Study Guide

Financial Management 2
(FM202B)

This module forms a compulsory core module for the following undergraduate academic
programme:

• BBA in Marketing Management

• BCom in Marketing and Management Science

Notional Hours: 200

Credits: 20

NQF: 6

Weeks: 16

IMM Graduate School Study Guide (FM202B) Page 1 of 199

Name & Surname:

Cell Number:

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Student Number:

Published by IMM Graduate School © Copyright Reserved

January 2020 Edition

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Contents
Icons Explained .............................................................................................................. 7

SECTION A: GENERAL INFORMATION .................................................................................... 8

Word of Welcome ......................................................................................................... 8

Programme Structure - Relationship with other modules .............................................. 9

Programme Structure – Bachelor of Commerce in Marketing and Management Science

.................................................................................................................................... 11

Financial Management (FM202B) .................................................................................... 15

Module purpose: ............................................................................................................. 15

Module outcomes: .......................................................................................................... 15

Study tips .................................................................................................................... 16

Tips for achieving good marks in your assessments ..................................................... 19

Academic Ethics .......................................................................................................... 21

Student Support at your fingertips ................................................................................. 25

Your Learning Process Checklist ................................................................................... 27

SECTION B ........................................................................................................................... 28

SUBMISSION OF ASSIGNMENT One ..................................................................................... 28

WEEK 1 – 6: ......................................................................................................................... 28

STUDY UNIT 1 ...................................................................................................................... 28

The Role of Financial Management .............................................................................. 28

Study Unit 1 – Relevance ......................................................................................... 28

Study Unit 1 - Glossary of Terms .............................................................................. 29

1. Study Unit 1 – Content ..................................................................................... 32

Revision Exercises .................................................................................................... 43

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 Study Unit 1 – Revision Exercises Solutions: ................................................................ 45

Study unit 1 – Progress check .................................................................................. 46

SECTION B ........................................................................................................................... 48

SUBMISSION OF ASSIGNMENT One ..................................................................................... 48

WEEK 1 – 6: ......................................................................................................................... 48

STUDY UNIT 2 ...................................................................................................................... 48

Study Unit 2: The fundamentals of time value of money ............................................. 48

Study Unit 2 - Relevance .......................................................................................... 48

Study Unit 2 – Glossary of Terms ............................................................................. 49

2. Study Unit 2 - Content...................................................................................... 51

Revision Exercises .................................................................................................... 64

Study Unit 1 – Revision Exercises Solutions: ................................................................ 68

Study unit 2 – Progress check .................................................................................. 69

STUDY UNIT 3 ...................................................................................................................... 71

Study Unit 3: Analysis of financial statements ............................................................. 71

Study Unit 3 - Relevance .......................................................................................... 71

Study unit 3 – Glossary of Terms .............................................................................. 72

3. Study Unit 3 – Content ..................................................................................... 74

Study Unit 3 – Revision Exercises ............................................................................. 99

Study Unit 3 – Revision Exercises Solutions: .............................................................. 102

Progress check ....................................................................................................... 103

SECTION C ......................................................................................................................... 105

SUBMISSION OF ASSIGNMENT Two ................................................................................... 105

WEEK 7 – 12: ..................................................................................................................... 105

STUDY UNIT 4 .................................................................................................................... 105

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 Study Unit 4: Short-term financial decisions .............................................................. 105

Study Unit 4 - Relevance ........................................................................................ 105

Study Unit 4 – Glossary of Terms ........................................................................... 106

4. Study Unit 4 – Content ................................................................................... 108

Revision Exercises: ................................................................................................. 116

Revision Exercises Solutions .................................................................................. 118

Study unit 4 – Progress check ................................................................................ 119

STUDY UNIT 5 .................................................................................................................... 121

Study unit 5: Long-term financial decisions................................................................ 121

Study Unit 5 – Relevance ....................................................................................... 121

Study unit 5 – Key concepts ................................................................................... 122

Study unit 5 – Glossary of Terms ............................................................................ 122

5. Study Unit 5 - Content.................................................................................... 124

Revision Exercises Solutions .................................................................................. 147

Study unit 5 – Progress check ................................................................................ 148

SECTION D ........................................................................................................................ 150

WEEK 13 – 14: ................................................................................................................... 150

STUDY UNIT 6 .................................................................................................................... 150

Study unit 6: Long-term investment decisions ........................................................... 150

Study Unit 6 – Relevance ....................................................................................... 150

Study unit 6 – Key concepts ................................................................................... 151

Study unit 6 – Glossary of Terms ............................................................................ 151

6. Study Unit 6 - Content.................................................................................... 153

Revision Exercises Solutions .................................................................................. 173

Study unit 6 – Progress check ................................................................................ 174

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SECTION E ......................................................................................................................... 176

REVISION AND EXAM PREPARATION ................................................................................. 176

WEEKS 15 .......................................................................................................................... 176

Reference list .................................................................................................................... 177

Addendum A ..................................................................................................................... 178

Glossary ............................................................................................................................ 179

Addendum C: Suggested solutions to revision exercises ..................................................... 182

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Icons Explained

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SECTION A: GENERAL INFORMATION

Word of Welcome

Welcome to Financial Management 2 (FM202B), a central part of the management function

in the firm. Financial Management means planning, organising, directing and controlling the
financial activities such as procurement and utilisation of funds of the firm. It means
applying general management principles to financial resources of the firm.

From a marketing perspective, it is important to understand how the activities you pursue
will be affected by the finance function, such as the firm’s cash and credit management
policies, ethical behaviours, role of financial markets in raising capital as well as other
financial issues.

Everyone connected with marketing should be well informed about finance because
financial decisions influence every aspect of business operations. Financial management is a
fascinating and enjoyable subject and it provides frameworks and techniques you will be
able to apply in your day-to-day marketing work as well as well as personal life.

T1he study guide has been primarily structured according to

• an organisational component (Section A), and

• a learning component (Section B - D).

The purpose of the organisational component is amongst other things to orientate you
towards financial management and to inform you about administrative issues, whilst the
purpose of the learning component is to structure the syllabus in terms of manageable
study units. The learning component will explain what topics are covered, in how much

IMM Graduate School Study Guide (FM202B) Page 8 of 199

depth, where to find relevant information pertaining to the subject and ultimately help you
to study the subject as realistically and practically as possible.
To ensure you get the maximum benefit from the study time you have available it is
recommended that you work through the study guide. This will help you identify both the
time you will need to complete the programme and by doing this you will be able to draw
up a detailed and workable study schedule.

Programme Structure - Relationship with other modules

BBA in Marketing Management

Herewith a summary of the BBA in marketing management programme indicating where
Financial Management 2 (FM202B) fits.

Programme Purpose
To empower qualifiers with graduate-level knowledge, specific skills and applied
competence in the field of Marketing Management to enable them to pursue practical and
rewarding careers in the marketing business environment. The purpose of the qualification

IMM Graduate School Study Guide (FM202B) Page 9 of 199

is also to provide graduates competence in marketing, business management and financial
management. Further, the purpose of the qualification is to assist and enable the student to
develop his/her intellectual capacity, understanding of the business and marketing
environment; and to think critically and innovatively and to build a foundation for further
specialisation in the field of marketing.

Programme Outcomes

Programme Exit-Level Outcomes:

1. Mastered an advanced knowledge of marketing principles and basic application skills in

marketing related field.
2. Demonstrate a broad understanding of business management knowledge, functional
areas within an organisation and how it applies to the business environment.
Furthermore, be able to take a strategic view of an organisation and align the strategies
with the objectives.
3. Select, apply and evaluate typical methods and procedure to assist in making informed
marketing decisions.
4. Furthermore, demonstrate a broad understanding of economics to understand how it
applies not only to the business world but also to everyday life.
5. Solve marketing problems in various types of organisations, such as retail-driven,
service-related, business-to-business, government related and NPOs.
6. Demonstrate a broad understanding of financial management knowledge and how it
applies to the marketing and business environment.
7. Produce a strategic marketing and business plan and be able to evaluate the success of
the plan.
8. Produce and communicate information in a business environment by applying proper
communication skills acquired which should also include the correct application of
intellectual property, copyright and plagiarism.
9. Demonstrate an advanced understanding of the economic context and systems within
which organisations operate and be able to link it to marketing opportunities.

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10. Understand the scope of responsibilities that go with a management position in the
marketing field and understand the accountability to senior management in an
organisation.

Programme Structure – Bachelor of Commerce in Marketing and

Management Science

Herewith a summary of the Bachelor of Commerce Marketing and Management Science

Degree programme indicating where Financial Management 2 (FM202B), fits into it.

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Programme Overview
Once you have successfully completed the modules and achieved the module outcomes
covered within the BCom in Marketing and Management Science programme, you will be
competent to do the following:

Programme Purpose
The purpose of this qualification is to provide candidates in the private, public and voluntary
sectors with comprehensive and in-depth knowledge of the principles, major theories and
paradigms, skills, methods and technology of the science and profession of the field of
marketing, management, supply chain, sales and project management. This, in order to
promote sustainable growth and development and maximise prosperity in all sectors of the
economy and society at large.
To develop competent leaders with applied economic, management, supply chain, project
management, sales and marketing skills as well as generic cross-functional knowledge and
skills to steer sustainable development, growth and prosperity in the most appropriate
direction.
To provide students who want to enrol for advanced studies in management, supply chain,
project management, sales and marketing, with a sound academic base, to apply their skills
and for further advancement in careers and academic studies in the field of marketing,
sales, supply chain, project management and management science.

Programme Outcomes

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Programme exit-level outcomes

 Students must demonstrate an integrated understanding of a broad scope of

management knowledge and how it practically applies to the disciplines of
marketing, sales management, supply chain and project management.
 To demonstrate a comprehensive understanding of the knowledge regarding
economics, financial management, research as applied to marketing, sales, supply
chain and project management activities in relation to the organisation and the
business environment in general.
 Students must be able to collect, analyse, organise and critically evaluate relevant
economic, financial, marketing and project related information to make sound
decisions in the organisation.
 To demonstrate ability to identify, analyse, evaluate, and critically reflect on
complex problems related to sales, marketing, operations and supply chain in the
organisation with the aim of finding evidence-based solutions.
 Evaluate, apply, and integrate sales, marketing, supply chain and project
management knowledge and skills and general business principles to real life
situations taking into account societal, ethical, and cultural considerations.
 Students must access, process and manage information, demonstrating the ability
to develop appropriate processes of information gathering for a given context or
use, also independently validating the sources of information and evaluating and
managing the information.
 Students use appropriate academic/ professional/occupational discourse to
produce and communicate information in a business environment, demonstrating
their understanding and own ideas and opinions on business science, marketing
sales, project management and supply chain related matters. Students must do so
whilst respecting conventions around intellectual property, copyright and
plagiarism.
 Critically analyse contemporary business information and evaluate the potential
future outcomes of sales, marketing, supply chain and project management

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 decisions.
 Students must show an understanding of the scope of responsibilities required of
a management position in the sales, marketing, supply chain, human resources
operations, project management functions, and understand the accountability to
senior management in an organisation.

IMM Graduate School Alumnus – Melanie Nicholson

A word from Alumni– Michelle Conradie

The topics covered in Financial Management 2 have given

me a solid understanding of a variety of financial principles
that I will carry with me through my career. The knowledge
gained in this module gave me the insight necessary to
understand the financial activities carried out in all
functional areas of business. Regardless of the career path
one chooses to follow, an understanding of these financial
principles will lead to better planning and decision-making,
both of which are core elements of a successful business.

The application of the financial principles in the field of marketing is vast. Having completed
this module, I have a broad base of financial knowledge that has enabled me to understand,
and play a part in, the financial aspects of marketing planning and budgeting. I’ve also been
able to participate in discussions and financial decision making in areas other than
marketing, giving me a clear advantage over colleagues who don’t understand the financial
principles taught in this module.

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Taking all of this into account, I feel that my education in Financial Management has been,
and will continue to be, crucial to my career in marketing, and perhaps one day in
entrepreneurial endeavours too.

Financial Management (FM202B)

Module purpose:
Financial Management means planning, organising, directing and controlling the financial
activities such as procurement and utilisation of funds of the firm. It means applying general
management principles to financial resources of the firm.

From a marketing perspective it is important to understand how the activities pursued will
be affected by the finance function, such as the firm’s cash and credit management policies,
ethical behaviours, role of financial markets in raising capital as well as other financial
issues.

Module outcomes:

By the end of the module, students should be able to:

 Understand the role and the environment of financial management and

fundamentals of risk and return.
 Understand the time value of money concept
 Analyse financial statements and help users in making informed decisions.
 Carry out short-term financial decisions required for a business to conduct business
successfully
 Carry out long-term financial decisions
 Carry out long-term investment decisions

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This module consists of 5 study units. You are expected to finish (including exam
preparation) these study units in 16 weeks. (Refer to student pacer outlining the 16-week
breakdown)

Study tips

Here are a few tips you should follow to ensure you have the best chance to successfully
complete this module:

• Make sure you use and develop all the tools you need to complete this task
successfully.
• Show a POSITIVE attitude and do not blame others for your failures.
• Take responsibility of your own progress and success.
• Communicate! Ask help when you need it. Ask questions. Find out what happens. Find
out when things happen and when you should be doing what! Read all instructions
carefully!
• Use all the available student platforms to ENGAGE with, learn from, solve problems
with, and discuss ideas with other fellow students and IMM Graduate School staff.
• Prioritise what is important. Manage your time and keep constant track of your
progress.
• Think of alternative ways to learn more effectively.
• Get Organised:
o Get all your required study material and buy your prescribed textbooks
o Familiarise yourself with eLearn
o Draw up your study timetable and commit to it (check the student pacer outlined
later in this study guide)
o Set clear objectives to achieve at deadline dates for every study unit

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Assessments explained
• Learning assessment comprise assignments and examinations. Please ensure that you
thoroughly read the 2018 IMM Graduate School Yearbook Assessment section for a
complete understanding of the rules and regulations governing assignments and
exams. There are specific rules that should be followed in terms of required font, font
size, formatting and layout, as well as referencing guidelines. You will be penalised for
not following these instructions.

• The marks grading system is as follows:

o 75% or more = Pass with distinction
o 50% - 74% = Pass
o 0% - 49% = Fail
• Note: Assessment of this module consists of two assignments and one examination.
These assess your skills level as described in the exit-level module outcomes.

Assignment

Why do you need to complete a practical assignment?

 Assignments help you to apply what you have learnt

 Assignments help to show you what you are still struggling with and what you still need
to learn or spend time on

 Assignments help the tutor or yourself to see what you are doing and what you can or
cannot do

 Assignments help you to measure your own progress and award marks that will indicate
your level of competence.

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Assignment term mark calculation
There will be two formative assignments. The average mark of Assignment 1 and
Assignment 2 will count 40% of the final mark. You will need to complete these two
assignments and hand them in before or on the due date and time as they contribute a
significant portion of your final mark. Ensure you start early to ensure you give yourself
sufficient time to complete both the assignments before the due date.

Study units covered during Study units covered during Study units covered during
weeks 1 – 5 weeks 7 – 11 weeks 13 – 14

1st assignment – the first 2nd assignment – 80% of Work not included in
40% of the work is covered the work is covered formative assessments – it

Week 6: Assignment Week 12: Assignment will be covered in the exam,

submission submission together with the work

completed during weeks 1 -
12. This work is for self-study.

Week 15: Revision

Examination

This module consists of one formal summative exam assessment which makes up the
remaining 60% of your final mark. The examination paper incorporates all practical and
theoretical content and concepts covered in the study guide linked to the module
outcomes.

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 Calculation of final mark
Your final module mark, or mark for the semester, will be calculated as follows:
Example:

• Assessment mark from assignment 1 = 65%

• Assessment mark from assignment 2 = 72%

• Examination Mark = 75%

Assignment mark 1 = 65%

Assignment mark 2 = 72%

Average mark from Assignment 1 & 2 = 68.5%

Term mark calculated as follows: 68.5 x 0.4 (as it contributes 40% towards your final mark)
= 27.4

Examination Mark = 75%

Exam mark calculated as follows: 75 x 0.6 (as it contributes 60% towards your final mark) =
45

Final mark calculated as follows:

Therefore, your final mark would be 27.4 + 45 = 72%

Tips for achieving good marks in your assessments

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• Firstly, do not leave the completion of your assignments until the last minute!
Assignments have been put in place for a good reason – it shows you what you are still
struggling with and what you still need to study. It shows you what you are doing and
what you can or cannot do. It measures your progress and awards marks that will
indicate your level of competence.
• Carefully consider the mark allocation of each question. By doing this it will help you
to achieve the maximum marks possible!
• For example: If a question counts 10 marks, ensure you include at least 10 keywords
or 10 steps or 10 core facts – depending on the requirement of the question. If a
question counts only one mark, it is more than likely that only one fact will be
required.
• If for example a question requires the listing of a process which includes 6 steps,
ensure you cover all 6 steps – marks are usually allocated according to the actual
process / steps – thus your response must be factually correct.
• Be careful to not rewrite the content word-for-word out of your study guide or any
other learning material, firstly you are making yourself guilty of plagiarism and
secondly it does not indicate that you actually understand the concept. Use your own
words – specifically when you need to answer a question using your own thinking or
interpretation.

“Our jobs as marketers are to understand how the customer wants to buy and

help them do so” Bryan Eisenberg

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Academic Ethics

Any assignment allows you to utilise various reading material that will assist you in the
completion of your assignment. Read the material with full attention and ensure you fully
understand each concept before you try and apply the learnt theory.

Use your own words to explain what you have read when answering a question. The marker
needs to see that you have understood the questions and are able to apply the learnt theory
to your answers. You have to use your own words and cannot simply “cut and paste” or
“copy” the content from any learning material.

When using something from any textbook, website, or any other material as part of your
assignment answers you have to acknowledge the original source be referencing the source
in your text as well as at the end of your document. Please consult the IMM Graduate
School Harvard referencing Guide (Addendum A and also available on our eLearn platform)
for a detailed explanation of how you should reference correctly.

The IMM Graduate School takes the copying of any material without proper referencing
extremely serious as this is known as plagiarism and you will face a disciplinary action if you
make yourself guilty of such a plagiarism practice. Please ensure you are familiar with the
IMM Graduate School Harvard referencing style guide as not to inadvertently commit such
an offence.

Planning your Financial Management 2 (FM202) studies

The IMM Graduate School has designed student pacers for each module. These pacers will
assist you in planning your studies to ensure you cover the entire syllabus and to schedule
your studies at manageable intervals. Distance learning requires careful planning and

IMM Graduate School Study Guide (FM202B) Page 21 of 199

scheduling of your studies and the student pacer will provide you with a guideline on how to
plan and not fall behind. Adhering to the student pacer will guide you and provide you with
a good start to achieve the targets set out for each module and to ensure you plan
beforehand to hand in your assignments before or on the due date and to ensure you have
sufficient time to study for your exam.

IMM Graduate School Study Guide (FM202B) Page 22 of 199

Learning Process per study unit
Not only should you adhere to the study plan guidelines, you should also ensure you
understand the learning process that takes place during each of the study units.

IMM Graduate School Study Guide (FM202B) Page 23 of 199

Prescribed learning material and additional support
You need to make use of the following prescribed material throughout your studies of this
module:

a. Els, G, Du Toit, E, Erasmus, P, Kotze, L, Ngwenya, Thomas, K

&Viviers, S. 2014. Corporate Finance: A South African Perspective, Oxford
University Press.

b. Prescribe IMM Graduate School Study Guide for FM202B, dated January
2020.

NB: the prescribed book forms the foundation of knowledge required to master all
learning outcomes. All the examples and required chapters must be attempted. The study
guide provides additional summaries, examples and information to unlock these concepts.

Please make use of all materials (additional resources, tutorial letters and relevant past
papers) available to you on the IMM Website and the eLearn portal.

We would also like to encourage you to make a habit of reading business and financially
orientated literature, magazines and newspapers such as:
1. Business Day
2. Business Report
3. Engineering News
4. Financial Mail
5. FinWeek
6. Strategic Marketing
7. Strategic Marketing Africa

Many of these are also available as electronic/online subscriptions.

IMM Graduate School Study Guide (FM202B) Page 24 of 199

Calculators

In Financial Management 2 you will have already used the specified

calculator (HP10BII+) to perform various calculations. The calculator will
continue to be used for various calculations in this module. The HP10BII+
can be bought at major retailers and online stores throughout South
Africa. You can shop around the following distributors (amongst others) to
secure the best price option: Firstshop.co.za, Makro, Waltons, Van Schaik,
PNA stores, most Incredible Connection Stores, Game stores and
Takealot.com. For international students, arrangements can be made
through the IMM GRADUATE SCHOOL national office. This calculator is a very useful tool in
day-to-day life; take the time to learn and explore its functions.

Student Support at your fingertips

You are registered for this module on a distance learning basis and you are expected to
work on your own 70% of the time. However, this does not mean that you are completely
on your own. Please use the available IMM Graduate School Student Support resources to
help you during your studies.

The IMM Graduate School is committed to assisting students with all queries,
and have introduced helpme@immgsm.ac.za, to answer all general queries.
This is supported by a ticketing system, that issues students with a unique ticket
number and ensures we are able to track the progress of queries, ensure prompt
response and swift resolution times.

NB: Please ensure that all module specific questions and queries are still posted
on the module specific discussion forums, available on eLearn. Do not leave your

IMM Graduate School Study Guide (FM202B) Page 25 of 199

 queries to the last day before you write your examination or before the
assignment submission due dates.

You are required to regularly visit eLearn as it is an essential source of

information that is continuously updated with topical material, additional
guidance, messages and tutorial letters.

eLibrary is an excellent place for you to read additional material on your own.
This tool will be extremely valuable when conducting research for your
assignments / projects / research reports. For access to the virtual library, please
follow the instructions available on eLearn.

Information Centres - the IMM Graduate School has libraries in all Student
Support Centres with textbooks and additional materials that could help you in
your assignments when you need to reference additional sources. For opening
times at facilities please enquire at your Student Support Centre. You have
access to free Internet at the Information Centre.

eTutorials - in our on-going efforts to support our students, the IMM Graduate
School hosts online tutorials in all our modules for additional guidance and
support. Subject matter experts share their knowledge through the use of a
presentation or video conferencing addressing learning outcomes, assignment
and examination preparation, etc., giving ample opportunity for student
feedback and interaction.

eDiscussion or eConsultation Hour – join group forums for discussions, to post

questions and to receive updates on specific modules.

The Journal of Strategic Marketing - the official publication of the IMM Institute of
Marketing Management, which keeps you up-to-date with the latest news and trends of

IMM Graduate School Study Guide (FM202B) Page 26 of 199

what is happening in the industry. Another publication is the Strategic Marketing Africa
magazine, which addresses the unique marketing challenges and opportunities in Africa.
These magazines are released quarterly and could assist you in providing examples to use in
assessments to back up your theoretical knowledge. Both of these magazines are available
electronically on eLearn.

Your Learning Process Checklist

At this point, you should understand the learning process explained above, as well as what
Financial Management 2 (FM202B) is all about and you should be ready to start your
journey towards the successful completion of your module.

Checklist Done / still to do / still to buy or access

Do you have access to all the prescribed – and

additional learning material?

• Prescribed textbook
• FM202 study guide
• IMM Graduate School eLearn platform
• IMM Graduate School eLibrary platform

Do you have a quiet place to study?

Do you have support from your close family /

friends / colleagues?

Do you know who to contact at the IMM

Graduate School when needed?

IMM Graduate School Study Guide (FM202B) Page 27 of 199

SECTION B
SUBMISSION OF ASSIGNMENT One
WEEK 1 – 6:

STUDY UNIT 1

The Role of Financial Management

Study Unit 1 – Relevance

This study unit introduces the role of financial management, which can be defined as the
business function that focuses on the use and selection of sources of capital in order to
achieve organisation goals. As marketers we will get to understand the importance of how
the role of financial management affects the activities we pursue.

We will also explain the role of financial management within an organisation and how this
differs from accounting and cost accounting. We will describe the function of a financial
manager and its relationship to other functional areas of any business and other subject
fields. The goal of the organisation in its broader context will also be identified. Key
concepts in finance such as, the agency theory, stakeholder theory and risk versus return
will be explained. Lastly, we touch on the role of ethics and corporate governance.

