Tumelo Matjekane Finance 2009 Revised

7/26/2019 Tumelo Matjekane Finance 2009 Revised

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2009

FINANCETumelo L Matjekane


2/12Tumelo L Matjekane | 2009 Page 2of 12

Scope and tools

of finance

Financial

markets and

participants Simplefinancial

market

More realistic

financial market

Interest rates, interest rate

futures and yields

The bridge

Market interest rates

Market prices

Shifting

resources

Accruing

X

(1 + i)

Discounting

(1+ i)PV

Multiple period

finance

NVP = -CF0+CFt

(1 + i)t

PV =CFt

(1 + i)t

Multiple period

analysis

Annuitiestables

Perpetuities

Cash flows all the

same

PV = CF/(1+i)

Annuity table

PV = CF/I

Continue forever

PV = CF (i-g)

Compound

interest

PV = [1 + (i/m)]mt

Continuous

compoundng

PV = CF0(eit)

Where e = 2.718

Interest rate risk

and duration

Calculation of duration

immunsation

(1) [(80/1.05) / 1029] +

(2) [(80/1.07) / 1029]...

Interest rate

futures

Expectations

Extrapolation

Hedging

Bonds

Face value coupon

rate

Term structure

YTM = r1+ (N1/

(N1+N2))(r2-r1)

Coupon effect on the

YTM

Forward

interest rates

(1 + i2)2= (1 + 0f1)(1 + 1f2)

Bond duration

A measure of the riskiness

Measures the interest rate

sensitivity of the bond

Indicates the change in value

of a bond for a 1% change in

interest rates

The greater the duration, the

further into the future the

average value is generated

A zero coupon is riskiest

bond

The lower the coupon

payment with the same

maturity and price, the riskier

YTM and the

coupon effect

The average return on the

bond if purchased at the

price in the market doesnt

determine the bond price,

the spot rate does that

The timing of the cashflows

affect the YTM of the bond

A difference in yieldsbetween bonds subjected to

the same discount rates

Convertible

bonds

Lower coupon than a straight

bond

Convertible into shares

Cost effective way of raising

finance when shares are at a

low current valuation

Cons: dilution

Advantage: solves agency

problems between

shareholders and

bondholders

Covenants: positive (financial

ratios) or negative

(restrictions on dividend)

Net present

value

= -CF0+

IRR = NPV = 0

CFt

(1 + IRR)

Internal rate of

return



Fundamentals of

company investment

decisions

Investment

decisions in all

equity corporations

Share values and

PE rates

Investment decisions in

borrowing corporations

Investment

decisions and

shareholder wealth

Residential claim

Limited liability

Corporate

equity

Market value of

common shares

Investment and

shareholder wealth

E0=Div1+ E2

(1 + re)2

Div1

1 + re+

Price per share =

Dividend per share

(re g)

=1

(re g)x Pay-out ratio

Price per share

Earnings per share

g = re (dividend per

share / price per share)

E0=Div1+ E1

1 + re Compare similar sector that uses the same

accounting conventions

A measure of how a company is doing

relative to its rivals/peers

Same ratio but different stages of

development?

Dependant on accurate share price

PE ratio

Share price



Earnings, Profit and

Cash Flow

Corporate cash flow Cash flow andprofits

Customers

Components

of cash flow

Interest amount x Tax rate

Operations Assets

Government

Income

Revenue

Expenses

operations

depreciation(salvage value?)

interest

Total expenses

Profit before tax

Tax

Profit after tax

Free Cash Flow

(Free Cash Flow) -(Interest tax shields)

FCF*

Free cash

flows

Differences

between accounting

figures andcashflow

Book values vs

market value

The treatment of non-cash items

such as depreciation

Cashflows that arise as a result of

projects undertaken

CAPEX recognised immediately in

cashflow

Treatment of sales/cash receipts

Opportunity cost

The inclusion of interest rates

Market values used for

WACC

Reflect the earning

ability

Book values are

historic

They are used by debt

suppliers

Estimating Cash

Flows for

Investment

Projects

Cannibalisation has to be taken into

account

Depreciation is not a cash flow, but a

tax shieldgreater time value

benefit Interest charges ignored because

built into the WACC

Opportunity costs have to be included

Associated costs

Cannibalisation

Competition from

competitor offerings

Treatment of cannibalisation,

depreciation and interest

charges



Company investment

decisions using WACC

FCF and Profits forborrowing

corporations

The adjusted PV

technique

Estimate the interest tax

shields (ITS) of the project

All equity rate found from

capital market experts (ru)

