Managerial Finance Seventh Edition Managerial Finance Seventh Edition FO Skae (Volume editor) M Com; MBA FAA Vigario B Com; CA (SA) FJC Benade B Sc; B Com (Hons); CA (SA) A Combrink B Com(Hons); CA (SA) A de Graaf M Com (Accounting); CA (SA) L Esterhuyse Com (Fin Man); CA (SA) WD Jonker B Compt (Hons); MBA S Klopper B Com (Acc) (Hons); CA (SA) S Ndlovu B Acc (Hons); MBL; ACMA; FCCA AE Nobyati B Com (Acc) Hons; CA (SA); RA; MBA GJ Plant BCom (Acc) (Hons); CA (SA); ACMA BL Steyn B Sc (Maths); B Compt (Hons); M Com (Accounting); D Com; CA (SA) M Steyn M Compt; CA (SA) Members of the LexisNexis Group worldwide South Africa DURBAN JOHANNESBURG CAPE TOWN LexisNexis (Pty) Ltd 215 Peter Mokaba Road (North Ridge Road), Morningside, Durban, 4001 Building No 9, Harrowdene Office Park, 124 Western Service Road, Woodmead, 2191 Office Floor 2, North Lobby, Boulevard Place, Heron Close, Century City, 7441 www.lexisnexis.co.za Australia LexisNexis, CHATSWOOD, New South Wales Austria LexisNexis Verlag ARD Orac, VIENNA Benelux LexisNexis Benelux, AMSTERDAM Canada LexisNexis Canada, MARKHAM, Ontario China LexisNexis, BEIJING France LexisNexis, PARIS Germany LexisNexis Germany, MÜNSTER Hong Kong LexisNexis, HONG KONG India LexisNexis, NEW DELHI Italy Giuffrè Editore, MILAN Japan LexisNexis, TOKYO Korea LexisNexis, SEOUL Malaysia LexisNexis, KUALA LUMPUR New Zealand LexisNexis, WELLINGTON Poland LexisNexis Poland, WARSAW Singapore LexisNexis, SINGAPORE United Kingdom LexisNexis, LONDON USA LexisNexis, DAYTON, Ohio © 2014 ISBN 978 409 12002 E-book ISBN 978 409 12000 First Edition 1999 Reprinted 2000 Second Edition 2001 Reprinted 2002, 2003, 2004 Third Edition 2005 eprinted 2005, 2006 Fourth Edition 2008 Fifth Edition 2011 Sixth Edition 2012 Reprinted 2013 Every effort has been made to obtain copyright permission for material used in this book Please contact the publisher with any queries in this regard Copyright subsists in this work No part of this work may be reproduced in any form or by any means without the publisher’s written permission Any unauthoris d r production of this work will constitute a copyright infringement and render the doer liable under both civil and criminal law Whilst every effort has been made to ensure that the information published in this work is accurate, the editors, publishers and printers take no responsibility for any loss or damage suffered by any person as a result of the reliance upon the information contained therein Editor: Lisa Sandford Technical Editor: Liz Bisschoff Printed in South Africa by Interpak Books Pietermaritzburg Preface We find ourselves in a financial world that is in turmoil today The c mplexity of the modern business environment is imposing an ever-growing demand on management, which requires a scientific approach to business decisions Consequently, managerial financing principles are used to an increasing extent to assist in the process of decision-making The managerial finance field continues to experience exciting change and growth, while the future promises to be an even more exciting ti e for finance professionals There is a vast amount of knowledge required in the field of financial anagement This textbook is aimed at students undertaking an introductory or intermediate course in corporate finance looking for a single book that will assist them from second year until their Qualifying Exam (QE) The primary objective of the book is to provide one “digestible”, affordable, South African textbook which can be used for more than one year by students with limited time at their disposal The subject of Managerial Finance is fundamental to understanding and running a company The subjects dealt with in this textbook include strategy, the time value of money; risk; cost of capital; portfolio management and the Capital Asset Pricing Model; the investment and financing decision; financial analysis; valuations; takeovers, mergers, acquisitions and restructuring; working capital management; foreign exchange markets and currency risk; money and capital markets; and interest rates and interest rate