FINANCIAL MANAGEMENT

BACHELOR OF COMMERCE (HONOURS)

DEGREE

FINANCIAL MANAGEMENT

MODULE GUIDE

Copyright © 2019

REGENT Business School

All rights reserved; no part of this book may be reproduced in any form or by any means, including
photocopying machines, without the written permission of the publisher

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TABLE OF CONTENTS

INTRODUCTION TO THE MODULE ......................................................................... 3

CHAPTER 1:
Financial Statements and Ratio Analysis ................................................................... 8

CHAPTER 2:
Time Value of Money and the Effect of Compound Interest ..................................... 26

CHAPTER 3:
Investment Appraisal Methods ................................................................................. 45

CHAPTER 4:
Share Valuation ........................................................................................................ 59

CHAPTER 5:
Bonds and Bond Valuation ....................................................................................... 70

CHAPTER 6:
The Cost of Capital................................................................................................... 79

CHAPTER 7:
Dividends and Dividend Policy ................................................................................. 94

CHAPTER 8:
Working Capital Management ................................................................................ 114

REFERENCES ....................................................................................................... 136

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INTRODUCTION TO THE MODULE

INTRODUCTION

This study guide on Financial Management has been devised in line with your
syllabus and the latest developments in the field of Financial Management. The
structure of the guide is simple and user- friendly and designed to maximise your
learning experience.

This module assumes that you are familiar with basic financial concepts, which you
have encountered in your undergraduate studies. Notwithstanding this, this guide is
written with a view to refreshing the students’ knowledge as much as possible in
order to ensure a seamless transition to post graduate level.

Teaching and Learning Strategies: The delivery will include guided reading by
students and discussions at workshops. Students will engage in self-study in
theoretical and practical topics, and problem solving exercises.

Contents and Structure: There are many frameworks, which can be used in the
study of managerial finance. We have selected a framework, which gives an
overview of the managerial finance function as a whole. Accordingly, this module
guide comprises of ten chapters.

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MODULE OUTCOMES
This module looks closely at the financial well-being of the firm and its shareholders
by investigating the role of financial management and of long-term and working
capital, and the financial measurement and choice of projects to invest in.

After working through this guide, you should be able to:

• Provide a critical analysis of past performance of a business through the use of

ratio analysis,
• Assess the feasibility of projects through investment appraisal techniques
• Estimate the cash flow of a project and evaluate implied business risk and its
suitability for inclusion in a firm’s portfolio of investments
• Demonstrate knowledge of the various sources of finance and critically evaluate
the implications of each type for finance sourcing
• Calculate the cost of capital in business environments by applying relevant
models
• Demonstrate knowledge of the management of working capital in the context of
a business

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SPECIFIC OUTCOMES AND CHAPTER ALIGNMENT

SPECIFIC OUTCOMES SPECIFIC OUTCOME ALIGNMENT

SO 1: Provide a critical analysis of past Chapter 1: Financial Statements and

performance of a business through the use Ratio Analysis
of ratio analysis

SO 2: Assess the feasibility of projects Chapter 3: Investment appraisal

through investment appraisal techniques methods

SO 3: Estimate the cash flow of a project Chapter 3: Investment appraisal

and evaluate implied business risk and its methods
suitability for inclusion in a firm’s portfolio of
investments

SO 4: Chapter 4: Share Valuation

Demonstrate knowledge of the various sources Chapter 5: Bond Valuation
of finance and critically evaluate the implications
of each type for finance sourcing Chapter 7: Dividend and Dividend policy

SO 5: Calculate the cost of capital in Chapter 6: Cost of Capital

business environments by applying relevant
models

SO 6: Chapter 8: Management of working

Demonstrate knowledge of the management of capital
working capital in the context of a business

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SPECIFIC OUTCOMES AND ASSESSMENT CRITERIA

SPECIFIC OUTCOMES ASSESSMENT CRITERIA

Students must have
SO 1: Provide a critical analysis of past outlined in a meaningful way the
various reports used to communicate
performance of a business through the financial information to shareholders
use of ratio analysis and other stakeholders; evaluated with
comprehension the results of the ratio
analysis and made recommendations
for future action; performed an in
depth analysis of the company’s
performance and made detailed
comparisons with other similar
companies in the same industry.

SO 2: Assess the feasibility of projects discussed in full the importance of the

investment appraisal process; and
through investment appraisal correctly calculated the feasibility of a
techniques potential project using investment
appraisal method

SO 3: Estimate the cash flow of a explained in detail which amounts

constitute cash flow in a business;
project and evaluate implied business discussed comprehensively the effect of
risk and its suitability for inclusion in a business risk on cash flows; correctly
calculated present value of cash flows
firm’s portfolio of investments for a potential investment

SO 4: Demonstrate knowledge of the explained with examples the different

types of shares in a company; discussed
various sources of finance and critically evaluatively the importance of raising
evaluate the implications of each type debt finance to a company as well as
the disadvantages of such; interpreted
for finance sourcing with insight the various methods used
to value shares of a company; described
in detail the relationship between
bond prices and interest rates

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SO 5: Calculate the cost of capital in discussed all the advantages and

disadvantages of the different forms
business environments by applying
of capital; analysed with insight the
relevant models relevant capital structure of the business
in order to determine the optimal capital
structure mix; correctly calculated the
weighted average cost of capital for a
company

SO 6: Demonstrate knowledge of the recognised with comprehension the

importance of the management of
management of working capital in the working capital; discussed elaboratively
context of a business alternative sources of short-term
borrowings; appreciated that there are
various possibilities for the short-term
investment of surplus funds; correctly
calculated the economic order quantity
for inventory; ensured management
with a high level of confidence and
accuracy of the debtors and creditors of
the company

READINGS

PRESCRIBED:
Els, G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.
(2014)

Corporate Finance, A South African Perspective, 2nd edition, Oxford

University Press.

RECOMMENDED READINGS
Ross, S; Westerfield, RW; Jordan, BD; and Firer C. (2009). Fundamentals
of Corporate Finance, 4th South African Edition, McGraw-Hill.

Correia, C; Flynn, D; Uliana, E and Wormald, M. (2008) Financial

Management, 6th Edition, Juta Publishing.

Marx, J; de Swardt, C; Beaumont Smith, M; Naicker, B; Erasmus, P. (2007)

Financial Management in Southern Africa, 2nd Edition, Pearson Education.

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CHAPTER 1: FINANCIAL STATEMENTS

AND RATIO ANALYSIS

CONTENTS

1. Introduction

2. Users of Annual Financial Statements

3. The Need for Comparisons

4. Types of Ratios

5. Limitations of Financial Statement Analysis

6. Calculation and Interpretation of Ratios

7. Approaches to Financial Statement Analysis

8. Typical Exam Type Questions

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Learning Outcomes

After working through this section you should be able to

• Outline the various reports used to communicate financial information to

shareholders and other stakeholders.
• Define what is meant by the interpretation of accounts.
• Identify the parties who use financial analysis.
• Calculate and interpret commonly used financial ratios.
• Evaluate the results of the ratio analysis and make recommendations for
future action.
• Identify the limitations of using accounting data to perform financial analysis.
• Outline the various approaches to financial statement analysis and to
identify when each approach is appropriate.
• Use Du Pont analysis for interpreting the financial results of a company.
• And outline the limitations of ratio analysis.

READINGS PRESCRIBED:

Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.

(2014) Corporate Finance, A South African Perspective, Oxford University
Press.

RECOMMENDED:

Chapter 3: 4th South African Edition, Ross S, Westerfield RW, Jordan BD and
Firer C, Fundamentals of Corporate Finance, (2009). McGraw Hill

Chapter 5: Correia, C; Flynn, D; Uliana, E and Wormald, M. (2008) Financial

Management, 6th Edition, Juta Publishing.

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1. 1. Introduction
Financial statement analysis concerns itself with the study of relationships within a
set of financial statements at a point in time and with the trends in these relationships
over time. It is a process which aims to evaluate the current and past financial results
of an organisation, with a view to testing its liquidity, solvency, profitability, asset
management and market value measures/ratios. The interpretation and evaluation of
financial data requires familiarity with the basic tools of financial statement analysis
(ratio analysis). Naturally, the type of financial analysis that takes place depends on
the particular interest that the analysts has in the enterprise.

1.2. Users of Financial statements

The following examples illustrate the different perspectives which various parties may
have when approaching the analysis of a company:

1.2.1. Shareholders and potential shareholders

They are interested in the profitability of the business as measured by the return on
their investment in equity. They will also wish to establish the financial stability of the
company in order to assess the risk attached to their investment.

1.2.2. Suppliers of short term credit

These may include banks that provide overdraft facilities or trade creditors supplying
goods on credit, will be interested in the ability of the company to pay its debts
promptly. Their time horizon is much shorter than shareholders, for example, in the
normal course of business, 90 days is the usual maximum credit term allowed by
suppliers.

1.2.3. Suppliers of long term credit

For example long term loans, mortgage bonds and debentures. These parties will be
interested in the company’s ability to meet its interest commitments and its ability to
repay the long term debts on maturity. Their analysis may thus be similar to that of
the shareholders, as they look to a further horizon and often have large amounts of
money due to them.

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1.2.4. Management
Management is concerned with every aspect of the company as their mandate is to
maximize the wealth of the shareholders and ensure continued operation. They must
ensure that the company is operating efficiently and effectively. Their particular focus
will be on profitability, risk and day to day running of the business.

1.2.5. Auditors
Are required to establish whether the company is a going concern and whether the
financial statements fairly present the published results of the company. To be in a
position to pass their opinion, an analytical review of the company is required.

1.2.6. Employees/Unions
Their primary concern is job security and assurance is that they are not being
exploited.

1.3. The Need for Comparisons

Comparison is a vital analytical process, since in financial analysis no number in
isolation can be meaningful. However, when compared with some or other
predetermined standard, that number gains some meaning, relevance and
usefulness. The most important factor revealed by comparative financial statements
is the trend. The trend indicates the direction of change, the rate of change and the
amount of change. Comparison may be facilitated by using:

- Historical standards
- Industry standards.

Historical standards are based on the past performance of the company, and are used
to establish trends of the company’s performance over several industry years.
Industry standards are determined/influenced by the following:-

• Type of operation: The major operation of the entity, distinguishing between

manufacturing, wholesale, retail or service type.

• Type of product: The nature of the product or service will make a considerable
difference to the perception of the riskiness of the business.

• Location: The physical location of the outlets for the goods or services of a
company will to a large extent determine growth potential of a company.

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• Clientele: Will be dependent upon the nature of goods or services provided, spending
capacity, and whether they have bargaining power and are there alternative sources.

• Suppliers: Whether the company relies heavily on suppliers for raw materials and
other essential components.

• Competition: Free competition should result in the survival of efficient companies

and the demise of those which are not efficient. Of course, the key to success is to
remain ahead of your competition through productivity and innovation.

1.4. Types of Ratios

1.4.1. Liquidity ratios: indicate the ability of the company to meet its short term
financial obligations/debt

1.4.2. Profitability ratios: express the effectiveness of the company in earning

profits and show its return on capital invested.

1.4.3. Financial leverage ratios: show the relative extent to which the capital
employed has been provided by shareholders and loan capital.

1.4.4. Market ratios: reflect the performance of the share price on the stock
exchange and the implications for shareholders.

1.4.5. Efficiency ratios: reflect the management ability of the company with regard
to its turnover and working capital.

1.5. Limitations of Financial Statement Analysis

• It is difficult to find comparable firms
• Differences in accounting practices (depreciation, stock valuations)
• Differences in financial year ends (28 February vs 31 December)
• Differences in capital structure (zero gearing, low gearing and high gearing)
• Seasonal variations (winter high sales vs summer high sales)
• One-time events (extraordinary write-offs, acquisition of a company carrying high
assessed losses)

1.6. The calculation and interpretation of ratios

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1.6.1. Liquidity Ratios

The ability of the firm to meet current debts is important in evaluating a firm’s financial
position as well as its ability to survive and grow. Certain basic ratios can be computed
that provide some guides for determining the enterprise’s short term debt paying
ability.

A. The Current ratio

The current ratio is the ratio of total current assets to current liabilities. The
components of current assets are: inventories, trade and other receivables and
cash. It is expressed as:

Current ratio = Current Assets

Current Liabilities

This ratio indicates the extent to which the claims of short term creditors are covered
by current assets that can be translated into cash readily (or is already in the form of
cash) in the short term. The popular rule of thumb for this ratio is 2:1. Ratios marginally
lower than 2:1 are acceptable. Strangely enough ratios higher that say, 3:1 could be
masking liquidity issues, like, the business is holding too much of stock (but more of
that later), its investment in receivables is too high (thus resulting in exposure to bad
debts and holding too much cash in short term accounts.

This is not the ideal situation, as the task of the FM is to ensure that the business’
resources are well invested. It must be noted that the current ratio is only one measure
of determining liquidity, and does not answer all the liquidity questions.

B. Acid-test (quick) ratio: As it normally takes longer to translate inventory into cash,
it is useful to measure the firm’s ability to pay off short term debt without relying on
the sale of inventory. The ratio is:

Acid Test Ratio = Current assets – Inventory

Current liabilities

Stated differently, current assets – Inventory = Receivables + Cash.

The popular rule of thumb is 1:1, but blind application should be avoided. If the ratio
is low, the firm may have difficulty in meeting its short term needs unless it is able to

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obtain additional current assets through conversion of some of its long term assets,
through additional financing, or through profitable operating results. Another way of
evaluating liquidity is to determine how quickly certain assets can be turned into cash.
How liquid, for example, are the receivables and inventory?

C. The Cash Ratio: this measures the amount of cash available as compared to
current liabilities. There is no rule of thumb ratio for this suffices to say, that a firm
should have an open line of credit available if they do not have sufficient cash
reserves. The ratio is:

Cash ratio = Cash

Current liabilities

D. Interval Measure
This ratio measures how many days of operating expenses are covered by current
assets. This ratio is useful as it gauges how long it will take for cash to dry up in the
event of a strike and a business is unable to receive any cash inflows. The formula
is:
Interval Measure = Current assets
Average daily operating Costs
Average daily operating costs = [Operating expenses – depreciation – interest
expenses]/365

1.6.2. Profitability
Profitability ratios indicate how well the enterprise has operated during the year.
These ratios answer such questions as: was the profit adequate? What rate of return
does it represent? What amount was paid in dividends? Generally, the ratios are
either computed based on sales or on an investment base such as total assets.
Profitability is frequently used as the ultimate test of management effectiveness.

A. Gross margin on sales

This is essentially the mark up ratio. This ratio is calculated as follows:
Gross Margin on Sales = Gross Profit x 100
Sales 1
This should be compared with the margins obtained over a number of years. A fall in
this ratio would indicate one or all of the following:-

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a. A reduction in sales price to attract new customers or because of price

competition.
b. An increase in cost of purchases without a corresponding increase in sales price.
c. An undervaluation of closing stock.
d. Possible stock theft.
e. Changes in sales mix.

B. Profit margin on sales

This is also known as the net profit margin. The formula is as follows:

Profit margin on sales = Net Income x 100

Net Sales 1

A decrease in the ratio in comparison to previous years would be the result of low
mark-ups, higher costs or a combination of these factors. One would have to analyse
individual components included in overheads to ascertain whether any specific item
has contributed to this decrease, e.g. disproportionate increases in advertising
expenditure.

C. Return on total assets

The return on total assets measures the profitability of the firm as a whole in relation
to the total assets employed. It is frequently referred to as the return on investments.
This ratio is calculated by dividing earnings by total assets.
Return on Total Assets = Net income after tax X 100
Total Assets 1

D. Return on equity
In order to measure the earnings power on the shareholders equity, we calculate the
return on equity ratio. This ratio relates to net income after tax, after deducting
preference dividends to shareholders’ equity, and is computed as follows:

Return on Equity = Net Income after tax – Preference Dividends

Equity (net worth)

Ordinary Shareholders Equity is made up of the following components:

• Ordinary share capital

• Share premium

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• Distributable reserves
• Non-distributable reserves

1.6.3. Asset Management and Solvency

Ratios A. Inventory Turnover Ratio
This ratio measures how quickly inventory is sold. Generally, the higher the inventory
turnover, the better the enterprise is performing. It is possible; however, that the
enterprise is incurring high “stock out costs” because not enough inventory is
available. This ratio is useful because it may indicate that some items may be turning
over quite rapidly whereas others might have failed to sell at all. The inventory
turnover ratio is:
Inventory turnover = Cost of Goods Sold

*Average Inventory

Average inventory = (inventory beginning of year + inventory at end of year) divided

by 2)

B. Stock Holding Ratio or Days Sales in Inventory

The ratio indicates the quantity of inventory on hand in relation to the quantity
purchased (the number of days the stock is held before it is sold). This ratio is
calculated as follows:
Days sales in Inventory = Inventory 365
Cost of Sales

C. Debtors (Accounts Receivable) Collection Period

This ratio measures the average number of days that it would take for the outstanding
accounts receivable to be collected and it is computed as follows:

Debtors Collection period = *Average Accounts Receivable

(Debtors) x 365 Credit Sales

*Average Accounts Receivable = Accounts Receivable at beginning of year +

Accounts Receivable at end of year) divided by 2. If this ratio is unduly high it may
point towards an inefficient accounts receivable collection department. To expedite

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collections, discounts may be offered to customers paying within a certain time period
say 15, 30 or 45 days.

The following methods may be used to ensure proper control of accounts

receivable:

• Offer discounts for prompt settlement

• Send statements timeously
• Use reminder options, like SMS, emails, telephone calls, etc.
• Charge interest on overdue accounts.
• Reduce credit limits
• Freeze available credit altogether on certain accounts
• Hand over errant accounts for collection.

• Blacklist clients who default.

• Sue habitual offenders.

D. Creditors (Accounts Payable) Payment

Period This ratio is computed as follows:

Creditors payment period = Accounts Payable

(Creditors) x 365 Credit Purchases

This ratio calculates the number of days it takes before creditors are settled. An
increasing trend in this ratio could indicate inability of the company to meet credit
obligations within a certain time period. And this will arise directly out of a poor
debtors’ collection ratio. It is important to ensure the business has a good reputation
in the eyes of creditors. Poor reputations tend to spread and may have a damaging
effect on the credit worthiness of the business.

E. Fixed Assets (Tangible Assets) Turnover Ratio

This ratio indicates the utilisation of plant, machinery and equipment relative to
operating levels as reflected by turnover and is calculated as follows:
Fixed Asset Turnover = Sales (Turnover)

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Fixed Assets
It indicates the efficiency with which operating assets are utilised to generate sales.

