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Oxford University Press is a department of the University of Oxford. It furthers the University’s
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Corporate Finance: A South African Perspective 3e
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Abridged contents
Foreword
Preface
Contributors
1. Introduction to financial management
Part One: Measurement
2.
3.
Financial statements
Ratio analysis
Part Two: Investment decisions
4.
5.
6.
7.
8.
9.
The time value of money
Investment appraisal methods
Estimating relevant cash flows
Appraising investment risk
Bond valuation and interest rates
Share valuation
Part Three: Financing decisions
10. Risk and return
11. Cost of capital
12. Sources of finance and capital structure
Part Four: Dividends
13. Distribution policy
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Part Five: Working capital management
14. Working capital management
Solutions
Index
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Table of contents
1.
Introduction to financial management
1.1
Introduction
1.2
Defining corporate finance
1.3
The financial manager
1.3.1
The role and responsibilities of the financial manager
1.3.2
Financial management decisions
1.4
The goals of financial management
1.4.1
Profit maximisation
1.4.2
Maximising the rate of return
1.4.3
Maximising shareholders’ wealth
1.5
Forms of business ownership in South Africa
1.5.1
Sole proprietorship
1.5.2
Partnership
1.5.3
Company
1.6
The agency problem and agency costs
1.7
Financial markets and institutions
1.7.1
Financial markets
1.7.2
Financial institutions
1.7.3
Flow of funds
1.8
Ethics and environmental, social and governance considerations
1.9
Conclusion
Part One: Measurement
2.
Financial statements
2.1
Introduction
2.2
The objective of financial reporting
2.3
Who are the users of financial reporting?
2.4
Information provided by financial reporting
2.5
Qualitative characteristics of useful financial information
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2.6
2.7
2.8
2.8.1
2.8.2
2.8.3
2.9
2.10
2.10.1
2.10.2
2.10.3
2.10.4
2.11
3.
Integrated reporting
Standardisation of financial statements
Statement of financial position
Assets
Total equity
Liabilities
Statement of profit or loss
Statement of cash flows
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
Changes in cash and cash equivalents
Conclusion
Ratio analysis
3.1
Introduction
3.2
Requirements for financial ratios
3.3
Norms of comparison
3.4
Types of ratio
3.5
Profitability ratios
3.5.1
Return on assets
3.5.2
Return on equity
3.5.3
Return on shareholders’ equity
3.5.4
Return on ordinary shareholders’ equity
3.6
Profit margins
3.6.1
Gross profit margin
3.6.2
Operating profit margin
3.6.3
Earnings before interest and tax margin
3.6.4
Net profit margin
3.7
Turnover ratios
3.7.1
Total asset turnover ratio
3.7.2
Property, plant and equipment turnover ratio
3.7.3
Current asset turnover ratio
3.7.4
Trade receivables turnover ratio
3.7.5
Inventory turnover ratio
3.7.6
Trade payables turnover ratio
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3.8
3.8.1
3.8.2
3.8.3
3.8.4
3.8.5
3.8.6
3.8.7
3.9
3.9.1
3.9.2
3.9.3
3.9.4
3.9.5
3.10
3.10.1
3.10.2
3.10.3
3.10.4
3.10.5
3.10.6
3.11
3.11.1
3.11.2
3.11.3
3.11.4
3.11.5
3.11.6
3.12
3.13
3.14
Liquidity ratios
Current ratio
Quick ratio
Cash ratio
Trade receivables turnover time
Inventory turnover time
Trade payables turnover time
Cash conversion cycle
Solvency ratios
Debt-to-assets ratio
Debt-to-equity ratio
Financial leverage ratio
Finance cost coverage
Preference dividend coverage ratio
Cash flow ratios
Cash flow to revenue ratio
Cash return on assets ratio
Cash return on equity ratio
Cash flow to operating profit ratio
Finance and dividend cost coverage ratios
Other cash coverage ratios
Investment ratios
Earnings per share ratio
Dividend per share ratio
Price-earnings ratio
Dividend payout ratio
Ordinary dividend coverage ratio
Market-to-book-value ratio
Financial gearing
DuPont analysis
Conclusion
Part Two: Investment decisions
4.
The time value of money
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4.1
Introduction
4.2
Interest rates
4.3
Future value and compounding of lump sums
4.3.1
Investing for a single period
4.3.2
Investing for more than one period
4.4
Compounding interest more frequently than annually
4.4.1
Semi-annual, quarterly and monthly compounding
4.4.2
Continuous compounding
4.5
Nominal and effective interest rates
4.6
Present value and discounting
4.7
More on present and future values
4.7.1
Determining an interest rate
4.7.2
Calculating the number of periods
4.8
Valuing annuities
4.8.1
Future value of an ordinary annuity
4.8.2
Future value of an annuity due
4.8.3
Present value of an ordinary annuity
4.8.4
Present value of an annuity due
4.8.5
Ordinary deferred annuities
4.8.6
Mixed streams of cash flows
4.8.7
Retirement funding
4.9
Perpetuities
4.10
Amortising a loan
4.11
Sinking funds
4.12
Conclusion
Appendix 4.1: Future value interest factor (FVIF) (R1 at i% for n periods)
Appendix 4.2: Present value interest factor (PVIF) (R1 at i% for n periods)
Appendix 4.3: Future value of an annuity interest factor (FVIFA) (R1 per
period at i% for n periods)
Appendix 4.4: Present value of an annuity interest factor (PVIFA) (R1 per
period at i% for n periods)
5.
Investment appraisal methods
5.1
Introduction
5.2
The importance of efficient investment appraisal
5.3
Types of investment project
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5.3.1
5.3.2
5.3.3
5.3.4
5.3.5
5.3.6
5.3.7
5.3.8
5.3.9
5.4
5.5
5.6
5.7
5.8
5.9
5.9.1
5.9.2
5.9.3
5.10
5.11
5.12
6.
Replacement projects
Expansion projects
Independent projects
Mutually exclusive projects
Complementary projects
Substitute projects
Conventional projects
Unconventional projects
Other types of project
The average return method
The payback period method
The discounted payback period method
The net present value method
The internal rate of return method
Comparing the net present value method and the internal rate of
return method
Net present value profile
Discussion of the net present value profile
Evaluating mutually exclusive projects by means of the internal rate
of return method
Modified internal rate of return
The profitability index
Conclusion
Estimating relevant cash flows
6.1
Introduction
6.2
The difference between profit and cash flow
6.3
Estimating relevant cash flows
6.3.1
Sunk costs
6.3.2
Opportunity costs
6.3.3
Finance costs
6.3.4
Inflation and tax
6.4
The components of project cash flows
6.5
Calculating the initial investment
6.5.1
Initial investment for an expansion project
6.5.2
Initial investment for a replacement project
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6.6
6.6.1
6.6.2
6.7
6.7.1
6.7.2
6.8
6.9
Calculating operating cash flows
Operating cash flows of an expansion project
Operating cash flows of a replacement project
Calculating the terminal cash flow
Terminal cash flow of an expansion project
Terminal cash flow of a replacement project
Capital gains tax
Conclusion
7.
Appraising investment risk
7.1
Introduction
7.2
What are uncertainty and risk, and why do they need to be
assessed?
7.2.1
Uncertainty and risk
7.2.2
Risk versus return
7.2.3
Approaches to risk in investment appraisal
7.3
Types of risk in investment projects
7.4
Probability distributions and expected values
7.4.1
Probability distribution
7.4.2
Expected value
7.5
Using scenario analysis, sensitivity analysis and simulation analysis
to assess risk
7.5.1
Scenario analysis
7.5.2
Sensitivity analysis
7.5.3
Simulation analysis
7.6
Break-even analysis as a measure of dealing with risk
7.6.1
Accounting break-even analysis
7.6.2
Accounting break-even analysis and operating cash flow
7.6.3
Cash break-even analysis
7.6.4
Financial break-even analysis
7.6.5
Summary of break-even measures
7.7
Conclusion
8.
Bond valuation and interest rates
8.1
Introduction
8.2
What is a bond?
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8.3
8.4
8.5
8.5.1
8.5.2
8.5.3
8.5.4
8.5.5
8.5.6
8.5.7
8.5.8
8.5.9
8.6
8.6.1
8.6.2
8.7
8.7.1
8.7.2
8.7.3
8.7.4
8.8
8.8.1
8.8.2
8.9
9.
Characteristics of bonds
How to value a bond
The different types of bond
Government bonds
Municipal bonds
Corporate bonds
Convertible bonds
Junk bonds
Zero-coupon bonds
Extendable and retractable bonds
Foreign-currency bonds
Inflation-linked bonds
Bond markets and bond ratings
Bond markets and reporting
Bond ratings
What determines bond returns?
Real interest rate and expected inflation rate
Interest-rate risk and time to maturity
Default risk
Lack of liquidity
The influence of interest and inflation rates on bonds
The difference between nominal and real interest rates
The Fisher effect
Conclusion
Share valuation
9.1
Introduction
9.2
The development of stock exchanges across the globe
9.3
Ordinary shares and preference shares
9.4
Defining share value
9.4.1
Market value
9.4.2
Book value
9.4.3
Intrinsic value
9.5
Share valuation
9.5.1
Dividend discount model
9.5.2
Free cash flow valuation model
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9.5.3
9.6
9.7
9.8
Relative valuation techniques
Ethical and environmental, social and governance risks
Market efficiency and behavioural finance
Conclusion
Part Three: Financing decisions
10. Risk and return
10.1
Introduction
10.2
Assessing the return and risk characteristics of a single security
10.2.1 Evaluating historical returns
10.2.2 Evaluating expected returns
10.2.3 Evaluating historical risk
10.2.4 Evaluating expected risk
10.2.5 Coefficient of variation
10.2.6 Summary: Single security return and risk
10.3
Assessing the return and risk characteristics of a portfolio
10.3.1 Assessing expected portfolio returns
10.3.2 Assessing expected portfolio risk
10.3.3 Portfolio risk: A closer look
10.3.4 Summary: Portfolio return and risk
10.4
The capital asset pricing model and the security market line
10.5
Multi-factor asset pricing models
10.6
Conclusion
11. Cost of capital
11.1
Introduction
11.2
Pooling of funds
11.3
Cost of capital
11.3.1 Cost of ordinary shareholders’ equity
11.3.2 Cost of preference shareholders’ equity
11.3.3 Cost of debt
11.4
Weighted average cost of capital
11.4.1 Calculating weighted average cost of capital
11.4.2 Assumptions surrounding the weighted average cost of capital
11.5
Using the weighted average cost of capital in investment decisions
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11.6
11.7
Marginal cost of capital
Conclusion
12. Sources of finance and capital structure
12.1
Introduction
12.2
Long-term sources of finance
12.2.1 External sources of equity finance
12.2.2 Internal sources of equity finance: Reserves and retained earnings
12.2.3 Non-current debt finance
12.3
Medium-term sources of finance
12.3.1 Term loans
12.3.2 Leases
12.3.3 Business angels, venture capital and private equity
12.3.4 Crowdfunding
12.4
Short-term sources of finance
12.4.1 Factoring
12.4.2 Invoice discounting
12.4.3 Bank overdrafts
12.4.4 Accounts payable
12.5
Debt versus equity: A summary
12.6
Optimal capital structure
12.7
Capital structure theories
12.7.1 Modigliani and Miller’s theory of gearing
12.7.2 Trade-off theory of gearing
12.7.3 Signalling theory of gearing
12.7.4 Pecking-order theory of gearing
12.8
Conclusion
Part Four: Dividends
13. Distribution policy
13.1
Introduction
13.2
Distribution policy issues
13.2.1 Information content
13.2.2 Clientele effect
13.2.3 Homemade dividends
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13.3
13.3.1
13.3.2
13.4
13.4.1
13.4.2
13.4.3
13.4.4
13.5
13.6
13.7
Dividend relevance versus dividend irrelevance
Dividend irrelevance
Dividend relevance
Elements of an entity’s distribution policy
Format of the distribution
Size of the distribution
Frequency of the distribution
Stability of the distribution
The dividend payment process
Stock splits and consolidations
Conclusion
Part Five: Working capital management
14. Working capital management
14.1
Introduction
14.2
What is working capital?
14.2.1 Current assets and current liabilities
14.2.2 Net working capital
14.3
Why is it important to manage working capital?
14.3.1 Liquidity
14.3.2 The risks of liquid assets
14.4
The cash conversion cycle
14.4.1 The elements of the cash conversion cycle
14.4.2 Calculating the cash conversion cycle
14.5
Managing cash
14.5.1 Cash budgeting
14.6
Managing inventory
14.6.1 The importance of inventory management
14.6.2 Methods of managing inventory
14.7
Managing accounts receivable (debtors)
14.7.1 The importance of managing accounts receivable
14.7.2 Establishing a credit policy
14.8
Managing accounts payable (creditors)
14.9
Conclusion
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Solutions
Chapter 1
Chapter 2
Chapter 3
Chapter 4
Chapter 5
Chapter 6
Chapter 7
Chapter 8
Chapter 9
Chapter 10
Chapter 11
Chapter 12
Chapter 13
Chapter 14
Index
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South Africa experiences a lack of financial management skills,
frequently associated with the country’s generally low skill levels.
Consequently, there is an urgent need for a textbook that clearly
elucidates the complex principles of financial management in an
accessible, contemporary manner. The third edition of Corporate
Finance: A South African Perspective continues to meet this
requirement with, among others, updated case studies and a short
discussion of King IV ™.
The South African corporate references, examples and extracts
used throughout this book enable students to understand the key
financial concepts that underpin management decisions. Using a
clear, concise approach, the book provides a thorough theoretical
overview of financial management as it applies within the local
South African corporate context. In addition, further pedagogical
features facilitate a practical approach to support and enhance
student understanding.
This third edition of Corporate Finance: A South African Perspective
covers the key topics in financial management to enable students to
understand the mechanics of financial decision making. This
textbook will more than likely contribute significantly to the
sustainable creation of wealth in South Africa. The authors,
publisher and everyone else who contributed to bringing this text to
you should be complimented.
Hendrik Wolmarans
Professor in Finance and Investments
University of Pretoria
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With so many financial management textbooks on the market, you
may be excused for questioning the need for another. However, as a
fellow lecturer in financial management at an institution of higher
education, I am aware that there is a niche area in finance that is not
serviced by the textbooks that are currently available.
The latest edition of Corporate Finance: A South African Perspective
has been published with two objectives in mind:
• Firstly, it serves as an entry-level textbook for undergraduate
students in various modules of financial management, written
in a language that is accessible to students who do not
necessarily have English as their home language.
• Secondly, it provides a textbook in financial management that
also incorporates the subjects of financial institutions and
financial markets, and how these operate within the financial
system and global economy. In addition, it addresses the topics
of financial planning, asset management, capital acquisition and
the important role played by ethics within finance.
Further adding value to this new book is the fact that lecturers
currently teaching financial or investment management and
corporate finance in various South African universities were tasked
to write the chapters. The immediate benefit to this book and its
readers is that these experts know what students require from a
textbook on financial management and which areas they
themselves find difficult in this subject.
The book has been designed in such a way that it provides greater
access to the learning experience for many students. Chapters begin
with an opening case study that links to each chapter’s core
concepts. This is reflected upon further with a concluding case
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study per chapter after the student has worked through the
material. Regular short questions throughout the chapters are
designed to test the reader’s comprehension of the material.
Students will also find detailed examples to help illustrate complex
financial issues and concepts as well as ‘Focus on ethics’ sections
that draw the reader’s attention to real-life corporate financial
ethical issues. Each chapter concludes with a review of what was
learnt and end-of-chapter problems that provide students with both
objective and subjective assessment opportunities.
We hope that you will find this book of value in your learning
experience in finance.
Professor Gideon Els
University of Johannesburg
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Gideon Els is an associate professor in the Department of
Accountancy at the University of Johannesburg.
Pierre Erasmus is a professor in the Department of Business
Management at Stellenbosch University, and serves as head of the
focus area financial management.
Suzette Viviers is a professor in the Department of Business
Management at Stellenbosch University.
Liezel Alsemgeest is a senior lecturer at the School of Financial
Planning Law at the University of the Free State.
Elda du Toit is an associate professor in the Department of
Financial Management at the University of Pretoria.
Sam Ngwenya is a professor in the Department of Finance and Risk
Management and Banking at Unisa, and serves as director of the
School of Economic and Financial Sciences.
Kevin Thomas is a senior lecturer in the Department of
Accountancy at the University of Johannesburg.
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1 Introduction to financial management
Suzette Viviers
Learning
outcomes
Chapter
outline
1.1
1.2
1.3
1.4
1.5
By the end of this chapter, you should be able to:
define corporate finance
explain the role and responsibilities of financial
managers
discuss three types of financial management
decision
identify the main goals of financial management
describe the main disadvantages associated
with shareholder wealth maximisation as a
financial management goal
describe the main forms of business ownership
in South Africa
discuss the agency problem and agency costs
understand the functions of financial markets
and institutions
explain how increased attention to ethics and
environmental, social and governance
considerations can impact on financial
management decisions.
Introduction
Defining corporate finance
The financial manager
The goals of financial management
Forms of business ownership in South
Africa
1.6 The agency problem and agency costs
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1.7
1.8
1.9
CASE STUDY
Financial markets and institutions
Ethics and environmental, social and
governance considerations
Conclusion
Value creation at Tiger Brands Ltd
Tiger Brands has been an integral part of everyday life in South
Africa since 1921. The entity produces household names such
as Ingrams, Doom, Koo, Fattis and Monis, Jungle Oats, All
Gold, Purity, Oros and Tastic, which are sold in 26 countries
across the globe. In March 2018, the largest listeriosis outbreak
in South Africa was traced to some of the company’s processed
meat products and production facilities (Mahopo, 2019). The
listeria bacteria found in Enterprise polonies‚ frankfurters and
smoked Russians caused 218 deaths (Mashego, 2019). The
company had to recall thousands of products, incinerate 4 500
tonnes of processed meat and close two of its production
facilities as well as an abattoir for almost seven months. Tiger
Brands suffered significant brand erosion and is currently
facing a multi-million rand class action lawsuit.
As will be pointed out in this chapter, an entity’s value is no
longer measured exclusively in financial terms. Cognisance is
now taken of value creation (or destruction) across six capitals.
Examples of these capitals at the food giant as at 30 September
2018 are given in the table that follows.
Capital
Description
Capital
Financial
Debt and equity
Debt = R991 million.
Equity = R17,3 billion.
Manufactured Physical
Tiger Brands owns and operates 44
infrastructure used to manufacturing sites in South Africa.
convert
Capital expenditure = R720 million.
raw materials into
finished products
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Natural
Natural resources
consumed to convert
raw materials into
finished products
The company uses energy, fuel and
water to convert raw materials
(such as sugar and rice) and
packaging into highquality food,
home, baby and personal care
products.
Water consumption decreased by
19,3% from 2017.
Human
Employees’ and
directors’ skills,
capabilities,
development and
experience
Tiger Brands developed key
capabilities of employees and
executives over the reporting year.
Intellectual
Knowledge, systems,
processes,
intellectual property
(such as recipes)
and brands
The company spent R845 million
on marketing initiatives and 5,3%
of net sales on innovation as well
as research and development
(R&D).
Social and
relationship
Stakeholder
relationships and
engagements, an
entity’s reputation,
values, governance
and safety systems
Socio-economic development
spend = R32 million.
The company had over 200
engagements with shareholders,
investors and analysts.
The Thusani Trust provides
bursaries for the children of
qualifying black employees; 381
students have graduated since
2007.
The listeriosis outbreak had a direct impact on financial capital
in that profitability decreased dramatically, reducing internal
reserves and dividends. The company’s share price also
plummeted, which increased its cost of capital. In addition,
intellectual as well as social and relationship capital were
adversely affected as a result of the incident.
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Sources: Compiled from information in Tiger Brands, 2019a; Struweg, 2018; Hedley, 2019a; Hedley,
2019b; Laing, 2018; Faku, 2019; Tiger Brands, 2018.
1.1
Introduction
As illustrated in the opening case study, value creation is no longer
measured solely in financial terms. In this chapter, we define
corporate finance, and look at the role and responsibilities of
financial managers, typical decisions taken by financial managers
and the goals that they pursue. In addition, we discuss the main
corporate forms of business ownership in South Africa, the agency
problem and agency costs, and financial markets and institutions.
Lastly, we provide an overview of ethics and various
environmental, social and corporate governance considerations,
given their impact on financial management decisions and value
creation.
1.2
Defining corporate finance
The concept of corporate finance encapsulates the financial function
and its management. The financial function is one of the key
business functions, along with manufacturing, marketing, human
resources, and information and communication technology. The
financial function is primarily concerned with the flow of cash to
and from an entity. More specifically, it deals with decisions related
to the procurement of various types of financial capital (financing
decisions), the application of capital (investment decisions) and
decisions concerning the relationship between the acquisition and
the application of capital. Financial management is a broader
concept that embraces the management of all facets of the financial
function, including planning, organising, directing and controlling.
It is important to note that financial management consists of
much more than merely keeping an eye on an entity’s books.
People often confuse financial management with financial
accounting. Accountants record financial activities in a business by
means of financial statements. Financial accounting has a historical
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perspective – it looks at past activities – whereas financial
management focuses on creating value in the future. Thus,
corporate finance or financial management, as it will be referred to
in this book, has a forward-looking perspective. Financial
managers, however, need accountants to provide them with
accurate, up-to-date information to help them make the best
decisions.
Financial management is also linked to economics. Financial
managers must make decisions within a constantly changing
economic environment. An understanding of economic indicators
(such as gross domestic product, or GDP, inflation, interest and
exchange rates) is necessary to make informed decisions. Economics
is a discipline that concerns itself with the production, distribution
and consumption of goods and services. The same could be said for
financial management in that entities have limited resources and
financial managers are responsible for using these resources in the
best possible manner to increase shareholders’ wealth.
Given South Africa’s status as an emerging market, its economy
is more susceptible to adverse developments in global financial
markets and trade tensions. The growth estimates of economists
influence the sales and production forecasts that financial managers
need to make. South African entities whose sales are closely tied to
the state of the economy (so-called cyclical entities) can expect sales
to grow by a meagre 0,9% in 2020. This predication is much lower
than the World Bank’s growth projections for sub-Saharan Africa
and the rest of the world over the same period (World Bank Group,
2020). These projections might change in light of the rapid spread of
the COVID-19 (coronavirus) (Hutt, 2020).
Financial managers also need to keep a close eye on the inflation
rate, as this rate influences the prices of resources (particularly
labour). At the end of July 2019, the inflation rate in South Africa, as
measured by the consumer price index, was 4%. According to the
South African Reserve Bank, inflation is expected to peak at 5,5% in
the first quarter of 2020 and settle at 4,5% in the last two quarters of
2021 (SARB, 2019). High inflation and the volatile South African
rand have become major sources of concern for local importers and
exporters, and have contributed to South Africa’s declining
attractiveness as an international investment destination. Food
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producers such as Tiger Brands also need to account for volatile
commodity prices (such as those of grain and sugar), which are
determined on international markets.
1.3
The financial manager
As discussed earlier, a financial manager is responsible for the
management of an entity’s financial activities.
1.3.1
The role and responsibilities of the financial
manager
To understand where the financial manager fits into the corporate
structure, refer to the organisational structure of a typical
manufacturing entity (Figure 1.1). Note that various designations,
such as financial director or chief financial officer (CFO), may be
used when referring to a financial manager.
Figure 1.1 Example of an organisational structure
Figure 1.1 shows that the financial director or manager is in charge
of managing the entity’s cash resources, its credit department, the
business’s capital expenditures, financial planning, tax affairs and
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recordkeeping. It is important to note that this is just one example
of an organisational structure. These structures differ greatly from
one business to another. For some idea of the typical day-to-day
roles of a financial manager, refer to the advertisement that follows
for a financial management position that was advertised by a local
recruitment agency.
Company and description: One of South Africa’s leading manufacturing
entities is looking for a professional and innovative financial manager to join
its team with operations based in Springs, Gauteng. The successful candidate
will be responsible for managing the entity’s financial policies and procedures
to ensure that the financial operations are implemented effectively in line with
business and profitability objectives.
Duties include, but are not limited to: Financial compliance, financial
control, reporting, processing and people management.
Education: BCom degree in Accounting.
Job experience and skills required: Five to eight years’ experience in a
manufacturing or fast-moving consumer goods environment, five years’
management experience, advanced Microsoft Excel skills, SAP knowledge,
CPA knowledge, a solid understanding of IFRS/GAAP standards, import and
export knowledge and a good understanding of accounting principles as well
as strong reporting and analysis skills. Employment-equity candidate
preferred.
Package: R1 million to R1,2 million annually plus pension and medical aid.
Source: Pnet, 2019.
In this section, we saw that financial managers are involved with a
broad range of activities on a daily basis. Entities must therefore
strive to employ only those individuals who have appropriate
qualifications and relevant experience, and who exhibit the highest
levels of integrity.
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1.3.2
Financial management decisions
The decisions that financial managers make can be categorised into
three main groups:
• In which non-current (long-term) assets should the entity
invest? Non-current assets in an entity such as a butchery can
include meat slicers, refrigerators, sausage fillers and vacuum
packaging equipment. This kind of decision is referred to as a
capital budgeting decision.
• Where will the necessary long-term financing be obtained to
acquire these and other non-current assets? Short-term assets
(such as inventory) should also be financed. Decisions regarding
the most appropriate forms of financing are called capital
structure decisions.
• How will the day-to-day financial activities of the entity be
managed? This category encompasses decisions about
managing cash and inventory, and paying short-term
obligations (such as the supplier of polystyrene containers).
These types of decision are referred to as working capital
management decisions.
The three main categories of financial decision ultimately determine
whether an entity will create value in the long run. Note that the
financial management activities in a small entity are often
performed by the owner(s). For a large listed company such as
Tiger Brands, these decisions are much more complex. The three
categories are discussed in greater detail in the sections that follow.
1.3.2.1
Capital budgeting
This category involves the acquisition and management of noncurrent assets, also called capital projects or capital investments. As
financial managers should always aim to create value, they should
only invest in value-adding non-current assets. Assume that the
owner of a butchery is interested in buying a second-hand delivery
van. Many of her clients are restaurants that are willing to pay a
small fee should their orders be delivered directly to their kitchens.
To determine whether or not the van will be a value-adding
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investment, the owner needs to evaluate its net present value
(NPV). To calculate the NPV, she needs to estimate the size, timing
and risk of the cash flows that will be generated by this capital
investment. Cash outflows will occur when the owner spends
money (for example, when she purchases the van or when she pays
a supplier); cash inflows will occur when she receives money. The
owner should estimate the size of these cash flows as well as when
they will occur (their timing). As will be explained in Chapters 5
and 6, we have to reduce the value of the future cash flows given
the uncertainty associated with these cash flows occurring. The
weighted average cost of capital (WACC) is generally used as the
appropriate discount rate (for more, see Chapter 11). If the van costs
R200 000, the NPV can be computed using the values in Example
1.1.
Example 1.1 Calculating the net present value of the new van(A)
Notes:
A: Assume that the van will only be used for deliveries and that it will have no residual value after
five years. In this introductory example, the change in net working capital is also omitted. More
realistic examples will be presented in Chapter 5.
B: Assume that the van will be depreciated over five years using the straight-line method. This
implies R200 000 ÷ 5 = R40 000 p.a.
C: In the 2019/20 tax year, small entities with taxable income of less than R75 750 do not have to
pay tax. Entities earning between R75 751 and R365 000 need to pay 7% of taxable income
above R75 750. In the next bracket (R365 001 to R550 000), small entities should pay R20 248 +
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21% of taxable income above R365 000. Those earning R550 001 and above should pay R59 098
+ 28% of taxable income above R550 000. Assume that this small-scale butchery falls in the
28% tax bracket (SARS, 2020).
If the present value of an asset’s cash inflows (that is, the sum of the
discounted operating cash flows) exceeds its cost, we say that the
asset has a positive NPV. All positive NPV investments are deemed
to be value-adding investments. Based on our calculations above,
the owner should thus purchase the van, as it has a positive NPV.
1.3.2.2
Capital structure
The second major category of financial management decision
relates to the capital structure of the entity. These decisions concern
the mix of debt and equity that the entity uses to fund its activities.
In the butchery example, the owner has to secure finances to pay for
the van and other non-current and current assets used in the entity.
She has a number of options: she could use some of her own
savings, raise funds from family members and friends, use the
retained earnings of the business or borrow money. Publicly listed
companies, such as Tiger Brands, could also issue ordinary and
preference shares or bonds. The chosen option(s) will have an effect
on the entity, both from a risk and from a value perspective.
Another factor that managers should consider is which form of
financing will be the cheapest. Risk will increase if the butchery
owner opts for a bank loan to finance the acquisition of the van, as
she will now have to pay back the interest and the principal
amount, even if no or fewer than the number of anticipated
deliveries are made. Alternatively, when management decides to
issue shares or bonds to the public, it has to remember that the
expenses involved with such an issue are very high. Consequently,
the specific mix of equity and debt should be considered very
carefully. Capital structure decisions are discussed in detail in
Chapter 12.
1.3.2.3
Working capital management
The third main category of financial management decision concerns
how to manage working capital. Working capital refers to the short******ebook converter DEMO Watermarks*******
term assets and liabilities of an entity, and typically includes
inventory, cash, trade receivables (debtors) and trade payables
(creditors). Decisions centre on how managers approach the day-today management of short-term assets and liabilities. Products may
be sold on a cash-only basis or on credit. Managers of entities that
sell on credit need to decide the payment terms they extend to their
clients as well as whether the entity will offer discounts for early
payments. The butcher in our example will also have to decide
whether she will pay cash for her supplies or buy them on credit.
All these decisions need to be made to ensure that the entity
functions efficiently, and that there are sufficient resources available
for it to remain profitable and liquid. Chapter 14 provides more
insight into working capital decisions.
One way to understand the interactions between these three
main categories of financial management decision is to look at an
entity’s statement of financial position (or balance sheet) (see Figure
1.2).
Figure 1.2 Interaction between the three main categories of financial decision
Notes:
A: The asset side of the statement of financial position. This side represents the total resources of the entity.
Capital budgeting decisions relate to the asset side of the statement, particularly the non-current (longterm) assets.
B and C: Capital structure decisions relate to the equity and liabilities side of the statement of financial
position.
D: Working capital management decisions relate to the day-to-day management of current assets and
current liabilities.
QUICK QUIZ
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Discuss the typical functions performed by a
1. financial manager.
2. What is the difference between a financial
manager and an accountant? Provide a brief
description of each.
3. Describe the three main categories of decision
that financial managers make.
4. Which side of the statement of financial
position is influenced by capital budgeting
decisions? Motivate your answer.
5. Which side of the statement of financial
position is influenced by capital structure
decisions? Motivate your answer.
6. Assume that the butcher in our example does
not have enough savings to buy the van. The
entity is already running an overdraft with
the bank. What other options are available to
the owner to source the required R200 000?
7. Do you think that the fortunes of a small
butchery are tied to the state of the economy?
Justify your answer.
8. Would it be wise for the butcher to sell her
products on credit? Motivate your answer.
1.4
The goals of financial management
According to the website of Tiger Brands, the entity aims to “target
best-in-class profitability, underpinned by a cost-conscious culture
as well as environmental, social and governance principles to drive
shared value creation” (Tiger Brands, 2019b: x). Other financial
management goals may include maximising earnings per share,
market value added or economic value added. Three goals deserve
closer attention, given how prevalent they are in financial
management practice. They are profit maximisation, rate of return
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maximisation and shareholder wealth maximisation.
1.4.1
Profit maximisation
To increase the net profit attributable to ordinary shareholders,
financial managers should increase the entity’s revenue and
decrease its operating and other expenses. The former can be
achieved through more effective marketing campaigns, whereas the
latter can be accomplished by, for example, increasing productivity,
reducing waste, streamlining production processes and using the
most cost-effective sources of debt funding. It should be noted that
extreme cost cutting can jeopardise the health and safety of
employees, customers and communities. The goal of profit
maximisation has two main flaws. Firstly, accounting profit can be
manipulated. Secondly, the goal of profit maximisation ignores the
timing and risk associated with generating the profit.
1.4.2
Maximising the rate of return
One way to overcome the shortcomings of profit maximisation as a
goal is to consider the investment necessary to generate the profit.
Financial managers may thus aim to maximise the ratio of net profit
after tax to total assets, instead of merely maximising net profit after
tax. The rate of return is a percentage that offers the advantage that
several investments can be compared with one another. Although
this financial management goal represents an improvement on the
goal of profit maximisation, it is still subject to the same flaws, in
that its inputs are accounting values (net profit and total assets),
which can be manipulated. Furthermore, the timing and risk
associated with generating the profit are also ignored.
1.4.3
Maximising shareholders’ wealth
Despite the importance of the two accounting-based goals
discussed above, both reflect the historical performance of an entity.
If the financial manager only looks at past performance as an
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indicator of future performance, the entity will not be able to grow.
Shareholder wealth maximisation represents a forward-looking
goal centred on increasing the wealth of the owners, or
shareholders, of the entity.
At any point in time, a shareholder’s wealth depends on the
number of shares that the shareholder owns and the current share
price. The wealth of a shareholder who owned 10 000 shares in
Tiger Brands on 22 January 2018 was 10 000 × R466,21 = R4 662 100
(ShareData Online, 2019a). This shareholder’s value decreased to R2
122 200 on 22 August 2019, as the share price on that day was only
R212,22 (ShareData Online, 2019a). The reduction in the
shareholder’s wealth can be attributed to the sharp decrease in the
entity’s bottom line (net profit), which in turn can be blamed on the
listeriosis outbreak, intense competition and weak economic
growth in South Africa. The latter is eroding consumer demand,
even for staples such as Tastic rice and Albany bread.
The concept of shareholder primacy, which gained prominence
in the 1980s, proposes that financial managers only engage in
activities that will have a positive influence on the entity’s current
share price. Many critics claim that this goal has created a fixation
on short-term results, fuelling inequality, environmental
degradation and excessive executive remuneration. A number of
studies show that managers who receive share options as part of
their compensation packages are more inclined to pursue shortterm performance and engage in unwarranted risk taking (MansKemp & Viviers, 2018). Critics claim that this kind of behaviour
contributed, in part, to the creation of the dot.com bubble in 2002
and the 2008 global financial crisis.
Mindsets are, however, starting to shift. A group representing
the most powerful chief executive officers in the United States
recently abandoned the idea of shareholder wealth maximisation at
all costs. The group, which is called the Business Roundtable, said
that businesses should rather commit to balancing the needs of
shareholders with those of legitimate stakeholders (Business
Roundtable, 2019). As the name suggests, stakeholders include all
those individuals and organisations that have a stake, or interest, in
the business, such as the employees, suppliers, customers, unions,
regulators, tax authorities and the general public.
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The notion of stakeholder inclusivity also features prominently
in the fourth King Report on corporate governance in South Africa
(henceforth referred to as King IV™). This report states that a
business “can no longer be seen as existing in its own narrow
universe (or society) of internal stakeholders or resources needed to
create value, as it also operates in, and forms part of general society.
In this view, the licensor of an entity is not just those individuals
and entities within its narrowly defined value chain, but society as
a whole.” (IoDSA, 2016: 4). Entities that treat their stakeholders
with respect are likely to reap the benefits in the long-term. A more
in-depth discussion on ethics and ESG considerations presented
later in the chapter.
QUICK QUIZ
1. Discuss the main goal of financial management.
2. Identify some of Tiger Brands’ stakeholders.
Which legitimate claims do these stakeholders
have on the entity?
3. Explain why a short-term focus can destroy
value across the six capitals (financial,
manufactured, natural, human, intellectual,
and social and relationship).
1.5
Forms of business ownership in South Africa
There are several legal forms of business ownership in South Africa.
We will only discuss the most common forms: sole proprietorships,
partnerships and companies. These types of entity each have their
own advantages and disadvantages.
It is important to understand how entities organise themselves
in a legal sense. If a business is regarded as a separate entity from
the owner, then the owner has limited liability for profits or losses.
If not, the owner or owners are responsible for profits or losses.
These corporate forms are discussed in more detail in the sections
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that follow.
1.5.1
Sole proprietorship
A sole proprietorship means that a single person has the controlling
interest in the entity. A more colloquial name for this legal form is a
one-person business. In the case of a sole proprietorship, the
success, or otherwise, of the entity is entirely in the hands of one
person. This means that if the entity prospers, the owner receives all
the benefits, but if it fails, the owner is responsible for all the losses.
These are the main characteristics of a sole proprietorship:
• Easy entry into the market. It is relatively easy to start a oneperson business from a legal perspective. There are few
formalities other than obtaining a trading licence.
• The lifespan of the entity is limited to the owner’s lifespan: the
entity will only survive for as long as the owner continues to run
it.
• The owner is generally also the manager. Because such entities
are run by the owners themselves, the owners make decisions in
their own best interests (in other words, they maximise their
own wealth).
• The business is not a separate entity from the owner. The owner
is fully liable for all the debts of the entity and has to pay
personal tax on its profits.
1.5.2
Partnership
A partnership is a private agreement with between two and 20
partners who contribute skills and equity to the business. A
partnership is very similar to a sole proprietorship in the sense that
the partners are also liable for any losses or debts the business
might incur. However, partners can raise more capital collectively
and have greater creditworthiness than a sole proprietorship.
The key characteristics of a partnership include the following:
• Easy entry into the market. It is easy to start a partnership; an
oral agreement between the partners can suffice, but to
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eliminate
potential
future
disagreements
and
misunderstandings, a written partnership agreement is
advisable.
• The lifespan of the entity is limited. The continuity of a
partnership can be unstable because a new partnership must be
formed if a partner leaves, becomes insolvent or dies, or if a new
partner joins.
• The business is not a separate entity from the partners. If the
entity should fail or incur debt, the partners will be liable and
their personal assets may be used to meet claims. If a partner
cannot satisfy their obligations, the other partners are compelled
to meet them. Partners are taxed in a personal capacity for any
profits acquired.
• Profits and debts are the liability of the partners in proportion to
their contribution to capital: the more you contribute towards a
partnership in terms of equity, the more profits you receive. By
the same token, the more you contribute towards a partnership,
the more liable you are for debts incurred it.
Due to the complexities involved in managing a partnership, many
fail. Success requires trust, a willingness among partners to
coordinate activities, commitment, good communication, joint
planning and joint problem resolution.
1.5.3
Company
A company is a separate legal entity from the owners of the
business. This means that a company can be sued and taxed
separately from the owners, and the owners have limited liability.
The Companies Act (No. 71 of 2008) makes provision for two
categories of company: non-profit and for-profit companies.
1.5.3.1
Non-profit companies
Non-profit companies (which are the successors to the Section 21
companies based on the old Companies Act) have to comply with a
set of principles stipulated in Schedule 1 of the Act. These
principles relate mainly to the purpose, objectives and policies of
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the company, matters related to directors, members and
fundamental transactions, and the winding up of non-profit
companies. The Act exempts non-profit companies from certain of
its provisions. In general, non-profit companies are not required to
comply with provisions pertaining to the following:
• capitalisation of profit companies
• securities registration and transfer
• certain provisions related to directors, the appointment of
company secretaries, auditors and audit committees
• public offerings of company securities
• takeovers, offers and fundamental transactions
• rights of shareholders to approve a business rescue plan
• dissenting shareholders’ appraisal rights.
The name of the non-profit company should be followed by the
letters ‘NPC’. A non-profit company must be incorporated by three
or more persons.
1.5.3.2
For-profit companies
The Act provides for four different types of profit company:
• Private company (Proprietary Limited or Pty [Ltd]): This type of
company is almost identical to its predecessor in the previous
Companies Act, with one key difference: it no longer limits such
companies to 50 members. The Act now defines private
companies as for-profit companies that are not public
companies, personal-liability companies or state-owned
companies. Its memorandum of incorporation prohibits offering
any of its securities to the public and restricts the transferability
of its shares.
• Personal-liability company (Incorporated or Inc): A company
that meets the criteria for a private company and whose
memorandum of incorporation states that it is a personalliability company (meaning the directors and past directors are
jointly and severally liable, together with the company, for any
debts and liabilities of the company that were contracted during
their respective periods of office).
• Public company (Limited or Ltd): A listed company that is not a
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state-owned company, private company or personal-liability
company. This type of company is similar to its predecessor in
the previous Companies Act. The minimum number of
members has been reduced from seven (in the previous Act) to
one in the current Act.
• State-owned enterprise (SOC Ltd): An enterprise, registered as a
company, that falls within the meaning of ‘state-owned
enterprise’ in terms of the Public Finance Management Act (No.
1 of 1999) or is owned by a municipality. Examples include
Eskom and the Industrial Development Corporation.
QUICK QUIZ
1. Discuss the main differences between a sole
proprietorship and a partnership.
2. What are the main differences between a
private and a public company?
3. What are the main differences between a nonprofit and a for-profit company?
4. What are the benefits and disadvantages
associated with public companies?
1.6
The agency problem and agency costs
In a sole proprietorship and some partnerships, the owners are
generally also the managers of the business. It is therefore assumed
that they will run the entity in such a manner as to maximise their
own wealth. However, in publicly listed companies, shares are held
by a large number of shareholders. As the shareholders cannot all
be involved in the day-to-day management of the entity, managers
are appointed. Managers therefore become agents and are obligated
to maximise the interests of those who appointed them (the
shareholders, also called the principals). Unfortunately, it is often
the case that managers run entities to protect their own interests
(such as their job security, benefits and personal wealth) rather than
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to promote the interests of the shareholders. This phenomenon is
known as the agency problem.
Can you trust someone else to look after your own interests as
well as you would look after them yourself? According to Adam
Smith, author of The Wealth of Nations (first published in 1776),
managers cannot be expected to watch over other people’s money
with the same anxious vigilance with which the owners of a
business would watch over their own money (Smith, 1776).
Consider the following example. You want to sell your house,
but do not have time to look for a buyer, so you appoint an estate
agent, Sam, to sell the house for you. You will pay Sam R10 000 to
sell the house, which is worth R500 000. In this scenario, you are the
principal and Sam is the agent, who should take care of your
interests. Whether Sam sells the house for R300 000 or for R600 000,
she will still receive R10 000 for her efforts. However, she was
appointed to look after your best interests, and she has failed to do
so if she sells the house for less than R500 000. Sam’s fee can be
construed as an agency cost because the agent deliberately did not
maximise your wealth as principal.
What would happen, however, if you came to an agreement
with Sam whereby you agreed to pay her 10% commission for
whatever amount she sold the house? In this case, Sam would be
motivated to sell the house for more, as she would then receive a
larger commission. The same holds true for an entity. If managers
are paid a flat salary every month for doing their jobs, they will not
necessarily be concerned about the share price (and the wealth of
the shareholders) because they will receive the same salary
regardless of what happens to the share price. However, if
shareholders give managers shares of their own, they have an
incentive to work harder in the interests of the shareholders.
Shareholders bear both direct and indirect agency costs. A direct
agency cost is any measurable amount incurred as a result of the
agency problem. Examples are managers spending money on
luxuries such as corporate jets and extravagant offices. They also
include overcompensating managers and costs associated with
‘keeping an eye on management’, such as paying auditors to ensure
managers’ actions are ethical and transparent.
Indirect agency costs mostly relate to missed opportunities. As
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an example, consider a listed meat-processing entity that intends
developing a range of sausages suitable for vegetarians, which the
entity plans to sell nationally. On the one hand, this could be a
high-risk project that might damage the share price. On the other
hand, it may also turn out to be a great success, which would boost
the share price. Even though the shareholders might be optimistic
about the project’s prospects, it might be rejected if management
feels that the project is too risky. Being human, managers are
naturally concerned about the repercussions of failure, such as job
losses or the withholding of bonuses. Now, imagine that in the
meantime, a rival entity launched a similar product range, which
became a huge success. The company that had delayed the launch
would thus have lost a valuable opportunity and hence suffered an
indirect agency cost.
It has been shown that if managers have a financial motivation
to increase shareholders’ wealth, agency costs can be controlled. As
such, their compensation packages are typically structured to
include share options and other performance-linked incentives,
such as cash bonuses. King IV™ contains several guidelines to
ensure fair and responsible executive remuneration. In line with
these guidelines, Tiger Brands has developed a remuneration policy
that is “holistic and encompasses the monetary elements of reward
as well as non-financial aspects such as growth, development and
work environment” (Tiger Brands, 2018: 76). Many South African
companies, including Tiger Brands, have been criticised for offering
executives excessive pay packages in an effort to align
managements’ goals with those of shareholders (Brown, 2017).
QUICK QUIZ
1. What is meant by the agency problem?
2. Which parties are involved in an agency
relationship?
3. Provide two examples of direct agency costs.
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1.7
Financial markets and institutions
Financial managers and investors do not operate in a vacuum; they
make decisions within a large and complex financial environment.
This environment includes financial markets and institutions, tax
and regulatory policies, and global and local economies. Starting
and growing an entity requires funding: financial markets and
institutions are necessary to ensure that funds flow between
borrowers and lenders. These markets act as intermediaries
between buyers and sellers of financial securities.
1.7.1
Financial markets
A financial market can be defined as a meeting place where
economic units with excess funds can transact with economic units
in need of funds. Financial markets thus bring together the
suppliers of funds and those seeking funds. There are two types of
financial market: the money market and the capital market. Markets
can also be divided into primary and secondary markets.
1.7.1.1
Money markets
A money market is a market where short-term debt securities are
bought and sold. Short-term debt securities are those securities with
a maturity of one year or less. Money markets do not have a
physical location, but participants (which include individuals,
entities, governments and financial institutions such as banks) are
connected electronically. The main purpose of a money market is to
enable participants that temporarily have extra funds to earn
interest on those funds. Other participants may be in need of shortterm financing; money markets provide a platform to bring these
parties together. The debt securities available from money markets
are called marketable securities.
1.7.1.2
Capital markets
A capital market is a market where long-term debt securities are
bought and sold. Long-term debt securities have a maturity of more
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than one year, and the main securities bought and sold are shares
and bonds. The Johannesburg Stock Exchange (‘the JSE’) is an
example of a capital market in South Africa, as are the four new
exchanges (ZAR X, 4AX, A2X and the BEE-focused Equity Express
Securities Exchange). The new stock exchanges were created to
offer businesses cheaper ways to access capital markets (Jooste,
2019). According to a market commentator, the dilution of the JSE’s
status as the sole capital market service provider in the country is a
positive move that has been broadly welcomed by the financial
industry.
1.7.1.3
Primary and secondary markets
A primary market is a market in which listed companies sell
securities for the first time. Therefore, when entities are in need of
funds, they can offer securities to participants in this market.
There are two types of primary-market transaction. The first is a
private placement, where the securities are only for sale to specific
buyers. The second is a public offering, which is available to the
general public.
When an entity decides to sell securities to raise funds, it has to
register a prospectus, in which all relevant information is made
available to the public. All the securities need to be underwritten.
This means that a merchant bank (a bank whose primary function is
to provide banking services to businesses and wealthy individuals)
acts as the underwriter and guarantees to buy all the remaining
securities that the public does not buy. The underwriter, therefore,
guarantees a certain amount of funds to the borrower and does so
in the hope that they will be able to sell the securities to the public
for a profit later.
Take, for example, the case of an entity that is in need of R50
million. It decides to make one million ordinary shares available to
the public at R50 each. If the public only buys 900 000 shares, there
will be 100 000 shares left. The underwriter will purchase the
remaining 100 000 shares. Therefore, the entity will have a
guaranteed R50 million (ignoring fees). The underwriter will then
try to sell the remaining 100 000 shares at a higher price than R50 at
a later stage in the hope of making a profit.
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A secondary market is a market in which the original securities
that were bought in the primary market can be traded. For instance,
if you were one of the investors who bought shares in the original
public offering for R50 and you decided to sell your shares, you
would do so in the secondary market. Consequently, a secondary
market needs a buyer and a seller, so that ownership of securities
can be transferred. Based on the above, it is clear that the five stock
exchanges in South Africa offer both primary and secondary
markets.
There are two types of secondary market: auction and dealer
markets. The main difference between auction and dealer markets
is the way in which trading is carried out.
1.7.1.4
Auction markets
In the case of an auction market, also known as a broker market, the
buyer and the seller of the securities are brought together by a
broker and the transaction takes place. A good example of an
auction market is the New York Stock Exchange. An auction market
has a physical location with a trading floor. Until 1996, the JSE was
an auction market.
1.7.1.5
Dealer markets
Dealer, or over-the-counter, markets do not bring the seller and
buyer of securities together directly. Instead, traders or securities
dealers offer to buy or sell securities at fixed prices. As the name
implies, the National Association of Securities Dealers Automated
Quotations (NASDAQ) is an automated exchange and dealer
market. The same applies to the JSE post-1996 and the four new
stock exchanges in South Africa.
1.7.2
Financial institutions
Financial institutions, such as banks, life insurers, pension funds
and collective investment schemes (which include unit trusts),
bring savers and lenders together in an effort to allocate funds
efficiently. Think, for instance, about your local bank. If you save
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money in a fixed-deposit account, you receive a certain amount of
interest. The bank pays you that interest in return for the
opportunity to lend your money to some party in need of funds. So,
if the owner of our small-scale butchery is in need of a specific
amount of money, she can go to the bank and apply for a loan, for
which she would be charged a certain interest rate. The bank thus
acts as a financial intermediary: it uses the money of savers
(suppliers of funds) to allocate funds to borrowers (demanders of
funds). The interest rate that the financial institution charges for
lending money is always more than the interest that is paid to
savers. The difference between the two interest rates represents the
financial institution’s revenue.
Financial institutions also generate income through service
charges. An example of a service charge is the service fee that you
pay every month on your bank account. The launch of online banks,
such as TymeBank and Discovery Bank, is forcing traditional banks
to reconsider their business models and fee structures.
Individuals, profit and non-profit entities, and governments
cannot act efficiently without financial institutions. Financial
institutions are governed by regulations that ensure that they act
according to established ethical and operational guidelines. South
African banks are required to adhere to the Banks Act (No. 94 of
1990) and other legislation, including the National Credit Act (No.
34 of 2005), to prevent reckless lending by financial institutions.
Life insurance companies, pension funds and collective
investment schemes are also managed in line with specific
regulations. One example is Regulation 28 of the Pension Fund Act
(No. 71 of 1956), which limits the extent to which retirement funds
may invest in particular assets or in particular asset classes. These
financial institutions all accept funds from policy, account and unit
holders, and invest the funds in capital markets.
1.7.3
Flow of funds
Financial markets, financial institutions and the major economic
units are all linked in the business environment. Figure 1.3
illustrates these interrelationships.
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Figure 1.3 Interrelationships between economic units
Notes:
A: The economic units in the business environment include individuals, entities and governments.
B: These economic units have a supply of funds and turn to the financial markets by investing in securities.
C: These economic units are in need of funds and approach the financial markets by issuing securities and
selling them, thereby receiving funds from the financial markets.
D: These economic units are in need of funds and turn to financial institutions to borrow funds.
E: These economic units are in supply of funds and approach financial institutions to conserve and grow
their funds.
F and G: Financial institutions can use the funds obtained from savers to invest in the financial markets.
They can also borrow funds from each other and/or the South African Reserve Bank.
QUICK QUIZ
1. Discuss the meaning of the term ‘financial
market’.
2. What is a money market and how does it differ
from a capital market?
3. What is the difference between a primary and a
secondary market?
4. What is the role of financial institutions in
the business environment?
5. Describe the relationship that exists between
financial markets and financial institutions.
6. Should local banks view the rapid pace of
technological change as a threat or an
opportunity? Motivate your answer.
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1.8
Ethics and environmental,
governance considerations
social
and
The word ‘ethics’ is derived from the Greek word ‘ethos’, which
refers to the character and guiding beliefs of a person, group or
institution. Ethical decisions refer to decisions on what is good,
right, just and fair when interacting with others (where others can
be broadly defined as humans, animals or nature). At the most
basic level, individuals, groups and institutions should refrain from
inflicting harm on others.
Morality, a closely related concept, refers to the customs (that is,
the traditions, practices and conventions) that are defined as
acceptable by society at a specific point in time. A society’s morals
are typically enshrined in its laws. Business ethics is a form of
applied ethics, in that ethical principles are applied in a business
context.
Examples of unethical behaviour in the business world abound,
and range from theft of assets and intellectual property to insider
trading, price fixing and inflating profits. Many of these activities
are illegal in South Africa and elsewhere in the world. Recent
developments in the global investment arena have placed the
spotlight firmly on ethical risks and risks associated with ESG
considerations.
The first of these developments is an initiative of the United
Nations called the Principles for Responsible Investment (PRI).
Institutional investors who are signatories of the PRI publicly
commit to integrating ESG considerations into their investment
analyses and ownership practices. The South African Government
Employees Pension Fund was one of the founding members of the
PRI in 2006. Several other asset owners, asset managers and
professional services providers have since followed its lead.
Although most engagements between entities and responsible
investors in South Africa take place in private, some investors are
beginning to question entities in public (Viviers & Els, 2017). The
majority of these discussions centre on seemingly excessive
executive remuneration, the lack of director independence and
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transformation.
The publication of King IV™ in 2016 represents the second
important driver of improved ethical and ESG risk management. In
this report, particular emphasis is placed on corporate governance.
Corporate governance is defined in the report as “the exercise of
ethical and effective leadership by a governing body towards the
achievement of the following governance outcomes: ethical culture,
good performance, effective control, and legitimacy” (IoDSA, 2016:
20). King IV™ reinforces the notion that good corporate governance
necessitates an holistic and interrelated set of arrangements that is
to be understood and implemented in an integrated manner.
King IV™ was developed in response to three important
changes that have taken place in recent years: a shift from financial
capitalism to inclusive capitalism, a move from short-term capital
markets to long-term, sustainable capital markets and the advent of
integrated reporting. The latter refers to a process that is grounded
in integrated thinking and that results in the production of periodic
integrated reports by an entity that highlight value creation over
time. In contrast to King III’s 75 principles, King IV™ only has 17
principles, which are set out in Table 1.1.
Table 1.1 Principles of King IV™
1
The governing body should lead ethically and effectively.
2
The governing body should govern the ethics of the organisation in a way that supports
the establishment of an ethical culture.
3
The governing body should ensure that the organisation is and is seen to be a
responsible corporate citizen.
4
The governing body should appreciate that the organisation’s core purpose, its risks and
opportunities, strategy, business model, performance and sustainable development are
all inseparable elements of the value-creation process.
5
The governing body should ensure that reports issued by the organisation enable
stakeholders to make informed assessments of the organisation’s performance and its
short-, medium- and long-term prospects.
6
The governing body should serve as the focal point and custodian of corporate
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governance in the organisation.
7
The governing body should comprise the appropriate balance of knowledge, skills,
experience, diversity and independence for it to discharge its governance role and
responsibilities objectively and effectively.
8
The governing body should ensure that its arrangements for delegation within its own
structures promote independent judgement, and assist with balance of power and the
effective discharge of its duties.
9
The governing body should ensure that the evaluation of its own performance and that of
its committees, its chair and its individual members support continued improvement in
its performance and effectiveness.
10 The governing body should ensure that the appointment of, and delegation to,
management contribute to role clarity and the effective exercise of authority and
responsibilities.
11 The governing body should govern risk in a way that supports the organisation in setting
and achieving its strategic objectives.
12 The governing body should govern technology and information in a way that supports the
organisation setting and achieving its strategic objectives.
13 The governing body should govern compliance with applicable laws and adopted, nonbinding rules, codes and standards in a way that supports the organisation being ethical
and a good corporate citizen.
14 The governing body should ensure that the organisation remunerates fairly, responsibly
and transparently so as to promote the achievement of strategic objectives and positive
outcomes in the short, medium and long term.
15 The governing body should ensure that assurance services and functions enable an
effective control environment, and that these support the integrity of information for
internal decision making and of the organisation’s external reports.
16 In the execution of its governance role and responsibilities, the governing body should
adopt a stakeholder-inclusive approach that balances the needs, interests and
expectations of material stakeholders in the best interests of the organisation over time.
17 The governing body of an institutional investor organisation should ensure that
responsible investment is practised by the organisation to promote the good governance
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and the creation of value by the companies in which it invests.
Source: IoDSA, 2016: 41–42.
Entities that pay close attention to these principles are likely to
formulate pro-environmental and pro-social policies. As will be
highlighted in Chapter 9, environmental considerations centre on
the responsible use of natural resources, whereas social
considerations typically centre on the well-being of employees,
customers and local communities.
QUICK QUIZ
1. Define the concepts of ethics and business
ethics.
2. Explain the importance of sound corporate
governance as outlined in King IV™.
3. Do you agree with the following statement:
‘Careful attention to the King IV™ principles
is likely to reduce the agency
problem?’Motivate your answer.
4. Tiger Brands reduced its water consumption by
19,3% in the 2018 financial year (Tiger
Brands, 2018: 12). Explain why shareholders
and other stakeholders should applaud the
company’s efforts in this regard.
1.9
Conclusion
This chapter provided an introduction to corporate finance. You
learnt the following:
• Financial management is a process of creating value, not only
for the owners (shareholders) of an entity, but also for other
stakeholders, such as employees, customers and suppliers.
• Financial managers make decisions that can be grouped into
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•
•
•
•
•
•
three main categories. Examples of decisions in these categories
include the following:
– In which non-current (long-term) assets should the entity
invest? These decisions are referred to as capital budgeting
decisions.
– How should the assets of the entity be financed? Decisions
relating to the most appropriate forms of financing are called
capital structure decisions.
– How should the day-to-day financial activities of the entity
be managed? These decisions are typically referred to as
working capital management decisions.
The most important goal of financial management is to increase
the wealth of the shareholders by increasing the current share
price. This goal is, however, being challenged, as mindsets are
shifting towards a more stakeholder-inclusive approach.
The main forms of business ownership in South Africa are sole
proprietorships, partnerships and companies.
In large entities, shareholders often appoint managers to act as
their agents. The agency problem occurs when these managers
do not act in the best interests of the shareholders. Shareholders
thus incur direct and indirect agency costs. Carefully structured
executive remuneration packages can be used to align
managers’ interests with those of shareholders.
Financial markets act as a platform to bring together buyers and
sellers of financial securities. There are two forms of financial
market: money markets and capital markets. Capital markets are
sub-divided into primary and secondary markets.
Financial institutions act as intermediaries to bring together
suppliers of funds (savers) and demanders of funds (borrowers).
Adherence to sound ethical and corporate governance principles
is likely to increase value creation across the six capitals in the
long term. The same applies to entities that manage social and
environmental risks proactively.
The opening case study illustrated how quickly value was
destroyed at Tiger Brands as a result of the listeriosis outbreak. A
similar example is provided in the closing case study.
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CASE STUDY
The price of anti-competitive behaviour
Aspen Pharmacare Holdings Ltd is a global supplier and
manufacturer of branded and generic pharmaceutical products,
infant nutritionals and consumer healthcare products. In June
2017, the Italian Competition Authority imposed a R73,7
million fine on the entity in relation to its portfolio of oncology
(cancer treatment) products. The Italian authorities found that
Aspen had increased the prices of its cancer drugs by between
300% and 1 500%, and had thus abused its dominant position
in the market.
Aspen’s conduct also came under the microscope in South
Africa. The Competition Commission launched an
investigation into three major pharmaceutical entities (Aspen,
Pfizer and Roche) for allegedly fixing the prices of cancer
medication. Commenting on the Commission’s announcement,
Aspen said that pharmaceutical prices in the country were
approved by the Department of Health in terms of the single
exit price regulatory framework, which establishes a universal
fixed price for each pharmaceutical product. According to an
Aspen spokesperson, the company did not increase the pricing
of its products outside of this regulatory framework. He added
that the company had demonstrated its commitment to
providing affordable quality medicines over many years
(Cokayne, 2017). The Commission subsequently dropped its
investigation.
On 14 August 2019, Aspen’s share price fell to its lowest
level in nine years after the company admitted to anticompetitive behaviour in the United Kingdom (UK). The entity
was instructed to pay a fine of £8 million to the UK
Competition and Markets Authority.
Sources: Compiled from information in ShareData Online, 2019b; Cokayne, 2017; Kahn, 2017; Kahn,
2019.
MULTIPLE-CHOICE QUESTIONS
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BASIC
1.
During the 2018 financial year, Tiger Brands spent R12 billion with B-BBEEverified suppliers, including R2 billion with black-owned enterprises (B-BBEE =
broad-based black economic empowerment). This expenditure mainly relates
to _________ capital.
Hint: Visit Tiger Brands’ Integrated annual report for 2018 (available at
http://www.sharedata.co.za/data/000072/pdfs/TIGBRANDS_ar_sep18.pdf).
A. financial
B. manufactured
C. social and relationship
D. intellectual
2.
Financial markets where long-term debt and ordinary shares are bought and
sold are called _________ markets.
A. money
B. primary
C. secondary
D. capital
3.
Identify the correct answer combination.
Working capital management refers to the management of …
i)
short-term liabilities.
ii) short-term assets.
iii) inventory.
iv) medium-term assets and liabilities.
v) medium-term loans.
A. Statements iv) and v)
B. Statements iii) and iv)
C. Statements i) and iii)
D. Statements i), ii) and iii)
4.
Evaluating the size, timing and risk of future cash flows is the essence of …
A. capital budgeting.
B. capital structure.
C. working capital management.
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D.
growth management.
5.
Capital structure refers to an entity’s …
A. long-term investments.
B. short-term assets.
C. short-term liabilities.
D. mix of debt and equity.
6.
Which ONE of the following is an example of an indirect agency cost?
A. Overspending by managers
B. Large bonuses being paid to managers
C. Consultants being paid to investigate managerial spending
D. The loss of market share owing to a high-return, high-risk project not
being undertaken
INTERMEDIATE
7.
If an entity only focuses on profit as a financial goal, then …
A. risk is ignored.
B. the size of the investment required to generate the profit is ignored.
C. the share price is ignored.
D. All of the above apply.
8.
If you are the owner (or part owner) of an entity that is going bankrupt, it would
be best for you if its business type were that of a _________.
A. sole proprietorship
B. public company
C. partnership
D. franchise
9.
Which ONE of the following statements is incorrect?
A. Ethical behaviour is at a level higher than that prescribed by law.
B. The board of directors plays a pivotal role in ensuring sound corporate
governance in an entity.
C. Good corporate citizens only abide by the letter of the law.
D. Stakeholders are demanding improved reporting on the ESG policies and
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practices of entities.
ADVANCED
10. You are considering investing in one of the entities listed in the table that
follows.
Notes:
A: There was no change in the number of ordinary shares issued by any of the entities since their
listing on the JSE.
Which entity is the most appealing from an ordinary shareholder’s point of
view?
A. Entity A, as the percentage change in its share price increased the most
from 2012 to 2019
B. Entity B, as it has the largest number of ordinary issued shares
C. Entity C, as it had the highest share price on 31 December 2019
D. Impossible to say
11. When evaluating the nature of corporate governance as practised by JSE-listed
companies, which of the following would one NOT investigate?
A. Board diversity in terms of race and gender
B. Board composition in terms of executive and non-executive directors
C. Directors’ attendance at committee meetings
D. The entity’s adherence to international codes of good practice
12. Many manufacturers of chocolates have been accused of using child labour in
their supply chains. The use of child labour could be considered a/an
_________ consideration.
A. environmental
B. social
C. corporate governance
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D.
financial
LONGER QUESTIONS
BASIC
1.
How is financial management linked to accounting and economics?
2.
Describe the three categories of financial management decision by means of a
practical example.
3.
What kind of financial markets are the JSE and the New York Stock Exchange?
4.
What are the main advantages of choosing a sole proprietorship over a
partnership as a legal form of business ownership?
INTERMEDIATE
5.
Explain how the goal of shareholder maximisation can lead to short-termism.
6.
Distinguish between the terms ‘agency costs’, ‘agency problem’ and ‘agency
relationship’ by making use of an example.
7.
Why is it important for entities to identify and manage ethical and ESG risks
proactively?
ADVANCED
8.
Read the case study below and answer the question that follows.
Mr James, the CFO of the Tiger Tobacco Company, loves
playing golf. He loves it so much that he plays golf every
Friday afternoon. He justifies the time away from the
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office by saying that he ‘networks’ with major customers
on the golf course. Mr James claims that these discussions
enable him to allocate funds more effectively across
product divisions. “Feedback from our largest customers
has played a significant role in allocating our capital
budget this year,” he says. Mr James’s membership fees
at the local golf club amount to R12 000 per year, which
do not include the cost of his weekly Friday visits to the
club. The entity pays for his annual membership fees and
the extra weekly Friday dues.
Does Mr James’s ‘networking’ on the golf course represent an agency cost to
the entity’s shareholders? If so, explain why.
9.
Is it morally wrong to test cosmetics and other beauty products on animals?
Motivate your answer.
10. Several pharmaceutical companies use animals to test the efficacy of their
products. Are their activities morally questionable? Motivate your answer.
KEY CONCEPTS
Accounting: The system of recording, verifying and reporting on the
value of assets, liabilities, income and expenses in the books of
an entity.
Agency cost: The cost incurred by the owners of an entity when
making use of agents (managers); associated with problems
such as the disparity between management’s and shareholders’
objectives.
Business ethics: The application of ethical standards to the business
environment.
Capital budgeting: The planning process used to determine if an
entity’s long-term investments, such as new machinery,
replacement machinery, new plants, new products, and research
and development projects, are worth pursuing.
Capital market: A marketplace where entities and governments can
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raise long-term funds. It is a market in which money is lent for
periods longer than a year.
Capital structure: The way in which an entity finances its assets
through a combination of equity and debt.
Company: An entity that complies with certain legal requirements in
order to be recognised as having a legal existence separate and
distinct from its owners; owned by its shareholders.
Corporate governance: The framework of rules and practices used by
an entity’s board of directors to ensure accountability, fairness
and transparency in the entity’s dealings with its shareholders,
creditors and other stakeholders.
Current assets: An asset on the statement of financial position that is
expected to be sold, or otherwise used, in the near future;
includes cash, cash equivalents, accounts receivable, inventory
and short-term investments.
Current liabilities: Liabilities of an entity that are to be settled in cash
in the near future, such as accounts payable.
Ethics: Principles defining the character or guiding beliefs of a
person, group or institution.
Financial function: One of the key business functions concerned with
the flow of funds to and from businesses.
Financial management: Management of the financial function in an
entity. The main goal of financial management is to increase the
wealth of the entity’s owners.
Financial manager: Decision maker in an entity who uses financial
statements to make capital budgeting decisions, capital structure
decisions and working capital decisions to create wealth for the
entity’s shareholders.
Money market: A financial market for short-term borrowing and
lending; provides short-term liquidity for securities such as
treasury bills, commercial paper and bankers’ acceptances.
Non-current assets (fixed assets): The asset class that is used to generate
an income or return a profit for an entity; an accounting term
used for assets (such as property and equipment) that cannot
easily be converted into cash.
Organisational structure: The manner and extent to which roles, power
and responsibilities are delegated, controlled and coordinated,
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and how information flows between levels of management.
Partnership: A form of entity involving an agreement between two or
more individuals who pool money, skills and other resources,
and share profit and losses in accordance with the terms of the
partnership agreement.
Shareholder: An individual or entity that owns one or more shares in
a company; shareholders collectively own the company.
Sole proprietorship: A form of entity whereby an individual acquires
all the benefits and risks of running a business, and where there
is no legal distinction between the assets and liabilities of the
entity and those of its owner.
Working capital management: The management of day-to-day financial
activities with specific reference to current assets and current
liabilities.
SLEUTELKONSEPTE
Aandeelhouer: ’n Individu of onderneming wat een of meer aandele
in ’n besigheid besit. Die aandeelhouers van ’n onderneming is
die gesamentlike eienaars daarvan.
Agentskapskoste: Die koste wat deur die eienaars van ’n besigheid
aangegaan word wanneer agente (bestuurders) aangestel word;
ontstaan as gevolg van uiteenlopende doelwitte van bestuur en
aandeelhouers.
Bedryfsbates: Bates in die staat van finansiële posisie wat in die
nabye toekoms ’n inkomste sal realiseer. Dit sluit kontant en
kontant ekwivalente, handelsdebiteure, voorraad en korttermyn
beleggings in.
Bedryfskapitaalbestuur: Die dag-tot-dag bestuur van die onderneming
se finansiële aktiwiteite met spesifieke verwysing na
bedryfsbates en bedryfslaste.
Bedryfslaste: Laste in die onderneming wat in die nabye toekoms
betaal moet word, soos handelskrediteure.
Eenmansaak: ’n Besigheid waar slegs een individu al die voordele en
risiko dra en die besigheid self bestuur. Daar is geen wetlike
onderskeiding tussen die bates en laste van die eienaar en die
onderneming nie.
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Etiek: Verwys na die karakter en waardes van ’n persoon, groep of
instansie.
Finansiële bestuur: Bestuur van die finansiële funksie met die oog
daarop om die eienaars se welvaart te maksimeer.
Finansiële bestuurder: ’n Besluitnemer wat finansiële state gebruik om
kapitaalbegrotings-, kapitaalstruktuur- en
bedryfskapitaalbesluite te maak om te verseker dat waarde vir
aandeelhouers ontsluit word.
Finansiële funksie: Een van die kern funksies van ’n onderneming wat
bemoeid is met die vloei van fondse van en na die onderneming
toe.
Geldmark: ’n Finansiële mark vir korttermyn-lenings. Verskaf
korttermyn-likiditeit met sekuriteite soos skatkis-wissels,
handelswissels en bankaksepte.
Kapitaalbegroting: Die beplanningsproses wat gebruik word om te
bepaal of ’n onderneming se langtermynbeleggings, soos nuwe
masjinerie, masjinerie wat vervang moet word, nuwe aanlegte,
nuwe produkte en nuwe navorsingsontwikkelingsprojekte, die
moeite werd is om aan te gaan.
Kapitaalmark: ’n Finansiële mark waar besighede en regerings
langtermyn fondse kan bekom. Dit is ’n mark waar fondse
geleen kan word vir periodes langer as ’n jaar.
Kapitaalstruktuur: Die manier waarop ’n besigheid bates finansier
deur die optimale gebruik van ekwiteit en skuld.
Korporatiewe bestuur: Die raamwerk van reëls en aktiwiteite
waardeur bestuur op ’n verantwoordelike, regverdige en
deursigtige wyse met hul belanghebbendes kan omgaan.
Maatskappy: ’n Besigheid wat sekere wetlike voorskrifte moet nakom
om as ’n besigheid, onafhanklik en apart van sy eienaars, erken
te word. Maatskappye word deur die aandeelhouers besit.
Organisatoriese struktuur: Die wyse en omvang waartoe rolle,
seggenskap en verantwoordelikheid gedelegeer, gekontroleer en
gekoördineer word en hoe inligting tussen die verskillende
vlakke van bestuur vloei.
Rekeningkunde: Die sisteem van aantekening, kontrolering en
verslagdoening van die waarde van bates, laste, inkomste en
uitgawes in die rekeningkundige state (verslae) van ’n
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besigheid.
Sake etiek: Die toepassing van etiese standaarde in die sake
omgewing.
Vaste bates (nie-bedryfsbates): ’n Uitdrukking wat in rekeningkunde
gebruik word vir bates (soos eiendom en toerusting) wat nie
maklik in kontant omgeskakel kan word nie.
Vennootskap: ’n Besigheid met twee of meer individue wat fondse,
vaardighede en ander hulpbronne saamvoeg en wins en verlies
deel soos in die vennootskapsooreenkoms ooreengekom.
WEB RESOURCES
http://www.iodsa.co.za
http://www.jse.co.za
http://www.resbank.co.za
https://www.tei.org.za
REFERENCES
Brown, J. (2017). Dissent amid bonuses. Fin24. Retrieved from
https://www.fin24.com/Companies/Retail/dissent-amidbonuses-20170312-2 [1 March 2020].
Business Roundtable. (2019). Business Roundtable Redefines the
Purpose of a Corporation to Promote ‘An Economy That Serves All
Americans’. Retrieved from
https://www.businessroundtable.org/business-roundtableredefines-the-purpose-of-a-corporation-to-promote-aneconomy-that-serves-all-americans [1 March 2020].
Cokayne, R. (2017). Aspen fined R73.7m by Italian competition
body. IOL. Retrieved from https://www.iol.co.za/businessreport/aspen-fined-r737m-by-italian-competition-body-9797540
[1 March 2020].
Faku, D. (2019). Tiger Brands cuts dividend by 15 percent. Business
Report. Retrieved from https://www.iol.co.za/businessreport/companies/tiger-brands-cuts-dividend-by-15percent23831669 [11 November 2019].
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Hedley, N. (2019a). Tiger Brands reports lower sales in wake of the
listeriosis crisis. BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/companies/retail-andconsumer/2019-05-22-tiger-brands-reports-lower-sales-in-wakeof-the-listeriosis-crisis/ [11 November 2019].
Hedley, N. (2019b). Tiger Brands plans to fight against listeriosis
class-action lawsuit. BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/companies/retail-andconsumer/2019-04-17-tiger-brands-plans-to-fight-againstlisteriosis-class-action-lawsuit/ [11 November 2019].
Hutt, R. (2020). The economic effects of the COVID-19 coronavirus
around the world. World Economic Forum. Retrieved from
https://www.weforum.org/agenda/2020/02/coronaviruseconomic-effects-global-economy-trade-travel/ [1 March 2020].
Institute of Directors Southern Africa (IoDSA). (2016). King IV:
Report on Corporate Governance for South Africa 2016. Retrieved
from
https://cdn.ymaws.com/www.iodsa.co.za/resource/collection/684B68A7B768-465C-8214-E3A007F15A5A/IoDSA_King_IV_Report__WebVersion.pdf [1 March 2020]. Reprinted by permission of
Institute of Directors South Africa (IoDSA).
Jooste, R. (2019). How are SA’s new stock exchanges doing?
Business Maverick. Retrieved from
https://www.dailymaverick.co.za/article/2019-04-03-how-aresas-new-stock-exchanges-doing/ [1 March 2020].
Kahn, T. (2017). Aspen loses Italy appeal over cancer drug prices.
BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/companies/healthcare/201706-15-aspen-loses-italy-appeal-over-cancer-drug-prices/ [11
November 2019].
Kahn, T. (2019). Aspen shares dive after £8m UK fine. BusinessDay.
Retrieved from
https://www.businesslive.co.za/bd/companies/2019-08-14aspen-shares-fall-to-five-month-lows-on-8m-anti-competitivefine/ [11 November 2019].
Laing, R. (2018). Tiger Brands maintains dividend despite falling
sales and profit. BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/companies/retail-and******ebook converter DEMO Watermarks*******
consumer/2018-11-22-tiger-brands-maintains-dividend-despitefalling-sales-and-profit/ [11 November 2019].
Mahopo, Z. (2019). Listeriosis linked firm sued for lack of hygiene.
Sowetan Live. Retrieved from
https://www.sowetanlive.co.za/news/south-africa/2019-0417-listeriosis-linked-firm-sued-for-lack-of-hygiene/ [2 March
2020].
Mans-Kemp, N. & Viviers, S. (2018). Executive performance
evaluation and remuneration: Disclosure and practices of
selected listed South African companies (2002–2015). South
African Journal of Accounting Research, 32(2–3), 154 –173.
doi/full/10.1080/10291954.2018.1465149.
Mashego, P. (2019). Tiger feels the pain. TimesLIVE. Retrieved from
https://www.timeslive.co.za/sunday-times/business/2019-0526-tiger-feels-the-pain/ [2 March 2020].
Pnet. (2019). Retrieved from https://www.pnet.co.za/jobs-Finance-Manager-Johannesburg-East-Network-Finance-3032546-inline.html?
cid=msearche_jobs___AllJobscidPartner_jobscoza [10 September
2019].
ShareData Online. (2019a). Tiger Brands Ltd. Retrieved from
http://www.sharedata.co.za/v2/Scripts/Quote.aspx?
c=TBS&x=JSE [28 February 2020].
ShareData Online. (2019b). Aspen Holdings Ltd. Retrieved from
http://www.sharedata.co.za/v2/Scripts/Summary.aspx?
c=APN&x=JSE [11 November 2019].
Smith, A. (1776). The Wealth of Nations. Edited by Edwin Cannan,
1904. Reprint edition 1937. New York: Modern Library.
Available at http://media.bloomsbury.com/rep/files/primarysource-93-adam-smith-the-wealth-of-nations-on-joint-stockcompanies.pdf [1 March 2020].
South African Reserve Bank (SARB). (2019). Statement of the
Monetary Policy Committee. Retrieved from
https://www.resbank.co.za/Lists/News%20and%20Publications/Attachm
[1 March 2020].
South African Revenue Service (SARS). (2020). Small Business.
Retrieved from
https://www.sars.gov.za/ClientSegments/Businesses/SmallBusinesses/Pa
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[1 March 2020].
Struweg, I. (2018). Three major mistakes Tiger Brands made in
response to the listeriosis crisis. Mail & Guardian.
https://mg.co.za/article/2018-03-21-three-major-mistakestiger-brands-made-in-response-to-the-listeriosis-crisis [11
November 2019].
Tiger Brands. (2018). Integrated annual report 2018. Retrieved from
http://www.sharedata.co.za/data/000072/pdfs/TIGBRANDS_ar_sep18.pd
[11 November 2019].
Tiger Brands. (2019a). About us. Retrieved from
https://www.tigerbrands.com/en/aboutus [11 November
2019]. TIIH: Tiger Brands Limited Role Equity Issuer
Registration No. 1944/017881/06.
Tiger Brands. (2019b). Investor. Retrieved from
https://www.tigerbrands.com/investor [11 November 2019].
TIIH: Tiger Brands Limited Role Equity Issuer Registration No.
1944/017881/06.
Viviers, S. & Els, G. (2017). Responsible investing in South Africa:
Past, present and future. African Review of Economics and Finance,
9(1), 122–156.
World Bank Group. (2020). Global Economic Prospects. Retrieved
from https://www.worldbank.org/en/publication/globaleconomic-prospects#firstLink51635 [1 March 2020].
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2 Financial statements
Pierre Erasmus
Learning
outcomes
Chapter
outline
2.1
2.2
2.3
2.4
By the end of this chapter, you should be able to:
discuss the objective of financial reporting
identify the users of financial reporting
describe the information that is provided by
financial reporting
classify the characteristics of useful financial
information
discuss the objectives of integrated reporting
identify the components included in the main
types of financial statement
distinguish between the three main types of
financial statement
describe the formats of a statement of financial
position, a statement of profit or loss and a
statement of cash flows.
Introduction
The objective of financial reporting
Who are the users of financial reporting?
Information provided by financial
reporting
2.5 Qualitative characteristics of useful
financial information
2.6 Integrated reporting
2.7 Standardisation of financial statements
2.8 Statement of financial position
2.9 Statement of profit or loss
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2.10 Statement of cash flows
2.11 Conclusion
CASE STUDY
Excellence in financial reporting for Sasol Ltd
In 2019, Sasol once again finished among the top ten entities in
the Excellence in Integrated Reporting Awards, based on the
results of an annual survey conducted by Ernst & Young. Since
the inception of the award eight years ago, this South African
entity has consistently managed to achieve this
accomplishment. The award, which focuses on the quality of
financial reporting, gives recognition to those entities that
provide valuable additional information in their annual
integrated reports. Some of the aspects that are considered in
the evaluation of the integrated reports include sustainability
reporting, information about the risk to which the entity is
exposed and the extent to which it exceeds minimum reporting
levels. Increased emphasis is also being placed on the way in
which entities report forward-looking information that will
enable the users of the financial statements to determine what
the entity’s targets and objectives are as well as what risks it
may face in the future.
An entity’s integrated report is intended to address some of
the limitations associated with the traditional format of
financial reporting. Among others, the focus is placed on those
factors that impact on the entity’s ability to create value over
time. Instead of disclosing only the financial capital that an
entity has employed, integrated reporting requires that
management report on all six capitals, representing the
financial, manufactured, natural, human, intellectual, and
social and relationship capital required to create value.
In the case of Sasol, the financial review included as part of
the integrated report provides a future-focused framework of
how the entity employs its capital to ensure long-term value
creation. A detailed explanation of the most important aspects
that could impact on the entity’s ability to generate sustainable
value provides stakeholders with additional information
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regarding the potential risks it will have to face as well as the
manner in which these risks will be addressed. The Excellence
in Integrated Reporting Awards also lists those entities that
provide only the minimum amount of information in order to
comply with accounting standards. These entities, which
obtained only a basic classification in the survey, provide very
limited information in their financial reports. An analysis of
their expected future cash flows on the basis of their published
financial statements will, therefore, be much more difficult
than in the case of an entity such as Sasol. Given the level of
distrust that currently exists between society and entities,
improved communication by means of detailed integrated
reports could help all stakeholders obtain a better
understanding of an entity’s ability to contribute towards longterm sustainable value creation.
Sources: Compiled from information in Graham, 2019; Integrated Reporting Committee of South
Africa, 2019.
2.1
Introduction
Suppose that you want to invest some of your hard-earned savings
in the shares of an entity. After reading about the quality of Sasol’s
financial reporting, you assume that it should be relatively easy to
obtain high-quality information about the entity from its annual
integrated reports. You decide to evaluate your potential
investment in the entity by analysing its published annual financial
statements and to base your investment decision on the results of
this analysis. When you download the entity’s 2018 annual financial
statements from its website, however, you are shocked to discover
that they contain a huge amount of information over a total of 158
pages, while the integrated report consists of an additional 98
pages. Furthermore, the format of the information is not necessarily
geared towards answering your questions about investing in the
entity’s shares. Now the task of analysing Sasol’s financial
statements may not seem to be quite so simple.
When attempting to analyse the financial position of an entity,
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external capital providers often struggle to obtain relevant financial
information about the entity. One of the main sources of
information that could give capital providers some of the answers
to their questions is the entity’s annual financial reports. Entities are
required to publish financial reports, which include a set of
financial statements, at the end of their financial year. These
statements should provide financial information about the entity
that is useful to its existing and potential investors, lenders and
other creditors.
The challenge, however, is to unpack the information provided
and to convert it into a format that facilitates financial analysis and
comparison. The statements are compiled according to various
accounting standards. As seen in the opening case study, some
entities only provide the minimum amount of information required
by these standards. Other problems are that the quality of financial
reporting may differ substantially, and the information provided in
published financial statements cannot always be compared with
different entities and over time.
In this chapter, we help you make sense of financial statements.
We introduce the three main types of financial statement that are
published as part of an entity’s annual financial report. Before
considering the format of these financial statements, it is important
that you understand the nature of the information that is provided
in an entity’s financial reports. Thus we provide a brief overview of
the objective of an entity’s financial reports as well as the primary
users of these reports and the characteristics of the information
contained in them. Then we discuss the development of integrated
reporting over the last few years, with a specific focus on the six
capitals that an entity employs. Next, we address the need to
standardise financial statements in order to simplify comparisons.
Finally, we discuss the components and formats of the statement of
financial position, statement of profit or loss and statement of cash
flows in detail.
In Chapter 3, we look at ways of evaluating an entity’s financial
position and performance by conducting a ratio analysis based on
these financial statements.
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2.2
The objective of financial reporting
Before you attempt to analyse the financial information provided in
Sasol’s financial statements, it is important that you understand the
nature of the information that is reported. Most of the entities that
are listed on the Johannesburg Stock Exchange (‘the JSE’) prepare
and present their financial reports according to the International
Financial Reporting Standards® (‘the IFRS® Standards’). These
standards are developed and approved by the International
Accounting Standards Board (‘the Board’), and are based on the
Conceptual Framework for Financial Reporting (‘the IFRS
Framework’). The first version of the IFRS Framework was issued
in 1989. It was partially revised in 2010. In March 2018, the Board
issued the latest revision of the IFRS Framework.
The IFRS Framework sets out the basic concepts that are
incorporated during the preparation and presentation of an entity’s
financial reports. The objective of financial reporting forms the
foundation of the IFRS Framework. This objective identifies the
primary users of financial reporting, and defines the type and the
nature of the information that should be provided to them. The
focus is placed on the information needs of an entity’s external
capital providers, who use this information to support their
decisions.
According to the IFRS Framework, the objective of financial
statements is “to provide information about an entity’s assets,
liabilities, equity, income and expenses that is useful to financial
statements users in assessing the prospects for future net cash
inflows to the entity and in assessing management’s stewardship of
the entity’s resources” (Deloitte, 2019). This information is
communicated to users by means of a set of financial statements,
consisting of the statement of financial position, the statement(s) of
financial performance (incorporating the statement of profit or loss
and other comprehensive income), the statement of changes in
equity, the statement of cash flows and the notes to these financial
statements.
Therefore, your idea of using Sasol’s financial statements as a
source of information seems to be justified: financial reporting
appears to centre on the provision of financial information about an
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entity. As a potential external capital provider without access to
detailed internal information about the entity, you would welcome
a source of information that fulfils your needs. More specifically, as
a potential share investor, you require specific information that
relates to the entity’s equity providers. It is also important that you
be able to evaluate your decision to invest in the entity’s shares (or
not, as the case may be) on the basis of the information obtained
from the financial reports. Bearing in mind the objective of financial
reporting explained above, the following three aspects should be of
importance to you:
• An entity’s existing and potential external capital providers,
which includes potential shareholders such as yourself, are
considered the primary users of financial information. Financial
reporting is therefore specifically directed towards the
information needs of these external capital providers. Financial
statements are thus a valuable source of information for external
capital providers: both those that have already provided capital
as well as potential future capital providers.
• Financial reporting provides financial information about the
entity’s economic resources, claims on these resources, and
changes in the resources and claims. In addition, it provides
information about how efficiently and effectively the economic
resources are being employed by management to ensure the
sustainability of the entity. This type of information is exactly
what is required by external capital providers when making
decisions about their capital contributions. You should therefore
be able to obtain the type of information regarding the
company’s financial position and performance that is relevant to
equity providers.
• Financial reporting attempts to provide useful financial
information that can be utilised by external capital providers to
inform their decision making. This means information that
possesses both the fundamental qualitative characteristics of
useful financial information and as many of the enhancing
characteristics as possible. You should therefore find that the
financial information reported in the financial statements
facilitates your investment decision.
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Although it is not necessary for you to study the details of the
accounting standards that direct entities’ financial reporting, you
should nevertheless develop an understanding of the influence
these standards have on the information reported in the financial
statements. Since the accounting standards are based on the
objective of financial reporting contained in the IFRS Framework,
the three aspects that were highlighted above are discussed in more
detail in the sections that follow.
QUICK QUIZ
What is the objective of financial reporting?
2.3
Who are the users of financial reporting?
Published annual financial reports are usually made available to all
the entity’s existing shareholders. It is important to be aware,
however, that it is not only the existing shareholders who are
interested in the information presented by the financial statements.
Although various stakeholders may be interested in an entity’s
financial information, its external capital providers are considered
to be the most important users of financial reporting because they
need to rely on the information provided in the entity’s financial
statements to assist them in their decisions about where to allocate
capital. The information provided in financial reports also supports
external capital providers in making informed decisions when
participating in voting on important corporate actions. In addition,
it assists them in evaluating management performance and in
deciding whether some form of intervention is required to address
areas of concern.
Consequently, the entity’s existing and potential equity
investors, lenders and other creditors are defined as the primary
users of financial reporting. Although the equity investors are
considered to be the owners of an entity, the only time they receive
a reward for their investment is if management decides to declare
dividends or another form of cash distribution, or if an increase in
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the company’s share price results in a capital gain. These investors
are interested in an entity’s ability to generate net cash inflows,
since this influences their dividend payments, and the market’s
perception of the entity’s ability to generate net cash inflows, since
this perception will influence its share price. Consequently, their
investment decisions are influenced by the amounts, timing and
uncertainties of an entity’s net cash inflows (as highlighted in
Chapter 9).
Lenders and other creditors are also interested in an entity’s
ability to generate net cash inflows, since these cash inflows are
required to make interest payments and finance the repayments of
the capital they provided to the entity. They will therefore focus on
similar factors as equity investors when deciding whether to
provide debt capital to an entity.
An entity’s tax calculation is conducted on the basis of the
information contained in the financial statements. To determine if
the calculations are correct, the South African Revenue Service
(SARS) requires entities to provide annual financial statements.
Other government organisations also use the financial statements to
obtain important economic statistics.
To ensure efficient internal decision making, it is also necessary
that the management of an entity always be informed about its
financial position. Management uses the financial statements, along
with other tools, to determine if its objectives have been achieved,
and for planning and control purposes.
Finally, although financial reporting is primarily for the benefit
of investors and credit providers, it is also useful to other
stakeholders not directly involved in the activities of an entity.
Examples of these are the entity’s clients, suppliers and
competitors, and stockbrokers.
Although a large amount of useful financial information is
provided by the financial reports, the users of financial information
may require additional information to make their economic
decisions. They may need to consider other pertinent sources of
information, including the Internet, trade reports and economic
forecasts.
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QUICK QUIZ
1. Identify the primary users of financial
reports.
2. Identify other stakeholders that may use an
entity’s financial reports.
2.4
Information provided by financial reporting
Financial reporting provides information about an entity’s
economic resources (its assets) and the claims on these resources (its
equity and liabilities). It also reflects information about an entity’s
financial performance as well as other transactions and events that
resulted in changes in its resources and claims. This information is
useful to the users of financial reporting because it helps them
evaluate an entity’s ability to generate net cash inflows. The
information can also be used to assess how effectively and
efficiently management has fulfilled its responsibility as steward of
the entity’s resources.
If you are interested in investing in Sasol, the first thing you
need to know about the entity is how strong or weak it is financially
(you should definitely not invest money in an entity with serious
financial problems.) The financial position of an entity is influenced
by the economic resources available to it and the capital structure
used to finance these resources. Its financial position is evaluated by
focusing on the assets, the liabilities and the shareholders’ equity,
which are indicated in the statement of financial position (also
known as the balance sheet). In the case of Sasol, you will,
therefore, focus on the assets that the entity owns and on how they
are financed.
The second question you need to address is whether Sasol is
making a profit or a loss. The financial performance of an entity
refers to its ability to generate income with its available assets. This
is evaluated by focusing on the income and expenses, as provided
in the statement of profit or loss (or income statement). In your
analysis of Sasol, you will consider, therefore, all the income
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generated during the financial year and compare it with the
expenses required in order to achieve this income. Investors are
usually interested in an entity’s earnings. This profit figure refers to
the profit that is attributable to the ordinary shareholders of the
entity. Because part of your investment return may be in the form
of dividend payments, you need to determine if any profits remain
after all the other expenses have been paid, since these profits will
be attributable to the ordinary shareholders. An entity’s board of
directors usually decides what portion of the attributable profit is
paid out as dividends and what portion is reinvested in the entity.
The final question we need to consider is what changes occurred
in the entity during the financial year. Changes in the financial
position of an entity depend on the investment, financing and
operating activities of that entity during the year. The statement of
cash flows (or cash flow statement) provides a summary of these
activities. We will, therefore, investigate Sasol’s statement of cash
flows to learn more about the cash generated or spent on operating,
investing and financing activities.
Focusing on these financial aspects alone, however, is not
sufficient. Analysts (and potential shareholders, such as yourself)
also need to investigate the risk associated with an entity as part of
their financial evaluation. For this purpose, it is important that the
financial statements and the notes to these statements contain
sufficient additional information to enable the evaluation of risk.
This type of information will be of great value during periods of
uncertainty because it should help an analyst understand what
effect economic changes may have on the future financial situation
of the entity.
QUICK QUIZ
Explain what information financial reporting
should provide.
2.5
Qualitative characteristics of useful financial
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information
An entity’s existing and potential external capital providers are
interested in its financial reporting because it provides useful
financial information on which they can base their decisions about
providing resources to the entity. Based on this information, the
external capital providers can decide whether to contribute
additional debt or equity capital, to maintain their current positions
or to reduce the levels of their current contributions.
To ensure that the financial information provided by financial
reporting is useful, the IFRS Framework identifies a number of
qualitative characteristics associated with the type of information
that will be most useful to the primary users of financial reporting.
• The first fundamental characteristic of useful financial
information is that the information provided in the financial
statements must be relevant to users. This means that
information should enable the external capital providers to
evaluate the historical, current and expected future changes that
may have an effect on the entity. They should also be able to use
the information to determine if their previous evaluations were
correct and, if not, to determine the necessary adjustments to be
made. This requirement is of great importance to a potential
shareholder such as yourself because it will enable you to make
an informed decision about investing in the entity.
• The second fundamental characteristic of useful financial
information is that the information should be faithfully
represented. This means that the information included in the
financial statements should be complete and should provide
sufficient detail to the users of financial information.
Furthermore, the information should be represented in a neutral
way that does not contain selection or representation bias.
Finally, the information should be error-free. Although a certain
level of measurement uncertainty may be associated with some
financial information included as part of an entity’s financial
statements, information is still considered useful if it is deemed
to be relevant and an attempt is made to represent the
information faithfully.
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These requirements enable the users of the financial statements to
obtain an accurate summary of the financial performance and
position of the entity. For example, if Sasol included inaccurate or
subjective information in its financial statements, it could cause you
to arrive at the wrong conclusions about the future financial
performance of the entity.
The usefulness of financial information is enhanced if the
information is also comparable, verifiable, timely and
understandable. According to the IFRS Framework, these four
characteristics are classified as enhancing qualitative characteristics
of useful financial information.
To increase the usefulness of the information provided to the
users of an entity’s financial reports, it is essential that the financial
information be comparable. In order to identify trends in the
financial performance and situation of an entity, the information
needs to be comparable over time. It should also be possible to
compare the financial information of different entities in order to
evaluate the performance of one entity against another. When
evaluating Sasol, you will be interested in knowing if the ability of
the entity to generate net cash inflows has improved over time. You
may also be interested in comparing the entity with another entity
to determine which one provides the best investment opportunity.
Since the entity’s external capital providers rely heavily on the
financial information reported in its financial reports, it is important
that the information be verifiable. This assures the users of financial
information that the information included in the financial
statements faithfully represents what it purports to represent.
Furthermore, information is only useful if it is made available
during the period in which it could have an effect on the users’
decisions. Timeliness is therefore considered to be an enhancing
characteristic of useful financial information. As a potential
investor, you would be dissatisfied if Sasol delayed the release of
important information that might have an influence on the expected
return on your investment.
The usefulness of financial information can also be enhanced by
ensuring that it is understandable. In order to provide the
information required by the users of the financial statements,
financial reports should be produced in such a way that the users of
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the reports can understand the information. In the Ernst & Young
Excellence in Integrated Reporting Awards (discussed in the
opening case study), the judges’ feedback for Sasol highlighted the
excellent explanations provided in the entity’s integrated annual
report. These explanations contribute towards improving the
understandability of information about the entity’s business model,
value chain and risk reporting.
QUICK QUIZ
1. Discuss the fundamental characteristics of
useful financial information.
2. What are the enhancing characteristics of
useful financial information?
2.6
Integrated reporting
Although financial reporting is an important source of information,
it is predominantly focused on providing financial information to
an entity’s external capital providers. Traditional financial
statements are increasingly being criticised as being short-sighted
and only focused on historical financial performance relevant to the
entity’s external capital providers. Often these statements contain
limited information about the potential challenges an entity may
face in the future. Sufficient detail regarding management’s strategy
to utilise the entity’s economic resources efficiently and how
management intends to address future challenges may also be
lacking. Additional non-financial information is required by users
who are attempting to evaluate an entity’s ability to continue
generating sustainable value. Since an entity does not operate in
isolation, it is also necessary that the focus of its reporting be
extended to include all stakeholders and not only its external
capital providers.
Over the past two decades, a marked increase in the level of
disclosure required from an entity has been observed. As a result of
increased pressure from various stakeholder groups and a changing
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regulatory environment, corporate reporting started to incorporate
environmental aspects, employee-related issues and corporate
social responsibility concerns by including a separate sustainability
report as part of the annual reports. Although this provided some
of the additional information required, many entities failed to
highlight the link between the financial and non-financial
information contained in the different reports. Limited attention
was also often given to how management intended addressing
sustainability concerns.
In an attempt to improve the efficiency of corporate reporting,
integrated reporting has been presented as a framework to enable
an entity to provide a more comprehensive overview of its
performance. Integrated reporting therefore extends beyond
focusing purely on financial performance by also considering
sustainability reporting, management commentary, corporate
governance aspects and so on. According to the International
Integrated Reporting Council, an integrated report is a “concise
communication about how an organization’s strategy, governance,
performance and prospects, in the context of its external
environment, lead to the creation of value over the short, medium
and long term” (IIRC, 2013: 7). Recognising the diverse set of factors
that are required to ensure long-term value creation and
highlighting the interdependencies between them is intended to
promote a more integrated approach to decision making and
planning, which should ultimately benefit all stakeholders.
To ensure sustainable value creation, it is therefore important to
understand the external factors that influence an entity, to identify
capital requirements in terms of the resources and relationships
required by the entity, and to explain how the entity interacts with
these external factors and capital requirements to create value.
Describing and measuring these key components of value creation
provides a much broader overview of performance than merely the
financial dimension, and requires that management reflect on both
the past and the expected future performance of the entity.
Management’s accountability is extended to cover a broader base
than just the entity’s financial capital by also focusing on its
manufactured, natural, human, intellectual, and social and
relationship capital requirements.
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Within the context of integrated reporting, financial capital
refers to funds available for the normal operations of an entity that
were obtained from external capital providers or generated
internally. Manufactured capital denotes the manufactured physical
objects that are available for normal operations, and includes items
such as buildings, equipment and infrastructure (for example,
waste and water treatment plants, roads and ports). Natural capital
includes all inputs required for the production of goods or services,
such as water, minerals and land. It also relates to the impact an
entity’s activities has on natural capital, such as biodiversity and
ecosystem health. Human capital incorporates aspects such as an
individual’s skills, experience, capacity to innovate, and ability to
understand and implement strategy. Intellectual capital refers to
intangible assets that provide an entity with a competitive
advantage. These include patents, copyrights and computer
software as well as the brand value and reputation associated with
the entity. Social and relationship capital represents institutions
contributing towards societal well-being as well as the relationships
between the entity and its community, different stakeholders and
other networks.
Although the publication of an integrated report is not
compulsory for all entities, entities listed on the JSE have been
required to provide an integrated report since 2010. Over time, the
quality of integrated reporting has improved, with positive trends
observed in terms of corporate governance and risk disclosure, and
the integration between financial information and sustainable value
creation. Among the problem areas identified in terms of integrated
reporting quality are the failure to link key performance indicators
and remuneration to future value creation, limited reporting of
environmental factors, and the tendency to exclude negative
outcomes and trade-offs from integrated reports. Addressing these
challenges would substantially improve the quality of the
information that is available to an entity’s different stakeholders.
QUICK QUIZ
1. Discuss the additional information provided by
integrated reporting.
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2. Distinguish between the six capitals included
as part of the integrated reporting framework.
2.7
Standardisation of financial statements
As pointed out in Section 2.5, one of the most important
characteristics of financial information is that it should be
comparable. The problem that often arises when we analyse
financial statements, however, is that the published financial
statements of different entities may not contain comparable
financial information. Although the published financial statements
that are provided as part of the annual reports are compiled
according to accounting standards, it is possible for two entities to
apply different accounting standards to report on the same item in
their financial statements. An entity may also change from one
accounting standard to another between two reporting dates. Over
the last few years, most South African entities have adopted the
IFRS Standards. Changes in the accounting standards that are used
to compile financial statements could have a noticeable effect on the
reported figures. If these changes are not recognised and included
during financial analysis, the result could be inaccurate and
inappropriate comparisons between items and over time.
Thus, the question that arises is one of how comparisons
between financial statements should be made. The way in which
analysts usually solve this problem is by standardising financial
statements in order to facilitate comparison between different
entities and across time. Standardised statements also simplify the
calculation of financial ratios (discussed in Chapter 3), which are
used to measure and evaluate financial performance. In some cases,
the standardisation process is straightforward and the items can
simply be obtained from the corresponding published financial
statements. In the case of other items, however, the process is more
complex. It may be necessary to consider both the statements and
the notes to the statements to obtain all the information that is
needed.
The purpose of this chapter is not to focus on the accounting
process that is followed to compile financial statements.
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Nevertheless, it is important to have a clear understanding of the
structure and components of these statements, and to be able to
distinguish between the various contributing items. Examples of
the three most important financial statements – the statement of
financial position, the statement of profit or loss and the statement
of cash flows – are discussed in the next sections of this chapter.
These statements are compiled with reference to the published
financial statements included in Sasol’s 2018 annual report, which
can
be
downloaded
from
the
entity’s
website
(https://www.sasol.com/investor-centre/financialreporting/annual-financial-statements/latest).
QUICK QUIZ
Explain the need to standardise financial
statements.
2.8
Statement of financial position
Your first concern with regard to your investment in Sasol is
whether or not the entity is in a strong financial position. The
statement of financial position provides a summary of an entity’s
financial position at a specific date (usually the end of its financial
year). A statement of financial position is organised into two
sections, distinguishing between its assets and its equity and
liabilities.
The asset section provides an indication of the resources that are
available to the company. The equity and liability section, on the
other hand, contains the various sources of capital used to finance
these assets and represents the claims on the entity’s resources. A
statement of financial position is, therefore, a summary of the
capital that was obtained by the entity over a certain period of time
and a breakdown of how this capital was deployed within the
entity. By investigating Sasol’s statement of financial position, you
should be able to learn more about the types of asset that the entity
has. Furthermore, you will be able to determine which forms of
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capital were used to finance these assets. Most importantly, you
should be able to determine to what extent the assets are financed
by means of debt capital and whether the entity will be able to meet
these obligations. Entities that have insufficient assets to cover their
liabilities may struggle to continue to exist.
The major elements reflected by the two sections of the
statement of financial position are summarised in Figure 2.1.
Figure 2.1 Major elements of a statement of financial position
The number of items reflected in a standardised financial statement
is usually determined by the purpose of your investigation. If an
analyst wants to obtain a broad overview of an entity’s total size or
determine the portion of equity capital used to finance the entity, it
may be sufficient to focus on the core items from the statement of
financial position, such as those provided in Figure 2.1. When
attempting to analyse something more complex, such as an entity’s
capital intensity, for instance, it becomes necessary to obtain a more
detailed breakdown of the various items included in the statement.
The size and complexity of the entity being reviewed also
influence the number of items that have to be considered. Smaller
entities may reflect simpler organisational structures than Sasol,
resulting in fewer items and less detailed information being
presented in their financial statements. When attempting to
compare Sasol to such an entity, it therefore becomes necessary to
aggregate the detailed information contained in its financial
statements under the broad items reflected by the smaller entity.
This is illustrated in Example 2.1.
Example 2.1 Understanding the details required in standardised financial
statements
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Spanjaard Ltd, a much smaller producer of chemical products than Sasol,
released its 2018 integrated annual report in February 2018 (the statement
can be downloaded from the entity’s website at www.spanjaard.biz/financials/).
In contrast to the 256 pages of information provided in Sasol’s annual
integrated and financial reports, Spanjaard’s integrated annual report consists
of only 94 pages. While the assets section of Sasol’s statement of financial
position includes 17 separate asset items, Spanjaard disclosed only 11 items.
If you are interested in estimating the size of the two entities by referring to
their total assets, this difference in the level of detail is not important.
Comparing Sasol’s total assets of approximately R440 billion with Spanjaard’s
total assets of R64 million should leave no doubt about the relative sizes of the
two entities. If you need to differentiate between the two entities’ asset
structures based on the relative contributions of the current and non-current
assets to the total assets, a quick comparison of the major elements reflected
in their statements of financial position should also be sufficient. Whereas the
majority of Sasol’s assets consist of non-current assets (82%), Spanjaard
invested only around 48% of its capital in non-current assets.
A more detailed analysis of the two entities’ assets emphasises the need
for standardisation. Spanjaard discloses intangibles and goodwill as two
separate items in its statement of financial position. The notes to the financial
statements reveal detailed information regarding these two items. In contrast,
Sasol reports the combined value of the two items, without providing additional
information on the composition of the amount disclosed. A direct comparison
between the two entities’ intangible assets and goodwill will only be possible
once these different classifications have been standardised.
