CORPORATE FINANCE A South African Perspective EDITEDBY GIDEON ELS ELDA DU TOIT I PIERRE ERASMUS I LIEZEL KOTZE I SAM NGWENYA KEVIN THOMAS I SUZETTE VIVIERS OXFORD UNIVERSITY PRESS SOUTHERN AFRICA
Table of Contents Introduction to~cqr^5 a^e_fjnaincial management 1 1.1 Introduction ~:~re:~:=..:::.:s..:.:. 2 1.2 What is corporate finance? 3 1.2.1 The role of corporate financial management 3 1.2.2 The financial manager 4 1.2.3 Corporate financial-management decisions...-. 5 1.3 The goals of financial management 7 1.3.1 Shareholders'wealth maximisation 8 1.4 The corporate forms of business 10 1.4.1 Sole proprietorship 10 1.4.2 'Partnership 11 1.4.3 Companies 11 1.4.4 Close corporation 12 1.5 The agency problem 13 1.5.1 Agency costs 13 1.5.2 Managerial versus shareholder goals 14 1.5.3 Managerial compensation 14 1.6 Financial markets and institutions 15 1.6.1 Financial markets 15 1.6.2 Financial institutions 17 1.6.3 Flow of funds 17 1.7 Corporate governance and ethics 18 1.7.1 Corporate governance 18 1.7.2 Business ethics 19 1.8 Conclusion '. 20 Part l: Measurement 27 2 Financial statements 29 2.1 Introduction 30 2.2 The objectives of financial statements : 31 2.3 Who are the users of financial statements? 32 2.4 Requirements for financial statements 33 2.5 The standardisation of financial statements 33 2.6 Statement of financial position 34 2.6.1 Assets '. : 36 2.6.2 Total equity 39 2.6.3 Liabilities 40 2.7 Statement of comprehensive income 41 2.8 Statement of cash flows 45 2.8.1 Cash flow from operating activities 46 2.8.2 Cash flow from investing activities 47 2.8.3 Cash flow from financing activities 47 2.9 Conclusion 48
Ratio analysis 57 3.1 Introduction 58 3.2 Requirements for financial ratios 59 3.3 Norms of comparison 60 3.4 Types of ratios 60 3.5 Profitability ratios 61 3.5.1 Return on assets 62 3.5.2 Return on equity 63 3.5.3 Return on shareholders' equity 63 3.5.4 Return on ordinary shareholders' equity :: 63 3.6 Profit margins : 63 3.6.1 Gross profit margin 64 3.6.2 Operating profit margin 64 3.6.3 Earnings before interest and tax margin 64 3.6.4 Net profit margin 64 3.7 Turnover ratios 65 3.7.1 Total asset turnover ratio 65 3.7.2 Property, plant and equipment turnover ratio 65 3.7.3 Current asset turnover ratio 66 3.7.4 Trade receivables turnover ratio 66 3.7.5 Inventory turnover ratio 66 3.7.6 Trade payables turnover ratio : 66 3.8 Liquidity ratios 67 3.8.1 Current ratio 67 3.8.2 Quick ratio 68 3.8.3 Cash ratio 68 3.8.4 Trade receivables turnover time 69 3.8.5 Inventory turnover time 69 3.8.6 Trade payables turnover time 69 3.8.7 Cash conversion cycle :' 69 3.9 Solvency ratios 69 3.9.1 Debt:assets ratio. 70 3.9.2 Debt:equity ratio 70 3.9.3 Financial leverage ratio 70 3.9.4 Finance cost coverage 71 3.9.5 Fixed payments coverage ratio 71 3.9.6 Preference dividend coverage ratio : 71 3.10 Cash flow ratios : 72 3.10.1 Cash flow to turnover ratio 72 3.10.2 Cash return on assets ratio 73 3.10.3 Cash return on shareholders' equity ratio 73 3.10.4 Cash flow to operating profit ratio 73 3.10.5 Finance and dividend cost coverage ratios 74 3.10.6 Other cash coverage ratios 74 3.11 Investment ratios 74 3.11.1 Earnings per share ratio 74 3.11.2 Dividend per share ratio 75 3.11.3 Price-earnings ratio 75 3.11.4 Dividend payout ratio 75
3.H.5 Ordinary dividend coverage ratio 76 3.11.6 Market-to-book value ratio 76 3.12 Financial gearing 76 3.13 DuPont Analysis 78 3.14 Conclusion 80 Part 2: Investment decisions 89 4 The time value of money. :':... 91 4.1 Introduction 92 4.2 Interest rates 93 4.3 Future value and compounding of lump sums 94 4.3.1. Investing for a single period : 95 4.3.2 Investing for more than one period 95 4.4 Compounding interest more frequently than annually 98 4.4.1 Semi-annual, quarterly and monthly compounding 98 4.4.2 Continuous compounding 101 4.5 Nominal and effective interest rates 102 4.6 Present value and discounting 104 4.7 More on present and future values 105 4.7.1 Determining an interest rate 105 4.7.2 Calculating the number of periods 106 4.8 Valuing annuities 107 4.8.1 Future value of an ordinary annuity 107 4.8.2 Future value of an annuity due : 112 4.8.3 Present value of an ordinary annuity 114 4.8.4 Present value of an annuity due : 115 4.8.5 Ordinary deferred annuities 116 4.8.6 Mixed streams of cash flows : 117 4.8.7 Retirement funding 119 4.9 Perpetuities 119 4.10 Amortising a loan 121. 