“Being good is good business.”

Anita Roddick, founder of The Body Shop

IMM Graduate School Study Guide (FM202B) Page 28 of 199

 Study Unit 1 – Module Outcomes

Let’s recap the relevant module outcome for this study unit

MO 1 Understand the role and the environment of financial management and

fundamentals of risk and return.

Study Unit 1 – Key Concepts

Let’s recap what the relevant module learning outcome is for this study unit:
• Differentiate the accounting fields from financial management.
• Differentiate profit maximisation from shareholder wealth maximisation.
• Describe how managerial finance function is related to economics and accounting.
• Discuss the actions a financial manager can may take to reduce the overall risk of a
company and the effects it may have on shareholders.
• What is the goal of an organisation.
• Discuss the possibility of an agency issue and its effects on a business.
• Discuss the elementary risks that affect all organisation and give 3 examples of each
category.
• Define business risks and finance risks and the methods at which each can be
measured.

Study Unit 1 - Glossary of Terms

Agency problem – the likelihood that managers may place personal goals ahead of
corporate goals.

IMM Graduate School Study Guide (FM202B) Page 29 of 199

Auction markets – are markets where transactions are done by means of a process of public
outcry.
Capital markets – a market that enables suppliers and demanders of long-term funds to
make transactions.

Corporate governance – the system used to direct and control a company. Defines the
rights and responsibilities of key corporate participants, decision – making procedures and
the way in which the firm will set achieve and monitor objectives.

Dealer markets – the market in which the buyer and seller are not brought together directly
but instead have their orders executed by securities dealers that make markets in the given
security.

Ethics – Basic concept of decent human behaviour. Includes fundamental principles that
define the character or guiding beliefs of a person, group or institution.

Maximising shareholders’ wealth – Obtaining the greatest wealth for shareholders based
on their number of shares and highest possible share price.

Maximising the rate of return – yielding the largest ratio of net after tax profits to total
assets.

Money markets – a financial relationship created between suppliers and demanders of

short-term funds.

Profit maximisation – the desire to yield the highest monetary return

Study Plan Progress

Week 1 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Progress

completed accessed / Week check
assistance

 Differentiate the Complete Sign-up for eLearn Week 1

accounting fields revision Consult eLibrary – 12.5 Hours

IMM Graduate School Study Guide (FM202B) Page 30 of 199

Key concepts Activities Material used / Time / Progress
completed accessed / Week check
assistance

from financial exercises Obtained

management feedback
 Differentiate profit
maximisation from
shareholder wealth
maximisation
 Describe how
managerial finance
function is related to
economics and
accounting
 Discuss the actions a
financial manager
can may take to
reduce the overall
risk of a company
and the effects it
may have on
shareholders

Week 2 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Progress

completed accessed / Week check
assistance

 What is the goal of Complete Sign-up for Week 2

IMM Graduate School Study Guide (FM202B) Page 31 of 199

Key concepts Activities Material used / Time / Progress
completed accessed / Week check
assistance

an organisation revision eLearn – 12.5

 Discuss the exercises Consult eLibrary Hours
possibility of an Obtained
agency issue and its feedback
effects on a business
 Discuss the
elementary risks that
affect all organisation
and give 3 examples
of each category

 Define business risks

and finance risks and
the methods at
which each can be
measured

1. Study Unit 1 – Content

1.1 Introduction

Finance can be broadly defined as the science and art of managing money. This involves
having a broader understanding of the macro-economic environment in which any
organisation/person operates and the balance of good business practices to manage funds
and make sound financial decisions.
At the personal level, finance is concerned with individuals’ decisions about how much of
their earnings they spend, how much they save, and how much they invest of their savings.
In a business context, finance involves the same types of decisions: how organisations raise
money from investors, how organisations invest money in an attempt to earn a profit, and

IMM Graduate School Study Guide (FM202B) Page 32 of 199

how they decide whether to reinvest profits in the business or distribute its profits back to
investors.
Through good financial management practices,
you will learn how to plan and budget effectively
so that we can gain a financial perspective around
the financial viability of a business, its operations
or a specific project. We are then required to
allocate the required resources to meet the
objectives of business or of the specific project as
planned. These resources include capital (financial
and/or assets) and labour. The transformation
process then requires one to execute planned processes and monitor their performance to
ensure that operations are carried out smoothly. You will also implement safeguards against
risk and to minimise losses. Lastly, the final component is in essence a feedback section
where we will evaluate how the operations are performing and report to various
stakeholders.

1.2 Define Financial Management

The general purpose of Integrated Marketing Communications is to inform, persuade and

remind customer to take action (Strydom, 2015).

Financial management can be described as the process of creating value for the organisation
and its stakeholders. Value can be created by reducing costs however to be more specific
financial management entails the use of different forms of capital to maximise the net
present value (NPV) of business opportunity decisions by reducing the weighted average
cost of capital (WACC). The concepts of NPV and WACC will be discussed later in this study
guide.
In order to understand the role of financial management
we need to understand how it differs from financial

IMM Graduate School Study Guide (FM202B) Page 33 of 199

accounting, cost accounting and management accounting. Firstly, financial accounting can
be defined as the representation of both the organisations financial activity and financial
position during a financial period (based on past information). Cost accounting focuses more
specifically around past and present costs related to specific products and how we control
these costs.

Lastly management accounting deals with both quantitative (amounts and figures) and
qualitative (the decisions and reasoning behind the figures) aspects in the preparation of
budgets and forecasts in making viable and valuable future decisions.

You may remember from Financial Management 1 how financial accounting and
management accounting differ in terms of the nature of the reports produced, level of
detail provided in the reports, regulatory requirements related to the format and timing of
accounting reports, interval at which reports are prepared as well as the range and quality
of information.

Financial management therefore goes far beyond the role of financial accounting which can
be described as “looking back” in terms of recording historical data, while financial
management can be described as “looking forward” as it seeks to create value into the
future whilst having a sound understanding of the data and operations in the past.

You can look at the figure below, used by the International Federation of Accountants
(IFAC), to explain the difference between financial accounting, cost accounting and
management accounting.

IMM Graduate School Study Guide (FM202B) Page 34 of 199

Both the finance function and the marketing function have the same core purpose, which
manifests in different ways:

• The finance function will attempt to maximise shareholder wealth via appropriate
financing and investment decisions, cost reduction, financial restructuring and
financial planning.
• The marketing function will attempt to maximise shareholder wealth via the “task of
developing and managing market-based assets, or assets that arise from the
commingling of the firm with entities in its external environment. Examples of market-
based assets include customer relationships, channel relationships, and partner
relationships. Market-based assets, in turn, influence shareholder value by
accelerating and enhancing cash flows, lowering the volatility and vulnerability of cash
flows, and increasing the residual value of cash flows” (Srivastava, Shervani & Fahey
1998:16).

IMM Graduate School Study Guide (FM202B) Page 35 of 199

The link of the marketing function to financial performance is further discussed by Lovett
and
MacDonald (2005). The effect of marketing on financial performance is two-fold:

• Marketing affects the share price of an organisation due to its effect on 'market share
and profitability' (Lovett & MacDonald, 2005:476).
• Marketing can also influence the 'perception of analysts and investors' (Lovett &
MacDonald, 2005:476).

Marketing therefore has a strong connection with financial performance. The finance and
marketing functions are linked by the same primary organisational goal (the obligation to
maximise shareholder wealth), and should not function in complete isolation from each
other, but rather in a harmonious manor to create a competitive advantage in order to
achieve the common organisational goal (See, 2006:52).

1.3 The Financial Manager

Organisational structures may differ from one organisation to the next, largely as a result of
the size of an organisation. However, what does remain constant is the important role that
the financial manager plays in any organisation. They are responsible for the organisations
financial management activities.
Refer to Figure 1.1 in the textbook for an example of an organisational structure.

The role of financial managers continues to evolve and grow over time. Managers must
therefore keep up to date with market trends and research or they will run the risk of
becoming antiquated, to the cost of their career, their organisation and the shareholders.
(Marney &Tarbert, 2011)

Financial managers are faced with financial management decisions on an ongoing basis.
These can be categorised into three main groups i.e. capital budgeting, capital structure and
working-capital management.

Capital budgeting is the process of evaluating and selecting long-term investments that are
consistent with the firm’s goal of maximising owner wealth. (Gitman, 2011)

IMM Graduate School Study Guide (FM202B) Page 36 of 199

Capital structure is the combination of equity and debt the business uses to finance itself.
(Stoltz et al, 2007).
Working capital can be defined informally as
the money needed by the firm as a “float” to
meet day-to-day expenses. More formally,
working capital represents the difference
between current assets and current liabilities.
(Marney & Tarbert, 2011).

1.4 The goals of financial management

Financial managers have various goals when making decisions on behalf of their
organisations. They are ultimately guided and motivated to achieve three main goals i.e.
profit maximisation, maximising the rate of return and maximising shareholders’ wealth.
Financial managers strive to increase net after-tax profits (profit maximisation) by increasing
turnover and reducing costs. However, the question has to be asked is profit maximisation a
reasonable goal on its own? The answer is no, it fails for a number of reasons: It ignores (1)
the timing of returns, (2) cash flows available to shareholders and (3) risk. (Gitman, 2011)

We will address these reasons later in study units 5 & 6 (Investment decisions).

Financial managers may use a different view to overcome the shortcomings of profit
maximisation by focusing on the ratio of net after tax profits to total assets. This is referred
to as maximising the rate of return.

The rate of return may be viewed as more important than profit maximisation in the sense
that, the rate of return will indicate whether management has achieved the most out of the
investment. (Stoltz et al, 2007)

Past performance is no guarantee of future performance and thus if a financial manager

only looks at past performance as an indicator of future performance, the firm will not be
able to grow. Shareholders’ wealth maximisation represents a forward-looking goal centred
on increasing the wealth of the owners, or shareholders, of the firm.

IMM Graduate School Study Guide (FM202B) Page 37 of 199

Remember a ‘share’ is a piece of equity a shareholder buys. By issuing shares to
shareholders, an organisation is able to raise funds and the return on the share from a
shareholders’ point of view is seen through the capital growth in the share price or
dividends.

Shareholders’ wealth is thus determined by the number of shares and the current share
price, which may vary from day to day. Thus, the financial manager must engage in
activities, which will have a positive effect on the firms share price.

1.5 The corporate forms of business in South Africa

There are four main legal forms of business entities that can operate in South Africa i.e. sole
proprietorships, partnerships, companies and closed corporations. There are various
advantages and disadvantages to each, which you can read in more detail in the textbook.
These were discussed in detail in Financial Management 1.
It is important to note that in terms of the new Company Act 71 of 2008, no new closed
corporations can be registered after 1 May 2011.

1.6 The agency problem/issue and agency costs

It has been established that the goal of the financial manager is to maximise the wealth of
the organisations’ owners. It’s also important to note that financial managers are employed
by an organisations’ owners and thus they are viewed as agents of the owners who are
tasked with carrying out duties in the running and managing of the organisation. The issue
arises when the financial manager puts their personal interest above that of the owners,
thus in contradiction with the goal of maximising the wealth of the organisations’ owners.
This gives rise to the term the ‘agency problem’, which is the likelihood that managers may
place personal goals ahead of corporate goals.

The agency cost is the cost incurred as a result of the agency problem.

IMM Graduate School Study Guide (FM202B) Page 38 of 199

1.7 Financial markets and financial institutions

Most successful firms have ongoing needs for

funds. External funding can be obtained
through financial institutions e.g. banks where
depositors’ savings are loaned to those seeking
funding and through financial markets, which is
defined as a meeting place where suppliers and
demanders of funds come together. There are
two types of financial markets i.e. money markets and capital markets.

Money markets deal with short-term finance, usually less than a year. Funding in money
markets is raised by the issuing of marketable securities, such as SA Treasury bills. (Gitman,
2011)

Capital markets are markets where the supply and demand for long-term (more than a
year) debt securities are traded. The main securities bought and sold are shares and bonds.

Financial markets can be further broken down into primary and secondary markets. Primary
markets are where listed companies and governments sell securities for the first time.
Secondary markets are markets where original securities bought on the primary market are
traded.

Auction markets or broker markets as they are also referred to, are markets where
transactions are done by means of a process of public outcry. (Stoltz et al, 2007) The
Johannesburg Stock Exchange (JSE) functioned as an auction market until 1996 where after
it became automated and has now become a dealer market. The New York Stock Exchange
however continues to operate as an auction market.

In dealer markets, traders offer to buy or sell securities at fixed prices. The actual sellers
and buyers are not directly brought together.

Financial Institutions

One of the most common sources of financing remains financial

institutions, such as commercial banks, life insurers, pension funds
and collective investment schemes (which include unit trusts),

IMM Graduate School Study Guide (FM202B) Page 39 of 199

bring savers and lenders together in an effort to allocate funds efficiently.

1.8 Business ethics and corporate governance

We have seen some monumental business scandals over the past decade or so, the likes of
Enron and WorldCom, which highlighted how power and greed corrupted CEO’s and
Directors, ultimately bringing down multibillion-dollar empires. Closer to home the
Competition Commission uncovered a cartel who had fixed the price of bread for 12 years.
What was shocking about this scandal was the audacity to manipulate the price of a basic
food item like bread, in a country, which has high levels of poverty.

In light of these corporate scandals, business ethics and corporate governance have become
important concepts from a financial management perspective.

Ethics is more than just complying with the law.

Ethical issues can have significant impact on an
organisations brand. In recent years Nike
sportswear faced bad publicity when it was
accused of using child labour and the use of
sweatshops in the manufacturing of their

sporting goods in countries like China and Pakistan. What is important to note is that while
the use of child labour is not unlawful in China and Pakistan it is most definitely deemed
unethical for organisations to make use of such practices.

Corporate governance can be described as the

framework of rules and practices used by an
organisation’s board of directors to ensure
accountability, fairness and transparency in the
organisation’s dealings with its shareholders,
creditors and other stakeholders.

Other stakeholders include the broader community and environment. Companies often
refer to triple bottom line accounting, which include the separate financial, social and
environmental bottom lines.

IMM Graduate School Study Guide (FM202B) Page 40 of 199

• In an effort to promote good corporate governance amongst South African
companies, the King Commission drew up a summary of the best international
practices in corporate governance. This summary is referred to as the King Report. The
latest updated version is King Report III, with its main focus on calling companies to
identify and manage the impact that they have (both positive and negative) on the
economic life of the community in which they operate.

1.9 Appraising investment risk

As marketers, our objectives include increasing sales and investigating market penetration
amongst others. In order to achieve such objectives, we are required to make certain
decisions. These decisions could range from whether to introduce a new product, enter a
new market perhaps beyond our borders, expand the number of existing stores or drop a
product line etc. Such decisions require capital investments, which carry some form of risk
to the organisation.

There are numerous forms of risk and may include the risk associated with launching
operations in a politically unstable country or it may be that the organisation takes on too
much debt or there may be a natural disaster that destroys some of its assets. These ‘risks’
and the likelihood of them occurring need to be managed to ensure that the organisation is
able to cope with them without being debilitated, should these unfavourable events occur
(Els, 2014).

1.10 Uncertainty and risk

In the most basic sense, risk is the chance of financial loss (Gitman, 2011). At the core of risk
is uncertainty, which is the result of us either not knowing all the possible variables and
outcomes, or us not being able to say for sure how probable each outcome is. Certain
theories such the probability theory can be used to manage risk by determining the
probability of each possible event happening. In this way, we change an uncertain situation
into one of risky choice (Stoltz et al, 2007).

IMM Graduate School Study Guide (FM202B) Page 41 of 199

1.11 Risk versus return

So as marketers, why would we want to take on risk? Well it’s

actually very simple, it’s the attraction of a return which ties in with
our objectives of growth, market penetration etc. Now that we
understand that any return has some level of risk, we can
appreciate the importance of risk management, which involves
achieving the minimum risk for a given level of return (Marney & Tarbert, 2011).

Formula 7.1 in the textbook shows the formula to be used for calculating the percentage
return from an investment.

1.12 Approaches to risk in investment appraisal

Whether we want to admit it or not, our lives revolve around some level of risk. The
question for individuals and organisations is what their level or appetite for risk is. Thus, one
could be risk-averse, risk seeking or risk-neutral.

1.12.1 Types of risk in investment projects

As mentioned earlier risk can take on various forms.

Elementary risks may affect all organisations or
investments and can further be categorised as either
systematic or unsystematic risk.

Systematic risk, which in essence is basic market

risk, is the result of economic changes or other
events that have an impact on a large percentage of
the market. It can also be referred to as non-
diversifiable risk as it emanates from the market. This was the case after the global financial
crisis of 2008, which first saw numerous banks fold in the US, resulting in the whole global
economy slowing down.

IMM Graduate School Study Guide (FM202B) Page 42 of 199

Unsystematic risk is more specific than systematic risk. Also referred to as diversifiable risk
because it is company specific such as the implementation of strategies, for example new
product development. It affects fewer or more specific investors at the same time. An
example of this would be South African government intervention in the cell phone market
by regulating the price that service providers can charge end users. This would directly
impact on the profitability of Vodacom, MTN and Cell C in the South African Market.

There are other categories of risk other than elementary risk, as per the table below these
include:

Types of Risk

Business risk Exchange rate risk

Financial risk Purchasing power risk

Interest rate risk Tax risk

Liquidity risk Credit or default risk

Market risk Country risk

Event risk

Now that you have completed study unit 1 it is advisable to work through the multiple-
choice and longer questions at the end of chapter 1 and 7. Answers to these questions can
be found at the back of the textbook.

Revision Exercises

Exercises:
The following questions should be attempted.

Question 1
“Closing unprofitable mines is not an easy option”

Johan Theron, Implats Group Executive: Corporate Relations

IMM Graduate School Study Guide (FM202B) Page 43 of 199

 Source: Mathews, C., 2014. Mining: who is over a barrel? Financial Mail. [Online]
Available at: http://www.financialmail.co.za/features/2014/02/20/mining-who-is-
over-a-barrel. [Accessed: 2 June 2014]

The main goal of a financial manager is to maximise shareholders’ wealth. One of the
decisions to be made could include the option of divestment from unprofitable projects;
however, this decision cannot solely be based on long-term wealth maximisation for
shareholders only.

Required:
Discuss the above statement by Johan Theron by explaining why the decision of divestment
is one that is challenging and cannot be considered in isolation. In your answer, explain the
impact of such a decision on other stakeholders and other factors that should be considered
when making such decisions.

Question 2

A mutual company differs from that of a listed company by the fact that the customers are
also the shareholders. Thus, the company is said to be owned by and run for the benefit of
its members, also being the customers.

Required:

Discuss the possibility of an agency problem that could arise if a mutual organisation were
to list its shares on a stock exchange and become a listed company. (In answering this
question, you may be required to consult further sources other than your prescribed
learning material. Be sure to reference any consulted resources correctly.)

Question 3

When assessing the overall risk of a company, financial managers should take cognisance of
business risk and financial risk.

Required:

3.1 Define business risk and discuss the method by which it may be measured.

3.2 Define financial risk and discuss the method by which it may be measured.

IMM Graduate School Study Guide (FM202B) Page 44 of 199

3.3 Discuss the actions a financial manager may take to reduce the overall risk of the
company and the effects this may have on shareholders.

Study Unit 1 – Revision Exercises Solutions:

Refer to suggested solutions at the end of this study guide (Addendum C). It is however
advised that learners attempt to respond to the questions first by themselves before
accessing the solutions for effective learning to take place.

IMM Graduate School Study Guide (FM202B) Page 45 of 199

 Study unit 1 – Progress check

You have come to the end of study unit 1.

Time to do a progress check to determine whether you have completed the required
content and exercises.

IMM Graduate School Study Guide (FM202B) Page 46 of 199

Your Progress Checklist YES / NO?

Did you read through each study unit outcome?

Did you go through all learning material

Did you complete all the relevant revision exercises and check your answers
against the answers provided?

At this point, you should be able to: (list study unit outcomes again)
• Differentiate the accounting fields from financial management
• Differentiate profit maximisation from shareholder wealth
maximisation
• Describe how managerial finance function is related to economics and
accounting
• Discuss the actions a financial manager can may take to reduce the
overall risk of a company and the effects it may have on shareholders
• What is the goal of an organisation
• Discuss the possibility of an agency issue and its effects on a business
• Discuss the elementary risks that affect all organisation and give 3
examples of each category
• Define business risks and finance risks and the methods at which each
can be measured

Are you ready to tackle the questions relevant to Study Unit 1 in

Assignment 1?

Complete assignment 1, question 1

IMM Graduate School Study Guide (FM202B) Page 47 of 199

SECTION B
SUBMISSION OF ASSIGNMENT One
WEEK 1 – 6:

STUDY UNIT 2

Study Unit 2: The fundamentals of time value of money

Study Unit 2 - Relevance

In this study unit, we explore the fundamentals of time value of money. It is important to
note that these fundamentals are not only of interest to accountants and financiers but also
to marketers, as it will influence our investment decision process. From an accounting
perspective, you may need to understand time value of money calculations to account for
certain transactions such as loan amortisation, lease payments and bond interest payments.
However, from a marketing perspective you need to understand time value of money
because funding for new programmes and products must be justified financially using time
value of money techniques

“Compounded interest is the eighth wonder of the world. He who understands it, earns it
... he who doesn’t ... pays it”

Albert Einstein- Theoretical physicist and philosopher of science

IMM Graduate School Study Guide (FM202B) Page 48 of 199

 Study Unit 2 – Module Outcomes

Let’s recap the relevant module outcome for this study unit

MO 2 Understand the time value of money concept

Study Unit 2 – Key Concepts

Let’s recap what the relevant module learning outcome is for this study unit:
• Discuss the role of time value of money in finance, the use of computational tools and
the basis pattern of cash flow.
• Discuss the role of time value of money in finance, the use of computational tools and
the basis pattern of cash flow.
• Ability to appraise the concept of lump sums, annuities, perpetuities and mixed
stream cash flows.
• Demonstrate a clear understanding of the effect that compounding interest more
frequently than annually has on effective annual rate of interest and future values
accordingly.
• Ability to single out a specific financial concept from a given case study and apply it
accordingly.

Study Unit 2 – Glossary of Terms

Annuity - An annuity is a series of equal payments or receipts occurring over a specified

time period

Compounding interest – Interest that is earned on both the principal and the reinvested
interest amount.
Discounting cash flows – The process of finding present values

IMM Graduate School Study Guide (FM202B) Page 49 of 199

Effective interest rate – The actually paid or earned

Future value – The value at a given future time of a present amount invested at a specific
interest rate

Nominal interest rate – The contractual annual interest rate charged by a lender or
promised by a borrower.

Present value – The current value of a future amount of money or series of future
payments, evaluated at a given interest rate

Study Plan Progress

Week 2 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Discuss the role of Complete Sign-up for eLearn Week 2

time value of money revision Consult eLibrary – 12.5 Hours

in finance, the use exercises Obtained
of computational feedback
tools and the basis
pattern of cash flow
 Ability to appraise
the concept of lump
sums, annuities,
perpetuities and
mixed stream cash
flows.

IMM Graduate School Study Guide (FM202B) Page 50 of 199

Week 3 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Demonstrate a clear Complete Sign-up for Week 3

understanding of the revision eLearn – 12.5 Hours

effect that exercises Consult eLibrary
compounding Obtained
interest more feedback
frequently than
annually has on
effective annual rate
of interest and
future values
accordingly.

 Ability to single out a

specific financial
concept from a given
case study and apply
it accordingly.

2. Study Unit 2 - Content

2.1 Introduction

Why do investors invest in organisations? The

answer is actually quite simple, because they
seek a return on that investment. Various
factors can influence the return on an
investment, these include the size of the
investment, the timing of cash flows generated

IMM Graduate School Study Guide (FM202B) Page 51 of 199

and the interest rate.

2.2 Interest rates

When we look at interest, we talk about interest earned on an investment. We also need to
understand the difference between simple interest and compounded interest. Simple
interest calculates interest only on the initial investment amount. Compounded interest is
reinvested with the investment amount thus earning interest on interest going forward.
Time value of money (TVM) will always be based on compounded interest for testing
purposes.

