MANAGEMENT DEVELOPMENT PROGRAMME FINANCE & FINANCIAL MANAGEMENT 19 OCTOBER 2018 UKZN INSPIRING GREATNESS

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Basil Russell
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1 MANAGEMENT DEVELOPMENT PROGRAMME FINANCE & FINANCIAL MANAGEMENT 19 OCTOBER 2018

2 To be covered SECTION-A 1. Financing a Business 1. Short-term Finance (Debt) I. Trade Credit II. Factoring III. Bank Overdrafts 2. Medium-term Financing I. Loans II. Hire Purchase III. Leasing 3. Long-term Financing I. Long-term Loans (Debentures & Loan-stock) II. Equity (ordinary, preference shares, etc) SECTION-B 1. Discounted Cash Flow Criteria I. Net Present Value (NPV) II. Profitability Index (PI) III. Internal Rate of Return (IRR) 2. Non-discounted Cash Flow Criteria I. Payback Period II. Accounting Rate of Return SECTION-C 1. Company Law, Forms of Businesses I. Sole Proprietorship II. Partnership III. Close Corporation IV. Private Company V. Public Company

3 financing a business SHORT-TERM FINANCE (DEBT) 1. Trade credit Usually used to finance receivables and inventories Taking advantage of good terms vs. being a trade risk 2. Factoring Accounts receivable arise through sales on credit To release this money tied up: the factoring company pays the trader and then collects the debts Factoring company earns money by interest and a collection fee Different from invoice discounting 3. Bank overdrafts A loan is usually for a fixed period of time, unlike an overdraft An overdraft is a facility Interest incurred only when, and to the extent, used Costs: interest and often an initial fee Rate of interest: risk and market rates Some businesses get a rate below prime Overdrafts are often secured by security including personal guarantees

4 financing a business 4. Hire purchase A way of financing the purchase of an asset The hire purchase company owns the asset for the duration of the agreement The hire purchase company hires the asset to the business The hirer has the use of the asset The risks associated with the asset are borne by the hirer At the end of the HP agreement, ownership of the asset is transferred to the hirer Consists of a deposit and a set number of installments If payments are not made as agreed the hire purchase company can repossess the asset Costs: repayments consist of repayment of capital plus interest charge Rate of interest usually higher than a bank loan Hire purchase is for a fixed period

5 financing a business 5. Leasing An agreement between the lessor (owner) and the lessee Lessee uses the asset Normally ownership is not transferred at the end of the lease Can be a short or long-term lease agreement This agreement is tied to a specific asset Can lease a telephone system, a property etc. Leases are usually for longer periods than HP agreements Two types: operating leases and finance leases Operating leases means renting an asset such as a photocopier (rental arrangement): full amount of rental usually treated as an expense A finance lease is the same as borrowing money to buy a specific asset (finance arrangement)

6 bonds & valuation

7 bonds & valuation COUPON RATE BOND MATURITY PAR/FACE VALUE

8 bonds & valuation callable bonds bond the issuer may repurchase back corporate bonds can be issued by: competitive dealing amongst dealer groups private placements prospectus to the public corporate bonds can be:

9 Factors affecting bond valuation: oexpected interest rates odefault risk (investment VS speculative bonds) omarkatibility Other bond attributes oterm to maturity & duration oyield to maturity ocoupon rate bonds & valuation When investor anticipates interest rate fall: invest in long duration (ie bond fund) When investor anticipates interest rate fall: invest in short duration (ie income fund) Bonds are less volatile then equities in short to medium terms Bond form a good part of a diversified portfolio

10 bonds & valuation BOND PRICE % 10% 11% YIELD/MARKET INTEREST RATE UKZN INSPIRING Ohpis GREATNESS Nevets 10/16/2018 1

11 bonds & valuation BOND PRICE ANNUITY PV OF COUPONS PRESENT VALUE OF FACE VALUE

12 bonds & valuation Where C : is the coupon payment per period r : is the coupon rate per period t : is the number of periods F : is the face value of the bond

13 bonds & valuation You should not confuse the coupon rate and the interest rate (YTM). The coupon rate is the rate which is used to calculate the amount of interest paid per period. The YTM is the interest rate that represents the rate of return on the bond.

14 bonds & valuation If the YTM is greater than the coupon rate, the bond price is less than the face value and such a bond is called a discount bond. If the YTM is less than the coupon rate, the bond price is greater than the face value and such a bond is called a premium bond.

