8th Edition
8th Edition
The book includes chapters on: ◆ the time value of money ◆ risk and return ◆ portfolio management ◆ financial
statement analysis ◆ bond and equity valuations ◆ the cost of capital ◆ capital budgeting ◆ working capital
management ◆ sources of finance ◆ capital structure ◆ leasing ◆ dividends and share buybacks ◆ mergers,
acquisitions and corporate restructuring ◆ risk management and derivatives ◆ international finance ◆ business
planning ◆ financial modelling.
Support material
Support material is made available to all prescribing institutions. It includes: ◆ answers to all chapter
questions ◆ PowerPoint® slides ◆ Multiple Choice Question tests and solutions ◆ selected readings ◆ videos
and Excel® models.
This book is recommended for ◆ undergraduate and postgraduate commerce or business students ◆ ITC and
APC candidates ◆ practising accountants ◆ internal and independent auditors ◆ business managers, corporate
finance practitioners, strategists and analysts.
Financial
Management
8th Edition
Carlos Correia
Other features
• Professional ethics and codes of conduct updated in terms of revisions by SAICA and CFA
• Use of Excel® models to provide detailed explanations of each topic in finance
• Extensive number of questions provided per chapter
• Relevant examples used to demonstrate application of finance theory
• Reference to insights and views of Warren Buffett on finance theory
David Flynn • Enrico Uliana • Michael Wormald • Johnathan Dillon
New features
• a chapter on Corporate Strategy and Business Models
• meets the requirements of Version 8 of SAICA’s Competency Framework, effective from January 2016, in
respect to financial management, financial risk management and corporate strategy
• incorporates the latest developments that affect corporate finance: King III; tax legislation; Companies Act
of 2008; rules of the JSE and capital markets; International Financial Reporting Standards (IFRS); official
guidelines on corporate valuations and integrated reporting
• sections on the no-arbitrage principle, the role of stakeholders, integrated reporting and the six Capitals
• new sections on EBITDA multiples, price earnings multiples, lack of marketability discounts and the effects
of share options on equity valuations
• new sections on revolving credits, repos, inflation-linked bonds, peer-to-peer lending, crowdfunding and
online invoice trading platforms
• new section on working capital strategies and taxation
• new sections on the market risk premium, CAPM and the Fama-French Three-Factor Model
• a section on replicating portfolios and option pricing and detailed examples of buying and selling CFDs
• guidance sections at the end of key chapters to assist readers to better understand and integrate key areas
in finance.
Financial
Now in its 8th edition, Financial Management is the leading text on the theory and application of corporate
finance in southern Africa. Set against the backdrop of a globalising world economy and recent developments in
financial markets, the text refers to real-world applications and financial decisions by South African companies.
Management
Financial Management
A’s ork al
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SA me ater
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s
d t y Fr rt m tion
e
gn nc po es
Ali ete sup qu
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Ex ITC
Carlos Correia
David Flynn • Enrico Uliana • Michael Wormald • Johnathan Dillon
www.jutaacademic.co.za
1270 Financial Man cvr v10.indd 1
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Juta Support Material
To access supplementary student and lecturer resources for this title visit the support material web page at
http://jutaacademic.co.za/support-material/detail/financial-management
Student Support
This book comes with the following online resources accessible from the resource page on the Juta Academic website:
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Exam and study skills
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Videos and Excel® models.
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Selected readings.
Help and Support
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8th edition
financial
management
Carlos Correia
David Flynn, Enrico Uliana,
Michael Wormald & Johnathan Dillon
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Financial Management
8th edition
First published 2015
Print first published in 1987
Second edition 1988
Third edition 1993
Fourth edition 2000
Reprinted 2001, 2002
Fifth edition 2003
Reprinted 2003 (twice), 2005
Sixth edition 2007
Reprinted 2007, 2008, 2010 (twice), 2012
Eighth edition 2015
Juta and Company (Pty) Ltd
First Floor
Sunclare Building
21 Dreyer Street
Claremont
7708
PO Box 14373, Lansdowne 7779, Cape Town, South Africa
© 2015 Juta & Company (Pty) Ltd
ISBN 978 1 4851 0277 9 (Print)
ISBN 978 1 4851 0490 2 (WebPDF)
All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the
publisher. Subject to any applicable licensing terms and conditions in the case of electronically supplied publications, a person may
engage in fair dealing with a copy of this publication for his or her personal or private use, or his or her research or private study. See
section 12(1)(a) of the Copyright Act 98 of 1978.
Proofreaders: Jenni Horn, Rutendo Mukuzwazwa, Erica Blomerus, Helen Correia and
Sa’diyya Pohplonker
Indexer: Clifford Perusset
Typesetter: Trace Digital Services
Cover designer: Joan Baker
The author and the publisher believe on the strength of due diligence exercised that this work does not contain any material that is
the subject of copyright held by another person. In the alternative, they believe that any protected pre-existing material that may be
comprised in it has been used with appropriate authority or has been used in circumstances that make such use permissible under
the law.
Contents
– a concise overview
Chapter 1
Overview of financial management . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-1
Chapter 2
The time value of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-1
Chapter 3
Risk and return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-1
Chapter 4
Portfolio management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-1
Chapter 5
Financial statement analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-1
Chapter 6
Valuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-1
Chapter 7
The cost of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-1
Chapter 8
Capital budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-1
Chapter 9
Further issues in capital budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . 9-1
Chapter 10
Capital budgeting: Risk analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10-1
Chapter 11
Working capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11-1
Chapter 12
Current asset management and short-term financing . . . . . . . . . . . 12-1
Chapter 13
Sources of finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-1
Chapter 14
Capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14-1
Chapter 15
Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15-1
Chapter 16
Dividends and share buy-backs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16-1
Chapter 17
Mergers, acquisitions and corporate restructuring . . . . . . . . . . . . . 17-1
Chapter 18
Risk management and derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . 18-1
Chapter 19
International financial management . . . . . . . . . . . . . . . . . . . . . . . . . 19-1
Chapter 20
Business planning and financial modelling . . . . . . . . . . . . . . . . . . . 20-1
Chapter 21
Corporate strategy and business models . . . . . . . . . . . . . . . . . . . . . 21-1
Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . T-2
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I-1
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Contents
Preface...........................................................................................................................................xxv
What does the book offer?.........................................................................................................xxvi
What resources does the book offer to the instructor?............................................................xxix
How does the book fit in with SAICA’s competency framework for
financial management?...............................................................................................................xxxi
Section A Introduction
Chapter 1 Overview of financial management...........................................................................1-1
Learning objectives.......................................................................................................................1-1
Introduction..................................................................................................................................1-1
1The context of financial management...................................................................................1-2
Development of financial management................................................................................1-2
Links with economics..............................................................................................................1-2
Links with accounting.............................................................................................................1-2
2The environment of financial management..........................................................................1-3
Forms of business organisations............................................................................................1-5
Taxation....................................................................................................................................1-8
Taxation of company profits...................................................................................................1-8
Dividend withholding tax.......................................................................................................1-9
3 What is the fundamental objective of financial management?...........................................1-9
Why is profit maximisation not the right objective for corporate finance?.....................1-10
Manipulation of accounting profits.....................................................................................1-10
Accounting profits and the cost of capital..........................................................................1-11
Risk........................................................................................................................................1-11
Shareholders want management to maximise value...........................................................1-11
Focus of financial management on decision-making.........................................................1-11
Economic Value Added (EVA)............................................................................................1-12
What about the ethics of maximising value?......................................................................1-13
4The role of the financial manager.......................................................................................1-13
Opportunities to create wealth............................................................................................1-14
Investment in operating assets.............................................................................................1-14
Investment in financial assets...............................................................................................1-15
Selecting the optimal finance mix........................................................................................1-15
Finance from capital markets..............................................................................................1-16
The interaction of investment and financing decisions......................................................1-17
From the real world: BHP Billiton and Pioneer Foods.....................................................1-20
5 Fundamental concepts of corporate finance.......................................................................1-20
Present Value.........................................................................................................................1-21
Time value of money............................................................................................................1-21
Risk and return.....................................................................................................................1-21
No Arbitrage Principle.........................................................................................................1-21
Efficient markets...................................................................................................................1-22
Portfolio theory.....................................................................................................................1-22
Capital asset pricing model..................................................................................................1-23
Financial analysis..................................................................................................................1-23
6Do managers act in the interest of shareholders?.............................................................1-23
Management incentives, share options and the financial crisis.........................................1-25
Another agency problem: shareholders and bondholders.................................................1-26
7Doing the right thing: ethics in business and King III.....................................................1-26
8 Corporate Governance and King III...................................................................................1-27
The Board of Directors........................................................................................................1-28
Sustainability and integrated reporting...............................................................................1-29
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Risk management..................................................................................................................1-29
The governance of Information Technology (IT) and its role in corporate finance........1-29
Solvency and liquidity tests..................................................................................................1-30
Business rescue......................................................................................................................1-30
Does corporate governance pay?.........................................................................................1-30
Auditors.................................................................................................................................1-31
9 Corporate Strategy...............................................................................................................1-31
Porter’s Five Forces Model..................................................................................................1-31
Rivalry among existing firms................................................................................................1-32
Threat of substitute products...............................................................................................1-33
Threat of new entrants and barriers to entry......................................................................1-33
Bargaining power of buyers..................................................................................................1-34
Bargaining power of suppliers.............................................................................................1-35
Competitive strategies: cost leadership and differentiation..............................................1-35
SWOT analysis......................................................................................................................1-36
PEST or STEP analysis........................................................................................................1-38
Sustainability related issues..................................................................................................1-38
10 Structure of the text..............................................................................................................1-39
Summary................................................................................................................................1-39
Appendix 1.1 Professional ethics and codes of conduct....................................................1-40
Appendix 1.2 Stakeholder considerations and good corporate citizenship......................1-43
Questions...............................................................................................................................1-48
Section B Foundations for decision-making
Chapter 2 The time value of money............................................................................................2-1
Is compound interest the most powerful force in the universe?...............................................2-1
Learning objectives.......................................................................................................................2-1
Introduction..................................................................................................................................2-1
1 Future value............................................................................................................................2-2
Single amount, single period..................................................................................................2-2
Single amount, multiple periods, annual interest compounded..........................................2-2
Single amount, multiple periods, non-annual compounding...............................................2-7
Annual effective rate..............................................................................................................2-8
Continuous compounding......................................................................................................2-9
Interpolation............................................................................................................................2-9
Series of investments, ordinary annuity (FVA) – multiple investments and multiple
periods...................................................................................................................................2-10
Series of investments, annuity due......................................................................................2-12
Future values when the timing of the cash flows and the compounding periods differ.....2-13
2 Present values.......................................................................................................................2-13
Single amount, single period, annual discounting..............................................................2-14
Single amount, multiple periods, annual discounting........................................................2-14
Stream of cash flows, ordinary annuity (PVA)...................................................................2-15
Stream of cash, annuity due.................................................................................................2-16
Stream of cash flows, deferred annuity...............................................................................2-18
Uneven stream of cash flows................................................................................................2-19
Perpetuities............................................................................................................................2-20
Growing perpetuities............................................................................................................2-20
Growing annuity....................................................................................................................2-21
Inflation and real returns.....................................................................................................2-21
3 Some real-world applications..............................................................................................2-22
Retirement planning.............................................................................................................2-22
Loan amortisation schedules................................................................................................2-23
Mortgage loan.......................................................................................................................2-24
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4 Financial calculators and spreadsheets..............................................................................2-25
Using financial calculators...................................................................................................2-25
Using Excel spreadsheets.....................................................................................................2-27
5The role of interest rates......................................................................................................2-30
The expectations theory.......................................................................................................2-32
The liquidity preference theory...........................................................................................2-32
The market segmentation theory.........................................................................................2-33
6 Applying the time value of money principles to bonds......................................................2-33
Summary................................................................................................................................2-36
Self-study problems...............................................................................................................2-38
Solutions to self-study problems..........................................................................................2-39
Questions...............................................................................................................................2-42
Chapter 3 Risk and return..........................................................................................................3-1
The 21st Century: a time of financial crisis and recovery for equities.....................................3-1
Learning objectives.......................................................................................................................3-1
Introduction..................................................................................................................................3-2
1The concept of risk.................................................................................................................3-3
Business risk............................................................................................................................3-3
Financial risk...........................................................................................................................3-7
Total company risk..................................................................................................................3-8
2Measuring expected return and risk.....................................................................................3-9
Measuring the expected return on a single share.................................................................3-9
Measuring risk for a single share.........................................................................................3-10
The mean–variance rule.......................................................................................................3-11
3Interpreting the summary statistics....................................................................................3-12
Properties of a normal distribution.....................................................................................3-12
Comparison of single shares................................................................................................3-14
Co-efficient of variation.......................................................................................................3-15
The z score.............................................................................................................................3-16
Co-variance and correlation.................................................................................................3-18
4Risk and return in financial markets.................................................................................3-19
Emerging markets.................................................................................................................3-27
Volatility and time periods: the Rip van Winkle solution to risk......................................3-27
What does Warren Buffett think?........................................................................................3-27
Risk-adjusted measures of performance.............................................................................3-28
From the real world: Unit Trust Funds...............................................................................3-29
Summary................................................................................................................................3-30
Self-study problems...............................................................................................................3-31
Suggested solutions...............................................................................................................3-31
Questions...............................................................................................................................3-33
Chapter 4 Portfolio management................................................................................................4-1
South African unit trusts invest offshore to diversify risk.........................................................4-1
Learning objectives.......................................................................................................................4-1
Introduction..................................................................................................................................4-1
1Two-asset portfolio risk and return.......................................................................................4-2
Measuring two-asset portfolio returns..................................................................................4-2
The principles of portfolio risk..............................................................................................4-3
Measuring two-asset portfolio risk........................................................................................4-7
Positioning an investor on the efficient frontier.................................................................4-12
2Multiple-share portfolio risk and return............................................................................4-13
The benefits of diversification.............................................................................................4-15
Introducing a risk-free asset.................................................................................................4-16
3 Beta analysis.........................................................................................................................4-18
Beta as a measure of a portfolio risk...................................................................................4-19
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Beta and the capital asset pricing model (CAPM).............................................................4-21
4The efficient markets hypothesis.........................................................................................4-24
The weak form......................................................................................................................4-24
The semi-strong form...........................................................................................................4-25
The strong form....................................................................................................................4-25
Testing for market efficiency................................................................................................4-25
Weak-form tests....................................................................................................................4-25
Semi-strong form tests..........................................................................................................4-26
Strong form tests...................................................................................................................4-26
Evidence of the efficiency of the JSE..................................................................................4-26
Is the CAPM used in practice?............................................................................................4-27
Summary................................................................................................................................4-28
Guidance to portfolio management: the risk and return concepts linking Chapters 3
and 4.......................................................................................................................................4-29
Self-study problem................................................................................................................4-31
Suggested solutions...............................................................................................................4-31
Appendix 4.1 Calculating the beta co-efficient..................................................................4-33
Appendix 4.2 Perspectives: Estimating the beta co-efficient.............................................4-37
Appendix 4.3 Perspectives: Behavioural finance................................................................4-42
Questions...............................................................................................................................4-45
Chapter 5 Financial statement analysis.....................................................................................5-1
Companies and investors employ financial ratios to evaluate performance............................5-1
Learning objectives.......................................................................................................................5-1
Introduction..................................................................................................................................5-2
1 Annual financial statements and the Integrated Report.....................................................5-2
Integrated Report...................................................................................................................5-2
Annual Financial Statements.................................................................................................5-5
Statement of Comprehensive Income (Statement of Profit or Loss and
Other Comprehensive Income).............................................................................................5-8
Statement of Financial Position.............................................................................................5-8
Statement of Cash Flows........................................................................................................5-8
2Objectives of financial analysis and stakeholders...............................................................5-9
Shareholders............................................................................................................................5-9
Credit grantors......................................................................................................................5-10
Management..........................................................................................................................5-10
Employees..............................................................................................................................5-10
Customers..............................................................................................................................5-11
Suppliers................................................................................................................................5-11
Acquisition and merger analysts..........................................................................................5-11
Auditors.................................................................................................................................5-11
Government...........................................................................................................................5-11
3 Limitations of accounting data............................................................................................5-11
Monetary expression.............................................................................................................5-12
Simplification and summarisation.......................................................................................5-12
Flexible accounting policies.................................................................................................5-12
Inflation.................................................................................................................................5-12
4 Approaches to financial statement analysis.......................................................................5-12
Comparative financial statements........................................................................................5-13
Index analysis........................................................................................................................5-13
Common size analysis...........................................................................................................5-14
Ratio analysis.........................................................................................................................5-15
5 Application of ratio analysis................................................................................................5-16
Liquidity ratios......................................................................................................................5-16
Asset management ratios.....................................................................................................5-17
Debt management ratios......................................................................................................5-19
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Profitability ratios.................................................................................................................5-21
Cash flow ratios.....................................................................................................................5-25
Market value ratios...............................................................................................................5-26
6 Structured ratio analysis.....................................................................................................5-27
Du Pont analysis....................................................................................................................5-27
7 Failure prediction.................................................................................................................5-29
Financial distress models......................................................................................................5-29
8 Limitations of ratio analysis................................................................................................5-30
9Economic Value Added (EVA™)...........................................................................................5-31
The use of EVA to measure performance at SABMiller...................................................5-33
Perspectives on EVA™ by Joel Stern..................................................................................5-34
10 What’s behind the numbers?...............................................................................................5-35
Understand the business and the industry sector...............................................................5-35
Understand management’s motives for selecting accounting policies..............................5-35
Understand the key drivers of value....................................................................................5-36
Understand which accounting policies are flexible............................................................5-36
Accounting for leases............................................................................................................5-36
Understand the warning signs..............................................................................................5-37
Understand the business and financial risks facing the company.....................................5-39
Sensitivity analysis.................................................................................................................5-39
Further factors to consider when analysing a company.....................................................5-39
From the real world..............................................................................................................5-43
Summary................................................................................................................................5-44
Guidance on Financial Analysis..........................................................................................5-45
Self-study problems...............................................................................................................5-47
Solutions to self-study problems..........................................................................................5-49
Appendix 5.1 Sustainable growth........................................................................................5-50
Questions...............................................................................................................................5-53
Chapter 6 Valuations....................................................................................................................6-1
Pricing on the JSE and value: why Edcon used valuation principles to go private.................6-1
Learning objectives.......................................................................................................................6-1
Introduction..................................................................................................................................6-1
1 Valuation – an overview..........................................................................................................6-2
What are the fundamental building blocks of a valuation?.................................................6-2
2The effect of risk and return on valuations..........................................................................6-3
3Required rate of return..........................................................................................................6-3
4 Valuation of debentures and bonds.......................................................................................6-4
Debentures and bonds in perpetuity.....................................................................................6-4
Redeemable debentures and bonds.......................................................................................6-5
From the real world................................................................................................................6-7
5 Valuation of preference shares..............................................................................................6-8
Cumulative non-redeemable preference shares...................................................................6-9
Non-cumulative preference shares......................................................................................6-10
Redeemable preference shares............................................................................................6-10
6 Valuation of ordinary equity................................................................................................6-10
Dividend discount model......................................................................................................6-11
Constant growth in dividends...............................................................................................6-11
Limitations.............................................................................................................................6-14
Valuing shares with a non-constant growth rate.................................................................6-15
From the real world: Woolworths........................................................................................6-17
Price multiples (relative valuation).....................................................................................6-18
The price-earnings (P/E) ratio.............................................................................................6-18
Using EBITDA or EBIT multiples to determine enterprise value...................................6-21
Market to book ratio............................................................................................................6-22
Price to sales ratio.................................................................................................................6-22
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Free cash flow model (discounted cash flow model).........................................................6-22
Terminal values......................................................................................................................6-23
The Economic Value Added (EVATM) approach................................................................6-26
Valuation of rights.................................................................................................................6-27
The impact of share options on equity valuations..............................................................6-28
7 Valuations and the financial manager................................................................................6-29
Pitfalls....................................................................................................................................6-29
Challenges.............................................................................................................................6-30
Perspectives: Valuations in the real world..........................................................................6-30
Summary................................................................................................................................6-32
Self-study problems...............................................................................................................6-33
Solutions to self-study problems..........................................................................................6-34
Appendix 6.1 Lack of marketability discount and other adjustments..............................6-37
Appendix 6.2 Exploring selected issues in valuations........................................................6-39
Appendix 6.3 Perspectives: the subjective nature of valuations........................................6-42
Questions...............................................................................................................................6-44
Chapter 7 The cost of capital......................................................................................................7-1
The weighted-average cost of capital (WACC) and the financial crisis...................................7-1
Learning objectives.......................................................................................................................7-1
Introduction..................................................................................................................................7-2
1The weighted-average cost of capital....................................................................................7-2
2The weighted-average cost of capital – principles and formula.........................................7-3
3The pooling of funds approach..............................................................................................7-4
4 Component costs of capital....................................................................................................7-7
Cost of new debt (Kd)............................................................................................................7-8
The cost of debt and Section 24J of the Income Tax Act..................................................7-10
Cost of preference shares (Kp)............................................................................................7-12
Cost of shareholders’ equity.................................................................................................7-13
Dividend yield and growth method.....................................................................................7-14
Capital asset pricing model (CAPM)..................................................................................7-14
Bond yield plus a risk premium method.............................................................................7-15
5 Weighting components of capital structure........................................................................7-16
6 Calculating the WACC.........................................................................................................7-18
7 Breaks in the WACC.............................................................................................................7-18
8 Funds from the non-cash flow items...................................................................................7-20
9Estimating the cost of capital of divisions..........................................................................7-20
10Operating leases, capital structure and the weighted-average cost of capital................7-21
11The weighted-average cost of capital – some practical issues..........................................7-23
The risk-free rate..................................................................................................................7-23
The market (equity) risk premium......................................................................................7-23
Surveys...................................................................................................................................7-25
Using the dividend growth model to determine the market risk premium......................7-25
Other indicators of the market risk premium.....................................................................7-25
Warren Buffett’s view...........................................................................................................7-26
Betas.......................................................................................................................................7-26
Adjustments to the cost of equity and WACC....................................................................7-26
The financial crisis, emerging markets and the cost of capital..........................................7-28
Taxation..................................................................................................................................7-28
The role of hurdle rates........................................................................................................7-28
From the real world: The cost of capital of South African firms......................................7-29
Summary................................................................................................................................7-31
Guidance on cost of capital..................................................................................................7-32
Appendix 7.1 CAPM and the Fama-French Three-Factor Model....................................7-33
Does CAPM work?...............................................................................................................7-33
Fama-French Three-Factor Model......................................................................................7-34
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Self-study problems...............................................................................................................7-37
Solutions to self-study problems..........................................................................................7-39
Questions...............................................................................................................................7-42
Section C Investment decisions
Chapter 8 Capital budgeting.......................................................................................................8-1
Expanding horizons: Kumba scales up production to meet demand for iron ore...................8-1
Learning objectives.......................................................................................................................8-1
Introduction..................................................................................................................................8-1
1Types of investment projects..................................................................................................8-2
Replacement or expansion.....................................................................................................8-2
Independent and mutually exclusive projects.......................................................................8-3
Divisible and indivisible projects...........................................................................................8-3
2 Capital budgeting techniques................................................................................................8-3
Net present value (NPV)........................................................................................................8-4
The internal rate of return (IRR).........................................................................................8-5
Payback method......................................................................................................................8-8
Accounting rate of return.......................................................................................................8-9
Discounted payback..............................................................................................................8-11
The profitability index..........................................................................................................8-11
Modified internal rate of return..........................................................................................8-12
Economic Value Added (EVA™) or economic profit........................................................8-12
3 Cash flow determination......................................................................................................8-14
Beginning-of-project cash flows...........................................................................................8-15
Annual operating cash flows................................................................................................8-15
Cash flow determination – some rules................................................................................8-16
Taxation..................................................................................................................................8-19
Depreciation allowances.......................................................................................................8-19
Recoupments and scrapping allowances.............................................................................8-21
Taxation effects of replacement decisions...........................................................................8-23
Capital Gains Tax..................................................................................................................8-23
End-of-project cash flows.....................................................................................................8-24
Application............................................................................................................................8-25
4 Post-audits.............................................................................................................................8-27
Summary................................................................................................................................8-28
Self-study problems...............................................................................................................8-29
Solutions to self-study problems..........................................................................................8-30
Guidance on capital budgeting............................................................................................8-33
Appendix 8.1 NPV/IRR: Conflict in rankings....................................................................8-35
Questions...............................................................................................................................8-38
Chapter 9 Further issues in capital budgeting..........................................................................9-1
It is Ayoba time! Connecting Africa and the Middle East........................................................9-1
Learning objectives.......................................................................................................................9-1
Introduction..................................................................................................................................9-1
1 Comparing projects with unequal lives................................................................................9-2
Unequal lives and project evaluation....................................................................................9-2
Replacement chains................................................................................................................9-4
Equivalent annual annuities...................................................................................................9-4
Equivalent annual costs..........................................................................................................9-5
2 Capital budgeting under inflation.........................................................................................9-5
Inflation and the discount rate..............................................................................................9-6
Investment bias.......................................................................................................................9-6
Discounting cash flows at the real rate of return.................................................................9-7
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Depreciation deductions........................................................................................................9-7
Adjusted real approach..........................................................................................................9-9
3 Capital rationing.....................................................................................................................9-9
Capital constraints and project rankings.............................................................................9-10
Profitability index..................................................................................................................9-10
The ranking of indivisible projects......................................................................................9-11
Multi-period capital rationing..............................................................................................9-11
Further perspectives on capital rationing...........................................................................9-13
4 Assessed tax losses................................................................................................................9-14
The utilisation of assessed losses.........................................................................................9-14
New ventures and ring-fencing provisions..........................................................................9-15
Synopsis..................................................................................................................................9-15
5 Abandonment value and optimal economic lives...............................................................9-16
Continuing evaluation..........................................................................................................9-16
Optimal economic life..........................................................................................................9-17
Replacement timing..............................................................................................................9-18
6Real (strategic) options........................................................................................................9-20
Examples of real (strategic) options....................................................................................9-21
Self-study problems...............................................................................................................9-23
Solutions to self-study problems..........................................................................................9-24
Summary................................................................................................................................9-26
Appendix 9.1 Capital budgeting in the real world.............................................................9-27
Appendix 9.2 Multiple internal rates of return..................................................................9-30
Questions...............................................................................................................................9-34
Chapter 10 Capital budgeting: Risk analysis..........................................................................10-1
A golden sunset..........................................................................................................................10-1
Learning objectives.....................................................................................................................10-1
Introduction................................................................................................................................10-2
1Traditional measures of risk................................................................................................10-2
Expected value and probability distributions......................................................................10-3
The Hillier model for multiple periods...............................................................................10-5
A note on expected values, probabilities and firm size......................................................10-7
2Decision trees........................................................................................................................10-8
3 Certainty equivalents..........................................................................................................10-11
4 Sensitivity analysis.............................................................................................................10-12
5 Break-even analysis............................................................................................................10-14
Zero net present value........................................................................................................10-14
Accounting break-even analysis.........................................................................................10-15
6 Scenario analysis................................................................................................................10-16
7 Abandonment and expansion.............................................................................................10-16
8Monte Carlo simulation.....................................................................................................10-18
9The capital asset pricing model.........................................................................................10-19
Project beta of an all-equity firm.......................................................................................10-20
Financial leverage and project betas.................................................................................10-21
More on market risk...........................................................................................................10-22
10Risk-adjusted discount rates versus certainty equivalents.............................................10-23
11Risk-adjusted discount rates versus the weighted-average cost of capital....................10-23
12 Further thoughts on risk analysis in capital budgeting..................................................10-24
Future uncertain cash outflows..........................................................................................10-24
Volatility and risk – a case study........................................................................................10-24
Corporate strategy and project risk...................................................................................10-26
Project management, project failure and other factors...................................................10-29
Self-study problems.............................................................................................................10-31
Solutions to self-study problems........................................................................................10-33
Summary..............................................................................................................................10-39
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Appendix 10.1 Capital budgeting – risk analysis with Excel®........................................10-39
Questions.............................................................................................................................10-47
Chapter 11 Working capital......................................................................................................11-1
Every cloud has a silver lining...................................................................................................11-1
Learning objectives.....................................................................................................................11-1
Introduction................................................................................................................................11-1
1 What is working capital?......................................................................................................11-2
2The objective of working capital policy...............................................................................11-3
The working capital cycle.....................................................................................................11-3
The impact of inflation on working capital policy..............................................................11-5
The impact of changes in sales on working capital policy.................................................11-5
3 Working capital policies.......................................................................................................11-5
4 Working capital financing policies......................................................................................11-7
5 From the real world............................................................................................................11-10
Working capital management by small business...............................................................11-12
Working capital strategies and cash flows.........................................................................11-12
Working capital management around the world..............................................................11-14
6 Forecasting working capital requirements.......................................................................11-14
7 Forecasting sales.................................................................................................................11-16
Factors to be considered.....................................................................................................11-16
Subjective forecasting.........................................................................................................11-17
Objective forecasting..........................................................................................................11-17
Summary..............................................................................................................................11-18
Self-study problems.............................................................................................................11-19
Solutions to self-study problems........................................................................................11-19
Questions.............................................................................................................................11-20
Chapter 12 Current asset management and short-term financing........................................12-1
Cash is King................................................................................................................................12-1
Learning objectives.....................................................................................................................12-1
Introduction................................................................................................................................12-1
1 Credit policy..........................................................................................................................12-1
Creditworthiness...................................................................................................................12-2
Setting the collection policy.................................................................................................12-2
Setting settlement discount policy.......................................................................................12-2
Analysing the impact of a change in credit policy on profitability....................................12-3
Analysing the impact of a change in credit policy: net present value analysis.................12-6
2 Accounts receivable management........................................................................................12-7
Making money out of offering credit to customers............................................................12-8
From the real world: Truworths and Mr Price....................................................................12-8
3Inventory management.........................................................................................................12-9
Inventory models...................................................................................................................12-9
Inventory control systems...................................................................................................12-13
Just-in-time (JIT) inventory management........................................................................12-14
Supply chain management (SCM).....................................................................................12-15
From the real world: Shoprite............................................................................................12-15
4 Cash management...............................................................................................................12-15
Reasons for holding cash....................................................................................................12-16
The management of float, cash concentration and electronic funds transfer................12-16
Cash budgets.......................................................................................................................12-17
5 Financing current assets....................................................................................................12-20
Accruals...............................................................................................................................12-20
Trade credit..........................................................................................................................12-20
Factoring and invoice discounting.....................................................................................12-21
Bank overdrafts...................................................................................................................12-23
Bankers’ acceptances (bank bills)......................................................................................12-24
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Revolving credit facility......................................................................................................12-25
Repurchase agreements (Repo market)...........................................................................12-26
Short-term financing: advantages and disadvantages......................................................12-27
Summary..............................................................................................................................12-27
Guidance on working capital.............................................................................................12-28
Self-study problems.............................................................................................................12-29
Solutions to self-study problems........................................................................................12-30
Appendix 12.1 The derivation of the Economic Order Quantity (EOQ) model...........12-33
Questions.............................................................................................................................12-35
Section D Financing decision
Chapter 13 Sources of finance..................................................................................................13-1
A lion retreats.............................................................................................................................13-1
Learning objectives.....................................................................................................................13-1
Introduction................................................................................................................................13-1
1 Financial markets.................................................................................................................13-2
Classification of financial markets.......................................................................................13-2
Interaction between market classifications.........................................................................13-3
The Johannesburg Stock Exchange.....................................................................................13-3
Alternative Exchange – AltX...............................................................................................13-6
The Development Capital Market (DCM).........................................................................13-7
Alternative methods of obtaining a listing..........................................................................13-7
Raising capital by listed companies.....................................................................................13-8
Setting an issue price............................................................................................................13-8
Rights issue............................................................................................................................13-9
Some facts about market liquidity.....................................................................................13-10
The JSE Derivatives Market..............................................................................................13-11
The JSE Debt Market (Interest Rate Market).................................................................13-11
2 Financial institutions.........................................................................................................13-13
Banks....................................................................................................................................13-13
Investment institutions.......................................................................................................13-14
Private equity and venture capital.....................................................................................13-14
Special institutions..............................................................................................................13-17
3Equity-related instruments................................................................................................13-19
Ordinary shares...................................................................................................................13-19
Retained earnings...............................................................................................................13-19
Preference shares................................................................................................................13-20
4Debt instruments................................................................................................................13-22
Corporate bonds, notes and debentures...........................................................................13-22
Long-term loans..................................................................................................................13-24
Bank loans...........................................................................................................................13-24
Fixed interest rate loans.....................................................................................................13-25
Variable interest rate loans................................................................................................13-26
Credit ratings.......................................................................................................................13-27
Short-term debt...................................................................................................................13-28
5 Hybrid instruments............................................................................................................13-29
6 Comparison of debt and equity.........................................................................................13-29
Return..................................................................................................................................13-30
Risk......................................................................................................................................13-30
Control.................................................................................................................................13-31
From the real world – corporate bonds and borrowings.................................................13-31
7Inflation-linked bonds........................................................................................................13-33
8 Alternative sources of finance............................................................................................13-34
Peer-to-peer lending...........................................................................................................13-34
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Crowdfunding......................................................................................................................13-35
Online invoice trading platforms.......................................................................................13-35
Supply chain finance...........................................................................................................13-36
9 Financing for black economic empowerment (BEE) entities..........................................13-36
From the real world: An analysis of the Metropolitan and
ABSA BEE transactions.....................................................................................................13-40
Guidance when presented with problems relating to sources of finance.......................13-41
Summary..............................................................................................................................13-43
Self-study problems.............................................................................................................13-44
Solutions to self-study problems........................................................................................13-45
Questions.............................................................................................................................13-46
Chapter 14 Capital structure....................................................................................................14-1
Learning objectives.....................................................................................................................14-1
Introduction................................................................................................................................14-2
1Risk profile............................................................................................................................14-2
Business risk..........................................................................................................................14-2
Financial risk.........................................................................................................................14-3
2 Leverage (gearing)................................................................................................................14-3
Impact on earnings...............................................................................................................14-3
Impact on risk........................................................................................................................14-4
3Optimal capital structure....................................................................................................14-8
The Modigliani-Miller approach.........................................................................................14-8
Trade-off theory..................................................................................................................14-11
Pecking order and signalling theories................................................................................14-13
Debt financing, free cash flow and conflicts between management and shareholders....14-13
4 Agency costs and inverted incentives: conflicts between shareholders
and bondholders.................................................................................................................14-14
Investing in high risk projects............................................................................................14-14
Running off with the money...............................................................................................14-15
No further investment by shareholders.............................................................................14-15
Playing for time...................................................................................................................14-15
Changing the capital structure of the firm........................................................................14-16
The use of loan covenants to manage shareholder and bondholder conflicts...............14-16
From the real world: Loan covenants at Aspen and Gold Fields...................................14-16
5The impact of inflation.......................................................................................................14-18
6The need for flexibility.......................................................................................................14-18
Target capital structure.......................................................................................................14-19
Short-term deviation from target.......................................................................................14-19
Financial flexibility..............................................................................................................14-19
Market timing theory..........................................................................................................14-20
7Debt and tax shields...........................................................................................................14-20
8 Financial leverage and a firm’s weighted-average cost of capital..................................14-23
9 Personal taxes.....................................................................................................................14-24
10 Capital structures in South Africa and around the world..............................................14-25
From the real world............................................................................................................14-28
11Edcon: capital structure and valuation of tax shields.....................................................14-30
Summary..............................................................................................................................14-32
Guidance on capital structure............................................................................................14-33
Self-study problems.............................................................................................................14-37
Solutions to self-study problems........................................................................................14-37
Questions.............................................................................................................................14-37
Chapter 15 Leasing....................................................................................................................15-1
Leasing in the airline sector is no laughing matter..................................................................15-1
Learning objectives.....................................................................................................................15-2
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Introduction................................................................................................................................15-2
1Types of leases.......................................................................................................................15-2
Operating leases....................................................................................................................15-3
Financial leases.....................................................................................................................15-3
Structuring of leases.............................................................................................................15-4
Direct lease............................................................................................................................15-4
Sale and lease-back...............................................................................................................15-4
Leveraged lease.....................................................................................................................15-4
2 What are the effects of leasing on financial statements?..................................................15-5
What are the requirements of the International Accounting Standard (IAS17)?...........15-6
What is wrong with the analysis and accounting for leases?.............................................15-7
A new Accounting Standard for Leases: all non-property leases are now finance leases.....15-8
3 Advantages of leasing.........................................................................................................15-11
Changing technology...........................................................................................................15-11
Tax advantages.....................................................................................................................15-12
Obtaining 100% debt financing.........................................................................................15-12
Operating flexibility............................................................................................................15-12
Reduction in operating leverage........................................................................................15-12
Coping with uncertain demand..........................................................................................15-12
Specialisation effects on maintenance, residual values and purchase costs...................15-12
Standardisation of contracts...............................................................................................15-13
Fewer restrictions................................................................................................................15-13
Off-Statement of Financial Position financing.................................................................15-13
Avoidance of capital expenditure controls and budgetary constraints...........................15-13
4Evaluating the leasing decision.........................................................................................15-13
Selecting an appropriate discount rate..............................................................................15-14
Calculating the net present cost.........................................................................................15-14
The net advantage of leasing and NPV.............................................................................15-17
From the real world............................................................................................................15-19
5The adjusted present value approach...............................................................................15-20
Summary..............................................................................................................................15-22
Self-study problems.............................................................................................................15-23
Solutions to self-study problems........................................................................................15-24
Appendix 15.1 Operating lease capitalisation and other pertinent leasing issues.........15-28
Questions.............................................................................................................................15-32
SECTION E INTEGRATED DECISIONS
Chapter 16 Dividends and share buy-backs............................................................................16-1
The dividend cut that made headlines around the world........................................................16-1
Learning objectives.....................................................................................................................16-2
Introduction................................................................................................................................16-2
1Dividend relevance – active variable or passive residual?................................................16-2
The residual approach to dividends....................................................................................16-3
2 Factors affecting the dividend decision...............................................................................16-6
The legal requirements of the Companies Act 71 of 2008: solvency and liquidity tests....16-6
Contractual obligations........................................................................................................16-7
Information content of dividends........................................................................................16-7
Taxation..................................................................................................................................16-9
The nature of shareholders................................................................................................16-12
3Dividend payment policies.................................................................................................16-13
Stable dividend amount......................................................................................................16-13
Stable payout ratio..............................................................................................................16-13
Stable dividend plus special dividend................................................................................16-15
4The payment of dividends..................................................................................................16-15
What happens to the share price when a share goes ex-dividend?.................................16-16
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Share splits and capitalisation issues.................................................................................16-17
From the real world: Sub-division of the ordinary share capital of Assore...................16-18
Dividend reinvestment plans (DRIPs) and scrip dividends.............................................16-20
5 Share buy-backs..................................................................................................................16-20
What is the effect of a share buy-back on the Statement of Financial
Position of a company?.......................................................................................................16-21
Why should companies repurchase their own shares?.....................................................16-22
Requirements and consequences of engaging in a share buy-back.................................16-22
From the real world............................................................................................................16-24
Dividends in specie..............................................................................................................16-25
Dividend yields....................................................................................................................16-25
Summary..............................................................................................................................16-28
Dividend policy and share repurchases: what is the evidence in South Africa..............16-28
Analysing the distribution decision – guidance and practical application......................16-29
Self-study problems.............................................................................................................16-32
Solutions to self-study problems........................................................................................16-33
Questions.............................................................................................................................16-36
Chapter 17 Mergers, acquisitions and corporate restructuring............................................17-1
The Edcon leveraged buy out: American and Irish bonds......................................................17-1
Learning objectives.....................................................................................................................17-1
Introduction................................................................................................................................17-2
1Types of mergers...................................................................................................................17-2
2Reasons for mergers.............................................................................................................17-2
Operating economies............................................................................................................17-3
Managerial skills...................................................................................................................17-3
Tax considerations – tax shield and assessed losses............................................................17-3
Use for excess liquidity.........................................................................................................17-4
Diversification.......................................................................................................................17-4
Lower financing costs...........................................................................................................17-4
Replacement costs................................................................................................................17-4
Technology.............................................................................................................................17-4
Products, product pipeline and reserves.............................................................................17-5
3The structuring of takeover offers and taxation................................................................17-5
Financing costs......................................................................................................................17-5
Capital Gains Tax (CGT) and Dividend Withholding Tax (DWT)...................................17-6
Depreciation and wear and tear deductions.......................................................................17-6
Further issues to consider in acquiring shares or assets....................................................17-7
4 Are mergers successful?.......................................................................................................17-7
5Terms of mergers..................................................................................................................17-8
Acquisition financed by cash................................................................................................17-8
Acquisition financed by share issue...................................................................................17-10
Post-merger price-earnings ratio.......................................................................................17-13
Sharing the merger benefit.................................................................................................17-14
Setting an offer....................................................................................................................17-16
6Dividends, working capital and net asset value...............................................................17-16
Dividends.............................................................................................................................17-16
Working capital...................................................................................................................17-17
Net asset value....................................................................................................................17-17
7Reverse takeovers................................................................................................................17-17
8Defensive tactics..................................................................................................................17-17
Proactive measures.............................................................................................................17-18
Reactive measures...............................................................................................................17-19
9 Legal procedures.................................................................................................................17-20
10Regulation of takeovers......................................................................................................17-21
11Unbundling and spin-offs..................................................................................................17-23
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Advantages..........................................................................................................................17-24
Disadvantages......................................................................................................................17-25
12 Leveraged buy-outs.............................................................................................................17-26
13 Business rescue and the corporate restructuring of financially troubled companies.....17-27
Financial distress.................................................................................................................17-27
Is business rescue a viable option?....................................................................................17-29
The direct costs of bankruptcy/liquidation and business rescue.....................................17-31
Workouts..............................................................................................................................17-31
What can the directors do to improve the chances of success of a business rescue......17-32
From the real world............................................................................................................17-32
Advising a financially troubled company..........................................................................17-33
14 South African mergers........................................................................................................17-34
Amalgamated Banks of South Africa (ABSA).................................................................17-36
The hostile Nedcor bid for Standard Bank Investment Corporation.............................17-36
The JD Group, Ellerines and African Bank.....................................................................17-37
The Nedcor BoE merger....................................................................................................17-37
BHP Billiton........................................................................................................................17-38
The hostile Harmony takeover bid for Goldfields...........................................................17-38
The takeover of ABSA by Barclays plc.............................................................................17-40
MTN acquisition of Investcom LLC..................................................................................17-41
AfriGroupe acquires AFGRI.............................................................................................17-41
The unbundling of Goldfields’ gold mines into Sibanye Gold........................................17-41
Vodacom’s proposed acquisition of Neotel......................................................................17-42
The battle for Adcock Ingram...........................................................................................17-43
Woolworths’ acquisition of David Jones...........................................................................17-44
Summary..............................................................................................................................17-44
Self-study problems.............................................................................................................17-45
Solutions to self-study problems........................................................................................17-46
Appendix 17.1 Mergers and acquisitions – an overview and alternative approach
to calculate exchange ratios...............................................................................................17-48
Appendix 17.2 Due diligence.............................................................................................17-51
Appendix 17.3 Business rescue in South Africa...............................................................17-55
Questions.............................................................................................................................17-58
Chapter 18 Risk management and derivatives........................................................................18-1
What does Warren Buffett think about derivatives.................................................................18-1
Learning objectives.....................................................................................................................18-1
Introduction................................................................................................................................18-2
1Risk management strategies................................................................................................18-2
Interest rate risk....................................................................................................................18-3
Refinancing risk....................................................................................................................18-3
Liquidity risk.........................................................................................................................18-4
Currency risks........................................................................................................................18-5
Credit risk..............................................................................................................................18-5
Market and commodity price risks......................................................................................18-6
General risks.........................................................................................................................18-6
2Rationale for financial innovation......................................................................................18-7
3 Fundamental derivative instruments..................................................................................18-8
Options..................................................................................................................................18-8
Valuation of options..............................................................................................................18-9
Replicating portfolio...........................................................................................................18-11
Black-Scholes Option Pricing Model.................................................................................18-13
Put-call parity......................................................................................................................18-15
Using Excel® to determine Black-Scholes option values................................................18-15
The Binomial Option Pricing Model.................................................................................18-16
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Options, the Greeks and implied volatility.......................................................................18-19
Futures and forward contracts...........................................................................................18-20
Pricing of futures and forward contracts...........................................................................18-22
4Risk-reducing techniques...................................................................................................18-23
Natural hedges (operational hedging)..............................................................................18-24
Hedging with futures, forwards, and options....................................................................18-25
From the real world: SAA and hedging in the gold mining industry..............................18-26
What does Warren Buffett think?......................................................................................18-28
Contracts for difference (CFD).........................................................................................18-29
Interest rate risk..................................................................................................................18-32
Hedging with interest rate swaps.......................................................................................18-32
Duration and immunisation...............................................................................................18-35
Hedging interest risk with Floors, Caps and Collars........................................................18-38
From the real world: SABMiller 2013...............................................................................18-42
Derivative use by South African companies.....................................................................18-42
5Return-generating techniques...........................................................................................18-44
Asset securitisation.............................................................................................................18-44
Tax arbitrage........................................................................................................................18-47
Convertible securities.........................................................................................................18-48
Summary..............................................................................................................................18-49
Solutions to self-study problems........................................................................................18-61
Self-study problems.............................................................................................................18-60
Appendix 18.1 Employee share options share based payments......................................18-49
From the real world............................................................................................................18-52
Appendix 18.2 Option trading strategies..........................................................................18-53
Appendix 18.3 A short introduction to hedge funds........................................................18-57
Appendix 18.4 Securitisation, banks and the financial crisis...........................................18-59
Questions.............................................................................................................................18-61
Chapter 19 International financial management....................................................................19-1
The end of the affair..................................................................................................................19-1
Learning objectives.....................................................................................................................19-1
Introduction................................................................................................................................19-1
1 Historical perspective...........................................................................................................19-2
2The balance of payments......................................................................................................19-4
Current account....................................................................................................................19-4
Capital account.....................................................................................................................19-5
Official reserves.....................................................................................................................19-5
3The foreign exchange market...............................................................................................19-6
Direct and indirect quotations.............................................................................................19-6
Bid–ask spread......................................................................................................................19-6
Mid-rate.................................................................................................................................19-7
Spot and forward transactions.............................................................................................19-7
Points......................................................................................................................................19-7
Forward rate and premium/discount...................................................................................19-7
Cross rates.............................................................................................................................19-8
4 Forces behind exchange rate movements............................................................................19-8
Interest rate parity................................................................................................................19-8
The purchasing power parity theory (PPP).......................................................................19-10
Big Mac exchange rates......................................................................................................19-12
Integrating the interest rate parity and purchasing power parity theories.....................19-13
Forecasting exchange rates.................................................................................................19-13
5 Foreign exchange exposure................................................................................................19-16
Translation exposure...........................................................................................................19-16
Transaction exposure..........................................................................................................19-18
Economic exposure.............................................................................................................19-18
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From the real world............................................................................................................19-19
6 Hedging policies..................................................................................................................19-19
Forward contract.................................................................................................................19-19
Money-market hedge..........................................................................................................19-21
Currency options.................................................................................................................19-23
Currency of invoice.............................................................................................................19-24
Leads and lags.....................................................................................................................19-24
Futures contracts.................................................................................................................19-24
Currency swaps....................................................................................................................19-26
7Exchange control................................................................................................................19-29
8 Covered-interest arbitrage.................................................................................................19-32
9The eurodollar market.......................................................................................................19-33
10Offshore financing by South African companies.............................................................19-34
Offshore borrowings...........................................................................................................19-34
Listing on foreign stock exchanges....................................................................................19-34
11Documentary letters of credit............................................................................................19-35
12 Analysis of foreign investments.........................................................................................19-36
Determination of future cash flows...................................................................................19-37
Determination of discount rate.........................................................................................19-38
13International portfolio diversification..............................................................................19-39
14 Analysis of a major project by BHP Billiton....................................................................19-40
Summary..............................................................................................................................19-41
Self-study problems.............................................................................................................19-42
Solutions to self-study problems........................................................................................19-43
Questions.............................................................................................................................19-44
Chapter 20 Business planning and financial modelling.........................................................20-1
It’s a journey, not a destination.................................................................................................20-1
Learning objectives.....................................................................................................................20-1
1 Business plans.......................................................................................................................20-1
What are the advantages of preparing a business plan?....................................................20-2
The content and structure of a business plan.....................................................................20-4
Background/strategy.............................................................................................................20-5
Products and services............................................................................................................20-6
Markets and marketing strategies........................................................................................20-7
Operations and production process.....................................................................................20-9
Management and executive team......................................................................................20-11
Legal, social and environmental factors............................................................................20-15
Financial information and projections..............................................................................20-15
The components of the financial projections section.......................................................20-17
Sensitivity and scenario analysis........................................................................................20-18
Porter’s Five Forces............................................................................................................20-18
What other factors will play a role in the financing decision?........................................20-19
From the real world: Invenfin............................................................................................20-19
From the real world: Industrial Development Corporation............................................20-20
2 Financial modelling............................................................................................................20-21
The design and layout of financial models........................................................................20-21
Avoiding spreadsheet errors..............................................................................................20-23
The use of spreadsheet models in corporate finance.......................................................20-24
The application of ‘what-if’ analysis in Excel®................................................................20-25
Financial models and topics in corporate finance............................................................20-26
3 Financial modelling and forecasting financial statements: an application...................20-26
Goal seek, data tables and sensitivity analysis..................................................................20-34
Circular references in Excel®............................................................................................20-36
Summary..............................................................................................................................20-37
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Appendix 20.1 Examples of Scenario Manager, Tornado Graph and
Monte Carlo Simulation.....................................................................................................20-37
Appendix 20.2 Spreadsheet modelling for selected topics in corporate finance...........20-39
Chapter 21 Corporate Strategy and Business Models............................................................21-1
1 Corporate strategy and industry analysis..........................................................................21-1
2 What is strategy?..................................................................................................................21-3
3Matrix models.......................................................................................................................21-5
4Michael Porter’s Five Forces model....................................................................................21-8
Rivalry among existing competitors..................................................................................21-10
Threat of new entrants and potential competitors...........................................................21-10
Threat of substitutes...........................................................................................................21-11
The power of customers.....................................................................................................21-12
The power of suppliers.......................................................................................................21-13
Porter’s value chain.............................................................................................................21-14
Porter’s four corners analysis.............................................................................................21-14
5Other strategic factors.......................................................................................................21-15
Analysis of competitors and customers.............................................................................21-18
Product life cycle.................................................................................................................21-18
6The building blocks of a business model..........................................................................21-19
Customer segments.............................................................................................................21-19
Value propositions..............................................................................................................21-22
Channels..............................................................................................................................21-25
Customer relationships.......................................................................................................21-27
Revenue streams.................................................................................................................21-28
Key resources......................................................................................................................21-29
Key activities........................................................................................................................21-29
Key partnerships.................................................................................................................21-29
Cost structure......................................................................................................................21-30
7Disruptive technologies, 3D printing and the role of big data.......................................21-30
Summary..............................................................................................................................21-34
Tables.............................................................................................................................................T-2
Index ............................................................................................................................................. I-1
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Preface
The 8th edition is aimed at students undertaking either an introductory or intermediate course
in corporate finance. The objective is to offer students an in-depth view of finance theory and
practice. This edition is up-to-date, relevant and offers insights into the application of financial
theories to maximise value. In the interests of the reader, we have expanded some complex
sections while simplifying others to retain focus. Each chapter begins with learning objectives
to guide the reader through the text, and concludes with self-study problems and detailed
solutions. A number of new questions and self-study problems have been added and we trust
that this will make the book even more useful to those preparing for finance examinations.
In particular, we have added recent ITC questions which reflect the direction that SAICA is
following in setting contextualised integrated questions.
The textbook has been updated to include sections on all the topics set out in SAICA’s
Competency Framework in respect to financial management, financial risk management and
corporate strategy. The book is aligned to Version 8 of the Competency Framework, which was
issued in September 2014. Changes arising from the Companies Act of 2008 have been included
such as the solvency and liquidity requirements and the provisions relating to takeovers and
business rescue. We have included a section on turning around financially troubled companies.
In line with the Competency Framework we have increased our focus on risk management.
Where relevant, we have referred to King III. Also, in line with the Competency Framework,
we have included a new chapter on corporate strategy and business models. We have also
included a chapter on business planning and financial modelling.
There is a greater emphasis on support materials such as PowerPoint slides, questions, the
use of Excel models as well as greater reference to applications of finance theory in a South
African context. In Chapter 5, we have changed the format of financial statements to be in
line with International Financial Reporting Standards and we have included a new section on
integrated reporting and the six Capitals. We have expanded the section on failure prediction
due to the introduction of the business rescue provisions of the Companies Act of 2008 and the
increased focus on financial distress. In Chapter 13, we have expanded the section on private
equity and and have introduced sections on inflation linked bonds, the use of repos, revolving
credits, and alternative sources of finance such as peer-to-peer lending, crowd funding and
online invoice trading platforms. We have updated Chapter 15 on leasing and in Chapter 17 we
have outlined an alternative way of dealing with merger terms. Chapter 18 has been expanded
to reflect the growing importance of the use of derivatives. We have made extensive reference
to financial decision-making by South African companies and each chapter includes a section
entitled ‘From the real world…’ which sets the topic in relation to the experience or actions
of a South African company. We have often referred to what Warren Buffett thinks about a
particular topic.
We have made extensive references to the JSE’s equity market, the JSE’s debt market and
the JSE’s derivatives market. We have endeavoured to offer an integrated view of finance, yet
we invite students to challenge conventional wisdoms. The focus is on financial decision-making
which will maximise the value of a company.
This edition has been influenced by the feedback we have received from colleagues and
tutors, and we would like to thank all who provided valuable suggestions. We are grateful to
the following contributors, Greg Beech, Gary Swartz, Dr Glen Holman, Etienne Swanepoel,
Professor Joel Stern, Philip de Jager and Darron West. We would like to thank Rutendo
Mukuzwazwa, Helen Correia and Erika Blomerus for editing each chapter. We would like to
thank Colin Smith for his suggestions and making his support material on financial calculators
available on the Website to our readers.
THE AUTHORS
Cape Town, January 2015
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What does the book offer?
Learning objectives
We have included learning objectives at the beginning of each chapter. Students can
use these to view the key issues that are covered in the chapter. Students can also test
themselves at the end of each chapter on whether these learning objectives have been realised.
Real world examples and references to listed South African
companies
We have included many real world examples and have made reference to listed South African
companies. The objective is to show how South African companies use corporate finance
in practice and to indicate the relevance of finance in the real world. For example, we have
included the application of time value of money principles to pensions and retirement planning
and have valued the contracts of Ronaldo and Rooney. We have valued Woolworths, analysed
the dividend policy of Anglo American and analysed the share buy-backs by Vodacom. We
study the integrated report of Truworths and compare its return on invested capital to its cost of
capital. We analysed the capital structure and cost of capital of Sasol and determined the EVA
of SABMiller. We explained the unbundling of Sibanye Gold from Gold Fields. We examined
the dividend policy of Shoprite and analysed CFR and Bidvest’s battle for Adcock Ingram. We
designed a financial model in order to value Clicks. We have analysed the leveraged buy-out of
Edcon by Bain Capital and we have valued Eskom bonds. We have also analysed developments
in the South African corporate bond market, the JSE, the AltX and the JSE’s derivatives
market.
Use of worked examples to explain corporate finance concepts
We have endeavoured to clearly explain the underlying concepts of corporate finance but
believe that it is important to also use worked examples in each chapter to indicate how to
apply these concepts. In most cases, such examples are concise and focus on a particular concept in each chapter.
Extensive use of Excel spreadsheet models
We believe that students should not only understand corporate finance but should also be able
to use Excel spreadsheets to solve many finance applications. This reflects the use of Excel
models in practice and will enable students to go out into the corporate environment with a
useful knowledge of how to use Excel spreadsheets to solve corporate finance problems, which
will offer them a competitive edge. For example, students are required to use Excel to solve
time value of money problems, such as pension plans and loan amortisation schedules. Excel is
employed to value corporate bonds and ordinary shares. Students are required to use Excel in
capital budgeting and forecasting future cash flows. The text explains how to use Excel in risk
analysis and how to build simple Monte Carlo simulation models. We have included in Chapter
20 a section on financial modelling, focusing on the design and application of spreadsheet
models.
Use of financial calculators
In Chapter 2, we have included a section on how to use financial calculators to solve time
value of money problems and have explained how financial calculators can be used to discount
future cash flows. We have solved problems with formulas and tables and have used the same
examples in explaining the use of financial calculators. We also offer a Guide to Financial
Calculators by Colin Smith, a senior lecturer at UCT, on how to use financial calculators. This
guide may be downloaded at www.commerce.uct.ac.za/correiabook.
Use of self-study examples at the end of chapters
At the end of each chapter there are comprehensive self-study examples with worked
solutions. This is to reinforce what has been covered in that chapter and prepares students to
embark upon the problems at the end of the chapter.
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Extensive number of straightforward and complex problems at the
end of each chapter
At the end of each chapter there are a large number of straightforward and complex questions
and problems. The ability to answer these problems will indicate a high level of understanding
of financial management.
Professional Examination Questions
We have included a significant number of professional examination questions from the Initial
Test of Competence (ITC) examinations as well as prior Qualifying Examination questions
set by the South African Institute of Chartered Accountants (SAICA). We have also included
questions from ACCA and CIMA. The inclusion of professional questions as well as
the inclusion of complex questions at the end of each chapter (as well as the additional
questions on the financial management website) assists students to prepare for professional
examinations. The majority of the integrated questions are sourced from SAICA’s ITC and
Qualifying Examinations. Any specimen questions and solutions released by SAICA relating to
the ITC will be made available on the book’s website and then clearly referenced with respect to
financial management topics assessed therein.
Textbook in line with SAICA’s Competency Framework
SAICA issued its Competency Framework for Chartered Accountants in 2009. The objective
was to ensure that there will be a greater contextualisation and integration of topics as well
as a greater focus on corporate strategy and risk management in the examination of Financial
Management. This edition has expanded the sections on corporate strategy and risk management and offers advanced questions in each chapter in order to offer a greater level of contextualisation in line with the Competency Framework. The Competency Framework was amended
in September 2014 when SAICA issued Version 8 of the Framework, which will be effective from
January 2016. We have aligned this book to Version 8 of the Competency Framework. We have
offered a detailed explanation of this in a separate section and have set out each competency
for the Strategy, Risk Management (in respect to financial risk management) and Financial
Management areas and we set out where we deal with each specific competency in the book.
We have endeavoured to ensure that we have covered Financial Management and Strategy and
Financial Risk Management topics and we refer each topic in the Knowledge Reference List to
a particular chapter in the book.
Although the textbook is primarily addressing the requirements of the ITC, the expansion
of the topics in this new edition relating to corporate strategy, business models, business
planning, risk management and practical issues of financial decision-making, will make the book
increasingly relevant for candidates preparing for the Assessment of Professional Competence
(APC) examination.
Integration of topics
We have endeavoured to integrate topics and show how chapters are linked. For example,
the use of the dividend discount model in Chapter 6 to value a company’s shares is linked to
the growing perpetuity formula in Chapter 2. We also integrate cost of capital (chapter 7) with
valuations (chapter 6) and with capital structure (chapter 14) by referring to each topic relative
to each other.
Ease of use and flexibility
Although we have tried to integrate topics, for pedagogical reasons, we have also been conscious that students will not cover all the topics in a standard unit on corporate finance. We
have used our experience in the classroom to ensure that some topics are separate and stand
on their own for the purpose of structuring course programmes and ensuring flexibility.
Focus on strategY
Financial management is about financial decision-making and we have gone further than other
textbooks to integrate corporate strategy into corporate finance. This is because we understand
the importance of strategic issues in financial decision-making. We have written extensively
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on corporate strategy in Chapters 1, 20 and 21 and within other chapters as we have placed
financial decision-making within the context of a company’s strategy. This means that we have
complied with the requirements of the Competency Framework in relation to corporate strategy,
which is included in SAICA’s Strategy, Risk Management and Corporate Governance competency
area. Questions in the ITC increasingly require analysis of a corporate situation or transaction.
Understanding corporate strategy will better prepare candidates to address these types of questions. Furthermore, companies are outlining their corporate strategy in their integrated reports
and we need to understand what strategy is (and what it is not) when we analyse integrated
reports. This also means that sometimes we need to adapt financial theory to a company’s strategic intent. For example, Sasol has a very low debt-equity ratio, which is not optimal in terms of
financial theory. Yet, this means that Sasol will be able to effectively finance its plans to expand
internationally within the next few years, which is a key component of its strategy.
Building-block approach
We have used a building-block approach to corporate finance whereby we build on the
fundamental concepts of finance and increase the complexity of each topic step-by-step in each
chapter. This enables units to be structured with flexible levels of complexity so that units may
be limited to a number of sections in each chapter. We have also used appendices partly for
the same reason.
GUIDANCE TO KEY TOPICS IN FINANCIAL MANAGEMENT
We have included guidance notes to students at the end of key chapters in order to assist and
prepare students to effectively deal with particular topics in examinations. Further, the guidance
to these key topics will enable students to better understand and integrate key areas of financial
management. The guidance sections have been written by Johnathan Dillon who brings his
extensive lecturing experience as well as his involvement in SAICA’s examination processes to
effectively assist students with these guidance notes to key chapters.
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What resources does the book offer to the
instructor?
Instructors are provided with a comprehensive Instructor’s Manual, available on the dedicated
website at www.jutaacademic.co.za and at www.commerce.uct.ac.za/correiabook. Instructors will
be able to obtain a username and password to access this site by emailing the principal co-author,
Carlos Correia at carlos.correia@uct.ac.za. Instructors will find the previous section on what the
textbook offers to be useful for course design and evaluating student performance. We understand the increasing demands placed upon academics and have endeavoured to ensure that this
edition supports the teaching objectives of academic instructors.
The textbook provides learning objectives, worked examples, clarity in writing, self-study
examples and a comprehensive number of end-of-chapter problems. There are references to
up-to-date, real world applications.
The Instructor’s Manual or Instructor’s section of the book’s website includes the following:
Complete solutions to end-of-chapter questions
A complete set of solutions to the end-of-chapter questions are provided in Adobe Acrobat
and Word format. Many questions have been used in a classroom setting and the solutions
reflect feedback received from students.
MCQ TESTS AND SOLUTIONS
Instructors currently have access to a series of MCQ tests and solutions, which they are able
to use if needed. These are available on the Instructor’s section of the book’s website. We are
planning to expand this into a system of assessment for students undertaking a course in financial
management.
Excel spreadsheet solutions
Instructors are provided with selected Excel solutions to end-of-chapter problems. This will
enable instructors to quickly alter variables to point out the effects on solutions. It will also
enable instructors to easily change the data in questions for examination purposes. There are
also Excel solutions for selected worked examples within each chapter.
Additional questions and solutions not in the textbook
The website includes additional questions and solutions not included in the textbook. This
offers instructors flexibility in assessment and enables changes in the set of questions used
from year-to-year.
PowerPoint slides
A full set of PowerPoint slides is available to prescribing institutions. The slides have been prepared by the authors and are relevant and up-to-date and follow the content of each chapter.
Email support
Lecturers prescribing the textbook can email Carlos at carlos.correia@uct.ac.za for further
explanations or clarification in relation to the content, questions or solutions.
Website for Financial Management
Juta & Co will maintain a companion website at www.jutaacademic.co.za and at www.
commerce@uct.ac.za/correiabook for the 8th edition of Financial Management, whereby
lecturers will be able to download PowerPoint slides, updated solutions, readings and other
material.
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READINGS, SURVEYS AND BETAS
The instructor’s section of the book’s website includes the BNPP Cadiz FRS Betas report which
sets out the betas of South African listed companies. We have also included the PwC Valuation
Methodology Surveys and the KPMG Cost of Capital Survey. The impact of labour strikes in
2013 and 2014 on the South African economy and business in general means that it is important
to have some insight into the workings of labour legislation, the labour relations framework and
unions. This is particularly relevant in respect to ITC questions, which refer either directly or
indirectly to labour issues and students are required to present an analysis into how to deal with
labour issues. In order to address this issue, we have included a report on the labour framework
in South Africa on the book’s website which instructors are welcome to download and use as
required.
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How does the book fit in with SAICA’s
Competency Framework and the Companies Act?
SAICA’s Competency Framework
The South African Institute of Chartered Accountants (SAICA) has introduced a Competency
Framework, which sets out the required competencies of Chartered Accountants at the point of
writing the Initial Test of Competence (formerly known as SAICA’s Part I Qualifying Examination).
The Initial Test of Competence (ITC) is an assessment of core technical knowledge and therefore
SAICA produced a document entitled “Detailed Guidance for the Academic Programme” (referred
to as the Competency Framework), which sets out the competencies and associated knowledge
required at the point of writing the ITC. This section summarises important aspects of SAICA’s
Competency Framework, most notably Version 8 thereof issued in September 2014 (effective
from January 2016).
In writing the 8th edition of Financial Management, we have as far as possible included the
changes relating to SAICA’s most recent Competency Framework (Version 8). In addition, we
have matched the specific Strategy and Financial Management competencies set out in SAICA’s
Competency Framework with the relevant chapters in the Financial Management textbook.
SAICA’s Competency Framework also includes a Knowledge Reference List for each
competency area, which sets out the content and levels of knowledge required to acquire the
specific competencies. We have matched the Knowledge Reference Lists relating to Strategy and
Financial Management to the relevant chapter(s) in the Financial Management textbook.
Ethics & Professionalism
In the Competency Framework SAICA has detailed pervasive qualities and skills required of all
Chartered Accountants, being Ethical Behaviour and Professionalism, Personal Attributes and
Professional Skills. We have included an Appendix in Chapter 1 on Professional Ethics which
follows the Code of Professional Conduct of SAICA. The Chartered Financial Analyst (CFA)
Institute has issued a Code of Ethics and Standards of Professional Conduct to guide the actions
of investment professionals which has been summarised in the same Appendix. Over time, we
expect a greater integration of ethics and financial management.
Integration of Information and Information Technology
SAICA’s Competency Framework requires the integration of information technology (IT) within
the specific competencies as information and IT have become pervasive in the tasks undertaken
by Chartered Accountants. IT is critical for financial management and without the advances in
IT, both in terms of software, models and systems, the functioning of capital markets would be
severely curtailed and the design of financial instruments would be compromised.
The focus on IT in a financial management environment is highly dependent on financial
models. Applications such as option pricing models, bond pricing, loan amortisations and
Monte Carlo simulation are dependent on programs such as Excel and Excel-based models and
programs such as Crystal Ball©. Capital budgeting, mergers and acquisitions, and valuations are
highly dependent on setting up detailed cash flow forecasts in Excel and the use of tools such as
Tornado graphs, Data Tables, Scenario Manager and Monte Carlo simulation.
In the Financial Management textbook, we have focused mainly on the use of Financial
Modelling and the use of Excel to solve financial management applications. We also refer to the
strategic importance and role of IT in a company’s business model.
We employ financial models throughout the textbook, to solve time value of money
applications such as loan amortisations, in risk and return and portfolio theory to determine such
aspects as standard deviations and efficiency frontiers, in capital budgeting to set out project cash
flows and compute NPV and IRR as well as undertake Monte Carlo Simulations. We employ
Excel in determining the cost of capital, valuations of bonds and equities, the determination of
yield to maturity (YTM), Free Cash Flow models, and we make use of Excel models to apply the
Black & Scholes option pricing model.
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Financial modelling is placed in a separate chapter (Chapter 20), where we focus on the
proper design and layout of financial models to optimise flexibility and reduce the potential for
errors, set out model documentation, apply audits of models, and explain the application of such
tools as data tables, goal seek, and scenario manager. We have included a section on the use
of financial modelling to forecast financial statements, determine free cash flows and financing
flows and determine the value of a company. The focus is on the use of financial modelling skills
to solve real world corporate finance applications.
Strategy, Risk Management and Governance
The Competency Framework refers to Strategy, Risk Management and Governance as a specific
competency area. Whilst many sections of this competency area, such as IT strategy, nonfinancial risk management and governance models, are beyond the scope of the Financial
Management textbook, we have addressed specific issues in the 8th edition relating to the Strategy
competencies. Firstly, a new chapter (Chapter 21) has been included which covers various aspects
of strategy and strategic models, as well as the building blocks of a business model. The content
covered in Chapter 21 is supported by real world examples of strategy in practice and builds on
Chapter 1 which includes a section on corporate strategy covering Porter’s Five Forces model,
SWOT analysis and PESTEL analysis. Chapter 1 now also includes an Appendix dealing with
stakeholders and corporate citizenship.
The Financial Management textbook predominantly focuses on risk management relating to
financial risks in line with SAICA’s Competency Framework (Version 8), which now specifically
includes a Financial Management competency entitled “Management of financial risks as part
of the entity’s risk management policy”. Chapter 1 includes a section on risk management while
aspects of risk assessment are also included in Chapter 5 dealing with financial analysis. Although
Chapter 18 and Chapter 19 focus on financial risks, the introduction to Chapter 18 includes an
overview of risk management. A section on aspects of Corporate Governance and King III is
included in Chapter 1.
THE COMPANIES ACT (NO. 71 OF 2008)
The Financial Management textbook includes reference to the Companies Act of 2008 (Act
71 of 2008) to the extent that this is relevant to financial management. This is in line with
the requirements of SAICA’s Competency Framework, which requires that knowledge of the
Companies Act is determined by the extent required by the specific competency area, in this case
being Financial Management.
The main areas of the Companies Act that has been included in the 8th edition are:
■■ Types of companies – differences between private and public companies;
■■ Share capital/stated capital – the use of no par value shares;
■■ Solvency and liquidity tests;
■■ Financial assistance for the purchase of shares;
■■ Distributions to shareholders;
■■ Share buy-backs;
■■ Issue of shares to the public;
■■ Sale of the greater part of a company’s assets;
■■ Mergers and fundamental transactions;
■■ Scheme of arrangement;
■■ Takeovers, mandatory offers, and the Takeover Regulation Panel; and
■■ Business rescue as an alternative to a private workout and liquidation.
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Specific competencies listed in SAICA’s Competency Framework
and the supporting knowledge reference lists relating to
Strategy and Financial Management
Competency levels:
Level A = Awareness; Level I = Initiates the task; Level X = Executes the task
Knowledge levels:
Level 1 = Basic; Level 2 = Intermediate; Level 3 = Advanced
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SECTION A
INTRODUCTION
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Overview of Financial
Management
1
You have arrived here because you are beginning your studies in finance, or you have to make a
financial decision and need principles to guide you or you may simply be curious about how the
financial world works. Finance is not a subject you study and then put away. It will have a profound
impact on your future and/or the future of your company. Developments in financial markets,
the enabling power of technology and a globalising world economy have created dramatic shifts
in financial markets and instruments. In this chapter, we will start at the beginning and explore
the objective of finance, corporate structures, the function of the financial manager, corporate
governance, sustainability and ethics. We will try to understand why management incentives may
not always be aligned with the interests of shareholders or bondholders. Did this perhaps play a role
in the global financial crisis? We will see.
LEARNING OBJECTIVES
After working through this chapter, you should be able to:
■■ Define what Financial Management is.
■■ Explain why the objective of financial management is to maximise the value of the firm.
■■ Define the role of the financial manager.
■■ Describe the various forms of business organisation.
■■ Understand how agency issues that arise between managers and owners impact on
wealth maximisation.
■■ Understand the underlying concepts of financial management.
■■ Understand what represents good corporate governance in terms of King III.
■■ Define the role of ethics in financial decision-making and understand the codes of
conduct issued by professional accounting and finance associations.
■■ Understand the role of corporate strategy in financial management and define strategic
frameworks such as Porter’s Five Forces, SWOT and PEST analysis.
Introduction
This text is essentially about the financial management of business enterprises. Companies
face two major financial management decisions:
■■ Which assets should the company invest in?
■■ How should the company finance these investments?
The first question requires that we find assets that will increase the value of the firm and the
second question requires us to raise capital – either equity or debt to finance the investment
in assets. These are important financial decisions, which sometimes mean that firms either
prosper or sometimes fail. These decisions occur within a strategic context. Corporate strategy
is the compass of the firm – financial managers will make decisions in line with a strategic
vision and the core values of the firm.
The decisions required in order to ensure the growth of the business enterprise, and
therefore of the funds invested, form the core of financial management. The success of any
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1-2
FINANCIAL MANAGEMENT
business enterprise depends on the strategic choices which are made and how the firm’s funds
are employed. The issues which are the focus of the financial manager relate to the sources and
uses of the funds. The criterion used to measure the effectiveness of the financial management
function is the increase in the value of the business enterprise.
1 The context of financial management
Financial management relies heavily on allied disciplines such as economics and accounting.
It is essentially an applied discipline which is approached from the perspective of the financial
manager of a business enterprise. Because of the existence of a securities exchange, a market
on which shares of companies are traded, we tend to use the listed company as the appropriate
enterprise for developing the principles of financial management. Such principles, however,
are applicable to all types of business enterprise.
Development of financial management
Individuals and organisations have been dealing in financial matters for centuries. The
most significant developments in organisational structures have, however, taken place
only recently. In particular, the separation of ownership from management, together
with advances in technology which enable securities markets to respond rapidly to new
information, have made a substantial difference to financial management.
Links with economics
Financial management does not take place in a vacuum – it occurs in the context of a specific
national and international economy. A knowledge of the fundamental principles of economics,
and some understanding of the interaction of economic forces, is essential for the practice of
corporate finance. The financial manager should be aware of the impact of economic indicators
such as changes in the gross domestic product, the balance of payments, foreign currency
exchange rates, inflation rates, employment figures and interest rates.
Economics is the source discipline for financial management. Deeply rooted in all
economic issues is the fundamental objective of making the best use of scarce resources. In
financial management, the scarce resource is financial capital – the savings of individuals and
organisations. The financial manager is responsible for making the best use of this resource.
This is illustrated in Figure 1.1.
Links with accounting
Financial statements are required to be produced in line with International Financial
Reporting Standards (IFRS). This information, together with any other relevant information,
is used by investors to place a value on the shares of the company. Accounting information has
many limitations, particularly regarding its historic perspective. Increasingly, IFRS requires
or allows assets and liabilities to be reflected at fair value (market value). Companies are also
permitted to revalue assets which were previously reported at depreciated cost in the Statement
of Financial Position. Moreover, accounting practices are designed to standardise reporting
procedures rather than to reflect economic reality. The financial manager will nevertheless
be required to analyse and interpret accounting data. This will be used in a forward-looking
perspective as the information required for financial management decisions.
The accounting profession has been criticised in recent times for its seeming inability to
develop measuring instruments, which are both reliable and relevant. This is particularly
noteworthy in the valuation of intangible assets such as research and development, brands,
patents and intellectual capital. The International Accounting Standards Board (IASB) has
also been criticised for the accounting rules relating to operating leases which have been
ineffective. It is expected within the next few years that IFRS will require the capitalisation
of all operating leases as well as financial leases. This problem of providing information to
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Overview of Financial Management
1-3
investors and managers is exacerbated by the complexities of auditing large companies engaged
in transactions such as joint ventures and using a range of financing instruments such as
derivatives and special purpose entities (SPEs). These two issues present formidable challenges
to the financial manager, who needs to place reliance on information published in the financial
statements of companies. Further, fraudulent accounting practices at some major companies
such as Enron, Worldcom and Lehman Brothers caused investors to lose billions of dollars.
Economics
How do individuals/organisations/countries make the best use
of scarce resources?
Financial management
How does the financial manager use best practice to add value to capital
received in the form of debt and equity and thereby create wealth?
The financial manager
Measured by the value created by finding projects with returns that
are greater than the firm’s cost of capital.
Figure 1.1 From economics to financial management
2 The environment of financial management
Financial management is practised in a changing business environment. A knowledge of the
economic systems and principles operating in this environment is essential. Individuals and
governments across the world have differing value systems and the financial manager must work
within the bounds of these systems. Economic policies – the considered decisions made by the
ruling government of the day, on how to make the best use of the country’s scarce resources
– flow from and reflect such values. The environment in which economic activity takes place
therefore depends upon the people who inhabit the country, the resources available within the
country, and the systems designed to promote economic activity. We need to consider these
factors before attempting to apply financial management principles within the South African
environment. What are the major forces currently shaping the South African economy? What
is the geography of the economic landscape?
■■ Deregulation/Regulations. Governments are increasingly removing regulations that restrict
economic activity. This has occurred in the banking sector, the telecommunications sector,
the electricity and gas sectors as well as other sectors such as the airline industry. How
will deregulation affect financial management decisions? For example, the deregulation
of shopping hours has impacted on the retail sector and will affect investment decisions
in this sector. SAA needs to consider the impact of competition in deciding on fleet
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replacement and expansion. In relation to financing decisions, companies are able to
obtain financing using a wide range of instruments and from a number of sources which
will reduce the cost of financing. At the same time, we are seeing increasing regulation of
pricing in some sectors such as electricity, water and pipelines. Bank regulation has come
under the spotlight since the financial crisis. Increasingly there are regulations arising from
competition law, labour law and environmental law.
■■ Taxation. South Africa has undertaken major changes to the tax system which are impacting
on investment and financing decisions. The significant reduction in the corporate tax rate
from 48% to 28% in the last 20 years has affected corporate investment and financing
decisions. The implementation of a 15% withholding tax on dividends has encouraged the
use of retained earnings to finance investments in capital projects. The introduction of a
capital gains tax (CGT) which is not indexed to inflation will have long-term effects but the
lower CGT rate as well as its deferral until realisation will encourage reinvestment. South
Africa’s custom and excise taxes have been lowered resulting in an increasingly competitive
environment for South African companies. Countries have become more competitive in
terms of corporate tax rates in order to attract foreign investment. There are tax deductions
to encourage investment in operating assets and borrowing costs are tax deductible. There
are further tax incentives to encourage research and development and investment in
manufacturing plant and equipment.
■■ Interest rates. Interest rates have fallen significantly over the last decade. This means that
interest rates are at low levels and this will reduce the effective cost of borrowing and
impact on the company’s investing and financing decisions.
■■ Inflation. Inflation has fallen significantly and companies are currently operating in a low
inflation environment. This needs to be factored into financial decision-making.
■■ Privatisation/Nationalisation. The privatisation of firms such as Telkom means that the
government has followed a policy of transferring businesses to the private sector. However,
recently there have been calls for nationalisation of such sectors as mining and the
government has begun issuing mining rights to a state mining company (AEMFC).
■■ Commercialisation/High input costs. The South African government is committed to a
process of commercialising certain public entities such as Transnet and Eskom. The focus
is on making the public sector more efficient. However, higher electricity tariffs (and the
effects of loadshedding) are increasing the costs of doing business in South Africa.
■■ Broad-based BEE. The implementation of Broad-based Black Economic Empowerment
is leading to changes in corporate ownership structures, management profiles,
employment, procurement policies and financing structures. The effect of BEE is
generally seen as positive for the South African economy.
■■ Globalisation and internationalisation. Globalisation has forced South African companies
to be internationally competitive and South African companies have expanded into
foreign markets and have obtained listings in London and New York. Companies are
also raising loans and issuing bonds offshore.
■■ Mergers and acquisitions. Increasingly we are seeing firms merging and there is increasing
consolidation in many sectors. For example, the merger of BHP of Australia and Billiton
of South Africa resulted in one of the world’s largest resource companies.
■■ Currency exchange rates. Foreign exchange rates are highly volatile and companies are
required to factor in future exchange rate movements in their investment and financing
decisions. The significant fall in the rand exchange rate from 2011 to 2014 has affected
exporters and importers of goods and services as well as foreign investors.
■■ Growth in the use of financial derivatives. The availability of futures and options markets
means that firms can use such instruments to hedge against price, interest rate, currency
and commodity price risks. However, the use of derivatives can result in substantial
losses when used for speculative purposes.
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■■ Developments in China, the USA and Europe. China’s burgeoning economy has resulted
in strong demand for resources and other exports from South Africa. At the same time,
local manufacturers are feeling the heat of competition from China. The continued
strong performance of the Chinese economy is crucial for exporters. It is expected that
the growth rate in China will fall over time. The USA has been incurring fiscal deficits
and undertaking “quantitative easing” by buying bonds in the market, which increases
the money supply and further reduces interest rates. This is not sustainable in the long
term. However, discontinuing this policy may have effects for emerging markets. A
debt crisis in the Euro zone – particularly for Greece - resulted in bailouts and austerity
measures which resulted in significant adverse economic effects. The UK experienced
a serious downturn and yet both the UK and Europe, including Ireland and Portugal,
have been experiencing a fragile economic recovery whilst in 2013, it was emerging
markets that have been buffeted by economic headwinds.
■■ Other factors. The aging of the population in Europe, parts of Asia, the USA and Australia
is causing shifts in demand patterns for products and has implications for public spending.
There will be economic effects from climate change and bird flu-type outbreaks can have a
profound, if temporary, impact on industries such as the airline and tourism sectors.
Forms of business organisations
Business entities can be classified in many different ways. One classification method is in terms
of the activity of the business. Using this system we can identify four main areas of activity:
Firstly, extractive activities such as mining and agriculture which form an important sector of
the South African economy. Secondly, manufacturing activities which involve the production
of goods using raw materials. Thirdly, the merchandising activities of wholesalers and retailers.
Finally, service activities which include a broad spectrum starting with government and
administrative services right through to professional services such as those provided by banks,
insurance companies, health care services, lawyers, and accountants.
From the viewpoint of financial management, however, it is also relevant to classify
activities in terms of their form of ownership. The form of ownership has numerous legal and
tax implications that affect financial management decisions. We will focus only on the common
forms of ownership encountered in business entities which have the objective of making a
profit. These are the sole proprietorship, the partnership, and the limited liability company.
Figure 1.2 Forms of business ownership
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The sole proprietorship
This is probably the most common form of business entity. Anyone conducting any legal form
of business activity may be established as a sole proprietor. For tax purposes, the income of
the business is considered to be personal income of the owner and is added to whatever other
assessable income may have been earned during any given tax year. Three major disadvantages
of this form of ownership are immediately apparent. Firstly, the continued existence of the
business depends on one person, the owner. Secondly, because most individuals have limited
funds available, growth is often hampered by the inability to raise further finance. Thirdly,
should the business fail, the owner’s liability is not limited, so there is a risk that his or her
personal estate may be declared insolvent.
The partnership
A partnership may be formed when two or more persons come together to start a business.
From an individual partner’s viewpoint it is identical in every respect to a sole proprietorship,
except that profits and losses are divided in an agreed proportion. A partnership has the
advantage of a pooling of the resources that each individual partner may be able to contribute.
These include contributions such as financial resources, technical skills, and management
expertise. There is usually a partnership agreement which will set out the responsibilities of
each partner and how each partner will share in the profits of the business.
From a legal perspective, partners are jointly and severally liable for the debts of the
partnership. This is a significant disadvantage as it means that each partner is responsible for
the actions and consequent debts of all other partners.
The close corporation
A close corporation may be formed by between one and ten persons who are referred to as
members. This form of ownership is governed by the Close Corporations Act 69 of 1984. It
requires compliance with some formalities and registration of a founding statement with the
Registrar of Companies.
The close corporation and the partnership have many similarities in that members
each have a proportional interest in the business, and owners are not distinguished from
management. Unlike a partnership, however, the interest of a member may be sold without
terminating the existence of the business. It also differs from a partnership in its tax liability.
A close corporation is taxed as an entity apart from the members. Tax is paid on the taxable
income of the close corporation as determined by the Income Tax Act. A major advantage
of the close corporation is the absence of the ‘jointly and severally liable’ provision which
covers partnerships. Members of a close corporation enjoy limited liability unless they
conduct themselves in a way which can be proved to be reckless or fraudulent. This removes
the exposure to personal liability in the event of liquidation of the business, thus making it an
attractive form of ownership for a small business enterprise. In terms of the Companies Act
of 2008, no further registrations of close corporations will be permitted, although current
close corporations will be allowed to remain in place. The close corporations as a legal entity
will fall away over time as close corporations are converted into private companies.
The company
The company is a separate legal entity from the owners and is governed by the Companies
Act. This means that a company is legally like any other person and can buy, sell and transact
in its own name. It can enter into contracts and raise finance, is required to pay tax and has
the same rights and responsibilities as a natural person. The owners of the company are called
shareholders, as ownership is represented by shares of a company. As the company is a separate
legal entity apart from the shareholders, it means that shareholders have limited liability. This
means that shareholders are only at risk up to what they have invested in the company. If a
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company fails, then the creditors cannot look to the personal assets of the shareholders. This
will encourage investment and enable companies to raise large amounts of capital and enables
shareholders to effectively diversify their investments. In a sense it creates an option-like
scenario, gains are unlimited and losses are limited to the amount invested in a particular
company. However, creditors are required to undertake additional risk and may require
that shareholders of smaller companies sign personal sureties. The word Limited (Ltd) must
appear in the name of the company to warn creditors that they have the right only to the
assets of the company and not to any of the shareholders’ personal assets.
There are two main types of companies, a private company which has to include the
words Proprietary Limited or (Pty) Ltd after its name, and a public company which will
have only the word Limited or Ltd after its name. Public companies may have their shares
listed on a stock exchange such as the JSE Securities Exchange and these companies have to
comply with the listing requirements of the JSE. The shares of public companies are freely
transferable and if listed, shareholders can freely buy and sell shares on the JSE. There are
about 400 listed companies in South Africa. Private companies often have restrictions on the
transfer of shares. A private company’s Memorandum of Incorporation (MOI) is required
to state that it is not permitted to issue shares to the public. Not all corporate entities have
limited liability. A personal liability company (Inc.) is a company whereby the directors and
past directors are jointly and severally liable, together with the company, for any debts and
liabilities of the company. However, we will not focus on this type of entity.
The use of the company entity form enables the separation of management from
ownership. The shareholders will elect a board of directors who will then appoint a
management team. A number of directors will usually be involved, as executive directors,
in the daily management of the affairs of the company. There will be a chairman of the
board, but day-to-day management will often be the responsibility of the Chief Executive
Officer (CEO). Although the separation of management and ownership enables the
company to raise large amounts of finance, it does have certain drawbacks. For example,
how do we know that management is motivated to follow the interests of the shareholders?
But more about that later. A company’s lifespan is not limited by the life-span of its
owners. It has continuity of existence unless, of course the company fails.
Although limited liability has enabled the expansion of companies, it has also been
misused by investors who hide behind the ‘corporate veil’. Increasingly, the law is shifting
responsibility to the directors of the company. For example, directors become personally
liable if they permit the company to trade whilst insolvent, that is where the company’s
liabilities exceed its assets.
How many shareholders are there in a company? It depends. A private company is
required to have at least one shareholder and the company is required to have at least one
director. However, it is true to say that many private companies have a few shareholders. A
public company has to have a minimum of 3 directors and the number of actual shareholders
can run into hundreds of thousands or more. Let’s look at a few listed public companies. At
the beginning of 2013, MTN had close to 142000 shareholders whilst Vodacom had 51 976
shareholders in 2013. Massmart had 6 236 shareholders in 2012 and Pioneer Foods had 5 154
shareholders in 2013. York Timber had 903 shareholders in 2013. How many corporate entities
exist in South Africa? A few years ago, the DTI indicated that there were close to 1.3m close
corporations, 400 000 private companies and close to 3 800 public companies in South Africa.
Table 1.1 summarises the differences between the various forms of business organisations.
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Table 1.1 Features of business entities
Taxation
Taxation is a significant cost to business. Tax laws are complex and constitute a separate and
specialised field of study. However, it is important to understand certain basic tax principles that
affect the daily decisions made in a business enterprise. These are considered briefly below.
Taxation of company profits
Company profits, reported in the income statement as ‘net profit’ for the year, are not the
complete basis for taxation. However, many of the accounting policies selected by company
management can have tax implications. A company is liable for taxation on its ‘taxable income’.
The ‘taxable income’, in turn, depends upon the revenue or turnover which is liable for taxation
and the expenses which may be deducted from such revenue in accordance with the current
tax legislation. Revenue from sales would, for example, normally be taxable. Similarly, certain
expenses such as salaries are normally amounts that will reduce the taxable or assessable amount.
However, some expenses may be deemed to be of a capital nature and thus be disallowed
for income tax purposes. Other items which frequently cause confusion are the depreciation
allowances which may be different from the amounts written off by the company as depreciation,
for the purposes of determining ‘net profit’. The corporate tax rate in South Africa in 2014 is
28%. Small business corporations may qualify to pay a tax rate of 10% on income up to R300 000
in 2014. The corporate tax rate has fallen significantly over the last 20 years. For example, in
1990, the corporate tax rate was 50%.
Assessed tax losses
A company which has built up an assessed loss, which is a loss for tax purposes from previous
years’ business operations, provides a situation of special interest for the financial manager.
Assessed losses are of value because they reduce the taxable income of future years until such
time as the assessed loss is reduced to zero.
Capital gains tax
Individuals and companies are subject to capital gains tax, which represents a tax on gains made
on long term assets. This means, for example, that fixed property and other assets sold above
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cost, will result in taxation for the individual or company which owned it. It also means that
shares purchased for the purpose of investment and which have grown in value over the years,
when sold at a profit by an individual give rise to a capital gains tax.
Individual taxation
Individual tax rates operate on a sliding scale. The highest marginal tax rate for individuals is
40% and the lowest tax rate is 18%. Individuals also qualify for tax rebates, meaning that the
18% tax rate will only effectively apply above a minimum income level. Individuals are subject
to capital gains tax on the sale of assets and individual shareholders are required to pay a final
dividend tax of 15% on dividends received after the introduction of the dividend withholding tax
system in 2012.
Dividend withholding tax
South Africa has moved from a secondary tax on companies (also termed as a dividend
tax) of 10%, which is a corporate tax, to a dividend withholding tax of 15% which is a tax
on shareholders. Shareholders were not taxed on dividends up to 2012. Companies were
required to pay a tax of 10% of the dividend but could set off any STC credits from dividends
received. The move to a dividend withholding tax system means that a company will withhold
15% of dividends payable to shareholders but this represents a tax on the shareholders. If
the shareholder is a South African resident company, then the dividend withholding tax will
not apply and such companies will be exempt from dividend tax.
If a company pays all its after-tax profits as dividends, then the following represents the
effective tax rate for every R100 of income, if we include the dividend withholding tax:
Effective tax rate = [R28 + 15% × R72]/R100 = 38.8%
In Financial Management we focus on the effects of corporate tax as investors will face
varying personal tax rates. We will generally assume that dividend tax is not a corporate tax. This
is also due to the interaction of capital gains tax and dividend tax. Surveys of practice indicate
that companies use the corporate tax rate in accounting for tax in financing and investment
decisions. Changes in the tax system can have a considerable impact on financial management.
Financial managers therefore need to keep up to date with changes in tax legislation.
3 What is the fundamental objective of financial management?
The objective of financial management is to maximise the value of the firm. We can convert this
into the objective of maximising shareholder value. If markets are efficient then this translates
into maximising the company’s share price. Why is this relevant? Management will use this
core objective to frame decision-making. Every investment or financing decision should be
preceded by the question – does this lead to an increase in shareholder value?
How does this relate to ethics, corporate governance and the roles of other stakeholders
such as employees, government, the community, suppliers and customers? The objective of
shareholder value maximisation does not have to be in conflict with ethical decision-making
and effective corporate governance. Further, a firm should consider the impact of its decisions
on the firm’s other stakeholders. A company that continues to drive down the cost of its inputs
by placing increasing pressure on its suppliers may find that its suppliers will either go out of
business or will reduce the quality of their products in order to achieve lower prices. This may
not be in the interests of the company in the longer term. The quality of the firm’s products
may be dependent on the quality of its inputs and so this policy may impact negatively on its
own value. We will come back some of these issues later in the chapter.
Is shareholder value relevant in the real world? BHP Billiton, which is one of the world’s
leading resources groups, states the following;
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We have a world-class portfolio of growth options that will ensure we are able to plan for the short
and long term and continue to create value for our shareholders
Grindrod, which is a major shipping and logistics group, states the following;
The Grindrod group’s vision is to create sustainable returns and long-term value for
shareholders.
Companies may focus on corporate profitability or growth in sales and although these may be
aligned with shareholder value, these measures are at best incomplete and may lead to poor
decision-making. For example, a focus on growth could lead the company to destroy value. We
will come back to this issue later in the book. For now, we will analyse the limitations with the
objective of profit maximisation.
Why is profit maximisation not the right objective for corporate finance?
Company profitability is important for shareholders and management. We often hear of
company management being focused on maximising profits. However, it is only part of the
story and it is not a well-thought out objective. Why?
Manipulation of accounting profits
Management may be able to increase this year’s profits by reducing such costs as advertising,
research and development, and replacement of plant and equipment. However, how would
investors react if a pharmaceutical company such as Merck or an IT company such as Intel
indicated it was reducing research and development costs? The reduction in costs would
increase this year’s profits but detrimentally affect future profits. A company can reduce
the current depreciation expense by not investing in new plant equipment but eventually
this will translate to the company becoming increasingly uncompetitive in terms of quality
and price.
Management may decide to maximise accounting profits by retaining profits and reinvesting
in projects which only offer low returns on investment. Although accounting profits will
increase, shareholders would have been able to reinvest the dividends to earn a higher return
in their own names.
Accounting profits are dependent on accounting policies and management may select policies
that may not reflect economic reality. For example, when is a sale recognised? What is the life of
depreciable assets? When is a cost an expense and when is it an asset? These offer management
flexibility in selecting accounting policies that may bolster profits in the short term.
Timing
Profit maximisation does not directly factor in the time value of money. A project that results
in a total profit of R20m per year for 5 years would be preferred to a project that generates
R10m per year for 10 years. Why? Profits that are received sooner can be reinvested to earn
higher future returns.
Cash flows
Accounting profits do not always reflect cash flows. Profits are determined by the company’s
accounting policies, whilst corporate finance is focused on cash flows.
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Accounting profits and the cost of capital
Accounting profits do not include an adjustment for the cost of equity financing. In practice,
accounting profits are often reported in terms of the company’s earnings per share (EPS). This is
determined by dividing the company’s net profit by the number of shares issued by the company.
For example, a company may disclose accounting profits of R100m and if the number of shares in
issue is 40m, then the EPS of the company will be R2.50 per share. Management may be focused
on growth in EPS, but this may be the wrong objective, as was shown with Enron, but more
about that later. The important issue is that accounting profits only reflect actual costs and not
opportunity costs. An important opportunity cost is the cost of shareholders funds or the cost of
equity which is not taken into account in determining accounting profit.
Risk
Profit maximisation ignores the impact of risk on value. Shareholders will prefer less risk and
will value a company not only in terms of its future cash flows, but also in terms of the risk of
those cash flows. For example, the risk of future cash flows of Tiger Brands will be lower than
the future cash flows of Harmony. Investors will adjust for risk in determining future cash
flows. This means that an investment that promises an increase in accounting profits but also
an increase in risk may actually result in a fall in the value of the company.
Shareholders want management to maximise value
What is an appropriate objective for management to follow? It should be able to encompass all
that has been mentioned before. Shareholders want management to maximise the value of the
firm, which really means that in the long term, management should maximise the value of the
shareholders’ interest in the company. In most cases this is measured by maximising the value
of the share price. What effect will a decision have on the value of the firm? This question
should guide the actions of management. Increasingly in line with developments in corporate
governance and King III, management are considering the interests of all stakeholders, in
order to ensure the long-term sustainability of the firm. We will come back to this later on.
Focus of financial management on decision-making
Financial management focuses on principles of decision-making. As decisions require that
estimations be made, there are few exact solutions applicable to any financial management
problem. Decisions are made on the basis of the information available at the time. With
hindsight, such decisions may prove to have been less than optimal. However, it must be
constantly borne in mind that decision-making requires acting without perfect knowledge of
the outcome.
The two variables on which financial management focuses as the primary input in decisionmaking are expected return and perceived risk. In the text we will concentrate initially on return
and then lead into evaluating, measuring and adjusting for risk. Once again, information
systems and programs such as Excel greatly enhance the ability of the financial manager to
cope with large volumes of data, set up financial models and test the sensitivity of the expected
outcome to deviations from estimates.
If we accept that the objective of corporate finance is to maximise the value of the firm, then
we need to determine how this is achievable. Firstly management needs to make investments
that offer a return that exceeds the cost of capital, i.e. the cost of financing. Secondly, the cost
of capital will take into account the underlying risk of the company’s investments. Thirdly,
the value of the firm will be increased by the company being able to reduce its cost of capital.
For example, a company such as BHP Billiton has decided to reduce the cost of loan finance
by issuing debt securities directly in the capital markets, rather than using financing from the
banks which involves a higher interest rate.
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Figure 1.3 Maximising the value of the firm
Economic Value Added (EVA)
We can calculate a company’s EVA to determine whether the company has added value over
a period by comparing a company’s return on invested capital to its cost of financing (cost of
capital). This means that we deduct the cost of financing from the company’s after-tax operating
profit. In relation to the future, the calculation of EVA corresponds to the determination of
a project’s net present value, which we will describe later. We can also determine the EVA
of a company over a period such as a financial year. For example, assume that a company
has reported operating profits of R70m after tax. If the company’s investment amounts to
R600m and its after-tax cost of financing is 9%, then the company’s EVA will be determined
as follows:
Table 1.2 Determination of EVA
We can see that if the company had reported an accounting profit of R50m for the year, then
the company’s EVA would have been a negative R4m and the company would have destroyed
shareholder value for that year. Later on in the book we will analyse the EVA of SABMiller a
great South African company that is now one of the world’s largest brewers.
Let’s go back to Enron, a company that was ‘laser focused on earnings per share’ and was
until its demise one of the most admired companies in the USA. The collapse of Enron cost
its shareholders billions of US dollars. Yet if we compare its accounting income to its EVA
in the few years prior to its failure, we obtain a very different perspective on the financial
performance of Enron.
The moral of the story is to remain keenly focused on the economics and not on the
accounting numbers.
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Figure 1.4 Enron: EPS vs EVA
Source: “Enron signals the end of the earnings management game” by Stern Stewart Research in EVAluation, Vol.4, Issue 5, April 2002
What about the ethics of maximising value?
This is a difficult question and we need to separate the honest and hardworking managers from
the rogues. There is nothing wrong in the objective of maximising value. What may be wrong is
how this is achieved. For example, to reduce costs a company may make use of child labour to
manufacture goods in a developing country. Increasingly, companies face reputational risk from
following such practices and this may reduce the value of the company’s brand. Unfortunately
the corporate landscape is littered with unethical practices by a number of companies. We believe
that ethical standards are fundamental in corporate finance and make sense in the longer term.
Companies that follow blatantly unethical practices will not survive. How is it possible to transact
in business without trust? Financial managers should focus on the interests of the shareholders
but should act in a responsible way.
In line with King III, a company is also required to consider the interests of society, and the
environment to ensure that the firm has a sustainable future. We will come back to this later in
the chapter.
4 The role of the financial manager
Having placed the environment and objectives of financial management into perspective, we
turn to the role of the financial manager. In many companies, the Chief Financial Officer (CFO)
represents the position of financial manager. However, the Chief Executive Officer (CEO) and
the Executive team will often be involved in financial decision-making and so we will stay with
the general term of “financial manager”. A pertinent question to pose is, ‘what does the financial
manager do?’ Once we have determined what the role of the financial manager is, the text will
explore the principles and theories which are commonly used for effective financial management.
Two primary roles are performed by the financial manager. The first of these is to pursue wealthcreating investment opportunities, and the second is to find funds to finance the investments. This is
illustrated in Figure 1.5 and further explained in this section.
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Operating Assets
#Non current
#Current
Capital Markets
#Equity
#Debt
Explores investment
opportunities and
makes investment
decisions
Explores financing
opportunities and
makes financing
decisions
FINANCIAL
MANAGER
Financial Assets
Money Markets
Figure 1.5 The role of the financial manager
Opportunities to create wealth
The first role of the financial manager is to explore investment opportunities within the context
of the type of business operation in which the company is engaged. Such opportunities are then
evaluated in order to establish whether they are profitable by determining whether they are
likely to increase the value of the business. Needless to say, there are often numerous possible
opportunities available from which to select. The financial manager is required to evaluate the
possibilities and rank them in order of potential profitability.
This may seem to be a relatively straightforward procedure. However, when it is considered
that such evaluation is based on predicted outcomes and that different opportunities have
different levels of risk attached to them, it becomes apparent that selection from among competing
investment opportunities requires consideration of many interacting factors. Investment
opportunities can be broadly classified into two categories, namely investment in operating assets
and investment in financial assets.
Investment in operating assets
An operating asset is any form of tangible or intangible asset bought with a view to its returning
a profit. So, for example, a manufacturing firm may consider buying plant and equipment as
operating assets. This investment would be undertaken to produce a product which, when sold,
would cover all costs related to the machine as well as material and labour costs. In addition,
some profit must be realised in order to compensate the investment in the operating asset.
Making the decision to invest in such an operating asset requires numerous estimations to
be made. These would depend on factors such as the saleability of the product and the costs
which are likely to be incurred. The financial manager is required to collect and evaluate such
information, make estimations about cash flows related to the project, and decide whether the
investment should be made or not.
This example can be generalised to virtually every decision by a company to spend money
on assets. A company decision to buy vehicles, equipment, additional warehouses and even
considerations relating to buying inventory, are all investment decisions which are central in the
day-to-day functioning of the financial manager. For the purpose of classification, a distinction is
usually drawn between non-current and current assets.
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■■ Non-current assets. From the financial management perspective, some assets are acquired in
order to produce goods or services which will be sold by the business. They include property,
buildings, machinery, equipment, and vehicles. Increasingly, intangible assets such as brands
and patents are becoming important in order to generate cash flows. For example, the
licence fees paid by MTN to acquire 3G or 4G LTE spectrum allocations are probably more
critical for its future cash flows than the cost of its base stations, towers and transmission
equipment. The intention of acquiring such assets will be to generate future cash flows which
will more than compensate for the outlay of funds for acquisition. As non-current assets
usually have a long-term use, they are usually funded from long-term sources of funds.
■■ Working capital. Inevitably, non-current assets require supporting current assets in order
to complete the operating cycle. An inventory of the goods produced must be kept on hand
in order to make them readily available to consumers. Consumers may be allowed to delay
payment, resulting in accounts receivable, a current asset. Cash must also be kept readily
available in the form of bank balances or funds available on short call. These three items,
inventory, accounts receivable, and cash, form the core of the current assets or working capital
of the business. Fortunately, investors do not usually have to finance all the current assets, as
creditors allow delayed payment for supplies to the business. The net amount, current assets
less current liabilities, is referred to as the net working capital of the business.
Investment in financial assets
What are financial assets? The investment in equity shares, preference shares and bonds as well
as other financial instruments such as derivatives and money market investments are classified
as financial assets.
As a company grows, it faces the option of acquiring additional operating assets, or purchasing
an interest in an existing operation through the purchase of the shares of a company already
in operation. This may be achieved with a view to expanding its investment in the present
business operation, or by purchasing the shares of another company already engaged in business
operations which may be in the same or a different type of industry. The latter case is referred to
as diversification and is usually seen as a means of spreading the risk of the company by having an
interest in different kinds of operations.
The financial manager must be capable of placing a value on financial assets in order to
make decisions about such assets. As with operating assets, this type of valuation requires the
prediction of numerous variables. The forces behind the interaction of such variables need to be
placed within a framework for decision-making in order to enable the financial manager to act
effectively.
Of equal importance to the financial manager is the value that potential investors place on
the company’s shares. As a high value is usually associated with maximising the value of the
company, it is important for the financial manager to understand the factors that result in the
company’s optimal value.
The valuing of financial assets is facilitated by capital markets. The JSE Securities Exchange,
for example, lists the trading prices of the shares of about 400 companies. If the market is
functioning efficiently, the listed prices will tend to be real economic indicators of value. As
they represent the aggregate of all information brought to bear by the market participants, they
reflect the price set by forces of supply and demand for any particular share, based on all public
information about the company.
Selecting the optimal finance mix
Having identified investment opportunities with wealth-creating potential, the second major role
of the financial manager is to raise funds in order to finance the investment. These two primary
functions are not neatly ordered. The financial manager is constantly looking for investment
opportunities and constantly making decisions regarding the source of funds to be used in order
to finance the investment projects.
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The objective, when canvassing financing alternatives, would be to obtain funds at the
lowest cost. The cost of finance from the viewpoint of the investor will usually be determined
by the risk which is seen to be associated with the investment. This in turn depends on the type
of projects being undertaken, the length of time for which the funds are provided, and the legal
standing of the finance in the event of liquidation of the company. Finance is usually obtained
in one of four ways – by going to the capital markets and attracting long-term finance, by
making use of suppliers’ credit, by going to the money markets and using short-term finance,
or by retaining profits which could otherwise be paid to shareholders in the form of dividends.
Finance from capital markets
Capital markets are markets in which long-term financing instruments are bought and sold.
The financial manager of a growing company is likely to be trying to acquire finance or, stated
differently, to be selling financial assets. We have been referring to investors generically up to
this point. Investors, however, all have different attitudes toward risk. Those who are prepared
to assume higher risk – with an expected high return – will prefer to acquire shares. Those who
are more risk-averse will prefer to purchase bonds which are more secure and invest in loans
secured against fixed property. Investment opportunities, from the perspective of individual
investors, can therefore be broadly categorised into shares or debt, in return for which they
offer their cash.
■■ Issue of shares. If a company raises long-term capital by issuing shares, ordinary
shareholders face the ultimate risk in that they will be the last to be repaid in the event of
liquidation. For this reason share capital is relatively expensive. Shareholders expect a high
return for the risk which they take. Shares may be packaged in different forms in order to
reduce the risk for some categories of shareholders. So, for example, shares of a certain type
may give the holder a preference payment of dividends and in some instances preference in
the event of liquidation. Ordinary shares, bear the highest risk, but also gain the most benefit
if a company is profitable and shows growth.
■■ Issue of debt. A company may go to the capital market in order to raise long-term debt.
Once again there are numerous forms of debt which could be issued. These range from
debentures or bonds, which may be secured by mortgage over immovable property or be
convertible into shares, to term loans at fixed interest rates or rates fluctuating with a base
rate such as the prime rate or JIBAR. Increasingly capital markets such as the JSE have
electronic trading systems in place. For example, it is possible to trade corporate bonds and
shares on the JSE. Markets for other long-term debt are usually created by investment banks
and other financial institutions which place long-term debt with companies for their clients.
These markets may have no specific location, but operate as a result of negotiation between
parties, often initiated by telephone.
Finance from money markets
Money markets play an essential role in satisfying short-term financing needs. This need arises
most frequently as a result of the cyclical or seasonal nature of many businesses. It would be an
unnecessary waste of resources to borrow funds for a long term and then keep them idle for a
large part of each year.
The money market creates the opportunity for short-term borrowings and short-term
investments of surplus cash. A bank overdraft facility is an example of a short-term borrowing,
which is normally renegotiated with the bank every year.
Finance from creditors
A large component of current assets often comprises goods purchased from suppliers. The extent
to which suppliers offer credit terms will determine their contribution to the financing of working
capital.
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Finance from retained income
A fourth method of obtaining finance is by retaining part of the company’s profits each year.
How much of the net earnings should a firm retain and how much should the firm pay as a
dividend? If the firm has highly profitable projects, then it should retain all its current profits
to invest in these projects. Yet, it is also true that if a company decides to cut its dividend,
this may cause its share price to fall. In a later chapter, we will study a number of dividend
theories, in regard to the effect that the dividend decision can have on the value of the firm.
The interaction of investment and financing decisions
The interaction of investment and financing decisions is evident from the Statement of
Financial Position of a company.
Figure 1.6 illustrates the Statement of Financial Position of Vodacom in a way which
highlights the distinction between the investment and the financing decisions. The investment
in assets equals the total financing provided by shareholders and debt holders. Some of the
providers of finance (shareholders and long-term debt providers) require a return on their
funds. Under current liabilities, trade and payables (mainly creditors) do not earn a return
in the same way (dividends or interest). This is because their return is already built into the
price of the goods purchased by the business.
The equity and non-current liabilities sections of the Statement of Financial Position,
reflects the claims by long-term investors in equity and debt against the assets of the business.
The business must operate in such a way as to generate an adequate return to all suppliers
of capital. Failure to do this will result in disinvestment and the consequent deterioration
of the business and its future prospects. The financial manager is therefore engaged in a
dynamic strategy of investigating investment opportunities that correspond with the business
objectives and ensuring that the optimal mix of equity, debt, and creditors is being used to
finance the profitable opportunities.
Vodacom, which is majority owned by Vodaphone, provides voice, messaging and data
services to about 51m subscribers, mainly in South Africa but also in other African countries.
Vodacom has invested in assets such as base stations and licences and uses borrowings and
equity capital such as retained earnings to finance its assets.
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Figure 1.6 Statement of Financial Position of Vodacom, showing investment and financing decisions
Figures 1.7 and 1.8 illustrate the interaction between the financing and investing activities of a
hypothetical business, using financial statements to illustrate the returns, assets and financial
claims on those assets.
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Figure 1.7 Statement of Comprehensive Income
Figure 1.8 Statement of Financial Position
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FROM THE REAL WORLD… BHP Billiton and Pioneer Foods
BHP Billiton is a leading global resources company with sales revenue in 2013 of US$66.0
billion, net operating cash flow of US$18.3 billion and net profit of US$10.9 billion. The
company has about 129 000 employees and contractors and operates in 26 countries. The
company is a major producer of iron ore, coal, oil and gas, copper, aluminium, manganese,
nickel and silver. BHP Billiton represents the merger of BHP, an Australian company, and
Billiton, which was essentially a South African company (although listed in London). BHP
Billiton is focused on maximising shareholder value and the company’s 2013 Integrated
Report makes numerous references to this objective. The company states the following;
Our purpose is to create long-term shareholder value through the discovery, acquisition,
development and marketing of natural resources. Our strategy is to own and operate large, longlife, low-cost, expandable, upstream assets diversified by commodity, geography and market. We
believe our proven strategy, when combined with our great orebodies and operational focus on
productivity, will deliver stronger margins throughout the economic cycle, a simpler and more
capital efficient structure, a substantial increase in free cash flow and growth in shareholder value.
We believe that the identification and management of risk is central to achieving our corporate
purpose of creating long-term shareholder value.
BHP Billiton has implemented remuneration incentives to align senior executive rewards
with sustained shareholder wealth creation
Pioneer Foods is a leading company in the food and beverage sectors. Its main divisions
include Sasko, Bokomo Foods, Ceres Beverages and its stake in Heinz Foods. Sales revenue
amounted to R20.6 billion in 2013. The company states the following in its 2013 Integrated
Report:
Annual performance bonuses will be based on a combination of performance achieved for growth
in profit above CPI and growth in economic value added above the Company’s weighted average
cost of capital. The capital employed is managed on a basis that enables the Group to continue
operating as a going concern in order to provide returns for shareholders and benefits for other
stakeholders and to maintain an optimal capital structure to reduce the cost of capital.
So how does this fit with our story so far? Firstly, the focus is on maximising shareholder
value. BHP Billiton sets out its investment strategy and attention to margins to achieve
strong cash flows. Further, risk management is central to the creation of shareholder value.
Remuneration structures for both companies are aligned to the creation of shareholder
value. Economic value is created when the return on capital employed is higher than the
cost of capital.
Further, management is focused on maximising the value of the company by investing
in projects which generate returns above the cost of capital. This will translate over time to
increases in shareholder wealth. Pioneer Foods refers to its financing and capital structure
policy. Pioneer Foods will select a target debt-equity ratio that results in the company
reducing its cost of capital to its lowest optimal level. These objectives are in line with what
this book is about.
5 Fundamental concepts of corporate finance
The emphasis in this text will be placed on the fundamentals essential to an understanding
of the issues and decisions that confront financial managers in their daily routines. All
practices in financial management, evidenced by the decisions and actions of the financial
manager, are based on underlying concepts. Of particular significance in finance is the
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assumption that people will choose an investment with a higher expected return rather
than a lower expected return, all other factors being constant. Similarly, if two investments
both have the same expected return, investors acting rationally will prefer the investment
with the lower risk.
Present Value
The present value concept enables us to determine the value today of expected future cash
flows. This means that we can compare investments with differing cash flows which will occur
at different times in the future. This concept is based on the premise that there are active
capital markets in order to determine appropriate required returns or discount rates.
Time value of money
The value of any investment is determined by both the size of the future cash flows and the
timing of the cash flows. Investors prefer to receive cash flows sooner rather than later, as
these cash flows can be reinvested to earn a return. The use of a discount rate to determine the
present value will include an adjustment to take into account the time value of money.
Risk and return
Corporate finance is based on the concept that investors will prefer low risk investments and
therefore will require higher returns from projects with higher risk. How do we measure risk?
How do we adjust for risk? These are questions we will address later in the text. For now, it
is important to understand that a company should only invest in a project that offers a return
that is in line with its level of risk. The discount rate that we use to determine the present
value should include an adjustment for risk. The Capital Asset Pricing Model is one model that
enables us to calculate a risk adjusted required return or discount rate.
When we apply a required return or discount rate to determine the present value of future
cash flows, the required return will be made up of the risk-free rate which reflects the interest
rate on government bonds, and a risk premium which includes an adjustment for risk. The riskfree rate reflects the time value of money.
Required return = Risk-free rate + Risk premium
No Arbitrage Principle
What is arbitrage? Arbitrage occurs when we buy and sell the same good in different markets
to take advantage of any price difference. If gold is trading in London for a higher price than in
Johannesburg, then we can buy gold in Johannesburg and sell gold in London. This represents
an arbitrage opportunity. A more inclusive definition states that arbitrage occurs when we are
able to make risk-free gains or when we are able to make gains with no investment. Of course,
an arbitrage gain is possible if traders make mistakes in setting prices but we would not expect
that such price differences would persist for a long time. In corporate finance, the no arbitrage
principle is important for determining prices for commodities, bonds, derivatives and equities.
A simple example will illustrate the no arbitrage principle. Anglo-American plc is listed
on the London Stock Exchange and has a secondary listing on the JSE Securities Exchange.
Assume that it is 11.00 am on a cold winter’s Tuesday morning in Johannesburg in July, that
the share price in London is £15 at 10.00 am (London is 1 hour behind South Africa at that
time of year). The Rand-Sterling exchange rate is R18 = £1 and Anglo-American is trading
on the JSE at R300 per share at that moment. If you are quick and there are zero transaction
costs, then you will buy sterling and then buy shares in London for an effective Rand cost of
R270 (£15 x 18). You would sell each share on the JSE for R300. This is risk-free arbitrage
as you will buy and sell at the same moment. If such arbitrage opportunities exist, then we
would expect this not to persist for very long. Why? Arbitrageurs would continue to buy in
London and this would raise the share price in London. As arbitrageurs continue to sell in
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Johannesburg, the price will fall on the JSE so that prices will move towards each other until
no further arbitrage opportunity exists. Arbitrage opportunities occur infrequently and are
quickly eliminated. Otherwise, transaction costs or taxation may offset any potential gain.
Corporate finance theory relating to capital structure and the pricing of financial instruments
and derivatives depend on this principle.
There are two types of arbitrage opportunities. Firstly, we can make a zero net investment
and be assured of a positive gain. Secondly, we can make a net investment today and be
assured of a positive gain in the future. In the first case, we may take offsetting positions in
assets simultaneously that will ensure we make a gain. The above example of buying shares in
London and selling the same shares in Johannesburg is such a case.
An example will indicate how we will make a certain profit in the future. Assume that the
current price for A Ltd is R100 per share and A Ltd does not pay a dividend. The interest rate
is 10% per year. Let’s assume that a financially strong company, B Ltd, indicates that it will
enter into contracts today to buy shares in A Ltd in a year’s time for R125. What would you
do? If this were the case then you would immediately borrow R100, buy one A Ltd share today
for R100 and enter into a contract today to deliver one share in A Ltd for R125 in one year’s
time to B Ltd.
In a year’s time, you deliver the share to B Ltd and you receive the sales proceeds of
R125; you pay back the loan of R100 plus interest of R10 and make a certain profit of R15.
Therefore, we do not expect that this would happen very often and so we can estimate that the
forward price is expected to be R110 as then there is no incentive for arbitrage. Another way
of explaining the no arbitrage principle is that there is no free lunch! Remember that if assets
result in the same cash flows or pay-offs, then the values of these assets should be equal.
Efficient markets
The efficient markets hypothesis (EMH) postulates that securities markets react immediately
and without bias to all information which becomes available. If the EMH actually applies
in practice, then it is impossible for any investor to earn a consistent return in excess of the
return warranted by the risk class of the investment.
Stated more simply, any ‘hot tips’ or news about ‘winners’ which will earn above normal
returns is out of date when heard, because the share market will already have absorbed the
information into the price. There are less rigorous levels at which this theory has been tested,
such as positing it applies only to publicly available information. Information comes to the
market in a random manner and prices react quickly to new information.
Are markets always efficient? New developments in finance indicate that markets do overreact to information and shares that do poorly in one period tend to do better in the next
period. Companies achieving very good returns in one period, tend to see a fall in returns in
a later period. This relates to a period of over three years. Investors are engaging in herdlike activity and there is a growing specialisation in what is now termed behavioural finance.
Although markets may not be viewed as perfectly efficient, the market is reasonably efficient in
compounding so much financial information into one measure, the company’s share price.
Portfolio theory
Almost intuitively we all know the dictum that we should never place all our eggs in one basket.
This is another way of saying that if we are to behave in a rational manner, we should diversify
our investments so as to reduce our risk. Portfolio theory has explored this theme with some
implications for financial management. A feasible method of mathematically quantifying risk
and the effect of diversification was developed. More consequential, however, is the further
development of investment principles pertinent to holding share portfolios. Essentially, risk
can be reduced by the combination of assets into portfolios of shares in different sectors of
the economy.
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Capital asset pricing model
The price of an asset is usually stated in terms of the required return on the asset. Such return
would clearly reflect the estimated risk of the asset. A capital asset pricing theory attempts to
measure the risk of a financial asset and to express the price in terms of the required return.
Developments which stemmed from portfolio theory led to a widely accepted theory
for pricing capital assets known as the capital asset pricing model. This model holds that a
certain level of risk applies in a market to all capital assets and must be borne by the investor,
while other risk is peculiar to the specific asset and can be eliminated through diversification.
The only risk of any significance to decision-making is therefore the risk which cannot be
eliminated. The model thus seeks to establish the impact of the undiversifiable risk, enabling
investors to establish the risk they are prepared to take from a portfolio in order to induce
them to purchase that portfolio.
The capital asset pricing model is often used in practice. Yet this model is also being
questioned and we will come back to this later in the book.
Financial analysis
Corporate finance requires an understanding of financial statements. Often, financial managers
are required to work with financial statements and understand the effect of accounting policies
or at least be able to deconstruct financial numbers to get to cash flows. Although we have
indicated the limitations of using accounting numbers, the reality is that often they will be our
first port of call. In order to determine future cash flows we can focus on financial statements
and make the necessary adjustments, such as adding back depreciation to determine a
company’s cash flows from operations.
Analysing the Statement of Financial Position indicates the decisions undertaken by
management. The level of non-current assets reflects the investment decisions of the company
and the decision of how much financing is provided by the creditors and shareholders is also
disclosed. In corporate finance we wish to optimise the investment in assets, net working
capital and financing structures that will maximise the value of the firm.
6 Do managers act in the interest of shareholders?
The separation of management and ownership means that the managers of many large
listed companies own a very small proportion of the shares of the company. This means that
shareholders and management have an agency relationship. In an agency relationship the
managers act as agents for the shareholders but may put their own interests first. Management
are the agents of the shareholders and should act to maximise the value of shareholders’ wealth.
Yet there is a real possibility that the shareholders as owners will experience losses because
managers take decisions that are in the best interest of managers and are detrimental to the
interest of shareholders.
What actions may management take that may not be in the interests of the shareholders?
Management may unnecessarily acquire an expensive corporate jet; operate from gleaming
head offices with views; and incur expensive travel such as spending about R45 000 for three
days in Rome on a ‘business’ visit. Management will be motivated to structure for themselves
overly generous remuneration plans. More serious for the wealth of shareholders is a propensity
to engage in the acquisition of companies in unrelated business areas – so called corporate
diversification and empire building.
Also, management might avoid risky but worthwhile projects as the risk to their own financial
position is high as compared to the risk of the project to well diversified shareholders. Let us
assume that Co. A and Co. B are considering undertaking oil exploration in two areas and
both have a 50% chance of striking oil. The value of the existing operations of each company
is R80m and striking or not striking oil will mean for each company, that it will either go out
of business by losing R120m or will treble its market value by adding R160m in value. Any net
loss will be financed by the firm’s shareholders. For a well diversified investor who owns equal
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shareholdings in both companies, it is easy; both companies should drill for oil as the expected
value of the total investment will grow from R160m to R200m. This is shown in Table 1.3.
Table 1.3 Management and risk
For management, it is not so easy. If the company invests, there is a 50% chance that the
company will fail and management will lose their jobs and possibly their pensions. Management
may also feel a sense of loyalty to their employees and their debt holders not to place the future
of the firm at risk. Therefore in this context, management of both companies may decide not to
invest in the project. Management may also decide to use less debt than optimal, as low debt
levels mean a lower propensity for bank managers to place them under pressure.
How do shareholders ensure a closer alignment of the objectives of shareholders and
management? In order to avoid conflicts of interest, and ensure that management do not follow
their own objectives, shareholders will incur monitoring costs which will include controls and
incentives to encourage management to take decisions that maximise shareholders’ wealth.
These controls and incentives reflect agency costs. Why would management be motivated to
maximise shareholders’ wealth? There are a number of reasons.
Shareholders appoint the board of directors at the annual general meeting and the board
has the responsibility to ensure that management acts in the best interests of the shareholders.
Although the executive directors and management may have effective control of the board
of directors, the current focus on proper corporate governance and the appointment of
independent and non-executive directors mean that it is expected that this will ensure a greater
propensity by the board to change the management team if it is not acting to maximise the value
of the firm. However, management controls the flow of information to the board of directors
and often non-executive directors are not able to spend the time required to understand fully
the complexities inherent in current business operations as well as being fully aware of the use
of complex financing instruments, such as derivatives.
It is also true that the Companies Act 2008 places greater responsibilities on the board of
directors and there are greater risks of personal liability. King III also places greater corporate
governance requirements on all directors.
Compensation plans provide incentives that ensure an alignment of the interest of
shareholders and management. For example, the granting of share options to management, so
that management will share in any share price appreciation, means that management will be
focused on maximising the share price. It is true that management are increasingly taking
actions such as cost cutting, reducing capital investment and focusing on increasing revenue.
The performance by South African banks in the last 15 years in reducing costs and raising
revenue and the share price is partly driven by the focus on shareholder value.
The threat of take-over is real for underperforming companies as a depressed share price
often reduces the effective cost of a take-over which invariably leads to the incumbent
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management team being shown the door. Ensuring a high share price means that a company
will be unattractive as a take-over target, although sometimes a strong management team may
be an incentive for the merger.
What is wrong with the theory? Although we can expect management to earn millions if
there has been a significant increase in shareholder wealth, there have been many cases where
management, particularly CEOs, have received very large payouts even when the company has
performed badly. Further, there may be very little correlation between share price movements
and executive performance. Share price movements may be driven by general economic
conditions and falling interest rates rather than by management performance.
Management incentives, share options and the financial crisis
Another issue relates to unintended consequences of management incentives. Share options
became the largest component of management remuneration. In theory, this should align the
interests of management with the interests of shareholders. In fact share options will only do
this if the options are deep in the money on issue date but this will often not be the case. Share
options can result in management being incentivised to take on higher risks than optimal from
the shareholders’ perspective. How? Let’s go through a simple example.
RM Ltd has 100 million shares in issue which are currently trading at R15 per share. The
market capitalisation of the firm is therefore R1 500m (15 × 100m). Management is issued with
10m share options whereby management has the right (not the obligation) to buy 10m shares in
the company for R15 per share. We will make this simple and will avoid time value and other
issues in option pricing for now. We will come back to these issues in Chapter 18. We will assume
that right after the issue of the options, an opportunity arises for the firm to invest in a project
that will either lose R1 000m resulting in a fall in the value of the equity in the firm to R500m or
the project may succeed resulting in a gain of R1 100m and an increase in the value of equity to
R2 750m. [R1 500m + R1 100m + R150m (proceeds from exercise of options)].
Due to the high risk of failure, and the risk-return profile, the shareholders may prefer that
the project is not accepted. The current shareholders will either gain R1 000m or lose R1 000m.
Why did we use a gain of R1 000m for the current shareholders and not R1 100m? If the project
fails, the share price will fall to R5. The options have no value and management will not exercise
their options and so the number of shares in issue will remain at 100m shares.
If the project succeeds, then the option holders will exercise their options to buy at R15 per
share as the share price is expected to be R25 per share after the exercise of all the options.
The company will issue 10m shares in terms of the options resulting in 110m shares in issue.
Let’s evaluate the relative wealth positions of current shareholders and management if the
project fails or succeeds as follows:
For the current shareholders, they may lose R1 000m or gain R1 000m [100m × (25 – 15)].
For the management team with options, their loss is limited to zero and their gain is R100m if
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the project succeeds. Management’s incentives indicate that the project should be accepted, as
they obtain a significant part of the gain whilst the shareholders would prefer not to accept this
project as they will take all losses. If the options had an exercise price of R10 and the current
share price was R15, then management would think twice about the project. This is because
they would then have something to lose. If the project fails, the options would have little value,
as the share price would then be R5.
It is true that the interests of management and shareholders are aligned in terms of the
focus on the share price. However, with share options, management may be incentivised
to accept higher risk projects. Of course, this conflict may be balanced to some extent by
management also being offered sizable salaries and a fixed remuneration. It’s a wonderful
world for management. Share options played a role in the financial crisis. Yet, it is also true
that we cannot simply blame management. It is all about creating the right incentives. You get
what you incentivise!
King III recognised the role that share-based incentives can play and stated that participation
should be restricted to employees and executive directors. Non-executive directors should not
receive share options or other incentive awards geared to the share price. Vesting of rights should
not be less than three years. There should be no re-pricing of options that are underwater.
Another agency problem: shareholders and bondholders
When banks lend funds to a company or when investors purchase a company’s bonds, they do
so on the basis of the risk of existing assets, future assets, the level of borrowings as a percentage
of total assets and the riskiness of the company’s future cash flows. Yet management may
undertake the following actions to transfer wealth from the debtholders or bondholders to the
shareholders in the short term:
■■ Issue more debt as this will reduce the value of existing debt.
■■ Increase dividends which means that the debtholders will have less security.
■■ Increase the risk of the assets as the full benefits will flow to the shareholders whilst the
losses will be partly borne by the debtholders.
Capital markets do not forget. Whilst shareholders may reduce the value of bonds or debt,
future access to capital markets will be limited and the cost of financing will rise. Companies
are focused on maintaining good bond and debt ratings as this ensures lower cost financing in
the future. Further, lenders include loan covenants which restrict the actions of firms to transfer
wealth from the bond holders to the shareholders. So banks will require that companies adhere
to certain net current ratios, debt ratios and dividend payment policies.
We will come back to the issue of loan covenants in Chapter 13.
7 Doing the right thing: ethics in business and King III
This book is about financial decision-making. Yet it is also true that most decisions have
an ethical dimension. Ethics should influence everything a company does and a company’s
reputation is often built on ethical values and good corporate governance. Increasingly,
reputation affects value and a company may fail simply by not applying ethics in its operations.
One can see what happened to Arthur Anderson when it lost its moral compass – but more
about that later.
King III states that the board should ensure that the company’s ethics are managed
effectively. This involves ensuring an ethical corporate culture, articulation and adherence
to ethical standards, and implementing a code of conduct and ethics-related policies. There
should be an integration of the code of conduct with a company’s operations and the company’s
ethics performance should be assessed, monitored and disclosed.
What do ethics mean? How do we define ethics? King III states that ethics refers to that
which is good or right. King III further states:
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Describing conduct as ‘good’ or ‘right’ means measuring it against standards, called ‘values’.
Ethical values are convictions we hold about what is important in our character and interactions
with others. Examples of ethical values are integrity, respect, honesty (truthfulness), responsibility,
accountability, fairness, transparency, and loyalty.
King III states that responsible corporate citizenship implies an ethical relationship between
the company and the society in which it operates. For example, AECI includes the following
values and policies:
WE WILL operate ethically, with integrity and care for others.
WE WILL operate safely and with care for the environment and the community.
Other companies such as Bidvest emphasise the role of ethical leadership and ethics in
business. Bidvest states the following in its 2013 integrated report:
Stakeholders can only derive full, sustained value from a business founded on honesty, integrity,
accountability and transparency.
Professional associations such as SAICA, ACCA, CIMA and the CFA Institute emphasise
professional ethics and a Code of Conduct for their members. We have included extracts from
SAICA’s Code of Professional Conduct and the CFA Institute’s Code of Ethics and Standards
of Professional Conduct in Appendix 1.1. We will focus now on corporate governance and the
role of King III in South Africa.
8 Corporate Governance and King III
Companies play a pivotal role in the global economy, in society and often have a significant
impact on the environment. The governance of companies is arguably almost as important as
the governance of countries. We explained in a prior section the potential conflicts between
shareholders, management and bondholders. Corporate governance may play an important role
in resolving some of these conflicts.
Corporate governance deals with the relationships between management, shareholders,
directors and other stakeholders. It includes the policies, procedures, processes and controls
employed in the management of a company. It includes the checks and balances required to
reduce the potential for conflict between management and the board of directors, shareholders
and other stakeholders.
The separation of ownership and control has led to an increased focus on such issues as
management accountability, transparency and the role of the board of directors who are elected
by the shareholders of the company. Management wield a substantial amount of power in the
light of widely dispersed shareholders. In other cases, minority shareholders have little power
to influence the actions of management. In the UK, the Cadbury report documented a code of
best practices to be followed by boards of directors. In the USA, CalPERS, which is one of the
world’s largest institutional investors, set out best practices to be followed by boards of directors.
The consequence of corporate scandals such as Enron, WorldCom and Tyco, was that the USA
passed the Sarbanes-Oxley Act (SOX) to ensure proper corporate governance processes. Yet it
is also true that the cost of the implementation of SOX has superseded the cost of the corporate
scandals to date and did not seem to prevent more recent activities at AIG and Lehman Brothers.
As De Montaigne wrote hundreds of years ago, ‘more laws, less justice’.
Corporate governance should ensure that management and the board of directors act in the
interest of the shareholders, although increasingly, this includes other stakeholders. The board
should be independent of management and there should be adequate systems of internal controls
in place, good IT governance and good risk management policies in place. Management should
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ensure that the company adheres to high ethical standards, acts within the law and complies with
all applicable regulations. Management should ensure that the company’s financial performance
and position, information on operations and risks are properly reported to its shareholders.
In South Africa, good Corporate Governance practice is set out in the King III report, which
became effective from 1 March 2010. The King III report recognises the board of directors as the
focal point of corporate governance.
The key principles of King III relate to effective leadership, sustainability and corporate
citizenship. The board of directors should set the ethical values of the firm and define corporate
strategy. Sustainability is defined as the primary moral and economic imperative of the current
century. Corporate citizenship requires that the company should operate in a sustainable manner
and sustainability is embedded in the South African Constitution. Companies are required to
consider the social, environmental and economic impacts of their operations. King III states that
strategy, risk, performance and sustainability are inseparable. What are the major requirements
of King III?
The Board of Directors
The majority of directors should be non-executive directors of which the majority should be
independent. Companies are required to apply or explain why the recommendations set out in
the King III were not adopted. A company is required to produce an integrated report, which
includes sustainability and financial reporting.
The responsibilities of the board of directors include that all entities should have an
effective and independent audit committee. In terms of the Companies Act, 2008, all listed and
public companies are required to have an audit committee. In terms of King III, all members
of the audit committee should be non-executive independent directors. The audit committee
is required to nominate the external auditor and agree fees as well as determine the nature
of non-audit services. The audit committee is required to review the financial statements
and ensure the integrity of the integrated report, including the reliability of the reporting of
sustainability issues. The audit committee is required to oversee a risk-based internal audit.
The board of directors is responsible for the governance of risk and is required to report on
the system and process of risk management and approve the risk management policy and plan.
The board is required to ensure that the risk management plan is monitored on a continuous
basis. The board is required to set the levels of risk tolerance and ensure that risk assessments
are undertaken and key risks are identified. Risk management is viewed as one of the main
pillars of corporate governance. Guidelines such as ISO 31000 are useful for the effective risk
management of companies.
Information technology has become an integral part of doing business and may create
significant risks and opportunities for companies. Directors are responsible for IT governance
and should evaluate and monitor IT expenditure as well as review such issues as disaster
recovery planning, adherence to laws and codes, reliance on IT systems, IT legal risks and
information security.
Management should not create incentives that reward short-term profits at the cost of
longer-term performance.
It is important for the CEO and Chairman functions to be separated. Why? The chairman
is required to manage board meetings and assist the board of directors to evaluate the
performance of the CEO. If the CEO and the chairman is the same person, then it becomes
much more difficult for the board to evaluate the CEO’s performance, set the CEO’s
remuneration and, if required, to fire the CEO. Effectively, the CEO would be evaluating
himself and let’s face it is unlikely to be an objective assessment. It is important to have a
strong independent chairman.
King III requires that companies provide an annual integrated report, which includes
sustainability reporting, and financial reporting.
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Sustainability and integrated reporting
In terms of King III, sustainability is a source of opportunity and risk for companies and a
fundamental shift is required in how companies are organised. The board of directors through
its audit committee should review the reporting of sustainability issues in the integrated report,
ensure that it is reliable and there is no conflict with the financial information. Adequate
information on the company’s financial and sustainability performance should be provided
and there should be commentary provided on the results and plans to build on the positives
and deal with any negatives. External assurance should be obtained for material sustainability
issues. A company is required to produce an integrated report each year and the emphasis
should be on substance over form. Integrated reporting is in line with the view of King III
that strategy, governance and sustainability are inseparable. Companies should ensure that
sustainability is integrated with its normal business operations and sustainability criteria
should be included in performance evaluation. There is the global reporting initiative (GRI),
which offers guidelines on sustainability reporting.
South African companies are regarded as world leaders when it comes to sustainability
and triple bottom line reporting. Yet, South Africa faces daunting environmental challenges
not only from the effects of climate change but also from the impact of its mining legacy. The
impact of gold mining on Gauteng’s water table is expected to have significant environmental
impacts. Radioactive uranium, tailings dams and concentrations of heavy metals and acids
will create significant challenges in the future. South Africa faces significant challenges in
relation to poverty, unemployment, health care, educational standards, crime and other social
dimensions that require the corporate sector and government to deal with in order to ensure
the sustainability of South Africa’s economic model. Whilst reporting is good, we think that
action is better.
Risk management
Risk management forms a key component of King III. The board is responsible for the
governance of risk, and is required to report on the effectiveness and process of risk
management as well as the effectiveness of the company’s system of internal controls. Internal
audit is required to report and assess a company’s internal controls and risk management.
Whilst many areas of risk management are beyond the scope of this book, we will focus on
financial risk management in Chapter 18.
The governance of Information Technology (IT) and its role in corporate finance
In terms of King III, the board is responsible for IT governance and should ensure that there
is an IT charter. There should be policies and controls in place and the IT strategy should be
aligned with the company’s sustainability objectives, and strategic and business processes. There
should be a Chief Information Officer and the board should evaluate the return on investment
from IT projects. There should be independent assurance on IT governance. Further, IT should
be part of the company’s risk management and the company should have adequate disaster
recovery arrangements in place. The company should ensure there are adequate systems in
place to address IT risks and the management of information. King III is having an impact on
companies. For example, Aspen stated the following in its 2013 Integrated Report;
The Board has adopted an IT governance charter in accordance with the King III
recommendations and has appointed a Chief Information Officer.
Why is IT critical for financial management? The efficient functioning of capital markets relies
on IT systems. Financial models and programs play a pivotal role in the design of financial
instruments, risk analysis and valuations. Throughout this text, we will refer to the use of Excel
financial models in applications such as loan amortisations, portfolio construction, option
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pricing models, project evaluation and valuations. We will use methods such as data tables,
goal seek, scenario manager and Monte Carlo simulation.
When we analyse and value companies, we need to consider the ability of the company to
be able to manage the IT risks and its ability to use IT to create value. For example, Edcon
is able to manage its inventory and the distribution of 275 million units only due to its IT
capabilities, which is provided by Accenture. At the same time, IT can change suddenly and
make a company’s business model obsolete. When we value companies we need to increasingly
take into account IT risks and capabilities. Further, IT governance and capabilities form a
critical part of a company’s strategy,
Solvency and liquidity tests
The Companies Act, 2008 imposes duties on directors to apply solvency and liquidity tests in
respect to transactions such as, the payment of dividends or distributions to shareholders, share
buy-backs, financial assistance to third parties for the acquisition of the company’s shares, and
loans and financial assistance made to related parties. Essentially, the board is required to be
satisfied that after the transaction, the company’s assets (fairly valued) exceed its liabilities
and that the firm will be able to pay its debts as they come due over the following 12 months.
Otherwise the directors may be personally liable for any loss. In corporate finance, these tests
will normally be applied when the company is considering making dividend distributions or
undertaking share buy-backs or when the company is considering corporate restructuring. We
will evaluate these tests in greater detail in Chapters 16 and 17.
Business rescue
King III refers to the Companies Act’s requirements regarding business rescue. This imposes
a duty on the board to consider instituting business rescue proceedings, as outlined in the
Companies Act, if the company is financially distressed. We will examine the workings of the
business rescue provisions in Chapter 17.
Does corporate governance pay?
A number of studies1 have found that there are positive effects for companies that focus on
improving their corporate governance structures. The return on assets was 19% better for
well-governed companies and return on equity was 24% better. Companies with effective
corporate governance structures achieve higher valuations. In South Africa, Abdo and Fisher
(Accountancy SA, May 2007) found that companies that achieved a high level of corporate
governance disclosure scores, significantly outperformed companies with low corporate
governance scores. In a study of 169 South African listed firms, Collins Ntim (2013) found
a statistically significant and positive association between good corporate governance and
corporate financial performance (SA Journal of Economics, 81(3), pp373-392)
A McKinsey survey of large institutional investors found that investors place corporate
governance at the heart of investment decisions. Investors were prepared to pay a premium of
12-14% in North America and Western Europe and a premium of 20-25% in Asia and Latin
America, and a premium of over 30% in parts of Asia and Africa for companies demonstrating
high governance standards. For South Africa, investors were prepared to pay a premium of
22%. Accounting disclosure was a key concern and investors wished to see more independent
boards and the adoption of more effective board practices.
1
See Anson, White & Ho (2003) “The Shareholder Wealth Effects of Calpers’ Focus List”, Journal of Applied
Corporate Finance, 15(3) and Henry (2008) “Corporate Governance Structure and the Valuation of Australian
Firms: Is there Value in Ticking the Boxes”, Journal of Business Finance & Accounting, 35(7).
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Auditors
Investors and financial managers rely on the integrity of financial statements. In corporate
finance, we use financial statements to value companies and make investment decisions and we
rely on auditors to certify that the financial statements fairly present the financial performance
and position of a company.
Yet corporate scandals such as Enron, WorldCom and Lehman Brothers have shaken the
confidence that investors have in auditors and accountants. Arthur Anderson (Anderson) was
one of the ‘Big Five’ public accounting firms in the world at the time of the Enron collapse.
It had over 80 000 employees, 350 offices in 84 countries and 100 000 clients. Anderson went
down with Enron but was Enron really the cause of Anderson’s demise? Not really. Rather, it
was the loss of its reputational integrity. Anderson earned only about 1% of its revenue from
Enron entities. However, criminal investigation of Anderson and evidence of obstruction of
justice, led to many of Anderson’s other clients racing for the door and appointing other more
reputable audit firms. The association with Anderson was undermining their own reputations.
As clients left en masse, Anderson crumbled very quickly. It was difficult to forget Anderson
staff shredding incriminating documents through the day and night. It was said that the
buildings were literally buzzing with the sound of shredders destroying key evidence.
In 2010, Ernst and Young were implicated with the downfall of Lehman Brothers as it
permitted the company to shift assets and liabilities off its balance sheet (Statement of
Financial Position). This made Lehman Brothers seem less geared than it really was. This
was called ‘window dressing’, a term which reflects the ethical ambiguity of accounting. Other
terms such as creative accounting, and earnings management do not sound like serious ethical
dilemmas but really are.
Auditors have not been that effective in uncovering fraud. A major USA study found
that auditors uncover only 11% of frauds. Employees, the media, analysts and short-sellers
are more effective at uncovering fraud. It is true that investors do place value on audited
financial statements and the role of the audit in protecting the integrity of financial statements.
An unqualified audit report does offer reasonable assurance about the integrity of financial
statements. It is important as a first step in any analysis to check that the report of the auditor
states that the financial statements present fairly, in all material respects the financial position
and performance of a company and that the financial statements have been prepared in line
with the Companies Act and International Financial Reporting Standards.
9 Corporate Strategy
Corporate strategy is about direction and action. It is important that a company sets out
its mission and objectives and understands the business environment that it is operating in.
Financial management decisions should be aligned with a company’s corporate strategy. A key
question relates to how a company should create a sustainable competitive advantage in each
sector it operates in. Should the firm focus on low cost or differentiation strategies? Often a
company needs to decide what businesses the company should be in and then focus on making
decisions that increase the value of the firm. This also means that sometimes a firm should
divest of poor-performing divisions.
In order to increase the value of the firm, we need to understand the competitive landscape,
and future likely developments in a sector. Further, management incentives need to be aligned
with a company’s strategy. Firms will often use models such as Porter’s Five Forces, SWOT
analysis and PEST or STEP analysis (now expanded into PESTEL analysis) in order to frame
their strategic analysis.
Porter’s Five Forces Model
Michael Porter of Harvard, based on extensive research and company interviews, set out the
five forces that impact on corporate and industry profitability. These are:
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■■ Level of rivalry amongst existing companies in the sector;
■■ Existence and threat of substitute products;
■■ Threat of new entrants and existence of barriers to entry;
■■ Bargaining power of a firm’s customers; and
■■ Bargaining power of a firm’s suppliers.
Each force involves understanding the interaction of a number of factors. For example, high
exit costs and spare capacity will mean that firms will tend to compete aggressively with each
other thereby reducing operating margins. Often, firms will analyse investment decisions in
terms of Porter’s Five Forces model. Therefore we will expand in greater detail on Porter’s
Five Forces model, which enables us to place a company’s corporate strategy in context.
Rivalry among existing firms
High industry growth should enable firms to achieve a higher level of profitability, as existing
firms will not need to compete to grow. Slow market growth will lead to a higher level of
rivalry and lower profitability as firms can only grow by taking market share away from their
competitors. If there are a large number of firms in the industry, then this will increase rivalry
leading to lower prices and lower returns. However, it may be seen as positive, as the potential
to grow market share exists if the company is introducing a product or distribution concept
that adds value and changes the rules of the game.
If a company has high fixed costs relative to variable costs, and the industry is characterized
by high fixed costs, then capacity utilisation is critical and firms will compete aggressively in
order to achieve a higher level of sales and production. Any expansion or new investment by a
company will involve a higher level of risk as the reactions of existing firms will be aggressive
and will reduce the potential returns, at least for a while. However, although the expansion or
new investment may involve high fixed costs, the adoption of new technology may result in a
significant reduction in the marginal production cost per unit. For example, the introduction of
the Airbus A350 will reduce significantly the operating cost per air mile, particularly in relation
to fuel costs and will result in an increased capacity for airlines investing in the A350.
If the product is highly perishable or involves high storage costs, then the potential for
aggressive competition increases as firms may try and offload inventory very quickly. This
will increase risk and reduce profitability. However, investments that add value in relation to
distribution efficiencies will create greater value. For example, the investment in technology
that allows firms to react more quickly to changes in consumer buying trends means that the
risk of any investment is reduced.
If switching costs are high, then initial entry into the market may result in a reduction in
risk if industry growth is high. In a static market, high switching costs will mean that new
products will find it difficult to obtain market share. However, existing companies may be able
to protect margins. Although low switching costs may result in the company being able obtain
market share, it will also mean that competition will remain high and returns will be subject to
competitive pressures. Low levels of product differentiation will also increase competition and
increase the risk of any new project in terms of its longer-term returns, although the absence
of strong brands may allow the firm to penetrate the market.
If there are high exit barriers and excess capacity, then firms will compete aggressively as the
cost of leaving the industry is high. If any investment involves highly specialised equipment,
then the market for equipment will be limited and the value of this equipment will reflect the
state of the industry. The firm will be exposed to high levels of risk as the abandonment option
has a low value. The diversity of participants in an industry and other effects of globalisation
may mean increased competition which will lead to lower margins.
To summarise, rivalry and price competition will be intense and profitability will be
constrained if the following factors apply:
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■■ There are many competitors of a similar size
■■ The industry growth rate is low, so that current companies have to compete aggressively
in order to grow market share
■■ There are high exit barriers
■■ Low switching costs apply so that customers can move easily
■■ Companies produce similar products and services
■■ There is spare capacity
■■ The products or services are perishable
Profitability will be enhanced if there are only a small number of competitors, there is a
high industry growth rate, exit barriers are low, there are high switching costs, products are
differentiated, there is no spare capacity and products are not perishable.
Threat of substitute products
The existence of substitute products restricts the ability of firms in an industry to raise prices.
Substitute products come from outside the industry but perform a similar function. In the
beverage sector, the ability to generate supernormal profits from the sale of aluminium cans
is limited due to the existence of glass and plastic bottle containers, which serve the same
function. TV may become increasingly subject to competition from the Internet as faster
broadband speeds become more widespread. Changes in technology may create substitute
products and whole industries may be subject to change and some products are more at risk
due to changes in technology. Yet the power of brands and image is powerful in differentiating
products such as footwear and clothing. In the food and the over-the-counter pharmaceutical
sectors, the power of brands has lost some value due to the increasing focus by the major
retailers on house (no name) brands. If any investment by a company is subject to the threat of
substitutes then this will increase firm risk and reduce profitability.
Threat of new entrants and barriers to entry
If a firm operates in an industry that has high barriers to entry, then the risk of operating in
the sector will be lower, as higher returns will be sustainable. However, high barriers to entry
will mean a higher level of risk and high start-up costs for companies trying to obtain entry to
a particular industry sector.
High barriers to entry exist where economies of scale require new companies to invest large sums
to achieve a meaningful market presence. For example, entry into the pharmaceutical industry
requires large investments in research and development and the building of relationships in the
health sector chain of medical practices and hospitals. In the soft drinks sector, substantial sums
are required for brand advertising and a few companies may control the distribution channels.
Further, the reduction in unit cost may require material investments in plant and equipment.
Government and legal barriers to entry may exist as companies may be required to adhere to strict
regulatory regimes and product evaluations such as the introduction of new drugs. The airline
industry and utilities are subject to regulations, which may act as barriers to entry.
It does mean that, for firms in the industry, any returns generated from investment decisions
may be sustainable, thereby reducing the risk of individual projects. However, the initial costs
will increase for a company trying to enter an industry, although the effect of government
regulations may serve to improve the competitive position of the firm once it has made a
successful entry. The concentration in the banking sector means that the major banks are now
effectively too large to fail and the government would step in to prevent bank failure due to
the overall impact of any failure on the financial system. This makes it relatively more difficult
for smaller banks to compete and banking regulations are a significant burden for the smaller
banks in relation to the large banks. However, industry concentration in a few large banks in
South Africa, allegedly charging high fees and providing poor service with complex pricing
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structures, with a focus on closing branches, and a dependence on legacy systems created the
environment which enabled the entry of Capitec Bank. It was only in 2002 that Capitec Bank
listed at R2 per share (The share price was R300 in 2014). The focus of Capitec is on providing
a simplified service, charging low fees, employing advanced IT systems and credit evaluation
systems, enabling cash withdrawals when shopping at the major retailers, providing banking
services to the lower-middle income market and growing its branch network.
Patents and licences create barriers against competition for a defined time period. If a
company is involved in the production of products with patents, then this will enable the
company to generate higher returns and maintain a sustainable competitive advantage and
charge higher prices. This reduces the risk of the company. However, the patented products
may have high levels of risk due to high research and development costs. There may be
first-mover advantages in terms of setting industry standards, obtaining government licences
and learning economies, which may deter other entrants from entering the sector. Firstmover advantages may reduce the risk of investing in a new project, although this reason
for competitive advantage is balanced by the high risk of failure, in that there may be good
reasons that the promised new market does not exist. For example, the investment in fibre
optic cabling by the telecom companies in the USA overstated the potential demand for
broadband services. Specialised technology, plant and equipment create a barrier to entry,
as the cost is not reduced by the disposal of assets at reasonable values if the project fails.
The investment in generalised factory space and assets such as trucks is not risky as the
value of these assets is not dependent on the performance of the project and its related
industry sector. Further, existing firms will tend to react very aggressively to new entrants
when specialised equipment is required for any investment, thereby increasing the risk to
companies making the decision to enter the sector.
Establishing distribution channels and relationships will mean high costs and higher risks
attaching to failure. For example, a new food product requires acquiring shelf space but there
are only a few major retail chains. If Pick n Pay, Woolworths, Spar and Shoprite do not agree
to carry the product, then sales will not occur. Competing products may have already built
up relationships with the major chains, which make it more difficult to obtain shelf space.
Is the product a high turnover item and does the firm advertise the product independently?
Acceptance may mean a substantial return and rejection by the major chains will mean absolute
failure. Project risk will therefore increase if we’re not sure that the major chains will allocate
shelf space to the product.
Companies that have effective control over distribution networks will be able to earn
higher returns. For example, Coca Cola controls an extensive distribution network. An
existing motor vehicle manufacturer such as BMW has an extensive network of dealerships.
New auto competitors will find it hard to break into the sector, as it will need to set up a
dealer network in order to compete effectively. Therefore, companies with dealerships or
retailers in the right locations will be able to earn higher returns.
Bargaining power of buyers
If there are many suppliers and only a few buyers, then buyers will tend to determine the price
and terms of the relationship. If a buyer purchases a significant proportion of the company’s
output, then the buyer will set the price. If products are not differentiated and switching costs
are low, then buyers will tend to be more aggressive in setting prices and quality standards.
Another factor is that the product must constitute a large percentage of cost to the buyer
for it to attract the appropriate level of attention. The above point has been made of the
relative position of buyers and suppliers in the food retail sector whereby the four chains have
huge bargaining power in relation to independent suppliers. This is underscored by the ability
of the retail chains to offer house or no-name brands, which reflects an ability to engage in
backward integration. Buyers may be weak if suppliers are able to create their own distribution
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network, there are high switching costs and if there are many buyers. It is critical to evaluate
the bargaining power of buyers if the project involves the supply of new products. Yet, an
existing firm with an established industry presence with a portfolio of existing products may
find that the marketing of a new product may be facilitated owing to the national presence
of a retailing chain. This will reduce the risk of introducing a new product and will certainly
expedite the national availability of the product. In another example, there are many component
manufacturers in the automotive industry but there are only a few car manufacturers.
Bargaining power of suppliers
If there are only a few suppliers and many customers, then the power of suppliers will be high.
For example, the power of Intel and Microsoft in relation to the PC manufacturers is high.
In South Africa, Tiger Brands is a major supplier of branded food products, but this power is
counterbalanced by the power of the retail chains. De Beers (now part of Anglo American)
was the major supplier of diamonds worldwide for many years and still sells about two thirds of
world production of gem diamonds. The pharmaceutical companies have held onto significant
levers of power in relation to the pricing of patented drugs. If the company is able to exercise
significant power over its suppliers, then the company will be able to reduce the cost of its
inputs and increase its profit margins.
Competitive strategies: cost leadership and differentiation
There are two generic competitive strategies that firms may adopt to sustain a competitive
advantage: cost leadership and differentiation. A cost leadership strategy involves the firm
being a low-cost producer and protects the firm against the potential for a price war. Airlines
are investing in new planes such as the Airbus A350 and the Dreamliner in order to reduce
fuel costs and other operating costs per air mile. The investment by BHP Billiton in the Mozal
aluminium smelter involved an investment of about US$2.2 billion, which represented a high
fixed cost. However, the smelter was able to produce aluminium at the time at a cash cost of
less than US$600 per tonne, which was significantly less than other major firms in the industry.
This reduced the real risk of the investment as the investment resulted in the company being
in a cost leadership position relative to other firms in the industry and in terms of utilising
capacity, as the LME (London Metals Exchange) price was unlikely to fall to such levels2.
Therefore, cost leadership will reduce risk if the result is the firm being able to produce at
a lower cost than other industry participants and if existing firms have already committed to
large capital investments in the sector. To achieve cost leadership, firms will focus on achieving
economies of scale, cost control, reduce investment in inventory, standardise product designs,
incur low R&D and achieve high levels of production and distribution efficiencies.
A differentiation strategy involves the development of unique products and services that
permit the firm to charge premium prices. Differentiation may involve R&D capabilities,
and marketing and product development expertise, a focus on quality, timing of delivery and
warranties that will enable the firm to obtain customer loyalty due to the attributes of the
product and the firm. An established firm, which is renowned for the quality of its products,
will imply a lower level of risk for new products.
Cost leadership will enable the firm to cut prices to deter potential new entrants, and also
enables the firm to offer lower prices to powerful buyers and allows the firm to compete on
price. Differentiation will result in customer loyalty and will result in a fall in the power of
The global aluminium sector is going through a very difficult time in 2014 due to overproduction and falling
prices. Although the cost of production at BHP Billiton’s Mozal and Hillside smelters remains lower than its
major competitors which are closing smelters due to losses, the low cost of production at the Mozal and Hillside
smelters is due to the low cost of electricity supplied in terms of long-term contracts. The company has had to halt
production at times to avoid load shedding by Eskom and this is also having an impact on costs. Yet the low cost
of production has allowed the company to ride out these stormy times so far.
2
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buyers, as there are fewer product alternatives. Further, differentiation reduces the threat of
substitutes and enables the firm to retain customers.
Investments might be viewed as investments impacting on operating effectiveness and this
may reflect lower costs of production or distribution or improvements in quality. The difference
in incremental costs may indicate a positive NPV. Yet in terms of meeting competition, the
relevant issue is of lost sales and revenue if we do not invest in new manufacturing processes.
In the cost-effectiveness scenario, the issue revolves around competitors obtaining cost
advantages, which will affect the firm’s position and its ability to compete in the future. Risk
may rise due to the effects of global competition and the geography of decision-making in a
volatile and complex business environment.
SWOT analysis
A company will often face internal and external forces, which impact positively or negatively
on the company’s performance. SWOT analysis is employed to set out a company’s internal
strengths and weaknesses and a company’s external opportunities and threats. A company
should focus on strategies and decisions that will make the most of its strengths and avoid
decisions that will bring to the fore its weaknesses. For example, a major strength for a
pharmaceutical company may relate to its strong portfolio of drugs under patent. A further
strength may relate to its wide distribution network and sales and marketing teams. A major
weakness may relate to the fact that the company has few new drugs under development,
particularly in the biotech sector. To address this weakness, the pharmaceutical company may
adopt a strategy of increasing its research and development capabilities. It may also decide to
purchase or enter into a joint venture with a smaller biotech company, which has a number of
new drugs in the ‘pipeline’ but has weak distribution and marketing capabilities.
Opportunities and threats relate to external factors. A threat may relate to the entrance
of a new competitor. For example, the entrance of Wal-Mart into the South African market
may pose a threat to a company such as Pick n Pay. A stronger Rand exchange rate would
be expected to increase the margins of a company such as Mr. Price that imports most of its
clothing products from Asia. A weak Rand may be a threat for a company such as Mr. Price.
Table 1.4 sets out a possible template for a SWOT analysis.
Table 1.4 SWOT analysis framework
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What are some examples of strengths, weaknesses, opportunities and threats?
Strengths: Strong brands, IT capabilities and systems, product quality, distribution channels,
human resources, state of the art equipment, management team, customer loyalty programmes,
low debt, accreditations, prices, certifications, supply chain management.
Weaknesses: Lack of skills, weak brands in certain segments, problems with customer retention,
unreliable suppliers, lack of new product development, problems with product quality, lack of
training, weak supply chain, over-dependence on CEO, lack of IT capabilities, poor financial
position and lack of capital to finance expansion.
Opportunities: New technologies, falling interest rates, changing demographics, changes
in consumer tastes, an increasing Black middle class, opening of African markets,
improved logistics and improvements in distribution channels, reduction in tariffs, access
to overseas markets, access to credit by potential customers, vulnerable competitors,
vertical integration.
Threats: Changes in technology may make products obsolete, changes in consumer tastes,
rising interest rates, changes in the exchange rate, inflation, tariff and tax increases, changes in
government regulations, climate change, seasonality, loss of key staff.
Let’s evaluate some examples. MTN and Shoprite have expanded into Africa and have been
very successful in the execution of this strategy. This represented a strategic opportunity for
these companies. Yet, threats related to political risks, government regulations and problems
with local partners. MTN succeeded in Nigeria whilst Vodacom struggled initially to manage
these threats.
The private health care providers in South Africa face daunting challenges in terms of changes
in government regulations. There are skills shortages due to nurses going overseas. Yet a rising
Black middle class is expected to significantly benefit the private health care companies as
well as the pharmaceutical companies such as Aspen, as more people obtain access to private
health care and join medical aids.
What are the potential problems with using SWOT analysis? It is subjective. Therefore, it is
important to prioritise and indicate what factors will have the most material impact on the
company’s operations, assets and levels of profitability. Do a what-if analysis – what is the
impact on the company’s profitability if the Rand appreciates by 10%. SWOT analysis can be
simply a laundry list. This may be dangerous. Just because we have set out all the factors, does
not mean that we have dealt with all the issues.
We need to set strategies in place. A weakness or threat should be matched with a strategy
to deal with the threat or weakness. Sometimes this is not possible, but we should endeavour
to adopt strategies as far as possible to deal with weaknesses and threats. We have no control
over exchange rates but we may create flexibility to change suppliers quickly, if required. It is
useful to be specific. If we have a cost advantage in relation to the cost of production, then
indicate what this is. Perhaps we can produce at R600 per ton whilst our competitors can only
produce at R900 per ton. Further we should set out strategies to leverage our strengths and
take advantage of opportunities.
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PEST or STEP analysis
PEST or STEP analysis refers to a framework for considering the Political, Economic, Social
and Technological factors that will have a material impact on a company’s operations and level
of profitability. What do these factors include?
Political: taxation, tariffs, labour legislation, environmental regulations, trade barriers, impact
of government policies such as income grants, provision of housing, health care regulations,
education and infrastructure. Companies may win or lose if there are changes in these factors.
A company providing low cost housing will gain from a focus by government to provide low
cost housing to South Africa’s population.
Economic: interest rates, economic growth rate, inflation rate, exchange rates. Lower interest
rates may mean a greater level of disposable income and greater spending by consumers
thereby increasing the demand for a company’s products.
Social: population growth rates, changing demographics and age distribution, focus on safety,
rising Black middle class, changing values, use of credit, focus on food quality and health,
increase in demand for travel. A growing population and a growing Black middle class have
increased the demand for the products of many South African companies. Companies such as
Truworths have benefited greatly by a rising Black middle class with access to credit.
Technological: advances in software and IT capabilities, research and development, automation,
robots, rate of change in processes. The improvement in IT has enabled companies to monitor
sales very carefully so that inventory management and orders reflect product sales particularly
for companies such as Edcon, Truworths and Shoprite. Inventory control due to scanning has
enabled a lower investment in inventory and lower losses from shrinkage and obsolescence.
PESTEL analysis
These days, PEST is becoming PESTEL due to the growing importance of environmental
and legal factors. Increasingly competition law, environmental law, consumer protection laws,
access to credit laws, employment and labour law, and health and safety regulations are all
having a material impact on corporate strategies. Climate change and the impact of South
Africa’s mining legacy will impact on sectors such as the agricultural sector and sectors that
make material use of water resources.
Sustainability related issues
The JSE introduced its Socially Responsible Investment (SRI) Index in 2004. All companies that
form part of the JSE All Share Index are evaluated in terms of environmental, social, governance
and related sustainability concerns and climate change impacts. This was known as triple bottom
line reporting. In 2014, there were 73 constituents of the index. The best performers in 2014
were Anglo American, Anglo American Platinum, Barloworld, Illovo Sugar, Lonmin, Netcare,
Royal Bafokeng Platinum, Vodacom and Standard Bank. The SRI Index criteria are aligned
with international benchmarks. Environmental evaluation is based on a company’s impact in
terms of climate change, air pollution, water pollution, waste and water consumption. In relation
to society, a company is expected to treat all stakeholders fairly and with dignity, develop and
empower its employees, ensure the attainment of key labour standards and employee relations
and promote safety at work as well as the health of its employees. The standards required in
terms of corporate governance are aligned with the requirements of King III.
Internationally, the Global Reporting Initiative (GRI) is an organisation that sets guidelines
on sustainability reporting. The GRI guidelines include, economic, environmental, and social
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categories. The social category has sub-categories, which include labour practices and decent
work, human rights, society and product responsibility. The GRI sets out the aspects of these
categories and the following are just a few aspects per category.
The Equator principles apply to banks lending mostly in developing economies. Banks that
adopt the equator principles make a commitment to fund projects only if these projects
adhere to sound environmental and social standards. Projects are evaluated in terms of their
social and environmental impacts – there are international benchmarks used in relation to
labour working conditions, emissions, community impacts, and health and safety concerns.
10 Structure of the text
We use a framework which gives an overview of financial management as a whole. The text is
divided into five sections, each building on knowledge gained from the previous section.
This first section has placed financial management as a discipline into perspective and has
focused on the role of the financial manager within the economic environment.
The second section will deal with the essential concepts and tools necessary to perform
the task of a financial manager. It is essential, for example, to be in a position to analyse
annual financial statements, to understand concepts relating to the time value of money and
the interaction of risk and return, and to be familiar with the principles of valuation and the
cost of capital. Once these principles have been mastered, progress can be made toward
understanding the variables interacting in the financial management decisions.
The third section focuses on the investment decision. We have identified two different types
of investment decision, namely the decision to invest in long-term operating assets (capital
budgeting), and the decision to invest in short-term operating assets (working capital
management).
The fourth section explores the financing alternatives. The balance between equity and
debt within the capital structure is considered as well as the effect of this balance on the cost
of finance. The possibility of leasing as a finance option and the implications of using foreign
finance become important issues in this section. Whilst the dividend policy of a company could
be discussed under a separate section, we have considered it to be a part of the financing
decision and have thus kept this issue together with other financing questions.
The fifth section has identified a number of integrated but specific topics. These include
mergers and acquisitions, risk management, international financial management, business
planning and financial modelling and finally we will come full circle by exploring corporate
strategy and business models in greater depth than we have done in this chapter.
Summary
The financial management function focuses primarily on decision-making with regard to
investment and financing decisions of a business enterprise. The primary objective of the
financial manager is to maximise the value of the firm. This objective is attained through the
analysis and selection of investment opportunities and the use of alternative sources of funds.
Further, adherence to good corporate governance as set out by King III and a focus on
ethical leadership, the environment and creating a positive impact on society will ensure that
the company has a sustainable future. Financial decision-making should take place within the
context of a company’s strategy.
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Appendix 1.1
Professional ethics and codes of conduct
The professional accounting associations offer guidance to members facing ethical dilemmas.
As professionals, accountants have an obligation to themselves, their colleagues and their
organisation to adhere to high standards of ethical conduct. In recognition of this obligation, the
South African Institute of Chartered Accountants (SAICA) and other professional accounting
bodies have issued ethical standards in a code of conduct for their members. SAICA has
determined that skills and integrity are the pre-eminent professional attributes of Chartered
Accountants in South Africa. The Code of Professional Conduct of SAICA is consistent in all
material respects with the Code of Ethics for Professional Accountants issued by the International
Federation of Accountants (IFAC) and conforms to the code issued by the International Ethics
Standards Board for Accountants (IESBA). The fundamental principles of the South African
Institute of Chartered Accountants Code of Professional Conduct are as follows3:
A professional accountant is required to comply with the following fundamental
principles:
Integrity
A professional accountant should be straightforward and honest in all professional
and business relationships. Integrity implies fair dealing and truthfulness. A chartered
accountant will not be associated with reports, statements or information, which contains
false or misleading statements, or contains information furnished recklessly or omits or
obscures information, if such omission or obscurity would be misleading.
Objectivity
A professional accountant should not allow bias, conflict of interest or undue influence of
others to override professional or business judgments.
Professional Competence and Due Care
A professional accountant has a continuing duty to maintain professional knowledge
and skill at the level required to ensure that a client or employer receives competent
professional service based on current developments in practice, legislation and techniques.
A professional accountant should act diligently and in accordance with applicable technical
and professional standards when providing professional services. A chartered accountant
shall not perform a professional service if a circumstance or relationship biases or unduly
influences the chartered accountant’s professional judgment with respect to that service. A
chartered accountant should take reasonable steps to ensure that everyone working under
his/her authority has the appropriate training and supervision. If relevant, a chartered
accountant should make clients, employers or other users of the chartered accountant’s
professional services aware of the limitations inherent in the services and should not
undertake any engagement if the chartered accountant is not competent to perform unless
advice and assistance is obtained to carry out the engagement.
Confidentiality
A professional accountant should respect the confidentiality of information acquired as a
result of professional and business relationships and should not disclose any such information
3
The summary is adapted from the Code of Professional Conduct, SAICA. Copyright SAICA. Reproduced with
the permission of SAICA. The rules of ethical conduct of the CIMA and ACCA are similar to those of SAICA.
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to third parties without proper and specific authority unless there is a legal or professional
right or duty to disclose. Confidential information acquired as a result of professional and
business relationships should not be used for the personal advantage of the professional
accountant or third parties. A chartered accountant shall maintain confidentiality in social
environments and should be alert to the possibility of inadvertent disclosure to business
associates and family members. Confidentiality of information should be maintained within
the firm and extends to information disclosed by prospective clients. The principle of
confidentiality continues even after the end of relationships with a client.
Chartered accountants may disclose confidential information if authorised by the client,
if the chartered accountant is required to respond to an inquiry by a regulatory body, or if
disclosure is required by law.
Professional Behavior
A professional accountant should comply with relevant laws and regulations and should
avoid any action that discredits the profession.
Each of these principles is discussed in greater detail in the Code and readers should
visit the SAICA website, www.saica.co.za for the complete Code of Professional Conduct.
The Chartered Financial Analyst (CFA) Institute has issued a Code of Ethics and Standards
of Professional Conduct4 to guide the actions of investment professionals. The CFA
Institute states that adherence to ethical standards is fundamental to ensuring that the
public maintains its trust in global financial markets.
The CFA Institute’s Code of Ethics requires its members to:
■■ Act with integrity, competence, diligence, respect, and in an ethical manner with
the public, clients, prospective clients, employers, employees, colleagues in the
investment profession, and other participants in the global capital markets.
■■ Place the integrity of the investment profession and the interests of clients above
their own personal interests.
■■ Use reasonable care and exercise independent professional judgment when
conducting investment analysis, making investment recommendations, taking
investment actions, and engaging in other professional activities.
■■ Practice and encourage others to practice in a professional and ethical manner that
will reflect credit on themselves and the profession.
■■ Promote the integrity and viability of the global capital markets for the ultimate
benefit of society.
■■ Maintain and improve their professional competence and strive to maintain and
improve the competence of other investment professionals.
The CFA Institute’s Standards of Professional Conduct covers seven broad areas;
professionalism, integrity of capital markets, duties to clients, duties to employers,
investment analysis, recommendations and actions, conflicts of interest and responsibilities
as a CFA Institute member or candidate.
Professionalism
Members are required to understand and comply with all relevant laws and regulations.
Members are required to be independent and maintain objectivity and should not make
4
This section draws from the Standards of Practice Handbook, 10th edition. (2010), which is published by the CFA
Institute. Copyright (2011), CFA Institute. Reproduced with permission from CFA Institute. All rights reserved.
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misrepresentations in regard to investment analysis or other professional activities. Further,
members should not be dishonest, engage in fraud or any other activity that impacts
negatively on their professional reputation, competence or integrity.
Integrity of markets
Members must not act on material non-public information that could affect the value of an
investment, nor engage in practices that could distort prices or impact on trading volumes
in order to mislead other market players.
Duties to clients
Members need to be loyal to their clients, exercise reasonable care and apply prudent
judgement. Members should place the interests of their clients above their own interests
and above the interest of their employer and deal fairly and objectively when providing
investment analysis, providing recommendations or undertaking other professional
activities. Any investment recommendation should be the result of inquiry of suitability in
relation to a client’s financial situation, investment objectives and portfolio. The reporting
of investment performance should be accurate, fair and complete. Members should keep
client information confidential, unless the member is required by law to disclose such
information.
Duties to employers
Members are required to act for the benefit of their employer and should not disclose
confidential information. Members should avoid receiving gifts or compensation that may
create conflicts with the interest of their employer. Members should try and ensure that
anyone subject to their supervision complies with applicable laws, rules, regulations and the
Code and Standards.
Investment analysis, recommendations and actions
Members are required to be diligent, independent and thorough in analysing investments,
and making recommendations, which are supported by research and analysis. Members
should disclose to clients the principles and format employed to analyse investments, select
securities and construct portfolios and employ judgement in identifying the important
factors to their analyses and to communicate these to their clients. Members are required
to disclose any significant limitations and risks associated with the investment process.
Members must retain appropriate records.
Conflicts of Interest
Members are required to disclose all matters that could impair their independence and
objectivity. Investment transactions for clients should take priority over any transaction for
the benefit of a member. Referral fees should be disclosed.
Responsibilities as a CFA Institute member
Members should not undertake any action that compromises the reputation or integrity of
the CFA Institute or the CFA designation.
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Appendix 1.2: Stakeholder considerations and good corporate citizenship
By Johnathan Dillon M.Com CA(SA)
Johnathan is a Senior Lecturer and Discipline Leader of Management
Accounting and Finance within the School of Accounting at NMMU. He
has a Masters in Finance and is a Chartered Accountant. He achieved a top
10 position in the 2005 SAICA Qualifying Examination Part I. He is actively
involved in SAICA’s ITC examination processes. Research interests include
capital budgeting, valuations and leasing.
Who are a company’s stakeholders? What classifies a company as a good corporate citizen?
Many people incorrectly think that a company’s shareholders are the only stakeholders
or the only stakeholder group which a company should consider when doing business
based on its primary objective of creating value. Furthermore, often there is an incorrect
notion that companies which donate large sums of money to charitable causes are good
corporate citizens. This section aims to dispel these misconceptions through summarising
some of the key concepts surrounding corporate citizenship and stakeholder theory.
Corporate citizenship is defined by the Corporate Citizen Research Unit at Deakin
University in Australia as:1
“a recognition that a business, corporation or business-like organisation, has social, cultural and
environmental responsibilities to the community in which it seeks a licence to operate, as well as economic
and financial ones to its shareholders or immediate stakeholders. Corporate citizenship involves an
organisation coming to terms with the need for, often, radical internal and external changes, in order
to better meet its responsibilities to all of its stakeholders (direct or indirect), in order to establish, and
maintain, sustainable success for the organisation, and, as a result of that success, to achieve long term
sustainable success for the community at large.”
The above definition emphasises a number of important issues, with the main theme
being the requirement for the management team of a company to not focus solely on the
company and its shareholders’ needs. A company should rather consider all stakeholders
when doing business in order to ensure the long-term sustainability of its business as
well as the community and environment within which it operates. This encompasses the
concept of corporate social responsibility which requires a company to take responsibility
for its impact on the environment and social welfare. A good corporate citizen is
therefore essentially a company which considers all stakeholders and accepts that it has
a responsibility to its local community and the natural environment. The community
and environment within which a good corporate citizen operates would therefore be
considered by the good corporate citizen when making any substantive business decisions
but still with the aim of delivering satisfactory returns for shareholders.
In this regard, annually the Corporate Responsibility (CR) Magazine publishes a list
of America’s 100 best corporate citizens on their website (http://thecro.com/) based on
companies’ environmental, climate change, human rights, employee relations, corporate
governance, philanthropy and financial rankings. In 2014 Bristol-Myers Squibb Co. was
placed top of the list, with other well-known companies in the top 10 including Johnson
& Johnson (2nd), Microsoft Corporation (4th), Coca-Cola (9th) and Walt Disney (10th).
Bristol-Myers Squibb is a pharmaceutical company that focuses on the development,
manufacturing, distribution of biopharmaceutical (biological) products.
Interestingly, the CR Magazine awards ‘yellow cards’ and ‘red cards’ and on their 2014
list Bristol-Myers Squibb received a ‘yellow card’ caution due to an on-going class action
lawsuit in which it is claimed to have contaminated a company site with toxic chemicals,
causing personal injuries to residents of the community surrounding the company’s
production facility. If that was the case then as a result thereof the company negatively
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impacted the natural environment and the local community! If a company is awarded a
‘red card’ then it is removed from the list.2
Identifying and managing stakeholders (stakeholder analysis)
From the aforementioned discussion it is evident that when a company operates then,
in addition to the local community and natural environment, all stakeholders (not only
shareholders) need to be considered. A stakeholder of a company is regarded as any
entity, natural or juristic, which has an interest in the company and either impacts or is
impacted by the company’s operations. The major stakeholders of most companies are
indicated in Figure 1.9.
Figure 1.9 Stakeholders of a company
Stakeholders commonly fall into one of three categories, namely internal stakeholders,
connected stakeholders and external stakeholders. Furthermore, each stakeholder has
particular interests and can exert influence in a particular way over the company in which
it has an interest. Table 1.5 indicates the three categories together with examples of the
particular interests of the various stakeholders and how they can exert influence over a
company.
One of the challenges for a company is to balance the often conflicting interests of
its various stakeholders. For example, shareholders want an appropriate return on their
investment (based on the risk to which they are exposed) which may be possible through
mechanising the company’s production process (reduction in labour costs, quicker
production time, less wastage, safer operations etc.). However, mechanisation leads to
job losses which conflicts with the need for job creation of employees, government, trade
unions and the local community. This example is currently a major challenge for the
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South African mining industry. The world’s top three platinum producing companies
located in South Africa, Anglo American Platinum, Impala Platinum and Lonmin, made
their intention to mechanise blasting and rock drilling processes clear in the media in
2014. This came after three years of labour turmoil, which climaxed with a five month
long wage strike during 2014, as well as pressure by government to make mine shafts safer
following reported fatalities. This will not be an easy decision for these mining companies
to implement as there is guaranteed to be resistance from workers and their trade unions.
Other conflicting relationships have been covered in Chapter 1, namely the conventional
agency problem between shareholders and management as well as the agency problem
that can arise between shareholders and the providers of debt finance (lenders).
Stakeholder theory was initially covered in a book written by R. Edward Freeman,
entitled Strategic Management: A Stakeholder Approach (1984). Subsequently stakeholder
theory has evolved but essentially there are two alternative views to stakeholder theory.
The weak view is one where stakeholders are seen as necessary and good in light of the fact
that they are needed for a company to fulfil its primary objective of maximising the wealth
of shareholders. When this view is taken, stakeholder relationships are appreciated and
the company ‘partners’ with stakeholders to create value for shareholders. The strong
view goes further where each stakeholder is seen as having an independent right to being
considered and looked after outside of the role that it plays in creating shareholder value.
With the strong view a company recognises that stakeholders have this independent
right as the company is afforded the privilege of operating by society and its various
stakeholders. Therefore with the strong view a company aims to balance the demands of
all its stakeholders, one of which is value creation for shareholders. Considering the fact
that management are a stakeholder, this could lead to them favouring their interests over
those of other stakeholders when following the strong view (amplifying the conventional
agency problem). Furthermore, if management are accountable to all stakeholders then
there is a sense that they are in fact accountable to no one. The weak view of stakeholder
theory is therefore favoured whereby stakeholders are to be considered but the primary
objective of the company remains shareholder value maximisation.3
Table 1.5 Stakeholder categories, interests and influences
Category
Internal
Stakeholder
Interests
Influence
Management (including
Remuneration, job
Decision maker
directors)
security, status, job
(possible agency
satisfaction
problem), resignation
Remuneration, job
Level of work
security, job satisfaction,
performance (quality),
safety
industrial action,
Employees
resignation
Connected
Shareholders
Return on capital
Director appointments,
invested, risk exposure
sell shares
Providers of debt
Interest and capital
Withdraw debt facility,
finance
repayment
enforce loan covenants,
Customers
Quality, value for
Reputation, legal claims,
money, service
repeat business or move
force liquidation
to a competitor
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Category
Stakeholder
Connected
Suppliers
Interests
(cont.)
Influence
Payment, profitability,
Non-supply, inferior
future business
service or quality, high
prices, withdraw credit
facility
Advisors
Competitors
Payment, future
Withhold advice, inferior
business, adding value
service
Industry reputation,
Rivalry, strategic
industry associations,
alliances, takeover
new developments
External
Government (local and
Legal operations, tax
Laws and regulations,
national, including tax
collection, job creation
taxes
Members’ rights
Lobby government, legal
authorities)
Industry associations
and trade unions
action, industrial action
Local community, public
Environmental
Publicity,
at large, interest groups
protection, job creation,
demonstrations, lobby
social responsibility
government
Stakeholder relationships need to be managed and this largely depends on the level
of interest of the stakeholder in the company’s operations and the degree of influence
(power) the stakeholder can exert over the company (as indicated in Table 1.5). In this
regard the power-interest matrix illustrated in Figure 1.10 is useful. This matrix was
originally developed by Aubrey Mendelow and subsequently adapted and simplified by
Gerry Johnson and Kevan Scholes.4
Figure 1.10 Mendelow’s power-interest matrix
Plotting stakeholders on the power-interest matrix assists a company in determining how
significant its various stakeholders are and how it should deal with particular stakeholders.
For example, a customer may fall into quadrant A based on the fact that it comprises a
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small portion of the company’s sales (low bargaining power) and the item purchased may
be a commodity in which case it can be obtained elsewhere (low level of interest). In such
a case the company should expend minimal effort on managing its relationship with the
customer; however, where a customer has more power and a higher level of interest, the
relationship needs to be more closely managed. Shareholders normally fall into quadrant
D, while government usually falls into quadrant C which a company should merely aim to
keep satisfied. The local community within which a company operates is normally placed
in quadrant B as it is very interested in the company’s operations but the community’s
power is limited, although protests can influence other more powerful stakeholders.
Stakeholder relationships should continually be managed and an analysis of
stakeholders should be performed whenever a company makes project investment and
other strategic decisions. A particular decision should be evaluated in terms of its impact
on all stakeholders, bearing in mind each stakeholder’s degree of power and level of
interest as indicated by Mendelow’s matrix. Essentially the company needs to determine
whether a strategic decision under consideration is acceptable to their stakeholders. This
links with criteria often used to evaluate potential strategic options, namely suitability,
acceptability and feasibility as outlined below:
■■ Is the strategy suitable? Does it fit in with the company’s vision and mission?
■■ Is the strategy acceptable? Is it acceptable to stakeholders based on expected
profitability, risk, environmental impact etc.?
■■ Is the strategy feasible? Does the company have the necessary resources?
When managing stakeholder relationships it is also important for a company to measure
the satisfaction of its various stakeholders. This will give the company an indication as
to whether it is successfully managing its relationships with its stakeholders. Although
measuring stakeholder satisfaction is often difficult due to the subjectivity thereof and it
often being qualitative in nature (e.g. where questionnaires are used), the following are
examples of how satisfaction can be measured:
■■ Shareholders – trading of shares (buying or selling), movement in share price
■■ Employees and management – staff turnover rates, remuneration policies relative to
the market
■■ Customers – percentage on-time delivery, price relative to competitors
■■ Local community – nature and extent of publicity
In conclusion, this section clearly highlights the importance of stakeholders and the need
for a company to consider and balance the interests of all its stakeholders. In doing so a
company will not only be a good corporate citizen but it will also ensure the long-term
sustainability of its operations.
References:
1. Work and Family Researchers Network, 2014. Corporate Citizenship, Definition(s) of
| Work and Family Researchers Network. [online] Available at: http://workfamily.sas.
upenn.edu/glossary/c/corporate-citizenship-definitions [Accessed 15 November 2014]
2. CR Magazine, 2014. CR’s 100 Best Corporate Citizens 2014. [online] Available at:
http://www.thecro.com/files/100BestList.pdf [accessed 14 November 2014]
3. Nordberg, D., 2011. Corporate Governance: Principles and Issues. London: Sage
Publications, pp. 42-43.
4. Olander, S. & Landin, A., 2005. Evaluation of stakeholder influence in the
implementation of construction projects. International Journal of Project
Management, 23, p. 322.
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FINANCIAL MANAGEMENT
Q
QUESTIONS
Question 1.1
Identify the fundamental objective of the financial manager.
Question 1.2
How do you expect deregulation to affect industry sectors and investment decisions? For example,
what happens if government permits deregulation in the electricity sector and permits the entry
of suppliers other than Eskom? Telkom have lost their monopoly. What effect has this had on
Telkom’s returns and investment decisions?
Question 1.3
Why do companies need a financial manager? What does a financial manager do?
Question 1.4
To what extent may the goals of the firm differ from those of the financial manager?
Question 1.5
Outline the most significant economic developments which the financial manager will need to
consider in making investment and financing decisions.
Question 1.6
Distinguish between operating assets and financial assets. Under what circumstances may one be
preferable to the other?
Question 1.7
Distinguish between capital markets and money markets. Under what circumstances do financial
managers seek finance from these two markets respectively?
Question 1.8
What are the advantages of the company form of business organisation?
Question 1.9
Outline four criteria which will result in differing financial impacts as a result of the choice of
business organisation.
Question 1.10
Mr Knight has obtained a patent on a new device that lures insects and electrocutes them once
they touch a grid inside the device. He is at the stage of manufacturing the first units and marketing
the device and has asked you to advise him whether he should operate as a sole trader, within a
partnership, a private company or public company. How would your advice change as the entity
grows over time?
Question 1.11
Distinguish between profit maximisation and value maximisation. Are these two concepts linked or
mutually exclusive?
Question 1.12
Assume that you have been appointed as the financial manager of a large listed company operating
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Overview of Financial Management
1-49
a chain of supermarkets throughout South Africa. Identify some specific investment decisions and
some specific financing decisions which you may be called upon to make.
Question 1.13
A business that is expanding is considering using debt to fund the planned projects. They plan
to arrange the financing first and then consider the expansionary projects once they know what
money is available. Comment on whether the financing decision should be considered before the
investment decision.
Question 1.14
From your understanding of financial accounting, what are your thoughts about the accuracy and
value of financial statements, such as the Statement of Comprehensive Income and the Statement
of Financial Position, for use by financial managers.
Question 1.15
Explain economic value added (EVA) and indicate why a company may have a positive accounting
profit and a negative EVA.
Question 1.16
Indicate why maximising accounting profits is not a useful corporate finance objective.
Question 1.17
Indicate why agency problems exist between management and shareholders. What factors will
ensure an alignment between the objectives of shareholders and management?
Question 1.18
Energy Ltd’s management, who have been issued with a substantial number of share options, are
considering investing in a high risk project which offers potentially significant returns. News of this
proposed project has been leaked into the market, and the ordinary share price immediately rose
but the price of the company’s corporate bonds fell sharply. Explain why this may happen.
Question 1.19
Why are the concepts of risk and time value of money important in making investment and financing
decisions?
Question 1.20
In the context of control, risk, transferability and tax rates, discuss the advantages of being a sole
trader, in a partnership or a company.
Question 1.21
Two multinational companies have recently published their objectives:
Company A:
‘Our company’s objective is to focus on the maximisation of global shareholder wealth. We will use
sophisticated measures to maximise cash flow in each country in which we operate. We will also
extensively outsource internationally in order to increase profitability.’
Company B:
‘Our company’s primary objectives are to enhance our customers’ satisfaction and to grow our
business. We aim to supply our customers with the highest quality products and provide outstanding
levels of sales and delivery service, incapable of being matched by our competitors, and thereby
increasing our market share.’
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FINANCIAL MANAGEMENT
Required:
Discuss and contrast these objectives. Comment upon any possible ethical implications of the
objectives.
(ACCA Strategic Financial Management December 2006)
Question 1.22
Provide examples of ethical issues that might affect capital investment decisions, and discuss the
importance of such issues for strategic financial management.
(ACCA Strategic Financial Management June 2007)
Question 1.23
You are required to analyse the 2014 Integrated Reports of Aspen, and Clicks. Evaluate the
corporate strategies of each firm in terms of Porter’s Five Forces model as is possible from the
information set out in each Integrated Report. [Note – you can download the respective Integrated
Reports from their corporate websites]
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SECTION B
FOUNDATIONS
FOR
DECISION-MAKING
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The time value of money
2
IS COMPOUND INTEREST THE MOST POWERFUL FORCE IN THE UNIVERSE?
How do you grow an investment of $1 into $8 571 over 49 years? Yet, this is what Warren Buffett
managed to achieve for his shareholders. Nearer to home, Allan Gray managed to do even better
by growing R10 into R142 100 over 39.5 years for Allan Gray’s investors. What is the compound
return that Warren Buffett and Allan Gray achieved for their shareholders and how do their returns
compare to investing in the market index? We will answer this question and analyse the formulae and
application of time value of money principles to real world problems. We will also analyse the role of
interest rates and determine how to value bonds.
LEARNING OBJECTIVES
After working through this chapter, you should be able to:
■■ Understand the role of time value of money in finance and understand the concept of
compound interest.
■■ Use formulae, tables, financial calculators and spreadsheets to determine:
–– the future value of a single amount invested today;
–– the future value of an annuity;
–– the present value of a single future amount;
–– the present value of an annuity;
–– the present value of a perpetuity;
–– the present value of a growing perpetuity;
–– the present value of a cash flow growing at a constant rate over a period of time;
–– the present value of uneven cash flow streams.
■■ Define and calculate an annual effective rate.
■■ Distinguish between nominal and real interest rates.
■■ Apply compounding and discounting to complex cash flow streams.
■■ Apply time value of money principles to real world problems and the valuation of
bonds.
■■ Establish the factors that determine the term structure of interest rates.
Introduction
In this chapter we will learn how to value estimated future cash flows and apply time value of
money principles to such applications as determining the repayments on a loan. The principles
outlined here are fundamental to all aspects of financial management and serve as essential tools
in the activities of the financial manager.
Companies and individuals often have opportunities to earn returns on investments. When
you invest in a savings account, you will earn a return, the interest rate, for a specified period.
When companies invest in plant and machinery, the company is expecting to earn cash flows over
a number of years. When you take out a student loan, you wish to know what the repayments
will be. A financial manager is required to value projects with cash flows that will occur at
different points in time. The timing of cash flows is an important component of corporate finance
decisions. Why is a rand today worth more than a rand in a year’s time? The simple answer is that
you can invest the rand today to accumulate to a larger sum in a year’s time. We are required to
determine future values and present values of cash flows. To do this, we will develop formulae
which we can apply to real world applications.
We can also use Tables which are found at the back of the book. However, increas­ingly we
use financial calculators and Excel or other spreadsheet programs to solve time value of money
problems. Whilst we do not often need the formulae to determine present values and future
values, and we could focus only on the use of financial calculators, it is useful to understand the
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FINANCIAL MANAGEMENT
formulae, as these are fundamental to many applications. Further, in the real world, we often
may need to set up our own financial spreadsheet models and we may be required to use the
formulae rather than use functions.
1 Future value
Investors expect to receive a return on their investments in the form of interest or other returns.
We need to increase the original amount invested by adding the interest that accrued during the
time of the investment. Future value is the value in rands that an investment or series of investments
will grow to over a stated time period at a specified interest rate. The following notation will form the
basis of the formulae to be applied in this chapter:
FV:
PV:
r:
PMT:
n:
The amount of cash which will have accrued by a given date resulting from
earlier single sum or periodic investments.
The value of an investment at the beginning of a period, sometimes referred to as
the principal sum.
The interest rate.
The periodic investments or instalments made, excluding single lump-sum
investments. This may occur at the end or beginning of each period.
The number of periods for which the investment is to receive interest.
Single amount, single period
Where a single amount is invested for a period of one year, the calculations are relatively
straightforward.
Example 2.1: Future value: one year hence
An amount of R100 is invested for one year at a rate of 12% p.a. What is the future value of this
investment at the end of the year?
FV = PV (1 + r) (Formula 2.1)
= R100 (1.12) = R112
The interest on the investment is clearly R12, and the future value of the investment after one
year is R112.
Single amount, multiple periods, annual interest compounded
An investment of a single amount accrues interest in each period and, frequently, the interest
is added to the original investment rather than being paid out. This is referred to as compound
interest. This very important concept in financial management results in interest being earned
on interest. The compounding effect has an immense impact on the value of an investment,
especially if the period of investment is lengthy. For example, R100 invested at 15% for three
years, with interest compounded annually, amounts to R152, while if it was left for 30 years, it
would accumulate to R6 621 and if left for 50 years would accumulate to R108 366. If interest
was not compounded in this way, the interest every year would remain at R15 and the investment
would grow by this amount each year and amount to R550 after 30 years or R850 after 50 years.
Interest is not earned on interest. This is referred to as simple interest.
Example 2.2: Calculating the future value: more than one year
An amount of R100 is invested for 10 years at a rate of 12% p.a. compound interest. What is the
future value of this investment at the end of 10 years?
Using Formula 2.1 we know that the future value at the end of year one is R112. If this whole
amount remains invested for another year, the future value at the end of year two will be:
FV = R112 (1.12) = R125.44
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The time value of money
2-3
The interest for the second year is:
R125.44 – R112.00 = R13.44
The interest for the second year is R1.44 higher than for the first year. This is because
interest at the rate of 12% has been earned on the interest of R12 earned at the end of the
first year as well as on the original R100. This can be checked by calculating the interest for
one year on R12 at 12% p.a.
= R12 3 0.12 3 1
= R1.44
In order to develop a formula for compound interest, the following logic can be applied:
For year one
FV = R100 (1.12) = R112
For year two
FV = R112 (1.12) = R125.44
For year three FV = R125.44 (1.12) = R140.50
For year two the calculation could be expressed as:
FV = R100(1.12)(1.12)
For year three the calculation could be expressed as:
FV = R100(1.12)(1.12)(1.12)
This can be generalised to:
FV = PV (1 + r)n(Formula 2.2)
For the example above this is:
FV =
=
=
R100 (1.12)10
R100 3 3.1058
R310.58
It is quite easy to calculate (1.12)10. We can also use financial calculators, Excel spreadsheets
or Table A. Table A, which is given at the back of this text, is referred to as the future
value of R1 table. It is drafted for all the commonly used interest rates for up to 50 different
periods. By consulting Table A and looking for the 12% column and the 10-period row,
the figure 3.1058 will be located. This is multiplied by the principal sum of R100 in order to
arrive at the future value of R310.58.
If only the interest component is required, the principal sum can be deducted. In this
case the compound interest earned for the 10 years is R310.58 less R100, that is R210.58.
We now have a formula for determining the future value and, we can calculate any
missing variable. The effect of compounding on the value of an investment can be remarkable.
The following graph depicts the future value of an investment at an interest rate of 12%,
assuming both compound interest and simple interest. The difference is due to interest
being earned on interest.
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Figure 2.1 Future values – compound interest and simple interest
Assume that you have always wanted to be a millionaire. Well, if you invest R10 000 today
at an interest rate of 10% for 50 years, you will reach your target of making over a million
rand. Of course, a million rand will mean less in 50 years’ time than it does today.
FV = R10 000 (1 + 0.10)50 = R1.174m
The level of interest rates or returns also has a significant effect on the future value. The
graph below indicates the effect that compounding at different interest rates has on future
value.
Figure 2.2 Future value of single investment of R10 000 at varying interest rates
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The time value of money
2-5
Warren Buffett is one of the world’s wealthiest men and the world’s most famous investor,
worth over $58.5 billion (about R640 billion) in 2013. Investing in his company, Berkshire
Hathaway from the beginning of 1965 to the end of 2013 would have resulted in a com‑
pound return of 19.7% per year. Assume that an old uncle invested $1 000 on your behalf in
Berkshire Hathaway at the time. What would you have been worth at the end of 2013? Remember
we are talking about a $1 000 investment 49 years ago. We can use Formula 2.2 as follows:
FV = 1 000 (1+0.197)49 = $6 708 314
Imagine the growth in wealth from $1 000 to about $6.7 million. You could retire before
starting to work. Perhaps, this is why Albert Einstein stated that the most powerful force in
the universe is compound interest. However, assume that your uncle had rather invested the
$1 000 in the general share market (S&P 500). This would have resulted in a compound return
of 9.8% per year. What is the accumulated sum at the end of 2013? Applying Formula 2.2 again:
FV = 1 000 (1+0.098)49 = $97 615
What a difference 9.9% (0.197 – 0.098) per year makes! Over a long period, even a few
percentage points difference add up to a significant amount due to the impact of compound
interest. Of course this is in the USA and we would like to know if you could have done as
well in South Africa. We will come back to this question a little later in the chapter.
Example 2.3: Calculating the principal amount
An investor wishes to invest a sum of money which will accumulate to R310.58 in 10 years
time. How much must be invested today, if the investor can earn a rate of 12% per year?
Changing the subject of Formula 2.2, it can be stated as:
PV =
=
=
FV
(1 + r)n
(Formula 2.3)
310.58
(1.12)10
310.58
3.1058
= R100
As expected from the results of Example 2.2, the required investment is R100. Table A may
also be used to expedite the calculation of (1.12)10. Looking at Table A, the future value
factor is 3.1058. We can also use a financial calculator. We solve the same problem later in
the chapter using a financial calculator – see section 4.
Example 2.4: Calculating the number of periods
An investor is informed that an investment of R100 will grow to R310.58. If it is known that
the applied rate is 12%, how many periods are necessary for the R100 to become R310.58?
Developing a formula to solve this would require the use of logarithms. However, by
referring to Table A, and finding the relevant factor, the number of periods can be determined
by inspection as follows:
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FINANCIAL MANAGEMENT
(1 + r) n = 
​ FV ​ or n = [(LN FV – LN PV)/LN (1 + r)]
PV
310.58
(1.12) n = 
​
​
100
(Formula 2.4)
= 3.1058
The number 3.1058 is the factor defined in Table A. Because it is known that the interest
rate is 12%, it is possible to move down the 12% column until the number nearest to 3.1058
is found. In this example it is found in the 10-period row. Let’s go back to the formula:
(1.12)n = 3.1058
We can use natural logarithms to solve for n:
nLN1.12 = LN3.1058
n = LN3.1058/LN1.12
n = 1.1333/0.11333
n = 10 years
Example 2.5: Calculating the interest rate
An investor is given the opportunity of investing R100 today with a promised future value of
R310.58 in 10 years’ time. At what rate is the investment accruing interest?
From equation 2.4, it is possible to make r the subject of the formula as follows:
(1 + r)n = 
​ FV ​(Formula 2.5)
PV
r = (FV/PV)(1/n) – 1
= (310.58/100)(1/10) – 1
= 0.12 or 12%
Instead of using the formula, Table A can again be used. This time one would search for a
number close to 3.1058 by looking along the 10-period row. Once the closest number to 3.1058 is
located, the column in which it is situated is the required interest rate. We can also use a financial
calculator or Excel spreadsheets to determine the interest rate (see section 4 on financial
calculators and Excel).
We analysed the performance of investing with Buffett in the USA. What about investing
in South Africa? Allan Gray is one of South Africa’s largest asset management companies.
Allan Gray stated in 2014 that if you had invested R10 000 in June 1974 with Allan Gray then
this investment would have grown to an incredible R142.1 million by 31 December 2013. If
you had invested in the JSE All Share Index over the same period, your R10 000 would
have grown to R6.7 million. Whilst the JSE appears to have offered a very good return,
Allan Gray’s performance seems to have been exceptional. What is the annual compound
return that Allan Gray earned over the period? What is the annual compound return from
investing in the JSE over the same period?
We can work with Formula 2.5 and we will count this as 39.5 years.
Allan Gray: R10 000 (1+r)39.5 = R142 100 000
r = (142 100 000/10 000)(1/39.5) 21 = 27.388% per year
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JSE All Share Index: R10 000 (1+r)39.5 = R6 700 000
r = (6 700 000/10 000)(1/39.5) 21 = 17.908% per year
In fact, Allan Gray has outperformed the JSE All Share Index by 9.48% per year and we
can see what a big difference this can have on the final accumulated amount. Allan Gray’s
investment performance compares well to Warren Buffett’s performance although we need
to be careful as relative performance depends on the beginning and ending period.
Single amount, multiple periods, non-annual compounding
It often happens that an investment offers a rate of interest per annum, but stipulates that
interest will be compounded at different intervals – quarterly or monthly, for example. This
means that interest is added more frequently than once a year. As a result there is more
opportunity for earning interest on interest. The net effect is that a higher return is obtained
on the investment than would have been the case had interest only been compounded
annually. In such a case the quoted per annum rate is called the quoted rate while the true
return in annual terms is higher if the number of compounding periods is more than once a
year, and is called the annual effective rate (see Formula 2.7).
Example 2.6: Future value, interest compounded monthly
An investor deposits R100 into an account which offers 12% p.a. interest compounded
monthly. Find the value of the investment at the end of one year.
Because interest is compounded monthly, it can be said that 12% over 12 months – i.e.
1% interest – is added every month. Using Formula 2.2 it can be seen that the investment at
the end of the second month would be:
FV = R100 (1.01) (1.01)
At the end of the twelfth month it would be:
FV = R100 (1.01)12
= R100 3 1.1268
= R112.68
The extra 68 cents, although not significant over a short period, will compound over longer
periods and can make a considerable difference. The effective rate in this example is
12.68%.
The formula required to generalise this calculation is as follows:
r ​  )mn
FV = PV (​​ 1 + 
​ m
​​ ​(Formula 2.6)
where m is the number of times within a year that interest is compounded and n is the
number of years.
If the investment were made for 10 years, the future value would be:
(
)
12 × 10
FV = R100 ​​ 1 + 
​ 0.12 ​  ​​
​
12
= R100 3 1.01120
= R100 3 3.300
= R330
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FINANCIAL MANAGEMENT
It is clear that Table A can still be used. The difference is that the necessary adjustment
must be made to the rate and the periods in order to read the table correctly. The formulae
and the tables work in periods rather than years. Monthly interest in this case is 1% for 120
periods. Unfortunately, few tables extend as far as 120 periods. Rather use the formula or
a financial calculator.
Annual effective rate
It is useful to be able to convert a quoted or nominal interest rate into an effective interest
rate for many reasons, particularly in order to compare investment alternatives with different
compounding periods. We can accept that two interest rates are equivalent if they have the
same effect, that is, if a single amount invested at one rate and compounded annually for
a length of time accumulates to the same future value as another rate compounded more
frequently.
The effective annual rate of interest is the annual rate that if compounded once a year
would give us the same result as the interest per period compounded a number of times per
year. The effective annual rate is calculated as follows:
r m
1 + re = ​​ 1 + 
​ mn ​  ​​ ​
(
)
where re is the effective rate and rn the nominal rate, compounded m times annually. This
converts to:
rn m
re = ​​ 1 + ​ 
– 1(Formula 2.7)
m ​  ​​ ​
(
)
Example 2.7: Converting nominal to effective interest rate
Ozbank offers the Ozplan Premium account, an investment account which requires a
minimum investment of R10 000. The account offers an interest rate of 6% per year, interest
compounded monthly. What is the annual effective interest rate?
Using Formula 2.7:
(
)
12
Effective rate = ​​ 1 + 
​ 0.06 ​  ​​ ​– 1
12
= 1.00512 – 1
= 1.06168 – 1
= 6.1678%
This means that 6% per year, with interest compounded monthly is equivalent to 6.168%
per year, with interest compounded annually.
Table 2.1 Effective rates
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We can use effective rates to compare investments or loans which have the same quoted rate
but different compounding periods. In terms of “truth in lending” rules, banks may disclose
the average percentage yield (APY) which is similar to computing the effective rate. Investec
in March 2014 was advertising a 12-month fixed deposit rate of 5.98% nominal and Investec
indicated that this represented an annual effective rate of 6.15%. The deposit earns interest
on a monthly basis, so there are 12 compounding periods in a year. Is the advertised effective
rate correct? If we apply Formula 2.7, we can see that the effective rate is correctly stated at
6.15% [(1+0.0598/12)12 – 1].
Continuous compounding
So far, in considering an investment which earns interest, we have used annual, semi-annual,
quarterly, monthly or daily compounding. However, why stop there? We could invest so that
interest is earned on interest every hour or every second. What happens is that we approach
a limit. We can see from Table 2.1 that the incremental increases in the effective interest
rate gets smaller as we move from annual to daily compounding. If we extend Table 2.1, then
hourly compounding would represent adding interest of 0.000006849 [6%/(365 3 24)] of the
principal every hour. This would result in an effective rate of 6.18363%. As we approach
infinity in terms of the number of compounding periods, the effective interest rate is
er – 1, whereby e is equal to 2.71828. In our example, if the investment is offering continuous
compounding, then this would result in an annual effective interest rate of:
Annual Effective Rate = 2.718280.06 – 1 = 6.18365%
The future value of an investment earning interest at 6% per year, with interest compounded
continuously, is determined by multiplying the present value by ern. If we were investing
R10 000 at 6% for 10 years, with interest compounded continuously, then the future value
would be:
Future Value = Present Value × 2.71828(0.06 × 10)
FV = R10 000 × 1.822119 = R18 221.19
Alternatively, using the effective annual interest rate:
FV = R10 000 × 1.061836510 = R18 221.19
Apart from simply determining the future value of an investment, continuous compounding
(and discounting) has other uses in finance, such as in the pricing of options.
Interpolation
When using Table A to determine the rate or number of periods, the exact table reading,
referred to as the accumulation factor, is seldom found. In order to obtain more accurate
solutions, interpolation should be used. Although not strictly arithmetically accurate,
interpolation does provide a better answer than estimation.
Example 2.8: Finding the interest rate
An investor deposits R100 into an account which promises a future value of R154 in six
years’ time. At what rate is interest being compounded annually?
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Using Formula 2.4:
(1 + r)n = 
​ FV ​
PV
154  ​ = 1.540
= ​ 
100
As we know it is for 6 years, by reading across Table A under six periods, we see that a factor
of 1.54 lies between 7% and 8% for 6 years:
Note that the future value of 1.540 lies between 7% and 8%. The difference in the table
readings between 7% and 8% is 0.0862 (1.5869 – 1.5007).
The factor of 1.54 required is 0.0393 (1.54 – 1.5007) above 7%. In order to determine
how far past 7% it is using interpolation, the following calculation is used:
0.0393
3 1% = 0.456%
0.0862
The interest rate so calculated is 7.456% (7% + 0.456%)
Although interpolation may be useful, it is no longer necessary in a world of financial
calculators and Excel spreadsheets [Financial calculator result: 7.4616%].
Series of investments, ordinary annuity (FVA) – multiple investments and multiple
periods
So far we have dealt with a single investment at the beginning of a period and considered
all the variables that can be determined. Investment opportunities are also available that
require a series of payments of a fixed amount for a specific number of periods. These are
known as annuities. For reasons which relate more to consistency of formulation and generally
accepted usage than to practical investment procedure, we will assume that the first instalment
is generally invested at the end of the period. This is known as an ordinary annuity and we
will apply this concept throughout this text unless otherwise stated. We will now develop the
necessary formulae and tables.
Example 2.9: Calculating the future value of an ordinary annuity
An investor pays equal instalments of R100 at the end of each year into a savings account
yielding an interest rate of 12% per year, compounded annually. What is the future value of
the investment at the end of three years?
An ordinary annuity means that the payment occurs at the end of each period and the
following table depicts the cash flows and the investment of each annuity payment.
Table 2.2 Future value of an ordinary annuity (FVA) at 12%
Year end
0
1
2
3
InstalmentR100R100R100.00
(1.12)1
R112.00
(1.12)2
R125.44
Future value =R337.44
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2-11
The first instalment earns interest for two years, the second instalment earns interest for
one year, and the third instalment receives no interest as it is deposited at the end of Year 3.
This can be expressed as:
FVA = R100 3 1.122 + R100 3 1.121 + R100 3 1.120
= 337.44
If the instalment is taken as the common factor, the future value interest factor of an annuity
can be written as:
3
∑
FVIFA = ​ ​(​ 1.12)​3 – t
t=1
Where t is the period for each instalment, this translates into the following formula:
n
∑
FVIFA = ​ ​​(1 + r)​n – t
t=1
This formula is cumbersome and requires a separate calculation for each of the years. A
more workable formula has been developed which achieves the same result. It is particularly
useful for calculations requiring fractions of rates or periods not provided for in the tables.
[
]
(1 + r)n – 1
FVA = PMT × ​ 
​
​  ​(Formula 2.8)
r
(1 + 0.12)3 – 1
= R100 × ​
​
​  ​

