Chapter 5
The financing decision
1. Introduction
• Statement of Financial Position
ASSETS
(Application of funds)
Non-current assets
Current assets
EQUITY AND LIABILITIES
(Source of funds)
Shareholders’ equity
Non-current liabilities
Current liabilities
• What type of capital?
• In what form?
2. Types of financing (p66)
Self study: Pages 66 - 69
Shareholders' equity
Debt Capital
• Degree of permanency
• Costs (dividends) are not
legally compelled
• Costs covered by after tax
profits
• Must be repaid
• Costs (financing cost)
legally enforceable
• Costs paid from before tax
profit
3. Partial or total financing (p69)
Self study: Page 69
• Partial financing
• Finance obtained for a specific asset or group of assets
• Period of finance is the same as lifespan of asset
• Usually debt finance
• Total financing
• Compares investment plan with current financing
• Financing of all the assets owned by the company
• Combination of equity and debt finance
4. The Signal Theory (p70)
Method of financing sends a certain signal to existing and potential shareholders.
The Pecking order theory:
o Retained earnings (internal equity)
o Debt
o Issuing of new shares (external equity)
5. Retained earnings as source of finance (p71)
• Internal equity utilised first
• Delivers highest earnings per share
EPS =
(1-t)(RoKinv – RvKv)
# ordinary shares
Ro x Kinv = EBIT
Rv x Kv = Finance cost
Kinv
t
Ro
Rv
Kv
= investment amount
Assume: no investment income and
= tax rate
no preference dividends.
= return on assets
= cost of debt
= amount of debt included in the investment
5. Retained earnings as source of finance (p71)
Ro x Kinv = EBIT
Ordinary shares
Debt @ 7%
Retained earnings
Total capital
Option 1
30 000 @ R10
R100 000
R400 000
Option 2
R250 000
R150 000
R400 000
Option 3
R400 000
R400 000
EPS for the different financing options if Ro = 14%
EBIT
Financing costs (Rv) (7%)
Profit before taxation
Taxation (40%)
Profit after taxation
Number of ordinary shares
Earnings per share (EPS)
56 000
(7 000)
49 000
(19 600)
29 400
130 000
22,6c
56 000
(17 500)
38 500
(15 400)
23 100
100 000
23,1c
56 000
(0)
56 000
(22 400)
33 600
100 000
33,6c
EPS for the different financing options if Ro = 5%
EBIT
Financing costs (Rv) (7%)
Profit before taxation
Taxation (40%)
Profit after taxation
Number of ordinary shares
Earnings per share (EPS)
20 000
(7 000)
13 000
(5 200)
7 800
130 000
6c
20 000
(17 500)
2 500
(1 000)
1 500
100 000
1,5c
20 000
(0)
20 000
(8 000)
12 000
100 000
12c
5. Retained earnings as source of finance (p71)
• Existing number of issued ordinary shares = 100 000
• Investment amount R400 000, t= 40%, Ro= 5%, Rv= 7%
EPS (1)
= (1-t)(RoKinv – RvKv)
# ordinary shares
= (1-0,4)[(5% x 400 000) – (7% x 100 000)]
(100 000 + 30 000)
= 6 cents
Option 1
Ordinary shares
Debt capital
Option 3
30 000@R10
R100 000
Retained earnings
EPS
Option 2
6c
R250 000
R150 000
R400 000
1,5c
12c
6. Debt as a source of financing (p72)
• Short-term sources (CL) – money market
• Long-term sources (NCL) – capital market
• Cost of long-term sources usually lower than short
term, but bound for longer period
• If we only finance with debt, we need to make a decision
on what combination of debt finance we will use
• For this discussion assume that the enterprise utilises
only debt capital
• Conservative vs aggressive approach
Total capital
requirement
6. Debt as a source of financing (p73)
Current
assets (CA)
Noncurrent
assets
(NCA)
Total assets
Permanent
Variable
Permanent capital requirement
January
10 000
50 000
60 000
60 000
0
February
20 000
50 000
70 000
60 000
10 000
March
25 000
50 000
75 000
60 000
15 000
April
40 000
50 000
90 000
60 000
30 000
May
35 000
50 000
85 000
60 000
25 000
June
20 000
50 000
70 000
60 000
10 000
July
15 000
50 000
65 000
60 000
5 000
August
25 000
50 000
75 000
60 000
15 000
September
30 000
50 000
80 000
60 000
20 000
October
40 000
50 000
90 000
60 000
30 000
November
25 000
50 000
75 000
60 000
15 000
December
15 000
50 000
65 000
60 000
5 000
Total
180 000
÷ 12
=15 000
= Minimum total capital
requirement
OR
= NCA + min CA
Variable capital requirement
= Total capital requirement –
permanent capital
Total variable capital
requirement for year
Avg variable capital
Graph (p74)
Capital requirement (p74)
Two different financing approaches (bl.74)
• Aggressive approach
• Conservative approach
Two financing approaches (p74)
6.1
Aggressive approach
• Borrow minimum (permanent capital with long-term sources
& variable capital with short-term sources)
Permanent capital requirement
LT-credit
Variable capital requirement
ST-credit
Assume:
Long-term credit rate = 8%
Short-term credit rate= 12%
Two financing approaches (p74)
6.1
Aggressive approach
• Borrow minimum (permanent capital with long-term sources
& variable capital with short-term sources)
Permanent capital requirement
R60 000 X 8% p.a.
