Upload
jkwabena
View
217
Download
0
Embed Size (px)
Citation preview
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 1/66
Sources of FinanceSources of Finance
&& Capital StructureCapital Structure
Chapters 13 & 14Chapters 13 & 14
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 2/66
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 3/66
3
Financial Markets
MONEY MARKETS
±Mainly for ST (<3 yrs) finance and mostly over
the phone
± Include investment & commercial banks &
finance houses
±Money markets deal in financial instruments
with a life of less than three years
CAPITAL MARKETS
± Mainly for LT (> 3yrs) finance (e.g. JSE and ALTX -
shares and debenture issues)
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 4/66
4
Primary, Secondary & Formal
Markets
Primary markets - New share/debentureissues (e.g. new JSE listing)
Secondary market Deals in previously
issued securities (e.g. buying/selling of shares on JSE)
Formal markets E.g. JSE, ALTX, SAFEX &
Bond Exchange of SA are highly regulated,specialising in a narrow range of standardised instruments accessible tosmall investors
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 5/66
5
Informal Over-the-Counter (OTC) Markets
Informal deals on OTC markets occur across a
desk or by using computer terminals &
telephones.
Most formal exchanges started as informal OTC
markets
Informal/OTC markets permit innovation/
flexibility according to needs of parties
Standardised instruments (e.g. OTC trading of currencies) do not need formal exchanges to
trade efficiently
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 6/66
6
Spot and Derivative Markets SPOT MARKETS trade instruments at agreed prices immediately
DERIVATIVE MARKETS defer settlement to a future date
Derivatives are used to manage risk (hedge), speculate & arbitrage
They are Flexible, have Low cost and offer significant Leverage and
Liquidity
Exchange traded derivatives.
Options and warrants are traded on the JSE and futures and
options on SAFEX.
Have Standardised contracts, marking to market and high levels of
liquidity.
Non-exchange traded derivatives are
Negotiated and customised, non-standardised and not traded on
an exchange. Examples are forward contracts, forward rate
agreements (FRAs) and swaps.
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 7/66
7
Interaction between market classifications
Markets classifications do not make themmutually exclusive. E.g. The sale of 1000Barloworld shares could be designated tothe following markets:
±capital shares are long-terminstruments;
±secondary money is exchanged forshares (Barloworld is not involved)
±spot money is exchanged and the scripdelivered immediately;
±formal shares are sold through a broker
on the JSE.
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 8/66
8
JSE Securities Exchange (JSE)
The JSE was formed as a market for shares of the many mining and financial companies formed after thediscovery of gold in SA
The JSE is SAs only stock exchange and governed by theSecurities Services Act, 2004 and its own rules and
directives
Trading on the JSE was in the form of an auctioninvolving brokers
In 1996 the JSE introduced electronic share trading (JET)
system From July 1999 JSE introduced the Share Transaction
Totally Electronic (STRATE) project, allowing transactionsto be settled and traded electronically
From Feb 2002 all JSE counters had moved to STRATE
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 9/66
9
JSE Listing Requirements Main Board
Subscribed capital at least R25m (not <25m shares)
Audited 3 year profit history last < R8m NPBT
Not <500 public shareholders (not employees/associates)
Not <2
0% of shares to be held by
the public Compliance with King II on Corporate Governance ± Audit committee / remuneration committee /separate
chair & CEO Compliance with International Reporting Standards
New requirements on auditors Independent directors Related party transactions Disclosure of director share trading activities
D
irectors to ensure compliance with listing requirements
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 10/66
10
Placement of Shares (vs public offer)
Ordinary shares are sold directly to agroup of institutional investors
Proportionate ownership may be
diluted No underwriting - quicker than rights
issue or public offer
Control and strategic allocation of
shares
No prospectus required
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 11/66
11
Alternative Exchange - ALTX
AltX is a division of the JSE.
Market for small/medium sized companies.