1.6.4. Market Value Measures

A. Earnings per Share (EPS):

The earnings per share figure ratio is probably the ratio most used by investment
analysts.
EPS is computed by dividing earnings, by the ordinary shares in issue.
= Net Income after tax and Preference Dividends Number of
Ordinary Share Issued

Essentially, this ratio answers the question, how much has each share earned. The
trend in the earnings per share ratio is a useful indicator of performance of the
company. Generally, the higher this ratio, the better the performance of the company.

B. Dividends per Share (DPS)

This indicates the amount of dividend attributable to each share. From the investors’
point of view, the higher this ratio the better, as the dividend per share will be greater.
The formula is:
Dividends per share = Dividends
Issued Shares

C. Price Earnings Ratio

The price earnings ratio (P/E) is a statistic used by analysts in discussing the
investment possibility of a given enterprise. It is computed by dividing the market price
of the share by its earnings per share.
Price earnings ratio = Market Price of Share
Earnings per Share

If a company’s P/E ratio drops steadily this indicates that investors are not confident
of the firm’s growth potential. Generally the greater the P/E ratio, the better the
perception of investors regarding the future growth of the company. The P/E ratio is
also an indicator of the value of a business as it essentially asks the question: over
how many years will earnings take to pay off the purchase price?

D. Dividend Cover

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This ratio, although not based on market values, affect the market value of shares. It
measures the extent of earnings that is being paid out in the form of dividends. A high
dividend cover would indicate that a large percentage of earnings is being retained
and reinvested within a firm while a low dividend cover would indicate the opposite.
The formula is:
Dividend cover = Earnings per Share
Dividend per Share
Generally, growth companies are characterised by high dividend cover since they re-
invest most of their earnings.

E. Dividend Yield
The dividend yield ratio indicates the return that investors are obtaining on their
investment in the form of dividends and is calculated as follows:

Dividend yield = Dividend per share

Market Price per share

F. Earnings yield
The earnings yield is calculated by taking the earnings per share and dividing it by the
market value of the share. This ratio indicates the yield that investors are demanding.
Earnings Yield = Earnings per share
Market price per share

G. Market to Book Ratio

The market to book ratio compares the market value of the firm’s investment to their
cost. A value of less than < 1 means that the firm has not been very successful in
creating value for its shareholders. The formula is:

Market to Book Ratio = Market value per share

Book value per share

Think Point

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Consider how the market-to-book ratio could be interpreted if you

were considering the purchase of the company's shares. Some
might feel a ratio less than one would be preferred since the shares
are selling below the equity value on the books. One could use this
point to comment that the market is evaluating the company's future
earning power while the book value figures reflect the cost at which
shares had previously been issued and the amount of the past
retained earnings on the company's balance sheet.

1.6.5 Gearing and Insolvency

Debt management plays an important role in financial management and the extent of
financial leverage of the firm has a number of implications. The more the financial
leverage a firm has, the higher the risk attached to it. However, the greater the risk,
the greater the return and if a firm earns more on the borrowed funds than it pays in
interest, the return on owners equity is increased. Furthermore, by raising funds
through debt, the shareholders can obtain finance without losing control of the firm
Equity is the basic risk capital of an enterprise. Every enterprise has some equity
capital which bears the risk to which it is unavoidably exposed. Equity capital is
permanent capital and not guaranteed to be repaid (excluding liquidation). Because
of their permanence, an enterprise can invest such funds in long term assets and
expose these to greater risks. However, debt (both short and long term) has to be
repaid. Funds are often raised from other sources than equity – the intention being
to increase the rate of return on equity – this is known as gearing or leverage. The
borrowed funds are used to generate a return and if this return exceeds the borrowing
cost then the company is trading profitability on the borrowed funds.

A. Debt Ratio
The debt ratio is the ratio of total debt to total assets and measures the percentage
of total funds provided by creditors. Total debt includes long term liabilities and current
liabilities. Total assets include fixed assets, investments and current assets. The
higher the debt ratio, the higher the financial risk. The ratio is calculated as follows:
Debt Ratio = Total Debt
Total Assets

B. Interest Cover

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This ratio is determined by dividing earnings before interest and tax (EBIT) by interest
charges. This ratio measures the extent to which earnings can decline without
causing financial losses to the firm and creating an inability to meet interest costs.
Interest cover = EBIT
Interest

A high interest cover ratio i.e. a situation where the interest expense is covered
several times by the EBIT earned reflects a very low interest charge in relation to
profitability and could be due to a large percentage of the debt finance being accounts
payable (creditors) which is effectively a free form of finance. One can conclude that
the interest cover ratio must be taken into account in determining the overall risk
attached to the company.

C. Debt Equity Ratio

This ratio indicates the extent to which debt is covered by shareholders funds/equity.
The debt equity ratio is calculated as follows:
Debt Equity = Total Debt
Total Equity

This ratio indicates the relationship between borrowed capital and invested capital
and provides creditors with some idea of the company’s ability to withstand losses
without impairing the interests of creditors. The higher this ratio is, the less “buffer”
there is available to creditors if the company becomes insolvent. From the creditor’s
point of view, a low ratio of debt to equity is desirable. A high debt equity ratio would
reduce the company’s chances of borrowing additional funds without an increase in
shareholders’ equity because of the high risk factor attached to the company.

1.6.6. Du Pont Analysis

No individual ratio provides an adequate assessment of all aspects of a firm’s financial
health. However, the Du Pont system introduces a systematic approach to ratio
analysis. It is a financial analysis and planning tool that uses basic accounting
relationships, and is designed to provide an understanding of the factors that drive
the return on equity of the firm.

• Profit marginTotal Asset turnover Equity multiplier

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• Operational Efficiency is measured by the profit margin

• Asset Use Efficiency is measured by the Total Asset Turnover
• Financial leverage is measured by the equity multiplier

7. Typical Examination Type Questions

Bujumbura Plastics are a manufacturing business who make containers for
domestic use and sell directly to end users (households).

Balance Sheets for 2017 and 2016 financial years are below:
Assets 2017 2016
Non-Current Assets 6 000 000 5 800 000
Inventory 300 000 200 000
Receivables 400 000 320 000
Cash 500 000 300 000
7 200 0006 620 000

Equity and Liabilities

Share Capital (R2 shares) 4 000 000 3 500 000

Retained Income 500 000 400 000

Long term Debt 2 000 000 1 800 000

Payables 700 000 920 000

7 200 000 6 620 000

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Their abbreviated Income Statement for the year

end 2017:

Sales (Credit sales is 60%) 2 300 000

Cost of sales 1 100 000

Depreciation 100 000

Interest expense 240 000

Tax (30%) 130 000

Net Income after Tax 300 000

Dividends 200 000

Retained Income 100 000

Required

1.1. Calculate the acid test ratio for 2017 (the ratio for last year was 0,65:1) and
comment.
1.2. Calculate their debt equity ratio for 2017. And comment on where the funds
generated have been utilised in 2017.
1.3. Calculate the earnings per share and dividends per share and comment on
their retention of funds.
1.4. Calculate the Debtors collection period (use average figures) and comment on
your findings, noting that debtors are given 60 days to pay their accounts. (Note:
Debtor’s collection in the previous year was 66 days). Can you offer suggestions to
the collection team in this regard?

1.5. Calculate the inventory turnover (use average inventory) and explain how this
ratio can be used to explain/improve operating efficiencies. Is this ratio healthy, noting
the type of industry that Bujumbura operate in?
1.6. Calculate the Return on Equity (using the DuPont Identity). If return on equity
was
14% last year. Will shareholders be happy with the current return? Why or why not?

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Illustrative Example
Simply Red Ltd
Balance Sheet as at 31 December 2017

Equity and Liabilities 2010 2011

Share capital (Par value R2) 200 000 200 000
Retained profit 490 000 510 000
Shareholders’ funds 690 000 710 000
Long term debt 250 000 424 000
Trade and other Payables 60 000 66 000
Total Equity and Liabilities 1 000 000 1 200 000

Tangible Assets
Plant and equipment at cost 1 200 000 1 480 000
Accumulated depreciation -500 000 -560 000
Net fixed assets 700 000 920 000
Current Assets
Inventory 150 000 150 000
Trade and other Receivables 100 000 120 000
Cash 50 000 10 000
Total current assets 300 000 280 000
Net assets 1 000 000 1 200 000
Market price per share 8, 20 9, 10

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2017 2016
Sales (40% cash sales) 1 080 000 1 200 000
Cost of sales (50% purchased on cr) 842 000 900 000
Gross profit 238 000 300 000
Operating expenses 104 000 114 000
Depreciation 32 000 60 000
Net profit before interest and taxes 102 000 126 000
Interest 23 000 39 600
Net profit before taxes 79 000 86 400
Taxes (30%) 23 700 25 920
Net profit after tax 55 300 60 480
Income Statement for the year ended 31 December 2017

Required
Calculate and comment on the following ratios for both years.
1. The current ratio
2. Acid test ratio
3. Cash ratio
4. Interval Measure
5. Total debt ratio
6. Debt equity ratio
7. Earnings per share
8. Dividends per share
9. Price earnings ratio
10. Market to book ratio
11. Dividend yield
12. Earnings yield
13. Inventory turnover ratio
14. Days sales in inventory
15. Days sales in receivables

16. Days sales in payables

17. Total asset turnover
18. Gross margin on sales
19. Net profit/margin on sales
20. Return on total assets.
21. Return on equity (using the du Pont Identity)

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CHAPTER 2: TIME VALUE OF MONEY

AND THE EFFECT OF COMPOUND
INTEREST

CONTENTS:

1. Compound Interest

2. Concepts used in Compound Interest

3. Compound Interest with Present Value and Future Value

4. Annuities

5. Future Value of an Annuity

6. Using Annuity Tables

7. Sinking Funds and Amortisation

8. End of Chapter Questions

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Learning Outcomes

After working through this section you should be able to:

• Carry out calculations involving compound interest.

• Calculate nominal and effective rates.
• Use compound interest to calculate the present value and future value of
an investment.
• Calculate the future value of an ordinary annuity.
• Calculate the present value of an ordinary annuity.
• Calculate an amount of sinking fund payment.
• Calculate the amount of amortisation payment

Prescribed Reading
Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.
(2014)
Corporate Finance, A South African Perspective, Oxford University Press.

Recommended Reading
Chapter 2: Brecher, R. (2009) Contemporary Mathematics for Business
and Consumers. 5th Ed. USA: South-Western Cengage Learning.

Chapter 5: Firer, C.; Ross, S. A.; Westerfield, R. W. and Jordan, D.

(2004) Fundamentals of Corporate Finance. 3rd Ed. UK: McGraw Hill.

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2.1. Compound interest

Compounded interest is interest charged on the original sum and un-paid interest.
Compound interest is applied a number of times during the term of a loan or
investment. Compound interest yields considerably higher interest than simple
interest because it pays interest on a previously earned interest. For compound
interest, the interest earned for each period is reinvested or added to the previous
principal before the next calculation (Brechner, 2009).

Example 1
An investment of R500 in a bank for 3 years at interest of 6% compounded per year.

Note:

At the end of year 1 you have (1.06) 500 = R530.

At the end of year 2 you have (1.06) 530 = R561.80.

At the end of year 3 you have (1.06) R561.80 = R595.51.

R595.51 = (1.06) 561.80

= (1.06) (1.06) 530

= (1.06) (1.06) (1.06) 500

= 500 (1.06)3

2.2. Concepts used in Compound Interest

This section uses a compound interest to explore various concepts including, the time
value of money, compound amount or future value (FV) and present amount or
present value (PV).

2.2.1. Time value of money

Time value of the money refers to the idea that the money in the present, is more
desirable than the same amount of money in the future, because it can be invested
and earn interest as time goes by (Brechner, 2009). If the bank owed R12 000, you
would prefer to have it now instead of one year from now.

2.2.2. Compound amount (future value)

A future value is the total amount of principal and accumulated interest at the end of
loan or investment.

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2.2.3. Present amount (present value)

A present value or a principal amount is an amount of money that must be
deposited today, at compound interest, to provide a specified lump sum of money
in the future.

2.2.4. Compounding periods

The interest can be computed annually, semi-annually, quarterly, monthly, daily
and continuously. Various compounding options and the corresponding number
of periods per year are shown in Table 1.1.
Table1: The number of compounding periods

Interest compounded Compounding period per year

Annually Every year 1
Semi-annually Every 6 months 2

Quarterly Every 3 months 4

Monthly Every month 12

Daily Every day 365 or 360

Continuously Infinite

To find the number of compounding periods of an investment, multiply the

number of years by the number of periods per year

For example, a principal amount invested for 3years with interest rate
compounded semi-annually is calculated as follows:

2.2.5. Conversion of interest per period

The interest rate used per period is known as a periodic rate. This is the interest rate
charged (and subsequently compounded) for each period, divided by the amount of
the principal. The periodic rate is used primarily for calculations and is rarely used
for comparison. The periodic is different from the quoted annual rate known as
nominal interest.

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To find the periodic rate we divide the nominal interest by the number of periods per
year

An example of converting an annual nominal interest of 12% into periodic rates is

shown in Table 1.2.

Table 2: Periodic rates

Nominal interest rate Periods per year Periodic rate Decimal
12% compounded annually 1 12% 0.12
12% compounded Semi-annually 2 6% 0.06
12% compounded quarterly 4 3% 0.03
12% compounded monthly 12 1% 0.01

2.2.6. Effective interest rates

To put different rates and frequencies of conversion on a comparable basis, we
determine the effective rate. The effective rate is the rate converted annually that will
produce the same amount of interest rate per year as the nominal rate converted for
periods per year Effective annual rate is the total accumulated interest that would be
payable up to the end of one year, divided by the principal. (Els 2010: 93)

Example 2
A nominal rate of 6% compounded annually, will also have the effective rate of 6%.
However, if the nominal rate 6% is compounded semi-annually, the amount of R1 at
the end of one year will be the accumulation factor for a rate per period of 3% and
two periods. This is (1.03)2 = R1.0609.

The interest on R1 for one year is then R1.069 - R1 = 0.0609. This is equivalent to
an annual rate of 6.09%. Thus, 6.09% compounded annually will result in the same
amount of interest as 6% compounded semi-annually.

The formula for the effective interest rate is as follows:

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Where: r = the effective rate, i = the nominal rate per period and m = the number of
periods.
Apply this formula to the previous example, the effective rate is calculated as follows:

It is important to note that economists generally prefer to use effective annual rates
to allow for comparability. In finance and commerce, the nominal annual rate may
however be the one quoted instead. When quoted together with the compounding
frequency, a loan/investment with a given nominal annual rate is fully specified (the
effect of interest for a given loan/investment scenario can be precisely determined),
but the nominal rate cannot be directly compared with loans/investment that have a
different compounding frequency.

2.3. Compound interest with present and future values

The compounding interest is used to calculate the future value of an investment when
the principal or present value is known. It is also used to calculate the present value
to be deposited now to earn a known future amount.

2.3.1 Future value and compound interest

Where: F = future value, P = principal or present value, i = periodic interest rate (in
decimal form) and n = number of compounding periods.

Example 3

Jock Stein invested R1200 at 8% interest compounded yearly for 5 years. Calculate:

3.1. His total investment at maturity and

3.2. The total amount of interest earned for the five year period?

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Example 4

Use the compound interest rate formula to calculate the compound amount of
R5000 invested, at 10% interest compounded semi-annually, for 3 years.

Solution

Compounding periods (n) = 2periods per year x 3 years = 6 periods

Periodic Interest rate (1) = 10/2 = 5% + 0.05

F =P(1+i)n = 5000 (1 + 0.05)6

= 5000(1.05)6-R6 700.48

2.3.2. Present value and compound interest

Using the compounding interest rate, the present value of an investment is
calculated as follows:

Where: P = principal or present value, F = future value, i = periodic interest rate (in
decimal form) and n = number of compounding periods.

Example 5
Ken Rosewall invested a certain amount of money at 8% interest compounded yearly
for 5 years and earned a future value of R1 763.19. Calculate the total amount of
investment.

Solution

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Since the interest rate is compounded annually there is no adjustment for the
compounding period and periodic interest rate

Example 6
Calculate the present value of R3 000 at interest rate of 16% compounded
quarterly, for 6 years.

Solution
Compounding periods (n) = 4 periods per year x 6years = 24 periods

Periodic interest rate = 16/4 = 4% = 0.04

2.3.3 Using compound interest tables

First estimate the number of compounding periods and interest rate period.
Determine whether you are using a table for a future value or present value and follow
the necessary steps. Tables for future value and present vale are in Table 1.1 and
1.2 respectively.

Steps for using compound interest tables

Step 1: Scan across the top row of the table to find the interest rate per period

Step 2: Look down that column to the row corresponding to the number of periods

Step 3: The table factor at the intersection of the rate per period column and the
number of period’s row is the future value or the present value of R1 at compound
interest rate. Multiply the table factor by the principal to determine the compound
amount.

2.4. Types of Annuities

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Business situations frequently involve a series of equal payments or receipts, rather

than lump sums. These equal payments or receipts are called annuities. An annuity
is the payment or receipt of equal amount of money per period for a specified amount
of time (Brechner, 2009). Common application of annuities include insurance and
retirement plan premiums and pay out, loan payments and saving plan for the future
events such as buying an expensive item or going to university.

2.4.1 Annuities Certain and Contingent Annuities

Annuities may be divided into two major categories namely annuities certain and
contingent annuities

An Annuity Certain is one for which the payments begin and end at fixed times. This
means that such annuity has a specified number of time periods such as R4000 per
month for 4 years.

A Contingent Annuity is one the date of the first or last payment, or both, depends
on some event. This annuity is based on an uncertain time period. Retirement plans,
social security and various life insurance policies are examples of contingent
annuities.

2.4.2. Ordinary Annuities and Annuities Due

Based on the date of the annuity payment, annuities can be classified into ordinary
annuities and annuities due.

Ordinary Annuity: this is when the annuity is made at the end of each period. E.g. A
salary paid at the end of each month is an example of an ordinary annuity.

Annuity Due: this is when the payment is made at the beginning of each period. E.g.
A rent payment paid at the beginning of each month is an example of an annuity due.

2.5. Future Value of an Annuity

The future value of an annuity is the total amount of the annuity payments and the
accumulated (or compounded) interests on those payments. It is also called the
amount of an annuity. In this section, we will differentiate the calculation of the future
value of an ordinary annuity from that of an annuity due.5.1. The future value of an
ordinary annuity

2.5.1. Manual calculation of ordinary annuity

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Calculate the future value of an ordinary annuity of R10 000 per year, for 3 years, at
6% interest compounded annually.

This is cumbersome to calculate. An annuity of 10 years, with payments made

monthly, would require 120 calculations. It is therefore easy to use formulae to solve
for a future value of an annuity.

