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FIN3701/1/2021–2023
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CONTENTS
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WELCOME
THE SCOPE OF FINANCIAL MANAGEMENT (FIN3701)
REQUIRED PRIOR LEARNING
FRAMEWORK OF FIN3701
MODULE AIM
MODULE OUTCOMES
THE LEARNING PACKAGE
ASSESSMENT IN THIS MODULE
SUGGESTIONS AND GUIDELINES
ONLINE OFFERING
ICONS USED IN THE MODULE
LEARNING MAP FOR THIS MODULE
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Topic 1: LONG-TERM INVESTMENT DECISIONS
Lesson 1: CAPITAL BUDGETING CASH FLOW
Lesson 2: CAPITAL BUDGETING TECHNIQUES
Lesson 3: RISK AND REFINEMENTS IN CAPITAL BUDGETING
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2
9
18
Topic 2: LONG-TERM FINANCING DECISIONS
Lesson 4: CALCULATING THE COST OF CAPITAL
Lesson 5: THE WACC, WMCC and IOS
Lesson 6: LEVERAGE
Lesson 7: CAPITAL STRUCTURE AND FIRM VALUE
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48
Topic 3: OTHER LONG-TERM FINANCIAL CONCEPTS
Lesson 8: PAYOUT POLICY
Lesson 9: LEASING, MERGERS AND ACQUISITIONS
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64
FEEDBACK ON THE LESSONS ACTIVITIES
74
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
91
CONCLUDING REMARK
101
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(iv)
INTRODUCTION
OVERVIEW
Dear Student
1
WELCOME
Welcome to the module in Financial Management (FIN3701), which is a third-year module.
To ensure that you share our enthusiasm for the field of study, we urge you to read this
overview in detail. Refer back to it as often as you need to, since it will certainly make
studying this module a lot easier. We trust that you will find this module interesting,
challenging and informative.
2
THE SCOPE OF FINANCIAL MANAGEMENT (FIN3701)
Having mastered the basic principles of financial management in the second-year module
on Financial Management (FIN2601), it is now time to direct our attention to further
theoretical and practical applications in the field of financial management. Financial
management is concerned with managerial decision making. The decisions involve the
acquisition funds and application of these funds in the acquisition of business assets.
Decision making can be short-term or long-term. Short-term decision making involves
the management of current liabilities and working capital. Short-term decision making
is comprehensively covered in the module “Working Capital Management (FIN3702)”.
In this module we focus on long-term decision making with regard to
• the efficient management of non-current assets (fixed assets)
• the efficient management of non-current liabilities and owner’s equity
Long-term funds such as ordinary shares, preference shares and long-term debt are
raised from different sources, which have different characteristics in terms of risk, cost
and control. In raising these funds it is critical to ensure that their cost is maintained at
minimum level and that proper balancing of risk and control factors are considered. In
order to achieve this objective, knowledge of the cost of capital, capital structure and
dividend policy is required. This module will cover these aspects comprehensively.
Funds procured need to be utilised in such a manner that they generate a return greater
than the cost of procuring them. This means that funds needed and acquired must be
invested in assets that will enable the company to produce at its optimal level and achieve
the goal of wealth maximisation. For this, a sound knowledge of capital budgeting and
cash flow, capital budgeting techniques, risk refinement, leasing, mergers and
acquisition is required, all of which are covered in this module.
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REQUIRED PRIOR LEARNING
This module does not stand alone – it forms an integral part of the financial management
field of study. This module builds on the fundamental principles and basic concepts
learned in Financial Management (FIN2601). Without a clear understanding of these
concepts and principles, the achievement of the learning outcomes of the module will
not be easy. The basic concepts and fundamental principles that were learned in FIN2601
include the basic valuation model, the time value of money, the valuation of shares and
debentures, and the principles of risk and returns. Thorough knowledge of these concepts
is required in order to complete this module successfully.
4
FRAMEWORK OF FIN3701
The tutorial matter in this module is divided into three main topics, namely long-term
investment decisions, long-term financial decisions and other long-term financial concepts.
Each topic is divided into a number of lessons. Each lesson has learning outcomes against
which you can measure your progress as you proceed through the module.
The study guide provides a framework of basic information into which you should
incorporate other relevant information. Consult the table of contents and chapter learning
goals in your prescribed book for information with which to supplement the basic
information found in the study guide. Figure 1 below illustrates the learning framework
for this module.
Figure 1: Framework of Financial Management 3701
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5
MODULE AIM
The aim of this module is to equip learners with the knowledge and skills to take long-term
investment and financing policy decisions that are in line with the goal of shareholder
wealth maximisation.
6
MODULE OUTCOMES
Unisa follows an outcomes-based approach to learning. In line with Unisa’s educational
policy, this module is thus also based on outcomes-based learning. The focus of this module
is therefore on the achievement of specific learning outcomes and not on memorising the
chapters in the prescribed textbook. The learning outcomes are linked to the activities,
assignments and examination. On completion of this module, you should be able to
• undertake long-term investment appraisal by applying recognised capital budgeting
techniques
• identify sources of financing, and advise management on the most appropriate sources
and cost of financing for the business
• determine the target capital structure and the value of the business
• advise management on dividend policy decisions in line with the goal of shareholder
wealth maximisation
• apply the lease versus buy decision
• outline the important considerations during the merger and acquisition process
7
THE LEARNING PACKAGE
The learning package of this module consists of the wrap-around study guide, prescribed
book and tutorial letters.
Wrap-around study guide
This is a wrap-around study guide – it is wrapped around the prescribed book to accompany
it. The purpose of this study guide is to
• guide you through the prescribed book
• help you understand and interpret the concepts in the book
by stimulating discussions and completing activities which should help you to achieve
the learning outcomes of this module.
Prescribed book
The details of the prescribed book on which this wrap-around guide is based appear in
the text box below. It is critical that you obtain a copy of this book.
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Gitman, LJ, Beaumont-Smith, M, Hall, J, Marx, J, Strydom, B & Van der Merwe, A.
Principles of Managerial Finance: Global and Southern African Perspective. 2021. 2nd
edition: Cape Town: Pearson Publishers. ISBN:978-1-77578-887-4
Recommended books
Please note that these books are only recommended and are not mandatory for you to
pass the module.
1.
2.
3.
4.
Besley, S & Brigham, EF. 2005. Essentials of managerial finance. 3rd edition. Mason:
Thomson/South-Western.
Brealey, R, Myers, S & Framclin, A. 2006. Principles of corporate finance. 8th edition.
New York: McGraw-Hill.
Lumby, S & Jones, C. 2003. Corporate finance: theory and practice. 7th edition. London:
Thompson/South-Western.
Ngwenya, S & Toit, E. 2010. Corporate finance: A South Africa percepective. Oxford
University. Cape Town: Oxford.
Tutorial letters
Several tutorial letters will be sent to you during the course of the semester. This module
forms part of a distance education course and the tutorial letters are our method of
communication with you. The tutorial letters contain valuable information on the module
itself as well as important information on the study material, assignments and their due
dates, lecturers and their contact details and examination details. For those of you who
have access to myUnisa, please ensure that you download, read and keep these tutorial
letters to help you keep abreast with the module.
8
ASSESSMENT IN THIS MODULE
You will be continuously assessed in this module. You will be assessed on your assignments
during the semester and also in the examination at the end of the semester. In addition,
you will have the opportunity to assess yourself through the self-assessment questions
included at the end of each lesson. We will give fewer and fewer answers to the assessment
questions as you progress through this module and your understanding of the financial
management field develops. This means that we make provision for facilitating the
development of your problem-solving and analytical thinking skills.
Assignments
The assignments for this module are provided in Tutorial Letter 101. There are various
reasons why it is extremely important to complete the assignments:
• Assignments 1 and 2 contribute towards your final assessment mark.
• Completing assignments will help you to achieve the learning outcomes for these
module.
(viii)
• Completing assignments will give you an idea of the type of questions to expect in
the examination.
Assessment questions in the study guide
At the end of each section in the study guide you will find a list of possible assessment
questions based on the work that has been covered in that section. We advise you to work
through these questions diligently, since they provide extremely useful opportunities to
prepare yourself for possible examination questions. Self-assessment plays a critical role
in mastering the learning outcomes and you should complete all the self-assessment
activities in the study guide.
You will find most of the answers to these questions in the learning material covered in
the study guide and the prescribed book. We believe that you should not encounter any
surprises in the examination. Consequently, it is in your own interest to work through
these assessment questions.
Activities in the study guide
You will come across various types of activities in this study guide, reflecting on the work
covered. We urge you to complete all the activities. The activities were developed in
such way that they help you to develop your conceptual skills, which are very important
in financial management. The activities will give you an opportunity to think of ways to
apply and implement new knowledge in your workplace. If you refer back to the learning
outcomes of this module, you will see that in several instances you have to interpret specific
concepts. Interpret means that you firstly have to possess the relevant knowledge, but
it goes even further than that. Only by completing activities and assignments will you
gain insight into the module.
Examinations
At the end of the semester your final assessment will be a written examination. Details
of the format of the examination can be found in Tutorial Letter 101. We suggest that for
the examination preparation, you revisit the aspects in each learning outcome that you
have studied and that are cited in the checklist, and revise all assignments, assessment
questions and activities in the study guide.
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SUGGESTIONS AND GUIDELINES
This study guide will help you to achieve competence for this module, provided that you
follow these guidelines:
• Use all the tutorial matter conscientiously according to the guidelines and the sequence
provided.
• Relate your learning to your work situation and identify as many practical examples
from your work experience as possible to promote your learning and growth.
• Use the study guide according to the guidelines provided.
• Do your own reading, searches and research to enhance your knowledge.
• Participate actively in the myUnisa Discussion Forum.
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ONLINE OFFERING
The myUnisa platform has been developed to assist students in their learning process.
It is therefore imperative for you to register for a myLife e-mail address and access to
myUnisa. This will enable you to access study material, submit assignments, the library
functions and various learning resources, download study material and chat to your
lecturers and fellow students about your studies and the challenges you encounter, and
also participate in online discussion forums.
11
ICONS USED IN THE MODULE
In order to guide you effectively through this study guide we make use of specific icons.
These icons serve as a guideline for what you have to do in each lesson. The icons that will
be used in this module are listed below, together with a description of what each means:
Learning outcomes. The aspects of a particular topic or lesson you
have to master (i.e. know and understand) and will be tested in the
examination to demonstrate competence.
Assessment criteria. The aspects of a particular topic or lesson you
have to master (i.e. know and understand) and will be tested in the
examination to demonstrate competence.
Key concepts. Attention is drawn to certain keywords or concepts that
you will come across in the topic or lesson.
Overview. The overview provides the background to a particular topic
or lesson.
Activity . These self-assessment activities should be performed in order
to develop a deeper understanding of the learning material.
Feedback. Feedback is provided on the self-assessment activities.
Study. The study icon indicates which sections of the prescribed book
you need to study (i.e. learn, understand and practise).
(x)
Assessment. When you see the assessment icon you will be required
to test your knowledge, understanding and application of the material
you have just studied.
Summary. This section provides a brief summary of what was covered in
a particular lesson and what can be expected in the following lesson(s).
Self-assessment feedback. This section provides feedback on selfassessment questions.
Checklist. After completion of a particular lesson, you should confirm
that all learning outcomes were in fact achieved and that you comply
with the assessment criteria.
12
LEARNING MAP FOR THIS MODULE
The learning map below illustrates the lessons that are to be covered in the completion
of the Financial Management module (FIN3701).
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Topic 1
LONG-TERM INVESTMENT DECISIONS
AIMS
The aims of this topic are to
1. explain the motives and terminology for capital expenditure and accurately calculate
the relevant cash flows
2. evaluate capital budgeting projects using the average rate of return, payback period,
net present value, internal rate of return, profitability index and equivalent annual
annuity techniques
3. incorporate risk (by means of risk-adjusted discount rates and certainty equivalents)
and make investment decisions where projects have unequal lives or are constrained
by capital rationing
INTRODUCTION
Topic 1 is divided into the following three lessons (SUs), which together constitute a vital
part of long-term investment decisions:
Lesson 1:
Lesson 2:
Lesson 3
Capital budgeting and cash flow principles
Capital budgeting techniques
Risk and refinements in capital budgeting
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LESSON 1
CAPITAL BUDGETING AND CASH FLOW
PRINCIPLES
CONTENTS OF LESSON
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
Tutorial matter
Learning outcomes
Key concepts
Overview
Summary
Activities
Feed back on activities
Self-assessment questions
Self assessment questions feedback
Checklist
1.1
TUTORIAL MATTER
Study chapter 11 in your prescribed book.
1.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
• explain the motives and terminology for capital expenditure
• recognise the steps in the capital budgeting process
• accurately calculate the incremental cash flows of proposed capital expenditure
1.3
KEY CONCEPTS
•
•
•
•
•
•
•
•
•
•
Capital budgeting
Capital expenditure
Operating expenditure
Capital budgeting process
Accept-reject approach
Book value
Sunk cost
Opportunity costs
Incremental cash flow
Change in net working capital
2
1.4
OVERVIEW
Introduction
In this lesson, capital budgeting is discussed in greater detail. The steps in the
capital budgeting process are described, beginning with proposal generation
and ending with follow-up, and the associated terminology is defined. The special
concerns involved in international capital budgeting projects are discussed next.
The lesson concludes with the basics of determining relevant after-tax cash
flows of a project, from the initial cash outlay to annual cash stream of costs and
benefits and terminal cash flow.
Capital budgeting is a process of deciding whether or not to undertake
the investment project. The process requires that relevant cash flows that
are associated with the investment be correctly estimated. Cash flow is
an important concept in capital budgeting that you need to understand to
enable you to evaluate investment projects, because it removes the effects of
accounting methods and delivers a clear picture of the inflows and outflows
of cash. It is critical that you develop a thorough understanding of basic
terminology in capital budgeting before you can attempt to calculate any
cash flow. The concepts are explained on section 11.1 in the prescribed
book. The cash flows that need to be estimated in capital budgeting decisionmaking are initial investment, operating cash flows and terminal cash flow.
Initial investment
Initial investment is the amount of money required to start a business or a
project. In the context of capital budgeting, it refers to the amount of money
needed for capital expenditure such as machinery, tools, property and plant.
Initial investment is calculated as the cost of new assets plus installation
costs minus after-tax proceeds from the disposal of any old assets plus the
increase in net working capital. Sunk costs are ignored as they are irrelevant
cash flow in capital budgeting decision-making. However, opportunity costs
must be included in the calculations of the initial investment.
Operating cash flow
Operating cash flow is the cash that a company generates as a result of normal
business operations. It is a better measure of a business’s profits than earnings,
because a company can show positive net earnings on the income statement but
not be able to pay its debts. During the capital budgeting process, the viability
of a project is evaluated based on the cash flows to be generated by the project
over its lifespan. Using discounted cash flow analysis, the project’s future value
of the cash flows over its life are brought back to the present value to determine
whether it is worthwhile for the company to pursue the project. Operating cash
flow must be calculated as revenues minus cost. Depreciation must be excluded,
since it is not a cash outflow. Although interest is a cash flow, it must be excluded
from the calculation of the operating cash flow because it is a financing expense.
Taxes must be included because taxes are paid in cash.
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Terminal cash flow
Terminal cash flow refers to the cash flow that takes place at the end of the
project life.
According to the calculation of terminal cash flow in table 8.9 in the prescribed
book, the change in net working capital that was taken into account during the
calculation of initial investment is reversed in the calculation of terminal cash flow.
If there was an increase in net working capital at the beginning of the project, it
will be treated as inflow at the end of the project. Note that in the calculation of
terminal cash flow, operating cash flow from the last year of the project life must
be excluded or calculated separately from the terminal cash flow calculation.
It is imperative to understand that the estimation of the relevant cash flow is
influenced by the motive of investment. If the investment project is new or an
expansion of the existing one, than the focus must be on the after-tax cash inflow
and outflow of the new project. In the case of a replacement decision, the aftertax cash inflow and outflows that will result from the disposal of the old asset
must be accounted for. In this case the decisions on whether to invest or not on
the project will be based on the incremental cash flow that would result from
the difference between the cash flow from the new asset and the old asset.
1.5
SUMMARY
In this lesson you were introduced to capital budgeting process. You learnt how
to estimate the relevant cash flows associated with long-term investment. It was
indicated that the calculation of relevant cash flows must place emphasis on the
after-tax cash flows of the project. The steps in the capital budgeting process
were described, beginning with proposal generation and ending with followup, and the associated terminology were defined. The lesson concluded with
the discussion of how the expansion and replacement motives influence the
calculation of relevant cash flow. In the following lesson, the focus is diverted to
the capital budgeting process.
1.6
ACTIVITIES
ACTIVITY 1.6.1
In your own words, define and explain how the following terms apply when capital budgeting
decisions are made:
•
•
•
•
•
•
•
•
independent projects
mutually exclusive projects
unlimited funds
capital rationing
accepts/reject approach
ranking approach
conventional cash flow pattern
annuity
4
• mixed cash flows
• incremental cash flows
ACTIVITY 1.6.2
Now let us see if you can calculate the book value, taxes and initial investment. Work through
question ST11-1 at the end of chapter 11 in the prescribed book.
ACTIVITY 1.6.3
This activity tests your understanding and application of relevant cash flows. Work through
question ST11-2 at the end of chapter 11 in the prescribed book.
ACTIVITY 1.6.4
Bottling Ltd is a manufacturer of glass bottles. The company has been advised by a consultant
to introduce plastic bottles for the coming Rugby World Cup, since glass bottles will not be
allowed in any of the stadiums. The consultant charged them R14 000 for the market study.
To produce the plastic bottles, the company will have to buy a machine for R120 000 and
two moulds, one for the containers and the other for the lids. The cost for both moulds is
R22 000 in total. The machine will be depreciated according to the straight-line method
over its two-year life span. At the end of the two years, the machine will be sold for 23%
of its initial costs.
The consultant projects the sales to amount to R80 000 for the first year, with a decrease
of 10% in the second year. The total fixed costs are R4 500 per year and the variable costs
are 15% of the sales.
Bottling Ltd will need plastic material worth R1 200 in order to commence with the production.
The Company will finance some of the plastic material using overdraft facilities of R1 000.
The cost of capital is 10%. Income and capital gains are taxed at 29%.
Reguired
Do a complete capital budgeting analysis of the incremental cash flows resulting from the
renewal. What is your recommendation? (Hint: Use NPV and IRR and comment on your
answers.)
1.7
FEEDBACK ON ACTIVITIES
Suggested feedback on activity 1.6.4 will be uploaded on myUnisa after the students have
attempted the activities.
