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Management Accounting: Standard Costing & Variance Analysis
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MANAGEMENT ACCOUNTING 378 MADE BY TAKINGNOTESU.COM Effy WWW.TAKINGNOTESU.COM STANDARD COSTING AND VARIANCE ANALYSIS Q P DIRECT MATERIAL Direct material units Budgeted manufactured units Direct material cost Direct material units QxP DIRECT LABOUR Labour hours Budgeted manufactured units Labour cost Labour hours QxP VARIABLE OVERHEADS Absorption (E.g. Labour hours) Variable manufacturing overheads E.g. Labour hours QxP FIXED OVERHEADS Absorption (E.g. Labour hours) Fixed manufacturing overheads E.g. Labour hours QxP STANDARD COST PER UNIT Input Opening balance Started anew Output Closing balance Completed = COST ELEMENT DIRECT MATERIAL CONVERSION COST (Direct labour, variable & fixed manufacturing overheads) = COMPLETED UNITS LESS: OPENING BALANCE CLOSING BALANCE Completed units Opening balance X Material opening output % Closing balance X Material closing output % Completed units Opening balance X Conversion cost opening output % Closing balance X Conversion cost closing output % TOTAL EQUIVALENT UNITS Completed units less opening balance Add: Closing balance Completed units less opening balance Add: Closing balance Price = AQ(SP – AP) Usage = SP(SQ – AQ) Direct costing system Absorption costing system (Actual sales volume – Budgeted sales volume) x (Budgeted selling price – Standard cost per unit) (Actual sales volume – Budgeted sales volume) x (Budgeted profit / Budgeted manufactured units) BUDGETED PROFIT Sales volume variance FLEXIBLE BUDGET Sales price variance (Actual selling price – Budgeted selling price) x Actual sales volume Material usage variance [(Actual equivalent material units manufactured x Q) – Actual direct material units] x P Material price variance Actual direct material units x (P – AP) Labour usage variance [(Actual equivalent conversion units manufactured x Q) – AQ] x P Labour price variance [(Actual equivalent conversion units manufactured x AQ x (P – AP) Variable overhead usage variance [(Actual equivalent conversion units manufactured x (Q – AQ) x P Variable overhead price variance [(Actual equivalent conversion units manufactured x AQ x (P – AP) Fixed overhead spending* variance Budgeted fixed overheads – Actual fixed overheads Budgeted fixed overheads – Actual fixed overheads Fixed overhead volume capacity* variance (Budgeted hours – Actual hours) x P Fixed overhead volume efficiency variance [Actual equivalent conversion units manufactured x Q) – Actual hours] x P Fixed overhead production volume variance Capacity + Efficiency ACTUAL PROFIT Over/(under) recovery = Spending* – Capacity* OR [(Actual hours x Q) – Actual fixed overheads] Sales volume variance Sales quantity variance Sales mix variance Market share variance Sales volume variance • • • • (Actual sales volume – Budgeted sales volume) x (Budgeted selling price – Standard cost per unit) Market size variance (Actual sales volume – Budgeted sales volume) x (Budgeted profit / Budgeted manufactured units) Sale contracts? = NO variance (investigate) Poor economic conditions Competitors Manufacturing problems Criticisms • • • • • • some writers question their usefulness, on the grounds that in an imperfectly competitive market structure, prices and quantities are interrelated lower/higher sales prices is higher/lower volume thus, the relevant analysis based on these variances are also interrelated consequently, it is argued that sales variance analysis does not generate any meaningful results BUDGETED SALES VOLUME (X) ACTUAL SALES VOLUME Prod 1 Units (1) Units (3) Prod 2 Sales mix variance Units (2) Units (4) TOTAL UNITS (1) TOTAL UNITS (2) (Y) STANDARD SALES VOLUME TOTAL UNITS (2) x Units (1) TOTAL UNITS (1) TOTAL UNITS (2) x Units (2) TOTAL UNITS (1) TOTAL UNITS (2) (Z) DIFFERENCE (A) CONTRIBUTI ON PER UNIT VARIANCE (X) – (Y) SP – SC (Z) x (A) (X) – (Y) (Z) x (A) TOTAL VARIANCE Prod 2 Prod 1 Sales quantity variance (Y) STANDARD SALES VOLUME TOTAL UNITS (2) x Units (1) TOTAL UNITS (1) TOTAL UNITS (2) x Units (2) TOTAL UNITS (1) TOTAL UNITS (2) (B) BUDGETED SALES VOLUME (Z) DIFFERENCE Units (1) (Y) – (B) (Z) x (A) Units (2) (Y) – (B) (Z) x (A) TOTAL UNITS (1) (A) CONTRIBUTION PER UNIT VARIANCE TOTAL VARIANCE Market size Actual market size Budgeted market size Difference A B A–B=D Budgeted market share Budgeted sales /B =E Contribution per unit Total contribution / budgeted sales Variance Ex Contribution • Market size variance indicates that an (F) additional or (A) less contribution of R… was expected, given that the market (F) expanded or (A) shrunk from B to A units • Overall market strengthened or weakened = due to what? Poor economic conditions o Luxury product = limited market Market share Actual market share Actual sales / A =F Budgeted market share Budgeted sales / B =G Difference Actual market size F–G XA Contribution per unit Total contribution / budgeted sales • The company (F) did [ (A) not ] attain the predicted market share of G% o [ (A) Instead, a market share of F% was attained, and the (F – G)% decline in market share, resulted in a failure to obtain a contribution of R… • Increased or decreased their market share = due to what? Adding new products? Etc… Labour usage variance Productive hours Labour usage variance Unproductive hours = [(Actual equivalent conversion units manufactured x (Q – AQ) x P Therefore, the AQ is, = Actual hours / Actual equivalent conversion units manufactured = 2 280 / 1 200 = 1,9 = 1 200 x (2 – 1,9) x 10 = 1 200 (F) PRODUCTIVE 2280 – 120 = 2 160 hours Therefore, the productive quantity is, = 2 160 / 1 200 = 1,8 = 1 200 x (2 – 1,8) x 10 = [(Actual hours – productive hours) x P] = 2 400 (F) UNPRODUCTIVE (Adverse) 120 hours = 120 x 10 = 1 200 (A) VARIANCE ANALYSIS STEP 1 Raw material Labour Quantity per kg, hour raw material units budgeted manufacturing units number of hours budgeted manufacturing units Variable overhead Absorption rate (Same as labour usually) Fixed overhead Absorption rate (Same as labour usually) Price per kg, hour raw material cost raw material units labour cost number of hours variable manufacturing overheads cost number of hours fixed manufacturing overheads cost number of hours Standard cost per unit QxP QxP QxP QxP STANDARD COST PER UNIT • Variable overhead and fixed overhead could potentially be given together as one R value, and is then required to be solved o HIGH-LOW METHOD Production volume (units) X LOWEST X HIGHEST X Maintenance costs (Rand value) Y LOWEST Y HIGHEST Y Y = A + B(X) B = HIGHEST Y – LOWEST Y HIGHEST X – LOWEST X Therefore, substitute B into Y = A + B(X) to solve A, and X = LOWEST X or HIGHEST X Y = LOWEST Y or HIGHEST Y Therefore, B is solved, and B equals variable overhead per unit A is solved after substitution, and A equals fixed costs Variable overhead and fixed overhead could potentially be given together as one R value, less B equals fixed overhead per unit WWW.TAKINGNOTESU.COM STEP 2 Input Opening balance Started anew Output Closing balance Completed Normal losses STEP 3 Cost element Direct material Conversion cost (direct labour, variable & fixed manufacturing overheads) Completed units Less opening balance Completed units Completed units Completed less OB Closing balance X Material closing output % Opening balance Opening balance Closing balance X Conversion cost closing output % WWW.TAKINGNOTESU.COM Closing balance X Conversion cost closing output % Total equivalent units Completed units Plus: normal loss Plus: abnormal loss Plus: closing balance Completed units Plus: normal loss Plus: abnormal loss Plus: closing balance STEP 4 Direct costing system Budgeted profit Sales volume variance • F budget < actual • A budget > actual Flexible budget Sales price variance • F sold at higher price • A sold at lower price Material usage variance • F used less • A used more direct material Material price variance • F paid less • A paid more for raw material Labour usage variance • F used less • A used more hours Labour price variance • F paid less • A paid more for labour Variable overhead usage variance • F used less • A used more hours Variable overhead price variance • F spent less • A spent more on overheads Fixed overhead spending • F spent more • A spent less Fixed overhead volume capacity • F actual > budgeted • A actual < budgeted Fixed overhead volume efficiency • F actual < standard • A actual > standard Actual profit 1. (Actual sales volume – budgeted sales volume) x (budgeted selling price – standard cost per unit) Absorption costing system 2. (Actual sales volume – budgeted sales volume) x (budgeted profit/budgeted manufactured units) 3. (Actual selling price – budgeted selling price) x actual sales volume 4. [(Actual equivalent material units manufactured x Q) – actual raw material units] x P 5. (Actual raw material units purchased x P) – (actual raw material units purchased x actual P) 6. [(Actual equivalent conversion units manufactured x Q) – actual usage] x P 7. (Actual hours x P) – (actual hours x actual P) 8. [(Actual equivalent conversion units manufactured x Q) – actual hours] xP 9. (Actual usage x P) – (actual hours x actual P) 10. Budgeted fixed manufacturing overheads – actual fixed manufacturing overheads 10. Budgeted fixed manufacturing overheads – actual fixed manufacturing overheads 11. (Budgeted hours – actual hours) x P 12. Actual equivalent conversion units manufactured x Q) – actual hours) x P WWW.TAKINGNOTESU.COM Mixture variance Product A Product B Product C Standard quantity p/u 0.1kg 0.07kg 0.1kg 0.27kg Actual Issuance 32kg 27.3kg 46kg 105.3kg 105.3 x ? / 0,27 39kg 27.3kg 39kg Variance 7kg (7kg) Standard cost p/kg R20 R40 R225 Variance R140 (R1 575) (R1 435) Yield variance Actual quantity of raw materials issued Standard manufacturing for issued raw materials (105.3kg / 0.27kg) Actually manufactured Variance Standard cost per unit (R2 + R2.80 + R22.50) Adverse variance (27.3 x 10) Budgeted profit Sales volume variance Flexible budget Sales price variance Material usage variance △ Material price variance ▲ Labour usage variance ☆ Labour price variance ★ Variable overhead usage variance ○ Variable overhead price variance ! Fixed overhead spending ✚ Fixed overhead volume capacity ☼ Fixed overhead volume efficiency ⚯ Actual profit 105.3 kg 390 kg 380 units (10) units R27.3 (R273) ACCOUNT CONTRA ACCOUNT IS VARIANCE DEBIT CREDIT No entry – – No entry Work-in-progress Material Work-in-progress Labour Work-in-progress Variable overheads Fixed overheads Fixed overheads Work-in-progress – +F +F +F +F +F +F +F +F +F – -A -A -A -A -A -A -A -A -A WWW.TAKINGNOTESU.COM GENERAL LEDGER DR Opening balance @ standard cost Bank (purchases @actual cost) Material price variance (F) ▲ MATERIAL CR Material price variance (A) ▲ Work-in-progress (actual quantity @standard cost) Closing balance @ standard cost DR Wages Labour price variance (F) ★ LABOUR CR Labour price variance (A) ★ Work-in-progress (actual hours @standard cost) DR VARIABLE OVERHEADS CR Bank (actual variable overheads) Variable overhead price variance (A) ! Variable overhead price variance (F) ! Work-in-progress (balancing) DR Bank (actual fixed overheads) Fixed overhead spending (F) ✚ Fixed overhead volume capacity (F) ☼ FIXED OVERHEADS CR Fixed overhead spending (A) ✚ Fixed overhead volume capacity (A) ☼ Work-in-progress (absorption rate @standard cost) DR Material Material usage variance (F) △ WORK-IN-PROGRESS CR Material usage variance (A) △ Labour Labour usage variance (F) ☆ Labour usage variance (A) ☆ Variable overheads Variable overhead usage variance (F) ○ Variable overhead usage variance (A) ○ Fixed overheads Fixed overhead volume efficiency (F) ⚯ Fixed overhead volume efficiency (A) ⚯ DR VARIANCE ACCOUNT CR Material usage variance (A) △ Material usage variance (F) △ Material price variance (A) ▲ Material price variance (F) ▲ Labour usage variance (A) ☆ Labour usage variance (F) ☆ Labour price variance (A) ★ Labour price variance (F) ★ Variable overhead usage variance (A) ○ Variable overhead usage variance (F) ○ Variable overhead price variance (A) ! Variable overhead price variance (F) ! Fixed overhead spending (A) ✚ Fixed overhead spending (F) ✚ Fixed overhead volume capacity (A) ☼ Fixed overhead volume capacity (F) ☼ Fixed overhead volume efficiency (A) ⚯ Fixed overhead volume efficiency (F) ⚯ Profit and loss (balancing) Profit and loss (balancing) WWW.TAKINGNOTESU.COM DISPOSITION OF VARIANCES After the disposition of variances, all inventory should be valued at actual costs CARRIED AT ACTUAL • COS • FG • WIP CALCULATE EQUIVALENT UNITS = COMPLETED LESS OB + CB @% Material price variance AQ(SP – AP) Material usage variance SP(SQ – AQ) Conversion variances • Labour variances (PRICE + USAGE) • Variable overhead variances (PRICE + USAGE) COS, less FG OB • FG o OB o Completed o (Sold) = COS, less FG OB o CB FG • FG @CB WIP • Materials: WIP x Material (100) % • Conversion: WIP x Conversion % Total + COS + FG + WIP (RM and conversion shall differ as above) = TOTAL Determine the ratios • COS/TOTAL • FG/TOTAL • WIP (RM or CONVERSION)/TOTAL Disposition MATERIAL CONVERSION COS, FG, WIP (PRICE + USAGE) COS, FG, WIP (LABOUR + VARIABLE) x Material price variance x Labour usage + price, variable overhead usage + x Material usage variance price WWW.TAKINGNOTESU.COM Journals, from the above ratios @ the particular variances Material price variance FAVOURABLE DR Variance CR COS CR FG CR WIP Material usage variance FAVOURABLE DR Variance CR COS CR FG CR WIP Conversion FAVOURABLE DR Variance CR COS CR FG CR WIP CARRIED AT STANDARD* • COS • FG • WIP • RM* MATERIAL PRICE Total to PURCHASES GET UNITS INTO KGs etc. + COS x RM Q + FG x RM Q + WIP (RM and conversion shall differ as above) x RM Q + RM* (ALREADY IN KGs) = TOTAL + USAGE = PURCHASES MATERIAL USAGE + COS x RM Q + FG x RM Q + WIP (RM and conversion shall differ as above) x RM Q = TOTAL CONVERSION + COS + FG + WIP = TOTAL Determine the ratios MATERIAL PRICE • COS @STD Q/PURCHASES • FG @STD Q /PURCHASES • WIP (RM) @STD Q /PURCHASES • RM/PURCHASES • USAGE/PURCHASES MATERIAL USAGE • COS @STD Q /TOTAL • FG @STD Q /TOTAL WWW.TAKINGNOTESU.COM • WIP (RM) @STD Q/TOTAL CONVERSION • COS/TOTAL • FG/TOTAL • WIP (CONVERSION)/TOTAL Disposition MATERIAL CONVERSION COS, FG, WIP, RM, BALANCING (PRICE) COS, FG, WIP COS, FG, WIP (USAGE) x Material price variance x Labour usage + price, variable overhead x Material usage variance usage + price Journals, from the above ratios @ the particular variances Material price variance ADVERSE DR COS DR FG DR WIP DR RM CR Variance (DISPOSITION THIS VALUE ONLY) DR Variance (material usage) = Material usage variance ADVERSE DR COS DR FG DR WIP CR Variance CR Variance* (material price usage) = • DISPOSITION THE TOTAL VARIANCE (usage + price usage) Conversion ADVERSE DR Variance CR COS CR FG CR WIP WWW.TAKINGNOTESU.COM WORKING CAPITAL • Working capital ratio = Current assets : Current liabilities = The norm of the working capital = ratio should be 2:1 • • • Quick ratio = (Current assets – inventory) : Current = liabilities = The norm of the quick ratio should = be 1:1 • • Working capital cycle = Debtors + inventory (RM, WIP, FG) = Days • Net Working capital Raw materials Work-in-progress Finished goods = Debtors + Inventory – Creditors = Days = Raw materials / Raw material purchases x 365 = Days = WIP / Cost of sales x 365 = Days = Finished goods / Cost of sales x 365 = Days • Compare days on hand calculated to the lifetime • Compare days on hand calculated to the lifetime Compare days on hand calculated to the lifetime Compare to the lifetime of the inventory Inventory should not be on hand longer than the lifetime of the inventory, as this means slow sales, and risk of obsolete stock o Possible discounts to get rid of old stock o Consider keeping less inventory on hand Is a measure of the number of times inventory is sold or used in a time period It reflects the company’s ability to flip its products for cash • • • Inventory on hand = Inventory / Cost of sales x 365 = Days • Inventory turnover (replacement) = Cost of sales / Average inventories = Times Mainly used to give an idea of a company's ability to pay back its liabilities with its assets, includes inventory (link amount of inventory on hand days to ability) Conservative policy is greater than the norm (less risk) Moderate policy is equal to the norm (moderate risk) Aggressive policy is less than the norm (high risk) Measures the ability of a company to pay its current liabilities when they come due with only quick assets, without having to sell its inventory Shorten working capital cycle and decrease risk as much as possible, without affecting efficiency of operations, by limiting debtors and inventory, and increasing creditors Shorten working capital cycle and decrease risk as much as possible, without affecting efficiency of operations, by limiting debtors and inventory, and increasing creditors • • • Debtors collection period = Debtors / (Credit) sales x 365 = Days • = Creditors / (Credit) purchases x 365 Creditors collection period Return on NET assets Return on TOTAL assets • = Purchases + Cost of sales + Closing balance – Opening balance = Profit before interest & tax / (Fixed assets + Net working capital) x 100 = EBIT / (FA + DEBTORS + INVENTORY – CREDITORS) x 100 =% = Earnings before interest & after tax / total assets x 100 = EBIAT / TA x 100 =% • Higher RONA means that the company is using its assets and working capital efficiently and effectively • The ratio is considered to be an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid You must constantly find ways to reduce costs and increase income to keep your ROTA as high as possible Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested A rising ROE suggests that a company is increasing its ability to generate profit without needing as much capital Extent to which debt is covered by equity • • Return on equity Debt/equity = Profit for the year / total shareholder funds x 100 =% = Total debt / Total equity Compare to contractual repayment terms Debtors should not be collected after negotiated terms o Levy interest on late payments o Grant early payment discounts o Send reminders to debtors to pay Compare to contractual repayment terms Creditors should not be settled after negotiated terms o Negatively affect relationship with suppliers o May be penalised with additional interest o Possible early payment discounts do not apply due to late payment • • • It is easy to say that a company should reduce its investment in inventory, accounts receivable and extend its payment terms with its creditors, but this may not always be the right thing to do • A company may decide to hold additional inventory because it wishes to be able to supply its customers immediately while its competitors may need to order inventory and are therefore only able to deliver much later o This enables the company to sell at a higher price o A customer may be prepared to pay a higher price to obtain immediate delivery and thereby avoid production stoppages within the customer’s factory, store or mine Lower inventories may result in disruptions in production or the loss of customers if the company is not able to make their delivery due to the company not being able to immediately fulfil their orders o BUT, there are various holding costs associated with holding high levels of inventory § Maintaining higher levels of current assets is also known as a conservative working capital financing approach • • • • • • • A company may pay its suppliers within 10 days because it obtains discounts that exceed the benefit of paying two months later, or May hold back on paying suppliers These types of actions are often not optimal and may lead to serious operational issues o Customers may be annoyed and future sales may be affected o This may also have serious impacts on the cash flows of suppliers § There is a risk of cash flow problems if a company is paying its creditors before there is cash from the debtors If the company is dependent on a single supplier and is not able to diversify its supplier base, then it may be more prudent to carry additional inventory in case there are production problems with the supplier Carrying higher inventory may mean that the company will be in a stronger position to negotiate prices with the supplier If prices are expected to increase, then a company may pre-order and purchase large quantities of products • Reduce its account receivables by offering customers significant discounts at year-end, pushing sales into their distribution channels by delivering goods but arranging to take back inventory later on • Reduction in trade receivable days through stricter enforcement of credit policy may have a negative impact on revenue o [Not] Achievable with given historical average of … days o May reduce … spend o Or … elsewhere where they can obtain more favourable credit terms • Increase average payment terms with its suppliers o Stretching creditors may be possible but it could have an impact on § Service levels § Reputation, and § Support from their suppliers DEBTOR MANAGEMENT IMPACT ON CHANGE IN CREDIT POLICY P = ▲G – ▲B – ▲D – ▲I G = [New sales x Gross profit percentage] – [Existing sales x Gross profit percentage] • B = [Bad debt % x New sales x (100 – New collection] – [Bad debt % x Existing sales x (100 – Existing collection] • D = Gross profit is higher (lower), therefore profit has increased (decreased) Bad debts are higher (lower), therefore profit has decreased (increased) [New collection x New sales x New discount if a debtor settles early*] – [Existing collection x Existing sales x Existing discount if a debtor settles early] • • *3/15 net 30, for example Discount is higher (lower), therefore profit has decreased (increased) Increase in debtors (▲New – Old) I = [1] Existing sales x (▲Debtors days / 365) [2] (▲Sales) x (New debtors days / 365) x COST OF SALES / SALES ([1] + [2]) x WACC • Might need to calculate debtors days, before and after change in credit policy o Existing: Debtors / (Credit) sales x 365 o New: § 2/15 net 45, where 30% of the debtors are expected to make use of the discount • (30% x 15) + (70% x 45) Decrease in debtors (▲New – Old) [1] New sales x (▲Debtors days / 365) [2] (▲Sales) x (Old debtors days / 365) x COST OF SALES / SALES ([1] + [2]) x WACC • Increase (decrease) in debtors results in an increase (decrease) in carrying costs, therefore profit has decreased (increased) Evaluation From the above-mentioned calculation, it is clear that the new policy will lead to a slight increase (decrease) in profit P, therefore it would be better to switch to the new credit policy (continue using the old credit policy) NPV (Will be given in required to calculate) (– 520 000 + 180 000 – 68 000) / 0.1 + 900 000 = (3 180 000) • Do not accept (as negative) 520 000 = Decrease in gross profit (▲G) • ß in profits 180 000 = Decrease in bad debts (▲B) • Ý in profits 68 000 = Increase in discounts (▲D) • ß in profits o 520 000, 180 000, 68 000 = Return from change in credit policy 900 000 = Decrease in debtors (▲I) 0.1 = WACC FACTORING Cash amount advanced = Sales x Credit sales % x 30/365 [debtors’ days] x (100 – Retention %) Plus: Service fee as a % of TOTAL SALES [Cash and credit] Plus: Finance cost fee as a % of CASH AMOUNT ADVANCED Less: Savings of administrative cost Less: Savings of bad debt (IF SOLD WITHOUT RECOURSE) Less: Savings on cash discount FACTORING Cost of factoring = XXX / Cash amount advanced XXX FINANCIAL STATEMENT ANALYSIS Who are the Users of Financial Statements? Equity investors • Return on capital • Capital preservation Auditors Give an opinion that financial statements are free from material misstatement. Credit grantors • ST = interest cover • LT = interest cover and capital preservation Other parties SARS – Tax paid is reasonable Management • Decision making • Control Take-over analysts Valuation of potential target companies Limitations on Ratio Analysis • • • • • • • Diversified into different industries Leader vs. average Different accounting policies “Window-dressing” Subjective assessment of good or bad Change in type of business Very old assets RATIO ANALYSIS WWW.TAKINGNOTESU.COM Employees • Job security • Wage & salary negotiations • Bonuses Market Value Ratios ,-./0 PE Ratio = 01-.234 • • • • Compare to the industry norm o Lower than industry norm could mean § shares are undervalued, § growth prospects could be less than other companies in the same industry meaning capital growth is limited § company has a higher risk than the rest of the industry Decrease: could be due to an increase in market price per share (e.g. 20%), which is less than an increase in EPS (e.g. 30%) Increase: could be due to an increase in market price per share (e.g. 30%), which is more than an increase in EPS (e.g. 10%) Opposite applies for a decrease in MPS and EPS 567 Dividend Pay-out Ratio = 867 567 Divided Yield = 967 • Compare to the industry norm • One must also consider that the return an investor receives is not only a dividend, but a growth in capital too ;.