risk These topics form an integrated whole Time value of money concepts, the analysis of financial statements and failure prediction are essential pre-requisites for the valuation of business enterprises, while liquidations and restructuring are the result of prolonged financial distress These topics should be considered within the context of the risk involved, working capital requirements and global and international developments in money and capital markets The needs of South African universities have been taken into account in the compilation of this book The textbook has been updated to include sections on all the topics set out in SAICA’s syllabus and Competency Framework We wish to thank the various academics who have prescribed Managerial Finance for their valuable input and sugg stions The book could however also serve as a valuable reference aid to practicing finance professionals The assistance of Robe t Skae and Lynette van den Heever in researching and compiling certain information is acknowledged The Authors Pretoria 2014 v Contents Page Chapter The meaning of financial manage ent 1.1 1.2 Financial management Goal of an entity 1.2.1 Shareholder wealth maximisation 1.2.2 Stakeholder theory 2 1.3 1.4 Business model or value creation model of an entity Stakeholders of an entity 1.4.1 Key stakeholder groups 1.4.2 Governance principles of stakeholder relations 1.4.3 Stakeholder engagement 1.4.4 Reporting to stakeholders Risk and return of investors 1.5.1 Business risk 1.5.2 Financial risk Overview of financial management 1.6.1 The investment decision 1.6.2 The finance decision 1.6.3 The management decision Capital markets 1.7.1 Raising quity finance on the Johannesburg Securities Exchange 1.7.2 Sustainability and responsible investment in the capital markets 6 9 10 11 12 14 17 17 17 18 Valuation of a ompany 20 Practice Questions 23 1.5 1.6 1.7 1.8 Chapter 2.1 2.2 Strategy and risk Strategy and the business environment The external environment 2.2.1 The political environment 2.2.2 The economic environment 2.2.3 The social environment 2.2.4 The technological environment 2.2.5 The regulatory environment 2.2.6 The market for the product or service 2.2.7 The competitive environment 2.2.8 Understanding the market and customer needs 2.2.9 The natural environment 28 29 29 30 30 30 30 31 31 32 32 vii Contents Managerial Finance 2.3 Internal environment 2.3.1 Value chain analysis 2.3.2 Product life cycle analysis 2.3.3 BCG Matrix 2.3.4 Resource audit Page 32 33 34 34 35 2.4 2.5 SWOT and gap analysis Selecting appropriate strategies 2.5.1 Product-market strategies 2.5.2 Competitive strategies 2.5.3 Growth strategies Implementing the strategies 2.6.1 Aligning organisational performance with strategy 2.6.2 Measurement of performance and reporting against strategic objectives Risk and the business environment 2.7.1 Risk management 2.7.2 Risk appetite 2.7.3 Risk management strategy 35 36 37 37 38 38 38 39 41 41 41 42 2.8 Governance principles relating to risk management 42 2.9 Risk identification 44 2.10 2.11 Risk assessment and evaluation Risk responses 2.11.1 Risk avoidance 2.11.2 Risk acceptance 2.11.3 Risk mitigation 45 45 45 45 45 2.12 Monitoring and reporting on risks 46 2.13 Enterprise risk management (ER ) 46 Practice questions 47 2.6 2.7 Chapter 3.1 3.2 Time value of money Future value 3.2.1 Compound interest formula 3.2.2 Solving for interest rate (i) and number of periods (n) 3.2.3 Introducing periods of time compared to years 3.2.4 Future value of an annuity Present value 3.3.1 Pr s nt value of a perpetuity 3.3.2 Periodic payment of a loan 3.3.3 Present value of a perpetuity 61 62 63 64 65 66 68 73 75 76 3.4 Present value of shares 77 3.5 Present value of debt 81 Practice q estions 85 3.3 Chapter viii Present and future value of money Capital structure and the cost of capital 4.1 Debt advantage 92 4.2 Debt disadvantage 93 4.3 Financial gearing 95 4.4 Debt as part of the capital structure 97 4.5 Compensating providers of capital 97 4.6 Traditional capital structure theory 98 4.7 The Miller and Modigliani theory 101 4.8 