COBMB1-B33

Unit 6: Financial Markets and Financing Decisions

by Joshua van Houten

 Learning Outcomes:

1. Explain financial markets.

2. Explain the types of short-term financing decisions.

3. Explain the forms and sources of long-term financing decisions.

4. Understand the optimum capital structure.

 Financial Markets
Financial Markets:

Is the marketplace where buyers and sellers exchange assets such as equities, bonds, derivatives and currencies. An

economy contains individuals and institutions that have surplus funds and those with a shortage of funds.

• Those with excess funds (investors) seek to invest, while those

with a shortage (borrowers) seek to borrow.
• Financial markets exist to satisfy those with surplus funds and
those with a shortage of funds.
• Financial markets are therefore the channels through which
holders of surplus capital can lend to those who require
finance.
• Financial institutions act as intermediaries in the transactions of
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 Financial Markets

The process within financial markets:

1. Financial markets use investment instruments or securities to achieve returns on investment. When investors
invest (or save) their money in the bank (intermediary/financial institution), the bank pays them interest on their
money. The bank then uses the money to lend it to borrowers.

2. The borrower must pay an interest rate to the bank for using the money. The rate that the bank pays to the
investors is less than the rate that they charge to the borrowers.

3. The bank makes a profit on the transactions, the investors receive a return (interest rate) on their investment from
the bank. The borrowers carry the cost because they pay a higher interest rate for borrowing the money from the
bank, but their need to obtain money, is satisfied.

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 Financial Markets
The main types of financial institutions are:

South African Reserve Bank (SARB)

The SARB is the banker of the nation and the government. It lays down policy for commercial banks, protects the
currency and maintain price stability in the interest of balanced and sustainable economic growth in South Africa.

Land and Agricultural Bank

This is a specialist agricultural bank guided by a government mandate to provide financial services to the commercial
farming sector and to agri-business.

Private sector banks

Private banks are banks owned by individuals, partners or shareholders that offer specialised financial services to
their clients to protect, grow and use their money. Examples of private banks include ABSA, Standard Bank, First
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 Financial Markets
The main types of financial institutions are:

The Corporation for Public Deposits (CPD)

The CPD accepts surplus funds from departments, institutions, and organisations in the public sector, pays interest,

and repays deposits on demand.

Post Bank

The post bank is generally known as the post office in South Africa. They are a government owned bank that takes

deposits from clients for saving purposes, but they do not grant credit. They also pay out money to people who

qualify for government social grants, on behalf of the Government.

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 Financial Markets
The main non-deposit-taking institutions are:
• Public Investment Commissioners
• Life Assurers, pensions, and provident funds
• Short-term insurers
• Unit trusts

IDC (Industrial Development Corporation)

They are a national development finance institution set up to promote economic growth and industrial development. They
are owned by the South African government under the supervision of the Economic Development Department
NTSIKA (Enterprise Promotion Agency)
This organisation offers non-financial support services to small, medium, and micro enterprises.
DBSA (Development Bank of South Africa)
This bank plays an important role in delivering developmental infrastructure in South Africa and the rest of the Africa. 5
 Financial Markets
Each type of institution is licenced for its specific purpose. Figure 2 provides an overview of financial markets:

Financial markets can be divided into two major markets:

1. Money markets - provide for shorter term financial needs

and offer specific financial instruments to fulfil that
purpose.
2. Other markets - focus to provide financial options for
long-term financial needs and use different financial
instruments such as equity, shareholding or debt financing
options which will be explained later in this chapter.

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 Financing Organisation Needs
All organisations need financing to grow their business. It is important to understand the options available to organisations
to meet both their short-term and long-term financing needs and how managers can decide which option would be best for
their organisation

Financing short-term organisation needs:

Short-term financing is lending or borrowing money for less than one year. Financing for the short-term, such as
financing the working capital (current assets and current liabilities) of the organisation, can include decision-making on a
combination of long-term and short-term finances.

Short-term financing includes:

1. Trade Credit
2. Accruals
3. Bank Overdrafts
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 Short-term Financing
1. Trade credit (terms of 30 or 60 days):

• Trade credit is the credit that suppliers extend to you when they allow you to buy now and pay later.

• Cash discount is a deduction that can be made from the price of goods or services if they are paid for within a
certain specified time period. This requires a cut in the list price of items by the seller.