Listing requirements less onerous and include: ± Share capital of R2m
± Public ownership = 10%
±Designated Advisor ± Induction programme for directors
Market Capitalisation of ALTX = R5bn. At Jan
2007 30 companies listed on AltX
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 12/66
12
JSE Liquidity What does market liquidity mean? Buy/sell large #
shares quickly at current price on secondary market. Why is market liquidity important? A primary market
(new issues) will not exist without efficient and liquid
secondary market
Significant increase in market liquidity from 5% in early
1990s to about 42% in 2006
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
28 50 67 39 71 22 101 23 42 82 87
Equity Capital Raised on the JSE (Rbn)
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 13/66
13
Capital is raised on the JSE?
New equity issues relate to assetacquisitions and restructurings
The number of new listings has fallen. Many de-listings on JSE in recent years.
JSE is still ranked 19th of worlds
exchanges ito market capitalisation(US$)
32nd in terms of market liquidity.
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 14/66
14
No. of companies listed on the JSE
Number of JSE listed companies fallen
significantly, mainly due to:
± restructuring by groups,
± unbundling,
± winding-up and
± mergers and acquisitions.
Delisted in recent years: I&J, BOE, McCarthy,
Genbel, Cadbury Schweppes, Safren, LTA
New listings 2006: Massmart, Kumba Resources,
Spar. Listing of Hulamin (Huletts Aluminium)
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 15/66
15
Instruments traded on the JSE
Shares - Approx. 400 companies are listed on JSE
Warrants ± Warrants are similar to options. Their values dependent on
the volatility of the underlying share, time to expiry, interestrates and exercise price
± Expire from 3-36
months ± Mainly issued by Deutsche Bank, Investec, ABSA, StandardBank and SG Securities - The issuer is also the market maker
± Bid-offer spreads are 0,5%
± Warrant positions are hedged directly in the share or options
markets ± Conversion ratio indicates how many warrants are required toacquire 1 underlying share.
Other securities traded include preference shares and fixedincome securities (YIELDX)
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 16/66
16
The South African Futures Exchange (SAFEX)
Merged with JSE in 2001 SAFEX is a division of JSE
It trades derivatives (futures/options)
Futures include Financial & Commodity Contracts Financial Futures contracts include futures contracts
on ALSI40 index, other indices and on individual
highly traded shares.
Agricultural markets division of SAFEX offers futures
contracts on beef and maize.
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 17/66
17
Bond Exchange of South Africa
Lists debt securities issued by government,parastatals and large companies.
Fixed & floating rate securities & Zero couponbonds
Interest normally payable semi-annually CPI linked bonds
Highly liquid turnover about 13 times in a year
Trading volume about R8-10 trillion pa (over R35
billion per day)(JSE turnover R6-9 billion pd). Why is the market favourable for the issue &
listing of new corporate bonds?
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 18/66
18
Rights Issues Inviting existing shareholders to subscribe for new
shares
% ownership remains constant if all shareholders take
up their rights
Issue price at a discount to current listed price Example
± Co. has 9m shares in issue. The current price is R6 and the
company wishes to raise R5m. The Co. plans to issue 1m
shares at R5. What is the value of a right?
± Current price is R6 and rights issue at R5 per share. Is the
value of each right R1?
± What is value of the company after the rights issue? PTO
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 19/66
19
Rights issue
Value of each right is 5,90 5,00 = R0,90
What is the signalling effect of rights issue?
No. of shares Price R
Existing 9,000,000 x 6.00 = 54,000,000
New 1,000,000 x 5.00 = 5,000,000
10,000,000 59,000,000
Theoretical value of shares after the rights issue = 59,000,000
10,000,000
= 5.90
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 20/66
20
Valuation of Rights
Alternatively, the value of a right may be stated as follows;
Value of right = ¼½
»¬-
«
1
)(
N
S Mc N
Where,
N = number of shares required to acquire rightMc = market price per shareS = subscription price per share
= ¼½
»¬-
« 10
)00.500.6(9
Value of right = 0.90
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 21/66
21
Financial Institutions
Markets require borrowers and lenders Financial institutions act as
intermediaries and tend to offer a global
package of services. Distinction betweentypes of institutions is fading
Commercial banking provides a variety
of services e.g. overdraft facility (ST finance), LT mortgages, Etc.
