Sect 1: Managerial finance.
 Managerial finance is concerned with the duties of the financial
manager in the business firm.
 Have a working knowledge of the legal forms of business
organisations.
 Know the difference between Par value and Market
value/Directors value.
 Know the difference between Authorised and Issued share capital
and between Preference and Ordinary shares.
 Goals of Managerial Finance:



Maximise profit (objective of the firm).
Maximise shareholder wealth (goal of the firm).
The role of ethics; Social responsibility.
 An agency relationship is the relationship between shareholders
and management in a firm.
1
The Financial System
Lenders
Borrowers
Money
Household Sector
Financial
Intermediaries
Indirect
Corporate Sector
Government
Sector
Money
Household Sector
Primary
Securities Corporate Sector
Securities
Money
Foreign Sector
Government
Sector
Foreign Sector
Dissintermediation
Primary Securities
 Primary Market: Where new securities are made available by
organisations in both the public and private sectors and are taken
up by the investor.
 Secondary Market: This is where existing securities are traded.
An active secondary is essential to create liquidity and tradability
of investments.
 Money Market: Where short-term debt instruments or
marketable securities with maturities of one year or less are
traded.
 Capital Market: Where long-term securities such as bonds and
shares are traded.
2
Sect 2: Capital budgeting & cash flows.
 Net present value (NPV).
 The difference between the market value of a project and its cost.
 How much value is created from undertaking an investment?

The first step is to estimate the expected future cash flows.

The second step is to estimate the required return for projects of this risk
level.

The third step is to find the present value of the cash flows and subtract the
initial investment. This is to determine whether the project is viable.
Computing NPV for the Project
You are looking at a new project and you have estimated the
following cash flows:
 Year 0:
CF = -165,000 (original investment)
 Year 1:
CF = 63,120
 Year 2:
CF = 70,800
 Year 3:
CF = 91,080
Your required return for assets of this risk is 12%.
 Using the formulas:
NPV =
CF3
CF1
CF2


 Par.val
2
(1  K e ) (1  K e )
(1  k e ) 3
NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000
= 12,627.42
3
Alternatively:
Year
Cash Flow
PV
1
63,120.00
56,363.39
2
70,800.00
56,453.16
3
91,080.00
64,845.76
=NPV @ 12%
177,662.91
Original Investment
-165,000.00
NPV
12,662.91
Decision rule.
 If the NPV is positive, accept the project.
4
 Internal rates of return (IRR).
 This is the most important alternative to NPV.
 IRR is the return that makes the NPV = 0.
 IRR is the discount rate that equates the PV of cash inflows
with the initial investment associated with the project.
 Decision Rule: Accept the project if the IRR is greater than the
required return.
Example:
The management of Tiger Engineering are considering the following
investment project. The following data is available:
Cost of plant and equipment
60 000
Salvage value
nil
Expected profit/loss
Yr 1
(15 000)
Yr 2
10 000
Yr 3
35 000
Tito Engineering uses the straight-line method of depreciation
for all fixed assets. The estimated cost of capital is 10% p.a.
Before calculations are done, the Cash Flows need to be calculated.
Cash flows.
Year
Profit/loss
Depreciation
Cash flow
1
(15 000)
20 000
5 000
2
10 000
20 000
30 000
3
35 000
20 000
55 000
5
ARR
ARR =
=
AvePr ofits
x100
AveInvestment
10000
x 100
30000
= 33.33%
NPV
Year
Cash flow
Discount factor
PV
10%
0
(60 000)
1
(60 000)
1
5 000
0.9091
4 546
2
30 000
0.8264
24 792
3
55 000
0.7513
41 321
NPV
10 659
IRR
Year
Cash flow
Disc fact
PV
17%
Disc fact
PV
18%
0
(60 000)
1
(60 000)
1
(60 000)
1
5 000
0.8547
4 273
0.8475
4 237
2
30 000
0.7305
21 915
0.7182
21 546
3
55 000
0.6244
34 342
0.6086
33 473
NPV
530
6
(744)
The IRR that we are seeking is a discount rate for which the NPV is
closest to 0 Rands. At 17% the NPV is closer to 0 Rands. By
interpolation,
17 530

