The Financing Decision
COMPONENT 5
THE FINANCING DECISION
1
INTRODUCTION
The investment decision, the financing decision and the dividend decision are
the three main financial problems that the financial manager is responsible for.
During the investment decision, it must be determined whether the capital spent
on certain projects or activities will provide a certain minimum return. If the project
is worthwhile in terms of its expected return, then the financing decision must
be tackled, namely where the required capital that must be invested in the project,
will come from. Should the correct financial resources be utilised and the
company realise a profit, then the third major question arises, namely, how the
attributable earnings must be appropriated. During the dividend decision, it must
be decided whether the attributable earnings will be distributed, retained in the
enterprise as a reserve or utilised as further financing. This chapter deals with the
financing question, i.e. where will the required capital come from? The various
sources of capital will each be evaluated separately in terms of their effect on the
profitability of the enterprise. Towards the end of the chapter, the effect of the
various sources of capital on the liquidity and solvency of the enterprise will be
discussed. Other aspects that will be dealt with in this chapter are the issuing
of further ordinary shares by means of a rights issue, the determination of the
sustainable growth rate and the functioning of the total leverage.
The Statement of financial position of an enterprise provides an overview of
especially the investment decision and the financing decision. On the asset side
we find the application of the various capital sources, in other words, the
investment of the capital in assets, be it short-term or long-term assets. On the
liabilities and equity side of the statement of financial position, we find the sources
of capital. These sources consist of the own and debt capital.
Statement of Financial Position of ABC Company
ASSETS
LIABILITIES AND EQUITY
Application of funds
Sources of funds
Non-current assets
Shareholders' equity
Current assets
Non-current liabilities
Current liabilities
The shareholders' equity is called the own capital as this represents the interest of
the owners in the company. The non-current liabilities (long-term) and the current
liabilities (short-term) form the borrowed capital or debt capital of the enterprise.
Remember that the deferred taxation liability is not included in the debt.
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Introduction to Financial Management
2
TYPES OF FINANCING
In a discussion of the types of financing a distinction must be made between
shareholders' equity and debt capital. Shareholders' equity consists of the
ordinary share capital, the preference share capital and all the reserves. Debt
capital is subdivided into those liabilities that are long-term in nature, the so-called
non-current liabilities, consisting primarily of debentures, long-term loans and
mortgages, and those that are short-term in nature, the so-called current liabilities,
consisting primarily of trade payables, bank overdraft, short-term loans and
payments in arrears. The shareholders' equity differs in various respects from the
debt. Firstly, with shareholders' equity, there is a degree of permanency, that is,
the capital is permanently available to the enterprise and does not have to be
repaid on a specific future date or over a specified period. Although ordinary
shares can be repurchased by the company and reserves can be utilised, this
does not influence the permanent character of these capital types as the actions
are based on management decisions and cannot be contractually compelled by
parties from outside the company. The only exception to this permanent nature of
shareholders' equity is preference shares that are redeemable or convertible on
or before a certain future date. On the other hand, all debt capital must be repaid
over the short or long term. The exception is debentures that are convertible
into ordinary shares. The convertibility into ordinary shares provides it with a
permanent character. Secondly, the cost of shareholders' equity is not a legally
compelled payment, whilst payment of the financing costs of debt can be enforced
legally and non-payment could lead to the liquidation of the enterprise. There is
a reasonable expectation that dividends will be paid on ordinary shares and in
the case of cumulative preference shares, the dividends in arrears will accumulate
and be paid eventually when attributable earnings are available. A third important
difference between shareholders' equity and debt is the fact that the financing cost
of debt is an expense that is subtracted to reduce the profit before tax (a tax
advantage), whereas the dividends on ordinary and preference shares are
covered by after-tax profits. Financing by means of debt can therefore lead to
less tax being paid, whereas shareholders' equity as a form of financing will not
lead to a tax saving. For this reason, financial management differs from financial
accounting. Financial accounting views redeemable preference shares as a noncurrent liability and the dividends on preference shares are indicated as finance
costs. Financial management classifies preference shares under shareholders’
equity, and as the dividends do not count for tax relief it is only entered after the
taxation calculation has been done.
2.1
ORDINARY SHARES
Most shares are ordinary shares. Typical characteristics of ordinary shares are:
•
Ordinary shareholders own a part of the company, i.e. they are co-owners of
the company. The assets and possessions of the company, therefore,
indirectly belong to the shareholders.
•
Shareholders have voting power on the basis of “one ordinary share, one
vote”. With their voting power, shareholders participate in the management of
the company as they can vote on issues such as takeovers, mergers and other
major aspects. However, they cannot vote on the amount of the dividend that
they will receive.
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The Financing Decision
•
Shareholders normally receive a portion of the attributable earnings of the
company in the form of dividends. Although they have no legal right to
dividends, they can lay claim to the profits that remain after all obligations have
been met.
•
Shareholders have a pre-emptive right to any new shares that the company
issues. This is to enable them to maintain their percentage interest in the
company.
•
Shareholders enjoy the benefit of limited liability. If the company should fail,
shareholders only lose the value of the shares that they possess. They cannot
personally be held liable for the obligations of the company.
•
Shares, and particularly listed shares, are tradable and thus very liquid.
Shareholders can easily and at very low costs get rid of their shares through
the mechanism of the JSE.
•
Shares have the potential to generate capital gains. If the company expands at
a steady rate, the market price of its shares will increase in value. This creates
the opportunity for shareholders to sell their shares at a higher price than the
price at which they purchased them, i.e. they can realise a capital profit.
