not exist in some cases or in others it may not be unique. To overcome this difficulty and to still be able to get a rate of return, an adjusted or modified internal rate of return is used. Unlike IRR, MIRR is calculated using a closed form formula that almost always produces a solution when at least one cash flow is negative and at least one cash flow is positive. IRR assumes that the cash flows can only be reinvested at the IRR. This leads to problems, as it may not be always possible to reinvest at an IRR that is much higher than the cost of capital. This issue does not arise with MIRR that assumes that the cash flows can be reinvested at the company's cost of capital. 12. Discuss why NPV is a better method to evaluate capital investments as compared to other methods. It is argued that NPV is a better method to evaluate capital investments as compared to the other methods. This is especially true when comparing mutually exclusive projects or when budget rationing is the only option (due to scarce resources that the organisation has at its disposal). The main reason NPV is preferred is the fact that one can always calculate NPV given the discount rate. Compare this to the IRR which may not always exist or it may not be unique. NPV provides an investor with a monetary amount that an organisation tends to gain or lose by investing in a project (and as most organisations want to keep an eye on the bottom line they will be more inclined to approve a profitable investment positive NPV). Other measures such as payback period provide time periods as compared to monetary amounts. The main advantage NPV has over IRR is that one is always able to calculate it with a discount rate whereas IRR may not yield a value in certain instances or there may be multiple IRR values. Another issue that renders IRR useless is when there is a ranking issue with the cash flows and comparative projects have opposing values for NPV and IRR. One project may have a higher IRR and lower NPV whereas the other project may have lower IRR and higher NPV. In cases of such conflict one can always make a decision about the investment based solely on NPV. The same holds true with projects with different lives, in such cases IRR does not provide any help yet we can alter the behaviour of NPV with either replacement chain NPV or the annual annuity method to make the decision. Regenesys Business School 107

112 Mini Case Study on Capital Budgeting Methods 1. Payback period: Project H: 2.85 years Project N: 2.67 years Project H: (R ) + R R = (R85 000) For year 3: / = 0.85 year = 2.85 years Project N: (R ) + R R = (R60 000) For year 3: / = 0.67 year = 2.67 years 2. NPV: Project H: NPV = (R x PVIFA14%, 4 years) R = (R x 2.914) R = R R = R6 400 Project N: Year Cash inflows (1) PVIF 14%t (2) Present value at 14% (1) x (2) 1 R R Total R IRR Present value of cash inflows R Less initial investment R NPV = R Project H: Calculator solution = 15.09% Project N: Calculator solution = 16.19% Regenesys Business School 108

113 4. Project Project H Project N Payback period 2.85 years 2.67 years* NPV R6 371 R11 552* IRR 15% 16%* * Preferred project Project N is recommended, because it has the shorter payback period and the higher NPV (which is greater than zero) and the larger IRR (which is greater than the 14% cost of capital). Sample analyses for FF Inc. Possible responses to the data provided. 1. The answer should be focused on using the current and quick ratios. While the current ratio has steadily increased, it is to be noted that the liquidity has not resulted from the most liquid assets as the CEO proposes. Instead, from the quick ratio one could note that the increase in liquidity is caused by an increase in inventories. For a fresh food firm one could argue that inventories are relatively liquid when compared to other industries. Also, given the information, the industry-benchmark can be used to conclude that the firm's quick ratio is very similar to the industry level and that the current ratio is indeed slightly higher. Again, this seems to come from inventories. 2. Inventory turnover, days sales in receivables, and the total asset turnover ratio are to be mentioned here. Inventory turnover has increased over time and is now above the industry average. This is good especially given the fresh food nature of the firm's industry. In 2012, it means for example, that every 365/62.65 = 5.9 days the firm is able to sell its inventories as opposed to the industry average of 6.9 days. Days' sales in receivables have gone down over time, but are still better than the industry average. So, while they are able to turn inventories around quickly, they seem to have more trouble collecting on these sales (although they are doing better than the industry). Finally, total asset turnover went down over time, but it is still higher than the industry average. It does tell us something about a potential problem in the firm's long-term investments, but again, they are still doing better than the industry. 3. Solvency and leverage is captured by an analysis of the capital structure of the firm and the firm's ability to pay interest. Capital structure: both the equity multiplier and the debt-to-equity ratio tell us that the firm has become less levered. To get a better idea about the proportion of debt in the firm, we can turn the D/E ratio into the D/V ratio: 2012:43%, 2011:46%, 2010:47%, and the industry-average is 47%. So based on this, we would like to know why this is happening and whether this is good or bad. From the numbers it is hard to give a qualitative judgement beyond observing the drop in leverage. In terms of the firm's ability to pay interest, 2012 looks pretty bad. However, remember that times interest earned uses EBIT as a proxy for the ability to pay for interest, while we know that we should probably consider cash flow instead of earnings. Based on a relatively large amount of depreciation in 2012 (see info), it seems that the firm is doing just fine. Regenesys Business School 109