Table 2.1 is an example of a statement of financial position based on
Sasol’s 2018 published financial statements. Although Table 2.1
contains many more items than the basic form of a statement of
financial position (as indicated in Figure 2.1), the major elements
are present in all entities’ financial statements.
Table 2.1 Example of a statement of financial position (based on Sasol Ltd at 30 June 2018)
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Source: Based on information at Sasol Ltd, 2018: 41.
Note that the first International Accounting Standard (IAS® 1)
requires that an entity provide comparative information when
presenting the statement of financial position. The minimum
requirement calls for the inclusion of the previous financial year’s
statement and notes. The comparative values for 2017 and 2016
provided in Sasol’s statement of financial position enable users of
the statement to compare changes that occurred over time. In cases
where an entity has applied an accounting policy retrospectively, or
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restated or reclassified items in the statement of financial position
that had a material impact on the information reflected in the
statement, two previous years’ statements should be provided.
The sections that follow examine the various items included in
the statement of financial position in more detail.
2.8.1
Assets
Assets represent a capital investment, usually with the idea of
applying the assets economically in order to generate income.
When evaluating an entity’s assets, it is normally possible to
distinguish between non-current and current assets. This distinction
is based on how the assets are applied as well as the period of time
over which they will be utilised.
2.8.1.1
Non-current assets
In those cases where assets are applied for a relatively long period
of time (more than one year), they are classified as non-current
assets. Based on the nature of the various assets classified as noncurrent assets, three broad types of asset are usually observed:
tangible, intangible and financial non-current assets. When
measuring the values of those items included as part of the noncurrent assets, an entity could select either an historical cost or a
current value measurement base. Historical cost measurement
bases provide information about the price at which an item was
initially purchased. If the historical cost declines over time, the
value reflected in the statement of financial position is adjusted to
reflect the impairment in value. In contrast, current value
measurement bases provide information that reflects the value of an
item at the reporting date. Reported values are adjusted to reflect
current conditions at the end of the entity’s financial year.
For most entities, tangible non-current assets – such as property,
equipment, vehicles, buildings and production facilities – form the
largest portion of the total assets. These assets are categorised as
property, plant and equipment (PPE) in the statement of financial
position. If an historical cost measurement base is applied, PPE is
indicated at its original purchase price (cost price). All the
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depreciation on the PPE that was included in the statement of profit
or loss over time is accumulated in the statement of financial
position under the accumulated depreciation amount. The balance
of this item provides an indication of the total amount of
depreciation that has been provided for on the PPE. Subtracting the
accumulated depreciation from the PPE at cost price gives an
indication of the carrying value of the assets. When items of PPE are
sold, the sales proceeds are compared with the carrying value to
determine if a profit or a loss has been generated by the transaction.
If a company has been using an item of PPE for a relatively long
period of time, the current replacement value may be substantially
higher than the historical cost. Evaluating the financial position of a
company based on historical cost values could result in an
underestimation of the company’s resources. This is considered to
be one of the major weaknesses of historical cost measurement
bases.
To overcome this problem, an entity could decide to select a
current value measurement base. One solution would be to disclose
the current values of the assets in the statement of financial position
by increasing the PPE value to reflect the current amount required
to replace the assets. The amount by which the PPE value is
increased will then be reflected as a revaluation reserve and
included as part of the entity’s equity. Alternatively, the items
included as part of PPE could be measured based on their fair
value. The fair value is based on the price that would be received if
the item were sold at the reporting date. A third approach would be
to estimate the value in use associated with the assets. This value
reflects the entity’s expectations about the amount, timing and
uncertainty of the future cash flows it expects to generate from
employing the assets.
Another tangible asset that is included as part of Sasol’s noncurrent assets is assets under construction. This item refers to assets
that are not yet completed and is shown separately from the PPE
figure because no depreciation is calculated on these items at this
point. Once construction has been completed, these assets are
included as part of PPE.
Unlike PPE and assets under construction, which consist of
tangible assets, goodwill, patent rights and manufacturing licences
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are examples of intangible non-current assets. Although these assets
are intangible, they still constitute resources controlled by the entity
that can be used to generate future economic benefits. As long as
the cost or value of an intangible asset can be measured reliably, it
will be classified as part of the non-current assets. Sasol’s intangible
assets include computer software, emission rights, and patents and
trademarks on which royalty payments are received. Another
intangible asset that may be found on the face of the statement of
financial position is goodwill (something that is not shown on
Sasol’s current financial statements). Goodwill is an asset
representing the future economic benefits produced by assets
acquired in a merger or acquisition that are not recognised
individually. One of the major problems associated with intangible
assets is their valuation. In most cases, it is difficult to allocate a
monetary value to intangible assets. Usually, a distinction is made
between specifically identifiable and non-identifiable intangible
assets. In the case of specifically identifiable intangible assets, such
as computer software, it is possible to provide amortisation over the
lifetime of the asset. For non-identifiable assets, such as goodwill, it
is not possible to provide for annual amortisation. Therefore,
annual impairment tests are conducted to compare the current
valuation of the goodwill with the value shown in the financial
statements. Any decrease in the value of the goodwill is written
down as an expense in the entity’s statement of profit or loss.
Long-term financial assets, such as investments in listed or
unlisted securities, long-term derivative financial instruments, longterm loans granted, long-term receivables and prepaid expenses are
also classified as non-current assets. Financial assets are reported at
fair value in the statement of financial position. Depending on the
type of financial asset, its fair value is usually estimated by
considering its current market value or original purchase price.
If an entity owns between 20% and 50% of the shares in another
entity, it is classified as an associated company. Equity-accounted
investments represent associated companies as well as investments
in joint ventures where the entity owns between 20% and 50% of
the shares in the partner company. Sasol, for instance, owns 49% of
the Qatar-based company ORYX GTL Ltd in terms of a joint
venture between the two entities, valued at R8,179 billion. This is
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reflected as part of the R10,99 billion equity-accounted investments
reported at the end of the 2018 financial year. All investments in the
shares of other entities (listed or unlisted) where the shareholding is
less than 20% are included as part of other long-term investments.
During 2018, Sasol reported other long-term investments to the
value of R951 million.
If an enterprise grants long-term loans to other parties (such as
employees, directors or other enterprises), these loans are also
included as non-current assets. Sasol reports long-term loans
granted (R2,582 billion), long-term interest-bearing receivables from
joint ventures (R1,204 billion) and long-term prepaid expenses
(R860 million) during 2018. Collectively, these items are categorised
as long-term receivables and prepaid expenses with a total value of
R4,646 billion. Long-term financial assets of R291 million are also
reported.
The post-retirement benefit assets reported as part of the noncurrent assets relate to post-retirement healthcare benefits and
pension benefits that the entity has to provide to employees once
they retire. The item reflects the assets available to cover claims by
retired employees that are part of the entity’s defined benefit plan.
A more detailed discussion of post-retirement benefit plans is
provided in Section 2.8.3.1.
Entities usually estimate the expected lifetime of assets and
calculate depreciation over this period. SARS allows entities to
deduct depreciation for tax purposes, based on allowances for wear
and tear provided for different asset classes (refer to
http://www.sars.gov.za/AllDocs/LegalDoclib/Rulings/LAPDIntR-R-BGR-2012-07%20%20Wear%20And%20Tear%20Depreciation%20Allowance.pdf for
more information on the rates prescribed for wear-and-tear
allowances). Differences in the accounting and tax treatment of
depreciation and wear-and-tear allowances can result in deferred
tax assets. This is illustrated in Example 2.2.
Example 2.2 Understanding deferred tax
Assume that you buy a delivery vehicle at a cost of R150 000. The expected
lifetime of the vehicle is estimated at two years, and you decide to calculate
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straight-line depreciation over this period. Suppose that for tax purposes,
however, SARS prescribes a wear-and-tear allowance that is calculated over a
period of three years. The difference between the wear-and-tear allowance
and the depreciation calculated using the two approaches is as follows:
Wear-and-tear allowance based on three years =
Depreciation based on two years =
Therefore, there is a difference between the amount of depreciation subtracted
in the statement of profit or loss and the wear-and-tear allowance allowed for
tax purposes. The period over which the two amounts are subtracted also
differs. The resulting difference in the tax amount shown in the statement of
profit or loss and the tax calculation completed to determine the tax payable to
SARS is as calculated in the table that follows.
In this example, the tax amount included in the statement of profit or loss
during the first two years will be lower than the tax amount paid to SARS
because the larger depreciation amount that is deducted will result in a lower
profit before tax. During year 3, however, the situation is reversed. The tax
amount included in the statement of profit or loss will now be larger than the
tax amount paid to SARS because the profit before tax value is larger than the
figure used for tax purposes. This results in the creation of a deferred tax asset
in years 1 and 2 of R7 500 each, and a reversal of R15 000 in year 3.
2.8.1.2
Current assets
Assets that are used for a relatively short period of time (usually
less than one year) are classified as current assets. Current assets are
usually part of, or used during, the production process. Sasol, for
instance, uses coal and crude oil to manufacture fuels in some of its
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processes. The coal forms part of the entity’s inventory and will
eventually be part of the finished products that are sold. In most
cases, it is possible to convert these current assets into cash quickly
and with relative ease.
The difference between non-current and current assets is usually
based on the following criteria:
• turnover rate of the capital (in other words, for how long the
item will be used)
• ease of conversion (in other words, how easy it is to convert the
item into cash)
• physical characteristics (for instance, fixed goods as opposed to
non-fixed goods).
All items required for the operations of an entity are included as
part of inventories. Many different types of item are included as
inventory, depending on the type of enterprise. In the case of a
manufacturing business, for instance, the inventory consists of the
raw materials used in the production processes. The inventory of a
retailer, on the other hand, consists of the finished goods that are
sold in its retail outlets. As mentioned above, a large portion of
Sasol’s inventory comprises the crude oil and other raw materials
used in its various processes. Other items included as part of Sasol’s
inventory are process and maintenance materials, work-in-process
and manufactured products not yet sold.
In cases where an entity allows credit sales, a certain portion of
these credit sales is normally still outstanding on the date on which
the statement of financial position is compiled. These outstanding
amounts are included under trade receivables. Any other
outstanding amounts that are not the result of the entity’s normal
operating activities are indicated as other receivables. Sasol also
includes employee payables and prepaid expenses (prepayments)
as part of this figure.
Cash and cash equivalents include the physical cash held on site
(for instance, the petty cash that is used to cover day-to-day
expenses) and the cash held in bank accounts. Cash restricted for
specific purposes, such as cash deposits serving as collateral for
bank guarantees, cash held in trust and cash held in terms of joint
operations, are also included in this amount.
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Short-term financial assets and short-term investments reflect
financial assets and investments with a lifetime of less than one
year. Examples of these items that are included in Sasol’s statement
of financial position are short-term forward exchange contracts and
commodity derivatives.
Tax receivable reflects tax repayments from SARS that are still
outstanding at the end of the financial year and where it is expected
that the repayment will take place within the next financial year.
The final item reported as part of Sasol’s current assets
represents assets in disposal groups held for sale. The value of R113
million reported in the 2018 statement of financial position includes
the R110 million carrying value of the Performance Chemicals Heat
Transfer Fuels business, which is expected to be sold during the
next financial year.
2.8.2
Total equity
The equity section of the statement of financial position provides a
breakdown of the different forms of equity capital used to finance
the entity’s assets. All capital provided by the shareholders of the
entity is included here. It is important to distinguish between the
contributions of the different types of shareholder that an entity
may have. A distinction is usually made between ordinary
shareholders’ equity, preference share capital and the noncontrolling interest.
The ordinary shareholders’ equity represents the total
shareholding of the ordinary shareholders in the entity, and
consists of the ordinary share capital, reserves and retained
earnings. The proceeds from the sale of ordinary shares to the
shareholders represent their portion of the ownership and
management of the business, and is reflected by the share capital. In
2018, Sasol reported issued share capital to the value of R15,775
billion.
A number of reserves are included as part of the ordinary
shareholders’ equity. Reserves reported in Sasol’s statement of
financial position include the investment fair value reserve, the
foreign currency translation reserve, the cash flow hedge
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accounting reserve and the remeasurement on post-retirement
benefits reserve. Another important item that is included here is the
entity’s share-based payment reserve. This reserve includes the
value of the Sasol Inzalo and Khanyisa share transactions, Sasol’s
previous and current broad-based black economic empowerment
(B-BBEE) programmes. It also reflects the Sasol long-term incentive
scheme.
The final item that is included as part of the entity’s ordinary
shareholders’ equity is the retained earnings. This represents the
accumulation of earnings that are not paid out to the shareholders,
but are instead reinvested in the business. During 2018, Sasol
reported a profit after tax of R10,146 billion, of which R8,729 billion
was attributable to the ordinary shareholders. The entity paid
dividends to the value of R7,952 billion in 2018 and reinvested the
remaining R777 million of the attributable profit as part of its
retained earnings.
The preference share capital is the capital that is obtained from
the sale of preference shares to investors. Preference shares provide
the shareholder with a preference right above the ordinary
shareholders in terms of dividend payments. Depending on the
type of preference share, it may guarantee the shareholder a fixed
dividend payment. Furthermore, it ensures that the dividends will
be paid before ordinary dividends are considered. The most
common forms of preference share consist of redeemable and nonredeemable, cumulative, participating and convertible preference
shares (see Chapter 9).
Although preference shares are classified as part of the
shareholders’ equity in Table 2.1, these items are also sometimes
referred to as semi-debt capital. The reason for this classification is
that preference shares have characteristics of both ordinary shares
and debt capital. According to the accounting standards applied to
compile financial statements, redeemable preference shares are
indicated as a non-current liability in the statement of financial
position. The reason for this classification is that like long-term
loans, these preference shares will be redeemed at some point in the
future. From the financial analyst’s point of view, however, it is
important to note that these preference shares are contributed by
the ‘owners’ of the entity, and so are considered to be part of the
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shareholders’ equity. Remember that preference shares improve the
solvency of the company, whereas the non-current liabilities (debt
capital) have a negative impact on it. The accounting standards
classify the dividends of redeemable preference shares as a finance
cost. Unlike finance costs, however, these dividends cannot be
subtracted for tax purposes. Financial analysts prefer to include the
dividends of redeemable preference shares with the other
preference dividend payments. If you compare Table 2.1 with
Sasol’s published statement of financial position, you will notice
that the preference shares are shown separately as part of the
entity’s equity (R7,493 billion), and not as part of the long-term debt
of R81,918 billion (R89,411 billion – R7,493 billion).
The shareholders’ equity represents the total capital contributed
by the entity’s ordinary and preference shareholders combined. In
most cases, the shareholders’ equity represents permanent capital
because it is available for a relatively long period of time or even
indefinitely.
If an entity owns more than 50% of the voting power in another
entity, the other entity is classified as a subsidiary. When the
financial statements of the majority shareholder (the controlling
entity) are compiled, the statements of the two entities are
completely consolidated. However, if the controlling entity does not
own 100% of the shares in the subsidiary, a portion of the items
included in the consolidated statements belongs to the remaining
minority shareholders. By including the minority, or noncontrolling interest, item in the statement of financial position, it is
acknowledged that part of the ownership belongs to the minorityinterest holders. Example 2.3 provides an example to illustrate this
concept.
Example 2.3 Understanding non-controlling interest
Assume that the information that follows is provided to you.
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Company A owns 75% of Company B’s share capital. Company B is, therefore,
considered to be a subsidiary of Company A. When Company A compiles its
statement of financial position, all the assets from Company B (R100) are
included with its own assets (R925) and the total value of R1 025 is indicated.
Company A’s capital of R1 000 appears in the consolidated statement of
financial position. However, a portion of the total assets of R1 025 in the
consolidated statement does not belong to the shareholders of Company A.
Therefore, the remaining portion of R25 is indicated as non-controlling interest.
The consolidated statement would appear as shown in the statement that
follows.
Consolidated: Company A
2.8.3
Liabilities
The liabilities section of the statement of financial position provides
a breakdown of the different forms of debt capital used to finance
the entity’s assets. A distinction is made between the non-current
and current liabilities in terms of the lifetime of the items. All longterm debt capital (that is, debt capital with a term of more than one
year) is classified under non-current liabilities. Short-term debt
capital (in other words, debt capital with a term of less than one
year) is classified under current liabilities. In most cases, the
liabilities of a business provide a significant portion of its capital
requirement.
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2.8.3.1
Non-current liabilities
The major types of non-current liability are interest-bearing
borrowings. These consist of all long-term debt capital with interest
payments and a final redemption of the capital. Sasol reported
secured and unsecured long-term debt as part of its long-term debt.
The secured debt is supported by providing specific items, such as
parts of Sasol’s plant or shares in the entity, as security. Finance
leases are also included as part of the long-term debt, and reflect the
liabilities associated with assets that were obtained by means of a
finance lease. From January 2019, entities are required to employ a
similar lease accounting model to reflect the liabilities associated
with assets obtained by means of operating leases.
Long-term provisions refer to future obligations that the entity
will have to cover. The expected future costs of these obligations are
calculated and discounted to determine the non-current liability
associated with the obligation. An example of long-term provisions
reflected in Sasol’s statement of financial position is environmental
provisions that show expected future rehabilitation costs that the
entity will have to incur on mining sites. In addition, share-based
payment provisions and other long-term provisions are reported.
Long-term deferred income and long-term financial liabilities
are also included as part of the entity’s non-current liabilities.
Post-retirement benefit obligations reflect the post-retirement
healthcare benefits and pension benefits that Sasol will have to
supply to its employees once they retire. The expected future
obligations arising from these benefits are discounted and reported
as a liability to reflect the obligations that Sasol will have to
provide. During the time that employees are employed, they make
contributions to cover these benefits. As part of the non-current
assets, the value of these contributions was reflected in the postretirement benefit assets. It is important to note that the value of the
assets (R1,498 billion) is less than the value of the liabilities (R11,9
billion). This is because the asset value reflects the present value of
the fund, while the liabilities refer to all expected future benefits.
Over time, additional contributions will contribute to the value of
the assets.
Deferred tax liabilities result from similar situations to those
described in Section 2.8.1.1 and illustrated in Example 2.2. The
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difference here, however, is that the taxable income is larger than
the accounting income, so a liability is created in the statement of
financial position.
2.8.3.2
Current liabilities
If items are purchased on credit and payment is only made after a
period of time, the outstanding amount is included as part of the
trade payables. This amount represents the future financial
obligations that the entity needs to honour. Any obligation that
must be honoured over the short term, but that does not form part
of the entity’s normal operating activities, is classified as other
payables. Accrued expenses are also included in this amount.
In order to make provision for short-term cash and capital
requirements, an entity could negotiate a bank overdraft facility.
Owing to its high cost, this facility is usually only used over the
short term.
All debt that is expected to be redeemed within the next
financial year is considered to be part of the current liabilities and is
indicated as short-term debt. If a portion of a long-term interestbearing loan (for example, debentures, long-term loans or
mortgages) is redeemable during the next financial year, the
amount should also be included as part of the current assets and
should no longer be indicated as a non-current liability. This is
reflected by classifying it as the current portion of long-term debt.
Short-term provisions refer to obligations that may arise during
the next financial year, and include items for employee provisions,
insurance-related provisions and provisions against guarantees.
Short-term financial liabilities and short-term deferred income are
also included as part of the entity’s current liabilities.
In some cases, an entity may have calculated its tax amount, but
the payment may still be outstanding at the end of the financial
year. In these cases, the tax payable figure represents the obligation
to make the tax payment in future. It is included as part of the
current liabilities because it is expected that the payment will take
place within the next financial year.
The final item included as part of the current liabilities reflects
the value of the liabilities in disposal groups held for sale. As
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explained in Section 2.8.1.2, this item refers to the liabilities of
business units that will most probably be sold during the next
financial year.
QUICK QUIZ
1. Distinguish between assets, equity and
liabilities.
2. Distinguish between current and non-current
assets.
3. Distinguish between current and non-current
liabilities.
2.9
Statement of profit or loss
The statement of profit or loss provides a summary of an entity’s
financial performance over a specific period of time (usually one
year). Within a statement of profit or loss, the revenue generated
during the financial year is allocated to the different stakeholders of
the entity (for example, suppliers, debt providers, government and
shareholders) up to a point where only the retained earnings are
left. At the end of the financial year, the retained earnings are
transferred to the equity of the entity and used as a source of
financing. From an analysis point of view, it is important to note
that the statement of profit or loss contains profit figures, and that
these values do not necessarily represent cash flows. The difference
between profit and cash flow is discussed in greater detail in
Section 2.10, which examines the statement of cash flows.
Table 2.2 is based on Sasol’s statement of profit or loss for the
year ended 30 June 2018, provided in the entity’s annual report (see
www.sasol.co.za). The various components of the statement of
profit or loss are discussed in this section.
Table 2.2 Example of a statement of profit or loss (based on Sasol Ltd, for the year ended 30 June
2018)
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Source: Based on information at Sasol Ltd, 2018: 40.
The revenue amount (sometimes also referred to as the entity’s
sales or turnover) includes all income received for products or
services rendered by the entity during the financial year. In Sasol’s
case, the largest portion of this figure (R178,463 billion) consists of
the sales of products produced in the entity’s energy and chemical
divisions. The remaining portion (R2,998 billion) is the income from
services rendered and other trading income.
The cost of sales amount includes the cost of raw materials,
electricity and other consumables used in Sasol’s production
process. The cost of inventory as well as all other costs that are
incurred up until the point of sale are included under cost of sales.
The gross profit is calculated by subtracting the cost of sales
from the revenue. This is the profit generated by the sales activities
of the entity.
Other operating income includes those income items that are not
part of the sales activities of the entity, but that are generated as
part of the operating activities. In Sasol’s statement of profit or loss,
items such as changes in rehabilitation provisions, trade payables
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and foreign currency loans, translation gains on trade receivables
and gains on derivatives (such as foreign exchange contracts) are
included here.
Operating expenses include all those expenses that are incurred
by the entity to support its primary (basic) activities. These include
selling and distribution costs, maintenance expenditure, employeerelated expenditure, exploration expenditure and feasibility costs,
and depreciation and amortisation. Remeasurement items to the
value of R9,901 billion are also included as part of operating
expenses. This item reflects the impact of impairments and writeoffs in the values of non-current assets on the entity’s operating
profit. The 2018 statement of profit or loss also includes a sharebased payment expense of R2,866 billion related to the Sasol
Khanyisa B-BBEE scheme.
The entity’s operating profit is obtained by adding the other
operating income to the gross profit and subtracting the operating
expenses from it. This figure is an indication of the profit that
resulted from the primary activities of the business that year. All
income items that are not part of the entity’s normal activities
should be excluded from this figure.
The investment income section includes all income generated by
the financial assets of the entity. In the case of Sasol, this figure
includes interest and dividends received from investments, interest
earned on cash and cash equivalents, interest earned on loans
granted and profits from the equity-accounted investments.
Finance cost is the interest that the entity has paid on debt
financing. In the notes to Sasol’s financial statements, a distinction
is made between the finance costs associated with debt capital, with
finance leases and with other items. From January 2019, IFRS 16
requires that entities also include an assumed interest charge on
properties obtained by means of operating leases as part of the
finance cost.
The profit before tax is calculated by adding the investment
income to the operating profit and subtracting the finance cost
(interest paid).
The profit after tax is obtained by subtracting the tax from the
profit before tax. This figure represents the portion of the profit that
is available to the non-controlling-interest shareholders and that
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can be used to pay preference dividends.
In the case of subsidiary companies, the results from the
financial statements are consolidated and all items are added
together. However, if the controlling company does not own 100%
of the shares in the subsidiary, provision must be made for the noncontrolling shareholders before any dividends can be paid. The
item defined as non-controlling interest in the statement of profit or
loss provides an indication of the portion of the profit that belongs
to the non-controlling shareholders. Therefore, it is subtracted from
the profit after tax before the preference dividends are paid.
If an entity has outstanding preference shares, any preference
share dividends that are declared to the preference shareholders
during the financial year are included in this figure. If you look at
Sasol’s published financial statements, you will note that the
preference share dividends are included as part of the finance cost.
The reason this item is included as a finance cost is that the
accounting standards consider preference shares to be a hybrid
form of financing that has characteristics of both debt and equity.
When analysing the financial statements of an entity, however, we
are interested in indicating this item individually.
The attributable earnings represent the portion of the profit that
is left after all the expenses have been allocated. This figure is of
great importance to the ordinary shareholders because it is the
profit that could be used for ordinary dividend payments.
The figure for ordinary dividends that is declared during the
year is the final item that appears on the statement of profit or loss.
This figure is the total amount that is paid to the ordinary
shareholders in the form of their dividends.
The retained earnings are the portion of the profit that was not
paid out as dividends to shareholders, but that was reinvested in
the entity. The retained earnings are transferred to the reserves of
the entity and used to finance its activities. If you consider the
statement of financial position for Sasol, you will see that this figure
is added to the opening balance of retained earnings. Although the
retained earnings are not paid to the shareholders in the form of
dividends, they still belong to the shareholders and are included in
the entity’s shareholders’ equity. As explained in Chapter 13, if
these retained earnings are reinvested in profitable projects in
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future, they should contribute to an increase in the value of the
ordinary shares.
QUICK QUIZ
Distinguish between the income and expenses
categories included in a statement of profit or
loss.
FOCUS ON ETHICS: Steinhoff
International Holdings NV
Steinhoff, a global furniture and household goods entity, has seen its
share price plummeting since its board announced on 5 December
2017 that its chief executive officer (CEO), Markus Jooste, was
stepping down with immediate effect. The board also announced that
new information had come to light relating to accounting irregularities
that required further investigation and that PricewaterhouseCoopers
would conduct an independent investigation into its books. It later
clarified that these ‘irregularities’ had been red-flagged by its auditors,
Deloitte.
Shares in Steinhoff International, the multi-national’s parent
company, which is dual listed on the Frankfurt Stock Exchange and
the JSE, have lost over 85% of their value since this news broke.
Steinhoff shares, which were changing hands at R46,24 at close of
trade on 5 December 2017, were trading at only R5,50 on 3 January
2018. This was a company that used to be one of the JSE’s ten
biggest companies by market capitalisation.
While it has often been lauded as one of South Africa’s most
successful global companies, Steinhoff was originally a West German
entity. The group’s origins date back to 1964, when German
businessman Bruno Steinhoff, a furniture sales agent, decided to start
his own business. He was successful, especially in forging links with
upholstery and furniture producers in the then East Germany. In 1989,
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following the fall of the Berlin Wall and the reunification of Germany,
Steinhoff acquired a number of businesses in the former East
Germany. It later expanded to Poland and Hungary. In the 1990s,
Bruno Steinhoff’s family bought a 35% interest in Gommagomma
Holdings, a South African entity that manufactured items such as
lounge suites, bedroom units and dining-room furniture. Steinhoff
apparently liked what he saw in South Africa, and in 1998,
Gommagomma, which had by then bought Victoria Lewis, changed its
name to Steinhoff Africa. Steinhoff International Holdings, meanwhile,
became the umbrella parent entity under which Steinhoff Europe and
Steinhoff Africa fell. Steinhoff listed on the JSE in 1998.
For many, Steinhoff International was the epitome of a successful
global retail entity. In its short 50-odd-year history, it was able to
make the transition from a small-time furniture pedlar, which sourced
low-cost furniture from eastern Europe and sold it into West Germany,
to a truly global retail giant, boasting a fully integrated supply chain
covering sourcing, manufacturing, distribution, logistics and retail.
This was the result of decades of conscious decisions to expand,
diversify and vertically integrate the business.
In the last few years prior to 5 December 2017, suspicions had
been aroused by the dizzying pace of Steinhoff’s acquisition drive.
What concerned many observers were the high levels of complexity
associated with these acquisitions along with the ability of the entity to
acquire ailing businesses and (almost instantaneously) show improved
results once these businesses had been incorporated into the group.
Soon after Jooste’s resignation, when the implications of the
reported accounting irregularities at Steinhoff started to sink in,
Sygnia Group CEO, Magda Wierzycka, said, “When I looked at the
financials … it took me exactly half an hour to figure out that the
structure was obfuscated, that financial items made no sense, that the
acquisition spree was not underpinned by any logic and was too
frenzied to be well thought out, and that debt levels were out of
control” (Naudé, Hamilton, Ungerer, Malan & De Klerk, 2018).
The company currently faces investigations or legal action
instituted by numerous bodies and authorities, including the JSE, the
Financial Services Board, the Department of Trade and Industry, and
the Companies and Intellectual Property Commission. It is also facing
two different class-action lawsuits in Germany and the Netherlands.
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Furthermore, executives of the company have been brought before
Parliament’s oversight committee on finance and its Standing
Committee on Public Accounts (Scopa).
The repercussions of the December 2017 announcements,
including the launch of various probes into Steinhoff’s financial affairs,
have been catastrophic for the company. According to media reports,
the company’s share price fell by 85% in the days that followed the
dropping of the initial bombshell; by 11 May 2018, it was sitting at a
measly R1,60.
At the time of writing, many new developments – including the
instituting of substantial financial claims against the company – were
being reported. Whether Steinhoff will survive in its current or an
altered form – or at all – remains to be seen.
Sources: Compiled from information in Cronje, 2017; Rose, 2018; Naudé et al., 2018.
QUESTIONS
1. Referring to the case study, state whether you think
stakeholders’ expectations had anything to do with the way
in which Steinhoff operated.
2. Discuss the comment by Sygnia Group CEO, Magda
Wierzycka: “… the structure was obfuscated … debt levels
were out of control.”
3. Refer to Section 2.5 and discuss how the requirements for
preparing financial statements can also be seen as part of
the ethics of correct financial statements.
2.10
Statement of cash flows
When conducting financial analysis, it is important to note that the
profit figures included in the statement of profit or loss do not
necessarily represent cash flows. If customers buy on credit, the
resulting profit is indicated before the cash flow is generated. And,
similarly, credit purchases result in an increase in inventory,
although the cash payment only occurs later. When evaluating an
entity, however, it is important to determine if sufficient cash flows
are generated. It sometimes happens that an entity reports large
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profits, but does not generate sufficient cash flows to provide for its
cash requirements. As a result, the entity may not have sufficient
cash available to cover its expenses and liabilities. This may
eventually result in liquidity problems that could put the entity at
risk.
The statement of cash flows provides a summary of an entity’s
ability to generate cash. Furthermore, it contains a breakdown of
the application of cash. A distinction is made between the cash
results of operating, investing and financing activities in the
statement of cash flows. The components of the statement of cash
flows are shown in Figure 2.2.
Figure 2.2 The components of the statement of cash flows
The cash generated from the normal operating activities of the
entity is known as cash from operating activities. The cash from
investing activities indicates how much cash is generated or spent
on the investment in additional fixed assets or investments. The
final component, the cash from financing activities, indicates the
cash flow generated by changes in the capital components of the
entity.
The statement of cash flows is compiled by considering the
current year’s statement of profit or loss, the current and previous
years’ statements of financial position and certain additional items
obtained from the notes to the financial statements. Table 2.3 is an
example of a statement of cash flows based on Sasol’s published
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financial statements.
2.10.1
Cash flow from operating activities
The first item included in Sasol’s statement of cash flows is cash
received from customers. This figure reflects the cash amount that
the entity’s customers have paid for the products sold and services
rendered during the financial year. You can immediately see that
this figure differs from the revenue reported in the statement of
profit or loss. The difference between the cash flow and the revenue
value is because some of the customers buy items on credit. To
calculate the cash received from customers, the revenue is adjusted
by taking the change in trade receivables into consideration.
We then subtract the value of cash paid to suppliers and
employees to determine the cash generated by operating activities.
Whereas the operating profit figure in the statement of profit or loss
(see Table 2.2) indicates the profits generated from the operating
activities of the entity, this value represents the cash that was
generated after the suppliers of the goods sold and all other
expenses were paid. The cash amount that is paid to suppliers and
employees is determined by considering the entity’s purchases and
adjusting this amount for the change in accounts payable (reflecting
the amount of cash purchases). Similarly, operating and all other
expenses are adjusted for prepayments and amounts that may still
be outstanding.
Table 2.3 Example of a statement of cash flows (based on Sasol Ltd, for the year ended 30 June
2018)
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Source: Based on information at Sasol Ltd, 2018: 44.
The next step is to include the finance income received on the
entity’s investments and the finance expenses paid on the debt
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capital. Both these items reflect the cash amounts, and are
calculated by considering the corresponding income or expense
amounts in the statement of profit or loss and adjusting them for
any prepayments or outstanding payments that may have to be
made.
The tax paid in cash is then taken into consideration in order to
calculate the cash available from operating activities. To calculate
the cash tax paid, it is necessary to consider the tax amount in the
statement of profit or loss, and adjust it to reflect changes that
occurred in deferred tax and tax payable.
For an investor such as yourself, the cash available from
operating activities is an important figure: it indicates if the entity
has generated sufficient cash flows to afford a dividend payment. If
a negative value is calculated, it indicates that the entity will only
be able to afford a cash dividend if cash is obtained somewhere else
(that is, by selling assets or obtaining additional external equity).
Alternatively, the entity could consider a stock dividend, whereby
the existing shareholders receive additional shares at no cost (see
Chapter 13 for a detailed discussion of dividends).
The dividends paid amount is determined by considering the
ordinary dividends that were declared during the financial year (as
reflected in the statement of profit or loss) and adjusting this
amount for any changes that occurred in the dividends payable
amount. Subtracting the dividends paid from the cash available
from operating activities leaves us with the cash retained from
operating activities. During 2018, Sasol generated a positive cash
amount of R26,354 billion from its operating activities.
When analysing the financial performance and position of an
entity, this figure is one of the important cash flow values to
consider. If an entity consistently fails to generate positive
operating cash flows, it can be seen as an indicator of serious
financial problems. Failure to generate positive operating cash
flows means that there are no surplus cash flows to invest in the
replacement and expansion of assets, and that additional cash will
have to be generated from financing. Alternatively, the entity may
have to sell some of its assets to finance the cash deficit. In the case
of start-up entities and ones that are still growing fast, negative cash
from operating activities is acceptable for a few years, but it is
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important that they start to generate positive cash flows at some
point. For a large, established entity such as Sasol, it is important
that a healthy, positive operating cash flow be generated.
According to the IFRS Standards, an entity may choose between
two formats to reflect the cash flow from operating activities. The
use of the direct method of presentation is encouraged under the
IFRS Standards, but the indirect method is also considered to be
acceptable. The direct method shows each major class of gross cash
receipts and gross cash payments that form part of the entity’s
operating activities. This is the format that is reflected in Sasol’s
financial reports. Alternatively, an entity may decide to represent
the cash flow from operating activities according to the indirect
method. This method starts with an entity’s profit from the
statement of profit or loss and adjusts it to remove the effects of
non-cash transactions. AECI, another entity operating in the
chemicals sector, applied the indirect method to reflect its cash flow
from operating activities in the statement of cash flows, as
illustrated in Example 2.4.
Example 2.4 Using the indirect method to present the cash flow from
operating activities
The section from AECI’s 2018 statement of cash flows that follows illustrates
the calculation of the cash generated from operating activities according to the
indirect method.
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The remainder of AECI’s statement of cash flows is similar to the format used
by Sasol.
Source: AECI, 2019: 28.
These differences in the calculation of the cash generated from
operating activities could present a problem if a detailed
comparison of Sasol and AECI’s cash flows were required. It is,
however, possible to convert the information provided by means of
the indirect method by applying the adjustments set out in Example
2.5.
Example 2.5 Converting items from the indirect method to the direct
method
Consider AECI’s 2018 financial statements. Based on the information provided
in the statements of financial position and profit or loss, the cash flow items
can be determined according to the direct method as shown in the table that
follows.
Trade and other receivables (opening balance)
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3 793
Revenue
23 314
Trade and other receivables (closing balance)
(4 650)
Tax differences *
Cash received from customers
50
22 507
Similarly, the cash paid to suppliers and employees can be calculated as
shown in the table that follows.
Trade and other payables (opening balance)
4 272
Purchases
14 802
Operating expenses
5 787
Trade and other payables (closing balance)
(5 010)
Tax differences *
Cash paid to suppliers and employees
11
19 862
Inventories (opening balance)
3 355
Cost of sales
15 528
Inventories (closing balance)
4 081
Purchases
14 802
* Small differences between the statement of financial position items and the
changes in working capital reflected in the statement of cash flows are
observed. These are the effect of tax differences.
2.10.2
Cash flow from investing activities
The second component of the statement of cash flows indicates the
cash generated and spent on the entity’s investing activities.
Additions to PPE, additions to assets under construction and
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additions to other intangible assets all represent cash incurred to
purchase additional assets. Additional cash contributions to equityaccounted investments indicate investments in associate companies
and joint ventures. Proceeds on disposals and scrappings are the
cash proceeds received from the sale of non-current assets. The cash
results of increases and decreases in investment are represented by
proceeds from the sale and purchase of investments. After the
inclusion of increases in long-term receivables, Sasol’s total cash
flow from investing activities amounted to a negative value of
R53,979 billion in 2018. If you compare this value with the positive
cash retained from operating activities of R26,354 billion in the
previous section, it is clear that Sasol did not generate sufficient
cash flows from its operating activities to cover all investing
activities. The shortfall of R27,625 billion will have to be financed by
the company’s external capital providers, or could contribute to a
decrease in the company’s cash and cash equivalents. This is
addressed in the next section.
It is once again important to note the difference between the
items reflected in the statement of cash flows and the statement of
profit or loss. In the latter, only the profit or the loss on the disposal
of non-current assets is reflected; similarly, only the gain or the loss
on investments that were sold is reflected.
2.10.3
Cash flow from financing activities
The final component of the statement of cash flows contains the
cash results of the entity’s financing activities. The major sources of
financing available to an entity consist of shares, long-term debt
and short-term debt. An increase in any of these forms of financing
results in a cash inflow, whereas a decrease corresponds to a cash
outflow. In this section of the statement of cash flows, a summary is
provided of the changes in these forms of financing and their
implications for cash flow.
If new share capital is issued, it will result in a cash inflow.
However, share capital that is repurchased requires a cash outflow.
The proceeds from long-term debt represent new long-term debt
obtained; the cash outflow associated with repayments of long-term
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debt refers to the retirement of debt. Similarly, proceeds from shortterm debt and repayments of short-term debt result in cash inflows
and outflows, respectively.
2.10.4
Changes in cash and cash equivalents
The increase/(decrease) in cash and cash equivalents is calculated
as the sum of the operating, investing and financing cash flows,
after provision has been made for certain cash flow items that are
not classified as part of these three activities. In the case of Sasol,
this figure amounts to a negative value of R12,284 billion (26,354 −
53,979 + 14,387 + 0,954) for 2018. (The positive cash flow of R954
million refers to the translation effects of cash and cash equivalents
of foreign operations included at the end of the statement, and the
reclassification of cash held for sale.) This large negative value
indicates that during 2018, Sasol did not generate sufficient cash
flows from its operating activities to finance all of its investment
activities. Although it raised additional cash from its external
capital providers, this additional cash inflow was not sufficient to
finance the shortfall. The cash deficit is reflected by a sharp
decrease in the entity’s cash holdings. Similar results are observed
for the previous two years as well, with the entity consistently
generating insufficient cash flow from its operating activities to
fund its investing outflows. Despite generating cash inflows by
means of financing activities, the entity’s cash holdings have been
in steady decline over the last three years, decreasing from R52,180
billion in 2016 to only R17,039 billion in 2018.
QUICK QUIZ
1. Explain the differences between the three
components of the statement of cash flows.
2. Describe the difference between the direct and
the indirect methods of calculating the cash
flow from operating activities.
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2.11
Conclusion
This chapter dealt with the three main types of financial statement
that are included in an entity’s annual financial report. You learnt
the following:
• The main objective of financial reporting is to provide useful
financial information to an entity’s existing and potential
external capital providers.
• The primary users of financial reporting are investors, lenders
and other credit providers. Other users include the management
of the entity, government and other stakeholders.
• The two fundamental qualitative characteristics of useful
financial information are relevance and faithful representation.
The usefulness of financial information is improved by
comparability, verifiability, timeliness and understandability,
which are defined as the enhancing qualitative characteristics of
useful financial information.
• Financial reporting provides information about an entity’s
economic resources (assets) and the claims to those resources
(equity and liabilities). Information pertaining to financial
performance and other transactions that result in changes in the
entity’s resources and the claims on the resources should also be
reported.
• Integrated reporting, proposed as a solution to some problems
associated with traditional financial reporting, requires a more
holistic overview of a broad set of financial and non-financial
factors. To ensure the sustainable creation of long-term value,
management’s accountability is extended to cover six capitals,
consisting of financial, manufactured, natural, human,
intellectual, and social and relationship capital.
• It is sometimes necessary to standardise the published financial
statements of an entity to ensure that they are comparable with
other companies and over time.
• The statement of financial position provides a summary of an
entity’s financial position at a specific date. This statement
consists of two main sections: the entity’s assets, and its equity
and liabilities. The asset part of the statement provides an
overview of the assets the entity owns. The equity and liability
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part reflects the various sources of capital used to finance these
assets.
• The statement of profit or loss provides a summary of an
entity’s financial performance over a specific period of time.
Within a statement of profit or loss, the revenue generated
during the financial year is allocated to the different
stakeholders of the entity up to a point where only the retained
earnings are left.
• The statement of cash flows provides a summary of an entity’s
ability to generate cash and the application of cash (that is, how
the cash is used). In this statement, a distinction is made
between the cash results of operating, investing and financing
activities.
Chapter 3 looks at financial evaluation of an entity’s financial
position and performance by means of ratio analysis. These ratios
are calculated by considering the information contained in the
financial statements. Thus, the quality of financial reporting has an
influence on the values of the ratios.
The case study at the beginning of this chapter was about the
fundamental importance of high standards in financial reporting. It
is essential to note, however, that not all entities provide the same
standards of quality in financial reporting as the top performers in
the survey referred to in the case study. One of the major concerns
for analysts who rely on published financial statements as sources
of information is that the information contained in them may be
inaccurate or insufficient for their purposes. The closing case study
of this chapter is about the well-known computer manufacturer
Dell at a time when the accuracy of the company’s financial
reporting was severely distorted due to earnings manipulation.
CASE STUDY
Manipulation of financial statements at Dell Inc.
A lengthy internal investigation at Dell has finally concluded
with the restatement of four years’ worth of financial
statements. The company has admitted to manipulating
financial statements in order to enhance quarterly earnings.
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The restatements will result in a reduction of net income by
US$92 million over the four-year period.
The investigation was huge. It reportedly involved 125
lawyers and 250 accountants. The team evaluated over five
million documents, conducted more than 200 formal
interviews and examined over 2 600 journal entries flagged by
specialised computer software.
The items under examination were largely related to Dell’s
deferred revenue on software sales. These items were generally
recorded in a way that would boost Dell’s earnings, when the
actual operations did not meet specified targets. Also at issue
was the way in which warranty revenue was booked, often
accelerating the recognition to boost current earnings.
Accounts were generally adjusted when closing a quarter, and
many of the favourable (but improper) changes were initiated
by senior executives.
The team of investigators determined that there were
material weaknesses in Dell’s internal controls and that
remedial actions are in order. In other words, Dell needs to
implement more checks and balances so that something like
this does not happen again.
Members of Dell’s management team say that they have
already started to correct the deficiencies by conducting more
in-depth account reconciliations and reviews at quarter end.
They believe that they now have a more complete review
system in place.
Part of the problem at Dell (and at all other companies) is
that there are accounts that require a great deal of judgment to
be applied in calculating balances. This is especially true of
accrual accounts, for which management will make certain
estimates. A small change in these estimates can have a great
impact on the financial statements. Users of the financial
statements are relying on the good judgment of management,
and there can be errors or fraud in putting that judgment to
work.
The US$92-million adjustment being made to Dell’s books
is less than 1% of the company’s net income over the period
affected. Although the dollars may not be significant when
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looking at the big picture, the problems associated with a lack
of internal controls are serious. Had this problem not been
detected, it could have gone on for many more years.
This case highlights just how easy it is for a company to
head down a destructive path with its financial statements.
Accounting manipulations that are small and are meant to be a
one-time thing can easily snowball into a mess that spans years
and costs millions of dollars to correct.
Sources: Coenen, n.d.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
Which of the following is NOT considered to be an enhancing characteristic of
useful financial information?
A. Timeliness
B. Subjectivity
C. Understandability
D. Comparability
2.
Which of the following persons is NOT considered to be a primary user of
financial reporting?
A. An existing redeemable preference shareholder
B. The entity’s bank manager
C. A potential shareholder
D. The entity’s financial manager
3.
Incenco Ltd used to finalise the compensation packages of its senior
management team one week after the entity’s financial reports were
completed. In future, the entity plans to finalise the compensation packages
one week before the end of the financial year and to include the information in
the financial reports.
On which of the following enhancing characteristics of useful financial
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information would this change be most likely to have an impact?
A. Comparability
B. Verifiability
C. Timeliness
D. Understandability
INTERMEDIATE
Use the information that follows, which was obtained from the statement of financial
position of Zetco Ltd, to answer Questions 5 to 8.
R
Retained earnings
Share capital
15 000
?
Property, plant and equipment at carrying value
26 500
Trade payables
20 000
Long-term loans
11 000
Inventories
20 500
Deferred tax liabilities
4 000
Goodwill
10 500
Bank overdraft
6 000
Reserves
5 000
Short-term loans
19 000
Deferred tax assets
8 500
Preference shares
8 000
Trade receivables
16 500
Investment in associates
17 500
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Non-controlling interest
Total assets
2 000
100 000
4.
Invento Ltd plans to replace the entity’s existing inventory system. The existing
system was developed internally 20 years ago and relies heavily on a set of
outdated assumptions. It will be replaced with a system that is used extensively
by entities operating in the same industry as Invento Ltd.
On which of the following enhancing characteristics of useful financial
information would this change be most likely to have an impact?
A. Comparability
B. Verifiability
C. Timeliness
D. Understandability
5.
Zetko Ltd’s current liabilities amount to __________.
A. R20 000
B. R26 000
C. R39 000
D. R45 000
6.
Zetco Ltd’s non-current liabilities amount to __________.
A. R4 000
B. R11 000
C. R13 500
D. R15 000
7.
Zetco Ltd’s total equity amounts to __________.
A. R20 000
B. R40 000
C. R60 000
D. R100 000
8.
Zetco Ltd’s share capital amounts to __________.
A. R10 000
B. R15 000
C. R20 000
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D.
R30 000
ADVANCED
Use the information that follows, which was obtained from the 2019 financial
statements of Cashco Ltd, to answer Questions 9 to 13.
Cashco Ltd compiles its statement of cash flows according to the direct method.
9.
Cashco Ltd’s cash received from customers is __________.
A. R85 000
B. R95 000
C. R100 000
D. R105 000
10. Cashco Ltd’s cash paid to suppliers is __________.
A. R68 000
B. R70 000
C. R74 000
D. R82 000
11. Cashco Ltd’s cash paid for operating expenses is __________.
A. R12 000
B. R14 000
C. R16 000
D. R20 000
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12. Cashco Ltd’s cash tax paid is __________.
A. R40 000
B. R45 000
C. R55 000
D. R80 000
13. Cashco Ltd’s cash dividends paid are __________.
A. R15 000
B. R38 000
C. R41 000
D. R47 000
Use the information that follows, which was obtained from the financial statements of
Assetco Ltd, to answer Questions 14 to 16.
■ The entity’s financial year ended on 31 December 2018.
■ The entity purchased a new machine during 2018.
■ An old machine with a cost price of R40 000 was sold at a profit of R5 000.
■ Depreciation of R30 000 was provided in the statement of profit or loss.
■ PPE (at carrying value) amounted to R130 000 and R150 000 at the beginning
and the end of 2018, respectively.
■ Accumulated depreciation amounted to R20 000 and R25 000 at the
beginning and the end of 2018, respectively.
14. The cost price of the new machine purchased is __________.
A. R60 000
B. R65 000
C. R130 000
D. R150 000
15. The carrying value of the old machine sold is __________.
A. R15 000
B. R40 000
C. R65 000
D. R130 000
16. The proceeds from the sale of the old machine are __________.
A. R10 000
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B.
C.
D.
R15 000
R20 000
R25 000
Use the information that follows, which was obtained from the financial statements of
Retco Ltd, to answer Questions 17 and 18.
■ Retco Ltd’s retained earnings reported in the statement of financial position
increased from R100 000 (at the end of 2017) to R150 000 (at the end of
2018).
■ Ordinary dividends of R40 000 and preference share dividends of R20 000 are
reported in the statement of profit or loss at the end of the 2018 financial year.
■ The company reported a profit before tax of R200 000 at the end of the 2018
financial year.
■ The company’s effective tax rate was 30% during 2018.
17. Retco Ltd’s profit after tax for the 2018 financial year is __________.
A. R140 000
B. R200 000
C. R250 000
D. R340 000
18. Retco Ltd’s non-controlling interest in the statement of profit or loss is
__________.
A. R30 000
B. R70 000
C. R90 000
D. R110 000
LONGER QUESTIONS
BASIC
1.
The information that follows, which was taken from the 2019 statements of
financial position and profit or loss for Copycat Ltd, is provided to you.
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COPYCAT LTD
STATEMENT OF FINANCIAL POSITION
2019
R’000
Long-term loans granted
440
Short-term loans
200
Retained earnings
200
Preference shares
500
Cash and cash equivalents
180
Current tax payable
140
Inventories
720
Share capital
1 000
Long-term loan
120
Debentures
180
Property, plant and equipment at carrying value
1 000
Trade receivables
360
Trade payables
360
COPYCAT LTD
STATEMENT OF PROFIT OR LOSS
Preference share dividend
2019
R’000
50
Cost of sales
1 200
Finance cost
58
Ordinary share dividend
250
Operating expenses
2 100
Revenue
3 600
Income tax expense
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61
Using the information provided to you, complete Copycat Ltd’s standardised
statement of profit or loss and statement of financial position.
INTERMEDIATE
2.
The items that follow, which are from the financial statements of Debco Ltd,
are provided to you.
DEBCO LTD
STATEMENT OF FINANCIAL POSITION
2019
R’000
2018
R’000
410 000
350 000
Dividends payable
2 000
3 000
Prepayments of operating expenses
2 000
3 000
Reserves
14 000
14 000
Long-term loans
40 000
44 000
Patents and licences
30 000
30 000
Trade payables
35 000
28 000
Inventories
45 000
30 000
Accumulated depreciation
200 000
160 000
Cash and cash equivalents
23 000
17 000
Current tax payable
3 000
5 000
Share capital
80 000
60 000
Long-term loans granted
20 000
20 000
Preference shares
40 000
50 000
Debentures
35 000
24 000
Retained earnings
26 000
18 000
Mortgage loans
95 000
80 000
Property, plant and equipment at cost price
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Trade receivables
60 000
50 000
Bank overdraft
20 000
14 000
DEBCO LTD
STATEMENT OF PROFIT OR LOSS
2019
R’000
Ordinary share dividends
28 000
Operating expenses
67 600
Preference share dividends
4 000
Investment income
1 800
Loss on the disposal of property, plant and equipment
2 000
Revenue
390 000
Finance costs
12 200
Income tax expenses
10 000
Cost of sales
260 000
On the basis of the items provided to you, compile the company’s standardised
statement of financial position and statement of profit or loss for 2019.
ADVANCED
3.
Your friend has identified Spanjaard Ltd, a company that manufactures and
distributes special lubricants and chemical products that are used for industrial
and automotive purposes, as a potential investment opportunity. He
downloaded the 2018 integrated annual report from the Spanjaard website, but
was unable to standardise the financial statements to enable comparisons with
other companies. He approached you to help him reflect the items reported in
the financial statements correctly. His attempts at standardising the company’s
financial statements are provided below.
SPANJAARD LTD
2018
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2017
STATEMENT OF FINANCIAL POSITION
R’000
R’000
Property, plant and equipment at cost
38 178
39 107
Long-term borrowings
389
386
Short-term borrowings
345
1 130
Intangible assets
1 141
1 622
Reserves
15 993
16 923
Inventories
16 768
17 051
Cash and cash equivalents
635
1 823
Non-current assets held for sale
126
0
Accumulated depreciation
9 184
8 009
Ordinary shares
407
407
0
207
Bank overdraft
7 035
4 820
Retained earnings
24 536
28 155
Deferred tax liabilities
4 164
5 092
Goodwill
437
437
Trade and other payables
11 479
11 831
Trade and other receivables
16 255
16 514
8
8
Current tax receivable
Dividends payable
SPANJAARD LTD
STATEMENT OF PROFIT AND LOSS
2018
R’000
2017
R’000
Cost of sales
(76 547)
(73 690)
Distribution expenses
(12 295)
(11 115)
Ordinary share dividend
0
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0
Administrative expenses
(33 567)
(34 538)
Revenue
117 678
120 055
Finance costs
(1 029)
(871)
Other operating income
329
202
Income tax expense
897
370
SPANJAARD LTD STATEMENT OF CASH FLOWS
2018
R’000
Cash tax received
207
Purchases of property, plant and equipment
(959)
Cash paid to suppliers and employees
Effects of exchange rate changes on cash and cash
equivalents
(119 158)
(46)
Decrease in borrowings
(1 623)
Purchases of intangible assets
(209)
Cash receipts from customers
117 839
Proceeds from borrowings
Finance cost paid
Proceeds from sale of property, plant and equipment
936
(1 029)
639
On the basis of these items, compile Spanjaard’s standardised statements of
profit or loss, financial position and cash flows.
KEY CONCEPTS
Assets: An entity’s capital investments, usually resources that are
economically invested to generate revenue.
Cash from financing activities: Cash flows resulting from changes in an
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entity’s ordinary shares, long-term debt or short-term debt.
Cash from investing activities: Cash flows generated or spent on an
entity’s investing activities, such as the purchases and sales of
property, plant and equipment or investments.
Cash from operating activities: Cash flows generated by the normal
operating activities of an entity.
Change in financial position: The change in the financial position of an
entity resulting from the investment, financing and operating
activities of the entity during the year.
Current assets: Those assets applied over a shorter period of time,
usually less than one year.
Current liabilities: Short-term debt items, including trade payables,
bank overdrafts and short-term loans.
Equity: Capital provided by equity providers, which consists of the
ordinary share capital, reserves, preference share capital and
non-controlling interest.
Financial performance: An entity’s ability to generate income with the
assets available to it.
Financial position: The financial position of an entity is determined by
the economic resources available to it and the capital structure
used to finance these resources.
Integrated reporting: Detailed reporting framework focusing on an
entity’s strategy intended to ensure sustainable value creation
by managing its resources and relationships as efficiently as
possible.
Liabilities: The debt capital provided by lenders and other creditors.
A distinction is usually made between current and non-current
liabilities.
Non-current assets: Assets that are applied for a period of more than
one year.
Non-current liabilities: All the long-term debt financing used to finance
an entity.
Qualitative characteristics of useful financial information: Financial
information is useful if it is both relevant and faithfully
represented. The usefulness of financial information is enhanced
if the information is comparable, verifiable, timely and
understandable.
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Shareholder’s equity: An entity’s total assets minus the total liabilities.
Standardisation of financial statements: The process that is followed to
ensure that statements are comparable with those of different
entities and over time.
Statement of cash flows: Statement that provides a summary of the
cash flows associated with an entity’s operating, investing and
financing activities.
Statement of financial position: Statement that evaluates the financial
position of an entity by focusing on its assets, liabilities and
shareholders’ equity.
Statement of profit or loss: Statement that provides a summary of an
entity’s income and expenses.
Users of financial reporting: The primary users of financial reporting
are the existing and potential investors, lenders and other
creditors that provide external capital. Other users include
management, government institutions and other stakeholders.
SLEUTELKONSEPTE
Aandeelhouersekwiteit: ’n Onderneming (meer spesifiek, ’n
maatskappy) se totale bates minus totale laste.
Bates: ’n Maatskappy se bates verteenwoordig die
kapitaalinvesterings wat gewoonlik aangegaan word met die
idee om die hulpbronne aan te wend om inkomste te genereer.
Bedryfsbates: Daardie bates wat oor ’n korter periode van tyd
aangewend word, gewoonlik minder as een jaar.
Bedryfslaste: Korttermyn vreemde kapitaal items, soos
handelskrediteure, oortrokke bankrekeninge en
korttermynlenings.
Belangegroepe: Die belangegroepe van ’n maatskappy sluit onder
andere die aandeelhouers, bestuur, verskaffers van vreemde
kapitaal en ander partye in.
Ekwiteit: Die kapitaal voorsien deur die ekwiteitsverskaffers, wat
bestaan uit die gewone aandelekapitaal, reserwes,
voorkeuraandelekapitaal en nie-beherende belang.
Finansiële posisie: Die finansiële posisie van ’n maatskappy word
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bepaal deur die ekonomiese middele tot sy beskikking en die
kapitaalstruktuur wat gebruik is om hierdie middele te
finansier.
Finansiële prestasie: Die finansiële prestasie van ’n maatskappy
verwys na sy vermoë om inkomste te genereer met die bates tot
sy beskikking.
Gebruikers van finansiële verslaglewering: Die primêre gebruikers van
finansiële verslaglewering is die bestaande en potensiële
beleggers, leners en ander krediteure wat eksterne kapitaal
voorsien. Ander gebruikers sluit bestuur, regeringsinstansies en
ander belangegroepe in.
Geïntegreerde verslaglewering: Gedetaileerde
verslagleweringsraamwerk wat fokus op ‘n maatskappy se
strategie om volhoubare waardeskepping te verseker deur
hulpbronne en verhoudings effektief te bestuur.
Kontant uit finansieringsaktiwiteite: Die kontantvloei wat voortvloei uit
veranderinge in ’n maatskappy se gewone aandele, langtermyn
vreemde kapitaal of korttermyn vreemde kapitaal.
Kontant uit investeringsaktiwiteite: Die kontantvloei wat gegenereer
word uit, of aangewend word vir, ’n maatskappy se
investeringsaktiwiteite soos die aankope of verkope van EAT en
beleggings.
Kontantvloei uit bedryfsaktiwiteite: Die kontantvloei wat gegenereer
word uit die normale bedryfsaktiwiteite van ’n maatskappy.
Kwalitatiewe eienskappe van bruikbare finansiële inligting: Finansiële
inligting is bruikbaar indien dit beide relevant en betroubaar
verteenwoordig is. Die bruikbaarheid van finansiële inligting
word verbeter indien die inligting vergelykbaar, verifieerbaar,
tydig en verstaanbaar is.
Laste: Die vreemde kapitaal wat deur leners en ander
handelskrediteure voorsien is. ’n Onderskeid word normaalweg
tussen bedryfslaste en nie-bedryfslaste getref.
Nie-bedryfsbates: Daardie bates wat vir ’n periode van meer as een
jaar aangewend word.
Nie-bedryfslaste: Al die langtermyn vreemde kapitaal wat gebruik is
om ’n maatskappy te finansier.
Staat van finansiële posisie: Hierdie staat evalueer die finansiële
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posisie van ’n maatskappy deur te fokus op die bates, laste en
ekwiteit.
Staat van kontantvloeie: Hierdie staat verskaf ’n opsomming van die
kontantvloei wat geassosieer word met ’n maatskappy se
bedryfs-, investerings- en finansieringsaktiwiteite.
Staat van wins of verlies: Hierdie staat verskaf ’n opsomming van ’n
maatskappy se inkomstes en uitgawes.
Standaardisasie van finansiële state: Die proses wat gevolg word ten
einde te verseker dat die state vergelykbaar is tussen
verskillende maatskappye en oor tyd.
Verandering in finansiële posisie: Die verandering in die finansiële
posisie van ’n maatskappy hang af van die investerings-,
finansierings- en bedryfsaktiwiteite van die maatskappy
gedurende die jaar.
WEB RESOURCES
www.aeci.co.za
www.fanews.co.za
www.iasplus.com
www.integratedreporting.org
www.moneyweb.co.za
www.sars.gov.za
www.sasol.co.za
www.spanjaard.biz
REFERENCES
AECI. (2018). Annual financial statements. Retrieved from
https://www.aeciworld.com/reports/ar-2018/pdf/full-afs.pdf
[25 February 2020]. AFE: AECI Limited Role Equity Issuer
Registration No. 1924/002590/06.
Coenen, T. (n.d.). Financial statement manipulation at Dell.
AllBusiness.com. Retrieved from
https://www.allbusiness.com/financial-statementmanipulation-at-dell-4968408-1.html
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[16 November 2019].
Cronje, J. (2017). A Steinhoff guide for dummies – updated for
2018. Fin24. Retrieved from
https://www.fin24.com/Companies/Retail/a-steinhoff-guidefor-dummies-20171208
[14 November 2019].
Deloitte. (2019). Conceptual Framework for Financial Reporting 2018.
Retrieved from
https://www.iasplus.com/en/standards/other/framework [25
February 2020]. Reprinted by permission of Deloitte/IAS Plus.
Graham, M. (2019). Can integrated reporting bridge widening trust
gap between business and society? IOL. Retrieved from
https://www.iol.co.za/business-report/opinion/canintegrated-reporting-bridge-widening-trust-gap-betweenbusiness-and-society-32922086 [11 November 2019].
Integrated Reporting Committee of South Africa. (2019). EY
Excellence in Integrated Reporting Awards 2019. Retrieved from
https://integratedreportingsa.org/ey-excellence-in-integratedreporting-awards-2019/ [11 November 2019].
International Integrated Reporting Council (IIRC). (2013). The
International <IR> Framework. Retrieved from
http://integratedreporting.org/wp-content/uploads/2013/12/1312-08-THE-INTERNATIONAL-IR-FRAMEWORK-2-1.pdf [11
November 2019]. Reprinted with permission from the
International Integrated Reporting Council © 2020.
Naudé, P., Hamilton, B., Ungerer, M., Malan, D. & De Klerk, M.
(2018). Business perspectives on the Steinhoff saga. USB
Management Review: Special report June 2018. Retrieved from
https://www.usb.ac.za/wpcontent/uploads/2018/06/Steinhoff_Revision_28_06_2018_websmall.pdf
[29 April 2020]. Reprinted by permission of the editor.
Rose, R. (2018). Steinheist: The inside story behind the Steinhoff
scandal. Daily Maverick. Retrieved from
https://www.dailymaverick.co.za/article/2018-11-14steinheist-the-inside-story-behind-the-steinhoff-scandal/ [14
November 2019].
Sasol Ltd. (2018). Annual financial statements at 30 June 2018.
Retrieved from https://www.sasol.com/investor******ebook converter DEMO Watermarks*******
centre/financial-reporting/annual-financial-statements/latest
[14 November 2019]. SOL: Sasol Limited Role Equity Issuer
Registration No. 1979/003231/06.
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3 Ratio analysis
Pierre Erasmus
Learning
outcomes
Chapter outline
By the end of this chapter, you should be able to:
discuss the requirements for financial ratios
identify the norms of comparison used to
evaluate ratios
identify the different types of ratio
define, calculate and interpret profitability,
liquidity, solvency, cash flow and investment
ratios
explain financial gearing
apply the DuPont analysis system to evaluate
return ratios.
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
3.11
3.12
3.13
3.14
Introduction
Requirements for financial ratios
Norms of comparison
Types of ratio
Profitability ratios
Profit margins
Turnover ratios
Liquidity ratios
Solvency ratios
Cash flow ratios
Investment ratios
Financial gearing
DuPont analysis
Conclusion
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CASE STUDY
But wait, there’s more …
In 2005, specialist retailing company Verimark listed on the
Johannesburg Stock Exchange (‘the JSE’) at an initial price of
R2,50 per share. During the first two years after listing, the
entity reported good profit figures and its share price increased
to R4,15 per share in April 2006. After that, however, the
entity’s financial performance was under pressure, and profit
levels consistently decreased until 2009. At the beginning of
2009, the entity’s shares traded at 28 cents per share. In a highly
controversial delisting offer in May 2009, the majority
shareholder proposed buying out minority shareholders at a
proposed buyout price of 50 cents per share. Although this
price represented a premium of 150% above the entity’s share
price at that stage, it would have resulted in a significant loss of
80% of the initial price that shareholders initially paid for the
entity’s shares. The questions shareholders most probably
asked themselves were whether it was possible to have
anticipated this shift in the entity’s share price, and more
importantly, whether the entity’s financial performance could
be expected to improve in future.
Unfortunately, there are no straightforward answers to
these questions. A number of factors could have contributed to
the decrease in the entity’s share price. In Chapter 2, we
established that the financial statements of an entity are sources
of information that may be used to assess its expected future
performance. If Verimark’s return on equity is calculated on
the basis of the information contained in its financial
statements, we can determine that it dropped from a level of
53,66% in 2006 to a negative return of −8,17% in 2009. On the
strength of this indicator, it appears that the information
contained in the financial statements did warn shareholders
that something was wrong. One of the problems that the
shareholders of the entity had to face during 2009 was trying to
establish if this decrease in the return on equity was a
permanent problem. Furthermore, they had to determine what
contributed to this sharp decline in the return on equity and if
this problem could be addressed in some way.
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A large group of the non-controlling shareholders strongly
opposed the proposed delisting of the entity. These noncontrolling shareholders argued that the price of 50 cents was
less than the fair value of the entity, and demanded a price of
R1,80 per share. Following a court judgment against the
delisting, the offer to delist was withdrawn and Verimark
remained listed on the Johannesburg Stock Exchange (‘the
JSE’). At the time of the delisting offer, Verimark’s financial
performance was indeed very poor. With hindsight, we can see
that if the entity had proven unable to improve its future
financial performance, the buyout price of 50 cents per share
might have been the best option at the time for shareholders.
Over the next two years, the entity showed a marked
improvement in its financial performance. By 2011, it had
managed to increase its return on equity to 41,53%, and during
June 2011, its shares traded briefly at more than R2 per share.
However, the entity’s volatile financial performance appears to
have dissuaded investors from considering it as an attractive
investment option and its share price steadily declined over the
next few years. In 2018, another offer was made to delist the
entity at a price of R1,50 per share. This time around, investors
overwhelmingly supported the offer and the entity was
delisted from the JSE in February 2019.
Sources: Compiled from information in Mahlangu, 2018; Hedley, 2019; Hasenfuss, 2009; Carte,
2010; Cobbett, 2009; Van Zyl, 2009.
3.1
Introduction
In Chapter 2, we discussed the three main types of financial
statement included in an entity’s annual report. We saw that these
financial statements provide valuable information about an entity’s
financial performance and position. We pointed out, however, that
the format in which this information is published is prescribed by
accounting standards, which does not always make it easy to
conduct financial analyses of an entity. Although we saw in
Chapter 2 that it was possible to determine the financial position
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and performance of Sasol Ltd, it is still not clear whether or not an
investment in the entity’s shares would prove to be a good idea.
Furthermore, it is difficult to compare the financial statements of
Sasol directly with those of another company, since they are
expressed in monetary forms. So, if a comparison between the
revenue figures of Sasol and those of a smaller company – such as
Spanjaard, for instance (the example cited in Chapter 2) – is made, a
large difference in absolute terms is observed. But this does not
necessarily serve as an indication that Sasol outperformed
Spanjaard. Because Sasol has a much larger investment in assets
than Spanjaard, it can be expected to generate a larger revenue.
In order to analyse the financial performance and position of an
entity, we often use the information provided in the financial
statements to calculate financial ratios. We conduct this ratio
analysis in an attempt to provide more information on certain
aspects of the entity in a format that is easily comparable over time,
between different entities and between different industries or
countries. Financial ratios are also easier to understand than the
monetary figures contained in financial statements. Calculating a
ratio makes it possible to establish a meaningful relationship
between items in the financial statements.
Since it is important for an analyst to determine if an entity has
managed to improve (or even maintain) its financial performance
and position, the values of the ratios are usually compared over a
period of time. This comparison should indicate whether significant
changes occurred and could highlight those areas where the entity
managed to improve as well as possible problem areas.
In this chapter, we provide an overview of some of the most
commonly applied financial ratios. In the first section of the
chapter, we focus on the requirements that should be adhered to
during the calculation and interpretation of ratios. In the second
section, we discuss the different norms of comparison. Next, we
identify the major groups of ratios. We consider financial gearing as
a way to evaluate the effect of using debt capital. In the final section
of this chapter, we explain the DuPont analysis system.
We illustrate the definitions, formulae and calculation of the
ratios by quantifying a number of financial ratios based on the
financial statements of Sasol provided in Chapter 2.
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3.2
Requirements for financial ratios
The primary objective of financial ratios is to simplify the process of
evaluating the financial performance and position of an entity. In
order to achieve this, these ratios need to meet a number of
requirements. The first requirement is that the comparison being
made be meaningful. It is important to note that the relationship
that is being investigated must be logical. A comparison between
salaries and goodwill, for instance, is not meaningful because the
value of this ratio would not provide any valuable information to
the users of the financial statements. To a potential investor such as
yourself, however, an indication of the return that Sasol is earning
on the capital provided by ordinary shareholders would be of
value.
The second requirement for financial ratios is that the value of
the ratio be a true indication of the financial performance of the
entity and only the relevant amounts be included during the
calculation of the ratio. For instance, when you want to evaluate an
entity’s operating performance, any items that do not form part of
operating activities should not be included as part of the analysis. If
you consider Sasol’s published financial statements for 2018, you
will note that items such as finance lease costs, profit from equityaccounted investments, investment income and finance costs are
reported separately from the operating income and expenses. The
reason for this is that these items are not connected to the entity’s
operating activities. Investment income and finance costs, for
instance, refer to income and costs associated with the entity’s
investing and financing activities, respectively. If the inclusion of an
item is expected to distort the evaluation of an entity’s operating
activities significantly, it could also be excluded from the
calculation of the relevant ratios. For example, in 2018, the Sasol
Khanyisa share-based payment amounting to R2,866 billion was
included as part of Sasol’s operating expenses. Since it could be
argued that this item was not part of the normal activities of the
entity, the figure could be excluded from any analysis of the entity’s
operating activities during 2018. Similarly, the payment could be
excluded when Sasol’s operating profitability is investigated.
The third requirement for ratios is that their values be
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comparable over a period of time as well as between different
industries and entities. This means that the ratio should be
calculated in a consistent manner. If an entity changes the
accounting policy used to compile its financial statements, this
should be taken into consideration when the ratios are calculated
and compared. Since most South African entities have converted to
the International Financial Reporting Standards (‘the IFRS
Standards’), it is important to consider the effect that differences
between these standards and those that are applied by entities that
operate in other countries may have on the values of the ratios
calculated. The majority of entities operating in the United States
(US) will most probably apply US GAAP, which differs
substantially from the IFRS Standards in terms of certain items. For
instance, while the IFRS Standards strictly prohibit the application
of the last-in-first-out (LIFO) inventory valuation approach, it is
acceptable under US GAAP. When comparing any aspect relating
to inventory valuation or the value of an entity’s cost of sales
between a South African entity and a US entity, this will have to be
considered. These items may have to be recalculated before being
included in a ratio analysis to ensure comparability.
QUICK QUIZ
Explain the requirements for financial ratios.
3.3
Norms of comparison
If the financial performance and position of an entity are evaluated
by means of ratio analysis, it is important to remember that ratios
should not be interpreted in isolation. Only by comparing the value
of a ratio with other ratios is it possible to determine if the financial
performance and position of an entity are improving or declining.
Therefore, a number of norms of comparison are proposed when
ratios are evaluated. In some cases, certain conventions relating to
the values of ratios are developed over time. An example of this is a
current ratio of 2:1, which is often accepted as an appropriate level
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for the current ratio (see Section 3.8.1). However, it is important to
note that this norm of comparison does not necessarily apply to all
types of business. Depending on the industry in which the entity
operates, different values may be acceptable. For instance, if a
comparison is made between a chemical company such as Sasol and
a retailing company such as Pick n Pay, one will observe marked
differences in the value of the current ratio. In 2018, a current ratio
of 1,36:1 was calculated for Sasol, compared with a value of only
0,80:1 for Pick n Pay. However, this difference does not necessarily
imply that Pick n Pay suffers from liquidity problems. Instead, an
investigation into the way in which Pick n Pay finances its activities
should reveal that the entity uses current liabilities quite
successfully to finance a portion of its capital requirement.
Another way to evaluate ratios is to investigate the financial
performance and position of an entity over a period of time. Using
this comparison, it is possible to determine if the entity’s financial
situation has improved or declined. It is also possible to determine
if any trends in the values of the ratios can be observed. In the case
of Sasol, for instance, a decrease in the current ratio from 2,60 in
2016 to 1,36 in 2018 is observed, representing a drop of almost 50%
over the three-year period.
A third way to interpret ratios is to compare similar entities that
operate in the same industry. This way, we can determine the
competitive position of the entity in relation to its competitors.
Industry averages can also be calculated for all entities in an
industry and are used to determine the relative position of an entity
within the industry. In the case of Pick n Pay, for instance, an
increase in the return on assets from 4% in 2013 to 6,2% in 2018 is
observed. During the same period, Shoprite, which is also listed in
the Food Retailers and Wholesalers sector of the JSE, reported a
decline in its return on assets from 10,8% to 8,4%.
QUICK QUIZ
Discuss the norms of comparison used to evaluate
ratios.
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3.4
Types of ratio
Various parties have different objectives when they examine an
entity’s financial statements to establish its financial performance
and position. Providers of debt capital, for instance, are interested
in the entity’s ability to make interest payments and eventually
repay the debt obligations. Management, on the other hand, is
interested in the profitability of the entity’s assets. And, as a
potential shareholder, you would be particularly keen to determine
the return earned on the entity’s shares and the dividend payments
you would receive on your investment.
There are a number of broad categories of ratio. Which ratios
you decide to use will depend on which characteristics of an entity
you wish to investigate. This chapter discusses seven main
categories of ratio.
The first category is profitability ratios. These focus on the
returns earned on an entity’s capital investments. Usually,
profitability ratios are influenced by the next two categories of
ratios: the entity’s profit margins and the turnover ratios of various
capital investments.
The fourth category is liquidity ratios. These ratios evaluate the
entity’s short-term financial position and compare the investment in
current assets with the amount of current liabilities in order to
determine if sufficient short-term assets are available to cover the
short-term liabilities. The turnover times of various components of
working capital are also usually included in an analysis of an
entity’s liquidity to determine how efficiently the investment in
working capital is utilised to generate revenue.
The fifth category is solvency ratios. These focus on the
proportion of the entity’s total capital that consists of debt capital.
In order to determine if an entity is able to meet certain
requirements, a number of coverage ratios are usually also included
when its solvency is evaluated.
The sixth category of ratios concerns the business’s statement of
cash flows. Cash flow ratios evaluate whether or not an entity is
generating sufficient cash to support its activities. Since most
obligations are repaid by cash payments, it is also important to
determine the cash coverage ratios to establish if sufficient cash
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flows are available to make these payments.
The final category of financial ratios comprises investment
ratios. These ratios quantify relationships that are of particular
importance to the shareholders of the entity.
The sections of this chapter that follow look at these different
types of ratio in more detail. Their formulae and interpretation are
also discussed. To calculate the ratios, we will use the example of
Sasol’s 2018 financial statements (refer to Chapter 2). Note that
these statements can be downloaded from OUPSA’s website,
Learning Zone, for ease of reference. In order to make it possible to
evaluate changes in the ratios, comparative values based on the
2017 financial statements are also provided.
QUICK QUIZ
What are the main categories of ratio and what
are their different purposes?
3.5
Profitability ratios
Profitability refers to the efficiency with which an entity utilises its
capital to generate revenue. When evaluating Sasol’s financial
performance, for instance, you would be interested in determining
the income generated by the entity. It is also important, however, to
know what amount of capital was invested in the assets utilised to
generate this income. If a large amount of income can be generated
by a small investment in assets, it would indicate that the entity is
highly profitable. Conversely, if a large investment in assets only
generates a small amount of income, this is an indication that the
assets are not utilised efficiently and that the entity is less
profitable.
It is possible to calculate the profitability (or return) of different
capital items included in an entity’s statement of financial position.
It is important, however, to ensure that a relevant comparison
between a capital item and the corresponding income or profit
figure is made. The higher the return that is earned on a capital
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item, the more efficiently the entity has used that capital item.
When evaluating the financial performance of an entity, it is
essential to evaluate its level of profitability because entities that are
able to utilise their invested capital efficiently are expected to
generate large profits and should create more value than entities
with lower levels of profitability.
When measuring profitability, the focus is usually placed on the
level of profit generated (that is, the profit margin) and the
efficiency with which the invested capital is utilised (as measured
by turnover ratios). These two factors combined provide an
indication of profitability. Table 3.1 shows the formulae and
calculations for the profitability ratios based on Sasol’s financial
statements.
Table 3.1 Profitability ratios based on Sasol’s financial statements
Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.5.1
Return on assets
The return on assets (ROA) ratio measures how efficiently the total
assets (in other words, the total capital) of an entity are utilised to
generate revenue. The relevant income item that needs to be
compared with the total assets is the profit after tax because this
represents the total income generated by the entity’s assets.
Sasol’s 2018 financial statements indicate that the entity
generated a return of 2,65% on the total assets invested in the
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enterprise. This value is less than half the ROA of 5,70% calculated
from the 2017 financial statements. When evaluating the
performance of the entity, it is important to understand what
caused this decline in its profitability. During 2018, Sasol’s total
assets increased by 10,10%. The profit after tax, however, decreased
by 50,63% during this period, resulting in the large decrease in
ROA. It was pointed out in Chapter 2 that the 2018 operating
expenses include a share-based payment expense of R2,866 billion.
Excluding this amount from the calculation results in an adjusted
ROA value of 3,33%, which is still substantially lower than the 2017
value.
When the ROA is higher from one year to the next, the entity is
making use of its total assets more efficiently than previously. In
order to improve the ROA (or any profitability ratio), an entity
either needs to improve the profit figure or reduce the amount of
assets, or achieve a combination of the two. However, the entity
must be careful not to reduce the total assets too much because this
may have a negative impact on its activities. The short-term
minimisation of total assets in order to increase the ROA may also
have a serious negative effect on the future profitability of the
entity.
Some analysts adjust the ROA ratio to add back the after-tax
finance cost (Finance cost × [1 – Tax]) to the profit after tax in order
to exclude the entity’s method of financing from the ratio. In this
adjusted version of the ratio, the adjusted profit after tax is
compared with the total assets. The value of this adjusted ratio can
be compared with the normal ROA to determine by what
percentage the entity’s profitability is reduced when the finance
cost is considered. Another adjustment to the ratio that is
sometimes made consists of removing all financial assets from the
total asset value and excluding the entity’s investment income from
the profit after tax. The value of this ratio provides an indication of
the return earned on the assets actively employed by the entity and
the income generated by these assets. By comparing the value of
this ratio with the normal ROA, it is possible to determine what
contribution the return on the entity’s investments had on its return
on assets.
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3.5.2
Return on equity
The return on equity (ROE) ratio indicates the return generated on
the total equity invested in the entity. This figure includes the
ordinary shareholders’ equity, preference share capital and the noncontrolling interest. Like the ROA value, you will observe a sharp
decline in Sasol’s ROE value: from 9,92% in 2017 to 4,77% in 2018.
Similar to the ROA, this decline could mainly be attributed to the
decrease in the profit-after-tax amount in the statement of profit or
loss. From 2017 to 2018, the equity amount also increased slightly,
by 2,98%.
3.5.3
Return on shareholders’ equity
The return on shareholders’ equity (ROSE) ratio provides an
indication of the return generated on the shareholders’ equity
invested in the entity. Since the objective of any company should be
the maximisation of shareholder value, this ratio is an important
element in the financial evaluation of an entity. If you compare the
calculation of this ratio with the previous one (ROE), you will note
that the non-controlling interest included in the statement of profit
or loss is subtracted from the profit after tax. The reason for this
deduction is to calculate the profit that is available to the preference
and ordinary shareholders of the entity. Using the Sasol example,
the value of this ratio also decreased, declining from 9,65% in 2017
to 4,27% in 2018. Once again, the main reason for the decline can be
attributed to the decrease in the profit after tax.
3.5.4
Return on ordinary shareholders’ equity
Whereas the ROSE ratio focuses on the return realised on the
shareholders’ equity, the return on ordinary shareholders’ equity
(ROSHE) ratio focuses only on that portion of the entity’s equity
that is provided by the ordinary shareholders. Since the ordinary
shareholders’ equity does not include the preference shareholders,
the preference dividends are not included in the calculation of this
ratio. The value of this ratio is slightly lower than the ROSE ratio,
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indicating that the ordinary shareholders realised a lower return
than the preference shareholders. As with the other return ratios,
however, it is important to notice that the value of this ratio also
declined from the previous year’s value (from 9,73% to 4,02%). This
is the result of the decrease in the profit after tax.
3.6
Profit margins
Given the changes we have observed in Sasol’s profitability ratios
in the previous section, it is important to understand what
contributed to the declines in 2018. One factor that can influence
profitability is an entity’s profit levels. Profit margins provide an
indication of the percentage of the revenue that shows as profit
after certain deductions are made. Table 3.2 provides the formulae
and calculations for profit margins based on Sasol’s financial
statements.
Table 3.2 Profit margins based on Sasol’s financial statements
Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.6.1
Gross profit margin
The gross profit (GP) margin is the portion of the entity’s revenue
that is realised as profit after the cost of sales has been subtracted.
In this example, 42,22% of Sasol’s revenue consists of the cost of
sales, so 57,78% remains in 2018 after provision is made for the cost
of the goods sold. The entity’s GP declined from the 58,57%
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reported in 2017.
3.6.2
Operating profit margin
The operating profit (OP) margin is the percentage of the revenue
that is realised as profit after provision has been made for all the
normal operating expenses. If an entity’s OP margin decreases, it is
usually an indication that the operating expenses increased as a
percentage of the revenue. An increase in the OP may be seen as an
indication that the entity’s operating activities are more efficient
and less costly. In Sasol’s case, however, OP decreased from 17,77%
during 2017 to a level of 8,98% in 2018.
3.6.3
Earnings before interest and tax margin
The earnings before interest and tax (EBIT) margin provides an
indication of the profit generated by an entity’s operating and
investment activities, but excluding any finance cost that resulted
from its financing activities. In comparison to the operating profit
margin, this ratio therefore considers the profit generated by the
entity’s total assets, and not only the assets that are utilised for
operating activities. Like the previous two profit margins, the value
of the EBIT margin also decreased, from 19,30% in 2017 to 10,73% in
2018.
3.6.4
Net profit margin
The net profit (NP) margin indicates how much of the initial
revenue is left after tax is paid. This figure is of great importance to
the entity’s equity providers because it indicates the portion of the
revenue that belongs to the non-controlling-interest shareholders,
can be paid out as ordinary or preference dividends, or can be
reinvested as the entity’s reserves. In our example, the decrease
from 13,05% to 6,12% in the value of this ratio should, therefore, be
a cause for concern for the entity’s equity providers.
It is important to view the decreases in Sasol’s profit margins in
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combination with the increasing assets and equity amounts
reflected in the financial statements. As we saw in Section 3.5,
decreases in all the profitability ratios were observed during 2018.
The question arises whether the decline in the profitability ratios
can be ascribed purely to the deteriorating profit margins, or if a
decline in the efficiency of investments also played a role.
3.7
Turnover ratios
Another factor that influences profitability is the efficiency with
which an entity utilises its assets. Turnover ratios provide an
indication of the speed with which an investment in assets is
converted into revenue. The higher the value of the ratio, the more
times per year the investment is utilised to generate revenue, and
the higher the total profit should be (if the entity is profitable).
Achieving a higher turnover ratio should, therefore, benefit any
profitable entity. Table 3.3 provides the formulae and calculations
for turnover ratios based on Sasol’s financial statements.
Table 3.3 Turnover ratios based on Sasol’s financial statements
Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
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3.7.1
Total asset turnover ratio
The total asset (TA) turnover ratio is an indication of the efficiency
with which an entity’s total assets are utilised to generate revenue.
The higher the value of the TA turnover ratio, the more times per
year the investment in total assets is converted into revenue. If an
entity is able to improve its TA turnover ratio while maintaining the
same profit margins, its return on assets should increase. Sasol’s TA
turnover ratio remained almost constant, decreasing only
marginally from a level of 0,44 to 0,43 times per year.
3.7.2
Property, plant and equipment turnover ratio
The property, plant and equipment (PPE) turnover ratio focuses
only on the utilisation of the entity’s investment in PPE. The
carrying value of the PPE – and not the cost price – is used when
the ratio is calculated. Like the TA turnover ratio, the value of the
ratio remained almost the same, with a slight increase from 1,10
times in 2017 to 1,11 times in 2018. No major change in the
efficiency of utilisation of the PPE is therefore observed.
3.7.3
Current asset turnover ratio
The current asset (CA) turnover ratio provides an indication of the
number of times per year that the investment in the current assets is
converted into revenue. In 2018, the value of this ratio increased
from 1,76 times to 2,14 times. Because the CA figure consists of
various items, a distinction is usually made between the turnover
ratios of some of these components.
3.7.4
Trade receivables turnover ratio
The trade receivables (TR) turnover ratio investigates the number of
times per year that the investment in the entity’s trade receivables is
converted into revenue. This ratio increased from 6,15 times to 6,33
times in 2018. This indicates that the investment in trade receivables
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was utilised slightly more efficiently during the year, which would
have contributed to the increase in the entity’s CA turnover ratio.
3.7.5
Inventory turnover ratio
The inventory (INV) turnover ratio focuses on the investment in
inventory. Since the cost of sales is determined by the amount of
inventory that is sold, this ratio does not focus on the value of the
entity’s revenue: the cost of sales figure is used instead. Sasol
reported a decline in the INV turnover ratio, from 2,91 times to 2,80
times. Unlike the increase in the TR turnover ratio mentioned
above, this would not have contributed to the increase in the CA
turnover ratio; instead, it would have had a negative impact on the
value of the ratio.
3.7.6
Trade payables turnover ratio
The trade payables (TP) turnover ratio evaluates the efficiency with
which the entity utilises trade payables to finance its purchases.
When the TP turnover ratio is calculated, the purchases of
inventory during the year are required. This value is not usually
included in the published financial statements. It is, however,
possible to estimate it by considering the opening and closing
inventory balances, and the cost of sales figure. For 2018, the
purchases value of R72,616 billion that was calculated for Sasol was
obtained by adding the cost of sales figure to the closing inventory
balance and subtracting the opening inventory balance. The value
of this ratio declined from a level of 2,00 times to 1,97 times. This is
an indication that on average, Sasol utilised relatively more trade
credit to finance its purchases.
When you look at the formulae for the ratios included in Tables
3.1–3.3, you may note that average values are calculated in some
cases. If items from the statement of financial position are used, it is
important to note that these items are measured on a specific date,
whereas the statement of profit or loss reports values that occurred
during a year. If substantial changes occurred in the values of the
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items obtained from the statement of financial position, the average
value should provide a better indication of the actual value of the
item than the one measured at year end.
In the discussion on profitability ratios in Section 3.5, we saw a
decline in their values from 2017 to 2018. Sasol’s ROA, for instance,
decreased to 2,65%, representing a decline of 53,49% from the 2017
ROA of 5,70%. When evaluating the financial performance of the
entity, it is important to identify what changes brought about this
decline. When the NP margin is considered, we note a substantial
decrease in the profit levels, from 13,05% to 6,12%. If the TA
turnover ratio is considered, we see a decrease from 0,44 during
2017 to a value of 0,43 times in 2018. In Sasol’s case, it would appear
that the decrease in the ROA figure is predominantly caused by the
decrease in the entity’s profit margins rather than by declines in its
turnover ratios.
QUICK QUIZ
1. Distinguish between return, profit margin and
turnover ratios.
2. Explain the relationship between an entity’s
return on assets, its net profit margin and
its total asset turnover time.
3.8
Liquidity ratios
Liquidity refers to an entity’s ability to honour its short-term
obligations. Adequate liquidity means that sufficient current assets
are available to cover the current liabilities. If an entity’s liquidity is
consistently at insufficient levels, it may lead to solvency problems,
which could threaten the business. The liquidity of an entity can be
evaluated by calculating ratios such as the current ratio and the
quick ratio.
Table 3.4 shows the formulae and calculations of the ratios for
liquidity based on Sasol’s financial statements.
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Table 3.4 Liquidity ratios based on Sasol’s financial statements
Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.8.1
Current ratio
The current ratio compares the entity’s current assets and current
liabilities. Using conventional norms of comparison, the value of
this ratio should be more or less 2:1 if an entity maintains
acceptable levels of liquidity. If a value of less than one is obtained,
it indicates that there is less than R1 of current assets available to
cover R1 of current liabilities, which could mean that the entity’s
liquidity is insufficient. Table 3.4 shows that there was a current
ratio of 1,36 for Sasol in 2018, indicating that the entity’s liquidity
levels appear to be below the conventional norm. The entity
experienced a decline in the value of this ratio from the previous
year (1,69 in 2017).
3.8.2
Quick ratio
The quick ratio (also referred to as the acid-test ratio) also
emphasises the entity’s current liabilities. Unlike the current ratio,
however, not all current assets are included in the calculation of the
quick ratio. Because it normally takes time to sell inventory,
investment in inventory may not be immediately available to
redeem the current liabilities. The same applies for assets held for
sale. Furthermore, tax receivable cannot be claimed over the short
term, and is, therefore, not available to cover the current liabilities.
Thus, when calculating the quick ratio, these three items are
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excluded. Consequently, the value of this ratio is a more
conservative estimate of the current assets that are available to
cover the current liabilities. Usually a value of 1:1 would be
considered acceptable, but, like the current ratio, the value may
differ from company to company and industry to industry. In 2018,
a value of 0,81 was calculated for Sasol. This is a decrease of 29,49%
from its 2017 value of 1,15.
3.8.3
Cash ratio
The quick ratio excludes some of the current assets, since it may not
be possible to convert the items into cash over the short term. When
calculating the cash ratio, the focus is solely on the cash and cash
equivalents available. This ratio indicates if sufficient cash is
available to cover the current liabilities. In most businesses,
investment in cash would not be sufficient to cover the current
liabilities. Sasol’s 2018 cash ratio of 0,29 indicates that less than 30%
of the entity’s current liabilities can be covered by the cash
available, which would not be seen as a very favourable liquidity
situation. Furthermore, we can see a sharp decrease in the value of
the ratio compared with Sasol’s 2017 level of 0,56.
A second important component to consider when evaluating an
entity’s liquidity is the turnover times of its current assets and
current liabilities. The turnover times of the current asset
components provide an indication of how long it takes to convert
the investment in the assets into revenue. The longer this takes, the
weaker the entity’s liquidity. For the current liabilities, the turnover
time provides an indication of the average period of time before the
liability is redeemed. Shorter turnover times indicate that liabilities
are paid earlier, which has a negative effect on liquidity. These
ratios will influence the entity’s cash conversion cycle. A more
efficient management of these components of working capital may
result in an improvement in the entity’s liquidity (as explained in
Chapter 14).
Table 3.5 shows the formulae and calculations for Sasol’s
turnover times.
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Table 3.5 Turnover time ratios based on Sasol’s financial statements
Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.8.4
Trade receivables turnover time
The turnover time of trade receivables (TR) shows the average time
that it takes to convert an investment in TR into revenue. This
represents the average collection period of the trade receivables
(that is, how long the customers who purchase items on credit take
on average to settle their accounts). If an entity observes an increase
in the value of this ratio over time, it could be a sign of a decrease in
liquidity. It could also be an indication that the credit terms that are
applied are too lenient. Sasol reported a slight decrease in the value
of this ratio, from 58,54 days in 2017 to 56,91 days in 2018.
3.8.5
Inventory turnover time
The inventory (INV) turnover time ratio calculates the average time
it takes to convert an investment in inventory into revenue.
Therefore, this ratio provides the average age of the inventory (in
other words, how long an item of inventory has been in the
business before it is sold). Like the inventory turnover ratio, this
ratio is calculated by using the cost of sales figure. An increase in
the turnover time has a negative effect on an entity’s liquidity,
whereas a decrease has a positive impact on liquidity. In Sasol’s
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case, we can observe an increase from 123,90 days to 128,62 days
from 2017 to 2018: an increase of about five days in the average time
it takes to sell an item of inventory.
3.8.6
Trade payables turnover time
The trade payables (TP) turnover time ratio indicates the average
period of time that it takes before the trade payables are repaid. If
the trade payable turnover time decreases, it means that the trade
payables are repaid earlier. This has a negative effect on the
liquidity of the business, whereas an increase in the turnover time
improves the liquidity. The increase in the value of this ratio from
179,63 days in 2017 to 182,32 days in 2018 indicates that Sasol
managed to extend the time it took to repay its creditors by almost
three days.
3.8.7
Cash conversion cycle
By adding the turnover times of the trade receivables and the
inventory, and subtracting the turnover time of the trade payables,
Sasol’s cash conversion cycle (CCC) can be calculated (refer to
Chapter 14 for a comprehensive discussion of the CCC). This
measure of liquidity can be used as an indication of the length of
time that elapses from when cash is spent on purchasing inventory
until the cash is received back from creditor customers. Studies
investigating the relationship between CCC and profitability report
an inverse relationship, and it would appear that entities can
improve their profitability by reducing the length of their CCC. In
2018, Sasol experienced an increase in its CCC from 2,81 days in
2017 to 3,21 days. This does not represent a substantial decline in
the entity’s liquidity management.
QUICK QUIZ
1. Distinguish between the current, quick and
cash ratios.
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2. Explain what the value of a turnover time
ratio represents.
3. Explain what effect an increase in an entity’s
trade receivables, inventory and trade
payables turnover time has on its cash
conversion cycle.
3.9
Solvency ratios
Solvency refers to an entity’s ability to cover its obligations when it
closes down its operating activities. Comparing an entity’s total
assets and total debt capital is, therefore, of great importance. In the
case where the value of an entity’s assets exceeds the value of its
liabilities, its level of solvency will be sufficient. If this is not the
case, however, the long-term survival of the entity may be at risk.
Table 3.6 contains the formulae of the main ratios applied to
evaluate an entity’s solvency. These ratios are quantified on the
basis of the information contained in Sasol’s financial statements.
Table 3.6 Solvency ratios based on Sasol’s financial statements
Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.9.1
Debt-to-assets ratio
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The first measure of solvency shown in Table 3.6 is the debt-toassets ratio. The relationship between the debt capital and the total
assets provides an indication of the portion of the total capital
requirement that is financed by means of debt capital. The higher
the value of this ratio, the weaker the business’s solvency position.
The value of 0,46 calculated for Sasol in 2018 means that 46% of the
total assets are financed with debt capital, and the remaining
portion of 54% is financed with equity. On the basis of this value, it
would appear that Sasol is maintaining an acceptable level of
solvency. If this value is compared with the figure of 0,43 in 2017,
we can see a slight decline in the entity’s solvency.
3.9.2
Debt-to-equity ratio
The debt-to-equity ratio is another way of assessing an entity’s
solvency. This ratio compares the amount of debt capital with the
equity capital. As with the debt-to-assets ratio, we can see a slight
decline in Sasol’s solvency, with an increase in the debt-to-equity
ratio from 0,74 to 0,86.
3.9.3
Financial leverage ratio
When calculating the financial leverage ratio, the average amount
of total assets is compared with the average amount of equity
capital included in the entity’s capital structure. In 2018, the value
of this ratio increased from 1,74 to 1,80, once again reflecting the
increase in the portion of debt capital utilised.
Another aspect that we need to consider when evaluating an
entity’s solvency is its ability to meet certain obligations. If an entity
is not able to cover some of its obligations, the result may be
problems with solvency. A number of coverage ratios can be
calculated to determine if sufficient profits are available to cover
these obligations. These coverage ratios usually focus on an
obligation that the entity is legally bound to consider, and then
compare it with the profits that are available to pay that obligation.
Table 3.7 contains the formulae of the main coverage ratios
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applied to evaluate an entity’s ability to meet its obligations. The
ratios are calculated on the basis of the information contained in
Sasol’s financial statements.
Table 3.7 Coverage ratios based on Sasol’s financial statements
Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.9.4
Finance cost coverage
When evaluating solvency, it is not sufficient to focus only on the
portion of debt capital included in the entity’s capital structure. It is
also important to determine if the entity is able to meet certain
obligations. The finance cost payable on debt capital usually
represents a legally enforceable obligation. If an entity does not pay
the finance cost on its debt capital, the debt capital providers can
take legal action to collect it. The finance cost coverage ratio
indicates if sufficient profits are available to pay the finance cost.
The relevant profit figure is the profit before finance cost and tax. In
our Sasol example, the finance cost coverage ratio for 2018 is more
than adequate because an amount of R6,96 is available for each R1
finance cost that needs to be paid. In the previous year, a higher
coverage ratio of 14,62 times was recorded.
As pointed out in Chapter 2, finance lease costs are included as
part of finance cost. From January 2019, entities must employ a
similar lease accounting model to recognise the assumed interest
charge on properties obtained by means of operating leases.
3.9.5
Preference dividend coverage ratio
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The preference dividend coverage ratio allows us to see if sufficient
profits are available to pay the preference dividends. The relevant
profit figure is the profit after tax and non-controlling interest
because preference dividends can only be paid after provision has
been made for all other obligations. An acceptable coverage ratio of
10,06 is calculated for Sasol in 2018. If we compare this value with
the coverage of 21,60 times in 2017, however, a decline in the ratio is
observed.
QUICK QUIZ
1. Identify the three solvency ratios discussed
in this section.
2. Explain how the value of a coverage ratio
should be interpreted.
3.10
Cash flow ratios
Most of the ratios we have discussed thus far concern information
contained in the entity’s statement of profit or loss and the
statement of financial position. It is, however, important to consider
if sufficient cash flows are generated to cover the entity’s expenses
and liabilities. It is also necessary to investigate the entity’s sources
of cash flows and how these cash flows are utilised.
In this section of the chapter, we look at a number of ratios that
are calculated by considering the entity’s statement of cash flows.
Table 3.8 contains some examples of these cash flow ratios based on
Sasol’s financial statements.
Table 3.8 Cash flow ratios based on Sasol’s financial statements
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Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.10.1
Cash flow to revenue ratio
The cash flow to revenue ratio quantifies the portion of the entity’s
revenue that is converted into cash retained from operating
activities. In the case of Sasol, the 2018 value of this ratio indicates
that R1 of revenue results in retained operating cash flow of 14,52
cents. This shows a deterioration from the 2017 situation, where
16,52 cents of operating cash flow was retained for every R1 of
revenue. Since the cash retained from operating activities represents
the cash available to fund investing activities or reduce the entity’s
dependence on external capital providers, the decline signals that
the entity was slightly less efficient in generating internal cash
flows.
3.10.2
Cash return on assets ratio
When the profitability ratios are calculated, the return on assets is
calculated to determine how efficiently the entity utilises its assets
to generate revenue. The cash return on assets ratio shows how
efficiently the assets are utilised to generate operating cash flows.
The decline from 9,40% to 8,19% in the value of this ratio for Sasol
during 2018 can be attributed to a decrease in the cash available
from operating activities, combined with an increase in the entity’s
total assets.
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3.10.3
Cash return on equity ratio
Similarly, the cash return on equity ratio determines the cash return
that the equity providers of the entity earned in a particular year.
The cash return on equity ratio for Sasol declined from 16,36% to
14,74% in 2018, reflecting the decrease in the cash available from
operating activities reported in the statement of cash flows. This is
an important factor to consider when deciding whether to invest in
the entity, since it highlights the decreasing amount of cash flow
available to pay dividends.
3.10.4
Cash flow to operating profit ratio
In Chapter 2, we saw that profits contained in the statement of
profit or loss do not necessarily represent cash flows. It is, therefore,
important that an entity be able to determine what portion of its
profits is eventually converted into cash flows. The cash flow to
operating profit ratio compares the operating cash flow that is
generated to the operating profit reported. In the case of Sasol, a
high value of 262,98% shows that for every R1 of operating profit,
operating cash flow to the value of R2,63 was generated. The value
of this ratio also increased substantially from the 2017 level of
143,86%. The high values obtained for this ratio could be explained
by the large amounts of non-cash items included during the
calculation of the operating profit (depreciation and amortisation,
impairments and so on).
When evaluating an entity’s ability to meet obligations, it is also
possible to focus on cash flows rather than profit figures. These
ratios should provide an analyst with an indication of whether or
not the entity has sufficient cash available. Since most obligations
need to be paid with cash, these ratios are of great importance.
Table 3.9 contains some examples of these coverage ratios based on
cash flow. Again, the ratios are based on Sasol’s financial
statements.
Table 3.9 Cash coverage ratios based on Sasol’s financial statements
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Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.10.5
Finance and dividend cost coverage ratios
When evaluating an entity’s ability to meet its obligations, it is also
possible to focus on cash flows rather that profit figures. The
finance cost coverage and the dividend coverage ratios determine
what cash flows are available to cover these two obligations. The
values of 9,62 and 4,31 times, respectively, indicate that Sasol had
sufficient cash flows available to pay finance costs and dividends in
2018. Although the dividend coverage ratio remained more or less
constant over the two years, the finance cost coverage declined
substantially from the 2017 value of 13,03. This decline is the result
of a 32,81% increase in the finance expenses paid amount.
3.10.6
Other cash coverage ratios
It is also important for an entity to determine if sufficient cash flows
are generated to cover its reinvestment in fixed assets, to repay its
long-term debt capital, and to cover its investing and financing cash
flows. If an entity is unable to generate sufficient operating cash
flows to cover these activities, it will have to obtain additional cash
flows from its capital providers to meet the cash demand. The
reinvestment coverage, debt repayment coverage, and the investing
and financing coverage ratios are used to determine if the cash
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flows are sufficient. A value of less than one for any of these ratios
indicates that additional cash will have to be raised. In the case of
Sasol, it can be seen that insufficient operating cash flows were
generated to cover the reinvestment in fixed assets in 2017 and
2018. Sufficient operating cash flows were generated to cover the
entity’s debt repayment in 2018, but the coverage declined
substantially from the 2017 value. When comparing the cash
retained from operating activities with the total cash required for
investing and financing activities, the value of the coverage ratio is
below one in 2017 and 2018. This signifies that the entity generated
insufficient cash flow from its operating activities to fund its
investing and financing activities. The resulting cash deficit results
in a decline in the entity’s cash and cash equivalents. From 2016 to
2018, Sasol’s cash and cash equivalents declined by 67,35%.
QUICK QUIZ
1. Identify the four cash flow ratios discussed
in this section.
2. Explain how the values of the cash coverage
ratios should be interpreted.
3.11
Investment ratios
One of the most important groups of users of financial statements is
the entity’s shareholders, both existing and potential. These
shareholders are interested in the potential benefits that their
investment will provide. They are also interested in finding out if
their investment in the shares of the entity is expected to increase or
decrease in value over time. The investment ratios discussed in this
section are, therefore, of great importance to the current and
potential shareholders of a business.
Table 3.10 shows some of the main types of ratio that the
shareholders of an entity should look at closely.
Table 3.10 Investment ratios based on Sasol’s financial statements
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Source: Ratios calculated by author Erasmus from the financial statements presented in Chapter 2, which
are based on information in Sasol Ltd, 2018.
3.11.1
Earnings per share ratio
The value of the earnings per share (EPS) ratio is an indication of
the attributable earnings that were earned per ordinary share
during the year. In the case of Sasol, a figure of R14,26 per share
was available to the ordinary shareholders in 2018. This value is
substantially lower than the EPS of R33,36 in 2017. This decline
corresponds to the decrease in Sasol’s ROSHE during 2018, as
discussed in Section 3.5. The decrease in the entity’s EPS reflects the
57,16% decrease in attributable earnings, combined with the 0,25%
increase in the number of ordinary shares. As indicated in Chapter
2, a relatively large expense in terms of the Sasol Khanyisa share
scheme was included in the 2018 statement of profit or loss. This
impacted negatively on the entity’s attributable earnings and
contributed towards the marked decline in the EPS.