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1.8
SELF-ASSESSMENT QUESTIONS
Multiple-choice questions
Question 1
Capital budgeting is the process used to …
(1) evaluate the profitability, liquidity and solvency of the firm.
(2) determine the minimum rate of return a firm must earn in order to maintain its market
value.
(3) determine if cash inflow will exceed cash outflow over the next three months.
(4) evaluate and select long-term investments consistent with owner wealth maximisation.
Question 2
Which one of the following is not an example of capital expenditure motives?
(1)
(2)
(3)
(4)
First National Bank is evaluating the start-up of a new branch.
SAA is considering the replacement of three Boeing 747s.
Boston College has to buy stationery for one of their lecturers.
KPMG is considering upgrading its 184 personal computers.
Question 3
The steps in the capital budgeting process are …
(1)
(2)
(3)
(4)
proposal generation, decision-making, implementation, review and analysis, follow-up.
proposal generation, review and analysis, decision-making, implementation, follow-up.
proposal generation, decision-making, implementation, follow-up.
proposal generation, review and analysis, decision-making, implementation.
Question 4
Each of the following statements is correct, except …
(1) an annuity is a stream of each of each annual cash flow.
(2) “independent” projects” means that the acceptance of one project eliminates the others.
(3) capital rationing means the firm only has a limited amount of financing available for
capital expenditure.
(4) a conventional cash flow pattern is one which involves an initial investment followed.
Question 5
Relevant cash flows are the …
(1)
(2)
(3)
(4)
incremental after-tax cash outflow and the resulting cash inflows.
operating cash inflows.
terminal cash flows.
sunk costs.
6
Question 6
SA Printing Ltd faces a replacement decision and intends purchasing new printing equipment at R300 000. The cost of installation is expected to amount to R10 000. The proceeds
from the sale of the present equipment are expected to amount to R135 000 and the tax
on the sale of the present equipment will be R35 000. The investment requires an increase
of R30 000 in inventory, R80 000 in accounts receivable and R40 000 in account payable.
The initial investment equals …
(1)
(2)
(3)
(4)
R210 000.
R250 000.
R280 000.
R360 000.
Question 7
SA Printing Ltd expects that its new printing facilities will generate the following Profit (or
loss) after taxes:
Net profit (or loss)
after taxes
Year 1
Year 2
Year 3
Year 4
Year 5
R24 000
R34 000
R 44 000
R64 000
-R6 000
The equipment can be purchased at R280 000 and depreciated on a straight-line basis over
a five-year period. The firm is subject to a 35% tax rate. The firm’s operating cash inflows
equal …
Operating cash flow
Year 1
Year 2
Year 3
Year 4
Year 5
1
R 80 000
R 90 000
R 100 000
R 120 000
R 50 000
2
R 80 000
R 96 000
R 156 000
R 176 000
R 50 000
3
R 82 000
R 69 000
R 135 000
R 91 000
R 50 000
4
R 85 000
R 34 000
R 65 000
R 64 000
R 50 000
*Excludes terminal cash flow of R 10 000.
Question 8
SA Printing Ltd expects that its new equipment can be sold for R 5000 at the end of its
five-year usable life and the firm will have to pay R 1 750 in taxes. Dismantling cost will
amount to R 1 000. The firm will be able to sell inventory associated with the project for
R 3000, factor accounts receivable and receive net R 8 750 and pay creditors of R 4 000.
The firm will not have to pay any tax on the sale of the present equipment. The terminal
cash inflow (excluding the final year’s operating cash flow of R 50 000) is expected to be …
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FIN3701/1
(1)
(2)
(3)
(4)
1.9
R 10 000.
R 20 000.
R 30 000.
R 40 000.
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
Suggested solutions to the self-assessment questions will be uploaded on myUnisa after the
students have attempted the questions.
1.10 CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activity?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcome?
Would you be able to meet the stated assessment criteria?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
Are any additional resources available from myUnisa?
8
LESSON 2
CAPITAL BUDGETING TECHNIQUES
CONTENTS OF LESSON
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
Tutorial matter
Learning outcomes
Key concepts
Overview
Summary
Activities
Feedback on activities
Self-assessment questions
Feedback on self-assessment questions
Checklist
2.1
TUTORIAL MATTER
Study chapter 10 in your prescribed book.
2.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
• accurately calculate, interpret and evaluate payback period, net present value and
internal rate of return
• compare net present value and internal rate of return techniques using net present
value profiles
• discuss net present value and internal rate of return in terms of conflicting rankings
and the theoretical and practical strengths of each approach
2.3
KEY CONCEPTS
•
•
•
•
•
•
Capital budgeting techniques
Payback period
Net present value
Internal rate of return
Conflicting rankings
Net present value profile
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FIN3701/1
2.4
OVERVIEW
Introduction
It is essential that proper screening of the investment proposal takes place before
funds can be committed to an investment project. The first part of the screening
(estimation of relevant cash flows) was highlighted and discussed in the previous
lesson. This lesson discusses the second part of the screening process, which
involves the use of capital budgeting techniques along with the estimated cash
flow to select long-term investments that are consistent with the firm’s goal of
maximisation of owner wealth. For the purpose of this lesson, the discussion will
be limited to the following capital budgeting techniques:
•
•
•
•
•
•
Payback period (PB)
Net present value (NPV)
Annualised net present value (ANPV)
Internal rate of return (IRR)
Profitable index (PI)
Modified IRR (MIRR)
All of the above techniques are based on the comparison of cash inflows and
outflows of the project, however, they are substantially different in their approach.
Most companies use multiple techniques for all their capital budgeting decisions.
Since each method looks at the investment from a different perspective, it is best
to employ multiple analyses and take the opportunities with the best return
according to all techniques. There are many pitfalls and you should take particular
care when applying the different capital budgeting techniques.
The prescribed book contains full explanations and comprehensive examples of
most of the techniques mentioned. Define each technique and take note of its
assumptions and decision rules. PI and MIRR will be fully discussed in the study
guide. Note that although ANPV is covered in chapter 11 in the prescribed book,
it is discussed in this lesson due to its use as a capital budgeting technique and
its close relation to NPV.
When you study and apply the respective capital budgeting techniques, always
make sure that you
• keep the purpose of the firm in mind
• use only incremental cash flows (you may draw a time line for each project
under consideration)
• can define each criteria precisely
• can write down an equation for each technique
• can identify the variables applicable to each technique
• know the inherent assumptions of each technique
• know the decision criteria applicable to each technique
• are aware of the limitations of each technique
• can critically compare the various techniques
10
Most companies use multiple techniques for all of their capital budgeting decisions
because each method looks at investment from a different perspective. Some
decision makers prefer the use of one technique over the other. Sometimes one
technique is theoretically superior to the other, but not in practice. Despite their
ability to aid in the capital budgeting analysis, the NPV and IRR techniques suffer
from several serious problems. In order to address these problems, it is critical to
understand the differences between the two techniques and decision makers’
preferences in their use.
Profitability index
The profitability index (PI) method compares the present value of future cash
inflows with the initial investment on a relative basis. Therefore, the PI is the ratio
of the present value of cash flows to the initial investment in the project.
PI = present value of cash flow
Initial investment
In this method, a project with a PI greater than 1 is accepted, but a project is
rejected when its PI is less than 1. Note that the PI method is closely related to
the NPV approach. In fact, if the net present value is negative, the project will be
having a PI of less than 1. On the other hand, if the net present value is negative,
the project will have a PI of less than 1. Therefore the same conclusion is reached,
whether the net present value or the PI is used. In other words, if the present
value of cash flows exceeds the initial investment, there is a positive net present
value and PI greater than 1, indicating that the project is acceptable.
Modified internal rate of return (MIRR)
The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two
weaknesses of the IRR. The MIRR correctly assumes reinvestment at the project’s
cost of capital and avoids the problem of multiple IRRs. However, please note
that in practice the MIRR is not used as widely as the IRR.
There are three basic steps of the MIRR:
1.
2.
3.
Estimate all cash flows as in IRR.
Calculate the future value of all cash inflows in the last year of the project’s life.
Determine the discount rate that causes the future value of all cash inflows
determined in step 2 to be equal to the firm’s investment at zero. This
discount rate is known as the MIRR.
MIRR is better than IRR because of the following reasons:
• MIRR correctly assumes reinvestment at the project’s cost of capital.
• MIRR avoids the problem of multiple IRRs.
Why the NPV and IRR sometimes select different projects
When comparing two projects, the use of the NPV and the IRR methods may
give different results. A project selected according to the NPV may be rejected
if the IRR method is used.
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Suppose there are two alternative projects, X and Y. The initial investment in each
project is R2 500. Project X will provide annual cash flows of R500 for the next 10
years. Project Y has annual cash flows of R100, R200, R300, R400, R500, R600, R700,
R800, R900, and R1 000 in the same period. Using the trial and error method as
explained before, you find that the IRR of project X is 17% and the IRR of project
Y is 13%. If you use the IRR method, project X should be preferred because its
IRR is 4% more than the IRR of project Y. But what happens to your decision if
the NPV method is used? The answer is that the decision will change depending
on the discount rate you use. For instance, at a 5% discount rate, project Y has a
higher NPV than project X has. But at a discount rate of 8%, project X is preferred
because of the higher NPV.
The purpose of this numerical example is to illustrate an important distinction:
the use of the IRR always leads to the selection of the same project, whereas
project selection using the NPV method depends on the discount rate chosen.
Project size and life
There are reasons why the NPV and the IRR are sometimes in conflict: size and
life of the project being studied are the most common ones. A 10-year project
with an initial investment of R100 000 can hardly be compared to a small threeyear project costing R10 000. Actually, the large project could be thought of as 10
small projects. So, if you insist on using the IRR and the NPV methods to compare
a big, long-term project with a small, short-term project, don’t be surprised if
you get different selection results. (See the equivalent annual annuity discussed
later for a good way to compare projects with unequal lives.)
Different cash flows
Furthermore, even two projects of the same length may have different patterns
of cash flow. The cash flow of one project may continuously increase over time,
while the cash flow of the other project may increase, decrease, stop, or become
negative. These two projects have completely different forms of cash flow, and
if the discount rate is changed when using the NPV approach, the result will
probably be different orders of ranking. For example, at 10% the NPV of project
A may be higher than that of project B. As soon as you change the discount rate
to 15%, project B may be more attractive.
When are the NPV and IRR reliable?
Generally speaking, you can use and rely on both the NPV and the IRR if two
conditions are met. Firstly, if projects are compared using the NPV, a discount
rate that reflects the risk of each project fairly should be chosen. There is no
problem if two projects are discounted at two different rates because one project
is riskier than the other. Remember that the result of the NPV is as reliable as the
discount rate that is chosen. If the discount rate is unrealistic, the decision to
accept or reject is baseless and unreliable. Secondly, if the IRR method is used,
the project must not be accepted only because its IRR is very high. Management
must ask whether such an impressive IRR is possible to maintain. In other words,
management should look at past records and existing and future business to see
12
whether an opportunity to reinvest cash flows at such a high IRR actually exists.
If the firm is convinced that such an IRR is realistic, the project is acceptable.
Otherwise, the project must be re-evaluated by the NPV method, using a more
realistic discount rate.
You should remember
The IRR is a popular method in capital budgeting. IRR is a discount rate that
makes the present value of estimated cash flows equal to the initial investment.
However, when using the IRR, you should make sure that the calculated IRR is
not very different from the realistic reinvestment rate.
Advantages and disadvantages of IRR and NPV
A number of surveys have shown that, in practice, the IRR is more popular than
the NPV approach. The reason may be that the IRR is straightforward, but, like
the NPV, it uses cash flows and recognises the time value of money. In other
words, while the IRR method is easy and understandable, it does not have the
drawbacks of the ARR(NPV?) and the payback period, both of which ignore the
time value of money.
The main problem with the IRR method is that it often gives unrealistic rates of
return. Suppose the cutoff rate is 11% and the IRR is calculated at 40%. Does this
mean that management should immediately accept the project because its IRR
is 40%? The answer is no. An IRR of 40% assumes that a firm has the opportunity
to reinvest future cash flows at 40%. If past experience and the economy indicate
that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect.
Simply put, an IRR of 40% is too good to be true. Therefore, unless the calculated
IRR is a reasonable rate for reinvestment of future cash flows, it should not be
used as a yardstick to accept or reject a project. Another problem with the IRR
method is that it may give different rates of return. Suppose there are two discount
rates (two IRRs) that make the present value equal to the initial investment. In
this case, which rate should be used for comparison with the cutoff rate? The
purpose of this question is not to resolve the cases where there are different IRRs.
The purpose is to let you know that the IRR method, despite its popularity in the
business world, entails more problems than a practitioner may think.
2.5
SUMMARY
This lesson continued the discussion of capital budgeting begun in the preceding
lesson, establishing the basic principle of determining relevant cash flow. The
lesson described the capital budgeting techniques used together with cash flow
to evaluate capital investment. It also explained advantages and disadvantages
of IRR and NPV and why the NPV and IRR sometimes select different projects or
conflicting projects. Note that it was assumed that cash flows projected in lesson
1 and capital budgeting techniques introduced in lesson 2 were applied in an
environment that was certain. In the next lesson, this assumption is relaxed and
risk factors are incorporated in the capital budgeting decision-making.
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2.6
ACTIVITIES
ACTIVITY 2.6.1
Eyethu Ltd is considering replacing its existing oven with a more advanced one. Below are
the details of both the existing and the new oven.
Existing oven
Book value
Remaining useful life
Depreciation
Earnings before depreciation,
interest and tax (EBDIT)
Current resale value
= R340 000
= 3 years
= R120 000 pa straight line
= R210 000
= R290 000
New oven
Purchase price
Estimated useful life
Resale value after 3 years
Depreciation
Increase in sales
Fixed costs
Variable costs
Tax rate
Required rate of return
=
=
=
=
=
=
=
=
=
R460 000
3 years
31% of purchase price
R160 000 pa straight line
R410 000 each year
R110 000
11% of sales
30%
10%
Required
Should the firm purchase the new oven? Base your answer on the NPV decision criteria.
ACTIVITY 2.6.2
Work through questions E10-1 to E10-5 at the end of chapter 10 in the prescribed book.
ACTIVITY 2.6.3
These activities test your understanding and application of different capital budgeting
techniques given two independent projects. You are given the projects Alpha and Bravo
below. (Cost of capital is 15%.)
Relevant information
Project Alpha
Project Bravo
Initial investment
R20 000
R20 000
Year (period)
Net cash inflow
Net cash inflow
1 t=1
R5 600
R13 000
2 t=2
R5 600
R7 000
3 t=3
R5 600
R6 000
4 t=4
R5 600
R2 000
5 t=5
R5 600
R2 000
14
Required:
1.
2.
2.7
Draw a time line for projects Alpha and Bravo, including all the decision
variables.
Calculate the following for each project:
a. Payback period (PB)
b. Net present value (NPV)
c. Internal rate of return (IRR)
d. Profitability index (PI)
FEEDBACK ON ACTIVITIES
Suggested feedback on the activities 2.6.1 will be uploaded on myUnisa after the students
have attempted the activities.
2.8
SELF-ASSESSMENT QUESTIONS
Multiple-choice questions (MCQs)
Question 1
SA Printing Ltd made an initial investment (II) of R 280 000 in printing equipment. The
investment is expected to generate the following cash inflows (cf):
Year
1
2
3
4
5
Cf
R 80 000
R 90 000
R 100 000
R 120 000
R 60 000
The firm requires that all investments must have a payback period of four years or less. The
payback period is … and based on the payback period, the investment should …
(1)
(2)
(3)
(4)
three years and one month, be undertaken.
three years and six months, not be undertaken.
four years and two months, be undertaken.
four years and eight months, not be undertaken.
Question 2
SA Printing Ltd has made an initial investment requiring R 280 000. The firm’s cost of capital
is 10%. The investment is expected to generate the following cash flows (CF):
Year
1
2
3
4
5
CF
R 80 000
R 90 000
R 100 000
R 120 000
R 60 000
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The net present value of the investment is closest to … and the investment should ...
(1)
(2)
(3)
(4)
–R 61 458, not be undertaken.
+ R 61 458, be undertaken.
– R 341 458, not be undertaken.
+ R 341 458, be undertaken.
Question 3
SA Printing Ltd has made an initial investment requiring R 280 000. The firm’s cost of capital
is 10%. The investment is expected to generate the following cash flows (Cf):
Year
1
2
3
4
5
Cf
R 80 000
R 90 000
R 100 000
R 120 000
R 60 000
The IRR of the project is closest to … and the investment should …
(1)
(2)
(3)
(4)
10, 18%, not be undertaken.
12, 88%, not be undertaken.
18, 22%, be undertaken.
22, 18%, be undertaken.
Question 4
SA Printing Ltd has made an initial investment requiring R 280 000. The firm’s profitability
index (PI) is … and the investment should …
(1)
(2)
(3)
(4)
0, 291, be undertaken.
0, 921, not be undertaken.
1. 000, not be undertaken.
1, 219, be undertaken.
Question 5
SA Printing Ltd has evaluated the viability of an investment. The firm should make the
investment if …
(1)
(2)
(3)
(4)
NPV is greater than zero.
IRR exceeds the cost of capital (WACC).
PI is greater than one.
All of the above.
Question 6
Conflicting rankings using NPV and IRR result from differences in …
(1)
(2)
(3)
(4)
discount rates.
magnitude of cash flows.
timing of cash flows.
Both 2 and 3 above.
16
Question 7
Conflicting rankings between investment alternatives may be solved by means of …
(1)
(2)
(3)
(4)
2.9
arbitration.
NPV profiles.
arbitrage.
CAPM.
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
Suggested solutions to the self-assessment questions will be uploaded on myUnisa after the
students have attempted the questions.
2.10 CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activity?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcome?
Would you be able to meet the stated assessment criteria?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
Are any additional resources available from myUnisa?
17
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LESSON 3
RISK AND REFINEMENTS IN CAPITAL BUDGETING
CONTENTS OF LESSON
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
Tutorial matter
Learning outcomes
Key concepts
Overview
Summary
Activities
Feedback on activities
Self-assessment questions
Feedback on self-assessment questions
Checklist
3.1
TUTORIAL MATTER
Study chapter 12 in your prescribed book.