1 1274
= 17.42%
7
IRR and NPV example.
 Suppose an investment will cost $90,000 initially and will generate
the following cash flows:
 Year 1: 132,000
 Year 2: 100,000
 Year 3: -150,000
 The required return is 15%.
 Should we accept or reject the project?
Hurdle rate is 15%.
Year 0
-$90,000
Year 1
$132,000
Year 2
$100,000
Year 3
-$150,000
IRR
10.11%
NPV fx 15%
Less initial
Reject
$91,769.54
-$90,000.00
investment
NPV at 15%
$1,769.54
Accept
You now have the dilemma of IRR indicating that you should reject
the project, but NPV indicating that you should accept it. What
would you suggest? If IRR says to reject, but NPV says to accept, go
with NPV.
Decision rule.
The NPV is positive at a required return of 15%, so you should
Accept.
8
If you use the financial calculator, you would get an IRR of 10.11%,
which would tell you to Reject.
You need to recognize that here there are non-conventional cash
flows that “corrupt” the IRR calculation and look at the NPV profile.
9
CAPM
Suppose the risk-free rate is 4%, the market risk premium is 8.6%
and a particular stock has a beta of 1.3. Based on CAPM, what is the
expected return on this stock?
Rf = 4%
Mkt risk premium = 8.6%
Therefore: RM = 8.6% + 4% = 12.6%
 = 1.3
ER = 4% + 1.3(12.6%  4%)
= 15.18%
Example with Mutually Exclusive Projects
Period
Project A
Project B
-500
-400
1
325
325
2
325
200
IRR
19.43%
22.17%
NPV
64.05
60.74
0
The required return for both projects is 10%.
Which project should you accept and why?
(Accept Project A because of NPV)
10
Old exam question.
The following information relates to two projects, Project A and
Project B from which one must be chosen by Construction
International.
After-tax cash flows
Year
Project A
Project B
1
0
36 000
2
18 500
36 000
3
36 200
36 000
4.
123 000
36 000
Both projects require an initial investment of R117 700
As the project manager of Construction International you are
required to:
3.1
Calculate the Net Present Value (NPV) for each project using a
discount rate of 12%. Which project would you use choose? Why?
3.2
Calculate the Internal Rate of Return (IRR) for both projects. Which
project should be chosen? Why?
(20)
11
3.1
PROJECT A
Year
Cash Inflow
Discount Factor Present Value
1
0
0.8929
0
2
18 500
0.7972
14 748
3
36 200
0.7118
25 767
4
123 000
0.6355
78 611
Total Present Value
119 126
Investment
117 700
NPV (positive)
1 426
PROJECT B
Net Inflow
R 36 000
Discount factor
x 3.0373
Total Present Value
109 342
Investment
117 700
NPV (negative)
8 358
DECISION:
Project A should be chosen because the NPV is positive. Reject
Project B because it has a negative NPV.
12
3.2
PROJECT A
Choosing the discount factor:
Step 1
Since we know the NPV is positive and above zero, although by a small
margin, pick a higher discount rate e.g. 13% (Trial and error is used to
obtain the higher rate).
Step 2
Year Cash
Inflow
Discount
Discount
Present
Present
Factor
Factor
Value
Value
12%
13%
12%
13%
0
0
1
0
0.8929
0.8850
2
R 18 500
0.7972
0.7831
R14 748
R14 487
3
R 36 200
0.7118
0.6931
R25 767
R25 090
4
R123 000
0.6355
0.6133
R78 166
R75 435
Total PV
R118 681
R115 012
Investment
(R117 700)
(R117 700)
NPV
R 981
Step 3
Interpolation:
The IRR is between 12% and 13%
IRR = 12 + ____981__
981+ 2 688
= 12 + 981_
3669
= 12.27%
13
(R2 688)
PROJECT B
Choosing the discount factor:
Step 1
Since we know the NPV is negative, pick a lower discount rate e.g. 10%
(Trial and error is used to obtain the lower rate).
Step 2
Year Cash Inflow Discount Discount Discount Present Present
Present
p.a.
1-4
36 000
Factor
Factor
10%
9%
3.1699
3.2397
Factor
Value Value Value
8%
10%
3.3121
Investment
9%
8%
114 116 116629 119235
117 700 117700 117700
NPV
(R3 584) (R1071)R1535
Step 3
Interpolation: The IRR is between 8% and 9%
IRR = 8 + __1535___
1071+1535
= 8+ 1535
2606
= 8.59%
Decision: Project A must be chosen because it has a higher IRR
(20)
14
Sect 3: Business risk.
 Types of risk:

Business risk arises from the nature of the environment in which a company
operates.

Operating risk arises from the nature of the operating activities of the firm.

Financial risk arises from the extent to which a firm relies on debt to finance
its operations.

Total risk is a combination of business, operating and financial risks.
 The effect of standard deviation on returns of different asset portfolios.
Consider the normal distributions for the returns of two different assets A and B.
Both have been constructed using 100 data readings of past returns.
Asset A
Asset B
Arithmetic mean (exp return)
15%
12%
Standard deviation (risk)
5%
3%
As asset A has a higher chance of earning below the expected return of 15%, asset
A carries more risk. Asset A has a greater risk because it has a higher std
deviation.
As asset A carries a higher risk than asset B, investors would demand a higher
expected return in order to purchase that share.
15
 Risks associated with different portfolios.