3.11.2
Dividend per share ratio
Usually, only a portion of an entity’s attributable earnings is
declared as an ordinary dividend. The dividend per share (DPS)
indicates the amount that investors receive per share in the form of
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dividends. Thus, of the R14,26 EPS calculated for Sasol, the
ordinary shareholders received a total of R12,99 per share in the
form of an ordinary share dividend during 2018. This is a 8,06%
decrease on the DPS paid in 2017.
When the EPS and DPS ratios are calculated, the number of
ordinary shares is required. A breakdown of the issued ordinary
shares is usually provided in an entity’s financial statements. In the
case of Sasol, the notes to the financial statements provided the
weighted average number of ordinary shares that were outstanding
during the financial years, and it is this figure (612,2 million and
610,7 million ordinary shares in 2018 and 2017, respectively) that
was used to calculate these two ratios.
3.11.3
Price-earnings ratio
The price-earnings (P/E) ratio indicates how many rands investors
are prepared to pay for each R1 EPS that is earned by the entity.
The value of 35,27 obtained for Sasol in 2018 indicates that investors
are prepared to pay almost 35 times more than the current EPS.
Compared to the 2017 value of 10,99, this improvement in the P/E
ratio indicates that investors were prepared to pay substantially
more per rand EPS during 2018 than in the previous year. It should
be noted that the entity’s EPS declined sharply during 2018. During
the same time, the share price increased by 37,21%.
3.11.4
Dividend payout ratio
The dividend payout ratio represents the portion of the attributable
earnings that is paid to investors. The value of 0,91 calculated for
Sasol during 2018 indicates that only 9% of the attributable earnings
was reinvested in the entity. The dividend payout ratio increased
substantially compared to the 2017 value of 0,42.
3.11.5
Ordinary dividend coverage ratio
The ordinary shareholders have the last claim on the profits of an
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entity. When the ordinary dividend coverage is calculated, the
focus is, therefore, placed on the attributable earnings (that is, the
earnings that are left after all other obligations have been paid).
Usually, an entity will only declare dividends if sufficient profits
are available to pay the dividends. If the ordinary dividend
coverage ratio is less than one, reserves from the previous years will
have to be used to pay the dividends. Alternatively, additional debt
capital will have to be obtained to finance the dividend payments.
The sharp decline in the value of the ordinary dividend coverage
from 2017 to 2018 reflects the large increase in the dividend payout
ratio discussed in Section 3.11.4. Although the value of the ordinary
dividend coverage ratio declined by 53,51% in 2018, it is still larger
than one. The entity therefore had sufficient attributable profit
available to cover the ordinary dividend payments in 2018.
3.11.6
Market-to-book-value ratio
The market-to-book-value ratio compares the market capitalisation
of the entity’s ordinary shares with the book value of the ordinary
shareholders’ equity. Because the market capitalisation is calculated
using the current market price, it incorporates investors’
expectations about future financial performance. The book value of
the ordinary shareholders’ equity refers to the total capital that the
ordinary shareholders contributed to the entity in the form of share
purchases and retained profits that were reinvested. The difference
between the two values should provide an indication of the price
investors are prepared to pay relative to the investment at book
values. A high value for this ratio could be seen as a sign that
investors are expecting high future earnings from the entity. In
Sasol’s case, we can observe an increase of 30,59% in the value of
this ratio from 2017 to 2018. This increase is largely due to the
increase in the market price per share observed during the period.
QUICK QUIZ
1. Distinguish between the earnings per share and
dividend per share ratios.
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2. Explain how the value of the price-earnings
ratio should be interpreted.
3. Explain how the market-to-book-value ratio is
interpreted.
3.12
Financial gearing
Financial gearing refers to the effect that the use of debt capital has
on the return on the shareholders’ equity. If an entity is able to
utilise debt capital efficiently, the result may mean increased
returns for its shareholders. If the utilisation of the debt capital is
not efficient, however, the use of debt capital will have a negative
effect on the return on shareholders’ equity.
Two important factors that need to be taken into consideration
when evaluating an entity’s financial gearing are the ROA and the
cost associated with the debt capital (RD). If an entity is able to
generate an ROA in excess of the RD, the return on the capital will
be higher than its cost. This so-called surplus return generated will
be transferred to the entity’s shareholders and the entity will
experience positive financial gearing. However, it is also important
to note that the opposite situation may occur. If the ROA is lower
than the RD, the entity is earning less on the debt capital than its
cost. In this situation, the deficit will also be transferred to the
shareholders and the use of debt capital will result in a decrease in
the ROSE. This situation is classified as negative financial gearing.
Example 3.1 illustrates these two scenarios.
Example 3.1 Evaluating financial gearing
Assume that the financial gearing of the two entities described below is
investigated.
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Assume that the operational aspects of the two entities are the same and that
both have an ROA of 15%. Assume that both entities have a cost of debt
capital of 10%. The abbreviated statements of profit or loss for the two entities
are given below.
From this example, it becomes clear that the ROSE for both entities is higher
than the ROA (15%). The higher ROSE can be attributed to the positive
financial gearing experienced by the entities (ROA > RD). Furthermore, the
ROSE is substantially higher for Company A (60%) than for Company B (20%).
The higher ROSE for Company A is the result of the high percentage of debt
capital in the capital structure.
If the financial performance of the two entities declines as a result of
economic circumstances and the ROA declines to a level below the cost of the
debt capital, or, alternatively, if interest rates increase to levels that are higher
than the ROA, the situation will change dramatically. Assume that the ROA
declines to 7% and interest rates stay at 10%.
In both cases, the ROSE (−20% and 4%) is lower than the ROA (7%). In this
situation, both entities are exposed to negative financial gearing, where ROA <
RD. We can also see that the change left Company A in a far weaker position
than Company B. Because Company A has a larger portion of debt capital in its
capital structure, it is more exposed to negative financial gearing than
Company B.
The information provided in this example can be summarised as follows:
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QUICK QUIZ
1. Explain how financial gearing influences an
entity.
2. Distinguish between positive, negative and no
financial gearing.
3.13
DuPont analysis
A convenient way of combining the information contained in the
various return ratios is to conduct a DuPont analysis. By applying
this technique, it is possible to obtain a breakdown of the return
ratios discussed in the previous sections of this chapter. DuPont
analysis also enables an analyst to understand what effect changes
in the components of the ratios have on the overall return generated
by the entity.
In this section, we focus on the ROA and ROE ratios. When
evaluating these measures by means of a DuPont analysis, it is
possible to identify the individual components that contribute to
the overall value of the return ratio. Furthermore, it is possible to
evaluate changes in the values of the ratios over time to determine
where possible problem areas exist. The analysis also allows one to
compare the ratios of similar firms to investigate where value is
created.
In order to explain how DuPont analysis works, the ROA and
ROE ratios for Sasol are provided in Figure 3.1.
Figure 3.1 DuPont analysis of Sasol’s return on equity (2018 and 2017)
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Using the information provided by the DuPont analysis, it is
possible to determine which factors contributed to the decline in the
overall ROE figure from 9,92% in 2017 to 4,77% in 2018. From
Figure 3.1, it becomes clear that the decline in the ROA and ROE
values came from the decrease in the net profit margin, since the
total asset turnover ratio remained constant and the leverage factor
increased only slightly during 2018.
If we consider the breakdown of the net profit margin, we can
determine what effect taxation, interest payments and the entity’s
EBIT margin had on the 2018 ROE value. The tax burden of 0,67
indicates an average tax rate of 33% for the entity. The interest
burden of 0,86 indicates that about 14% of the profit before tax
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consists of finance cost. Although the entity is reporting an EBIT
margin of 10,73%, the net profit margin of 6,12% reflects the profit
that is left after provision has been made for the finance cost and
the tax that the entity has to pay. A comparison with the 2017
values indicates that the EBIT margin as well as the tax and interest
burdens decreased during 2018. The combination of these changes
contributed to the decrease in the net profit margin.
It is also possible to compare the various components identified
in Figure 3.1 with those of other entities to determine those areas in
which Sasol is able to outperform its competitors. In the previous
chapter, a discussion of Spanjaard, a much smaller producer of
chemical products than Sasol, was included to point out some of the
differences that may exist between the financial statements of two
entities. If we calculate Spanjaard’s total asset turnover ratio, a
value of 1,83 is obtained. Sasol’s total asset turnover ratio of 0,43 is
therefore much lower than Spanjaard. In contrast to Spanjaard,
however, Sasol only generated a substantially higher net profit
margin of 6,12% (Spanjaard reported a loss after tax, resulting in a
negative net profit margin of –3,85%). This higher net profit margin
combined with the lower total asset turnover ratio resulted in an
ROA of 2,65%, which far exceeds Spanjaard’s negative ROA of –
7,05%. Even if combined with Sasol’s more conservative usage of
debt capital (the entity’s financial leverage ratio is lower than
Spanjaard’s leverage ratio of 1,57), Sasol was able to generate an
ROE of 4,77% in 2018, compared to the negative value of –11,08%
reported by Spanjaard. As highlighted in Example 3.1, financial
gearing has the potential to increase shareholders’ return, but the
use of debt can also have a devastating impact on their returns if
the entity fails to earn a sufficient return on the debt. The
shareholders of Spanjaard learnt this lesson the hard way.
QUICK QUIZ
Identify the components of return on equity that
are usually included in a DuPont analysis.
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FOCUS ON ETHICS: The ethical
importance of ratios to external users of financial
statements
For ratio analysis to be useful, it is critically important that the
underlying financial statements be accurate. Financial statements
should represent the underlying economic position of the entity fairly
to their external users. External users rely on these financial
statements to provide essential, accurate financial and non-financial
information that is used in the decision-making process of whether or
not to invest in an entity.
In Chapter 2, you were provided with information about
accounting irregularities that occurred at Steinhoff International
Holdings NV. The extract included a quote by the chief executive
officer (CEO) of the Sygnia Group, Magda Wierzycka, who said, “When
I looked at the financials … it took me exactly half an hour to figure
out that the structure was obfuscated, that financial items made no
sense, that the acquisition spree was not underpinned by any logic
and was too frenzied to be well thought out, and that debt levels were
out of control” (Naudé, Hamilton, Ungerer, Malan & De Klerk, 2018).
Source: Mowen, Hansen & Heitger, 2009: 708.
QUESTIONS
1. Why do you think external users of financial information put
such a high premium on the use of ‘ethical ratios’?
2. Do you think that the CEO of the Sygnia Group was of the
opinion that the financial statements of Steinhoff represent
the underlying economic position of the entity fairly?
Motivate your answer.
3. Would the use of ‘ethical ratios’ have made a difference to
the final outcome at Steinhoff? Motivate your answer.
3.14
Conclusion
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This chapter discussed the main types of financial ratio that can be
used to evaluate the financial performance and position of an
entity. You learnt the following:
• The main requirements for financial ratios are to provide
meaningful comparisons between items in the financial
statements; only relevant amounts must be included in their
calculations and financial ratios need to be comparable over
time.
• When evaluating financial ratios, it is important to compare
their values with conventional norms, with the value of the ratio
calculated for the entity over a period of time or with the values
of the ratio obtained for similar entities.
• The main categories of ratio are profitability, liquidity, solvency,
cash flow and investment ratios.
• Profitability ratios evaluate the efficiency with which an entity
utilises its capital to generate revenue.
• Liquidity ratios refer to an entity’s ability to cover current
liabilities by means of its current assets.
• Solvency ratios investigate the relationship between an entity’s
debt capital and its total assets.
• Cash flow ratios determine if sufficient cash flows are generated
to cover the entity’s obligations.
• Investment ratios are used to determine the benefits that the
investors of the entity earned.
• DuPont analysis provides a breakdown of the components that
contribute to an entity’s ROE in order to evaluate changes in the
ratio.
• Financial gearing refers to the effect that the use of debt capital
has on the return on the shareholders’ equity.
Financial ratios are calculated to convert the information provided
in an entity’s financial statements into a format that is easily
understandable and that can be compared with different entities
and over time. Conducting a ratio analysis should make the
financial performance and position of an entity clearer. Possible
explanations for changes in the entity’s situation may be provided
by comparing the values of the ratios.
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The case study at the beginning of this chapter focused on the
decline in Verimark’s share price. The question that arose was
whether it was possible to anticipate the unfavourable share price
movement on the basis of the information provided in the entity’s
financial statements. Although a large number of factors ultimately
influence an entity’s share price, the entity’s financial performance
can also play an important role in the way in which the market
assesses it. In the case of Verimark, we saw that the ROE figure
indicated a sharp decrease in the profitability of the shareholders’
investment in the entity. If it is possible to determine which factors
brought about this decrease in the ROE, we should then be able to
understand which factors influenced the return shareholders
received on their investment.
This brings us to the closing case study of this chapter, which
applies a DuPont analysis using the information we have about
Woolworths in an attempt to understand what caused the sharp
decline in this company’s ROE and share price following the
acquisition of David Jones in 2015.
CASE STUDY
Woolworths going Down Under
In 2015, South African retailer Woolworths finalised the
purchase of David Jones, an Australian department store chain.
The entity paid more than R21 billion to acquire David Jones,
representing a premium of R5 billion (more or less 25%) above
the market value of the entity. The majority of the acquisition
was financed by means of debt, increasing the entity’s longterm interest-bearing borrowings from R623 million in 2014 to
R14,922 billion in 2015. Over the same period, the finance costs
increased from R136 million to R1,494 billion. The acquisition
was intended to diversify Woolworths’ operations, and it was
expected that additional profits before finance cost and tax of
around R1,5 billion would be generated within the first five
years following the deal.
It soon became clear, however, that a number of challenges
existed in terms of the turnaround of David Jones. The poor
performance of Woolworths’ Australian businesses not only
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impacted on the entity’s bottom line, but is also reflected in the
marked decline in its share price. The entity’s ROE declined
from 43,01% in 2014 to a negative return of –11,48% in 2019.
Before the announcement of the 2015 financial results,
Woolworths’ shares were trading at around R100 per share. By
the time the 2019 financial results were reported, it was down
to a value of R53,93 per share.
If we were to conduct a DuPont analysis to compare the
components of Woolworths’ ROE for 2014 and 2019, we would
obtain the breakdown set out below.
Source: Created by author Erasmus.
This DuPont analysis makes it clear that the biggest
contributing factor to the decline in ROE is the net profit
margin. The value of this ratio decreased from 7,53% in 2014 to
a negative value of −1,48% in 2019. During the same period, the
total asset turnover ratio increased from 1,78 times to 2,03
times per year. The combined effect of these two ratios is
reflected in the large decline in the entity’s ROA, which
dropped from 13,43% in 2014 to –3,02% in 2019. This decline is
further amplified by the relatively high degree of financial
gearing the entity employed, resulting in the disappointing
deterioration of the ROA.
The big question shareholders now face is whether the
entity can turn its financial performance around. According to
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the CEO, Ian Moir, management realises that mistakes were
made during the acquisition of David Jones, but believes that
they know how to fix these. Only time will tell when the
decision to go Down Under will stop dragging the entity’s
financial performance down.
Sources: Compiled from information in De Klerk, 2019; Smith, 2018; Kew, 2018.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
Which of the following transactions will have an impact on an entity’s return on
equity?
A. An increase in the dividend rate of the entity’s redeemable preference
shares from 10% to 12%
B. A decrease in the interest rate paid on convertible debentures
C. Converting all the entity’s convertible preference shares into ordinary
shares
D. An increase in the reinvestment rate of profits from 20% to 40%
2.
An entity’s current ratio should improve if …
A. it purchases a large amount of inventory in a cash transaction.
B. it takes longer to repay its trade creditors.
C. it increases the amount of prepayments to the insurance company to
equal three months’ premiums instead of two months’ premiums.
D. it manages to extend the maturity of a long-term loan that would have
been repaid six months from now by another five years.
3.
If an entity is able to improve its gross profit margin while maintaining the same
amount of revenue, it would increase the value of its …
A. trade receivables turnover ratio.
B. current assets turnover ratio.
C. inventory turnover ratio.
D. total asset turnover ratio.
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4.
Which of the following is NOT a requirement for financial ratios?
A. A meaningful comparison between items from the financial statements
should be made.
B. Only relevant amounts should be included during the calculation of a ratio
to ensure a true reflection of financial performance.
C. Comparisons between the values of ratios calculated for different entities
should be possible.
D. The timeliness of ratios should be ensured by only considering ratios
based on a single financial year.
INTERMEDIATE
5.
An entity’s operating profit margin would improve if its …
A. finance cost could be reduced.
B. surplus PPE were sold at a profit.
C. dividend income received on share investments increased significantly.
D. PPE were depreciated over a shorter period of time than is currently the
case.
6.
Zimco Ltd noticed a marked decline in its ROE. Which of the following
transactions that the entity completed during the past financial year most
probably contributed to this decline?
A. The entity converted all its preference shares into ordinary shares.
B. Additional PPE was purchased and financed by means of a bank loan.
C. Surplus PPE was sold at its carrying value and the proceeds were used to
repurchase some of the entity’s preference shares.
D. The entity adjusted its credit policy, resulting in an increase in its trade
receivables turnover time.
7.
An entity’s cash flow to turnover ratio could be improved by …
A. increasing credit sales.
B. increasing credit purchases of inventory instead of paying cash.
C. decreasing the amount of depreciation provided for on PPE.
D. increasing the prepayment of operating expenses.
Consider the ratio analysis that follows, which was conducted for Unsure Ltd. With
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which statements in Questions 8 to 12 do you agree?
2018
2017
Inventory turnover ratio
6 times
4 times
Price-earnings ratio
12 times
10 times
Net profit margin
9%
10%
Finance cost coverage
8 times
12 times
Financial leverage ratio
0,75
0,95
Cash dividend coverage
14 times
8 times
Earnings per share
15 cents per share
20 cents per share
Total asset turnover time
90 days
180 days
Cash conversion cycle
15 days
45 days
8.
The entity experienced an increase in its return on assets, based on the …
A. increase in its net profit margin.
B. increase in the finance cost coverage.
C. decrease in the total asset turnover time.
D. improvement in the cash dividend coverage.
9.
The entity managed to improve its solvency, as reflected by the …
A. improvement in the cash dividend coverage.
B. improvement in the finance cost coverage.
C. lower financial leverage ratio.
D. weaker earnings per share.
10. The entity’s liquidity …
A. deteriorated, as indicated by the lower cash conversion cycle.
B. decreased as a result of the lower finance cost coverage.
C. improved, as reflected by the increased inventory turnover ratio.
D. improved, as indicated by the increase in the cash dividend coverage.
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11. The entity’s investment potential …
A. declined, as reflected by the lower earnings per share.
B. improved, as reflected by the price-earnings ratio.
C. deteriorated as a result of the lower profitability reflected by the total
asset turnover time.
D. decreased as a result of the increased use of debt capital, indicated by
the lower financial leverage ratio.
12. The entity managed to achieve an increase in its return on equity from 2017 to
2018 by …
A. increasing the amount of debt in its capital structure, as reflected by the
decrease in its financial leverage ratio.
B. improving its profit levels, as indicated by the increase in the net profit
margin.
C. ensuring that sufficient cash is available to pay dividends, shown by the
increase in the cash dividend cover.
D. improving its profitability, as reflected by the decrease in the total asset
turnover time.
ADVANCED
Use the information that follows, which was obtained from the financial statements of
Combo Ltd, to answer Questions 13 to 17.
Total equity
R100 000
Retained earnings (statement of profit or loss)
R20 000
Current liabilities
R75 000
Ordinary share dividends
R4 000
Taxation
R5 000
Non-current liabilities
R25 000
Shareholders’ equity
R75 000
Profit before tax
R35 000
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Revenue
R800 000
Non-controlling interest (statement of profit or loss)
R5 000
Preference shares
R20 000
Finance cost
R10 000
13. Combo Ltd’s total asset turnover time is __________.
A. 0,5 times
B. 1 time
C. 2 times
D. 4 times
14. Combo Ltd’s return on equity is __________.
A. 10%
B. 25%
C. 30%
D. 35%
15. Combo Ltd’s return on shareholders’ equity is __________.
A. 20,3%
B. 26,7%
C. 33,3%
D. 40,0%
16. Combo Ltd’s return on ordinary shareholders’ equity is __________.
A. 24,0%
B. 30,0%
C. 41,7%
D. 43,6%
17. Combo Ltd’s ordinary dividend coverage is __________.
A. 5 times
B. 6 times
C. 7,5 times
D. 8,75 times
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18. Highcor Ltd reported revenue of R500 000 and an EBIT margin of 20%. The
entity’s effective tax rate was 28%, while the finance cost to EBIT ratio was
10%. The entity had debt to the value of R250 000 and the debt-to-equity ratio
was 2:1. The entity’s return on equity is equal to __________.
A. 2,59%
B. 5,76%
C. 14,36%
D. 51,84%
LONGER QUESTIONS
BASIC
1.
Look at the information that follows, which was taken from the financial
statements of Juju Ltd and Tutu Ltd.
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Both entities have 100 000 ordinary shares issued. Assume that Juju Ltd had
opening inventory to the value of R200 000, while Tutu Ltd’s opening inventory
amounted to R40 000.
a)
Calculate the ratios listed in the table that follows (you can ignore the use
of average values).
Ratio
Juju Ltd
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Tutu Ltd
Current ratio
Quick ratio (acid-test ratio)
Trade receivables turnover ratio
Inventory turnover ratio
Cash turnover ratio
Trade payables turnover ratio
Cash conversion cycle
Current asset turnover ratio
Total asset turnover ratio
Return on equity
Return on assets
Financial leverage ratio
Earnings per share
b)
c)
If you were the credit manager for a supplier, to which one of these
entities would you approve the extension of (short-term) trade credit?
Why?
In which one would you buy shares? Why?
INTERMEDIATE
2.
In Question 3 at the end of Chapter 2, items from the financial statements of
Spanjaard Ltd were provided. You were required to compile the statement of
profit or loss and the statement of financial position based on this information.
Using the resulting financial statements, conduct a detailed ratio analysis of
Spanjaard.
a) Calculate the ratios listed in the table that follows for 2018.
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b)
c)
d)
Compare the 2018 values of Spanjaard’s ratios with those of the previous
year, and highlight positive and negative changes that occurred during
the year.
Compare the 2018 values of Spanjaard’s ratios with Sasol’s ratios and
highlight the major differences that exist between the two entities.
Provide possible reasons for these differences.
Conduct a DuPont analysis based on the 2018 results of Sasol and
Spanjaard. Indicate what caused the differences between the two entities.
ADVANCED
3.
The 2019 statement of profit or loss, statement of financial position and
statement of cash flows for Copycat Ltd are presented below.
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COPYCAT LTD
STATEMENT OF PROFIT OR LOSS
2019
R’000
2018
R’000
Revenue
3 960
3 600
Cost of sales
(792)
(1 200)
Gross profit
3 168
2 400
Operating expenses
(2 200)
(2 000)
Depreciation
(110)
(100)
Operating profit
858
300
Finance cost
(58)
(58)
Profit before tax
800
242
Income tax expense (25%)
(200)
(61)
Profit for the year
600
118
Preference share dividend
(50)
(50)
Attributable profit
550
68
Ordinary share dividends
(225)
(250)
Retained earnings
325
(182)
2019
R’000
2018
R’000
Property, plant and equipment (PPE) at carrying
value
825
1 000
Long-term loans granted
440
440
Non-current assets
1 265
1 440
COPYCAT LTD STATEMENT OF
FINANCIAL POSITION
ASSETS
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Inventories
792
720
Trade receivables
396
360
Cash and cash equivalents
198
180
Current assets
1 386
1 260
Total assets
2 651
2 700
Ordinary shares (250 shares)
566
1 000
Retained earnings
525
200
1 091
1 200
10% preference shares
500
500
Shareholders’ equity
1 591
1 700
Long-term loan
110
120
Debentures
180
180
Non-current liabilities
290
300
Trade payables
393
360
Short-term loans
223
200
Current tax payable
154
140
Current liabilities
770
700
2 651
2 700
COPYCAT LTD
STATEMENT OF CASH FLOWS
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2019
R’000
EQUITY AND LIABILITIES
Ordinary shareholders’ equity
TOTAL EQUITY AND LIABILITIES
Cash received from customers
3 924
Cash paid to suppliers and employees
(3 301)
Cash generated by operating activities
893
Finance expenses paid
(58)
Tax paid
(185)
Cash available from operating activities
650
Dividends paid
(275)
Cash retained from operating activities
375
Additions to property, plant and equipment (PPE)
(186)
Proceeds from sale of property, plant and equipment (PPE)
230
Cash flow from investing activities
44
Share capital repurchased
(434)
Repayments of long-term debt
(10)
Proceeds from short-term debt
23
Cash flow from financing activities
(401)
Increase/(decrease) in cash and cash equivalents
18
Cash and cash equivalents at the beginning of the year
180
Cash and cash equivalents at the end of the year
198
a)
Calculate the ratios listed in the table that follows based on the 2019
financial statements.
Ratio
Current ratio
Quick ratio (acid-test ratio)
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2019
Trade receivables turnover ratio
Inventory turnover ratio
Cash turnover ratio
Current asset turnover ratio
Total asset turnover ratio
Debt-to-equity ratio
Return on assets
Return on equity
Earnings per share
b)
Calculate the cash coverage ratios listed in the table that follows based
on the 2019 statement of cash flows.
Ratio
2019
Finance cost coverage
Dividend coverage
Reinvestment coverage
Debt repayment coverage
Investing and financing coverage
KEY CONCEPTS
Cash flow ratios: Ratios that evaluate whether an entity is generating
sufficient cash flows to support its activities.
DuPont analysis: A type of analysis that makes it possible to obtain a
breakdown of an entity’s return ratios. DuPont analysis enables
an analyst to understand what effect changes in the components
of the return ratios have on the overall return generated by the
entity.
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Financial gearing: The effect that the use of debt capital may have on
the return on the shareholders’ equity. If an entity is able to
utilise debt capital effectively, it may result in increased returns
for its shareholders. If the utilisation of debt capital is inefficient,
however, the use of debt capital will have a negative effect on
the return on the shareholders’ equity.
Liquidity ratios: Ratios that investigate whether sufficient current
assets are available to cover an entity’s current liabilities.
Norms of comparison: Certain conventions, comparisons over a period
of time and comparisons between similar entities that are
usually used when evaluating ratios.
Profitability ratios: Ratios that evaluate the efficiency with which an
entity utilises its assets. They focus on the returns earned by an
entity’s capital investment.
Profit margins: The percentage of the revenue that is eventually
realised as profit after all deductions are made.
Ratio analysis: A process of calculating and interpreting comparisons
between items in the financial statements in order to evaluate an
entity’s financial performance and position.
Requirements for ratios: In order to be useful for the financial
evaluation of an entity, ratios need to be meaningful, relevant
and comparable.
Solvency ratios: Solvency refers to an entity’s ability to cover all its
obligations when it eventually closes down its operating
activities. Solvency ratios compare the total assets and the total
debt capital of an entity.
Turnover ratios: The value of a turnover ratio provides an indication
of how many times a year an investment in assets is converted
into revenue.
SLEUTELKONSEPTE
DuPont analise: Deur die toepassing van ’n DuPont analise is dit
moontlik om ’n uiteensetting van ’n maatskappy se
rentabiliteitsverhoudingsgetalle te verkry. Die DuPont analise
stel ’n analis in staat om te verstaan watter invloed veranderinge
in die komponente van die rentabiliteitsverhoudingsgetalle op
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die algehele rentabiliteit van die maatskappy het.
Finansiële hefboomwerking: Die effek wat die gebruik van vreemde
kapitaal op die rentabiliteit van aandeelhouersbelang kan hê.
Indien ’n maatskappy in staat is om vreemde kapitaal effektief
aan te wend, mag dit ’n toename in rentabiliteit vir die
aandeelhouers tot gevolg hê. Indien die aanwending van die
vreemde kapitaal egter oneffektief is, sal die aanwending van
vreemde kapitaal ’n negatiewe effek op die rentabiliteit van die
aandeelhouersbelang hê.
Kontantvloei verhoudingsgetalle: Verhoudingsgetalle wat evalueer of ’n
maatskappy voldoende kontantvloei genereer om sy aktiwiteite
te ondersteun.
Likiditeitsverhoudingsgetalle: Verhoudingsgetalle wat ondersoek of
voldoende bedryfsbates beskikbaar is om die maatskappy se
bedryfslaste te dek.
Omloopsnelhede: Die waarde van ’n omloopsnelheid verskaf ’n
aanduiding van hoeveel keer per jaar ’n investering in bates
omskep word in inkomste.
Rentabiliteitsverhoudingsgetalle: Hierdie verhoudingsgetalle ontleed
die effektiwiteit waarmee ’n maatskappy sy bates aangewend
het; hul fokus op die opbrengste wat verdien is op ’n
maatskappy se kapitaalinvesterings.
Solvabiliteitsverhoudingsgetalle: Solvabiliteit verwys na ’n maatskappy
se vermoë om al sy verpligtinge na te kom indien dit uiteindelik
sy bedryfsaktiwiteite staak. Solvabiliteitsverhoudingsgetalle
vergelyk die totale bates en die totale vreemde kapitaal van ’n
maatskappy.
Vereistes vir verhoudingsgetalle: Ten einde geskik te wees vir die
finansiële ontleding van ’n maatskappy, moet
verhoudingsgetalle betekenisvol, relevant en vergelykbaar wees.
Vergelykingsnorme: Wanneer verhoudingsgetalle geïnterpreteer word,
word konvensies, vergelykings oor ’n periode van tyd en
vergelykings tussen soortgelyke maatskappye normaalweg
gebruik.
Verhoudingsgetal-ontleding: ’n Proses wat die berekening en
interpretasie van vergelykings tussen items in die finansiële
state behels ten einde die finansiële evaluasie van ’n
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maatskappy se finansiële prestasie en posisie teweeg te bring.
Winsmarges: Die persentasie van die inkomste wat uiteindelik as
wins realiseer nadat alle aftrekkings gemaak is.
WEB RESOURCES
www.fin24.com
www.picknpay.co.za
www.sasol.co.za
www.spanjaard.biz
REFERENCES
Carte, D. (2010). Verimark’s big bounce. Moneyweb. Retrieved from
http://www.moneyweb.co.za/moneywebindustrials/verimarks-big-bounce [17 November 2019].
Cobbett, J. (2009). Court blocks Verimark delisting. Moneyweb.
Retrieved from http://www.moneyweb.co.za/moneywebspecial-investigations/court-blocks-verimark-delisting [17
November 2019].
Cullen-Meyer, M. (2018). How to calculate return on equity,
forecast future ROE, and conduct DuPont analysis. TinyTrader.
Retrieved from https://tinytrader.io/2018/12/27/how-tocalculate-return-on-equity-forecast-future-roe-and-conductdupont-analysis/ [4 May 2020]. Reprinted by permission of
Matt Cullen-Meyer.
De Klerk, R. (2019). Humbled Woolies battles to regain its blue
chip status. IOL BusinessReport. Retrieved from
https://www.iol.co.za/business-report/opinion/opinionhumbled-woolies-battles-to-regain-its-blue-chip-status-28879693
[17 November 2019].
Hasenfuss, M. (2009). Court halts Verimark delisting. Fin24.
Retrieved from https://www.fin24.com/Companies/Courthalts-Verimark-delisting-20090828 [26 February 2020].
Hedley, N. (2019). Verimark shareholders approve delisting.
BusinessDay. Retrieved from
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https://www.businesslive.co.za/bd/entities/retail-andconsumer/2019-01-17-verimark-shareholders-approvedelisting/ [17 November 2019].
Kew, J. (2018). Woolworths’ quest for southern hemisphere
domination loses steam. Fin24. Retrieved from
https://m.fin24.com/Companies/Retail/woolworths-quest-forsouthern-hemisphere-domination-loses-steam-20180822 [26
February 2020].
Mahlangu, A. (2018). Delisting plan sends Verimark shares soaring.
BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/entities/retail-andconsumer/2018-10-22-delisting-plan-sends-verimark-sharessoaring/ [17 November 2019].
Mowen, M.M., Hansen, D.R. & Heitger, D.L. (2009). Cornerstones of
Managerial Accounting (3rd ed.). Mason, OH: Cengage Learning.
Naudé, P., Hamilton, B., Ungerer, M., Malan, D. & De Klerk, M.
(2018). Business perspectives on the Steinhoff saga. USB
Management Review: Special report June 2018. Retrieved from
https://www.usb.ac.za/wpcontent/uploads/2018/06/Steinhoff_Revision_28_06_2018_websmall.pdf
[29 April 2020]. Reprinted by permission of the editor.
Sasol Ltd. (2018). Annual financial statements at 30 June 2018.
Retrieved from https://www.sasol.com/investorcentre/financial-reporting/annual-financial-statements/latest
[14 November 2019].
Smith, C. (2018). We are clear on mistakes and how to fix them Woolworths CEO. Fin24. Retrieved from
https://www.fin24.com/Companies/Retail/we-are-clear-onmistakes-and-how-to-fix-them-woolworths-ceo-20180823 [26
February 2020].
Van Zyl, A. (2009). Verimark delisting opposed. Fin24. Retrieved
from http://www.fin24.com/Entities/Verimark-delistingopposed-20090722 [17 November 2019].
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4 The time value of money
Sam Ngwenya and Pierre Erasmus
Learning
outcomes
Chapter
outline
4.1
4.2
4.3
By the end of this chapter, you should be able to:
use various computation tools to analyse the
role of time value in finance
calculate, interpret and explain the future value
and present value of single amounts or lump
sums, and investigate the relationship between
them
calculate, interpret and explain the future value
and present value of annuities (ordinary
annuities, annuities due and ordinary deferred
annuities)
calculate, interpret and explain the present
value of a perpetuity
calculate, interpret and explain the present
value and future value of a mixed stream of
cash flows
determine deposits needed to accumulate a
future sum, calculate instalments to amortise a
loan and calculate an interest rate or growth
rate
calculate the present value, future value,
interest rate and time period using discounting
and compounding principles.
Introduction
Interest rates
Future value and compounding of lump
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sums
4.4 Compounding interest more frequently
than annually
4.5 Nominal and effective interest rates
4.6 Present value and discounting
4.7 More on present and future values
4.8 Valuing annuities
4.9 Perpetuities
4.10 Amortising a loan
4.11 Sinking funds
4.12 Conclusion
Appendices
CASE STUDY
A bird in the hand …
The old adage that says, ‘A bird in the hand is worth two in the
bush’ is very relevant to investors who own shares in
manufacturing entities. According to the dividend discount
model, the value of an entity (as reflected by the price of its
shares) is positively related to and determined by its dividend
payments. This model maintains that the value of an entity’s
shares increases dramatically with an increase in dividend
payments over time. Given the competitive nature of modernday high-tech industries, many manufacturing entities decide
to plough back their after-tax earnings into the business rather
than paying cash dividends to shareholders.
The rationale behind the reinvestment of an entity’s profits
in the business rather than the distribution of these profits to
the shareholders is usually that the entity will use these
reinvested funds to earn additional profits in future,
contributing to increased expected future dividend payments
to its shareholders. However, there is an important question
worth considering: how much would those future dividends
(that is, the ‘two birds in the bush’) be worth to shareholders
today? Furthermore, how long will the shareholders have to
wait before they receive a dividend on their investment?
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On 28 June 2010, the electric car manufacturer Tesla (started
by the South African-born Elon Musk) launched its initial
public offering (IPO) at a price of US$17 per share. This was the
first IPO of a car manufacturer in the United States (US) since
the listing of Ford in 1956. The entity has experienced a marked
increase in its share price since its IPO, and by 2017, Tesla had
overtaken General Motors and Ford to become the largest car
manufacturer in the US based on market capitalisation. One
aspect that made this achievement remarkable was the
enormous difference in the production levels of the two
entities. While Tesla sold a modest total of 76 000 cars during
2016, Ford sold almost 7,6 million cars.
Since its IPO in 2010, Tesla has never paid a dividend to its
shareholders. According to the entity’s website, “Tesla has
never declared dividends on our common stock. We intend
retaining all future earnings to finance future growth and
therefore, do not anticipate paying any cash dividends in the
foreseeable future” (Tesla, 2019). In contrast to Tesla’s zerodividend policy, Ford has been paying regular quarterly cash
dividends to its shareholders. Between 2016 and 2019 alone,
Ford paid dividends to the value of US$10,06 billion to its
shareholders. Despite calls for the entity to discontinue its
dividend payments and rather reinvest its profits to finance
future growth, Ford has signalled its intention to continue
rewarding shareholders by maintaining an attractive dividend
yield.
Despite not returning any cash to its shareholders in the
form of a dividend, Tesla’s share price has increased from the
IPO level of US$17 per share to US$223,46 nine years later.
Shareholders who invested in the entity at the time of its first
listing would therefore have realised a total return of 1 214%,
translating into an annual return of 33,14% per year over the
nine-year period. An investment of US$10 000 in Tesla shares
in 2010 would have increased more than tenfold to a final value
of US$131 447 by 2019. Over the same period, Ford’s share
price increased from US$10,43 to US$17,80, representing an
annual return of just 6,12% per year over the nine years. In
Ford’s case, however, shareholders also received quarterly cash
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dividends totalling US$4,68 during this period. This increased
their annual return to 9,68% per year. An investment of the
same US$10 000 in Ford would only have increased to a final
value of US$22 969 by 2019 (assuming all dividends received
were reinvested).
Based on its performance during the first nine years
following its IPO, Tesla’s decision to reinvest all profits
benefitted its shareholders. Although Ford’s shareholders
enjoyed the benefit of receiving regular cash proceeds on their
investment, their overall returns lagged far behind those of
investors who decided to invest their money in Tesla. As will
be pointed out in Chapter 7, however, it is not only the return
on an investment that should be considered when evaluating
an investment opportunity, but also the risk associated with it.
Concerns regarding Tesla’s capacity to continue increasing
sales and the entity’s ability to finance its activities have
already enabled Ford to overtake it once again in terms of
market capitalisation in 2019.
Although it may therefore appear that cash in the hand
today is not necessarily better than the promise of receiving
cash at some future date, it should be noted that Tesla’s
shareholders are still waiting for the entity to generate stable
profits. If it fails to achieve this, a cash dividend in the hand
will remain a dream.
Sources: Compiled from information in Collins, 2019; Garg, 2019; Rosevear, 2019; Rosenbaum,
2019; Mourdoukoutas, 2019; Nasdaq, 2019, Tesla, 2019; Ford, 2019; Eule, 2017.
Application activity
Ford includes an investment calculator on its website
(https://shareholder.ford.com/investors/stockinformation/investment-calculator/default.aspx) where you
can calculate the return on an investment in the entity’s shares
stretching back to 1999. It also makes provision for the
reinvestment of dividends. Consider the impact of buying
shares at different dates on the return earned. (For example, if
you had purchased the shares in 1999, you would have ended
up earning a negative annual return of around –2,5%.)
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4.1
Introduction
When investors decide to invest their money, some form of return
on their investment is usually required. In the case of shares (such
as in the opening case study), this return is usually in the form of
dividend payments received during the investment period as well
as the gain that may arise from the capital appreciation of the initial
purchase price. For an investment in a government bond, the return
may be in the form of constant semi-annual coupon payments,
combined with the return of the principal amount at the bond’s
maturity.
As illustrated in the opening case study, the value of an
investment critically depends on the size and timing of the cash
flows associated with the investment. In general, the larger the cash
inflows (such as dividends or interest received) and the sooner the
receipt of these cash flows, the more valuable the investment. Other
factors, such as the frequency with which the cash flows take place
as well as the investment period, also play a role in the evaluation
of an investment.
In this chapter, we will go into more detail about the time value
of money (TVM), and particularly consider why cash flows to be
received in the near future are more valuable than cash flows to be
received in the distant future.
We begin the chapter by distinguishing between the important
concepts of simple and compound interest. We then explain how to
calculate and compare the value of money at different points in
time (for example, in the future and in the present). We also look at
different types of cash flow, such as single amounts (also called
lump sums), constant cash flows (annuities), infinite cash flows
(perpetuities) and mixed cash flows (inflows and outflows).
4.2
Interest rates
When money is invested, some form of return (or interest) is
earned. Although different forms of return can be earned, for
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simplicity’s sake, this chapter refers to the interest rate that is
earned on an investment.
When considering the interest that is earned on an investment, it
is important to understand the difference between simple interest
and compound interest. Simple interest is earned on the principal
amount (in other words, the original investment) only, and the
interest earned is not reinvested. In the case of compound interest,
however, all interest earned is reinvested together with the
principal amount. Interest is, therefore, earned on the original
principal as well as on the interest that has been reinvested. This is
known as the interest-on-interest principle. For the purposes of this
book, compound interest is always assumed in any TVM problem.
Example 4.1 illustrates the calculation of simple and compound
interest.
Example 4.1 Calculating simple interest and compound interest
Sibusiso receives a bonus of R1 000. Since he does not have any outstanding
debt, he decides to invest the money for a period of five years.
Let’s suppose that Sibusiso needs to decide between an investment in a
savings account that offers a simple interest rate of 10% p.a. or a savings
account offering compound interest of 10% p.a. How much money would
Sibusiso have in each case after a period of five years?
In the case of simple interest, the final value of the investment can be
calculated as shown below.
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At the end of the investment period of five years, Sibusiso would therefore have
R1 500. Take note that the interest earned is R100 per year throughout the
five-year period because interest is only earned on the principal (the initial
capital amount invested).
Now let’s suppose that Sibusiso invests R1 000 in the savings account
offering interest at 10% p.a., and that the interest earned will be reinvested
(compounded). How much money will Sibusiso now have after five years?
At the end of the investment period of five years, Sibusiso will have R1 610,51
in his account if interest is compounded.
Note that there is a larger return on the investment if compound interest is
earned (R1 610,51) than if simple interest is offered (R1 500,00). The reason
more interest is earned in the case of compounded interest is that the annual
interest payments are not only calculated on the initial principal amount of R1
000, but on the principal amount plus the reinvested interest payments. The
difference in returns between simple and compound interest in this example is
R110,51 (R1 610,51 – R1 500,00).
QUICK QUIZ
1. TVM is based on the concept that a rand to be
received at some time in the future is worth
more than a rand owned today. True or false?
Motivate your answer.
2. What is the difference between simple interest
and compound interest?
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4.3
Future value and compounding of lump sums
We saw in the opening case study that two investors who invested
the same amount in the shares of Tesla and Ford at the same time
would have ended up with two very different final values after nine
years. By comparing the final values of their investments, we saw
that the investment in Tesla was the better option since it yielded
the highest return (unfortunately, the shareholder who chose Ford
did not know that this would be the case). By comparing their
initial investment amounts at the beginning of the investment
period and reconsidering the values of these investments at the
same point in time at the end of the investment period nine years
later, we were able to determine which option yielded superior
returns. This illustrates one of the fundamental aspects of the TVM:
in order to evaluate investment options, we have to compare their
values at similar points in time. Although these two investments
had the same initial values, their final values differed substantially.
We usually refer to the initial value of an investment as its present
value and the final value as the future value.
Investment options are usually assessed by using either future
value (FV) or present value (PV) techniques. FV techniques
typically determine the accumulated value of all cash flows at the
end of a project (that is, Tn), whereas PV techniques discount all
cash flows to the start of a project (that is, time zero, or T0). A future
value is, therefore, the value of the cash you will receive at a given
future date, whereas the present value refers to the cash in your
hand today.
Thus the relationship between FV and PV can be explained as
follows: FV is the value of a present amount of money at a given
future date; PV represents the current rand value today of a future
amount of money. Stated differently, PV is the amount of money
you would invest today at a given interest rate for a specified
period of time to equal a certain FV. In the opening case study, the
investment in Tesla therefore had a PV of US$10 000, which
accumulated to an FV of US$131 447.
When incorporating the TVM in the evaluation of an investment
opportunity, it is important to consider the timing of the cash flows.
For some investments, the cash flow pattern can become quite
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complex. A timeline can be used as a graphic representation of the
cash flows associated with a given investment in order to simplify
this problem. Figure 4.1 provides an example of a timeline covering
four periods of time (which could be, for example, years, months or
days) and indicates the points in time when the cash flows occur.
The negative value (−R10 000) represents a cash outflow (in this
example, an initial investment of R10 000 at T0), whereas the
positive values represent cash inflows: R3 000 at the end of year one
(T1), R5 000 at the end of year two (T2) and so on.
Figure 4.1 Timeline depicting an investment’s cash flows
Let’s now return to Sibusiso’s situation in Example 4.1 and suppose
that he invests his R1 000 in a savings account that pays 10%
interest per year. How do we determine the future value of this
investment?
4.3.1
Investing for a single period
Suppose that Sibusiso invests his R1 000 for a period of one year.
How much will his investment be worth after one year? (In other
words, what is the FV of his investment at the end of the year?)
Example 4.2 illustrates the calculation of the FV of his investment.
Example 4.2 Calculating the FV for a single period
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In general, if you invest a sum (PV) for one period at an interest rate
of i, the final value of your investment will grow to FV = PV × (1 +
i) at the end of the period. In our example, PV is R1 000 and i is
10%, so Sibusiso’s investment will grow to FV = R1 000 × (1 + 0,10)
= R1 100 after one year. Note that this example is based on a single
lump-sum investment (in other words, a single cash flow that is
invested for a single period). Later in the chapter, we will look at
the FV of investments where more than one cash flow occurs.
4.3.2
Investing for more than one period
Let’s now assume that Sibusiso decides to invest his money for a
period of two years. Example 4.3 illustrates the calculation of the FV
of his investment.
Example 4.3 Calculating the FV for more than one period
In Example 4.2, we calculated the FV of the investment at the end of the first
year.
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Let’s assume that Sibusiso leaves the R1 100 that he had accumulated at
the end of the first year in the account for an additional year. The FV at the end
of the second year can then be calculated as follows:
FV2 = R1 100 + (R1 100 × 0,1)
= R1 100 + R110
= R1 210
The sum of R1 210 is, therefore, the FV of his investment of R1 000
that was invested for a period of two years at an interest rate of 10%
p.a. In general, if you invest PV for two periods at an interest rate of
i, the final value of your investment will grow to FV = PV × (1 + i)2.
The general equation to calculate the FV of a lump sum at the
end of period n at an interest rate of i% can, therefore, be written as
follows:
Where:
FVn = the future value at the end of period n
PV0 = the present value at period T0 (in other words, now)
i = the rate of interest paid or earned per period
n = the total number of periods (in this case, years) of the
investment
Interest factor tables include various future and present value
interest factors that can be used to calculate FV and PV values.
Table 4.1 provides an example of the future value interest factors
(FVIF) of R1 at i% at the end of n periods (FVIFi,n).
Table 4.1 Interest factor of R1 at i% at the end of n periods (FVIFi,n = [1 + i]n)
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Note: *** Figure too large to be shown.
Using interest factor tables, the FV at the end of period n can be
calculated using the following equation:
Where:
FVn = the future value at the end of period n
PV0 = the present value at period T0 (in other words, now)
FVIFi,n = the future value of R1 at the end of period n calculated at
an interest rate of i%
In Example 4.3, we calculated the FV of Sibusiso’s investment at the
end of two years by applying the formula approach. From Table
4.1, we can see that the FVIF at 10% for two years (FVIF10%,2) is
located at the intersection of the 10% column with the two-period
row, and equals 1,210. Based on this value, the FV of his investment
can be calculated as shown in Example 4.4.
Example 4.4 Calculating the FV for more than one period using interest
factor tables
FV2 = PV0 × FVIF10%,2
= R1 000 × 1,210
= R1 210
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The four basic interest factor tables are included in the appendices
at the end of this chapter. Note, however, that not all the interest
factor values can be illustrated in the interest factor tables provided
in the appendices, as they would take up too much space. You are,
therefore, encouraged to master the use of a financial calculator
when solving TVM problems.
Financial
calculators
normally
include
numerous
preprogrammed financial routines that can be used to solve
problems based on the TVM. Since different institutions use
different financial calculators, we do not refer to a specific type, but
explain important financial calculator keys that are common to all
calculators.
The most common financial calculator keys used in TVM
calculations are:
• FV: future value
• PV: present value
• PMT: payment amount (used for annuities)
• n: number of periods
• i: interest rate per period.
The golden rule when using a financial calculator is to make sure
that you clear your financial calculator before starting a new
calculation. Doing so ensures that you do not use the answer of the
previous calculation in the new calculation. Also ensure that only
one payment per period is selected; most financial calculators have
a function that can be used to calculate an FV of monthly payments,
which converts all calculations to 12 payments per period.
Example 4.5 illustrates the use of a financial calculator to work
out the FV in Example 4.3.
Example 4.5 Using a financial calculator to calculate the FV for more
than a single period
Let’s consider Sibusiso’s investment of R1 000 at an interest rate of 10% for a
period of two years. Using a financial calculator, the FV can be calculated as
follows:
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QUICK QUIZ
1. FV is the value of a future amount at the
present time, found by applying compound
interest over a specified period of time. True
or false? Motivate your answer.
2. What effect would an increase in the interest
rate have on the FV of an amount deposited in
a savings account?
3. What effect would a decrease in the number of
periods have on the FV of an amount deposited
in a savings account?
It is important to note that TVM problems can also be solved by
making use of an Excel spreadsheet, which can produce accurate
solutions extremely quickly. In the real world, accountants and
other finance practitioners often use spreadsheets to evaluate large,
complex investment alternatives that require massive amounts of
financial information. Using Excel spreadsheets for this purpose
enables them to save time by building sophisticated financial
models that can be used to solve complex financial problems.
However, this textbook does not cover the use of spreadsheets.
4.4
Compounding interest more frequently than
annually
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In the examples we have considered thus far, interest has been
compounded annually (in other words, once a year). However,
interest is often computed more frequently than once a year.
Savings institutions such as banks may compound interest halfyearly (semi-annually), quarterly, monthly, weekly, daily or even
continuously.
The following terminology is normally used by banks to refer to
the different frequencies of compounding:
• nominal annual rate compounding annually (NACA)
• nominal annual rate compounding semi-annually (NACSA)
• nominal annual rate compounding quarterly (NACQ)
• nominal annual rate compounding monthly (NACM).
4.4.1
Semi-annual, quarterly and monthly compounding
When compounding interest, it is possible to use compounding
frequencies of less than one year. For the purpose of this section, the
focus is on interest compounded semi-annually, quarterly and
monthly. The general formula that is applied when interest is
compounded more than once per period is as follows:
Where:
FVn = the future value at the end of period n
PV0 = the present value at period T0 (in other words, now)
i = the rate of interest paid or earned per period
n = the total number of periods of the investment
m = the number of times interest is compounded per period
Semi-annual compounding of interest involves two compounding
periods per year. Instead of the interest rate being paid or
calculated once a year, half of the stated interest rate is paid or
calculated twice a year. Similarly, quarterly compounding of
interest involves four compounding periods per year. A quarter of
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the stated interest rate is therefore paid four times a year. In the
case of monthly compounding, 12 compounding periods within the
year are used. One-twelfth of the stated interest rate is paid 12 times
a year.
In Example 4.3, we calculated the FV of Sibusiso’s investment if
it was invested for two years at an annual compound interest rate
of 10% per year. Let’s now consider what the effect of different
compounding frequencies would be on his investment.
Example 4.6 Calculating the FV with semi-annual, quarterly and monthly
interest compounding
Let’s suppose that the interest rate of 10% is compounded semi-annually.
Since the interest is now compounded twice a year, we must divide the annual
interest rate by two (that is, ) to obtain a rate of 5% per period. Since there
are two compounding periods per year, we need to multiply the number of
years by two (that is, 2 × 2) to obtain the total number of four periods.
Using the formula
Using a financial calculator
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Now let’s assume that interest is compounded quarterly. Since the interest is
compounded four times per year, you must divide the annual interest rate by
four (in other words,
to obtain a rate per quarter of 2,5%. Since there are
four compounding periods per year, you must multiply the number of years by
four (2 × 4) to obtain the total number of eight periods.
Using the formula
Using a financial calculator
In the case of monthly compounding, the interest is compounded 12 times per
year, so you must divide the annual interest rate by ( ) to obtain a rate per
period of 0,833%. Since there are 12 compounding periods per year, you must
multiply the number of years by 12 (2 × 12) to obtain the total number of 24
periods.
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Using the formula
Using a financial calculator
From these calculations, we can see that the FV increases when we
increase the frequency of the compounding of the interest
payments. Since we are focusing on compound interest, according
to which all interest received is reinvested, this should not be
surprising. The more frequently interest payments are
compounded, the more times per period the interest earned is
reinvested, and, consequently, the larger the total interest amount
earned.
4.4.2
Continuous compounding
In Section 4.4.1, we discussed investment alternatives with differing
frequencies of compounding of interest. Based on the examples
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used to illustrate the different compounding frequencies, we saw
that the total amount of interest earned increases if interest is
compounded more frequently per period. The reason for this
increase is that interest on interest is earned more times per year. It
is possible to further increase the frequency with which interest is
earned beyond the monthly payments illustrated in Section 4.4.1.
This is known as continuous compounding, a process in which it is
assumed that interest is earned continuously. Continuous
compounding can also be considered as an infinitely small
compounding period; this is achieved by taking the limit of n to
infinity. The formulae for calculating the FV and PV if interest is
compounded continuously are as follows:
Where:
FVn = the future value at the end of period n
PV0 = the present value at period T0 (in other words, now)
i = the rate of interest paid or earned per period
e = the base of the natural log (the exponential function, which has
the value of 2,7183)
The calculation of the FV of an investment that earns interest
continuously is illustrated in Example 4.7.
Example 4.7 Calculating the FV with continuous compounding
Let’s reconsider Sibusiso’s deposit of R1 000 in the savings account for a
period of two years at an annual interest rate of 10%, but let’s now assume
that the interest is compounded continuously. Calculate the FV.
Using the formula
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With continuous compounding, we see that the FV is larger than in
the case of monthly compounding (as illustrated in Example 4.6).
Once again, this should not be surprising, since continuous
compounding entails a higher compounding frequency. This, in
turn, results in a higher amount of interest earned on the reinvested
interest.
Example 4.8 Calculating the PV with continuous compounding
Suppose that Lindelwa would like to know how much she must deposit in a
savings account in order to receive an amount of R2 000 at the end of 25
years if an annual interest rate of 8% (compounded continuously) is applied.
Using the formula
Lindelwa therefore needs to deposit R270,67 now in order to ensure that it will
accumulate to R2 000 after 25 years.
QUICK QUIZ
What action should one take to adjust for
interest and the number of periods when interest
is compounded more than once in a year (for
example, semi-annually, quarterly, monthly and
so on) when calculating the FV of a single
amount?
4.5
Nominal and effective interest rates
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The nominal, or stated, interest rate is the contractual annual
percentage rate of interest charged by a lender or promised by a
borrower. The effective, or true, annual rate is the annual rate of
interest actually paid or earned. The effective annual rate (EAR)
includes the effects of compounding frequency, whereas the
nominal annual rate does not. The relationship between these two
interest rates is illustrated by Example 4.9.
Example 4.9 Formula for calculating the effective annual interest rate
Bank A advertises that you can earn 10% interest p.a. on a one-year fixed
deposit. Interest will accumulate once a year. Bank B also advertises that you
can earn 10% interest p.a. on a one-year fixed deposit. Interest will, however,
accumulate monthly. Would it be better to invest your money with Bank A or
Bank B?
You can calculate how much you would receive after one year if you invested
R100 with Bank A as shown below.
Using the formula
FV = PV × (1 + i)n
= R100 × (1 + 0,1)1
= R100 × 1,1
= R110,00
In this case, you do not earn interest on interest, since interest is only paid at
the end of the compounding period. The nominal and effective rates are,
therefore, the same (both are 10%).
You can calculate how much you would receive at the end of the year if you
invested R100 in a fixed deposit with Bank B as shown below.
Using the formula
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The FV in the case of the deposit made with Bank B is, therefore, more than
the FV of the deposit with Bank A. The reason for the difference in the values
can be ascribed to the compound interest that is earned monthly in the case of
Bank B. As a result, the total interest earned is slightly higher. Although both
banks offer an interest rate of 10%, the different compounding frequencies
result in higher interest earned with Bank B.
Using the calculations in Example 4.9, we can calculate the EAR by
substituting values for the nominal annual rate, i, and the
compounding frequency, m, in Formula 4.6.
Example 4.10 illustrates the use of Formula 4.6 to convert a nominal
annual rate to an EAR.
Example 4.10 Calculating the effective annual rate
What is the EAR if an annual nominal rate of 8% is compounded quarterly?
Using the formula
What does this calculation mean? It means that the investment will
earn 8,24% interest if interest is paid every quarter, compared with
only 8% if the interest is paid only once a year. In other words, if
you use the nominal interest rate (p.a.) and compound (in other
words, receive) interest more regularly, you effectively earn more
interest on the investment.
An example of the difference between a nominal and an
effective interest rate is provided on Investec’s website
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(https://www.investec.com/en_za/savings-accounts/access-aftera-fixed-period/fixed-term-deposits.html). If you consider the
effective and nominal rates quoted by the bank, you will observe a
similar pattern to the one provided in Examples 4.9 and 4.10: the
greater the compounding frequency, the higher the effective rate
becomes.
QUICK QUIZ
1. Differentiate between the nominal (stated)
annual rate and the effective annual rate.
2. The nominal and effective rates are equivalent
for annual compounding. True or false?
Motivate your answer.
4.6
Present value and discounting
When we discussed FV in the previous section, we asked questions
such as the following: ‘What will my current investment of R1 000
grow to if it earns interest at 10% p.a. for the next five years?’ We
saw that the answer to this question can be obtained by calculating
the FV of R1 000 invested for five years at an interest rate of 10%
p.a. (FV = R1 610,51).
Suppose, however, that you need to have R10 000 available in
five years’ time and that you can earn 10% interest on your money.
How much do you have to invest today to reach your target value?
The answer to this question can be obtained by calculating the
present value (PV) of the future amount. More specifically, the PV
is the amount of money that would have to be invested today at a
given interest rate over a specified period to equal the future
amount. Alternatively, PV is the amount today that is equivalent to
a future payment, or series of payments, that has been discounted
by an appropriate interest rate. Since money has time value, the PV
of a promised future amount is worth less the longer you have to
wait to receive it. The process of calculating the PV is referred to as
discounting.
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The PV of a future amount can be calculated mathematically by
making use of the following equation:
This formula can also be written as follows:
Where:
FVn = the future value at the end of period n
PV0 = the present value at period T0 (in other words, now)
i = the rate of interest paid or earned per period
n = the total number of periods of the investment
We can utilise financial tables to calculate the PV of an FV occurring
at the end of period n by using the following formula:
Where:
PVIFi,n = the present value interest factor at i% interest over n
periods
Note that for the remainder of this chapter, we will no longer refer
to FVn and PV0, but only to FV and PV. The reason for this is that an
FV, by definition, is always calculated at time n, and a PV is always
calculated at time 0.
Example 4.11 illustrates the calculation of a PV using the
formula, interest factor tables and a financial calculator.
Example 4.11 Calculating the PV of an FV
Suppose that Fikile wishes to find the current value (PV) of R1 700 that will be
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received eight years from now, assuming that the annual interest rate is 8%.
Using the formula
PV = FV × (1 + i)–n
= R1 700 × (1,08)–8
= R1 700 × 0,5403
= R918,46
Using interest factor tables
PV = FV × PVIF8%,8
= R1 700 × 0,540 (see Appendix 4.2)
= R918,00
Using a financial calculator
Earlier in our discussion of FVs, we mentioned that interest is often
compounded more than once a year. However, we do not give
examples of semi-annual, quarterly and monthly compounding in
this section because the principles applied in the calculation of FVs
are similar to the calculation of PVs.
QUICK QUIZ
1. What is meant by the term ‘present value’?
2. What is the relationship between present value
and future value?
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4.7
More on present and future values
There are various calculations that should be considered when
calculating present and future values.
4.7.1
Determining an interest rate
Sections 4.3–4.6 explained how to calculate an investment’s FV and
PV. The interest rate was given in the examples included in these
sections. It is often necessary, however, to calculate the return on an
investment. Example 4.12 illustrates how the interest rate is
calculated.
Example 4.12 Calculating interest rates
Suppose that you invest R1 080 now. In return, you will receive R1 517 after
three years. Calculate the interest (or growth) rate of your investment.
Using the formula
Using interest factor tables
From the interest factor table (see Appendix 4.2), the value closest to 0,712
under period 3 is PVIF12%,3 = 0,712. Therefore, the interest or growth rate is
12%.
Alternatively, you can calculate the interest or growth rate as follows:
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From Appendix 4.1, you can see that the value 1,405 under period 3
corresponds to an interest or growth rate of 12%.
Using a financial calculator
From the answers obtained in Example 4.12, we can determine that
the increase in your initial investment from R1 080 to R1 517 during
the period of three years is equivalent to 11,99% per year.
4.7.2
Calculating the number of periods
Sometimes it is necessary to work out the number of time periods it
will take for an initial investment to accumulate to a given FV. For
instance, if you know that you are going to require R3 000 in three
years’ time and you currently have R1 200 to invest, you can apply
this approach to determine if a specific investment option will be
acceptable. Example 4.13 illustrates the calculation of the number of
time periods it takes to generate a certain FV.
Example 4.13 Calculating the number of periods needed to generate a
given amount of cash
Sibusiso is saving for a trip overseas in four years’ time. The cost of the trip is
expected to be R25 000. He wishes to determine if his initial deposit of R15
000, earning 12% annual interest, will grow to R25 000 by that time.
Using a financial calculator
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Thus, if Sibusiso invests his money at 12%, it will take 4,51 years before he
will have accumulated the amount required to pay for the overseas trip. If he is
able to earn more than 12% per year, the period of time it will take to generate
the required R25 000 will be shorter. Alternatively, he will have to provide a
larger initial deposit now to ensure that the future amount of R25 000 is
accumulated four years from now.
QUICK QUIZ
1. What effect would a decrease in the interest
rate have on an investment’s FV?
2. What effect would an increase in the number of
periods have on an investment’s FV?
4.8
Valuing annuities
An annuity is a series of equal payments (cash outflows) or receipts
(cash inflows) occurring over a specified time period. An annuity
consists of constant payments made at regular intervals (monthly,
quarterly, annually and so on). Examples of annuities include bond
payments, student-loan repayments, car-loan repayments,
insurance premiums, mortgage repayments, retirement savings,
leases and rental payments.
There are two types of annuity: ordinary annuities (or annuities
in arrears) and annuities due (or annuities in advance). In the case
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of an ordinary annuity, the payments or receipts occur at the end of
each period; with an annuity due, they occur at the start of each
period.
4.8.1
Future value of an ordinary annuity
The FV of an ordinary annuity is the value to which a stream of
expected or promised future payments will accumulate after a
given number of periods at a specific compounded interest.
Example 4.14 illustrates the calculation of the FV of an ordinary
annuity.
Example 4.14 Calculating the FV of an ordinary annuity
Suppose that you deposit R2 000 at the end of each of the next five years in a
savings account that pays an interest rate of 10% p.a. What will the FV of your
savings account be after five years?
When tackling a problem of this nature, it is advisable to draw a timeline
on which you position the cash flows before attempting to solve the problem,
as shown below.
In this example, we calculate the FV of each individual cash flow, and then add
these values together to get the FV of the multiple cash flows. Using the FVIF,
as discussed in Section 4.3.2, the calculation of the FV of an ordinary annuity
is done as shown in the table that follows.
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Note: *
Note that the FVIF used in this calculation is found in Appendix 4.1.
The problem can also be solved by making use of the formula for
the calculation of the FV of an ordinary annuity, which is as
follows:
Where:
FVA = the future value of an annuity
PMT = payments made at the end of the period
i = the interest rate per period
n = the total number of periods
Using the future value interest factor of an annuity (FVAIF), the
formula for the calculation of the FV of an ordinary annuity can be
rewritten as follows:
Example 4.15 illustrates the calculation of the FVA by means of the
formula, interest factor tables and a financial calculator.
Example 4.15 Calculating the FVA
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What amount will accumulate if we deposit R5 000 at the end of each year for
the next five years? Assume an interest rate of 6% p.a. compounded annually.
Using the formula
Using interest factor tables
Using a financial calculator
In Example 4.15, we calculated the FV of an ordinary annuity.
Sometimes it is necessary to determine the annuity payments based
on a specified future value (for instance, if you want to determine
how much you have to deposit in a savings account every month in
order to generate a certain amount after a specified number of
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months). In order to calculate the PMT required to accumulate a
specified FV, the following formula is applied:
Example 4.16 illustrates the calculation of the annuity required to
accumulate to a given FV.
Example 4.16 Calculating monthly annuity payments
Tinyiko wants to invest a monthly sum that will accumulate to R100 000 after
ten years. How much must she deposit each month if her bank offers her an
interest rate of 8,5% p.a., compounded monthly?
Using the formula
Using a financial calculator
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In order to accumulate a sum of R100 000 after ten years, a monthly deposit
of R531,52 at the end of each month is therefore required.
Thus far, we have solved problems in which the compounding
period (for example, monthly) is the same as the payment period
(also monthly). But this is not always the case in real life. It is
common to find situations where compounding, for example,
occurs monthly, but payments are made semi-annually.
An entity may, for instance, obtain a loan with monthly interest
compounding and use the money to purchase a government bond
that makes semi-annual payments. When evaluating this sort of
investment, it is necessary to take the different frequencies of the
compounding and payments into consideration. Two methods can
be used to solve problems where there is a difference in the
compounding and payment intervals: the deconstruction method
and the rate equivalence method.
4.8.1.1
Deconstruction method
When using this method, the annuity is broken down into a series
of PVs of single sums. In other words, we calculate the PV for each
individual payment, and then add these individual values to get the
PV of the annuity (PVA). Example 4.17 illustrates the application of
the deconstruction method.
Example 4.17 Calculating the PVA using the deconstruction method
You have a second-hand sports car that you wish to sell. Your cousin Jacob
offers to purchase the car from you by making three annual payments of R50
000 starting one year from today. What is the current value of the offer if the
prevailing interest rate is 7% p.a. compounded monthly?
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Therefore, the PV under monthly compounding and annual payments can be
computed as follows:
PVA = PV3 + PV2 + PV1
= R40 553,95 + R43 485,60 + R46 629,17
= R130 668,72
4.8.1.2
Rate equivalence method
When using the rate equivalence method, we convert the
compounding period (for example, quarterly) so that it is the same
as the payment period (monthly). Thus, we convert the monthly
compounded period into an equivalent annual compounding
period so that the compounding period becomes the same as the
payment period. Example 4.18 illustrates the use of the rate
equivalence method.
Example 4.18 Calculating the PVA using the rate equivalence method
We begin by changing the monthly compounding period to an annual
compounding period:
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The annual rate is, therefore, computed as:
We now substitute this annual value of i in the present value of an annuity
equation:
Note that the differences in the solutions are due to rounding.
Using a financial calculator
In order to use the financial calculator, we need to ensure that both the
payments and the compounding occur over the same period of time. Since the
payments are made annually, we thus need to calculate the effective annual
interest rate. In the calculation above, we saw that this was 7,23%.
Although your cousin is paying you a total of R150 000 (R50 000 ×
3), you effectively receive a total of only R130 668,36 for the car.
4.8.2
Future value of an annuity due
The cash flow stream of an annuity due (or an annuity in advance)
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is similar to that of an ordinary annuity, except that each payment
occurs at the beginning of a period rather than at the end. Insurance
premiums and rent payments are examples of payments that are
usually in the form of an annuity due; these payments are usually
made in advance (in other words, at the beginning of each month).
The formula for calculating the FV of an annuity due is similar
to that for calculating the FV of an ordinary annuity. The only
difference is that the annuities due first need to be converted to
payments at the end of each period before the normal formulae are
applied. Example 4.19 illustrates the calculation of the FV of an
annuity due.
Example 4.19 Calculating the FV of an annuity due
What amount will accumulate if you deposit R5 000 in a savings account at the
beginning of each year for the next five years? Assume an interest rate of 6%
compounded annually.
Using the formula
Because this is an annuity due, each payment is moved ahead one period in
order to convert the cash flow stream into an ordinary annuity. This is achieved
by multiplying the PMT by (1 + i). The resulting cash flows of R5 300 (5 000 ×
1,06) at the end of each period are, therefore, equivalent to the cash flows of
R5 000 at the beginning of each period.
We then calculate the FVA as follows:
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Using interest factor tables
Using a financial calculator
When using a financial calculator, it is possible to begin by converting the
payments at the beginning of the period to payments at the end of the period,
as described in the previous two calculation methods. The solution will then be
similar to the one for an ordinary annuity. However, most financial calculators
have a function that can be used to calculate the value of an annuity due. In
order to use this function, you first need to set the calculator to begin mode
(BGN). The FVA is then calculated using the following keys:
4.8.3
Present value of an ordinary annuity
The PV of an ordinary annuity (PVA) is the current value of a
stream of expected or promised future payments that have been
discounted to a single equivalent value today. The PVA can also be
thought of as the amount you must invest today at a specific
interest rate so that when you withdraw an equal amount each
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period, the original principal and all accumulated interest will be
completely exhausted at the end of the annuity.
You can use PV interest factor tables or a financial calculator to
calculate the PV of each individual cash flow, and then add the PVs
to get the PV of the multiple cash flows. The problem can also be
solved by making use of the following formula:
Where:
PVA = the present value of an annuity
PMT = the payments made at the end of the period
i = the interest rate per period
n = the total number of periods
Using the present value interest factor of an annuity (PVAIF), the
formula for calculating the PV of an ordinary annuity can be
rewritten as follows:
Examples 4.20 and 4.21 illustrate the calculation of the PVA.
Example 4.20 Calculating the PV of an ordinary annuity
Suppose that you need an investment that will pay R2 000 at the end of every
year for the next five years at an annual interest rate of 10%. How much
should you invest today?
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Using the formula
Using interest factor tables
PVA = PMT × PVAIF10%,5
= R2 000 × 3,791 (see Appendix 4.4)
= R7 582,00
Using a financial calculator
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Example 4.21 Calculating the PV of an ordinary monthly annuity
What amount should you invest today at 6% p.a., compounded monthly, so
that you can withdraw R1 500 at the end of each month for the next five
years?
Using a financial calculator
4.8.4
Present value of an annuity due
As explained in Section 4.8.2, the cash flows of an annuity due
differ from the cash flows of an ordinary annuity: each payment of
an annuity due occurs at the beginning of a period rather than at
the end. As with the approach used for the calculation of the FVA,
it is possible to change the payments from the beginning to the end
of the year by multiplying them by (1 + i). Example 4.22 illustrates
the calculation of the PV for an annuity due.
Example 4.22 Calculating the PV of an annuity due
What amount must you invest today at 6% interest, compounded annually, so
that you can withdraw R5 000 at the beginning of each year for the next five
years?
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Using the formula
Using a financial calculator
First set the calculator to begin mode (BGN).
4.8.5
Ordinary deferred annuities
In the case of an ordinary deferred annuity, equal annual payments
will start at some future point in time. This type of annuity is used
if an investor wishes to invest a sum of money now, but only wants
payments to begin at some future date. These annuities may be
purchased with a single payment or, as is more often the case, with
a series of periodic payments. Deferred annuities are most
commonly purchased by individuals who wish to make periodic
payments during their working lives in order to receive monthly or
annual income payments from the annuities during their
retirement. Example 4.23 illustrates the calculation of the payment
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amounts for a deferred annuity.
Example 4.23 Calculating payments for an ordinary deferred annuity
Your friend Jacob wants to buy a car worth R50 000 (ignore deposits and other
costs) by financing it over a period of 36 months. Suppose that an interest rate
of 20% p.a. (compounded monthly) is charged. How much would he pay per
month if he only wants to make his first payment after six months? What would
the monthly payment be if he did not defer the first payment by six months?
This calculation will have to be made in two steps because the first payment is
only made after six months. Note that the present value of R50 000 will have
to be adjusted to reflect the interest that is due for the next six months.
Therefore, we first calculate the FV of R50 000 after six months. Once the FV
has been calculated, we can calculate the payments to be made starting after
six months.
Using the formula
Step 1: Calculation of FV of R50 000 after six months:
Step 2: Calculation of monthly payments over the remaining 30 months:
Using a financial calculator
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The calculator solution for this example can be divided into two steps. The first
step is to calculate the FV; the second step is to calculate the monthly
payments.
Step 1: Calculation of FV of R50 000 after six months:
Step 2: Calculation of monthly payments:
If he did not defer the first payment by six months, the monthly payment would
be calculated over the full 36 months:
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4.8.6
Mixed streams of cash flows
The annuity problems discussed in the previous sections are based
on equal payments made over a number of periods. During the
process of capital budgeting (described in more detail in Chapter 6),
where long-term investment decisions are evaluated, the cash flows
resulting from the initial investment are usually not in the form of
an annuity. Unequal cash flows will most probably be generated
over a project’s lifetime and, in some cases, positive cash flows may
occur as well as negative cash flows. The question, therefore, arises:
what happens if the cash flows of a project or investment are
different amounts during the term of the investment?
We usually refer to the cash flow pattern of an investment with
unequal cash flows as a mixed stream of cash flows. It is not
possible to use the annuity formulae and calculator solutions we
discussed in the previous sections for a mixed cash flow stream.
Example 4.24 illustrates the calculation of the PV of a mixed stream
of cash flows.
Example 4.24 Calculating the PV for mixed streams of cash flows
As a reward for taking care of your uncle during his terminal days of illness, he
instructs his lawyer to make payments into your account for a period of five
years, as shown in the table that follows.
Assuming an interest rate of 10% p.a., calculate the PV of the cash flows.
Remember that this cannot be calculated as an annuity because the amounts
are not constant.
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Making use of the interest factor tables, the solution can be calculated by
computing the individual PV of each individual cash flow as follows:
PV = FV1 × (PVIF10%,1) = 5 000 × 0,909 = 14 545,00
PV = FV2 × (PVIF10%,2) = 5 000 × 0,826 = 14 130,00
PV = FV3 × (PVIF10%,3) = 6 000 × 0,751 = 14 506,00
PV = FV4 × (PVIF10%,4) = 6 000 × 0,683 = 14 098,00
PV = FV5 × (PVIF10%,5) = 1 000 × 0,621 = 14 621,00
PV = FV5 × (PVIF10%,5) = 1 000 × 0,621 = 17 900,00
Using a financial calculator
The calculation can also be computed with a financial calculator by using the
cash flow function (Cfi).
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4.8.7
Retirement funding
It is sometimes useful to be able to determine the lump-sum
investment of the annuity required to provide adequately for
retirement. To achieve this, an investor must estimate the length of
time prior to retirement, the return that will be earned on the funds
invested during and after this period and, finally, the amount of
funds required for retirement.
Since most individuals are not in a position to invest large sums,
retirement plans are generally structured to require monthly
contributions from the investor. On retirement, the investor receives
a lump sum and an annuity. Under current law, a maximum lumpsum payment of one-third of the accumulated sum at the retirement
date can be withdrawn in cash; the remaining two-thirds are
converted into monthly pension payments.
Example 4.25 Calculating the FV of a retirement annuity
You are currently 35 and wish to retire at 65. If you pay R20 000 annually into
a retirement annuity that pays 10% interest p.a., what will be the value of your
investment when you turn 65? If your life expectancy is 75 years and you want
to withdraw an annual amount of R500 000 from your retirement annuity once
you have retired, would you have made sufficient provision for your retirement?
Using interest factor tables
Step 1: Calculate the FV of your annual investments in the retirement annuity
after 30 years:
FVA = R20 000 × FVIFA10%,30
= R20 000 × 164,494
= R3 289 880
Step 2: Calculate the PV of your withdrawals over the ten-year retirement
period:
PVA = R500 000 × PVIFA10%,10
= R500 000 × 6,145
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= R3 072 500
Using a financial calculator
Step 1: Calculate the FV of your annual investments in the retirement annuity
after 30 years:
Step 2: Calculate the PV of your withdrawals over the ten-year retirement
period:
Since the PV of your withdrawals at your retirement 30 years from now is less
than the accumulated amount in your retirement annuity at that stage, you will
have sufficient funds to cover the next ten years. If you live beyond the age of
75, however, the retirement annuity will be exhausted.
QUICK QUIZ
1. Explain why the FV is higher for an annuity
due than for an ordinary annuity.
2. In the case of an ordinary annuity, the cash
flow occurs at the beginning of each period.
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True or false? Motivate your answer.
3. Explain the difference between an annuity due
and an ordinary deferred annuity.
Application activity
Although retirement may be the last thing on a student’s mind,
ensuring that you make adequate provision for your retirement is
extremely important. Since most individuals are only expected to
retire at age 65, you can benefit from compound interest that is
earned over a relatively long period.
Many entities provide retirement savings calculators. For
instance, you could find an example by visiting Old Mutual’s
website
(https://www.oldmutual.co.za/v5/campaigns/omretirement-calculator/). Use this retirement savings calculator to
determine the effect of starting to save for retirement too late or of
not contributing a sufficiently large amount to your retirement
fund.
4.9
Perpetuities
A perpetuity is an annuity in which the periodic payments begin on
a fixed date and continue indefinitely. It is sometimes referred to as
a perpetual annuity. Fixed coupon payments on permanently
invested (irredeemable) sums of money are a good example of
perpetuities. A fund for a scholarship paid perpetually from an
endowment also fits the definition of a perpetuity. In the South
African context, the closest instrument to a perpetuity bond is a
non-redeemable preference share paying a fixed dividend.
There are three types of perpetuity:
• An ordinary perpetuity is when payments are made at the end
of the stated periods.
• A perpetuity due is when payments are made at the beginning
of the stated periods.
• A growing perpetuity is when the periodic payments grow at a
given rate (g).
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The formula used to calculate the PV of an ordinary perpetuity
(PV∞) is as follows:
The formula used to calculate the PV of a perpetuity due is as
follows:
The formula for calculating the PV of a growing perpetuity is as
follows:
Examples 4.26 and 4.27 illustrate the calculation of the PV of an
ordinary perpetuity and a growing perpetuity.
Example 4.26 Calculating the PV of an ordinary perpetuity payment
Charity wishes to start a bursary to fund the top five matric students in her
former high school in memory of her late father, who was the principal of the
school for 30 years. The governing body of the school requires R125 000 per
year to pay the school fees of five matric students as well as to buy them
uniforms, stationery and textbooks. Since the school fees and the price of the
other items increase every year according to inflation, it was agreed that
inflation should be estimated at 5% per year. Determine the amount that
Charity must donate to the governing body now to fund the bursary.
Using the formula
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Example 4.27 Calculating the PV of a growing perpetuity
Calculate the PV of a growing perpetuity based on the following information:
• Cash flow at the end of the first year: R60 000
• Growth rate (g): 10%
• Opportunity cost of capital (i): 20%
QUICK QUIZ
What is the difference between an ordinary
annuity and a perpetuity?
In the previous sections, we have explained the methods for
calculating the PV and FV of lump sums, ordinary annuities,
annuities due, deferred annuities and perpetuities. In Sections 4.10
and 4.11, the focus is on two specific applications of these methods:
amortising loans and sinking funds, and how to calculate the
periodic payments required.
4.10
Amortising a loan
Loan amortisation refers to the settlement of a debt by means of
equal periodic repayments over a specified period of time. These
payments provide a lender with a specified interest return and
repayment of the loan principal over the specified period. Part of
each payment (or instalment) goes towards interest due for the
period and the remainder is used to reduce the principal (the loan
balance). In other words, the total instalment (or payment) =
interest + capital redemption. As the balance of the loan is
gradually reduced, the interest amount decreases, and a
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progressively larger portion of each payment therefore goes
towards reducing the principal.
The loan amortisation process involves calculating the future
payments, over the term of the loan, whose PV at the loan interest
rate equals the amount of initial principal borrowed. Amortisation
refers to the type of instalment loan, such as a mortgage bond or a
personal loan. The periodic payment amount is usually constant.
Lenders use a loan amortisation schedule to determine the payment
amounts and the allocation of each payment to interest and
principal. In the case of home mortgages (bonds), these schedules
are used to calculate the equal monthly payments necessary to
amortise – or pay off – the mortgage at a specific interest rate over
15 to 30 years. An amortisation schedule shows the repayment
details for a loan, including the amount of each payment that is
apportioned to interest and to capital (the principal debt).
Example 4.28 illustrates the calculation of the payments to
amortise a loan over a period of time.
Example 4.28 Calculating the payments to amortise a loan
You want to determine the equal, annual end-of-year payments necessary to
fully amortise a loan of R6 000 at 10% interest over four years.
Using a financial calculator
From this calculation, you know that you need to repay a total of R1
892,82 at the end of each of the next four years in order to redeem
the loan. Part of this payment is interest on the outstanding loan
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amount, while the rest is used to redeem part of the capital.
Example 4.29 illustrates how the split between the interest and
capital component is made.
Example 4.29 Calculating the mortgage repayments and balance of an
amortising loan
Sibusiso wishes to apply for a loan of R500 000 from EBN Bank to buy a new
house. Assume that the term of the loan is 20 years and the interest rate is
14% p.a., compounded monthly. Calculate the following:
1. His monthly instalment
2. The interest and the capital component of instalment number 13
3. The outstanding balance on the loan after instalment number 13 has been
paid.
Using a financial calculator
His monthly instalment therefore amounts to R6 217,60 per month.
You can use the amortisation function on your calculator to calculate the
interest and capital component of instalment number 13.
13 INPUT 13 (to reflect that instalment number 13 is being considered)
Shift AMORT
Interest = R5 775,95
Capital = R441,66
Outstanding balance = R494 639,39
Note that the solution may be calculated differently depending on
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the financial calculator that you are using; refer to your financial
calculator’s user manual.
Most spreadsheet programs (such as Excel) also contain a
function that can be used to solve amortisation problems.
Example 4.30 illustrates the construction of an amortisation
schedule.
Example 4.30 Constructing an amortisation schedule
Suppose you have borrowed R220 000 from Alsa Bank at an interest rate of
12% p.a. to be repaid over the next six years. Construct the amortisation
schedule if equal payments are required at the end of each year.
Using a financial calculator
The amortisation schedule is presented in the table that follows.
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Figure 4.2 shows the amortisation graph of the schedule shown in
the table in Example 4.30. The graph has been constructed by means
of a spreadsheet. The principal amount owing at year end (balance)
decreases from T0 to T6. Note that the cumulative interest has
grown over the same period of time. Also note how the principal
repayments increase and the annual interest levels decrease as you
get closer to paying off the loan.
Figure 4.2 Graphical representation of amortisation
QUICK QUIZ
1. The loan-amortisation process involves
calculating the future payments (over the term
of the loan) whose present value at the loan
interest rate equals the sum of the amount of
initial principal borrowed and the amount of
interest on the loan. True or false? Motivate
your answer.
2. With an amortised loan, the payment amount
remains constant over the life of the loan,
the principal repayment portion of each
payment increases over the life of the loan
and the interest portion of each payment
declines over the life of the loan. True or
false? Motivate your answer.
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FOCUS ON ETHICS: Is it ethical for
banks to charge more interest than stipulated in
the original loan contract?
The repossession of motor vehicles due to consumers defaulting on
their monthly payments as a result of the harsh economic conditions
has received attention recently in the media and other forums. Most of
these repossessions involve the country’s big four banks, which
dominate with a market share of more than 97%.
Banks usually provide loans to clients at a specific interest rate to
be paid over a certain number of periods. The client is required to pay
back the interest and the debt by making monthly payments. Recent
reports indicate that some banks are charging interest on interest
when a client falls into arrears on the vehicle loan. When financing a
motor vehicle, banks usually calculate the loan based on the cost of
the vehicle plus interest over the life of the loan, divided by the
number of instalments. For example, if a client purchases a motor
vehicle at a cost of R220 000 and pays a deposit of R20 000, the
balance of R200 000 can be financed through a bank loan. If the bank
charges an interest rate of 12% and the instalment is payable over a
period of six years, the monthly payment for the loan can be
calculated as R3 910,04. If the client begins defaulting on instalments
during the fifth year of the loan, the bank will start charging interest
on the arrears, which will ultimately increase the original loan of R200
000. In other words, the balance will not be calculated according to
the interest rate that is specified in terms of the contract entered by
the client, but will consist of a portion of simple interest as well as
compound interest.
Source: Compiled from information in Ryan, 2019b.
QUESTION
Do you think it is ethical for banks to charge interest on interest in
cases where clients default on their monthly payments, an action that
might lead to clients having their vehicles repossessed?
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4.11
Sinking funds
When borrowing money, an entity may be required to provide for a
sinking fund payment each period to have enough money
accumulated at a specific date to pay back the loan. When issuing
bonds, for instance, some issuers also include a sinking fund
provision, where each payment consists of a principal repayment
and interest component.
The same principle applies to an entity that will need to replace
equipment, such as a machine, in the future. The idea of a sinking
fund is to ensure that the entity has enough money to replace or
pay off the replacement item in the future.
The following information is needed when performing sinking
fund calculations:
• the amount to be repaid or the purchase price of the investment
(also the scrap or resale value of the current equipment, if
applicable)
• the period of the sinking fund
• the interest applicable during the period of the sinking fund
• the expected inflation rate that will be applied during the period
of the sinking fund.
A sinking fund can also be a means of repaying funds that have
been borrowed through a bond issue. The issuer makes periodic
payments to a trustee, who retires part of the issue by purchasing
the bonds in the open market.
From the investor’s point of view, a sinking fund adds safety to
a corporate bond issue. In the case of a sinking fund, the issuing
entity is less likely to default on the repayment of the remaining
principal upon maturity, since the amount of the final repayment is
substantially less. This added safety affects the interest rate at
which the entity is able to offer bonds in the marketplace. A sinking
fund schedule is similar to an amortisation schedule.
Example 4.31 illustrates the calculation of a sinking fund
schedule.
Example 4.31 Calculating a sinking fund schedule
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An entity wants to save R100 000 over the next five years so that it can
expand its plant facility. How much must be deposited at the end of each year
if the money earns interest at a rate of 6% p.a.? Construct a complete sinking
fund schedule.
Using a financial calculator
The sinking fund schedule can be constructed as shown in the table that
follows.
Note that interest on the sinking fund deposit is calculated at the
rate of 6% (for example, 17 739,64 × 6% = 1 064,38 for year 2). There
is no interest for year 1 because deposits are made at the end of the
period. The increase in the fund (see Column 4) is calculated by
adding the interest in year 2 to the deposit in year 1 (in other words,
1 064, 38 + 17 739,64 = 18 804,02). The process is repeated to obtain
the remaining increases in the fund for years 3 to 5. The calculations
in Column 5, ‘Amount in fund at end of period’, are similar to the
calculations performed in Column 3.
QUICK QUIZ
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A sinking fund can also be a means of repaying
funds that have been borrowed through a bond
issue. The issuer makes periodic payments to a
trustee, who retires part of the issue by
purchasing the bonds in the open market. True or
false? Motivate your answer.
4.12
Conclusion
This chapter explored the principles of the time value of money.
You learnt the following:
• A lump sum refers to a single payment or receipt of cash at a
specific point in time. A distinction was made between initial
cash flows (occurring at time zero: that is, now) and future cash
flows that occur at some point in the future.
• The future values and present values of lump sums, annuities
and mixed cash flows can be calculated by making use of
formulae, financial tables or a financial calculator.
• An annuity can be defined as a stream of equal, periodic cash
flows over a specified period of time, in equally spaced time
intervals. These payments are usually annual, but can occur at
other intervals, such as monthly (for example, bond payments).
Annuity formulae allow complex problems to be resolved in a
systematic manner.
• A perpetuity is a perpetual stream of constant or constantly
growing cash flows.
• A mixed cash stream consists of non-constant cash flows, in
which different cash flows occur every period.
• Loan amortisation refers to settling a debt by means of equal
periodic payments over a period of time. Therefore,
amortisation is a schedule showing the repayment details for a
loan, including the amount of each payment that is apportioned
to interest and to capital redemption (the principal debt).
• Sinking funds are used to accumulate money over time by
depositing periodic payments in a fund. Sinking funds can be
used, for example, to make provision for the replacement of
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assets or for a loan that needs to be repaid.
The principles developed in this chapter feature prominently in this
book, especially in Chapter 5, which looks at investment appraisal
methods, Chapter 6, which deals with relevant cash flows, Chapter
8, which considers bond valuation, and Chapter 9, where the focus
is on the valuation of an entity’s shares. Most investments, whether
they involve real assets or financial assets, can be analysed using
the discounted cash flow approach.
Albert Einstein famously said that compound interest is the
most powerful force in the universe. According to him,
“Compound interest is the eighth wonder of the world. He who
understands it, earns it; he who doesn’t, pays it.” As we have seen
in this chapter, earning compound interest over a long period of
time ensures that the final value of an investment increases
exponentially. The same principle, however, also applies when we
have to pay interest, such as in the case of home loans. Since these
loans are typically repaid by means of monthly payments over 25 or
30 years, even small amounts quickly accumulate to large values.
The closing case study in this chapter is an example of the impact
that additional monthly administration fees had on some
homeowners.
CASE
STUDY
Claims that Standard Bank overcharged holders of home
loans
In 2012, the Supreme Court of Appeal ruled in favour of the
National Credit Regulator (NCR) against Standard Bank for
overcharging administration fees on home loans. The claim
stemmed from a change in the amount that money lenders
could charge as administrative fees. Under the Usury Act (No.
73 of 1968), money lenders could charge a fee of R5 per month
for administration. When the Act was replaced by the National
Credit Act (No. 34 of 2005), this fee increased to a maximum of
R50 per month. According to the NCR, however, money
lenders could only adjust the monthly fee on existing loans if
they formally entered into an agreement with the holder of the
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loan to negotiate the change in the fee.
Following the ruling, Standard Bank reconsidered those
home loans where it had charged an increased administration
fee between June 2009 and December 2012. For many loan
holders, the impact of the increased administrative fee was
substantial, often amounting to more than R10 000. In those
cases where the fee was increased erroneously, Standard Bank
credited the Usury Home Loan consumers’ accounts to rectify
the impact it had on their outstanding balances. The bank also
communicated with all its affected customers to inform them
about adjustments to its administrative fees. In January 2013,
Standard Bank declared that all affected customers had been
refunded.
However, claims that Standard Bank did not refund all
affected customers and that some customers are still being
charged the increased administrative fee, despite not having
entered into a new agreement with the bank, are still surfacing.
It is alleged that only half the affected customers were
refunded and that the refund only amounted to 45% of the
amount that was due. Given the large number of customers
potentially affected and the size of the refunds, failing to adjust
all affected customers’ accounts would have a big impact on
Standard Bank’s statement of financial position. Standard Bank
responded to these claims by saying that there were no factual
foundations for these allegations and that it had addressed the
problem in line with the Supreme Court of Appeal’s
judgement.
Sources: Compiled from information in Ryan, 2018, 2019a; SAPA, 2012; Van der Merwe, 2011.
It can be concluded from the closing case study that even a small
amount of money may cause great misfortune over the long run,
since a rand today is worth more than a rand at a future date. It is
easy to argue that R50 is not a significant amount of money, for
example. However, if we consider the impact of an extra R50 per
month on a 25-year home loan at an interest rate of 10% per year we
find that it will accumulate to a final value of more than R66 000
over the period of the loan.
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The NCR has been mandated to receive and investigate
complaints and ensure that consumer rights are protected in order
to protect consumers from unfair and discriminatory actions by
participants in the credit market.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
You are purchasing a new machine and have been presented with three
repayment options. The first option requires a payment of R11 000 at the end
of each year for the next ten years. The second requires payments of R10 000
at the beginning of each year over the same period. The third requires a onceoff payment of R108 854,75 at the end of the fifth year from now. If you can
earn interest of 10% p.a. on your investments, which alternative would you
choose?
A. Option 1
B. Option 2
C. Option 3
D. All of them would be acceptable
2.
Which is the effective interest rate earned on an investment if the nominal
interest rate is 16% p.a., but interest is compounded at the end of each
quarter?
A. 3,78%
B. 16,00%
C. 16,99%
D. 18,11%
3.
Theo plans to fund his retirement annuity with a contribution of R25 000 at the
beginning of each year for the next 15 years. If Theo can earn 10% p.a. on his
contributions, how much will he have at the end of the fifteenth year?
A. R375 000
B. R481 360
C. R794 312
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D.
R873 743
4.
A client tells you that she is saving for retirement, and wants to accumulate
R13 million. If she plans to save for the next 20 years, how much must she
save at the end of each year if the interest rate is 12% p.a.?
A. R180 424
B. R202 075
C. R226 975
D. R650 000
5.
Natalie is considering buying a car for R80 000. The bank has quoted her an
interest rate of 12% p.a. (compounded monthly). If she wishes to repay the
principal amount over 60 months, how much will her monthly instalments be?
A. R1 333
B. R1 780
C. R3 533
D. R9 611
INTERMEDIATE
6.
Amanda has just secured a permanent job. She plans to start saving for her
retirement immediately. To live comfortably, she estimates that she will need
R12 million by the time she retires at 60, exactly 38 years from now. The
annual amount that she should deposit at the beginning of each year in a
savings account paying 6% interest is closest to __________.
A. R83 300
B. R88 300
C. R93 300
D. R101 300
7.
John requires a minimum return of 24% p.a., compounded monthly, on all his
investments. How much would he be prepared to pay for an investment
offering semi-annual payments of R500 over the next six years (correct to the
nearest rand)?
A. R1 926
B. R3 011
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C.
D.
R3 097
R4 682
8.
Lerato wants to set up a bursary fund for finance students at Stellenstroom
University. At the beginning of the first year, the total bursary amount will be
R50 000, but it will have to increase at 5% p.a. to make provision for inflation.
If the fund can earn a return of 10% p.a., how much does Lerato need to
provide now to ensure that perpetual payments can be made at the beginning
of each year?
A. R500 000
B. R1 000 000
C. R1 050 000
D. R1 100 000
9.
Determine the final value of the stream of cash flows listed in the table that
follows, received at the end of each of the next five years, assuming that you
can earn 11% interest on your investments.
A.
B.
C.
D.
Year
Amount
1
R3 000
2
R6 000
3
R9 000
4
R6 000
5
R3 000
R19 886
R30 000
R33 509
R41 225
10. You are planning to buy a vehicle. The bank charges you interest at 18% p.a.
compounded monthly over a four-year repayment period. You can afford
monthly instalments of R1 500 at the end of each month and you have a
deposit of R20 000. What is the maximum price you can pay for a vehicle?
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A.
B.
C.
D.
R24 035
R31 064
R71 064
R124 348
11. To pay for her son’s university education, Susan intends to save R3 000 at the
end of each quarter for the next ten years in a savings account paying interest
at 9% p.a., compounded monthly. The amount that Susan will have in her
account at the end of the tenth year is closest to __________.
A. R191 359
B. R192 070
C. R195 074
D. R201 334
12. You want to purchase a new bicycle that costs R25 000. If you are charged an
interest rate of 6% p.a. compounded monthly, how many months will it take
you to repay the amount if you deposit R2 500 now and R1 000 at the end of
every month thereafter (correct to the nearest whole number)?
A. 9
B. 12
C. 15
D. 24
ADVANCED
Use the information that follows to answer Questions 13 to 17.
Steven received a loan of R1 200 000 from the bank in order to buy a new house.
The term of the loan is 25 years and the interest rate is 18% p.a., compounded
monthly.
13. His monthly instalment is closest to _________.
A. R4 000
B. R18 209
C. R57 916
D. R219 503
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14. The principal repayment component of instalment number 10 is closest to
_________.
A. R206
B. R239
C. R371
D. R586
15. The interest component of instalment number 10 is closest to __________.
A. R9 774
B. R12 506
C. R17 970
D. R21 331
16. The outstanding balance on the loan after instalment number 10 has been paid
is closest to __________.
A. R864 510
B. R907 227
C. R1 104 881
D. R1 197 761
LONGER QUESTIONS
BASIC
1.
Leonard has received a loan of R1 500 000 from ENB Bank to buy a new
house. The term of the loan is 25 years and the interest rate is 15% p.a.,
compounded monthly. Calculate the following:
a) His monthly instalments
b) The interest component and the outstanding balance of instalment
number 25
c) The total of the interest and capital components in the third year
(instalments 25–36).
2.
You have received a loan, which you must pay back in the form of a lump sum
equal to R17 908,48 five years from now. Suppose that the loan is instead
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repaid in semi-annual payments, the first due six months from now and the last
at loan termination five years from now. What would the amount of each
instalment be if the interest rate was 12% p.a., compounded semi-annually?
INTERMEDIATE
3.
Zandre, who turned 20 today, plans to retire on her 60th birthday. For the next
20 years (in other words, until her 40th birthday), she wants to invest the same
amount at the end of each year, and then leave the final value in the fund for
the remaining 20 years until her retirement. She wants to be able to withdraw
R250 000 at the end of each year for 20 years once she retires. The first
withdrawal will therefore be on her 61st birthday.
a) How much must she set aside at the end of each year during the next 20
years if she can earn 10% p.a. on her funds?
b) Suppose that she keeps on contributing annually for the full 40 years
preceding her retirement. What will the annual amount that she has to
invest be to get the same benefit of R250 000 per year?
ADVANCED
4.
Tom Soone (aged 20) and Harry Lait (aged 30) began work at the same entity
today. Tom starts to invest R2 000 per month in a retirement fund. Harry, after
realising that he has not made any provisions for retirement yet, decides to
invest R3 000 per month. Both men will retire at 65. Assume that the
retirement fund earns a return of 9% p.a., compounded monthly.
a) What will the final value of their investments be when they retire?
b) Suppose that Harry wants to accumulate the same final amount as Tom
at retirement. What will his annual contribution to the retirement fund
have to be?
c) If Harry cannot afford to invest more than R4 000 per year in the
retirement fund, until what age will he have to invest if he wants to
accumulate the same amount as Tom at the age of 65?
d) Suppose that Tom decided only to invest R2 000 per month for the first
ten years and to leave the final amount in the fund for the remaining
years until his retirement. Calculate the final value of his retirement fund
when he retires. (This illustrates the benefit of starting to save at a young
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age: do you think Harry will now be in a better position than Tom?)
KEY CONCEPTS
Annuity due: An annuity for which constant payments occur at the
beginning of each period; also known as annuity in advance.
Compound interest: Interest is earned on both the principal (capital
invested) and reinvested interest (that is, interest on interest).
Deferred annuity: A type of annuity contract that delays payments of
income, instalments or a lump sum until the investor elects to
receive them.
Effective interest: Effective annual rate (EAR) of interest actually paid
or earned (in other words, true annual interest rate).
Future value (FV): The value at a given future time of a present
amount of money deposited today in a savings account earning
specific interest.
Monthly compounding: Compounding of interest over 12 periods
within a year.
Nominal interest rate: Contractual annual rate of interest charged by a
lender or promised by a borrower (in other words, stated or
quoted interest rate).
Ordinary annuity: An annuity for which constant payments occur at
the end of each period; also known as annuity in arrears.
Perpetuity: An ordinary annuity whose payments continue forever.
Present value (PV): The current value of a future amount of money or
series of future payments, evaluated at a given interest rate.
Quarterly compounding: Compounding of interest over four periods in
a year.
Semi-annual compounding: Compounding of interest over two periods
in a year.
Simple interest: Interest is earned on the principal (capital invested)
only, not on principal and interest reinvested.
Time value of money (TVM): The concept that holds that a rand today is
worth more than a rand in the future because a rand can earn
interest if invested today to be drawn at a future date.
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SLEUTELKONSEPTE
Effektiewe rentekoers: Effektiewe jaarlikse rentekoers (EAR) wat
werklik betaal of verdien word (met ander woorde, die werklike
jaarlikse rentekoers).
Enkelvoudige rente: Rente word slegs op die hoofsom (kapitaal wat
geïnvesteer is) verdien, en nie op die rente wat her-investeer is
nie.
Gewone annuïteit: ’n Annuïteit waar konstante betalings plaasvind
aan die einde van elke periode; ook bekend as ’n
agternabetaalbare annuïteit.
Halfjaarlikse samestelling: Samestelling van rente oor twee periodes in
’n jaar.
Kwartaallikse rentesamestelling: Die samestelling van rente oor vier
periodes in ’n jaar.
Maandelikse rentesamestelling: Die samestelling van rente oor 12
periodes binne ’n jaar.
Nominale rentekoers: Kontraktuele jaarlikse rentekoers gehef deur ’n
uitlener of voorsien deur ’n lener (met ander woorde, die
gekwoteerde rentekoers).
Perpetuïteit: ’n Gewone annuïteit waar betalings oor ’n oneindige
periode plaasvind.
Saamgestelde rente: Rente wat verdien word op beide die hoofsom
(kapitaal wat geïnvesteer is) en rente wat her-investeer is (met
ander woorde, rente op rente).
Teenswoordige waarde (PV): Die huidige waarde van ’n toekomstige
geldbedrag of reeks van toekomstige betalings, bereken teen ’n
spesifieke rentekoers.
Toekomstige waarde (FV): Die waarde op ’n spesifieke toekomstige
datum van ’n teenswoordige bedrag wat vandag in ’n
spaarrekening gedeponeer is en wat ’n spesifieke rentekoers
verdien.
Tydwaarde van geld (TVM): Die konsep dat ’n rand vandag meer werd
is as ’n rand in die toekoms, aangesien ’n rand rente kan verdien
indien dit vandag geïnvesteer word en in die toekoms onttrek
word.
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Uitgestelde annuïteit: ’n Tipe annuïteite kontrak waar die betaling van
inkomste, paaiemente of enkelbedrag uitgestel word totdat die
belegger besluit om dit te ontvang.
Vooruitbetaalbare annuïteit: ’n Annuïteit waar konstante betalings aan
die begin van elke periode plaasvind.
SUMMARY OF FORMULAE USED IN THIS CHAPTER
WEB RESOURCES
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http://www.investec.co.za
https://www.ncr.org.za
https://shareholder.ford.com/investors/stockinformation/investment-calculator/default.aspx
http://www.standardbank.co.za
REFERENCES
Collins, J. (2019). Ford Should Eliminate Its Common Dividend.
Forbes. Retrieved from
https://www.forbes.com/sites/jimcollins/2019/09/10/fordshould-eliminate-its-common-dividend/#2fb5f7cb57bd [24
November 2019].
Eule, A. (2017). Tesla vs. Ford: Understanding Wall Street’s Math.
Barron’s. Retrieved from
https://www.barrons.com/articles/tesla-vs-fordunderstanding-wall-streets-math-1491339408 [24 November
2019].
Ford. (2019). Investors: Stock Information. Retrieved from
https://shareholder.ford.com/home/default.aspx [24
November 2019].
Garg, A. (2019). Should Ford Investors Brace for a Dividend Cut?
Market Realist. Retrieved from
https://articles2.marketrealist.com/2019/10/should-fordinvestors-brace-for-dividend-cut/ [24 November 2019].
Mourdoukoutas, P. (2019). Ford Beats Tesla, Again. Forbes.
Retrieved from
https://www.forbes.com/sites/panosmourdoukoutas/2019/07/06/fordbeats-tesla-again/#4a6be7b470f0 [24 November 2019].
Nasdaq. (2019). Market Activity. Retrieved from
https://www.nasdaq.com/market-activity/stocks/f/dividendhistory [27 February 2020].
Rosenbaum, E. (2019). Ford surpasses Tesla in market cap as old
and new automaker stocks diverge post earnings. CNBC.
Retrieved from https://www.cnbc.com/2019/04/26/fordsurpasses-tesla-in-market-cap-on-earnings-rally-ev-demand******ebook converter DEMO Watermarks*******
slump.html [24 November 2019].
Rosevear, J. (2019). Better Buy: Tesla vs. Ford Motor. The Motley
Fool. Retrieved from
https://www.fool.com/investing/2019/10/13/better-buytesla-vs-ford-motor.aspx [24 November 2019].
