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[2015]

BUSINESS FINANCE

By Ignatius Samukange

1
...
Scope of business finance
1
...
1
...
The science of the management of money and other assets
...
The management of money, banking, investments, and credit
...
Finances, monetary resources or funds, especially those of a government
or corporate body
...
The supplying of funds or capital
...
1
...
To provide or raise the funds or capital for: financed a new car
...
To supply funds to: financing a daughter through law school
...
To furnish credit to
1
...
Such activities are
usually the concern of senior managers, who must use financial forecasting to
develop a long-term plan for the firm
...
When a company plans to expand, it may rely on cash
reserves, expected increases in sales, or bank loans and trade credits extended
by suppliers
...
The value of the company's stock is a
constant concern, and managers must decide whether to reinvest profits or to
pay dividends
...
When deciding how to
deploy corporate assets to increase growth, financial managers must also

consider the benefits of mergers and acquisitions, analyzing economies of scale
and the ability of businesses to complement each other
...
3 Definitions of corporate finance
1
...
1 Corporate finance
It is the acquisition and allocation of a corporation's funds or resources, with the
goal of maximizing shareholder wealth (i
...
, stock value)
...
g
...
g
...

Resource allocation is the investment of funds; these investments fall into the
categories of current assets (such as cash and inventory) and fixed assets (such
as real estate and machinery)
...

1
...
2 Corporate finance
It is the field of finance dealing with financial decisions that business enterprises
make and the tools and analysis used to make these decisions
...
Although it is in principle different from managerial finance which
studies the financial decisions of all firms, rather than corporations alone, the
main concepts in the study of corporate finance are applicable to the financial
problems of all kinds of firms
...
Capital investment decisions are long-term choices about which
projects receive investment, whether to finance that investment with equity or
debt, and when or whether to pay dividends to shareholders
...

1
...
3 Corporate finance
Corporate or Business Finance is basically the methodology of allocating
financial resources, with a financial value, in an optimal manner to maximize the
wealth of a business enterprise
...
3
...
It generally involves balancing
risk and profitability
1
...
4
...
It involves planning,
directing, monitoring, organizing and controlling of the monetary resources of an
organization
...
Financing decision or where do we get money from;
2
...
Dividend decision or how much to distribute and what to retain
...
4
...

1
...


They involve planning, procuring, directing, organizing, monitoring and controlling
of the monetary/financial resources of an entity
...
This involves performing financial analysis and
planning, making investment decisions, making financing decisions, making
dividend decisions and developing and implementing corporate strategies
...
Finance functions
From the definition of business finance, the financial management activities that
can be identified are performing financial analysis and planning, making
investment decisions, making financing decisions, making dividend decisions and
developing and implementing corporate strategies
...
1 Performing financial analysis and planning
Financial analysis and planning is concerned with:


Transforming financial data into a form that can be used to monitor
the firm’s financial health/condition;



Evaluating the need for increased (or reduced) productive capacity;



Determining what financing is required
...
It is a form of SWOT
analysis (i
...
strengths, weaknesses, opportunities and threats)
...
2 Making investment decisions
Investment decisions determine both the mix and type of an entity’s assets,
i
...
they determine the size and composition of an entity’s assets
...
The financial manager also decides which noncurrent assets to acquire and when existing non-current assets need to be
modified, replaced, or liquidated
...
The results of previous
investment decisions are shown in the assets section of the statement of
financial position (balance sheet)
...
3 Making financing decisions
Financing decisions determine how a firm’s assets are financed
...
First, the most appropriate mix of short-term and long-term
financing must be established
...
Many of these decisions are dictated by necessity, but
some require in-depth analysis of the financing alternatives, their costs, and
their long-run implications
...
The equity and liabilities
section of the statement of financial position (balance sheet) shows the
results of previous financing decisions
...
4 Making dividend decisions
Dividend decisions determine how earnings are distributed to shareholders or
retained for reinvestment
...
The
value of a dividend payout must be balanced against the opportunity cost of
the retained earnings lost as a means of equity financing, as additional funds
will have to be raised in order to finance profitable projects
...

2
...

The finance strategy also identifies opportunities for advancing the interests
of the firm, such as merger and acquisition activities
...
Financial goal of the firm
3
...
e
...
Because
maximization of shareholder wealth achieves the objectives of the firm’s
owners, it is considered the primary goal of the firm
...
e
...
e
...
e
...
When considering each financial decision alternative in terms of its
impact on the market price of the firm’s shares, financial managers should
accept only those actions that are expected to increase share price
...
Because share price
represents the owner’s wealth in the firm, share-price maximization is
consistent with owner- wealth maximization
...
e
...
Wealth maximization takes into account the timing of

returns, their magnitude and their risk
...
The magnitude of returns directly affects the
value created for shareholders
...
e
...
Risk and return are the key determinants of
share price, which represents the wealth of the owners in the firm
...
Higher return (i
...
cash flow) is
generally associated with higher share price
...