•
Ordinary shareholders have the last claim to the assets and profit of the
company. If the company should fail, they are last in the queue, behind the
creditors, receiver of revenue and the preference shareholders, to receive
anything from the company.
2.2
PREFERENCE SHARES
Preference shares still provide a share in the company, but normally their voting
power is limited, or the shareholder has none. These shareholders, however, are
a step ahead of the ordinary shareholders in the case of bankruptcy and the
distribution of profits. A fixed dividend is guaranteed for as long as the shares
exist (the dividend is calculated as a percentage of the par value [face value] of
the share). With the exception of cumulative preference shares, the enterprise
must first realise a profit before the dividend will be paid. The market price of
preference shares is more stable than that of ordinary shares.
There are different types of preference shares. There can also be a combination
of these types.
•
Cumulative preference shares: If the company does not have the cash to pay
dividends, then the dividends will accumulate and will be paid back as soon as
there are funds available.
•
Non-cumulative preference shares: No outstanding dividends from previous
years will be paid back.
•
Participating preference shares: These shareholders may receive a higher
dividend than was previously determined if the company experiences a larger
profit than was expected.
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Introduction to Financial Management
•
Convertible preference shares: These shares can be converted into a fixed
number of ordinary shares or debentures.
•
Redeemable preference shares: On a certain future date, these shares will be
bought back at their par value by the company.
2.3
RESERVES
Reserves are created when profits are not distributed in the form of dividends.
This portion is then reinvested in the enterprise (retained earnings). Reserves
can also be formed at the stage when income is determined through the formation
of hidden reserves. Reserves increase the creditworthiness of the enterprise since
they provide an extra guarantee to creditors and increase the risk-carrying ability
of the enterprise.
A distinction can be made between distributable and non-distributable reserves.
Distributable reserves are built up from attributable earnings and are available
for distribution to the ordinary shareholders in the form of dividends, be it a cash
dividend or a capitalisation issue. The most important item included here is the
retained earnings. The general reserve, which is built up for the replacement of
assets, is also a distributable reserve.
Non-distributable reserves are all reserves that cannot be paid out to the ordinary
shareholders in the form of a dividend. These reserves include items such as
revaluation reserves and capital redemption reserves.
The ordinary share capital plus all reserves make up the ordinary shareholders'
equity of the enterprise. The ordinary shareholders' equity is often called the
controlling share capital as the ordinary shareholders normally hold the voting
power in the enterprise. When the preference share capital is added to the
ordinary shareholders' equity, the shareholders' equity is determined.
2.4
NON-CURRENT LIABILITIES
All long-term (more than one year) debt capital is classified as non-current
liabilities. The major type of non-current liability is interest-bearing borrowings,
which include all long-term debt capital where interest payments (financing cost)
and final redemption of the capital provided are required. Examples are: long-term
loans where a certain amount is borrowed, the interest rate can be fixed or vary
along with general interest rates and the redemption can be spread over the term
of the loan or be done at the end of the period. Mortgage loans are basically the
same as long-term loans, except for the difference that the loans are covered by
an asset (property) as security and that the repayment is done over the term of
the loans. On the other hand, with debentures, a fixed amount is borrowed for a
fixed period at a fixed interest rate; the interest is paid annually or semi-annually,
and the amount borrowed is paid back at the end of the term.
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The Financing Decision
2.5
CURRENT LIABILITIES
All short-term (less than one year) debt capital is classified as current liabilities. In
most cases, current liabilities provide an important contribution to the total capital
requirement, in particular to the variable capital requirement of the enterprise.
Examples of current liabilities are:
•
•
•
•
•
3
Trade payables which are created when items are purchased on credit and
payment only takes place after a period of time. If payment is on time, there
is normally no interest obligation (financing costs).
Short-term loans are loans that will be redeemed within the next financial year.
Any portion of the non-current liabilities that must be redeemed within the
next year will also be listed under the current liabilities as the current portion
of interest-bearing borrowings.
Further current liabilities are amounts due or payable such as interest
payable (financing cost obligation that is due but has not been paid yet),
dividends payable (dividends that have been declared but not paid yet) and
taxation payable.
Bank overdraft is funds borrowed against the bank account. This is usually
only applied over the short term due to the high financing cost associated
with such a facility.
THE SIGNAL THEORY
This theory implies that the method used by a company to finance its capital
needs will send a certain signal to its existing and potential shareholders. During
the composition of its capital structure, the management of the company will at
all times keep the enterprise goal of maximization of shareholders’ wealth in
mind. Any form of financing that affects the shareholders’ wealth (share price)
negatively, must be avoided.
Supporters of this theory believe that the use of internal financing, i.e. the use of
retained earnings, will send the most positive signal to shareholders. Using
retained earnings is typical of a management that plans for the future (longevity)
of the company as they are not distributing all their attributable earnings. They are
providing for the sustainable growth of the company. Furthermore, the application
of retained earnings provides various advantages to the company. Firstly, the
financing is immediately available to the company. There is no long time delay
due to negotiations for credit (debt) and no time loss due to a rights issue.
Secondly, there is no negative influence on the solvency as would be the case
with acquiring interest-bearing borrowings. The share price is also not diluted
(pushed down) as with a rights issue.
