Financial Management. What is new in the 8th edition? Carlos Correia, David Flynn, Enrico Uliana, Michael Wormald & Johnathan Dillon

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1 Financial Management, David Flynn, Enrico Uliana, Michael Wormald & Johnathan Dillon What is new in the 8th edition? The 8th edition consolidates what was undertaken in the 6th and 7th editions but still includes important changes. The 8th edition completely brings the book up to date with current developments in capital markets and tax legislation and is in line with the Companies Act of Where relevant, the 8th edition refers to developments in corporate governance such as King III. There is an increased focus on corporate strategy, business models and risk management. The South African Institute of Chartered Accountants (SAICA) introduced the SA Competency Framework in 2010 for the training of Chartered Accountants in South Africa. This was amended in Version 8 of the SA Competency Framework was issued in September 2014 and is effective from January The principles and the requirements of the SA Competency Framework are adhered to in the 8th edition. Carol Cairney, one of the drafters of the SA Competency Framework, reviewed the Financial Management competencies and the Knowledge Reference List for the 7th edition and we are grateful to Johnathan Dillon for reviewing and ensuring the alignment of the 8th edition to Version 8 of SAICA s Competency Framework. This textbook is one of the few textbooks published in South Africa that is focused on complying with the SA Competency Framework in relation to the coverage of the relevant topics, the use of real world examples of SA companies, the focus on contextualization and the use of detailed and relevant questions as well as providing an increased focus on strategy and risk management. The textbook has expanded the use of professional examination questions, particularly questions from SAICA s Initial Test of Competence (ITC) examination (Part 1 of SAICA s Qualifying Examination). Whilst the integration of other subjects is not appropriate for this textbook, the book undertakes a high level of integration within the area of financial management. The 8th edition of Financial Management covers all the topics as set out in Version 8 of the SA Competency Framework. The SA Competency Framework is covered in detail in the book whereby we match each topic indicated in the Competency Framework and Knowledge Reference List to the relevant chapter in the Financial Management Textbook. The book has been completely updated to reflect current developments. What changes are included in the 8th edition of Financial Management? We have updated and expanded the real world examples in all the chapters and have included new developments relating to regulations, changes in Company Law and ensured an alignment to Version 8 of SAICA s SA Competency Framework. We have expanded topics such as risk management, business models and corporate strategy and have added a brand new chapter on Corporate Strategy and Business Models. In the following section, we set out the major changes that have been made to each chapter: Ch01 Overview This chapter has been updated and includes sections on professional ethics, corporate governance and King III. The section on corporate strategy includes SWOT and PESTEL analysis as well as Porter s Five Forces Framework. The section on the entity s mission and corporate goals and objectives has been expanded to reflect changes arising from the SA Competency Framework. We have updated and expanded references to real companies such as Vodacom, Aspen, AECI, Bidvest, MTN, Grindrod, Pioneer Foods and BHP Billiton. We have included a new section on the No Arbitrage Principle, which is a key concept in the pricing of financial instruments such as futures and options. We have included brief sections on sustainability, SRI, GRI and the Equator principles. We have added a new appendix on stakeholder considerations and corporate citizenship due to the increased focus on the role of 1

2 stakeholders and corporate social responsibility. These changes, and particularly the increased focus on corporate strategy and risk management (also covered in Chapters 21 and 18), ensure that the textbook is in line with the SA Competency Framework. Ch02 The time value of money We have updated the section on interest rates, bond yields and the term structure of interest rates. We have updated the sections on Warren Buffett and Allan Gray and have included a self-study example using time value of money principles to compare the contracts of Cristiano Ronaldo and Wayne Rooney until A guide to financial calculators is available on the book s website, which may be downloaded by students. Ch03 Risk and return The section on market returns and standard deviations has been updated. We have set out the equity returns and bond returns for 17 countries including South Africa. We compare returns and standard deviations for equities and bonds. We have updated the section on cumulative returns of investing in equities and bonds. A new section evaluates the relative volatilities of two sectors Food Processors and Mining over time. We analyse the share price movements and volatility of returns of investing in Anglo American. We refer to the Rip van Winkle solution to risk by relating volatility to time periods and we refer to Warren Buffett s thoughts on volatility. Reference is made to risk and emerging markets. We refer to the returns from investing in Coronation, Prudential and Allan Gray Funds as well as the JSE s Satrix ALSI Fund. The chapter includes definitions of the Sharpe ratio, the Treynor ratio, the Sortino ratio and Jensen s Alpha. The chapter expands on measuring downside risk, default probabilities, ratings and updates the section on market risk premiums. Ch04 Portfolio Theory We have updated the JSE betas for each sector as well as for selected companies. We refer to the concentration of the JSE. We have included a section, which questions whether CAPM works in the real world. We