Ryan, C. (2018). Are banks routinely overcharging on vehicle loans
in arrears? Moneyweb. Retrieved from
https://www.moneyweb.co.za/news/south-africa/are-banksroutinely-over-charging-on-vehicle-loans-in-arrears/ [1
December 2019].
Ryan, C. (2019a). Claim that Standard Bank’s R5 overcharge on
mortgages ballooned to R2bn. Moneyweb. Retrieved from
https://www.moneyweb.co.za/news/companies-anddeals/claim-that-standard-banks-r5-overcharge-on-mortgagesballooned-to-r2bn/ [1 December 2019].
Ryan, C. (2019b). Thousands of vehicles are being repossessed each
year based on false figures. Acts Online. Retrieved from
http://www.acts.co.za/news/blog/2019/05/thousands-ofvehicles-are-being-repossessed-each-year-based-on-false-figures
[1 December 2019].
SAPA. (2012). Victory for consumer rights. IOL. Retrieved from
https://www.iol.co.za/business-report/economy/victory-forconsumer-rights-1435457 [1 December 2019].
Tesla. (2020). Tesla. Prospectus supplement dated April 30, 2020.
Dividend policy. p. S-8. Retrieved from
https://www.sec.gov/Archives/edgar/data/1318605/000119312520128995
[04 May 2020].
Van der Merwe, J. (2011). Banks overcharging unwary bond
holders. The Witness. Retrieved from
https://m.news24.com/Archives/Witness/Banksovercharging-unwary-bond-holders-20150430 [1 December
2019].
Appendix 4.1: Future value interest factor (FVIF) (R1 at i% for n
periods)
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Appendix 4.2: Present value interest factor (PVIF) (R1 at i% for n
periods)
Appendix 4.3: Future value of an annuity interest factor (FVIFA) (R1
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per period at i% for n periods)
Appendix 4.4: Present value of an annuity interest factor (PVIFA) (R1
per period at i% for n periods)
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5 Investment appraisal methods
Sam Ngwenya and Pierre Erasmus
Learning
outcomes
Chapter
5.1
By the end of this chapter, you should be able to:
understand the importance of investment
appraisal techniques
distinguish between the different types of
investment project
calculate, interpret and evaluate the average
return
calculate, interpret and evaluate the payback
period
calculate, interpret and evaluate the discounted
payback period
calculate, interpret and evaluate the net present
value
calculate, interpret and evaluate the internal rate
of return
define the net present value, and construct and
interpret a graph of its profile
calculate, interpret and evaluate the modified
internal rate of return
calculate, interpret and evaluate the profitability
index
understand why ranking investment proposals
on the basis of the net present value method
and the internal rate of return method may lead
to conflicting rankings.
Introduction
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outline
CASE STUDY
5.2
The importance of efficient investment
appraisal
5.3 Types of investment project
5.4 The average return method
5.5 The payback period method
5.6 The discounted payback period method
5.7 The net present value method
5.8 The internal rate of return method
5.9 Comparing the net present value method and
the internal rate of return method
5.10 Modified internal rate of return
5.11 The profitability index
5.12 Conclusion
Expanding Distell Ltd’s global footprint
Distell, the Stellenbosch-based liquor group, has come a long
way since 2000, when a merger between Stellenbosch Farmers’
Winery Group Ltd and Distillers Corporation (SA) Ltd resulted
in the formation of the entity. Since then, it has achieved a
number of milestones and today proudly proclaims itself as
“Africa’s leading producer and marketer of wines, spirits,
ciders and other ready-to-drink (RTDs) beverages, enjoyed
responsibility by people across the world” (Distell, 2019: 2).
The entity is currently also the second largest cider producer in
the world, and its international flagship product, Amarula
Cream, is the second best-selling cream liqueur in the world.
Its other products, including well-known brands such as
Nederburg, Klipdrift brandy and Fleur du Cap, are distributed
to 82 countries throughout the world.
Distell proclaims that its long-term success depends on the
ability to continuously develop its brands, resulting in the
entity’s approach of constantly improving its knowledge of
market segmentation and its understanding of its consumers,
refining the positioning of its brands and applying appropriate
investment decisions. The entity strives to maximise value for
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all its key stakeholders, including shareholders, employees,
suppliers, customers and society. An entity’s ability to
maximise stakeholder value can be appraised by evaluating its
revenue growth, profitability through operating margin
improvement, asset efficiency, sustainability and corporate
responsibility.
To achieve its objective of stakeholder value maximisation,
Distell needs to identify and evaluate investment opportunities
that will either sustain and enhance its existing activities or
enable the entity to achieve growth by expanding into new
markets. In 2013, Distell acquired Scotch whisky producer Burn
Stewart in a transaction valued at R1,9 billion. This transaction
gave Distell access to a market in which it previously had no
presence, filling a gap in its existing product range. The
acquisition was also expected to contribute to cost reductions
as a result of economies of scale. In addition to this acquisition,
Distell invested R277,5 million in the replacement of existing
assets and a further R464,6 million on capacity expansion.
In December 2017, Distell entered into an agreement to sell
its cognac business, Bisquit Dubouche et Cie (‘Bisquit’) to
Campari Group, one of the largest spirit groups in the world,
for €52,5 million (about R800 million). According to Richard
Rushton, Distell managing director, the reason for the sale was
to enable the entity to focus on ready-to-drink ciders and
whisky as well as expansion into Africa. At the time of
acquiring Bisquit, Distell had thought it would provide access
to the Russian and Chinese cognac markets. However, this
expectation was not fulfilled, as the cognac industry is a
heavily concentrated industry, with the top three players
having a significant share of the market, especially in the two
premium-end growth markets in the world (China and the
United States). It was hoped that the disposal of Bisquit would
allow the entity to focus its efforts on accelerating its growth in
key product categories and markets where it believed it could
deliver more attractive returns and achieve its growth
aspirations.
The entity seems well aware of the importance of investing
in profitable ventures. One of its strategic financial goals is to
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ensure that annual returns exceed the entity’s weighted
average cost of capital by at least 5%. Given the entity’s track
record, it would appear that this approach is indeed
contributing to its success. If we consider the ten-year period
from 2009 to 2018, Distell managed to reward investors with a
total share return of 15,9% per year. In total, the entity
contributed R66,5 billion to its stakeholders over this time, a
reminder of the benefits that efficient capital investment can
create.
Sources: Compiled from information in Distell, 2013, 2019; Smith, 2017; Hasenfuss, 2012.
5.1
Introduction
How do entities evaluate investment projects? The opening case
study highlights the approach taken by Distell when deciding
whether to undertake a new investment project. Since the decision
to go ahead with a proposed investment involves an extremely
large amount of money, the investment decision needs to be taken
cautiously after all the relevant factors have been considered. If an
entity wants to ensure that its capital is employed as efficiently as
possible, it is essential that only those investment projects that will
contribute to the creation of value for the shareholders be accepted.
Failure to ensure this may have a detrimental effect on the entity’s
profitability.
Entities operate by raising finance, which is then invested in
assets (usually real assets, such as plant and machinery), from
various sources. Some entities also invest in financial assets, such as
shares in other entities or loans to organisations and individuals.
Most investments involve outflows (in other words, payments) of
cash, which result in inflows (that is, receipts) of cash. Typically, an
investment project involves a relatively large initial investment (or
outflow of cash) at the beginning of the project. In the opening case
study, Distell’s initial investments entailed the expansion
acquisition of Burn Stewart, the replacement of existing assets to
reduce operating costs and to improve efficiency, and the
investment in expansion capacity to increase production.
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After the initial investment, a stream of cash inflows and
outflows, spread over the project’s lifetime, is usually generated.
For Distell, cash inflows will be generated when additional
products are manufactured and sold, and cash outflows will be
necessitated by costs such as salaries and maintenance.
Furthermore, provision may have to be made for cash outflows
resulting from additional investments made over the project’s
lifetime. Distell, for instance, reports the value of its grapevines as
biological assets. Since these grapevines have a limited lifetime
(estimated as 20 years), they have to be replaced from time to time,
requiring additional investments. Finally, in some cases, large cash
outflows may also be required at the end of the project’s lifetime. In
the case of Distell, some of the entity’s grapevines are planted on
leased land. If the lease period expires, costs may have to be
incurred to restore the land.
Selecting which investment opportunities to pursue and which
to avoid is a vital matter to entities. In order to evaluate the
feasibility of an investment project, investment appraisal methods
(also known as capital budgeting methods or techniques) are
usually used. These techniques evaluate the expected cash outflows
and the resulting cash inflows to determine if the project is
profitable.
Before discussing investment appraisal methods, it is important
to point out that the financial evaluation of a potential investment is
usually based on the following fundamental assumptions:
• Investment decisions are made in accordance with the valuemaximising criterion, which is based on the time value of money
(see Chapter 4) and discounted cash flow principles.
• Evaluating investment proposals is based on the approach of
incremental net cash flows after tax (see Chapter 6), and not on
the accounting approach to income and profit.
In this chapter, we consider how an entity should evaluate its
investments. Before looking at some of the appraisal techniques that
can be used to evaluate an investment, we discuss the importance
of ensuring efficient investment decision making within an entity.
We also provide a discussion of the capital budgeting process and
make a distinction between the different types of investment
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decision. The first two investment appraisal methods that are
discussed (the average return method and the payback period
method) ignore the time value of money. In the sections that
remain, we introduce a number of investment appraisal methods
that do take the time value of money into account. These include
the discounted payback period method, the net present value
method, the internal rate of return method, the modified internal
rate of return method and the profitability index method. We
include a discussion of those situations where the net present value
method and the internal rate of return method may provide
conflicting results in order to highlight the problems that may be
experienced with some of the appraisal methods.
5.2
The importance of efficient investment appraisal
Most entities continuously manage a large number of investment
projects. It is not only necessary for an entity to consider the
maintenance of its existing asset base, but it may also have to
consider investment opportunities to increase its activities.
Choosing an investment project is not a once-off decision to invest
in certain assets that will never change. If an entity attempts purely
to maintain the status quo, it may find itself in a position where
very little (or no) growth is achieved. Ultimately, this could
threaten the survival of the entity. To achieve growth, it will need to
consider investment opportunities in which it can profitably invest
its capital.
To achieve the overriding financial objective of maximising
shareholders’ value, an entity needs to ensure that it identifies and
invests in investment opportunities that will contribute to the value
of the entity. Capital budgeting is the process of identifying and
analysing the various investment opportunities that are available,
and deciding how to allocate the entity’s scarce capital resources
(land, labour and capital) to the investment alternatives.
Capital budgeting entails the investment of large amounts of
capital in long-term investment alternatives, so it is crucial that an
entity ensure that only value-creating investments are accepted.
Since investment decisions define the entity’s strategic direction, it
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cannot afford to accept investments that are not in line with its
objectives and that are not profitable. Furthermore, such
investments are usually long term. Thus, if an entity implements
the wrong investments, it may have a long-term negative impact on
its profitability and ultimately threaten its survival. The acceptance
of an investment project means that the entity’s capital is locked
into it and cannot be released when other investment opportunities
become available.
Failure to conduct efficient capital budgeting may also result in
insufficient production facilities. If an entity fails to identify
expected increases in demand for its products and does not invest
in increased production capacity, it will not be able meet consumer
demand. Alternatively, an entity may face the problem of
overinvesting in physical capacity, resulting in an investment being
made in idle capacity that could have been utilised more efficiently
in other investments. A similar situation is faced by service-oriented
entities.
An investment opportunity requires funding. If efficient longterm planning is not conducted, an entity may not be able to find
the capital required to finance its investments. During the capital
budgeting process, it is therefore important to determine how much
capital is required and when it needs to be available as well as the
source that provides it.
The capital budgeting process usually consists of a number of
steps:
• Step 1: Identifying all possible investment alternatives. It is
important that the focus not be placed only on those
opportunities that are in line with the entity’s current
operations, but that other alternatives also be considered. An
entity may decide to expand its current operations, move into
new markets, consider adding new products or services, or even
acquire entities involved in totally different activities. In some
cases, it may also have to make certain strategic investments
now in order to achieve its objectives in the future.
• Step 2: Determining the relevant cash flows associated with the
investment alternatives. After the investment alternatives have
been identified, it is necessary to determine their expected cash
inflows and outflows. Calculating the relevant cash flows to
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•
•
•
•
consider during the investment appraisal process is discussed in
more detail in Chapter 6.
Step 3: Determining the entity’s cost of capital. In order to
ensure that the investment opportunities will create value, it is
important to determine if the return earned on the projects will
exceed the entity’s cost of capital. Determining an entity’s cost of
capital is addressed in more detail in Chapter 11.
Step 4: Evaluating the projects. An extremely significant
component of the capital budgeting process entails the appraisal
of the investment alternatives’ financial feasibility. To determine
if shareholders’ value will be created, investment appraisal
methods are usually employed to evaluate the financial
implications of a project. It is important to note, however, that
the entity may also have to consider certain non-financial
aspects during the appraisal process, including the project’s
contribution to the strategy of the entity, for example, or matters
pertaining to regulation. In the case of Distell, for instance, an
increased focus on corporate social responsibility may have
negative financial implications for the entity, but may be
required nonetheless.
Step 5: Decision making. Once the acceptable projects are
identified, the entity needs to decide if they should be
implemented. Because financial resources are scarce, the entity
usually has to decide which project to implement first on the
basis of the return that such a project will generate. It may also
have to postpone the implementation of other acceptable
projects if insufficient capital is available.
Step 6: Following up. The final step is to re-evaluate the entity’s
investment projects continually. The investment appraisal
process is usually based on several assumptions regarding the
future. If the actual situation differs from these assumptions, the
consequence may be that a previously acceptable alternative is
no longer financially feasible. At the moment, for instance,
Distell is considering ways to address a substantial decrease in
the demand for its brandies. The entity may have to re-evaluate
the financial feasibility of some of its existing brands and
redirect investment towards more profitable alternatives.
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It is apparent from the preceding discussion that an entity needs to
take great care to make the right investment decisions. Failure to do
so may have serious financial implications and, ultimately, threaten
the entity’s ability to survive.
It is important to note that an entity may have to choose
between different types of investment project. Section 5.3 looks at
some of the most common categories of investment project.
QUICK QUIZ
1. Discuss the importance of making the right
investment decisions.
2. Identify the steps that should be followed in
the capital budgeting process.
5.3
Types of investment project
Before we discuss the investment appraisal methods that can be
employed to evaluate the financial feasibility of an investment
opportunity, it is important to understand that there are different
categories of investment project. Depending on the type of project,
the application of one appraisal method may be more appropriate
than another. Note that it is possible for certain investment
opportunities to fall under more than one category.
5.3.1
Replacement projects
Most assets have a finite lifetime and have to be replaced at some
point. A replacement project is usually necessitated when an asset
reaches the end of its useful lifetime, and is too old and inefficient
to be used any longer. Usually, older assets are subject to higher
maintenance costs, which have a negative effect on the financial
performance of the entity. An entity may also have to consider
replacing assets before the end of their economic lifetime if new
technology becomes available that would result in significant cost
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reductions.
Replacement projects are appraised by considering the cash
flows generated with the existing asset in place and comparing
them with the cash flows that would be generated if it were
replaced by the new asset. The objective is to determine if the
incremental cash flows generated by the replacement project would
be sufficient to justify the initial investment. Often, an entity may
have several replacement alternatives available. In this case, it
needs to identify the most beneficial replacement option in which to
invest.
An example of a replacement project can be found in the
opening case study. Distell invests a substantial amount of its
capital in the replacement of the existing assets used in its
production facilities each year. This is done to ensure the
operational efficiency of the assets and to reduce maintenance costs.
Examples of some assets that require periodic replacement include
wine presses, pumps, bottling plants and the barrels used to mature
wine.
5.3.2
Expansion projects
If an entity wishes to expand its current level of operations, it may
have to consider expansion projects. Examples include the
expansion of production capacity, the range of products or the
market. Expansion can be achieved either internally (the entity
invests additional capital in the expansion of its operations) or by
means of external expansion (the entity takes over or merges with
another entity). We saw in the opening case study that Distell
expanded its operations and product range by acquiring another
drinks company. The entity also expanded its cider production
capacity at its primary production plant in Paarl and the bottling
facilities at its secondary production site in Springs.
Expansion projects are appraised by considering the cash flows
generated by the project. The objective is to determine if the cash
flows generated by the expansion will be sufficient to justify its
initial investment. As in the case of replacement projects, an entity
may have several expansion options available. Once again, the
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projects that are most profitable will usually be accepted.
5.3.3
Independent projects
In the case of an independent project, the acceptance of the project
does not influence the other projects that are under consideration.
Independent projects are unrelated and it is possible for an entity to
accept all independent projects that are financially feasible. In most
cases, however, entities do not have unlimited sources of capital.
Capital constraints may limit their choice to only the most
profitable projects.
If several independent projects are available, the financial
feasibility of each project is usually evaluated separately by means
of an investment appraisal method. If an entity has sufficient capital
available, all those projects that meet the criteria of the investment
appraisal method will be accepted. If limited capital is available, the
entity should identify the combination of projects that will yield the
highest return on the available capital. For instance, Distell’s
acquisitions of the Bisquit cognac brand in 2009 and Burn Stewart
Distillers in 2013 would be classified as independent projects by
Distell, since the two entities produce different products.
5.3.4
Mutually exclusive projects
When considering a group of mutually exclusive projects, the
implementation of one project results in the automatic rejection of
all the other alternatives. It is not possible for the entity to accept
more than one of the alternatives under consideration, even if
several projects meet the criteria of the appraisal method employed.
Usually, the entity will decide on the project that offers the highest
level of profitability relative to the size of its initial investment.
When evaluating mutually exclusive projects, the profitability of
each project and the incremental rate of return of each project are
usually evaluated. An investment in a new production facility, for
example, is usually an example of a mutually exclusive project. The
entity would typically identify and evaluate a number of options,
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but in the end, only one of these options would be selected.
5.3.5
Complementary projects
If the acceptance of one project is expected to have a positive effect
on the entity’s other projects, it is usually classified as a
complementary project. During the evaluation of a complementary
project, it is important to remember that the expected improvement
in the cash flow of the other projects should be included in the cash
flows of that project. If two projects are strongly complementary,
one of the projects will become a prerequisite for the other. In this
case, one project cannot exist without the other. Examples of
complementary projects are often found in the automotive industry.
For example, the decision to expand the production of cars being
manufactured also has a positive effect on the manufacturers of the
components used in those cars.
5.3.6
Substitute projects
Substitute projects are those where the implementation of one
project could have a negative effect on the cash flows generated by
the entity’s other projects. This is often referred to as
cannibalisation. The existence of this type of project emphasises the
need to consider all the possible opportunity costs associated with a
project and to understand what effect the implementation of the
new project may have on the entity’s current situation. If we
consider the example of the automotive industry again, the decision
to manufacture a cheaper version of an existing model may result in
a loss of sales in the more expensive models, since customers may
decide to switch to the lower-cost option.
5.3.7
Conventional projects
Most investment projects require a substantial cash outflow at the
beginning of the project. In the case of a conventional project, this
initial cash outflow will then be followed by a series of cash inflows
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throughout the project lifetime. Usually, these projects do not
require additional investments and the annual cash inflows
generated are larger than the corresponding period’s cash outflows.
During the application of some of the appraisal methods discussed
in Sections 5.4–5.11, it is important to note that the nature of a
project’s cash flow stream may influence the choice of appraisal
method.
5.3.8
Unconventional projects
In the case of unconventional projects, the initial cash outflow at the
beginning of the project is followed by positive cash flows in some
years and negative cash flows in others. For instance, some projects
may require additional investments during the project’s lifetime.
For certain projects, large investments may also be required at the
end of the project. This situation often occurs in the mining
industry, where it may be necessary to incur large expenses at the
end of the project to ensure that, for example, safety regulations are
addressed and pollution is not caused.
5.3.9
Other types of project
Sometimes entities have to invest in projects that do not fall under
the classifications provided in the sections above. In some cases,
entities may have to make capital investments that are of tactical or
strategic importance. Entities may also be forced to make capital
investments to meet legal or regulatory requirements (in the case of
mining entities, for instance, capital investments that reduce
environmental impact may be required). Today, entities also spend
substantial sums of money on corporate social investment projects
(such as building schools in local communities). Distell attempts to
ensure its sustainability by promoting socio-economic stability,
attempting to curb alcohol abuse and minimising the entity’s
impact on the environment.
Once an entity has identified possible investment alternatives
and determined which type of investment project they are, it is
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necessary to evaluate the projects’ financial feasibility. In the
sections that follow, we discuss a number of investment appraisal
methods. The first two of these methods, the average return method
and the payback period method, do not take the time value of
money into account. All the subsequent methods do consider the
time value of money.
QUICK QUIZ
Identify the different types of investment
project.
5.4
The average return method
A simple technique that is sometimes used to evaluate an
investment project is the average return (AR) method. This
technique considers the initial cash investment a project requires
and compares this figure with the average annual cash flow
generated by the project over its lifetime. A project’s AR is
calculated using the formula that follows.
Where:
C0 = initial investment required
Ct = cash flow in period t
n = project lifetime
The project’s AR is usually compared with the entity’s cost of
capital in order to evaluate its financial feasibility. If the AR exceeds
the cost of capital, the project would be acceptable; if the AR is less
than the entity’s cost of capital, the project would most probably be
rejected.
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Example 5.1 illustrates the application of the AR method.
Example 5.1 Calculating the AR for two investment projects
Sizwe Ltd is in the process of choosing between two investments, Project A
and Project B. Project A requires an initial investment of R25 000; Project B
requires an investment of R100 000. The relevant annual cash inflows for each
project are shown in the table that follows, after which timelines depicting
relevant cash flows for the two projects are set out.
Project A
Project B
Calculate the AR for Projects A and B. Assume that Sizwe Ltd’s cost of capital
is 10%.
Using the equation for calculating AR, the AR for Project A can be
determined as follows:
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The AR for Project B can be determined as follows:
Given that the entity’s cost of capital is 10%, both projects would be
acceptable, since the AR values exceed the cost of capital. Project A
offers a higher return (AR = 50%) than Project B (AR = 37,50%).
If we consider the timing of the cash flows, however, we can
observe a number of differences between the two projects. Firstly,
the size of the initial investment required for Project A is much
lower than for Project B. We will also have to determine if the entity
has sufficient capital available to invest in one or both of the
projects.
Furthermore, we can see that the earlier cash flows associated
with Project B are relatively larger than those associated with
Project A. If a rational investor had to choose between the two
alternatives, they would most probably opt for Project B because
the cash inflows received can be reinvested and a return can be
earned on this investment. The sooner these cash flows are
received, the greater the return on the reinvestment. Project B
might, therefore, yield larger reinvestment returns than Project A.
The difference in the size of the cash inflows would also
influence the riskiness of the projects. In the case of Project A, the
larger cash inflows occur later in the project’s lifetime than is the
case with Project B. An investor would need to wait longer,
therefore, to receive the largest portion of the total cash inflows. On
the basis of this, a rational investor would most probably prefer
Project B to Project A, since the risk associated with the project may
be less.
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Some of the problems associated with the AR method can be
seen in the example. A summary of the major advantages and
disadvantages of the AR method is provided in Table 5.1.
Table 5.1 Advantages and disadvantages of the AR investment appraisal technique
Advantages
Disadvantages
■ The AR investment appraisal
■
technique is simple to use and
quick to calculate.
■ It is easy to understand and apply
the measure.
■
■ It can be used to compare
investments if the project lifespans
are more or less the same and the
cash flows generated by the
projects are reasonably stable.
By using the average annual cash flows, the
measure tends to be insensitive to fluctuations
in cash flows during the project lifetime. For
projects with relatively long lifetimes, this may
result in large errors.
The AR method does not take into account the
time value of money, despite the fact that the
different cash flow patterns may have a major
influence on the total value of a project.
QUICK QUIZ
1. Define the AR method.
2. Discuss the advantages and disadvantages of
the AR method.
5.5
The payback period method
The payback period (PBP) method calculates the expected number
of years after which the initial investment amount (C0) of an
investment project is recovered from the project’s net cash flows (Ct
). The aim of the PBP method is to determine how long it will take
to recover the initial capital outlay. The PBP of a project is
calculated by determining the number of years it takes before the
cumulative forecasted net cash flows equal the initial investment, as
shown in Formula 5.2.
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Thus, the PBP is determined by accumulating the net cash flows
until the amount is just less than the initial investment. The portion
of the next year’s net cash flow that is required to ensure that the
accumulated cash flow is equal to the initial investment is then
determined.
The length of the maximum acceptable PBP is usually
determined by the entity’s management. The decision-making
criterion for the PBP in respect of a project is that those projects
with a PBP shorter than the period stipulated by management may
be accepted, whereas projects with a longer PBP are rejected. When
comparing two or more projects, the PBP method is sometimes also
used to rank them according to the period of time it will take to
recover the initial investment. Shorter PBP projects are assumed to
be more liquid than those with a longer PBP because the initial cash
investment is recovered more quickly. If considering the riskiness
of a project, we could also interpret a longer PBP as an indicator of
a higher degree of risk, since the certainty with which cash inflows
occur may decrease over time.
Example 5.2 illustrates the application of the PBP method using
the information provided in Example 5.1.
Example 5.2 Calculating the PBP for two investment projects
You are required to calculate the PBP for Projects A and B. Based on the cash
flows already provided in Example 5.1, the calculation for Project A is as
follows:
The cash flow in year 1 is R5 000; in year two, it is R10 000. At the end of
year two, the accumulated cash flow is, therefore, equal to R15 000 (5 000 +
10 000). This is R10 000 less than the initial investment of R25 000.
Consequently, only R10 000 of the R15 000 cash flow in year three is
required. The PBP can therefore be calculated as follows:
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The PBP for Project B can be determined as follows:
Using the PBP method as an appraisal criterion, Project B is
preferred because it has a shorter recovery period (2,13 years) than
Project A (2,67 years). An investor would, therefore, recover the
invested capital more quickly by investing in Project B. In terms of
the riskiness of the projects, Project B may also be preferred, since
risk usually increases with the length of time it takes to recover the
invested amount.
Table 5.2 lists the advantages and disadvantages of the PBP
appraisal technique. Despite its disadvantages, the PBP method is a
relatively simple appraisal method and remains a useful technique
to use in the evaluation of investment proposals because its
emphasis is on liquidity and risk. The PBP investment appraisal
technique is sometimes used to rank multiple projects in order of
investment priority based on their PBP values.
Table 5.2 Advantages and disadvantages of the PBP investment appraisal technique
Advantages
Disadvantages
■ The PBP investment appraisal
■ The payback standard can only be
technique is simple to use and quick
determined subjectively. It cannot be
to calculate.
specified explicitly in terms of the goal of
the entity to maximise shareholder wealth.
■ It can serve as a criterion of risk if it is
assumed that risk increases over time ■ The PBP method does not take the cash
(for example, the risk of technological
flows that occur after the PBP has been
obsolescence).
reached into account and is, therefore, not
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It could serve as an indicator of
■ liquidity because the quicker the initial
investment is recovered, the earlier the ■
generated cash is available for
alternative use.
■
a reliable measure of overall project
profitability.
The emphasis is on short-term profitability
rather than profitability over the entire life
of the project.
It does not take into account the time
value of money, despite the fact that the
different cash flow patterns may have a
major influence on the total value of a
project.
■ The PBP method ignores the order in which
cash flows occur within the PBP and
ignores subsequent cash flows entirely.
■ It does not consider the cost of capital in
any way.
■ It makes no distinction between projects
of different sizes, with different capital
requirements and with different lifetimes.
QUICK QUIZ
1. Define the PBP method.
2. What are the advantages and disadvantages of
the PBP method?
The main problem with the AR and PBP methods is that they
ignore the time value of money. In the sections that follow, we
discuss several appraisal measures that address this shortcoming.
The first of these is the discounted payback period method.
5.6
The discounted payback period method
As discussed, one of the major disadvantages associated with both
the AR and the PBP methods is that the time value of money is
ignored. For both methods, the timing and the size of the cash flows
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are ignored, and we have seen that this may have a serious effect on
the accuracy of the methods. If investment project appraisal is to be
based on the discounted cash flow principles associated with value
maximisation, it is necessary to identify appraisal methods that
incorporate the time value of money in their calculations.
The discounted payback period (DPB) method is a variant of the
PBP method and it attempts to address this weakness. The major
difference between the PBP method and the DPB method is that the
latter is calculated on cash flows that are discounted at the entity’s
cost of capital. Thus, this method calculates the expected number of
years required to recover the initial investment by considering the
discounted net cash flows generated by the project.
Example 5.3 illustrates the application of the DPB method using
the information provided in Example 5.1 and supposing that Sizwe
Ltd has a cost of capital of 10%.
Example 5.3 Calculating the DPB for two investment projects
You are required to calculate the DPB for Projects A and B. The table that
follows shows the discounted cash inflows for the two projects.
The DPB is calculated in a similar way to the PBP. The only difference is that
the cash flows are first discounted by the entity’s cost of capital, and then
accumulated until the initial investment amount is recovered. If we consider
Project A, the accumulated discounted cash flows after three years come to
R24 079,63 (4 545,45 + 8 264,46 + 11 269,72). Only R920,37 of the fourth
year’s discounted cash flow is, therefore, required to recover the initial
investment of R25 000. Consequently, the DPB for Project A can be calculated
as follows:
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The DPB for Project B can be determined as follows:
Compared with the PBP values calculated in Example 5.2, the DPB
method yields larger values. This is because the discounted cash
flows are lower than the cash flows; as a result, it will take the
entity longer to recover the initial investment.
It is important to note that the DPB method is still exposed to
some of the limitations of the PBP method. The main advantages
and disadvantages of the DPB method are listed in Table 5.3.
Table 5.3 Advantages and disadvantages of the DPB investment appraisal technique
Advantages
Disadvantages
■ It takes the entity’s cost of
capital into consideration when
calculating the discounted
values of expected future cash
inflows.
■ It is simple to use and quick to
calculate.
■ Like the PBP method, the payback standard can
only be determined subjectively. It cannot be
specified explicitly in terms of the goal of the
entity to maximise shareholder wealth.
■ It does not take into account the cash flows that
occur after the DPB has been reached and is,
therefore, not a reliable measure of overall
project profitability.
■ The emphasis is on short-term profitability rather
than profitability over the entire life of the
project.
■ The DPB method ignores the order in which cash
flows come within the project lifetime and
ignores subsequent cash flows entirely.
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■ It makes no distinction between projects of
different sizes, with different capital
requirements or different lifetimes.
QUICK QUIZ
1. Define the DPB method.
2. What are the advantages and disadvantages of
the DPB method?
5.7
The net present value method
The net present value (NPV) of a project is the difference between
the present value (PV) of all expected net cash inflows and the PV
of all expected net cash outflows calculated over the expected life of
the project. With the NPV method, all expected future net cash
flows are discounted at the entity’s cost of capital (i) in order to
determine their PV compared to the initial investment (the capital
outlay required by the investment). Formula 5.3 is used to calculate
the NPV.
The rationale behind calculating a project’s NPV is that an entity
should only invest in those projects where the PV of the expected
future cash inflows will be greater than the present value of all the
cash outflows. By using the entity’s cost of capital, the NPV should
indicate whether the entity’s required return on capital is achieved.
In cases where the PV of the cash inflows is greater than the PV of
the cash outflows, the project should contribute to the creation of
value. Alternatively, if the PV of the cash inflows is less than that of
the cash outflows, it should be seen as an indication that the project
will not generate sufficient returns to meet the entity’s cost of
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capital.
The decision-making criteria applied when utilising the NPV
method can be summarised as follows:
• Accept projects where the NPV > 0.
• Reject projects where the NPV < 0.
• Projects with an NPV = 0 will increase the scale of the business;
management will be indifferent as to whether or not the project
should be undertaken.
Example 5.4 illustrates the calculation and interpretation of the
NPV method using the information provided in Example 5.1.
Example 5.4 Calculating the NPV for two investment projects
You are required to calculate the NPV for Project A and Project B, where Sizwe
Ltd’s cost of capital is 10%.
Using a financial calculator
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The NPV of Project B can be calculated as follows:
Using a financial calculator
The general criterion for the NPV method states that projects with
an NPV > 0 should be accepted. In this example, the NPV values for
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both projects are positive. Which project(s) should be accepted?
Before we can answer this question, we need to determine which
type of project we are dealing with.
If the two projects are independent projects, we could accept
them both because their NPVs are positive. However, we will have
to determine if the entity has sufficient capital available to finance
them both (in this case, R125 000).
If the two projects are mutually exclusive projects, however, we
can only accept one of them. Although both projects are expected to
generate positive NPVs, the entity can only invest in one. In this
case, Project B appears to be the better alternative, since it is
expected to generate a higher NPV. The NPV for Project A (R12
739,91) is less than the NPV for Project B (R23 229,29), so Project B is
preferable.
Table 5.4 lists the advantages and disadvantages of the NPV
technique.
Table 5.4 Advantages and disadvantages of the NPV investment appraisal technique
Advantages
Disadvantage
■ The NPV technique is logically consistent
■ A possible disadvantage of the NPV
with the entity’s goal of maximising
method is that it may be difficult to
shareholders’ wealth.
understand.
■ It offers theoretically correct decisions.
■ It is relative easy to calculate.
■ It uses all the cash flows of the project and
discounts them correctly.
QUICK QUIZ
1. Explain the NPV method.
2. Explain the decision criteria associated with
the NPV method.
3. What are the advantages and disadvantages of
the NPV method?
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4. Explain why a distinction needs to be made
during the evaluation of independent and
mutually exclusive projects by means of the
NPV method.
5.8
The internal rate of return method
The internal rate of return (IRR) investment appraisal technique is
based on concepts that are similar to the NPV method. Like the
NPV method, with the IRR method, a project is evaluated by
considering the initial investment it requires and the expected
future cash flows that the project will generate, and it compares the
return of the project with the entity’s cost of capital. However,
unlike the NPV method, where the entity’s cost of capital is used to
calculate the PV of all the project’s cash flows, the IRR method
attempts to determine the discount rate that equates the PV of the
expected net cash inflows and the PV of the net cash outflows. In
other words, the IRR method can be defined as the discount rate
that will result in an NPV of zero. The IRR can be expressed in the
following formula:
The decision-making criteria for the IRR method are as follows:
• Accept projects where the IRR > cost of capital.
• Reject projects where the IRR < cost of capital.
• If the IRR = cost of capital, the project will not add value to the
entity, but only increase the scale of the business; thus,
management will be indifferent as to whether the project should
be undertaken or not.
Example 5.5, which uses the information provided in Example 5.1,
illustrates the calculation and interpretation of the IRR method
when applied to evaluate independent and mutually exclusive
projects.
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Example 5.5 Calculating the IRR for two investment projects
You are required to calculate the IRR for two projects using the cash flows
given in Example 5.1. Suppose that Sizwe Ltd’s cost of capital is 10%. Using a
financial calculator, the values are determined as shown below.
Calculating the IRR for Project A
Calculating the IRR for Project B
The general criterion for IRR states that only those projects whose
IRR values are greater than the entity’s cost of capital should be
accepted. In this case, both the projects’ IRR values are greater than
the entity’s cost of capital of 10%. Consequently, if the two projects
are independent projects, both are acceptable. If the entity has
limited capital and is only able to invest in one of the projects, it
would most probably choose Project A, since the value for IRR for
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Project A (27,27%) is greater than the value for Project B (22,47%).
If we assume that the two projects are mutually exclusive,
however, we know that management can only implement one of
them. If a similar approach to the NPV method were employed, it
would entail choosing the project with the largest IRR value,
meaning that Project A would be implemented. However, this
decision differs from the one obtained when the NPV method was
applied to evaluate the two mutually exclusive projects. According
to the NPV method, Project B would be implemented because it
yielded the largest NPV.
On the basis of this comparison, it would appear that the NPV
and IRR methods provide conflicting results when applied to
evaluate the two projects if they are mutually exclusive. Should we
invest in Project A or Project B? We are not able to answer this
question yet. However, in the next section, we provide a
comparison of the NPV method and the IRR methods in order to
shed more light on this question.
Before we move on to compare the NPV method and the IRR
method, we first need to highlight another aspect with regard to the
calculation of the IRR method. This is shown in Example 5.6.
Example 5.6 Multiple and no-solution IRR values
You are investigating two investment projects. Project C requires an initial
investment of R100 000 and has a lifetime of four years; Project D requires an
initial investment of R1 500 and has a lifetime of two years. You are required
to evaluate the two projects by means of the IRR method.
Relevant cash flows for Projects C and D
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Calculating the IRR for Project C using a financial calculator
Calculating the IRR for Project D using a financial calculator
In the case of Project C, no solution is obtained for the IRR
calculation. The reason for this is that no matter what discount rate
is used, the NPV of the cash flows will never be equal to zero
because only negative cash flows are generated. In this example, the
IRR method cannot be used as an appraisal method, but the NPV
method can.
More than one IRR value will be calculated for Project D. Once
again, the NPV method could have been applied to evaluate the
project, since an NPV can be calculated. However, the IRR method
is not a suitable appraisal method to use in this example, since we
do not know which IRR value to consider.
These two examples highlight a major weakness of the IRR
method: in those cases where conventional projects are evaluated,
the IRR method can usually be applied without calculation
problems. However, in the case of unconventional projects – such
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as the two included in Example 5.6 – calculation problems may
occur. Project C yields no IRR value because there are no changes in
the signs of the cash flows, whereas Project D generates more than
one IRR because more than one change in the sign of the cash flows
occurred.
These, and other advantages and disadvantages of the IRR
method, are listed in Table 5.5.
Table 5.5 Advantages and disadvantages of the IRR investment appraisal technique
Advantages
■ The IRR method of
■
investment appraisal
is easy to understand ■
and communicate.
■ It is easy to calculate ■
with the aid of a
■
financial calculator.
■ It makes intuitive
economic sense.
■ It works well with
simple
acceptance/rejection ■
problems.
Disadvantages
The IRR method may not work well in some complicated
acceptance/rejection problems.
It is difficult to calculate when positive and negative cash
flows are present.
It can easily be misapplied.
It assumes that interim positive cash flows are reinvested at
the same rates of return as the project that generated them.
This is usually an unrealistic scenario; a more likely situation
is that the funds will be reinvested at a rate closer to the
business’s cost of capital. Thus, IRR often gives an unduly
optimistic picture of the projects under study.
If the project has irregular cash flows alternating several
times between positive and negative values, numerous IRRs
can be identified for such a project. This may lead to
confusion and the wrong investment decisions being made.
QUICK QUIZ
1. Explain the IRR method.
2. What are the advantages and disadvantages of
the IRR method?
3. What are the general criteria for accepting or
rejecting a project using the IRR method?
4. Discuss the different approaches that are
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followed to evaluate independent and mutually
exclusive projects by means of the IRR method.
FOCUS ON ETHICS: Ethics in capital
budgeting
The ‘accept’ versus ‘reject’ approach in capital investment decision
making is a typical finance decision because it forces the financial
manager to choose between two mutually exclusive projects. Although
only two courses of action are observable, there may be many
possible motivations underlying the given action.
In capital investment decision making, the NPV rule supposedly
gives management a clear, decisive motive when choosing whether to
accept or reject a capital project. The NPV rule can be summarised as
follows (Dobson, 1997: 30): “Sunk costs should be ignored and …
projects should be terminated when the expected present value of
cash flows, given that the project is rejected or terminated today, is
greater than the expected present value of cash flows, given that the
project is accepted or continued for at least one additional period.”
Financial managers who abide by the NPV rule aim to maximise
shareholder value, and are therefore honouring their fiduciary duties to
their shareholders and acting ethically. Note, however, that the
motivation is strictly economic (that is, strictly within a financial
framework).
Source: Adapted from Dobson, 1997: 70.
QUESTIONS
1. On the basis of this information, would you agree that using
the NPV rule in capital investment decision making is
ethical?
2. What other motivations do you think a financial manager
may have to consider when accepting or rejecting an
investment project?
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5.9
Comparing the net present value method and the
internal rate of return method
As seen in Sections 5.7 and 5.8, which focused on the NPV and IRR
appraisal methods, conflicting rankings may sometimes be obtained
when mutually exclusive projects are evaluated by applying the
two methods. For the two projects under investigation, the NPV
method indicated that Project B should be accepted, whereas the
IRR method seemed to indicate that Project A should be accepted.
Which of the two methods is preferable in such a situation?
5.9.1
Net present value profile
In order to investigate this problem, it is important to begin by
constructing an NPV profile. An NPV profile is a graph that plots a
project’s NPV against different cost-of-capital rates. An example of
how to construct an NPV profile is provided next.
Consider the information provided in Example 5.1 (relevant
cash inflows for Project A and Project B) and the timeline depicting
relevant cash flows for Project A and Project B. When using the
discount rates of 0%, 5%, 10%, 15%, 20%, 25% and 30% for the cost
of capital, we can construct the NPV profiles for Projects A and B by
determining their NPVs and plotting them against the discount
rates. The NPVs for the two projects are calculated as shown in
Table 5.6.
Table 5.6 Calculating NPV (Projects A and B)
Cost of capital
NPV Project A
R
NPV Project B
R
0%
25 000
50 000
5%
18 244
35 456
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10%
12 740
23 229
15%
8 207
12 843
20%
4 437
3 935
25%
1 272
−3 770
30%
−1 407
−10 486
Figure 5.1 depicts the NPV profiles for Projects A and B derived
from the calculations shown in Table 5.6.
Figure 5.1 NPV profile for Projects A and B
5.9.2
Discussion of the net present value profile
The IRR for Project A is 27,27%; the IRR for Project B is 22,47%.
These values are represented at the point on the graph at which the
two NPV profiles intercept the horizontal axis (see Figure 5.1). The
NPV values that were calculated at the entity’s 10% cost of capital
can be found on the vertical axis of the graph by considering the
discount rate of 10%. Another important rate that can be obtained
from the NPV profile is the point at which the two projects
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intercept. This rate, which is called the crossover rate, represents
the discount rate at which the NPVs of the two projects are the
same.
The NPV profile can also be used to explain the contradictory
results that were obtained when the NPV method and the IRR
method were used to evaluate the two projects, and we assumed
that they represented mutually exclusive projects. If we consider
those discount rates below the crossover rate, we find that the NPV
of Project B is always larger than the NPV of Project A. Once we
move to those discount rates beyond the crossover rate, however,
we find that the situation is reversed. The NPV of Project A is now
the largest. What is more important is that the two methods will
produce the same recommendations in the case of mutually
exclusive projects if we have a cost of capital that exceeds the
crossover rate. Below the crossover rate, they will yield
contradictory results (as we saw at the cost of capital of 10% applied
in the examples).
The reason for this situation can be ascribed to the shape of the
two curves. If we consider mutually exclusive projects whose
corresponding NPV profiles have the same slope and do not
intercept, it would not matter which appraisal method we used.
The reason for the differences in the slopes of the two projects
investigated above can be explained by two factors:
• The size of the investment amount plays an important role. In
the example used to illustrate the appraisal methods in this
chapter, we saw that Project B required a much larger initial
investment than Project A.
• The timing of the cash flows also plays a significant role. In the
case of Project A, small cash flows were generated at the
beginning of the project and relatively larger cash flows
occurred later. The opposite was observed for Project B, where
the relatively large cash flows occurred at the beginning of the
project’s lifetime.
When evaluating mutually exclusive projects, we should therefore
take the crossover rate into account as well as the cost of capital. In
cases where the crossover rate is lower than the entity’s cost of
capital, we could employ either the NPV method or the IRR
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approach to evaluate the projects, since the same recommendation
will be obtained. In cases where the entity’s cost of capital is less
than the crossover rate, however, it may be more conservative to
use the NPV method to evaluate mutually exclusive projects.
In spite of this, some entities prefer to evaluate mutually
exclusive projects by means of the IRR method. In these cases, we
need to consider the approach described in Section 5.9.3.
5.9.3
Evaluating mutually exclusive projects by means of
the internal rate of return method
When applying the NPV method to evaluate mutually exclusive
projects, the project with the higher NPV is usually accepted. In the
case of the IRR method, however, we saw that the project with the
highest IRR may not necessarily be the better investment
alternative. In order to evaluate mutually exclusive projects by
means of the IRR method, the calculation of the projects’ IRR values
serves as the first round of evaluation. It is also necessary to
investigate the IRR on the incremental cash flows of the two
projects to determine if the difference in the initial investment
required generates sufficient incremental cash flows to justify
choosing the more expensive investment alternative over the other.
In the case of the two projects under evaluation by Sizwe Ltd,
both options are acceptable because they generate a return in excess
of the entity’s cost of capital. However, one alternative requires a
substantially larger initial investment than the other. Thus, we need
to determine if the additional R75 000 initial investment required in
the case of Project B will generate sufficient incremental cash
inflows in future. For this purpose, the incremental cash flows
between the two projects need to be calculated. The incremental
cash flows then also need to be evaluated by means of the IRR
method.
Example 5.7, which uses the information provided in Example
5.1, illustrates the calculation and interpretation of the IRR method
when applied to evaluate mutually exclusive projects.
Example 5.7 Calculating the IRR for two mutually exclusive investment
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projects
You are required to calculate the IRR based on the incremental cash flows of
the two projects. Suppose that Sizwe Ltd’s cost of capital is 10% and that the
two projects are mutually exclusive.
Calculating the IRR based on the incremental cash flows using the financial
calculator
Thus, the IRR on the incremental initial investment of R75 000 is
19,48%. If we had invested R25 000 in Project A, we would have
earned an IRR of 27,27%. If we decided to invest an additional R75
000 and selected Project B instead of Project A, the IRR on this
incremental investment would still be in excess of the entity’s cost
of capital. In the case of mutually exclusive projects, we would,
therefore, choose Project B. The IRR on the incremental cash flows
corresponds with the crossover rate indicated in Figure 5.1.
Consequently, in terms of the NPV profile, we would accept the
larger project in those cases where the crossover rate is in excess of
the entity’s cost of capital. If the crossover rate is less than the cost
of capital, the incremental investment will not generate sufficient
returns to justify the larger initial investment sum required, and so
the smaller project should be accepted.
It is important to note that even though the IRR of Project A
exceeds that of Project B, we need only focus on the IRR of the
incremental cash flows when evaluating the mutually exclusive
projects. If the IRR on the incremental cash flows is greater than the
entity’s cost of capital, the larger project should be accepted (even if
the IRR on the larger project is lower than the IRR of the smaller
project).
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QUICK QUIZ
1. Do the NPV and IRR methods always agree in
terms of whether one should accept or reject
proposed investments? Explain your answer.
2. How is the NPV profile used to compare
projects?
3. What causes conflicts in the ranking of
projects by means of the NPV and the IRR
methods?
5.10
Modified internal rate of return
Managers often prefer to evaluate projects on the basis of a
percentage return instead of on NPV. Consequently, a number of
entities apply the IRR method rather than the NPV method,
regardless of its limitations. One of the problems we have seen that
is associated with the IRR method is that it may yield multiple
values for projects with unconventional cash flows. In addition, for
some projects, it may be impossible to calculate an IRR value.
Another problem associated with the IRR method is the implicit
assumption that all future cash inflows can be reinvested at the
project’s IRR. For projects with high IRR values, this could be an
unrealistic assumption, as there may be no investment options that
offer this level of return.
In an attempt to improve the IRR methodology by including a
more conservative view of the reinvestment rate earned on the cash
flows generated during a project’s lifespan, the modified internal
rate of return method (MIRR) was developed. This method also
solves the problem of multiple IRR values, since all negative cash
flows included in a project’s cash flow stream are converted into a
single cash outflow at time zero and all positive cash flows are
accumulated as one cash inflow at the end of the project’s lifetime.
A project’s MIRR is established by calculating the present value
of all the cash outflows of a project (discounting them by using the
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entity’s cost of capital) and comparing this value with the future
value of all cash inflows at the end of the project’s lifespan
(accumulated at the cost of capital). The MIRR is then calculated as
the discount rate that will ensure that the present value of the cash
outflows equals the present value of the future cash inflows.
Thus, a project’s MIRR can be calculated by means of the
following equation:
Example 5.8, which uses the information provided in Example 5.1,
illustrates the calculation and interpretation of the MIRR method.
Example 5.8 Calculating the MIRR for two investment projects
Future values of the cash inflows for Projects A and B
Based on the PV of Project A’s cash outflows and the future value of its cash
outflows, its MIRR is calculated by means of the following equation:
Solving the equation yields an MIRRProject A of 21,93%.
Similarly, the MIRR for Project B is determined as follows:
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Solving the equation yields an MIRRProject B of 15,90%.
Alternatively, we can solve the MIRR by means of a financial calculator.
Calculating the MIRR for Project A using a financial calculator
Calculating the MIRR for Project B using a financial calculator
Solving the MIRR for the two projects under consideration yields
values in excess of the entity’s cost of capital. Thus, in the case of
independent projects, both projects are financially viable.
However, it is important to note that the MIRR method may still
provide conflicting results for mutually exclusive projects when
compared with the NPV method. Thus, from a theoretical point of
view, the NPV method is the best method to use under these
circumstances.
The advantages and disadvantages associated with the MIRR
method are listed in Table 5.7.
Table 5.7 Advantages and disadvantages of the MIRR investment appraisal technique
Advantages
Disadvantages
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■ The MIRR method of investment appraisal ■ In the case of mutually exclusive
is easy to understand and communicate.
projects, the same problems
associated with the IRR method may
■ It has a more realistic assumption with
occur (see Table 5.5).
regard to the reinvestment of cash inflows
that are received than is the case with the
IRR method.
■ It solves the problem of multiple IRR values
and can be applied to evaluate
unconventional projects.
QUICK QUIZ
1. Explain how the MIRR of a project is
calculated.
2. What are the main advantages and disadvantages
of the MIRR method?
5.11
The profitability index
The profitability index (PI) investigates the relationship between the
initial investment amount and the expected pay-off of a proposed
project. In other words, the PI is a measure of a project’s
profitability relative to each rand invested in the project. The PI is
also known as the profit investment ratio (PIR) or the value
investment ratio (VIR). It is a handy tool for ranking projects
because it allows management to identify the amount of value
created per unit of investment. If an entity experienced capital
constraints, it would most probably attempt to invest in those
projects that create value the most efficiently. The PI is defined as
follows:
Therefore, the value of a project’s PI can be calculated by means of
the following equation:
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A PI value of one is considered the lowest acceptable value of the
index, as any value lower than one would indicate that the PV of a
project’s expected cash flows is less than the initial investment
amount. Consequently, insufficient future cash flows are generated
to justify the initial investment. As the value of the PI ratio
increases, so does the financial attractiveness of the proposed
project.
Investment decisions based on the PI should be approached
with caution because the measure does not take the size and extent
of the project into consideration. The general decision-making
criteria for PI are as follows:
• Accept projects where the PI > 1.
• Reject projects where the PI < 1.
• Projects with a PI = 1 will only increase the scale of the business;
management will be indifferent as to whether the project should
be undertaken or not.
Example 5.9, which uses the information provided in Example 5.1,
illustrates the calculation and interpretation of the PI method.
Example 5.9 Calculating the PI for two investment projects
You are required to calculate the PI for Projects A and B. Assume that Sizwe
Ltd’s cost of capital is 10%.
The first step entails calculating the total present value of the expected
future cash flows. This is illustrated in the table that follows.
Discounted cash inflows for Projects A and B
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Based on the PV of Project A’s future cash flows, its PI value can be calculated
as follows:
The PI for Project B can be calculated as follows:
Since both the PI values are greater than one (1,51 and 1,23), both
projects could be accepted in the case of independent projects (once
again assuming that the investor can afford the total initial
investment of R125 000 that will be required). If the two projects are
mutually exclusive, selecting the highest PI would result in the
entity investing in Option A. As was seen in the previous sections,
however, the optimal investment alternative is provided by Option
B. Employing the PI method when evaluating mutually exclusive
projects may be problematic.
Table 5.8 lists the advantages and disadvantages of PI as an
investment appraisal technique.
Table 5.8 Advantages and disadvantages of the PI investment appraisal technique
Advantages
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Disadvantages
■ PI is easy to calculate.
■
■ It is one of the best methods to use when an
accept/reject decision has to be made. (The NPV
■
method is another useful technique for such
decisions.)
■ It may be useful when funds available for investment
are limited.
■ It is useful when evaluating independent projects.
PI is a difficult concept to
understand.
It is problematic and may not
work well when used to
evaluate mutually exclusive
projects.
QUICK QUIZ
1. Explain the PI method.
2. Explain the decision-making criteria for the
PI method.
3. What are the advantages and disadvantages of
the PI method?
5.12
Conclusion
This chapter explored a number of investment appraisal methods
that can be applied to evaluate investment projects. You learnt the
following:
• Efficient investment appraisal is required to ensure that an
entity invests its capital in projects that will create value.
• Before an investment project is subjected to various investment
appraisal techniques, it is important to determine which type of
project it is in order to select the most appropriate appraisal
method.
• A distinction can be made between those appraisal methods that
take the time value of money into consideration and those that
ignore it.
• The average return method is a relatively simple appraisal
method that expresses the average annual cash inflow as a
percentage of the initial investment.
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• The payback period method calculates the period of time it takes
to recover the initial investment amount from the cash flows
generated by the project.
• The discounted payback period is determined by discounting
the future cash flows at the entity’s cost of capital and
determining the period of time those discounted values will take
to recover the initial investment required.
• The net present value of a project is determined by calculating
the present value of all future cash flows at the entity’s cost of
capital and comparing this value with the initial investment
required. Projects yielding positive net present values are
accepted; those that yield negative net present values are
rejected.
• The internal rate of return method determines the discount rate
that will ensure a zero net present value. It is compared with the
entity’s cost of capital to evaluate the financial feasibility of a
project.
• In the case of mutually exclusive projects, the net present value
and the internal rate of return methods may provide conflicting
results with regard to the acceptability of the projects. In these
cases, the net present value is the more conservative measure to
apply.
• The modified internal rate of return is calculated by discounting
all cash outflows to the beginning of the project’s lifetime and
accumulating all the cash inflows at the end. The measure is
then calculated as the discount rate that will ensure that a zero
net present value is obtained based on these two values.
• The profitability index is calculated by dividing the present
value of all future cash flows by the initial investment amount.
PI values in excess of one indicate that a project is acceptable;
values of less than one indicate that the present value of the
future cash flows are less than the initial investment required.
Financial appraisal techniques are applied to determine if a project
will contribute towards the creation of shareholder value. If an
entity is able to identify projects that will contribute to this
objective, implementing those projects should result in an increase
in the value of the entity. Failure to do so, however, will have the
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opposite effect.
The case study at the beginning of this chapter focused on the
success that Distell achieved by identifying investment
opportunities that contributed to the maximisation of stakeholder
value. Part of Distell’s success could be ascribed to its goal of
earning at least 5% more on its investments than its cost of capital.
By contrast, the closing case study concerns an entity that is
currently experiencing problems delivering value to its
shareholders as a result of making large investments in unprofitable
ventures.
CASE STUDY
Aveng and shareholder returns
In this chapter, we saw that in order to maximise shareholders’
value, an entity needs to ensure that its projects earn more than
its cost of capital. In the case of Aveng, a South African
construction company, dismal returns on shareholders’ equity
have been generated over the last few years. If the closing share
price of the entity is considered, we find that it decreased from
a high of R66,20 on 29 August 2008 to a low of 2 cents by 30
August 2019. If you had invested in Aveng for the 11-year
period from 2008 to 2019, you would have lost 99,97% of the
value of your investment. In annual terms, your investment
would have earned a negative share return of –52,14% per
year: in other words, only half of the value at the beginning of
each year would have been left by the end of that year! Those
unfortunate shareholders who find themselves in this situation
most probably wonder why the entity failed to create
shareholder value.
A potential explanation for Aveng’s poor share
performance can be linked to the entity’s failure to generate
returns that exceed the cost of capital it employed. Over the
five-year period from 2014 to 2018, the entity reported negative
earnings before interest and tax (EBIT) every year except for
2016. At the same time, it substantially increased the amount of
debt it used to finance its activities. As a result, the entity
generated a negative average return on capital employed of –
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8,7% per year, compared to its average cost of capital of 13,2%
during this time. Expressed in terms of project evaluation, the
entity’s activities therefore represented a negative NPV: a sure
way to destroy shareholders’ value.
In 2019, the entity started a process to reduce its debt.
Unfortunately, this entailed selling a large number of its most
profitable operations. The question that investors face is
whether this process will succeed in increasing the profitability
of Aveng’s investments to a level where its return exceeds the
entity’s cost of capital. If Aveng is not able to improve its
return on capital employed and to lower its cost of capital, the
entity that was once the largest construction company in South
Africa will cease to exist.
Source: Compiled from information in Arnoldi, 2019; Hedley, 2019; Ngcuka, 2019; Wasserman,
2018; Iress Research Domain.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
Which ONE of the following is an advantage of the PBP?
A. It disregards cash flows after the PBP.
B. It does not take the time value of money into account.
C. It does not consider the cost of capital in any way.
D. It serves as a criterion of liquidity because the faster the initial investment
is recovered, the earlier the generated cash is available for alternative
use.
2.
Which of the following is considered to be one of the disadvantages associated
with the NPV method?
A. It is logically consistent with the entity’s goal of maximising shareholders’
value.
B. It offers theoretically correct decisions.
C. It provides results in a format that is difficult to understand.
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D.
3.
It uses all the cash flows of the project and discounts them properly.
GlobePost Ltd is considering replacing its old delivery vehicle with a new, more
fuel-efficient, model. The initial investment required is R150 000, and the
delivery vehicle will generate the following cash inflows:
Year 1: +R60 000
Year 2: +R80 000
Year 3: +R100 000
Year 4: +R120 000
Year 5: −R90 000.
If the entity’s cost of capital is 10%, the NPV of the replacement project is
__________.
A. −R150 000
B. +R71 871
C. +R120 000
D. +R221 871
4.
Which of the following is NOT one of the advantages associated with the IRR
method?
A. It considers all the cash flows of the project and discounts them properly.
B. It makes intuitive economic sense.
C. It is difficult to calculate in the case of conventional projects.
D. It always works well when applied to mutually exclusive projects.
Use the information that follows to answer Questions 5 and 6.
An entity is evaluating the three independent projects. The initial investment required
and the IRR values of the three projects are presented in the table that follows.
Project
Initial investment
R
IRR
Project Alpha
100 000
15%
Project Bravo
200 000
19%
Project Charlie
150 000
17%
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5.
If the entity’s cost of capital is 17%, it could …
A. accept Project Alpha and reject the other two projects.
B. accept Projects Alpha and Bravo, and reject Project Charlie.
C. accept Projects Bravo and Charlie, and reject Project Alpha.
D. accept all three projects.
6.
If the entity had R250 000 available to invest, it could …
A. accept Project Alpha and reject the other two projects.
B. accept Projects Alpha and Charlie, and reject Project Bravo.
C. accept Project Bravo and reject the other two projects.
D. accept Projects Bravo and Charlie, and reject Project Alpha.
7.
Which of the following is considered to be one of the advantages of the PI
method?
A. It is a difficult concept to understand.
B. It may not work well in the case of some mutually exclusive projects.
C. It is problematic when evaluating independent projects.
D. It may be used when available investment funds are limited.
INTERMEDIATE
8.
An entity is evaluating a proposal that requires an initial investment of R50 000
and results in cash flows of +R10 000, −R20 000, +R30 000, +R20 000 and
+R20 000 over the next five years. The PBP of the project is __________.
A. two years
B. two-and-a-half years
C. three years
D. four-and-a-half years
Use the information that follows to answer Questions 9 and 10.
An entity is evaluating three mutually exclusive projects. The NPVs and IRRs of the
projects are presented in the table that follows.
Project
NPV
Project A
+R1 000
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IRR
30%
9.
Project B
+R2 000
25%
Project C
−R2 000
20%
The entity should …
A. accept Project A and reject the other projects.
B. accept Projects A and B, and reject Project C.
C. accept Project B and reject the other projects.
D. accept Project C and reject the other projects.
10. Based on the information provided, it can be assumed that the entity’s cost of
capital is __________.
A. less than 20%
B. equal to 20%
C. larger than 20%
D. larger than 30%
11. Tshwane Ltd needs to decide which of two mutually exclusive projects to invest
in. The cash flows of the two projects are presented in the table that follows.
Year
Project Echo
R
Project Delta
R
0
−100 000
−30 000
1
20 000
6 000
2
15 000
12 000
3
40 000
18 000
4
20 000
12 000
If the entity’s cost of capital is 10%, what is the NPV of the project with the
highest IRR?
A. R2 909
B. R7 092
C. R25 709
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D.
R135 366
Use the information that follows to answer Questions 12 to 15.
Tamatie Ltd needs to replace its existing security system and is considering two
alternatives. The projects are equally risky and the entity’s cost of capital is 10%.
The expected flows of the two projects are presented in the table that follows.
Year
Project Secura
R
Project Protecta
R
0
−500 000
−450 000
1
−400 000
150 000
2
−200 000
150 000
3
−100 000
150 000
4
400 000
150 000
5
600 000
150 000
6
800 000
150 000
7
−200 000
250 000
12. Which pattern of cash flow is depicted in Project Protecta?
A. Conventional cash flow pattern
B. Unconventional cash flow pattern
C. Substitute cash flow pattern
D. Complementary cash flow pattern
13. The NPV for Project Secura is __________.
A. −R89 662
B. −R109 351
C. −R781 579
D. −R1 323 953
14. The NPV of Project Protecta is __________.
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A.
B.
C.
D.
R331 579
R823 953
R781 579
R1 323 953
15. Based on the NPV of both projects, which decision should management make?
A. Accept Project Protecta and reject Project Secura.
B. Accept Project Secura and reject Project Protecta.
C. Accept both Project Protecta and Project Secura.
D. Reject both Project Protecta and Project Secura.
ADVANCED
Use the information that follows to answer Questions 16 to 19.
Gamma Ltd has a total capital budget of R500 000 and its cost of capital is 15%.
The entity has identified the five independent projects presented in the table that
follows.
16. Project C’s IRR is most probably closest to __________.
A. 12%
B. 15%
C. 17%
D. 19%
17. The NPV of Project D is most probably __________ and the NPV of Project E
is most probably __________.
A. positive; negative
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B.
C.
D.
zero; positive
negative; positive
negative; zero
18. Using the NPV approach for ranking investment projects, which project(s)
should the entity accept?
A. Only A
B. A and C
C. A, B and C
D. A, B and E
19. If the entity’s capital budget decreases to R200 000, which projects should the
entity accept based on the IRR approach?
A. Only A
B. Only B
C. Only C
D. A, B and C
LONGER QUESTIONS
BASIC
1.
Steelmate Ltd is considering a new product line. It is anticipated that the new
product line will entail an initial investment of R700 000 at time 0 and an
additional investment of R1 million in year 1. After-tax cash inflows of R250
000 are expected in year 2, with R300 000 in year 3, R350 000 in year 4 and
R400 000 each year thereafter through to year 10. Although the product line
might be viable after year 10, the entity prefers to be conservative and end all
calculations at that time.
a) If the cost of capital is 15%, what is the NPV of the project? Is it
acceptable?
b) What is the IRR?
c) What would be the case if the cost of capital were 10%?
d) What is the project’s PBP?
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INTERMEDIATE
2.
StellenCo Ltd is considering two investment projects, Project Xeno and Project
Yeno, each of which requires an initial investment of R500 000. The entity’s
cost of capital is 20%. Assume that the projects will produce the after-tax cash
flows presented in the table that follows.
Year
Project Xeno
R
Project Yeno
R
1
100 000
250 000
2
150 000
200 000
3
250 000
150 000
4
400 000
100 000
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
Calculate the AR for each project.
Calculate the PBP for each project.
Calculate the DPB for each project.
Calculate the NPV for each project.
Calculate the IRR for each project.
Calculate the MIRR for each project.
If the two projects are independent and the cost of capital is 15%, which
project(s) should StellenCo Ltd undertake?
If the two projects are mutually exclusive and the cost of capital is 20%,
which project(s) should StellenCo Ltd undertake based on the NPV
method?
If the two projects are mutually exclusive and the cost of capital is 15%,
which project(s) should StellenCo Ltd undertake based on the NPV
method?
If the two projects are mutually exclusive and the cost of capital is 30%,
in which project(s) should StellenCo Ltd invest?
ADVANCED
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3.
Grappi Ltd is considering investing in one of two mutually exclusive projects:
Project A and Project B. The initial investments for Projects A and B are R500
000 and R850 000, respectively. The expected relevant cash flows for the two
projects are presented in the table that follows.
Year
Project A
R
Project B
R
1
−300 000
250 000
2
−150 000
250 000
3
−100 000
250 000
4
600 000
250 000
5
600 000
250 000
6
800 000
250 000
7
−200 000
0
a)
b)
c)
d)
e)
4.
Using the values 0%, 5%, 10%, 15% and 20% for the entity’s cost of
capital, construct the NPV profiles for Projects A and B.
Calculate the IRR for the two projects.
Calculate the crossover rate for the two projects.
Outline the problems that may occur when the IRR method is used to
evaluate the two mutually exclusive projects.
Explain how the IRR method should be applied in this case to evaluate
mutually exclusive projects.
You are required to evaluate the four mutually exclusive projects presented in
the table that follows by focusing on their IRR.
a) Calculate the IRR for each project.
b) Assume that the entity’s cost of capital is 10% per year. Indicate which
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c)
d)
5.
project(s) are not acceptable, based on their IRRs. Motivate your answer.
Calculate the IRR on the incremental investment for the remaining
(acceptable) projects.
Indicate which project(s) should be accepted. Motivate your answer by
referring to your answers in Question 4. a) and c). Assume that the
entity’s cost of capital is 10% per year. No capital rationing is applicable.
Amanzimtoti (Pty) Ltd, a manufacturing company, wishes to expand and
modernise its facilities. The installed cost of a new machine will be R130 000.
The new machine will be depreciated over a five-year straight-line period. The
entity has the opportunity to sell its four-year-old existing machine for R35
000. The existing machine originally cost R60 000 and was being depreciated
over a six-year period on a straight-line basis. Sales revenue from expansion
will amount to R70 000 per year, and operating expenses and other costs
(including depreciation) will amount to 40% of sales. The new machine will
result in the change in net working capital presented in the table that follows.
Anticipated changes in current assets and current liabilities
R
Accruals
–2 000
Inventory
+50 000
Accounts payable
+40 000
Accounts receivable
+70 000
Cash
+5 000
Notes payable
+15 000
The following additional information is available:
■ Tax rate: 28%
■ Cost of capital: 12,39%.
a)
b)
Calculate the PBP, the NPV and the IRR of the expansion project.
On the basis of the NPV and the IRR of the expansion project, state
whether the entity should expand and modernise its facilities.
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c)
If the entity’s acceptable payback period is 3,5 years, would you
recommend the expansion based on the calculated PBP?
KEY CONCEPTS
Average return (AR): The average annual cash flow generated over a
project’s lifetime, divided by the initial investment amount. An
AR value in excess of the entity’s cost of capital would indicate
that a project is financially acceptable.
Capital budgeting: The process of identifying and analysing the
various investment opportunities that are available, and
deciding how an entity will allocate its scarce capital resources.
Complementary project: The acceptance of this type of project has a
positive effect on the cash flows of the entity’s other projects.
Conventional project: A project that requires a cash outflow at the
beginning of the project lifetime, followed by a stream of cash
inflows.
Discounted payback period (DPB): The number of years it takes to
recover an initial investment by accumulating the future cash
inflows discounted at the cost of capital.
Expansion project: A project that enables an entity to expand its
current level of activities either through the internal expansion
of activities or through external expansion by means of
acquisitions.
Independent project: The implementation of one project does not have
an effect on the cash flow of another project; consequently, an
entity may decide to invest in one or both of them.
Internal rate of return (IRR): The discount rate that equates the present
value of the expected future cash inflows and the present value
of the future cash outflows. The IRR measures the rate of return
earned over the full lifetime of a project, but it assumes that all
cash flows can be reinvested at the IRR rate.
Modified internal rate of return (MIRR): An adjusted version of the IRR
method, in which the present value of the expected cash inflows
and the future value of the expected cash outflows are
calculated at the entity’s cost of capital, and compared to
determine the return on the project.
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Mutually exclusive projects: The acceptance of one of the projects under
consideration will result in the rejection of all the other
alternatives.
Net present value (NPV): The difference between the initial investment
amount and the present value of a project’s expected future cash
flows, discounted at the appropriate cost of capital. The NPV is
a direct measure of the value that a project creates for the
entity’s shareholders.
Net present value profile: Graph of a project’s NPV calculated at
different discount rates.
Payback period (PBP): The number of years it takes an entity to recover
the initial investment amount from the future cash flows
generated.
Profitability index (PI): A capital appraisal technique calculated by
dividing the present value of a project’s future cash inflows by
the initial investment amount. A PI value greater than one is
equivalent to a positive NPV.
Replacement project: Type of project in which an existing asset needs
to be replaced by a new one at the end of its economic lifetime
as a result of technological changes or to achieve cost reductions.
Substitute project: Type of project whose implementation may have a
negative effect on the entity’s other projects.
Unconventional project: Type of project where the initial cash outflow
at the beginning of the project lifetime is followed by both
positive and negative cash flows.
SLEUTELKONSEPTE
Aangepaste interne rentabiliteit (MIRR): ’n Aangepaste weergawe van die
IRR metode waar die teenswoordige waarde van die verwagte
kontantinvloeie en die toekomstige waarde van die verwagte
kontantuitvloeie bereken word teen die maatskappy se koste
van kapitaal, en vergelyk word om die projek se opbrengskoers
te bereken.
Gemiddelde opbrengs (AR): Die gemiddelde jaarlikse kontantvloei wat
oor die projekleeftyd gegenereer is, gedeel deur die aanvanklike
investeringsbedrag. ’n AR waarde wat groter as die maatskappy
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se koste van kapitaal is sal aandui dat ’n projek finansieel
aanvaarbaar is.
Interne rentabiliteit (IRR): Die verdiskonteringskoers wat die
teenswoordige waarde van die verwagte toekomstige
kontantinvloeie gelykstel aan die teenswoordige waarde van die
toekomstige kontantuitvloeie. Die IRR meet die opbrengskoers
wat verdien is oor die volle leeftyd van ’n projek, maar is
gegrond op die aanname dat alle kontantvloeie teen die IRR
koers her-investeer kan word.
Kapitaalbegroting: Die proses waarvolgens die verskillende
investeringsgeleenthede wat beskikbaar is geïdentifiseer en
ontleed word, en waar besluit word hoe ’n onderneming sy
skaars kapitaalbronne sal aanwend.
Komplementêre projek: Die aanvaarding van die projek het ’n
positiewe effek op die kontantvloeie van die maatskappy se
ander projekte.
Konvensionele projek: ’n Projek wat ’n kontantuitvloei aan die begin
van die projekleeftyd benodig, gevolg deur ’n stroom van
kontantinvloeie.
Netto teenswoordige waarde (NPV): Die verskil tussen die aanvanklike
investeringsbedrag en die teenswoordige waarde van ’n projek
se verwagte toekomstige kontantvloeie, verdiskonteer teen die
toepaslike koste van kapitaal. Die NPV is ’n direkte maatstaf
van die waarde wat ’n projek genereer vir die maatskappy se
aandeelhouers.
Netto teenswoordige waarde profiel: ’n Grafiek van ’n projek se NPV
wat bereken is teen verskillende verdiskonteringskoerse.
Onafhanklike projekte: Die implementering van een projek het nie ’n
effek op die kontantvloei van ’n ander projek nie, en gevolglik
kan ’n maatskappy besluit om in een of beide te investeer.
Onderling uitsluitende projekte: Die aanvaarding van een van die
projekte onder oorweging sal lei tot die verwerping van al die
ander alternatiewe.
Onkonvensionele projek: ’n Projek waar die aanvanklike
kontantuitvloei aan die begin van die projekleeftyd gevolg word
deur beide positiewe en negatiewe kontantvloeie.
Substituut projek: Die implementering van ’n projek wat ’n negatiewe
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effek op die maatskappy se ander projekte kan hê.
Terugverdienperiode (PBP): Die aantal jare wat dit ’n onderneming
neem om die aanvanklike investeringsbedrag terug te verdien
uit die toekomstige kontantvloeie wat gegenereer word.
Uitbreidingsprojek: ’n Projek wat ’n maatskappy in staat stel om sy
huidige vlak van aktiwiteite uit te brei deur die interne
uitbreiding van aktiwiteite, of die eksterne uitbreiding by wyse
van oornames.
Verdiskonteerde terugverdienperiode (DPB): Die aantal jare wat dit neem
om die aanvanklike investering terug te verdien deur die
toekomstige kontantinvloeie, wat verdiskonteer is teen die koste
van kapitaal, te akkumuleer.
Vervangende projek: ’n Projek waar ’n bestaande bate vervang moet
word met ’n nuwe een aan die einde van sy ekonomiese leeftyd,
as gevolg van tegnologiese veranderinge, of om kostebesparings
te verkry.
Winsgewendheidsindeks (PI): ’n Kapitaalinvesteringsontledings tegniek
wat bereken word deur die teenswoordige waarde van ’n projek
se toekomstige kontantinvloeie te deel deur die aanvanklike
investeringsbedrag. ’n PI waarde groter as een is ekwivalent aan
’n positiewe NPV projek.
SUMMARY OF FORMULAE USED IN THIS CHAPTER
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WEB RESOURCES
www.aveng.co.za
www.distell.co.za
REFERENCES
Arnoldi, M. (2019). Aveng sells Grinaker-LTA for R100m.
Engineering News. Retrieved from
http://www.engineeringnews.co.za/article/aveng-sellsgrinaker-lta-for-r100m-2019-08-12/rep_id:4136 [2 December
2019].
Distell. (2013). Integrated Annual Report 2013. Retrieved from
https://www.distell.co.za/knowledge/pkdownloaddocument.aspx?
docid=1029 [26 February 2020].
Distell. (2019). Integrated annual report 2019. Retrieved from
https://www.distell.co.za/knowledge/pkdownloaddocument.aspx?
docid=1234 [26 February 2020]. CDGHE: Distell Group
Holdings Limited Role Equity Issuer Registration No.
2016/394974/06.
Dobson, J. (1997). Finance ethics: The rationality of virtue. Lanham:
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Rowman & Littlefield Publishers. Reprinted by permission of
the publisher through Copyright Clearance Center.
Hasenfuss, M. (2012). Distell soars. BusinessLIVE. Retrieved from
http://www.financialmail.co.za/fm/2012/08/29/distell-soars
[6 March 2014].
Hedley, N. (2019). Ailing Aveng sells two businesses to bolster
balance sheet. BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/companies/industrials/201907-12-ailing-aveng-sells-two-businesses-to-bolster-balancesheet/ [2 December 2019].
Iress South Africa (Australia) Pty Ltd. Research Domain. Software
and database.
Ngcuka, O. (2019). Losses more than double at Aveng. Moneyweb.
Retrieved from
https://www.moneyweb.co.za/news/companies-anddeals/aveng-delays-release-of-full-year-results-by-a-day/ [2
December 2019].
Smith, C. (2017). Distell sells cognac business for R800m, MD
explains why. Fin24.com. Retrieved from
https://www.fin24.com/Companies/Agribusiness/distellsells-cognac-business-for-r800m-md-explains-why-20171221 [1
December 2019].
Wasserman, H. (2018). 10 years ago, this company was the largest
construction firm in SA. Then it lost 99.5% of its value. Here’s
what happened. Business Insider. Retrieved from
https://www.businessinsider.co.za/the-rise-and-fall-of-aveng2018-5 [2 December 2019].
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6 Estimating relevant cash flows
Sam Ngwenya and Pierre Erasmus
Learning
outcomes
Chapter
outline
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
By the end of this chapter, you should be able to:
justify why cash flows, and not profits, are
relevant to capital budgeting decisions
explain how tax considerations and depreciation
for tax purposes affect capital budgeting
decisions
calculate the initial investment associated with a
proposed capital expenditure
determine the relevant operating cash flows
associated with a proposed capital expenditure
calculate the terminal cash flow associated with
a proposed capital expenditure.
Introduction
The difference between profit and cash
flow
Estimating relevant cash flows
The components of project cash flows
Calculating the initial investment
Calculating operating cash flows
Calculating the terminal cash flow
Capital gains tax
Conclusion
CASE STUDY South African Airways releases new state-of-the-art aircraft
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In June 2019, South African Airways (SAA) said in a statement
that it is introducing the latest technology available in ultralong-haul aircraft on non-stop flights between Johannesburg
and New York. SAA will supplement its existing long-haul
fleet with two new Airbus A350-900s, which are modern, twinengine, wide-body aircraft. These new-generation aircraft boast
fuel efficiency as well as other benefits and advantages,
according to SAA. The airline said these aircraft present an
opportunity for SAA to reduce fuel burn by approximately
20% compared to the aircraft currently operating on that route.
This will translate into significant cost savings that will
contribute towards improved operating costs and financial
performance. In addition, it will lessen the impact of flying on
the environment, as SAA will also be able to reduce its carbon
emissions.
SAA, which will lease the aircraft for up to three years, will
take delivery in the second half of 2019. The aircraft will be
operational in SAA’s branding as soon as the entity has
complied with the regulatory authority’s requirements.
The new aircraft will replace two Airbus A340-600s that are
15 years old. Given that SAA reported operating losses every
year from 2012 to 2017, the expected reduction in fuel and
maintenance costs associated with the new aircraft could
contribute towards an improvement in its profitability. While
the airline has been successful in reducing its fuel costs from
2012 to 2017, maintenance costs increased from R1,739 billion
to R4,895 billion over this period due to an ageing fleet of
aircraft.
Although SAA could use the proceeds from the sale of the
existing aircraft to reduce the increase in its liabilities resulting
from the new lease transaction, the question is whether the
expected reduction in operating costs will be large enough to
cover the cost of the replacement. SAA will only be able to
alleviate the severe level of financial distress it is currently
experiencing if the benefits associated with the replacement are
sufficient to outweigh the cost of the new aircraft.
Source: Compiled from information in Eiselin, 2019; Mahlakoana, 2019; SAA, 2017.
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6.1
Introduction
The SAA case study is a good example of an entity replacing its
existing non-current assets with new assets to improve the
efficiency of its existing activities. Alternatively, an entity may
consider a strategic investment in new current assets to expand its
existing activities in order to boost future sales and ensure a
competitive advantage in the marketplace. Although the
replacement decision faced by SAA calls for a large capital
investment, the entity cannot avoid (or delay) this investment if it
wants to remain competitive and return to profitability. Large
capital investments are usually also necessary for expansion in
existing markets or to enter new markets.
A business that invests a considerable sum of money in a project
does so in the expectation of generating future cash flows that will
be sufficient to warrant the large initial investment that is required.
Before managers acquire new capital assets, they therefore need to
be sure that the investment will yield a positive net present value
(NPV). The process of evaluating projects and deciding whether or
not to undertake them is the main focus of capital budgeting (also
known as investment appraisal), which was described in Chapter 5.
In this chapter, we focus on the calculation of cash flows in
order to evaluate capital investments and determine if they
contribute to the overall objective of shareholder wealth
maximisation. We start by making a distinction between accounting
profits (as discussed in Chapter 2) and cash flows. In the section
that follows, we focus on how to estimate those cash flows that are
relevant to investment appraisal as well as how to identify the basic
components of cash flow. We discuss the terms ‘sunk costs’ and
‘opportunity costs’, and highlight the need to focus on incremental
cash flows during project evaluation. We also look at how to
calculate the initial investment, operating cash flows and terminal
cash flows for both expansion projects and replacement projects.
We conclude with an illustration of the influence of capital gains tax
on cash flows.
6.2
The difference between profit and cash flow
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When the financial feasibility of an investment project is
investigated, the focus should be on the project’s cash flow and not
on the profit that results from investing in it. The reason is that
profit represents an accounting item that is calculated on the basis
of a set of accounting standards. The profit of a project does not
necessarily represent its cash flow. For example, an entity’s profit
after tax is calculated after depreciation is subtracted. However,
depreciation is a non-cash expense. Thus, the profit figure contains
items that are of a non-cash nature.
Another important distinction between profit and cash flow is
that profits are calculated for a certain period of time (for example,
the financial year), whereas cash flows are determined at a specific
point in time (that is, when the cash is physically received or spent).
The difference between profit and cash flow can be best
described by a simple example. Suppose that you bought a textbook
for R300 cash and it was the last copy in the bookshop. Your friend
offers you R350 for the textbook, but indicates that they can only
pay you at the end of the month. If you decide to go ahead with the
transaction, you will make a profit of +R50 now (R350 − R300) if
you apply the accounting principles used to determine profits.
However, your cash flow situation would be −R300 now (R0 −
R300), because you have paid cash for the book and have not yet
received any cash. When your friend pays you at the end of the
month, your cash flow situation will be +R350 (R350 − R0).
We saw in Chapter 4 that it is not only the cash flow amounts
that should be considered during project evaluation, but also the
timing of these cash flows. Cash flows provide a clearer picture of
the value and timing of a transaction’s results than profits.
Consequently, capital investment appraisal focuses on the cash flow
of a project, and not on the profit.
Section 6.3 explains how to estimate the relevant cash flows.
6.3
Estimating relevant cash flows
In capital budgeting, managers should only be concerned with
relevant cash flows. What is meant by a relevant cash flow? It is the
cash flow that reflects the change in an entity’s overall future cash
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flows as a direct consequence of accepting a capital investment
project. Because relevant cash flows are defined in terms of changes
to the overall cash flow of the entity, they are also called
incremental, or additional, cash flows.
If an entity is evaluating the expansion of its current activities, it
is usually a simple process to calculate the incremental cash flow of
the project. Since the expansion project contributes to the entity’s
existing activities, the entity only needs to consider the cash flows
that are associated with the new project.
Determining the relevant cash flows for investment projects that
are entered into in order to replace existing assets, however, is
usually more complex. It is first necessary to calculate the entity’s
current overall cash flow (that is, the cash flow from its current
projects). After this has been calculated, the entity’s expected
overall cash flow after the replacement investment has been made
should be calculated. The difference between these two cash flows
represents the incremental cash flow associated with the
replacement project.
It can be difficult to determine the relevant cash flows to be
included in the investment appraisal process. It is important to note
that all possible effects on the entity’s current cash flows should be
considered and included when calculating the incremental cash
flow. The following components, which are discussed in the
sections below, require specific attention: sunk costs, opportunity
costs, finance costs, and inflation and tax.
6.3.1
Sunk costs
A sunk cost is a type of cost that has already been incurred in the
process of evaluating a capital investment proposal. A typical
example includes a consulting company’s fee to conduct a
feasibility study or environmental impact assessment before a
project is accepted. The consultant’s fee has to be paid whether or
not the project is accepted. During the investment appraisal
process, the focus should only be placed on those cash flows that
will result from accepting the project. Sunk costs are unrecoverable
past costs and should therefore be excluded when determining a
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project’s incremental (that is, additional) contribution to the overall
cash flow of the business.
6.3.2
Opportunity costs
An opportunity cost refers to the most valuable alternative that
would be forgone if a particular investment were undertaken. For
example, assume that management needs to decide whether or not
to build a new factory. Suppose that the entity already owns land
that can be used for this purpose. When evaluating this project, the
value of the piece of land has to be taken into account, since the
entity could sell it to generate a cash inflow. The current value of
the piece of land should, therefore, be included as part of the
project’s relevant cash flows.
6.3.3
Finance costs
Additional financing costs that arise from accepting a project (such
as additional interest charges) should be ignored when estimating a
capital project’s cash flows. The reason for this is that the cost of
financing is already included in the entity’s cost of capital (see
Chapter 11 for a detailed discussion on the cost of capital). If the
finance cost were subtracted from the cash flows, this cost would be
included twice in the analysis.
6.3.4
Inflation and tax
Managers should consider inflation and taxes when estimating a
project’s cash flows. In countries with relatively high inflation rates,
such as South Africa, the cost of raw materials and labour tends to
increase over time, which has the effect of lowering operating
profits and cash flows. As a consequence, the selling prices of
products also change over time.
Capital gains tax was introduced in South Africa in 2001 and
becomes applicable when assets are sold at prices exceeding their
original cost prices. Price changes and the effects of tax should be
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captured in a manager’s cash flow calculation to ensure accurate
NPV and internal rate of return (IRR) values, and to inform sound
accept/reject decision making. All incremental cash flows should
be shown on an after-tax basis.
Example 6.1 illustrates how these four cost elements are
accounted for when calculating a project’s relevant cash flows.
Example 6.1 Identifying relevant cash flows
Assume that the GAS Company is considering building a new factory on an
existing piece of land. The entity purchased the land four years ago for R1
million and management is of the opinion that it could currently be sold for R3
million. Assume that capital gains tax is charged at 14%. Furthermore, assume
that the piece of land is financed by means of a long-term loan that incurs
interest at 10% per year. You are required to indicate the relevant cash flows
for the project.
■ First of all, the original purchase price of R1 million represents a sunk cost,
as it was incurred in the past and it is not possible to recover it. It is,
therefore, not included in the evaluation of the project.
■ However, the entity needs to include the R3 million as an opportunity cost,
as this is the amount that could be received if the piece of land were sold
instead of developed.
■ Furthermore, if the entity decides to sell the land, it will have to pay capital
gains tax on the capital gain of R2 million. Thus, the after-tax amount that
will be associated with the piece of land is R2,72 million (R3 million
proceeds, minus capital gains tax of 14% × R2 million).
■ The finance cost on the long-term loan that was used to finance the
purchase is not included in the relevant cash flows because it will be
included in the entity’s cost of capital during the investment appraisal
process.
QUICK QUIZ
1. Explain why financial managers should use cash
flows and not accounting profits when
evaluating the merits of capital projects.
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Identify the sunk cost in this example: a
2. business hires a consultant to assess the
viability of outsourcing its credit collection
operations and to list the possible agencies
to which it could outsource this function. The
business spends R121 000 on the consultant’s
fees before evaluating the proposals. You
estimate that further costs for setting up an
outsourcing contract, such as legal fees and
stamp duty, would amount to R240 500 and that
the present value of cost savings from
outsourcing will amount to R320 450.
3. What has been the trend in the inflation rate
in South Africa in recent months? What are
economists predicting about future inflation
rates in South Africa?
6.4
The components of project cash flows
The cash flow stream of a capital project can usually be divided into
three components: the initial investment, operating cash flows and
the terminal cash flow. Figure 6.1 summarises these components on
a timeline.
Figure 6.1 Basic components of project cash flow
From this timeline, it can be seen that the initial investment of the
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proposed project is a cash outflow of R40 000. This is followed by
the operating cash flows of the project during its lifetime of five
years, commencing with a cash inflow of R8 000 in the first year
(T1), which increases to R16 000 in year 5 (T5). The terminal cash
flow of R15 000 occurs in the final year of the project. Note that the
operating cash flows are the incremental after-tax cash flows
resulting from the project during its lifetime, whereas the terminal
cash flow is the after-tax non-operating cash flow occurring at the
end of the final year of the project.
You will remember from Chapter 5 that a distinction can be
made between conventional and unconventional projects, according
to the pattern of their cash flow streams. In Figure 6.1, the project
exhibits a conventional cash flow pattern: the initial cash outflow is
followed by a stream of cash inflows. An example of an
unconventional cash flow pattern is provided in Figure 6.2. The
project represented by Figure 6.2 has an initial investment that
requires a cash outflow of R60 000 followed by both positive and
negative cash flows in years 1 to 5. In year 6, a positive operating
cash flow is generated, but the terminal value of the project is
negative, resulting in a net cash outflow of R30 000 at the end of the
year.
Figure 6.2 Unconventional cash flow pattern
QUICK QUIZ
1. What is the difference between conventional
cash flows and unconventional cash flows?
2. Which of these two cash flow patterns is most
likely to take place in practice when we
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evaluate capital budgeting projects? Motivate
your answer.
3. Which of these two cash flow patterns would
you expect for the investment situation facing
SAA in the opening case study? Motivate your
answer.
FOCUS ON ETHICS: Relevant cash
flows and COVID-19
The year 2020 will be remembered for many reasons, but primarily for
the catastrophic role the coronavirus (COVID-19) played in the
decimation of the world economy. Industry and production came to a
halt in virtually every country in the world, augmenting the human
catastrophe associated with the crisis.
The COVID-19 pandemic had a monumental effect on business in
that the principles of future and present value seemed to dissipate,
with many chief executive officers questioning whether there would
still be a ‘future’ left in ‘future value’ for their specific entity once
things returned to ‘normality’.
In the days leading up to the declaration of COVID-19 as a global
pandemic, financial markets across the world became extremely
volatile. The graph that follows indicates the change in value of
selected stock market indices worldwide from 1 January to 18 March
2020.
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Sources: Created by author Els using information compiled from Yahoo! Finance, 2020a, b, c;
Investing.com, 2020a, b, c, d, e, f, g, h.
As is evident in the graph, all stock market indices showed negative
values after 6 March, as investors tried to sell off as much of their
stock as possible. This practical example of how investors perceive
‘future value’ shows that they were not optimistic about world
markets at that stage.
In addition to affecting the world’s financial markets, COVID-19
has played and will continue to play an important role in the amount of
capital investment that will be undertaken in the next few months.
The graph that follows indicates the annual amount of capital
investment in South Africa as a percentage of gross domestic product
(GDP) at current prices.
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Source: Created by author Els using information compiled from issues of the Quarterly Bulletin
of the South African Reserve Bank, 1946–2018 (SARB, n.d.).
Data shows that shortly after World War II, capital investment in South
Africa made up slightly more than 15% of GDP. Over the years, it has
increased and decreased, and by the end of December 2019, it was
about 20%. How will this figure change in the months leading up to
2020’s global pandemic and thereafter? Entities tend to be cautious
about investing in property, plant and equipment if there is uncertainty
about the general economy; this tendency becomes even more
pronounced when it is obvious that the economies of countries are
vulnerable to devastation by an ‘external force’ that is smaller than a
speck of dust.
In April 2020, the International Monetary Fund (IMF, 2020)
projected that the world economy could contract by as much as 3%,
which is even greater than the contraction seen after the 2008/09
financial crises.
For an entity, capital investment involves more than simply
expanding its investment in non-current assets. Everything that the
entity plans and performs as part of its capital investment strategy has
a consequence on more than just its bottom line. There is an intrinsic
ethical link with its wider stakeholders as well: its future employees,
managers and shareholders.
QUESTIONS
1. Do you think that ethics had a role to play in entities closing
their doors at the start of the worldwide COVID-19
pandemic? Briefly motivate your answer.
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2.
3.
4.
5.
6.
6.5
Once entities are again in a position to invest in capital
expenditure projects, do you think that costs associated
with the COVID-19 pandemic should be included in the
capital budget as a sunk cost? Why or why not?
Do you think that costs associated with the COVID-19
pandemic will result in unconventional cash flows in capital
investment projects? Motivate your answer.
When looking at relevant cash flows, incremental cash flow
is described as “… the net additional cash flows generated
by a company by undertaking a project” (XPLAIND, n.d.).
Would you describe costs related to the COVID-19 pandemic
as additional or incremental in nature? Motivate your
decision.
Refer to the last paragraph of the ‘Focus in ethics’ text.
What do you think the ethical duty of management was
towards entities’ stakeholders during the COVID-19
pandemic?
What new ethical ‘rules’ do you think entities will have to
take into consideration in the post-COVID-19 era?
Calculating the initial investment
A project’s initial investment consists of the total up-front costs and
typically includes:
• the cost of the investment
• shipping and installation costs
• training costs
• any change in net working capital.
Remember that the initial investment should be calculated on an
after-tax basis. In Section 6.3, you learnt that the methods for
calculating the relevant cash flows for replacement and expansion
projects are different. When these calculations are discussed in the
remainder of this chapter, a distinction will be made between
replacement projects and expansion projects in order to illustrate
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the different methods used.
6.5.1
Initial investment for an expansion project
In the case of an expansion project, the relevant cash flow is
determined by considering the additional cash flows created by the
new project. When determining the- initial investment, the focus is
therefore on the additional cash flows that result from the project.
Table 6.1 shows the basic format for calculating the initial
investment of an expansion project.
Table 6.1 Calculating initial investment for an expansion project
Total cost of the new asset
(xxxx)
Purchasing price
(xxx)
Shipping and installation cost
(xxx)
Change in net working capital
(xxxx)
Initial investment
(xxxx)
The total cost of a new asset consists of the purchasing price and
any additional costs that enable the asset to come into operation
(such as shipping and installation costs). Sales tax paid on the
transaction (value-added tax) must also be included. Example 6.2
illustrates the method used to calculate the total cost of a new asset.
Example 6.2 Calculating the total cost of a new asset
Khoza Ltd is considering the purchase of an additional compressor for its
production facility. The price of the new compressor is R80 000 (excluding
15% VAT). The cost of transporting the compressor to the factory is R8 000
and the installation cost is R10 000. Using this information, the total cost of
the new machine can be calculated as shown below.
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Investing in a capital project may also necessitate additional
investment in net working capital. For example, managers may
need to increase inventory, which may, in turn, increase accounts
payable. The formula for calculating net working capital is as
follows:
Generally, current assets increase by more than current liabilities,
resulting in an increased investment in net working capital. This
increased investment is treated as an initial outflow of cash. If the
change in net working capital were negative, it would be shown as
an initial cash inflow.
Example 6.3 illustrates the method used for calculating changes
in net working capital.
Example 6.3 Calculating changes in net working capital
If the purchase of the new compressor by Khoza Ltd results in the accounts
receivable increasing by R50 000, inventory increasing by R30 000 and
accounts payable increasing by R58 000, what will be the change in net
working capital?
If Khoza Ltd purchases the new compressor, an additional amount of R22 000
will be required to invest in net working capital. This amount represents a cash
outflow.
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Thus, the total initial cost of the expansion project discussed in
Example 6.3 (the purchase of a new compressor) amounts to a cash
outflow of R110 000 + R22 000 = R132 000.
6.5.2
Initial investment for a replacement project
Let’s now consider the method for calculating the initial investment
for a replacement project. When evaluating a replacement project, it
is not sufficient merely to focus on the additional cash flows
associated with the new asset. We also need to consider what effect
the removal of the existing asset has on the entity’s future cash
flows.
Calculating the total cost of the new asset and the change in net
working capital is similar to calculating the cost of an expansion
project, as described in Section 6.5.1. When an old asset is replaced
with a new one, the old asset can usually be sold. The after-tax
proceeds from the sale of the old asset reduce the initial investment
cost of the replacement project. The net working capital required by
the old asset is also freed up if it is replaced with a new asset. The
after-tax proceeds and the change in net working capital associated
with the old asset therefore need to be included when determining
the initial investment of the replacement project. The initial
investment can be calculated as shown in Table 6.2.
Table 6.2 Calculating initial investment when an old asset is replaced with a new one
Total cost of new asset
(xxxx)
Purchasing price
(xxx)
Shipping and installation cost
(xxx)
After-tax proceeds from sale of old asset
xxxx
Proceeds from sale of old asset
xxx
Tax on sale of old asset
xxx
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Change in net working capital of old asset
xxxx
Change in net working capital of new asset
(xxxx)
Initial investment
(xxxx)
When replacing an old asset with a new one, the book value (or
carrying value) of the old asset must be calculated first:
Although depreciation is not a cash expense, it does play a major
role in determining the book value of an asset and in terms of tax if
the asset is sold. There are a number of methods that may be used
to depreciate capital assets. For the purpose of this chapter, assets
will be depreciated on a straight-line basis.
The corporate tax rate in South Africa is determined annually in
February by the minister of finance in the budget speech. For the
purpose of the tax calculation, we shall assume the corporate tax
rate of 28% that came into effect on 1 April 2008 (SARS, 2019). The
tax is calculated on the profit or loss incurred by the sale of the
asset. Removal costs incurred can be deducted from the profit when
the tax is calculated.
The formula for calculating the tax on the sale of the asset is as
follows:
In some cases, the old asset can be sold for more than its book
value. In this case, a taxable profit will be generated by the
transaction, which will increase the amount of tax that the entity
needs to pay. The tax on the profit on the sale of the asset will
therefore represent a cash outflow and will reduce the sales
proceeds. If the old asset is sold for less than its book value, the
transaction will generate a loss. The tax of this loss on the sale of the
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asset will represent a tax benefit for the entity and will increase the
sales proceeds.
Example 6.4 illustrates the method for calculating the after-tax
proceeds from the sale of an old asset.
Example 6.4 Calculating the after-tax proceeds from the sale of an old
asset
Suppose that Khoza Ltd is thinking of buying a new compressor to replace its
old one. Khoza Ltd purchased the old compressor two years ago for a total cost
of R60 000. The old compressor is depreciated on a straight-line basis over a
period of five years. The old compressor also required an increase in net
working capital of R10 000.
Using Formula 6.2, we can calculate the book value of the old compressor
after two years as follows:
Suppose that Khoza Ltd decides to sell the old compressor after two years for
R65 000 and that the removal of the old compressor will cost R5 000. Since
the old compressor is sold at a price that is greater than the book value, the
profit will be taxable. The tax effect of this transaction is calculated as follows
using Formula 6.3:
The after-tax proceeds from the sale of the old compressor in this example are
equivalent to the selling price to be received minus the removal cost and the
tax that has to be paid on the accounting profit. Consequently, the sale of the
old compressor will generate a total cash inflow of 65 000 – 5 000 – 6 720 =
R53 280.
Suppose now, however, that the old compressor can only be sold for R25 000.
What will the after-tax proceeds be in this situation?
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The loss on the sale of the asset resulted in a tax benefit for the entity, since
the loss will reduce the tax that the entity has to pay. This tax benefit is treated
as a cash inflow. Consequently, the after-tax proceeds from the sale of the old
asset are 25 000 − 5 000 + 4 480 = R24 480.
The methods used to calculate the components of the initial
investment amount have been shown in the preceding examples.
The calculations for Khoza Ltd’s initial investment for an expansion
project and a replacement project are summarised in Table 6.3.
Table 6.3 Initial investment amounts: Expansion and replacement projects
On the basis of the initial investment amounts calculated above, the
purchase of an additional compressor requires an initial cash
outflow of R132 000. If the entity replaces an old compressor with a
new one, the initial investment amount is a cash outflow of R68 720.
The lower initial investment required for the replacement project is
the result of the after-tax proceeds generated by the sale of the old
compressor and the return of the net working capital required to
support it.
In this section, the focus has been on the initial investment
required at the beginning of a capital investment project. We look at
how to calculate the operating cash flows that result from this initial
investment in a project in Section 6.6.
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QUICK QUIZ
Identify the typical components of an initial
investment for an expansion project and a
replacement project.
Calculating operating cash flows
6.6
After the initial investment has been made in a capital investment
project, a number of cash flows are usually generated over the
project’s lifetime. The major objective of efficient capital budgeting
is to identify those projects in which these cash flows are sufficient
to justify the initial investment.
In most cases, the capital investment represents an investment
in fixed assets that will be used as part of the operating activities of
the entity. By utilising the assets, operating cash flows are usually
generated. This section looks at how to calculate the operating cash
flows of a project.
6.6.1
Operating cash flows of an expansion project
If an entity is considering investing in a project that will result in
the expansion of its activities, the relevant operating cash flows
associated with the expansion need to be determined. Example 6.5
illustrates the method used to calculate the operating cash flow
when an entity expands its operations by investing in a new
machine.
Example 6.5 Calculating operating cash flows for an expansion project
Khoza Ltd is purchasing an additional compressor. Assume that the new
compressor has a useful life of five years and is depreciated over a period of
five years using the straight-line method. Suppose that the profits that will be
generated by the new compressor before interest, depreciation and taxes are
as presented in the table that follows.
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Annual operating cash flows can be calculated by making use of the income
statement format. The table that follows shows the income statement format
for calculating operating cash inflows.
When calculating the operating cash flow, the depreciation on the asset is
subtracted in order to calculate EBIT. Depreciation, which is not a cash flow
item, is included in the calculation above because it can be subtracted for tax
purposes. After the NOPAT figure is calculated, the depreciation is added back
to convert the profit figure to a cash flow figure.
Note that the operating cash flow must be calculated for each year or
period, except in cases where variables such as EBITDA and depreciation
remain constant. In such cases, one pro forma income statement holds for a
number of years. This is not often the case because the impact of inflation
should be integrated into our analysis.
Using the information provided in this example, the annual operating cash
flows for the new compressor are calculated as follows:
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The depreciation amount of R22 000 is calculated by taking the total cost of
the new compressor (R92 000 + R18 000) and dividing it by the expected
lifetime of five years (R110 000 ÷ 5 = R22 000). After the depreciation
amount has been subtracted, the tax can be calculated. By adding back the
depreciation amount, the operating cash flow of the new compressor is
calculated. Thus, the annual operating cash flow generated by the new
compressor amounts to R37 120 for each of the five years that the
compressor will be used.
6.6.2
Operating cash flows of a replacement project
In the case of a replacement project, an asset that is already being
used to generate operating cash flows is usually replaced with
another asset that will be used to generate operating cash flows in
future. Example 6.6 illustrates the method for calculating the
operating cash flows when replacing an old asset with a new one.
Example 6.6 Calculating operating cash flows for a replacement project
Khoza Ltd is purchasing a new compressor to replace an old one. The EBITDA
over the next five years for both the new compressor and the old compressor is
shown in the table that follows.
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The annual after-tax operating cash flows are the incremental after-tax cash
flows that the replacement project will provide. Generally, these cash flows fall
into three categories:
■ incremental savings (positive cash flow) or expenses (negative cash flow)
■ incremental revenue (positive cash flow)
■ the tax savings due to depreciation.
The annual operating cash flow of the old compressor is calculated as shown
in the table that follows.
During years 4 and 5, no depreciation is calculated on the old compressor
because it is fully depreciated by then.
Based on the figures obtained in the calculation of the operating cash flow
for the new compressor in the previous section and the operating cash flows of
the old compressor provided in the table above, the annual incremental cash
flows are calculated as shown in the table that follows.
By replacing the old compressor with the new one, an incremental operating
cash inflow is generated in each of the five years. Usually, an entity would only
consider replacing an old asset if the new asset were able to achieve cost
savings or generate higher incomes. The question, however, is whether the
incremental cash inflows are sufficient to justify the additional investment that
is required to purchase the new compressor. Before this question can be
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answered, it is necessary to calculate the final component of a project’s cash
flow: the terminal cash flow. This is the focus of Section 6.7.
QUICK QUIZ
Explain the different methods used for
calculating the operating cash flows for
expansion projects and replacement projects.
6.7
Calculating the terminal cash flow
The terminal cash flow relates to the end of the project’s lifetime.
The terminal cash flow may have a number of components, but the
three common categories are the estimated salvage value, shutdown costs and the recovery of the investment in net working
capital that was provided for at the beginning of the project’s
lifetime as part of the initial investment.
6.7.1
Terminal cash flow of an expansion project
The terminal cash flow of an expansion project is calculated as
shown in Table 6.4.
Table 6.4 Calculating the terminal cash flow for an expansion project
After-tax proceeds from sale of new asset
xxxx
Proceeds from sale of new asset
xxx
Tax on sale of new asset
xxx
Change in net working capital of new asset
(xxxx)
Terminal cash flow
(xxxx)
Example 6.7, which uses the information provided in Example 6.6,
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illustrates the calculation of the terminal cash flow for the new
compressor.
Example 6.7 Calculating the terminal cash flow for an expansion project
Suppose that, five years from now, the new compressor can be sold for R34
000, and that removal and clean-up costs are R5 000. Khoza Ltd is subject to
a tax rate of 28%. The terminal cash flow of the expansion project is therefore
calculated as follows:
The R22 000 change in net working capital, which was included as a cash
outflow as part of the initial investment calculated in Example 6.3, is recovered
at the end of the project’s lifetime. The reason for this is that the project will be
terminated and the increased investment in net working capital is not required
any more. Consequently, the cash outflow of R22 000 in year 0 is reversed
and a cash inflow of R22 000 is indicated in year 5.