3
...
To achieve this goal, the financial manager would take
only those actions that are expected to make a major contribution to the firm’s
overall profits
...




It ignores risk
...
e
...
Profits do not necessarily result
in cash flows available to the shareholders
...
Profit
maximization also disregards risk i
...
the chance that actual outcomes may
differ from those expected
...
Return and risk are the key determinants of share price, which
represents the wealth of the owners in the firm
...
Higher cash flow is generally associated with higher
share price
...
Because profit
maximization does not achieve the objectives of the firm’s owners, it should
not be the primary goal of the firm
...
Forms of business entities
Business entities can be classified in terms of their form of ownership
...
The common forms of business ownership that have the objective
of making a profit are sole proprietorships, partnerships and companies
...
1 Sole proprietorship
A sole proprietorship is a business owned by one person who operates it for his
own profit
...
The profit of the firm is taxed only once
...
As a result, the business will
cease to exist on the retirement or death of the owner
...
However, for
accounting purposes, the business is regarded as a distinct entity separate from
the owner
...
2 Partnership
A partnership is a business owned by two or more people who operate it for
profit
...
The law does not recognize a partnership as a
separate legal entity
...
However, for accounting purposes, the partnership is regarded as a
distinct entity separate from the owners
...
The partnership agreement sets
out how management decisions are taken and profits are shared
...
In a general partnership, all partners have unlimited
liability
...
A
limited partner is usually prohibited from being active in the management of the
entity
...
3 Company
A company, or a corporation, is a form of business entity that is created by law as
a distinct legal person separate from the owners
...
It has a perpetual existence which is
unaffected by changes in the membership of the company
...
The profit of the firm is taxed
twice
...
A public limited company can offer its shares to members of the
public, where as a private limited company cannot
...

Such principles, however, are applicable to all forms of entities
...
Questions
Question 1
Why is share-price maximization consistent with owner-wealth maximization?
Question 2
What is the primary financial goal of management of a company? As a financial
manager, how would you operate to achieve this goal?
Question 3
Why should a company concentrate primarily on wealth maximization instead of
profit maximization?
Question 4
Why is profit maximization not consistent with wealth maximization?
Question 5
The functions of financial management include three major decisions a company
must make
...


Required:
Identify and discuss the three major financial management decisions
...
CONCEPTS OF VALUE AND RETURN
2
...
The interest rate is the
price that is paid for the use of money
...
Taking a long-term view of the firm
requires the financial manager to explicitly recognize the time value of money
...
e
...

2
...
1 Time
Because firms and investors can always find opportunities to earn positive
returns on their funds, the timing of cash flows has important economic
consequences
...
The utility of a dollar now is greater than that of a dollar to be
received in the future
...
e
...

The rate of exchange between certain future consumption and certain current
consumption is the pure rate of interest, and this occurs even in a world of no
inflation and no risk
...


2
...
2 Inflation
The price of time (or the interest rate needed to compensate for time preference)
exists even when there is no inflation, simply because people generally prefer
consumption now to consumption later
...


Therefore, if there is inflation, the

providers of finance will have to be compensated for that loss in purchasing
power as well as for time
...

2
...
3 Risk
Risk is the chance of a financial loss
...

This compensation, known as risk premium, ensures that the return is
commensurate with the risk taken
...
2 Future values
Future value is the value of a present amount at a future date found by applying
compound interest over a specified period of time
...
Principal is the amount of money on which
interest is paid
...
Compounding is a process of
moving forward in time to find an equivalent cash flow in the future
...

2
...
1 Future value of a single amount
The general equation for the future value of a single amount at the end of a
specified period is as follows:
FVn = PV x (1+k)n
Where: FVn = the future value at the end of period n
PV = the initial principal, or present value
k = the periodic (e
...
annual) rate of interest
n = the number of periods (e
...
years)
Financial tables have future value interest factors that have been developed from
the formula and used to simplify time value calculations
...
The investment pays 6% interest compounded
annually
...