<.;024 Dividend Per Share (DPS)= 2= => 4?1-04 867 Earnings Yield = 967 • Compare to the industry norm 01-2.234 Earnings Per Share (EPS) = 2= => 4?1-04 Dividend Cover = 01-2.234 ;.<.;02;4 Debt Management 8@AB Interest Cover = A2C0-04C • Used to determine how easily a company will be able to pay their interest expenses Fixed charge coverage ratio = EBITDA + Operating Lease exp / (Interest + operating lease expense) B=C1D 50EC Debt Ratio = B=C1D F440C4 • How much of the company’s total assets were financed through debt in the current year • Consider operations and investments for the following year and this will effect debt ratio B=C1D 50EC Debt Equity Ratio = B=C1D 8GH.CI Asset Management Ratios 8@AB Return on operating assets (ROA) = J,0-1C.23 F440C4 71D04 Fixed Asset turnover = K.L0; F440C4 71D04 Asset Turnover = F440C4 • Total assets increase/decrease • Total sales increase/decrease Working capital cycle = Raw Material Days + WIP Days + Finished Goods Days + Debtorsd Days − Creditorsd Days AIM: Shorten length of cycle ad decrease risk BY: Limiting RM days, WIP days, FG days, debtors’ days and increasing creditors’ days F<0-130 B-1;0 g0/0.<1ED04 Debtors collection period = x 365 h-0;.C 71D04 • Increase/decrease • Too long: bad debt, poor collection and management, poor sales • Too short: too strict on customers which may result in lower sales WWW.TAKINGNOTESU.COM Inventory turnover = • • • h=4C => 71D04 A2<0C=-I Increase/decrease and compare to the industry norm Too low: threat of stock becoming obsolete and keeping stock that does not add value to the business, not being able to sell stock Too high: could run out of stock, company may not have cash to buy stock Creditors’ days = B-1;0 h-0;.C=-4 h-0;.C 6H-/?1404 x 365 Liquidity Ratios Current Ratio = Current Assets: Current Liabilities • measures if the company will be able to pay ST debt in the next 12 months with current assets • compare to the industry norm • if there was a significant increase in cash as well as a significant increase in ST borrowings, it is most likely that a ST loan was incurred o if this situation continues, the company will incur interest on the loan and liquidity will decrease Quick Ratio = (Current Assets − Inventory): Current Liabilities • Inventory is a less liquid asset; therefore the quick ratio is sometimes a better indication of liquidity Profitability Growth in sales q-=44 6-=>.C Gross profit Margin = 71D04 • Compare increase/decrease in GP to increase/decrease in sales • An increase in GP but decrease in sales could result from purchases of material that took place at a much higher price 8@AB Operating profit Margin = 71D04 • • • Increase/decrease Could be due to the increase/decrease in gross profit if operating expenses and deprecation remained constant or in line with inflation Compare to industry r0C 6-=>.C Net profit Margin = 71D04 • Increase/decrease • Main reason for the change is the change in gross profit as well as an increase/decrease in finance costs • If the margin increased: o company’s ability to generate profit out of its normal operating activities has improved • If the margin decreased: o company’s ability to generate profit out of its normal operating activities has deteriorated • Compare to industry 8@AB Return on total assets (ROA) = B=C1D F440C4 • EBIAT = EBIT X 72% • NOPAT = net profit + (interest x 72%) • If ROA has increased: o company’s ability to generate profit by making use of its assets has improved o due to the fact that company’s profitability (EBIT) improved • If ROA has decreased: o company’s ability to generate profit by making use of its assets has deteriorated o due to the fact that company’s profitability (EBIT) declined • Compare to industry norm Return on equity (ROE) = • • r0C 6-=>.C 8GH.CI An indication of the company’s ability to generate a return for its’ shareholders on the funds that they have invested in the company Increase/decrease WWW.TAKINGNOTESU.COM F • Compare to the industry norm o If ROE < industry norm, there will be a string possibility that the shareholders may decide to sell their shares and rather invest in a more profitable company Cash Flow Operating Activities • The company generated a positive/negative cash amount from operations of X-cents for each R1 profit /14? >D=s >-=t =,0-1C.=24 o Formula for x-cents = =,0-1C.23 ,-=>.C • The cash generated from operations should be able to the company’s obligations with regard to interest and tax o This is the case if net cash flows from operations is a positive. It would therefore be unlikely that the company would experience financial distress • Working Capital: o If sales increase, it is expected that working capital will increase accordingly o Debtors: § Increase in accounts receivable: growth in sales? Change in credit policy? Poor Management? Problems with collection? § Consider increase/decrease in debtors and debtors’ days. • If growth in debtors > growth in sales: indication of a decrease in recoverability I debtors o Creditors: § Consider increase/decrease in creditors and creditors’ days • Pressure to pay? Alternative financing source? o Inventory: § Consider increase/decrease in inventory • Decrease/increase in sales? Prices increased? Shortages or suplus? Investing Activities • Consider increase/decrease in PPE o If increase in PPE > increase in sales § Possible that PPE was purchased at the end of the year and no sales on these assets have been generated yet • Acquisition of equipment o Replacement or expansion Financing Activities • Increase/decrease in dividends paid o Compare to the increase/decrease in profits o If dividends paid > profits it could indicate: § No future investment projects were identified § Low growth prospects • Share buy-backs: can explain why balances don’t grow a lot • Movement in loans? • Change in interest rates? • What type of financing o Is company replacing LT loans with ST loans Cash Management • Increase/decrease in cash and cash equivalents at year end • Compare profit before tax and interest with cash from operations • Is sufficient cash generated by the business WWW.TAKINGNOTESU.COM Other Financial Statement Considerations 1. Structured Analysis: Du Pont • Objective of financial management is to maximise wealth and measure how effectively this objective is achieved • Du Pont uses ROE as the overall measure of success • The Du Pont Formula for ROE is as follows Net Profit % Total asset turnover Gearing Net Profit Sales Total Assets x x Sales total Assets Equity Net Profit % Return on assets Return on Equity • • Compare this to the industry norm o You will have to calculate ROE using Du Pont’s Formula for the industry Comment on your findings: o Income: Company generates a higher/lower net profit than the industry (use net profit%) o Asset Efficiency: Company applies its assets more/less effectively than the industry (sales/total assets) o Debt Management: Company utilises financial gearing more/less than the industry, as a bigger/smaller portion of total assets than in the industry is financed by borrowed capital (use total assets/equity) 2. What’s behind the numbers • It is important to understand: o The business and industry sector o Business and financial risks o Key drivers o Management’s motives for selecting accounting policies o Accounting policy with flexibility • Understand certain warning signs o Increase in accounts receivable that exceeds the increase in sales. o Increase in inventory that exceeds the increase in sales. o Restructuring, non-recurring charges and asset write-downs or sales o Accounting income and tax losses. o Accounting income and a negative operating cash flow § Trying to overstate their accounting (try make it look better) o Complex company structures and related party transactions. § E.g. Steinhoff o Accounting policies in relation to research and development, depreciation and leasing. o Accounting practices that are at variance with the norm for the industry sector. o Lack of corporate governance. o Changes in auditors, Qualified opinions or published disagreement with the auditor. § If company wants to do something that auditors don’t agree with, company fires auditor o Changes in revenue recognition policies. o Vendor financing and financing structures. § Complicated way of saying they’re selling a lot on debt -> showing sales that aren’t accurate o Changes to provisions and reserves. Further Factors to Consider • Are the directors selling their shares in the company? • Is the company aggressive about acquisitions? WWW.TAKINGNOTESU.COM • • • • • Are the customers of the company performing well? Is the company subject to litigation? Do they have operational risks? Do they have insurance? o Employees – exposed to strikes o Mining – world economy has impact on sales prices Does the company have environmental liabilities? Are there rumours about product quality? Is management incentivised to focus on shareholder interest? 3. Failure Prediction Consider Altman’s Z-Score § Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Z>2,99 Safe Zone • • • • • Z<1,81 Distress Zone 1,81 < Z < 2,99 Danger Zone X1 = Working capital/ Total assets X2 = Retained earnings / Total assets X3 = EBIT / Total assets X4 = Market value of equity / book value of total liabilities X5 = Sales / Total assets 4. Economic Value Added EVA = Return – (WACC x invested capital) EVA = NOPAT – (WACC x (Equity + Interest-Bearing Liabilities)) WWW.TAKINGNOTESU.COM MEASURING RELEVANT COSTS AND REVENUES FOR DECISION-MAKING • • Decision-making involves choosing between alternatives Making decisions requires that only those costs and revenues that are relevant to the alternatives are considered STEP 1: IDENTIFYING RELEVANT COSTS AND REVENUES STEP 1: (FINANCIAL FACTORS) • The relevant costs and revenues required for decision-making are only those that will be affected by the decision o Relevant costs are future costs that differ between alternatives o Irrelevant costs consists of sunk costs, allocated costs and future costs that do not differ between alternatives § Decision-making is concerned with choosing between future alternative courses of action, and nothing can be done to alter the past, past costs (also known as sunk costs) are not relevant for decision-making • Sunk costs cannot be avoided, regardless of the alternatives being considered § Fixed costs are also irrelevant for decision-making • Still allocated to cost objects, but disregarded for decision-making • Will not change whichever alternative is chosen o Merely a redistribution of the same costs between cost objects and do not affect the level of cost to a company • They will only change if there is a dramatic change in organisational activity resulting from the alternative chosen • The relevant financial inputs for decision-making purposes are therefore future cash flows, which will differ between the various alternatives being considered o In other words, only differential (or incremental) cash flows should be taken into account STEP 2: NON-FINANCIAL FACTORS • Difficult to quantify decision only in monetary terms o (1) Cost of manufacturing a component internally may be more expensive than purchasing from an outside supplier (outsourcing) § Therefore, the effect of such decision might lead to redundancies and a decline in employee morale that results from redundancies arising from closure decision, that could affect future output § The company will now be at the mercy of the supplier who might seek to increase prices on subsequent contracts and/or may not always deliver on time • Affect how the company will meet customer’s requirements • This could result in a loss of customer goodwill and a decline in future sales o If the component can be obtained from many suppliers and repeat orders for the company’s products from customers are unlikely, then the company may give little weighting to these non-financial factors o However, if the component can be obtained from only one supplier and the company relies heavily on repeat sales to existing customers, then the qualitative factors will be of considerable importance WWW.TAKINGNOTESU.COM § § § o Even though the purchase price is less than the current total unit cost of manufacturing, however, the unit costs include some costs that will be unchanged whether or not the components are outsourced In this situation, the company may consider that the quantifiable cost savings from purchasing the component from an outside supplier are insufficient to cover the risk of the qualitative factors occurring (2) However, the decision to purchase from an outside supplier could result in the closing down of the company’s facilities for manufacturing the component • Consider the signal it sends out from the closing down • Management should consider what the effect of the loss of the market share will have on the company as a whole (closure of a branch, therefore still running other branches) • Management should also consider what effect the possible dissatisfaction of the clients at the closing branch who now have to find other businesses to satisfy their needs will have on the reputation of the company • Therefore, the effect of such decision might lead to redundancies and a decline in employee morale that results from redundancies arising from closure decision, that could affect future output • It is also important that management pay attention to how accurate the pre-estimates on which the calculations are based, are (3) Special pricing decisions relate to pricing decisions that typically involve one- timeonly orders or orders at a price below the prevailing market price CLIENT • The possibility exists that the client may demand the lower price for all their purchases of the product in future o Creates an expectation of a lower price in future • Management must consider what the effect would be on their relationship with their clients if they were not to accept the special price order • A company should be willing to accept a special price order to attract a customer for long-term retention • If the other clients were to find out about the special price, they may feel unhappy with the fact that they don’t get the product at a special price • Accepting the order prevents the company from accepting other orders that may be obtained during the period at the going price o Assuming that no better opportunities will present themselves during the period • Management must consider whether they will maybe be able to sell the units to someone else at a price higher than agreed upon (even though still at a special price) COMPETITION • Competitors may engage in similar practices of reducing their selling prices in an attempt to unload spare capacity o This may lead to a fall in the market price, which, in turn, would lead to a fall in profits from future sales o The loss of future profits may be greater than the shortterm gain obtained from accepting special orders at below the existing market price WWW.TAKINGNOTESU.COM § § However, finding a customer outside a company’s normal market, it is unlikely that the market price would be affected However, if the customer has been within the company’s normal market retail market there would be a real danger that the market price would be affected RESOURCES • The company has unused resources that have no alternative uses that will yield a contribution to profits • However, if the materials are to be replaced then the decision to use them on an activity will result in additional acquisition costs compared with the situation if the materials were not used on that particular activity • Where the materials have no further use apart from being used on a particular activity, the materials will result in lost sales revenue, and this lost sales revenue will represent an opportunity cost that must be assigned to the activity, if not used FIXED COSTS • Fixed costs are unavoidable for the period under consideration o (4) Replacement of equipment § The book value of equipment is a past (sunk) cost that cannot be changed for any alternative under consideration § Only future costs or revenues that will differ between alternatives are relevant for replacement decisions § Management should consider how reliable the pre-estimates regarding the reliability of the new vehicles and its effect on the costs, are § Maybe the two options should be compared in order to identify the better one of the two o ONCE OFF COSTS ARE TREATED SEPARATELY IN CONCLUSION Examples include § § Sale of assets Purchases of assets WWW.TAKINGNOTESU.COM RISK AND UNCERTAINTY Risk and uncertainty • A distinction is often drawn between risk and uncertainty: o Risk is applied to a situation where there are several possible outcomes and there is relevant past experience to enable statistical evidence to be produced for predicting the possible outcomes § Probabilities are used to measure the risk of alternative courses of action. o Uncertainty exists where there are several possible outcomes, but there is little previous statistical evidence to enable the possible outcome to be predicted. § Probabilities are not used. Probabilities • • Because decision problems exist in an uncertain environment, it is necessary to consider those uncontrollable factors that are outside the decision-maker’s control and that may occur for alternative courses of action o These uncontrollable factors are called events or state of nature § For example, in a product launch situation, possible states of nature could consist of events such as a similar product being launched by a competitor at a lower price, at the same price, at a higher price or no similar product being launched at all The likelihood that an event or state of nature will occur is known as its probability, which is normally expressed at a decimal form between 0 and 1 o All probabilities will add up to 1 § For example, if a tutor indicates that the probability of a student passing an exam is 0.7, therefore 0.3 indicates the probability of a student not passing an exam. § The information can be represented in a probability distribution • A probability distribution is a list of all possible outcomes for an event and the probability that each will occur Outcome Pass exam Do not pass exam Total Probability 0.7 0.3 1 WWW.TAKINGNOTESU.COM Probability distributions and expected values • • • A manager is considering whether to make product A or product B, but only one can be produced The estimated sales demand for each product is uncertain A detailed investigation of the possible sales demand for each product gives the following probability distribution of the profits for each product (1) Outcome Profits of R600 000 Profits of R700 000 Profits of R800 000 Profits of R900 000 Profits of R1 000 000 Product A probability distribution (2) Estimated probability (3) Weighted (1 x 2) 0.10 R60 000 0.20 R140 000 0.40 R320 000 0.20 R180 000 0.10 R100 000 Total = 1 Expected value = R800 000 (1) Outcome Profits of R400 000 Profits of R600 000 Profits of R800 000 Profits of R1 000 000 Profits of R1 200 000 Product A probability distribution (2) Estimated probability (3) Weighted (1 x 2) 0.05 R20 000 0.10 R60 000 0.40 R320 000 0.25 R250 000 0.20 R240 000 Total = 1 Expected value = R890 000 Which product should the company make? • • • You will see from the above example, that there is a one in ten chance that profits will be R600 000 for product A But there is also a four in ten chance that profits will be R800 000 A more useful way of reading the probability distribution is to state that there is a seven in ten chance that profits will be R800 000 or less o This is obtained by adding together the probabilities for profits of R600 000, R700 000 and R800 000 o Similarly, there is a three in ten chance that profits will be R900 000 or more Expected values • Expected values ((3) in table) is calculated by the following equation: = ? px o o • p = probability of outcome x = value of outcome The expected value of a decision represents the long-run average outcome that is expected to occur if a particular course of action is undertaken many times WWW.TAKINGNOTESU.COM Attitudes to risk by individuals • • • How do we determine whether or not a risky course of action should be undertaken? o The answer to this question depends on the decision-maker’s attitude to risk There are three possible attitudes: o An aversion to risk (risk averter) o A desire for risk (risk seeker) o An indifference to risk (risk neutral) Consider two alternatives, A and B, which have the following possible outcomes, depending on the state of the economy (i.e. state of nature): Possible returns State of the economy A (R’000) Recession 90 Normal 100 Boom 110 • B (R’000) 0 100 200 If we assume that the three states of the economy are equally likely, then the expected value for each alternative is R100 000 o A risk seeker is one who, given a choice between more or less risky alternatives with identical expected values, prefers the riskier alternative (alternative B) § A risk seeker would generally choose the alternative that has the highest expected value is unlikely to be put off by low probabilities of any of the potential adverse outcomes o A risk averter would choose to avoid risk and select the less risky alternative (alternative A) § Majority of investors are risk averse o A risk neutral is one who is indifferent to risk and would be indifferent to both alternatives because they have the same expected values and will choose a course of action that gives the highest expected value. Decision tree analysis • • • Many outcomes may be possible and some outcomes may be dependent on previous outcomes A useful analytical tool for clarifying the range of alternative course of action and their possible outcomes is a decision tree o A decision tree is a diagram showing several possible courses of action and possible events (i.e. states of nature) and the potential outcomes for each course of action § Each alternative course of action or event is represented by a branch, which leads to subsidiary branches for further courses of action or possible events § Decision trees are designed to illustrate the full range of alternatives and events that can occur, under all envisaged conditions § The value of a decision tree is that its logical analysis of a problem enables a complete strategy to be drawn up to cover all eventualities before a firm becomes committed to a scheme Note that the joint probability of two events occurring together is the probability of one event times the probability of the other event WWW.TAKINGNOTESU.COM • • • • • A company is considering whether to develop and market a new product Development costs are estimated to be R180 000, and there is a 0.75 probability that the development effort will be successful and a 0.25 probability that the development effort will be unsuccessful If the development is successful, the product will be marketed and it is estimated that: o (1) If the product is very successful profits will be R540 000; o (2) If the product is moderately successful profits will be R100 000; o (3) If the product is a failure, there will be a loss of R400 000 Each of the above profit and loss calculations is after taking into account the development costs of R180 000 The estimated probabilities of each of the above events are as follows: o (1) Very successful = 0.4 o (2) Moderately successful = 0.3 o (3) Failure = 0.3 Of the decision tree that is on the following page Outcome Loss of R400 000 Loss of R180 000 Profit of R100 000 Profit of R540 000 Probability 0.225 0.25 0.225 0.30 WWW.TAKINGNOTESU.COM WWW.TAKINGNOTESU.COM CAPITAL BUDGETING • • Capital budgeting is the analysis and evaluation of investment projects that normally produce benefits over a number of years A prospective project’s lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark Types of investment projects 1. Replacement or Expansion • • Replacement refers to the acquisition of an asset to maintain existing production o The new machine may result in cost savings due to increased efficiencies o The firm is producing an established product line and the cost savings are usually relatively certain Expansion refers either to expansion of existing product lines to new markets, or to the introduction of new product lines o If the project refers to a new product line, estimated demand may be highly uncertain o Therefore, making it difficult to estimate future cash flows 2. Independent vs. Mutually Exclusive Projects • • Independent projects are projects where the acceptance of one does not affect the acceptance of another o Project A may be accepted or rejected irrespective of whether Project B was accepted or not Mutually Exclusive are alternatives o Either one or the other can be accepted but not both 3. Divisible vs. Indivisible Projects • • A divisible project may be split into a number of different parts, each capable of being undertaken on its own o E.g. Considering to buy a car to run become an Uber If a project is indivisible then the entire project must be undertaken o E.g. Renovate a building Capital budgeting techniques (1) Net present value (NPV) • • Step 1: Calculate future cash flows Step 2: Discount at the company’s required rate of return o Interpretation: Positive answer § Present value of cash flows > cost • à Accept o Interpretation: Negative answer § Present value of cash flows < cost • à Do not accept • • • This method takes time value of money into account If the discount rate of the company increases, NPV will decrease With this method it is determined whether the initial investment, in present value terms, can be repaid by future cash flows WWW.TAKINGNOTESU.COM • A positive figure means that value is created by the project and a negative value implies that the project cannot repay itself o In this case the NPV of the project is R…, which is positive, the project must therefore be accepted Example, • • • • • Assume Project A has an initial investment of R20m And results in cash flows of R10m for the next four years If the firm’s WACC (cost of capital) is 15%, should we accept this project? o Based on the answer, NPV is positive § Therefore, accept the project CF0 CF1 CF2 CF3 CF4 I/YR 2nd function P/YR 2nd function NPV -20 000 000 10 000 000 10 000 000 10 000 000 10 000 000 15 1 R8 549 784 The net present value of the project is a good indication of whether or whether not the project can be accepted (positive NPV) However, when there is more than one project that is divisible, a combination of projects with a lower net present value can be better o If there are limited funds, sometimes only a portion of the initial investment can be taken into account (limited to the limited funds) § For example, R1 500 000 of limited funds available, but there is a project worth R900 000 and R1 100 000 • The full R900 000 is accepted (highest probability index), and then only R600 000 of the R1 100 000 o The NPV is then apportioned to R600 000 of R1 100 000 o And added to the NPV of the R900 000 project o If however, the initial investment of the combination of projects is less than the limited funds available, simply add the NPVs together (2) The Internal Rate of Return (IRR) • • • • • • The IRR is the discount rate that causes the present value of net future cash flows to equal the cost of the investment (rate at which NPV = 0) It reflects the implicit return of the project stated in percentage terms Rate at which returns of project are reinvested If a company’s IRR > Company’s required rate of return o à Accept the project For mutually exclusive projects o à Choose option with highest IRR § However, IRR must be > WACC A disadvantage is that IRR ignores the size of the project (3) Modified Internal Rate of Return (MIRR) • • • • • The IRR and NPV methods may generate conflicting rankings for mutually exclusive investments This is due to the reinvestment assumption o NPV assumes reinvestment at the cost of capital o IRR assumes reinvestment at the projects IRR The MIRR calculates the terminal value of cash flows by making use of the more conservative cost of capital, rather than the IRR that is higher (if the project is to be accepted) Since the adjusted internal rate of return (MIRR) addresses the shortcomings of the internal rate of return (reinvestment of funds at cost of capital and not at IRR), it should give us an answer which corresponds with the NPV method A disadvantage of this method is however that the answer is expressed in percentage terms and therefore does not take into account the size of the initial investment WWW.TAKINGNOTESU.COM • • • The MIRR is …%, which is higher than the company’s cost of capital of …%, and this project should be accepted on the basis of this o Or vice versa MIRR is determined by calculating the rate that causes the present value of the terminal value of a project’s inflows to equal the present value of the project’s cash outflows Terminal value is determined by reinvesting the cash flows at the cost of capital or any other specified rate Example, Project 0 1 2 3 A -100 20 20 110 B -100 60 50 30 Project A: • Terminal value o = (110 x1) + (20 x1.12) + (20x1.12x1.12) o =157.48 • MIRR: o CF0 = -100 o CF1 = 0 o CF2 = 0 o CF3 = 157.48 o MIRR = 16.34% Therefore, choose Project B Assume cost of capital = 12% Project B: • Terminal value o = (30 x1) + (50 x1.12) + (60x1.12x1.12) o =161.26 • MIRR: o CF0 = -100 o CF1 = 0 o CF2 = 0 o CF3 = 161.26 o MIRR = 17.27% (4) Profitability Index (PI) • • • • The PI measures a project’s return in relation to its cost This index related the future benefits of a project to the cost of the project (Benefit/Cost ratio) The PI gives us a good indication of how much value we get for each Rand we invest in a project In this case the project’s PI is …, which is greater than 1; and the project should thus be accepted o Less than 1; and the project should thus be rejected Payback value of future inflows Present value of cost of the investment = • • • Insufficient funds to take on all the projects that are profitable, Therefore, its profitability index must be calculated The index calculates which projects are the most profitable in comparison with the limited funds (the initial capital outline) o o It is thus best to accept (highest profitability index) fully and To invest the remaining (limited funds less initial investment in project with the highest profitability index) in the (second highest profitability index), since the projects are divisible WWW.TAKINGNOTESU.COM (5) Payback Method • The payback method measures the time that it takes to recover the cost of the investment from the cash flows generated by the project Indication of the amount of time the funds are at risk Disadvantages o It ignores cash flows after the payback period (it is therefore not a profitability indicator and creates bias against long term investments) o It ignores the time value of money • • Example, Year Project A Project B 0 -100 -100 1 40 50 2 50 60 3 20 10 Project A: Project B: Payback Period = 2 +10/20 = 2.5 years Payback Period = 1 + 50/60 = 1.83 years Therefore, choose Project B as payback period is shorter (6) Discounted Payback • • The discounted payback method takes into account the time value of money It is the time it takes for the present value of a project’s cash flows to equal the cost of the investment Disadvantage o It ignores cash flow after payback • Example, Cost of capital = 15% Payback Period = 2.33 years Cash Flow Y0 Y1 Y2 Y3 Y4 • • • • • Present Value -12 000 4 000 6 000 6 000 1 000 Cumulative -12 000 3 478 4 537 3 945 572 -12 000 -8 522 -3985 -40 40 / 572 = 0.07 o Therefore, Discounted Payback = 3 + 0.07 = 3.07 Looking at the shortest payback period does not give the whole picture Initial capital outlay will be recovered the quickest from cash flows, but it ignores the fact that at other projects may receive positive cash flows for a longer period after the capital outlay has been recovered It also ignores the time value of money and Favours projects where larger amounts of cash flows are received early during the project lifetime WWW.TAKINGNOTESU.COM (7) Accounting Rate of Return (ARR) • Management might find it important that any project accepted must meet a certain accounting rate of return which will have a favourable effect on the company’s return on investment ARR is the expected average annual increase in net income if the project is accepted The major difference between net income and cash flows relate to depreciation and other non-cash flow items • • Average incremental net income (NI) Average investment = Where, average incremental income is Total increase in NI Useful life = And, average investment is Cost 2 = • Disadvantages o Ignores time value of money o Short term vs. long term: can make the incorrect decision by solely looking at short term Example, • • • Initial cost = R1 100 000 Asset is written off on a straight line basis over 5 years for tax and accounting purposes Company’s current ROI = 20% YEARS Cost Projected Cash Flows Depreciation Net Income Tax NI after tax • • 0 -1 100 000 1 2 3 4 5 300 000 450 000 450 000 450 000 450 000 -220 000 80 000 -22 400 57 600 -220 000 230 000 -64 400 165 600 -220 000 230 000 -64 400 165 600 -220 000 230 000 -64 400 165 600 -220 000 230 000 -64 400 165 600 Average incremental net income = (57600 + 165600 + 165600 + 165600 + 165600) / 5 = 144 000 Average investment = 1 100 000 / 2 = 550 000 o ARR = 144000/550000 = 26.2% The effect on the company’s return on investment Y0 Y1 Net after tax 57 600 Asset 1 100 000 880 000 ROI (NI after tax) / 5% asset • Y2 165 600 660 000 Y3 165 600 440 000 Y4 165 600 220 000 Y5 165 600 0 19% 25% 38% 75% Conclusion o Project has a decline in year 1 and 2, from year 3 they experience a big increase WWW.TAKINGNOTESU.COM Economic Value Added (EVA) • = EVA and economic profit is determined by deducting the company’s cost of capital from the firm’s operating after-tax but before interest income Earnings after tax before interest – (WACC x Invested capital) Determining the cashflows to be used (1) Cash flow at the beginning of the project (2) Annual operating cash flows (3) Tax effect of each project phase (4) Cash flow at the end of the project • (1) Cash flow at the beginning of the project o The initial investment may result in § Cost of acquisition § Proceeds from the sale of existing assets § Tax effects § Change in working capital requirements Example, • • • Buy from suppliers at R100000 and we have to pay within 30 days. We sell the stock at R150000 and debtors have to pay us back in 30 days after sale. We hold the stock for 60 days before selling it 1st Jan 1st Feb 1st March 1st April 1st May 1st June Net cash flow Contribution Net Working Capital investment • • • • Jan Feb March April May June -100 000 150 000 -100 000 150 000 -100 000 150 000 -100 000 150 000 -100 000 -100 000 -100 000 -100 000 50 000 50 000 50 000 50 000 50000 -250 000 50000 50000 Average net working capital: Creditors = -100000 Inventory = 200000 Debtors = 150000 o NWC = 250 000 WWW.TAKINGNOTESU.COM 50000 50000 • (2) Annual operating cash flows o The incentive for investing in projects is the generation of future positive cash flows. The cash flows must reflect after tax cash flows. o Cash flow determination § § § (1) Evaluate all alternatives (2) Separate • Accounting of working capital from explicit cash flows • Account for contribution separately from working capital • Financing from investment decisions • Using WACC instead of interest in cash flow (3) Use • Incremental cash flows • Firms are operating as going concerns and the evaluation of any project should include only incremental cash flows and not existing cash flows • Include additional expenses / income that result from the project • After tax cash flow • Changes in working capital rather than level of investment For example, assume that a firm’s investment in inventory will amount to 10% of sales Y0 Y1 Sales Inventory Change in inventory § Y2 Y3 Y4 300 28 280 40 400 25 250 30 (25) (5) 2 (12) 40 (4) Include • • • • • • • • All operating costs The effects of new product lines on existing product lines The introduction of a new product line may result in the reduction in the demand for existing product lines The net incremental investment in working capital A new project often requires an incremental investment in working capital, and this should be included as an outlay at the beginning of the project If the net investment in working capital is to be recovered at the end of the project, then this amount is included as an inflow We have to include this in our analysis because such investment has to be financed and the time value of money has to be considered Opportunity Cost o Project A Y0 Repair Income § Y1 Y2 Y3 -10000 5000 NPV = R1041 @ 12 % WWW.TAKINGNOTESU.COM 2000 7000 o Project B Y0 Sell scrap § § § o Y1 NPV = R500 @12% Therefore, would choose project A (higher NPV). A – B = R541 Incremental Approach: Choosing Project A Repair -10000 Income Opportunity -500 Cost -10500 § o o Y3 500 Y0 o Y2 Y1 Y2 Y3 5000 2000 7000 5000 2000 7000 NPV = R541 @ 12% Opportunity cost is usually included but with asset replacement two methods can be used to do calculations § One cash flow table • Incremental approach (additional cash flow) • Include opportunity cost § Two cash flow table (one for project A and one for project B) • Use total cash flow for each asset • Compare net present value calculated for each asset Disadvantages § Tax related to this method becomes very complicated Ignore § Sunk costs • Sunk costs are costs that have already incurred • Consider the tax effects of past decisions: unless the tax deduction is ringfenced to the project, then the firm would obtain the benefits of the tax deduction whether the investment takes place or is abandoned § Allocated costs • These costs are a portion of existing costs and therefore the project will not result in increased costs, but merely bring about a revised subdivision of these costs § Finance charges • The discount rate takes into account the cost of finance, and the cost of debt is a component of the cost of capital • Therefore, to include finance charges in future cash flows would be double counting WWW.TAKINGNOTESU.COM • (3) Tax effect of each project phase o Tax is a major expense for most companies and it is therefore necessary to determine the effect that a project will have on a company’s tax VAT Depreciation Allowances § Cost x allowance rate x tax rate Deduction from taxable amount owed (resulting in a lower cash outflow) § Special depreciation allowance (S12C) • When a new plant and machinery is used in the process of manufacture and brought into use for the first time on or after 15 December 1989 • Allowance = 40% in first YOA, 20% in subsequent 3 YOAs • Tax allowance = tax saving = cash inflow • Effect on cash flow = cost x allowance rate x tax rate • Small business corporations (S12E) • Machinery and plant = 100% • Other depreciable assets = 50%, 30%, 20% • Wear and Tear (S11(e)) • Cost x Allowance Rate x Tax Rate Recoupments and Scrapping Allowance (S8(4)(a) and 11(o)) § Recoupment: Selling Price > Tax Value § Cash Outflow = (selling price limited to cost – tax value) x tax rate § Scrapping Allowance: Selling Price < Tax Value § Cash Inflow = (tax value – selling price) x tax rate Tax Effect of Replacement Decisions § The decision to replace or sell current equipment may result in either recouping or scrapping allowance, yet if such equipment had a tax value § Then the future depreciation allowances ‘lost’ due to such sale and any future recoupment avoided, should also be included in the analysis Capital Gains Tax § Inclusion rate for companies is 66.6% (old rate = 66.6%, new rate = 80%) (old effective tax rate for companies = 66.6 x 28%, new effective tax rate for companies = 80% x 28%) § Base cost will not include amounts allowed as a deduction for income tax purposes o o o o o o Example using new rate, • • • • SP = R1.2m CP = R1m Tax Value = R400000 Total tax = (1.2m – 1m)* 80% * 28% o = R44 800 a WWW.TAKINGNOTESU.COM o Determining after tax cash flow Example, A is planning on replacing equipment with current tax value of R8m (purchased for R20m three years ago). Depreciation is 20%, current market value is R11m. Remaining useful life is 5 years, when it is expected to have a market value of R4,5m. Calculate the cash flow and tax effects Sale Loss of Sale in Y5 Tax effects Net Cash Flows Y0 11000000 Y1 Y2 Y3 Y4 Y5 (840000) 10160000 (1120000) (1120000) (1120000) 0 (1120000) 0 0 0 (4500000) 1260000 (3240000) 4000000 4000000 Taxation Recoupment 3000000 Loss of Depreciation Allowance Recoupment avoided in Y5 Net effect on 3000000 taxable income Tax Effect (28%) 840000 Calculations: 1) Recoupments Sales Price (if < cost) Tax Value Recoupment • • Y0 11000000 (8000000) 3000000 (4500000) 4000000 4000000 0 0 (4500000) 1120000 1120000 0 0 (1260000) Y5 4500000 0 4500000 2) Depreciation lost in the future: Cost Rate Depreciation 20000000 20% 4000000 There are 2 years deductions remaining Conclusion o The decision to sell the asset results in the loss of future depreciation allowances, but also results in the avoidance of a recoupment on the sale of equipment in year 5. (4) Cash flow at the end of the project o o o o Proceeds on the sale of assets Recoupments or scrapping allowances 8(4)(a) ; 11(o) Capital gains tax Return of working capital Post Audit • • • • • It is important to compare one’s actual results with the estimated cash flow, used in capital budgets of projects and to provide any explanations for differences. This process is called post audit. The main objectives of a post audit are o Improve the capital budgeting process o Improve the management of projects subsequent to implementation It also provides useful information on replacement decisions Post audits also ensure that management, and particularly the sponsors of projects, work hard to achieve the forecasts Post audits may also have detriments o Many projects will not achieve projected returns, and it is important that sponsors are evaluated on their total performance and not only on problem projects o It may be difficult to separate the project from the rest of the firm’s operations WWW.TAKINGNOTESU.COM • Management should be evaluated on projects that should have been accepted and yet were rejected Despite the problems of post audits, they are useful to monitor and improve the performance of projects subsequent to implementation • Practical issues in capital budgeting (1) Unequal lives • In the case of projects with uneven lifetimes, it is not sufficient to only look at the net present value of the project, since it does not give a comparable value per annum over the project lifetime Equivalent annual annuity (PV = NPV, N = USEFUL LIFE, I/YR = COST OF CAPITAL, PMT) o Highest • • • For independent projects it makes no difference if they have unequal lives or not, since we accept a project of based off of whether it has a positive NPV or not HOWEVER, with mutually exclusive projects, it is important that we are able to compare them Project X Y • • Y0 -5.2 -8 Y2 2.8 2.5 Y3 2.8 2.5 Y4 Y5 Y6 2.5 2.5 2.5 If we look at these two projects without comparing equal lives, we find (assume cost of capital is 15%) o NPV X = 1.301 o NPV Y = 1.722 § Based off this alone, we would select Project Y as it offers a higher NPV However, if we take equal lives into consideration Project X1 X2 Y • Y1 2.8 2.5 Y0 -5.2 -8 Y1 2.8 2.5 Y2 2.8 2.5 Y3 2.8 -5.2 2.5 Y4 Y5 Y6 2.8 2.5 2.8 2.5 2.8 2.5 We find o NPV X = 2.178 o NPV Y = 1.722 § Based off equal lives, we would find that Project X generates a higher NPV • Problems with this method o It may not be practically applicable o Assumes the project can be repeated twice o Timely o Only works if one number is a factor of the other • Equivalent Annual Annuities (EAA) o o EAA makes projects with unequal lives comparable To compute a project’s EAA we perform the following steps: § Calculate the NPV of project / Present value factor of an annuity for the period of the project WWW.TAKINGNOTESU.COM o o • Project X: § NPV § Present value factor (three years 0,15) § EAA: NPV/PVF § PV = 1,301, I = 14%, N = 3, PMT = 2,3216 Project Y: § NPV § Present value factor (six years 0,15) § EAA: (NPV/PVF) § PV = 1,722, I = 14%, N = 6, PMT = 0,44 • Project X would therefore be preferred as it has a higher EAA 1,301 2,3216 0,56 1,722 3.8887 0.44 Equivalent Annual Cost (EAC) o o Comparison of projects with similar annual cash flows This is done by = [Cost of Project / Relevant Present Value Factors] o Project X: § (1) Cost § (3) Present Value Factor (from (2)) § (4) EAC (Cost/PVF) (5,2/2,24) § (2) PV = 5,2, I/YR =14%, N = 3, • PMT = 2,24 o 5,2 2,24 2,3216 Project Y: § (1) Cost 8 § (3) Present Value Factor (from (2)) 2,0572 § (4) EAC (Cost/PVF) (8/2,0572) 3,8887 § (2) PV = 8, I/YR = 14%, N = 6, • PMT = 2,0572 o Project Y did minimise the annual cost of the investment o However, Project X did result in an incremental positive cash flow of R0,3m which more than offsets the annual cost disadvantage (2) Capital Rationing • • • Under capital rationing, a firm limits the total quantity of funds to be invested in projects Therefore, even though certain projects have a positive NPV, they could still be rejected based on capital restraint The aim now is to maximise the sum of projects NPVs without exceeding the capital restraints • Divisible projects o = = Calculate the profitability indices of the projects PV Cost of investment OR NPV + Cost Cost of investment o o Rank in order of highest to lowest If your capital limit allows you to include a portion of a project, the project may be divided (i.e. divisible) WWW.TAKINGNOTESU.COM § § o o • Indivisible projects o o o o • For example, ranked in order of PI, the following projects can be accepted A R10m + B 30m + C (80% x R25m) = R60m (limited capital, therefore can only accept projects costing up to R60m) PI is greater than 1; and the project should thus be accepted PI is less than 1; and the project should thus be rejected Calculate the optimal mix of projects by determining which projects your capital limit allows you to combine Rank the optimal mixes in order of descending NPVs Choose highest NPV § And remaining funds are reinvested @WACC If your capital limit allows you to include a portion of a project, the project may NOT be divided (i.e. indivisible) Investment Cost NPV Investment Cost NPV A 40 6 A+E 50 8 B 30 5.4 C+E 60 6.5 C 50 4.5 B+D 55 9.7 D 25 4.3 B+E 40 7.4 E 10 2 D+E 35 6.3 Further perspectives o o o o (1) The use of a hurdle rate § In order to manage capital rationing constraints, firms may decide to use a hurdle rate that is higher than the cost of capital to discount future cash flows • This will bring down the NPVs of all projects • Then, the cost of all positive NPVs will be within the capital limit (2) The cost of capital rationing § Determining the cost of capital rationing may be achieved by determining the incremental NPV not achieved due to capital rationing § i.e. What is the combined NPV given up due to capital rationing? (3) Reasons for capital rationing § To raise additional funds, a firm may have to issue additional equity § Thereby, losing control • Shareholder would therefore prefer to retain control even if this results in declining projects with positive cash flows (4) Capital rationing over more than one year § Management may extend the analysis over more than one period (4) Example, • Capital limit = R40m, Cost of capital = 12% Project A B C 0 -40 -22 -18 1 80 10 15 2 30 60 50 WWW.TAKINGNOTESU.COM NPV 55,344 34,76 35,253 PI 2,384 2,58 2,959 • • • The company would normally invest in B and C as the two are within the capital limit and offer the highest NPV However, assume there is a new project D (costs R120m) which has a very positive NPV, which exceeds what the company loses by not investing in B and C The correct answer would be to invest in project A and reject B and C, as this enable the company to invest in D (80+40=120) (3) Assessed Loss (AL) • • When a company experiences an assessed loss, SARS allows the company to offset this loss against future tax payable This results in lower tax having to be paid in future years Summary of