Formula future value of an ordinary annuity

Where: FVA= future value of annuity, P= annuity payment, i= interest payment and
n= number of periods (years x periods per year).

Example 7

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Suppose that you have won the lottery and will receive R5 000 at the end of every
year for the next 20 years. As soon as you receive the payments, you will invest them
at your bank at an interest rate of 12 percent per annum compounded annually. How
much will be in your account at the end of 20 years, assuming you do not make any
withdrawals?

Example 8
Calculate the future value of an ordinary annuity of R1 000 per month, for 3 years,
at 12% interest compounded monthly.

2.5.2. The Future Value of an Annuity due

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An annuity due is one in which payments are made at the beginning of the payment
interval. The formula for a future value of the annuity due is a modification of a formula
for the future value of an ordinary annuity. A future value of an ordinary annuity of n+
1 payment is similar to the amount of a corresponding annuity due.
The Formula Future Value of an Annuity due

Where: FVA= future value of annuity, P= annuity payment, i= interest payment and
n= number of periods (years x periods per year).

Thus, the annuity due = ordinary annuity x (1+ i)

Example 9

Calculate the future value of an annuity due of R1 000 per month, for 3 years, at
12% interest compounded monthly.

2.5.3 Present value of an annuity

Present value of an annuity is the sum of the present values of all payments or receipts
of the annuity. This is a lump sum amount of money that must be deposited now to
provide a specified series of equal payment (annuities) in the future. Similar to the
future value, the calculation of the present value of an ordinary annuity due is also
different to that of an annuity due.

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2.5.3.1. Present value of an ordinary annuity

The present value of an ordinary annuity is calculated as follows:

Where: PV = present value (lump sum), P= annuity payment, i= periodic interest

rate and n= number of periods (years x periods per year)

Example 10
Calculate the present value of an ordinary of R1 000 per month, for 4years, at 12%
interest compounded monthly.

Solution

2.6. Using annuity tables

Annuity tables may be used to calculate the future and present values of ordinary
annuity and annuity due. Future and present values are shown in Tables 2.1 and
2.2 respectively.

Steps for calculating future value of an ordinary annuity

Step 1: Calculate periodic interest for the annuity (nominal rate / periods per year)

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Step 2: Determine the number of periods of the annuity (years x periods per year)

Step 3: From Table 2.1, locate the present value table factor at the
intersection of the periodic rate column and the number of period’s row.

Step 4: Calculate the present value of the ordinary annuity

Future value of an ordinary annuity = annuity table factor x annuity payment

Steps for calculating future value of an annuity due

Step 1: Calculate periodic interest for the annuity (nominal rate / periods per year)

Step 2: Calculate the number of periods of the annuity (years x periods per year)
And add one period from the total.

Step 3: From Table 2.1, locate the table factor at the intersection of
the Periodic rate column and the number of period’s row.

Step 4: Subtract 1 from the ordinary annuity factor to get to the

annuity due table factor
Step 5: Calculate the present value of the annuity due.

Steps for calculating present value of an ordinary annuity

Step 1: Calculate periodic interest for the annuity (nominal rate / periods per year)

Step 2: Determine the number of periods of the annuity (years x periods

per year) Step 3: From Table 2.2, locate the present value table factor at

the intersection of the periodic rate column and the number of period’s row.

Step 4: Calculate the present value of the ordinary annuity

Present value of an ordinary annuity = annuity table factor x annuity payment

For example, if the interest rate is 10 percent per year, the investment of R100
received in each of the next 5 years is 3.791 x R100 = R379.1.

Steps for calculating present value of an annuity due

Step 1: Calculate periodic interest for the annuity (nominal rate / periods per year)

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Step 2: Calculate the number of periods of the annuity (years x periods per year)
and subtract one period from the total.

Step 3: From Table 2.2, locate the table factor at the intersection of the periodic
rate column and the number of period’s row.

Step 4: Add 1 to the ordinary annuity factor to get to the annuity due table factor.

Step 5: Calculate the present value of the annuity due.

For example, if the interest rate is 10 percent per year, the investment of R100
received at the beginning of each of the next 5 years is (3.791 + 1) x R100 =
R479.1

2.7. Sinking funds and Amortisation

In the previous Sections, 2.2 and 2.3, the amount of the annuity payment was known
and we were calculating the future or present value (lump sum) of the annuity. In this
section, we will be calculating annuity payments when the future or present value is
known. In this case we will refer to sinking fund and amortisation.

2.7.1. Sinking funds

A sinking fund situation occurs when the future value of an annuity is known, and the
periodic payments required amounting to that future value is known. A sinking fund
is an account used to set aside equal amounts of money at the end of each period,
at compound interest, for the purpose of saving for future obligation.

The sinking fund payments may be calculated using the following formula:

Sinking fund payment =

Where: FV = amount needed in the future,

i = interest rate per period and

n = number of periods.

Example 11

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El Loco needs R100 000 in 5years to pay off a bond issue. What sinking fund payment
is required at the end of each month, at 12% interest compounded monthly, to meet
this financial obligation?

0.01
100000 x = 100000 x 0.0122444 = R1224.44
0.8166967

2.7.1.1. Calculating the amount of an amortisation payment by table

We can use the future value of annuity table (Table 2.1) to calculate an amount of the
payment as follows:

Sinking fund payment =

Example 12
What sinking fund payment is required at the end of each 6-month period, at 6%
interest compounded semi-annually, to amount to R12 000 in 4years?

Solution

Sinking fund payment =

12000
= R1349.48
8.89234

2.7.2. Amortisation

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Amortisation is the opposite of a sinking fund. Amortisation is a financial arrangement

whereby a lump-sum obligation is incurred at compound interest now, such as a loan,
and is paid off or liquidated by a series of equal periodic payments for a specified
amount of time (Brechner, 2009).

Amortisation payments may be calculated, by using a formula as follows:

Amortization payment =

Where: PV = amount of the loan or

obligation,

i = periodic interest rate (nominal / periods per year) and

n=number of periods (years x periods per year)

Example 13
What amortisation payment is required each month, at 18% interest, to pay off R5 000
in 3 years?

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2.7.2.1. Calculating the amount of an amortisation payment by table

We can use the present value of annuity table (Table 2.2) to calculate an amount of
an amortisation as follows:

Amortization =

Example 14
What amortisation payments are required each month, at 12% interest, to pay off a
R10 000 in loan 2 years?

2.8. End of Chapter Questions

1. A finance company makes consumer loans at a nominal annual rate of 36%
compounded monthly. What are the nominal interest rate, the periodic interest
rate and the number of periods?

2. Find the effective interest rate equivalent to 8% compounded semi-annually.

3. An amount of R1 500 is deposited in a bank paying an annual interest rate of

4.3%, compounded quarterly. Find the balance after 6 years.

4. Your goal is to accumulate R30 000 after 17 years from now. How much must
you invest now to have, at an interest rate of 8% compounded semi-annually?

5. If R500 accumulated to R700 in 5years with a certain interest compounded

quarterly, what is the rate of interest?

6. How many years will it take R175 to amount to R230 at interest rate of 4.4%
compounded annually.

7. An ordinary annuity starts on June 1, 1988, and ends on December 1, 1993.

Payments are made every 6 months. Find the number of periods (n).

8. Find the present value of an annuity of an annuity of R100 at the end of each
month for 30 years at 6% compounded monthly.

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9. An investment of R200 is made at the beginning of each year for 10 years. If

interest is 6% effective, how much will the investment be worth at the end of 10
years?

10. The premium on a life insurance policy is R60 a quarter, payable in advance.
Find the cash equivalent of a year’s premiums if the insurance company charges
6% compounded quarterly for the privilege of paying a smaller amount every
three months instead of all at once for the year.

11. A family buys a R600 000 home and pays R100 000 down. They get a 25-year
mortgage for the balance. If the lender charges 12% converted monthly, what is
the size of the monthly payment?

12. A debt of R5000 is to be amortized by 5quarterly payments made at 3 month

intervals.

13. If interest is charged at the rate of 12% convertible quarterly, find the period
payment and construct an amortisation schedule. Round the payment up to the
nearest cent.

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CHAPTER 3: INVESTMENT APPRAISAL

METHODS

Contents

1. What is our aim in appraising projects?

2. Use of investment appraisal techniques in practice

3. Factors affecting cash flows relevant cash flows Sensitivity analysis

Probability

4. Other considerations

5. Answer to Self-check Question

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Objectives

After working through this section you should be able to:

• Understand the importance of the investment appraisal process

• Distinguish between the various types of investment projects
• Calculate interpret and evaluate the payback method.
• Calculate interpret and evaluate the Accounting Rate of Return method
(ARR).
• Calculate interpret and evaluate the Net Present Value Method (NPV)

READINGS

Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.

(2014) Corporate Finance, A South African Perspective, Oxford University
Press.

Chapter 9: Fundamentals of Corporate Finance , 4th South African Edition,

Ross S,
Westerfield RW, Jordan BD and Firer C, 2008

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3.1. Introduction
Financial managers are responsible for:
• Investment decision (Capital budgeting)
• Financing decision (Capital structure)
• Day to day cash flow decisions (Financial planning)

Goal of financial management is to maximise the (present) value of the firm’s

shares. Therefore the objective is to maximise expected value from all projects
and operations of the company. So the focus should be on making value creating
investment decisions. So you need to identify and know when these opportunities
exist and you need to measure the expected value.

In investment opportunity requires funding. If efficient long term planning is not

conducted, a company may not be able to find the capital required to finance its
investments.

3.2. Steps in the Capital Budgeting Process

1. The capital budgeting process consists of at least six steps:

2. Identify all possible investment alternatives. In this way due scrutiny and
attention is given to all possible options.

3. Determine the relevant cash flows associated with each of the possible
investment alternatives.

4. Determine the company’s cost of capital (this is discussed in greater detail in

the chapter headed Cost of Capital (Chapter 7)

5. Evaluate the various projects. Various investment appraisal methods are

used in order to test financial feasibility.

6. Make the investment decision. This is done when all project cash flows
(inflows and outflows) have been ascertained.

7. This is the final step and known as the follow up step. This means that every
project is evaluated in order to ensure value creation.

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3.3. Aims of Appraising Projects?

A firm will appraise investment projects because such projects could help it
achieve its overall objective. What is this likely to be? We’ll look at some
possibilities:

• To maximise profit, either in terms of Rs or as a percentage of the capital

invested – this sounds like a good idea, but it should be realised that this
would not necessarily be in the company’s, and therefore the shareholders’,
interest. Profit could increase temporarily if quality were to be sacrificed or
unsuitable forms of financing used, but this would not result in long-term
benefit for the firm

• To ensure the continuation of the business – in circumstances where the

business already has problems, this could be considered essential, but would
be a rather limited aim under more normal conditions

• To promote the growth of the business. This may take many forms and
involve many different tasks like: increasing market share, increasing sales
volume or even improving efficiencies.

• To maximise the wealth of shareholders – this covers business survival,

return on investment and future growth. Shareholders will perceive wealth
maximisation through dividends paid out and rising share values.

This concept may seem to ignore the needs of others involved with the firm –
employees, customers, suppliers, and long-term creditors – who surely should
also be entitled to a fair return for their input to the business. However, this is
not necessarily contradictory, because if no attention is paid to these
providers the adverse effects of, for example, poor industrial relations or
inferior quality products are likely to reflect on profit, dividends and share
price, so shareholders’ wealth would not be maximised.

3.4. Types of Investment Projects

1. Replacement Projects: these occur when certain assets are reaching the end
of their useful life and need to be replaced. For example the purchase of a new
printing machine to replace the more costly to maintain older machine. This
may entail calculating revenues from the sale of the older asset or costs
incurred in scrapping the asset and comparing these to the cost incurred and
revenue generated from the purchase of the newer asset.

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2. Expansion Projects: these projects are undertaken to grow the size of the
business. This may entail the acquisition of a book binding machine that will
complement the printing process, thus reducing costs and increasing the
profitability of the firm. Of course other projects may also be assessed before
choosing the most viable one.

3. Independent Projects: These projects do not affect the current running and
profitability of the business but they are assessed and evaluated on the basis
that they may increase shareholder wealth. For example, the acquisition of
an electricity generator that may assist in the production process, should
there be electricity blackouts.

4. Mutually Exclusive Projects: generate their own savings or possibly their

own revenue streams, thus resulting in an improvement in the bottom line.
Essentially such choices do not hinge on the current status quo or projects
being undertaken.

5. Complementary Projects: this occurs if the acceptance of one project will

have a positive effect on the other projects being undertaken. For example,
a vacuuming machine being added to a car wash business may give that
business a competitive edge over other businesses in the same field.

6. Substitute Projects: are that project that may have the effect of negatively
affecting the cash flows generated by the company’s other projects. This is
often referred to as cannibalization.

7. Conventional Projects: these are projects that require an initial large cash
outlay but result in positive cash inflows over the lifetime of the project.

8. Unconventional Projects: this requires a substantial cash outlay initially and

it yields cash inflows in some years and cash outflows in some other periods
(Els 2010: 142-4).

3.5. Payback Period

Payback Period calculates the number of years after the initial investment amount
of an investment project is recovered from projects net cash inflows. The rule is,
if payback is:
➢
Less than the maximum time allowed then invests in the project.
➢
Greater than the maximum time allowed then don’t invest in project.

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Illustrative Example
An initial outlay of R2200 is required and cash flows of R600, R900 and R1 400
accrue in years 1, 2 and 3 respectively. Should the project be accepted and what
is the payback period?

Year Cash flow (p.a) Accumulated Cash Flow

1 600 600
2 900 1 500
3 1 400 2 900

Solution:

By inspection we note that payback must occur between year 2 (with cumulative
revenue of R1 500 and year 3 (cumulative revenue of R2 900). To calculate the
exact period (or time in year 3), we need to make an important assumption: that
revenue is earned equally throughout the period. A workable formula is:
= years before full recovery + unrecovered cash flow at beginning of year X 365
Cash flow during the year 1

Our answer is, therefore =2 years + [700/1400 X 365]

=2 Years and 182.5 days

NB

The amount of R700 is arrived at by taking the investment of R2 200 and

deducting the R1 500 from it. Essentially we are asking ourselves, how long it will
take us to earn the R700 in year 3. we use 365 because it is more useful to have
our answer in days.

Example 1

Messi Motors have just made an investment of R420 000 in a state of the art
wheel alignment machine, details of which are below:

• Expected useful life 6 years (straight line depreciation)

• Salvage value 120 000
• Cost of Capital 10 %
• Tax rate 30%

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• Expected cash flows after tax is as follows:

Year Cash Flows

1. 66 000
2. 96 000
3. 126 000
4. 181 000
5. 68 000
6. 50 000

Solution
Year Cash Flow Cumulative Cash Flow

1 66 000 66 000

2 96 000 162 000

3 126 000 288 000

4 181 000 469 000

5 68 000 537 000

6 50 000 587 000

Payback is: 3 years and [132 000/181 000 X 365]

3 years and 266, 18 days (You may round off to 267 days)

3.5.1. Advantages of the Payback Period

1. It is easy to understand and calculate.
2. It adjusts for uncertainty of later cash flows. (Ross: 277)
3. It serves as a criterion to measure liquidity, because the quicker the initial
investment is paid off, the earlier the generated cash is available for alternate
use. (Els: 148).

3.5.2. Disadvantages of the Payback Period

1. It ignores the time value of money.
2. It is very subjective.
3. It insists on a cut off period
4. It ignores cash flows beyond the cut off period

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5. There is a definite bias against long term projects that require a large
research and development outlay (Ross 277).
6. It ignores the order in which cash flows occur within the payback period.
7. It does not consider the cost of capital in any way.
8. It makes no distinction between projects of different sizes with different
capital requirements and with different lifetimes.

3.6. Accounting Rate of Return (ARR)/Average Accounting Return (AAR)

The accounting rate of return method takes the average accounting profit that
the investment will generate and expresses it as a percentage of the average
investment in the project as measured in accounting terms. A flawed approach
to making a capital budgeting decision is the ARR. It requires the following data
to be available:

a. Average profit = Total profits/no of years

b. Average Investment = [Initial investment + salvage value]/2

The Formula

ARR = Average annual profits x 100

Average investment* 1

Average investment = Initial capital employed + residual value 2

The Decision Criteria

To decide whether the return is acceptable, we must compare the percentage
with the minimum required by the business. If the firm has a target ARR less than
the percentage achieved, then this investment is acceptable, otherwise not.

An example
We can use the same data from the previous example:

Messi Motors have just made an investment of R420 000 in a state of the art
wheel alignment machine, details of which are below:

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• Expected useful life 6 years (straight line depreciation)

• Salvage value 120 000
• Cost of Capital 10 %
• Tax rate 30%
Expected cash flows after tax are as follows:
Year Cash Flows

1. 66 000
2. 96 000
3. 126 000
4. 181 000
5. 68 000
6. 50 000

Required:

Calculate the ARR.

Solution
Cash flows need to be converted to net profit. This will entail adding back the
depreciation tax shield.

Depreciation per annum, calculated as follows:

Cost of investment R420 000

Salvage value R120 000
Depreciable value R300 000
Depreciation per annum = 300 000/6
= 50 000 per annum.

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Depreciation tax shield = R50 000 X 30% Net Profit

= R15 000

Year Cash Flows

1 66 000 81 000

2 96 000 111 000

3 126 000 141 000
4 181 000 196 000
5 68 000 83 000
6 50 000 65 000

Total Net Profit 677 000

Average Net Profit 677 000/6 = R112 833

Average investment [420 000 + 120 000]/2 = 270 000

ARR = Average Profits/Average Investment X 100

= 112 833/270 000 X 100

= 41, 79%

Advantages of the ARR

1. It is relatively easy to calculate

2. Data that’s needed is easily available in the annual financial statements
(Ross; 279).

Disadvantages of the ARR

1. It ignores the time value of money

2. The salvage value may not be realistic

3. It is based on accounting profits (these are merely book entries), not on cash
flows (which are the lifeblood of any business).

4. It is not a rate of return in any meaningful sense (Ross; 279)

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3.7. Net Present Value (NPV)

Relevant cash flows

We already know that investment appraisal involves actual cash flows, so that we
must adjust if necessary for such things as accruals and prepayments and
depreciation if we are working from a profit and loss account.

We also know that we are dealing with uncertainty – we are attempting to forecast
future flows, which will be more doubtful the further into the future we try to go.
We may have to:

• consult all those who will be concerned with a project to obtain their
estimates for the level of revenue and expenditure that should arise

• undertake market research, to ensure project success.

• utilise statistical techniques to derive future data from past performance.

When using NPV, we must apply the following.