Suggested solution
Alpha Limited
Value of investment in 5 years = FV5
= PV x (1+k)5
= $800 x (1
...
3382
= $1 071
2
...
2 Future value of an annuity
An annuity is a stream of equal cash flows that are spaced at equal intervals, e
...

annually
...
The future value of an annuity
is an equivalent cash flow located at the end of the last period of the annuity
...
The future value of an ordinary
annuity is calculated as follows:
FVAn = A x [(1+k)n – 1]
k
Where: FVAn = the future value of an annuity
A = the amount of the annuity

Or
Using financial tables:
FVAn = A x FVIFAk,n
Question 2
Beta Limited wishes to invest $1 000 at the end of each of the next 5 years
...

Required:
Calculate the future value of the ordinary annuity
...
7507
= $5 751
(ii) Annuity due
An annuity due is a series of identical equally-spaced cash flows with the cash
flows received at the beginning of each period
...

Question 3
Sigma Limited wishes to invest $1 000 at the beginning of the year for each of
the next 5 years
...

Required:
Calculate the future value of the annuity due
...
07]
= $1 000 x (5
...
07)
= $1 000 x 6
...
3 Present values
Present value is the current value (i
...
the value now) of a future amount
...
The interest rate is
usually referred to as the discount rate, required return, cost of capital, or
opportunity cost
...


Discounting is the process of moving backward in time to find an

equivalent cash flow today
...

Although future value and present value techniques result in the same decisions,
financial managers tend to rely primarily on present value techniques
...

2
...
1 Present value of a single amount
The general equation for the present value of a future amount is a follows:
PV = FVn x

1
______
(1+k)n

Or
Using financial tables:
PV = FVn x PVIFk,n
Question 4
Delta Limited will receive $1 700 from an investment 8 years from now
...

Required:
Calculate the present value of the amount to be received
...
5403
= $919
2
...
2 Present value of an annuity

The present value of an annuity is the equivalent cash flow located at the
beginning of the first period of the annuity
...
The annuity consists of cash flows of $700 at the end of each
year for 5 years
...

Required:
Calculate the purchase price of the ordinary annuity
...
9927
= $2 795
(ii) Present value of an Annuity due

The present value of an annuity due is calculated as follows:
PVA = A x [{1- ____1_____} +1 ]
(1+ k)n-1
____________
k
Or
Using financial tables:
PVAk,n(annuity due) = A x [PVIFAk,n x (1+k)]
Question 6
Beta Limited wants to determine the most it should pay to purchase a particular
annuity due
...
The firm requires the annuity to provide a minimum return of
8%
...

Suggested solution
Beta Limited
PVA8%,5years = A x [PVIFA8%,5years x 1
...
9927 x 1
...
3121
= $3 018
(iii) Present value of a perpetuity
A perpetuity is an annuity with an infinite life
...
It never stops providing its holder with a cash flow at the end of
each year
...
e
...
The
university indicated that it requires $200 000 per year to support the chair, and
the endowment would earn 10% per year
...

Suggested solution
Catholic University
PVA = A/k
= $200 000/0
...
4 Risk and return of a single asset
2
...
1 Risk and return
To achieve the goal of share-price maximization, the financial manager must
asses the two key determinants of share price, i
...
risk and return
...

2
...
2 Return on a single asset
Return is measured as the total gain or loss experienced on behalf of the owner
of an investment over a given period of time
...
The formula for calculating the rate
of return is as follows:
kt = Pt – Pt-1 + Ct
Pt-1
Where: kt

=

the actual, expected or required rate of return during period t

Pt

=

the price (or value) of an asset at time t

Pt-1

=

the price (or value) of an asset at time t -1

Ct =

the cash flow from the asset in the time period t – 1 to t
...
However, if probabilities can be assigned to a number of
alternative outcomes, it is possible to statistically determine the most likely
expected return
...
A probability
distribution sets out all the possible events with their expected frequencies of
occurrence
...

The expected return of an asset is measured by the weighted arithmetic mean
...
10

50%

Boom

0
...
45

20%

Recession

0
...
10

(5%)

Required: Determine the expected return of the ordinary share
...
10x50 + 0
...
45x20 + 0
...
10x(-5)
= 22%
2
...
3 Risk of a single asset
Risk is the expectation that the actual outcome of an investment may differ from
the expected outcome
...
The magnitude of the possible difference between the
actual outcome and the expected outcome reflects the magnitude of the risk
...
Risk-aversion is the attitude towards risk in which an increased return is
required for an increase in risk
...


(a) Variance and standard deviation
As statistical indicators of an asset’s risk, both the variance (δ2) and the standard
deviation (δ) measure the dispersion of the possible outcomes around the
expected return
...