introduce the Fama-French Three Factor Model, which we explain in greater detail in Chapter 7. The chapter refers to the diversification aims of Coronation and Allan Gray in relation to setting up portfolios. We have included a guidance section for students at the end of the chapter, which links and reconciles the risk and return concepts of Chapters 3 and 4. Ch05 Financial Statement Analysis The 8 th edition now includes a section on Integrated Reporting. The chapter explains the six Capitals in line with the International Integrated Reporting Framework, which was published in December The chapter examines the guiding principles and the content elements set out in the Framework. We explain the role of strategy, sustainability and business models and the use of financial and non-financial information to effectively report on the company s performance and likely future strategies. The chapter includes an analysis of the Integrated Report of Truworths. Financial Statements are presented in line with International Financial Reporting Standards (IFRS). We have restated how we present the Statement of Cash Flows and have expanded the section on stakeholders to include customers and suppliers. We have updated the ratios of real world companies such as Truworths, Bidvest, MTN, SABMiller and Tiger Brands. We have included a new section on the possible impact of timing issues on the analysis of ratios. For example, we analyse the effect that investing during the year will have on certain ratios when revenue and income are only included for part of the year but the financial statements reflect the full increase in a company s assets. We suggest ways to adjust for this. We have expanded the section on the EBITDA margin and have set out the advantages and disadvantages of using EBITDA. We have expanded the sections on Return on Capital Employed (ROCE) and Return on Invested Capital (ROIC). The sections on solvency and liquidity ratios, as well as the section on failure prediction have been expanded in line with the requirements of the SA Competency Framework and the Companies Act 71 of At the end of the chapter, we have included a guidance section for students on financial 2

3 analysis, which sets out important considerations when undertaking financial analysis and answering financial analysis questions in the ITC. Ch06 Valuations We have expanded the section on P/E ratios and Market to Book ratios. There are updated examples of valuing SA companies. We have included a section on the use of forward P/E ratios. The chapter also focuses on the use of EBITDA multiples to determine enterprise value and we refer to the valuation by Brait of Pepkor using EBITDA multiples and compare this to the realised value achieved in the Steinhoff buyout of Pepkor. We have included a section on the valuation of rights in order to complete the chapter. We have added a new section on how to take into account employee share options in equity valuations. The chapter includes a new section by Greg Beech on the issues to consider when undertaking valuations in the real world. We have also included a new appendix 6.1 on the lack of marketability discount and other adjustments to valuations. This is often applied in the valuation of unlisted securities and reference is also made to adjustments for minority interests and controlling interests. In Appendix 6.2 we include new sections on the valuation of participating and convertible preference shares and the valuation of non-controlling interests. We also explain the effect of treasury shares as well as the impact of operating leases on equity valuations. We have expanded the number of valuation questions, which are mainly sourced from SAICA s ITC (QE: Part 1) examination. This means that more questions have been included which are more closely aligned with the SA Competency Framework. Ch07 Cost of Capital We expand on the bond yield plus premium approach to determine the cost of equity. This is in line with the SA Competency Framework. The section on market risk premiums for 18 countries including South Africa has been updated and the section on divisional costs of capital has been extended and we have also extended the section on unlevering and relevering betas. We have set out a number of independent sources from the real world in order to determine a likely market risk premium for South Africa. We have included a section on the WACCs disclosed by selected JSE companies such as Sasol, AVI, Datatec, African Rainbow Minerals, Distell and Grindrod. We estimate Sasol s WACC and reconcile this to the Sasol s reported WACC in its Integrated Report. We have expanded the section on the use of a target capital structure and the role of debt in setting an optimal capital structure to reduce a company s WACC. We compare the use of a target capital structure to book values and market values. We have rewritten the section on breaks in WACC and relate this to what may happen in the real world. The chapter includes new sections on adjustments to WACC including adjustments for lack of marketability and the factors included in deciding on a specific risk premium as well as the small firm risk premium. We refer to surveys such as the PwC Valuation Methodology Survey and the KPMG Cost of Capital and Impairment Testing Survey. We have included a section on the use of total beta to determine WACC when there are undiversified investors. We also comment on the effect of the resources sector on equity betas in South Africa and refer to changes in the risks of investing in emerging markets. We refer to the use by a number of South African companies of a hurdle rate, which is often at a premium to a company s WACC. We have reported the ROIC and WACC of Truworths over time. In Appendix 7.1 we tackle the issue of whether CAPM applies in the real world, despite its widespread use. We present the evidence that CAPM tends to understate the cost of equity of low beta companies and overstate the cost of equity of high beta companies. We then explain the Fama-French Three Factor Model and the role of the market premium, size premium and value premium in determining the cost of equity. We then use an example to depict how the Fama-French model can be employed to determine a company s cost of equity. We have expanded the questions to include a recent ITC question and have included a further question, which requires the unlevering and relevering of betas. 3