• Cash rebate is money returned to the purchaser if goods and services are paid for within a certain specified
time period. This does not require a cut in the list price of the items by the seller.

• The terms for trade credit are usually 30 or 60 days. To ensure prompt payment, suppliers often offer a cash
discount.

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 Short-term Financing
1. Trade credit (terms of 30 or 60 days):

The financial implication of the cash discount for the organisation is calculated by using the following formula:

• Rebates are amounts that retailers receive from suppliers as a form of promotion where they will pay back a
certain amount after the retailer has bought the product at full price but paid for it within a certain period. Retailers
often use these rebate amounts to give customers temporary discounts on certain products to stimulate sales.

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 Short-term Financing
1. Trade credit (terms of 30 or 60 days):

Answer:

As using the formula above shows, Maizeys can earn a return of 56% per annum if they pay within 10 days and
invested the money. They should take advantage of the rebate. 10
 Short-term Financing
1. Trade credit (terms of 30 or 60 days):

The main advantages of trade credit are that it is:

• Readily available to businesses that pay their suppliers regularly (and can result in a saving on the cost of
borrowing i.e. interest).

• An informal method to obtain credit compared to securing finances from traditional lenders. The business can
obtain additional credit by paying its bills within the discount period.

• More flexible and there is no need to negotiate a loan agreement or provide security or pay according to a rigid
repayment schedule.

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 Short-term Financing

2. Accruals

Are liabilities that remain unpaid. They represent liabilities for services that have been provided but have not yet
been paid for. The most common example is accrued salaries. Employees provide labour but are not paid until the
end of the month.

3. Bank overdrafts

Is an arrangement with a bank to borrow an amount up to a certain maximum. Overdraft arrangements are
generally reviewed annually, and interest is charged daily on the outstanding balance. The bank can change the
limit any time and they can ask to pay back the money sooner than expected. This is a convenient source of money
but can also be costly.

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 Short-term Financing
4. Debtor Financing

Is a term that is used for all types of products that fund a business by financing its invoices. Many businesses
need debtor financing especially those with cash flow problems.

There are two most common forms of debtor financing:

1. Invoice discounting - is short-term borrowing against your outstanding invoices. That means that the
organisation is selling existing debtors and future credit sales to a debtor financing company. The company buys
the outstanding invoices at a discount and pays the client immediately which provides a necessary cash injection
for the organisation. Credit and collections are handled by the client rather than by the finance company and the
financier company collects payment from the debtors when the invoices are due.

2. Invoice factoring - involves selling a debtor’s ledger for a fee. In factoring, the provider (third party) takes the
responsibility to manage the sales ledger, credit control and chase the customers to settle their invoices. 13
 Short-term Financing
4. Debtor Financing

There are three approaches to short-term debt financing:

1. Matching approach

This involves matching the period for which the finance is obtained with the expected life of the asset. Fixed assets
are financed by using long-term deals while current assets are financed with short-term bridging finance.

2. Aggressive approach

This refers to the overuse of short-term funds. This is when permanent current assets are partially financed with
short-term funds instead of using long-term finance.

3. Conservative approach

The use of a greater proportion of long-term funds than what is required. Temporary and permanent current assets are
funded by long-term finance. Manager use more long-term funds than is needed, which is less risky. 14
 Long-term Financing
Organisations need long-term financing to grow their business. Long-term financing refers to funding that is obtained for a
time frame that exceeds one year in duration. There are three methods of long-term Financing:
1. Equity Financing
2. Retained Earnings
3. Long-term debt Financing

1. Equity financing:

Is a process of raising capital through the sale of shares. It means the organisation issues additional shares or stock to an
investor in exchange for capital. Organisations can sell ordinary shares, or they can issue preference shareholders’
capital.

Ordinary shares:

Issuing ordinary shares is the first option to raise finance for the business. The true owners of a business are the holders
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 Long-term Financing
1. Equity financing:

The characteristics of ordinary shares are:

• Liability is limited to the amount invested by the shareholders.

• Success depends on the performance of the business.

• Ordinary shareholders are the owners of the business and have full control.

• Shares are tradable on the JSE.

• Shareholders do not earn interest for the money that they have invested in the organisation. They receive
dividends.