Once the expected return and the risk have been established, the mean-variance
rule can be applied when evaluating two mutually exclusive investments
...
keA > keB and δ2A ≤ δ2B ; retun n risk invoved,…
2
...
It relates the units
of return to the units of risk
...
If the mean-variance
rule fails to discriminate between two mutually exclusive investments with
different expected returns, the coefficient of variation can be used, such as in the
following scenario:
keA > keB and δ2A > δ2B

The CV can also be used to evaluate more than two investment projects
...
VALUATION OF BONDS AND SHARES
3
...
Valuation is a process that links risk and
return to determine the worth of an asset
...
e
...
The value of
an asset depends on the cash flow(s) it is expected to provide over the
ownership period
...
e
...
The combination
of the magnitude of the cash flow and its timing fully defines the expected return
from the asset
...
In general, the
greater the risk of a cash flow, the lower its value
...

3
...
It is a contract
under which the borrower agrees to make payments of interest and principal, on
specific dates, to the holders of the bond
...
The coupon interest rate is the stated rate of interest on a
bond
...


The value of a bond is the present value of the payments its issuer is
contractually obligated to make, from the current time until it matures
...
The bond matures in five years time
...

Required:
Determine the value of the bond
...
2743 + 1 000 x 0
...
3 Present value of preference shares
Preference shares are a hybrid, having some of the characteristics of equity (i
...

ordinary shares) and debt (i
...
bonds)
...
They are
similar to equity in that the preference dividend may be passed without throwing
the company into bankruptcy
...
The shares
have a nominal value of $1 each, and carry a dividend of 10%
...

Required:
Compute the value of the preference shares
...
08
= $125

3
...
4
...
e
...
e
...

Although a shareholder can earn capital gains by selling shares at a price above
that originally paid, what is really sold is the right to all future dividends
...

(i) Zero-growth model
This is an approach to dividend valuation that assumes a constant, non-growing
dividend stream
...
The required rate of
return on similar ordinary shares is 15%
...

Suggested solution
Sigma Limited
P0 = D / Ks
= 3 / 0
...
It assumes that the
dividend will grow at a constant rate, but the rate is less than the required rate of
return
...
e
...
50
...
The required
return on similar ordinary shares is 15%
...

Suggested solution
Delta Limited
P0 = D1 / (Ks - g)
= 1
...
15 – 0
...
75
3
...
2 Capital asset pricing model (CAPM)
Because an investor can create a portfolio of assets that will eliminate virtually all
diversifiable risk, the only relevant risk is non-diversifiable risk
...
The
measurement of non-diversifiable risk is of primary importance in selecting
assets with the most desired risk-return characteristics
...

The primary conclusion of CAPM is that the relevant risk of an individual share is
its contribution to the risk of a well diversified portfolio, that is, its non-diversifiable
risk
...
It describes the relationship between the
required rate of return and the non-diversifiable risk of the firm as measured by
the beta coefficient (β)
...
The (Rm - Rf) portion of the risk premium is called the market risk
premium
...
Sigma Limited
has a beta of 0
...

Required:
Compute the required return on the shares of Sigma Limited
...
4(22-14)
= 14 + 3
...
2%
The objective of a valuation can be achieved without actually calculating a value
for the ordinary shares but, rather, by comparing the actual return with the
expected return
...
If the actual return equals the expected return, the shares are
correctly priced
...
If the actual return is lower than the expected return, the shares
are overpriced
...
When the
shares are overpriced, investors sell their holdings
...
The
following information is available:
Actual return on the ordinary share

30%

Market price per Gamma ordinary share

$1
...
9

Required:
Apply CAPM to determine whether the Gamma ordinary share is correctly priced
...
9 (25 – 15)
= 15 + 9
...
Therefore, the Gamma ordinary
share is underpriced
...
INVESTMENT DECISION
4
...

Capital budgeting is a key process in the investment decision
...
As the capital budgeting
decision results in the firm tying up a substantial amount of funds for a number of
years, it should be taken in the content of the firm’s strategic plan
...
Generation of investment proposals;
2
...
Evaluation of cash flows;
4
...
Continual reevaluation of investment projects after their acceptance and
subsequent implementation
...
2 Types of investment projects

Classification is relevant for evaluating project risk and determining the ranking of
projects
...

4
...
1 Replacement or expansion
Replacement refers to the acquisition of an asset to maintain existing production
...
Expansion
refers to expansion in existing product lines or to the introduction of new product
lines
...
2
...
Mutually exclusive projects are projects that complete with one
another (i
...
they are alternatives) and the acceptance of one project eliminates
the others from further consideration
...
2
...
An indivisible project is a project
that cannot be divided into separate parts and the entire project must be
undertaken
...
3 Cash flow determination
Capital budgeting evaluates expected future cash flows in relation to initial cash
outflows today
...
Incremental cash flows are the additional
cash flows (i
...
outflows and inflows) expected to result from the proposed
investment
...