The arbitrage process 102 Contents Page 4.9 Optimal capital structure – traditional world 4.10 The cost of capital 4.10.1 Ordinary equity 4.10.2 Retained earnings 4.10.3 Preference shares 4.10.4 Debt 106 107 108 109 109 110 4.11 The Weighted Average Cost of Capital 110 4.12 Calculating the growth rate 4.13 Cost of capital for foreign investments 4.13.1 Discount rate for a foreign investment 113 115 115 Practice questions 116 Chapter 5.1 5.2 Portfolio management and the Capital Asset Pricing Model Background to portfolio theory The concept of risk and return 5.2.1 Investors’ attitudes to risk 5.2.2 Probabilities and expected values 5.2.3 Single-asset risk measures 5.2.4 Comparing the risk of two stand-alone assets/projects Portfolio risk and return 5.3.1 Two-asset portfolio risk and return 5.3.2 The efficient frontier Diversification 5.4.1 Systematic versus unsystematic risk 143 144 145 145 146 149 150 150 153 154 154 5.5 The securities market line (SML) 155 5.6 5.7 The capital asset pricing model (CAP ) CAPM applications 5.7.1 CAPM and weighted average cost of capital (WACC) 5.7.2 CAPM and the investment appraisal decision 5.7.3 Limitations in using CAPM in investment appraisal decisions 155 159 160 161 164 Practice questions 164 5.3 5.4 Chapter The investment decision 6.1 Capital budgeting 182 6.2 6.3 Correct WACC to be us d Traditional m thods of inv stment appraisal 6.3.1 Payba k period method 6.3.2 Dis ounted payback period 6.3.3 Net p esent value method (NPV) 6.3.4 Net p esent value index method (NPVI) 6.3.5 Different project life cycles 6.3.6 Internal rate of return (IRR) 6.3.7 Comparative example of NPV and IRR 6.3.8 Modified internal rate of return (MIRR) The investment decision 6.4.1 Inflation 6.4.2 Relevant costs and revenues 6.4.3 Opportunity costs and revenues 6.4.4 Discount rate (cost of capital) 6.4.5 Changes in working capital requirements 6.4.6 The financing of the project 6.4.7 Tax losses 6.4.8 Recoupment/scrapping allowances 182 184 184 185 186 189 190 192 193 194 196 196 198 200 200 201 201 201 201 6.4 ix Table of statutes Page Close Corporation Act 69 of 1984 504 Companies Act 61 of 1973 504, 537, 538 Companies Act 71 of 2008 250, 281, 393, 419, 421, 422, 504, 537, 538, 540, 541, 551, 573 Competition Act 89 of 1998 31, 504 Consumer Protection Act 68 of 2008 31 Corporate Laws Amendment Act 26 of 2006 504 Income Tax Act 58 of 1962 260, 261, 263, 267, 268, 269, 275, 387, 388, 389, 390, 391, 393, 394, 395, 397, 398, 399, 401, 403, 486, 559, 573 National Credit Act 34 of 2005 249, 256, 343, 344, 345, 392 National Environmental Management Act 107 of 1998 31 Occupational Health and Safety Act 85 of 1993 31 Securities Services Act 36 of 2004 504 Skills Development Act 97 of 1998 31 Usury Act 73 of 1968 345 695 Index Page A absorptions and amalgamations 551 acceptance 45 acid-test (quick) ratio 286 acquisition 38 advantages of debt 255 aggressive financing 336 alliances 38 Alternative Exchange (AltX) 17 annuity due 66, 74 annuity 66, 73 Ansoff’s Growth Vector Matrix 37 apply or explain 7, arbitrage process 102 A-score model 312 asset beta 158 asset stripping 503 asset turnover 287 asset use efficiency 313 attitudes to risk 145 avoidance 45 B backward integration 501 balanced score ard 315 bank loans 254 banker acceptance 271 Baumol model 340 B-BBEE 30 BCG Matrix 34 behavi ural implications 504 beta c efficient 156 beta 163 bill of exchange 272 bird-in-hand 574 B ack Economic Empowerment (BEE) lock-in discount 424 bond 397 bonus issues/share splits 569 book value method 15 brands 463 business model canvas business model 4, 417 697 Index Managerial Finance Page business rescue plan 541 business rescue practitioner 540 business rescue 538 business risk 9, 93 business trust 419 business valuation principles 412 business vehicle 418 business 311 C capital asset pricing model 155 capital budgeting 182 capital contribution 544 capital gearing ratio 286 capital growth 11 capital lost 546 capital market 17, 251 capital rationing 187, 190 capital requirements 543 capital structure and solvency ratios 286 capital structure 