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 22/66
22
Investment Banking
Corporate finance services relating tomergers , corporate restructuring andraising of finance
Lending of a short-or medium-term nature
Money-market actively trading in money & forex markets for clients and for ownaccount
Public issues and the private placing of shares
Large amounts of loan finance can be raised
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 23/66
23
Venture Capital and Private Equity
Venture capital and private equity assist with
launching and developing business Venture capital and private equity markets are less
efficient than the public markets
± Transaction costs are far higher
± There are a small number of buyers and sellers
± There are no reporting requirements info is notfreely available
± There are different investment objectives of venture capitalists and private equity investors
± The risk of failure is higher than in formalmarkets
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 24/66
24
Private Equity Major private equity firms include;
± Brait ± Ethos
± Venfin
± Investec
± Foreign private equity funds are entering the market Shoprite, Consol Glass, Alexander Forbes and even
Edcon were private equity targets. Companies will beunlisted if a private equity transaction goes ahead.
Private equity firms provide expertise, organisefinancing and often increase the debt levels of firms
Private Equity firms have a limited time horizon andwill exit by listing or selling the firm (ex. BTR Dunlopsold to a foreign firm) Venfin sold its stake in Vodacom
to Vodaphone.
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 25/66
25
Industrial Development Corporation
The IDC expects a meaningful contribution fromthe owner
The owner must share the risk by funding 33% of total assets
The IDC considers loan finance which is equal toowners interest in the business
Development is emphasized
Empowerment related financial buy-ins ortakeovers
Focus on fixed assets and greenfield projects Impact on job creation and exports
Ex. Sasol / Iscor
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 26/66
26
Business Partners
Business Partners was formed toguide and promote entrepreneurship
Focus on small business
It will invest between R150 000 and
R15m depending on the owners
contribution, risk and collateral Insist on Equity participation
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 27/66
27
Public enterprises
Public Investment Corporation
±Increased profile / active shareholder
±Assets under management > R600
billion ±Financing of BEE transactions
±Isibaya Fund
National Empowerment Fund (NEF)
Khula Enterprise Finance
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 28/66
28
Equity-Related Instruments
Ordinary share issue (Ks)or use retained earnings (Kr)ORDINARY SHARES K E = (D1/P0)+g (Issue cost P0= P0(1-F)
Or K E = Rf + ß(Rm - Rf)
Offer capital growth (P1- P0) and dividends (D1) income
Return (dividends plus capital growth) exceeds that oninterest-bearing instruments (Kd). Why? Higher risk
Most investors tend to be pension funds and insurance
companies
Share Issue Expenses include: Listing fee, Advertising,brochures/prospectuses, Professional fees (legal, audit,
stock broker and JSE fees), Bankers Fee, Underwriting
Commission (2-3%, Taxes and Duties
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 29/66
29
Retained Earnings K E = (D1/P0)+g (No issue cost)
Cost of retained earnings = the cost of new equity Retained earnings vs dividends (dividend cover/payout ratio)
Immediate source of finance with no flotation/issue cost
Shareholders will forego dividend if expected future growth
Preference shares Hybrid of equity and debt
Fixed dividend payment not compulsory
Nominal rate may be based on after-tax rate for LT debt (No tax)
Preference shares are useful when tax positions of parties differ. ± Participating (fixed dividend plus share in remaining profits) ± Redeemable or Indefinite ± Convertible to ordinary shares
± Banks may subscribe at rate equal to7
0-7
4% of the primerate.(STC credit).