3.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
• explain the approaches to dealing with risk in the capital budgeting process
• incorporate risk into the capital budgeting process by applying the behavioural
approach
• incorporate risk into the capital budgeting process by applying risk-adjusted discount
rates
• determine the optimal capital budget under the capital rationing constraint
• compare projects with unequal lives by using annualised net present value
3.3
KEY CONCEPTS
•
•
•
•
•
•
Behavioural approach
Risk-adjusted discount rate
Scenario analysis
Simulation
Annualised net present value
Capital rationing
18
3.4
OVERVIEW
Introduction
In lessons 1 and 2 we developed the major decision-making aspects of capital
budgeting. Cash flows and budgeting models have been integrated and discussed
in providing the principles of capital budgeting. We stated in lesson 1 that the
first step in the capital budgeting process is to decide on the number of projects
we want to invest in and then estimate the cash flows that will come from the
chosen projects. Furthermore, we indicated in lesson 2 that the second step is to
evaluate the estimated cash flows that will come from the chosen projects using
capital budgeting techniques in order to choose the best projects. However, there
are more complex issues beyond those presented. In this lesson we discuss the
third step in capital budgeting, which is to estimate the riskiness of the estimated
cash flows that will come from the selected best projects.
A significant degree of uncertainty is usually associated with capital budgeting
projects. This lesson looks at behavioural approaches for dealing with risk and
the use of risk-adjusted discount rates to explicitly recognise risk in the analysis
of capital budgeting projects. The lesson concludes with a discussion on capital
budgeting refinements, which must often be made in the analysis of capital
budgeting project to accommodate mutual exclusive projects having unequal
lives and capital rationing in the context of risk.
Behavioural approaches for dealing with risk
The techniques that are used to include the elements of risk under this approach
in capital budgeting are risk in cash inflows, scenario analysis and simulation.
The scenario analysis avoids the chance of making estimation errors by providing
more than one estimate of future cash inflows of a project. It gives a more precise
idea about the variability of the cash inflows.
Scenario analysis provides information about the cash inflows under three
assumptions. Firstly, “pessimistic”, secondly, “most likely”, and thirdly, “optimistic”
outcomes associated with the project. Using the three different situations it
explains how sensitive the cash inflows are. The higher the difference between
the pessimistic and optimistic cash inflows, the riskier the project and vice versa.
Study the section on risk and cash flow, scenario analysis, simulation and work
through activities 3.6.1 and 3.6.2.
Risk-adjusted discount rates
This technique assumes that the higher the rate of return, the higher the risk
involved. This means that the investor expects that when more risk is involved,
if everything goes well, the return on investment will be higher. It also implies
that the less risk involved, the lower the returns.
To calculate the rate of risk we have to ascertain two elements associated with
it. These elements are:
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FIN3701/1
a.
b.
Risk-free rate: this is the rate which will be computed by assuming a ‘no risk’
situation. At this rate, future cash inflows will be discounted.
Risk surplus or risk premium rate: this shows the additional return derived
by taking risk over and above the normal rate.
The risk-adjusted discount rate is calculated by combining the above rates. In this
way the risk elements as well as the time element are considered.
Now study the section on risk-adjusted discount rate in your prescribed book,
after which you must attempt activity 3.6.3.
Comparing projects with unequal lives
The replacement decision typically involves two mutually exclusive projects. When
the mutually exclusive projects have significantly different lives, an adjustment
would be necessary. We discuss two approaches in this regard, namely the
replacement chain approach and the annualised net present value approach.
The replacement chain approach
This procedure extends one or both projects until an equal life is achieved. For
example, project A has a six-year life, while project B has a three-year life. Under
this approach, the projects would be extended to a common life of six years.
Project B would have an adjusted NPV equal to the NPVb plus the NPVb discounted
for three years at the project’s cost of capital. Then the project with the higher
NPV would be chosen.
In order to make sure that you understand and can apply this approach, work
through activity 3.6.4.
The annualised net present value (ANPV) approach
It is cumbersome to compare projects with different lives. For instance, one project
might have a four-year life versus a ten-year life for the other. This would require
a replacement chain analysis over 20 years, the lowest common denominator of
the two lives. In such a case, it is often simpler to use an alternative approach:,
the annualised net present value method.
This method involves the following three steps:
1.
Calculate each project’s NPV over its original life.
2.
Find the constant annuity cash flow or annualised net present value, using
the equation:
3.
Assuming infinite replacement, calculate the infinite horizon (or perpetuity)
of each project using the equation:
Study section 12.5 in your prescribed book and work through activity 3.6.5.
20
Capital rationing
Capital rationing applies when management places a limit on the amount of
finance to be used for investment. Normally, one would accept all projects that
will increase the wealth. There are, however, limitations such as space, capacity of
workers, and availability of finance as well as other reasons for capital rationing.
Now study the section on capital rationing in your prescribed book, after which
you should attempt activity 3.6.6.
3.5
SUMMARY
In this lesson we learnt about the concept of risk in capital budgeting (the chance
that cash flows estimated being over or under the capital budget). Risk in capital
budgeting is addressed through the behavioural approaches and by means of the
use of risk-adjusted discount rates. Other refinements discussed were the concepts
of capital rationing and the comparison of projects with unequal lives. This was
the final lesson in topic one on long-term investment decision making. Topic two
of this module focuses in greater detail on long-term financing decision making.
3.6
ACTIVITIES
ACTIVIT 3.6.1
From the following data, find out which project is better.
Project A
Project B
Year
Cash inflow
(R)
Probability
Co-eff
Cash inflow
(R)
Probability
Co-eff
1
4 000
0, 9
5 000
0, 8
2
4 000
0, 8
6 000
0, 7
3
2 000
0, 6
3 000
0 ,5
Each of the projects requires a cash outlay of R 10 000. Riskless discounting rates are 10%
for both projects.
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ACTIVITY 3.6.2
A company is considering two mutually exclusive projects to increase its plant capacity.
The management has developed pessimistic, most likely and optimistic estimates of the
annual cash inflows associated with each project. The estimates are as follows:
Project X
Project Y
R 30 000
R 30 000
Net investment
-
Cash inflows:
-
Pessimistic
-
R 1 200
R 3 700
Most likely
-
R 4 000
R 4 000
Optimistic
-
R 7 000
R 4 500
i.
ii.
Determine the NPV associated with each estimate given for both the projects.
The projects have 20 years of life and the company’s cost of capital is 10%.
Which project do you consider should be selected by the company and
why? PV factor at 10% for 20 years is 8, 51.
ACTIVITY 3.6.3
Project A is less risky, compared to project B. Management considers a risk premium rate at
5% for Project A and 10% for Project B in discounting the cash inflows. Riskless discounting
rate is 5%.
Year
Project A
Project B
0
-R 10 000
-R 10 000
1
4 000
5 000
2
4 000
6 000
3
2 000
3 000
Advise which project should be selected.
ACTIVITY 3.6.4
Sims Industries CC is considering two machines to replace an old one. Machine A has a life
of 10 years, will cost R 24 500, and will produce net cash savings of R4 800 per year. Machine
B has an expected life of five years, will cost R20 000, and will produce net cash savings in
operating costs of R6 000 per year. The company’s cost of capital is 14%.
Calculate the NPV for both machines and make the necessary adjustment for Project B’s NPV.
ACTIVITY 3.6.5
Use the answer obtained in activity 3.6.4 to calculate the annualised net present value of
machines A and B.
22
ACTIVITY 3.6.6
Valley Co-op is attempting to select the best of a group of independent projects competing
for the enterprise’s fixed capital budget of R4,5 million. The enterprise recognises that any
unused portion of this budget will earn less than its 15% cost of capital, thereby resulting
in a present value of inflows that is less than the initial investment. In the table below the
enterprise has summarised the key data to be used in selecting the best group of projects.
Project
Initial Investment
IRR
PV of inflows @ 15%
A
R5 000 000
17%
R5 400 000
B
R 800 000
18%
R1 100 000
C
R2 000 000
19%
R2 300 000
D
R1 500 000
16%
R1 600 000
E
R 800 000
22%
R 900 000
F
R2 500 000
23%
R3 000 000
G
R1 200 000
20%
R1 300 000
Use the internal rate of return (IRR) approach to select the best group of projects.
a.
b.
c.
Use the net present value (NPV) approach to select the best group of projects.
Compare, contrast and discuss your findings in (a) and (b).
Which projects should the enterprise implement? Why?
ACTIVITY 3.6.7
Work through questions E12-1 to E12-5 at the end of chapter 12 in the prescribed book.
3.7
FEEDBACK TO ACTIVITIES
Suggested feedback on the activities will be uploaded on myUnisa after the students have
attempted the activities.
3.8
SELF-ASSESSMENT QUESTIONS
Multiple-choice questions (MCQs)
(1) Risk in capital budget should, in theory, be incorporated by means of …
1. standard deviations (σ).
2. certainty equivalents (CEs).
3. capital asset pricing models (CAPM).
4. risk–adjusted discount rates (RADR).
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FIN3701/1
(2) A project is expected to generate the following cash inflows with associated probabilities:
Year
1
2
3
4
5
Net cash inflow
R 15 000
R 25 000
R 35 000
R 45 000
R 38 000
CE
0.90
0.80
0.70
0.60
0.50
The risk-free rate of return is 12%. The initial investment is R 60 000. Using certainty
equivalents, the NPV is closest to …
1.
2.
3.
4.
R 13 376, 16.
R 28 692, 25.
R 44 000, 00.
R 48 406, 00.
(3) The risk-free rate of return is 10%. A project has a risk-adjusted discount rate of 15%.
It has an initial investment of R 120 000 and is expected to generate net cash inflows
of R 45 000 per annum for five successive years. The NPV using a RADR is closest to …
1.
2.
3.
4.
R 18 805.
R 30 840.
R 50 585.
R 105 000.
(4) An enterprise has R1 000 000 available for capital projects, cost of capital of 15% and
is considering the following:
Project
Initial investment
IRR
NPV
A
R 500 000
22%
R 300 000
B
R 200 000
18%
R 200 000
C
R 300 000
16%
R 150 000
D
R 290 000
16%
R 180 000
E
R 300 000
10%
R 50 000
The firm should combine the following projects:
1.
2.
3.
4.
A, B and C
A, B and D
A, B and E
B, C and D
(5) T he most efficient technique for the comparison of mutually exclusive investments
with unequal lives is to …
1.
2.
3.
4.
consider only cash flows during the payback period.
simply compare the NPV figures.
use the annualised NPV figures.
use risk–adjusted discount rates (RADR).
(6) An enterprise is considering two mutually exclusive projects. Project M has a life of
four years and an NPV of R 4 540 800. The enterprise has a cost of capital of 15%.
Determine the ANPV of each project and recommend the project that the enterprise
should invest in.
24
3.9
SELF-ASSESSMENT QUESTIONS FEEDBACK
Suggested solutions to the self-assessment questions will be uploaded on myUnisa after the
students have attempted the questions.
3.10 CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activity?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcomes?
Would you be able to meet the stated assessment criteria?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
Are any additional resources available from myUnisa?
25
FIN3701/1
26
Topic 2
LONG-TERM FINANCING DECISIONS
AIMS
This topic aims to
1.
2.
3.
4.
identify the most appropriate sources of financing for the firm
accurately calculate the component cost and weighted average cost of capital
evaluate the interrelationships between operating, financial and total leverage
determine the target capital structure and the value of the firm
INTRODUCTION
Topic 2 is divided into the following four lessons (SUs), which play a vital role in long-term
investment decisions:
Lesson 4:
Lesson 5:
Lesson 6:
Lesson 7:
Calculating the cost of capital
The WACC, WMCC and IOS
Leverage
Capital structure and firm value
27
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LESSON 4
CALCULATING THE COST OF CAPITAL
CONTENTS OF LESSON
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
Tutorial matter
Learning outcomes
Key concepts
Overview
Summary
Activities
Feedback on activities
Self-assessment questions
Feedback on self-assessment questions
Checklist
4.1
TUTORIAL MATTER
Study chapter 9 in your prescribed book.
4.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
• understand the key assumptions, the basic concepts and the specific sources of capital
associated with the cost of capital
• determine the cost of long-term debt and the cost of preference shares
• calculate the cost of ordinary share equity and convert it into the cost of retained
earnings and the cost of new issues of ordinary shares
4.3
KEY CONCEPTS
•
•
•
•
•
Cost of capital
After-tax cost of debt (ri = rd(1-t))
Cost of preference shares (rp = D/N)
Cost of retained earnings (rs = (D1/P0 + g))
Cost of new ordinary shares (rn = (D1/N + g))
28
4.4
OVERVIEW
Introduction
In the preceding lessons, you were introduced to the capital budgeting process
and the techniques used to evaluate acceptability of investment or capital projects.
In this lesson, the cost of capital is introduced in order to compare the cost of
financing an investment project and the rate of return that such a project earns.
The mechanics of computing the sources of capital debt, preference shares,
ordinary shares, and retained earnings are reviewed. Cost of capital is the rate of
return that a firm must earn on the projects in which it invests to maintain the
market value of its shares. It can also be defined as the rate of return required by
investors or market suppliers of capital to invest their funds in the firm. Even with
good estimates of project cash flows, the application of NPV and IRR decision
techniques and adequate consideration of project risk, a poorly estimated cost
of capital can result in the destruction of shareholder value. Underestimation of
the cost of capital can result in the mistaken acceptance of poor projects, while
overestimation can result in good projects being rejected. Most firms attempt
to maintain a desired mix of debt and equity financing. This lesson will focus on
the cost of sources of capital, mainly debt and equity funding.
You are encouraged to devote time and effort to learning the materials in this
lesson. The selection of acceptable projects encountered in your professional life
or investment decisions made in your personal life will be correct if they earn a
return higher than the cost of capital.
Cost of long-term debt
Long-term debt can be in the form of borrowing or taking out a bank loan, in
which case the cost will be the interest charged by the lender of funds. Funds can
also be raised through the sale of a bond. Interest payments are tax deductible
and therefore the cost of long-term debt is calculated as an after-tax cost.
Cost of preference shares
A firm can raise funds by issuing preference shares. Preference shareholders
are referred to as creditors of the firm and they have the right to receive their
stated amount of dividends before the firm can distribute earnings to ordinary
shareholders. Although preference shares have some similarities to debt capital,
no tax adjustment must be made in the calculation of its cost. This is because
preference share dividends are paid out of the firm’s after-tax cash flows. However,
the cost of issuing such shares to the firm’s creditors or flotation costs must be
taken into account.
Cost of ordinary shares
A firm can raise funds by issuing ordinary shares in a form of retained earnings
or new shares. Ordinary share dividends are paid out of the firm’s after-tax cash
flows and therefore no tax adjustment must be made in the calculation of its cost.
If the firm raises funds through retained earnings (by not paying cash dividends
to ordinary shareholders), there will be no flotation costs. Two techniques for
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calculating the cost of ordinary shares are the constant-growth valuation (Gordon)
model and the capital asset pricing model (CAPM). The cost of retained earnings
is equal to the cost of ordinary shares. If the firm raises funds through issuing
additional ordinary shares, flotation costs will be incurred. The technique for
calculating the cost of new ordinary shares is the constant-growth valuation
(Gordon) model.
4.5
SUMMARY
In this lesson, you were introduced to the concept of cost of capital. The techniques
of computing different sources of capital (long-term debt, preference shares,
retained ordinary shares and new ordinary shares) were reviewed. By applying
the techniques presented in this chapter to estimate the firm’s cost of capital, the
financial manager will improve the likelihood that the firm’s long-term decisions
will be consistent with the goal of maximising the shareholder’s wealth. In the
following lesson, the focus will be on the overall cost of capital (weighted average
cost of capital).
4.6
ACTIVITIES
ACTIVITY 4.6.1
In your own words, define and explain how the following terms apply when determining
the cost of capital:
•
•
•
•
•
•
Before-tax cost of debt
After-tax cost of debt
Cost of preference shares
Cost of retained earnings or internal equity
Required return on ordinary shares
Cost of external equity or cost of issuing new ordinary shares
ACTIVITY 4.6.2
Vuvuzela Manufacturers aims to expand its production capacity by investing R14 million
in new plant and machinery for the coming Football World Cup.
The management of Vuvuzela wants to maintain the present 40% debt in the firm’s capital
structure. The company expects to have net income of R2.8 million and bases it’s dividend
payments on the residual theory..
Debt financing may be obtained at a before-tax cost of 16%. Ordinary shares, which are
currently selling for R30 a share, may be issued to net R20 after flotation costs.
The firm paid a dividend (Do) of R1.50 per share in the previous financial year and had
a growth rate of 7% over the past few years. It is expected that this growth rate will be
maintained in future. The tax rate is 40%.
30
REQUIRED
• Identify the various forms and amounts of new financing required for the project.
• Calculate the component costs.
• Calculate the weighted average cost of capital that should be used for the expansion.
4.7
FEEDBACK ON ACTIVITIES
Suggested feedback to activity 4.6.2 will be posted on myUnisa under the Additional
Resources folder after the students have attempted the activities.
4.8
SELF-ASSESSMENT QUESTIONS
Question 1
Use the following information to calculate the after-tax cost of a 20-year, 11% debenture:
y
y
y
Appropriate tax rate is 35%
R1 000 par value
Currently selling for R940
(1)
(2)
(3)
(4)
6.0%
7.7%
11.0%
11.8%
Question 2
A firm is considering issuing 15% preference shares that are expected to sell for R11 per
share (par value). The flotation cost is expected to be R1 per share. The cost of a preference
share is …
(1)
(2)
(3)
(4)
15.0%.
16.5%.
17.5%.
18.0%.
Question 3
The ordinary shares of Gauteng Stokvel Syndicates are trading at R50 per share on the
JSE. The firm declared a dividend (D0) of R5 per share. The annual growth rate of dividends
over the past six years was 10%. Management is of the opinion that this growth rate will
be maintained in future. The firm’s cost of an ordinary share is:
(1)
(2)
(3)
(4)
11.0%
21.0%
22.5%
23.5%
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Question 4
An investment analyst of Sinkwa Sokuphila Inc provided the following information:
Estimated beta coefficient = 1.1
Expected return on the market = 16%
Risk-free interest rate = 6%
Expected dividend growth rate = 10%
Current dividend (D0) = R 3.20 per share
Which one of the following is the correct market price of an ordinary Sinkwa Sokhuphila
share?
(1)
(2)
(3)
(4)
R 32.1
R 35.2
R45.7
R50.3
Question 5
An investment analyst has the following information in respect of Rovhuwa Ltd.
The company’s market risk coefficient is 0.9, the rate of return on the JSE All Share Index
was 21.25% over the previous five years and the rate of return on short-term government
debentures is currently 16.75%. Rovhuwa has maintained a growth rate of 13% in their EPS
over the previous three years. Calculate Rovhuwa’s required rate of return.
(1)
(2)
(3)
(4)
4.9
20.8%
21.6%
22.4%
23.5%
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
Suggested solutions to the self-assessment questions are found at the end of this study guide.