Systematic risk.

Unsystematic risk.
There are two types of risk, namely Market and Specific risk.
Market risk is that portion of a securities price movement that can be attributed to
movement to the market as a whole. This portion of risk is known as systematic risk
and cannot be diversified away by including it in the market portfolio. This risk is
known as beta.
The 2nd element of risk is that portion of price movement unique to the specific asset
and is defined as non-systematic or diversifiable risk and is denoted as alpha. Nonsystematic risk is further divided into industry risk or company specific risk.
ER
CML
A’s return
B
A
Rf
A’s systematic risk, “S”
A’s unsystematic risk, “U”
16
A’s total risk
 Portfolio illustration:
Suppose we mix a portfolio of 40% in Investment A, 40% in Investment B, which
may earn only 7% in a good market but booms to 14% in a recession, and we put
the other 20% in government investment G earning 4%. Portfolio Expected Return
for Portfolio ‘P’:
E(RP) = [.40 x E(RA)] + [.40 x E(RB)] + [.20 x E(RG)]
Where E(RA) =8.8%, E(RB) =9.8%, and E(RG) = 4% (the risk-free rate)
E(RP) = (.40 x .088) + (.40 x .08) + (.20 x .04)
E(RP) = .0824 or 8.24%
Note: The percentage weights are based on the total dollars invested in each
security. If we invested $100,000 as follows: $40,000 in A, $40,000 in B, and
$20,000 in G, then we would have the 40%-40%-20% mix above.
The variance of this portfolio is 0.00000434062 and the standard deviation is
.0020736 or about +- 2/10 of 1%. In other words, diversifying eliminated almost
all of the diversification risk or unexpected return.
17
 The Efficient Frontier.
ER
C
B
D
A
R
 Efficient frontier and CML.
ER
CML
Markowitz efficient
frontier
M
Rf
CAL A
A
R
18
 CAPM as a measure of systematic risk.
The CAPM is defined as:
Re = Rf + β(Rm – Rf)
Example.
If the Rf = 4% and the E(RM)=11.5%
Suppose we select an asset ‘i’ with a bi =0.7. The expected return on this asset is
therefore (using CAPM)
E(Ri)= Rf + [E(RM) - Rf] βi
= .04 + [.115 - .04] x .7
= .04 + (.075 x .7)
= .04 + .0525
= .0925 or 9.25%
Because the Beta is low risk (less than market), the expected return is less than the
market rate.
 Does CAPM work?

Know the assumptions behind CAPM.

Know what other difficulties occur.

While there are imperfections in the CAPM assumptions, it is certainly worth
considering as a practical method with a logical background for financial
managers to use to determine the cost of capital.
19
Sect 4: Long-term sources of finance.
 Sources of long-term financing.

Equity financing.
o Ordinary shares.

Non-equity financing.
o Preference shares.

New issues.

Rights issues.

Share splits and bonus issues.

Retained earnings.

Debt financing.
o Debentures.
o Secured or unsecured debentures.
o Convertibles.
o Loans.
o Warrants.
o Bank overdrafts.
o Leases (Finance, sale and leaseback, operating).
o Hire purchase.
o Franchising.
o Grants.
o Venture capital.

Lease-or-buy decisions.
20
 Example (lease or buy).

Beta Transport is considering the purchase of a tanker for R400 000 cash.
Alternatively, the tanker could be leased on a 5-yr contract for R110 000 p.a.

If the tanker is owned, the service and maintenance charges will be R16 000
p.a, whereas the lease charge includes maintenance and servicing.

The salvage value of the tanker in 5 years times is expected to be nil.

The company uses the straight-line method of depreciation.