0.12
[
]
= R100 × 3.3744
= R337.44
We can also use Table B to determine the future value of an ordinary annuity. This table is
known as the future value of an annuity of R1 per period and contains the future value interest
factor of an annuity (FVIFA). Table B is closely related to Table A. In fact, Table B is the
accumulation of Table A for n – 1 periods plus a factor of one. This relationship exists as
Table B assumes the payment takes place at the end of the period, while Table A assumes
the payment occurs at the beginning.
n Table A – 1%Table B – 1%
11.01001.0000
21.0201
e.g.2.0100
+1
31.03033.0301
41.04064.0604
51.05105.1010
The FVIFA is the portion of Formula 2.8 which appears in brackets. Using Table B to
calculate the FVA therefore requires only the product of the instalment and the Table B
FVIFA which for our example is as follows:
FVA = PMT × FVIFAn;r
= R100 × FVIFA3;12%
= R100 × 3.3744
= R337.44
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Similar principles to those already developed for dealing with a single amount investment
can be used to determine the rate or number of periods as well as for more frequent
compounding.
Series of investments, annuity due
Where specifically stated, an annuity may be structured by depositing the first instalment at
the beginning of the period. Such an annuity is known as an annuity due. Because Table B
has been compiled for ordinary annuities, certain adjustments need to be made if an annuity
due accumulation factor is required. In our example, we can have a three year annuity of an
equal payment which occurs at the end of each period, or an equal payment which occurs at
the beginning of each period.
Example 2.10: Calculating the future value of an annuity due
An investor pays an instalment of R100 at the beginning of each year into a savings account
yielding 12% per year interest compounded annually. What is the future value of the
investment at the end of three years? It is useful to use a diagram of cash flows to develop
the relevant formula.
Table 2.3 Future value of an annuity due at 12%
Year end
0
1
2
Instalment
R100
R100
R100
3
(1.12)1
R112.00
(1.12)2
R125.44
(1.12)3R140.49
Future value of annuity due = R377.93
In this case all three instalments earn interest. We could undertake three separate
calculations and sum the results. In order to adjust the Table B reading, an annuity due
requires the reading under 3 + 1 periods, but without the first instalment. The table reading
is thus adjusted by adding one period, that is, by reading under four periods rather than
three periods and then deducting one from the factor indicated by Table B. This converts
the table reading to reflect investment at the beginning of a period rather than the end of
the period as follows:
FVA = PMT × (FVIFA(3 + 1); 12% – 1)
= R100 × (4.7793 – 1)
= R377.93
The formula for the future value of an ordinary annuity, Formula 2.8, can similarly be
adjusted for an annuity due as follows:
[(
) ]
(1 + r)n + 1 – 1
​  ​– 1 ​(Formula 2.9)
FVAdue = PMT ​ ​ 
​
r
[(
) ]
(1 + 0.12)4 – 1