• Compare the Present Value (PV) of the project in respect of:

• Net operating benefits (cash inflows)

• Net costs of investment (cash outflows)

• This is then discounted at an appropriate risk adjusted discount rate

(reflecting the correct risk adjusted opportunity cost of the project). In
layman’s terms, the business seeks to adjust costs and revenues with an
estimated inflation rate in order to ensure that what may have started as a
lucrative project does not become less so or even a loss as a result of the
ravages of inflation.

a. If NPV > 0, invest.

b. If NPV < 0, do not invest.
c. If NPV = 0, indifferent between investing or not

NPV: An example

Messi Motors have just made an investment of R420 000 in a state of the art wheel
alignment machine, details of which are below:

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Expected useful life 6 years (straight line depreciation)

Salvage value 120 000

Cost of Capital 10 %

Tax rate 30%

0 (420 000)
1 66 000
2 96 000
3. 126 000
4. 181 000
5 68 000
6 50 000

Required:
Calculate the NPV of this project and state whether the project should be
accepted or rejected.
Year Cash Flows DF (10%) Discounted Cash Flow

0 (420 000) 1 (420 000)

1 66 000 0.9091 60 001
2 96 000 0.8264 79 334
3. 126 000 0.7513 94 664
4. 181 000 0.6830 123 623
5 68 000 0.6209 42 221
6 50 000 0.5645 28 225
120 000 0.5645 67 740
NPV 75 808

The project should be accepted as its NPV is positive.

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Notes
a. The PVIF tables are used at a factor of 10%.

b. The factors can be worked out using the formula PV = 1/(1+r)t

c. Cash flows must be after tax. If it is before tax, it must be converted to after
tax.

Advantages of NPV

1. It accounts for the time value of money.

2. It is logically consistent with the company’s goal of maximising shareholder
wealth.
3. It is relatively easy to calculate.
4. It uses all the cash flows of a project and discounts them consistently.
5. It is realistic in outlook.

Disadvantages of NPV
1. Fixed assumptions are made around the variables affecting project cash flows
such as: exchange rates, selling prices, inflation.

2. NPV’s major problem is that it relies crucially on predicting the future.

End of Chapter Questions

Shukriya Salvagers have just made an investment of R350 000 in a new VW
Amarok delivery vehicle.
Further details:
• Expected useful life 5 years (straight line depreciation)
• Salvage value 50 000
• Cost of Capital 10 %

Year Cash flows

1. 120 000

2. 70 000

3. 70 000

4. 100 000

5 (12 000)

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Required:

1. Calculate the Payback Period and the Accounting Rate of Return

2. Shukriya requires a payback period of no more than 3 years and a return
of at least 30%. Purely on the basis of these criteria, should this project be
accepted
3. Use the NPV method to determine project viability. On the basis of this
calculation, should the project be accepted? Why/why not?

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CHAPTER 4: SHARE VALUATION

Contents

1. Introduction

2. Ordinary shares and Preference shares

3. Defining Value

4. Share Valuation

5. End of chapter questions

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Objectives

After working through this section you should be able to:

• Distinguish between ordinary shares and preference shares.

• Distinguish between par value, market value, book value and intrinsic value.
• Explain the importance of share valuation.
• Calculate and interpret the various methods used to value company shares.
• Apply the appropriate method to calculate the intrinsic value of a share.
• Assess the growth prospects of a firm from its P/E ratio.

READINGS

This unit has been designed to be read in conjunction with the following textbooks:

PRESCRIBED:
Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.
(2014) Corporate Finance, A South African Perspective, Oxford University
Press.

RECOMMENDED READINGS
Chapter 8: Ross, S; Westerfield, RW; Jordan, BD; and Firer C. (2009).
Fundamentals of Corporate Finance, 4th South African Edition, McGraw-Hill.
Chapter 6: Correia, C; Flynn, D; Uliana, E and Wormald, M. (2008) Financial
Management, 6th Edition, Juta Publishing.

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4.1. Introduction
In this chapter we discuss what is considered to be an acceptable return and also how
a company values its shares. The concepts of preference shares and ordinary shares
are also dealt with. Then a few models are presented to assist financial managers in
their financial decision making procedures. The focus then shifts to expected and
required returns and then to market efficiency. The overriding concern with this
chapter is the consistent wish to maximise shareholder wealth. Whilst this term is used
to merely pay lip service to this very important concern, we nevertheless explore this
ideal at length.

4.2. Ordinary Shares and Preference Shares

4.2.1. Ordinary Shares

The owners of these shares are essentially the owners of the company. They become
the owners of the productive assets of the company and have a vote at the AGM. They
have the right to elect the board of directors who in turn appoint the managers to
oversee the day to day running of the business. Ordinary shareholders also have the
pre-emptive right to purchase any fresh issue of shares before they are offered on the
open market to the general public. (Els 2010: 255)

4.2.2. Preference Shares

Preference shares are also known as preferred stock. Preference shares are shares
in the equity of a company, and which entitle the holder to a fixed dividend amount by
the issuing company. This dividend must be paid before the company can issue any
dividends to its ordinary shareholders. Also, if the company is dissolved, the owners
of preference shares are paid back before the holders of ordinary shares. However,
the holders of preference shares do not usually have any voting control over the affairs
of the company, unlike the ordinary shareholders.

4.2.2.1. Types of Preference Shares

• Redeemable Preference Shares: The issuing company has the right to buy back
these shares at a certain price on a certain date. Since the call option tends to cap
the maximum price to which a preference share can appreciate (before the
company buys it back), it tends to restrict stock price appreciation.

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• Convertible Preference Shares. The owner of these preference shares has the
option, but not the obligation, to convert his/her preference shares to ordinary
shares at some conversion ratio. This is a valuable feature when the market price
of the common stock increases substantially, since the owners of preference
shares can realise substantial gains by converting their shares.
• Cumulative Preference Shares: If a company does not have the financial
resources to pay a dividend to the owners of its preference shares, then it still has
the payment liability, and cannot pay dividends to its common shareholders for
as long as that liability remains unpaid.
• Non-cumulative Preference Shares: then it does not have the obligation to is
rarely used. If a company pays a scheduled dividend, pay the dividend at a later
date. This clause
• Participating Preference Shares: The issuing company must pay an increased
dividend to the owners of preference shares if there is a participation clause in
the share agreement. This clause states that a certain portion of earnings (or of
the dividends issued to the owners of ordinary shares) will be distributed to the
owners of preferences shares in the form of dividends.

4.3. Defining Value

4.3.1. Market Value

Buyers and sellers determine the market value of each share of stock through the
prices they're willing to sell for or to pay for each share. When the demand for a
particular stock is greater than the supply of shares available, the price increases.
Buyers choose to pay more to receive a share of stock. If the demand for that share
is less than the supply of shares, the price decreases --- buyers aren't willing to pay
as much for each share.

4.3.2. Par Value

Public companies attach a rand value, or par value, to each class of share it issues.
The business uses par value to record the shares issued in the financial records. The
actual price received for the stock usually includes an amount greater than par value.
The company records the amount received above par value as additional paid in
capital and this is known as share premium. Par value never changes.

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4.3.3. Intrinsic Value

The actual value of a company based on an underlying perception of its true value
including all aspects of the business, in terms of both tangible and intangible assets.
This value may or may not be the same as the current market value. Value investors
use a variety of analytical techniques in order to estimate the intrinsic value of
shares/securities in the hope of finding investments where the true value of the
investment exceeds its current market value.

4.3.4. Book Value

The book value of a share is the total value of the company’s assets less the total
value of its liabilities and then divided by the total number of shares issued to ordinary
shareholders.
4.4. Share Valuation: Discounted Cash Flow Models and Techniques
These models are based upon the premise that the price of a share must be equal to
the discounted present value of the cash flows that an investor expects to receive.
This model reflects reality for the investor. The cash flow the investor expects to
receive in the long term will take the form of dividends. These models rely upon the
accurate prediction of future dividend flows. Variations in the model are due to the
timing and variations in amount of the expected dividends. The discount rate used is
the cost of equity funds invested. There are two basic steps: first to estimate the cash
flows and secondly to determine the present value of the cash flows.

For a short-term investor (assume a 1 year investment):

Value = PV of dividends at year-end + PV of share price at year end.

In the longer run an investor or succession of investors expect to receive a stream of

future dividends.

Value = PV of all future dividends.

A general formula for this would be:

Po = D1
(1 + r) t

4.4.1. Zero Growth Dividends

This is used for stocks that have earnings and dividends that are expected to remain
constant over time (zero growth). Thus Dividend income can be viewed as
perpetuity.

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Example
A preference share pays a R2, 00 dividends and the share has a required return of
10%. What is the most that a person will pay for this share?
P0 = D/r
= R2/0.10
= R20

4.4.2. Constant growth dividends

This is used for stocks that have earnings and dividends that are expected to grow
at a constant rate forever. This implies that:
D1 = D0(1 +g)

The intrinsic value is

Where g = perpetual growth rate in dividends and D0 (1+g) = D1

If the price of a share is known, we can use the above formula to estimate the
required rate of return (k):

k=

Example

An ordinary share has just paid a dividend of R2 and the share has a required return
of 10%. Dividends are expected to grow at 6% per annum. What price would you be
willing to pay for this share?

Solution

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4.4.3. Supernormal growth or Multistage Growth

Models This model assumes that two stages of dividend
growth exist:

➢
A first stage with a high growth rate for n years (say years 1 to 5, the
‘supernormal’ period) and
➢
a second stage with a constant growth rate forever (say years 6 to 20, the
‘normal’ period).
The equation for the supernormal or two-stage DDM is:

Example
An ordinary share has just paid a R2.00 per share dividend and the share has a
required return of 15%. Dividends are expected to grow at 20% in the first 2 years and
from the year 3 the growth will be 5% per year forever. What is the price you should
be willing to pay for the share?

Solution

4.4.4. Price Earnings Ratio

This is the most common method used in share market valuations and it concentrates
on the firm’s price/earnings multiple. This is the ratio of the price per share to its
earnings per share. As an on-going entity, minority shareholders’ expectations of
dividends depend upon the firm’s ability to earn a positive return on equity capital.
This return is described in the financial statements as earnings attributable to ordinary

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shareholders (after allowing for payment of interest on loans and debentures, taxes,
and preference dividends). These attributable earnings divided by the number of
ordinary shares outstanding is the earnings per share (EPS). The relationship
between a share price and its EPS is the P/E ratio. Generally a high P/E ratio signals
a favourable perception by the market of a share’s earning power, or its on-going
ability to earn a positive EPS.

P/E ratio = P0 / EPS

Where EPS is expected earnings per share (E1).

Thus, P0 = P/E x E1

P/E Ratios are a function of two factors

• Required Rates of Return (k) (inverse relationship)

• Expected Growth in Dividends (direct relationship)

P0 = (1 − b)

E1 k−g
If g = 0 then the P/E ratio simplifies to:
P0 1
=
E1 k

Example
Given the following information estimate P/E ratio and V0: E1 = R2.50

g=0

k = 12.5%

Suggested Solution

Since g = 0, P/E = 1/k

P/E = 1/0.125 = 8
V0 = P/E x E1 = 8 x R2.50

= R20.00

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An Example with Growth

Given the following information estimate P/E ratio and V0:

b = 60%; ROE = 15%; k = 12.5%; (1-b) = 40%, E0 = R2.50

Suggested Solution
g = ROE x b = 15% x 60% = 9% E1

= R2.50 (1.09)

= R2.725

P/E = (1-b) /(k-g)

= (1 - 0.60) / (0.125 - 0.09)

= 11.4

P0 = P/E x E1 = 11.4 x R2.73

= R31.14

Pitfalls in Using P/E Ratios

➢
Earnings management is a serious problem,
➢
P/E should be calculated using pro forma earnings,
➢
A high P/E implies high expected growth, but not necessarily high stock
returns,
➢
Simplistic, assumes the future P/E will not be lower than the current P/E. If
expected growth in earnings fails to materialize the P/E will fall and investors
may incur large losses.

Intrinsic value and Market Price

Market value (P0): the market value is a consensus value of all traders. In equilibrium
the current market price will equal intrinsic value (V0). The comparison of market value
to the intrinsic value is used by investors as a trending signal.

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Trading Signals

➢
If V0 > P0 Buy: it is under-priced
➢
If V0 < P0 Sell or short sell: it is overpriced
➢
If V0 = P0 Hold as it is fairly priced

4.4.5. Market to Book Ratio

High ratio indicates a large premium over book value, and a ‘floor’ value that is often
far below market price.

Formula = Market price per share

Book value per share

4.5. End of Chapter Questions

1. Differentiate between the following terms: Earnings Yield, Dividend Yield, and the
PE Ratio.
2. Do shares with low dividend yields tend to have a high or a low PE ratio?

3. List the most important factors that would influence an investment analyst in the
rating of PE ratios.

4. A firm projects an ROE of 20%; it will maintain a plowback ratio of 0.3. The firm is
expecting earning of R2 per share and investors expect a return of 12% on the
stock. What is expected price and P/E ratio of the firm?

Suggested Answers
1. Earnings Yield is the earnings before payment of dividends, divided by the current
share price. Dividend yield is the actual dividend itself divided by the current share
price. The PE ratio is the current share price divided by the earnings – it is in fact
the inverse of the earnings yield. Therefore a low earnings yield is indicative of a
high PE ratio and both usually indicate a highly sought after share.

2. A share with a low dividend yield usually has a low earnings yield and therefore
a high PE ratio.

An analyst would consider the following as important factors:

• The growth of future earnings per share is the most important factor.

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• Investors prefer a minimum fluctuation from expected earnings. Volatile shares

consistently get a lower share market rating.

• Investors prefer companies having favourable prospects for long term growth.

• Companies heavily involved in research and development project an image of

growth. As a result these companies enjoy a much higher market rating than
companies not committed to research and development projects.

• The frequent introduction of new products is a factor that helps a firm to acquire
a high PE ratio.

• Companies that are operating in markets or sectors enjoying a rapid growth in

demand for their products have a much superior market rating than companies
that have reached a maturity stage in the product life cycle.

4. g = ROE b = 0.20 0.30 = 0.06 = 6.0%

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CHAPTER 5: BONDS AND BOND

VALUATION

Contents

1. Introduction

2. Bonds

3. Why invest in Bonds?

4. Pricing of Bonds

5. Calculation of YTM on Bonds

6. Bond Prices and YTM

7. Duration

8. End of chapter questions

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Objectives

After working through this section you should be able to:

• Explain fixed income markets and securities.

• Understand the relationship between bond prices and interest rates.
• Estimate the present value of a bond.
• Understand the yield curve and its usefulness as an analytical tool.
• Calculate the duration of a bond.

READINGS PRESCRIBED:
Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.
(2014) Corporate Finance, A South African Perspective, Oxford University
Press.

RECOMMENDED READINGS
Chapter 7: Ross, S; Westerfield, RW; Jordan, BD; and Firer C. (2009).
Fundamentals of Corporate Finance, 4th South African Edition, McGraw-Hill
Chapter 10 and 11. Bodie, Z.; Kane, A. and Marcus, J. A. (2010) Essentials
of Investment.8th Edition. New York: McGraw Hill

5.1. Introduction
Businesses and governments do not have sufficient capital to fund all their projects
and therefore borrow in order to fund their activities. Historically, companies have
borrowed money from banks who in turn have secured the money from bank
depositors. Smaller companies can only borrow from banks. However, larger
companies have access to and can borrow directly from all lenders in the market. This
can be advantageous to both the lender and the large company because the lender
can earn a higher rate and the borrower can borrow at a lower rate.

An example to illustrate this

The prevailing rate with banks on wholesale deposits at present is 5%, the bank then
in turn lends at say prime 9% (July 2012).The bank is making a spread of 4%. However
if the borrower goes directly to the lender, the lender may elect to only charge the
borrower 7%. It is easy to see how both parties score, provided the borrower honours

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his obligation. This process whereby the borrower borrows directly from the lender
without using banks is known as disintermediation.

Modern day governments have always been able to borrow directly from investors in
this way. The instrument that enables this lending and borrowing process to be
undertaken is generally a fixed-income security, commonly called a bond. The bond
is in essence the “IOU” of the borrower.

5.2. Bonds
A bond can be described as a tradable debt instrument that is issued by a borrower.
It pays interest (known as ‘a coupon’) for a fixed period of time, at a predetermined
rate, at regular intervals until maturity, when principal amount is then repaid in full. A
bond is tradable, unlike a deposit with a bank where the depositor is only entitled to
repayment. Tradable means that the bondholder (lender) can either retain the bond
until repayment date, or he can sell the bond on to another investor.

Bond characteristics and terminology

➢
The par value or face value is the original value of the bond which must be repaid
upon expiry. In South Africa, the usual par value of a bond is R1 000.

➢
The coupon is the interest paid on the bond. These coupon payments are paid
at regular intervals usually annually, semi-annually or quarterly.
➢
The maturity date describes the term of the loan, when the bond is to be
redeemed.

➢
Yield to Maturity (YTM): it is a required return on a bond. This is a discount rate
used in the valuation of bonds.

➢
A zero coupon bond: A special type of bond that does not pay interest. It is traded
at a deep discount, rendering profit at maturity when the bond is redeemed for its
full face value.

➢
At par: When a bond is selling at price = Par Value (This would happen when the
coupon rate = YTM).

➢
Discount bond: When a bond is selling at price < Face Value (The coupon rate
< YTM).
➢
Premium bond: When a bond is selling at price > Face Value (coupon rate >
YTM).

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5.3. Why Invest in Bonds?

Bonds offer investors (lenders) a fixed income, with the possibility of limited capital
growth. They are less risky than shares because interest payments are made from
company profits, before dividends and if the company goes into liquidation,
bondholders are repaid before shareholders. Bonds issued by companies are often
secured by the fixed assets of the issuing company. Government bonds are more
secure than corporate bonds; a government is less likely to default on payment.

5.4. Pricing of bonds

The value of a bond depends upon the expected yield from fixed interest investments
given current interest rates and the investors’ expectation of the issuer defaulting on
the bond terms. When valuing a bond we are effectively valuing the cash flows from
the bond coupon and the redemption value of the bond.

Calculation of the price of a bond with semi-annual compounding

We will use our previous example but we will assume that the coupon is paid semi-
annually and has 10 years to maturity:

A firm borrows R1 000 by issuing a bond with coupon rate of 10% per annum paid
semi-annually and promises to pay back the principal in 10 years. If the current market
interest rates on a similar bond are 10%, what is the value of this bond?

Solution
r = 10%; matures in 10 years; 10% coupon paid semi-annually.

Step 1: Determine Cash flows

Face value = R1 000

Annual coupon payments = coupon rate × face value

= 0.10 x 1000

= 100

Semi-annual coupon payment = 100/2 = 50

Step 2: Determine number of periods

(10 years to maturity) x (number of periods in a year) = 10 x 2 = 20

Step 3: Determine the discount rate per a period

Step 4: Use PV formula to find price on bond

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5.5. Calculating YTM on a bond

We want to establish how you might calculate the interest rate (YTM) on any bond
that is trading in the secondary market. Given the market price of a bond and its
coupon, we want to estimate its implied YTM.