• Share capital is the money that shareholders have invested in the organisation and it available for an unlimited
time. It serves as a long-term source of finance.
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 Long-term Financing
1. Equity financing:

The disadvantages of issuing ordinary shares are:

• A reduction in profit reduces the amount that is paid out as dividends.

• Voting rights of shares may devolve to block owners (other than existing owners).

• Cost and risk of issuing shares may be higher than other forms of financing.

Preference shareholders’ capital:

Is the type of capital stock issued by the organisation. The word “preferred” refer to the dividends that are paid out by
the organisation. There are two types preference shareholders’ capital:

1. Ordinary preference shares - involves forfeiting a dividend if directors decide not to declare one.

2. Cumulative preference shares - retain the right to receive a dividend at the end of the year. 17
 Long-term Financing

1. Equity financing:

Characteristics of preference shares are as follows:

• A preferential claim over an ordinary share, but limited returns.

• A preferential claim over assets in cases of liquidation.

• An unlimited term of availability.

• Variable authority on voting rights.

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 Long-term Financing
2. Retained profit:

The portion of profit that the organisation decides to keep in the business and not to distribute to shareholders.
The purpose is to reinvest the money in the business. It is also referred to as internal financing and holds various
advantages for the business:

• It is more cost effective than other forms of long-term financing.

• Immediate availability.

• Flexibility of capital structure, e.g. organisation can decide.

• No control by shareholders.

• It serves as an alternative form of financing.

• No interest or redemption obligations. 19

 Long-term Financing
3. Long-term debt financing

Borrowed funds that will be repaid over a period of more than one year. Debt finance is usually cheaper than
equity.

Debt financing is cheaper than equity for the following reasons:

• The cost of raising the funds is lower.

• Equity investors demand a higher rate of return on their investments.

• Interest paid on debt is tax deductible.

• Debt is less risky than equity because interest is paid before dividends and taxes.

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 Long-term Financing
3. Long-term debt financing

In case of liquidation of an organisation, debt has preference over equity.

Debt can be obtained in two ways:

1. A loan is a contract according to which the receiver of funds agrees to make interest payments to the supplier of
funds, as well as repaying the principal sum.

2. Credit is extended when a supplier provides a business with the power to dispose of assets (for example, selling
products) and repay them over an extended period over time.

Long-term debt quite often refers to debt that matures over a period of 10 to 30 years or even longer. It can be in
the form of debt securities, debentures, term loans or leases. An example of a debt security is a bond.

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 Long-term Financing
3. Long-term debt financing
The following types of loans are Important:

1. Debentures

Are unsecured bonds which means that the loan is not secured by an asset but backed by the creditworthiness
and reputation of the issuer. This is the most common form of long-term debt for companies. It is a negotiable
certificate that it can be traded on financial markets. The borrower issues the certificate to the lenders showing the
conditions of the loan. The payment includes a fixed interest and a fixed repayment amount of the capital.

2. Bonds

Is financial instrument that was created to raise capital. It is an agreement between the lender (issuer) and the
investor (borrower). The investor purchases a bond to raise money for a project. This instrument consists of secured
loans that are issued with fixed assets. For example, a mortgage bond is issued for fixed property. 22
 Long-term Financing
Long-term debt financing

The following types of loans are Important:

3. Registered term loans

An amount that is borrowed and the borrower agree to pay an amount plus a prime interest rate monthly over a
certain period. These loans are usually issued by a registered financial service provider and are recorded by them.
These are unsecured loans and not freely negotiable.

4. Financial leasing

A financial lease is a form of credit financing. It is a contract that involves giving a lessee the rights to use the
asset even though the lessor is still the legal owner of the asset. The lessee makes regular payments and may also
own the asset at the end of the payment period. The lessor makes the asset available for use by the lessee. Aircraft
for example, are often leased. 23
 Long-term Financing
Long-term debt financing

The following types of loans are Important:

4. Financial leasing

An operating lease can also be used to finance the operations of the organisation. It is important to know that an
operating lease is different to a financial lease because it does not allow ownership and does not terminate after a
period. There are two basic forms of leasing are available:

1. Direct leasing - This involves regular payments that are determined by the value of the asset plus interest. The
lease amount is paid back by the end of the term of the lease, which is usually the lifespan of the asset.