4 Ch08 Capital Budgeting There are few changes to this chapter. We have updated the tax legislation in relation to capital allowances and have updated the bank of questions to comply with the SA Competency Framework. We refer to a McKinsey survey of management views on the capital budgeting process. We have included a short section on the use of future values to evaluate projects and reconcile this to the project s NPV. We have included a guidance section for students at the end of the chapter with examples, which explains the total and incremental approaches to capital budgeting. Ch09 Further issues in Capital Budgeting We have revised and updated the information and examples in this chapter. We write about MTN s investment in its network as their subscribers move over to data. We also write about SAA s decision to undertake a fleet replacement. The questions have been expanded to include more professional examination type questions and we have added a recent lengthy ITC question. Ch10 Capital Budgeting: Risk Analysis We have rewritten the section on strategic analysis to make the application of the Porter s Five Forces Framework specific to analysing project risk. We have written about general corporate strategy in Chapters 1 and Chapter 21 in line with the requirements of the SA Competency Framework. In Chapter 10, we have expanded upon the current challenges facing the aluminum sector in order to bring the information on the Mozal smelter up to date. We included a new section on project management and project failures. The questions have been updated and expanded to more closely match the requirements of the SA Competency Framework. The section on Monte Carlo simulation with Excel also refers to the use of Crystal Ball. We have updated the Excel applications such as Tornado graphs. Ch11 Working Capital We have expanded the section on a company s working capital cycle. We analyse the funding of working capital by Clicks and Pick n Pay. We have included selected working capital ratios for selected JSE companies such as Pick n Pay, Tiger Brands, Barloworld, Clicks and Aspen. We have included a new section on working capital strategies and cash flow including the tax effects and include an example to explain how changes in working capital will affect after-tax cash flows. Our experience is that this often creates issues for students in solving problems in valuations and capital budgeting. We include an analysis of working capital management around the world based on an EY survey. Ch12 Current Asset Management and Short-term Financing We have expanded the section on offering credit to customers and we have included sections on supply chain management and the management of float and cash concentration. We have included a new section, with a detailed example, on the use of a revolving credit facility to fund short-term requirements. We have added a new section on repurchase agreements (repos) where we explain with an example how repurchase agreements (repos) work. The addition of sections on repurchase agreements (repos) and revolving credit facilities reflects the wide use of these short-term funding mechanisms in South Africa. In the guidance section at the end of the chapter, we set out and define the relevant working capital ratios. Ch13 Sources of Finance The chapter begins with the failed rights issue by AngloGold Ashanti and has been updated in relation to changes in the JSE Requirements and changes in the Companies Act. We have updated market data as well as information on IPOs. We have added a new section explaining the JSE Debt Market (Interest Rate Market) and we expand on changes in corporate bond spreads as well changes to South Africa s sovereign credit rating. We have also expanded the section on Private Equity and have updated the information on the IDC. The chapter expands on the issue of floating rate notes. We analyse the sources of finance at Sasol, Tiger Brands, MTN and Adcorp. We have introduced a new section on inflation-linked bonds, as these instruments have become an important part of the funding of governments, parastatals, utilities and some large companies. We have included a detailed 4

5 example of how inflation linked bonds work. Changes in technology are enabling the creation of alternative sources of finance. We have added new sections on peer-to-peer lending, crowdfunding and online invoice trading platforms. We refer to real world examples of alternative financing sources. We also refer briefly to supply chain finance. Chapter 13 ends with a guidance section for students on how to manage questions relating to sources of finance. The focus is on how the sources of finance link together and the section sets out the key issues students should consider when faced with sources of finance problems. The section on BEE funding has been updated (particularly in relation to taxation). We have updated the section on a company providing financial assistance for the acquisition of a company s own shares and we set out the requirements of the Companies Act of Ch14 Capital Structure We have added a further example on the impact of debt on a company s return on equity. We also have added a new section on how financial leverage impacts on an investment s IRR. Other textbooks often overlook this issue and we further relate this to the use of debt by private equity funds in making acquisitions. We analyse Bain Capital s projected IRR from its highly leveraged investment in Edcon and analyse the impact of its debt structure and poor operating performance on the interest rate asked by banks to refinance its debt in We have expanded the section on the conflicts between shareholders and bondholders and have updated