4.10 CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activities?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcomes?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
32
LESSON 5
THE WACC, WMCC and IOS
CONTENTS OF LESSON
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
Tutorial matter
Learning outcomes
Key concepts
Overview
Activities
Self-assessment
Summary
Checklist
5.1
TUTORIAL MATTER
Study chapter 9 in your prescribed book.
5.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
• calculate the weighted average cost of capital (WACC) and discuss different weighting
schemes
• describe the procedures used to determine break points and the weighted marginal
cost of capital (WMCC)
• explain the weighted marginal cost of capital (WMCC) and its use with the investment
opportunity schedule (IOS) to make financing or investment decisions
5.3
KEY CONCEPTS
•
•
•
•
•
Weighted average cost of capital (WACC)
Weighting schemes
Weighted marginal cost of capital (WMCC)
Break point
Weighted marginal cost of capital (WMCC) and investment opportunity schedule (IOS)
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5.4
OVERVIEW
Introduction
In the preceding lessons, you were introduced to cost of capital in order to
compare the cost of financing an investment project and the rate of return that
such a project earns. In this lesson, weighted average cost of capital (WACC),
weighted marginal cost of capital (WMCC) and the investment opportunity
schedule (IOS) are introduced in order to compare the overall cost of capital and
investment opportunities available to the firm. The weighted average cost of
capital is the expected average future cost of funds over the long run. Weighted
marginal cost of capital is the firm’s WACC associated with the next rand. The
investment opportunity schedule is a ranking of investment possibilities, from
best to worst.
This lesson will also focus on the use of WMCC and IOS in order to make financing
and investment decisions simultaneously.
Weighted average cost of capital (WACC)
The weighted average cost of capital (WACC), ra, is an average of the firm’s cost of
long-term financing. It is calculated by weighting the cost of each specific type of
capital by its proportion in the firm’s capital structure. Companies normally use
the targeted WACC to develop a capital structure that is optimal for the future,
given present investor attitudes toward financial risk. Target capital structure
weights are most often based on desired changes in historical book value weights.
Unless significant changes are implied by the target capital structure weights,
little difference in the weighted marginal cost of capital results from their use.
The sum of the weighted values gives the WACC of the firm.
The following equation is used to calculate the WACC:
ra = (wi x ri) + (wp x rp) + (ws x rs or n)
Where:
ra = weighted average cost of capital
wi = proportion or percentage of long-term debt in capital structure
ri = after-tax cost of long-term debt
wp = proportion or percentage of preference share in capital structure
rp = cost of preference share
ws = proportion or percentage of ordinary share equity in capital structure
rs = cost of an ordinary share
Note: The sum of all capital structure weights equals 1.
Firms can calculate weights based on either book value or market value and
using historical or target proportions.
34
Example: Using book value weights
Assume the following capital structure for Cape Mart Company:
Mortgage bonds (R1000 par value)
Preference shares (R100 par value)
Ordinary shares (R40 par value)
Retained earnings
Total
R20 000 000
R 5 000 000
R20 000 000
R 5 000 000
R50 000 000
The book value weights and overall cost of capital can be computed as follows:
Source
Book value (R)
Weights
Cost
Weighted cost
Debt
20 000 000
40%
5.14%
2.06%
Preference shares
5 000 000
10%
13.40%
1.34%
Ordinary shares
20 000 000
40%
17.11%
6.84%
Retained earnings
5 000 000
10%
16.00%
1.60%
Total
50 000 000
100%
11.84%
Overall cost of capital (ra) = 11.84%
In addition to the data from the example above, assume that the market share
prices are as follows:
Mortgage bonds =
Preference shares =
Ordinary shares
=
R1 100 per bond
R90 per share
R80 per share
The firm’s number of shares in each category is:
Mortgage bonds =
R20 000 000 = 20 000
R1000
Preference shares =
R5 000 000 = 50 000
R100
Ordinary shares
=
R20 000 000 = 500 000
R40
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Therefore, the market value weights are:
Source
Number of
shares
Price
Market value
Debt
20 000
R1 100
R22 000 000
Preference shares
50 000
R90
R 4 500 000
Ordinary shares
500 000
R80
R40 000 000
Total
50 000 000
R66 500 000
The R40 million ordinary share value must be split into the ratio of 4:1 (the R20
million ordinary share versus the R5 million retained earnings in the original capital
structure, to make it R32 million for ordinary shares and R8 million for retained
earnings), since the market value of the retained earnings has been impounded
into the ordinary shares.
The firm’s weighted average cost of capital is as follows:
Source
Book value (R)
Weights
Cost
Weighted cost
Debt
22 000 000
33%
5.14%
1.70%
Preference shares
4 500 000
7%
13.40%
0.94%
Ordinary shares
32 000 000
48%
17.11%
8.21%
Retained earnings
8 000 000
12%
16.00%
1.92%
Total
66 500 000
100%
12.77%
Overall cost of capital (ra) = 12.77%
Weighted marginal cost of capital (WMCC)
The weighted marginal cost of capital (WMCC) is the firm’s weighted average cost
of capital associated with its next rand of total new financing. The WMCC is of
interest to managers because it represents the current cost of funds should the
firm need to go to the capital markets for new financing. The WMCC schedule
increases as a firm goes to the market for larger sums of money because the
risk exposure to the supplier of funds of the borrowing firm’s risk increases to
the point that the lender must increase its interest rate to justify the additional
risk. As the volume of financing that the firm plans to raise increases, the cost
of various types of financing (debt, preference shares and ordinary shares) will
increase, increasing the firm’s WACC.
36
The WACC may increase as a result of the following factors:
• Suppliers of funds who require higher returns in a form of dividends or growth
as compensation for the increased risk introduced by larger volumes of new
financing.
• Lenders of funds who require higher returns in a form of interest as compensation for the increased risk introduced by larger volumes of new financing.
• The use of new ordinary shares, which also increases the firm’s WACC. New
financing will be provided by retained earnings until this supply is exhausted,
and then it will be obtained through new ordinary shares. Retained earnings
are less expensive than issuing new shares because there is no flotation cost
associated with the issue of retained earnings
Break points
The break point is the level of total new financing at which the cost of one of the
financing components rises, thereby causing an upward shift in the weighted
marginal cost of capital (WMCC).
The following equation is used to calculate break points:
BPj = AFj
wj
Where:
BPj = break point for financing source j
AFj = amount of funds available from financing source j at a given cost
wi = capital
structure weight (stated in decimal form) for the specific financing
source j
The next step after calculating the break points is to find the WACC over each
range of total financing between break points (between zero and the first break
point, and then between the first and the second break point, and so on). For each
of the ranges of total new financing between break points, certain component
capital costs will increase. The WMCC schedule or graph can be constructed
using the above data.
Investment opportunity schedule (IOS)
A firm has different investment opportunities and the one with the highest
return will be the first to be selected. As the firm accepts additional investment
opportunities, the return on them will decrease. The IOS schedule or graph can
be constructed using the above data. The investment opportunities schedule is
a ranking of the firm’s investment opportunities from the best (highest returns)
to worst (lowest returns). The schedule is structured so that it is a decreasing
function of the level of total investment. The downward direction of the schedule
is due to the benefit of selecting the projects with the greatest return first. The
structure also helps in the identification of the projects that have an IRR in excess
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of the cost of capital, and to see which projects can be accepted before the firm
exceeds it limited capital budget
The IOS and the WMCC schedule
The IOS and WMCC graphs are used to choose the most favourable investment
opportunities. These investments are the ones that have both the highest return
(IRR) and the lowest cost (WACC). The firm can accept investment projects up
to the point at which the marginal return equals the weighted marginal cost
of capital projects to the left of the cross-over point of the IOS, and the WMCC
lines have an IRR greater than the firm’s cost of capital. Undertaking all of these
projects will maximise the owner’s wealth. Selecting any projects to the right
of the cross-over point will decrease the owner’s wealth. In practice, managers
normally do not invest to the point where IOS = WMCC due to the self-imposed
capital budgeting constraint most firms follow.
5.5
SUMMARY
In this lesson you were introduced to the concept of the weighted average cost
of capital, weighted marginal cost of capital and the investment opportunity
schedule.
The weighted average cost of capital is the future average cost of funds over the
long run. The weighted marginal cost of capital is the firm’s weighted average
cost of capital associated with the next rand of total new financing.
The investment opportunity schedule, in combination with the weighted marginal
cost of capital, can be used to find the level of financing or investment that
maximises the owner’s wealth. With this approach, the firm accepts projects up
to the point where the marginal return on its investment equals its weighted
marginal cost of capital. The next lesson introduces the concept of leverage.
5.6
ACTIVITIES
ACTIVITY 5.6.1
In your own words, define and explain how the following terms apply when determining
the cost of capital:
•
•
•
•
Weighted average cost of capital (WACC)
Break points
Weighted marginal cost of capital (WMCC)
Investment opportunity schedule (IOS)
ACTIVITY 5.6.2
Dalton Ltd – a manufacturer of high quality JoJo tanks – has maintained stable annual sales
of R500 000 for the past two years and is expected to remain stable for the next five years.
Although the market for JoJo tanks has been expanding, Dalton Ltd could not share in this
38
growth due to the technical problems experienced with the current injection moulding
machine. To increase its production and sales, the company is considering replacing the
current machine with a more technically advanced model, which will cost the company
R3 000 000.
The outlay would be offset partially by the sale of the old machine. The old machine cost
R1 500 000 two years ago and can be sold for R500 000 before tax. The lifespan of the old
machine was originally six years and depreciation is calculated on a straight line basis. The
total fixed operating costs for old machine is R80 000 (excluding depreciation) and will be
constant for the next five years.
As a result of the acquisition of the new machine, sales are expected to increase by 5 000
lessons per year in each of the next three years and to stabilise in the following two years.
The new injection moulding machine will be depreciated on a straight-line basis over five
years and will be terminated and sold at the end of the fifth year for a scrap value of R600 000.
The company is currently selling 25 000 tanks annually. The total fixed operating costs of
R120 000 (including depreciation) will be constant for the next five years. Variable cost per
unit is R5.
As a result of switching to the new machine management expects cash to increase by R20
000, accounts receivable by R40 000 and inventory by R60 000. At the same time, accounts
payable will increase by R50 000 and accruals by R10 000.
The company intends to finance the replacement of the machine as follows:
Debt: The company can raise the first R400 000 by selling 20-year, 9% (paid semi-annually)
coupon bonds, each with a par value of R1 000. Because similar-risk bonds earn returns
greater than 9%, the firm must sell the bonds for R980 to compensate for the lower coupon
rate. The flotation costs are 3%. Additional debt in excess of R400 000 will have an after-tax
cost of 8,4%.
Preference shares: Dalton Ltd is contemplating issuing 10% preference shares, which are
expected to sell for a par value of R80 per share. The cost of issuing and selling the shares
is expected to be R7.
Ordinary shares: The retained earnings amount to R300 000. Any amount in excess of
R300 000 will be raised by issuing new ordinary shares. The company’s ordinary shares are
currently selling for R50, and it expects to pay a dividend of R4 at the end of the coming
year (2016). The flotation costs for issuing new shares amount to R4, 90. The dividends paid
on the outstanding shares over the past six years (2010–2015) were as follows:
Year
Dividends
2015
2014
2013
2012
2011
2010
R3,72
R3,62
R3,47
R3,33
R3,12
R2,97
The management of Dalton Ltd wants to maintain the present 60% equity, 25% debt and
15% preference shares in the firm’s capital structure.
Assume a tax rate of 29%.
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Required
Calculate the company’s degree of total leverage from 2017 to 2018.
Calculate the company’s component costs of capital.
Calculate the company’s financial leverage above the level of EBIT in the third year and also
the breakeven point of equity and debt.
Calculate the weighted average cost of capital within the following ranges of financing:
• R0 to R500 000
• R500 001 to R1 600 000
• above R1 600 000
MC consulting advised Dalton Ltd management to restructure their capital structure as
follows: 45% equity, 15% preference share and 40% debt.
Which capital structure would you recommend between the current one and the one
suggested by MC consulting if the objective is to maximise earnings per share?
Note: Use the information from the second year for 1.5.
5.7
FEEDBACK ON ACTIVITIES
Suggested feedback on the activity will be posted on myUnisa’s Additional Resources
folder after the students have attempted the activities.
5.8
SELF-ASSESSMENT
Question 1
TWT Ltd has determined its optimal capital structure, which comprises the following:
Form of capital
Weight
After-tax cost
Long-term debt
40%
6%
Preference shares
10%
11%
Ordinary shares
50%
15%
The weighted average cost of capital is:
(1)
(2)
(3)
(4)
10%
11%
15%
20%
Question 2
Afrox Ltd has to make an unavoidable capital investment of R1 000 000 this year. The firm’s
dividend policy requires that it should pay 55% of its earnings attributable to ordinary
shareholders (earnings are R800 000 this year) in the form of dividends. If Afrox maintains
40
an optimal debt ratio of 40%, which one of the following shows the correct weight of each
form of financing in the calculation of the WACC?
(1)
(2)
(3)
(4)
40% debt, 36% retained earnings, 24% new ordinary shares
40% debt, 60% retained earnings
60% debt, 32% retained earnings, 8% new ordinary shares
40% debt, 30% retained earnings, 30% new ordinary shares
Question 3
Safron Ltd is financed 60% by equity and 40% by debt. The firm expects that it will exhaust
retained earnings of R300 000 (rr = 14%) and will have to issue additional new ordinary
shares (rn = 16%) to meet its financing needs. The firm will be able raise to R150 000 by
means of debt financing (rd = 7. 8%); additional debt can be obtained at
rd = 8. 45%. The break points (BPj) are:
BPequity
BPdebt
R300 000
R400 000
R500 000
R600 000
R200 000
R325 000
R375 000
R425 000
Question 4
The interpretation of weighted marginal cost of capital (WMCC) schedule and investment
opportunity schedule (IOS) may be done as follows:
(1) Accept all projects indicated by the IOS that are below the WMCC.
(2) Accept only the project indicated at the crossover point of the WMCC an d the IOS
schedule.
(3) Accept only those projects indicated on the IOS up to the point where the firm’s financing is exhausted.
(4) Accept only projects indicated on the IOS above the WMCC up to the point where the
WMCC and IOS cross each other.
5.9
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
Suggsted solutions to the self-assessment questions are found at the end of this study guide.
41
FIN3701/1
5.10 CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activities?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcomes?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
42
LESSON 6
LEVERAGE
CONTENTS OF LESSON
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
Tutorial matter
Learning outcomes
Key concepts
Overview
Summary
Activities
Feedback on activities
Self-assessment questions
Feedback on self-assessment questions
Checklist
6.1
TUTORIAL MATTER
Study chapter 13 in your prescribed book.
6.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
• discuss leverage
• discuss breakeven analysis, the operating breakeven point and the effect of changing
cost on it
• understand the operating, financial and total leverage and the relationships between
them
6.3
KEY CONCEPTS
•
•
•
•
•
•
Leverage
Breakeven analysis, operating breakeven point and operating leverage
Degree of operating leverage
Degree of financial leverage
Total leverage
Degree of total leverage
43
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6.4
OVERVIEW
Introduction
In the preceding lessons, you were introduced to the weighted average cost of
capital (WACC), weighted marginal cost of capital (WMCC) and the investment
opportunity schedule (IOS). In this lesson, leverage is introduced. Leverage results
from the use of fixed cost assets or funds to magnify returns to the firm’s owners.
The concepts of operating, financial and total leverage are covered. The total
leverage is derived from the sales revenue up to the earnings before interest and
tax (EPS) of the firm’s income statement. The degree of operating, financial and
total leverage is addressed to provide tools to measure the relative differences
in risk of various operating and financial structures within the firm. Breakeven
analysis, which lays the foundation for leverage concepts, is also discussed.
Breakeven analysis
Breakeven analysis is the cost-volume-profit analysis used to indicate the level
of operations necessary to (1) cover all costs and (2) to evaluate the profitability
associated with various levels of sales. The operating breakeven point is the level of
sales at which no profit or loss is shown by the firm. At that point, earnings before
interest and tax (EBIT) equal R0. To determine the breakeven point, costs must
be divided into (1) variable costs, which are costs that vary in direct proportion
to a change in volume of sales lessons, and (2) fixed costs, which are costs that
are constant regardless of the volume of sales lessons.
The following equation is used to calculate the breakeven point:
Q = FC
(P-VC)
Where:
Q = sales quantity in lessons
FC = fixed operating cost per period
P = sale price per unit
VC = variable operating cost per unit
In view of the above equation, an increase in cost (FC or VC) tends to increase
the operating breakeven point, whereas an increase in the sales price per unit
(P) tends to decrease the operating breakpoint.
Operating leverage
Operating leverage results from the use of fixed costs and is a measure of operating
risk. It shows the effect that a change in sales has on EBIT. The operating leverage
is derived from the sales revenue up to the EBIT of the firm’s income statement.
The degree of operating leverage (DOL) is a numerical measure of the firm’s
operating leverage and can be calculated using the following equation:
44
DOL at a given level of sales (Q) = percentage change in EBIT
percentage change in sales
= Q x (P-VC)
Q x (P-VC)-FC
Financial leverage
Financial leverage results from the use of fixed financial costs (particularly interest
on debt and any preference share dividends) and is a measure of financial risk.
It shows the effect that a change in EBIT has on EPS. The financial leverage is
derived from the EBIT up to the EPS of the firm’s income statement. The degree
of financial leverage (DFL) is a numerical measure of the firm’s financial leverage
and can be calculated using the following equation:
DFL at a given level of sales (Q) = percentage change in EPS
percentage change in EBIT
=
EBIT
EBIT-I-[PD x 1÷ (1-T)]
Where:
PD = preference dividend
T = tax rate
Total leverage
Total leverage results from the use of fixed costs, both operating and financial,
and is a measure of total risk. It shows the effect that a change in sales has on
the EPS. The total leverage is derived from the sales up to the EPS of the firm’s
income statement. The degree of total leverage (DTL) is a numerical measure
of the firm’s total leverage and can be calculated using the following equation:
DTL at a given level of sales (Q) = percentage change in EPS
percentage change in sales
=
Q x (P-VC)
Q x (P-VC)-FC-I-[PD x 1÷ (1-T)]
Where:
PD = preference dividend
T = tax rate
6.5
SUMMARY
In this lesson you were introduced to the concept of leverage. The amount of
leverage (fixed cost assets or funds) employed by a firm directly affects its risk,
return and share value. Generally, higher leverage raises risk and return and lower
leverage reduces risk and return. The total leverage is the combined effect of
fixed costs, both operating and financial, and is therefore directly related to the
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firm’s operating and financial leverage. The next lesson introduces the capital
structure and firm value.
6.6
ACTIVITIES
ACTIVITY 6.6.1
In your own words, define and explain how the following terms apply when determining
leverage.
