Mancosa
Managerial Finance: Ch’s6-10
Mark Kalkwarf
markk@iquadts.co.za
(w) 011 797-8654
(c) 0825786261
“Greatness is not a function of circumstance. It is first and foremost a
function of conscious choice and discipline”.
(Jim Collins: 2009)
1
Managerial Finance: Questions to be answered.
Managerial Finance aims to answer the questions that are central to the
operations of today¹s industries and their financial management:
* Why are financial aspects so important?
* What should firms do about new investment, mergers and dividends?
* Why are share prices important?
* How much should firms borrow?
* Why are cash flows and risk analysis so important?
2
Sect 6: Gearing and shareholders’ wealth.
 Gearing (Financial leverage) refers to the extent to which a firm relies on
debt.
 Leverage: using given resources in such a way that the potential positive
or negative outcome is magnified.
o Leverage amplifies the potential gain from an investment.
o Leverage also increases the potential loss.
 Debt capital includes all long-term borrowing incurred by the firm.
 Equity capital consists of the long-term funds provided by the firm’s
owners, the shareholders.
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 Example: effect of long-term loan on EPS.
In the example below, the geared firm has R5 million of 10% debentures and R5 million
of equity. The low-geared firm is ungeared and has no debt and has equity of R10
million. Co tax rate 30%.
Geared Firm (R)
Ungeared Firm (R)
Operating profit
2 000 000
2 000 000
Interest
(500 000)
(Nil)
Profit before tax
1 500 000
2 000 000
Tax @ 30%
(450 000)
(600 000)
Profit after tax
1 050 000
1 400 000
1050000
5000000
1400000
10000000
21c
14c
600 000
600 000
(500 000)
(Nil)
Profit before tax
100 000
600 000
Tax @ 30%
(30 000)
(180 000)
70 000
420 000
70000
5000000
420000
10000000
1.4c
4.2c
EPS
Operating profits
Interest
Profit after tax
EPS
Shareholders in the geared company experience greater volatility in EPS.
4
Sect 7: Dividend policy.
Company can retain profits or pay out in form of dividends.
Dividend policy may impact on investors and perception of company.
Depends on situation of company now and in the future.
Also depends on preferences of investors and potential investors.
Cash dividends are the cash flows that a firm distributes to its common
shareholders.
A share of common stock gives its owner the right to receive all future
dividends.
 Know what the key factors are in formulating a dividend policy.
 Know what cash dividend payments and dividend reinvestment plans are
about.
 Explain the motives for using share dividends, share splits and share
repurchases.
5
NB: It is important for the financial manager to develop and implement
a dividend policy that is consistent with the firm’s goal of maximising
the share price.