According to the theory, the issuing of ordinary shares (a rights issue) as a source
of financing is considered the last option due to the negative signal that it
provides. A rights issue creates the impression with the shareholders that the
shares are overvalued. As shareholders do not have complete insight into the
actual value of the assets of the company, they can easily view the issuing of new
ordinary shares as an indication of the shares being overvalued. The new shares
are normally sold at an issue price which is lower than the existing market price;
therefore, the rights issue will push the market price downwards. The value of the
company is now dispersed over more shares which will also lead to a drop in the
market price. During a rights issue, the company itself experiences a long time69
Introduction to Financial Management
lapse till the eventual receipt of the required capital (finance) and a substantial
administrative process of issuing and distributing the prospectus and other
documents is required. It is a relatively expensive method of attracting capital.
On the other hand, acquiring debt as financing is viewed by investors as a positive
signal. It sends a message to investors that management is positive as to its
ability to pay the additional finance costs (interest) as well as its ability to repay
the debt. Although additional loan capital (debt) affects the solvency of the
company negatively, shareholders view the working of positive financial leverage
on the earnings per share as more important and very positive. Furthermore, the
finance costs (interest obligation) of debt are treated as an expense, and they
may be subtracted from the profit before taxation. Thus, a tax reduction is
achieved. Dividends (preference and ordinary) are paid out of profit after tax. The
use of debt is thus more positive from a cost/taxation perspective. The acquisition
of debt is much faster and simpler than a rights issue.
All these signals projected from selecting a specific form of financing lead to the
so-called “pecking order” theory. According to this theory, the company, in its
search for financing (capital), will first use retained earnings. Thereafter, it will
consider debt (loan capital), then convertible debt and preference shares and
lastly, it will resort to issuing new ordinary shares.
In the discussion of the various forms of financing, this order, as proposed by the
pecking order theory, will be applied.
4
RETAINED EARNINGS AS SOURCE OF FINANCING
The management of a company will, according to the pecking order theory, use
internal equity by means of retained earnings as its first source of financing.
From the perspective of earnings per share, it would seem that retained earnings
are the most beneficial source of financing as it provides the highest EPS.
Furthermore, it has the advantage that it never is paid back and there are
no financing costs associated with it. However, ordinary shareholders want to
receive a dividend and they will be very unhappy if all the attributable earnings
are reinvested as financing year after year.
Example:
Rasco Limited considers the following investment:
Investment = R400 000
Tax rate
= 27 percent
Existing ordinary share capital = 100 000 shares = R1 million
Expected Ro
Expected EBIT
14%
@ 14%: R56 000
70
5%
@ 5%: R20 000
The Financing Decision
Rasco Limited considers the following three financing options:
Ordinary shares
Debt @ 7%
Retained earnings
Option 1
30 000 @ R10
R100 000
Option 2
R250 000
R150 000
Option 3
R400 000
If the return on total assets is equal to 14%, the following earnings per share will
be obtained according to the various mixes of financing utilised.
EPS for the different financing options if Ro = 14%
EBIT
56 000
56 000
Financing costs (Rv) (7%)
(7 000)
(17 500)
Profit before taxation
49 000
38 500
Taxation (27%)
(13 230)
(10 395)
Profit after taxation
35 770
28 105
Number of ordinary shares
130 000
100 000
Earnings per share (EPS)
27.52c
28.11c
56 000
(0)
56 000
(15 120)
40 880
100 000
40.88c
A return on total assets of 5% will achieve the following earnings per share.
EPS for the different financing options if Ro = 5%
EBIT
20 000
20 000
Financing costs (Rv) (7%)
(7 000)
(17 500)
Profit before taxation
13 000
2 500
Taxation (27%)
(3 510)
(675)
Profit after taxation
9 490
1 825
Number of ordinary shares
130 000
100 000
Earnings per share (EPS)
7.30c
1.83c
20 000
(0)
20 000
(5 400)
14 600
100 000
14.60c
It is obvious that when the Ro is high (14%), retained earnings provide the best
financing option in terms of earnings per share. The moment the R o drops (5%),
then retained earnings are an even better financing option!
5
DEBT AS A SOURCE OF FINANCING
In the following discussion of debt capital as a source of financing the assumption
will be made that the enterprise is fully financed with debt. This is something that
will not happen in practice, as all enterprises will have a certain amount of share
capital in their financial structure. Omitting share capital from the discussion,
however, simplifies and clarifies the explanation.
The debt of an enterprise consists of two main groups, namely the short-term
sources of financing (current liabilities) that are available on the money market
and the long-term financing sources (non-current liabilities) that are available
on the capital market. Normally the cost (interest) of the long-term sources of
financing is lower than that of the short-term sources. However, the lender is
bound for a longer period and must pay the interest even if he does not require
the capital any more.