•
•
•
•
•
•
leverage
breakeven analysis, operating breakeven point and operating leverage
degree of operating leverage
degree of financial leverage
total leverage
degree of total leverage
ACTIVITY 6.6.2
Use the following projected information supplied by ICT (Pty) Ltd, a new business that will
be starting to sell laptops next month, to answer the questions that follow:
Total sales of laptops
32 lessons per month
Selling price per laptop
R2 400
Labour costs per laptop
R 950
Material cost per laptop
R700
Other direct cost per laptop
R4 500 per month
Interest cost on loan
R3200 per month
Rent for the factory
R1 500 per month
• Calculate the breakeven point for ICT (Pty) Ltd in lessons and value.
• How many laptops must they sell per month to generate a profit of R20 000? Present the
answer in the form of an income statement.
• If the owners of ICT (Pty) Ltd want a return of 12%, on sales, how many laptops must they
sell? Present the answer in the form of an income statement.
6.7
FEEDBACK ON ACTIVITIES
Suggested feedback will be posted on myUnisa under the Additional Resources folder
after the students have attempted the activities.
46
6.8
SELF-ASSESSMENT QUESTIONS
Question 1
Which of the following statements are correct?
(a) Leverage in a firm results from the use of fixed cost assets or funds to magnify the
returns to the firm’s owners.
(b) The more leverage a firm uses, the lower the risk of insolvency.
(c) The operating breakeven point is that point where EBIT = total operating expenses.
(d) Financial leverage uses fixed financing costs to maximise the firm’s earnings per
share (EPS).
(1) a & b
(2) a & d
(3) b & c
(4) c & d
Question 2
A firm has fixed operating costs of R4 500, the sales price per unit is R12 and its total variable cost is R7 000. The firm expects to sell 1 000 lessons. The breakeven point is … lessons.
(1)
(2)
(3)
(4)
300
600
900
1000
Question 3
Nando’s Ltd is able to increase earnings before interest and taxes (EBIT) by 80% if sales can
increased by 50%. The degree of operating leverage is …
(1)
(2)
(3)
(4)
0.625 and operating leverage exists.
1 600 and operating leverage does not exist.
0.625 and operating leverage does not exist.
1 600 and operating leverage exists.
Question 4
Nando’s Ltd has an EBIT of R200 000, an interest expense of R50 000, a preference share
dividend of R4 000 and a tax rate of 40%. The firm’s degree of financial leverage (DFL) at
the EBIT level of R200 000 is …
(1)
(2)
(3)
(4)
1.25.
1.40.
1.50.
1.65.
Question 5
Based on your answers to questions 3 and 4 above, Nando’s Ltd has a degree of total
leverage (DTL) of ….
(1)
(2)
(3)
(4)
0.78.
1.09.
2.24.
2.40.
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6.9
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
Suggested solutions to the self-assessment questions are found at the end of the study guide.
6.10 CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activities?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcomes?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
48
LESSON 7
CAPITAL STRUCTURE AND FIRM VALUE
CONTENTS OF LESSON
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
7.10
Tutorial matter
Learning outcomes
Key concepts
Overview
Summary
Activities
Feedback on activities
Self-assessment questions
Feedback on self-assessment questions
Checklist
7.1
TUTORIAL MATTER
Study chapter 13 in your prescribed book.
7.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
• describe types of capital, external assessment of capital structure and capital structure
theory
• explain the optimal capital structure using a graphical view of the firm’s cost of capital
functions and a zero-growth valuation model
• discuss the EBIT-EPS approach to capital structure
• compare alternative capital structures using the EBIT-EPS approach, incorporating the
risk considerations and basic shortcomings of the approach
• illustrate the implication of different financing plans for the firm and determine the
optimum capital structure according to risk, return and the firm’s value
7.3
KEY CONCEPTS
•
•
•
•
•
•
Debt and equity ratio
Expected earnings per share E(EPS)
Standard deviation of EPS
Coefficient of variation (CV) of EPS
Asymmetric information
Optimal capital structure
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FIN3701/1
7.4
OVERVIEW
Introduction
In the preceding lessons, you were introduced to cost of capital, WACC and
leverage.
In this lesson, capital structure and firm value are introduced. Capital structure
is linked to other financial decision variables and it is therefore important to
understand the basic characteristics of debt and equity when planning a capital
structure. Poor capital structure decisions can result in a high cost of capital,
while effective capital structure decisions can lower the cost of capital. Capital
structure is discussed with regard to a firm’s optimal mix of debt and equity,
and the EBIT-EPS and valuation model approaches to evaluate capital structure
as well as important qualitative factors are presented. The lesson explains how
concepts such as breakeven analysis, leverage, and risk arising from borrowing
will impact onthe student’s professional life and personal life.
Types of capital
A firm used two types of capital, which is debt and equity. Debt has a due date
and has to be paid back, whereas equity has no due date. Interest on debt or
loan capital must be paid but dividends are only due when declared. The cost of
debt is lower than the cost of other sources of financing because of its low risk.
Sources of equity capital are (1) preference shares and (2) ordinary shares, which
include retained earnings.
Capital structure theory
Capital structure is the mix of long-term sources of funds (debt and equity).
The higher the debt ratio, the greater the financial leverage in the firm’s capital
structure. The financial leverage is different for different industries. The optimal
capital structure is the mix of long-term sources of funds (debt and equity)
that will minimise the firm’s overall cost of capital. This mix is in line with the
goal of maximising the shareholder’s wealth. At this point, there is no specific
methodology to use in determining the optimal capital structure. There are also
arguments about whether the optimal capital structure actually exists. The cost
of debt financing is based on the following factors:
•
•
•
•
tax benefits
probability of bankruptcy
agency costs
asymmetric information
The optimal capital structure and the firm’s value
The optimal capital structure is the point at which the weighted average cost of
capital is minimised, thereby maximising the firm’s value.
50
The value of the firm can be calculated using the following equation:
V = EBIT (1-T)
WACC (ra)
= NOPAT
ra
Where:
V = firm’s value
T = tax rate
ra = weighted average cost of capital
EBIT = earnings before interest and taxes
NOPAT = net operating profit after taxes
Assuming that NOPAT is constant, the firm’s value is maximised at the point
where ra is minimised.
Comparing alternative capital structures
Alternative structures can be compared by using the EBIT-EPS approach. In using
this approach, it is important to note that focusing on earnings ignores risk. The
EBIT-EPS approach involves selecting the capital structure that maximises EPS
over the expected range of EBIT.
7.5
SUMMARY
This lesson considered capital structure and firm value. Any quantitative analysis
of capital structure must be tempered with other considerations, for example,
revenue stability, cash flow and contractual obligations. This lesson concludes
the topic on long-term financial decisions. Topic three will look at the other
long-term financial concepts of dividend policy, leasing mergers and acquisition.
7.6
ACTIVITIES
ACTIVITY 7.6.1
In your own words, define and explain how the following terms apply when determining
the capital structure and the firm’s value:
•
•
•
•
•
•
Debt and equity ratio
Expected earnings per share E(EPS)
Standard deviation of EPS
Coefficient of variation (CV) of EPS
Asymmetric information
Optimal capital structure
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ACTIVITY 7.6.2
A totally equity-financed company with 10 000 outstanding ordinary shares, each with
a book value equal to market value of R35, is in the process of introducing debt into its
capital structure. Funds raised through debt will be used to retire some of the shares and
the company’s aim is to maintain the same total amount of financing. The company pays
all its earnings as dividends and is subject to a 29% tax rate. The expected sales are R530
000, fixed costs are estimated at R251 000 and variable costs are estimated at 30% of sales.
The following capital structures are being considered:
•
•
•
•
capital structure A at 40% debt ratio
a loan provided by Standard Bank at 20% per annum interest rate
capital structure B at 50% debt ratio
a loan provided by Capitec Bank at 18% per annum interest rate
Required
•
•
•
•
7.7
Calculate the number of shares to be purchased under each proposed capital structure.
Calculate the earnings per share for each proposed capital structure.
Calculate the weighted average cost of capital for each proposed capital structure.
Based on the value of the firm approach, which capital structure would you advise the
company to choose if its objective is to maximise its value?
FEEDBACK ON ACTIVITIES
Suggested feedback will be posted on myUnisa under the Additional Resources folder
after the students have attempted the activities.
7.8
SELF-ASSESSMENT QUESTIONS
Question 1
Which one of the following is incorrect?
Capital structure decisions of the firm are important because they have an impact on the
… of the firm.
(1)
(2)
(3)
(4)
ordinary share prices
cost of capital
EBIT
EPS
Question 2
Harmony Ltd has expected earnings per share, E(EPS), of R1.25 and a standard deviation
(σ) of earnings per share of R1.50. The firm has made the following
52
risk-return estimates:
Coefficient of variation
ks
0.83 14%
1.20 18%
1.88 22%
Assuming that all earnings will be paid out as dividends, the expected share price (Po) is …
(1)
(2)
(3)
(4)
R5.68.
R6.94.
R8.93.
R10.42.
Question 3
PWC Ltd has achieved an EBIT of R21 844 300. The firm’s required rate of return (ks) is 20%
and the firm is subject to a 35% tax rate. The firm’s value is estimated to be closest to …
(1)
(2)
(3)
(4)
R 63 770 000.
R 70 993 975.
R 109 221 500.
R 168 033 077.
Question 4
ABIL Ltd’s capital structure currently consists of a long-term loan of R750 000 at an interest cost of 16% per year, 20 000 preference shares with a dividend of R4 per share and 300
000 ordinary shares on which a dividend of 50c per share was paid during the year. If the
company’s effective tax rate is 40%, calculate the company’s financial breakeven point.
(1)
(2)
(3)
(4)
R152 133
R184 500
R253 333
R302 168
Question 5
Which one of the following capital structure would maximise the firm’s value?
Debt ratio
WACC
(1)
(2)
(3)
(4)
12.0%
11.5%
11.0%
11.8%
20%
30%
40%
50%
Question 6
The most important consideration in deciding on capital structure is the cost of capital.
Other considerations include …
(1)
(2)
(3)
(4)
control, flexibility and timing.
economic and industry conditions.
the impact on financial ratios.
All of the above.
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7.9
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
Suggested solutions to the self-assessment questions are found at the end of this study guide.
7.10
CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activities?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcomes?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
54
Topic 3
Other long-term financial concepts
AIMS
The aim of this topic is to provide students with knowledge and skills to manage dividend
policy, leasing, mergers and acquisition.
LEARNING OUTCOMES
After working through this topic, you should be able to
1. make dividend policy decisions that are in line with the goals of the firm
2. apply the lease versus buy decision
3. describe the important considerations involved and demonstrate the procedures
used in the mergers and acquisitions process
INTRODUCTION
Topic 3 is divided into the following two lessons (SUs):
Lesson 8: Payout policy
Lesson 9: Leasing, mergers and acquisitions
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FIN3701/1
LESSON 8
PAYOUT POLICY
CONTENTS OF LESSON
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
Tutorial matter
Learning outcomes
Key concepts
Overview
Summary
Activities
Feedback on activities
Self-assessment questions
Feedback on self-assessment questions
Checklist
8.1
TUTORIAL MATTER
Study chapter 14 in your prescribed book.
8.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
• describe the fundamentals of payout policy and the key arguments regarding the
relevance and irrelevance of dividends
• discuss the key factors involved in formulating a payout policy
• evaluate the three types of payout policy
• explain the reasons for undertaking share splits and share repurchases
8.3
KEY CONCEPTS
•
•
•
•
•
•
•
•
•
Dividend relevance theory
Residual theory
Informational content
Clientele effect
Bird-in-the-hand argument
Dividend payout ratio
Regular payout policy
Share dividend
Share split
56
8.4
OVERVIEW
Introduction
There are three important decisions a firm must make–investment, financing
and dividend decisions. All these decisions are interrelated and are normally
made with the aim of achieving the overriding objective of the firm, which is the
maximisation of shareholder’s wealth. Investment and making financing decisions
have been fully discussed in the previous lessons. This lesson concentrates on the
dividend decision from the viewpoint of the firm and the investors. The discussion
of the payout policy will concentrate on the arguments for the relevance and
irrelevance of dividends, types of dividend policies, forms of dividends, and their
possible effects on the value of the firm.
The lesson notes that dividend cash outflows reduce corporate assets while
enhancing personal wealth, and therefore have implications for both the student’s
professional life and personal life.
The basics and mechanics of pay-out policy
Dividends are paid in either cash or shares and are typically issued quarterly. They
may be paid only out of retained earnings and not from invested capital such
as capital stock or the excess received over share par value. In general, the more
stable a company’s earnings, the more regular its issue of dividends.
A company’s dividend policy is important for the following reasons:
a.
b.
c.
d.
It bears upon investor attitudes. For example, stockholders look unfavourably
on the corporation when dividends are cut, since they associate the cutback
with corporate financial problems. Further, in setting a dividend policy,
management must ascertain and fulfil the objectives of its owner. Otherwise,
the stockholders may sell their shares, which in turn may bring down the
market price of the stock. Stockholder dissatisfaction raises the possibility
that control of a company may be seized by an outside group.
It impacts the financing programme and capital budget of the firm.
It affects the firm’s cash flow position. A company with a poor liquidity
position may be forced to restrict its dividend payments.
It lowers stockholders equity, since dividends are paid from retained earnings
and so results in a higher debt-to-equity ratio.
If a company’s cash flows and investment requirements are volatile, the company
should not establish a high regular dividend. It would be better to establish a
low regular dividend that can be met even in years of poor earnings.
Relevant dates associated with dividends are as follows:
1.
2.
Declaration date. This is the date on which the board of directors declares
the dividend. On this date, the policy regarding payment of the dividend
becomes a legal liability of the firm.
Date of record. This is date on which the stakeholder is entitled to receive
the dividend.
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FIN3701/1
3.
Ex-dividend date. The ex-dividend date is the date on which the right to the
dividend leaves the shares. The right to a dividend stays with the stock until
four days before the date of record. That is, on the fourth day prior to the
record date, the right to the dividend is no longer with the shares, and the
seller, not the buyer of that stock, is the one who will receive the dividend.
The market price of the stock reflects the fact that it has gone ex-dividend
and will decrease by approximately the amount of the dividend.
Study sections 14.1 and 14.2 in your prescribed book and work through activity
8.6.1.
The relevance of payout policy
If the dividend affects the value of a firm, then the dividend is clearly relevant
and must be actively managed. If, on the other hand, the dividend has no real
effect on value, then it is irrelevant and it would simply be the balancing figure
after the financing and investment decisions are taken.
The two theories on the importance of dividends (their relevance and irrelevance)
and the influence of dividend payouts on the value of the firm should be studied
in conjunction with the relevant chapters in the textbook on cost of capital and
the influence of the capital structure on the value of the firm. Note especially that
Gordon’s theory is of greater practical value and that a dividend policy should
be developed that corresponds to the primary objective of the firm, namely the
maximisation of the wealth of the firm’s owners.
Study the section on relevance of payout policy in your prescribed book, after
which you must attempt activities 8.6.2 and 8.6.3.
Factors affecting dividend policy
The following factors influence a firm’s dividend policy:
•
•
•
•
•
•
•
•
Legal constraints
Contractual constraints
Internal constraints
Flotation costs
The firm’s growth prospects
Taxation
The needs of the owners
Market considerations
The following are some of the legal obligations that apply in South Africa:
• Dividend “payouts” from capital are forbidden. (If no profit is made in a specific year, dividends can in fact be paid out of the undistributed profit of the
previous year.)
• A firm under judicial management may not pay out dividends before all obligations have been met.
• Returned earnings may be taxed in certain circumstances.
58
Some of the above requirements and constraints may be in conflict with the
goal of the firm. It is therefore the task of the financial manager and the board
of directors to accommodate the constraint in the dividend policy in such a way
that the goal of the firm can be achieved.
Study section 14.4 (factors affecting dividend policy) in your prescribed book. In
order to make sure that you understand how these factors affect the dividend
policy of the firms, work through the reflective activity 3.6.4.
Types of dividend policies
There are three other ways of compensating the shareholder without a dividend
payout in cash, namely:
• Share/Stock dividend
• Share splits
• Share repurchases
Read up on the three methods. Three approaches can be followed in formulating
a dividend policy:
• Constant payout ratio
• Regular dividend
• Low-regular-and-extra dividend
Study the three approaches in section 14.5 (type of dividend policies), bearing
in mind that a dividend policy may be a combination of all three. However, it
is important that a particular dividend policy should be formulated with due
allowance for constraints within the firm and the goals of the firm. Investors and
management should always know why a specific dividend policy is being followed.
After studying the section on the types of dividend policies in your prescribed
book, work through activity 8.6.5.
Other forms of dividends
There are three other ways of compensating the shareholder without a dividend
payout in cash, namely:
• Share/Stock dividend
• Share splits
• Share repurchases
Study the three methods in section 14.6 in your prescribed book and attempt
activity 8.6.6.
8.5
SUMMARY
In this lesson the fundamentals of dividend policy and the relevance of dividends
were explored. Factors influencing dividend policy and the types of dividend
policies were also discussed. In the next lesson the concept of leasing, mergers
and acquisition are discussed in greater detail.
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8.6
ACTIVITIES
ACTIVITY 8.6.1
Mvela Ltd has declared a dividend of R1.30 per share to shareholders of record on Tuesday,
May 2. The firm has 200 000 shares outstanding and will pay the dividend on May 24. How
much cash will be needed to pay the dividend and when will the shares begin selling
ex-dividend?
ACTIVITY 8.6.2
Describe the residual theory of dividends and the key arguments with regards to dividend
relevance and irrelevance.
ACTIVITY 8.6.3
Limpopo Corporation had a net income of R800 000 in 2013. Earnings have grown at an
8% annual rate. Dividends in 2013 were R300 000. In 2014, the net income was R1 100 000.
This, of course, was much higher than the typical 8% annual growth rate. It is anticipated
that earnings will go back to the 8% rate in future years. The investment in 2014 was R700
000. How much dividend should be paid in 2014, assuming the following:
(a) A stable dividend payout ratio of 25% is maintained.
(b) A stable rand dividend policy is maintained.
(c) A residual-dividend policy is maintained and 40% of the 2014 investment is financed
with debt.
(d) The investment for 2014 is to be financed with 80% debt and 20% retained earnings.
Any net income not invested is paid out in dividends.
ACTIVITY 8.6.4
Now let us see:
Reflect on the factors that affect dividends as set out in section 8.3 .Which factors do you
think are less important and which are not applicable to the South African environment?
At the same time suggest and justify which ones should be removed in the South African
context.