Know what the key factors are in formulating a dividend policy.
 Legal constraints;
 Contractual issues;
 Internal constraints;
 Growth prospects;
 Owner considerations;
 Market considerations;
 Market friction;
 The clientele effect;
 Signalling;
 Agency considerations.
6
Sect 8: Foreign risk management and project evaluation.
Exposure: vulnerability to risk.
For interest rates: any rise in interest rates will mean that total interest
charges will rise.
Foreign exchange exposure will affect importers and exporters.
Unless goods are paid for immediately, changes in exchange rates will
leave traders vulnerable to losses (also possible gains).
In order to reduce the firm’s exposure to rate fluctuations, hedging is
undertaken to reduce this exposure.
This process has come to be called financial engineering.
7
Interest risk management.
A company should seek to have a maturity mix and should also attempt to
have a combination of fixed interest and floating interest obligations.
Interest Rate Swap (IRS) example.
An IRS is a contractual agreement in which two parties agree to exchange
periodic interest payments. The periodic cash flows are denominated in the
same currency.
Your bank’s assets have an average fixed rate of 10% with an average
maturity of 5 years. Bank liabilities are composed of short-term deposits that
are pegged to LIBOR. You would like to hedge against the possibility of
rising interest rates by entering into a plain-vanilla interest rate swap. A
swap dealer has offered you the following quarterly swap – 8% fixed for
LIBOR floating with a notional principal value of $50 million for 5 years.
Diagram and compute the relevant quarterly cash flows for the bank.
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8% Fixed
Bank
Swap Dealer
LIBOR
LIBOR
Depositors
10% Fixed
Loans
The cash flows that apply to this example are the following:
 The bank’s LIBOR-based payments to depositors are offset by the swap
dealer’s LIBOR payment to the bank.
 The bank is receiving 10% from its loan portfolio and is paying 8% fixed
to the swap dealer. The net inflow to the bank is a fixed 2% annually on a
$50 million basis.
 The relevant quarterly cash flow is:
(2% / 4) ($50 million) = $250,000
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 Currency swaps.
This is the exchange of a specified amount of one currency for a specified
amount of another currency at specified dates in the future.
 Commodity swaps.
A commodity swap is an agreement to exchange a fixed quantity of a
commodity at fixed dates in the future.
 FRA’s
This incorporates an agreement on the interest on future borrowing or for
future lending.
 Interest rate guarantee.
This is simply a more expensive version of the FRA as the interest rate is
guaranteed.
The maximum borrowing rate that would apply on settlement date is
guaranteed.
If the market rate at maturity is higher than the guaranteed rate, the dealer
must pay the firm the difference.
If the market rate is lower, then the guarantee will be ignored and the
market rate will be used.
10
Foreign exchange risk management.
FX market permits the transfer of purchasing power denominated in one
currency for that of another currency.
An exchange rate is simply the price of one country’s currency expressed in
terms of another country’s currency.
In practice, almost all trading of currencies takes place in terms of the US
dollar.
Exchange risk is caused by changes in currency quotes due to unexpected
political and economic events (fundamental data).
Exchange rate quotations are generally in the form of the following:
Bid ZAR7.4400
Ask ZAR7.4500
The forward premium is simply the
Forward  Spot
Spot
Forward . premium.or.discount    Forward .rate  spot.rate 

spot.rate

360

 #.of . fwd.contract.days 
 Forward .rate  spot .rate 
 is known as the forward differential.
spot .rate


The term 
11
Interest Rate Parity. IRP shows that there is a relationship between the spot
and forward exchange rates and the domestic and foreign interest rate in the
countries represented by the exchange rates.
Thus, in familiar terms, IRP will be:
 Forward .exchange.rate  spot.exchange.rate 

spot.exchange.rate


rd – rf  


1  rd 
Forward (DC/FC) = Spot (DC/FC) 