LT-credit
= R4 800
Variable capital requirement
ST-credit
R180 000/12 X 12% p.a.
Total finance costs
• Risks
= R1 800
= R6 600
Two financing approaches (p74)
6.2
Conservative approach
• Borrow maximum with long-term sources
Maximum capital requirement
LT-credit
Two financing approaches (p74)
6.2
Conservative approach
• Borrow maximum with long-term sources
Maximum capital requirement
R90 000 X 8% p.a.
Advantages/Disadvantages?
LT-credit
= R7 200
A comparison between the two approaches indicates the
following in terms of risk and profitability (p75)
• Aggressive – more profitable but higher risk
• Conservative – more expensive but lower risk
Financing plan
Risk
Total financing
costs
Aggressive
Highest
R 6 600
Highest
Conservative
Lowest
R 7 200
Lowest
Profitability
IN SUMMARY
• TOTAL CAPITAL REQUIREMENT per month
= Current assets + Non-current assets
• PERMANENT CAPITAL REQUIREMENT per month
= Minimum total capital requirement (in total assets column) OR
= Non-current assets + minimum of current assets
• VARIABLE CAPITAL REQUIREMENT per month
= Total capital requirement – permanent capital requirement
• AGGRESSIVE APPROACH
• Permanent capital requirement – LT credit
• Variable capital requirement – ST credit
• CONSERVATIVE APPROACH
• Maximum capital requirement – LT credit
6.3 Critical period (p76)
 What if unused capital is re-invested for periods of non-utilisation?
• Some of the finance costs can be recovered and reduce the
effective cost of finance
 Return on re-investment will be low – money needs to be liquid
 By re-investing the unutilised capital, you decrease the finance cost
 Acceptability of effective cost depends on the period of nonutilisation
 Utilised for longer – long-term option becomes more
advantageous
6. Debt as a source of financing (p73)
Current
assets (CA)
Noncurrent
assets
(NCA)
Total assets
Permanent
Variable
January
10 000
50 000
60 000
60 000
0
February
20 000
50 000
70 000
60 000
10 000
March
25 000
50 000
75 000
60 000
15 000
April
40 000
50 000
90 000
60 000
30 000
May
35 000
50 000
85 000
60 000
25 000
June
20 000
50 000
70 000
60 000
10 000
July
15 000
50 000
65 000
60 000
5 000
August
25 000
50 000
75 000
60 000
15 000
September
30 000
50 000
80 000
60 000
20 000
October
40 000
50 000
90 000
60 000
30 000
November
25 000
50 000
75 000
60 000
15 000
December
15 000
50 000
65 000
60 000
5 000
Total
180 000
÷ 12
=15 000
Permanent capital
= Minimum total
capital
OR
= NCA + min
CA
Variable capital =
Total capital –
permanent capital
Effective period of use (n)
n = 6 months
2 ways to calculate the effective period of use (n)
• Method 1 :
• Method 2 :
Critical period (p77)
 Effective cost of variable capital requirement financed
with long-term credit (Example pg. 77-78)
rℓ = PL + 12 – n (PL – PC)
n
rℓ
PL
PC
25
= the effective cost of the LT credit
= LT interest per year
= Interest rate that can be earned during
period of non-requirement
n
= Period that LT credit will be used for
(period of utilisation)
12-n = Period of non-requirement
Conservative approach: example only focuses on financing
Critical
(p76)
the variable
capitalperiod
requirements
Example
Long-term capital can be borrowed at 8% p.a., and short-term at 12%
p.a. Unutilised capital is reinvested at 6% p.a.
Variable capital requirement is R30 000 for 3 months (n=3)
Aggressive:
R30 000 x 12% x 3/12
Max variable capital requirement
Conservative:
R30 000 x 8% x 1 year
R30 000 x 6% x 9/12
Period of non-requirement (12 – n)
Effective cost
Cost
R900
R2 400
(R1 350)
R1 050
14%
Critical period (p76)
Example: Long term capital can be borrowed at 8% p.a. (PL), and
short term at 12% p.a (PK). Unutilised capital is reinvested at 6% p.a
(PC). Variable capital requirement is equal to R30 000 for 3
months.
rℓ = PL + 12 – n (PL – PC)%
n
= 8 + 12 – 3 (8 – 6)%
3
= 14%
AGGRESSIVE VS CONSERVATIVE with REINVESTMENT
rℓ > PK
Aggressive approach better (fin. costs lower)
rℓ < PK
Conservative approach better (fin. costs lower)
Critical period (p77)
Example
Long term capital can be borrowed at 8% p.a., and short term at
12% p.a. Unutilised capital can be reinvested at 6% p.a.