14, 91 capitalisation issues 578 CAPM and the investment appraisal decision 161 CAPM and weighted average cost of capital 160 carrying value 413 cash offers 511 cash operating cycle 337 change in revenue 291 cheap finance 270 chief financial officer clean fair value 661 clientèle effect 574 close corporation 419 Code for Responsible Investing in South Africa (CRISA) 18 coefficient of variation 150 collection policy 346 Committee of Sponsoring Organisations of the Treadway Commission (COSO) 46 common size statements 282 company 419 comparative financial stat m nts 282 comparator entity 428 competitive environment 31 competitive st ategies 37 compound inte est fo mula 63 concentrated marketing 31 conditions for a reorganisation scheme 543 conglomerate acquisition 502 consci us capitalism conservative financing 336 ervative hedge 335 tant dividend/earnings method 568 constant growth 78 contingent liabilities 463 control premium 411, 423 convertible debentures 83 convertible debt 400 convertible securities 255, 412 convertible 387 698 Index Page correlation coefficient 151 cost leadership 37 cost of capital for foreign investments 115 cost of capital 107 coupons 397 covariance 151 credit policies 343 critical success factors (CSFs) 38 crowdfunding 272, 274 cumulative non-redeemable 389 cumulative 387 current multiple 429 current ratio 286 customer perspective 40 D David Kaplan 315 David Norton and Robert Kaplan’s Balanced Scorecard (BSC) 40 debt (solvency) ratio 95 debt advantage 92 debt covenants 393 debt disadvantage 93 debt to equity (D:E) ratio 95 debt 254, 392 debtor factoring 348 debtor finance 271 debtors’ management 343 decision trees 217 deductive methods 446 degree of operating leverage 285, 293 designated advisor 18 different project life cycles 190 differential inflation 196 differentiated marketing 31 differentiation 37 direct and indirect quotes of exchange rates 218 dirty fair value 661 disadvantages of debt 255 discount rate for a for ign inv stment 115 discount rate 13, 200 discounted cashflow 384 discounted payba k period method 185 diversification 154 dividend decisions 573 dividend payo t ratio 287 dividend policy 570 dividend stability and information content 577 dividend tax (DT) 573 dividend yield 11 divi ible projects 188 down ide ri k 11 drivers of value 384, 386, 392 DuPont analysis 313 E earnings multiples 428 earnings per share 285 earnings yield percentage (EY%) 432 699 Index Managerial Finance Page earnings-yield 288 economic efficiency effectiveness (3 Es) economic environment 30 economic order quantity 350 economies of scale 502 Edward Altman 311 efficient frontier 153 enterprise risk management (ERM) 27, 46 entry into new markets 502 environmental, social and governance (ESG) 18 Equator Principles on Financial Institutions (EPFIs) 18 Equator Principles 217 equity beta 158 equity funds 251 equity 274 equivalent annual income 191 ESG 217 eurobonds 272 EVA® (Economic Value Added) 288, 308, 458 evaluating the projects at the Weighted Marginal Cost of Capital (WMCC) 183 expected return 143, 155 expected values 145, 216 explicit forecast 450 ex-post 149 F failure prediction models 311 fair market value of a shareholding 440 fair market value 410 Fama-French Three-Factor Model 446 finance decision 14 finance lease 266 financial analysis 282, 283 financial decisions 543 financial distress 538 financial gearing 92, 95 financial leverage 313 financial measures 39 financial perspective 40 financial reasons 502 financial reporting prin iples 412 financial risk 10, 93 financial strategy 12 financing a missed dividend 570 fire sale 412 firm-specific risk 154 Five Forces Framework 38 fixed r variable dividend 387 fixed-rate b nd 398 focus trategy 37 foreign direct investment 218 foreign finance 270 forward integration 501 forw rd multiple 429 free c shflow 448 future value of an annuity 66 future value 62 700 Index Page G G4 guidelines gap analysis 35 geared or levered beta 158 gearing 10 gearing ratio 95 general inflation 196 Global Reporting Initiative goals 28 going concern 417 Gordon dividend growth