2.3 Future value and compounding of lump sums

In order to evaluate two alternative investment options, we need to adhere to a time value
of money fundamental, which is that comparison needs to be done at a similar point in
time. Investment options are usually assessed by using either future value (FV) or present
value (PV) techniques.

Future value technique determines the accumulated value of all cash flows at the END of
the project. In contrast present value technique discounts all cash flows to the START of a
project. In other words, FV is the value of a known present amount of money at a given
future date, while PV is the current rand value today of a known future amount of money.

The calculation of FV can be performed using the following equation:

= X( )

Where:

= future value at the end of period n

= present value at period T0

= rate of interest paid or earned per period

= the total number of periods of the investment

IMM Graduate School Study Guide (FM202B) Page 52 of 199

While the textbook explains mathematically how to calculate future values (FV), it’s
important to note that you will be required to do all calculations using the prescribed
calculator.

At the end of chapter 4 your textbook provides Appendix tables, indicating future value
(FV) and present value (PV) amounts of R1 at various interest rates and number of
periods. However again you will not be provided with these during tests or exams and you
will therefore need to be able to calculate these by using your calculator at the risk of
losing time and not being able to solve for certain variables manually.

Therefore, before we go on any further discussing time value of money (TVM) let us gain a
better understanding of the various elements and how to use your HP 10bll+ financial
calculator.
The time value of money (TVM) functions keys can be located on the top row of your
calculator i.e.
The time value of money (TVM)functions keys can be located on the top row of your calculator i.e.

N = Number of periods

I/YR= Interest rate per year

PV= Present value

PMT = Payment amount

FV= Future value

It’s also very important to understand the number of payment periods in a year. Normally
calculations are done on an annual basis and interest rates are given as a ‘per annum’ rate.
Therefore, it’s important to set the correct number of periods per year on your calculator.
Calculating interest payments on an annual basis means that our payment per year (P/YR) =
1. To set your calculator payment period to 1, do the following:

Press the number 1, then hit the second function ( )(red/orange) shift key and then press
P/YR key. To check that your payment per year period is correct, again hit the second
function (red/orange) shift key, then the C ALL key. On your display screen, it will show how
many periods per year.

IMM Graduate School Study Guide (FM202B) Page 53 of 199

Students also need to understand whether we have an outflow of money (indicated as a
negative amount) or an inflow of money indicated as a positive amount. In other words,
from our perspective if we were to invest R1,000 that would be an outflow of money as we
would no longer have the cash in our possession, thus it would be –R1,000. However, when
we receive the money back with 10% interest it would be an inflow of cash thus depicted as
positive e.g. +R1,100

While the textbook uses the Sharp financial calculator, we will now practice redoing the
textbook exercises by using the prescribed HP 10bll+ financial calculator.

Invest R1,000 at an interest rate of 10% per year for a period of 2 years. Calculate the future
value (FV) of this investment.

Therefore, the following information is given to us:

PV = R1,000
I/YR = 10%

N=2

Thus on your calculator do the following:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• - 1000, PV
• 10, I/YR
• 2, N

IMM Graduate School Study Guide (FM202B) Page 54 of 199

 • FV
• The answer will now display as 1210

Please note that you can enter any of the given variables in any order as long as your
unknown variable is the last one pressed, in this case the FV.

2.4 Compounded interest more frequently than annually

For simplicity purposes, most examples are based on calculating interest annually. However,
interest may be calculated more frequently than just once a year. Nominal annual rates can
be compounded annually (NACA), semi-annually (NACSA), quarterly (NACQ) or monthly
(NACM).

The compounded interest rate can be expressed as follows:

x( )

Where:

future value at the end of period n

= present value at period T0 (i.e. now)

= rate of interest paid or earned per period

= the total number of periods of the investment

= the number of times interest is compounded per period

As per our previous example, you invest R1, 000 at an interest rate of 10% compounded
semi-annually. Calculate the future value (FV) of this investment after 2 years.

PV = R1, 000

I/YR = 10%
N=2

M=2

There are two ways of calculating FV for compounded interest periods. Thus on your
calculator do the following:

IMM Graduate School Study Guide (FM202B) Page 55 of 199

IMM Graduate School Study Guide (FM202B) Page 56 of 199
Option 1:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• - 1000, PV
• 5, I/YR
• (10 ÷ 2 getting the yearly interest rate to be per half
year)
• 4, N (2 x 2 as two years x twice a year)
• FV
• The answer will now display as 1215.51
• The golden rule for compounding:
• ALWAYS TIMES(X) THE TIME (N) AND DIVIDE THE INTERSET (I/YR)!

Option 2:

Because the interest is semi-annually, you need to set your payments per year (P/YR) to 2
(as there are 2 halves to the year). You can do this by doing the following:

• 2, (red/orange), P/YR
• (red/orange) shift, C ALL
• (2 P_Yr) should be displayed on the screen
• - 1000, PV
• 10, I/YR
• 4, N (2 x 2 as two years x twice a year)
• FV
• The answer will now display as 1215.51

2.5 Nominal and effective interest rates

As mentioned at the start of this study unit, compounded interest is the result of interest
being earned on interest. This gives rise to the term effective interest rate, which is different
from the nominal interest rate.

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The nominal interest rate is the contractual or advertised interest rate that lenders or
borrowers of cash will publish. However, the effective annual rate (EAR) includes the effects
of compounding interest.

The effects of compound interest can be graphically appreciated by the diagram below:

2.6 Present value and discounting

Previously we calculated what would be the future value (FV) of a current investment, so
many periods from now. Present value (PV) calculations are in essence the inverse of FV
calculations. This can be best explained via an example:

The following example can be used to calculate present value.

Imagine you wanted a R1,700 pay-out 8 years from now and you knew that you could get a
guaranteed interest rate of 8% per annum. You could calculate your present value (PV)
investment now that would ensure this return.
FV = R1,700

I/YR = 8%

N=8

The above example can now be calculated on our HP 10bII+ as follows:

IMM Graduate School Study Guide (FM202B) Page 58 of 199

 • (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• 1700, FV
• 8, I/YR
• 8, N
• PV
• The answer will now display as – 918.46

The answer is displayed as a negative due to the initial investment being an ‘outflow’ that
we would need to make to get the return of R1 700.Also because of the direction of that
cash flow on a timeline.

We all know that R100 today is worth more than the same R100 one year from now. Money
has a time value component to it, thus the PV of a promised future amount is worth less the
longer you wait to receive it. In other words, its value diminishes over time. This concept is
known as discounting.

Let’s practice with the following example. If we were to receive payment in a year’s time, for
a R1,000 loan given out, what is the present value of that R1,000 if the discount rate is 7%.

The PV can be calculated as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• 1000, FV
• 7, I/YR
• 1, N
• PV
• The answer will now display as – 934.58

2.7 Determining interest rates and number of periods

You have probably by now gathered that as long as we have 3 variables we can calculate the
fourth. Thus, we can also use our calculator to work out the interest rate (I/YR) and the
number of periods (N).

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Imagine that 3 years ago, you invested R1,080 and today you received R1,517 as a return on
that investment. What interest or growth rate did you receive on your investment?
The calculation can be done as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• - 1080, PV
• 1517, FV
• 3, N
• I/YR
• The answer will now display as 11.99
• Remember to always write your answer as a %.

2.8 Determining the number of periods

In terms of calculating the number of periods we can look at the following example: How
long will it take you to grow a R15,000 investment to R25,000 at an interest rate of 12%?

The calculation can be done as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• - 15000, PV
• 25000, FV
• 12, I/YR
• N
• The answer will now display as 4.51

2.9 Valuing annuities

An annuity is a series of equal payments or receipts occurring regularly over a specified time
period. A common example of an annuity payment is a mortgage bond repayment.

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There are two types of annuities - ordinary annuity (annuity in arrears) and annuity due
(annuity in advance). Thus with ordinary annuities payment or receipt occurs at the end of
each period.

For the purpose of this module, we will only deal with ordinary annuities.

We will now do an annuity calculation by looking at the following scenario. Imagine you
made annuity payments of R5,000 per year for a period of 5 years, at an interest rate of 6%
per annum compounded annually. What amount would have accumulated after the 5
years?
The calculation can be done as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• - 5000, PMT
• 5, N
• 6, I/YR
• 1, (red/orange), P/YR
• FV
• The answer will now display as 28185.46

We can also calculate the present value (PV) of annuities. Imagine you wanted an annuity
payment of R3,000 at the end of each year for the next 5 years at an interest rate of 8%.
How much would you need to invest now in order to achieve this.

The calculation can be done as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• 3000, PMT
• 5, N
• 8, I/YR
• 1, (red/orange), P/YR
• PV
• The answer will now display as-11978.13

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As mentioned annuities deliver consistent payments, however in reality many investments
do not. Most projects generate unequal cash flows, we refer to these unequal cash flows as
a mixed stream of cash flows.

It’s important to note that when cash flows are not constant you cannot calculate present
values (PV’s) or future values (FV’s) by using the annuity payment (PMT) function. The PMT
function can only be used for identical regular payments.

Thus in the case of mixed stream cash flows you need to calculate each year’s cash flow
individually and then add all the years together.
Let’s practice on the following example. You will receive the following payments over the
next 5 years i.e. R5000, R5000, R6000, R6000 and R1000. Assuming an interest rate of 10%
calculate the PV of the cash flows.
The calculation can be done as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• For Year 1
• 5000, FV
• 1, N
• 10, I/YR
• PV
• The answer will now display as – 4545.45

For Year 2

• 5000, FV
• 2, N
• 10, I/YR
• PV
• The answer will now display as – 4132.23

For Year 3

• 6000, FV
• 3, N

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• 10, I/YR
• PV
• The answer will now display as – 4507.89

For Year 4

• 6000, FV
• 4, N
• 10, I/YR
• PV
• The answer will now display as – 4098.08

For Year 5

• 1000, FV
• 5, N
• 10, I/YR
• PV
• The answer will now display as – 620.92

Now add all the PV cash flows from the various years i.e.

• - 4545.45 - 4132.23 - 4507.89 - 4098.08 - 620.92 =

• - 17904.57 will be displayed as your answer.

2.10 Perpetuities

Perpetuity is an annuity in which the periodic payments begin on a fixed date and continue
indefinitely.

There are three types of perpetuities:

• Ordinary perpetuity where payments are made at the end of the stated periods.
• Perpetuity due, where payments are made at the beginning of the stated periods.
• Growing perpetuity is when the periodic payments grow at a given rate (g).

For the purpose of this study unit, we will only look at ordinary perpetuities.
Refer to the examples in the textbook for practical examples.

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Now that you have completed study unit 2 it is advisable to work through the multiple-
choice and longer questions at the end of chapter 1 and 7. Answers to these questions can
be found at the back of the textbook.

Revision Exercises

Exercises:
The following questions should also be attempted:

1. If you invest R668 today over a period of 5 years, how much will it be worth if you
could earn a rate of 14.5% per annum, compounded monthly?

A. R 948

B. R 1 355

C. R 4 460

D. R 1 373.26

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2. You are promised an amount of R50 000 in 3 years’ time. Currently you could earn
5% interest per annum, compounded monthly. What is the amount worth today?

A. R 58 781

B. R 57 881

C. R 43 049

D. R 43 912

3. Peter and Linda want to buy a car. They have a deposit of R80 000, and decide to
purchase a BMW priced at R240 000. Currently the bank is willing to give them
finance over 54-month period at a rate of 10% per annum, compounded monthly.
What would their monthly repayment be given the information above?

A. R 2 963

B. R 3 692

C. R 16 094
D. R 3 212

4. Kgotso wants to buy a house that costs R500 000. The bank wants a deposit of R150
000. If Kgotso invests R3000 per month in a fund the will yield 21.6% per annum,
compounded monthly. How long will it take Kgotso to have his deposit?

A. 50 months

B. 12 months
C. 36 months
D. 48 months

5. John Abbot bought a house 10 – years ago for R550 000. He is hoping to sell the
house within the next couple of months and wants to get a general idea of what it
might be worth one day. He read an article, which stated that house prices have

IMM Graduate School Study Guide (FM202B) Page 65 of 199

 increased by approximately 10% per annum, compounded monthly over the past 10
years. Based on this John should expect to receive approximately:

A. R 1 489 000

B. 6 05 000

C. R 550 000

D. R 1 100 000

6. Paul wants to buy a new car. The asking price is R250 000, and he plans to make a
deposit of 15% of the purchase price. South Bank is willing to finance the reminder of
the amount over a 48-month period at an interest rate of 10.5% per annum,
compounded monthly. Calculate Paul’s monthly repayments.

A. R6 401

B. R 22 449

C. R 4 801
D. R 5 441

7. A father needs to make a payment of R90 000 ten years from now in order to pay for
his daughter’s tertiary education. How much will he need to invest today to meet his
first tuition goal if the investment earns 8% annually, compounded monthly?

A. R 41 567.64

B. R 40 547.11
C. R 32 473.43
D. R 90 000

8. A couple plans to set aside R2 000 per month in a conservative portfolio projected to
earn 7% a year, compounded monthly. If they make they make their first savings
contribution at the end of the month, how much will they have at the end of the 20
years?

IMM Graduate School Study Guide (FM202B) Page 66 of 199

 A. R 1 033 253.31

B. R 1 041 853.32

C. R 1 000 548.58

D. R 2 025 548.55

9. Sam just bought a new house on a bond worth R1 000 000. If Sam has to pay back R9
650.21 every month over the next 20 years at an interest rate of 10% per year
compounded monthly. How much, in total, would Sam have paid the bank at the end
of 20 years?

A. R 1 000 000

B. R 1 100 000
C. R 2 316 050.40

D. R 2 435 255.30

Exercise 1

Imagine you invest R10 000 at an interest rate of 6% per year and you want to know what
the future value (FV) of this investment will be after 2 years.

Exercise 2

Imagine you wanted a R20 000 pay out 5 years from now and you knew that you could get a
guaranteed interest rate of 8% per annum. You could calculate your present value (PV)
investment now that would ensure this return.

Exercise 3

Imagine that 3 years ago you invested R1 500 and today you received R2 000 as a return on
that investment. What interest or growth rate did you receive on your investment?

Exercise 4

How long would it take you to double your R5 000 investment at an interest rate of 15%?

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Exercise 5

Imagine you are planning to launch a new product line and your projections of revenue sales
for the next three years are: Year 1 R150 000; Year 2 R225 000 and Year 3 R400 000. What is
the PV of the new product line based on these projections assuming an interest rate of 7%?

Study Unit 1 – Revision Exercises Solutions:

Refer to suggested solutions at the end of this study guide (Addendum C). It is however
advised that learners attempt to respond to the questions first by themselves before
accessing the solutions for effective learning to take place.

IMM Graduate School Study Guide (FM202B) Page 68 of 199

 Study unit 2 – Progress check

You have come to the end of study unit 2.

Time to do a progress check to determine whether you have completed the required
content and exercises.

IMM Graduate School Study Guide (FM202B) Page 69 of 199

Your Progress Checklist YES/NO?

Did you read through each study unit outcome?

Did you go through all learning material?

Did you complete all the relevant revision exercises and check your
answers against the answers provided?

At this point, you should be able to:

• Discuss the role of time value of money in finance, the use of

computational tools and the basis pattern of cash flow.
• Discuss the role of time value of money in finance, the use of
computational tools and the basis pattern of cash flow.
• Ability to appraise the concept of lump sums, annuities, perpetuities
and mixed stream cash flows.
• Demonstrate a clear understanding of the effect that compounding.
interest more frequently than annually has on effective annual rate
of interest and future values accordingly.
• Ability to single out a specific financial concept from a given case
study and apply it accordingly.

Are you ready to tackle questions relevant to Study Unit 2 in assignment 1?

Complete Assignment 1, Question 2

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STUDY UNIT 3

Study Unit 3: Analysis of financial statements

Study Unit 3 - Relevance

As a marketer, it is important that you understand the effects of your decisions on the
organisation’s financial statements. Ratio analysis, especially those involving sales figures,
will effect decisions on inventory, credit policies and pricing decisions, which are all
important aspects to marketers. In study unit 3 we will have a brief look at two of the
financial statements, statement of profit and loss (previously known, and referred to in your
textbook as the statement of comprehensive income) and statement of financial position
and the nature of the information contained in these reports. We will then focus on a few of
the most commonly applied financial ratios to establish a meaningful relationship between
different items in the financial statements.

“Show me the money”

Famous line from the movie, Jerry Maguire featuring Cuba Gooding Jr and Tom Cruise

IMM Graduate School Study Guide (FM202B) Page 71 of 199

 Study Unit 1 – Module Outcomes

Let’s recap the relevant module outcomes for this study unit

MO 3 Analyse financial statements and help users in making informed decisions

Study Unit 1 – Key Concepts

Let’s recap what the relevant module learning outcomes are for this study unit
After completing this study unit, you should be able to:

• Discuss the objective of financial reporting.

• Review the key contents of income statement and Balance sheet.
• Identify the stakeholders/users of financial statements and their specific interest.
• Use financial ratio to analyse the organization’s profitability, profit margins, activity,
liquidity and solvency position accordingly.
• Discuss gearing and its effect to the shareholders and debt funders.

Study unit 3 – Glossary of Terms

Financial gearing – it’s the use and effect of debt capital to finance the organisations’ assets.

Liquidity ratios – ratios that investigate the firms short term liquidity, that is, whether
sufficient current assets are available to cover the company’s current liabilities.

Profit margins – the percentage of turnover that is left after deducting expenses.
Profitability ratios – evaluate the effectiveness of the organisations assets to generate
turnover.

IMM Graduate School Study Guide (FM202B) Page 72 of 199

Solvency ratios –measures the organisations ability to cover all its debt obligations in the
event of closing down.
Statement of profit and loss – provides a summary of an organisation’s revenue and
expenses.

Statement of financial position – evaluates the financial position of a company by focusing

on its assets, liabilities and shareholders’ equity.

Turnover ratios – indicates how many times a year an asset is converted into turnover.

Study Plan Progress

Week 4 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Discuss the objective Complete Sign-up for Week 4

of financial reporting revision eLearn –12.5 Hours

 Review the key exercises Consult eLibrary
contents of income Obtained
statement and feedback
Balance sheet
 Identify the
stakeholders/users of
financial statements
and their specific
interest

IMM Graduate School Study Guide (FM202B) Page 73 of 199

Week 5 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

• Use financial ratio Complete Sign-up for eLearn Week 5

to analyse the revision Consult eLibrary – 12.5 Hours

organization’s exercises Obtained
profitability, profit feedback
margins, activity,
liquidity and
solvency position
accordingly
• Discuss gearing
and its effect to
the shareholders
and debt funders.

3. Study Unit 3 – Content

3.1 Introduction
An organisation’s annual financial reports are a great source of financial information to
various stakeholders. Companies are required by law to publish financial statements at the
end of their financial year. The financial statements are usually prepared according to the
International Financial Reporting Standards (IFRS), which ensures the information is relevant
and that it is faithfully represented. By adhering to the standards, the information can also
be compared year on year within the same entity and entity on entity in the same industry.

Note: The statement of financial position and the statement of profit and loss are the only
two required statements which you need to know for this module. In FM101, these two
statements were explained in detail and you were expected to draw up the statements from

IMM Graduate School Study Guide (FM202B) Page 74 of 199

information provided from the organisation’s financial records. Although you need to know
the detail provided in each of these statements you will not be required to compile the
individual statements based on financial information provided.

3.2 The objective of financial reporting

The presentation of organisation’s financial statements is done in accordance with

International Financial Reporting Standards (IFRS). The objective or general purpose of
financial reporting is to provide financial information about the reporting entity that is
useful to existing and potential investors, lenders and other creditors in making decisions
about providing resources to the entity (McConnell, 2011).

3.3 Users of financial reporting

There are numerous stakeholders that have an interest in an organisation’s financial

statements and that may be required to make various decisions relating to it and its
operations.

Figure 3.1: Stakeholders interested in financial reports

• Current and prospective shareholders are interested in the firm’s current and future
level of risk and return, which directly affect the share price. Shareholders need to

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 assess their worth in the organisation. Shareholders finance the business and require
compensation for the fact that they are foregoing the opportunity of earning a return
on alternative investments
• Organisational management need financial statements to help them plan and control
the activities of the company
• Lenders or creditors are interested in the short-term liquidity of the firm and its ability
to make interest and principal payments.
• Labour unions need to review the financials as a basis for their wage negotiations
• Investment analysts require statements to analyse the company for investment
purposes
• Revenue services (SARS) require these statements to determine and check taxes owed
to the state

Note: When analysing and evaluating the financial statements of an organisation, it is

important to know from which point of view (the user) you are coming from. This will be
addressed later in this unit.

3.4 Information provided by financial statements

Cuba Gooding Jr and Tom Cruise immortalised the phase “show me the money” in the 1996
movie Jerry Maguire: that’s exactly what financial statements do. They show you where an
organisation’s money came from, where it went, and where it is now.

The statement of financial position provides information about the organisation’s financial
position in terms of its economic resources (assets) and the claims against these resources
(equity and liabilities).

The statement of profit and loss addresses the financial performance of the organisation in
terms of its ability to generate income with its available assets. In other words, it establishes
whether the organisation is making a profit or loss.

While the statements are important they are not sufficient for analysts and potential
shareholders to assess the risk associated with the organisation on their own. Thus, notes to
the financial statements provide valuable additional information in evaluating the risk.

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3.5 Qualitative characteristics of useful financial information

While we understand the importance of the information provided by financial statements,

the question must be asked how reliable is this information? According to the IFRS
Framework, relevance and faithful representation are defined as the two fundamental
qualitative characteristics of useful financial information.
Information must be relevant to users and should enable the external capital providers to evaluate
the historic, current and expected future changes that may have an effect on the organisation.
Furthermore, the information should be comparable.

• The usefulness of the information is further enhanced if it is comparable, verifiable,

timely and understandable.
• In terms of being faithfully represented, this means that the information should be
complete and provide sufficient detail to the users of financial information. The
information provided should be represented in a neutral way and not bias in any way.
Finally, the information should be error-free.

3.6 Standardisation of financial statements

Globalisation has resulted in the world becoming more and more interconnected. Multi-
national companies operate across the globe resulting in financial managers at different
locations submitting financial figures through to a head office or holding organisation, often
in a completely different country. This has resulted in a drive towards global, standardised
reporting standards. The Enron and Worldcom scandals also contributed towards a drive for
global standards. This contributed to the International Accounting Standards Board (IASB)
developing a framework for Financial Reporting in 2010.

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3.7 Statement of financial position and statement of profit and loss

You have already been introduced to the various financial statements during your FM101
module. Thus, we will not go into great detail but rather remind you of what these
statements contain.
The statement of financial position presents a summarised statement of an organisations
financial position at a given point in time. The statement balances the organisations assets
(what it owns) against its financing, which can be either debt (what it owes) or equity (what
was provided by owners). Remember the basic accounting equation? The major elements of
a statement of financial position are reflected in this equation.

Assets = Owners equity + Liabilities

Assets = Non-current assets + current assets

Liabilities = Non-current liabilities + current liabilities

Note: Study the Sasol example of a statement of financial position from your textbook
(section 2.7) as well as the sections that discuss the various items included in a statement of
financial position. It is important that you have a solid foundation in the understanding of
each of the items making up the statement of financial position.

The statement of profit and loss provides a financial summary of the organisations operating
results during a specified period.

Note: Study the Sasol example of a statement of profit and loss and its various components.
Again, it is important that you have a solid foundation in the understanding of each of the
items making up the statement of profit and loss. As previously mentioned, although you
will not be required to draw up the statements, you need to know the various components
so as to be able to calculate and interpret the different ratios discussed in the next section.

Note: Section 2.9 in your textbook is only for reading purposes.

Ratio Analysis

Study Els (2014, Chapter 3)

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Please note: The following paragraphs from chapter 3 of your prescribed textbook are
excluded and not examinable:
• Par 3.5.3 & 3.5.4
• Par 3.6.3
• Par 3.7.2 & 3.7.3
• Par 3.8.3 & 3.8.7
• Par 3.9.3
• Par 3.9.5 to 3.10.6
• Par 3.11.4 to 3.11.6
• Par 3.13

3.8 Ratio analysis introduction

While financial statements provide information about an organisation’s financial position

and performance, it doesn’t necessarily tell us how it compares to other organisations in the
same industry or against other industries. Financial ratios however, can convert financial
information into meaningful comparative information in a format that is easily comparable
over time, between different companies and between different industries and countries.
Thus, ratio analysis consists of calculating and interpreting financial ratios to analyze and
monitor an organizations’ performance. This information is valuable to a number of
stakeholders, which we have already addressed earlier.