Operating flows are relevant
...
Costs associated with financing (i
...
financing flows) are embodied in the
required rate of return
...
A project’s cash flow
consists of three basic components, i
...
initial investment, operating cash flows
and terminal cash flow
...
3
...
The initial investment may result in the following
cash flows:
Cost of acquisition
Proceeds from sale of existing assets;
Tax effects;
Change in working capital requirements
...
3
...

4
...
3 Terminal cash flow
This is the after-tax non-operating cash flow occurring in the final year of the
project, i
...
end-of-project cash flow
...
The end of a project may involve cash flows arising from:
Proceeds on sale of the asset;
Recoupment or scrapping allowance
Return of working capital

4
...
They can be classified into two broad categories, i
...
nondiscounted cash flow techniques and discounted cash flow techniques
...
They do not take into account the time value of money
...

4
...
1 Accounting rate of return ( ARR)
The accounting rate of return is also known as the average rate of return
...

ARR = Average annual after-tax profits x 100
Initial investment
OR
Average annual after-tax profits x100
Average investment
Where: Average investment = Initial investment
2
Decision rule (or criterion):
The decision is to either accept or reject an investment proposal
...

If ARR < the hurdle rate, reject the project
...
The projects must be ranked from best
to worst
...
It uses accounting profit, rather than cash flows
...
It does not take into account the timing of returns, i
...
it ignores the
time value of money
...
The number of alternative ARR calculations may tempt decision
makers to abuse the technique to suit their purposes
...
There is a high degree of arbitrariness in defining the cut-off (or
hurdle rate)
...
4
...
It can also be
used as a crude indicator of risk as it indicates how long the funds will be at
risk
...

Decision rule (or criterion):
For independent projects, the decision rule is:
If PBP ≤ the cut-off PBP, accept the project
...

For mutually exclusive projects, the decision rule is:
Accept the project with the lowest PBP, which is also less than or equal to the
cut-off PBP, and reject the rest
...
It ignores the time value of money, i
...
it assumes that the time
value of money is zero
...
It ignores cash flows beyond the PBP
...

3
...

4
...
They take into account the time value of money
...

4
...
1 Net present value (NPV)
The NPV is a capital budgeting technique that is found by subtracting a
project’s initial investment from the PV of its net cash inflows discounted at a
rate equal to the firm’s cost of capital
...

The NPV is calculated as follows:
NPV =

Where: CFt = the cash flow at time t
K = the cost of capital
I = the initial investment
Note: Cash flows are assumed to occur at the end of each time period
Decision criterion:
For independent projects, the decision criterion is:
If NPV ≥ $0, accept the project
If NPV < $0, reject the project
For mutually exclusive projects, the decision criterion is:
Accept the project with the highest NPV, which is also greater than or equal to
zero dollars, and reject the rest
...

4
...
2 Equivalent annual annuities (EAA)
Equivalent annual annuities [or equivalent annual income (EA1)] are used to
evaluate mutually exclusive projects with unequal lives
...
A
project’s NPV can be restated in terms of an annual annuity such that the
company is indifferent between the project’s NPV and the annuity
...
To compute a project’s EAA, the following steps are performed:
1
...

2
...
EAA
=NPV/PVIFAk,n
...


Decision Criteria
Accept the project with the highest EAA, which is also greater than zero, and
reject the rest
...
5
...
e
...
Mathematically, the
IRR is found by solving the following equation for the value of k that causes the
PV – I or NPV = $0:
= I or

]–I=0

Where: IRR = k
The methods that are commonly used to calculate the IRR are the trial-and-error
method, NPV profile and interpolation
...
If the NPV
is positive, choose a higher discount rate and calculate the NPV
...
Repeat the
process until a NPV =$ 0 is obtained
...
The
NPV profile measures how a project’s NPV changes in response to a change in
the discount rate
...
The line (or graph)
crosses the horizontal axis at the project’s IRR, i
...
where the NPV = $0

NPV Profile

(c) Interpolation:
Interpolation is a mathematical technique for estimating unknown intermediate
values
...
e
...


If the IRR < k, reject the project
...

4
...
5 Profitability index (PI)
The profitability index (PI) is a benefit/cost ratio
...

If PI < 1, reject the project
...