model 388, 445, 451 growth rate 113 growth strategies 38 H headline earning 433 headline earnings per share 295 hedging 334 hidden factors 422 historical cost 409 historical or trailing multiple 429 horizontal acquisition 501 hybrid capital 250, 273 hybrid instruments 397 I income approach 415 independent events 187 independent projects 187 indexed financial statements 282 indivisible projects 188, 190 inflation 196 inherent risks 44, 45 initial public offering (IPO) 274 Institute of Directors in South Africa (Io SA) 18 integrated reporting integrated thinking Interest and interest-rate risk 393 interest cover 286 internal process perspe tive 40 internal rate of return (IRR) 259, 264 internal rate of etu n method 192 international capital budgeting 218, 219 International Integrated Reporting Committee International Integrated Reporting Council interpolation 192 intrinsic value 411 invent ry management 348 inventory turnover 286 inve tment decision 12, 196 investment opportunities 503 IPO 18 irredeemable debt 81 J Johannesburg interbank agreed rate (JIBAR) 387 Johannesburg Securities Exchange 17 701 Index Managerial Finance Page John Argenti 312 JSE SRI Index 19 just in time 353 K keep versus replacement 205 King Code of Governance Principles (King III) 6, 42 KPIs 8, 29, 38 L Laszlo’s Sustainable Value Matrix 36 leadership 502 learning and growth perspective 40 lease or buy decision 266, 267 level of control 421 levels of working capital 333 license to operate limitations in using CAPM 164 liquidation value 412, 543 liquidity preference 337 liquidity 286 loan capital 255 M macro risks 44 maintainable earnings 431, 437 management buy-outs 513 marginal analysis 207 marginal WACC 182 market capitalisation 411 market comparable approach 415 market price multiples 444 market pricing 38 market risk 154 market segmentation 31 market value method 15 market value 410 marketability discount 423 marketing gains 502 Markowitz 143 maturity-matching 334 McKinsey conve gence value-driver formula 452 mean 149 merger 500 mezzanine capital 273 mezzanine finance 250, 514 Michael P rter 37 micro risks 44 Miller and Modigliani theory 97, 101 Mi er and Modigliani 570 Mi er-Orr model 342 minority discount 423 mission 28 mitig tion 45 modified internal rate of return method 194 money cashflow 196 money market 251 702 Index Page money rate of return 196 Monte Carlo analysis 215 multi-period capital rationing 187 mutually exclusive events 187 mutually exclusive projects 187 MVA 458 MVIC (market value of invested capital) 425 MVIC/EBITDA multiple 441 MVIC/Sales (MVIC/S) multiple 445 N National Credit Act (NCA) 256 natural environment 32 net assets 462 net present cost (NPC) 259 net present value index method 188 net present value method 186 net present value 13 net working capital 334 no growth 77 nominal rates of return 198 non-constant growth 80 non-cumulative redeemable 391 non-cumulative 387 non-financial analysis 314 non-financial measures 39 non-redeemable (perpetual) 388 non-redeemable 387 normal distribution curve 147 O off-balance sheet financing 266 open market principle 506 operating lease 213, 266 operational efficiency 313 opportunity costs and revenues 200 optimal capital structure 106 ordinary annuity 73 organic growth 38, 499 Osterwalder and Pigneur owner level premiums and discounts 472 P P/E multiple 288, 432 partnership 419 parts 256 payback peri d method 184 perfect hedge 335 perpetuity 76 PESTLEGE 29 p ant and equipment 463 p oughback 113 political environment 29 portfolio risk and return 150 portfolio theory 143 portfolio variance 151, 152 predatory pricing 38 703 Index Managerial Finance Page preference shares 82, 254, 386 preferential Ccpital funds 540 present value of a perpetuity 76 present value of an annuity 73 present value of debt 81 present value of shares 77 present value 68 price of recent investment 426 price skimming 38 price/book (P/B) multiple 445 pricing strategies 38 primary market 17 principles for responsible investment (UNPRI) 18 probabilities 145 probability theory 216 probability 215 product life cycle analysis 