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Introduction to Financial Management
In the discussion that follows we study the situation of Lazy M Limited. From their
financial planning for the coming year, it is derived that the current assets and
non-current assets of Lazy M will be as in the table below:
TABLE 1
Month
January
February
March
April
May
June
July
August
September
October
November
December
THE CAPITAL REQUIREMENTS OF LAZY M LIMITED FOR THE
COMING YEAR
Current
assets
Non-current
assets
Total assets
[(1) + (2)] =
Permanent
capital
requirement
(1)
10 000
20 000
25 000
40 000
35 000
20 000
15 000
25 000
30 000
40 000
25 000
15 000
(2)
50 000
50 000
50 000
50 000
50 000
50 000
50 000
50 000
50 000
50 000
50 000
50 000
(3)
60 000
70 000
75 000
90 000
85 000
70 000
65 000
75 000
80 000
90 000
75 000
65 000
(4)
60 000
60 000
60 000
60 000
60 000
60 000
60 000
60 000
60 000
60 000
60 000
60 000
Total
Variable capital
requirement
[(3) - (4) =
(5)
0
10 000
15 000
30 000
25 000
10 000
5 000
15 000
20 000
30 000
15 000
5 000
180 000
÷ 12
= 15 000
From the table, one can see that the permanent capital requirement (column 4),
i.e. the capital requirement that will remain constant throughout the year,
is R60 000. This consists of the non-current assets of R50 000 that are
fixed for the whole year, plus the lowest current assets of the various months
(R10 000 in January). Every month the enterprise, therefore, requires at least a
constant amount (permanent capital requirement) of R60 000. Over-and-above
this R60 000 there is also a variable capital requirement (column 5) that is
a function of the total capital requirement in that specific month. For example, in
February the total amount required is R70 000; the permanent capital requirement
is R60 000; therefore, the enterprise requires a further (variable) R10 000 in
February. By adding the variable capital requirements of the various months
and dividing the total by 12, we find that the average variable capital requirement
of Lazy M is R15 000 per month. Furthermore, we determined that the current
money market rate (short-term) is 12% p.a. and the long-term rate (capital market)
is 8% p.a. The capital requirements of Lazy M are illustrated in Figure 1.
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The Financing Decision
Variable
capital
requirement
90
80
70
60
Permanent
capital
requirement
CAPITAL REQUIREMENT
(R’ 000)
100
50
40
0
Jan
FIGURE 1
Feb
Mar
Apr
May June July
Aug
Sep
Oct
Nov
Dec
CAPITAL REQUIREMENTS OF LAZY M LIMITED FOR THE YEAR
The above capital requirement can also be illustrated as in Figure 2
Minimum current assets
50
Non-current assets
Variable capital
requirement
Ave var cap req
Permanent capital
requirement
60
Max var cap req
75
Maximum capital requirement
Maximum current assets
CAPITAL REQUIREMENT
(R’ 000)
90
0
n
6 months
FIGURE 2
CAPITAL REQUIREMENTS OF LAZY M LIMITED FOR THE YEAR
Lazy M can now follow one of two financing approaches.
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Introduction to Financial Management
5.1
THE AGGRESSIVE APPROACH
According to the aggressive approach, the enterprise will only borrow the absolute
minimum amount of capital each month so that there will be no unutilised capital
and, thus, no unnecessary financing costs paid. This implies that the enterprise
will borrow the permanent capital requirement on a long-term basis (@ 8% p.a.)
and that the variable capital requirement will be provided for from short-term
sources (@ 12% p.a.). The total financing costs for the year will be as follows:
Long-term credit (column 4) (R60 000 @ 8% p.a.)
Short-term credit (column 5) ( R180 000 12 @ 12% p.a.)
Total financing costs
R4 800
1 800
R6 600
This approach certainly contains certain dangers (risks) for the enterprise. Should
the capital requirement increase drastically due to an increase in the current
assets, the enterprise will experience severe difficulties in obtaining further shortterm funds as it is already requiring substantial amounts in certain months (see
April and October). The enterprise’s short-term sources of financing are already
exhausted. Secondly, there are no reserve short-term sources of financing
available should speculative opportunities (for example, inventory purchases at
very special prices) arise. In the third place, the financing costs could vary
substantially throughout the year as short-term interest rates tend to fluctuate
much more than the long-term rates do. In the fourth place, money market
conditions can become tight, meaning that funds are not readily available. The
enterprise will then not be able to obtain the funds they require.
5.2
THE CONSERVATIVE APPROACH
A second financing option for the enterprise is to acquire the maximum capital
requirement that may arise throughout the year (R90 000 in April and October)
by means of long-term sources of financing for the full year. There will then
always be sufficient capital available irrespective of what the capital need of the
specific month is. The short-term sources of financing will not be utilised and are
now available in full for emergencies or speculative opportunities. However, the
disadvantage of this approach is that certain amounts of capital may be unutilised
at a cost during certain months. Using the conservative approach, the total costs
for the year will be:
Long-term credit (R90 000 @ 8% p.a.)
Total financing costs
R7 200
R7 200
The financing costs are now more expensive than when using the aggressive
approach. A comparison between the two approaches indicates the following in
terms of risk and profitability:
Financing plan
Aggressive
Risk
Highest
Total financing
costs
R6 600
Profitability
Highest
Conservative
Lowest
R7 200
Lowest
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The Financing Decision
In most cases, enterprises will follow an approach midway between the
conservative and aggressive approach.
5.3
THE CRITICAL PERIOD
Although the conservative approach will lead to higher financing costs, it is
sometimes financially more advantageous than the aggressive approach should
the unutilised part of the long-term financing be reinvested over the short term.
Some of the financing costs are thus recovered (earned back) and this can
decrease the total financing costs to such an extent that it will be cheaper than the
aggressive approach.
It is now necessary to determine the effective cost per annum of the variable
capital requirement that is financed with long-term credit. Should the capital be
reinvested over the short term during the period that it is not being utilised (period
of non-requirement), that reinvestment will earn a very low interest rate, say 6%
per annum in the case of Lazy M. The low interest rate is due to the fact that the
funds are reinvested for a short period and must be very liquid. Many people tend
to reason that since the long-term credit is borrowed at 8%, and the enterprise
is earning 6% on the reinvested capital, the cost to the enterprise is only 2%!