Variable capital requirement is R30 000 for 9 months (n=9)
Aggressive:
R30 000 x 12% x 9/12
Conservative:
R30 000 x 8% x 1 year
R30 000 x 6% x 3/12
Period of non-requirement (12 – n)
Effective cost
Cost
R2 700
R2 400
(R 450)
R1 950
8.67%
Critical period (p77)
Example: Long term capital can be borrowed at 8% p.a. (PL), and
short term at 12% p.a (PK). Unutilised capital is reinvested at 6% p.a
(PC). Variable capital requirement is equal to R30 000 for 9
months.
rℓ = PL + 12 – n (PL – PC)%
n
= 8 + 12 – 9 (8 – 6)%
9
= 8,67%
AGGRESSIVE VS CONSERVATIVE with REINVESTMENT
rℓ > PK
Aggressive approach better (fin. costs lower)
rℓ < PK
Conservative approach better (fin. costs lower)
Critical period (p78)
• Critical period (CP)
Period where the cost of the long-term credit and short term
credit is the same:
Critical period = (PL – PC) x 365 days (12 months)
(PK – PC)
If n > CP:
If n < CP:
Conservative approach with reinvestment better
Aggressive approach better
Critical period (p78)
• Critical period
= (PL – PC) x 12 months
(PK – PC)
= (8 – 6) x 12
(12 – 6)
= 4 months
Eg. n = 9 (3) & CP = 4
n (9) > CP (4)
n (3) < CP (4)
Conservative approach with reinvestment
Aggressive approach better
Chapter 5
The financing decision
What have we done so far?
PECKING ORDER THEORY
o Retained earnings (internal equity)
o Debt capital
o Issuing of new equity (external equity)
o Preference shares
o Ordinary shares
7. Preference shares as source of financing (p79)
Please read section 7 on page 79:
• Cumulative preference shares sometimes seen as semi-debt because
dividend rate is fixed.
• Dividend rate pre-tax: =
Preference dividend rate
(1 - t)
• If pre-tax dividend rate < 𝑅𝑜 = positive leverage effect
7. Preference shares as source of financing (p79)
Example:
• 6% Preference shares
• Tax rate = 40%
Dividends rate pre-tax
=
=
=
Preference dividend rate
(1 - t)
6%
(1 − 0.4)
10% (compare with Ro)
Advantages and disadvantages of preference share capital over debt
Questions with solutions textbook: Problem 7 on page 35
a. What is the rate of return on preference shares?
Preference share dividends:
R4 000 x 100 = 8%
R50 000
1
37
Finance costs:
R100 000 x 15% = R15 000
b. What is the tax rate?
c. What is the rate of return (before tax) on preference shares?
d. How will you prefer to obtain the capital: by means of debentures or preference
shares? Motivate.
Problem 7 – Additional question: Will the application of preference share capital be beneficial for the
ordinary shareholders?
R100 000 + R5 000 100
R0 =
𝑥
= 17.5%
R600 000
1
YES: Ro (17.5%) > Pre-tax dividend rate (13.33%) – Positive leverage effect
What have we done so far?
PECKING ORDER THEORY
o Retained earnings (internal equity)
o Debt capital
o Issuing of new equity (external equity)
o Preference shares
o Ordinary shares
o Study maximization of shareholders’ wealth from the viewpoint of 1)
functioning of financial leverage and 2) calculation of indifference point.
Examples focus on combination between ordinary share capital and debt
capital
8. Ordinary shares as a source of financing (p79)
8.1
Financial leverage and ordinary shareholders’ equity
Financial leverage factor:
=
Return on equity (Re)
Return on total assets (Ro)
>1
+ fin. leverage
Return on ordinary shareholders’ equity
Ro > Rv and Re > Ro
Rb at various Ro and Rv (page 80)
Return on ordinary shareholders’ equity (Rb) with debt (Kv)
as % of total capital
Ro
Rv
0
20
40
60
80
16
16
18
21,3
28
48
12
12
13
14,7
18
28
8
8
8
8
8
8
4
4
3
1,3
-2
-12
0
0
-2
-5,3
-12
-32
Rb = Ro + Kv (Ro – Rv)
Kb
Rb = 12% + 60 (12%-8%) = 18%
40
Attracting Kv over the LT beneficial to ordinary shareholders as long as Ro > Rv
8.2
Point of indifference (p81)
5% < 7%
12% > 7%
Ro = 12%
12% x R5000
Ro = 5%
8.2
Point of indifference formula (page 82)
• Provides an indication of how far the expected operating profit
can decrease to the point where no benefit from the financial
leverage is obtained.