5.6. Bond Prices and Yield To Maturity

The YTM is the yield on the stock, which combines the income together with any loss
arising on maturity (or if the bond is trading at less than par value it combines the
income together with the profit arising on maturity).

Bond prices and YTM have an inverse relationship

• When YTM is very high the value of the bond will be very low.

• When YTM approach zero, the value of the bond approaches the sum of the cash
flows.

The graphical relationship between the yield to maturity and the term to maturity is
called the Yield Curve. See yield curve in Figure 6.2.

Figure 5.1: Yield curve

It would be an oversimplification to assume that a single interest rate existed and all
bond prices varied uniformly in response to a change in it. Governments usually have
absolute control over short term interest rates through monetary policy and their ability
to set reserve requirements in the banking system. Rates for longer dated
commitments are established by market forms, i.e. an interest rate to persuade
people to lend balanced against a rate to encourage people to borrow. This will give

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rise to different rates of interest for borrowing over different time periods. The
relationship between the yield to maturity and the term to maturity is called the term
structure of interest rates because it relates yield to maturity to the term of each bond.
A typical yield curve and its variations are shown by Figure 6.3.

Figure 5.2 variations of the yield curve

➢ Longer dated bonds have higher yields than shorter dated ones, because
money is tied up for longer.

➢ Potential investors will usually need to be persuaded to lend for longer

periods and must therefore be offered a higher return.

➢ The curve is virtually flat when one considers longer dated bonds. In fact
there is virtually no difference in lending for 15 – 20 years.

➢
If there is an anticipated increase in interest rates then curve B will
become the new yield curve. It will have the following distinct features:

➢ The curve will rise more sharply and flattens out at a higher level.

➢ This indicates that bond investors do not believe that current low values of
interest are sustainable but that economic pressures will cause a rate rise.

➢
If there is an anticipated decrease in interest rates then curve C will become
the yield curve with the following features:

➢ The flatter curve indicates that expectations are for rates to fall in the longer
term.
➢ Borrowers will not enter into long-term commitments because they believe
that by maturity, they can achieve low interest rates.

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➢
Curve D illustrates a yield curve when it is strongly felt that interest rates will
fall.

➢ This is a negative yield curve and is a more extreme version of our previous
scenario. If the government raises short-term rates to very high levels then all
bond investors will expect a fall in long term rates. This will be reflected by
yields in longer dated bonds.

5.7. Duration
The concept of duration was introduced by Frederick Macaulay in 1938. It is “a
measure of the effective maturity of a bond, defined as the weighted average of the
times until each payment, with weights proportional to the present value of the
payment (Bodie, et al., 2010:337).

5.7.1. The Duration formula

n
tCF t
t

t =1 (1 = y )
Dmac =
P
Where: Wt = Weight of time t, present value of the cash flow earned in time t as a
percent of the amount invested, CFt = Cash Flow in Time t, coupon in all periods
except terminal period when it is the sum of the coupon and the principal, y = yield to
maturity, P0 = bond’s price, and D = Duration

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Example
Calculate the duration of a bond priced R1 033.12. The bond has a 9% coupon
rate, 4 year annual payments and its yield to maturity is 8%.

5.7.2. Characteristics of duration

Characteristics of duration can be summarised as follows:
➢
Duration increases with maturity
➢
A higher coupon results in a lower duration
➢
Duration is shorter than maturity for all bonds except zero coupon bonds
➢
Duration is equal to maturity for zero coupon bonds
➢
All else equal, duration is shorter at higher interest rates
➢
The duration of a level payment perpetuity is

1+y
Dperpetuity = ; y = YTM
y

5.8. End of Chapter Questions

1. Explain in simple terms, the concept of rising interest rates producing a capital
loss in bonds.
2. In a commentary on the market, a South African Fund Manager says the
following: “The gilt market is firmer today and is 3 points lower at 11.365%.”
Explain what he is saying.
3. Find the duration of a bond with a 6% coupon rate paid annually. If it has three
years to mature and yields a maturity of 6%, what is the duration if yield to maturity
is increased to 10%.

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Answers

1. A general increase in interest rates will mean that the required return on interest
bearing securities (bonds) will also have to increase in order to remain competitive.
The interest on bonds is known as the coupon and is a predetermined or fixed
percentage of its face value. In order for that coupon to represent a higher
percentage, the actual amount paid for the bond will have to decrease. This results
in the inverse relationship between the price of a bond and its yield. PBα (1/i).

2. The answer to this is described by the inverse relationship between the price of
bonds and their yield. This fall in rates will result in a stronger or firmer gilt price.
Three points lower means that the rate has fallen from 11.395% to 11.365% (100
basis points is 1% and therefore 3 points is 0.03%).

3. A Duration: YTM = 6%

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CHAPTER 6: THE COST OF CAPITAL

Contents

1. Introduction

2. The Importance of calculating Cost of Capital

3. Elements of the Cost of Capital

4. The Weighted Average Cost of Capital (WACC)

5. Calculating the Cost of Equity

6. Calculating the Cost of Preference Share Capital

7. Calculating the Cost of Debt

8. End of Chapter Questions

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Objectives

After working through this section you should be able to:

• Calculate the cost of equity using the dividend valuation method

• Compute the cost of redeemable debt, and convertible securities
• Use CAPM to calculate the beta of a company and to estimate the cost of
capital to appraise projects.

READINGS
This unit has been designed to be read in conjunction with the following textbooks:

PRESCRIBED:
Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.
(2014) Corporate Finance, A South African Perspective, Oxford University
Press.

RECOMMENDED READINGS
Chapter 14: Ross, S; Westerfield, RW; Jordan, BD; and Firer C. (2009).
Fundamentals of Corporate Finance, 4th South African Edition, McGraw-Hill.

Chapter 7: Correia, C; Flynn, D; Uliana, E and Wormald, M. (2008) Financial

Management, 6th Edition, Juta Publishing.

Chapter 15: Marx, J; de Swardt, C; Beaumont Smith, M; Naicker, B;

Erasmus, P.
(2007) Financial Management in Southern Africa, 2nd Edition, Pearson
Education.

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6.1. Introduction

What do we mean by the cost of capital?

➢
It represents the total cost of funds raised by a company.
➢
It’s the return that different types of investors are paid to ensure that they
place their funds within the company and keep their funds in that company.
➢
It’s the minimum return that a company must get on its projects to earn
sufficient to pay this expected return to investors.
➢
This means that it is also the opportunity cost because, if investors don’t get
the required return, they will move their funds elsewhere.

6.2. The Importance of Calculating the Cost of Capital

➢
Benchmarking the firm’s return against similar firms in the industry.
➢
Assessing the value creation potential of new projects as compared to the
cost of capital.
➢
It is an important calculation to make as it forms the basis of calculating the
value of the firms

6.3. The Elements of the Cost of Capital

6.3.1. The Risk-free Rate of Return

Here we are referring to investments with a risk-free yield, such as government
bonds.

6.3.2. The Premium for Business Risk

This is an addition to the risk-free rate of return to allow for uncertainties connected
with the cash flows of a particular project, or the health of the company as a whole.
The higher the anticipated risk, the higher this additional percentage will be.

6.3.3. The Premium for Financial Risk

This is an addition that takes into account the gearing of the company: for example, if
this increases, then equity-holders will need a higher return to compensate them for
the increased amounts of interest which must be deducted from operating profit. Many
firms use both equity and borrowed capital. As equity capital carries the greater risk,

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investors will require a greater return than lenders of borrowed capital. In addition,
long-term and short-term lenders may expect different rates of return.

6.4. Weighted Average Cost of Capital (WACC) Basic Assumptions

1. Dividends on ordinary shares are expected to remain at their current rate during
the lives of the project/s to be appraised.

2. Preference shares and debentures are irredeemable.

The cost of equity capital will, therefore, be based on the current rate of dividend but,
as it is extremely unlikely that equity and debt are in equal proportions, we shall need
to calculate a weighted average. The basic formula for the WACC is:

WACC = [Proportion of Debt X Cost of Debt] + [Proportion of Equity X Cost of

Equity] = [(D/V) X Rd (1 – Tc)] + [(E/V) XRe]

6.5. Weighted average cost of Debt - Rd

When estimating the cost of debt, we have to include the Long Term debt and Short
Term debt, we need to consider the historic (coupon rate) vs future (Yield to Maturity)
costs. When looking at debt (traded as well as untraded) we need to observe the cost
of debt, risk ratings (from credit rating agencies) and use the risk free yield curve
(maturity) and add a premium for credit, and liquidity risk. Lastly we need to consider
whether the interest rate is floating or fixed. Interest expenses are deductible for tax
purposes and thus this also needs to be considered when calculating WACC.

6.6. Weighted average cost of capital – Return on Equity

When estimating the cost of equity, two options are available:

6.6.1. The Dividend Growth (DG) Model Approach

• assume a constant growth in dividends
P= D
1
0
R −g
e
D
Rearranging g gives 1

R e = +g
P
0

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6.6.2. Advantages of the Dividend Growth Model

➢
The dividend valuation model is simple to use.

➢
It allows for the fact that future dividends should grow if profits are re invested and
that shareholders are likely to value their shares according to their future dividends
expectations.

6.6.3. Disadvantages of the Dividend Growth Model

➢
The DG method also assumes that that the market value of the share is in
equilibrium so that the share price is correct.

➢
although it allows for the fact that future dividends should grow if profits are
reinvested, and that shareholders are likely to value their shares according to their
future dividend expectations, it assumes that all shareholders behave in the same
way – which is improbable

Where no growth in dividends is expected in the future, we used the formula: Cost of
equity Ke = (D1/P0) + g.

Our calculation is based on the assumption that the market price of a share will be the
discounted future cash flows of revenues from that share, and on a constant growth
rate in dividends. It is sometimes called the ‘Gordon Growth model’. (DG Model)

So, for example, if we have a company with shares currently valued by the market at
R800 000, but with a nominal value of R500 000, last declared dividend 15% and an
expected growth rate of 5%, we would have for cost of equity:

Current dividend R500 000 x 15% = 75 000

So d1 will be 75,000 x 1.05 = 78,750

Ke = (78,750/800,000) + 0.05 = 0.1484375 or 14.84%

We do not simply relate the 78,750 back to the nominal value of the shares, as we are
trying to find the expected return based on what owners would have to invest now, i.e.
the market value.

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Cost of Equity – the dividend valuation model

Solution
Let’s calculate the current dividend:

Dividend =R2X0,12

= R0, 24

However we need to calculate the value of D1. Hence, we project this dividend at a
growth rate of 6%.

D1 = Do x g
D1 = R0.24 x 1.06
= 0.2544

Now let’s calculate the cost of Cost of equity

Ke = (D1/P0) + g
Ke = 0.2544 + 0,06
2,8

= 15.09
6.6.4. The Capital Assets Pricing Model (CAPM)
Approach The formula
Re given by: RE = Rf + βE [RM - Rf ]

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Represented by:

P0 = the current price of the share

D1 = Dividend in Year 1

g = growth rate

Rf = the risk free rate

β = the risk co-efficient (also known as beta)

RM = the market return

6.6.5. The CAPM shows that the expected return is dependent on three
variables

1. The pure time value of money: this is measured by the risk free rate [Rf]. This is
the reward for merely waiting for your money without taking any risks. The best
indicator of the risk free rate is the yield on government bonds (also referred to as
treasury bills).

2. The reward for bearing systematic risk: this is measured by the market
risk
premium, which is denoted as follows: (Rm – Rf). This component is the reward
the market offers for bearing an average amount of systematic risk in addition to
waiting.
3. The amount of systematic risk: as measured by β. This is the amount of
systematic risk that is present in a particular asset, relative to an average asset.

Beta factor: The beta factor is ‘the measure of a share’s volatility in terms of market
risk’. The beta factor of the market as a whole is taken to be 1. This means that:

• results for individual shares which are greater than 1 imply a greater degree of
volatility

• Results which are less than 1 imply a lower degree of volatility.

• It should then be possible to predict what will happen to the return on a share if
there is a change in the market return.

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Using CAPM
In Section 2, we looked at the use of the Capital Asset Pricing Model in assessing a
project’s systematic risk. We did not, however, attempt to calculate . Now we are going
to see how , once derived, can be used to obtain the cost of a firm’s equity.

Example
Suppose that we have this information about the current market return and the risk-
free return:
The market return is 12%, the risk free return is 8%, and the β is 1,4. Then:

Re = Rf + βE [RM - Rf ]

Re = 8% + 1, 4[12% - 8%]

Re = 8% + 1,4. 4%

Re = 13, 6%

How will this differ from using the dividend valuation model? If we assume that prices
in the stock market are in equilibrium, and that a firm’s dividends reflect systematic
risk only, then the two methods produce approximately the same result. However, in
practice:

➢
The dividends used in the dividend valuation model may include an allowance for
specific as well as systematic risk.
➢
The current share values used in the model may not in fact be in equilibrium.
➢
The CAPM assumes that there is equilibrium in the stock market, and considers
systematic risk only.
➢
So far, we’ve presumed that we know what the beta factor for a share is. We can in
fact calculate it, although in practice it’s easier to look it up.

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6.6.6. Advantages of the CAPM

➢
The CAPM allows for variations in share prices and returns as the result of market
risk. Therefore it can indicate whether the share at the moment is higher or lower than
it should be and what it should change to.

6.6.7. Disadvantages of the CAPM

➢
It assumes the stock market is a perfect market with no dealing charges and with all
investors having the same perception of security.
➢
It also assumes that there is a risk- free rate at which all investors may borrow
without limit.
➢
It ignores taxes.

An Example

Suppose La Roja Beperk has the following capital structure (ignore reserves):

Equity : 5 000 000 R1 ordinary shares, market price currently R1, 70

Preference Shares : 2 000 000 @ R0.50 yielding 10%, market price currently R0.55

Debentures : 2 000 000, 15% debentures, issued at R1, 00, market price currently

R1.08

Bank loan : R1 000 000 12% bank loan

They have paid a dividend of 20c per share last year and they expect dividends to
grow by 5%. The corporate tax is 30%.

Calculate their cost of capital, using the Dividend Growth Model as your basis
for valuing equity.

Solution
First, we need to calculate the overall market value of these investments, by
multiplying the original values by the market price divided by the nominal value in each
case, and totalling.

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Ordinary Shares: 5 000 000 x 1.7 8 500 000

Preference 1 000 000 x 0.55/0.50 1 100 000
Debentures: 2 000 000 x108/100 2,160,000

Bank Loan: 1 000 000 1,000,000

Overall market
value
12 760 000

Now let’s find the proportion of this total represented by each type of capital:

Equity: 8 500 000/12 760 000 = 0.6661

Preference: 1 100 000/12 760 000 = 0.0862
Debentures: 2 160 000/12 760 000 = 0.1693
Bank loan: 1 000 000/12 760 000 = 0.0784
1.0000

Let’s calculate the rate of return for each type of capital

Equity = D1 + g
Po

= 0.20 (1 + 0, 05) + 0, 05 Workings [0,21/1,7 = 0,1235]

1, 7

= 17, 35%

Preference shares = D/P X 100 (note: dividends at present = 50c X 10%

= 5C)

= 0, 05/0, 55 X 100

= 9, 1%

Debentures = 15 x (1-TC)
= 15%X0,7

= 10.5%

Loans = [0, 12 X (1 – Tc]

= 0,12X0,7
= 8, 4%

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Rate of Return Proportion Unit Cost

Equity: 17,35 X 0,6661 = 11,5568
Preference shares: 9,09 X 0,0862 = 0,7836
Debentures: 10.5 X 0,1693 = 1,7778
Loans 8,40 X0,0784 = 0,6586
WACC = 14,78%

This would be the minimum rate to apply for investment appraisal, assuming that all
projects to be evaluated bear the same risk, and that finance would be raised in the
same proportions as currently exist.

Key 1 2 1x2 3 4 3X4

Present Present Individual
Equity Type Nominal Proportion
Unit total Cost of
Value
value value ROI Capital
8 500
Ordinary Shares 5 000 000 1.7 000 0.6661 17.35 11.5576
Preference 1 100
Shares 2 000 000 0.55 000 0.0862 9.1 0.7845
2 160
Debentures 2 000 000 1.08 000 0.1693 10.5 1.7778
1 000
Loans 1 000 000 1 000 0.0784 8.4 0.6583
12 760
Total 10 000 000 000 1 14.78

NB: The calculation for debentures and the loan interest is multiplied by 70 per cent,
i.e.

[1 – Tc] Debentures and interest on loan are tax deductible and as a result, do not
bear tax. The same cannot be said of dividends, as it is an after tax cost.

In order to equalise the tax effect, the debenture and bank-loan interest weighting is
reduced by multiplying it by 1 minus the given corporate tax rate (30 per cent).

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Exercise 1

Tigerbrands Ltd has the following capital structure:

Equity

2 000 000 R2 ordinary shares, market price R2, 50

Preference

1 000 000 12% R1 preference shares, market price R1, 20

Reserves

R1 500 000

Bank loan

R500 000 15% bank loan

Debentures

R1 750 000 16% debentures, market price R110 (issued at R100).

The current and expected future rate of ordinary share dividend is 20%. What is the
firm’s weighted average cost of capital? Tax rate is 33%.

Solution

Calculate overall market value Market Value Proportion

Ordinary shares 4,000,000 x R2.50/2 =5,000,000 57.97

Preference shares 1,000,000 x 1.20/1 =1,200,000 13.91
Bank loan =500,000 5.80
Debentures 1,750,000 x 110/100 =1,925,000 22.32
Total 8,625,000 100.00

Relevant returns: %
Ordinary shares 20 x 2/2.50 = 16.00
Preference shares 12 x 1/1.20 = 10.00
Debentures 16 x (1-TC) = 10.72

Weighted average cost of capital: %

Ordinary shares 57.97 x 16= 9.28
Preference shares 13.91 x 10= 1.39
Bank loan 5.80 x 15 x 67/100 = 0.58
Debentures 22.32 x 10.72 = 2.43
WACC 13.68

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6.7. Cost of Preference Share Capital

Because this is fixed dividend capital, i.e. amounts paid to shareholders will not
fluctuate

(unless, of course, there are no profits from which to pay the obligation), we can
consider the cost of preference share capital to be similar to the cost of debt capital,
ignoring taxation, which is dealt with below.
Kp = D/P0
D = Dividend. We do not consider a D1, as dividends on preference shares are
constant.
P0 = the current value/price of the preference share.