The company’s tax rate is 30% and the pre-tax cost of debt is 10%.
Required:
 Calculate the cost of owning; use the discounted cash flow method.
 Calculate the cost of leasing; use the discounted cash flow method.
 Advise on the option to be adopted. Justify your answer.
Owning.
DETAIL
Y1
Y2
Y3
Y4
Y5
(11 200)
(11 200)
(11 200)
(11 200)
(11 200)
24 000
24 000
24000
24 000
24 000
Net Cash Flow
12 800
12 800
12 800
12 800
12 800
PV Factor @ 7%
0.9346
0.8734
0.8163
0.7629
0.7130
11 963
11 180
10 449
9 765
9 126
NPV
R(347 517)
Purchase price
Y0
(400000)
Service charge 16000 x
0.7
Dep. Tax shield 80000 x
0.3
PV Cash Flow
(400000)
Leasing.
DETAIL
Y1
Y2
Y3
Y4
Y5
(110 000)
(110 000)
(110 000)
(110 000)
(110 000)
Tax shield 0.3
33 000
33 000
33 000
33 000
33 000
Net Cash Flow
(77 000)
(77 000)
(77 000)
(77 000)
(77 000)
0.9436
0.8734
0.8163
0.7629
0.7130
(71 964)
(67 252)
(62 855)
(58 743)
(54 901)
NPV
R(315 715)
Lease payments
PV Factor @ 7%
PV Cash Flow
Recommendation: it is advantageous to lease rather than to buy.
21
Sect 5: Cost of capital.
 The equation for the CAPM model is: ERe = Rf + β(Rm – Rf).
 Gordon growth Model (DDM)
 Zero growth.
 Constant growth.
 Two-stage or Supernormal growth.
The equation for the supernormal or two-stage DDM is:
Po=
D0(1+g)1+ D0(1+g)2+ D0(1+g)3+ ……… + Pn
(1+k)1
(1+k)2
(1+k)3
(1+k)n
Pn represents the terminal val of the stock at the end of the initial
high growth stage.
22
 Weighted Average Cost of Capital.
Market values.
Ordinary equity: E = Po x no of shares
= R5.00 x 1 000 000
= R5 000 000
Preference capital: P = Po x no of pref shares
= R10.00 x 200 000
= R2 000 000
Debt: Current market val of debt is equal to the present val of
interest payments plus the present val of the capital repayment.
The future cash flows must therefore be discounted at the
current required rate of return given in the question as a yield
to maturity.
Example:
Suppose a company has R2 mil, 8% debentures due in 5 yrs
with a current yield-to-maturity of 10%
The interest payment (coupon rate) made by the company is equal to
R160 000 (8% x R2 000 000). As the same amount will be paid
every year, this indicates that we will be dealing with an
annuity. Thus the appropriate table needs to be utilised.
23
The current market val of debt can be calculated as follows:
D = PVAint + PVcap repayment
D = R160 000 x PVAIF5YRS,10% + R2 000 000 x PVIF5yrs,10%
Using the PVAIF and PVIF tables to obtain the PVA and PV factors:
D = (R160 000 x 3.7908) + (R2 000 000 x 0.6209)
= R606 528 + R1 241 800
= R1 848 325
24
Cost of equity.
This relates to the return investors require as compensation for the
expected inflation, time value of money, and the risk to which their
investment is exposed.
The two generally recognised methods for determining the required
return on equity are:
 DDM (DVM)
D1 = Do x (1 + g)
Re = D1/Po + g
or
Re = Do (1 + g)/Po +g
 CAPM
Re = Rf + β(Rm – Rf).
25
Cost of preference shares.
Preference shares have some debt characteristics. Specifically the div
payable is usually a fixed amount.
Rp = D/Po
26
Cost of debt.
Interest rates represent the price paid for the use of borrowed
capital.
Note that the cost of debt from the point of view of the company is
the current market interest rate – the rate at which the company
could borrow today.
This current interest rate, called the yield to maturity (YTM) of the
company’s debt, can be determined by observing the current market
price at which the firm’s existing debentures are trading.
Yield to maturity is defined as the interest rate that will make the
present value of a debentures remaining cash flows (if held to
maturity) equal to its current market prices. (Ikova, 2001: 25)
Example:
Coupon rate:
8%
Term :
5yrs
Current YTM:
10%
Co tax rate:
30%
RD = YTM (1 –Tc)
= 10 (1 – 0.3)
= 7%
27
 Weighted Average Cost of Capital.
 A firm’s overall cost of capital must reflect the required return
on the firm’s assets as a whole.
 If a firm uses both equity and debt financing, the cost of capital
must include the cost of each, weighted to proportion of each in
the firm’s capital structure.
 WACC equation: WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
Example.
ABC Corp has 1.4 million common shares valued at R20 per share =
R28 million.
Debt has face value of R5 million and trades at 93% of face (R4.65
million) in the market.
Total market value of both equity + debt thus = R32.65 million.
Equity % = .8576 and Debt % = (1-.8576) = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per SML: RE = 4% + (7% x .74)=9.18%; Tax rate
is 40%; Current yield on market debt is 11%
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
28
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.
 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.
29
 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.
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.
30
Sect 10: Valuation, mergers and acquisitions.
Example. 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.
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
=
R1 250 000
Premium paid
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.
31
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.
32