the section on loan covenants as it relates to Aspen and Gold Fields. We have added a new section on how financial flexibility and market-timing theory may affect the capital structure of a firm. We also note that SARS is investigating highly levered capital structures and interest tax shields are no longer certain. We present updated debt to capital ratios for industry sectors. The chapter also evaluates the impact that the increase in financial leverage may have on a firm s cost of capital. We analyse the capital structure decisions and policies of JSE listed companies such as Grindrod, Hudaco and BHP Billiton and we include a detailed analysis of the capital structure and funding decisions of Edcon. At the end of the chapter, we have included a guidance section, which will assist students by explaining the strategic considerations, which should be considered when evaluating a firm s capital structure decision. This enables students to integrate the topic with other related key topics and should assist students to better answer a possible ITC question on capital structure. We have also included all the relevant capital structure ratios. Ch15 Leasing We have updated the section on the accounting for leases, which is now aligned to the exposure draft issued in We define Type A and Type B leases and use examples of Type A and Type B leases to indicate the impact that lease accounting is expected to have on company balance sheets (statements of financial position) and income statements as well as the likely impact on financial ratios. We have added to the real world examples of leasing. In particular, we explain in detail MTN s sale and leaseback of its cell phone towers and the economic rationale for MTN s leasing structures. In Appendix 16.1, we write about the capitalisation of operating leases and set out the industry sectors most likely to make use of leases. We explain the difference between operating and finance leases and set out the impact on key financial statement ratios and we explain the developments in accounting for leases. We also explain the potential effect of lease capitalisation on Altman Z scores as well as on a company s Economic Value Added (EVA). Ch16 Dividends and Share Buybacks The additions and changes to Chapter 16 were mainly framed by the implementation of the Companies Act of 2008 in 2011 (very soon after the publication of the 7 th edition) and the implementation of a dividend withholding tax (DWT) in This chapter has been extensively updated and we have removed the sections on secondary tax on companies (STC), which no longer applies. We refer to the Companies Act, particularly in relation to distributions and share buybacks and we include the solvency and liquidity tests of the Companies Act of We analyse the effect of a DWT on the effective tax rate. 5

6 We make extensive reference to real world companies and include information about the dividend and buyback practices of companies such as MTN, BHP Billiton, Sappi, AVI, and Truworths. We analyse the share splits of Assore and Implats and we analyse the dividend reinvestment policy of Growthpoint. We analyse the impact of a share buyback on a company s Statement of Financial Position and ratios in terms of the Companies Act, We analyse the share buybacks undertaken by Truworths and the dividend in specie arising from the unbundling of Sibanye Gold from Gold Fields in We evaluate dividend yields in South Africa and in other countries as well the dividend yields per sector. The real world examples have been updated and we present survey evidence of dividend policy in South Africa. Ch 17 Mergers, Acquisitions and Corporate Restructuring We have restated the formulas for determining the maximum and minimum exchange ratios to make these formulas more logical and understandable to readers. We have retained the formulas set out in the 7 th edition in footnotes. We have increased a section on greenmail and corporate raiders. We have updated the section on corporate restructuring, which deals mainly with the analysis of financially troubled companies as well as the development of business recovery plans. This is in line with the SA Competency Framework. The chapter also updates the section on the application of the business rescue provisions set out in the Companies Act. The chapter also analyses BEE transactions. The chapter has updated the section on the regulation of takeovers in line with the Companies Act 71 of 2008 and we have updated the section on Competition Law in South Africa. The chapter includes sections on the legal structuring of takeovers and analyses the new Takeover provisions of the Companies Act of We write about recent real world mergers and acquisitions, including the acquisition of the iconic Australian retailer David Jones, by Woolworths. We analyse the unbundling of Sibanye Gold from Gold Fields. We focus not only takeovers that succeeded but also on those that failed such as the Nedbank offer for Standard Bank and the offer by Harmony for Gold Fields and we track the impact on the wealth of each set of shareholders by the proposed takeover not going ahead. We write about why the Ellerines acquisition led to the collapse of African Bank. We document the battle for Adcock Ingram by CFR and Bidvest. Finally, we analyse how Woolworths structured the funding of the David Jones acquisition. In Appendix 17.1, we set out an overview of the merger process, and also set out an alternative approach to calculate exchange ratios whereby we do not need formulas to determine maximum and minimum exchange ratios. In Appendix 17.3, Etienne Swanepoel of Webber Wentzel updates his overview of the business rescue provisions of the Companies Act of Ch 18 Risk Management This chapter focuses on risk management and may be divided into three sections; an overview of financial risk management strategies, an introduction to options and futures, and a section on hedging with derivatives and swaps. We have included a new section on how to set up a replicating portfolio, which will result in the same payoffs