​ ​– 1 ​
= R100 ​ ​
​
0.12
= R377.93
It is possible to multiply our solution from applying Formula 2.8 by (1+r/m) to arrive at the
same solution1. In our example (see previous page), R337.44 × (1+0.12/1) = R377.93.
1
We are grateful to Colin Smith for making this point.
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2-13
An annuity due will have a higher future value than an ordinary annuity because the investment
is made earlier, which means that each instalment will earn interest for an additional period.
Future values when the timing of the cash flows and the compounding periods
differ
So far, to use the formulae, and financial calculators, we have had a cash flow per period and
an interest rate for the same period. Therefore, if there are quarterly payments, interest is
compounded quarterly. What do we do when there may be quarterly payments but interest is
compounded monthly? For example, a company deposits R10 million per quarter for 5 years
and interest is 6% per year, compounded on a monthly basis. One way is to determine the
effective interest per quarter and apply this in our calculations of future value. The monthly
rate is 0.5% [6%/12] and there are 20 quarters.
Effective quarterly rate = (1.005)3 – 1 = 0.015075
[
]
(1+ .015075)20 – 1
​  ​
FVA = 10m × ​ 
​
0.015075
= R10m × 23.14075
= R231.41m
2 Present values
Present value is a powerful concept in finance. If you receive money today, you can invest
it to earn interest. This means that you will prefer to receive R100 today rather than R100
in a year’s time, as you can invest it and earn a return. Up to now we have wanted to know
what the future value will be in, say, five years’ time if we invest, say, R100 today. For
example, R100 invested for one year at 8% will result in a future value of R108. We now
turn the question around: how much do we need to invest today to reach a target of R108 if
the interest rate is 8%?
The present value, that is the value today, of a stream of expected future cash flows can
be established in much the same way as future values. Many valuation problems in financial
management involve calculating the present value of a stream of cash flows that is expected
in the future. Present value enables us to make direct comparisons between investments. It is
difficult, for example, to decide between alternative investments offering income streams which
may differ in the level of cash flows and the timing of such cash flows. For example, how do we
compare investments A and B with cash flows as set out in the following table? We can compare
the investments by determining the present value of the cash flows of each project, but more
about that later.
Project
0
1
2
3
A
-20
16
5
5
B
-20
1
5
23
Cash flows in Rm
The calculation of present values uses similar reasoning to the calculation of future values.
Instead of referring to compounding, we refer to discounting, which is the inverse of
compounding. The rate used to move cash flows back to the present is called the discount
rate. Why call this a discount rate? For example, if we purchase goods at a discount, we pay
less than 100% (1) of the price. You will notice that the factors in Table C are all less than 1
and this confirms that we are discounting back to today’s value.
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Single amount, single period, annual discounting
A rand today is worth more than a rand at a future time. This is the essence of the concept
of time value. Money received immediately is likely to be used productively and to be worth
more in the future.
Different individuals will generally have differing time-preference rates for money – that
is, they will apply different discount rates to future cash flows. These differences can be
attributed to the different needs or opportunities which would require them to make use
of the cash. The primary factors for determining an individual’s time-preference rate for
money, remain the time value of money, the risk attached to the investment, and inflationary
expectations.
Example 2.11: Calculating the present value of a future amount due in one year’s time
An investment offers the opportunity to receive R100 one year from now if R90 is paid
immediately. Should an investor who applies a 12% discount rate make the investment?
As present value is the inverse of future value, Formula 2.3 can be applied.
PV = 
​  FV n ​
(1 + r)
= 
​  100 1 ​
(1.12)
= R89.29
The present value of the investment to the investor is R89.29. As this is less than the cost of
the investment, of R90, it is not a worthwhile investment. One way of conceptualising this
outcome is to ask whether the investor would give R90 (the cost of the investment today)
in exchange for R89.29 (the value of the investment today). The answer is obviously no. In
much the same way as with future values, the formula can be adapted in order to determine
other variables if they are unknown.
Single amount, multiple periods, annual discounting
An amount of money to be received more than one year in the future clearly has an even
smaller present value than if it were to be received in a year’s time. Because interest rates
are compounded annually, the same principle is applied to discounting.
Example 2.12: Calculating the present value of a future amount due more than one year in
the future
An investment offers the opportunity to receive R100 in ten years’ time. If an investor
applies an interest factor of 12%, what is the highest price which will be offered for the
investment?
Applying Formula 2.3 the outcome is as follows:
FV ​
PV = ​  
(1 + r)n
100  ​
= ​ 
(1.12)10
= R32.20
The investor would therefore be prepared to pay any amount up to R32.20 for the investment.
If the required payment was R30, for example, the investor would purchase the investment
because it would be equivalent to paying R30 today and receiving R32.20 today.
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2-15
Formula 2.3 can also be written as:
[
]
1
PV = FV × ​ ​  
​  ​
(1 + r)n
[
]
= R100 × ​ 
​  1 10 ​  ​
(1.12)
= R100 × 0.3220
= R32.20
Table C reflects discount factors for all commonly used ranges of interest rates and periods.
It is referred to as the present value of R1 table, or PVIF, denoting that it provides the
present-value interest factor for a single sum to be received at a future date. It displays the
portion of the formula which is in brackets above.
Stream of cash flows, ordinary annuity (PVA)
A series of equal cash flows, the first of which is due at the end of the first period, is called
an ordinary annuity. In order to establish the present value of an ordinary annuity (PVA), the
future cash flows must be discounted to the present.
Example 2.13: Calculating the present value of an ordinary annuity
An investor wants to buy an annuity of R100 for the next three years. If a bank is prepared
to pay interest at 12%, how much must be invested today?
This is another way of asking what the present value of a stream of three annual payments
is. It can be illustrated as shown in Table 2.4.
Table 2.4 Present value of an ordinary annuity at 12%
Year end
0
1
2
3
Cash flowR100R100R100
R89.28
R79.72
R71.18
R240.18
1
(1.12)1
1
(1.12)2
1
(1.12)3
= Present value of the annuity
From Table 2.4 it is apparent that:
(
)
1  ​ + ​ 
1  ​  ​
PVA = R100 ​ 
​  1 1 ​ + ​ 
1.122 1.123
1.12
∑(
n
)
t
= R100 ​ ​​​​ 
​  1  ​  ​​ ​​
t=1 1.12
This relationship can be generalised and expressed in the equation:
∑(
n
)
t
PVA = PMT ​ ​​​​ 
​  1  ​  ​​ ​​
t=1 1+r
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FINANCIAL MANAGEMENT
It can be more conveniently expressed as follows:
(
)
1 – 
​  1 n ​
(1 +r)
​  ​(Formula 2.10)
PVA = PMT × ​ 
​
r
(
)
1 – 
​  1 3 ​
(1.12)
​  ​
= R100 × ​ 
​
0.12
= R100 × 2.4018
= R240.18
Again, the above formula is particularly useful when a specific rate or period cannot be
found in the tables.
A set of tables, referred to as the present value of an annuity of R1 per period, has been
compiled. Table D provides the present value interest factor for the annuity (PVIFA).
Reading from Table D, the solution should be:
PVA = PMT × PVIFA3;12%
= R100 × 2.4018
= R240.18
We can also use a financial calculator to solve these problems and do so in a separate section
later in this chapter.
In order to conceptualise what is happening in practice, follow Table 2.5.
Table 2.5 Ordinary annuity
An investment of R240.18 today earning an interest rate of 12% will enable an investor to
withdraw an equal payment of R100 each year for three years. This is a very powerful concept
in real world financial applications. For example, you may wish to invest now to be able
to withdraw a pension of R100 000 per year for three years. Equipment may cost R240 180
and a company borrows this amount and is required to repay the loan and interest in the
form of annuity payments of R100 000 each year.
Stream of cash flows, annuity due
A stream of cash flows may be structured in such a way that the initial payment is received
immediately rather than at the end of the first period. The calculation of the present value
of an annuity structured in this way requires an adjustment to the tables. Because the first
payment is received immediately, its present value is equal to its quoted value – that is, it
does not need to be discounted.
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Example 2.14: Calculating the present value of an annuity due at 12%
An investor wants to buy an annuity of R100 for the next three years, each instalment being
paid at the beginning of the year. If a bank is prepared to pay interest at 12%, how much
must be invested today?
It can be seen that the amount will be invested and the first instalment will immediately
be repaid. It can be illustrated as shown in Table 2.6.
Table 2.6 Calculating the present value of an annuity due at 12%
Year end
Cash flow
0
R100
1
R100
2
R100
3
1
R89.29
(1.12)1
1
R79.72
(1.12)2
R269.01
How does an annuity due relate to an ordinary annuity? The following diagram reflects this
relationship in terms of how we will restate the formulae and the tables.
If Table D is used it will be noted that the reading is exactly the same as if it were a twoyear annuity, but we need to add one to the present value factor because the immediate
instalment is not discounted. Using Table D:
PVAdue = PMT × (PVIFAn – 1; 12% + 1)
= R100 × (PVIFA2; 12% + 1)
= R100 × (1.6901 + 1)
= R100 × 2.6901
= R269.01
The present value of R269.01 for an annuity due can be compared with that of an ordinary
annuity calculated in Example 2.13 with a present value of R240.18. The annuity due has a higher
present value because the cash flows occur earlier than in the case of an ordinary annuity.
Formula 2.10 can be adjusted for annuities due as follows:
1
​
​  ​
1 – ​ 
(1 + r)n – 1 +1
PVAdue = PMT ×
​  ​
​ ​ 
​
​
r
​  1 2 ​  ​
1 – ​ 
(1.12)
= 100 ×
+1

​ ​
​ ​
​
​
0.12
{[ (
{[ (
)]
)]
}
}
(Formula 2.10a)
= R100 × 2.69005
= R269.01
We can also multiply our solution to formula 2.10 by (1+r/m) to obtain the same value, so
that R240.18 × (1+0.12/1) = R269.01.
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FINANCIAL MANAGEMENT
What the formula is doing is reducing the number of discounting periods by one and
effectively adding [1 x PMT] to recognise that the present value of the first payment equals
its quoted value, as it occurs today.
In order to further conceptualise what is happening in practice, follow Table 2.7.
Table 2.7 Annuity due
Stream of cash flows, deferred annuity
A deferred annuity is an annuity which begins at some time in the future. This would occur if
an investor wanted to invest a sum of money now, but wanted the annuity to commence only
at some future date. An example of a deferred annuity is a pension plan.
Example 2.15: Present value of a deferred annuity
Let’s assume an investor wishes to invest a sum of money today which will yield three equal
instalments of R100, the first payable three years from today. If interest accrues at 12%, what
amount must be invested?
This is a present-value problem, requiring us to compute the value today of a stream of
future cash flows, the first of which is deferred. The cash flows can be illustrated as shown in
Table 2.8.
Table 2.8 Present value of an annuity deferred at 12%
Year end
0
1
2
3
Cash flowR100
R71.18
R63.55
R56.74
R191.47
1
(1.12)3
1
(1.12)4
4
5
R100
R100
1
(1.12)5
Table D is compiled on the assumption that the first cash flow arises at the end of period
one. Because of the deferred period, the table readings can easily be adjusted as follows:
PVA = 1 × (PVIFA5; 12% – PVIFA2; 12%)
= R100 × (3.6048 – 1.6901)
= R100 × 1.9147
= R191.47
The investment of R191.47 will earn interest for three years at the end of which the first
instalment of R100 will be paid out. The balance will earn interest for another year before
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2-19
the next instalment is paid out, and similarly for the third instalment. The amount of R191.47
is the amount which must be invested at period 0 to make the cash flows possible.
The following diagram indicates what is happening with a deferred annuity:
Figure 2.3 Deferred annuity
In the first three years, interest is earned until the end of Year 3 at a rate of 12%, when
the first withdrawal of R100 occurs. In Year 4, interest is earned on the balance of R169 so
that it will reach a level of R189 at the end of Year 4. After paying out another R100, there
remains a balance of R89, which with interest will grow to R100 by the end of Year 5, which
exactly equals the withdrawal of R100.
Uneven stream of cash flows
Companies will often be required to evaluate investments or projects which result in an
uneven stream of future cash flows. Further, cash flows may be negative in certain periods.
What do we do to determine present values in such cases? The annuity tables cannot be
used. Each cash flow must be treated separately and discounted using Table C: the present
value of R1. The present value of any cash flow can then be summed and the net present
value of the stream of uneven cash flows established.
Let’s go back to an earlier example. How do we evaluate Projects A and B?
Project
0
1
2
3
A
-20
16
5
5
B
-20
1
5
23
Cash flows in Rm
We are required to discount each cash flow. We will assume a discount rate of 10%. If we
add up the cash flows, Project A results in total cash flows of R26m, whilst Project B results
in total cash flows of R29m. Yet we have to wait longer for the cash flows of B. Let’s discount
each cash flow by applying the formula 1/(1 + r) n or by referring to Table C. Otherwise, you
can also use a financial calculator.
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FINANCIAL MANAGEMENT
Project
0
1
2
3
A
-20
16
PV Factor 0.9091
14.5455
5
0.8264
4.1322
5
0.7513
3.7566
Cash flows in Rm
}
Present Value 22.4343
If we do the same for Project B, the present value is R22.32m. This means that although
Project B has higher total cash flows, Project A has a higher present value of cash flows.
As the cost for both projects is equal, we would prefer to select Project A. We will use a
financial calculator to solve this problem later in the chapter.
Perpetuities
All annuities discussed so far have a finite life. The cash flows take place over a specific
time and then cease. There are cases of annuities which provide cash flows for an infinite
period. Such cash flows are called perpetuities. An example of perpetuity would be a nonredeemable preference share paying a fixed dividend.
Example 2.16: Calculating the present value of a perpetuity
An investor wants to buy 1 000 non-redeemable 9% preference shares of R1 each. If the
interest rate which he applies is 12%, what is the present value of the investment?
In essence the investor is buying a future cash flow in perpetuity amounting to 9% of
R1 000, that is R90. Because a 12% return on the investment is expected, this problem
requires the principal sum to be determined.
PV = 
​ PMT
r ​(Formula 2.11)
90  ​
= ​ 
0.12
= R750
The cash flow in perpetuity of R90 represents a return of 12% on R750. The investor who
requires a return of 12% will therefore be prepared to pay no more than R750 which is the
present value of the investment.
Let’s relate the formula of perpetuity to that of an annuity. We determine the present value
of an ordinary annuity by applying the following formula:
1 – 
​  1 n ​
(1 + r)
PVA = PMT
​  ​
​ 
​
r
As n approaches infinity, 1/(1 + r)n approaches zero and the formula becomes PMT × 1/r,
which is the perpetuity formula.
[
]
Growing perpetuities
If a cash flow is growing at a constant rate, then we call this a growing perpetuity and this is
a very useful concept in valuing companies, and so we will return to this in a later chapter
in another guise. The following could be a future cash flow stream which is discounted at a
given interest rate, r.
PMT2
PMT3
PMT1
​ + ​ 
​ + ​ 
​ + ..............
PV = 
​
(1 + r)
(1 + r)2
(1 + r)3
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2-21
If the payment is growing at a steady rate, then we can use the payment just made, PMT0,
and apply the growth rate and so the formula becomes:
PMT0(1 + g)
​
(Formula 2.12)
PV = 
​
(r – g)
We will come back to this in a later chapter and will explain the derivation of this formula
in greater detail.
If a company has just made a payment of R10 million and this is expected to grow at the
expected inflation rate of 3% per year and the discount rate is 8%, then the present value
of this payment stream is:
10m(1 + 0.03)
PV = _____________
​     ​= R206 million
(0.08 – 0.03)
Growing annuity
If an amount is growing at a constant rate for a specified number of years, then we can use
the following formula to determine the present value rather than discounting each cash
flow.
[
]
(1 + g)n
1 – ​ n ​
(1 + r)
PV of a Growing Annuity = PMT (1 + g) ×
​  ​
​ ​ 
r–g
(Formula 2.13)
Assume that you have just graduated and you are expecting an annual salary of R360 000
(today’s value) which you expect to grow at a rate of 6% per year for the next 40 years, at
which time you will retire. What is the present value of your future salary over your working
life if your required return is 9% per year? Assume an annual salary payable once a year.
[You can easily change this by using monthly rates and your monthly salary.]
[
]
(1.06)40
​
1 – ​ 
(1.09)40 = R8 554 551
PV of a future salary = R360 000 (1 + 0.06) ×
​ ​    ​
0.09 – 0.06
This means that the present value of your future salary earned over 40 years is just over
R8.5 million. This is before taking into account such issues as taxation which will reduce the real
worth of your future salary. We are assuming that your first year’s salary will be R381 600.
We can do these calculations the ‘long’ way by using Excel spreadsheets. Invariably this is
how it is done in practice and we will show you later how to use Excel spreadsheets to solve
time value of money problems.
Inflation and real returns
The effect of inflation is to reduce the value of money over time. Whilst investing in a bank
account may offer an interest rate of 4.8% per year, we need to consider the impact that
inflation will have on the purchasing power of money. If expected inflation is 3% per year
then you are not really making 4.8%. A R1 000 investment earning 4.8% will result in you
accumulating R1 048 by the end of the year. However, you will need R1 030 at the end of the
year for what you could have purchased for R1 000 at the beginning of the year. Obviously, this
will affect pension decisions as we may think that a pension of R30 000 per month is sufficient
but that is based on its current purchasing power. What will a pension of R30 000 per month
starting in 30 years’ time be able to purchase in relation to today’s prices? In other words,
what is the present value of R30 000 in 30 years’ time? Inflation of 3% per year amounts to
0.25% per month.
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[
]
1
PV = R30 000 × ​ 
​
​  ​
(1.0025)360
PV = R30 000 × 0.4070 = R12 210
This means that a pension of R30 000 in 30 years’ time will be able to buy only what R12 210
can buy today, and that is at the beginning of the retirement period. It is worse at the end.
The moral of the story is to include inflation in your investment calculations. A real return
refers to the return we make after deducting inflation. If an investment is offering 4.8% per
year and inflation is 3%, then the real return is approximately 1.8%. A more accurate way
of calculating the real return is as follows:
1 + real return = (1 + nominal return) / (1 + inflation rate)
We will come back to this again in a later chapter.
3 Some real world applications
Retirement planning
Time magazine ran a cover which read: ‘Will you EVER be able to RETIRE?’ This explored
the effect that falling share prices would have on the retirement prospects of millions of
Americans. In South Africa, the combined effects of people living longer lives, low interest
rates and lower expected future returns from the share market, mean that the economy
will not be able to afford to pay old age pensions and retirees will not have accumulated
sufficient amounts in their pension funds to retire comfortably. This issue is compounded by
the low savings rates of South Africans. A few years ago, a Business Day editorial indicated
that only 6% of South Africans would be able to retire without experiencing a reduction
in their standard of living. Referring to an Alexander Forbes survey, the editorial stated that the
average employee will retire on a pension equivalent to 28% of his/her final salary. Employees
are contributing less than 10% of their salary to their pension fund whilst Old Mutual reported
that employees should contribute 15% of their salary over 40 years in order to maintain their
standard of living on retirement.
Time value of money principles are critical in retirement planning. Whilst the last thing
on your mind may be retirement, it will affect your parents, and the earlier you start the better
off you will be. Increasingly there are careers in financial planning and managing pension
and retirement funds. So, how can we apply time value of money principles to retirement
planning?
It is useful to be able to determine the single sum investment or the annuity required
to provide adequately for retirement. To achieve this, an investor must estimate the length of
time prior to retirement, the return that will be earned on the funds invested during and after
this period and, finally, the amount of funds required for retirement.
As most investors are not in a position to invest single lump sums, retirement plans are
generally structured to require monthly contributions from the investor. On retirement, the
investor will usually receive a pension which is in the form of an annuity.
Example 2.17: Calculating the required contribution to a retirement fund
Kate Smith wishes to retire in 30 years’ time and has estimated that she will require a
monthly pension income of R24 000 per month for 20 years subsequent to retirement. Kate
will contribute to a retirement fund which will enable her to take out a monthly pension of
R24 000 after retirement. The retirement fund is currently earning a return of 9% per annum,
interest compounded monthly, and this level of return is expected to remain unchanged and
to be sustainable over the next 50 years. Determine the monthly contribution that Kate is
required to make to the retirement fund over the next 30 years.
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First we need to calculate the present value required at retirement date to generate an
annuity of R24 000 per month for 20 years. The interest rate is 0.75% per month (9%/12)
and there are 240 months (12 3 20). The ‘present value’ of the pension in 30 years’ time is
established as follows:
[
]
1
1 – _________
​
​
(1.0075)240
PV = 24 000 × ​​ _____________
​  ​
​
0.0075
= 24 000 × 111.14495
= R2 667 479
This is the present value of the amount required to sustain a monthly payment of R24 000
for 20 years. This is the amount that she needs to accumulate in 30 years time to be able to
purchase an annuity or pension of R24 000 for 20 years after retirement.
The monthly contribution required over the next 30 years to generate an accumulated sum
of R2 667 479 is calculated as follows:
[
]
(1.0075)360 – 1
R2 667 479 = PMT × ​ 
​  ​
​
0.0075
= PMT × 1 830.7435
PMT = R2 667 479/1830.7435 = R1 457.05 per month
Of course, the above solution assumes that we are able to predict the return the fund will
earn and the amount required at retirement age. In practice this is often very difficult as
factors such as inflation and future returns are largely unknown. However, the advantage of
such an exercise is that it gives us an indication, based on certain assumptions, of the level
of investment required.
Let’s see what happens when three very realistic events occur: people live longer, start
saving later and the returns on retirement funds are expected to be at lower levels in the
future. What happens to the required monthly payment if the expected lifespan after
retirement is 30 years, returns have fallen to 6% per year and Kate starts saving only 20 years
before retirement? Do the workings and you will find that Kate will need to have accumulated
R4 002 999 by retirement date and this translates into a monthly contribution of R8 663.73 per
month for the next 20 years. This is almost 6 times the figure of R1 457.05 with our previous
assumptions. So it is easy to understand why there are corporate pension plans under water
and investors unhappy owing to falling returns, although I am sure they are not complaining
about living longer lives. Governments will find it difficult in the future to afford the payment
of adequate old age pensions and the government is promoting later retirement. Increasingly
we will see older people doing part-time work to supplement pensions. The pension crisis is on
the horizon, so plan early.
Loan amortisation schedules
There are many real world applications of the repayment of loans on the basis of equal
instalments over a number of years. What are some of the applications that will affect
you now and in the future? Firstly, you may need to repay a student loan on the basis of
instalments. You will purchase a car and may need to repay the car financing loan on an
instalment basis. Also, you may purchase residential property which requires that you repay
a mortgage loan over 30 years in monthly instalments.
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Let’s firstly assume the following example.
You have purchased an old but beautiful red Alfa Romeo for R100 000. The dealer has
given you a car loan at an interest rate of 7% per year, interest compounded annually and
repayable in equal instalments over 5 years. What is the annual instalment?
[
]
1  ​
1 – ​ 
(1.07)5
​  ​
R100 000 = PMT × ​ ​  
0.07
PMT = R100 000/4.1002
= R24 389.07 per year
This can be broken down into payment of interest and principal and set out in a loan
amortisation schedule as in the following table.
Table 2.9 Loan amortisation
The first instalment of R24 389.07 is made up of R7 000 of interest (R100 000 × 7%) and
a repayment of principal of R17 389.07. The balance at the end of the year is R82 610.93
(R100 000 – R17 389.07). The second instalment at the end of the second year includes
interest of R5 782.77 (R82 610.93 × 7%) and a repayment of capital of R18 606.30. The
interest component falls over time as the capital amount is reduced to zero by the end of
the 5th year.
Mortgage loan
Assume that you have set your heart on an apartment that is 5 minutes from the beach and
the price is R2 million. You have managed to obtain a 100% mortgage loan from the bank
at an interest rate of 7.2%, interest compounded monthly, which means that you will be
charged a monthly interest rate of 0.6%. The term of the loan is 30 years i.e. 360 months.
What is your monthly repayment on the mortgage loan?
​[
]​
1
​
1 – ​ 
(1.006)360
​  so PMT = R2 000 000/147.3214
R2 000 000 = PMT × 
​
0.006
= R13 575.76 per month
If we draw a graph of the mortgage loan amortisation schedule over 30 years, it will indicate
the balance of interest and the amortisation of the mortgage loan. The principal component is
relatively small but increases over time. This can be quite disheartening in the first few years.
For example, of the first month’s instalment of R13 575.76, the interest component is R12 000
and only R1 575.76 will be allocated to repaying the R2 million loan. A monthly instalment of
R13 575.76 over 30 years will result in the repayment of the R2 million loan and interest. So
how much interest will be paid over the term of the mortgage loan?
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Figure 2.4 Loan amortisation
If we multiply R13 575.76 by 360 months, we find that the total amount paid is close to
R5 million (R4 887 274) and so total interest amounts to R2 887 274. That is quite a sum
and so next time someone tells you that he purchased an apartment for R2 million and sold
it for R5 million, the sums are a little more complicated than they seem. There are costs
such as maintenance and you have to live somewhere so take off the rent you would have
had to pay.
4 Financial calculators and spreadsheets
Using financial calculators
Financial calculators are programmed to compute future values and present values and
other related variables. Financial calculators require you to enter the data using the relevant
Input keys which for the HP-10BII are as follows:
What do these keys mean?
N = number of periods
I/YR = interest rate as a percentage
Enter a number, so if the rate is 10%, enter 10, not 0.10. Other calculators may reflect the
interest rate per period as [i] and the number of periods as [n].
PV = present value
PMT = annuity payment (Specify this as a zero when working with single sums only.)
FV = future value
In most cases, three or four inputs will be specified, and the financial calculator will solve
for the remaining variable. On some calculators you will need to press the COMPUTE key
prior to pressing the missing input key.
What to watch out for when using a financial calculator
Outflows are recorded as negative cash flows. An investment will be recorded in present
value terms as a negative amount. If you borrow, you will receive the loan amount today
which will be recorded as a positive cash flow and the repayments will be reflected as
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negative amounts. Ensure that you clear the memory. Enter a zero for any variable that is
not relevant in a particular case. For example, when determining the future value of a single
sum investment, enter a zero for the PMT key.
Ensure that the financial calculator is programmed for annual compounding by doing
the following steps:
Enter 1, then press SHIFT key and then the PMT (P/YR) key. We will make adjustments
later for non-annual compounding.
Let’s do some of the previous examples by using an HP-10BII financial calculator.
An investment of R100 invested for 10 years earning 12% per year compound interest will
result in a future value of R310.60. Key in the following input values and press the FV key
for the solution.
First enter the present value as a negative number, –100 or press 100 followed by (–),
depending on the calculator being used, and then press the PV key. Then enter 10 and press
N, enter 12 and press I/YR, enter 0 and press PMT and then press FV (or Comp FV) to find
the answer.
If given a FV of 310.6 with the number of periods being 10 and an interest rate of 12%,
then key in the following variables and press the PV key to find the answer of –100:
What is the interest rate that will achieve a present value of R100 growing to R310.60 within
10 years? Enter the inputs, then press the [I/YR] key to determine the interest rate of
12%.
We have assumed so far that the company has annual compounding. If the compounding
period is less than a year, then we will need to input the number of compounding periods per
year. This requires us to press the number of periods per year, then press the SHIFT key and
(P/YR).
Let’s go back to the first example and assume monthly compounding. We need to program
the financial calculator for monthly compounding by undertaking the following steps:
Enter 12, and then press the SHIFT key and then the PMT (P/YR) key.
This means that the financial calculator is now programmed for monthly compounding. The
present value is R100, the interest rate is 12% per year and N is 120 months.
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Remember to input the annual interest rate. The financial calculator will divide it by the
number of compounding periods per year. The effect of compounding interest each month
rather than each year is to increase the future value from R310 to R330. Remember to input
the number of months.
Present values
What is the present value of an annuity of R100 per year for three years at an interest rate
of 12%?
The present value is R240.18. This assumes that the annuity occurs at the end of each year.
What is the present value of an annuity that starts at the beginning of each year? Firstly,
set the calculator to the beginning of year by pressing the SHIFT key and press the BEG/
END key. Then enter PMT of –100, N of 3, I/YR of 12, FV of 0 and then press PV to find
the answer of R269.
Remember to reset your financial calculator back to end of period mode by pressing the
SHIFT key and the BEG/END key. Usually we will assume that cash flows occur at the end
of each period. Remember always to ensure that you clear the memory and all previous
inputs by pressing the SHIFT key and then the C ALL key.
How do we use a financial calculator to determine the present value of an uneven stream
of cash flows? We will use the CFj and the I/YR keys to input data and press the NPV key
for the answer. Let’s assume that Project A has the following cash flows:
YR
1
2
3
CF Rm
16
5
5
Assume there is no cash flow now today, i.e. time zero. You will still need to input a value,
so enter zero. Firstly, input 0 then press the CFj key, then input 16 and press the CFj key,
input 5 and press the CFj key, input 5 and press the CFj key, input 10 and press the I/YR
key and then press the SHIFT key followed by pressing the NPV key to find the answer of
R22.4343m.
Using Excel spreadsheets
Although financial calculators can be very useful, in practice managers will prefer to use
Excel spreadsheets to solve time value of money problems. Excel is a very powerful tool
in many applications of corporate finance and useful in financial modelling. Like financial
calculators, Excel has many built-in time value of money functions, yet it goes further as it
allows us to obtain a visual perspective and permits us to put cash flows on a time line by
using a cell to reflect a time period. It also allows us to build financial models so that we can
see the effect of changing variables without redoing the whole calculation.
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We place the relevant values in cells. Although this is not necessary as we can use Excel as
a financial calculator, it does represent best practice as it enables us to undertake sensitivity
analysis. Values are therefore anchored in cells and when we change the value in a particular
cell the answer will change. We will use Excel to solve a few time value of money problems.
What is the future value of R10 000 invested today for 20 years at an interest rate of
6% interest compounded annually? In Excel we will place these values within cells. In our
example there are no annuity payments and so the type (beginning of period =1, end of
period =0) is not relevant. We have used Cell B8 to place the Future Value function which
is; =FV(rate, nper, pmt, PV, type). We place the rate in Cell B6, and the number of periods
is placed in Cell B5. The PV is placed in Cell B3. The payment (pmt) is placed in Cell B4
and type is placed in Cell B7.
The objective is to calculate the future value and so we type the Excel Future Value function
in Cell B8, which in this case would be: =FV(B6,B5,B4,-B3,B7). The answer of R32 071
appears in the cell. What this means is that we can now change each variable and see what
happens to future value. For example, if we expect that the interest rate will be 10%, then
place this in Cell B6, and the answer in Cell B8 will now indicate a value of R67 275.
Let’s use Excel to determine the present value of an ordinary annuity of R7 000 per year
for 5 years at an interest rate of 6% per year. We will use the same Excel function but we will
use a separate worksheet. Insert R7 000 in Cell B3 as the payment and 6% in Cell B4 as the
discount rate. We will place 5, being the number of payments, in Cell B5. The future value is
zero and we place this in Cell B6 and place a 0 for type in Cell B7, to indicate that this is an
ordinary annuity. This means that the annuity payment is received at the end of each period
and starts in this case, in a year’s time. In Cell B8, we insert the Excel function, =PV(rate,
nper, pmt, FV, type) and refer to the relevant cells where these variables have been placed.
The answer is R29 486.55.
What is the present value if the annuity was an annuity due? If this is the case, then simply
change the value of Type, B7, to 1. The present value indicated in Cell B8 will increase to
R31 255.74.
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The main functions in Excel to solve time value of money problems are:
Future Value:
Present Value:
Interest rate:
Number of periods:
Payment:
= FV (rate, nper, pmt, PV, type)
= PV (rate, nper, pmt, FV, type)
= RATE (nper, pmt, PV, FV, type)
= NPER (rate, pmt, PV, FV, type)
= PMT (rate, nper, PV, FV, type)
There are many other functions that you can use but we have limited this to the above for
now. In most cases you can omit the type or indicate a zero. Excel indicates which variables
are important to enter.
In Excel we can also set out the cash flows in Cells with each cell indicating a time period.
This is particularly useful for determining the present value of uneven cash flows, but we
can use it also for any type of cash flow. We then use the =NPV function which will discount
the future cash flows at a specified discount rate. Remember that the NPV function assumes
that the first cash flow occurs in one period’s time from today.
The NPV function in Excel requires us to indicate the discount rate and the RANGE of
cash flows to be discounted and will assume that each cell represents a period. We simply
indicate in a Cell =NPV(rate, range). In the following example, the discount rate has been
placed in Cell E3 and the cash flows have been placed in Cells C5 to G5. Therefore in Cell
B7, you will type =NPV(E3, C5:G5) and the answer will indicate R29 486.55.
If we are discounting a series of cash flows which commence today, then we should indicate
the range that should be discounted, in this case C11 to F11 and then add today’s cash flow
at today’s value. In reality we are discounting the cash flows in periods 1 to 4 by using the
NPV function and adding to this the value of Cell B11, which is R7 000.
The NPV function is very useful for discounting a series of uneven cash flows.
We will come back to the use of Excel spreadsheets in later chapters. We have just touched
the surface in terms of using spreadsheets to solve corporate finance problems.
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5 The role of interest rates
When we borrow money, we need to pay for the use of these funds. This is interest and the
interest rate is normally indicated as a percentage of the amount borrowed, which is called the
principal amount. A company may borrow to invest in plant and equipment and is prepared to
pay for the loan because the use of the borrowed funds is expected to generate a value greater
than the cost of borrowing. The bank lending the funds to the firm will lend at a rate that is
higher than the cost of such funds to the bank. The bank may be borrowing from other banks,
its depositors, the South African Reserve Bank or from the issue of bonds. Supply and demand
for funds will drive interest rates, although the South African Reserve Bank can influence
short-term interest rates by setting the “repo” rate, which is the interest rate that banks borrow
from the South African Reserve Bank.
In general, the interest rate, which represents the return required by the lender, is
influenced by three main variables. They are:
■■ The time value of money. People prefer to receive money sooner rather than later. This
principle arises because money can be invested to earn more money. Thus the earlier
cash is received, the greater is the potential for increasing wealth.
■■ The risk of the capital not being repaid. If there is some uncertainty that the capital amount
will be repaid, a premium will be required. When there is a high degree of certainty,
for example in the case of loans to the government in the form of treasury bills, bonds
or other ‘gilt’ investments, the premium will be low. This is consistent with the most
fundamental principle in financial management: that return must be commensurate with
the risk taken.
■■ Inflation. In times of rising prices it is evident that the purchasing power of money
decreases over time. Any lender would expect to be compensated for this decline in
purchasing power. If the interest rate did not compensate for inflation the lender would
be poorer when the capital is repaid than at the time of the loan.
Liquidity will also impact on the interest rate. If a security is liquid, then it can be converted quickly
into cash at a realistic or fair value. Investors will demand a liquidity premium if a company’s
bonds are not liquid. The lack of liquidity was an important factor during the global financial crisis.
The rate of interest does not remain constant but depends on expected changes in
these variables. Figure 2.5 represents a typical yield curve which reflects the ruling interest
rates on investments maturing at various times in the future. The term structure of
interest rates, as it is called, reflects the rates of interest charged at any given time for
borrowing over different periods, from short-term to long-term. It seems reasonable to
expect that longer-term loans carry more risk than short-term loans, so we would expect to
see an upward-sloping curve. If this is coupled with the expectation that inflation rates are
likely to escalate in the future, an upward slope such as that in Figure 2.5 would result.
14
12
10
8
6
4
Figure 2.5 Typical yield curve
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So what is the yield curve in South Africa? This is also called the term structure of interest
rates. Yields quoted for RSA Government Fixed Coupon bonds on 7 March 2014 were as
follows and we can plot a yield curve to depict the term structure of interest rates.
Table 2.10 South African Government Bond Yields
Government bonds pay varying coupon interest rates. A coupon rate of 10.5% for the R186
issue means that the South African government will pay investors R10.50 per year on a R100
bond. This is normally paid semi-annually, so an investor will receive R5.25 per R100 bond
every half year. The coupon rate stays fixed at 10.5%. However, the price that this bond
is trading at means that investors will receive a yield of 8.5% per year. The R186 will be
redeemed in 3 instalments on 21 December 2025, 21 December 2026 and 21 December 2027
when the par value of R100 will be repaid to investors. If we plot these yields, we can see
that generally the yield curve in March 2014 is upward sloping.
Figure 2.6. Yield curve in South Africa
A number of theories have been developed to explain the term structure of interest rates.
The most commonly quoted theories are the expectations theory, the liquidity preference theory
and the market segmentation theory. We can also refer to the precautionary motive for holding
liquid or short-term assets.
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The expectations theory
Assuming an investor is faced with the choice of investing a sum of money for one year in a bond
at a fixed interest rate, or for five years in a five year bond. Which alternative will be chosen? If
it is expected that interest rates will decline during the next five years, it will be better to invest
for five years as a higher interest rate will be obtained from the investment than if a series of
five one-year investments had been made. If this expectation of generally declining interest
rates was held by all investors, then the five-year investment would be in greater demand if
offered at the same rate as the one-year investment. This demand would force the rate of the
five-year investment down, until both alternatives would be equally attractive.
This leads to the question of which factors are likely to contribute to expectations
relating to the increase or decrease in interest rates on bonds. The expected inflation rate
is a significant factor. An investor would clearly hope at the end of a year to be at least as
wealthy as the result of an investment as at the beginning of the year. The interest received
should therefore at least compensate for the loss of purchasing power as a result of inflation.
In fact, as most interest received is taxable, the investor would expect the after-tax interest
to at least compensate for inflation. In essence, the expectations theory holds that the slope
of the term structure of interest rates depends on the expected future spot rates of interest. If it is
expected that future rates of interest will be higher, the yield curve will be upward-sloping.
The liquidity preference theory
A second theory which attempts to explain the term structure of interest rates introduces
an element of risk. When dealing with gilt investments such as government bonds, the risk
is not related to default on the capital invested, but rather to interest rate fluctuations. For
example, assume you hold both a 6-year RSA Government and a one-year RSA Government
Bond, each with a coupon rate of 8%, when the market rate of interest is also 8%. If the
market interest rate rises, the negative effect on the value of the 6-year RSA Bond would be
far greater than on the one-year RSA Bond. The interest rate risk is greater, the longer the
period to maturity. Figure 2.7 illustrates the effect of changes to the market interest rate on
the price of two 8% RSA Bonds with differing maturity dates.
Figure 2.7 Value of 8.0% RSA Bonds on 1 October 20x6
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As these investments are RSA Bonds, the risk of default on repayment is virtually zero.
However, there is considerable risk for the longer-term bond if market interest rates
increase. If the market rate on 1 October 20x6 is 8%, the value of both bonds will be
the same at R100. If the market interest rate rose on that date to 11%, for example, the
value of the 6 year Bond would decline by R12.69(100.00 – 87.31) considerably more
than the decline in value of the 1 year Bond due at the end of September 20x7, of only
R2.70 (100.00 – 97.30).
The reasons for the greater variability of the 6 year bond stems from the difference in
the timing of the cash flow between the two investments. Investors holding the 6 year bond
are locked into receiving a 8% return on R100 for 5 years longer than holders of the 1 year
bond.
As investors prefer certainty to uncertainty, the theory holds that investors will generally
prefer short-term investments to long-term ones. As a result the short-term rates will tend
to be lower than long-term rates because of the higher demand for short-term investments.
However, short-term bonds are exposed to reinvestment rate risk. When we need to reinvest
maturing short-term bonds (‘rolling-over’) then we are uncertain what the interest rate will
be at the time.
The market segmentation theory
The market segmentation theory is based on the premise that different investors have
differing investment preferences as to timing due to legal, regulatory, business and personal
motives. Life insurance companies and pension funds have long term liabilities and prefer
to invest in securities which have distant maturity dates. Banks may invest in short-term
securities as most of their liabilities are of a short-term nature. This theory implies that
interest rates are determined by demand and supply factors in these market segments.The
other factor is that the Reserve Bank will have a greater influence over short-term rates
rather than long term rates.
6 Applying the time value of money principles to bonds
The principles of the time value of money are applied in the valuation of bonds. A bond
is a financial instrument issued by government and companies to raise funds. The bond or
debenture will stipulate that the issuer is obliged to pay the bond holder a fixed interest or
coupon rate until the maturity of the bond when the capital amount, usually R100, will be
repaid to the bond holder. The bond document is a negotiable instrument, meaning that
it can be traded during its life span by investors wishing to buy or sell bonds. The name
dates back to earlier days when the bond certificate had attached to it, a series of coupons,
which entitled the bondholder to collect the interest by surrendering each coupon on the
due date.
A Treasury bond is in fact a loan to the government for a number of years. The name of the
bond is the RSA Government bond; the annual interest rate payable may be 7.5% (the coupon
rate); the year in which the capital amount of the loan will be repaid may be 2023 (the year of
maturity). An investment in a bond is thus the purchase of a stream of expected cash flows.
The cash flows are virtually certain, given the credibility of the issuer of the bond, and are thus
considered to be a low risk investment. Investment in bonds are most typically made by large
pension funds, to ensure that the fund has an allocation of low risk investments with a certain
interest cash flow to the fund.
The terminology and valuation procedures relating to bonds and bond portfolios are
complex and detailed coverage is not undertaken here. We will focus on applying the time
value of money principles we have studied so far.
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FINANCIAL MANAGEMENT
■■ A bond is a financial instrument offering two distinct cash flows. Firstly, it offers
a stream of regular cash flows in the form of coupon payments. Using time value
principles, this is identical to annuity cash flows on regular, equally spaced time periods
in the future. Secondly the repayment of the nominal value will occur on maturity date.
Using time value principles, this is the equivalent of a single sum payment at a determined
future date.
■■ An investor who purchases the bond and holds the bond to maturity has a high degree
of certainty that each coupon amount of R3.75 will be paid twice a year (semi-annually)
on the specified dates, and that the face value or par value will be returned on maturity
date. The investor will thus receive a coupon return of 7.5% per year.
■■ Bonds may be bought and sold during the period from issue to maturity. It is not
uncommon for a bondholder to sell a bond to a willing buyer, who wishes to hold bonds
at a time when a new issue is not available.
■■ The selection of the coupon rate is dependent upon economic factors at the time of
the issue. Prevailing interest rates, inflationary expectations and the expected return of
investors from bonds in a similar risk category are the most important factors. These
determine the required rate of return of investors in bonds. The required rate of return
is also referred to as the Yield to Maturity (YTM).
■■ Even more significant in understanding what follows, is the awareness that interest rates
in the economy may change during the life of the bond. Such changes will impact on the
YTM, and therefore on the value of the bond. Note, however, that if the bondholder
simply retains possession of the bond, the return to the bondholder over the life of the
bond will be 7.5% per year.
■■ There are consequently three variables that impact on the value of a bond. They are
firstly the coupon rate at which the bond was issued, secondly the ruling market rate
in the economy at the time of valuation, which is reflected in the required YTM, and
thirdly the period of time remaining to maturity.
We are now in a position to explore the valuation of bonds. We will value an RSA Government
security which has a fixed coupon rate of 10% per year, and a face value of R100. Coupon
interest is payable semi-annually and the maturity date is the end of October 2018. Assume
the current date is 1 November 2014. The current market yield (yield to maturity) on similar
securities is 8% per year (4% per half-year)2. What is the value of this RSA Government
security? The future cash flows from investing in this security can be depicted as follows:
The discount rate to apply to the future cash flows will be 4% per half-year (8%/2). We will
assume that the cash flows will occur at the end of April and October of each year
The valuation of the bond can be done in two steps using the principles of present value
calculation. Step 1 entails discounting the coupon cash flows, which are an annuity, using
Formula 2.10. Step 2 entails discounting a single sum, the nominal value to be received on
maturity date, using Formula 2.3.
In terms of market convention, we quote rates on an annualised basis (interest rate per period × number of
periods in a year). This is not the effective annual rate, which is (1.04)2 = 8.16%.
2
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Step 1: Present value of an annuity of R5 for 8 periods at 4% per half-year.
[
]
1 – 
​  1 8 ​
(1.04)
​  ​
PVA = PMT × ​ 
​
0.04
PVA = R5 × 6.7327
= R33.66
Step 2: Present value of a single amount of R100 to be received in 8 periods’ time at
4% per half-year.
PV = R100 3 0.7307
= R73.07
Sum of two streams of cash flows = R33.66 + R73.07
= R106.73
We can also use the present value factors for each cash flow and then sum the present values
to obtain the value of the bond. Otherwise, use the NPV function in Excel to discount the
future cash flows at 4% per period.
The value of the bond is trading at a higher value than par because investors are requiring a
return of 8% per year (4% per half-year) and the bond is offering a coupon rate of 10% per
year (5% per half-year). A price of R106.73 means that investors will receive a return of 8%
per year (4% each half-year) until maturity. If market interest rates rise to 12%, then the
value of the bond would fall to R93.79, which is below par as the bond is offering only 10%
per year whilst the market is offering at 12%. At a price of R93.79, investors will receive a
return of 12% per year (6% per half-year). If the market interest rate is 10% per year, then
the market value should equal the par value of the bond. If we redo the valuation at 10%
(5% per half-year) we will see that this is true.
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A useful point to note here is that investors and bond portfolio managers aim to forecast the
timing and magnitude of interest rate changes in the economy. It is evident that if a fall in
market interest rates is correctly forecast, the purchase of bonds prior to that date will result
in a significant capital gain on sale, after the YTM responds to the rate fall.
We have seen a fall in market interest rates (and inflation) over the last 10 years in South
Africa, and interest rates in the USA and Japan have been at historically low levels. Also
refer to the South African Reserve Bank website (www.resbank.co.za) for more information
about interest rates. The fall in interest rates has resulted in a rise in bond values over this
period.
We saw in a previous example that the price volatility increases with the term to maturity.
Therefore the value of a 5-year bond will change to a greater extent than a 1-year bond.
However, the price volatility is also linked to the coupon rate. The lower the coupon rate
the more volatile will be the changes in price to changes in interest rates. This simply reflects
the fact that you can reinvest the coupon payments at the market rate. A composite measure
of term to maturity and coupon is called a bond’s duration and the greater the duration of a
bond, the more sensitive a bond’s value will be to changes in market interest rates.
In conclusion to this section on bonds, the following principles summarise the use of time
value principles and the impact on bonds:
■■ A bond offers two cash flows – a series of coupon payments at a specified constant rate,
and the repayment of the nominal value of the bond at maturity.
■■ When the yield to maturity (YTM) differs from the coupon rate, cash flows are
discounted at the YTM in order to establish the present value of the bond.
■■ If the YTM moves above the bond coupon rate, the value of the bond falls below its par
value. If the YTM moves below the coupon rate, the value of the bond rises above its
par value.
■■ When the YTM differs from the coupon rate, the length of time remaining to maturity
of the bond impacts on the magnitude of the difference between the nominal value and
the market value.
■■ The longer the term to maturity, the greater the impact on present value. This was
graphically presented in Figure 2.7.
■■ Although not illustrated here, it also follows that if two bonds have different coupon
rates, the value of the bond with the lower coupon rate will change relatively more than
the bond with the higher coupon rate when the market YTM rises or falls.
■■ Finally, apart from the typical bond as described, bonds may come with other
characteristics. Bonds could have call options, which applies to some corporate bonds.
This allows the company to redeem the bonds at the option of the company, prior to
maturity date. RSA Government securities will pay coupons semi-annually (twice each
year). The cash flow line is thus constructed in periods of 6 months rather than annually.
Another example is a zero coupon bond, where there are no coupons. Only the future par
value, repayable on redemption date is therefore discounted to the present by the YTM.
Summary
In this chapter, we have focused on an important and fundamental concept in financial
management, namely the fact that money has a time value. The time value of money is one
of the variables that affects the interest rate. Two other variables that affect the interest rate
are expected inflation and risk. The risk attached to an investment relates to the expected
stream of cash flows from the investment as well as the ultimate return of the capital sum
invested.
If money is being loaned or invested, the investor expects the future value to be greater,
because a reward for permitting another person the use of the funds must be received, in
addition to the repayment of the original amount invested. The future value is determined
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by compounding the interest at the agreed rate. It may be important to calculate the
effective annual rate when comparing different options. This differs from the quoted rate
when interest is compounded more frequently than once a year. It is the effective rate which
is relevant for purposes of comparison and evaluation. Two basic types of future values can
be identified. They are the future value of a single amount investment and the future value
of an annuity.
The determination of present values is even more important in financial management
than future values. Present values of cash flows will clearly be lower if the cash flows
are to be received in the distant future. The interest factor is therefore used to discount
expected future cash flows to their present value. Some present value calculations require
special attention. They are the cases of annuities due, deferred annuities, uneven streams,
perpetuities, and instalment loans.
Mortgage loan amortisations and retirement planning are two cases where time value of
money principles are applied. The valuation of bonds illustrates another significant area for
applying these principles. A bond is essentially a long-term loan, which offers the holder a
series of stable cash flows during its life and a repayment of the nominal amount on maturity
date. It was shown that the value of a bond may fluctuate dependent upon the coupon rate
on the bond, the yield to maturity required by investors and the period of time remaining
to maturity.
We used examples to illustrate the more important formulae and to demonstrate the use
of the tables. We also expanded on the use of financial calculators and Excel Spreadsheets
to solve time value of money problems. The concepts developed are not complex. However,
great care must be taken to formulate each problem correctly and to recognise the type of
investment which a particular situation reflects. Many of the concepts developed in this
chapter will be used extensively later in the text.
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S
SELF-STUDY PROBLEMS
S2.1
You deposit R10 000 in a bank account which is paying 4.8% per year, interest compounded
annually. How much will you have accumulated in the account in 5 years time? What will
you have accumulated if interest is compounded monthly?
S2.2
You have purchased a motor car for R120 000 and you have obtained a car loan for the total
amount, which requires you to pay this amount over 5 years at an interest rate of 7.2%. If
interest is compounded monthly, determine the monthly payment required over the 5 years
if the first payment is due immediately.
S2.3
What is the present value of a zero coupon bond, with a par value of R100, which is due to
be redeemed in 10 years’ time, when the current market interest rate for such bonds is 6%,
interest compounded semi-annually?
S2.4
You wish to purchase an apartment in Port Elizabeth which is situated in a tree-lined
avenue. The purchase price, with costs, is R710 000 and you are able to obtain a 100%
mortgage loan at an interest rate of 6%, interest compounded monthly. The term of the
loan is 20 years. Assume that property values are expected to rise at a rate of 9% per
year (0.75% per month). You will be able to rent out the apartment after costs at a rate
of R4 000 per month for the first year. Interest and rent are payable at the beginning of
each month.
Required:
What is the expected value of the apartment in 20 years time? What is the mortgage loan
repayment at the beginning of each month? What is the net amount you have to pay in each
month?
S2.5
Wayne Rooney signed a four-year extension to his contract with Manchester United in
February 2014. Manchester United is required to pay £15.6 million per year until June 2019
which amounts to £300 000 per week. However, this amount is taxable. Assume a UK tax rate
of 45%. The effective date of the new contract extension begins on 1 July 2015. The current
contract, which is for £250 000 per week, comes to an end at 30 June 2015. It has been reported
however that Rooney’s endorsement earnings of £1.8m per year were significantly less than
that of Messi and Cristiano Ronaldo. The Portuguese footballer is expected to earn £15m in
endorsement earnings for the year up to June 2015. He has other earnings from projects such
as his underwear line CR7, which we will ignore. Earnings from image rights are expected to
increase to £17m for the year ending 30 June 2016 and are expected to grow by 7% per year
after 2016 until 2019. Ronaldo’s after-tax salary (with bonuses) until 30 June 2015 is £15m per
year. Earnings from image rights for Rooney are expected to grow by 7% per year from 2014.
Ronaldo signed a new contract with Real Madrid to extend his current contract, which
expires in June 2015, for another 3 years until 2018. We will however assume that he will be
able to renew his contract for a further year until June 2019, on the same terms. The new
salary (after tax) amounts to £17.6 million per year and Ronaldo will become the highest paid
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footballer in the world. Ronaldo won the Ballon d’Or again in 2014 and Ronaldo scored over
225 goals for Real Madrid up to 2013. In terms of image rights, Ronaldo split this income 6040 with the club but his share has been increased under the new contract. Ronaldo’s salary is
after tax but you can assume he pays a 52% tax rate on his earnings from his image rights. The
relevant interest rate is 5% per year. We will assume that all payments to the players occur at
the end of each year. Assume that the current date is 1 July 2014.
Required:
What is the present value of Rooney’s after-tax earnings at 1 July 2014? What is the present
value of Ronaldo’s after-tax earnings on the same date? How do they compare?
Solutions to Self-study Problems
S2.1
The future value at an interest rate of 4.8% with annual compounding is:
FV = 10 000 (1.048)5 = R12 641.73
The future value with monthly compounding is determined by using a monthly rate of 0.4%
(4.8%/12) and 60 months (5 × 12):
FV = 10 000 (1.004)60 = R12 706.41
The higher amount is due to interest earning on interest more often over the period.
S2.2
This is an annuity due. The monthly payment on the car loan is determined by using
60 months and an interest rate of 0.6% (7.2%/12). Remember with an annuity due there is
one less discounting period.
{[
] }
1 – 
​  1 59 ​
(1.006)
​ ​+ 1 ​
120 000 = PMT × ​ ​ 
​
0.006
120 000 = PMT [50.5637]
PMT = 120 000/50.5637
PMT = R2 373.24 per month
If we use a financial calculator, then press 12 followed by SHIFT and P/YR to change the
financial calculator to monthly compounding. Also, press the SHIFT key and the BEG/END
key to change the mode to Beginning of the period, i.e. to indicate to the financial calculator
that the cash flows will occur at the beginning of each period.
The payment that is required to repay the loan and interest will amount to R2 373.24 per
month at the beginning of each month for 5 years.
S2.3
A zero coupon bond is a bond with no coupon payments and the value is dependent on the
redemption date and the par value. The par value is R100 and the redemption date is in 10
years time. The discount rate is 3% per half year and there are 20 six-monthly periods. The
value of the zero coupon bond is determined as follows:
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PV = FV/(1.03)20
PV = 100/1.8061
PV = R55.37
S2.4
The expected value of the apartment in 20 years’ time is:
FV = 710 000 (1.0075)240
FV = 710 000 (6.009152)
FV = R4 266 498
If property keeps on appreciating at a rate of 9% per year, then the value in 20 years’ time
is expected to be over R4.2m. If the rate of appreciation is 6% per year then the value in 20
years’ time will be R2.35m, so 3% makes quite a difference.
The monthly repayment due at the beginning of each month is determined by applying
the annuity due formula:
710 000 = PMT ×
{[
] }
1
​
1 – 
​
(1.005)239

​  ​+ 1 ​
​ ​
​
0.005
710 000 = PMT/(140.2787)
PMT = 710 000/140.2787
PMT = R5 061.35
You will need to pay in R1 061.35 each month after taking into account the net rental of
R4 000 per month. At a marginal tax rate of 40%, the interest and other costs would be
deductible for tax purposes. Remember that the rental should also grow over time.
Using a calculator and ensuring that you use a beginning of period mode and monthly
compounding as in S2.2 above, the payment is determined to be R5 061.35.
S2.5
The value of Wayne Rooney’s contract as at 1 July 2014 is £41.025 million (about R730 million).
Cash flows and the present value are set out in the following spreadsheet. Earnings from image
rights have been increased by 7% in each year so that the earnings from image rights for the
year ending 30 June 2015 is £1.926m (£1.8m × 1.07). We need to deduct tax at 45% and we
have discounted the future earnings at 5% per year.
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The value of Ronaldo’s after-tax earnings as at 1 July 2014 is £111.042 million (about R2 billion)
– almost 3 times the value of Rooney’s after-tax earnings! The image rights are expected to
grow by 7% per year after 2016 and the question indicates that his income from his image
rights is expected to be £17m in 2016.
Football players will try and use corporate structures to reduce the tax payable on the income
from their image rights, by for example, diverting such income to a company. This is what
landed Messi in court charged with tax evasion.
Note: Although Ronaldo is paid in Euros, we have converted his Euro earnings into Sterling (Pounds) at the exchange
rate at the time (2014).
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Q
QUESTIONS
Question 2.1
How much will you accumulate if you are offered the following investments?
■■ R10 000 invested for 12 years at an interest rate of 8%, interest compounded annually.
■■ R12 000 invested for 6 years at an interest rate of 6%, interest compounded annually.
Question 2.2
How many years will it take for R1 000 to become R2 000 if an investment offers 6% per year,
interest compounded annually?
Question 2.3
To what amount will regular payments of R1 500 per month at the start of each month accumulate
by the end of two years if the payments are earning interest monthly at 6% per annum?
Question 2.4
You wish to travel to Europe in 5 years’ time and you will need R30 000 at the time. If you currently
have R15 000, what interest rate must you earn each year to reach R30 000?
Question 2.5
A bank is offering 6% per year, interest compounded monthly on a Special Savings account. If
you deposit R8 000 today, how much will you accumulate by the end of 10 years? What is the
annual effective rate?
Question 2.6
Calculate the future value of a R2 000 investment made now under each of the following interest
rate and investment period alternatives. Assume annual compounding.
Question 2.7
Use the investment alternatives in Question 2.6 but assume that semi-annual compounding is
available on your initial investment. What will be the future value for each investment alternative?
Also calculate the future values assuming quarterly compounding.
Question 2.8
A student borrowed R5 600 at the beginning of each year at 8% p.a. compound interest. How
much is owed at the end of her third year?
Question 2.9
You are planning to take a holiday in Mauritius when your current savings of R10 000 reach R20 000.
(a) If you plan to take your holiday at the end of five years from now, what annual rate of interest
will you have to earn on your savings account?
(b) If you are willing to wait seven years before taking your holiday, what annual rate of interest
would be necessary on your savings account?
(c) If you can earn 7% per year compounded semi-annually on your savings account, how long
will it take before you have adequate funds to take your holiday?
Question 2.10
If a lump sum of R8 000 left in the bank for four years has grown to R10 164 with interest
compounding and paid at the end of each month, what annual rate of interest has the bank been
paying?
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Question 2.11
The manufactured price of an article was R2 880. Every time the article changed hands, the price
was raised by 20%. If it was eventually sold for R5 972, how many times did it change hands?
Question 2.12
In terms of a bequest, a man can receive R2 250 immediately or R3 600 in 12 years’ time. At what
rate is compound interest earned, on an annual basis?
Question 2.13
At the birth of his daughter, a man invested R1 000 at 6% p.a. compounded annually. What
amount would accrue to her if she left the money invested until she attained the age of
(a) 18 years, (b) 21 years, (c) 40 years, (d) 60 years?
Question 2.14
A special savings bond pays R30 in 10 years for each R10 invested today. At the time of his son’s
birth a man invests R5 000 in such bonds and at the end of 10 years reinvests the maturity value
of the bonds at 12% p.a. compounded half-yearly. How much will be available to his son at age
18? Would it have been better for the father to have invested the original R5 000 immediately in
the 12% investment?
Question 2.15
A bank agrees to lend you R10 000 today in return for your promise to pay the bank R18 380 in
nine years’ time. What rate of interest is the bank charging you?
Question 2.16
An individual has just put her life’s savings into a bank account yielding 4% p.a., interest
compounded semi-annually. Assuming she makes no withdrawals, how long must she wait until
she has doubled her money?
Question 2.17
Mr A. Miller is a young financial director of a listed company. Although he enjoys his work, he
wants to retire at the age of 35 (in 10 years’ time) and go sailing in the Mediterranean around the
Greek islands. He estimates that he will need to have R1.2m to buy the yacht and an additional
R200 000 to pay for supplies and mooring costs. Mr Miller intends to make equal annual payments
into a bank account on which he can earn 6% interest compounded annually.
(a) What amount must Mr Miller pay annually to achieve his objective in 10 years’ time? The
first payment is to be made at the end of the first year.
(b) Instead of making equal annual payments, Mr Miller wants to make one single sum payment
today, investing it at 6% interest compounded annually. What should this single sum be?
Question 2.18
You borrow from Better Bank to buy a car, and make monthly repayments of R1 053.35 at 12%
p.a. compounded monthly. Your loan is for a period of 4 years. How much did you borrow?
Question 2.19
You want to travel to Brazil to visit friends when you graduate three years from now. The trip is
expected to cost a total of R20 000 at that time. You have deposited R12 000 in an account paying
6% interest annually, maturing three years from now. You have inherited a further lump sum and
plan to use it to finance the balance. If you are going to put this money in an investment earning
10% per year over the next three years, how much must you deposit now, so you can visit your
friends at the end of three years?
Question 2.20
You can buy a music system for one cash payment today of R6 600 or ten quarterly payments
of R750, starting at the end of three months. If you could invest the cash and earn 6% per
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annum, with quarterly compounding, would you prefer to pay in cash or make the quarterly
payments?
Question 2.21
You have just received an inheritance of R329 760. You plan to put the entire amount in an
account earning 8% compounded annually and to withdraw R40 000 at the end of each year. For
how many years can you continue to make the withdrawals?
Question 2.22
You buy a studio apartment for R800 000 and put down a deposit of R200 000. Your repayments are
R6 673.35 per month for the 15 years you intend to pay the apartment off in. What is the annual
rate of interest on this loan?
Question 2.23
If your company borrows R2 000 000, repayable over ten years at 9% per annum with annual
compounding and equal annual payments, how much of the loan will be outstanding after three
years?
Question 2.24
A retirement plan guarantees to pay you or your estate a fixed annual amount for 20 years. At the
time of retirement you will have R313 600 to your credit in the plan. The plan anticipates earning
10% interest annually over the period you receive benefits. How much will your annual benefits
be assuming the first payment occurs 1 year from your retirement date?
Question 2.25
WEC Ltd is planning to save R2 million per year for five years. The first deposit, which is presently
being made, and all subsequent deposits, will earn interest at a 12% annual rate.
(a) Calculate the future value for this annuity if interest is compounded semi-annually.
(b) Calculate the future value for this annuity if interest is compounded quarterly.
(c) How would your answer in part (a) have changed if the initial deposit was not made until the
end of the first year?
Question 2.26
A student managed to acquire an interest-free loan of R80 000. After completing her studies and
beginning to work, she saves R15 000 every year and invests the amount at 12.5% p.a. compound
interest. What additional amount is required to fully repay the loan after four years of saving?
Question 2.27
In order to provide for R10 million to build a new warehouse in five years’ time, a company
plans to make equal payments at the end of each six months into a fund which earns 9% per
year interest compounded semi-annually. After two years of payments, escalating costs lead the
directors to increase the semi-annual deposit so that the fund will contain R12 million at the
scheduled time of building. Find the increased semi-annual payment required for the remaining
3 years.
Question 2.28
A company has taken out a R480 000 loan. The loan is due at the end of six years, and the
repayment amount is R779 648. What is the interest rate that the company is charged?
Question 2.29
A man wants to have R48 000 in eight years’ time, so he decides to invest a certain sum half yearly
at 14% p.a. interest compounded semi-annually. He invests the first sum at the end of the first six
months and the same sum every half year thereafter. What would the difference in the instalment
have been if he had paid the first instalment immediately?
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Question 2.30
If a company wants to accumulate a total amount of R500 000 in 20 years’ time, what annuity amount
must it invest at the end of each year during the 20-year period? The applicable interest rate is 10% p.a.
Question 2.31
If you purchase an asset for R520.60 and it yields R100 per year for seven years, what is your rate
of return on this investment?
Question 2.32
Assume a 13% RSA Government security (par value R100) with a redemption date of 15 July
2033, was quoting a yield to maturity of 8% on 16 July 2015. RSA Government Securities pay
interest semi-annually. Determine the market price of the 13% RSA security on 16 July 2015.
Question 2.33
A loan of R1.5 million was made to a farmer, bonded against fixed property at an interest rate
of 8% p.a. compounded quarterly. The farmer agreed to pay off the loan in equal quarterly
instalments over a period of 12 years. As a result of severe drought, at the end of five years, the
farmer requested relief. It was agreed that the interest rate would be reduced to 4% p.a. By how
much will the quarterly repayments of the farmer be reduced?
Question 2.34
Longlife Insurance Company agrees to buy the entire R100 million issue of 14% debentures of the
Expand Manufacturing corporation, provided that the price will allow a yield of 8% per year compounded
semi-annually. The debentures carry semi-annual interest and are redeemable at par in 20 years. How
much cash does the corporation realise from the sale, if brokerage is 1% of the sale price?
Question 2.35
Calculate the annuity, payable in 12 annual instalments, which can be bought for R5 000 cash if
the first instalment is paid immediately, and interest is compounded at 11% p.a.
Question 2.36
On his son’s 12th birthday a father wants to invest a certain amount to enable him to withdraw
R8 000 each quarter from his 17th to his 21st birthday. Calculate the sum he will have to invest if
compounded interest is reckoned at 12% per annum, compounded quarterly.
Question 2.37
CC Company Ltd wants to establish a series of uniform deposits to be made on 1 January of 2x04,
2x05, 2x06 and 2x07 into a fund in order to make withdrawals of R2 million on 1 January 2x12,
2x13 and 2x14. What must the size of these deposits be to enable CC to make withdrawals if the
fund will earn interest at the rate of 12% p.a. interest compounded annually?
Question 2.38
What is the present value today of a perpetuity that pays R400 per year if the first payment does
not begin until four years hence and if 10% is the relevant discount rate?
Question 2.39
A machine is bought with a loan which must be repaid in 20 equal half-yearly instalments of
R6 500. The first instalment is payable four years after the loan has been negotiated. What is the
price of the machine if compound interest is added every half year at 14% p.a. on the outstanding
amount?
Question 2.40
A firm’s earnings per share grew from R5.78 to R12.48. During the same ten-year period, its
sales grew from R60 million to R156 million. Calculate the difference in growth rates between
EPS and sales.
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FINANCIAL MANAGEMENT
Question 2.41
A non-redeemable preference share pays a R15 dividend each quarter. What is the maximum
price an investor should pay for the share if a yield of 8% per year is required?
Question 2.42
Normal carpeting costs a company R280 per running metre and lasts five years. Is it more
economical to purchase a special fibred carpet at R420 per running metre which will last eight
years if the money is worth 12% p.a.?
Question 2.43
What is the value of an investment at the end of 20x9 if you intend to contribute R10 000 at the
beginning of each year from 20x5 to 20x9? You can earn an interest rate of 6% p.a. (interest
compounded monthly).
Question 2.44
You want to retire in 30 years and will require a monthly income of R20 000 for 10 years after
retirement date. If the return you can obtain is 12% p.a. (interest compounded monthly), how
much must you contribute every month for the next 30 years in order to obtain an annuity of
R20 000 per month for 10 years after retirement date?
Question 2.45
You bought a small apartment for R950 000 on 1 February 20x4 (registration date) and you
obtained an 80% mortgage bond on that date. The bond interest rate since 20x4 has stayed
constant at 7.2% per annum, interest compounded monthly. The rate of 7.2% is the actual return
that the bank is earning. Bond repayments are payable in advance on the first day of the month.
The mortgage bond had a term of 20 years from 1 February 20x4. What is the capital balance
outstanding on your bond on 1 April, 20x13 (before April’s bond repayment)?
Question 2.46
You have started a small manufacturing company. You have bought a machine in terms of a
suspensive sales agreement whereby you are required to make equal monthly instalments from
today, 1 April 2x08, to 1 March 2x13. The cash price of the machine is R220 000. Finance charges
are linked to the prime overdraft rate. The bank will charge you a premium of 1% above the
prime rate which is currently 11%.
Required:
(a) Determine the equal monthly instalment amount required to purchase the machine over five
years.
(b) If the prime rate increases to 14% today, before your first instalment payment, what will be
the increase in your monthly instalment amount?
(c) The bank offers to give you a three-month ‘holiday’ so that you acquire the machine today
but the monthly repayments begin on 1 July 2x08. The last payment is still on 1 March 2x13.
What will your monthly instalment be if the prime rate is currently 11%?
Question 2.47
SX Company has issued 3 353 793 cumulative redeemable preference shares. The following is an
extract from SX’s annual financial statements for the year ending 30 June 2x04.
The cumulative redeemable preference shares carry a dividend of 12.5% per annum on the issue price
of R1.00 per share and will be redeemed at a price of R1.00 per share in five equal annual instalments,
payable on 31 December each year, commencing on 31 December 2x05.
Assume the preference dividend is payable annually on 31 December. Investors require a
return of 9% p.a. (interest compounded annually) on similar preference shares.
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The time value of money
2-47
Required:
Determine the price you would be prepared to pay for 100 SX Ltd cumulative preference shares.
Assume the current date is 31 December 2x04 (ex. dividend). Your share will be redeemed in five
equal annual instalments.
Question 2.48
You have purchased a pre-owned motor vehicle in terms of a suspensive sales agreement. You are
required to pay monthly instalments from today, 1 June, 2x01 to 1 May 2x06. The cash price of the
car is R128 496.00. Finance charges are linked to the prime overdraft rate; the rate is prime plus a
premium of 1% per annum. The prime rate is currently 8% per annum, interest compounded monthly.
Required:
(a) Determine the equal monthly instalment amount required to purchase the motor vehicle
over five years.
(b) If in a year’s time, on 31 May 2x02, the prime rate increases to 11%, what will be the new
monthly instalment amount from that date?
Question 2.49
Mirton Ltd has non-cumulative, non-redeemable preference shares in issue. The issue price was
R1.00 each and the coupon preference dividend rate is 12% per annum, payable once a year in
arrears. The company has not paid out a dividend in recent years but expects to recommence
dividend payments in two years’ time from today. What is the value of each preference share if
similar preference shares are quoting yields of 9% per annum?
Question 2.50
Mr Smart has just turned 50 years old and wishes to plan for his retirement at the age of 60 in
10 years’ time. He is considering either investing R90 000 at the end of each year over this 10year period in a mutual fund or investing R150 000 per annum in an all-equity retirement fund.
Mr Smart is on a marginal tax rate of 40% and his annual contribution to the retirement fund
will be fully tax deductible. You may assume that any tax benefit will be realised at the same time
as the contribution during the initial 10-year period. His annual contribution to the mutual fund
is not tax deductible. In 10 years’ time, the total accumulated amount in the mutual fund may be
withdrawn and is subject to tax at a rate of 10% of the difference between cost and the selling
price. If Mr Smart selects the retirement fund option then the accumulated amount must be used
to acquire a 10-year annuity which is taxable.
When Mr Smart retires, he expects his marginal tax rate to decrease to 30%. The financial
institution expects both the retirement fund and the mutual fund to grow at an annual
compounded rate of 9% over the initial period. The financial institution will be able to acquire
a monthly annuity on Mr Smart’s retirement, which will result in a return of 9% per annum,
interest compounded monthly. This reflects Mr Smart’s required return on funds invested
during his retirement period. You may assume that tax is payable once a year, at the end of each
year. You may assume that differences in transaction costs for the two options are immaterial.
Mr Smart is in a position that he will not pay tax on any mutual fund income. The mutual fund
income is immediately reinvested, and forms part of the 9% annual return.
Required:
Determine whether Mr Smart should select the retirement fund option or the mutual fund option
based on the value relative to cost of each alternative on retirement date if he wishes to maximise
his after tax wealth.
Question 2.51
You are considering investing in a fund whereby you will receive one third of the accumulated
sum as a single sum payment in 30 years’ time on retirement date, and a monthly income of
R24 000 for 10 years subsequent to retirement date. You will undertake the policy through one
of the major financial institutions which can earn a return of 6% per annum, interest compounded
monthly.
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Required:
Determine the monthly contribution that you are required to make over the next 30 years to
obtain the single sum payment on retirement date and a monthly income of R24 000 for 10 years.
Question 2.52
Two years ago, A Ltd needed to accumulate a total of R600 000 by the end of four years to acquire
new imported plant and machinery from an Italian supplier. To do so, A Ltd makes equal semi-annual
deposits into a fund which earns 8% per annum, interest compounded semi-annually. To date, the
company has made four equal semi-annual deposits into the fund. The rand has recently declined
against the Euro, and to acquire the plant and machinery, A Ltd now requires to accumulate a total
of R1 000 000 in two years’ time. However, A Ltd can from now on earn 10% per annum, interest
compounded semi-annually. All monies accumulated to date will from now on earn a return of 10%
per annum, interest compounded semi-annually. What is the increased equal semi-annual deposit
that A Ltd will need to make so that the fund will contain R1 000 000 in two years’ time?
Question 2.53
A 6-year bond, an RSA Government Security with a nominal value of R100 000 and coupon rate
of 9% is issued today, when the YTM required by investors is 9%.
Required:
(a) Calculate the present value of the stream of coupon payments, excluding the nominal face
value payable on maturity.
(b) Calculate the present value of the nominal face value of the bond.
(c) Sum the two values obtained in (a) and (b) above, and briefly explain the reasons for the
amount that you have calculated.
(d) Without further calculation, estimate what the value of the bond will be in three years’ time,
if the YTM remains unchanged, and explain your choice of estimate.
Question 2.54
A 20-year RSA Government Security with a nominal value of R10 000 and coupon rate of 6%
was issued 15 years ago, when the YTM required by investors was 6%.
Required:
(a) Calculate the value of the bond 12 years ago, when the YTM was 6%.
(b) Calculate the value of the bond today, if the required YTM is 12%.
(c) If the YTM changed to 10% today, as a result of a decrease in interest rates in the economy,
calculate the value of the bond today using a YTM of 10%.
Question 2.55
As a bond portfolio manager, you purchase a 10% RSA Government Security with a nominal
value of R10 million. It has 7 years to maturity. The yield to maturity (YTM) at the date of
purchase is 12%, which is immediately after the coupon has been paid. You hold the bond
for exactly 1 year, receiving the next coupon, and then sell the bond. The YTM at the date
of sale has fallen to 9%.
Required:
(a) Calculate the amount received from the coupon payment.
(b) Calculate the price that you paid for the bond.
(c) Calculate the price for which you sold the bond.
(d) Explain the reason for the profit or loss which was made over the one year holding period,
with reference to the principles underlying the time value of money.
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3
THE 21ST CENTURY: A TIME OF FINANCIAL CRISIS AND RECOVERY FOR EQUITIES
The financial crisis, market turmoil and falling equity values reminded investors that investing
in equities often involves taking on significant levels of risk. Although equity markets have
recovered, we should not forget how large the falls in equity values were in late 2008 and early
2009. Let’s place the financial crisis in context. Credit Suisse reported that the developed World
Index fell by 55% which represented a loss of R150 trillion or R150 000 for every man, woman
and child in the developed world1.This is serious, but we should also consider equity returns
over the longer term and that additional risks should be rewarded with higher returns. The
developed world index for the ten years to 2010 offered investors a return that was close to zero.
It began with the crash of technology and telecommunication equity values in the USA when the
NASDAQ index lost about 80% of its value. In South Africa, Nedcor reported a loss of over R3.3
billion on its investment in Dimension Data. The dramatic rise of the share price in Dimension
Data was matched only by its spectacular fall in 2001.
By the time of the Iraq war in 2003, world equities fell again but recovered strongly until the
credit crisis which was followed by a financial and economic crisis in 2008 and early 2009. Yet
emerging markets performed strongly and offered very positive returns for investors up to 2011.
South Africa is an emerging market and experienced positive gains in equity values from 2001
to 2013. The question is whether the higher returns in emerging markets came with higher risks.
In 2013 and 2014, emerging markets experienced a significant amount of volatility and
capital outflows which were matched with falls in currency values.
In this chapter, we firstly analyse risk in terms of operating and financial leverage. The chapter
explains expected returns, the normal distribution and measures of volatility such as standard
deviation. The chapter concludes with the analysis of risk and return in financial markets.
LEARNING OBJECTIVES
After working through this chapter, you should be able to:
■■ Distinguish between business risk and financial risk.
■■ Calculate the following indicators of return:
– earnings before interest and tax;
– percentage return to shareholders;
– expected return based on probabilities.
■■ Calculate the following indicators of risk:
– degree of operating leverage;
– degree of financial leverage;
– degree of combined leverage;
– variance of returns;
– standard deviation of returns;
– co-efficient of variation;
– z score;
– co-variance and correlation.
■■ Understand the history of equity returns and bond returns.
1
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Introduction
Financial management is about making investment and financing decisions. Such decisions involve
risk. What is risk? How do we determine required returns? It is understandable that an investment’s
risk will affect the required return. The higher the risk, the higher the required return. So, what kinds
of risks do companies face? When a company builds a new manufacturing plant, there is the risk
that the product will not sell sufficient units for the company to break-even. Further, the company
may not be able to achieve the expected price due to unexpected competitive pricing decisions. A
high level of operating leverage may mean that a company’s earnings are significantly affected by
a small change in sales. A mining company such as Gold Fields may find that the initial capital cost
and the ongoing costs of operating a gold mine may be significantly higher than expected at the
time of the investment. A company borrowing funds may be subject to interest rate hikes which
may result in reduced cash flows. Yet, companies may experience substantial improvements in
operating returns due to unexpected price increases. For example, BHP Billiton’s investment
in Mozal smelter was undertaken when the price of aluminium was about $1 100 per ton. In
2006, the price was over $2 700 per ton. In 2008 the aluminium price fell dramatically from
over $3 000 per ton to about $1 200 during the economic crisis. By October 2010, the price of
aluminium had recovered to $2 400 per ton. In late 2014, the aluminium price had fallen to $1900
per tonne again indicating the underlying volatility of the metal price. Risk is often measured in
terms of the volatility of expected returns and the potential for loss. In order to make investment
decisions we need to measure and adjust for risk.
Few questions about future events can be answered with certainty, because we don’t know
whether these decisions are good or bad until future events either confirm or repudiate the
expectations on which the decisions were based. Money is invested by financial managers in
assets which, it is forecast, will generate income and increase the value of the firm. Similarly,
investors make investment decisions based on their expectations, and only in the future
will it be possible to determine whether these investments were profitable. Evidently, not
every investment decision will be profitable, because no one can consistently make accurate
predictions about the future.
Making predictions is clearly hazardous, because you will sometimes be wrong. Methods
must be sought to keep the margin of error as low as possible. Information about the past
must rank as a significant input into predictions about the future. However, if it is known
that the past is unlikely to be replicated in the future, information about past events is of
little value and must be replaced with realistic estimates of future expectations. This chapter
suggests methods by which expected return can be measured. It discusses the uncertainty
that surrounds such expected returns – i.e. the risk that the returns may not be achieved –
and measures this risk. This requires the application of certain basic statistical techniques.
Once a method of measuring expected return and the estimated risk of not getting this
return has been established, some techniques for comparing investment opportunities with
different risk and return profiles are examined. The foundation is thus laid for consideration
of issues relating to portfolio theory. These issues are introduced in Chapter 4.
The historical evidence of share returns will be examined in the last section of this
chapter. We evaluate the international and South African evidence of whether the higher
risk of investing in equities was rewarded with higher returns. Did equities offer returns that
were higher than bonds?
Risk can be measured by comparing the risk of one investment with that of the market
as a whole. This risk comparison is denoted by a firm’s beta which measures the relative
volatility of a share to the market. If a firm’s beta is 1.2, then this means that the firm’s
shares are more volatile than the market. If the market goes up by 5%, then we would expect
the share price of the firm to go up by 6% (5% 3 1.2). The market is assigned a Beta score
of 1.0 and every share has a score that can be measured against this norm. We write about
this measure of risk in Chapter 4.
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1 The concept of risk
The word risk is usually used in the context of a potential hazard or the possibility of loss
resulting from a given action. In financial management, the term indicates that there is an
expectation that the actual outcome of a project may differ from the expected outcome. The
magnitude of the possible difference reflects the magnitude of the risk. Risk may also be
positive as you may receive more than you expected from your investment.
The terms risk and uncertainty are often used interchangeably. There is, however, a
formal difference between these two terms. Uncertainty implies either that all the alternative
possible outcomes cannot be identified or that no probability can be attached to the alternative
possible outcomes. Risk implies that it is possible to attach probabilities to identified expected
outcomes. This strict distinction between the two terms is, however, not necessary for our
purposes.
From the viewpoint of an investor, investment opportunities can be broadly classified
into two categories:
■■ Investment opportunities with certain outcomes (no expectation that the actual outcome
will differ from the expected outcome); and
■■ Investment opportunities with uncertain outcomes (some probability that the actual
outcome will differ from the expected outcome).
An example of a certain outcome is an investment in 8% government bonds, maturing
in ten years. This may be regarded by some to have a measure of uncertainty should the
government not honour its obligation, but insolvency of the country implies that all other
investments are at least as badly affected. The South African government, with its power to
manage the money supply and to impose taxes, is accepted to be the ultimate benchmark of
risklessness in the economy. Examples of investments with risky outcomes are the purchase
of shares on the JSE or the purchase of fixed property with a view to deriving capital gains.
A pertinent question is: why would an investor prefer a risky investment to one that is
risk-free? The answer is that it offers a higher expected return. However, this does not fully
answer the question why some investors prefer risky investments while others avoid risk.
The preference for risk which some investors exhibit is generally accepted to be a function
of the utility which an individual derives from making the investment. Because individuals
differ both in their needs and in their personality traits, it follows that there will always be
a spectrum of investors, some of whom are more prone to looking for high-risk investments
with high expected returns, while others will maximise their utility through accepting lower
expected returns with concomitant lower risk.
Risk is also a function of age. Older investors approaching retirement do not readily
embrace risk as they do not have the ability to replace investment losses whereas the young
are more prone to embrace risk. This is why financial planners need to consider the age and
thus the risk profile of their clients when compiling appropriate investment portfolios.
Turning specifically to investment in the shares of listed companies, there are two major
areas of risk which will be considered by potential shareholders: business risk and financial risk.
Business risk
Business risk results from the nature of the business itself. It includes all the uncertainty
that surrounds the industry in which the business operates. This is reflected in the variability
of sales and the structure of costs. The variability of sales results from factors such as the
likelihood of increased competition, the availability of substitute products, and the effect
of recession. Rapid changes in technology and market shifts are also factors that may lead
to increased business risk. The structure of costs depends on the relationship between
fixed and variable costs, illustrated in Example 3.1. The effect of business risk on financial
performance is measured by the variability of earnings before interest and taxes (EBIT).
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FINANCIAL MANAGEMENT
Example 3.1: Cost–volume–profit analysis
Leverage Ltd has the following budgeted information:
■■ Fixed costs (F) R10 million per year;
■■ Variable costs (VC) R400 per unit;
■■ Selling price (S) R1 000 per unit; and
■■ Expected demand 30 000 units (minimum).
Figure 3.1 illustrates these facts graphically. From Figure 3.1, it is apparent that sales revenue
increases in proportion to demand. Fixed costs remain constant within a relevant range
regardless of the sales volume, as illustrated in Figure 3.1, while variable costs commence at
zero and increase in proportion to units sold, as illustrated in Figure 3.1.
Figure 3.1 Behaviour of costs and revenues
In order to match sales revenue against total cost of sales, fixed costs (such as rent, depreciation,
and administrative overheads) and variable costs (such as materials and direct labour) must
be added together. The point at which sales revenue equals total cost is the volume of sales
required in order to break even, that is, to make neither a profit nor a loss. This is illustrated in
Figure 3.2.
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Figure 3.2 Break-even volume
It is apparent from the graph that around 16 600 units must be sold in order to break even.
If demand falls below 16 600, a loss will be incurred. Note that each time a unit is sold, it
makes a contribution of R600 toward the fixed cost (R1 000 – R400). No profit is earned
until all fixed costs have been covered. The break-even point, that is, to make neither a
profit nor a loss, can be precisely calculated using a simple formula, as follows:
fixed costs
(Formula 3.1)
Break-even units =
contribution
per unit
=
F
S – VC
=
10 000 000
1 000 – 400
= 16 667 units
Once the break-even number of units has been sold, each additional unit sold will add its contribution
(R1 000 – R400) to the profit. Table 3.1 indicates the effect on EBIT of different sales volumes.
Table 3.1 Effect of volume on EBIT of Leverage Ltd.
It can be seen that, while sales increase by 33​ _31 ​% from 30 000 units to 40 000 units, EBIT has
increased by 75% from R8m to R14m. This results from the leverage effects of fixed costs.
The degree of operating leverage obtained at 30 000 units can be expressed as follows:
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FINANCIAL MANAGEMENT
DOL =
contribution (Formula 3.2)
EBIT
DOL =
S – VC
S – VC – F
In the case of Leverage Ltd, this can be calculated as:
30m – 12m
DOL at 30 000 units =
8m
= 2.25
This means, for example, that an increase in sales contribution of 10% will lead to an
increase of 10% × 2.25, that is 22.5% in EBIT. This can be checked against the figures
1
_
produced in Table 3.1. An increase in sales of 33​
% led to an increase in EBIT of
​
3
1
_
75% (33​  3 ​% × 2.25). Assume, now, that Leverage Ltd decides to install machinery which
will increase the fixed costs by R5m and reduce the variable costs by R150 per unit to
R250 per unit. The resulting graphic representation is illustrated in Figure 3.3.
Figure 3.3 Change in fixed and variable costs
From Figure 3.3 it is clear that the break-even point has shifted. It is determined using
Formula 3.1:
15 000 000
Break-even units =
1 000 – 250
= 20 000 units
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The degree of operating leverage will also change if we use the results illustrated below:
Table 3.2 Degree of Operating Leverage
The EBIT at 30 000 units is lower than it was previously, while at 40 000 units it is higher.
This results from the higher fixed costs and lower variable costs. The DOL at 30 000 units
is calculated as follows:
30m – 7.5m
DOL at 30 000 units =
7.5m
=3
It is confirmed by the fact that an increase of 33​ _31 ​% in sales resulted in an increase of 100%
(33​ _13​% × 3) in EBIT.
Which cost structure is preferable? There is no correct answer to this question. The
original cost structure is less risky as the break-even number of units of 16 667 is easier to
attain than the 20 000 required by the second cost structure. However, as sales increase, a
higher EBIT is obtained using the second cost structure. This is a classical risk/return issue.
The riskier option offers greater potential losses if sales volume is low, but greater potential
profits when sales volume is high. The total business risk is therefore a function both of sales
and costs.
It is worth noting that managers do not have total control over the DOL. Often the
nature of the industry prescribes the extent to which the business must incur fixed costs.
Financial risk
Financial risk results from the practice of financing a part of the firm’s assets with interestbearing debt, with a view to increasing the ultimate return to the ordinary shareholders.
Interest must be paid regardless of the performance of the firm. As a result, a firm which is
liable for fixed interest payments is exposed to a risk of default which is not faced by a firm
financed exclusively with shareholders’ funds.
When the company is experiencing boom sales, the return on assets is likely to be consid‑
erably higher than the cost of the debt. As a result, positive financial leverage is experienced,
which enhances the return on equity. However, in recessionary times the opposite effect is
experienced, resulting in the possibility of defaulting on creditors. The company without
debt is not subject to this risk, as all losses are fully absorbed by the shareholders.
The degree of financial leverage (DFL) arises only after the EBIT has been calculated. It
is identical in concept to the DOL, as it increases fixed costs, being the fixed cost of interest
which must be paid. The formula for determining the DFL is as follows:
DFL =
EBIT (Formula 3.3)
EBIT – I
where: EBIT = earnings before interest and tax
I = total interest expense on all debt
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FINANCIAL MANAGEMENT
Total company risk
Operating leverage and financial leverage work together to create what is referred to as the
degree of combined leverage (DCL). This results from the product of the degree of operating
leverage and the degree of financial leverage and may be expressed as follows:
DCL =
S – VC
(Formula 3.4)
S – VC – F – I
Stated more simply:
Contribution
DCL =
Net income before taxation
DCL can also be stated as: DCL = DOL 3 DFL
Example 3.2:
Table 3.3 shows abbreviated contribution income statements of two companies.
Table 3.3 Income Statements
Find the degree of operating leverage, the degree of financial leverage, and the degree
of total leverage for each company. Using the appropriate formulae, the following results
are obtained:
Table 3.4 Degree of Combined Leverage
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Although both companies have similar sales revenues, it emerges that the net income of
Leverhi is considerably more sensitive to a decline in sales revenue. For example, if sales
revenue declines by 20%, the net income of Leverhi will fall to R13.7m while the net income
of Gearlow will only fall to R20.2m. The converse is also apparent in that an increase in
sales revenue will benefit Leverhi considerably more than Gearlow. Again, this reflects the
typical risk and return relationship. Leverhi is classified as a more risky business operation
because of the greater potential loss in times of economic adversity. However, it has a
greater potential for profit should sales revenue increase.
The use of DCL as a means of assessing risk is useful for the management of a company,
particularly when budgets are being prepared or capital expenditure is being considered.
Investors do not normally have access to this type of information. However, investors do
understand that companies that operate in such sectors as the airline, oil, aluminium,
chemical, shipping, steel, and manufacturing and hotel sectors will be subject to relatively
high levels of operating leverage. These are capital intensive industries requiring significant
investments in airplanes, property, ships, and plant and equipment. High levels of operating
leverage may be accentuated by high levels of financial leverage. Companies that operate in
the retail sector such as Pick n Pay and Foschini may have low levels of operating leverage.
Retailers will however often have fixed commitments in relation to long-term leases.
Investors use mainly stock market indicators to assess risk.
2 Measuring expected return and risk
An investor is able to measure past returns from investment in a single share with relative
ease. The two components of return are the dividends received and the capital appreciation
of the share, expressed as follows:
Rs =
P1 – P0 + D (Formula 3.5)
P0
where: Rs = return to shareholder
P0 = share price at the beginning of the period
P1 = share price at the end of the period
D = dividends received during the period
capital profit/loss + dividend
Put more simply the return =
price paid for the share
Depending on the purpose of the calculation, the period may be a week, a month, a year, or
any other period. For the purpose of comparison, annual returns are most useful.
Note that capital appreciation is included regardless of whether or not the shares were
sold and the capital appreciation realised. The capital appreciation represents the cash
which could have been realised had the shares been sold.
Like all decisions, the investment decision depends upon forecasting future events. Past
returns may be a valuable input used in forecasting expected future returns. If, however,
information is available which indicates that conditions in the future will differ from those
in the past, such information must be taken into account when determining the expected
return.
Measuring the expected return on a single share
Expected returns on an investment with an uncertain outcome cannot be accurately
quantified. However, if probabilities can be assigned to a number of alternative outcomes,
it is possible to statistically determine the expected return.
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The probability of an event occurring is the frequency with which that event is expected
to occur relative to all other events. A probability distribution sets out all the possible
events with their expected frequencies of occurrence. Once the probability distribution is
established, it is possible to apply a simple statistical technique in order to provide the
measure of expected return.
Example 3.3: Measuring return
Following extensive analysis and forecasting, you have established that an investment in
Mills Ltd offers the following probability distribution of returns, given different states of
the economy:
Note that the probabilities add up to 100%. Traditionally, probabilities are denoted by
decimals between zero and one. All events are mutually exclusive. These conditions are all
necessary in order to perform a probability analysis. The expected return is determined as
in Table 3.5.
Table 3.5 Calculating the expected return (Re)
The expected return on the investment is 12%. The formula is calculated as follows:
n