However, as a relative measure of profitability, it ignores the scale (or size) of the
investment
...

INVESTMENT DECISIONS QUESTIONS
Question 1 (ARR and PBP)
Beta Limited has an opportunity to invest in a project with the following the
following estimated future after-tax cash flows:
Year

$

0

(8 000)

1

2 400

2

3 000

3

4 000

4

3 200

5

1 800

Additional information:
1
...
Depreciation is charged on a
straight-line basis
...
The ARR hurdle rate, based on initial investment, is 20% and the
cut-off PBP is 3 years
...
the ARR ;
2
...

Question 2 (NPV)
Alpha Limited is considering the purchase of new state-of-the-art equipment with
a view to expand its operations
...


Required:
Use the net present value technique to evaluate the proposed investment project
...
The
projects are expected to generate the following after-tax cash flows:
Year

Project A
$

Project B
$

0

(52 000)

(80 000)

1

28 000

25 000

2

28 000

25 000

3

28 000

25 000

4

---------

25 000

5

---------

25 000

6

---------

25 000

Additional information:
1
...

2
...

Required:
Use the EAA to evaluate the two mutually exclusive projects
...
e
...

Required:
Use the IRR to evaluate the project
...
Give
your answer correct to two decimal places
...

5
...
1 Financial markets
Finance can be raised from various sources, with terms and conditions that
satisfy the needs of particular investors and that produce the risk/ return
relationship required by the entity
...
They provide a
forum in which suppliers of funds and demanders of funds can transact business
...

5
...
1 Money and Capital markets
Short-term debt instruments, such as TBs, are traded in the money markets
...

5
...
2 Primary and Secondary markets
The primary market is the market in which securities are initially issued (ie a
market for new issues of finance)
...
Thus, the primary market is a source of
finance (i
...
funds are raised), while the secondary market is not a source of
finance
...
g
...
Both primary and secondary markets are
found in both money and capital markets
...
1
...
They bring together
borrowers

( i
...
seekers of funds) and lenders (i
...
those with funds to invest)
...

5
...
2
...
The primary
sources of finance for a company are the ordinary shareholders
...
The
shareholders include the general public, pension’s funds, insurance companies
and other companies
...
The ordinary share capital and retained earnings are referred to as
equity (i
...
owners’ interest)
...
The ordinary shareholder is a
residual owner as he receives what is left after all other claims on the firm’s
income and assets have been satisfied
...

(b) Preference Shares
Preference shares area hybrid, having some of the characteristics of equity and
some of debt
...
However, if the company has insufficient funds to pay the dividend, this
dividend may be passed
...
Preference
shareholders are not normally given voting rights
...
They are also
usually given preference over ordinary shareholders with respect to the

distribution of assets during liquidations
...
They are also available in a variety of forms to suit the
particular requirements of the company and the needs of the investors, such as
participating preference share, redeemable preference shares and convertible
preference shares
...
2
...
Debenture bonds are issued in a way similar to the issue of shares
...
The main terms of the debenture contract are the rate of interest and
the repayment conditions
...

(b) Mortgage bonds
A mortgage bond is a long- term loan which is usually secured over the
immovable property of the company (i
...
land and buildings) and which bears a
variable interest rate
...
The amount of funds that can be raised depend
primarily on the value of the property and the purpose for which the loan is
raised
...
The terms
and conditions may be set to suit the requirements and preferences of the parties
concerned
...
Like loans, they can be
structured in almost any way
...

Leases can be categorized as either finance or operating leases
...
The lesser bears the risk of ownership, such as
incurring losses if the asset becomes obsolete, and retaining the obligation for
repairs, maintenance and insurance
...

Usually, the lessee has no right of cancellation or termination of the contract
...
The lessee is usually
responsible for maintenance, insurance and repairs and incurs losses if the asset
becomes obsolete
...

5
...
Much of short-term finance is raised spontaneously through
trade creditors and accruals
...

5
...
1 Accounts payable
Accounts payable are spontaneous liabilities that arise from the normal course of
business
...
They are a major source of unsecured financing
...
3
...
Accruals are
liabilities for services received for which payment has yet to be made, e
...
wages
and taxes
...
3
...
The terms
and conditions may be set to suit the requirements and preferences of the parties
concerned
...
3
...

5
...
5 Banker’s acceptances
A banker’s acceptance is created when a company sells a bill of exchange to the
bank to be settled on a predetermined date
...
3
...

5
...
4
...
The two components of
capital are equity capital and debt capital
...
e
...
Equity capital

can be raised externally by issuing shares, or internally through retaining
earnings
...
4
...