as an option. If the replicating portfolio and an option has the same payoffs, then we can use the value of the replicating portfolio today to determine the current value of an option. We include an example of a replicating portfolio and how we use this to determine the value of an option. We use this to also explain how we determine delta. This forms the basis of the Black-Scholes Model. We have expanded the section on Options and Interest Rate Swaps and we have updated the section on collars, floors and caps in line with the SA Competency Framework. We have updated all data in regard to interest rates, the JSE and market prices. We have expanded the section on CFDs mainly by including detailed examples of the purchase and sale of CFDs and how we can use CFDs to go short on shares. We have included a new section on the use of derivatives by South African companies. We have added a recent ITC question to the set of questions in this chapter. We refer to the risk 6

7 management policies of selected South African companies such as BHP Billiton, Rainbow Chicken, SABMiller, AngloGold and SAA. Dr. Glen Holman has updated his section on hedge funds. Ch19 International Financial Management We have updated the exchange rates and market data to November 2014 and have updated the section on currency forecasts. The chapter has added a section on developments in emerging market currencies. We have updated the information on the law of one price and we analyse currency forecasts set by the major banks. We have updated and expanded the section on exchange control in relation to its effects on business transactions, corporate borrowings and investments. We refer to Gold Fields analysis of its exposure to movements in the currency rates. We have updated the section on futures and currency swaps. We have expanded the section on the risk management of currency exposure and refer to the practices of selected JSE listed companies. Ch 20 Business Planning and Financial Modelling The SA Competency Framework requires that Chartered Accountants are able to develop business plans and this chapter presents the principles, advantages and practices involved in the preparation of a business plans. The chapter also focuses on the proper design and layout of financial models. The chapter also refers to setting up sensitivity analysis, the use of Scenario manager and Data Tables. The chapter includes the use of financial modelling to forecast future financial statements, free cash flows and financing flows. The chapter includes a detailed DCF (free cash flow) valuation set out as an Excel model with the relevant references and formulas which students can replicate. In the 8 th edition, we have expanded the section on Data Tables in Excel. We have changed the calculation of interest income and expense in the model. We have expanded the section on Circular references in Excel and explain how to enable iterations or avoid circular referencing by changing formulas and references. Ch 21 Corporate Strategy and Business Models Chapter 21 is a brand new chapter. Version 8 of the SA Competency Framework, which is effective from January 2016, includes a greater focus on corporate strategy and further requires that candidates understand the nine Building Blocks of a Business Model. The chapter begins with a section contrasting strategy and industry analysis and presents a comparative analysis of Aspen and Adcock- Ingram. The chapter then defines strategy and refers to a number of leading corporate strategy books, theories and writers such as Marikides, Rumelt and Michael Porter. The chapter includes many real world examples of corporate strategy and also focuses on the role of innovation. In terms of the SA Competency Framework, the chapter explains Matrix Models such as the BCG growth-share matrix, the GEC-McKinsey matrix and Ansoff s product-market matrix. The chapter then sets out an extensive analysis of Porter s Five Forces model. This expands upon what is presented in Chapters 1 and 20 and includes many real world examples. We explain Porter s Four Corners Analysis model and evaluate other strategic factors such as industry growth rates, government policies, deregulation, technology and innovation. We link advances in technology to business disruption and provide real world examples of disruption/innovation in the insurance, banking and retailing sectors in South Africa. We write about the analysis of competitors and customers. In line with the SA Competency Framework we explain product life cycles and include a new section on the building blocks of a business model. We explain each building block which includes customer segments, value propositions, channels, customer relationships, revenue streams, key resources, key activities, key partnerships and cost structure. For each building block, we provide a detailed explanation and real world examples. The final section of the chapter examines disruptive technologies, 3-D printing and the role of Big Data. We include the results of a McKinsey study on the 10 IT-enabled future business trends for the next 10 years. We include examples of changes to business models and sectors over the last 15 years. 7

8 Conclusion The 8 th edition of Financial Management is aligned to Version 8 of the SA Competency Framework in relation to the Strategy, Risk Management (in respect to financial risk management) and Financial Management competencies. This makes it a big book as it includes the theory of corporate finance, strategy, and financial risk management as well as an extensive bank of simple, intermediate and complex questions. The 8 th edition completely brings the book up to date with current developments in capital markets and tax legislation and is in line with the Companies Act of We have included many recent ITC questions. Support materials include PowerPoint s, PDF and Word solutions, selected Excel examples, readings, Financial Calculator guides, MCQ tests and solutions, a few videos and reference material such as company betas and surveys and articles on related topics. 8