6.7.2
Terminal cash flow of a replacement project
In the case of a replacement project, it is necessary to calculate the
terminal cash flow for the new asset as well as the terminal cash
flow of the existing asset that is being replaced. The incremental
terminal cash flow of a replacement project can be calculated as
shown in Table 6.5.
Table 6.5 Calculating the terminal cash flow of a replacement project
After-tax proceeds from sale of new asset
Proceeds from sale of new asset
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xxxx
xxx
Tax on sale of new asset
xxx
After-tax proceeds from sale of old asset
xxxx
Proceeds from sale of old asset
xxx
Tax on sale of old asset
xxx
Change in net working capital of new asset
xxxx
Change in net working capital of old asset
(xxxx)
Terminal cash flow
(xxxx)
Example 6.8, which uses the information provided in Examples 6.6
and 6.7, illustrates the calculation of the incremental terminal cash
flow for the replacement of the old compressor.
Example 6.8 Calculating the terminal cash flow for a replacement project
Suppose that five years from now, the old compressor has no salvage value,
but the same removal and clean-up cost incurred for the new compressor will
have to be paid. Khoza Ltd is subject to a tax rate of 28%. The incremental
terminal cash flow of the replacement project is therefore calculated as
follows:
Although the old compressor has no salvage value five years from now, the
removal cost is incurred, resulting in a loss of −R5 000 from the termination of
the old compressor. This loss results in a tax benefit of +R1 400. The after-tax
proceeds from the old compressor are therefore −R3 600 (−R5 000 + R1
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400).
The net working capital requirement of the old compressor is also taken
into consideration to reflect the fact that it will not be required any more. Since
the incremental terminal cash flow needs to be calculated for a replacement
project, the cash flows relating to the old compressor are subtracted from
those of the new compressor. This reflects the difference between the cash
flows for the old compressor and the new compressor.
The relevant cash flows of the expansion project and the
replacement project are summarised in Table 6.6.
Table 6.6 Relevant cash flows of the compressor projects for Khoza Ltd
Year
Relevant cash flows for
expansion project
R
Relevant cash flows for
replacement project
R
0
(110 000) + (22 000) = (132 000)
(110 000) + (22 000) + 53 820 + 10 000
= (68 720)
1
37 120
15 040
2
37 120
16 480
3
37 120
17 920
4
37 120
22 720
5
37 120 + 42 880 = 80 000
24 160 + 36 480 = 60 640
If the new compressor were purchased as an expansion project, the
initial investment would be higher than if it were purchased as a
replacement project. The reason for this difference is that the old
compressor can be sold in the case of a replacement project; this sale
generates a cash inflow that reduces the initial investment.
However, the annual operating cash inflows of the expansion
project are higher than in the case of the replacement project. The
reason for this difference is that the replacement project takes the
incremental operating cash flows beyond those generated by the
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existing compressor into account, whereas the expansion project
focuses on the operating cash flows of the new compressor on its
own.
The terminal cash inflow of the expansion project is higher than
that of the replacement project. This can be explained by the fact
that the incremental terminal cash flow of the replacement project is
taken into account in the calculation.
QUICK QUIZ
1. Identify the typical components of a project’s
terminal cash flow.
2. Discuss the difference between the terminal
cash flows for expansion projects and
replacement projects.
6.8
Capital gains tax
When the initial investment and terminal cash flow values were
calculated for most of the previous examples, provision was not
made for capital gains tax (CGT) because all the assets were sold at
prices less than their original cost prices. However, an asset might
be sold for a price in excess of its original purchase price as well as
in excess of its book value. In such a situation, it is important to
note that the transaction will be subject to CGT.
For entities, CGT to be paid is determined by calculating the net
capital gain on a transaction and including an amount determined
by the relevant inclusion rate with the entity’s normal taxable
income. The current inclusion rate of 80% pertaining to entities
came into effect on 1 March 2016 (SARS, 2019).
Example 6.9 illustrates how CGT is calculated on an asset that is
sold for more than its original cost price.
Example 6.9 Calculating capital gains tax
Suppose that Gainer Ltd decides to sell an existing asset for R550 000.
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Assume that the entity had purchased this asset four years previously for R300
000 and that straight-line depreciation was calculated over the expected asset
lifetime of six years. If the tax rate is 28%, the tax implications will be as
follows:
The total profit resulting from the sale of the asset is therefore equal to R450
000 (R550 000 − R100 000). Since the asset was sold for more than the
original cost price, a capital gain of R250 000 was realised (R550 000 − R300
000). For tax purposes, the total profit should therefore be split into the capital
gain of R250 000 and an accounting profit of R200 000 (R450 000 − R250
000).
The tax implication of the transaction is as follows:
This additional tax amount of R112 000 represents a cash outflow. Thus, the
after-tax proceeds from the sale of the asset represent a cash inflow of R438
000 (R550 000 − R112 000).
However, assume that the enterprise can sell the asset for only R40 000.
The total loss on the sale amounts to R60 000 (R40 000 − R100 000). Since
the asset was sold for less than the original cost price, no capital gain was
realised.
The tax implications are as follows:
The tax benefit of R16 800 now represents a cash inflow. The after-tax
proceeds from the sale of the asset represent a cash inflow of R56 800 (R40
000 + R16 800).
QUICK QUIZ
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Distinguish between an accounting profit and a
capital gain.
6.9
Conclusion
In Chapter 5, we discussed a number of investment appraisal
methods. After studying this chapter, you should understand how
the cash flows from investment projects are calculated. The chapter
described how managers should calculate the relevant cash flows of
capital projects. In particular, we discussed the following subjects
and concepts:
• When capital projects are appraised, the focus should be placed
on cash flows and not profit.
• Sunk costs and additional finance costs should not be included
when determining a project’s relevant cash flows.
• By contrast, opportunity costs, inflation and tax should be
included when estimating a project’s relevant cash flows.
• When evaluating capital investment projects, the focus should
be placed on the incremental cash flow that will result from
accepting the project.
• Although the procedure differs slightly when estimating cash
flows for an expansion project and a replacement project, the
cash flow streams of most investment projects can be separated
into three components: the initial investment at the start of the
project, the operating cash flows during the life of the project
and the terminal cash flow at the end of the project.
• In cases where assets are sold for more than their original cost
price, the resulting capital gain is taxable.
In conclusion, you should be aware that the capital budgeting
process plays a major role in evaluating various investment projects
and making decisions about which projects should be implemented
in order to add value to the business. Only those projects that will
generate sufficient cash flows to warrant the initial investment will
result in a positive net present value (NPV) and should be
undertaken.
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The opening case study was about SAA’s decision to replace
some of its older aircraft with newer, more efficient models in 2019.
The rationale behind this decision was that the expected cost
reductions would improve the struggling airline’s financial
situation. As we saw in 2020, this was too little, too late.
The closing case study highlights the importance of constantly
re-evaluating capital budgeting decisions. Any significant
deviations from the estimated cash flows included during the
evaluation of a project’s financial feasibility or major delays in the
time it will take to receive these cash flows could negatively impact
on the long-term sustainability of a project. In the case of Eskom, a
combination of these factors is causing major headaches for South
Africa.
CASE
STUDY
Eskom’s problems with the Medupi and Kusile power stations
When construction started on the Medupi power station in
2007, it was estimated that the new power station would be
operational by the end of 2013 at a total cost of R69,1 billion. A
year later, construction of the Kusile power station
commenced, scheduled to be completed by 2014 at a cost of
R80,6 billion. Once completed, the combined output of the two
power stations would amount to an additional capacity of 9
588 MW, which Eskom intended to use while some of its
existing coal power stations were removed from the grid for
maintenance.
To prevent the national power grid from experiencing
blackouts, many of these ageing power stations – some
constructed in the 1960s and 1970s – have been operating at
maximum capacity, with limited maintenance taking place. As
a result, these power stations are in desperate need of extensive
maintenance to extend their lifetimes and to prevent
unplanned outages.
By the middle of 2019, however, construction on the new
power stations was nowhere near completion. As well as the
construction taking more than twice as long as planned, the
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cost of the two power stations had increased from a total of
R149,7 billion to more than R300 billion at that stage. To make
matters worse, the reliability of the two new power stations
was even less than that of the existing power stations that they
were supposed to replace. In addition to the reduced capacity
of the new power stations, continuous technical problems
caused by design errors and poor workmanship by corrupt
contractors along with coal supply problems, water restrictions
and carbon taxes are all expected to increase the cost of
generating electricity.
Industry experts have voiced their concerns that by the time
it is fully operational, the Kusile power station may not be able
to compete against lower-cost electricity generated by cleaner
and more flexible electricity producers. Despite a call from the
South African Treasury for Eskom to consider selling its coal
power stations to independent electricity providers and using
the proceeds to reduce its enormous debt of more than R450
billion, the entity has indicated that construction will continue
until the two new power stations are fully operational and
contributing to its electricity-generating capacity. Until then,
the rest of the country will remain in the dark about whether
Eskom can survive this fiasco.
Sources: Compiled from information in Caboz, 2019; Donnelly, 2019; Yelland, 2019; Khumalo, 2019;
Naidoo, 2019.
As we saw in 2020, this was too little, too late.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
A merger transaction between two entities could be considered as an example
of a __________.
A. replacement
B. expansion
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C.
D.
renewal
divestment
2.
When evaluating the initial investment for a replacement project …
A. only the increase in net working capital associated with the new asset is
relevant.
B. the increases in net working capital associated with the new asset and
the existing asset are both considered to be cash outflows.
C. the increases in net working capital associated with the new asset and
the existing asset are both considered to be cash inflows.
D. only the difference between the net working capital associated with the
new asset and the existing asset is relevant.
3.
Estate duties paid on the purchase of a piece of land that is now considered as
part of a future expansion project would be classified as …
A. incremental historical costs.
B. incremental past expense.
C. opportunity costs forgone.
D. sunk costs.
4.
An increase in an entity’s operating expenses that resulted from a delay in the
construction of a new factory would be classified as …
A. incremental costs.
B. lost resale opportunities.
C. opportunity costs.
D. sunk costs.
5.
Increased production efficiency resulting from a replacement project would
most probably be reflected by …
A. an increase in overall operating cash outflows.
B. a decrease in the initial investment required.
C. incremental operating cash outflows.
D. positive incremental operating cash flows.
6.
When calculating the annual operating cash flow, which item should NOT be
considered?
A. Revenue
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B.
C.
D.
Depreciation
Taxation
Finance cost
INTERMEDIATE
7.
WP Manufacturers Ltd purchased a machine with a cost price of R100 000
(excluding VAT) three years ago. Delivery and installation costs were R35 000.
The machine’s economic lifetime was estimated at five years and straight-line
depreciation was calculated over this period. If the machine were to be sold
now, its book value would be __________.
A. R50 000
B. R54 400
C. R60 000
D. R150 000
8.
Mvelalela Ltd is considering replacing one of its existing machines with a new
machine. As a result of the replacement, it is expected that accounts receivable
will increase from R40 000 to R65 000, inventory will decrease from R60 000
to R15 000, accounts payable will increase from R40 000 to R50 000 and
deferred tax will increase from R100 000 to R250 000. The project’s initial
investment should reflect a change in net working capital that resulted in a …
A. negative cash flow of R30 000.
B. positive cash flow of R30 000.
C. negative cash flow of R60 000.
D. positive cash flow of R60 000.
9.
GardenCo Ltd is selling a machine for R45 000. The machine was purchased
and imported one year ago at a total cost of R40 000, and straight-line
depreciation is provided over its expected economic lifetime of four years.
Assume a tax rate of 28% and that all capital gains are taxable. The cash flow
effect of this transaction will be more or less equal to __________.
A. −R4 200
B. +R40 800
C. +R41 080
D. +R45 000
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ADVANCED
Use the information that follows to answer Questions 10 to 15.
Mumpamumpa Ltd is considering purchasing a new machine to replace an existing
one. The existing machine was purchased three years ago at a cost of R180 000
(including VAT), and transport and installation costs were R70 000. It was subject to
straight-line depreciation calculated over its expected economic lifetime of five years.
The new machine will cost R300 000 (excluding VAT and transport and delivery
costs of R5 000). The existing machine can currently be sold for R175 000, with
removal costs of R5 000. If the existing machine is used until the end of its
economic lifetime of five years, its expected scrap value is negligible; removal costs
of R4 000 will, however, have to be incurred to remove it from the factory.
The new machine has a useful life of five years and is depreciated over this
period using the straight-line method. It is expected that two years from now, the
new machine can be sold for R380 000 before tax, with removal costs of R10 000.
The entity is subject to a tax rate of 28% and all capital gains are taxable at the
standard rate. Replacing the existing machine with the new machine is expected to
increase the entity’s annual earnings before interest, taxes and depreciation by R50
000.
To support the extra business resulting from the purchase of the new machine,
accounts receivable will increase from R35 000 to R65 000, inventory will increase
from R15 000 to R30 000, and accounts payable will increase from R30 000 to R35
000.
10. The after-tax proceeds from the sale of the existing machine are now
__________.
A. R50 400
B. R150 400
C. R154 000
D. R175 000
11. The net working capital associated with the existing machine is __________.
A. R20 000
B. R40 000
C. R60 000
D. R80 000
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12. The initial investment of the replacement transaction is now __________.
A. −R197 600
B. −R239 600
C. −R259 600
D. −R410 000
13. The operating cash flow of the replacement transaction is __________.
A. R21 600
B. R41 600
C. R50 000
D. R55 600
14. The after-tax proceeds from the sale of the new machine two years from now
is __________.
A. R325 200
B. R326 320
C. R329 120
D. R332 400
15. The terminal value of the replacement transaction two years from now is
__________.
A. +R363 070
B. +R364 190
C. +R367 070
D. +R369 200
LONGER QUESTIONS
BASIC
1.
Speedpost Ltd is considering purchasing a new delivery vehicle at a total cost
of R100 000 to replace a fully depreciated delivery vehicle that is expected to
last for five more years. The new delivery vehicle is expected to have a fiveyear life and straight-line depreciation will be provided over this period. The
entity estimates the revenues and expenses (excluding depreciation and
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finance cost) for the new delivery vehicle and the old delivery vehicle will be as
shown in the table that follows. The business is subject to a tax rate of 28%.
a)
b)
Calculate the operating cash flows associated with each delivery vehicle.
Calculate the incremental operating cash flows resulting from the
proposed replacement.
INTERMEDIATE
2.
Masstransport Ltd is considering replacing its existing truck with a newer, more
fuel-efficient truck. Two alternatives are available: a Mercados or a Foord. The
existing truck, a Toyetu, was purchased three years ago at a total cost of R160
000 and is being depreciated on a straight-line basis over eight years. The
Toyetu has a remaining economic lifetime of five years.
The new Mercados truck costs R195 000 plus R5 000 licensing fees. It
has a five-year economic lifetime, over which straight-line depreciation will be
calculated.
The new Foord truck will cost R210 000 plus R15 000 licensing fees. It
has an economic lifetime of five years. Straight-line depreciation will also be
calculated over its economic lifetime. The replacement transaction would
require R10 000 additional working capital for the Mercados and R20 000 for
the Foord. The projected earnings before interest, taxes and depreciation for
the alternatives are provided in the table that follows.
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The existing Toyetu truck can be sold today for R50 000, while its expected sales
price five years from now will be zero. Five years from now, the Mercados truck can
be sold for R210 000 and the Foord truck for R190 000. Assume a tax rate of 28%
and that capital gains are taxable at the standard rate. For each of the two
replacement alternatives, calculate the following:
a) The initial investment
b) The operating cash flows
c) The terminal cash flow.
ADVANCED
3.
Industro Ltd is evaluating the expansion of its production capacity by
constructing a new factory. The factory will be built on a piece of land that the
entity purchased ten years ago for R800 000. A property valuation conducted
recently at a cost of R10 000 indicated that the current fair value of the land is
R1 000 000. The construction of the factory will cost R800 000 in total.
Special equipment with a cost price of R180 000 plus R20 000 for installation
costs is required. The entity calculates depreciation based on the straight-line
approach. No depreciation is provided on the land, while buildings are
depreciated over a period of 20 years. Equipment is depreciated over a period
of five years. Five years from now, the entity will sell the land, factory and
equipment for a total of R1,2 million (before tax). The net working capital
requirement of the new factory is R45 000.
A sales forecast indicated that the products manufactured in the new
factory will generate additional earnings before finance cost, depreciation and
taxes to the value set out in the table that follows.
Year
EBITDA
R
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1
15 000
2
30 000
3
60 000
4
50 000
5
20 000
Assuming that the corporate tax rate is 28% and that capital gains tax can be
ignored, calculate the following:
a) The initial investment required for the new factory
b) The expected incremental annual operating cash flows resulting from the
new factory
c) The terminal value of the project at the end of the five-year project
lifetime.
4.
Anzac Enterprise is considering the purchase of a new modern machine to
replace an existing machine with mechanical defects. The existing machine
was originally purchased two years ago for R300 000. The machine was
depreciated using the straight-line method over a period of four years and has
a usable life of three years. The current machine can be sold for R200 000
after removal and cleaning costs. The new machine can be purchased at a
price of R500 000 and straight-line depreciation will be calculated over a
period of three years. The new machine requires installation at a cost of R100
000 and has a usable life of three years. If the new machine is purchased, the
following is expected to happen:
■ a rise in investment in trade receivables by R40 000
■ an increase in the inventory investment of R60 000
■ an increase of R25 000 in trade and other payables.
All working capital will be recouped at the end of the project’s life. Earnings
before depreciation, interest and taxes are expected to be R350 000 for each
of the next three years with the old machine, and R600 000 in the first year
and R650 000 in the second and third years with the new machine. The
market value of the old machine will be zero at the end of three years and the
new machine could be sold for R150 000 before taxes. If the entity’s tax rate is
28%, calculate the following:
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a)
b)
c)
The initial investment associated with the proposed replacement decision
The incremental operating cash inflows for years 1 to 3 associated with
the proposed replacement
The terminal cash flow associated with the proposed replacement
decision.
KEY CONCEPTS
Conventional cash flow: Initial cash outflow followed by a series of
cash inflows.
Incremental cash flows: The expected additional cash flows that result
from accepting a proposed capital expenditure.
Initial investment: The initial cash required to pay for a proposed
project at the beginning of its lifetime.
Operating cash flows: Periodic cash flows occurring throughout a
project’s lifetime that result from the initial cash investment,
excluding the terminal cash flow.
Opportunity cost: The most valuable alternative that is forgone if a
particular investment is undertaken.
Sunk cost: A cost that has already been incurred, cannot be reversed
and does not affect the relevant cash flow of a potential
investment.
Terminal cash flow: After-tax net cash flow associated with the
termination of a project.
Unconventional cash flow: Initial cash outflow followed by a series of
inflows and outflows.
SLEUTELKONSEPTE
Aanvanklike investering: Die aanvanklike netto kontant investering
wat vereis word deur ’n voorgestelde projek aan die begin van
die projekleeftyd.
Bedryfskontantvloei: Periodieke kontantvloei versprei oor die
projekleeftyd wat plaasvind na aanleiding van die aanvanklike
investering, maar wat nie die terminale kontantvloei insluit nie.
Geleentheidskoste: Die mees waardevolle alternatief wat verbeur
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word indien ’n spesifieke investering aangegaan word.
Inkrementele kontantvloei: Die verwagte addisionele kontantvloei wat
die resultaat is van ’n voorgestelde kapitaalinvestering.
Konvensionele kontantvloei: ’n Aanvanklike kontantuitvloei, gevolg
deur ’n reeks kontantinvloeie.
Onkonvensionele kontantvloei: ’n Aanvanklike kontantvloei gevolg
deur ’n reeks kontantinvloeie en -uitvloeie.
Terminale kontantvloei: Die na-belaste netto kontantvloei verbonde
aan die beëindiging van ’n projek.
Versonke koste: ’n Koste wat alreeds aangegaan is en wat nie
verwyder kan word nie, en wat dus nie die relevante
kontantvloei van die huidige investeringsbesluit beïnvloed nie.
SUMMARY OF FORMULAE USED IN THIS CHAPTER
WEB RESOURCES
https://www.flysaa.com/za/en/footerlinks/aboutUs/financialResults.html
http://www.sars.gov.za/TaxTypes/CGT/Pages/default.aspx
REFERENCES
Caboz, J. (2019). Treasury wants Eskom to sell its coal stations these companies could be interested. Business Insider. Retrieved
from https://www.businessinsider.co.za/treasury-wantseskom-to-sell-its-coal-stations-2019-8 [4 December 2019].
Donnelly, L. (2019). Medupi and Kusile: Costly and faulty. Mail &
Guardian. Retrieved from https://mg.co.za/article/2019-02-1500-medupi-and-kusile-costly-and-faulty [4 December 2019].
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Eiselin, S. (2019). South African Airways leases two A350 aircraft.
aeroTELEGRAPH. Retrieved from
https://www.aerotelegraph.com/en/south-african-airwaysleases-two-a350-aircraft
[3 December 2019].
International Monetary Fund (IMF). (2020). World economic outlook,
April 2020: The great lockdown. Retrieved from
https://www.imf.org/en/Publications/WEO/Issues/2020/04/14/weoapril-2020 [18 May 2020].
Investing.com. (2020a). Bovespa (BVSP). Retrieved from
https://za.investing.com/indices/bovespa-historical-data?
end_date=1589879165&st_date=1577836800 [18 May 2020].
Investing.com. (2020b). CAC 40 (FCHI). Retrieved from
https://za.investing.com/indices/france-40-historical-data?
end_date=1589880343&st_date=1577836800 [18 May 2020].
Investing.com. (2020c). DAX (DE30). Retrieved from
https://za.investing.com/indices/germany-30-historical-data?
end_date=1589880041&st_date=1577836800 [18 May 2020].
Investing.com. (2020d). Dow Jones Industrial Average (DJI). Retrieved
from https://za.investing.com/indices/us-30-historical-data?
end_date=1589879885&st_date=1577836800 [18 May 2020].
Investing.com. (2020e). FTSE 100 (UK100). Retrieved from
https://za.investing.com/indices/uk-100-historical-data?
end_date=1589880227&st_date=1577836800 [18 May 2020].
Investing.com. (2020f). KOSPI (KS11). Retrieved from
https://za.investing.com/indices/kospi-historical-data?
end_date=1589880663&st_date=1577836800 [18 May 2020].
Investing.com. (2020g). Nikkei 225 (JP225). Retrieved from
https://za.investing.com/indices/japan-ni225-historical-data?
end_date=1589880534&st_date=1577836800 [18 May 2020].
Investing.com. (2020h). South Africa Top 40 (SA40). Retrieved from
https://za.investing.com/indices/ftse-jse-top-40-historicaldata?end_date=1589879566&st_date=1577836800 [18 May 2020].
Khumalo, S. (2019). Eskom’s Medupi and Kusile to cost R36bn to
complete, will not be halted — Mabuza. Mail & Guardian.
Retrieved from https://mg.co.za/article/2019-04-04-eskomsmedupi-and-kusile-to-cost-r36bn-to-complete-will-not-be******ebook converter DEMO Watermarks*******
halted-mabuza
[4 December 2019].
Mahlakoana, T. (2019). SAA acquires new state-of-the-art aircraft in
its fleet. Eyewitness News. Retrieved from
https://ewn.co.za/2019/06/30/saa-acquires-new-state-of-theart-aircraft-in-its-fleet [3 December 2019].
Naidoo, P. (2019). Eskom Shoots Down South African Treasury’s
Power Plant Sale Plan. Bloomberg. Retrieved from
https://www.bloomberg.com/news/articles/2019-0829/eskom-shoots-down-south-african-treasury-s-power-plantsale-plan [4 December 2019].
South African Airways (SAA). (2017). Integrated Report 2017.
Retrieved from https://www.flysaa.com/about-us/leadingcarrier/media-center/financial-results [3 December 2019].
South African Reserve Bank (SARB). (n.d.). Quarterly Bulletin.
South African Revenue Service (SARS). (2019). Guide for tax
rates/duties/levies. (Issue 14). Retrieved from
https://www.sars.gov.za/AllDocs/OpsDocs/Guides/LAPDGen-G02%20%20Guide%20for%20Tax%20Rates%20Duties%20Levies.pdf [4
December 2019].
XPLAIND. (n.d.). Incremental cash flows. Retrieved from
https://xplaind.com/174931/incremental-cash-flows [19 May
2020].
Yahoo! Finance. (2020a). HANG SENG INDEX (^HSI). Retrieved
from https://finance.yahoo.com/quote/%5EHSI/history?
p=%5EHSI [18 May 2020].
Yahoo! Finance. (2020b). NASDAQ 100 (^NDX). Retrieved from
https://finance.yahoo.com/quote/%5ENDX/history/?
guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&gu
-xcxBmKUb0WBFbYxMkkAwVooi90YzqC3fcBfP_qm8QMGtpIHiZmQDeR3r7efcoWckIjaRe8O6oLoMrFD_vrlcAR19_CVkLgwXshNzU3H7HbdWeMCSYhxgo5h5
[18 May 2020].
Yahoo! Finance. (2020c). S&P 500 (^GSPC). Retrieved from
https://finance.yahoo.com/quote/%5EGSPC/history?
p=%5EGSPC [18 May 2020].
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Yelland, C. (2019). The crisis at Kusile and Medupi continues ….
Moneyweb. Retrieved from
https://www.moneyweb.co.za/news/south-africa/the-crisisat-kusile-and-medupi-continues/ [4 December 2019].
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7 Appraising investment risk
Elda du Toit and Sam Ngwenya
Learning
outcomes
Chapter
outline
7.1
7.2
7.3
7.4
7.5
7.6
7.7
CASE STUDY
By the end of this chapter, you should be able to:
understand the importance of recognising risk in
investment appraisal
identify the various types of risk involved in
investment projects
discuss the use of probability distributions and
expected values in risk assessment
discuss and apply scenario analysis, sensitivity
analysis and simulation analysis in investment
projects
apply break-even analysis as a measure of
dealing with risk.
Introduction
What are uncertainty and risk, and why do
they need to be assessed?
Types of risk in investment projects
Probability distributions and expected values
Using scenario analysis, sensitivity analysis
and simulation analysis to assess risk
Break-even analysis as a measure of dealing
with risk
Conclusion
Shoprite: Provider of affordable goods in South Africa
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The Shoprite Group of Companies started from small
beginnings in 1979 with the purchase of a chain of eight
supermarkets in the Western Cape for R1 million. The next 30
years were marked by various acquisitions and innovative
expansion strategies that made Shoprite into the R72-billion
business that it is today.
In 1983, the group opened its first branch outside the
Western Cape in Hartswater, in the Northern Cape. At the end
of that year, Shoprite opened its 21st outlet, in Worcester, and
celebrated an increase in turnover of almost 600% over the four
years of its existence. A year later, Shoprite accelerated its
growth by buying six food stores from Ackermans. In 1986, the
group expanded to the Free State, opening a store in
Bloemfontein. Shoprite was listed on the Johannesburg Stock
Exchange (‘the JSE’) with a market capitalisation of R29
million. At that point, it owned 33 outlets. Two years later,
Shoprite ventured over the Vaal River and opened two stores
in Limpopo province, the first of which was in Polokwane.
These acquisitions and expansions continued throughout
the 1990s and into the new millennium. While consolidating its
new business, which for the first time gave Shoprite
countrywide representation, the group also put expansion
plans for the rest of the continent and into Mauritius into
action.
In 2004, Shoprite started moving further afield, trading as a
wholesale operation in India. It franchised its first Shoprite
Hyper in a modern shopping centre in Mumbai. In 2005, the
group acquired both Foodworld, with 13 stores, and
Computicket, and opened its first Shoprite Liquor Shop. In
December 2005, Shoprite entered the Nigerian market when it
opened a supermarket in a new shopping centre in Lagos. In
2006, the group stopped trading in Egypt owing to ongoing
restrictions on retailing. Its seven stores were closed, resulting
in a loss of R19,9 million.
In December 2007, Shoprite announced an investment of
US$80 million in the Democratic Republic of Congo for the
development of two world-class supermarkets in Lubumbashi
and Kinshasa.
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By 2008, the group was added to the JSE Top 40 Index of
blue-chip entities. It became South Africa’s largest grocery
chain by market value in 2009, when it acquired Transpharm.
In March 2011, the group acquired the franchise division of
Metcash, which includes trade names such as Friendly, Seven
Eleven and Price Club Discount Supermarket. In April 2012,
Shoprite became the first South African retailer to enter the
Democratic Republic of Congo (DRC) when it opened the
doors of a new world-class supermarket in Gombe, Kinshasa to
an eagerly awaiting public.
Most important in the South African landscape, the group
created a record number of 9 201 job opportunities during 2013.
It also introduced the first shopping bag manufactured from
recycled plastic.
By June 2016, approximately 76% of South Africa’s total
adult population (in excess of 29 million customers) indicated
they shop at one of the group’s supermarket brands. During
this year, the group had a record one billion transactions in a
single year (equal to 86 customers served per second).
In worsening economic conditions, the group was able to
increase total turnover by 3,1% to R145,3 billion in the financial
year ending 1 July 2018. Positive volume growth of 2,7% with a
3,3% increase in customer numbers as well as local market
share gains reflect the group’s excellent performance.
In December 2018, the Shoprite Group opened its first
Shoprite supermarket in Kenya. The new store in Westgate
Mall, Nairobi provided for the creation of more than 200 new
job opportunities for people from the local community.
Based on revenue, Shoprite emerged as the biggest South
African retailer in the 2019 Deloitte Global Powers of Retail
Report, which ranks the 250 biggest retail groups across the
world. It is the only South African retailer to be listed in the top
100 and is placed 86th in the world.
Today, the Shoprite Group trades with 2 738 outlets in 15
countries across Africa and the Indian Ocean islands,
employing more than 146 000 people.
The various investments that Shoprite has made in order to
expand its business all carry some form of risk for the entity. In
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addition, it continues to take risks on a daily basis, including
the following:
• the risks associated with launching operations in a
politically unstable country
• the risks associated with taking on too much debt
• the risks associated with natural disasters that could
potentially destroy some of its fixed assets.
These risks and their likelihood of occurring need to be
managed to ensure that the entity is able to cope with
unfavourable events without becoming debilitated.
Source: Adapted from Shoprite Holdings Ltd, 2019.
7.1
Introduction
The case study on the history of Shoprite shows that entities that
wish to expand are often faced with capital investment decisions,
which may, at times, carry a high level of risk. Risk can arise from
various events or circumstances that may have an impact on the
success of an investment. This is especially the case when
investments are made in entities or projects in foreign countries.
These investments pose different challenges from those that are
made locally. We discuss these challenges in more detail later in the
chapter.
For the sake of simplicity, we did not take risk into
consideration when evaluating capital investment projects in
Chapter 5. However, since capital investment decisions are about
the future and the future is uncertain, these projects are subject to
risk. Thus it is essential to take risks into account in order to make
effective financial and investment decisions.
In this chapter, we examine the impact of risk and the
uncertainties associated with capital investment decisions. Because
investment decisions are usually based on long-term predictions of
financial, technological and other relevant factors, management
should consider risk and uncertainty when these decisions are
made. We discuss various methods that incorporate risk into the
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evaluation of capital investment decisions in this chapter, including
probability distributions, expected values, scenario analysis,
sensitivity analysis, simulation analysis and break-even analysis.
7.2
What are uncertainty and risk, and why do they
need to be assessed?
One can never be entirely sure what the future will hold. However,
with thorough planning, and by assessing and evaluating potential
outcomes, it is possible to anticipate the chances that a project or
investment will not turn out as expected. All investment decisions
have some element of uncertainty, but it is possible to reduce the
likelihood of an unfavourable outcome.
7.2.1
Uncertainty and risk
Certainty can be defined as a state where there is no doubt about
something. Uncertainty is the converse: one does not know which
events or factors will influence the success of a project and, because
of this, one cannot attach probabilities to the occurrence of possible
events.
When it comes to capital projects, as discussed in Chapter 5,
certainty implies that the decision maker has complete prior
knowledge of all events that might affect a decision, such as the life
of a particular project, the extent of cash flows and the times at
which they will occur, the terminal value of the project,
technological considerations, operational interruptions and the
discount rate. The investment appraisal methods introduced in
Chapter 5 assume an environment of certainty. The relevant cash
flows of all projects were assumed to have the same risk level as the
entity. In practice, however, such an environment is rare. The cash
flows associated with different projects usually have different levels
of risk, and the acceptance of a project generally affects the entity’s
overall risk level.
Risk is therefore encountered when there is the possibility of
incurring a loss or experiencing misfortune because of uncertainty
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about the future. Consider the example of an individual who
purchases shares in an entity as an investment. Due to a world
economic slowdown, there is uncertainty about the future
profitability of the entity in which the individual has invested.
Consequently, there is the risk that the investment will not deliver
the desired returns. Even though analysts make predictions, the
future is still inherently uncertain and there is, therefore, a chance –
or risk – that estimates concerning future returns in an investment
are not accurate.
A term that is often used where project or investment risk is
involved is ‘probability’. Probability refers to the likelihood that a
particular event will occur. It is expressed either as a percentage or
as a decimal value. An outcome that is absolutely certain will have
a probability of 100% or 1,0. To illustrate probability, take the
example of an entity that has the opportunity to invest in a newly
established organisation. Analysts believe that uncertainty in the
marketplace means there is a 50% chance that the new organisation
will make a loss in the first year and a 50% chance that it will be
extremely profitable.
Probability also highlights the difference between uncertainty
and risk. Although uncertainty and risk are often used
interchangeably, strictly speaking they are not the same concepts.
Risk is when there is more than one possible outcome for a project,
but when the probabilities of the outcomes are known. Uncertainty
is when there are also several different outcomes, but the
probabilities are unknown. Therefore, by estimating the
probabilities of different outcomes (and by applying other
principles of risk management), we change an uncertainty into a
manageable risk.
7.2.2
Risk versus return
If an entity invests money in a project or makes an investment, it is
with the aim of generating some sort of return (in other words,
getting something back from the investment). The percentage
return from an investment can be calculated using the following
formula:
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Where:
rt = percentage return over period t − 1 to t
Ct = cash expected to be received over period t − 1 to t
Pt = price or value of the investment at the end of the investment
period, time t
Pt − 1 = price or value of the start of the investment period, at time t
−1
Example 7.1 Calculating return on investment
Beta Ltd has purchased shares in Charlie Ltd as an investment. Financial
analysts predicted that Charlie Ltd will do very well and that Beta Ltd will
generate a healthy return from the investment. At the end of the first year, the
board of directors wants to know what percentage return the investment is
generating. The entity’s required rate of return is 15% on similar investments,
and the board wants to make sure it is worth holding onto the investment.
The investment originally cost Beta Ltd R1 500 000 and Beta Ltd received
R40 000 in dividends at the end of the first year. Based on market values, the
investment is now worth R1 700 000.
The percentage return from the investment can be calculated as follows
(using Formula 7.1):
This means that Beta Ltd is earning a 16% return on the investment. Given the
required rate of return of 15% that the entity expects from its investments, the
return is acceptable.
In addition to the return earned from an investment (as calculated
above), the risk attached to the investment should also be taken into
account. If any unfavourable financial or economic conditions arose
unexpectedly, the entity might lose the return it aimed for, or, in the
worst-case scenario, even the original investment. Thus, it is good
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practice to evaluate whether any uncertainties surround the
proposed investment and the probability of those uncertainties
becoming reality.
Different types of investment carry different types of risk. Each
investment, therefore, needs to be assessed individually for the
risks that may result in a loss in the value of that investment. For
example, an investment in corn is exposed to the risk of natural
disasters, such as drought or hail, which could result in a loss. Even
if a proposed investment appears to promise a particular return, the
risk of not earning a return or perhaps even losing the original
investment should still be taken into account. Only then is it
possible to decide if it is worth accepting the investment.
7.2.3
Approaches to risk in investment appraisal
Risk tolerance refers to the amount of risk an entity is willing to
take when making an investment. It is very much entity-specific,
and is based on the perceptions of management and the financial
position of the entity. Usually an individual or entity is willing to
accept more risk if a greater return can be expected.
Risk tolerance can be divided into the following three categories:
• Risk-averse investors prefer to avoid risk and will not accept
higher risk unless the returns are disproportionately higher to
compensate them for taking on more risk.
• Risk seekers are willing to take on more risk even if the expected
returns are not proportionately higher.
• Risk-neutral investors expect a proportionate increase or
decrease in return for accepting an increase or decrease in risk.
Risk tolerance is illustrated graphically in Figure 7.1.
Figure 7.1 Levels of risk tolerance
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If it is the case that the uncertainties associated with an investment
are plentiful or the potential loss is significant, it may be best not to
make the investment. Table 7.1 is a risk-rating scale, which is a
useful measure to determine whether or not a project should be
considered on the basis of the level of risk an entity is willing to
accept.
Table 7.1 Risk-rating scale
Source: Created by author Du Toit.
Let us illustrate the risk-rating scale with an example: consider the
case of an entity that has the opportunity to invest in a project that
is greatly affected by the weather. Research has established that the
risk severity of the effect an adverse weather change may have is
moderate and the likelihood that the weather will turn for the
worse is probable. According to the matrix in Table 7.1, the risk
rating for the investment is high. The entity will make a decision on
whether or not to accept the investment based on its risk-tolerance
levels.
QUICK QUIZ
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1. Explain the concepts of uncertainty and risk
in terms of financial investments to a family
member or friend who has little knowledge of
finance.
2. The risk-rating scale can be applied to any
area of risk one has to evaluate. Identify an
area of risk you face regularly (for example,
being in a motor-vehicle accident) and use the
scale to give the risk a rating.
7.3
Types of risk in investment projects
There are various types of risk that an entity may need to consider
when making a decision about investments. Not all the risks listed
here are applicable to all entities. Individual entities need to
evaluate which risk categories apply to them.
The elementary risks (in other words, those that may affect all
entities or investments) are called systematic and unsystematic risk.
Systematic risk is basic market risk. This type of risk arises
because of economic changes or other events that affect large
portions of the market. An example is a political event that may
adversely affect several of the assets in an investor’s portfolio. It is
extremely difficult to find protection against systematic risk. It is,
however, possible to hedge (avoid) this type of risk by using the
derivatives market. Hedging is a technique designed to eliminate or
reduce risk. A derivative is a financial instrument with a value that
is derived from some other asset, event, value or condition (known
as the underlying asset).
Unsystematic risk is more specific than systematic risk and is,
therefore, often called specific risk. Unsystematic risk affects fewer
investments at the same time. For example, a fire that destroys a
factory affects the entity to which the factory belongs and its profits
for the financial year. This type of risk is more centralised.
In addition to elementary types of risk, there are several other
categories of risk:
• Business risk is the risk that an entity may not be able to finance
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•
•
•
•
•
•
•
•
•
•
its operating costs due to insufficient cash flow, for example.
Business risk arises from the operating activities of the
company.
Financial risk is the risk that an entity may not be able to cover
its debt obligations. This type of risk may arise from its financial
policy (in other words, the use of debt in its capital structure).
Interest-rate risk is the risk that interest-rate changes may affect
the value of an investment adversely. If an asset is financed by
means of a loan, an increase in interest rates typically leads to a
higher financing cost, resulting in the asset yielding lower
returns.
Liquidity risk is the risk that an investment cannot be sold at a
reasonable price.
Market risk refers to the risk that market factors unrelated to the
investment (for example, political, economic or social factors)
may adversely affect the value of an investment. Market risk
may also be classified as systematic risk.
Event risk is the possibility that an unexpected event may have
an effect on an entity and/or an investment.
Exchange-rate risk is the risk that an investment and/or return
on investment may be negatively affected by fluctuations in the
exchange rate. If a South African company imports products
from the United States, for example, a depreciation of the rand
against the US dollar means the imported products become
costlier, leading to lower returns.
Purchasing-power risk relates to the possibility that changes in
price levels caused by inflation may affect investments and/or
investment returns.
Tax risk is the possibility that unfavourable changes in tax laws
may affect an investment and/or the returns on an investment.
Credit or default risk refers to the risk that an entity or
individual may not be able to pay the returns due on an
investment or, in the worst case, pay back the amount originally
invested.
Country risk refers to the risk that political and/or financial
events in a country may affect the worth of an investment or the
returns on an investment in that country.
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It is advisable to go through the list of possible types of risk and
establish which are likely to affect the value of a particular
investment and the returns that can be expected. Based on the
investor’s risk-tolerance levels, a decision can then be made
whether or not it is worthwhile making the investment.
QUICK QUIZ
Refer to the case study about Shoprite at the
beginning of this chapter and establish which of
the risks listed above apply to the company.
Explain your reasoning. (Hint: Think of the
activities in which the company engages and
compile the list accordingly.)
7.4
Probability distributions and expected values
When an entity has the opportunity to invest in a new project, some
analysis about the project has to be done beforehand. In some cases,
depending on the size and cost of the proposed investment, the
help of experts can be commissioned. By analysing a number of
variables, it is possible to determine what possible outcomes can be
expected. From these possible outcomes, the general risk attached
to an investment can be assessed.
7.4.1
Probability distribution
A detailed discussion of probability distribution is beyond the
scope of this chapter. However, to understand the principles of
working with probabilities, it is necessary to be familiar with the
basic concept.
Probability distribution is a statistical technique that establishes
the likely outcome of an uncertain event. Probability distribution is
shown in the form of a table or equation that links each possible
outcome of an event to the relevant probability of that outcome
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being the result. For example, say that an entity shows the
probabilities in Table 7.2 for achieving three levels of return.
Table 7.2 Example of probabilities attached to the expected returns of an investment
Outcome
Probability
Return
Optimistic
30%
18%
Most likely
40%
12%
Pessimistic
30%
6%
100%
This means there is a 30% chance that the investment will make a
return of 18%, a 40% chance that it will make a 12% return and a
30% chance that it will make a 6% return. Note that the probabilities
always add up to 100% or 1,0.
Example 7.2 illustrates how probability distributions can be
used to assess risk.
Example 7.2 Using probability distributions to assess risk
An entity has the opportunity to invest in one of two possible investments. Each
investment costs R100 000. Financial analysts predict the possible outcomes
for the two investments set out in the table that follows.
The probability distribution of the two investments (with the same probabilities
of 30%, 40% and 30%) can be illustrated in a bar graph, as follows:
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Probability distributions are most often presented as a bell curve, as follows:
From the bell curves shown above, one can see that even though both
investments have the same probability (40%) of a 10% return, Investment A is
riskier than Investment B. This is because Investment A has a greater range
(distribution) of possible outcomes. This range can also be calculated by
subtracting the most optimistic outcome from the most pessimistic outcome,
as shown in the table that follows.
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7.4.2
Expected value
One of the simplest ways of evaluating whether a project will add
value to an entity is by using probabilities to calculate the expected
value of the project. The expected value is an average of the
possible outcomes, weighted by the probability of the outcomes
actually occurring.
The expected value of a project can be calculated using the
following formula:
Where:
r = the expected (average) return
rj = the return for the jth outcome
Prj = the probability of occurrence for the jth outcome
n = the number of outcomes considered to calculate an expected
value
Example 7.3 Determining expected value
Joy Ltd has commissioned a market research report about a new product that
the company plans to launch in the near future. At best, the company expects
to sell 200 000 units of product. The market expert has prepared the table of
probable outcomes that follows.
Using the formula for calculating expected values
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This means that the entity can expect to sell an average of 137 500 units of
product. At best, it would sell 200 000 units and at worst, 25 000. This is the
most basic method of evaluating whether it is worthwhile taking on a project,
taking the company’s risk-tolerance levels into account.
QUICK QUIZ
Calculate the expected values for Investments A
and B in the probability analysis (refer to
Example 7.2).
FOCUS ON ETHICS: Financial
statement fraud
In 2018, the Association of Certified Fraud Examiners (ACFE) reported
that financial statement fraud costs stakeholders (for example,
investors, creditors, pensioners and employees) significant amounts,
as it is the most costly fraud. Stakeholders in entities expect strong
corporate governance processes in these organisations to ensure the
integrity, transparency and quality of financial information. Financial
statement fraud is a threat to stakeholders’ confidence in an entity’s
published statements. This is especially the case in South Africa after
Steinhoff International Holdings NV was found to have committed
financial statement fraud.
Source: Compiled from information in ACFE, 2020; Naudé, Hamilton, Ungerer, Malan & De
Klerk, 2018.
QUESTIONS
1. If the financial statements of an entity are extremely
unfavourable and a financial manager has a personal
interest (such as a management bonus) at stake, it is
possible that the manager might ‘adjust’ these numbers to
ensure an optimistic view is presented to stakeholders.
What repercussions could this have on the stakeholders of
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2.
7.5
the company?
What ethical issues do you think are raised by the example
of Steinhoff? Could this be seen as irregular behaviour on
the part of the entity? If so, why?
Using scenario analysis, sensitivity analysis and
simulation analysis to assess risk
In general, the value of a capital investment project will most
probably be estimated using discounted cash flow methods. The
investment opportunity yielding the highest value as measured by
the resultant net present value (NPV), for example, will be selected.
The main challenge encountered when working with capital
investment projects is knowing how reliable the NPV estimate is, as
the reliability of the NPV estimate depends on the following factors:
• Projected versus actual cash flows. NPV estimates are made
before the project is undertaken in order to decide if it should be
undertaken. Estimated cash flows are based on a distribution of
possible outcomes in each period. Specifically, each future cash
flow is a probability-weighted average of possible cash flows for
that future period. After the cash flows have occurred, the actual
(or realised) NPV may turn out to be less favourable than the
estimated NPV.
• Forecasting risk (that is, estimated risk). There is always the
possibility of making a bad investment decision because of
errors in the original cash flow projections. This means that a
project that would have realised an NPV > 0 may be rejected or
a project that turns out to realise an NPV < 0 may be accepted.
• Sources of value. It is important to be sceptical of projects with
estimated NPVs greater than zero. Actual NPVs that are greater
than zero are rare in a highly competitive environment. There
are, however, exceptions to this rule. Examples include legal
monopoly rights via patents and trademarks.
Large corporations often use sophisticated methods to incorporate
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risk into capital budgeting, but every businessperson should know
a few basic techniques for evaluating uncertainty.
To guard against a possible false sense of security from an NPV
estimate, scenario, sensitivity and simulation analyses can be
conducted. These analyses identify which risk factors have the
strongest influence on NPV estimates.
In a scenario analysis, the best- and worst-case value of each
input is chosen in order to model best- and worst-case scenarios,
and calculate NPVs.
In the case of sensitivity analysis, an estimate is made of how the
NPV would change if one of the input variables changed (usually a
set of alternatives to the base-case value).
With a simulation analysis, several input variables are
contrasted simultaneously. A distribution of possible NPV
estimates (in other words, a combination of elements from scenario
and sensitivity analysis) is then constructed.
When there is a range of different outcomes expected for an
investment, it is possible to make use of these three techniques to
assess the expected outcome. Scenario analysis, sensitivity analysis
and simulation analysis are covered in the sections that follow.
7.5.1
Scenario analysis
Scenario analysis can be seen as the most basic form of a ‘what-if’
analysis. It is a process of analysing future events by considering
alternative possible outcomes (that is, scenarios). With scenario
analysis, various scenarios are identified and the effect of these
scenarios on the outcome of an investment or capital project is
evaluated. Although scenario analysis is probably the most widely
used risk-analysis technique, it has its limitations, in that it analyses
the effect on return if the value of one variable is changed at a time;
the other variables are held constant. In the case of scenario
analysis, an investment or capital project’s return is calculated
using base-case projected information. It is then possible to indicate
the best- and worst-case scenarios, estimating the values of each
variable that fall within each scenario.
This is best explained by means of an example: the base case of a
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project indicates a turnover of R25 000 per square metre for a new
shop that is opening. The expected operating margin is 4%. The
worst-case scenario indicates a turnover of R20 000 per square
metre and an operating margin of 3%, while the best-case scenario
indicates a turnover of R30 000 per square metre and an operating
margin of 5%. From this information, the expected return from the
new shop can be determined using information for the base-case,
best-case and worst-case scenarios.
Scenarios can also be set in terms of macroeconomic factors,
such as inflation and interest rates, or for more subjective data, such
as those relating to competitive actions and strategies. Scenario
analysis is useful for indicating the viability of an investment or
capital project if the values of the variables could be significantly
different from what is expected, both in a positive and a negative
sense. It is useful for indicating the potential downside. However,
like sensitivity analysis, scenario analysis does not indicate whether
the project should be accepted or rejected: it is merely an indication
of ‘what could happen’. Therefore, the risk tolerance of the investor
will still be the determining factor.
Example 7.4 Conducting a scenario analysis
Jonathan and Simphiwe have gone into a business venture and are
establishing the Fairways Driving Range. Clients will rent a bucket of golf balls
and practise their drives on the range.
The Fairways Driving Range expects demand to be 20 000 buckets at R30
per bucket per year. Equipment costs R200 000; it will be depreciated using
the straight-line method over five years and will have a residual value of zero.
Variable costs are 10% of rentals; fixed costs are R450 000 per year. Assume
no increase in working capital or any additional capital outlays. The required
return is 15% and the tax rate is 35%.
The following inputs would be used when performing a scenario analysis
on the data available for the Fairways Driving Range:
■ Base-case (in other words, most likely) scenario: Rentals are 20 000
buckets, variable costs are 10% of revenues, fixed costs are R450 000,
depreciation is R40 000 per year and the tax rate is 35%.
■ Best-case (optimistic) scenario: Rentals are 25 000 buckets, variable costs
are 8% of revenues, fixed costs are R450 000, depreciation is R40 000
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per year and the tax rate is 35%.
■ Worst-case (pessimistic) scenario: Rentals are 15 000 buckets, variable
costs are 12% of revenues, fixed costs are R450 000, depreciation is R40
000 per year and the tax rate is 35%.
Fairways Driving Range scenario analysis
Note that the worst-case scenario results in a tax credit. This assumes that the
owners had other income against which the loss is offset.
According to the base-case scenario, the statement of comprehensive
income is as follows:
The NPV and IRR results are presented in the table that follows.
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7.5.2
Sensitivity analysis
Sensitivity analysis is a variation on scenario analysis. It is a method
of establishing how sensitive the expected return from a project is to
a change in the value of a key variable of the project.
The ultimate outcome of an investment or an investment project
is based on a number of variables. In the case of a capital project,
these variables include the discount rate, annual operating
revenues, annual operating costs, expected project life and the
residual value of assets. The reason for conducting a sensitivity
analysis for several variables (one at a time) is to see which
variables’ best- and worst-case scenarios produce the biggest
changes to NPV (in other words, to establish to which variables the
NPV is most ‘sensitive’).
For example, an entity’s management may want to know what
the impact will be on a project’s outcome if the sales price is
increased by 10% or if costs are reduced by 15%.
The first step in sensitivity analysis is to calculate a single
expected outcome for an investment or capital project, and then to
use it as a reference or base value. Using additional information,
two or more situations can be formulated by making changes to
relevant variables.
An example of this method is to estimate the NPVs for capital
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projects with different cash flow estimates: usually pessimistic,
most likely and optimistic. A range can then be determined by
subtracting the optimistic outcome NPV from the pessimistic
outcome NPV. A project depicting the greatest value of the range is
the project with the greatest risk because it has the most
uncertainty.
Example 7.5 Carrying out a sensitivity analysis
For the purpose of this example, we will use the information from the Fairways
Driving Range project (see Example 7.4) with the following inputs:
■ Base case: The Fairways Driving Range expects rentals to be 20 000
buckets at R30 per bucket per year. Equipment costs R200 000. It will be
depreciated using the straight-line method over five years and will have a
residual value of zero. Variable costs are 10% of rentals and fixed costs
are R450 000 per year. Assume no increase in working capital and no
additional capital outlays. The required return is 15% and the tax rate is
35%.
■ Best case: Rentals are 25 000 buckets and revenues are R750 000. All
other variables are unchanged.
■ Worst case: Rentals are 15 000 buckets and revenues are R450 000. All
other variables are unchanged.
Again, the worst-case analysis results in a tax credit, which assumes that the
owners had other income against which the loss is offset.
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Figure 7.2 indicates the Fairways Driving Range’s sensitivity analysis of rentals
versus NPV.
Figure 7.2 Fairways Driving Range sensitivity analysis
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7.5.3
Simulation analysis
Simulation analysis (an extension of scenario analysis) is a statistical
method that makes use of probability distributions and random
numbers to estimate a variety of risk outcomes. By applying these
to the various cash flow components of a capital project and by
repeating the process a number of times, a probability distribution
of project returns can be established. The more times the analyst is
able to repeat the process, the more feasible the end result is likely
to be, giving the investor a better risk-adjusted indication of the
return that can be expected from an investment.
Computers and advanced statistical software have made the use
of simulation analyses easier and more cost-effective. The Monte
Carlo Method – named after the resort town renowned for its
casinos – was developed by scientists working on the development
of the atom bomb, but has only gained popularity with the advent
of the personal computer.
A Monte Carlo software program randomly generates values for
different uncertain variables over and over in order to simulate a
model that can be used for decision-making purposes. Since its
introduction in World War II, Monte Carlo simulation has been
used to model a variety of physical and conceptual systems. The
technique is used by professionals in such widely different fields as
finance, project management, energy, manufacturing, engineering,
research and development, insurance, oil and gas, transportation
and the environment.
Monte Carlo simulation performs risk analysis by building
models of possible results obtained by substituting a range of
values (probability distribution) for any factor that has inherent
uncertainty. It then calculates results over and over, each time using
a different set of random values from the probability functions.
Depending on the number of uncertainties and the ranges specified
for them, a Monte Carlo simulation may involve thousands or tens
of thousands of recalculations before it is complete. Monte Carlo
simulation then produces distributions of possible outcome values.
The use of probability distributions results in variables having
different probabilities for different outcomes.
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QUICK QUIZ
Explain the differences between scenario,
sensitivity and simulation analyses to a friend.
7.6
Break-even analysis as a measure of dealing
with risk
Break-even analysis is most useful as a tool when capital
investment projects are being considered. Before a capital project is
undertaken, it is useful to measure the point at which the project
breaks even and to identify the sales level below which it will start
losing money.
We know that total cost (TC) is equal to the sum of variable
costs (VC) (costs that change with the quantity of output) and fixed
operating costs (FC) (costs that do not change with the quantity of
output). Remember, however, that FC is a short-term concept. In
the long run, all costs, including plant and equipment, are variable
in nature.
We assume that VC per unit (that is, marginal cost) is constant (v).
However, in real situations it may not be, as VC depends on the
number of units.
Example 7.6 Calculating the total cost
If we refer back to Example 7.5 and use the same data, we can calculate the
total cost for each case.
Fairways Driving Range: Total cost calculations
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The break-even point is the point at which operations neither make
money nor lose money. The formula for the break-even point is:
TR = TC
Where:
TR = the total revenues
TC = total costs or expenses for an operation
One can expand this formula as follows:
Where:
P = selling price per unit
Q = unit sales
FC = fixed cost
VC = variable cost per unit
Here, Q (expressed in number of units) is the break-even point in
sales. This is the point at which enough units are sold to cover the
fixed costs. The component of the formula (P − VC) is sometimes
referred to as the contribution margin; it is named thus because the
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difference between the selling price per unit (P) and the variable
cost per unit (VC) contributes to covering the fixed cost (FC). As
seen from Formula 7.4, the break-even point depends on fixed costs,
variable costs and the unit price of a product, and the break-even
point is compared with the expected unit sales (volume of sales) to
determine if the project will break even. The break-even point is
illustrated in Figure 7.3.
Figure 7.3 Graphical depiction of break-even point
7.6.1
Accounting break-even analysis
Accounting break-even analysis determines the break-even point at
which there is no gain or loss; hence costs or expenses are equal to
revenues or incomes. This is the point that results in zero net profit
after tax for the project.
We know that net profit after tax (NPAT) = (Sales – Variable cost
– Fixed cost – Depreciation) × (1 − t), therefore:
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If we set NPAT = 0 and solve for Q, we find:
0 = (P.Q − VC (Q) − FC − D) × (1 − t)
Because NPAT is zero, the pre-tax profit will also be zero.
Therefore:
Example 7.7 Calculating the total cost
If we refer back to Example 7.5 and use the same data, we can calculate the
accounting break-even point as follows:
Solve for Q: FC + D = Q(P − v)
Please note that the break-even calculation is not affected by taxes.
We know intuitively that the break-even quantity is the ratio of the
fixed accounting costs that must be covered (even if the quantity
sold is zero) to the contribution margin (in other words, how much
the sale of each unit contributes to covering these fixed accounting
costs).
In the case of Fairways Driving Range, we note that if sales do
not reach 18 148 buckets, the entity will incur losses, not only in the
accounting sense, but also in the financial (that is, the NPV) sense.
This is explained in the section that follows.
7.6.2
Accounting break-even analysis and operating cash
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flow
In addition to understanding where the accounting break-even
occurs, we also need to know what the operating cash flow (OCF) is
at the accounting break-even quantity.
OCF = PBIT + D
= (S − VC − FC − D) + D
=0+D
Therefore, OCF = D at accounting break-even quantity.
We can see intuitively that the OCF is just enough to pay off the
annual cost (or depreciation) of the investment (given straight-line
depreciation). In this case, it means that the payback period is equal
to the project’s life. We also know that the internal rate of return
(IRR) = 0, since the accounting break-even does not discount future
cash flows. Furthermore, an accounting break-even point
corresponds with a negative NPV. Therefore, accounting breakeven is not the best measure for determining the quantity necessary
to cover the true value of all costs, since it does not take the time
value of money into account. Due to this reason, setting profit after
tax equal to zero does not guarantee that the NPV will be equal to
zero.
In order to derive a break-even measure, consider the
relationship between sales volume (Q) and OCF (ignoring taxes).
Since S = P.Q and VC = v.Q, the equation for OCF can be
rewritten as follows:
Where:
(P − v) = contribution margin/unit
If we now rearrange this equation to solve for Q, we find:
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Example 7.8 Calculating the accounting break-even point with operating
cash flows
If we refer to Example 7.5 and use the same data, we can calculate the
accounting break-even point taking operating cash flow into account, as shown
below.
This is exactly the same quantity as we calculated in Example 7.7.
7.6.3
Cash break-even analysis
Using an accounting break-even point, we saw that NPAT = 0.
Below this point, the OCF becomes a negative value. It is, therefore,
important to know the cash break-even point of the project.
From Formula 7.8, we know that:
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To derive a formula for the cash break-even point, we know that the
OCF in Formula 7.8 should be equal to zero. This means that:
Example 7.9 Calculating the cash break-even point
If we refer to Example 7.5 and use the same data, we can calculate the cash
break-even point as follows:
7.6.4
Financial break-even analysis
Financial break-even analysis calculates the necessary quantity of
units that must be sold when NPV = 0. Remember that in this case,
we first need to calculate the OCF before we can proceed with the
calculation.
Example 7.10 Calculating the financial break-even point
If we refer to Example 7.5 and use the same data, we can calculate the
financial break-even point as follows:
OCF = 5-year annuity, which when discounted at 15% = R200 000.
That is:
R200 000 = OCF × 3,352 (15%, 5 year, annuity factor)
We know intuitively that the financial break-even quantity is the ratio of the
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fixed operating costs that must be covered plus the annuitised value of the
initial investment to the contribution margin (that is, how much the sale of each
unit contributes to covering these fixed accounting costs).
In other words,
Where:
AII = annuitised initial investment
Figure 7.4 illustrates the various break-even points for the Fairways
Driving Range.
Figure 7.4 Accounting, cash and financial break-even points for the Fairways Driving Range
7.6.5
Summary of break-even measures
The various types of break-even measure can be summarised as
follows:
• General expression
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Ignoring taxes, the relation between OCF and quantity of output
or sales volume (Q) is:
This relation can be used to determine the accounting, sales and
financial break-even points.
• Accounting break-even occurs where net profit is zero. OCF is
equal to depreciation when net profit after tax is zero, so the
accounting break-even point is:
A project that just breaks even on an accounting basis has a
payback exactly equal to its life, a negative NPV and an IRR of
zero.
• The cash break-even point occurs when OCF is zero. The cash
break-even point is thus:
A project that just breaks even on a cash basis never pays back,
its NPV is negative and equal to the initial outlay, and the IRR is
–100%.
• Financial break-even occurs when the NPV of the project is zero.
The financial break-even point is thus:
where OCF is the level of OCF that results in zero NPV.
A project that breaks even on a financial basis has a discounted
payback equal to its life, a zero NPV and an IRR equal to the
required return.
7.7
Conclusion
This chapter illustrated the importance of incorporating risk into
the process of deciding whether or not to accept or reject an
investment project (referred to as investment appraisal). It also
demonstrated the methods that can be used to incorporate risk in
such important decisions. You learnt the following:
• In a financial context, risk is the likelihood that the return on an
investment will be affected in an unfavourable way by a variety
of factors. Certainty is a state in which only one end result is
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possible. Uncertainty is a state in which it is impossible to
predict the future return on an investment exactly.
• There are various methods used by entities to measure risk:
– Sensitivity analysis is used in the evaluation of investment
projects to establish how sensitive the return on an
investment is to changes in the values of key variables.
– Scenario analysis overcomes the limitations of sensitivity
analysis by taking the probability of changes in key variables
associated with inputs in the cash flows into consideration.
– Break-even analysis is a means to determine at what stage a
business, service or product will be profitable.
• By applying the methods discussed in this chapter, it is possible
to reduce the risk of unforeseen circumstances having a negative
impact on the value of investments. In particular, this chapter
explained:
– the importance of incorporating risk into the investment
appraisal process
– how to identify the various types of risk involved in
investment projects
– the use of probability distributions and expected values in
risk assessment
– scenario analysis, sensitivity analysis and simulation analysis
in investment appraisal
– the application of break-even analysis as a measure of
dealing with risk.
All entities want to expand and create wealth for their shareholders.
To do so, they have to take on new investment opportunities and
accept projects that will give them a leading edge over their
competitors. The opening case study showed how Shoprite
expanded by opening new shops throughout Africa. The retailer
has to consider the risks attached to these proposed investments
before accepting them. The closing case study indicates how politics
and labour organisations (unions) can pose a risk for investments.
Labour regulations that favour employees’ interests over those of
employers have the potential to discourage foreign investors.
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CASE
STUDY
CEO’s resignation letter suggests SAA is being forced into
administration: Analyst
Vuyani Jarana, chief executive officer (CEO) of South African
Airways (SAA) resigned in June 2019. The former Vodacom
Group executive had been brought in about 18 months
previously to lead a recovery at the airline, which has been
unprofitable since 2011, and is mired in mismanagement and
corruption scandals. But a lack of clarity on state funding and
the slow nature of decision-making processes persuaded him
to resign, according to a letter sent to SAA chairman Johannes
Bhekumuzi Magwaza, seen by Bloomberg.
“Lack of commitment to fund SAA is systematically
undermining the implementation of the strategy, making it
increasingly difficult to succeed,” according to the letter.
Finance Minister Tito Mboweni has made it clear the
government is reluctant to approve a further outlay, saying he
favours shutting down the company.
Calls made to Jarana’s mobile phone went straight to voice
mail. The board of SAA said in a statement it had accepted
Jarana’s resignation and thanked him for his service. The
resignation was first reported by the Fin24 website.
“The SAA board is dealing with the CEO matter,” Pravin
Gordhan, minister for Public Enterprises, said by text message.
The move highlights the extent of the challenge facing
South African President Cyril Ramaphosa, who has pledged to
clean up state entities and restore their financial health as he
starts a new five-year term. Ratings companies and the nation’s
auditor general have identified the parlous finances of state
entities as a key risk to the economy.
Jarana’s announcement follows that of Eskom SOC
Holdings Ltd CEO Phakamani Hadebe, who said he would
leave the debt-laden power utility after just 16 months due to
the “unimaginable demands” of the job. Transnet SOC Ltd, the
state-owned ports and rail operator that has also been linked to
multiple graft allegations, is also looking for a permanent
leader.
SAA secured a R5-billion (US$342 million) bailout in the
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October mid-term budget to help it repay loans, but a further
commitment has not been forthcoming, according to Jarana’s
letter. This has made it hard to secure cash from outside
lenders, and the airline has approached Bank of China and
African Export-Import Bank about funding.
Meanwhile a R3,5-billion bridge facility from local banks
expires this month, Jarana said.
“The resignation letter appears to strongly suggest that the
airline is being forced into administration, deliberately or
indirectly, by government,” Peter Attard Montalto, the head of
capital markets at research company Intellidex, said by phone
from London.
Source: Adapted slightly from BusinessTech, 2019.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
The likelihood that a particular event will occur is known as a/an __________.
A. probability
B. uncertainty
C. risk
D. certainty
2.
What is the generally accepted relationship between risk and return?
A. The higher the risk, the higher the expected return
B. The higher the risk, the lower the expected return
C. The lower the risk, the higher the expected return
D. None of the above
3.
An entity that is willing to accept more risk for higher returns can be called
__________.
A. risk-neutral
B. risk-averse
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C.
D.
risk-seeking
risk-tolerant
4.
Which definition describes purchasing-power risk?
A. The risk that political and/or financial events in a country will affect the
worth of or the returns on an investment
B. The risk that changes in price levels as a result of inflation will affect
investments and/or investment returns
C. The risk that an unexpected event will have an effect on an entity and/or
an investment
D. The risk that interest-rate changes will adversely affect the value of an
investment
5.
The risk that an entity will not be able to finance its operating costs (having too
much fixed costs) is called __________.
A. liquidity risk
B. business risk
C. event risk
D. financial risk
6.
Which method of analysis measures how a project’s outcome changes if the
value of any of its input variables is changed, assuming that all other variables
stay constant?
A. Sensitivity analysis
B. Scenario analysis
C. Probability distributions
D. Simulation analysis
7.
The objective of __________ is to select a group of projects that provides the
highest overall NPV, but does not require more funds than were budgeted for.
A. scenario analysis
B. sensitivity analysis
C. simulation analysis
D. capital rationing
8.
__________ measures the risk of a capital budgeting project by estimating
the NPVs associated with the optimistic, most likely and pessimistic cash flow
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estimates.
A. Simulation analysis
B. Sensitivity analysis
C. Scenario analysis
D. Break-even analysis
9.
Which ONE of the following methods calculates the lowest point of return or
other benefit an investment or project needs to generate so as not to make a
loss?
A. Sensitivity analysis
B. Scenario planning
C. Break-even analysis
D. Probability distributions
INTERMEDIATE
10. An investment that was made for R150 000 two years ago has in the
meantime increased in value to R180 000 and has delivered R20 000 worth of
dividends over the two years. What is the return on the investment?
A. 20%
B. 28%
C. 33%
D. 17%
11. From a practical viewpoint, the preferred method to use for the risk adjustment
of capital budget cash flows is __________.
A. simulation analysis
B. sensitivity analysis
C. risk-adjusted discount rates
D. internal rates of return
12. An advantage of the use of simulation analysis in the capital budgeting process
is the …
A. generation of a continuum of risk-return trade-offs rather than a singlepoint estimate.
B. dependability of predetermined probability distributions.
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C.
D.
availability of a continuum of risk-return trade-offs that may be used as
the basis for decision making.
accuracy generated by its modelling capabilities.
13. Which of the following defines systematic risk?
A. The risk that an entity will not be able to cover its debt obligations
B. The risk that interest-rate changes will adversely affect the value of an
investment
C. Basic market risk that arises from events that affect the larger market
and against which it is not generally possible to seek protection
D. More specific risk against which at least partial protection can be sought
ADVANCED
14. What is an investment’s expected return if the probable returns set out in the
table that follows are expected?
A.
B.
C.
D.
Outcome
Probability
Return
Strong economy
30%
20%
Normal economy
50%
12%
Weak economy
20%
2%
16,0%
12,4%
10,4%
11,3%
LONGER QUESTIONS
BASIC
1.
One year ago, Y Ltd purchased 10 000 shares in C Ltd at a market price of
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R14 per share. The market price per share is currently R18 and a dividend of
R0,50 per share was paid recently. Calculate the rate of return on this
investment after one year.
INTERMEDIATE
2.
An entity has the opportunity to invest in one of two investments. Each
investment costs R100 000. Financial analysts predict the possible outcomes
set out in the table that follows for the two investments..
Calculate the range of returns for the two investments and comment on the
riskiness of the investments.
3.
GoodLuck Ltd is planning to manufacture and sell a new product. Market
research has shown that there is demand for this product based on the
expected outcomes set out in the table that follows.
Outcome
Probability
Units sold
Pessimistic
30%
500 000
Most likely
40%
1 500 000
Optimistic
30%
2 000 000
The product’s proposed selling price is R20 per unit. Calculate the expected
total sales value from the probabilities provided.
4.
Buzz Ltd wants to invest in a new piece of machinery that will improve the
production cycle. The machinery will cost R2 million. The selling price of the
new products will be R850 per item, with a variable cost of R550 per unit.
Total fixed cost will be R500 000. The machinery is expected to last 15 years
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and will have no value at the end of its life. The company uses a cost of capital
of 15%.
Calculate the number of units of product that must be sold to break even.
ADVANCED
5.
Uncertainty Ltd is considering investing in one of two projects. The projects
both require an initial investment of R500 000. The investment is expected to
generate the cash flows set out in the table that follows consistently for five
years under different circumstances.
Outcome
Project Maybe
Project Perhaps
Pessimistic
R100 000
R10 000
Most likely
R140 000
R140 000
Optimistic
R150 000
R250 000
Using a discount rate of 12%, calculate the company’s pessimistic, most likely
and optimistic estimates of the expected NPV. Make a recommendation on
which project to invest in, assuming the company is risk-averse.
The financial manager of YETI Ltd has established that a proposed project is
expected to deliver the cash flows set out in the table that follows.
Year
Cash flow
R
0
(250 000)
1
100 000
2
160 000
3
80 000
4
150 000
Market analysis has shown that the risk of entering a new market may affect
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the cash flows that were initially established. The company makes use of a
discount rate of 12% for all investments.
a) Calculate the NPV using the original cash flows.
b) Using certainty equivalents of 80% of the original cash flows, calculate a
more realistic NPV for the company.
7.
Kwela Manufacturers Ltd is considering a new product. The company is unsure
about its price and the variable cost associated with it. Kwela’s marketing
department believes that the entity can sell the product for R500 per unit, but
feels that if the initial market response is weak, the price may have to be 20%
lower to compete with existing products. The entity’s best estimates of its costs
are fixed costs of R3,6 million and a variable cost of R325 per unit. Concern
exists about the variable cost per unit owing to the costs of raw materials and
labour, which are currently volatile. Although the entity expects this cost to be
about R325 per unit, it could be as much as 8% above that value. The entity
expects to sell about 50 000 units per year.
a) Calculate the entity’s break-even volume assuming its initial estimates
are accurate.
b) Perform a sensitivity analysis by calculating the break-even point for all
combinations of the sale price per unit and the variable cost per unit.
(Hint: There are four combinations in total.)
c) In the best case, how many units will the entity need to sell to break
even?
d) In the worst case, how many units will the entity need to sell to break
even?
e) If each of the possible price/variable cost combinations is equally
probable, what is the entity’s expected break-even point?
f)
Based on your solution to Question e), should the entity go ahead with the
proposed new product? Explain your answer.
KEY CONCEPTS
Break-even analysis: A method of analysing projects that establishes
the point at which a capital project breaks even; used to identify
the sales level below which it will start to lose money.
Business risk: The risk that an entity will not be able to finance its
operating costs due to insufficient cash flow.
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Capital investment decisions: Decisions regarding investments that
require a significant capital outlay.
Capital project: A project that requires a significant initial capital
outlay and is expected to generate some form of return for the
investor.
Certainty: A state in which there is no doubt about something.
Certainty equivalents: A method to incorporate the expected risks of a
project or investment into the expected outcomes of the project
by converting the expected cash flows into equivalent riskless
cash flows.
Country risk: The risk that political and/or financial events in a
country will affect the value of an investment or returns on that
investment.
Event risk: The possibility that an unexpected event will have a
negative effect on an entity and/or an investment.
Exchange-rate risk: The risk that an investment and/or return on
investment will be negatively affected by fluctuations in the
exchange rate.
Expected value: An average of the possible outcomes, weighted by
the probability of the outcomes actually occurring.
Financial risk: The risk that an entity is not able to cover its debt
obligations.
Interest-rate risk: The risk that interest-rate changes will adversely
affect the value of an investment.
Liquidity risk: The risk that an investment cannot be readily sold on
an active market at a reasonable price.
Market risk: The risk that market factors unrelated to the investment
(for example, political, economic or social factors) will adversely
affect the value of an investment.
Portfolio: Collective term for combined investments.
Probability: The likelihood that a particular event will occur,
expressed as a percentage or a decimal figure.
Probability distribution: A statistical technique used to establish the
possible outcome of an uncertain event.
Purchasing-power risk: The possibility that price level changes due to
inflation will affect investments and/or investment returns.
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Risk: The possibility of incurring a loss or experiencing misfortune
because of uncertainty about the future.
Risk-averse: An investor who prefers to avoid risk and will not
accept higher risk unless the returns are disproportionately
higher to compensate them for taking on more risk.
Risk-neutral: An investor who expects a proportionate change in
return for accepting a change in risk.
Risk seeker: An investor willing to take on more risk even if the
expected returns are not proportionately higher.
Risk tolerance: The level of risk an entity or an individual is willing to
accept when making an investment.
Scenario analysis: A method that uses different scenarios to establish
probable values for several variables.
Sensitivity analysis: A method that measures how a project’s outcome
changes if the value of any input variables are changed,
assuming that all other variables stay constant.
Simulation analysis: A statistical method that makes use of probability
distributions and random numbers to estimate a variety of risky
outcomes.
Systematic risk: The basic market risk that arises as a result of
economic changes or other events that affect large portions of
the market.
Tax risk: The possibility that unfavourable changes in tax laws will
affect an investment and/or the return on an investment.
Uncertainty: A situation in which one does not know which events or
factors will influence the end result of a project, or to what
extent.
Unsystematic risk: A category of risk that is more specific than
systematic risk (see above); also referred to as ‘specific risk’.
SLEUTELKONSEPTE
Belastingrisiko: Die kans dat ongunstige veranderinge in
belastingwette die waarde van ’n belegging en/of die opbrengs
op ’n belegging sal affekteer.
Besigheidsrisiko: Die risiko dat ’n maatskappy te veel vaste koste in
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verhouding met veranderlike koste het en daardeur nie in staat
is om bedryfskostes te finansier nie.
Gebeurtenis risiko: Die kans dat ’n onverwagse gebeurtenis ’n
negatiewe effek op ’n maatskappy en/of belegging sal hê.
Gelykbreek analise: ’n Metode om projekte te evalueer wat sal bepaal
by watter punt die kapitaal projek gelykbreek, sodat dit bepaal
kan word watter vlak van verkope tot ’n verlies sal lei.
Kapitaalbeleggingsbesluite: Besluite rondom beleggings wat ’n
aansienlike kapitaaluitleg vereis.
Kapitaalprojek: ’n Projek wat ’n aansienlike aanvanklike
kapitaaluitleg vereis en waarvan verwag word dat dit ’n vorm
van opbrengs vir die belegger sal verskaf.
Koopkrag risiko: Die kans dat prysvlak veranderings as gevolg van
inflasie beleggings en/of beleggingsopbrengste sal affekteer.
Krediet- of nalatigheidsrisiko: Die risiko dat ’n maatskappy of individu
nie die verskuldigde opbrengste op ’n belegging kan betaal nie
of in ’n erge geval nie die oorspronklike belegging kan
terugbetaal nie.
Landsrisiko: Die risiko dat politiese en/of finansiële gebeure in ’n
land die waarde of opbrengs van ’n belegging sal affekteer.
Likiditeitsrisiko: Die risiko dat ’n belegging nie geredelik in ’n aktiewe
mark teen ’n aanvaarbare prys verkoop sal kan word nie.
Markrisiko: Die risiko dat markfaktore wat nie verband hou met die
belegging nie (byvoorbeeld politiese, ekonomiese of sosiale
faktore) die waarde van die belegging negatief sal beïnvloed.
Nie-diversifiseerbare risiko: Sien sistematiese risiko.
Onsekerheid: Wanneer ’n persoon nie weet watter gebeurtenisse of
faktore die eindresultaat van ’n projek sal beïnvloed nie en ook
nie tot watter mate nie.
Onsistematiese risiko: Alle risiko’s wat meer spesifiek is as
sistematiese risiko en dus na verwys kan word as ‘spesifieke
risiko’.
Portefeulje: Wanneer meer as een belegging gehou word is die
kombinasie van beleggings kollektief bekend as ’n portefeulje
van beleggings.
Rentekoers risiko: Die risiko dat rentekoers veranderinge die waarde
van ’n belegging negatief sal beïnvloed.
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Risiko: Wanneer daar die moontlikheid is dat verliese gely kan word
as gevolg van toekomstige onsekerhede.
Risiko neutraal: Beleggers wat ’n proporsionele toename of afname in
opbrengs verwag voordat ’n toename of afname in risiko
aanvaar sal word.
Risiko soekers: Beleggers wat gewillig is om meer risiko te aanvaar,
selfs as die verwagte opbrengs nie proporsioneel hoër is nie.
Risiko toleransie: Die vlak van risiko wat ’n maatskappy of individu
sal aanvaar wanneer ’n belegging gemaak word.
Risiko vermydend: Beleggers wat verkies om risiko te vermy en wat
nie hoër risiko sal aanvaar nie tensy die opbrengste
proporsioneel hoër is om te vergoed vir die addisionele risiko.
Scenario analise: ’n Uitbreiding van sensitiwiteitsanalise, wat
verskillende scenario’s gebruik om moontlike waardes vir
verskeie veranderlikes te bepaal.
Sekerheid: ’n Staat waar daar geen twyfel oor iets is nie.
Sekerheidsekwivalente: ’n Metode om die verwagte risiko van ’n
projek of belegging by die verwagte uitkomste van die projek of
belegging te inkorporeer deur die verwagte kontantvloeie om te
skakel in ekwivalente risikovrye kontantvloeie.
Sensitiwiteitsanalise: ’n Metode wat meet hoe ’n projek se uitkoms sal
verander as die waarde van een van die inset veranderlikes
verander terwyl aangeneem word dat alle ander veranderlikes
konstant bly.
Simulasie analise: ’n Statistiese metode wat gebruik maak van
waarskynlikheidsverdelings en toevallige nommers om ’n
verskeidenheid riskante uitkomste te beraam.
Sistematiese risiko: Die basiese markrisiko as gevolg van ekonomiese
veranderinge of gebeurtenisse wat groot dele van die mark
affekteer.
Verwagte waarde: ’n Gemiddelde van alle verwagte uitkomste,
gebaseer op die gewig van die onderskeidelike moontlikhede
dat die verwagte uitkomste werklik sal plaasvind.
Waarskynlikheid: Die kans dat ’n bepaalde gebeurtenis sal plaasvind,
uitgedruk as ’n persentasie of desimale getal.
Waarskynlikheidsverdeling: ’n Statistiese tegniek wat bepaal wat die
uitkoms van ’n onsekere gebeurtenis sal wees.
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Wisselkoers risiko: Die risiko dat ’n belegging en/of die opbrengs op
die belegging negatief beïnvloed sal word deur wisselkoers
skommelinge.
SUMMARY OF FORMULAE USED IN THIS CHAPTER
WEB RESOURCES
http://www.investopedia.com
REFERENCES
Association of Certified Fraud Examiners (ACFE). (2020). Report to
the Nations: 2018 Global Study on Occupational Fraud and Abuse.
Retrieved from https://www.acfe.com/report-to-thenations/2018/default.aspx [2 March 2020].
BusinessTech. (2019). CEO resignation letter suggests SAA is being
forced into administration: Analyst. Retrieved from
https://businesstech.co.za/news/business/320899/ceoresignation-letter-suggests-saa-is-being-forced-into******ebook converter DEMO Watermarks*******
administration-analyst/ [8 February 2020]. Reprinted by
permission of BusinessTech.
Naudé, P., Hamilton, B., Ungerer, M., Malan, D. & De Klerk, M.
(2018). Business Perspectives on the Steinhoff Saga. University of
Stellenbosch Business School. Retrieved from
https://www.usb.ac.za/wp-content/uploads/2018/06/USBManagement-Report-Steinhoff-Saga.pdf [2 March 2020].
South Africa Shoprite Holdings Ltd. (2020). Integrated annual
report 2019. Retrieved from
https://www.shopriteholdings.co.za/investor-centre/latestintegrated-report.html [4 March 2020]. SHP: Shoprite Holdings
Limited Role Equity Issuer Registration No. 1936/007721/06.
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8 Bond valuation and interest rates
Liezel Alsemgeest
Learning
outcomes
Chapter
outline
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
CASE STUDY
By the end of this chapter, you should be able to:
explain what a bond is and describe the main
characteristics of a bond
calculate the value of a bond
describe the various types of bond, bond
market and bond rating
examine what determines bond yields
explain the relationship between bonds,
interest rates and the inflation rate.
Introduction
What is a bond?
Characteristics of bonds
How to value a bond
The different types of bond
Bond markets and bond ratings
What determines bond returns?
The influence of interest and inflation
rates on bonds
Conclusion
Coffee is my cup of tea
On 20 August 2007, the Starbucks Corporation (Starbucks)
floated US$550 million in ten-year bonds at a coupon rate of
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6,25%. Two months before the Starbucks bonds were floated,
the credit markets were unstable. Liquidity declined as
investors sought greater returns for the risk they were taking
on. During times of volatility, issuers must deliver higher
interest rates. Starbucks waited for a window with less volatile
conditions and therefore lower interest rates to issue its bonds.
In 2013, Starbucks again announced that the entity would
borrow an additional US$750 million from investors for
‘general corporate purposes’. This meant that Starbucks could
use the funds for corporate expansion, share repurchases
and/or acquisitions.
The Starbucks bond was rated as a ‘Baa1’ by Moody’s and a
‘BBB+’ by Standard & Poor’s (S&P) (see Section 8.6.2).
Moody’s, S&P and Fitch are credit-rating agencies that
categorise credit according to the risk attached to it. An entity
with an S&P rating of AAA would have less risk and,
therefore, a smaller return than an entity such as Starbucks,
with a credit rating of BBB+.
In 2012, S&P raised Starbucks from a BBB+ to an A–.
However, Moody’s lowered Starbucks’s rating twice (once in
2008 and once in 2009) to Baa3, after which the rating was
increased again to Baa2 in 2013. Then, in 2014, the rating was
increased to A3. In 2018, all three rating agencies downgraded
Starbucks. The reason behind the downgrade was an
announcement by the entity that it would increase
shareholders’ returns, which would increase debt. Both S&P
and Fitch downgraded the entity from an A– to a BBB+, while
Moody’s slashed the rating from an A3 to a Baa1.
In 2018, Starbucks floated a new bond issue of one billion
dollars. The Starbucks bond characteristics, or determinants,
for the US$1 billion float are as follows:
• GROUP: NASDAQ:SBUX
• COUPON: 4,500 PCT
• MATURITY: 15/11/2048
• TYPE: NOTES
• ISSUE DATE: 10/08/2018
• ISS PRICE: 98,962 PCT
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• RATINGS: Baa1 (Moody’s); BBB+ (S&P); BBB+ (Fitch)
• PAY FREQ: SEMI-ANNUAL
• YIELD: 3,73%.
Sources: Compiled from information in Cole, 2007; Starbucks: Stories & News, 2014; International
Business Times, 2013; Jariel & Bacani, 2018; Markets Insider, 2019.
8.1
Introduction
A bond is a form of debt financing used by governments and the
corporate sector, usually to finance expansion. Bonds are one of the
alternatives available to entities in need of finance. We discussed
how you can determine the current values of future cash flows in
Chapter 4. In addition, you learnt how to determine an
investment’s value by calculating the present value (PV) of all the
future cash flows. You will apply this knowledge when studying
this chapter on bonds.
In this chapter, we provide an introduction to bonds and explain
the characteristics of bonds. These characteristics include the
coupon, coupon rate, maturity, nominal value and the yield-tomaturity.
We also discuss how to calculate the value of a bond, and we
explain the different types of bond, bond market and rating as well
as the determinant of bond yields. Lastly, we look at the
relationship between interest and inflation rates and bonds, which
provides an economic perspective on this subject.
8.2
What is a bond?
When governments or entities – such as Starbucks, the example in
the case study – need funds, they can borrow money on a long-term
basis from the public. The public buys the bond from the borrower
(the issuer) and becomes the bondholder (lender). The borrower is
obliged to pay interest (coupon) to the lender at fixed intervals. At
the end of the life of the bond (maturity), the borrower will repay
the principal amount (also referred to as the nominal value and the
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face value). Therefore, at fixed intervals, the lender will receive
interest payments, and at the end of the life of the bond, the
principal will be repaid by the borrower. The borrower generally
uses the funds obtained from the flotation of bonds to finance longterm investments (in the case of entities) or to finance current
expenditure (in the case of governments).
8.3
Characteristics of bonds
Imagine that you need to borrow R10 000 from Joe. He tells you that
you only have to repay the R10 000 in ten years’ time. In the
meantime, however, Joe wants you to pay 10% interest per year on
the R10 000 every year. This would be regarded as an interest-only
loan. Similarly, a bond is an interest-only loan because only interest
will be paid every period and the amount borrowed will be repaid
at the end of the loan. Bonds have certain unique characteristics that
are vital in understanding this form of debt financing. These are the
nominal value, the coupon and coupon rate, the maturity and the
yield-to-maturity.
Let us suppose that the loan from your friend Joe is a bond. The
nominal value (also called the face value) is the amount being
borrowed from the lender that will have to be repaid when the
bond reaches the end of its term. In this case, you have to repay R10
000, therefore R10 000 is the nominal value, or face value.
Joe also asked for interest payments of 10% on the nominal
amount every period. This is called the coupon rate and refers to
the fixed interest rate (on the nominal value) that the borrower has
to pay the lender every period. Market interest rates are not fixed
and may increase or decrease at any time. One of the characteristics
of a bond, however, is that the coupon rate remains fixed
throughout the life of the bond. The coupon is the amount that the
borrower has to pay the lender every period (Nominal value ×
Coupon rate = Coupon). If you calculate the actual amount that you
will have to repay Joe every year, it comes to R1 000 (R10 000 ×
10%).
Maturity is another important characteristic of a bond. This
refers to the time left until the bond reaches the end of its term and
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the nominal value has to be repaid. Joe gave you ten years to repay
the R10 000, so the maturity in this example is ten years.
The yield-to-maturity (YTM) can be defined as the interest rate
required in the market. If the interest rate in the market is more
than the coupon rate, investors in the market will receive a higher
interest rate than investors buying the bond. Thus, investors buying
the bond will have to be compensated. This is done by means of the
bond being sold to them at a cheaper price, which is known as
trading at a discount. The same is true if the interest rate in the
market is currently lower than the fixed coupon rate of a bond. In
this case, investors who decide to invest in the bond will receive a
higher interest rate than investors in the market and, for that
privilege, they have to pay a higher price for the bond (the bond is
trading at a premium). If the YTM and the coupon rate are the
same, the bond will sell for its nominal value (at face).
Remember that a bond is a loan that makes fixed payments for a
specified period of time. It is therefore a type of annuity (see
Chapter 4).
Figure 8.1 Bond values and interest rates
With reference to Figure 8.1:
• A: The YTM is more than the coupon rate, therefore the bond
will be selling at a discount.
• B: The coupon rate is more than the YTM and investors will
receive a higher coupon than they would have received in the
market. The bond will now be trading at a premium.
• C: When the YTM and the coupon rate are equal, then the bond
will be selling for the nominal value.
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As can be seen from Figure 8.1, the coupon rate is a straight line.
This means that the coupon rate is fixed and does not go up or
down. The YTM, on the other hand, is variable, indicating that it
goes up and down, as dictated by the market. The important thing
to remember here is that if the YTM increases, the value of a bond
decreases and vice versa.
Consider the Starbucks bond in the case study at the beginning
of the chapter. You will see that the coupon rate is defined as 4,5%
of the nominal amount. The nominal amount is US$100, which
means that the coupon is US$4,50 per year, therefore US$2,25 every
six months (because payments are made semi-annually). This
remains fixed throughout the life of the bond. The bond matures on
15 November 2048. The YTM is 4,56%, which is slightly more than
the coupon rate. This means that investors in the market will
receive a higher interest rate than investors in the Starbucks bond.
Thus, investors in the Starbucks bond must be compensated for
choosing to invest in Starbucks. The bond will be sold to them for
less than US$100; to be precise, the PV of the bond is US$98,962
(trading at a discount).
We will discuss how to calculate the PV as well as other values
later in the chapter.
QUICK QUIZ
1. What is a bond?
2. What are the five characteristics of bonds?
3. If the coupon rate is less than the YTM, what
happens to the price of the bond?
8.4
How to value a bond
Imagine that you have decided to buy a Starbucks bond with a
nominal value of US$100. You know that you will receive a coupon
rate of 4,5% and, therefore, a coupon of US$4,50. Let’s pretend that
the YTM (the interest rate in the market) is 5%, which indicates that
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you are receiving less interest than other investors in the market.
Therefore, you will be compensated for this. Let us also pretend
that the maturity of the bond is ten years. With all of this
information, you should be able to calculate how much this bond is
currently worth (the PV of the bond).
It is important to note that we work with five variables when
calculating the value of a bond:
• Firstly, there is the nominal value of the bond, which is usually
to the value of R1 000 (or US$100), unless specified otherwise.
• Secondly, there is the coupon rate, which is a fixed percentage
and indicates the fixed amount that the investor will receive (an
interest payment).
• Thirdly, there is the time to maturity.
• Fourthly, there is the YTM, or current interest rate in the
markets (not a fixed interest rate).
• Lastly, there is the PV of the bond, which is the amount that
investors will pay for the investment.
Using a financial calculator, we deal with these variables as shown
in Figure 8.2.
Figure 8.2 Using a financial calculator to work out bond variables
It is important to remember that if you have any four of the
variables, you will be able to calculate the fifth unknown variable.
Let us imagine that the Starbucks bonds are sold at face value
(R1 000). A timeline shows what happens when you buy a bond
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(see Figure 8.3). The timeline in Figure 8.3 shows that you have
decided to buy a Starbucks bond and the current value of the bond
is R1 000. Thus, this is a cash outflow. From then on, you will
receive interest (coupons) to the amount of R45, and when the bond
matures, you will also receive the nominal value of the bond,
together with the last coupon payment.
Figure 8.3 Variables of a bond on a timeline
Remember that the PV of an annuity is estimated by calculating all
the future cash flows and adding them together (see Chapter 4).
Because a bond is also a type of annuity (in other words, fixed
payments are received for a specified period of time), the same rule
applies here. So, it is important to know that we are working with
two bond components: the annuity part (the coupon payments) and
the lump sum (nominal value), which will be paid at maturity. The
PV of the annuity and the nominal value should be calculated
separately, and then added together to work out the PV of the
bond. From Figure 8.3, it can be seen that the R1 000 lump sum has
to be discounted back by ten years. The formula that is used is as
follows:
Bond value = PV of the coupons + PV of the nominal amount
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Where:
C = the annuity payment
N = the coupon value
i = the interest rate
t = the time to maturity
To calculate the PV of the annuity, we use the following formula:
And to calculate the PV of the nominal amount/lump sum, we use
the following formula:
Now, let us put the Starbucks bond variables of the example
(Section 8.4) into the equation:
Now, the two values have to be added together:
Bond value = R613.913 + R347.477 = R961.39
The PV of the Starbucks bond is therefore R961.39 when calculated
by way of the formula. When we calculate the answer using a
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financial calculator, the decimals might differ slightly.
Now let us look at a much easier way of calculating the value of
a bond. When using a financial calculator, remember that a cash
outflow has to be indicated by a negative sign (−), whereas all the
cash inflows will be regarded as positive. This is done as follows
using a financial calculator:
When entering the variables, it is important to note that all of the
four variables given are entered as positive. The answer (PV =
R961,39) comes out as a negative. This is because it is a cash
outflow.
It is important to note that South African bonds are mostly semiannual in nature. This means that they make two payments per
year and not just one, which also affects how they are calculated.
Example 8.1 illustrates how to calculate the value of a bond that
makes semi-annual payments.
Example 8.1 Calculating the value of a bond with semi-annual payments
Derrick is interested in buying a bond from Make-A-Lot-Of-Money Company.
The bond has a maturity of 12 years and a coupon rate of 7%. The YTM is 8%.
If the nominal value of the bond is R15 000 and it makes semi-annual
payments, what is the price of the bond?
The important thing to remember is that if the coupon rate is 7% on R15
000, it means that the coupon payment is R1 050 for a year. Because the
payments are made semi-annually, Derrick will receive R525 (that is, R1 050
÷ 2) every six months. Or, if you work it out differently, he will receive a 3,5%
coupon every six months (R525). Thus, if the maturity is 12 years and Derrick
receives two payments every year, he gets 24 coupon payments in total.
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Remember that three things need to change when we are working with
semi-annual payments:
■ The maturity has to double (Maturity × 2).
■ The coupon rate has to be halved (Coupon rate ÷ 2).
■ The yield-to-maturity has to be halved (YTM ÷ 2).
Now we can work out the price of the bond.
Using the equation
Thus, the total PV of the bond is: R5 851,83 + R8 006,25 = R13 858,08.
Using a financial calculator
Because the YTM is more than the coupon rate, we know that the PV of the
bond should be less than the nominal value of the bond. The bond is,
therefore, sold at a discount (trading at a discount) to compensate the investor
for the lower coupon rate than the interest rate that they would have earned in
the market (YTM).
Example 8.2 illustrates how to calculate the time to maturity.
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Example 8.2 Calculating the time to maturity
Hein wants to invest in a bond with a nominal value of R1 000. The price of the
bond is currently R1 090 and it pays 6% coupons. The current market interest
rate on bonds is 5,5%. How much time is left to maturity?
Now let us consider an example in which we have to calculate the
coupon rate.
Example 8.3 Calculating the coupon rate
Imagine a bond selling currently for R1 123. The nominal value of the bond is
R1 000, the YTM is 10% and the time to maturity is 13 years. What is the
coupon rate of the bond?
Using the equation
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The coupon payment is R117,316, but what is the coupon rate?
We know that the coupon rate (11,7316%) should be more than the YTM
(10%) because the bond is sold for more than the nominal value, and is
therefore sold at a premium (trading at a premium).
Using a financial calculator
When calculating the payment (coupon payment) on the financial calculator,
we still have to determine the actual coupon rate.
Example 8.4 illustrates how to calculate the YTM.
Example 8.4 Calculating the YTM
Sam wants to buy a bond with a R10 000 nominal value payable in ten years’
time. The bond pays 10% coupons and is currently selling for R9 000. What is
the YTM?
When using the equation to calculate the YTM, it is a process of trial and
error.
Total bond value = PV of the lump sum + PV of the annuity
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We now have to use trial and error as well as what we know about bond prices
and interest rates to ‘guess’, as it were, what the YTM (1 + t) might be. We
know that the bond is currently selling for less than the nominal price (trading
at a discount). This indicates that the interest rate in the market (YTM) is more
that the coupon rate, which is 10%.
So let us try a YTM of 11%:
Total bond value = R5 889,23 + R3 521,84 = R9 411,07
The value of R9 411,09 indicates that the YTM is not 11% and needs to be a
bit bigger. Let us try 11,5% this time:
Total bond value = R5 767,77 + R3 367,06 = R9 134,83
We are almost there! This process should continue until the correct yield has
been found. The YTM for this bond is 11,752%.
This can become quite a lengthy process when calculating the YTM using
an equation. It is easier to use a financial calculator.
Using a financial calculator
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Example 8.5 Calculating the YTM of a semi-annual bond
Lloyd is in the market for a semi-annual paying coupon bond that matures in
13 years’ time. The bond pays 7% coupons and is currently selling for 103%
of the face value. Calculate the YTM.
Remember, this is a semi-annual bond and so three things need to
change:
■ The maturity has to double (13 × 2 = 26).
■ The coupon rate has to be halved (7% ÷ 2 = 3,5%).
■ The yield-to-maturity has to be halved (YTM ÷ 2).
When using the equation to calculate the YTM, it is a process of trial and error.
Total bond value = PV of the lump sum + PV of the annuity
We now have to use trial and error as well as what we know about bond prices
and interest rates to ‘guess’ what the YTM might be. We know that the bond is
currently selling for more than the nominal price (trading at a premium). This
indicates that the interest rate in the market (YTM) is less that the coupon rate,
which is 7%.
Let us try a YTM of 6%:
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Total bond value = R625,69 + R463,69 = R1 089,38
The value of R1 089,38 indicates that the YTM is not 6% and should instead
be a little larger. Let us try 6,5% this time:
Total bond value = R608,06 + R435,37 = R1 043,73
This process should be continued until the correct yield has been found. The
YTM for this bond is 6,652%.
This can become quite a lengthy process when calculating the YTM using an
equation. It is easier to use a financial calculator.
Using a financial calculator
This is one more extremely important step to remember: the answer of I/YR =
3,3258 is the semi-annual yield. It should therefore be multiplied by 2 to get
the yearly yield (YTM):
YTM = 3,3258 × 2 = 6,652%
QUICK QUIZ
1. What is the YTM of a bond with a maturity of
15 years, a nominal value of R1 000, a face
value of R1 000 and a coupon rate of 10%?
2. Why is the PV negative when using a financial
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calculator?
3. What are the two payments whose PV has to be
calculated to determine the price of a bond?
8.5
The different types of bond
There are many different types of bond available to investors. For
the purpose of this textbook, we will focus on nine types of bond,
which are discussed in the sections that follow.
8.5.1
Government bonds
Securities from the government are collectively known as treasuries
and are classified according to the length of their maturity.
• Debt securities with a maturity of less than one year are known
as treasury bills.
• Debt securities with a maturity of more than one but fewer than
ten years are known as treasury notes.
• Treasury bonds are debt securities maturing in more than ten
years.
Debt issued by governments of countries that are economically
stable is regarded as one of the safest investments in the market. It
is unlikely that a country will default on payments, but it can
happen. The debt securities of many developing countries carry
substantial risk. However, the national government of a country is
in control of the supply of its currency and also has the power to
print money to pay its debts. Because of this, the debt securities of
many developed countries are considered to be risk-free.
The South African Treasury currently has two series of RSA
Retail Savings Bonds on issue:
• two-, three- and five-year fixed-rate retail savings bonds (with
two-, three- and five-year maturities, respectively)
• three-, five- and ten-year inflation-linked retail savings bonds
(with three-, five- and ten-year maturities, respectively).
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Retail savings bonds are backed by the full faith of the government.
They can be purchased from the National Treasury, the Post Office
or Pick n Pay.
The main objectives of the issue are to:
• create awareness among members of the public of the
importance of saving
• diversify the financial instruments on offer to the market
• target a different source of funding.
The South African Retail Bond forms a very small portion of the
government bond market and is primarily used as a savings tool.
Major government bonds raise billions of rands’ worth of funds.
8.5.2
Municipal bonds
Cities, towns and regional municipalities can support their debt by
means of property taxes. However, recent examples in South Africa
have shown that municipal managements do go bankrupt, although
this does not happen often. Cities such as Johannesburg issue bonds
to help finance capital expenditure on infrastructure (for example,
the stadiums for the 2010 FIFA World Cup, the Gautrain and roads)
or to refinance some of their debt. A major advantage of municipal
bonds is that the interest received is tax exempt. Thus, the yield is
normally a little lower than corporate bonds, which makes these
bonds an extremely attractive form of investment on an after-tax
basis.
8.5.3
Corporate bonds
Entities can also issue bonds. The Starbucks bond referred to in the
opening case study is an example of a corporate bond. These types
of bond are generally characterised by higher yields because of the
higher risk associated with entities compared with the perceived
lower risk of government bonds. The reason for this is that the
chance of an entity defaulting on payments may be greater than
that of a (stable) government defaulting on payments.
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Corporate bonds can be classified into the following types:
short-term corporate bonds, which have a maturity of less than five
years
intermediate bonds, which have a maturity of between five and 12
years
long-term corporate bonds, which have a maturity of more than 12
years.
Entities are classified according to the industry in which they
operate (for example, real estate or retail bonds) and according to
their credit rating. The creditworthiness of an entity is tied to its
business prospects and financial capacity. An entity with a high
credit rating (that is, where the possibility of defaulting on
payments is low) is regarded as a safe investment and so the yield
that the investor receives is low. An entity with a low credit rating
(in other words, where the possibility of defaulting on payments is
high) is regarded as a riskier investment, which is reflected by the
higher yield.
8.5.4
Convertible bonds
A convertible bond gives the owner the right to convert the nominal
amount of a bond to ordinary shares of the issuing entity at a
certain fixed ratio (referred to as the conversion ratio). Convertible
bonds have coupon payments and because they are debt securities,
they rank above any equity in a default situation.
Example 8.6 Calculating the share value of convertible bonds using a
conversion ratio
If you owned a convertible bond of R1 000, it would give you the right to
convert the bond into ordinary shares at a fixed, predetermined ratio of, for
instance, 4:1. This means that the owner of the bond can convert the nominal
value of the bond (R1 000) to R250 worth of ordinary shares (R1 000 ÷ 4 =
R250). If each share is worth R1, then the bondholder will receive 250 shares.
If, however, the share price is R25 per share, then the bondholder will only
receive ten shares (250 shares ÷ R25). Thus, the price of the share affects the
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value of a convertible bond substantially.
In the previous example, the conversion was made using a
predetermined conversion ratio. One may, however, also use a
conversion price. In this case, it is the price at which a given
convertible security (such as a convertible bond) can be converted
to ordinary shares. The conversion price is specified when the
security is issued. Example 8.7 explains this process.
Example 8.7 Calculating the share value of convertible bonds using a
conversion price
Assume you own a convertible bond of R1 000 and it gives you the right to
convert the bond into ordinary shares at a conversion price of R27,50 per
share. This means that you will receive 36,36 shares (R1 000 ÷ R27,50). The
amount of 36,36 shares is then the conversion ratio. If you also know that the
entity’s shares were trading at R25 per share at the time of the conversion,
you can determine that the conversion price of R27,50 was 10% higher than
the actual share price.
8.5.5
Junk bonds
Junk bonds are also called high-yield bonds. They are issued by
entities considered to be highly risky and speculative. Bonds can be
rated from ‘AAA’ (very high quality) to ‘C’ (very risky) to a ‘D’
rating, which represents the ‘default’ category, or the category of
bonds that have an extremely high risk of non-payment to the
bondholder. Bonds with a rating of ‘BBB’ and higher are referred to
as investment-grade bonds because they have an acceptable level of
risk, whereas bonds with a rating of ‘BB’ and lower are called
speculative-grade bonds and have a higher level of default.
A junk bond is considered speculative grade or below
investment grade. South African bonds are currently regarded as
junk bonds. These high-yield bonds became known as junk bonds
because they developed negative connotations and were not widely
held in investment portfolios. Mainstream investors and
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institutions did not deal in these bonds because they would not
accept the risk imposed on them, so they were termed ‘junk’.
Nevertheless, studies have indicated that portfolios of higher-yield
bonds have higher returns than other bond portfolios, indicating
that the higher yields do compensate for the default risk of some of
the bonds.
8.5.6
Zero-coupon bonds
As the name implies, a zero-coupon bond has no coupon payments.
Instead, the bond is offered at a considerable discount to the face
value. Example 8.8 illustrates this.
Example 8.8 Zero-coupon bonds
Electronix Ltd. is selling ten-year zero-coupon bonds with a face value of R1
000 at a YTM of 7%. How much will you have to pay for the bond?
Using a financial calculator
This indicates that you will pay R508,35 today and you will receive R1 000 in
ten years’ time.
