FINANCE

Tumelo L Matjekane

2009
 Scope and tools
of finance

Financial Interest rates, interest rate

markets and futures and yields
participants Simple
financial
· The bridge market
· Market interest rates Forward
· Market prices interest rates
Shifting
resources (1 + i2)2 = (1 + 0f1)(1 + 1f2)
Interest rate risk
Interest rate and duration
futures
· Calculation of duration
· Expectations
Accruing (1) [(80/1.05) / 1029] +
Discounting · Extrapolation
X PV (2) [(80/1.07) / 1029]...
(1+ i) · Hedging
(1 + i)
· immunsation
Bonds

· Face value ≠ coupon

rate
· Term structure
Internal rate of Net present
· YTM = r1 + (N1/
return value (N1+N2))(r2-r1)
IRR = NPV = 0 · Coupon effect on the
CFt
YTM
CFt NVP = -CF0 +
= -CF0 + (1 + i)t
(1 + IRR)

Convertible
Bond duration
bonds

· Lower coupon than a straight

bond · A measure of the riskiness
More realistic · Convertible into shares · Measures the interest rate
financial market · Cost effective way of raising sensitivity of the bond
finance when shares are at a · Indicates the change in value
low current valuation of a bond for a 1% change in
· Cons: dilution interest rates
· Advantage: solves agency · The greater the duration, the
problems between further into the future the
shareholders and average value is generated
bondholders · A zero coupon is riskiest
· Covenants: positive (financial bond
ratios) or negative · The lower the coupon
(restrictions on dividend) payment with the same
maturity and price, the riskier

Multiple period
finance

CFt YTM and the

PV = coupon effect
(1 + i)t
Multiple period Compound Continuous · The average return on the
analysis interest compoundng bond if purchased at the
price in the market doesn’t
PV = [1 + (i/m)]mt determine the bond price,
PV = CF0(eit) the spot rate does that
Where e = 2.718 · The timing of the cashflows
affect the YTM of the bond
Annuities Perpetuities · A difference in yields
tables between bonds subjected to
the same discount rates
· Cash flows all the · PV = CF/I
same · Continue forever
· PV = CF/(1+i) Ø PV = CF (i-g)
· Annuity table

©Tumelo L Matjekane | 2009 Page 2 of 12

 Fundamentals of
company investment
decisions

Investment Investment Investment decisions in Share values and

decisions and decisions in all borrowing corporations PE rates
shareholder wealth equity corporations

Corporate Share price

equity
Investment and
· Residential claim shareholder wealth Price per share =
· Limited liability
Dividend per share
g = re – (dividend per
(re – g) share / price per share)

Market value of
common shares

PE ratio

Price per share 1

= x Pay-out ratio
Div1 + E1 Div1 Div1 + E2 (re – g)
Earnings per share
E0 = E0 = +
1 + re 1 + re (1 + re)2
· 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

©Tumelo L Matjekane | 2009 Page 3 of 12

 Earnings, Profit and
Cash Flow

Corporate cash flow Cash flow and

profits

Income
Revenue
Expenses
Components Free cash operations
of cash flow flows depreciation – (salvage value?)
interest
Total expenses
Profit before tax
Tax
Profit after tax

Free Cash Flow

Government
Customers

Assets (Free Cash Flow) -(Interest tax shields)

Operations

FCF*

Differences
between accounting Book values vs Interest amount x Tax rate
figures and market value
cashflow
· The treatment of non-cash items · Market values used for
such as depreciation WACC
· Cashflows that arise as a result of · Reflect the earning
projects undertaken ability
· CAPEX recognised immediately in Estimating Cash
· Book values are
cashflow historic Flows for
· Treatment of sales/cash receipts · They are used by debt Investment
· Opportunity cost suppliers Projects
· The inclusion of interest rates

Treatment of cannibalisation,
depreciation and interest Associated costs
charges
· Cannibalisation
· Cannibalisation has to be taken into · Competition from
account competitor offerings
· Depreciation is not a cash flow, but a
tax shield – greater time value
benefit
· Interest charges ignored because
built into the WACC
· Opportunity costs have to be included

©Tumelo L Matjekane | 2009 Page 4 of 12

 Company investment
decisions using WACC

FCF and Profits for

borrowing Investment NPV
corporations and the WACC

The debt cost is the The adjusted PV

after tax debt cost technique

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

= rd x (1 – Tc)

D E
WACC (rvx*) = (rd*) + (re)
V V

Investment value
for borrowing
corporations
The WACC – NPV method

n Unleveraged free cash flow t

NVP0 = ∑
t=0 (1 + WACC)t
Overall company rate
Ø An average n FCF*t
= ∑ t
t=0 (1 + rvx*)