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 30/66
30
Debt-Related Instruments
MT finance = 1 to 3 years Long-term finance 5 and 10 years
Classification of Debt :
± Fixed Interest, e.g. debentures
± Variable interest fluctuates with market forces- e.g.mortgage bonds
± Secured debt
± Debt covenants (Debt/Quick ratios, overall debt,
dividend payments/cover)
± Unsecured debt
± Covertible, redeemable, indefinite & participating
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 31/66
31
Structuring the repayment of loans
Instalments versus Bullet (Residual) payment.E.g. Loan of R8m at 11% repayable in
instalments or single pmt at end. Cash flows?
Principle: Consider risk & cash flows from
underlying asset.
Cash Flows 0 1 2 3 4 5
Loan with equal instalments -2,164,562 -2,164,562 -2,164,562 -2,164,562 -2,164,562
or
Loan with capital payable at end of term -880,000 -880,000 -880,000 -880,000 -8,880,000
R8 m /3, 6 96
1 1 % x R8 m = R8 8 0 0 0 0
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 32/66
32
Debentures Debenture trust deed specifies terms (payments, interest,
security) Trustees represent debenture holders
Restrictive covenants (PTO)
Mortgage bonds LT loan secured over fixed property
Terms vary
Restrictive covenants
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 33/66
33
Credit Ratings
Standard & Poor / Moody provide independentratings of the risk of bond issues
If a bond issue is rated AAA what is theprobability of default?
What is the spread on the Barloworld bond issue?Go to www.bondexchange.co.za. Check up BAW1under Data services MTM report. Ex. On 1 Feb2007, yield is 8.86% which is at a premium of 80
basis points (0.8
%) above the R15
3 (govt. bond)yield.
What will Barloworld do with its divisions?.
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 34/66
34
Commonly used to fund movable assets
Lessor retains legal ownership of the asset until paid
Lessee has use of the asset for part or full useful life
Lease payments include capital plus TVM (return)
ST Debt ST finance matches seasonal/cyclical Wcap cycle
ST finance = form of bridging finance
AP provide part of seasonal/cyclical finance needs
Short-term finance = higher risk than long-term finance Sources: Overdraft, BA (90 day Acceptances)
Bills and Notes
Foreign loans interest rates < RSA Cost of forward
cover could eliminate cost advantage
Leases
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 35/66
35
± Equity has a residual right to income & Ke>Kd
± Cost of debt is tax deductible ± Debt - contractual right to capital/interest when
due, profit or not & restrictive covenants
± STC payable on net dividends paid-personal, not RI
± Debt tends to have a finite life no affect on %SH
± Life of equity= life of the firm
± Equity holders control the entity
± Cap. structure = debt & equity (Risk profile Ke/d)
± Debt increases risk (fin. Distress) & return (leverage
when ROA >Kd)
± Signalling effects of a rights issue may be negative
Debt & Equity
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 36/66
36
BEE Financing structures Industry charters
Section 38 Now financial assistance tobuy shares
Source of financing for BEE entities
±Vendor financing (shares, prefs, loans orbonds)
±BEE entity issues pref shares to banks at70-74% of prime & use entity assets assecurity or Initial public Offering(IPO)
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 37/66
37
BEE Financing structures
BEE Holdings Ltd
100%R30m
Originalshareholders
SPV LtdR510m
Prefs
49% 51%
Metro Ltd
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 38/66
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 39/66
39
Levels of Equity Control
±75% of share capital allows passing of specialresolutions
±50% + share - enables the passing of ordinary
resolutions ±20% or 30% of share capital = effectivecontrol listed coy
± 35% = effective control in terms of the
Takeover Code ± Control of the board
±Default Arrears Pref dividends have voting
rights
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 40/66
Capital structureCapital structure
Chapter 14Chapter 14
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 41/66
41
Learning outcomes Leverage increases return (if ROA>Kd) - potential loss to
SHs Debt increases financial risk.
No optimal capital structure under certain assumptions.
Inclusion of tax, distress and other costs alters optimal
capital structure.
Theory of capital structure - practical situations.