The owner of the bond pays taxes on the coupon, although no
coupon (interest) is received. According to Section 24J of the Income
Tax Act (No. 58 of 1962), the accrued interest (coupons) will be
taxable as revenue income and not as a capital gain. To determine
the capital gains tax that will have to be paid on a zero-coupon
bond, it is necessary to deduct both the accrued coupons and the
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original purchase price from the proceeds gained from the disposal
of the bond. This gain will then be taxed as capital gains. This may
be an attractive investment option because the investor eliminates
reinvestment risk and zero-coupon bonds generally have better
yields than coupon-paying bonds. The yield of a zero-coupon bond
is different from the yield of a normal bond from the same issuer.
8.5.7
Extendable and retractable bonds
Extendable and retractable bonds pay a lower interest rate (coupon
rate) to investors. The reason is that extendable and retractable
bonds have more than one maturity date. As the name implies,
extendable bonds give the holder the right to extend the initial
maturity to a later maturity date. An investor would be attracted to
an extendable bond to take advantage of potentially falling interest
rates (as interest rates fall, bond prices increase), without assuming
the risk of a longer bond.
Retractable bonds, on the other hand, give the bondholder the
right to retract the maturity (in other words, make the maturity
shorter). This kind of bond would be attractive to an investor who
believes interest rates will rise and bond prices will fall.
Bond issuers find extendable and retractable bonds attractive
because of the lower interest rate and because the options given to
buyers make the issues easier to sell.
8.5.8
Foreign-currency bonds
A foreign-currency bond is issued in a currency other than the
issuer’s own currency in order to take advantage of international
interest-rate variations and for diversification purposes. For
instance, a South African entity in need of US dollars may issue a
bond for sale in the United States. Citizens of the United States are
able to buy these bonds, giving the South African entity their muchneeded dollars; the lenders will receive their coupon payments in
dollars, while diversifying their portfolio (that is, investing in
another country). Bonds issued in foreign currencies have names
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that imply the specific currency. For example, US dollar bonds are
known as ‘Yankee bonds’, Japanese yen bonds are ‘Samurai bonds’,
British pound bonds are ‘Bulldog bonds’ and New Zealand dollar
bonds are ‘Kiwi bonds’.
8.5.9
Inflation-linked bonds
An inflation-linked bond provides protection against inflation. This
is done by increasing the nominal value (face value) by the change
in inflation, measured by the Consumer Price Index (CPI). As the
principal increases, the coupon rate is applied to this increased
amount, so the coupon also increases. This ensures that the investor
is protected against inflation risk. Inflation-linked bonds were
introduced in South Africa for the first time on 2000.
QUICK QUIZ
1. What is the difference between corporate bonds
and government bonds?
2. When can a bond be referred to as a junk bond?
3. What are Japanese yen foreign bonds known as?
8.6
Bond markets and bond ratings
In this section, we discuss bond markets and reporting as well as
bond ratings by the three main rating agencies in more detail.
8.6.1
Bond markets and reporting
In general, most bond markets are over-the-counter (OTC) markets.
An OTC market is not a physical location where securities are
traded, but a collection of dealers around the world who buy and
sell bonds. Dealers communicate with one another and with
investors via an electronic network.
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A bond market can be described as a financial market where
participants buy and sell debt securities, usually in the form of
bonds. Bond markets are also known as debt, credit or fixed-income
markets. There are, however, a few exchanges that list bonds. A
good example is the New York Stock Exchange (NYSE), which is
the world’s largest centralised bond market and represents mostly
corporate bonds. The United States stock market is actually a little
smaller than the bond market. The stock market has just over US$30
trillion in market capitalisation, while the bond market was worth
around US$40 trillion in the early months of 2019 (McPartland,
2018).
Table 8.1 is a typical example of how bonds are reported in the
bond markets.
Table 8.1 Example of bond price reporting
Note: The all-in price is the price of the bond per R100 nominal, including accrued interest (sum clean price
plus accrued interest). It is used to calculate the consideration due by an investor on the settlement date
for purchasing a bond; clean price is the price of the bond per R100 nominal excluding accrued interest;
accrued interest is the interest due if the bond is transacted between coupon dates.
Source: Momentum SP Reid Securities, 2020.
The South African bond market is a leader among emerging market
economies. The Bond Exchange of South Africa (BESA) is a large
bond exchange. Its reported turnover in 2008 was R19,2 trillion,
with approximately 1 100 debt securities issued by 100
governments and corporate borrowers, with a total market value of
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R935 billion. In 2008, the Johannesburg Stock Exchange Ltd (JSE)
put in a bid to buy BESA. In June 2009, BESA became a wholly
owned subsidiary of the JSE. This means that shares, bonds and
derivatives are traded in one market.
In South Africa, all long-term government bonds can be
regarded as relatively risk-free. For this reason, the R186
government bond, which matures in 2026, is often used as the riskfree rate in South Africa.
8.6.2
Bond ratings
A bond is rated according to the creditworthiness of the issuing
entity. This is a useful tool for investors because the entity or
organisation is rated by independent agencies in terms of its
likelihood of defaulting on payments. Entities’ coupons are
dependent on their ratings. If an entity has a credit rating of AAA,
for instance, this implies that there is almost no risk of it defaulting
(the risk is almost zero). Remember, the lower the risk, the lower
the return rate (interest), so the coupon rate will be fairly low for a
bond from an AAA-rated entity. If, on the other hand, an entity has
a credit rating of BBB, it means that there is a greater risk of it
defaulting on payments; because of this risk, there would be a
higher coupon rate to compensate for the increased risk carried by
the investor.
The world’s leading rating agencies are Moody’s, Standard &
Poor’s (S&P) and Fitch. There are other rating agencies, but these
three dominate the market, with approximately 90–95% of the
world market share. Table 8.2 shows the ratings that these three
agencies assign to debt securities.
Table 8.2 Credit ratings by Moody’s, S&P and Fitch
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Source: Wolf Street, 2020.
The short-term ratings indicate the potential level of default within
a 12-month period, whereas the long-term ratings show the
potential default level for a longer period.
It is important to note that all bonds with a rating of BB and less
can be rated as junk bonds because their ratings imply that they are
of non-investment quality and are therefore speculative. Rating
agencies may sometimes differ in their ratings of the same bond,
but their ratings will only differ slightly.
In the opening case study, Starbucks was shown to have an S&P
rating of BBB+, which (according to Table 8.2) indicates that the
bond issue is of a lower medium grade, but is not speculative. This
means that it is a medium-safe investment.
South Africa’s rating reached its highest peak from 2006 until
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2012, with a BBB+ rating. However, the case study at the end of the
chapter indicates that South Africa currently has an S&P rating of
BB with a stable outlook. This is regarded as non-investment grade,
or ‘junk’ status. The last time South Africa’s rating was this low was
at the dawn of democracy in 1994. This rating indicates that South
Africa is regarded as stable, with the elections over and Cyril
Ramaphosa at the helm of the country. The South African
government is expected to pursue reforms, attempt to improve
economic growth in the country and focus on containing fiscal
deficits.
Ratings may change as the situation in an entity or a country
changes.
QUICK QUIZ
1. Which are the three main credit-rating
agencies?
2. According to these entities, is the South
African government a safe investment? How do
you know that?
3. What does it mean to default?
FOCUS ON ETHICS: The ethics of
credit-rating agencies
“In 2008, US$14 trillion of highly rated bonds fell to junk status,
resulting in the largest U.S. financial crisis since the Great Depression.
Credit-rating agencies (CRAs) have come under intense scrutiny as a
result of this disaster, including congressional inquiries and
government investigations.” (Scalet & Kelly, 2012).
The quotation above, which is the opening section of an article
published in the Journal of Business Ethics, indicates the importance
and value that investors and governments worldwide place on the
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ratings produced by international credit-rating agencies. During the
global financial crises in the early part of this century, credit-rating
agencies were criticised for their rating judgements (Binici, Hutchison
& Weichend Miao, 2018).
A sovereign rating agency assesses (in other words, rates) a
government on the basis of its financial health, which includes its
ability to service its debt. Thus, the rating provided by the agency
indicates the level of confidence that agency has in the government in
question (CFI Education, 2020). Serious events in a country that may
affect its financial and/or social structure commonly result in the
rating agencies downgrading the rating of that government.
QUESTION
Do some background reading on the Eurozone Crisis of
2009. Do you think that credit-rating agencies behaved
unreasonably in downgrading the sovereign ratings of
certain countries?
8.7
What determines bond returns?
Investors put their money into bonds and other debt securities for
the purpose of receiving compensation for the risk they are
prepared to take. The return (or coupon) an investor receives
consists of compensation for the following mix of variables: the real
interest rate, the expected inflation rate, interest-rate risk, default
risk and lack of liquidity. These determinants are discussed in the
sections that follow.
8.7.1
Real interest rate and expected inflation rate
The main reason these factors determine a bond’s return is that the
nominal interest rate (the coupon rate) is dependent on the
expected inflation rate and the real interest rate. When the real
interest rate is added to the inflation rate, it provides a fairly
accurate estimate of the coupon rate. Therefore, if either or both of
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these two variables were to increase, it would also increase the
coupon rate, and vice versa. This relationship can be referred to as
the inflation premium inherent in the compensation of a bond. The
relationship between these two variables and the coupon rate are
discussed in more detail in Section 8.8.
8.7.2
Interest-rate risk and time to maturity
Generally, the longer the time to maturity, the higher the financial
compensation for the investor. The reason for this is that the bond is
exposed to more changeability if the maturity is longer, particularly
changes in interest rates. Long-term bonds have much more
interest-rate risk than short-term bonds. Therefore, extra
compensation is required for investors in long-term bonds. This can
be referred to as the interest-rate premium. As the closing case
study in this chapter indicates, South Africa had an interest-rate cut
in June of 2019 due to the contraction of the economy. Long-term
bonds are much more exposed to interest-rate cuts and hikes than
shorter-term bonds. Interest-rate cuts lead to an increase in bond
prices.
8.7.3
Default risk
A very important determinant of financial compensation (coupon
rate) is the risk of default. This is the risk that investors have to take
to compensate for the fact that the bond issuers may not be able to
make payments (in other words, they may default on payments).
Bond ratings indicate if a bond is of high quality or if the risk for
default is high. The higher the risk of default, the higher the
compensation for the investor. This is called the credit risk
premium.
8.7.4
Lack of liquidity
Liquidity refers to the ease with which a security or asset can be
transformed into cash. Some bonds trade more often than others; if
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a bond is not traded regularly, it means that it is not very liquid.
Thus, if you need cash quickly and you have an illiquid bond, you
might struggle to transform the bond into cash. Investors with
illiquid bonds would, therefore, demand compensation for the lack
of liquidity because it increases their risk. This is called the liquidity
premium.
QUICK QUIZ
1. What are the determinants of bond coupon
rates?
2. Complete this sentence: The longer the bond’s
maturity, the higher the _________.
3. Why is a lack of liquidity a risk for a bond
investor?
8.8
The influence of interest and inflation rates on
bonds
Two of the major influences that have an impact on bond yields are
the inflation rate and the market interest rate. There are two kinds
of interest rate: the nominal rate and the real interest rate. Both of
these rates are discussed in this section, along with their relation to
inflation.
8.8.1
The difference between nominal and real interest
rates
Firstly, it is important to distinguish between the nominal interest
rate and the real interest rate. In the simplest terms, it can be said
that the nominal interest rate is the rate of return that has not been
adjusted for inflation (so inflation is still included in the figure). The
real interest rate, however, has been adjusted for inflation (inflation
is not included in the figure). Inflation can be described as the
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sustained, rapid increase in the general price level, which is
mirrored in the correspondingly decreasing purchasing power of
the currency.
Consider this example as an illustration: Amir has received a
bonus. She decides to save R1 000 of the bonus in a savings account.
She will be able to earn a rate of return of 12% per year on the
money in the savings account. She wants to buy a pair of leather
boots that cost R1 200. With an interest rate of 12%, she will have R1
120 in her account to buy the boots in one year. During that year,
though, the inflation rate is 4%. This means that the price of the
boots will have gone up by 4%:
R1 200 × 4% = R48
R1 200 + R48 = R1 248
The boots now cost R1 248 and Amir has only saved R1 120. That is
a difference of R128. Thus, even though she received R120 in
interest (12%), inflation ate away some of her return. What rate of
interest did she actually earn? We calculate this by using the
following formulae:
Now it is easy to work out. The future value (FV) of Amir’s
investment after one year is R1 120. The inflation rate is 4%. Thus,
R1 120 ÷ 1,04​ = R1 076,92. In reality, Amir did not earn R120 in
interest, but only R76,92 (R76,92 ÷ R1 000 × 100 = 7,69%). Amir
actually only received 7,69% in interest, not 12%, because of the
impact of inflation. This is the real interest rate, or rate of return.
8.8.2
The Fisher effect
The relationship between the nominal interest rate, the real interest
rate and the inflation rate can best be explained by an equation
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proposed by economist Irving Fisher, called the Fisher effect. It is
essential to take the inflation rate into consideration because you
need to know what you will ultimately be able buy with your
money (in other words, what your purchasing power will be), so it
is necessary to receive compensation for the effect that inflation has
on that buying power. In essence, the following could be an
estimate:
Real interest rate = Nominal interest rate – Expected inflation rate
Alternatively:
Nominal interest rate = Real interest rate + Expected inflation rate
According to Fisher, the relationship between the three variables
(nominal interest, real interest and inflation rate) is as follows:
Where:
n = nominal return
r = real return
i = inflation rate
Let us look again at the example of Amir, who wants to save R1 120
for her boots. We can use the Fisher equation to calculate what the
real rate is that she would receive for her money in the savings
account. Remember, in the example, the inflation rate (i) was 4%
and the nominal interest rate (n) was 12%.
By reorganising the equation, it is also possible to calculate the
nominal return:
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1 + n = (1 + r) × (1 + i)
1 + n = (1,0769) × (1,04)
1 + n = 1,119976
n = 12%
The nominal rate of return, therefore, consists of three parts. One
part is represented by the real return (r), the second part is
represented by the inflation rate (i), or the decrease in the
purchasing power, and the third part is representative of the fact
that because of inflation, less money was earned on the investment.
Therefore, the nominal rate is 12%.
The economic downturn experienced in South Africa and the
rest of the world may lead to higher inflation rates. This could have
a negative effect on the real interest rates that investors receive (see
the case study at the end of this chapter).
QUICK QUIZ
1. What is the difference between the nominal
interest rate and the real interest rate?
2. What is the Fisher effect equation?
3. Why is the inflation rate important in bond
valuation?
8.9
Conclusion
This chapter dealt with the valuation of bonds and the influence of
interest rates on bonds. You learnt the following:
• A bond is a debt instrument issued by either a government or a
corporation in need of funds. The bond pays interest on the
nominal amount (coupon payments). The loan has a fixed
maturity. When it reaches maturity, the nominal amount is
repaid.
• A bond consists of the following variables:
– Nominal value: The amount borrowed by the issuers
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•
•
•
•
•
•
– Coupon rate: The fixed interest rate that the issuer promises
to pay every period
– Coupon: The payment made to the lender (owner of the
bond) every period; the coupon is calculated by multiplying
the nominal value by the coupon rate
– Yield-to-maturity (YTM): The prevailing interest rate on a
specific bond in the market; whereas interest rates in the
market change, the coupon rate on a bond remains fixed
– Maturity: The number of years until the bond matures, or
reaches the end of the loan (when the nominal amount has to
be repaid)
– Price of the bond (or its present value, or PV): The current
selling price of the bond investment; this is dependent on the
nominal value, the coupon rate, the maturity and the YTM.
When the YTM (the interest rate in the market) and the coupon
rate differ, the price of the bond also differs from the nominal
value of the bond. When the interest rate in the market goes up,
the price of the bond goes down to compensate the investor for
earning a lower coupon rate (trading at a discount).
When the YTM is lower than the coupon rate, the price of the
bond increases relative to the nominal value. The price of the
bond will be higher because the bond will pay a higher coupon
rate than in the market; the investor has to pay more for that
privilege.
If the YTM and the coupon rate are equal, then the price of the
bond equals the nominal value.
When calculating the price of a bond, the PV of the lump sum
paid out at maturity (the nominal value) must be calculated and
added to the PV of all the future cash flows (the coupon
payments).
A bond that makes semi-annual payments makes two payments
a year, one every six months. This means that the coupon rate
has to be divided by two, and the coupon payment and maturity
have to be multiplied by two.
There are various types of bond, including government,
municipal, corporate, convertible, zero-coupon, extendable,
retractable, foreign-currency, junk and inflation-linked bonds.
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• The New York Stock Exchange is the biggest bond exchange in
the world; South Africa’s BESA is a leader in emerging
economies. Mostly, the bond market is an OTC market.
• Moody’s, Standard & Poor’s and Fitch are the three main creditrating agencies.
• Bonds are rated in order to indicate the level of risk of payment
default to investors.
• The bond coupon rate is dependent on the real interest rate
implicit in the coupon, the expected inflation rate, the time left
to maturity, and the interest rate risk, default risk and liquidity
risk.
• The difference between real and nominal interest rates is that
the real interest rate has been adjusted for inflation, whereas the
nominal rate has not been adjusted for inflation.
• The Fisher effect illustrates the relationship between the
nominal interest rate, the real interest rate and the inflation rate.
The opening case study gave an example of an international
corporate bond (the Starbucks bond). The closing case study
discusses the current interest rate situation in South Africa and
illustrates how economic factors have an impact on interest rates.
CASE STUDY
The South African economy and interest rates
South Africa is currently rated as BB with a stable outlook (S&P
rating). A BB-rated entity is regarded as having significant
speculative characteristics, but it could also have some quality
and protective characteristics, and is less vulnerable to nonpayment than other speculative issues. However, an entity
with this rating faces major ongoing uncertainties, or exposure
to adverse business, financial or economic conditions that
could lead to the obligor having inadequate capacity to meet its
financial commitments.
South Africa is experiencing its biggest economic
contraction in a decade. For that reason, there have been calls
for the Reserve Bank to cut interest rates in a bid to boost
economic growth and consumer spending. In July of 2019, the
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benchmark repo rate was cut by 25 basis points, giving a total
of 6,5 percent. The forecast for inflation rates for 2019 is
currently in the mid-range levels (approximately 4,4%).
Sources: Compiled from information in Collier, 2019; Vollgraaf, 2019.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
A bond is an investment in which the issuer makes equal payments to the
bondholder at regular time intervals for a fixed period of time. Therefore, a
bond can be referred to as __________.
A. multiple future cash flows
B. coupon payments
C. an annuity
D. zero coupon
2.
If a bond’s nominal value is R10 000 and the bond sells for R10 000, then …
A. the bond is trading at a discount.
B. the bond is trading at a premium.
C. the coupon rate is more than the YTM.
D. the bond is trading at the nominal value.
3.
Which ONE of the following is NOT a characteristic of a bond?
A. Face value
B. Coupon payment
C. Maturity
D. Dividend yield
4.
A very risky bond with a high yield can be regarded as …
A. a bond from a developing country.
B. a junk bond.
C. a default bond.
D. a zero-coupon bond.
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5.
A bond that allows the bondholder to make the bond’s maturity shorter can be
classified as …
A. an inflation-linked bond.
B. an extendable bond.
C. a discount bond.
D. a retractable bond.
6.
When the YTM is more than the coupon rate, then a bond can be classified as
a __________ bond.
A. premium
B. junk
C. discount
D. retractable
7.
If a bond is R1 000 at maturity and the bond is currently selling for R1 000,
then …
A. the YTM is more than the coupon rate.
B. the coupon rate is more than the YTM.
C. the YTM and the coupon rate are the same.
D. the bond is selling at above the nominal value.
8.
Which of the following does NOT determine a bond’s return?
A. Maturity premium
B. Credit-risk premium
C. Liquidity premium
D. Interest-rate premium
9.
The prevailing interest rate on bonds in the market is known as the
__________.
A. coupon rate
B. nominal rate
C. real rate
D. YTM
INTERMEDIATE
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10. Izzy Ltd is issuing a bond with a maturity of 12 years, after which R15 000 will
be paid to the bondholder. The market interest rate is 7,25%. The bondholder
receives a coupon of R1 050 every year. What is the bond selling for at
present?
A. R15 000,00
B. R16 574,21
C. R14 706,08
D. R14 828,91
11. Gary has decided to invest R995 in a bond that will repay R1 000 after seven
years. The bond makes semi-annual payments and the market interest rate is
8%. What percentage will Gary receive every six months?
A. 34,54%
B. 79,04%
C. 3,52%
D. 3,95%
12. You want to own an asset with a real return of 10%. The inflation rate is
currently 3,6%. What nominal interest rate would you have to earn?
A. 13,6%
B. 8,4%
C. 14,2%
D. 13,96%
13. Which of the following bonds has the highest return?
A. A bond with a B3 rating
B. A bond with a Baa1 rating
C. A bond with a BB rating
D. A bond with a BBB rating
14. Which of the following bonds has the greatest interest-rate risk?
A. Five-year; 9% coupon
B. Five-year; 7% coupon
C. Seven-year; 7% coupon
D. Nine-year; 9% coupon
E. Nine-year; 7% coupon
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ADVANCED
15. Bond A is a 5% coupon bond; Bond B is an 8% coupon bond. The market
interest rate is 9% and both bonds have a maturity of 12 years. If the interest
rate drops by 3%, what will the price change of both bonds be?
A. Bond A = 77,89%; Bond B = 79,51%
B. Bond A = −28,93%; Bond B = −25,12%
C. Bond A = 28,39%; Bond B = 25,77%
D. Bond A = 25,77%; Bond B = 28,90%
16. Refer back to Question 15. What do the results of the question illustrate?
A. The higher the inflation rate, the greater the price sensitivity of the bond
B. The higher the coupon payment, the lower the price sensitivity of the
bond
C. The lower the coupon rate, the greater the price sensitivity of the bond
D. The higher the coupon rate, the greater the price sensitivity of the bond
17. Suppose you bought an 11% coupon bond one year ago for R955. The bond
sells for R925 today. It has a face value of R1 000. What were your total rand
return and your nominal rate of return on this investment over the past year?
A. R110 and 8,4%
B. R110 and 9%
C. R30 and 8,57%
D. R80 and 8,38%
E. R80 and 15,73%
LONGER QUESTIONS
BASIC
1.
Lucky wants to invest in an R11 000 bond that is currently selling for R11 050
and matures in four years. The YTM is 12%.
a) What is the coupon payment?
b) What is the coupon rate?
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2.
A General Co. bond has an 8% coupon and pays interest semi-annually. The
current market price is 102% of the face value. The bond matures in 20 years.
What is the yield to maturity?
3.
The interest rate in the market increases to more than the coupon rate being
paid on a particular bond.
a) What will happen to the price of that bond?
b) Why?
INTERMEDIATE
4.
Frog (Pty) Ltd issued a bond five years ago at a nominal value of R10 000. The
investors receive a yearly interest payment of R1 500. The market interest rate
five years ago was 15,5%. The market interest rate has now decreased by 2%.
The bond matures in 15 years’ time.
a) What is the maturity of the bond?
b) Indicate the YTM.
c) Indicate the coupon rate.
d) What was the value of the bond five years ago?
e) What is the current value of the bond?
5.
Xian has some cash that she wants to invest. She has decided to invest in a
semi-annual R1 000 bond that pays a coupon rate of 12%. The bond matures
in ten years. She pays R980 for the bond.
a) What is the YTM?
b) Is the bond selling at a discount or at a premium?
c) What would the YTM be if she paid R1 090 for the bond?
6.
Nusana has a savings account that provides her with 15,25% interest every
year. Last year, the inflation rate was 6%; this year, the inflation rate declined
to 5,75%. What are the real rates of interest that she earned last year and this
year?
7.
Cola Ltd wants to issue new 20-year bonds to the public to raise capital. The
entity already has 9% coupon bonds on the market that sell for R1 090. They
make yearly payments and mature in 15 years. What coupon rate should the
entity set on its new bonds if it wants to sell them at the nominal or face value?
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ADVANCED
8.
You have to make a choice between two bonds. Bond A makes semi-annual
payments, has a maturity of five years and has a coupon rate of 12,5%. Bond
B has a maturity of six years and a coupon rate of 12,2%. The nominal value of
each bond is R15 000 and the interest rate in the market is 12,35%.
a) What is the value of Bond A?
b) What is the value of Bond B?
c) Which bond is trading at a premium and which is trading at a discount?
9.
Daniel is close to retirement. He has chosen to invest some of his retirement
funds in a bond portfolio. He has decided to invest his money into equal
amounts of three bonds. He has a choice of two portfolios, each containing
three bonds. Their respective ratings according to Moody’s are set out in the
table that follows.
a)
b)
c)
Portfolio 1
Portfolio 2
Bond A: Rating = Aa3
Bond D: Rating = Aa1
Bond B: Rating = Aaa
Bond E: Rating = Ba1
Bond C: Rating = A2
Bond F: Rating = Aaa
Which portfolio do you think would be the best for Daniel?
Why do you think this portfolio and not the other one would be
appropriate for Daniel?
Which portfolio would be best for a young working adult with a bit of extra
cash to invest?
KEY CONCEPTS
Annuity: A loan that makes fixed payments over a specific period.
Bond: A loan made by the issuer promising to pay a fixed interest
rate every period and to repay the nominal value at the maturity
of the bond.
Bond that makes semi-annual payments: A bond paying coupons twice a
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year, every six months.
Convertible bond: A bond that can be converted into a predetermined
amount of the entity’s equity.
Coupon: The nominal value multiplied by the coupon rate.
Coupon rate: The fixed interest rate paid on the nominal value to the
bondholder every period.
Default risk: The possibility that a bond issuer will default by failing
to repay the principal and the interest in a timely manner.
Extendable bond: A type of bond whose maturity the bondholder can
extend.
Foreign-currency bond: A bond issued by an issuer in a currency other
than its national currency.
Future value (FV): The value at a given future time of a present
amount of money deposited today in a savings account earning
specific interest.
Inflation-linked bond: A bond that provides protection against
inflation. As inflation increases, the nominal amount also
increases, as do the coupon payments.
Interest-rate risk: The possibility of a reduction in the value of a bond
as a result of a rise in interest rates.
Junk bond: A bond rated ‘BB’ or lower by rating agencies because of
its high default risk.
Maturity: The end of the lifetime of a bond, when the nominal value
has to be repaid.
Nominal rate of return: The rate of return that has not been adjusted for
inflation.
Nominal value: The principal value that the issuer has to repay to the
bondholder at the maturity of a bond.
Present value (PV): The current value of a future amount of money or
series of future payments, evaluated at a given interest rate.
Real rate of return: The rate of return after it has been adjusted for
inflation.
Retractable bond: A bond that enables the holder to retract the
maturity (make it shorter).
Trading at a discount: Occurs when the YTM is more than the coupon
rate and the price of the bond decreases relative to the nominal
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value.
Trading at a premium: Occurs when the YTM is less than the coupon
rate and the price of the bond increases relative to the nominal
value.
Yield-to-maturity (YTM): The current market rate of return on bonds.
Zero-coupon bond: A debt security that does not pay interest (a
coupon), but is traded at a large discount.
SLEUTELKONSEPTE
Annuïteit: ’n Lening wat vaste betalings oor ’n spesifieke periode
maak.
Buitelandse valuta skuldbrief: ’n Skuldbrief wat uitgereik word in ’n
geldeenheid anders as die nasionale geldeenheid.
Inflasie-gekoppelde skuldbrief: ’n Skuldbrief wat beskerming verskaf
teen inflasie. As inflasie toeneem, so sal beide die nominale
bedrag en die koeponbetalings toeneem.
‘Junk’ skuldbrief: ’n Skuldbrief wat as ‘BB’ en laer geklassifiseer word
as gevolg van die hoë risiko van wanbetaling.
Koepon: Die nominale waarde vermenigvuldig met die koeponkoers.
Koeponkoers: Die vaste rentekoers wat bereken word op die
nominale waarde van die skuldbrief en betaal word aan die
skuldbrief houer elke periode.
Nominale rentekoers: Die rentekoers wat nie aangepas is vir inflasie
nie.
Nominale waarde: Die prinsipaal of gesigswaarde wat die uitreiker
moet terugbetaal aan die skuldbriefhouers wanneer die
skuldbrief verval.
Opbrengs tot verval: Die huidige markkoers op skuldbriewe.
Reële rentekoers: Die rentekoers wat aangepas is vir inflasie.
Rentekoers risiko: Die moontlikheid van ’n vermindering in die
waarde van ’n skuldbrief as gevolg van ’n styging in
rentekoerse.
Skuldbrief: ’n Lening word gemaak deur die uitreiker wat belowe om
’n vaste rentekoers elke periode te betaal, asook om die
nominale waarde op die vervaldatum van die skuldbrief te
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betaal.
Skuldbrief wat tweejaarlikse betalings maak: ’n Skuldbrief wat koeponne
twee keer ’n jaar betaal, een keer elke ses maande.
Terugtrekbare skuldbrief: ’n Skuldbrief waar die skuldbriefhouer die
vervaldatum van die skuldbrief kan herroep (korter maak).
Verhandel teen ’n korting: Wanneer die opbrengs tot verval meer is as
die koeponkoers en die skuldbrief prys daal relatief tot die
nominale waarde.
Verhandel teen ’n premie: Wanneer die opbrengs tot verval minder is
as die koeponkoers en die skuldbrief prys styg relatief tot die
nominale waarde.
Verlengde skuldbrief: ’n Skuldbrief waar die skuldbriefhouer die
vervaldatum van die skuldbrief kan verleng (langer maak).
Vervaltyd: Die einde van die leeftyd van ’n skuldbrief wanneer die
nominale waarde van die skuldbrief terugbetaal moet word.
Verwisselbare skuldbrief: ’n Skuldbrief wat omgeruil kan word vir ’n
voorafbepaalde hoeveelheid van ’n besigheid se ekwiteit.
Wanbetalingsrisiko: Die moontlikheid dat ’n skuldbrief uitreiker
versuim om die prinsipaal terug te betaal en die rente op die
regte tydstip.
Zero-koepon skuldbrief: ’n Skuld sekuriteit wat nie rente (koepon)
betaal nie, maar teen ’n groot korting verhandel word.
SUMMARY OF FORMULAE USED IN THIS CHAPTER
SUMMARY OF FORMULAE USED IN THIS CHAPTER
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WEB RESOURCES
http://www.bondexchange.co.za
http://www.fitchratings.com
http://www.investopedia.com
http://www.investorwords.com
http://www.moodys.com
http://www.nyse.com
http://www.sharenet.co.za
http://www.standardandpoors.com
REFERENCES
Binici, M., Hutchison, M. & Weichend Miao, E. (2018). BIS
Working Papers No 704. Are credit rating agencies discredited?
Measuring market price effects from agency sovereign debt
announcements. Retrieved from
https://www.bis.org/publ/work704.pdf [25 February 2020].
CFI Education. (2020). What is a Rating Agency? Retrieved from
https://corporatefinanceinstitute.com/resources/knowledge/finance/ratin
agency/ [25 February 2020].
Cole, M. (2007). Starbucks bonds: Wake up and smell the coffee!
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Financial Week, 3 September 2007.
Collier, G. (2019). How to make the most of the latest interest rate
cut. Moneyweb. Retrieved from
https://www.moneyweb.co.za/financial-advisor-views/howto-make-the-most-of-the-latest-interest-rate-cut/ [9 February
2020].
International Business Times. (2013). Starbucks Seeks More Debt
Financing, In New Debt Issuance Worth $750 Million. Retrieved
from https://www.ibtimes.com/starbucks-seeks-more-debtfinancing-new-debt-issuance-worth-750-million-1402435 [25
February 2020].
Jariel, C.M. & Bacani, E.L. (2018). Update: Rating agencies hit
Starbucks with downgrades on expected debt increase. Retrieved
from https://www.spglobal.com/marketintelligence/en/newsinsights/trending/lihfm-z1t6lcw-awqlhbig2 [9 February 2020].
Markets Insider. (2019). Starbucks 18/48. Retrieved from
https://markets.businessinsider.com/bonds/starbucks_corpdlnotes_201818-48-bond-2048-us855244as84 [9 February 2020].
McPartland, K. (2018). Understanding The $41 Trillion U.S. Bond
Market. Retrieved from
https://www.forbes.com/sites/kevinmcpartland/2018/10/11/understand
us-bond-market/#79d136151caf [25 February 2020].
Momentum SP Reid Securities. (2020). SA Bonds/Gilts: 2020/02/24.
Retrieved from https://www.sharenet.co.za/free/gilts.phtml?
scheme=imaraco [25 February 2020]. © 2020 Momentum
Securities (Pty) Limited is an authorised financial and credit
provider. Registration no. 1974/000041/07 A member of the JSE
Ltd FSB license number 29547 NCR CP 2518.
Scalet, S. & Kelly, T. (© 2012). The ethics of credit rating agencies:
What happened and the way forward. Journal of Business Ethics,
111(4), 477–490 (477). Reprinted by permission of Springer
Nature through Copyright Clearance Center.
Starbucks: Stories & News. (2014). Starbucks Senior Unsecured Debt
Rating Upgraded by Moody’s Investor Service To A3. Retrieved
from https://stories.starbucks.com/stories/2014/starbuckssenior-unsecured-debt-rating-upgraded-by-moodys-investorservice/ [9 February 2020].
Vollgraaf, R. (2019). SA interest rates may fall, and not due to
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politics. Fin24. Retrieved from
https://www.fin24.com/Economy/sa-interest-rates-may-falland-not-due-to-politics-20190717 [9 February 2020].
Wolf Street. (2020). Corporate redit rating scales by Moody’s, S&P, and
Fitch: How the big three US credit rating agencies classify corporate
bonds and loans by credit risk, or the risk of default. Retrieved from
https://wolfstreet.com/credit-rating-scales-by-moodys-sp-andfitch/ [25 February 2020]. Reprinted by permission of
WOLFSTREET.com.
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9 Share valuation
Suzette Viviers
Learning
outcomes
Chapter
outline
9.1
9.2
By the end of this chapter, you should be able to:
differentiate between ordinary shares and
preference shares
distinguish between market value, book value
and intrinsic value
explain the importance of share valuation
determine the intrinsic value of a share using
the dividend discount model
determine the intrinsic value of an entity using
the free cash flow model
determine the relative value of an entity using
financial ratios
differentiate between expected and required
rates of return
explain why more investors are taking
cognisance of ethical and environmental, social
and governance risks
explain what is meant by an efficient market
describe some of the main cognitive errors that
market participants can exhibit
explain how cognitive errors exhibited by market
participants can result in market inefficiencies.
Introduction
The development of stock exchanges across
the globe
9.3 Ordinary shares and preference shares
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9.4
9.5
9.6
9.7
9.8
CASE STUDY
Defining share value
Share valuation
Ethical and environmental, social and
governance considerations
Market efficiency and behavioural finance
Conclusion
Oceana Group Ltd
Oceana, which is the largest fishing entity in Africa, is listed on
the Johannesburg and Namibian stock exchanges. The entity’s
fishing and production-related activities are conducted
through three operating divisions: Lucky Star, Daybrook
Fisheries and Blue Continent Products. A fourth division, CCS
Logistics, provides refrigerated warehouse facilities in South
Africa, Namibia and Angola. The entity specialises in catching,
processing, marketing and distributing canned fish, fishmeal,
fish oil, lobster, horse mackerel, squid and hake.
Although Oceana mainly targets lower-end consumers, the
entity also sells lobster, hake and certain canned fish products
to upper-end consumers. Oceana’s products are sold in
markets across Africa, Asia, Europe, the United States and
Australia. Sales of the iconic Lucky Star brand have increased
in South Africa in recent years, as more consumers are feeling
the pinch of the slowing economy. Lucky Star products are not
only marketed as affordable and nutritious, but also as
sustainably caught and processed.
The fishing giant did not pay a final dividend in 2017, but
rewarded shareholders with a generous final dividend in 2018.
The group’s chief executive officer said that the 304c per share
final dividend in 2018 was the result of higher sales, improved
operating efficiencies and better management of the entity’s
foreign currency exposure. Despite a relatively strong financial
performance, the entity’s share price has decreased quite
substantially in recent years.
Sources: Compiled from information in ShareData Online, 2020a; Oceana Group Ltd, 2017a; Lucky
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Star, 2020; BusinessDay, 2018a.
9.1
Introduction
In this chapter, we discuss various topics relating to the valuation of
entities. As the shares of publicly listed companies are traded on
stock exchanges, we start with a brief overview of the development
of stock markets around the world. We then distinguish between
ordinary shares and preference shares. Next, we present various
definitions of value, along with some of the most prominent models
used by financial managers, shareholders and other stakeholders to
determine the intrinsic value of an entity. The price-earnings and
price-book ratios are also introduced as measures of an entity’s
relative value.
When evaluating the investment potential of an entity such as
Oceana, investors have traditionally only considered dividend
payments and stock market performance. However, many investors
are now also integrating ethical and environmental, social and
governance (ESG) considerations into their investment analyses
(PRI, 2019). As will be shown later in this chapter, environmentally
conscious investors might be concerned about the long-term
sustainability of Oceana’s fishing operations, whereas socially
minded investors might praise the entity for their efforts to promote
broad-based black economic empowerment (B-BBEE) in South
Africa. Finally, our focus shifts to the concepts of market efficiency
and behavioural finance.
9.2
The development of stock exchanges across the
globe
The first ‘stock exchange’ in Europe was established by French king
Phillip the Fair in the 12th century to facilitate credit transactions. In
the 13th century, commodity traders in Bruges (a city in modernday Belgium) gathered in the house of a merchant whose surname
was Van der Burse. In 1309, the traders institutionalised their
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meetings and the institution became known as the Bruges Bourse.
The French word bourse means ‘purse’, and later came to signify a
place where trading in financial instruments takes place. Other
bourses soon opened in Ghent (also in Belgium) and in Amsterdam
(in the Netherlands). The London Stock Exchange opened its doors
much later, in 1773. The first stock exchanges in the United States
were established in Philadelphia in 1791 and in New York a year
later. As indicated in Table 9.1, 59 regulated stock exchanges were
members of the World Federation of Stock Exchanges at the end of
July 2019.
Table 9.1 Prominent stock exchanges
Source: World Federation of Exchanges, 2019.
The Johannesburg Stock Exchange (‘the JSE’) came into existence in
1887, one year after the discovery of gold on the Witwatersrand
(JSE, 2013a). The exchange provided a platform where new mining
and financial companies could raise equity capital from members of
the public. In 1995, substantial amendments made to legislation
resulted in the deregulation of the JSE. In December of that year, the
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market capitalisation of the stock exchange exceeded R1 trillion for
the first time in its history. After more than a century of operating
an open outcry (in other words, verbal) trading system, the
exchange switched to an order-driven, centralised, automated
trading system in 1996.
In 2001, the JSE acquired the South African Futures Exchange
and became the leader in equities as well as equity and agricultural
derivatives trading in South Africa. In 2005, the JSE demutualised,
and in June 2006, it became a publicly listed company. Three years
later, in June 2009, the Bond Exchange of South Africa also became
a wholly owned subsidiary of the bourse. The JSE is the largest
exchange on the African continent and is among the top 20
exchanges globally based on market capitalisation.
To promote B-BBEE, the JSE created an empowerment segment
in 2011 where B-BBEE shares can be bought and sold in a regulated
market. A number of locally listed companies have created B-BBEE
share schemes to give previously disadvantaged South Africans the
opportunity to own a stake in the entity and participate in its
growth.
QUICK QUIZ
1. What are the implications of the JSE serving
as the primary and secondary market for most
listed financial securities in South Africa?
Refer to Chapter 1 for a review of primary and
secondary markets.
2. What are the requirements for entities to list
on the JSE? Hint: Visit the website of the
exchange (https://www.jse.co.za/listingprocess/listing-on-the-jse).
3. On 31 July 2015, 395 entities were listed on
the JSE’s main board and AltX (an alternative
exchange launched in 2003 for small and midsized listings) (JSE, 2019). In contrast, only
357 entities were listed at the end of July
2019 (JSE, 2019). Why have so many entities
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delisted from the local exchange since 2015?
9.3
Ordinary shares and preference shares
The terms ‘shares’, ‘equities’ and ‘stocks’ are often used
interchangeably and represent investors’ ownership of the
productive assets of an entity. Productive assets refer to the current
and non-current assets used to generate profits. The term ‘share’
will be used in this chapter, as it is more frequently used in the
South African context (JSE, 2013b).
Listed companies can issue different types of share to raise
equity capital from the public. The main types are ordinary shares
(called common stock in the United States) and preference shares
(called preferred stock in the United States). Ordinary shareholders
are not guaranteed dividends, but may vote at shareholder
meetings. Voting occurs on a range of topics, such as the election of
directors, share repurchases, mergers and acquisitions (M&As), and
the entity’s executive remuneration policy. Whereas most votes are
binding, approval of the entity’s executive remuneration policy is
non-binding. This means that the entity does not have to amend its
policy even if more than 50% of shareholders voted against it.
Ordinary shareholders also have a pre-emptive right, which means
that they have the right to purchase additional shares issued by the
entity in future.
A second class of ordinary shares can be listed and traded on the
JSE: B-class ordinary shares (JSE, 2013c). These shares are subject to
the listed company’s articles of association. Holders of these shares
have fewer or no voting rights and may not have a right to any
payment of capital when the entity is dissolved. Dividends for these
shares are not fixed and may be higher than dividends for
preference shares. Should the issuing entity dissolve, B-class
ordinary shareholders may receive a dividend after the entity’s
debt, preference dividends and A-class ordinary dividends have
been paid.
Investors who purchase preference shares have no voting rights
(except under certain circumstances), but receive preferential
treatment when it comes to the distribution of the entity’s profits
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and assets in the event of liquidation. Preference shares normally
offer a fixed dividend.
There are five types of preference share:
• cumulative
• non-cumulative
• participating
• convertible
• redeemable.
In the case of cumulative preference shares, any dividends that
have not been paid in a particular period will accumulate over time
(JSE, 2013d). This means that if an entity is unable to pay dividends
for a specific period, it will still be liable for those dividend
payments once it is in a position to resume dividend payments. The
preference shareholder therefore remains entitled to those
dividends. By contrast, non-cumulative preference shares do not
entitle shareholders to any missed dividends. In this case,
dividends that have not been paid in a particular period do not
accumulate and the entity is not liable to pay those dividends in the
future.
Participating preference shares allow shareholders to receive a
higher dividend than was initially set by the entity should it
perform better than expected. As such, these shareholders’
dividend payments have a lower limit, but no upper limit. As the
name suggests, convertible preference shares allow shareholders to
convert their shares into a predetermined number of ordinary
shares at a specified date.
Lastly, redeemable preference shares can be called back by the
issuing entity either at a fixed rate on a specified date or over a
certain period of time. More information about the different types
of preference share is provided in Chapter 12.
QUICK QUIZ
1. Why would an entity issue B-class ordinary
shares?
2. Describe the main differences between ordinary
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shares and preference shares.
3. Very few entities in South Africa raise new
equity capital by issuing preference shares.
Why do you think this is the case?
4. Assume that Oceana would like to raise equity
capital to pursue growth opportunities. Would
it be advisable for the entity to issue
cumulative preference shares? Motivate your
answer.
9.4
Defining share value
Three definitions of share value are discussed in this section:
market value, book value and intrinsic value. Note that the term
‘par value’ is no longer used, as the Companies Act (No. 71 of 2008)
changed the basis on which companies are capitalised compared to
the 1973 version of the Act. Shares issued in terms of the 2008 Act
have no nominal or par value. An entity’s board of directors must
determine the price at which shares may be issued.
9.4.1
Market value
Once shares are traded in the secondary market, their market value
is determined by demand-and-supply forces (in other words, what
buyers are prepared to offer per share and what sellers are willing
to accept in return). The market values (prices) of all listed
companies
are
available
on
websites
such
as
http://www.sharedata.co.za and http://www.sharenet.co.za.
Total market value on a particular date can be determined by
multiplying the entity’s market price per share on that date by the
number of ordinary shares in issue.
9.4.2
Book value
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The market value of an entity’s ordinary shares is usually very
different from its book value as reflected in the statement of
financial position. The book value of ordinary shares is equal to
total assets minus liabilities, preference share capital and intangible
assets. In other words, the book value is what an entity would have
left over if all its assets were to be sold for their book values and all
liabilities were to be paid. The book value per share is therefore
equal to the book value of ordinary shares, as reflected in the
statement of financial position, divided by the number of issued
ordinary shares outstanding. If market value exceeds book value,
management has created value for the entity’s shareholders.
Consider the information provided in Table 9.2. Do you think
that Oceana’s management has created value for the entity’s
shareholders over the period 2014 to 2018? Motivate your answer.
You may recall from Chapter 1 that value creation may also be
considered in relation to the other five capitals (manufactured,
natural, human, intellectual, and social and relationship).
Table 9.2 Oceana Group’s market value and book value at year end (September)
Source: Information compiled by Iress Research Domain from Oceana Group Ltd, 2020.
9.4.3
Intrinsic value
Intrinsic value – also called economic value – is often used by
prospective investors when evaluating investment opportunities.
They can use the following decision rules to guide them when
making investment decisions:
• If intrinsic value > market value, buy the share, as it is
undervalued.
• If intrinsic value < market value, do not buy the share (or sell it
if you own it), as the share is overvalued.
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Two models used to determine the intrinsic value of a share are
discussed in the section that follows.
QUICK QUIZ
1. Differentiate between market value, book value
and intrinsic value.
2. At the end of July 2019, 13 JSE-listed
companies were classified as food producers.
Oceana’s main competitors in this sector
include Sea Harvest Group Ltd and Premier
Fishing and Brands Ltd. Sea Harvest
specialises in deep-sea trawling and sells
more than 50 frozen and chilled seafood brands
(Sea Harvest, 2020a). The entity sells to
consumers in 22 countries, including South
Africa (Sea Harvest, 2020b). In addition to
commercial fishing, fish processing and
marketing, Premier is involved in aquaculture
through its abalone farm and the manufacturing
of environmentally friendly fertiliser
products through the Seagro brand (ShareData
Online, 2020b). On 31 July 2019, Oceana’s
share price closed at R68,53 (ShareData
Online, 2020a), whereas Sea Harvest closed at
R18,85 (ShareData Online, 2020c) and Premier
at R1,97 (ShareData Online, 2020b). Why are
the prices of these three competitors so
different?
9.5
Share valuation
One of the main models used to determine the intrinsic value of a
share is the dividend discount model (DDM). As the name
suggests, future dividends are estimated and discounted to today
using an appropriate discount rate. A second commonly used share
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valuation model uses free cash flows (FCFs) instead of dividends.
9.5.1
Dividend discount model
Formula 9.1 can be used to determine the present (current) value of
future dividends and hence the intrinsic value of a share:
Where:
0 = the intrinsic value of a share today
D1 = the expected dividend paid at the end of period 1
D2 = the expected dividend paid at the end of period 2
Dn = the expected dividend paid at the end of period n
ke= the rate of return required by ordinary shareholders (also called
the cost of ordinary share capital in Chapter 11)
Notice that 0, the price that investors are willing to pay for a share
today, depends on the expected future dividends and the discount
rate (ke). As you will see in Chapter 11, ke incorporates investors’
views on the riskiness of the entity. The terms ‘required rate of
return’ and ‘cost of equity’ can be used interchangeably, as they
refer to two sides of the same coin.
Formula 9.1 can be simplified depending on the expected
growth rate in dividends. In this regard, three scenarios can be
considered: zero-dividend growth, constant dividend growth and
variable dividend growth.
An entity’s chosen dividend policy, and hence the pattern of
future dividend payments, depends on various factors (see Chapter
13 for more information on this important financial management
decision). Many of these factors are evaluated when conducting a
fundamental analysis. On the macro level, consideration should be
given to the political, legal, economic, social and technological
factors that might influence an entity’s cash flows, and hence its
ability to pay a cash dividend. Fundamental analysts also evaluate
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market factors (which relate to consumers, suppliers and
competitors) and micro factors (which centre on entity-specific
factors such as brand loyalty and operational efficiency).
QUICK QUIZ
Which macro, market and micro factors could have
an impact on Oceana’s future performance and
dividend payments? Are these factors likely to
be different for a food producer such as Astral
Foods Ltd, which is classified as an integrated
poultry producer? Motivate your answer.
9.5.1.1
Zero-dividend growth
Preference shares are prime examples of shares that offer no
dividend growth. As the growth rate, g, is zero, we find that D0 =
D1 = D2 = … = D∞. Consequently, Formula 9.1 simplifies to:
Where:
kp = the rate of return required by preference shareholders (also
called the cost of preference share capital in Chapter 11)
Note that Formula 9.2 represents the present value of a perpetuity.
Refer to Chapter 4 for a discussion on perpetuities.
Example 9.1 Calculating the price of preference shares
Seagull Ltd issued preference shares that pay an annual dividend of R7 per
share. If the shareholders require an 11% return on their investment, what is
the intrinsic value of these preference shares?
Solution
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9.5.1.2
Constant dividend growth (the Gordon model)
Some entities opt to increase dividends at a constant rate over the
long term. By doing so, management sends a signal to the market
that the entity is financially sound. In this model, dividends are
thus expected to grow at a constant growth rate, g, forever. This
assumption implies that:
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dn = D0(1 + g)n
Alternatively, we can say that:
D1 = D0(1 + g)1
D2 = D1(1 + g)1
Dn = Dn – 1(1 + g)1
Based on the assumption above, the intrinsic value of a share can be
determined as follows:
Formula 9.3 indicates that the intrinsic value of a share today, 0,
depends on the dividend to be paid at the end of the next period,
D1, divided by the difference between the rate of return required by
ordinary shareholders and the constant dividend growth rate. An
important assumption when using the Gordon model (named after
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its creator, Prof. Myron J. Gordon) is that g should be smaller than
ke. If the expected growth rate exceeds ordinary shareholders’
required rate of return, 0 will be a nonsensical answer.
Example 9.2 Calculating the price of ordinary shares
TightLines Ltd has just paid an ordinary dividend of R1,15 and dividends are
expected to grow at a constant growth rate of 8% p.a. indefinitely.
Shareholders require a rate of return of 13,4% on investments of similar risk.
What is the intrinsic value of this entity?
Solution
As shown in Example 9.3, one of the benefits of using the Gordon
model is that the expected price of a share can be determined at any
future point.
Example 9.3 Calculating the price of ordinary shares in two years’ time
What will the intrinsic value of TightLines’ shares be two years from now?
Solution
QUICK QUIZ
1. Why will TightLines’s intrinsic value in two
years from now ( 2) be higher than its current
value ( 0)?
2. What will the intrinsic value of TightLines’
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shares be five years from now?
In cases where the Gordon model is applicable, we can rearrange
Formula 9.3 to calculate the expected rate of return of the share in
question (see Formula 9.4).
The first component of Formula 9.4 is called the dividend yield,
whereas the second component was previously defined as the
constant growth rate in dividends. From a mathematical point of
view, it can be shown that should g be constant forever, 0 will also
grow at the same rate. As such, g can also be referred to as the
capital gains yield.
Example 9.4 Calculating the return on ordinary shares
Investors are interested in purchasing ordinary shares in Squid Ltd. The entity’s
shares are currently priced at R80. The last dividend paid by the entity was R2
per share and dividends are expected to grow at a constant rate of 5% per
year forever. What is the return that investors expect to earn should they invest
in these shares?
Solution
If investors require an 8% return on these shares to compensate them for the
investment risk they are taking on, should they invest? No; the expected return
earned on Squid’s ordinary shares (7,63%) is less than the required rate of
return (8%). Ordinary shareholders will not be adequately rewarded for taking
on investment risk should they decide to invest in the entity.
The decision rules we formulated earlier can thus be extended as
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follows:
• If expected return > required return and intrinsic value > market
value, buy the share, as it is undervalued.
• If expected return < required return and intrinsic value < market
value, do not buy the share (or sell it if you own it), as the share
is overvalued.
Consider Oceana’s final dividend payments from 2008 to 2019, as
shown in Table 9.3. What do you notice about its dividend growth
rate?
Table 9.3 Oceana’s final dividend payments
Year
Divident per share
Cents
2018
243,20
2017
0,00
2016
303,45
2015
220,15
2014
230,35
2013
188,70
2012
217,60
2011
183,00
2010
175,00
2009
153,00
2008
130,00
Source: Information compiled by Iress Research Domain from Oceana Group Ltd, 2020.
As in Oceana’s case, dividends at most other entities fluctuate from
one year to the next. It is better to use a variable dividend growth
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model to determine the intrinsic value of these entities.
9.5.1.3
Variable dividend growth
As the name of this model suggests, dividend growth is expected to
change over time. Start-up entities often resort to reinvesting funds
in the first few years of operation. Only once they have established
themselves in the marketplace can they start paying a dividend.
Another typical example of variable dividend growth is when an
entity launches a successful new product and rewards its
shareholders with higher-than-usual dividends for a limited period
of time. Once competitors start copying this new idea, the entity has
to lower its prices, which reduces profit margins. Inevitably,
dividend growth will return to a lower, constant level.
Example 9.5 Calculating the price of ordinary shares using variable
dividend growth
BluFin Ltd has just paid a dividend of R5 per share. Investors anticipate that
dividends will grow at 30% for the next three years due to the successful
launch of a new product. Thereafter, dividend growth will decrease to 10% p.a.
indefinitely. If investors require a 20% rate of return, how much would they be
willing to pay for one BluFin share?
Solution
Current dividend (D0 ) = R5
High growth rate (g1) = 30% for three years
Constant growth rate (g2) = 10% per year forever thereafter
Ordinary shareholders’ required rate of return (ke) = 20%
The mathematical solution to this question is:
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Alternatively, the process can be broken down into five steps:
Step 1: Calculate the dividends during the high-growth period.
Step 2: Calculate the present value (PV) of high-growth dividends.
Step 3: Determine the value of all the constant dividends that will occur after
the high-growth period.
Step 4: Determine the PV of the constant dividends after the high-growth
period.
Step 5: Find the sum of all the PVs (in other words, those calculated in Steps 2
and 4).
Note that the answers are rounded off at each step in the example that follows.
Step 1: Calculate the dividends during the high-growth period.
Year 1: D1 = D0(1 + g1) = 5,00 × (1 + 0,3) = 6,50
Year 2: D2 = D1(1 + g1) = 6,50 × (1 + 0,3) = 8,45
Year 3: D3 = D2(1 + g1) = 8,45 × (1 + 0,3) = 10,99
Step 2: Calculate the PV of the high-growth dividends.
FV = 6,50; n = 1; i = 20; compute PV = 5,42
FV = 8,45; n = 2; i = 20; compute PV = 5,87
FV = 10,99; n = 3; i = 20; compute PV = 6,36
Total PV of high dividends: 17,65
Step 3: Determine the value of all the constant dividends that will occur after
the high-growth period.
In this case, the high-growth period ends after three years and
constant growth starts in year 4. Therefore, we need to calculate 3:
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Step 4: Determine the PV of the constant dividends after the high-growth
period.
This is the PV of what you calculated in Step 3.
FV = 120,89; n = 3; i = 20; compute PV = 69,96
Step 5: Find the sum of all the PVs (in other words, those calculated in Steps 2
and 4).
0= 17,65 + 69,96 = R87,61
Would prospective investors be interested in purchasing shares in BluFin if the
market price per share were R89? No; based on their estimates of future
dividends and the riskiness of the entity, BluFin shares are only worth R87,61
each. It would be unwise to purchase BluFin shares, as they are overvalued.
One major drawback of the DDM is that it can only be used to value
entities that pay dividends. In cases where entities do not pay
dividends, the free cash flow (FCF) model, described in the section
that follows, can be used.
9.5.2
Free cash flow valuation model
Instead of using dividends, this model values the FCFs generated
by the entity. FCF represents the cash flow that is available to all
investors – ordinary shareholders, preference shareholders and
debt holders – after provision has been made for investments in
non-current and current assets. The value of equity can be
determined using Formula 9.5.
We discuss each element of Formula 9.5 in more detail in the
sections that follow.
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9.5.2.1
Value of non-operating assets
Besides cash, an entity normally has various other non-operating
assets, such as listed and unlisted investments, property and nonoperating loans. Example 9.6 provides a practical illustration.
Example 9.6 Valuing non-operating assets
Marlin Ltd is a commercial fishing entity that mainly operates off the shores of
South Africa and Namibia. The entity has three non-operating assets, as set
out in the table that follows.
Using this information, we can value Marlin’s non-operating assets as shown
below.
9.5.2.2
Value of operations
As illustrated in Formula 9.6, the value of an entity’s operations is
the present value of future FCFs discounted at the entity’s weighted
average cost of capital, or WACC. Refer to Chapter 11 for a more indepth discussion of WACC.
Where:
Vop = value of operations
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FCFn = free cash flow in period n
WACC = weighted average cost of capital (discount rate)
As indicated earlier, FCF represents the cash flow actually available
for distribution to all investors after the entity has invested in all
non-current assets and working capital necessary to sustain
ongoing operations. The FCF in a particular period can be
calculated by means of Formula 9.7.
The value of operations has two components. First, we have to
forecast the entity’s FCFs over what is called the forecast horizon.
This period represents the period before FCFs begin to grow at a
constant rate. The second component is the value of continuing
operations after the forecast horizon. We call this second
component the terminal value and calculate it by means of Formula
9.8.
Where:
FCFN = free cash flow in the final year of the forecast horizon
WACC = weighted average cost of capital
g = expected constant growth rate in FCFs after the forecast horizon
Formula 9.8 is only valid if a business is expected to operate in
perpetuity and if its economic life is not limited by a finite resource.
The same five steps used in the variable dividend growth model
can be used to determine the value of operations. This is illustrated
in Example 9.7.
Example 9.7 Determining the value of operations
Marlin has made the five-year projections set out in the table that follows.
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Notes:
A: Management plans to buy new fishing boats and equipment, such as fish
finders and refrigerators, over the forecast horizon.
B: As indicated in Chapter 14, working capital is the difference between an
entity’s current assets and current liabilities. Cash, inventory, accounts
receivable and accounts payable are expected to fluctuate, as these values are
highly dependent on fishing conditions.
Assume that the tax rate is 28% and that Marlin’s WACC is 12%. After year 5,
it is expected that FCFs will grow by 5% p.a. in perpetuity.
Step 1: Calculate the FCFs during the forecast horizon.
Step 2: Calculate the PV of FCFs during the forecast horizon by using a
financial calculator.
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Step 3: Determine the terminal value.
Step 4: Determine the PV of the terminal value.
FV = 189 600 000; n = 5; i = 12; PV = 107 584 132
Step 5: Find the sum of all the PVs (in other words, those calculated in Steps 2
and 4.
Value of operations = 3 581 294 + 107 584 132 = R111 165 426
9.5.2.3
Value of non-equity claims
The last element of the FCF valuation model deals with the nonequity claims on the entity. These generally include long-term
liabilities such as long-term debt and provisions, but exclude
operating liabilities such as trade payables (creditors).
Example 9.8 Valuing non-equity claims
Marlin has the non-equity claims listed in the table that follows.
Using this information, we can value Marlin’s non-equity claims as shown
below.
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9.5.2.4
Value of equity
In the final step, we determine the value of the entity’s equity using
Formula 9.5:
Value of non-operating assets
Plus: Value of operations
Minus: Value of non-equity claims
Value of equity
R17 900 000
R111 165 426
R26 231 700
R102 833 726
QUICK QUIZ
Calculate the value of Marlin’s equity using a
WACC of 8%.
Selected operating assets, non-operating assets and non-equity
claims at Oceana are presented in Example 9.9.
Example 9.9 Identifying selected FCF valuation model inputs at Oceana
Source: Oceana Group Ltd, 2017c.
A major advantage of the FCF valuation model is that it quantifies
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the implicit assumptions and projections of buyers and sellers. This
model is also less susceptible to overvaluing an entity during
market bubbles and periods of high earnings. The model is,
however, extremely sensitive to assumptions and so the results
generated can be highly volatile. This is especially true when
calculating the terminal value, as the terminal value often forms a
large portion of the value of operations. Another drawback of this
valuation model is that it is not always possible to project FCFs
accurately over long periods of time.
9.5.3
Relative valuation techniques
In addition to the DDM and the FCF valuation models discussed
earlier in this chapter, prospective investors can also use financial
ratios to determine the relative value of a share. Various financial
ratios can be used to compare the market value of a share to certain
accounting measures, such as earnings, cash flow, revenue and
book value. These ratios are only meaningful once they are
compared with the ratios of other entities that operate in the same
sector.
9.5.3.1
Price-earnings ratio
By far the most important relative valuation technique is the priceearnings (P/E) ratio. This ratio shows how much investors are
willing to pay today per rand of reported earnings. P/E ratios are
generally higher for entities with strong growth prospects and
lower for riskier entities. Formula 9.9 shows how to calculate the
P/E ratio. You may recall from Chapter 3 that we use the number of
outstanding shares at year end.
Example 9.10 Calculating a P/E ratio
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Calculate and interpret the P/E ratio for SASSI Ltd based on the entity’s most
recent financial statements. The market price per share was R23 on 31 July
2019 and the entity had 50 million ordinary shares outstanding.
SASSI Ltd: Statement of financial position at 31 July 2019 (R million)
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Interpretation
The current market price per share is 8,19 times larger than the entity’s last
reported EPS. Investors are thus willing to pay R8,19 for every R1 of reported
earnings.
In earlier sections of this chapter, dividend growth models were
used to estimate the price of a share. The same can be done using
the P/E ratio, as illustrated in Example 9.11.
Example 9.11 Calculating the price of ordinary shares using P/E ratios
Assume that the average P/E ratio of the sector in which SASSI is listed is
10,5. What would the entity’s share price be?
Solution
Using the EPS as calculated from the financial statements (where EPS =
R2,81), we find:
Price per share = 10,5 × 2,81 = R29,51
QUICK QUIZ
On 23 August 2019, Oceana had a P/E ratio of
10,4 (ShareData Online, 2020a), whereas Sea
Harvest and Premier Fishing and Brands had P/E
ratios of 12,6 (ShareData Online, 2020c) and 5,6
(ShareData Online, 2020b) respectively. How much
are investors willing to pay for every R1 of
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Oceana’s based on reported earnings? Based
purely on their P/E ratios, which of the three
fishing entities was the most valuable on 23
August 2019? Motivate your answer.
Note that Formula 9.9 is called a trailing P/E ratio, as it uses
reported or historical earnings. Should an investor estimate the
entity’s EPS and use it instead, reference is made to a forward P/E
ratio.
9.5.3.2
Price-book ratio
Another useful relative valuation technique is the price-book ratio.
This ratio is calculated using Formula 9.10. As with Formula 9.9, we
use the number of outstanding shares at year end in this
calculation.
Refer to Section 3.11 for more details on this important ratio.
Although slightly different terms are used in this chapter, the
interpretation of the two ratios remains the same.
Example 9.12 Calculating the price of ordinary shares using price-book
ratios
Calculate and interpret SASSI’s price-book ratio.
Interpretation
The current market price per ordinary share is 1,23 times larger than the book
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value per ordinary share. The higher this ratio, the more value management
has created for ordinary shareholders.
QUICK QUIZ
1. Calculate Oceana’s price-book ratio on 30
September 2018 if the number of ordinary
shares in issue was 116 875, ordinary
shareholders’ interest equalled R4 625 348 000
and the share price closed at R83,91.
Source: Information compiled by Iress Research Domain from Oceana Group Ltd, 2020.
2. Would you say that Oceana’s management has
created value for its shareholders in 2018
based on this measure? Motivate your answer.
9.6
Ethical and environmental,
governance risks
social
and
In the preceding sections, we assessed the value of an entity by
looking at accounting and market-based performance measures. As
indicated in the ‘Focus on Ethics’ feature, value can easily be
destroyed if management fails to identify and manage risks
associated with ethical as well as ESG issues.
FOCUS ON ETHICS: The cost of
screwing up
“We’ve totally screwed up.” These words were uttered by Michael
Horn, former CEO of Volkswagen Group America, when it came to light
that the company had sold thousands of diesel vehicles with a ‘defeat
device’. Sophisticated software installed in these vehicles detected
when they were being tested and subsequently reduced emissions.
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Volkswagen Group’s share price dropped by 20% on the day that
news of the scandal broke (22 September 2015).
It is not uncommon for a company’s share price to fall when news
of unethical behaviour is exposed. What makes the VW case unique is
the massive outcry of discontent by slighted customers and
shareholders on social media. This very public demonstration of
displeasure fuelled the ongoing divestment of VW shares long after
Horn apologised and resigned from his position. Some of VW’s largest
investors initiated legal proceedings in light of the investment losses
they suffered in the aftermath of the scandal. Shareholders also began
pushing VW and other car manufacturers to disclose more details on
how pollution regulations affect their operations.
In April 2017, VW was ordered to pay a fine of US$2,8 billion to
United States authorities in relation to the scandal. Had the company
not engaged in unethical behaviour, that US$2,8 billion could instead
have been distributed to shareholders in the form of dividends or
reinvested into profitable capital projects.
Sources: Compiled from information in Hotten, 2015; Davis, 2015; Chopping & Dauer, 2015;
Currie, 2015; Associated Press, 2017.
In light of the cost of ‘screwing up’, investors are increasingly
evaluating entities’ policies and practices to mitigate the impact of
climate change, minimise waste, and reduce air, water and soil
pollution. They are also assessing the extent to which entities use
alternative energy sources and green infrastructure. Social
considerations mainly centre on the protection of human rights
(including health and safety), employee training and development,
and community involvement. Job creation, B-BBEE and HIV/Aids
are particularly important social considerations in the South African
context. In terms of corporate governance, more attention is given
to issues such as board independence, board diversity (in terms of
race, gender, age and experience), fair and responsible executive
remuneration, and audit quality.
ESG risks are not homogenous (similar) across economic sectors.
As such, managers should employ a differentiated approach to
identify and manage the most important risks in their sector.
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Selected ESG considerations at Oceana are highlighted in Table
9.4.
Table 9.4 ESG considerations at Oceana
Environmental •
•
•
•
•
•
Social
•
Oceana is committed to and supports responsible fishing practices.
The company is a founder member of the Responsible Fisheries
Alliance, and has partnered with the World Wildlife Fund and other
members of the Responsible Fisheries Alliance to advance an
ecosystems approach to fisheries management.
The majority (80%) of harvested commercial fishing rights by volume
in 2018 were on the green list of the South African Sustainable
Seafood Initiative (SASSI). Species on this list can “handle current
fishing pressure”.
Many seabirds and non-target fish species are caught alongside hake
by deep-sea trawlers.
Greenhouse gas emissions intensity at land-based facilities was 2,2%
lower in 2018 than in 2016.
Plans are in place to ensure that no food that is fit for human or
animal consumption is sent to landfills, but that it is directed to
fishmeal processing facilities.
Plans are in place to reduce the use of potable water by 40% in the
short term.
Oceana invested R21,9 million in 2018 (R22,2 million in 2017) on
employee skills development in areas such as marine science, vessel
crewing, artisans, supply chain management, IT, finance and food
safety, quality and processing.
• The company had an independently accredited B-BBEE level 1 rating
in 2018. This is the highest rating that a listed company can achieve.
• There were no occupational fatalities at the company in 2018. The
number and severity of safety incidents also decreased during the
year.
• Oceana is one of very few companies in the sector that provides
minimum guaranteed hours (and hence income) to seasonal
employees.
• Corporate social investment spend in 2018 in South Africa totalled
R4,6 million.
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•
•
Corporate
governance
•
•
The company provided meals to 600 South African learners on a daily
basis in 2018.
Residents in Hout Bay have complained for years about the foul smell
that the Lucky Star fishmeal factory creates when in operation.
Oceana’s 2018 board of directors consisted of six men and two
women. Of the eight directors, three were white men, whereas the
rest were African, coloured or Indian. Half of all directors were
between 40 and 59 years of age. The others were older than 60.
The remuneration committee was satisfied that executive
compensation in 2018 was linked to long-term performance and
value creation.
Sources: Compiled from information in Oceana Group Ltd, 2018a; Le Cordeur, 2015; Villette, 2018; Oceana
Group Ltd, 2018c; South African Sustainable Seafood Initiative (SASSI), 2020.
Which of the ESG issues listed in Table 9.4 are the most important
in Oceana’s sector (food producers)? In other words, which of these
potential risks could have the biggest impact on the entity’s longterm performance? Note that answers to these questions are
subjective, as different responsible investors have different ESG
priorities. Keep in mind that ethical principles such as honesty,
integrity and justice underpin all ESG considerations.
QUICK QUIZ
1. Refer to the discussion on fundamental
analysis earlier in this chapter. Would you
classify responsible fishing practices as a
macro, market or micro factor? Motivate your
answer.
2. The share price of Steinhoff International
Holdings NV dropped from R46 to R6 in December
2017 after news of accounting irregularities
were announced (Fin24, 2017; Bonorchis & Kew,
2017). Although shareholders bore the brunt of
the scandal, other stakeholders were also
affected. Explain how restructuring costs,
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legal fees, fines and a dented reputation
could have impacted on the entity’s
relationship with other financiers, employees,
customers, suppliers and tax authorities.
3. Research shows that a positive relationship
exists between social considerations and EPS
in the consumer goods sector (Solomons, 2018).
Why do you think this is the case? Hint: This
sector includes food producers such as Oceana
and Tiger Brands Ltd. In March 2018, Tiger
Brands had to recall processed meat products
from supermarkets and had to suspended
operations at several of its processing plants
due to a listeria outbreak. This bacteria
killed over 200 people and infected more than
1 000 (Khumalo, 2018).
9.7
Market efficiency and behavioural finance
Whether shares are under- or overvalued depends on whether the
stock market(s) in which they are traded are efficient. In an efficient
market, share prices are said to be in equilibrium. Market values are
thus equal to intrinsic values and expected rates of return are equal
to required rates of return. Prices also react quickly to new
information about an entity. News that exceeds the market’s
expectation (such as a higher-than-expected dividend payment)
usually leads to an increase in the share price and vice versa. A
third characteristic of an efficient market is that no gains can be
made by investors who engage in fundamental and/or technical
analysis. Remember that fundamental analysts evaluate the macro,
market and micro factors that may influence an entity’s share price
in future. By contrast, technical analysts look to uncover recurrent
and predictable patterns in stock prices using advanced software
programs.
A great deal of research has been undertaken to determine
whether financial markets are, indeed, efficient. Researchers
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typically distinguish between three forms of market efficiency:
weak, semi-strong and strong.
• In the case of the weak-form of market efficiency, a share’s
current price already reflects all information about the issuer
that can be derived by examining historical market trading data,
such as prices and volumes. This information is available to all
investors at virtually no cost, so if it contained any clues about
future performance, everybody could, and would, exploit such
information to engage in profitable trades.
• Semi-strong market efficiency means that a share’s current price
already reflects all publicly available information about the
entity, such as information contained on its website, in its
integrated report and in announcements on the Stock Exchange
News Service (SENS). As this information is available to all
investors at a low cost, anybody can use it to evaluate the future
prospects of an entity and trade accordingly.
• Strong-form market efficiency (which incorporates the previous
two forms) suggests that a share’s current price already reflects
all public and private (insider) information relevant to the
entity’s performance. Insiders – such as directors, accountants
and lawyers – are privy to confidential information that could
have profound effects on an entity’s share price (for better or for
worse) once it becomes public. Unethical insiders who are also
shareholders generally sell some shares before bad news is
announced (which would cause a decline in the share price and
their wealth). In the case of good news, they would buy more
shares before the announcement, so that they could benefit from
a capital gain should the price increase. Such behaviour,
however, is illegal and unethical.
Most of the research on market efficiency indicates that markets are
weak-form efficient. This implies that no gains can be made by
technical analysts, but that some abnormal returns can be made by
fundamental analysts. Despite the merits of the JSE’s listing
requirements and legislation to curb the unscrupulous use of
insider information, much of this still takes place in South Africa.
As long ago as 407 BC, the Greek philosopher Plato warned that
legislation alone is insufficient to promote ethical behaviour. He
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argued that “…good people do not need laws to tell them to act
responsibly, while bad people always find a way around the law”
(Plato Quotes, n.d.).
Market efficiencies can partly be attributed to cognitive errors
made by investors, financial managers and other market
participants. Scholars in the field of behavioural finance have
identified two main categories of cognitive error:
• The first category deals with belief perseverance and shows that
people often cling to previously held beliefs. They also commit
statistical, information processing and memory errors to justify
their beliefs. Familiarity bias is a common mistake. It refers to
the tendency to favour that which is familiar. A financial
manager who exhibits this bias might extend credit to a longstanding client despite the client taking longer to pay their
account. Furthermore, some investors believe (erroneously) that
‘household names’ offer higher expected returns than unfamiliar
entities. Confirmation bias also falls in the first category of
cognitive errors and suggests that people who display this bias
ignore information that contradicts their views. As such, they
might invest in financial and/or real assets despite being
advised not to do so. Three other behavioural pitfalls in the
belief perseverance category include overconfidence, illusions of
control and excessive optimism. Overconfident individuals not
only overestimate their performance relative to others, but they
also express unjustified certainty in the accuracy of their beliefs
and forecasts. It has been shown that overconfident managers
often overpay for target entities in M&As and use more debt
compared to rational managers. As the name suggests, illusions
of control refers to decision makers who overestimate their
ability to control future events. Investors who strive to time the
market typically exhibit this cognitive error. Individuals could
also overestimate the frequency of favourable outcomes and
underestimate the frequency of unfavourable outcomes, in
which case we say that they demonstrate excessive optimism. A
manager who sets unrealistic sales targets demonstrates this
behavioural pitfall. Another important cognitive error in this
category relates to individuals who base their decisions on what
others are doing. Herding behaviour is dangerous, as decision
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makers are influenced by emotions such as fear and greed, and
fail to do their own independent analyses. Herding contributes
greatly to the creation of market bubbles and crashes.
• The second category of cognitive error shows that people often
process information illogically and irrationally. Two biases in
this category include anchoring and status quo bias. Many
people rely on reference points or anchors when making
decisions. Anchors often include the first piece of information
received, past experiences, purchase prices or analysts’
recommendations. Although anchors could be useful in decision
making, they generally result in people underestimating
unknown values, such as expected dividends, sales volumes or
operating expenses. According to the status quo bias,
individuals perceive changes from the status quo (the current
situation) as a loss. This bias could explain why many entities
spend vast amounts of money on maintaining legacy IT
applications and infrastructure rather than developing new,
strategic IT initiatives.
Finance in action: From the desk of Warren Buffett
Warren Buffett, one of the richest men in the world,
describes his investment style as ‘value investing’. This
strategy involves buying financial securities that appear
to be undervalued. Investors the world over keep a close
eye on decisions taken by Warren Buffett. There are even
websites providing details on his trading activities. Steps
to ‘invest like Buffet’ involve making a list of criteria
before buying a share, investing in sectors and entities
with which you are familiar, staying in cash if necessary,
tracking your investments and selling at the right time.
Investors who base their decisions on websites such as
these probably display the familiarity bias.
Sources: Compiled from information in Investor’s Business Daily, 2019; Ashanti,
2013.
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9.8
Conclusion
This chapter has concerned itself with the characteristics and
valuation of ordinary shares and preference shares in South Africa.
You learnt the following:
• Stock markets originated in the Middle Ages and have become
sophisticated markets for facilitating the transfer of funds
between borrowers and lenders.
• Ordinary and preference shares are the main types of financial
security traded on the JSE. Although both types of share
represent equity capital, they have distinct characteristics. The
main differences between ordinary and preference shares relate
to the voting powers of shareholders, and their claims on the
assets and profits of the entity.
• There are several definitions of share value. We concentrated on
market value, book value and intrinsic value. Whereas
accountants are more interested in book values, financial
managers and investors place more emphasis on market and
intrinsic values, as these are forward looking in nature.
• Various models can be used by financial managers,
shareholders, prospective investors and other stakeholders to
determine the intrinsic value of an entity. The dividend discount
model (DDM) is often used and can be modified to reflect zerodividend growth, constant dividend growth and variable
dividend growth. In cases where entities do not pay dividends,
the free cash flow (FCF) model can be used to determine the
intrinsic value of the entity. Analysts can also assess financial
ratios, which compare the market value of an entity to certain
accounting measures, such as earnings or book value.
• Investors are increasingly scrutinising the manner in which
entities are identifying and managing ethical and
environmental, social and governance (ESG) risks. Unethical
and unsustainable business practices not only destroy
shareholder value, but have repercussions across the other five
capitals as well.
• Investors should only purchase the shares of an entity when the
expected return of the share exceeds its required return. If the
expected return is less than the required return, the share is
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overvalued and should not be purchased (or should be sold if it
is held).
• In an efficient market, the expected return of an entity equals its
required return. Share prices also change very quickly when
new information about an entity is made public.
• Markets are not perfectly efficient, as participants do not always
act rationally. Research shows that individuals are often
influenced by their emotions, previously held beliefs and
cognitive ability to process information.
Read the case study about Oceana at the beginning of this chapter
again. In light of what you have learnt in this chapter and the
information presented in the closing case study, would you invest
in the company? Motivate your answer.
CASE STUDY
Value creation at Oceana
Oceana’s mission is to be the leading empowered African
fishing and commercial cold storage company. The company
strives to achieve this mission by responsibly harvesting and
procuring a diverse range of marine resources, promoting food
security by efficiently producing and marketing relevant
products for global markets, actively developing the potential
of all its employees and investing in the communities in which
it operates.
Some of the company’s key risks include marine resource
availability, pollution, fresh water availability, climate
variation, irresponsible environmental management practices,
carbon tax impacts, the impact of ocean mineral, gas and oil
extraction, and energy security. The company reacted to the
third risk (fresh water availability) by investing in pioneering
water technology and desalination plants in the Western Cape
in 2018. These investments not only reduced Oceana’s reliance
on water in the drought-stricken province, but also provided
job security to over 2 000 employees. To reduce irresponsible
fishing practices, management piloted a new device on one of
its trawlers in 2017. This device allows large mammals (such as
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dolphins) to swim out of the trawling net unharmed.
The company is looking to acquire aquaculture operations,
as both Sea Harvest and Premier have similar operations.
Aquaculture, or aquafarming, involves cultivating fresh and
saltwater populations of fish under controlled conditions.
Sources: Oceana Group Ltd, 2017b, 2018b; BusinessDay, 2018b.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
Indicate the correct answer combination. Investors who purchase ordinary
shares of an entity …
i)
receive a regular, constant dividend.
ii) become the owners of the productive assets of that entity.
iii) may vote at annual general meetings.
iv) have the right to elect a board of directors.
v) have a pre-emptive right when the entity issues new shares to raise
equity capital.
A. Alternatives (i), (ii) and (v)
B. Alternatives (ii), (iii), (iv) and (v)
C. Alternatives (i), (iii) and (iv)
D. All of the alternatives are correct.
2.
Redeemable preference shares are shares …
A. in which dividends that have not been paid in a particular period will
accumulate.
B. in which dividends that have not been paid in a particular period will not
accumulate.
C. that can be called back by the issuing entity on a stated future date.
D. that allow shareholders to receive a higher dividend than was initially set
by management.
3. The South African government was the first African government to implement a
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sugar tax in 2018. This tax is intended to reduce the consumption of sugary
drinks and improve citizens’ health. The sugar tax can be regarded as a(n)
__________ consideration for local investors who plan to invest in entities
producing sodas, juices and energy drinks.
A. environmental
B. ecological
C. social
D. corporate governance
Use the information that follows to answer Questions 4 and 5.
Pearl Ltd has R85 million in assets and R40 million in liabilities. It has 1,4 million
ordinary shares outstanding. The replacement cost of the assets amounts to R115
million. The current price is R90 per share.
4.
What is Pearl’s book value per share?
A. R1,68
B. R2,60
C. R32,14
D. R60,71
5.
What is Pearl’s market value per share?
A. R2,60
B. R32,14
C. R60,71
D. R90,00
6.
Which of the following is NOT a relative valuation approach?
A. The price-earnings ratio
B. The price-sales ratio
C. The price-cash flow ratio
D. The discounted cash flow ratio
7.
If board members of an entity can make an abnormal profit on the stock market
on the basis of private information in their possession, then the market does
NOT exhibit the __________ form of efficiency.
A. weak
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B.
C.
D.
8.
semi-strong
strong
mild
Shores Ltd’s ordinary shares are trading at 20 000 cents per share. Ordinary
shareholders’ equity amounts to R20 million and the entity has 50 000 ordinary
shares outstanding. Total capital equals R40 million. Shores’s price-book ratio
is __________.
A. 0,5
B. 1
C. 2
D. 4
INTERMEDIATE
9.
Indicate the correct answer combination. Stock market bubbles can be
attributed to investors exhibiting …
(i) herding behaviour
(ii) confirmation bias
(iii) excessive optimism
A. Alternatives (i) and (ii)
B. Alternatives (ii) and (iii)
C. Alternatives (i) and (iii)
D. All three alternatives are correct.
10. If the intrinsic value of a share exceeds its market value, prospective investors
should …
A. buy the share, as it is overvalued.
B. buy the share, as it is undervalued.
C. not buy the share, as it is overvalued.
D. not buy the share, as it is undervalued.
11. OffShore Ltd pays a constant annual dividend. The intrinsic value of the share
will …
A. remain constant over time.
B. increase over time.
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C.
D.
decrease over time.
increase when shareholders’ required rate of return increases.
12. As an investor, you require a return of 13% on both Share X and Share Y.
Share X is expected to pay a dividend of R3 in the following year, whereas
Share Y is expected to pay a dividend of R4 in the following year. The expected
growth rate of dividends for both shares is 7%. The intrinsic value of Share X
…
A. cannot be calculated without knowing the market rate of return.
B. will be greater than the intrinsic value of Share Y.
C. will be the same as the intrinsic value of Share Y.
D. will be less than the intrinsic value of Share Y.
13. On 31 December 2019, Floaters Ltd had 1 000 000 000 ordinary shares
authorised and 761 159 181 shares issued. The closing price of the entity’s
ordinary shares on this date was 403 cents. The market capitalisation of the
entity on this date was __________.
A. R1 000 000 000
B. R4 030 000 000
C. R3 067 471 499
D. The correct answer is not listed.
14. Indicate the correct answer combination. The market value of ordinary shares
…
i)
is the price determined by demand-and-supply forces on a stock
exchange.
ii) is the same as the intrinsic value of the shares.
iii) changes on a daily basis for liquid entities.
iv) is based on the book value of the entity’s equity.
v) is based on the market value of the entity’s assets.
A. Alternatives (i) and (iii)
B. Alternatives (ii) and (iii)
C. Alternatives (iii), (iv) and (iv)
D. Alternatives (i) and (v)
15. Which ONE of the following statements regarding market efficiency is
incorrect? In an efficient market …
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A.
B.
C.
D.
the expected rate of return on a share is equal to its required rate of
return.
share prices react quickly when new information about a listed company
is released.
the intrinsic value of a share is equal to its market value.
some investors can make abnormal returns by evaluating the historical
prices of shares.
16. Based on your calculations, the intrinsic value of Sailor Ltd is 1 380 cents. It is
currently selling for 1 300 cents on the JSE. The entity’s shares are held as
part of a fully diversified portfolio. You should …
A. buy more Sailor shares.
B. sell all the Sailor shares that you currently own.
C. sell some of the Sailor shares that you currently own.
D. do nothing.
ADVANCED
17. AbalonePro Ltd is an aquaculture entity that produces abalone for the Asian
market. Given the competitive nature of the sector, the entity’s management
prefers to plough back earnings rather than distribute them to shareholders in
the form of cash dividends. The entity has only paid a dividend twice in more
than a decade. The __________ discounted dividend model would be the
most appropriate to use when calculating the intrinsic value of AbalonePro’s
shares.
A. zero-dividend growth
B. constant dividend growth
C. variable dividend growth
D. no growth
18. Assume that Hake Ltd has been listed on the JSE in the food producers sector
since 1980. The performance of this entity is not very sensitive to the state of
the economy. Consequently, shareholders have become used to receiving
steadily growing dividends over the years. The __________ discounted
dividend model would be the most appropriate to use when calculating the
intrinsic value of Hake’s shares.
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A.
B.
C.
D.
zero-dividend growth
constant dividend growth
variable dividend growth
no growth
19. When using the FCF valuation model, accruals are classified as __________.
A. an operating asset
B. a non-operating asset
C. a free cash flow
D. a discount factor
20. Which ONE of the following statements regarding the FCF valuation method is
incorrect?
A. The model can be used to determine the intrinsic value of start-up
entities that do not pay dividends.
B. The model uses the cost of equity capital as the discount rate.
C. The entity’s WACC is used as the discount rate.
D. It is possible that the value of non-operating assets equals zero.
LONGER QUESTIONS
BASIC
1.
A preference share will pay a dividend of R2,75 in the forthcoming year and
every year thereafter (in other words, dividends are not expected to grow).
Investors require a return of 10% on this share. What is the intrinsic value of
this preference share?
2.
LongLine Ltd’s next dividend payment will be R4 per share. The dividends are
anticipated to maintain a 6% growth rate per year forever. If the entity’s shares
are currently selling for R45 per share, what is the investor’s expected return?
3.
The Shelly Company is a start-up entity. No dividends will be paid to ordinary
shareholders over the next five years, as profits need to be retained to finance
the entity’s expansion. The entity will most likely begin to pay a dividend of R6
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per share in year 6. Analysts expect that the entity’s dividends will increase by
5% per year thereafter. If the required return on this share is 23%, what is the
intrinsic value of the share?
4.
JBAY Surfing Ltd has just paid an ordinary dividend of R7,20 per share.
Dividends are expected to grow at a constant rate of 6% per year indefinitely. If
investors require a 12% return, what is the intrinsic price of the share? What
will the price be in three years? In 15 years?
5.
Refer to Question 4. Assume that the current market price of JBAY Surfing’s
shares is R126. Would you be interested in buying this share? Motivate your
answer.
6.
The ordinary shares of Herring Ltd currently sell for R25,40 per share. The
entity recently paid a dividend of R1,30 per share and expects to increase this
dividend by 3% annually. What is the expected rate of return on this share?
Would you be interested in investing in the shares of this entity if you require a
9% return? Motivate your answer.
INTERMEDIATE
7.
SurfsUP Ltd is expected to grow at a rate of 20% p.a. for the next two years.
Dividend growth is expected to decrease to 8% p.a. for the following two years,
and then to 4% p.a. thereafter. Assuming the current dividend is R2 and the
required rate of return is 15% percent, compute the intrinsic value of the share.
ADVANCED
8.
Consider the information set out in the table that follows, which presents the
statement of financial position for Mosselbank Ltd for the year ending
December 2019. (All values are in millions of rands.)
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Other pertinent information:
■ Expected FCF at the end of year 1: −R18 million
■ Expected FCF at the end of year 2: −R23 million
■ Expected FCF at the end of year 3: R46,4 million
■ Expected FCF at the end of year 4: R49 million
■ FCF is expected to grow at a constant rate of 5% p.a. after year 4
■ The entity has a WACC equal to 10,84%.
Use the FCF valuation model to determine the value of the entity’s equity.
KEY CONCEPTS
Behavioural finance: A field of study that acknowledges the role of
emotions, previously held beliefs and cognitive ability in
financial decision making.
Book value: The value of a financial security as reflected in an entity’s
statement of financial position.
ESG risks: Environmental, social and corporate governance risks that
could influence the value of an entity.
Expected return: The return investors expect to earn on a share based
on their estimates of future dividends and the riskiness of the
entity.
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Free cash flow: The cash flow available for distribution to all
investors after the entity has made all investments in noncurrent assets and working capital necessary to sustain ongoing
operations.
Intrinsic or economic value: The estimated value of a financial security
based on investors’ estimates of future cash flows and the
riskiness of the entity.
Market value: The value of a financial security as determined by
demand-and-supply factors in financial markets.
Ordinary share: A financial instrument issued by an entity that gives
investors voting rights and entitles them to a share of the profits
that remain once interest on bonds and dividends on preference
shares have been paid. Ordinary shares also entitle shareholders
to share in the assets of the entity in the event of liquidation.
Preference share: A financial instrument issued by an entity that
ranks higher in priority when it comes to distribution of
dividends; the dividends on preference shares have to be paid
before dividends on ordinary shares are paid. Preference
shareholders also receive preferential treatment in sharing in the
assets of the entity in the event of liquidation.
Required return: The financial return required by investors when
investing in a share; the required return compensates investors
for the investment risk they are taking on.
SLEUTELKONSEPTE
Boekwaarde: Die waarde van ’n finansiële sekuriteit soos gereflekteer
in die balansstaat van ’n maatskappy.
ESG-risiko’s: Omgewings-, maatskaplike en korporatiewe
bestuursrisiko’s wat die waarde van ’n maatskappy kan
beïnvloed.
Gedragsfinansies: ’n Studieveld wat erkenning gee aan die rol van
emosies, individue se bestaande oortuigings en kognitiewe
vermoëns in finansiële besluitneming.
Gewone aandeel: ’n Finansiële instrument wat deur ’n maatskappy
uitgereik word wat stemregte aan beleggers verleen, wat hulle
reg gee op ’n aandeel van die winste wat oorbly nadat rente op
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obligasies en dividende op voorkeuraandele betaal is en hulle
reg gee om in die geval van likwidasie te deel in die bates van
die maatskappy.
Intrinsieke of ekonomiese waarde: Die beraamde waarde van ‘n
finansiële sekuriteit gebaseer op beleggers se ramings van
toekomstige kontantvloei en die risikoprofiel van die
maatskappy.
Markwaarde: Die waarde van ’n finansiële sekuriteit soos bepaal deur
vraag en aanbod in die finansiële markte.
Vereiste opbrengs: Die opbrengs wat van beleggers vereis word om in
’n aandeel te belê ten einde gekompenseer te word vir die
beleggingsrisiko wat hulle aanvaar.
Verwagte opbrengs: Die opbrengs wat beleggers verwag om te
verdien gebaseer op hul ramings van toekomstige dividende en
die risikoprofiel van die maatskappy.
Voorkeuraandeel: ’n Finansiële instrument uitgereik deur ‘n
maatskappy wat hoër prioriteit geniet by die verspreiding van
dividende, wat beteken dat die dividend op voorkeuraandele
betaal word voordat dividende op gewone aandele betaal word.
Voorkeuraandeelhouers ontvang ook voorkeurbehandeling
deur in die geval van likwidasie te deel in die bates van die
maatskappy.
Vrye kontantvloei: Die kontantvloei wat werklik beskikbaar is vir
verspreiding aan alle beleggers na die maatskappy alle
beleggings in vaste bates en bedryfsbates gemaak het om
voortgesette bedrywighede in stand te hou.
SUMMARY OF FORMULAE USED IN THIS CHAPTER
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WEB RESOURCES
http://www.jse.co.za
http://www.sharedata.co.za
http://www.sharenet.co.za
http://www.unpri.org
http://www.world-exchanges.org
REFERENCES
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Principles. Retrieved from
https://www.moneycrashers.com/invest-like-warren-buffett/
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[11 February 2020].
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2020].
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price plunge nears 90%. Retrieved from
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[11 February 2020].
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portfolio pays off. Retrieved from
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BusinessDay. (2018b). Oceana sets sights on offshore acquisitions.
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Chopping, D. & Dauer, U. (2015). Norway Oil Fund to Sue
Volkswagen Over Emissions Scandal. Retrieved from
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2020].
Currie, A. (2015). VW scandal fuels investor fears about environment.
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2020].
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February 2020].
Fin24. (2017). Steinhoff share price: From R46 to R6 in under three days.
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Investor’s Business Daily. (2019). Warren Buffett Stocks: What’s
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[11 February 2020].
Iress South Africa (Australia) Pty Ltd. Research Domain. Software
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Johannesburg Stock Exchange (JSE). (2013a). JSE Overview.
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Johannesburg Stock Exchange (JSE). (2013c) B-Ordinary Shares.
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Johannesburg Stock Exchange (JSE). (2013d). Preference Shares.
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Johannesburg Stock Exchange (JSE). (2019). Market Highlights.
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[2 March 2020].
Khumalo, S. (2018). Tiger Brands reels from impact of listeriosis
outbreak. Retrieved from
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Le Cordeur, M. (2015). Oceana to keep ‘smelly’ fishmeal factory open.
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February 2020].
Lucky Star. (2020). About us. Retrieved from
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https://luckystar.co.za/about-us/ [11 February 2020].
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2020].
Oceana Group Ltd. (2017b). Environmental sustainability. Retrieved
from http://oceana.co.za/sustainability/environmentalsustainability/ [11 February 2020].
Oceana Group Ltd. (2017c). Our business model. Retrieved from
http://oceana.co.za/our-business/our-business-model/ [11
February 2020]. Reprinted by permission of Oceana Group Ltd.
Oceana Group Ltd. (2018a). 2018: Integrated Report for the Year Ended
30 September. Retrieved from
http://oceana.co.za/pdf/Oceana_Integrated_Report_2018_1.pdf
[11 February 2020].
Oceana Group Ltd. (2018b). Sustainability report for the year ended 30
September. Retrieved from
http://oceana.co.za/pdf/Download%20Oceana%20Sustainbility%20Report
[11 February 2020].
Oceana Group Ltd. (2018c). United Nations Global Compact
Communication on Progress. Retrieved from
http://oceana.co.za/pdf/Oceana%20Group%20Communication%20on%20
[11 February 2020].
Oceana Group Ltd. (2020). Integrated reports. Retrieved from
http://oceana.co.za/investors/integrated-reports/ [4 March
2020].
Plato Quotes. (n.d.). BrainyQuote.com. Retrieved from
https://www.brainyquote.com/quotes/plato_161536 [25
February 2020].
Principles for Responsible Investment (PRI). (2019). What is
responsible investment? Retrieved from
https://www.unpri.org/pri/an-introduction-to-responsibleinvestment/what-is-responsible-investment [4 March 2020].
Sea Harvest. (2020a). International. Retrieved from
https://www.seaharvest.co.za/international/ [11 February
2020].
Sea Harvest. (2020b). Our business. Retrieved from
https://www.seaharvest.co.za/our-story/our-business/ [11
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February 2020].
ShareData Online. (2020a). Oceana Group Ltd. Retrieved from
http://www.sharedata.co.za/v2/Scripts/Quote.aspx?
c=OCE&x=JSE [11 February 2020].
ShareData Online. (2020b). Premier Fishing and Brands Ltd.
Retrieved from
http://www.sharedata.co.za/v2/Scripts/Summary.aspx?
c=PFB&x=JSE [11 February 2020].
ShareData Online. (2020c). Sea Harvest Group Ltd. Retrieved from
http://www.sharedata.co.za/v2/Scripts/Quote.aspx?c=SHG
[11 February 2020].
Solomons, R. (2018). Assessing the business case for environmental,
social and corporate governance practices in South Africa.
Unpublished MCom dissertation, Stellenbosch University,
Stellenbosch.
South African Sustainable Seafood Initiative (SASSI). (2020).
South Africa’s Oceans are Under Threat. Retrieved from
http://wwfsassi.co.za/ [11 February 2020].
Villette, F. (2018). Fresh Air for Hout Bay fails in bid to close ‘smelly’
factory. Retrieved from
https://www.iol.co.za/capetimes/news/fresh-air-for-houtbay-fails-in-bid-to-close-smelly-factory-15463313 [11 February
2020].
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© World Federation of Exchanges. All rights reserved.
BIBLIOGRAPHY
Bodie, Z., Kane, A. & Marcus, A.J. (2014). Investments. 10th Global
Edition. London: McGraw-Hill Education – Europe.
Grosvenor, M.B. & Grosvenor, G.M. (Eds). (1977). The Middle Ages.
Washington DC: National Geographic Society.
Shefrin, H. (2007). Behavioral corporate finance: Decisions that create
value. London: McGraw-Hill/Irwin Series.
Solomons, R. (2018). Assessing the business case for environmental,
social and corporate governance practices in South Africa.
Unpublished master’s thesis. Stellenbosch University,
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Stellenbosch.
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10 Risk and return
Suzette Viviers
Learning
outcomes
By the end of this chapter, you should be able to:
calculate the holding period return of a single
security
differentiate between arithmetic and geometric
average returns
calculate the expected return of a single security
determine the expected risk of a single security
calculate the coefficient of variation of a single
security
calculate the expected return of a portfolio
explain what is meant by covariance
calculate the correlation coefficient of a portfolio
calculate the expected risk of a portfolio
consisting of two securities
differentiate between systematic and nonsystematic risk
calculate the beta coefficient of a single security
and a portfolio
calculate the required rate of return of a single
security and a portfolio using the capital asset
pricing model
explain the rationale for using a multi-factor
asset pricing model to determine the required
rate of return of a share.
Chapter
10.1 Introduction
outline
10.2 Assessing the return and risk characteristics
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10.3
10.4
10.5
10.6
CASE STUDY
of a single security
Assessing the return and risk characteristics
of a portfolio
The capital asset pricing model and the
security market line
Multi-factor asset pricing models
Conclusion
Taste Holdings Ltd
Taste Holdings is a South African-based management
company that owns and licenses a portfolio of retail brands.
The company has two main divisions: food and luxury goods.
Three fast-food franchise brands (Starbucks Coffee, Domino’s
Pizza and Maxi’s) target middle- and upper-income
consumers, whereas The Fish & Chip Co. seeks to attract lowto middle-income consumers. The luxury goods division caters
to first-time jewellery buyers and discerning watch collectors.
The NWJ brand is aimed at entry-level watch buyers and offers
a wide range of gold and silver jewellery. Arthur Kaplan,
which is the largest retailer of luxury Swiss watches in South
Africa, targets middle- and upper-income consumers. World’s
Finest Watches, the third brand in Taste Holdings’ luxury
goods division, specialises in premium watches.
In the first half of 2017, Taste attempted to raise funds for its
food division by selling its luxury goods division. However,
tough economic conditions in the country at the time thwarted
the company’s plans. In an effort to raise cash, management
thus engaged in three rights issues, the first in June 2017, then
in December 2017 and again in December 2018. In November
2019, Taste Holdings announced that it would dispose of its
food brands Maxi’s and The Fish & Chip Co. to focus on its
new strategic direction. The company had already sold its local
Starbucks franchise to another entity for R7 million earlier in
the year. In terms of its new strategic direction, Taste is set to
become a focused luxury retail group consisting of NWJ,
Arthur Kaplan and World’s Finest Watches.
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Given the company’s dire cash position, Taste Holdings
stopped rolling out new Domino’s and Starbucks stores in
South Africa in 2018. The company’s annual total returns over
the period 2014 to 2018 are set out in the table that follows.
Total return incorporates changes in a company’s share price
and dividend payments in a particular year.
Sources: Information compiled by Iress Research Domain from Taste Holdings, 2020b; Claasen,
2018; Laing, 2018; Mchunu, 2019.
10.1
Introduction
Like Taste Holdings, many South African entities have experienced
negative returns as a result of the depressed local economy. A great
deal of uncertainty also prevails in terms of expected returns. You
may recall from Chapter 9 that various models can be used to
calculate expected returns. In this chapter, we look at how required
rates of return can be computed. We show that investors demand
higher required rates of return from riskier investments (whether
these are made into financial assets, such as shares or bonds, or real
assets, such as refrigerators or stoves). Note that the words ‘assets’
and ‘securities’ can be used interchangeably.
This chapter is divided into two main sections. The first section
concerns itself with the return and risk characteristics of a single
security. We explain that this type of assessment can be ex post (in
other words, using historical data) or ex ante (that is, using expected
or future values). Next, we investigate the return and risk
characteristics of a portfolio (a collection of securities). We give
particular attention to the distinction between systematic and non******ebook converter DEMO Watermarks*******
systematic risk, and the measurement of the former. Finally, we
show how financial managers and investors can use a single factor
asset pricing model to make investment decisions. The chapter
concludes by briefly introducing a number of multi-factor asset
pricing models that investors can use to compute required rates of
return.
10.2
Assessing the return and risk characteristics of
a single security
In this section, we assess the return and risk characteristics of a
single (in other words, individual) security. Note that this type of
assessment can be ex post (that is, using historical data) or ex ante
(that is, using expected or future values). We will start with the
valuation of an investment’s historical returns.
10.2.1
Evaluating historical returns
Refer to Example 10.1.
Example 10.1 Calculating historical returns
Suppose you bought ordinary shares in Foodies Ltd one year ago at R100 per
share. Today, exactly one year later, you receive a dividend of R4 per share.
The current share price is R120. If you choose to sell the share today, what is
the return you earned on this investment?
The historical one-year holding period return (HPR) can be calculated as
follows:
Where:
r = historical holding period return (HPR) (pronounced ‘r-bar’)
Pt = price of the security at the end of the holding period
Pt – 1 = price of the security at the beginning of the holding period
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Dt = distributions received at the end of the holding period
Distributions take the form of cash dividends in the case of shares and
coupons in the case of bonds. Applying Formula 10.1 to Foodies, we find:
Hint: Aways express the holding period return (that is, your answer) as a
percentage.
Note that the holding period return can also be called the total
return and can be written as follows:
QUICK QUIZ
Calculate the historical (one-year) holding
period return for Foodies, assuming that the
share price at the end of the period (Pt) was
R80. The share price decreased during the year
because of pressure on consumers’ disposable
income. Note: In this case,
will consist of a
capital loss yield plus a dividend yield.
Now assume that two years have lapsed since you initially bought
shares in Foodies. What would your historical return be? In this
case, we need to compute a multi-period average return using
either an arithmetic or a geometric averaging technique.
An arithmetic average is calculated as follows:
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Where:
r A = arithmetic average return
rt = holding period return in year t
n = number of years
By contrast, a geometric average is calculated as follows:
Where:
r G = geometric average return
rt = holding period return in year t
n = number of years
The advantage of the geometric average is that it incorporates the
concept of compounding (refer to Chapter 4 for a discussion on
compounding). Also note that the terms ‘average return’ and ‘mean
return’ can be used interchangeably.
Example 10.2 Calculating historical returns
Use the data for Foodies that follows to calculate its multi-period return using
both the arithmetic and the geometric averaging techniques.
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Using the total returns for Taste Holdings provided in the opening
case study, we find the arithmetic average to be 40,70%. We can use
an Excel spreadsheet to compute the geometric return as shown
below.
Once we have calculated the historical returns of an investment, the
question then becomes, how good or bad are these returns? To
answer this question, we need to select a benchmark against which
the investment’s performance can be evaluated. Returns on
investments with similar levels of risk can serve as such a
benchmark. Investors should also consider the level of inflation
over the evaluation period because inflation erodes purchasing
power.
Firer, Ross, Westerfield and Jordan (2012: 371) computed the
historical returns for a number of South African securities over the
period 1900 to 2010. Their findings are presented in Table 10.1.
Table 10.1 Historical returns of South African securities (1900–2010)
Type of security
Average annual return
Large-company shares
14,7%
Long-term government bonds
7,2%
Short-term money market funds
6,2%
Inflation
5,0%
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Source: Firer et al., 2012: 371.
Although it is valuable to consider historical performance, investors
are generally more interested in what they could earn in future on a
particular investment. So our attention now turns to measuring the
expected – or ex ante – returns of a single security.
10.2.2
Evaluating expected returns
When evaluating the future prospects of an investment, investors
are confronted with uncertainty. For example, what will happen to
the share price of Taste Holdings in the next six weeks? In six
months? In six years? Economists and market analysts often have
different views when it comes to estimating the future performance
of a security. Investors can turn to probability theory for guidance
when dealing with uncertainty. A probability refers to the chances
or odds that a future event will occur.
A weather forecast is an everyday application of probability
theory. Farmers are usually interested in knowing what the chances
of rain will be on a given day. If the weather office forecasts a 10%
chance of rain, farmers know that there is also a 90% chance of no
rain. Probabilities always add up to 100%.
Example 10.3 Evaluating expected returns using probability theory
Assume that you are interested in buying ordinary shares in Vegan Ltd. This
entity specialises in vegan cuisine and has a number of restaurants across
South Africa. Using your insight into the local economy and the demand for
restaurants offering vegan-friendly menus, you attach the probabilities set out
in the table that follows to five possible states of the economy. You also
determine a likely rate of return of Vegan’s shares in each of the economic
states that are likely to occur over the next 12 months.