3.9 Types of ratios

There are different types of financial ratios and depending on the type of stakeholders and
information needed, certain ratios will be more meaningful than others. For the sake of
interpretation, ratios are classified into groups of ratios and you will be examined on the
following:
• Profitability ratios
o Return on assets

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 o Return on equity
• Profit margins
o Gross profit margin
o Operating profit margin
o Net profit margin
• Turnover ratios and turnover times ratios
o Total asset turnover ratio
o Trade receivables turnover ratio
o Trade receivable turnover time
o Trade payables turnover ratio
o Trade payables turnover time
o Inventory turnover ratio
o Inventory turnover time
• Liquidity ratios
o Current ratio
o Quick ratio
• Debt or solvency ratios
o Debt to assets ratio
o Debt to equity ratio
o Finance cost coverage
• Investment ratios
o Earnings per share
o Dividends per share
o Price earnings ratio

Note:
 Your prescribed textbook discusses more than the above ratios. You will only be
examined on the ratios as discussed in this study guide.
 Ratio analysis is not only the calculation of a value but more importantly, it is the
interpretation of the value, which is what you will also be examined on.

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 The relevant measurement unit in which ratios are expressed must be learnt. It is
important that you indicate the unit of measure for each ratio that requires one. Marks
may be lost if this is neglected. (Days, cents, times etc.).

3.10 Types of ratio comparisons

Cross-sectional analysis is the comparison of different organizations’ financial ratios at the

same point in time and involves comparing the organizations ratios to those of other
organisations in its industry or to industry averages.

Benchmarking is a type of cross-sectional analysis in which the firm’s ratio values are
compared to those of a key competitor or group of competitors that it wishes to emulate.
Comparison to industry averages is also popular.

Time-series analysis is the evaluation of a single organizations financial performance over

time using financial ratio analysis. Comparison of current to past performance, using ratios,
enables analysts to assess the organisation’s progress and determine trends.

3.11 Limitations to using ratio analysis

• Ratios that reveal large deviations from the norm merely indicate the possibility of a
problem and not the cause of the problem.
• A single ratio does not generally provide sufficient information from which to judge
the overall performance of the organisation.
• The ratios being compared should be calculated using financial statements dated at
the same point in time during the year.
• It is preferable to use audited financial statements.
• The financial data being compared should have been developed in the same way.
• Ratios are calculated from balance sheet figures which show a firm's position at a
specific point in time and this may well not be the average position, specifically in
industries that are highly cyclical by nature. 

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• Accounting practices varies in areas such as asset valuation and classification of
liabilities and may therefore distort the picture when comparing firms.
• The quality of assets is not reflected in the ratios and again this may not be a true
reflection of the ability or inability of the firm to utilise them fully.

3.12 Ratio analysis: A case study

Each of the ratios will be calculated and interpreted using the following SARA (Ltd) example.
This also serves as an indication of how you will be required to answer your assignment
and/or examination questions.

Exam tip: It is important to know how to approach a financial ratios question in

your assignment and exam. Firstly, the case scenario and accompanying notes
will give an indication of what possible problems/concerns the organisation
could be experiencing. This is needed qualitative information for your answer,
use it! Secondly, the required will state from which user perspective you must
approach the question. For example, if you are looking from an investor point of
view, certain ratios such as return on assets and return on equity will be more
valuable than others such as payable turnover. However, if you were a supplier
(creditor) to the organisation, the payable turnover ratio will be more important
to you than the return on assets or return on equity.
Note: The textbook requires ‘averages’ to be worked out. This is NOT required of a student.
Only the figure drawn from the financial statements must be used, NOT an average. For
example, in the textbook, the return on assets (ROA) is calculated by adding up the two total

IMM Graduate School Study Guide (FM202B) Page 82 of 199

assets figures for the past two years and then, dividing it by 2. This is not necessary. If in an
assignment/exam you are required to calculate the ROA for 2014, you take the profit for
2014 and divide it by the total assets for 2014.

Revision Question

SARA (Ltd) is a South African listed fashion retail chain organisation that has
stores open in both Europe and the UK. Mr Zin has been the CEO for the last 6
months and after extensive research, the organisation now wants to expand
SARA (Ltd) to the United States of America (USA). Mr Zin wants to open 20 new
stores in the USA by the middle of the 2015 financial year. You are an
investment analyst at a well-known investment firm. Your manager sees this as a
possible opportunity to invest in SARA (Ltd).

He provides you with the following financial statements and additional information:

Statement of Financial Position

of SARA (Ltd) as at 31 December 2013

2013 2012

R’000 R’000

ASSETS

Non-current assets 139 400 131 900

Plant and equipment at carrying amount 66 400 67 200

Intangible fixed assets 69 600 62 800

Other fixed assets 3 400 1 900

Current assets 697 700 662 100

Inventories 86 700 82 600

Trade receivables 527 800 501 800

Cash and cash equivalents 83 200 77 700

TOTAL ASSETS 837 100 794 000

IMM Graduate School Study Guide (FM202B) Page 83 of 199

EQUITY AND LIABILITIES

Equity attributable to equity holders 446 000 402 300

Issued ordinary share capital (R1 par) 31 300 31 300

Retained earnings 414 700 371 000

Non-current liabilities 262 400 262 100

Long term debt 250 000 250 000

Provisions 12 400 12 100

Current liabilities 128 700 129 600

Trade payables 63 500 61 500

Accrued expenses 65 200 68 100

TOTAL LIABILITIES 391 100 391 700

TOTAL EQUITY AND LIABILITIES 837 100 794 000

Extract of the Statement of Profit and Loss

of SARA (Ltd) for the year ended 31 December 2013

2013 2012

R’000 R’000

Turnover 784 700 753 200

Cost of sales (353 200) (340 900)

Gross profit 431 500 412 300

Operating expenses (314 900) (297 000)

Other expenses (depreciation) (19 000) (16 200)

Operating profit 97 600 99 100

Finance costs (10 000) (9 000)

Profit before tax 87 600 90 100

Income tax expense (21 500) (22 525)

Profit after tax 66 100 67 575

IMM Graduate School Study Guide (FM202B) Page 84 of 199

Notes to the financial statements:

• An ordinary dividend of R733 000 was declared in 2013 and R758 000 in 2012.
• Revenue relates to credit sales only.
• Cost of sale is assumed to represent annual purchases.

You have obtained the following data from the Stock Market at SARA’s year-end:

• Closing share price for 2013: 3,97

• Closing share price for 2012: 3,05

Required:

Calculate and interpret the various ratios of SARA (Ltd).

3.12.1 Profitability ratios

Profitability refers to the efficiency with which an organisation utilizes its capital to generate
turnover. In other words, how well does the organisation use the capital invested in its
assets to generate sales? The two most common measures of profitability are:

• Return on assets (ROA) ratio measures how efficiently the total assets of an
organisation are utilised to generate turnover. The higher the firm’s return on total
assets, the better.

• Return on equity (ROE) ratio indicates the return generated on the total equity
invested in the organisation.

General points:

One method of interpreting ratios is to look at how the ratio was calculated, that is, the
numerator and denominator. For example, if ROA is low, there can be two things causing it
to be low: either the profit after tax is low, or total assets are too high. If profit after tax is
low, then you can refer to the profit margin ratios (statement of comprehensive income) to

IMM Graduate School Study Guide (FM202B) Page 85 of 199

investigate this further. If the total assets are too high, there may be inefficiencies, you can
refer to the turnover ratios to investigate the assets more. This same method can be applied
to ROE and all other ratios that you are required to calculate and interpret in this unit. From
this understanding, it is important to note that ratios cannot be interpreted in isolation, as
all ratios are connected to each other. Remember, think like an analyst, and investigate the
WHOLE case of the organisation.

Solution to SARA:

Profitability ratios: SARA(Ltd)

Returns on assets (ROA): 2013 2012

Profit after tax 66 100 67 575

Total assets 837 100 794 000

Remember with ratios 0.0789… x 100 = 0.08510… x 100 = 8.51%

expressed as a % the answer 7.90%
is ‘x 100’ to get the decimal
to a %.

Returns on equity (ROE):

Profit after tax 66 100 67 575

Total equity 446 000 402 300

14.82% 16.80%

Comment:

• Return on assets may be improved if the receivables are reduced.

• Return on equity is quite low considering the amount of financial leverage.
Shareholders may be unhappy with this return mainly due to the high operational
inefficiencies.

3.12.2 Profit Margins

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Profit margins enable analysts to evaluate the organisations profits with respect to a given
level of turnover. Without profits, a firm could not attract outside capital and therefore
great importance is placed on boosting profits.

• Gross profit (GP) margin measures the percentage of each sales rand remaining after
the firm has paid for its goods.

• Operating profit (OP) margin is the percentage of turnover that is realised as a profit
after we made provision for all operating expenses, that is, expenses over and above
cost of sales other than interest and taxes.

• Net profit (NP) margin is the final profit after interest and taxes have been paid. This
margin is important because it indicates what profit is available for distribution to
investors. The net profit can be paid out as ordinary or preference dividends, or it may
also be reinvested in the organisation (retained earnings) so as to build up reserves.

General points:

Take note that profit margins just deal with the statement of profit and loss. If there is a
problem in the statement of profit and loss, it is because either revenue/sales are too low or
expenses are too high.

There could be a number of reasons why revenue/sales are low. For example, a downturn in
the economy, low investments into successful marketing or possibly inefficiencies in the
assets, more specifically current assets. Remember assets must ‘work’ for the organisation
in order to generate revenues/sales. If there is a problem with the assets, it could translate
into poor revenue/sales and thus low profits.

Expenses could be high due to high cost of sales. The current suppliers to the firm may not
be the best with regards to price, but their quality could be the best. In some cases, some
organisations have low gross profit margins due to the type of product they sell, for

IMM Graduate School Study Guide (FM202B) Page 87 of 199

example, food retailers cannot have high profit margins. Operational expenses may also be
too high, again relating to asset inefficiencies or poor management controls. Lastly, finance
costs could be high due to the high usage of short-term credit which, if too high, may be a
very ineffective form of financing.

Solution to SARA:

Profit Margins: SARA (Ltd)

2013 2012

Gross profit margin:

Gross profit 431 500 412 300

Turnover 784 700 753 200

54.99% 54.74%

Operating profit margin:

Operating profit 97 600 99 100

Turnover 784 700 753 200

12.44% 13.16%

Net profit margin:

Profit after tax 66 100 67 575

Turnover 784 700 753 200

8.42% 8.97%

Comment:

• Among the 3 profit margin ratios the reduction in the gross margin to the operating
margin is a major concern, almost a 40% reduction. Operational expenses may be too
high and this may demand an investigation as to the cause thereof.

3.12.3 Turnover ratios

This group of ratios is designed to measure how effectively management is utilizing the
firm’s assets. In particular, the asset management ratios seek to ascertain whether the

IMM Graduate School Study Guide (FM202B) Page 88 of 199

investment in assets is justified in relation to activity as measured by turnover (sales
income).
• Total asset turnover ratio is an indication of the efficiency with which an
organisation’s total assets are utilised to generate turnover.

• Trade receivables turnover ratio indicates the number of times per year that the
investment in the organisation’s trade receivables is converted into turnover.

• Trade receivables turnover time shows the time it takes to convert the investment in
trade receivables into turnover (i.e. how long does it take customers who buy on
credit on average to repay their accounts). This ratio is useful in evaluating the firm’s
credit and collection policies.

Note: Trade receivables are also referred to as debtors.

• Trade payables turnover ratio indicates the efficiency with which an organisation uses
trade payables to finance its purchases. In other words, it’s the number of times per
year that the average trade payable balance makes up the total annual purchases. The
‘purchases’ of inventory which is used in this ratio is not usually included in the
published financial statements. One could however estimate this figure by considering
the opening and closing inventory balances and the cost of sales figure.

If however there is no such information to calculate the purchases, the cost of sales figure
must be used.

IMM Graduate School Study Guide (FM202B) Page 89 of 199

• Trade payables turnover time indicates the average time that it takes before the
trade payables are repaid.

Note: Trade payables are also referred to as creditors.

General points:
• Asset turnover:

Here we see how much revenue/sale ever R1 in assets can generate for us. We would want
the ratio to at least be 1 times, that is for every R1 invested in assets the organisation is
generating R1 in revenue/sales. It is important to check if the organisation is asset intensive.
For example, a mining organisation may have a 1 times ratio and a consulting organisation a
2 times ratio. It’s not to say the consulting organisation is better, the consulting organisation
may not be so asset intensive as the mining organisation and thus the asset turnover and
even the ROA may be distorted.

• Receivables:

Receivables is an asset, it is money that is yet to be paid to the organisation. It is important

as in most cases, customers buy on credit and if an organisation did not offer the credit, it
would lose out on a large portion of its customers. However, this asset must be monitored
carefully. If the asset becomes too high, it starts causing a few problems. Firstly, it is an asset
and assets need to be financed. This financing is at a cost to the organisation, thus
increasing expanses. Secondly, it is ‘siting money’. There is a major opportunity cost here as
an organisation can use that money more effectively, for example, an expansion. Lastly,
there is a major risk attached to this asset. There is a possibility that an organisation may
not receive the cash that is owed to them at all – credit default risk – which again will be a
major cost to the organisation (bad debts). This is why it is important for an organisation to
have a healthy credit system that allows customers credit enough to increase revenue/sales
but not enough to cost the organisation.

• Payables:

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Payables, in theory, can be called ‘free financing’ as it is credit (which is funding current
assets, namely inventory) extended to an organisation by its suppliers. Due to this free or
rather cheap financing, it is important to use this to its maximum benefit, such as paying
suppliers on the last day of payment. However, caution must be taken to not damage
suppler relations or incur penalties for late payments. One should also consider the
relationship between the payables days and the receivables days. We would want to be able
to recover money from our customers in time to settle our accounts with suppliers.

• Inventory:

Inventory levels can be high or low, depending on what type of organisation it is and where
they are in the business cycle. The main concern with inventory is whether an organisation
is moving it or not? If there are low levels of turnover, there may be a possibility that there
is too much inventory on hand and therefore a risk of having outdated stock and/or high
levels of inefficiencies in inventory management may exist. On the other hand, if inventory
turnover is high there may also be inefficiencies with regards to economies of scale
(assuming the organisation is not using modern costing techniques such as Just In Time (JIT)
inventory management). In other words, we may be losing out on potential sales by not
stocking enough of the inventory etc.

Solution to SARA:

Turnover Ratios: SARA (Ltd)

2013 2012
Total Asset turnover:
Turnover 784 700 753 200
Total assets 837 100 794 000
0.94 Times 0.95 Times
Trade receivables turnover ratio
Turnover 784 700 753 200
Trade receivables 527 800 501 800
1.49 Times 1.50 Times
Trade receivables turnover time

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 Trade receivables 527 800 501 800
Turnover/365 784 700/365 753 200/365
245.50 Days 243.17 Days
Trade payables turnover ratio
Purchases 353 200 340 900
Trade payables 63 500 61 500
5.56 Times 5.54 Times
Average payment period:
Trade payables 63 500 61 500
Purchases/365 353 200/365 340 900/365
65.62 Days 65.85 Days
Inventory turnover:
Cost of sales 353 200 340 900
Inventory 86 700 82 600
4.07 Times 4.13 Times
Inventory turnover time:
Inventory 86 700 82 600
Cost of sales/365 353 200/365 340 900/365
89. 60 Days 88.44 Days

Comment:

• Their asset turnover is very low – not even covering itself once. This may be due to the
high level of receivables that are stagnant in their books. If the trade receivables are
reduced, there will be a higher asset turnover, which will also be a more accurate
representation of what operations in the organisation.
• The collection period is extremely high; SARA must review its credit policies. This could
be one of the man contributing factors to the high level of trade receivables.
Customers are not paying.

IMM Graduate School Study Guide (FM202B) Page 92 of 199

• The payables period seems to be consistent; however, there is no indication of the
supplier’s credit terms. If supplies are providing a 60-day credit policy, SARA must pay
within 60 days or there will be adverse effect on their suppler relations.
• There is a 4 times turnover of inventory, considering that SARA is a fashion retail
organisation this 4 times may be indicating the change in inventory due to the change
season, which may be the norm.

3.12.4 Liquidity ratios

Organisations must take care not to invest all the funds obtained in non-current long-term
assets. Since payments take place regularly, firms must keep so-called liquid assets that can
be converted into money easily, so that the necessary payments can be made in time.

The concept of liquidity indicates the ongoing ability of a business to meet its current
obligations on time.

• Current ratio compares an organisation’s current assets to its current liabilities and is
an indication of the firm’s ability to meet its short-term obligations. Generally, the
higher this ratio the more liquid the firm is considered to be.

• Quick ratio also referred to as the acid-test ratio, compares an organisation’s current
assets less inventory/stock to its current liabilities. The reason why it excludes
inventory is because inventory is the least liquid form of current asset. The quick ratio
provides a better measure of liquidity when the organisations inventory can be easily
converted into cash. If the inventory is liquid, then the current ratio is the preferred
measure of overall liquidity.

General points:

The liquidly state of an organisation is vitally important for healthy asset utilisation and
correct usage of current liabilities. Ideally, we would want to have more current assets then
current liabilities. In some cases, the ratios could be conservative i.e. considerably more

IMM Graduate School Study Guide (FM202B) Page 93 of 199

assets than liabilities, which could be good or bad. Conservative could mean a variety of
things (again, looking at the numerators and denominators of the two ratios to see what is
causing what) such as too many current assets (asset inefficiencies) too much cash in the
bank or possibly underutilisation of current liabilities. However, there may also be reasons
for the conservativeness, such as seasonal fluctuations in demand/inventory. Other cases
may be when the ratios are aggressive, with a low asset to liability ratio. Again, it could be
good or bad. Aggressive levels may mean that there is high level of efficiencies in the
operations however; the organisation is running a high risk of not covering its short-term
liabilities or not have sufficient inventory on hand for operations/sales.

Solution to SARA:

Liquidity Ratios
2013 2012
Current ratio:
Current assets 697 700 662 100
Current liabilities 128 700 129 600
5.42 OR 5.42:1 5.11 OR 5.11:1

Quick Ratio:
Current assets – inventory 697 700 – 86 700 662 100 – 82 600
Current liabilities 128 700 129 600
4.75 OR 4.75:1 4.47 OR 4.47:1

Comment:
• Both the current and quick ratios are extremely conservative (high) and increasingly
so.
• This may indicate that that SARA is using long term financing to finance their working
capital.
• However, on investigation their trade receivables are extremely high and represent
5/8 of their assets.

IMM Graduate School Study Guide (FM202B) Page 94 of 199

• This represents a major opportunity cost to SARA, as they will have to fund that large
amount of sales that have not been received in cash.

3.12.5 Solvency ratios

Solvency refers to an organisation’s ability to cover its obligations when it closes down its
operating activities. The debt position is also an indication of the amount of other people’s
money being used to generate profits. The more debt a firm has, the greater the risk of
being unable to meet its contractual payments.

• Debt to assets ratio indicates how much debt the organisation has taken on to finance
its total assets. The higher the value the weaker the business’s solvency position.

• Debt to equity ratio is another way of viewing an organisation’s solvency by

comparing the amount of debt capital to equity capital.

• Finance cost coverage measures the firm’s ability to make contractual interest
payments. If the firm does not pay the finance cost on its debt, the debt capital
providers can take legal action to collect it.
( )

General points:

Please refer to the ‘financial gearing’ section in the end of this unit and in your textbook
for more understanding of these concepts.

Solvency ratios measure the financial risk of an organisation, that is, how much debt is used
in the organisations capital structure to finance its assets. The higher the debt the higher the
financial risk! So what – why is there a relationship? The more debt an organisation uses the
more fixed interest payments it must make in a year, thus increase the breakeven point of
the organisation, that is, the organisation has to increase revenue in order for it to pay its
obligations (fixed interest payments to services the debt), putting pressure on its

IMM Graduate School Study Guide (FM202B) Page 95 of 199

performance – that pressure is the risk element. Organisations can have high financial risk
(high levels of debt and interest payments) if they can afford it. The affordability is
measured by a high finance cost coverage and low business risk (the risk associated to cash
generation is low i.e. is easy to make money).

Solution to SARA:

Solvency ratios: SARA (Ltd)

2013 2012
Debt to asset ratio:
Total debt 391 100 391 700
Total assets 837 100 794 000
0.4672 OR 46.72% 0.4933 OR 49.33%
Debt to equity ratio
Total debt 391 100 391 700
Total equity 446 000 402 300
0.8769 OR 87.69% 97.37 OR 97.37%
Finance cost coverage ratio:
Earnings before interest and tax 97 600 99 100
Finance cost 10 000 9 000
9.76 Times 11.01 Times

Comment:

• SARA has a high level of financial leverage; this may be acceptable as the business risk
profile of SARA (retail organisation) is fairly low.
• Despite the high level of debt, SARA does show supporting earnings to meet the
obligations of debt providers.

3.12.6 Investment ratios

Market value ratios indicate the relationship of the firm’s share price to dividends and
earnings. They are strong indicators of what investors think of the firm’s past performance
and future prospects. If the firm’s liquidity, asset management, debt management and

IMM Graduate School Study Guide (FM202B) Page 96 of 199

profitability ratios are all good, investors will value the shares of the firm highly and the
market value ratios will be high.
• Earnings per share (EPS) ratio is an indication of the attributable earnings that were
earned per ordinary share during a year. In other words, what return did I receive for
every share that I hold?

• Dividends per share (DPS) ratio is the actual dividend amount ordinary shareholders
receive for every share they hold.

• Price earnings (P/E) ratio indicates how many Rands investors are prepared to pay for
each R1 EPS that is earned by the organisation. The level of this ratio indicates the
degree of confidence that investors have in the firm’s future performance. The higher
the P/E ratio the greater the investor confidence.

General points:

Naturally, an investor would want high and growing EPS. DPS may not always be as high as
EPS as the organisation may retain funds for investment purposes. In some cases, the DPS
may be higher the EPS as the organisation pays DPS out of retain earnings.

Solution to SARA

Investment ratios: SARA (LTD)

2013 2012
Earnings per share:
Profit after tax - pref. div. 66 100 67 575
Number of ordinary shares 31 300 31 300
R2.11 R2.16

IMM Graduate School Study Guide (FM202B) Page 97 of 199

Dividends per share
Ordinary dividends 733 000 758 000
Number of ordinary shares 31 300 31 300
R23.42 per share R24.22 per share
Price earning (P/E) ratio:
Price per share 3,97 3,05
Earnings per share R2.11 R2.16
1.88 1.41

Comment:
• The PE ratio along with the organisation share price has increased showing high
investor confidence.

3.13 Financial gearing

Financial gearing refers to the usage and effect of using debt capital (as a source of long
term financing to finance the organisations assets) on the shareholders’ equity. The usage of
debt financing in the long-term capital structure of an organisation is referred financial
leverage.

Note: The concept of financial leverage is also dealt with in unit 5 and is thus important that
students acquire a basic undemanding of this concept now.

Debt management plays a role in financial management and the extent of financial leverage
of a firm has a number of implications. Firstly, the more financial leverage the firm has the
higher the financial risk will be. This is measured by either the debt to assets ratio or the
debt to equity ratio.

As more debt financing is incurred, more interest, a fixed cost, is expected. Thus, the
increase in fixed costs (interest payments) will result in the earnings of the organisation to
become more volatile i.e. a higher breakeven point. This is measured by the finance cost
coverage ratio.

IMM Graduate School Study Guide (FM202B) Page 98 of 199

The higher breakeven point creates financial risk, however additional risk yields additional
return and if the firm earns more on borrowed funds than it pays in interest, the return on
owner’s equity is magnified. Finally, by raising funds through debt, the shareholders can
obtain finance without losing control of the firm.