Pecking order approach.
Effect of inflation on the cost of debt. Optimal capital structure and need for flexibility.
Tax shield makes debt more attractive within risk
attitudes
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 42/66
42
Financing Decision
Separate Investment and financing
decisions
Balance Sheet: Assets = Equity + Liabilities
(mainly debt)
Financing of assets (D/E ratio) is a strategic
decision (+types of debt & equity
capital structure. Big Q uestion? Does capital structure
affect entity value?
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 43/66
43
Business Risk Determined by operating activities, industry
and product range, e.g. retail store vs softwaredeveloper
Risk = level of fixed to variable costs i.e.operating leverage = Total contribution/EBIT
Balancing Business and Financial risk ± Match long-term assets with long-term finance
Financial risk
DE ratio i.e. Interest rate and capital risk Equity financing dividends and capital growth
Debt = LT&ST Contractual interest & capital dues
± Secured or unsecured
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 44/66
44
Operating Leverage Example: FC R100 000 ; V C R4 pu; SP R10 pu; Volume 30 000 Upa
Contribution: 30 000 x (R10-R4) = R180 000 EBIT is R80 000 (R180 000 - R100 000)
Level of Operating Leverage = R180 000/80 000 = 2,25
Every 1% increase (fall) in sales/contribution = a 2,25% increase(fall) in EBIT.
Current Forecast Increase
Sales , , 10.0%
Variable costs - , - , 10.0%
Contribution , , 10.0%
Less: fixed costs - , - ,
EBIT , , 22.5%
Operating leverage % / % 2.25
Operating leverage , / , .
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 45/66
45
Financial Leverage Debt levers net earnings up or down if ROA>Kd
Example: Co. A is 100% equity financed & Co. B has D:Eof 40:60 Kd =12,5%.
As the firm is borrowing at 8.875% (12.5% x 0.71) aftertax and earning a ROA of 28%, this results in an increasein the ROE to 41.4%.
Note: ROA = EBIT(1Note: ROA = EBIT(1--t)/Total Assetst)/Total Assets
(Rm) Co. A Co. B
Equity 1,000 600
Debt - 400
Total Assets 1,000 1,000
EBIT 400.0 400.0
Interest - -50.0
400.0 350.0
Tax -116.0 -101.5
Net income 284.0 248.5
Return on Assets 28.4% 28.4%
Return on Equity 28.4% 41.4%Interest rate 12.5%
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 46/66
46
Degree of Financial Leverage?
DFL on net income: = EBIT/(EBIT - I)
E.g.: U se example below plus interest cost of R16 000
± DFL = R80 000/R64 000 = 1,25
When EBIT changes 1% NIBT changes by 1,25%
D
FL = R8
0 000/R6
4 000 = 1,25
22,5
x1,25
= 28
,125
R Current Forecast Change
Sales 300,000 330,000 10.0%
Variable costs -120,000 -132,000 10.0%
Contribution 180,000 198,000 10.0%
Less: fixed costs -100,000 -100,000
EBIT 80,000 98,000 22.5%
Interest -16,000 -16,000
Net Income 64,000 82,000 28.1%
Tax at 29% -18,560 -23,780
Net Income after tax 45,440 58,220 28.1%
X
2,25
X1,,25
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 47/66
47
Degree of Combined leverage (DCL)
D
CL = combined effect of D
OL &D
FL ±DCL = Contribution/(EBIT - I) or (DOL x DFL)
Example: DCL = R180 000/R64 000 = 2,8125
Or DCL = DOL(2,25) X DFL(1,25) = 2,8125
+10% in sales = +28,1% NIBT and NIATR000 Current Forecast Change
Sales 300,000 330,000 10.0%
Variable costs -120,000 -132,000 10.0%
Contribution 180,000 198,000 10.0%
Less: fixed costs -100,000 -100,000
EBIT 80,000 98,000 22.5%
Interest -16,000 -16,000
Net Income 64,000 82,000 28.1%
Tax at 29% -18,560 -23,780
Net Income after tax 45,440 58,220 28.1%
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 48/66
Negative effect of financial leverage?