 1  rf 
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 Currency options.
A currency option is a contract that gives its owner the right, but not the
obligation, to buy/sell an amount of a particular currency (or asset) at a fixed
rate of exchange during a specified time period.
Terminology:
 A call option is an option to buy the underlying asset.
 A put option is an option to sell the underlying asset.
 An American option is any option that can be exercised at any time
during the period stated.
 A European option can only be exercised at the end of the period.
 Strike or exercise price: This is the fixed price specified in the option
contract at which the holder of the option can buy or sell the underlying
asset.
 Expiration date: The last day on which the option may be exercised.
 Price of an option:
o At the money – same as the spot rate.
o In the money – more favourable than the spot rate.
o Out the money – less favourable than the spot rate.
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Options example.
ABC shares sell for R55 and have a call option available on them that sells
for R10. This call option can be exercised for R50 with a life of five months.
The exercise price of R50 is called the option’s strike price. The R10 price
of the option is called the option’s premium.
If the option is purchased for R10, the buyer can purchase the stock from the
option seller over the next five months for R50. The seller or writer of the
option gets to keep the R10 premium no matter what the stock does during
this time period. If the option buyer exercises the option, the seller will
receive the R50 strike price and must deliver to the buyer a share of ABC
stock. If the stock price of ABC falls to R50 or below, the buyer is not
obliged to exercise the option. The option holder will only act if it is
profitable to do so.
A put option is the same as a call option except the buyer of the put has the
right to sell the put writer a share of ABC stock at any time during the next
five months in return for R50.
The owner of the option is the one who decides whether to exercise the
option or not. If the option has value, the buyer can either exercise the option
or sell the option to another buyer in the secondary options market.
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Futures example.
Cash-and-Carry Arbitrage.
Suppose the spot price of silver is $4.65 and that the one-year futures price is
$5.20. The appropriate interest rate is 8%. Design a cash-and-carry arbitrage
and compute your profits per troy ounce.
Our goal is to perform riskless arbitrage. Intuitively, the spot price looks too
low relative to the futures price. So let’s buy the spot and sell the futures.
However, riskless arbitrage means that we don’t have any of our own funds
at risk. So let’s borrow enough money today to buy an ounce of silver and
sell futures against that purchase.
 Borrow $4.65 today -> Owe $4.65 (1.08) = $5.02 in one year.
 Buy one ounce of silver today, cost = $4.65. Also, sell futures for
delivery of one ounce in a year at $5.20.
 In one year, we deliver the silver on the futures sale and receive $5.20.
We pay off our loan of $5.02 and pocket the $.18 difference. This is a
riskless profit.
Suppose that in the example above, the futures price was less than $5.02. If
this was the case, arbitrage would still be possible, but now we would
perform a reverse cash-and-carry arbitrage.
The futures price must be constrained by the following relationship:
F0,t  S 0 (1  C )
15
Triangular currency arbitrage. (This example does not take transaction
costs into account)
Currency arbitrage involves buying a currency in one market while
simultaneously selling it at a higher price in a second market. Arbitrage will
continue until prices return to their equilibrium state. That is, the value of the
sold currency will fall while the value of the purchased currency will rise.
Example: would a profit exist if:
 1.2705 CHF can buy 1USD, and
 1USD sells for 6.3500 ZAR, and
 1 ZAR sells for 0.1995 CHF.
To find out, sell your dollar and buy 6.3500 ZAR.
Then buy (0.1995 x 6.3500) = CHF 0.7588 with the R6.3500.
Now buy (0.7588 x 1.2705) = $0.9641 with your CHF.
You just made a $0.0359 loss from converting these currencies. However,
does an arbitrage opportunity exist at all?
YES: Sell your dollar and buy 1.2705 CHF.
Then, sell the 1.2705 CHF and buy 6.3684 ZAR (1.2705/0.1995).
Now buy (6.3684/6.3500) $1.0029.
You have just made a profit of $0.0029 from simply applying this arbitrage
opportunity.
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Sect 9: Working capital management.
Working capital management involves management of the firm’s current
assets and current liabilities.
Working capital is the difference between CA and CL.
Carrying costs are costs that rise with increases in the level of investment in
current assets.
Shortage costs are costs that fall with increases in the level of investment in
current assets.
Cash and net working capital provide a buffer that lets the firm meet its
ongoing obligations.
Factoring is an advance of funds against a firm’s book debt. Factoring is a
source of short-term finance.
The cash budget tells the manager what borrowing is required or what
lending will be possible in the short run.
17
The following is an example of a cash budget for the 90 days provided