The overall NPV Estimate the interest tax

method shields (ITS) of the project

Find the overall All equity rate found from

company rate capital market experts (ru)

=
Debt market value Debt required
x
Total market value rate

Equity market value Equity required

+ x
Total market value rate APV = (all equity value) + (ITS value) – present cost

D E Therefore:
= (rd) x (re)
V V
n
FCF*t
APV0 = ∑
t=0
[ (1 + ru) t +
ITSt
(1 + rd)t
]
n Free cash flow
Value of project = ∑
t
t=0 (1 + overall required rate)

n FCFt
= ∑ t
t=0 (1 + rv)

©Tumelo L Matjekane | 2009 Page 5 of 12

 Applications of company
investment analysis

The payback Profitability index

period n
∑ FCF*t
· What about cashflows after payback t=1 (1 + rv*)t
period? PI =
· If discounting – time value of money -FCF0*
and riskiness of project
· Can only be used if the t0
· Payback concentrates on liquidity
cash flow is an outlay
1 · Used in capital rationing
1 -
Payback = situations
rv* rv*(1+rv*)n
· Unsuitable for ranking
investments

Average Capital rationing

accounting return
on investment Internal rate · Soft/internal rationing: dept.
of return budgets and decisions
· (Expected accounting · hard/external rationing:
profit) / (net book value of financial markets not willing
investment’s assets) to fund
· Trial and error method
· Uses accounting numbers, · Use the PI
· Doesn’t reflect scale of
not same as cashflow · Use NPV
the project
· No discounting, therefore · Based on outlay due to
· More than one change of
no reflection of time value cash constraints
sign – different answers
of money
· No changing interest rate
· No riskiness too
over time
· Assumes reinvestment of
cash flows at the IRR
Cost – benefit which isn't always true
ratio · Advantage: can produce
crossover rates EVA analysis
· As long as the IRR >
· The rates between the PV of the
Hurdle rate (discount
cash inflows and the cash outflows · Capital charge against
used for NPV), the NPV
of an investment the net cash flows left
will be positive
· Investment accepted over = the economic
n inflowst value added
when IRR > Hurdle rate
∑ · Example on pg 39.
t=0 (1 + rv*)t
CBR = n outflowst Incremental cash
∑
(1 + rv*) t flow analysis
t=0
· Acceptable only if
Leasing
· Choosing among
ratio > 1
Investment inter- investments on the
basis of their IRR
relatedness
· The cross-over rate:
the IRR of the
· Purely contingent incremental cash flow
· Somewhat positive
· Independent
· Somewhat negative
· Mutually exclusive

Inflation Economies of leasing NPVs?

· The inflation rate free return
· 1+nominal return = (1+real
return)(1+inflation rate)
· A contract for payment is a debt obligation analogous
to a loan · NPV of leasing vs
borrowing/purchase
· Advantage: allows for higher tax benefits than
cash flow
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 leasing – specialisation creates
expertise and efficiency

©Tumelo L Matjekane | 2009 Page 6 of 12

 Risk and company
investment decisions

Risk and
individuals Using the CAPM in Other considerations
evaluating company
· The SML investment
· The certainty equivalents
· The higher the risk, the decisions
higher the return
· CFce = CF-[(E(rm) – rf)/
· The value of diversification (variance rm)][covariance
Estimate the WACC of the CF,rm]
· The Correlation coefficient
company investments · Risk resolution across time
(ranges from -1 to +1)
· Covariance = SD x SD + · No constant risk across time
Correlation coefficient
· Joint probabilities distribution

Estimate the rv* for the

investments vs for the company

The market model

and individual asset
risk

· Undiversifiable or
systematic risk
· The market factor:
overall economic
activity

Estimating the
risk of a project

· If the project is simply an extension of

scale, the normal β is used
Systematic riskj The market model · If the new project is in a different area, a
listed company could be used as proxy
Systemic risk = SD of for the risk
return x correlation of E(rj) = rf + [E(rm) – rf]βj · The beta of the company must be
j with market Used to estimate the rd and ungeared
the rv* · For an unlisted company, use β from
similar listed and adjust accordingly
· Steps:
1. find Bu =Be(E/V) + Bd(D/V)
2. adjust for revenue volatility
· E(rj) – Expected return 3. adjust for operational gearing
· Rf – Risk free return 4. readjust the reconstructed and ungeared
· [E(rm) – rf] – Compensation β for any financial gearing planned for
for risk bearing project
· βj – Risk beta coefficient 5. find rd and re
6. find rd* using rd(1-Tc), then find rv*
The Beta