Re = ​ ​​​  Pj 3 Rj(Formula 3.6)
j=1
where:
Rj = the jth possible outcome
Pj = the probability of the jth outcome
n = the number of possible outcomes
Measuring risk for a single share
Having earlier defined risk as the magnitude of expected difference between actual outcome
and expected outcome, a commonly used statistic to measure this magnitude is the variance
as calculated in Table 3.6, using the same data as Example 3.3.
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Table 3.6 Calculating the variance
x
Risk may also be expressed as the standard deviation rather than the variance. The standard
deviation is simply the square root of the variance.
 = ​ 2 ​(Formula 3.7)
where:
 = standard deviation
2 = the variance


The standard deviation is ​ 0.0386 ​= 19.65%
The formula for finding the standard deviation from the raw data may be written as follows:


n
=​
j=1
Pj × (Rj – Re)2 ​ ​(Formula 3.8)
where: Pj = the probability of the jth outcome
(Rj – Re)2 = the deviation squared of the jth outcome from the expected
return calculated in Formula 3.6
The mean–variance rule
Once the expected return (measured by the weighted arithmetic mean) and the risk
(measured by the variance or standard deviation) have been established, a general rule
becomes apparent. It is commonly referred to as the mean–variance rule and is applicable
to all investment decisions made by rational risk-averse investors. The rule holds that
investment A will be preferred to investment B provided one of the following two conditions
exist:
■■ either the mean expected return on investment A exceeds that of investment B and the
variance of A is equal to or less than that of B,
■■ or the mean expected return on A exceeds or is equal to the expected return on B and
the variance of B is greater than that of A.
It has given rise to the technique of mean–variance analysis, which is a widely-used way of
making investment decisions. The rule is applicable to all risk-averse investors, regardless
of the degree of their risk aversion, and is illustrated in Figure 3.4.
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Figure 3.4 The mean–variance rule
The following can be seen from Figure 3.4:
■■ Investments W and X are always preferred to investments Y and Z respectively as they
offer superior returns for the same risk in each case.
■■ Investment X is superior to investment Y because it offers the same expected return but
is subject to less risk.
The mean–variance rule can now be applied to relevant investments. The measure of risk
which will be used in this text will be the standard deviation (the square root of the variance)
as it is more commonly used and is more easily applied to statistical manipulation arising
from the normal distribution to be discussed in the next section.
3 Interpreting the summary statistics
The expected return is simply the weighted average of each return predicted for a given
state of the economy. The risk associated with the expected return is measured by the
standard deviation of the return. The facts provided in Example 3.3 could be graphed as
in Figure 3.5.
Figure 3.5 depicts a discrete probability distribution. Five mutually exclusive states of the
economy have been identified. In fact, there are numerous possible states which could exist,
each of that could be assigned a probability. The result could be graphed as a continuous
probability distribution.
Properties of a normal distribution
Past company returns tend to follow a normal distribution. This means that in general
they are symmetrically distributed around a central value, with decreasing frequency of
occurrence as the distance above or below this central value increases.
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Figure 3.5 Probability distribution of Mills Ltd rates of return
Using the data of Mills Ltd, a continuous probability distribution could be roughly drawn
using the known characteristics of the normal distribution. From Figure 3.5 it is not absolutely
apparent that the distribution has the characteristics of a normal or Gaussian distribution.
The normal distribution was first investigated in detail by the German mathematician
Gauss. Its properties can be applied when results tend to be symmetrically distributed
around a central value with increasing rarity of occurrence as the distance away from the
central value increases. Where only five discrete probability states have been identified, the
resulting histogram may not appear symmetrical. This is largely a result of the small number
of discrete probability states and does not detract from acceptance of normal distribution
characteristics as the basis for determining the descriptive statistics. The most important
properties of the normal distribution for an understanding and interpretation of risk as we
have defined it are:
■■ Half the area under a normal curve is to the left of the expected return and half is to the
right. This means that the curve always peaks at the expected return.
■■ Standard deviations demarcate points that cover the following area under the normal
distribution curve:
– Between +1 and –1 = 68.3%
– Between +2 and –2 = 95.5%
– Between +3 and –3 = 99.7%
Using the standard deviation as the unit of measurement, it is possible to establish the area
under the normal curve at any point by referring to Table E, at the end of the book. This will
be explained later in the chapter.
These facts, together with the summary statistics obtained for Mills Ltd, are illustrated
in Figure 3.6 from which the following observations can be made:
■■ The curve peaks at 12%, the expected rate of return. There is therefore a higher
likelihood of a return of 12% than of any other return.
■■ There is a 68.3% chance that the return will be between –1σ and +1σ. Because the
standard deviation has been calculated to be 19.65%, this means that there is a 68.3%
chance that the expected return will be between –7.65% (12% – 19.65%) and 31.65%
(12% + 19.65%). Conversely, there is a 31.7% chance that the return will be outside
this range. As risk is the possibility that the outcome will be worse than expected, the
chance of the return being below –7.65% is only half of 31.7%, that is 15.85%.
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Figure 3.6 Continuous probability of Mills Ltd’s rates of return: normal distribution
■■ There is a 95.5% chance that the actual return will fall between +2 and –2 that is,
between 51.3% (12% + 2 × 19.65%) and –27.3% (12% – 2 × 19.65%). Looking at the
adverse side of the risk, we can say that there is a 2.25% chance, (half 100 – 95.5%), that the
actual return will be below –27.3%. Similar numbers can be generated for the range –3 to
+3.
■■ It must again be stressed that this measure of risk applies to an individual who invests
only in the shares of one company (which in this example is Mills Ltd).
Comparison of single shares
We have focused on the summary statistics relating to a single investment opportunity.
When faced with alternative investment opportunities, the investor who wishes to make a
choice between two single investment opportunities needs some rationale on which to base
the decision process. The strategy that should be adopted is illustrated in Examples 3.4 and
3.5 which follow.
Example 3.4: Choosing between two alternatives: identical expected returns
A financial analyst has gathered information regarding the performance of two listed shares
over the last five years. Trinpak is listed under the paper and packaging sector, and Claycor
under the building and construction sector.
The following summary statistics are generated:
TrinpakClaycor
Return to shareholders
22.0%
22.0%
Standard deviation of return
9.2%
15.4%
In this case, past performance may be used as a surrogate for expected future returns. Given
that the expected return is identical for both investment alternatives, on what basis is a
choice between the two alternatives made?
These two alternatives are represented in rough graphs in Figure 3.7.
It is immediately apparent that Trinpak has a much tighter distribution of returns. The
probability of performing really badly, if past performance is used to predict the future,
is much lower than that of Claycor. Faced with these two alternatives, it is likely that an
investor would rather invest in Trinpak Ltd than Claycor Ltd. This is consistent with the
mean–variance rule which implied that, in general, investors will select the alternative with
lower risk when the expected returns are identical.
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Figure 3.7 Distribution of returns: identical expected return
With investors showing a preference for Trinpak on the basis of the facts outlined, what is the
likely result? The greater demand for Trinpak is likely to force its price upwards. Conversely,
the lesser demand for Claycor would place downward pressure on its price until an equilibrium point, where return commensurate with the risk establishes the market price.
When comparing shares which have different expected returns, the decision is more
complex. Looking at the above distributions an investor could surmise that Trinpak has the
characteristics of a defensive stock e.g. a bank, insurance company or utility. These stocks
are preferred during times of uncertainty and recession. Claycor, on the other hand, is not
unlike a resource stock where the returns are poor in times of recession and high during
a boom. The recent rush into resource stocks at the expense of more defensive stocks is a
signal that an upturn in the world’s economy is expected soon. The probability factors used
in this chapter may have been skewed towards a more optimistic outcome.
Example 3.5: Selecting between two alternatives: different expected returns
An investor is considering the following two alternatives from which to select the most
acceptable investment:
Atlas Ltd Brenco Ltd
Expected return
28%
20%
Standard deviation
14%
8%
Which investment should be selected?
This problem does not have a ready answer. The distributions are depicted in a rough graph
in Figure 3.8.
It is apparent that Brenco Ltd offers a lower expected return, but this is not surprising as
the degree of risk is lower than that of Atlas Ltd.
If an investor wishes to choose between these two shares, some basis of comparison is
required. Using the properties of the normal distribution, two indicators, the co-efficient of
variation and the z score, may be used.
Co-efficient of variation
The co-efficient of variation (CV) relates the units of return to the units of risk. It expresses
the units of risk per 1% of return as follows:
CV =
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Figure 3.8 Distribution of returns: different expected returns
Using the CV, the following results are obtained for Atlas and Brenco:
AtlasBrenco
CV
14/28 = 0.5
8/20 = 0.4
The results indicate that Atlas Ltd exposes the investor to 0.5 units of risk for each expected unit
of return, while Brenco exposes the investor to only 0.4 units of risk for every unit of return. On
a relative basis, therefore, Brenco seems to offer a better trade-off between expected return and
risk. Note that this approach is not rigorous and serves only as an additional indicator to assist
investors when selection between two alternatives with different expected returns is required.
The z score
The z score is used to help establish the probability of a return falling below a given level.
For example, an investor may wish to determine the probability of the returns being zero or
less. The following procedure would be adopted.
First, find the z score using the following formula:
_
– ​x​​
z = ____
​ x 
where:
x = the given rate being examined
–x = the expected return (the mean)
 = the standard deviation
(Formula 3.10)
Consult Table E – the standard normal distribution (at the end of the book) – and determine
the area to the right of 0% by reading from the table. The figure obtained is the probability
of returns falling between 0% and the mean. Then interpret the results.
Using the z score, the following results are obtained for Atlas and Brenco:
Atlas
Brenco
Z score at 0% 0 – 28 = –2 0 – 20 = –2.5
14
8
Table reading
0.4772
0.4938
% Probability (0.5 – Table)
2.28%
0.62%
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Note that Table E is constructed for only one side of the symmetrical curve, as a z score
table for the mirror image side would be identical. In order to establish the probability of
returns being less than zero, the table reading is deducted from 0.5 (the left-hand side of the
distribution with which we are dealing). The probability is then expressed as a percentage.
This is illustrated for Atlas Ltd in Figure 3.9.
Figure 3.9 Using z scores
This approach once again does not provide perfect information, but allows investors to
develop perceptions regarding the risk/return relationship.
It should be clear that 0% return is a critical point because once returns fall below this
point the investor suffers not only a zero return on capital but also a loss of capital invested.
Investors may, however, be sensitive to other points in the operation of probable returns.
If, for example, an investor wishes to establish the probability of returns being below 15%,
exactly the same procedures are followed.
Atlas has a lower probability than Brenco of generating returns below 15% and (as is
apparent from the earlier calculation) it has a higher probability of returns below 0%. These
indicators are consistent with expectations regarding risk and return.
Atlas
Brenco
Z score at 15% 15 – 28 = – 0.93 15 – 20 = – 0.63
14
8
Table reading
0.3238
0.2357
% Probability (0.5 – Table)
17.62%
26.43%
We can use the Excel function = NORMSDIST to determine the standard normal
cumulative distribution function rather than employ Table E. For example, if you enter
= NORMSDIST(-2) in an Excel worksheet cell, the result will be 2.28%.
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Co-variance and correlation
Co-variance measures how share returns move together and specifies the strength of the
relationship between share return movements. It indicates the extent that share returns
co-vary. For example, we would expect that the share prices of resource companies would
move together. In general, if the share price of Gold Fields goes up, then we would expect
the share price of Harmony also to increase. The share prices of these companies tend to
co-vary.
Mathematically, the co-variance between x and y is denoted as follows:
1
Cov(x,y) = ​ 
n​
n
_
_
​ ​(x – ​x​x​)(y – ​​y​y​)(Formula 3.11)
i=1
i
i
where n is the number of observations.
If share returns tend to co-vary, then the actual returns will tend to be above or below their
means for the same period and the product of this relationship will be positive. If share
returns move in opposite directions, then the co-variance will be negative.
Cov(x,y) > 0, x and y will tend to move in the same direction
Cov(x,y) < 0, x and y will tend to move in opposite directions
Cov(x,y) = 0, x and y are independent. There is no relationship between the returns of x and y.
What does co-variance indicate? It is a number and it is difficult to interpret on its own.
We use the correlation co-efficient, xy, which is a standardised version of the co-variance,
to determine the relative strength of the linear relationship between x and y. We need the
covariance to determine the correlation co-efficient which is denoted as follows:
Cov(x,y)
rxy = ​  
  ​(Formula 3.12)
x
y
The correlation co-efficient is between –1 and +1. A correlation co-efficient of (+1) indicates
that share returns are perfectly correlated. This means that a (+10%) share return by x is
matched by a (+10%) return by y. If the share return of x is (–10%), then the share return
of y will also be (–10%). A correlation of (–1) indicates that shares are perfectly negatively
correlated. Therefore a (+10%) share return by x is matched by a (–10%) return by y.
We can restate the above formula as follows:
Cov(x,y) = rxysxsy(Formula 3.13)
How do we calculate the co-variance? We will use the example set out in Table 3.7 and do
it the long way before simply using the relevant Excel functions. We will come back to this
example in Chapter 4 on Portfolio Management. Why is co-variance important from a risk
perspective? If the returns of investments do not co-vary, it means that portfolio risk will be
lower than if the returns do co-vary. We will expand more on this in Chapter 4.
In Table 3.7, we have two shares P and Q which offer the returns as set out in the table for
each year. We calculate the mean return for P and Q and then set out the difference between
the return
_ and_ the mean for each observation, to comply with part of the above formula,
i.e. (x – ​x​)(y – ​y​). We then sum the product of the differences and calculate the average of
the product to determine the co-variance. We can use the Excel functions, COVAR (array
1, array 2) and CORREL (array 1, array 2) to determine the co-variance and the correlation
co-efficient.
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Table 3.7 Co-variance and correlation
We have used the Excel functions to support the calculations. Note that we have determined
the co-variance by using percentage returns. If using absolute numbers, the co-variance
would be 127, but the correlation would remain at 97.8%. We will come back to this example
in Chapter 4.
4 Risk and return in financial markets
In this chapter, we have noted that investors will demand a higher return for taking on a
higher level of risk. If a government bond is offering an expected return of 6% per year,
then we would demand a higher return for investing in corporate bonds and an even higher
return for investing in ordinary shares. Why? A company’s earnings are subject to greater
economic risks and share prices can be volatile. The additional return that investors will
demand for investing in ordinary shares rather than government bonds is called the equity
premium or the market risk premium. We will come back to this issue in Chapter 7. In
this section we would like to understand whether, historically, ordinary shares have offered
higher returns than government bonds. The question of whether investors have been
rewarded for taking on the additional risks of being invested in ordinary shares is important
as the risk/return relationship is critical to the theory of finance.
In South Africa, investors in ordinary equities earned a real return of 7.4% per year over
the period 1900 to 2013, a period of 114 years. A real return is what you earn after deducting
inflation. Investors in bonds earned a real return of 1.8% per year over the same period. You
will note from Table 3.8 that South Africa (together with Australia), offered the highest equity
returns in the world over this period. Equities in the USA offered a return of 6.5% per year
while Germany offered a return of 3.2% only. Equity returns in Russia and China were deeply
affected by war and revolution, which resulted in expropriation and we have therefore not
included these countries in Table 3.8, which sets out the real returns for equities and bonds.
It is interesting to convert these returns into cumulative real returns for each country.
One Rand (or equivalent) invested at the beginning of 1900 in ordinary equities would have
grown to R33721 in real terms while R1 in bonds would have grown to only R8.1 in real
1
How did we work this out?
Equity: FV = R1 × (1.073858)114 = R3372
Bonds: FV = R1 × (1.01847)114 = R8.1
Please note that there are slight rounding differences in terms of the Credit Suisse returns indicated in Table 3.8
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terms. This is a big difference and reflects the power of compounding. These accumulated
sums tell the real story of investing over long periods of time. The extra 5.6% return per
year offered an investor an increase of R3363.9 on the R1 investment compared to a bond
investor who accumulated R8.1 only. Table 3.8 also discloses real returns for a shorter period
from 1964−2013, which is 50 years. In the latter period, South Africa was second to Sweden
with respect to equity returns.
Table 3.8 Real returns for equities and bonds
Table 3.9 presents the compound annual returns from investing in the All Share Index
(ALSI), Bonds and Cash (Money Market Index) over the period 1987 to early 2010.
Table 3.9 Returns for equities, bonds and cash in South Africa
The nominal return from investing in equities is higher than investing in bonds and cash –
but not by much – resulting in a market risk premium of 1.43% that is much less than
over the period 1900 to 2013. We will explain what the Sharpe ratio means later in the
chapter.
What about risk? Do investors earn higher returns for undertaking higher levels of risk?
Table 3.10 presents the returns from investing in equities and bonds and the associated
volatilities as indicated by the standard deviations for each country and asset class. Equities
on average do earn higher returns than bonds but also report higher levels of volatility.
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Table 3.10 Nominal returns for equities, bonds and associated standard deviations
The return for the world is 8.5% for equities and 4.8% for bonds. The standard deviation
for equities is 17.7%, whilst for bonds the standard deviation is only 10.4%. This is over the
period 1900 to 2011. There have been specific periods whereby bonds in South Africa have
outperformed equities. In Figure 3.10, we present the returns and standard deviations for
equities, bonds and short-term treasury bills for South Africa. Lower returns for less volatile
assets are matched with lower volatilities.
Figure 3.10 Returns and standard deviations for equities, bonds and treasury bills for the
period, 1900 – 2011
Source: Credit Suisse Global Investment Returns Yearbook, 2012
Figure 3.11 determines the accumulated amounts in real terms from investing R1 in 1900
(or one year before 1900) in equities for selected countries. The annual compound returns
in Table 3.8 do not adequately capture the differences in real accumulated values from
investing in equities and reinvesting all income over 114 years.
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Figure 3.11 Accumulated amounts stated in real terms from investing 1 unit of local currency in equities
(and reinvesting all income) from 1900 to 2013
In real terms, after inflation, investing R1 in 1900 would result in an accumulated amount
of close to R3 372 by the end of 2013. If your great-grandfather had invested R1 000 in
equities in 1900, and had bequeathed this to you, you would have received R3.372 million at
the beginning of 2014. Only Australian investors would have done as well. Yet, to be fair we
should also include currency effects. Figure 3.11 depicts returns and accumulated amounts
in each country’s own currency.
When we take into account the fact that the Australian Dollar has appreciated against the
Rand, then Australian investors have done significantly better than South African investors. In
fact, we often refer to Rand hedges, which are shares that should protect investors against any
depreciation in the Rand and the JSE’s market capitalisation is dominated by groups such as
MTN, SABMiller, BHPBilliton, BAT, and Naspers that have significant international operations.
What about other periods?
Figure 3.12 presents the cumulative returns of investing R1 in either the JSE ALSI,
Bonds or Cash over the period between January 2004 and September 2014.
Although equities have been more risky, the returns to investors have been significantly
greater than that of bonds and cash.
In another study by Professor Brian Kantor of Investec Securities Research, the mean
return for the JSE ALSI (All Share Index) was 15.29% for the period January 1970 to
July 2005 whilst bonds offered an annual return of 11.9%. The results are presented in
Table 3.11. We have updated this to 2014. Investing in equities was much more risky and
offered higher returns. However, although bonds implied higher levels of risk, they offered
marginally better returns than an investment in cash over this period. Investors in equities
were also required to accept significant annualised falls in equity prices in some months.
Accepting the upside was no problem (if you were invested) but it was necessary to live
through the reversals in values as well.
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Figure 3.12 Investment of R1 in equities, bonds and cash in January 2004 – September 2014 South Africa
Source of data: Prof. Brian Kantor – Investec Securities
Table 3.11 Nominal annual returns and standard deviations
Have equities always outperformed bonds? It depends on our starting date. In South Africa,
bonds actually outperformed equities from 1990 to May 2005. That is a long time.
What about small companies? In the USA, since 1926, investing in “small value caps”
offered investors an additional return of 3.6% per year. From 1990 to 2010, the excess mean
return for small caps in South Africa was found to be between 1.98% and 3.24%, relative to
large market cap firms2.
Let’s compare the volatilities of different sectors. We will select the general mining
sector and the food producers sector. Anglo American plc is a key component of the general
mining index and Tiger Brands is a key component of the food processors index. We have
determined the monthly percentage changes in the general mining and food processors
indices. This is presented in Figure 3.13.
See Auret and Cline (2010). Size and value investment strategies on the JSE, Conference Paper presented at the
African Finance Journal Conference, Stellenbosch, 2010.
2
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Figure 3.13 Monthly percentage changes in General Mining and the Food Producers Indices:
May 2004-Sept 2014
We can clearly see that the Mining Index is more volatile than the Food Processors Index
over the period. Therefore, if we are investing in companies that form part of the Mining
Index, we need to be prepared to accept the additional volatility and risk that comes with
investing in these companies. The standard deviation of the General Mining Index was
7.9% per month whilst the standard deviation for the Food Producers Index was only
4.4%.
In Figure 13.14, we set out the daily percentage changes in the Food Processors’ Index
and the General Mining Index side by side. We can see that the Mining Index has been
significantly more volatile than the Food Processors’ Index. The daily standard deviation
from 26 May 2004 to 15 October 2014 is 1% for the Food Processors’ Index and 2.2% for
the General Mining Index.
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Figure 3.14 Daily percentage changes in general mining and food processors indices: 26 May 2004 –
15 October 2014
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Let’s evaluate the share price movement and volatility of Anglo American plc which is a
company that forms part of the General Mining Sector on the JSE. The group is one of the
world’s leading resource companies and Figure 3.15 depicts the movement in Anglo American’s
share price from May 2004 to September 2014. The movement in share price initially reflected
the increase in commodity prices that was driven by Chinese demand. Then the economic crisis
struck in the latter half of 2008 and the share price fell sharply from a high of R539 in June
2008 to R141 within a period of eight months. The dramatic fall in Anglo American’s share
price indicated the risks of investing in equities. Although equity markets have recovered, we
can see that the share price in 2014 has only come back to levels applicable in May 2006.
Figure 3.15 Movement in the Anglo American share price: May 2004 – September 2014
When we plot the share price, we do not obtain a clear picture of the underlying volatility
in Anglo American’s share price. In Figure 3.16, we plot the monthly percentage changes in
Anglo American’s share price over the same period.
Figure 3.16 Monthly percentage changes in the Anglo American share price: June 2004 – September 2014
The graph of changes in the share price indicates the increased volatility around the time of
the economic crisis. The falling share price was matched with an increase in volatility. Over
the period, the standard deviation was 9.36% per month which was higher than the standard
deviation of the General Mining Index. This means that 68% of the monthly percentage
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changes in the share price were in the range of 29.36% to +9.36%. The average monthly
return was 0.932%. If you are going to invest in equities then you do need to be ready to accept
the associated volatility in returns. However, the evidence indicates that investors (over the
long term) do earn higher returns for accepting the higher risks of investing in equities.
Emerging markets
The growth in emerging markets and capital flows to emerging markets has been phenomenal.
Whether this will be sustained is an open question, but future growth will mainly occur in
emerging markets such as China, India and Brazil. Emerging markets is also where 70% of the
world’s population lives and South Africa is an emerging market. Emerging markets produced
an annualised return of 10% per year in the decade to 2010 whilst for the developed world; this
was close to zero. However, in the three years to October 2014, emerging markets reported
lower returns than developed markets. MSCI reports that emerging markets experienced an
average annual return of only 1.65% while developed markets experienced an average annual
return of 10.37%. Therefore, there has been a reversal in the relative performance of many
emerging markets to developed markets. Yet, despite this, Dimson, Marsh and Staunton of
London Business School write in the 2014 Credit Suisse Global Investment Returns Yearbook
that “from 2000 to 2013, the terminal wealth accruing from investing in emerging markets
was almost twice that from an equivalent investment in developed markets.”What about risk?
Emerging markets have always been seen as more risky. Is this true? The emerging markets
index has generally been more volatile and emerging markets reported an annualised standard
deviation of 29% over the 25 years to 2013 as compared to developed markets which reported
an annualised standard deviation of 21%. The beta of emerging markets to developed markets
is 1.303. Investors should expect higher returns from investing in emerging markets as there
is more risk there. From a diversification perspective, investors can reduce the risk of their
portfolio by investing in both developed markets and emerging markets. We will come back to
the issue of diversification and risk in the next chapter.
Volatility and time periods: the Rip van Winkle solution to risk
Volatility is often time dependent. The shorter the time interval, the greater the volatility
will be on an annualised basis. Annual holding periods generate greater volatilities than
5-year or 20-year holding periods. A study by Firer and Staunton (Investment Analyst
Journal, 56, 2002) found that an annual holding period resulted in a standard deviation
of 23% for equities. However, as we increase the investment period and evaluate a 5-year
holding period, we find that there is a significant fall in the standard deviation to 9.9%.
If we follow the Rip van Winkle solution to risk and fall asleep for 20 years, then we will
find that the standard deviation for a 20-year holding period is only 5.5%. If you invest for
20-year holding periods, then equities have always out-performed bonds. The markets have
offered maximum positive real returns of close to 100% and negative real returns of close to
-60% over a one year holding period. Over a 5-year holding period, the maximum positive and
negative returns are 20% and -20%. Over a 20-year holding period, the maximum real return
is about 12% and the maximum negative return is close to zero. If we go back to Figure 3.15,
if you had invested in Anglo American in May 2006, went to sleep and you only woke up in
September 2014, you would have looked at the share price and it would have hardly moved.
You would have missed a roller coaster ride of volatilities and price movements.
What does Warren Buffett think?
According to Buffett, volatility is not a valid measure of risk and an investor should try
to rather understand the business and the volatility inherent in the business. The risk
that counts is not beta but the possibility of permanent loss. The quality of the business
3
Source: Credit Suisse Global Investment Returns Yearbook, 2010
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determines the level of risk. The competitive strength of Coca Cola and Gillette (now part
of Proctor and Gamble) reduces the risk of investing in these companies relative to other
companies that do not have a sustainable competitive advantage but may have similar betas.
What do we think? We think that the importance of volatility may be overstated and we
agree that a more relevant measure of risk relates to the probability of failure. We will come
back to this when we evaluate project risk in Chapter 10 and we focus not only on measures
of volatility but also on the strategic context of an investment. Yet our view is also more
nuanced. Why? We consider that volatility may be relevant for determining the probability
of business failure. It depends on the company.
Firstly, let’s assume a company is mining and producing platinum and the company has
high levels of debt. Platinum prices have been volatile and therefore the company’s share
price has also been volatile. Even though the market is expected to recover, the banks may
force the winding up of the company before markets are able to recover. If the share price
is undervalued at that point, then the company may not be able to raise equity finance to
prevent bankruptcy. Remember that the company and the market is expected to recover
but due to price volatility and fixed borrowing costs and fixed operating costs, the company
is incurring losses. A company with little debt is far less likely to fail as it does not have to
meet fixed borrowing costs or arrange debt refinancing in volatile times. Corporate survival
is the key factor as this enables a company to be around to take advantage of investment
opportunities when the market does recover. The question we should ask is whether volatility
endangers the existence of a company. If not, then volatility may not be that important.
Investors like Warren Buffett in fact welcome volatility as it offers opportunities to
purchase good businesses at distressed prices. This does not mean that there is no risk – at
least for investors who are forced to sell in a time of volatility due to pressure, placed by
the lenders. However, we also agree that there is much more to risk than simply evaluating
volatility, particularly volatility over short time intervals. We will come back to the issue
of volatility and risk in Chapter 10. We need to understand that Buffett does not like
debt financing. Yet betas are affected materially by the level of debt financing. A highly
geared company will tend to have high betas. We will analyse the impact of debt on betas in
Chapter 7. Buffett also does not believe necessarily in diversification although in this case
his company, Berkshire Hathaway, does hold a diversified portfolio. The expression, ‘Don’t
put all your eggs in one basket’ is replaced by Mark Twain’s alternative advice: ‘Place all
your eggs in one basket but watch that basket’.
Risk-adjusted measures of performance
In Table 3.10 and Figure 3.10, equities offer higher returns but also higher volatility than
bonds and bills. However, the question is whether returns are enough to offset the additional
risks of equities. Further, it is useful to compare portfolios and unit trusts on the basis of
risk-adjusted returns. We have already explained the co-efficient of variation which is equal
to an investment’s standard deviation divided by its mean return. We will now explain a few
other risk adjusted measures often used by fund managers to evaluate performance relative
to risk.
Treynor ratio
This ratio measures the excess return per unit of systematic (unavoidable) risk as indicated
by a portfolio’s beta.
Treynor ratio = (average return of portfolio – average risk-free rate)/Beta of
portfolio
The Treynor ratio is particularly useful to compare unit trusts that may invest in similar sectors.
A fund with a higher Treynor ratio has achieved a higher return adjusted for market risk.
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Sharpe ratio (reward to variability ratio)
Whilst the Treynor ratio measures excess return per unit of systematic risk, the Sharpe
ratio measures excess return per unit of total risk as indicated by an investment’s standard
deviation.
Sharpe ratio = (average return of asset – average risk-free rate)/Standard Deviation
Auret and Vivian (see Table 3.9) conclude on the basis of the Sharpe ratio, that bonds
offered a superior risk-adjusted return than equities over the period 1987 to 2010.
Jensen’s Alpha
Portfolio managers are often evaluated on their ability to generate positive Alpha. The
Capital Asset Pricing Model (CAPM), which we will cover in Chapter 4, is used to determine
a theoretical risk-adjusted required return.
Alpha = portfolio return – (risk-free rate + portfolio beta 3 (market return –
risk-free rate))
If a portfolio generates a return that is higher than its risk-adjusted required return, then
the portfolio manager will have generated positive Alpha. Essentially, the manager has
generated an excess return in relation to the risk-adjusted required return.
Sortino ratio
This is similar to the Sharpe ratio but this ratio only evaluates downside risk.
Sortino ratio = (average return of asset – minimum acceptable return)/downside
deviation
Downside deviation is the standard deviation of negative asset returns. This measure
assumes that investors are not concerned with upside volatility and are only concerned with
downside risk. Rather than use the average risk-free rate, we can set a target return or
minimum acceptable return.
From the Real World – Unit Trust Funds
The main objective of Coronation Fund Managers in introducing its Global Absolute Fund
was to achieve low risk and real returns. The 10-year annualised return to 30 September
2014 for this fund was 17.12% with a standard deviation of 7.97%.
The fund states its investment objective as follows:
The Coronation Global Absolute Portfolio targets positive real returns consistently
over all time periods and with an overriding focus on limiting downside returns or
portfolio losses.
The Sharpe ratio of the Coronation Global Absolute Fund at the end of September 2014 was
1.10 and its Sortino Ratio was 2.23. In order to achieve its investment objectives, the Fund is
able to invest in South African and foreign equities, South African and foreign fixed interest
securities, listed property stocks, preference shares, hybrid securities and derivatives.
The Prudential Balanced Fund reported a return of 15.6% per year since inception
(for individuals) and a standard deviation of 11.3%. Its Sharpe ratio was 2.1 while its
Sortino ratio was 5.0.
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The Allan Gray Balanced Fund has over R100 billion under management. This is a big
number. The Fund Statement states that:
The Fund invests in a mix of shares, bonds, property, commodities and cash.
The Fund may buy foreign assets up to a maximum of 25% of the Fund (with an
additional 5% for African ex-SA investments).
The annualised 10-year return on this fund up to 30 September 2014 was 16.7%. The
standard deviation of the Fund (since inception) was 9.3%. The Allan Gray Equity Fund
invests in JSE listed equities only and its annualised 10-year return was 19.7% while its
annual return since inception in 1998 was 26.5% per year. Its standard deviation since
inception was 16.2%. This compares to the JSE All Share Index (ALSI), which offered an
annual return of 18.7% per year with a standard deviation of 18% from 1998 to September
2014. This means that Allan Gray was able to achieve a higher return with a lower level
of risk than the JSE ALSI.
A low-cost way of getting access to the JSE is to invest in Index Funds such as the
Satrix ALSI Fund which is offered by the JSE Securities Exchange and simply tracks the
performance of the FTSE/JSE All Share Index, thereby offering investors exposure to
the 160 largest shares, but at a very low cost. The annual return over the five years to 30
September 2014 was 17.37% per year. How does this form of passive investing compare
to active investing by Allan Gray and Coronation? The Allan Gray Equity Fund earned
an annual return (after fees) of 17.6% over the five years to 30 September 2014 and the
Coronation earned an annual return of 19.3% (after fees) over the same period.
Summary
All investment decisions necessitate consideration of the required return, the expected
return, and the estimated risk. The risk to which a company is exposed can be classified into
two distinct categories. Firstly, there is business risk, measured by the degree of operating
leverage. Secondly, there is financial risk for a firm which has introduced fixed-interest debt
into its capital structure. Financial risk is measured by the degree of financial leverage. The
total risk is a product of these two categories and is expressed by the degree of combined
leverage.
For the investor, a statistical technique is used for expressing the risk of an investment as the
variation of expected returns, quantified in the form of the standard deviation of expected returns.
As a result, two fundamental parameters in financial management, namely the expected return
and the risk of an investment, can be captured in two summary statistics, the arithmetic mean and
the standard deviation.
These summary statistics may be used to gain greater insight into the probabilities of expected
outcomes. In order to make such interpretations, a normal distribution of expected returns is
assumed and the properties of such distributions are used for further analysis. The co-efficient
of variation and the z scores enable comparison to be made between two individual shares with
differing expected returns and risk profiles.
An analysis of equity returns and bond returns indicates that investors do earn higher
returns for taking on the higher risks of investing in equities. Risk adjusted measures of
performance can be used to compare and rank the risk adjusted performance of funds.
The foundation has now been laid for further consideration of risk and return in the context
of a portfolio of shares. This chapter has been somewhat simplistic in assuming that the risk and
return information about individual shares is relevant for deciding between individual shares.
The next chapter provides the rationale for holding a portfolio of shares and further develops
the concepts discussed in this chapter.
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S
SELF-STUDY PROBLEMS
The following limited information is available for returns on two shares listed on the Stock
Exchange.
Despite the limited number of readings, a normal distribution of returns may be assumed.
In addition, past performance is considered to reflect expected future performance.
Required:
(a)Calculate the average return, standard deviation, and co-efficient of variation for each
of the two shares.
(b)Using the properties of a normal distribution and the z score tables, establish the
probability for each share of a return lower than 10%.
(c)Taking the role of an investment adviser, recommend one of the two shares to a client
who wishes to make a choice between an investment in Gipley Ltd or an investment in
Petros Ltd. Advise the client of some of the issues which should be considered.
Suggested solutions
(a)
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(b) Return lower than 10%
(c) All investment choices depend on the individual investor’s propensity for risk. It is
apparent that Gipley is a more volatile share than Petros. Because of this characteristic,
investors require a higher expected return than they do for an investment in Petros. This
is evidenced from the higher return which has been achieved in the past.
Based on the analysis, there is still a lower probability of achieving a return of less than
10% by buying the shares of Gipley rather than Petros. However, investors who are
very risk averse may consider even such a risk to be unacceptable. It can be calculated
that the probability of suffering a negative return from an investment is around 0.5%
or one chance in 200, while there is virtually no chance at all, based on probabilities, of
suffering a negative return from an investment in Petros.
The most significant issues, once probabilities based on past performance have
been discussed, relate to future expectations. We are not told, for example whether
these companies are both listed in the same sector. Industry factors and the investor’s
expectations regarding the future would be considered.
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Q
QUESTIONS
Question 3.1
A dictionary defines risk as ‘the chance of bad consequences’, and uncertainty as ‘not to be
depended on’.
Required:
(a) Discuss these terms in the context of financial management.
(b) Identify the relationship between estimated risk and expected return, with respect to a
financial investment.
(c) Explain why an investment in a government security may be considered to be a riskless
investment.
Question 3.2
When you take a risk you should be rewarded with a return. Why is this nexus the cornerstone
of finance?
Question 3.3
Different financial instruments have different inherent risks. Describe the risks associated with
the following:
1. Government bonds
5. Preference shares
2. Corporate bonds
6. Convertible notes
3. Debentures
7. Convertible Preference shares
4. Ordinary shares
Question 3.4
When assessing the overall risk of a company, financial managers take cognizance of business
risk and financial risk.
Required:
(a) Define business risk and discuss the method by which it may be measured.
(b) Define financial risk and discuss the method by which it may be measured.
(c) Discuss the actions a financial manager may take to reduce the overall risk of the company
and the effects this may have on shareholders.
Question 3.5
The following information is available for Astrid Ltd and Duncast Ltd:
Required:
(a) Find the break-even point for each company in units.
(b) Calculate the degree of operating leverage for each company at 25 000 units.
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(c) Explain the differences that you observe between these companies’ break-even points and
degrees of operating leverage.
Question 3.6
The income statement of Flexet Ltd for the past year is as follows:
Required:
(a) Calculate the degree of operating leverage.
(b) Calculate the degree of financial leverage.
(c) Calculate the degree of combined leverage.
(d) Find the break-even point in units.
Question 3.7
The following are abbreviated contribution income statements of two companies, both of which
are active in the food and beverage industry.
Required:
(a) Calculate the degree of operating leverage.
(b) Calculate the degree of financial leverage.
(c) Calculate the degree of combined leverage.
(d) Find the break-even point in rands.
(e) Discuss the relative riskiness of the two companies based on the leverage factors calculated.
Question 3.8
An investor purchased 500 shares in Glicks Stores Limited at the beginning of its financial year at
R22.50 per share, paying 3% brokerage costs. The book value per share on that date was R10.60.
During the course of the year, the company paid a dividend of R2.40. One year later, the company
reported earnings per share of 470 cents. On that date the book value per share was reported as
R13.80. The investor sold the shares for R30.70 each, paying 3% brokerage on the transaction.
Required:
(a) Calculate the return which the shareholder earned for her investment in Glicks stores Ltd.
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(b) Discuss the difference between return on equity, return on investment, and the return to the
shareholder.
(c) If the investor had decided not to sell the shares at the end of the year, calculate her return.
(d) Comment on the riskiness of the investment in Glicks Stores Ltd based on the information
provided.
(e) If the period had been eight months rather than one year, all other information remaining
the same, calculate the return to the shareholder.
Question 3.9
You wish to purchase shares in two companies of the following six that are available:
■■ Company A with an expected return of 10% with a standard deviation of 10%
■■ Company B with an expected return of 10% with a standard deviation of 15%
■■ Company C with an expected return of 15% with a standard deviation of 15%
■■ Company D with an expected return of 10% with a standard deviation of 20%
■■ Company E with an expected return of 15% with a standard deviation of 20%
■■ Company F with an expected return of 20% with a standard deviation of 20%
Required:
(a) Plot these shares on a risk/return graph such as indicated below.
20
15
Return
%
10
5
5
10
15
20
Risk (Standard Deviation)
%
(b)As an investor who is willing to take risks in the hope of retiring early, which two shares
would you buy? Explain.
(c)As a cautious investor who requires a steady return on your investments, which two shares
would you buy? Explain.
(d)Investors are said to be risk averse. Does this mean they will not invest in risky assets?
(e)Why are government bonds considered low risk when there is always the chance that
interest rates will change and the value of the bond will change accordingly?
Question 3.10
Lighthouse Ltd is considering investing in a project that may offer the following possible rates of
returns. The probability distribution of returns from the project is set out below:
Probability
Return
10%
–30%
20%
–5%
40%
15%
20%
30%
10%
40%
What is the expected return from the project? What is the standard deviation of returns?
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Question 3.11
Emma Dlamini is considering two investments and can only invest in either the shares of Company
X or in the shares of Company Y. The following information regarding returns and probability
distributions of returns is relevant:
Required:
(a) What is the expected return of X and Y?
(b) Calculate the standard deviations of X and Y’s returns
(c) What is the co-efficient of variation?
(d) What would you recommend? Why?
(e)Instead of Share Y offering a probability of 20% of achieving a 30% return, assume instead
that the possible return is 40%. How would this affect the investment decision?
Question 3.12
Home Wares Ltd is a listed company which provides home solutions. The company has benefited
indirectly from the growth in residential developments. As an investor in the shares of the
company, you wish to determine how the company’s shares have performed in relation to the
market. You would like to also understand the relative risk of investing in the company as
compared to the market. The following information on returns for Home Wares and the market
is relevant:
Determine the average return for the company and the market. What is the standard deviation
for the company and the market? Comment on the results.
Question 3.13
Based on various scenario planning and economic forecasts, the probability of various states
of the economy have been determined by an economic analyst. The various possible states of
the economy depend upon factors such as the national debt, foreign investment prospects and
internal political factors. The financial manager of Plus-Two Ltd, manufacturers of fashion
wear for teenagers, have predicted the most likely return to shareholders given the state of the
economy as follows:
Conditional state of the economyProbability of Expected
state of economy
return
Boom
5%
40%
Strong economy
15%
20%
Moderate economy
60%
10%
Recession
15%
0%
Deep recession
5%
–10%
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Required:
(All calculations may be rounded to two decimal places of a percentage.)
(a) Calculate the expected return.
(b) Calculate the variance of the expected return.
(c) Calculate the standard deviation of the expected return.
(d) Assuming a normal distribution of returns, calculate the probability that shareholders will
receive a return in excess of 25%.
Question 3.14
Environ Ltd has gathered the following information regarding the probable costs of two alternative
projects designed to recycle effluent which is environmentally sensitive. One of the projects must
be accepted in accordance with legislation relating to environmental pollution. The possible net
cash flows have all been discounted at 16%, but are heavily dependent upon factors that cannot
be predicted with certainty. However, probabilities of occurrence have been established.
Required:
(a) Calculate the expected present value (or cost) of each of the two projects.
(b) Using mean-variance analysis, and the assumption of continuous probabilities, recommend
which project should be accepted.
(c) Discuss the issues that will require consideration depending upon whether the probabilities
are discrete probabilities or a continuous probability distribution.
Question 3.15
Siyabonga Ltd is attempting to measure the riskiness of two projects which have the following
cash flows in different, equally likely, states of the economy.
Required:
(a) Establish, using the standard deviation of cash flows as a measure of risk, which project is
riskier.
(b) Establish, using the co-efficient of variation of cash flows as a measure of risk, which project
is riskier.
(c) Explain which measure of risk you would prefer.
Question 3.16
Baxter Ltd is faced with a problem of fluctuating costs of materials which differ, dependent upon
the type of machine which is used. Two different machines, each producing the same product,
are available. Various possible fluctuations from the estimates have been established for each
machine. The resultant table of possible costs and probabilities assigned to those costs is as
follows:
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Binding machine
Flexing machine
Probability
Costs
Probability
Costs
%
R000
%
R000
10%
40%
30%
20%
750
900
1,420
1,500
20%
30%
50%
1,050
1,400
1,300
Required:
(a) Determine the most likely cost for each machine, assuming:
(i) that the probabilities are discrete;
(ii)that the probabilities reflect point estimates on a continuous distribution which closely
approximates a normal distribution.
(b) For each machine, determine the probability that the cost will be in excess of R1.2 million,
using the properties of a normal distribution and z scores.
Question 3.17
The past returns on an investment in the shares of Nwabisa Ltd have been recorded and processed
to produce the following statistical indicators:
Mean return
24%
Standard deviation
9%
You may assume that the distribution around the mean has the properties of a normal
distribution.
Required:
(a) State the most likely return which an investor may expect to receive from an investment in
the shares of Nwabisa Ltd.
(b) Discuss the issues which should be considered in establishing the likelihood of the return
being different to the expected return.
(c) Using z scores, establish the probability of the following outcomes:
(i) a return of more than 33%
(ii) a return of less than 10%
(iii) a negative return.
Question 3.18
The following summary statistics are generated for the investment listed below.
Mean returnStandard
deviation
Government bonds
8%
2%
Paveco Ltd
14%
8%
Energet Ltd
18%
12%
Argyle Ltd
20%
11%
You may assume that the distribution around the mean has the properties of a normal
distribution.
Required:
(a) Provide reasons (if such reasons exist) as to why an investment in a government bond may
have a standard deviation other than zero.
(b) Calculate the co-efficient of variation for each of the three shares.
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(c) Assume an investor is considering purchasing one of the above four shares. Identify
considerations which should be taken into account and make a recommendation, if possible.
(d) Identify an incongruity which exists between the summary statistics of Energet and Argyle
and discuss whether such summary statistics are feasible.
(e) Calculate the probability of the return on investment in the shares of Paveco being
negative.
Question 3.19
As a financial planner you are called upon to advise your clients on the shares they should invest
in. The choices are:
(a)
Mr Fossil who is risk averse wants you to rank the shares in the order he should consider
investing in them.
(b) Mr Steady is risk neutral and also seeks the appropriate order of investments in which he
should invest.
(c) Mr Quickbuck is a risk taker who wants to retire early in life. Suggest the appropriate order
of the above investments that will satisfy his risk profile.
Question 3.20
The following returns have been obtained from the company’s respective financial statements:
(a) Calculate the expected return and standard deviation of the above companies.
(b) An investor requires high returns but is indifferent as to the risk. Which company would he
invest in?
(c) You are a risk averse investor. Does your choice change?
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4
SOUTH AFRICAN UNIT TRUSTS INVEST OFFSHORE TO DIVERSIFY RISK
A unit trust represents the pooling of investors’ funds into a collective investment. Investment
managers such as Allan Gray, Old Mutual, Sanlam, Cadiz and Coronation invest these funds
in shares, property, bonds and money market instruments. Unit trusts enable small investors to
invest a small amount of money and yet achieve effective diversification. According to Allan Gray,
the “benefit of diversification is that risk is spread among investments that are uncorrelated - for
example, if an investor invested in a single share and if that share’s price went down, the investor
would be at risk of significant monetary loss. But if an investor invested in a unit trust that invests
in 40 shares, and one of those shares underperforms, the effect will be minimal and could even be
cancelled out if another share outperforms” (Allan Gray Unit Trusts August 2010)
Seema Dala of Allan Gray writes that that the JSE “makes up just over 1% of the world’s total
listed equity universe by market capitalisation. It is also a concentrated index: approximately 40%
of the total market capitalisation on the ALSI consists of just five shares − BHP Billiton, SAB,
Anglo American, Richemont and MTN. Intuitively it makes sense to increase exposure to the sectors
and markets that are underrepresented in our local market. Adding international equity exposure
diversifies your returns.” (Allan Gray Quarterly Commentary, Q1, 2013) Coronation’s Global
Managed (ZAR) Feeder Fund, with Tony Gibson as portfolio manager, “is broadly diversified across
countries, which includes mainly developed economies, as well as emerging market economies”.
Coronation’s June 2014 Fund Factsheet states that the fund is suitable for South African investors
who want to diversify their portfolios into foreign equity markets. In this chapter we will explore the
concept of diversification and portfolio theory.
LEARNING OBJECTIVES
After working through this chapter, you should be able to:
■■ Explain the impact of diversification on the expected return and risk of a portfolio of
shares.
■■ Calculate the following indicators of risk and expected return on a portfolio of shares:
–– expected return on a two-asset portfolio;
–– risk of a two-asset portfolio using covariance;
–– expected return on a multi-share portfolio;
–– beta of a portfolio;
–– expected return on a leveraged portfolio;
–– standard deviation of a leveraged portfolio.
■■ Understand the concept of an efficient frontier.
■■ Apply the concept of the security market line.
■■ Evaluate the concept of market efficiency.
■■ Use Excel to determine betas.
■■ Understand the use of betas in practice.
Introduction
The old adage that you shouldn’t place all your eggs in one basket reveals a general approach
to risk. Because virtually all future outcomes are uncertain, it would not be wise for an
investor to place all available funds in one investment. At the time of investment, it is not
known with certainty which investments will succeed and which will fail. It is therefore sensible
to diversify into a number of investments in the expectation that those which are profitable
will at least compensate for the loss which may be sustained from those that are not. This is
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the fundamental principle for adding a risk premium to the risk-free rate, for an individual
investment opportunity which is not risk-free, in order to arrive at the required return for
that investment. This principle was fully outlined in Chapter 3.
In this chapter we describe the effect on expected return and estimated risk of diversifying
– of investing in more than a single investment. We confine the discussion to investments on
securities markets, because the share prices are known at the time of purchase and there is a
past record of returns available which is useful for forecasting future returns. The principles
of portfolio management may, however, be generalised to encompass all assets in which an
investor may invest. These include investments in businesses not listed on a stock market,
property investments, works of art, stamps, or any asset which may lead to an increase in
wealth as a result of income generated or capital gains realised.
Using modern portfolio theory and the capital asset pricing model, it will be demonstrated
that holding a portfolio of shares will always be a superior investment strategy to selecting
an individual share. Portfolio management is based on the work of many researchers but
pioneered by Markowitz (1959) and Sharpe (1964). Portfolio theory is based on a number of
assumptions regarding the way in which investors and stock markets function. While these
assumptions may seem restrictive, the principles are fundamental to an understanding of
investment strategies and are essential to an understanding of financial principles.
Portfolio management focuses on the investment principles used by both individual
and corporate investors. This is relevant to the financial manager since the objective of the
financial manager is to create wealth through effective business operations. The financial
manager must be aware of the approach taken by all investors, who determine the share
price of the business by their demand for, and supply of, the share through the stock market.
The principles of portfolio theory are also applicable to the financial manager’s function of
structuring the portfolio of assets held by the business, from which its income is derived.
1 Two-asset portfolio risk and return
Holding more than one investment in financial assets is generally referred to as holding a
portfolio of investments (although there may be a one-asset portfolio). The principles used
when establishing the expected return of a portfolio will be discussed using a two-asset
portfolio and then by generalising the principles to a portfolio with many financial assets.
Example 4.1: Investing in a two-asset portfolio
An investor decides to invest R10 000 in a portfolio which may consist of any combination
of shares in Plasco Ltd and Quinco Ltd. The following summary expected return (Re) and
standard deviation () statistics are available for the two companies:
Plasco Re = 30%;  = 12.6% and Quinco Re = 20%;  = 10.3%
If, for example, R5 000 is invested in Plasco and R5 000 in Quinco, it would be expected that
the return on the portfolio would be a weighted average of the proportion invested in each.
This example will be used as a basis for establishing the measure of return and the measure
of risk for possible portfolio combinations.
Measuring two-asset portfolio returns
An investor who decides to diversify by buying shares in two companies will expect a return
dependent on the proportion of funds invested in each share. The expected return of the
portfolio will quite simply be the weighted average of the expected returns of the individual
shares as depicted in Table 4.1.
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Table 4.1 Expected returns for various portfolios of P and Q
It is clear from Table 4.1 that the greater the proportion of funds invested in P Ltd, the higher the
expected return becomes. The general formula for calculating the expected return of a portfolio
n
is:
Rp = ​​ ​​  Wi × Ri(Formula 4.1)

i=1
where: Rp = the expected return on the portfolio
Wi = the proportion of funds invested in share i
Ri = the expected return on share i
Expected return is not the only parameter on which to base the decision. A measure of risk
for the various portfolio combinations is required.
The principles of portfolio risk
The risk of a portfolio depends not only on the riskiness of the individual shares which
compose the portfolio, but also on the relationship between their returns. The tendency
may be to expect that portfolio risk is calculated in a similar fashion to portfolio return – i.e.
using a weighted average. However, this is not the correct procedure.
Assume we are able to collect the historical information on the share price performance
of the two shares P and Q, and they are as listed in Table 4.2.
Table 4.2 Past performance of shares P and Q, and an equally weighted portfolio PQ
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The following is apparent from the data collected and processed:
■■ Share P has an average return of 30% over the period, and share Q has an average
return of 20%.
■■ The standard deviation of returns has been calculated using Excel, and reflects the
greater variability of returns for share P, with a standard deviation of 12.6% compared
to 10.3% for share Q.
■■ Of particular relevance is the fact that the two shares tend to move in similar directions
in each year. In year 1, for example, both shares achieved well above the mean return,
whereas in year 2 both shares achieved well below their mean. This pattern is evident
throughout the 8-year period.
■■ The standard deviation of an equally weighted portfolio lies between those of each
individual share. Because the shares move in near-perfect unison, the risk of the
portfolio reflected in the standard deviation of 11.4% is very close to the weighted
average of the two standard deviations.
The results are reflected in Figure 4.1.
Figure 4.1 Returns on P and Q: near-perfect unison: 50/50 portfolio
The measure of harmony in movement between the two shares can be calculated in further
summary statistics. When only one share was under consideration we used the square root of
its variance, the standard deviation. For two shares we use the covariance, often expressed in
a standardised form as the correlation co-efficient. This statistic reflects the degree to which
two variables move together. The values of correlation lie between +1, which is perfect
positive correlation, and –1, which is perfect negative correlation. Note the correlation coefficient is a high positive figure of 0.978.
A correlation co-efficient of 0 indicates that there is no correlation between the two
variables. In this hypothetical example, where P and Q move in near-perfect unison, a state
of near-perfect positive correlation exists. This situation would seldom exist in practice.
Covariance and correlation are explained in greater detail in Chapter 3 and the data
set out in Table 4.1 for shares P and Q is used in Chapter 3 to define and determine the
covariance and correlation co-efficient. We apply the appropriate calculations, as well as use
Excel to determine covariance and correlation. Please refer to Chapter 3.
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Assume now that all the rates of return are identical to those in Table 4.2, but that the
timing is different. Notice from Table 4.3 that the average return and standard deviation for
each share remains identical, but the co-movement, reflected in the covariance statistic and
the correlation co-efficient, is significantly different.
Table 4.3 Past performance of shares P and Q, and an equally weighted portfolio PQ
If the data were as presented in Table 4.3:
■■ Share P has an average return of 30% over the period, and share Q has an average
return of 20%. This is identical to the previous case.
■■ The standard deviation of returns has been calculated using Excel (=STDEVP), and
reflects the greater variability of returns for share P, with a standard deviation of 12.6%
compared to 10.3% for share Q. This too is identical to the first case. Note that we have
determined the population standard deviation. We did not use the STDEV function,
which calculates the standard deviation for a sample1.
■■ The difference, however, is that the two shares move in opposite directions in each year.
In Year 1, for example, when P performs well above its mean return, Q performs well
below its mean return. This pattern is evident throughout the 8-year period.
■■ The result of this pattern of returns is that an equally weighted portfolio tends to
have very similar returns each year, thus there is much greater consistency, and less
variability, reflected in the very small standard deviation of the portfolio of only 1.9%.
■■ Of equal interest is the correlation co-efficient, which is very highly negative at minus 0.9667.
Later in the chapter, the manual calculation of these important summary statistics for a twoasset portfolio will be demonstrated. Figure 4.2 illustrates the movement of each share over
the 8-year period, and that of an equally weighted portfolio, based on the historical returns in
Table 4.3.
1
In order to be accurate, we should really divide by (n–1) rather than n in our examples. See for example, Table
4.4 and the Self-study example at the end of the chapter in which we should divide the squared deviations by (5–1)
rather than by 5. In practice, we will be working with very large samples and so there will be very little difference
between the use of (n–1) or n. So we have retained n to reflect the reality that the results will be very close in
practice whilst in our examples which have very limited observations, the effect will be significant. In Excel, use the
=STDEV function to reflect the standard deviation of a sample.
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Figure 4.2 Returns on P and Q: near-perfect negative correlation: 50/50 portfolio
The frequency distributions of returns on share P, share Q, and the portfolio of shares P and
Q respectively, are roughly graphed in Figure 4.3.
Figure 4.3 Frequency distribution of two individual shares and the portfolio of two shares
The following can be noted:
■■ The dispersion around the mean of Q Ltd is considerably tighter than the dispersion
around the mean of P Ltd. This is in accordance with the expectation that P Ltd is more
risky than Q Ltd, but offers a higher expected return.
■■ The dispersion around the mean of the portfolio of 50% P Ltd and 50% Q Ltd is tighter
than that of either P Ltd or Q Ltd. This means that the risk of the portfolio, in this case,
is lower than the risk of holding either P Ltd or Q Ltd individually.
Just as it is unlikely that two shares will be perfectly positively correlated, it is also unlikely
that two shares will be perfectly negatively correlated. Because of the many general factors
that are likely to influence all shares in a fairly similar manner at any given time, shares will
tend to be positively correlated rather than negatively correlated. In general, however, it can
be accepted that anything less than perfect positive correlation will cause the portfolio risk
to be lower than the weighted average of the standard deviations of the two shares held in
the portfolio.
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Measuring two-asset portfolio risk
The risk of a two-asset portfolio has been demonstrated in principle to depend upon the
extent to which returns move in harmony with each other. The extent of this co-movement
may be measured by calculating the covariance between two shares, denoted by covA,B, or its
normalised statistic, the correlation co-efficient, denoted as rA,B. Once these indicators have
been calculated, it is possible to derive the variance and standard deviation of the two-asset
portfolio. These procedures are best illustrated using an example.
Example 4.2: Statistical calculations for two-asset portfolio
Information is available for two shares – Benix Ltd, listed under the general retail sector, and
Genhold Ltd, listed under the media and entertainment sector. The returns for shareholders
have been calculated for the last five years.
Before proceeding with the statistical procedures illustrated in Table 4.4, the following must
be noted:
■■ The number of data points used is for illustrative purposes only. Five points are
inadequate for any meaningful statistical interpretation in practice.
■■ It is assumed that the distribution has the characteristics of a standard normal
distribution.
■■ Past performance is considered to be valid for the purpose of predicting future
expectations.
Table 4.4 provides the basis for calculating the mean and standard deviation for each share,
as well as the covariance and correlation co-efficient of the two shares.
Table 4.4 Calculation of the mean, standard deviation and covariance
From Table 4.4 the following should be noted:
■■ Columns one and two list the past returns to shareholders over the last five years. Each
column_ is totalled and divided by the numbers of readings (five) in order to obtain the
mean (​x​), which then serves as the expected return.
■■ Columns three and four reflect the deviations from the respective means. These are
squared in columns five and six. The columns are totalled and divided by the number of
readings (five) in order to obtain the variances (2) of 0.10% and 0.356%. The variances
may be converted to standard deviations () by finding their square roots.
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■■ Each deviation of Benix (db) in column three is multiplied by the deviations of Genhold
(dg) in column four, in order to obtain (db)(dg) in column seven. These are totalled
and divided by the number of readings (five) in order to obtain the covariance covbg of
– 0.026%.
■■ Note that these two shares did not always move in harmony. For example, in year one, when
Benix achieved 2% above its mean performance of 24%, Genhold achieved 6% below
its mean performance of 30%. These contrary performances have resulted in a negative
covariance of –0.026%.
■■ The covariance term may be normalised – i.e. expressed in a manner such that
all readings will fall between –1 and +1. Such normalised covariance is called the
correlation co-efficient and is calculated as follows:
covbg
bg = 
​  ×  ​
(Formula 4.2)
b
g
– 0.026%
 ​
= ​
3.16% × 5.97%
= – 0.14
where:
bg = correlation co-efficient of B and G
b = standard deviation of B
g = standard deviation of G
covbg = covariance of B and G
This summary statistic indicates that there is a slight negative correlation between Benix
and Genhold.
It also follows from Formula 4.2 that if both standard deviations are known, as well as
the correlation co-efficient, then the covariance may be calculated as follows, all notation
being identical to Formula 4.2
covbg = bg × b × g(Formula 4.3)
We now wish to measure the variance of a portfolio of shares comprising a proportion
of both Benix and Genhold shares. We will thus develop a variance matrix from which a
formula for calculating the variance and standard deviation of a portfolio may be derived.
Assume we wish to construct a portfolio of 25% Benix and 75% Genhold. The first step
in constructing a variance matrix requires that the relative weighting for each block in the
matrix be determined. This is illustrated in Table 4.5.
Table 4.5 Weights in a variance matrix. This requires that the relative weighting for each block in the matrix
be determined.
Benix (25%)Genhold (75%)
Benix (25%)
0.0625
0.1875
Genhold (75%)
0.1875
0.5625
From Table 4.5, the following must be noted:
■■ The figures obtained in each block represent the weighting which each will have in the
total variance of the portfolio.
■■ The sum of the weightings is equal to one.
The relative variance and covariance figures may now be inserted. In Table 4.6, it is apparent,
for example, that the block matching Benix with Benix uses the variance of Benix, while the
block matching Benix with Genhold uses the covariance between Benix and Genhold.
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Table 4.6 Variance matrix for Benix and Genhold
Benix (25%)Genhold (75%)
Benix (25%)
0.0625 × 0.10%
0.1875 × –0.026%
Genhold (75%)
0.1875 × –0.026%
0.5625 × 0.356%
The sum of all the variances and covariances multiplied by their weightings in the matrix
equals 0.19675% (0.00625% + 0.20025% – 0.004875% – 0.004875%). This is the variance of
the portfolio comprising 25% Benix and 75% Genhold.
This method of arriving at the variances is cumbersome and may be expressed and
calculated by a formula which derives from the matrix as follows:
 2p​ ​= W​2b​ ​2b​+ W​2g ​ ​2g ​+ 2WbWg × covbg
(Formula 4.4)
where: ​2​= the variance of the portfolio
p
2
W​
​and W​2g ​= the weight (proportion) invested in B and G respectively
b
(note: Wb + Wg = 1)
​2b​ and ​2g ​= the variance of returns on shares B and G respectively
covbg = the covariance of the returns on the two shares
Applying Formula 4.4 to calculate the risk of a portfolio comprising 25% in Benix and 75%
in Genhold results in the following:
​2p​= (0.25)(0.25)(0.10%) + (0.75)(0.75)(0.356%) + (2)(0.25)(0.75)(–0.026%)
= 0.19675%

So p = ​ 0.19675% ​
= 4.44%
Note that Formula 4.4 can also be expressed using the correlation co-efficient, if the
covariance is not known, as follows (with notation identical to Formula 4.4). Refer back to
formula 4.3 for a breakdown.
​2p​= W​2b​​2b​+ W​2g ​​2g ​+ 2WbWgbgbg(Formula 4.5)
Of course, you may not like formulae 4.4 and 4.5. Well, in this example we can determine the
standard deviation of the portfolio in another way. Firstly, we will use Excel to determine
the weighted average return for each year by multiplying the return for each security by
its weighting in the portfolio to determine a weighted-average return for each year. For
example, we would determine the weighted-average return for Year 2 to be 31.3% [(0.25 ×
20%) + (0.75 × 35%)]. We then determine the average return and standard deviation of the
portfolio returns. In this case, we have used the Excel function [=STDEVP(B16..F16)] to
determine the standard deviation of 4.44%. This agrees with the result that we obtained by
using Formula 4.4 and is presented in Table 4.7.
Table 4.7 Portfolio return and portfolio standard deviation
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Example 4.3: Risk of two-asset portfolios
Share P has Re = 30%;  = 15% and share Q has Re = 20% and  = 10%. The correlation
co-efficient for the returns of the two companies is known to be +0.4. Determine the risk of
the portfolio for weights of p = 100%, 75%, 50%, 25% and 0%.
Only one calculation is shown as an example, where Wp = 25% (by default Wq must
be 75%), the others being tabulated in Table 4.8. Use Formula 4.5 to check the standard
deviations of the portfolio combinations (p) tabulated in Table 4.8. To solve for Rp refer
back to Formula 4.1:
​2p​= (0.0625)(0.0225) + (0.5625)(0.01) + 2(0.75)(0.25)(0.4)(0.15)(0.10)
= (0.001406) + (0.005625) + (0.002250)
= 0.009281

So p= ​ 0.009281 ​
= 0.096338 = 9.6%
Note that in this case the risk of the portfolio as measured by the standard deviation is lower
than the risk of Q Ltd. In other words, holding the portfolio is less risky than the lowest-risk
individual share. This is a special case and cannot be generalised. In all cases, however, the
portfolio risk measured by the portfolio standard deviation will be less than the weightedaverage standard deviations of the two shares. The full range of risk for holding different
proportions of the shares is as follows.
Table 4.8 Portfolio risk and return
% Invested in P Ltd
% Invested in Q Ltd
p
Rp
100%
0%
15.0%
30.0%
75%
25%
12.5%
27.5%
50%
50%
10.5%
25.0%
25%
75%
9.6%
22.5%
0%
100%
10.0%
20.0%
We are now in a position to graph the expected return and risk of portfolios comprising
different proportions of shares in P Ltd and Q Ltd. This is displayed in Figure 4.4.
Figure 4.4 Feasible set of portfolio of two assets
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The line ABC represents a feasible set of portfolios, that is, all the possible combinations
of P and Q are represented. It makes sense to hold a combination of P and Q which lies
between points A and B, because any portfolio between B and C would be inferior to a
portfolio between A and B. Point y, for example, is superior to point C because it results in
a higher return for the same degree of risk. These relationships were originally identified by
Markowitz, who gave the name efficient frontier to the line AB.
In Table 4.9, we have expanded Table 4.8 to include more portfolio weightings. We then
apply Formula 4.5, assuming a correlation (p) of 0.4 and the same returns and standard
deviations.
The resulting standard deviation and expected return is presented in Table 4.9. If the
weighting of P is 25%, we will note that the portfolio standard deviation is 9.6%, which is
what we calculated using Formula 4.5.
Table 4.9 Portfolio risk and return — expanded
We have then calculated the same tables assuming a correlation (p) of 1, –1 and 0. We can
plot this to see how correlation will affect portfolio risk as measured by its standard deviation.
The relationship between the portfolio return and risk for each level of correlation (p) is
depicted in Figure 4.5.
Figure 4.5 Portfolio risk and return for P & Q
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Perfect correlation (p = 1) results in a straight line from P to Q and so diversification does
not result in lower risk relative to return as the standard deviation is simply a weighted
average of the standard deviations of P and Q. If the correlation between the share returns
of P and Q are less than 1, then there will be some benefit from diversification. If P and Q
are perfectly negatively correlated (p = –1), then this will result in a significant reduction in
risk depending on the relative weightings of P and Q in the portfolio. A portfolio made up
of 40% of P and 60% of Q will result in a portfolio with zero risk, if the share returns are
perfectly negatively correlated (p = –1).
It is important to note that with diversification and less than perfect correlation, we get
a weighted-average rate of return but a less than weighted-average level of risk. We get
something for nothing.
Positioning an investor on the efficient frontier
We must now address the question of which combination of stocks should be selected by
an investor. Unfortunately, there is no way of calculating this as it is dependent on the
utility function of the investor. The term utility is derived from economics and refers to
the subjective satisfaction obtained by an individual from taking certain actions or being
subjected to certain circumstances. The well-known concept of diminishing marginal
utility implies that, as expected investment return increases, the additional subjective
satisfaction of an investor declines at an increasing rate. The rate of decline is dependent
upon the attitude toward risk of the individual investor. The more risk-averse an individual
is, the steeper the decline in marginal utility will be. This is illustrated in Figure 4.6.
Figure 4.6 Utility curves
From Figure 4.6 it is clear that the risk-indifferent individual displays no diminishing marginal
utility, i.e. he or she continues to derive utility proportional to the increase in expected
investment returns. The utility function is, therefore, linear. The moderately risk-averse
individual requires increasingly higher returns in order to enjoy a given level of utility – the curve
therefore adopts a convex shape. The extremely risk-averse investor’s curve slopes even more
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steeply upward, indicating the relatively greater increase in expected return required for a
given quantum of utility.
The straight line and curves in Figure 4.6 are also known as indifference curves. This means
that individuals represented by those curves are indifferent to investment opportunities
offering the combination of return and utility lying along their particular slope. It is important
to note that it is the slope, or steepness, of the line that distinguishes the risk characteristics
of individual investors.
The utility functions can be superimposed onto the risk-return space illustrated in Figure
4.7. Figure 4.7 indicates the indifference curves for two investors X and Y.
Figure 4.7 Indifference functions
The following can be seen in Figure 4.7:
■■ Three discrete indifference curves of investor X are X1, X2, and X3. The curves proceed
in an upward and leftward direction, depicting the increasing return being sought for
increased risk. The slope of the curve reflects the risk preference of the investor. Curve
X1 does not encounter any investment opportunity. Curve X2, although offering less
utility, is the first to contact the opportunity set of feasible portfolios on the efficient
frontier. Curve X3 meets the efficient frontier at two points, although both points offer
less utility than point X. Investor X will select the portfolio represented by point X.
■■ The indifference curves illustrated for investor Y are Y1, Y2, and Y3. Investor Y is
more risk averse than investor X. This is evident from the fact that the utility curves
of investor Y are steeper, with a greater return required for accepting each unit of
risk than X. As a result, a portfolio will be selected by Y, which has less risk than that
selected by X. It will, however, also have a lower expected return.
2 Multiple-share portfolio risk and return
The principles relating to the calculation of the expected return and the risk of a portfolio
with more than two shares are identical to those of a two-share portfolio as per Formula 4.4.
The expected return is the weighted average of the expected returns of all the shares in the
portfolio. The relevant formula is thus Formula 4.1.
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The risk of a multiple-share portfolio, although identical in principle to that of a twoshare portfolio, is considerably more onerous to calculate. If, for example, 40 shares are
held, the variance matrix will have 1 600 blocks. For each share held, its variance (weighted
by the square of the proportion invested in that share), plus its covariance with every other
share in the portfolio (weighted by the product of the proportions invested) has to be
calculated. For a portfolio of 40 shares, 40 variances plus 780 covariances (each appearing
twice) would have to be calculated.
More formally, a two asset portfolio comprises of a 2 × 2 matrix. Similarly a three asset
portfolio comprises of a 3 × 3 matrix. It follows that a forty asset portfolio comprises of a
40 × 40 matrix. This matrix contains n terms. In the above example, n represents the individual
asset variances. The remaining (n2 – n) terms comprises the covariances between portfolio assets.
(n2 – n) = (402 – 40) = 1 560
or
1560/2 = 780, as each covariance appears twice.
From the formula which follows, it can be seen that the first term is the sum of all the
variances, and the second term is the sum of all the covariances.
n

n
n

​2p​= ​ ​ ​​  W​2i ​​2i ​+ 2 ​ ​ ​​
​
​ ​ ​WiWjcovij
i=1
i=1
(Formula 4.6)
j=1
i= j
where: ​2p​= the portfolio variance
​2i ​= the variance of share i
Wi and Wj = the proportions invested in share i and share j respectively
covij = the covariance between the returns of shares i and j
The opportunity set of all portfolios of shares on a market such as the ASX can now be
graphed as in Figure 4.8.
Figure 4.8 Opportunity set of share portfolios
The shaded area represents portfolios of shares available.
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The following should be noted from Figure 4.8:
■■ A, C, D and E are individual shares, which are portfolios of one share.
■■ The scalloped line AEDC results from the portfolio effect from two-share portfolios of
AE, ED and DC respectively.
■■ All possible portfolios, in the feasible set F (the shaded area), are dominated by the
portfolios that lie along AB, the efficient frontier. This means that, for any portfolio
within the feasible set F, the portfolios along the line AB will offer a superior return
to those vertically below the line, for the same risk. (For example, portfolio X offers a
higher return than portfolio Y, for the same risk.)
■■ Investors will invest only in portfolios that lie along the efficient frontier. The portfolio
which they will select (that is, the specific point along line AB) will be a function of their
risk preference as determined by their indifference curves.
The benefits of diversification
It is evident from the preceding discussion that investors can benefit from allocating their
funds to more than a single investment. This process of diversification has the effect of
reducing the variability of the portfolio returns. Stated differently, the expected return of a
portfolio will be the weighted average of returns, but the risk will be less than the weighted
average of the variances. In general, it has been shown from research studies that a relatively
small number of shares are required in a portfolio in order to derive the major benefit of
reduced risk. This is illustrated in Figure 4.9, which also introduces some important concepts
of risk. These form the basis of the remainder of this chapter.
Figure 4.9 Effect of diversification – portfolio risk
The following can be seen from Figure 4.9:
■■ The risk of the portfolio decreases rapidly with the first few shares held and then levels
off until there is no meaningful reduction in risk resulting from an increase in the
number of different shares in the portfolio.
■■ Using eight shares as an example, and reading off line ABC, the total risk of this
portfolio is in the region of 30%.
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■■ By enlarging the portfolio to, say, 20 shares, further benefit can be derived in
risk reduction, whereafter the marginal benefits of further diversification become
considerably reduced.
■■ A point is reached where all the shares in the market could hypothetically be held. At
this point the investor is still exposed to some risk. A market-portfolio risk of 20% is
assumed in this example.
■■ It is useful to distinguish between the two kinds of risk. Specific risk relates to variability
in returns caused by factors unique to the company, such as the type of industry in
which it operates and the product it sells. This is often referred to as unsystematic
diversifiable risk, or company risk. An investor may eliminate this type of risk by
diversification.
■■ The remaining risk results from the vagaries of market sentiment and of economic
cycles. It is influenced by factors such as inflation, varying interest rates and foreign
exchange rates. All companies, although not equally sensitive to these economic
fluctuations, nevertheless tend to be affected in a similar way. This type of risk is
generally referred to as systematic risk, non-diversifiable risk or market risk, and cannot
be eliminated by diversification.
Introducing a risk-free asset
Certain assumptions have been made in presenting the case for diversification, and these need
to be clearly identified. They are some of the assumptions that underlie a model developed from
the work of Markowitz (1959) and Sharpe (1964), generally referred to as modern portfolio theory
(MPT).
Like most models, the assumptions do not perfectly reflect reality. However, the model
can be tested by relaxing the assumptions and determining whether the results obtained are
similar to those obtained when applying the assumptions. If this is seen to be the case, the
model is considered to be robust, and to be a reasonable representation of reality. The MPT
model discussed so far is based on the following significant assumptions:
■■ All investors are rational and prefer less risk rather than more for a given rate of return.
■■ All investors have full and equal access to all available information which results in
them all having similar expectations.
■■ There are no transaction costs such as brokerage; the markets are perfectly competitive;
and all financial assets are divisible.
■■ There is no taxation.
Sharpe (1964) introduced the concept of a risk-free asset together with the assumption that
investors can borrow or lend at the risk-free rate. By introducing the risk-free asset, a new
dimension of thought about the capital market was made possible. The effect of introducing
a risk-free asset such as a treasury bill is illustrated in Figure 4.10.
The following should be noted in Figure 4.10:
■■ Rf is the risk-free rate at which investors can borrow or lend.
■■ RfMC is known as the capital market line (CML). It is a tangent to the efficient frontier
EF, with M being the market portfolio – i.e. it contains all the financial assets available
in the market, proportional to the value of the individual’s portfolio.
■■ The point L1 represents the portfolio that could be held by an investor L if there
were no riskless assets available, and represents a rational choice. However, with the
introduction of a risk-free asset, it is clear that investor L could include a proportion of
the risk-free asset into the portfolio and move vertically up to point P, thereby enjoying
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
Figure 4.10 The capital market line
g reater expected return for the identical risk at point L1. However, investor L will act in
accordance with his or her particular utility function, thus selecting point L2 rather than
point P.
■■ The point L2 represents a point to which investor L could move, based on the
indifference curves. At this point, investor L will invest partly in the market portfolio
M and will invest (lend) the remainder at the risk-free rate. By so doing, higher utility
is achieved as a result of being exposed to lower risk than would have existed had
portfolio L1 been purchased.
■■ It is of fundamental importance to note that investor L is investing in a combination of
the market portfolio M and the risk-free asset R. The proportion of each is dependent
upon the point of tangency with line RfMC. The closer to point Rf, the greater the
proportion invested in the risk-free asset.
■■ Similarly, the point B1 represents the portfolio a less risk-averse investor B would
acquire if there were no risk-free asset available. However, with the introduction of
the risk-free asset, B will borrow at the risk-free rate and invest personal funds as well
as the borrowed funds into the market portfolio M. This results in a move to a higher
indifference curve at point B2. B has thus levered a portfolio by borrowing at the riskfree rate with an obligation to pay interest on the borrowed funds, but investing them
together with personal funds in the market portfolio, thus increasing the net expected
return.
Example 4.4: Including a risk-free asset in the portfolio
An investor has indifference curves so that her portfolio has Rp = 25% and p = 17% before
there is a risk-free asset available on the market. The return on the market Rm = 22%, and
the standard deviation of the market, m = 12%. A riskless asset becomes available so that
Rf = 12%, and she is able to borrow or lend at that rate. She has an amount of R10 000
available to invest.
This investor is less risk-averse than the average investor (will accept more risk). She can
benefit from borrowing and levering her portfolio. If she decides to borrow an additional
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R5 000, her new expected return as a result of borrowing may be calculated using the
following general formula:
Rpl = WRf + (1 – W)Rm(Formula 4.7)
where: Rpl = the expected return on a leveraged portfolio
W = t he percentage of the investor’s own funds invested in the risk-free
asset (borrowed or lent)
Note that the investor is borrowing in order to invest more money in the market portfolio.
In this case, therefore, W is a negative variable as it indicates the payment of interest which
will have to be made.
Applying Formula 4.7, the expected return on a leveraged portfolio is:
Rpl = WRf + (1 – W)Rm
Rpl = (–0.5 × 0.12) + (1.5 × 0.22)
= 27%
The investor therefore expects to receive a return of 22% on R15 000 and will have to pay
interest at 12% on R5 000. A quick check using the actual figures proves this:
Received: 22% × R15 000 = 3 300
Paid: 12% × R5 000 = –600
Return on investment of R10 000
= 2 700
In order to establish the risk of the new portfolio, Formulae 4.6 or 4.5 for risk of a two-asset
portfolio are appropriate, the market portfolio being considered as one asset and the riskfree asset as the other. Because the risk-free asset has  = 0, the formula loses two of its
terms and simplifies to:

pl = ​ W​m2 ​ ​ ​m2 ​ ​(Formula 4.8)