Example
The Brandon group has a target capital structure of 50% equity, 5% preference shares
and 45% debt. Their cost of equity is 16%, preference shares 7, 5% and debt 9%.
Their tax rate is 35%. Calculate:

d. Their WACC

e. Their non-executive director has approached you and asked your thoughts on
using preference equity to finance a new project, as she believes that this is
cheaper than debt financing.

Solution

a. Using the equation to calculate the WACC, we find:

WACC = 0, 50(0, 16) + 0, 05(0, 075) + 0, 45(0, 09)(1 – 0, 35)

= 0, 1101 (11, 01%)

b. It must be remembered that interest is tax deductible and dividends are not, hence
we must look at the:

After-tax cost of debt, which is

=0,09(1–0,35)

= 0, 0585 or 5, 85%

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Hence, on an after-tax basis, debt is clearly cheaper than preference shares which
cost 7, 5%%

6.8. End of Chapter Questions (taken from previous exam papers)

1. Suppose AA Carriers has a beta of 1,3. The return on market is 12% and the risk
free rate is

7%. AA's last dividend was R2 per share and they expect a growth rate of 8%. The
share is currently trading at R20.

1.1. Using the CAPM approach, calculate the Return on equity.

1.2. What is their return on equity using the Dividend Growth (DG) Model?

1.3. Discuss 2 advantages of the CAPM approach.

2. Bugsy’s Bag Manufactures (BBM) shares have a beta of 1,32. Market analysts
suggest a risk free rate of 4,5% and a market return of 11 %. BBM paid a dividend of
R2,10 per share last year and expect dividends to grow by 5%. Their shares sell for
R28 per share at present (the par value of their shares isR20). Calculate BBM cost of
equity using:

2.1. The Dividend Growth Model

2.2. The Capital Assets Pricing Model.

2.3. Explain briefly the reason for the difference in your answers above.

3. Bassa Braziers Ltd, operate in the fabrication industry. They feel that some of their
older gas welding machines need to be replaced. They seek your help in order to
calculate their cost of capital. Their present capital structure is as follows:

• 600 000 R2 ordinary shares now trading at R2,40 per share.

• 200 000 preference shares trading at R2,50 per share (issued at R3 per share).
10 % p.a. fixed rate of interest.

• A bank loan of R1 000 000 at 12 % p.a. (payable in 5 years’ time)

Additional data
a. The company’s beta is 1,4. A return on market of 15% and a risk free rate of 6 %.
b. Its current tax rate is 28 %.
c. Its current dividend is 50c per share and they expect their dividends to grow by 7
% p.a.

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Required

3.1. Assuming that the company uses the CAPM to calculate their cost of equity,
calculate their weighted average cost of capital.

3.2. A further R500 000 is needed to finance the expansion which option should they
use (from ordinary shares, preference shares or loan financing) and why?

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CHAPTER 7: DIVIDENDS AND

DIVIDEND POLICY
Contents

1. Introduction

2. The Clientele Effect

3. Dividend Policy: Is it Relevant?

4. Types of Dividends

5. Real World Factors affecting a High Dividend Payout

6. Practical Issues in respect of the Payment of Dividends

7. Signalling

8. The Dividend Decision

9. The Residual Dividend Approach

10. Share Repurchase: An alternative to Cash Dividends

11. Share splits and scrip dividends

Objectives

After working through this section you should be able to:

• The various types of dividends and how they are paid.

• Be aware of the practical issues behind dividend decisions
• How dividend policies work in practice.
• Why share repurchases is an alternative form of dividend.
• understand the theory of dividend irrelevancy
• Discuss the dividend payment process and the various dividend options
available to the company.
• The difference between cash and scrip dividends.

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READINGS

Chapter 17: Fundamentals of Corporate Finance 4th South African Edition,

Ross S, Westerfield RW, Jordan BD and Firer C, 2008

Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.

(2014) Corporate Finance, A South African Perspective, Oxford University
Press.

Chapter 16: Correia, C; Flynn, D; Uliana, E and Wormald, M. (2008) Financial

Management, 6th Edition, Juta Publishing.

Chapter 18: Marx, J; de Swardt, C; Beaumont Smith, M; Naicker, B; Erasmus,

P. (2007) Financial Management in Southern Africa, 2nd Edition, Pearson
Education.

7.1. Introduction
A company’s dividend policy is the approach they adopt towards dividend payments.
Key questions start to emerge, like:

a) Will they pay their shareholders a dividend, or not?

b) How large will it be?

c) How often will they make payments? (Els 2010: 366))

Dividends are non-contractual payments to shareholders as compensation for their

investment. Profit after tax (and minority interests, if any) will either be distributed as
cash dividends or retained and reinvested in the firm. The traditional view of dividends
is that the level will affect share prices, although no clear relationship has been found
in various research studies. It’s not always the case that firms would want to declare
as high a dividend as possible.

The key questions are:

• Should the firm pay out money to its shareholders? or

• Keep the money and invest it for the shareholders?

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An assumption underlying much of the academic finance literature is that managers

make decisions that lead to maximizing the wealth of their firm’s shareholders as
reflected in ordinary share prices.
Most economists would answer: managers have a criterion for evaluating
performance and deciding between alternative courses of action, and that the criterion
should be maximization of the long-term market value of the firm. This Value
Maximization proposition has its roots in 200 years of research in economics and
finance.

The decisions of corporate financial managers fall into two broad categories:

1. Investment decisions: Investment decisions involve determining the type and

amount of assets that the firm wants to hold.

2. Financing decisions concern the acquisition of funds in the form of both debt and
equity to support a firm’s operating and investment activities.

Dividend decisions, as determined by a firm’s dividend policy, are a type of financing

decision that affects the amount of earnings that a firm distributes to shareholders
versus the amount it retains and reinvests. Dividend policy refers to the pay-out policy
that a firm follows in determining the size and pattern of cash distributions to
shareholders over time. The board, with the input of senior management, sets a
corporation’s dividend policy. Under real-world conditions, determining an appropriate
pay-out policy often involves a difficult choice because of the need to balance many
potentially conflicting forces.

Conventional wisdom suggests that paying dividends affects both shareholder wealth
and the firm’s ability to retain earnings to exploit growth opportunities because
investment, financing, and dividend decisions are interrelated.

For example, if a firm decides to increase the amount of dividends paid, it retains fewer
funds for investment purposes, which may force the company into the capital markets
to raise funds. In practice, managers carefully consider the choice of dividend policy
because they believe such decisions affect firm value and hence shareholder wealth.

Investors view dividend policy as important because they supply cash to firms with the
expectation of eventually receiving cash in return. Thus, managers act as though their
firm’s dividend policy is relevant despite the controversial arguments set forth by Miller
and Modigliani (1961) that dividends are irrelevant in determining the value of the firm.

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Others are less sanguine about how dividends affect the value of a firm’s shares. In
their pioneering study, Miller and Modigliani (1961) (hereafter MM) provide an elegant
analysis of the relationships among dividend policy, growth, and the valuation of
shares. On the basis of a well- defined but simplified set of perfect capital market
assumptions (e.g., no taxes, transaction and agency costs, and information freely
available to everyone), MM set forth a dividend irrelevance theorem. In their idealised
world, investment policy is the sole determinant of firm value. Therefore, if managers
focus on making prudent investment choices, payout policy and capital structure
should take care of them. MM’s irrelevance message suggests that pay-out policy is
an economically trivial issue that managers can largely ignore if they make sensible
investment decisions. Early studies by Black and Scholes (1974), Miller (1986), and
Miller and Scholes (1978, 1982) support the dividend irrelevance argument.

As De Angelo and De Angelo (2007) point out, MM’s dividend irrelevance principle
rests on an unstated assumption that forces firms to choose among pay-out policies
that distribute 100 percent of the free cash flow generated each period by investment
policy. In addition, shareholders are indifferent to receiving a given amount of cash as
a dividend or through stock repurchases.

Thus, MM’s theory leads to the contentious conclusion that all feasible payout policies
are equally valuable to investors. Yet De Angelo and De Angelo contend that the set
of possible payout policies is not as limited as MM assumes and that payout policy
matters. Bernstein (1992: 176) notes, however, that the “MM theory was admittedly an
abstraction when it was originally presented,” and “no one—least of all Modigliani and
Miller—would claim that the real world looks like this.” Although examining dividend
policy in perfect capital markets can provide useful insights about the conditions under
which dividends may affect stock prices, the dividend irrelevance theorem can also be
misleading. Bernstein (1992: 180) notes, “The final test of any theory is how accurately
it portrays the real world, blemishes and all.”

Black (1976; 05) assesses the contributions of dividend researchers post-MM and
concludes, “The harder we look at the dividend picture, the more it seems like a puzzle,
with pieces that just don’t fit together.” Feldstein and Green (1983, p. 17) echo Black’s
sentiments, stating, “The nearly universal policy of paying substantial dividends is the
primary puzzle in the economics of corporate finance.”

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7.2. The Clientele Effect

It is important to remember that not all investor have the same or similar needs. Some
investors may prefer a cash dividend, others would prefer to have their funds
reinvested so that the company can grow and thus the share price grows.(Els 2010;
369). Investors such as retirees would prefer a cash dividend as their need for cash is
far greater than an employed person. Dividends and capital gains are taxed at different
rates and at different times and these have a further effect on investor preferences.

The clientele effect implies that an investor in need of current income will invest in a
company that has a high payout ratio. Whereas an investor not interested in current
income will prefer shares in a company with low dividend pay-outs, but with high capital
growth potential (Els 2010: 369). When a company’s dividend policy changes,
investors may adjust their shareholdings accordingly and this may influence the share
price.

7.3. Dividend Policy: Is it Relevant?

Consider a firm that can pay out dividends of R10 000 per year for each of the next
two years or can pay R9 000 this year, reinvest the other R1 000 into the firm and then
pay R11 120 next year. Investors require a 12% return.

If the company will earn the required return, then it doesn’t matter when it pays the
dividends. Assuming that the second dividend is a liquidating dividend and the firm
ceases to exist after period 2, then:

Market Value with constant dividend

PV = 10 000 / 1.12 + 10 000 / 1.122
= 16 900.51

Market Value with reinvestment

PV = 9 000 / 1.12 + 11,120 / 1.122

= 16 900.51

Explanation

Recall the dividend growth model: P0 = D1 / (RE – g). In the absence of market
imperfections, such as taxes, transaction costs and information asymmetry, it can be
shown that an increase in the future dividend, D1, will reduce earnings retention and

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reinvestment. This will reduce the growth rate, g. Therefore, both the numerator and
the denominator increase and the net effect on P0 is zero.

There are 4 reasons as to why Dividend Policy should be regarded as relevant

a. “A bird in the hand is worth two in the bush” If a dividend is declared, you are
quite certain of receiving it. This is not necessarily so for a capital gain.

b. The signalling process: this is when the dividend announcement is used to

communicate information to the shareholders about the company.

c. The tax preference explanation. In South Africa, dividends and capital gains are
subject to capital gains tax (CGT). Because capital gains tax is delayed until the
shares are sold, investors may prefer capital gains to dividends.

d. The agency explanation: This theory states that if funds are retained in the
company, it may not always be used optimally. Paying larger dividends thus
reduces the internal cash flow subject to management discretion.

Terminology

Dividend: This is a payment made out of a firm’s profits to its owners (called
shareholders). This may take the form of a cash payment or further shares.

7.4. Different Types of Dividends:

7.4.1. A regular cash dividend: This takes place once or twice a year. Once in mid-
year if earnings are already healthy. This is called an interim dividend. And one at year
end. This is called a final dividend.

7.4.2. Special Dividend: occurs as a result of an unusual event, perhaps the sale of
a part of the business.

7.4.3. Liquidating Dividend: usually declared when the business is sold off.

7.4.4. Homemade Dividends: is the selling of shares in the appropriate proportion to

create an equivalent cash flow to receiving the dividend stream you want. If you
receive dividends that you don’t want, you can purchase additional shares and
likewise, if you don’t receive dividends you need, then you sell off a portion of that
investment to compensate for the shortfall in dividends not received. So if an investor
expected a dividend of R200 in period 1 and R190 in period 2, but only receive R170
in period 1, then the investor will sell shares to the value of R30 to compensate for this

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loss in dividend. In the same way if an investor received more than he expected in
period 1, then he may use the additional sum of dividends to buy more shares in the
company in order to compensate for a possible loss of dividend in the next period.

These examples indicate that even if shareholders are not happy with the dividend
policy of a company, they can create their own “homemade dividends”. It must be
noted that homemade dividends do not take costs and taxes into account. If they did,
the scenario can be entirely different.

Dividend reinvestment plans (DRIPS) allow investors to reinvest dividend income back
into the issuing company without paying commissions. Many plans also allow
shareholders to buy additional shares directly from the company, often on a set
schedule. This again avoids commissions, although in some cases you pay a small
service fee. You are still liable for any taxes owed on the dividend payments.

7.5. Real-World Factors Favouring a Low Dividend Payout

7.5.1. Taxes
Investors that are in high marginal tax brackets might prefer lower dividend payouts.
If the firm reinvests the capital back into positive NPV investments, then this should
lead to an increase in the stock price. The investor can then sell the stock when she
chooses and pay capital gains taxes at that time. Taxes must be paid on dividends
immediately, and even though qualified dividends are currently taxed at the same rate
as capital gains, the effective tax rate is higher because of the timing issue.

However with STC (Secondary Tax on Companies) now being phased out and
converted into a new dividends tax, whereby 10% (the current rate) is held from the
amount declared to shareholders. This amount is then paid by the company. Thus if
dividends of R100 000 is declared, then only R90 000 is paid out to the shareholders.
CGT is also charged at 10% of the capital appreciation amount. (Els 2010; 374)

7.5.2. Flotation Costs

If a firm has a high dividend payout, then it will be using its cash to pay dividends
instead of investing in positive NPV projects. If the firm has positive NPV projects
available, it will need to go to the capital market to raise money for the projects. There
are fees and other costs (flotation costs) associated with issuing new securities. If the

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company had paid a lower dividend and used the cash on hand for projects, it could
have avoided at least some of the flotation costs.

7.5.3. Desire for Current Income

Individuals that want current income, i.e., retirees, can either invest in companies that
have high dividend payouts or they can sell shares of stock. An advantage to dividends
is that you don’t have to pay commission. Trust funds and endowments may prefer
current income because they may be restricted from selling stock to meet expenses if
it will reduce the fund below the initial principal amount.

A fascinating real-world example of the desire for increased dividend payout can be
found in Kirk Kerkorian’s battle with the management at Chrysler. In late 1994, Mr.
Kerkorian demanded that Chrysler use its cash hoard (about $6.6 billion at the time)
to increase the cash dividend on common stock and to institute a stock repurchase
program. The management of Chrysler contended that, in the interest of prudent
management, they were amassing cash with which to ride out the next cyclical
downturn. Unhappy with Chrysler’s response, Mr. Kerkorian offered $55 per share
(nearly $23 billion total) to take over Chrysler. This bid ultimately failed, but Chrysler’s
management did raise the dividend. Incidentally, Ford and GM subsequently found it
necessary to publicly defend their large cash positions in the period after the Chrysler
takeover bid.

7.5.4. Tax and Other Benefits from High Dividends

Corporate investors – at least 70% of dividends received from other corporations
does not have to be included in taxable income

Tax-exempt investors – tax-exempt investors do not care about the differential tax
treatment between dividends and capital gains. And, in many cases, tax-exempt
institutions have a fiduciary responsibility to invest money prudently. The courts have
found that it is not prudent to invest in firms without an established dividend policy

7.6. Practical Issues in respect of the Payment of

Dividends Let’s start by looking at actual restrictions on
payment of dividends.

• While dividends can be paid from past and present earnings, they cannot be paid
from any capital reserve.

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• So, if any funds have been transferred from income statements, or another revenue
reserve, into a capital reserve, such as a capital redemption reserve, then this
reserve is not available for payment of cash dividends.

• This rule also covers funds which have been entered directly into a capital reserve,
and have never come from the income statement, such as share premium and
revaluation reserves. As we have already seen, such reserves may be used for the
issue of bonus shares, which may be considered to take the place of cash dividends
in a particular year.

• Companies that are insolvent cannot legally pay dividends; that is, if their external
liabilities exceed their assets.

Now we’ll look at some practical restrictions.

• A company with high profits but poor liquidity may be unable to pay cash
dividends
– it’s no use expecting the bank to increase overdraft facilities just so that a
company can try to impress its shareholders.

• A company with a loan requiring redemption may need to retain funds for this
purpose.

• Companies with various kinds of debt capital may in fact have agreed to
restrictions on dividend payments to protect long-term creditors.

• If a company is expanding quickly, it will need to retain funds to finance new fixed
assets and working capital.

Companies that do not have wildly fluctuating profits are more likely to pay out a
higher percentage of earnings than companies with more volatile profits. Listed
companies with a good profit record are better able to raise additional capital when
they need to – other companies will need to retain more of their own earnings to
finance operations. Also, remember that issuing new shares or debentures involves
issue costs, which obviously do not apply to using retained earnings.
• If companies sell additional equity, control by existing shareholders is diluted
(control may even change hands), whereas if additional debt is sold, there is a
greater risk of fluctuating earnings for these shareholders (remember that, the
higher the gearing, the better ordinary shareholders do in good years, but in poor
years they will probably receive a very low return). To prevent this, a company may
choose to retain more of its earnings rather than distribute them in cash dividends.

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• Shareholders do not all pay the same marginal tax rate – if a company believes that
its shareholders are higher-rate taxpayers, they may believe that capital gain from
rising share prices (which is only taxable when the shares are actually sold) is
preferable to a high cash dividend on which tax is assessable now. The reverse
would obviously apply if a company believes it has only standard-rate taxpaying
shareholders.

Important Dividend Dates: An Example

1. Declaration date: the board of directors declares the payment of a dividend

2. Last day to trade: last day to qualify for the dividend

3. Ex-dividend date: next working day after the last day to trade – The shareholder
registered on this day is no longer entitled to receive the dividend

4. Record date: This is the date on which the shareholder register is accessed to
determine who will receive a dividend.

5. Payment date: the dividends are actually paid to shareholders

If we consider taxation, we should note that its impact is caused not only by the
rates of tax on income and capital gains, but the type of tax system in force in a
particular country. Taxes on income tend to be higher than those on capital gains,
and, of course, in most countries capital gains are only taxable when realised. Tax
systems can involve the payment of tax by the company and the shareholder on
the same amount of money (the dividend) – this is double taxation and happens
in countries using the classical system.

7.7. Signalling
Is it possible that when a dividend is announced, particularly if there is a significant
rise in its level, that the firm is trying to signal its confidence in its future? If so, and if
the stock market reacts favourably to this ‘information’, there is an implication that

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some information available to the management of the company is not already

incorporated in the share price, i.e. the stock market is not ‘strong form’ efficient.