This is a great mistake, so let us try and clarify this with the following example.
Example:
The enterprise borrows its capital over the long term at 8% p.a., and over the
short term at 12% p.a. Unutilised capital is reinvested during periods of
non-requirement at 6% p.a. The variable capital requirement of the enterprise
is equal to R30 000 for three months, i.e. if all the variable capital requirements
throughout the year are accumulated it is as though the enterprise requires an
additional R30 000 for three months.
According to the aggressive approach, the enterprise will borrow R30 000 for
only three months at 12% p.a. which will result in a total cost of:
R30 000 x 12% x 3 12 months = R900
According to the conservative approach, the enterprise will borrow the R30 000
for the full year at 8% p.a. and then reinvest the unutilised R30 000 for the nine
months period of non-requirement at 6 % p.a., which will result in a total cost of:
R30 000 x 8% x 1 year
= R2 400
Minus R30 000 x 6% x 9 12 months
Total cost
= (1 350)
= R1 050
As the cost per annum of the long-term financing option (R1 050) is more than
the cost of the short-term option (R900), it is quite clear that the effective cost of
the long-term option must be greater than the 12% p.a. of the short-term option.
The cost of the long-term option can be calculated with the following formula:
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Introduction to Financial Management
12 - n
(PL - PC)%
n
= the effective cost of the long-term credit
= the interest rate per annum on long-term credit
= the interest rate that can be earned by the long-term credit
during the period of non-requirement
= the period that the long-term credit will be utilised by the
enterprise
rℓ = PL +
where: rℓ
PL
PC
n
The effective cost of the long-term financing thus amounts to:
rℓ = 8 +
12 - 3
(8 - 6)% = 8 + 6
3
= 14%
However, should the R30 000 variable capital requirement be required for nine
months, the picture changes considerably.
Cost of the aggressive approach:
R30 000 x 12% x 9 12 months
= R2 700
Cost of the conservative approach:
R30 000 x 8% x 1 year
Minus R30 000 x 6% x 3 12 months
Total cost
= R2 400
=
(450)
= R1 950
The cost of the long-term financing (R1 950) is now much cheaper than the
cost of the short-term financing (R2 700), and therefore the effective cost of the
long-term option should be lower than the 12% p.a. of the short-term option. The
effective cost is:
12 - 9
(8 - 6)% = 8 + 0,67
9
= 8,67%
rℓ = 8 +
Normally PL > PC, since the capital that is borrowed over the long term must be
reinvested over the short term in very liquid instruments. As can be deduced from
the above formula, the effective cost of the long-term capital is equal to the cost
(interest) per annum on the long-term credit plus the difference between the
interest paid and the interest earned in the period of non-requirement, where the
period of non-requirement leads to the factor
12 - n
n
The above example raises another aspect. When the variable capital was
required for three months, the effective cost of the long-term credit was 14%,
relative to the 12% of the short-term credit (period of non-requirement =
9 months). When the variable capital was required for nine months (period of
non-requirement = 3 months), then the effective cost of the long-term credit was
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The Financing Decision
8,67% relative to the 12% of the short-term credit. It is clear that the longer the
period of utilisation of the capital, the more advantageous the long-term option
becomes and at a certain stage, the long-term option becomes cheaper than the
short-term option. The critical period is the period where the cost of using longterm credit is equal to the cost of short-term credit. Should the variable capital
requirement be required for this period (time), then it will make no difference
whether long-term- or short-term credit is utilised. The moment the period of
utilisation is longer than the critical period, then long-term capital will be more
advantageous, and for periods shorter than the critical period, short-term capital
is more advantageous. The critical period is determined with the following formula:
Critical period =
PL - PC
x 12 months
PK - PC
where:
PK = the interest rate per annum on short-term credit.
[the 12 months can be replaced by 365 days or 52 weeks]
To calculate the critical period it is required that
PL - PC
< 1,
PK - PC
i.e. PK > PL > PC
In the above example, the critical period is:
8 - 6
=
x 12
12 - 6
= 4 months
In exceptional circumstances, it could occur that the long-term rate will be higher
than the short-term rate. Let us assume an enterprise issued debentures at 10%
(long-term rate) 8 years ago. At that stage, the short-term rate was 14%. Over the
8 years, interest rates gradually declined, so the short-term rate presently is 9%.
However, the enterprise is obligated (till maturity) to still pay 10% on the
debentures, and therefore the long-term rate is now higher than the short-term
rate. Under these circumstances, the critical period will be longer than a year,
which does not make sense.
A number of objections can be raised against the calculation of the critical
period. It is assumed that interest rates are constant and that the long-term rate
is lower than the short-term rate. In practice, the interest rates fluctuate. Secondly,
it is assumed that the capital requirement increases and decreases gradually,
which also is not the situation in reality.
In summary, it can be stated that the permanent capital requirement of the
enterprise will be provided with long-term sources of financing as the cost of longterm financing is normally cheaper than that of short-term financing. The variable
capital requirement will, from a profitability angle, be financed from short-term
resources according to the aggressive approach, but this creates a risk for the
enterprise. Should the enterprise decide to use long-term capital to provide for
the variable capital requirement and then reinvest the unutilised capital for the
period of non-requirement, then this option may become cheaper than the
aggressive approach. The critical period must first be determined and if the period
of utilisation of the variable capital is longer than the critical period, then using
long-term capital will be advantageous.