Please refer to the example in section 3.12 in your textbook for an illustrated
example on financial gearing.

Note: Section 3.13 in your textbook is only for reading purposes.

Now that you have completed study unit 3 it is advisable to work through the multiple-
choice and longer questions at the end of chapter 2 and 3. Answers to these questions can
be found at the back of the textbook.

Study Unit 3 – Revision Exercises

Exercises:
Chapter 2

Attempt all the multiple-choice questions in the textbook. Longer questions 1, 2 and 3
(excluding statement of cash flows) in textbook.

Chapter 3

Longer questions 1, 2 and 3. Only attempt those ratios that are given in this study guide.

The following question should also be attempted:

Question 1

You are the loan officer at BankBest Bank (BBB). Your main responsibility is to review
applications for loans.

You are at present reviewing an application by the Hammer Tools Company (HTC). HTC
manufactures various types of high quality punching and deep-drawing press tools for

IMM Graduate School Study Guide (FM202B) Page 99 of 199

kitchen appliance manufacturers. John Smith, the financial manager of HTC, has submitted
a justification to support the application for a short-term loan from BBB to finance an
increase in revenue from 2011 to 2012.

An extract of the statement of profit and loss and statement of financial position of HTC,
submitted with the justification to BBB, are provided below:

Extract of the Statement of Profit and Loss

of Hammer Tools Company for the year ended 31 December 2012
2012 2011
R’000 R’000
Revenue (all credit) 45 000 40 909
Cost of sales (23 000) (20 909)
Gross profit 22 000 20 000
Selling and admin expenses (13 000) (11 818)
Other expenses (depreciation) (3 000) (2 000)
Finance costs (412) (400)
Profit before tax 5 588 5 782
Income tax expense (2 235) (2 313)
Profit for the year 3 353 3 469

An ordinary dividend of R733 000 was declared in 2012 and R758 000 in 2011.

Statement of Financial Position of Hammer Tools Company as at 31 December 2012

2012 2011
R’000 R’000
ASSETS
Non-current assets
Land 1 000 1 000
Plant and equipment at carrying amount 18 000 16 000

Plant and equipment at cost 31 000 26 000

Accumulated depreciation (13 000) (10 000)

IMM Graduate School Study Guide (FM202B) Page 100 of 199

Current assets
Inventories 5 220 5 000
Trade receivables 7 600 6 000
Cash and cash equivalents 1 800 2 000

TOTAL ASSETS 33 620 30 000

EQUITY AND LIABILITIES
Equity attributable to equity holders
Issued ordinary share capital 4 000 4 000
Retained earnings 16 620 14 000
Non-current liabilities
Debentures 4 000 4 000
Current liabilities
Trade payables 2 600 2 000
Accrued expenses 6 400 6 000

TOTAL EQUITY AND LIABILITIES 33 620 30 000

You have obtained the following industry averages:

Gross profit margin 50%

Operating profit margin 15%
Net profit margin 8%
Return on assets 10%
Return on equity 20%
Current ratio 1.5
Quick ratio 1.0
Debt : Total assets 0.5
Finance cost coverage 25
Trade receivables turnover time 45 days
Asset turnover 1.6

Required:

IMM Graduate School Study Guide (FM202B) Page 101 of 199

Prepare a memorandum to submit to your boss, as to whether finance should be granted to
Hammer Tools Company (HTC). Show all calculations.

Study Unit 3 – Revision Exercises Solutions:

Refer to suggested solutions at the end of this study guide (Addendum C). It is however
advised that learners attempt to respond to the questions first by themselves before
accessing the solutions for effective learning to take place.

IMM Graduate School Study Guide (FM202B) Page 102 of 199

 Progress check

You have come to the end of Study Unit 3.

Time to do a progress check to determine whether you have gone through all the required
content, completed all the exercises.

IMM Graduate School Study Guide (FM202B) Page 103 of 199

Your Progress Checklist YES / NO?

Did you read through each study unit outcome?

Did you go through all learning material

Did you complete all the relevant revision exercises and check your answers
against the answers provided?

At this point, you should be able to:

• Discuss the objective of financial reporting

• Review the key contents of income statement and Balance sheet
• Identify the stakeholders/users of financial statements and their
specific interest
• Use financial ratio to analyse the organization’s profitability, profit
margins, activity, liquidity and solvency position accordingly
• Discuss gearing and its effect to the shareholders and debt funders.

Are you ready to tackle questions relevant to Study Unit 3 in Assignment 1?

Complete assignment 1, question 3

IMM Graduate School Study Guide (FM202B) Page 104 of 199

SECTION C
SUBMISSION OF ASSIGNMENT Two
WEEK 7 – 12:

STUDY UNIT 4

Study Unit 4: Short-term financial decisions

Study Unit 4 - Relevance

In study unit 4, we will focus on the importance of short-term capital management, which
ensures that an entity is able to perform its daily operational requirement and conduct
business successfully. As a marketer, you need to understand credit selection and
monitoring because sales will be affected by the availability of credit to purchasers. Sales
will also be affected by inventory management.

“Turnover is vanity, profit is sanity, and cash is reality.”

Banker’s mantra

IMM Graduate School Study Guide (FM202B) Page 105 of 199

 Study Unit 4 – Module Outcomes

Let’s recap the relevant module outcome for this study unit

MO 4 Carry out short-term financial decisions required for a business to conduct

business successfully

Study Unit 1 – Key Concepts

Let’s recap what the relevant module learning outcome is for this study unit:
• Explain the terms and elements of working capital management
• Understand working capital management and net working capital
• Discuss and calculate the operating and cash conversion cycles and their respective
funding requirements
• Prepare and interpret a cash budget
• Discuss inventory management systems
• Demonstrate the ability to manage accounts receivables including relaxing and
tightening credit standards
• Discuss payables management and its importance thereof

Study Unit 4 – Glossary of Terms

Working capital – a pool of current assets that are in use to empower and organisation to
conduct its daily operations.

Liquidity – the ability of an asset to be converted into cash with having to lower its present
value in order to create a market for it.

IMM Graduate School Study Guide (FM202B) Page 106 of 199

Creditors/payables – an organisation to which another organisation owes money to in the
short term.
Debtors/accounts receivables – money owed to an organisation by its customers

Study Plan Progress

Week 7 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Explain the terms Complete Sign-up for Week 7

and elements of revision eLearn – 12.5 Hours

working capital exercises Consult eLibrary
management Obtained
 Understand working feedback
capital management
and net working
capital

Week 8 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Discuss and Complete Sign-up for eLearn Week 8

calculate the revision Consult eLibrary – 12.5 Hours

operating and cash exercises Obtained
conversion cycles feedback
and their respective

IMM Graduate School Study Guide (FM202B) Page 107 of 199

Key concepts Activities Material used / Time / Week Progress
completed accessed / check
assistance

funding
requirements
 Prepare and
interpret a cash
budget

Week 9 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Discuss inventory Complete Sign-up for Week 9

management revision eLearn – 12.5 Hours

systems exercises Consult eLibrary
 Demonstrate the Obtained
ability to manage feedback
accounts receivables
including relaxing
and tightening credit
standards

 Discuss payables
management and its
importance thereof

4. Study Unit 4 – Content

4.1 Introduction

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In unit 1 you were introduced you to the three financial management decisions i.e. capital
budgeting, capital structuring and working capital management. Our focus in this section is
on the management of the short-term assets and liabilities of the firm, also referred to as
short-term (working) capital management. This includes the management of all assets that
are to be sold or converted into cash within the next 12 months, as well liabilities that need
to be paid within 12 months.

4.2 What is working capital?

Working capital refers to the current assets and

current liabilities that the firm uses in its day-
to-day operations. Current assets include
inventory, accounts receivable, marketable
securities, and cash, while current liabilities
include notes payable, accruals, and accounts
payable.

4.3 Net working capital

Net working capital is commonly defined as the difference between current assets and
current liabilities. A positive net working balance is when the current assets exceed the
current liabilities. As expected, a negative net working capital balance is when current
liabilities exceed current assets. Firms thus strive to maintain a positive net working capital.

As marketers, we sometimes get obsessed with driving sales, while finance managers get
obsessed with managing costs, however from a working capital perspective both efforts are
futile if no actual payment is received for the goods or services sold. Firms thus need to
convert their current assets from inventory to receivables to cash as quickly as possible so
that it can be used to pay current liabilities.

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4.4 Why is it important to manage working capital?

As mentioned, firms require a positive net working capital so that they can meet their
current liabilities. As the saying goes, “Cash is King”, therefore firms need to ensure liquidity
for short-term financial decision making. A shortage in working capital can affect an
organisation in different ways. Customer service can be effected if not enough stock is
available to meet customers’ demands. However, too much stock means that cash is tied up
and there is a risk that stock may become dated. As previously mentioned a sale is worthless
if payment is not received from outstanding debtors.

From a current liabilities perspective, a firm needs to manage their accounts payable to
ensure good supplier relationships. If a
firm is unable to meet its current
liabilities their credit ratings could be
affected and the ability to obtain credit
in future.

4.5 The cash conversion cycle

The cash conversion cycle is the amount of time a firm’s resources are tied up. It is
calculated by subtracting the average payment period from the operating cycle. The
operating cycle is the time from the beginning of the production process to the collection of
cash from the sale of the finished product.

Graphically, it can be illustrated as follows:

IMM Graduate School Study Guide (FM202B) Page 110 of 199

A = pay accounts payable

B = sell finished goods on account

C = collect accounts receivable

D = average age of inventory (AAI)

E = average collection period (ACP)

F = average payment period (APP)

G = cash conversion cycle (CCC) where:

H = operating cycle (OC)

Revision Question

The following information was extracted from the financial statements of VIP Ltd for the
year ended 30 June 2014:

Sales (30% for cash) 1 700 000

Cost of goods sold 1 360 000

Purchases (all on credit) 965 000

Accounts receivable 125 000

Accounts payable 114 000

Inventory (1 July 2013) 622 000

Required:

Calculate the following:

a) Average age of inventory
b) Average collection period

IMM Graduate School Study Guide (FM202B) Page 111 of 199

c) Average payments period
d) Cash conversion cycle

Solution:

a)

Note: Inventory being referred to here is “closing inventory”

= 60.922 = 61 days

Cost of sales = opening inventory + Purchases – closing inventory

R1 360 000 = R622 000 + R965 000 – closing inventory

CI = R227 000

b)

= 38.34 = 38 days

Credit sales = R1 700 000 x 70%

= R1 190 000

c)

IMM Graduate School Study Guide (FM202B) Page 112 of 199

 = 43.119 = 43 days

d)

= 61 + 38 – 43 = 56 days

Exam tip: Know how to calculate the full cash conversion cycles as well as it
various components.

4.6 Managing cash

Current assets comprise of inventory, accounts

receivable and cash. Cash is naturally the most
liquid current asset as it is already in cash form
and thus available for use in transactions.

A cash budget depicts the expected cash inflows

and outflows of an organisation over a specific period and ensures that there is sufficient
cash on hand for daily transactions and operations. A cash surplus is the result of spending
less cash than what is available, while a cash deficit is the result of spending more cash than
is available.

Thus, the purpose of the cash budget is to plan its expenditure in advance so that a cash
deficit can be avoided.

Please work through example 14.3 in the textbook with regards to preparing a cash
budget

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4.7 Managing inventory

As marketers, we can create demand for our

product through smart advertising and
marketing campaigns however, it may be all
in vein if there is no inventory to meet the
demand. Thus, the need for inventory is
crucial.

Therefore, while no inventory or limited

inventory is a bad thing it’s important to
note that too much inventory is also a bad thing as working capital can be tied up in too
much inventory. So what is the optimum inventory quantity and when exactly should we be
reordering? These questions can be answered by making use of the economic order
quantity (EOQ) model and the reorder point calculation.

Please refer to the textbook and work through the calculating EOQ formula and the
reorder point.

Other techniques for managing inventory include:

• The ABC system that divides inventory into three groups – A, B and C, in descending
order of importance and level of monitoring.
• The Just-in-Time system that minimises inventory management by having materials
arrive at exactly the time they are needed for production.
• Computerised systems such as the materials requirement planning (MRP) and
enterprise resource planning (ERP).

4.8 Managing accounts receivable (debtors)

Another area where working capital can be tied up in is accounts receivable. Again, it’s
important to understand that while a sale may have taken place, from a working capital

IMM Graduate School Study Guide (FM202B) Page 114 of 199

point of view it’s of no worth until payment is received. Manufacturers and suppliers of
goods or services tend to extend a line of credit to their customers. In other words, they
offer them payment terms. The norm tends to be 30 days. So customers have 30 days to pay
for the goods or services.

While an organisation will hope to attract customers by offering them credit terms, it’s
important to ensure that these customers do pay their debts. Amounts not paid will need to
be written off as bad debts. Thus, it is important to minimise the likelihood of doubtful
debts and the best way to manage this is at source, in other words ensuring the
creditworthiness of their customers. Accomplishing this goal entails the setting of credit
selection and standards and determining credit terms.

Please refer to your textbook in terms of a establishing a credit policy and in particular the
five C’s of creditworthiness. You also need to understand and be able to calculate the
effect of tightening (or relaxing) credit standards on the firm’s profit. Work through
example 14.5 in your prescribed textbook.

4.9 Managing accounts payable (creditors)

While we may offer our customers a line of credit so too can our suppliers also offer us a
line of credit. This is deemed a form of short-term financing. By not having to pay for
purchases immediately, firms have more cash on hand thus impacting favourably on the
cash conversion cycle.

Sound management of accounts payable (creditors) can also increase the firm’s working
capital. You need to be able by means of a simple calculation establish whether it is cheaper
for the firm to borrow from the bank and pay cash for purchases or to ‘borrow’ from the
supplier by buying on credit.

IMM Graduate School Study Guide (FM202B) Page 115 of 199

Now that you have completed study unit 4 it is advisable to work through the multiple-
choice and longer questions at the end of chapter 1 and 7. Answers to these questions can
be found at the back of the textbook.

Revision Exercises:

Questions
The following questions should also be attempted:

Question 1

High Stakes Traders produces gambling equipment. They have an inventory turnover of 9
times a year (which is 40 days), an average collection period of 35 days and an average
payment period of 45 days. The firm’s annual sales are R2 000 000 of which 60% is cost of
goods sold, and purchases are 55% of cost of goods sold. (Assume a 360-day year for your
calculations)

Required:

IMM Graduate School Study Guide (FM202B) Page 116 of 199

1.1 Calculate the Operating Cycle of the business

1.2 Calculate the Cash conversion cycle of business

Question 2

You assist companies, in your spare time, to manage their working capital as you realised
that working capital management is an integral part of financial management. One of your
clients, Rayman Ltd, wants you to assist them in looking into different working capital
financing policies as well as cash management. Rayman Ltd, a manufacturer of affordable
sunglasses supplied you with an extract from their balance sheet as at 30 June 2012:

Current asset R

Inventor 93 750
Accounts receivable 62 750

Cash 15 825

Current liabilities

Accounts payable 120 400

They also supplied the following additional information:

1) Total sales for the year amounted to R 580 000. All sales are on credit.

2) The gross profit percentage is 25%.

3) The balance of the inventory account at the beginning of the year was R 63 150.
Required:

2.1 Calculate the cash conversion cycle of Rayman Ltd. Assume 365 days per year.

2.2 Explain to your client three ways how they can improve their cash conversion
cycle.

IMM Graduate School Study Guide (FM202B) Page 117 of 199

 Revision Exercises Solutions

Refer to suggested solutions at the end of this study guide (Addendum C). It is however
advised that learners attempt to respond to the questions first by themselves before
accessing the solutions for effective learning to take place.

IMM Graduate School Study Guide (FM202B) Page 118 of 199

 Study unit 4 – Progress check

You have come to the end of study unit 4.

Time to do a progress check to determine whether you have completed the required
content and exercises.

IMM Graduate School Study Guide (FM202B) Page 119 of 199

Your Progress Checklist YES/NO?

Did you read through each study unit outcome?

Did you go through all learning material?

Did you complete all the relevant revision exercises and check your
answers against the answers provided?

At this point, you should be able to:

• Explain the terms and elements of working capital management
• Understand working capital management and net working capital
• Discuss and calculate the operating and cash conversion cycles and
their respective funding requirements
• Prepare and interpret a cash budget
• Discuss inventory management systems
• Demonstrate the ability to manage accounts receivables including
relaxing and tightening credit standards
• Discuss payables management and its importance thereof

Are you ready to tackle questions relevant to Study Unit 4 in Assignment

2?

Complete Assignment 2, question 1

IMM Graduate School Study Guide (FM202B) Page 120 of 199

STUDY UNIT 5

Study unit 5: Long-term financial decisions

Study Unit 5 – Relevance

This unit addresses two key financial issues namely the cost of capital as well as the capital
structure of an organisation. Firstly, we will look at how debt and equity can be used as
sources of financing as well as how to calculate the cost of debt and equity. Secondly, we
will get to understand the concept of weighted average cost of capital. Lastly, we explore
the optimal capital structure for an organisation. Marketers need to understand the
organisation’s cost of capital because projects that are being looked at must earn returns
that are more than the ‘cost’ of capital to be acceptable. Marketers also need to understand
the capital structure of the organisation and the role financial leverage plays in the optimal
capital structure of an organisation.

“No matter how great the talent or effort, some things just take. You can’t produce a baby
in one month by making nine women pregnant.”

Warren Buffet - Business magnate, investor and philanthropist

IMM Graduate School Study Guide (FM202B) Page 121 of 199

 Study Unit 5 – Module Outcomes

Let’s recap the relevant module outcomes for this study unit

MO 5 Carry out long-term financial decisions

Study unit 5 – Key concepts

Let’s recap what the relevant module learning outcomes are for this study unit.
After completing this study unit, you should be able to:

• Demonstrate a clear understanding of cost of capital and its specific sources

• Be sufficiently familiar with computation of cost of equity
• Be sufficiently familiar with computation of cost of debt
• Understand the concept of weighted average cost of capital (WACC)
• Calculated the WACC and discuss the concept of optimal capital structure

Study unit 5 – Glossary of Terms

Capital structure – the mixture of different types of long term debt and equity financing

Cost of capital – the return required by the providers of long term capital

Gearing – the use of debt financing in the long term capital structure of an organisation

Optimal capital structure – the capital structure that results in the lowest possible WACC

Weighted average cost of capital – the overall cost of capital of an organisation based on
the cost of each source of finance weighted on a suitable proportional basis, such as market
value or book value

IMM Graduate School Study Guide (FM202B) Page 122 of 199

 Study Plan Progress

Week 10 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Demonstrate a clear Complete Sign-up for Week 9

understanding of revision eLearn – 12.5 Hours

cost of capital and its exercises Consult eLibrary
specific sources Obtained
 Be sufficiently feedback
familiar with
computation of cost
of equity

Week 11 Time allocation: 12.5 hours

Key concepts Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Be sufficiently Complete Sign-up for Week 10

familiar with revision eLearn – 12.5 Hours

computation of cost exercises Consult eLibrary
of debt Obtained
 Understand the feedback
concept of weighted
average cost of
capital (WACC)

IMM Graduate School Study Guide (FM202B) Page 123 of 199

Key concepts Activities Material used / Time / Week Progress
completed accessed / check
assistance

 Calculated the
WACC and discuss
the

5. Study Unit 5 - Content

5.1 Introduction
When looking at a statement of financial position as illustrated in figure 5.1 we see that an
organisation has a set of assets (left) which is financed by a pool of funds namely debt and
equity (right).

Equity
Assets
Debt

Figure 5.1: A pool of capital finances the assets of an organisation

This pool of funds (right side) is also known as the long-term capital structure, which is a
mixture of debt and equity. In some rare cases, it may be just one of the two elements. This
long-term capital (right side) requires a return that must be generated by the assets (left
side). This is illustrated in figure 5.2. Long term capital (made up of ‘non-current’ elements
in the statement of financial position) are sources that are intended to be used for five or
more years as opposed to medium term financing with a maturity of between one to five
years and short term financing with a maturity of up to one year (made up of ‘current’
elements in the statement of financial position).

IMM Graduate School Study Guide (FM202B) Page 124 of 199

 Equity
Assets
Debt

Figure 5.2: Assets must generate a required return to service the long-term capital

In this unit, you will work through the theoretical aspects and the calculations of the costs of
the different sources of long-term capital financing. It is essential for any business
practitioner to be conscious of this ‘cost of long term capital’ as the assets in a business
must at minimum create a return in order to cover the use of capital. Any return generated
after the return required by the capital may indicate that the assets are creating value for
the shareholders – thus achieving the goal of maximising shareholder wealth.

Study Els (2014, Chapters 12)

5.2 Equity verses debt

We begin with chapter 12 in order to gain a theoretical understating of the basic types of
long-term capital. There are two main sources of long-term capital that are available to
finance the assets of an organisation, that is, equity and debt. Furthermore, equity sources
may be internal (use of own generated funds) or external (raising new funds).

5.3 Equity as a source of financing

Equity has three main forms it can take which are summarised in table 5.1 which follow:

IMM Graduate School Study Guide (FM202B) Page 125 of 199

Table 5.1

Source Type Characteristics

External sources 1.Ordinary shares • Shareholders have ownership rights over

of equity (Class A shares) the organisation
(raised by: • Highest risk as they are paid last in the
prospectors, event of liquidation and/or earnings
offer for sale by distribution
tender, private • Due to their high risk, providers require a
placement higher return over all other forms of
and/or rights capital financing
issue) • Receive a return in the form of dividends
and/or capital growth

2.Preference shares • Shareholders have part ownership of the

(Class B shares) entity
• Second highest risk as they get
preference over ordinary shares in the
case of asset and earnings distribution
but are second in line to debt. The
“preference” is a fixed obligation i.e.
guarantees a fixed rate of dividend to the
holder of such shares in return for the
finance they have provided
• Return is fixed in dividend form
• Types included: convertible, cumulative,
participating and redeemable

Internal sources 3.Retained earnings • Accumulated earnings of the entity

of equity • May be the ‘cheapest’ form of financing
as they are the companies own funds that
require no return. However, they do

IMM Graduate School Study Guide (FM202B) Page 126 of 199

Source Type Characteristics

come at an opportunity cost to

shareholders if it is not paid out as
dividends
• The cost of retained earnings is the same
cost as the cost of ordinary shares

5.4 Debt as a source of financing

Long term debt as compared to equity financing, has got no ownership rights and thus
cannot participate in the management of the company. In other words, a shareholder
(owner), equity, is different from a lender, debt. Debt may take the form of bonds,
debentures and/or mortgage bonds.
As debt has interest payments, these payments are recorded as expenses in the statement
of profit and loss and thus, have a tax benefit, that is, an organisation will pay less tax due to
the increase in expense of interest payments. Remember, tax is calculated on ‘taxable
income’ and these expenses reduce this taxable income, which essentially means less tax.
This tax shield is one of the reasons why debt is a cheaper source of financing over equity.

Another reason is due to the different risk profiles between the two sources of long-term
capital.

Equity, with specific reference to ordinary shares, has a higher risk profile as it only shares in
the profits that remain after;
1) short term debt providers (current liabilities),
2) long term debt providers (non-current liabilities) and
3) preference shares (equity) have been serviced.

Although there is no limit as to what ordinary

share providers can earn, (unlike debt and
preference shares that have fixed amounts of
interest) they are on the bottom of the pecking

IMM Graduate School Study Guide (FM202B) Page 127 of 199

order, and thus have a higher risk. The same situation or pecking order, will apply in the
case of a distribution of assets such as liquidation, again, illustrating the risk ordinary shares
(equity) has.

Liquidation refers to the process by which a company (or segments thereof) is brought to an
end and the assets of the company are redistributed to the capital providers. Debt providers
are first to receive funds/assets from the asset distribution in order to be paid back their
capital that they lent out, thereafter, equity providers receive what is remaining

Furthermore, debt is generally secured over the assets of the business, thus reducing the
risk exposure of the debt providers as equity is not secured. This concept is summarised in
figure 5.2.

The term ‘secured’ in debt financing refers to the case where the borrower of a loan has
pledged certain assets (e.g. property) as collateral for the loan. This collateral serves as
security in the case of the borrower defaulting on payments to the lender.