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A: Note that the probabilities add up to 100%
From the forecasts, it is clear that Vegan will do very well during periods of
economic growth and will suffer during recessionary periods. As an investor,
you are interested in knowing what the average return will be if you invest in
this entity. This question can be answered by calculating the average (mean)
expected return:
Where:
= average expected return (pronounced ‘r-hat’)
n = number of economic states
Pri = probability of the ith economic state occurring
ri = anticipated rate of return of Vegan if the ith economic state occurs
Using Formula 10.5, we can calculate Vegan’s average expected return:
(0,1)(−15) + (0,2)0 + (0,4)(5) + (0,2)(10) + (0,1)(25) = 5%
Hint: Express probabilities as fractions and returns as percentages when using
Formula 10.5. Always show the average expected return (that is, your answer)
as a percentage.
Interpretation
If you invest in Vegan’s ordinary shares, you expect to earn an average return
of 5% on your investment over the next 12 months.
QUICK QUIZ
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1. What is meant by the term ‘probability’?
2. What is meant by the concept ‘average expected
return’?
10.2.3
Evaluating historical risk
Investment decisions should never be based on returns only,
whether they relate to real assets or financial assets. Investors also
need to evaluate the risk attached to the investment. Generally
speaking, risk refers to the loss of something valuable (such as
money). It can, however, also refer to an outcome that differs from
what we expect. In financial and investment terminology, risk
refers to the volatility of an investment’s returns.
It is of critical importance that investors consider the risk of an
investment, especially as high levels of expected return are
generally associated with high levels of risk. As indicated in the
‘Focus on ethics’ feature that follows, Ponzi schemes typically
promise investors extremely high rates of return that cannot
realistically be sustained over a long period of time.
FOCUS ON ETHICS: Ponzi schemes
Charles Ponzi was an Italian businessman and con artist in the United
States and Canada at the beginning of the 20th century. He promised
investors a 50% return on investment within 45 days or 100% return
within 90 days. He told investors that he bought discounted postal
reply coupons in other countries and redeemed them at face value in
the United States. In reality, he was paying early investors using the
investments of later investors. The perpetuation of his scheme,
therefore, required an ever-increasing flow of money from new
investors. Charles Ponzi’s scheme ran for over a year before it
collapsed, costing ‘investors’ US$20 million.
Almost a century later, Bernard Madoff swindled investors out of
an estimated US$64,8 billion. The scheme, which collapsed in 2009,
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was the largest investor fraud committed by a single person in history.
South Africa has also seen its share of Ponzi schemes in the past.
For example, in 2009, the R10-billion Frankel Investment Scheme run
by Barry Tannenbaum was uncovered. The entity supposedly operated
as an importer and exporter of active pharmaceutical ingredients
(APIs). Tannenbaum claimed that APIs were used in the manufacture
of generic medicines, especially antiretroviral medication. Investors
were told that the scheme had purchase orders from major
pharmaceutical entities, such as Adcock Ingram, Aspen and Novartis,
for APIs valued in the many millions. Investors could therefore expect
massive returns. The scheme was eventually exposed by suspicious
investors.
In another local Ponzi scheme, albeit a smaller one, Graeme
Minne and his wife Erika duped almost a thousand investors out of
millions of rands. Minne claimed to have been involved in forex
trading, and investors were under the impression that they were
earning interest of 65% over a year or 4% a month. In reality, there
weren’t any serious profits from forex trading, making Minne reliant
on getting new investors to pay the interest of the existing investors.
In June 2019, legal proceedings began in the Durban Regional
Court in which Yunus Moolla and his wife Fathima Carawan faced 11
000 charges in relation to a R1-billion ‘get rich quick’ Ponzi scheme.
More than 100 witnesses, some of whom committed their life savings
to the scheme, are expected to testify during the course of the trial.
Moolla and Carawan are charged with conducting the business of a
bank. They unlawfully accepted deposits from members of the public.
The court case was still ongoing at the time of writing.
Sources: IOL, 2009; Hazelhurst & Buthelezi, 2013; Wikipedia, 2020; Broughton, 2019.
The discussion on Ponzi schemes illustrates that investments
offering returns that seem ‘too good to be true’ are likely to be ones
that are very risky (if not unlawful).
QUICK QUIZ
Consider the total returns of Taste Holdings and
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two competitors (Famous Brands Ltd and Spur
Corporation Ltd) for five calendar years. Famous
Brands is a quick-service and casual dining
restaurant franchisor that owns brands such as
Steers, Wimpy, Debonairs Pizza, Fishaways, Mugg
& Bean and Milky Lane. Spur Corporation consists
of Spur Steak Ranches, Panarottis Pizza Pasta,
John Dory’s Fish Grill Sushi, RocoMamas and The
Hussar Grill, among others.
Which of these three competitors exhibited the
most return volatility (and hence the most
historical risk) over the period 2014 to 2018?
Motivate your answer.
Sources: Information compiled by Iress Research Domain from Famous Brands, 2017; Spur Corporation,
2020a.
Having defined risk, let’s now look at measuring the risk of a single
security. As with returns, the evaluation can be based on an ex-post
or an ex-ante basis. Let’s start with an ex-post perspective. Using the
statistical measures of variance and standard deviation, we can
measure the extent to which actual returns (also called realised
returns) differ from the historical average return. From statistics, we
know that the historical variance can be calculated as follows:
Where:
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σ2
= variance of returns
n = number of historical periods
r1, r2, rn = actual (realised) return in periods 1, 2 … n
r = average historical return (as calculated previously)
As the variance is difficult to interpret, instead we calculate the
standard deviation, which is simply the square root of the variance.
The greater the standard deviation:
• the more the actual returns differ from the average return
• the more risk there is when investing in a particular security.
Using an Excel spreadsheet and the geometric return that we
computed earlier for Taste Holdings (–51,14%), we can find the
entity’s historical variance and standard deviation as shown below.
Firer et al. (2012) calculated the historical standard deviations for a
number of South African securities over the period 1900 to 2010.
From Table 10.2, you can see that large-company shares not only
yielded the highest overall returns, but were also the most risky
asset class.
Table 10.2 Historical standard deviations of South African securities (1900–2010)
Type of security
Large-company shares
Average annual return
Standard deviation
14,7%
23,3%
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Long-term government bonds
7,2%
9,4%
Short-term money market funds
6,2%
5,7%
Inflation
5,0%
6,4%
Source: Firer et al., 2012: 376.
QUICK QUIZ
1. Interpret the arithmetic means and historical
standard deviations of all the securities
contained in Table 10.2.
2. Compare Firer et al.’s (2012) findings in
Table 10.2 with similar research conducted in
the United States in the period 1926–2016.
A: These figures can be compared to those of the
short-term money market funds in the South
African study.
Source: Ross, Westerfield & Jordan, 2019: 399.
Why do you think small-company shares in the
United States is such a risky asset class? Why
are the historical returns of South African
securities (see Table 10.2) so much higher than
those in the United States?
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10.2.4
Evaluating expected risk
The statistical measures of variance and standard deviation can also
be used to determine the expected level of risk associated with an
investment. In this case, we use Formula 10.7:
Where:
σ 2 = variance of returns
n = number of anticipated economic states
Pri = probability of the ith economic state occurring
ri = anticipated rate of return if the ith economic state occurs
= average expected return (as calculated previously)
Using Formula 10.7 and the figures for Vegan introduced earlier,
we can calculate the entity’s variance and standard deviation as
follows:
Interpretation
If you invest in Vegan’s ordinary shares, you can expect to earn an
average return of 5%. Assuming that the returns are normally
distributed, there is, however, a two-thirds chance that the actual
return will fall within one standard deviation from the expected
average return. This implies that there is a two-thirds likelihood of
the actual return falling within the range of 14,49% (5% + 9,49%)
and −4,49% (5% − 9,49%). It is important to note that the standard
deviation is only a good measure of an investment’s risk if its
returns are normally distributed.
10.2.5
Coefficient of variation
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What should investors do in cases where investment opportunities
have different average expected returns and standard deviations?
They can calculate the coefficient of variation (CV) to standardise
the risk and return characteristics of these securities. CV is
calculated as follows:
Example 10.4 Evaluating investments using CV
Consider the data for Vegan and a competitor called Vegetarian presented in
the table that follows. If you were in a position to invest in the securities of only
one of these two entities, which one would you select? Assume that you are a
risk-averse investor (that is, an investor who prefers the lowest level of risk for
a given level of return).
As a risk-averse investor, you would most likely select Vegetarian, as it has the
lowest CV and hence the lowest risk per unit of return.
QUICK QUIZ
1. Use the information that follows to calculate
the expected returns, standard deviations and
CVs for Pizza Ltd and Pasta Ltd.
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2. If you could invest in only one of the two
shares, which one would you select? Motivate
your answer.
10.2.6
Summary: Single security return and risk
Table 10.3 provides a summary of the formulae used to assess the
return and risk characteristics of a single security using both the expost and the ex-ante perspectives. The main conclusion that we can
draw from evaluating the return and risk characteristics of single
securities is that riskier investments (in other words, those with
larger standard deviations) also tend to offer investors higher
returns.
It is, however, unwise to invest all your funds in one security.
The phrase ‘don’t put all your eggs in one basket’ is apt. Instead,
investors should create portfolios consisting of a selection of
securities. In this way, investors can diversify, or spread, their risk.
A portfolio consisting of financial assets could contain ordinary
shares, preferences share, corporate bonds, Treasury bills and
money market instruments as well as other securities. In contrast, a
real asset portfolio could consist of different plant, property and
equipment.
The section that follows looks at the techniques used to
determine the return and risk characteristics of portfolios.
Table 10.3 Formulae for assessing the return and risk characteristics of a single security
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10.3
Assessing the return and risk characteristics of
a portfolio
As investors are predominantly interested in future returns, only
the ex-ante perspective is discussed in the sections that follow.
10.3.1
Assessing expected portfolio returns
The following formula can be used to determine the expected
return of a portfolio:
Where:
p = expected return of a portfolio
n = number of securities included in the portfolio
wi = weight of security i in the overall portfolio
i = average expected return of the ith security, as calculated
previously
Example 10.5 Assessing portfolio return
You would like to invest in a portfolio consisting of two shares, A and B (refer to
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the information in the table that follows). You will invest R100 000 and R300
000 in the two shares, respectively. Based on your economic forecasts, the
average expected returns of the two shares are 10% and 25%, respectively.
What is the average return that you will earn on this portfolio?
Using Formula 10.9, we find:
p = (0,25)(10) + (0,75)(25) = 21,25%
Hint: Express weights as fractions and returns as percentages when using
Formula 10.9. Always show portfolio return (that is, your answer) as a
percentage.
10.3.2
Assessing expected portfolio risk
Whereas expected portfolio return is simply the weighted average
of the individual securities’ returns, expected portfolio risk is not
the weighted average of the individual securities’ standard
deviations. Note the following:
Instead, the expected risk of a portfolio consisting of two securities
is calculated as follows:
Where:
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= variance of the returns of a portfolio
wA = weight of Security A in the overall portfolio
wB = weight of Security B in the overall portfolio
= variance of Security A
= variance of Security B
= covariance of the returns of Securities A and B
An important consideration when evaluating portfolio risk is the
measurement of covariance. Covariance indicates the extent to
which the returns of securities in the portfolio move together.
Covariance is calculated as follows:
Where:
= covariance of a portfolio consisting of two securities, A
and B
n = number of anticipated economic states
= probability of the ith economic state occurring
rA,i = anticipated rate of return on Security A if the ith economic
state occurs
= average expected rate of return on Security A
r B, r = anticipated rate of return on Security B if the ith economic
state occurs
B = average expected rate of return on Security B
A positive covariance implies that the securities’ returns move in
the same direction over time, whereas a negative covariance implies
that their returns move in opposite directions. As covariance is
difficult to interpret, instead we calculate the correlation coefficient
(ρ) (pronounced as ‘rho’). The correlation coefficient can be
computed using Formula 10.12:
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The correlation coefficient always varies between −1 and +1. Figure
10.1 illustrates how to interpret the correlation coefficient. The
closer ρ is to +1 and −1, the stronger the relationship between the
securities’ returns (positive and negative, respectively).
Figure 10.1 Interpreting the correlation coefficient
The returns of securities operating in the same sector (such as Taste
Holdings, Famous Brands and Spur Corporation) often exhibit
positive correlation. This is good news for investors when the
particular sector is flourishing, but not such good news when the
sector is experiencing challenging times. The benefits of
diversification, and hence the reduction of portfolio risk, are
therefore minimal when combining securities that are positively
correlated.
By contrast, diversification is effective when combining
securities that are negatively correlated. Assume that you create a
portfolio consisting of the shares of a furniture retailer that sells on
credit and the shares of a debt-collection entity. When the economy
is growing and interest rates are low, consumers tend to purchase
more furniture on credit, which leads to increased sales, profits,
dividends and hence returns for the furniture retailer. Should
interest rates increase, however, consumers would tend to buy less
and generally also find it difficult to honour their credit
repayments. Sales would consequently decrease and bad debts
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would rise, reducing the retailer’s returns. However, debt-collection
entities flourish during economic downturns, yielding increasing
returns. Therefore, the pattern of offsetting returns effectively
reduces portfolio risk.
In reality, it is extremely difficult to find entities that are
negatively correlated (debt-collecting entities being the exception).
Nonetheless, investors should strive to include entities with the
lowest positive correlation in their portfolios.
QUICK QUIZ
You would like to create a three-share portfolio
consisting of the companies that are listed on
the Johannesburg Stock Exchange (‘the JSE’) set
out in the table that follows.
Which three-share combination would be most
likely to have the lowest correlation
coefficient?
Example 10.6 Assessing portfolio risk
You are considering investing in the ordinary shares of two listed companies
operating in the same sector: Country Lodges Ltd and SafariPlus Ltd. More
details on the two entities are provided in the table that follows.
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Based on your expectations, what will the portfolio risk of this two-asset
portfolio be?
We start by calculating the weights of the individual investments in the
overall portfolio.
Next, we use Formula 10.12 to calculate the covariance between the two
securities:
Next, we use the covariance in Formula 10.10 to calculate the portfolio risk of
the two-asset portfolio:
Risk-averse investors also prefer portfolios that yield the highest
returns for the lowest level of risk. Research has shown that
portfolio risk can be decreased by adding more securities to a
portfolio, especially if these securities’ returns are negatively
correlated. Therefore, the question that we now consider is whether
portfolio risk can ever be completely eliminated. This brings us to
the next section, which investigates the two main components of
portfolio risk (as measured by σp).
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10.3.3
Portfolio risk: A closer look
As indicated in Figure 10.2, total portfolio risk can be reduced by
increasing the number of securities in a portfolio. However, the
reality is that portfolio risk can never be completely eliminated.
This is because total portfolio risk consists of two components: nonsystematic risk and systematic risk. Only one of these, nonsystematic risk, can be eliminated through diversification.
Figure 10.2 Total portfolio risk
Non-systematic risk refers to events that negatively affect the
returns of one or a limited number of entities in a particular
economy. Examples of such negative events are strikes, shortages of
raw materials, failed marketing campaigns, lawsuits and fraud. As
these events only affect a restricted number of entities, they are also
referred to as entity-specific risks. Entity-specific risk can be
minimised and even completely eliminated by including several
diverse securities in a portfolio. Entity-specific risk is therefore also
known as diversifiable risk. Theoretically speaking, a portfolio that
consists of all the securities in a particular market will have no
entity-specific risk.
By contrast, systematic risk refers to events that (systematically)
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affect the returns of all or a very large number of entities in an
economy. Examples of such events are unexpected global events
(such as major terrorist attacks or pandemics) and unexpected
changes in economic variables, such as interest rates and oil prices.
Systematic risk is also called market risk or non-diversifiable risk,
as this type of risk can never be eliminated, irrespective of the size
(diversity) of the portfolio.
As non-systematic (entity-specific) risk can be eliminated by
means of diversification, investors should only be concerned about
systematic (market) risk. A security’s exposure to market risk can
be measured by calculating its beta coefficient (β). A security’s beta
coefficient indicates the degree to which its returns move with the
overall market. In South Africa, the FTSE/JSE All-Share Index
(ALSI) is often used as a proxy for, or representation of, the market
portfolio.
We can calculate the beta coefficient of a security by using
Formula 10.13:
Where:
βi = beta coefficient of Security i
= covariance of the returns of Security i and the market
portfolio
= variance of the market portfolio
When β = 1, a security’s returns move in perfect synchronisation
with the market portfolio (in terms of direction and magnitude). A
beta > 1 means that the security has more market risk than the
average security (which has a beta of 1). Consider an entity that has
a beta of 2. If the returns on the market portfolio increase or
decrease by 10%, the returns on this entity are likely to increase or
decrease by 20%. A beta < 1 suggests that the security has less
market risk than the average security. The returns of an entity that
has a beta of 0,5 will thus only increase or decrease by 5% should
the returns on the market portfolio increase or decrease by 10%. The
returns of entities with negative betas move in the opposite
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direction to the overall market. The returns of a debt-collecting
entity with a beta of –1,5 will thus decrease by 15% when the
market portfolio increases by 10%, and vice versa. Notice that the
interpretation of β is very similar to that of ρ.
It is also possible to calculate a beta coefficient for a portfolio:
Where:
βp = beta coefficient of a portfolio
n = number of securities included in the portfolio
wi = weight of Security i in the overall portfolio
βi = beta coefficient of the ith security
Example 10.7 Calculating the beta coefficient of a portfolio
Calculate and interpret the beta coefficient of the portfolio consisting of three
shares presented in the table that follows.
In this case, we have equal weights, which implies that:
Interpretation
The return of this three-share portfolio is slightly riskier than that of the market
portfolio (which has a beta coefficient of 1).
QUICK QUIZ
1. Explain the difference between non-systematic
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and systematic risk.
2. Would you classify electricity shortages
caused by Eskom as a non-systematic or a
systematic risk in the South African market?
3. On 30 August 2019, Taste Holdings had a beta
coefficient of 0,2520, whereas Famous Brands
and Spur Corporation had beta coefficients of
0,2081 and 0,2636, respectively. Interpret
these beta coefficients.
4. Which one of the three competitors mentioned
in Question 3 has the least market risk?
Motivate your answer.
Sources: Information compiled by Iress Research Domain from Famous Brands, 2018, 2019; Spur
Corporation, 2020b; Taste Holdings, 2020a.
Although the FTSE/JSE ASLI represents the theoretical market
index in South Africa, many market participants prefer to use the
FTSE/JSE shareholder weighted ALSI (SWIX). This index was
created to meet market participants’ need for:
• an objective benchmark for measuring stock market
performance
• an index that achieves the goal of risk diversification
• an investable universe for local interest
• an index that is compliant with current legislation
• an index that represents the current investment patterns of asset
managers more closely.
10.3.4
Summary: Portfolio return and risk
As indicated in Table 10.4, the ex-ante (expected) return of a
portfolio can be determined by computing the weighted average of
the individual securities’ returns. Expected portfolio risk (σp), on
the other hand, is much more complex, as the covariance between
the individual securities’ returns needs to be taken into account.
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Table 10.4 Formulae for assessing the ex-ante return and risk characteristics of a portfolio
A: This formula applies to a portfolio consisting of two securities. The formula can be expanded when adding
more securities to the portfolio.
We have seen that total portfolio risk consists of two components:
non-systematic (entity-specific) risk and systematic (market) risk.
Non-systematic risk can be eliminated by investing in a broadly
diversified portfolio, whereas market risk always remains present,
irrespective of the size of the portfolio. A security or portfolio’s
exposure to market risk can be measured by calculating its beta
coefficient.
As will be shown in the section that follows, beta is used to
determine an investor’s required rate of return. You will remember
from Chapter 9 that investors should only invest in a security if its
expected return exceeds its required return. The same applies when
evaluating a portfolio’s prospects.
10.4
The capital asset pricing model and the security
market line
Assume that you would like to invest in a portfolio that mimics the
South African stock market. This portfolio would consist of shares
of all the companies listed on the JSE. The rationale for investing in
such a broadly diversified portfolio is that it has no entity-specific
risk at all, only market risk. As stated before, the FTSE/JSE ALSI or
ALSI (SWIX) is often used as a proxy for the market portfolio in
South Africa. Risk-averse investors generally also invest in risk-free
securities. Financial securities issued by governments, such as
Treasury bills, are typically regarded as risk-free instruments, as the
probability of default is very small. This assumption has, however,
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been challenged in recent years, as the instruments issued by some
governments have been downgraded to junk status, including those
of the South African government (refer to Section 8.6.2 for more
information).
If you invest all your funds in a portfolio that mimics the market
index, you will earn the market return, denoted as rM. The beta of
this investment will be 1 (remember that beta indicates the extent to
which the returns of an investment move with the market; in this
case, the portfolio’s returns are moving in perfect synchronisation
with the market).
If, however, you invest all your funds in a Treasury bill issued
by the South African government, you will earn a risk-free return, rf
. The beta of this investment will be zero, as the returns of Treasury
securities do not move with the market at all.
Using the (x, y) coordinates of (0, rf) and (1, rM), we can draw the
risk-return graph shown in Figure 10.3. Note that Point F represents
a portfolio that is 100% invested in the risk-free security (0, rf),
whereas Point M represents a portfolio that is 100% invested in the
market portfolio (1, rM). The line that results by connecting Points F
and M is called the security market line (SML). The SML is a
straight line that shows all combinations of the risk-free security
and the market portfolio. The formula for the SML (Formula 10.15)
is one of the most important formulae in modern portfolio theory
and forms part of the larger body of knowledge known as the
capital asset pricing model (CAPM). The SML formula shows us the
rate of return that investors require to be properly compensated for
accepting market risk when investing in a single security or
portfolio. It also represents the cost of ordinary shareholders’ equity
(ke). As will be shown in Chapter 11, ke is an important element of
an entity’s weighted average cost of capital.
Figure 10.3 The security market line
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Where:
r = required rate of return
rf = risk-free return on a government security (such as a Treasury
bill)
βi = beta coefficient of the security or portfolio being analysed
rM = return on the market portfolio
It should be clear from Formula 10.15 that the minimum return on
any risky investment should be the risk-free rate. Given that the
SML is a straight line, we see that risky investments (that is, those
with betas greater than zero) require positive rates of return in
excess of rf . We also see that the higher the beta, the higher the
return required by investors. Example 10.8 illustrates the use of the
accept/reject rule (in other words, only invest when the expected
return is greater than the required return).
Example 10.8 Comparing the required return with the expected return
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You are considering whether or not to invest in a portfolio that consists of four
shares. The invested amounts and beta coefficients of each share are listed in
the table that follows.
The expected rate of return on the market index is 12% and the risk-free rate
on a Treasury bill is 6%. Based on your economic forecasts, the expected rate
of return on the portfolio ( ) is 15%. Should you invest in this portfolio?
To answer this question, we need to follow three steps.
Step 1: Calculate the portfolio’s beta.
Step 2: Use the SML formula to calculate the rate that investors require on this
investment to compensate them for taking on market risk.
Step 3: Compare the expected portfolio return ( p) with the portfolio’s required
rate of return (r).
Expected return on this portfolio = 15%
Required return on this portfolio = 11,04%
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You should invest in the portfolio because its p > r. In other words, its
expected return exceeds its required return.
Alternatively, we could calculate the required rate of return of each of the
individual shares, multiply it by each share’s weight in the overall portfolio, and
then determine the sum of the weighted returns, as shown in the table that
follows.
Note that the required rate of return is virtually the same, irrespective of the
method used. The SML coordinates in this case are set out in the table that
follows.
The graph that follows illustrates the SML for the four-share portfolio.
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The acceptance region lies above the SML, whereas the rejection region lies
below the SML.
QUICK QUIZ
1. Why does the market index have a beta of 1?
2. Assume that an entity has a large negative
beta (remember that a negative beta implies
that the entity’s returns move in the opposite
direction to the market). You add this entity
to your existing portfolio. What would the
impact on the portfolio beta and the required
rate of return of the portfolio be?
3. What is meant by the required rate of return
of an investment?
4. Calculate the required rate of return for the
SV Company if it has a beta coefficient of 0,3
(evidence that its returns are not very
sensitive to changes in the economy), the
return on a broad market index is 15% and the
return on a risk-free Treasury bill is 8%.
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Would you invest in the shares of SV Company
if its expected return were 12%? If its
expected return were 9%? Justify your
decisions.
It should be noted that estimating a security’s required rate of
return depends on the type of information that is available to the
analyst. If the required rate of return, which is estimated by means
of dividend growth models (explained in Chapter 9), differs from
the return computed using Formula 10.15, an average return can be
calculated and used. The CAPM is regarded as a single factor asset
pricing model as it only evaluates a share’s exposure to one risk
factor: market risk (rM - rf). Critics of the CAPM have long
questioned the accuracy of a required return that is calculated using
only one factor. A number of multi-factor models have thus been
proposed, the most prominent of which are described in the section
that follows.
10.5
Multi-factor asset pricing models
In 1976, the economist Stephen Ross proposed the arbitrage pricing
theory (APT). He argued that a share’s required rate of return
should be evaluated in terms of its sensitivity to a range of
macroeconomic factors, such as gross domestic product (GDP)
growth, expected inflation, tax rate changes and dividend yield.
APT’s acceptance has been slow, as Ross’s model did not specify
which specific factors to include. In 1992, Eugene Fama and
Kenneth French found that small entities and entities with high
book-to-market ratios (so-called value entities) offer above average
returns. As such, they proposed a three-factor asset pricing model
that included size and value factors in addition to the CAPM’s
market risk factor. In 2015, Fama and French extended their model
to include factors that capture an entity’s operating profitability and
investments. Their five-factor model is presented in Formula 10.16.
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Where:
r = Fama–French five-factor required return for a share
rf = risk-free rate
b = the share’s sensitivity to each of the respective factors
(rM - rf) = market risk factor, computed as the return on the market
index minus the risk-free return
r SMB = size factor, computed as the return on a portfolio of small
entities minus the return on big entities
r HML = value factor, computed as the return on a portfolio of high
book-to-market ratio entities minus the return on low book-tomarket ratio entities
r RMW = operating profit factor, computed as the return on a
portfolio on entities with robust operating profitability minus the
return on entities with weak operating profitability
r CMA = investment factor, computed as the return on a portfolio of
entities with conservative investments minus the return on entities
with aggressive investments
Harvey, Liu and Zhu (2015) surveyed hundreds of academic papers
that have investigated asset pricing over the past 50 years. In these
articles, more than 300 different factors were reported to influence a
share’s required return.
10.6
Conclusion
This chapter focused on risk and return. You learnt the following:
• The return and risk characteristics of single securities can be
either ex post (that is, using historical data) or ex ante (using
expected or future values). The same principles apply whether
financial assets or real assets are being analysed.
• The calculation of ex-ante values requires educated guesses
regarding the future state of the global and local economy, and
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•
•
•
•
•
the likely performance of the security or portfolio being
investigated.
The return and risk characteristics of a portfolio can be either ex
post or ex ante.
Total portfolio risk has two elements: systematic risk and nonsystematic risk. Although total risk can never be completely
eliminated, it can be substantially reduced by creating a
diversified portfolio (in other words, a portfolio where the
returns of securities are correlated negatively or weakly
positively).
It is also essential to consider the level of market (or systematic)
risk to which an investment is exposed. Investors should only
invest in single securities and portfolios whose expected returns
(based on economic forecasts) exceed their required rates of
return (as indicated by the security market line, or SML).
Financial managers and investors can use the SML to make
investment decisions in financial assets or in real assets. The
SML, which is part of the capital asset pricing model (CAPM),
suggests that riskier investments require higher returns.
The single factor CAPM has been extended by scholars such as
Eugene Fama and Kenneth French to include other risk factors.
These multi-factor models provide a more accurate measure of a
share’s required rate of return.
In the opening case study, we saw that Taste Holdings’ total returns
have deteriorated significantly in recent years. One reason might be
that the prospects of both divisions (food and luxury goods) are
closely tied to the state of the local economy. In other words, these
two divisions are positively correlated to the market. The closing
case study provides some statistics on the conditions that South
African consumers have been facing of late and the impact that this
has had on entities such as Taste Holdings.
CASE STUDY
Keeping afloat in a floundering economy
According to the South African Reserve Bank, unemployment
in South Africa increased from 25,4% in the third quarter of
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2014 to 27,6% at the end of the first quarter of 2019. The central
bank also reported that the real growth rate in the country’s
gross domestic product (GDP) decreased from 2,1% to –3,2%
over the corresponding period. Furthermore, the prime interest
rate rose to over 10% during this period.
The combined effect of these economic developments is
very clear in Taste Holdings’ 2019 results. For the financial year
ending February 2019, the entity reported a 44% decrease in
full-year earnings before interest, tax, depreciation and
amortisation (EBITDA), down from R150,59 million in the
previous financial year. This weaker performance is mainly
ascribed to the 12% fall in revenue in the luxury goods
division.
However, Taste Holdings’ chief executive officer is upbeat
about the entity’s journey to profitability. A systematic review
of the entity’s operations in 2018 revealed that greater
emphasis should be placed on the food division. The entity
consequently closed manufacturing operations and started
streamlining the supply chain that services its restaurants.
Management is also looking at opening six new Starbucks cafés
and ten Domino’s restaurants in the 2019/20 financial year.
At the time of writing, South Africa was in lockdown due to
the COVID-19 virus. It is anticipated that this event will have
devastating consequences for companies such as Taste
Holdings.
Sources: Rangongo, 2019; SARB, 2020a, 2020b, 2020c
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
The covariance of Taste Holdings Ltd and Famous Brands Ltd is likely to be
__________, as they operate in the same sector.
A. negative
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B.
C.
D.
neutral
positive
zero
2.
Which ONE of the following is NOT a factor in the Fama–French five-factor
asset pricing model?
A. Momentum
B. Size
C. Value
D. Operating profit
3.
You are evaluating the historical returns of two securities, X and Y. Based on
the data in the table that follows, which security has the higher geometric
average?
A.
B.
C.
D.
4.
Year
Security X’s returns
Security Y’s returns
1
2%
9%
2
18%
11%
Security X
Security Y
The two securities have the same geometric average return.
It is impossible to calculate.
Indicate the correct ranking of South African securities on the basis of their
historical returns over the period 1900–2010. Rank them from the highest to
the lowest return.
A. Short-term money market funds; long-term government bonds; largecompany shares
B. Large-company shares; long-term government bonds; short-term money
market funds
C. Large-company shares; short-term money market funds; long-term
government bonds
D. Long-term government bonds; large-company shares; short-term money
market funds
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5.
Diversification is most effective when the returns of securities are …
A. perfectly positively correlated.
B. moderately positively correlated.
C. moderately negatively correlated.
D. perfectly negatively correlated.
6.
Another term for systematic risk is __________.
A. market risk
B. entity-specific risk
C. non-diversifiable risk
D. Alternatives (A) and (C) are correct.
INTERMEDIATE
7.
The larger the variance of an investment’s returns, the …
A. more the actual returns will tend to differ from the average return.
B. larger the standard deviation.
C. greater the risk associated with the investment.
D. All of the above apply.
8.
Total portfolio risk consists of …
A. non-systematic risk plus entity-specific risk.
B. non-systematic risk plus market risk.
C. entity-specific risk plus diversifiable risk.
D. systematic risk plus market risk.
9.
A security that has a beta coefficient of 1,25 exhibits …
A. more systematic risk than the average risky share.
B. less systematic risk than the average risky share.
C. more entity-specific risk than the average share.
D. less entity-specific risk than the average share.
10. Investors should buy a security if …
A. its expected return < its required return.
B. its expected return = its required return.
C. its expected return > its required return.
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D.
its expected return > its forecasted return.
11. The national electricity provider, Eskom, has announced that it will increase
tariffs significantly over the next couple of years to finance its maintenance and
expansion programmes. Such tariff hikes represent a source of __________
for local investors.
A. entity-specific risk
B. total risk
C. diversifiable risk
D. market risk
ADVANCED
12. Assume that the required return on a security is 15,75% and the return on a
broad market index is 14%. If the security has a beta coefficient of 1,25, what
is the risk-free rate of return?
A. 7,00%
B. 14,00%
C. 12,50%
D. 15,75%
13. You have invested R10 000 in a portfolio consisting of three shares. The shares
are held in equal proportions. The portfolio is quite risky: the beta coefficient is
1,9. You decide to lower the overall portfolio risk by selling one of the shares,
which has a beta coefficient of 1,8. If you replace this share with another one
that has a beta coefficient of 0,3, what will the new portfolio beta coefficient
be?
A. 1,30
B. 1,40
C. 1,90
D. 1,95
14. Indicate the correct answer combination.
i)
The coefficient of variation (CV) standardises the risk and return
characteristics of securities.
ii) When faced with a decision between two securities, a risk-averse
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iii)
iv)
A.
B.
C.
D.
investor will choose the one with the lowest CV.
The CV of a security is calculated using the following formula:
When faced with a decision between two securities, a risk-averse
investor will choose the one with the highest CV.
Alternatives (i) and (ii)
Alternatives (ii) and (iii)
Alternatives (iii) and (iv)
The correct answer combination is not listed.
15. Which of the investments described in the table that follows would you select if
you could select only one? Assume that you are a risk-averse investor.
A.
B.
C.
D.
Grilled Ltd, as it has the highest coefficient of variation
Baked Ltd, as it has the lowest coefficient of variation
Baked Ltd, as it has the highest expected return
Fried Ltd, as it has a very high standard deviation
LONGER QUESTIONS
BASIC
1.
2.
Assume that you bought shares in Travel Ltd on 30 June 2018 for a price of 3
900 cents per share. Also assume that you received a dividend of 196 cents
per share on 30 June 2019. On the same day, you decide to sell your shares
for 5 415 cents per share. Calculate the holding period return on this
investment. Show the relevant formula.
You are evaluating an investment that yielded a return of 5% in year 1, −3% in
year 2 and 12% in year 3. What are the arithmetic and geometric averages for
this investment? Show the relevant formulae.
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INTERMEDIATE
3.
You have identified the Salsa and Mambo entities as possible investments. You
have estimated three possible states of the local economy, each with its own
probability of occurrence. Your estimates for the expected performance of the
two entities under each state of the economy are presented in the table that
follows.
Show the relevant formulae when answering the questions below.
a)
b)
c)
4.
Calculate the expected returns of both shares.
Calculate the expected risk of both shares.
Calculate the covariance and correlation coefficient of these two
securities.
d) Interpret the correlation coefficient as calculated in Question 3c).
e) Calculate the expected return of a portfolio consisting of 75% Salsa and
25% Mambo.
f)
Calculate the expected risk of a portfolio consisting of 75% Salsa and
25% Mambo.
Consider the information that follows about a portfolio that consists of two
shares, Coffee and Tea.
a)
Coffee
Tea
Investment in portfolio (R)
40 000
70 000
Standard deviation (σ)
15%
2%
Calculate the standard deviation of the portfolio if the correlation
coefficient between the two shares equals 0,4. Indicate the relevant
formula for portfolio standard deviation (σp).
b) Comment on the following statement: Portfolio risk can be eliminated by
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combining two shares in a portfolio if the shares are perfectly positively
correlated. Motivate your answer.
5.
Consider the data below, and then answer the questions that follow.
■
■
■
The rate of return on a Treasury bill is 6%.
The beta of Share X is 1,2; the beta of Share Y is 0,3.
The return on a broad share market index is 12%.
Show all the relevant formulae.
a)
b)
c)
d)
6.
7.
Calculate the expected return of each share individually.
Calculate the expected return of a portfolio that is created by investing
equal proportions in these two shares.
Assume that you are a risk-averse investor. Would you invest in this
equally weighted portfolio consisting of Shares X and Y? Motivate your
answer.
Based on your calculations, is this portfolio overvalued or undervalued?
(You will recall from Chapter 9 that a security or portfolio is undervalued if
expected return > required return and overvalued if expected return <
required return.)
Based on your research of the economy as well as the restaurants and pubs
sector, you anticipate that PizzaIn Ltd will yield an expected rate of return of
11%. The entity has a beta of 1,5. The risk-free rate is 5% and the market’s
expected rate of return is 9%. Should you invest in this security? Justify your
answer.
Consider the information provided for Tour SA Ltd below, and then answer the
questions that follow. This entity operates in the travel and leisure sector, and
owns several upmarket hotels and resorts.
31 December 2019
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31 December 2018
Closing share price
245 cents
Dividend per share (DPS)
8 cents
Beta coefficient
1,46
a)
b)
c)
165 cents
Calculate the holding period return on this share. Indicate the relevant
formula.
Comment on the entity’s beta.
The return on the market index for the same period was 39% and the
risk-free rate of return was 9%. Was the share overvalued or undervalued
on 31 December 2019? Motivate your answer.
KEY CONCEPTS
Arithmetic mean: An averaging technique that indicates the return
earned on an investment in an average period.
Beta coefficient: A measure of systematic risk that indicates the
degree to which a security’s returns move with or against the
overall market.
Coefficient of variation (CV): Risk per unit of return.
Covariance: The extent to which the returns of securities move
together.
Cyclical entities: Entities whose sales and earnings tend to rise and
fall in line with fluctuations in the business cycle.
Defensive entities: Entities that are not likely to react sharply to a
change in the level of economic activity.
Expected return: The return that an investor expects to earn on an
investment based on their forecast of the economy and the
entity’s prospects.
Expected return of a portfolio: Weighted average of the expected
returns of the individual securities included in the portfolio.
Geometric mean: An averaging technique that indicates the
compound return earned on an investment in an average
period.
Holding period return (HPR): The historical return of an investment over
a single holding period (for example, a year).
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Non-systematic risk: Negative events that affect the returns of one or a
few entities in an economy. This type of risk can be diversified
away in a large portfolio.
Portfolio: A collection of financial securities, such as ordinary shares,
preferences shares, corporate bonds, government bonds,
Treasury bills and money market instruments.
Probability: The chances or odds that an event will occur in future.
Required return: The rate of return that investors require from an
investment to compensate them for taking on market risk. The
required rate of return is calculated by means of the SML
equation.
Risk: An outcome that differs from what an investor expected;
linked to the volatility of investment returns.
Systematic risk: The risk that remains in a portfolio after all entityspecific risk has been diversified away.
SLEUTELKONSEPTE
Beta-koëffisiënt: ’n Meting van die sistematiese risiko wat aandui tot
watter mate ’n sekuriteit se opbrengs saam met die algehele
mark beweeg.
Defensiewe maatskappye: Maatskappye wat heel moontlik nie skerp
sal reageer teenoor ’n verandering in die vlak van ekonomiese
aktiwiteit in ’n land nie.
Geometriese gemiddelde: ’n Tegniek wat gemiddelde opbrengs
aandui; toon die saamgestelde opbrengs wat ‘n belegging oor ’n
gemiddelde tydperk verdien.
Koëffisiënt van variasie: Risiko per eenheid opbrengs.
Kovariansie: Die mate waartoe die opbrengs van sekuriteite in
dieselfde rigting beweeg.
Nie-sistematiese risiko: Negatiewe gebeure wat die opbrengs van een
of ’n paar maatskappye in ’n ekonomie beïnvloed. Hierdie soort
risiko kan gediversifiseer word in ’n groot portefeulje.
Opbrengs tydens beleggingstydperk: Die historiese opbrengs van ’n
belegging oor ’n enkele beleggingstydperk (soos ’n jaar).
Portefeulje: ’n Versameling finansiële sekuriteite soos gewone
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aandele, voorkeuraandele, maatskappy-obligasies,
regeringsobligasies, skatkiswissels, geldmarkinstrumente, ens.
Rekenkundige gemiddelde: ’n Tegniek wat gemiddelde opbrengs
aandui; toon wat ’n belegging oor ’n gemiddelde tydperk
verdien.
Risiko: ’n Uitkoms wat verskil van dit wat ’n belegger verwag; die
onbestendigheid van beleggingsopbrengste.
Sikliese maatskappye: Maatskappye waarvan die verkope en
verdienstes geneig is om sterk te verander soos die vlak van
ekonomiese aktiwiteit in ’n land verander.
Sistematiese risiko: Die risiko wat oorbly in ‘n portefeulje nadat al die
maatskappy-spesifieke risiko’s gediversifiseer is.
Vereiste opbrengs: Die koers van opbrengs wat beleggers van ’n
belegging benodig om hulle te kompenseer vir markrisiko.
Vereiste opbrengs word bereken deur middel van die SMLvergelyking.
Verwagte opbrengs: Die opbrengs wat ’n belegger verwag om te
verdien op ’n belegging in die toekoms gebaseer op sy/haar
vooruitskatting van die ekonomie en die maatskappy se
vooruitsigte.
Verwagte opbrengs van ’n portefeulje: Geweegde gemiddelde van die
verwagte opbrengste van die individuele sekuriteite in die
portefeulje.
Waarskynlikheid: Die kans of moontlikheid dat ’n toekomstige
gebeurtenis kan plaasvind.
SUMMARY OF FORMULAE USED IN THIS CHAPTER
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WEB RESOURCES
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https://www.fsca.co.za
http://www.fundsdata.co.za
https://www.resbank.co.za
http://www.sharedata.co.za
http://www.sharenet.co.za
REFERENCES
Broughton, T. (2019). Durban couple accused in R1bn ponzi scheme
appear in court at last. TimesLIVE. Retrieved from
https://www.timeslive.co.za/news/south-africa/2019-06-18durban-couple-accused-in-r1bn-ponzi-scheme-appear-in-courtat-last/ [13 February 2020].
Claasen, L. (2018). How Starbucks owner Taste Holdings plans to
turn things around. Financial Mail.
https://www.businesslive.co.za/fm/money-andinvesting/results/2018-12-06-how-starbucks-owner-tasteholdings-plans-to-turn-things-around/ [13 February 2020].
Fama, E.F. & French, K.R. (1992). The cross-section of expected
stock returns. The Journal of Finance, 47(2), 427–465.
Fama, E.F. & French, K.R. (2015). A five-factor asset pricing model.
Journal of Financial Economics, 116, 1–22.
Famous Brands. (2017). Leading brands. Retrieved from
https://famousbrands.co.za/brands/leading-brands/ [13
February 2020].
Famous Brands. (2018). Downloads. Retrieved from
https://famousbrands.co.za/downloads/ [4 March 2020].
Famous Brands. (2019). Integrated annual report. Retrieved from
https://famousbrands.co.za/pdfs/Famous_Brands_IAR_13116.pdf
[4 March 2020].
Firer, C., Ross, S.A., Westerfield, R.W. & Jordan, B.D. (2012).
Fundamentals of Corporate Finance (5th South African edition).
Boston: McGraw-Hill. Tables and graphs reprinted by
permission of McGraw-Hill LCC.
Harvey, C.R., Liu, Y. & Zhu, H. (2015)…. and the cross-section of
expected returns. Review of Financial Studies, 29(1), 5–68.
Hazelhurst, E. & Buthelezi, L. (2013). Bank shines light on pyramid
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schemes. IOL. Retrieved from https://www.iol.co.za/businessreport/economy/bank-shines-light-on-pyramid-schemes1583249 [2 March 2020].
IOL. (2009). R10bn scam exposed. Retrieved from
https://www.iol.co.za/business-report/economy/r10bn-scamexposed-704708 [2 March 2020].
Iress South Africa (Australia) Pty Ltd. Research Domain. Software
and database.
Laing, R. (2018). Taste Holdings asks shareholders for yet another
helping. BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/companies/retail-andconsumer/2018-12-19-taste-holdings-asks-shareholders-for-yetanother-helping/ [13 February 2020].
Mchunu, S. (2019). Taste Holdings is getting ready to dispose of
Maxi’s and The Fish & Chip Company. Business Report.
Retrieved from https://www.iol.co.za/businessreport/companies/taste-holdings-is-getting-ready-to-disposeof-maxis-and-the-fish-and-chip-company-37589440 [13 February
2020].
Rangongo, T. (2019). Taste Holdings upbeat about journey to
profitability. Fin24. Retrieved from
https://www.fin24.com/Finweek/Business-andeconomy/taste-holdings-upbeat-about-journey-to-profitability20190723 [13 February 2020].
Ross, S.A., Westerfield, R.W. & Jordan, B.D. (2019). Fundamentals
of corporate finance (12th edition). Boston: McGraw-Hill.
Republished with permission of McGraw Hill LLC; permission
conveyed through Copyright Clearance Center, Inc.
Ross, S.A. (1976). The arbitrage theory of capital asset pricing.
Journal of Economic Theory, 13(3), 341–360.
South African Reserve Bank (SARB). (2020a). Rates. Retrieved
from
https://www.resbank.co.za/Research/Rates/Pages/RatesHome.aspx [13 February 2020].
South African Reserve Bank (SARB). (2020b). Selected historical
rates. Retrieved from
https://www.resbank.co.za/Research/Rates/Pages/SelectedHistoricalExch
Rates.aspx [13 February 2020].
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South African Reserve Bank (SARB). (2020c). Unemployment rate,
SA. Retrieved from
http://wwwrs.resbank.co.za/webindicators/SDDSDetail.aspx?
DataItem=LABT079A [13 February 2020].
Spur Corporation. (2020a). Business profile. Retrieved from
https://www.spurcorporation.com/business-profile/groupprofile/ [13 February 2020].
Spur Corporation. (2020b). Results Centre. Retrieved from
https://www.spurcorporation.com/investors/results-centre/
[4 March 2020].
Taste Holdings. (2020a). Audited results. Retrieved from
http://www.tasteholdings.co.za/annualReport.php [4 March
2020].
Taste Holdings. (2020b). Luxury Goods Division. Retrieved from
https://www.tasteholdings.co.za/brand-fast-foodfranchises.php [13 February 2020].
Wikipedia. (2020). Ponzi scheme. Retrieved from
http://en.wikipedia.org/wiki/Ponzi_scheme [13 February
2020].
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11 Cost of capital
Kevin Thomas
Learning
outcomes
By the end of this chapter, you should be able to:
discuss the importance of the cost of capital for
an entity
explain what is meant by pooling of funds
identify, calculate and interpret the various costs
of capital, such as ordinary shares, preference
shares and debt
calculate and interpret the weighted average
cost of capital for an entity
advise on the use of the weighted average cost
of capital in investment decisions
explain and calculate the marginal cost of
capital.
Chapter
outline
11.1
11.2
11.3
11.4
11.5
Introduction
Pooling of funds
Cost of capital
Weighted average cost of capital
Using the weighted average cost of capital
in investment decisions
11.6 Marginal cost of capital
11.7 Conclusion
CASE STUDY
Discovery’s performance versus its cost of capital
Discovery Ltd is a South African integrated financial services
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entity. This company, which is listed on the Johannesburg
Stock Exchange (‘the JSE’), offers health insurance, life
assurance, investments, wellness, short-term insurance and
credit card products.
In 2019, Discovery launched the world’s first behavioural
bank. (A behavioural bank is one that provides clients with
incentives to spend less, save more and insure for adverse
events.) Discovery’s new bank is completely digital.
In the presentation of its 2018 results, Discovery explained
that its capital management philosophy is to earn a return on
capital of the risk-free rate or return + 10% (Discovery, 2018).
The entity was able to achieve an actual capital return of the
risk-free rate + 9.6%, thereby almost achieving its target.
You will recall from Chapter 10 that the risk-free rate
represents the return on a government security (such as the
R186 government bond, which has a current yield of just over
8%). Thus, Discovery has a target return on capital of around
18%, which the entity almost achieved in 2018.
You will learn in this chapter that if Discovery has a
required return of 18%, then its cost of capital is 18% because
the providers of capital (in other words, the lenders and
shareholders) require a return of 18%. However, entities
should aim to achieve a return in excess of their cost of capital.
Discovery probably has a cost of capital lower than 18%, as it is
aiming to exceed this return for its shareholders.
You will also learn that when Discovery launched its digital
behavioural bank, it was possible that its cost of capital would
change due to the fact that it had not previously operated a
bank, and the return required by the lenders and shareholders
might change (depending on the risk of the new bank).
Source: ITWeb Africa, 2018; Discovery, 2018, 2020.
11.1
Introduction
Cost of capital is the cost an entity incurs when raising debt and
equity capital to fund its operations. What exactly does this mean?
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To help explain the concept, we will break down the term ‘cost of
capital’ into its components, ‘cost’ and ‘capital’. Once we
understand each component, we should have a better
understanding of the meaning of the term.
In this context, ‘cost’ refers to the price that the entity has to pay
to gain access to capital, in the form of interest and dividends.
‘Capital’ refers to finance, or funds that an entity needs to finance
its assets and operations. Capital can also be thought of as the
various sources of finance that an entity raises and of which it
makes use. Thus, cost of capital means the price (cost) paid by an
entity to raise finance (capital). This cost does not refer to the
transaction costs incurred in raising finance, but rather the cost
incurred that the provider of capital requires as a return on the
finance provided.
All businesses, regardless of their size, need to raise finance to
operate. Entities raise finance at their inception (that is, when they
start operating) and later if they require additional finance for
expansion or acquisitions.
An entity’s capital falls into two broad categories: debt and
equity. Types of debt (known as debt instruments) include bonds,
debentures, loans and overdrafts (covered in Chapter 8). Equity
instruments include ordinary shares and preference shares (covered
in Chapter 9). As illustrated in Table 11.1, the returns required by
various providers of capital represent various capital costs.
Table 11.1 Comparison of cost of capital with required return
Required return
Return required by bondholders (see Chapter 8) and other
lenders
Cost of capital
Cost of debt capital
Return required by ordinary shareholders (covered in Chapters 9 Cost of ordinary share
and 10)
capital
As outlined in the case study above, Discovery’s cost of capital was
probably less than 18% for 2018, but this may have changed in line
with the fortunes of its digital behavioural bank because of the risk
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profile of the bank and the required return expected by the lenders
and shareholders. We can therefore say that the sum of the capital
providers’ required rates is approximately equal to the cost of
capital for the entity.
This discussion highlights the crucial importance to an entity of
knowing what its cost of capital is. Cost of capital is always
expressed as a percentage. Like Discovery, all entities should aim to
earn a return on invested capital that exceeds their cost of capital.
11.2
Pooling of funds
Capital projects are not necessarily financed using only debt or
equity. The pooling-of-funds principle states that the various
sources of finance available to an entity are grouped together (in
other words, pooled) and used in total to fund capital projects.
Entities often establish a long-term target capital structure.
(Capital structure is covered in more detail in Chapter 12.) This
essentially means that an entity decides in advance how much debt
and how much equity, as a percentage, it is aiming to include in its
capital structure. For example, if an entity has a target capital
structure of 75% equity and 25% debt, it means that for every R3 of
equity that it raises, it will aim to raise R1 of debt in the long term.
As this is a target capital structure, it does not mean that the capital
structure will always be 3:1, but that the capital structure will
average out at 3:1 in the long term.
If an entity raises equity today to finance a new investment, it
should not use the cost of the equity to appraise the new
investment, but instead its weighted average cost of capital
(WACC) (refer to Sections 11.4 and 11.5). The converse also applies:
where an entity raises debt to finance a new investment, it should
not use the cost of the new debt to appraise the investment, but
once again it should rather use the WACC. The WACC is preferred
in each of these circumstances, as it is not always possible to
identify which funds are used to finance which investments. Thus,
entities generally pool all their funds and use the funds in the pool
at the weighted average cost. Only in exceptional circumstances do
entities ring-fence certain funds for specific projects.
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Referring to the Discovery case study again, we can conclude
that Discovery makes use of the pooling-of-funds principle.
Discovery’s debt and equity will have different costs, whereas its
(weighted average) cost of capital in 2018 would have been below
18%. As mentioned, the introduction of the digital behavioural
bank is likely to change the (weighted average) cost of capital.
Discovery will use its (weighted average) cost of capital rather than
the cost of any new debt or equity to appraise new investment
projects.
Finance in action: Challenges in calculating the
cost of capital
Steven Chapman, B.Com (Hons) CA (SA) MBA (Cape
Town – Gold Medal), has been a corporate and
transaction advisor for the past twenty years, and was
previously the financial director of various entities.
Steven offers the following tips in respect of the
practical use of the WACC:
■ Beta is an essential part of the capital asset pricing
model (CAPM), but it is not always simple to
calculate. Professional equity risk services operated
by competent statisticians provide betas for JSElisted companies on a quarterly basis in return for an
annual subscription.
■ Beware of incorrect CAPM calculations arising where
financial managers assume a beta of 1,0 because
they do not understand the concept of beta, cannot
calculate beta and/or cannot access a professionally
calculated beta.
■ When calculating the total amount of interestbearing debt with reference to an entity’s statement
of financial position, look carefully at disclosed
amounts in non-current liabilities as well as in
current liabilities.
Commentary by Steven Chapman.
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11.3
Cost of capital
As mentioned in the introduction to this chapter, the cost of capital
is the cost to a business of raising finance. As the required rates of
return of the various providers of capital are approximately equal
to the cost of capital for the entity, all entities must aim to achieve a
return in excess of their cost of capital. Entities that do not achieve a
return in excess of their cost of capital will be unable to attract
future capital to grow and expand. The cost of capital can be
thought of as the ‘cut-off’ rate that separates worthwhile and less
worthwhile investment opportunities.
Most entities raise finance in the form of ordinary shares,
preference shares and various form of debt. Therefore, for our
purposes, cost of capital includes three components:
• cost of ordinary shareholders’ equity
• cost of preference shareholders’ equity
• cost of debt.
In the sections that follow, we investigate each of these capital
sources and consider how each one is calculated. Calculating the
cost of capital for each of these separate components is important
because it forms the first step of the calculation of the WACC (refer
to Section 11.4.1).
11.3.1
Cost of ordinary shareholders’ equity
Ordinary shareholders’ equity consists of ordinary shares raised
externally via a new share issue or rights issue, or raised internally
via retained earnings. It should be noted that although retained
earnings are included as an item under equity in the statement of
financial position, they do not have the same cost as ordinary
shareholders’ equity. Retained earnings are, however, not a free
source of finance because there is an opportunity cost associated
with this type of equity. (This is revisited in Chapter 12.)
Calculating the cost of ordinary shareholders’ equity is a
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challenging task because the return that the ordinary shareholders
require must include compensation (that is, reward) for the risk
incurred by investing in the ordinary shares of an entity. The
required return is likely to vary from year to year. The cost of
ordinary shareholders’ equity is often referred to as the cost of
ordinary shares or as the cost of equity.
There are generally two methods used to calculate the cost of
ordinary shares: the dividend discount model, or DDM (introduced
in Chapter 9), and the CAPM (presented in Chapter 10).
11.3.1.1 The dividend discount model
The size, frequency and stability of dividend payments depends on
the entity’s dividend policy. If the entity does not declare
dividends, then this method cannot be used to calculate the cost of
ordinary shareholders’ equity.
Ordinary shareholders often expect dividends to increase each
year. Some entities therefore adopt a policy whereby dividends are
increased at a constant rate each year. The constant dividend
growth model (also called the Gordon growth model) states that the
market price of a share is assumed to be the present value of the
future dividends (where a constant growing dividend is paid each
year in perpetuity).
This version of the DDM (which was covered as part of share
valuation in Chapter 9) is formulated as follows:
The model may be rearranged as follows to calculate the cost of
ordinary shares:
Where:
ke = cost of ordinary shareholders’ equity
D0 = current dividend
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P0 = ex-dividend market price of ordinary shares
g = expected constant annual growth rate in dividend
As D0(1 + g) is equivalent to the current dividend plus growth for
one year, we can also equate D0(1 + g) as = D1. Therefore, the
dividend growth model can be rewritten as follows:
Example 11.1 Calculating the cost of ordinary shareholders’ equity using
the Gordon (constant dividend) growth model
Growth Ltd’s ordinary shares are currently trading at R4 per share. A dividend
of 30 cents per share has just been paid and the directors estimate that
dividends will increase by 10% per year in perpetuity. Calculate the cost of
ordinary shares.
Note the following:
■ We do not need to adjust the share price for the dividend, as the dividend
has already been paid.
■ Ensure that you perform your calculation in either cents or in rands. If you
mix up cents and rands, you will get an incorrect answer.
Estimating the expected growth rate (g) in dividends is often the
most difficult aspect of applying the dividend growth model. The
growth rate can be calculated from historical dividend information,
assuming the historical average annual growth rate will continue in
perpetuity. Example 11.2 illustrates how the dividend growth rate
may be determined using a financial calculator.
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Example 11.2 Determining the dividend growth rate
Dividend Ltd has paid the dividends set out in the table that follows over the
last four years.
Calculate the average annual growth rate in dividends.
The average annual growth rate can be calculated in a number of ways, but
the easiest method is to use the time value of money principles on a financial
calculator.
PV = the dividend in the first (base) year (PV is always input as a negative)
FV = the dividend in the last year
N = the number of periods of growth in dividends (in this case, 4 years – 1
year)
Therefore, the average annual growth rate (g) is 14,47%.
The main advantage of using the DDM to estimate the cost of
ordinary shares is the model’s simplicity. The model can, however,
only be used by entities that currently pay dividends. It ignores risk
and relies on the assumption that dividends grow at a constant rate
annually. This is not always the case, as illustrated in Example 11.2,
where we calculated an average annual growth rate because the
entity did not pay a dividend with constant annual growth. In light
of these shortcomings, managers and shareholders often use the
CAPM to estimate an entity’s cost of equity.
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11.3.1.2 Capital ass et pricing model
The CAPM incorporates risk into the estimation of the cost of
ordinary shares. You will recall from Chapter 10 that the required
rate of return on a share can be calculated as follows when using
the CAPM:
Where:
ke = cost of ordinary shareholders’ equity (also represents the rate of
return required by ordinary shareholders)
rf = risk-free return on a government security
β = beta coefficient of the entity
rM = return on the market portfolio
rM − rf = market risk premium (the difference between rM and rf )
Example 11.3 Calculating the cost of ordinary shareholders’ equity using
CAPM
Capital Ltd has a beta of 1,3. The expected return on the market portfolio is
15% and the current risk-free rate of return is 8%. Calculate the cost of the
ordinary shareholders’ equity.
If the information provided in the question only includes the market risk
premium (and not the expected return on the market portfolio), then we can
calculate the cost of equity (ke) using the market risk premium in the example
above as (15% – 8%) = 7%.
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Components of the capital asset pricing model
You may recall from Chapter 10 that the risk-free rate of return (rf )
in the CAPM is the return on risk-free securities. As there is no such
thing as a risk-free security, we make use of the next closest security
to a risk-free security: government bonds.
The return on the market portfolio (rM) is the return that is
expected on a portfolio of securities that are generally invested in
equities. Equities, bearing a higher risk, should also generate a
return in excess of government bonds. This excess is known as the
market risk premium (rM – rf ).
The beta coefficient is a measure of market risk (in other words,
volatility).
If, for example, the JSE/FTSE All-Share Index increases or
decreases by 10% and the market price of a particular share
included in the All-Share Index also increases or decreases by 10%,
then that share is said to have a β of 1,0 (in other words,
).
Summarised in a slightly different way from Chapter 10, the beta of
an entity’s share can, therefore, be estimated using the following
formula:
Example 11.4 Calculating the beta of a share
Assume Beta Ltd is one of the Top 40 entities listed on the JSE. The share
price of Beta Ltd has decreased over the past 12 months by 18%. The
JSE/FTSE Top 40 Index has decreased by 15% over the past 12 months. Using
the information provided above, calculate the beta of Beta Ltd.
Although the CAPM incorporates risk, this model requires the
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return on the risk-free rate of return, the return on the market
portfolio and the beta coefficient of the entity in question to be
readily accessible. This is not always the case, especially for entities
whose shares are not listed on a stock exchange. The CAPM is a
single-factor, single-period model, meaning that the cost of capital
calculated to use as a discount rate may not be appropriate for the
whole life of the project. In principle, both the models should result
in similar estimates for an entity’s cost of ordinary shares. In
practice, however, this may not always be the case.
QUICK QUIZ
1. Briefly discuss the two models that can be
used to calculate the cost of ordinary shares.
2. Tabulate the advantages and disadvantages of
each method of calculating the cost of
ordinary shares.
11.3.2
Cost of preference shareholders’ equity
The cost of preference shares is related to the dividend that is paid
on the preference share. Preference dividends are a distribution of
after-tax profits, and preference dividends are therefore not
deductible for tax purposes, irrespective of whether or not the
preference shares are redeemable. However, the calculation of the
cost of preference shares depends on whether the preference shares
are redeemable or not. (For an explanation of what redeemable
preference shares are, refer to Chapter 12.)
If the preference shares are non-redeemable, the cost of
preference shares can be calculated using perpetuity principles. If
the preference shares are redeemable, then the cost of preference
shares can be calculated using annuity principles.
11.3.2.1 Non-redeemable preference shares
The cost of non-redeemable preference shares can be calculated
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using perpetuity principles as follows:
Where:
kp = cost of preference shareholders’ equity (also represents the rate
of return required by preference shareholders)
D = fixed annual dividend (in perpetuity)
P0 = ex-dividend market price of preference shares
Example 11.5 Calculating the cost of non-redeemable preference shares
Non-Redeemable Ltd has 9% non-redeemable preference shares in issue. The
preference shares pay an annual dividend of 9 cents and are currently trading
at R1,08. Calculate the cost of preference shares.
11.3.2.2 Redeemable preference shares
The cost of redeemable preference shares can be calculated using
annuity principles on a financial calculator where:
PV = the current market price of the preference shares (PV is always
input as a negative)
FV = the value of the preference shares at redemption adjusted for
any discount or premium on redemption
n = the number of periods until the preference shares are redeemed
PMT = the fixed gross (before tax) dividend paid on the issued
value of the preference shares
i = the cost of preference shares to be calculated
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Example 11.6 Calculating the cost of redeemable preference shares
Redeemable Ltd has 9% redeemable preference shares in issue. The
preference shares pay an annual dividend of 9 cents and are currently trading
at R1,08. The preference shares are redeemable at par in five years’ time.
Calculate the cost of preference shares.
Using a financial calculator
QUICK QUIZ
1. Distinguish between redeemable and nonredeemable preference shares and explain why
the cost is calculated differently for each.
2. Explain why the dividend paid on preference
shares is not deductible for tax purposes.
11.3.3
Cost of debt
The cost of debt is the return that the entity’s lenders demand on
new debt. In other words, it is the interest rate that an entity must
pay on any new debt issued. The cost of debt can be obtained by
observing the current interest rates in the market. The principles of
bond valuation, explained in Chapter 8, will be applied in this
chapter to calculate the cost of debt.
As with preference shares, if the debt is non-redeemable, then
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the cost of debt can be calculated using perpetuity principles. If the
debt is redeemable, then the cost of debt can be calculated using
annuity principles.
The main difference between calculating the cost of preference
shares and the cost of debt is that the interest on debt is taxdeductible, whereas the dividend on preference shares is not taxdeductible. Non-redeemable debt is not a common occurrence in
South Africa, but may be encountered in other countries.
11.3.3.1 Non-redeemable debt
The cost of non-redeemable debt can be calculated using perpetuity
principles as follows:
Where:
kd = after-tax cost of debt
i = fixed annual interest (in perpetuity)
t = rate of company tax (expressed as a percentage)
P0 = ex-interest market price of debt
Example 11.7 Calculating the cost of non-redeemable debt
Non-Redeemable Ltd has 8% non-redeemable debentures in issue. The nonredeemable debentures have a nominal value of R100 and are currently
trading at R90. The corporate tax rate is currently 28%. Calculate the cost of
the non-redeemable debentures.
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11.3.3.2 Redeemable debt
The cost of redeemable debt can be calculated using annuity
principles on a financial calculator, where:
PV = the current market price of the debt
FV= the value of the debt at redemption, adjusted for any discount
or premium on redemption
n = the number of periods until the debt is redeemed
PMT = the fixed net interest paid on the nominal value of the debt
i = the cost of debt to be calculated
Example 11.8 Calculating the cost of redeemable debt
Redeemable Ltd has 8% redeemable debentures in issue. The debentures
have a nominal value of R100 and are currently trading at R90. The
debentures are redeemable at R105 in five years’ time. The corporate tax rate
is currently 28%. Calculate the cost of these debentures.
Figure 11.1 is a graphic representation of the different methods for
calculating the three cost-of-capital components: ordinary shares,
preference shares and debt.
Figure 11.1 Calculating the cost of capital components
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QUICK QUIZ
1. Explain what irredeemable or perpetual debt
is.
2. Explain why interest paid on debt is
deductible for tax purposes.
FOCUS ON ETHICS: Cost of capital
As outlined in earlier chapters, Steinhoff International Holdings NV’s
share price collapsed in December 2017 amid revelations of
accounting irregularities. The Steinhoff saga is possibly the biggest
corporate fraud in South African business history and the share price
crash wiped more than R200 billion off the JSE.
An entity’s reputation for ethical behaviour is reflected in the value
of the entity’s securities. One may argue that if an entity’s competitors
adopt low ethical standards, it would be unprofitable for the entity to
adopt high ethical standards. However, this presumption is plainly
incorrect.
Potential customers reduce the price they are willing to pay if
there is significant uncertainty about the quality of the product to be
supplied. By credibly promising to act in an ethical manner, an entity
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can differentiate its product(s) and increase demand. Similarly,
shareholders make their cost-of-capital calculations in the light of an
entity’s ongoing reputation for fair dealing. High-quality entities should
enjoy a relatively lower cost of capital as one of the many benefits tied
to their reputation for fair dealing and sound ESG management. Lowquality entities can generally expect a relatively higher cost of capital
and higher supplier costs as typical disadvantages tied to their poor
reputation.
In essence, investors require a higher return (which means a
higher cost of capital) from entities that they perceive as having a
more uncertain future or an untrustworthy reputation. Steinhoff’s debt
was downgraded amid the accounting irregularities scandal, which
resulted in an increase in its cost of debt. In addition, the share price
collapse will have resulted in an increase in the return required by
shareholders due to the significant increase in risk. This downgrade in
debt and increase in the required return by shareholders would have
increased Steinhoff’s cost of capital.
Sources: CNBC Africa, 2018; Rose, 2018.
QUESTION
How does an entity’s reputational risk relate to its cost of
capital?
11.4
Weighted average cost of capital
The weighted average cost of capital (WACC) is the overall return
that an entity must generate on its existing assets to maintain the
value of its ordinary shares, preference shares and debt. The WACC
needs to be determined because each cost-of-capital component has
a different cost. The different costs are due to the different level of
risk that different capital providers attach to the entity.
Debt is generally the cheapest source of finance and so has the
lowest cost of capital. This is because the interest on debt is taxdeductible, security is often provided to the lender, and the debt
ranks ahead of the ordinary shares and preference shares on
liquidation. Preference share capital is generally the second******ebook converter DEMO Watermarks*******
cheapest source of finance, as preference shareholders rank ahead
of ordinary shareholders on liquidation. Ordinary shares are
normally the most expensive source of finance because ordinary
shareholders are the ultimate owners of the entity and bear the
most risk. This high risk that is undertaken is compensated by the
ordinary shareholders’ need for a higher rate of return.
The WACC can be ascertained by calculating the cost of each
source of finance weighted by the proportion of finance used. The
weighting can be determined by making use of either book values
or market values. Market values are preferred because they provide
a more accurate measure of an entity’s value.
We can refer back to the opening case study to see whether
Discovery would use book-value weightings or market-value
weightings. Discovery’s cost of equity is most probably calculated
using market values, as the ordinary shares are listed on the JSE,
whereas the cost of debt financing depends on the sources of debt
finance that it has raised. If Discovery does not have any listed debt
finance (such as bonds), but only bank loans, then it would
probably use the book values of debt to calculate the WACC. An
entity can use a combination of book values and market values if it
does not have market values for all its sources of finance.
11.4.1
Calculating weighted average cost of capital
A three-step process should be followed when calculating the
WACC:
• Step 1: Calculate the after-tax component cost of each source of
finance that an entity has in its capital structure. The categories
may include ordinary shares, preference shares and debt. The
component cost of each category of finance referred to in Step 1
has already been covered in Section 11.3 of this chapter.
• Step 2: In order to calculate the WACC, the relevant weighting
of each component of the cost of capital needs to be determined.
Market or book values may be used to determine the relevant
weighting of each component. However, as the WACC is a
marginal concept, it would be more appropriate to use the
market values than the book values. The weighting of each
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component cost must be between 0% and 100%, with the total
weighting not exceeding 100%.
• Market values are a more appropriate measure to use because
they give a better reflection of economic reality. Book values are
obtained from the statement of financial position (that is, the
balance sheet) and may not reflect economic reality. Therefore,
to calculate a WACC that is more representative of economic
reality, market-value weightings are considered more
appropriate. We will therefore focus on market values, as this is
the preferred weighting.
• Step 3: The after-tax cost of each component must be multiplied
by the weighting of each component to determine the
contribution of each component (in other words, the result from
Step 1 is multiplied by the result from Step 2 for each
component cost). The contribution of each component should
then be added together to calculate the overall WACC.
These three steps are covered in more detail in the sections that
follow.
Remember that the result of the WACC must lie between the
lowest component cost of capital and the highest component cost of
capital because a weighted average is being calculated.
The following formula can be used to calculate the WACC if an
entity has ordinary shares, preference shares and debt in its capital
structure:
Where:
ke = cost of ordinary shares
kp = cost of preference shares
kd = before-tax cost of debt
Ve = value of ordinary shares (market value) in the entity’s capital
structure
Vp = value of preference shares (market value) in the entity’s capital
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structure
Vd = value of debt (market values) in the entity’s capital structure
t = corporate tax rate
Alternatively:
Where:
we = weighted average value of ordinary shares (market value)
wp = weighted average value of preference shares (market value)
wd = weighted average value of debt (market value)
The cost of debt used in Formulae 11.7 and 11.8 must always be the
after-tax cost of debt, as the interest on debt is deductible for tax
purposes. Thus, if you use the before-tax cost of debt, you must
adjust it for the tax rate.
The WACC can also be calculated by presenting either of the
formulae in tabular format. Table 11.2 illustrates the way in which
the formula is adapted to the table layout.
Table 11.2 WACC formula presented as a table
A: If an entity has more than one debt instrument (for example, debentures and a bank loan), each debt
instrument should be accounted for separately regardless of whether the formula or the tabular format is
used. This is done because each debt instrument is likely to have a different cost.
Example 11.9 Calculating WACC
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WACC Ltd has provided the information presented in the table that follows at
31 December 2019.
The corporate tax rate is 28%.
Calculate the WACC using market values.
The before- and after-tax cost of ordinary shares and preference shares are
the same because dividends are not tax-deductible. The after-tax cost of debt
must be determined first, as interest is tax-deductible.
kd = kd(1 – t)
kd = 9% (1 – 0,28)
kd = 6,48%
Alternatively, the after-tax cost of debt can be determined while calculating the
WACC, as demonstrated below.
1. Calculation of market values using Formula 11.7:
2. Calculation of market values using the table:
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Reasonability check: Does the WACC lie between the lowest after-tax cost
of capital (that is, 6,48% debentures) and the highest after-tax cost of
capital (that is, 12% ordinary shares)? The answer is yes.
11.4.2
Assumptions surrounding the weighted average cost
of capital
The WACC assumes that when an entity raises finance, it is added
into a pool of funds. (Pooling of funds was explained in Section
11.2.) The WACC can be used as the discount rate when calculating
the net present value (NPV) for new capital investments, provided
certain assumptions are met. These assumptions are as follows:
• The WACC assumes that the capital structure of an entity is
reasonably constant. If this is not the case and the weightings
used in the WACC calculation change significantly, it will result
in a large change in the WACC. To ensure that the capital
structure remains reasonably constant, the appropriate capital
structure to use is the target capital structure.
• New investments do not have significantly different risk profiles
from the entity’s existing investments.
• All cash flows are constant perpetuities.
QUICK QUIZ
1. List the three steps used to calculate the
WACC.
2. Explain the difference between market-value
weightings and book-value weightings.
11.5
Using the weighted average cost of capital in
investment decisions
As mentioned earlier, the WACC is the entity’s cost of raising
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different sources of finance that may be used as the cut-off rate to
determine which potential projects are worthwhile for capital
investment purposes and which are not. Businesses should only
make investments when the expected return is greater than the
WACC because this will increase the market value of the ordinary
shares in the long term (by ensuring that the required return
exceeds the cost of capital). Therefore, if a business is looking to
make a new investment, it should only do so if the internal rate of
return (IRR) on this new capital investment exceeds the business’s
WACC. In situations where multiple investments are considered,
only investment(s) with positive differences between the IRR and
the WACC should be accepted, starting with the investment with
the highest positive difference. This would be the case if the
multiple investments (projects) were independent (see Section
5.3.3), as it is possible for an entity to accept all independent
projects that are financially feasible.
However, if the multiple investments are mutually exclusive
(see Sections 5.3.4 and 5.9.3), where only one investment can be
accepted, we should rather accept the larger project if the IRR of the
incremental cash flows is greater than the entity’s cost of capital.
Not accepting projects with IRRs in excess of the WACC will
weaken the long-term prospects of an entity. The WACC must be
used as the benchmark (and not the cost of the specific source of
finance to be used) when deciding whether or not to accept a
project.
These are two reasons for using the WACC when appraising
investments:
• New capital investments that are being considered must be
financed by new sources of finance or retained earnings, and the
WACC incorporates the cost of these new sources of finance.
• The WACC reflects an entity’s long-term future capital structure
as well as its cost of capital. Therefore, the WACC is an
appropriate discount rate – or cut-off (hurdle) rate – to use in the
evaluation of new investments.
There is also one reason for not using the WACC when appraising
investments. New long-term investments may have risk
characteristics that are different from a business’s current
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investments. Therefore, the inherent business risk related to the
new investment may be higher or lower than the risk to which the
entity is currently exposed. This situation may apply to Discovery
because the digital behavioural bank that it launched recently
probably has a different risk profile from Discovery Health and
Discovery Life.
In the absence of any information to suggest the use of a more
appropriate discount rate or cut-off rate, it is recommended that the
WACC be used as the appropriate discount rate for evaluating
investment decisions.
Example 11.10 Using the WACC to appraise investments
Investment Ltd is currently considering in which (if any) of the projects set out
in the table that follows it should invest.
Assume that Investment Ltd has a WACC of 10,01%, as calculated in Example
11.9 (where we used market-value weightings). Advise the directors of
Investment Ltd in which projects (if any) it should invest.
An entity should only invest in projects where the expected return exceeds
the WACC. Project B is the only project that exceeds the WACC. Project B
should therefore be selected. The expected returns from Projects A and C are
less than the WACC, and should therefore be rejected for investment purposes.
Project D has a return equal to the WACC, so it may be selected, but it will only
provide a return equal to the WACC. If, for some reason, Project D does not
generate a return of 10,01% because of overoptimistic forecasts, then the
required return will be less than the WACC. So to err on the side of caution,
Project D should also be rejected.
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QUICK QUIZ
1. Discuss the reason(s) for using the WACC for
appraising investments.
2. Discuss the reason(s) for not using the WACC
for appraising investments.
11.6
Marginal cost of capital
One of the assumptions of the WACC, discussed earlier, is that the
capital structure of an entity remains reasonably constant. If an
entity is considering a large investment project that would
significantly affect its current capital structure, then the
assumptions of the WACC no longer apply and it would not
necessarily be the correct discount rate to use.
Instead, the most appropriate cost of capital to use in this case
would probably be the marginal cost of capital, which is defined as
the cost of raising the next rand of capital, and this will take place at
the going rate in the market for debt and equity. The entity’s cost of
equity, although theoretically a forward-looking value, is, for
practical purposes, based on historical volatility. In practice, the
actual capital structures of most entities should vary around the
target capital structure that has been established by management.
QUICK QUIZ
Differentiate between the cost of capital and
the marginal cost of capital.
11.7
Conclusion
Chapter 11 has dealt with the cost of capital. You learnt the
following:
• The cost of capital is the rate of return that an entity’s providers
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•
•
•
•
•
•
•
•
•
•
•
•
of capital require on the funds they have provided.
Cost of capital relating to an investment depends on the risk of
that investment.
Cost of capital depends primarily on the use of funds, and not
the source of those funds.
When a suitable project is identified, the investment in the
project is financed from a pool of funds rather than by a specific
form of finance.
Cost of capital consists of:
– ordinary shares
– preference shares
– debt.
The cost of ordinary shares can be calculated by making use of
either the dividend discount model (DDM) or the capital asset
pricing model (CAPM).
The DDM used to calculate the cost of ordinary shares depends
on whether a constant dividend is paid, necessitating the use of
the dividend valuation model, or whether a constant growing
dividend is paid, necessitating the use of the dividend growth
model.
If dividends paid are not constant, then a constant average
annual growth rate can be calculated for use in the dividend
growth model.
The CAPM method of estimating the cost of ordinary shares
specifically incorporates risk into the calculation.
The beta coefficient is a measure of the change in the price of an
individual security compared with the change in the return on
the overall market or a market index.
The dividend paid on preference shares is not tax-deductible,
whereas the interest paid on debt is tax-deductible.
The calculation of the cost of preference shares and debt
depends on whether these sources of finance are redeemable or
non-redeemable.
The weighted average cost of capital (WACC) is the overall cost
of capital of an entity based on the cost of each source of finance
weighted on a suitable proportional basis, such as market
values.
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• Determining the WACC is critically important because it is often
used as the discount rate when evaluating suitable investment
opportunities. Investments that result in a positive net present
value using the WACC as the discount rate should be accepted,
as these investments should generate long-term wealth for the
ordinary shareholders.
• The marginal cost of capital is the incremental cost of the capital
structure before and after the introduction of new capital.
As illustrated in the ‘Finance in action’ feature earlier in the chapter,
calculating the cost of capital can often pose some challenges. The
case study that follows provides guidance on how the cost of
capital is calculated in the real world.
CASE STUDY
Cost of capital in practice
PwC Corporate Finance performs a biennial valuation
methodology survey to find out from industry valuation
practitioners what methods they use to perform valuations as
well as how they calculate an entity’s cost of capital. The
2016/17 survey revealed the following interesting results from
respondents relating to cost of capital:
• Valuation practitioners ordinarily estimate the cost of
equity by using CAPM.
• 33% use the R186 Government bond (maturing on 11
December 2026) as a benchmark for the risk-free rate in the
CAPM calculation.
• The JSE All-Share Index (ALSI) is the most popular market
index to use as proxy for a beta calculation.
• The market risk premium used (rM – rf ) ranges from 2% to
20%, with an average of between 6% and 8% used in South
Africa.
Source: PwC South Africa, 2017.
MULTIPLE-CHOICE QUESTIONS
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BASIC
1.
The required rate of return for the providers of capital is also known as the
__________.
A. cost of equity
B. cost of debt
C. cost of preference shares
D. cost of capital
2.
The pooling-of-funds principle states that …
A. projects are financed specifically out of equity or debt, depending on the
project’s return.
B. finance raised for projects is grouped together and projects are not
necessarily financed specifically out of equity or debt.
C. projects are financed out of either equity or debt.
D. projects are financed out of ordinary shareholders’ equity, preference
shareholders’ equity or debt.
3.
Three Ltd has ordinary shares of R2 in issue, which are currently trading at
R40 per share. Three Ltd is expected to pay a dividend of R5 per share next
year. What is the cost of the ordinary shares?
A. 40,00%
B. 5,00%
C. 12,50%
D. 250,00%
4.
Which of the following statements relating to the cost of debt is incorrect?
A. Interest paid is tax-deductible when calculating the cost of debt.
B. The cost of debt is generally lower than the cost of ordinary shares.
C. The before-tax cost of debt is equal to the YTM on any outstanding
debentures.
D. It is generally easier to calculate the cost of ordinary shares than the cost
of debt.
5.
The current market price of Five Ltd’s shares is R72 per share. Five Ltd is
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expected to pay a dividend of R4 per share in one year’s time. Five Ltd has
adopted a constant dividend payout ratio, whereby the dividend and the
earnings are expected to grow at a rate of 8% per year indefinitely. What is the
cost of the ordinary shares?
A. 13,56%
B. 14,00%
C. 5,55%
D. 6,00%
6.
Six Ltd’s redeemable debentures are currently trading at 105% of their nominal
value. The debentures mature in ten years and pay an annual coupon rate of
8% per year. What is the cost of debt? (Ignore tax.)
A. 9,09%
B. 8,34%
C. 7,28%
D. 8,00%
7.
Which of the following statements is incorrect? Cost of capital is …
A. the same as the required rate of return.
B. an appropriate discount rate to use for investing decisions.
C. the return required on a project to compensate investors for the use of
their funds.
D. equal to the cost of debt or ordinary shares, depending on which type of
financing an entity uses the most.
8.
Eight Ltd has non-redeemable preference shares of R100 in issue that pay an
annual dividend of R8 per share. The preference shares are currently trading at
R96 per share. Assume a tax rate of 28%. What is the cost of the preference
shares?
A. 8,33%
B. 6,00%
C. 8,00%
D. 5,76%
9.
The R186 government bond is currently yielding a return of 7,5% and the
market risk premium is currently 5%. If the beta of Nine Ltd is 1,4, calculate
the cost of the ordinary shares.
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A.
B.
C.
D.
4,00%
14,5%
15,5%
The cost of ordinary shares cannot be calculated in this instance.
10. Which of the following is never required to calculate the cost of ordinary
shares?
A. Risk-free rate of return
B. Return on the market portfolio
C. Dividend growth rate
D. Company tax rate
11. Which of the following statements is an advantage of the dividend discount
model when used to calculate the cost of ordinary shares?
A. The fact that risk is inherently accounted for
B. Its ease of use and simplicity
C. The appropriateness and ease of use if dividends are not declared
D. The fact that non-constant growth can be incorporated
12. Twelve Ltd has paid the dividends listed in the table that follows over the last
three years.
Year
Dividend
1
R370 000
2
R520 000
3
R610 000
Calculate the average annual growth rate in dividends over the last three years.
A. 64,86%
B. 40,54%
C. 18,13%
D. 28,40%
13. When calculating the cost of ordinary shares using the CAPM, the level of risk
and volatility is measured by __________.
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A.
B.
C.
D.
the risk-free rate of return
the market risk premium
beta
alpha
14. Which of the following weightings is generally the most appropriate to use
when calculating the WACC?
A. Replacement values
B. Residual values
C. Carrying values
D. Market values
INTERMEDIATE
15. Suppose that Fifteen Ltd’s cost of ordinary shares is 15%, the cost of
preference shares is 12% and the before-tax cost of debt is 9%. If the target
capital structure is 50% ordinary shares, 20% preference shares and 30%
debt, and the tax rate is currently 28%, what is Fifteen Ltd’s WACC?
A. 11,84%
B. 12,00%
C. 12,60%
D. 9,07%
16. Sixteen Ltd has a beta of 1,25 and a cost of equity of 12%. If the market risk
premium is 4%, calculate the risk-free rate of return.
A. 5%
B. 6%
C. 7%
D. 8%
17. The appropriate cost of capital for a project depends on the …
A. type of security issued to finance the project.
B. type of asset used in the project (that is, whether they are current or noncurrent assets).
C. total risk of the entity’s equity.
D. risk associated with the project.
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ADVANCED
18. Eighteen Ltd has a beta of 0,8 and a cost of equity of 14%. If the return on the
market portfolio is 15%, calculate the risk-free rate of return.
A. 10%
B. 8%
C. 6%
D. 4%
19. Suppose Nineteen Ltd has a cost of equity of 18% and a cost of debt of 11%. If
the target gearing ratio (where gearing is calculated as Debt ÷ [Debt + Equity])
is 40% and the tax rate is 28%, calculate the WACC.
A. 15,20%
B. 13,97%
C. 15,11%
D. 15,99%
20. Which of the following statements relating to the WACC is incorrect?
A. The cost of equity can be calculated using either the earnings approach
or the CAPM approach.
B. The cost of debt is the return that lenders require on the entity’s issued
debt instruments.
C. The cost of equity is the return that equity investors require on their
investment in an entity.
D. If an entity has preference shares in its capital structure, the cost of the
preference shares should be included in the cost of capital.
LONGER QUESTIONS
BASIC
1.
2.
Explain the principle of pooling of funds.
ABC Ltd has a beta of 1,2. The rate of return on risk-free assets is currently
9% and the market risk premium is 7%. Calculate the cost of ordinary shares
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for ABC Ltd.
3.
DEF Ltd has ordinary shares in issue that are currently trading at R30 per
share. The next dividend is expected to be R2 per share. If DEF Ltd adopts a
dividend growth rate of 5%, which is expected to remain constant indefinitely,
calculate the cost of equity.
4.
GHI Ltd has 11% R2 non-redeemable preference shares in issue. If the
preference shares are currently trading at R1,80, calculate the cost of the
preference shares.
INTERMEDIATE
5.
JKL Ltd plans to issue 200 000 9% non-redeemable debentures of R100 each.
The debentures are expected to trade at R110 each immediately after being
issued. It is expected that flotation costs will amount to R5 per debenture and
the tax rate is currently 28%. Calculate the cost of the debentures.
6.
MNO Ltd has a cost of ordinary shares of 18% and a before-tax cost of debt of
8%. If the target debt-to-equity ratio is 0,50 and the current tax rate is 28%,
calculate the WACC.
7.
Discuss which discount rate is most appropriate when evaluating an investment
opportunity.
ADVANCED
8.
You are provided with the extract that follows from the statement of financial
position of Capital Ltd at 31 December 2019.
R million
Ordinary share capital (R2 shares)
1,5
12% non-redeemable preference share capital (R1 shares)
2,5
Retained earnings
4,5
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10% redeemable debentures
3,5
Total
12
Additional information:
■ The ordinary shares are currently trading at R12 per share, the
preference shares at R1,10 each and the debentures at R90 per R100
nominal value.
■ An ordinary dividend of 50 cents per share has recently been paid and
dividends are forecast to grow at 10% p.a. for the foreseeable future.
■ The debentures are redeemable in six years’ time at the nominal value of
R100.
■ Company tax is currently 28%.
Calculate the WACC of Capital Ltd using market-value weightings.
9.
Glassbot Ltd, a newly established glass bottling entity, is about to list on the
JSE and requires assistance in establishing its weighted average cost of
capital. The managing director, who does not have a financial background, has
approached you and asked for assistance, as she has heard that it is
imperative for entities to calculate their cost of capital. The entity plans to issue
20 000 8% non-redeemable debentures of R100 each. The initial market price
of the debentures is expected to be the same as the issue price. A company
tax rate of 28% is applicable. Glassbot will also issue 8 000 000 ordinary
shares of R1 each. The risk-free rate of return is currently 6%, while the
expected return on the market amounts to 13%. An entity of Glassbot’s nature
is estimated to have a beta (β) of approximately 1,1.
a) Calculate the component cost of the debentures of Glassbot.
b) Calculate the component cost of the ordinary shares of Glassbot.
c) Calculate the WACC of Glassbot, assuming the debentures and ordinary
shares are the only sources of finance.
Source: Adapted from University of Johannesburg, 2017.
10. You have recently been appointed as the financial manager of Techknow Ltd,
an entity that supplies information technology hardware and software to large
corporate customers. One of the project managers has requested you to
perform a cost of capital calculation. The previous financial manager did not
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complete the cost of capital calculation before he left and only provided the
information presented below.
Notes
1. Assume that the return on the R186 Government bond is 7%, that the
market risk premium is 5% and that the beta ( β ) of Techknow Ltd is
1,3.
2. The 13% preference shares are non-redeemable. There are 500 000
preference shares of R5 each in issue and they are currently trading at
R5,50 per share.
3. The 10% debentures have a nominal value of R100 each and the
debentures are currently trading at R95 each. The debentures are
redeemable in five years’ time at nominal value. Interest on the
debentures is paid semi-annually.
4. The required return on similar long-term bank loans is currently 9%.
Additional information:
• You may assume the calculations performed by the previous financial
manager are correct.
• A company tax rate of 28% is applicable.
a)
b)
Complete the WACC calculation by solving the missing figures
(represented as A – I) in the previous financial manager’s table.
Advise the directors of Techknow Ltd whether they should invest in two
projects (I and T) with expected returns of 13,5% and 10,5%,
respectively. Provide reasons for your answer.
Source: Adapted from University of Johannesburg, 2018.
KEY CONCEPTS
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Beta coefficient (β): A measure of a security’s volatility, which
indicates the degree to which a security’s price moves with the
market.
Cost of capital: The cost to a business of raising finance. Also known
as the required rate of return.
Marginal cost of capital: The cost of raising the next rand of capital.
Market risk premium (rM – rf): The excess return on the market portfolio
(rM ) above the return on risk-free securities (rf ).
Pooling of funds: A principle that states that the various sources of
finance available to an entity are grouped together (in other
words, pooled) and used in total to fund various projects.
Return on the market portfolio (rM): The return that is expected on a
portfolio of securities that are generally invested in equities.
Risk-free rate of return (rf ): The return on risk-free securities (in other
words, government bonds).
Weighted average cost of capital (WACC): The overall return that an
entity must generate on its existing assets to maintain the value
of its ordinary shares, preference shares and debt.
SLEUTELKONSEPTE
Beta koëffisiënt (β): ’n Maatstaf van volatiliteit, wat aandui tot watter
mate ‘n aandeelprys beweeg relatief tot die mark.
Geweegde gemiddelde koste van kapitaal (WACC): Die totale opbrengs wat
’n onderneming moet genereer op sy bestaande bates ten einde
die waarde van die gewone aandele, voorkeuraandele en
vreemde kapitaal te handhaaf.
Koste van kapitaal: Die koste vir ’n onderneming om finansiering te
verkry.
Marginale koste van kapitaal: Die koste verbonde aan die volgende
rand van kapitaal wat verkry word.
Markrisiko premie (rM – rf ): Die surplus opbrengs op die
markportefeulje (rM ) bo die opbrengs op risiko-vrye sekuriteite
(rf).
Opbrengs op die markportefeulje (rM): Die verwagte opbrengs op ’n
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portefeulje van sekuriteite wat hoofsaaklik in aandele belê is.
Poel van fondse: ’n Beginsel wat aandui dat die verskillende bronne
van finansiering wat beskikbaar is vir ’n onderneming
saamgevoeg word en in totaal gebruik word om verskeie
projekte te finansier.
Risiko-vrye opbrengskoers (rf): Die opbrengs op risiko-vrye sekuriteite
(bv. Staats-effekte).
SUMMARY OF FORMULAE USED IN THIS CHAPTER
WEB RESOURCES
https://www.cnbcafrica.com
https://www.dailymaverick.co.za
http://www.discovery.co.za
REFERENCES
CNBC Africa. (2018). Inside the Steinhoff saga, one of the biggest cases
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of corporate fraud in South African business history. Retrieved from
https://www.cnbcafrica.com/insights/steinhoff/2018/06/28/steinhoffrise-fall/ [13 February 2020].
Discovery. (2018). Results and cash dividend declaration for the year
ended 30 June 2018. Retrieved from
https://www.discovery.co.za/assets/discoverycoza/corporate/investorrelations/annual_results_presentation_fy18.pdf [15 February
2020].
Discovery. (2020). Welcome to behavioural banking. Retrieved from
https://www.discovery.co.za/bank/behavioural-bank [15
February 2020].
ITWeb Africa. (2018). Discovery launches digital bank. Retrieved from
https://www.itweb.co.za/content/WnpNgM2ALk87VrGd [15
February 2020].
PwC South Africa. (2017). Valuation methodology survey 2016/2017:
Closing the value gap. Retrieved from
https://www.pwc.co.za/en/assets/pdf/closing-the-value-gap2016-2017.pdf [15 February 2020]. Reprinted by permission of
PwC.
Rose, R. (2018). Steinheist: The inside story behind the Steinhoff
scandal. Daily Maverick. Retrieved from
https://www.dailymaverick.co.za/article/2018-11-14steinheist-the-inside-story-behind-the-steinhoff-scandal/ [13
February 2020].
University of Johannesburg. (2017). Financial Mathematics
Examination. (Question 5, May 2017).
University of Johannesburg. (2018). Financial Mathematics
Examination. (Question 5, May 2018).
BIBLIOGRAPHY
BPP Learning Media. (2018). CIMA Study Text, Strategic Paper F3
Financial Strategy. London: BPP Learning Media Ltd
Correia, C., Flynn, D., Uliana, E., Wormald, M. & Dillon, J. (2017).
Financial Management (8th edition). Cape Town: Juta.
Firer, C., Ross, S.A., Westerfield, R.W. & Jordan, B.D. (2012).
Fundamentals of Corporate Finance (5th South African edition).
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Berkshire: McGraw-Hill Higher Education.
Marx, J., De Swart, C.,Pretorius, M. & Rosslyn-Smith, W. (2017).
Financial Management in Southern Africa (5th ed.). Cape Town:
Pearson Education.
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12 Sources of finance and capital structure
Kevin Thomas
Learning
outcomes
Chapter outline
By the end of this chapter, you should be able to:
distinguish between long-, medium- and shortterm sources of finance
explain and discuss the different types of equity
finance
calculate and interpret the value of a right
explain and discuss the different types of debt
finance
distinguish between equity and debt finance
evaluate and advise management on whether to
use borrow-and-buy or lease financing
explain, calculate and interpret how gearing
increases returns to shareholders and financial
risk
analyse and evaluate capital structure
provide recommendations for achieving an
optimal capital structure
distinguish between the various capital structure
theories.
12.1 Introduction
12.2 Long-term sources of finance
12.3 Medium-term sources of finance
12.4 Short-term sources of finance
12.5 Debt versus equity: A summary
12.6 Optimal capital structure
12.7 Capital structure theories
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12.8 Conclusion
CASE
STUDY
Steinhoff International Holdings NV: The need to raise
additional finance
As mentioned in previous chapters, Steinhoff is a South
African-based furniture retailer that is listed on the
Johannesburg Stock Exchange (‘the JSE’) as well as the
Frankfurt Stock Exchange in Germany. The entity was rocked
by an accounting scandal in December 2017. The Steinhoff
crash wiped more than R200 billion off the JSE, erased more
than half of the wealth of South African tycoon Christo Wiese
and substantially reduced the market value of the pension
funds of millions of ordinary South Africans.
Steinhoff said its French furniture retail unit Conforama
Holdings SA raised a total of about US$356 million to ensure
the stability of its capital structure and operations after debt
rose and revenue fell between 2017 and 2018. As at the end of
December 2018, Conforama’s net financial debt was €1,72
billion, outstripping its equity. The market value of the entity’s
property was valued at €1,02 billion. Operating expenses,
driven by store opening plans, new marketing campaigns and
numerous projects, rose long before Steinhoff disclosed
accounting irregularities in December 2017.
If an entity’s revenue decreases and losses are incurred (as
in Conforama’s case), management may need to raise
additional finance through debt or equity so that investments
can take place to increase revenue and profitability.
Sources: Rose, 2018; Bloomberg, 2019.
12.1
Introduction
Every business, no matter how big or small, requires sufficient
finance (or capital) to begin and maintain operations. Without
finance, no projects can be undertaken and the business’s daily
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operating activities cannot take place.
Various sources of finance are available in the financial markets
for entities to use. There are two broad categories of finance: equity
and debt. A distinction can also be made between external and
internal sources of finance.
Businesses need to consider the cost of each source of capital
when evaluating whether to raise equity or debt finance and
essentially the optimal mix of equity and debt finance. Chapter 11
addressed the cost of capital and the weighted average cost of
capital (WACC). You will recall from Chapter 10 (‘Risk and return’)
and Chapter 11 (‘Cost of capital’) that because of tax benefits and
the security generally offered to investors, debt finance is usually
cheaper than equity finance. If debt finance is cheaper, then why do
businesses not finance most of their capital requirements using debt
instruments? The short answer is that the use of debt finance also
increases financial risk. The concept of using more debt to finance a
business is known as gearing (or leverage).
The mix (or combination) of debt and equity, known as the
capital structure, is critically important for an entity. A balance
should be found between using sufficient debt to take advantage of
tax benefits, while keeping financial risk at a minimal (or
manageable) level. Table 12.1 summarises the various sources of
debt and equity finance, split over the long, medium and short
term. The sections that follow cover these sources of finance in
more detail. The relevant sections are indicated in brackets in Table
12.1.
Table 12.1 Sources of finance available to entities
Equity finance is generally long term (and sometimes medium
term) in nature, while debt finance can be long term, medium term
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and short term. It is often quite difficult to distinguish between noncurrent (or long-term), medium-term and current (or short-term)
sources of debt finance. Use this general guideline to distinguish
among the various maturities:
• Current (or short-term) sources of finance include any debt
instrument with a maturity of up to one year.
• Medium-term sources of finance include instruments with a
maturity of between one and five years.
• Non-current (or long-term) sources are for five years or longer.
12.2
Long-term sources of finance
As shown in Table 12.1, long-term sources of finance can include
both equity and debt finance. This is also known as the capital
structure of an entity or the capital employed. In this section, we
consider external and internal sources of equity finance as well as
various sources of long-term debt finance. Equity finance refers to
the finance provided by the owners of an entity, and consists of
external and internal sources.
12.2.1
External sources of equity finance
External sources of equity finance relate to sources of finance raised
outside the entity, such as ordinary shares and preference shares.
12.2.1.1 Ordinary shares
The ordinary shareholders are the ultimate owners of an entity. The
ordinary shareholders take on the highest risk of any of the
providers of capital and, therefore, expect a return commensurate
with this risk. The ordinary shareholders receive a return in the
form of capital growth in the share price (if the entity performs
well) and any dividends that are declared. Ordinary dividends are
not tax-deductible for the entity paying the dividend, and are thus
an appropriation of after-tax profits. In actual fact, there is a
withholding tax paid by the shareholder when an entity declares a
dividend.
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Entities can raise equity finance in the form of ordinary share
capital on a financial market, such as a stock exchange. A stock
exchange can act as both a primary and a secondary market. You
may recall from Chapter 1 that a primary market, such as a stock
exchange, helps entities raise external capital. As a secondary
market, the stock exchange is concerned with matching investors
who want to buy and sell shares in a particular entity, without the
entity being directly affected. The secondary market, therefore, is
not a source of finance, but is of essential importance, as investors
buy and sell shares in the hope of making a capital gain. A capital
gain is realised when an investor sells a share to another investor at
a price higher than the original purchase price.
In South Africa, entities can obtain a primary listing on the JSE if
they are large enough; small entities can list on the Alternative
Exchange (AltX) of the JSE. Since 2016, four additional stock
exchanges have emerged alongside the JSE in South Africa: ZAR X
(2016), 4 Africa Exchange (2017), A2X (2017) and Equity Express
Securities Exchange (EESE) (2017). However, the JSE remains the
largest stock exchange in South Africa and Africa (Khumalo, 2017;
Wikipedia, 2019b).
Methods of obtaining a stock-exchange listing
Entities can list on a stock exchange such as the JSE in a number of
ways. Some of the more common methods of obtaining a listing are
outlined in the sections that follow.
Offer for sale (prospectus issue) and offer for
subscription
Finance is raised by an entity offering its shares at a fixed price to
the public in the form of a prospectus. A prospectus is a brochure
outlining the background of the entity, including recent financial
statements and possibly forecasts, and explaining why the entity
plans to list and how it intends using the finance from the listing (in
other words, how it will invest the capital raised). Members of the
public can apply for shares in the entity that wishes to list. The
entity looking to raise finance can arrange for the issue of shares to
be underwritten, if necessary. Underwriting is the process of
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ensuring that all the shares that an entity plans to issue are
purchased. An underwriter such as an investment bank agrees to
purchase any shares not subscribed for by the public in return for
an underwriting fee. The benefit of underwriting is that the
underwriter purchases any shares not subscribed for, thus ensuring
that the share listing is successful. However, the underwriter
charges an underwriting fee for this service. Investment banks such
as Goldman Sachs, Rand Merchant Bank and Sasfin Bank perform
underwriting services for entities that want to list on a stock
exchange in South Africa. Underwriting fees range between 4% and
7% of the gross proceeds of the share issue.
Buying shares this way means that shareholders avoid
transaction costs because they do not purchase the shares on the
stock exchange. If the issue of shares is oversubscribed (in other
words, the public applies for more shares than are on offer), then
the shares are issued on some sort of pro rata (that is, scaled down)
basis. For example, each investor receives 50% of the shares that
they applied for if the share issue was two times oversubscribed.
An offer for sale is similar to an offer for subscription. An offer
for subscription is also known as an initial public offering (or IPO)
if it is the first time that an entity is offering the general public the
opportunity to subscribe for unissued shares. The main difference
between an offer for sale and an offer for subscription is that in the
case of an offer for subscription, the entity offers the unissued
shares to the public and therefore receives the proceeds. In an offer
for sale, however, existing shareholders invite the public to
purchase some of their shares and these existing shareholders
receive the proceeds.
In February 2019, Naspers Ltd unbundled its shares in
MultiChoice Group Ltd (the biggest pay TV broadcast provider in
Africa) following the listing of MultiChoice Group on the JSE. One
of the reasons for the unbundling of MultiChoice Group from
Naspers was to unlock value for Naspers’ shareholders (Naspers,
2019). Uber (the ride-hailing entity) listed in May 2019 on the New
York Stock Exchange (NYSE) at US$45 per share, valuing the entity
at US$82 billion. The IPO was oversubscribed. Within three months,
Uber’s share price was 20% lower than its IPO price due to concerns
about how and when it would become profitable (Strauss, 2019).
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Offer for sale by tender (auction)
An offer for sale by tender is similar to a prospectus issue, but the
shares are not issued at a fixed price. Instead, potential investors
must tender for shares at or above a minimum fixed price. The
shares are then allotted to the investors who bid the highest price
(much like an auction). When Google listed on the NASDAQ in
2004, it used a modified auction process known as a Dutch auction
to issue its shares for its IPO (Cornell University, 2014).
Private placement
In the case of a private placement, shares in an entity are offered to
institutional clients and no offer is made to the public. The shares
are, therefore, placed privately with a few large institutions. Private
placements have become popular in South Africa in recent years
because they are easier and cheaper to arrange than an offer for sale
or an offer for sale by tender.
Rights issue
A rights issue is used if an entity needs to raise additional finance
after previously listing its ordinary shares on a stock exchange. The
entity offers its current (existing) shareholders the right to apply for
new shares in proportion to their current holding. The current
shareholders are offered the first right to purchase shares if an
entity is planning to raise additional finance so that they can
maintain their existing holding, and they are rewarded for their
loyalty. Shares in a rights issue are often offered at a discount to the
current share price to entice shareholders to subscribe for the
shares.
If no discount is offered, then shareholders have the option of
buying shares on the stock exchange at the current market price
rather than subscribing for shares in a rights issue. However, a
further advantage of a rights issue is that shareholders save on
transaction costs: unlike buying shares on the stock exchange, a
rights issue does not incur transaction costs. A rights issue may be
underwritten to ensure that all the shares are taken up and the full
amount of finance is raised.
In 2014, Woolworths Holdings Ltd (a South African retail
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group) had a rights issue to raise capital for the purchase of
Australian department store David Jones. In January 2019, Taste
Holdings Ltd (a South African management group and franchisor
of retail brands) announced it had a successful fully underwritten
rights issue to raise R132 million for the expansion, maintenance
and working capital of Starbucks and Domino’s Pizza franchises
(Mchunu, 2019). However, in November 2019, Taste Holdings
announced that it would sell the Starbucks and Domino’s Pizza
master franchise rights, as the franchises were not profitable
(Tarrant, 2019). Other South African entities that have had rights
issues in recent years include Curro Holdings Ltd (an entity that
owns and manages private schools), which raised finance to build
additional schools and upgrade existing schools, Aveng Ltd (a
construction entity that has been battling due to the weak
economy), which had a rights issue to fund the early redemption of
a portion of its existing debentures, and Omnia Holdings Ltd (a
diversified chemicals and fertiliser entity), which used the proceeds
of its rights issue to repay debt (Gernetzky, 2019).