It is noticeable that, in a hostile takeover bid, the target company often announces a
higher dividend level in its efforts to prevent its shareholders from accepting an offer
from a predator.

What happens when firms change dividends?

Share prices decline on div cuts because future dividends are expected to be lower,
not because of a change in pay-out ratio. Share price increases on increased
dividends because market reacts to managements signal about the future

Researchers have found evidence that the stock market takes notice of dividend
announcements as information on which to base the level of share prices.

7.8. The Dividend Decision

1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on absolute levels.
3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather
than short- run changes in earnings.
4. Managers are reluctant to make dividend changes that might have to be
reversed. Thus they prefer to select sustainable levels of dividends.

7.9. Residual Dividend Approach

The term residual dividend refers to a method of calculating dividends. A dividend is a
payment made by a company to its shareholders. It is essentially a portion of the
company's profits that is divided amongst the people who own shares in the company.
A residual dividend policy is one where a company uses residual or leftover equity to
fund dividend payments. This is done after funding is set aside for projects that they
wish to engage in. Typically, this method of dividend payment creates volatility in the
dividend payments that may be undesirable for some investors.

7.9.1. Procedure to calculate residual dividend

1. Determine the amount of funds available without having to sell new equity or
raise loans.

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2. Decide whether or not a dividend will be paid.

3. If funds needed are less than the generated, then a dividend will be paid.

Illustrative Example

Du Pont Ltd follows a strict residual dividend policy. Their debt equity ratio is 3. (3:1)

a. If their profits are R180 000 for the current year, what is the maximum amount of
capital spending possible with no new equity?

b. If planned investment outlays for the current year are R760 000, will du Pont be
able to pay a dividend? If so, how much?

c. Does Du Pont maintain a constant dividend payout? Explain.

Solution

a. Since the company has a debt-equity ratio of 3, they can raise R3 in debt for
every
R1 of equity. The maximum capital outlay with no outside equity financing is:

Maximum capital outlay = R180 000 + 3(R180 000) = R720 000.

b. If planned capital spending is R760 000, then no dividend will be paid and new
equity will be issued since this exceeds the amount calculated in a.

c. No, they do not maintain a constant dividend payout because, with the strict
residual policy, the dividend will depend on the investment opportunities and
earnings. As these two things vary, the dividend payout will also vary.

7.10. Stock Repurchase: An Alternative to Cash Dividends

A stock repurchase occurs when a company buys back its own shares. They may do
this via:

1. A Tender offer – where the company states a purchase price and the desired
number of shares it wishes to acquire

2. An Open market transaction – where the company buys stock in the open
market

A stock repurchase is also similar to a cash dividend in that it returns cash from
the firm to the stockholders. This is another argument for dividend policy
irrelevance in the absence of taxes or other imperfections. If we assume no market

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imperfections, then stockholder wealth is unaffected by the choice between share

repurchases and cash dividends.

7.10.1. Real-World Considerations in a Repurchase

Stock repurchases send a positive signal that management believes the current price
is low. Tender offers send a more positive signal than open market repurchases
because the company is stating a specific price. The stock price often increases when
repurchases are announced. Stock repurchase allows investors to decide if they want
the current cash flow and associated tax consequences. Given our tax structure,
repurchases may be more desirable due to the options provided stockholders. One of
the most important market imperfections related to cash dividends versus share
repurchases is the differential tax treatment of dividends versus capital gains. When a
company does a share repurchase, the investor can choose whether to sell their
shares and take the capital gain (loss) and the associated tax consequences. When a
company pays dividends, the investor does not have a choice and taxes must be paid
immediately.

Although share repurchases have traditionally been viewed as positive signals from
management, not everyone agrees. An article in the November 17, 1997 issue of
Forbes magazine suggests that some buybacks are ill-advised.

“In the early 1980s, IBM began a big buyback program. Between 1985 and 1990 it
bought back nearly 50 million shares, shrinking its common capitalization by 8%. The
buybacks ended with the collapse of IBM‟s stock in 1991. Before the decline was over,
IBM was down 75% from its high. Why, at a time of huge expansion in the computer
industry, didn’t IBM have better uses for its cash?”

A quick search of stock repurchase announcements following the terrorist attacks on

September 11 found at least nine companies that specifically cited a desire to support
American financial markets and confidence in the long-term prospects of the economy
and the company as reasons for the repurchase. Some of these companies were
Cisco, E-Trade, and Pfizer. At least fourteen other major companies made repurchase
announcements in the week that followed the attacks. These announcements were for
new or continuing repurchases without specifically mentioning the attacks or support
for the markets. These companies include Intel, Federal Express, and PeopleSoft. It
should be pointed out that distributing cash via share repurchases is desirable from
the viewpoint of the investor even in the absence of a capital gains tax differential.
Essentially, a repurchase allows the investor to choose whether to take cash now (and

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incur taxes) or hold on to the stock and benefit from the (unrealised) capital gain.
Additionally, empirical evidence indicates that repurchase announcements are often
viewed by market participants as favourable signals of future firm prospects and/or as
evidence that management believes that shares are undervalued.

Share Repurchase and EPS

While EPS rises with a repurchase (there are fewer shares and presumably net
income doesn’t decrease), the market value of those earnings is the same as with a
cash dividend.

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7.11. Scrip Dividends:

A scrip dividend is a dividend that is not paid out in cash. Shareholders are given
additional shares in lieu of their shareholding. Since there are more shares in issue,
each is worth less. There are no cash flow implications. What actually occurs is that
funds are transferred from the distributable reserves account to the share capital. It is
in effect a mini rights issue with substantially reduced costs.

Illustrative Example

The owner’s equity accounts for SKR International are shown below: Ordinary
shares (par
value R1) R 10 000

Share premium R180 000

Retained income R586 500
Shareholder’s equity R776 500

a. If SKR shares sell currently for R25 per share and a 10% scrip dividend is
declared, how many new shares will be distributed?

b. Show the effect on the equity accounts.

c. If SKR declared a 25% scrip dividend, how would the accounts change?

Solution

a. Shares in hands of shareholders at present is

10 000. New shares will amount to 1 000 (10 000

X10%)

Since the par value of the new shares is R1, the share premium per share is R24.
The total share premium is therefore:

Share premium on new shares = 1 000 X R24 = R24 000

b. Shareholders’ equity

Ordinary share (R1 par value) 11 000

Share premium 204 000
Retained profits 561 500
R776 500

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c. The shares outstanding increases by 25 per cent, so: New shares outstanding
= 10 000(1, 25) = 12 500

New shares issued = 2 500

Since the par value of the new shares is R1, the share premium per share is R24. The
total share premium is therefore:

Share premium on new shares = 2 500(R24) = R60 000

Ordinary share (R1 par value) R12 500

Share premium 240 000

Retained profits 524 000

R776 500

Question 1
Consider four different shares, all of which have a required return of 15 percent and a
most recent dividend of R4,50 per share. Shares W, X, and Y are expected to maintain
constant growth rates in dividends for the foreseeable future of 10 percent, 0 percent
and - 5 percent per year, respectively. Share Z is a growth share that will increase its
dividend by 20 percent for the next two years, and then maintain a constant 12 percent
growth rate thereafter.

1.1. What is the dividend yield for each of these four shares?

1.2. What is the expected capital gains yield?

1.3. Discuss the relationship among the various returns that you have calculated for
each of these shares

Solution

NOTE

We are asked to find the dividend yield and capital gains yield for each of the shares.
All of the shares have a 15 per cent required return, which is the sum of the dividend
yield and the capital gains yield. To find the components of the total return, we need
to find the share price for each share. Using this share price and the dividend, we can
calculate the dividend yield. The capital gains yield for the share will be the total return
(required return) minus the dividend yield.
W: P0 = D0(1 + g) / (R – g) = R4,50(1,10)/(0,15 – 0,10) = R99,00

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Dividend yield = D1/P0 = 4,50(1,10)/99,00 = 5% Capital gains yield = 0,15 – 0,05 =

10%

X: P0 = D0(1 + g) / (R – g) = R4,50/(0,15 – 0) =

R30,00 Dividend yield = D1/P0 = 4,50/30,00 =

15%

Capital gains yield = 0,15 – 0,15 = 0%

Y: P0 = D0(1 + g) / (R – g) = R4,50(1 – 0,05)/(0,15 + 0,05) =

R21,38 Dividend yield = D1/P0 = 4,50(0,95)/21,38 = 20%

Capital gains yield = 0,15 – 0,20 = – 5%

Z: P2 = D2(1 + g) / (R – g) = D0(1 + g1)2(1 + g2)/(R – g) = R4,50(1,20)2(1,12)/(0,15
–
0,12)

= R241,92
P0 = R4,50 (1,20) / (1,15) + R4,50 (1,20)2 / (1,15)2 + R241,92 / (1,15)2 = R192,52

Dividend yield = D1/P0 = R4,50(1,20)/R192,52 = 2,8% Capital gains yield = 0,15 –

0,028 = 12,2%

In all cases, the required return is 15%, but the return is distributed differently between
current income and capital gains. High growth shares have an appreciable capital
gains component but a relatively small current income yield; conversely, mature,
negative-growth shares provide a high current income but also price depreciation over
time.

Question 2

Bujumbura Inc has declared a 12% scrip dividend.

The market value of its shares is R20 per share. Its Equity Accounts are as follows:
Ordinary share capital (R1 per share) 350 000

Share Premium 1 650 000

Retained Profits 3 000 000

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Ordinary Shareholders’ equity 5 000 000

Show the effect on the equity section that the scrip dividend will have. (Show your
workings)
Solution

With a share dividend, the shares outstanding will increase by one plus the dividend
amount, so: New shares outstanding = 350 000(1,12) = 392 000

The share premium is the capital paid in excess of par value, which is R1, so: Share
premium for new shares = 42 000(R19) = R798 000

The new share premium will be the old share premium plus the additional share
premium for the new shares, so:

Share premium = R1 650 000 + 798 000 = R2 448 000

The new equity portion of the balance sheet:

Ordinary share(R1 par value) R 392 000

Share premium 2 448 000

Retained profits 2 160 000
R5 000 000

11. End of Chapter Questions

Corleone Collieries is deciding whether to pay out R60 000 in excess cash in the form
of an extra dividend or a share repurchase. Current profits are R3,00 per share and
the share sells for

R30. Their abbreviated balance sheet before paying out the dividend is:

Equity 240 000Bank/cash 60 000

Debt 60 000other assets 240 000

300 000 300 000

Evaluate each alternative (i.e.: pay the dividend or repurchase the shares) by:

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1.1. Calculating the number of shares in issue.

1.2. The dividends per share (for the first alternative, i.e. pay the dividend)

1.3. Calculate:

1.3.1. The new share price.

1.3.2. The EPS

1.3.3. The price-earnings ratio

Question 2

2.1 Distinguish between a residual dividend policy and a stable dividend policy.

2.2 Mphela Manufacturing is unsure as to whether to pay out R50 000 in excess cash
in the form of an extra dividend or a share repurchase. Current profits are R 2,25 per
share and each share sells for R 20.

Their abbreviated balance sheet before paying out the R50 000 dividends is:

Equity 250 000

Debt 50 000

Total Capital 300 000

Cash 50 000

Other Assets 250 000

Evaluate the two alternatives in terms of the effect on the price per share, earnings
per share and Price Earnings Ratio

Question 3

The Equity accounts of Blydskap Ltd are shown below:

Ordinary Share Capital (R2 par value) R200 000

Share Premium 80 000

Retained Profits 100 000

Total Shareholders’ Equity 380 000

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3.1. If Blydskap’s shares sell for R10 per share, and a 10% scrip dividend is
declared, how many new shares will be distributed?
3.2. Redraft the Equity accounts section of the balance sheet.

3.3. Has this been a wise decision? Explain.

3.4. Tygerberg Ltd has declared an annual dividend of 90c per share. Their after tax
profits for the year was R60 000 and they have 12 000 share in issue.

3.4.1. Calculate profit per share.

3.4.2. What is their payout ratio?

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CHAPTER 8: WORKING CAPITAL

MANAGEMENT

CONTENTS

1. Introduction

2. Annual Reports

3. Objective of Financial Statement Analysis

4. Limitations of Financial Statement Analysis

5. Approaches to Financial Statement Analysis

6. Application of Ratio Analysis

7. Du Pont Analysis

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Learning Outcomes
After working through this section you should be able to

• Outline the various reports used to communicate financial information to

shareholders and other stakeholders.
• Define what is meant by the interpretation of accounts.
• Identify the parties who use financial analysis.
• Calculate and interpret commonly used financial ratios.
• Evaluate the results of the ratio analysis and make recommendations for
future action.
• Identify the limitations of using accounting data to perform financial analysis.
• Outline the various approaches to financial statement analysis and to identify
when each approach is appropriate.
• Use Du Pont analysis for interpreting the financial results of a company.
• And outline the limitations of ratio analysis.

PRESCRIBED:

Chapter 19 Fundamentals of Corporate Finance , 4th South African Edition,

Ross, S; Westerfield, RW; Jordan, BD; and Firer C, 2009.

Chapter 11: Financial Management, 6th Edition, Juta Publishing, 2000

Correia, C; Flynn, D; Uliana, E and Wormald, M

Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S.

(2014) Corporate Finance, A South African Perspective, Oxford University
Press.

Chapter 9: Financial Management in Southern Africa, 2nd Edition, Pearson

Education, 2007,

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8.1. Introduction
Working capital management incorporates a range of items that needs to be managed
in order to ensure the smooth everyday operations of the firm. In an entity like
Vodafone, these items may include:

➢
Inventory: This may include handsets (phones) which will be handed to
contracted customers, modems, routers, laptops, etc. this used to be referred
to as stock in trade in years gone by and is integral to the growth and
development of any institution.
➢
Receivables: These are the debtors of the business. They may be internet and
contract customers, tenants, etc. if they are not managed optimally, the
business will experience cash flow problems that may eventually lead to
bankruptcy.
➢
Cash: This will include cash in the current account, investment accounts, petty
cash and cash float. Cash is really the lifeblood of any institution. Weak cash
inflows can stymie the growth of any business.

➢ Payables: this will include suppliers from whom Vodafone relies on for
materials, supplies, banks, etc. if creditors terms are not adhered to regularly,
they may eventually alter their credit terms, thus placing a strain on the firm’s
finances. (Els;393)

It goes without saying that working capital must be managed according to the
business’ individual needs. However, the basic principles of working capital
management apply to all businesses, irrespective of their size or stage of
development. If net working capital is positive in value, it means that the firm is able to
pay its current liabilities as they become due.

Low working capital means that the business is going to battle to pay back its current
liabilities. Further, too high levels of working capital may mean that the business has
too much cash tied up in debtors and inventory.

8.2. The Working Capital Cycle

A typical cycle in a manufacturing firm will be similar to the following:
➢
The business orders and then receives the raw materials that are required for
their production processes.

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➢
It follows that this transaction will reduce their cash balances or incur debt in the
form of accounts payable.
➢
Labour will then be used to turn the raw materials into finished goods. The cash
will then be reduced further.
➢
The finished goods will then be sold. This may either be a cash sale or a credit
sale. A credit sale will increase the accounts receivable and a cash sale will
increase their cash balance.
➢
The creditors account by this time will fall due and must then be settled. The cash
balance may then be depleted and if this is indeed the case, then an overdraft may
need to be negotiated.
➢
Eventually, the cycle is completed when the monies are received from the
debtor/s and the cycle thus continues in much the same way (Correia: 11-2).

Some ratios worth noting here are:

1. Raw material Inventory Days: Raw material Inventory

X 365 Purchases

This answer tells us the number of days for which the business has materials on
hand for the manufacturing process.
2. Work-in-process Inventory Days: Work in Process Inventory X 365
Purchases

3. Finished Goods Inventory Days: Finished goods Inventory X 365

Cost of Sales

This ratio highlights the period for which the business has sufficient stock for resale
purposes. Management’s ultimate goal must be to shorten the working capital cycle
by as much as possible without affecting the efficient running of the business. The
cycle can be shortened by reducing material processing time. Offering lucrative
discounts to debtors to settle their accounts before due date. And paying creditors as
per credit agreement to secure cash discounts or avoid interest charges.

8.3. Sales Forecasting

The following factors must be considered when forecasting sales:

a) The availability of historical data. This is used to predict future sales. Notice that
in many restaurants, their service is much faster and efficient during peak periods.

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This is so because they take cognizance of their sales and what are the fast
moving items during the peak periods (which may be Friday and Saturday lunch
and dinner time). They may start the cooking processes for spareribs and steaks
well before peak time arrives and may just need a few minutes to finish off a meal
that may take more than 45 minutes to prepare.

b) Economic indicators: they give some sort of idea of the state of the economy.

c) These indicators may be interest rates, GDP, inflation rates and exchange rates.

d) Competitors activities: Apple’s IPad revolutionized the tablet PC industry and

forced key competitors to review their product offering/s. the same may be said of
the television monitor industry that moved from analogue to digital over a 20 year
period but from plasma to LCD to LED to 3D in less than 5 years, such is the rapid
pace of change.

e) Supplier activities: businesses can only be as efficient as their suppliers. For this
reason businesses strive to have as many suppliers as they possibly can get on
their data base, this to improve supplier service delivery and have alternate
sources available in case of non-performance by supplier.

f) Government Regulations: tariffs, duties and other protective elements must also
be considered.

g) Plant Capacity: is an overriding factor when forecasting. Is the plant capable of

running 2 shifts or even 3 shifts when necessary?

h) Market Surveys: give management an idea about customer tastes and

preferences.

i) Promotional Campaigns: are designed purely to create awareness of the

product offerings in the consumer domain. (Correia: 11-11)

8.4. What is Inventory Management?

Inventory management is the process of efficiently overseeing the constant flow of
units into and out of an existing inventory. This process usually involves controlling the
transfer in of units in order to prevent the inventory from becoming too high, or
dwindling to levels that could put the operation of the company into jeopardy.
Competent inventory management also seeks to control the costs associated with the

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inventory, both from the perspective of the total value of the goods included and the
tax burden generated by the cumulative value of the inventory.