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Introduction to Financial Management
6
PREFERENCE SHARES AS SOURCE OF FINANCING
After the internal equity (retained earnings) and debt have been depleted as
sources of financing, the management will turn to external equity (preference
and ordinary shares) to satisfy its need for capital. According to the pecking order
theory, preference shares are preferred as a source of financing above ordinary
shares. Preference shares, and in particular cumulative preference shares, are
often viewed as semi-debt in the sense that the cost of financing (dividend rate)
is fixed. However, keep in mind that the dividend is paid out of profits remaining
after taxation and, therefore, must be recalculated to a value before tax in the
following manner:
Preference dividend rate
(1 - t)
Should this pre-tax dividend rate be smaller than R o, then there is a positive
financial leverage effect and the application of preference shares as a source
of financing will be beneficial for the ordinary shareholders. A great advantage
of preference shares over debt is the fact that the enterprise is not legally
obligated to pay the dividend. Therefore, the non-payment of the dividend
cannot force the enterprise into liquidation. Furthermore, the use of preference
shares will improve the solvency of the enterprise, whereas debt will have the
opposite effect. Unfortunately, the pre-tax dividend rate of preference shares is
normally higher than the cost of debt (R v).
7
ORDINARY SHARES AS A SOURCE OF FINANCING
The financial aim of the enterprise is the maximisation of the shareholders' wealth
and in particular, that of the ordinary shareholders. In this section, the combination
of ordinary share capital and debt that will achieve this aim from the viewpoint of
the functioning of financial leverage will first be studied. Then the same problem
will be examined from the angle of the calculation of the indifference point.
7.1
THE FINANCIAL LEVERAGE AND EQUITY
Later in this chapter the total leverage, which consists of the financial leverage
and the operating leverage, will be dealt with. In brief, the operating leverage
deals with the application of fixed and variable costs and is reflected in the
composition of the assets of the enterprise. On the other hand, financial leverage
deals with the methods of financing of the enterprise and the effect thereof can be
seen in the combination of debt and equity.
In Component 2, we dealt with the financial leverage factor which was calculated
in the following manner:
Return on equity (Re )
Return on assets (Ro )
A positive or beneficial financial leverage effect is obtained when the return on
total assets (Ro) is greater than the cost of debt (R v) (finance costs). The logic
78
The Financing Decision
behind this is that should an enterprise borrow R100 at 5% (R v = 5%) and the
enterprise can earn 8% (R o = 8%) with that money, then the extra 3% earnings
are available for the ordinary shareholders.
The financial leverage can be interpreted as follows:
Positive leverage:
Negative leverage:
No leverage:
Ro > Rv and Re > Ro
Ro < Rv and Re < Ro
Ro = Rv and Re = Ro
The relationship between Ro, Re and Rv can be investigated by means of the
following equation:
Re = [Ro +
Kv
(Ro - Rv)]
Ke
Where:
Kv
Ke
= Debt capital
= Equity
In Table 2, the return on equity (Re) is calculated at various returns on assets (Ro)
if the cost of debt capital (Rv) is equal to 8%, and the debt varies as a percentage
of total capital.
TABLE 2
Re AT VARIOUS Ro AND Kv
Return on equity (Re) with debt (Kv) as % of total
capital
0
20
40
60
80
Ro
Rv
16
16
18
21,3
28
48
12
12
13
14,7
18
28
8
8
8
8
8
8
4
4
3
1,3
-2
-12
0
0
-2
-5,3
-12
-32
The above table is read as follows: If the return on total assets (R o) = 12% and
the debt = 60% of the total capital, then the return on equity (Re) = 18%. As the
return on total assets (R o) of 12% is more than the cost of debt (Rv) which is 8%,
the additional 4% will go to the shareholders; the more debt capital there is, the
fewer shareholders there will be and thus the greater the return on equity. The
data from Table 2 is illustrated in Figure 3.
From Table 2 and Figure 3 it is quite clear that as long as the financial leverage
effect is positive (i.e. Re > Ro > Rv), it will be beneficial for the shareholders if the
enterprise utilises as much debt as possible as a source of financing. The
influence that the excessive application of debt could have on the solvency and
liquidity of the enterprise, however, should also be considered.
79
Introduction to Financial Management
Re
50
Ro = 16%
40
30
Ro = 12%
20
10
Ro = Rv = 8%
0
-10
Ro = 4%
-20
Ro = 0%
-30
0
FIGURE 3
20
40
60
80
Kv
Re AT VARIOUS Ro AND Kv
If there is no leverage effect (i.e. Re = Ro = Rv), then it will not matter which source
of financing is utilised from a profitability perspective. Where the leverage effect is
negative (i.e. Re < Ro < Rv), the enterprise must avoid debt as far as possible.
7.2
THE POINT OF INDIFFERENCE
A second angle from which the question of debt versus ordinary share capital can
be viewed is the effect that it has on the earnings per share (EPS). Consider the
following example:
Financing structure of:
Ordinary shares (number of shares)
Debt @ 7% p.a.