4.ii Sinking funds 125 4.12 Conclusion 127 Appendix 135 5 Investment appraisal methods 139 5.1 Introduction. 140 5.2 The importance of efficient investment appraisal -. : 141 5.3 Types of investment projects 143 5.3.1 Replacement projects. 143 5.3.2 Expansion projects 144 5.3.3 Independent projects 144 5.3.4 Mutually exclusive projects 144 5.3.5 Complementary projects 144 5.3.6 Substitute projects 145 5.3.7 Conventional projects...145 5.3.8 Unconventional projects : 145
5.3.9 Other types of projects : 145 5.4 The average return method 146 5.5 The payback period method 148 5.6 The discounted payback period method 150 5.7 The net present value method 151 5.8 The internal rate of return method -. : 154 5.9 Comparing the net present value and internal rate of return methods 157 5.9.1 Net present value profile 158 5.9.2 Discussion of the NPV profile 158 5.9.3 Evaluating mutually exclusive projects by means of the IRR method 159 5.10 Modified internal rate of return 160 5.11 The profitability index 163 5.12 Conclusion 164 6 Estimating relevant cash flows 173 6.1 Introduction 174 6.2 The difference between profit and cash flow 175 6.3 Estimating relevant cash flows 175 6.3.1 Sunk costs : 176 6.3.2 Opportunity costs 176 6.3.3 Finance costs.. 176 6.3.4 Inflation and tax :. 176 6.4 The components of project cash flows v 177 6.5 Calculating the initial investment 180 6.5.1 Initial investment for an expansion project, 180 6.5.2 Initial investment for a replacement project-. 182 6.6 Calculating the operating cash flows 184 6.6.1 Operating cash flows of an expansion project. 184 6.6.2 Operating cash flows of a replacement project. : 186 6.7 Calculating the terminal cash flow...:.:' : 187 6.8 Capital gains tax : 189 6.4 Conclusion 190 7 Appraising investment risk 197 7.1 Introduction. 198 7.2 What are uncertainty and risk and why do they need to be assessed?. 199 7.2.1 Uncertainty and risk : :.. 199 7.2.2 Risk vs return 200 7.2.3 Approaches to risk in investment appraisal 201 7.3 Types of risk in investment projects 202 7.4 Probability distributions and expected values 203 7.4.1 Probability distribution : 203 7.4.2 Expected value 205 7.5 Using scenario analysis, sensitivity analysis and simulation analysis to assess risk 206 7.5.1 Scenario analysis,. 207 7.5.2 Sensitivity analysis. 208 7.5.3 Simulation analysis 209 7.6 Break-even analysis as a measure of dealing with risk 210 7.6.1 Accounting break-even analysis 212
7.6.2 Accounting break-even analysis and operating cash flow 213 7.6.3 Cash break-even analysis 214 7.6.4 Financial break-even analysis 215 7.7 Conclusion 216 Bond valuation and interest rates 225 8.1 Introduction : 226 8.2 What is a bond? 227 8.3 Characteristics of bonds 227 8.4 How to value a bond ; 228 8.5 The different types of bonds 234 8.5.1 Government bonds 234 8.5.2 Municipal bonds 235 8.5.3. Corporate bonds 235 8.5.4 Convertible bonds. 235 8.5.5 Junk bonds 236 8.5.6 Zero-coupon bonds. 236 8.5.7 Extendable and retractable bonds 237 8.5.8 Foreign-currency bonds 237 8.5.9 Inflation-linked bonds 237 8.6 Bond markets and bond ratings 238 8.6.1 Bond markets and reporting 238 8.6.2 Bond ratings 239 8.7 What determines bond returns? 241 8.7.1 Real interest rate and expected inflation rate 241 8.7.2 Interest rate risk and time to maturity 241 8.7.3 Default risk 242 8.7.4 Lack of liquidity. : 242 8.8 The influence of interest and inflation/rates on bonds 242 8.8.1 The difference between nominal and'real interest rates 242 8.8.2 The Fisher Effect 243 8.9 Conclusion 244 Share valuation 253 9.1 Introduction 254 9.2 Ordinary shares and preference shares, 255 9.3 The development of stock exchanges...257 9.4 Defining value 257 9.4.1 Par value 257 9.4.2 Market value : 257 9.4.3 Book value 258 9.4.4 Economic/intrinsic value 258 9.5 Share valuation 258 9.5.1 Discounted cash flow techniques 259 9.5.2 Relative valuation techniques 263 9.6 Expected return and required return 266 9.7 Market efficiency 267 9.8 Conclusion 268