Balancing the tasks of inventory management means paying attention to three key
aspects:

a) The first aspect has to do with time. In terms of materials acquired for inclusion in
the total inventory, this means understanding how long it takes for a supplier to
process an order and execute a delivery. Inventory management also demands
that a solid understanding of how long it will take for those materials to transfer out
of the inventory be established. Knowing these two important lead times makes it
possible to know when to place an order and how many units must be ordered to
keep production running smoothly.

b) Calculating what is known as buffer stock is also key to effective inventory

management. Essentially, buffer stock is additional units above and beyond the
minimum number required to maintain production levels. For example, the
manager may determine that it would be a good idea to keep one or two extra
units of a given machine part on hand, just in case an emergency situation arises
or one of the units proves to be defective once installed. Creating this cushion or
buffer helps to minimise the chance for production to be interrupted due to a lack
of essential parts in the operation supply inventory.

c) Inventory management is not limited to documenting the delivery of raw materials

and the movement of those materials into operational process. The movement of
those materials as they go through the various stages of the operation is also
important.

d) Typically known as a goods or work in progress inventory, tracking materials as

they are used to create finished goods also helps to identify the need to adjust
ordering amounts before the raw materials inventory gets dangerously low or is
inflated to an unfavourable level.

e) Finally, inventory management has to do with keeping accurate records of finished

goods that are ready for shipment. Accurately maintaining figures on the finished
goods inventory makes it possible to quickly convey information to sales personnel
as to what is available and ready for shipment at any given time.

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8.5. Successful Inventory Management

Successful inventory management involves balancing the costs of inventory with the
benefits of inventory. Many small business owners fail to appreciate fully the true costs
of carrying inventory, which include not only direct costs of storage, insurance and
taxes, but also the cost of money tied up in inventory. This fine line between keeping
too much inventory and not enough is not the manager's only concern. Others include:

a) Maintaining a wide assortment of stock but not spreading the rapidly moving
ones too thin as this will result in costly stock outs.

b) Increasing inventory turnover, but not sacrificing the service level.

c) Keeping stock low, but not sacrificing service or performance.

d) Obtaining lower prices by making volume purchases, but also ensuring that the
business does not end up with slow-moving inventory.

e) Having adequate inventory on hand, and at the same time ensuring that the
business does not getting caught with obsolete items.

8.6. Inventory Control Techniques

To maintain an in-stock position of wanted items and to dispose of unwanted items, it
is necessary to establish adequate controls over inventory on order and inventory in
stock. There are several proven methods for inventory control. They are listed below,
from simplest to most complex.

a) Visual control enables the manager to examine the inventory visually to determine
if additional inventory is required. In very small businesses where this method is
used, records may not be needed at all or only for slow moving or expensive items.

b) Tickler control enables the manager to physically count a small portion of the
inventory each day so that each segment of the inventory is counted every so
many days on a regular basis.

c) Click sheet control enables the manager to record the item as it is used on a
sheet of paper. Such information is then used for reorder purposes.

d) Stub control (used by retailers) enables the manager to retain a portion of the price
ticket when the item is sold. The manager can then use the stub to record the item
that was sold.

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Today, the use of computer systems to control inventory is far more feasible for small
business than ever before, both through the widespread existence of computer service
organizations and the decreasing cost of small-sized computers. Often the justification
for such a computer-based system is enhanced by the fact that company accounting
and billing procedures can also be handled on the computer.

a) Point-of-sale terminals relay information on each item used or sold. The

manager receives information printouts at regular intervals for review and action.

b) Off-line point-of-sale terminals relay information directly to the supplier's computer

who uses the information to ship additional items automatically to the
buyer/inventory manager.

8.7. Developments in Inventory Management

In recent years, two approaches have had a major impact on inventory management:
Material Requirements Planning (MRP) and Just-In-Time (JIT and Kanban). Their
application is primarily within manufacturing but suppliers might find new requirements
placed on them and sometimes buyers of manufactured items will experience a
difference in delivery.

Material requirements’ planning is basically an information system in which sales

are converted directly into loads on the facility by sub-unit and time period. Materials
are scheduled more closely, thereby reducing inventories, and delivery times become
shorter and more predictable. Its primary use is with products composed of many
components. MRP systems are practical for smaller firms. The computer system is
only one part of the total project, which is usually long-term, taking one to three years
to develop.

Just-in-time inventory management is an approach which works to eliminate

inventories rather than optimize them. The inventory of raw materials and work-in-
process falls to that needed in a single day. This is accomplished by reducing set-up
times and lead times so that small lots may be ordered. Suppliers may have to make
several deliveries a day or move close to the user plants to support this plan.

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8.8. Inventory Costs are basically categorised into two major headings

8.8.1. Ordering Cost

Cost of procurement and inbound logistics costs form a part of Ordering Cost. Ordering
Cost is dependant and varies based on two factors - The cost of ordering excess and
the Cost of ordering too less.

Both these factors move in opposite directions to each other. Ordering excess quantity
will result in carrying cost of inventory whereas ordering less will result in increase of
replenishment cost and ordering costs.

8.8.2. Carrying Cost

Inventory storage and maintenance involves various types of costs namely:

8.8.2.1. Inventory Storage Cost

Inventory storage costs typically include Cost of Building Rental and facility
maintenance and related costs. Cost of Material Handling Equipment’s, IT Hardware
and applications, including cost of purchase, depreciation or rental or lease as the
case may be. Further costs include operational costs, consumables, communication
costs and utilities, besides the cost of human resources employed in operations as
well as management.
8.8.2.2. Cost of Capital
This includes the costs of investments, interest on working capital, taxes on inventory
paid, insurance costs and other costs associate with legal liabilities.

The inventory storage costs as well as cost of capital is dependent upon and varies
with the decision of the management to manage inventory in house or through
outsourced vendors and third party service providers.

8.9. Economic order quantity (EOQ)

8.9.1. Definition
EOQ is that size of the order which gives maximum economy in purchasing any
material and ultimately contributes towards maintaining the materials at the optimum
level and at the minimum cost. In other words, EOQ is the amount of inventory to be
ordered at one time for purposes of minimising annual inventory cost.

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The quantity to order at a given time must be determined by balancing two factors:

1. The cost of possessing or carrying materials and

2. The cost of acquiring or ordering materials. Purchasing larger quantities may

decrease the unit cost of acquisition, but this saving may not be more than offset
by the cost of carrying materials in stock for a longer period of time.

EOQ Model

Example
Bayer Ltd produces chemicals to sell to wholesalers. One of the raw materials it buys
is sodium nitrate, which is purchased at the rate of R22,50 per ton. Bayer’s forecasts
show an estimated requirement of 5 750 000 tons of sodium nitrate for the coming
year. The annual total carrying cost for this material is 40% of acquisition cost and the
ordering cost is R595. What is the Most Economical Order Quantity?

The EOQ Formula is:

Where:
D = Annual Demand

C = Carrying Cost

S = Ordering Cost

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Data
D = 5 750 000 tons

C = 0.40(22.50) = R9.00 per ton, pa. S = R595 per order

Calculate the EOQ

= 27 573,135 tons per Order.

This model makes certain key assumptions:

▪ No safety stock is carried.

▪ There is no shortage in the delivery of the order.
▪ Demand is at uniform rate and does not fluctuate.
▪ Lead Time for order delivery is constant.

Another Example:

Slindile runs a mail-order business for gym equipment. Annual demand for the
exercise cycle is 16 000 units. The annual holding cost per unit is $2.50 and the cost
to place an order is $50.
Calculate economic order quantity (EOQ)

EOQ =

8.9.2. Re-order Level or Ordering Point or Ordering Level

8.9.2.1. Definition of a Re-order Point

This is that level of materials at which a new order for supply of materials is to be
placed. In other words, at this level a purchase requisition is made out. This level is
fixed somewhere between maximum and minimum levels. Order points are based on
usage during time necessary to requisition order, and receive materials, plus an
allowance for protection against stock out. The order point is reached when inventory
on hand and quantities due in are equal to the lead time usage quantity plus the safety
stock quantity.

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8.9.2.2. Formula of Re-order Level or Ordering Point:

The following two formulae are used for the calculation of reorder level or point.
Ordering point or re-order level = Maximum daily/weekly/monthly usage X Lead time

The above formula is used when usage and lead time are known with certainty.
Therefore, no safety stock is provided. When safety stock is provided then the
following formula will be applicable:

Ordering point/re-order level = Max daily/weekly/monthly usage x Lead time +Safety

stock

Example

Maximum daily requirement 800 units

Time required to receive emergency supplies 4 days
Average daily requirement 700 units

Minimum daily requirement 600 units

Time required for refresh supplies One month (30 days)

Calculate the ordering point or re-order level

Solution

Ordering point = Maximum daily or weekly or monthly usage x Lead time

= 800 x 30

= 24 000 units

8.10. Minimum Limit or Minimum Level of Stock

8.10.1. Definition
The minimum level or minimum stock is that level of stock below which stock should
not be allowed to fall. In case of any item falling below this level, there is danger of
stopping of production and, therefore, the management should give top priority to the
acquisition of new supplies.

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8.10.2. Formula

Minimum level/limit can be calculated by the following formula or equation: Minimum

level = Re-order level – Average or normal usage X Normal re-order period Or the
formula can be written as:

Minimum level = Re-order level or ordering point – Average usage for Normal period

Self-check Question
Data per day

Normal usage 100

Maximum usage 130

Minimum usage 70

Re-order point 25 – 30 days.

Calculate the minimum limit or level

NB: To calculate minimum limit of materials we must calculate re-order point or re-
order level first.

Calculation:

Ordering point = Maximum daily or weekly or monthly usage X Maximum re-order

= 130 X 30

= 3 900 units

Minimum limit = Re-order level – Average or normal usage X Normal re-order period

= 3900 – (100 × 27.5*) [25+30]/2

= 1150 units

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8.11. Danger Level of Materials or Inventory Stock

8.11.1. Definition and Explanation:

Some enterprises also calculate danger level. When this level of stock is reached,
then emergency steps are taken by the management to acquire material supplies.

When danger level is reached, the business attempts to purchase materials from the
nearest possible source so that the workers and plant and machinery may not remain
idle due to shortage of materials supplies.

8.11.2. Formula:
Danger level can be calculated by the help of the following formula or equation:
Danger level = Average daily requirement X Time required to get emergency supply

Example:

Solution:
Danger level = Average daily requirement × Time required to get emergency supply

=700×4

= 2,800 units

8.12. The Cash Conversion Cycle

Calculating the cash conversion cycle (CCC) is an easy way to assess a business’
liquidity. The key elements of the CCC are inventory, receivables and payables. The
cycle is calculated as follows:

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➢
Average age of inventory (AAI)
➢
Average collection period: debtors (ACP)

➢
Average payment period: creditors
(APP) The formula is:

CCC = AAI + ACP – APP

Solution

a. AAI = 365/6 = 60, 83 days. (Inventory turns over every 60, 83 days) Therefore:

CCC = AAI + ACP – APP

= 60, 83 days + 37 days – 62 days

= 35, 83 days.

This means that Black Box Ltd has to wait an average of 35, 83 days from when the
inventory is purchased on credit until it receives its cash from its debtors.

b. Inventory = 60,83/365 X (R2 200 000 X 0,6) = R219 912

Debtors = 37/365 X R2 200 000 = R223 014

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Creditors = 62/365 X (2200 000 X 0, 6) = R224 219

Resources Invested = R667 145

This simply means that at any given time R667 145 is “tied up’ in the business and is
not available for day to day transactions.

8.13. Strategies for the Effective Management of the Cash Conversion Cycle
Businesses with positive cash conversion cycle have options of pursuing certain
strategies to minimise the cash conversion cycle. Caution must be exercised to ensure
that such strategies don’t do more harm than good. Three such strategies are
available:

8.13.1. Stretching Accounts Payable

This entails paying accounts payable as late as possible without damaging their credit
rating and also not incurring additional charges.

A possible solution may be to offer the client a settlement discount for earlier
settlement. Sometimes a firm may prefer to settle after the discount period as it may
have cash flow issues. In order to calculate the cost of foregoing the discount, the
following formula is used:
Cost of foregoing = CD X 365
(1 - CD) N

Where:

CD
= Cash discount

N = Number of days foregone

365= The calendar year

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Self-check Question
Assume that a firm is offered 2/10 net 30, indicating that if the account is settled in
10 days, the firm may keep a discount of
2%. If the discount is not taken, then the full amount is payable in 30 days. The cost
of foregoing the discount is calculated as follows:
Cost of foregoing = CD X 365 (1 - CD) N

= 0, 02X 365 (1 – 0,02) 20

= 37, 25%

Conclusion: If the rate at which the firm can borrow (overdraft rate is, say 16%, they
would be better off using their overdraft to claim the discount on offer.

8.13.2. Efficient Purchasing and Inventory

Management This can be achieved by:
➢
Increase inventory turnover by forecasting demand better and by planning to
ensure that purchases coincide with the forecasts made.

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➢
With better purchasing planning, scheduling and control techniques, the firm can
reduce the length of the purchasing cycle and this in turn will lead to an increase
in the inventory turnover.

8.13.3. Speeding up the Collection of Accounts

Receivable This has been discussed elsewhere, but a brief
summary follows:
➢
Offer discounts for prompt settlement
➢
Send out statements timeously
➢
Send out reminders for accounts that are not settled promptly
➢
Charge interest on overdue accounts
➢
and over errant clients for collection.

8.14. Working Capital Financing Policies

There are essentially three approaches a firm may use to determine their short term
and long term financing. These approaches are:

➢ The Conservative Approach

➢ The Moderate Approach

➢ The Aggressive Financing Approach

8.14.1. The Conservative Approach

A firm using this approach will tend to finance all their permanent assets and most
projects with long term funds. It must be noted, however, that the cost of long term
financing is higher interest charges; their costs will obviously be higher. But there risk
level is lower as they make less use of short term debt. (Marx: 152). The conservative
approach is depicted in figure 1 below.

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Figure 1: The Conservative Approach

8.14.2. The Moderate Approach

This is also known as the Maturity Matching Approach. Essentially this method
involves matching the asset and liability maturities to minimise the risk of the firm not
paying off its maturing liabilities. The ideal situation is to match revenue streams
perfectly with cash outflows. For example, inventory expected to be sold within 30
days could be financed with a 30 day short term loan (or suppliers credit if it is easily
available). (Marx: 152)

The matching of maturities does become a little complicated and can be fraught with
uncertainty if the life span of the asset is expected to change (become shorter). What
could happen if for example, the inventory is not sold within 30 days? Raise another
loan?

It is worth noting that firms with limited borrowing capacity could actually close their
doors if they cannot raise sufficient funds. The moderate approach is depicted in figure
2 below.

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Figure 2: The Moderate Approach

8.14.3 The Aggressive Financing Approach

This approach aims at financing seasonal needs and even long term needs with short
term funds. Firms using this approach operate with less working capital. It must be
conceded however that the degree of aggressiveness varies from firm to firm. This is
obviously a risky approach. If the total financing requirement turns out to be higher
than anticipated, then the firm may find that short term financiers refusing to extend
credit to the firm. (Marx 152)

And if this is the case then long term borrowers may also be reluctant to advance funds
as well. Using short term funds is far cheaper than using long term funds and if well
managed, then the increase in income margins may be very high. The aggressive
approach is depicted in figure 3 below.

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Figure 3: Aggressive Financing Approach

8.15. John Maynard Keynes identified 3 reasons for holding cash

1. The Speculative Motive: the underlying principle here is that cash is held for
unexpected opportunities that may arise, e.g. Bargain purchases, “fire” sales,
attractive interest rates, etc.
2. The Precautionary Motive: emphasises the need for a financial reserve. The belief
here is a safety net is needed for that emergency moment where a business may be
vulnerable.
3. The Transaction Motive: this need to hold cash is based on the need to conduct
normal business, ie. Purchase materials, pay bills, etc.

8.16. Unsecured Sources of Short term Financing

16.1. Accounts payable: Credit from suppliers’ (interest bearing or non interest
bearing).

16.2. Accruals: bills that are paid in arrears.

16.3. Unsecured Bank loans.

16.4. Open lines of credit made available by banks.

16.5. Revolving credit.

16.6. Bankers acceptance (bill of exchange). (Marx: 155)

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8.17. Secured Sources of Short term Financing

17.1. Characteristics of Secured Sources of Short term Loans

17.1.1. Lenders prefer collateral with a duration that is closely linked with the term of
the loan.

17.1.2. Accounts receivable and inventory are preferred sources of collateral as they
are highly liquid

17.1.3. Interest rates on secured short term loans are higher than on unsecured short
term loans. This is due to the large amount of administration tasks that need to be
performed. Besides in order to qualify for a secured loan, the business has exhausted
all its unsecured loan facilities. (Marx: 159)

8.18. Accounts Receivable as Collateral

Accounts receivable are regarded as short term security as a result of the high liquidity
level of this asset.

8.18.1. The pledging process is as follows

a. The lender compiles a list of acceptable accounts with billing dates and sums
due.

b. Then the lender analyses the historical payment pattern on the account to
calculate the average payment period for each customer.

c. Once the lender selects the accounts they wish to accept, they then adjust the
values for returns, discounts etc in order to protect them should the customer
make use of such options.
d. The lender then determines the percentage to be advanced against this
collateral. (Marx: 159)

Terminology
a. Notification Pledge: The customer is told to remit the amount due directly to the
lender.

b. Non-Notification Pledge: the customer pays the supplier who then remits the
amounts due to the lender.
c. Pledging Cost: this cost is usually 2% -5% above prime rate and is charged in addition
to the interest charge. An administration fee in addition to this may also be charged.

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8.18.2. Factoring
This entails the sale of accounts receivable to a factor or other financial institution to
obtain funds. A factoring cost is levied and includes costs such as commission (1% -
3%), interest charges (which are inevitably above prime rate).

8.18.2.1. Advantages of Factoring

➢
Cash is received immediately after the sale is made, thus reducing the working
capital that is needed.
➢
The collection function is handled by the factor, thus reducing time spent on
collection and the myriad of administration costs attached to this task.

Solution
Book value of the account 5 000
Reserve (10% of R5 000) (500)
Cost of factoring (2,5 of R5 000) (125)
Funds available for advance 4 375
Interest on advance (1,5% of R5 000) 75
Net value of advance 4 300

So, if the debtor pays in full, Joylands net cost is R200 (the cost of factoring and
interest, R125 + R75)

REFERENCES

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Els. G; Du Toit, E; Erasmus, P; Kotze, L; Ngwenya, S; Thomas, K; Viviers, S. (2014)

Corporate Finance, A South African Perspective, Oxford University Press.

Ross, S; Westerfield, RW; Jordan, BD; and Firer C. (2009). Fundamentals of

Corporate Finance , 4th South African Edition, McGraw-Hill.

Correia, C; Flynn, D; Uliana, E and Wormald, M. (2008) Financial Management, 6th

Edition, Juta Publishing.

Marx, J; de Swardt, C; Beaumont Smith, M; Naicker, B; Erasmus, P. (2007) Financial

Management in Southern Africa, 2nd Edition, Pearson Education.

Brecher, R. (2009) Contemporary Mathematics for Business and Consumers. 5th Ed.
USA: South-Western Cengage Learning

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