· You get higher returns for

· The ratio of the asset’s SD of
taking on greater risk
return x correlation with
· Specific/systematic risk and
market, divided by SD of
diversifilable risk Various adjustments
market returns
· β is the measure of a can be made to the bet
· βj = (systematic riskj) / δm
share’s market risk to reflect the financing
= (δjm)/(δ2m) … known as
· The rj is the return on the structure of a project
the regression coefficient
share
· The rm is the return on the
market

Operational gearing Revenue Risk

βu x [(project revenue
βu = revenue adjusted βu x [(1+project volatility) / (company
fixed cost %) / (1+company fixed cost %)] revenue volatility)]

©Tumelo L Matjekane | 2009 Page 7 of 12

 Company dividend policy

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

shareholders as the servicing of that type of capital

Dividend Dividend clienteles:

irrelevancy I irrelevancy II

Clienteles

Frictions Company
dividend policy
· Different preferences to
· Taxation · Passive residual dividend payouts
· Transaction costs dividend policy · Attracted to shares of a
· Brokerage fees or optimal company that pursues a
· Floatation costs dividend policy policy relevant to them

Imputation tax –
credits to avoid
double taxation Widows and
Fat cats orphans

High tax bracket, · Low tax bracket

therefore prefer · Prefer to
low payouts consume now
· High payout

Other considerations
in dividend policy

Company
dividend payout
strategy

· The company has to

decide which type of
shareholders it wants
to attract through its
dividend policy
Dividends and
Dividends and signalling
share repurchase

· Communication with the · Repurchase = cash dividend

markets and shareholders or even a liquidation exercise
through dividend cuts and – a positive signal
increased pay-outs · Targeted share repurchase?
· Share dividends and share – a negative signal Passive residual
splits are used as signals 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 cash
necessary to undertake all good investments

©Tumelo L Matjekane | 2009 Page 8 of 12

 Company capital structure

Capital structure, risk

and capital cost
Capital structure and
agency problems

The SML Capital structure · Shareholders vs Bondholders

· The debt claim
require lower rate
· Equity require
highest
Financial risk
and risk · Defaults?
· Monitoring costs
· EBIT Capital structure · Solution:
· The more borrowing the Ø Call provisions
decisions and taxes
company does, the EBIT- Ø Convertibility
EPS line gets steeper Ø Maintenance of certain ratios
· Taking on more debt causes included in contracts
equity risk to increase – · Bankruptcy costs:
increase equity required rate Ø A change in ownership from
shareholders to bondholders
Ø Litigation costs
Ø Time
Ø Other implicit costs e.g.
opportunity costs
Business risk

· Results of debt in the · Business cycle

company
· Tax benefits – ITS vs
depreciation
· Ability to service debt
in all scenarios?
· Volatile returns/highly
competitive sector?
– capital structure
· Cash flow generation
from operations?
· Level of fixed costs
· Volatility of sector
Capital structure Capital structure
· Strength of brand
relevance with taxes irrelevancy II: Taxes
· Competition
· Input costs
· Pricing power · ITS – tax advantage As more borrowing is undertaken by
· diversification · A company with debt in it’s companies in economies with
structure will be more progressive tax regimes, the interest
valuable than one that rates necessary to sell bonds to high
doesn’t borrow personal tax investors will cause the
· Interest deductability makes benefits of company borrowing to
the company’s cost of capital disappear
lower, the more debt it uses
· VITS = ITS/rd
· V = VU (Unleveraged) + VITS

Capital structure
irrelevance I: M&M

· M&M: if shareholder wealth is

the same regardless of
capital structure, then capital
structure is irrelevant Making the
· D+E = V
· In a frictionless capital
company borrowing
market, how much or how decisions
little debt a company has in
its capital structure is
· The lender is interested in
irrelevant
the debt claim to the total
company value
· Market value of assets
difficult to get, book values Factors in the Why not 100% debt?
easier borrowing decision
· Simulation models used for
planning · Taxation on shareholders
· Examine companies of · Ability to generate enough and bondholders
similar lines of business cash flow · Other forms of tax shields
· Ability to utilise tax shield e.g. depreciation and lease
· Collateral · Imputation system for
· Ability to access financial dividends
markets · The risk of financial distress
· Debentures · Costs of financial distress and its costs
· Convertible debt securities
that carry the tax benefits of
borrowing