Management must decide on the level of debt, relative to equity, that it wants to
maintain, and it must also decide on the types of debt and types of equity it plans
to hold
...
4
...
The
relationship between the firm’s cost of capital and its value is that the lower the
cost of capital the higher the value of the firm and vice versa
...
4
...
This does not necessarily mean that the firm will permanently be at
exactly that target, but that over a period of time it will be striving towards that
position
...

5
...
5 Weighted average cost of capital (WACC)
The cost of capital is the rate of return that a firm must earn on its investment
projects to maintain the market value of its shares
...
Thus,
it is the rate if return required, given the firm’s existing target capital structure (i
...


the desired optimal mix of debt and equity financing that the firm attempts to
maintain)
...
This composite cost of capital is the weighted average cost of capital
(WACC)
...
It is found by weighting the cost of each specific type of capital by its
proportion in the firm’s capital structure
...


5
...
6 Weighting schemes
The weights that are used in computing WACC can be calculated as book value
or market value as historic or target
...
e
...
Market value
weights measured the proportion of each type of capital at its market value
...

(b) Historic versus target weights
Historic weights can be either book value or market value weights, based on
actual capital structure proportions
...
Firms
using target wrights establish such proportions on the basis of the optimal capital
structure they wish to achieve
...
The market – related interest rate for debentures in a similar class
to those given above has risen to 19%
2
...
CAPM and dividend growth model data:
Current market price of an ordinary shares

$5
...


Expected constant growth rate

17
...
a

Beta

1
...
Assume a tax rate of 30%
5
...

Required:
(a) Calculate the component costs of capital
(b) Calculate the WACC
...

6
...
1 Dividend policy theories
The dividend policy is an integral part of the firm’s financing decisions
...
A major aspect of the dividend policy is to
determine the appropriate allocation of profits between dividend payments and
additions to the firm’s retained earnings
...
In other words,
does the dividend decision rank equally with the investment and financing
decisions in its effect on the value of the company, or is it merely a consequence
of the other two factors? The answer probably lies somewhere between these
extremes
...

Therefore, dividends are relevant
...

Therefore, dividends are irrelevant

6
...
1 Dividend relevance theory

Myron Gordon and John Lintner argue that dividends affect the value of the firm
and, therefore, dividends are relevant
...
The dividend growth model (or Gordon growth model) bases the value of
a company on expected future dividends as follows:
Vo = D1/(k-g)
According to this model, dividends have a positive effect on value, that is, an
increased expected dividend results in an increase in the value of the firm
...
This is commonly known as the bird in hand theory
...

In practice, finance managers and shareholders appear to be of the view that
dividend policy affects the value of the firm
...
1
...


The payment of dividends reduces the growth

potential of the firm, hence future dividends will be lower
...
Given that the firm has acceptable investment
opportunities which could utilize all its funds, and a target capital structure, if the
firm pays a dividend; it would have to raise the funds just paid out as dividends
by issuing new shares
...
If the dividend is paid, the shareholder will
receive cash
...
Thus there will be more shares in

issue for the same assets, and so the value of existing shares will be diluted by
the amount of the dividend
...

What has been gained in cash on receipt of a dividend has been lost through the
dilution of the value of the shares
...
The M& M argument makes the following assumptions:


No taxes



No transaction costs



No market imperfections

Relaxing these assumptions could change the position
...


The

supporters of the dividend should be paid only if a company has no other use for
the funds
...


This view

manifests itself in the residual approach to dividends
...
1
...
They are “what is left over after decisions regarding investment and
financing have been made” This means that dividends should be paid only if
there are no investment opportunities available in which the firm can place those
funds and earn the required return for the given level of risk
...


The company should accept all projects which exceed the required rate of return
...

6
...
Yet companies are appear to pay dividends as a matter of
policy and that a great deal of importance is placed on the dividend
...
Some of the factors that firms should analyze when
approaching a dividend policy decision are:
6
...
1 Legal requirements
Common law rules determine the amount that can be distributed as dividends
...

6
...
2 Contractual obligations/ Restrictions in debt contracts
Dividend payment can be restricted by some loan agreements
...


For

example, the restriction may be expressed as a maximum percentage of
cumulative earnings retained in the firm
...
2
...
On the
basis of this assessment the firm can determine its likely future residual funds
...
2
...
For example, when a firm announces a high dividend,
that will be viewed by investors as indicating that management is confident about
the company’s earnings
...
2
...
A
firm’s ability to pay dividends may be influenced by the availability of cash
...