= Wmm = 1.5 × 0.12
= 18%
The investor, by using the borrowing facility, has levered herself from Rp = 25% and p =
17% to Rpl = 27% and pl = 18% which offers higher utility to her.
In much the same way, an investor who is more risk-averse than average (prefers less
risk), could invest a proportion of available funds into the risk-free asset. The result would
be to move down the line RfMC to a point such as L2 in Figure 4.11, which would place the
investor on a higher utility curve than at point L1. It is clear from Figure 4.11 that all points
along the capital market line in fact dominate the efficient frontier, except point M (the
market portfolio, an unlevered portfolio comprising only shares and no riskless asset).
3 Beta analysis
Modern portfolio theory has undoubtedly been the most important development in finance
theory during the twentieth century. The theory as discussed thus far does, however, have
practical shortcomings. Firstly, the determination of portfolio risk of a multishare portfolio
is extremely onerous. Secondly, the notion that investors would, in practice, purchase a
proportion of all the shares in the market is impractical, although investment in some
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unit trusts or by buying the all-share index may be comparable to investment in a market
portfolio.
It has already been noted that great benefit in risk reduction is achieved by diversifying
into a relatively small number of different shares and that the marginal benefit of further
risk reduction soon becomes negligible. It has also been noted that company-specific risk,
also referred to as unsystematic risk, is the element which can be diversified away, whereas
investors always remain subject to market risk. Sharpe recognised these shortcomings and
devised a measure that reflects the sensitivity of an individual share to fluctuations in the
market, thereby measuring the share’s non-diversifiable risk. The measure is known as the
beta of a share.
Because investors will not be rewarded for risk that can be eliminated by diversification,
only the market risk as measured by beta is relevant. The measure is called beta because it
is represented by the term b in the straight line equation y = a + bx – i.e. it is the slope of a
line representing the returns on a given share when compared with the returns of the share
market as a whole. This is reflected in Figure 4.11.
Figure 4.11 Graphic representation of beta
By definition, the market has a beta of one. For example, a share which on average increases its
return by 10% when the market returns increase by 10%, and vice versa, will also have a beta
of one. If a share increases on average by 15% when the market increases by 10%, it has a
beta of 1.5. If a share increases on average by 5% when the market increases by 10% it has a beta
of 0.5. Beta is thus a measure of the volatility of a share relative to the volatility of the whole
share market.
Beta as a measure of portfolio risk
It must be stressed that the future beta of a share is the relevant measure of its market risk.
However, the beta is established from past information on the assumption that it will remain
fairly stable over time. The total risk of any individual share is:
Total risk = Systematic (market) risk + Unsystematic (specific) risk
As unsystematic risk can be eliminated by diversification, the risk which is of interest to the
investor is the systematic risk as measured by the beta of the portfolio.
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The major advantage arising from the use of beta analysis is that the beta of a portfolio of
shares is simply the weighted-average of the individual share betas, expressed as follows:
n

p = ​ ​ ​​  Wjj(Formula 4.9)
j=1
where: Wj = the weight of share j in the portfolio
It is now possible to establish the two parameters of risk and return for a portfolio quite
easily, provided the betas of the individual shares are known. Investors will therefore manage
their portfolios by selecting a portfolio which has a beta that provides them with maximum
utility. As beta is a linear concept, it is possible to graph a security market line (SML) which is
used for displaying the risk-return relationship for individual shares held within a diversified
portfolio. The formula for the SML, which is known as the Capital Asset Pricing Model is:
Ri = Rf + i(Rm – Rf)(Formula 4.10)
where:
Ri = the required return on share i
Rf = the risk-free rate
i = the beta of share i
Rm = the expected return on the market as a whole
It is apparent that, for given shares, the premium for risk (Rm – Rf) will be greater as beta
increases because that share is more volatile (risky) than the market average. The SML is
illustrated in Figure 4.12.
Figure 4.12 The security market line
The expected return of all shares will fall along the SML. This pricing model, known as the
capital asset pricing model (CAPM), makes it possible for investors to create and adjust
portfolios of their choice. Any individual share that does not plot along the SML is either
overpriced or underpriced because its expected return differs from its required return, thus
requiring a price adjustment to restore equilibrium. If the market is functioning efficiently,
the forces of supply and demand will restore the price to equilibrium, on the SML.
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Example 4.5: Portfolio management
An investor holds a portfolio of 20 shares with an expected return of 28% and a beta of 1.3. He
wants to withdraw 25% of the funds currently invested in share A, which has Ra = 24% and
βa = 0.9, and invest them into share B, which has Rb = 35% and βb = 2.0. What is the
expected return and beta of the new portfolio?
The expected return of the remaining 75% of the portfolio must first be determined as
follows:
28% = (0.25 × 24%) + (0.75 × Rx)
The expected return on the remaining 75% of the portfolio Rx is calculated as follows:
Rx = [28% – (0.25 × 24%)] / 0.75 = 29.3%
The expected return of the new portfolio will be:
Rpn = (0.75 × 29.3%) + (0.25 × 35%)
= 30.725%
Similarly the beta of the remaining 75% of the portfolio must first be determined as
follows:
1.3 = (0.25 × 0.9) + (0.75 × βx)
The beta of the remaining 75% of the portfolio is βx and is calculated as follows:
βx = [1.3 – (0.25 × 0.9)] / 0.75 = 1.43
The beta of the new portfolio will be:
βpn = (0.75 × 1.43) + (0.25 × 2)
= 1.5725
Beta and the capital asset pricing model (CAPM)
In statistical terms, beta is a regression co-efficient expressing the relationship between an
individual share and the market with the variance of the market, and it can be determined
through least squares regression analysis. Usually weekly or monthly returns are used over a
period of years for the company’s shares. For a measure of the market as a whole, the market
index is used. The procedures for calculating beta are demonstrated in Appendix 4.1. In
Appendix 4.2, Professor Dave Bradfield offers us his perspectives on the determination of
betas for BNP Paribas/Cadiz Equity Risk Service, which is one of the most popular source
of betas for corporate finance practitioners. Betas for South African companies may also
be sourced from other services such as Bloomberg, Reuters and McGregor BFA. Different
researchers may arrive at different betas depending on the method of calculation employed,
the number of past observations, and other assumptions that have to be made. Betas may
be established for individual shares as well as for industry sectors. Betas are subject to
fluctuation, although portfolio betas have been found to be fairly stable over time.
Table 4.10 illustrates betas calculated for sectors on the JSE. A beta of 1.68 for the
General Mining sector indicates that this sector is relatively more volatile than the overall
index. This means that if the overall market changes by 1%, then the General Mining sector
changes in the same direction by 1.68%. Betas for some sectors are larger than others.
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Food and Drug retailers are on the other side of the beta spectrum, with an industry beta
of 0.37. This is significantly lower than the market beta of one and reflects the lower risk of
investing in this sector. Food and drug retailers are expected to offer stable cash flows. Some
other betas seem to offer questionable results and we need to apply betas with a degree of
judgement and understanding of the underlying statistical dimensions of the data employed.
Table 4.10 JSE Beta analysis
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In South Africa, the resources sector constitutes close to 30% of the market capitalisation
of the JSE. This means that the betas of firms outside the resources sector will be lower in
relation to the All Share Index because of the dominance of the resources sector and its
higher volatility.
Returns are measured as a percentage increase or decrease in the share price (plus
dividends received) at the end of the month, if monthly readings are taken, over the share
price at the end of the previous month. The equation for finding the beta of a company in
simple regression form if monthly data are used is:
Ri = α + βi(Rm) + e(Formula 4.11)
where: Ri = the monthly return on the share i
α = the intercept on the vertical axis
βi = the slope of the regression line for share i
Rm = the monthly return on the market
e = a random error term
In order to find β, the usual statistical procedures for regression are required, solving for α
(alpha) and β (beta). It should be noted that the random error term e is expected to be zero
as random errors should sum to zero. The intercept alpha should also be zero when excess
returns are used. Any deviation from zero in the alpha indicates that the share has at some
time been inefficiently priced, a situation which is unlikely to persist if the market is efficient.
Figure 4.13 illustrates the process used to establish the beta of share i. Monthly readings
have been taken of the return on the market as measured by the change in the market index
and plotted against the returns on share i, adapted for monthly returns. It is clear that share
i has a low beta, probably in the region of 0.5. Its low beta results from the fact that it is
clearly less volatile than the market as a whole. Investors would therefore expect to receive
a return less than that of the market. The line has an alpha which is greater than zero in this
instance, indicating a price appreciation over this period which was in excess of that of the
market as a whole. In general, this relative appreciation will not be expected to continue
indefinitely.
Figure 4.13 Regression analysis to establish market risk (beta)
Once the beta of an individual share is known, it is relatively easy to apply the CAPM since
the risk-free rate and expected return on the market are usually readily available.
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Example 4.6: Capital asset pricing model
An investor wants to add shares in Investgro Ltd to her portfolio. Investgro has a beta of
0.5, the risk-free rate is 7%, and the return on the market is 12%. Establish the expected
return on Investgro.
Using Formula 4.10:
Ri = Rf + βi (Rm – Rf)
= 0.07 + 0.50(0.12 – 0.07)
= 9.5%
The expected return on Investgro Ltd, as anticipated, is less than the 12% expected return on
the market. The investor would now attempt to establish whether the actual return is likely to
be higher or lower than 9.5%. If it is likely to be higher, the share is underpriced and should be
bought. Using the SML, the relationship can be plotted and Investgro’s position established as
in Figure 4.14.
Figure 4.14 SML to plot share i
In order to develop modern portfolio theory and the capital asset pricing model, many assumptions
were necessary. Relaxing the assumptions and applying the theory to practice has not always met
with widespread acceptance. Using the theory has provided a very neat and intuitively appealing
framework for thinking about risk and return, thus assisting in mastering the fundamental
concepts. Considerable benefit has thus been derived from this area of investment theory.
4 The efficient markets hypothesis
Perhaps the most significant assumption of modern portfolio theory and the CAPM is the
assumption of perfect capital markets. In a less rigorous form, the assumption is that all capital
markets are efficient. A body of theory known as the efficient markets hypothesis (EMH) has
developed over the years. Fama (1970) suggested three forms of market efficiency.
The weak form
The first level of efficiency, known as the weak form of the EMH, holds that share-market prices
follow a random walk. This is likened to the path of a drunk where it is impossible to predict
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whether the next step will be to the left or right. The information impounded in the share prices
is thus considered to fully reflect the historic price sequence of each individual share. As a result,
it follows that price changes are independent of one another, making it impossible to predict
a future price based on a series of past prices. An apparent implication of this theory is that
it is not possible to use technical analysis or charting, which is still widely used by investment
analysts, in order to obtain returns consistently above the risk level of the investment.
The semi-strong form
The second level of efficiency known as the semi-strong form of the EMH, holds that all
publicly available information about a share is impounded immediately and without bias
into the share price. The historic price sequence is thus also included in the information set.
If this is so, it is not possible through fundamental analysis to extract new information which
will enable superior returns to be consistently earned. This is because such information
has already been absorbed by the market and is immediately reflected in a price change.
The market price reflects all the publicly available information, and it is therefore the best
indicator of the risk-return relationship of a share. Only with inside information is it possible
to identify shares that are incorrectly priced.
An interesting aspect of efficiency is that it requires the presence of investors who do not
accept the efficiency of the market. As a result, they are engaging in fundamental analysis
in an attempt to discover new information. This activity in turn contributes further to the
market efficiency.
The strong form
The third level of efficiency, known as the strong form, holds that all information, both
privately and publicly held, is impounded into the share price immediately and without bias.
Thus it is impossible for any investor to consistently outperform the market, even with ‘inside’
information.
Testing for market efficiency
The efficiency of a stock market is an empirical issue – i.e. it requires empirical evidence
in order to be substantiated. However, testing for efficiency is, in practice, not without
complications, and results must often be interpreted with circumspection.
By far the most empirical work on share price behaviour has been conducted on share
prices quoted by the New York Stock Exchange (NYSE). The research has resulted in fairly
consistent results indicating that the NYSE is efficient at least at the semi-strong level. There
is no reason to accept that this conclusion for the NYSE applies to other markets. Each market
must thus be tested in its own right. The types of tests conducted by studies on the NYSE can
be classified into categories dependent upon which level of efficiency is being tested.
Weak-form tests
■■ Serial correlation tests. Any relationship between successive changes can be statistically
measured using a correlation co-efficient. If prices are proven to follow a trend – i.e.
if price changes in one period are related to price changes in a preceding period, a
correlation co-efficient of between –1 and +1 will become evident. If the market is
efficient in the weak form, no consistent correlation would be evident – i.e. the value of
the correlation co-efficients would approximate zero.
■■ Mechanical investment strategies. If all trading rules based on historical price patterns
fail to earn more than a simple buy-and-hold strategy, the market would be proved to
be efficient in the weak form. Such rules or strategies include filter rules and the buying
or selling of shares based on price movements above or below their moving average.
The problem with this type of research is that the number of potential trading rules is
virtually infinite, but only the known rules that are thought or claimed to be effective
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are tested. If a rule which is effective becomes publicly known, the widespread use
of such a rule will cause it to become ineffective. The possibility, however remote,
therefore exists that an unpublished but successful trading rule may exist.
Semi-strong form tests
These tests are applied in an attempt to establish whether share prices react immediately
and in the right direction to new information which becomes publicly available. Information
which is likely to affect the share price falls into certain convenient categories for researchers,
such as news of capitalisation issues, mergers, earnings, and dividend announcements, and
changes in accounting policy that will affect reported earnings. If the market consistently
responds speedily and in the right direction, efficiency in the semi-strong form is confirmed.
An example that illustrates the application of this form of testing is the change of accounting
policy from FIFO to LIFO. In an inflationary climate, such a change will cause the reported
profits – and thus the reported earnings per share – of a company to decline from those
expected if profits were reported on a FIFO basis. The economic substance of the company
has not changed, however, so the share price should not be affected by this policy change.
Should the policy used for accounting for stock be applicable for taxation purposes, it is
likely that the tax payable will be less. The firm’s cash flow will benefit as a result, having a
positive effect on the share price. In a case like that, the unusual situation of a lower-thananticipated reported profit should lead to an increase in the share price. If the market is
successful in absorbing these economic implications and reacting immediately and in the
right direction, efficiency in the semi-strong form is confirmed.
Strong-form tests
These tests are designed to establish whether investors who are able to gain access to inside
information can consistently achieve abnormal returns. Company officials are privy to inside
information but are prohibited from trading on such information, subject to severe fines
and penalties. It is therefore self-evident that testing of trading by such persons, should they
flout the regulations, is not possible.
Professional portfolio managers, such as managers of mutual funds and unit trusts
should be able to take advantage of market inefficiencies. This may also be due to access
to superior sources of information and to the inherent skills of such managers. Do fund
managers outperform the market? The international evidence is that professional fund
managers tend not to outperform the market index. On average, investors lose by placing
their money with professional fund managers. This may be due to the higher costs of
investing in such funds. Further, fund managers that perform well in one quarter tend
to perform poorly in the following quarter. The realisation of the inability of most
professional fund managers to outperform the market index has led to a dramatic rise in
index funds in the USA which are low cost and essentially simply track the market index.
Passive investing seems to be here to stay.
Evidence of the efficiency of the JSE
The efficiency of the JSE is an issue of considerable importance to South African investors.
During the last three decades a number of studies have addressed this issue. Research has
been popular but inconclusive for academics and post-graduate students. The implications
of market efficiency at the semi-strong level are of far more relevance to financial managers
than debating whether the JSE is an efficient market or not. Complicating issues on the
JSE are the relatively small number of shares listed, but more particularly the existence of
many closely held and thinly traded shares. For example, let’s compare the tradeability of
certain companies by analysing the number of days within the five years up to September
2014 that the companies did not trade. It is difficult to argue that the JSE is efficient for the
smaller companies that do not trade. The following indicates the percentage of days in the five
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years to September 2014 that the selected shares traded. As we can see, Crooke’s shares were
traded only on 37% of the days in the last 5 years as compared to Sasol, which was traded every
day in the last 5 years. Small companies and closely held groups tend to be thinly traded.
How have professional fund managers performed in South Africa? In a study by Wessels and
Krige2, it was found that although fund managers were able to achieve short-term quarterto-quarter persistence in returns, the longer term persistence in performance tended to
disappear. Bradfield and Swartz3 found that the top quartile funds indicated a high degree
of persistence of returns from quarter to quarter. However, persistence declined over longer
periods. However, there were a few funds that exhibited persistence in either outperforming
or underperforming the ALSI.
Let’s evaluate for example the investment performance of Allan Gray. In the 41 years to
September 2014, Allan Gray Equity has managed to achieve an annualised return of 26.5%
as compared to the annualised return of 18.7% for the ALSI. This has been achieved at a
slightly lower level of risk. Allan Gray has been able to outperform the ALSI in 30 of the
41 years since inception. The evidence is that most managers are unable to beat the market
index, but there are a few exceptions. However, we need to understand that Allan Gray is
active sometimes in affecting managerial performance and decisions.
What about passive investing in South Africa? For example, investors are able to invest
in the Satrix 40 index fund which is offered by the JSE at a very low cost, and passive index
fund investing is expected to grow in South Africa.
Is the CAPM used in practice?
Yes. In a PWC survey of South African investment professionals, it was found that the CAPM is
by far the most dominant method used in practice to determine a company’s cost of equity. The
CAPM is based on the use of betas and Bloomberg and BNP Paribas/Cadiz Equity Risk Service
are the most popular sources of betas. The use of betas in determining the cost of equity is
dominant in South Africa and in many other countries such as the USA, the UK and Australia.
Yet, Warren Buffett thinks differently. As he states in one of his letters to his shareholders:
To invest successfully, you need not understand beta, efficient markets, modern portfolio
theory, option pricing or emerging markets.
What do we think? The use of betas makes sense but we may need to apply judgement in
particular cases by analysing the underlying data and we need to take care in not double
counting for risk. Further, there are other issues in determining the cost of equity and we
will come back to this when we study the cost of capital in Chapter 7.
Does CAPM work? The evidence from empirical studies is that we need to extend CAPM in
order to explain share returns adequately. The SML is flatter than indicated by CAPM. FamaFrench (1992) was able to increase the accuracy of predicting share returns significantly by
including size and value factors, as well as a market beta factor. Small companies and companies
with high book values relative to their share price (value shares) tend to produce higher returns
Wessels, DR and Krige, JD (2005). The persistence of active fund management performance, SA Journal of
Business Management, 36(2).
3
Bradfield, D and Swartz, J (2001). Recent evidence on the persistence of fund performance – a note. SA Journal
of Accounting Research, 15(2).
2
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than indicated by beta alone and according to Fama-French, these represent risk factors. There
are therefore three sources of risk – market risk, size risk (investing in smaller companies
implies higher risk) and low book-to-market ratios (which will often include companies that are
experiencing financial distress or changes to their business models). The Fama-French Three
Factor Model includes a market beta factor, as in CAPM, and then includes a size factor and
a value factor to predict a company’s expected/required return. In the annexure to Chapter
7, we explain this model in greater detail and we also indicate how practitioners make ad-hoc
adjustments to CAPM to take into account these factors in determining a required return.
From the real world
You may ask whether the principles of diversification are relevant in the investment
decisions undertaken by asset managers such as Allan Gray and Coronation. The following
are extracts from their correspondence with their investors, which indicate the importance
of diversification in reducing portfolio risk.
Seema Dala of Allan Gray writes:
“Diversification is only useful when the assets being added to the portfolio have low correlations
with the existing assets. As we add asset classes to a portfolio, which have negative or zero
correlations to the assets, which are already in the portfolio, the portfolio becomes more
diversified. This should in turn reduce the volatility, or unpredictability, of portfolio returns.”
With regard to developed markets, she states the following: “… asset classes are highly
uncorrelated to the ALSI, so adding these (developed market) assets to a portfolio of local assets
would significantly reduce overall portfolio volatility” (Quarterly Commentary Q1: March 2013)
Coronation in its Global Capital Plus Portfolio Fund Sheet, as at 31 August 2014, states:
Overall portfolio risk is managed through the inclusion of non-correlated asset classes and
stocks are selected on an equal measure of upside return and downside risk.
Summary
The rationale for investing in a portfolio of shares rather than a single share is based on the
benefit received in the form of risk reduction by diversification. The expected return of a
portfolio is the weighted average return of the shares held in the portfolio. The risk, however,
is not a weighted average of risks because of the effect of less than perfect correlation of
returns among the shares in the portfolio.
The capital asset pricing model is an appropriate method of pricing individual shares
held by a diversified investor. Establishing the beta of a company enables the effect of that
particular share on the overall portfolio to be assessed. Using beta analysis it is possible to
manage a portfolio of shares in accordance with the desired level of market risk, the specific
risk having been eliminated through diversification.
The CAPM is based on a number of assumptions. The efficiency of the capital market
is a fundamental assumption which has significant implications for financial management.
Although the evidence regarding the efficiency of the JSE is inconclusive, it would be unwise
to react as if it were inefficient.
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Guidance to Portfolio Management
Summary of the risk and return concepts linking Chapters 3 and 4
by
Johnathan Dillon M.Com CA(SA)
Chapter 3 deals with the concepts of risk and return in relation to a single share, as well as
with the comparison of single shares. Chapter 4 does the same, except in relation to a portfolio
of shares. The table below presents a summary of the pertinent concepts of these chapters
relevant to analysing shares:
RETURN
1 share
Expected return (Re) of
share
RISK
COMPARISON
Standard deviation () or
Co-efficient of variation
variance (2) of share
(CV)
Or
Or
Beta () of share
z score
Standard deviation () or
variance (2) of the
portfolio, calculated as:
2 shares
(portfolio)
___
Weighted average of
p = √
​ ​2p​ ​ ​​
shares’ expected returns
​ ​2p​​  = ​W​2a​  ​​2a​ ​ ​ + ​W​2b​​

​  2b​ ​​  +
(Rp)
2WaWbcovab
Co-efficient of variation
(CV)
Or
z score
Or
Weighted average of
shares’ betas ()
The standard deviation
() or variance (2) of
the portfolio can be
3+ shares
(portfolio)
Weighted average of
shares’ expected returns
(Rp)
determined using a
Co-efficient of variation
lengthy formula similar to
(CV)
that used under 2 shares
Or
above
z score
Or
Weighted average of
shares’ betas (p)
A summary of important risk symbols is presented in the table below:
SYMBOL
NAME OF SYMBOL
​ ​2a​ ​

Variance of share a
a
Standard deviation of share a
SUMMARY OF WHAT IT MEASURES
The extent to which the expected returns of the share
deviate from the mean.
The same as what the variance measures – it is merely
the square root of the variance and in a standarised
form.
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SYMBOL
CVa
Covab
ab OR rab
NAME OF SYMBOL
SUMMARY OF WHAT IT MEASURES
Co-efficient of variation of
Relates the units of return to the units of risk by mea-
share a
suring the units of risk per 1% of return.
Co-variance of two shares a
and b
Correlation co-efficient of two
shares a and b
The extent to which the returns of two shares move
together and in which direction (that is, the relationship between the returns of the two shares).
The same as what the co-variance measures – it is
merely the standardised form of the co-variance as it
falls between −1 and +1.
The proportion of variability (the goodness of fit)
​r​2ab​​  OR R2
Co-efficient of determination
between two data sets (in this instance, share
of two shares a and b (also
a returns and share b returns) and is merely the
known as R-squared)
square of the correlation co-efficient; hence, it will be
between 0 and +1.

Beta of a share
The non-diversifiable risk of a share as reflected by
the share’s sensitivity to fluctuations in the market.
The important risks covered in these chapters, as well as how they link together and are
measured, are summarised below:
Total risk for an individual share or portfolio can be expressed as follows:
Total risk = systematic (market) risk + unsystematic (specific) risk
Total risk is measured by calculating the variance or standard deviation of the returns of the
share or portfolio. However, when taking into account the concepts of business and financial
risk covered in Chapter 3, the total risk of an entity that shareholders are exposed to can also
be expressed as follows:
Total risk = business risk + financial risk
A somewhat useful measure of this expression of total risk is the degree of combined leverage
(DCL), which equals contribution divided by profit before tax or the degree of operating
leverage (DOL) multiplied by the degree of financial leverage (DFL). However, as noted in
Chapter 3, the DCL does not entirely measure all facets of business and financial risk. This
expression of total risk also links directly with the asset beta and equity beta concepts covered
in greater detail in Chapters 7 and 10, as well as with the need to “unlever” and “relever” betas
in certain situations.
Systematic risk (also referred to as non-diversifiable or market risk) is the risk that remains
after diversification, that is, the risk of being in the economic system in which the entity
operates. No amount of diversification can eliminate this risk. Systematic risk is measured
by calculating the beta of a portfolio or share’s returns in relation to the returns on a fully
diversified market portfolio.
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Unsystematic risk (also referred to as diversifiable, specific or company risk) is the risk of a
portfolio in excess of the systematic risk. Investors can reduce or even eliminate this risk by
holding more and more shares until the portfolio risk equals the market / systematic risk.
Sovereign risk is essentially the risk of a country based on economic, political and financial
factors, that is, the country’s financial health and creditworthiness, which have a bearing on the
systematic risk of a market. Therefore, the higher the sovereign risk of a country, the higher
the systematic risk of an economic system and consequently the higher the risk of all entities
operating within that particular country.
Business risk is the risk relating to the operating activities of the entity, that is, the risk inherent
in its operations ignoring how the entity’s operations are financed.
Financial risk is the additional risk placed on an entity (and on ordinary shareholders) as a
result of the decision to finance with debt rather than equity.
S
SELF-STUDY PROBLEMS
Shares A and B have the following historical dividend and price data:
Required:
(a) Calculate the realised rate of return (or holding-period return) for each share in each
year. Assume an equally weighted portfolio. What would the realised rate of return on
the portfolio be in each year from 20.2 through 20.7? What are the average returns for
each share and for the portfolio?
(b) Calculate the standard deviation of returns for each share and for the portfolio.
(c) Based on the extent to which the portfolio has a lower risk than the shares held individually,
would you assess that the correlation co-efficient between returns on the two shares is
closer to 0.9, 0.0 or – 0.9?
(d) If you added more shares at random to the portfolio, what is the most accurate statement
of what would happen to σp?
– σp would remain constant, or
– σp would decline to somewhere in the vicinity of 15%, or
– σp would decline to zero if enough shares were included.
Suggested solutions
(a) The return to the shareholder for each period for holding a share is calculated as follows:
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Dividends for the period + Share price at the end of period
​ – 1
Return = 
​
Share Price at beginning of period
The returns are presented in the following table:
The following are some of the workings of the returns set out in bold in the above table for
year 20.3:
2.00 + 16.00
22.50
3.40 + 35.50
43.75


​– 1 = –20%​
​– 1 = –11.09%
​
–0.20 + –0.1109

​
​= –15.54%
2
The deviations from the mean return for each year as well as the product of the deviations
is set out in the following table in order that we may determine the variance, standard
deviation for each share as well as the covariance and correlation co-efficient. This is the
long way of doing it and we will also use Excel statistical functions to determine the same
results.
The following are some more workings on how we get to the deviations and variance and
covariance calculations for 20.3.
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The squared deviations for Share A, Share B and the Portfolio are simply determined as
follows:
A: (-0.3141)2 = 0.0987
B: (-0.2249)2 = 0.0506
C: (-0.2695)2 = 0.0726
The covariance (product of the deviations of A and B) for 20.3 is (-0.3141)(-0.2249) =
0.0706.
Alternatively, we could also use Formulae 4.2, 4.3 and 4.4:
Correlation co-efficient:
0.0342
​= 0.8907 (Rounding effect: correl = 0.8914)
​ 
(0.1961)(0.1958)
(b) Variance and standard deviation of portfolio:
(c) Closer to 0.9. The fact that the two shares are very similar in the direction in which
returns move, results in a high correlation co-efficient, resulting in less risk reduction
from investing in both than would have been the case had the correlation co-efficient
been low or negative.
(d) The p would decline to a point which reflects the systematic risk, that is, the risk of the
market. This is certainly not zero. It would also not remain constant, as the more shares
added, the greater would be the effect of less than perfect positive correlation between shares,
reducing portfolio risk. If the market risk is in the region of a standard deviation of 15%
(which seems reasonable), this is the most likely figure to which the portfolio risk will decline.
Appendix 4.1 Calculating the beta co-efficient
Beta has been defined as the sensitivity of an individual share to changes in the index
of the stock market as a whole. The market as a whole has a beta of one. Individual
shares will thus have betas reflecting their relative sensitivities to the market beta of 1.
An individual share, for example, which increases in price on average by 15% when the
market index rises by 10% and the risk-free rate is constant, will have a beta of 1.5. Beta
has a special application in the capital asset pricing model in the expression:
Rj = Rf + βj (Rm – Rf)
(Formula 4.12)
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where: Rj = the return expected on share j
Rf = the risk-free rate of return
Rm = the return expected on the market
βj = the percentage change in an individual share’s return for a 1%
change in the market return
βj, in turn, can mathematically be expressed as:
Covjm _______
rjmjm
βj = _____
​
​ = ​
​
(Formula 4.13)
Varm
 2m
where:
rjmjm = the covariance of share j’s return with the market return (also
written as covjm)
m2 = the variance of the market return
Modern portfolio theory suggests that covariance with the market is the only relevant risk,
as unsystematic or specific company risk is virtually eliminated through diversification
into a portfolio of shares. Beta reflects the covariance of an individual share with the
market, standardised by dividing this covariance by the market variance. It is thus the
only relevant measure of the risk of an individual share held by an investor in a portfolio.
Despite criticisms and counter evidence, the CAPM remains a widely used model. For
example, services such as Bloomberg regularly publish beta co-efficients for securities
quoted on the NYSE while, for example, the BNP Paribas/Cadiz Equity Risk Service has
regularly updated such co-efficients for companies listed on the JSE.
Despite the fact that betas are available for many South African shares, some analysts
prefer to calculate betas based on the most recent series of price and market data. Judgement
is involved in applying the techniques for calculating the beta of a share. However, the
beta is in essence simply a regression co-efficient reflecting the slope of a straight line
graph regressing the excess returns of an individual share against the excess return of the
market as a whole. The excess return is the difference between the return and the risk-free
rate, often referred to as the risk premium. The calculation in Table 4.11 is based on ten
monthly readings in order to demonstrate the method of calculation. In practice many
more readings would be taken, and the computation would be done by computer.
Table 4.11 Calculating beta
(1)
Monthend
(2)
(3)
(4)
(5)
(6)
(7)
ExcessExcess
return on return of
ShareMarketCo-Market
share J market
deviation deviation variance
variance
%
%
(2) –3.6
(3) –2.7
(4) x (5)
(5)2
Jan
Feb
Mar
Apr
May
June
July
Aug
Sept
Oct
Mean
4
–1
7
5
–4
9
3
10
–4
7
3.6
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3
0.4
0.3
0
–4.6
–2.7
3
3.4
0.3
6
1.4
3.3
–1
–7.6
–3.7
4
5.4
1.3
3
-0.6
0.3
6
6.4
3.3
–2
–7.6
–4.7
5
3.4
2.3
2.7
0.12
12.42
1.02
4.62
28.12
7.02
–0.18
21.12
35.72
7.82
11.78
0.09
7.29
0.09
10.89
13.69
1.69
0.09
10.89
22.09
5.29
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=
covjm
m2
4-35
= 11.78 = 1.63
7.21
Table 4.11, illustrating the calculation of beta, indicates that share J has a beta of 1.63,
that is, on average, if the market index increases by 10%, the price of share J is expected
to increase by 16.3%.
The procedure illustrated in Table 4.11 is as follows:
1. Record the returns on share J for each month using Formula 3.5 adapted as follows:
P – P0 + D
Rj = __________
​ i
​
P0
where: Rj = the excess return on share J for one month
P1 = the share price at the end of the month
P0 = the share price at the beginning of the month
D = any dividend which may have been paid during the month
2. Record the return on the market as a whole for each month using the overall market
index as the basis, as follows:
OMI1 – OMI0
Rm = ____________
​
​+ OMD0
OMI0
where: Rm
= the return on the market as a whole for one month
OMI1 = the overall market index at the end of the month
OMI0 = the overall market index at the beginning of the month
OMD0 = the overall market monthly dividend yield
3. Calculate the excess returns for both share J and the overall market by deducting the
risk-free rate from the returns recorded in 1 and 2 above (columns 2 and 3).
4. Calculate the means for each set of excess returns and record the deviations from the
means (columns 4 and 5).
5. Calculate the variance for the market (m2)(column 7).
6. Calculate the covariance of the return of share J with the returns of the overall market
(covjm)(column 6).
7. Calculate the beta in accordance with Formula 4.13.
In this calculation the excess returns have been used, and dividends received on shares
have been included. There will be no significant difference in the calculated beta if
dividends are ignored and only price movements are used to calculate the share and
market returns, because of their relative stability. Ignoring dividends and using the
full return rather than the excess return is an alternative method which is used in
practice.
Using Excel to determine betas
We can use Excel to determine betas. We will reorganise the data for Share J and the
market as follows in Excel.
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We then highlight cells B4..K5, then click on Insert and then go to the Charts banner.
Then select the scatter chart type. Once we have the graph, click on the data points (data
points will be highlighted) and right click and then select Add Trendline. After that select
the Linear option, and click on the Display equation on chart box and then the Display
R-squared value on chart box. This will display the equation in the form of y = bx + a,
where b is the slope and a is the intercept. In effect we are using regression analysis to
determine a company’s beta. A line that best fits the data will be inserted by Excel into
the scatter graph.
It is also possible to determine the beta directly by using the SLOPE function in Excel.
We can determine R-squared (R2) by using the RSQ function and we can determine the
intercept by using the INTERCEPT function.
Cell B7 = SLOPE(B5..K5,B4..K4)
Cell B8 = INTERCEPT(B5..K5,B4..K4)
Cell B9 = RSQ(B5..K5,B4..K4)
The R-squared indicates the goodness of fit and a low R2 indicates a high level of unsystematic or diversifiable risk. The beta may be sensitive to unique events. Assume that in our
example, Share J’s excess return in October is 20% rather than 7%. This will significantly
impact on the beta which falls to 0.49 as compared to 1.63. The R2 falls to 35.7%. It is
important to analyse the underlying data and trends. Of course, in this example we are
looking only at a few data points and this effect has been accentuated. However, the
principle remains valid. Use betas with caution and apply your judgement. In the last few
years, retailers have experienced significant increases in share prices which may reflect
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consolidation in the sector as well as favourable macro-economic factors. For periods
of time, we will see movements in a company’s share price that may be unrelated to the
market due to unique or firm specific events. For example, Vodacom’s beta in June 2010 was
only – 0.12, but this may reflect underpricing of Vodacom when it was listed on the JSE and
the company experienced a subsequent upward movement in its share price which was not
related to the movement in the market, at least for a period of time. In the future, we would
expect Vodacom’s share price to be driven increasingly by macroeconomic factors, although
the company should remain a low risk investment. The beta for MTN was 0.86.
By September 2014, the beta of Vodacom was 0.62 while MTN was indicating a beta
of 0.67 for the five years to 30 September 2014.
Let’s go back to R-squared. If a company’s beta is matched with a high R2, this will
indicate that the movements in the company’s share price are highly dependent on
movements in the market. If the beta reflects a R2 of 1, then returns are driven only by
market movements and all data points would be on the line
A low R2 indicates that there is very little relationship between movements in a company’s
share price and movements in the overall market. To put it another way, most of the
changes in the company’s share price reflects unsystematic risk or diversifiable risk. What
we cannot diversify away is systematic risk.
Table 4.12 indicates the betas and R2 for selected firms, sectors and indices. We would
expect that sectors would depict a higher R2.
The table also indicates that there may be a separation between the resources and
other sectors. South Africa is unusual as the resources sector constitutes about 30% of
the overall JSE market capitalisation. As resource companies tend to depict a higher level
of systematic risk, it may mean that other industrial, financial and retail companies may
indicate betas which are understated. However, the complexities arising from whether
there is market segmentation is beyond the scope of this chapter.
Table 4.12 Betas and the use of R-squared to measure diversifiable risk
Appendix 4.2 Perspectives: Estimating the Beta Co-efficient
Prof. Dave Bradfield offers us his perspectives on estimating beta coefficients in South Africa. This is particularly relevant for practitioners
and users of betas. Dave is Head of Research at BNP Paribas/Cadiz
Securities and a professor at the University of Cape Town. BNP Paribas/
Cadiz Securities has been rated first in the Financial Mail rankings for
risk management for the last 18 years. Dave has published widely and
has won numerous awards for his outstanding research in the area.
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Introduction
The estimation of the beta co-efficient has traditionally been achieved by running
a Market Model regression. Running this regression however can lead to a variety of
practical considerations which in turn could result in several different beta estimates.
Some of these considerations could be purely measurement-related such as: How does
one measure returns? What market proxy should be used? How long should the return
intervals be? How many data points are needed? On the other hand, a further set of
considerations involves the assumptions and the inferences such as: Is thin trading a
problem? Is the market segmented? Are betas likely to be stable?
This Appendix reviews some of the procedures that need to be considered to
ensure the resulting betas are accurate. For users of published betas, it gives readers an
understanding of the care needed in the estimation of beta co-efficients.
The Market Model
The basic concept of beta arises because all stocks tend to move to some extent with
movements in the overall market. Clearly some stocks tend to move more than others
when the market moves; hence their sensitivity to movements of the overall market index
is an important measure, widely known as the beta co-efficient.
The Market Model has traditionally been used to estimate the beta co-efficient:
Rit = ai + βiRmt + eit(1)
where Rit = the return on asset i at time t,
Rmt = the return on the market (or benchmark) at time t,
ai and βi = the intercept and slope (beta) co-efficients to be estimated for asset i.
The market model is commonly estimated using ordinary least squares regression (OLS).
In this instance the OLS estimate of beta is simply:
cov(Rit; Rmt)
​(2)
i = ​ 
var(Rmt)
It should be noted that the market model is not based on any assumptions about investment
behaviour but simply posits a linear relationship between stock returns and the market
return. Figure 4.13 and Figure 4.14 show the scatter diagrams for the two stocks Anglo
American and SABMiller regressed on the All Share Index (ALSI) respectively. It is
evident that the estimated ordinary least squares (OLS) beta for Anglo American is 1.49
and for SABMiller is 0.86, indicating their differing sensitivities to market movements. It
should be noted that whilst this Appendix focuses on the estimation of betas on individual
stocks, the concept could be applied to any asset, including investment portfolios.
Figure 4.15: Scatter diagram for Anglo American
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Figure 4.16: Scatter diagram for SABMiller
Return measures
The user has two choices. Either discrete or continuously compounded returns can be
used, as long as the consistency between the asset returns and the market index proxy
is maintained. It is generally accepted that returns are continuously generated through
calendar time; however, because trading occurs at discrete intervals, observers view returns
as if they are generated at discrette intervals. For both the discrete and continuously
compounded returns it is important to note that the returns should be adjusted for
capitalisation changes and dividends.
The Market Index
In theory market capitalisation weighted indices are preferred to equally weighted indices
because they are superior proxies to the true market portfolio. Hence in South Africa, the
All Share Index (ALSI) should be used. It should be noted that some practitioners argue
that there is a segmentation between the Resources and Financial and Industrial sectors
on the JSE and consequently prefer to use these sub-sector indices as an overall market
proxy for stocks belonging to these sectors. It should, however, be noted that the theory
calls for an index that is as comprehensive as possible in covering the market.
Length of the estimation period
Estimates based on many years of historical data may be of little relevance because the
nature of the business risks undertaken by companies may have changed significantly
over a long period such as 10 years. The choice of a 5-year estimation period is based on
the findings that betas tend to be reasonably stable over 5-yearly periods. The selection
of a 5-year period represents a satisfactory trade-off between a large enough sample
size to enable reasonably efficient estimation and a short enough period over which the
underlying beta could be assumed to be stable.
The return interval
Research has been directed at establishing the impact that different interval lengths have
on estimates of beta. As a consequence, subsequent researchers generally use monthly
intervals (over a 5-year period) to compute the returns needed for the estimation process,
resulting in 60 data points of monthly returns.
Correcting for the regression bias using a Bayesian adjustment
A number of studies have documented that individual stock betas have a regression
tendency towards the grand mean of betas of all stocks on the exchange. This regression
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bias can be described as follows: an estimated beta co-efficient which is far higher than the
average beta is more likely to be an overestimate of the true beta than an underestimate.
Similarly, a very low estimated beta is more likely to be an underestimate. Thus the
estimates of beta obtained from the regression analysis may be suboptimal for forecasting
purposes. To correct for the regression bias, a ‘Bayesian’ adjustment can be implemented.
Hence betas can be corrected as follows:
–
b = wbOLS + (1 – w)bOLS(3)
s2b
​(4)
w = ​
(s2b + s2OLS)
where b
= the OLS estimate of beta
__OLS
​
b​OLS = the average OLS beta of all stocks in the market
OLS = the standard error of the OLS estimate of beta
b = the cross-sectional standard deviation of all the estimates of beta in the
market
It can be readily seen from the above formulation (4) that the weight, w, assigned to the
OLS beta will be large if the cross-sectional standard deviation, (b), is large. In other
words, if the spread of the betas across the stocks is so large as to make all values of
beta equally likely, then the OLS beta estimator is optimal. Conversely, if the standard
error of the OLS beta estimate, OLS, is large relative to b, then w will be small and the
Bayesian estimate of beta will be ‘shrunk’ towards the overall average beta of the stocks
on the market. Therefore an estimate of beta which falls outside the usual spread of
beta (and which has a large standard error) is likely to be an overestimate. Hence the
above expression corrects for the commonly observed phenomenon that very high beta
estimates that are unreliable (large standard errors) tend to be overestimates and very
low betas that are unreliable tend to be underestimates.
Adjusting for thin-trading
The bias in beta estimates caused by thin-trading on the JSE has been well documented.
If a stock is thinly traded then it is likely that the month-end price may not arise from
a trade on that day but may instead be recorded as the price last traded during the
month. Consequently the recorded price on the market index at month-end may not be
matched to a trade for the stock on the day – hence a mismatch occurs. This mismatching
phenomenon clearly has an impact on the covariance estimate between the stock and the
market proxy, leading to a downward bias in this covariance estimate and consequently a
downward bias in the estimate of beta.
Several researchers have derived techniques for obtaining unbiased estimates for beta
in infrequently traded environments. Two distinctly different approaches have emerged;
the ‘trade-to-trade’ estimator and the Cohen estimators. It was found that the ‘trade-totrade’ was superior for application on the JSE. In the trade-to-trade method the returns
on the stock and on the index are measured between the times of the last trades in
successive months. Thus a statistical correction needs to be made for potential durations
in return no longer being equal. Furthermore, to improve the efficiency a correction is
required for the heteroscedasticity in the residual component. This leads to the final
trade-to-trade estimator proposed by Dimson and Marsh:
Rmt
Rit