Scenarios 1 • The company has an assessed loss and is able to utilise the loss from the OPERATING INCOME of existing projects within the same time • • 2 The company has an assessed loss but a new project allows there to be a faster utilisation of the assessed loss • • • 3 The company has an assessed loss but no other income • • 4 The project creates an assessed loss because of tax allowances and low profitability levels in the initial years, but the firm is able to set this off against other profits 5 The project creates a tax loss but the company is unable to set off such losses against other income of the firm • • • • Therefore, there is no additional benefit generated by the new project Ignore the assessed loss when evaluating the new project The cash flow benefits of utilising the assessed loss in the early years should be included as well as the opportunity cost of not being able to use the assessed loss against existing profits at a later stage Take into account when evaluating the project The utilisation of the existing assessed loss does not result in an opportunity cost, and the full benefit of the assessed loss should be included in the evaluation of the new project This assumes that no other projects will arise that would enable the utilisation of the assessed loss Tax limitations exist, for example the company being required to continue training in order to be able to use the benefit of the assessed loss Take into account the full effect of the assessed loss when evaluating the project The company includes tax savings owing to the acceptance of the project in those years The assessed loss gets carried forward until the project itself can utilise the assessed loss The company is required to carry forward the assessed loss created by the project to such a year that the firm is able to use such losses in later years against the income of that project Take assessed loss into account immediately WWW.TAKINGNOTESU.COM Examples • • DEW Ltd currently has an assessed loss of R9m and the company’s current profit before tax is R3m per year The possibility of accepting a new project exists o The project will increase the company’s profit before tax with R1.5m per year o The company’s current tax rate is 28% Without project Taxable income Assessed loss • Year 2 3 (3) – Year 3 3 (3) – Year 1 3 (3) – 1.5 (1.5) – Year 2 3 (3) – 1.5 (1.5) – Year 3 3 – 3 1.5 – 1.5 R3m + R3m + R3m = 9m With project Taxable income Assessed loss Taxable income Assessed loss • • Year 1 3 (3) – R3m + R1.5m + R3m + R1.5m = R9m R4.5m will be applicable for tax (1) Scenario 1 • • • BB Ltd has an existing assessed loss of R100 and going forward is EXPECTED TO GENERATE PROFITS o Therefore, ignore the assessed loss when evaluating the new project The company expects that in year 1 they will be able to fully utilise the assessed loss using profit generated from its current operations The company expects that a new project will generate taxable income of R150 and R200 in year 1 and 2 respectively Taxable income Tax @28% Year 1 150 (42) Year 2 200 (56) (2) Scenario 2 • • • BB Ltd has an existing assessed loss of R100 and DOES NOT HAVE ANY TAXABLE INCOME against which to utilise against o Take into account when evaluating the project The company expects that in year 2 its current operations will allow it to utilise the assessed loss The company is considering accepting a project that will generate taxable income of R150 and R200 in year 1 and 2 respectively Taxable income Assessed loss Opportunity cost Total taxable income Tax @28% Year 1 150 (100) 50 (14) WWW.TAKINGNOTESU.COM Year 2 200 100 300 (84) (3) Scenario 3 • • • BB Ltd has an existing assessed loss of R100 and does not have any taxable income o The company will not be able to utilise its assessed loss through its current operations o The acceptance of the project will put the company in a position to utilise its assessed loss The entity also does not expect to generate any taxable income in the future its current operations The company expects a new project will generate R150 and R200 taxable income in year 1 and 2 respectively o The utilisation of the existing assessed loss does not result in an opportunity cost, and the full benefit of the assessed loss should be included in the evaluation of the new project Taxable income Assessed loss Total taxable income Tax @28% Year 1 150 (100) 50 (14) Year 2 200 200 (56) (4) Scenario 4 • • • BB Ltd is considering a project that in year 1 will yield an assessed loss of R125 In year 2 however the project will generate taxable income of R200 o The assessed loss gets carried forward until the project itself can utilise the assessed loss The company has other profit generating activities however the project’s assessed losses are ring-fenced according to tax legislation Taxable income Assessed loss carried forward Total taxable income Tax @28% Year 1 (125) 125 0 0 Year 2 200 (125) 75 (21) (5) Scenario 5 • • • BB Ltd is considering a project that results in a tax loss of R125 in year 1 In year however the project generates taxable income of R200 o The company is required to carry forward the assessed loss created by the project to such a year that the firm is able to use such losses The company has existing profit generating activities Taxable income Total taxable income Tax @28% o o Year 1 (125) (125) 35 Year 2 200 200 (56) The company’s existing operations allow the project’s full assessed loss to be utilised earlier as opposed to only in year 2 Note that the total tax payable is the same as in scenario 4 (R35 – R56 = R21) WWW.TAKINGNOTESU.COM Question discussion • • • • • • • It seems as if the company can utilise the assessed loss over a period of … years (AL/PBT) even without accepting the project If the project is however accepted, the assessed loss will be utilised over a period of … years [AL/(PBT + project contributions)] o There is therefore a time value of money benefit to utilising the AL faster, if the project is accepted As far as the cash flow of the project is concerned – for the first … years, no tax needs to be paid (cash flow for tax purposes therefore amounts to R0) o Years utilising assessed loss In the … year, after the company’s profit has been deducted from the remaining assessed loss, an assessed loss of only R… will remain. The project will therefore be taxed on (remaining profits after remaining AL). The tax is R… o Years after the assessed loss is utilised The total tax saved by the project is R… These cash flows (tax previously not paid, as result of the utilisation of the assessed loss) must be included as opportunity cost from years after last bit of assessed loss is deducted (PBT x 28% = per annum) in the cash flow of the project since the company must now pay more tax due to the fact that the assessed loss was already partially utilised by the project As from year after last bit of assessed loss is deducted forward the project will have a normal cash outflow of 28% of the taxable profit of the project, due to the fact that the AL has now been fully utilised WWW.TAKINGNOTESU.COM (4) Abandonment Value and Optimal Economic Lives • • The financial manager should conduct regular evaluations about whether a project should be abandoned or not This is achieved by comparing: o NPV of remaining cash flows (economic value) o Current abandonment value Example, o i = 10% Year Cash Flow Abandonment Value 1 (actual) 250 350 2 (forecast) 3 (forecast) 4 (forecast) 5 (forecast) 200 150 100 50 240 150 75 0 NPV 1: o o CF0 = -350; CF1 = 200; CF2 = 150; CF3 = 100; CF4 = 50 NPV = R65,06 § As the NPV is positive (present value of project’s expected operating cash flows exceed abandonment value) the company should continue operating the project NPV 2: o o CF0 = -240, CF1 = 150, CF2 = 100, CF3 = 50 + 0 NPV = R16,57 NPV 3: o o CF0 = -150; CF1 = 100; CF2 = 50 NPV = (R17,769) § The NPV is negative • HOWEVER the firm should include estimated future abandonment values in the analysis • • This will continue until the end of year 4 Abandon in year 4 Adjusted NPV: o o CF0 = -150; CF1 = 100 + 75 NPV = R9,09 § Therefore, although the project’s abandonment value exceeds the present value of the project’s cash flows at the end of year 3, the firm should delay abandonment until the end of year 4 WWW.TAKINGNOTESU.COM Optimal Economic Value • The estimation of future abandonment values a the initial investment stage enables the financial manager to determine the project’s optimal economic life, so that the project’s NPV at time zero is optimized We calculate a project’s NPV for its full maximum operational life Then determine the project’s NPV if the abandonment option is exercised at the end of each particular period • • Example, • • Cost of the project = R520 I/YR = 10% Year Cash Flow Abandonment Value 1 250 350 Time Period Net Present Value CF0 = -520; CF1 = 250 + 350 = 600 NPV = R25,455 CF0 = -520; CF1 = 250; CF2 = 200 + 240 = 440 NPV = R70,909 CF0 = -520; CF1 = 250; CF2 = 200; CF3 = 150 + 150 = 300 NPV = R97,956 CF0 = -520; CF1 = 250; CF2 = 200; CF3 = 150; CF4 = 100 + 75 = 175 NPV = R104,787 CF0 = -520; CF1 = 250; CF2 = 200; CF3 = 150; CF4 = 100; CF5 = 50 + 0 = 50 NPV = R84,607 1 year 2 years 3 years 4 years 5 years • • • • • 2 200 240 3 150 150 4 100 75 5 50 0 Therefore, the optimal economic life is 4 years Continuing abandonment value analysis is important as a project’s expected cash flows may change over the asset’s life Abandonment value analysis is very useful when an active second-hand market exists for the type of asset involved A high abandonment value offers the firm some protection against project failure However, if the asset is highly specialised, the abandonment value of the asset will tend to correlate highly with changes in expected cash flows WWW.TAKINGNOTESU.COM 3 Replacement Timing • In many cases, a company’s operations are expected to continue indefinitely and the decision revolves around when the company should replace current capacity There will be a trade-off between o Rising maintenance costs, and o Falling residual values and replacement cost of assets Choose the option where the ECONOMIC ANNUAL COSTS are at its lowest • • Example, Year Cost / Residual value (reduces by 10% each year) 0 1 20 000 Maintenance (increases by 15% each year) • • • • 0 4 5 18 000 (20 000 x 90%) 16 200 14 580 13 122 11 810 2 300 2 645 (2 300 x 110%) 3 042 3 498 4 023 PV = (NPV 16 557) N=3 I = 16% § Therefore, PMT = EAC = (7 372) (same for every year) 0 1 (20 000) 1 3 WACC = 16% 1 year o CF0 = (20 000); CF1 = (2 300) + 18 000 = 15 700 § NPV = (6 466) 2 years o CF0 = (20 000); CF1 = (2 300); CF2 = (2 645) + 16 200 = 13 555 § NPV = (11 909) 3 years o CF0 = (20 000); CF1 = (2 300); CF2 = (2 645); CF3 = (3 042) + 14 580 = 11 538 § NPV = (16 557) o o o Year 2 2 3 4 5 (20 000) (20 000) (20 000) (20 000) (20 000) 15 700 (18 000 – 2 300) (2 300) (2 300) (2 300) (2 300) 13 555 (16 200 – 2 645) (2 645) (2 645) (2 645) 11 538 (14 580 – 3 042) (3 042) (3 042) 9 624 (13 122 – 3 498) (3 498) 2 3 4 7 787 (11 810 – 4 023) 5 NPC (6 466) (11 909) (16 557) (20 582) (24 122) EAC (7 500) (7 419) (7 372) (7 355) (7 367) • Therefore, replace the asset every 4 years, because this is where EAC is at its lowest WWW.TAKINGNOTESU.COM Strategic Options • • Strategic option should be evaluated as part of the NPV calculation Real NPV = NPV (original project) + NPV (strategic options) • Some examples of strategic options include o o o o o o o o o o o A process that will maximise flexibility A process that will allows the production of different outputs from a fixed set of inputs The ability to abandon project The ability to expand a project The ability to temporarily close down production if variable costs exceed revenues The ability to terminate initiation and construction until circumstances change The ability to delay a project The ability to lease an asset Research and development costs can create options to undertake other projects Exploration activities can be viewed as options The ability to introduce a series of products one at a time will allow the firm to evaluate the success of the product before introducing the next product in the range WWW.TAKINGNOTESU.COM VALUATIONS DEBENTURES Redeemable If the cash flow is even, calculate PV FV Redemption value (may be at premium or discount) PMT Nominal value x coupon rate I/YR Discount rate / required rate P/YR Times per year N Total number of payments Non-redeemable PMT i PMT i Nominal value x coupon rate Discount rate / required rate OR If the cash flow is uneven, calculate NPV EXAMPLES Redeemable • • • • Nominal value of debt R100 Coupon rate 15% per annum, and payments are made twice a year Redeemable in 5 years Market return on similar debentures is 9% per annum FV PMT I/YR P/YR N PV 100 (100 ∗ 0,15) 2 9 2 5*2 R123,74 Non-redeemable • • • Nominal value of debt R 100 Coupon rate 15% per annum (100*0,15 = 15) Rate of return in market is 9% per annum Therefore, value = = 15 0,09 R166,67 PREFERENCE SHARES Redeemable Non-redeemable Cumulative Non-cumulative Cumulative Non-cumulative If the cash flow is If the cash flow is PMT PMT even, calculate PV even, calculate PV i i FV Redemption FV Redemption value value PMT Nominal PMT Nominal (may be at (may be at value x value x premium or premium or dividend dividend discount) discount) rate rate PMT Nominal PMT Nominal i Discount i Discount value x value x rate / rate / dividend rate dividend rate required required rate rate I/YR Discount I/YR Discount rate / rate / required rate required rate P/YR Times per P/YR Times per year year N Total N Total number of number of payments payments OR OR If the cash flow is If the cash flow is uneven, calculate NPV uneven, calculate NPV Redeemable • • • • You currently own preference shares with a nominal value of R100 This preference shares have an annual dividend rate of 10% Similar preference shares trade on the JSE at an annual return of 12% These preference shares are redeemable at the option of the issuing company in 4 years’ time and the expectation is that dividends on similar instruments will be 8% in 4 years’ time • Current rate > market rate = REDEEM (POV = BUS, SH OPPOSITE RULES) o Value: FV = 100; n = 4; PMT = 10; I/YR = 12; PV = R93,92 Current rate < market rate = NOT REDEEM (POV = BUS, SH OPPOSITE RULES) o Value: Perpetuity = 10 ÷ 0,12 = R83,33 • Non-redeemable & cumulative • • • • Sell 100 preference shares Issue price is R1 each Dividend rate of 10% (100*1*0,10) Similar shares trade at a dividend rate of 8% Therefore, value = = 10 0,08 R125 If dividends are deferred If dividends are deferred If dividends are deferred If dividends are deferred 1) Calculate perpetuity 2) Calculate deferred dividend (remember the current year's and onwards) 3) NPV 1) Calculate NPV 1) Calculate perpetuity 2) Calculate deferred dividend (remember the current year's and onwards) 3) NPV 1) Calculate perpetuity 2) NPV If dividends are in arrears Not applicable If dividends are in arrears If dividends are in arrears 1) PV 1) PV If dividends are in arrears Not applicable Non-redeemable & cumulative: DIVIDENDS DEFERRED Sell 100 Preference shares Issue price is R1 Dividend passed over for next 2 years 12% preference dividends Required rate of return is 14% If dividends are in arrears 1) Calculate perpetuity 2) Calculate deferred dividend (remember the current year's and onwards) 3) NPV (PREFERRED) OR PV Non-cumulative & non-redeemable: DIVIDENDS DEFERRED Sell 100 Preference shares Issue price is R1 Dividend passed over for next 2 years 12% preference dividends Required rate of return is 14% If dividends are in arrears 1) Not applicable 2) Calculate perpetuity 3) Calculate deferred dividend (NOT APPLICABLE AS IT IS NON-CUMULATIVE) 4) NPV (PREFERRED) OR PV BASIS POINTS Interest rate was originally 10% 1 percentage point = 100 basis points 10% = 10 x 100 = 1 000 base points Decrease with 260 basis points = 1 000 – 260 = 740 basis points / 100 = 7,4% Decrease with 2,6% = 10% – (2.6%*10%) = 9,74% Decrease with 2,6 percentage points = 10% -2,6% = 7,4% VALUATION OF ORINDARY EQUITY Dividend discount model Price multiples (relative valuation) Free cash flow model (discounted cash flow model) EVA NAV VALUATIONS Controlling Interest Enterprise Non-controlling Interest Equity Price multiples FCF EVA NAV Dividend discount model • • Project the future dividends of the firm Discount the dividends at the firm’s cost of equity • Assume constant growth rate in dividends • Stated as follows: P0 = o o o o D1 k–g P0 Value of ordinary share D1 Next period’s dividends [D1 = D0(1 + g)] k = cost of equity g = growth rate in future dividends § g= • • Historical growth in dividends Future growth in dividends (limited to earnings growth) WWW.TAKINGNOTESU.COM Equity Dividend discount model • Limitations o It assumes that growth is constant o Only applicable where the required return is higher than growth rate § Ke > g o If growth exceeds the required rate of return, the model gives a negative valuation to the shares § Ke < g • • Zero growth in dividends (expected growth rate of dividends) Stated as follows (simply the PV of a perpetuity): PO D1 k = • Two-stage valuation o A Ltd is a young company in the electronic games sector o Estimated 3 years before competitors are able to enter this market o A Ltd just paid a dividend of 60c o Required rate of return is 12% o Growth for the next 3 years is expected to be 30% § AND THEREAFTER is it expected to be 6% (normal growth for the industry) For example, STAGE 1 1. Calculate PV of dividend until the growth rate changes • • • • Dividend year 1 R0.60 x 1.30 = R0.78 Dividend year 2 R0.78 x 1.30 = R1.01 Dividend year 3 R1.01 x 1.30 = R1.31 STAGE 2 2. Value the growth on the date the growth rate changes • Valuing the shares in year 3 • Thus the formula will be: These dividends are discounted at 12% to arrive at PV o 1 = 0,6964 o 2 = 0,8052 o 3 = 0,9324 o 1 + 2 + 3 = R2.434 / share P3 = D4 k–g P3 = 1.39 0.12 – 0.06 P3 = R23.17 • Where, [D4 = D3(1 + g)] [R1.39 = (1.31 x 1.06)] • Where, g is after year 3 • P3 must be discounted = R16.49 • THEREFORE, the value of a share in A Ltd is = R2.434 + R16.49 = R18.92 WWW.TAKINGNOTESU.COM Steps to solve two-stage valuation Calculate dividends for first period of constant growth Calculate present values of each dividend for first period of constant growth Calculate present value factor of last year of first period of constant growth (PV / FV) Calculate net present value for first period of constant growth Calculate the value of the ordinary share for the last year of first period of constant growth Discount this determined value to year 0 Calculate the net present value by adding the present values of each period of constant growth WWW.TAKINGNOTESU.COM Price multiples • PE RATIO Measures the relationship between the company’s EPS and share price PE ratio • • Investors are prepared to pay (answer) times the firm’s EPS The value of the company based on the industry sector average PE would be: Value = • • • • • • MPS EPS = EPS x PE ratio High level of financial leverage may equal lower PE ratios o Reflects the higher risk profile Companies with high PE ratios may indicate that the company’s share price is overvalued And yet a high PE ratio may indicate very low reported EPS Advantages (applicable to EY) o Easy to use o Data is easily, quickly and cheaply accessible o Data is easy to understand and interpret Disadvantages (applicable to EY) o Based on historical earnings o PE ratio or EY approach do not require any detailed analysis o High PE ratio may simply reflect very low reported earnings in the last period o A company reporting losses will report a negative PE ratio o Based on accounting earnings rather than cash flows A company may use expected earnings or forecast earnings to determine valuation PRICE TO BOOK VALUE RATIO Price to book value (BV) ratio MPS BV per share = Where, BV per share is SH’s equity No. of shares & Share value = BV per share x Price to BV ratio • Earnings yield (EY) = Investor’s required rate of return EY = o EPS MPS Riskier share is indicated by a higher EY A share with excellent growth probabilities is indicated by a lower EY The value of the company’s shares based on the industry sector average EY would be: Value • • • = EPS EY OR Expected earnings Required rate of return Dividends yield (DY) = Applicable for valuation of NCI DY = DPS MPS WWW.TAKINGNOTESU.COM • EBITDA or EBIT multiples to determine enterprise value • • Earnings before interest, tax, depreciation and amortisation Earnings before interest and tax o Use EBITDA and EBIT multiple to determine the enterprise value of the firm EBITDA multiple EBIT multiple (works exactly the same of EBITDA) § o Enterprise value EBITDA Enterprise value EBIT Where, Enterprise value = MV of equity + MV of debt + MV of preference shares – Cash Value of enterprise, EBITDA: = EBITDA multiple x EBITDA o Value of equity, EBITDA = Value of enterprise – MV of debt + Cash o + – = – = – = + or – = – = – = – = Advantage of using EBITDA § Ignore differences in financial leverage § Ignore differences in depreciation policies, and the situation where 1 firm has older assets and therefore lower depreciation charge • However, the capitalisation of all operating leases should address this issue Revenue COS GP Other operating expenses EBITDA (ENTERPRISE) Depreciation and/or amortisation EBIT (ENTERPRISE) Interest income / interest expense Net profit before tax Tax Net profit after-tax Preference dividends Profit attributable to ordinary SHs Ordinary dividends (EQUITY) Retained earnings (EQUITY) WWW.TAKINGNOTESU.COM FCF model • • • • • • Value the FCF to the firm, or Value the FCF to equity FCF TO THE FIRM approach of valuing ordinary equity requires that we Estimate the future after-tax operating cash flows of the firm We discount these cash flows at the company’s cost of capital (WACC) And we deduct the value of debt to get to the value of ordinary equity • Value of the company = FCF to the firm + Non-operating assets o FCF to equity = Value of the company – MV of debt – MV of prefs • • • FCF TO EQUITY is the amount of cash generated by the company It is operating after-tax cash flows Less the net financing cash flows o Such as interest (after-tax), and o Changes in debt levels Discounted at the company’s cost of equity • + – – = + or – + or – + or – = + or – + or – – + or – = Revenue Operating costs Tax cash flows Net operating profit after-tax Non-cash flow items (depreciation and/or amortisation) Change in NWC Net capital expenditure FCF TO THE FIRM discounted @cost of capital Interest income / interest expense Change in debt Preference dividends Change in preference share capital FCF TO EQUITY discounted @cost of equity ValueFIRM Terminal value • FCFF(n+1) o = FCFF x g • • FCFEn+1 (Ke – g) = • FCFFn+1 (WACC – g) = ValueEQUITY Terminal value CF0 = 0 CF1 = FCFF + Terminal value I/YR @ WACC NPV • • • • ß FCFF + Terminal value o CF0 = 0 CF1 = FCFF + Terminal value I/YR @ WACC NPV Plus: Cash Plus: Investment Less: Debt Equals = Value of equity Where, o FCFF = Net operating profit after tax + depreciation – net capital expenditure – net increase in working capital o FCFE = Net operating profit after tax (and after financing costs) + depreciation – net capital expenditure – net increase in working capital WWW.TAKINGNOTESU.COM For example, FCF Value of Enterprise: Value of Equity Terminal Value in FCFF Terminal Value in FCFE Fn (enterprise) = FCFF (n+1) Fn (equity) = FCFE (n+1) WACC - g Ke – g When calculating FCFn+1, make sure that once-off items have been excluded FCF is zero after the forecast period Terminal Value = Present Value of perpetual CF = PV of zero =0 FCF remains constant Terminal Value = Present Value of perpetual CF after the forecast = PV of perpetuity with no growth period = FCFFn+1 / WACC à (enterprise) = FCFEn+1 / Ke à (equity) FCF grows at a Terminal Value = Present Value of perpetual CF constant rate after the = PV of perpetuity with constant growth forecast period = FCFFn+1 / [WACC – g] à (enterprise) = FCFEn+1 / [Ke – g]à (equity) Example: Application Question 1 2002 24812 (9138) 24784 (5438) (5267) 29753 EBIT TAX (C1) DEPRECIATION CAPEX (C2) CHANGE IN NWC (C3) FCFF TERMINAL VALUE (C4) NET FCFF 29753 2003 29735 (8811) 25584 (3187) (4338) 38983 2004 34188 (10519) 34584 (44188) (5761) 8304 38983 702728 711032 Calculations 1. Tax SoCI Interest Paid (28%) Current Tax O/B Deferred Tax O/B Current Tax C/B Deferred Tax C/B 