6
...
6 Ability to borrow
If a firm has the ability to borrow on a comparatively short notice, it may be
relatively financially flexible, the greater the ability of the firm to borrow, the
greater its financial flexibility, and the greater its ability to pay a cash dividend
6
...
7 Control
If a firm pays substantial dividends, it may need to raise capital at a later time
through the issue of shares in order to finance profitable investment
opportunities
...

6
...
8 Nature of shareholders/ Needs of shareholders
Shareholders are attracted to companies that satisfy their needs with regards to
cash income and capital growth
...
2
...
If external
investments offer a higher return, then a higher dividend must be paid
6
...
The policy must be formulated with two
objectives in mind;



To maximize the wealth of the owners;



To provide for sufficient financing
...
3
...


The firm pays a fixed dividend amount

regardless of the level of earnings
6
...
2 Stable payout ratio
Also known as constant payout ratio
...

6
...
3 Stable dividend plus bonus
Also known as lower regular plus extra
...

6
...
The company’s cost of capital is 25%
...
The company’s debt-to-equity ratio is 2:3
...
Retained earnings amount to $1 000 000
...
The company would like to invest in all profitable projects and has
adopted the residual approach to dividends for the purpose
...
WORKING CAPITAL MANAGEMENT
7
...
e
...
Working capital policy
refers to basic policy decisions on the optimal level of investments in current
assets, and the optimal financing thereof
...

Certain levels of working capital are required for the firm to operate efficiently
...
Should the investment in working capital be too high, funds are
being wasted through not earning the return required
...

7
...
2
...
Cash equivalents are
marketable securities
...

Cash equivalents are held for the purpose of meeting short-term cash
commitments rather than for investment or other purposes
...
Therefore, an
investment normally qualifies as a cash equivalent only when it has a short
maturity of, say, three months or less from the date of acquisition
...
2
...
These
transactions are necessary to conduct business
...

Excess funds may be invested in highly liquid marketable securities that can
easily be converted into cash
...

(d) Loan covenants motive
To maintain the amount of liquidity specified by banks and other lenders
...
2
...
The
cash budget is a report showing the firm’s projected cash inflows and outflows
over a specified period
...
The objective of a cash budget is to ensure that sufficient cash is
available at all times to meet the level of operations that are outlined in the other
budgets
...
An entity can avoid cash
balances that are surplus to its requirements by enabling management to take
steps in advance to invest the surplus cash in short-term investments
...

7
...
e
...
The financial manager controls trade receivables through
the establishment and management of a credit policy and a collection policy
...
e
...

7
...
1 Creditworthiness
Credit analysts often use the ‘five Cs of credit’ to focus their analysis on the key
dimensions of an applicant’s creditworthiness
...

(a) Character
This is the applicant’s record of meeting past obligations, i
...
financial,
contractual and moral
...

(c) Capital
This is the financial strength of the applicant as reflected by its capital structure
...

(d) Conditions
These are the current economic conditions and business climate as well as any
unique circumstances affecting either party to the credit transaction
...
3
...

(a) Financial statements
The firm can analyze the applicant’s liquidity, activity, debt and profitability
positions
...

(c) Bank checking
It may be possible for the firm’s bank to obtain credit information from the
applicant’s bank
...

(e) The firm’s own experiences
A study of the promptness of past payments can be useful
...
3
...
The common collection techniques are:
•

Letters;

•

Telephone calls;

•

Personal visits;

•

Collection agencies (i
...
debt collectors);

•

Legal action
...
4 Management of inventory
Inventory is a current asset that permits the production-sale process to operate
with a minimum of disturbance
...
Some of the techniques that
are commonly used in managing inventory are the economic order quantity, the
reorder point and just-in-time
...
4
...
This is the order quantity that minimizes the total ordering
and carrying costs (i
...
the total relevant cost)
...
The carrying
costs are the variable costs per unit of holding an item in inventory for a specified

time period
...

The EOQ model is expressed as follows:
EOQ =

(2 xCoxD ) / Cc

Where: D = the demand in units for a period
Co = the ordering cost per order
Cc = the carrying cost per unit per period
TRC = Q/2xCc + D/QxCo
Where: Q = the order quantity, but not necessarily the EOQ
7
...
2 Reorder point
Once the EOQ has been determined, the reorder point must be determined
...
The reorder point takes into account the
lead time needed to place and receive orders
...
4
...

Ideally, the firm would have only work-in-process inventory
...

7
...
At present the firm makes 5 orders of 40 000 units per
order at a cost of $120 per order, including freight handling and all paperwork
...

The company is reviewing its inventory policy
...




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