Total capital
Company A
5 000 (# 5 000)
0
5 000
Company B
1 000 (# 1 000)
4 000
5 000
Earnings per share at different returns on assets:
Ro = 12%
Ro = 5%
Co A
Co B
600
600
250
250
Finance costs (interest)
0
(280)
0
(280)
Profit before taxation
600
320
250
(30)
Tax (27%)
(162)
(86.40)
(67.50)
(0)
Profit after taxation
438
233.60
182.50
(30)
Number of shares
5 000
1 000
5 000
1 000
Earnings per share
8.76c
23.36c
3.65c
-3.00c
Operating profit
80
Co A
Co B
The Financing Decision
The example clearly indicates that as long as the return on total assets (R o)
is greater than the cost of debt (Rv) (12% > 7%), then the enterprise with more
debt capital (Co B) will provide a better earnings per share (23.36c vs 8.76c). The
moment the Ro drops to below the Rv (5% < 7%), then company A with more
ordinary share capital is more beneficial for the shareholders (3.65c vs -3.00c).
During the decline in the operating profit from R600 to R250, the positive effect
of the financial leverage has been eradicated. The operating profit where the
functioning of the financial leverage is neutralised is called the indifference point.
At this operating profit, the enterprise will earn the same earnings per share,
irrespective of which source of financing is utilised. The indifference point is
calculated as follows:
EPS of Co A = EPS of Co B
Where earnings per share (EPS) =
(Operating profit - finance costs)(1- tax rate) - preference share dividends
Number of ordinary shares
[if there is no investment income and/or profit/loss on PPE]
Therefore, the operating profit at the point of indifference in the above example is:
=
Thus, Ib = R350
If the operating profit decreases from R600 to R350, then the advantage of
positive financial leverage will disappear. Should the operating profit decrease
to less than R350, the effect of the financial leverage will become negative and
financing by means of ordinary shares will be more beneficial. Therefore, with
an operating profit of more than R350, Ro > Rv and there is positive financial
leverage. With an operating profit of less than R350, Ro < Rv and there is a
negative financial leverage. This situation is depicted in Figure 4:
EPS
(cent)
20
Debt
15
Advantage for debt
10
Ordinary shares
5
Advantage for
ordinary shares
0
0
FIGURE 4
100
200
300
400
THE POINT OF INDIFFERENCE
81
500
600
Operating profit
Introduction to Financial Management
8
ISSUING FURTHER ORDINARY SHARES BY MEANS OF A RIGHTS
ISSUE
When an enterprise wants to increase its ordinary share capital, it will provide
its existing shareholders with the opportunity (pre-emptive right) to purchase
the new shares so that they can maintain their proportional (percentual) voting
power in the enterprise. The new shares are sold by means of a rights issue.
The number of new shares being offered to the shareholders is based on their
existing shareholding (i.e. a pro rata distribution of shares takes place). The
shares offered by the rights issue are usually available at a price below the
current market price. When a company announces a rights issue, the following
information should be provided: the issue ratio, the issue price, the record date
and the closing date of the offer.
Issue ratio (N): The issue ratio will be a function of the issue price of the new
shares and the amount of capital required.
Issue price: The issue price is usually lower than the current market price of the
existing shares and is, therefore, a function of the market price. In order to ensure
that investors take up all the shares being offered by the rights issue, the issue
price should be as low as possible.
Example:
Let us assume an enterprise currently has 1 000 000 issued ordinary shares.
The company requires a further R6 million, and plans a rights issue at R15 per
share. What is the issue ratio?
Solution:
Number of new shares
=
=
=
Issue ratio (N)
Capital required
Issue price
R6 000 000
R15
400 000 shares
Existing number of issued shares (old)
Planned number of shares (new)
1 000 000
=
400 000
= 2½ (2,5)
=
1 new share is therefore issued for each 2,5 existing shares.
Another example:
The issued ordinary share capital of a company is 26 500 000 shares. Let us
assume the present market price is R9,50 and the company plans an issue price
of R8,50. If the company requires new capital of R17 million, what will the issue
ratio be?
82
The Financing Decision
Solution:
Number of existing shares =
Number of new shares
=
=
=
Issue ratio (N)
26 500 000 shares
Capital required
Issue price
R17 000 000
R8,50
2 000 000 shares
Existing number of issued shares (old)
Planned number of shares (new)
26 500 000
=
2 000 000
= 13¼ (13,25)
=
1 new share will be issued for every 13,25 existing shares.
Allocation letters: Allocation letters are sent to all the existing shareholders on
the record date notifying them of how many new shares they may purchase
according to their existing shareholding. It is possible to trade these letters (also
called rights letters) on the securities exchange separately from the existing
shares.
Cum-rights period: The period of time between the formal announcement of the
rights issue and the last day of cum rights trading, is known as the cum rights
period. If the shares are sold during this period, the purchaser of the shares also
obtains the rights accompanying them.
Ex-rights period: From the day following the last day of cum rights trading until
the closing date of the offer, the shares and the rights are traded individually. Any
person now purchasing some of the old (existing) shares has no right to the new
shares.
9
SUSTAINABLE GROWTH RATE
Another teasing question for the financial manager is: “At what rate can the
enterprise continue to grow with the sources of financing available without
affecting the return of shareholders, the solvency and the liquidity of the
enterprise, i.e. by maintaining the existing financing mix as though it is an optimal
mix?”
Various aspects arise from this question: In the first place, there is the assumption
that the present mixture of the sources of financing is optimal. The mixture must
first be investigated and optimised before the sustainable growth rate can be
calculated. In this section, we will assume that the mixture is optimal.
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Introduction to Financial Management
Secondly, the term sustainable growth rate could refer to the growth in turnover
(sales), the total assets, the profit or the profitability. In this section, the emphasis
is on the growth in the total capital of the enterprise.