15 bonds & valuation WHEN INTEREST RATES INCREASE THE BOND ISSUERS GAIN SINCE THEY PAY THE CONTRACTED COUPONS AND PRINCIPAL BOND INVESTORS MAKE GOOD RETURNS WHEN INTEREST RATES (YTM) DECLINES WHEN ISSUERS ANTICIPATE AN INCREASE IN INTEREST RATES, THEY GAIN BY BORROWING MORE WHEN BOND INVESTORS ANTICIPATE A REDUCTION IN INTEREST RATES, THEY BUY MORE BONDS

16 bonds & valuation A bond which the issuing company can buy back at a predetermined price is called a callable bond

17 bonds & valuation Callable bonds provide the company a way to refinance the debt when the interest rate becomes lower

18 capital budgeting (Sasol Case) R13 billion CAPEX in 2006 gas to liquid plants in Qatar & Nigeria a polymer plant in Iran an unnamed project in SA risk : reward relationship critical

19 capital budgeting (Sasol Case) R13 billion capex in 2006 gas to liquid plants in Qatar & Nigeria a polymer plant in Iran an unnamed project in SA risk : reward relationship critical

20 equity valuation Financial Markets Foreign Exchange Market Capital Market Money Market Commodities Market Equity Market Bond Market

21 equity valuation shareholders PRIMARY MARKETS Board of directors chief executive office SECONDARY MARKETS Financial Director Marketing Director HR Director

22 equity valuation

23 equity valuation OTHER FACTS ABOUT JSE REVENUE STREAMS (2008) Largest SSF market in volume Take-over of BESA trades a day World 20 largest exchange Corn futures endorsed by CBOT Appr R10 bln traded daily ( R696 bln traded at NYSE) 10% 15% 5% 7% 27% 16% Equities Trading Fees Risk Management Listing Fees Equity Derivatives Commodity Derivatives Information Sales 13% 7% Technology Services Other Streams 2

24 equity valuation CEO & Exec Mngt Board of Directors share-holders

25 equity valuation Capital Gain Dividend Payout

26 equity valuation share ownership means owning a portion of the business, and is rewarded by dividends when profits are made, but high risk when the business is doing badly

27 equity valuation Peter buys 100 FSR shares on 1 Jan 2010 at R20 per share = R2 000 Peter sells 100 FSR shares on 31 Dec 2010 at R25 per share = R2 500 Peter has made a capital gain of R500 in 1 year Equals 25%

28 equity valuation = number of shares issued X price per share

29 equity valuation note the difference between authorised and issued shares

30 equity valuation CATEGORIES (MAIN BOARD) LARGE CAPS (BLUE CHIPS) MID-CAPS SMALL CAPS ALT- X

31 equity valuation o FTSE/All Share Index (J203) o Top 40 Index o Dow Jones o S&P500 onasdaq o DAX o CAC

32 COST Brokerage fees AMOUNT R50 Strate R10.92 Securities Transfer Tax (STT) Investor Protection Levy R25.00 R0.02 Vat R8.53 Total Fees R94.47 Dealing Cost Percentage equity valuation 0.94%

A mandate is signed Details of a relationship Close

33 equity valuation Your objectives How much you have Knowledge of markets Call the stockbroker The stockbroker A mandate is signed Details of a relationship Close communication & reporting Long term commitment & continued learning Returns

34 capital budgeting decisions it is fixed assets that determine the business of the firm airline business (planes) shipping business (ships) freight business(trucks)

35 capital budgeting techniques capital expenditure is done in-order to: increase firms level of operation greater production more market share generate more revenue

36 capital budgeting process, the steps 1. a proposal must be made; 2. review and analysis of the proposal; 3. costs and benefits are estimated; 4. report preparation and recommendations; 5. implementation and 6. follow-up

37 capital budgeting: an evaluation Once cash flows for the project have been established, a method is required to determine if the project is acceptable

38 capital budgeting techniques (NPV) An investment should create value for the shareholders; Its worth (return) should should be more than its costs; Example: buy run-down house for R spend R on painting, plumbing, renovations; your total investment is R if you sell the house for R , you have created R value making a decision whether R was worth it, is at the centre of capital budgeting

39 capital budgeting (NPV) Net Present Value (NPV) is the difference between an investments market value and its initial investment.

40 capital budgeting (DCF) Discounted Cash Flow (DCF) is the process of valuing an investment by discounting its future cash flows.

41 capital budgeting (DCF) an example A fertilizer business: cash revenue: R per annum cash costs (including taxes) : R per annum period for the business: 8 years salvage value after 8 years: R the project initial cost: R selected discounted rate: 15% number of shares outstanding: is this a good OR bad investment?