Effect of high leverage when economy down
Co. A & B have operating income of R20m. Co. B
has fixed interest of R44m charge. ROA & ROE?
EBIT x 0,71 = R14,2/1000 Assets = 1,42%
(' m) Co. A Co. B
EBIT 20.0 20.0
Interest - -44.0 20.0 -24.0
Tax -5.8 -
Net income 14.2 -24.0
Return on Assets 1.42% 1.42%
Return on Equity 1.42% -4.00%
ROA = EBIT(1ROA = EBIT(1--t)/Total Assets Debt B = 400t)/Total Assets Debt B = 400
ROE = NIAT/EquityROE = NIAT/Equity EqEq uu ityity A=1000 & B=600A=1000 & B=600
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 49/66
49
Financial leverage & risk
Avoid debt in uncertainty and variableoperating returns
Low risk operating cash flows should
encourage higher levels of financialleverage.
Match asset terms with finance terms. ST
financing may not be renewed andcompounds financial risk
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 50/66
50
C a p i t a l s t r u c t u r e
Equity
± Share capital
± Reserves
± Outside shareholders interest
± Deferred taxation
Debt
± Long term liabilities
± Interest bearing debt ± Permanent portion of other current liabilities?
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 51/66
Capital structure: Traditional (Trade off)
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 52/66
52
Capital structure: Traditional (Trade-off)
approach
Ke and Kd stay unchanged asD
ebt soW
ACC until Ke and Kd increase from financial risk.
Debt ratio with lowest WACC = Optimal capital structure
Effect of NOI approach (M&M) on WACC & Ke?
WACC remains constant and Ke rises as D/E ratio
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 53/66
53
M&M and Arbitrage Co. A and Co. B incomes and values.
V e = 0,9m/0,2 = R4,5m and 0,6/0,2 = R3m
V d = 0,3m/0,15 = R2m
Investor with 10% of B can sell for R0,3m (Ve), borrowR0,15m and buy 10% in A for R0,45m
Re in A is R67500(R90000 22500 Interest)vs R60 000 in
B with less or equal risk (borrow Ro,2m).
M & M - N OT s u st ai na bl e! ?
C o . A C o . B
N e t e r t i I c e 9 , 9 , I t e r e s t - - 3 ,
A il le t s h r e h l e rs 9 , ,
V l e f E q ity , , 3 , ,
V l e f D e b t , ,
V l e f c y , , , ,
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 54/66
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 55/66
55
M&M with taxes With taxes, the WACC falls as D:E increases
Where is the flaw in this? Ke > Kd(1-t)D
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 56/66
56
M&M with taxes ±Too much debt increases the cost of financial
distress. ±Too much debt could reduce EBIT.
±Too much debt will incur agency costs.
±Too much debt will lead to an increase in Kd
VL = VU + PV I - PVF - PVEBIT - PVA - PVD
P V I = P V of expected interest tax shield
P V F = P V of expected financial distress P V EBIT = Reduction in value from lower EBIT
P V A = Reduction in value from agency costs
P VD = Reduction in value from increased cost of debt
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 57/66
57
Effect of financial leverage on Vo Initially, interest tax shield increases returns/value up to point X.
Value starts falling as financial distress and other costs increase
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 58/66
58
Capital stru ct u re: Contemporary approach.Consistent with M&M, with taxes, and financial
distress and related costs
Ke as DFL (initially little change).
D/E ratio influences lenders willingness to lend
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 59/66
59
Pecking Order Theory No target capital structure
Financing follow a preferred hierarchy:
1. RI is 1st preference of financing
2. 2nd debt/loan finance
3. Convertible debt/preference shares4. Lastly, the issue of new equity
Why? Limit sharing of control and residual income!