2002 7032 2062 3573 4232 (2866) (4895) 9138 2003 8698 1367 2866 4895 (3747) (5268) 8811 2004 10541 1140 3747 5268 (4608) (5569) 10519 2. Capital expenditure PPE C/B Capitalised Expenditure Movement Depreciation Increase 2001 120919 2002 99135 2438 2003 77551 1625 2004 87968 812 (19346) (24784) 5438 (5438) (22397) (25584) 3187 (3187) 9604 (34584) 44188 (44188) WWW.TAKINGNOTESU.COM 3. Net Working Capital Inventory Debtors Creditors Provisions 2001 34485 43656 (37887) (1847) 38407 Increase 2002 39182 48895 (41958) (2445) 43674 5267 2003 42770 52953 (45067) (2644) 48012 4338 4. Terminal Value • • • Ke = Rf + B(Rm – Rf) Ke = 6% + 0,8(12% - 6%) Ke = 10,8% • • Kd = 10% x 0,72 Kd = 7,2% • • • WACC target = 80:20 WACC = (10,8 x 80%) + (7,2 x 20%) WACC = 10,08% • • • • FCFF(2015) 2014 Add: Non-Recurring Expenses Sustainable FCF2014 • • • Terminal Value = FCFF(n+1) / (WACC – g) Terminal Value = (48304 x 1,03) / (10,08% - 3%) Terminal Value = 702728 8304 40000 48304 Value of Firm CF0 = 0, CF1 = 29753, CF2 = 38983, CF3 = 711032, I = 10,08% NPV = R599507 Value of Equity Value of Firm Plus: Cash Plus: Investment in Associate Plus: Other Investments Less: Long-Term Debt Less: Short-Term Debt Value of Equity 599507 204 2006 4335 (38574) (6442) 561035 WWW.TAKINGNOTESU.COM 2004 47502 57984 (49169) (2544) 53773 5761 EVA • The value of a company increases only if it invests in projects that offer returns above the company’s WACC • • EVA = (Return on capital – WACC) x Invested capital Where, o Invested capital = BV of firm’s non-current assets + NWC (Current assets – non-interest-bearing liabilities) • Value of the firm = BV of its net assets + PV of the company’s future EVAs ValueFIRM BV of net assets + EVA1 EVA2 + 1 + WACC (1 + WACC)2 …And so on until EVAn + Vn (1 + WACC)n • NAV • • Where, o Net assets = Non-current assets + NWC (Current assets – non-interestbearing liabilities) o EVA = (Return on capital – WACC) x Invested capital o Vn = Terminal value of the equity at the end of the explicit forecast Value of equity Plus/less: Any revaluations in assets WWW.TAKINGNOTESU.COM e For example, what is the value of the company using EVA? • • • • • • After-tax return on capital of 25% o Maintain this for 3 years BV of operating assets (PPE + NWC) is R180m WACC is 10% The company expects competitors to enter the sector which will mean that the company’s return on capital = WACC from year 4 onwards Depreciation of R15m o But reinvesting R15m each year in operating assets o BV will therefore remain constant Outstanding debt of R60m BV NOPAT Less: Capital charge EVA 0 180 ROC x BV 25% x 180 WACC x BV 10% x 180 45 – 18 1 180 2 180 3 180 45 45 45 (18) (18) (18) 27 27 27 Therefore, Value of the firm = BV of its net assets + PV of the company’s future EVAs Value of the firm = 180 + 67.15 + 0 (terminal value) = 247.15 AND, value of the firm – value of debt = value of equity Value of equity = 247.15 – 60 = 187.15 WWW.TAKINGNOTESU.COM Adjusting for risk • Risk Factors May Include: o o o o o o o o Listed versus unlisted § Listed companies are less risky as there are more requirements, they need to have met in order to be listed Size Private versus public Company § Public companies have more shareholders and can therefore be seen as less risky Gearing § The more debt the company has, the riskier they are § ✘ Higher debt ratio § ✓ Lower debt ratio Growth rates Liquidity § Liquidity ratios are a good indication of risk Union involvement Degree of regulation PE RATIO COST OF CAPITAL • • • Adjusted downwards for risk Higher the risk, the lower the PE ratio (Max 4) • • • Adjusted upwards for risk Higher the risk, the higher the cost of capital (Max 4) • Steps to calculate PE ratio • Steps to calculate Ke o o o o o (1) Identify a company with a similar risk (1) profile (2) Determine PE ratio of similar company (3) Adjust PE ratio of a similar company for (3) differences with company being valued (4) Apply adjusted PE ratio in calculations o o o • (1) Identify a company with a similar risk (1) profile (2) Determine Ke of similar company (3) Adjust Ke of a similar company for (3) differences with company being valued (4) Apply adjusted Ke in calculations (2) Determine Ke o Ke = Rf + B(Rm – Rf) § WWW.TAKINGNOTESU.COM Get the variables from a company that is similar to the company being valued • Usually the same debt equity ratio is a good indicator COST OF CAPITAL Reasons for calculating a company’s cost of capital • Does the return on a project exceed the company’s required return as indicated by its cost of capital? Evaluation of capital projects • Valuation of companies • • Determination of a company’s EVA or economic profit Use of WACC to: Determination of fair value of assets for corporate purposes • • • • A company’s WACC enables investors to undertake discounted cash flows valuations of companies A company’s cost of capital is used to discount a firm’s forecasted future operating cash flows Investors are making increasing use of Economic Value Added, or economic profit, to evaluate the financial performance of companies and management is increasingly evaluated on the basis of EVA EVA is determined as follows; o EVA = Operating income – (WACC x Invested Capital) Frame pricing decisions for industries subject to regulatory review This is particularly relevant when there is an absence of a liquid, orderly market for a company’s assets Adding or destroyed value? o ROIC (Return on Invested Capital) compared to WACC Principles for determining a firm’s cost of capital Use a weighted average • We are interested in determining the required return that will provide a of the costs of the return to all providers of financing to the firm different sources of finance • Cost of new financing is relevant • Therefore, use the interest cost of raising new debt and not the average cost of past debt and not average cost of past debt issues and loans Use marginal costs • Do not use the average interest rate on bonds and loans reported in the company’s financial statements • Use data that refers to the future in calculating the cost of equity and the cost of debt • The discount rate should be stated after corporate tax Include the effects of corporate tax • Future cash flows are often stated in nominal terms and therefore we Use nominal rates should use a nominal rate as a discount rate • Real cash flows can be discounted at the real required return Use market values or a • The use of market values is more relevant in determining the true cost target capital structure of each financing source WACC = Kd (1- t)(D/V) + Ke (E/V) Kd Ke t D E V = = = = = = • cost of debt (before tax) cost of equity marginal company tax rate market value of debt market value of ordinary equity market value of the firm If the company has issued preference shares this would be included as a separate component in the above formula WACC = Kd (1- t)(D/V) + Ke (E/V) + Kp (P/V) Step 1. Step 2. Step 3. Calculate the marginal cost of every source of finance, including the tax effect (use nominal rates) Calculate the weight of every component of financing (use market values) Calculate the weighted average cost of capital WACC = S (marginal cost x weight) 1 Source Equity • Dividend growth model (highest of the two) Kr = D1/P0 + g Ks = D1/P0(1-F) + g • Capital Asset Price Model Ke = Rf + b (Rm - Rf) • Bond yield plus risk premium Bond yield risk + risk premium Preference shares • Redeemable • Non-redeemable Loans or debentures • Redeemable • Non-redeemable Weighted average cost of capital 2 3 4 Cost Weight Contribution BEFORE TAX AFTER TAX 5 2 COST 3 Can be given %, or % = MARKET VALUE/sum of each source’s market value 42x3 5 Sum of CONTRIBUTIONS The company requires a return of X% per year which is smaller/bigger than the cost of capital of Y% (Y = WACC) For that reason the WACC is not acceptable/acceptable, therefore the company needs/does not need to to look at alternative sources of finance to ensure the return is greater than the WACC Cost Equity Dividend growth model (highest of the two) • • Kr = D1/P0 + g à cost of existing equity Ks = D1/P0(1-F) + g à new issue of equity P0 D1 k g F • • = = = = = current market price of the share next period’s dividend required rate of return sustainable growth rate in future dividends flotation costs Sometimes, calculating the growth in earnings, and growth in dividends is required for next period’s dividends Growth in earnings, and growth in dividends are calculated as follows: For example; Earnings (profit) history: 2009 R 32 000 000 8 000 000 TAKE NOTE Earnings Dividends o 2010 R 35 000 000 8 750 000 Earnings § PV = 32 000 000 § FV = 38 000 000 § N=2 § P/YR = 1 • I = 8.97% Dividends § PV = 8 000 000 § FV = 9 500 000 § N=2 § P/YR = 1 • I = 8.97% o Capital Asset Price Model • Ke = Rf + b (Rm - Rf) Ke Rf b Rm = = = = required rate of return risk free rate beta of the share return on the market portfolio WWW.TAKINGNOTES.CO.ZA 2011 R 38 000 000 9 500 000 Preference shares REDEEMABLE PV = net receipt (Vp – issues costs) FV = redemption amount N = number of payments PMT = preference dividend • I/YR = Kp NON-REDEEMABLE Preference dividend = nominal value*preference dividend rate Vp = preference dividend/required return Net receipt = Vp – issues costs Kp = preference dividend/net receipt Loans • Kd (1- t) Debentures REDEEMABLE Value (if not given, face value) FV = redemption amount Pmt = redemption amount*% / (P/YR) P/YR = number of payments per year I/YR = similar investments N = number of payments x P/YR • PV = ? NON-REDEEMABLE Interest or coupon = face value*coupon rate Vd = Interest or coupon/required return Net receipt = Vd – issues costs Kd = Interest or coupon/net receipt THEN… • Kd (1- t) PV = net receipt (PV – issues costs) FV = redemption amount N = number of payments x P/YR PMT = coupon or interest • I/YR = Kd THEN… • Kd (1- t) WWW.TAKINGNOTES.CO.ZA Market values Equity Market value = MPS x number of shares CALCULATIONS • • • Price Earnings Ratio = MPS/EPS EPS = earnings/number of shares MPS = EPS x PE o Therefore, market value = MPS x number of shares • • • • Given the price currently trading Given the issue value per share Given share capital Therefore, number of shares = share capital/issue value per share o Therefore, market value = number of shares x price currently trading Preference shares • Preference dividend = Nominal value x preference share rate o o R Market value = number of preference shares x preference dividend/current rate of return % Market value = current rate of return Loans • Loan in SFP Debentures • Market value per debenture x debentures issued • Market value: o FV = redemption amount o Pmt = redemption amount*% / (P/YR) o P/YR = number of payments per year o I/YR = similar investments o N = number of payments x P/YR § PV = ? • Debentures issued: o Debentures in SFP/face value per debenture WWW.TAKINGNOTES.CO.ZA WEIGHTING COMPONENTS OF CAPITAL STRUCTURE • • • • • • • • • • • We assume that there is an optimal or target capital structure that will maximise the value of a company and reduce cost of capital The basic concepts underlying a target capital structure rest on the principle that the use of debt, which is less costly than equity, increases the financial leverage of a company Furthermore, debt it less costly than equity and also results in an interest tax shield (tax saving) The company is normally able to deduct the interest expense from taxable income If we use equity financing, then this will not result in any tax deduction Therefore, the use of debt should increase the value of a company However, as a company increases its debt financing relative to equity, this will increase the risks that a company will face if that company cannot meet its interest payments Also, higher interest rates may result in losses and then the interest tax shield is not worth very much As a company’s debt/equity ratio increases, it will find that the cost of debt becomes increasingly expensive o Therefore, debt is good up to a point o After this optimal debt/equity ratio, the present value of all the financial distress costs will exceed the benefit of debt, leading thereafter to a fall in the value of a company The target capital structure is the debt/equity ratio, which leads to an optimal value of the company There are 3 possible capital structure weights that can be used to determine a company’s WACC; ideal approach is in this order o The target capital structure o The current market values of debt and equity financing o The accounting or book values of debt and equity that are disclosed in the Statement of Financial Position WWW.TAKINGNOTES.CO.ZA MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING FIRMS CAN EXPAND Internal expansion or organic growth External expansion Takeover, by acquiring control of shares and assets in another company Acquisition of longterm operating assets TYPES OF MERGERS Horizontal Vertical Conglomerate Either expands forward to a customer Firms in same industry merges Firms in unrelated lines of business merge Virgin Group Or expands backwards to a supplier Shoprite purchases Checkers Eskom purchases a coal mine REASONS FOR MERGERS Results in synergistic benefits Due to Operating economies Vxy > Vx + Vy Vxy < Vx + Vy Tax considerations Value of the combined company (Vxy) is greater than the combined value of the separate companies (Vx) and (Vy) Management issues Access to technology WWW.TAKINGNOTESU.COM & other factors • • • OPERATING ECONOMIES • TAX CONSIDERATIONS • • MANAGEMENT SKILLS TECHNOLOGY • • Lower unit costs through higher production Particularly for horizontal mergers Operating economies may be affected by: o Economies in purchasing § Increased size will enable the company to exercise greater market power over suppliers • Achieve lower cost prices • Extended payment terms o Standardisation and reduction in no. of products § Cost savings from producing complex & similar products o Combination of production facilities (PF) & warehouses (W) § PF: Cost savings & effective utilisation of spare capacity § W: May reduce distribution costs o Reduction in no. of retail outlets o Combination of IT and administrative functions § Cost savings in respect of personnel and office rentals § Integration of systems may result in benefits for the group o Consolidation of research and development programmes § Research and development programmes have become very costly, and so it is imperative for companies to merge to be able to afford it If the takeover is structured as a sale of the business o Then any interest expense will be deductible for tax purposes One reason for undertaking a merger may be to obtain the benefit of the taxassessed loss of the target company With proper management, the firm could experience an improvement in its financial position A firm w/ strong management resources may take over a firm currently earning low returns in order to introduce improved management, & reap benefits In order to acquire the technological knowledge that the target company possesses Use for excess liquidity • • Diversification • • • • OTHER FACTORS Lower financing costs • Replacement costs • Products • Company with surplus cash resources may decide to utilise such liquidity in order to acquire other companies Or take over another firm in order to obtain its strong liquidity position A company in a particular business field may decide to enter into an unrelated business area Reduce variability of its returns Reduce investors’ required rate of return However, it is easier for SHs of public companies to diversify for themselves If the takeover is structured in the form of a transfer of assets & liabilities o Then any interest expense will be deductible for tax purposes A firm who wishes to increase its production capacity may find it cheaper to do so via the acquisition In order to obtain access to the target company’s product range (particularly branded products) WWW.TAKINGNOTESU.COM THE STRUCTURING OF TAKEOVER OFFERS AND TAXATION FINANCING COSTS • Assuming that the company obtained a loan to pay the purchase price of the assets & Buy liabilities assets o If the takeover is structured in the form of a transfer of assets & liabilities § Then any interest expense will be deductible for tax purposes • Assuming that the company obtained a loan to pay the purchase price of the ordinary shares Buy o Usually, as the funds are not utilised in the production of income, the interest shares expense would not be deductible § However, a company may obtain a deduction in terms of s 24O CAPITAL GAINS TAX (CGT) AND DIVIDEND WITHHOLDING TAX (DWT) • Will increase the base cost (SP = future CP) Buy o Thereby reducing CGT in the future assets § If the company acquires the shares, this may mean increasing CGT in future as assets will remain at their original base cost • SHs subject to DWT (of 15%) once the company distributes the accumulated profit or Buy RE as dividends shares o This will not arise if the company acquires the assets rather than the shares • Securities transfer tax (STT) of 0,25% on the transfer of shares DEPRECIATION AND W&T Buy • Company will qualify for depreciation or W&T assets • s 12C = 20% of the CP (unless the company is defined as a connected person [CP]) • Company will not earn any depreciation or W&T Buy • Will be subject to a tax recoupment once the asset is sold in the future shares o This is in addition to CGT if SP > CP For example, a company can acquire either the assets or shares for R100 (interest is deductible in terms of s 24O) ASSETS SHARES (1) Operating cash flow 40 40 Depreciation @20% (20) 20 40 (2) Interest @10% (10) (10) Taxable income 10 30 (3) Taxation @28% (2,8) (8,4) (4) Net cash flow after tax [(1) – (2) – (3)] = (4) 27,2 21,6 FURTHER ISSUES TO CONSIDER IN ACQUIRING SHARES OR ASSETS • Have to pay for 100% of the assets in order to control Buy • Avoid buying any skeletons in the cupboard (‘skeletons’ = undisclosed liabilities) assets o You buy only what you want • Special resolution in order to dispose of all the assets • Only have to pay for 50,1% in order to control • Hostile takeover Buy o Incredibly difficult to pull off in SA shares • Need not change existing contracts • Inherently taking on the liabilities WWW.TAKINGNOTESU.COM ARE MERGERS SUCCESSFUL? WHY DO MOST MERGERS FAIL? Overoptimistic appraisal of market potential • Overestimation of synergies Paying too much Lack of post-acquisition integration Other reasons for failure include o o o o o o o o o o o Excessive financial leverage Timing delays relating to the disposal of non-core divisions Poor business fit Clash of corporate cultures Divisions may occur at board level Regulatory delays may affect the ability to realise synergies within a reasonable time frame Inadequate due diligence undertaken by the acquiring company Loss of key customers and key staff Higher than expected costs Loss in the value of brands that attached to the individual companies Ineffective and poor communication with § Employees • Be candid about potential job losses • Lock in key staff members § Customers § Suppliers TERMS OF MERGERS Acquisition FINANCED BY CASH FINANCED BY SHARES ISSUE WWW.TAKINGNOTESU.COM ACQUISITION FINANCED BY CASH (3) Dividend discount model (1) FCFE (2) Price-earnings ratio • Financed by cash o o o If the company is listed § Examine the current MV of the shares If the company is not listed § Employ valuation methods to calculate intrinsic worth of shares Minimum and maximum cash price for the target company § The MINIMUM price is what the target company is currently worth • An acquiring company will usually need to pay a minimum cash price for the target company’s shares or assets o SHs of the target company to agree to the transaction o o § Listed company § This is always the share’s trading price Unlisted company § This is the value of a NCI’s equity interest The MAXIMUM price is the current value of the target company plus all the synergistic benefits that are expected to arise from the merger • The acquiring company would not want to pay more than a certain maximum price (1) Free cash flow to equity (FCFE) FCFE of the merged company – FCFE of acquiring company = FCFE of the target company (inclusive of any synergy benefits) Discounted @Keacq = Discounted @Keacq = Discounted @Keacq = WWW.TAKINGNOTESU.COM MV of the merged company’s equity – MV of the acquiring company’s equity = MV of the target company (inclusive of any synergy benefits @MV) (2) Price-earnings ratio (PE ratio) Target’s earnings + any synergy benefits • • PE ratio of acquiring company x = MV of target company’s equity (inclusive of any synergy @MV) A high PE ratio usually signifies that a company has high growth prospects If a company with a low PE ratio acquires a company with a high PE ratio, the acquiring company will suffer a dilution in its EPS o Set an appropriate exchange ratio to avoid any dilution in its EPS ACQUISITION FINANCED BY SHARES ISSUE EXCHANGE RATIO (1) EPS (2) MPS • (1) EPS o When an acquisition is financed through the issue of shares in acquiring company, we have to determine the exchange ratio o No. of shares in the acquiring company to be exchanged for 1 share in the target company o Merger will result in dilution of EPS for 2 years § After which the EPS will be at a higher level & growing at a faster rate • Therefore, the acquirer will temporarily accept a dilution in EPS Post-acquisition EPS Pre-acquisition EPS • Synergy o If earnings are expected to increase due to synergistic benefits, there may be a range of possible exchange ratios at which the merger will not result in a dilution in EPS WWW.TAKINGNOTESU.COM Exchange ratio = EPS of target company EPS of acquiring company Total no. of shares issued = Exchange ratio x No. of shares in target company For example Acquiring company 220c 4m EPS No. of shares Target company 110c 1m • Expected synergistic benefits from the merger R1.9m (given) • Exchange ratio = = EPS of target company EPS of acquiring company SHs in T own 1 share before merger, and 0.5 shares after the merger 110 220 = 0.5 • Total no. of shares issued = Exchange ratio x No. of shares in target company = 0,5 x 1m = *500 000 shares in the acquiring company Post-merger EPS will be: Post-merger consolidated earnings [(R2.20 x 4m) + (R1.10 x 1m)] Synergistic earnings Post-merger number of shares (400 000 + *500 000) Post-merger EPS (11.8 ➗ 4.5) • SHs in A own 1 share before merger, and own 1 share after the merger 9.9m 1.9m 11.8m 4.5m 262c EPS of acquirer (EPSA) o Earnings No. of shares o 9.9m 4.5m o = 220c WWW.TAKINGNOTESU.COM • EPS of target (EPST) o EPSA x ER o R2.20 x 0.5 o = 110c Effect of EPS for acquirer’s SHs = 262c – 220c = Earning 42c per share more • Effect of EPS for target’s SHs = (262c x 0.5) – 110c = Earning 21c per share more In this case, each SH of each company is better off o Minimum and maximum exchange ratio (ER) to avoid EPS dilution § The MINIMUM exchange ratio (ERMIN) • § The MAXIMUM exchange ratio (ERMAX) • § Acquirer’s EPS starts to decline if any more shares are issued by the acquirer Target’s EPS starts to decline if any less shares are issued by the acquirer NB! REMEMBER • Synergy o If earnings are expected to increase due to synergistic benefits, there may be a range of possible exchange ratios at which the merger will not result in a dilution in EPS Therefore, EPST ERMAX = ERMIN = EPSA Synergy benefits No. of shares in the target company prior to acquisition (NT) EPSA + + EPST Synergy benefits No. of shares in the acquiring company prior to acquisition For example, EPS No. of shares Acquiring company 220c 4m Target company 110c 1m WWW.TAKINGNOTESU.COM Expected synergistic benefits from the merger R1.9m (given) 1.9m 1m 1.10 + ERMAX = 2.20 ERMAX = 1.364 (own 1.364 shares) ERMIN = 1.10 1.9m 4m 2.20 + ERMIN • = 0.41 (owns 0.41 shares) Originally the exchange ratio was 0.5 ERMAX Post-acquisition consolidated earnings Post-acquisition number of shares Post-acquisition EPS • ERMIN 11.8m 4m + (1m x 1.364) = 5.364m R2.20 This formula works as the SH is in the exact same position as before Post-acquisition consolidated earnings Post-acquisition number of shares Post-acquisition EPS • R2.675 (2,675 x 0.41 = 1.10) ACQUIRER 1.10 x 1m = R1.1m 1.364 x 1m x 2.20 = R3m Test 4m + (1m x 0.41) = 4.41m • TARGET Pre-acquisition Post-acquisition 11.8m Pre-acquisition Post-acquisition 2.20 x 4m = R8.8m 2.675 x 4m = R10.7m Test = R3m – R1.1m = R1.9m (SB) • = R10.7m – R8.8m = R1.9m (SB) WWW.TAKINGNOTESU.COM (2) MPS o ER MP per target company MP per acquiring company = § § § § MVs take into account factors such as future growth, relative risk and other pertinent information An exchange ratio based on this formula results in neither party experiencing a change in MVs This assumes that no synergistic benefits will occur Synergistic benefits can arise for a number of reasons but they generally fall into one of the following categories • • • o Lump-sum (once-off) synergies Synergies in perpetuity Synergies resulting from a change in the discount MARKET PREMIUM (synergistic benefits will occur) § Calculation of market premium ACQUISITION FINANCED BY SHARES ISSUE EXCHANGE RATIO (1) EPS (2) MPS = MP per acquiring company x ER MP per target company • 1 – = % The acquiring company will be paying the target company’s SHs the premium % over current MV WWW.TAKINGNOTESU.COM o POST-MERGER PE RATIO § § § § Necessary to estimate the post-merger PE ratio We can use the current PE ratios as an initial estimate of the post-merger PE ratio If there is no change in the market’s perception of the firm • Then the post-merger PE ratio will be an average, weighted according to the current earnings of the two firms (PE ratioacquiring and PEtarget) For example, X Ltd to acquire Y Ltd No. of EPS shares MP P/E X 4.20 6 33.60 8 Y 1.80 1.5 21.84 12.1333 • The management of X Ltd expects synergistic cost savings from the merger to be R2m per year, but does not envisage a change in the group’s PE ratio Total earnings Weighting X 25.20 (4.20 x 6) 0,90323 (25.20/27.90) 8 Y 2.70 (1.80 x 1.5) 0,09677 (2.70/27.90) 12.1333 P/E Postmerger P/E 7.2258 (8 x 0,90323) 1.1742 (12.13 x 0.09) 27.90 o 8.4 If there is a change in the market’s perception of the firm § Do NOT use the PE ratio • I.e. MVSB = Synergy earnings x PE ratio o Rather use: MVSB = MV of post-acquisition combined company – MV of pre-acquisition target company – MV of pre-acquisition acquiring company WWW.TAKINGNOTESU.COM o SHARING THE MERGER BENEFIT § Benefit is shared between the acquiring company and the target company § Merger benefit to the target company’s SHs (ERMAX) • MVSB = Synergy earnings x PE ratio MPT ERMAX o + = MVSB No. of shares in the target company prior to acquisition (NT) MPA SHARING THE MERGER BENEFIT § Benefit is shared between the acquiring company and the target company § Merger benefit to the target company’s SHs (ERMIN) • MVSB = Synergy earnings x PE ratio MPT ERMIN = MPA WWW.TAKINGNOTESU.COM + MVSB No. of shares in the acquiring company prior to acquisition (NA) DIVIDENDS, WORKING CAPITAL (WC) AND NET ASSET VALUE (NAV) • Dilution in DPS • For example, A Ltd wants to acquire B Ltd MPS DPS No. of shares • WC • NAV • B R40 2 2 000 000 R30 2 1 000 000 o Exchange ratio will be based upon MV § = 30 ➗ 40 = 0,75 • 75 A shares will be issued for every 100 B shares • This will result in a dilution in DPS for the target company’s SHs (B), if A Ltd maintains its existing dividend o Dilution for B Ltd’s SHs per 100 shares § Prior to merger • = 100 x R2 = R200 § Post-merger • = (100 x 0,75) x R2 = R150 o To overcome this, A Ltd may issue convertible debentures, preferred ordinary shares or convertible preference shares Dividends • • A Dividends represent income received by the target company’s SHs If this income stream is highly valued by the SHs o Merger agreement should be structured so that the target company’s SHs receive an income similar to the income stream that existed prior to the merger Acquiring company wishes to obtain access to the liquidity of the target company WC position of both parties will therefore be important in determining the terms of the merger NAV of a firm is based on accounting book values WWW.TAKINGNOTESU.COM LEGAL PROCEDURES (Self-study) • Disposal of all or the greater part of the assets or undertaking of a company o Approved by a special resolution of the SHs • Amalgamation, merger or takeover offer or agreement o Permitted to merge if after merger, each merged company will satisfy the solvency and liquidity tests • Scheme of arrangement o Between the company and the holders of a class of securities o Company needs to obtain an independent expert’s report on the transaction for the SHs to consider o Approval by special resolution REGULATIONS OF TAKEOVERS (Self-study) • Takeover Regulation Panel is required to regulate all affected transactions, in order to o Ensure the integrity of the marketplace and fairness to the holders of a class of securities o Ensure the provision of the necessary information to the SHs so that they can make fair and informed decisions o Prevent actions designed to impede, frustrate or defeat an offer, or the making of an informed decision by the firm’s SHs • Regulations generally only apply to public companies, o But will also apply to private companies § IF the transfer of shares between unrelated parties exceeds the prescribed % (10%) • Affected transactions include o Disposal of all or the greater part of the assets o Undertaking of a regulated company o Scheme of arrangement between a regulated company and the holders of a class of securities o Acquisition or intention to acquire a beneficial interest in the remaining voting securities of a regulated company not already held by a person o Mandatory offers § If SHs acquire shares so that they have 35% or more of the shares of the company § Also triggered by share buy-back • o Then they will be required to make an offer to the remaining SHs Compulsory acquisitions § If an offer has been accepted by 90% of a class of securities of a regulated company, and the offeror wishes to acquire all the remaining securities • Entitled and bound to acquire the securities concerned, on the same terms as the original offer WWW.TAKINGNOTESU.COM TUTORIAL QUESTION • (a) Calculate the maximum price that the acquirer should pay for a 100% interest in the target o The MAXIMUM price is the current value of the target company plus all the synergistic benefits that are expected to arise from the merger § § § = (EarningsTARGET + EarningsSYNERGY) x PE ratioACQUIRER = (6 666 667 + 1 512 000) x 5,30 = 43 346 935 • EarningsTARGET o Dividend (given) o Dividend pay-out ratio § DPS EPS o EarningsTARGET • EarningsSYNERGY o Increase in sales (given) o GP % (65 934 000/109 890 000) o Increase in GP o After tax o EarningsSYNERGY • • • 5 000 000 / 75% 6 666 667 3 500 000 x 60% 2 100 000 x 72% 1 512 000 PE ratioACQUIRER o Market capitalisation (7 000 000 x 22,90) 160 300 000 o Profit for the year / 30 245 283 o PE ratioACQUIRER 5,30 (b) Calculate the exchange ratio if the acquirer decides that abovementioned transaction should rather take place via a share exchange scheme o Abovementioned transaction determined the maximum price § Therefore, the exchange ratio will be the maximum exchange ratio (b) Also calculate the premium (if any) o NOT specified § EPS EPST ERMAX = § MPS • = Synergy benefits No. of shares in the target company prior to acquisition (NT) EPSA MVSB = Synergy earnings x PE ratio MPT ERMAX + + MVSB No. of shares in the target company prior to acquisition (NT) MPA WWW.TAKINGNOTESU.COM o If we are given that the market perception has changed § § § § MVSB = MV of post-acquisition combined company – MV of pre-acquisition target company – MV of pre-acquisition acquiring company • o ” The market sentiment with regards to the acquisition is of such a nature that the benefits of synergy will be recognized by the market, but no change in the individual company’s Price/Earnings multiples are anticipated” § NO CHANGE IN MARKET PERCEPTION • • Can employ this method whether the market’s perception has changed or not THEREFORE, o MVSB = Synergy earnings x PE ratio EPS EPST ERMAX = o o Synergy benefits No. of shares in the target company prior to acquisition (NT) EPSA EPST § 6 666 667 4 000 000 § = 1,67 Synergy benefits § o + R1 512 000 EPSA § 30 243 785 7 000 000 § = 4,32 WWW.TAKINGNOTESU.COM 1,67 ERMAX 1 512 000 4 000 000 + = 4,32 § o • = 0,47 Premium = MP per acquiring company x ER MP per target company = 22,90 x 0,47 15 – 1 = % 1 = – 28,02% – MPS o MPT Price-earnings ratio (PE ratio) Target’s earnings + any synergy benefits x PE ratio = MV of target company’s equity (inclusive of any synergy @MV) MV of target company’s equity (inclusive of any synergy @MV) / No. of sharesT = MP o § EarningsT x PE ratioT No. of sharesT § 6 666 667 x 9 4 000 000 § R15 MVSB § = Synergy earnings x Weighted average PE • WAPE Acquirer Target o o o Earnings Weight x PE 30 243 785 0,8193826 6 666 667 0,1806173 36 910 452 = 1 512 000 x 5,97 = R9 026 640 MPA § R22,90 • Given WWW.TAKINGNOTESU.COM = WAPE 5,30 9 4,34 1,63 5,97 15 ERMAX 9 026 640 4 000 000 + = 22,90 § o = 0,75 Premium = MP per acquiring company x ER MP per target company = 22,90 x 0,75 15 – – 1 = % 1 = 15,04% • (c) Discuss what the purpose is of regulating these transactions in terms of the act • (d) Assume that the exchange ratio for the acquisition of the target by the acquirer is set at 0,65 o Calculate what the effect will be on the value of a shareholder’s investment, if the investor owned a 5% interest in target before the acquisition o Compare the value of the investment before the merger, to after the merger § § § § Value of investment before merger • MPT • Total no. of sharesT • SH • Value of investment before merger x 5% R3 000 000 Total number of shares after merger • No. of sharesAcquier • No. of sharesTarget x ER • Total no. of sharesMerged Entity 7 000 000 (4 000 000 x 0,65) 2 600 000 9 600 000 Total MV after merger • EarningsT • EarningsA • EarningsSYNERGY • EarningsMerged Entity • WAPE • Total MV after merger 6 666 667 30 243 785 1 512 000 38 422 452 x 5,97 229 324 371 Value of investment after merger • Total MVMerged Entity • Total no. of sharesMerged Entity • MPMerged Entity • SH (4 000 000 x 5% x 0,65 [ER]) • Value of investment after merger 229 324 371 / 9 600 000 R23,89 x 130 000 R3 105 434 WWW.TAKINGNOTESU.COM 15 4 000 000 § • Impact on value of investment • Value of investment before merger • Value of investment after merger • Increase in value R3 105 434 R3 000 000 R105 434 (f) Explain why the acquisition of Nakit Limited by Juwelen Limited o Even in the absence of synergy earnings o Can still be financially beneficial for both companies’ shareholders o Exchange ratio is set at 0,23 A WWW.TAKINGNOTESU.COM PERFORMANCE MEASUREMENT • • A functional organisational structure places similar activity under the same manager, e.g. marketing, finance, procurement, etc. Departments are often operated as cost centres o In a functional structure only the organisation as a whole is operated as an investment centre A divisional organisational structure places individual products or services under the same manager. Units are often operated as profit or investment centres. A decentralised structure is in place and managers are more autonomous o In a divisional structure the organisation is sub-divided into several profit or investment centres o Divisionalisation is best suited to organisations that perform independent, diverse activities o Where an organisation performs activities that are very similar and have to be carefully inter-linked, divisionalisation is often inappropriate • Advantages of divisionalisation o Quicker decision-making o Better decision-making according to local needs o More job satisfaction and increased motivation for managers o Managers are developed and gain experience o Top management can focus on central issues • Disadvantages of divisionalisation o Sub-optimal decisions (no goal congruence) o Duplication of activities and assets o Loyalty to the unit instead of the organisation as a whole (units do not cooperate, but compete) o Cost of gathering information increases o Top management loses control • A responsibility centre is a unit within an organisation where an individual manager is held responsible for the unit’s performance o Managers are measured based on what they can control Cost (or expense) centre Income centre Profit centre Investment centre • Þ Manager held responsible for costs Þ Manager held responsible for income (and for selling expenses only) Þ Manager held responsible for profit (income and cost controllable) Þ Manager held responsible for profit and investments made in order to earn the profit Þ Measures such as ROI, RI and EVA are specifically applicable here Derivation of assets (investment) for ROI, RI and EVA o The usage of historical cost for measurement of assets, cause measures to rise over time, as assets is measured at historical cost, while return increases each year by inflation § Thus adjust historical cost by inflation. o The usage of net book value (Historical cost less accumulated depreciation) causes measures to look better each year, as investment decreases each year § Managers will tend to keep old assets § Accordingly goal congruence is not attained § The best value to use may be the economical or replacement value of the assets WWW.TAKINGNOTESU.COM Return on investment (ROI) = Return Investment • Advantages of ROI o Gives a percentage and can therefore compare units of different sizes directly, or can compare with indicators such as cost of capital, interest on government bonds, etc. o Measures the relationship between income generated and the size of the investment, and encourages productive use of assets o Easy to understand and to interpret o Outsiders frequently measure the organisation according to ROI, so it makes sense to also measure units in this manner • Disadvantages of ROI o Can work against goal congruence (see class example). o Short term measure that uses historical information. Projects that only render good results in the long term are often rejected Residual income (RI) = Return – (Investment x Required rate of return) • Advantages of RI o Does not pose the same goal congruence problem as ROI o A different required rate of return can be used for each unit. It can, for example, be adjusted upwards for units that have risky operations, to take the risk-return relationship into account. • Disadvantages of RI o Gives an absolute value and therefore does not take the size of the unit into account o Short term measure that uses historical information. Projects that only render good results in the long term are often rejected Economic value added (EVA) is adjusted income before interest after tax less (weighted average cost of capital x adjusted long-term assets plus net current assets) = Adjusted EBIAT – (Adjusted invested capital x WACC) • Advantages of EVA o Does not pose the same goal congruence problem as ROI (same argument as with RI) o Emphasises the creation of shareholder value • Disadvantages of EVA o Gives an absolute value and therefore does not take the size of the unit into account (same argument as with RI) o Short term measure that uses historical information. Projects that only render good results in the long term are often rejected o Various adjustments have to be made to accounting figures before they can be used o Adjustments are often arbitrary WWW.TAKINGNOTESU.COM CLASS EXAMPLE 1 • • • Required is to determine which division performed better We identified controllable and non-controllable expenses of the divisional managers o Cannot keep them accountable for things that were out of their control WACC = 15% • ROI: Return on investment (%) Return Investment (TA & TL) = o Add back all non-controllable expenses to divisional (net) profit before taxation § § Return Investment ROI • Salaries of the supervisors Head office fee allocated to divisions AGTERLAND 350 + 200 + 300 120 8 500 1 000 10% 12% 9 500 10,21% BOLAND 350 + 200 + 150 180 3 500 1 000 20% 18% 9 500 19,56% RI: Residual income = Return – (Investment x required rate of return) • Divisional managers are rewarded with a performance bonus if they manage to increase their controllable residual income • Return (from above): add back all non-controllable expenses to divisional (net) profit before taxation Return Investment@15% RI • AGTERLAND 850 120 8 500 x 0,15 1 000 x 0,15 (425 000) (30 000) BOLAND 750 3 500 x 0,15 175 000 180 1 000 x 0,15 30 000 EVA: Economic value added = Adjusted EBIAT – (Adjusted invested capital x WACC) • • Add back training cost to return (from above): add back all non-controllable expenses to divisional (net) profit before taxation Deduct EVA amortisation on training costs assets to Return (from above): add back all noncontrollable expenses to divisional (net) profit before taxation LESS • Adjusted invested capital x 15% AGTERLAND = [(850 000 + 25 000 – 23 000) – (8,65m x 0,15)] = (R445 500) BOLAND = [(700 000 + 15 000 – 18 000) – (3,6m x 0,15)] = R157 000 WWW.TAKINGNOTESU.COM CLASS QUESTION 1 • (a) Create table: ROI o Return on investment will decrease with WC § This is a negative WITHOUT WC 2 400 000 9 600 000 25% Return Investment RETURN ON INVESTMENT • WC 720 000 3 600 000 20% WITH WC 3 120 000 13 200 000 23,6% WC 720 000 (540 000) 180 000 WITH WC 3 120 000 (1 980 000) 1 140 000 (b) Create table: RI o Residual income will increase with WC § This is a positive WITHOUT WC 2 400 000 (1 440 000) 960 000 Return Investment x 15% RESIDUAL INCOME The 15%: measuring divisional performance by way of 'residual income', a return of 15% per annum on total assets will be required (given) CLASS QUESTION 2 • Meet 15% ROI target for a bonus • WACC is 12% • Only accept investments with a ROI greater than or equal to 15% Option 1 Operating profit Investment RETURN ON INVESTMENT o PRELIM 649 000 4 400 000 14,75% OPTION 1 PRELIM 649 000 4 400 000 OPTION 1 (90 000) ADJUSTED 649 000 4 310 000 15,01% ROI = 15,01% Option 2 Operating profit Investment RETURN ON INVESTMENT o (45 000) 320 000 14,75% ADJUSTED 649 000 4 675 000 13,88% ROI = 13,88% § Conclusion • • • Both options work against goal congruence Thus, both options will lead to short-sighted decisions Thus, agree with the financial manager's statement WWW.TAKINGNOTESU.COM TUTORIAL QUESTION (b) • (1) Using divisional net profit before tax, however, managers are responsible for investments o Appropriate measures are § ROI § RI § EVA • (2) Size of divisions differ o Not fair • (3) Differ in nature o Inappropriate • (4) Asset base of divisions not taken into account, which only marginally will boost their profit • (5) No segregation of measuring performance of managers and divisions • (6) We identified controllable and non-controllable expenses of the divisional managers o Cannot keep them accountable for things that were out of their control § This includes the rental expense and head office fee o However, should still be included in measuring the performance of the divisions, as the types of expenses need to be incurred in order to operate • (7) The use of a set percentage to allocate profits to divisions is an arbitrary allocation method. In order to properly incentivize division’s to generate profits, they should be allocated a percentage based on their performance • (8) All divisions that generate a loss for the financial year be excluded from being allocated a share of group profits, and this is appropriate WWW.TAKINGNOTESU.COM TRANSFER PRICING • • • • • • A transfer price is an internal price between units of the same organisation Income for transferring division = cost for receiving division o Transfer price between units cancels out when results are combined Transfer price situations usually occur within decentralized units therefore makes sense that prices are negotiated between units rather than imposed by head office o Negotiations should take place within the acceptable price range § Transfer pricing decisions often lead to conflict between units § Transfer price depends on the negotiating skills of managers and therefore does not necessarily lead to the fairest performance measurement of units § Takes up time Evaluate divisional performance o The choice of a transfer price influences the behaviour of and decisions made by divisional managers, as the transfer price has an influence on their performance measurement o Transfer pricing principles apply to any type of responsibility centre (cost, income, profit or investment centre) § For cost centres there is no profit motive, so the transfer price will only reimburse the supplying division for its costs o When managers act in their own best interest and simultaneously also in the best interest of the organisation as a whole, goal congruence is achieved Purpose of transfer pricing o Maintain goal congruence, by motivating divisional managers to make good economic decisions o To provide information that is useful for evaluating the managerial and economic performance of the divisions o Move profits between units o Maintain unit autonomy o Should be administratively practical (cost benefit) § Where the number of transfers between units are small, a good transfer pricing system is less important § • • • • Unlikely that a single transfer price will satisfy all four these goals Transfer pricing methods 1. 2. 3. 4. 5. 6. 7. Market price Cost-plus (only variable cost plus ‘profit’) Incremental cost (also known as ‘marginal’ cost) Full cost (including fixed cost) Negotiated price (may use one of the other bases as starting point) Incremental cost plus opportunity cost Market price is the best transfer price for decision-making and performance management o If there are any expenses, such as selling expenses that can be saved because units are transferred and not purchased externally, deduct these savings in costs to encourage receiving division to purchase within division Negotiations are more suitable if there is a market for the intermediate product. If there isn’t one, the transferring unit is usually in a very weak negotiating position Sometimes the difference between the minimum and maximum price is allocated in proportion to the variable costs of each unit in order to calculate the final transfer price. Disadvantage: large variable costs are ‘rewarded’. The units’ relative risk profiles can also give an indication as to how profit should be shared – higher risk should accompany higher return WWW.TAKINGNOTESU.COM • If the minimum price exceeds the maximum price – do not transfer. (If one follows the steps correctly and first evaluates what’s in the organisation as a whole’s best interest, one will usually already know the transfer should not take place) General, summary for transfer prices: • Minimum price per unit is: o Incremental cost per unit for transferor o Plus, opportunity cost per unit for transferor • Maximum price is the lesser of: o Incremental contribution per unit (without deducting transfer price) for receiver o Market price if can be purchased externally • Remember o The minimum price is the least the transferring unit can receive and still choose to act in the best interest of the organisation as a whole. o The maximum price is the most the receiving unit can pay and still choose to act in the best interest of the organisation as a whole CLASS EXAMPLE 1 è At what price should they transfer the Bick Pen? ç • Selling price Manufacturing cost Distribution cost Contribution • How do I divide the PROFIT of R4 between the 2 units? o Depends on the TRANSFER PRICE that Unit A asks Unit B for a Bick Pen • If the TRANSFER PRICE is R8/u, how is the PROFIT divided between the units? 