2. Leaseback agreements - In this transaction permanent assets are involved which means that certain assets are
sold to the credit supplier and at the same time leased back to the selling firm. Businesses needing capital
generally seek to enter into such agreements 24
 Financial Decisions
Organisations need to implement sufficient risk management measures. They must focus on consumer needs and
requirements and implement the necessary financial controls to prevent the organisation from failure. There are
three specific areas of risk management that all organisations focus on:

1. Organisation Risk

2. Financial Risk

3. Investment Risk.

1. Organisation risk

The risk associated with day-to-day activities. Organisation risk can change from low to high risk depending on
external factors and internal factors in the organisation. The main organisation risk is insufficient income to cover
all the costs of the day-to-day running of the business. This risk impacts on their profit forecasting. The
organisation cannot be certain of its rate of return on assets (ROA). 25
 Financial Decisions
1. Organisation risk

The risk varies from industry to industry and is influenced by the following factors:

• Quality of management, for example are they qualified and competent?

• Situation with labour which can be stable, expensive, experienced or inexperienced etc.

• Stability of sales, for example is there a continuous demand for the products?

• Type and availability of raw material, for example incorrect raw material has an effect on efficiency and output.

• Degree of fixed costs in relation to variable cost.

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 Financial Decisions
2. Financial risk

• The risk that the organisation will not be able to pay interest on debt. The risk is created when the organisation
uses both debt and equity to finance its operations. There is no risk to use debt because the risk is covered by
the interest rate that is payable. The risk is determined by the ability of an organisation to pay the interest. This
risk is carried by both the organisation and its shareholders. The financial risk is the added risk of the use of debt
and equity. It is important for the financial manager to determine the cost of a combination of financing options
(capital) available in comparison to the expected return on equity (ROE) to ensure appropriate use of funds.

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 Financial Decisions
2. Financial risk

Cost of capital

• It refers to the costs of borrowing and using capital. The use of capital also implies that there is an opportunity of
making a specific investment which could result in a return on the investment. It is important to compare the
rate of return on the investment with the amount that could have been earned if the same money was put into
a different investment with equal risk.

• A key objective for any organisation is to minimise the cost of capital. That is why calculating the cost of
capital is crucial to capital investment and financing decisions. It serves as a measure of the profitability of
investment proposals. It can further assist in minimising risk by combining different sources of capital. The
capital structure of an organisation refers to the combination of long-term financing options such as ordinary
shares, preference shares and debt 28
 Financial Decisions
2. Financial risk

Calculating the Weighted Average Cost of Capital (WACC)

The WACC is determined by weighting each category of capital proportionately. When calculating the WACC
all these sources of financing must be included. The WACC calculation is done to arrive at an average cost to
finance a project. The organisation must evaluate whether they will continue with the financing ratios as are, or
whether they must adjust the ratios or types of the combination of financing options in their capital structure.

There is a three-step approach to be followed to calculate the WACC:

1. Calculate the after-tax cost of each form of capital

2. Calculate the proportion of each form of capital in the total structure

3. Multiply the cost and the proportion of total capital to determine the weighted average.
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 Financial Decisions
2. Financial risk
Calculating the Weighted Average Cost of Capital (WACC)

• Example:

• The information below relates to the capital structure of Somali Ltd. Use the information to calculate the
company’s Weighted Average Cost of Capital (WACC).

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 Financial Decisions
2. Financial risk
Calculating the Weighted Average Cost of Capital (WACC)

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 Financial Decisions
2. Financial risk

The optimal capital structure

• Refers to the combination of debt and equity financing to minimise the weighted average cost of capital for
the organisation..

• The capital structure of an organisation always implies financial risk, and the level of risk is reflected in the
cost of capital. This can be described as variances in profit income due to the inclusion of interest payments on
long-term debt. Organisations need to use financial leverage to try and reduce cost and risk.

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 Financial Decisions
3. Investment, demand, competitive and capability risks

• Competitive risk - refers to the risk that the organisation might lose their customers to competitors who
might be more prepared for unforeseen demands of products and services.

• Capability risk - refers to the risk that the organisation might not be able to offer a product of value to
customers at a price that they are prepared to pay. It could be that the cost of the capability is too high, and
that the organisation cannot earn the required profit by offering the product.

• Other risks - to be considered that can influence the financial performance of the organisation include investment
risk, demand risk, competitive risk and capability risk.

• Investment risk - refers to the expectation of investors to receive a specific return on the investment and the
fear of having a negative return.

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