• Indifference point :
EPS of A = EPS of B
+ Investment income
+ (-) Gain (loss) from the disposal of PPE
EPS: A
(Operating profit – Fin. costs)(1-t) – PS div
Number of ordinary shares issued
EPS: B
= (Operating profit – Fin. costs)(1-t) – PS div
Number of ordinary shares issued
Financial structure:
Company A
Company B
Ordinary share capital (# Shares)
R5 000 (#5000)
R1 000 (#1 000)
Debt capital @ 7% p.a.
0
4 000
Total capital
5 000
5 000
EPS: A
(Op profit– Fin. costs)(1-t) – PS div
Number of issued shares
Operating profit > R350 =
Positive leverage effect
=
=
EPS : B
(Op profit– Fin. costs)(1-t) – PS div
Number of issued shares
(lb- 0)(1-0,4) – 0
5 000
=
(lb- 280)(1-0,4) – 0
1 000
(lb- 0)(0.6) – 0
5 000
=
(lb- 280)(0.6) – 0
1 000
0,6 lb
5 000
=
0,6 lb- 168
1 000
600 Ib
840 000
Ib
= 3000 Ib – 840 000
= 2400 Ib
= R350
Recap: Table 2 on page 81
Ro = 12%
Comp A Comp B
Operating profit
Fin costs(Rv=7%)
Profit before tax
Tax (40%)
Profit after tax
Number of shares
EPS
600
0
600
600
(280)
320
(240)
360
5 000
(128)
192
1 000
7,2c
19,2c
Ro = 5%
Operating profit
Fin costs (Rv=7%)
Profit before tax
Tax (40%)
Profit after tax
Comp A Comp B
250
250
0
(280)
Number of shares
EPS
250
(100)
150
(30)
(0)
(30)
5 000
3c
1 000
-3c
Positive financial leverage:
Negative financial leverage:
Ro > Rv
Ro < Rv
Operating profit > Indifference point
Operating profit < Indifference point
Questions with solutions textbook:
Problem 8, page 36
Questions and Solutions textbook: Page 36, Problem 8
An enterprise requires R3 million to finance a new production facility that will result in a profit before
finance costs and taxation of R350 000 per year. The enterprise has two alternative plans for its
financial structure:
A
B
70% ordinary shares and 30% debt capital, or
40% ordinary shares and 60% debt capital.
With the first plan shares can be issued at R30 each, and the interest rate on the debt capital will
amount to 10%. With the second plan shares will be issued at R35, and the interest rate on the
debt capital will amount to 11%. The company has a marginal tax rate of 40%.
a.
b.
Calculate the earnings per share for both plans
Calculate the point of indifference
Plan A: 70% Ordinary shares; 30% Debt capital
Plan B: 40% Ordinary shares; 60% Debt capital
Ordinary share capital (@ R30 each)
R2 100 000
Ordinary share capital (@ R35 each)
R1 200 000
Debt capital (10%)
R 900 000
Debt capital (11%)
R1 800 000
Total capital
R3 000 000
Total capital
R3 000 000
A
R0 (11,67%) > Rv (10/11%)
EBIT
Finance costs
R900 000 x 10%
Profit before tax
Tax (40%)
Profit after tax
Preference share dividends
Attributable earnings
Number of ordinary shares
EPS
Attributable earnings
# issued shares
B
350 000
350 000
(90 000)
R1 800 000 x 11% (198 000)
260 000
152 000
(104 000)
(60 800)
156 000
0
91 200
0
91 200
156 000
R2 100 000 =
R30 p.s
70 000
R156 000 =
70 000
222,86c
R1 200 000 =
R35 p.s
R91 200 =
34 286
34 286 (rounded)
266,00c
Financing structure of:
A
Ordinary share capital (@ R30 p.s)
Debt capital (10%)
Total capital
EPS: A
(Operating profit– Fin. costs)(1-t) – PS div
Number of issued shares
=
=
B
R2 100 000
(@ R35 p.s)
R1 200 000
R 900 000
(11%)
R1 800 000
R3 000 000
R3 000 000
EPS : B
(Operating profit– Fin. costs)(1-t) – PS div
Number of issued shares
(lb- 90 000)(1-0,4) – 0
70 000
=
(lb- 198 000)(1-0,4) – 0
34 286
0,6 lb- 54 000
70 000
=
0,6 lb- 118 800
34 286
20 571,6Ib – 1 851 444 000
6 464 556 000
Ib
= 42 000 Ib – 8 316 000 000
= 21 428,4 Ib
= R301 681,69
Operating profit (R350 000) above Ib (R301 681,69) – positive leverage