42 capital budgeting (DCF) an example what we need to do is: calculate the present value of the future cash flows at 15% discount rate the net cash inflow will be R R = R6 000 we have an 8 year annuity of R6 000 with a single lump sum of R2 000 at the end of year 8

43 capital budgeting (DCF) an example Time (years) Initial cost Inflows outflows Net inflow salvage Net Cash Flow

44 capital budgeting (DCF) an example Present value = R6 000 X (1 1/(1.15) ^8) / /(1.15) ^8 = R6 000 X /3.05 = R = R (R6 000 X PVIFA 15%: 8) + R2000 X PVIF 15%:8) When we compare this with R estimated cost, the NPV is: NPV = -R R = -R Therefore: this is NOT A GOOD INVESTMENT!

45 capital budgeting (NPV) a conclusion an investment should be accepted if the NPV is positive, and rejected if it s NPV is negative

46 capital budgeting: the Payback Rule payback is the amount of time required for an investment to generate net cash flows sufficient to recover its initial cost

47 capital budgeting: the Payback Rule, an example an initial investment: R after the first year, the firm has recovered: R this leaves R outstanding the cash flow in the second year is: R this means that this investment pays itself off in 2 years this means that its PAYBACK PERIOD = 2 years

48 capital budgeting: the Payback Rule Payback period

49 capital budgeting: Payback Rule further examples Year Project A Project B Project C Project D Project E 0 -R100 -R200 -R200 -R200 -R

50 capital budgeting: the Payback Rule, the weaknesses is calculated by simply adding up the future cash flows; there is no discounting involved; and so the time value of money is completely ignored; the risk factor between projects is not considered by the Payback cash flows after payback period are completely ignored there is no rationale for coming up with the cut-off period

51 capital budgeting: the Payback Rule, the strengths easy to understand adjusts for uncertainty of later cash flows; and biased towards liquidity

52 the Average Accounting Return (AAR) also called an Accounting Rate of Return (ARR) it is an investments average net income divided by its average book value

53 the Average Accounting Return (AAR) = average net income average book value

54 the Average Accounting Return (AAR) an example an example: opening a new store at a mall:- required initial investment: R the store life in years: 5 years depreciation period: 5 years depreciation method: straight line depreciation per year: / 5 = per year tax rate: 25%

55 the Average Accounting Return (AAR) an example Year 1 Year 2 Year 3 Year 4 Year 5 Revenue R R R R R Expenses Earnings before deprec R R R R R Depreciation Earnings before taxes R R R R0 -R Taxes (25%) Net income R R R R0 -R50 000

56 the Average Accounting Return (AAR) an example An average net income = R ( ) 5 = R Average book value = R = R ARR = R50 000/R250 = 20%

57 the Average Accounting Return (AAR) according to ARR, a project is acceptable if its average accounting return exceeds a target average accounting return

58 capital budgeting: Internal Rate of Return an IRR is a discount rate that makes an NPV of an investment ZERO

59 capital budgeting: Internal Rate of Return based on IRR rule, an investment is accepted if the IRR exceeds the required return, otherwise it should be rejected

60 capital budgeting: Internal Rate of Return when an NPV is equal to ZERO we are indifferent between taking or not taking an investment opportunity

61 capital budgeting: Internal Rate of Return an IRR is a discount rate that makes an NPV to be equal to ZERO

62 capital budgeting: Internal Rate of Return An example: a project costs R100 today, and pays R110 in 1 year, what is the rate of return on the project? = /100 = 10% Therefore 10% is the IRR

63 capital budgeting: Internal Rate of Return Year 0 Year 1 Year 2 -R100 +R60 +R60 NPV = 0 = /(1+IRR)+60/(1+IRR)^2 Use trial and error, IRR will be equal to 13.1%

64 capital budgeting: Internal Rate of Return Discount rate NPV 0% R20 5% R % R % -R % -R8.33 IRR is somewhere here

65 capital budgeting: Internal Rate of Return

66 capital budgeting: Internal Rate of Return An example: a project has a total up-front cost of -R the cash flows are R100 in year 1, R200 in year 2 and R300 in year 3 what is IRR? if we require 18%, should we take the investment? Discount Rate NPV 0% R % R % R % R % R39.61

67 capital budgeting: Internal Rate of Return Our IRR = 15% and therefore if our required rate of return was 18% we should NOT take the investment

68 QUESTIONS

Capital Budgeting, Part I

Capital Budgeting, Part I Lakehead University Fall 2004 Capital Budgeting Techniques 1. Net Present Value 2. The Payback Rule 3. The Average Accounting Return 4. The Internal Rate of Return 5. The Profitability