Low risk to provider – Cheaper to receiving organisation Long term debt

Preference shares

Ordinary shares
High risk to provider – Expensive to receiving organisation

Figure 5.2: Risk and cost scale of long-term financing

Exam tip: Refer to your textbook with regards to the quick guide to debt and
equity financing summary. You may be asked to differentiate between and/or
discuss the advantages and disadvantages of the different sources of long-term
capital financing.

Note: It is not required that a student be able to calculate the theoretical ex-rights price
(TERP) of a share as illustrated in the textbook, chapter 12.

5.5 Medium-term finance

IMM Graduate School Study Guide (FM202B) Page 128 of 199

There are various medium-term financing options available to organisations; these include
leasing, factoring and invoicing discounting.

Exam tip: Know how to compare and contrast between the different types of
medium term finance. However, you will not be asked to do any form of
calculations on medium-term financing.

Study Els (2014, Chapters 11)

5.6 Pooling of funds: the capital structure

In practice, seldom do organisations set aside funds

specifically for individual projects/assets but rather
pool together different sources of long term finance
and use these combined funds to implement various
projects/assets. The pooling of these funds gives rise to
the term, capital structure, which is the combination
and balance of equity and long-term debt financing.

For example, as marketers, we may wish to launch new product lines (an additional asset to
the existing assets of the business) however; we may not have financing available to do so.
Thus, it’s important to understand both the need and cost associated with raising capital.
Raising capital will however come at a price either in the form of interest (debt) or dividend
payments (equity).

5.7 Cost of capital

The cost of capital is the rate of return that an organisation’s providers of long-term capital
require on the funds they have provided.

The cost of capital is in effect interest (debt) or dividends (equity) payments made.
Naturally, we will only borrow money to finance our assets with the intention of using that
money to gain a return that is greater than that of the cost of capital.

IMM Graduate School Study Guide (FM202B) Page 129 of 199

For the purpose of this course, we will focus on the following three components of cost of
capital as follows:
1. Cost of ordinary shareholders’ equity
2. Cost of preference shares
o Non-redeemable
o Redeemable
3. Cost of debt
o Non-redeemable
o Redeemable

Exam tip: Know how to calculate the cost of each form of capital

Note: Calculating the various costs of capital is the first step in calculating the WACC which
we will look at later in this study unit.

5.8 Cost of ordinary shareholder’s equity

Organisations can raise capital by selling off part ownership of their business to investors in
the form of ordinary shares. The cost of ordinary shares can be calculated by either making
use of dividends or the Capital Asset Pricing Model (CAPM).

The dividends models focus on the cash flows that are paid to each share, whereas the
CAPM focus on risk exposure in the market. This is important to note as equity providers
(shareholders) may receive the return on their capital by either dividend payments or
capital growth and in some cases both.

5.8.1 Dividends

Dividends are paid to shareholders as a return for investing their capital in a business. In
other words, it’s a pay-out of earnings to the lenders of funds. Dividend pay-outs are
dependent on an organisation’s dividend policy, which could withhold part of the earnings
they pay-out as some of it may be used to reinvest. The cost of ordinary shareholder’s

IMM Graduate School Study Guide (FM202B) Page 130 of 199

equity can only be calculated if a dividend is declared. There are two methods that can be
used:
1. The dividend valuation model – where constant dividends are paid
2. The dividend growth model – where a constant growing dividend is paid

5.8.1.1 The dividend valuation model

The dividend valuation model assumes that the market price of a share is the present value
of all the future dividends, where a constant annual dividend is paid each year for infinity
into the future, thus taking the form of a perpetuity). Dividend valuation model is as
follows:

Where:

= cost of ordinary shares (equity) - Which will usually be what you are trying to calculate

= constant annual dividend (in perpetuity)

= ex-dividend market price of ordinary shares

The term “ex-dividend” indicates that the market share price excludes the dividend
payment from it.

5.8.1.2 The dividend growth model

The dividend growth model assumes that the market price of a share is the present value of
the future dividends (where a constant GROWING dividend is paid each year in perpetuity).
Dividend valuation model is as follows:
( )
Where:

= cost of ordinary shares

= current dividend

= market price of ordinary shares

= expected constant annual growth rate in dividend

Although all the elements of the formula can be easily sourced, the dividend growth rate
may need to be calculated. This can be done with a calculator. For example, forecasted
dividends were illustrated as follows:

IMM Graduate School Study Guide (FM202B) Page 131 of 199

 Year 2013 2012 2011 2010

Dividend R250 000 R225 000 R190 000 R175 000

The average annual growth rate in dividends can be calculated by using the time value of
money (TVM) principles as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• -175000, PV
• 3, N
• 250000, FV
• I/YR
• The answer will now display 12.62

(The rate is 12.62% or 0.1262 as a decimal)

Revision Question

Duchess Corporation wishes to determine its cost of ordinary equity ( ). The market price,
( ), of its ordinary equity is R50 per share. The firm expects to pay a dividend (D1) of R4 at
the end of the coming year, 2016. Currently, it is 2015. The dividends paid on the issued
shares over the past 6 years (2009–2014) were as follows:

Year Dividend

2014 3.80

2013 3.62

2012 3.47

2011 3.33

IMM Graduate School Study Guide (FM202B) Page 132 of 199

2010 3.12

2009 2.97

Note how the dividend has GROWN each year, so we must use the ‘dividend growth model’
and will need a growth rate. We can calculate the annual rate at which dividends have
grown (g) from 2009 to 2014 using the time value of money (TVM) principles.

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• -2.97, PV
• 5, N
• 3.80, FV
• I/YR
• The answer will now display 5.05

Substituting = R4, P0 = R50, and g = 5.05% into the previous equation yields the cost of
ordinary equity:

= (R4 ÷ R50) + 0.0505 = 0.08 + 0.0505 = 0.1305, or 13.05%

Note: You will notice that the formula provides however, in the example we used .
represents already grown by the ( ) in the formula. In other words, will be the
dividends for the current year 2015 and ( ) or will be the dividends for 2016, the
next year. Therefore, in the current example, we could of given you the dividends of the
current year 2015 , which then you would have to grow by ( ).

Please refer to the textbook for the advantages and disadvantages of the dividend
methods.

5.8.2 CAPM

The general understanding behind the CAPM is that equity providers must get compensated
in two ways: time value of money and risk. The risk-free rate ( ) in the formula represents
the time value of money aspect which compensates an investor form placing funds into the

IMM Graduate School Study Guide (FM202B) Page 133 of 199

investment over a period of time. The second part of the formula ( ( )) represents
the risk aspect, a risk premium, where an investor will be compensated for taking on
additional risk. This risk compensation is calculated by multiplying the beta coefficient ( )
(beta ( ) is a measure of volatility or rather the systematic risk of a security in comparison
to the market as a whole.) of the share by the market risk premium (the difference between
the risk-free rate and the return on a market portfolio) The CAPM formula can be expressed
as follows:

( )

Where:

= cost of ordinary shares

= risk-free rate of return

= beta coefficient of the share

= return on market portfolio

( ) = market risk premium (the difference between( ))

Exam tip: Please take note of the information given to establish which variables
have been given and which are required to be calculated.

Revision Question

Duchess Corporation now wishes to calculate its cost of ordinary equity ( ) by using the
capital asset pricing model. The firm’s investment advisors and its own analysts indicate that
the risk-free rate ( ) equals 7%; the firm’s beta ( ) equals 1.5 and the market return ( )
equals 11%.

Substituting these values into the CAPM, the company estimates the cost of ordinary equity,
, to be:

= 7.0% + [1.5  (11.0% – 7.0%)] = 7.0% + 6.0% = 13.0%

IMM Graduate School Study Guide (FM202B) Page 134 of 199

The CAPM technique differs from the dividend models in that it directly considers the firm’s
risk, as reflected by beta, in determining the required return or cost of ordinary equity. The
dividend models do not look at risk; they use the market price, P0, as a reflection of the
expected risk–return preference of investors in the marketplace. The dividend models and
CAPM techniques for finding are theoretically equivalent, though in practice estimates
from the two methods do not always agree.

Please refer to the textbook for the advantages and disadvantages of the CAPM method.

5.9 The cost of preference shares

The cost of preference shares is related to the dividend paid on preference shares.
Preference dividends are fixed payments that are distributed from after-tax profits and thus
not tax deductible. Interest paid on debt on the other hand is tax-deductible.

5.9.1 Non-redeemable preference shares

The term ‘non-redeemable’ indicates that the shares have no maturity date, that is, there is
no a date in which the organisation must buy back the shares from its shareholders. Thus,
non-redeemable preference shares can be calculated using a perpetuity calculation.

Where:
= cost of preference shares

= fixed annual dividend (in perpetuity)

= market price of preference shares

5.9.2 Redeemable preference shares

Redeemable preference shares have a maturity date and can be calculated using annuity
principles from time value of money (TVM) on a calculator as illustrated in the revision
question which follows.

IMM Graduate School Study Guide (FM202B) Page 135 of 199

 Revision Question

Assume that XYZ Trading Ltd has 9% redeemable preference shares in issue. The
preferences shares have a par value R1 and are currently trading at R1.15. The preferences
shares are redeemable 3 years’ time. Calculate the cost of the preferences shares.

Let’s break this down a bit:

The 9% refers to the rate we will use to calculate the fixed annual dividend on each share
(PMT). The word ‘par-value’ just refers to the face value of the share which is mentioned in
the official of the company and will always be given to you (we use the par value with the
rate to get the fixed dividend). ‘Currently trading’ implies that the price is the current
market price.

These shares are ‘redeemable’ so we don’t use the perpetuity formula. We follow this
calculation:
• Start off by first calculating the PMT value i.e. the
payments made to the preference shares. PMT = 1 x 9% = 0.09
• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• -1.15, PV
• 1, FV
• 3, N
• 0.09, PMT
• I/YR
• The answer will now display 3.63

5.10 The cost of debt

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The cost of debt is the interest rate that an organisation must pay on the money it has
borrowed. Interest is an expanse a business must pay and it is therefore tax deductible. As
with preference shares, debt can also take the form of non-redeemable or redeemable.

5.10.1 Non-redeemable debt

As you recall, non-redeemable means that there is no maturity date to pay back the capital.
Thus, the cost of non-redeemable debt can be calculated using perpetuity principles as
follows:
( )
Where:

= after-tax cost of debt

= fixed annual interest amount (in perpetuity)

= company tax rate (expressed as a percentage)

= market price of debt

5.10.2 Redeemable debt

Redeemable debt (which has a maturity date) can be calculated using annuity principles
from time value of money (TVM) on a calculator as illustrated in the revision question which
follows.

Revision Question

Assume that XYZ Trading Ltd has 9% redeemable debentures in issue. The debentures have
a par value R150 and are currently trading at R135. The debentures are redeemable at R160
in 3 years’ time. The prevailing company tax rate is 28%. Calculate the cost of debentures.

• Start off by first calculating the PMT value i.e. the

payments made to the debentures after tax. (150 x 9%) x (1 - 0.28)
= 9.72
• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen

IMM Graduate School Study Guide (FM202B) Page 137 of 199

 • -135, PV
• 160, FV
• 3, N
• 9.72, PMT
• I/YR
• The answer will now display 12.65

Note: You will notice that the calculations between preference shares and debt are similar
and only differ in one aspect which is tax that is excluded from the debt payments.

5.11 A summary of calculating the cost of capital

Ordinary shares Preference shares Debt

Non- Non-
Dividends CAPM Redeemable Redeemable
redeemable redeemable
Valuation model ( ) Perpetuity formula Annuity principles Perpetuity formula Annuity principles

(TVM) ( ) (TVM)

Growth model

( )

5.12 Weighted average cost of capital (WACC)

We have already dealt with the calculation of each of the separate components of long term
capital. As previously mentioned, these different types of capital are not specifically set
aside for particular projects, but rather pooled together which leads to the need for
calculating the weighted average cost of capital (WACC). WACC is the overall cost of capital
of an entity based on the cost of each source of finance ‘weighted’ according to a suitable
proportional basis, such as market value or book value.

Calculating the WACC follows a three-step approach as follows:

• Step 1: Calculate the after-tax cost of each category of capital (we have dealt with this
in section 5.6 to 5.10)

IMM Graduate School Study Guide (FM202B) Page 138 of 199

• Step 2: Determine the relevant weighting of each component.
• Step 3: Determine the contribution of each component and then add each
contribution together to obtain the WACC.

The WACC formula can be expressed as follows:

Where:

= cost of ordinary shares

= cost of preference shares

= after-tax cost of debt

= value of ordinary shares (book or market value)

= value of preference shares (book or market value)

= value of debt (book or market value)

Revision Question

Assume that ABC Ltd has a market value of debt at

R45 000 and a market value of equity at R90 000. The
total capital structure equals R45 000 + R90 000 =
R135 000. Therefore the capital structure of ABC Ltd is
33.33% debt (45 000/135 000) and 66.67% equity (90 000/135 000) both of which when
combined add up to 100%. The after tax cost of debt is 9.5% whilst the equity has a cost of
16%. In order to calculate the WACC we will have to ‘weight’ the costs according to their
weighting in the capital structure. The debt’s weighted cost of capital will then be calculated
by multiplying its cost of 9.5% by its weighting of 33.33% equalling a weighted cost of 3.17%.
The same can be done for equity (16% 66.67% = 10.67%). We can then add the two
weighted cost (3.17% + 10.67%) in order to get a weighted ‘average’ cost of capital of
13.84%, thus equalling the WACC for ABC Ltd.

Please refer to the example in the textbook for practice.

IMM Graduate School Study Guide (FM202B) Page 139 of 199

Exam tip: Know how to calculate the WACC of an organisation as well as the different costs
of capital.

5.13 Gearing

So far, we have looked at debt as a means of financing and have understood that because of
the tax benefit, as well as the security generally offered to it, long-term debt financing is
cheaper than equity financing. So why can’t we just finance our business with cheap debt?

While debt may be cheap, it increases the financial risk of the entity, that is, the more debt
the higher the fixed interest payments thus increasing the chances of bankruptcy if the
entity cannot make its fixed interest obligations.
Organisations seek to supplement their expensive equity financing with cheaper debt
financing in order to reduce their total cost of capital (WACC) up to a point of healthy
financial risk taking. This is referred to as the capital structure of an organisation. The
practice of using debt in addition to equity financing in business is referred to as gearing or
leverage. Generally, companies said to be highly geared are said to have a high amount of
debt.

Leverage therefore refers to the effects that fixed costs (which refers to the fixed interest
payments needed to service the long-term debt financing) have on the returns that
shareholders earn; higher leverage generally results in higher, but more volatile returns.

Please refer to section 12.7 in your textbook for an illustrated example on the
financial effects of gearing.

5.14 Optimal capital structure

The optimal capital structure refers to the point at which an entity’s WACC is at its lowest
possible point, so that returns for shareholders are maximised.

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For example, consider an organisation that is 100% financed by equity. The board wishes to
decrease the companies cost of capital by introducing cheaper debt financing. The
organisation will then employ debt financing up to a point, that the increase in financial risk
that is associated with debt financing does not increase the cost of equity. This is illustrated
in
figu
re
5.4.

Figu
re
5.4:
The
opti
mal capital structure

If the organisation increases the debt financing too much, the increased financial risk will
cause the equity providers to increase their required return. Thus, the WACC of an
organisation will increase after a certain point (point ‘A’ as seen in figure 5.4)

Exam tip: Know how to discuss what the optimal capital structure of an
organisation.

5.15 Using WACC in investment decisions

So why is it so important to understand what an organisation’s WACC is? There are two
main reasons for this

Firstly, from an investment point of view if an organisation were to borrow money in order
to use the funds to generate revenue, the organisation must make sure that the return is at
least equal or preferably greater than the cost of borrowings i.e. WACC

IMM Graduate School Study Guide (FM202B) Page 141 of 199

Secondly, WACC is critically important because it is often used as the discount rate when
evaluating suitable investment opportunities. Investments that result in a positive net
present value using the WACC as the discount rate should be accepted, as these
investments should generate long-term wealth for the ordinary shareholders. This is dealt
with in the next study unit, the long-term investment decisions.

Now that you have completed study unit 1 it is advisable to work through the
multiple-choice and longer questions at the end of chapter 1 and 7. Answers to
these questions can be found at the back of the textbook.

Study Unit 5 - Revision Exercises

The following questions should also be attempted:

Question 1

You are the financial manager of Independent Crushers (Pty) Ltd, a company owning a
quarry in the Eastern Cape. The company has been approached by Murray and Robs Ltd to
provide all the crushed stone requirements for the Gautrain contract.

In order to accept this contract, it will be necessary for the company to invest in a mobile
crushing unit which will have to be imported from Germany, the total cost of which is
expected to be R12.5 million. The managing director of Independent Crushers (Pty) Ltd is
extremely upbeat about this contract, particularly as she has been able to obtain loan
financing for the new plant from the supplier Hartley Plc in Germany at an effective interest
rate of 5% p.a. She has requested you to prepare a presentation for the board of directors
basing your profitability calculations on the cost of the specific loan from Germany. You are
not too comfortable with this request as you are familiar with the current financial structure
of the company which is as follows:

IMM Graduate School Study Guide (FM202B) Page 142 of 199

 Equity and liabilities Notes R

Ordinary share capital (5 000 000 shares) 1 5 000 000

10% Preference shares of R5 each 2 1 000 000

15% Long-term debt (R2 par value) 3 3 000 000

18% Secured bank overdraft 4 1 000 000

Notes:

1. The accepted current risk-free rate is 8%. Whilst the mining industry is considered to be
relatively stable for the short to medium term, a risk premium for similar listed
companies is 10%. Independent Crushers (Pty) Ltd usually also includes an added risk
premium of 5% for private companies.
2. The preference shares are non-redeemable. The new issue price of these shares is
currently R6.50.
3. The long-term debt is redeemable at a premium of 10% above the par of R2, in five
years. Interest is calculated annually in arrears. Similar bond instruments are trading at
present value of R1.80 each.
4. Whilst the company has a bank overdraft facility of R4 million, the average bank
overdraft is as reflected above. Please take note that this overdraft is secured by a
bond over the plant and equipment. It is expected that the Gautrain project will result
in an increase of the overdraft to an average of R2 million.
5. Assume a tax rate to the company of 29%.
6. The accepted debt to equity ratio for the mining industry is 40% debt and 60% equity.

Required:

1.1 With reference to the nominal values as reflected in the current capital structure of
Independent Crushers (Pty) Ltd, to what extent does the company conform to the
benchmark debt/equity ratio?

1.2 Comment on the accuracy of evaluating the profitability of this project on the loan
funding from Germany only.
1.3 Calculate the following:

i) The cost of ordinary shares

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 ii) The cost of preference shares

iii) The cost of the long term debt

iv) The cost of the secured bank overdraft

1.4 Calculate the current weighted average cost of capital (A) of Independent Crushers
(Pty) Ltd by calculating the values indicated by question marks from the table
provided below

WEIGHTED AVERAGE COST OF CAPITAL

Component Book Value Weight Cost Weighted
Ordinary shares 5 000 000 ? 24.5% ?
Preference share 1 000 000 ? 9.2% ?
Long term debt 3 000 000 ? 12% ?
Secured bank overdraft 1 000 000 ? 11.35% ?
? ? (A)

Note:

• It is not necessary to redraw the table, however, show all workings.

• The costs of the components given in the table above should be used independently
of your answers in Question 1.3
• Round off your calculation to two decimal points.

1.5 If the loan from Germany is utilised, how will it affect the current capital structure of
Independent Crushers (Pty) Ltd? Also, indicate how the acceptance of this loan will
affect the risk profile of the company.
Question 2

“Leasing would seem to be an ideal way for companies in the transportation and logistics
industries to control their exposure to the ups and downs of the business cycle.”

Source: Steve Saxon, Mckinsey & Company

Required:

2.1 State whether you agree or disagree with the above statement and motivate your
answer.

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 Hint: Your answer should include a comparison between the theoretical advantage of
leasing and the practical limitation in the above statement.
Question 3

The board of directors of TRUE Ltd require R15 million for expansion of their existing factory
and are investigating different financing options for this project. A summary of TRUE current
statement of financial position and extract from the statement of financial performance for
the period ended 30 September 2012 shows the following:

Statement of Financial Position 2012

R’000
Capital Employed

R10 ordinary shares 12 000

Share premium 1 000
Distributable reserves 2 000
Non-distributable reserves 3 000
Shareholders interest 18 000

10% preference shares (R5 issue price) 4 000

16% debentures (indefinite) 14 000
Long term loan 20 000
56 000
Employment of capital
Fixed assets 42 000
Net current assets 14 000
56 000

Financial Performance R’000

Operating income 12 340

Debenture interest 2 240

IMM Graduate School Study Guide (FM202B) Page 145 of 199

Long term loan interest 3 600
Income before taxation 6 500

Dividend per share R2.50

Growth in dividend per share 8%
Dividend Yield
0.11111
( i.e. Dividend/ share market value)

Debenture

Long-term debentures similar to those issued by TRUE are currently yielding a return of 22%
(before taxation).

Long-term loan

The long-term loan matures on 30 September 2016. The long-term loan is currently being
offered at a yield to maturity of 20%. The finance required for expansion will be raised
through a long-term loan at the current ruling interest rate. The tax rate is 28%. The
Financial director of TRUE believes that the market price of the existing ordinary shares and
the cost of existing debt finance will not change as a result of the proposed issue of a long-
term loan.

Required:

3.1 Calculate the value of equity as well as the cost of equity

3.2 Calculate the value of debentures as well as the cost of debentures

3.3 Calculate the value of debt as well as the cost of debt.

3.4 Calculate the weighted average cost of capital

IMM Graduate School Study Guide (FM202B) Page 146 of 199

 Revision Exercises Solutions

Refer to suggested solutions at the end of this study guide (Addendum D). It is however
advised that learners attempt to respond to the questions first by themselves before
accessing the solutions for effective learning to take place.

IMM Graduate School Study Guide (FM202B) Page 147 of 199

 Study unit 5 – Progress check

You have come to the end of study unit 5.

Time to do a progress check to determine whether you have completed the required
content and exercises.

IMM Graduate School Study Guide (FM202B) Page 148 of 199

Your Progress Checklist YES/NO?

Did you read through each study unit outcome?

Did you go through all learning material?

Did you complete all the relevant revision exercises and check your
answers against the answers provided?

At this point, you should be able to:

• Demonstrate a clear understanding of cost of capital and its specific
sources
• Be sufficiently familiar with computation of cost of equity
• Be sufficiently familiar with computation of cost of debt
• Understand the concept of weighted average cost of capital (WACC)
• Calculated the WACC and discuss the concept of optimal capital
structure

Are you ready to tackle questions relevant to Study Unit 1 in Assignment

2?

Complete Assignment 2, Question 2

IMM Graduate School Study Guide (FM202B) Page 149 of 199

SECTION D
WEEK 13 – 14:

STUDY UNIT 6

Study unit 6: Long-term investment decisions

Study Unit 6 – Relevance

In this study unit, we will focus on the long-term investment decisions, which involve
investments in assets with life spans longer than a year. The decision making process is
commonly known as capital budgeting. Capital budgeting is the process of evaluating and
selecting long-term investments that are consistent with the firm’s goal of maximizing
shareholder value.
We will look at factors that influence investment decisions as we seek to understand how to
apply appropriate quantitative (measurable) capital budgeting techniques when evaluating
investments. Specific focus is given to the payback period method, the discounted payback
period, the net present value method and the internal rate of return method.

From a marketing point of view, you need to understand the capital budgeting process to
grasp how proposals for new marketing programmes for new products and for expansion of
existing products and projects will be evaluated by the management of the firm.

capital structure of an organisation.

IMM Graduate School Study Guide (FM202B) Page 150 of 199

 Study Unit 6 – Module Outcomes

Let’s recap the relevant module outcomes for this study unit

MO 6 Carry out long-term investment decisions

Study unit 6 – Key concepts

Let’s recap what the relevant module learning outcomes are for this study unit.

After completing this study unit, you should be able to:

• Understand basic capital budgeting concepts and their importance to decision making.
• Estimating relevant cash flows.
• Ability to thoroughly appraise and evaluate project/non-current asset investments
using capital budgeting techniques.
• Briefly discuss the possible conflict in ranking between NPV and IRR technique.
• Appraise the investment evaluation process.