APV = (all equity value) + (ITS value)present cost

Investment value

for borrowing

corporations

Investment NPV

and the WACC

The debt cost is the

after tax debt cost

Overall company rate

An average

The overall NPV

method

Find the overall

company rate

APV0= +

n

t=0

[FCF*t

(1 + ru)tITSt

(1 + rd)t]

Therefore:

=

+

xDebt market value

Total market value

Debt required

rate

Equity market value

Total market valuex

Equity required

rate

E

V(rd)=

D

Vx (re)

Value of project =n

t=0

Free cash flow

(1 + overall required rate)t

=n

t=0

FCFt

(1 + rv)t

rd* = (debt required rate x 1corporate tax rate)

= rd x (1Tc)

WACC (rvx*) = (rd*)D

V+ (re)

E

V

The WACCNPV method

=n

t=0

FCF*t

(1 + rvx*)

t

NVP0 =n

t=0

Unleveraged free cash flow t

(1 + WACC)t



Applications of company

investment analysis

The payback

period

Average

accounting returnon investment

Costbenefit

ratio

Profitability index

What about cashflows after payback

period?

If discountingtime value of money

and riskiness of project

Payback concentrates on liquidity

NPVs?

Incremental cash

flow analysis

Capital rationing

Leasing

Internal rate

of return

Inflation

Investment inter-relatedness

The rates between the PV of the

cash inflows and the cash outflows

of an investment

Trial and error method

Doesnt reflect scale of

the project

More than one change of

signdifferent answers

No changing interest rate

over time

Assumes reinvestment of

cash flows at the IRR

which isn't always true

Advantage: can producecrossover rates

As long as the IRR >

Hurdle rate (discount

used for NPV), the NPV

will be positive

Investment accepted

when IRR > Hurdle rate

Purely contingent

Somewhat positive

Independent

Somewhat negative

Mutually exclusive

Choosing among

investments on the

basis of their IRR

The cross-over rate:

the IRR of the

incremental cash flow

Economies of leasing

NPV of leasing vs

borrowing/purchase

cash flow

Can only be used if the t0

cash flow is an outlay

Used in capital rationing

situations

Unsuitable for ranking

investments

Soft/internal rationing: dept.

budgets and decisions

hard/external rationing:

financial markets not willing

to fund

Use the PI

Use NPV

Based on outlay due to

cash constraints

The inflation rate free return

1+nominal return = (1+real

return)(1+inflation rate)

Payback = -1

rv*(1+rv*)n

1

rv*

PI =-FCF0*

FCF*t

(1 + rv*)t

n

t=1

Acceptable only if

ratio > 1

CBR =n

t=0

outflowst

(1 + rv*)t

n

t=0

inflowst

(1 + rv*)t

A contract for payment is a debt obligation analogous

to a loan

Advantage: allows for higher tax benefits than

alternative forms of borrowing and purchasing an

asset Costa of information asymmetry can be lowered, asset

obsolescence can be factored in

Economies of scale in leasingspecialisation creates

expertise and efficiency

EVA analysis

Capital charge against

the net cash flows left

over = the economic

value added

Example on pg 39.

(Expected accounting

profit) / (net book value of

investments assets)

Uses accounting numbers,

not same as cashflow

No discounting, therefore

no reflection of time value

of money

No riskiness too



Risk and company

investment decisions

Risk and

individuals Using the CAPM in

evaluating companyinvestment

decisions The SML

The higher the risk, the

higher the return

The value of diversification

The Correlation coefficient

(ranges from -1 to +1)

Covariance = SD x SD +

Correlation coefficient

Joint probabilities distribution

Systematic riskj

The market model

and individual asset

risk

Undiversifiable or

systematic risk

The market factor:

overall economic

activity

Systemic risk = SD of

return x correlation of

j with market

Estimate the WACC of the

company investments

Revenue Risk

Estimate the rv* for the

investments vs for the company

u x [(project revenue

volatility) / (company

revenue volatility)]

Operational gearing

u = revenue adjusted u x [(1+project

fixed cost %) / (1+company fixed cost %)]

Various adjustments

can be made to the bet

to reflect the financing

structure of a project

Other considerations

The certainty equivalents

CFce= CF-[(E(rm)rf)/

(variance rm)][covariance

CF,rm]

Risk resolution across time

No constant risk across time

Estimating the

risk of a project

If the project is simply an extension of

scale, the normal is used

If the new project is in a different area, a

listed company could be used as proxy

for the risk

The beta of the company must be

ungeared

For an unlisted company, use from

similar listed and adjust accordingly

Steps:

1. find Bu =Be(E/V) + Bd(D/V)

2. adjust for revenue volatility

3. adjust for operational gearing

4. readjust the reconstructed and ungeared

for any financial gearing planned for

project

5. find rd and re6. find rd* using rd(1-Tc), then find rv*The Beta

The ratio of the assets SD of

return x correlation with

market, divided by SD of

market returns

j = (systematic riskj) / m

= (jm)/(2m) known as

the regression coefficient

The market model

E(rj) = rf + [E(rm) rf]jUsed to estimate the rd and

the rv*

E(rj)Expected return

RfRisk free return

[E(rm)rf]Compensation

for risk bearing

jRisk beta coefficient

You get higher returns for

taking on greater risk

Specific/systematic risk and

diversifilable risk

is the measure of a

shares market risk

The rjis the return on the

share

The rmis the return on the

market



Taxation

Transaction costs

Brokerage fees

Floatation costs

Dividends and signalling

Other considerations

in dividend policy

Dividends and

share repurchase

Repurchase = cash dividend

or even a liquidation exercise

a positive signal

Targeted share repurchase?

a negative signal

Frictions Company

dividend policy

Passive residual

dividend policy

or optimal

dividend policy

Company dividend policy

Dividend

irrelevancy I

Dividend clienteles:

irrelevancy II

High tax bracket,

therefore prefer

low payouts

Different preferences to

dividend payouts

Attracted to shares of a

company that pursues a

policy relevant to them

Fat catsWidows and

orphans

The company has to

decide which type of

shareholders it wants

to attract through its

dividend policy

Low tax bracket

Prefer to

consume now

High payout

Clienteles

Company

dividend payout

strategy

Imputation tax

credits to avoid

double taxation

Passive residual

dividend policy

Find all investments with positive NPVs and retain as

much cash as is necessary to undertake these

investments, if there is cash left over only then might

a dividend be paid

Only raise new equity capital when internally

generated funds are insufficient to provide the cashnecessary to undertake all good investments

Dividends are the amounts of cash that a company distributes to its

shareholders as the servicing of that type of capital

Communication with the

markets and shareholders

through dividend cuts and

increased pay-outs

Share dividends and share

splits are used as signals



The debt claim

require lower rate

Equity require

highest

Capital structure

relevance with taxes

Capital structure

decisions and taxes

Capital structure

irrelevancy II: Taxes

ITStax advantage

A company with debt in its

structure will be more

valuable than one thatdoesnt borrow

Interest deductability makes

the companys cost of capital

lower, the more debt it uses

VITS = ITS/rd

V = VU (Unleveraged) + VITS

The SML Capital structure

and risk

EBIT

The more borrowing the

company does, the EBIT-

EPS line gets steeper

Taking on more debt causes

equity risk to increase

increase equity required rate

Company capital structure

Capital structure, risk

and capital cost

Capital structure and

agency problems

Debentures

Convertible debt securities

that carry the tax benefits of

borrowing

Capital structure

irrelevance I: M&M

Making thecompany borrowing

decisions

M&M: if shareholder wealth is

the same regardless of

capital structure, then capital

structure is irrelevant

D+E = V

In a frictionless capital

market, how much or how

little debt a company has in

its capital structure is

irrelevant

As more borrowing is undertaken by

companies in economies with

progressive tax regimes, the interest

rates necessary to sell bonds to highpersonal tax investors will cause the

benefits of company borrowing to

disappear

The lender is interested in

the debt claim to the total

company value

Market value of assets

difficult to get, book values

easier

Simulation models used for

planning

Examine companies of

similar lines of business

Shareholders vs Bondholders

Defaults?

Monitoring costs

Solution:

Call provisions

Convertibility

Maintenance of certain ratios

included in contracts

Bankruptcy costs:

A change in ownership from

shareholders to bondholders Litigation costs

Time

Other implicit costs e.g.

opportunity costs

Factors in the

borrowing decision

Ability to generate enough

cash flow

Ability to utilise tax shield

CollateralAbility to access financial

markets

Costs of financial distress

Why not 100% debt?

Taxation on shareholders

and bondholders

Other forms of tax shields

e.g. depreciation and lease

Imputation system fordividends

The risk of financial distress

and its costs

Financial risk

Results of debt in the

company

Tax benefitsITS vs

depreciation

Ability to service debt

in all scenarios?

Volatile returns/highly

competitive sector?

capital structure

Cash flow generationfrom operations?