ACTIVITY 8.6.5
Over the last 10 years, the firm has had the earnings per share as shown in the following table:
Year
Earnings per share
Year
Earnings per share
2013
R4.00
2008
2.40
2012
R3.80
2007
1.20
2011
R3.20
2006
1.80
2010
R2.80
2005
-0.50
2009
R3.20
2004
0.25
60
(a) If the firm’s dividend policy was based on the constant payout ratio of 40% for all
years with positive earnings and 0% otherwise, what would the annual dividend
for each year be?
(b) If the firm had a dividend payout of R1.00 per share, increasing by R0.10 per share
whenever the dividend payout fell below 50% for two consecutive years, what
annual dividend would the firm pay each year?
(c) If the firm’s policy was to pay R0.50 per share for each period except when earnings
per share exceed R3.00 when an extra dividend equal to 80% of earnings beyond
R3.00 would be paid, what annual dividend would the firm pay each year?
(d) Discuss the pros and cons of each dividend policy described in Part A through C.
ACTIVITY 8.6.6
Pinetown Paper has the following shareholders’ equity account. The firm’s ordinary share
has a current market price of R30 per share:
Preference share
R100 000
Ordinary share (10 000 shares at R2 par)
20 000
Share premium
280 000
Retained earnings
320 000
Total shareholder’s equity
R720 000
(a) Show the effects on Pinetown Paper of a 5% share dividend.
(b) Show the effects of a 10% and 20% share dividend.
(c) In light of your answers to a and b, discuss the effects of share dividends on shareholders’ equity.
ACTIVITY 8.6.7
Work through questions ST14-1 at the end of chapter 14 in the prescribed book.
8.7
FEEDBACK ON ACTIVITIES
Suggested feedback on the activities is found at the end of this study guide.
8.8
SELF-ASSESSMENT QUESTIONS
(1) According to the residual theory of dividends, if the firm’s equity needs exceed the
amount of retained earnings, the firm would …
1.
2.
3.
4.
borrow to pay the cash dividend.
sell additional stock to pay the cash dividend.
pay no cash dividends.
do not need to reconsider its dividend policy.
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(2) The clientele effect refers to …
1. the relevance of dividend policy for share value.
2. the firm’s ability to attract shareholders whose dividend preferences are similar
to the firm’s dividend policy.
3. the informational content of dividends.
4. the “bird-in-the hand” argument.
(3)Modigliani and Miller, recognising that dividends do somehow affect share prices,
suggest that positive effects of dividend increases are attributable …
1.
2.
3.
4.
directly to the dividend policy.
directly to the optimal capital structure.
not to the informational content but to consistency in the payment of dividends.
not to the dividend itself but to the informational content of the dividends with
respect to future earnings.
(4) Gordon’s bird-in-the-hand argument suggests that …
1.
2.
3.
4.
dividends are irrelevant.
firms should have a 100% payout policy.
shareholders are generally risk averse and attach less risk to current dividends.
the market value of the firm is unaffected by dividend policy.
(5) A firm has an optimal capital structure of 40% debt and 60% equity. The 2002 investment
opportunity schedule totals R4 200 000. If the 2001 retained earnings are R3 million
and the firm follows the residual theory of dividends, it would pay … in dividends.
1.
2.
3.
4.
R0
R 480 000
R 1 320 000
R1 800 000
(6) The dividend policy must be formulated considering two basic objectives, namely …
1.
2.
3.
4.
delaying the tax liability of the shareholder and information content.
maximising shareholder wealth and delaying the tax liability of the shareholder.
maximising shareholder wealth and providing for sufficient financing.
maintaining liquidity and minimising the weighted average cost of capital.
(7) The purpose of share split is to …
1.
2.
3.
4.
affect the firm’s capital structure.
decrease the dividend.
enhance the trading activity of the share by lowering the market price.
increase the market price of the share.
(8) The repurchase of shares … the earnings per share and … the market price of shares.
1.
2.
3.
4.
8.9
increases; increases
decreases; decreases
increases; decreases
decreases; increases
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
Suggested solutions to the self-assessment questions will be uploaded on myUnisa after you
have attempted the questions.
62
8.10 CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activities?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcome?
Would you be able to meet the stated assessment criteria?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
Are any additional resources available from myUnisa?
63
FIN3701/1
LESSON 9
LEASING, MERGERS AND ACQUISITIONS
CONTENTS OF LESSON
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
9.10
Tutorial matter
Learning outcomes
Key concepts
Overview
Summary
Activities
Feedback on activities
Self-assessment questions
Feedback on self-assessment questions
Checklist
9.1
TUTORIAL MATTER
Study chapters 17 and 18 in your prescribed book.
9.2
LEARNING OUTCOMES
After working through this lesson, you should be able to
•
•
•
•
•
•
•
•
•
•
9.3
distinguish between operating and capital leases
explain leasing arrangements
calculate the lowest cost of financing of a lease-versus-purchase decision
determine the influence of operating and capital leases on financial ratios
explain the advantages and disadvantages of leasing
explain the difference between mergers and consolidations
differentiate between the broad categories of mergers and specific types of mergers
explain the motives for merging
demonstrate the factors critical to the success of a merger or acquisition
identify the financial considerations to be addressed in the merger or acquisition
process
KEY CONCEPTS
•
•
•
•
•
•
Operating lease
Capital lease
Merger
Acquisition
Consolidation
Friendly merger
64
•
•
•
•
•
•
9.4
Strategic merger
Horizontal merger
Vertical merger
Concentric merger
Conglomerate merger
Synergy
OVERVIEW
Introduction
This lesson introduces you to leasing, convertible securities, mergers and
acquisitions. Leasing is another way in which a firm can finance its assets. Leasing
follows a process in which a firm can obtain use of certain fixed assets for which
it must make a series of contractual, periodic, tax-deductible payments. Merger
refers to the consolidation of companies. Two companies in this case combine
to form one new company. Acquisition differs from a merger in the sense that
one company purchases another company but no new company is formed. In
this lesson, the motives for and types of mergers as well as procedures to analyse
and negotiate mergers are discussed. The elements critical to the success of a
merger and the financial aspects to be considered are also discussed.
Note: Share purchase warrants, derivative instruments, share swap transactions
and international mergers were explained in previous chapters in the prescribed
book. These sections are comprehensively covered in the international and risk
management subjects. Read through them as they will not be assessed in this
module.
The sections that need to be studied in the prescribed book and which will be
assessed are the following:
• Section 17.2:
• Section 17.3:
• Section 18.1:
Leasing
Convertible securities
Merger fundamentals
Types of leases
Leasing provides an alternative to purchasing an asset in order to acquire its
services without directly incurring any fixed debt obligation. There are two basic
types of leases available to the business firm:
1.
2.
An operating lease is basically a short-term lease. It is cancellable at the
option of the firm leasing the asset (the lessee). Such leases are commonly
used for leasing items such as computer hardware, cash registers, vehicles
and equipment.
A financial (capital) lease is a longer-term lease than an operating lease. It
constitutes a noncancellable contractual commitment on the part of the
lessee to make a series of payments to the firm that actually owns the asset
(the lessor) for the use of the asset.
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Operating leases transfer the benefit of the asset for only a portion of its useful
life. The risks and rewards remain with the lessor. The lessee pays a periodic
sum (rent) while using the asset. With operating leases there is no impact on the
balance sheet and the lease payments are charged as an expense to the income
statement. In the cash flow statement the rental is treated as part of the cash
flow from operating activities.
A financial manager can use leasing as so-called off-balance-sheet financing
by classifying a lease for accounting purposes as an operating lease rather
than a capital lease. Normally, this can only be done if the operating lease is
indistinguishable from a capital lease. This has an influence on the financial ratios
of a firm. If a firm uses a capital lease, an asset and a liability will appear on the
balance sheet as a result of the lease; the rent paid will appear in the income
statement as an expense.
The lease-versus-purchase decision
The lease-versus-purchase decision is a decision that commonly confronts firms
considering the acquisition of new assets. It is a hybrid capital budgeting decision
which forces a company to compare the leasing and purchasing alternatives. To
make an intelligent decision, an after-tax cash outflow, present value comparison
is needed. There are special steps to take when making this comparison.
When considering a lease, take the following steps:
1.
Find the annual lease payment. Since the annual lease payment is typically
made in advance, the formula to be used is:
Amount of lease = A + A(PVIF)I,n-1 or A = Amount of lease
1 + (PVIF) I, n-1
This step may not be necessary since this amount is usually available.
2.
3.
4.
Calculate the interest. The interest is segregated from the principal debt in
each of the annual loan payments because only the interest is tax-deductible.
Find the cash outflows by adding interest and depreciation (plus any
maintenance costs), and then compute the after-tax outflows.
Find the present value of the after-tax cash outflows, using a financial
calculator or the financial tables in Appendix C.
Study section 17.2 on leasing and 17.3 on convertible securities in your prescribed
book and work through activities 9.6.1, 9.6.2 and 9.6.3.
The influence of capital leases on financial ratios
A firm that chooses transactions structured as capital leases rather than operating
leases will experience
• a lower current ratio. This is due to an increase in the current liabilities, in other
words the portion of the liability that is current.
• a higher debt-equity ratio. This is due to the increase in liabilities while equity
remains unchanged.
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• a lower times-interest-earned ratio. The times-interest-earned ratio is also
called interest cover. The depreciation on the asset acquired by means of the
capital lease results in an increase in depreciation, thus lowering the earnings
before interest and taxes.
• lower net income in earlier years and higher net income in later years (if
straight-line depreciation is used). This is due to the greater amounts of depreciation being written off during the initial years. As the depreciable value
of the asset declines, so does the annual amount of depreciation.
• increased operating cash flows. Operating cash flows are found by adding
back non-cash charges to net income after tax. One of these non-cash charges
is depreciation. By adding an increased amount of depreciation as a result of
the capital lease, the operating cash flow is increased.
Merger and acquisition fundamentals
A merger is the combination of two or more firms in such a way that the resulting
firm maintains the identity of one of the merger firms, while a consolidation is the
combination of two or more firms to form a completely new corporation. Take a
moment to think about examples of such merged as well as consolidated firms
in South Africa. A good example is that of PricewaterhouseCoopers, which was
formed in 1998 from a merger between Price Waterhouse and Coopers & Lybrand.
Consolidations are generally made between similarly sized firms; mergers normally
result from a large firm acquiring the assets or shares of a smaller company.
The larger firm pays for its acquisition in either cash or shares (ordinary and/or
preference). A holding company is a company that has a voting control in one or
more other corporations. The companies controlled by a holding company are
normally referred to as subsidiaries. The holding company arrangement differs
from a consolidation and a merger in that the holding company consists of a
group of subsidiary firms, each operating as a separate corporate entity, while a
consolidated or merged firm is a single entity. Transnet is a good example of a
holding company in South Africa. Transnet is a holding company with subsidiaries
such as South African Airways, Portnet and Metrorail. It is important that you
grasp the above fundamentals at this stage. You need to be able to identify such
companies in practice. These clear concepts are sometimes blurred in practice,
but the principles governing mergers and acquisitions are usually enforced by
various institutions, such as the South African Revenue Service, the Competition
Commission of South Africa and the Ministry of Finance.
Study section 18.1 (on merger fundamentals) in your prescribed book and work
through activity 8.6.4.
Types of mergers
This section looks at broad categories of mergers and specific types of mergers.
Broad categories of mergers
A friendly merger is one where the target company’s management supports
the acquiring company’s proposal, and the firms work together to negotiate
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the transaction. If the target company is not receptive to the takeover proposal,
a hostile merger situation exists, and the acquirer must try to gain control by
buying enough shares in the market, often through tender offers. Think back
to the proposal of Nedcor Bank’s offer to Standard Bank (Stanbic) a while ago.
Can you recall why the proposal failed? If not, search online for reports on the
proposed merger.
Strategic mergers are undertaken to achieve economies of scale by combining
operations of the merged firms for greater productivity and profit. The goal of
financial mergers is to restructure the acquired company to improve cash flow.
The acquiring firm believes there is hidden value that can be unlocked through
restructuring activities, including cost cutting and/or divestiture of unprofitable
or incompatible assets.
Daimler-Chrysler’s original intent to merge was based on a strategic objective.
It wanted to combine its worldwide operations and achieve economies of scale
in the various car plants around the world.
Please take note that Gitman refers to hostile and financial mergers as well.
Essentially, these are paired off as opposites of the above mergers. You need to
understand them as belonging to this broad category of mergers.
Specific types of mergers
• A horizontal merger is the merger of two firms in the same line of business.
• A vertical merger involves the acquisition of a customer or supplier.
• A concentric merger is the acquisition of a firm in the same general industry,
but neither in the same line of business as, nor a supplier or customer to the
acquiring firm.
• A conglomerate merger occurs when firms in unrelated businesses merge.
The merger/acquisition process
The merger/acquisition process is usually more holistic than one thinks. Very often
one tends to focus heavily on the financial and accounting aspects, ignoring the
other so-called non-objective factors. The following elements were identified
in research conducted by Deloitte Consulting and Deloitte & Touche as being
critical to the success of a merger or acquisition:
•
•
•
•
•
•
•
•
E stablish a merger and acquisition strategy that focuses on the sources of value.
Focus on synergies by identifying and quantifying them early in the process.
Conduct an effective due diligence across all functional areas of management.
Plan for and structure integration early on: the quicker this integration occurs,
the greater the chances of success.
Focus integration on clearly defined drivers of value.
Address retention issues early and often.
Maintain communication throughout the merger and acquisition cycle.
Keep in mind the importance of culture.
Source: Mergers and Acquisitions: Maximising the Payoff. 2001. Business Brief.
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August/September:14.
In addressing a merger or acquisition it is therefore important to consider a wide
range of factors. Naturally, the emphasis of this module would be on the financial
aspects that are considered and affected during a merger or an acquisition.
Consider the following relationship:
Vab = Va + Vb + Synergy
Where: Vab = the value of the company (post-merger)
Va = the value of company A (pre-merger)
Vb = the value of company B (pre-merger)
Synergy = the economies realised in the merger (increased revenue/cost
reductions)
Source: Van Horne, JC. 1998. Financial management and policy. 11th edition.
Englewood Cliffs, NJ: Prentice Hall.
Using the above identity, the maximum price that company A ought to pay for
company B is Vab – Va. This forms the basis for the transactions that are effected
during the merger and acquisition process.
Some financial considerations during the merger and acquisition process
The following elements need special attention during the merger and acquisition
process:
• Is the transaction a purchase of assets or a purchase of shares?
• Is the transaction taxable or tax free? Please note that with the introduction
of capital gains tax in South Africa, such transactions (e.g. the purchase of
assets for more than their book value) are deemed to be a capital gain and
will be taxed.
• The accounting treatment of such a transaction. In terms of Generally Accepted
Accounting Practice Statement AC409, guidelines are provided for acquiring
a business interest and uniting a business interest. The general consensus is
that unless the acquirer cannot be identified, a business combination should
be accounted for as an acquisition.
According to Bowman and Gilfillan (2013:22), mergers and acquisitions in South
Africa generally involve one of the following transactions:
• The most common way to obtain control of a company in a recommended
offer is through a scheme of arrangement.
• Where an offer is not recommended, a takeover offer may also be used to
obtain control of a company.
• Control of a company may also be obtained by the bidder, or a vehicle set
up for that purpose, purchasing the assets of the target company (sale of
business). This type of transaction would normally have to be approved by a
simple majority of the target company’s shareholders at a general meeting.
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Mergers and acquisitions in South Africa
Also according to the Mergers & Acquisitions Review, 4th edition, one of the main
drivers of local M&A activity in recent years has been a type of transaction that
is unique to the South African environment, namely BEE transactions. Over the
past 10 years or so, the South African government has put in place a regulatory
framework aimed at ensuring the economic empowerment of previously
disadvantaged black South Africans. It has become a key commercial imperative
for companies aiming to do business in South Africa to ensure that they have
sufficient empowerment credentials. From a M&A perspective one of the key
elements of the government’s BEE policies has been the targets prescribed in
respect of black equity ownership, and most of the major companies in South
Africa have concluded transactions in terms of which they have disposed of a
significant equity stake (generally up to 25%) to black shareholders.
Such transactions have created their own challenges, particularly as BEE investors
often do not have access to sufficient funds to pay for the stake that they are
acquiring. Previously, the prohibition in South African company law on a company
providing financial assistance for the purchase of its shares made vendor financing
of such transactions more difficult; however, this prohibition has been relaxed
recently. One of the more significant recent BEE transactions of 2010 was the South
African Breweries broad-based empowerment transaction worth R7,7 billion.
MTN has also recently announced its revised BEE deal with a value of R8 billion.
9.5
SUMMARY
This lesson was the last in this module on long-term investment and financial
decisions. It presented the basic types of leases, mergers and acquisitions. The
lease-versus-purchase decisions were reviewed. The influence of capital leases
on financial ratios was discussed, and the advantages and disadvantages of
leasing were highlighted. Fundamentals of mergers and the types of, and motives
for, mergers were discussed. The elements vital to the merging process were
highlighted and the financial considerations needing special attention during
the merger/acquisition process were briefly considered.
9.6
ACTIVITIES
ACTIVITY 9.6.1
Azambezi Tours has decided to acquire a second-hand four-seater propeller aeroplane
costing R100 000 that has an expected life of five years, after which the plane is not expected
to have any residual value. The asset can be purchased by borrowing money or it can be
leased. If leasing is used, the lessor requires a 12% return. As is customary, lease payments
are to be made in advance, that is, at the end of the year prior to each of the 10 years. The
tax rate is 50% and the firm’s cost capital, or after-tax cost of borrowing, is 8%.
70
(a) For the leasing plan, calculate the following:
(1) The after-tax cash outflow for each year
(2) The present value of the cash outflow
(b) For the purchasing plan, calculate the following:
(1) The annual interest expense deductible for tax purposes for each of the five years
(2) The after-tax cash outflow resulting from the purchase for each of the five years
(3) The present value of the cash outflows
(c) Finally, compare the present value of the cash outflow streams for these two plans and
determine which plan would be preferable. Justify your answer.
ACTIVITY 9.6.2
Monomutapa is attempting to determine whether to lease or purchase equipment. The
firm is in the 40% tax bracket and its after-tax cost of debt is currently 8%. The terms of the
lease and the purchase are as follows:
Lease: Annual end-of-year lease payments of R25 200 are required over the three-year life
of the lease. All maintenance costs will be paid by the lessor; insurance and other costs will
be borne by the lessee. The lessee will exercise its option to purchase the asset for R5 000
at termination of the lease.
Purchase: The equipment, costing R60 000, can be financed entirely with a 14% interest
loan requiring annual end-of-year payments of R25 844 for three years. The depreciation
for each of the years is as follows:
Year 1
Year 2
Year 3
R19 800
R27 000
R 9 000
The firm will pay R1 800 per year for a service contract that covers all maintenance costs.