34 product-market strategies 37 profitability 285 property 463 public listing 17 publicly trading securities 422 purchasing power parity 218 Q qualitative (non-financial) factors 217 R RAFT random numbers 215 ratios 284 real rates of return 198 reasonability test 415, 467 recoupment/scrapping allowances 201 redeemable debt 82 redeemable 389 regular 66 regulatory environm nt 30 relevant costs and r v nu s 198 replacement chains 190 replacement cost approa h 415 required rate of etu n 155 required retu n 11 residual risk 42, 45 resource a dit 35 responsible investment 18 retenti n ratio 113 return n capital employed 287 return n equity 287, 313 return on invested capital 287 return 144 rights issues 252 risk ppetite 41 risk ssessment 42 risk averse 41 risk capacity 41 risk committee 42 risk control 45 704 Index Page risk culture 41 risk evaluation 45 risk financing 45 risk identification 42, 44 risk management policy 42 risk management strategy 42 risk management 41 risk mapping 45 risk mitigation 42 risk monitoring 46 risk neutral 41 risk premium 159 risk responses 42, 45 risk seeking 41 risk 144 risk 213 risk-averse 145 risk-free rate of return 155 risk-pro 145 risk-return methods 246 Robert Norton 315 role-players in business rescue 539 S scrip dividends 578 secondary markets 17 secondary tax on companies (STC) 570 section 24J of the Income Tax Act 260, 393 secured finance 250 securities market line 155 security offered 393 security 398 selective or discriminatory pricing 38 sensitivity analysis 215 share offers 512 share options 412 share price 503 share repurchases 578 shareholder wealth maximisation simulation 215 simultaneous liquidation of rossholding companies 555 single-period capital rationing 187 six capitals skipped dividend 577 smart arg ment 509 SMART 28 social environment 30 sole pr priet rship 420 sources and f rms of new finance 271 ources of finance 251 South African Pension Funds Act 19 special dividend 577 stab e dividend payment method 568 st keholder engagement s keholder theory s andard deviation 148 statutory requirements 570 Stern Stewart & Co 308 705 Index Managerial Finance Page stewardship model stock market listing 251 strategic analysis 28 strategic benefits 502 strategic planning 28 strategy 28 sustainability reporting sustainable Swiss Verein 420 SWOT 29, 35 synchronised inflation 196 synergy benefits 507 synergy 410, 502 systematic 154 T tailor-made finance 250 takeover 499 target WACC method 16 target WACC 182, 184 tax allowances 201 taxation time lags 201 technological environment 30 technology 503 theory 98 time value of money 61 total debt ratio 286 traditional theory 97 traditional 98 treasury shares 412, 578 two-in-the-bush theory 574 types of liquidations 551 U UN Millennium Development Goals uncertainty and risk 213 uncertainty 213 undifferentiated mark ting 31 ungeared or unlev r d b ta 158 United Nations Conference on Sustainable Development (Rio+20) unsecured finan e 250 unsystematic isk 154 upside risk 11 users of financial information 280 V valuati n appr aches 415 valuati n meth dologies 416 valuation outlines 464 va uation premiums and discounts 423 va uation report 425 va uation 20 v lue analysis v lue chain analysis 33 value creation model value 408 variance 148 706 Index Page vertical acquisition 501 vision 28 voluntary 551 W WACC 15, 182, 418 weighted average cost of capital 12, 110 weighted average risk 157 Working capital changes 201 X Y yield to maturity method 260, 394 yields to maturity 258 Z Z-score model 311 707 ... 18 2 18 4 18 4 18 5 18 6 18 9 19 0 19 2 19 3 19 4 19 6 19 6 19 8 200 200 2 01 2 01 2 01 2 01 6.4 ix Contents Managerial Finance Taxation time lags Tax allowances Page 2 01 2 01 6.5... 12 .4.3 Management buy-outs Page 511 511 511 513 Practice questions 515 12 .4 Chapter 13 13 .1 Financial distress Companies Act 71 of 2008 537 13 .1. 1... interest at a discount rate of 14 % = = 10 0 000 10 0 000 + (1 + 0 ,14 ) 87 719 + (1 + 0 ,14 ) + 76 947 + 10 0 000 (1 + 0 ,14 ) 67 497 + + 10 0 000 (1 + 0 ,14 ) 59 208 + + 000 000 (1 + 0 ,14 ) 592 080 R883 450 Market