Part 3: Financing decisions 277 10 Risk and return 279 10.1 Introduction 281 10.2 Assessing the return and risk characteristics of a single security 281 10.2.1 Evaluating historic returns 281 10.2.2 Evaluating expected returns 284 10.2.3 Evaluating historic risk 285 10.2.4 Evaluating expected risk : 288 10.2.5 Coefficient of variation!" 289 10.2.6 Summary-single security return and risk 290 10.3 Assessing the return and risk characteristics of a portfolio 291 10.3.1 Assessing expected portfolio returns 291 10.3.2 Assessing expected portfolio risk 291 10.3.3 Portfolio risk: A closer look 294 10.3.4 Summary: Portfolio return and risk 296 10.4 The security market line 296 10.5 Conclusion 299 11 Cost of capital 309 n.i Introduction 310 n.2 Pooling of funds 311 n.3 Cost of capital 312 n.3.1 Cost of ordinary shareholders' equity 313 n.3.2 Cost of preference shares 318 n.3.3 Cost of debt 319 n.4 Weighted average cost of capital 322 n.4.1 Calculating weighted average cost of capital 322 n.4.2 Assumptions of weighted average cost of capital 325 n.5 Using weighted average cost of capital in investment decisions 326 n.6 Marginal cost of capital 327 ii.7 Conclusion 327 12 Capital structure 335 12.1 Introduction 336 12.2 The different types of equity finance 336 12.2.1 External sources of equity finance 336 12.2.2 Internal sources of equity finance - reserves and retained earnings 340 12.3 The different types of non-current debt finance 340 12.3.1 Bonds and debentures 341 12.3.2 Mortgage bonds 341 12.3.3 Other non-current loans 341 12.4 Debt versus equity 341 12.5 Medium-term finance 342 12.5.1 Term loans 342 12.5.2 Leases 342 12.5.3 Finance leases 342 12.5.4 Operating leases 343
12.5.5 Sale and leaseback. 343 12.5.6 The borrow and buy versus lease decision 343 12.5.7 Discount rate 347 12.5.8 Assessed losses 347 12.5.9 Factoring 348 12.5.10 Invoice discounting.'." 349 12.5.H Other sources of medium-term finance 349 12.6 Gearing 351 12.7 Capital structure 352 12.8 Optimal capital structure,: 353 12.8.1 Modigliani and Miller's theory of gearing 354 12.8.2 Traditional theory of gearing 354 12.9 Conclusion 355 Part 4: Dividends 363 13 Dividend policy 365 13.1 Introduction 366 13.2 Dividend policy issues 367 13.2.1 Information content 368 13.2.2 Clientele effect 369 13.2.3 Homemade dividends 369 13.3 Is it important to have a dividend policy? 370 13.3.1 Dividend irrelevance 370 13.3.2 Dividend relevance 371 13.4 The level of dividend payout 372 13.4.1 Deciding on the dividend level...-. 373 13.4.2 The residual distribution model 374 13.4.3 Fixed dividend cover.<'. 374 13.4.4 Constant growth 375 13.5 The dividend payment process 375 13.6 Payout policy options 376 13.6.1 Cash dividend 376 13.6.2 Share dividend 377 13.6.3 Share repurchase 377 13.7 Stock splits and consolidations...378 13.8 Conclusion 379 Part 5 : Working-capital management 387 14 Working-capital management 389 14.1 Introduction 390 14.2 What is working capital? 391 14.2.1 Current assets and current liabilities 391 14.2.2 Net working capital 392 14.3 Why is it important to manage working capital? 392 14.3.1 Liquidity 394
14.3.2 The risks of liquid assets 394 14.4 The cash conversion cycle 395 14.4.1 The elements of the cash conversion cycle 396 14.4.2 Calculating the cash conversion cycle 396 14.5 Managing cash 398 14.5.1 Cash budgeting 398 14.6 Managing inventory 400 14.6.1 The importance of inventory management 400 14.6.2 Methods of managing inventory 401 14.7 Managing accounts receivable (debtors) ṿ ". 402 14.7.1 The importance of accounts receivable management 402 14.7.2 Establishing a credit policy 403 i4.8> Managing accounts payable (creditors) 405 14.9 Conclusion : 406 Solutions : 415 Index 475