Business risk

Business cycle

Level of fixed costs

Volatility of sector

Strength of brand

Competition

Input costs

Pricing power

diversification



Optimisation and

short-term investments

Management ofshort-term assets

and financing

Management of

cash balances

Credit sales

Collection period

Debts (bad)default

Expected profit = (no. of good

customers x profit/customer)

+ (no. of bad customers x

loss/customer)

Short term assets are

less risky

Long term assets are

more specific to the

line of business and

therefore more risky

Working capital

management

Risk, return

and term

Current ratio Quick ratio

Optimising of cash

replenishment amounts

Risk and rates of

return on

financing by term

Combining risk and

rates of return on

assets and financing

Short term finance more risky

Short term finance less costly

than long term

Long term financing are low

risk and return

Assets:

Short term: low risk, low return

Long term: high risk, high return

Financing:

Short term: high risk, high return

Long term: low risk, low return

Therefore finance short term assets

with short term liabilitiesmaturity

matching

Liquidity ratios

Management of short-

term financing

Management of

receivables

Financial and ratio

analysis

Profitability ratios

Capital structure

ratios

Efficiency ratios

Profit margin

ROTA ROE

Return on

specific

assets

Fixed to

current ratio

Debt

ratio

Times

interest

earned

Inventory

turnover

Average

collection

period

Fixed asset

turnover

Transaction uses

Precautionary and

anticipatory reserves

Compensating balances

r = [(2 x D x T)/i]

economic order quantity

R = [(3 x T x S2)/4i]1/3+ M

U = M + 3(R - M)

Trade credit

2/10 net 30?

Effective interest rate when

a discount is given = (i) =

[1 + [0.02/(1-0.02)]]

365/20

- 1

Current assets

Current liabilities

CA - inventory

CL

Profit before tax

Revenues

Profit before tax

Total assets

Profit attributable

to shareholders

Owners quity

Profit before tax

Specific asset

Profit before financial

results

Interest charges

Total debt

Total assets

Fixed assets

Current assets

Cost of sales

Inventory Trade receivables

Revenues per day

Sales

Fixed assets



Spot and forward

exchange rates

Forward exchange,

interest rates and inflation

Exchange rates

and interest rates

Interest rate parity

Relative interest

rate = relative FX

discount/premium

International financial

management

The foreignexchange market

International financialmanagement

Spot rate Forward rate

Transaction costs of

hedging Foreign exchange option

International capital markets

Long term funds = Eurobonds

Short term borrowings =

Eurocurrency

Lower borrowing rate in

Euromarkets vs National

capital markets

(1+NR)n= (1+RR)

n+ (1+inflation rate)

n

Hedging international

cash flows

Financial solutions to

other international

investments risks

moral hazards : non-compliance, confiscation,

restriction on repatriation.

Solution: automatic and

irreversible counter-

incentives, participation of

the World Bank in loans.

The law of one price:

the same thing cantsell for different prices

at the same time.

Purchasing power parity

(PPP).

Present Future

Forward exchange

contract

Hedging transactionsInvesting in foreign

real assets

Financial sources for

foreign investments

Avoid forward foreignexchange estimation


12/12

Options valuation

Call option

Put option

Allows holder to sell

something (e.g.

shares) at a fixed

price for a fixed

period of time

Options, agency, derivatives

and financial engineering

Options Derivatives

Binomial Black-Scholes-

Merton

Return/outcome derived

from some other assetsvalue or return outcome

Hedging of risk

They therefore serve to

reduce not increase risk

One party exchanges

one stream of cash

flow for another

Derivatives designed to

hedge interest rate and

foreign exchange risk

Agency costs

Shareholders vs

Bondholders vs Managers.

Solution: an efficient market

for takeovers, call

provisions.

Designing hybrid/exoticfinancial securities to fit very

specific risk shaping intentions

of a firm or other institutions.

Building blocks: credit

extension, price fixing, price

insurance.

Allows holder to

purchase another

security (e.g.

shares) at a fixed

price for a fixed

period of time

Agency

Financial

engineering

Swaps Exotics

A combination of

derivatives

financially

engineered to

meet the very

specific risk

objectives of a

single firm

Y = (Cu-Cd)/(So(u-d)) Z = (uCd-dCu)/((u-d)(1+rf)

Where u = eT

And d = 1/u

Market value = YSo + Z = Co

Then determine the premium

or discount

Co =SoN(d1)Xe-rfT

N(d2)

Where d1= [ln(So/X) +

rfT]/[(T)+ 0.5(T)]And d2= d1- (T

)

Real option

Option to alter,

abandon or extend

Option based on

timing

Documents

Tumelo Matjekane Finance 2009 Revised