Study unit 6 – Glossary of Terms

Capital budgeting – the process of identifying and evaluating different investment

opportunities in order to decide on how an organisation will allocate its sources resources
(long term capital).

Discounted payback period – the time period (years) it take for an organisation to pay back
its initial investment by addition of the future cash flows that have been discounted at the
cost of capital (WACC).

Internal rate of return – the discount rate at which the NPV equals zero.

IMM Graduate School Study Guide (FM202B) Page 151 of 199

Net present value – the difference between the initial investment amount and the present
value of the future expected cash flows that have been discounted at the cost of capital
(WACC).

Payback period – the time period (years) it take for an organisation to pay back its initial
investment.

Study Plan Progress

Week 13 Time allocation: 12.5 hours

Learning elements Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Understand basic Complete Sign-up for Week 13

capital budgeting revision eLearn – 12.5 Hours
concepts and their
importance to exercises Consult eLibrary
decision making Obtained
 Estimating relevant
feedback
cash flows
 Ability to thoroughly
appraise and
evaluate
project/non-current
asset investments
using capital
budgeting
techniques

IMM Graduate School Study Guide (FM202B) Page 152 of 199

Week 14 Time allocation: 12.5 hours

Learning elements Activities Material used / Time / Week Progress

completed accessed / check
assistance

 Ability to thoroughly Complete Sign-up for Week 2

appraise and revision eLearn – 12.5 Hours
evaluate
project/non-current exercises Consult eLibrary
asset investments Obtained
using capital
budgeting feedback
techniques
 Discuss the
advantages and
disadvantages of
capital budgeting
techniques
 Understand the of
capital and its
relation to
maximising
shareholders wealth

6. Study Unit 6 - Content

6.1 Introduction

From our earlier study units, we came to understand that one of the objectives of financial
management is the creation of shareholder value. Shareholder value can be achieved
through growth, which normally requires large capital investments into assets, which in
turn, are used in the generation of income over time. The question however is which
projects or investments will contribute positively towards increasing the value of the
company and thus ultimately increasing shareholder value. In other word, will the
assets/projects perform well and be worth investing in.

IMM Graduate School Study Guide (FM202B) Page 153 of 199

Selecting which investment opportunities to pursue and which to avoid is of vital
importance to an organisation. In order to evaluate the feasibility of an investment project,
investment appraisal methods or capital-budgeting methods are usually used. These
techniques evaluate the expected cash outflows and the resulting cash inflows to determine
if the project is profitable or not. The results of these methods can also be compared to
choose between alternatives.

Investment decisions are considered on which

alternative will provide the highest possible value,
based on time value of money, that is, the discounted
cash flow principal. Evaluating investments proposals
is based on the approach of relevant (incremental) net
cash flows after tax, and not on the accounting
approach to income and profit. For example,
investment decisions are made on which investment
option produces the most net cash flow (income less all expenses).

6.2 Estimating relevant cash flows

Before we look at different evaluation techniques, it’s important to understand certain

fundamentals and thus we will focus on from chapter 6.
• Difference between profit and cash flow: we
remind ourselves from accounting principles
that profit and cash flow are not the same
thing. Profit includes non-cash items such as
depreciation, bad debts and accounting
adjustments. Thus when evaluating projects,
we are concerned with cash flows only.

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• Estimating relevant cash flows – by this we mean only the cash movement that occurs
as a direct consequence of accepting a capital investment project. When evaluating
capital investment options, it’s important to consider the effects of sunk costs,
opportunity costs, finance costs and lastly inflation and tax.

6.2.1 Sunk costs versus opportunity costs

Sunk costs are cash outflows that have already been made (paid out in the past) and
therefore have no effect on the future cash flows relevant to a current decision.
Sunk costs should not be included in a project’s incremental cash flows.

Opportunity costs are cash flows that could be realized from the best alternative use of an
owned asset. I.e. the cost of the lost opportunity of another thing that asset could have
been used for or contributed to.

Opportunity costs should be included as cash outflows when one is determining a

project’s incremental cash flows.

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 Revision Question

Jankow Equipment is considering renewing its drill press X12, which it purchased 3 years
earlier for R237 000 by retrofitting it with the computerized control system from an
obsolete piece of equipment it owns. The obsolete equipment could be sold today for a high
bid of R42 000 but without its computerized control system, it would be worth nothing.

• The R237 000 cost of drill press X12 is a sunk cost because it represents an earlier cash
outflow.
• Although Jankow owns the obsolete piece of equipment, the proposed use of its
computerized control system represents an opportunity cost of R42 000—the highest
price at which it could be sold today.

Note: In your textbook under Chapter 6, please note that sections 6.4 – 6.8 are for reading
purposes only. The points below however relate to Chapter 5 and must be understood for
testing purposes.

6.3 Investment evaluation

The capital budgeting process consists of five steps:

1. Proposal generation. Proposals for new investment projects are made (brainstormed) at
all levels within a business organization and are reviewed by finance personnel.
2. Review and analysis. Financial managers perform formal review and analysis to assess
the merits of investment proposals
3. Decision-making. Firms typically delegate capital expenditure decision making on the
basis of monetary limits.
4. Implementation. Following approval, expenditures are made and projects implemented.
Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored and actual costs and benefits are compared with
those that were expected. Action may be required if actual outcomes differ from
projected ones.

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6.4 Types of investments

It is important to distinguish between certain types of investments projects.

6.4.1 Expansion versus replacement projects

Expansion projects are simply new project an organization wishes to take on in order to
increase its current operations. Developing relevant cash flow estimates is mostly
straightforward in the case of expansion decisions. In this case, the initial investment,
reverent operating cash inflows, and terminal cash flow are merely the after-tax cash
outflow and inflows associated with the proposed capital expenditure.

Replacement projects deal with the possible renewal or ungraded of an asset. Identifying
relevant cash flows for replacement decisions is more complicated, because the firm must
identify the incremental cash outflows and inflows that would result from the proposed
replacement.

6.4.2 Independent versus mutually exclusive projects

Independent projects are projects whose cash flows are

unrelated to (or independent of) one another; the acceptance
of one does not eliminate the others from further
consideration. For example, if an organization decides to invest
in a new operational software system for its customer
relationship management, such a decision if accepted, will not influence any other current
or future project acceptance decisions.

Mutually exclusive projects are projects that compete with one another, so that the
acceptance of one eliminates from further consideration all other projects that serve a
similar function. For example, if a marketing organisation wins a contract to do the
advertising of a product for a client, the contract may have a restraint of trade in it that
prohibits the organization to do the marketing of the client’s competitors.

6.4.3 Complementary versus substitute project

A project is defined as complementary when it has a positive effect on another project. The
opposite is true for substitute projects where the acceptance of a project will negatively
affect another.

IMM Graduate School Study Guide (FM202B) Page 157 of 199

6.4.4 Conventional versus unconventional projects

Conventional projects experience a single cash out flow in the beginning of the project,
which will be followed by a constant positive cash inflow thereafter. However,
unconventional projects experience fluctuations in the negative and positive cash flows.

6.4.5 Capital budgeting techniques

We will now cover the four main capital budgeting techniques of which each are vitally
important to your studies.

6.5 The payback period method

The payback period (PBP) method calculates how long, in

years, it will take to recover the initial investment
amount for a specific investment project. Cash
generated from the project is based on the net cash
flows, that is, all income less all expenses.

6.5.1 Decision criteria:

• The length of the maximum acceptable payback
period is determined by management.
• If the payback period is less than the maximum acceptable payback period, accept the
project.
• If the payback period is greater than the maximum acceptable payback period, reject
the project.

Revision Question

Invest Big has the option of investing in the following two projects with their forecasted net
cash flows:

Year Project A Project B

0 (R200 000) (R400 000)
1 R120 000 R40 000

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 2 R90 000 R60 000
3 R50 000 R120 000
4 R40 000 R240 000
5 R30 000 R340 000

Invest Big has decided on a required payback period of 3 years.

For project A:

 Initial out flow of money (R200 000)

 Return from first year + R120 000
 Balance after year 1 (R80 000)
 The return for year 2 is R90 000 which is greater than
the balance of (R80 000). Therefore, we need to calculate a fraction
i.e. R80 000 ÷ R90 000 = 0.89
 Thus, the PBP for project A is 1.89 years.

For project B:

 Initial out flow of money (R400,000)

 Return from first year + R40 000
 Balance after year 1 (R360 000)
 Return from second year + R60 000
 Balance after year 2 (R300 000)
 Return from third year + R120 000
 Balance after year 3 (R180 000)
 The return for year 4 is R240 000 which is greater than the balance of
(R180 000). Therefore, calculate the fraction i.e.
R180 000 ÷ R240 000 = 0.75

 Thus, the PBP for project B is 3.75 years.

If we compare and rank the outcomes of the two projects as illustrated in table 6.1 we see
that Project A falls within the 3-year payback limit set by Invest Big. Thus, on this bases
Project A must be accepted.

IMM Graduate School Study Guide (FM202B) Page 159 of 199

Table 6.1

Project A Project B
Payback period 1.89 years 3.75 years

The payback period is primarily used as a risk measurement tool. It answers the question of
“how long will it take to get our money back form this investment?” Some organisations
and individuals will prefer to have their capital paid back as soon as possible even if there
are cash flows after the payback period.

Please refer to the textbook for the advantages and disadvantages of the payback
period method.

6.6 The discounted payback period

The discounted payback period is calculated in the same manner as the payback period
however, it takes the present value (PV) of the future cash flows into account.

Revision Question

Using the information provided on Invest Big, we can calculate each year’s FV return in PV
terms. In other words, we must discount the future net cash flows to present value.

Note: Refer back to Study Unit 2 (TVM) for PV calculations.

Assuming Invest Big has a discount factor or WACC of 8% (which will always be given to you
in a test), we can calculate the PV’s for project A as follows:

For year 1 the calculation is as follows:

 (red/orange), C ALL
 (1 P_Yr) should be displayed on the screen
 120000, FV

IMM Graduate School Study Guide (FM202B) Page 160 of 199

  8, I/YR
 1, N
 PV
 The answer will now display -111111.11

Thus, the PV of the FV return of R120 000 after 1 year, is worth R111 111.11 in today’s
money assuming an 8% discount factor.

For year 2, the calculation is as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• 90000, FV
• 8, I/YR
• 2, N
• PV
• The answer will now display -77160.49

For year 3, the calculation is as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• 50000, FV
• 8, I/YR
• 3, N
• PV
• The answer will now display -39691.61

For year 4, the calculation is as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• 40000, FV
• 8, I/YR
• 4, N
• PV

IMM Graduate School Study Guide (FM202B) Page 161 of 199

• The answer will now display -29401.19.

For year 5, the calculation is as follows:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• 30000, FV
• 8, I/YR
• 5, N
• PV
• The answer will now display -20417.49

The same PV calculations can now be performed for Project B’s FV’s. The table 6.2 now
depicts the PV’s of project A and B.

Table 6.2

Project A Project B

Cash flow Cash flow

Year Cash flow discounted at 8% Cash flow discounted at 8%
0 (R200 000) (R400 000)
1 R120 000 R111 111.11 R40 000 R37 037.04
2 R90 000 R77 160.49 R60 000 R51 440.33
3 R50 000 R39 691.61 R120 000 R95 259.87
4 R40 000 R29 401.19 R240 000 R176 407.16
5 R30 000 R20 417.50 R340 000 R231 398.29

You can now calculate the discounted PBP for the two projects as follows:

Project A:

• Initial out flow of money (R200 000.00)

• Return from first year + R111 111.11

IMM Graduate School Study Guide (FM202B) Page 162 of 199

• Balance after year 1 (R88 888.89)
• Return from second year + R77 160.49
• Balance after year 2 (R11 728.40)
• The discounted return for year 3 is R39 691.61, which is greater than the balance of
(R11 728.40). Therefore, calculate the fraction i.e. R11 728.40 ÷ R39 691.61 = 0.30

Thus, the discounted PBP for project A is 2.30 years.

Project B:

• Initial out flow of money (R400 000.00)

• Return from first year + R37 037.04
• Balance after year 1 (R362 962.96)
• Return from second year + R51 440.33
• Balance after year 2 (R311 522.63)
• Return from third year + R95 259.87
• Balance after year 3 (R216 262.76)
• Return from fourth year + R176 407.16
• Balance after year 4 (R39 855.60)
• The discounted return for year 5 is R231 398.29, which is greater than the balance of
(R39 855.60). Therefore, calculate the fraction i.e. R39,855.60 ÷ R231,398.29 = 0.17

Thus, the PBP for project B is 4.17 years.

If we compare and rank the outcomes of the two projects as illustrated in table 6.3 we see
that Project A still falls within the 3 year payback limit set by Invest Big. Thus, on this bases
Project A must be accepted.

Table 6.3

Project A Project B

Payback period 1.89 years 3.75 years

IMM Graduate School Study Guide (FM202B) Page 163 of 199

Discounted payback period 2.30 years 5.17 years

It must be noted that the discounted payback period takes longer to payback the capital as
compared to the payback period. This is due to the discounting of the net cash flows.

Please refer to the textbook for the advantages and disadvantages of the
discounted payback period method.

6.7 The net present value method

Simply put, the net present value (NPV) of a project is the difference between the present
values (PV) of all expected net cash inflows and the cost of the project.

Consider figure 6.1 that represents Project A of Invest Big.

0 1 2 3 4 5

Investment Cash inflow Cash inflow Cash inflow Cash inflow 4 Cash inflow

IMM Graduate School Study Guide (FM202B) Page 164 of 199

 Cash outflow 1 2 3 5

40 000

(200 000) 120 000 90 000 50 000 30 000

=PV 8%

=PV 8%

=PV 8%

=PV 8%

=PV 8%

NPV

Figure 6.1
At the present day (period 0) Invest Big must invest R200 000 in Project A. This project will generate
net cash flows at the end of every year for 5 years after which the project will end, as illustrated in
figure 6.1. The point of the NPV calculation is to discount the future cash flows from periods 1 to 5
to the present day (period 0) in order to subtract it from the initial expense of the project R200 000.
The future cash flows used will be discounted with the organisation WACC.

Decision criteria:

• If the NPV is greater than zero rand, accept the project.

• If the NPV is less than zero rand, reject the project.

From Invest Big, the NPV of Project A and Project B can be calculated as follows, by using
the already discounted cash flows from the discounted payback period calculation done
before.

Project A = 111111.11 + 77160.49 + 39691.61 + 29401.19 + 20417.50 – 200000.00

= 77781.90

Project B = 37037.04 + 51440.33 + 95259.87 + 176407.16 + 231398.29 – 400000.00

= 191542.69

IMM Graduate School Study Guide (FM202B) Page 165 of 199

An alternative way to calculating an NPV is made possible by entering the original net cash
flows into the calculator as flows
Project A:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• -200000, (This will show as CF 0)
• 120000, (This will show as CF 1)
• 90000, (This will show as CF 2)
• 50000, (This will show as CF 3)
• 40000, (This will show as CF 4)
• 30000, (This will show as CF 5)
• 8, I/YR
• (red/orange), NVP
• 777781.91

Thus, the NPV for Project A is R777 781.91.

Project B

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• -400000, (This will show as CF 0)
• 40000, (This will show as CF 1)
• 60000, (This will show as CF 2)
• 120000, (This will show as CF 3)
• 240000, (This will show as CF 4)
• 340000, (This will show as CF 5)
• 8, I/YR
• (red/orange), NVP
• 191542.69

Thus, the NPV for Project B is R191 542.69.

IMM Graduate School Study Guide (FM202B) Page 166 of 199

The general rule with regards to NPV is that any project that has a NPV greater than zero
(NPV > 0) should be accepted as it is adding value to shareholders.
• If for example the NPV of a project was 0 it indicates that that at the current WACC
the project is just breaking even.
• Any negative value will indicate that the project will make a loss.
• If projects are independent of each other than both projects can be accepted as both
have positive NPV’s. However, if the projects are mutually exclusive meaning we can
only choose one, and then choose the project with the highest NPV.

If we compare and rank the outcomes of the two projects as illustrated in table 6.4, we see
that Project A and B both have positive NPVs. If the projects are independent of each other
then both projects can be accepted as both have positive NPV’s. However, if the projects are
mutually exclusive meaning we can only choose one, we would then choose the project with
the highest NPV, that is, project A

Table 6.4

Project A Project B

Payback period 1.89 years 3.75 years

Discounted payback period 2.30 years 5.17 years

NPV R777 781.91 R191 542.69.

Please refer to the textbook for the advantages and disadvantages of the NPV
method.

6.8 The internal rate of return method

IMM Graduate School Study Guide (FM202B) Page 167 of 199

The internal rate of return (IRR) as an investment evaluation method is similar to the NPV
method, however, unlike the NPV method, where the company’s cost of capital is used to
calculate the PV of all the project’s cash flows, the IRR method attempts to determine the
discount rate required for the project to break even. Thus, the IRR method calculates the
discounted rate that will result in the NPV equalling 0.

Decision criteria:

• If the IRR is greater than the cost of capital, accept the project.
• If the IRR is less than the cost of capital, reject the project.

We can now practice calculating the IRR on our calculator by using the information provided
in the previous example. It’s important to remember however that when calculating IRR
that the initial investment in a project is an outflow of money and thus it needs to be
entered as a ‘negative’ amount. If you do not enter the initial amount as a negative figure,
you will get an error reading when calculating the IRR

For Project A:

• (red/orange), C ALL
• (1 P_Yr) should be displayed on the screen
• -200000, (This will show as CF 0)
• 120000, (This will show as CF 1)
• 90000, (This will show as CF 2)
• 50000, (This will show as CF 3)
• 40000, (This will show as CF 4)
• 30000, (This will show as CF 5)
• (red/orange), IRR/YR
• 26.72

Thus, the IRR for project A is 26.72%

For Project B:

• (red/orange), C ALL

IMM Graduate School Study Guide (FM202B) Page 168 of 199

 • (P_Yr) should be displayed on the screen
• -400000, (This will show as CF 0)
• 40000, (This will show as CF 1)
• 60000, (This will show as CF 2)
• 120000, (This will show as CF 3)
• 240000, (This will show as CF 4)
• 340000, (This will show as CF 5)
• (red/orange), NVP
• 19.74

Thus, the IRR for project B is 19.74%

If we compare and rank the outcomes of the two projects as illustrated in table 6.5, we see
that Project A and B both have IRRs greater than the WACC of 8%. If the projects are
independent of each other than, both projects can be accepted. However, if the projects are
mutually exclusive meaning we can only choose one, the one with the highest IRR must be
chosen.
Table 6.5

Project A Project B

Payback period 1.89 years 3.75 years

Discounted payback period 2.30 years 5.17 years

NPV R777 781.91 R191 542.69.

IRR 26.72% 19.74%

Please refer to the textbook for the advantages and disadvantages of the IRR
method.

6.9 Comparing the net present value and internal rate of return methods

IMM Graduate School Study Guide (FM202B) Page 169 of 199

Conflicting rankings happen when there are disagreements in the rankings given by the NPV
and IRR, resulting from differences in the a) magnitude and b) timing of cash flows. One
underlying cause of conflicting rankings is the implicit assumption concerning the
reinvestment of intermediate cash inflows—cash inflows received prior to the termination
of the project.

For example, the NPV calculation discounts the future cash flows at the organisations
WACC. Thus, when the project is taken, the previous ‘discounting’ now becomes the
opposite – investing. Therefore, we can say that the initial investment is invested at the
WACC.

We follow this same principal in the IRR method. The IRR method finds the discount rate at
which the NPV will result in 0. Thus, when the project is executed, the initial investment will
be invested at the discounted rate calculated by the IRR. Therefore we can say that the
initial investment is invested at the IRR rate. This however is not realistic.

In summary the NPV assumes intermediate cash flows are reinvested at the cost of capital,
while IRR assumes that they are reinvested at the IRR.

6.10 So which approach is better?

On a purely theoretical basis, NPV is the better approach

because NPV measures how much wealth a project creates
(or destroys if the NPV is negative) for shareholders. Despite
its theoretical superiority, however, financial managers
prefer to use the IRR approach just as often as the NPV
method because of the preference for rates of return.

Now that you have completed study unit 6 it is advisable to work through the
multiple-choice and longer questions at the end of chapter 7. Answers to these
questions can be found at the back of the textbook.

IMM Graduate School Study Guide (FM202B) Page 170 of 199

 Study Unit 6 - Revision Exercises

The following questions should also be attempted:

Question 1

THIS QUESTION CONSISTS OF TWO INDEPENDENT PARTS

PART A

You are the financial manager of Growth Limited, a South African property development
company which is currently considering two mutually exclusive projects with the following
relevant cash flows.

Cash Flows Project A Project B

Initial investment (100 000) (120 000)
Inflow year 1 30 000 100 000
Inflow year 2 62 000 10 000
Inflow year 3 34 000 5 000
Inflow year 4 40 000 6 000

Required:

1.1. Define and discuss the concept ‘mutually exclusive’ in the above scenario.

1.2. Choose between the projects by using the ‘payback method’. Show all calculation
1.3. In most cases when applying the ‘payback method’ to capital investment decisions
there are certain limitations that accompany it. Discuss these limitations.

PART B

You are supplied with the following information regarding two mutually exclusive projects.

• Project A

This project will cost R400 000 initially. It will generate net cash inflows of R210 000
for the first year, after which it will increase by 10% per year until year 3. There will
be a net cash inflow of R45 000 in the final year of the project namely year 4.

IMM Graduate School Study Guide (FM202B) Page 171 of 199

• Project B

This project will cost R600 000 initially. It will generate net cash inflows of R250 000
per year for the next 2 years, after that it will increase to R280 000 per year for the
last two years of the project.

Management want to use the ‘NPV method’ in choosing the best alternative. The
project leader told you that he doesn’t like this method, as it only gives a number as
an answer. He advised management to rather use the ‘IRR method’ as it gives a
percentage which is easier to interpret. He also told you that these two methods are
in any case exactly the same.

Assume cost of capital is 16%.

Required:

1.4. Choose between the two projects by using the Net Present Value method. You must
provide sound reasoning in your answer.

You may use the table below in your answer book to lay out the cash flows
required for your calculations. You are reminded to clearly differentiate between
positive and negative cash flows.

Project A Project B
0
1
2
3
4
NPV

1.5. State whether you agree or disagree with the Project Leaders statement “these two
methods are in any case exactly the same”, and motivate your answer by explaining
the difference between the NPV-method and the IRR-method

IMM Graduate School Study Guide (FM202B) Page 172 of 199

Question 2

Projects A and B, of equal risk, are alternatives for expanding the Rosa Company’s capacity
the firms cost of capital is 13%. The cash flows for each project are shown in the following
table.

Project A Project B
Initial investment R80 000 R50 000
Year Cash inflows
1 R15 000 R15 000
2 R20 000 R15 000
3 R25 000 R15 000
4 R30 000 R15 000
5 R35 000 R15 000

Required:

2.1. Define the concept “mutually exclusive”

2.2. Calculate each projects payback period

2.3. Calculate the net present value (NPV) for each project.
2.4. Assuming the IRR of the above Project A is 14.61% and Project B is 15.24%. Evaluate
and discuss the rankings of the two projects on the basis of your findings above.

Revision Exercises Solutions

Refer to suggested solutions at the end of this study guide (Addendum C). It is however
advised that learners attempt to respond to the questions first by themselves before
accessing the solutions for effective learning to take place.

IMM Graduate School Study Guide (FM202B) Page 173 of 199

 Study unit 6 – Progress check

You have come to the end of study unit 6.

Time to do a progress check to determine whether you have completed the required
content and exercises.

IMM Graduate School Study Guide (FM202B) Page 174 of 199

Your Progress Checklist YES/NO?

Did you read through each study unit outcome?

Did you go through all learning material?

Did you complete all the relevant revision exercises and check your
answers against the answers provided?

At this point, you should be able to:

• Understand basic capital budgeting concepts and their importance to
decision making.
• Estimating relevant cash flows.
• Ability to thoroughly appraise and evaluate project/non-current
asset investments using capital budgeting techniques.
• Briefly discuss the possible conflict in ranking between NPV and IRR
technique.
• Appraise the investment evaluation process.