Insurance and other costs will be borne by the enterprise. The firm plans to keep the
equipment and use it beyond the three-year period over which it will be depreciating.
(1) Calculate the after-tax cash outflows associated with each alternative.
(2) Calculate the present value of each cash outflow stream using the after-tax cost of debt.
(3) Which alternative, lease or purchase, would you recommend?
ACTIVITY 9.6.3
During the past two years Madiba Ltd issued three separate convertible bonds. For each
of them calculate the conversion price.
(a) A R1 000-par-value bond that is convertible into10 ordinary shares
(b) A R2 000-par-value bond that is convertible into 20 ordinary shares
(c) A R1 500-par-value bond that is convertible into 30 ordinary shares
9.7
FEEDBACK ON ACTIVITIES
Suggested feedback on the activities will be uploaded on myUnisa after you have attempted
the activities.
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9.8
SELF-ASSESSMENT QUESTIONS
Question 1
Assets leased under … leases generally have a usable life longer than the term of the lease.
(1)
(2)
(3)
(4)
financial
operating
capital
direct
Question 2
A capital or capitalised lease is otherwise known as …lease.
(1)
(2)
(3)
(4)
an operating
a financial
a direct
a leveraged
Question 3
A firm that needs funds for operations normally initiates a …
(1)
(2)
(3)
(4)
direct lease.
leveraged lease.
sale-leaseback.
capital lease.
Question 4
Common forms of business combination include all of the following, except …
(1)
(2)
(3)
(4)
congeneric formation.
consolidations.
mergers.
holding companies.
Question 5
A combination of two or more companies to form a completely new company is called a …
(1)
(2)
(3)
(4)
congeneric formation.
consolidation.
merger.
holding company.
Question 6
The company in a merger transaction that is being pursued as a takeover potential is called
the … company.
(1)
(2)
(3)
(4)
acquiring
target
holding
conglomerate
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9.9
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
Suggested solutions to the self-assessment questions will be uploaded on myUnisa after you
have attempted the questions.
9.10 CHECKLIST
Did you read the chapter in full in order to get an overall impression
of the content?
Have you done the activities?
Did you complete the assessment?
Have you studied the contents of this chapter?
Have you achieved the learning outcome?
Would you be able to meet the stated assessment criteria?
Have you discussed any challenges of this lesson with fellow students
(personally or via the Discussion Forum on myUnisa), your tutor or
lecturer?
Are any additional resources available from myUnisa?
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FEEDBACK ON THE LESSONS ACTIVITIES
LESSON 1: CAPITAL BUDGETING AND CASH FLOW PRINCIPLES
Activity 1.8.2 ST8-1 or ST11-1
(a)
(b)
Book value
=
Installed cost – Accumulated depreciation
Installed cost
Accumulated depreciation
Book value
=
=
=
R500 000
R500 000 x 0.20 x 4
= R400 000
R500 000 – R400 000 = R100 000
=
=
=
=
Sale price–Book value
R80 000–R100 000
R20 000 loss
R20 000 x 0.30 = R6 000 tax savings
=
=
=
(R800 000)
(R50 000)
(R850 000)
Taxes on sale of old equipment:
Gain on sale
Taxes
(c)
Initial investment:
Cost of new equipment
Plus installation costs
Total installed cost – new
After-tax proceeds from sale of old equipment
Proceeds from sale of old equipment
Plus taxes on sale of old equipment
Total after-tax proceeds – old Net working capital increase
Initial investment
=
=
=
=
=
R80 000
R6 000 (tax savings)
R86 000
(R70 000)
R834 000
Activity 1.8.3 ST8-2 or ST11-2
(a)
Initial investment:
Cost of new equipment
Plus installation costs
Total installed cost – new
=
=
=
(R1 000 000)
(R200 000)
(R1 200 000)
(Depreciable value)
After-tax proceeds from sale of old machine
Proceeds from sale of old machine
=
Taxes on sale of old machines
=
Total after-tax proceeds – old =
Net working capital increase
=
Initial investment=
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R400 000
(R30 000)
R370 000
(R150 000)
(R980 000)
Book value of old machine
R400 000 – R300 000
R100 000 x 0.30
Change in net working capital
(b
=
R600 000 – (600 000 x 0.25 x 2) = R300 000
=
=
=
=
R100 000 (capital gain)
R30 000 (tax payable)
(R80 000) + (R120 000) + R50 000
R150 000
Incremental cash flow
New machine
Year 1
Year 2
Year 3
EBDIT
R1 200 000
R1 300 000
Depreciation
(R 400 000
(R 400 000)
(R 400 000)
EBIT
R 800 000
R 900 000
R 900 000
Taxes
(R240 000)
(R 270 000)
(R 270 000)
NOPAT
R 560 000
R 630 000
R 630 000
Depreciation
R4 00 000
R 400 000
R 400 000
Operating cash inflows
R 960 000
R1030 000
R1030 000
Old machine
Year 1
Year 2
Year 3
EBDIT
R700 000
R700 000
R700 000
Depreciation
(R150 000)
(R150 000)
EBIT
R550 000
R550 000
R700 000
Taxes
(R165 000)
(R165 000)
(R210 000)
NOPAT
R385 000
R385 000
R490 000
Depreciation
R150 000
R150 000
Operating cash inflows
R535 000
R535 000
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Incremental cash flow
Year 1
Year 2
Year 3
New machine
R960 000
R1030 000
R1030 000
Old machine
R535 000
R 535 000
R 490 000
Incremental cash flow
R425 000
R 495 000
R 540 000
(c)
Terminal cash flow
After-tax proceeds from sale of new machine
• Proceeds from sales on new machine
=
• *Tax payable=
R300 000
(R90 000)
Total after-tax proceeds
R210 000
After-tax proceeds from sale of old machine
R0
R150 000
Recoupment of working capital
Terminal cash flow
R360 000
*Book value; R1 200 000 – (R1 200 000 x 0.333 x 3) = R
0 Tax on sale; 0.30 x (R300 000 –
R0) = R90 000
LESSON 2: CAPITAL BUDGETING TECHNIQUES
Activity 2.6.2: E9-1 to E9-5 or E10-1 to E10-5
E9-1 or E10-1: Payback period
The payback period for Project Hydrogen is 4.32 years. The payback period for Project
Helium is 5.75 years. Both projects are acceptable because their payback periods are less
than Elysian Fields’ maximum payback period criterion of six years.
E9-2 or E10-2: Net present value
Year
1
2
3
4
5
Cash inflow
Present value
R400 000
R 377 358.49
375 000
R 333 748.67
300 000
R 251 885.78
350 000
R 277 232. 78
200 000
R 149 451.63
Total
R1 389 677.35
NPV = R1 389 677.35–R1 250 000 = R139 677.35
Herky Foods should acquire the new wrapping machine.
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E9-3 or E10-3: Comparison of two projects
Project Kelvin
Present value
Present value of cash inflow
NPV
-R450 000
R515 419.40 (PMT = R200 000, N = 3, I/YR = 8, PV =?)
R65 419.40
Project Thompson
Present value of expenses
Present value of cash inflows
NPV
R275 000
R277 373 (PMT = R60 000, N = 6, I/YR = 8, PV =?)
R2 373
Based on NPV analysis, Axis Corporation should choose to overhaul the existing system.
E9-4 or E10-4: Internal rate of return
You may use a financial calculator to determine the IRR of each project. Choose the project
with the highest IRR.
Project T-Shirt
PV = -150 000
N=4
PMT = 80 000
Solve for I/YR = 39.08%
Project Board Shorts
PV = -250 000
N=5
PMT = 120 000
Solve for I/YR = 38.62%
E9-5 or E10-5:
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Note: The IRR for Project Terra is 10.68%, while that of Project Firma is 10.21%. Furthermore,
when the discount rate is zero, the sum of Project Terra’s cash flows exceed that of Project
Firma. Hence, at any discount rate that produces a positive NPV, Project Terra provides
the higher net present value.
Activity 2.6.3:
Question 1, ignore this question.
Question 2.
Project
PB
NPV
IRR
PI
Alpha
3,57 years
(R1 228)
12,38%
0.9386
Bravo
2 years
R 2 682
23.00%
1.1341
LESSON 3: RISK AND REFINEMENTS IN CAPITAL BUDGETING
Activity 3.6.1: Certainty equivalent co-efficient
Project A
Project B
Cash
inflow
Certainty
Eq.co-eff
PV
Factor
@ 10%
PV of
cash
inflow
Cash
inflow
Certainty
Eq.co-eff
PV
Factor
@ 10%
PV of
cash
inflow
R4 000
0.9
0.909
R3 272
R5 000
0.8
0.909
R3 636
R4 000
0.8
0.826
R2 643
R6 000
0.7
0.826
R3 469
R2 000
0.6
0.751
R 901
R3 000
0.5
0.751
R1 127
R6 817
R8 232
Less initial outlay
(R10 000)
(R10 000)
NPV
-R3 184
NPV
-R1 768
Comment: Project B is better than Project A. Since the NPV of both projects are negative,
neither of the projects should be accepted.
78
Activity 3.6.2: Scenario analysis
(i)
PROJECT X
PROJECT Y
Cash inflow estimates
Cash inflow estimates
Pessimistic
Most
likely
Optimistic
Pessimistic
Most
likely
Optimistic
a. A
nnual cash
inflow
R1 200
R4 000
R7 000
R3 700
R4 000
R4 500
b. P
V factor
@10% for 20
yrs
8.5140
8.5140
8.5140
8.5140
8.5140
8.5140
c. PV
R10 216
R34 056
R59 598
R31 501
R34
056
R38 313
d. N
et
investment
(cash outlay)
R30 000
R30 000
R30 000
R30 000
R30
000
R30 000
e. NPV (c – d)
-R19 783
R4 055
R29 596
R1 498
R4 052
R8 308
(ii)
Comment: Project Y should be selected because, even under the pessimistic situation
the NPV of Project Y is positive, meaning it earns more than the cost of capital.
Activity 3.6.3: Risk-adjusted discount rate
Risk-adjusted discount rate for Projects A and B:
Project A: = 5% + 5% = 10%
Project B: = 5% + 10% = 15%
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Statement of NPV:
Statement showing NPV of Project A at a discounting factor of 10%:
Year
Cash inflows
Disc. Factor @ 10%
PV of cash
inflows
1
R4 000
0.909
R3 636
2
R4 000
0.826
R3 304
3
R2 000
0.751
R1 502
R8 442
Less: initial outlay
(R10 000)
NPV
-R 558
Statement showing NPV of Project B at a discounting factor of 15%:
Year
Cash inflows
Disc. Factor @ 15%
PV of cash inflows
1
R5 000
0.870
R 4 347
2
R6 000
0.756
R 4 536
3
R3 000
0.658
R 1 972
Less: initial outlay
R10 000
R10 857
NPV
R 857
Since the NPV of Project B is positive, Project B should be preferred.
Activity 3.6.4: Replacement chain (common life) approach
NPVA
= R4 800 (PVIFA10,14%) – R24 500
= R4 800 (5,2161) – R24 500 = R537,28
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Project B’s extended timeline can be set up as follows:
Year
0
1
2
3
4
5
6
7
8
9
10
Cash
flow
-200
60
60
60
60
60
60
60
60
60
60 (hundreds)
Adjusted NPVB
Or, alternatively,
Adjusted NPVB
= R6 000 (PVIFA10,14%)–(PVIFA5,14%) – R20 000
= (PVIFA5,14%) – R20 000
= R6 000 (5,2161) – R20 000 (0,5194) – R20 000
= R31 296.60 – R10 388,00 –R20 000
= R908,60
= R6 000 (PVIFA5,14%) – R20 000
= R6 000 (3,4331) – R20 000
= R20 598,60 – R20 000
= R598,60
= NPVB + NPVB discounted for five years
= R598,60 + R598,60 (PVIF5,14%)
= R598,60 + R598 (0,5194)
= R598,60 + R310,91
= R909,51
Activity 3.6.5: Annualised Net Present Value/Equivalent Annual Annuity (EAA)
From the example above, NPVA = R537,28 and NPVB = R598,60.
To obtain the constant annuity cash flow or EAA we do the following:
EAAE = R537.28/PVIFA10,14%= R537,28/5,2161 = R103,00
EAAB = R598,60/PVIFA5,14%= R598,60/3,4331 = R174,36
Thus the infinite horizon NPVs are as follows:
Infinite horizon NPVA = R103,00/0,14 = R735,71
Infinite horizon NPVB = R174,36/0,14 = R1 245,43
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Activity 3.6.6: Capital rationing.
a) Rank by IRR
Project
IRR
Initial investment
Total investment
F
23%
R2 500 000
R2 500 000
E
22
R 800 000
R3 300 000
G
20
R1 200 000
R4 400 000
C
19
B
18
A
17
D
16
Projects F, E and G require a total investment of R4 500 000 and provide a total present
value of R5 200 000 and therefore a net present value of R700 000.
b) Rank by NPV (NPV = PV – Initial investment)
Project
NPV
Initial investment
F
R500 000
R2 500 000
A
R400 000
R5 000 000
C
R300 000
R2 000 000
B
R300 000
R 800 000
D
R100 000
R1 500 000
G
R100 000
R1 200 000
E
R100 000
R 800 000
Project A can be eliminated because, while it has an acceptable NPV, its initial investment
exceeds the capital budget. Projects F and C require a total initial investment of R4 500
000 and provide a total present value of R5 300 000 and a net present value of R800 000.
However, the best option is to choose Projects B, F and G, which also use the entire capital
budget and provide an NPV of R900 000.
82
c) T he IRR approach uses the entire R4 500 000 capital budget, but provides R200 000
less present value (R5 400 000 – R5 200 000) than the NPV approach. Since the NPV
approach maximises shareholder wealth, it is the superior method.
d) The enterprise should implement Projects B, F and G, as explained in parts (b) and (c).
Activity 3.6.7: Capital rationing
E12-1: Sensitivity analysis
Using the 12% cost of capital to discount all of the cash flows for each scenario to yield
the following NPVs, resulting in a NPV range of R19 109,78:
Pessimistic
R3 283,48
Most Likely
R6 516,99
Optimistic
R15 826,30
E12-2: Using IRR as selection criteria
The minimum amount of annual cash inflow needed to earn 8% is R11,270.
45,000/PVIFA8%,5
R45,000/3.993 = R11 269,72
Calculator solution = R11 270,54
The IRR of the project is 12.05%. The project is acceptable since its IRR exceeds the firm’s
8% cost of capital. Since the required cash flow is much less than the anticipated cash
flow, one would expect the IRR to exceed the required rate of return.
E10-3: Risk-adjusted discount rates
Project Sourdough RADR 7.0%
NPV = R17 141,09
Project Greek Salad RADR = 8.0%
NPV = 13 325,48
Yeastime should select Project Sourdough.
E10-4: ANPV
You may use a financial calculator to determine the IRR of each project. Choose the project
with the higher IRR.
Project M
Step 1:
Find the NPV of the project.
NPV= R21 359,55
Step 2:
Find the ANPV.
PV = R21 360
N=3
I=8
PMT = R8 288,22
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Project N
Step 1:
Find the NPV of the project.
NPV = R13 235,82
Step 2:
PV
N
I
PMT
Find the ANPV.
R13 235,82
=7
=8
R2 542,24
Based on ANPV, you should advise Outcast, Inc. to choose Project M.
E10-5: NPV profiles
The investment opportunity schedule (IOS) in this problem does not allow us to determine
the maximum NPV allowed by the budget constraint. In order to determine whether the
IOS maximises the NPV for Longchamps Electric, we will need to know the NPV for each
of the six projects. However, it does appear likely that Longchamps Electric will maximise
firm value by selecting Project 4 (IRR = 11%), Project 2 (IRR = 10%), and Project 5 (IRR =
9%). The total investment in these three projects will be R135 000, leaving R15 000 excess
cash for future investment opportunities.
LESSON 6: L EVERAGE
Activity 6.5.1
Prescribed book reference: Chapter 13(.1)
Break-even analysis
Prescribed book reference: Chapter 13(.1)
Degree of operating leverage
Prescribed book reference: Chapter 13(.1)
Degree of financial leverage
Prescribed book reference: Chapter 13(.1)
Total leverage
Prescribed book reference: Chapter 13(.1)
Degree of total leverage
Prescribed book reference: Chapter 13(.1)
84
LESSON 7: LEVERAGE AND CAPITAL STRUCTURE
Debt and equity ratio
Prescribed book reference: Chapter 13(.2)
Expected earnings per share E(EPS)
Prescribed book reference: Chapter 13(.2)
Standard deviation of EPS
Prescribed book reference: Chapter 13(.2)
Coefficient of variation (CV) of EPS
Prescribed book reference: Chapter 13(.1)
Asymmetric information
Prescribed book reference: Chapter 13(.2)
Optimal capital structure
Prescribed book reference: Chapter 13(.2)
LESSON 8: PAYOUT POLICY
Activity 8.6.1: Relevant dividend dates
The firm will need R260 000 of cash to pay the dividend. Because a weekend intervenes,
the share will begin selling ex-dividend on Friday, April 28, which is four days before the
date of record.
Activity 8.6.2: Residual theory of dividends
Prescribed book reference: Chapter 14(.3)
Dividend relevance and irrelevance
Prescribed book reference: Chapter 14(.3)
Activity 8.6.3
(a)
Net Income = R1 100 000
Dividend payout = (R1 100 000 x 25%) = R275 000
(b) R300 000 equal to the dividend payout for 2013
(c) Investment opportunities = R700 000 of which 60% will be funded from equity, this
means (R700 000 x 60%) = R420 000 from equity.
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Earnings available for dividend payment = (R1 100 000–R420 000) = R680 000
(d) Investment opportunities = R700 000 of which 20% will be funded from equity, this
means (R700 000 x 20%) = R140 000 from equity.