To a large extent, the sustainable growth rate is driven by the amount of the
attributable earnings (profit after taxation and preference share dividends) that are
reinvested in the enterprise. The moment the attributable earnings come into the
reckoning, one is working with a profit after taxation. Therefore, one should
translate all values (amongst others, Ro and Rv) to after-tax values.
The sustainable growth rate is a function of the portion of the attributable earnings
that is reinvested and the return on equity (Re), i.e. g = ReB. It follows that the
sustainable growth rate of an enterprise is equal to the return on equity (Re) if no
dividends are paid (B = 1). From this, we can derive that if no dividends are paid,
the sustainable growth rate will be calculated with the following formula:
g
Kv
(Ro - Rv)](1 - t)
Ke
= [Ro +
Dividend payments, however, will decrease the ability of the enterprise to grow.
Any dividend payments must be taken into consideration during the calculation,
and this is done by inserting the factor B into the formula, where:
B =
Attributable earnings - ordinary share dividends
Attributable earnings
The formula for the sustainable growth rate now is:
g
= [RoB +
Kv
(Ro - Rv)B](1 - t)
Ke
Example:
Given:
Equity (Ke)
Debt (Kv)
Total capital (Kt)
R400
200
R600
Taxation rate
B
27%
70%
The sustainable growth rate is:
g
Kv
(Ro - Rv)B](1 - t)
Ke
200
= [(25% x 0,70) +
(25% - 10%)0,70](1 - 27%)
400
= [17,5% + 5,25%](0,73)
= 16.61%
= [RoB +
84
The Financing Decision
The sustainable growth rate indicates that the total capital of the company,
consisting of a combination of debt and equity capital, can grow by a maximum of
16.61% (R99.66), without causing financial strain to the company. Given the
optimal debt-to-equity ratio (200/400), equity capital can grow by a maximum of
R66.44 (R400 x 16.61%) and debt capital by R33.22 (R200 x 16.61%).
10
THE TOTAL LEVERAGE FACTOR
The total leverage factor consists of the financial- and operating leverage. The
functioning of the financial leverage has been discussed earlier in this chapter as
well as in chapter 3 and, in brief, comes down to the calculation of the leverage
factor by means of the following formula:
Return on equity (Re )
Financial leverage factor =
Return on total assets (Ro )
Let us assume that R e is equal to 20% whilst R o is equal to 8%, then the
leverage factor will be equal to 2,5. Should the enterprise during the next year
succeed in raising the return on total assets to 10% and all other factors in the
enterprise remain more or less the same, then the return on equity will increase
to 25% (10% x 2,5 leverage factor).
The utilisation of fixed and variable costs in the enterprise brings the operating
leverage into the picture. Think back to the calculation of the break-even point
during break-even analysis. The larger the fixed costs of the enterprise, the flatter
the total cost curve of the enterprise would be, but also the total cost curve would
start at a higher level than when experiencing lots of variable costs. The breakeven point is where the total cost line intersects the total income line, i.e. that level
of income where no profit or loss is realised. As soon as the income moves past
the break-even point, then the profit of the enterprise with a larger fixed cost
component will increase more pronouncedly than that of the enterprise with more
variable costs, as the gap between the income and total cost lines will increase
faster. The operating leverage factor can be calculated with the following formula:
Operating leverage factor
=
Percentage change in the operating profit
Percentage change in the revenue
If the operating leverage factor is 1,5 it implies that if the revenue (turnover/sales)
of the enterprise should increase by 8%, then the operating profit will increase by
12% (8% x 1,5 operating leverage factor).
The total leverage factor is the financial leverage factor multiplied by the
operating leverage factor. In the case where the financial leverage is 2,5 and
the operating leverage is 1,5 the total leverage factor will be 3,75 (2,5 x 1,5) .
This means that if the enterprise’s revenue should increase by 10%, then the
return on equity will increase by 37,5% (10% x 3,75)! It is quite apparent that the
financing decision (financial leverage) can play a major role in the improvement
of the earnings of the shareholders, but the role of the investment decision
(operating leverage) must not be neglected.
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Introduction to Financial Management
11
THE INFLUENCE OF THE FINANCING DECISION ON THE SOLVENCY,
LIQUIDITY AND CONTROL OF THE ENTERPRISE
In the final instance, the influence of the financing decision on the solvency, liquidity
and the control of the enterprise must be noted. This is summarised in the following
table:
TYPE OF FINANCING
EFFECT ON
SOLVENCY
EFFECT ON
LIQUIDITY
EFFECT ON THE CONTROL
OF THE SHAREHOLDERS
Long-term debt
capital
Reduce solvency of
the enterprise
No effect on the
short-term liquidity
No effect on the position of the
ordinary shareholders
Short-term debt
capital
Reduce solvency of
the enterprise
Reduce liquidity of
the enterprise
No effect on the position of the
ordinary shareholders
Ordinary share
capital
Improve solvency
No negative effect on
the liquidity
Increase in the number of issued
ordinary shares could lead to a
change in the position of the
shareholders
Cumulative
preference shares
(semi-debt)
Improve solvency
Required payment of
preference dividends
may have negative
effect on liquidity
Since preference shares do not
have voting power, there is
little/no effect on the control of
the shareholders
Retained earnings
Improve solvency
No negative effect on
the liquidity
Forms part of the ordinary
shareholders’ equity, therefore
no negative effect on the control
of the shareholders
86