below for the XYZ Company.
CASH BUDGET FOR 90 DAYS
$ 320,000
Beginning cash balance
Add:
Estimated collections on accounts receivable
750,000
Estimated cash sales
250,000
$1,320,000
Deduct:
Estimated payments on accounts payable
$ 800,000
Estimated cash expenses
150,000
Contractual payments on long-term debt
150,000
Quarterly dividend
50,000
$1,150,000
Estimated ending cash balance
$ 170,000
18
Cash cycle is the time between cash disbursement and cash collection.
Operating cycle = inventory period + accounts receivable period.
Inventory t/o = Cost of goods sold/ave inventory.
Inventory period = 365 days/inventory t/o.
Receivables t/o = Cr sales/ave acc’s receivable.
Receivables period = 365 days/receivables t/o.
Cash cycle = Operating cycle – accounts payable period.
Payables t/o = cost of goods sold/ave payables.
Payables period = 365/payables t/o.
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Assume the following financial statement information:
AMOUNT (R000’s)
ITEM
Inventory
350
Receivables (debtors)
280
Payables (creditors)
230
Cost of sales
480
Credit sales
700
Credit purchases
520
1. Calculate the operating cycle.
2. Calculate the cash cycle.
Answer.
1. Calculating the operating cycle:
Inventory period:
Inventory/cost of sales x 365 days = 350/480 x 365 days = 266 days
Debtors period:
Debtors/cr sales x 365 days = 280/700 x 365 days = 146 days
Operating cycle:
Inventory period + debtors period = 266 + 146 = 412 days
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2. Calculating the cash cycle:
Creditors period:
Creditors/creditors purchases x 365 days = 230/520 x 365 days = 161
days
Cash cycle:
= operating cycle – creditors period
= 412 days – 161 days
= 251 days.
21
Know how to do the cash budget.
Know how to calculate the effective cost of factoring.
Know what Credit Management entails.
Know what Inventory Management entails.
Know how to work out EOQ.
22
Economic order quantity (EOQ).
 Economic order quantity is the level of inventory that minimizes the
total inventory holding costs and ordering (shortage) costs.
 Managers have to find a balance between purchasing too little and
purchasing too much.
C = cost of placing an order
U = annual usage
H = inventory (stock) holding cost per unit
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Example.
You are the newly appointed management accountant at Kelso
Industries. The company uses the EOQ model to determine the quantity
of raw material Z54 to order from REM Ltd. The following details
regarding raw material Z54 are brought to your attention:
 Kelso Industries consumes 2400 units of material Z54 each
working day.
 It is estimated that there are 250 working days in the 2008
financial year.
 The cost of placing an order amounts to R120.
 The cost of holding inventory per unit is estimated at R3,90 plus
11% of the invoice price per unit.
 The invoice price per unit is R10.
REQUIRED:
i.
Calculate the EOQ for raw material Z54 for the 2008
financial year.
ii.
Calculate the number of orders that should be placed
during 2008.
(Round off calculations to the nearest whole number.)
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i)
=
=
= 5 367 UNITS
ii)
The number of orders that should be placed per annum is
calculated as follows:
=
=112 orders
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Sect 10: Valuations, mergers and acquisitions.
You need to know all the theory from this chapter.
You need to know all the methods of valuing a target (Asset based
valuations, Earnings basis, Acc’ting rate of return, Div yield and especially
the Div discount method.
Increase/decrease in a company’s share price post-merger.
Micro Ltd makes a cash offer of R1.50 a share for Macro Industries.
Macro has 2 500 000 shares selling at R1 a share and has an EPS of R1.40.
Micro has 7 500 000 shares with a market value of R22.5 million and an
EPS of R1.85.
The total synergistic benefit of the merger amounts to R2.5 million.
Calculate:
1.
The premium paid to Macro and the benefits to both companies.
2.
The post-merger market value of Micro.
3.
The post-merger increase/decrease of Micro’s share.
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Answer:
1.
# of shares in Macro
=
2 500 000
Amount Micro has to pay
=
2 500 000 x R1.50
=
R3 750 000
=
R3 750 000 – R2 500 000
Premium paid
=
R1 250 000
Macro will gain R1.25m out of the R2.5m gain from the merger and Micro
shareholders will benefit from the balance of R1.25 m.
2. Post-merger market value of Micro.
Pre-merger market value
=
R22.5m
Macro market value
=
R 2.5m
Synergy benefits
=
R 2.5m
R27.5m
Less cash paid to Macro
=
R 3.75m
Therefore post-merger market value =
R23.75m
3. Micro post-merger share price
=
R23.75m / 7.5m
=
316.67c
Therefore, the merger has increase Micro’s share price by 16.67c.
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Valuation of target market.
 Techniques used in asset based valuation.
Balance sheet valuation, replacement cost valuation and realizable value
methods.
 Earnings basis.
 Accounting rate of return.
 Dividend yield.
 Discounted cash-flow.
2) Types of mergers and acquisitions.
 Mergers.
 Acquisitions.
 Proxy content.
 Leveraged buyouts (LBO’s)
3) Types of mergers.
 Horizontal.
 Vertical.
 Conglomerate.
28
Good luck with your studies
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