Are you ready to tackle questions relevant to Study Unit 6?

IMM Graduate School Study Guide (FM202B) Page 175 of 199

SECTION E
REVISION AND EXAM PREPARATION
WEEKS 15

Final Progress Check

You have now covered every module outcome and the associated learning activities or
exercises relating to this module.

Weeks 15 Time
allocation: 12.5 hours

Learning elements Activities Material used / Time / Week Progress

completed accessed check

 Exam preparation & Complete Consult eLibrary Weeks 15

Examination revision Obtain feedback 12.5 Hours

Are you ready for your final assessment?

Let’s recap again:

 Can you explain each core concept?

 Did you complete all the review exercises?
 Did you compare your answers with those answers provided in the study guide?
 Are you more aware of the same basic principles applied around you in your work
environment or day-to-day life?
 Consult eLearn for more exam tips on how to study and how to prepare yourself for
the exams.

Good luck for your upcoming examination.

IMM Graduate School Study Guide (FM202B) Page 176 of 199

Reference list

The overall content of this study guide is based on the prescribed textbook of this module.

Els, G. et al (2014), Corporate Finance a South African perspective 2nd edition, Oxford
University Press Southern Africa (Pty) Ltd, Cape Town.

Alphabetical list

Beginners guide to financial statements. Available

http://www.sec.gov/investor/pubs/begfinstmtguide.htm (Accessed 13 November 2014)

Gitman, L.J. (2011), Principles of Managerial Finance: Global and Southern African
Perspectives 2nd edition, Pearson Education South Africa (Pty) Ltd, Cape Town.

Marney J. and Tarbert H. (2011), Corporate Finance for Business, Oxford University Press,
New York.

McConnell, P. (2011), The objective of financial reporting and the qualitative characteristics
of useful information – what investors should know. Available http://www.ifrs.org/investor-
resources/2011-perspectives/january-2011-perspectives/Pages/objective-of-financial-
reporting.aspx (Accessed 13 November 2014)

See, E. (2006) Bridging Finance. Financial Executive. July/August., pp. 50-53.

Srivastava, R.K., Shervani, T.A., & Fahey, L. (1998). Market-Based Assets and Shareholder
Value: A Framework for Analysis, Journal of Marketing, 62, pp. 2-18.

Stoltz A. et al (2007), Financial Management, Pearson Education South Africa (Pty) Ltd, Cape
Town.

IMM Graduate School Study Guide (FM202B) Page 177 of 199

Addendum A

IMM Graduate School’s Harvard Referencing Guidelines

Read the Guidelines here.

IMM Graduate School’s Action Verbs (Bloom’s Taxonomy)

Read the Action Verbs here

IMM Graduate School Study Guide (FM202B) Page 178 of 199

Glossary

• Agency problem – the likelihood that managers may place personal goals ahead of
corporate goals.
• Annuity - An annuity is a series of equal payments or receipts occurring over a
specified time period
• Auction markets – are markets where transactions are done by means of a process of
public outcry
• Capital budgeting – the process of identifying and evaluating different investment
opportunities in order to decide on how an organisation will allocate its sources
resources (long term capital)
• Capital markets – a market that enables suppliers and demanders of long-term funds
to make transactions.
• Capital structure – the mixture of different types of long term debt and equity
financing
• Compounding interest– Interest that is earned on both the principal and the
reinvested interest amount
• Corporate governance – the system used to direct and control a company. Defines the
rights and responsibilities of key corporate participants, decision – making procedures
and the way in which the firm will set achieve and monitor objectives.
• Cost of capital – the return required by the providers of long term capital
• Creditors/payables – an organisation to which another organisation owes money to in
the short term.
• Dealer markets – the market in which the buyer and seller are not brought together
directly but instead have their orders executed by securities dealers that make
markets in the given security.
• Debtors/accounts receivables – money owed to an organisation by its customers

IMM Graduate School Study Guide (FM202B) Page 179 of 199

• Discounted payback period – the time period (years) it take for an organisation to pay
back its initial investment by addition of the future cash flows that have been
discounted at the cost of capital (WACC)
• Discounting cash flows – The process of finding present values
• Effective interest rate – The actually paid or earned
• Ethics – Basic concept of decent human behaviour. Includes fundamental principles
that define the character or guiding beliefs of a person, group or institution.
• Financial gearing – it’s the use and effect of debt capital to finance the organisations’
assets
• Future value– The value at a given future time of a present amount invested at a
specific interest rate
• Gearing – the use of debt financing in the long term capital structure of an
organisation
• Internal rate of return – the discount rate at which the NPV equals zero.
• Liquidity – the ability of an asset to be converted into cash with having to lower its
present value in order to create a market for it.
• Liquidity ratios – ratios that investigate the firms short term liquidity, that is, whether
sufficient current assets are available to cover the company’s current liabilities.
• Maximising shareholders’ wealth – Obtaining the greatest wealth for shareholders
based on their number of shares and highest possible share price.
• Maximising the rate of return – yielding the largest ratio of net after tax profits to total
assets.
• Money markets – a financial relationship created between suppliers and demanders of short-
term funds.
• Net present value – the difference between the initial investment amount and the
present value of the future expected cash flows that have been discounted at the cost
of capital (WACC)
• Nominal interest rate– The contractual annual interest rate charged by a lender or
promised by a borrower
• Optimal capital structure – the capital structure that results in the lowest possible
WACC

IMM Graduate School Study Guide (FM202B) Page 180 of 199

• Payback period – the time period (years) it take for an organisation to pay back its
initial investment
• Present value – The current value of a future amount of money or series of future payments,
evaluated at a given interest rate
• Profit margins – the percentage of turnover that is left after deducting expenses.
• Profit maximisation– the desire to yield the highest monetary return
• Profitability ratios – evaluate the effectiveness of the organisations assets to generate
turnover.
• Solvency ratios –measures the organisations ability to cover all its debt obligations in
the event of closing down.
• Statement of financial position – evaluates the financial position of a company by
focusing on its assets, liabilities and shareholders’ equity.
• Statement of profit and loss – provides a summary of an organisation’s revenue and
expenses
• Turnover ratios – indicates how many times a year an asset is converted into turnover.
• Weighted average cost of capital – the overall cost of capital of an organisation based
on the cost of each source of finance weighted on a suitable proportional basis, such
as market value or book value
• Working capital – a pool of current assets that are in use to empower and
organisation to conduct its daily operations.

IMM Graduate School Study Guide (FM202B) Page 181 of 199

 Addendum C: Suggested solutions to revision exercises

Study Unit 1
Question 1:
All decisions that a financial manager is set to take must not be considered in isolation as there are
various other considerations to take into account other than just the impact on the bottom line. In
this case, the divestment decision may result in the following (amongst others):

The unacceptable social consequences of putting people out of work, the micro environment of
other small business will be negatively influenced.
Trade Union strikes as we have in South Africa.
Possible brand damage through poor publicity and negative press.
The impact on suppliers to Implats – they will suffer the loss in business.
Other financial consequences; some of the lossmaking mines are contributing towards paying
the companies overheads.

Students are required to make some analysis of the stakeholders to answer this question. This could
include political, economic, social, technological, environmental and legal considerations.

Question 2:
A mutual organization is where a company is owned by and run for the benefit of its members –
there are no external members (shareholders) to pay the profits to. In this case the investors/policy
holders own the company and any profits received will get distributed between these
investors/policy holders. 

If a mutual company is listed the company will then have shareholders, and in this case a possible
agency problem may exist.

The purpose of the firm has now changed, form one of maximizing benefits to its policy holders
(which were also the owners) to, a new state of maximizing returns on the policy holders and also
shareholders wealth.

The shareholders may not necessarily own investment or policies within that firm however they do
seek an optimal return of their stock purchase. This return could be short- or long-term, the
shareholders can sell their stock at any time. Investors/policy holders however are in it for the long
run.

There is a conflict of interest here that management will have to be aware of this balance that is
needed

Question 3:

IMM Graduate School Study Guide (FM202B) Page 182 of 199

3.1 Business risk is the risk associated with the type of goods or services being offered. It is the
risk that sales will fluctuate and that goods or services on offer either will not be able to be
supplied, or will not be in demand. Some goods and services are seasonal; others may have
transient demand as a result of fashions, consumer taste or technological development.
Business risk also arises from the nature of the cost structure of the business. A business
with a commitment to meet high fixed costs is considered to be more risky than a business
in which most costs are variable. Business risk is measured by the degree of operating
leverage, which is defined as Contribution/EBIT.

3.2 Financial risk results from the method selected to finance the assets of the business.
When only equity is used, the shareholders do not have a commitment to meet fixed
interest charges. In times of adversity, the return to shareholders will fall, but there will
be no creditors demanding interest payments. The relative quantum of debt in the
capital structure is measured by the debt/equity ratio. The degree of financial leverage is
measured by EBIT/Net income.

3.3 The financial manager can reduce the risk of the company, firstly by seeking investment
opportunities with low risks. This may be difficult, as a business operating in a specific
industry is unlikely to be able to find such investments in that type of industry. The
financial manager could diversify to investment in projects in a different industry, with
lower risk. The chances are however, that the expertise of the business will not be able
to cope with such diversification. If the business risk is high, the financial manager may
attempt to offset this by aiming for a capital structure with little debt, thus not exposing
the company to both business and financial risk. Any change in the risk profile of the
company will have an effect, all other factors remaining constant, on the share price of
the company. A reduction of risk, all other things remaining equal, will increase the
share price, as investors are prepared to risk a higher capital outlay for an expected
return which is less risky.

IMM Graduate School Study Guide (FM202B) Page 183 of 199

Study Unit 2
Questions:
1. D
 12, , P/YR
 -668, PV
 0, PMT
 60, N
 14.5, I/YR
 FV, (answer will pop up) 1,373.26

2. C
 12, , P/YR
 50 000, FV
 5, I/YR
 0, PMT
 36, N
 PV, (answer will pop up) -43,048.81

3. B
 12, , P/YR
 -160 000, PV
 0, FV
 54, N
 10, I/YR
 PMT, (answer will pop up) 3, 691.59

4. C
 12, , P/YR
 -3000, PMT
 0, PV
 150 000, FV
 21.6, I/YR

IMM Graduate School Study Guide (FM202B) Page 184 of 199

 N, (answer will pop up) 35.98

5. A.
 12, , P/YR
 -550 000, PV
 0, PMT
 120, N
 10, I/YR
 FV, (answer will pop up) 1, 488, 872.82

6. D
 12, , P/YR
 10.5, I/YR
 -212500, PV
 48, N
 0, FV
 PMT, (answer will pop up) 5, 440.72

7. B
 12, , P/YR
 90 000, FV
 120, N
 8, I/YR
 0, PMT
 PV, (answer will pop up) -40, 547.11

8. B
 12, , P/YR
 2 000, PMT
 7, I/YR
 240, N
 0, PV
 FV, (answer will pop up) 1, 041, 853.32

IMM Graduate School Study Guide (FM202B) Page 185 of 199

9. C
9650.21*240 = 2, 316, 050.40

Exercise 1:

 1, , P/YR
 - 10 000, PV
 6, I/YR
 2, N
 FV, (answer will pop up) 11,236.00

Exercise 2:
 1, , P/YR
 20 000, FV
 8, I/YR
 5, N
 PV, (answer will pop up) -13,611.66

Exercise 3:
 1, , P/YR
 - 1 500, PV
 2 000, FV
 3, N
 I/YR, (answer will pop up) 10.06

Exercise 4:
 1, , P/YR
 - 5 000, PV
 10 000, FV
 15, I/YR

IMM Graduate School Study Guide (FM202B) Page 186 of 199

 N, (answer will pop up) 4.96

Exercise 5:
For year 1

 1, , P/YR
 150 000, FV
 1, N
 7, I/YR
 PV, (answer will pop up) -140,186.92
For year 2

 1, , P/YR
 225 000, FV
 2, N
 7, I/YR
 PV, (answer will pop up) -196,523.71

For year 3

 1, , P/YR
 400 000, FV
 3, N
 7, I/YR
 PV, (answer will pop up) -326,519.15

Now add all the PV’s of the mixed stream cash flows
 - 140,186.92 - 196,523.71 - 326,519.15 =
 - 663,229.78

IMM Graduate School Study Guide (FM202B) Page 187 of 199

Study Unit 3
Question 1
Memorandum

To: financial manager (BBB)

From: loan officer (BBB)
Re: hammer tools company (HTC) loan application
Date: 5 April 2014

Introduction

The purpose of this report is to provide you with my recommendation regarding the short-term loan
application of Hammer Tools Company. I have split my memorandum into various sections (all
calculations are in R’000):

Profit margins
Ratio 2012 2011 Industry
Gross profit margin R22 000 R20 000
R45 000 R40 909
= 48.89% = 48.89% = 50%
Operating profit margin R 6 000 R 6 182
R45 000 R40 909
= 13.33% = 15.11% = 15%
Net profit margin R 3 353 R 3 469
R45 000 R40 909
= 7.45% = 8.48% = 8%

The gross profit margin has remained the same for 2011 and 2012 at 48.89% showing consistency in
the management of sales activities. This is just slightly below the industry average. The operating
profit margin and net profit margin have decreased from 2010 to 2011 and are now below the
industry average. The profitability does not appear to be a major problem at this stage, but should
be monitored in the future, as revenue increased, while profits decreased slightly from 2010 to
2011. This could be due to an increase in operating costs and further investigation must be made
into streamlining and efficiency within operations.

IMM Graduate School Study Guide (FM202B) Page 188 of 199

Turnover ratios
Ratio 2012 2011 Industry
Total asset turnover R45 000 R40 909
R33 620 R30 000
= 1.34 times = 1.36 times = 1.6
Trade receivables turnover R 7 600 x 365 R 6 000 x 365
time R45 000 R40 909
= 61.64 days = 53.53 days = 45 days
Trade Payables turnover R 2 600 x 365 R 2 000 x 365
time R23 000 R20 909
= 41.26 days = 34.91 days Unknown

The asset turnover is slightly lower than the industry. The receivables days are much longer than the
industry average of 45 days. There has been a significant worsening in collection days in the year
under review (15.15%), which raises concern over the ability of the company to settle its (increasing)
short term debt situation in future. Receivables have increased as a result of the increase in revenue
(10%). However, this may be an indication of possible overtrading.
The industry average has not been given, but from the information we can see that the payables
days are significantly shorter than the receivables days. Payables day is worsening in line with the
receivables days. This may indicate weak management of working capital, and is probably the
reason why HTC is requesting a short-term loan. If HTC can request its suppliers to extend credit
terms to say 60 days, receivables can be recovered before amounts are due to payables

Liquidity ratios

Ratio 2012 2011 Industry

Current ratio R14 620 R13 000
R 9 000 R 8 000
= 1.62:1 = 1.63:1 = 1.5
Quick ratio R14 620 – R5 220 R13 000 – R5 000
R9 000 R8 000
= 1.04:1 = 1.00:1 = 1.00
The current ratio of STC is slightly better than that of the industry. The fact that it is line with the
rest of the industry indicates that current liabilities should be able to be settled with ease. As with

IMM Graduate School Study Guide (FM202B) Page 189 of 199

the current ratio, the quick ratio of STC is in line with the industry. It seems that STC will have
sufficient liquid funds to settle its debts as they fall due.

Profitability ratios

Ratio 2012 2011 Industry

Return on assets R 3 353 R 3 469
R33 620 R30 000
= 9.97% = 11.56% = 10%
Return on equity R 3 353 R 3 469
R20 620 R18 000
= 16.26% = 19.27% = 20%

All the return on capital ratios have decreased from 2011 to 2012. The return on assets ratio is far in
excess of the industry average, while the return on equity ratio is less than the industry and
decreasing. Perhaps HTC is less capital intensive than the rest of the industry (i.e. lower asset base).
HTC could lease its premises through operating leases as there is no property evident on the balance
sheet.

Solvency ratios

Ratio 2012 2011 Industry

Debt to assets ratio R 13 000 x 100 R12 000 x 100
(Total debt : Total assets) R33 620 R30 000
= 38.67% = 40.00% = 50%
Finance cost cover R6 000 R6 182
R 412 R 400
= 14.56 = 15.46 = 25

The debt ratio is below the industry average and has decreased slightly from 2010 to 2011. The debt
ratio does not pose a significant financial risk though. Although the interest cover is below the
industry average, it is still high enough not to pose any significant risks relating to the repayment of
interest.

IMM Graduate School Study Guide (FM202B) Page 190 of 199

Conclusion

HTC have specifically applied for a loan to finance the increase in revenue. The entity is still
profitable and liquid. It does not pose a significant financial risk, as the debt and gearing ratio are
not very high. HTC however need to focus on the management of working capital and guard against
possible overtrading.

I would advise the bank to advance the loan to finance the working capital, as HTC is entering a
growth phase. However, the bank should monitor the liquidity position on a regular basis.

IMM Graduate School Study Guide (FM202B) Page 191 of 199

Study Unit 4
Question 1

1.1 Operating Cycle = AAI + ACP

= 40 + 35
= 75 days

1.2 Cash Conversion Cycle = OC – APP

= 75 -45
= 30 days
Question 2

2.1
Average age of inventory = Inventory/ (Cost of sales/365)
(580 000 x 0.75) = 435 000
= 93 750/ (435 000/365)
= 78,66 days

Average collection period = Accounts receivable/ (Credit sales/365)

= 62 750/ (580 000 /365)
= 39,49 days

Average payment period = Accounts payable/ (Credit purchases/ 365)

= 120 400/ (465 600/365) (93 750 + 435 000 – 63 150)
= 94,39 days

Cash conversion cycle = AAI + ACP – APP

= 78.66 + 39.48 – 94.39
= 23.76 days

2.2 Inventory conversion can be shortened by inventory management.

Account receivable collection can be shortened credit terms etc.
Accounts payable payment can be lengthened by paying as late as possible.

IMM Graduate School Study Guide (FM202B) Page 192 of 199

Study Unit 5
Question 1
1.1 Yes, Conforms to, Current debt/equity = 40%: 60% (i.e. 3+1: 5 + 1)

1.2 Not accurate

Reasons:
 Measuring projects against the cost of individual sources of capital will lead to incorrect
decisions.
 Over the long term, a company will draw from a pool of funds in proportion to the
capital structure to finance investment. It follows that investments must be evaluated
against the cost of the entire pool of funds.
 Different providers to be paid.
 More info needed to elaborate.

1.3
i) Cost of ordinary shares
Risk-free rate 8%
Risk premium 10%
Added premium for private companies 5%
23%

ii) Cost of preference shares

Dividend 50c
Market value of shares R6,50

Cost (%) (50/6, 50) 7.69%

iii) Cost of the long term

N 5
FV R2,20
PV R-1,80
PMT R0,30
I 19.67%

After tax 13.97% (19.67 x (1 – 29%))

IMM Graduate School Study Guide (FM202B) Page 193 of 199

 iv) Cost of the secured bank overdraft
Before tax 18%
After tax 12.78% (18% x (1 – 29%))

1.4
WEIGHTED AVERAGE COST OF CAPITAL

Book value Weight Cost Weighted

Component
Ordinary shares 5 000 000 50% 24.5% 12.25%
Preference shares 1 000 000 10% 9.20% 0.92%
Debentures 3 000 000 30% 12.00% 3.60%
Bank OD 1 000 000 10% 11.35% 1.14%
10 000 000 100% 17.91%

1.5 The debt/equity ratio will change to approx.

75%: 25% (2 + 3 + 12, 5: 5 + 1)
This will increase the risk (finance) profile considerably increase, larger, more debt

Question 2

2.1 Ordinary shares

Equity Value

DY = Dividend ÷ Market Value

Market Value = Dividends ÷ Dividend Yield

= 2.5÷ 0.111 = 22.5 x 1200,000 = 27,000,000

Cost of Equity

Market value = D1 ÷ Ke-g

22.5 = (2.5x1.08) ÷ (Ke-8%)
Ke = 20%

IMM Graduate School Study Guide (FM202B) Page 194 of 199

2.2 Debentures

Debenture Value

Payments ÷ Discount rate

14,000,000 x 16% x 0.72
22% x 0.72

= 1 612 800
15.84%

=10 181 818.18

Cost of Debenture

22% x 0.28 = 15.84%

2.3 Long term loan

Value of Debt

PMT = 3,600 000 x 0.72 = 2 59 2000

I = 20% x 0.28 = 14.4%
N=4
FV = 20,000000
PV = 19,167,685.53

Cost of Debt

20% x 0.72 = 14.4%

2.4 Weighted Average Cost of Capital

Market Value Weights Return WACC

Equity 27,000,000 48% 20% 9.6%

Debenture 10,181,818 18% 15.84% 2,85%

Long term Loan 19,271,036 34% 14.4% 4.90%

Total 56,452,854 100% 17.35%

IMM Graduate School Study Guide (FM202B) Page 195 of 199

Study Unit 6
Question 1
PART A
1.1
 Mutually exclusive projects compete with one another, in this case A vs B
 only one alternative can be chosen,
 in other words, I need to choose the best option
 which will only be one
 The best option (depending on the selection criteria imposed be management) could be the
highest return (NPV/IRR) and/or the fastest payback.
1.2
Project A Project B
2,24 years 3,83 years
2 years 3 months 3 years 10 months
2 & 3/12 years 3 & 10/12 years
Project K must be chosen
1.3
 The payback method ignores time value of money unlike the NVP/IRR/discounted payback
methods therefore not determine whether any wealth maximisation will occur
 Payback does not take risk explicitly into account however management many consider it as
a measure of risk exposure. The longer the firm must wait to recover the funds the higher
the possibility of calamity. NPV/IRR/discounted payback methods do take risk into account
in the form of a discount rate. Risk will be reflected by the discount rate.
 The payback period ignores cash flows after the payback period which can be a major loss of
wealth creation. NPV and IRR take into account the cash flows from the entire investment
period, and is therefore more reliable and universally applicable.
 Payback target set subjectively by management. NPV and IRR methods are based on
objective measures of risk and return such as cost of capital.

IMM Graduate School Study Guide (FM202B) Page 196 of 199

PART B
1.4
Project A Project B
0 (400 000) (600 000)
1 210 000 250 000
2 231 000 250 000
3 254 100 280 000
4 45 000 280 000
NPV 140 349.33 135 333.62

Project A will be chosen as it has the largest NPV, when NPV is positive it means that the projects
return is higher than the required return, which results in shareholder wealth creation and
maximisation. The project with the largest NPV must be chosen as it will add the most value, in other
words it will maximise shareholders’ wealth.

1.5
Disagree.
Motivation:
 The difference between these methods is that IRR assumes that we will reinvest all inflows
at the IRR rate
 NPV method assumes that the cash inflows are reinvested at the cost of capital
 NPV is a better method as the assumption is more reasonable and realistic
 IRR can give you different rankings
 IRR can sometimes have more than one IRR
Question 2
2.1
Projects/investments that compete with one another (same function); the choice of one project
eliminates the others from further consideration

IMM Graduate School Study Guide (FM202B) Page 197 of 199

2.2
Payback period

Project A Project B

Initial Cash Outlay (80 000) (50 000)

Year 1 15 000 15 000
Year 2 20 000 15 000
Year 3 25 000 15 000
20 000
Year 4 /30 000 15 000
5 000
Year 5 - /15000
Payback 3.66 years 4.333 years
3yrs 8 months 4yrs 4 months

2.3
Project A Project B

1 P/Yr 1
13 % I/Yr 13 %
- R80 000 CF0 -R50 000
R15 000 CF1 R15 000
R20 000 CF2 R15 000
R25 000 CF3 R15 000
R30 000 CF4 R15 000
R35 000 CF5 R15 000
R3 659.68 NPV R2 758.47

2.4
 The projects are mutually exclusive, thus one must be chosen.
 NPV = positive for both → highest NPV = Project A
 IRR = both greater than cost of capital (13%) → highest IRR = Project B
 NPV and IRR give a conflicting ranking, but NPV is a superior method.
 Thus, choose Project A(highest NPV).

IMM Graduate School Study Guide (FM202B) Page 198 of 199

 Copyright 2020

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IMM Graduate School Study Guide (FM202B) Page 199 of 199