RI has no control or covenant compliance issues
Debt will result in loan covenants and reporting to lenders
New equity may impact on control and greater market scrutiny
Info asymmetry reflects presently mispriced securities
Issue equity when ordinary share prices are high
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 60/66
60
Financial leverage and systematic risk(ß)
ß=systematic risk, affected by financial leverage.
ßL = ßU [1+(D/E)(1-t)] & ßU = ßL/[1+(D/E)(1-t)]
Effect of inflation
Real return(r)=9% & inflation(f)=10%. Nom.rate(Rn)? Rn = (1+r)(1+f)1 = [(1+,09)(1+,1)]1=0,199 19,9%
Nominal rate(Rn)=19,9% & inflation(f) =10%. r?
r =[(1+Rn)/(1+f)]1 and [(1+,199)/(1+,1)]-1=9%
Real rate(r)=9% & nominal rate(Rn) is=19,9%. f?
f =[(1+Rn)/(1+r)]1 and [(1+,199)/(1+,9)]-1=10%
Tax deduction on nominal cost of debt
High inflation = appreciating assets & Interest
WACC Some Principles
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 61/66
WACC Some Principles W eighted average costs of all finance sources
Uses market rates of debt and equity at target D:E or MV
Includes corporate tax effects (Kd after tax)
Ke and Kd include inflation, so should expected cash flows
Real Return (r) (14%) = Risk-free (8%) + Risk (6%)
Nominal rate (Rn)(21%) =Rf (8%)+Risk (6%)+Inflation (7%)
Nominal rate (Rn) = (1 + r)(1 + f) 1
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 62/66
62
From the real world..
Grindrod
Target debt-equity ratio of 100% (50:50.)
Could company keep to this target?
Why not go to www.grindrod.co.za and check for the latest
debt-equity ratio?
158%
106%
29%
107%
61%
53%
33%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
1999 2000 2001 2002 2003 2004 2005
Debt
%
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 63/66
63
Capital Structure : Signalling theory
Management use financing decisions to influence(signal) market perceptions and value of entity
± issue equity if shares perceived to be overvalued
or market considers debt too high
± Increase debt if market perception is underlevered
i l i i &
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 64/66
64
Capital restructuring in USA & Ve M&M assumes real investment & operating
Cflows unaffected by D
/E ratio i.e. Sameoperating decisions if debt is 80% debt or 0%
In reality dramatic in D/E and div. payoutratios directly affects MVe
LBOs active in late 1980s (huge debt burden) &restructured US economy. (disposal of non-coreassets)
Agency cost of free cash flow? If operating cash
and no +NPV projects need to return cash toSH or invest in low return projects or diversif y and destroy value.
Result: MVe by trillion US dollars. Will same
happen in RSA from BEE?
Effect of debt?
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 65/66
65
Effect of debt? Compulsory Interest & debt servicing costs versus
optional dividends
Bankruptcy Interest cost effects IS Ke does not. SA entities have too
little debt
Trend to reduce capital and DOL if DFL .
Problems of overcapacity lead to consolidation. Debt encourages sale of unrelated business entities
(unbundling)
Concentration of equity in the hands of insiders
Debt effects sales and implicit product warranties Growing entities need constant in capital debt is
not appropriate
Optimal capital structure is achieved with lower ratings
(M
V).
Why is debt low in SA entities?
8/8/2019 Lecture 20 Chp13&14 Sources Fin & Cap Struct
http://slidepdf.com/reader/full/lecture-20-chp1314-sources-fin-cap-struct 66/66
Why is debt low in SA entities?
PPC has D/E ratio below 5% based on MV with cash balances nodebt
Same is true for Shoprite, Pick n Pay, Alexander Forbes etc.
SA Companies are buying-back shares for more realistic capital
structures - Not enough. The future = private equity firms buying out companies, incurring a
lot of debt, paying large dividends or buy-back shareVe
E.g. Manchester United. Glaser mostly used Manchester Utdsborrowing capacity to buy Manchester Utd. Why? The club wasungeared.