MANAGEMENT DEVELOPMENT PROGRAMME FINANCE & FINANCIAL MANAGEMENT 19 OCTOBER 2018
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, 2008 2. Forms of Businesses I. Sole Proprietorship II. Partnership III. Close Corporation IV. Private Company V. Public Company
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
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
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)
bonds & valuation
bonds & valuation COUPON RATE BOND MATURITY PAR/FACE VALUE
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:
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
bonds & valuation BOND PRICE 1039 1000 963 9% 10% 11% YIELD/MARKET INTEREST RATE UKZN INSPIRING Ohpis GREATNESS Nevets 10/16/2018 1
bonds & valuation BOND PRICE ANNUITY PV OF COUPONS PRESENT VALUE OF FACE VALUE
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
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.
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.
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
bonds & valuation A bond which the issuing company can buy back at a predetermined price is called a callable bond
bonds & valuation Callable bonds provide the company a way to refinance the debt when the interest rate becomes lower
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
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
equity valuation Financial Markets Foreign Exchange Market Capital Market Money Market Commodities Market Equity Market Bond Market
equity valuation shareholders PRIMARY MARKETS Board of directors chief executive office SECONDARY MARKETS Financial Director Marketing Director HR Director
equity valuation
equity valuation OTHER FACTS ABOUT JSE REVENUE STREAMS (2008) Largest SSF market in volume Take-over of BESA 69 319 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
equity valuation CEO & Exec Mngt Board of Directors share-holders
equity valuation Capital Gain Dividend Payout
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
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%
equity valuation = number of shares issued X price per share
equity valuation note the difference between authorised and issued shares
equity valuation CATEGORIES (MAIN BOARD) LARGE CAPS (BLUE CHIPS) MID-CAPS SMALL CAPS ALT- X
equity valuation o FTSE/All Share Index (J203) o Top 40 Index o Dow Jones o S&P500 onasdaq o DAX o CAC
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%
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
capital budgeting decisions it is fixed assets that determine the business of the firm airline business (planes) shipping business (ships) freight business(trucks)
capital budgeting techniques capital expenditure is done in-order to: increase firms level of operation greater production more market share generate more revenue
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
capital budgeting: an evaluation Once cash flows for the project have been established, a method is required to determine if the project is acceptable
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 R325 000 spend R125 000 on painting, plumbing, renovations; your total investment is R450 000 if you sell the house for R500 000, you have created R50 000 value making a decision whether R50 000 was worth it, is at the centre of capital budgeting
capital budgeting (NPV) Net Present Value (NPV) is the difference between an investments market value and its initial investment.
capital budgeting (DCF) Discounted Cash Flow (DCF) is the process of valuing an investment by discounting its future cash flows.
capital budgeting (DCF) an example A fertilizer business: cash revenue: R20 000 per annum cash costs (including taxes) : R14 000 per annum period for the business: 8 years salvage value after 8 years: R 2 000 the project initial cost: R30 000 selected discounted rate: 15% number of shares outstanding: 1 000 is this a good OR bad investment?
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 R20 000 R14 000 = 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
capital budgeting (DCF) an example Time (years) Initial cost 0 1 2 3 4 5 6 7 8-30 000 Inflows 20 000 20 000 20 000 20 000 20 000 20 000 20 000 20 000 outflows -14 000-14 000-14 000-14 000-14 000-14 000-14 000-14 000 Net inflow 6 000 6 000 6 000 6 000 6 000 6 000 6 000 6 000 salvage 2 000 Net Cash Flow -30 000 6 000 6 000 6 000 6 000 6 000 6 000 6 000 8 000
capital budgeting (DCF) an example Present value = R6 000 X (1 1/(1.15) ^8) / 0.15 + 2 000/(1.15) ^8 = R6 000 X 4.48 + 2 000/3.05 = R26 880 + 656 = R27 579 (R6 000 X PVIFA 15%: 8) + R2000 X PVIF 15%:8) When we compare this with R30 000 estimated cost, the NPV is: NPV = -R30 000 + R27 536 = -R2 4 64 Therefore: this is NOT A GOOD INVESTMENT!
capital budgeting (NPV) a conclusion an investment should be accepted if the NPV is positive, and rejected if it s NPV is negative
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
capital budgeting: the Payback Rule, an example an initial investment: R50 000 after the first year, the firm has recovered: R30 000 this leaves R20 000 outstanding the cash flow in the second year is: R20 000 this means that this investment pays itself off in 2 years this means that its PAYBACK PERIOD = 2 years
capital budgeting: the Payback Rule - 50 000 30 000 20 000 10 000 10 000 Payback period
capital budgeting: Payback Rule further examples Year Project A Project B Project C Project D Project E 0 -R100 -R200 -R200 -R200 -R50 1 30 40 40 100 100 2 40 20 20 100-50 000 000 3 50 10 0-200 4 60 130 200
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
capital budgeting: the Payback Rule, the strengths easy to understand adjusts for uncertainty of later cash flows; and biased towards liquidity
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
the Average Accounting Return (AAR) = average net income average book value
the Average Accounting Return (AAR) an example an example: opening a new store at a mall:- required initial investment: R500 000 the store life in years: 5 years depreciation period: 5 years depreciation method: straight line depreciation per year: 500 000 / 5 = 100 000 per year tax rate: 25%
the Average Accounting Return (AAR) an example Year 1 Year 2 Year 3 Year 4 Year 5 Revenue R433 333 R450 000 R266 667 R200 000 R133 333 Expenses 200 000 150 000 100 000 100 000 100 000 Earnings before deprec R233 333 R300 000 R166 667 R100 000 R33 333 Depreciation 100 000 100 000 100 000 100 000 100 000 Earnings before taxes R133 333 R200 000 R66 667 R0 -R66 667 Taxes (25%) 33 333 50 000 16 667 0-16 667 Net income R100 000 R150 000 R50 000 R0 -R50 000
the Average Accounting Return (AAR) an example An average net income = R100 000+150 000+50 000+0+(-50 000) 5 = R50 000 Average book value = R500 000 + 0 2 = R250 000 ARR = R50 000/R250 = 20%
the Average Accounting Return (AAR) according to ARR, a project is acceptable if its average accounting return exceeds a target average accounting return
capital budgeting: Internal Rate of Return an IRR is a discount rate that makes an NPV of an investment ZERO
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
capital budgeting: Internal Rate of Return when an NPV is equal to ZERO we are indifferent between taking or not taking an investment opportunity
capital budgeting: Internal Rate of Return an IRR is a discount rate that makes an NPV to be equal to ZERO
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? = 110 100/100 = 10% Therefore 10% is the IRR
capital budgeting: Internal Rate of Return Year 0 Year 1 Year 2 -R100 +R60 +R60 NPV = 0 = -100 + 60/(1+IRR)+60/(1+IRR)^2 Use trial and error, IRR will be equal to 13.1%
capital budgeting: Internal Rate of Return Discount rate NPV 0% R20 5% R11.56 10% R4.13 15% -R2.46 20% -R8.33 IRR is somewhere here
capital budgeting: Internal Rate of Return
capital budgeting: Internal Rate of Return An example: a project has a total up-front cost of -R435.44 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% R164.56 5% R100.36 10% R46.15 15% R0.00 20% R39.61
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
QUESTIONS