​
 ​= ai​ Dit ​+ bi ​
 ​+ eit(5)
​ Dit ​
​ Dit ​
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where
4-41
Dit = the proportion of a month between successive traded months for
stock i and month t
Rit = the returns computed over the last traded day in each month
Rmt = the market returns matched to the same consecutive traded days as
stock i
Other issues relating to the use of betas
The stability of betas
Detection of beta stability is clouded by the fact that only the estimates of beta are
observable. Changing estimates do not necessarily imply stable underlying betas. Research
indicates that the results of tests on the stability of betas are difficult to interpret but the
JSE betas were found to be as stable as betas of stocks on the UK market.
Robust estimation of beta
Research indicates that the robustness required for estimating betas involved downweighting, not only of the outlying residual values, but also of the outlying market returns.
Dynamic estimation of beta
Filtering and smoothing techniques can serve as useful aids in the interpretation of time
series of return observations. Techniques are available that categorise the movements
in the levels of stock returns as either permanent shifts in the riskiness of the firm, or as
one-off events attributable to specific circumstances.
Using a ‘beta book’
There are many services that supply betas and associated estimates arising from the Market
Model. We have included an extract from the Financial Risk Service (September 2005)
published by Cadiz. This is one of the most widely used beta services in South Africa
(according to a PWC survey). This service uses both the trade-to-trade correction procedure
given in equation (5) as well as the Bayesian correction procedure (equation (3)).
The above table represents the output from a typical beta service. The columns give
statistics emerging from market model regressions. The following interpretations are
relevant:
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Alpha: This is the average return (per month) on the share when the market on average
does not move.
Std err(b): The standard error of beta is a statistical measure of the reliability of
the estimate of beta. The lower this figure is, the more reliable the estimate of beta.
Statisticians set up confidence intervals for the estimate of beta by adding and subtracting
2 × Std err(b) from the beta estimate. There is a 95% chance that the true beta lies in
this interval.
Total risk: This is the standard deviation of returns measuring the share’s total risk
expressed in % per month.
Unique risk (or non-systematic risk) reflects the fluctuations in the security’s returns that
are linked to events unique to the company (e.g. bad management, worker strikes, etc.).
R2: This can be interpreted as the proportion of the share’s total risk accounted for by
its market risk. Note that a high beta will not necessarily produce a high R2. In statistical
terms, R2 is the co-efficient of determination of the regression.
Days not traded: The number of days over the period of analysis during which the
security did not trade. This provides an indication of the extent to which the security
is thinly traded. Over the last 60 months, the JSE traded for 1 248 days, about 21 days
per month. If a particular security, for example, has been listed for five years and has
‘691 days not traded’ recorded, then it has been traded only about 45% of the time
(100 × [1 – 691/1 248]). In some instances, for extremely thinly traded securities, more
than 5 years of data is needed.
Summary4
The primary aim of this appendix has been to provide guidance to the practitioner wanting
to estimate betas. Research in South Africa has indicated the significant bias in beta
estimates caused by thin trading as well as the regression tendency (for betas to revert to
the mean). Hence of all the refinements briefly discussed, the most important of these
are the thin-trading correction (especially when it is known that stocks suffer from thintrading) and the Bayesian correction.
Appendix 4.3 Perspectives: BEHAVIOURAL FINANCE
Darron West (MCom CA(SA) CFA) is a senior lecturer in the
Department of Finance and Tax at the University of Cape Town and
holds a concurrent position at Foord Asset Management. He has
watched behavioural finance at work during his career in the South
African financial markets over the last decade. His experience spans
derivatives, structured investment products, fund management, venture
capital, non-profit organisations and insurance which has led him to the
conclusion that EQ might well be more important than IQ.
Classical finance theory teaches us the proverbial efficient
markets hypothesis (EMH). In a nutshell, the EMH postulates
Please refer to Investment Analyst Journal, No. 57, 2003 for references to research studies and go to the BNP
Paribas Cadiz Securities website, www.cadiz.co.za, for further information. This is based on the article in the
Investment Analyst Journal, “On estimating the beta co-efficient” by D Bradfield, pp 47-52.
4
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that prices on traded assets reflect all known information; hence, such prices are unbiased.
Consequently, it is impossible to consistently outperform
the market on a risk-adjusted basis except through sheer luck. Investors seek to maximise
their utility, and as such they have rational expectations (on average, but for every lunatic
there is an offsetting sane and prudent participant).
However, even a casual analysis of the price series of an equity market compared
with its rational valuation (the present value of discounted cash flows) illustrates that the
unexplained component of the efficient market models is substantial. Why is it that at
the late stages of a bull market, prices appear to be driven up without any consideration
of value? Why is it that at the end of market crashes, prices appear to be in free fall
as investors exit their holdings irrespective of value? If EMH held, surely participants
should always take advantage of fundamentally mispriced securities?
The fact is, they don’t. The evidence suggests market overreaction is beyond the
realms of rationality. Price is not equal to the present value of discounted cash flows, risky
assets are not necessarily rated lower than riskless assets and markets are not reasonably
efficient most of the time.
The reality is that market participants are not automatons. Programme trading aside,
market participants are human beings with all the foibles and trappings of that condition.
Truly understanding the financial markets must involve an understanding of investor
psychology and the associated (and often systematic) non-rationality that follows. This
does not imply that EMH should be dismissed; rather, it connotes an attempt to have a
more complete understanding of market behaviour.
It would be trite to suggest that behavioural finance is merely the incorporation of
psychology into finance, but it certainly involves specific consideration of human and
social cognitive and emotional biases and dispositions in better understanding how and
why economic decisions are made, and how these decisions affect market prices, returns
and the allocation of resources.
A simple test will reveal a differential treatment of risk. Given a choice between (1)
a 100% chance of winning R1m, and (2) an 89% chance of winning R1m, a 1% chance
of winning nothing and a 10% chance of winning R5m, most people would choose (1),
even though the rational probability weighted payoff of (2) is higher. However, when
faced with a choice between (3) an 11% chance of winning R1m and (4) a 10% chance
of winning R5m, most people would choose (4). The rational utility preference is simply
not consistent, and the cognitive impact of certainty or near-certainty is far higher than
perceived remote or unlikely events.
The experiment above is an exposition of prospect theory, coined seminally by
Kahneman and Tversky in 1979 (for which Kahneman was awarded the Nobel Prize for
Economics in 2002). Prospect theory shows how human beings have a concave utility
curve for gains, and a convex utility curve for losses. More bluntly, we feel the pain of
losses (even small ones) from a reference point far more acutely than we feel the joy of
gains. Many of the observed behaviours and biases inherent in human participation in the
financial markets flow from this simple basis.
Once sensitised to them, it is hard not to observe these behavioural biases in ourselves
and in others. Most revolve around the perception and understanding of loss. Because it
is painful to make a mistake, we attempt to avoid regret by altering the basis of evaluation
so as to change an outcome from failure to ‘deferred success’. Separating actual losses
from paper losses, holding on to losing stocks and selling winners early are all symptoms.
Similarly, as the fabled (and, indeed, fictional) ostrich, we figuratively bury our heads
in the sand when confronted with new information that would challenge our beliefs or
assumptions (and so force a reversal of the action we have taken, or induce regret).
This ‘cognitive dissonance’ manifests broadly, from avoiding advertisements for newly
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purchased products (in case they are cheaper elsewhere), to avoidance of information
about a new investment (in case it proves to be misguided).
Research has shown how we are influenced by reference points (anchoring) in
determining outcomes, we fail to view portfolios on an aggregate basis (creating mental
compartments), we create the illusion of patterns where none exist and attribute gains
to bad luck (the problem of overconfidence), and we fit hypotheses to data instead of
considering probabilities more rationally (the representativeness heuristic).
In fields requiring some prospective estimation to justify decisions, overconfidence
has been shown to be a perennial failing. Forecasts have been shown to be both too high
and hardly useful at predicting turning points. Furthermore, studies examining gender
differentials have shown that women are less overconfident, trade less (thus incurring
lower costs) and produce better returns than men (which begs the question why the fund
management industry remains so male dominated!).
Is behavioural finance merely a tool for poking the EMH full of holes? Hardly,
challenging the EMH is a starting point, as is using the knowledge of human behavioural
biases to guard against prejudicial or damaging financial conduct. The real power of
behavioural finance has still to be harnessed, at the very least to fill the gaps between
EMH models and actual market outcomes, and perhaps as a grand unifying theory of
finance.
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Q
QUESTIONS
Question 4.1
The following summary statistics are available with regard to shares A, B and C:
■■ Expected returns:
Ra = 10%;
Rb = 13%;
Rc = 20%
■■ Standard deviations:
a = 8%;
b = 15%;
c = 25%
■■ Correlation co-efficient:
rab = 0.6;
rac = 0.8;
rbc = –0.4
Required:
(a) Determine which of shares A, B, and C would be the most attractive to a risk-averse investor
who uses the mean-variance criterion to minimise the risk per unit of return. A ranking of
shares A, B, and C is required.
(b) An investor intends to hold a portfolio of investments comprising two of the three shares
A, B and C (equal amounts would be invested in each of the two shares), therefore the
following options are available:
– Option 1: 50% in each of shares A and B
– Option 2: 50% in each of shares A and C
– Option 3: 50% in each of shares B and C
Determine which of the three options would be the most attractive to a risk-averse
investor. A ranking of the options is required.
Question 4.2
Two shares, P and Q, offer the following four historical percentage annual returns:
An investor decides to hold a portfolio of 40% invested in share P and 60% invested in share Q.
It is evident that the calculations will suffer from small sample bias. Nevertheless, you are
required to demonstrate the procedures used for the calculations and your ability to interpret
the results.
Required:
(a) Calculate the correlation co-efficient of shares P and Q.
(b) Calculate the expected return on the portfolio.
(c) Calculate the variance of the portfolio.
(d) The investor believes that the risk of a portfolio containing any combination of P and Q will
always be less than the risk of holding either P or Q alone. Discuss whether you agree or
disagree with this view, giving reasons.
Question 4.3
An investment of R500 000 held by your company at the riskless rate of return of 8% has just
matured. It has been decided to invest the proceeds in ordinary shares listed on the JSE. Two
shares, A and B, have been identified with a correlation co-efficient between A and B (rab) of
zero, and you can invest the full R500 000 in either of them, or in a portfolio with some of each.
The following facts are available regarding the two shares:
Share AShare B
Expected return10%14%
Standard deviation of returns
10%
15%
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Required:
(a) Draft a table which shows ‘expected portfolio % return’ and ‘% standard deviation of
portfolio return’, given that the five following portfolios are considered: Investment in share
A (the balance in share B) – 100%; 75%; 50%; 25%; 0%.
(b) Sketch a graph that plots the five portfolios in terms of expected risk and return. Label points
that indicate:
(i) The feasible set of portfolios.
(ii) The efficient set of portfolios.
(iii) The indifference curves of an extremely risk-averse investor, and
(iv) The indifference curves of a moderately risk-averse investor.
Question 4.4
The following limited information on annual returns is available for two shares listed on the
Johannesburg Securities Exchange.
Year
Hifli
Lowfli
20.1
18
16
20.2
22
12
20.3
36
10
20.4
12
18
Despite the limited number of readings, a normal distribution of returns may be assumed. In
addition, past performance is considered to reflect expected future performance.
Required:
(a) Calculate the average return and standard deviation of each share.
(b) Calculate the covariance of returns for a portfolio comprising shares in both Hifli and
Lowfli.
(c) Calculate the correlation co-efficient of returns in a portfolio of shares of Hifli and Lowfli.
(d) Assume you have R10 000 available to invest. If you wanted to buy either Hifli or Lowfli,
which one would you buy? Explain your conclusion.
(e) If you choose to invest R3 000 in Hifli and R7 000 in Lowfli, calculate your expected return
from the portfolio and a measure of risk.
(f) Explain briefly the rationale for investors choosing to hold portfolios of shares rather than
individual shares.
Question 4.5
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Required:
Referring to the diagram, you are required to discuss the significance of each of the following:
(a) curve ANMB
(b) curves 1, 2, 3
(c) line FC
(d) point A
(e) point B
(f) point F
(g) point M
(h) point N
(i) point P
Question 4.6
Illustrate the following with a diagram or graph, ensuring that relevant lines, points, and axes are
clearly labelled (no values need be placed on axes, and graphs need only be sketched):
(i) the probability distribution of returns on two individual shares with different expected
returns;
(ii) opportunity set of share portfolios and the capital-market line. Indicate with an L the
positioning of a leveraged portfolio;
(iii) the effect on risk of holding an increasing number of individual shares in a portfolio;
(iv) the security-market line – indicate with an R the positioning of a share with a higher-thanaverage market risk; and
(v) approximate regression lines for four shares with beta values of 3, 1, 0.4, and 20.4 respectively.
Question 4.7
Ms Lightfoot wishes to invest 50% of her savings in shares of Company A and 50% in shares of
Company B. The expected returns and standard deviations for A and B are as follows:
CompanyExpected ReturnStandard
Deviation of returns
A10%15%
B15%20%
Required:
(a) What is the expected return of the portfolio?
(b) What is the variance and standard deviation of returns of the portfolio if the correlation
between the returns of A and B is:
a. +1.0
b. +0.0
c. -0.8?
(c) Assume that she wishes to invest 40% in Company A and 60% in Company B. How would
this change the expected return of the portfolio? Recalculate the variance and standard
deviation of the portfolio’s returns, if the correlation of returns is zero.
Question 4.8
As an investor, Ms Malinga is considering investing in shares rather than bonds. This is due to
the recovery in equity markets. She is considering investing in the shares of three companies,
Company X (a utility), Y (a retailer) and Z (a mining company). The expected return on the
market is 12% and the risk-free rate is 7%. She wishes to use the CAPM to estimate the required
rate of return for the three shares. The beta for each share is set out as follows.
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ShareBeta
X
0.50
Y
0.85
Z
1.20
What is the required return for investing in the shares of X, Y and Z?
Question 4.9
The risk free rate has just increased from 5% to 8%.
1. How would this change the intercept point of the capital market line with the efficiency
frontier?
2. How would this change the slope of the securities market line?
3. What does this say about the type of securities that would be preferred in times when interest
rates are rising?
Question 4.10
Imagine you have R200 000 to invest in a portfolio of two risky securities plus a riskless asset. The
following information contains four risky securities that are in different industries:
Required:
(a) Which two stocks did you choose and why?
(b) Given that your wealth is allocated to these two stocks plus the riskless asset in the proportions
of 15%, 45% and 40% respectively, what is your expected rand and percentage return for
your portfolio?
(c) Use the Markowitz technique to calculate the variance of this portfolio.
Question 4.11
Mr. Bhamjee places 40% of his funds in Security X which has a return of 12% and 60% of his
money in Security Y which has a return of 18%. The standard deviation on Security X is 20%
and on Y is 15% respectively.
Required:
(a) Calculate the expected return on the portfolio.
(b) Calculate the standard deviation for the portfolio if the correlation between the stocks is
+0.5.
(c) Calculate the standard deviation for the portfolio if the correlation between the stocks is -0.5.
(d) Which of the above correlation factors is the best for the portfolio? Explain why this is so.
Question 4.12
A security analyst provides the following forecasts for the forthcoming year for an investor
seeking to invest R100 000:
State of theProbabilityReturn ofReturn onReturn on
economy
of state
market portfolioSecurity A
government security
Strong
0.2
25%
27%8%
Moderate
0.5
15%
17%8%
Weak
0.3
5%
–3%8%
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Required:
(a) Compute the expected return (mean value), standard deviation, and co-efficient of variation
for each of the following three portfolios:
(i) The entire amount of R100 000 is invested in the market portfolio.
(ii)An amount of R70 000 is invested in the market portfolio and the remaining R30 000 in
a government security.
(iii)An amount of R50 000 is borrowed at the government security rate of 8% and the full
R150 000 is invested in the market portfolio.
(b) Plot the above three portfolios on a graph depicting risk (p) and return (Rp). Please label
the relevant aspects clearly.
(c) Critically comment on the investment analysis in part (a) and part (b) above.
(d) Compute the beta for Security A and determine an appropriate return for Security A based
on its beta value.
(e) Discuss the significance of the beta value for Security A, computed in part (d) above, in
terms of risk and expected return.
Question 4.13
The capital asset pricing model provides a basis for arriving at the expected rate of return on a
security or portfolio by reference to the risk-free rate, the expected return on the market, and
the beta value of the security or portfolio. The beta value measures only a component of total
risk – that which is referred to as systematic risk.
Required:
(a) Using the capital asset pricing model, calculate the expected rate of return on a security for
which:
– the risk-free rate is 11%;
– the expected return on the market is 22%; and
– the beta value is 1.2.
(b) Give the reasoning to justify the consideration of only systematic risk in estimating the
expected return on a security.
Question 4.14
The following facts pertain to Amtel, a share listed in the industrial sector of the JSE Securities
Exchange.
Beta co-efficient
= 1.6
Expected dividend (D) = R3
Expected growth rate (g) = 5%
In addition it is ascertained that the current risk-free rate is 12% and that the required rate of
return on shares with a beta co-efficient of 1 is 17%.
Required:
(a) At what price would you expect Amtel to be quoted today?
(b) Assuming there was an increase in the money supply which reduced the riskless rate to 10%,
at what price would you expect Amtel to be quoted?
(c) If, in addition to (b) above, the required rate of return on the market dropped to 15%, at
what price would you expect Amtel to be quoted?
(d) In addition to (b) and (c) above, assume new management of Amtel institutes policies that
increase expected growth to 7%, and expected stability in profits causes the beta co-efficient
to decline to 1.2. Determine the new equilibrium price.
(e) Discuss two factors that you consider to be significant drawbacks in effectively using the
capital asset pricing model for the valuation of shares on the JSE.
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Question 4.15
You have recently been appointed as the portfolio manager of a small syndicate holding the
following shares:
ShareInvestmentShare Beta
P
R800 000
1.2
Q
R400 000
1.8
R
R500 000
2.0
S
R300 000
1.4
It has been established that there is a 60% probability that the market return will be 14%.
However, should the recession deepen, the return will drop to 8%.
Required:
(a) Establish the rate of return anticipated from share R if the risk-free rate is 7%.
(b) Calculate the effect on the expected return and risk of the portfolio of the sale of shares in P
and reinvestment of the R800 000 in a new share X with a beta of 2.5.
(c) Briefly discuss what action, if any, you would take as the portfolio manager if you anticipate
an economic recession in the near future.
Question 4.16
Identify the curves or points referred to below by writing down the relevant letter(s) reflected
on the diagram:
(a) the efficient frontier where the investor is able neither to borrow nor to lend;
(b) the efficient frontier where the investor is able to lend at the risk-free rate but is not able to
borrow;
(c) the efficient frontier where the investor is able to lend and to borrow at the risk-free rate;
(d) the market portfolio;
(e) a portfolio where 75% of the investor’s funds are invested in the market portfolio and 25%
in risk-free securities;
(f) an example of a portfolio where the investor has borrowed to invest in the market;
(g) an example of an inefficient portfolio; and
(h) the optimal portfolio for an investor with the set of indifference curves given in the diagram
where he is able to invest in risk-free securities.
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Question 4.17
The following data are available for four shares listed on the JSE:
ShareExpected return %Expected beta
1
Jampak
17.0
1.3
2
Colder
14.5
0.8
3
Moonpak
15.5
1.1
4
Zappi
18.0
1.7
The risk-free rate is 10% and the expected return on a market portfolio is 15%.
Required:
(a) Draw a graph depicting the security-market line and plot each of the four shares.
(b) On the basis of the expectations, identify the shares which are overvalued and those which
are undervalued.
(c) If the risk-free rate were to rise to 12% and the expected return on the market portfolio to
16%, which shares, if any, would be undervalued?
(d) Assume you held a portfolio invested equally in each of the four shares under market
conditions as per (c) above. You want to invest in a fifth share, so that the portfolio beta is
1.2, and you are equally invested in five shares.
(i) What should be the beta of the fifth share?
(ii) What would be the expected return on the new portfolio?
(iii)Discuss briefly whether it would be appropriate to use beta as a measure of risk for the
new portfolio.
Question 4.18
You have been called upon to advise a client with regard to an investment of R100 000 in shares
in the industrial sector of the JSE. You have gathered data and assigned probabilities to expected
returns under four possible market conditions. The following probabilities have been assigned
to two individual shares, and to a unit trust. The unit trust is a widely diversified portfolio with
a beta of 1.
% Expected returns
Market conditionProbabilityAruntexBoumetCD Trust
Poor
0.2
–10
10
–5
Moderate
Good
0.3
5
10
15
0.4
30
15
25
Exceptional
0.1
45
20
35
You may assume that, despite the small number of readings, the distributions all have the
characteristics of a normal distribution. In addition, you may assume that borrowing and lending
is possible at the risk-free rate of 10%.
Required:
(a) Find the expected return, standard deviation, and co-efficient of variation for each of Aruntex
and Boumet.
(b) Find the correlation co-efficient for the returns from Aruntex and Boumet.
(c) Calculate the beta of Boumet.
(d) If your client borrowed R70 000 and invested R170 000 in a certificate of deposit Trust,
calculate the expected return and total risk of the investment.
(e) If your client invested R20 000 in Aruntex and R80 000 in Boumet, calculate the expected
return and total risk of the portfolio.
(f) Identify three simplifying assumptions used in developing the capital asset pricing model.
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Question 4.19
The following information gives estimated data concerning share returns:
State of the economyProbability of each
state occurring
Rates of return if state occurs
Market
Share A
Deep recession
0.05
–20%
–30%
Mild recession
0.25
10
5
Average
0.35
15
20
Mild boom
0.20
20
25
Strong boom
0.15
25
30
In addition, it is estimated that the risk-free rate will be constant at 8%.
Required:
(a) Calculate the expected rates of return on the market and share A.
(b) Calculate the estimated beta for share A. What is the market’s estimated beta?
(c) Based on the estimated (ex ante) beta, calculate the required rate of return for share A.
Would it be more meaningful to use an ex post beta to calculate the required rate of return?
Explain your answer.
Question 4.20
Helga Mnguni has recently graduated. During her three years of study she has accumulated
savings of R10 000 and a good grasp of the theories underlying risk and return as they apply
to the JSE. She has followed three particular companies closely and has used statistical data
relating to these shares in a project. She now wishes to invest her funds into some combination
of these shares applying the principles of portfolio theory. Her data for the three companies are
as follows:
BarloworldDeltaWooltru
Expected return
15%
25%
20%
Variance of return
64%
225%
81%
Beta
1.0
1.5
1.2
Correlation co-efficient
Barloworld/Delta
–0.3
Barloworld/Wooltru
+0.6
Delta/Wooltru
+0.2
Helga wishes to invest in a portfolio which comprises two of the three shares, applying R5 000 to
each of the two selected.
Required:
(a) Determine the portfolio of two shares which would be most attractive and comment on your
recommendation.
(b) Calculate the covariance of returns on the market with returns of Delta.
(c) Identify the fundamental principle of portfolio theory and the most significant assumptions
on which portfolio theory is based.
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Question 4.21
Two shares record the following percentage returns based on five readings:
Required:
(a) Calculate the correlation co-efficient for shares A and B.
(b) Calculate the beta of B.
(c) Sketch the possible combinations of A and B which could be held by an investor in a risk/
return space. Label both axes and Points A and B. Indicate the following on the graph with
regard to the portfolio:
(i) Point P, where an investor who is highly risk-averse may invest.
(ii) Point Q, where an investor who is not highly risk-averse may invest.
(iii) Point R, where an investor could, but would not, invest.
(d) If the risk-free rate is 9%, and the return on the market is 11.5% sketch the securities market
line. Label both axes clearly. Indicate the following on the graph:
(i) Point X, a share with the same systematic risk as the market.
(ii) Point Y, an overpriced share.
(iii) Point Z, underpriced share.
Question 4.22
Using the letters of the alphabet given below, label the following clearly on a diagram of the
security market line where the risk-free rate is 15%:
(a) the systematic risk and the expected rate of return on the market portfolio;
(b) an example of an underpriced security;
(c) an example of an overpriced security;
(d) an example of a correctly priced security;
(e) the systematic risk and the expected rate of return for a portfolio where 25% of the total
resources are invested in risk-free securities and 75% in the market portfolio;
(f) the expected rate of return and systematic risk for an example of a security constituting a
defensive investment; and
(g) the expected rate of return and systematic risk for an example of a security constituting an
aggressive investment.
Question 4.23
Describe the three concepts of the ‘efficient market hypothesis’ (EMH) and discuss the possible
implications of these concepts with respect to technical analysis and fundamental analysis.
Question 4.24
You are required to discuss why investors’ utility curves are important in modern portfolio theory
(MPT). Use a diagram (graph) to demonstrate your answer.
Question 4.25
A number of investigations have been undertaken into the use made by shareholders of the annual
reports of companies in which they have invested. Several of these show that the annual report is
regarded as an important source of information for making decisions on equity investment.
Other studies indicate that the market price of the shares in a company does not react in the
short term to the publication of the company’s annual report. How would you reconcile these
findings with each other, and with the ‘efficient markets hypothesis’?
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financial statement analysis
5
Companies and investors employ financial ratios to evaluate
performance
Management and investors make extensive use of financial analysis and financial ratios to
monitor and evaluate corporate performance. Of course, as you walk into a Clicks store, you
may be curious as to what the average gross margin is that Clicks makes on each product. What
is its operating margin after deducting other operating expenses? Another issue you may think
about is how long, on average, do its goods stay on its shelves? However, for the management
of Clicks, the turnover of inventory is critical for managing its business effectively and it will
be monitoring its inventory turnover ratios, the gross margin per product line and its operating
margins for its divisions very closely.
Investors are also interested in seeing whether Clicks has been able to improve or maintain its
margins and whether the company has been able to improve its operating efficiency by reducing
its inventories and operating expenses. Ratios will help investors to evaluate whether they should
invest in the company or not.
Warren Buffett is probably the world’s most famous investor. So which ratios does Buffett
look for when he is deciding to invest in a company?
Buffett is focused on return on equity rather than on earnings per share and likes to invest
in companies with high profit margins. However, the return on equity should be driven by
operations and not by increasing the debt/equity ratio. In fact, Buffett prefers companies to have
low debt/equity ratios. Companies should trade at reasonable price-earnings (P/E) ratios but he
would rather discount future cash flows than simply invest in low P/E companies or companies
with high dividend yields or low price to book ratios. Studies have indicated that companies with
low P/E ratios and low price to book ratios have outperformed other companies in the subsequent
10 year periods.
Financial analysis goes beyond ratio analysis. We need to evaluate whether the accounting
policies used by companies are appropriate. We need to read what the Chief Executive Officer
(CEO) and Chief Financial Officer (CFO) write in the integrated annual report and we
sometimes need to read between the lines. Furthermore, integrated reporting goes beyond just
evaluating financial indicators. We need to evaluate firm performance in terms of sustainability
and how it impacts on society and the environment.
In this chapter, we will also evaluate how we use ratios to predict company failure. We will
determine the economic value added (EVA) of a company, which will indicate whether a firm
is adding or destroying value. We will then go beyond the numbers to understand a company’s
performance and financial position and will list some warning signs of potential problems with a
company’s annual financial statements.
LEARNING OBJECTIVES
After working through this chapter, you should be able to:
■■ Outline the various reports used to communicate financial information to stakeholders.
■■ Identify the objectives of financial statement analysis.
■■ Identify the limitations of using accounting data to perform financial analysis.
■■ Outline the various approaches to financial statement analysis and to identify when each
approach is appropriate.
■■ Calculate and interpret commonly used financial ratios.
■■ Draw up a Du Pont analysis and interpret a structured financial analysis.
■■ Use failure prediction models to establish potential financial distress.
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■■ Outline the limitations of ratio analysis.
■■ Calculate and interpret Economic Value Added (EVA).
■■ Identify the warning signs in regard to the quality of accounting data.
INTRODUCTION
Any analysis of a firm by management, investors, and other interested parties, should include
an examination of the company’s annual financial statements. In terms of King III, all listed
companies are also required to produce an integrated report.
In the first part of this chapter, we will examine the financial information that is available
in the integrated report and the annual financial statements. We will focus mainly on the
annual financial statements but will also explain the integrated reporting framework. This
analysis will be followed by a consideration of the objectives of financial analysis. In the
second part of the chapter, we will discuss and apply the techniques of financial statement
analysis such as ratio analysis, which are useful in assessing the firm’s relative risk and
profitability.
1 ANNUAL FINANCIAL STATEMENTS AND THE INTEGRATED REPORT
At the end of every financial year, the directors of each company have to produce annual
financial statements and in terms of the Companies Act (2008), are obliged to present them
to shareholders at the annual general meeting (AGM). The financial statements must, in
conformity with International Financial Reporting Standards (IFRS), fairly present the
state of the affairs of the company and the results of operations for the financial year. In
terms of the Companies Act, a company is required to include an Independent Auditor’s
report and a Director’s report within the annual financial statements.
Annual financial statements may also include reviews by the Chairman, the CEO and
may include segmental reviews, analysis and reviews by the CFO and heads of operating
divisions. When financial statements are combined with reviews, this is often called the
annual report. Therefore, the annual report contains financial information, which may
be broadly categorised into descriptive and quantitative information. The descriptive
statements, which include the chairman’s, the CEO and CFO’s reports, describe the firm’s
operating results during the past year and may discuss any new developments that will take
effect during future years.
If a company produces an integrated report, in addition to the annual financial statements,
then this will often include the reviews by the Chairman, the CEO and the CFO.
Integrated Report
In addition to the Company’s Act of 2008, listed JSE companies need to adhere to the
principles of King III (see Chapter 1). In terms of King III, a listed company should produce
an integrated report, in addition to the annual financial statements. An integrated report
effectively requires a company to include information about its strategy, its governance, its
risk management, its current financial performance, as well as its prospects for the future.
The integrated report should set out the company’s economic, social and environmental
impacts and should therefore include non-financial information. For example, a brewer
such as SABMiller that uses significant quantities of water (about 5 litres of water per litre
of beer) would report on how it is reducing its usage of water over time. In fact, SABMiller
is a leader in analysing and reducing its levels of water usage. SABMiller would also be
expected to participate in initiatives to promote responsible drinking and support campaigns
to discourage users driving while under the influence of alcohol. Integrated reporting is
about understanding a company’s business model, and sustainability is a key consideration.
An integrated report should indicate how a company creates value. It should set out how the
external environment affects the company and how the company employs the resources and
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relationships (the Capitals) to create value. So what are the six Capitals indicated within the
Integrated Reporting Framework? The Capitals are depicted in Figure 5.1.
Figure 5.1 The use of the capitals to create and sustain value
The International Integrated Reporting Framework, which was published in December 2013,
defines these capitals in greater detail. Financial capital consists of financing or funds mainly
obtained in the form of debt and equity issues, as well as funding generated from operations
or investments. Manufactured capital refers to physical objects such as buildings and
equipment. Intellectual capital refers to intellectual property such as patents, copyrights,
rights and licences and organisational capital such as systems and protocols. Human capital
includes people’s competencies, capabilities and experience. Social and relationship capital
refers to institutions, networks and the relationships between stakeholders, as well as the
ability to share information. Natural capital refers to all renewable and non-renewable
environmental resources such as water, air, land, eco-systems, forests and minerals.
A company’s business model employs these capitals as inputs and converts them into
products or services. The focus is on how a company uses these capitals to create value.
With reference to the Integrated Report, the International Integrated Reporting Framework
published by the International Integrated Reporting Council (IIRC, December 2013, p. 5)
sets out its guiding principles for preparing an integrated report and the content elements
that should form the basis of an integrated report. Two important guiding principles for
the preparation of integrated reports are that the report should have a strategic focus and
future orientation and should describe its relationships with its stakeholders. These two
guiding principles are reproduced below:
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■■ Strategic focus and future orientation: An integrated report should provide insight into the organisation’s
strategy, and how it relates to the organisation’s ability to create value in the short, medium and long term,
and to its use of and effects on the capitals.
■■ Stakeholder relationships: An integrated report should provide insight into the nature and quality of the
organisation’s relationships with its key stakeholders, including how and to what extent the organisation
understands, takes into account and responds to its legitimate needs and interests.
Other guidelines refer to the connectivity of information (which, for example, refers to
dependencies and interrelatedness between factors), materiality, conciseness, reliability and
completeness, consistency and comparability. The content elements describe what should be
included in an integrated report and are reproduced below (see IIRC, December 2013, p.5):
CONTENT ELEMENTS
An integrated report includes eight content elements that are fundamentally linked to one another and are not
mutually exclusive:
■■ Organisational overview and external environment: What does the organisation do and what are the
circumstances under which it operates?
■■ Governance: How does the organisation’s governance structure support its ability to create value in the
short, medium and long term?
■■ Business model: What is the organisation’s business model?
■■ Risks and opportunities: What are the specific risks and opportunities that affect the organisation’s ability
to create value over the short, medium and long term, and how is the organisation dealing with them?
■■ Strategy and resource allocation: Where does the organisation want to go and how does it intend to get
there?
■■ Performance: To what extent has the organisation achieved its strategic objectives for the period and what
are its outcomes in terms of effects on the capitals?
■■ Outlook: What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy,
and what are the potential implications for its business model and future performance?
■■ Basis of presentation: How does the organisation determine what matters to include in the integrated
report and how are such matters quantified or evaluated?
So how do we use the information provided in an integrated report to evaluate and analyse
performance? Only listed companies will tend to produce integrated reports. If you are
analysing a listed company, then it is important to evaluate a company’s integrated annual
report by evaluating its report in relation to the IIRC’s guidelines and content elements.
Does the company’s integrated report include information that clearly sets out the
company’s strategy? This means that the company not only sets out its strategic objectives
but also sets out how it aims to achieve these objectives. It is also important that the
company indicates its current position and the challenges it is currently facing and how it
plans to address these challenges in the future. Has the company indicated how it will use
the Capitals to create and sustain value? The company should report on the state of its
relationships with its stakeholders and the risks and opportunities facing the company. The
following questions may also help us to analyse a company’s integrated report:
■■ How well does the company’s integrated report reflect the guiding principles and the
content elements set out in the Framework?
■■ How does the integrated report compare with the integrated reports of other
companies in the same sector? For example, is the information consistent and
comparable? A company may report information that contradicts information by other
companies in the same sector. Are differences in performance explained by differences
in strategy?
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■■ How does the information in the integrated report compare with or support information
set out within the integrated reports of its suppliers and customers?
■■ Is the information set out in the integrated report consistent with the information from
independent sources?
The integrated report may include both financial and non-financial information and the
company may use key performance indicators (KPIs) to set targets and report how it is
achieving or failing to achieve these benchmarks.
From the real world: Truworths’ Integrated Report
Truworths sets out the material issues facing the company under the following headings:
Managing the risk of fashion
Delivering sustained finiancial performance
Managing the risk of credit
Adopting leading information technology systems
Maximising supply chain efficiency
Being the employer of choice
Expanding retail presence
Accelerating transformation
Truworths sets out its objectives and targets and how it has performed, as well as the
challenges encountered during the year. It refers to fashion forecasting, analysis
of buying patterns, markdowns, response to exchange rate volatility and the use of
information technology. Truworths refers to its inventory turnover ratio, adoption of a
quick response fashion model, and ensuring the diversity of its supplier base. Managing
the risk of credit is important as the company offers its customers extended credit terms
and charges interest. This involves increasing collections capacity, the adoption of new
credit scorecards, credit bureau scoring, new account opening processes, the adoption of
new technologies and the management of rising delinquency rates, as well as compliance
with legislative and regulatory requirements. We refer you to the Truworths’ corporate
website for access to its integrated report www.truworths.co.za/investors.
Annual Financial Statements
The annual financial statements are required to be set out in terms of the International
Accounting Standard Presentation of Financial Statements (IAS 1). Financial statements
present the financial position and financial performance of a company. IAS 1 states that
the objective of financial statements is to provide information about the financial position,
financial performance and cash flows of an entity that is useful to a wide range of users in
making economic decisions. Financial statements answer such questions as:
■■ What are the company’s assets?
■■ What are its liabilities?
■■ How much have the shareholders contributed in equity and retained earnings?
■■ How much has been distributed to the shareholders?
■■ What are the company’s income and expenses, including gains and losses?
■■ What were the cash inflows and outflows for the period under review?
A complete set of Annual Financial Statements will comprise:
■■ A Statement of Financial Position as at the end of the period (also known as a Balance
Sheet);
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■■ A Statement of Comprehensive Income. Companies have been able to present income
and expenses in two separate statements, an Income Statement and a Statement of
Comprehensive Income. It is proposed that companies should present profit or loss and
other comprehensive income separately within a continuous statement (to be termed
the Statement of Profit or Loss and Other Comprehensive Income);
■■ A Statement of Changes in Equity for the period;
■■ A Statement of Cash Flows for the period; and
■■ Notes, comprising a summary of significant Accounting Policies and other explanatory
information.
The annual financial statements collectively offer an indication of a firm’s performance and
its financial position at the end of the financial year. Comparative information is disclosed
for the previous year, along with historical summaries of key operating statistics for the past
five years or more.
Table 5.1 sets out a Statement of Comprehensive Income (also termed Statement of
Profit or Loss and Other Comprehensive Income) as well as the Statement of Changes
in Equity which we will use in this chapter to evaluate the company’s performance. The
company, Typical Limited, has 500m ordinary shares in issue.
Table 5.1 Statement of Comprehensive Income and Statement of Changes in Equity
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Table 5.2 Statement of Financial Position (Balance Sheet)
The quantitative information and the descriptive information are equally important. While
the financial statements report the financial state of affairs for the past year, the information
provided in the integrated report and in the reviews by the chairman, the CEO and CFO
gives the background to the reported events, as well as indicating management’s perceptions
about the expected future prospects. Thus the quantitative information tends to be fairly
objective while the descriptive information included in the reviews is more subjective.
Analysts use the information contained in the integrated report, and annual financial
statements or the annual report to form expectations about future earnings and dividends,
and their variability.
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Statement of Comprehensive Income (Statement of Profit or Loss and Other
Comprehensive Income)
A Statement of Comprehensive Income (Income Statement) summarises a firm’s income and
expenditure over a financial year. A typical Statement of Comprehensive Income (Income
Statement) is reproduced in Table 5.1.
The Statement of Comprehensive Income (Income Statement) records the income and
expenditure for the 20.1 and 20.2 financial years. Sales revenue is disclosed at the top of
this statement. Cost of sales is deducted from the sales revenue figure to arrive at gross
profit. Various operating costs are deducted from the gross profit to give earnings before interest
and taxation. Financing costs are deducted from this, these being the interest paid on long-term and
short-term liabilities. This results in profit before taxation. Profit after taxation that is attributable
to the ordinary shareholders, is available for distribution to the shareholders through dividends.
The income tax rate will reflect an effective rate that may differ from the corporate tax rate of
28% owing to differences between accounting income and taxable income. Typical Limited has
an effective tax rate which is between 29-30%. To enhance growth, the firm reinvests earnings
of the firm that are not paid out to the shareholders in the form of dividends. This is disclosed
in the Statement of Changes in Equity, where the amount of dividends and transfers to retained
earnings are shown. The earnings and dividends, including dividend cover, may also be reported
on a per share basis. The Statement of Changes in Equity will also disclose changes in equity
due to share repurchases, the issue of shares and share-based payment expenses.
Statement of Financial Position
While the Statement of Comprehensive Income indicates the results of operations over
a certain period, the Statement of Financial Position provides a financial ‘snap shot’ at
a particular point in time, normally the end of the financial year. The lower half of the
Statement of Financial Position, which is reproduced in Table 5.2, shows the sources of
capital, being divided between equity and debt. The upper half reflects the employment of
capital, this being the firm’s long-term and current assets.
The shareholders’ equity comprises share capital and retained earnings. Debt comprises
long-term liabilities and current liabilities. Long-term liabilities are debt obligations with
more than one year remaining until maturity. Current liabilities are financial obligations
with less than a year remaining until maturity. While these amounts are all to be repaid
within the next financial year, they will be replaced with new current liabilities so that a
proportion of the current liabilities can be considered permanent.
In the Statement of Financial Position, the assets are listed in order of liquidity. Less
liquid assets are presented first. Assets with a useful life of more than one year are referred to
as non-current assets. Normally these assets would include plant, equipment, furniture, land,
buildings, and any other assets that have a useful life in excess of one financial period. With
extended usage these assets will deteriorate and, as a result, depreciation is provided to reflect
the decline of the assets’ useful life. The current assets or working capital of the firm consists
of assets that are normally converted into cash within one year and form part of the operating
cycle. Net working capital is current assets less current liabilities (excluding short-term interest
bearing loans and dividends payable).
Statement of Cash Flows
This statement is designed to show the cash generated from or utilised in three major areas,
operating activities, investing activities and financing activities. Although not separately
disclosed in the Statement of Comprehensive Income in Table 5.1, you have determined
that the depreciation charge included in the expenses of the company amounts to R120m
for the year. If the Statement of Cash Flows for Typical Limited is examined (Table 5.3),
it can be seen that the major generators of cash for 20.2 were the operating activities. The
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major consumers of cash were investing activities and financing activities. The bottom of the
statement reconciles the increase in cash and cash equivalents with the balance at the end of
the year. This statement is particularly useful in assessing the financial health of a company.
Research studies have indicated that one of the most useful indicators of financial health is
the relationship between cash flow and total debt.
Table 5.3 Statement of Cash Flows
2 Objectives of financial analysis and stakeholders
The overall objective of financial statement analysis is to examine a firm’s financial position
and returns in relation to risk, with a view to forecasting the firm’s future prospects. In
examining the specific objectives of users of financial statements we need to identify different
categories of users and their information requirements. Users of the integrated report and
annual financial statements will include stakeholders such as shareholders, management,
employees, suppliers, customers, and credit granters and lenders, government and society.
Shareholders
Shareholders are the suppliers of a firm’s equity risk capital. This capital is exposed to all the
risks of ownership and provides a cover for the debt that has a preferential claim to income
and capital on liquidation. Normally this risk capital will receive returns in the form of
dividends only after the prior claims of debt for interest have been satisfied. On liquidation,
ordinary shareholders have a claim to what remains only after the prior claims of creditors
and preferred shareholders have been met.
As a result, the informational needs of equity investors are among the most demanding
of all users of financial information. Their interest would lie in all aspects and stages of
operations, profitability, liquidity, capital structure, and valuation.
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Credit grantors
Credit grantors provide firms with loan capital in various forms and for a variety of purposes.
This may take the form of short-term or long-term credit.
Trade creditors who supply goods or provide services on credit normally provide shortterm credit. Most trade credit ranges from 30 to 90 days with cash discounts occasionally
allowed for specified earlier payment. Normally the trade creditor does not receive interest
for the extended credit, the reward being the profit that flows from trading. Short-term
credit is also provided by the commercial banks. This type of credit takes the form of bank
overdrafts or term loans, and interest is payable on the outstanding balance.
Long-term credit is usually provided by commercial banks or by financial institutions in
the form of long-term loans. These loans may be secured or unsecured. Firms can also obtain
long-term funds through the sale of debentures or non-participating preference shares.
A significant characteristic of all credit extension relationships is the fixed nature of
the reward accruing to the credit grantor. If a firm should be highly profitable, the credit
grantor’s return will be limited to the agreed rate of interest. However, should the firm
incur losses, the credit grantor could lose his income if the firm stops paying interest and,
moreover, he might not recover his capital. This downside risk/return relationship has
a major impact on the credit grantor’s point of view and will influence his objectives in
conducting a financial analysis.
While the equity investor is interested primarily in future earnings and the variability of
these earnings (as these factors will determine future returns), the credit grantor, on the
other hand, is concerned primarily with specific security provisions and cash flow forecasts.
Examples are the market value of assets pledged, the existence of other resources, and the
projection of sufficient future cash flows to enable the repayment of principal and interest.
In the case of short-term credit, the credit grantor is concerned primarily with the present
financial condition and the liquidity of the firm, the type of current assets, and the rate of
their turnover. The evaluation of long-term loans requires a far more detailed and forwardlooking analysis. Future profitability in the long term and cash flow analysis would indicate
the firm’s ability to meet the interest charges arising from its debt as well as other operating
commitments.
Both long-term and short-term credit grantors would also be concerned with the firm’s
capital structure. The level of financial leverage determines the level of financial risk and
indicates the extent that debt is covered by assets. The relationship of equity capital to debt is
an indicator of the adequacy of equity capital and of the cushion against loss that it provides.
Management
Management would use financial analysis to assist them in exercising control and in viewing
the firm in the way that outsiders, such as creditors and investors see it. This perspective
helps management to identify actions that will maximise shareholder wealth and ensure that
the firm receives an optimal allocation of capital resources.
Financial analysis can be undertaken by management on a detailed and continuous
basis, as management has unlimited access to accounting and other financial information.
Structured financial analysis is particularly useful in exercising control. An evaluation
provides valuable clues as to important changes in underlying financial operating conditions
as the analysis makes use of numerous relationships and interrelationships among financial
variables occurring within the firm. Identification of such changes, and a quick response to
rectify underlying problems, form the essence of control.
Employees
In order to negotiate for improved wages and benefits, employees and unions need to study
the annual report of the firm to find the relationship between profitability and the amounts
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paid to employees. Employees may also be interested in the long-term viability of the firm
since this has a bearing on future job security. In this regard their interests would be similar
to those of long-term credit grantors – the future long-term profitability of the firm.
Customers
Customers may wish to analyse the financial statements in order to ensure the future reliability
of supplies and the value of warranties. If the company provides warranties and spare parts,
then customers will want to ensure that the company is financially secure and has a sustainable
business model in the longer term. Furthermore, customers can also use information from the
financial statements to negotiate improved prices if the financial performance and financial
position of the company indicates that the company is financially secure.
Suppliers
The company’s suppliers will analyse the integrated report and annual financial statements in
order to evaluate the company’s profitability and financial position so that the suppliers can
continue to sell to the company and to ensure that any trade credit provided to the company is
secure. Suppliers will monitor the company’s liquidity and ability to pay its short-term debts.
It is also important for a company to analyse the financial statements of its suppliers to ensure
the reliability of the supply of goods. For example, Truworths, in its 2013 integrated report,
stated it had faced disruptions due to suppliers restructuring or closing down.
Acquisition and merger analysts
In identifying possible acquisition or merger candidates, analysts attempt to determine
an economic value for a firm as a whole. The analysis of financial statements helps in the
determination of an economic value and in assessing the potential synergistic benefits. Thus
the objectives of the acquisition and merger analyst are similar to those of the equity investor,
except that in the analysis of an acquisition one must, in addition, stress the valuation of
assets, including intangible assets such as goodwill, patents, and any liabilities transferred.
Auditors
An auditor is called upon to express an opinion on the fairness of the presentation of financial
statements. The major purpose of the audit process is to obtain the greatest possible degree
of confidence about the absence of material errors and irregularities that, if undetected,
would affect the fairness of presentation. As material errors or irregularities would affect
the various financial, operating, and structural relationships, the use of financial statement
analysis could lead to the detection of such errors and irregularities. Further, the process
of financial analysis requires the auditor to have a deep understanding and grasp of the
audited firm and this overview will help to indicate the most relevant type of audit work. If
the financial statement analysis is conducted at the end of an audit, the analysis will provide
an overall indication as to the reasonableness of the financial statements in general.
Government
Financial statement analysis may serve the needs of government departments. For example,
SARS could use financial statement analysis to check the reasonableness of income tax
returns and payment of indirect taxes such as VAT.
3 Limitations of accounting data
Financial statement analysis is dependent upon accounting data. While the importance of
accounting data in financial decision-making should not be understated, there are certain
limitations. If these limitations are considered, the correct perspective can be applied to the
analysis. The major limitations of accounting data are as follows.
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Monetary expression
Accounting data contains information that can be expressed in terms of monetary value.
Hence any attribute that cannot be expressed in terms of rand value would tend to be
ignored. For example, the Statement of Financial Position of Typical Limited lists the rand
value of all the assets, yet one of the company’s most important attributes is its management
team. The accounting data makes no effort to value these human resources. Likewise there
could be some negative aspects that are not reflected by the accounting data. This also
makes it imperative that we study the integrated report and the reviews by management to
understand what is behind the numbers. It is also important that we study the notes to the
annual financial statements.
Simplification and summarisation
As accounting tries to record highly complex and diverse economic events, there is often
a need for simplification and summarisation. The simplification process is necessary in
order to classify the numerous types of transactions into a limited number of accounting
categories. This will inevitably result in a loss of some clarity and detail that may have
been useful. Likewise, in the financial statements, it is necessary to summarise the account
categories to keep the size and detail within reasonable bounds.
Flexible accounting policies
A proportion of the financial data contained in financial statements is based on subjective
and flexible criteria, rather than objective criteria. The subjectivity arises from the estimation
and judgement of the accountants who prepare the financial statements. If different
accounting policies are used, the financial statements of different firms may not be uniform
or comparable. For example, it is necessary to decide on a depreciation policy based on
estimates of the expected future life of assets.
Revenue recognition policies focus on the question: when is a sale made? Management
will have some discretion as to the recognition of income particularly where the sale
constitutes a combination of goods and services to be provided in the future. Management
has further accounting flexibility in relation to, for example, effectively structuring the terms
of a lease to ensure it is an operating lease rather than a financial lease. The capitalisation
or expensing of research and development costs is another area providing management with
flexibility.
Inflation
While the disadvantage of monetary expression is the exclusion of information that cannot
be expressed in rand value terms, the advantage is that it provides a common denominator
which enables comparison between such diverse assets as investments and raw material
inventory.
Inflation leads to a decline in the purchasing power and so reduces the standard of value
of the currency. These changes are not necessarily reflected in accounting data. For example,
when measuring returns, care must be taken when comparing current income against assets
purchased twenty years ago.
Using traditional accounting methods leads to the reported profits being seriously
overstated. This is chiefly due to the depreciation and cost of sales figures being based on
out-of-date information.
4 Approaches to financial statement analysis
The analyst has a variety of techniques available for analysing financial statements and can
choose the technique best suited to a specific purpose. Among the more common analytical
techniques are:
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■■ comparative financial statements and trend analysis;
■■ index analysis;
■■ common size analysis; and
■■ ratio analysis.
Comparative financial statements
The comparison of financial statements is accomplished by setting up Statements of
Financial Position, Statements of Comprehensive Income, or Statements of Cash Flows
side-by-side and reviewing the changes that have occurred from year to year. The most
important factor revealed by comparative financial statements is the trend. The trend
will indicate the direction of change, the rate of change, and the amount of the change.
A meaningful trend can be established only if financial information is available for
a number of years. Normally the minimum would be five years and the ideal would
probably be ten years. This information is important for analysts as it helps them to
project future results.
Index analysis
Index analysis is similar to comparative financial statements except that a base year is chosen
and all values for that year are expressed as 100%. Subsequent years are then expressed in
terms of percentages calculated on the base year. For example if, in the base year, accounts
receivable amounted to R80m and in the following year they amounted to R120m, the
index analysis would express accounts receivable as 100% in the base year and 150% in the
following year. Let’s apply index analysis to Typical Ltd.
Although sales revenue has grown significantly by 54% over the year, the increase
in cost of sales and expenses has been much more dramatic resulting in a fall in profit
before interest and tax. Management would wish to investigate the reasons for this and to
investigate which corrective measures the company can implement in the future. Perhaps,
the firm has focused on growing sales at the expense of profitability.
Table 5.4 Indexed Statement of Comprehensive Income
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Table 5.5 Indexed Statement of Financial Position
Common size analysis
It is often useful to show individual items as a proportion of the total group. In a common
size Statements of Financial Position, each item is expressed as a percentage of total assets.
In the common size Statement of Comprehensive Income, sales revenue is expressed as
100% and every other item is expressed as a percentage of sales revenue. The common size
Statement of Comprehensive Income and Statement of Financial Position are reproduced
in Tables 5.6. and 5.7.
Table 5.6 Common size Statement of Comprehensive Income
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A common size analysis enables us to monitor changes and trends in margins and costs. The
company has seen a reduction in the gross profit margin. It is useful to evaluate this over a
number of years to see whether this reflects a trend towards a lower level of profitability in
the future. For example, the fall in gross profit margin may reflect an increased competitive
environment or the entrance of new competitors or a fall in the prices of substitute products.
Otherwise, suppliers may have the power to raise prices and the company has been unable to
pass these cost increases to its own customers. The fall in net margin is greater as distribution
and selling expenses as well as administration and other expenses have grown to reflect a
greater proportion of sales revenue.
Table 5.7 Common size Statement of Financial Position
Ratio analysis
A ratio expresses the relationship between one quantity and another. The ratio of 80
to 100 is expressed as 0.8:1, 0.8 or 80%. While the computation of ratios is simple, the
interpretation tends to be more complex. In examining the computation and interpretation
of a few frequently used ratios, it must be stressed that there is an infinite number of ratios
available. Many of these may be insignificant, for to be significant the ratio must express a
relationship that is meaningful. This would be reflected by a clear, direct, and understandable
relationship between the two variables. For example, sales turnover and the cost of goods
sold would display such a relationship, while on the other hand we would not expect a
relationship to exist between selling costs and the amount invested in fixed assets.
Since ratios are used by analysts to make projections about the future, the analyst should
also understand the factors that will affect such ratios in the future.
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5 Application of ratio analysis
A ratio contains little meaningful information on its own. For a ratio to be effectively
interpreted, it needs to be either compared with historic ratios to identify trends, or with
industry ratios, or with management’s goals and standards, and it must be evaluated in the
context of associated ratios.
When comparing a firm’s ratio to industry ratios, care must be taken to ensure that the
firm itself does not unduly bias the industry ratios and that the comparison of financial data is
appropriate. As industry ratios are the mean ratios for a large number of firms, it is possible
that the individual ratios vary extensively. This would result in the industry ratios being less
meaningful.
Ratios may be categorised into six groups: liquidity ratios, asset management ratios, debt
management ratios, profitability ratios, cash flow ratios, and market value ratios. Each of
these categories will be discussed and illustrated using Typical Limited’s financial statements
as an example.
Liquidity ratios
A major concern of any analyst is whether the firm will be able to meet its maturing financial
obligations. A full liquidity analysis requires the preparation of a cash budget as described in
Chapter 12. However, by examining the Statement of Cash Flows and the amount of cash on
hand and other current assets in relation to the maturing financial obligations, ratio analysis
indicates a measure of liquidity. The two best known measures of liquidity are the current
ratio and the quick ratio.
Current ratio. The current ratio is calculated by dividing current assets by current liabilities.
Current assets normally include cash, accounts receivable, and inventory, while current
liabilities consist of accounts payable and accrued expenses. This ratio indicates the extent
to which the claims of short-term creditors are covered by assets that can be translated into
cash in the short term. The calculation of the current ratio for Typical Limited at year end
20.2 is shown below:
current assets
208 ​ = 1.73:1
____
Current ratio = ​ _______________
​= ​
120
current liabilities
20.1 = 1.83:1
As a rule of thumb, the current ratio should be in the region of 2:1. Typical Limited has a
current ratio which is close to this benchmark although it has decreased from 20.1. This is
caused by a greater increase in accounts payable and short-term borrowings than in accounts
receivable, cash and inventory.
Quick ratio. As it normally takes longer to translate inventory into cash, it is useful to measure
the firm’s ability to pay off short-term obligations without relying on the sale of inventory.
The quick ratio, or acid test ratio, is calculated by deducting inventory from current assets
and dividing the remainder by current liabilities. The quick ratio for Typical Limited is:
current assets – inventory
65 = 1.19:1
______________________
​ = ________
​ 208 –  ​
Quick ratio = ​
120
current liabilities
20.1 = 1.23:1
The rule of thumb for the quick ratio is 1:1. Typical Limited has a ratio that is above this
benchmark. The ratio is declining as a result of the firm having relatively less accounts
receivable and cash resources in comparison to current liabilities.
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In 2013, the South African pharmaceutical company, Adcock Ingram had a current ratio of
1.18 (2012 : 1.89) and a quick ratio of 0.64 (2012 : 1.26). Why did these ratios change so much
from 2012 to 2013? This is because Adcock Ingram increased its short-term borrowings by
R1 billion. As this relates mainly to acquisitions, this debt should be structured as a longterm loan. If we exclude this, then the current ratio and quick ratio in 2013 would be 1.81
and 0.98 respectively. In comparison, in 2013, Bidvest Ltd had a current ratio of 1.3 and
a quick ratio of 0.80. Does this mean that Bidvest is poorly managed and may experience
potential liquidity problems? Not necessarily. Over the last 15 years, companies have
increasingly focused on reducing their net investment in working capital by using methods
such as Just-in-time and advances in technology. Bidvest uses significant financing from its
creditors, and also has significant cash balances of over R8.4 billion to enable it to deal with
any liquidity issues. Current ratios closer to 1:3 are becoming the new norm.
Asset management ratios
This group of ratios is designed to measure how effectively management is utilising the
company’s assets. In particular, the asset management ratios seek to ascertain whether the
investment in assets is justified in relation to activity as measured by sales revenue.
Inventory turnover. The inventory turnover ratio is defined as sales divided by inventory.
As sales are recorded at selling price and inventory is recorded at cost price, it is more
meaningful to calculate the ratio by dividing the cost of sales by inventory. The inventory
turnover ratio for Typical Limited is:
2 036
cost of sales
​ = ​ _____
​= 31.3 times
Inventory turnover = ​ ___________
inventory
65
20.1 = 20.1 times
The inventory turnover ratio is very high and, when compared against its 20.1 ratio, shows
a significant increase. Excessive inventories are unproductive and represent an investment
with a low or zero rate of return. The increased inventory turnover ratio would also tend to
indicate that there was no build-up of damaged or obsolete inventory.
It should be noted that the inventory level used for the ratio is the inventory held at a point in
time, this being the year-end. However, in reality, most firms’ inventory levels would be seasonal
and thus it would make sense to use average inventory levels rather than the year-end inventory
level. It is not, however, always possible to adjust for such a situation as the information to
calculate average inventory levels may not be available. The sum of the opening and closing
inventory levels divided by two is not necessarily the average inventory level as no allowance has
been made for volatility or seasonality during the year. Further, for the sake of comparability, it
is necessary to calculate the firm’s ratio in the same manner as the industry ratio.
If cost of sales is not disclosed or the industry and comparative ratios are based on sales,
then we would determine the inventory turnover ratio by dividing sales by inventory. Also
we may wish to be able to reconcile all our ratios to a common base. However, this does
result in an overstatement of the true inventory turnover and is problematic if there is a
change in a company’s gross margin. In relation to working capital, another ratio is:
Sales/net operating working capital
This is essentially sales divided by (inventory + receivables – payables) and indicates the
extent of financing provided by suppliers as well as the efficiency of managing a company’s
working capital.
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Average collection period. The average collection period represents the average length
of time that a firm must wait after making a sale before receiving the cash. The average
collection period which is used to analyse the accounts receivable is calculated by dividing
average daily sales into accounts receivable to find the number of days’ sales tied up in
receivables. Where a firm sells for cash and on credit, only credit sales should be used if a
detailed split in sales is available.
accounts
receivable
122  ​ = 12.46 days
​ = ​ _________
Average collection = ​ _________________
3 573/365
sales/365
20.1 = 16.99 days
The collection period of just under 13 days is well below that of most companies. This ratio
indicates that the credit period extended by Typical Limited is very low.
This ratio can be compared with the terms on which the firm sells its goods. For example,
Typical Limited could sell both for cash and on credit. If half the sales were for cash and the
other half on credit with terms calling for payment within 30 days, the average collection
period should be 15 days. As the actual average collection period is less, it would indicate
that customers were, on average, keeping to the credit policy. On the other hand, an average
collection period that was above 15 days would indicate that, on average, customers were
not keeping to the credit policy but there could still be some customers who were. Any
customers exceeding the credit terms could be identified through the use of an ageing
analysis. Management would also be concerned if the credit policy was too tight, as this
could have the effect of reducing credit sales.
In 2013, Shoprite had an inventory turnover (COS/Average inventory) of 7.7 times whilst
Tiger Brands had an inventory turnover of only 4.8 times. This reflects the differing
nature of operations of the two firms. Tiger Brands is involved in the manufacture of
food products whilst Shoprite is mainly involved in the retailing of food. Truworths’
integrated report indicated a target inventory turnover ratio of 6.0−6.5 for 2013 but
the company only achieved an inventory turnover of 5.4 for the year. Nevertheless, this
remains a credible performance. Tiger Brands had an average collection period of 54
days in 2013. Debtors’ days (the average collection period) for Truworths increased very
slightly to 211 days in 2013. This reflects its business model, which is based on granting
its customers extended credit and charging interest. Truworths’ lower inventory turnover
was due to a weakening economy and customers who were over extended in terms of
their levels of personal debt.
Fixed asset (non-current asset) turnover. The fixed asset turnover ratio indicates the utilisation
of property, plant, machinery, and equipment relative to operating levels as reflected by
sales revenue. The fixed asset turnover ratio is:
3 573 ​
sales  ​ = ​ _____
Fixed asset turnover = ​ __________
1 227
fixed assets
= 2.91 times
20.1 = 2.04 times
The ratio of 2.91 times compares favourably with that of the previous year (2.04 times)
indicating that Typical Limited is generating a higher level of sales from its fixed assets than
it had done in the past.
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Asset turnover. This ratio measures the utilisation of all the firm’s operating assets in relation
to sales revenue and is calculated as follows:
sales
Asset turnover = ​ ______________
​ operating assets
3 573  ​ = 2.49 times
= ​ ___________
1 227 + 208
20.1 = 1.76 times
If we determine the asset turnover on the basis of Sales/(PPE + NWC), i.e. sales relative to
property, plant and equiptment and net working capital (which is current assets less trade
payables), then the asset turnover would be 2.67 [3573/(1227 + 208 – 98] and the comparable
20.1 ratio would be 1.88.
The total asset turnover has improved considerably. The increase in turnover is greater
than the increase in assets required to generate sales. This would indicate more efficient
asset management relative to the level of operations.
As sales are over the year, it may be more useful to divide sales by average net assets
(non-current assets plus net working capital). For example, assume that a company with sales
of R200m and net assets of R100m increases its net assets by a further R100m halfway during
the financial year. Assume that the investment in net assets will also generate sales of R200m
per year. At year end, the net assets will have doubled to R200m but sales only include sales
revenue for the second half of the year (200 + 0.5 × 200). So, if we use year end net asset
values, then it seems that the company has reduced its asset turnover from 2 to 1.5 (300/200).
Does this mean that the company has become less efficient in managing its assets? No, it is
simply that we have 100% of the new assets but only 50% of the revenue from these assets.
If we average the net assets, we obtain an average value of net assets of R150m
[(200 + 100)/2] and the asset turnover will then be 2, which is the same as the prior year.
Of course, matching asset acquisitions and revenue is not always easy if acquired at different
points in time during the year.
Tiger Brands reported its asset turnover ratio from 2009 to 2013 in its 2013 integrated
report, which is set out below;
Tiger Brands
2009
2010
2011
2012
2013
Asset turnover (avg net assets)
3.2
2.9
2.8
2.6
2.1
The trend is worrying as it indicates that Tiger Brands is making less efficient use of its
assets over time and is generating less revenue from its assets over this period.
Debt management ratios
Debt management plays an important role in financial management and the extent of
financial leverage of the firm has a number of implications. Firstly, the more financial
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leverage the firm has, the higher its financial risk will be. As debt finance incurs interest,
a fixed cost, earnings become more volatile with debt finance. However, additional risk
yields additional return and if the firm earns more on the borrowed funds than it pays in
interest, the return on owners’ equity is magnified. Finally, by raising funds through debt,
the shareholders can obtain finance without losing control of the firm.
It can thus be seen from the above that there are basically two aspects to financial
leverage: firstly, a change in financial risk and, secondly, some implications for the returns
attributable to shareholders. The debt management ratios will try to assess the impact of
financial leverage on risk while the profitability ratios will indicate the impact of financial
leverage on shareholders’ returns.
Debt ratio. The debt ratio is the ratio of total debt to total assets and measures the percentage
of total funds provided by creditors. Total debt would include current liabilities and, in most
instances, preference shares. The higher the debt ratio, the higher the financial risk and,
while a very high ratio might be unattractive because of the high level of risk, a very low
ratio would also be unattractive because of the leveraged returns foregone. The debt ratio
for Typical Limited is:
debt  ​ Debt ratio = ​ __________
total assets
400 + 120  ​ = ​ ___________
1 227 + 208
= 36.24%
20.1 = 36.36%
The ratio indicates that just over one third of assets are funded by debt. The debt ratio has
strengthened marginally on the 20.1 ratio. This would indicate that Typical Limited has
moderate financial risk. However, as mentioned previously, it is important to note that
financial risk is the measure of variability of returns caused by fluctuating earnings and
fixed-interest repayments. Hence it is necessary to examine interest charges and earnings
before a complete assessment can be made of the financial risk.
Debt to equity. The debt to equity ratio is similar to the debt ratio except that it measures the
ratio of total liabilities to total equity. The ratio is as follows:
total debt  ​ = _________
​ 400 + 120
Debt to equity = ​ __________
​= 56.83%
915
total equity
20.1 = 57.14%
This ratio indicates the extent that debt is covered by shareholders’ funds1. This ratio
indicates medium financial risk and is consistent with the interest cover ratio.
An issue that arises with this ratio is the appropriate treatment of deferred tax. Frequently
deferred tax is regarded as equity. This is based on the premise that the liability is unlikely to
arise, as there will always be new tax allowances to replace those that are reversing. Should
it be expected that the liability is going to arise, it is suggested that the deferred taxation be
treated as debt.
Bidvest reported a debt to equity ratio of 17.2% and research studies have indicated
that most South African companies have debt to equity ratios that are below 40%. The
net debt (long-term borrowings + short-term borrowings – cash) to equity ratio of Tiger
Brands was 32% in 2013 compared to 10% in 2012.
1
If we only include interest bearing debt, then the debt to equity ratio would be 46% [(400 + 22)/915].
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Although Tiger Brands’ debt to equity ratio is relatively low at 30%, what is worrying is
that this ratio has increased significantly from 10% just one year earlier. This is probably
due to its expansion into Africa and the acquisition of companies such as Dangote Flour
in Nigeria. An interesting fact is that the real debt to equity ratio of Bidvest is higher if
we include the present value of its operating lease commitments.
Times interest earned (interest cover). The times interest earned ratio is determined by
dividing earnings before interest and taxes by the interest charge. This ratio measures the
extent to which earnings can decline without causing financial losses to the firm and creating
an inability to meet the interest cost. Failure to meet this obligation could lead to legal
action and ultimately insolvency. It should be noted that the before-tax profit figure is used
as the numerator, as income taxes are computed after the interest expense is deducted. The
times interest earned for Typical Limited is:
EBIT  ​ = ____
​ 282 ​ ​ = 2.82 times
Times interest earned = ​ _______
100
interest
20.1 = 5.23 times
This ratio reflects a high interest charge in relation to profitability. Further, there is a
considerable deterioration of this ratio from 20.1 to 20.2. This reflects the increased longterm borrowing in 20.2 and increased interest rates. In addition, the short-term debt has
increased proportionately more than the long-term debt. The high interest cost may indicate
that borrowing levels are higher during the year than at year end.
The interest cover of Bidvest was 10, compared to 8 for Tiger Brands in 2013. However,
just one year earlier, the interest cover of Tiger Brands was 25.
EBITDA coverage ratio. Operating income (EBIT) is after depreciation and amortisation,
which are non-cash flow charges. Therefore, it may be more relevant to determine the degree
that interest payments are covered by a figure that is closer to cash flow from operations
rather than analysing only earnings coverage.
EBIT + depreciation + amortisation
​
EBITDA coverage = ________________________________
​
Interest
There are a number of other coverage ratios that we could compute. For example, we
may wish to determine the following fixed charge coverage ratio:
EBIT + depreciation + amortisation + lease payments
________________________________________________
​
Fixed charge coverage =
​
Interest + lease payments
The fixed charge coverage for Bidvest is 3.09 which is much lower than the interest
cover of 10 mainly due to the fact that Bidvest reported operating lease charges totaling
R1.72 billion in 2013.
Profitability ratios
The ratios previously examined have tended to measure management efficiency and risk. As
profitability is the result of a large number of policies and decisions, the profitability ratios
will show the combined effect of liquidity, asset management, and debt management on
operating results.
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Gross profit margin on sales. The gross profit margin on sales ratio is computed by dividing
gross profit by sales revenue. If we apply this to Typical Limited we get the following:
gross profit _____
​ = ​  1 537 ​= 43.0%
Gross profit margin = __________
​
3 573
sales
20.1 = 48.0%
The gross profit margin has declined and this could indicate that markups have been reduced
in order to increase sales revenue. If the reduction is not part of a management strategy,
the decline in this ratio could also reflect a weakening in inventory control and possible
inventory losses as well as increased competition.
Net operating profit margin on sales. The net operating profit margin on sales ratio is
computed by dividing net income before interest and tax by sales revenue. If we apply this
to Typical Limited we get the following:
EBIT ​ = _____
​  282  ​= 7.89%
Net operating profit margin = ​ _____
3 573
Sales
20.1 = 18.02%
The net operating profit margin is fairly low and it has dropped considerably from 20.1.
This could be the result of higher costs, lower markups or a combination of these factors.
Companies are increasingly reporting EBITDA and the EBITDA margins.
The net profit margin after interest and tax can be determined as follows:
Net profit
​
Net profit margin = _________
​
Sales
Another indicator of profitability is based on the ratio of earnings before interest,
depreciation and amortisation (EBITDA) to sales. For Typical Ltd, its EBITDA margin
would be determined as follows:
282 + 120
EBITDA margin = _________
​ EBITDA
​ = ​ _________
​= 11.3%
3 573
sales
A company such as MTN will often refer to its EBITDA margin, which was 43.1% in 2013.
Although the EBITDA margin can be useful, it may often overstate the returns of capitalintensive firms. A company may have a high depreciation charge due to the fact that it has a high
level of investment in property, plant and equipment. Although depreciation and amortisation
are non-cash flow expenses, it will offer some indication of the capital expenditure required to
maintain operations in the future. However, banks often use EBITDA to determine how much
a company is able to borrow. For companies that are not required to undertake any material
capital expenditure in the future, this may be a useful indicator of debt capacity. However, in
most cases, it is not a good indicator of cash flow as it ignores capital expenditure and investment
in working capital. Furthermore, interest and tax are relevant expenses. Warren Buffett does not
like EBITDA. As he states:“We’ll never buy a company when the managers talk about EBITDA”.
He states more colourfully,“Does management think the tooth fairy pays for capital expenditure?”
The following depicts the gross profit margins, operating margins and net profit margins
of Shoprite and Tiger Brands in 2013 and 2009.
Tiger Brands makes and owns products such as Jungle Oats, All Gold, Koo, Fatti’s & Moni’s, Black
Cat, Tastic, Beacon, Albany, Renown, Enterprise, Energade, Oros, Ingrams, Doom, and Jeyes.
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Shoprite has been able to grow all its profit margins over the 4 years whilst Tiger Brands has
seen a significant fall in its profit margins over the same time. This is partly due to the fact that
Shoprite, Pick n Pay and Woolworths have been promoting the sale of house brands (private
labels) and this is affecting Tiger Brands. Further, its other projects have resulted in poor returns.
Bidvest reported an operating margin of 5% in 2013. In contrast, Kumba Iron Ore
earned an operating profit margin of 52% in 2013.
Return on assets (ROA). The return on assets measures the profitability of the firm as a whole
in relation to the assets employed. It is frequently referred to as the return on investment
(ROI). The ratio is calculated by dividing earnings by assets. However, there are three
possible definitions of earnings: earnings before interest and tax (EBIT), earnings before
interest but after tax (EBIAT) which is more commonly referred to as net operating profit
after tax (NOPAT), and net profit which is after interest and tax (NPAT). We will apply these
definitions to the Typical Limited financial statements using total assets as the denominator.
282
​
​ = 19.65%
Return on total assets (ROA) = __________
​  EBIT  ​ = ___________
1 227 + 208
total assets
20.1 = 31.67%
128 + (100 × 0.72)
​
​= 13.94%
Return on total assets (ROA) = __________
​  NOPAT  ​ = _________________
1 227 + 208
total assets
20.1 = 22.32%
128
​
​ = 8.92%
Return on total assets (ROA) = __________
​  NPAT  ​ = ___________
1 227 + 208
total assets
20.1 = 17.95%
In the case of Typical Limited, irrespective of how earnings are defined, the return on total
assets has declined from 20.1. It could be said from the above analysis that, irrespective of
how earnings are defined, the assessment will be the same. This will not always be the case.
Deciding which definition of earnings should be used depends upon the objectives of the
analysis.
■■ Using earnings before interest and tax is useful for comparing firms in different tax
situations and with different degrees of financial leverage.
■■ Using earnings before interest but after tax (NOPAT) is conceptually the most correct
approach. The reason for this is that it excludes interest, which is a cost of financing, but
includes taxation that is an operating cost.
■■ The final interpretation of earnings is to use net profit after interest and tax. This tends to
understate the return as the after-tax cost of debt finance has not been removed. In this
case the degree of financial leverage will have an impact on the return on total assets.
The returns on assets were based on total assets. However, it may be more useful and relevant
to determine the return on net operating assets, which are total assets less current liabilities
(excluding short-term debt). This is also termed return on capital employed (ROCE), due to
capital employed being defined as the long-term capital raised to finance operations, that is,
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long-term debt plus equity or total assets less current liabilities. However, short-term debt
should normally be excluded from current liabilities. Also, it would be correct to exclude
non-operating financial investments and excess cash from total assets. Remember that it is
important to be consistent so we should divide operating income by net operating assets.
Furthermore, within the context of analysing value creation, the conceptually correct
definition of return on capital employed is net operating profit after tax (NOPAT) divided by
net operating assets. Instead of the term return on capital employed (ROCE), other terms
often used are return on invested capital (ROIC), as well as return on net assets (RONA),
which we will treat as equivalent. If we apply this to Typical Limited, we get the following:
128 + (100 × 0.72)
NOPAT
_________________
​
Return on Capital Employed (ROCE) = ​ __________________
​ = ​
Net operating assets
1 435 − 98
= 14.96%
20.1 = 23.91%
Note that the current liabilities deducted above must relate to operating activities. For
example, the current portion of long-term loans and other interest-bearing debt included
in current liabilities is not deducted from total assets to derive net operating assets when
calculating ROIC or ROCE.
A straightforward definition of invested capital or net operating assets is working capital
plus fixed assets. In the case of Typical Limited, the current liabilities of R98m is assumed
to relate to operations as this relates to trade and other payables. It is best to exclude shortterm interest-bearing borrowings from operating current liabilities.
128 + (100 × 0.72)
NOPAT
Return on Invested Capital (ROIC) = ​ ______________
​ = _________________
​
​= 14.96%
Invested capital 1 227 + (208 − 98)
In line with Economic Value Added (EVA) covered later in the chapter, if ROCE or ROIC
is calculated, as defined above, then it can be compared to the firm’s weighted-average cost
of capital (covered in Chapter 7), in order to determine whether value has been created or
destroyed. A firm’s weighted-average cost of capital (WACC) is the average cost that it pays
on its long-term sources of finance. Therefore, if ROCE or ROIC exceeds WACC, the firm
has generated more from its investment in net operating assets than it needs to pay to its
providers of debt and equity finance and so value has been created. Conversely, if WACC
exceeds ROCE or ROIC, then the firm has destroyed value.
If we calculate ROIC based on average invested capital (average fixed assets plus average
current assets less average non-interest bearing liabilities), then ROIC would be:
128 + (100 × 0.72)
NOPAT
​ = ​ _________________
​
Return on Invested Capital (ROIC)= ______________________
​
Average invested capital 1 182 + (196 − 93)
= 15.57%
In this case, it is immaterial whether we use the average or the closing values of invested
capital. However, it is important to use average invested capital if there has been a material
change in the invested capital from the prior year. We have assumed that the cash is operating
cash, but if this is excess cash, then we need to deduct this from invested capital as we are
comparing operating income relative to operating assets.
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Bidvest reported a ROIC of 17.4% for 2013, although if we use average net assets rather
than year-end asset values, then the ROIC increases to 19.4%. Although Bidvest earned
an operating margin on sales of only 5%, its return on invested capital is much higher. As
the cost of capital of Bidvest is likely to be around 11−13%, Bidvest has created value.
Shoprite’s ROIC (if we exclude its R6 billion cash and cash equivalents from its net
operating assets), is very high at 37%. We saw that Tiger Brands had an operating margin
on sales that was higher than Shoprite’s, but Tiger Brands’ ROIC is significantly lower at
15.5% (its ROIC is 18% if we use average net operating assets).
In the USA, McKinsey reported for over 5000 non-financial companies that the
median ROIC over the period 1963−2008 was about 10%, although the median ROIC has
increased in more recent years. Sectors such as pharmaceuticals and personal products
that are based on patents and brands reported ROICs of 15−20% while sectors such as
utilities, airlines and paper reported ROICs of only 5−10%. High ROIC companies tend
to experience a fall in ROIC within 10 years but high ROIC companies tend to sustain
their advantage over low ROIC companies over time.
Return on equity. The ratio of net profit after interest and taxes to ordinary equity measures
the return on equity. If we apply this to Typical Limited we get the following:
net profit
128 ​= 13.99%
​ = ​ ____
Return on equity = _____________________
​
total shareholders funds 915
20.1 = 28.21%
From this ratio it can be seen that the return on shareholders funds has declined significantly
over the two years. This is to be expected, given the increased costs and decline in the other
profitability ratios.
The return on equity of Tiger Brands in 2013 was 18% and this compares to the return of
equity of 35% the company earned in 2009, reflecting a more difficult trading environment
and difficulties with its investment in Nigeria. Bidvest also earned a return on equity of
18% in 2013. Shoprite earned a return on equity of 24%, which was lower than its ROIC,
due mainly to its large cash balances. In contrast, Kumba Iron Ore earned a return on
equity of 75% in 2013 but this was expected to decline in line with the fall in the iron
ore price.
Cash flow ratios
Cash flow is the essence of any business. If the cash flow is inadequate, the firm will be
unable to meet its future financial obligations and will be forced ultimately to either curtail
or cease operations. As a result, most analysts consider the analysis of cash flow as one of
the best indicators of financial stability. Further, research studies have found that the cash
flow to total debt ratio is a reliable indicator of financial distress.
Cash flow to total debt. This cash flow ratio measures the cash flow generated from trading
activities in relation to total debt. The ratio is calculated as follows:
cash flow from operations ____
_______________________
​ = ​  239 ​= 56.63%
Cash flow to total debt =
​
422
total debt
This ratio reflects the ability of Typical Limited to generate cash flow and it is clear from
this ratio that the company is unlikely to suffer from financial distress. No comparative is
available as only the 20.2 Statement of Cash Flows is given.
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We have included long-term and short-term debt in the denominator. To be more
prudent, we could have used operating cash flow after capital expenditure, which would
result in a cash flow to debt ratio of only 6.87% [(239 − 210)/(400 + 22)]
Market value ratios
These ratios indicate the relationship of the firm’s share price to dividends and earnings.
They are indicators of what investors think of the firm’s past performance and future
prospects. If the firm’s liquidity, asset management, debt management, and profitability
ratios are all good, investors will value the shares of the firm highly and the market value
ratios will be high.
Dividend yield ratio. The dividend yield ratio indicates the return that investors are obtaining
on their investment in the form of dividends. The share price for Typical Limited was R2.80
at 30 June 20.2 (R3.75 in 20.1). The ratio is calculated as follows:
dividend per share _____
​ = ​  10.6c ​= 3.79%
Dividend yield = ​ ________________
280c
price per share
20.1 = 5.28%
The dividend yield might at first appear to be low. However, it is higher than the average
dividend yield on the JSE. The current total dividend yield for the JSE is between 2-3%. See
Chapter 16 for more on dividend yields in South Africa. In the long term, shareholders would
earn both dividends and capital appreciation, and so the total return would be considerably
higher than the dividend yield.
The dividend yield of Tiger Brands in 2013 was 2.9%. The dividend yield of Shoprite was
only 1.8%.
Earnings yield. The earnings yield is calculated by taking the earnings per share and dividing
it by the market price of the share. This ratio indicates the yield that investors are demanding.
Applying the ratio to Typical Limited we get the following:
earnings per share _____
​ = ​  25.6c ​= 9.14%
Earnings yield = ​ ________________
280c
price per share
20.1 = 12.64%
Price-earnings ratio (P/E). A similar ratio to the above is called the price-earnings ratio. The
price-earnings ratio also shows how much investors are willing to pay per rand of reported
profits. This ratio is, in fact, the inverse of the earnings yield, being the price per share
divided by the earnings per share. Thus the price is regarded as being a multiple of the year’s
earnings. Applying this to Typical Limited we arrive at the following:
price per share
280c  ​= 10.94 times
_____
Price-earnings ratio = ​ ________________
​ = ​
earnings per share 25.6c
20.1 = 7.91 times
Generally, price-earnings ratios are higher for firms with high growth prospects and lower
for firms that are regarded as being risky. The marked increase in the price-earnings ratio is
probably the result of the drop in earnings. The average price-earnings ratio in South Africa
in 2014 was about 17.
The price-earnings ratio of Tiger Brands was 18. In contrast, Shoprite was on a P/E ratio
above 28 in 2013 indicating market expectations of a high growth in earnings in the future.
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Dividend cover. Another ratio which is not based on market values yet affects market values is the
dividend cover ratio. This ratio measures the extent of earnings that are being paid out in the form
of dividends. A high dividend cover would indicate that a large percentage of earnings is being
retained and reinvested within the firm, while a low dividend cover would indicate the converse.
earnings per share 25.6c
​= 2.42 times
Dividend cover = ​ ________________
​ = ​ _____
dividend per share 10.6c
[20.1 = 2.39 times]
This ratio indicates that the dividend cover has increased marginally and that Typical
Limited is paying out some 40% of its earnings as dividends, while the balance is reinvested
on behalf of the shareholders.
6 Structured ratio analysis
So far we have examined a number of important ratios and analysed them by comparing
them to both ratios from previous years and industry averages. We can combine these ratios
to obtain an overall picture of the company. This is often referred to as structured analysis.
Du Pont analysis
The Du Pont model is a frequently used structured analysis technique. Figure 5.2 displays a
modified Du Pont analysis for X Limited, and includes industry comparisons where applicable.
As the objective of financial management is the maximisation of wealth, a structured
analysis should aim towards measuring how effectively this objective is achieved. The
Du Pont model uses the return on equity as the overall indicator of success. While profit
maximisation would not be a primary objective, a satisfactory return on shareholders’ funds
would be required to maximise wealth.
The strength of this model lies in its ability to arrange many possibly confusing financial ratios
into three broad categories: those associated with income, those associated with investment
(activity), and those associated with capital structure. These broad categories are reflected in
Figure 5.2. The diagnostic capability of the model allows attention to be focused on the problem
areas rather than haphazardly proceeding through a time-consuming unstructured analysis.
In applying the Du Pont analysis to X Limited, we notice some important characteristics
about the company. The return on equity is significantly better than the return on equity
made by the industry. Moving across in the chart from left to right will help us understand
why this is so. It can be seen that two factors make up the return on equity – firstly, the return
on assets and, secondly, the financial leverage multiplier (FLM). The first is a measure of
income in relation to total assets and the second is a measure of assets financed by ordinary
equity. When these two ratios are multiplied, the result is the return on equity.
This relationship is explained by the following formula:
net profit
total assets
​ × ​ __________
​
ROE = __________
​
equity
total assets
By cancelling total assets we get:
net profit
ROE = _________
​
​
equity
We can further expand this to include the net profit margin on sales.
net profit ______
sales  ​ × ​ ______
assets  ​
​ × ​ assets
ROE = _________
​
equity
sales
NP%
ROA
ROE
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In Figure 5.2, X Limited has achieved a ROE of 35.9% as compared to the industry
sector ROE of 13.4%. Yet when we break this down we find that this was because
the company achieved a higher net profit margin of 5.56% as compared to 4.1% for
the sector and also managed to make a more efficient utilisation of its assets. The
company’s asset turnover of 2.07 compares favourably to the sector’s asset turnover of
1.6. The net result is that X Limited has a return on assets of 11.51% as compared to a
return on assets of 6.56% for the sector. However, the company also makes greater use
of financial leverage resulting in an ROE that is close to 3 times higher than the sector.
The use of financial leverage to bolster ROE may mean that the company is subject
to higher risk than the sector. The Du Pont analysis indicates that it is the combined
impact of focusing on achieving a higher net profit margin on sales, of generating a
greater amount of sales from its assets and making greater use of debt that results in a
much higher ROE than the sector.
X Ltd R58 840
Figures in R000
Net profit
X Ltd 5.56%
Net profit
margin
X Ltd 11.51%
ROA
4
Income
X Ltd R1 058 679
Ind 4.1%
Sales
×
Ind 6.56%
X Ltd R1 058 679
X Ltd R63 247
Sales
Fixed assets
X Ltd 2.07 x
Total asset
turnover
+
4
X Ltd R510 633
X Ltd R407 271
Total assets
Current
assets
Ind 1.6 x
X Ltd 35.9%
ROE
×
Activity
+
X Ltd R40 115
Ind 13.4%
Other assets
X Ltd R510 633
Total assets
X Ltd 3.12 x
Financial
leverage
multiplier
Ind 2.05 x
Capital
structure
4
X Ltd R163 926
Ordinary
equity
Figure 5.2 Du Pont analysis for X Limited
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This is the kind of interrelationship that occurs throughout the chain of indicators in the Du
Pont model. A brief analysis of these interrelationships indicates that X Limited’s high return
on equity is the result of both high financial leverage and a higher-than-average return on
assets. Likewise the return on assets is a combination of an above industry net profit margin
accentuated by a higher asset turnover relative to the industry ratio. While this type of analysis
has many benefits, the major one is that it gives us an overall understanding of the firm.
7 Failure prediction
Although ratio analysis provides insight into a firm’s operations, the interpretation is
subjective rather than objective. As a result it relies on the perception of the analyst. For
example, a company may have a current ratio that is significantly weaker than that for the
industry. Exactly how bad is this situation? Is this bad enough to cause concern? To what
extent could the interest cover or debt ratio offset the weak current ratio?
As a result of analysts requiring more objective assessments, predictive models based on
ratios have been developed. Most of the research to date has been applied in connection
with the prediction of financial distress and multivariate discriminant analysis (MDA) has
been used to classify companies as subject to financial distress or not. This classification is
made on the basis of each company’s characteristics as measured by its financial ratios.
Financial distress models
The best known of these models was developed by Edward Altman who applied MDA to a
sample of companies and developed a discriminant function that classified companies either
as failed or successful. Altman’s model is as follows:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0X5 (Formula 5.1)
Where: X1 = working capital/total assets
X2 = retained earnings/total assets
X3 = earnings before interest and taxes/total assets
X4 = market value of equity/book value of total liabilities
X5 = sales/total assets
Altman found that companies with a Z-score above 2.99 were unlikely to fail and companies
with Z-scores below 1.81 were likely to fail.
Altman found that a zone of uncertainty existed from 1.81 to 2.99. This meant that if
the model was applied to a company and a score of between 1.81 and 2.99 was obtained,
a classification could not be made with certainty. However if the score was below 1.81,
the company was almost certain to fail while if the score was above 2.99, the company was
almost certain to succeed.
A similar model has been developed in South Africa by Dr J. H. de la Rey at the Bureau
of Financial Analysis in Pretoria. The model is as follows:
k = –0.01662a + 0.0111b + 0.0529c + 0.086d + 0.0174e + 0.01071f – 0.068811
(Formula 5.2)
where: a = total outside financing/total assets × 100%
b = profit before interest and tax/average total assets × 100%
c = total current assets + listed investments/total current liabilities
d = profit after tax/average total assets at book value × 100%
e = cash flow profit after tax/average total assets × 100%
f = total stocks/inflation-adjusted total assets × 100%
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This model achieved a 96% success rate in classifying the companies in the sample as either
financially failed or financially sound. For practical purposes, the model was developed in
such a way that the point of separation between financially sound and financially failed firms
is zero. The further a firm moves above zero, the more financially sound the firm will be. On
the other hand if the result becomes negative, the firm is likely to fail financially. A zone of
uncertainty exists from –0.2 to +0.2, which means that a result in this area is inconclusive.
Altman has updated and improved his original model with the new Zeta model. Little
information is available about this model as it is used as a basis for a credit rating financial
service that is offered by Zeta services. It is claimed that the newer model can predict
financial distress with a greater degree of accuracy than the previous model.
Further, in the mid-1990s Altman modified the Z-score and devised the Z” (EM) model
to evaluate non-manufacturers and companies in emerging markets. The sales/total assets
ratio was excluded and the market value of equity is replaced by the book value of equity.
This model has successfully been applied in South Africa and in other emerging economies.
The Z” model is set out as follows:
Z’’ = 6.56 X1 + 3.26 X2 + 6.72 X3 + 1.05 X4 (Formula 5.3)
Where: X1 = working capital/total assets = (current assets – current liabilities)/TA
X2 = retained earnings/total assets
X3 = EBIT/total assets
X4 = book value of equity/total liabilities
The Z” score critical barriers are set as follows:
Z” > 2.60 “Safe” Zone
1.10 < Z” < 2.60
“Grey” or “Danger” Zone
Z” < 1.10
“Distress” or “Fail” Zone
According to research by William Beaver, the cash flow to total debt ratio was found to be the
most useful single ratio to predict corporate failure. There are other proprietary methods
in use such as the H-Score® by Company Watch and Moody’s KMV methodology which is
based on a proprietary option pricing model and other risk metrics to predict failure.
8 Limitations of ratio analysis
While ratio analysis is very useful for evaluating performance, there are limitations that
need to be considered before it is applied mechanically:
■■ Some firms are diversified into different industries and it is therefore misleading to
compare such firms against one set of industry averages. In order to provide additional
information, companies provide segmented reporting which outlines the contribution
made by each line of business to sales, total assets, operating income, and return on
assets.
■■ In many instances management would strive to be up with the sector leaders, in which
case it might be preferable to make comparisons with firms that are regarded as being
sector leaders.
■■ In making inter-firm comparisons, or comparing against industry averages, the effect of
different accounting policies must be considered. As International Financial Reporting
Standards are issued, these problems are reduced but not entirely eliminated.
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■■ In making a comparative analysis, the timing of year-ends should be considered for both
of the firms being compared or the industry average. This timing could lead to ratios
being affected by seasonality. The inventory turnover ratio, for example, would be fairly
sensitive.
■■ It is possible for a firm to ‘window dress’ its financial statements, thus reflecting an
improved financial position. For example, Worldcom capitalised operating expenditure
while Leisurenet used a revenue recognition policy that recorded revenue up front. In
this way both companies managed to show substantially increased profits although their
cash flow continued to deteriorate. Leisurenet’s main operating assets, its gyms, were
acquired by Richard Branson (Virgin Active).
■■ It is difficult to assess how bad or how good a ratio is. This subjective assessment will
depend upon the perception of the analyst. Furthermore, some ratios might indicate
strong points while others might indicate weak points and it is difficult to assess to what
extent the strong points offset the weak points. However, as mentioned in the section on
failure prediction, effective models can be established to avoid such a problem.
■■ As financial statements are normally prepared on a historic cost basis, unadjusted
for inflation, the accounting amounts are removed from economic value. This will be
reflected by the understatement of fixed assets and possibly inventory, while the value of
long-term debt will decline in real terms. This results in equity being understated. These
factors make ratio comparisons over time for a given firm, and across firms at a given
point in time, less reliable than would be the case in the absence of inflation.
■■ Also, a company may have a high ROA only because the company owns very old and
depreciated plant and equipment. This makes it difficult to compare this company’s
ROA to another company that has newer assets on the Statement of Financial Position,
which would have been purchased at a higher cost. The newer assets also have higher
book values as they have a longer time to be depreciated.
Where companies do use fair value and mark-to-market accounting to value assets and
liabilities in financial statements, we need to evaluate the assumptions used to value the
assets or liabilities. For example, are the assumptions used to value employee share options
reasonable? Is the discount rate used valid?
The above limitations do not negate the usefulness of ratio analysis but it is important
that analysts should be aware of them and make the necessary adjustments. Applying ratio
analysis blindly, using a procedural approach, is dangerous as the effectiveness of the exercise
depends upon the interpretation of the ratios by ­­– and hence the skill of – the analyst. If
an analyst applies ratio analysis perceptively, ratios will provide useful insights into a firm’s
operations. This skill is acquired through experience and from a thorough understanding of
financial statements and a company’s business.
9 Economic value added (EVA™)2
Economic Value Added (EVA™) is a financial performance measure that tries to capture
the true economic profit of an enterprise. EVA™ is also a performance measure which is
linked to the creation of shareholder wealth over time. It is claimed that by implementing
a complete EVA™-based financial management and incentive compensation system,
managers will obtain superior information – and superior motivation – to make decisions
that will create the greatest shareholder wealth in any publicly owned or private enterprise.
Put more simply, EVA™ is net operating profit minus an appropriate charge for the
opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of
true ‘economic’ profit, or the amount by which earnings exceed or fall short of the required
2
EVATM is a registered trademark of Stern Stewart & Co.
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minimum rate of return that shareholders and lenders could get by investing in other
securities of comparable risk.
EVA™ = Net Operating Profit after Tax (NOPAT) – {Capital × The Cost of Capital}
The capital charge is the most distinctive and important aspect of EVA™. With traditional
financial analysis, many companies may appear profitable while in fact they are not. When
a business returns a profit that is less than its cost of capital, it does not create wealth; it
destroys it. EVA™ corrects this error by explicitly recognising that when managers employ
capital they must pay for it, just like any other expense.
By taking all the capital costs into account, including the cost of equity, EVA™ shows the
rand amount of wealth a business has created or destroyed in each reporting period. In
other words, EVA™ is profit the way shareholders define it. If the shareholders expect, say,
a 20% return on their investment, their wealth will only grow to the extent that their share
of after-tax operating profits exceeds 20% of equity capital. Everything before that is just
building up to the minimum acceptable compensation for investing in a risky enterprise.
For example, assuming that the cost of capital for Typical Limited is 16%, the EVA™
would be calculated as follows:
Despite having generated a profit of R128 million in 20.2, the return is below the cost of
capital and so shareholder value has been destroyed by an amount of R14 million, a fairly
dismal performance.
EVA™ was developed to help managers incorporate two basic principles of finance into
their decision-making. The first is that the primary financial objective of any company should
be to maximise the wealth of its shareholders. The second is that the value of a company
depends on the extent to which investors expect future profits to exceed or fall short of
the cost of capital. By definition, a sustained increase in EVA™ will bring an increase in
the market value of a company. This approach has proved effective in virtually all types
of organisations; from emerging growth companies to turnarounds. This is because the
current level of EVA™ is not what really matters. Current performance is already reflected
in share prices. It is the continuous improvement in EVA™ that brings continuous increases
in shareholder wealth.
EVA™ has the advantage of being conceptually simple and easy to explain to nonfinancial managers. It starts with familiar operating profits and simply deducts a charge for
the capital invested in the particular business unit. By assessing a charge for using capital,
EVA™ makes managers care about managing assets as well as income, and helps them
properly assess the trade-offs between the two. This broader, more complete view of the
economics of a business can make dramatic differences.
Most companies use a number of measures to express financial goals and objectives.
Strategic plans often are based on growth in revenues or market share. Companies may
evaluate individual products or lines of business on the basis of gross margins or cash flow.
Business units may be evaluated in terms of return on assets or against a budgeted profit
level. Finance departments usually analyse capital investments in terms of net present
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value, but weigh prospective acquisitions against the likely contribution to earnings growth.
Bonuses for line managers and business-unit heads typically are negotiated annually and
are based on a profit plan. The result of the inconsistent standards, goals, and terminology
usually is a lack of cohesive planning, operating strategy, and decision-making.
EVA being a single financial measure links decision-making with a common focus –
how to improve EVA? EVA provides a common language for all employees and allows
management decisions to be modelled, monitored, communicated and compensated in a
single and consistent way – always in terms of the value added to shareholder investment.
A related indicator is a firm’s Market Value Added (MVA). This is the difference between
the book value of the firm’s equity and its market value.
Sometimes firms’ EVA and MVA figures do not reconcile, either because the market
expects a fall in future EVAs or the market may have had a temporary adjustment in value.
The use of EVA to measure performance at SABMiller
SABMiller is a South African company that has become a major global brewer and although
it is now also listed in London, it retains its South African base. It has operations in over
40 countries, employed over 40 000 employees and achieved a sales turnover of US$14.53
billion in the year ending 31 March 2005. The number of employees has grown to over
70 000 in 2010 and group revenue was US$26.35 billion in 2010 and earnings before interest,
tax and amortisation (EBITA) was US$4.381 billion. The company has performed extremely
well in terms of its share price offering investors a total shareholder return of 164% (up
to March 2005) since listing in London in 1999. From 2005 to 2010, SABMiller provided a
total shareholder return of 150% as compared to 50% for the FTSE 100 index. SABMiller
is focused on delivering shareholder value and the company has implemented the EVA
system to measure performance. The following is an extract from the company’s financial
statements for the year ending 31 March 2005:
In focusing on shareholder value added, the group uses EVA™ as a key indicator of annual performance.
As noted previously, SABMiller is continually investing in new brewing operations and most new
investments impact negatively on EVA™ in the short term. Key factors to be borne in mind are: EVA™ is
calculated using operating profit after tax, adjusted for exceptional and non-recurring items; the capital
charge is calculated on opening economic capital – adjusted for acquisitions, any impairments of assets
of continuing business units, and goodwill previously eliminated against reserves. The group’s weighted
average cost of capital (WACC) is applied against the resulting investment; and WACC, at 8.75% (as
in 2004), takes account of relevant individual country risk profiles and the group’s overall debt profile.
SABMiller returned EVA™ of US$505 million in the year under review (2004: US$241 million). This
increase is the result of the improved business performance outlined earlier, partially offset by a higher
capital charge that reflects the acquisitions made during 2005.
SABMiller disclosed a summary of how it calculates the company’s EVA in its financial
statements. This is reflected in Table 5.8.
SABMiller no longer discloses its EVA. A back-of-the-envelope calculation for 2010,
indicated that EVA was negative, around –US$300m. This was probably due to the poor
performance of the USA divisions at the time. The operating asset base of SABMiller in
2010 was over US$30 billion.
Although SABMiller had increased its operating asset base to about $48bn by 2013,
we estimate that SABMiller in 2012 and 2013 reported a positive EVA for each year as its
operating profit had doubled since 2010.
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Table 5.8 Determination of EVA by SABMiller
Perspectives on EVATM by Joel Stern
Professor Joel Stern has been at the forefront of advancing the
cause of shareholder value management and is the founder of
Economic Value Added (EVA). He is CEO of Stern Stewart.
Joel has written or co-authored eight books, and writes for the
Financial Times and the Wall Street Journal. He is associated
with a number of graduate schools and has taught at Columbia
and UCT for many years.
EVA is often described as trading profit minus a capital charge for debt and equity capital.
Perhaps more clearly, it is total capital multiplied by the spread, the rate of return on total
capital (ROTC) minus the weighted average cost of capital (C):
EVA = TC [ROTC – C]
This encourages management to maximise performance by:
• Growing the firm (increase TC) but only if ROTC exceeds C;
• Improving performance on existing capital (↑ ROTC); and
• Harvesting losers and disgorging cash to shareholders (↓ TC and ROTC – C becomes
larger on the remainder).
My message, however, is more complex than just measurement. To achieve valueenhancing behaviour, management needs to reinforce the asset management process by
prioritising the process in terms of declining order of EVA improvement, accompanied
by an incentive compensation system tied to sustainable EVA improvement, where a
portion of incentive declarations are paid out now, the rest held at risk subject to loss if
sustainable results fail to be achieved.
Although discounting expected future free cash flows yields firm value, it is possible, even
desirable, for free cash flow (FCF) to be negative when firms have projects with expected
returns above the cost of capital. The practical problem is that incentive contracts cannot
be written on FCF, since negative FCF can be beneficial. EVA improvement always means
value improvement, so incentives based on EVA are congruent with shareholder needs.
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10 What’s behind the numbers?
Ratio analysis is based on accounting numbers and their value is dependent on the quality
and the integrity of the accounting data that make up the financial statements. The
company’s financial statements will be subject to an independent audit and the company
should adhere to generally accepted accounting principles and the International Financial
Reporting Standards (IFRS). Whilst there are instances where this may not apply, the fact
remains that management has sufficient flexibility to significantly impact on the results of
the company and yet remain safely within the rules. The company may do so by selecting
accounting policies that enable the company to present results that favour its point of view
and still remain within the boundaries of IFRS.
There are other distorting effects such as comparing companies, when one has newer
plant and equipment and reports significantly lower returns on assets and the other may
have older and fully depreciated assets resulting in high returns. The effect of using historical
cost in the Statement of Financial Position results in objective and verifiable costs at the
expense of more subjective but relevant data. Management may also be driven to make
accounting choices which do not adhere to accounting rules.
There are a number of important factors to understand when we evaluate the quality of
accounting data and disclosure.
Understand the business and the industry sector
It is important to understand the business. Warren Buffet understands Gillette (Procter
& Gamble) because millions of people get up and shave in the morning, but he does not
understand the economics of the Internet and avoided the boom and the bust of the IT
companies. In the past, the automobile sector revolutionised transport but of the few
thousand motor manufacturers in the USA, there are only three that remain. Investing in
this sector initially may have cost you money, although it would have been a good idea, as
Buffett states, to go short on horses.
What are the company’s strategies? Undertake a strategic analysis of the industry and
the company by evaluating the company’s products, the position of the buyers and suppliers
and the competitive landscape. Are the products subject to foreign competition and at risk
of technological obsolescence? Does the company own strong brands? Does the company
own patents? Do the accounting policies adopted by the company make sense in terms of
the company’s business model? Does the company adhere to the norms of the industry
sector?
Understand management’s motives for selecting accounting policies
We need to relate the accounting policies adopted by the company to any inherent motive
that management may have to state returns and assets in a certain way. What are some of
the issues facing management that may influence the choice of accounting policies?
Loan covenants. The banks may impose limits on a number of accounting ratios such
as interest cover and working capital ratios. This means that if a company is in danger of
violating its loan covenants, it is more likely to select accounting policies that will reduce the
likelihood of the company transgressing its loan covenants.
Management incentives. If management’s remuneration is tied to the company’s accounting
results or even the company’s share price, in terms of share options or bonuses, then
management may select accounting rules that will maximise company profitability to ensure
increased remuneration levels.
Taxation. A company may select policies that will result in the company incurring a lower
tax liability.
Regulatory issues. If a company operates in a regulatory environment, then it may select
accounting policies that will optimise its position in relation to the regulatory authority. For
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example, a utility’s cost of capital will be used by a regulatory authority to determine the
pricing of the company’s products and services. The utility will use parameters that increase
its cost of capital and use accounting policies that will increase the value of its assets and
reduce its level of accounting profitability. The company may select accounting policies to
reflect low returns if the industry is subject to regulatory review.
There are a number of other issues. For example, if a company is subject to a takeover,
the company will wish to quickly increase its earnings to push up the price and thereby make
the offer much more unattractive.
Understand the key drivers of value
Each industry sector will have a few key ratios that are critical to that industry. For example,
the operating margin for the retail sector is important. If Shoprite is able to increase its
operating margin from 2.0% to 6%, then this is critical for the valuation of the company.
Inventory control is critical in the retail sector and working capital ratios are very important
in evaluating company performance. In the banking sector, the evaluation of credit risk and
managing interest rate spreads is critical. For manufacturers, the productivity of capital
and capacity utilisation is important and there is a focus on asset turnover and returns on
invested capital. In the pharmaceutical sector, the level of R&D to sales is relevant and for
companies with highly branded products, the management of brands and the investment in
advertising are important.
Understand which accounting policies are flexible
It is important to evaluate which accounting policies offer flexibility. Which depreciation
policy does the company use and what are the expected useful lives of the company’s
assets? Are the company’s operating leases really operating leases or finance leases that
have circumnavigated the rules? What is the company’s policy in relation to research
and development costs? What is the company’s revenue recognition policy? What is the
company’s allowance for bad debts and inventory obsolescence? Does the company’s
provision for warranty claims reflect economic reality?
Accounting for leases
We have indicated that investors and analysts should understand the company’s accounting
policies in relation to leasing. Due to the importance of accounting for leases on a company’s
financial statements and ratios as well as expected changes in accounting for leases, it is
important to analyse this in greater detail.
Leases can be classified as either operating or finance leases. The definition has been
crucial in financial analysis. Companies are required to capitalise finance leases. The principle
is that if a lease transfers substantially the risks and rewards of ownership to the lessee, then
the lease should be considered to be a finance lease. There are specific guidelines such
as the term of the lease in relation to the asset’s economic life, which will guide whether
a lease is a finance lease. In a finance lease, a company will capitalise future contractual
lease payments so that a company will record the ‘right to use’ as an asset and the lease
obligation as a liability. The leased asset is treated as an owned asset and is depreciated
over its useful life or the term of the lease. In this case, lease payments are separated into
two components – interest and the repayment of principal. This is similar to the buy and
borrow option. In contrast, operating lease obligations do not appear on the Statement of
Financial Position (balance sheet) and lease payments are treated as an operating expense.
Whilst we will come back to accounting for leases in Chapter 15, this is a fundamental issue
in the financial analysis of a company. Why? Companies will often structure leases so that
they avoid defining leases as finance leases. Operating leases have represented a significant
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source of ‘off-balance sheet’ financing. Bidvest Ltd reported operating lease charges of
R1.72 billion in 2013 and only R4.2 million in depreciation on capitalised finance leases.
In terms of proposed changes to IFRS, all leases will be required to be capitalised whether
such leases are operating or finance leases. What will be some of the effects of capitalising
all leases? The following are some of the effects of the change in lease accounting:
■■ Increase in assets and liabilities for most companies, particularly companies operating
in such sectors as airlines and logistics;
■■ Lower asset turnover ratios;
■■ Increase in debt/equity and debt ratios;
■■ Increase in current liabilities;
■■ Initial decrease in net income as interest plus depreciation in the early years will
exceed the operating lease payment. In later years, this will reverse and net income will
increase as interest falls with the fall in the principal amount owing;
■■ Increase in operating income and operating cash flow as this will no longer include
operating lease payments; and
■■ Increase in EBITDA.
The change to IFRS and the requirement to capitalise all operating and finance leases
reflects what Stern Stewart and analysts have been doing for many years to calculate EVA
and properly analyse financial statements. Finally, IFRS has realised that this is the right
thing to do. However, we need to be aware that companies may switch to “outsourcing”
contracts and restructuring the ownership of operations so that capital and liabilities are
excluded from group accounts. For example, Coca-Cola either does not own or only owns a
minority stake in many of the bottling plants. This means that the company does not have to
consolidate the capital intensive bottling plants onto its own Statement of Financial Position
which will have a negative impact on its ratios. Coca-Cola has long-term contracts with the
bottling plants. MTN is disposing of its towers either to a foreign company in which it will
own 49% of the equity or other independent companies thereby effectively reducing its
consolidated asset base in the future. This will probably bolster its return on assets in the
future. Perhaps all non-cancellable obligations should be capitalised.
Understand the warning signs
What are some of the warning signs pointing to problems with the company’s financial
report? What are the so-called ‘red flags’ relating to accounting disclosure and practice? The
following may reflect potential problems in relation to business and accounting practices:
■■ Increase in accounts receivable that exceeds the increase in sales. This may reflect the
company pushing sales into its distribution channels which may be returned, or it may
reflect a relaxation of credit policy which may result in an increase in bad debts in the
following year.
■■ Increase in inventory that exceeds the increase in sales. This may reflect faltering demand
for the company’s products or a fall in economic activity that will result in lower demand
in the next year. This may lead to write-downs or lower margins on sales. However, an
increase in inventory may also reflect an expectation of increased sales in the next year.
Where is the increase occurring? Is it in materials, work-in-process, or finished goods?
Does it reflect increased returns from the distributors? Watch any increase in workin-process as this may reflect operational problems and some companies may use this
account to hide assets and projects that have no value.
■■ Restructuring, non-recurring charges and asset write-downs or sales. The misuse of
restructuring charges to create reserves and bolster future returns is well recognised
and investors should evaluate the validity of each charge. What are reasons for the
charge? Also if a company often reports non-recurring charges or significant write-
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downs, then it may mean that the company is not able to react in time to a changing
business environment. The industry sector itself may be at risk. Sometimes to hide poor
operating results, a company may engage in asset sales, realising a large profit on asset
sales to bolster revenue and earnings per share.
■■ Accounting income and tax losses. Watch out for companies that consistently report
positive accounting income and yet continue to incur tax losses. Whilst this is quite
possible, at least for a short period, it is not sustainable and may reflect dubious
accounting practices. There may be good reasons for a company reporting different
incomes for financial reporting and tax purposes, yet we would expect there to be a
consistent relationship between the company’s reported accounting income and its
taxable income. A changing relationship between accounting income and taxable
income is a warning sign.
■■ Accounting income and a negative operating cash flow. Focus on the company’s cash
flow statement. A company that is reporting accounting income and yet is consistently
reporting a negative cash flow is heading for the rocks. Whilst this may happen for
good reasons, such as significant capital investments which will bolster future sales and
operating returns, it may also reflect a company chasing growth at all costs even when
returns are lower than the company’s cost of capital. It is important to evaluate the
company’s accounting policies and analyse the differences between the Statement of
Comprehensive Income and the Statement of Cash Flows. Evaluate the investments in
relation to the potential of the company, the sector and the size of the company and its
stage of expansion and development.
■■ Complex company structures and related party transactions. Companies may use complex
structures and related party transactions to hide problems. Enron used special purpose
entities to take liabilities off its Statement of Financial Position and yet retained the
credit risk of such transactions. Do you understand the company structure? Does it
make sense in terms of the company’s business model and operations?
■■ Accounting policies in relation to research and development, depreciation and leasing.
Companies may decide to capitalise R&D costs in order to bolster earnings and
may select long asset useful lives to reduce the annual depreciation charge. Further,
companies may lease assets over a number of years and avoid the classification of such
leases as finance leases by estimating long useful lives for the underlying assets. For
example, a plane may have an estimated useful life of 25 years and so a lease for 15
years will not fall within the rules requiring that the lease be classified as a finance lease.
This will understate the asset base and overstate the company’s return on assets.
■■ Accounting practices that are at variance with the norm for the industry sector. If a company
adopts accounting policies that are at variance with other companies in the sector, then
this may reflect problems with the quality of the accounting data. Evaluate the reasons
why the company has adopted different policies.
■■ Lack of corporate governance. A lack of good corporate governance policies may
mean that the CEO may exercise too much power and the accounting practices
may be overly influenced by the CEO’s view. Independent directors and audit
committees act as a counter-balance and ensure a greater credibility in relation to
the accounting numbers.
■■ Changes in auditors, qualified opinions or published disagreements with the auditor. A
published disagreement with the auditor over the choice of an accounting policy
or a change in auditors for no apparent reason may indicate future problems. A
qualified audit report is certainly a problem. Auditors are increasingly subject to
litigation risk and will be likely to disagree with company policies which do not fall
within the ambit of generally accepted accounting practice. Also, we need to be
careful when a large company appoints a small auditing firm whereby fees from the
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company becomes a dominant source of income for the auditing firm. Research
indicates that large companies audited by small firms are less likely to receive
qualified audit reports.
■■ Changes in revenue recognition policies. It is important to evaluate any change in the
company’s revenue recognition policies. This is a difficult area as it is subject to
interpretation. If a company’s revenue consists of the provision of goods and services
over a number of years, then the difficulties of revenue recognition is compounded.
What revenue should be recognised this year as compared to the next few years?
How does the company attach relative values to the services and the initial product
components?
■■ Vendor financing and financing structures. What if the company making the sale is also
offering finance to the customer. Is this really a sale or more like a loan? Vendor
financing provided impetus to the growth of such companies such as Cisco, but if
economic circumstances change, then the company will not be able to collect its debts
and its products will have little value.
■■ Changes to provisions and reserves. Evaluate any transfers to or from reserves. For
example, banks maintain provisions for bad loans whereby the bank will estimate the
proportion of bad loans it will incur. Yet in a particular year which just happens to be
a year of poor operating results, the bank may reduce the provision for ‘good’ reasons,
but which also happen to save the day in terms of the bank’s level of profitability.
Understand the business and financial risks facing the company
We have identified a number of business risks that companies face in Chapter 10 which are
relevant here. How much is the company dependent on one product, one customer, one
supplier and one geographic market? What is the risk of technological obsolescence? What
is the risk of litigation? Is the company subject to high debt levels? Is the company subject
to substantial competition and what is the growth rate of the industry sector?
Although ratio analysis is important, it is critical to go behind the numbers to evaluate
the quality of the accounting data, the quality of disclosure and to analyse management’s
incentives to use spotlights rather than floodlights on the numbers reported in the company’s
financial statements.
Sensitivity analysis
In Chapter 10 we will explain the use of sensitivity analysis in project evaluation. In financial
analysis, we may also wish to understand how sensitive a company’s operating returns and
ratios are to changes to the key business drivers, such as the selling price, costs and volumes.
For example, Rainbow reported a possible significant decline in its return on assets due to
an increase in the cost of inputs such as feedstock. In explaining its sensitivity to commodity
prices in 2013, Tiger Brands reported that a 10% increase in the price of wheat, maize, rice
and sorghum would reduce profit after tax by R327m. This information is useful to analyse
a company as we understand how sensitive operating income and returns will be to changes
in the key business drivers.
Further factors to consider when analysing a company
Other factors may be as important as financial analysis and financial ratios. We have set out
some other factors that may be important in analysing a company. This is not exhaustive but
provides a few indicators of what we should look out for when analysing a company.
Are the directors selling shares in the company?
Whilst we can understand that directors may sell shares for personal reasons to buy a home
or settle family obligations, major sales of shares by directors should be a warning sign.
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Alternatively, the purchase of shares indicates that the directors consider the value of the
company to be understated by the market.
Is the company aggressive in recognising revenue in relation to long-term contracts?
It may be prudent to carefully analyse companies that recognise revenue from the entering
into long-term service contracts in the first year, rather than spreading out the revenue over
the term of the contract. It is often difficult to maintain such growth and this often creates
the temptation for the executives to manage earnings to create the impression that growth
is sustainable.
Is the company aggressive about acquisitions?
Companies that engage in acquiring other companies at a frenetic pace often will make one
acquisition too many that will often lead the company into financial trouble. It is difficult to
integrate and consolidate businesses if the company makes too many acquisitions. This is
made worse if the acquisitions are financed with debt financing.
Are the company’s customers performing well?
If the company’s customers are in financial trouble, then it is only a matter of time before
the customers reduce purchases or place pressure on pricing thereby impacting on the
company’s margins.
Is the company subject to litigation?
Whilst in the USA, litigation may often be spurious and may in fact indicate that the
company is doing well; we need to monitor major litigation cases in process against the
company. Litigation may have significant economic impacts on the company. For example,
miners in South Africa are instituting class action lawsuits against mining companies as a
result of suffering from silicosis and lung disease arising from gold mining operations. On
the basis of the numbers of miners subjected to lung disease over time (20−30% of miners
contracted silicosis), this could prove significant to the market capitalisation of a company
such as AngloGold Ashanti, although it pales in comparison to the human cost of this tragic
legacy on miners and their families.
Is the company subject to significant operational risks?
Gold mining in South Africa is subject to significant operational risks due to unstable ore
strata and the tremendous depths at which companies are required to mine. In sectors
that companies will experience significant operating risks, we need to carefully monitor
company performance and their approach to risk management. There is no point in actions
that result in cost savings but also result in dramatic increases in operating risks. The case
of Toyota installing faulty accelerator pedals which put buyers at risk and BP’s actions in
the Gulf, reflects break-downs in risk management. BP was responsible for lapses in safety
standards that placed employees, facilities and the environment at risk prior to the major
spill in the Gulf. Drilling at tremendous depths raised the operational risk of BP and it
was alleged that this was compounded by a focus on costs rather than on safety. Further,
trust was destroyed resulting in customer boycotts and significant liabilities for BP and
Toyota. As a financial analyst, if you had focused on the extensive number of violations of
regulations by BP, you would have avoided investing in BP thereby saving money even if
the financial results and ratios were indicating an excellent performance. This was because
the risk had risen.
All companies will have operational risks but it is important to analyse how a company
is managing these risks. Do not just believe what the company says – look at the way the
company acts. You have to often expand beyond the financial statements by analysing
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regulatory information and you often need to read between the lines. For example, Rainbow
has set out the major operational risks it faces; being, disease outbreaks at farms, a significant
increase in feed raw material costs, dust explosions and fire. Rainbow has taken measures
to mitigate these risks.
Does the company have insurance to cover major operating risks?
It is important that companies are adequately covered for major risks such as fire, flooding,
accidents and other disasters. Check on the company’s information on insurance.
Does the company have actual or potential environmental liabilities?
Companies may have extensive environmental liabilities. The South African mining sector
has legacy challenges in relation to mining practices in the past which have resulted in
pollution, toxic underground water and safety hazards due to radioactive sites from uranium
contamination. In some lakes adjacent to mines the water is at the same acidity level as
battery acid. Environmental restoration and rehabilitation is costly and provision needs
to be made for these costs. For example, Harmony, which is one of South Africa’s major
gold producers, is facing significant environmental challenges. Government now requires
companies to make provisions for environmental rehabilitation. Once mining activity
has ceased, the environmental degradation continues. This is particularly relevant in the
Witwatersrand Basin. Environmental liabilities will eventually become a major issue in the
mining sector.
Are there reports of problems with product quality?
As companies engage increasingly in the outsourcing of production and focus more
on cost reduction, there may be impacts on product quality. This has happened to Dell,
Sony (exploding batteries), Toyota (faulty accelerators), food colouring (Sudan I), CadburySchweppes (salmonella), Ford, Firestone, Mittal Toys, and companies in the pharmaceutical
industry. Product recalls are expensive; not only in terms of cost but also in terms of
damaging a company’s brand name. They can have a significant impact on a company’s
future profitability and sales.
Are there reports of any serious issues with its stakeholders such as its customers, suppliers and
employees?
The lack of proper management of labour issues in South Africa’s mining industry has
placed the platinum mining sector at risk and management need to be more proactive
about managing labour relations. Furthermore, safety concerns and fatalities have led
to the closure of mines for periods of time. Companies need to monitor the financial
condition of suppliers as financial distress may impact on the ability of suppliers to
deliver to the company on time without compromising on quality. If its customers are
growing in number, then it is important for the company to increase its capacity in order
to meet the increased demand for its products. If there are reports of product returns from
customers, then this may imply falling standards in product quality that will have financial
consequences.
Does the company have strong brands?
Strong brands create loyal customers and provide a company with protection against
competitors. Yet companies can easily destroy brand loyalty by compromising on product
quality to save costs.
Furthermore, the move by Shoprite, Clicks, Woolworths and Pick n Pay to promote
private labels (house brands) will put pressure on the pricing of branded products.
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Does the company communicate well with its shareholders and analysts?
The company should be open in terms of providing information to its shareholders
and analysts. You should look for evidence of how a company communicates with its
shareholders. For example, the CEO of Enron swore at an analyst for asking a valid and
relevant question. This indicates that the CEO may have had something to hide. Enron
failed soon thereafter.
Is management incentivised to focus on shareholder interests?
Executive managers that are paid with performance bonuses, shares and share options will
be incentivised to act in the interests of shareholders. We need to qualify this however, by
stating that share options may lead management to take on additional risks that may not
be in line with shareholders’ interests. This is because option holders have only the upside.
Therefore, it may pay management to take on more risky projects as they will not share in
any losses. However, there could be reputation risk from incurring losses. We will cover
options in Chapter 18.
Is the quality of management superior to other companies in the sector?
Quality of management is an important criterion for investing in a company, although this is
often reflected finally in the financial ratios. Management quality is indicated by the quality
of strategic, operating and financial decisions taken by management.
Does the company make optimal use of Information Technology?
Successful companies make optimal use of IT to manage sales, inventory and operations.
Companies such as Shoprite and Edgars use IT extensively to manage inventory not only
from a control perspective, but to determine sales patterns and link this back to production
and procurement and to efficiently manage millions of transactions and accounts. Edgars
uses IT to manage over 4 million customer accounts. We should evaluate a company’s
investment in IT and the performance of the IT function. Have there been any reports of
system break downs?
Does the company have valuable intangible assets?
Intangible assets include the quality of management, the quality of the people, the
training of personnel, advertising, research and development capabilities, innovation,
management of the supply chain, inventory management practices, IT capabilities and
customer service. Companies will often expense costs relating to these items and yet they
are hidden assets.
There are other factors to consider in specific situations. When companies undertake
mergers then it is important to undertake due diligence procedures. We expand on this
in Chapter 17.
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FROM THE REAL WORLD . . .
Companies, analysts and credit rating agencies such as Standard & Poor’s use ratios
extensively to analyse the credit quality of companies. It is interesting to note which
ratios are relevant in each industry sector. For example, the gross profit and net profit
margins, as well as inventory turnover ratios are critical in the retail sector.
Standard & Poor’s
Standard & Poor’s is a leading credit rating organisation which provides information on
the creditworthiness of companies. Standard & Poor’s rates over US$11 trillion in bonds
and other financial obligations of companies operating in over 50 countries. The following
are some of the more relevant ratios that Standard & Poor’s uses to determine a company’s
rating and which has a major impact on the cost of debt financing for firms:
EBIT interest coverage
Long-term debt/capital
EBITDA interest coverage
Total debt/capital
Funds from operations/total debt
Return on capital
Free operating cash flow/total debt
Operating income/sales
Dun & Bradstreet
Dun & Bradstreet is a major credit rating agency and the company focuses on the
following solvency, efficiency and profitability ratios when analysing companies:
Solvency
Efficiency
Profitability
Quick ratio (acid test or liquidity)
Current ratio
Current liabilities to Net Worth1
Total liabilities to Net Worth
Fixed assets to Net Worth
Collection Period Ratio (days)
Sales to Inventory
Assets to Sales
Sales to Net Working Capital
Accounts Payable to Sales
Return on Sales (%)
Profit Margin
Return on Asets
Return on Net Worth (ROE)
1
Net worth is equivalent to shareholders equity
ABSA sectoral ratios for South Africa
ABSA used to compile ratios for industry sectors in South Africa. A summary of some
of the ratios for selected sectors in 2007 is set out in Table 5.9.
Table 5.9 Sectoral ratios in South Africa
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The banking sector is not included in Table 5.9 owing to the nature of the sector.
Important ratios in the banking sector in 2007 are the percentage of non-performing
loans (2.43%), the return on assets (1.55%), and the return on equity (16.02%), the
interest margin (4.07%) and the cost to income ratio (60.11%).
Summary
In this chapter we have discussed the main methods used to analyse the financial statements of
a business. Financial analysis is designed to determine the relative strengths and weaknesses
of a firm. To do this it is necessary to get some benchmark which is normally based on either
historic performance or on how other firms within the same industry perform.
Investors need financial information in order to estimate both future cash flows from the
firm and the riskiness of these cash flows. Managers need to be aware of their firm’s financial
position in order to detect its strengths and weaknesses so as to enable decisions that will
maximise shareholders’ wealth.
The most popular approach to financial analysis is through the use of ratios. These ratios
fall conveniently into six broad categories:
■■ liquidity ratios;
■■ asset management ratios;
■■ debt management ratios;
■■ profitability ratios;
■■ cash flow ratios; and
■■ market value ratios.
The ratio analysis procedure is as follows: calculate a ratio, compare it with the previous
ratios to establish if there is any trend, and/or to compare it with those of other firms in the
same industry to judge the relative strength of the firm in question. If a structured system of
analysis is used, such as the Du Pont system, the interrelationship of ratios will help identify
the cause of a weakness that is discovered. While ratio analysis does have some limitations,
if it is used perceptively these limitations will not negate the effectiveness of the analysis.
EVA is a measure of performance that deducts an appropriate charge for the opportunity
cost of all capital invested in an enterprise from net operating profit. As such, EVA is an
estimate of true ‘economic’ profit, or the amount by which earnings exceed or fall short of
the required minimum rate of return that shareholders and lenders could earn by investing
in other securities of comparable risk.
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Guidance on Financial Analysis
by
Johnathan Dillon M.Com CA (SA)
Evaluating the performance of a firm is far broader than merely calculating financial
statement ratios and commenting thereon. There are many other important considerations,
some of which are covered in this section. Nonetheless, ratio analysis remains an important
element of broader performance evaluation and some useful pointers are provided below:
Pointers on ratio analysis
It is crucial to note the following in relation to the calculation and interpretation of financial
statement ratios covered in this chapter:
■■ Du Pont analysis: Prior to performing all possible ratio calculations for the various
categories of ratios, it is very useful to utilise the Du Pont model and calculate a few
key ratios. This provides a high-level overview of performance and insight into where
further investigation and ratio calculations are necessary.
■■ Consistency: When comparing and interpreting ratios, it is essential that the ratios be
calculated consistently between firms or across financial years.
■■ Context: Calculating ratios in isolation is largely meaningless – ratios are better
understood within the context of information relating to the firm and its industry.
Besides news sources, context is often obtained by reading the firm’s integrated report,
sustainability report or notes to the financial statements.
■■ Comparison: The analysis of ratios and performance is improved when compared to
targets/budget, prior years, benchmarks or another firm, whether in the same or similar
industry. Comparing the various ratios calculated is also important to identify possible
links, causes and consequences.
■■ Average balances: If relevant information is available then, depending on the ratio, it is
generally more correct to calculate ratios using average balances relating to amounts
disclosed in the firm’s statement of financial position. Examples include return on
equity (net profit after tax divided by average equity), average collection period
(average accounts receivable divided by credit sales per day) and asset turnover (sales
divided by average operating assets). Instances in which this would not be appropriate
include liquidity ratios and debt management ratios where the analysis is at a specific
point in time, namely, the end of the financial year.
■■ Movements and other percentage calculations: As noted in this chapter, ratio analysis is
not the only tool that can be used to analyse financial statements. It is often very useful
to calculate the percentage changes (movements) in amounts from one year to another.
In addition, calculating significant costs as a percentage of sales or total costs is also
useful. These percentages aid in identifying trends and potential problems (for example,
accounts receivable increasing at a greater rate than sales). They are also useful as they
provide greater context within which calculated ratios can be interpreted.
Further insights into broader performance evaluation
Over and above the financial statement analysis techniques discussed in this chapter, broader
performance evaluation of a firm encompasses many facets. A number of key concepts
related to broader performance evaluation are briefly covered below:
■■ Strategy: Performance should be compared to the firm’s long-term strategic plan, that
is, is the firm on track to achieve its long-term goals (mission and vision)? Performing
a SWOT analysis (an analysis of its strengths, weaknesses, opportunities and threats)
and analysing the industry’s profitability (using Porter’s five forces) will also aid in
determining whether the firm is performing well considering its circumstances.
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■■ Growth: Growth is an important concept in relation to performance evaluation and is
often a sign of success. There are numerous ways of measuring growth, such as growth
in revenue, profitability, ROCE, market share, number of products and cash flow from
operations. When focusing on conventional ratio analysis calculations, these pertinent
growth calculations are easily omitted. Growth is not always a positive sign, especially
excessive growth, which could be an indication of overtrading and looming bankruptcy
or takeover.
■■ Cost management: Analysing costs is also a vital consideration when evaluating
performance, most notably containing or reducing operating costs. However, it is
often necessary for a firm to increase expenditure (such as marketing costs or research
expenditure) in order to increase sales volumes or innovate. Therefore, cost cutting is
not always a good sign.
■■ Break-even analysis and capacity: Besides being an indicator of business risk, calculating
a firm’s break-even level of sales (and margin of safety) is invaluable as it provides an
indication of whether the actual level of sales is satisfactory. Furthermore, knowing
a firm’s practical capacity level is helpful when analysing performance as it indicates
whether a firm can in fact break even (if not yet at that point). It also indicates the
potential upside if demand increases or the need to increase capacity in the near future
which may require a substantial capital outlay.
■■ Non-financial factors: Performance evaluation must not focus solely on “the numbers”
(financial performance) but should also analyse how the firm is performing in relation
to its customers, operations, employees, infrastructure development (non-financial
performance), and so on. Performance can therefore also be measured in relation to the
expectation of various stakeholders. However, shareholders remain the most important
stakeholders that the management of a profit-orientated firm should predominantly
focus on.
■■ Long-term focus: It is important to not only have a short-term focus when evaluating
the performance of employees, as this could impact negatively on their behaviour and
the long-run performance of a firm. Performance measures that result in a short-term
focus include ROCE and other profitability ratios. For example, management may delay
necessary capital investment in order to keep the ROCE ratio high in the short run. In
such instances, it is recommended that the period over which performance is measured
be lengthened beyond one year in order to avoid a short-term focus.
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S
SELF-STUDY PROBLEMS
S5.1
Barrax Limited has the following Statement of Financial Position (balance sheet) at the end
of 20x5. The current liabilities include short-term interest bearing debt of R10 million. The
company has 10 million ordinary shares in issue and the current share price is R8.20.
What is the company’s debt to equity ratio? What is the company’s market capitalisation?
What is the company’s debt to market capitalisation ratio? What is the company’s current
ratio?
S5.2
A company has R18 million in inventories and this represents 2 months sales. What is the
company’s inventory turnover ratio (sales/inventory)?
S5.3
Dome Limited is an industrial holding company. Extracts from the company’s latest annual
Financial Statements are as follows:
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Required:
Calculate all the relevant ratios for Dome Limited as at 30 June 20.2 and 20.1.
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Solutions to Self-study problems
S5.1 Solution
1. Total debt = Long term debt + short-term debt = R50m + R10m = R60m
Debt to Equity = 60/60 = 100%
2. Market capitalisation = share price × number of shares in issue = R8.20 × 10m
= R82m
3. Debt to market capitalisation = 60/82 = 73%
4. Current ratio = current assets/current liabilities = 40/30 = 1.33
S5.2 Solution
Sales = [inventory/no. of months sales] × 12
Sales = (18/2) × 12 = R108m
Inventory turnover (sales/inventory) = 108/18 = 6
S5.3 Solution
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APPENDIX 5.1 SUSTAINABLE GROWTH
Introduction
The rationale for growth requires that companies achieve a superior return on assets.
However, the return on the assets is only one of the factors affecting growth. The company’s
financial policies must be of a nature that permits the company to take advantage of
growth opportunities. These financial policies dictate the level of sustainable growth.
The determinants of growth
Growth is possible, firstly, if there are growth opportunities and, secondly, if the company’s
financial strategies are structured to allow the company to grow.
Return on assets
A company can grow at the rate of return on its assets if it does not pay any dividends and
is not financed from outside sources – i.e. if it is entirely financed by shareholders’ funds.
Let us examine this.
Example 5.1: Return on assets
Company A has assets of R1 000m and earns 20% on those assets. It can therefore grow
at 20%. Assume it has 100m shares of R10 each. Assume also that assets are reflected at
market values.
Assets
Shareholders’ equity
Value per share R
Beginning of year
End of the year
Rm
Rm
1,000
1,000
R10.00
1,200
1,200
R12.00
The growth rate has been the return on assets, which is based on EBIAT.
Dividend policy
Note that we imposed certain limiting assumptions on our company, namely there was
no outside finance nor was there any dividend. Let us now introduce the payment of a
dividend.
Example 5.2: Dividend policy
Assume company A pays a dividend of 25% of its earnings.
Return on assets after tax
R200m
Dividend
R50m
Assets at end of year
R1,150m
Shareholders’ equity at end of year
R1,150m
The growth has been the return on assets that have been retained in the company. As there
is no financial leverage, the ROA is equal to the firm’s ROE. This may be expressed as:
Sustainable growth rate = Rp
where: R = percentage return on assets after tax
p = proportion of earnings retained
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Applying this to company A:
SGR = 20 × 0.75
= 15%
Company A can grow earnings at a rate of 15%.
Capital structure
Let us now introduce some external financing.
Example 5.3: Capital structure
Assume that company A is financed 60% by equity and 40% by debt bearing interest at
10% per year. The company’s Statement of Financial Position at the beginning of the year
will therefore appear as follows:
Statement of Financial Position
Rm
Equity600
Debt400
1,000
Assets1,000
Net income after tax (20% of assets)
Interest on debt: 10%
40
Tax shield on interest (t = 30%)
-12
Net profit
Dividend
25%
Retained earnings
200
28
172
43
129
The company can grow by its retained earnings of R129m [(which is a growth rate of
12.9% (129/1000)]. In addition it can raise further finance against the R129m in the target
debt-equity ratio which, in this case, is 4:6. Therefore it can raise debt of R86m. Assets
will grow to R1 215m (by 21.5%) financed by R729m (600 + 129) in equity and R486m
(400 + 86) in debt.
This may be expressed as follows:
SGR = __
​ D ​(R – i)p + Rp(Formula 5.4)
E
where: R = percentage return on assets after tax
p = proportion of earnings retained
D = debt
E = equity
i = percentage interest rate on debt after tax
Applying this to the above case:
SGR = ____
​ 400 ​(13%) × 75% + 20% × 75%
600
= 21.5%
Note that the growth determined logically above amounted to R215m which is 21.5% of
R1 000m. This formula is often referred to as Zakon’s formula.
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With this formula, as with any other ratio, care must be taken to ensure that the terms
used are internally consistent. In this case, if the return on assets is regarded as return
on net assets, the debt should be long-term debt and the interest rate the average rate on
that debt, whereas if the return on assets is the return on total assets, total debt and the
average rate of interest thereon should be used.
Summary
The determinants of growth are:
■■ the return on assets;
■■ the interest rate on debt;
■■ the debt-equity ratio; and
■■ the retained earnings ratio.
If a company wants to grow it needs to consider these parameters.
Given that its investment opportunities (R in the formula) permit the growth, the
company then has to arrange its financial policies in such a way as to make the growth
possible. This can be done either by increasing the debt ratio or by reducing the dividend
payout. The company does not usually have much influence over the interest rate.
Example 5.4
Zak is in an industry in which the typical growth rate is in the region of 12% per year. The
following details apply to Zak:
■■ Return on assets
15% (after tax)
■■ Debt-equity ratio
4:6
■■ Interest on debt
10%
■■ Dividend policy
70% payout
■■ Tax rate
30%
Suggested solution
4 ​ (8%) × 30% + 15% × 30%
SGR = ​ __
6
= 6.1%
Note: 8% = 15% – (10% × 0,70)
Given the financial policies adopted by Zak, it cannot match the growth in the industry.
The primary cause of the low growth in this case is the abnormally high dividend payout.
A 12% growth could be achieved if the dividend were to be reduced.
4 ​(8%) × p + 15% × p
12% = ​ __
6
p = 59%
Thus a growth rate of 12% could be sustained if the earnings retained were 59% or, in
other words, if the company changed its dividend policy to paying out only 41% of its
earnings.
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Q
QUESTIONS
Question 5.1
ABC Limited is listed on the JSE. There are various stake-holders.
(a) As an existing shareholder, which ratios would you choose so as to monitor your investment?
(b) As a creditor providing goods to the company on credit which ratios would you analyse?
(c) As a lender of long-term loans to the company, which ratios would you use so as to safeguard
your money?
Question 5.2
Your company wishes to borrow money but does not want to over extend itself and become
vulnerable to changes in market conditions. Which ratios would be useful in analysing the extent
to which they can borrow? Would the industry averages be of any use and if so why?
Question 5.3
How does the Du Pont system of analysis identify the components of the return on investment?
How does this relate to the return on equity?
Question 5.4
What are the implications of using income before tax for the analysis of profitability? What are
the implications of using income before interest and taxes for this purpose?
Question 5.5
Certain rule-of-thumb ratios exist – for example, a current ratio of 2:1 or quick ratio of 1:1. What
purpose do these rule-of-thumb ratios serve?
Question 5.6
What are the most serious limitations of the use of industry averages in ratio analysis?
Question 5.7
Redrack Ltd operates in the retail sector. The company has experienced tough trading conditions
in the last year. The company’s net profit margin was 3% and the company achieved an asset
turnover of 1.7. The company’s debt-equity ratio is 40%.
Required:
(a) What is the company’s Return on Assets (ROA)?
(b) What is the company’s Return on Equity (ROE)?
(c) Assume that the company expects to experience an increase in its net profit margin to 10%
and its asset turnover is expected to be 2.5 in the coming year. The company’s debt-equity
ratio will be 66.67%. What effect will these changes have on the company’s ROE?
Question 5.8
Tryon Ltd is a clothing manufacturer that also operates a chain of clothing stores. The company’s
debt consists of bank loans amounting to R8.5 million and the company’s sales revenue is R32
million per year. The company is currently earning a net profit margin after tax of 8% per year.
The corporate tax rate is 28% and the company is paying an interest rate of 9% per year (before
tax).
Required:
What is the times-interest-earned ratio? How will this change if the company’s net profit margin
falls to 6% and the interest rate rises to 10% per year?
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Question 5.9
Ukuza Ltd has appointed a new CEO due to experiencing lower returns in the past year. Its
ROE had fallen to 8% for the first time in its history. The company expects its operating income
(EBIT) to be R12 million and sales revenue is expected to be R80 million for coming year.
The company’s asset turnover is expected to be 1.6 times and the company is expected to pay
R2 million in interest on a debt level of R25 million. The asset turnover is on the basis of noncurrent assets plus net working capital. The corporate tax rate is 28%.
Required:
(a) What is the company’s expected debt-equity ratio?
(b) What is the company’s expected ROE?
Question 5.10
Stax Ltd is a listed company which has produced the following summarised Statement of
Comprensive Income and Statement of Financial Position for the year ended 30 June 20x5.
Required:
(a) What is the debt-equity ratio?
(b) What is the interest cover (times interest earned)?
(c) What is the total asset cover? What is the fixed asset cover?
(d) What is the company’s net profit margin?
(e) What is the operating return on assets?
(f) What is the return on equity (ROE)?
(g) If the company’s cost of capital is 11%, what is the company’s EVA?
(h) Assume that the company’s market capitalisation is R52.5m and the company has 7 million
shares in issue. Determine the company’s earnings per share (EPS)? What is the company’s
price-earnings (P/E) ratio? How does this compare to the average for the JSE of 16?
Question 5.11
Umklomelo Ltd has the following Statement of Financial Position at the end of 20x5. The current
liabilities include short-term interest bearing debt of R40 million. The company has 100 million
ordinary shares in issue and the current share price is R12.00.
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Required:
(a) What is the company’s current ratio?
(b) What is the company’s debt-equity ratio?
(c) What is the company’s market capitalisation?
(d) What is the company’s debt to market capitalisation ratio?
Question 5.12
Instax Ltd is a company involved in the production of auto components. The following
information is extracted from the company’s financial statements for the years ending
30 June, 20.7 and 30 June, 20.6.
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Required:
Comment on the company’s liquidity position and the company’s management of working capital
in 20.7 as compared to 20.6 based on the relevant ratios.
Question 5.13
The following statistics have been extracted from the five most recent years’ annual financial
statements of Jules Ltd, a manufacturing company engaged in the footwear industry.
Years ended 30 June:
20.2
20.3
20.4
20.5
20.6
Ratios
Profit before tax: to capital employed
12.0%
12.8%
9.6
6.9%
2.5%
Profit before tax: to sales
6.0%
5.8%
5.3%
5.7%
2.8%
Sales: to capital employed (net assets)
2.0×
2.2×
1.8×
1.2×
0.9×
Current ratio
0.9
0.8
0.9
0.7
0.5
Total debt: to shareholders’ funds
7.0×
6.8×
7.6×
9.1×
12.1×
Retained profit: to shareholders’ funds
14.9%
17.9%
18.2%
20.3%
9.5%
Retained profit: to operating profit
20.0%
20.9%
16.7%
17.8%
8.3%
2.3×
2.2×
1.7×
1.7×
1.3×
Interest cover
Index Numbers: Jules Ltd
Sales
100
122
179
215
262
Profit before tax
100
118
159
205
123
Fixed assets
100
125
189
362
590
Total debt
100
116
159
238
348
Long-term debt
100
107
221
431
735
Notes
1. No new issues of shares were made during the period.
2. Dividends remained constant throughout the period.
3. The ratio of long-term debt to shareholders’ funds at 30 June, 20.2, was 2.5:1.
Required:
Comment briefly on the circumstances under which these figures might reflect good or bad
financial management of the company.
(CIMA)
Question 5.14
The following ratios have been extracted from the financial statements of a company listed on
the JSE under the general retailers sector. For comparative purposes the sector ratios are also
shown.
Company
Sector average
20.5
20.4
20.5
20.4
Current ratio
0.81:1
0.86:1
1.68:1
1.58:1
Quick (acid-test) ratio
0.30:1
0.17:1
0.60:1
0.55:1
Debt ratio
0.668
0.640
0.510
0.517
Interest cover
33.32×
31.10×
6.87×
7.83×
Fixed charge cover
11.01×
10.23×
4.93×
5.51×
Fixed assets to owners’ equity
1.49:1
1.38:1
1.11:1
1.17:1
Sales to owners’ equity
15.11:1
14.49:1
9.01:1
9.71:1
Net income after tax
Up 6.5%
Up 14.2%
Down 3.1%
Up 3.2%
171.2c
160.8c
–
–
Up 16.6%
Up 30.1%
Earnings per ordinary share
Book value per ordinary share
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Required:
(a) Prepare a list of comments stating how each of the above items indicates how profitable the
company is and how each of the above items indicates what the future prospects are likely
to be. The implications of each ratio should be given separately and then the collective
inference that may be drawn should be given.
(b) What warnings should you offer about the limitations of ratio analysis for the purpose stated
here?
Question 5.15
At the end of 20.3, the assets and profit of Division S (part of a group) were as follows:
Rm
Fixed assets (book value)
300
Net current assets
40
Assets (capital employed)
340
EBIT
64
The fixed assets of Division S consist of land (R120m) and five separate items of plant and
equipment each costing R60m which are depreciated to zero over five years on a straight-line
basis. For each of the past years, on 31 December, it has bought a replacement for the asset
that has just been withdrawn and it proposes to continue this policy. Because of technological
advances the asset manufacturer has been able to keep his prices constant over time. The group’s
cost of capital is 15%.
Required:
Assuming that, except where otherwise stated, there are no changes in the above data, you are
required to deal with the following separate situations:
(a) Division S has the opportunity of an investment costing R60m and yielding an annual profit
of R10m.
(i) Calculate its new Return on Assets (ROA) if the investment were undertaken.
(ii) State, with brief reasons, whether you would recommend that the investment be
undertaken.
(b) Division S has the opportunity of selling, at a price equal to its written-down book value of
R24m, an asset that currently earns R3.9m p.a.
(i) Calculate its new ROA if the asset were sold.
(ii) State, with brief reasons, whether you would recommend the sale of the asset.
(c) Assuming that over the past four years the cost of Division S’s total fixed assets has increased
by 10% p.a. but that its EBIT has only increased by 6% p.a., calculate its ROA for next year
if inflation now ceases.
(d) Assuming that Division S decides to spend R6m p.a. on special promotional campaigns each
of which will yield an EBIT of R2m p.a. for five years, calculate its ROA at the end of the
fourth year (20.7) on the basis of the campaign expenditure being:
(i) charged as a cost of the period;
(ii) capitalised and amortised over five years.
(CIMA)
Question 5.16
As the management accountant for a group of four similar companies, you have recently
introduced an interim comparison scheme. A summary of basic information received from each
company for the period under review is given below and you are required to:
(a) present the information to management in such a way as to compare clearly the results
achieved by each company with those of the rest of the group; and
(b) write a short constructive report to the directors of company A, setting out the possible
reasons for the differences in their results as compared with the rest of the group.
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CompaniesABCD
RmRmRmRm
Operating profit
221
209
315
162
Current assets
520
385
525
315
930
715
975
585
Sales
Fixed assets
2,470
1,980
2,925
1,665
Production cost
1,605
1,228
1,784
1,016
Selling cost
370
317
497
300
Administration cost
274
226
329
187
(CIMA)
Question 5.17
The comments below were by different people looking at the same set of published accounts.
You are required to give your opinion on the statements made.
(a) The quick ratio is below the norm of 1:1 so the business:
(i) is technically insolvent;
(ii) is suffering a liquidity crisis; and
(iii) probably need not take any corrective action.
(b) Each R100 of total assets is financed by R37.50 debt and R62.50 equity. The business:
(i) should borrow more money, because the ratio of debt to total assets is too low; and
(ii) must not increase its borrowing because the debt-equity ratio is above 50%.
(CIMA)
Question 5.18
Three companies in the same business risk category produced the following abbreviated results
for the financial year ended 31 March, 20.1:
PropcorTecfinSadev
RmRmRm
Ordinary shareholders’ equity
640
230
390
16% Mortgage bond
120
–
–
18% Long-term loans
102
55
318
862
285
708
PropcorTecfinSadev
RmRmRm
Fixed assets
684
Net working capital
Inventory
Debtors
Cash resources
Overdraft and creditors
260
494
178
25
214
319
263
612
204
28
154
51
109
(396)
(375)
(552)
862
285
708
Net operating income
353
185
250
Interest
90
10
58
Net income before tax
263
175
192
Taxation
126
84
92
Net income
137
91
100
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Required:
(a) For each company, calculate three different measures (expressed as a percentage) for return
on assets. Please define each measure clearly.
(b) Comment briefly on the comparative performance of the companies in achieving return on
assets.
Question 5.19
The consolidated Statement of Comprehensive Income and Statement of Financial Position of
the Ikhwezi group for the year ending 30 September, 20.8 are given below:
The Ikhwezi group is involved in the manufacturing and marketing of packaging products and
printing paper and related products.
The price of each ordinary share at year end was R25.50 and there were 46 759 000 ordinary
shares in issue. The total market value of the preference shares (included in share capital)
amounted to R1m.
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Required:
(a) Using ratio analysis, comment on the group’s liquidity position, its debt and asset management
and profitability performance in 20.8 as compared to 20.7.
(b) Apply the Altman failure prediction model to Ikhwezi’s data in 20.8 to assess the likelihood
of corporate failure.
Question 5.20
Shadeports Limited operates in the home and office improvements industry. The company
constructs carports and protective structures for motor vehicles in homes, large office blocks,
and factories. The company was launched 15 years ago by an entrepreneur, Robbie Phelps. It
developed through aggressive marketing and has branches throughout South Africa. It obtained
a listing on the main board of the JSE in 20.8. The summarised Statement of Financial Position
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and Statement of Comprehensive Income for the financial year ended 31 December, 20.11, have
been obtained for analysis.
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Industry ratios for 20.11:
■■ Current ratio2:1
■■ Acid test (quick ratio)1:1
■■ Inventory turnover (sales/inventory)
6×
■■ Accounts receivable collection period
40 days
■■ Debt ratio50%
■■ Times interest earned6×
■■ Net income before interest and tax/total assets
17%
■■ Return on ordinary shareholders equity
21%
Required:
(a) Compute the relevant ratios for 20.11 and 20.10 required for an analysis of the company’s
liquidity position and management of current assets. Comment on your findings.
(b) Compute the relevant ratios for 20.11 and 20.10 required for an analysis of the company’s
use of debt to finance its operations. Comment on your findings.
(c) Compute four profitability ratios, two of which will provide information regarding the
operating effectiveness, and two of which will assist in establishing the effectiveness of the
use of assets. Comment on the selection of the ratios which you consider appropriate and the
information which they provide.
(d) Compute the return on shareholders’ equity based on book values and compare this with
market indicators of return. Comment on the differences and explain the relevance of each
figure calculated.
(e) Identify the additional information which may be available if a Statement of Cash Flows is
prepared and explain how this may assist in your analysis.
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Question 5.21
XYZ Brewing Company (Pty) Ltd is in the business of manufacturing and selling beer. Its two
major brands are Don and Skok. The company is very old and established and for many years has
operated from the original main plant. At the beginning of its 20.6 financial year, the company
purchased a second plant which was owned by a family business. This plant consisted of a brewery
and a can-manufacturing operation, together with extensive inventory and other assets. Certain
of the major assets were revalued in determining the purchase price. XYZ Brewing Company
(Pty) Ltd paid cash in settlement of the price agreed upon for the purchase of all the assets.
The company has grown satisfactorily during the last few years. One of the reasons for the
growth in sales is the policy of granting more favourable credit terms to distributors than its three
main competitors.
You have been approached by a client who is considering investing in XYZ Brewing Company
(Pty) Ltd. She has provided you with Statements of Financial Position (balance sheets) and
Statements of Comprehensive Income (income statements) for the last five years. Prior to your
assessment, one of your employees has prepared financial statements expressed in percentage
terms, calculated certain ratios and obtained industry statistics.
Required:
(a) Evaluate the financial statements of XYZ Brewing Company (Pty) Ltd with particular
attention to liquidity, capital structure, profitability and turnover.
(b) State the advice you would give your client and list any additional information you would
require before making a firm recommendation.
The information is set out on the next two pages:
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Question 5.22
In an article entitled ‘Causes and Prediction of Corporate Failure’, Dr G. Andrews writes:
Altman recognised the shortcomings to which a univariate approach is subject. For example, a food chain
may have poor liquidity ratios but due to the nature of the industry, may actually be in a healthy position,
despite these ratios which indicate difficulty. Altman thus adopted a multivariate approach which combines
and analyses ratios … This method allows an entire profile of ratios to be considered and also assesses the
interaction between ratios.
Despite the successful predictive ability of this type of failure prediction model, which is based
on a sophisticated type of ratio analysis, the model is nevertheless subject to the same limitations
as conventional ratio analysis.
Required:
Explain the limitations underlying ratio analysis, and indicate how Altman’s failure prediction
model overcomes any of these limitations.
Question 5.23
Pipa Stores Limited, a public company listed on the JSE, has been engaged in the mass retailing
of food and other consumer goods for twenty years. During this period the company has displayed
consistent growth as evidenced by the increase in its total assets and earnings.
Since opening, the number of outlets increased from three to the current 94, employing
nearly 19 000 people. In the last 10 years the five-yearly compounded earnings growth has only
once been below 25% with the average being in the region of 34%. However, growth is expected
to decline and further estimates suggest that an expected compounded growth of 20% is feasible
and realistic due to international expansion. The shares trade at a PE of 15x.
The abridged financial statements are as follows:
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Required:
Compute and comment on what you consider to be the most relevant ratios. Use the Altman
failure prediction model to assess the likelihood of corporate financial distress.
Question 5.24
Supremo Tankers (Pty) Ltd (‘Supremo’) operates a fleet of trucks and trailers to provide
logistical services to brick manufacturers in Gauteng and Mpumalanga. These services
mainly entail the transport of bricks on behalf of brick manufacturers to their customers.
Supremo owns 100 trucks together with ‘flat-bed’ trailers. These transport vehicles have
loading equipment specially designed to load and unload bricks. The logistical services are
offered to customers on one of the following bases:
■■ An annual contractual basis to transport bricks from the brick manufacturer’s premises
to specified locations, based on a minimum number of loads per week. These contracts
provide for a fixed monthly charge subject to changes in diesel fuel prices. Contracts
specify that diesel fuel represents 20% of the total charge to customers and Supremo
adjusts monthly charges to customers with immediate effect in the event of a change in
the retail price of diesel fuel; or
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■■ A per load basis in terms of which Supremo charges an agreed transport fee per
kilometer travelled from the brick manufacturer’s premises to the delivery destination.
These charges also fluctuate depending on diesel fuel prices, based on the principle that
diesel fuel costs represent 20% of the total per kilometre charge to customers.
The shareholders in Supremo are Sergio Parisse (70%) and BWI Holdings (Pty) Ltd (‘BWI’)
(30%), which is a black economic empowerment investment company owned by
three prominent black businesswomen. Mr Parisse started Supremo in 1985 and
has been instrumental in developing the business into the leading logistics provider
to brick manufacturers in the provinces in which it operates. Supremo focuses
exclusively on services to brick manufacturers.
Supremo’s profitability has declined significantly in the 2009 and 2010 financial years,
mainly because of lower activity levels in the brick manufacturing industry. Research by an
industry association revealed that sales volumes of brick manufacturers were 25% lower in
2009 than in the previous year, and that sales volumes declined by a further 5% in 2010. The
decline in demand for its services that Supremo has experienced has also had an effect on its
capacity utilisation. Prior to 2009 Supremo was able to optimise load volumes and to ensure
that it carried full loads on most occasions. This changed in 2009 and now many of the
trailers are empty on one or more legs of a journey. For example, bricks may be delivered
to a destination, but the trailer remains empty until the truck reaches the next customer.
DAB Bank is the commercial banker to Supremo. DAB Bank has exclusively financed
the acquisition of trucks and trailers by Supremo over the past five years on an installment
sale basis. DAB Bank requires a deposit of 20% of the purchase price of new vehicles when
financing Supremo’s acquisition of trucks and trailers. The installment sale is repayable in
equal monthly installments over six years and the capital outstanding bears interest at the
prevailing prime overdraft rate (currently 10%). The bank overdraft balance with DAB
Bank at 31 December 2010 was R28 405 000. As a result of the ongoing operating losses,
DAB Bank has informed Supremo that they are required to reduce their bank overdraft
balance to R5 million by 28 February 2011. If this overdraft balance is not reduced, then
DAB Bank will withdraw the overdraft facilities.
Supremo has historically adopted a policy of trading in or disposing of trucks after five
years.
Supremo has found that after this period, trucks become very expensive to maintain and
repair costs increase exponentially. This does not apply to trailers as Supremo has workshop
facilities where it overhauls and cost-effectively maintains trailers to extend its useful life
to more than ten years. The demand for used trucks has declined dramatically over the
past two years, which has had an adverse impact on disposal prices. The strength of the
rand has also impacted on used truck prices. The trucks that Supremo uses are imported
and a strengthening rand has resulted in minimal price increases of new trucks, which in
turn affects the resale values of used trucks. Prior to 2009 Supremo generally disposed of
trucks at prices that were higher than the carrying values. The financial results and financial
position as per the management accounts for the year ended 31 December 2010 are set out
in the following pages:
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Notes
1. Revenue declined by 10% in the 2009 financial year compared to 2008. Supremo did
not increase annual or per kilometre charges to customers in 2009 and 2010, except for
changes relating to diesel fuel price fluctuations.
2. Details of the cost of sales are set out in the table below:
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Diesel fuel prices decreased on average by 35% during the 2009 financial year. In 2010,
diesel prices increased on average by 8%.
3. Operating and administrative costs are mainly fixed costs, with only 5% of these total
expenses being variable in relation to revenue and activity levels in the 2009 and 2010
financial years.
4. Supremo owns the property in Johannesburg from which it operates. The net book
value and tax base of land and buildings at 31 December 2010 was R17 120 000. The
property was acquired in 2002 for R19 million and a further R1 million was immediately
spent on refurbishing the premises. Buildings are depreciated to a zero residual value
on a straight-line basis over 50 years (the depreciation charge for the 2010 financial
year was R360 000). At 31 December 2010 the net book value of the vehicle fleet was
R139 300 000 (2009: R130 900 000).
5. Interest-bearing liabilities represent the balance outstanding on instalment sale
agreements.
Reduction of the bank overdraft
The shareholders of Supremo have met to discuss plans of action to reduce the bank overdraft
to R5 million by February 2011. BWI has indicated that it has no cash resources available
to subscribe for shares in Supremo or to advance a shareholder’s loan to the company. Mr
Parisse has in principle agreed to purchase the land and buildings owned by Supremo for
R30 million, which represents the fair market value. He has furthermore agreed to lease
the property to Supremo for five years at a market-related rental of R200 000 per month,
subject to annual inflation escalations. The proceeds from the sale of the property will be
used to reduce the company’s bank overdraft.
Required:
(a) Analyse and comment on the revenue and gross profit performance of Supremo
in the 2009 and 2010 financial years. Calculate relevant ratios in support of your
comments.
(b) Identify and outline at least two possible actions that Supremo could take to
return to profitability on a sustainable basis and at least two possible actions
that Supremo could take to improve the cash flow generation of the business.
(c) Critically discuss, from the perspective of Supremo, the proposed sale and
leaseback of the land and buildings.
(QE)
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PRICING ON THE JSE AND VALUE: WHY EDCON USED VALUATION PRINCIPLES
TO GO PRIVATE
What does management do when it considers the market is undervaluing the company? This
was the question that the management of Edcon considered in 2007. Edcon was the largest
non-food retailer in South Africa with 32% share of the South African clothing and footwear
market yet management considered that that the share price was understating the value of the
group. Management put in place an auction process whereby international private equity firms
were invited to tender for Edcon. Bain Capital bid R25 billion which was regarded as a high
price for Edcon. Bain Capital beat two other rivals for the group. The final offer represented a
price of R46 per share which was 51% above the price of R30.40 per share that the company
was trading on the JSE before the announcement of buyout talks. The price was at a significant
premium to the JSE price. Why was this? The team at Bain Capital would have carefully valued
Edcon on the basis of discounted expected future cash flows and on the basis of EBITDA and
P/E multiples. Edcon appeared to be undervalued in relation to its international peers. Yet apart
from Merrill Lynch which valued the group at R46 per share prior to the buy-out, most analysts
valued Edcon within a range of R35 to R41 per share. The increase in value was expected to
arise mainly from the restructuring of the group as well as the value of tax shields arising from
the issue of bonds to finance the transaction. By 2014, it had become clear that the expected
increase in operating cash flows and savings used in the forecasts to justify the higher valuation had
not materialised and that any benefits from tax shields and leverage had been overstated. Edcon in
2014 was facing an uncertain future. Perhaps the market had got it right all along! In this chapter,
we will explore how to value bonds and we will analyse how to value companies on the basis of
discounted cash flows and price multiples.
LEARNING OBJECTIVES
After working through this chapter, you should be able to:
■■ Outline the concepts applied in the valuation of assets.
■■ Value debentures, bonds and preference shares using a discounted cash flow technique.
■■ Value ordinary equity using the dividend discount model.
■■ Employ the Free Cash Flow model to value the firm and the ordinary equity of a firm.
■■ Apply price multiples such as the price-earnings ratio to value ordinary shares.
■■ Employ the EVA approach to value ordinary equity.
■■ Adjust valuations for issues such as lack of marketability, share options and noncontrolling interests.
Introduction
In Chapter 2, we used time value of money principles to value bonds and debentures.
Although the valuation of preference shares is similar to the valuation of bonds, the
valuation of ordinary shares is much more challenging. Why is this? Bonds and preference
shares result in fixed income streams and so we can predict the future cash flows from such
securities. In the case of ordinary shares, this is much more difficult as ordinary shares will
result in cash flows which depend on many factors such as the state of the economy, the
actions of competitors, changes in currency rates, operating costs and the ability of the
company to grow market share.
In this chapter we will focus mainly on two methods of valuing ordinary shares; the
dividend discount model and the free cash flow model. We will also undertake relative
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valuations by using such indicators as price-earnings ratios (P/E) and market to book ratios.
Finally, we will use the EVA approach to value a company’s equity. We will apply what we
learn and value a real company.
1 Valuation – an overview
In corporate finance, the valuation of any asset is determined by its future cash flows. The
value of any security is equal to the present value of the security’s expected future cash flows
discounted at an appropriate discount rate which reflects the underlying risk of such an
investment. An investment with uncertain cash flows will be valued less than an investment
which offers a greater level of certainty in terms of future cash flows. Investors need a
market to reflect trading prices. The JSE is a market that creates a listed price or value based
on the buying and selling interactions of millions of investors. As the future is uncertain
by definition, our estimation of future cash flows may be subject to error and yet we are
required to estimate future cash flows, discount cash flows and compare our value to the
listed share price. We should adjust our parameters and apply sensitivity analysis to our
valuation. Remember that although we may get to the wrong number we can still make the
right decision. Assume we value a company’s share price at R12, and the current listed price
is R8. Well, perhaps the real value is only R10 and so we got the wrong number but we made
the right decision to buy at the current price.
There are a number of valuation myths that we need to consider at the beginning:
■■ The valuation is quantitative and therefore correct. A value is usually expressed
quantitatively and may be the result of a formula or complex Excel model. As a result,
many often place an undue presumption of accuracy on the answer. Any combination
of inputs to the model will produce an answer; the important questions are what
informed the inputs, what assumptions were made, what was the purpose of the
valuation (e.g. a valuation for liquidation will likely be different from one for disposal
and again different from one for merger purposes), who are the parties, what are their
needs, what is their bargaining position, what is the size of the ownership?
■■ The valuation is objective. Valuations are influenced by the biases and needs of the
people performing them. Unintentionally the valuer may make assumptions which
generate an answer which satisfies a perceived need. For example, an equity analyst may
not want to be seen to be the odd person out and overestimate the growth potential of a
business. This was a common problem in the valuation of technology companies.
■■ The valuation has precision. Valuations are a function of estimates about future cash flows
and estimates of the cost of capital. Consequently even in the best circumstances they are
approximations.
■■ The valuation is valid over an extended time period. Since valuations are functions of
estimates about the future, as new information is received so the estimates of the future
change and the valuation changes. Estimates about the future would be influenced by
new information about the state of the economy, industry growth rates, interest rates
and currency rates.
■■ Only the answer matters. The answer can be important, but the benefit of carrying out a
valuation is that the rigorous process enables us to understand the fundamentals of the
business and what drives the value. It also uncovers the key variables on which the value
relies. This is particularly important, because if we know which variables influence the
value we can determine the sensitivity of the valuation to changes in those variables. Put
another way, we know what we’re betting on.
What are the fundamental building blocks of a valuation?
As the valuation of an investment is the present value of future cash flows, any valuation will
be affected by the following factors:
■■ The amount of each future cash flow;
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■■ The timing of such cash flows;
■■ The riskiness of future cash flows; and
■■ The required rate of return.
The amount and timing of future cash flows will be driven by the nature of the investment
and the management of such investments. The riskiness of future cash flows will depend
on the nature of the investment, and sensitivity to economic factors such as interest rates,
inflation and changes in currency rates.
The required rate of return (the discount rate) will be affected by a number of factors
such as the current government bond yield and the riskiness of future cash flows. We will
estimate the amount and timing of future cash flows and we will adjust the required rate of
return to take into account the riskiness of future cash flows.
2 The effect of risk and return on valuations
The value of an item is inextricably bound to the return it generates and to the risk it
carries. This is true whether one is referring to monetary values and returns or simply to
benefits received. In this chapter we shall be concerned only with items whose value can be
expressed in monetary terms. In Chapter 2 we examined the mathematics of compounding,
discounting, and present value. We will now use these tools to value assets.
Example 6.1: Impact of return on value
Assume there are two assets: asset A yielding R1.0 million per year, and asset B yielding
R1.2 million per year. Assuming the risk is similar then clearly asset B is worth more than
asset A. We cannot, with the information supplied, say how much each asset is worth, but
we will agree that B is worth more than A, thus demonstrating that the return an asset yields
has a bearing on its value.
Example 6.2: Impact of risk on value
Now assume that there are two assets, C and D, each yielding R1 million per year, but asset
C is riskier than asset D. D is clearly worth more than C. Again we cannot place a value on
these assets but we do know that risk has a bearing on the value.
What, then, is needed to value the asset? All valuation models function on the
relationship between expected return and risk, and this is reflected in the required return
for that particular type of asset. If the expected return we receive on an asset, based on its
cost to us, is less than the return received on similar risk assets, then our asset is not worth
the price we paid for it.
Example 6.3: Valuation by comparing rates of return
Cost of asset
R10 million
Expected annual return
R1 million
Return on similar assets
12%
In this example it is clear that the asset is not worth R10m. This asset is returning only 10%
__
(​  1 ​), whereas it should yield 12%. An investor expects to receive a return of R1m by buying
10
an asset of similar risk, which yields a return of 12%, for less than R10m. Assuming a
perpetuity, then only R8.33m needs to be invested at 12% to earn a return of R1m.
3 Required rate of return
Since the value of an asset is the present value of future cash flows, we need a rate at which
to discount our future cash flows. The determination of the required rate of return is thus a
crucial issue. It is the return that the investor requires, given the environment in which the
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investment is made. This can change at any time with changes in the expectations regarding
that environment. In some cases the rate is relatively easy to determine, particularly where
there are similar assets trading on the market.
For example, if the valuer wants to know the required return on a five-year debenture, it
is possible to identify other debentures of similar period and risk and determine their return.
However, the asset most frequently being valued is equity capital, and it is more challenging
to identify similar shares in order to observe the expected return. In such cases one needs
to try to establish the required return, given the particular circumstances pertaining to the
companies concerned.
The required return on a company’s shares is the cost of equity for those shares for
the company. Various models have been developed for calculating the cost of equity. The
calculation of the cost of equity will be covered in Chapter 7 using both the CAPM and
dividend growth models. We turn now to a consideration of valuation models for some of
the main categories of financial assets.
4 Valuation of debentures and bonds
We now revisit what we did in Chapter 2 when we used time value of money principles to
value debentures and corporate bonds. The valuation of fixed income securities such as
debentures, bonds and preference shares is relatively straightforward as these securities will
pay a fixed interest amount per period, which is usually on a semi-annual or quarterly basis.
When we value bonds, we need to understand some relevant terms. Par value refers to
the stated face value of the bond. Often bonds will be issued with a stated face value of
R100 and companies will normally issue and redeem bonds at this price. The company is
required to make fixed interest payments on bonds. These are known as coupon payments
and the payment divided by the par value is known as the coupon interest rate. There is no
relationship between the current market yield which changes day to day and the coupon
interest rate, except at the time of issue. Companies do sometimes issue bonds which may
pay a coupon interest rate for an initial period and then this becomes a variable rate of say
the JIBAR (Johannesburg Interbank Agreed Rate) quoted swap rate plus a premium of 2%.
Companies may also issue what is often termed as floating rate notes which are bonds that
pay a variable interest rate which may be issued at a premium to a rate such as the JIBAR
swap rate. There are other bonds which do not make any coupon interest payments; such
bonds are called zero coupon bonds. Bonds and debentures will normally have a maturity
date, or redemption date which represents the date that the bond will be redeemed. Yield
to maturity refers to the implicit return that an investor will earn by holding the bond or
debenture until maturity. This represents the market yield on a bond.
Debentures and bonds in perpetuity
A debenture in perpetuity has no redemption date and will continue indefinitely to pay
interest at the coupon rate. Such debentures are also known as non-redeemable bonds or
notes.
Example 6.4: Valuation of a bond in perpetuity
A non-redeemable bond has a face value of R100 and pays a coupon rate of 15% per annum.
The current market rate for similar bonds is 9%.
The value of the bond is clearly not R100. You will receive R15 (100 3 15%) every year,
and you should be getting R9 (100 3 9%). The required return may be said to be 9%.
Chapter 2 showed that the present value of an amount received in perpetuity can be
calculated by capitalising the return received at the required rate.
Value of the bond 5 R15/0.09
5 R166.67
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Redeemable debentures and bonds
A redeemable debenture has a maturity date on which redemption will take place. It cannot
therefore be capitalised in perpetuity.
There are two different types of cash flows involved in the valuation of redeemable
debentures. One is the periodic interest payment and the other is the repayment of the capital
at the date of redemption.
Example 6.5: Valuation of redeemable debentures (bonds)
A bond has a face value of R100 and pays an annual coupon interest rate of 15% per year,
and it is redeemable in five years time. Similar bonds have a market yield of 9%.
The interest is an annuity since the same amount is received each year. The present value
of the interest is therefore the annual interest discounted at the required rate of return,
which in this case is 9%. The discount factor used is that for an annuity at 9% for a period
of five years. Using Table D:
Present value of interest = R15 3 3.8897
= R58.34
To this must be added the value of the capital redemption. Since this is only to be received
in five years time it must be discounted for that period at the required return. The discount
factor used is that for an amount received in five years’ time at 9%.
Present value of capital = R100 3 0.6499
= R64.99
The value of the redeemable bond is therefore:
R58.34 + R64.99 = R123.33
Again we note that the value is higher than the face value since the actual return is higher
than the required return.
Using a Financial Calculator:
Using a financial calculator, enter the number for each variable followed by the function
key and then press the PV function for the answer. The answer represents the amount that
you would have to pay today for the future coupon payments and redemption of the face
value.
We can depict the above bond’s cash flows as follows and use the Excel NPV function to
determine the value of the bond:
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We can see that a bond in perpetuity offering a coupon rate of 15% is valued at R166.67 as
compared to a bond which offers the same rate for 5 years, which is valued at R123.33. The
lower value reflects the fact that at the end of 5 years, investors will be required to reinvest
at the lower market rate of 9% per year.
The valuation of a redeemable bond may be expressed in general terms as:
n
_______
_______
I
P
​ (Formula 6.1)
t ​ 1 ​
(1
1
r)
(1
1
r)n
t51
Vd =  ​
where: r = required rate of return
n = number of periods
I = coupon payment per period
P = redemption of principal amount
If we are given a price for a bond or debenture, then the interest rate or discount rate that
makes the above formula true or valid, is the yield to maturity (YTM). Remember that this
is the same as the internal rate of return (IRR) and we can use the IRR function on most
financial calculators to determine a bond’s yield to maturity.
A bond may have a call provision which enables the company to call the bond or debenture
prior to its maturity date. For example, assume a bond is issued at a coupon rate of 12% and
the maturity date is in 10 years time. However, the company can call the bond any time from
year 5 until year 10. If the company calls the bond then the company may be required to pay
a premium above face value. We can then compute the yield to call. Why is this important?
Well, if market yields have fallen significantly, then it is probable that the company will call
in the bonds after 5 years and reissue at a lower interest rate. The return that an investor will
earn is probably the yield to call and not the higher yield to maturity.
In the above example, assume that the bond is currently trading at a price of R118. What
is the bond’s yield to maturity? We can use the IRR function on a financial calculator, or we
can use Excel as follows:
Using a Financial Calculator:
Using a financial calculator, enter the number for each variable followed by the function
key and then press the I/YR function for the answer. The answer of 10.2% represents the
interest rate that ensures that the sum of the present values of the coupon interest payments
and the redemption value equal the price of R118.
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FROM THE REAL WORLD….
Eskom has been issuing bonds in order to raise capital to finance the building of power
generating capacity. Eskom has raised over R7.25 billion through the issue of its ES18
bonds. The ES18 bond offers a coupon rate of 9.25% per year with interest payable semiannually on 20 April and 20 October of each year. The redemption date is 20 April 2018.
The face value of each bond is R100. The ES18 bond is expected to offer a yield of 47
basis points (0.47%) above the yield on the government R204 bond, which was trading at
a Yield to Maturity (YTM) of 7.72%. What is the value of the bond on 20 October 2010?
The required return is 8.19%, which represents the government bond yield plus a risk
premium (7.72% + 0.47%). This rate translates to 4.095% per half-year and this is the
discount rate we have used to value the bond. The coupon payment due on 20 October
would be paid to the previous holder.
We can set out the future coupon payments and the redemption payment in Excel and
determine the value of the bond by determining the NPV as at 20 October 2010, assuming
the next coupon payment will occur on 20 April 2011.
We can also use the Present Value tables or formulae to determine the present value
of the coupon payments which is an annuity and the present value of the maturity value
which is the face value of the bond.
As there is no accrued interest, the value in this case also represents the bond’s clean
price. The clean price is the value of a bond obtained by discounting all coupon payments
(and the maturity value) after the next interest payment date and excludes any accrued
interest up to that date. Therefore on 1 October 2010, the clean price should be equal
to R105.85. We checked this to the JSE. The clean price of the ES18 bond quoted with
a settlement date of 1 October by the JSE was R105.86. Therefore, our calculations are
correct. If we were valuing the bond on 1 October 2010, then we would need to add the
accrued interest to the bond’s clean price (at 1 October 2010) to get to the bond’s allin price (also called the bond’s dirty price). We will show you how to use Excel to value
bonds in terms of the all-in price and the clean price and then compare this to the quoted
price on the JSE’s interest rate market as at 1 October 2010. To use Excel to value the
bond as at 1 October 2010, you should use the DATE and PRICE functions in Excel.
The PRICE function in Excel enables us to value a bond that pays periodic interest.
The Excel function is as follows:
Price(settlement, maturity, rate, yield, redemption, frequency, basis)
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Use the DATE function to enter the settlement and maturity dates. In this case we will
set the settlement date as 20 October 2010 in order to determine the clean price of the
ES18 bond.
The PRICE function in this case offers us the clean price of the bond. As you can see, this
agrees with our clean price calculation. If we were valuing the bond with a settlement date
of 1 October 2010, then we would add accrued interest which is determined as follows:
Coupon rate 3 Face Value 3 (D/365)
where:
D 5 number of days from last interest payment date to the current settlement
date.
In our example, the number of days from the last interest date, 20 April to 1 October is
164 days and the accrued interest would amount to:
9.25% 3 R100 3 164/365 5 R4.16
If we use Excel, we will see that the clean price would be R105.85 at 1 October 2010 and we
add the accrued interest of R4.16 to get to an all-in price of R110.01. The JSE was quoting
an all-in price of R110.021.
5 Valuation of preference shares
Debenture holders (bondholders) receive a fixed interest payment each period. Preference
shareholders receive, in most cases, a fixed dividend payment. However, the company is not
obliged to pay a dividend and dividends are payable only after all expenses, including interest,
have been paid. As dividends involve a higher level of risk, investors expect to receive a
higher return. However, whilst interest is fully taxable, dividends were tax-free in the hands of
investors until 31 March 2012, and so investors who were concerned primarily with after-tax
income, required a lower pre-tax yield from preference shares. For example, a debenture with
an interest rate of 10% yielded the holder an after-tax return of 7.2% at a tax rate of 28%. If the
investor’s marginal tax rate is 40%, then this would result in an after-tax return of 6%. Firms in
South Africa were issuing preference shares at about 75% of the prime rate. The introduction
of a dividend withholding tax of 15% from 1 April 2012 for shareholders, means that preference
shares retain an advantage relative to debt. Why issue preference shares? Firstly, companies
There are bond pricing and rounding conventions and so we may obtain slight differences in prices and accrued
interest. We used the quoted YTM in this case to reflect the required return. Generally, you need to set the
required return based on yields offered by similar bonds. On 15 December 2014, the ES18 was indicating a YTM
of 7.67% and a price of 104.56.
1
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may not be able to utilise the interest deductions owing to accumulated losses or depreciation
deductions. Secondly, companies may be acquiring shares rather than operating assets and in
terms of the Income Tax Act, the company is not able to deduct interest on loans employed to
acquire shares. Thirdly, RSA banks have been willing to subscribe for preference shares issued
by firms at a rate which transfers most of the ‘interest’ tax shield to the firms.
Preference shares may be cumulative or non-cumulative in terms of dividends in arrears
and they may be either redeemable or non-redeemable. Some preference shares are
convertible into ordinary shares and some are classified as participating which means that
they will participate, at a specified rate, in the profits due to the company. We will normally
assume that preference shares are cumulative.
Cumulative non-redeemable preference shares
The valuation of a preference share is the present value of an annuity received in perpetuity.
Example 6.6: Valuation of preference share
A person would like to sell 100 preference shares. The shares have an issue price of R1 each,
and carry a dividend of 10%. Similar shares available on the stock exchange yield an 8% dividend. What is the value of the preference shares?
This requires the valuation of an amount received in perpetuity. The amount is the annual
dividend which in this case amounts to 100 3 R1 3 10% = R10. The capitalisation rate
would be the required rate of return, which is given as 8%.
The present value of the shares is R10/0.08 = R125
Notice how the value depends on the future returns and not on the issue price. We see that
the above shares are worth R125 because they yield R10 per year and it would cost R125 to
buy shares which yield R10. If we bought shares for R125 we would expect to get a return
of 8%. Therefore our annual return would be R125 3 8%, which is R10. Clearly, then, our
shares which give us R10 per year, are worth R125. It has already been mentioned that preference shares have a right to the dividend after all expenses have been met. There are times
when there are insufficient cash resources available to meet the obligation to the preference
shareholders and so the dividend is not paid (the dividend is said to have been passed). If the
preference shares are cumulative, then the dividend owing for previous years has to be made
good before the company can distribute any dividends to its ordinary shareholders. In such
cases it is necessary to estimate when the arrear dividends will be received and to discount
these to the present value at the required rate of return. Similarly, if there is an expectation
that future dividends may fall into arrears, the date of receipt of those dividends must also
be estimated.
Example 6.7: Cumulative preference share dividends in arrear
You own 100 preference shares with an issue price of R1 each in a company that has just
paid the preference dividend and has made an announcement that financially difficult times
are ahead. It is expected that the dividend for the next two years will be passed; thereafter
normal dividend payments are expected to be resumed. The preference dividend is 12%
and the required return is 14%.
The dividend for years one and two (R100 3 12% 3 2 = R24) will be received only at
the end of year three, while the dividend for year three (R12) and thereafter will be received
on schedule. One way of dealing with this is to carry out the valuation at the end of year
three and discount that value back to the present. The value at the end of year three is the
dividend which will be received on that date (arrear dividend for years one and two and the
dividend for year three) plus the value of the perpetuity.
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Value of dividend received in year three = R36.00
Value of perpetuity in year three = R12/0.14 = R85.71
Value of preference shares at end of year three = R121.71
Discounted back to the present, using Table C at 14% at the end of three years, the value
of the 100 preference shares is:
R121.71 3 0.6750 = R82.15 per share
Non-cumulative preference shares
Non-cumulative preference shares simply involve the valuation of the preference dividend.
An additional point to consider is whether the dividend is likely to be passed in the future
or not. If there is any probability that the dividend will be passed, the preference shares will
be worth less, since there will be no cash flow in certain years.
Example 6.8: Non-cumulative preference share dividend passed
Assume the same details as in Example 6.7 except that the preference shares are noncumulative. In this case the dividend passed for years one and two will not be received at
all – instead we have only the perpetuity starting in year three.
Value of perpetuity at the end of year 3 = ____
​ R12 ​ 5 R85.71
0.14
The value of the perpetuity in year three plus the dividend received in year three can be
discounted back to the present, using Table C at 14% at the end of three years. The value of
the preference shares is R65.95 [(R85.71 + 12.00) 3 0.675].
Redeemable preference shares
The valuation of redeemable preference shares is similar to the valuation of redeemable
debentures, which was illustrated in Example 6.5. A problem in valuing redeemable
preference shares, however, is that there will be instances when they may be redeemable
only at the option of the company. In carrying out such a valuation it is necessary to assess
the likelihood of redemption on a particular date. If the coupon interest rate is higher than
the current market interest rate, then the likelihood is that redemption will take place.
6 Valuation of ordinary equity
The valuation of ordinary shares is more difficult than valuing bonds or preference shares
for the following reasons:
■■ Future cash flows are uncertain as earnings and dividends are dependent on such factors
as the state of the economy, currency rates, operating costs, interest rates, product
acceptance and the level of competition in the sector.
■■ Ordinary shares have no maturity and companies are assumed to have an indefinite life.
■■ The cost of equity and the cost of capital are subject to greater uncertainty and more
difficult to observe than bond yields.
However, the principles remain constant. The valuation of a company remains – the present
value of future cash flows. It is just more challenging to determine what the future will bring
in terms of cash flows and the discount rate.
The future cash flows that will accrue to ordinary shareholders are dividends. Changing
expectations about the growth of future dividends can have a significant impact on the value
of a company. We can also use earnings or free cash flows to value a company’s equity as
there should be a close relationship between earnings, cash flows and future dividends.
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There are various methods available to determine the value of ordinary equity:
■■ Dividend Discount Model. The value of ordinary equity is determined by the present
value of future dividends. This is also called the dividend growth model due to the effect
of growth in dividends on value.
■■ Price Multiples (relative valuation). The value of ordinary equity is determined by
using price multiples such as the price-earnings ratio or the market to book ratio.
■■ Free Cash Flow Model. We determine the free cash flows to the firm and discount this
at the firm’s cost of capital. The result is the value of the firm. We deduct the value of
debt from the value of the firm to arrive at the value of the ordinary equity. We can also
discount the equity cash flows at the cost of equity.
■■ EVA Discount Model. This requires that we discount a firm’s future EVAs at the firm’s cost of
capital. EVA was explained in Chapters 1 and 5.
Dividend discount model
The dividend discount model requires that we project the future dividends of the firm and
discount the dividends at the firm’s cost of equity. As the firm has an indefinite life, and we
can expect earnings and dividends to grow over time, the computation of value is facilitated
if we assume a constant growth rate in dividends. Companies will normally only pay out a
percentage of earnings and the balance is reinvested to generate increased earnings and
dividends in future years. This model is also known as the dividend growth model. We will
firstly assume that dividends will grow at a constant growth rate.
Constant growth in dividends
How do we determine the value of equity if dividends are expected to grow at a constant
rate? The assumption of constant growth rate means we can use the formula of a growing
perpetuity to determine the value of equity. Firstly, we will analyse how the dividend constant growth model is derived.
The dividend growth model is based on the present value formula which is described as:
Cn 2 1
Cn
C1
C2
_______
............. _________
Present Value = ​ _____
​ 1 _______
​
​​
​
2 ​ 1
n 2 1 ​ 1 ​
1 1 r (1 1 r)
(1 1 r)n
(1 1 r)
(Formula 6.2)
where: C = cash flow (expected dividend) per period
r = discount rate
Where the cash flow is growing at a constant rate, the above formula may be restated as:
C1
Present Value = ​ _____
r 2 g ​(Formula 6.3)
In the case of ordinary equity, the periodic cash flow is the dividend received, and so the
above model can be used as a valuation model. It is normally stated as follows:
D
​  1 ​(Formula 6.4)
Po = _____
k2g
where: Po = value of ordinary share
D1 = next period’s dividend [D1 = Do(1 + g)]
k = cost of equity
g = growth rate in future dividends
If we refer to Chapter 2, we are really valuing a growing perpetuity. If we assume that there
will be no growth in dividends, then we are valuing a perpetuity and the present value of
dividends will be determined by D1/k.
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How does this formula work? Does the growth formula ignore future prices? In fact we can
show how the formula is derived by including future prices:
Po =
D1 1 P1
​ _______
​
11k
However, the value in a year’s time, P1, will also be determined by the future dividend in
year 2 and the price at the end of Year 2:
P1 =
D2 1 P2
​ _______
​
11k
If we substitute P1 into the formula above:
D2 1 P2
D1
_______
_____
Po = ​  1 1 k ​ 1 ​  (1 1 k)2 ​
Similarly, the value at Year 2 will be determined by the present value of the dividend to be
received in Year 3 and the present value of the price at the end of Year 3. Therefore the
value becomes:
D3 1 P3
D
D2
_______
Po = _____
​  1 ​ 1 _______
​
​
2 ​ 1 ​
11k
(1 1 k)
(1 1 k)3
We can continue this to infinity so that the value of the share is:
D
D3
Dn 2 1
Dn
Pn
D2
Po = _____
​  1 ​ 1 _______
​
​ 1 ​ _______
​​ 1 ........ ​ __________
​ 1 ​ ________
​ 1 ​ ________
​
11k
(1 1 k)n
(1 1 k)n
(1 1 k)2
(1 1 k)3
(1 1 k)n 2 1
The last expression is the price of the share at time infinity which discounted back to its
present value approaches zero. We are therefore left with the present value of the stream
of future dividends to infinity, which under the assumption of constant growth, reduces to
Formula 6.4. Sometimes we want to know the implicit constant growth rate in the share
price of a company. Is the assumption of future growth reasonable?
Formula 6.4 can be restated as follows to determine the implicit growth rate:
kP 2 Do
g = ________
​  o
​(Formula 6.5)
Po 1 Do
How do we value shares if investors are selling in a few years time?
Let’s come back to the issue of selling shares. What if an investor is planning to sell the
share in a few years’ time? Sometimes investors, particularly during the boom in technology
stocks, indicated that future dividends were not relevant, as they were planning to sell the
shares after a few years and were focused on capital gains. Often there were no dividends,
only the promise of future earnings and dividends. The market correction has changed this
philosophy and current dividends have become more highly valued. However, coming back
to our first point, if an investor is planning to hold a particular share for only three years,
then the valuation formula becomes:
D3 1 P3
D
D2
Po = _____
​  1 ​ 1 ________
​
​ 1 ​  ________
​
2 11k
(1 1 k)
(1 1 k)3
Although the value to the investor today is affected by the value of the share in Year 3, the
future rational investor buying the share will pay a price that is determined by the future
dividends from Year 4 onwards. Remember, the future investor is buying a stream of future
dividends. During the initial period, the company may experience an improvement in
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sales or operating margins which is expected to increase future dividends. Expectations of
future dividends may change dramatically and suddenly values will change. Yet the value of
the ordinary equity will remain anchored to the principle of discounted future dividends.
Although investors may bet on events that will significantly impact on future dividend
expectations, these events may or may not happen.
If we apply the constant growth dividend model, we need to determine the following 3
variables:
■■ The next year’s dividend [current dividend 3 (1 + growth rate)];
■■ The discount rate (i.e. the cost of equity); and
■■ The growth rate in future dividends.
The next year’s dividend will be reasonably easy to forecast, by taking into account the
current year’s dividend. We simply need to take the current dividend and apply the constant
growth rate to obtain next year’s dividend per share.
The discount rate is the cost of equity, which is the return that investors require from the
investment, given the level of risk. This is discussed in greater detail in Chapter 7.
The growth rate is more difficult to estimate. Dividends are a function of policy as well
as the prevailing economic environment. The growth rate in dividends is often difficult to
determine and the assumption of a constant growth rate may not be realistic. The dividend
discount model is more relevant when we are valuing a firm with steady earnings growth
operating in a mature industry sector. The assumption of a real growth rate which is similar
to the expected real GDP growth rate plus the expected inflation rate may be relevant for
many companies operating in certain sectors. We can also make further adjustments for
productivity improvements.
What is the role of future earnings?
If one views the dividends paid by a company over the long term, then the effect of dividend
policy will tend to be smoothed out over time and the growth in dividend will more closely
reflect the growth in earnings generated by the company. Consequently, in trying to make
an estimate of growth in future dividends, it is often better to estimate the growth in future
earnings. Future earnings are not the only possible surrogate – they are merely suggested
as being potentially suitable. Growth in cash flow may well be better, or, depending on the
particular company, it may be some item even further removed from the actual dividend,
such as sales. Which surrogate is best will depend on which item most closely reflects future
dividend growth. It is suggested that expected growth in earnings and cash flow are likely to
be good surrogates for expected growth in dividends for many companies.
If dividends are affected by the growth in earnings per share and operating cash flow, then
it is important to evaluate the factors that will impact on the growth in earnings and operating
cash flow. Firstly, inflation will result in a growth in earnings per share. Even if the firm is
unable to grow in real terms, inflationary growth will result in an increase in future dividends.
Secondly, the reinvestment of earnings should result in an increase in future earnings and
dividends.
Is it possible to increase the value of a company’s shares by increasing dividends?
No, life is not that simple. Increasing next year’s dividend will increase D1 in our valuation
formula but may reduce future growth in dividends. If a company pays a higher dividend,
it means the company is reinvesting less, which will tend to reduce the future growth rate
in dividends. In most cases, higher dividends will increase equity values if the increase in
dividends is supported by earnings growth. If a company’s earnings per share is growing by
less than its dividend per share, then the growth rate in dividends is not sustainable unless
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earnings growth accelerates. On the other hand, the reinvestment of earnings and maintaining a high dividend cover will increase the value of the equity only if the company’s return
on capital is greater than the company’s cost of capital. Otherwise, growth could actually
result in the destruction of value.
The sustainable growth rate which is covered in Chapter 5 may be used as a reasonability
check as the model takes into account the return generated on assets, the degree of financial
leverage and the percentage of earnings reinvested. The model was designed to calculate
the growth in equity which should in turn reflect the potential growth in dividends.
Example 6.9: Valuation using the dividend growth model
Company X reported profits of R250m in the most recent year and has a dividend cover of
two. The industry in which it operates is in the mature phase of its development. The company expects to grow at the GDP growth rate of 3% per year. The required rate of return
in that industry is 10%.
Applying the dividend growth model:
D
Po = _____
​  1 ​
k2g
Earnings are R250m and dividend policy is to have a cover of two times, so the dividend is:
R250m/2 = R125m
The other variables needed for the formula are given; growth is 3% and the required return
is 10%. The value of the company is:
R125m(1 + 0.03)/(0.10-0.03) = R1 839.3m
Limitations
The model is limited in the following respects:
■■ It assumes that growth is constant.
■■ It is applicable only where the required return is higher than the growth rate. As growth
approaches the required rate of return, so the value of the shares approaches infinity.
This is not likely to be a realistic valuation as it is highly improbable that a company
would be able to maintain this level of growth indefinitely.
■■ If growth exceeds the required rate of return, the model gives a negative valuation to
the shares, which is clearly absurd.
However, we can make adjustments to avoid the above limitations such as estimating future
dividends for a specific period and use the constant growth formula only once we reach a
steady state of growth.
Zero growth in dividends
If dividends are expected to remain at a fixed level, then the value of the equity is simply
the present value of a perpetuity and may be valued as follows:
Value = D1/k
If a company is expected to pay a dividend of R0.80 per share indefinitely, then the value
per ordinary share, if the cost of equity is 11% is:
Value = 0.80/0.11 = R7.27
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Let’s go back to Example 6.9 but now assume that dividends are not expected to grow and will
remain at a constant level of R125m per year. How would this change the valuation of the company?
Value = R125m/0.10 = R1 250m
This is much lower than the value we determined then of R1 839m. Even a low growth rate of
3% per year adds about R589m [1 839m – 1 250m] to our valuation. Of course, the assumption
here is that the dividend will remain initially at R125m. If we are not growing, we may be able to
afford to pay a higher dividend per year and this would increase the value of the ordinary shares.
Valuing shares with a non-constant growth rate
How do we value companies that are growing at a faster rate than the general economy and
this rate of growth is expected to last for a few years? How do we value a company that is
growing at a higher rate than the firm’s cost of capital, a relationship which is patently not
sustainable? There are also business cycles and we need to look through the cycles to estimate
the long term growth rate in earnings and dividends.
What is a normal cycle for a firm to follow? Companies which are starting up tend
to experience high growth rates in earnings and tend to reinvest their earnings to take
advantage of high returns on capital. As competitors move into the sector or the company
becomes the dominant market player, growth in earnings tends to slow. The company will
reduce the rate of investment and as the cash starts piling up, the company is eventually
forced to use the funds to pay dividends. After a few years, dividend growth should be in
line with earnings growth.
A few observations about dividends, earnings and growth are worth noting. Dividends
and earnings must grow at the same rate over the long term. If dividends grow at a slower
rate than earnings, the dividend yield will tend towards zero, which is not feasible in the
long-term as the investor will want to get the money out of the company.
A dividend growth that is greater than the earnings growth is not sustainable. This is
intuitively obvious. It can also be shown by the sustainable growth formula. An abbreviated
version of the SGR formula is: SGR = Return on equity 3 Retention ratio. But if dividends
grow at a faster rate than earnings the retention ratio will eventually become negative,
consequently the SGR is negative which is not credible. Dividends (or earnings) cannot grow
at a faster rate than the economy indefinitely. However there can be a finite period of high
growth. Consider a typical product life cycle. The product starts off slowly, it then enters the
growth phase, this growth phase slows down as the product approaches maturity, a plateau
period is reached, and then there is the decline and eventually the demise of the product.
These phases can be extended or shortened according to the strategies of management, but
nonetheless, to a greater or lesser extent, all products follow a similar pattern.
In the earlier growth phase one tends to find that the growth is faster than normal. As
competitors enter the market the growth rate will slow down and, as the market starts to
become saturated, the product reaches its plateau period. The question is whether the model
can cope with this type of situation. Indeed it can. There are two stages to the calculation:
value the high growth period and value the constant growth in dividends thereafter. This is
illustrated in Example 6.10.
Example 6.10: Two-stage valuation
High-Fly Limited is a young company in the electronic games sector. It has an appealing
new product which is expected to capture the market. It is estimated that it will be three
years before competitors are able to enter this market. High-Fly has just paid a dividend of
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60 cents per share. The required return for the sector is estimated to be 12% per annum.
Growth for the next three years is expected to be in the region of 30% and thereafter it is
expected to be the normal growth for the industry which is 6% per annum. To value the
shares of High-Fly one needs to follow the two stages mentioned above.
Stage 1: Calculate present value of dividend until the growth rate changes.
Dividend Year 1 R0.60 3 1.30 = R0.78
Dividend Year 2 R0.78 3 1.30 = R1.01
Dividend Year 3 R1.01 3 1.30 = R1.31
These dividends are discounted at 12% to arrive at the present value of R2.43 per share.
Stage 2: Value the growth on the date the growth rate changes.
The formula needs to be adapted very slightly as we are valuing the shares in year three
using the dividend stream expected from year four. Thus the formula will be:
V3 = D4/(k – g)
We know k to be 12% and g, after year three, will be 6%. The dividend will be the dividend
received in year three increased by 6%:
R1.31 3 1.06 = R1.39
Applying the formula:
R1.39/(0.12 – 0.06) = R23.17
The value in year three of the future stream of dividends is R23.17. This must be discounted
to its present value.
R23.17 3 0.7118 = R16.49
The value of a share in High-Fly2 is:
R2.43 + R16.49 = R18.92
If more than two distinct growth periods are expected, this approach can be adapted to a
three-stage or n stage model. To value the high growth period we must estimate the duration of the high growth period and the size of the dividend during this period. High returns
± We have rounded off the PV factors to 4 decimal places and future dividends to 2 decimal places. Using actual
values, and a financial calculator or Excel, we will determine a more accurate value of R19.02.
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attract competitors into the market; therefore the difficulty of entering the market affects
the length of the period for which high returns can be sustained. Barriers to entry include
patents, trademarks, brands and company size and control over the distribution network,
amongst others. The size of the dividend is determined by the expected earnings, capital
requirements, and the dividend payout policy.
What other cycles are important? For example, a company could be operating in the mining
sector which is subject to commodity price cycles. Furthermore, declining reserves could
mean falling revenues and a terminal life for the company. We need to take into account
industry and company information in forecasting future dividend payments.
Valuing shares which do not pay dividends for many years
Let’s take an example of a biotech company that is developing a new drug. Perhaps, the
company will operate with losses for the first seven years before making a profit and may
only start paying a dividend after 10 years. For example, assume the company will start
paying a dividend of R0.20 per share in Year 11 which is expected to double in Year 12 and
again in Year 13. Assume that thereafter the dividend will grow at 7.5% per year. The cost
of equity is 14% as the company is perceived to be high risk. The value of the shares today
would be R2.69, calculated as follows:
The values of shares in companies with distant dividend cash flows are very sensitive to
changes in expectations of dividends and/or risk. For example, if the risk of the company
falls due to a successful Phase III clinical trial, or if interest rates fall and the cost of equity
is now 11%, then the value today will rise from R2.69 to R6.71.
From the real world... Woolworths
Let’s apply the dividend growth model to Woolworths, which is one of the retail giants in
South Africa. Management have been very successful in increasing the company’s share
price and the company has consistently been able to record increases in reported earnings
and dividends. Yet the company operates in the retail sector which is mature and Shoprite,
Edcon and Pick n Pay are the dominant players. The cost of equity of Woolworths should
be around 13%, if we use a simple calculation of a risk-free rate of 8% plus a risk premium
of 5%. The growth in the retail market should reflect underlying growth in GDP of about
3% per year and with inflation of about 5%, we will use a sustainable constant growth rate
of 8%.
The company on 12 December 2014 was trading at a price close to R74.63. If we compare
the dividends and earnings per share of Woolworths in recent years, we see the following
pattern:
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The growth in earnings per share (EPS) from 2008 to 2014 has been 21.3%
[​(3.652/1.149)​1/6​– 1] per year and the growth in dividend per share (DPS) has also been
21.3% [​(2.515/0.79)​1/6​– 1] per year. This is a high rate of growth. We need to forecast how
long the company will be able to maintain a high growth rate. If we assume 5 years of a
growth rate of 15% per year, (average of EPS and dividend growth, 2012-2014), followed by
a constant growth rate in dividends of 8%, then the value would be determined as follows:
The valuation of R72.57 is at a single point in time and yet a valuation within the
range of R67 – R78 seems to be reasonable. Valuations can be sensitive to interest
rates and the use of a lower required return of 12% would increase the above
valuation to R91.13. The use of a required return of 14% would result in a value of
R60.20. Woolworths is currently driving savings from its value chain and is focusing
on reducing costs and future changes in operating margins may increase the value of
the company. The price in 2014 was at a slight premium to our valuation using the
dividend growth model.
Price multiples (relative valuation)
Whilst the dividend discount model and the free cash flow model are both based on discounting future cash flows, investors also use price multiples such as the price-earnings
(P/E) ratio and the price to book value ratio to determine whether shares are over or
under-valued.
The price-earnings (P/E) ratio
The P/E ratio measures the relationship between the company’s earnings per share and
the share price. If a company’s share price is currently trading at R15 and the earnings per
share is R1.25, then the company is on a P/E ratio of 12 (15/1.25). Investors are prepared
to pay 12 times the firm’s earnings per share.
How do we use P/E ratios to value companies? We need to find out the P/E ratios of
comparable companies or the sector’s average P/E ratio. For example, assume that we are
valuing a company in the food and drug retailers sector which is trading at a P/E ratio of 12.
The sector average is 17 and therefore this may indicate that the company is undervalued,
but there could be other valid reasons for the difference in P/E ratios.
The value of the company based on the industry sector average P/E would be:
Value = EPS  P/E = 1.25  17 = R21.25
We would therefore buy the share as the current price is R15.
Companies experiencing high growth rates in earnings will normally have high P/E ratios
whilst companies with a high level of financial leverage may have lower P/E ratios, to reflect
the higher risk profile of such companies.
Companies with high P/E ratios may indicate that the company’s share price is overvalued
and yet a high P/E ratio may indicate very low reported earnings per share for a particular
year. For example, assume that a company experiences a temporary fall in operating income
and encounters a fall in its EPS from R1.25 to R0.75. Owing to the temporary nature of such
a setback, the share price has not fallen (nor risen) and yet the P/E ratio has dramatically
risen to 20 (R15/0.75).
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The earnings yield (EY) is the inverse of the P/E ratio. If we determine that the fair EY
for a company, based on comparable companies, is 7.143% (P/E = 14), then if the company
has an EPS of R1.10, the company’s shares will be valued at R1.10/.07143 = R15.40.
The use of a comparable P/E ratio (or EY) may be useful for valuing unlisted companies.
We use the P/E ratio of a comparable listed company and make an adjustment for the lack
of marketability. For example, if a listed company is currently trading on a P/E ratio of
10, we may apply a P/E ratio of 7 to value the unlisted company3. The determination of
an appropriate P/E or EY will require that we consider specific risk factors to adjust the
comparable P/E ratio or earnings yield.
The P/E ratio may not be comprehensive, so why is it popular? Well, it is quick and it is
easy. The data for listed companies is easily available and understandable. It is a useful and
swift indicator of value.
What are the disadvantages of using the P/E ratio? It is based on historical earnings
figures, although companies may use the forward P/E ratio which takes into account next
year’s earnings. This may not be enough to reflect the future. Detailed models require an
analysis of the assumptions of future earnings, whilst the P/E ratio or EY approach do not
require any detailed analysis. Also, a high P/E ratio may simply reflect very low reported
earnings in the latest period, and which may be a temporary setback for that period only. A
company incurring losses will report a negative P/E ratio, which is meaningless.
There is another difference with using the P/E ratio. It is based on accounting earnings
rather than cash flows. Whilst we would expect to see differences between accounting
earnings and cash flows, we would expect a reasonably constant relationship over time. If
management changes accounting policies which impact on EPS, then this will also affect
the company’s P/E ratio without affecting the company’s underlying operations. We need
to monitor accounting earnings and changes in accounting policies for companies which are
under pressure to report increased earnings. Enron reported a rising EPS whilst at the same
time reporting a negative EVA.
The final question comes back to the issue of whether high P/E ratios indicate that shares
are over-valued? Whilst there may be very valid reasons for an individual company to have
a high P/E ratio, in the late nineties high technology companies were trading at P/E ratios
which patently lacked credibility, sometimes exceeding 100. The very high P/E ratios did
indicate that the general pricing of tech stocks represented a bubble. The P/E ratios reached
historical highs. What is more interesting is that Shiller in his book Irrational Exuberance
(2000), reported that on average, companies with high P/E ratios experienced low real
returns in the subsequent 10 year period. There is a negative relationship between high P/E
ratios and subsequent long-term returns.
The P/E ratio for January in each year from 1881 to 1989 for the USA was plotted against
the subsequent 10 year real return and almost all observations fall between the lower and
upper boundaries as depicted in Figure 6.1.
The average P/E ratio in South Africa for all sectors in 2014 was about 17. McKinsey
report that the average P/E ratio for S&P500 companies increased from 9 in 1980 to 30 in
1999, yet the increase in P/E was concentrated in the largest 30 companies, with an average
P/E ratio of 45. This represented historic highs.
What about the Internet companies in 2014? Amazon had a share price of over $300 per
share but was reporting a net loss! Twitter, Pandora, and LinkedIn had very high cash flow
multiples (EBITDA multiples). Facebook was on a P/E of over 70. Google was at a more
reasonable P/E of 27.
For unlisted companies, we need to apply a discount for lack of marketability (DLOM). Although this discount
varies, studies have indicated that average discounts are within the range of 20% to 30%. We will come back to
this issue later in the chapter.
2
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×
×
×
× ×
×
×
×
×
× ×
×
×
×
× ×
×
× ×
×
×
×
×
×
×
×
×
×
Figure 6.1 Price-earnings ratios and the subsequent 10 year real returns
Reference: Robert J. Shiller Irrational Exuberance, Broadway Books, 2001
The price-earnings ratios of some South African retailers on 12 December 2014 was as follows:
Pick n Pay’s higher P/E ratio is due mainly to investor expectations of a recovery in earnings and
we would expect Pick n Pay to trade on a lower P/E ratio in the future. The sector is generally
trading on high P/E ratios. Let’s assume that you are required to value a food retailer. You
may decide to use the average P/E of 21.74, which excludes Pick n Pay and Clicks (non-food
retailer) and if the company is unlisted, you would reduce this by 20-30% (say 25%) due to
its unlisted status. If the maintainable earnings of the company you are valuing is R40m, then
you may value this company at R652.2m [R40m × (21.74 × 0.75)]. Often we need to select the
most comparable company or companies in order to derive a meaningful valuation.
The use of forward P/E ratios
A company may use expected earnings or forecast earnings to determine a valuation. It is
important to be consistent and apply a forward P/E of a comparable company and not the
trailing or historic P/E. Otherwise, we can make a significant error of principle in our valuation
of a company’s equity. Let’s take an example. ABC Ltd is an exporter that has an EPS of R3.00
per share and its share price is R30.00. All of a sudden, due to the fall in the value of the Rand,
we expect net earnings to double to R6.00 in a year’s time. The share price will also respond
immediately and we will assume the share price doubles.
The historic EPS remains at R3.00 per share, so that the P/E ratio goes up to 20.
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A day later, we are required to value XYZ Ltd, an exporter. We determine that the most
comparable company is ABC Ltd which is now trading on a P/E ratio of 20. Assume the forward
(expected) EPS of XYZ Ltd is R4.00. Its historic EPS per its financial statements is R2.00 per
share. We multiply the P/E of 20 by the forward EPS of R4.00 per share and derive a value
of R80.00 per XYZ share. This would be the wrong thing to do, as this would significantly
overvalue the equity of XYZ Ltd. The right way to value this company is to multiply the
forward EPS by the comparable company’s forward P/E. The expected EPS of ABC Ltd is
R6.00 and its forward P/E is therefore 10 (R60/6), so that the value per XYZ share would be:
Value per share = forward P/E × forward EPS = 10 × R4.00 = R40.
We could also use the Price/NOPAT ratio and the Price/EBITDA ratios to capitalise earnings
and determine the value of a firm.
Using EBITDA or EBIT multiples to determine enterprise value
We use the P/E ratio to determine the value of ordinary equity but we use an EBITDA or
EBIT multiple to determine the enterprise value of the firm. The advantage of determining an
enterprise value and using an EBITDA multiple is that we can ignore differences in financial
leverage. It also enables us to ignore differences in depreciation policies and the situation
where one firm has older assets and therefore a lower depreciation charge. Of course, there
remain issues regarding the fact that one firm may have entered into operating leases to
finance the acquisition of assets. However, the capitalisation of all operating leases should
address this issue. The determination of firm value by the use of EBITDA and EBIT multiples
to determine the enterprise or firm value has become a standard valuation method in practice.
If comparable firms are trading on an average EBITDA multiple of 7.5 times, and the
firm we are valuing has an EBITDA of R240 million, then the enterprise value of the firm
will be R1 800 million [R240m 3 7.5]. We can then deduct the value of debt to determine
the value of the equity in the firm.
Brait is an investment holding company, which held a 37.1% holding in Pepkor. The
Pepkor group includes Pep Stores, Ackermans and other retailers and operates in 15
countries. Brait used an EBITDA multiple of 8x to value Pepkor’s enterprise value at the
following dates:
How did Brait get to an EBITDA multiple of 8? Brait used a peer group of Mr Price, Truworths
& Foschini which are listed companies and which were trading at an average EBITDA multiple
of about 11.6x at the time. As Pepkor is an unlisted group, it should trade at a discount to
its listed comparable companies and Brait used an effective discount of 31% to account for
Pepkor’s unlisted status [(11.6-8.0)/11.6]4.
Steinhoff subsequently purchased Pepkor at an enterprise value of R73.382 billion using a combination of equity
and cash. The price paid was at a significant premium to Brait’s valuation. We could argue that as Steinhoff was
a listed company, then the discount for Pepkor’s unlisted status would no longer apply. Steinhoff was acquiring
control and should be able to generate cost savings or synergistic earnings from co-ordinating its current operations
and the Pepkor group’s operations and this could have led to a premium. Business Day reported on 30 November
2014, that JP Morgan had indicated a concern that Steinhoff was overpaying for Pepkor.
4
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Market to book ratio
The market (price) to book ratio is the share price of the company to the company’s book
value per share.
Book value per share = Shareholders equity/No. of ordinary shares
As the net assets (assets – liabilities) equal the shareholders’ equity, this represents the net
asset value per share. The market to book ratio is obtained by dividing the share price by
the book value per share.
Market to book = Share price/book value per share
High growth companies will tend to have high market to book ratios. This ratio will also
be affected by the nature of the industry sector. In the late nineties, the average price to
book ratio in the USA increased significantly from about 1.3 in 1990 to close to 5 in the
year 2000. This has fallen back and in the USA, the average market to book ratio in 2014
was about 3. We would use this ratio as we would use the P/E ratio to value companies. If
similar companies are trading at a market to book ratio of 2.5 and our company’s net asset
value per share is R1.80, then the value per share is estimated at R4.50 (2.5 × 1.80). Market
to book ratios are often used to value banks.
The market to book ratios may vary widely across companies and industry sectors. The
market to book ratios for Barloworld, Tiger Brands and Woolworths are presented in the
following table.
Woolworths’ focus on return on equity is evident in the company’s commitment to minimising invested capital. Barloworld has a low market to book ratio and is trading at just above net
asset value. Woolworths increased it market to book ratio from 5.75 in 2010 to 8.56 in 2014.
This reflects a very high market (price) to book ratio.
Price to sales ratio
The price to sales ratio is calculated by dividing the sales per share into the share price.
This ratio is often used when companies are making losses and yet are growing sales. It is a
comparative indicator of value and was particularly used to value internet or new economy
companies. Another ratio often used to value Internet companies was the PEG ratio, which
is the forward P/E ratio divided by the growth rate.
The price multiples of market to book and price to sales suffer many of the disadvantages
of the P/E ratio. Yet they are quick indicators of relative values.
Free cash flow model (discounted cash flow model)
In the previous section, we valued the ordinary equity of a company by estimating the company’s future dividends. Increasingly, analysts are applying the free cash flow model to value
the equity of a company. There are two derivations; either we value the free cash flow to the
firm or we value the free cash flow to equity. What do we mean by free cash flow? What is
different here?
The free cash flow 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
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the company’s cost of capital and we deduct the value of debt to get to the value of ordinary
equity. It is a direct valuation which forces us to focus on the key drivers of value and the
operations of the company.
The free cash flow to equity is the amount of cash generated by the company which is
available to be withdrawn by the shareholders. It is operating after-tax cash flows less the net
financing cash flows such as interest (after-tax) and changes in debt levels.
The valuation of the firm on the basis of projected operating cash flows is more relevant
for investors who are acquiring the company and may actually influence what the future cash
flows will be.
If we use the cash flows to the firm approach then we will discount operating cash flows
before financing cash flows such as interest and loan repayments.
The formula is as follows:
FCFn 1 Vn
FCF1
FCF2
____________
ValueFirm = __________
​​
​ 1 ​​ ____________
​
2 ​ 1 ......... ​ ​
1 1 WACC (1 1 WACC)
(1 1 WACC)n
where:
(Formula 6.6)
FCF = NOPAT (net operating profit after tax) + depreciation – net capital
expenditure – net increase in working capital
WACC = weighted-average cost of capital (i.e. required return for the firm)
Vn = terminal value of the firm at the end of the explicit forecast period.
This is often referred to as the enterprise value. We then deduct the value of debt at the
current date to obtain the value of ordinary equity.
The formulation for the cash flow to equity approach is as follows:
FCFE
1 Vn
FCFE
FCFE2
___________
n
ValueEquity = ​ ______1 ​ 1 _______
​
​ 1 ......... ​
​ (Formula 6.7)
2
11k
(1 1 k)n
(1 1 k)
where:
FCFE = Net profit after tax (and after financing costs) + depreciation – net capital
expenditure – net increase in working capital 6 change in debt financing
k = cost of equity
Vn = terminal value of the equity at the end of the explicit forecast period.
A consideration of this model will reveal that it is conceptually similar to the dividend
model. Earnings which are cash earnings can be distributed to shareholders, less whatever
is required to maintain or grow the business, that is, the capital investment. If the residual
theory of dividends was applied, the resultant figures should bear a very close resemblance
to those generated through the calculation of free cash flow to equity. As firms seldom pay
the theoretical dividend, the FCFE model has the advantage that it also explicitly considers
investment in assets, working capital and the capital structure.
Terminal values
How do we determine a firm’s terminal value at the end of the explicit forecast period? The
valuation of the firm is determined as the present value of the cash flows during the explicit
period and the present value of the terminal value (also known as the continuing value).
Value =
PV of Cash flows during the Explicit Period +
PV of the Terminal Value
How long should the explicit period be? In practice, firms often forecast operating cash
flows for 10 years and add a terminal value at the end of this period. The explicit period
should be based on how long it will take for the firm to reach a steady state. This may mean
that thereafter the firm expects to achieve a sustainable and reasonably constant growth
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rate, or that the firm may continue generating constant or declining cash flows. Otherwise,
the firm may close down (such as a mining entity) and sell its assets.
Where growth is expected, the points discussed with regard to the constant growth model
apply. Assuming constant growth at the end of the explicit period, the model becomes:
FCFEn 1 1
FCFn 1 1
Vn(Equity) = ​ _________
​ (Formula 6.8)
​​ or Vn(Firm) = ​​ __________
WACC 2 g
k2g
where:
g = expected growth rate
Two-stage (or more) models can be used if growth rates are expected to change, as discussed under the dividend growth model. Multi-stage models are based on an explicit
consideration of the variables for a finite period(s), followed by a growing perpetuity at a
constant growth rate. This is what we do by setting out the cash flows for the specific period
and adding the terminal value based on the constant growth model.
A variation on the FCFE model is to value the firm as opposed to the equity, using the
Free Cash Flow to the Firm (FCFF) model. In this case the firm is valued before taking into
account financing cash flows and the value of the debt is subtracted to arrive at the value of
the equity. The following differences from the FCFE model should be noted:
■■ Use NOPAT (net operating profit after tax) rather than net income. Net income is after
deduction of finance costs, which are not relevant in this approach as we are concerned
with the operating results for the firm as a whole, which are available to reward all
stakeholders.
■■ Use WACC (weighted-average cost of capital) as the discount rate rather than the cost of
equity.
■■ Do not incorporate debt changes in calculating the free cash flow.
This is the approach we prefer. Why? The focus is on operating cash flows and on the key
drivers of value from operations. However, we recommend the use of the cash flows to
equity approach for valuing highly levered firms and for valuing financial institutions.
Example 6.11: Free cash flow to the firm approach
Stop-to-Shop Ltd is a company that operates in the retail sector. The company has recently
reported an operating income (EBIT) of R72 million for the year ending 20x3 on sales of
R600 million for the year. The company expects to maintain current operating margins for
the next 4 years, when the before tax operating margin is expected to fall to 9% of sales
due to increased competition. The growth in sales revenue is expected to be 14% per year
for the next four years until 20x7 and thereafter the company is expected to experience a
sustainable growth rate in sales of 6% per year. The company’s weighted-average cost of
capital is 11% and the corporate tax rate is 28%. The investment in inventory is 18% of
sales and the investment in accounts receivable is 12% of sales. Accounts payable are 16%
of sales. Operating cash is at 2% of sales.
The company expects to maintain the net book value of its property, plant and equipment
at a constant ratio to sales and the net book value of fixed assets for the year ending 20x3
was R120 million. The depreciation charge for the year ending 20x3 is R10 million. The
company expects depreciation to be 8% of the opening book value of fixed assets (PPE).
The value of outstanding debt at the end of 20x3 is R320 million. The company has 280
million shares in issue. Use the free cash flow (to the firm) model to value the company and
the ordinary shares.
We have used an Excel spreadsheet to set out the future cash flows. The value of the firm is
made of two parts: the value of the cash flows during the specified period and the continuing
value (terminal value) which assumes a constant growth rate after the initial period.
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The growth rate in sales revenue is 14% per year until 20x7. Thereafter, growth falls to
a sustainable rate of 6% per year so that sales in 20x8 are 1 074.2m (1 013.4m  1.06 =
1 074.2m). The workings relating to capital expenditure and the net investment in working
capital (which represents cash outflows) are set out below.
In Chapter 20, we set up a financial model in Excel and employ the DCF (free cash flow)
method to value a company. The DCF (free cash flow) method has also become known as
the Income Approach to valuations while the use of price multiples is also called the Market
Approach to valuations.
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The Economic Value Added (EVA™) approach
The use of the economic value added (EVA) approach to value a company has grown in recent
years. This is also termed the abnormal earnings method of valuation. The value of a company
increases only if it invests in projects that offer returns above the company’s weighted-average
cost of capital (WACC).
The EVA of a firm is determined as follows:
EVA = (Return on Capital – WACC) 3 Invested Capital
We could define earnings above the cost of capital as abnormal earnings and if we restate
the above EVA formula, then:
EVA = Return – (WACC 3 Invested Capital)
The return is defined in this case as net operating profit after tax (NOPAT), so that:
EVA = NOPAT – (WACC 3 Invested Capital)
Invested capital is the sum of the book value of a firm’s non-current assets plus the net
working capital (current assets – non-interest bearing liabilities).
The value of the firm is made up of the book value of its net assets and the present value
of the company’s future EVAs.
Value of Firm = Book Value + PV of future EVAs
The valuation of the firm’s equity requires that we deduct the value of the debt from the
value of the firm. The value of the firm is the book value of assets (ABV) plus the discounted value of future net operating profit less the capital charge of the book value of
assets multiplied by the firm’s cost of capital (ABV × WACC). We could set out the value
of the firm as follows:
NOPAT1 2 ABVo(WACC)
NOPAT
2 ABV1(WACC)
______________________
2
ValueFirm 5 ABVo 1 _______________________
​
​ 1 ​
​ (Formula 6.9)
1 1 WACC
(1 1 WACC)2
NOPATn 2 ABVn 2 1(WACC) 1 CVn
1 ........... _______________________________
​
​
(1 1 WACC)n
The EVA or abnormal earnings approach requires that we determine a terminal or continuing value (CVn). There are three major scenarios:
■■ Positive EVAs or abnormal earnings will cease and the firm will continue to earn its
WACC. The continuing value of the firm will be zero as EVAn + 1 = 0.
■■ Positive EVAs will continue at a constant amount after the initial period. The
continuing value is the value of an EVA perpetuity which is EVAn + 1/WACC.
■■ Positive EVAs will continue to grow at a constant growth rate and the continuing value
is determined by the formula, EVAn + 1/(WACC – g).
Each possible scenario will be driven by economic, industry and firm specific factors. A company earning high returns will experience increasing competition which will drive returns
down to the firm’s WACC, unless there are barriers to entry, such as patents, brands, size of
capital investment required and control over the distribution network.
Example 6.12: EVA valuation
GoFlow Ltd is a company that is currently experiencing an after-tax return on capital of 25%.
The book value of the company’s operating assets (property, plant & equipment and net
working capital) at the end of the current financial year is R180 million. The company’s cost of
capital is 10%. The company expects to maintain its return on capital for another 3 years. The
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company expects competitors to enter the sector which will mean that the company’s return on
capital will equal its WACC from Year 4 onwards. The company is recording depreciation of
R15 million per year but is investing R15m each year in operating assets. The book value is
therefore expected to remain constant. The company has outstanding debt of R60m. What
is the value of the equity of the company using the EVA approach?
If we use the free cash flow model to value the company, then we should get to the same
answer. As depreciation is equal to the net investment in assets, the company’s free cash
flow is equal to the company’s net operating profit after tax (NOPAT). The free cash flow
valuation is depicted in the following table:
As we can see, the two methods result in the same value for the firm and the ordinary
equity.
Valuation of rights
A company may wish to raise additional equity capital by making an issue of ordinary shares
to its existing shareholders in order to fund expansion or to reduce its level of debt. This is
termed a rights issue, as existing shareholders will have the right to subscribe for ordinary
shares in the company at a specified price per share. For example, if a share is currently
trading in the market at R20 per share, the company may make a rights issue at R15 per
share to its shareholders, who will either take up the right to purchase at R15 or will sell the
right in the market. For example, on 23 March 2012, Murray & Roberts, the construction
group made a rights issue in which each shareholder was entitled to receive 34 ordinary
shares for every 100 shares held at a subscription price of R18.00 per share. The share price
at the time was trading at around R29.00 per share. The question is how do we value the
right to purchase a share for R18.00, which has a current market value of R29.00? We could
say that it should be worth R11.00 (R29.00-R18.00) but this does not consider the effect of
the increased number of shares on the value per share after the rights issue, essentially the
effect of dilution. We will come back to determine the value of a right in Chapter 13 when
we study sources of finance.
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The impact of share options on equity valuations
A share option gives the holder the right to purchase a share at a specified price in the future.
The right to buy is in fact termed a call option and we study the valuation of call and put (the
right to sell) options in detail in Chapter 18. A simple example would be a company that has
issued 10m share options to its executive directors whereby the directors have the right to buy
ordinary shares in the company at R2.50 per share within 7 years. This is what we call the strike
or exercise price. Let’s assume that the share price was R2.30 at the time of the issue of the
options but we are valuing the company’s ordinary shares three years later and the share price
has risen significantly to R10.00 per share. We are performing a valuation of the company’s
ordinary shares for an asset management firm, which considers that perhaps the current share
price is understating the value of the company.
If a company has issued share options and they are still outstanding and exercisable at
a future date then this may reduce the current value of the company’s equity shares. The
question is how do we take this in account? We will assume that there are currently 40m
ordinary shares in issue. We will assume that we determined the enterprise value based on
a DCF (free cash flow) valuation to be R600m at the valuation date and the value of debt
is R120m, resulting in an equity value of R480m (600m-120m). This means that the value
per share would be R12.00 (R480m/40m) per share. This would indicate that we should buy
the shares in the company as the current price is R10. However, we have not considered the
impact of the share options on the value per share. In our example, the options are seriously
“in the money” (share price (R10) > exercise price (R2.50)). There is very little likelihood that
the shares will not be exercised based on probable share price movements over the next four
years. It is highly unlikely that the share price will ever come back to its exercise price of R2.50
within the next four years.
We should really discount the revenue of R25m from the exercise of the options so that this
should be around R17m-R19m resulting in a value from R9.94 to R9.98. Either way, what
seemed to be a share offering value, the fact is that once we take into account the share
options, it no longer offers value. It seems that the market has got it right and has already
factored in the dilution from the share options. When share options are seriously in the
money, the best approach is to add the value/cash flow that would be gained by the company if
the options were exercised (i.e. strike price x number of options) to the total value of equity and
then add the number of new shares that would be issued if the options were exercised to the total
number of shares in issue.
If share options are seriously out of the money (whereby the share price is significantly below
the exercise price), then there is very little likelihood that the share options would be exercised
within the next four years. We would simply ignore the revenue from the exercise price (it’s not
going to happen) and we do not add the number of options to the number of shares.
We could also follow the accounting approach so that if the company’s share price is R10
and there are 10m share options with a exercise price of R2.50 per share, then with the revenue
from the exercise of the options (R2.50 × 10m), we could purchase 2.5m shares at the market
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price of R10 per share. We increase the number of shares by the effective dilution which is
7.5m (10m – 2.5m) shares in this case to derive the value per share. This is in line with the
concept of diluted earnings per share (EPS) calculated for financial reporting purposes. Share
options are only dilutive if the options are ‘in the money’ (i.e. the strike or exercise price is
less than the current share price). Effectively we add the net number of shares that would be
converted which are considered ‘not for value’ to the total number of shares in issue. This
accounting method offers a reasonable estimate but is less accurate than the other methods to
account for share options in our valuation.
If the share price is reasonably close to the exercise price at the date of the valuation, then
it is best to undertake a valuation of the options using the methods described in Chapter 18.
In this case, deduct the value of the options from the value of the equity but use the current
number of shares to determine the value per share.
7 Valuations and the financial manager
The focus on shareholder value means that management will be highly focused on maximising
the value of the company. Therefore the determination of the intrinsic value of a company is
important to the financial manager even when the company is a listed company. Management
will take actions which are focused on increasing shareholder value.
The valuation of any company is based on assumptions about the future and therefore
different analysts will have differing views on the value of a company. When it comes to
making investment decisions, although different valuation methods may offer different
values, we do expect to be sufficiently ‘in the money’ so that we make the right decision. For
example, if a financial manager values a company at R12 per share and the current price is
R11, then we may decide not to invest as our valuation is too close to the price. The range
of possible values could be R10–R13 per share if we change our parameters.
How do valuations affect the management function? Management will use valuation models
in specific scenarios:
■■ The valuation of companies or divisions for the purposes of acquisition or divestment.
■■ The valuation of the company in order to determine the correct share exchange ratio when
a merger or acquisition is due to be paid in the form of equity.
■■ The valuation of equity to decide on the optimal capital structure for the firm.
■■ The valuation of the equity in a company is important in the decision to make a rights
issue or the initial decision to list a company.
■■ The decision to undertake a share buyback requires management to undertake a valuation
of the company’s equity.
■■ Management’s remuneration may be based on the valuation of the company’s equity.
Valuations are often used in negotiations and two parties with differing objectives will often
present differing valuations in order to drive the price in their favour. It is important that the
acquiring company does not disclose how the value of the company will be increased by the
acquiring company’s future actions. The principle is to try and avoid paying for the value that
you are going to create. However, you may have to give away part of the value to be created
to get the deal done.
Pitfalls
Applying valuation models is fraught with pitfalls, whichever approach is used. Some of the
more common pitfalls include:
■■ Confusing the valuation of the firm with the valuation of the equity. Valuation of equity
requires bottom line earnings/cash flows discounted at the cost of equity. Valuation of the
firm requires operating profit/cash flows discounted at the WACC.
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■■ Not adequately recognising a change in gearing during the valuation period and the effect
this has on the cost of capital.
■■ Not recognising that earnings/cash flows emanating from new assets are riskier than those
from replacement assets, and that the discount rate should therefore increase.
■■ Not being able to find comparable firms to use as benchmarks for relative valuations
■■ Not recognising that control is worth something. Consider carefully what additional value
is to be generated through control.
■■ Double counting risk by reducing expected returns and increasing the discount rate.
■■ Double counting synergies by increasing expected returns and reducing the discount rate
for the risk reduction.
■■ Including a premium for control by up to three times, by increasing expected returns,
reducing the discount rate and adding a premium.
■■ Increasing the discount rate to account for additional country risk. Most of the country
(sovereign) risk is already reflected in the risk-free rate.
■■ Recognising the income from non-core assets and adding the value of these assets, as this
constitutes double counting.
Challenges
High growth, startup, and loss-making companies provide particular challenges in valuations. There is no history to guide the future, or the future may look markedly different from
history. In such cases the basic principles still apply, but the valuer must be all the more rigorous in understanding the underlying fundamentals that are expected to drive the future
value. A useful technique is to assume an acceptable or target value at an appropriate date
in the future (e.g. sell-off date, listing plan). Then work back from this value to see what
the key variables to justify this value must be. In this way the great uncertainty is identified in a small number of factors. These can then be assessed and possibly actively
managed.
For example, how do we value a company such as Amazon.com? Work back from the future.
What share of the retail market is Amazon.com expected to achieve within the next 10 years?
What is the operating margin that Amazon.com can achieve in relation to other traditional
retailers? What is the investment that the company is required to make in inventory and
working capital? Estimating future market penetration and margins enables us to determine
whether the current listed price is reasonable as the market has limits.
PERSPECTIVES
Valuations in the real world
by Greg Beech
Greg Beech, is a CA (SA), and has over 22 years experience in the mergers and acquisition
advisory industry. He has also worked in private equity for various investment banks. Greg
chairs the APC Examinations Committee at SAICA and lectures part time at GIBS and
Wits Business School.
The ability to value a listed company, private company or joint venture,
is a pervasive skill required in business. At some stage in your career
you will be required to perform a valuation or review one. Learning the
mechanics of DCF and earnings based valuations is important to avoid
an error. However, you should make peace with the fact that your valuation is likely to be
incorrect. All valuations, except those in a liquidation scenario, are forward looking. In
DCF valuations, we present value the forecast free cash flows into infinity. In earnings based
valuations, we estimate sustainable profits by reviewing historical performance and forward
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projections. Given that valuations are implicitly forward looking, we should acknowledge
that we are unable to predict the future with 100% accuracy.
Having made peace with the fact that we are likely to under or over-estimate the
future cash flow and profit performance of a business, the objective in our valuations
should be to minimize the error. As mentioned above, it is critical that we do not make
technical errors in our valuations. We should know and apply the theory correctly to the
circumstances. For instance, the cost of equity and WACC formulas should be ingrained
into our memories for the purposes of DCF valuations. We should endeavour to critically
evaluate historical and forecast profits for non-recurring items and possibly for accounting
adjustments that are more appropriately treated as assets or liabilities. For example, it
may be preferable to exclude ‘income from associates’ from sustainable profits for the
purposes of our earnings based valuations and rather add the fair value of the investment
in the associate company to the valuation result. Naspers’ investment in Tencent, the
Chinese based social media and online gaming business, is a classic case of this dilemma.
When valuing Naspers, we could either apply a PE multiple to the income from Tencent
or value its 33.8% interest in Tencent separately. The latter is recommended and would
involve valuing Naspers’ core operations and then adding the fair value of its stake in
Tencent to that valuation result.
The most common errors in DCF valuations that I encounter in practice include:
■■ Using a short dated government bond yield as the risk free proxy. We should rather use
actively traded government bond yields which are redeemable in 10 or 20 years time;
■■ Over optimistic forecasts of future cash flows. Sometimes these forecasts assume
growth in cash flows, which are unlikely to be achieved without significant investment
in infrastructure to support this growth. Also, growth may assume that the company’s
market share grows to unrealistic levels. The current hype in social media company
valuations may assume growth in the digital advertising market which is unrealistic;
■■ Target capital structures used in the estimation of WACC, which have little
resemblance to practical reality. For example, assuming a constant debt to equity
ratio of 30% whereas the forecast cash flows indicate that the business will be cash
generative and have no need for debt facilities in two years time;
■■ Calculating WACC based on book values of debt and equity instead of market values
thereof; and
■■ Forecasting free cash flows for three years and then assuming a constant growth
thereafter. It may be more sensible to forecast cash flows for the next 20 or 30 years,
if the business is Eskom.
Earnings based valuations often include errors and ‘over-exuberance’. Errors that I
sometimes encounter include:
■■ ‘J curve’ profit projections. For example, a business that has been experiencing
declining profitability is suddenly assumed to increase EBIT by 30% per annum for
the foreseeable future; and
■■ Blindly using published listed company EBIT or EBITDA multiples without
first interrogating these or recalculating them first. Reported profits may require
adjustment for non-recurring items such as impairments prior to determining historic
PE multiples.
Valuing businesses provides an intriguing challenge. We can always review our valuation
results of listed companies against their future share prices. Some such as Robert Shiller
would argue that this is a futile exercise given that stock markets, in his opinion, tend to be
‘irrationally exuberant’ and may over-value listed company shares. Be warned though that
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whilst stock markets may be volatile in the short term, in the long term they are remarkably
efficient.
The valuation of private companies is very challenging in practice. The number of
private companies far outweighs listed companies and hence, we are likely to be presented
with more opportunity to test our expertise in this arena. The valuation principles applied
to private companies are identical to those in valuing listed companies except that we do not
have published betas and earnings multiples. We therefore need to use data from similar
listed companies and adjust these to our particular circumstances. The on going challenge
in valuing private companies is to use an appropriate discount for the lack of marketability
of their shares and to identify specific risks.
The exciting part about valuations as a topic is that it is inextricably linked to most other
areas of financial management. Competencies such as financial analysis, risk and return,
the time value of money, working capital management, capital structure, strategy and risk
management are all implicitly part of the valuation process.
Summary
The most important factors that influence all valuations are the risk and the return applicable to the asset being valued. The value is the present value of future cash flows. To
calculate this, an estimate of the future cash flows is needed. These amounts must then be
discounted to the present at the required rate of return, the appropriate rate of return being
determined by the risk pertaining to those future cash flows. This is the basic principle upon
which all valuations are based.
We have valued debentures and bonds by discounting future coupon payments and the
principle amount at the market yield. The valuation of preference shares is similar to the
valuation of debentures and bonds.
We have used the dividend discount models, free cash flow models, price multiples such
as the P/E ratio and the EVA approach to value ordinary equity. The use of valuation models
will help the financial manager in relevant decision-making.
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S
SELF-STUDY PROBLEMS
S6.1
Maxcor Ltd issued corporate bonds five years ago with a coupon rate of 12% and a par
value of R100. The current date is 1 July 20x4. The redemption date is 30 June 20x9 and
the coupon payment occurs on 30 June of each year. Bonds issued by firms of similar risk
and with the same term to maturity, are currently trading on yields of 8% per year. What is
the value of each bond issued by Maxcor?
S6.2
Metro Ltd has issued bonds with a face value of R100 which pay a coupon rate of 6%.
Coupon payments are payable semi-annually. The quoted yields on similar bonds are currently 8% per year. The maturity date is in 10 years’ time. What is the value of each Metro
bond? What is the bond’s annual effective yield?
S6.3 [Note: 6.3, 6.4 and 6.5 are related questions]
ABC Ltd operates in the pharmaceutical sector and has just paid a dividend of 20 cents per
share. The shareholders require a return of 12% per year. The company expects to be able
to grow its dividend by 6% per year indefinitely into the future. What is the value of each
ordinary share in ABC?
S6.4
What will happen to the value of each share in ABC Ltd above if the company is able to
grow its current dividend of 20 cents per share by 20% per year for the next 3 years and
thereafter growth is expected to be 5% per year?
S6.5
Assume that ABC Ltd now decides to commit all its earnings to finance research into the
development of new drugs and no dividend will be paid for the next 4 years. The dividend
in Year 5 is expected to be 40 cents, and thereafter dividends are expected to grow at a rate
of 8% per year. What is the value of each share in ABC Ltd?
S6.6
Large Ltd is a listed industrial company. Extracts from its annual report are as follows:
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The retained profit will be used to fund expansion while the depreciation charge will be used
to cover asset replacement. The cost of equity is estimated to be 12% and the weightedaverage cost of capital is 11%. The average price earnings ratio for industrial companies
listed on the JSE is 15x. Financial analysts have estimated Large to have a beta of 1.5. From
the year 20.5, cash flows and dividends are expected to grow at the rate of 6% per annum
in perpetuity. The company tax rate is 28%.
Required
Calculate the value of the equity as at 30 June, 20.0, using three different approaches.
Solutions to self-study problems
S6.1 Solution
The value of a bond consists of adding the value of an annuity [the coupon payment] to the
present value of a single sum [the maturity value] to be received in five years time.
Using formulae to value an annuity and the present value of a single future single amount:
[
] [
1 2 ______
​  1 5 ​
(1.08)
__________
1
Value = 12 ​
​ 1 100 ​ __________
​ 0.08
(1 1 0.08)5
]
Value = 12[3.9927] + 100[0.6806]
= 47.91 + 68.06
= 115.97
Using a financial calculator:
Remember to enter 12 and press PMT, enter 5 and press N, enter 8 and press I/YR, enter
100 and press FV and finally press PV and the calculator will return a PV of 115.97. The
FV in this case refers to the face value of R100 due on maturity.
Using Excel, the long way, we calculate the following:
S6.2 Solution
The interest rate is 4% per six months and there are 20 semi-annual payments.
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Using formulae to value an annuity and the present value of a single future single amount:
[
] [
1 2 _______
​  1 20 ​
___________
1
(1.04)
___________
Value = 3  ​ 1100 ​  (1 1 0.04)20 ​
​
0.04
]
Value = 3[13.5903] + 100[0.4564]
= 40.77 + 45.64
= 86.41
Remember that we need to divide the interest rate per year by the number of compounding periods per year and double the number of years to obtain the number of six-monthly
periods.
Using a financial calculator, the solution will be as follows:
The annual effective rate is [1 + 0.08/2]2 – 1 = 8.16%. In terms of market convention, if
interest is payable semi-annually at a rate of 4%, the rate per year is quoted as 8%.
However, the correct rate is the annual effective rate of 8.16%.
S6.3 Solution
The current dividend [D0] is R0.20.
Constant growth rate = 6%
Required return = 12%.
The value of each share is:
Value = D0(1 + g)/(k – g)
= 0.20(1.06)/(0.12 – 0.06)
= R3.53
S6.4 Solution
The company’s dividend will grow at a rate of 20% per year for the next 3 years and thereafter the dividend will grow at a constant rate of 5% per year.
The dividend in Year 1: 0.20 × 1.20 = 0.24
The dividend in Year 2: 0.24 × 1.20 = 0.29
The dividend in Year 3: 0.29 × 1.20 = 0.35
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S6.5 Solution
It is sometimes assumed that we cannot use the dividend growth model to value the shares
of companies that are not paying a dividend. Yet, a company will pay a dividend in some
form, at some time in the future. In this case, the company expects to pay a dividend in 5
years’ time. The value of the share relates to a dividend of 0.40 receivable at the end of Year
5, which will grow at a constant rate of 8% per year thereafter.
The value of the share at the end of year 5 will be:
Value5 = D5(1 + g)/(k – g)
= 0.40(1.08)/(0.12 – 0.08)
= R10.80
If we add the dividend of R0.40 receivable at the end of Year 5, then we obtain a total
value of R11.20 at the end of Year 5. However, we need to discount this value by 12%
per year for 5 years to obtain the current market value of the share. The PV factor is
0.5674 [1/(1 + 12%)]5 .
Value0 = R11.20 3 0.5674 = R6.36
S6.6 Solution
1. Dividend discount model
We can firstly discount the total dividends for the planning period. The value of the dividends for the first five years is R206.2m.
We can determine the value of the equity at the end of year 5, by applying the dividend
growth model:
Value5 = D5(1 + g)/(k – g) = R83m(1 + 0.06)/(0.12 – 0.06) = R1 466.3m
Value today = R1 466.3m/(1.12)5 = R832.0m
Total value = R206.2 + R832.0m = R1 038.2m
2. Price-earnings ratio
Large would appear to be more risky than the average industrial company as the beta is high at
1.5. Thus a fair price-earnings ratio would be in the region of 10. We will apply a forward P/E
of 10.
E1 = 120
V0 = 120 3 10
= R1 200 million
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3. Free Cash Flow to the Firm approach
The valuation methods give us a range of values – from R1 038m to R1 241m for the
equity of the company. The net asset value is only R376m. Simplifying assumptions for
our dividend and free cash flow models also create differences.
APPENDIX 6.1
Lack of marketability discount and other adjustments
The lack of marketability discount is relevant in the valuation of a private company. If one
compares a listed entity to a similar non-listed entity then one can reasonably assume that
the non-listed entity will have a lower value than the listed company. Investing in a listed
company (if actively traded) will mean that investors can realise their investments at the
quoted price within a short period of time. Marketability is about how quickly an investment
can be realised at a given or quoted price. The size of what the lack of marketability discount
should be, is always difficult to determine, as one cannot directly observe lack of marketability
discounts. However, one is able to determine which lack of marketability discounts investment
banks, accounting firms and other valuation experts use in their valuations. An important
survey is the PwC Valuation Methodology Survey, which includes leading investment banks,
private equity firms, and accounting firms operating in South Africa. Investors in unlisted
and private companies will require a higher required return due to the lack of marketability
or liquidity. The adjustment occurs by deducting a lack of marketability discount after we
have determined the value of an investment.
What is the evidence for a marketability discount? Firstly, we can use survey data and
according to the 2012 PWC Valuation Methodology Survey, an appropriate discount for an
equity interest less than 24% is 15%. In the PWC survey, 82% of respondents indicated that
they do apply marketability discounts, mainly to the market value of equity. The range of
discounts applied either to equity or enterprise value by SA firms are indicated as follows:
A further indicator of marketability is to monitor how shares that have restrictions on
trading are priced to the underlying freely tradeable shares.
In terms of Sasol’s BEE ownership structure, the Sasol BEE shares (SOLBE1) were
listed and have traded on the JSE since February 2011. An investor can sell his/her Sasol
BEE Ordinary shares to BEE compliant persons up to 7 September 2018 and thereafter an
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investor can sell the SASOL BEE shares to anyone. Therefore, there are restrictions on the
sale of these listed shares until 2018. Sasol is one of the most liquid shares on the JSE and
the Sasol BEE shares (by cash invitation) have the same economic rights as the ordinary
Sasol shares. As the pool of BEE investors is limited, a major difference between the listed
prices of Sasol and Sasol BEE shares will relate to the lack of marketability. In fact, the
volumes traded and the bid-ask spreads indicate there are serious illiquidity issues relating
to the sale of Sasol BEE shares.
The Sasol BEE (SOLBE 1) shares traded at an average discount of 26% for the period
of February 2011 to November 2014. The range is 20-30% except for the short period of
November 2011 to February 2012 when it reached 33%-35%. In the USA, studies and court
cases have used discounts that are mostly in the range 20-30%.
Figure 6.2 Share price movements of Sasol and BEE Sasol (SOLBE1) shares
We noted previously that Brait used an EBITDA multiple of 8x when the average comparable
company was trading on an EBITDA multiple of 11.6. This represented a discount of 31%
to account for Pepkor’s unlisted status.
Minority discounts
A minority discount is different to the marketability discount as it relates to the lack of
operational control. PwC state that minority shareholders cannot set dividend policy or
the timing of dividend payments, nor influence the appointment of directors, and are not
able to decide on the sale or purchase of assets or which suppliers should be selected and
so on.
The PwC Survey found that 82% of respondents apply a minority discount and apply
this to the market value of equity when using the income approach (DCF free cash flow)
valuation method. The use of minority discounts is often not applied when using the
market approach (price multiples) as the listed share price in most cases reflects a minority
valuation. This is why when a listed company is subject to a take-over, we see a significant
rise in the share price. The average minority discount was 18% for a 1-24% interest and
14% for a 25-49% interest.
The relevance of applying a minority discount depends on the nature and purpose of the
valuation. It is expected that there would be an additional discount for a minority interest
as opposed to a controlling interest in a private unlisted company although there will be
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an interweaving of marketability and minority discounts. It is more difficult to sell a noncontrolling interest than a controlling interest in a company even for an unlisted company.
PwC in the 2012 Valuation Methodology Survey state that:
Even after we discount the minority interest for the lack of control, it is usually harder
to sell a non-controlling stake than a controlling ownership interest. The marketability
discount is therefore expected to decrease with the size of the ownership share.
PwC (2012) go on to state that: “even controlling ownership interests will be subject to some
form of illiquidity discount”.
Control premium
If we use price multiples such as the price-earnings ratios of listed companies, to value the
equity in an unlisted company, then it is relevant to note that these price–earnings ratios
often reflect minority valuations. Therefore, if we are valuing a controlling interest in an
unlisted company, we should then add a control premium to the equity value. The PWC
2012 survey found that 85% of the respondents did make a control premium adjustment
and the average premium applied for a 51-74% interest was 19%, while a 75-100% interest
attracted an average premium of 22%.
Firms also make adjustments to the discount rate for specific firm risks. We will refer to
these adjustments in Chapter 7 where we discuss cost of capital.
APPENDIX 6.2
Exploring selected issues in Valuations
By Johnathan Dillon
In this section we will evaluate how specific issues and instruments may impact on the
valuation of a company or the ordinary shares of a company or group. We will expand our
section on the valuation of preference shares by considering the valuation of participating
preference shares and convertible preference shares. We will then evaluate how we should
consider how we should include non-controlling interests and treasury shares in our
valuation of a group of companies. Finally, we conclude by evaluating how to adjust for
operating leases in our valuation of a company.
Participating preference shares
In addition to receiving their stipulated preference share dividend, participating
preference shareholders receive a portion of equity earnings. The valuation of a
participating preference share therefore involves the valuation of the future preference
dividend stream, as covered in the previous examples, as well as the valuation of their
equity income participation portion.
Example 6.1.1: Valuation of participating preference shares
8 million participating preference shares were issued for R1 that pay an annual preference
dividend of 4% on the issue price. The participating preference shares are irredeemable and
shareholders are entitled to 10% of any dividend distributed to ordinary shareholders i.e.
if ordinary shareholders receive a dividend of R2 million then the preference shareholders
receive an additional dividend of R200 000. The company has 10 million ordinary shares
in issue, which are currently trading at a price of R5 per share. Similar non-participating
preference shares listed on the stock exchange yield an 8% dividend. Assuming a person
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holds 100 of the company’s participating preference shares, what is the value of his/her
preference shares?
(i) Value the preference share dividends in perpetuity:
(R1 × 4%)/0.08 = R0.50
(ii) Value the equity income participating portion:
Market value of ordinary shares = 10m × R5 = R50m
Therefore, equity value attributable to the participating preference shareholders
= R50m × 10% = R5m
Value of the participating portion per preference share
= R5m/8m = R0.625 per share
Therefore, the total value of each participating preference share
= R0.50 + R0.625= R1.125
And the total market value of 100 participating preference shares
= 100 × R1.125 = R112.50
Any other instrument that also has a participating portion, such as participating debentures,
will be valued in the same way as illustrated above.
Convertible preference shares
Convertible preference shares are convertible into another financial instrument, usually
ordinary shares, sometime in the future. They may automatically convert on a specific date
or at the option of the holder or firm. The valuation of convertible instruments is complex as
these instruments effectively include an option, namely the option to convert. The valuation
of a convertible preference share therefore involves the valuation of the future preference
dividend stream, as covered in the previous examples, as well as the valuation of the option
to convert. A simplistic example is presented below, which ignores the valuation of the
option component (as this is covered in Chapter 18 in greater detail), in order to introduce
some of the basic concepts associated with valuing instruments.
Example 6.1.2: Valuation of convertible preference shares
Convertible preference shares were issued for R100 that pay an annual preference dividend
of 5% on the issue price. Each preference share is convertible at the option of the holder
into 2 ordinary shares in 10 years time. If the shares are not converted at that point in
time, they can be redeemed for the original issue price or become non-redeemable with an
increased annual dividend of 7% payable thereafter. The current market price of ordinary
shares is R24 and it is expected to rise to R62 in 10 years time. Similar non-convertible
preference shares listed on the stock exchange yield an 8% dividend. What is the value of
one convertible preference share?
Following a simplified approach, the minimum value of the convertible preference share
is the future dividend stream of the preference share for 10 years plus the expected maturity
value. In this instance there are three options available to the preference shareholders in
10 years time:
1. If converted, the ordinary shares obtained are expected to be worth R124 (R62 × 2
shares);
2. If redeemed then R100 will be realised;
3. If neither of the above are selected and the shares become non-redeemable then each
preference share is expected to be worth R87.50 ((R100 x 7%)/0.0.8).
Based on the above possible maturity values, it is assumed that preference shareholders will
exercise their right to convert in order to obtain the greatest value of R124.
The value of one convertible preference share will therefore be (discounting the future
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cash flows/value using the 8% yield for similar non-convertible preference shares) = ((R100
× 5%) × 6.710) + (R124 × 0.463) = R90.96.
It is important to note that this example has been solved simplistically – the technically
correct approach to valuing convertible instruments is to value the option (right to convert)
separately as covered in Chapter 18. Furthermore, a higher discount rate than 8% should
be used when discounting the equity value of R124 (ideally the cost of equity) because of
the uncertainty relating to the market price of ordinary shares (equity conversion value
obtained) on conversion date.
This next section considers a number of issues that are often overlooked or incorrectly
dealt with when valuing a company or group of companies.
Issues relating to the valuation of a group of companies
Non-controlling interests
Non-controlling interests (NCI), also known as minority interests, within a group of
companies represent portions of subsidiary companies that do not belong to the shareholders
of the holding company. Therefore when valuing the ordinary equity of a holding company
or any instrument linked thereto (e.g. convertible or participating preference shares) all
NCI is to be excluded. In such an instance the valuation is only concerned with valuing the
equity interests of the holding company and earnings flowing to the holding company’s
shareholders i.e. the earnings after NCI have received their share of the subsidiary
company’s income.
In this instance 80% of the
Subsidiary company’s assets and
liabilities (or earnings/cash flows)
must be included when valuing the
consolidated group of companies
(i.e. Holding company plus its 80%
interest in Subsidiary company).
Figure 6.3 Non-controlling interest
Excluding the NCI value from the value of the group is usually done in one of the following
two ways:
■■ The entire subsidiary company’s value is included in the value of the group and then
the NCI value is deducted. This is usually done by including the aggregate of the
subsidiary company’s earnings or cash flows (depending on the valuation approach
adopted) when valuing the group. In such an instance the estimated market value
of the NCI must then be deducted (especially if the book value thereof does not
approximate market value).
■■ Alternatively, a subsidiary company’s earnings or cash flows can initially be excluded
when valuing the holding company. In such an instance the subsidiary company
is valued separately (assuming sufficient information is available) and then the
proportion thereof owned by the holding company is added onto the initial value of
the holding company determined when excluding the subsidiary company.
Treasury shares
Strictly defined, treasury shares are shares that a company has repurchased from
shareholders and are held by the company as an investment in itself (i.e. the shares remain
issued share capital and are not cancelled) – this is not permitted in South Africa by the
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Companies Act of 2008, as explained in Chapter 16. The Companies Act does however
permit a subsidiary company(ies) to acquire a maximum of 10% of the issued share capital
of its holding company and any such shares do not need to be cancelled but they carry no
voting rights. Effectively in a group context these are treasury shares held within the group,
which ‘cancel out’ upon consolidation. Any such treasury shares are in fact owned by the
holding company’s shareholders indirectly through the subsidiary company.
Therefore when valuing a group of companies, a simple way of dealing with this issue
is for any shares of the holding company that are held as treasury shares by its subsidiary
companies within the group to be deducted from the number of shares outstanding (issued
share capital) of the holding company. The equity value of the group on a per share basis
is then calculated as the equity value of the group (holding company plus subsidiary
companies) divided by this lower number of equity shares of the holding company held
‘outside’ the group.
The impact of operating leases on free cash flow valuations
As with capital structure and cost of capital, operating leases should also be adjusted for
when valuing firms. Adjustments for operating leases in the free cash flow valuation would
essentially remove the interest component of the operating lease expense from operating free
cash flows and then deduct the present value of the future minimum lease payments, together
with other liabilities, from the firm value determined in order to derive the value of equity.
With these adjustments, profits will not be impacted by operating leases but there will rather
be a capital expenditure cash flow deducted relating to operating leases (as would be the
case with finance leases or other property, plant and equipment purchased). Technically these
operating lease adjustments should be made to remove the financing component of operating
leases from the firm’s free cash flows and correctly value the operations of the firm.
By making the adjustments described above, firm value would be higher due to the higher
free cash flows from operations. However, this higher value is subsequently reduced by the
operating lease liability that is deducted. Therefore irrespective of whether the adjustment
is made or not, should the same equity value not result? This was the topic of a research
paper by Aswath Damodaran entitled, “Dealing with Operating Leases in Valuation”, in
which the following was concluded:
“Converting operating lease expenses into financing expenses should have no impact
on equity valuation… As long as the debt ratio stays stable, and operating leases are
fairly valued, treating operating leases as debt should have a neutral effect on the
value of the equity in the firm.” (Damodaran, 1999 NYU Working Paper)
This is however debatable as the debt ratio does in fact change when capitalising operating
leases – refer to Chapter 7 for more in this regard.
Appendix 6.3 Perspectives
The subjective nature of valuations
Gary Swartz is head of the Institute of Accounting Science, and he offers us his perspectives
on valuations. Gary has a Masters degree in Finance and is also a Chartered Accountant
(SA). He has a wealth of experience in teaching Management Accounting and Finance at
undergraduate and post-graduate levels. His research interests include value relevance,
valuation models, sustainability and intellectual capital. Gary is also integrally involved
in the profession, sitting on a number of committees for the South African Institute of
Chartered Accountants (SAICA). Prior to the Institute of Accounting Science, Gary was
an Associate Professor at WITS University for 13 years, and previous to that spent 7 years
at Deloitte, including two international secondments to Los Angeles and Miami.
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Although based on quantitative methods, valuations are heavily reliant on qualitative
assumptions, and are therefore at best, an art. Valuations are influenced by institutional,
macroeconomic and personal factors, which are all continuously changing, and are in
essence, an attempt to predict and quantify the future. When determining variables, what
may be valuable to one person may actually be considered detrimental to another.
In addition to this, many qualitative factors are not captured in rigid quantitative
methods despite their obvious impact on value. Some of these factors may influence value
in the eyes of many, while others may be important only to a few. Below is a sample of
factors that can impact value but which are not directly taken into account with traditional
quantitative approaches:
■■ Dominant market share
■■ Location of operations
■■ Union-management relations
■■ Competence of management
■■ Company size and critical mass
■■ Strength of competition
■■ Technological capability and expertise
■■ Size of backlog
■■ Strength of customer–vendor relationships
■■ Tax considerations
■■ Intangible assets
While valuing a company is not an exact science, it is also not a total mystery. Valuation is
an art developed through experience, and through careful consideration of the methods and
variables available. Given the complexities of analyzing all the direct and indirect factors
influencing a company’s value, it is often a good practice to develop a range of possible
values using different methods, and performing scenario and sensitivity analysis thereon,
including quantifying risk using statistical modelling thereby quantifying a realistic range of
fair market value.
Usefulness of the annual financial statements
The usefulness of historic cost financial statements is also increasingly being questioned,
the main limitations being the historic cost nature, complexity, and being bound by
reporting standards. The introduction of IFRS 13 (replacing the use of the international
valuation standards) by the IASB is an attempt to remedy this shortfall by closing the gap
between market value and book value by requiring assets to be fair valued in line with
finance valuation principles. The standard brings IFRS significantly closer to market value
principles in its valuation principles, which are for the most part in line with commercial
valuation principles. The standard however limits the closure of this gap by fatally requiring
verifiable valuation measures to be used first, and only at the extreme to use non-verifiable
methods and variables.
This is understandable considering the need to audit annual financial statements, which
would become incredibly difficult with non-verifiable inputs, however it does still place a
severe limit on the value relevance of the financial statements.
The end result of the implementation of IFRS 13 is therefore that the annual financial
statements are not necessarily more useful from a valuation perspective per se, but they are
required to disclose a significant amount of additional information where non-verifiable
methods are used. It is therefore a step in the right direction, but we still have a long way to
go to close the book to market gap.
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Q
QUESTIONS
Question 6.1
If it is true that the stock market is efficient, and that publicly available information is reflected
in the share price, what is the point in carrying out a valuation of a listed company?
Question 6.2
If shares in a company are widely held, then a potential agency problem exists between management and the company’s shareholders. Explain why shareholders may have legal control but not
effective control of the company.
Question 6.3
Calculate the value of a R100 debenture in each of the circumstances detailed below. The
debenture pays a coupon rate of 11% and the required rate of return is 9% per year.
(a) In perpetuity
(b) Redeemable in 6 years’ time at par
(c) Redeemable in 6 years’ time at a premium of 10%
(d) Purchased one year ago at a discount of 10% and redeemable in four years time at par
Question 6.4
Blackwall Ltd issued corporate bonds 3 years ago with a coupon rate of 10% and a par value
of R100. The redemption date is 31 December 20x10 and the coupon payment occurs on 31
December of each year. The current date is 1 January 20x5. What is the value of each bond
issued by Blackwall if the bonds issued by firms of similar risk and with the same term to maturity, are currently trading on yields of 7% per year?
Question 6.5
African Supplies Ltd has issued bonds with a face value of R100 and which pay a coupon rate
of 7% per year. The company is required to make coupon payments semi-annually on 30 June
and 31 December of each year. The current date is 1 July 20x5. The yields on similar bonds are
currently 8% per year. The maturity date is in 5 years’ time. What is the value of each bond?
What is the bond’s annual effective yield?
Question 6.6
Calculate the value of 1 000 preference shares in A Ltd. The dividend rate is 10% on an issue
price of R1 per share and is cumulative. Dividends are three years in arrears and no dividend
is expected for another two years from today (i.e. the company will pass one more year of dividends). It is expected that arrear dividends will be made up over a two-year period once dividend
payments are recommenced. The return on similar preference shares is 13%.
Question 6.7
Mirton Ltd has non-cumulative non-redeemable preference shares in issue. The issue price is
R100 each and the coupon preference dividend rate is 12% per annum, payable once a year in
arrears. The company has not paid out a dividend in recent years but expects to recommence
dividend payments in two years time from today. What is the value of each preference share if
similar preference shares are quoting yields of 10% per annum?
Question 6.8
QTS Ltd has issued debentures, which have a coupon rate of 8% and mature in 10 years time.
The face value of each debenture is R100. Assuming semi-annual coupons, what is the value of
each debenture? Debentures with similar risk profiles are offering yields of 10% per year.
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Question 6.9
Smithlite Ltd is currently paying a dividend of 30 cents per share. The required return (cost of
equity) is 12% per year. The company will maintain the dividend at its current level indefinitely
into the future as the company’s earnings are not expected to grow in future years. What is the
value of each ordinary share?
Question 6.10
Naledi Ltd is currently paying a dividend of 80 cents per share. The company expects to be able
to increase its dividend by a constant growth rate of 5% in the future. Shareholders require a
return of 11% per year. What is the value of each share in the company?
Question 6.11
WUW Ltd is listed and the company’s share price is currently trading at a price of R24. The
company has recently paid a dividend of R1.20 per share. The shares in the company had been
trading at R25.20 prior to the dividend. Shareholders require a return of 11% per year. The current dividend is expected to grow at a constant growth rate in the future. What is the constant
growth rate in dividends that shareholders expect to achieve?
Question 6.12
Mr Buffo has purchased 100 000 shares in Bolton Ltd at a share price of R15 per share. The
company has recently paid a dividend of R0.90 per share. The current earnings per share is
R1.25. The company is expected to achieve a constant growth in earnings and dividends of 6%
per year. What is the expected rate of return that shareholders expect to achieve? What is the
current dividend yield? What is the company’s current P/E ratio? What is the firm’s forward
P/E ratio?
Question 6.13
Clifton Ltd manufactures swimwear, fashion accessories and sunglasses. The company’s designs
have resulted in a high growth rate in earnings and dividends. The company expects to grow
its current dividend of 120 cents per share by 30% per year for the next 4 years and thereafter
growth is expected to be 5% per year? If shareholders require a return of 10% per year, what is
the value of each ordinary share in Clifton Ltd?
Question 6.14
Biofirst Ltd is experiencing high growth in earnings but does not pay any dividends. However, it
is expected that the company will commence paying dividends in 5 years’ time and the first dividend will be R1.40 per share. The dividend will grow at 6% per year thereafter. If the required
return is 10%, what is the value of the share?
Question 6.15
Mac Bank has issued non-redeemable, non-cumulative converting preference shares (CPS) with
an issue price of R100 per share. The dividend rate is 7.38% p.a. payable half-yearly in arrears
on 15 June and 15 December each year and the Conversion Date. The preference shares converts at a 5% discount to the prevailing market price of Ordinary Shares. You may assume that
the expected price of ordinary shares in Mac Bank on conversion date is R29.00. The current
market yield for similar preference shares is 6% per year (3% half-yearly).
Required:
Value each preference share if the conversion date is 15 June 20x4. Assume the current date is
15 June 20x3 (just before the preference dividend payment, which you will receive). What is the
yield to maturity? If the share price is expected to be R35, rather than R29 on conversion date,
will this change your valuation? (Indicate simply whether it will increase, decrease or have no
effect on your valuation.)
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Question 6.16
Sunlite Ltd has issued zero coupon bonds of R100 each which are redeemable on 30 June 2015.
Similar bonds with an ‘A’ rating are currently indicating a market yield of 8% (4% per half-year).
The company has also issued bonds of R100 each with a coupon rate of 10% per year, interest
payable semi-annually, which also mature on the same date in 2015. Similar bonds are offering
an annual market yield of 8% (4% per half-year). The current date is 1 July 2005.
Required:
(a) Value the zero coupon bonds at the current date.
(b) Value the 10% coupon bonds at the current date.
(c) Indicate as an investor which bond you would prefer if you were expecting market interest
rates to rise.
Question 6.17
Alin Gas is a major utility, being a provider of gas in the country. The company is expected to
experience solid growth of 12% per year in after-tax earnings for the next 4 years, after which
earnings are expected to grow at a sustainable growth rate of 5% per annum. As Alin Gas is a
utility company, it is seen as low risk and the cost of equity of the company is estimated to be
10%.
Alin Gas has just declared a dividend of 33 cents per share for the 20x3 financial year and the
company is expected to maintain a constant dividend payout ratio of 70% of after-tax earnings
in the future. The listed share price is R6.57 at 31 December 20x3. Assume there is a year until
the 20x4 dividend.
Required:
Using the Dividend Discount Model, determine the value of each Alin Gas ordinary share, if the
cost of equity for the company is 10%.
Question 6.18
Amcor Limited is a global packaging company, with a major share of the market for metal, paper
and plastic packaging. The company has issued unsecured convertible notes (bonds) with the
following terms:
Par value: R9.35
Coupon rate: 6.5% payable semi-annually on 1 April and 1 October.
Redemption date: 1 October 20x3 or 1 October 20x8.
The current market interest rate for similar bonds is 6%. As the current share price is significantly below the conversion price, you can assume that the conversion option has no value.
Required:
(a) Value each Note, assuming a redemption date of 1 October 20x8. If the current listed price
of each Note is R8.60, indicate whether you would invest in the Amcor Notes. Assume the
current date is 1 April 20x2 (after the payment of interest).
(b) If the share price per ordinary share is R8.08 in April 20x3, and this is expected to remain
at the same price until October 20x3, indicate how this compares to the price of the Notes
at that time of R10.55. (Conversion terms: 1.27 shares per Note.)
Question 6.19
BHP Billiton has experienced a significant improvement in operating cash flows due to favourable macro­economic and geopolitical factors and due to strong demand by China. The market
prices of resources have risen dramatically in US Dollar terms. BHP Billiton has reported
significant growth in earnings for the year ending 30 June 2004 and the company reported an
increase in EPS to US$0.55 (R3.87) as compared to US$0.30 in 2003. The substantial rise in the
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value of the South African rand means that the improvement in BHP Billiton’s earnings is less
when stated in rands. Earnings and dividends are expected to grow by 18% over the next 5 years
in rand terms; thereafter the growth rate will be 7% per year. The dividend in 2004 amounted
to R1.73. The listed price of BHP Billiton in June 2004 was around R59.30.
Required:
Using the Dividend Discount Model, determine the value of each BHP Billiton ordinary share,
if the cost of equity for BHP Billiton is 10%.
Question 6.20
CM Ltd is a company operating in the retail sector. The company experienced some difficult
trading conditions in 20x2 and the company’s share price had fallen in line with the difficulties
experienced by the group. In 20x3, the company’s dividend per share amounted to 26 cents and
Mr. O’Grady, an investment analyst, was recommending the share to his clients as he expected
margins to improve significantly in the future. The share price was around R6.50. In 20x4, the
price of CM had improved significantly and the price is R8.90 at the time of writing. The dividend had been increased to 29 cents per share. The significant growth in earnings means that
you expect the current dividend to grow at a rate of 20% per year for the next 4 years after which
you expect the sustainable growth rate to be 7% per year. The required rate of return is 11%.
What is the value of CM’s ordinary shares?
Question 6.21
Solar Link Ltd is a company which manufactures solar heating devices. The company has issued
debentures, which are paying an annual coupon interest rate of 14% per year, in arrears. The
par value is R100 per debenture. The debentures were issued 3 years ago and are redeemable in
5 years’ time. Market interest rates have fallen and similar debentures are now offering yields of
8% per year. Interest is payable in arrears and you can assume that the company has just made
an interest payment on 31 December 20x2, which is the current date.
Required:
Determine the value of each debenture at 31 December 20x2.
Question 6.22
In the annual financial statements of Alpha Limited for the year ending 31 December, 20.9, the
following long-term liability in outstanding bonds was disclosed in the Statement of Financial
Position:
Assume that the capital repayment of R2m per annum and the annual interest on the unsecured
bonds are payable on 30 September of each year. Interest is charged annually in arrears.
Required:
Value the bonds on 1 October, 20.10 if similar bonds are offering yields of 11% per annum.
Question 6.23
Nkandla Ltd is a recently established company involved in the design of financial accounting
software. The company has recorded high growth rates in earnings and dividends over the last
three years of 30% per annum. The company expects to experience a growth rate of 30% per
annum over the next three years, but thereafter expects growth in earnings and dividends to
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decline to a constant 8% per annum due to increased competition and maturing product lines. The
current earnings per share is R3.20 and the company follows a policy of maintaining a constant
dividend cover of two. The ordinary shareholders’ required rate of return is 13% per annum.
Required:
Determine the value of each ordinary share in Nkandla Ltd.
Question 6.24
A company recorded the following earnings per share (EPS) and dividend per share (DPS)
figures over the last five years.
The current risk-free rate is 8% and brokers have determined that over a period of four years,
the beta coefficient of the company has been very close to one. The current market premium
for investing on the JSE is 6%. The net asset value per share is 1742 cents. The current market
price of the company is R122.00 per ordinary share.
Required:
(a) Determine the return that investors require for investing in ordinary shares.
(b)What is the expected growth rate in dividends that is implicit in a market price of R122.00
per share? Are investors expecting a higher or lower growth rate than the past growth rate
(20.6–20.10) in dividend per share?
Question 6.25
The following information is available about two different ordinary shares, Company A and
Company B:
Company ACompany B
Earnings per share
R2.50
R7.25
Dividends per share
R1.00
R5.00
Growth in earnings
8%
4%
R26–R20
R60–R56
1.3
0.8
Price range