Earnings available for dividend payment = (R1 100 000 – R140 000) = R960 000
Activity 8.6.4: Residual theory of dividends
Prescribed book reference: Chapter 14(.3)
Activity 8.6.5
(a)
YEARS
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
EPS
0.25
-0.50
1.80
1.20
2.40
3.20
2.80
3.20
3.80
4.00
Dividend payout
0.10
0.00
0.72
0.48
0.96
1.28
1.12
1.28
1.52
1.60
(b)
YEARS
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
EPS
0.25
-0.50
1.80
1.20
2.40
3.20
2.80
3.20
3.80
4.00
Dividend payout
1.00
1.10
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
86
(c)
YEARS
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
EPS
0.25
-0.50
1.80
1.20
2.40
3.20
2.80
3.20
3.80
4.00
Dividend payout
0.50
0.50
0.50
0.50
0.50
0.50 + (3.20 x 80%) = 3.06
0.50
0.50 + (3.20 x 80%) = 3.06
0.50 + (3.80 x 80%) = 3.54
0.50 + (4.00 x 80%) = 3.70
(d)
Prescribed book reference: Chapter 14(.5)
Activity 8.6.6
Type of dividend policies
(a) 5%
Share
Dividend
(b) (1) 10%
Share
Dividend
(b) (2) 20%
Share
Dividend
Preferred stock
R100 000
R100 000
R100 000
Ordinary shares (xx,xxx
shares
R2.00 par)
21 0001
22 0002
24 0003
Paid-in capital in excess of
par
294 000
308 000
336 000
Retained earnings
85 000
70 000
40 000
Shareholders’ equity
R500 000
R500 000
R500 000
1
10 500 shares
2
11 000 shares
3
12 000 shares
c. S hareholders’ equity has not changed. Funds have only been redistributed between
the shareholders’ equity accounts.
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Activity 8.6.7
ST14-1
Prescribed book reference: Appendix B
LESSON 9: LEASING, MERGERS AND ACQUISITIONS
Activity 9.6.1: Lease versus-purchase decision
Annual lease payment:
Amount of lease = A + A(PVIF)I, n-1 or A = Amount of lease
1 + (PVIF) I, n-1
R100 000
= R23 216
1 + (3.3073)
Step 2 and 3 can be done in the same schedule, as follows:
(1)
(2)
(3) = (1) – (2)
(4)
(5) = (3) x (4)
Year
Lease
payment
Tax
saving
After tax
cash flow
PV at
8%
PV of cash
outflow
0
R23 216
R11 608
R23 216
1.000
R23 216
1
R23 216
R11 608
R11 608
0.9259
R10 748
2
R23 216
R11 608
R11 608
0.8573
R 9 952
3
R23 216
R11 608
R11 608
0.7938
R 9 215
4
R23 216
R11 608
R11 608
0.7350
R 8 532
R11 608
(R11 608)
0.6806
(R7 900)
5
R53 763
If the asset is purchased, the firm is assumed to finance it entirely with a 10% unsecured
term loan. Straight-line depreciation is used with no salvage value. Therefore, the annual
depreciation is R20 000 (R100 000/5years). In this alternative, first find the annual loan
payment by using:
88
A = Amount of lease
(PVIF) I,n
A = R100 000
(PVIF) I,n
= R100 000 = R26 381
(PVIF)10%,5 years
Calculate the interest by setting up a loan armortisation schedule:
(1)
(2)
(3) = (1) x
(10%)
(4) = (1)
–(3)
Year
Loan
payment
Beginning
of year
principal
1
R26 381
2
(5) = (3)–(4)
Interest
Principal
End of year
principal
R100 000
R10 000
R16 381
R83 619
R26 381
R 83 619
R8 362
R18 019
R65 600
3
R26 381
R 65 600
R6 560
R19 821
R45 779
4
R26 381
R 45 779
R4 578
R21 803
R23 976
5
R26 381
R 23 976
R2 398
R23 983
-R8
Because of rounding errors, there is a slight difference between (2) and (4). Steps 3 (cash
outflows) and 4 (present value of those outflows) can be done as follows:
Year
(1)
(2)
(3)
Loan
payment
Interest
Depreciation
1
R26
381
R10 000
R20 000
2
R26
381
R8 362
3
R26
381
4
5
(4) = (2) +
(3)
(5) = (4)
x (50%)
Tax
savings
(6) =
(1) – (5)
cash
outflow
(7)
PV at 8%
(8) = (6)
x (7) PV
of cash
outflow
R30 000
R15 000
R11 381
0.9259
R10 538
R20 000
R28 362
R14 181
R12 200
0.8573
R10 460
R6 560
R20 000
R26 560
R13 280
R13 101
0.7938
R10 400
R26
381
R4 578
R20 000
R24 578
R12 289
R14 092
0.7350
R10 358
R26
381
R2 398
R20 000
R22 398
R11 199
R15 182
0.6806
R10 333
Total
deductions
R52 088
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The sum of the present values of the cash outflows for leasing and purchasing by borrowing,
shows that purchasing is preferable because the PV of borrowing is less than the PV of
leasing (R52 088) versus R53 763). The incremental savings would be R1 675 (R53 763 –
R52 088).
Activity 9.6.2: Lease versus-purchase decision
Calculate the interest by setting up a loan armortisation schedule:
Year
(1)
(2)
(3) = (1) x (14%)
(4) = (1) –(3)
(5) = (3)–(4)
Loan
payment
Beginning
of year
principal
Interest
Principal
End of year principal
1
R25 844
R60 000
R8 400
R17 444
R42 556
2
R25 844
R42 556
R5 958
R19 886
R22 670
3
R25 844
R22 670
R3 174
R22 670
R0
After-tax cash outflows for purchase option:
Year
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Loan
payment
Maintenance
Depreciation
Interest
at 14%
Total
deductions
Tax shield
Aftertax cash
outflows
(2) + (3) +
(4)
0.40 x (5)
(1 + 2)
– (6)
1
R25 844
R1 800
R19 800
R8 400
R30 000
R12 000
R15 644
2
R25 844
R1 800
R27 000
R5 958
R34 758
R13 903
R13 741
3
R25 844
R1 800
R9 000
R3 174
R13 974
R 5 590
R22 054
After-tax cash outflows for purchase option: (continue)
End of year
After-tax cash
outflow
PVIF8%,n
PV of outflows
1
R15 644
0.926
R14 486
2
R13 741
0.857
R11 776
3
R22 054
0.794
R17 511
R43 773
90
Lease option:
Year
(1)
(2)
(3) = (1) – (2)
(4)
(5) = (3) x (4)
Lease
payment
Tax saving
(0.40)
After tax cash flow
PV at 8%
PV of cash
outflow
0
R25 200
R10 080
R15 120
0.926
R14 001
1
R25 200
R10 080
R15 120
0.857
R12 958
2
R25 200
R10 080
R15 120 + R5 000
0.794
R15 975
R42 934
3
FEEDBACK ON SELF-ASSESSMENT QUESTIONS
LESSON 1: CAPITAL BUDGETING AND CASH FLOW PRINCIPLES
SELF-ASSESSMENT QUESTIONS
1. The correct answer is option 4.
2. The correct answer is option 3.
3. The correct answer is option 2.
4. The correct answer is option 2.
5. The correct answer is option 1.
6. The correct answer is option 3.
Calculations:
Purchase price
R 300 000
+ Installation
R 10 000
- After-tax proceeds from sale of
present equipment
RR 100 000
*
+ Change in net working capital
RR 70 000
= Initial investment
R 280 000
Increase in accounts receivable
R 80 000
+ Increase in inventory
R 30 000
- Increase in accounts payable
(R 40 000)
= Change in net working capital
*
91
R 70 000
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7. The correct option is 1.
Calculations:
Net profit (or
loss) after tax
+
Depreciation
= Operating
cash flow
Year 1
Year 2
Year 3
Year 4
Year 5
R 24 000
R 34 000
R 44 000
R 64 000
-R 6 000
R 56 000
R 56 000
R 56 000
R 56 000
R 56 000
R 80 000
R 90 000
R 100 000
R 120 000
R 50 000
8. The correct option is 1.
After-tax proceeds from the sale of new equipment
- Dismantling cost
+ Recovery of net working capital
Terminal cash flow
(R 3250)
1 000
* 7 750
10 000
Inventory
+ Accounts receivable
- Accounts payable
Net working capital*
R 3 000
8 750
4 000
7 750
LESSON 2: CAPITAL BUDGETING TECHNIQUES
Question 1: The correct answer is option 1.
The payback period is three years and one month, and the investment should be undertaken
because the payback period is shorter than the required payback period of four years.
Year
Net cash inflow
1
R 80 000
2
R 90 000
3
R 100 000
R 270 000 + R 10 000 from year 4 = R 280 000 (Assuming a constant cash flow of R 10 000
per month during year 4).
92
Question 2: The correct answer is option 2.
The NPV is closest to R 61 458 and the investment should be undertaken because the
NPV is greater than zero. The investment will add value to the firm and therefore increase
the shareholders; wealth.
Year
Net cash flow PVIF10%
PV of net cash flow
1
R 80 000
0, 909
R 72 727, 44
2
R 90 000
0, 826
R 74 380, 50
3
R 100 000
0, 751
R 75 131, 99
4
R 120 000
0, 683
R 81 962, 36
5
R 60 000
0, 621
R 37 255, 70
Total PV of CF
R341 458, 00
- (Initial Investments)
R280 000, 00
NPV =
R 61 458, 00
(NPV = R 61 455 using a financial calculator)
Question 3: The correct answer is option 3.
The IRR is 18,22% and the investment should be undertaken because the IRR exceeds the
cost of capital of 10%. The investment will add value to the firm and therefore increase
the shareholders’ wealth.
Year
Net cash flow
PVIF18.221%
PV of net cash
flow
1
R 80 000
0, 845870
R 67 669, 60
2
R 90 000
0, 715496
R 74 380, 50
3
R 100 000
0, 605217
R 60 521, 70
4
R 120 000
0, 511935
R 61 432, 20
5
R 60 000
0, 433031
R 25 981, 83
Total PV OF CF
R 280 000, 00
-(Initial
Investments)
R280 000, 00
NPV =
R.
93
0, 00
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Question 4: The correct answer is option 4.
The profitability index (PI) is 1,219 and the investment should be undertaken. For every
one rand invested, the investment will return R 1 219. The investment will add value to
the firm and therefore increase the shareholders’’ wealth.
PI = Total PV cash inflows
Initial investment
PI =
R 341 458
R 280 000 = 1,21
Question 5: The correct answer is option 4.
The firm should make the investment if the NPV is greater than zero, IRR exceeds the cost
of capital (WACC) and PI is greater than one. An investment that satisfies these criteria
will add value to the firm and therefore increase the shareholders’ wealth.
Question 6: The correct answer is option 4.
Conflicting rankings using NPV and IRR result from differences in the magnitude and
timing of cash flows.
Question 7: The correct answer is option 2.
Conflicting rankings between investment alternatives may be solved by means of NPV
profiles.
LESSON 3: RISK AND REFINEMENTS IN CAPITAL BUDGETING
1. The correct answer is option 2.
Risk in capital budgeting can best be incorporated by
(CEs).
means of certainty equivalents
2. The correct answer is option 1.
Year
Net cash
flow
CE
Certain CF
PVIF12%
PV of net
cash flow
1
R 15 000
0,90
R13 500
0,893
R 12 053,57
2
R 25 000
0,80
R20 000
0,797
R 15 943,88
3
R 35 000
0,70
R24 500
0,712
R 17 438,62
4
R 45 000
0,60
R27 000
0,636
R 17 158,99
5
R 38 000
0,50
R19 000
0,567
R 10 781, 11
Total PV of Cf
R 73 376,16
Initial investment
R 60 000, 00
NPV
(NPV = R30 846,98 using a financial calculator)
94
R 13 376,16
3. The correct answer is option 3.
Year
Net cash flow
RADR (15%)
PV of net cash flow
1
R45 000
0,870
R39 150
2
R45 000
0,756
R34 020
3
R45 000
0,658
R29 610
4
R45 000
0,572
R25 740
5
R45 000
0,497
R22 365
Total PV of CF
R150 885
Less: Initial outlay
(R120 000)
NPV
R30 885.00
(NPV = 30,846.98 using financial calculator)
4. The correct answer is option 2.
Projects A, B and D together require an investment of R990 000, which does not exceed
the R1 000 000 that is available. These projects have IRRs that exceed the cost of capital of
15% and all of them have NPVs greater than zero. Shareholder’s wealth will be maximised
by combining these three projects, given the constraint.
Project
Initial investment
IRR
NPV
A
R500 000
22%
R300 000
B
R200 000
18%
R200 000
D
R290 000
16%
R180 000
Total investment
R990 000
5. The correct answer is option 3.
The most efficient technique for the comparison of mutually exclusive investments with
unequal lives is to use the annualised net present value (ANPV) approach.
6. Using the ANPV approach will result in the following ANPV figures:
ANPVm = NPVM = R 2 855 000 = R 1 000 000
PVIF15%, 4
2, 855
ANPVn = NPVn
= R 4 540 800 = R 1 200 00
PVIF15%,6
3, 784
Based on the above ANPVs, the enterprise should invest in Project N. Project N will add more
value to the enterprise than Project M will.
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LESSON 4: LEVERAGE
4.1 Feedback on self-assessment questions
1. The correct answer is option 2.
Using a financial calculator
1000
FV
-950
PV
20
N
110
PMT
Input
I/YR
Answer = 0,1179 or 11,79%
After-tax cost = 0,1179 (1 – 0,35) = 7,67%
2. The correct answer is option 2.
The equation
Remember that the flotation cost must first be subtracted from the selling price in order
to get Np.
96
3. The correct answer is option 2.
The cost of ordinary shares is calculated by using the Gordon model.
4. The correct answer is option 4.
The market price is calculated by first using the capital asset pricing model to calculate
the required rate of return, and then using the Gordon model to determine the market
price of ordinary shares.
Ks = Rf + β (km–Rf )
Ks = 6 + 1.1 (16 – 6)
= 17%
5. The correct answer is option 1.
The required rate of return is calculated by using the capital asset pricing model.
Ks = Rf + β (km–Rf )
= 16,75 + 0,9 (21,25 – 16, 75)
= 20,80%
LESSON 5: THE WACC, WMCC and IOS
1. The correct answer is option 2.
Form of capital
Weight
After-tax cost
Weighted cost
Long-term debt
0,40
6%
2,40%
Pref shares
0,10
11%
1,10%
Ordinary shares
0,50
15%
7,50%
11%
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2. The correct answer is option 1.
40% debt financing (given)
Retained earnings = R800 000 x (1 – 0,55)
= R800 000 x 0,45 = R360 000
Weight of retained earnings
Balance of financing
= R360 000 x R1 000 000 x 36%
= 100%–(40%+ 36%)
= 24% from new ordinary shares
3. The correct answer is option 3.
BPequity
BPdebt
R500 000
R375 000
For equity (retained earnings) R300 000 / 0,60 = R500 000
For debt R150 000 / 0,40 = R375 000
4. The correct answer is option 4.
Accept only those projects indicated on the IOS above the WMCC up to the point where
WMCC and IOS cross each other.
LESSON 6: LEVERAGE
Question 1: The correct answer is option 2.
Leverage in a firm results from the use of fixed cost assets or funds to magnify the returns
to the firm’s owners. Financial leverage uses fixed financing costs to maximise the firm’s
earnings per share.
Question 2: The correct answer is option 3.
Operating break-even point = Total fixed cost ÷ (price per unit–variable cost per unit)
= R4 500 ÷ (R12–R7) = 900 lessons
Question 3: The correct answer is option 4.
(80% ÷ 50%) = 1.6 and operating leverage exists.
NB: Option 2 and 4 should read 1.600 and not 1 600.
98
Question 4: The correct answer is option 2.
DFL = % change in EPS
% change in EBIT
= EBIT
EBIT–I–[PD ÷ (1-t)]
= R200 000
R200 000–R50 000–[4 000 ÷ (1–0.4)]
= 1.4
Question 5: The correct answer is option 3.
DTL = DFL x DOL = 1.6 X 1.4 = 2.24
LESSON 7: THE FIRM’S CAPITAL STRUCTURE
Question 1: The correct answer is option 3.
Capital structure decisions of a firm are important because they have an impact on the
earnings per share, cost of capital and ordinary share price of the firm.
Question 2: The correct answer is option 2.
Coefficient of variation = δ ÷ E(eps) = (R1.50 ÷ R1.25) = 1.20
P0 = E(eps) ÷ ks = R1.25 ÷ 0.18 = R6.94
Question 3: The correct answer is option 2.
Value = [EBIT x (1-t)] ÷ ks
= [R21 844 300 x (1-0.35)] ÷ 0.20
= [R21 844 300 x (0.65)] ÷ 0.20
= R14 198 795 ÷ 0.20
= R70 993 975
Question 4: The correct answer is option 3.
Interest = 0.16 x R750 000 = R120 000
Preference share dividends = 20 000 shares x R4 = R80 000
Financial break-even point = Interest + [preference share dividends ÷ (1-t)]
= R120 000 + [80 000 ÷ 0.60]
= R120 000 + R133 333
= R253 333
Question 5: The correct answer is option 3.
The firm’s value is maximised if the cost of capital is kept as low as possible. In this case
the lowest cost of capital is 11%, achieved with a debt ratio of 40%.
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Question 6: The correct answer is option 4.
Capital structure has to take in cognisance of all the considerations.
LESSON 8: PAYOUT POLICY
Questions 1: The correct answer is option 3.
With the residual theory approach, no cash dividend is paid as long as the firm’s equity
need is in excess of the amount of retained earnings.
Question 2: The correct answer is option 2.
Modigliani and Miller argue that a clientele effect exists that causes the firm’s shareholders
to receive the dividends they expect.
Question 3: The correct answer is option 4.
According to Modigliani and Miller, if dividends do affect value, they do so solely because
of their informational content, which signals management’s earnings expectations.
Question 4: The correct answer is option 3.
Current dividend payments are believed to reduce investor uncertainty, causing investors
to discount the firm’s earnings at a lower rate.
Question 5: The correct answer is option 2.
Investment opportunities = R4 200 000 of which 60% will be funded from equity. This
means R2 520 000 from equity.
Retained earnings = R3 000 000, of which R2 520 000 will go to funding the investment
opportunities. This leaves R480 000 earnings available for dividends.
Question 6: The correct answer is option 3.
Dividend policy needs to consider owner wealth maximisation as well as the financial
requirements of the firm.
Question 7: The correct answer is option 3.
A share split increases the number of shares belonging to each shareholder, thereby
lowering the share price in order to enhance trading activity.
Question 8: The correct answer is option 1.
Share repurchases enhance shareholder value by reducing the number of shares issued and
send a positive signal to investors that management believes the shares are undervalued.
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LESSON 9: LEASING, MERGERS AND ACQUISITIONS
2.2 Feedback on self-assessment questions
Question 1
The correct answer is option 2.
Question 2
The correct answer is option 2.
Question 3
The correct answer is option 3.
Question 4
The correct answer is option 1.
Question 5
The correct answer is option 2.
Question 6
The correct answer is option 4.
CONCLUDING REMARK
Please do not hesitate to contact any of your module lecturers with queries and/or
problems related to this module.
We wish you every success in your studies.
Your FIN3701 lecturers
DEPARTMENT OF FINANCE, RISK MANAGEMENT AND BANKING
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