10 (4) (2) 4 UNIT A Transfer price R8 Variable cost (R4) Profit R4 o • Will there be conflict between the units? § Suppose both Unit A and Unit B are profit centres ✓ § Suppose Unit A is a profit centre, but Unit B is a cost centre ✘ If the TRANSFER PRICE is R4/u, how is the PROFIT divided between the units? UNIT A Transfer price R4 Variable cost (R4) Profit R0 o • UNIT B Sales price R10 Purchase cost (R8) Distribution cost (R2) Profit R0 UNIT B Sales price R10 Purchase cost (R4) Distribution cost (R2) Profit R4 Will there be conflict between the units? § Suppose both Unit A and Unit B are profit centres ✓ § Suppose Unit A is a profit centre, but Unit B is a cost centre ✘ What would be a desired TRANSFER PRICE? o A desirable TRANSFER PRICE will therefore be between R4 minimum (A does not make a profit) and R8 maximum (B does not make a profit) which will divide the PROFIT of R4 between the 2 units WWW.TAKINGNOTESU.COM TRANSFER PRICING METHODS (to determine our own transfer price) • (1) Market price o o Suppose the TRANSFER PRICE is equal to the MARKET PRICE of R6 Suppose for Unit A to sell the Bick Pens externally, R1's marketing costs, in addition to R4's variable cost, must be incurred Which scenario is in the best interest of the company as a whole? § Unit A sells pens externally UNIT A External sales R6 Marketing cost R1 Variable cost (R4) Profit R1 § Sales price R10 Purchase cost (R6) Distribution cost (R2) Profit R2 Unit A transferring pens to Unit B (the best scenario) UNIT A Internal transfer R6 Variable cost (R4) Profit R2 • • UNIT B UNIT B Sales price R10 Purchase cost (R6) Distribution cost (R2) Profit R2 How can the company encourage Unit B to purchase internally instead of buying it externally? o If there are any expenses that can be saved because the units are transferred and not purchased from outside, o Deduct these expenses from the TRANSFER PRICE to encourage the recipient to purchase from within the business § Therefore, in this scenario, the adjusted TRANSFER PRICE would be R5 (marketing costs are saved) Cost methods o o Cost-bases can be useful in situations where a market price cannot be determined However, use standard cost rather than actual cost § (2) Cost-plus (only variable cost plus ‘profit’) • = Variable costs x (1 + %) • = Transfer price o E.g. R5 x 1.1 = R5.5 § (3) Incremental cost (also known as ‘marginal’ cost) § (4) Full cost (including fixed cost) + % • = Full cost x (1 + %) • = Transfer price o E.g. R85 x 1.1 = R93.5 WWW.TAKINGNOTESU.COM § (5) Incremental cost plus opportunity cost • = Variable costs + (SP – variable costs [taking into account variable selling costs]) • = Minimum price o • Therefore, if there is spare capacity and no other form of revenue sacrificed, opportunity cost is zero and only incremental cost is used (6) Negotiated price (may use one of the other bases as starting point) o o Where units are highly autonomous, transfer prices may be determined through negotiation In the best interests of the company § Thus, negotiations must take place within the acceptable price range Minimum price £ Transfer price £ Maximum price • • • MINIMUM Is the least the transferring unit can receive and still choose to act in the best interest of the organisation as a whole Incremental cost per unit for transferor PLUS Opportunity cost per unit for transferor • • MAXIMUM Is the most the receiving unit can pay and still choose to act in the best interest of the organisation as a whole Lesser of: o Incremental contribution per unit (without deducting transfer price) for Receiver OR o Market price if can be purchased externally • If there is spare capacity and no other form of revenue sacrificed, opportunity cost is zero o Opportunity cost = Capacity limits + Profit limits • If minimum price > maximum price o Do not transfer internally (= LOSS) WWW.TAKINGNOTESU.COM CLASS EXAMPLE 2 REQUIRED If division B decides to buy from the other company, calculate what the impact of the decision will be respectively on the profits of division A and X plc, assuming external sales of ProdX cannot be increased • • • (1) Division B has been approached by another company which has offered to supply 2500 units of ProdX for R35 each (2) Current transfer price @R40 (sales to division B) (3) Market price @R45 • Which option would department B prefer? o R35 < R40 § Purchasing externally is only R35 • Impact on division A? o (R40 – R22) x 2 500 = (R45 000) § Lost contribution • Impact of company as a whole? o (R35 – R22) x 2 500 = (R32 500) § Company spends R13/u more CLASS EXAMPLE 3 REQUIRED Provide advice on the determination of an appropriate transfer price for the sale of product Y from division Able to division Baker • • Selling price R42 Purchase price R38 • • Variable cost X: R32 Variable cost Y: R35 • (i) TRANSFER PRICE for product Y: (spare capacity) o o • Minimum price R35 + R0 (opportunity cost) Maximum price R38 § Therefore, between R35 and R38 (ii) TRANSFER PRICE for product Y: (full capacity, therefore opportunity cost) o o Minimum price R35 + (R42 – R32) = R45 Maximum price R38 § Therefore, between R45 and R38 • If minimum price R45 > maximum price R38 o Do not transfer internally (= LOSS) WWW.TAKINGNOTESU.COM CLASS EXAMPLE 4 • (a) Accept the offer or not? o Spare capacity? Yes § 40 000 – 30 000 = 10 000 o Additional contribution? § [R1 095 – (R420 + R210 + R126)] x 8 500 = R2 881 500 • • (b) Calculate the minimum and maximum prices? o Is there an opportunity cost? § There is spare capacity, therefore, no opportunity cost o o • ACCEPT OFFER o Fixed costs are excluded, as only relevant costs are taken into account in this calculation Minimum price R756 + R0 Maximum price R1 350 (c) Accept the offer or not? o Spare capacity? No (given) § Therefore there is opportunity cost o o Minimum price R756 + (R1 400 – R756) = R1 400 Maximum price R1 350 § Do not transfer, • as the minimum transfer price is greater than the maximum price o and therefore not in the best interests of the business as a whole WWW.TAKINGNOTESU.COM TUTORIAL QUESTION GARDENS PREPARATION SP = R1150 Demand: 7200kg ASSEMBLY Capacity: 8000kg Require: 2400kg 8 000 - 7 200 800 (spare capacity) • • • 1 600 (would be @ an opportunity cost) …Capacity Variable costs (450 + 400) ³ 800 units = 850 + (1150 – 900) o o Market price: R1070 800 units R850 R1100 …Transfer 800 units @ 850 < TP < 1070 ³ 800 units (…2400 – 800) § Next 1600 units purchased externally @ 1100 < TP < 1070 • As minimum price > maximum price o Therefore, DO NOT transfer 1600 units § If transfer price of R1050 is not accepted, and therefore sold externally • …Contribution o 7200 x (1150 – 450 – 400 – 50) = 1 800 000 § If transfer price of R1050 is accepted, and therefore sold externally • ...Contribution o 2 400 x (1050 – 450 – 400) = 480 000 o 5 600 x (1 150 – 450 – 400 – 50) = 1 400 000 o Total = 1 880 000 § ROI will increase with R80 000 (as investment stayed the same) WWW.TAKINGNOTESU.COM TREASURY THE ROLE OF TREASURY THE TREASURY DEPARTMENT • Treasury management is the corporate handling function of all financial matters, the generation of external and internal funds for the business, the management of currencies and cash flows, and the complex strategies, policy and procedures of corporate financing • Description • • Advantages • • • CENTRALISED TREASURY DEPARTMENT Treasury acts as the bank of the group, ensuring that each department has access to the correct funds at the correct times Prevents mixture of surpluses and overdrafts in the bank accounts of departments Larger amounts of money can be invested and borrowed, and at lower bank charges Expertise of employees and ability to specialize Buffer cash (emergency cash required to be held) is lower TREASURY DEPARTMENT AS A COST CENTRE Management of the department responsible only for keeping costs within targets DECENTRALISED TREASURY DEPARTMENT • • • Sources of financing can be diversified and matched with local assets More freedom and responsibility assigned to departments Local treasury function can react more effectively to local needs TREASURY DEPARTMENT AS A PROFIT CENTRE • The treasury department generates large profits • Advantages o Staff motivated to generate best return for company o If treasury asks a fee, subsidiaries would be more aware of costs and use treasury department more diligently • Disadvantages o If treasury speculates it can lead to huge losses o Subsidiaries might use third parties instead of treasury if treasury asks a fee o Difficult to measure and judge performance o Admin costs can increase 6 MAIN FUNCTIONS OF TREASURY 1. 2. 3. 4. 5. 6. Corporate financial goals Corporate finance Liquidity management Currency management Fund management Other WWW.TAKINGNOTESU.COM RISK MANAGEMENT Liquidity risk Cash management • • Interest rate risk Natural hedging o Commodity risk Exchange rate risk Opposite positions are taken in the market through the normal course of business Advantages of natural hedging § § • • • Natural hedges are free Minimisation of risk arising from matching revenue and costs in the same currency Interest rate • Options • Options swaps • Forwards • Forwards Duration and • Futures • Futures immunisation Floors, caps, collars Cash Management Liquidity Amount of cash that a company will keep on hand depends on the motives of the company • • • Transaction motive o Required for daily cash flow Precaution motive o Needed in order to pay unexpected expenses Speculation motive o Determined by whether the company has a policy of acquisitions WWW.TAKINGNOTESU.COM • • • INTEREST RATE SWAPS Swap interest rates on a notional amount (1) A floating rate borrower may want to hedge against fluctuating interest rates (2) One borrower may not be able to raise the particular debt package required on terms as favourable 1. A Ltd is paying a variable interest rate on its borrowings of R100m, 7.5% in year 1 and then 10% in year 2 • Year 1 A pays the original bank, interest of = 100m x 7,5% x ¼ = R1.875m • Year 2 = 100m x 10% x ¼ = R2.5m 2. A Ltd wants to fix its interest rate 3. A Ltd enters into an interest rate swap with another bank, whereby A Ltd will pay a fixed rate of 9% on R100m INTEREST RATERISK 4. Settle the net difference at the end of every quarter • Year 1 A pays the other bank, a net interest of = 100m x (9 – 7,5)% x ¼ = R375k • Year 2 = 100m x (9 – 10)% x ¼ = (R250k) 5. Total cost of financing • Year 1 = R1.875m + R375k = R2.25m • Year 2 = R2.5m – R250k = R2.25m 6. LOAN AMOUNT LESS: INTEREST PAID TO SWAP PLUS: INTEREST RECEIVED FROM SWAP LESS: INTEREST PAID ORIGINAL LESS: REPAYMENTS à Decreases value of loan on which interest is paid originally TOTAL (INFLOW OR OUTFLOW) Advantages of interest rate swaps • • • • Fix interest rates in periods of interest volatility or rising interest rates Choose variable rate if interest rates are expected to fall Change interest nature of borrowings without having to renegotiate existing loans Flexible and quick way of changing structure of debt WWW.TAKINGNOTESU.COM • • • DURATION AND IMMUNISATION Debt with a longer duration is more sensitive to changes in interest rates Hedge against interest rate volatility by ensuring the term of the debt matches The following formula should be used, for immunisation of risk Duration of assets x market value of assets = Duration of liabilities x market value of liabilities o Assets > Liabilities à Interest rate risk à Risk interest rate will decrease à Receiving less o Assets = Liabilities à No interest rate risk o Assets < Liabilities à Interest rate risk à Risk interest rate will increase à Paying more 1. Issue debentures of R1000 each, bearing interest at 15% annually, redemption of capital at maturity in 5 years 2. Issue loan of R1000, bearing interest at 15% annually, payable in 5 equal instalments 3. The current market rate is 15% 4. Debenture value at current market rate, market rate can change N 5 I/YR 15% PMT 150 (1 000 x 15%) FV 1000 PV 1000 5. Loan value at current market rate N 1 I/YR 15% PMT 150 (1 000 x 15%) FV 1000 PV 1000 6. PRESENT VALUE OF CASH FLOWS, % OF VALUE, DURATION IN YEARS Debenture CASH FLOW 1 150 2 150 3 150 4 150 5 1150 PV OF CASH FLOWS = 130,43 = 113,42 (243,87– 130,43) = 98,61 (342,48– 243,87) = 85,77 (428,25– 342,48) = 571,77 1000 CALCULATION N = 1, I/YR = 15, PMT = 150, FV = 0, PV = ? N = 2, I/YR = 15, PMT = 150, FV = 0, PV = ? N = 3, I/YR = 15, PMT = 150, FV = 0, PV = ? N = 4, I/YR = 15, PMT = 150, FV = 0, PV = ? 1000 – 85,77 – 98,61 – 113,42 – 130,43 % OF VALUE PV OF CASH FLOWS TOTAL PV DURATION = 0,13 (130,43/1000) = 0,13 (0,13 x 1) = 0,11 = 0,22 (0,11 x 2) = 0,1 = 0,3 (0,1 x 3) = 0,09 = 0,36 (0,09 x 4) = 0,57 = 2,85 (0,57 x 5) 1 WWW.TAKINGNOTESU.COM 3,86 Loan N=5, I/YR=15 PV=1000 FV=0 PMT=? CASH FLOW PV OF CASH FLOWS 1 298,32 = 259,41 2 298,32 = 225,56 (484,97– 259,41) 3 298,32 = 196,15 (681,12– 484,97) 4 298,32 = 170,56 (851,68– 681,12) 5 298,32 = 148,32 CALCULATION N = 1, I/YR = 15, PMT = 298,32, FV = 0, PV = ? N = 2, I/YR = 15, PMT = 298,32, FV = 0, PV = ? N = 3, I/YR = 15, PMT = 298,32, FV = 0, PV = ? N = 4, I/YR = 15, PMT = 298,32, FV = 0, PV = ? 1000 – 170,56 – 196,15 – 225,56 – 259,41 % OF VALUE PV OF CASH FLOWS TOTAL PV DURATION = 0,26 (259,41/1000) = 0,26 (0,26 x 1) = 0,22 = 0,44 (0,22 x 2) = 0,2 = 0,6 (0,2 x 3) = 0,17 = 0,68 (0,17 x 4) = 0,15 = 0,75 (0,15 x 5) 1000 • 1 2,63 Therefore, 1000 x 3,86 = 1000 x 2,63 o 3860 > 2630 § Interest rate risk à Risk interest rate will decrease à Receiving less FLOORS (Lender) • • CAPS (Borrower) • • COLLARS • • Market rate % + (Market rate– Cap) – (Floor–Market rate) = Rate FLOORS, CAPS, COLLARS Set a minimum interest rate to earn on investments Market rate < Floor o Still receive original interest, but is reimbursed Floor – Market rate Set a maximum interest rate to pay on borrowings Market rate > Cap o Still pay original interest, and is reimbursed for Market rate – Cap Represents a combination of caps and floors A company with borrowings at variable rates wants to protect itself against rising interest rates, but is willing to give up some of the benefit of a falling interest rate o Cap, 10% à Market rate > Cap, reimbursed for Market rate – Cap o Floor, 4% à Market rate < Floor, reimbursed Floor – Market rate WWW.TAKINGNOTESU.COM • • • • • • Advantages of Collars Flexibility: the notional amount and term can differ from the underlying loan Relative certainty in terms of cost of borrowing: the rang of borrowing costs will be known Protection from upward spikes in the interest rates Shape of the Yield Curve: generally floating ST rates will be lower than LT fixed rates but are subject to greater volatility. Collars will reduce the volatility implicit in floating rates Lower Cost: the cost involved with using caps and floors may be lower than the costs involved of using LT fixed interest rates Zero Cost: premium payable for the cap is set off by the premium receivable for the floor • • • • • • Disadvantages of Collars Interest rates will vary as opposed to fixed interest rates Loss of benefit of falling interest rates Mismatch between the underlying loan and the term and the notional amount of the Collar To receive a zero cost, the floor rate might have to be set at a rate that is higher than the company hoped for Costly to cancel a Collar Uncertainty regarding tax WWW.TAKINGNOTESU.COM OPTIONS • Right, but not obligation (can choose to exercise or not) to buy or sell an asset at some date in the future at a predetermined price • Acquire an option, to buy, or to sell, at a predetermined price o o Call option, the right to buy Put option, the right to sell § E.g.: Buy an option to sell at R2500 at some date in the future • At the time of expiry, the price is o o R2000 à Exercise option to still sell at R2500 R3500 à Do not exercise option to still sell at R2500 FORWARDS • A commitment to buy or sell an asset on a specified future date at a specified price, as chosen by the participating parties • E.g.: Enter into a contract to buy (at lowest) on a specified future date at a specified price of R3000, on the day of entering into the contract the price is R2800 COMMODITY RISK o o (1) On the specified future date, the price is R3500 § The loss would’ve been = R3500 – R2800 = (R700) § However, there is a contract in place, R3000, the profit is = R3000 – R3500 = R500 • Gross settlement o R3000 § Contract price • Net settlement o R3500 – R500 (PROFIT) = R3000 (2) On the specified future date, the price is R2500 § The profit would’ve been = R2500 – R2800 = R300 § However, there is a contract in place, R3000, the loss is = R3000 – R2500 = (R500) • Gross settlement o R3000 § Contract price • Net settlement o R2500 + R500 (LOSS) = R3000 WWW.TAKINGNOTESU.COM FUTURES • A commitment to buy or sell an asset on a specified future date at a specified price, except it involves the trading of standardised contracts on a formal exchange • Hedging of futures contract o (1) Establish position in spot market LONG SHORT • I do not need • I need something something o (2) Hedge in futures market • I am long, therefore go short SELL • I am short, therefore go long BUY ü REMEMBER: SHORT = SELL o (3) Establish profit or loss in the spot market § (Spot rate @ contract – spot rate @ transaction date) x Q o (4) Establish profit or loss in the futures market § (Rate to sell – rate to buy) x Q = + LOSS or – PROFIT § Opposite contract, if future expires • If future expires before transaction date, then there is no future contract, therefore @ spot rate • If future expires on transaction date, use spot rate on transaction date to calculate profit or loss • If future expires after transaction date, then enter into opposite contract with the same expiry date o (5) Physically settle the futures contract = buy or sell @ futures (or spot rate if there is no futures contract) – Contract profit or loss [(Rate to sell – rate to buy) x Q = + LOSS or – PROFIT] WWW.TAKINGNOTESU.COM Exchange rate risk • Translation risk o The effect that a change in the exchange rate will have on the recorded accounting results of a company o Translation risk does not affect cash flow, it may be viewed as accounting exposure • Transaction risk o The potential for gains or losses which arise when one enters into transactions whose terms are stated in foreign currency • Economic risk o Economic risk measures the long-term real effects of a change in the exchange rate EXCHANGE RATE RISK Concepts • • Importers buys foreign currency to pay in foreign currency to foreign supplier Exporter sells foreign currency to receive foreign currency from foreign client • BASE CURRENCY/QUOTED CURRENCY o 1:QUOTED CURRENCY § If quoted currency is local currency, direct quotation • Direct quotation means how much local currency can be bought with 1 unit of foreign currency • Bid-ask [mid-rate = (BID+ASK)/2] spread, profit = ASK – BID o Bank buys base at bid § An individual wants to sell foreign currency à BID o Bank sells quoted at ask § An individual wants to buy foreign currency à ASK • Calculating the premium % = (Forward/future rate – Spot rate)/Spot rate x 12/n o Expected exchange rate (given premium) = exchange rate x premium x n/12 • Cross rates o ZAR/GBP 1: 0,06 o GBP/INR 1: 89,19 § Calculate INR/ZAR • Find the common currency o GBP • Common currency to 1 o GBP/ZAR o 1/0,06 = 16,67 § Therefore, 1 GBP = 16,67 ZAR • Calculate new cross rate o INR/ZAR o 89,19 (want this at 1) and 16,67 § Therefore, 1 INR = 16,67/89,19 § 1: 0,19 WWW.TAKINGNOTESU.COM • What determines exchange rate movements? o Interest rate parity § Interest rate differences between two countries determine the difference between the spot and the forward exchange rate • • Interest rate in USA = 4% Interest rate in SAU = 12% o o o o Borrow cheaply in USA, invest in SA Capital will flow out of the USA, into SA Sell $, buy R Therefore, in the spot market, $ will weaken, R will strengthen § Hedge with an opposing position in the forward market § Buy forward contract for $, sell forward contract for R § Therefore, in the forward market, $ will strengthen and R will weaken § Currently you can get a futures contract for USD:ZAR at a premium of 6% for $1000 (ZAR10 x 1.06 = ZAR10.60) • • • • • • • § § § Investor can borrow $1000 in USA at 4% Convert $1000 to R10 000 Invest R10 000 in SA at 12% End of the year, have = R11 200 Convert R11 200 to $ using the futures contract (R10.60) = $1056.60 Repay $ loan of $1000 plus interest of 4% = $1040 Profit = $16.60 Futures contracts to sell R and buy $ would increase in demand The futures price (of $) would strengthen until there is no more profit to be made from hedging a borrowing and investing arrangement This equilibrium can be written as Forward rate Spot rate 1 + interest rate of quoted currency = 1 + interest rate of base currency WWW.TAKINGNOTESU.COM o Purchasing power parity § § § Changes in exchange rates determined by changes in relative price levels (inflation) of basket of goods High relative inflation in country devalues the relative exchange rate of the country (1) Current prices • A product costs R240 in SA • Exchange rate ZAR/USD is R7.30 • Expected cost in USA is $32.88 • Cost in USA is $55 • • § What will happen? What will happen? o Buy in SA at R240, export and earn $55 x R7.30 = R401.50 o Profit = R161.50 o Demand in USA ↓ Price in USA ↓ o Demand in SA ↑ Price in SA ↑ o Based on this, the USD/ZAR exchange rate SHOULD be R240 / $55 = R4.36 / $1, but the actual value is R7.30 / $1 o Therefore the R is undervalued by (R7.30 – R4.36) / R7.30 = 40% (2) Forward rates Forward rate 1 + inflation rate of quoted currency = Spot rate 1 + inflation rate of base currency WWW.TAKINGNOTESU.COM Hedging • OPTIONS Right, but not obligation (can choose to exercise or not) to buy or sell foreign currency at some date in the future at a predetermined price E.g.: $1 000 000 in 3 months’ time. Hedge with an option @R11,50 at a premium of 1,1% The current exchange rate is R11,05 IMPORTER EXPORTER Type of option Buying, therefore call Selling, therefore put Premium of = R11,05 x 1 000 000 x = R11,05 x 1 000 000 x 1,1% 1,1% 1,1% = R121 550 = R121 550 EXERCISE Buying, therefore want Selling, therefore want Exchange rate the lowest price the highest price of R11,60 > YES, R11,50 NO, R11,60 Option Net price Pays premium Does not pay premium + 1 000 000 x R11,50 DOES NOT EXERCISE, + R121 550 therefore use spot rate = R11 621 550 + 1 000 000 x 11,60 – R121 550 = R11 478 450 IMPORTER Buying, therefore call = R11,05 x 1 000 000 x 1,1% = R121 550 Buying, therefore want the lowest price NO, R11,20 Type of option Premium of 1,1% EXERCISE Exchange rate of R11,20 < Option Net price • • FORWARDS EXPORTER Selling, therefore put = R11,05 x 1 000 000 x 1,1% = R121 550 Selling, therefore want the highest price YES, R11,50 Pays premium Does not pay premium DOES NOT EXERCISE, + 1 000 000 x 11,50 therefore use spot rate – R121 550 + 1 000 000 x 11,20 = R11 378 550 + R121 550 = R11 321 550 A commitment to buy or sell a specified quantity of foreign currency on a specified future date, as chosen by the participating parties E.g.: Importer imports goods from a foreign country, goods are valued at $100 000, and are to be received on 1 September, and to be paid for on 1 December Enter into a forward contract to buy foreign currency on a specified future date at a premium of 7%, on the day of entering into the contract the exchange rate is R11,20 o On the specified future date, the expected exchange rate will be: § § R11,20 x (7% x 3/12) = R11,396, The current exchange rate is R11,80 WWW.TAKINGNOTESU.COM § However, there is a contract in place, net settlement, the profit is = R11,396 (forward) – R11,80 (spot) = (R0,404) x $100 000 = (R40 400) (PROFIT OF FORWARD CONTRACT) • o On the specified future date, the expected exchange rate will be R11,20 x (7% x 3/12) = R11,396, the current exchange rate is R10,90 § However, there is a contract in place, net settlement, the loss is = R11,396 (forward) – R10,90 (spot) = R0,496 x $100 000 = R49 600 (LOSS OF FORWARD CONTRACT) • • Gross settlement o R11,396 x $100 000 = R1 139 600 Gross settlement o R11,396 x $100 000 = R1 139 600 Close-out of forward o Foreign currency is no longer needed o Therefore, enter into offsetting forward ft WWW.TAKINGNOTESU.COM • A commitment to buy or sell a specified quantity of foreign currency on a specified future date, except it involves the trading of standardised contracts on a formal exchange E.g.: IMPORTER BUYS FOREIGN CURRENCY, THEREFORE BUY FUTURES CONTRACT South African importer will pay on 1 October 2016 $400 000 Enters into futures contract on 1 July 2016 Spot rate on 1 July 2016 R14,9867 Futures rate on 1 July 2016 for 1 October 2016 R15,2111 Contract specified quantity $100 000 • Therefore need 4 futures contracts RAND WEAKENS R15,3565 • • • FUTURES Derivative market Contract price = 4 x $100 000 x R15,2111 = R6 084 440 Spot rate on expiry = 4 x $100 000 x R15,3565 = R6 142 600 PROFIT = R6 084 440 – R6 142 600 = R58 160 • • • Spot market Creditor = $400 000 x R14,9867 = R5 994 680 Payment of creditor = $400 000 x R15,3565 = R6 142 600 LOSS = R5 994 680 – R6 142 600 = (R147 920) Effective cost + Payment to creditor R6 142 600 – PROFIT in derivative market (58 610) = Effective cost R6 084 440/400 000 • • • RAND STRENGTHENS R14,0565 Derivative market Spot market Contract price • Creditor = 4 x $100 000 x R15,2111 = $400 000 x R14,9867 = R6 084 440 = R5 994 680 Spot rate on expiry • Payment of creditor = 4 x $100 000 x R14,0565 • = $400 000 x R14,0565 = R5 622 600 = R5 622 600 LOSS • PROFIT = R6 084 440 – R5 622 600 = R5 994 680 – R5 622 600 = (R461 840) = R372 080 Effective cost + Payment to creditor R5 622 