Risk-free return
7.0%
7.0%
Expected market return
13.5%
13.5%
Required:
On the assumption that the companies’ growth rates will continue, develop an estimate of the
value of the ordinary shares.
Question 6.26
NWM is a company which expects to generate the following after-tax operating cash flows for
the financial years 20x5 to 20x8, after which the company expects future after-tax cash flows to
grow at a constant and sustainable rate of 6% per year. The company’s cost of capital is 10%.
The company’s financial year-end is 30 June.
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The company has outstanding loans amounting to R42 million as at 30 June 20x4. There are
100m ordinary shares in issue. The company’s net investment in working capital is expected to
be 10% of sales revenue. The current level of net working capital is R15m. The company will
not need to invest in any further capital expenditure in the future. Operating cash flow to sales
from 20x9 will be at 6.667% of sales. What is the value of the ordinary equity of the company
at the end of 20x4?
Question 6.27
The board of directors of TP Cleaning Services (Pty) Ltd has discussed the possibility of listing
their company on the JSE. The activities of the company consist of the cleaning of office buildings
after hours and the cleaning of windows of office buildings. There is presently no listed company
in this business. The listing would be accomplished by offering 4 000 000 new ordinary shares of
five cents each to the public. This issue of shares would be structured to:
(a) obtain the required spread of shares in terms of the requirements of the Stock Exchange;
and
(b) strengthen the equity capital base for planned expansion.
The results of TP Cleaning Services (Pty) Ltd for the five years to 30 June were as follows
(amounts are given in thousands of rands):
For the six months to 31 December, 20x7, the turnover was R6.3m, the operating income R1.77m
and the net income after tax was R890 000. On 30 June, 20.7, the net asset value of the company was
R18m. As auditor of the company you have been asked to advise the board of directors on certain
aspects of the proposed listing.
Required:
Determine a possible issue price per share for the 4 000 000 shares, showing your workings and
reasoning and the assumptions you have made in arriving at the valuation.
Question 6.28
Laceto Ltd, a group specialising in the sale of electrical goods, is currently considering a takeover bid for a competitor in the electrical goods sector, Omnigen Ltd, whose share price has
fallen by 205 cents during the last three months.
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Summarised data for the financial year to 31 March 20x2:
The share price of Laceto is currently 380 cents, and Omnigen’s current share price is 410 cents.
Laceto has 80 million issued ordinary shares and Omnigen has 30 million issued ordinary shares.
Laceto’s non-current liabilities consist of 12% debentures with three years to maturity, at a par
value of R100, and a current market price of R105.20 per debenture.
The finance team of Laceto has produced the following forecasts of financial data for the
activities of Omnigen if it is not taken over. These estimates would remain the same after the
takeover except for the investment in fixed assets and net working capital, which would reflect
the same proportion to sales as Laceto’s investment in net fixed assets and net working capital.
The corporate tax rate is 28% per year, payable in the year that the taxable cash flow occurs.
Depreciation in 20x2 was R20m. The accounting depreciation charge is equal to the tax depreciation allowance.
The risk-free rate is 7% per year and the market equity premium is expected to be 5% per
year. Omnigen’s current equity beta is 1.2. This is expected to increase to 1.3 if the company is
taken over. The gearing for determining the cost of capital of Omnigen should be based on a debt
to equity ratio of 50%.
The future nominal cash flows of Omnigen after investment in non-current assets and net
working capital are expected to grow at 5% per year after 20x6.
Additional notes:
■■ The realisable value of Omnigen’s assets, net of all debt repayments, is estimated to be
R82.0 million.
■■ The PE ratios of two of Omnigen’s quoted competitors in the electrical industry are 13 and
15 respectively.
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Laceto expects to achieve the same rate of efficiency with Omnigen as it is currently achieving in
terms of its own investment in net fixed assets and its investment in net working capital. Both are
measured in relation to sales. Laceto’s current assets and current liabilities only reflect operating
working capital and the company has no surplus cash balances. Operating cash is 1% of sales. Any
fixed assets not required by Omnigen will be disposed at book value.
Omnigen has R5m in cash resources but is required to hold 1% of sales in cash to maintain
continuing operations and this reflects the same proportional investment as Laceto in operating
cash, which is included in the new working capital of Laceto.
Required
What is the maximum price that Laceto could pay for the shares of Omnigen on the basis of a
free cash flow valuation? Discuss any issues arising from this valuation. Also, briefly consider
the use of price-earnings ratios and net asset value to value the company.
(ACCA – adapted)
Question 6.29
Sippe Ltd is a company listed on the Stock Exchange. Sippe Ltd is a manufacturer of a range of
sports drinks and is the industry leader in this segment of the local beverage market. Mr. Hilton,
the financial director of Sippe Ltd, has approached you to assist in negotiations for the sale of a
25% equity interest in the business. The directors of Sippe Ltd collectively own 65% of the ordinary shares in issue and would like to sell part of their shareholding to Houston Beverages Inc.
Mr Hilton requires you to value the business of Sippe Ltd and the directors intend using your
valuation for the purposes of their negotiations. In order to assist you, Mr Hilton has provided
you with extracts from the projected Statement of Comprehensive Income and Statements of
Financial Position for the next three years together with extracts from the draft Statement of
Comprehensive Income and Statement of Financial Position for the year ended 28 February
20.1.
Additional information
■■ The abnormal item included in the 20.2 projected Statement of Comprehensive Income
relates to the discontinuance of the information technology activities of Sippe Ltd which it
intends outsourcing.
■■ Sippe Ltd proposes expanding its manufacturing capacity in 20.4 and R40 million of the
total 20.4 capital expenditure budget has been set aside for this purpose. No disposals of
fixed assets are budgeted for over the next three years.
■■ The investment in the associate represents a 49% shareholding in Rolling Wheels (Pty)
Ltd. Rolling Wheels (Pty) Ltd is a logistics company which distributes all of the products
of Sippe Ltd in the Gauteng and North West provinces. The shareholding in Rolling
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Wheels (Pty) Ltd was bought by Sippe Ltd four years ago when it decided to outsource
its distribution activities. The remaining 51% shareholding is held by a consortium of
investors who have control of Rolling Wheels (Pty) Ltd.
In terms of the shareholders’ agreement, Rolling Wheels (Pty) Ltd matches or beats
the best distribution rates that Sippe Ltd can achieve in the Gauteng and North-West
provinces. Rolling Wheels (Pty) Ltd has historically not declared dividends and this policy
will remain in force for the foreseeable future. In Mr Hilton’s view the accounting value of
the investment in Rolling Wheels (Pty) Ltd approximates its market value.
■■ Other investments represent premiums paid in respect of key man insurance policies
entered into by Sippe Ltd over the past seven years. The present surrender values of these
policies total R4.335 million.
You may assume the following for the purposes of your valuation of Sippe Ltd:
Beta co-efficient
Interest rates on the company’s long-term borrowings
Inflation
Market risk premium
Risk-free rate
Corporate income tax rate
0.80
10%
3%
6%
6%
28%
Mr Hilton has indicated that the target debt ratio of Sippe Ltd is 20%. The cash flows of 20.4
are expected to be sustainable into the foreseeable future.
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Required
Value the business of Sippe Ltd at 28 February 20.1 using the discounted cash flow method.
Include your workings and any assumptions you make in your answer.
(QE – adapted)
Question 6.30
Lifestyles Ltd is a company that focuses on providing and distributing products for the upper end of
the retail market. The management undertook a leveraged buyout a few years ago, which resulted
in a high debt ratio. The increase in interest rates has increased the firm’s financing charges and the
high interest rates have also had a negative effect on demand for the company’s products.
The earnings before interest and tax in the last financial year ending on 30 June 20x0, amounted
to R53.1m and this was significantly below the EBIT achieved in the prior year of R62.8m. The
management has imposed operational changes and the market is expected to recover over the next
five years, resulting in a higher growth rate than the stable growth rate expected after that period.
Management expects to achieve a trading profit (EBIT) percentage of 12% during the high-growth
phase, and a EBIT to Sales ratio of 9% during the stable growth phase.
The level of financial leverage is relatively high and the target capital structure calls for a debt
ratio of 25%, which is expected to occur after the five-year period of high growth. The current debt
ratio is 50% and although the firm expects to reduce the debt ratio over the next five years, the firm
is expected to have a high equity beta for that period of 1.30. In the stable growth period, the equity
beta is expected to fall, and the debt ratio is expected to fall to 25%.
The investment in inventory is expected to be 18% of sales revenue and the investment in
Accounts receivable is expected to be 15% of sales revenue. Accounts payable are expected to be
11% of sales revenue. These ratios will apply in the next five years and thereafter. The investment in
working capital balances for the last year reflects these percentages. Capital expenditure amounted
to R31m in the past financial year. The tax rate is 30% and the sales turnover in the current financial
year ending on 30 June 20x0 was R825m. Depreciation amounted to R20.7m for the financial year
ending 30 June 20x0. The amount reflected in the financial statements, as accounting depreciation is
equal to the depreciation tax allowance and this will remain so in the future.
The long-term interest rate facing the firm is currently at a rate of 15.5%. The current yield
on the long-term RSA gilts is 14.3%. The 90-day Treasury bill rate is currently 12.5%. The firm
had undertaken variable rate financing to finance the management buyout. The growth rate in
EBIT, once it recovers from the weak results in the past financial year, is expected to be 8% per
annum until 20x5. Sales revenue, capital expenditure and depreciation are expected to grow
at 8% per annum until 20x5. The base year is 20x0 for sales revenue, depreciation and capital
expenditure.
In the period of stable growth, the firm expects to reduce its equity beta to 1.00. The growth rate
in EBIT and sales revenue is expected to be 5% per annum indefinitely. The debt ratio will reduce
to 25% and the cost of debt is expected to fall to 12%. The long-term government bond rate is
expected to be 11% from year 5, and the short-term Treasury bill rate is expected to be 10%. In the
stable growth phase, capital expenditure is expected to equal the depreciation charge.
The equity (market) premium is expected to be 5%. However, there is an alternative view by
ANB Investment Bank that the equity premium in South Africa is 3%, and the ‘risk-free’ rate
already includes a country risk premium. The historical market premium in the USA for the last
70 years has been 6.5%. The value of outstanding debt is R274m.
Required:
(a) Determine the value of the equity of the firm using the Free Cash Flow to the Firm approach.
Justify your use of parameters for the discount rate.
(b) Explain the differences between the Free Cash Flow to Equity and the Free Cash Flow to
the Firm approaches, when they should offer similar results and when each method is more
suitable.
(c) Indicate possible formulas for determining terminal values, based on the DCF model, and
comment on the possible effects of using each formula to determine the value of the firm.
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Question 6.31
Secure (Pty) Ltd is a security company that has been in operation in the Gauteng and NorthWest provinces for five years. The business consists of the following divisions:
■■ Manufacturing of security systems and fencing;
■■ Installation and erection of security systems and fencing; and
■■ A 24-hour radio linked reaction service.
Secure (Pty) Ltd was recently approached by one of its competitors, CrimeBust Ltd, with a view
to acquiring a controlling interest in Secure (Pty) Ltd at the end of March 20x0. CrimeBust Ltd
is active only in KwaZulu-Natal and Mpumalanga. Business in these areas exhibited dramatic
growth over the past year and CrimeBust Ltd is now considering expanding into other provinces.
The management of CrimeBust Ltd considered organic growth, but decided rather to grow by
acquisition.
In your capacity as the financial director to CrimeBust Ltd you have been approached to
assist in the negotiations to acquire a controlling interest in Secure Ltd. The financial director of
Secure (Pty) Ltd provided you with the following working schedule:
Manufacturing and installation
Secure (Pty) Ltd is planning to make a substantial investment in research and development
during the year ending 31 March 20x1. For accounting purposes, such costs are written off in
the year that they are incurred, while the SA Revenue Service will allow the cost to be written
off over four years. It is expected that the sales of systems and fencing of Secure (Pty) Ltd will
increase dramatically as a result of this research and development.
Fixed investment capital will be fully utilised by the end of March 20x1. Depreciation and
wear and tear are calculated at 20% per year.
Reaction service
The service has been in operation for three years. The directors are not concerned about the
division, despite the fact that the return of the division does not contribute significantly to the
profit position of Secure (Pty) Ltd. Stiff competition has been given as the primary reason for
the division’s underperformance.
Secure (Pty) Ltd has found that the buyers of its systems and fencing prefer to be linked to
other reaction services (the systems of Secure (Pty) Ltd are generic enough to be linked to any
reaction service).
No significant growth is expected for the reaction service division. No head office costs would
be saved if the reaction service division were closed.
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Head office
Head office controls all the financing activities of the company. The company owns the block
of flats next to its offices, which comprise 50% of the market value of the head office property,
plant and equipment. All the rent received arises from this particular property.
Other information
As financial advisor to CrimeBust Ltd, some time ago you established the following after-tax
rates with a view to performing a valuation of CrimeBust Ltd:
Earnings yield
Dividend yield
Cost of debt
Cost of equity
Cost of capital
15%
9%
12%
22%
20%
Inflation is estimated at 7%.
Required
(a) Advise the management of CrimeBust Ltd regarding the most appropriate method you would
use to determine a purchase price for the interest in Secure (Pty) Ltd. Motivate your answer
fully.
(b) State, with reasons, the additional information you would require to enable you to determine
a purchase price for the interest in Secure (Pty) Ltd assuming that the interest is to be valued
using the free cash flow method.
(QE)
Question 6.32
Ditech Ltd is listed in the Information Technology (IT) sector of the JSE Securities Exchange
South Africa. The company commenced business as a retailer of computer equipment six years
ago, and established an outsourcing division during the 20x0 financial year.
The Outsourcing Division enters into long-term contracts (typically between five and ten
years) with small and medium size corporate clients. In terms of the standard service level
agreement between Ditech Ltd and a client, Ditech Ltd:
■■ undertakes a comprehensive assessment of the systems needs (hardware as well as software)
of the client company;
■■ provides the necessary IT platform;
■■ undertakes to perform software upgrades as often as is appropriate;
■■ guarantees that all hardware will be replaced at least once every three years; and
■■ accepts responsibility for all routine servicing of the client company’s computer network
(this includes the provision of consumables such as printer ink and paper up to specified
maximum quantities, after which clients are charged for any incremental usage).
The Outsourcing Division makes use of outside consultants in addition to its own professional staff
to perform its contractual duties. The division also employs a number of agents, responsible for
sourcing clients on a commission basis. Initial commission is earned when a new client is signed up,
and in addition there is an annual commission for the duration of the contract.
Amfurn Ltd, a national supplier of office furniture, was signed up as an outsourcing client by
Ditech Ltd in April 20x1. In terms of the contract, Amfurn Ltd pays a monthly fee of R122 000
(excluding VAT) in return for which Ditech Ltd supplies its equipment as well as providing the
full range of services as set out above. The monthly fee will increase at a fixed escalation rate
of 8% per annum over the six-year period of the contract. This transaction is considered to be
typical of the business performed by the Outsourcing Division of Ditech Ltd, both in terms of its
nature and its size. The worksheet on the following page summarises aspects of the transaction
with Amfurn Ltd from the point of view of Ditech Ltd:
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During discussions with the financial director of Ditech Ltd, the following aspects came to your
attention:
1. Since management believes that most of the work has been done when the initial client
assessment has been completed, they recognise 50% of the budgeted profit in the first year
of specific outsourcing contracts. For example, in the Amfurn Ltd transaction R1 053 672
(50% x R2 107 344) was recognised in the 20x1 financial year. The balance will be recognised
evenly over the remaining term of the contract.
2. The company further recognised a gross profit amounting to R660 000 on the supply of
equipment to Amfurn Ltd in April 20x1. This profit was not credited to the Outsourcing
Division but instead to the Equipment Division of Ditech Ltd.
3. During the financial year ended June 20x1, Ditech Ltd decided to factor its debtors’ book.
The factoring house has recourse to Ditech Ltd in the event of debtors failing to pay amounts
owing.
4. The net asset value of Ditech Ltd at 31 December 20x1 was R10 per share.
The cash flow statements from the annual reports of Ditech Ltd, are set out on the following page:
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The latest information relating to a range of companies listed in the Information Technology
sector of the JSE Securities Exchange South Africa is summarised below:
Required:
(a) Discuss the accounting treatment adopted by Ditech Ltd for the revenue and costs associated
with the Amfurn Ltd outsourcing contract. Discuss whether it complies with statements of
generally accepted accounting practice.
(b) Critically evaluate and comment on the cash flows of Ditech Ltd for the financial years ended
30 June 20x0 and 20x1.
(c) Discuss, with reasons, whether the current market capitalisation of Ditech Ltd of R315
million is a fair reflection of the value of the company. In your answer you should highlight
risk factors that may impact on the valuation of Ditech Ltd.
(QE adapted)
Question 6.33
Biotec Ltd is a small South African biotech company which started operations five years ago and
has so far expended R56m on the development of an enzyme based drug which is expected to
reduce and defer the debilitating effects of Type II diabetes. The potential for the drug is huge
as it replaces and complements current oral therapies and the new drug is expected to be eligible
for about 10% of current Type II diabetes sufferers in South Africa and the world. There are
currently 140m sufferers of Type II diabetes in the world with about half unaware that they have
the disease. This means that the number of potential patients will amount to 10% of 70m and it
is expected that this number will grow by 8% per year, from the end of 20x3.
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The major market will be the USA with Europe also being a major source of potential patients.
The company is expected to achieve penetration rates (% of eligible or potential patients using
the drug) in each year as follows:
Rate of Market Penetration
20x4
20%
20x5
30%
20x6
45%
The current drug under development is subject to the results of the Phase III clinical trial and
then requires FDA and other regulatory approvals. The probability of success in the clinical trial
is 50% and the subsequent probability of FDA and other regulatory approval is 70%.
The gross profit percentage is expected to be 80% of the sales price. The company is expecting
the annual patient price to be R120. Although the company would be able to achieve double this
rate in the USA, Europe and Asia, the company is setting a relatively low price to enable the
company to meet the challenge of expected new competing drugs in the future. The company is
required to use a major pharmaceutical company to market the drug worldwide.
Diabetes is really an epidemic. Fifteen years ago, there were 30 million people worldwide who
had diabetes but this had grown to 177 million. It is expected that Type II diabetes (adult onset
diabetes), of which there are currently 140 million sufferers, will grow at a rate of 8% per year for the
next 50 years (from the end of 20x3). This is due to the aging of the population, sedentary lifestyles
and changing diets. In Type II diabetes, people lose the balance between insulin and blood sugar.
When the pancreas falters in the production of insulin, cells will not absorb the required amounts
of glucose, resulting in a rise in blood sugar, which leads to other complications. Currently other
drugs will enhance the ability of the pancreas to produce insulin or reduce the capacity of the liver
to produce excess glucose. There are side effects such as weight gain and gastrointestinal problems.
However, the sulfonylurea class of drugs are very cost effective and are generic-based but these
types of drugs lose effectiveness for 45% of patients within 6 years.
Biotec Ltd is developing an enzyme, called Inglukinase, that is able to regulate both the
secretion of insulin by the pancreas and the production of glucose by the liver. Currently, the new
drug is to be subjected to Phase III clinical trials, and the results are expected within 6 months.
This is followed by the FDA and other regulatory approval process which will take a further
6 months, so that if both are successful, then production and sales will commence from 20x4.
Assume cash flows occur at the end of each year. The current date is 2 January 20x3.
The drug is expected to reach a maximum penetration rate of 45% within three years and will
remain at this level for the indefinite future. Because of the development of new drugs, the price
will be retained at current levels and growth will be driven only by the underlying growth in the
number of Type II diabetes patients. Although the normal lifecycle of a drug is about 12 years,
Biotec expects that the drug will have an indefinite life due to competitive pricing from the initial
production phase.
In order to market the new drug all over the world, the company will enter into a joint venture
with Plax Pharmaceuticals Ltd, a major pharmaceutical company with a worldwide distribution
and marketing network, whereby Plax will acquire 50% of the equity of Biotec. The company is
also managing the regulatory approval process. The marketing costs to be incurred will amount
to 15% of sales revenue and general support and administrative costs are expected to be 50% of
the marketing costs. However, in 20x4, to gain market acceptance marketing costs will amount
to 50% of sales revenue and administrative costs will also be 50% of the marketing cost for that
year.
From 20x7, marketing costs and administrative costs will not relate to sales revenue and the
expected amounts will be the 20x6 amounts which are thereafter expected to increase at an annual
rate of 4%. Net working capital balances are expected to reflect the following ratios:
Accounts Receivable – 60 days sales
Accounts Payable – 60 days (cost of goods sold)
Inventory – 90 days (cost of goods sold)
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Operating cash is expected to be 1% of sales revenue. The company is required to spend R125
million at the beginning of 20x3 on advanced manufacturing and diagnostic equipment.The
equipment is also required to fast-track the approval process. No further capital expenditure will
be required in future years. The capital expenditure is 100% deductible in the year of acquisition
(strategic industrial allowance) and the research and development costs are also deductible in
the year incurred. The company has a tax assessed loss of R52 million prior to this expenditure.
The cost of capital for the biotech sector is expected to be 20%. Accounting depreciation and
amortisation is expected to be R15m per year once the company commences production. The
company expects to expend R10m per year for the years 20x3 to 20x6 on research and development and thereafter this annual amount is expected to increase at a rate of 4% per year. The
development of the new drug has been due to the efforts of Dr Charles Parker, and his research
team, but no further drugs are expected to be developed in the longer term.
The valuation of Biotec will be used by Plax Pharmaceuticals in order to decide on a price
for 50% of the company. The corporate tax rate is 30%. Plax will take on any currency risk and
the future cash flows of the company will not be affected by currency movements. The current
assets and liabilities of the company are immaterial until the company begins production and
you may assume that the investment in working capital will take place at the end of each year at
the same time that the underlying sales and costs occur. The company has interest-bearing loans
at a variable rate on the Statement of Financial Position at the current date amounting to R45
million.
Required:
Employ the Free Cash Flow Model to value the ordinary equity of Biotec Ltd as at January 20x3.
How would your value change if the capital expenditure can be deferred until the FDA and other
regulatory approval is obtained?
Question 6.34
Brand Ltd commenced operating forty years ago as a manufacturer of heavy-duty industrial
equipment and has over the past 20 years significantly diversified its business activities to include
other equipment manufacture, industrial distribution and motor dealerships. Brand Ltd operates in ten countries, employs approximately 2 500 personnel and is considered to be an industrial brand management company.
Brand Ltd is owned by three non-related families who are not actively involved in the
business.
At a recent off-site meeting and as part of formulating the future growth strategy of the
business, the management of Brand Ltd determined that the way forward for them and ultimately
for Brand Ltd was to list on the JSE Securities Exchange in the near future. Management
would as part of the listing seek to be incentivised with a reasonable equity stake. Alternatively,
they propose a management buyout of Brand Ltd to be funded by a consortium that would
include private equity players and financial institutions. The financial manager of Brand Ltd was
requested to perform a preliminary valuation of Brand Ltd to evaluate these options. The results
of that valuation are set out below and on the following page:
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The following was attached to the valuations for information purposes:
Brand Ltd has forecast capital expenditure amounting to R26 million, R24 million and R15
million for the 20x5, 20x6 and 20x7 financial years respectively. It is anticipated that the capital
expenditure will be incurred evenly during the respective financial years and will be financed
solely by external borrowings.
Proceeds on the sale of plant are projected to be R8 million, R12 million and R9 million in the
20x5, 20x6 and 20x7 financial years respectively. As at 31 December 20x4 the net asset value of
Brand Ltd was R101million. Total assets at the same date amounted to R194 million. The weightedaverage cost of capital of Brand Ltd is currently 15%. The company’s expected growth rate after the
20x7 financial year is 4% per annum. The dividend policy is to distribute, as a dividend, 60% of each
financial year’s profit after tax in the next financial year.
Required:
(a) Critically analyse the audited and forecast income statements of Brand Ltd and discuss any
issues arising from your analysis.
(b) Critically evaluate and comment on the earnings and free cash flow valuations performed
by the financial manager. Your answer should include re-performing any aspect of the
valuations that you consider necessary, together with your supporting reasons, and highlight
any information that would be required in order to finalise the valuations.
(c) Discuss the general shortcomings of earnings based valuations.
(QE adapted)
Question 6.35
The board of directors of Wurrall Ltd has requested the production of a four-year financial
plan.
The key assumptions behind the plan are:
1. Historically, sales growth has been 9% per year. Uncertainty about future economic prospects
over the next four years from 20x5–20x8 however implies that this growth rate will reduce
by 1% per year after the financial year 20x5 (e.g. to 8% in 20x6). After four years, growth is
expected to remain constant at the 20x8 rate.
2. Cash operating costs are estimated to be approximately 68% of sales.
3. Tax allowable depreciation for the past few years has been approximately 15% of the net
book value of plant and machinery at year end. This is expected to continue for the next few
years.
4. Stocks, debtors, cash in hand and ‘other creditors’ are assumed to increase in proportion to
the increase in sales.
5. Investment in, and net book value of, plant and machinery is expected to increase in line with
sales. No investment is planned in other fixed assets other than a refurbishment of buildings
at an estimated cost of R40 million in late 20x7.
6. Any change in interest paid as a result of changes in borrowing may be assumed to be effective
in the next year. Wurrall plans to meet any changes in financing needs, with the exception of
the repayment of the fixed rate loan, by adjusting its overdraft.
7. Wurrall currently pays 7% per annum interest on its short-term borrowing.
8. Corporation tax is expected to continue at its present rate over the next four years.
9. For the last few years the company’s dividend policy has been to pay a constant percentage
of earnings after tax. No changes in this policy are planned.
10. Wurrall has borrowed extensively from the banking system, and covenants exist that prevent
the company’s gearing (book value of total loans to book value of total loans plus equity)
exceeding forty percent for a period of more than one year.
11.The company’s managing director has publicly stated that both profits before tax and
Wurrall’s share price should increase by at least 100% during the next four years.
The company’s current share price is 210 cents, and its weighted-average cost of capital is 11%.
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The summarised financial accounts of Wurrall are presented as follows:
Required
(a) Produce pro forma Statements of Financial Position and profit and loss statements for each
of the next four years. Clearly state any assumptions that you make.
(b) Critically discuss any problems or implications of the assumptions that are made in each of
points (1) to (4) and point (9) in the question.
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(c) Using free cash flow analysis, evaluate and discuss whether or not the managing director’s
claims for the future share price are likely to be achievable. (The operating cash flow element
of free cash flow may be estimated by: EBIT(1 – t) plus depreciation.)
(d) Using financial ratios or other forms of analysis, highlight any potential financial problems
for the company during this period. Discuss what actions may be taken with respect to these
problems.
(ACCA Paper 3.7 2004)
Question 6.36
Cementex (Pty) Ltd (‘Cementex’) is a black economic empowered (BEE) group that supplies
products to customers in the building and construction industries. Carmachio Investments, a
broad based BEE group, currently holds 26% of Cementex’s shares and the executive directors hold 74%. Cementex has quarries in the provinces of the Free State and Limpopo and raw
materials from these operations is used to make concrete blocks and bricks as well as readymix concrete. The group extracts and crushes dolerite rock from its quarries. This material is
processed into what is commonly known as aggregates, namely sand (fine particles of rock) and
stone (larger particles of rock). These aggregates are sold to customers involved in road building
and construction activities. Cementex also uses aggregates as a raw material in the manufacture
of concrete blocks and bricks as well as ready-mix concrete.
Cementex has numerous factories in the Free State and Limpopo that manufacture concrete
blocks and bricks. The factories are situated close to major customers to minimise transport
costs. Cementex has its own fleet of trucks that delivers ready-mix concrete to customers at
construction and building sites. The construction industry is experiencing significant growth
because of spending on infrastructure by government and parastatal organisations, and the
continued boom in the non-residential building sector.
The shareholders of Cementex have been approached by Mediterranean Investments L.L.C
(‘Mediterranean Investments’), a major building products group based in Dubai, United Arab
Emirates. Mediterranean Investments has proposed the acquisition of 100% of the issued share
capital of Cementex as it is eager to participate in the continued growth in the construction
industry in South Africa over the next five years. Mediterranean Investments has submitted a
formal purchase offer of R60 million for the total equity of Cementex to its shareholders. The
Chief Executive Officer (CEO) of Cementex, Mr Phillips, is of the opinion that the purchase
price offered is far too low. His opinion is based on the price-earnings (P/E) multiples of similar
listed companies on the JSE Ltd, such as the following:
Mr Phillips also noted that Mediterranean Investments recently acquired a major concrete brick
manufacturer in France based on an historic P/E multiple of 13. He told his fellow shareholders
in Cementex that a slight discount to this multiple of 13 would be appropriate for Cementex
given the weakness of the rand against major international currencies. Mr Phillips has suggested
a fair value of R160 million for Cementex based on forecast profit after tax of R13.3 million
for the year ending 30 June 20x7 and using a P/E multiple of 12. The income statements for the
years ended 30 June 20x5 and 20x6 of Cementex are summarised on the next page, together with
the forecast for the year ending 30 June 20x7:
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Notes
1. Revenue for the half year ended 31 December 20x6 amounted to R35 million (20x5:
R26 million). The executive directors of Cementex are confident that the company will achieve
revenue of over R70 million during the 20x7 financial year, based on the current order book.
2. Cementex’s average borrowing cost is currently 11% per annum and it earns 7.5% per annum
on call deposits with banks.
Required
1. Comment on the forecast profitability of Cementex (Pty) Ltd for the year ending 30 June
20x7 versus the actual result achieved in the 20x6 financial year.
2. Perform your own P/E valuation for a 100% stake of Cementex.
– Identify any issues which should be considered or that are likely to impact on the offer
price and,
– Comment on any shortcomings implicit in (or underlying) either of the proposed valuations above (i.e. the R60m offered by Mediterranean and the R160m proposed by Mr
Phillips.)
(QE – adapted)
Question 6.37
PreFab (Pty) Ltd (‘PreFab’) manufactures, sells and rents out prefabricated units, and is the
leading manufacturer of these products in South Africa. Units are manufactured at its factory
situated in Centurion, Gauteng. PreFab’s individual units vary from 12m2 to 612m2 and because
of the modular format of units, can be sized according to customer requirements.
PreFab supplies significant volumes to various South African government departments,
which accounted for 22% of the company’s revenue in the 20x7 financial year. The government
uses PreFab’s units for new schools and in low cost housing developments. Various government
departments have also embarked on an extensive infrastructural development programme and
PreFab is confident that it will benefit from increasing expenditure from them.
The rest of PreFab’s customer base is diversified and no single customer accounts for more
than 10% of the company’s total revenue. Some of these customers, for example South African
and African mining groups involved in exploration projects and new mining projects, use
prefabricated units to provide temporary accommodation for staff. Others use the units for office
accommodation on a temporary or permanent basis. The construction industry is undergoing a
major growth phase and many of the major construction groups use PreFab’s units as temporary
offices and residential accommodation on construction sites.
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PreFab also rents out units to customers, and the demand for rental units is increasing. The
minimum rental period is three months, and monthly rentals of units are determined as the historical
cost of the unit divided by 24. In order to keep up with customer demand for rental units, PreFab
has utilised most of its historical cash flows and raised term loans from banks to fund the acquisition
of units by the Rental division. The Rental division was started in January 20x6.
Steven Hamilton founded PreFab 11 years ago and is still the Chief Executive Officer (CEO)
of the company. Mr Hamilton’s family trust, The Hamilton Family Trust, owned 100% of the
shares in issue until July 20x7. The Hamilton Family Trust advanced a R35 million loan to PreFab
in 20x0 which loan bears interest at 13% per annum, payable annually in arrears, and has no fixed
date of repayment. Effective from 1 July 20x7 BBZ Holdings, a broad-based black economic
empowerment (BEE) investment group, acquired a 30% interest in the company and advanced
an interest-bearing shareholder’s loan of R15 million to PreFab on the same date. The terms
and conditions of the loan are the same as those applicable to The Hamilton Family Trust loan.
The PreFab shareholders’ agreement contains a clause that provides that if any shareholder
disposes of its equity to a third party, the purchase consideration would first be allocated to
shareholder loan accounts and thereafter to the shares. Xtatic Ltd (‘Xtatic’), a company listed on
the JSE Ltd, has recently approached the shareholders of PreFab with an offer for the acquisition
of a 100% shareholding in the company. Xtatic is in the process of formulating an offer price
for PreFab shares and has indicated that a key condition of the acquisition would be that Steven
Hamilton remains as CEO of PreFab for three years after the acquisition. Xtatic has indicated
that it will pay cash for the shareholding in PreFab. Xtatic is a major manufacturer and supplier
of mining and construction capital equipment, and is aggressively growing through acquisitions.
Abridged historical and forecast Statements of Comprehensive Income of PreFab
Notes
1. The periods of rental agreements vary from three months to 12 months with the option to
renew. PreFab has a long waiting list for rental units and accordingly plans to acquire further
units to rent over the next three years.
2. Cost of sales for the Rental division comprises mainly depreciation, maintenance and
servicing costs of units. Rental assets are depreciated on a straight-line basis over ten
years. Depreciation amounted to R2 million in the 20x6 financial year. The Rental division
purchases prefabricated units from the Manufacturing division at the same prices at which
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units are sold to external customers, which in total amounted to R30 million in 20x7 (20x6:
R20 million). It is forecasting acquisitions of R40 million in the 20x8 financial year. The
Manufacturing division revenue shown in the Statements of Comprehensive Income includes
sales at market value to the Rental division.
3. The auditors of PreFab recommended that a once-off cost associated with the BEE deal in
July 20x7 be recognised in the company’s annual financial statements. The auditors are of
the opinion that the difference between the fair value of shares acquired by BBZ Holdings
and the actual cost of their share subscription (which was a nominal amount) should be
accounted for based on their interpretation of IFRS 2, Share-based payment, and AC 503,
Accounting for black economic empowerment (BEE). The following journal entry, which can
be assumed to be correct, was processed at year end:
4. PreFab invited various client representatives to accompany them to the Rugby World Cup
held in France in October 20x7. The company deemed this to be a non-recurring expenditure
and hence disclosed it separately in the Statement of Comprehensive Income.
5. PreFab incurred a penalty due to the late supply of prefabricated units to Galaxy Mining.
Such a penalty has never previously been incurred, because PreFab generally refuses to
include a late supply clause in supply contracts. The late supply occurred as a result of
disruptions caused by a ten-day strike by PreFab manufacturing employees over proposed
wage increases. The strike took the executive directors of PreFab by surprise, as no such
incident had occurred in the preceding three years.
6. The company’s effective normal tax rate has historically been 29%. In the 20x7 financial year
the effective tax rate increased due to the non-deductibility of the BEE transaction costs.
PreFab’s budgeting for and forecast of earnings have generally been highly accurate. Steven
Hamilton is confident that forecast profit after tax of R32 million will be achieved in the year
ending 31 December 20x8, particularly given that the 12-month forward order book at the end of
February 20x8 exceeded R100 million.
The above cash flow forecasts have been reviewed and approved by the board of directors of
PreFab.
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Additional information
1. The total interest-bearing liabilities and cash balances were as follows at 31 December 20x7
2. The following information is available regarding companies listed on the JSE Ltd which
operate in the same industry as PreFab:
■■ Their average increase in headline earnings per share in the 20x7 calendar year was
25%, and they are expecting similar increases in 20x8;
■■ Their average price earnings multiple, based on 20x7 reported profits, is currently 12.0;
■■ Their average total revenue in the 20x7 calendar year was R175 million; and
■■ They all have BEE shareholders.
Required:
1. Assuming that you were tasked to perform an earnings based valuation of Prefab (Pty) Ltd
based on the profits achieved in the 20x7 financial year:
(i) state, with reasons, what adjustments, if any, you would make to the reported profit after
tax for the effects of the transfer pricing arrangement between the Manufacturing and
Rental divisions;
(ii) state, with reasons, what other adjustments you make to the reported 20x7 profit after tax
in order to derive a sustainable earnings figure for the purposes of your valuation; and
(iii) indicate, with reasons, what price earnings multiple you would use to value PreFab (Pty)
Ltd.
2. Perform a free cash flow valuation of PreFab (Pty) Ltd in order to value 100% of the shares in
issue of the company and the shareholder loan accounts. For the purposes of your valuation:
■■ assume that PreFab (Pty) Ltd’s weighted-average cost of capital is 17.5%;
■■ base the valuation on information from 1 January 20x8; and
■■ assume that the company’s annual growth in free cash flows will be 2% from the 20x11
financial year onwards.
State any additional assumptions that you have made.
3. Identify and describe five key business risks faced by PreFab (Pty) Ltd.
4. Critically discuss whether or not it is in the best interests of PreFab (Pty) Ltd to have a
transfer pricing arrangement whereby the Rental division acquires prefabricated units from
the Manufacturing division at the same price that units are sold to external customers
(QE – adapted)
Question 6.38
AutoRite Ltd is a manufacturer of auto components for the South African motor industry. The
company is also expanding into offshore markets and the company is a Tier 1 supplier to motor
manufacturers such BMW, GM and VW. The motor manufacturers are referred to as OEMs
(Original Equipment Manufacturers). The company’s financial year end is 30 September and the
company has recently tabled its financial statements for the year ending 30 September 20x3. A
Japanese supplier to the company is interested in purchasing a 25% equity stake in the company
and the current shareholders wish to determine the value of the company in terms of setting
a price for 25% of the ordinary shares of the company. The company is unlisted and the only
comparable company is Metair Ltd.
The company manufactures wiring components for cars and the company is based in Natal.
The South African motor industry is currently experiencing weak local demand after a few
years of record sales of units due to a strong economy and due to structural changes in demand
patterns. The motor industry in South Africa provides employment to over 300 000 people and is
seen as the ‘bedrock of the South African manufacturing base’. The government (DTI) provides
support to the industry in terms of the Automotive Production and Development Plan (APDP)
which has resulted in a significant increase in unit and component exports.
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Globally the industry is facing challenging times. There is increasing consolidation amongst
auto part suppliers due to pressures from the OEMs. There is excess capacity and the companies
are operating in a highly competitive environment. The financial difficulties at GM and Ford are
sending warning signs to suppliers that the sector will continue to be under pressure. Delphi, one
of the largest auto part suppliers was placed in Chapter 11. There is expected to be a shake up
in the industry as the respective market shares of auto makers changes with the Japanese and
Korean manufacturers expected to benefit at the expense of the major US auto manufacturers.
The continuing reduction in auto part suppliers is expected to continue as consolidation is
necessary to achieve economies of scale. Increased R&D will be required due to an increased
level of complexity and innovation required to be achieved in the new models. Major recalls
have indicated the risks that come with a higher level of complexity. Price wars have resulted
in pressure on margins and the increased focus on emission standards will further impact on
margins in the future. Yet, OEMs are expected to increasingly shift production of components
to the developing world and South Africa is expected to benefit from this trend. China is a longterm threat and is expected to play an increasing role in the supply of auto parts.
The local industry is however doing well due an increased level of exports which have partly
offset falling sales in the domestic market. The APDP incentives will be retained at least until
20x7. Industry sales growth is expected to be over 10% per year for the next 5 years. Yet, local
OEMs are beginning to place price points and car prices are under scrutiny by the Competition
authorities in South Africa. OEMs are also shifting inventory requirements to suppliers such as
AutoRite. Further, it is difficult to achieve JIT due to relatively short runs.
AutoRite has a strong management team that has the necessary experience of managing
a company in this sector. The management have been able to manage a very high growth rate
in sales & profits. AutoRite’s management has produced pro forma financial statements for
the next few years for the purposes of you undertaking a valuation of the company. These are
presented in Annexure 1. The company is expecting sales growth over the next 3 years of 12%
per year. Thereafter, sales growth is expected to be 8% per year reflecting inflation growth in the
sector and the company expects to achieve no volume growth. The company expects to sustain
the margins indicated in the forecasted financial statements for the years after 20x6. The cost of
capital of the company is 15%.
The company is labour intensive and therefore the proposed capital expenditure in the future
is reasonable in relation to sales growth. There is little R&D as the company pays licence fees
for imported technology. Depreciation in each year amounts to 20% of the property plant &
equipment (PPE) opening balance. The provisions in each year’s Statement of Financial Position
arise from operations and not financing activities. The corporate tax rate is 28%. Investments
in the Statement of Financial Position reflect investments in associate companies, which are not
expected to generate any earnings over the next few years. The market values of the investments
in associate companies are 1.7 times the book value of the investments. The loan assets are
interest free and have been made to a supplier in order to assist the supplier integrate its IT
system with that of AutoRite. This has resulted in supply chain cost savings for AutoRite.
It has been decided that the company’s current bank balances are not required in order to
maintain operations and the company will use short-term financing in the future and use cash
balances to reduce short-term borrowings in 20x4. This is reflected in the projected financial
statements. There are 6.48m ordinary shares in issue. The company’s interest payments are
based on the loan balances at the beginning of each year.
Required:
1. Set out the Free Cash Flows of the firm for the years 20x4 to 20x7.
2. Undertake a DCF (free cash flow) valuation of AutoRite on 1 October 20x3. What is the
value of the ordinary equity of AutoRite?
3. Set out the Financing Cash Flows of the firm for the years 20x4 to 20x7. Be specific about the
financing cash flows.
4. Assume for this section, that the current share price of AutoRite is R15.70. The company has
recently issued 500 000 call options with an exercise price of R16.30. The annual volatility as
measured by the standard deviation of the company’s share price is 23.5%. The call options
are to be exercised in 3 month’s time. The annual risk-free rate is 12% (1% per month).
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The up-factor
is based on a probability (p) of 55.6936%, assuming risk neutrality. Use the