The terms of a rights issue are announced once the entity has
established how much finance is required and what the issue price
will be. The number of shares to be issued will then be the
balancing figure. The terms of a rights issue are expressed, for
example, as ‘1 for 3’, which means that an entity has three million
shares in issue and requires an additional one million shares to
raise the required finance. The theoretical ex-rights price (TERP) of
a share can be calculated as shown in Example 12.1.
Example 12.1 Calculating a rights-issue price
Wrong Ltd needs to raise additional finance to fund an expansion project that it
is currently evaluating. It currently has five million ordinary shares in issue,
which are trading on the JSE at a price of 300 cents per share. Management
would like to raise R3 million and has decided that it will offer the shares in the
rights issue at a 20% discount to the current market price. The rights issue is
expected to be fully subscribed. Ignore transaction costs.
1. Calculate the rights issue price.
2. Calculate the number of shares to be issued by Wrong.
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3. Calculate the TERP of one Wrong share.
4. Calculate the value of one right.
Solutions
1. The current share price is 300 cents. The rights issue is being offered at a
20% discount to the current share price. The rights issue price is
calculated as follows:
300 cents × (1 – 0,2) = 240 cents
2. Wrong is planning to raise R3 million at an issue price of 240 cents, or
R2,40, each. Therefore, the number of shares that need to be issued can
be calculated as follows:
3. The TERP can be calculated in a number of ways. These approaches are
illustrated below.
Using a table
The terms of the rights issue can be expressed as ‘1 for 4’ (5 million
shares ÷ 1,25 million shares).
The table above gives rise to Formula 12.1:
Where:
Pp = pre-issue share price
Pn = new issue share price
No = number of ‘old’ shares
Nn = number of ‘new’ shares
N = total number of shares
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You will notice that we can use either the ratio of total shares or the ratio
of individual shares, provided that we are consistent with the approach
adopted.
4. The value of a right is the theoretical gain that shareholders can make
by taking up their rights. The value of a right is the difference between
the TERP and the rights issue price. This can be calculated as follows:
Value of a right = TERP – Rights issue price
Value of a right = 288 cents – 240 cents
Value of a right = 48 cents per ‘new’ share or 12 cents (48 cents ÷ 4
shares) per ‘old share’.
How shareholders react to a rights issue depends on how the rights
issue affects them. If shareholders take up their rights (in other
words, purchase their allocated shares) in a rights issue, they will
maintain their proportionate shareholding in the entity. If they do
not take up their rights, they will experience a dilution of their
existing shareholding.
The issue of additional shares in a rights issue also results in a
decrease in the entity’s earnings per share because there are more
shares in issue after the rights issue. If the rights are issued at a
significant discount to the current market price (for example, 50%
or more), then shareholders will experience a significant decline in
the value of their shares.
Entities may also issue different classes of ordinary share, such
as A and B shares. The different classes of share generally have
different voting rights. This is done to allow the original founders
or management to retain control of the entity, even though they
own a minority of the shares. One of the reasons this is done is to
secure an entity’s independence and prevent hostile takeovers so
that control of the entity is maintained. However, you will probably
realise that good corporate governance practice does not endorse
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the use of different classes or ordinary shares that have different
voting rights, as it gives a minority of shareholders control of an
entity. Naspers (the biggest entity in Africa by market
capitalisation) has two classes of ordinary shares: ‘N’ class ordinary
shares, which have one vote per share and are listed on the JSE, and
unlisted ‘A’ class ordinary shares, which have one thousand votes
per share (Naspers, 2020).
Entities often incentivise management by offering them share
options as part of their remuneration package. This is done to align
the goals of management (agents) and the goals of shareholders
(principals). This principal–agent relationship is known as agency
theory (refer to Chapter 1, where it was introduced). In some
instances, directors opt to forego a salary, but instead to receive
share options in the entity that vest over time. For example, a
director might receive shares of R1 million in lieu of a salary of R1
million. This is a high-risk, high-return situation for a director
because if the entity does not perform well and the share price
drops, the director will make a capital loss when they sell their
shares (in relation to the price at which they received the shares).
However, if the share price increases above the share price at which
the director received the share options, they could make a capital
gain on the sale of the shares.
From an entity’s perspective, the issue of shares in lieu of a
salary does not result in much risk. In the scenario described in the
previous paragraph, the entity either has to pay R1 million for the
shares to issue to the director or R1 million for the salary for the
work performed by the director. If the share price increases or
decreases, only the director gains or loses, not the entity. Koos
Bekker, the chief executive officer (CEO) of Naspers from 1997 to
2014, did not earn a salary or bonus for the last 15 years, but instead
received share options that vested over time. The market value of
Naspers increased from US$1,2 billion to US$45 billion while he
was the CEO. This method of remuneration made Koos Bekker an
extremely wealthy man, as the share price of Naspers increased
significantly under his leadership. In 2019, he was the fourth
wealthiest person in South Africa, with a personal fortune of
approximately US$2,3 billion (Wikipedia, 2019a).
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Broad-based black economic empowerment
The primary purpose of broad-based black economic
empowerment (B-BBEE) is to address the legacy of apartheid and
promote the economic participation of black people in the South
African economy. In 2019, Barloworld (a distribution entity listed
on the JSE) sold a 14% interest amounting to R3,5 billion in its local
property portfolio to a majority black-owned entity, in a transaction
that will enhance Barloworld Ltd’s empowerment credentials. The
entity’s B-BBEE ownership increased to 48% as a result of the
transaction. Barloworld issued 6,6 million ordinary shares as part of
its B-BBEE deal (Njobeni, 2018). What do you think the benefits of
such a B-BBEE deal are for the shareholders as well as the entity?
12.2.1.2 Preference shares
Preference shares entitle the preference shareholder to receive a
fixed rate of dividend in return for the finance provided to an
entity. Preference shares carry part ownership of an entity. The
dividend paid on preference shares is not deductible for tax
purposes, as the preference dividend is an appropriation of aftertax profits and not a payment of an expense, such as interest.
Whereas interest is a compulsory payment, the payment of a
preference dividend is not compulsory. (Refer to the various types
of preference share described below to understand what happens if
an entity does not pay a preference dividend that is due.)
Preference shares and their dividends rank ahead of ordinary
shares in the event of liquidation, but behind debt finance.
Therefore, preference shares have the characteristics of equity.
However, preference shares may be redeemable or the shareholders
may only receive their fixed dividend and not share in additional
profits. Thus, preference shares may also have some debt
characteristics and are consequently referred to as hybrid
instruments.
Various types of preference share can be issued by entities.
Some of the more common types of preference share are discussed
in the sections that follow.
Convertible preference shares
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Convertible preference shares may convert into ordinary shares or
some other security at some time in the future depending on certain
circumstances. Depending on the terms, it may be the issuer’s
option or the holder’s option to convert the preference shares into
ordinary shares.
Cumulative preference shares
Preference shares may be cumulative or non-cumulative in nature.
Cumulative preference shares are those in which the dividend will
accumulate in the event that it is not paid when due. An entity may
not have sufficient cash to pay the preference dividend in a certain
year. If the preference shares are cumulative, then the preference
dividend will be forgone, but paid at a later date.
The preference shareholders may receive voting rights when the
preference dividend is in arrears and an ordinary dividend may not
be paid until such time as all the arrear preference dividends have
been paid. Preference shares are cumulative in nature, unless
specifically issued as non-cumulative. If the preference dividend is
not paid in the case of non-cumulative preference shares, then the
preference shareholder forfeits the right to receive a preference
dividend that year.
Participating preference shares
Participating preference shares receive a fixed dividend and the
preference shareholders share (‘participate’) in the profits with the
ordinary shareholders in a manner agreed between the parties.
Thus, participating preference shares display elements of the
characteristics of both preference shares and ordinary shares.
Redeemable preference shares
Redeemable preference shares are preference shares that will be
redeemed (that is, repaid to the preference shareholder) at some
point in the future. An entity that issues redeemable preference
shares needs to ensure that it has sufficient cash flow to repay the
preference shares or that it can issue additional finance to fund the
repayment when due. Redeemable preference shares display the
characteristics of debt instruments, as the capital needs to be repaid.
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As at the end of 2018, there were approximately 17 preference
shares listed on the JSE (six cumulative and 11 non-cumulative
preference shares). This is a small number compared to the more
than 350 ordinary shares issued by listed companies.
12.2.2
Internal sources of equity finance: Reserves and
retained earnings
Reserves include retained earnings, revaluation reserves and share
premiums. Retained earnings are the accumulated profits that an
entity has retained over the period that it has been in existence. This
is an important source of finance for many entities. Retained
earnings are generally the cheapest source of finance for an entity,
as the accumulated profits are available immediately and
transaction costs (such as flotation costs) are avoided. Retained
earnings are not the same as surplus cash.
Retained earnings are not a ‘free’ source of finance, however.
They have an opportunity cost associated with them, as they could
have been paid out as a dividend to the shareholders instead of
being retained within the entity. The amount of retained earnings
held by an entity depends on its growth strategy and distribution
policy (refer to Chapter 13).
In terms of the Companies Act (No. 71 of 2008), entities in South
Africa may no longer authorise any new par value shares (that is,
shares with a nominal value of, for example, R1 attached to them).
This means that entities will no longer require a share premium (the
excess of the share issue price above the par value of the shares).
While there is no legal requirement for an entity to reclassify its
existing share premium, it may not recognise an increase in the
share premium in the future. Entities may therefore combine their
share capital (of par value shares) and any share premium into one
stated capital account (of no par value shares).
QUICK QUIZ
1. Explain the various ways in which an entity
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can list its shares on a stock exchange.
2. Define and explain the purpose of a rights
issue.
3. Distinguish among the various types of
preference share that an entity can issue.
4. Explain why retained earnings are considered
to be the cheapest form of equity finance, but
are not a ‘free’ source of finance.
12.2.3
Non-current debt finance
Non-current debt finance generally consists of debt instruments
that are issued for five years or longer. Debt may be classified as
fixed rate or variable (floating) rate. This refers to the interest that
will be charged on the debt instrument. In the case of a fixed
interest-rate loan, the interest rate does not fluctuate on the debt
instrument for the duration of the period. In the case of a variable
rate, the interest rate may fluctuate during the period of issue,
depending on economic factors such as inflation.
Debt instruments may also be classified as secured or
unsecured. In the case of secured debt, an entity offers one or more
of its assets as security for the repayment of the debt. If the entity is
unable to repay the capital or interest, then the secured assets will
be disposed of to settle the amount owing. Unsecured debt is riskier
for the lender because no security is offered. Therefore, in the case
of unsecured debt, the lender will demand a higher rate of return in
the form of higher interest rates to satisfy the additional risk taken
on.
The major sources of non-current debt finance are discussed in
the sections that follow.
12.2.3.1 Bonds and debentures
The word ‘bond’ is a generic term that refers to a number of noncurrent debt instruments, including debentures. A debenture is a
marketable security that arises out of a contract between the entity
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issuing the debenture and the investor(s). It is an acknowledgement
of debt by the entity. Debentures usually pay a fixed rate of interest
and are often secured over certain assets belonging to the entity.
These conditions are flexible, however. A detailed discussion of
bonds and their valuation is included in Chapter 8.
Recently, there has been a trend towards entities issuing green
bonds. Green bonds are bonds where the capital raised is used
exclusively for the financing or refinancing of new or existing
projects that encourage environmental sustainability and/or have a
climate benefit. Green bonds allow issuers to raise capital to finance
green investments, while investors can satisfy environmental, social
and governance (ESG) mandates and address climate-related risks
as part of their portfolio construction (JSE, 2020). Growthpoint
Properties and Nedbank are South African entities that have
recently issued green bonds.
12.2.3.2 Mortgage bonds
A mortgage bond is a non-current loan that is usually secured
against the property of an entity and generally incurs interest at a
variable rate. Entities that need to invest in property may well
consider a mortgage bond as a suitable source of finance, as buying
property often involves a large capital expenditure.
12.2.3.3 Other non-current loans
Entities may require non-current loans to finance a variety of assets
or projects within the business. Non-current loans (such as term
loans) can be obtained from various financial institutions, including
banks. The duration, interest rate and repayment terms depend on
the conditions agreed with the financial institution. Entities
generally try to match the funds with the acquisition of assets.
Thus, if a non-current asset with an expected life of ten years needs
to be purchased, then some form of long-term finance will be
sought, such as a non-current loan.
As mentioned in the opening case study, Steinhoff’s French
furniture retail unit, Conforama Holdings SA, had net financial
debt of €1,72 billion as at the end of December 2018. Its non-current
debt at 31 December 2018 exceeded its equity (Bloomberg, 2019).
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QUICK QUIZ
1. Discuss the benefits of raising debt finance.
2. Explain how green bonds differ from
conventional bonds as a source of financing.
12.3
Medium-term sources of finance
Medium-term finance generally has a maturity of between one and
five years. The major sources of medium-term finance are discussed
in the sections that follow.
12.3.1
Term loans
A term loan is a loan of a fixed amount for a specific term, or
period. Term loans generally have a fixed repayment schedule.
Security is often required to access a term loan. Term loans are
popular among smaller businesses because they can be negotiated
easily and quickly through a financial institution, such as a bank.
Banks generally offer flexible repayments and the loan bears
interest at a variable rate.
12.3.2
Leases
A lease is an agreement entered into between a lessor and a lessee.
The lessor (owner) agrees to provide the right to use an asset for a
specific period of time to a lessee (party using the asset) in return
for a lease payment or a series of lease payments. As a lease
provides the lessee the right to use an asset for an agreed period of
time, it is appropriate to consider leasing as a medium-term source
of finance.
Under IFRS 16 (‘Leases’), a lease is defined as “a contract, or part
of a contract, that conveys the right to use an asset (the underlying
asset) for a period of time in exchange for consideration” (IFRS
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Foundation, 2016). IFRS 16, which came into effect on 1 January
2019, does not require a lessee to classify its leases (as finance and
operating leases). Entities now need to account for all leases in the
same way as they account for finance leases (under the previous
lease statement, IAS 17). However, under IFRS 16, lessors must
continue to classify leases as either finance leases or operating
leases. IFRS 16 prescribes a single lessee accounting model that
requires the recognition of an asset and corresponding liability for
all leases with terms over 12 months unless the underlying asset is
of low value. Finance leases are essentially term loans and form
part of the lessee’s capital structure (IFRS Foundation, 2016).
12.3.2.1 Sale-and-leaseback transactions
A sale-and-leaseback arrangement refers to a situation in which a
business sells one of its assets, but leases it back from the purchaser
because it still requires the use of that asset. The main purpose of a
sale-and-leaseback transaction is to convert a non-current asset into
liquid cash that can be used to finance the business. The cash
outflows that result from the transaction only take place in
instalments over the period of the lease. In essence, a sale-andleaseback arrangement allows a business to continue using an asset
even though it no longer owns the asset. For example, South
African Airways (SAA), which went into business rescue in
December 2019, could consider selling some of the aircraft that it
owns to raise finance, and then lease the aircraft back from the
purchaser. This would allow SAA to use the aircraft to transport
passengers and so continue its daily operations.
12.3.2.2 The borrow-and-buy versus lease decision
Once an entity has decided to invest in an asset, it needs to decide
whether to take out a loan and buy the asset or to lease it. This
decision – known as the borrow-and-buy versus lease decision –
follows on from the investment decisions covered in Chapter 5.
Financing decisions are concerned with evaluating the financing
option with the least cost (that is, the financing option with the
lowest negative net present value [NPV]). A discounted cash flow
approach is adopted by preparing separate tax calculations and
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cash flows for each financing option considered. This approach
makes it easier to account for assessed losses that may arise and to
ensure flexibility if an entity has to evaluate three or more different
financing options, such as two borrow-and-buy options (in other
words, loans) and a lease or a borrow-and-buy option and two lease
options.
Approach to be followed for leases
Lease payments are generally deductible from profit before tax as
an operational expense. Lease payments must, therefore, be
included in both the tax calculation and the cash flow calculation.
Maintenance costs are also generally deductible from profit before
tax as an operational expense. If maintenance costs are payable by
the lessee, then the maintenance costs should also be included in
both the tax calculation and the cash flow calculation.
Approach to be followed for borrow-and-buy options
Allowances for wear and tear are only granted by the South African
Revenue Service (SARS) to the owner of an asset. Thus, when an
entity leases an asset, the entity does not receive the wear-and-tear
allowance as a tax deduction, but instead the lease payment is taxdeductible (refer to the approach described above for leases). Note
these guidelines:
• When an entity borrows money and buys an asset, the entity is
entitled to claim a wear-and-tear allowance (if applicable).
• Maintenance costs for an entity are generally deductible from
profit before tax as an operational expense.
• If maintenance costs are payable by the owner, then the
maintenance costs should also be included in both the tax
calculation and the cash flow calculation.
• If an asset is disposed of at the end of the project, then a profit or
loss for tax purposes, known as a recoupment or a scrapping
allowance, may arise.
• Management needs to determine whether a recoupment or
scrapping allowance has resulted on the basis of the selling price
less the tax value of the applicable asset. The recoupment or
scrapping allowance is included in the tax calculation, whereas
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the selling price of the asset or residual value is included in the
cash flow calculation.
If specific cash flows are relevant to all the various options being
evaluated, then you could choose either to include the specific cash
flow for each option or to exclude the specific cash flow for each
option. You would end up with a different final result, but your
ultimate decision would not change. However, care should be taken
if you are asked to evaluate three different options consisting of, for
example, two different leases and a borrow-and-buy arrangement.
It would not be an option to exclude maintenance costs if you were
evaluating these three different options and the maintenance costs
were paid by the lessor in the case of one of the leases, but by the
lessee (owner) in the case of an alternative lease and the borrowand-buy option.
These principles are demonstrated in Example 12.2.
Example 12.2 Selecting a borrow-and-buy option or a lease option
Table Mountain Tours (Pty) Ltd is considering investing in a new cable car. The
entity can either borrow the money required to purchase the cable car by
obtaining a five-year loan from Cape Town Bank at an interest rate of 10% or it
can enter into a lease with Western Cape Finance House. Finance lease
payments of R90 000 per year, payable in arrears, will need to be made for a
period of five years if the asset is leased.
The new cable car can be purchased at a cost of R400 000. If the asset is
purchased, Table Mountain Tours will qualify for a wear-and-tear allowance
from SARS of 25% per year on the straight-line method. The estimated
residual value of the asset at the end of the five years is R60 000.
Under either option, Table Mountain Tours will be responsible for
maintenance costs of R50 000 per year, beginning in year 2.
The current rate of tax is 28% and tax is payable in the year in which it is
incurred. SARS will allow interest, lease and maintenance costs to be deducted
for tax purposes. Assume that Table Mountain Tours has sufficient taxable
income to ensure that all deductions can be made immediately (in other words,
there is no assessed loss).
Evaluate whether Table Mountain Tours should borrow the money from Cape
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Town Bank and purchase the asset or whether the entity should lease the
asset from Western Cape Finance House.
We will demonstrate and explain two alternative solutions for the borrow-andbuy option.
Borrow-and-buy: Alternative 1
Alternative 1 considers the fact that if an entity borrows money, the interest
paid is tax-deductible. The entity also needs to calculate annual payments that
must be made on the loan and included as a cash outflow.
Calculation of annual payment
The annual payment can be calculated on a financial calculator using time
value of money principles.
Using a financial calculator
Note that the interest payments are derived from the amortisation function
(AMRT) on a financial calculator, as illustrated in the loan amortisation table
that follows.
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It is not necessary to prepare a full loan amortisation table unless specifically
requested.
Tax calculation
Cash flows
Discount rate = 10% × (1 − 28%) = 7,2%
NPV = −R388 308 (using a financial calculator)
Borrow-and-buy: Alternative 2
Alternative 2 considers the fact that if the discount rate used is the same as
the after-tax cost of debt, then instead of calculating an annual payment and
the annual interest expense, the cash cost of the asset can be included as a
cash outflow in year 0 (for simplicity’s sake). The outcome should be the same
as the answer in Alternative 1, bar small rounding and timing differences of the
cash flows. Like Alternative 1, Alternative 2 is only suitable if the entity does
not have an assessed loss situation.
Tax calculation
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Cash flows
Discount rate = 10% × (1 − 28%) = 7,2%
NPV = −R388 308 (using a financial calculator)
Lease
Tax calculation
Cash flows
Discount rate = 10% × (1 – 28%) = 7,2%
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NPV = −R377 514 (using a financial calculator)
Based on the preceding calculations, Table Mountain Tours should lease the
cable car because it is cheaper to finance the asset in this way. In other words,
the lease option has a lower net present cost than the borrow-and-buy option.
12.3.2.3 Discount rate for lease versus buy decisions
You may recall from Chapter 11, which dealt with the cost of
capital, that the weighted average cost of capital (WACC) was the
appropriate discount rate to use when evaluating capital
investments. The WACC may be adjusted upwards or downwards,
depending on the specific circumstances of the project being
considered for investment purposes. For example, if an entity were
evaluating an investment in another country, the WACC might
need to be adjusted depending on various risk factors in that
country (for instance, political risk and geographic location).
By contrast, however, the after-tax cost of debt is generally used
as the discount rate when evaluating financing alternatives. The
after-tax cost of debt is considered an appropriate discount rate to
use because, in this case, we are evaluating the financing options
(that is, the rate at which we would borrow or lease). As interest
paid on borrowed funds is tax-deductible, the after-tax cost is
preferred to the before-tax cost. We also need to use the same
discount rate for both the borrow-and-buy option and the lease
option to make the calculations comparable.
The general rule of thumb is to use the WACC when evaluating
capital investment options and the after-tax cost of debt when
evaluating financing options. This explains why a discount rate of
7,2% (the after-tax cost of debt) was used in Example 12.2.
12.3.2.4 Assessed losses for lease versus buy decisions
As mentioned earlier, the tax calculation is done separately from
the cash flow calculation so that managers can easily identify
whether an assessed loss has arisen or not. If the tax calculation and
the cash flow calculation were combined, it would not be so easy to
identify whether or not an assessed loss has arisen.
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In essence, an assessed loss is a loss for tax purposes. It may be
more formally defined as the excess of tax-deductible expenses over
taxable income. SARS does not grant a taxpayer a refund in the
event of an assessed loss, but rather allows the taxpayer to carry the
assessed loss forward so that it can be deducted against future
taxable income. If managers calculate an assessed loss in the tax
calculation, they should not calculate any tax refund for that year,
but instead carry the assessed loss forward to the following year
and set it off against any future taxable income.
Example 12.3 illustrates how the tax calculation should be
performed if there is an assessed loss.
Example 12.3 Selecting a borrow-and-buy option or a lease option with
an assessed loss
Assume the same information as given in Example 12.2, except that Table
Mountain Tours currently has an assessed loss that will be utilised by the end
of year 1. This example uses Alternative 1 for the borrow-and-buy option.
Borrow and buy: Alternative 1
Tax calculation
Cash flows
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Discount rate = 10% × (1 − 28%) = 7,2%
NPV = −R390 764 (using a financial calculator)
Lease
Tax calculation
Cash flows
Discount rate = 10% × (1 − 28%) = 7,2%
NPV = −R379 093 (using a financial calculator)
Based on our calculations, Table Mountain Tours should lease the cable car
because it is cheaper to finance the asset this way (as the lease option has a
lower net present cost than the borrow-and-buy option).
12.3.3
Business angels, venture capital and private equity
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Entrepreneurs face many challenges when starting a new business.
The term ‘business angel’ or ‘angel investor’ refers to a wealthy
individual who has both the time and the money to invest in a startup business. The use of business angels for financing is popular in
the United States. The investment of capital at an early stage of a
project can help develop an idea and provide the base from which
to begin producing a proposed product or service that results in a
profitable entity. Generally, the business angel not only provides
money, but also becomes involved in the project, acting as a guide
or mentor. By providing this kind of seed funding, business angels
essentially provide a bridge between a fledgling business idea and
an entity that is developed enough to receive funds from a venture
capitalist. The business angel’s objective is usually to sell their stake
for a significant profit within two to five years. If the business fails,
the entrepreneur does not have to pay back the money the angel
invested, as they would have to with a loan.
A business angel may sell their stake to a venture capitalist once
the start-up has reached critical mass. Venture capitalists do not
generally invest in very small businesses (that is, start-ups) because
of the significant amount of administration and monitoring that is
required.
‘Venture capital’ is the term used to describe finance provided
to new, often high-risk ventures. Investing in a start-up entity is
extremely risky and so venture capitalists require a significant
reward for the equity finance they invest. Venture capitalists can
expect and receive returns as high as 40% for the entities that
succeed because many fail and the venture capitalists lose out (just
as a business angel loses out if the start-up fails).
As many start-up businesses fail, venture capitalists often
provide financing in stages to limit their potential loss if the startup business does indeed fail. If certain targets and milestones are
reached, then further financing may be provided. Some venture
capitalists specialise in providing finance for certain stages of an
entity’s development. The fact that finance is only provided once
certain targets are reached serves as a powerful motivating factor
for the owners of the entity. Venture capitalists often require
representation on the board of directors owing to the significant
financing that they provide. Some venture capitalists also provide
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debt financing. Most venture capitalists exit after anywhere
between four and seven years.
The term ‘private equity’ refers to equity finance for private or
unlisted entities, where a private equity organisation buys and
restructures entities that are not publicly traded. Private equity
includes transactions where a listed company is bought out by a
private equity organisation, and then delisted from the stock
exchange. This is done as entities can sometimes be run more
profitably if they are not listed and under constant public scrutiny.
Private equity deals often use a high proportion of debt when
making acquisitions. The debt is capitalised on the statement of
financial position of the acquired entity. After the private equity
organisation has owned the acquired entity for a while (typically
between five and ten years on average), it is likely to refinance the
debt and pay some cash out to its shareholders, or enter into a trade
sale, an IPO or a secondary buyout. Private equity investment in
southern Africa more than doubled from 2016 to 2017, reaching a
total of R31,3 billion (Smith, 2018). The major private equity
investors in South Africa include Brait SE, the Industrial
Development Corporation (IDC), Ethos, Investec Ltd and Invenfin
(part of Remgro Ltd).
Business Partners (previously known as the Small Business
Development Corporation) is a local organisation that was formed
to promote entrepreneurship by investing in viable small-business
ventures. To date, Business Partners has provided business loans
worth over R19,5 billion to small and medium businesses (Business
Partners, 2020).
Finance in action: Advice to entrepreneurs on the
raising of finance
You read Steven Chapman’s commentary on the
challenges of calculating the cost of capital in Chapter
11. Here he gives practical tips for entrepreneurs to
remember when negotiating with business angels,
venture capitalists and private equity investors:
■ Draw up a professional business plan with financial
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■
■
■
■
■
forecasts, which covers the normal business plan
topics (there are many templates on the Internet)
and rehearse your presentation to the financiers.
You may only get one chance to negotiate the best
deal for yourself, so seek professional assistance from
a reputable transaction advisor.
Be aware that financiers may require in excess of
50% of the entity’s equity to allow them to exercise
control over the entity until certain predetermined
financial milestones have been met. These
milestones may include the achievement of
predetermined annual profit levels and/or the
repayment of debt. Negotiate an agreement upfront
that once these milestones have been achieved
(which should enhance the value of the entity and,
accordingly, the financier’s investment), you will
have an option to regain control of the entity by
acquiring a portion of the equity from the financier
at a below-market price.
Seek professional assistance from a competent and
experienced attorney. Ensure that all contracts are in
writing and have been signed, and contain details of
all agreements reached.
Be aware that you may be exposed to an extended
process that includes finalising your business plan,
seeking out and identifying a potential financier, and
then presenting your plan to that person,
negotiating a letter of intent, negotiating a written
contract and achieving predetermined milestones.
You will need stamina and determination to succeed
in this process. At the same time, you will need to
give constant attention to your business to improve
cash flows and profitability in order to keep the
business attractive for potential financiers.
Commentary by Steven Chapman.
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12.3.4
Crowdfunding
Crowdfunding has become more prevalent as a means of financing
small businesses over the past decade or so. Crowdfunding is a
mechanism that allows small businesses to raise small amounts of
money from a large group of investors, typically via the Internet or
social media. In the early days, crowdfunding helped musicians
who required finance to record an album or to go on tour.
Rewards-based crowdfunding initiatives provide a reward to
the individuals contributing to the business by providing them with
a product or service in exchange for their contribution. Equity and
debt-based crowdfunding both exist in the market today. Investors
providing equity crowdfunding will be offered shares in the
business and may earn a return on their investment if the business
succeeds. Small businesses can also apply to borrow money online.
Investors may lend money to the small business through funds set
up to provide loans, generally unsecured. Borrowers will make
money via the interest paid by the small business.
One benefit of crowdfunding is that it provides entrepreneurs
with a platform from which to present their business ideas to a far
wider pool of investors or borrowers than was traditionally the
case. In the past, it was really only banks, business angels and
venture capitalists that provided finance to small businesses.
Another benefit is that an entrepreneur may enjoy more flexible
financing options that are not limited to either debt or equity
(Startups.com, 2020).
12.4
Short-term sources of finance
Current, or short-term, sources of finance generally include any
instruments with a maturity of up to one year. Many businesses are
affected by seasonality because sales do not occur evenly
throughout the year. For example, Dairymaid (jointly owned by
Nestlé SA and Tiger Brands Ltd) sells a lot more ice cream in
summer than in winter. As a result, short-term finance is often
required as a means of bridging finance to ensure the entity has
sufficient liquidity during a period of downturn in sales. The major
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sources of short-term finance are discussed in the sections that
follow.
12.4.1
Factoring
Factoring is the sale of an entity’s trade receivables to a third party
(known as the factor). The factor charges a commission for
purchasing the receivables by paying a discounted amount of cash
to the entity. The entity benefits in that it converts its receivables
into liquid cash and the factor benefits by paying a discounted
price. Factoring is typically used by entities that sell goods on credit
and have large trade receivable balances or long-outstanding
receivable days. Furniture retailers, trucking entities and freight
brokers are examples of entities that make use of factoring. For
example, a furniture retailer such as Steinhoff (refer to the opening
case study) may utilise factoring, as it sells furniture and beds on
credit. These are large household purchases that customers tend to
buy on credit. If Steinhoff required cash for working capital
purposes (that is, to convert receivables into cash), it could factor its
receivables. Factoring can also be used by small businesses that
need to convert their receivables into cash. Refer to Chapter 14 for
more details on working capital management.
Factoring can take place in one of two ways: with recourse or
without recourse. Factoring with recourse means that if the debtor
(receivable) defaults on the amount owing to the factor, the entity
(and not the factor) must bear the bad debt. In the case of factoring
without recourse, the factor bears the risk of the debtor defaulting.
As the factor bears additional risk in factoring without recourse, it
charges a higher commission in the form of the discount calculated.
12.4.2
Invoice discounting
Invoice discounting involves a factor advancing approximately 75%
to 80% of the face value of approved outstanding sales invoices to
an entity. The entity is, therefore, able to access liquid cash
relatively easily. The entity needs to repay the factor once the
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debtor (receivable) has repaid the entity. Invoice discounting is
different from factoring in that the trade receivables are not sold to
a third party. This means that the customer avoids having to deal
directly with the factor. Consequently, invoice discounting is now
more popular than factoring.
12.4.3
Bank overdrafts
A bank overdraft is a short-term source of finance where a bank
allows an entity to withdraw money from its bank account such
that the available balance drops below zero. The bank account is
then referred to as ‘overdrawn’. The bank charges the entity interest
on the overdrawn balance and sets an overdraft limit that the entity
may not exceed. Bank overdrafts may be repayable by the bank on
demand, requiring the entity to repay the outstanding balance
immediately. Bank overdrafts are flexible sources of finance, as
interest is only payable on the amount borrowed. However, they
may be quite expensive (especially if they are unsecured), as the
interest rate charged is generally higher than term loans.
12.4.4
Accounts payable
Accounts payable, or creditors, are purchases made on credit from
suppliers. This is a short-term source of finance that the supplier
accepts to allow the entity the benefit of being able to wait before
having to pay for purchases. Refer to Chapter 14 on working capital
management for further information on accounts payable.
QUICK QUIZ
1. Discuss the importance of leasing as a source
of finance.
2. Distinguish between factoring and invoice
discounting as short-term sources of finance.
3. Briefly describe three other sources of
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medium-term finance available to small or
start-up businesses.
FOCUS ON ETHICS: Applying ethics in
raising finance for non-profit organisations
Non-profit organisations (NPOs) need to work towards producing their
own policies for ethical fundraising and investment. These policies are
necessary, as donors (one of the main sources of funding for NPOs)
are becoming increasingly sceptical of NPOs. Policies relating to
ethical fundraising should not only be designed with the donor in
mind, but should also be integrated with other quality management
systems. Donors want to know how NPOs are raising funds, and may
even request background information about board members and
senior managers. They require assurance that their money is being
spent in a responsible manner, and that business is being conducted
in an open and transparent way. A written fundraising policy can thus
go a long way to allay donors’ fears or suspicions.
For example, the Salvation Army made a resolution some years
ago not to apply for Lotto funding, as Lotto is a game of chance (that
is, gambling) that causes severe economic distress among many of
the families in the areas in which the organisation works. The
Salvation Army is proud of having taken this stand and makes it
known to its supporters.
Source: SANGONet, 2011.
QUESTIONS
1. Why do donors want to know how NPOs raise finance?
2. What are the implications (financial and reputational) for the
Salvation Army of not applying for Lotto funding?
12.5
Debt versus equity: A summary
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Sections 12.2, 12.3 and 12.4 distinguished between long-, mediumand short-term sources of equity and debt finance. Table 12.2
provides a summary of the similarities and differences among
ordinary shares, preference shares and debt.
Table 12.2 Quick guide to equity and debt finance: Similarities and differences
Once financial managers have a sound understanding of the
various sources of finance available to them, they should consider
the optimal mix of debt and equity finance. Gearing plays a role in
selecting this mix.
12.6
Optimal capital structure
Financial gearing (or leverage) refers to the total amount of interestbearing debt included in an entity’s capital structure. (Gearing was
discussed in detail in Chapter 3, so we will only return briefly to the
concept here.) Gearing can be calculated in a number of ways. Two
of the most common ways of calculating gearing are provided in
the formulae that follow.
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Or:
When financial managers are calculating gearing, they should use
market values rather than book values where possible, as market
values are more representative of reality than book values.
If market values are used to calculate the shareholders’ equity,
then the current share price multiplied by the number of shares
should be used. The retained earnings and reserves should be
excluded when calculating market values, as they are inherently
included in the current share price. If market values are not
available, then book values may be used.
You will remember from Chapter 11 that the cost of debt was
the lowest cost of the various sources of finance available to an
entity. Debt generally has the lowest cost because the interest paid
on the debt is tax-deductible and because debt is often secured over
some of the entity’s assets. Thus, if an entity increases the amount
of debt in its capital structure, it can lower its WACC and so
generate a higher return for the shareholders. The drawback with
this is that in order to increase the return for the shareholders, an
entity has to take on additional financial risk. This is the concept of
gearing. More debt implies more interest, which increases the
chances of bankruptcy if an entity cannot meet its interest
obligations. Thus, a balance needs to be struck between the amount
of debt in the capital structure and the additional return managers
strive to achieve for their shareholders.
Example 12.4 illustrates the benefit of including debt in the
capital structure of an entity.
Example 12.4 Illustrating the benefit of using debt in the capital
structure
You are provided with the extracts that follow from the financial statements of
Equity Ltd and Geared Ltd for the most recent financial year.
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Additional information:
■ Equity and Geared are identical in all respects, except for the manner in
which they are financed. Equity is 100% equity financed, while Geared is
50% equity financed and 50% debt financed (that is, non-current
liabilities).
■ The market value of equity is not provided.
■ The non-current liabilities of Geared consist of a 12% bank loan repayable
in ten years’ time. This is the only interest-bearing debt that the entity has.
■ Assume the corporate tax rate is 28%.
1.
2.
3.
4.
Calculate the earnings per share for both entities.
Calculate the return on assets for both entities.
Calculate the return on equity for both entities.
Calculate the financial gearing for both entities (if gearing is calculated as
follows: Interest-bearing debt ÷ [Shareholders’ equity + Interest-bearing
debt] × 100 ÷ 1).
Solutions
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Note 1: Return on assets can be calculated in a number of ways. Return
on assets is often calculated as Profit after tax ÷ Average total assets, as
illustrated in Chapter 3. However, as the return on assets aims to measure
the efficiency of the operations of an entity, it is often better to use the
operating profit after tax (but before finance costs) to calculate the return
on assets because finance costs do not form part of the operations. We
therefore use the net operating profit after tax (that is, NOPAT) to calculate
the return on assets in this example.
The calculations and ratios provided in Example 12.4 demonstrate
that both entities generate the same return on assets of 14.4%, but
that Geared is able to generate a significantly higher earnings per
share and return on equity because of the higher gearing ratio.
Equity does not have any debt in its capital structure and so is
unable to generate as high a return on equity as Geared.
It is important to remember, however, that the additional
earnings per share and return on equity that is generated is the
result of greater financial risk. If the operating profit were to drop
from R100 million to R25 million owing to difficult trading
conditions, the benefit of gearing would be lost, as Geared would
not even be able to cover its compulsory interest payments.
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Example 12.5 calculates the same ratios as Example 12.4, except
that we now assume an operating profit of R25 million.
Example 12.5 Illustrating the negative impact of using debt in the capital
structure
You are provided with the extracts that follow from the financial statements of
Equity and Geared for the most recent financial year.
The additional information provided in Example 12.4 is still applicable.
1.
2.
3.
4.
Calculate the earnings per share for both entities.
Calculate the return on assets for both entities.
Calculate the return on equity for both entities.
Calculate the financial gearing for both entities (if gearing is calculated as
follows: Interest-bearing debt ÷ [Shareholders’ equity + Interest-bearing
debt] × 100 ÷ 1).
Solutions
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Note 1: Return on assets can be calculated in a number of ways. Return
on assets is often calculated as Profit after tax ÷ Average total assets, as
illustrated in Chapter 3. However, as the return on assets aims to measure
the efficiency of the operations of an entity, it is often better to use the
operating profit after tax (but before finance costs) to calculate the return
on assets because finance costs do not form part of the operations. We
therefore use the net operating profit after tax (that is, NOPAT) to calculate
the return on assets in this example.
Example 12.4 illustrates the benefits of gearing, while Example 12.5
illustrates the negative impact of gearing. Increasing the gearing of
an entity can increase the earnings per share and the return on
equity for shareholders if the entity generates sufficient profits to
cover the finance costs incurred. However, increasing the gearing of
an entity also increases the financial risk because if the profits
generated do not cover the finance costs, the earnings per share and
the return on equity will drop below that of an all-equity-financed
entity.
Several theories have emerged to determine the optimal level of
capital structure that an entity should use. The most prominent
capital structure theories are discussed in Section 12.7.
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12.7
Capital structure theories
The relevant theories that have emerged to address the optimal
level of capital structure are discussed below.
12.7.1
Modigliani and Miller’s theory of gearing
In 1958, Professors Franco Modigliani and Merton Miller (often
referred to as M&M) proposed that an optimal capital structure
does not exist. They argued that the value of an entity is determined
by the value of its assets and not by the manner in which those
assets are financed. M&M’s theory was, however, based on the
following assumptions:
• Individual investors can borrow at the same rate and terms as
an entity.
• Taxation is ignored.
• Transaction costs are ignored.
• Financial distress costs (such as a higher cost of capital charge or
bankruptcy costs) are ignored.
• There is symmetry of market information (in other words,
investors have access to the same information as management).
M&M’s proposition that an optimal capital structure does not exist
is based on the premise that a business’s WACC will not change,
irrespective of its level of gearing. This claim contradicts what we
discussed earlier in this chapter as well as in Chapter 11. However,
M&M argued that as more interest-bearing debt is added to the
capital structure of an entity, the financial risk increases. This has
been illustrated in the sections above. M&M furthermore argued
that as financial risk increases, the ordinary shareholders require a
higher return for the additional risk that they have taken on.
Therefore, the benefit of the cheaper debt is exactly offset by the
more expensive equity.
M&M’s irrelevance theory has the following limitations:
• In reality, individuals are not generally able to borrow at the
same rate and on the same terms as entities (especially larger
‘blue-chip’ entities). A ‘blue-chip’ entity is a highly rated, often
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multi-national entity that has been in existence for a long period
of time (for example, Coca-Cola and Naspers).
• Taxation cannot be ignored in the real world. The interest on
debt is tax-deductible, whereas the dividend paid on equity is
not. Dividends paid are subject to additional withholding taxes
and capital gains tax is payable on any capital growth of
ordinary shares (once sold).
• Transaction costs are incurred in the real world.
• High levels of gearing carry the dangers and costs of financial
distress.
In 1963, the two scholars acknowledged that taxes and transaction
costs cannot be ignored. They then demonstrated that the
introduction of debt can be beneficial where tax relief applies, since
interest payments are tax deductible, while dividend payments are
not. Thus, entities benefit from increasing levels of debt in their
capital structures.
12.7.2
Trade-off theory of gearing
This theory suggests that as the gearing ratio increases, the WACC
decreases (because debt is cheaper than equity) and the value of the
entity increases up to a point where the increasing risk associated
with the entity leads to a higher required return by the
shareholders. This, in turn, cancels out the benefits of cheaper debt.
At that point, the WACC starts to increase and the value of the
entity starts to decrease. The trade-off theory of gearing assumes
the WACC will be lowest at the level of gearing that represents the
lowest point of the WACC line (see Point OCS – optimal capital
structure – in Figure 12.1).
Figure 12.1 Trade-off theory of gearing
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While M&M implied that the WACC will continue to decrease up
to a gearing level of 100% with the introduction of corporate
taxation, the trade-off theory of gearing proposes that the WACC
will decrease until a certain point, and then start to increase as the
rising cost of equity (and possibly debt) becomes increasingly
significant.
The following can be ascertained from Figure 12.1:
• The cost of equity (ke ) increases as the level of gearing increases,
as financial risk causes profits to become more volatile and the
ordinary shareholders require higher returns.
• Debt is assumed to be a cheaper source of finance than equity.
Interest on debt is tax-deductible.
• The after-tax cost of debt (kdt ) increases after a certain level of
gearing, as interest cover decreases and fewer assets remain to
offer as security.
• The WACC falls initially as the level of debt increases, and then
increases as the cost of equity (and debt) becomes more
expensive.
• The optimum level of gearing is where the WACC is at a
minimum (Point OCS).
• The capital structure that minimises the WACC also maximises
the value of the entity.
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12.7.3
Signalling theory of gearing
M&M based their theory of capital structure irrelevance on the
assumption that all investors have access to the same information as
management regarding an entity’s future investment opportunities.
Management is likely to have access to better information than
shareholders. However, many shareholders focus on management
decisions to determine the value of an entity. For instance, if the
management of an entity considers the market price of its shares to
be overvalued, it may decide to issue additional shares to raise new
equity. Conversely, if management considers the market price to be
undervalued, it may repurchase the entity’s shares in order to
support the share price.
In this situation, characterised by asymmetrical information, the
value of an entity could be influenced by its choice of capital
sources. The decision to issue new shares could result in a decline
in share prices, since investors may interpret it as a signal that the
current share price is overvalued or that management is concerned
about the future performance of the entity. The signalling theory of
gearing proposes that management always ensure that reserve
borrowing capacity is available to be used when investment
opportunities become available. As a result, entities may be
including relatively more internal equity capital in their capital
structures than expected under the trade-off theory.
12.7.4
Pecking-order theory of gearing
The information asymmetry that occurs between management and
investors gives rise to the development of the pecking-order theory
of gearing. According to this capital structure theory, managers
should first utilise internally generated funds (in the form of
retained earnings) to finance viable investment opportunities,
followed by the use of short-term and long-term debt financing.
Only when insufficient capital can be raised from these sources
should management issue additional preference and ordinary
shares in the entity (in that order).
An important implication of this theory is that management
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may increase financial gearing to dangerous levels to avoid
increased scrutiny by investors associated with the issuing of new
equity and debt. Management may also reduce the levels of cash
distributions that are made to the entity’s shareholders to increase
retained earnings. Factors that impact on an entity’s distribution
policy are discussed in more detail in Chapter 13.
QUICK QUIZ
1. Explain the concept of financial gearing.
2. What are the differences between Modigliani
and Miller’s theory of gearing and the tradeoff theory of gearing?
12.8
Conclusion
Chapter 12 has dealt with capital structure decisions. You learnt the
following:
• The mix of debt and equity finance that an entity adopts is
known as the capital structure.
• An entity’s capital structure consists of various sources of longterm and medium-term finance. Short-term finance forms part
of an entity’s working capital management.
• Equity and debt are the two main categories of finance available
to entities to fund their operations.
• Equity sources of finance include external sources, such as
ordinary shares and preference shares.
• Equity sources of finance also include internal sources, such as
retained earnings and reserves. Retained earnings are not a
‘free’ source of finance.
• Rights issues occur when an entity wishes to raise additional
ordinary share capital from existing shareholders. In a rights
issue, existing shareholders are given the first right to purchase
shares, usually at a discount to the current market price.
• Non-current debt finance includes bonds and debentures,
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mortgages and term loans.
• Various types of medium-term sources of finance are available
to businesses, including term loans and leasing.
• Small entities may find it more difficult to raise finance than
larger entities. Therefore, sources such as business angels,
venture capital, private equity and crowdfunding may be
appropriate.
• Sources of short-term finance include factoring, invoice
discounting, bank overdraft and accounts payable.
• There are various implications that an entity must consider
when deciding between equity and debt sources of finance.
These include the tax effect, the risk and return effect, and the
effect on control via voting rights.
• Gearing (or leverage) refers to the amount of debt included in an
entity’s capital structure.
• The trade-off theory of gearing states that entities have an
optimal capital structure or gearing ratio. The optimal capital
structure refers to the ratio at which an entity’s WACC is at its
lowest point, so that returns for shareholders are maximised.
Entities are often encouraged to increase the level of debt (in other
words, increase the gearing) of which they make use in their capital
structure to generate additional returns for the shareholders. This
target capital structure is illustrated in the case study that follows,
which also shows the interrelated nature of investing, financing and
dividend decisions.
CASE STUDY
Network Healthcare (Netcare) Holdings Ltd
Netcare is the largest private hospital network in South Africa.
It previously owned hospitals in the United Kingdom, but is in
the process of exiting that market. During an interview in May
2019, the CEO, Richard Friedland, explained that the increase
in debt levels was a deliberate strategy on the part of the entity
to achieve an ideal capital structure. The CEO and other
directors believed that the entity was significantly undergeared
and paid a special dividend as a result. Paying a special
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dividend resulted in Netcare’s equity decreasing, translating to
an increase in its gearing, as it now has less equity in its capital
structure. Netcare has a capital structure policy of maintaining
net debt levels to annualised EBITDA (earnings before interest,
tax, depreciation and amortisation) below 2,5 times. Friedland
explained that Netcare’s 2019 gearing was “perfectly
manageable”, as it was below its maximum level. Some of
Netcare’s key financial ratios for 2019 versus 2018 are provided
in the table that follows.
These ratios indicate that Netcare’s interest cover has
decreased, while its financial gearing ratio has increased
slightly, but as indicated by the CEO, Netcare is very lowly
geared. The ROA and the ROE increased from 2018 to 2019 due
to an increase in profitability and a reduction in equity.
Sources: Based on an interview on Business Day TV, 2019; Netcare Limited, 2019.
MULTIPLE-CHOICE QUESTIONS
BASIC
1.
Which ONE of the following is NOT an example of an external source of
finance?
A. Preference shares
B. Debentures
C. Retained earnings
D. Ordinary shares
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2.
Which ONE of the following is NOT a method of obtaining an initial stock
exchange listing?
A. Rights issue
B. Offer for sale
C. Private placement
D. Auction
3.
If you sell your rights in a rights issue to another party, then …
A. the number of shares that you own in the entity decreases.
B. your percentage ownership in the entity increases.
C. you experience a loss in shareholder wealth.
D. your percentage ownership in the entity is diluted.
4.
A preference share that receives a fixed dividend and additional profits and will
be redeemed in five years’ time is known as a …
A. non-participating redeemable preference share.
B. participating redeemable preference share.
C. non-participating non-redeemable preference share.
D. participating non-redeemable preference share.
5.
The sale of an entity’s trade receivables to a third party is known as
__________.
A. invoice discounting
B. factoring
C. gearing
D. leasing
6.
All of the following are examples of medium-term sources of finance except for
__________.
A. debentures
B. leasing
C. a three-year term loan
D. business angels
7.
An entity has 12 million ordinary shares currently trading at R1,50 each and
100 000 debentures currently trading at R95 each. Calculate the gearing ratio
of the entity assuming that it has no other interest-bearing debt, where gearing
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is calculated as follows: Interest-bearing debt ÷ (Shareholders’ equity +
Interest-bearing debt) × 100 ÷ 1.
A. 189,47%
B. 34,55%
C. 289,47%
D. 52,78%
8.
A transaction in which an owner sells an asset, and then leases it back from
the purchaser is known as a __________ transaction.
A. lease
B. mortgage lease
C. sale-and-leaseback
D. leverage lease
9.
In 1958, Modigliani and Miller proposed that __________ does NOT exist.
A. a perfect gearing correlation
B. a revised return on equity
C. a balanced lease
D. an optimal capital structure
10. The capital structure proposition that an entity borrows up to the point where
the marginal benefit of the interest tax shield derived from an increase in debt
is just equal to the marginal expense of the resulting increase in financial
distress costs is called the __________ theory of gearing.
A. trade-off
B. Modigliani and Miller’s
C. signalling
D. pecking-order
INTERMEDIATE
11. Eleven Ltd has five million shares in issue at a market price of R7,50 a share. It
wants to raise R15 million via a rights issue. The issue price is R6 per share.
What is the theoretical ex-rights price (TERP)?
A. R7,50
B. R6,00
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C.
D.
R7,00
R1,50
12. Which ONE of the following statements about gearing is correct?
A. Gearing is most beneficial when profit before interest and tax is relatively
low.
B. Increasing the amount of equity in the capital structure has a favourable
effect on the earnings per share.
C. The return on equity for two identical entities is exactly the same,
irrespective of the type of financing used to fund the entities.
D. The return on assets for two identical entities is exactly the same,
irrespective of the type of financing used to fund the entities.
13. An entity has 300 000 ordinary shares in issue at a current market price of
R50 per share. Management wishes to raise R3 million via a rights issue at a
subscription price of R40 per share. How many rights are required to purchase
one of the new shares?
A. 0,80
B. 1,25
C. 10
D. 4
14. The __________ is the appropriate discount rate to use when evaluating
financing decisions.
A. WACC
B. before-tax cost of equity
C. before-tax cost of debt
D. after-tax cost of debt
15. The trade-off theory of gearing states that the optimum level of gearing is
where the __________ is at a minimum.
A. cost of equity
B. before-tax cost of debt
C. WACC
D. cost of preference shares
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ADVANCED
16. Which ONE of the following makes an asset a likely candidate for leasing?
A. The costs of buying and selling the asset (in other words, the transactions
costs) are low.
B. Borrowing to purchase the asset would subject the entity to debt-related
restrictions.
C. The future market value of the asset can be accurately predicted.
D. Technological changes related to the asset are unlikely.
17. Assume that a lease involves four equal annual payments to a lessor. Each
payment takes place at the beginning of each year. The lessee has an after-tax
cost of borrowing of 8% p.a. Which cumulative discount factor should be used
to find the present value of the lease payments? (Refer to the appendices at the
end of Chapter 4.)
A. 3,577
B. 2,577
C. 3,312
D. 4,312
18. An ungeared entity has an operating profit of R2,5 million, net profit (after tax)
for the period of R1,8 million and a cost of capital of 15%. A geared entity that
has exactly the same assets and operations has R10 million in face value debt
paying a 10% annual coupon. The debt sells at face value in the market. If the
tax rate is currently 28%, what is the value of the geared entity?
A. R10 million
B. R12 million
C. R14,8 million
D. R22 million
19. Which ONE of the following is incorrect regarding the underwriting of shares?
A. The method of marketing the shares to the public is usually determined
by the underwriter.
B. The underwriter generally sets the price for the share issue.
C. The entity issuing the shares, not the underwriter, bears all the risk from
adverse price movements in the share price.
D. It is common for a number of underwriters to underwrite a share issue
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jointly so that the risk in marketing the share issue is spread across a
number of banks rather than just one bank.
20. Which of the following statements is/are correct? The gearing of an entity will
…
(i) increase as the debt-to-equity ratio increases.
(ii) decrease as the entity’s retained earnings increase.
(iii) decrease if the entity makes a loss.
A. (i) only
B. (ii) only
C. (iii) only
D. (i) and (ii)
LONGER QUESTIONS
BASIC
1.
Your aunt is the founder of a successful business. Given the entity’s growing
capital needs, she is considering listing the entity on a local stock exchange.
Explain three alternative methods of obtaining a stock-exchange listing to her.
2.
A listed company is looking to raise additional equity for expansion purposes.
Explain to the CEO what a rights issue is and whether a rights issue is suitable
in the company’s circumstances.
3.
Airline A is newly established and currently owns a small fleet of aircraft. It is
looking to increase the number of routes that it flies. Airline B, which owns a
large fleet of aircraft, is currently facing liquidity issues. Distinguish between a
lease and a sale-and-leaseback transaction, and explain whether Airlines A and
B should lease aircraft or enter into a sale-and-leaseback arrangement.
INTERMEDIATE
4.
ABC Ltd is considering raising additional equity finance. The entity currently
has a market capitalisation of R30 million. It is aiming to raise an additional R8
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million and has decided to offer the shares in a rights issue at a 20% discount
to the current market price of R50 per share. The rights issue is expected to be
fully subscribed. Ignore transaction costs.
a) Calculate the number of shares to be issued by ABC Ltd.
b) Calculate the theoretical ex-rights price (TERP) of one ABC share.
c) Calculate the value of one right.
5.
MNO Ltd is looking to raise additional equity finance through the issue of
preference shares. The managing director, who is unfamiliar with the different
types of preference share, has received a list of the characteristics of the
various shares from an investment bank. Assist the managing director by
identifying each type of preference share described based on its
characteristics.
a) A preference share that may convert into ordinary shares or some other
security at some time in the future depending on the realisation of certain
circumstances
b) A preference share where the dividend will accumulate in the event that it
is not paid when due
c) A preference share that receives a fixed dividend and shares in the profits
with the ordinary shareholders
d) A preference share that will be repaid at some point in the future.
6.
PQR Ltd is looking to raise additional finance to grow and expand. An advisor
has suggested that PQR look to raise finance via redeemable preference shares
or redeemable debentures. The advisor did not recommend an issue of
ordinary shares, as this might change the ownership structure of the entity.
Tabulate the differences between redeemable preference shares and
redeemable debentures, and recommend whether PQR should issue the
preference shares or the debentures.
7.
You are provided with the extracts that follow from the financial statements of
GHI Ltd and JKL Ltd.
STATEMENTS OF PROFIT OR LOSS
GHI Ltd
R’000
Operating profit
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750 000
JKL Ltd
R’000
850 000
Finance cost
–
(100 000)
Profit before tax
750 000
750 000
Income tax expense
(210 000)
(210 000)
Profit for the period
540 000
540 000
GHI Ltd
R’000
JKL Ltd
R’000
Ordinary share capital
500 000
250 000
Retained earnings
2 000 000
1 750 000
–
1 000 000
100 000
100 000
2 600 000
3 100 000
STATEMENTS OF FINANCIAL POSITION
Non-current liabilities (10% interest-bearing debt)
Current liabilities
TOTAL EQUITY AND LIABILITIES
Note: Both GHI and JKL have 250 000 shares in issue. Assume a corporate tax
rate of 28%.
a) Calculate the earnings per share for GHI and JKL.
b) Calculate the return on assets for GHI and JKL.
c) Calculate the return on equity for GHI and JKL.
d) Calculate the gearing ratio for GHI and JKL (if gearing is calculated as
follows: Interest-bearing debt ÷ Shareholders’ equity).
e) Interpret the above ratios for GHI and JKL.
ADVANCED
8.
You are provided with the diagram that follows illustrating the trade-off theory
of gearing.
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Using the diagram, illustrate the market value perspective associated with this
theory.
9.
DEF (Pty) Ltd operates two ferries from Cape Town’s V&A Waterfront to Robben
Island. It wishes to acquire an additional ferry because of the high demand
from passengers.
At a board meeting, proposals were put forward for three different options
to finance the new ferry. It was made clear at the meeting that the business is
unable to raise any further equity finance.
The ferry to be acquired will be the same under all three financing options.
The price of the ferry will be R5 million at 1 January 2021 and it will have a
useful operating life of five years. After this time, the terms of the operating
licence granted by the Western Cape Provincial Government require that the
ferry be scrapped for reasons of health and safety. The net proceeds are
expected to be zero. DEF’s financial year end is 31 December. The entity has a
before-tax cost of debt of 10%, a WACC of 12% and a cost of equity of 15%.
Option 1: Lease 1
The ferry can be leased with equal payments of R1,4 million, payable annually
in arrears. The lease term would be five years. The lease cannot be cancelled
within the lease term (of five years). DEF would be responsible for all the
maintenance costs of R200 000, payable annually in arrears.
Option 2: Lease 2
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The ferry can be leased using a series of separate annual contracts. The
annual expected lease rental would be R1,5 million payable annually in
advance, with the first payment to be made on 1 January 2021. Maintenance
costs would be paid in full by the lessor (in other words, they are included in
the annual lease rental). There is no obligation for either party to sign a new
annual contract on termination of each lease contract.
Option 3: Loan to purchase the ferry
Cape of Good Hope Bank is willing to offer a five-year loan of R5 million so that
the ferry can be purchased. The bank will charge an annual interest rate of
10% p.a. for the duration of the loan. These annual repayments are to be made
at the end of each of the five years. The loan would be secured over DEF’s
non-current assets. DEF would be responsible for all the maintenance costs of
R200 000, payable annually in arrears.
Taxation
Tax should be assumed to arise at the end of each year and to be paid one
year later. The current tax rate is 28% and this is not expected to change in the
near future. All lease payments, interest payments and maintenance costs are
deductible in full for tax purposes in the year of payment. SARS will grant a
wear-and-tear allowance of 20% p.a. on the straight-line basis on the
purchase price of the new ferry. DEF has sufficient profits from the existing
ferries to ensure that tax allowances can be deducted immediately.
a)
Evaluate the net present cost at 1 January 2021 for each of these
options:
■ Lease 1 (Option 1)
■ Lease 2 (Option 2)
■ Loan to purchase the ferry (Option 3).
Advise the directors of DEF on the optimal method for financing the new
ferry.
b)
Discuss the financial and non-financial factors that should be considered
when deciding which of the three methods of financing the new ferry is
the most appropriate.
10. STU Ltd is a manufacturer of specialist components for the motor industry. The
entity is based in Rosslyn, just outside of Pretoria. Its capital structure is as
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follows:
■ 5 000 000 ordinary shares of R1 each, currently trading at R12,50 per
share on the JSE
■ 10 000 000 7% redeemable preference shares of R1 each, currently
trading at R0,80 per share on the JSE
■ 200 000 8% non-redeemable debentures, secured over the entity’s noncurrent assets; these debentures are currently trading at R90 each per
R100 nominal value.
To finance expansion, the directors of STU want to raise R5 million for
additional working capital requirements. Cash flow from operations before
interest and tax is currently R15 million p.a. If the expansion goes ahead, cash
flows are expected to increase to R17 million p.a. The current rate of tax,
which is expected to continue for the foreseeable future, is 28%.
STU’s directors are currently considering three forms of finance:
■ lternative 1: Equity (ordinary shares) via a rights issue at a 20% discount
to the current market price
■ Alternative 2: 9% non-redeemable debentures of R100 each, secured
over the entity’s current assets
■ Alternative 3: Factoring the entity’s trade receivables; this is likely to
provide a once-off amount (lump sum) of cash of approximately R5
million.
Assume the following:
■ The profit after interest and tax equals cash flow.
■ The required rate of return on equity will remain at the current rate of
12% p.a. irrespective of the type of finance that is raised.
■ There are no transaction costs.
■ Shares issued during the rights issue do not need to be weighted.
■ The market price of the new 9% debentures is equal to its nominal value.
a) For the current capital structure and for Alternatives 1 and 2, calculate
the following:
■ The expected earnings per share (in cents)
■ The expected market value of the entity using the current prices provided
above
■ The expected financial gearing ratios (Interest-bearing debt ÷ [Interestbearing debt + Equity]) using market values
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■
b)
The expected WACC using market values.
Assume you are the financial manager of STU. Advise STU’s directors of
the issues to be considered before deciding on which form of finance to
choose out of the three financing alternatives outlined above. Make
reference to your calculations in a) above.
Source: Adapted from CIMA, 2005.
KEY CONCEPTS
Assessed loss: Excess of tax-deductible expenses over taxable
income.
Business angels: Individuals who invest in small start-up entities.
Crowdfunding: A mechanism that can be used by small businesses to
raise small amounts of money from a large group of investors,
typically via the Internet.
Factoring: The sale of an entity’s trade receivables to a third party
(known as the factor).
Gearing (or leverage): The amount of debt included in an entity’s
capital structure.
Invoice discounting: Involves a factor advancing approximately 75–
80% of the face value of approved sales invoices outstanding to
an entity. Invoice discounting differs from factoring in that the
trade receivables are not sold to a third party.
Lease: A contract (or part of a contract) that conveys the right to use
an asset (the underlying asset) for a period of time in exchange
for consideration.
Optimal capital structure: The capital structure that results in the
lowest possible WACC.
Private equity: Equity finance for private or unlisted entities. Private
equity deals use a high proportion of debt when making
acquisitions. The debt is capitalised on the balance sheet of the
acquired entity.
Rights issue: Situation whereby an entity offers its existing
shareholders the right to subscribe for new shares in proportion
to their current holding.
Venture capital: Finance provided to new, often high-risk ventures
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when starting up.
SLEUTELKONSEPTE
Aangeslane verlies: Die surplus van die belasting-aftrekbare uitgawes
oor die belasbare inkomste.
‘Business angels’: Welgestelde individue wat beide die tyd en geld
het om te investeer in klein, nuwe ondernemings.
‘Crowdfunding’: ’n Meganisme wat deur klein ondernemings gebruik
kan word om klein bedrae geld by ‘n groot groep beleggers in te
samel, gewoonlik via die Internet.
Faktorering: Die verkoop van ’n entiteit se handelsdebiteure aan ’n
derde party (die faktor).
Faktuur-verdiskontering: Behels dat ’n faktor ongeveer 75%–80% van
die sigwaarde van goedgekeurde verkoopsfakture aan ’n entiteit
vooruit verskaf. Faktuur-verdiskontering verskil van faktorering
aangesien die handelsdebiteure nie aan ’n derde party verkoop
word nie.
Hefboom: Die gedeelte vreemde kapitaal in ’n entiteit se
kapitaalstruktuur.
Huurkontrak: ’n Kontrak (of deel van ‘n kontrak) wat die reg verleen
om ’n bate (die onderliggende bate) vir ‘n periode te gebruik in
ruil vir teenprestasie.
Optimale kapitaalstruktuur: Die kapitaalstruktuur wat tot die laagste
moontlike geweegde gemiddelde koste van kapitaal sal lei.
Privaat-ekwiteit: Ekwiteitsfinansiering vir private of ongenoteerde
entiteite. Privaat-ekwiteit transaksies maak gebruik van ’n groot
deel vreemde kapitaal wanneer oornames gemaak word. Die
vreemde kapitaal word in die staat van finansiële posisie van
die oorgeneemde entiteit gekapitaliseer.
Regte uitgifte: Die situasie waar ’n entiteit bestaande aandeelhouers
die reg aanbied om vir nuwe aandele in verhouding tot hul
bestaande aandeelhouding aansoek te doen.
Waagkapitaal: Finansiering wat verskaf word aan nuwe, dikwels hoërisiko ondernemings wanneer hulle begin word.
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SUMMARY OF FORMULAE USED IN THIS CHAPTER
WEB RESOURCES
https://www.businesspartners.co.za
https://www.jse.co.za
http://www.savca.co.za
REFERENCES
Bloomberg. (2019). Steinhoff says French retail unit has raised new
money to stabilise firm. Fin24. Retrieved from
https://www.fin24.com/Companies/steinhoff-says-conforamahas-raised-new-money-to-stabilise-firm-20190411 [20 February
2020].
Business Day TV. (2019). Netcare warns of a cloudy outlook for
healthcare [Video]. Retrieved from
https://www.youtube.com/watch?v=7RgO1_BuZKQ [21
February 2020].
Business Partners. (2020). About the company. Retrieved from
https://www.businesspartners.co.za/en-za/about/about-thecompany [9 March 2020].
Chartered Institute of Management Accountants (CIMA). (2005).
Financial Mathematics Examination. (Question 4, November 2005).
Reprinted by permission of CIMA.
Chartered Institute of Management Accountants (CIMA). (2015).
CIMA for exams in 2015. Strategic Paper F3. London: BPP
Learning Media. Reprinted by permission of CIMA.
Cornell University. (2014). Dutch Auction IPO: How Companies Like
Google Sold Its Shares. Retrieved from
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http://blogs.cornell.edu/info2040/2014/09/20/dutch-auctionipo-how-companies-like-google-sold-its-shares/ [9 March 2020].
Gernetzky, K. (2019). Omnia falls almost 9% after giving details
about rights issue. BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/companies/industrials/201908-12-omnia-falls-almost-9-after-giving-details-about-rightsissue/ [9 March 2020].
IFRS Foundation. (2016). IFRS 16: Leases. Retrieved from
https://www.ifrs.org/-/media/project/leases/ifrs/publisheddocuments/ifrs16-effects-analysis.pdf [21 February 2020].
Copyright © 2020 IFRS® Foundation. Used with permission of
the IFRS Foundation. All rights reserved. Reproduction and use
rights are strictly limited. Please contact the IFRS Foundation for
further details at permissions@ifrs.org. Copies of IASB®
publications may be obtained from the IFRS Foundation’s
Publications Department.
Johannesburg Stock Exchange (JSE). (2020). Introducing JSE Green
Bonds, home to Africa’s Green Capital Market. Retrieved from
https://www.jse.co.za/trade/debt-market/bonds/green-bonds
[9 March 2020].
Khumalo, K. (2017). Meet SA’s newest stock exchange. IOL.
Retrieved from https://www.iol.co.za/businessreport/markets/meet-sas-newest-stock-exchange-11520706 [9
March 2020].
Mchunu, S. (2019). Taste savours shareholders’ backing of rights
offer. IOL. Retrieved from https://www.iol.co.za/businessreport/companies/taste-savours-shareholders-backing-ofrights-offer-19031849 [9 March 2020].
Naspers Ltd. (2019). Naspers announces completion of listing and
unbundling of MultiChoice Group. Retrieved from
https://www.naspers.com/news/naspers-announcescompletion-of-listing-and-unbund [9 March 2020].
Naspers Ltd. (2020). The Naspers voting control structure ensures the
continued independence of the group. Retrieved from
https://www.naspers.com/about/control-structure [9 March
2020].
Netcare Limited. (2019). Annual integrated report 2019. Retrieved
from
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https://www.netcare.co.za/InvestorReport/Netcare_annual2019/documents/annual_integrated_report_2019.pdf [21
February 2020]. NTC: Netcare Limited Role Equity Issuer
Registration No. 1996/008242/06.
Njobeni, S. (2018). Barloworld unveils a R3.5bn BEE deal.
BusinessDay. Retrieved from
https://www.businesslive.co.za/bd/companies/industrials/201811-19-barloworld-unveils-a-r35bn-bee-deal/ [9 March 2020].
Rose, R. (2018). Steinheist: The inside story behind the Steinhoff
scandal. Daily Maverick. Retrieved from
https://www.dailymaverick.co.za/article/2018-11-14steinheist-the-inside-story-behind-the-steinhoff-scandal/ [20
February 2020].
SANGONet. (2011). Are you applying ‘ethics’ in raising funds?
Retrieved from http://www.ngopulse.org/article/are-youapplying-%E2%80%98ethics%E2%80%99-raising-funds [21
February 2020]. Reprinted by permission of SANGONet.
Smith, C. (2018). Private equity investment in Southern Africa more
than doubles. Fin24. Retrieved from
https://www.fin24.com/Economy/private-equity-investmentin-southern-africa-more-than-doubles-20180727 [9 March 2020].
Startups.com. (2020). What is Crowdfunding? Retrieved from
https://www.fundable.com/learn/resources/guides/crowdfunding/what
is-crowdfunding [9 March 2020].
Strauss, D. (2019). Uber’s IPO was the biggest of 2019. Here are the
19 firms that have bought the most shares since. Markets Insider.
Retrieved from
https://markets.businessinsider.com/news/stocks/19-firmswho-have-bought-most-uber-shares-post-ipo-2019-81028450956#19-tiger-global-management1 [9 March 2020].
Tarrant, H. (2019). Taste loses its appetite, will exit Starbucks and
Domino’s. Moneyweb. Retrieved from
https://www.moneyweb.co.za/news/companies-anddeals/taste-loses-its-appetite-will-exit-starbucks-and-dominos/
[9 March 2020].
Wikipedia. (2019a). Koos Bekker. Retrieved from
https://en.wikipedia.org/wiki/Koos_Bekker [9 March 2020].
Wikipedia. (2019b). List of African stock exchanges. Retrieved from
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https://en.wikipedia.org/wiki/List_of_African_stock_exchanges
[9 March 2020].
BIBLIOGRAPHY
BPP Learning Media. (2018). CIMA Study Text, Strategic Paper F3
Financial Strategy. London: BPP Learning Media Ltd.
Correia, C., Flynn, D., Uliana, E. Wormald, M. & Dillon, J. (2019).
Financial Management (9th ed.). Cape Town: Juta.
Firer, C., Ross, S.A., Westerfield, R.W. & Jordan, B.D. (2012).
Fundamentals of Corporate Finance (5th South African ed.).
Berkshire: McGraw-Hill Higher Education.
Marx, J., De Swart, C., Pretorius, M. & Rosslyn-Smith, W. (2017).
Financial Management in Southern Africa (5th ed.). Cape Town:
Pearson Education.
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13 Distribution policy
Liezel Alsemgeest
Learning
outcomes
Chapter
outline
By the end of this chapter, you should be able to:
explain the fundamental issues addressed by an
entity’s distribution policy
discuss the major arguments in favour of and
against the distribution of an entity’s attributable
earnings to its shareholders
highlight the major theories that have been
developed to explain the distribution decisions of
entities
describe the individual elements of an entity’s
distribution policy by referring to the format,
size, stability and frequency of distributions
differentiate between ordinary and special
dividends
differentiate between cash dividends and share
dividends
discuss the dividend payment process
differentiate between the three main dividend
policies (residual, fixed dividend cover and
constant dividend growth rate)
examine stock splits and consolidations.
13.1 Introduction
13.2 Distribution policy issues
13.3 Dividend relevance versus dividend
irrelevance
13.4 Elements of an entity’s distribution
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policy
13.5 The dividend payment process
13.6 Stock splits and consolidations
13.7 Conclusion
CASE STUDY
Dividends matter
When evaluating the financial performance of an entity,
shareholders often focus on its distribution policy. An entity’s
distribution policy determines the amount of attributable
earnings that is distributed to its shareholders. For
shareholders who are interested in receiving cash, the
distribution policy contains important information about the
expected return their investment will yield. This information
could be especially valuable during periods of economic
uncertainty and turmoil in financial markets.
Research over a 90-year period indicates that a portfolio of
dividend-paying shares in the United States outperformed a
portfolio consisting of non-dividend-paying shares by an
average of 1,48% per year. The dividend-paying portfolio was
characterised by lower levels of risk (using the beta coefficient
as a measure of risk), particularly during periods of weak
economic growth.
A study in 2017 showed that several companies listed on
the Johannesburg Stock Exchange (‘the JSE’) have paid
uninterrupted dividends since listing on the exchange and
have shown sequential dividend growth of between five and
18 years. The two top dividend-paying entities in this study
were Shoprite Holdings Ltd (a retail entity) and Sanlam Ltd (a
life assurance entity). Both of these entities showed
uninterrupted dividend growth for the full 18 years under
review. Next in line were Naspers Ltd (an e-commerce and
technology entity), with 16 years, and EOH Holdings Ltd (an
IT service provider), with 15 years. Other well-known entities
include Capitec Bank Holdings Ltd (11 years), Compagnie
Financiere Richemont SA (a luxury goods holding company)
(eight years), FirstRand Ltd (a bank) (eight years), and Clicks
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Group Ltd (a pharmaceutical health and beauty retail entity),
Pick n Pay Stores Ltd (a retail entity) and Standard Bank Group
Ltd, which all showed five years of uninterrupted dividend
growth.
There are various reasons why shareholders find these
entities attractive, including the following:
• They are consistent in an inconsistent world.
• If the investor reinvested dividends into the share, the
compounded growth could lead to massive returns.
• Management only increases dividends if it knows that it can
sustain the increase. Thus, dividend growth is a message
that management envisages future profitability.
• Research has shown that on average, higher dividend
payments lead to future higher earnings growth.
There seems to be no downside to choosing consistent
dividend-paying shares. A serious investor, however,
obviously takes more into account than the fact that an entity
pays a good and frequent dividend. Simply belonging to the
list mentioned above does not mean that an entity cannot
struggle or go bust. After all, the ‘unsinkable’ Titanic is at the
bottom of the ocean.
Interestingly, Shoprite decreased its dividend payment in
2018 due to adverse market and economic conditions.
However, Sanlam, which also reported a decrease in headline
earnings of 8%, decided to increase its dividend by 8%.
Sanlam’s share price increased immediately after the
announcement of the higher dividend, but fell by a significant
percentage during the week that followed.
Due to the challenging economic environment currently
being experienced, some entities have found it difficult to
continue paying high dividends and have subsequently started
to cut dividends. Merafe Resources Ltd is one such entity. In
August of 2019, management announced that it would have to
withhold its interim dividend because of lower ore prices that
had stunted the entity’s growth in the preceding months. This
announcement came after management declared a R200million interim dividend in 2018 and a total full-year dividend
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of R351 million. After the withholding announcement was
made, Merafe shares closed 2,48% lower.
City Lodge Hotels Ltd is another entity that recently
announced lower dividend payouts. The entity declared a total
dividend per share of 366 cents in 2019, which was 19,4% lower
than 2018. After this announcement, shares in the hotel chain
closed 2,56% lower.
Sources: Compiled from information in Van Vuuren, 2018; Faku, 2019; Cokayne, 2019.
13.1
Introduction
An entity’s distribution policy reflects the approach that
management adopts towards cash distributions. In other words,
will the entity distribute some of its cash to shareholders? If the
answer to this question is yes, how big should the distribution be?
How often will shareholders receive payments? Some researchers
claim that the choice of a distribution policy has a significant effect
on the value of an entity’s shares. However, others argue that an
entity’s distribution policy does not have an impact on its share
price. The opening case study illustrates that share prices react
differently when an entity skips a dividend, lowers it or increases it.
In this chapter, we examine why shareholders react differently to
different distribution decisions.
We start off by considering the fundamental issues that form the
basis of an entity’s distribution policy. Before highlighting some of
the dividend theories that were developed in an attempt to explain
the market’s reaction to dividend payments, we present the major
arguments for and against the relevance of an entity’s distribution
policy from a valuation perspective. We then discuss details
included as part of an entity’s distribution policy, such as the
format, size, stability and frequency of the distributions. We give
specific attention to share repurchases, as this form of distribution
has become more popular in recent years. Although stock splits and
consolidations are not regarded as dividend payments, we discuss
these elements in the final section of this chapter because of their
effect on the earnings and dividend per share of an entity.
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13.2
Distribution policy issues
If an entity generates a positive attributable earnings amount, it has
a number of choices as to how it can allocate the earnings. Figure
13.1 illustrates these options.
Free cash flow (FCF) can be used to maintain the ongoing
operations of the entity (to maintain current profits), to expand
operations (to increase future profits) or to repay debts (to reduce
future finance costs). If the entity decides to retain attributable
earnings for the purpose of growth, it can do this by either
investing in new projects or investments with a positive net present
value (NPV), or by acquiring other entities.
If management decides to distribute attributable earnings, this
may be in the form of cash dividends, share dividends or share
repurchases. In the case of the latter, the entity buys back shares
from existing shareholders. If management decides to do this, the
number of outstanding shares is reduced. This means that each
remaining shareholder’s ownership stake increases, as there are
fewer shares in issue.
Figure 13.1 Allocation of attributable earnings
The decision to retain earnings or to distribute them has important
consequences for an entity. If FCF is distributed, shareholders can
decide how they want to reinvest the cash that they receive. From
the entity’s perspective, however, it means that less cash is available
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to invest in future projects, which could suppress the growth of the
entity. If FCF is retained and invested into profitable projects,
future income might increase.
In spite of this, shareholders who prefer to receive cash
dividends may view the non-payment of dividends as a negative
signal about the entity’s expected future performance. As a result,
they may appraise the entity’s shares at a lower value, which may
result in a decrease in the share price. This is exactly what was
observed in the case of Merafe in the opening case study. When it
skipped a dividend payment owing to decreased profit levels, the
entity’s share price dropped (in other words, shareholders reacted
negatively to the news). Even though management indicated that
the suspension of its dividend payments was a temporary move
necessitated by adverse market conditions and that the entity
planned to reinstate dividends as soon as market conditions
improved, the entity’s share price dropped.
You will recall that Chapter 9 looked at the valuation of
ordinary shares. If the discounted dividend model is used to value
an entity, the specific distribution policy that the entity employs
may have a pronounced effect on its valuation. To illustrate this, it
is necessary to examine the formula from Chapter 9 that was used
to determine the value of an entity’s share price (Formula 9.3):
Where:
P0 is the value of the share
D1 is the expected dividend that will be paid at the end of period 1
ke is the required return on the entity’s shares
g is the estimated dividend growth rate
When looking at this formula, it is clear that the size of the dividend
and the expected future growth in dividend payments influence the
intrinsic value of the share. Depending on an investor’s preference
for dividends, the entity’s decision to pay a dividend could,
therefore, have either a favourable or a negative impact on the
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entity’s share price. Thus, the question is what the best policy for
dividend payments is. In the opening case study of this chapter, we
saw that all entities on the list of best dividend payers increased
their dividends year on year. Two factors may have an effect on
whether shareholders perceive a dividend payment as positive or
negative: the information content and the clientele effect.
13.2.1
Information content
Information content refers to the information conveyed to the
public with a dividend announcement. An announcement may be
perceived as positive and may thus have a positive effect on the
share price. Alternatively, an announcement may be perceived as
negative and have the opposite effect. An announcement about a
change in the distribution policy of an entity may also be perceived
as either positive or negative. Share price movements can be
attributed to a change in the distribution policy of the entity and to
changes in the expected amount of future dividends. In the opening
case study, it is clear that Merafe sent out a negative signal to the
market about management’s expectations of the entity. This had a
negative impact on the entity’s share price.
In general, it is logical to expect that a dividend increase will
send a positive signal to the market, whereas a dividend cut will
send a negative signal. When a dividend increase is announced, the
signal to the market is that things are going well and that there are
funds available to increase the current income of shareholders.
When there is a dividend cut, however, this may create the
impression that the entity has not performed well and that all
available funds have to be reinvested in it. This may also be
interpreted as a signal that the entity will not be able to support the
level of dividend payments in future.
Managers (insiders) usually have more information about an
entity’s prospects than shareholders (outsiders). Consequently, a
dividend payment can be construed as an expression of
management’s confidence in the future of the entity, which explains
the strong positive relationship between the dividend
announcement and the share price. Alternatively, a dividend cut
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could convey management’s lack of confidence in the future of the
entity, which may have a negative influence on the share price.
However, this raises the issue of why Sanlam’s shareholders
initially reacted positively to the dividend announcement, but the
share price decreased during the week following the
announcement. One possible explanation is that shareholders were
satisfied with the dividend announcement, but they
understandably perceived the decrease in headline earnings as
negative, albeit at a slower-moving pace. Alternatively, it could
have been an indication that shareholders would have preferred the
entity to retain earnings.
It should be noted that share price movements are determined
by many factors, including market sentiment and shareholders’
expectations.
13.2.2
Clientele effect
Not all shareholders have the same income needs. Some
shareholders (or clientele) prefer entities that pay cash dividends,
whereas others prefer entities that reinvest earnings so that their
operations – and share prices – can grow. It would be fair to say
that retired individuals fall into the first category (that is, they tend
to favour entities that pay dividends to those that do not). They are
also more likely to invest in entities with higher dividend payout
ratios compared to those with lower dividend payout ratios. Other
shareholders prefer entities that retain attributable earnings in
search of future capital gains. You may recall that a capital gain
occurs when a share is sold at a price that exceeds the purchase
price. Shareholders in this category are typically younger investors
who may not be in need of current income. These shareholders
prefer entities with low dividend payouts, but with high capital
growth potential.
When an entity’s distribution policy changes, shareholders may
adjust their shareholding accordingly, which may influence the
share price. For instance, imagine that you bought shares in an
entity that has an extremely high dividend payout policy. You want
current income from these shares, which is why you acquired them.
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If the entity were to decide that it will no longer pay a high
dividend, you (and other like-minded shareholders) would
probably decide to sell your shares. The supply of the share will,
therefore, increase, which may result in a decrease in the share price
(as was experienced in the case of Merafe).
13.2.3
Homemade dividends
If we assume that markets are perfectly efficient and that there are
no transaction costs or taxes, then shareholders who are dissatisfied
with the dividend payments of a particular entity can create
homemade dividends to satisfy their specific desires. Imagine, for
instance, that an investor wants current income in the form of
dividends from their investment in Lazy Leopard Ltd. The investor
expects R2 000 in dividends on date 1 and R1 000 in dividends on
date 2. The earnings can be invested at a rate of 10%. What would
the investor do if they instead received R1 900 on date 1 and R1 110
on date 2?
An investor who wanted a cash flow of R2 000 on date 1, but
only received R1 900, might sell shares worth R100 to make up the
total of R2 000. Because the investor gave up R100 worth of shares,
this means that they could have earned a total of R110 (R100 × 1,10).
Thus, the investor would receive R1 110 as a dividend on date 2,
but because they gave up R110, they would in fact have a net
dividend of R1 000 (R1 110 − R110).
In contrast, let us consider an investor who also expects
dividends of R2 000 and R1 000 on dates 1 and 2, respectively. If the
entity declared a dividend of R2 200 on date 1 and R780 on date 2,
the investor could simply take the extra R200 received at date 1 and
invest it at 10%. This will earn the investor R220 (R200 × 1,10). At
date 2, when the investor receives the dividend of R780, they
simply need to add the additional R220 earned as part of the
previous dividend as well as the interest earned on it, giving a total
cash flow of R1 000 (R780 + R220).
These examples indicate that even if shareholders are
dissatisfied with an entity’s dividend payments, it is possible for
them to create their own homemade dividends to suit their specific
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needs. However, it is important to note that the example in the
previous paragraph does not take transaction costs or taxes into
consideration. If these market imperfections were taken into
account, the matter would not be as simple as indicated here.
Another important aspect to keep in mind is that many
shareholders are not happy to sell their shares to create the
homemade dividends that they require. People are complex
creatures. The behavioural finance concept of mental accounting
suggests that people have separate mental accounts for income
(such as dividends, salary and commission) and capital (such as
shares, property or any other investment). People would rather
spend from their ‘income’ account than from their ‘capital’ account.
QUICK QUIZ
1. Explain a dividend’s information content
effect.
2. Interpret the clientele effect.
3. Discuss homemade dividends.
4. Explain whether a dividend announcement has
the same impact today as it had 20 years ago.
Keep in mind that shareholders now have access
to much more information about entities,
industries and economies. Information has not
only become more easily accessible, but also
significantly cheaper.
13.3
Dividend relevance versus dividend irrelevance
Are dividends important? To answer this question, it is important
to know exactly what a distribution policy entails. The most
important question is whether an entity’s distribution policy calls
for a dividend to be paid or, instead, requires that its attributable
earnings be retained for the sake of growth. Thus, the entity can
have a high dividend payout ratio (pay out most of its attributable
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earnings as dividends) or a low ratio if it decides to distribute fewer
dividends. It may even decide to pay no dividends and to retain all
earnings.
There are two major schools of thought when it comes to the
effect of dividend payments on an entity’s value: those who are of
the opinion that dividend payments are relevant and those who
believe that they are irrelevant. This section examines these two
opposing theories.
13.3.1
Dividend irrelevance
In 1961, Merton Miller and Franco Modigliani published a
theoretical paper on dividend policy, growth and the valuation of
shares. (M&M, as these authors are commonly called, were also
mentioned in Chapter 12 in relation to capital structure decisions.)
In their dividend paper, they argued that if a market is efficient (in
other words, all information – both internal and external – is
reflected in the share price), and if we ignore taxes, flotation costs
and transaction costs, then the dividend payments of an entity will
have no effect on the value of a share. (Refer to Chapter 9 to revise
the characteristics of an efficient market.)
According to M&M’s theory of dividend irrelevance,
shareholders can buy or sell shares and create their own dividend
policy. Unfortunately, this theory is based on a set of implausible
assumptions, including the following:
• Personal income taxes or corporate income taxes do not exist.
• There are no flotation or transaction costs when an entity issues
shares.
• Dividend policy has no impact on an entity’s capital budgeting.
• Information about future prospects is readily available to all
shareholders.
• Leverage has no impact on the cost of capital of an entity.
M&M thus theorised that only an entity’s ability to generate free
cash flow and the risk associated with the activities in cash
generation are important when determining the value of an entity.
Thus, if an entity paid a smaller dividend (or no dividend) than a
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shareholder expected, that shareholder could sell some shares to
generate cash flow. If the dividend were higher than expected, the
surplus amount could be reinvested (as explained earlier). These
assumptions are definitely not practical in the real world. Although
information is indeed readily available to shareholders, entity
insiders are likely to have access to superior information than the
average shareholder. In addition, as mentioned earlier,
shareholders do not really want to have to sell their shares for
income. Thus, while M&M’s theory is theoretically plausible, it does
not hold water in the real world. Dividends are, therefore, relevant.
13.3.2
Dividend relevance
The most important thing to understand about M&M’s dividend
irrelevance theory is the assumption that all shareholders are
indifferent (that is, they have no preference for capital gains over
cash dividends or the other way around). We know that this is not
always the case. Shareholders are not all the same: some prefer a
current income, while others prefer capital gains. We also know
that we do not generally deal in efficient markets and that there are
real-world factors, such as taxes and costs, that render a market
imperfect.
There are various explanations used to justify why dividend
payments should be regarded as relevant.
• The ‘bird-in-the-hand’ explanation: This theory stems from the
old proverb, ‘A bird in the hand is worth two in the bush.’ This
proverb, which originated in the 15th century, probably meant
that it was better for a hunter to hold onto something (one bird
with which to feed their family) than to risk losing it by trying to
get something better (two birds), as they might end up with
nothing. The proverb essentially warns against taking risks. In
the context of this chapter, the proverb can be understood as
cautioning us that it is better for a shareholder to receive a
dividend than to hope for a capital gain should the entity retain
its earnings. It is important to note that this theory implies that
shareholders discount the expected capital gain yield at a higher
rate than the dividend yield. Entities that have a high dividend
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•
•
•
•
payout (and thus a low expected capital gain yield) can pay
shareholders who prefer a high current payout a lower total rate
of return than entities that have a low dividend payout.
The information content/signalling explanation: This is when
the dividend announcement is used to communicate
information to shareholders about the entity (see Section 13.2.1
for a more in-depth explanation). An entity’s choice of
distribution policy is therefore interpreted as a signal about
management’s view of its expected future performance.
The tax-preference explanation: According to this theory, the
distribution policy is relevant because in South Africa, both
dividends and capital gains are subject to tax. However, since
the payment of capital gains tax is delayed until the shares are
sold, shareholders may prefer capital gains to dividends.
The agency explanation: This theory states that if attributable
earnings are retained within an entity, a situation may occur in
which management does not use the retained funds optimally.
A way of reducing the cost related to the principal–agent
relationship is to have a higher dividend payout ratio. The
rationale behind this theory is that the increased scrutiny of the
management of the entity by the suppliers of capital leads to
better management behaviour (additional monitoring is part
and parcel of outside financing). Paying larger dividends
reduces resources subject to management discretion, forcing the
entity to seek more external financing. When an entity engages
in a rights issue, management is usually evaluated critically (a
situation that some managers prefer to avoid).
The catering explanation: According to this relatively recent
adaptation of the clientele theory (see Section 13.2.2 for a more
in-depth explanation of the clientele effect), entities may actually
design their distribution policies to align their cash distributions
with the requirements of their largest shareholders. In situations
where shareholders require large cash distributions, entities
consequently increase their cash dividends. If shareholders
prefer to benefit from increased future capital gains, entities
choose to reinvest a larger portion of their attributable earnings
to stimulate future growth. With reference to the opening case
study, Sanlam could be considered as an example of an entity
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that ensures that it maintains the dividend payments that are
required by its shareholders, even though the headline earnings
decreased in 2018.
If we lived in a world with no market imperfections in which
shareholders were indifferent towards both dividends and capital
gains, the distribution policy of an entity would not have an
influence on the return received by shareholders. However, in a
real-world context in which we have to deal with costs and taxes,
dividend payments do seem to have an impact on the value of a
share.
In the section that follows, we introduce the four elements of an
entity’s distribution policy.
QUICK QUIZ
1. Discuss whether or not dividend payments are
relevant.
2. Describe some of the major explanations
justifying the relevance of an entity’s
distribution policy.
13.4
Elements of an entity’s distribution policy
An entity’s distribution policy usually describes the format of the
distribution that will be made to shareholders, the size of the
distributions, the stability of distributions and the frequency with
which they will occur. We discuss each of these elements in more
detail below.
13.4.1
Format of the distribution
The main types of distribution that JSE-listed companies usually
consider are cash dividends (these could be ordinary or special
dividends), share repurchases and share dividends.
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13.4.1.1 Cash dividends
Most entities distribute part (or all) of their attributable earnings to
their shareholders in the form of cash dividend payments. As we
saw earlier in the chapter, some shareholders prefer to receive a
cash dividend, while others are more interested in capital gains.
Trends in the propensity to pay cash dividends
Although cash dividends have historically made up a substantial
proportion of long-term shareholders’ total returns, a number of
recent studies have reflected a declining propensity among entities
to pay cash dividends. In the first major study on the topic, Fama
and French (2001) showed that the percentage of industrial entities
in the United States paying cash dividends decreased from 66,5% in
1978 to 20,8% in 1999. Since Fama and French’s ground-breaking
study, a number of researchers have investigated the phenomenon
of ‘disappearing dividends’. Table 13.1 illustrates Baker and
Weigand’s (2015) ‘disappearing dividends’ in the United States.
Table 13.1 The changing relationship between total returns, capital gains and dividend yields
(1801–2012)
Source: Baker & Weigard, 2015: 130.
It is clear from Table 13.1 that dividends (as a percentage of return)
have decreased significantly over time. It seems unlikely that there
will be a change in this trend in the future.
Fatemi and Bildik (2012) evaluated the dividend payment
patterns of listed companies in 33 countries (including South
Africa). They established a significant decline in the propensity to
pay dividends across all 33 countries over the period 1985 to 2006
and hence concluded that “the disappearance of dividends seems to
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be a worldwide phenomenon” (2012: 664).
The South African dividend distribution landscape has changed
significantly as a result of the promulgation of the Companies
Amendment Act (No. 37 of 1999). South African entities have been
allowed to repurchase their shares since the middle of 1999.
Dividend-withholding tax (DWT) was introduced in April 2012,
meaning that the dividend is taxed in the hands of the shareholder
and not of the entity. This introduction was intended to make South
Africa a more attractive investment destination by eliminating the
double taxation on dividends. This tax amendment was also
expected to increase dividend payouts by entities, resulting in
South Africa not necessarily mirroring the decline of cash dividends
experienced by the rest of the world.
Figure 13.2 illustrates the dividend payout trends of the JSE
from the period 1999 to 2014.
Figure 13.2 Dividend payout trends of the JSE (1999–2014)
Figure 13.2 indicates that there was a definite increase in dividend
payments after 2012 due to the tax amendments. Wesson, Hamman
and Bruwer (2015) have attributed the decreasing propensity to pay
cash dividends globally to the surge in share repurchases.
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13.4.1.2 Special dividends
Also called an extra dividend, a special dividend is usually paid
only under exceptional circumstances. It is a non-recurring
dividend and is set apart from the typical recurring dividend cycle.
A special dividend is normally paid due to the selling of an asset or
any other special windfall (for example, a larger-than-expected
profit for a specific year). The reason it is declared as a special
dividend and not an ordinary dividend is due to the fact that any
increase in the ordinary dividend will raise shareholders’
expectations that the dividend increase will continue in the future.
Thus, the special dividend is communicated as a one-time event.
Researchers have found that the announcement of a special
dividend affects an entity’s share price in a similar way to the
announcement of an ordinary dividend. Although the
announcement of a special dividend may convey positive
information to the market, it has a lower signalling impact than the
information conveyed by an increase of an ordinary dividend.
A good example of a special dividend involved Exxaro
Resources, the entity that supplies Eskom, the national electricity
provider, with coal. The entity announced a special dividend of 897
cents per share in 2019 in light of the sale of 26% of its membership
interest in an entity called Tronox (Hedley, 2019).
13.4.1.3 Share repurchases
An entity may also decide to distribute attributable earnings to its
shareholders in the form of a share repurchase. A share repurchase
is similar to a cash dividend in the sense that the entity makes a
cash payment to its shareholders. However, an important difference
between a cash dividend payment and a share repurchase is that a
share repurchase results in a decline in the number of issued shares.
This could have a positive effect on the entity’s earnings per share
(EPS), since the earnings are distributed among a smaller number of
shares after a share repurchase than previously. It is important to
note that this positive effect on the EPS is artificial, since the
increase did not occur as a result of economic value-creation
activities, such as increased earnings or decreased costs.
Some of the reasons attributed as motives for an entity to engage
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in a share repurchase • include the following:
• increasing the entity’s degree of financial leverage
• warding off potential hostile bidders in acquisition transactions
• attempting to time the equity market so that the entity benefits
by increasing its value as a result of undervalued share prices.
Chen and Chou (2015) argue that an entity’s leverage is affected by
its EPS and that many managers decide to use share repurchases as
a way of boosting EPS. They are usually motivated by the fact than
this boost in the EPS (although artificial) could benefit them
personally through performance bonuses and an increase in the
value of their own shares.
As mentioned earlier, South African entities have only been
allowed to repurchase their ordinary shares since July 1999.
Although some researchers argue that the decision to get involved
in a share repurchase might partly explain the overall decline in the
propensity to pay cash dividends, a study by Nyere and Wesson
(2019) indicates that entities involved in specific share repurchases
did not drop their dividend payout ratios significantly.
There are different ways in which an entity can repurchase its
ordinary shares. These include tender offers to its existing
shareholders, purchasing its own shares on the open market or a
negotiated buyback with a large shareholder.
Trends in share repurchases
Grullon and Michaely (2002) show that share repurchases have not
only become an important form of payout for entities in the United
States, but also that entities finance their share repurchases with
funds that would otherwise have been used to increase dividends.
These authors found that young entities in particular favour share
repurchases over cash dividends. Although large, established
entities in Grullon and Michaely’s study did not cut their dividends
over the period 1980 to 2000, many showed a higher propensity to
distribute cash through share repurchases.
According to Chivaka, Siddle, Bayne, Cairney and Shev (2009),
South African entities were likely to follow the international trend
of increasingly substituting cash dividends for share repurchases.
Surprisingly, the data showed that the South African situation did
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not exactly mirror that of its global counterparts. A study by
Wesson, Hamman and Bruwer (2015) found that although share
repurchases have become more popular since 2005, dividend
payouts were still the most popular form of payout method for
South African entities. These results corresponded with the results
from the study by Nyere and Wesson (2019), as can be seen in
Figure 13.2. Research on the nature and size of share repurchases in
South Africa is complicated, however, as amendments to the
Companies Act (No. 71 of 2008) introduced a number of unique
reporting challenges (Bester, Hamman, Brummer, Wesson & SteynBruwer, 2008; Bester, Wesson & Hamman, 2012).
Example 13.1 illustrates the effect of a share repurchase for the
shareholder.
Example 13.1 Understanding the effect of a share repurchase
You own 150 000 shares in Liquid Lizard Ltd, which has a total of one million
shares outstanding. The entity decides to repurchase 200 000 shares at R5
per share (the current share price is R4) at a total cost of R1 million. This
decreases the number of shares outstanding to 800 000. If the entity has
attributable earnings of R12 000 000, the EPS before the share repurchase
will be 12 (R12 000 000 ÷ 1 000 000 shares). If the number of shares
outstanding changes to 800 000, the new EPS after the share repurchase will
be 15 (R12 000 000 ÷ 800 000 shares). A share repurchase increases the
EPS, even if attributable earnings remain the same because of the decrease in
the number of shares held by the public. In essence, the shareholders are
interested in their specific shareholding. By repurchasing shares, the entity
manages to increase the EPS of the shareholders, maximising the
shareholders’ wealth.
13.4.1.4 Share dividends
An entity may decide to issue dividends in the form of shares rather
than cash. This entails the entity issuing more shares to existing
shareholders in a predetermined ratio. Although shareholders end
up with more shares, their total investment is worth more or less
the same, since the total value of the entity now has to be
distributed among more shareholders than before. A great
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advantage of receiving shares as dividends rather than cash is that
there are no immediate tax consequences for the investor when
share dividends are declared, as in the case of cash dividends. Also,
because the investor now owns more shares, possible future
earnings could be maximised, as dividends are paid as a value
multiplied by the number of shares held. Capital gains tax will only
have to be paid when the shares are eventually sold.
Example 13.2 illustrates the implications of a share dividend.
Example 13.2 Understanding the implications of a share dividend
Suppose that Liquid Lizard Ltd has decided to declare a 15% share dividend to
its existing shareholders. This means that for every 100 shares owned, the
investor will receive 15 extra shares in the entity.
If you owned a total of 150 000 shares in this entity, you would receive an
extra 22 500 shares (150 000 × 15%), increasing your total number of shares
to 172 500 shares. This would mean that the entity would have to increase its
total shares in issue by 15%. If the entity had one million shares outstanding at
a price of R5 a share before the share dividend was declared, it would have to
issue an additional 150 000 shares to its existing shareholders (resulting in a
total of 1 150 000 shares outstanding after the share dividends were issued).
If nothing else changed within the entity, the shareholding would increase by
15%, but because of the rise in the number of shares outstanding, the share
price would also drop. The new share value would be around R4,35 per share
(1 million × 5 ÷ 1 150 000 = R4,348).
Thus, if you owned 150 000 shares in Liquid Lizard at a price of R5, your
investment would be worth a total of R750 000 before the share dividend took
place. If your shareholding increased by 15%, but the share price decreased to
R4,348, your total investment would still amount to R750 030 (172 500
shares × R4,348).
FOCUS ON ETHICS: Steinhoff’s share
repurchases
On 5 December 2017, the chief executive officer (CEO) of Steinhoff
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International Holdings NV, Marcus Jooste, resigned following reported
accounting irregularities. Immediately after the announcement, the
share price dropped by 66%, plummeting a further 90% after it was
discovered that Steinhoff had inflated profits and assets by a
staggering US$12 billion. In March 2019, the share price was still
96% down from its original value.
During 2017, Steinhoff repurchased 78,4 million shares in a
transaction valued at R5 billion. The substantial cash outlay took place
just weeks after Steinhoff’s audit committee was alerted to potential
problems by Deloitte. Although it is not uncommon for entities to
repurchase their shares, this appears to have been the first
repurchase by Steinhoff since its listing in Frankfurt in 2015. At the
time of the repurchase, the share price was R61 per share, which was
higher than the entity’s net asset value of R51,12.
The management of Steinhoff has had a disturbing track record of
initiating share repurchases when share prices are at their highest and
their motive for doing so is not necessarily in ordinary shareholders’
best interests. Perhaps, with the benefit of 20/20 hindsight, one can
speculate about whether Steinhoff executives may have started the
share repurchases in an attempt to drive up the share price. Share
repurchases can be used as a tool for capital management, but they
can also be used to manipulate an entity’s share price or to show an
inflated EPS.
Sources: Compiled from information in Planting, n.d.; Crotty, 2018.
13.4.2
Size of the distribution
Once an entity has decided on the format of the distribution, it also
needs to decide on the size of that distribution. Some entities (such
as Shoprite) are well known for the large cash distributions (the
total monetary value of the cash dividend [ordinary or special] or
the share repurchase) that they make to their shareholders.
Analysts point out that Shoprite’s decision to cut these high
dividend payments during the market uncertainty in 2018 and 2019
was the main reason for the large drop in its share price, indicating
that the size of the cash distribution needs to be determined with
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care.
In contrast to an entity that maintains a high dividend payout
ratio, some entities decide to retain all their attributable earnings.
These entities usually argue that they have access to a large number
of profitable investment opportunities and that the high degree of
reinvestment contributes to the creation of shareholder value
(capital gains) in future. A zero-dividend-per-share (DPS) policy is
very often followed by young, fast-growing entities. A good
example of such an entity is Stadio Holdings, which was
established in 2016, but has yet to pay a dividend to shareholders
(Fin24, 2019). These entities usually choose to reinvest as much of
their attributable earnings as possible. However, shareholders
should be careful: an entity with a dividend payout ratio (DPR) of
0% might be viewed as an entity that is under financial strain and
has insufficient earnings to afford a dividend payment. While the
former group of 0% DPR entities is expected to exhibit high growth
in future, the latter group, those that may be under financial strain,
may fail to earn a return.
According to Kantor (2019), the dividend payout ratio of JSElisted companies increased much faster than earnings over the
period 1995 and 2016. Over this period, the average DPR per year
was 40%. This ratio stands at about 60% in 2019. This observation is
illustrated in Figure 13.3, which shows the JSE All-Share Index,
earnings and dividends per share for 2012 to 2018.
Figure 13.3 JSE All-Share Index, earnings and dividends per share (2012–2018; 2012 = 100)
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The year-on-year growth rates of earnings versus dividends are
presented in Figure 13.4. The figure shows that from the latter part
of 2017, the growth rates of dividends were higher than those of
earnings, which pushed the average DPR higher.
Figure 13.4 JSE growth in All-Share Index earnings and dividends per share (2012–2018)
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QUICK QUIZ
1. Differentiate between a share dividend and a
cash dividend.
2. Discuss the two main forms of cash
distribution and explain how they differ from
each other.
13.4.2.1 The residual distribution model
When determining the size of their dividend payments, some
entities choose to follow the residual distribution model. This
model states that dividends will only be paid to shareholders if all
other financially feasible investment opportunities (in other words,
projects with a positive NPV) have been financed. Imagine, for
instance, that Sarah wants to buy an iPad. She does not want to use
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credit to obtain it, so she decides that she will buy the iPad if she
has enough money left at the end of the month. If she does not have
enough money left at the end of the month, she will have to save a
little bit more. The same principle applies to entities following this
dividend distribution model: if there are no funds available in a
particular period after all other opportunities have been paid for,
the shareholders do not receive a dividend.
Imagine you own shares in Dougie’s Doughnuts Ltd. As an
investor, you can only earn interest on funds up to 12%. However,
Dougie’s Doughnuts intends investing in a project with a positive
NPV that will earn the entity an internal rate of return of 24%.
Would it be better for you to receive the dividends and invest the
amount at 12% or for the entity to retain attributable earnings and
finance the project that will earn 24%? The answer is easy: if the
entity can earn more than the shareholder, it would be better for
both the entity and the shareholder if the attributable earnings were
retained and invested in the identified project.
Imagine that a specific entity has a list of possible capital
expenditure projects with positive NPVs lined up for the future.
Let’s say that the entity needs R10 million to upgrade machinery
and buy new equipment for 2020, for example. The entity generated
R12 million in attributable earnings for the 2019 financial year.
According to the residual d