©Tumelo L Matjekane | 2009 Page 9 of 12

 Working capital
management

Risk, return
and term Management of
short-term assets
· Short term assets are and financing
less risky
· Long term assets are
more specific to the
line of business and
therefore more risky Optimisation and Management of short-
short-term investments term financing

· Trade credit
Risk and rates of · 2/10 net 30?
return on · Effective interest rate when
a discount is given = (i) =
financing by term [1 + [0.02/(1-0.02)]]365/20 - 1
Management of
· Short term finance more risky receivables
· Short term finance less costly
than long term · Credit sales
· Long term financing are low · Collection period Management of
risk and return · Debts (bad) – default cash balances
· Expected profit = (no. of good
customers x profit/customer) · Transaction uses
+ (no. of bad customers x · Precautionary and
loss/customer) anticipatory reserves
· Compensating balances

Optimising of cash
Combining risk and replenishment amounts
rates of return on
assets and financing · £r = [(2 x £D x £T)/i]½
· “economic order quantity”
Financial and ratio · £R = [(3 x £T x S2)/4i]1/3 + £M
Assets: analysis · £U = £M + 3(£R - £M)
· 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

Efficiency ratios
with short term liabilities – maturity
matching

Inventory Average Fixed asset

turnover collection turnover
period
Cost of sales Sales

Inventory Trade receivables Fixed assets

Profitability ratios Revenues per day

Capital structure
Return on ratios
Liquidity ratios Profit margin specific
assets
Profit before tax

Revenues Profit before tax

Times
Specific asset
Fixed to Debt interest
Current ratio Quick ratio ROTA ROE
current ratio ratio earned
Current assets CA - inventory Profit before tax Profit attributable Total debt
Fixed assets Profit before financial
to shareholders
Current liabilities CL Total assets Total assets results
Current assets
Owners quity
Interest charges

©Tumelo L Matjekane | 2009 Page 10 of 12

 International financial
management

The foreign International financial

exchange market management

· The law of one price:

the same thing can’t
sell for different prices
at the same time.
· Purchasing power parity
(PPP).

Hedging international
cash flows
Financial sources for
· Transaction costs of foreign investments
hedging
· Foreign exchange option · International capital markets
· Long term funds = Eurobonds
Spot and forward
· Short term borrowings =
exchange rates Eurocurrency
· Lower borrowing rate in
Euromarkets vs National
capital markets

Exchange rates
and interest rates

· Interest rate parity

· Relative interest
Spot rate Forward rate
rate = relative FX Financial solutions to
discount/premium other international
Present Future investments risks

· “moral hazards” : non-

compliance, confiscation,
· Forward exchange restriction on repatriation.
contract · Solution: automatic and
· Hedging transactions irreversible counter-
Investing in foreign incentives, participation of
real assets the World Bank in loans.

· Avoid forward foreign

exchange estimation

Forward exchange,
interest rates and inflation

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

©Tumelo L Matjekane | 2009 Page 11 of 12

 Options, agency, derivatives
and financial engineering

Options Derivatives

· Return/outcome derived
from some other asset’s
value or return outcome
· Hedging of risk
· They therefore serve to
Call option reduce not increase risk
Put option Real option
· Allows holder to
purchase another
· Allows holder to sell · Option to alter,
security (e.g. abandon or extend
something (e.g.
shares) at a fixed
shares) at a fixed · Option based on
price for a fixed timing
price for a fixed
period of time
period of time Exotics
Swaps

· A combination of
· One party exchanges derivatives
Options valuation one stream of cash financially
flow for another engineered to
· Derivatives designed to meet the very
hedge interest rate and specific risk
foreign exchange risk objectives of a
single firm

Binomial Black-Scholes-
Merton
· Y = (Cu-Cd)/(So(u-d))
· Z = (uCd-dCu)/((u-d)(1+rf)
· Co =SoN(d1) – Xe-rfTN(d2)
· Where u = eδ√∆T
· Where d1 = [ln(So/X) +
· And d = 1/u
rfT]/[δ(T)½ + 0.5δ(T½)]
· Market value = YSo + Z = Co
· And d2 = d1 - δ(T½)
· Then determine the premium
or discount

Financial
engineering

Agency · Designing hybrid/exotic

· Agency costs
· Shareholders vs
Bondholders vs Managers.
· Solution: an efficient market
for takeovers, call
provisions.
financial securities to fit very
specific risk shaping intentions
of a firm or other institutions.
· Building blocks: credit
extension, price fixing, price
insurance.

©Tumelo L Matjekane | 2009 Page 12 of 12