formula, e​ t ​ to determine the up and down factors. What is the value of each call option
using a simplified binomial model over 3 time periods? What would be the value of a put
option, assuming put-call parity? (Note: e = 2.718282) What effect would the value of the
call options have on the value of each share of AutoRite as determined in part 3. How would
your approach change if the firm’s call options were deep in the money?
[Note: Part 4 should only be completed once you have covered options in Chapter 18.]
Annexure 1
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Question 6.39
Worldwide Logistics (Pty) Ltd’s financial director has produced the following projected profit
and loss statements for the years 20x7 to 20x10. The company’s year-end is 30 June. The company is expecting a significant increase in revenue in 20x7, but thereafter the company is expecting to experience a fall in sales growth in each year. The growth rate expected to be achieved
in 20x10 is projected to be the sustainable growth rate that the company will be able to achieve
each year after 20x10. This is a nominal growth rate.
The projected summarised Statements of Financial Position are set out below. The company has
estimated that R200 million in cash balances at the end of June 20x6 is surplus to the company’s
needs and the company will use this to reduce its financing requirements in 20x7. The company
has estimated that operating cash will amount to 1% of sales revenue from 20x7 onwards. The
company’s provisions relate to the company’s ongoing operations. The reduction in ordinary
share capital in 20x9 reflects the effect of a projected share buy-back. The company is also planning to reduce its long-term borrowings by R400 million at the end of 20x9.
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The company has a loan covenant that the debt-equity ratio will not exceed 80%. Investments
represent non-interest bearing strategic assets which support the company’s normal operations.
The interest rate on long-term borrowings is a fixed rate of 10% until 20x10. Thereafter the
interest rate becomes a variable market related interest rate. The current market rate on similar
long-term borrowings is 11%. The interest rate on short-term loans and overdrafts is a variable
rate. The growth rate in revenue for 20x10 is expected to be sustainable into the future. The
current date is 1 July 20x6. Interest for any year is based on the opening balances of short-term
debt and long-term debt. The corporate tax rate is 28% and the company’s weighted-average cost
of capital is estimated to be 12%.
Required
1. Set out the operating Free Cash Flows of the company over the next 4 years and use these to
value the ordinary shares of the company. You should ensure that you include a terminal or
continuing value in your calculation of the value of the company’s ordinary shares
2. Set out the financing cash flows of the company in a separate schedule.
3. Comparable firms are currently trading on a price-earnings ratio of 9. Compare this to the
company’s current P/E ratio. Set out the advantages and disadvantages of using earnings
based valuation method in relation to using a DCF (free cash flow) valuation method.
4. Use financial analysis and some key ratios to highlight potential problems for the company
over the next few years. The key ratios should be the debt-equity ratio, interest cover, the
current ratio, the asset turnover ratio, return on capital employed and the EBIT to Sales
ratio. What recommendations would you make in relation to the company’s operations and
financing decisions?
Question 6.40
Savusa Limited (‘Savusa’) is a large media group listed on the JSE Securities Exchange. The
Board of Directors of Savusa has decided to follow a strategy of diversifying and expanding
through acquisitions. Numerous potential acquisition opportunities are being explored
including acquiring a controlling interest in Oxus Proprietary Limited (‘Oxus’).
Savusa is considering the acquisition of a 60% shareholding interest in Oxus. The
present shareholders in Oxus are Mr Depp (the Chief Executive Officer) and Ms Grape
(the Chief Financial Officer), who jointly founded the business in 2000. Oxus publishes a
range of magazines which are distributed free of charge to target markets. One of their bestknown titles is Health News; a 120-page, A4-sized magazine distributed on a quarterly basis
to doctors, specialists, healthcare professionals and hospital managers across the country.
Health News contains articles about medical developments, which may be of interest to
anyone working in the healthcare industry. Given the circulation of over 20 000 copies,
the magazine attracts significant advertising spend from manufacturers and distributors of
medicines, hospital supplies and products, and medical equipment and consumables.
Oxus owns and publishes 25 magazines which it distributes to the following industries:
■■ Healthcare (seven titles)
■■ Construction and engineering (three titles)
■■ Investment and asset management (four titles)
■■ Weddings (three titles)
■■ Automotive retail (two titles)
■■ Wine (two titles)
■■ Entertainment and arts (four titles).
Oxus has over the years developed various databases of individuals and businesses which
may be interested in their magazines, including a database of over 25 000 engineering and
construction professionals to whom their engineering titles are distributed.
Savusa approached Mr Depp and Ms Grape to find out whether they would be interested
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in selling shares in Oxus. During initial discussions the two partners were convinced of the
merits of forming part of a larger media group and in realising some value for their efforts
over the past 12 years. Mr Depp and Ms Grape are equal shareholders in Oxus and are
willing to sell 30% each to Savusa at fair market value (to be negotiated).
Ms Grape has performed a valuation of Oxus for the purposes of the negotiations and
has e-mailed this to the directors of Savusa.
Her valuation and explanatory notes are summarised below:
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Notes
1. The 2010 financial information has been audited. The 2011 financial information is
based on the latest management accounts. The forecasts for the financial years ending
31 December 2012 to 2014 have been reviewed by the directors of Oxus, who have
approved these for release to Savusa.
2. Revenue growth in the 2010 and 2011 financial years (‘FY2010’ and ‘FY2011’) was
affected by the poor economic conditions. Oxus has entered into an agreement with
Savusa to publish a 100-page glossy magazine to celebrate Savusa’s 50th anniversary in
2012. Oxus expects to earn revenue of R2.5m from this once-off publication at a gross
profit margin of 40%.
3. Print costs are determined based on the quality and number of pages in the magazines.
Mailing costs vary according to the number of copies of the magazines distributed.
Other cost of sales items are largely fixed in nature.
4. Sales persons earn a commission of 10% of advertising sold. Oxus is considering changing
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the commission basis to 20% of gross profit earned on particular magazines. However, it
still needs to engage with relevant employees before making this change. The forecasts
are based on the assumption that the current policy will remain in place throughout the
forecast period.
5. Investments represent a portfolio of listed shares that Oxus acquired in FY2008. The
company earns dividend income from the share portfolio. In addition, the annual
increase in the fair value of the share portfolio is recognised as ‘other income’.
6. Oxus employs journalists to write articles for its numerous publications. As from
FY2012, Oxus will encourage its journalists to resign and enter into freelance contracts
with the company, thus only writing articles as and when required. The management of
Oxus believes that this will benefit both parties. Journalists will be free to work for other
publications and generate significantly more revenue than they currently earn at Oxus.
The company will in turn convert a fixed expense into a variable cost, and also reduce its
operating costs.
7. You may assume that the ratios listed have been correctly calculated.
8. R2.5m was spent on upgrading the information technology infrastructure in FY2011 to
cater for growth over the next 5 to7 years. Normal capital expenditure is in the region of
R1m to R1.2m per annum.
9. Oxus’s policy is that clients should pay for advertising prior to the publication of
magazines, but the company rarely enforces this policy and allows clients to pay amounts
owed for advertising within a reasonable period. However, from FY2012 Oxus plans to
focus on collections to improve cash flows and encourage clients to pay amounts when
due.
10. Oxus normally declares a dividend equivalent to 50% of after tax profits. However, in
FY2011 no dividend was declared or paid due to higher than normal capital expenditure.
11. The discount rate of 17.5% was derived from Savusa’s weighted average cost of capital
of 12.5% (as disclosed by Savusa to Oxus) plus a 5% premium for the fact that Oxus is
an unlisted, smaller company. Savusa’s cost of equity is 16,0%, its after-tax cost of debt
is 7.25% and the debt/equity ratio per its most recent audited statement of financial
position was 40.0%.
12.Continuing value (discounted cash flows from FY2015 onwards) was estimated using
the Gordon Growth Model [(cash flow FY2014 x 1.04)/(17.5% – 4%) x 0.524 (discount
factor for 2015)].
Required:
(a) Prepare a memorandum to the Board of Directors of Savusa in which you critically
review and advise on the valuation performed by Ms Grape. Include an analysis of and
commentary on the following:
–– The financial forecasts of Oxus;
–– Any errors of principle contained in the valuation;
–– The discount rate used to discount future cash flows of Oxus; and
–– The reasonability of the valuation derived.
At least half of your report should be devoted to an analysis of and commentary on the
financial forecasts included in the valuation. Assume that the mathematical calculations
in the discounted cash flow valuation presented in the table in the scenario are correct.
(b) With regard to the proposed change in the commission structure for sales persons at
Oxus –
–– discuss whether this will encourage more appropriate behaviour within the
company from Oxus’s perspective; and
–– identify any issues that the sales persons may have with the proposed scheme.
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(c) Describe two potential benefits and two negative consequences for Oxus of the proposed
initiative to use freelance journalists rather than to employ these individuals on a fulltime basis.
(QE)
Question 6.41
The Clicks Group managed to grow sales revenue by 6.2% in 2011. The low rate of sales
growth reflected a low inflation rate of only 1.6% for the group in 2011. Condensed annual
financial statements for the year ending 30 August 2011 are set out below and on the
following page.
In order to estimate future sales growth for the next 5 years and thereafter, it is important
to analyse the information provided in the integrated report of Clicks and estimate firstly
the sales growth rate for the explicit period of 5 years and the sales growth rate to be used
in the determination of the terminal value. The company’s cost of capital is estimated to be
13%. The market value of interest-bearing liabilities reflects their book value. The gross
profit margin is expected to be 22% for 2013 and 2014, and thereafter revert to the gross
profit margin achieved in 2011. In relation to future estimates for the projected Statement
of Comprehensive Income, the following expense ratios are relevant:
■■ Occupancy costs to sales: 3%
■■ Employment costs to sales: 10.5%
■■ Other costs to sales: 6.2%
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The borrowing rate is 9% and the lending (deposit) rate is 8%. You can apply these rates to
opening balances (to avoid circularities). Depreciation and amortisation is expected to be
10% of the opening non-current book value of plant and machinery and intangible assets.
Other income is expected to be 5% of sales revenue. In relation to “balance sheet” items,
goodwill is not expected to change and the company is not expected to invest in goodwill
in the future. The net closing book value of Plant & Machinery to Sales is expected to be
6.2% in the future and the book value of Intangible assets is expected to be 2.1% of sales.
The operating lease liability is expected to be 0.9% of sales in the future. Any change in the
operating lease liability will affect the deferred tax asset of the group. The distribution to
shareholders cover is set out in the Integrated Report to be 1.8 in the future.
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In terms of working capital balances, the company expects to achieve the following:
■■ Inventories to sales
■■ Accounts receivable to sales
■■ Accounts payable to sales
■■ Tax owing to sales
13.0%
7.0%
18.5%
0.3%
These ratios are very close to the ratios in 2011. Property, plant and equipment and
intangibles are expected to stay constant as a percentage of sales in the future. No further
expenditure on goodwill is expected in the future. The corporate tax rate is 28%. The current
share price is R41 per ordinary share.
Required:
(a) Determine the estimated sales growth rate for the next 5 years and the sales growth rate
for the terminal period. Explain the positive and negative factors impacting on your
estimates. Explain how you used the 2011 Integrated Report to reach your conclusions
about future growth.
(b) Set out projected summary Statements of Comprehensive Income and Statements of
Financial Position for the years 2012 to 2016. [Do this in Excel – refer to Chapter 20 for
guidelines.]
(c) Determine and set out the future free cash flows of Clicks over the next 5 years.
(d) Determine the terminal value of Clicks at the end of year 5.
(e) Determine the enterprise value and the value per ordinary share as at 30 August 2011.
How does this compare to the current share price? [Use the diluted number of ordinary
shares at the above date – do not undertake a separate valuation of the options or share
appreciation rights.]
(f) Set out the Financing Flows for the years 2012 to 2016 and ensure that future operating
cash flows equal the financing flows.
(g) What happens to the value per share if the cost of capital is 12%?
[Note there will be rounding differences, as we will be doing this in Excel.]
6-42
[Note: This is an integrated question (SAICA ITC Examination, June 2014). You need to have
studied Chapter 7 on the cost of capital]
OPM (Pty) Ltd (‘OPM’) is a private equity company that invests in established small to
medium unlisted companies that have growth potential, within the agricultural and industrial
sectors. Due to the higher risk associated with private equity investments, the directors target
a return from OPM’s investments of an average of five percentage points above the return on
the Johannesburg Stock Exchange’s Top 40 index in the medium to longer term. OPM has
just over R2 billion invested at present, with individual investments ranging in size from R50
million to R150 million. Prior to making a new investment, OPM performs a thorough due
diligence investigation of the target firm. Investment terms are stipulated to ensure success.
These include incentives for operating managers of the target firm, a retention period for
senior management and representation on the board of the target firm by OPM executives.
In addition to senior management and the board of directors, OPM has the following staff
complement:
■■ Deal initiators – employees responsible for sourcing new private equity investments
(target firms) and presenting findings to senior management. Deal initiators also
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negotiate with the target firm, based on a mandate from senior management that
has been approved by the board of directors. The remuneration packages of all deal
initiators have a performance element that is linked to the value created by their
investments.
■■ Back office staff – employees responsible for undertaking due diligence investigations
and valuing investments for financial reporting and performance management purposes.
This is undertaken for both potential new investments and existing OPM investments.
It is done independently of the deal initiators, whose performance is based on the value
created by investments.
■■ Accountants and administrative assistants – employees responsible for compiling
monthly management accounts, financial statements and other matters related to
administration.
■■ Cleaning and security staff.
Back office division and Investment Oversight Committee
The firms in which OPM has invested submit compulsory management and financial reports.
When deemed necessary, back office staff undertakes surprise visits to these firms. These
provide valuable information that assists with the monitoring of investments. Quarterly
valuations are performed by the back office team and submitted to the Investment Oversight
Committee of the board of directors. This Committee considers the assumptions used, assesses
the accuracy of the data used and approves the final valuations. The Investment Oversight
Committee comprises the following four members:
■■ Mr. Brian Heynes, CA(SA) – finance director and chairman of the Investment
Oversight Committee. He has 15 years’ work experience within the financial services
industry and has held these two positions at OPM for the past three years.
■■ Mr. Edward Sithole – chief executive officer and chairman of the board. He has
recently been appointed to these positions after working for many years at a leading
international mining group as managing director of their South African operations.
■■ Ms. Brenda Koopman, CA(SA) – a senior deal initiator who was co-opted onto the
Committee during the 2013 financial year (‘FY2013’) after the resignation of a senior
board member who was also a member of this Committee. She is the best-qualified
private equity finance professional at OPM and is the wife of Mr. Henry Koopman, who
manages OPM’s back office division.
■■ Prof. Melanie Naicker – independent non-executive director, who sits on the boards of
two other listed companies. She has a PhD in strategy and has been employed with the
specific aim of providing OPM with strategic insights with respect to their investment
decisions.
Investment in Crescent Chickens (Pty) Ltd
In June 2014 Mr. Henry Koopman tasked back office staff with performing the work necessary
to value all of OPM’s investments at the end of OPM’s most recent financial year on 31 May
2014. Mr. Koopman reviews all valuations before submission to the Investment Oversight
Committee and his performance and remuneration are linked to the accuracy of the valuations
as assessed by the Investment Oversight Committee.
Details collected by a back office staff member relating to one of OPM’s investments, namely
Crescent Chickens (Pty) Ltd (‘CC’), are presented in appendices A and B. The valuation of
CC has not yet been completed, as the staff member responsible for valuing the company
has been booked off sick for an extended period. However, the deadline for submission of
all of OPM’s investment valuations by the back office division to the Investment Oversight
Committee is Monday, 30 June 2014.
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Appendix A: Information relating to the valuation of Crescent
Chicken (Pty) Ltd
Company background
CC is a poultry producer operating within South Africa and was established in 1978.
The company’s operations are predominantly located in KwaZulu-Natal, and through
various brands it provides quality, affordable poultry products to customers throughout
the country. The customer base of CC mainly comprises major food retailers as well
as companies operating in the food services industry (such as fast food outlets). CC is
regarded as a mid-tier poultry producer with approximately a 2% market share in South
Africa, delivering an estimated 350 000 chickens per week to its customers.
Acquisition by OPM
OPM acquired a controlling stake in CC on 1 June 2010. Prior to this date the majority
shareholders of CC were the management team members who had founded the company.
The management team, all of whom are close to retirement, sold the majority of their shares
to OPM in order to diversify their personal wealth prior to retirement. The terms of
the acquisition required that the management team remain in the employ of the company
until the end of FY2014. OPM paid R65 million for 60% of the equity shares of CC in issue
– the purchase price was based on a price-earnings multiple of 8,0 applied to net profit
after taxation for the year ended 31 May 2010. Subsequent to the acquisition, OPM
streamlined and aggressively expanded CC’s operations by means of debt finance, as CC
has historically had a very low gearing ratio.
Industry and company update (as at 14 June 2014)
The poultry industry has experienced significant pressures in recent years, mainly as a result
of rising input costs and the inability to pass the cost increases on to customers. Selling prices
have been constrained as a result of a flood of cheap chicken imports, which resulted in local
poultry producers being price takers at the mercy of the large retail chains. In addition, the
poultry industry remains fragmented, with no single supplier or group of suppliers dominating
the market. This has placed additional downward pressure on operating margins.
In line with the industry, CC has struggled to remain profitable and reported losses in
recent years. However, it has managed to report a profit for its FY2014. Extracts from the
draft financial statements for FY2014 as well as a projection of expected results for the
next three financial years are presented in appendix B, together with selected supporting
information which may be pertinent for the purposes of valuing CC. The forecast has
been prepared by CC’s financial manager, who included the following comment when
submitting the information to OPM’s back office:
‘OPM has increased the financial leverage of CC to an exceptionally high level; hence my
forecast has included a constant dividend policy (dividend cover of four times earnings) with
excess cash being used to decrease debt levels in future years rather than reward shareholders.
In addition to reducing CC’s excessive gearing, the implementation of a constant dividend
policy will provide shareholders with greater certainty regarding future distributions.
Taking into consideration future economic projections and the state of the poultry industry,
CC’s sustainable nominal growth rate beyond FY2017 is expected to be 6% per annum,
largely due to its smaller size. The South African long-term nominal economic growth rate
is forecast to be 8% per annum.
Surprise visits during the year
Two surprise visits were made to CC’s head office and operations by a team of back office
staff members during the past two years. The following pertinent information was noted:
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22 September 2013 surprise visit
■■ A new packaging process was installed during August 2013 which gives CC the edge
over competitors, as no other chicken producer has a similar packaging process. This
process guarantees what CC describes as a ‘fresher for longer’ product.
■■ A new operations manager was appointed on 1 September 2013 after the unexpected
resignation of the previous operations manager, who had worked for the company
for 23 years. In his resignation letter the former operations manager stated that his
resignation was due to stressful working conditions and a breakdown in relations
between the operations and finance divisions.
■■ Overall employee morale appeared lower than on previous visits.
13 June 2014 surprise visit
■■ No significant business process changes had occurred since the surprise visit in
September 2013 – all production processes, including the new packaging process,
appeared to be operating well.
■■ The operations manager who had been appointed on 1 September 2013 tendered his
letter of resignation during May 2014 and will be leaving the employ of the company
on 30 June 2014. CC has not yet found a suitable replacement and has no suitably
qualified internal staff members who would be able to fill the position.
■■ Employee morale remains on the low side but seems to have improved since the last
surprise visit.
Other information
The following market information has been gathered to assist with the valuation of CC:
■■ The current yield on the R186 long-term government bond is 7.8% per annum, while
short-term government treasury bills are yielding 4.9% per annum.
■■ The prime overdraft rate is presently 8.5% per annum.
■■ The average historic market risk premium for the South African equity market is
5.5% per annum.
■■ Current information applicable to listed poultry producers and the wider agricultural
sector is presented below:
Mr Henry Koopman believes the most appropriate way to lever and unlever betas is to use
the following Hamada formula:
BU = BL / [1 + (1 – T)(D/E)]
Where: BU = Unlevered beta
BL = Levered beta
T = Taxation rate
D = Market value of debt
E = Market value of equity
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Appendix B: Financial information relating to Crescent
Chicken (Pty) Ltd
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Notes
1. The operating expenses for FY2014 include remuneration paid to the management team that
founded CC and who were required to remain in the employ of the company until the end of
FY2014. Their remuneration was approximately R2.5m less in aggregate during 2014 than the
amount a similar management team would have been paid at market rates. This has been taken
into account in the forecast figures.
2. Interest income comprises interest on CC’s cash balances. Cash and cash equivalents reflect
operating cash requirements.
3. Interest on long-term borrowings is payable at a variable rate linked to the prime overdraft
rate. The interest rate payable is set at 250 basis points (2.5%) above the prime overdraft
rate. OPM’s target long-term debt-equity ratio for CC is 25% and is based on market values,
although the forecast which was prepared by the financial manager did not incorporate this.
4. CC had an unutilised assessed tax loss of R12.58m on 31 May 2014. This has correctly been
accounted for and the benefit thereof was fully recognised in accordance with IAS 12, Income
Taxes, resulting in a net deferred tax asset balance in the 2014 statement of financial position.
5. CC accounts for all property, plant and equipment in accordance with the cost model of IAS
16, Property, Plant and Equipment. Property, plant and equipment are reflected at a book value
close to the assets’ market value, except for the items specified below:
■■ Land and buildings acquired on 1 June 1990 at a cost of R3.8m now have a market value
of R30m. The property is used for operations and had a book and tax value of R2m on 31
May 2014. The fair value of the property was R12.5m on 1 October 2001.
■■ Equipment with a book value of R15.6m has an estimated market value of R4m.
6. Biological assets comprise chicken breeding stock and broilers (chickens specifically bred for
meat production). These assets are measured at their market value.
7. When the financial manager submitted the financial information to OPM’s back office he
indicated that a major customer had filed for bankruptcy on 12 June 2014. The customer
comprised 4% of the outstanding trade and other receivables balance at 31 May 2014, after
50% had been provided for in the form of an inclusion in CC’s allowance for doubtful debts at
year end due to a poor settlement history and long overdue invoices. Initial indications are that
CC will receive no compensation in respect of the amount owed.
8. Ordinary share capital comprises 1.5m shares in issue. The shares are held as follows:
The transferability of CC’s ordinary shares is restricted in terms of a ‘right of first refusal’ clause in the
shareholders’ agreement in terms of which shareholders are required to offer any shares they intend to sell to
other shareholders before such shares may be offered to third parties.
Required:
(a) Identify and describe the conflicts of interest that arise from the composition of the
Investment Oversight Committee of OPM. (12)
(b) Perform valuations of OPM’s equity interest in CC at 31 May 2014, using the following
valuation techniques:
■■ Free cash flow method,
■■ Earnings-based method; and
■■ Net asset value method.
Show all workings and set out the key assumptions you have used in each method. (41)
(c) Based on the results of your valuation in part (b) above, make a recommendation,
with reasons, to the Investment Oversight Committee regarding the appropriate
valuation method and value of the investment in CC as at 31 May 2014. (7)
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the cost of capital
7
The Weighted Average Cost of Capital and the Financial Crisis
Sasol is a major South African energy and chemicals group. It mines coal and produces liquid
fuels and chemical products. The group also produces gas and oil. Sasol is the largest producer
of synthetic fuels in the world with sales of over R181 billion. In the 2013 integrated report,
Sasol indicated that its weighted average cost of capital (WACC) is 12.95% in South Africa,
8%−11.20% in Europe and 8% in the USA. Sasol’s share price appreciated strongly in 2013
and early 2014 before falling significantly at the end of 2014 due to the collapse in the oil price.
In 2009, the financial crisis had a significant impact on its operations and expansion plans, and
the company experienced a sharp fall in its share price. What was the effect of the financial crisis
on Sasol’s cost of capital?
Sasol reported that the volatility of financial markets, the lack of liquidity and the increase in the
cost of debt affected the company’s cost of capital. In March 2009, the board of directors approved
a revised WACC from 11.75% to 13.25% for its South African operations. The lower WACC in
Europe and North America is due to significantly lower interest rates in these regions compared to
South Africa and an emerging market risk premium for South Africa. In 2014, Sasol’s WACC of
12.95% remains close to the WACC that Sasol adopted during the financial crisis. Sasol states that
it will manage its capital structure in order to reduce the group’s cost of capital.
Sasol should employ WACC to evaluate the economic viability of its capital projects but instead
uses a return of 1.3 times WACC to determine its targeted return. In its 2013 integrated report,
Sasol states that it uses this target return (hurdle rate) because certain capital projects do not
generate a return. An additional reason set out by Sasol for using a target return higher than its
WACC is to “ensure that the group only targets capital investment projects that meet the economic
returns required by our stakeholders, while providing a buffer for changes in economic conditions
applicable to the asset.” It seems that even in 2014, the volatility and disruptions caused by the
financial crisis endure when it comes to setting Sasol’s required return.
LEARNING OBJECTIVES
After working through this chapter, you should be able to:
■■ Understand the concept of the weighted-average cost of capital (WACC).
■■ Determine the cost of debt.
■■ Determine the cost of preference share capital.
■■ Calculate the cost of equity using the dividend growth model and the CAPM approach.
■■ Understand the practical issues of estimating the CAPM parameters.
■■ Understand how a firm’s capital structure affects a firm’s WACC.
■■ Calculate a firm’s WACC.
■■ Understand the use of the WACC in determining a firm’s Economic Value Added (EVA).
■■ Understand alternative methods of determining the cost of equity.
■■ Determine the cost of capital of divisions, including unlevering and relevering betas.
■■ Reflect on adjustments made in practice to the cost of equity.
■■ Comprehend the evidence of the market risk premium based on surveys and historical
returns.
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7-2
FINANCIAL MANAGEMENT
■■ Understand why companies use hurdle rates that differ from its WACC to evaluate
projects.
■■ Reflect on the empirical evidence of CAPM.
■■ Understand how to use the Fama-French Three-Factor model to determine a company’s
cost of equity.
Introduction
You will recall that the financial manager is required to create wealth through effective
and efficient use of financial resources. The financial manager applies these resources, in
accordance with the strategic objectives of the business, by seeking investment opportunities
which achieve a return at least equal to that required by investors. If the business in question
is a company, and the shareholders provide all the required funds, the rate of return required
by shareholders is that company’s cost of capital.
When the assets required by the company are not financed totally by shareholders’
funds, each R1 invested emanates in some proportion from various sources of funds. The
proportion in which it is decided to use various sources of finance is the capital structure of
the company.
For example, company A, which requires R500m in financing, may issue ordinary
shares for the full amount or may decide to raise R300m through the issue of ordinary shares
and the remaining R200m through the issue of debt. Deciding on the capital structure of
a company is not straightforward; the decision is made by management, who try to select
the option most likely to succeed in creating wealth for the shareholders. This chapter does
not debate the issues relating to selection of an optimal capital structure. We will do this
in Chapter 14. Many companies are of the view that an appropriate target capital structure
will reduce their cost of capital. For example, in its 2013 integrated report, Distell states that
an objective of management is to “maintain an optimal capital structure to reduce the cost
of capital.” In this chapter we will focus on determining the overall rate of return required,
given an existing target capital structure. Before we can determine a company’s WACC, we
first have to calculate the marginal cost of debt, preference shares and ordinary equity and
then determine the weight of each financing source within the company’s capital structure.
If a company has equity and debt only and the cost of equity is 12% while the after-tax cost
of debt is 8%, and if we assume a target debt ratio of 50%, then the company’s WACC will
be 10% (50% × 12% + 50% × 8%).
In order to develop the procedure, two assumptions are made. Firstly, it is assumed that a
target capital structure exists for each company. This means that management accepts that an
ideal proportion of equity and debt exists in the financing of the company. Secondly, for now it is
assumed that the assets into which the funds will be invested fall into a similar risk category (i.e.
that the company uses one overall rate of required return). The approach to be adopted when
assessing projects with risks different from that of the overall company will be discussed
later in the chapter.
In this chapter, we will firstly explain the importance of the weighted-average cost of
capital and explain the underlying principles. Then, we will explain the pooling of funds
concept and determine the component costs such as the cost of ordinary equity, preference
shares and the cost of debt. Thereafter, we evaluate the use of a target capital structure and
the determination of individual weightings before we analyse such issues as divisional costs
of capital and explore the important practical issues involved in setting a weighted-average
cost of capital in the real world.
1 The weighted-average cost of capital
Why is the weighted-average cost of capital (WACC) so important? The following are some
compelling reasons for calculating a company’s cost