600 + LOSS in derivative market R461 840 = Effective cost R6 084 440/400 000 Expiry date is usually the same as payment date, what if this is not the case? • Future expires, therefore enter into an opposite position o Buying future contracts, therefore, sell future contracts WWW.TAKINGNOTESU.COM South African importer will pay on 15 September 2016 Enters into futures contract on 1 July 2016 Spot rate on 1 July 2016 Spot rate on 15 September 2016 Futures rate on 1 July 2016 for 1 October 2016 Futures rate on 15 September 2016 for 1 October 2016 Contract specified quantity • Therefore need 4 futures contracts • • • Derivative market Contract price of buying futures = 4 x $100 000 x R15,2111 = R6 084 440 Contract price of selling future = 4 x $100 000 x R15,3658 = R6 146 320 PROFIT = R6 084 440 – R6 146 320 = R61 880 • • • $400 000 R14,9867 R15,3235 R15,2111 R15,3658 $100 000 Spot market Creditor = $400 000 x R14,9867 = R5 994 680 Payment of creditor = $400 000 x R15,3235 = R6 129 400 LOSS = R5 994 680 – R6 129 400 = (R134 720) Effective cost + Payment to creditor R6 129 400 – PROFIT in derivative market (61 880) = Effective cost R6 067 520/400 000 What if amount to be hedged is not divisible by the contract quantity? • E.g.: $410 000 versus $400 000 o The remaining $10 000 leave unhedged o Hedge through smaller contracts Currency of Invoice • One method of minimising foreign exchange exposure is to choose the currency of invoice which satisfies the particular requirements of a firm engaged in international trade Leads and Lags • • • • • • Firms will utilise leads and lags when a currency is expected to move in one particular direction Leads and lags involve the speeding up or slowing down of payments or receipts in foreign currency Assume the rand is expected to depreciate within the next few months SA exporters may decide to lag foreign currency receipts by, for example, giving overseas customers extended credit Once the rand depreciates, the exporter will receive more rands in exchange for dollars The opposite applies for leads Bi- or Multilateral Netting • • Setting off outstanding payments or receipts between two or more companies that trade with each other, so only the net amount is paid Coordination is required in order to save purchase and transfer costs of forex WWW.TAKINGNOTESU.COM Money market hedges IMPORTING • • • • USD BUY ZAR SELL Purchasing goods Pays in foreign currency Therefore, needs to buy foreign currency Wants to pay now to reduce risk o Take out loan locally, to invest internationally Invest à Receive interest • $/Interest rate (% x n/12) Borrow à Pay interest • x Exchange rate • = Rands • Rands x Interest rate (% x n/12) Payment Total costs EXPORTING • • • • USD SELL ZAR BUY Selling goods Receives in foreign currency Therefore, needs to sell foreign currency Wants to receive now to reduce risk o Take out loan internationally, to invest locally Borrow à Pay interest • $/Interest rate (% x n/12) Invest à Receive interest • x Exchange rate • = Rands • Rands x Interest rate (% x n/12) Receipt Total receipt Compare total receipt or total costs, to forward rate Forward rate = Spot rate x (1 + interest rate (quoted)) Forward rate = Spot rate x (1 + interest rate (base)) Compare forward rate (forward rate x $) to opportunity cost (Rands x 1+ %, the rate at which you could have invested) Of all comparisons, choose the cheapest one if buying (opposite for selling) WWW.TAKINGNOTESU.COM COST-VOLUME PROFIT ANALYSIS • CVP analysis examines the relationship between changes in activity and changes in total sales revenue, costs and net profits in the short run (one year or less) A numerical approach to cost-volume-profit analysis • Can be a quicker and more flexible method than the diagrammatical method Break-even point in units Contribution per unit = Fixed costs Contribution per unit = Selling price per unit – Variable cost per unit [(A units x A contribution per unit) + (B units x B contribution per unit)] (A units + B units) For multi-product situations you should base your answer on the average contribution per unit to calculate break-even in units Break-even in units: Fixed costs (A + B) Average contribution per unit Break-even in units for each product = A units: B units = Units to be sold to achieve a target profit = = = = = Target profit Profit-volume ratio (contribution margin ratio) • Represents the proportion of each R1 of sales to cover fixed costs and provide for profit Break-even point in Rands Percentage margin of safety • Indicates by how much sales may decrease before a loss occurs • Higher margins of safety are associated with less risky activities (Fixed cost + Target profit) Contribution per unit Sales volume x Variable cost per unit Less: Fixed cost Current profit Plus: (Balancing) Target profit wanting to achieve = Contribution per unit Sales price per unit = Fixed cost Contribution margin ratio = Expected sales – Break-even sales (in units) Expected sales WWW.TAKINGNOTESU.COM • • • • • • • • • Estimated fixed costs are R60 000 These include the fees paid to performers, the hire of the venue and advertising costs Variable costs consist of the cost of a pre-packed buffet that will be provided by a firm of caterers at a price, which is currently being negotiated, but it is likely to be in the region of R10 per ticket sold The proposed selling price of the ticket is R20 (1) The number of tickets that must be sold to break even (2) How many tickets must be sold to earn R30 000 target profit? (3) What profit would result if 8 000 tickets were sold? (4) What selling price would have to be charged to give a profit of R30 000 on sales of 8 000 tickets, fixed costs of R60 000 and variable costs of R10 per ticket? (5) How many additional tickets must be sold to cover the extra cost of television advertising of R8 000? Calculations: • • • • • • (1) Break-even point in units o = Fixed costs/contribution per unit o = 60 000/10 o = 6 000 tickets (2) Units sold for the target profit o = Fixed costs + target profit)/contribution per unit o = (60 000 + 30 000)/10 o = 9 000 tickets (3) Profit from the sale of 8 000 tickets o = Contribution per unit x number of units o = 10 x 8 000 o = R80 000 (4) Selling price to be charged o = Required revenue/sales volume o = (Fixed costs + variable costs + target profit)/sales volume o = (60 000 + 8 000 x 10 + 30 000)/8 000 o = R21.25 (5) Additional sales volume o = Increase in fixed costs/contribution per unit o = 8 000/10 o = 800 Assume that the caterers’ charges will be higher per ticket if ticket sales are below 4 000 but lower if sales exceed 12 000 o Thus the R10 variable cost relates only to a sales volume within a range of 4 000 to 12 000 units o Therefore 4 000 – 12 000 is the relevant range WWW.TAKINGNOTESU.COM Sensitivity analysis o The sensitivity of sales volume … § Required volume [BEP + additional sales volume (A)] to achieve a target profit (TP) • TP = (BEP x (1) contribution/u) + (A x (2) contribution/u) – FC o If there are any additional costs to be taken into account, minus it from (2) contribution/u § § Increase or decrease in the selling price • o Then calculate the % increase in sales volume required FC + TP + ADDITIONAL COSTS TO BE INCLUDED [(SP/u x 100 + increase or – decrease) – VC/u] The sensitivity of net profit to a change … § How much, and with what % can each input change before profit is less than required? • For example, o Minimum profit required is R350 000 o Profit is R600 000 o Sales volume is 100 000 units o SP/u R18 o VC/u R8 o FC is R400 000 § § § § Sales volume • (350 000 – 600 000) ÷ R10 o ÷ 100 000 (units) SP/u • (350 000 – 600 000) ÷ 100 000 o ÷ R18 (SP/u) VC/u • (350 000 – 600 000) ÷ 100 000 o ÷ R8 (VC/u) FC • (350 000 – 600 000) o ÷ R400 000 (FC) WWW.TAKINGNOTESU.COM § For example, a % increase of costs • • • § (1) Calculate the % increase of the cost in rand value (2) = % increase of cost in rand value Net profit (3) = % o Net profit will decrease by % § Depending on the %, net profit is sensitive, or is not sensitive to an increase in costs A % increase of VC/u • • • • • (1) Need break-even point (BEP) o Will usually be given margin of safety and are then required to work backwards (2) BEP x SP/u = INCOME o And, INCOME = EXPENSES (3) Need budgeted sales volume o Given in question usually (4) Calculate expenses based on sales volume o CP/u x sales volume = EXPENSES § Include • Raw materials • Direct labour • Manufacturing overheads (fixed and variable) • Administrative expenses • Selling and distribution (5) Use high-low method to calculated VC/u o = (4) – (2) (3) – (1) o § = VC/u § Less: RM/u DL/u Change in sales mixture • • Give the current sales mixture for A and B, 2.5:1 Give the proposed changed sales mixture for A and B, 2:1 o Discuss the increase or decrease that will come about for A and B § A will decrease § While B will increase o Discuss the increase or decrease in the net profit WWW.TAKINGNOTESU.COM STEP 3: ACCEPT OR REJECT OPTIONS • Income • o Additional units o Additional income Purchases o • Additional units OPTION 2 REJECT ACCEPT XX (Same) XX (Same) XX (Only an advantage if accepted) (XX) (XX) (Additional expense) (XX) (If fixed, it’s the same whether accepted or rejected) (XX) (Additional expense) @NORMAL NUMBER OF UNITS SOLD + ADDITIONAL UNITS SOLD XX (Same) – (XX) – Labour (XX) (If fixed, it’s the same whether accepted or rejected) o – Additional units • Variable manufacturing overheads • Fixed manufacturing overheads Any other additional expense that may occur when an option is accepted or rejected • OPTION 1 @NORMAL NUMBER OF UNITS SOLD XX (Same) WWW.TAKINGNOTESU.COM RELEVANT ADVANTAGE OR DISADVANTAGE – Accept – Reject – (Accept – Reject) – (Accept – Reject) (Accept – Reject) – OPTIMISATION The action of making the best or most effective use of a situation or resource Identifying relevant costs and revenues • • The relevant costs and revenues required are only those that will be affected by the decision. o Costs and revenues that are independent of a decision are irrelevant and don’t need to be considered o The relevant financial inputs for decision-making purposes are therefore future cash flows, which will differ between the various alternatives being considered. § In other words, only the differential cash flows should be taken into account, and cash flows that will be the same for alternatives are irrelevant The following can therefore be applied in identifying relevant and irrelevant costs: o Relevant costs are future costs that differ between alternatives; o Irrelevant costs consist of suck costs, allocated costs and future costs that don’t differ between alternatives Importance of qualitative/ non-financial factors • In many situations, it is difficult to quantify all the important elements of a decision in monetary terms. o Factors that cannot be express in monetary terms are qualitative or non-financial factors. § E.g. Decline in employee morale that results from redundancies o It is essential that qualitative factors be brought to the attention of management during the decision-making process, because otherwise there may be a danger that a wrong decision will be made. o Management must consider the availability of future supplies and the likely effect on customer goodwill if there is a delay in meeting orders. o If the component can be obtained from many suppliers and repeat orders for the company’s products from customers are unlikely, then the company may give little weighting to these qualitative factors. § However, if the component can be obtained from only one supplier and the company relies heavily on repeat sales to existing customers, then the qualitative factors will be of considerable importance Special pricing decisions • Special pricing decisions relate to pricing decisions outside the main market. Typically, they involve one-time-only orders or orders at a price below the prevailing market price Evaluation of a long-term order • In the short term, direct labour and fixed costs may be irrelevant costs • In the long term, however, it may be possible to reduce capacity and spending on fixed costs and direct labour o All costs and revenues are relevant to the decision because some of the costs that were fixed in the short term could be changed in the longer term § It is therefore important to make sure that the information presented for decision-making relates to the appropriate time horizon § If inappropriate time horizons are selected, there is a danger that misleading information will be presented Product mix decisions when capacity constraints exist • • In the short term, sales demand may be in excess of current productive capacity For example, output may be restricted by a shortage of skilled labour, materials, equipment and space WWW.TAKINGNOTESU.COM o When sales demand is in excess of a company’s productive capacity, the resources responsible for limiting the output should be identified § These scarce resources are known as limiting factors. • Within a short-term period, it is unlikely that constraints can be removed, and additional resources acquired • Where limiting factors apply, profit is maximized when the greatest possible contribution to profit is obtained each time the scarce or limiting factor is used Outsourcing and make-or-buy decisions • Decisions on whether to produce components or provide services within the organization or to acquire them from outside suppliers, are called outsourcing / ‘make-or-buy’ decisions Discontinuation decisions • Most organizations periodically analyse profits by one or more cost objects, such as products or services, customers and location o Periodic profitability analysis can highlight unprofitable activities that require a more detailed appraisal to ascertain whether they should be discontinued Determining the relevant costs of direct material • • • Assumption: materials required would be purchased at a later date, so the estimated purchase price would be the relevant material cost o Where materials are taken from existing inventories you should remember that the original purchase price represents a sunk cost and is irrelevant for decision-making § However, if the materials are to be replaced then the decision to use them on an activity will result in additional acquisition costs compared with the situation if the materials were not used on that particular activity (i.e. Relevant cost) If materials have no further use apart from being used on a particular activity, the relevant cost will be 0. If the materials have some realizable value, the use of the materials will result in lost sales revenues, and this lost sales revenue will represent an opportunity cost Determining the relevant costs of direct labour • • • If a company has temporary spare capacity and the labour force is to be maintained in the short term, the direct labour cost incurred will remain the same for all alternative decisions o The direct labour cost will therefore be irrelevant for the short-term decision-making purpose o However, if casual labour is used and workers can be hired on a daily basis, a company may then adjust the employment of labour. The labour cost will increase if the company accepts additional work and will decrease if production is reduced (i.e. Labour will be a relevant cost) If full capacity exists and additional labour supplies are unavailable in the short term, and where no further overtime working is possible, the only way that labour resources could then be obtained for a specific order would be to reduce existing production. o This would release labour for the order, but the reduced production would result in a lost contribution, and this lost contribution must be taken into account when ascertaining the relevant cost for the specific order The relevant labour cost per hour where full capacity exists is therefore the hourly rate plus an opportunity cost consisting of the contribution per hour that WWW.TAKINGNOTESU.COM Optimal production mixture Step 1 PRODUCT Y PRODUCT Z TOTAL Demand Q/u Total Q needed Available Limit • Maximum demand • Quantity per unit o RAND PER UNIT divided by QUANTITY PER KG § § § • Direct material Direct labour Overheads Total quantity needed o Maximum demand x Quantity per unit § COMPARE TOTAL QUANTITY NEEDED to what is AVAILABLE • To determine whether you need to limit the resource or not Step 2 PRODUCT Y PRODUCT Z Contribution/U Contribution per limited resource • Contribution per unit o SP – VC/U • Contribution per limited resource o Contribution per unit divided by Q/u o Determine a ranking per resource § Higher ranking if the resource contribution per limited resource is less than the other product WWW.TAKINGNOTESU.COM Step 3 Direct material Direct labour Overheads Available Product Y / Q per unit (Y) How many can I therefore manufacture? Demand Based on the lesser of how many can I therefore manufacture? X Q per unit (Y) How many can I therefore manufacture? Manufacture Limit to what is available or how many can I therefore manufacture? Remaining Available less manufacture / Q per unit (Z) How many can I therefore manufacture? Product Z Demand X Q per unit (Z) How many can I therefore manufacture? Manufacture Remaining Step 4 • • Conclusion on the optimal production mix (DEMAND Y: DEMAND Z) Round down (as you cannot make .5 of a product) WWW.TAKINGNOTESU.COM SHADOW PRICE • Represents how much contribution will increase with each additional unit of scarce resource that can be obtained Also represents how much contribution will decrease if a unit of a scarce resource is lost Maximum price to pay for additional scare resources • • MAXIMUM PRICE = Shadow price + Current cost o Will pay for additional units of a scarce resource For example, (a) Calculate the optimal production mix Step 1 Demand in metres Total Q needed FORTIFENCE 1 800 DECOFENCE 3 500 900 2 700 3 125 6 250 • Welding time • Labour time Available • • TOTAL 4 025 8 960 1 900 8 000 Welding time Labour time Step 2 FORTIFENCE SP/u VC/u (RM + L + VOH) Contribution/U Contribution per limited resource • Welding time (/ Q/u) = = o • • 2 300 (1 525) 475 (1 623) 677 = = 677 1,25 542 1 = = o 2 000 475 0,5 950 Ranking Labour time (/ Q/u) DECOFENCE 475 1,5 317 = = 1 Ranking 2 Contribution per unit o SP – VC/U § Fortifence • 2 000 – 1 525 = 475 § Decofence • 2 300 – 1 623 = 677 WWW.TAKINGNOTESU.COM 677 2,5 271 2 Available Fortifence / Quantity per unit = How many can I manufacture? Demand X Quantity per unit = Need Still available (1 900 – 900) | (8 000 – 2 700) Decofence / Quantity per unit = How many can I manufacture? Demand X Quantity per unit = How many can I manufacture? • • Welding time 1 900 Labour 8 000 0,5 3 800 1 800 0,5 (900) 1 000 1,5 5 333 1 800 1,5 (2 700) 5 300 1,25 800 800 1,25 (1 000) 0 2,5 2 120 800 2,5 (2 000) 3 300 Welding time is depleted first, But can rent more hours at R300 per hour o Which currently contributes R541,60 of income per hour § Thus, the premium is lower than the shadow price and time will be rented in order to meet 2 120 units • Therefore, 2 120 x 1,25 = 2650 o 2 650 – 1 000 (available) = 1 650 more hours of welding time needed Optimal production mix • 1 800 : 2 120 o Would have been only been 1 800 : 800, but the business shall rent as many hours as they need in order to meet 2 120 WWW.TAKINGNOTESU.COM ACTIVITY BASED COSTING • Allocation of overheads o Specifically, indirect costs § Based on an allocation basis • For example, o Direct labour hours o Machine hours • Purpose o Many indirect costs are relevant for decision-making § There is a danger that only incremental costs that are uniquely attributable to individual products will be classified as relevant and indirect costs will be classified as irrelevant for decision-making • Types of cost systems o (1) Direct costing systems § Only assign direct costs to cost objects o (2) Absorption costing systems o (3) Activity based costing systems § (2 & 3) Both assign indirect costs to cost objects • Activities vs. cost drivers ACTIVITIES Consist of the aggregation of many different tasks, events or units of work that cause the consumption of resources • COST DRIVERS A cost driver represents a measure that exerts the major influence on the cost of a particular activity Activity based costing steps o o o o o o (Step 1) Identify activities (Step 2) Allocate overheads to each activity (Step 3) Identify applicable cost drivers for each activity (Step 4) If applicable, re-allocate the overheads of service activities to other activities (Step 5) Calculate the overhead cost per cost driver (Step 6) Allocate the overheads, per cost driver, to products For example, (Step 1) Identify activities Machine Assembly Production scheduling (Step 2) Allocate overheads to each activity 250 000 500 000 25 000 (Step 3) Identify applicable cost drivers for each activity Machine hours Labour hours Production runs (Step 5) Calculate the overhead cost per cost driver Cost driver 25 000 25 000 5 000 Overhead cost per cost driver R10 R20 R5 WWW.TAKINGNOTESU.COM Quality inspections 75 000 Number of inspections 10 000 R7,50 TUTORIAL QUESTION How to layout a question (Step 1) Identify activities (Step 2) Allocate overheads to each activity Invoice processing 80% number of invoices 20% number of invoice lines Baking pizza in oven Large pizza Small pizza Deliveries Motorcycles The rest Other overhead cost (Step 3) Identify applicable cost drivers for each activity (Step 4) Calculate rate Cost driver Total cost driver 84 000 Invoices 6 000 14 21 000 Invoice lines 32 000 0,66 105 000 80 000 3,25 2 70 000 15 000 55 000 Number of orders received Distance traveled 6 000 40 000 2,5 1,38 75 000 Number of orders received 6 000 12,5 (Step 5) Calculate the overhead cost per cost driver NO. 345 NO. 654 Invoice processing 80% number of invoices 20% number of invoice lines Baking pizza in oven Large pizza Small pizza Deliveries Motorcycles The rest Other overhead cost 14 x 1 = 14 0,66 x 2 = 1,32 14 x 1 = 14 0,66 x 1 = 0,66 4 x 3,25 = 13 2x2=4 2,5 1,38 x 2 (there and back) x 6,25km = 17,25 12,5 x 1 = 12,5 60,57 +180 240,57 WWW.TAKINGNOTESU.COM 2,5 1,38 x 2 (there and back) x 3km = 8,28 12,5 x 1 = 12,5 48,44 +65 106,91 INTEGRATION • Integration is how, in an exam question, there can be multiple sections asked in one question Class question Sales and gross profit determination • Sales manager is responsible for sale of air conditioners and related sales expenses o Annual performance based on total annual gross profit from sale of air conditioners o Performance measurement Inventory valuation • • • Direct raw materials: o Procurement manager’s responsibility to control inventory storage and make purchases § Annual performance measured on cost savings related to purchases and inventory costs • Performance measurement o Direct raw material A and B are readily available § Optimisation Direct labour: o Type A staff are artisans who are remunerated at R50/hour, there are 20 artisans employed and each works 8 hours a day o Type B staff are engineers, there are 5 of them who each work for 8 hours a day and are not allowed to work overtime. They are paid R250 per hour § Optimisation Manufacturing overheads: o Allocated based on machine hours, there are 5 machines that can be operated for 24 hours per work day § Optimisation Assistance and maintenance division • • • • • • • General manager is considering closing down this division since it does not contribute to the profitability of the company o Would rather make use of an external service provider Invoice price R250, external service provider can render the service at R275. R400 000 will be received from the service provider from client references Electronic parts are provided to the assistance and maintenance division by the manufacturing division. If the division is closed down, 60% of these will still be provided to the external service provider Two artisans will be dismissed, and the remaining ones will not work any overtime Five service vehicles are currently being leased, one of which will be kept by the company for the manufacturing division o The service provider will take over the lease for the remaining 4 vehicles Maintenance machines, which have no sales value, will be kept for quality control purposes 10% of general operating expenses relating to the assistance and maintenance division are not specific to this division and are allocated to it o Relevant information WWW.TAKINGNOTESU.COM
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